How to Invest Against Central Bank Headwinds

While the longer-term outlook for stocks is relatively promising, it’s the shorter-term perspective that is fraught with uncertainty as central banks attack inflation through rate hikes.

Stu Kedwell, co-manager of the 4-star gold-rated $2.4 billion PH&N Canadian Equity Value Fund F (also available in D series) says there is a chance their moves could tip economies into recession.

“The change in liquidity and resulting change in financial conditions could either pressure some other investors to make shorter-term decisions, which could impact pricing, or companies may have more leverage than they otherwise should,” says Kedwell, senior vice-president and senior portfolio manager, co-head of North American equities at Toronto-based RBC Global Asset Management (RBC GAM). “Any time you go through a period when central banks are removing liquidity that can be problematic for some investors. It’s not problematic for us because we don’t use leverage and have a longer time horizon. But it can create a lot of volatility.”

Don’t Underestimate the Ukraine-Russia Impact

A 26-year industry veteran, who joined RBC GAM in 2002, Kedwell acknowledges that while the Ukraine-Russia conflict is a humanitarian crisis, the impact on supply chains and reaction in commodity markets is discounted to some degree. “At this juncture, while we would all like to see a resolution to the war in Ukraine, I am focused on the removal of liquidity by central banks.”

However, Kedwell adds, even these moves are discounted to some degree. “When yield curves have moved the way they have, the market is trying to anticipate the future. A good degree of the tightening that we will see has already been priced into the yield for the next 12 months.”

Market’s Partly Pricing in a Recession

A parallel concern is an impact on earnings, Kedwell notes. “There is probably a 50% chance of a recession priced into the stock market. So there are two things we have to discount: first, what will valuations be, once interest rates run their course. The S&P 500 multiple is back to 17 times earnings. Just like much of the interest rate moves are likely reflected, the valuation move has taken place to some degree. The second question will be, what earnings levels do we apply those valuation levels to? And that’s where our scenario-based approach is really important. Because for a company, or a market, we can ask, what does this look like in recession, and how far are those earnings from current expectations? What will be the multiple applied to those earnings? Then we can construct a portfolio in a manner that delivers as much positive optionality as possible—regardless of the environment that ends up.”

Kedwell is part of a four-person team that includes Doug Raymond, senior vice-president and senior portfolio manager, co-head of North American equities, Sarah Neilson, vice-president senior portfolio manager and Irene Fernando, vice-president and senior portfolio manager. Relying on a value approach that measures stocks based on a range of scenarios, Kedwell and Raymond have overseen the portfolio since the fund’s inception in December 2009. Year-to-date (June 9) PH&N Canadian Equity Value Fund F has returned 1.60%, versus -1.73% for the Canadian Equity category. On a 5-year and 10-year basis, the fund has returned an annualized 8.87% and 9.93% respectively. In contrast, the category has returned an annualized 7.34% and 8.57% for the same periods.

“While there are always issues as re-financing costs rise, our major area of focus is on earnings,” Kedwell reiterates, adding that earnings growth expectations for 2023 are 5-6% in the U.S. and similarly for Canada. “That likely reflects a bit of a soft landing in the economy. There could be a risk to earnings, should the economy slow further.”

Soft Landing Still in the Cards

Kedwell notes that if there is a “soft landing”, the market bottom will be sooner. “In the event of a recession, which could play out in the next six to 12 months, it could be further into 2022. There is some seasonality to the market since it often rallies a little bit in the summer and has a tougher time in the fall,” says Kedwell, who argues that inflation has likely peaked and may stabilize by year-end.

Given the market correction in late April, Kedwell and his team have been taking advantage of lower prices to use up some of the fund’s 2% cash levels on existing and new holdings. “If there are 11 sectors in the S&P/TSX Index the only ones that trade with valuations higher than their historical levels, are staples, communications, industrials and utilities. They are highly defensive. But the remainder of the market is trading in line or below its historical valuation. Even though the cash might be 2%, it hasn’t held back the fund’s performance. The key thing is you can find businesses trading below-average valuations.”

Banking on Value Picks

At the margins, the managers have reduced some utilities and consumer staples companies that have seen their prices rise, and re-deployed the proceeds into several companies. For example, they like Onex Corp. (ONEX), and Power Corp. (POW), both of which trade at a discount to their net asset values. “We have also redeployed a little bit of capital into the banks,” says Kedwell, noting that four of the top 10 positions are Canadian banks.

From a sector perspective, financial services is the largest weighting at 32.5% of the portfolio, followed by 19.1% energy, 11.9% industrials, and 9.5% basic materials.

In building the portfolio, the managers apply different attributes to different sectors. “In the energy and basic materials sectors, you’re looking for low-cost providers, with strong management teams and reasonable balance sheets so that the company can weather the ups and downs of the commodity environment,” says Kedwell. “In the financial services area, you are looking for strong returns on equity and returns on capital. Not that this isn’t the case in the basic materials area where you tend to sink a ton of capital and then you harvest it for some time. But the commodity price ends up being a large determinant in returns. You need to look at the balance sheet and cash cost structure.”

High Conviction, High Concentration

Running a portfolio of 83 names, of which the top 10 accounts for almost 40% of the fund, the managers cite Maple Leaf Foods Inc. (MFI), a large Canadian meat and protein provider. “They have built their business responsibly with a strong focus on profitability and managing their environmental footprint,” says Neilson, who joined RBCGAM in 2004, after four years of working as an engineer in the automotive industry. “They are carbon-neutral, and have a visionary goal of being the most sustainable protein company on earth.”

The firm, which had revenues of $4.5 billion in 2021, “has made some sizeable strategic investments over the last few years to achieve a goal of margin improvement,” says Neilson. “But the market is in a wait-and-see approach on that. We’ve had a very challenging environment because Maple Leaf Foods has a labour-intensive business which has had COVID-related issues, inflationary pressures and supply-chain difficulties. But management is increasingly focused on delivering EBITDA [earnings before interest depreciation and amortization] margin improvements of over 2% into 2023. They are seeking to grow sales in some of their higher-margin products, like those raised without any antibiotic needs. Those are a growing share of the market.”

Shares in Maple Leaf Leafs are trading at about $28, for an enterprise value to EBITDA metric of 7.5 times. The shares pay a dividend yield of 2.85%. The managers believe there may be about a 30% upside in the next two years, based on earnings and valuation improvements.

Another favourite is Altagas Ltd. (ALA), a Calgary-based energy infrastructure firm that operates a natural gas distribution network in the U.S. and a midstream energy business in Western Canada. “We built a position in 2018 when things were going wrong for the company and the market really reflected that,” says Neilson. “Back then they had closed a large utility acquisition that burdened the company with a significant amount of debt and financing requirements that the market anticipated would hinder their dividend payout ability, and possibly require a massive equity need. The share price was severely punished and went down to about $15 [in late 2018] near where we entered the stock.”

Yet despite market pessimism, Neilson had faith in the company. “We saw a path through a management change, and a dividend right-sizing, that would help improve its position, both financially and in the market.” Indeed, a new management team is in place and with a focus on capital allocation, it has reduced the firm’s debt. “As they got through this period, increasing value accrued to shareholders.” Today, the share price has doubled to $30.

Looking ahead, Neilson and her team believe that Altagas’s utility business rate base growth may be about 8-10%, while the midstream business will benefit from increasing natural gas production, as the industry develops liquefied natural gas capacity. “On top of steady earnings growth and dividend growth of 5-7%, there could be some re-evaluation upside from there, which should be reflected in an increased share price.”