How to invest against and against central banks

Soft landing is still possible. (Photo: 123RF)

The long-term outlook for equities is relatively good, but short-term uncertainty prevails as central banks fight inflation by raising interest rates.

Stu Cadwell, co-CEO of Canadian equity fund PH&N, the F-series (with a gold rating of 4 stars, $ 2.4 billion in assets under management, also available in the D-series), says the measures could push the economy into recession.

“Variable levels of liquidity and the impact it has on financial conditions may force some other investors to make shorter-term decisions that will affect prices, or companies may have more financial leverage than they should otherwise,” says Stu Cadwell. Senior Vice President and Senior Portfolio Manager, Co-Head of RBC Global Asset Management’s North American Shares in Toronto (RBC GAM). “When you are going through a period when central banks are withdrawing liquidity, this can be problematic for some investors. This is not a problem for us, because we do not use financial leverage and our time horizon is longer. But this can create great instability. “

The impact of the conflict between Ukraine and Russia should not be underestimated

Stu Cadwell, who has 26 years of experience in the industry and joined RBC GMA in 2002, agrees that while the conflict between Ukraine and Russia is a humanitarian crisis, the impact on supply channels and reactions in commodity markets has been partially renewed. “At the moment, although we would all like to see a solution to the war in Ukraine, I am focusing on withdrawing liquidity from central banks.”

However, adds Stu Cadwell, even these movements are not taken into account to some extent. “When the yield curves change the way they do, the market tries to calculate the future. Much of the boost we’ll see has already been taken into account for performance over the next 12 months. “

The market is partially setting prices in a downturn

Another concern is the impact on profits, says Stu Cadwell. “There is probably a 50% chance that the recession will be assessed by the stock market. So we need to consider two things: first, what the estimates will be after interest rates take effect. The S&P 500 index recovered to 17-fold profit. Just as most interest rate changes are likely to be reflected, the valuation movement has also taken place to some extent. The second question will be: at what levels of earnings do we apply these levels of assessment? And here our scenario approach is really important. Because for a company or a market, we may be wondering what it looks like in a recession and how much these profits are lower than current expectations. What multiple will be applied to these profits? Then we will be able to create a portfolio in such a way as to offer as many profitable options as possible, regardless of the final environment of the game. “

Stu Cadwell is part of a four-member team that includes Doug Raymond, Senior Vice President and Senior Portfolio Manager, North American Equity Co-Manager, Sarah Nilsson, Vice President and Senior Portfolio Manager, and Irene Fernando, Vice President and Senior Portfolio manager. Using a value-based approach that measures stocks under different scenarios, Cadwell and Raymond have controlled the portfolio since the fund was founded in December 2009. From the beginning of the year (May 27), the PH&N Canadian Equity Value Fund returned 2.5%, compared to -1.00% for the Canadian Equity category. During the 5-year and 10-year periods, the fund’s annual income was 9.18% and 9.94%, respectively. Instead, the category recorded annual returns of 7.53% and 8.55% for the same periods.

“While there are always problems when refinancing costs rise, we focus primarily on profits,” says Stu Cadwell, adding that earnings growth forecasts for 2023 are 5-6% in the United States, the United States and the same in Canada. “It probably reflects a soft landing in the economy. If the economy slows down further, there may be a risk to profits. “

Soft landing is still possible

Stu Cadwell points out that if there is a “soft landing”, the bottom of the market will be reached sooner. “In the event of a recession that could happen in the next 6-12 months, it could happen later in 2022. There is a certain seasonality in the market, as it often recovers a bit in the summer and experiences a more difficult period of decline, ”explains Stu Cadwell, who argues that inflation is likely to have peaked and may stabilize by the end of the year.

Given the market correction in late April, Stu Cadwell and his team took advantage of lower prices to use some of the fund’s 2% cash on existing and new holdings. “Of the 11 sectors in the S&P / TSX index, the only ones that are traded above their historical levels are goods, communications, industry and utilities. They are very defensive. But the rest of the market is trading at or below its historical value. Despite the fact that the cash is 2%, it did not worsen the work of the fund. The bottom line is that you can find stocks that are trading below average.

Focus on valuable stocks

In terms of margins, managers cut some utilities and consumer goods companies, where prices rose, and redistributed revenue to several companies. For example, they like Onex Corp. (ONEX) and Power Corp. (POW), both of which are traded at a discount to the value of their net assets. “We’ve also redistributed some of our capital to banks,” said Stu Cadwell, noting that four of the 10 largest holdings are Canadian banks.

From the point of view of the sector, financial indicators have the largest weight of 32.5% of the portfolio, followed by energy with 19.1%, industrial enterprises with 11.9% and basic materials with 9.5%.

When building a portfolio, managers apply different attributes to different sectors. “The energy and basic materials sectors are looking for low-cost suppliers with strong management teams and smart balance sheets so that the company can withstand the ups and downs of the raw materials market,” says Stu Cadwell. Financial services are about finding high returns on equity and return on equity. Not that this is not the case in the commodity business, where you tend to take a ton of capital and accumulate it over a period of time. But commodity prices are ultimately an important factor in profits. You need to look at the balance and structure of cash expenditures.

Strong faith, strong concentration

At the head of a portfolio of 83 items, the top 10 of which is almost 40% of the fund, managers mention Maple Leaf Foods Inc. (MFI), a major Canadian supplier of meat and protein products. “They built their business responsibly, focusing on profitability and managing their environmental impact,” said Sarah Nilsson, who joined RBCGAM in 2004 after four years as an engineer in the automotive industry. “It is a carbon neutral company with a vision to be the most sustainable protein company in the world.”

The company, which earned $ 4.5 billion in 2021, has made significant strategic investments over the past few years to achieve its profit-making goal, ”said Sarah Nilsson. But the market is in the observation phase. We went through a very difficult environment because Maple Leaf Foods is a time-consuming business facing COVID, inflationary pressures and supply chain problems. But management is increasingly focusing on improving EBITDA margins (interest income, taxes, depreciation) by more than 2% in 2023. They want to increase sales of some of their marginal products, such as those that do not require antibiotics and are a growing market share. Shares of Maple Leaf are traded at approximately $ 28 at a value of 7.5 and EBITDA of 7.5. Shares pay a dividend income of 2.85%. Managers estimate that this could increase by about 30% over the next two years due to improved revenue and valuation.

Another favorite is Altagas Ltd. (ALA), an energy infrastructure company in Calgary that operates a natural gas distribution system in the United States and a medium-sized energy company in Western Canada. “We invested in it in 2018, when things were bad for the company, and the market really reflected that,” says Sarah Nilsson. At the time, the company had completed a major acquisition of a utility that burdened the business with high debt and financing requirements, which the market said would hamper its ability to distribute dividends and possibly require a huge need for share capital. The share price was severely punished and fell to almost $ 15 at the time we invested in this stock at the end of 2018. “

But despite the pessimism of the market, Sarah Nilsson believed in business. “We expected that a change in management and an adjustment to dividends would improve its position both financially and in the market.” In fact, a new management team has been created, and by focusing on capital allocation, it has reduced the company’s debt. “Throughout this period, shareholder value has risen.” Today, the stock price has doubled to $ 30.

Sarah Nilsson and her team later estimated that the base rate for Altagas’ utility business could grow by about 8-10%, while medium-sized businesses will benefit from increased natural gas production as the industry develops its liquefied natural gas capacity. “In addition to stable earnings growth and dividend growth of 5-7%, there may be some revaluation, which should lead to an increase in stock prices.”