Brian Madden, chief investment officer, First Avenue Investment Counsel

FOCUS: North American equities 

MARKET OUTLOOK:

With first-quarter earnings mostly behind us, the S&P 500 and S&P TSX Composite Index have been resilient in digesting the second quarter of earnings recession. TSX returns at five per cent are lower than S&P 500 returns at eight per cent. However, the distribution of returns is broad-based in Canada versus narrow in the U.S. The median S&P 500 stock is unchanged year to date whereas the median TSX stock is plus five per cent.

The implication is a handful of gigantic U.S. companies are soaring, but the majority of stocks are stagnant. Narrowly led markets are inherently flimsier than broad-based rallies, foot soldiers need to advance alongside the “generals” in order for the ground to be held. We accordingly favour Canada, with 60 per cent of our portfolios invested in Canada versus 40 per cent in the U.S.

Both markets are making higher lows and are testing the top of yearlong trading ranges, amidst an eroding corporate earnings backdrop. Trailing 12-month earnings for the TSX and the S&P 500 are negative two per cent from January peaks. In our view, this pattern is telling of investor complacency with respect to:

Debt ceiling debate – we’re also complacent here – this will end only one way – with the limit increasing.
Expectation for multiple rate cuts by the U.S. Federal Reserve later this year.
“Soft landing” for corporations – S&P 500 earnings expected to grow despite 65 per cent probability of recession this year as forecast by the New York Fed and private sector experts.

The asymmetric risk and reward setup argues for a conservative stance in equity portfolios, emphasizing well-capitalized, high-quality defensive businesses versus credit-dependent, discretionary and cyclical companies. Nevertheless, we are data-driven and will watch intently as these uncertainties resolve themselves. We stand ready to shift portfolios into stocks we have pre-researched and that are on standby for the “all clear” macroeconomic signal.

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TOP PICKS

Open Text (OTEX TSX)

Latest purchase May 2023 at $54.99

Open Text is a cloud and site-based enterprise information management software and solutions company. With an installed base of 150 million plus users across over 125,000 companies globally, over 80 per cent of the company’s revenues are recurring, which affords them good sales visibility and negligible customer concentration risk. The company is a sluggish organic grower but a great serial acquirer. The recent $6 billion acquisition of Microfocus, while certainly its largest and likely its most controversial, carries $400 million in synergies and on our math should prove to be 40 per cent accretive to earnings. Despite a mighty rally of 60 per cent off the October lows, the shares trade at just nine times earnings versus a historic average of 13x. Over the last 25 years, Open Text has generated a compound annual return of 13.4 per cent. This is nearly double what the TSX Index overall has achieved and nearly 10x the meager 1.4 per cent return of the aggregate TSX tech sector, proving decisively that “boring” tech can indeed be beautiful.

TMX Group (X TSX)

Latest purchase February 2022 at $123.63

TMX Group owns and operates global markets, including the Toronto Stock Exchange and Montreal Exchange, among others. Additionally, it is a growing player in data, analytics, and insights in various asset classes and geographies. TMX is a consistent grower, with over two-thirds of its revenue recurring and with earnings and dividends increased at an eight per cent compound rate over the last decade. Trading at 19x earnings, the shares trade at a discount to global peers. This is a gap we expect will narrow as the company continues to expand beyond its domestic equity trading roots into adjacent and faster-growing derivatives trading and clearing as well as data analytics and insights platforms. 

Arista Networks (ANET NYSE)

Latest purchase November 2022 at $130.60

Arista Networks is a leader in providing cloud networking solutions including ethernet routers, switches, cards, and related software for data centers and campus workspace environments. The company is a critical component supplier to tech sector leaders like Meta, Microsoft, Alphabet, and Amazon. It should stand to benefit as these companies step up a fresh new spending arms race to deploy very computationally intensive and hardware-intensive AI initiatives. We expect the company will grow earnings at a compound rate of 15 per cent over the next three years. The shares have pulled back 20 per cent from the recent all-time highs, and now trading at an undemanding 22x earnings we see a compelling combination of growth and value in the shares at current levels.