Political meddling creates 2 buying opportunities

Political and regulatory problems can create buying opportunities for the patient investor. Vancouver-based HollisWealth® portfolio manager Elvis Picardo calls on his experience in international capital markets to identify two stocks to buy that he calls “textbook examples of buying opportunities created by political/regulatory noise”.

Political_MeddlingPolitical and regulatory risks—broadly defined as risks emanating from the political and/or regulatory environment that can have an adverse impact on a company’s prospects and profitability—are among the many threats businesses must deal with and manage. Companies in certain sectors, such as mining and energy, arguably have greater exposure to these risks than those in other sectors. For example, a mining company’s flagship project may be stalled indefinitely if it does not receive a key permit, or if a supportive government is supplanted by a hostile one.

In recent months, however, political and regulatory risks appear to be on the rise, making a growing number of companies in disparate sectors vulnerable to them. Witness the ongoing brouhaha over the expansion of the Trans Mountain pipeline, which has been dubbed one of the most polarizing energy projects in years. Or the General Data Protection Rule (GDPR) that came into effect across the European Union on May 25. Firms that are not in compliance with GDPR—which aims to give individuals more rights over their personal data—face fines of up to 20 million euros or 4 per cent of global annual revenues, whichever is higher. And then there are US President Donald Trump’s tweets, which can cause short-term volatility in stocks that are the target of his ire.

In some cases, the ‘noise’ from political and regulatory problems can create buying opportunities for the patient investor. The key here is distinguishing which development is a true signal of prolonged or terminal decline for a company’s fortunes, and which one is mere noise that could be transitory in nature, and hence prove to be a good buying opportunity.

We highlight here two stocks that we believe are textbook examples of buying opportunities created by political/regulatory noise. Both stocks are presently in our clients’ investment portfolios.

Will Ford follow through with Hydro One threats?

Exhibit 1 is Hydro One* (TSX—H), one of the largest electric utilities in North America. Its transmission network serves most of Ontario, which is home to 38 per cent of Canada’s population. While rising bond yields have taken their toll on the Canadian utility sector, which is down almost 10 per cent for the year, Hydro One has also been affected by its emergence as a hot-button issue in Ontario’s recent provincial election.

Consumers in Ontario pay higher rates for their power than those in any other province. The Globe and Mail notes that since 2006, the top rate for power in Ontario has surged four times faster than inflation. In a July 2017 report, the Fraser Institute stated that Toronto had the highest hydro rates across Canada, with the average monthly residential hydro bill $60 higher than the national average.

Hydro One was partially privatized in November 2015, when the utility had its initial public offering. The province of Ontario still owns 47 per cent of Hydro One, giving it a significant degree of control over the company.

Capitalizing on consumers’ dissatisfaction with the utility, Ontario Progressive Conservative party leader Doug Ford has vowed to fire the CEO and Board of Directors of Hydro One. Ford has labelled Hydro One CEO Mayo Schmidt the “six million-dollar man”, based on Schmidt’s total compensation of $6.2 million in 2017. Earlier in May, Hydro One’s negative news flow continued, with reports that the company’s executives and directors had awarded themselves a $25,000 annual pay hike, bringing annual compensation for directors to $185,000.

On the positive side, Hydro One is the quintessential defensive utility investment, since 99 per cent of its revenues are derived from regulated operations. It recently raised its quarterly dividend by about 5 per cent to $0.23 per share, for an indicated dividend yield of 4.7 per cent. The stock’s 11 per cent decline this year provides a good entry point, as it trades at about 14 times analysts’ average EPS estimate of $1.38 for 2019 (source: FactSet).

We view the pending acquisition of Avista Corp—a regulated utility with headquarters in Spokane, Washington, and operations in five US states—as a near-term catalyst for the stock. The acquisition increases Hydro One’s geographic and asset diversification, and the company expects it to be accretive to EPS in the mid-single digits in the first full year of operation. Post-acquisition, Hydro One expects to continue growing its dividend and maintain its targeted payout ratio of 70 per cent to 80 percent. Industrial Alliance Securities (of which HollisWealth is a division) rates the stock as a ‘Buy’ with a $26 price target.

Qualcomm awaiting Chinese approval of NXP deal

Exhibit 2 is Qualcomm Inc. (NASDAQ—QCOM). This global technology stock is the world’s biggest provider of mobile chips. Qualcomm also holds a massive portfolio of patents relating to technology that connects cellphones to cellular networks. In October 2016, Qualcomm bid $47 billion for Dutch chip maker NXP Semiconductors, a leader in automotive chips and secure identification, to solidify its leadership in new 5G wireless technology and diversify into new areas. The deal is still in limbo. While Qualcomm has received approval from eight of the nine required regulators globally, China has yet to approve the deal.

Over the past couple of years, smart-phone makers including Apple and Samsung have challenged Qualcomm’s licensing practices, since it charges a licence fee based on the value of the phone and not its components. Apple, one of Qualcomm’s largest customers, had sued the company more than a year ago on grounds that it should pay a fee based only on the value of Qualcomm’s connectivity chips and not the entire cellphone. In a bid to resolve the licensing dispute, Qualcomm recently lowered the price cap on which its royalties are based by $100 per phone, to $400.

Several rapidly unfolding developments have resulted in Qualcomm’s price chart resembling a roller-coaster ride in recent months. The licence dispute with Apple and other cellphone manufacturers had dragged Qualcomm’s stock price down to a 19-month low just below $50 in September 2017. In the first week of November 2017, Qualcomm surged after Broadcom made an unsolicited $103-billion offer to buy the company.

On March 12, 2018, President Trump blocked the proposed deal between the two companies, citing national security concerns. Meanwhile, Qualcomm is in the cross-hairs of the simmering trade war between US and China.

In April, the US Department of Commerce slapped a seven-year ban on component sales to Chinese phone maker ZTE Corporation by American suppliers, because ZTE had violated trade restrictions on Iran. The impact on Qualcomm is twofold. Most ZTE smartphones use Qualcomm processors, so an inability to sell to ZTE would dent Qualcomm’s revenues by about 2 per cent. As well, China could block the Qualcomm-NXP deal in retaliation against the US ban on ZTE.

As a result, Qualcomm’s stock has become something of a proxy for measuring the ebb and flow of trade tensions between the world’s two largest economies. Lately, the tone of exchanges between the two nations has become more conciliatory, and tensions appear to have lessened. On May 26, President Trump said that the US would allow ZTE to remain in business after it pays a $1.3-billion fine, changes its management and board, and provides high-level security guarantees.

That news has been positive for Qualcomm, which is also getting a lift from a new $10-billion stock repurchase authorization announced by the company on May 9. Qualcomm recently reaffirmed its guidance for fiscal 2019 non-GAAP EPS of $5.25 (which includes $1.50 EPS accretion from NXP), growing to $6.75 – $7.50 upon resolution of licensing disputes.

A resolution of its licensing dispute with Apple this year would imply that the stock is trading at a forward P/E multiple of between 8 and 9, a compelling multiple for a large-cap technology stock. With a number of catalysts on the horizon for Qualcomm, we believe the stock should be in a good position to make up for lost ground in relation to its peers over the rest of the year, as the noise dissipates and attention returns to its solid fundamentals.

Disclosures: * Industrial Alliance Securities is a member of Hydro One’s underwriting syndicate.  HollisWealth clients hold shares of Hydro One and Qualcomm in their portfolios. Elvis Picardo holds shares of Hydro One in his personal accounts.

This information has been prepared by Elvis Picardo, Portfolio Manager, HollisWealth®, and does not necessarily reflect the opinion of HollisWealth®. HollisWealth® is a division of Industrial Alliance Securities Inc., a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. The information contained in this publication comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. For more information about HollisWealth, please consult the official website at www.holliswealth.com.

Elvis Picardo, CFA, CIM, is a Portfolio Manager with HollisWealth® in Vancouver.   Prior to joining HollisWealth, he was Vice-President Research and a Portfolio Manager at a leading independent investment dealer in Vancouver. His experience in international capital markets has enabled him to develop a global perspective on portfolio management.

This is an edited version of an article that was originally published for subscribers in the June 2018/First Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

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