Mackenzie Cundill Team
What happened in the previous 3 months? What contributed positively to performance? What detracted from performance?
The second quarter was marked by volatility surrounding the UK vote to exit the European Union. Notably toward the end of the quarter, a “risk-off” sentiment in the market depressed the valuation of many value stocks as investors seek the perceived “safety” of largely expensive, but low volatility sectors such as Consumer Staples, Telecommunications, and Utilities. We took the opportunity to add to holdings we believe were trading at bargain prices for the long term.
Over the last three months, our positions in the energy space contributed positively as energy prices continued to recover in Q2. However, our holdings in forestry companies detracted from performance due to the overhang of the Softwood Lumber Agreement negotiations. We believe once the negotiations are finalized, the underlying value of these companies will be recognized by the market, especially in light of the improvement in the U.S. housing market and new builds.
Outlook & Strategy
What are the key opportunities you see?
Value stocks, by their nature, underlie slow-growing, cyclically challenged, out-of-favour, or underperforming businesses. During periods of slow economic growth or investor uncertainty, it is normal to see these types of stocks/businesses underperform. Recently, we have been in the midst of a mid-cycle, ‘profit’ recession. This has especially been the case for companies with more economically sensitive, cyclically challenged earnings such as financial services and resources – fertile grounds for traditional value stocks. Hence value has underperformed quite simply because growth has been anemic, and due to investor neglect/risk aversion. This has been especially so since Brexit, but in general because of the perceived fragility in the global economy.
The Mackenzie Cundill Team’s base case is that we are entering a period of economic re-acceleration, not recession, specifically in corporate earnings. Recent U.S. economic data has generally been surprising on the upside, and so have earnings. Although we are very, very early in the Q2 reporting season, U.S. corporate earnings are expected to re-accelerate from recession-like levels in the coming quarters based on consensus. If this proves to be correct, the value style should re-emerge and outperform on both a relative and absolute basis.
What are key risks that need to be managed?
We believe that the risks of a U.S. recession are relatively remote. In fact, it is more likely that a stronger U.S. economy and potential inflation are being ignored in the marketplace and we need to keep a watchful eye there. Those risks are not necessarily bad for the stock market per se, but the portfolio should be positioned in such a way that captures the probability of these scenarios.
Growth stocks, or those companies that have continued to exhibit growth in a low-growth world, have attracted a disproportionate amount of investor capital (and garnered expensive valuations). Low-volatility, high-quality stocks have also performed well in the recent past as low/negative bond yields have pushed investors further out on the risk/return spectrum and into bond-like equities. This has transpired almost irrespective of valuation, creating what many to believe to be a bond-proxy/low-volatility bubble. The valuation spread between low volatility stocks versus the market (and Value) is at a worrying extreme, and is unsustainable in our view.
How are you positioning portfolios in response to this outlook?
We have added to our U.S. exposures in general. Specifically, we have added to areas that will benefit from a recovery in earnings and normalization of risk appetite. These include Industrials, Financials, and Enterprise Technology. Recent portfolio additions have also been in price-makers, i.e. companies that have the ability to price products to keep abreast of inflation.
We are overweight U.S. banks, which stand to benefit should interest rates rise at a faster than expected clip to curb inflation.
We are underweight bond proxies and low volatility stocks. Particularly, we are underweight Consumer Staples, Utilities, Telecommunications, and REITs.