The year 2022 was a very difficult year for the financial markets; however, our portfolios outperformed their respective indexes by 10% to 15%.
Equities fell by more than 15%, their worst year since 2008, while Fixed-Income fell by more than 10%. It was the first time in over 50 years that these two asset classes fell by more than 10% in the same year, and this is due to the sharp rise in inflation and interest rates. At the end of 2021, the U.S. Federal Reserve (Fed) rates stood at 0.1% and it forecast 0.9% for the end of 2022. Today, the rates stand at 4.33%, the largest hike in recent history.
Our outperformance was due to our tactical activity during the year and our diversified portfolio made up of high-quality equities. In 2021, we outperformed in a bull market by focusing on recovery stocks rather than those that benefited from the pandemic. At the beginning of 2022, we wrote that stocks should now be analyzed according to their impact from inflation as it had been greatly underestimated due to disruptions linked to the pandemic. The future proved us correct right away, and the situation was magnified by the invasion of Ukraine.

In our Q3 financial letter, we noted that inflation would slow due to high inventories, falling commodities and a slowing economy but that the latter would be contained due to labour shortages and huge cash reserves held by consumers. This scenario has started to come true in the last three months and the market has begun to bet on it. Our portfolios benefited from this, rising twice as fast as the markets in Q4, and we are confident that this scenario will continue in 2023.

Slowdown in Inflation

There are many signs that inflation is now slowing as quickly as it rose. Most commodities, including oil and wheat, rose by more than 50% at the beginning of the year before ending it at the same level than they started. Container prices were up 52% in April before dropping by 55% and ending the year down 30%. Inflation for the last three months stands at 0.6%, an annual inflation rate of less than 3%.
The market expects that rates will stop rising and even fall in 2023. We agree with the first point but are not convinced with the second. Higher inflation could occur due to demographics and the lack of resources. This scenario would be extremely favourable for our long-term returns.
The Fed may hike interest rates too far because it has not yet changed its message. We expect it to keep pace with inflation. The last two major indicators that are still driving inflation are employment and real estate. This situation is normal as they generally follow the economy. There is a major labour shortage, but the Fed is monitoring wage increases and employment offers, and they are back to 2021 levels. Real estate is rising due to the cost of financing and rent, and prices continue to hold despite rising rates and falling demand. There have been no forced sellers yet, but that could happen in 2023.
In 2022, we stated that several sectors were in a bubble due to easy money and new investors. Those sectors were technology, long-term fixed-income securities, cryptocurrency, and Canadian real estate. The first three burst in 2022 and investors suffered huge losses. Real estate will likely follow and could be the biggest risk to economic growth in 2023.
In Canada, a $500,000 mortgage currently costs about $2,400 in interest alone. Over the past 25 years, our real estate sector has grown three times faster than in the U.S. In addition, 40% of Canadians have variable interest rates compared to 1% of Americans. After a market rebalancing, which we find likely, real estate should do well over the long term because of the shortage of houses and high immigration.

Market Outlook in 2023

As the recent past has proven, it is dangerous to make predictions. You must be ready to change your opinion at any time.
Nonetheless, we are quite confident for 2023. Last year, investors were the most negative since 1987, and they believe that the problems from 2022 will continue this year. History has taught us that investing when everyone is afraid often pays off in the long run. Crises and uncertainty are part of economic cycles and have often preceded sharp increases. After a negative year, the stock market has risen by over 20% in 53% of cases since 1950. The stock market rises by an average of 17% twelve months after inflation peaks whether there is a recession or not. If there is a recession, the rise happens closer to the end of the 12 months and the year is more volatile.
In addition, our analysis shows that companies have started to perform based on their results and profit estimates, and not solely on their exposure to inflation. For example, the industrial, financial and technology sectors were impacted by inflation in the first half of the year. The industrial sector has rebounded strongly in the last three months, while the financial sector has stabilized and the tech sector has continued to fall.
As in the past, we will focus on equities that are easy to understand, that are leaders in their industry and that have good profit margins and will be able to maintain them. We will remain very active to adapt to changing market conditions.
Here is a summary of our exposure by sector.

Industrials and Consumer Discretionary

Both sectors were heavily affected by inflation but had opposite results in 2022.
Consumer discretionary fell during the year due to weakness in e-commerce, retail, and automotive. We were overweight in this sector at the beginning of the year but ended the year underweight. We sold Canadian Tire, our largest position at the end of 2020, with a 75% gain over two years. We anticipated that the high demand for certain products that arose during the pandemic would not last and that it would run into problems related to high inventories. This proved to be correct as the stock has lost 27% since then. It remains an excellent company and we expect to revisit it within 18 months.
The shift in consumer spending, especially in travel, explains why we purchased stocks in the industrial sector over the summer, making it our most overweight sector at the moment. We forecast that travel was going to be the priority for getting back to normal. Since capacity did not increase, prices were likely to, which would not bother wealthy people with record savings. That is what happened. Air Canada and Boeing are now in our ten biggest positions. Both posted small negative returns for the year but bounced back in Q4. Boeing has risen 57% in the last three months. Fifty-five percent of their revenues come from the military sector and an aircraft order made today will be delivered in 2028 at the earliest.
CP remains our largest position in the sector, up 12% for the year, and we believe it is well positioned for the future. Uber is our worst-performing position in the sector, down over 40%, but we believe it will bounce back as it is beginning to show very good cash flow, especially in mobility.

Commodities: Energy and Materials

You would think that these sectors that benefit from inflation would have both increased in 2022. Energy, the most disliked sector, was the only positive sector in the markets in 2022, up by over 50%. Materials finished at the same level than at the beginning of the year after a sharp increase in the first quarter. At the start of the year, we were overweight both sectors and still are.
We made a lot of purchases in energy in 2021, after realizing that demand would be higher than supply. That is what took place, and the situation was worsened by the invasion of Ukraine. Oil producers only reinvest 39% of their profits nowadays. Prices fell at the end of the year with fears of a slowing global economy, the lockdown in China and the sale of 200 million barrels of oil by the U.S. from its strategic reserves. All three factors are expected to be mitigated by 2023, with Americans having to buy back some of the oil sold. The sector is still unpopular and is trading two-times cheaper than the rest of the market, a first in 50 years. The energy transition will be highly complex and fossil fuels still account for over 80% of global energy production. The stocks in this sector will generate huge profits this year and will mostly return them to shareholders.
Our two biggest winners in this sector are Schlumberger, a European equipment manufacturer, up 80%, and Arc Energy, a natural gas producer, up 62%.
In materials, our biggest position remains Nutrien, in agriculture. The stock rose 7% in 2022 but was up over 50% in the spring. We did not take any profits because we were uncertain about the consequences of the war in Ukraine, given that the world’s two largest fertilizer producers are Russia and Belarus. We believe that the company is well positioned and that demand will exceed supply for a few years.
Our third-largest position, Canfor, a wood producer, dropped by 34%. It is still more than double our initial purchase price in 2020, and we took profits in 2021. The company will suffer in the short term but has promising long-term prospects and is trading at less than five times earnings.
Last, base metals, such as gold which has been down since summer 2020, bounced back at the end of the year and we believe they will continue to rebound in 2023.

Financials

Financials, the largest sector in Canada, is the sector where we are most underweight. Banks are difficult to analyze and should be affected by the decline in real estate. However, since they will also benefit from higher interest rates, we have started to make purchases, focusing on banks that are less dependent on Canada.
Our three largest positions outperformed the sector and are not Canadian banks: Wells Fargo, Manulife and Element Fleet. The latter, which manages and finances car fleets for large corporations, increased by 45% in 2022 and has a favourable outlook.

Technology

Technology, the most loved sector, fell by almost 40% in 2023. The drop was dramatic because almost half of the U.S. market was tied to it at the beginning of the year and retail investors were holding too much of it. Several stocks that never posted profits plunged by over 70%. Despite this, investors purchased more than $100 billion in the sector in 2022. History has taught us that that is a risky strategy; therefore, we will be very selective.
We held 9% of our equities in this sector at the beginning of 2022. Unfortunately, that percentage was the most detrimental to our returns. Our stocks are down by approximately 35%. We still consider them to be good stocks. During the year, we took advantage of the drop to buy leaders in their sector with good profit margins and good long-term themes and ended the year with 12% in the sector.
These firms are mainly in the semiconductor and software industries. We have initiated positions in Apple, Palo Networks (cybersecurity), Constellation Software and CGI, two stable Canadian software companies.

Consumer Staples and Healthcare

These 2 sectors considered defensive, did their job in 2022, finishing the year at the same level than the start. We overweighted them because we can find good companies that generate strong profits with sustainable long-term competitive advantages.
Our largest positions in consumer staples are still Alimentation Couche-Tard and Costco. After an excellent year in 2021, the former rose by 13% while the latter fell by 19%, which is still better than other retailers. We continue to believe in their long-term model.
Healthcare has been a pleasant surprise for our portfolios. At the beginning of the year, we took profits in CVS and Pfizer, which had performed well in 2021. Pharmaceuticals tend to fall each two years before U.S. elections, before rising again quickly. This year was no different. Between July and October, we seized the opportunity to buy Gilead, Merck, and Novartis, and they have risen by about 30% since then.
In this uncertain start of the year, the first reflex of investors is to add to these defensive sectors; however, we will most likely take profits in stocks that are now expensive.

Real Estate, Communications and Utilities

We anticipated that these sectors would not perform well and that turned out to be the case. Their revenues are often negotiated in advance and companies mostly hold a lot of debt and are affected by inflation and rising interest rates.
We sold our positions in Rogers and TC Energy at the beginning of the year and took profits in Telus. They have since fallen by 25%. We will remain cautious in these sectors.