Market Call: John Zechner's outlook on North American Large Caps

Key Concepts

• Earnings Season: The period when publicly traded companies release their financial results.
• Valuations: The assessment of a company's worth, often expressed as a multiple of earnings or revenue.
• Catalyst: An event or factor that causes a significant change in a stock price or market trend.
• ISM Data: Institute for Supply Management data, which provides insights into the manufacturing and services sectors.
• ADP Data: Automatic Data Processing data, which reports on private sector employment.
• Cyclical Companies: Companies whose performance is closely tied to the economic cycle.
• Wealth Effect: The phenomenon where consumers spend more when they feel wealthier, often due to rising asset prices.
• Long Bond Exposure: Investing in long-term government bonds, which can act as a hedge against economic weakness.
• Infrastructure Names: Companies involved in building and maintaining public infrastructure.
• Subprime Lenders: Financial institutions that provide loans to borrowers with poor credit histories.
• Net Asset Value (NAV): The per-share market value of a company's assets minus its liabilities.
• Operating Cash Flow: The cash generated from a company's normal business operations.
• GLP Drugs: Glucagon-like peptide-1 drugs, used for diabetes and weight management.
• PBM Market: Pharmacy Benefit Manager market, which negotiates drug prices on behalf of health insurers.
• AI Transformation: The integration of artificial intelligence into business processes and products.
• Hyperscalers: Large cloud computing providers like Microsoft, Amazon, and Google.
• Passive Investing: Investment strategies that aim to replicate the performance of a market index.
• Equity Exposure: The amount of money invested in stocks.
• Value Trap: A stock that appears cheap based on traditional valuation metrics but continues to underperform.
• Softwood Lumber Tariffs: Taxes imposed on lumber imported from Canada into the United States.
• Globalisation: The increasing interconnectedness of economies and societies worldwide.
• Application Software: Programs designed for end-users, such as word processors or design software.

Market Overview and Economic Indicators

John Zechner of J. Zecher Associates discusses the current market sentiment, noting that while Canadian companies are reporting earnings, themes are similar to the US. He observes that earnings disappointments are being severely punished, and even earnings beats are not always rewarded, particularly in higher-value tech stocks. This suggests an underlying weakness in the overall market, despite averages that might appear stable. Zechner attributes this to the market's heavy weighting towards a few large stocks like Apple and Alphabet, while the broader market, particularly below the "Mag Seven," is performing poorly.

Key Data Points and Observations:

• Weakening Economic Data: Zechner points to continuing weak ISM and ADP data, indicating that employment is not significantly improving.
• CEO Commentary: Negative commentary from CEOs of cyclical companies, including transportation and delivery services, signals a slowdown.
• Consumer Weakness: Fast-food chains like Chipotle and Cava are missing numbers, indicating weakness in consumer spending. Zechner notes that while employment has been a strong support for the consumer, deteriorating employment numbers, combined with a potential waning wealth effect from stock market gains, suggest the consumer's resilience is nearing its limit.

Investment Strategy and Sector Allocation

Zechner outlines a more cautious investment approach, shifting away from cyclical sectors and consumer discretionary stocks. He has significantly reduced exposure to tech, particularly semiconductors, and has moved towards software. He has also increased long bond exposure as a hedge against economic weakness and has reduced exposure to financials, citing their economic sensitivity.

Key Portfolio Adjustments:

• Reduced: Cyclical sectors, consumer discretionary, tech (especially semiconductors), financials.
• Increased: Long-term bonds, software.
• Focus on: Infrastructure names in Canada, energy sector capital spending.

Zechner notes a positive buzz in Toronto regarding potential capital inflows back into Canada, citing the Ovintiv deal as a significant indicator. He also sees potential in the mining sector.

Company-Specific Analysis and Stock Picks

The discussion then delves into specific companies, with Zechner providing his outlook and recommendations.

Lululemon (LULU)

• Outlook: Zechner believes Lululemon's valuation has become more attractive, and its brand remains strong. While acknowledging that the company might not be "hot" currently, he doesn't recommend abandoning the stock due to its strong brand and category.

MDA (MDA)

• Concerns: The loss of the EchoStar contract and the potential risk to the Globalstar contract (due to rumors of Apple selling its Globalstar stake to SpaceX) are significant concerns. Losing these contracts could be a substantial blow to the company.
• Positives: Zechner highlights the growth in direct satellite services, increased infrastructure spending favoring Canadian companies, and MDA's capabilities in assimilating space data. He sees MDA filling a gap left by Maxar.
• Recommendation: Zechner has been buying MDA, believing the company will survive even if the worst-case scenario for the Globalstar contract occurs, given its backlog and future potential.

Microsoft (MSFT)

• Valuation: Zechner acknowledges that Microsoft is a very expensive stock.
• Strengths: Azure's continued strong growth (40%+) and Microsoft's ability to deliver cloud services are key positives. He uses his company's switch to Microsoft Cloud as an example of its effectiveness.
• Concerns: The competitive cloud market, Oracle's entry, and the monetization of AI are significant questions for Microsoft and other hyperscalers.
• Recommendation: Zechner does not own Microsoft because he finds other, cheaper opportunities. However, he recognizes it's a significant company to miss out on. He expresses concern about the overall sector weakness and the potential for rapid and sharp market movements due to high equity exposure and passive investing trends.

Shopify (SHOP)

• Valuation: Shopify's valuation is considered very high, even compared to Microsoft.
• Strengths: Zechner highlights Shopify's high annual growth rates (20-30%) and its unique market position. He sees it as similar to Amazon a decade ago, with improving operating profits and margins.
• Recommendation: Zechner likes Shopify and sees no reason to sell. He holds a decent position in the stock, though not at an index weight. He believes the company has a unique product and is well-positioned to capture the online transformation market.

Well Health Technologies (WELL)

• Recent Performance: Numbers were a bit weaker on the US side, and the company is expected to divest some US assets to focus on Canada.
• Concerns: Zechner finds it difficult to get a firm grip on companies at the growth stage in healthcare due to regulations and competition.
• Recommendation: Zechner previously owned Well Health but sold it. It's on his radar, but not currently in the portfolio. He wants to see a clearer focus on Canada and divestment of US assets.

Nutrien (NTR)

• Outlook: Zechner likes Nutrien, considering it undervalued relative to historical trading levels.
• Strengths: Dominant in key markets, strong vertical integration into retail operations.
• Potential Catalysts: Rumors of selling the phosphates division could lead to debt reduction or stock buybacks.
• Recommendation: Zechner views Nutrien favorably for the long term, citing its market share in potash and nitrogen and its integrated retail operations.

UnitedHealth (UNH)

• Concerns: Zechner notes that health insurance in the US remains a difficult market. Criminal charges against UnitedHealth are a significant negative.
• Alternative: He prefers CVS as a better play in the sector due to its drugstores and PBM business, offering a cheaper multiple (12x forward earnings) compared to UnitedHealth (high teens).

West Fraser Timber Co. Ltd. (WFG)

• Industry Challenges: Zechner describes the current outlook for lumber companies as "miserable," with many not making money.
• Tariffs: He highlights the negative impact of tariffs on softwood lumber.
• Recommendation: While not owning West Fraser, he is interested in companies at their worst-case scenarios. He prefers Interfor due to its US-domiciled lumber, making it less impacted by tariffs. He questions the rationale behind tariffs and suggests trade issues should be settled.

GoEasy (GSY)

• Concerns: Zechner is watching GoEasy after its recent tumble but needs more comfort regarding the quality of its subprime mortgages and potential for further write-downs.
• Analogy: He compares it to Home Capital, which was eventually bought out at a superior price.
• Recommendation: Not currently owned, but under close watch. He emphasizes that a significant pullback doesn't guarantee a stock is a buy if credit quality is a concern.

Past Picks Review

Zechner reviews his past stock picks:

Atkins (AT)

• Performance: Up 27% since his pick, benefiting from nuclear energy projects.
• Strengths: Expertise in CANDU reactors, growth in nuclear projects, and a shift to a better business model with long-term fixed-price contracts that offer higher margins and stability.
• Recommendation: Still owns it.

Pfizer (PFE)

• Performance: Down 5% since his pick, with a total return of about 0.5%.
• Concerns: The pharma space was impacted by political uncertainty. He notes it could be a "value trap" trading at 10x earnings with a 6% dividend yield.
• Strengths: Reinvestment of COVID vaccine profits into growth areas like oncology drugs. He sees potential growth from these investments and their existing pipeline.
• Recommendation: Still owns it and would buy more at current levels, citing downside protection and dividend yield.

Meta Platforms (META)

• Performance: Up 6% since his pick, but has seen a significant drop recently.
• Concerns: Negative reaction to AI spending and its productivity. Meta lacks a public cloud but implements AI through its existing platforms (WhatsApp, Instagram, Facebook).
• Strengths: AI implementation is driving advertisers to its platforms, leading to good revenue and advertising numbers. He believes hyperscalers will be the first to monetize AI effectively.
• Recommendation: Continues to own it and added to the position. He sees it as one of the best immediate beneficiaries of AI monetization.

Celestica (CLS)

• Performance: Had a great run, but Zechner sold it. He believes he left money on the table.
• Concerns: Potential for overcapacity in data centers, similar to the telecom bubble in the 2000s. He cites the Deep Sea news as an example of how quickly AI advancements can impact data center needs. Celestica is a low-margin business, making capacity issues more critical.
• Valuation: Trading at 40x earnings, which he considers excessive for a low-margin business.
• Recommendation: Take some profits and trim the position.

Dollarama (DOL)

• Performance: Consistent annual growth of 5-10%.
• Strengths: Strong same-store sales growth, store expansion in Canada and internationally (Mexico).
• Concerns: High valuation, potential for increased competition, and the impact of tariffs on sourcing.
• Recommendation: Zechner believes the trend will continue but not at the same pace. He compares its valuation favorably to Costco. He is monitoring the impact of tariffs on its lower-margin business.

MEG Energy / Cenovus Energy (CVE)

• MEG Energy Takeover: The deal is done, with 86% voting in favor.
• Cenovus Outlook: Zechner would prefer to own energy stocks with more natural gas exposure for better future growth. He notes Cenovus has improved its refining operations and the MEG assets will be a good fit.
• Recommendation: He would be more inclined to invest in companies with more natural gas exposure, such as Arc Resources.

Whitecap Resources (WCP)

• Outlook: Zechner likes Whitecap, considering it a steal on the Crescent Point acquisition.
• Strengths: Prime assets in the Montney Duvernay, good management, light oil production, and growth profile.
• Recommendation: He prefers Whitecap over Cenovus for an oil-levered name. He acknowledges concerns about the price of oil but believes the stock may fully reflect these concerns.

Amazon (AMZN)

• Performance: Had a good run-up.
• Strengths: AWS has returned to 20%+ growth. Zechner believes Amazon, Alphabet, and Meta will monetize AI effectively. He also highlights the significant cash flow generated by Amazon Studios, which is often overlooked.
• Recommendation: Continues to like Amazon and added to the position. He sees it as a strong player in retail, AWS, and media.

Econo (ECON)

• Strengths: Will benefit from infrastructure build-out, particularly in Ontario. They have improved margins on existing contracts and are moving towards a fee-for-service model, reducing earnings volatility.
• Recommendation: Positive outlook due to increasing infrastructure spending in Canada.

Thomson Reuters (TRI)

• Concerns: Valuation is the primary issue, trading at 25x cash flow, which is considered excessive for the level of growth.
• Strengths: Dominant in legal and financial verticals.
• Recommendation: The stock has come under pressure due to valuation concerns, similar to some Mag Seven tech companies.

New Top Picks

Zechner shares his latest top picks:

Torex Gold (TXG)

• Valuation: Trading at a discount to Net Asset Value (NAV) and about 5x operating cash flow.
• Strengths: Successfully transitioned to the Media Luna mine, bringing it into full production without missing a step. Generating free cash flow and has found underground periphery with copper content.
• Gold Market Outlook: Zechner believes gold stocks are cheap and gold could go higher, driven by central banks diversifying reserves away from the US dollar and fiat currencies.

Cargojet (CJT)

• Valuation: Trading at 6x forward operating cash flow, a significant discount to its typical 8-15x range.
• Strengths: Long-term contracts, particularly with DHL. Reduced capital expenditures. East-west routes into China.
• Concerns: Short-term demand risk due to trade issues and movements in Asia.
• Recommendation: Zechner believes the stock is cheap and has already reflected bad news, mitigating downside risk. He anticipates a return to globalization will benefit transport companies.

Adobe (ADBE)

• Valuation: Trading at 16x forward earnings, suggesting some of the worst has been priced in.
• Strengths: Core programs like PDFs will continue to be used, and AI can be implemented to enhance their effectiveness. He believes companies will not rip out decades of software investment solely because of AI alternatives.
• Concerns: Pricing might come under pressure over time, and demonstrating increased usage and productivity to clients will be crucial.
• Recommendation: Zechner believes the market is worrying too much too quickly about AI's impact on application software, creating an opportunity.

Conclusion

John Zechner presents a cautious outlook on the broader market, citing underlying weakness despite seemingly stable averages. He emphasizes the importance of valuation and the potential for significant market swings. His investment strategy involves shifting away from cyclical and consumer discretionary stocks towards software, long-term bonds, and specific infrastructure and energy plays. He highlights opportunities in companies with strong fundamentals that are currently trading at attractive valuations, particularly those that have been unfairly punished by market sentiment or short-term concerns. The discussion also touches upon the evolving landscape of AI and its potential impact on various sectors, from hyperscalers to application software providers.