How to Invest Against and Against Central Banks

A soft landing is still possible. (Photo: 123RF)

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

Stu Kedwell, co-manager of PH&N Canadian Equity Fund, Series F (Gold rating, 4 stars, $2.4 billion in assets under management, also available in Series D), says these measures could lead to a recession in the economy.

“Changing liquidity levels and the impact this has on financial conditions could force some other investors to make short-term decisions that will affect prices, or companies could have more financial leverage than “they should otherwise,” says Stu Kedwell. . Senior Vice President and Senior Portfolio Manager, Co-Head of North American Equities at RBC Global Asset Management in Toronto (RBC GAM). “Any time you go through a period where central banks are withdrawing liquidity, this can be a problem for some investors. This is not a problem for us, because we do not use financial leverage and our time horizon is longer. But that could create a lot of volatility.”

Do not underestimate the impact of the conflict between Ukraine and Russia

Stu Cadwell, who has 26 years of industry experience and joined RBC GMA in 2002, agrees that while the conflict between Ukraine and Russia is a humanitarian crisis, its impact on supply chains and commodity market responses is being partly renewed. “At this point, while we would all like to see a resolution to the war in Ukraine, my focus is on central bank liquidity withdrawals.”

However, Stu Cadwell adds, even these movements are discounted to some extent. “When yield curves have changed the way they are, the market tries to calculate the future. Most of the tightening we will see is already factored into performance over the next 12 months.”

The market is partially valuing the recession

Another concern is the impact on profits, notes Stu Kedwell. “There is a 50% chance that a recession will be priced into the stock market. So we need to consider two things: first, what the valuations will be after the interest rates take effect. The S&P 500 multiple recovered to a 17x gain. Just as most interest rate changes are likely to be mirrored, valuation movement has also taken place to some degree. The second question would be: At what levels of income do we apply these valuation levels? And this is where our script-based approach really matters. Because for a company or a market, we may wonder what it looks like in a recession and how much these earnings are below current expectations. What multiplier will be applied to this profit? We can then build the portfolio in such a way that it offers as many value propositions as possible, regardless of the final environment.”

Stew Cadwell is part of a four-person team that includes Doug Raymond, Senior Vice President and Senior Portfolio Manager, Co-Head of North American Equities, Sarah Neilson, Vice President and Senior Portfolio Manager, and Irene Fernando, Vice President and Senior Portfolio Manager. Using a value-based approach that measures stocks according to a range of scenarios, Cadwell and Raymond have controlled the portfolio since the fund’s inception in December 2009. Since the beginning of the year (May 27), the PH&N Canadian Equity Value Fund has returned 2.5%, compared to -1.00% for the Canadian equities category. Over the 5-year and 10-year periods, the annual return of the fund was 9.18% and 9.94%, respectively. In contrast, the category recorded annual returns of 7.53% and 8.55% for the same periods.

“While there are always challenges when refinancing costs rise, our focus is primarily on profits,” reiterates Stu Kedwell, adding that profit growth forecasts for 2023 are 5-6% in the US and Canada. “It probably reflects some kind of soft landing in the economy. If the economy slows further, there could be a risk to earnings.”

Soft landing is still possible

Stu Kedwell points out that in the case of a soft landing, the market bottom will be reached earlier. “In the event of a recession that could occur in the next 6-12 months, it could come later in 2022. There is some seasonality in the market, as it often bounces back a little in the summer and has a more difficult period in the fall,” explains Stu Kedwell, who argues that inflation has probably peaked and could stabilize by the end of the year.

Given the market correction at the end of April, Stew Cadwell and his team took advantage of lower prices to use some of the fund’s 2% cash for existing and new investments. “Of the 11 sectors in the S&P/TSX index, the only ones trading above their historical levels are commodities, communications, manufacturing and utilities. They are very defensive. But the rest of the market is trading at or below its historical valuation. Despite the fact that cash is 2%, this has not reduced the performance of the fund. The bottom line is that you can find stocks that trade below the average price.”

Focus on value promotions

As a last resort, managers cut some utility and consumer goods businesses that had risen in price and reallocated the proceeds to several businesses. For example, they like Onex Corp. (ONEX) and Power Corp. (POW), both of which trade at a discount to net asset value. “We also reallocated some of the capital to banks,” says Stu Kedwell, noting that four of the ten largest assets are owned by Canadian banks.

In terms of the sector, the financial sector represents the largest weight with 32.5% of the portfolio, followed by energy with 19.1%, industry with 11.9% and basic materials with 9.5%.

When building a portfolio, managers apply different attributes to different sectors. “In the energy and basic materials sectors, it’s about finding low-cost suppliers with strong management teams and sound balance sheets so that the company can withstand the ups and downs of the commodity market,” says Stu Kedwell. In the financial services industry, we are talking about high return on equity and return on equity. Not that this isn’t the case in the commodity business, where you tend to take a ton of capital and hoard it over a period of time. But commodity prices are ultimately an important factor in earnings. You have to look at the balance sheet and the cash cost structure.”

Strong faith, strong focus

At the head of a portfolio of 83 items, the top 10 of which account for almost 40% of the fund, managers call Maple Leaf Foods Inc. (MFI), a major Canadian supplier of meat and protein products. “They have built their business responsibly, with a strong focus on profitability and managing their environmental impact,” says Sarah Neilson, who joined RBCGAM in 2004 after four years as an engineer in the automotive industry. “This is a carbon neutral company with a vision to be the greenest protein company in the world.”

The company, which posted $4.5 billion in 2021 revenue, “has made significant strategic investments over the past few years to achieve its goal of improving profitability,” said Sarah Neilson. But the market is in the observation phase. We are facing a very difficult situation as Maple Leaf Foods is a labour-intensive business that has experienced challenges from COVID, inflationary pressures and supply chain issues. But management is increasingly focused on boosting EBITDA (earnings before interest, taxes, depreciation and amortization) margins by more than 2% in 2023. antibiotics and make up a growing market share.” Maple Leaf shares are trading at around $28 for an enterprise value to EBITDA ratio of 7.5. The shares pay a dividend yield of 2.85%. Managers estimate upside potential could be around 30% over the next two years thanks to improved earnings and valuation.

Another favorite is Altagas Ltd. (ALA), a Calgary-based energy infrastructure company that operates the natural gas distribution system in the United States and a medium-flow energy company in Western Canada. “We invested in it in 2018 when the company was doing poorly, and it really reflected in the market,” says Sarah Nilson. At the time, the company completed a major utility acquisition that saddled the business with high debt and funding needs that the market felt hampered its ability to distribute dividends and may have required a huge equity requirement. The stock price took a big hit and dropped to almost $15 by the time we invested in these stocks at the end of 2018.”

Yet despite the market pessimism, Sarah Neilson believed in the business. “We expected that the change in management and the dividend adjustment would improve its position both financially and market-wise.” Indeed, a new management team is in place, and by focusing on capital allocation, it has reduced the company’s debt. “Throughout this period, the value to shareholders has been rising.” The share price has doubled to $30 today.

Going forward, Sarah Neilson and her team estimate that Altagas utility base rate increases could be around 8-10%, while the transportation and processing business will benefit from increased natural gas production as the industry develops its capacity to production of liquefied natural gas. “In addition to sustained earnings growth and a 5% to 7% increase in dividends, there could be some upward revaluation from there, which should drive up the share price.”

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