Searching For A Bargain - Volume IV: Where Contrarians Look After A Monster Rally

Summary

• 2020’s bipolar market action continues as new highs follow a record crash in the first half.
• This article will review international market valuations versus valuations found on North American exchanges.
• It will also discuss beaten-up American sectors, contrary Canadian opportunities, and general trends.

Introduction

Twice a year I conduct a screen of North American indexes, international benchmarks, and a top-to-bottom assessment of the existing watchlist here at Contra the Heard Investment Newsletter. This latest watchlist could not be more different than the one produced in March and April. At that time, the COVID-19 Coronavirus had altered the investment landscape significantly, with major global benchmarks falling into bear market territory. By contrast, markets are now back at record highs, and 2020 may go down as the year of the bipolar stock market.

As a result, the watchlist has contracted significantly. Today the list includes 607 US stocks, 117 Canadian names, and 29 ETFs. By contrast, the spring 2020 watchlist included 701 US names, 152 Canadian companies, and 42 ETFs. Those interested in the spring 2020 review can read about it here.

During this review process, I was repeatedly greeted by companies that had rallied, yet in many cases revenues were down significantly and profitability was gone. Moreover, a lot of companies I had been interested in during March have since taken on a lot more debt, and/or have seen insiders selling in droves. This cocktail of attributes explains why the watchlist and resulting shortlist is much smaller than it was six months ago.

The goal of this process is to identify opportunities worthy of further review, or companies which may make good portfolio additions in the coming months and years. After this review, 19 of the 635 US names fit into this category. In Canada, the shortlist is 6, with three ETFs high on the radar too.

Before reading further, keep in mind that I will not be discussing the individual names found during the process. Instead, this article will provide an overview of the countries and industries we are looking at closely.

International versus North American Valuations – the US Remains Expensive

America is much more expensive than it was last year, and remains high compared to historic norms and other regions. One way to compare different countries is to use the so-called “Buffett Indicator,” which compares a nation’s current market cap to gross domestic product versus historic norms. Guru Focus provides this information here:

Source: Guru Focus’s Sept 3, 2020 Global Market Cap to Gross Domestic Product Table

Based on this metric, the United States is expensive and Canada is fairly valued. Though the Buffett Indicator is useful, considering an array of measurements produces more reliable signals. StarCapital does this by tracking a variety of metrics:

Source: StarCapital’s Aug 31, 2020 Global Stock Market Valuation Table

Here too, the United States looks overvalued. According to StarCapital, it is one of the more expensive nations, along with Brazil, India, Switzerland, and the Netherlands. Meanwhile, Canada is in the middle of the pack. Austria, Poland, Russia, South Korea, and the Czech Republic are the most undervalued, while China, Spain, Singapore, Italy, and Germany are close behind.

Understandably, many of these undervalued nations carry more risk than either the US or Canada. From corruption and limited rule of law in places like China and Russia, to poor demographics and massive debts in much of Europe, none of these geographies are for the faint of heart. Buyer beware!

Though there are many index funds which follow these geographies, a handful of ETFs which track these countries specifically are:

• iShares MSCI Austria ETF (EWO)
• Deutsche X Trackers Harvest CSI 300 China A-Shares ETF (ASHR)
• iShares China Large-Cap ETF (FXI)
• iShares MSCI China ETF (MCHI)
• SPDR S&P China ETF (GXC)
• iShares MSCI Germany ETF (EWG)
• iShares MSCI Italy ETF (EWI)
• Poland (EPOL)
• iShares MSCI Russia Capped ETF (ERUS)
• VanEck Vectors Russia ETF (RSX)
• VanEck Vectors Russia Small-Cap ETF (RSXJ)
• iShares MSCI Singapore Capped ETF (EWS)
• iShares MSCI South Korea Capped ETF (EWY)
• iShares MSCI Spain Capped ETF (EWP)

Going long on cheaper markets is one strategy, but shorting the expensive ones is another. We do not short here at Contra the Heard Investment Letter, but those who do may want to consider these ETFs, which track the world’s relatively overvalued markets:

• iShares MSCI Brazil ETF (EWZ)
• iShares MSCI India Index ETF (INDA)
• WisdomTree India Earnings ETF (EPI)
• iShares S&P India Nifty Fifty Index ETF (INDY)
• iShares MSCI India Small Cap Index ETF (SMIN)
• Invesco India ETF (PIN)
• VanEck Vectors India Small-Cap Index ETF (SCIF)
• iShares MSCI Netherlands ETF (EWN)
• iShares MSCI Switzerland ETF (EWL)
• Invesco CurrencyShares Swiss Franc Trust (FXF)
• Invesco QQQ ETF (QQQ)
• iShares Core S&P 500 ETF (IVV)
• SPDR S&P 500 Trust ETF (SPY)
• Vanguard S&P 500 ETF (VOO)
• Vanguard Total Stock Market ETF (VTI)

We do own international ETFs here at Contra the Heard Investment Newsletter, but our preference is to generate foreign exposure through American Depositary Receipts or to invest in international organizations listed in North America. American Depositary Receipts are a mixed blessing, however, as while they do give investors exposure to enterprises abroad, they generally also come with high fees.

Beaten-up American Sectors

The rebound from March has seen valuations increase for most sectors. Here is a valuation breakdown for the S&P 500 today:

Source: Guru Focus’s S&P 500 sectoral breakdown – Sept 2020.

Though most sectors are clearly overvalued, there are a few that are not. Energy, for example, is one such sector. Skilled investors should be able to find value in this space, but be warned – it’s full of landmines given that shareholder dilution is common, many balance sheets are debt-heavy, and overall cash flows have evaporated. Other debt-heavy industries that showed up in droves during this review included REITs, steel companies, airlines, specialty chemical makers, hospitality providers, and restaurants.

Financials are beaten up too, in everything from asset managers and regional institutions to international banks and insurance companies. Covid has not turned into a housing crisis, and banks are in much better shape than they were in 2008, but the second or third order impacts of COVID-19 may include defaults among individuals, households, and companies (especially as government “stimulus” subsides). If defaults occur, it will impact the banks. In the aftermath of 2008, Contra the Heard took several positions in American banks. Though most were sold years ago, recently I took a position in First US Bancshares (FUSB). You can read more about First US Bancshares or Contra’s bank holdings in the prior cycle here and here.

Other sectors or sub-groups which showed up consistently during this screening process included apparel retailers, cruise ships, casinos, movie theaters, transportation/logistics companies, data outsourcing companies, home furnishing providers, auto part suppliers, and international telecoms.

Contrary Canadian Sectors

Unlike stock exchanges in the United States, the Toronto Stock Exchange is primarily concentrated in three sectors: financials, energy, and mining.

Source: TMX Group - Sept 4, 2020.

Of these three, mining has shot higher with shining metal prices, while banks have returned to form, and energy has lagged. The precious metal rally has benefitted Contra the Heard given it has some exposure to the space via various positions, including Sprott (SII), Alacer Gold (OTCPK:ALIAF), and Major Drilling (OTCPK:MJDLF).

Canadian oil outfits, however, like their US counterparts, are in a tough spot. This is made even more challenging by the cost of extracting from oilsands, pipeline problems, and the discount Canadian oil gets versus West Texas Intermediate. Balance sheets among Canadian oil companies are often stretched as well, with a lot of debt compounded by significant shareholder dilution. Add on falling revenues and net losses, and investing in this industry requires a great deal of skill and courage.

Aside from energy, Canadian investors may be able to find downtrodden opportunities in retail, asset management, aerospace, and in basic materials including pulp, paper, and specialty chemicals. The REIT sector is another contrary space, but the industry outlook appears bleak, and balance sheets often look stretched. Nevertheless, it is in these non-oil or mining sectors where we are finding the most interesting Canadian companies for consideration at the moment.

A Quick Comment on the Market and Portfolio Positioning

The dichotomy between March 2020 and August 2020 could not be more profound. 2020 may go down as the year of the bipolar market given that the stock market’s shocking collapse in the first half of the year has now been matched by an equally shocking rally. Central bank liquidity, commitments to do “whatever it takes”, and government backstops or “stimulus” have overwhelmed the bears. But how far central banks and governments can and will go remains to be seen. It is also unclear what the longer-term benefits and drawbacks will be. One thing appears certain though, and that’s the time-proven fact that while central bankers, politicians, and c-suite officials may claim to be free market supporters in theory, in reality, many only support “free markets” while prices go up.

Before central banks and governments initiated supportive measures, investors faced the possibility of asset and consumer price deflation coupled with a deep recession. While this risk may still be in play, investors now face the possibility of asset price inflation, consumer price inflation, or both.

Unfortunately, it is difficult to position a portfolio for both deflation and inflation, as deflation punishes holding stocks, while inflation punishes holding cash. Personally, I am trying to position my portfolio in a middle ground by holding both. By taking this (admittedly ambivalent) approach, I will ideally be less injured than I would be otherwise if deflation prevails, but will also reap fewer rewards than I would otherwise if markets continue to rally or inflation prevails.

Conclusion

2020 has been a volatile year. This volatility has been reflected in the difference between the watchlist review conducted in March and the recent review conducted in August. Since March, many companies have rallied, yet revenues and profits have fallen, debt has ballooned, and insiders have headed for the exits. As a result, my watchlist has contracted from 895 securities in March to 753 securities today.

Many international markets (especially Austria, Poland, Russia, and South Korea) appear cheap compared to North American exchanges, where US stocks have some of the richest valuations out there. Though North America is expensive, specific sectors including energy, financials, and certain consumer discretionary subsectors remain cheap. There are also many beaten up REITs, airlines, transportation companies, and specialty chemical makers, to name a few other sectors.

The trick between now and the next review in six months will be to take the top candidates on the current watchlist, and to invest in the most interesting prospects among them. Any purchases made in the near future must also be considered within a framework where it is unclear if a central bank-fueled inflation environment will prevail over a deflationary environment brought about by Covid-19 and the accompanying reductions in economic activity. The recent rally suggests the central banks are winning, but it is still too soon to tell what will happen as we continue to struggle forward through these challenging times.

Disclaimer

The opinions expressed – imperfect and often subject to change – are not intended nor should be taken as advice or guidance. Contra the Heard Investment Newsletter is not an investment advisor or financial advisor. Contra the Heard Investment Newsletter provides research, it does not advise. The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed by the author.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long MJDLF, ALIAF, SII, FUSB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.