Jason Mann, chief investment officer at EdgeHill Partners
Focus: North American equities

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MARKET OUTLOOK

Last year was all about owning “beta,” while generating “alpha” was hard. Simply owning mega-cap growth stocks without regard for valuation was the best strategy.  Passive investing dominated investor flows.

When we were here in January, we noted that when markets are stable with such good returns, people feel the market is getting less risky when in fact the complacency makes the market more risky.

We also noted that markets are born on pessimism and die on euphoria, and we believed that January markets had entered the “euphoria” stage.

Everything has changed in the last two months. Volatility has exploded and we are in a full-blown correction in most global equity markets.

We think that the popping of the bubble sectors (cannabis and crypto) is a forewarning of what may happen to high-priced growth stocks broadly.

High-priced growth isn’t confined to the tech sector, and not all tech stocks are expensive, but overall the valuations are back to the highs reached in 1999 to 2000. As a per cent of the index, the tech sector is back to levels of the dot-com era.

We think that the growth investing style, which dominated last year’s returns, is at most risk, and that investors should be looking to rotate to higher quality, lower valuation stocks found in materials, industrials and discretionary. For yield, REITS have the best risk-reward in our view.

Investor fund flows have become problematic as well. The highs in January saw the largest inflows into stocks on record, followed by the largest outflows during the initial selloff.  Since then, investors have bought each successive top, and sold each successive drop.  This creates “trapped” buyers and puts the “FOMO” and “buy-the-dip” mentality at risk.

WILL PASSIVE INVESTING BECOME ACTIVE PANIC?

We can’t know if this correction is the start of the next bear market. Economic data is slowing, but is still at high levels on an absolute basis. Tax cuts will start to show up in the Q1 earnings, and earnings will be the next big “event” to help determine the path of this late-cycle market.

TOP PICKS

TRANSCONTINENTAL (TCLa.TO)

Transcontinental is a stock that we have recommended in the past, and it has become topical again and worthy of being a top pick. They’re in the commercial print business – flyers, newspapers, magazines, catalogs — and have been a consolidator in what’s been a shrinking industry.

More recently, they’ve been diversifying the business into packaging through acquisitions. To that end, they announced the other day a US$1.3 billion deal to buy Coveris Americas. It’s their seventh purchase in packaging and they are now the seventh largest in that business. Packaging now represents 48 per cent of their business.

Transcontinental is using their balance sheet for this deal – so they will be three times levered and will need to get it below two times in two years to keep their investment grade rating, but they have a solid history of integrating and rationalizing costs in difficult businesses.

The stock has consistently been a free-cash flow machine, and has traded cheaply. It scores in the top 3 per cent of all stocks for us on valuation at 4.3 times enterprise value to earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) , 8.6 times price-to-earnings (P/E), 21 per cent return on equity (ROE), and a decent yield that’s sustainable.

Price momentum has been just “OK,” but valuation outweighs that. The recent selloff is related to a $250-million equity deal that was initially not fully sold, and came to market on the Easter Monday and Passover holidays with the Dow down 3 per cent. Deal is fully sold now, and that noise creates the opportunity here to step in.

METHANEX (MX.TO)

Another stock that fits the theme of reasonably priced industrial stocks. Methanex is a best-in-class chemicals company in a cyclical commodity business. It produces methanol, which is used in fuel-blending, flooring, paints, sealants, synthetic fibres, etc. They’re about 14 per cent of global production – the largest player. Half the market is concentrated in the top handful of producers.

Methanex is one of the rare stocks that scores well on both price momentum and cheap valuation (top 10 per cent of all stocks in Canada on those two metrics). Valuation reasonable 8.6 times price to free cash flow, 9 times EV/EBITDA, solid ROE at 23 per cent, smallish yield of 2.2 per cent but plenty of room to increases with a low payout ratio.  It also has a conservative balance sheet that might be considered under-levered.

More recently, there’s been speculation that Methanex could be a target for CF Industries. We’re somewhat skeptical given the lack of obvious synergies, although methanol and ammonia production are similar in terms of the business and they do have a lot of geographic overlap with operations in Alberta, Trinidad and the U.S. Gulf. It does highlight the valuation difference though. CF trades at 11 times 2018 EBITDA versus Methanex at 7 times forward EBITDA.

ARC RESOURCES (ARX.TO)

This pick is a bit of an outlier in that it’s an energy stock in a sector that’s well and truly been left for dead. If we see rotation away from expensive growth stocks and toward more cyclical value stocks, and if we’re in a correction and not the start of a new bear market, then the energy sector may be poised for some positive flow of funds.

ARC is conventional oil and gas producer with assets in the Montney in B.C., and Cardium in Alberta. They’re largely insulated to the AECO pricing problems, which is a key differentiator versus gas peers. It’s a small long for us on a valuation basis. On that metric, it scores in the top 15 per cent of all stocks in Canada, not just among energy stocks.

6.1 times EV/EBITDA, 1.3 times book value, 7.4 times backwards cashflow. They pay a yield of just over 4 per cent, so not the highest in the sector, but with a solid balance sheet and a reasonable payout ratio, the yield is sustainable, which isn’t something you can say about peers.

Its momentum is tough like everyone in the sector, although on a relative basis it has fared much better than others. You don’t have the same operating leverage here,which means they won’t go broke while you wait for a turn.

ARC  is a bit of a contrarian pick – small position for now, but one of our top energy picks that will be bigger as the sector turns higher.

AIR CANADA (AC.TO)

• Then: $13.81
• Now: $26.28
• Return: 90.29%
• Total return: 90.29%

INDUSTRIAL ALLIANCE (IAG.TO)

• Then: $55.03
• Now: $52.72
• Return: -4.19%
• Total return: -0.98%

GENERAL MOTORS (GM.N)

• Then: $37.34
• Now: $38.10
• Return: 2.03%
• Total return: 7.30%

Total return average: 32.20%