Chapter 34: Portfolio Management Strategy Update: Pivoting from Fundamental Growth to Visibility of Present Value
Dear Clients,
We hope you are well. In prior installments of our journal, we had prepared clients for an intrinsic value of 3500 on the S&P500, predicated on what we believed at the time to be a fair multiple of 14x price to earnings. This target, which we landed close to this summer, contemplated a market completely driven by multiple compression, as we have seen this year, while 2022 earnings growth has actually remained positive. In this type of environment of elevated inflation and rising borrowing costs, present value characteristics driven by fundamental visibility, dividends and buybacks tend to prevail over an intermediate timeframe. We have been positioning client portfolios in these areas, with a view that the down-trending markets may be more prolonged. We wish to reinforce the message that all the valuation change in companies this year has been driven by multiple compression.
From a markets perspective, part of the reason for this down-trending market is the policymaking of the US Federal Reserve. In the November FOMC meeting, US Federal Reserve Chair Jerome Powell guided a pathway for a series of slower future interest rate hikes, but raised the terminal rate of interest expected in 2023, more- so than the markets expected. This has contributed to a repricing in growth instruments whose intrinsic values carry large weightings in future-dated cash flows, and since June, we have been reducing the portfolio’s exposure to these future-oriented growth and small cap areas. In addition, with a now higher terminal Federal Funds Rate, the US Federal Reserve will likely overtighten financial conditions, landing the economy into a more protracted recession. As a result of these events, we have recalibrated our earnings growth expectations for 2023, and now expect the market to trough between the 3000-3200 level, predicated on re-adjusted earnings revisions. This said, once earnings revisions are recalibrated, and underlying business/financial stability starts to be recognized again, an earnings recovery will likely ensue, resulting in a possible recovery for the S&P500. This, however, will take time.
At the same time, from a business perspective, corporate fundamentals remain resilient. Their resiliency is buttressed by high switching costs, wide economic moats, and strong pricing power to offset the inflationary environment we are in. These business characteristics combined with prudent financial management result in companies that are highly profitable both on an absolute and relative basis. As the growth component of portfolios is repriced in a higher interest rate environment, we have been shifting the portfolio into dividend generating companies whose return characteristics are enhanced in a higher borrowing cost environment –these include the banks, who borrow short and lend long, leading to enlarged profit margins; income producing real estate investment trusts that sustain high dividend growth and yields, to be competitive with elevated interest rates at the short-end; and blue-chip asset managers with high switching costs and prudent capital allocation practices that return capital through disciplined buyback activity. These companies, which have high visibility into their current income streams, will likely be rewarded on a relative basis in an environment of higher interest rates.
From an integrated perspective, the down-trending nature of these markets has been challenging for many investors. But we wish to reassure clients that the fundamental characteristics of the companies have changed very little. For instance, industry pricing power within luxury goods is not just being contemplated for 2022, but 2023 as well. Wide-moat, cash generative businesses such as Google and Microsoft are maintaining market share in this environment, and returning their free cash flows to shareholders in the form of significant buybacks and dividends. Despite a slowdown in consumer activity, insider-owned Simon Property Group still raised their profit guidance for the year, along with the dividend and a sizeable buyback authorization, returning capital to shareholders. Capital allocation practices which favour organic growth, share buybacks, and small, tuck-in acquisitions are being rewarded in the current investment climate. For example, a recent addition to the portfolio, Bank of America, was once a company that grew by acquisition through its mergers of Countrywide, Merrill Lynch and MBNA in the pre-2008 period. Given the issues associated with subprime credit, Bank of America hired new leadership to re-focus the organization on organic growth and capital return, which then grew book value and led to earnings growth as the second largest money center in the USA. Banks, being highly regulated entities, are very well capitalized today as evidenced by their solvency characteristics, and trade at undemanding valuations relative to underlying earnings power, which enables them to pay sizeable dividends. So, as clients can see, companies with strong balance sheets and current profitability are able to return capital in a disciplined fashion to shareholders, which is highly valued in the current environment.
Finally, with relatively favourable year-end reporting, it may be reasonable for investors to expect a temporary trend change heading into the 2022 year end and possibly early 2023, lifting risk assets in the more economically sensitive areas of the market. We will be utilizing such opportunities to reposition portfolios in companies with favourable present value characteristics, including visibility, stability of earnings and favourable return of capital characteristics.
We hope clients have found this piece helpful and we welcome any commentary.
Warmest regards,
Grace Wang, CIM, PFP | Senior Portfolio Manager
Samuel Jang, CFA | Investment Associate | samuel.jang@rbc.com
Leslie Mah | Associate Advisor | leslie.mah@rbc.com | 604-257-7059
Jennifer Hamilton | Associate | jennifer.hamilton@rbc.com | 604-257-2537
RBC Dominion Securities
Phone: (604) 678-5794
Fax: (604) 257-7391 745
Thurlow Street, 20th floor
Vancouver, BC V6E 0C5
https://ca.rbcwealthmanagement.com/Grace-Wang-Portfolio-Management/