Portfolio Update

Global equity markets delivered positive returns during the month of July, following a difficult first half of the year. Geopolitical risk, high inflation and monetary policy tightening have raised fears of a recession taking place in the latter half of this year and 2023. With inflation well above the 2% target, central banks in the developed world remained steadfast in their campaign to raise policy rates. During the month of July, the Federal Reserve and the Bank of Canada increased their benchmark rates by 0.75% and 1%, respectively. As well, the European Central Bank embarked on a path of monetary tightening for the first time in 11 years by raising its key interest rate to 0% from -0.5%. Investors seem to have perceived these inflation-lowering measures as reassuring: the S&P 500 climbed 8.5% (in Canadian dollars), the S&P/TSX rose 4.7% and the MSCI World gained 5.6% during the month of July. These gains suggest the possibility of a recession scenario was largely priced into the market during the first half of the year. As highlighted in our most recent Economic and Capital Markets Outlook, the likelihood and severity of a possible recession differ across economies, with the United States and Canada relatively well positioned to address current headwinds.

Our portfolios continue to outperform their respective benchmarks on a year-to-date basis. We owe this to an investment strategy that favours market-leading companies that have the balance sheet strength to weather challenges in the broader economy and that trade at attractive valuations. We invest in these companies over securities that are either overly sensitive to rising interest rates or trade well above their intrinsic value.

Risks of a Short-Term Focus

“The stock market is a device for transferring money from the impatient to the patient.”
Warren Buffett

Much has been written in the realm of behavioral finance about an investor’s tendency to revert toward short-termism. One way this can manifest itself is the insistence on trying to time the market rather than focusing on long-term growth by remaining invested in the market. In periods of volatility, such as the one we are currently experiencing, this may seem like a tempting investment tactic. However, the process of selling your risky investments and temporarily shifting to cash ultimately entails two very difficult decisions: when to sell and when to re-enter the market. These decisions are almost impossible to time perfectly as no one knows with certainty when the market has reached its highest and lowest points. Chart 1 shows the impact on a hypothetical $1 million investment when the best 20, 50, 100 and 200 days in the market were missed over the 20-year period ending July 31^st, 2022. An investor who remained fully invested in the market over the period generated an annualized return of 7.9% while an investor who missed the 20 best days returned just 1.2% annually.

Furthermore, an investor who missed the 50, 100 and 200 best days generated negative returns. Investors who shift their portfolio to cash and try to time when to re-enter the market incur the risk of missing the market’s biggest gains. Remaining invested through both the bull and bear markets is crucial to long-term success – timing these cycles is not.

Portfolios with Lower Valuations Tend to Provide Better Protection in an Economic Slowdown

Our analysis has shown that companies trading at lower multiples of earnings perform relatively better than those trading at higher multiples during periods of slowing GDP growth. Although the level of outperformance varies over time, low-valuation stocks have typically provided better downside protection in most economic slowdowns since World War II. In general, our companies have lower valuations and higher yields than the underlying market
(Table 1).

Past economic slowdowns have been attributed to a variety of factors, among them are elevated inflation and interest rate increases. Our portfolios are made up of market leaders that are well positioned to weather the impacts of both over the long term. Companies we view as overvalued are often priced to reflect unsustainable growth targets. As companies contend with the current inflationary environment, growth targets become more difficult to achieve, and overvalued companies face greater downward price pressure. Additionally, increases in interest rates lead to higher borrowing costs. We believe the companies in our portfolios have the balance sheet strength to absorb these higher interest costs and allocate excess capital effectively.

Concluding Thoughts

Patience in the face of volatility will continue to benefit investors over the long term – the longer the time frame, the greater the likelihood of a positive outcome. We seek to construct our portfolios with this approach in mind, where short-term market gyrations are viewed as opportunities to increase our position in companies with solid fundamentals that we believe will perform well over time.