What Does A Yellow Light Mean?

Lower Growth Heightens Volatility

But as everything slows, so do returns. Concerns abound about falling earnings and valuations. Year-to-date performance is showing the worst start for the stock market in over 50 years. With 10-year Treasury yields having essentially doubled from year end, bond returns are also poor. These asset classes are normally negatively correlated. But interest rates are reverting from such low levels that they needed to adjust higher despite the economy slowing, especially given high inflation rates. Nearly all asset classes have suffered materially. From their highs, the following are down significantly: Nasdaq 26% (enduring its worst YTD decline in its history), S&P 500 16%, All Country World Index 17%, Russell 2000 (small caps) 27%, High-Yield bonds 13%, and Preferred shares 19%.

We have been cautious, wary of elevated valuations and economic deceleration. We saw the yellow light flashing. Therefore, we have held cash, avoided expensive stocks (as always), maintained hedges by shorting the U.S. stock market (or via an inverse long), and purchased high-quality companies that had already suffered declines, where we believed prospects were appealing notwithstanding a slowing backdrop.

Red Light District

Here’s where we still don’t want to go—where the unsavoury investments are found. We continue to avoid unprofitable over-hyped companies whose valuations haven’t fallen enough to reflect their underlying realities. The list of once high-flying companies that have suffered more than 70% declines from highs keeps growing (e.g., Shopify, Netflix, PayPal, Robinhood, Peloton, AMC Entertainment, Roku, Zoom).

Most cyclical companies aren’t attractive either. Their revenues are susceptible to lower volumes and poorer selling prices while costs remain vulnerable to inflation. Too many investors are still overweight commodity stocks. Taxi drivers have mostly forgotten about cryptocurrencies and want to discuss energy stocks.

Elevated input costs, including raw materials, shipping, and salaries should hamper most companies’ profit margins, where they can’t pass along price increases to offset their ascending costs. That’s why Amazon mentioned inflation 23 times in its earnings transcript. Everything was inflating except its stock price.

At the same time, revenue growth is likely to weaken, further impacted by foreign exchange rates too as a strong USD restrains international receipts for U.S. companies.

We are looking for companies that can somewhat control their destiny. Earnings growth is driven by revenue growth and margin enhancements, and both may be under pressure for most companies. On conference calls, companies are talking down growth or talking up costs, or both.

Interest rates at the administrative short end of the yield curve have much further to rise as monetary authorities react to control inflation. The bond market has reacted well in advance though. The 10-year Treasury yield having more than doubled off the bottom. After touching 3.2% recently, up from 1.2% less than a year ago, it may level off, or even decline if softening persists. However, bonds generally still don’t offer attractive yields. Though, high-yield is much more attractive than in the recent past since yields have jumped to 7.5%. But many of these issuers are over-levered and may struggle to meet obligations if profits are under pressure. Not to mention, refinancing should be more difficult in this environment—higher rates, uglier fundamentals, and nervous lenders.

Going Green

When everyone else is turning negative, we tend toward positive. Not because we’re contrarian for the sake of it. But better investment opportunities are presented when sentiment turns so negative. Though there is still some room to decline, we believe this outsized correction is close to bottoming.

Bullish sentiment has now collapsed to 30-year lows. Surveys recently exhibited the lowest reading since 1992. Oddly, participants weren’t yet practicing what they were preaching, and stock ownership had not turned meaningfully lower. Once enough selling takes place, showing that investors have generally capitulated, a bottom should be in place.

The seasonal slump period (sell in May and go away) is almost always worse during this lead-up period to U.S. mid-term elections, where the markets are down slightly on average from May through November. But then the market has its best seasonal period post the November elections, where the S&P 500 has lifted by an average annualized 21%, without a single decline since 1900.

Furthermore, in periods when the sentiment reading was this low, stocks were higher one year later in 37 of 38 occasions.

These two stats coalesce our outlook. Though sentiment is pessimistic, investors have yet to sell in droves. Purchases of double leveraged ETFs and call option buying have only recently turned down from euphoric highs. Institutionally, pessimism is high too, near '08 levels; however, portfolios are still overweighted in equities. We expect widespread selling to occur soon and lead to a meaningful bottom.

Meanwhile, reported earnings are still outperforming analyst estimates. And expected earnings remain on the rise. This is the most important longer-term factor for stocks. And we don’t get too worried until a recessionary signal occurs that would bring along with it deteriorating earnings and falling valuations.

Consumer sentiment may be negative, but the job market remains rock solid. In the U.S., there are over 11 million openings, up from a recent 7 million monthly average.

Company insiders haven’t tilted to the sell side—a good sign for both company fundamental prospects and valuations.

The world’s insatiable attraction to the U.S. dollar should help support U.S. financial assets too. We continue to hold mostly U.S positions.

Our Strategy

We were too early with our hedges, reinstating them in mid 2020, after successfully hedging in early 2020. We believed the market had fully recovered to its fair market value (FMV), despite pandemic headwinds. Then the government stimulus, accompanying demand spike, change in the U.S. government, and advent of vaccines propelled the market into overvaluation.

Though our timing was off then, we seem to be back in sync with the markets. And we’ve been honing our TRACTM index tools to better time overall market and sector ups and downs. It appears that the S&P 500 has another 5-10% to fall. That would place it one TRACTM floor down from its peak—the maximum for a correction outside of a recessionary period. Since WWII, only 4 declines without a recession exceeded 20% with an average of those declines of 28%. Furthermore, of the 25 non-recessionary corrections where the S&P 500 fell by less than 20% since WWII, they lasted a median of 89 days. The current correction is already at day 135.

Our goal is to lose less than the market on the way down and outperform on the way up (that should always be your money manager’s objective)—the problem was we didn’t anticipate the market rising like it did in 2021. And we needed to wait patiently until the markets regressed.

In our view, our portfolios are now the highest quality since our inception. Features of our holdings include competitive advantages (brand recognition, market share, low costs), high returns on capital, substantial free cash flow, low leverage, impressive growth, and meaningful undervaluation versus our FMV estimates. Our convictions are high for our current holdings, and we are looking to take advantage of any further market weakness to average down in some and add new investments in others.

Tackling inflation may not be so easy now that price increases are more broadly based. Central banks may need to react more aggressively than we’re anticipating. If that’s the case then market valuations may have much further to fall as valuations could drop to below-average levels. This is another aspect to be mindful of as we look to reduce our hedges.

Our Portfolios

The following descriptions of the holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described. Below, we discuss each of our new holdings and updates on key holdings if there have been material developments.

All Cap Portfolios—Recent Developments for Key Holdings

Our All Cap portfolios combine selections from our large cap strategy (Global Insight) with our best small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. Importantly, they tend to recover back to their fair values much faster than smaller stocks, so they can be traded more frequently for enhanced returns. The smaller cap positions are less liquid holdings which are potentially more volatile; however, we hold these positions because they are cheaper, trading far below our FMV estimates making their risk/reward profiles favourable. There were no material changes in our smaller cap holdings recently.

All Cap Portfolios—Changes

In the last few months, we sold Iamgold when it inflected down from a ceiling. We also made changes within our large cap positions summarized in the Global Insight section below.

Global Insight (Large Cap) Portfolios—Recent Developments for Key Holdings

Global Insight represents our large cap model (typically with market caps over $5 billion at the time of purchase but may include those in the $2-5 billion range) where portfolios are managed Long/Short or Long only. A complete description of the Global Insight Model is available on our website. Our target for our large cap positions is more than a 20% return per year over a 2-year period, though some may rise toward our FMV estimates sooner should the market react to more quickly reduce their undervaluations. Or, some may be eliminated if they decline and breach TRAC™ floors. At an average of about 60 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear much cheaper, in aggregate, than the overall market.

Global Insight (Large Cap) Portfolios—Changes

In the last few months, we made several changes in our large cap positions. We bought TELUS International, Salesforce, Microsoft, Bath & Body Works, Five Below, US Bancorp, Simon Property Group, and Alphabet. We sold Lockheed Martin, Berkshire Hathaway, Bristol Meyers, and Coterra Energy as each achieved our FMV estimates, and Ericsson as it broke down through a floor.

TELUS International (TI) provides digital customer experience solutions to more than 600 global businesses, working with some of the biggest in gaming, communications, Ecommerce, and financial technology. Early last year, Telus spun out TI in the largest technology IPO in Canadian history. The IPO was a success, with TI’s stock rising 30% on its first trading day. However, the last six months have not been kind to it, its share price falling 40% to now trade below its first day of trading. TI continues to post impressive results. First-quarter revenues and earnings per share grew by 19% and 14%, respectively. The company is spending aggressively to hire new talent (nearly 7,000 new employees added this year) to manage new business wins. As the company achieves scale, we see margins and cash flow expanding. Using conservative growth estimates our FMV is $35.

Salesforce’s cloud-based offerings should maintain strong demand since investments to drive productivity and enhance worker flexibility are a must in the new hybrid work environment. Many technology companies experienced a demand ‘pull-forward’ during the global shutdown as businesses scrambled to purchase the necessary hardware and software to enable employees to work from home and consumers radically altered buying habits. As things return to normal, demand for everything from Netflix to Pelotons has deteriorated, sending overvalued tech stocks tumbling. While we recognize that growth will likely fade from current levels for Salesforce, we believe its current valuation reflects growth expectations which are too pessimistic. The company has a commanding market share exceeding 30%, high switching costs, and cross selling opportunities. Furthermore, Salesforce’s true profitability has been masked by heavy investments in technology and employees. Our FMV estimate is $260.

Microsoft was repurchased during the quarter as shares corrected from fair value. The company continues to fire on all cylinders, capitalizing on key technology trends such as cloud (Azure), business productivity and mobility (Windows, Office 365, Teams), social media and advertising (830 million LinkedIn users), and gaming (Xbox). It produced more than $20 billion of free cash flow during the third quarter alone. Cloud is growing 30% annually, remarkable for a business line in excess of $100 billion. The number of $100 million plus Azure deals doubled year-over-year as large corporations invested heavily in cloud. On the gaming side, constrained console supply will see gaming revenues decline mid-to-high single digits for the fourth quarter. Our FMV estimate is $330.

Bath & Body Works was spun out from Victoria’s Secret last year. The company is a leading specialty retailer with consistent same-store-sales growth, high sales per square foot, attractive operating margins, and enviable returns on capital. Growth should continue to come from new stores, international expansion, and current category enhancements. Its substantial free cash flow should allow the company to continue to repurchase shares. Its relatively low-ticket items have historically allowed the company to weather soft economic periods. Our FMV estimate is above $80.

Five Below, another specialty retailer, operates more than 1,200 retail dollar-type stores across 40 U.S. states. Its stores feature an assortment of unique items geared towards teens. In fact, Five Below co-engineers many of its products with manufacturers. These one-of-a-kind and on-trend products create loyal customers that shop frequently. We see the company uniquely positioned as a high-quality retail growth story, set to expand its store count to 3,500 by '30, double revenues by '25 and expand margins along the way as operating leverage comes with scale. Our FMV estimate is $225.

Simon Property Group is one of the largest REITs in the world, managing nearly 200 million square feet of shopping, dining, and entertainment properties. Simon’s stock fell dramatically in the 2020 market correction as investors feared that shopping malls and entertainment destinations would struggle to survive in a post-pandemic world. Today, its over 200 malls and outlets appear to be in solid shape, generating $1 billion of free cash flow in the first quarter of '22. Occupancy is at 93%, and the number of lease terminations is at a 5-year low. Simon has over $8 billion of available liquidity, and nearly all its debt is fixed at low rates, positioning it well for a rising interest rate environment. Our $150 FMV estimate does not attribute any value to Simon’s development pipeline nor its SPARC Group business which holds investments in several retailers. In the meantime, its dividend yield is a healthy 5.7%.

U.S. Bancorp is the fourth largest U.S. bank. We have long considered USB the best-run U.S. bank with its nuts-and-bolts focus on consumer and business banking, payment services, and wealth management. Management’s investments in the bank’s digital capabilities are starting to pay off, boosting revenue via increased use of its banking and mortgage portals (top-ranked in the industry) and lower costs via branch count reductions. USB’s acquisition of California-based Union Bank will catapult USB to the fifth largest competitor in California and is expected to be 6-8% accretive to overall earnings next year. Our estimate of FMV is $63, while it sports a 3.7% dividend yield.

Alphabet is mostly known for its Google and YouTube products. Its Cloud products and services are its real growth engines though, growing at a 40% plus annual clip. The company’s Q2 results were not met enthusiastically; much attention was paid to YouTube’s disappointing growth. We see YouTube’s slower growth as temporary, impacted by Russia’s invasion of Ukraine and the fast growth of YouTube Shorts, a short-form video feature that has a lower monetization rate. YouTube remains a streaming behemoth, accounting for 50% of ad-supported streaming time. Armed with over $130 billion of cash and marketable securities, Alphabet has the firepower to make acquisitions, invest heavily in R&D to stay ahead of the competition, or return cash to shareholders via buybacks. Our $2,900 FMV estimate does not give any value to Alphabet’s early-stage ventures such as Waymo.

Walt Disney’s share price declined over 40% since its post-pandemic high. The shares price was overvalued at its peak, fueled by hype from subscriber growth at streaming service Disney+ and excitement around the return of global theme park visitors, movie theatre showings, and cruise line voyages. Enthusiasm has quickly turned to concern—poor results from rival Netflix has put streaming growth into question, new lockdowns in China have dented the outlook for high cash-flow Parks, and rising inflation will likely pressure margins and crimp consumer spending for movies, merchandise, and theme park visits. We see these concerns as overblown. Disney’s unbeatable content will power streaming and theatrical growth for years to come, and we see tremendous long-term international opportunities in parks and cruise lines. Our FMV estimate is $170.

Income Holdings

It has been less than a year since high‑yield corporate bond yields bottomed at all-time lows of 3.9%. The yield has since lifted to 7.5%. Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of about 5.6%, and most of our income holdings—bonds, preferred shares, REITs, and income funds—trade below our FMV estimates. We are now finding more attractive investments to purchase. While we have been tentative during the bond and stock market corrections we anticipated, we have recently deployed some capital, sold a few positions that reached our targets (RioCan REIT, Vistra, and Whitestone REIT), and one that was exposed to Russia (Dynagas LNG Partners), and are looking to become fully invested.

We recently purchased Broadmark Realty Capital, a lender to real estate projects with high-quality collateral (mostly residential projects where principal losses have been negligible over many years). Its shares yield 11% and trade well below our FMV estimate of $11. We also bought Simon Property Group, yielding 5.7%, as detailed above, and Medical Properties Trust. Medical Properties is a U.S. net lease REIT with hospital tenants. Its compelling attributes include long-term leases (greater than 15 years), 100% occupancy, inflation escalators, solid rent coverage, and mission critical real estate since hospitals can’t simply move. It yields 6.4% with potential upside to our FMV estimate of $25.

Spoiler Alert

The economy is slowing, even without central bank tightening which will further dampen economic activity. We don’t believe a recession will result since overall demand remains robust. Our Economic Composite suggests the same. Though, of course, we’ll monitor it diligently for an alert to a cycle peak. In turn, inflation should naturally moderate without overly aggressive monetary tightening.

Valuations have compressed, leaving the markets reasonably valued. Because headwinds are in place, we continue to invest in companies we believe are less susceptible—both less reliant on economic growth and already materially undervalued. Since markets have begun to throw the babies out with the bathwater, we have been comfortable deploying capital into investment opportunities where prices have become unduly depressed.

There was no wall of worry until recently. It has been partially rebuilt. Slowdowns can trigger accelerations in market activity as we’ve recently witnessed. Both on the downside as panics ensue and spikes that follow once capitulation passes and prices revert. The markets may fall somewhat further but a prolonged decline, without a recession, seems improbable. It should be difficult for markets to fall too far while underlying values continue to rise. We believe the share prices of high-quality companies trading well below FMVs should do well, especially if the markets continue to rotate from growth to value. While the yellow light turned red, we expect it to change to green shortly. Stay tuned.

Randall Abramson, CFA

Generation PMCA Corp.

May 17, 2022

All investments involve risk, including loss of principal. This document provides information not intended to meet objectives or suitability requirements of any specific individual. This information is provided for educational or discussion purposes only and should not be considered investment advice or a solicitation to buy or sell securities. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. This report is not to be construed as an offer, solicitation or recommendation to buy or sell any of the securities herein named. We may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities named in this report. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. E.&O.E.

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