This time’s recovery will take longer

BMO’s James Thai argues that as the market slowly recovers it’s critical to separate winners from losers

Michael Ryval 16 April, 2020 | 1:32AM
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As the COVID-19 coronavirus continues to spread havoc at home and around the world, markets have slowly begun to recover from last month’s deep losses. But the shape of economies has changed and when it comes to stock selection, James Thai, director and portfolio manager, disciplined equities at Toronto-based BMO Global Asset Management, argues that it’s critical to adopt a partial top-down view and separate the winners from losers.

It’s hard to call
“What’s different about this downturn, as compared to previous ones, is the sharpness. We’ve never seen an environment where the economy has come to a complete stop in less than four weeks,” says Thai, lead manager of the $1.6 billion BMO Canadian Equity F. “Whether it is short-term or long-term, it’s too early to make a definitive call. But with the magnitude of the change in the economy it will take a little longer to rebound. I wouldn’t expect to go back to where we were at the end of last year within a few months. It will take longer than that.”

Markets are leading indicators of the economy and given a 20% rebound from the lows reached at the end of March, most observers are looking ahead at 2021. “Things are probably going to be better a year from now,” says Thai, a Toronto native and a 20-year industry veteran. All told, his team oversees about $30 billion in assets held in Canadian and U.S. retail and institutional funds. “But there is likely to be short-term volatility as companies start to report the second quarter, when we see the full impact of the economic downturn. Those numbers will not be good, for sure.”

One of the most startling economic measures is that almost one million Canadians applied for employment insurance in the week of March 16. “The previous high was 300,000 initial claims and that was in the depth of 2008 financial crisis,” says Thai. In addition, the speed and severity of the stock market correction is another distinguishing marker for this downturn, especially for those individuals who are close to retirement. “When the market drops by 35%, a 20% rebound is not enough to get you back where you started.”

Thai believes that even though governments have stepped in with a slew of programs to help individuals and businesses cope with the economic shock, it’s hard to know if the measures are sufficient. “It’s taken a long-term economic depression off the table. But I don’t think it will be enough to take a recession off the table,” says Thai, who has earned both a Bachelor and Master’s of Applied Science in Computer Engineering from University of Waterloo. “The one good thing that came out of the 2008 financial crisis is that governments learned they had to react quickly and decisively and try not to finesse things too much. It also took a while for these support programs came into place,” says Thai, adding that it could many months before people are comfortable about going to sporting events or large gatherings. “That’s probably what caused a longer recession. This time, the mechanisms and the experience gained from the financial crisis allowed governments to react much faster and with large dollar amounts of support.”

Good time to buy
Make no mistake, however, from an equity perspective valuations are now more attractive, provided one has a long-term outlook. “If you look at metrics such as price-to-earnings, obviously price has come down dramatically. The big question is, have the earnings come down more or less than the price?  We won’t have any clarity until we have the second quarter behind us. But what the market is looking at are earnings in 2021.”

The market is signaling that it expects a rebound and things will be back to normal by next year. “It’s now a question of which companies can survive the next few quarters,” says Thai. “There will be winners and losers from this crisis.”

Companies with exposure to the digital economy will be better off, Thai argues. “Anything in e-commerce, whether it’s a national retailer or a supply chain or the real estate that’s required for that business will be better off. On the flip side,” Thai adds, “anything that requires a physical location may be hurt. For example, movie theatres and certain types of restaurants will find it challenging to rebound as quickly.”

Thai observes that non-cyclical or defensive companies should continue to gain from the economic downturn. These include telecoms, utilities and consumer staples. “If things are uncertain for the next two quarters they will continue to benefit,” says Thai. “Cyclicals, such as financials, energy, commodities, or anything that involves discretionary consumer spending have underperformed. But if I am completely wrong and the economy shoots up starting in the summer, then you’re likely to see the cyclicals out-perform. There are so many unknowns. It’s one of the hardest times to make forecasts.”

From an investment perspective, Thai and his team utilizes a quantitative model that depends on a number of metrics, which Thai describes as factors. These include growth, value, profitability, management, momentum, sentiment, and environmental, social and corporate governance (ESG). These factors are used in Core Alpha strategies used to manage larger and mid-cap companies. The objective is to out-perform the benchmark S&P/TSX Composite Index.

Thai’s top picks
BMO Canadian Equity F, which falls under the Core Alpha strategy, has a relatively small list of 45 stocks, which have received high scores on an internal score card. From a sector standpoint, the weightings are close to or under the benchmark, as, for instance, financials account for 27% of the portfolio, versus 31% in the benchmark and industrials are 12% versus 14% for the benchmark. “We focus on selecting the best of each sector.”

One favorite name is Empire (EMP.A), which operates major supermarket chains such as Sobeys and FreshCo. “It has decent profitability and growth and is reasonably valued. While it doesn’t shoot the lights out, it’s positive in enough of the factors that it comes up as a pretty scorer overall.”  On a price-earnings basis, it is trading at 13.9 times 2021 earnings, versus peers that trade between 16 and 18 times forward earnings. One key attraction is Empire’s development of an online grocery delivery business that will be launched next year. “They will be well-positioned to benefit if people get used to ordering groceries online,” Thai says.

Another top holding is Toronto-based Constellation Software (CSU), is best known as an aggregator of software developers. “They have grown by acquiring very small businesses and being able to deploy capital in a very intelligent way,” says Thai. “Their profitability is very high and they benefit from consistent cash flows. In this environment they are very well-positioned to start deploying some of that capital they have been saving up.” The stock trades at 26.5 times 2021 earnings. That compares favorably to global peers that trade at around 40 times forward earnings.

From a performance standpoint, year-to-date BMO Canadian Equity F has returned -21.71% (as of April 8), or 1.94% below the Canadian Equity category, and 1.8% below the benchmark. However, since 2017, when the fund adopted the Core Alpha approach, it averaged -1.98%, versus -2.21% for the category, and -1.08 for the benchmark.

Looking ahead, Thai argues it’s critical to think about which companies will survive this traumatic period. “Some companies may be cheap because they will not do as well in the future. That is the challenge of picking the stocks right now,” says Thai, “We have to separate the winners from the losers. In normal times, you can do a lot of bottom-up analysis and just focus on the companies. But when there are a lot of macro impacts, you have to think about a top-down approach.”

Using Empire as an example, Thai says one has to determine what its future earnings might be. “But you also have to take into account some of the changes at the macro level. These include the change to online grocery delivery and consumer behavior. People may be eating more often at home, and less at restaurants.”


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Michael Ryval  is a Toronto-based freelance writer who specializes in business and investing.

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