Equity Commentary: As at September 30, 2021
Source: David Picton | Jeff Bradacs, CFA | Michael Kimmel, CFA | Michael Kuan, CFA | Travis Irwin, CFA
Publish Date: Oct 15, 2021
As we go into the Fall, we believe we are starting the final chapter of a mid-cycle transition. In the final chapter, quality stocks tend to come under pressure. The catalyst in the prior years was the U.S. Federal Reserve (“the Fed”) moving away from maximum accommodation. In 1994/2004 this was marked by rising rates and in 2011 it was marked by the end of Quantitative Easing 2. This time around we have the taper. This is us moving away from maximum accommodation. The market is generally anticipating this change and the Fed confirmed this at their September meeting. This is a tightening of financial conditions and when that happens multiples tend to come under pressure. This process started at the beginning of September when the Fed started to pivot. It is entirely plausible that multiples could have more downside and this is something we typically see during this phase.
The second issue we are dealing with is the fact that earnings will likely be different from here. We believe earnings revision breadth will come down starting this quarter. Given the headwinds we are suddenly dealing with (labour shortages, wage pressures, input cost issues, supply chain bottle necks, etc), earnings revisions breadth could actually turn negative shortly and earnings surprises will likely not be able to match the pace we've seen over the past year.
For most of the quarter the S&P 500 Index (“the Index”) appeared immune to mid-cycle headwinds as it continued ahead setting a record with 2021 registering as the most daily new highs for the Index. Between the rise of COVID Delta variant, Fed Tapering, and the Evergrande crisis, the S&P 500 finally corrected in September by 5% to eke out a modest gain for the quarter. While September marks the first material correction for the Index, beneath the Index levels there has been an ongoing correction phase in the market since Q1 with 62% of S&P 500 companies off 10%+ from their 52-week highs and 16% of the market in bear market territory (down 20% from their 52-week highs)1.
Based on observations from past cycles, it is normal to see a correction phase during mid-cycle regimes. Within our hedge equity portfolios, we have favored quality and growth at a reasonable price (GARP) components - two factors that tend to fare well as we transition through the mid-cycle.
Small Cap Spotlight
We would like to highlight our position in Canadian Western Bank (CWB). Canadian Western Bank is a Schedule 1 chartered bank that provides commercial loans, real estate financing, and offers consumer loans and deposits. CWB has spent the better part of the last 5-years modernizing its franchise. We are now seeing signs of these investments paying off through its improved deposit mix and more stable volume growth. In each of the last two quarters CWB has increased its guidance for loan volumes and EPS growth on the back of their strong execution, an important signal for continued performance. While it has been delayed, the company works towards adopting Advanced Internal Ratings Based (AIRB) conversion which will help them drive growth even further once this is complete as a result of lower capital requirements. This will likely commend a premium to its Canadian bank peers. Historically, in periods of accelerating EPS growth (ahead of the industry) CWB has traded at a premium to the bank group (as high as double digit EPS multiples).
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