Also available in PDF: McMurtry Investment Report Portfolio – August 2022
Investment Commentary August 2022
US Yield Curve
The 10-2-year US Treasury yield curve inverted sharply from last month’s 0.06% to the current level of minus 0.41%. This is a material change and does indicate the probability of an upcoming recession is increasing. While many economists and the US government have still not formally announced that the domestic economy is in a recession, the negative GDP growth over the last two quarters would normally indicate that a recession has already begun. However, economists argue that the strong growth in employment is not a normal sign of a recession.
US Corporate Debt Spreads
As of August 4, 2022, Baa rated US corporate bond spreads relative to 10-year US Treasuries actually declined by 9 basis points to 2.32%. This does not indicate any immediate panic in the US economy.
Covid – 19 Health Stats
Covid cases in North America are gradually improving and this is resulting in the removal of most lockdowns. The Chinese situation is much more complicated with lockdowns continuing.
Equity Market Valuations
The recent market rebound has caused the Forward PE of the S&P 500 to rise back up to 17.4 times from 16.1 times last month.
Central Bank Monetary Policy
It is obvious to me that the US Federal Reserve was much too late in increasing interest rates to stop domestic inflationary pressures. Contrary to what many believe, the Federal Reserve is very unlikely to stop their hawkish approach until there are clear signs that inflation is peaking. They are much more worried about the level of inflation than the negative repercussions on the economy from higher interest rates.
As a result of the persistently high inflationary pressures combined with strong employment growth in the US, I am maintaining the same high cash levels and low equity weights as last month. Should the equity market retest its recent lows once again, having a higher cash weight will be most helpful in reducing portfolio volatility.
However, it is also important to note that there are some signs that inflation is peaking. Lower commodity prices, weak housing prices, lower shipping costs, high inventory levels and a much weaker global economy may be just starting to put pressure on inflationary concerns. This is one of the reasons why equity markets rebounded last month. The US real return Tips ETF indicates that the expected rate of US inflation has come down from last month’s 3% to the current 2.46%.
Once the Federal Reserve determines that the rate of domestic inflation has peaked, they will most likely back off their aggressive interest rate increases. Equity markets will also react favourably when this occurs. I do not think that inflation has peaked yet, but this is a key factor to monitor.
The only change I am making this month in the asset mix is to remove European equities from both portfolios with the funds redeployed into equities in Canada and the US. The European economy is facing a major headwind from the very high natural gas prices as a result of the Russian / Ukraine war.
Equity Sector Weights
As a result of the impending recession, many cyclical sectors have fallen sharply. In particular both the REITS and Materials sectors appear to be already discounting a recession. Consequently, I have decided to increase my REIT weight from the current underweight the North American benchmark to a market weight. As I am already at market weight the Materials sector, I am not making any changes to that sector, except to point out that Teck B, Capstone and Lundin are starting to look attractive on a long- term basis.
Individual Equity Changes
In a blog dated August 5th, I added back Premium Brands to both portfolios in the Consumer Staples sector. The recent decline in share price provides a buying opportunity. Second quarter revenues, adjusted EBITDA and adjusted EPS rose year over year by 23.1%, 16.6% and 12.2% respectively. Company management expects EBITDA to reach $600 million by 2023 from the projected $510-530 million range for this year. The company trades on a forward PE of 19.2 times, reasonable given the projected growth in EPS of 16.2% this year and 23% in 2023. The company offers an attractive dividend yield of 2.8%.
In a blog dated July 31st, I added NuVista Energy to the Growth portfolio. The company is a small cap producer of condensates, natural gas and natural gas liquids principally in the Montney region of Alberta. The company has a healthy balance sheet and is using its free cash flow to pay off its long- term debt and to buy back stock. The shares trade at a very reasonable 2.93 times Enterprise Value to Forward EBITDA. The company does not pay a dividend.
In a blog dated July 25th, I advised subscribers to reduce their holdings in Agnico Eagle by 50% with the funds redeployed back into more Franco Nevada. While I continue to like both companies, Agnico is a producer affected by rising operating costs. On the other hand, Franco is a pure royalty company with very low operating costs that also has some energy exposure. In the current period of flat gold bullion prices, Franco should perform better than Agnico. However, when bullion prices start going back up again, Agnico has more price leverage than Franco has.
In a blog dated July 15th, I added Altagas to both portfolios in the Utility sector. The company is one of the largest energy infrastructure companies in North America. It operates in both regulated natural gas distribution in the US and a midstream business in Canada through its ownership in the Ridley Island Propane Export Terminal near Prince Rupert, BC. EPS are projected to grow by 8% this year. The company’s recent acquisition of the remaining 25.97% of Petrogas it does not yet already own, is expected to be immediately accretive to EPS. The company pays a dividend of 3.75%. Its shares trade on a forward PE of 14.90 times.
In a blog dated July 12th, I deleted Freeport McMoran, First Quantum and Hudbay Mining from all portfolios as a result of the upcoming recession. On the same date I added Teck B to both portfolios. Teck has a much more diversified product mix than the others with its coking coal operation that is used exclusively to make steel. Coking coal prices are holding up much better than base metal prices at this time. The company has a strong balance sheet and is trading at a reasonable valuation. I continue to recommend Lundin Mining and Capstone with their strong balance sheets.
In a blog dated July 9th, I recommended a switch out of Target into Ulta Beauty. Target ‘s earnings are being negatively affected by rising operating costs and lower margins. On the other hand, Ulta Beauty’s revenues, earnings and operating margins remain strong. The company operates 1300 retail stores where they offer cosmetics, skincare, haircare, fragrances and bath products. The company has a loyalty program with 37 million members. During the last quarter same store sales rose by 18%. The shares currently trade with on a forward PE of 18.66 times, reasonable taking into account the company’s long term growth prospects. As the shares do not pay a dividend, I am only adding them to the Growth portfolio.
I am deleting Ball Corp from my Growth portfolio. The much weaker than expected 2nd quarter highlighted weakening North American demand, a 25% increase in operating costs, a much weaker balance sheet and plant closures in Arizona and Minnesota. Over the last six months operating cash flows declined sharply from a positive $168 million last year to the current level of minus $398 million.
In response to my deletion of European equities from my Asset Mix recommendations, I am deleting the iShares ETF XEU MSCI Europe and the iShares ETF EUFN European Financial. However, I am still maintaining individual European equities such as AstraZeneca and the European Residential REIT.
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