Portfolio Update

Equity markets declined during September, with the recent sell-off leaving major indices near June lows. Year-to-date, the S&P 500 returned -17.2% (in Canadian dollars), S&P/TSX -11.1%, MSCI World -18.9% and the MSCI Emerging Markets Index -20.8%. Persistently high inflation and expectations of further monetary tightening are heightening recession concerns. Global economies are adjusting to a slower growth path and recession risk varies across regions. On balance, we believe robust labour markets and healthy consumer balance sheets provide a significant buffer against the impact of rising interest rates. As we detail in our October Economic and Capital Markets Outlook, share price weakness is explained by a sharp contraction in market multiples as company earnings have remained relatively resilient. With investors discounting a pessimistic economic scenario unfolding, we see more compelling valuations beginning to emerge.

Equities continue to offer a higher return potential in the medium term

Despite continued market turbulence, we are maintaining a tilt to equities within balanced mandates. To begin with, we believe stocks provide greater longer-term return potential than fixed income securities at this juncture. Even as 30-year government yields have risen by 142 basis points year-to-date, a backdrop of monetary tightening and a period of higher-than-average inflation spells trouble for long-term bonds. Second, the recent declines in the equity market appear to reflect a pessimistic outlook on the global economy. Our read of economic data suggests that while there are risks in the short-term, a global recession is not a foregone conclusion. And even if there is a period of economic weakness ahead, we believe the companies held in our portfolios are well-positioned to weather the economic weakness. Our portfolio companies are showing lower leverage than their respective benchmarks. In addition, profitability and cash flow generation is higher today than in the year before the pandemic. Third, valuations are inexpensive: our Canadian equity portfolio is trading at 8.1 times estimated 2023 earnings and our international equity portfolio is valued at 9.0 times (Table 1). A lot of bad news has been priced in.

Historically, investors who have entered the market at these low valuation levels have benefitted. Finally, the choice to sell equities and invest the proceeds in fixed income or cash ultimately entails two decisions: when to sell and when to re-enter the market. As highlighted in our August Portfolio Update, getting the timing on both decisions right is very difficult. Missing the best-performing days in the equity market can be damaging to the long-term growth of a portfolio.

Mitigating the risks in forecasting earnings

We have discussed at length the risk of rising interest rates on stocks trading at high multiples (June Portfolio Update). However, the risk to these companies extends beyond just rising interest rates. High-multiple stocks derive more of their economic value from future forecasted earnings. We are not immune from the challenges and risks in forecasting earnings: company-specific and economy-wide events require a continuous review of our estimates. However, we mitigate this risk by investing in companies trading at lower valuations and by forecasting over a 3-5 year cycle. Companies trading at low valuations derive a greater portion of their value from near-term earnings which have higher visibility and are generally less volatile than earnings forecasted long into the future. The companies held in our portfolios do not depend on near-perfect execution of high-growth projections to justify their market price. In addition, should the economic cycle enter a difficult phase, with earnings growth at risk of being temporarily challenged, we believe our companies can navigate these headwinds more effectively.

Concluding thoughts

Our portfolios are constructed to generate value-added performance over medium- and long-term horizons. Companies trading at stretched valuations embed ambitious growth prospects: increased competition and execution errors can significantly weaken their outlook, resulting in lower than anticipated future profits. Our avoidance of excessive share price valuations and emphasis on allocating capital to companies with a strong management team and a sustainable long-term strategy which trade at a reasonable multiple of earnings has benefited our portfolios. Our patient approach as volatility increases is one of the keys to prudent investing. We are confident this disciplined investment strategy will continue to contribute to preservation and growth of your capital.