Stock Picking is Key

While equity markets appear to be on a tear, thanks in part to optimism that the COVID-19 vaccines will prompt an economic turnaround, Rob Taylor argues that many valuations are full and stock-picking discipline is the key to generating returns.

“The market has had a big run. It’s not unusual to see some sort of a correction or a consolidation when you have such a big move in the stock market over a short period of time,” says Taylor, lead manager of the $182.7 million four-star rated Canoe Equity Portfolio Class F, and senior vice-president at Toronto-based Canoe Financial Inc. “What we would say is, ‘Yes, there could be pullbacks, but they will be short and shallow in nature.’”

Looking to the Recovery
“Pullbacks should be buying opportunities,” says Taylor, who believes that the economic recovery is still some ways off since the bulk of the population will not be vaccinated for several months. “It will be the back half of 2021 before we enter the true recovery. We won’t be back to fully ‘normal’ until next year. But the market is forward-looking and pricing in what that recovery might look like.”

Taylor says the recovery hinges on the economy going beyond the pandemic. “The risk is that we don’t get past the pandemic. But we believe we will. And the vaccine is the reason why,” says Taylor, who joined Canoe Financial in 2013, after a brief career as an accountant and a switch to investment management in 2002, when he joined BMO Asset Management Inc. Currently, Taylor oversees in aggregate about $2.2 billion in assets.

What to Look for When Picking Stocks
Taylor points out that the top six names in the S&P 500 Index account for 22% of the overall market. “We saw this same high degree of concentration in 2000 and the 1970s. When you get to these levels, this means you are over-valued.”

Given the dominance of a handful of technology or technology-related stocks, Taylor argues that the case for being a stock-picker is as strong as ever. “It’s becoming increasingly clear that the market is concentrated in fewer stocks. Those stocks are trading far above historical norms. The case for stock-picking is simple: there is an over-concentration, and over-valuation, in a few names. That has created an opportunity in many names that have been largely ignored.”

Pointing to the discrepancy between over-valued and under-valued stocks, Taylor notes, “That divide is setting up one of the best stock-picking environments that we have seen for some time. We are finding some really interesting opportunities.”

A bottom-up growth-at-a-reasonable-price investor with a value tilt, Taylor seeks companies with four principal attributes. “We look for companies that can provide sustainable growth over multiple cycles, free cash flow generation and strong management teams with a focus on returns,” says Taylor. “We also like to find optionality, or potential future opportunities that are not priced into the stock today.”

Because Canoe Equity Portfolio is part of the Canadian Focused Equity category, its mandate allows significant exposure to the U.S. Currently, there is about 37% in those markets, plus 56% in Canada, 6% in international markets and 1% cash. From a sector standpoint, the largest weighting is in financials at 25%, followed by 20% energy, 18% materials and 15% healthcare.

In 2020, the fund returned 8.2%, matching the category. Over three and five-year periods, the fund had an annualized 6.67% and 9.72%, compared to 4.67% and 7.48% for the category.

Stocks to Watch
One of the top names in a portfolio with 44 holdings is Tourmaline Oil Corp., Canada’s largest natural gas producer that is primarily active in Alberta and B.C. “It’s a best-in-class energy company, with a very low-cost structure, and has one of the best management teams in the Western Canadian sedimentary basin,” says Taylor, adding that the stock trades at less than 3.5 times enterprise value (EV) to debt-adjusted cash flow and has a 12% free cash flow yield, compared to a historical multiple of eight times.

“There is optionality that makes it attractive,” says Taylor. “There is an M & A ‘lever’ to this company because it is a smart consolidator and has executed many strategic value-added transactions in the past. The second ‘lever’ is that natural gas fundamentals are improving. We have very tight global markets and increased liquefied natural gas demand. There is a large arbitrage between the price you get for natural gas overseas and what you get in North America today. We think that gap will close over time. Finally, there is more capital discipline in the industry. So there will be less supply growth. And it’s an area where demand is growing globally.” While stock is trading at about $18, Taylor believes it can rise to $25-30 in the next 12 to 18 months.

Another favorite is Anthem Inc., a U.S.-based managed care company that provides health insurance and has seen its stock trade sideways for two years due to the uncertainty around the U.S. presidential election. “We think the regulatory risk is extremely low. In fact, the Democratic sweep is beneficial, given its greater-than-peer exposure to Medicaid,” says Taylor. “If you had an extreme left-wing agenda that wanted to nationalize health insurance in the U.S. these companies would be out of business. But that’s not going to be the case with the incoming administration.”

Taylor adds that the company has been a consistent double-digit earnings grower and trades at a 9% free cash flow yield. The stock trades at 11 times 2022 earnings per share, compared to comparable firms that trade in the high teens multiples. “There is a significant re-rating potential this year. As the U.S. election concerns abate, sentiment will lift.” The stock is trading at about US$312, although Taylor believes it has the potential to rise to US$500 in the next 12 to 18 months.

Looking ahead, Taylor maintains that his team’s disciplined approach, which has contributed to the fund’s strong longer-term performance, will stand it in good stead. “We focus less on where the puck has been and more on where it will be. Being patient and disciplined is what distinguishes what we do, versus an index investor.”