Rachel, my 15 year old daughter, is taking a grade 10 business course that includes a unit on the stock market and investing. It’s an important part of the high school curriculum, and I have felt compelled to supplement the teacher’s work with some overlooked lessons of my own. At least for Rachel’s sake. The students are all part of a stock market challenge, selecting three investments at the start of the term, tracking the performance each week, and competing over the five months of the course for the best performing ‘portfolio’. You can see where I’m going with this. I was thankful that Rachel offered to entertain my advice in her selections. We agreed to choose our investments using three separate strategies. The first investment was a proven wealth creator and compounder of capital – Brookfield Asset Management. The second investment was a business embarking on a material change in strategy intended to provide future growth and to diversify their business – Westshore Terminals. And the third investment was a newer, emerging business in a sector experiencing tremendous growth but with an unproven track record – Quisitive Technology Solutions. We are currently in third place.

I have highlighted the faults in the class challenge to Rachel. Three investments is not a suitable number for any portfolio. Watching the fluctuations in price week to week will only lead to poor decisions. And five months is far too short of a time period to evaluate the true merits of your investment decisions. It’s been useful to have the selections of the other student’s portfolios to drive home these lessons as the portfolios consisting of cryptocurrencies, Tesla and/or stocks quoted on Reddit have provided great examples. Rachel has been reluctant, to-date, to share my views with her teacher or her classmates on what has been overlooked in this class.

Market Comments

The volatility and minor selloff in global markets over September and early October weren’t significant enough to be considered a correction, but they felt more damaging than they were because of the long, consistent run of positive periods we had experienced since mid-2020. I think the decline can be explained by any combination of investor worries – the Chinese real estate sector, fading encouraging Covid news, rising bond yields, economic momentum potentially plateauing – whether real or perceived to be an influence.

Third quarter earnings season may have arrived just in time too. The trend in corporate earnings had been fairly consistent, and predictable, since economies began to reopen over a year ago. As the momentum of economic activity gathered steam, so too did the expectations and the results of most companies in most sectors of the market. That trend started to change in early fall of this year as the pace of upward revisions from research analysts started to slow. Third quarter expectations were low relative to the previous four or five quarters.

The positive market results over the past month or so have been a reflection of the encouraging corporate results outpacing these muted expectations. Market performance will follow corporate performance, based on both the direction of corporate profit growth and the strength of that growth. Companies have indicated that demand remains strong and backlogs, indicative of future demand, are also healthy.

Some of the tempered expectations leading up to the results this quarter were due to the well documented challenges of sourcing materials, the significant strain on logistical infrastructure, and the difficulty in attracting and retaining workers. Many companies have now said they have found ways to adapt, or manage, by sourcing materials from new suppliers or passing on cost increases to protect profit margins. For many companies, this adaptation has meant improved efficiencies due to advances in technology and productivity improvements to be able to do more with less. As we see these bottlenecks and resource restrictions get resolved, I think it sets up for a continued runway of corporate earnings strength through most of 2022.

Labour shortages and wage pressures are a greater risk, in my view, than the materials shortages, the transportation bottlenecks, the port congestion and the supply chain issues. The pool of available workers in many regions seems to have shrunk, and it’s not clear how easily it will right itself. Since the onset of the Covid pandemic people have left the work force for various reasons – early retirement, child care, concern for personal safety, or government assistance providing little incentive to work. Low immigration levels help to explain the high job vacancy rates as well. Should this labour shortage persist long enough to create sustained wage pressure as the market for workers becomes increasingly competitive, it may start to produce a headwind to corporate earnings and affect the positive momentum for markets. This will be something I’ll be watching in the early part of next year.

Dividend Growth

I have talked extensively about the risks to our client’s fixed income assets in an environment of rising interest rates. We have been actively making changes with the bonds and bond funds we own to ensure we are best able to protect capital. Rising bond yields will result in a decline in the value of our current bonds and bond funds. There are implications for our equity investments as well, particularly for dividend paying companies. As interest rates rise and bond yields increase, there is the potential for selling pressure to affect the prices of dividend paying stocks such as utilities, financials and renewable companies. It is natural for investors to migrate towards the safety of bonds as the difference in yields between bonds and stocks narrows. The winners in this type of environment will be those dividend paying companies that have a track record of consistently growing their dividend year after year, and those companies that have purposefully indicated the pace of dividend growth investors can expect from them over the next three to five years. If a company’s dividend yield can match or exceed the expected rate of increase of rising interest rates, the pressure to move to a bond or fixed income investment will be less and the company’s stock will perform better.

The Office of the Superintendent of Financial Institutions (“OSFI”), the governing regulator for the Canadian banks and insurance companies, removed the restriction on dividend increases and share repurchases on November 4. This paves the way for companies to announce their plans to return capital to shareholders for not only 2021 and 2022, but hopefully set expectations for the next several years. This is positive news for Canadian banks and insurers.

We are not trading the Canadian banks based on the markets expectations for dividend increases or share buybacks. Each bank has their target payout ratio – the percentage of annual profit they distribute to shareholders via dividends. The restriction on dividend increases and buybacks during Covid has resulted in this payout ratio falling below target for most banks. Therefore, they have some catch up to play. While it may be tempting to switch to owning the bank or banks with the highest expected dividend increase based current versus projected payout ratio, I think it’s a short-term tactic with minimal relative benefit as almost all banks will announce a material increase with their upcoming quarterly results. I continue to favour Royal Bank for its dominant market position in most business segments, Canadian Imperial Bank of Commerce for its leading consumer lending business, and TD Bank for its U.S. banking business and sensitivity to higher interest rates.