Teal Linde, manager, Linde Equity Fund

FOCUS: North American mid and large cap stocks

MARKET OUTLOOK:

Large cap growth stocks lifting the S&P500 no longer deserve premium valuations.

So far in 2023, U.S. markets have broadly gained with the S&P 500 up seven per cent.  However, seven megacap stocks - Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta and Tesla - account for essentially all of the S&P 500’s year-to-date gains. 

These seven stocks have rallied as retail investors have returned to the market in full force, perhaps viewing the severe market decline of 2022 as presenting a buy the dip opportunity – a behaviour pattern among those who believe the bear market is over, or considered a bear market rally by those who believe it is not.  Nonetheless, after taking a pause last year, retail investor participation in the market reached a new all time high earlier this year.  And naturally, these bullish investors have been drawn to the large cap tech names they are most familiar with – with seeming disregard of fundamentals.

The recent megacap stock outperformance has ensued despite the announcements of significant cost cutting measures in response to sharply slowing growth.  Amazon, Meta, Alphabet and Microsoft have let go of tens of thousands of employees.  Consequently, the market seems to be reacting positively to cost cutting measures with their potential short-term boost to profitability.  Yet the sharp appreciation in their share prices has resulted in their P/E multiples rising back up to premium valuation levels deserving of rapidly growing companies.  But these stars of the prior decade are no long the fast growing companies they once were.  Considering that this overpriced group of stocks represent one quarter of the S&P500, the U.S. market continues to trade above its historical average, despite high interest rates and recessions risks. 

Investors should be searching more for midcap stocks that could become large caps by the end of the decade.

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TOP PICKS

ENSIGN ENERGY SERVICES (ESI TSX)

Last purchased on March 15, 2023 at $2.96

Ensign just completed its best first quarter since 2014 back when its stock traded over $10 per share, yet today its stock is trading around $2. For the current year, the company expects to generate around $200 million in free cash flow.  Now investors often get excited with anticipated free cash flow yields of 15 or 20 per cent.  In the case of Ensign, with its $400 million market cap, its $200 million in free cash flow works out to a 50 per cent free cash flow yield.  For perspective, a 50 per cent free cash flow yield represents enough cash flow to buy back all of a company’s shares in two years.  Or they could return half, or $100 million, of their free cash flow to shareholders in the form of a dividend, which would result in a 25 per cent dividend yield.  If Ensign decided to pay such a dividend, you can be certain the stock won’t be sitting around $2 per share.  The stock would have to double in price just to bring the dividend yield down to 12.5 per cent, which would still be very high.  The buying back the company in two years or 25 per cent dividend yield simply provide scenarios illustrating just how inexpensive Ensign’s stock has become.  But before any buy backs or dividend reinstatements occur, the company is prioritizing earmarking its $200 million in free cash flow to paying down its large debt load incurred from its takeover of Trinidad Drilling in 2018.  But even the process of paying down $200 million in debt should translate to a corresponding $200 million increase in the equity value of the company, which would translate to a one-year 50 per cent boost to the company’s stock.

DELTA AIR LINES (DAL NYSE)

Last purchased on April 18, 2023 at $35.17

A sector that is still down considerably since pre-COVID is the airlines.  Airlines were among the hardest hit stocks during the pandemic as air travel dropped as much as 90 per cent.  However, even with air travel roaring back, planes full, and ticket prices high, many of their share prices are still not much above where they traded in 2020.  Granted, airlines have issued stock and/or raised a lot of debt during the pandemic to cover losses.  But these factors are not enough to justify such discounted valuations for an industry that has successfully emerged from the worst period of airline history.  Delta has shown greater deft in maneuvering through the pandemic and appears better positioned than its competitors to outperform the industry in the years ahead due to its strategy of allocating far more premium seats (along with enhanced passenger service) that are more profitable than economy class seats in their planes than its peers.  Delta is ranked the number one airline by the Wall Street Journal for five of the last six years, number one by Conde Nast Reader’s Choice Awards, and is a favourite among analysts with a higher proportion of Strong Buy and Buy recommendations than United, American and Air Canada.  This industry leading airline can be bought today at only six times 2023 expected earnings, and five times next years expected earnings.

ARITZIA (ATZ TSX)

Last purchased on May 3, 2023 at $33.35

Aritzia recently announced strong quarterly results, but disclosed increased investment spending to support its industry leading growth that is expected to contribute to a decline in adjusted EBITDA margins from 16 per cent to 12 per cent for the current fiscal year.  Short-term investors ran for the exits, pummeling the stock down 21 per cent on the news.  Management, however, expects EBITDA margins to return to 16 per cent the following year as transitory distribution centre pre-opening costs, inflationary pressures, and inventory storage costs subside.  Supporting the long-term thesis and providing an entry point for those waiting to get in to ATZ, the company expects to grow square footage space by 15 per cent in the current fiscal year.  The combination of double digit square footage growth and strong same store sales growth has been the engine driving Aritzia’s long-term growth success.  Therefore, the mid and long term growth thesis remains intact as the U.S. has only recently become a source of 50 per cent of the company’s revenues.  Years of additional growth across the U.S., and other countries – currently reached through ecommerce - will reward long-term investors.

Past Picks: May 16, 2022

 PREMIUM BRANDS (PBH TSX)

• Then: $102.09
• Now: $98.00
• Return: -4%
• Total Return: -1%

COLLIERS (CIGI TSX)

• Then: $143.86
• Now: $123.36
• Return: -14%
• Total Return: -14%

LINAMAR (LNR TSX)

• Then: $50.16
• Now: $66.27
• Return: 32%
• Total Return: 34%

Total Return Average: 6%