Chapter 38: Quality Prevails
Dear Clients,
With Q2 earnings season having concluded, the market has signaled that earnings and the economy are heading into a soft landing accompanied by a mild recalibration and rebound in earnings. From “rolling recession” in 2022, we have now started to price in a “rolling recovery.”
At a fundamental level, secularly growing, wide economic moat companies, with expanding addressable markets continue to lead our client portfolios higher, with their sizeable net cash positions being deployed into innovation kickers such as productivity enhancers and generative AI, as well as large buybacks that reduce the share count, returning capital to shareholders. Moreover, we wish to delve deeper into the quality of the earnings beats. Most earnings beats, if not all, are based on a recovering earnings profile driven by revenue growth that has been sustained even through a rate-hiking cycle that has mitigated overall economic growth. This is because R&D spending remains resilient and is secular – and companies, witnessing the compressing timeframes of their product and technological cycles – are loathe to reduce spending that would otherwise eat into demand during an economic recovery. We witnessed this with the semiconductor equipment makers, where elevated volatility in the share price in 2022 gave rise to attractive valuation opportunities, which we capitalized upon. Accumulating these shares at highly discounted earnings valuations, while their profit streams were still intact, was rewarded this year. As we will remind clients, volatility – fluctuations in the share price – is NOT the same thing as risk. Furthermore, 2022 was a year of cost optimizations for most companies. With most of these optimizations now complete, the benefits of profit margin expansion are now being fully borne out and rewarded in the market. So, our portfolio positioning reflects a barbell approach of stable, return-of capital companies; juxtaposed by technology innovators that are leading the secular share shifts within their respective markets. This is how we have been positioned since 2018, we augmented these positions throughout the pandemic and 2022’s downturn, and we are witnessing the strength of the results being recognized by broader markets this year.
On the topic of the earnings recalibration which we mentioned in prior investment journals – we believe this is now largely in the rearview mirror, with earnings expectations having been over-recalibrated with most large cap growth guidance being maintained. While the S&P500 trades at a current multiple of 21x, we believe it is important to look at normalized earnings – and on a forward multiple of 18.6x 2024 earnings, we would believe the market remains reasonably valued. Some investors may ask about the breadth of the earnings recovery. To that, we would respond that in most earnings driven market recoveries – market breadth tends to broaden out as greater participation is attained. We witnessed that this earnings season, with the banks first reporting constructive results, followed by large cap technology in conjunction with consumer discretionary which had already priced in a recession in 2022. The message that most companies gave this quarter was resounding: we are in a recovery. The increase in market participation mirrors what we witnessed in 2011, with the homebuilders leading a housing recovery which then led to banking recovery, and finally a consumer rebound. Finally, the string of cooling employment market reports in late August, indicating moderating payrolls, wage inflation and job vacancies, indicates that the tighter monetary policy is having its intended effect without major demand dips, lowering the likelihood of successive US Federal Reserve rate increases in September and November.
This said, it is still important to be judicious about security selection. Buying low-valuation companies with less defensible economic moats can lead to profit impairments which we would define as RISK. “Cheap” can come with its own set of reasons, oftentimes resulting in the earnings being disrupted. We have seen this bifurcation in areas where “winner-take-all” effects prevail, such as cloud computing, data storage, semiconductors, digital advertising, and animal healthcare. This has created elevated volatility and an uneven recovery, but also opportunity as this bifurcation widens.
A common question we receive from investors is “Why not capture some profits every year?” To that, we would remind clients that the power of compounding rests in gains building upon prior gains. Without this reinvestment effect, wealth would not compound. Furthermore, every decision is two decisions. The decision to sell necessitates a decision to re-enter the market at some point, at which point prices may be significantly higher. This is why we remind our clients of what Peter Lynch once said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” This is true of compounding gains, and it is also true of re-investing dividends, which compounds gains even further.
We would like to remind clients that earnings growth ultimately drives security valuations in the long term, and our focus remains on being investors of these secular winners at reasonable valuations. This approach has outperformed because it focuses on the drivers of value creation that are not evident to the markets initially, otherwise known as “option value." This creates an expectations difference in what a security is priced at, versus its true underlying asset value.
Combined with durable economic moats and a widening economic profile in client holdings, we will reiterate to clients that “quality prevails.” We hope clients have found this update helpful and we welcome your comments.
We wish you a pleasant changing of the seasons.
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
Valeria Sordi | Administrative Assistant | valeria.sordi@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/