On Friday, January 14th, 2022, our annual Equity conference in Toronto came to an end. Four days of meetings and presentations from internal and external experts. Analysts, strategists and fellow portfolio managers. Their conclusion was unanimous. 2022 was going to be a positive year. Sure, there were signs of inflation, some supply chain disruptions and a large segment of the world still worried about Covid (i.e. China). But the previous 3 years had been very good and 2022 was still going to be such a year.

Fast forward to Friday, January 13th, 2023, our most recent Equity conference. Rita and I left Toronto in awful weather and took the train home. We had a lot of time to reflect on the conference. What came out of these four days of meetings was that everyone and their mother has a negative outlook for this year. Now, I don’t know how 2023 will end up. Like everyone else, I am well aware of interest rates, the war in Ukraine, public debt, various credit losses and a looming US recession.

But do I know what the market will do in the next few months? No clue.

The reason for this is that short term performance for the stock market is mostly driven by psychology. In other words, whether we’ll have a positive or negative year is more a factor of investor sentiment than anything else. Certainly, more than actual financial data.

Take for instance 2021 vs 2022. The first year was very good and the following was incredibly bad. Yet the earnings per share of the S&P 500 grew by 9.35% in 2022. You would have expected a good stock market,  instead the S&P500 went down by -19.44%. The reason is investor psychology. At the end of 2021, investors were willing to pay 25.5 times the earning of the S&P500. Twelve months later, the same investors were willing to pay 18.8 times the earnings of the same S&P500. For the TSX60, earning grew by 25.5%, but the multiple paid went from 17.6 in 2021 to only 12.8 in 2022.

If fact, 2022 turned out to be a historical year. Yes, stock market indices worldwide went down (The MSCI World index by -19.46%, the Nasdaq by -33.10% and the TSX 60 by -8.66% helped by oil), but it’s the bond market that really made it a historical year. According to theWall Street Journal, it was the worst year for bonds since 1842. Truly the worst in recorded history. How bad? The 30-year US Treasuries down by -32.1%, the 30-year Government of Canada down by -27.9% and the DEX Bond Universe Index down by -11.72%. Scary numbers indeed. 

Still there is a bit of good news for investors 

The first one is that in the long run, market performance is dictated by earnings. In other words, if a company doubles it’s earning in 10 years, the stock should do very well. This is well illustrated by the following chart. Since 1945, the S&P500 has basically gone in one direction (up) and followed earnings (table1). Research has shown that stock markets on a 120-month basis are 85% of the time driven by earnings. In contrast, on a 12-month basis, 85% of the performance is driven by sentiment, illustrated by multiple expansions or contractions. 

And earnings growth has been largely governed by economic growth (table 2). The gap between nominal GDP growth and earnings growth can be attributed to the fact that GDP includes governments, companies and people. Earnings are only dependent on companies. So more focused on growth but the direction is the same. Up.

The question becomes; where do you see economic growth in a few years? And with that answer, I’ll tell you where the stock market is going. So turn off CNBC, BNN and the likes. Forget the opinions and feelings of your friends.

Start instead with a credible estimate of how big nominal GDP will be. One source that doesn’t have anything to sell you and isn’t trying to get elected is the Congressional Budget Office (CBO). It regularly publishes its baseline projections of what the economy would look like in the current year and the following 10 years. Their projection for real inflation-adjusted GDP is for growth between 2.7% and 1.8%. Considering that real GDP is nominal GDP adjusted for inflation, it would be important to know what inflation will look like. Right now, inflation is coming down and It’s projected to be around 2.5%/2.75% on average for the next 10 years. 

With the economy growing, albeit slower than prior to 2008, we should expect the overall market to grow as well. 

My job is then to arm myself with the estimates outlined above and spend time finding the businesses that will be dominant in their economic sector 10 years from now. To outperform, I should also use periods of market weakness to add more of them.

As of Dec 31st, 2022, our long-term performance remains enviable (the second good news). Our 10-year average annual return for our Global 35 is 12.75%, compared to 10.02% for the relevant indices, for which I’m very proud but remain humble because a certain element of luck is always involved in such numbers. Our 1-year return in 2022 was -6.97%. Not happy about it, but to be expected from time to time. 

How do we generate such returns over the long run? By investing as co-owners in a small enough group of companies that our big winners can really move the needle but at the same time a group that’s diversified enough so that my mistakes won’t destroy the portfolio. We aim for between 35 and 45 companies. Companies like Richelieu Hardware, CP Rail, Metro, Parker Hannifin, Novo Nordisk, Visa and Microsoft. 

How do we choose them? The fundamental metrics of return on equity (ROE), dividend history and historical competitive moat are good starting blocks. Then, at what price do you pay for such business? Let’s look at a few of them.

Return on shareholders’ equity is a well-regarded measure of company performance. Its net profit divided by common and preferred equity. In other words, the higher the better. Companies like Novo Nordisk and Microsoft for instance all have a high ROE (respectively 70.6 and 39.0 on average in the past 5 years).

Dividends are paid in cash as you know. When we say dividend yield, we’re simply dividing the cash dividend by the present price of the stock. This distinction is important because the cash dividend is what you get in your pocket. And if the board of a company raises its dividend, its more cash paid out to you. Also, because a dividend is paid in cash, it represent money that the companies will not have for other things. Therefore, raising the dividend is a sign of strength. It means we’ll do so well tomorrow that we, the company, can pay out this cash dividend and still run the business (grow, invest, pay down debt, etc.). And because you can’t ask for it (the cash) back and cutting your dividend is a big no-no, raising your dividend is a big positive signal.

So, when companies like Metro (29 consecutive years) and Parker Hannifin (66 consecutive years) raise their dividend, it says a lot. 

Take Metro’s 29 year track record. Through 3 recessions, the 9/11 terrorist attacks, impeachment of two US Presidents, the Y2K worries, 1 global financial crisis and 1 world epidemic, Metro has raised its dividend every year since 1994. Were the board members/executives worried at some point about something in the future that could impact Metro’s financial strength? It’s almost certain. Afterall, they’re human and suffer from the same doubts and worries as the rest of us.

However their underlying business was strong, the company never overreached on leverage and so the company was (and probably will continue to be) optimistic about tomorrow and raised its dividend. For 29 years in a row… In the past 10 years, the dividend as increased on average by 15% per year.   

Does it make Metro a sure thing? No, of course not. Take mid-2007 to early 2008 (table 1).  

The Great Financial Crisis is not yet on full blown display. And anyway, why would a grocer implode like it did? 50% down in 8 months (the blue line). Enough to shake anyone’s confidence. Especially when compared to the TSX 60 (the green line). Doing much better and fueling the belief that you can’t beat the index, right? I’m certain that many sold during those dark months between July 2007 and March 2008. We didn’t and the end results speak for themselves (table 2).

We have a new holding in the Global 35 portfolio, Parker-Hannifin. The chart looks very similar to Metro, with numerous periods when the S&P 500 did much better (US company, so we compare it to this index). But over a reasonable length of time, it’s not even close.

Parker-Hannifin is a diversified manufacturer of motion and control technologies systems. It provides these for a wide variety of commercial, mobile, industrial, and aerospace clients. Although few analysts cover it (no Canadian firm does), we like it for its dividend history (remember 66 years in a row of raising their dividend), reasonable price, high ROE and impressive free cashflow. In Canada at least, few people seem to have heard about it. Let’s hope it stays that way and we can keep on buying it for a long time.

All this to say, regardless of the clouds on the horizon, a prudent, logical and long-term investor will always find a good home for their savings. 

Can there be market volatility in our future? Yes of course. In fact, it’s a near certainty.

As I’ve said numerous times, market volatility is like turbulence when flying, uncomfortable but not deadly. What is deadly in investing is first and foremost panicking and selling to wait until things calm down and it’s time to reinvest. I’ve heard of it numerous times, but I’ve never seen proof of it. Never. If someone has accomplished what Warren Buffett can’t even seem to be able to do (his investment portfolio is down $56 billion this year), let me know. However please realize that whoever claims they’ve been able to do this could do it again is guilty of great exaggeration or outright lying.

So, what should you do? We still have a war in Ukraine, inflation is still running high, interest rates (although very reasonable by historical comparison) are not coming down anytime soon and could still go higher, the debt celling drama in the USA will very soon dominate the financial news cycle and overall profits should come down has the economy slows down. Furthermore, RBC and their colleagues on Bay Street & Wall Street are calling for a recession at some point in the next 12 months.

I would do the following:

1. Re-evaluate that your time horizon is still that of a long-term investor (7 years and more) Please note that I’m not talking about your age, but rather your time horizon. I’m hoping that we all have a few years left in front of us, so therefore time-horizon is more about when you need your money then what age you are. If you’re 75 years old, in good health and your house and toys are paid for, you need money for your everyday expenditures and you have time on your side. However, if you’re 25 years old and your money needs to go towards a down payment on a house in 3 years, your time horizon is short term.
2. Be honest about your stomach. I might dismiss volatility as simple turbulence but you might not and that’s ok. The important part is acknowledgement. Knowing what kind of investor you really are and adjusting your asset allocation accordingly, without any FOMO.   
3. FOMO. The Fear Of Missing Out. Comparing yourself to the supposed gains of that successful friend/neighbor/brother-in-law/colleague that we all have. Same guy (typically a man) that knew in advance that marijuana, bitcoin and Cathy Wood were going to be BIG. He sold, of course, at the right time. Made a ton of money… Of course. I’ll simply say that comparing yourself is the source of most misery when it comes to money.
4. Review your financial plan. Yes, that tedious and boring exercise that frankly you were not sure about. It will be your roadmap. Where are you on the road to financial independence? We employ fancy words in my industry, but at its core, your plan should show you if your future aspirations are feasible. Where will the money come from? Investment income, government pensions, capital withdrawal? Do you have room for extra expenses or should you try to cut a little?
5. Our relationship with you is first and foremost a conversation. You share with us your desire, your vision going forward and your goals. We are responsible for translating them into YOUR wealth management (portfolio management, planning and reviewing, creating a legacy for the next generation). Most simply, it’s a conversation with flows and back and forth. We need to trust each other and we need to be transparent with each other.  A long walk along the axis of time and money, if you want.
6. This long walk will enable the miracle of compound interest happening. Imagine a stock capable of growing its dividend per annum in perpetuity (or at least for the next 20 years…). Fast forward to the future and a shareholder could theoretically recoup his or her entire cost base over time while retaining ownership of the underlying stock. Companies that can consistently grow their dividends are also likely to experience share price appreciation. Adding fixed income as ballast and the source of capital for the next few years also helps.

This classical formula, often disparaged but never replaced, with a proper financial plan is key. Especially in these volatile times.

Lastly, as a business we’ve grown a lot in the past years, mostly thanks to you and your trust. Your deposit of new moneys and your referrals of family and friends are the absolute best compliment we can get. Thank you.

Sincerely,

Charles