Darren Sissons, partner and portfolio manager, Campbell, Lee & Ross

FOCUS: Global and technology stocks 

MARKET OUTLOOK:

Given the likelihood of higher-for-longer interest rates and the current geopolitical uncertainty in China, Ukraine and the approaching U.S. elections, optionality and mean revision are now key risk management considerations for investors.

The regime change in interest rates has driven changes in both social policy and the markets. Workers are demanding higher compensation, which is squeezing corporate profit margins. Higher costs of capital amid a slower global economy are challenging valuation multiples of higher growth companies. Inflation remains unanchored and above the two per cent target. Unemployment levels are rising. Economic data and corporate earnings are trending negative year-over-year. Rent control, strikes and populism make for a complex political landscape. Collectively, these social and market trends are a toxic mix for investors.

The trajectory of indices looks somewhat grim for those investing in indexes. Passive returns for buy-and-hold investors have been a white-knuckle ride, i.e., the S&P 500 and the Nasdaq Composite have identical three-year charts characterized by deep sell-offs, vertical escalations and declines more recently.  Three-year returns on SPY and QQQ proxies for the S&P 500 and Nasdaq Indexes have generated annualized returns of only 7.75 per cent and 8.5 per cent, respectively. Subtract fees, brokerage costs and other costs of one to three per cent and returns have been pedestrian at best despite the large market swings. Further, for non-U.S. investors, any decline in the value of the U.S. dollar will drive additional return erosion.

Amid the doom and gloom encapsulated in the September market decline is an opportunity for those who care to look. Moving into September and October, smart money raised a cash cushion or added portfolio protection. While a return drags in a rising market, cash offers significant optionality during market sell-offs. Consequently, those with cash reserves now have a plethora of investable targets.   

While the cash optionality is critical for generating sustainable returns over the longer term, it’s probably a little early yet to deploy substantial portions of the war chest. However, building a wish list, if not already in place, is an ideal start. Given heightened inflation, sectors that benefit from rising prices remain obvious targets, for example, financials, metals, energy and more broadly commodity second derivatives. Equally so, in an inflationary environment, income becomes scarce, so income-generating companies with sustainable and growing dividends are worth investigating. 

Mean revision remains a valid theme as well. Leading index constituents, which are typically large-cap growth names presently, have seen limited downside while the mid-cap and slower-growing value and GARP portions of indexes have inexpensive valuations and elevated yields.  If the field of mathematics offers any guide, then the mean revision on valuation multiples and dividend yields is merely a matter of time. Consequently, an investor sector and subsector rotation into mid-cap, value and growth at a reasonable price (GARP) should be expected. High-yielding names with good balance sheets and manageable low-interest-rate debt are attractive targets. Companies divesting divisions and sitting on large cash cushions are also an interesting dynamic. Fixed-income will be appropriate too but investors should be mindful of the impact of rates being lowered somewhat during a recession.

On balance, be mindful of risk, have a risk management plan and remember you make money when you buy, so be judicious when deploying capital into new opportunities.

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TOP PICKS:

British American Tobacco PLC (BTI NYSE)

Operating in a deeply out-of-favour sector, BTI is currently yielding nine per cent. An effective treasury management division has stratified debt across longer timeframes at low average interest rates with no significant near-term maturities. The company’s transitioning away from combustible tobacco into a range of heat-not-burn and consumable products will be less onerous for ESG and socially-minded investors. It’s a prime target for income-oriented investors given the elevated yield. Equally so, it’s attractive to investors targeting dividend yield mean revision i.e., the company average dividend yield per share over the 10 and 15-year periods ranged from a low of 4.4 per cent to a high of 6.8 per cent. A mean revision and an eventual yield compression with the associated capital gain therefore seems logical.

Canadian Natural Resources (CNQ TSX)

Currently yields 4.2 per cent. Thirty-two years of proven reserves with the largest natural gas reserves in a politically attractive jurisdiction. Free cash flow post the dividend is $11 billion or 12 per cent of the current market capitalization. It has $5.5 billion in buybacks planned for 2023. Debt, as with its global large-capitalization peer group is declining rapidly. Once debt falls below $10 billion ($12 billion as of June 30, 2023), management-guided 100 per cent of free cash flow will be returned to shareholders.

Johnson & Johnson (JNJ NYSE)

Dividend aristocrat JNJ currently yields 3.07 per cent and has increased its dividend for 62 consecutive years. Growth should accelerate now given the lower growth consumer business Kenvue has been split-off i.e., capital will now be concentrated on the remaining higher growth medical device and pharmaceutical businesses. It has approximately US$23 billion in cash reserves adjusted for the Kenvue selldown. It will therefore be well-positioned to be an active tuck-in acquirer during the coming recession. 

PAST PICKS: July 20, 2022

BHP Group (BHP NYSE)

• Then: US$50.86
• Now: US$55.28
• Return: 9%
• Total Return: 23%

Nestle SA (NESN SWX)

• Then: 113.26 CHF
• Now: 103.72 CHF
• Return: -8%
• Total Return: -6%

Suncor Energy (SU TSX)

• Then: $41.04
• Now: $44.03
• Return: 7%
• Total Return: 14%

Total Return Average: 10%