Jason Mann, co-founder and chief investment officer, EHP Funds

FOCUS: North American equities

MARKET OUTLOOK:

• Despite the rally of the lows in July, markets have continued to be volatile across asset classes, and we don’t believe we are out of the woods yet.
• The reality is that the U.S. Federal Reserve is not our friend anymore, and is making it clear that they are determined to tighten enough to bring inflation back down. It will talk hawkishly until the very last minute of hikes – there is no upside to them turning dovish in its narrative as it undermines the very things they are trying to accomplish.
• With quantitative tightening coming in size this fall and with corporate earnings guidance starting to deteriorate, we may well be set up for another leg lower in the markets. Europe is more likely to enter a recession first given its energy crisis.
• Whether or not this slowdown results in a recession, markets may find it tough to make much headway.
• Much of the inflation decrease in July was driven by declines in energy prices, but that is at risk of reversing, keeping inflation stickier for longer.
• What we’re describing is “stagflation” where inflation increases as growth slows from its peak.
• In a stagflation environment, you want a barbell approach of stocks that benefit directly from inflation; commodities and related businesses, as well as high-quality, larger-cap, low-volatility stocks with strong earnings growth (as opposed to speculative top-line growth).
• We’d still avoid unprofitable tech as there can be no bottom for them if the market resumes its downturn.
• Overall, we’re maintaining weights to high-quality cyclicals in energy and materials (fertilizers, copper and steel). Consumer staples balance out the portfolio. We’re avoiding or are net short expensive growth stocks and bond-proxy sectors like REITs.
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TOP PICKS:

Whitecap Resources (WCP TSX)

• Clearly over the last few years or so you could have picked just about any energy stock and returns would have been remarkable. After a five-year bear market (and negative $40 oil during the pandemic), it’s clear that the world is now short on energy in all forms, and oil has become a key driver of inflation.
• We don’t think that the structural reasons why this has been true will be solved anytime soon. In many ways, government and social demands for more environmentally friendly energy production have made the problem worse in the short run – there has been underinvestment, and a lack of policy to encourage new traditional production. Essentially, we’re forcing transition before we have the supply from green energy, and so this may persist for some time.
• Energy companies are currently some of the cheapest, with the best earnings growth. They are the new growth stocks, although obviously cyclical.  That said, we’d argue that “this time is different” in the sense that their cyclicality in the past was in part tied to levered balance sheets. The opposite is true today, with many energy companies debt free or on their way to being debt free.
• Whitecap is a western Canada producer, predominantly light oil. Like many energy companies, it screens as very cheap, 1.6x EV/EBITDA, 5.9x cash flow, decent yield at 4.4 per cent and a very low payout ratio. Despite energy weakness in June and July, it is rebounding again and price momentum is still stronger than in other sectors.
• WCP has lagged recently which is why we are highlighting it now. It is buying XTO Energy Canada for $1.7 billion - a big deal for them – adding 32k BoE production and 20+ years of inventory for the future.
• It has been in the penalty box a bit by investors who would have preferred it to keep the balance sheet under-levered and buy back stock and pay dividends rather than growth by acquisition strategy.
• We think the stock can play catch up though as they deliver the cash flow and de-lever, and it’s trading at a meaningful discount to its Montney peers.

Zendesk (ZEN NYSE)

• This one is a merger arbitrage pick, which is one of the strategies we use in our funds, where we earn a return by buying stocks in the process of being acquired at a discount to the price we’ll eventually get once the merger closes.
• In this case, Zendesk is in the process of being acquired by private equity buyers at a price of $77.50. What makes it interesting though is that Zendesk was formally a target of another company (Momentive) that was ultimately voted down by shareholders as undervaluing the company given there was interest from other bidders at prices expected to be north of $140/share.
• So, in many ways this deal feels like a “take-under,” and it sets up for activist shareholders to seek a bump in price, especially if there is any type of recovery in the tech market. In fact, there is already an alternate proposal from an activist suggesting it recapitalize and buy back shares at a higher price.
• Situations like these can be attractive as you have a firm deal and a return to that price, with “free” optionality that a market rally or activist shareholders encourage a bump to the price to get the deal done.

Linamar (LNR TSX)

• Linamar has been a holding for us a number of times over the years, but like many cyclical stocks there are times we want to avoid it and times we want to own it. We think despite the economic softening, Linamar is attractive here.
• Linamar is an industrial component manufacturer, known for its auto parts business but has expanded over the years into industrial and agriculture manufacturing.
• The pandemic and the Ukraine war have constrained supply in autos in particular and there is now a large imbalance between inventories of cars for available sale vs. the pent-up demand for cars. It will take years of strong production to rebuild inventories and fulfill demand. Perversely, a moderate slowdown in the overall economy that loosens supply chains may actually help companies like Linamar.
• Stock is cheap at only 4.6x EV/EBIDTA, 11.8x PE. It has no net debt now, so the balance sheet is in great shape. Insiders have been purchasing 1.5 million shares at these levels.
• Price momentum is turning higher as well as expectations of growth return.