We are joined this week by contributing editor Ryan Irvine, who gives us his outlook for the markets and updates some previous recommendations. Ryan is the CEO of KeyStone Financial (www.KeyStocks.com) and is one of the country’s top experts in small-cap stocks. He is based in the Vancouver area. Here is his report.
Ryan Irvine writes:
In the wake of last month’s decision by the U.S. Federal Reserve to hold interest rates steady, the tone and direction of North American equity markets has been decidedly negative. In fact, the S&P 500 is off around 4% since the Sept. 17 announcement, adding to its significant losses for the year.
Curiously enough, the threat of higher rates in the U.S. had been widely blamed for equity market declines prior to the Fed’s decision.
If we follow this logic, the decision to hold rates steady should have rallied the market. Of course, this may ultimately be the case in the coming months, but we think there is also another simple factor at play: Markets were generally overvalued, particularly given the weak environment for global growth.
Despite recent declines, the S&P 500 is still trading near 15.5 times forward 12-month earnings, above the 10-year median of 14.7 times, according to Thomson Reuters data. Couple this with the estimate that third-quarter earnings are expected to decline 3.7%, and you have a market that is not positioned for gains in the near term.
With the recent declines, the market generally is not starkly overvalued but, with a lack of growth, we do not see the hurry to purchase a basket of stocks as broader markets tend to revert to the median P/E in the long term. Selectivity will continue to be key.
Cash on the sidelines should prove to be valuable as opportunities will likely present themselves over the next year. In some cases, we are starting to see a couple of select solid companies begin to trade at more attractive levels. Having said this, we must be cognizant of the low growth environment and search for value and pockets of growth – preferably in one simple package.
Investors are now focusing on the Fed meeting on Oct. 27-28 as the next chance for the central bank to raise interest rates for the first time since 2006.
A growing number of economists and market observers are now wondering whether the Fed will raise rates at all this year. Interest rate futures indicated only a 16% chance of a hike at the Fed’s next meeting, with a 42% chance in December. Remember, however, that the same futures were calling a rate hike at the September meeting a slam-dunk at one point earlier this year.
We think individual equity investors would be wiser to pay attention to the individual stocks they own and the businesses behind those stocks rather than the possibility of a 25 basis point rate hike this year by the Fed. In the end, hike or no hike, the fundamentals of the businesses you own will have a far greater impact on your portfolio than a small change in interest rates at one given point in time – particularly if you invest for the long term (1-10 years plus).
What we do expect is continued volatility in 2015. Take advantage of it long term.
Merus Labs International Inc. (MSLI, Financial)
Originally recommended on March 28/15 at C$2.72, US$2.13. Closed Friday at C$1.91, US$1.46.
Background: Merus Labs is a specialty pharmaceutical company focused on acquiring established products. The company leverages its expertise in European and North American markets to optimize the value of underdeveloped pharmaceutical assets. It currently has products in the area of urology/women’s health, anticoagulants and anti-infectives.
We recommended buying a half position in March of this year. The company’s shares subsequently rose to the $3.30 range but have been hit over the past month along with the pharma/biotech sector generally.
Recent developments: In the U.S. last week, Democrats on the House of Representatives committee on oversight and government reform sent a letter to the committee’s Republican chairman seeking a subpoena that would force Canada’s largest pharma company, Valeant Pharmaceuticals (VRX, Financial), to turn over documents tied to the U.S. price hikes of two heart drugs.
At one stage, Valeant’s shares traded down 16.5%, before recovering a portion of the losses. Well-respected fellow Canadian pharma stock Concordia Healthcare Corp. fell more than 25% on Monday. Like Valeant, Concordia has an aggressive acquisition strategy, whereby it manages and acquires legacy pharmaceutical products and acquires and develops orphan drugs.
At issue for both was the practice of hiking drug prices after acquisitions. Reports state that Valeant’s heart drugs, Nitropress and Isuprel, saw 212% and 525% price increases after Valeant acquired them.
Politicians have chimed in on the issue and Hillary Clinton’s tweet this week received significant attention: “Price gouging like this in the specialty drug market is outrageous.”
Clearly, skyrocketing drug prices is an area of focus for a number of Democratic presidential hopefuls and raises a specter of uncertainty for companies selling into the U.S. market.
Merus’ shares have been hit in sympathy with the entire pharma sector, despite the fact that 90% of the company’s sales are in Europe and the remaining 10% are in Canada. As such, the current uncertainty in the U.S. pharma market has no impact on the company.
Action now: Buy the company in its current range to hold for 2-3 years.
Enghouse Systems Limited (EGHSF, Financial)
Originally recommended on March 7/11 (#21109) at C$9.10. Closed Friday at C$55.78, US$42.04.
Background: Enghouse is a leading global provider of enterprise software solutions serving a variety of distinct vertical markets. Its strategy is to build a larger and more diverse software company through strategic acquisitions and profitable growth.
Enghouse was introduced to the IWB in our February 2011 installment when the stock traded at C$9.10. In our June update with the stock in the $50 range, we maintained our near- and long-term ratings on the stock at Hold.
Recent developments: On Sept. 10, the company reported that its third-quarter revenue rose 28.3% to $71.3 million from $55.5 million in the third quarter last year. Adjusted EBITDA for the quarter was $18.5 million ($0.68 per share, fully diluted) compared to $14.4 million ($0.53 per share) in last year’s third quarter. Net income for the quarter was $8.1 million ($0.30 per share) compared to the prior year’s third-quarter net income of $7.2 million ($0.27 per diluted share).
Enghouse closed the quarter with $91.3 million in cash, cash equivalents and short-term investments, compared to $84.9 million on Oct. 31, 2014. The cash balance was achieved after payments of $27.3 million for acquisitions (net of cash acquired) and dividends of $8.4 million year to date. The company continues to have no long-term debt.
Having said all this, Enghouse is no longer a secret in Canadian markets. The stock trades at premium valuations as a result of its excellent long-term track record of growth. We believe the company is fairly valued at present, trading at around 22 times adjusted EBITDA cash out and 32 times next year’s expected earnings per share.
The company’s cash is held in Canadian dollars. The drop in the Canadian dollar versus the U.S. dollar has impacted the size of Enghouse’s acquisition war chest as acquisitions are most often completed in U.S. dollars. The decline is offset somewhat by the fact that the company does operate primarily in U.S. dollars.
Action now: We reiterate our Hold advice on a valuation basis. Long term, we expect Enghouse will continue to outperform the market and, as such, for those with a two-year plus outlook, we would buy on 5% to 10% pullbacks.
Athabasca Minerals Inc. (ABM, Financial)
Originally recommended on Jan. 30/12 (#21204) at $0.485. Closed Friday at $0.26.
Background: Athabasca Minerals is a resource company involved in the management, exploration and development of aggregate and silica sand projects. These activities include contract works, aggregate pit management, aggregate production and sales from corporate-owned pits, new aggregate development and acquisitions of sand and gravel operations, and development and supply of frac sand for Western Canada.
Athabasca Minerals was originally recommended in the IWB in January 2012 in the 48 cents to 55 cents range. With the stock surging to the $2.40 range in the early fall of 2012, driven by two sets of record quarterly earnings, we recommended investors sell half their positions. We advised holding remaining positions to continue to participate in the solid long-term potential Athabasca possesses.
Recent developments: In our last update we stated that, after selling half of our initial positions above the $2 range, we decided to hold the remaining position to participate in the potential of the company’s Firebag Frac Sand Project. The initial numbers for the project appear attractive but in the current market it may be difficult to raise the estimated initial capital costs of $87.8 million.
Management has stated the Firebag Project is on target to be in production by 2016. This appears overly optimistic. There are plenty of hurdles ahead of this date including permitting and raising substantial capital. At the time of the last update, we continued to hold our remaining position having already made a significant profit by selling half the original stake. We were not keen to add to any new positions in the current environment.
Outlook: The corporation continues to focus on the optimization of existing aggregate operations and will seek to minimize costs under the current low oil price environment. With the downturn in the economy and anticipated lower sales, management has taken steps to preserve margins and cash flows.
Management is exploring additional diversification including long-term crushing contracts for regional municipalities and counties, which will allow for higher utilization of the corporation’s existing equipment and the potential sale of aggregates. The aggregates division is well positioned to react to any increase in demand for sand and gravel.
With respect to the Firebag Frac Sand Project, Athabasca will focus on permitting and engineering for the plant and Lynton trans-loading location. Capital expenditures including equipment under lease obligation and resource properties for the six months ended June 30 have been reduced from a year-to-date budget of $5 million to $2 million.
Conclusion: We see further weakness in the company’s shares heading into tax-loss selling season. While we are loathe to sell based on the calendar, we do not see Athabasca’s share price recovering until energy prices move higher and capital spending resumes in the Western Canadian Sedimentary Basin. As we see the second element as being at least a year out, there are currently better places to employ our capital.
Action now: We recommend investors Sell their remaining positions and redeploy.
Exco Technologies Limited (EXCOF, Financial)
Originally recommended on Feb. 27/12 (#21208) at C$4.25, US$4.22. Closed Friday at C$14.50, US$11.32.
Background: Exco Technologies is a global supplier of innovative technologies servicing the die-cast, extrusion, and automotive industries. It has 18 locations in 10 countries, employs more than 5,000 people, and serves a diverse and broad customer base.
The stock was recommended in February 2012 as a Buy at $4.25. In our most recent update in March of this year, we rated the company as a near-term Hold and long-term Buy for those with an investment time horizon of beyond one year, with stock trading at the $15.50 level.
Recent developments: Overall, we were very pleased with Exco’s third-quarter fiscal 2015 financial results. Consolidated EBITDA for the quarter was $18.2 million compared to $14.9 million in the same quarter last year, an increase of 22%. Year-to-date consolidated EBITDA was $55.1 million compared to $38.4 million, an increase of 43% over last year. Exco’s Enterprise value to EBITDA ratio remains relatively reasonable at 8.7.
Conclusion: Fundamentally, Exco now trades with a price-to-earnings multiple of 16 based on its last 12 months, with the stock up over 200% (not including dividends) since our original recommendation. Given the strong start to 2015, we expect Exco is positioned to earn around $1 per share on an adjusted earnings basis in 2015, giving it a more attractive forward looking earnings multiple of 14.5.
While the third-quarter earnings per share figure may have slightly missed what we considered too optimistic estimates, we see the results as another positive. There was renewed discussion about potential “tuck-in” acquisition opportunities in the conference call and with the company building its cash position, this could again help to spur growth.
Action now: Given the sluggish prospects for global growth near term, we maintain our near-term rating at Hold (for those with an outlook of less than six months). We remain decidedly positive on the company mid-term and maintain our long-term rating at Buy (for investors with a greater than one-year time horizon) given the above average long-term growth potential. While the company’s industry is cyclical, we believe the current environment appears positive for the next 12-24 months.
