Why Investors Should Look Beyond Macro

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Craig Jerusalim

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Craig Jerusalim, senior portfolio manager, Canadian equities at CIBC Asset management.

I am generally guilty of being called an optimist at times, and I definitely came into this year more positive than most. However, I’ve started to see more signposts with respect to inflation, interest rates, inventories, and overall demand start to wane, such that I’ve turned more cautious in my near-term outlook, especially after the rally in equities we experienced to start the year.

We have to remember that there is a significant lag from the time rates move higher until the point where they begin to choke off demand and have their desired outcome of cooling off growth. And we’re only starting to feel the full brunt of that monetary tightening now. We’re definitely seeing it in housing and starting to see more pockets of weakness emerge for the consumer. While jobs are aplenty and the overall health of the consumers started the year from a very strong level, much of their excess savings have now been depleted. Inventory levels are rising and a more cautious tone is being expressed by management teams that we hear from through quarterly earning season.

But we also have to remember that the stock market is not the economy and the economy is not the stock market. The three biggest factors that drive equity market returns are sentiments, as reflected in valuation multiples; company earnings driven by revenue and margins; and future growth, which is very idiosyncratic and sector dependent. And when you look at stocks through this lens, the story is somewhat nuanced, but definitely not all bad. Let’s start with the positive.

In Canada, overall valuations are quite attractive. This is in sharp contrast to the S&P 500 that is back trading above its long-term average multiple. Over the past 20 years, both the TSX and the S&P 500 have oscillated around a 17-times multiple of earnings. Recently, the S&P 500 has been close to 18 times while the TSX has remained sub 13 times forward earnings. Some of this may be explained away by sector mix, but the biggest takeaway is that the TSX looks quite cheap, and it’ll be hard-pressed to get much cheaper outside of a really ugly financial crisis-type scenario of which we are simply not expecting.

Earnings outlook is where the story starts to get cloudier and where my cautious near-term outlook takes hold. As the economy slows and revenues fall, we will likely see margins and therefore earnings start to contract, at least until businesses adapt and cut costs to reestablish those prior margins. This is all part of the evolving, rolling economic cycle and nothing overly concerning. Many companies have had a lot of time to prepare for this upcoming slowdown and adjust to a higher-rate environment. And at least now, with higher starting interest rates, central banks will have ammunition to support the economy when needed.

Typically, earnings per share or EPS for the broad benchmark contract about 25% during a recession or 35 to 40% during a financial crisis, like the one we experienced in 2008. There’s no evidence to suggest that that is the case this cycle, but forward earnings have only contracted about 8 to 10% in the U.S. and Canada respectively, suggesting that there may be more pain left to churn through. That being said, the cheap valuation for the TSX offers a nice counterbalance as we could see multiples expand as investors begin to look through the downturn.

And then there’s the final point on growth, and this is what I’m most optimistic about. First of all, I would characterize the start of 2023 as a market that saw value return to favour. However, I’d also say that we’ve experienced a very low-quality rally. Stocks that performed the worst in 2022 have seen the biggest bounce back in 2023, as well as unprofitable companies. In fact, the amount of unprofitable companies in the Russell 3000 is now higher than at any time other than through the tech crash and the financial crisis.

Now, we have all seen the evidence and follies of market timing, and the bears will always stay bearish and miss the ultimate recovery. But right now, I’m seeing a tremendous amount of opportunities in mispriced growth stocks, not the unprofitable, long-duration growth stocks that led in 2020 and 2021, but high-quality businesses that have growth characteristics greater than the overall market, and are surprisingly trading at valuations cheaper than the overall market. This is a great setup for patient investors willing to ignore market timing signals and instead focus on sectors and stock selection as their main source of alpha.

Let’s dig into some of those areas of mispriced growth out there. I still see the most mispriced growth opportunities in energy today. This energy cycle is so different from any other cycle I’ve experienced or studied, and while it is dangerous to say this time is different, I do think this energy cycle is different.

Starting with the supply side of the equation, we will likely never see another major new oil sands project ever be sanctioned or a net new North Sea project or even a new pipeline be built. And that’s due to the environmental uncertainty combined with NIMBYism, or not in my backyard, and a more empathetic First Nations consideration. No one is going to invest billions of dollars upfront not knowing what their return on investment will look like five, 10, or 20 years down the road.

Plus, the other source of major supply growth, being the short cycle shale growth, is also hitting hurdles. Not only have the best locations already been exploited, but the fast decline profile of shale production suggests companies need to constantly be recycling cash flows back into the ground. But investors are now demanding that all that free cash flow be returned in the form of dividends and buybacks, starving companies of future production growth. Any company that announces major investments at the expense of a return would suffer harsh consequences from fickle investors today.

These two dynamics have also shifted the utility of OPEC+ to once again begin acting like the cartel that they are. Such that if demand falls for whatever reason, OPEC+, which includes Russia, can cut production knowing that North American producers won’t simply steal the market share like they did through much of the last decade.

And then on the demand side, even if you take the most optimistic position out there for electric vehicle adoption, it is hardly going to make a dent in global oil demand because almost all of the growth outlook is coming from emerging markets where the emerging middle class consume much more energy as they transition from rural to urban dwellings.

In addition, we also have the eventual restocking of the Strategic Petroleum Reserve in the U.S. that is only seen outflows for the past few years, all in an anticipation of the next oil shock when the SPR will be counted on once again. And then you have an upside case in oil demand as China reemerges from its extended COVID shutdown. And that increased demand is what could take oil back to triple digits, even if that’s not factored into our base case.

And the final piece of the puzzle is valuation. Many of the highest-quality producers in Canada are still trading near trough valuations on a funds from operation and free cash flow yield metric despite this positive backdrop. While I won’t argue for multiple expansion, this hard-to-see multiples contract from current levels, which means shareholder returns will be coming from cash flows that these companies are producing.

Since many of these companies, like CNQ and Tourmaline and Cenovus, have already paid down all their debt or are close to their targets, it means that nearly 100% of the cash flows after sustaining CapEx are being returned to shareholders in the form of dividends and buybacks. And unlike their U.S. peers, many of the Canadian producers have long-life, low-decline, and low-cost production, meaning investors don’t need to worry about dilutive M&A or the urgency to replace existing barrels.

Moving onto another interesting area where we see lots of inexpensive growth prospects is financials. Now, I wish I could get more positive on the banks in the short term because they definitely satisfy the inexpensive valuation criteria, and it’s usually a good rule of thumb to buy the Canadian banks when the group is trading at less than 10 times forward earnings. But right now, there are a lot of fundamental uncertainties working against the bank subsector. The group is facing slowing loan growth, especially in mortgages, deteriorating credit metrics with rising provisions for credit losses, challenging operating leverage with rising labour and fixed costs, and a harsher regulatory backdrop with rising minimum capital requirements that will impact profitability.

I’ll also say that the banks are currently cheap for good reason. Given their high dividend yields and the strong oligopoly in Canada, the group will do just fine in the medium term. However, there are many more nonbank financials that have the opportunity to thrive, even if the economy does soften and will likely grow earnings regardless of inflation and the economic backdrop.

In fact, higher interest rates are supportive for companies like Trisura that benefits from a hard insurance market. A hard market is the term for rising premiums. Also, Element Fleet that has the scale and competitive moats to constantly raise prices. And finally, Brookfield Corporation whose collection of real assets of infrastructure or renewable power and real estate often have automatic inflation escalators built into their contracts. All three of these companies are also trading well below intrinsic value despite their strong growth prospects.

So in conclusion, although I do spend time thinking and worrying about the macro outlook, the vast majority of our efforts are spent seeking out the companies that are best in class with sustainable competitive advantages and quality attributes that can thrive regardless of the picture that the market is currently painting.