Mackenzie All Cap Value Team
- Synchronized global growth in both developed and emerging markets persisted into the third quarter of 2017. Growth in North America was modest to robust quarter-over-quarter as unemployment rates remained at their lowest levels in a decade, manufacturing activity firmed and inflation ticked higher, running over 2% in the United States and around 1.6% in Canada. In September, Bank of Canada governor Stephen Poloz saw continued momentum in the domestic economy and felt it necessary to tap the brakes again, raising rates for the second time in under two months. While the Canadian equity market has been fairly lackluster year-to-date, the S&P TSX Composite edged higher over the recent quarter, returning 3.0%.
- In Canada, larger capitalization, value stocks were the strongest performers during the period. This was driven by cyclical companies including those in the Energy sector, the result of higher crude prices; and Financials, the result of higher interest rates and widening net interest margins.
- One of the top contributors to performance over the quarter was Chemtrade Logistics Income Fund, a provider of industrial chemicals and services to North America, and a longstanding portfolio holding. Chemtrade has benefited from increased pricing in its chemicals, particularly those associated with the oil and gas business and from synergies generated through its acquisition of Canexus Corporation, a producer of sodium chlorate, chlorine and hydrochloric acid that expanded Chemtrade’s chemical product portfolio.
- Detracting from portfolios broadly, were industries that Amazon has recently entered or has communicated interest in entering, including food distribution and pharmaceutical distribution. One such company is The Kroger Co., a leading operator in the grocery business. Kroger has taken great strides to incorporate technology into its operations. It provides grocery shoppers with the ability to order online and pickup in-store and has implemented sophisticated modeling to better understand customer buying patterns in order to personalize its marketing. It has a growing private label offering “Simple Truth” which provides higher margins than branded products, and is incorporating more organic food offerings into its product mix to satisfy increasing customer demand. When we purchased the company it had sold off sharply due to a deflationary price environment that was pressuring grocery business margins. However, it was still generating a 5% free cash flow yield off of these depressed earnings. The Amazon purchase of Whole Foods caused a negative reaction in the stock price, further depressing the valuation. We believe this reaction is emotionally driven and does not reflect the quality of Kroger’s business. We continue to hold the shares and believe that Kroger will remain a profitable and dominant grocer in the U.S. going forward.
- After a very strong year for value stocks in 2016, this year has proven more difficult for the Canadian market. Investors are justifiably reluctant to allocate capital to resource sectors given the recent history of volatility and as a result, higher quality safe-haven types of companies have outperformed. In the low growth environment that has characterized global economies, investors are “paying up” for growth, particularly stable growth. The technology sector has therefore attracted capital in lieu of resource companies, which have proven to be much less predictable. In Canada, where the technology sector is less relevant, capital has been allocated to consumer and industrial companies with strong growth records. In terms of the energy sector, companies appear to have experienced a re-rating lower of their earnings and cash flows as investors worry about the longer term implications of alternative cleaner energy solutions, such as electric vehicles. It will be difficult for energy producers to regain their historic multiples under such an overhang of concern. We are optimistic, however, that the breadth of the current global growth trend could be constructive for resource sectors broadly.
- Worries about overheating in the Canadian housing market have subsided somewhat as prices declined in the key Toronto and Vancouver markets from the feverish pace earlier this year. With the BoC likely to take a pause on any further rate moves, the housing market should shift back to the fundamentals of supply, demand and affordability. Stable to improving employment and wage levels, particularly in Western Canada, should provide a backdrop to a stable housing market. We expect Canadian banks to grow earnings and sustain valuation multiples under such a scenario.
- Through the fog of elevated valuations, we have uncovered pockets of relative value, albeit very few. A selection of US banks and segments of the Canadian energy sector are two such areas. Our models suggest that stocks are generally trading at the high end of our estimates of fair value. As a result, the downside risk is beginning to outweigh upside potential. We have reduced our exposure to smaller capitalization companies as they hit our valuation targets, allocating the proceeds to larger-cap companies. Although we believe the expansionary part of the economic cycle still has legs, it is always difficult to predict a top and one must act prudently as the cycle continues to mature.