WHAT ARE THE EXPECTATIONS?
As I write this, companies in the TSX Composite Index are reporting earnings for the fourth quarter (Q4) of 2023. If looking only at the strength we have seen in equity markets, it would be easy to assume that everything is on track for a strong finish to the 2023 earnings year. However, analysts have forecasted that Q4 2023 earnings will be down 1.1% from the same period in 2022.
Source: Scotiabank GBM Portfolio Strategy, Bloomberg, FactSet, Morningstar CPMS
WHAT ARE ECONOMIC INDICATORS TELLING US?
If we look at the decline in Canadian manufacturing new orders, the rising unemployment rate, and the decline in the S&P Global Canada Purchasing Managers Index (PMI), it’s evident that Canadian economic data has been weakening. The PMI is based on a survey sent to purchasing managers at service-type businesses asking if they expect the volume of business activity to increase or decline in the next period.
This contrasts with the estimates by the analyst community shown in the chart above. It is anticipated that TSX earnings per share will lift off starting in Q2 2024 and hit record quarterly earnings by Q4 2024. Moreover, the 2024 annual earnings are projected to grow 10% above 2023. We know that stock markets are forward-looking, but we remain cautious of headwinds that may impact this growth.
WHAT ARE THE HEADWINDS?
REVENUE GROWTH IS A RISK.
Canadian consumer spending is 60% of gross domestic product. Interest rates are much higher now than they were in 2022. This has resulted in consumers spending more on mortgages and rent. According to Bank of Canada simulations, payments on currently outstanding mortgages will increase 18% by the end of 2024 from the level they were at in February 2022. This is in addition to higher car payments and food inflation, which will likely result in lower consumer spending overall. This will likely make it difficult for revenue to grow throughout 2024.
PROFIT MARGINS ARE A RISK.
TSX profit margins reached a record high of 13.8% (trailing twelve months) in the middle of 2022. By mid-2023, profit margins had declined to 11.0%.
Currently, the market expects that profit margins will move back to 2022 levels, but hurdles are apparent. High rates will likely result in significant increases in interest costs for companies with floating-rate debt or maturing fixed-rate debt.
Shipping rates are another area of cost escalation. The recent attacks on ships in the Red Sea have resulted in considerable disruptions to shipping channels. This has led to numerous vessels taking longer routes to avoid the Red Sea, triggering a 25% year-over-year increase in the cost to ship a 40-foot container. Keep in mind, however, that these shipping rates are nowhere close to the levels reached during the COVID-19 pandemic, but are disruptive nonetheless.
Source: Scotiabank GBM Portfolio Strategy, Bloomberg
HOW DO WE PROTECT OUR PORTFOLIOS?
The key to protecting our portfolios is ensuring the expectations we use in our analysis are reasonable for the environment outlined above. With the headwinds described, we feel we should be cautious about projecting higher-than-average revenue growth and profit margins. While there may be companies that achieve record profitability or revenue, we shouldn’t expect the whole portfolio to experience this.
A PORTFOLIO EXAMPLE WITH REASONABLE EXPECTATIONS
Recently, we added to Nutrien in the Canadian large cap strategy. For those who are unfamiliar, Nutrien is an important global producer of potash and nitrogen used in fertilizers. It also operates a global retail business that distributes crop input and protection products.
In 2023, the price of potash declined between 25% and 50% depending on the market. The decline in nitrogen has been similar. As you can imagine, this has had a sizable impact on Nutrien’s revenue and earnings.
On its Q3 2023 conference call, the company indicated that it expected earnings before interest, tax and depreciation (EBITDA) of between $5.8-6.4 billion USD in 2023. To put this in perspective, consider that EBITDA was $12.2 billion USD in 2022, and the company states a mid-cycle level of EBITDA would be something like $7.0-7.5 billion USD.
When we look at commodity businesses, we don’t try to predict future commodity prices. Rather, we look at the marginal cost – the price at which the next producer will be incented to add more production. This can be also thought of as a break-even price for a commodity producer.
Currently, Nutrien’s two main commodities are trading at their marginal cost, so expectations are not high for the commodities. Also, the stock’s current valuation multiple is below its average since the company was formed in 2018 (with the combination of Potash Corporation of Saskatchewan and Agrium).
While we are waiting for the commodities and/or the multiple to move higher, Nutrien continues to pay a dividend and bought back $1 billion USD in shares in the first nine months of 2023. We can’t forget that we are also getting a strong global retail business that has stable and growing EBITDA.
We think adding to a company that we feel is attractively valued, even using lower than average commodity prices, can help protect the portfolio if expectations in the market turn out to be too optimistic.
