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Worrying Top-Down, Investing Bottom-Up

2021-05-28, Steven Kim



Despite the continued economic recovery anticipated in North America this year, ample concerns remain from a top-down perspective. With the S&P/TSX Composite and S&P 500 both above their pre-pandemic highs, optimism is abundant and a fear of missing out seems to be outweighing cautious consideration for fundamental risks in the markets.

Source: S&P Capital IQ

In its recent reporting, Canadian bank BMO highlighted expectations for the Canadian and US economies to post their strongest growth in decades in 2021. Despite the anticipated economic recovery, it’s interesting to note that while BMO reports positive retail and commercial borrower trends, in some cases they are just reaching pre-pandemic levels. Economic and health indicators have improved, but as market sentiment has seemingly become less concerned about risk, we are more cognizant (as always) about what could derail our portfolios.

Geopolitical concerns are an ever-present issue, and the resurgent conflict in the Middle East, military maneuvers near Russian borders, and past US/China trade flare-ups are reminders that anything can happen. Inflation is a silent thief of real returns to investors and savers that should not be underestimated, especially if it were to outpace central bankers’ expectations. Currently, from a Main Street perspective, lenders such as BMO report their borrowers will likely be able to pass through their own input cost inflation to end-customers. In conjunction with the risk of higher inflation, interest rates are low and equity valuations are elevated (reflecting a lower margin of safety), particularly south of the border. Valuations have grown in the US, with the S&P 500 currently at ~22x forward P/E, up from ~19.3x before the pandemic. Higher long-term interest rates would be troublesome for long bond portfolios, and while 2022 earnings growth could provide further support for equity valuations, significant optimism does seem baked into the markets when evaluating the plethora of IPOs with high valuations and high growth expectations.

The list of top-down worries will always be long and significant. Although we are circumspect, we understand our limitations in knowing all potential risks and being able to call them correctly. As a result, our clients should not anticipate large scale portfolio shifts based on our top-down concerns. This is because while worrying top-down, QV’s process is to invest bottom-up. While macro and market calls can come down to coin flips, QV portfolios invest in real businesses that provide products & services to customers, while generating revenues and cash flows. Therefore, we can control the price we pay for assets, how much underlying leverage the portfolio contains, and our ability to remain invested in tough periods without being forced sellers.

While one cannot say with confidence where inflation and interest rates are going, we can have higher confidence investing in the resilience of companies like Parkland Corp., a holding in the QV Canadian Small Cap Strategy. Although the bulk of its fuel station business has been negatively impacted by pandemic-related lower fuel consumption, Canadian convenience store organic growth was 5.5% and Canadian operating costs were down 9% in the most recent quarter. Importantly, the key question is whether one can confidently ascertain that this business will be better in the next 5-10 years. We believe the odds are in our favour. Each acquisition by Parkland’s established management team improves purchasing power (reduces costs) of the network. In addition, the company is just beginning to capitalize on its reach and customer base, having signed up ~1.9mm loyalty program members in five quarters since the pilot launch. Finally, Parkland’s consistent excess cash generation and well managed balance sheet increase the likelihood that this business will be even stronger in the next 5 years.

While continuing to have concerns about the broader market, our bottom-up focus on individual stocks and diversification within our portfolios help mitigate the possibility of being wrong. We remain invested and believe our portfolios will differentiate themselves from the market over time.

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.