Our Thoughts... May 2023 Commentary

Despite a turbulent March, North American markets posted positive year to date returns. As always, the question is where do we go from here?

The state of the portfolio is strong. Over the past year our US companies generated a 22% return on equity while growing revenue 9% and our Canadian companies generated a 14% return on equity and grew revenue 10%. Our portfolio still remains very inexpensive as we always measure the value of each of our companies and compare the total weighted value against the current market price. The difference is the ‘Value Gap’.

Today the Value Gap of the portfolio is over 60%, the second largest we have ever seen, only behind that of the 2008/9 period where the portfolio rose 62% in the following 12 months.

Macroeconomic forecasting is not critical to investing?

We believe consistently excellent performance can only be achieved through superior knowledge of companies and their securities, not through attempts at predicting what is in store for the economy, interest rates or the broader securities market. Skill, hard work, and insight can lead to a knowledge advantage, and thus to potentially superior investment results. Therefore, our investment process is entirely bottom-up, based on proprietary, company specific research.

We believe that no one has the predictive ability required to correctly time markets consistently. This is why we invest whenever attractively priced assets are available. Concern about the market climate may cause us to tilt toward more defensive investments, increase selectivity or act more deliberately. Holding investments that decline in price is unpleasant in the short-term, but the inherent strength of the North American economy will in the near future drive these investments higher, so long as our judgement about the underlying business was reasonable.

Although we are stock pickers, we still must consider the economic, social and political context in which the stocks are being picked, because sometimes the environment dominates. This is such a time.

The consensus view is that we are heading towards a recession. Thus far, the economic data is of two minds. The rate of inflation has been coming down, wage rates have been moderating and interest rates have been rising but remain at the average of the past 30 years. Recent employment data has been very robust, however the banking industry is in turmoil after events of mid-March.

Overall the US banking system is healthy?

In the first quarter of 2023, the collapse of Silicon Valley Bank and two other regional banks specializing in cryptocurrencies sparked concerns about the health of the US banking system and the potential for a wider economic fallout. The government’s intervention to stabilize the banking sector seems to have succeeded, for now.

The banking industry is very healthy and while this turmoil is certainly worrying, there is almost no possibility of a recurrence of the 2008 financial crisis. Bank capital has improved significantly since 2008,?partly due to stricter bank regulations and capital requirements. The equity cushion in the banking industry is by far the highest it has been in years.

The poor financial management that led to a mismatch of deposit and liabilities, combined with the concentration of the depositor base, were unique problems that led to the demise of Silicon Valley Bank. These issues will undoubtedly cause tighter regulations on?small and medium sized banks in the future.

?Apart from its implications for new bank regulation, the regional banking crisis will likely be negative for the US economy. Lending conditions have tightened since the second quarter of 2022 and may tighten more resulting in further negative impact on overall economic growth.

The inflation rate is coming down

After nearly two years of higher inflation squeezing consumer wallets and contributing to the unprecedented swift rise in interest rates, a decline in the rate of inflation is now underway.

From peak inflation last June, the inflation rate in Canada has averaged just 0.2% per month (under 3% annual rate), and US inflation has averaged under 0.3% per month.

In both Canada and the US, core CPI (that is CPI less volatile food and energy) has been quite steady at 0.3% per month for the last 6 months — a 4.0% annual rate, more than double both central bank’s target.

The US Producer Price Index for final demand declined 0.5% in March, on an unadjusted basis, the index for final demand advanced just 2.7% for the 12 months ended in March.

Importantly, the major causes of the increasing inflation over the last two years are simmering down. Russia’s invasion of Ukraine sent global commodity prices soaring in early 2022, but energy prices have been coming down since then (see chart).

The supply chain disruptions of early 2022 are now ameliorating and combined with slightly softer consumer demand have slowed inflation in core goods. Housing inflation remains high but rent increases for new transactions have begun to stall.?

While inflation may not be falling as fast as the central bankers had initially hoped, it is coming back to manageable levels.

The Central Banks seem to be nearing the end of their tightening cycle

Since March 2022, the Canadian and American central banks have hiked interest rates at an unprecedented pace in an attempt to bring down inflation. The Bank of Canada rate jumped from 0.25% last March to 4.5% today, and it appears the bank will hold that rate for a while. The Federal Reserve raised interest rates from 0.25% last March to 5.0% - 5.25% now. The Fed suggested that it would likely be the last increase and expect a decrease in interest rates in 2024.

Interestingly, Futures markets prices are at odds with the Fed’s view. Futures markets are pricing in interest rate cuts for the second half of 2023, reflecting the concern that overly aggressive monetary tightening could tip the economy into a recession.

?Labour market conditions continue to be bright

Canadian employment is rising, and the unemployment rate has been holding steady at 5.0%, just shy of the record low 4.9% set last June and July. This is good news because the labour force itself has been growing. While wages rose 4.5% year-over-year in January, the rate of wage inflation has been trending down since last summer.

The US labour market has been strong as well. The unemployment rate, at 3.5% is just 0.1% above its 50-year low and the number of unemployed persons, at 5.8 million, has stayed steady. Wage rates have risen 4.2% over the past year, barely keeping up with inflation.

Unemployment will probably remain very low. Diminished legal immigration over the course of the pandemic and baby boomers reaching retirement age has left the economy short of workers. Wage growth should continue to moderate as the inflation rate trends down.

Could the economy slip into recession??

Recession fears dominate the news cycle, and unusually, key recession indicators have been flashing for nearly a year without Canada, the US or the eurozone going into a recession. The post-Covid rebound has receded, though major economies have maintained positive year-over-year growth.

The Banking system turmoil has furthered the vulnerabilities of an economy facing a rapid rise in interest rates in a very short period of time. As the economy confronts these challenges, it may soften, but by how much? We do not have the answer. Regardless, it appears that if a recession were to come it would be short lived and shallow. The economy in late 2023 should be on the mend. Meanwhile, the turmoil is causing stock prices to gyrate creating unusual opportunities, and some hardship.

The biggest position in our portfolio is the Toronto Dominion Bank (TD). The stock has continued to weaken, in part due to the weak stock price of Charles Schwab, of which TD has a 12% holding (over $10 billion). When the Schwab stock price was rising, TD didn’t get any benefit, so it is a bit puzzling why TD has been negatively impacted as the Schwab stock has declined.?Additionally, TD has made an offer to buy First Horizon Corp, a US regional bank. It is widely expected that TD will renegotiate the offer price as a result of the banking turmoil that has struck the price of every regional US bank. We will have to wait and see.

TD trades are priced at just over $80, under 10 times earnings, with a dividend yield of 4.7%. It remains one of the most, if not the most, conservative, highly capitalized North American banks. Go figure!

We continue to remain invested in companies with strong recurring revenue in businesses that enjoy a tailwind. We are confident that our portfolio will enjoy a strong rebound when the economy is supportive again.

The bear market has proved challenging to another one of our holdings, Blackstone. But it will eventually give way to a tailwind driving a surge of inflows of assets into Blackstone, boosting earnings and dividends.

Some high-net-worth investors requested redemptions of Blackstone’s retail REIT in excess of the allowed monthly limit, hurting the share price over the last few months.

On April 11th, Blackstone closed its latest global real estate fund with $30.4 billion of new total capital commitments — the largest real estate or private equity drawdown fund ever raised. Blackstone’s three opportunistic strategies (Global, Asia, Europe) now have $50 billion of capital commitments. It is clear, despite the market environment, that Blackstone’s ability to raise vast sums of money continues unabated.

An estimate by alternative asset data provider Preqin sees the alternative asset industry doubling by 2027 with high-net-worth investors being a big driver of that growth. Blackstone should see a flood of inflows into these products as investors seek to capitalize on the next bull market.?

This will grow the company's fee related earnings and position it to capture higher performance revenue. Those dual drivers should power accelerated distributable earnings growth in the coming years. The higher earnings should put a charge in the company's stock price, helping fuel substantial returns while adding to its already lucrative (5.4% yield) dividend income.??

In an interesting development, JP Morgan has asked senior executives to be in the office 5 days a week. Other banks in New York have made similar requirements. For people with significant responsibility, working remotely does not work. Company culture suffers. Many of the naysayers about office occupancy might find they have been too pessimistic. We have recently initiated a new position in Allied Properties REIT. The share price, which is down about 63% from its peak, has been way oversold and its strong downtown Toronto development program that is coming to fruition over the next few years will prove to be very successful.