A sa fer way to play energy
It’s kind of a dangerous market right here given this inflection
It’s been about six months since investors have seen a shift like the one currently in the works as a result of the belief that the U.S. Federal Reserve will stay lower for longer on interest rates.
The U.S. dollar is starting to come off — now down five per cent versus the loonie this month alone — but the most obvious change has been in commodities.
Most beaten-down sectors such as energy and materials are moving higher, and there is a “junk rally” in the most over-levered companies.
“People will talk endlessly about oil and the supplydemand picture, the Saudis, et cetera,” said Jason Mann, portfolio manager of EdgeHill Partners’ EHP Advantage Fund. “All you really need to look at is what the U.S. dollar is doing, and oil is going to do the opposite.”
Mann, whose highly diversified long/short fund holds between 400 and 500 names, noted that this usually happens at a changeover point, or during a regime shift.
On the flip side, everything that benefited from a strong U.S. dollar — consumer discretionary and staples, industrials with U.S. exposure and even health care — has taken a shot across the bow.
But the tricky part is deter- mining whether these trends are just a short-term check on the way to more U.S. strength.
If that’s the case, then the old trends will reassert themselves and that means oil stocks are overbought. But if U.S. growth is shifting lower, a weaker greenback is in the cards, as the Fed will hold back on interest rate hikes.
“It’s kind of a dangerous market right here given this inflection,” Mann said, noting that a lot of funds effectively had a long U.S. dollar trade in one way or another.
He is starting to respect the price momentum in energy and materials and shift more dollars into them, after being neutral on both sectors up until recently and net short energy in the fall.
That lines up with his goal of targeting the best combination of value and price momentum for the portfolio.
“There has certainly been value in energy, but there hasn’t been particularly good price momentum until this month,” he said. “Now we’re starting to see both.”
One relatively recent addition to the fund is Badger Daylighting Ltd. (BAD/TSX), whose hydrovac excavation business is tied to the energy sector as well as several other industries.
Badger’s price momentum is starting to improve, but the company also has a 10-year track record of revenue and EBITDA growth of around 18 per cent annually on average. It boasts a very high return on equity of 27 per cent, a strong balance sheet and one of the best cost structures.
“It’s a safer way to play energy,” Mann said. “It’s in that sweet spot of cheap and rising that we look for.”
Another way he’s playing the recovery in energy is through TransAlta Corp. (TA/TSX).
Mann noted that at 8x trailing EBITDA, TransAlta’s stock is trading at a pretty substantial discount to its peers at around 13x. The company is also able to push assets down to subsidiary TransAlta Renewables Inc. (RNW/TSX), and get a valuation bump each time because they are being sold at a higher multiple.
“They’re well hedged, so it’s got good visibility on earnings,” he said. “It’s also been beating on earnings and has improving price momentum.”
Broadly speaking, the S&P 500, for example, almost hit a record high just last week, so any corrections are happening internally — more of a money rotation than a broad selloff.
But there is still reason to be cautious about valuations. If a growth scare emerges — and Wednesday’s weak U.S. GDP numbers raise the odds of that happening — some sectors and stocks have a long way to drop before they get back to value territory.
Since the consumer discretionary theme is losing traction, Canadian companies that sell into the U.S. may be vulnerable.
One that Mann thinks was priced for perfection is DHX Media Ltd. (DHX.B/TSX), which he is now short.
The company recently lost its Disney programming rights to rival Corus Entertainment Inc., but Mann felt the stock was already very expensive relative to its growth profit.
He noted that DHX doesn’t really generate a lot of cash, trades at lofty multiples, is facing a momentum shift, and the Canadian Radio-television and Telecommunications Commission’s decision on pick-and-play could lead to subscriber losses.
“It could have a long way to fall before it’s considered a value stock again,” he said.