McMurtry Investment Report – November 2022

Consumer spending represents about 70% of the North American economy and consequently has a major effect on economic growth. This sector is very cyclical but is very different than industrial cyclicals whose profitability is tied more to industrial production.

As we all know higher interest rates are a major headwind for consumer cyclicals at this time. Spiraling inflation is causing the central banks to sharply increase interest rates. It appears that inflation is much more of a concern for central banks than the negative repercussions from an economic recession.

This sector is a relatively diverse one and includes general retailers, hotels, cruise lines, casinos, OEM auto manufacturers, auto parts producers, home improvement retailers, restaurants, and home builders.  It does not include airlines even though they perform in a similar fashion to the consumer cyclical industry.

The gradual ending of Covid is encouraging consumers to travel, go out to dinner and spend. This is a major tailwind. However higher interest rates and rampant inflation are both making the consumer a little more cautious at this time. Although the employment situation is quite strong, the threat of an impending recession does not help consumer sentiment.

In this report, I will try to summarize the important factors in each sub sector of this group. Let me start with the home improvement stocks like Home Depot and Lowes. During Covid consumers did not have that much to spend their money on with a few exceptions like home improvement. Millions of dollars were allocated to home renovations instead of travel and going out. Taking into account how much has already been spent in this area, I am less enthused by the home improvement sector going forward with revenue growth really backing off.  Currently, I have both Home Depot and Lowes in both portfolios. Based on the above factors, I am deleting Home Depot from both portfolios, while keeping Lowes. The latter company is trading at a much cheaper valuation than Home Depot and has a much lower cash flow dividend payout with only a slightly lower dividend yield.

In regards to the traditional leisure sub-sectors such as hotels, cruise lines, and casinos, I am not convinced that a weakening consumer will continue to spend heavily at this juncture. These groups tend to be the most cyclical in the consumer discretionary sector and a recession looming on the horizon will not help. Furthermore, in the interim, much higher interest rates and inflation are really starting to curb discretionary spending.

Home builders are experiencing a major headwind from rising rates at this time. Although their valuations have come down sharply, I am not comfortable with this area until rates stabilize and a clearer picture emerges of how deep an economic recession we are about to experience.

While all these discretionary stocks are experiencing major headwinds, it is still important to determine which ones have already discounted an economic recession and which ones have further to fall.

In a period of higher rates, it is imperative to stay away from overly leveraged companies as their operating cash flows start to decline in a recession.

Selectively I still like several retailers with their specific market niche and growth prospects. Dollarama is one retailer that is virtually recession-resistant, yet the company remains in a growth mode. Another example is Artizia. The company continues to deliver solid numbers and expectations point to more growth. In the US I like Ulta Beauty with their 3000-plus stores that offer one-stop shopping for beauty products and services. I have also just added Lululemon which continues to show significant growth, while its valuation has come off in this market decline. All four of these companies do not seem to be negatively affected by either Amazon, Walmart, or Nike.

Both the auto parts companies and the OEM manufacturers have experienced material supply constraint issues over the last 12-18 months as a result of the semiconductor and labour shortages we have experienced. However, it finally appears that there is some light at the end of the tunnel with a gradual improvement in the supply of microchips from Asia. Some formerly bullish auto analysts now expect total demand destruction from the upcoming recession. I think they are totally overreacting for two reasons. There remains a very long order backlog even with the expected decline in demand. Secondly, the share prices of these companies have already discounted a possible recession with their very low valuations. These auto companies have already taken major steps to both shore up their balance sheet and rejig their focus going forward. A recent example of this is Ford’s decision to write off their investment in the self-driving car technology, opting instead to focus more on the electrification of vehicles.

Currently, I have Ford, Gentex and Magna in my model [portfolios. I am deleting the US auto parts company, Gentex from both portfolios. The stock is trading at a much higher valuation than the others and its EPS revisions for the last quarter of this year and for the year 2023 continue declining. More specifically Gentex is trading at an Enterprise Value to forward EBITDA of 12.09 times, compared to Magna’s 5.37 times. At current prices Ford is trading at an EV/ Forward EBITDA of 3.51 times.