Post thumbnail alt text

Grocery Shopping While Hungry

BOTTOM-UP OPPORTUNITIES DESPITE SHIFTING OPPORTUNITY COSTS

2023-08-25, Steven Kim



Have you ever gone grocery shopping while famished? If my experience is any indication, questionable or regrettable decisions are often made. Likewise, yield-starved investors who purchased negative yielding bonds within the last 5-6 years may now regret speculating that interest rates would have stayed low or gone lower. Today, the global stock of negative yielding bonds is much lower in value, approximately $0.5 trillion compared to its peak of over $18 trillion in late 2020. The fact that total US GDP was about $24 trillion in 2021 provides context to that amount.

Source: Bloomberg Barclays Global Agg Neg Yielding Debt Index

This craving for investment yields extended to many market participants. Investors were pushed out on the risk spectrum into non-investment grade (or “junk”) bonds, along with various alternative asset classes. Equity investors took on increasing valuation risk to gain equity exposure. Before this period, the price-to-earnings ratio of the S&P 500 was 14-16x (or 6.7% earnings yield) in 2014, versus 20-25x (4.4% earnings yield) in 2021. For much of the past decade, cash was also maligned in portfolios as ‘trash’.

SATING THE APPETITE WITH HIGHER INTEREST RATES

As the markets now adjust to a different interest rate environment, the period when ‘there was no alternative’ and savings deposit rates at Canadian banks were virtually nonexistent seems like a bad dream. In hindsight, those who were guilty of filling their shopping carts (investment portfolios) while hungry for yields did so because a world of higher inflation & higher rates seemed a pipe dream at the time.

Today, however, the market’s appetite for yield is sated. Cash is no longer a 4-letter word and is borderline ‘treasure’ with its tall yield. Pundits, strategists and logic make a reasonable case for low risk ‘cash’ over other asset allocations. This is because short-term Guaranteed Investment Certificates (GIC) now in some cases offer 1 year interest rates above 5.5%. The case for ‘cash’ at these return rates is reasonable, considering flexibility to redeploy later and the relative improvement over the offer of nil a few years ago. In practice, overall asset allocation, effective real yields after taxes/inflation and reinvestment outlook are all critical to account for.

PET VALU – A REPRESENTATIVE PORTFOLIO OPPORTUNITY

As managers of our clients’ capital, cash in QV portfolios is a residual or outcome of the opportunities available. In simple terms, higher cash levels may reflect less attractive investment opportunities, and vice versa. Although we acknowledge the appeal of higher short-term yields available in cash-like instruments, we continue to see attractive relative opportunities.

For example, we recently added to Canadian small cap holding Pet Valu (PET), a retailer of pet-related products across Canada. We believe the underlying cashflow growth potential of the business provides built-in inflation protection. Canadian pet industry spending has grown at over 6%/annum over the past 25 years. In addition, we expect PET’s revenues to show resilience, as spending on pets is closer to essential than discretionary. Alongside that tailwind, PET makes the case that it can grow its store network by 4-5%+ per annum with modest capital investments required. Combined, PET’s medium-term revenue growth outlook of high single digits to low double digits is appealing. The company’s cash generation levels and capital light business model ensure that it is not overly reliant on debt to achieve the store network growth. Despite potential increases in interest costs on its existing debt, we anticipate larger revenue growth opportunities as highlighted above.

PET’s valuation levels have recently improved from above 20x earnings (<5% earnings yield) to ~15x (6.7% earnings yield). This has been caused by concerns such as new entrants to the space and slowing momentum off an exceptional growth period. In our assessment, the entrance of international players into Canada is often ‘easier said than done’ by virtue of the logistical challenges of a disparate population base over a very large area. From a medium-term perspective, we take the near-term concerns as an opportunity and have added to our toehold position. In summary, PET’s potential high-single-digit cashflow growth in the next 3-5 years, 1.5% dividend yield, and undemanding P/E of 15x support our view that it is an attractive business ownership opportunity for the strategy, irrespective of various inflation scenarios or short-term GICs yields.

All views and projections are the expressed opinion of QV Investors Inc. and are subject to change without notice. This Update is provided for informational purposes only. QV Investors takes no legal responsibility from any losses resulting from investment decisions based on the content of this Update.

ABOUT THE AUTHOR

Steven Kim | Portfolio Manager, Canadian Equities

Steve oversees QV’s investment process and makes portfolio decisions for the Canadian small and mid cap strategies.