Finding Opportunities in a Recession

Featuring

Colum McKinley

From

Related Article

Text transcript

Colin McKinley, senior portfolio manager, CIBC Asset Management.

Investors in Canadian equity markets can expect a number of things this year. First I think volatility unfortunately is likely to remain, and I think in the near term we’re going to see more volatility, just as we’ve seen throughout the market’s history. But over the longer term we remain quite constructive on Canadian equities.

And so as of May 31st of this year, year to date, the S&P/TSX is up about 1%. That’s actually lagged the U.S. market. The S&P 500 is up about 5% during that same time period and most of the outperformance in the U.S. market has come from technology-related companies. So I do think there’s an opportunity for Canadian businesses in the Canadian market to catch up with broader markets around the world.

And if we look from a valuation perspective, the Canadian equity market is quite attractive today. So on a 10-year average, comparing the 10-year average on both a PE and a price-to-book basis, the Canadian equity market is trading well below its historic average valuation. And Canadian markets are much cheaper on both those metrics compared to U.S. peers. So I think there’s an attractive valuation argument that can be made for many sectors in the Canadian marketplace and we are seeing many opportunities in Canadian equities to deploy capital into what we think are some of the highest quality businesses at very, very attractive prices.

There are always risks in equity investing and equity markets, and for quite some time we’ve seen many forecasters have been looking for and calling for a recession, an economic slowdown. And yet what we have seen is the economy be stronger than many have expected. But I think the reality is the economy is likely one of the areas that we continue to monitor. We have come through an environment where we have seen the fastest normalization of interest rates. So both the Bank of Canada and the Federal Reserve have aggressively hiked interest rates. They have removed the stimulus, the low interest rate environment that existed throughout the COVID environment.

And these higher interest rates, they always have the effect of slowing consumption, slowing the economy, and that’s what we’re seeing them do as a way to battle against inflation. Now, we are seeing the recent inflation data come under control, not that that problem has been fully alleviated, but it is giving more latitude for central banks to start to pause their interest rate hikes. And so we are likely closer to the end of that hiking cycle than we have been in quite some time.

And so far, we see the economy has continued to run strong, consumers have been buoyed by very strong employment levels, and I think employment is a key area to watch. If we saw a rise in unemployment levels, I think that would be a serious threat to the economy. And we do expect to have a period of time of sluggish growth in corporate profitability. But for a large extent, we think that’s priced into many stocks and market participants have been anticipating this recession for quite some time.

So there are opportunities in the Canadian marketplace today that we think are quite attractive. I think one area that we would highlight is the Canadian banks. And if you look at the banking, the S&P/TSX composites banking sub index, over the last year to May 31 2023, that bank index is down 16%. And there’s been a number of factors that have contributed to that. The banks have faced higher taxes, they’ve had increased capital requirements. We’ve seen challenges in the U.S. banking system that has affected a sentiment. But if we stand back and we look at these stocks over the last 10 years and we think about them on a total return, so the price appreciation plus their dividends, they have grown at a compound annual growth rate of 9.8%. So outperforming the TSX, which is about a 7.7% return over that same time period.

And so yes, banks have underperformed in the short term, but over long term we know that they have been great compounders of wealth for Canadian investors and strong source of dividend yields. The valuations today, given the period of underperformance, are quite attractive. Banks are trading at 9.5 times price-to-earnings ratio, that compares to a long-term average, a 10-year average of about 10.7 times price-to-earnings. On a price-to-book basis, also quite cheap, trading at about 1.3 times price-to-book versus long-term average of 1.7. So the valuations for what we know are good businesses or great businesses are quite inexpensive, and the dividend yields are incredibly strong. So dividend yields today of 5.2%.

We just saw four of the banks in the recent reporting increase their dividends. And we think that’s going to be a hallmark, it’s always been a hallmark for the banks, that they can grow their dividends over time. So we’re going to see more of that into 2023 and into 2024. And so far, I think for long-term investors this is a great opportunity to accumulate a high quality business that you know has compounded wealth over time, but you’re doing so at a valuation that is quite attractive. And I think every time we can take advantage of those, that short term volatility in the marketplace, it works to our advantage as investors.

Investors should always approach the market with a level of caution and being concerned about potential risks and uncertainty that could enter individual companies or sectors. I think if we look today, one of the areas that there is some substantial changes taking place that creates an incredible amount of uncertainty is in office real estate. And it’s a industry that continues to be challenged coming out of the COVID environment, the world, the economy. We have adopted new ways to work. There’s many companies that are still a 100% coming to the office, but there are many companies that have adopted a hybrid cycle where people are coming in one or two days a week or three or four. And there’s many situations where people are just as productive working from home a 100% of the time, and it brings to them a higher quality of life and a different experience.

And so as a result of that, businesses are still assessing the amount of office capacity they need. And this will take some time for this to play out in the economy. Most leases are quite long-term in duration, eight to 10 years is the average office lease, that’s outstanding today. As companies navigate this, it’s going to affect the landlords and the cash flows that those businesses generate. And so there’s still a lot of uncertainty there in a market that will take a long time to digest. And so I think that’s an area where investors should be cautious.

So with all the forecasts of the pending recession and economic doom, people are looking for ways to recession proof their portfolios. And I think there’s three pieces of advice that I would suggest that individuals should look at. I think the first is buy high-quality companies that focus on businesses that have demonstrated that they can navigate uncertainty. That they have gone through recessions in the past and that they can use them to their advantage and gain market share, launch new products, develop things, really make their business better for the next economic boom, which will surely follow.

I think the second piece of advice I would suggest is avoid highly-levered businesses. That is your enemy if the economy slows dramatically. And so avoiding highly-levered companies I think is a good strategy at all times. I think especially when economic uncertainty exists, when companies could face uncertainty on their cash flows, that becomes more and more challenging.

And the third is, think long-term. Recessions will come and go. For investors with a long-term investment horizon, they can create opportunities. This is the environment where you can buy good businesses, but at great prices. And so when others are worried about the recession and the pending slowdown, that may be a great opportunity to actually be deploying capital and looking for opportunities over the long term.