Investment Commentary November 2021
US Yield Curve
The ten minus two- year US Treasury yield curve declined modestly by 11 basis points to 1.10%. As the yield curve remains positive and is still considerably above December 31st level of 0.80%, this is not something to be concerned about in regards to the domestic US economy.
US Corporate Debt Spreads
As of November 1st, 2021, Baa rated US corporate bond spreads relative to 10-year US Treasuries actually narrowed by 16 basis points to 1.69%, compared to the same time last month. This modest decrease is clearly an indication that there is no upcoming recession.
Covid – 19 Health Stats
Covid daily new cases are definitely improving especially in North America, India and Brazil. Global daily new cases are now under 500,000, down sharply from 800,000 in April. Daily cases continue climbing in Russia and the UK, however. The Centre for Disease Control in the US has just given their approval to Pfizer’s Covid vaccine for children 5-11 years old in addition to the drug company’s new anti-viral that is showing an 89% efficacy rate regarding Covid hospitalizations and deaths. Pfizer’s announcement along with Merck’s previous one about their own anti-viral, may be the final blow in dealing with Covid-19 in North America, according to Dr. Scott Gottlieb.
Equity Market Valuations
Taking into account the recent equity market strength, the forward PE multiple of the S&P 500 index rose to 21.2 as of the end of October, from last month’s 20.70 times. This compares to the long -term median of 19.6 times
Central Bank Monetary Policy
The US Federal Reserve will start tapering its pace of bond purchases later this month by $15 billion out of a total of $120 billion monthly. This is the first step in the process of increasing interest rates. Domestically the Bank of Canada has ended its quantitative easing program this week. Under their new mandate the Bank of Canada will only purchase bonds to replace maturing ones.
I am making some changes to my recommended asset mix with a 5% reduction in cash for both portfolios and a corresponding increase of 1% in preferred shares, a half of 1% increase in US Tips and a 3.5% increase in common equities. In addition, I am dividing the category – Canadian Regular Bonds into Government of Canada 1–5-year bond ladder ETF’s and Canada Investment Grade 1-5 year corporate bond ladder ETF’s. Finally, I am increasing European Equities by 1% for both portfolios. Taking into account the gradual expected increase in US interest rates by the Federal Reserve, the improvement in global daily Covid cases, the two new anti-virals from Pfizer and Merck, the eventual re-opening of the global economy and the relatively strong quarterly earnings reports, equity markets may not experience a short- term correction but a Christmas rally instead. This is the main reason for increasing my equity weight at this time even after the sharp runup. As you are all very much aware, there has been lots of market volatility recently in equity sectors and individual companies that disappoint on a quarterly earnings basis. All this is a healthy sign for the markets. However, it is still important to be prudent with your overall asset mix and this is why I am keeping at least 15% in cash at this time.
Equity Sector Weights
I remain overweight my North American benchmark Financials, Energy, Materials, Industrials, Consumer Discretionary and Real Estate. I remain underweight Consumer Staples, Healthcare, Technology, Utilities and Communications.
Cyclical industries with pricing power continue to perform better in the market to ones that cannot pass on raw material cost increases to their clients in the form of price increases.
Individual Equity Changes
In a portfolio blog on November 2nd, I added Bank of Montreal to both portfolios. The bank’s current 37% dividend payout combined with a Common Equity Tier 1 ratio of 13.4% will encourage both stock buybacks and dividend increases, especially with the federal regulator, OSFI, granting the Canadian banks and insurance companies’ permission to do so.
In a portfolio blog dated October 20th, I added FedEx to both portfolios. The company continues to experience strong revenue growth and is expected to deal effectively with rising costs through the increased usage of drone deliveries and a switch from gas powered trucks to electric.
In a portfolio blog dated October 7th, I added Applied Materials to the Growth portfolio. This is one of the world’s largest suppliers of equipment to the semiconductor industry. The current shortage of semiconductor chips will surely benefit supply companies like Applied Materials with demand expected to remain strong for the next several years.
In addition to the above changes to the portfolios, I would like to review the fundamental outlook for several companies in my model portfolios that are currently experiencing some headwinds.
Let us get started with the consumer products company, Unilever. While the company is a very strong one, it continues to experience both sales problems in Emerging Markets as a result of Covid-19 as well as sharply higher operating costs. This is leading to shrinking operating margins. Based on these ongoing problems, I have decided to delete the company from both portfolios in the Consumer Staples area.
In the healthcare sector, Curaleaf has experienced a share price decline in the midst of the very strong equity markets. Curaleaf remains one of the strongest companies in the cannabis industry and is expected to benefit from the opening up of the US market. In addition, the company continues to make acquisitions and grow their revenues accordingly. It is only a matter of time before the company starts to make money on an operating cash flow basis. I recommend to continue holding this company and to buy more at current prices if you are underweight.
In the Materials sector, Osisko Metals has not kept pace with the strong equity share price performance of many base metal companies. However, it is important to point out that this is an exploration play with no production or revenues at this time. Over the last year the company has reported that there is considerable potential to expand its current orebody of lead / zinc with ongoing very positive test results. In addition, the company is effectively dealing with some water issues and this is likely to lead to materially lower operating costs once the mine is operational. My recommendation is to keep the company in my Growth portfolio.
In the Materials sector, Pan American Silver has experienced poor share price performance in the current environment. Pan American has significant leverage to silver prices that are expected to pick up with higher inflation and a peaking of the US dollar internationally. The company offers a reasonable valuation combined with a strong balance sheet. Significant growth opportunities exist with the company’s La Colorada Skarn mine in Mexico and with an exploration deposit in Escobal, Guatemala. I am leaving this silver miner in the Growth portfolio.
In the Communications sector I am switching Activision Blizzard for Electronic Arts for the Growth portfolio. While Activision Blizzard’s last quarter led to results that met expectations, Electronic Arts’ results far exceeded expectations. Electronic Arts’ revenues for the quarter were up over 58% with net bookings up a strong 104%. Activision is currently involved in allegations of sexual discrimination and harassment and announced that two recent gaming titles, Diablo 4 and Overwalk needed to be delayed until 2023. At current prices Electronic Arts is trading at a reasonable 19.74 PE based on forward EPS, taking into account its EPS growth rate for 2022 is 24%. Both year over year growth in revenues and EBITDA are expected to both be at least 24% year over year. I would also like to point out that the video gaming industry continues to register strong growth with these positive trends expected to continue in a post pandemic era with lifestyle changes becoming more permanent.
In the Consumer Discretionary sector, I am recommending that Martinrea be deleted from both portfolios with proceeds being redirected into Magna, a company I already have in both portfolios. The last quarterly report for Magna was largely in line, but Martinrea’s results sharply disappointed investors. While the two companies are in the same industry and face similar supply issues as a result of semiconductor shortages, Magna is a much larger and stronger competitor that will much better be able to weather the short- term issues that are expected to gradually ease up in the latter half of next year. Magna has a much stronger balance sheet with a debt / equity ratio of only 0.207 times compared to Martinrea’s 0.78 times. Magna is currently trading at an attractive 4.5 times Enterprise Value / Forward EBITDA.
Lastly in the Industrials sector I want to review the fundamentals for Aecon. Aecon’s last quarterly report was weaker than last year’s numbers on an EPS basis, but largely in line with consensus. Next year’s EPS are expected to rise by 24%. Aecon’s share price performance has been much weaker than WSP Global and Stantec, companies that are also in my Growth and Income portfolios. The reason the share price sharply retreated after the quarterly press release was much more to do with a statement saying that SA Energy Group, a company where Aecon has a 50/ 50 joint venture with another company, has started arbitration to resolve issues related to delays from the pandemic on the Coastal Gas Pipeline project. Aecon indicated in a press release that unless these issues are dealt with in a timely manner that there could be a meaningful negative impact on Aecon’s earnings, cash flow and financial position. This puts a level of uncertainty that was not present previously. However, it is essential to review all the relevant facts for stocks we own before making a hasty decision to liquidate one’s holdings. This past Friday there was an announcement from TC Energy that they have decided to provide up to $3.3 billion in additional, bridge financing to cover cost overruns related to the Coastal Gaslink pipeline. Coastal is owned by a group of companies including LNG Canada that have asked TC Energy to build the pipeline. TC Energy in turn has asked Aecon to build a portion of the pipeline. The announcement from TC Energy may clearly make it a lot better for Aecon in its financial dealings with Coastal. Based on this recent development and taking into account Aecon’s cheap valuation, I have decided to keep my holding in Aecon for both portfolios until I obtain more clarification regarding TC Energy’s recent announcement and its effect on the financing of the Coastal pipeline.
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