August 1, 2023

The Reporter – Second Quarter 2023

It's summer. Warm and sunny days abound, and the fresh air’s calling you outside. For some, it's the perfect time to tee off! Make no mistake, golf is a strategic game. To make the perfect shot, we need to take into account everything: the distance, weather conditions, terrain, natural features, ponds and sand traps. Indeed, your biggest obstacle in golf isn't your partner or some external force. It's navigating the unpredictable terrain. That's why it's best to focus on your own game and ignore distractions.^{note de bas de page 1}

You probably know where this is going. As it turns out, golfing and investing are actually quite similar. With some tweaks, all the above applies just as much to financial markets.

When it comes to portfolio management, each investment decision is carefully assessed based on our management style, as well as a range of changing factors (like economic forecasts, monetary policy, corporate earnings growth or the quality of the management team). Again, the biggest obstacle here isn't another investor or some external force. It's how unpredictable the market is. That's why it's best to invest in what's tried and true, and not get caught up in media hype and what others are doing.

At the beginning of the year, "recession" was the word on everyone's lips, but we're gradually starting to hear talk of growth. What's most important here is sticking to investment principles. Independent thinking is key to withstanding market fluctuations and avoiding getting swept along with the crowd. In this newsletter, we'll take a look at this surge of optimism and where it came from. More importantly, we'll explain why we're maintaining our portfolio position.

HIGHLIGHTS – Q2 2023

After erasing gains since the beginning of the year, financial markets regained momentum in mid-March. Monetary policy was expected to loosen due to increased recession risk, a direct consequence of the failure of Silicon Valley Bank. Then, a barrage of good news helped restore confidence and brought calm to the financial community in the second quarter.

We need only look at the US regional banking sector (which was showing signs of stabilization), the raised debt ceiling, the smaller-than-expected contraction in corporate earnings, the slowing annual inflation and the labour market, which remains robust in both the US and Canada. The recession outlook has since been pushed back to 2024, and some financial experts are even looking at an economic recovery scenario where a recession is avoided completely. Because of this, financial markets performed better than expected in the first half of the year.

You may notice a clear gap here. Indeed, there's a significant difference in returns between the S&P 500 and S&P/TSX. This was mainly due to the strength of a handful of tech stocks, namely Apple, Microsoft and Nvidia. These alone make up nearly 20% of the index, and were responsible for 60% of the performance of the S&P 500 in 2023. Because securities in the S&P 500 are weighted based on their market capitalization, it's important to look at the S&P 500 Equal Weight Index. The idea behind an equally weighted index is to provide a balanced representation of a market, since all included stocks are given the same weight in the performance calculation. For the first half of the year, this index generated a return of +4.53%, far less than the S&P 500 (+14.28%) and less than the S&P/TSX (+5.76%).

The growing popularity of AI is undoubtedly one of the main drivers of this outperformance, especially after the arrival of the ChatGPT chatbot. Though it's still too early to determine which companies will benefit from this, Nvidia clearly seems to be on top, thanks to its high-performance graphics chips. Their stock is up 190% this year despite its high price-to-earnings ratio (around 200X). That's why we strongly prefer our position in Alphabet (formerly Google), whose shares still align with our "3-for-1" principle, to take advantage of this high-growth niche.

PERFORMANCE REVIEW – FIRST HALF OF 2023

In light of the above, it may be tempting to increase our risk by deploying cash in the growth portfolio to reduce the yield spread with the benchmark index. The catch is that it's hard to take a bolder investment approach, simply because interest rates might stay high for longer than expected. And it's precisely because of the surprising resilience of the economy that central banks have no other choice but to continue tightening their monetary policy and keep postponing the first expected rate cuts.

As our portfolio manager Daniel Ouellet mentioned in a video in June, it's always a matter of financial math. Based on the closing price on June 30 (4450), the S&P 500 was trading at a price-to-earnings ratio of 19X, which is higher than the average multiple of 17X recorded in the last 25 years. Given the high interest rates, this 19X multiple suggests an unattractive risk/return ratio for the S&P 500, especially as it's trading above the upper limit of its well-known range of 3600 to 4300 points. This is to say that we're very comfortable with our cash portion in the growth portfolio, which was recently increased to 18.5% after taking profits out of two high-performing securities (Unilever and Orange). You can find a summary of these transactions in the appendix.

In the near future, economies will also feel the full effect of the cumulative interest rate increases. This is called the transmission delay, a concept we described in The Reporter – 2023 Outlook. Although monetary policy decisions are implemented quickly, it can take time for their real effects to be fully felt in the economy. Remember that for consumer spending, which is the lifeblood of the economy, it takes an average of 8–14 quarters for a rate hike to have a negative impact.

With the precipitous rise in interest rates that began in spring 2022, it will only be next year that we can assess the impact on economic growth. This is why we extended the fixed-income bond portion to 7.6, which is slightly higher than the corresponding benchmark index (7.4). The Bank of Canada will have a hard time keeping interest rate hikes in check given the increasing burden of household debt. This suggests that it's safe to hold bonds.

CONCLUSION

You'll notice that we've largely repeated what we said in the previous issue of The Reporter. Despite recent changes in the stock market and in economic and financial conditions, our portfolio strategy remains the same. This shows how committed we are to our management style. We aim to preserve capital and maintain a justified position in the current context. Let's go back to our golf analogy: even with such unpredictable markets, we have to keep our eyes on the ball, focus on own game and ignore distractions. Caution is key.

APPENDIX

Sources:

Ian Cassel (2023). Three Golf Stories About Investing. MicroCapClub.