A Look Back to 2022 Performance Drivers and a Look Forward into 2023 Portfolio Positioning

Chapter 35: A Look Back to 2022 Performance Drivers and a Look Forward into 2023 Portfolio Positioning

Dear Clients,

As 2022 concludes, we wish to provide a review of the performance factors influencing our portfolios’ year-to-date (YTD) returns. Recall that there are two main drivers of performance – a company’s valuation multiple, which determines how much an investor is willing to pay for each dollar of earnings in that company; and its earnings profile, which is mainly measured by profit growth. This year, the US S&P 500’s performance can be explained solely by valuation multiple compression, as a result of a number of macroeconomic shocks, ranging from inflation and interest rate increases to a possible growth slowdown in profits. Valuation compression has had an impact on a wide range of cyclical and even defensive industries, across a spectrum of investment styles ranging from quality earnings growers to deeply discounted value stocks. Yet, in spite of this multiple compression, aggregate earnings in 2022 within the S&P 500 are still positive and expected to grow 6% by the December year end. From a fundamental perspective, stable earning, dividend generating companies with reasonable payouts, in industries with capital preservation characteristics, have done well. Adaptability and earnings resilience have been key. For example, one of our sizeable holdings in technology, Apple, grew annual earnings per share by 9.5%; there were persistent pricing power effects among all three of our luxury goods companies, resulting in positive expected profit growth for the 2022 fiscal year end in February; and large bellwether industrials Honeywell and KLA Corporation (KLAC) are returning capital to shareholders at a rapid clip, bolstering returns against an expeditiously rising yield curve at the front end. Despite achieving these business results, Apple shares are down 18.9% YTD, underperforming the S&P 500; at one point during mid-June, Hermes’ shares were down 36% YTD, which is when we established a position; and despite its strong capital return policies, KLAC shares compressed by 4.3% YTD. Although they have differing business models, these companies have certain characteristics in common: They sport wide economic moats with durable franchises, fortified balance sheets, and earnings resiliency even in a downturn.

The performance profile of these quality growers contrasts to the cyclical tailwinds we have witnessed favouring the energy sector. We use Canadian Natural Resources (ticker: CNQ, not owned in our portfolios) as an example. With this year’s inflation shock resulting from the war in Ukraine, WTI crude oil prices peaked at US $123/barrel in March, before receding 37% from June to the present. In spite of this reversal in crude oil prices, CNQ shares have appreciated 49% YTD, which we view as overpriced relative to its underlying commodity. Mean reversion, in which profits fluctuate from periods of growth to compression, is very common in the energy sector. This is evident in CNQ’s future revenue forecasts, which is for a peak in March 2023, before a 20% drop by fiscal 2026. If this forecast materializes, investors in CNQ shares today would be paying a forward premium for shares whose profitability profile would be diminishing in the future. Finally, even with receding oil prices as referenced above, the shares have appreciated 13% since the end of June, underscoring how crowded the shares’ ownership has become. We believe that opportunities outside of the energy sector are more favourable over the long term because they exhibit predictable growth characteristics with more valuation stability.

More broadly speaking, like we examine the durability of individual companies outlined above, we can examine the long run durability of the US S&P 500 versus the Canadian S&P TSX. Despite the Canadian energy sector’s outperformance this year, over the long run, it is the US S&P 500 that creates the vast majority of stock market wealth due to its composition of steadily growing and compounding companies with predictable growth characteristics. In contrast, the S&P TSX’s gains since the pandemic have mainly been concentrated in two sectors – energy and materials – which, as described above, are more sensitive to reversals in the economic environment. Similarly, risk management is very important, as in this regard, we look for an economic moat as a signifier of quality. The Canadian S&P TSX index’s quality characteristics are mixed, as there were significant capital drawdowns in non-viable cannabis producers this year, hampering the performance of an otherwise stable healthcare index; and a sharp decline in a highly concentrated Canadian technology sector, underscoring less earnings resiliency than US peers who have expeditiously returned capital to shareholders. Having a comparative advantage, otherwise known as an economic moat, contributes to the earnings resiliency characteristics in the companies we seek.

In terms of portfolio positioning for 2023, we have structured client portfolios using a barbell approach. At the front end of the curve, we have shortened equity duration in many of our portfolio positions, prioritizing earnings resilience that translates into favourable return of capital characteristics such as dividend growth or share buybacks. At the long end of the curve, we have continued to hold deeply discounted earnings growers that are both cash generative and sport wide economic moats, primarily in the US blue-chip technology sector. We believe a combination of these two approaches will benefit from both a “higher for longer” interest rate environment in 2023, and an eventual Federal Reserve policy shift (otherwise known as a “pivot”), which would result in longer duration stocks outperforming at that juncture point. Yesterday’s FOMC meeting underscores a moderation in the pace of future interest rate increases, signaling a likely pause sometime in 2023. At the same time, we are mindful of a market-wide earnings recalibration heading into 2023, which is why we have selected companies that we believe have the most durable profit structures with as little earnings revisions recalibration as possible.