Jason Mann, CIO, Co-Founder at EdgeHill Partners

FOCUS: North American Equities

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MARKET OUTLOOK:

• We often talk about the U.S. dollar as being the one chart to watch — we think that this is still the case, and we are at potential cross-roads for the U.S. dollar again after a period of weakness.
• The cyclical rally off the bottom in February was bolstered by a weak USD, and now that the Fed is once again talking about rate hikes, the USD is looking stronger. That could pressure commodities and Canada in general.
• A rate hike, or the ongoing threat of one, could also pressure what we think is the most “overbought” trade in the market: the “defensive” trade whereby low volatility and safer, dividend-paying stocks have led the market higher.
• It seems that in a low interest rate environment where bonds aren’t providing income any more, investors are turning to “bond alternatives” like Utilities, REITs, Telcos and Staples. We would strongly suggest that there is no true alternative to bonds. In a repeat of the “taper tantrum” of 2013, we could see these sectors off 20 per cent or more.
• Gold stocks would be worse. Given their huge run-up this year and their typically negative correlation with interest rates, a move by the Fed could hit golds meaningfully. It’s a volatile sector at the best of times, and is already off 20 per cent from its highs earlier this month. If sentiment turns, coupled with rising rates, gold stocks could have meaningful downside even from here.
• These factors make it a tricky market to navigate. Our approach is to maintain balance between cyclical and more defensive sectors. We like cyclicals that don’t have as much direct commodity exposures: Industrials, Consumer Discretionary and Tech. Financials have been a lagging sector overall that should catch up in a rising rate environment: insurance, banks and non-bank lenders.

Top Picks:

Linamar (LNR.TO)

• We like the auto parts space in general for its cyclical exposure and valuation. The three players in Canada: Magna, MartinRea and Linamar are all cheap. We’ve recommended Magna before, and this time we’d like to highlight Linamar.
• They manufacture a full range of auto parts and also have their SkyJack industrial division.
• Is a very cheap stock. In fact, it is the single cheapest stock in the TSX for us, with high ROEs of 22 per cent, 5x EV/EBITDA, best-in-class margins, a 7.3x PE and a good balance sheet.
• The one knock against it is its recently poor momentum, but that appears to be changing post their most recent earnings report.
• The fear with these stocks is sluggish demand for autos. Ford and GM have generally been disappointing in this regard lately with Ford forecasting lower auto sales to come.
• But, with an aging fleet (avg. age >10 years in U.S.) and with continuing strong employment, we think that that risk is more than priced into these parts stocks and they are simply too cheap to ignore.

CGI Group (GIBa.TO)

• IT services and outsourcing, systems integrations and consulting services.
• Consistently a top performer operationally and currently scores in top 10 per cent on valuation for us with ROE at 18 per cent and a stellar balance sheet with no net debt. PE at 18x isn’t the cheapest but they’ve been growing at north of 10 per cent per year, so in that context not unreasonable.
• Growing bookings faster than revenues so their “book to bill” ratio is >1.
• Scores well on price momentum with stock near all-time highs.
• They have used their strong balance sheet in the past to make accretive acquisitions — having good free cash flow and strong balance sheet gives them options. Have capacity for up to $3 billion of acquisitions given current balance sheet.

*SHORT* Tesla Motors (TSLA.O)

• Let’s start with the facts: Tesla makes great cars and is a true innovator in the electric vehicle space. Elon Musk, the founder, is a remarkable visionary who has managed to innovate in not only electric autos, but also in commercial space transport (SpaceX) and Solar (Solar City).
• It is also a fact that TSLA is an extremely expensive stock. It trades at 12x book value and 6x sales. No other valuation metric is even usable since they generate negative cash flow, negative EBITDA, and negative EPS. With a market cap of $31 billion, it is effectively a concept stock at this point. They will also need to raise as much as $2 billion this year.
• They’ve had a track record of disappointments on deliveries, EPS and revenues, which tends to get shrugged off given faith in Musk.
• They have a lot of new competition on the horizon from BMW, Porcshe, Audi and VW.
• Bottom line: Don’t mistake a great car for a great investment.
• The investment story is about to get much worse with the controversial purchase of related company SolarCity.
• SolarCity sells rooftop panels and despite falling from $60 to $20, it is also expensive at 3.8x sales and negative EBITDA, CashFlow and earnings.
• It’s a very questionable use of TSLA’s balance sheet to effectively save a failing business where Musk is also the largest holder and Chairman. It will be a big drag on cash flow and balance sheet once consolidated.
• There are multiple things that have to go perfectly to make any sense of these valuations, and a lot of things that could go wrong where any one of them could seriously impair the future growth and valuation of the company.
• As momentum has started to roll over, coupled with high volatility and excessive valuation, those are the characteristics we look for in our shorts.

Chorus Aviation (CHRb.TO)

• Then: $5.56
• Now: $6.01
• Return: +8.09%
• TR: +17.29%

Ritchie Brothers Auctioneers (RBA.TO)

• Then: $35.80
• Now: $45.92
• Return: +28.25%
• TR: +31.22%

Raging River Exploration (RRX.TO)

• Then: $8.13
• Now: $10.85
• Return: +33.39%
• TR: +33.39%

Total Return Average: +27.30%