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Investors hunting for value in the U.S. stock market have to contend with a trifecta of challenges: high valuations, high margins and slowing global growth, said Daniel Dreyfus, a partner at 3G Capital.
The best opportunities, therefore, reside in stocks capable of bucking each of those trends, he said, explaining his focus on the combination of reasonable valuations, low margins relative to potential and little exposure to the global economy.
"We think the opportunities today in the market are in companies where they're under-earning."
Mr. Dreyfus spoke in Toronto on Wednesday at the Capitalize for Kids investing conference, which raises money for the Hospital for Sick Children.
Trading multiples on U.S. stocks are at the higher end of their historical range, while profit margins are "extremely elevated," he said. Combine that with wobbly economic growth readings, and investors should expect choppiness over the next year or so.
"Looking at the markets going into 2016, we think it's time to be reasonably cautious. There are definitely opportunities out there on the long side, but the key is to be selective."
Here are some of the top investing ideas presented by the conference's speakers.
Daniel Dreyfus, partner, 3G Capital
Stock pick: Reliance Steel & Aluminum (RS)
Close: $54.90 (U.S.), up 89¢
Identifying underappreciated U.S. companies with the potential to increase margins is a challenging undertaking in today's market environment.
The best candidates likely have some exposure to two wounded sectors: energy and housing, he said.
Housing activity in the United States is still in the process of recovering from the Great Recession and the bursting of the real estate bubble, while the global oil market is likely in a "bottoming process."
Reliance is one of those stocks with exposure to both, he explained.
The company processes metals products for a variety of end users, mostly non-residential U.S. construction companies, as well as some energy firms. "This is really a distribution business," he said. And it has virtually no business outside the United States.
And the company has the proven ability to withstand economic and industry downturns, having in its 20-plus years of trading history lost money in just one single quarter – the second quarter of 2009. "This is a cash machine."
Daniel Lewis, managing partner, Orange Capital
Stock pick: Amaya Inc. (AYA)
Close: $28.50, up $4.17
Amaya's stock performance has been shaky since it announced its acquisition of PokerStars in June, 2014, as an ensuing insider trading investigation clouded the stock.
"The stock is controversial in nature, for reasons we really object [to]," Mr. Lewis said. "This is really a media storm … It doesn't affect the operations."
Investigation aside, the company has 40-per-cent EBITDA margins, minimal capital expenditures, a diversified revenue base and earnings growth in excess of 30 per cent a year, he said. "The company is really a classic tech story where they're disintermediating the real estate owners and casino operators."
Mr. Lewis said he sees the potential for aggressive earnings growth and a tripling in Amaya's share price over the next three years.
Blair Levinsky, partner and co-founder, Waratah Capital Advisors
Stock (short): High Liner Foods Inc. (HLF)
Close: $14.08, down $1.51
The implosion of the resource sectors has pushed Canadian investors into other parts of the domestic stock market, leading to a rise in valuations without a corresponding improvement in earnings, Mr. Levinsky said.
"It's an overcrowding phenomenon which leads to a scarcity premium."
One such stock trading at an undue premium is High Liner, he said. "The valuation is not reflecting reality."
On the surface, High Liner's numbers may look good, with strong recent growth in revenue and EBITDA, as well as steadily rising dividends. But the company has undertaken a campaign of acquisitions, which have "masked some tremendous declines in the business," Mr. Levinsky said.
Organic volume growth at High Liner has undergone 13 successive quarters of declines, margins have compressed and debt used to support M&A has spiked.
As a result, Mr. Levinsky expects the company's EBITDA targets to prove unrealistic.
"This is an example of value destruction," he said.
The stock has declined substantially over the previous two months, but is still facing 50-cent-downside, he said.
Jeffrey Smith, CEO, Starboard Value
Stock pick: Advance Auto Parts (AAP)
Close: $192.04 (U.S.), up $2.51
The advanced age of the average U.S. vehicle, combined with resilience to economic decline, has positioned the after-market auto-parts business well in recent years.
And indeed those trends have benefited Advance's peers. But while Advance itself has little problem generating revenues, its margins substantially lag its competitors, Mr. Smith said.
"It's becoming more and more inexcusable for Advance to allow this margin discrepancy to continue."
On Wednesday, activist investor Starboard announced a 3.7-per-cent stake in Advance, fuelling an 11-per-cent one day gain in the stock to around $190. Mr. Smith said he sees the potential for $350 per share.
"We have a plan," he said. Reshaping the supply-chain strategy, improving working capital and divesting non-core assets could lift profit margins by up to 750 basis points, he said.
"It's not a scale problem," he said. "It's an execution issue."
Tim Shufelt