Going against the grain and investing counter to the tide of prevailing market sentiment can be a difficult proposition for many investors. With many economic indicators currently flashing ‘late cycle’ caution signs coupled with inflationary pressures not seen in 40 years, the current market environment clearly favours stable businesses exhibiting defensive characteristics such as earnings and cash flow resiliency, pricing power and strong balance sheets to name a few.
Within the S&P 500, this trend has been evident on a year-to-date basis with the outperformance of the health care, consumer staples and utilities sectors relative to the weak returns in consumer discretionary and other more cyclical sectors. Nonetheless, as bottom-up investors, investing in a countercyclical fashion in out-of-favour, high-quality franchises can be valuable in the context of a broadly diversified strategy. In contemplating countercyclical opportunities, investors need to be open to the possibility that recent share price declines and improved valuations may already discount several of the downside risks feared by markets. Accurately forecasting macro-economic factors which can drive operating and financial results is an inexact science. As markets continually readjust expectations for individual stocks, the ensuing volatility can often produce compelling opportunities to acquire high quality franchises at a discount to their respective intrinsic values.
The QV Global Equity Strategy acquired shares of Lennox International earlier this year. Lennox is a leading designer and manufacturer of heating, ventilation, air conditioning (HVAC) and refrigeration systems for residential and commercial end markets. We identified Lennox as a compelling opportunity following a nearly 50% share price decline related to concerns around the US housing cycle. In Lennox, we like the steady growth nature of the business as well as its underlying visibility given its skew to the North American replacement market – which accounts for about 80% of total industry unit volumes. Driven by product line and distribution investments, Lennox has delivered consistent, double-digit growth in earnings, cash flow and dividends over the past 10 and 15 years – resulting in margin expansion and market share gains. The business generates returns on invested capital in excess of 40% – well above the portfolio average and indicative of the high-quality nature of the franchise. Today, Lennox shares trade at close to 16x forward earnings (after peaking at 31x in late 2020/early 2021) versus their long-term average of 21x.
Similarly, the QV Global Equity Strategy recently acquired additional shares of Swedish bank Svenska Handelsbanken. Increasing exposure to bank stocks late in an economic cycle has historically been a risky proposition due to weakening fundamentals, including deteriorating credit quality and decelerating loan growth. Banks often experience negative earnings and declining book values under these conditions. However, Handelsbanken possesses a 25-year history of materially stronger credit experience relative to its peers over multiple economic cycles, including in recessionary environments.
Source: Svenska Handelsbanken
For example, during the Global Financial Crisis in 2008/2009, its loan loss ratio peaked at slightly over 0.2% of total loans – significantly better than the peer group which posted total losses in excess of 1% of loans. Furthermore, credit quality improved during the COVID-19 pandemic while the broader peer group experienced increased loan losses during the period. In its most recent quarter, the bank also posted improved lending margins on higher interest rates while its capital levels were strong and well above regulatory requirements. Accordingly, we believe Handelsbanken faces comparatively lower downside risk versus an average bank given these strong fundamentals. Meanwhile, the bank’s shares only trade at a slight premium to book value while offering 13% ROE in its most recent quarter.
As macro-economic indicators continue to point to potential downside risks for the economy, we remain focused on identifying high quality franchises that trade at attractive valuations in relation to their underlying value. We believe that selectively considering quality countercyclical opportunities, often being sold indiscriminately in markets dominated by macro-economic concerns, is a sensible approach to capital allocation within a broadly diversified strategy.
