18 Months Later…
We believe that the day the Western world woke up to the risks of COVID-19 was March 11, 2020, when actors/couple Rita Wilson and Tom Hanks announced they had tested positive. If Forrest Gump could catch it, anyone could. At that point, markets had already priced in much of the pandemic and would bottom a couple of weeks later (35 days peak-to-trough).
Searching for value post-pandemic.
With news of the Delta variant dominating headlines, it is worth examining whether a strong economic recovery should remain our baseline assumption, and if we should continue to stay fully invested despite elevated market multiples. Read
Economies are in full recovery mode with vaccination rates improving daily across OECD countries. Worldwide COVID-19 cases have fallen 17% week over week with G7 nation cases falling 25-30%. As anticipated, most of the Western world will be vaccinated by fall, setting up a return to normal economic activity. Investors need to decipher the permanence of change in consumer and industrial companies as a return to normal will spur different behaviours from a locked-down economy.
As we enter May, markets are in the midst of a stellar first quarter earnings season. The strength was likely anticipated given the 5% rally markets enjoyed in the first half of the month but confirmed our view that better than anticipated earnings would make the market appear less expensive than indicated by its 23x P/E multiple. Revenue and earnings per share are beating estimates by an average of 72% and 83%, respectively (hat tip to Morgan Stanley). The earnings beats are by a wider margin than usual, although this is a typical early cycle trend. For the third quarter in a row, mega-cap technology companies reported outstanding results. On average, the group beat revenue estimates by 8% and EPS estimates by 35%, demonstrating the operating leverage of internet-enabled businesses.
The last 373 days.
From March 23, 2020 through March 31, 2021 the S&P 500 returned 77.6% (before dividends), making it one of the greatest investment periods in history. Hindsight is 20/20 of course, but even with perfect foresight of the severity of the coronavirus and its impact on global economic activity, an investor that sold at the February 2020 high would have missed out on a 17% gain (again before dividends) in the subsequent 13 months. So how can investors navigate markets that are seemingly detached from reality?
At MWG, we turn to our investment philosophy, based on the following tenets. The first one can be summarized in different ways, including the stock market is not the economy/the random walk of wall street/nobody knows a thing, all of which allow us to ignore noise, stay fully invested and participate in the long-term compounding of the stock market. The second tenet could be summarized as micro over macro as our focus remains on buying strong companies that we are comfortable owning with indifference to the macro environment. Finally, think long term. While the pandemic was devastating on a variety of levels, the opportunity to buy companies like Starbucks or Airbus, for example, at a price ~50% lower than the prior month was extremely attractive to us as we viewed long-term coffee consumption and air travel as unaffected by the pandemic (the emphasis on long-term cannot be understated). In short, don’t waste a good crisis.
So where to from here? Your guess is as good as ours. But we feel comfortable owning companies like Alphabet, Facebook and Amazon that are the new digital landlords for e-commerce. Or Aritzia, which used the pandemic to hire best-in-class talent in fashion e-commerce SKU count as it continues to grow its design, lease premier real estate and expand its influence in women’s apparel. Or Linamar, a company that has consistently added to its capital base and grown its full cycle earnings potential. Case in point, in the 2002-2007 cycle, Linamar’s EPS peaked at $1.58. In 2012-2020, its EPS peaked at $8.94. We expect this cycle’s EPS peak will far eclipse its historic levels in the coming years.
The MWG Global Equity Growth Fund
returned 2.9% in March, bringing its year-to-date return to 9.1%. The top performing portfolio companies were Spin Master (+36% at exit), BMW (+19%), and Alliance Data (+15%), while Twilio (-14%), Royal Caribbean (-9%), and Adyen (-5%) underperformed.
During the month, we added two names; German e-commerce retailer Zalando and Canadian-based mining exploration driller Major Drilling. Zalando is the largest e-commerce platform for apparel in Europe with 36M customers. The company’s focus on customer-centricity and selection makes it a first stop for consumers browsing for a new item (“if I cannot find an item on Zalando, it doesn’t exist”). The company is expanding its fulfilment and marketing services for European retailers through its partner program, which allows retailers to tap into its customer base but maintain control over their inventory, branding, and pricing. We believe this strategy will lead to an accelerating return on equity through the decade even as the company expands into new countries and product lines (such as beauty and homeware). The company is guiding to a tripling of sales on its platform by 2025.
Major Drilling provides exploration drilling services to mining companies around the world. Following a five-year bear market that saw depressed levels of exploration and capital expenditures for new mines, metal prices surged in 2020. Now, with copper prices eclipsing US$4/lb and gold prices supportive of ongoing exploration, we expect capital spending to increase. Unlike the prior mining cycle from 2004-2012, the company’s drilling rig fleet is in good shape and does not require a large retrofit program, a claim its competitors cannot make as some find themselves in financial difficulty. Major Drilling provides a high-torque play on a broad increase in exploration spending without assuming the geological risks from company-specific exploration results.
To fund the new positions, we exited our positions in Tapestry and Spin Master Inc.
The MWG Income Growth Fund
returned 5.5% in March, bringing its year-to-date return to 14.1%. The top performing portfolio companies were Intertape Polymer (+18%), Newell Brands (+15%), and Canadian Natural Resources (+13%), while Chemtrade Logistics (-3%), Broadcom (-1%) and BP (-1%) underperformed.
During the month, we added Canwel Building Materials. Canwel is a vertically integrated distributor of homebuilding products such as lumber/wood products, fibres, siding and insulation, with locations across Canada and the Western U.S. The company also owns treating and planing facilities, timberlands and pressure-treated wood production plants (among other assets). The company proved its operating discipline in 2020, as it was able to increase gross margin despite the stresses in the industry, and should benefit from continued strength in home building and renovation activity. We also believe Canwel will continue to consolidate and take advantage of new geographies or vertical integration opportunities. The shares yield 5.3%.
The concept of interest rate duration should be front and center in investors’ minds. Duration is an asset’s sensitivity to change in interest rate. For years, falling interest rates provided a tailwind to markets…real estate, bonds, equities, you name it. With the reopening of economies on the horizon, rates are beginning to increase, with the U.S. 10- year Government yield rising 60 bps year-to-date. This move likely explains the underperformance in many large-cap growth stocks as these companies derive most of their value from their long-dated cash flows five-plus years out. Whether this move in rates is a simple adjustment or the start of a longer move higher is yet to be determined. Read
Gamestop is a one-of-a-kind market event that will go down in investment lore. The legendary trade, with roots as early as September 2020; the blow-up, the hedge funds that took it too far; and the cinema, as the entire world watched in awe and spectacle. While the theatrics provide a great reason to break out the popcorn, it’s difficult to see the lessons from the whole debacle beyond the old investment adage, “Short selling has potential for unlimited losses.” The chaos created a large hedge fund de-grossing (selling long positions to fund margin requirements/or reduce short positions) and was responsible for the volatile market that closed out in January. Read
The holidays are often a time to reflect, and there was a lot to think about over an unostentatious Christmas period with restricted travel and gatherings. We will delve into our performance in more detail below, but let’s review how your investments performed in 2020. Read
Equity markets surged to new highs in November on a flood of successful COVID-19 vaccine results, with the S&P 500 index rising 8%. With healthcare analysts now forecasting a sufficient level of vaccinations to achieve herd immunity by late spring 2021, markets have been looking through the second wave and the recurrence of social distancing in most of the Western world.
Are we there yet?
Despite a good earnings season, markets moved lower in October on high expectations in the tech sector and deflated optimism regarding the reopening trade. Whether it was also the stalled stimulus deal, the resurgent second wave of COVID-19 or election night jitters is up for debate, but as we move through another winter with COVID-19 case counts rising, the market is priced for uncertainty. Read
Moving Through the Second Wave…
Last month, we stated our belief that it was unlikely a second wave of the Coronavirus would lead to a revisiting of the market lows. This belief was tested in September as more countries around the world entered the second wave (Canada, Europe, Japan). The virus is not proving as deadly as it was in March 2020 as death/ hospitalization rates remain low relative to published case counts. This is having the effect of lessening the perceived risk of contracting the virus. Moreover, with social distancing regulations in place and businesses making the necessary adjustments, governments are more hesitant to encourage lockdowns for economic reasons.
The Stock Market is Not the Economy.
It’s becoming increasingly apparent that the COVID-low in the market occurred in March. That statement may seem blindingly obvious with the S&P500 reaching a new all-time high on September 2, but after a continuous bombardment of headlines like “economy sucks, stocks overvalued”, it can be tough to see the forest for the trees.
Technology remained in focus in July, with results from the technology leaders speaking to the durability of these businesses. Economic activity plunged in the Q2 of 2020 (recall the Coronavirus did not affect North American economies until the last 3 weeks of Q1), with U.S. GDP falling at a 32.9% annualized rate. Recently released financials for most internet technology companies, however, reveal how the world is adjusting to a digitally enabled future.
Figure 1: Revenue, EBITDA & free cash flow growth for mega-cap technology companies
The companies highlighted in Figure 1 above grew their revenue, on average, 18% during a quarter in which many companies will report revenue or cash flow declines in excess of 20%. This resiliency further proves out the concept of valuing these companies more like stable utilities as opposed to obsolescent-prone technologies. Smaller, high growth software companies have fared even better. For example, Global Equity Growth Portfolio holding Twilio grew its Q2 2020 revenue 46%. According to Bernstein Research, tech outperformed the broad market by 22% in the first half of the year.
Sectors like banking, retail and commodities, which tend to be more affected by the cyclicality of the economy, continued to plough forward. Many companies are reporting gradual improvement through July. However, the economic trough is so deep that a gradual improvement is unlikely to move the needle financially. While COVID-19 remains an issue, the fact that a resurgence in cases in the southern U.S. is not leading to widespread deaths or market panic should be viewed positively. This supports our recovery thesis, although economies will remain choppy until a COVID-19 vaccine is available.
We believe society will continue to adjust to social distancing measures as a new normal and thus expect markets will shift focus to the U.S. Presidential race. Betting odds have shifted in favour of Joe Biden (from a 40% to a 60% chance of winning) since June in response to the Trump Administration’s handling of the Coronavirus pandemic (the U.S. has far and away the highest number of cases per capita in the G7).
It’s difficult to determine the future course of the Coronavirus but it does appear that U.S. daily case counts peaked in July (see Figure 2 below). If cases continue to trend downward, even temporarily, Trump may be able to shift focus back to the economy and China. However, it’s too soon to call this one just yet.
Figure 2: U.S. Coronavirus case counts with 7-day average
The MWG Global Equity Growth Fund rose 3.2% in July, bringing its year-to-date return to -1.0%. Over the past twelve months, the portfolio has returned 6.7%. The top performers in June were Twilio (+25% return), Intuitive Surgical (+19%) and Pfizer (+17%). Raytheon and Aritzia were our weakest performers during the month (-9% and -7%, respectively). Continued strength in the Canadian Dollar also reduced results from our U.S. portfolio when converted to Canadian dollar.
We initiated two new positions in the Fund in July. We started a 2% weighting in Aon, a global Insurance broker and business consultant. The company offers a broad range of solutions, such as risk, retirement, health & benefits, and re-insurance, aimed at large businesses. Insurance brokers enjoy high retention rates (90+ percent) without needing to take on the risk of underwriting or employing regulatory capital. Thus, any organic growth occurs at very high incremental margins. Aon has seen its free cash flow margin increase to 19.1% from 8.2% in 2010, along with a similar improvement in return on capital metrics. Aon (the #2 player in the industry after Marsh & McLennan) is in the process of acquiring the #3 player, Willis Towers Watson, to create the industry’s largest broker. We believe the additional scale and synergies should prove significantly accretive to Aon’s EPS. Valuation is not undaunting at 19x P/E and 5.5% free cash flow yield.
We also purchased a 1% position in Tyler Technologies. Tyler is a provider of local and state government software in verticals such as financial management, courts and judicial services, record keeping and education (among others). Tyler’s cloud-based solutions are much more dynamic than legacy software systems built in the 1980s and 1990s. Thus, as governments look to modernize systems and empower public services, Tyler should see strong demand. The company estimates that its systems represent about 6% of the installed base and believes that up to 70% of existing systems are candidates for replacement. The company is also an active acquirer, completing 11 tuck-in acquisitions in the past three years. The valuation is stretched at a 67x P/E but Tyler generates strong free cash flow and has a very long runway of growth.
As well, we exited our position in IBM. While we are encouraged with the management changes and the inroads made in its cloud computing division, the Coronavirus has accelerated its clients’ move to the cloud, with some analysts suggesting COVID-19 has pulled forward five years of digital strategy initiatives. At this time, IBM does not have the right suite of products in the marketplace, and we believe IBM’s new management team may have a more difficult time pivoting to the cloud.
The MWG Income Growth Fund rose 0.2% in July and is down -26.3% year to date. Over the past twelve months, the portfolio has returned -20.9%. Intertape Polymer (+33%), Evertz (+12%) and PRO Reit (+8%) were the top performing equities during the month. Chorus Aviation (-21%), Corus Entertainment (-16%) and American Hotels (-15%) most hampered performance.
We made no portfolio changes and continue to believe the portfolio will recover with continued increases in economic activity. Specifically, banks should see loan losses decline.
Equity markets closed out the second quarter on a high note, extending the rally off the low of March when investor fears surrounding the economic impacts of the Coronavirus were at their peak. The month was not without volatility, however, as it featured a rapid ascent in early June, a subsequent decline in cyclical stocks and several single days of large declines (including a 6-7% decline in indices on June 11).
Equity markets posted a second consecutive month of gains in May. Volatility indicators calmed, providing some comfort to investors, and focus shifted to the re-opening of economies. Notably, most companies have reported financial results and were able to provide investors with some clarity regarding the depth and duration of the impact of the Coronavirus. With social distancing measures still in effect as economies re-open, businesses that can generate revenue in the face of depressed foot traffic, through delivery, click-and-collect or digital services, have grown their share of wallet to the detriment of those industries that have been affected to a greater extent.
Investors remain anxious, with many in denial of the market recovery. However, tangible data points are pointing to a solid change in both market and economic indicators. From a technical standpoint, more stocks in the S&P 500 are above their 50-day moving averages, a measure of relative short-term stock support, than at any other time in the last 20 years, with a reading of 95%.
At MWG, we often opine the benefits of a recession as a chance for businesses to recalibrate operations, trim excess and win market share from weaker competitors. Similarly, recessions have a wash-out effect on investors as losing positions are dumped once and for all, long-term winners are sold to book profits and new positions are established to benefit from the recovery. This portfolio re-organization creates a musical chairs-like scenario as investors race to position for the recession only to find out they have missed the market bottom. As more and more stocks recover, investors lament on missing the rally, tricked by the market they were so sure they could time, only to later submit and re-enter at higher prices.
To be clear, there will be another sell-off/correction/recession, but it is unlikely to be caused by the Coronavirus. Companies have adjusted operations to manage through lockdown/social distancing measures, governments have a playbook on how to help affected business and better therapies or vaccines should be available in short order. That’s not to say heavily affected industries such as travel and entertainment won’t see further deterioration but growth in other discretionary sectors and digital expansion should persist.
Interest rates remain accommodative, digital growth is fueling economies and households appear apt to start spending and re-opening. We believe we should see markets continue to move higher.
The MWG Global Equity Growth Fund rose 5.0% in May, bringing its year-to-date return to –5.2%. Over the past twelve months, the portfolio has returned 6.5%.
The portfolio benefitted from strong returns from our most recent purchase, Twilio, which rose 79% on very strong results, as well as Royal Caribbean (24%) and Linamar (18%) on recovery hopes. Tapestry and Alliance Data were our weakest performers during the month, although we believe both companies will provide lots of torque in an economic recovery (the two companies have returned 23% and 26% in June).
We made no additions or deletions to the Global Equity Growth Fund. Our target weight changes were driven purely by market fluctuations. Upon reviewing each position, we felt the relative performance and new weightings were justified given the outlook for each company.
The MWG Income Growth Fund fell -1.6% in May and is now down 28.2% year to date. Over the past twelve months, the portfolio has returned -20.3%
We made no changes to target allocations during the month. After a strong rebound in April, many positions reversed gains in the first half of May as the market rotated towards growth over value stocks, which compose a large segment of the fund. Real Estate, Financials and Industrials continue to be impacted by COVID-19 concerns; however, we believe there is the potential for above-average returns over the next 18 months. Case-in-point, preliminary data suggests the portfolio has returned 11% in the first week of June.
We have stress-tested all the companies in the portfolio, and we believe that as the economy opens up, business activity will normalize and the profitability of many companies will return to 2019 levels. As such, share prices should follow. We continue to find opportunities for companies paying dividends in the 6%-10% range that are covered by cash flow once adjusted for the impact of COVID-19.
V-Shaped Recovery? So far so good, but...
The markets continued their recovery from March lows, with hopes pinned on the rapid response from governments around the world to backstop workers through aggressive unemployment benefits and their support of affected industries through favourable loan programs. Behind the scenes, massive liquidity was provided to financial markets to stabilize bond markets, which flowed through to equity markets. As well, epidemic modelling of COVID-19 cases and hospital data indicates that infection rates are peaking or declining in many hard-hit jurisdictions, allowing governments to start implementing plans to re-open shuttered sectors of the economy. Read
It’s never priced in…
Equity markets suffered one of their sharpest drawdowns in history during the month of March as the expansion of the Coronavirus through the Western Hemisphere led to extreme social distancing and a sharp decline in demand.
We now have a new worry in the financial markets, with the World Health Organization deeming the outbreak of the Wuhan Coronavirus as a Global Public Health Emergency. There is still much unknown about the virus and its ultimate effects on the economy. What we do know currently is that Chinese economic growth will be impacted, and thus, revenue and profits of companies with operations in China and those selling into the country will be affected. For example, both Apple and Nike have closed all their retail stores in China. Cyclicals and industrials will be impacted as well, with airlines and cruise lines cancelling trips. China’s oil consumption is down 20% as factories suffer and in-country transport is limited. Read
Happy New Year!
With each new year comes the opportunity to reflect on the months just past, as well as prepare for the year ahead.
Our aim in 2020 is to build upon our successes over the last year and drive further growth of the Murray Wealth Group, while continuing to provide you with the same level of transparency and insight we have always brought. We’re excited about the many new opportunities that await us in 2020, and we look forward to sharing those with you as they come to fruition.
With December now in full swing, we want to wish all our readers a wonderful Christmas season and a Healthy, Prosperous and Happy New Year!
So far, 2019 is turning out to be a great year for investors, far better than what many anticipated during the near panic selling experienced in last year’s 4th quarter.
November was very generous, with major North American indices registering gains of 3.4 – 3.9%. The markets often rally into the new year.
This year, commentators have focused on FOMO (Fear of Missing Out) as institutional investors, who had raised cash or reduced their exposure to volatility in anticipation of weaker markets, panicked to reduce cash levels in fear of losing their bonuses or jobs (both of which are tied to performance). Read
Our October market report is being written in a small café in Kyoto, Japan, as Bruce and Jamie tour different parts of Asia following a family wedding. Never fear, our commitment to investing (and jet lag) have kept us closely following the rise in equity markets to all-time highs.
We will touch on some thoughts from our Asian travels in our November monthly research. Read
September brought a major rotation in equity markets, with growth stocks suffering substantial pullbacks from peak levels and out-of-favour value stocks rallying. Generally, the more profitable growth companies were able to withstand the volatile markets, but several high-profile growth-at-any-cost stocks (See Figure 1) suffered peak-to-trough pullbacks of 35-40%. With year-to-date gains still strong, long-term investors in high growth stocks are likely barely batting an eye, but the strong IPO slate in the first half of 2019 likely brought an influx of investor interest and new money into the sector. Read
Trade and tariff concerns escalated in early August as the Trump Administration raised the stakes with a new round of tariffs on Chinese goods and an escalation of existing tariffs. To date, the tariffs have had a limited effect on U.S. consumers as the U.S. has focused tariffs on products that are easily substitutable, with multiple origin destinations, and products that are isolated from the U.S. consumer. However, the new tariffs announced in early August will impact consumer-related goods such as apparel and electronics. Although the U.S. pushed back the implementation of the new tariffs after the initial announcement, it represents an escalation in the trade war between the two countries.
Powell delivered the rate cut the market wanted on July 30. The first decrease in interest rates since 2012. The question was (is) whether this would be a ‘one and done’ scenario or if additional cuts should be expected before 2020. Fed Chairman Powell was non-committal indicating the rate cut was “a mid-cycle adjustment to policy,” and not “the beginning of a lengthy cutting cycle.” While the market negatively reacted to Powell’s commentary, ultimately the rate cut helped the market rally through June and July.
Attention quickly turned from Fed-watching to trade wars when President Trump tweeted a new round of tariffs on US$300B of Chinese goods. Trump and Powell have publicly clashed on the pace of rate cuts and it’s speculated that Trump is using trade and tariffs to stall the economy and build the case for additional rate cuts. Trump would then be in position to make a trade deal with China in 2020 and spark the economy into the next election.
Overall, the U.S. earnings season should be viewed positively with a focus on technology bellwethers beating on revenue and reducing capex (hello, MSFT, GOOG, IBM, FB, AAPL) all while the outlook for cloud-based computing remains strong. We highlight a news release from LinkedIn, indicating its intention to move from its in-house servers to the Azure public cloud Infrastructure (not shocking as LinkedIn and Azure are both Microsoft companies). The real nugget is that the migration will be multi-year initiative, again indicating the long runway for cloud growth. LinkedIn is a relatively simple company with website and user data as well as its apps for various platforms. That it will take three-plus years to fully migrate highlights the complexity as well as the opportunity. Consider AT&T’s cloud deal announced with Microsoft – the largest ever (upwards of US$2B of revenue although timeframe and other relevant was not provided). AT&T (recently integrated US$85B Time Warner merger) would have dozens of legacy data systems to migrate over time as well as new use cases such as its apps for its soon to launch streaming platform. Best of all, cloud computing has so far eschewed any scrutiny from U.S. antitrust watchdogs even though four companies (MSFT, AMZN, GOOG, IBM) are poised to control much of the server infrastructure housing U.S. corporate, government and citizen data (our crystal ball thinks this will be an issue at some point).
TSX-listed companies will report en masse in the first two weeks of August providing additional information into the domestic economy. The TSX continues to suffer from a lack of institutional dollar flow as capital flees Canada. In July, the market increased a meagre 0.1%. The market remains concerned about elevated housing risks and negative energy sentiment. We are not immune to these effects with holdings in commodity producers Stelco, Cameco and Enbridge (pipelines) as well as an 80% weighting to Canada in our Income Fund. However, the banking sector remains healthy and there are a number of global champions headquartered in Canada that present opportunities. Read
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