Market Call: Andrey Omelchak's outlook on North American Small & Mid Caps

Summary of BNN Bloomberg Market Call with Mark Fernandez-Andre (April 1st, 2024)

Key Concepts:

• Build Canada: A significant investment in Canadian infrastructure driving economic opportunities.
• Geopolitical Risk: Impact of global events (Venezuela, Greenland, Panama Canal, US foreign policy) on investment strategies.
• AI Disruption: Concerns and opportunities presented by Artificial Intelligence across various sectors.
• Resource Complex vs. High Technology: Balancing Canada’s natural resource wealth with investment in innovation.
• North American Small & Mid-Cap Markets: Focus on investment opportunities within these segments.
• Supply Chain Issues: Challenges impacting manufacturing and delivery of goods, particularly in the automotive and battery sectors.
• Vertical Market Software: Specialized software solutions tailored to specific industries, and their resilience to AI disruption.

1. Macroeconomic Overview & Geopolitical Influences

The discussion began with the recent agreement between Ottawa and Beijing to reduce tariffs, described as a logical step for the Canadian government to forge independent trade relationships. However, uncertainty remains regarding the Kuzma trade agreement, with potential for postponement. Fernandez-Andre emphasized the need for Canada to “forge its own path” and not be “held hostage” by ongoing negotiations with any single trade partner. He highlighted a broader geopolitical shift, referencing the Monroe Doctrine and increased US assertiveness in the Western Hemisphere, suggesting a need for investment in national defence and domestic priorities.

2. Investment Themes: Build Canada & Beyond

A central theme was the “Build Canada” initiative, seen as a significant and investable opportunity. Fernandez-Andre believes real money will flow into this sector, translating into improved operating results for companies involved. Beyond infrastructure, he identified a need to leverage Canada’s natural resources to fund investment in high technology and aerospace. He cautioned against relying solely on the resource complex, advocating for diversification.

3. Market Performance & Sector Analysis (2023 Review)

Last year’s market was described as “bipolar,” driven by the resource complex, particularly gold equities which experienced a ten-year rally fueled by geopolitical events. Canadian banks also performed well, supporting benchmark indices. However, technology companies underperformed due to concerns about AI disruption and its potential impact on business models.

4. Company-Specific Analysis & Recommendations

• Well Health Technologies: Fernandez-Andre views this as a “great buying opportunity,” citing a parts valuation indicating significant upside. He emphasized the importance of divesting US operations (currently in progress) to focus on the Canadian market, where consolidation opportunities exist and return on invested capital is high. The planned IPO of Wellstar was highlighted as a potential value unlocker.
• MDA Space: Despite recent volatility and contract losses, Fernandez-Andre remains positive, citing its mission-critical role in both Canada and potentially Europe. He stressed the need for client base diversification and highlighted its exposure to defence and national security themes.
• Boyd Group: Recommended as a solid hold, benefiting from the Build Canada initiative and a healthy dividend yield. He noted improving same-store sales growth and positive insurance market dynamics.
• Constellation Software: Despite a significant stock price drop, Fernandez-Andre believes the sell-off is overdone, citing a free cash flow yield exceeding 8%. He anticipates continued M&A activity and potential benefits from AI implementation.
• NFI Group: Acknowledged supply chain issues (currently battery-related) but believes they are transitory. He sees long-term potential driven by the Build Canada initiative and the need for public transportation.
• Vitaris (formerly VitalHub): Viewed as a potential takeover target, benefiting from the healthcare technology sector. He believes the company is not significantly threatened by AI disruption.
• Dextra Group: Positioned to benefit from Build Canada’s modular housing initiatives, with potential for further growth and accretive acquisitions.
• Elektra: A small-cap lithium-ion battery company with a strong safety record and a focus on high-growth industries like warehouse automation, defence, and data centres. Fernandez-Andre highlighted its potential for significant growth, particularly in the energy storage sector.
• Descartes Systems: Recommended as a strong buy, benefiting from its mission-critical role in logistics and its resilience to AI disruption.
• Information Services Corporation: Recommended as a hold, citing its quasi-monopoly position and sustainable dividend yield.
• Tricera Group: A specialty insurance company with growth potential in both Canada and the US, potentially a takeover target.

5. AI & Technological Disruption

The impact of AI was a recurring theme. Fernandez-Andre argued that vertical market software companies, with their deep integration with clients, are less vulnerable to AI disruption than some other sectors. He believes companies like Constellation Software and Descartes Systems can even leverage AI to innovate and improve their offerings.

6. Key Arguments & Perspectives

• Canada’s Strategic Position: Fernandez-Andre emphasized the importance of leveraging Canada’s natural resources to invest in high-tech industries and maintain competitiveness.
• Geopolitical Awareness: He stressed the need to understand and adapt to the changing geopolitical landscape.
• Focus on Free Cash Flow: He consistently highlighted the importance of free cash flow generation and capital allocation as key indicators of investment potential.
• Long-Term Perspective: He advocated for a long-term investment horizon, particularly in companies with strong fundamentals and growth potential.

7. Notable Quotes

• “We have to forge our own path. We have to stand firm on our feet, and we have to make agreements with other countries.”
• “At some point, real money will start flowing [into Build Canada], and I think that this will translate into the operating results of the companies.”
• “Canada should count our blessings. We have an immense resources, natural resources that we should take advantage of, but we should not build a whole economy around natural resources complex.”

8. Data & Statistics

• Gold prices rallied significantly after a ten-year period of stagnation.
• Canadian banks performed well in the past year, supporting benchmark indices.
• Elektra is expected to triple its manufacturing capacity with a new plant in Jamestown, New York.
• MDA Space closed $10 billion in backlog, with an additional $1.2 billion announced recently.
• Constellation Software deployed $1.7 billion in capital last year.

9. Synthesis/Conclusion

Fernandez-Andre presented a cautiously optimistic outlook for the North American small and mid-cap markets, emphasizing the importance of identifying companies benefiting from key themes like Build Canada, national security, and technological innovation. He stressed the need for a long-term investment perspective, a focus on free cash flow, and an awareness of the evolving geopolitical landscape. He highlighted several specific companies with strong potential, while also acknowledging the risks and uncertainties inherent in the market. His overall message was one of strategic investment in Canadian companies poised to capitalize on emerging opportunities.