Time to build up cash for potential pullback buys
The U.S. economy appears to have made a turn for the better in recent weeks, but there remain plenty of signs that warrant near-term caution for equity investors.
Although housing, autos, wages and other job-related data seem to be improving, important indicators such as market breadth have been fairly weak for both the S&P 500 and S&P/TSX composite indexes.
Trading volumes are rather tepid, and closely watched sentiment data point to high levels of investor complacency.
Recent data from the American Association of Individual Investors show that the bulls and bears are about even, but a lot of institutions are sitting in neutral.
“We’ve had a really choppy market where the indexes have effectively done nothing for about eight months,” said Mike Archibald, a portfolio manager at Aurion Capital Management, pointing to the uncertainty surrounding the U.S. Federal Reserve’s next moves as well as relatively weak Canadian and U.S. earnings.
But since stocks look fairly valued for the most part, the Aurion team, including co-managers Greg Taylor, Craig MacAdam and Bob Decker, thinks raising some cash makes a lot of sense at this point.
The managers of the Dynamic Aurion Tactical Balanced Fund and the Aurion II Equity Fund aren’t calling for a market correction, but having a bit of dry powder to buy good businesses will be useful if stocks pull back three to seven per cent — something they consider a real possibility.
They also recommend being fairly selective in terms of both sector and stock selection, favouring Canadian names in the non-bank financial and non-retail consumer discretionary sectors, as well as health-care stocks on both sides of the border.
“They continue to exhibit very strong momentum characteristics in terms of fundamental earnings growth, cash-flow growth, sales growth, while valuations by and large aren’t that expensive,” Archibald said. “They also have good economic sensitivity in anticipation of global growth into 2016 and 2017.”
Taylor noted that M&A trends are expected to remain, so names such as Valeant Pharmaceuticals International Inc. and Concordia Healthcare Corp. should continue to add value.
“We’re still in this unique environment where the acquirer is going up as much as the acquiree, in some cases,” he said. “It is definitely a function of the low interest rate environment, but we think Fed hikes won’t be enough to kill that theme.”
Valeant is adding organic growth to its growth-through-acquisition story, but the company certainly has the balance sheet and firepower to make more deals.
Meanwhile, Concordia is kind of like the next Valeant: a younger company with a beneficial tax position following the same acquisitive strategy.
The M&A theme also permeates non-bank financials. Archibald highlights Element Financial Corp., which has raised $2.6 billion in the expectation of making a large acquisition, either General Electric Co.’s vehicle-fleet-management business or something similar.
“We really like that business as it’s got a lot of torque,” he said. “It’s pretty cheap, and if they can do this at a reasonable price, there is material upside to earnings and profitability going forward.”
Recent addition Cott Corp. also fits into the acquisition theme, as well as the managers’ preference for non-retail consumer stocks that also happen to generate a lot of revenue outside of Canada.
Once a soft drink maker beholden to pricing pressure from WalMart Stores Inc., Cott’s purchase of a home-and-office water delivery company quickly made it the second-largest U.S. player in that business.
“They are executing very well, and they are deleveraging quickly because it’s a big cash-flow business,” MacAdam said.
“And there are a whole lot of opportunities to improve the business, as well as make tuck-in acquisitions.”
Seeing some weakness in pure retailers, evidenced by the recent struggles of Wal-Mart and Target Corp., the managers have sought exposure to the consumer in areas such as gaming through names like Intertain Group Ltd. and NYX Gaming Group Ltd. .
“Frankly, the valuations got a little too rich for us in the retail space,” Taylor said.
“They are still good companies, but with concerns about Canadian consumer debt levels and whether the west is going to have a recession due to the oil sell-off, is it really the time to stretch on valuations?
“For us, it’s just time to step back from that space and look for growth in other areas.”
The valuations got a little too rich
for us in the retail space