Equity Commentary: As at September 30, 2020

Source: David Picton | Jeff Bradacs, CFA | Michael Kimmel, CFA | Michael Kuan, CFA

Publish Date: Oct 21, 2020

Read Time: 9 minutes

Canadian Equities

The Canadian equity market (S&P/TSX Composite Index) continued its recovery during the third quarter up 4.7% with early cyclical sectors including Industrials, Materials, and Consumer Discretionary outperforming the index. The Energy sector continued to lag the market, however, divergence within the sector was massive with natural gas weighted names up 30%+ (Tourmaline Oil Corp. and ARC Resources Ltd. for example) while weighted oil names were down close to 30%. For the Canadian economy, the housing market saw a resurgence during the quarter as pent up demand created by lockdowns led to record July home sales. The robust July home sales was the strongest month for homes sales recorded over the past 40 years with 30% more homeowners closing on properties compared to this time last year¹.

Since the March lows, both the economy and equity markets have seen rapid rebound fueled by extraordinary level of monetary easing, record level of fiscal transfers to households, and pent up consumer demand. Looking forward, with consumer income support fading and parts of the economy remaining at reduced operating capacity due to social distancing, the pace of economic recovery is expected to lose steam. For equity markets, we expect heightened volatility as investors weigh between headwinds of a moderating economic backdrop and upside appeal of equities given an ultra-low rate environment and accommodative central banks. Lastly, heading into fall we highlight that there is an upside fat tail in equities if a trial on a Covid-19 vaccine is successful. In this scenario, we think a vaccine approval could challenge assumptions about negative real rates and steepen the yield curve supporting a rotational into cyclicals and challenge tech leadership.

U.S. Equities

Amidst the COVID backdrop we married our typical framework for tackling stock selection (positive change, good value, high quality) with a slight adaptation for the unique environment. We thought there would be four types of outcomes for various companies. We thought there would be a first segment of companies whose business was pulled forward. E-commerce companies were obvious beneficiaries and we were quick to establish/boost positions here. The second category of stocks we liked were V-shaped recovery candidates. While operations may have been abruptly interrupted, as soon as the economy was able to re-start, these businesses were going to see a big inflection in their operations. Sought after retailers and restaurant operators, housing companies and auto levered companies are examples of names that drew our attention. U-shaped recovery candidates are those that we feel will take longer than normal to experience a recovery. The banks fall into this category as they are being used for social financing purposes during this crisis. As such we have reduced weightings to the Financial sector. Finally, there are companies where COVID ended their prospects for future viability. Mall operators would fall into this category. Obviously, we have steered clear of these unfortunate structural losers.

We believe we are on the cusp of a new economic cycle. We are getting closer to a vaccine and new rapid-testing protocols should soon help normalize the economy. The COVID hangover will keep current positioning in place for some time but it should gradually transition towards a more cyclical cycle with the potential for commodities to lead the way. The unthinkable prospect of inflation appearing in the system seems more plausible with the U.S. Federal Reserve now expressly targeting it, ample fiscal and monetary stimulus and elevated savings rates.

Regulatory headlines remain an overhang over large technology companies but we present three thoughts to bear in mind. First, any proposed bill will require Republican support. It is our view that lots of change will be required between now and any House-led proposal to split or breakup any tech company. Secondly, passing laws takes time, on average, it could take 3-4 years to get a bill passed and only 3% of proposed bills ever get passed. Expect this to take time and require a lot of compromise. Lastly, in the event of Democratic sweep in the November elections, the makeup of the Senate won’t be far from a 50/50 split. In that scenario you can assume that there are enough “Blue Dogs” as part of that majority – conservative Democrats - who will likely be tough to convince of such draconian measures. The final point to make is that the stocks likely embed much of this risk. Trading at low double-digit EBITDA multiples despite EBITDA growth in excess of 20% would suggest concerns are well built into the share prices.

International Equities

European equities have been lackluster over the past 3 months, essentially ending the quarter unchanged having traded within a very tight range. This was rather disappointing given the favourable conditions for European equities to close some of 150%+ underperformance gap relative to the US that has developed over the past decade. The prevailing thought was Europe had re-emerged from the first wave of COVID, its politicians have finally come to their senses and willing to stimulate the economy and allow some form of debt mutualization, and the global rotation from growth to value (which Europe is over-exposed to) was just beginning. This spurred fund inflows to European equities for the first time a number of years. However, this optimism did not last long. Europe seems to have hit a second COVID wave and the re-imposition of some restrictions have slowed the service sector down; Fears about a no deal Brexit has re-emerged as we head towards the year-end deadline.

As government around the world offer fiscal support to their economies, many are taking the opportunity to use the policies to also do good for the environment. Across Europe, many countries, led by Germany and France, are offering higher incentives for Battery Electric Vehicle (BEV) purchases as part of their stimulus package. As well, China extended their new energy vehicle purchase subsidies for another 2 years, giving another boost to EV demand. We continue to hold stocks in companies that will see market share gains as a result of this shift. We also initiated a position in a Chinese electric vehicle manufacturer that has sales doubled over the past year and recently earned the highest net promoter score amongst customers in China.

With much of the world still uncomfortable and/ or face restrictions with air travel, dining out, and attending cultural events, there is plenty of disposable income to be spent elsewhere. Areas such as home improvement and recreation vehicles have seen a big boost in demand. Another industry that has done well are the online gaming operators. The market has focus on the likes of DraftKings Inc., in the US as a winner, especially with major sports resuming plan. In Europe, the likes of GVC Holdings PLC and Evolution Gaming Group AB (Evolution) are winning at the expense of on-premise operators. Evolution is unique in that it produces and licenses live casino table games to other online operators and benefits from the growth in the industry in general.