The Long and Short of It
What generally follows that expression is a succinct synopsis. We’re always trying to be concise; however, distilling complex economic and investment matters usually requires several pages. Case and point, explaining why we are simultaneously long and short will take more than a few paragraphs to properly convey our rationale.
We own stocks (long positions) principally because stock markets rise over time. Populations grow, unit volumes rise, revenues increase, profits expand, underlying valuations track higher—up and to the right—and stock prices follow suit. We look to participate in the upward bias of long-term market trends, selecting individual securities we believe to be higher quality and more undervalued than the averages.
In the short term, market prices can fluctuate considerably from price volatility fueled by market psychology. This is generally driven by market participants reacting to specific events or when recessions occur which periodically interrupt the upward trajectory. Therefore, we short from time to time, particularly when we expect a recession, to hedge against expected declines—to mitigate losses we may incur on our long positions during market downturns.
Because we don’t have a crystal ball, even when our models are suggesting a market setback, we still don’t wish to eliminate our longs since the upward bias of the market is a powerful force—markets rise most of the time, and by healthy compounding amounts. It’s also much simpler to invest from a bottom-up standpoint since there are fewer moving parts to individual companies whereas a top-down stance is subject to all sorts of external influences.
Though, if we foresee a downturn, as we do now, we may raise additional cash and alter the nature of our long positions for additional protection.
Our favourite investment period was during the year 2000 when the dot-com bubble burst, and the market rotated to previously ignored stocks. As market prices normalized, our longs went up and our shorts went down. Perhaps it’s wishful thinking that this best-of-both-worlds scenario could repeat; though, we see similarities in the makeup of today’s market.
Because we expect a U.S. recession to begin soon, we are short the S&P 500, which remains fully valued, lifted up by a handful of behemoth companies. And, we remain long high-quality, recession-resistant companies, whose share prices are at compelling discounts to our estimated fair market values (FMVs). Since we aren’t certain of the timing of market declines or our stock holdings rising to close disconnections with value, we emphasize our long positions and hold a smaller short position as a hedge (a one-page explanation—not bad).
The Recession is Coming (Shortly)
Our Economic Composite (TEC™), which has historically forewarned of a recession (without a false signal), on average 10 months prior to the peak in the business cycle, triggered a negative signal for the U.S. last October. Based on the historical average, we could be a mere 3 months away from the recession onset. And the U.S. is not alone. We’re concerned about many nations because negative signals have also occurred for Canada, Germany, and the U.K.
The primary driver of TEC™ is the inversion of the yield curve, more specifically when the 90-day T-bill rate exceeds the 10-year bond. Generally, this inversion, from central banks raising short-term administered rates, causes economic deterioration to begin after about 6 months. The inversion during this cycle is historically extreme—as considerable as it was in 1929, 1973, and 1980—periods when harsh recessions ensued.
The rise in interest rates has been felt across the U.S. economy. Commercial and Industrial loan growth is declining, for the first time since 2020. And it began declining before the recent U.S. bank failures, which were 3 of the 4 largest of its kind. Lending standards have become stricter. And bank deposits have been fleeing to money-market funds where rates are much more attractive. This inhibits lending because loan-to-deposit ratios must be maintained. At the same time, corporations are also less willing to borrow because of economic uncertainty and higher costs (not just higher rates but higher processing fees, premiums for riskier loans, tighter covenants, and/or the need to post additional collateral). And rising loan delinquencies (those not current on their loan payments) are forcing banks to charge more.
Consumers are feeling the pinch too. Credit card rates have jumped to 24%, used car loans to 14%, and 9% for new cars, all record highs, and overall U.S. consumer debt just hit a new high.
All of this should entail fewer new loans which means even less money circulating in the system. Normally, when credit flows are negative, GDP growth is too.
0 to 5 in a Year
That's breakneck speed for a central bank—the Fed increasing from 0% to 5% was the steepest of the last several rate-hike cycles. And it’s not just via higher interest rates. The Fed’s tightening on other fronts too, which has removed money from the system. The Fed will likely now wait and watch for economic changes before adjusting short-term rates further.
While long-term rates appear to be headed higher as the market sells bonds, short-term rates are likely done rising. Inflation (PCE 4.2%), though far from central bank targets (less than 2%), has declined substantially while economic growth has slowed considerably, and the U.S. banking system can’t currently handle further rate hikes.
The LEIs (U.S. Conference Board’s Leading Economic Indicators) are rarely this negative and continue to fall, which has always indicated a pending recession. The Conference Board’s probability of recession model is now at 99%. It was only this high during the last 2 recessions.
Small business optimism index readings have collapsed to multi-year lows, which has negative implications for hiring and capital expenditures plans, also lowering the need for credit.
Would You Like Fries with That?
Apparently not. McDonald's recently announced that more customers around the world are answering no to that question. Customers everywhere appear to be cutting back.
TJX Companies reported that its flagship TJ Maxx stores are suffering from shrinkage (that’s theft, not the reaction one may get from cold water). How does that even work? Are people stuffing shopping bags, wearing out multiple articles of clothing, or just leaving in new clothes, leaving the old ones behind? Either way, it’s noteworthy regarding vulnerable consumers.
Speaking of shrinkage, the U.S. money supply growth rate has been negative for several months—a highly unusual occurrence. It was falling at the steepest rate since the 1930s prior to the recent bank failures. This occurs infrequently and should inhibit growth. For this reason, and others noted above, bank credit is contracting. Office vacancies continue to rise too—San Francisco’s averaged nearly 30% this past quarter, which also doesn’t auger well for lenders or commercial loans in general. And corporate bankruptcy filings in the U.S. hit a 12-year high in early 2023. All this before a recession has even been revealed.
Not only has our signal triggered but the normal precursors to a recession are occurring. Layoff announcements continue, and average work weeks have shortened, a precursor to rising unemployment. That being said, the job market in the U.S. remains remarkably strong—the unemployment rate essentially hasn't budged in the last year from record-low levels. But unemployment is a lagging indicator and job openings, albeit still relatively high, have fallen more than 20% from peak levels.
Inventories are being reduced. Investment spending is declining. In fact, there have now been 4 consecutive quarters of declining investment spending as a percentage of GDP. This last occurred during the Great Recession. And it just turned negative in Q1. Historically, when there have been 2 consecutive negative quarters (15 occurrences since 1950), a recession has followed on 12 occurrences. In Q1, overall U.S. GDP levels grew by a mere 1.1%.
The U.S. Purchasing Managers Index for manufacturing has shown contraction since last November. The PMI index for services has continued to be expansionary, bolstering the overall economy; however, it has declined markedly from its fall 2021 high. Major stock market bottoms around a recession have always occurred after the recession’s onset. And market bottoms coincide with manufacturing PMI bottoms. We’re not there yet.
And then there’s the U.S. debt ceiling, which is normally a non-issue but is still a concern with parties at loggerheads. More important, overall government debt in the U.S. and many other nations is way too high. With higher interest rates, the amount of interest now being paid on U.S. government debt has skyrocketed. Hopefully, budget cuts are coming but would also put a damper on economic growth.
Geopolitical risk, always a wildcard, is certainly heightened when we’re seeing images of Vladimir Putin and Xi Jinping embracing.
The average investor allocation to equities is still high and dropping from recent levels near all-time highs. Allocations to stocks tend to fall rather abruptly during recessions which exacerbates selling pressure, ultimately resulting in capitulation.
Meanwhile, markets are overbought. Bullish sentiment is high. And volatility is unusually low. Investors appear complacent. The calm before the storm?
Earnings, though in decline since last summer, have continued to exceed expectations. In the most recent quarter, despite 80% of companies beating earnings expectations, the upside surprise was a mere 1% (by far the smallest of the last couple of years), while the results have primarily been supported by price increases since volumes are declining. Only 4 of the 11 key S&P 500 industry sectors had positive earnings growth. Bellwether Home Depot just reported that it expects its first annual sales decline in 10 years. Target also offered poor guidance as consumer purchases of discretionary items have waned.
Company conference calls are now replete with negative terminology such as "uncertain”, “challenging”, or "difficult". The tone is clearly changing with the environment.
Valuations are somewhat out of whack. Unless inflation or interest rates are about to dive, today’s real yields suggest a forward price-to-earnings (P/E) multiple below prevailing valuations. The Nasdaq and S&P 500 P/E multiples of next-12-month estimated earnings are above their respective 20-year averages, even though interest rates are higher, which suppresses FMVs. This is somewhat astounding since prospects of a recession are high and earnings estimates are declining. And the key components of FMV—earnings, growth rates, and interest rates—are heading in unfavourable directions. To justify higher market levels in the short term, valuation multiples would need to expand, unlikely given the near-term prospects for earnings and interest rates.
There are elements of speculation as well. AI stocks are all the rage. The relative price strength of technology stocks versus the S&P 500 appears to be at the tail end of a massive multi-year spike only witnessed twice before–-the dot-com bubble in '99/2000 and the Nifty 50 era in the late '60s. Technology’s relative P/E versus the S&P 500 is 20% above its 20-year average. And the recent S&P 500 returns have been dominated by a handful of behemoths, a phenomenon usually only witnessed at market tops.
While most believe we are enduring a slowdown, most don’t believe a recession is coming and have yet to react. Markets have risen year-to-date while the economy has held relatively steady. Since TEC™ is alerting us to a recession, we remain comfortable with a less than fully invested stance. We prefer to maintain a hedge in place until the market sufficiently discounts a recession, or there’s a complete reversal of the economic outlook.
Meanwhile, we are comfortable owning undervalued positions with solid growth profiles, non-cyclical businesses lines, essential products or services, manageable balance sheets, and attractive returns on capital, even if they have been temporarily discarded by investors. And we have sold positions that have reached our FMV estimates or broken down in our TRACTM work.
The following descriptions of the holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described. Below, we discuss each of our new holdings and updates on key holdings if there have been material developments.
All Cap Portfolios—Recent Developments for Key Holdings
All Cap portfolios combine selections from our large cap strategy (Global Insight) with our small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. The smaller cap positions tend to be less liquid holdings which are more volatile; however, we may hold these positions where they are cheaper, trading at relatively greater discounts to our FMV estimates, making their risk/reward profiles favourable. There were no material changes in our smaller cap holdings recently.
All Cap Portfolios—Changes
We made changes among our large cap positions summarized in the Global Insight section below.
Global Insight (Large Cap) Portfolios—Recent Developments for Key Holdings
Global Insight represents our large cap model (typically with market caps over $5 billion at the time of purchase but may include those in the $2-5 billion range) where portfolios are managed Long/Short or Long only. At an average of about 70 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear much cheaper, in aggregate, than the overall market.
Global Insight (Large Cap) Portfolios—Changes
In the last few months, we made several changes in our large-cap positions. We bought CVS Health, Cigna Group, Capgemini, W.R Berkley, Empire, and Henry Schein. We sold some positions including Salesforce, Koninklijke Ahold Delhaize, Cooper Companies, and Microsoft when they increased toward our FMV estimates and Bank of America, Bath & Body Works, and Onex in reaction to declines resulting in TRACTM sell signals.
CVS Health’s share price has declined over 30% during the last year. It’s hard to find a large cap healthcare stock more disliked. The company did reduce its EPS guidance for this year slightly on its first quarter conference call. But market participants appear more concerned about the increased scrutiny over pharmacy benefit manager (PBM) pricing and industry concentration. We have seen these issues raised before—they make for good political headlines—but no evidence has emerged that suggests PBMs impact the affordability of healthcare. We expect investors to eventually refocus on CVS’s long-term earnings potential. It has uniquely differentiated itself, aiming to become a leading healthcare solutions provider focused on improving health outcomes by covering insurance, pharmacy, and home-based care. Our estimated FMV is $117.
Cigna Group has also been caught up in concerns about intensifying PBM regulatory scrutiny. In Cigna’s case, just 12% of earnings comes from spread pricing and rebate retention, the primary focus of the House Oversight Committee. The company aims to move away from a rebate retention model to service fees. As with our CVS investment thesis, we expect market concerns to fade, and we are optimistic about Cigna’s long-term outlook. We foresee cash flow from operations eclipsing $10 billion by 2025 and have a current $360 FMV estimate.
Capgemini, based in Paris, France, is a global consulting firm that helps clients navigate cloud, data, AI, and cybersecurity technologies. Its key competitive advantage is the deep relationships it forms with clients—over 325,000 global technology experts position themselves as strategic partners to CTOs and CXOs, providing custom-tailored solutions from the world’s leading technology companies, including Adobe, Amazon, Microsoft, and Alphabet. Capgemini’s strong customer relationships translate to sticky recurring revenues. As illustrated by recent strong results at Microsoft and Alphabet, spending on technologies that enhance productivity and elevate customer experience remains robust, even as corporations adopt a more cautious posture toward spending. Our €192 FMV estimate assumes a slowdown in tech spending.
W.R. Berkley is a leading multiline insurer known for its underwriting discipline. Over the long-run, the company’s approach has delivered industry-beating metrics. However, its discipline is currently hurting short-term results because management has temporarily stepped away from professional and liability insurance since premiums have materially declined. Insurance segments tend not to follow each other in a lockstep fashion. As a multiline insurer, W.R. Berkley can afford to pull back on lines experiencing weak pricing and emphasize ones experiencing strong pricing. Management has reported evidence of firming in property and reinsurance. Meanwhile, income from the company’s investment portfolio, with a short duration of 2.4 years and yielding 3.8%, should rise as proceeds are reinvested at higher rates. Our $69 FMV estimate assumes the company generates a 14% return on equity in the coming years, even lower than analyst estimates, which exceed 16%, in case some of the challenging pricing lasts longer than expected.
Empire Co., the Canadian conglomerate based in Nova Scotia, owns grocery brands such as Sobeys, IGA, Farm Boy, and FreshCo. Since its growth and profit margins have lagged its domestic peers, so too has its share price, substantially underperforming Metro and Loblaw over the last several years. To boost margins and growth, management unveiled Project Horizon in 2022, an initiative that aims to generate an incremental $500 million in annualized EBITDA (on a base of $2.2 billion) by the end of fiscal 2023 from a combination of cost savings and expanded market share. At the same time, management is navigating a harmful cybersecurity incident, lingering pandemic supply chain challenges, inflation, shifting consumer behaviour, and the rollout of its nationwide e-commerce business, Voilà. Once the one-time issues are behind them, and the benefits of Project Horizon are clear, we believe the discount between Empire and its Canadian peers will narrow. Our FMV estimate is $45.
Henry Schein dominates its global dental equipment industry with a market share above 30%. Serving more than 1 million customers across 32 countries, its scale is unmatched. We believe investors are overly focused on the short-term earnings dilution from its recently announced acquisitions of Salon-de-Provence-based Biotech Dental, Brazilian S.I.N. Implant System, and Australian healthcare products distributor RHCG Medical. The company has an excellent track record of acquiring strong regional players and integrating them into its catalogue of over 300,000 products. Shares don’t appear to reflect that the company is likely to achieve long-run annual sales growth of 3% and 5% free-cash-flow margins, which drives our estimated FMV of $96.
U.S. high-yield corporate bonds (ICE BofA Index) yield 8.4%. That’s nearly twice year-ago levels. Though corporate yields could rise further if longer-term government yields rise or if defaults rise and spreads versus government bonds widen. Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of about 6.3%, and most of our income holdings—bonds, preferred shares, REITs, and high-yielding common shares—trade below our FMV estimates.
We purchased several new REIT positions in the last few months when some appealing opportunities finally surfaced, such as: Whitestone, a sunbelt shopping centre landlord, yields 5.6% with a $15 estimated FMV; Alexandria, a lessor of laboratory space, yields 4.1% with a $158 estimated FMV; VICI Properties, the second largest triple-net lease provider owns irreplaceable properties with leading casino tenants, yields 5% with a $40 estimated FMV; Segro, a U.K.-based owner of warehouse and industrial properties, yields 3.3% with a £10 FMV; and W.P. Carey, a single-tenant industrial, warehouse, and retail net lease provider, yields 6.2% with a $95 estimated FMV. Broadmark Realty Capital was sold since better opportunities were available.
To Make a Long Story Short
We anticipate a recession because last October our Economic Composite, TEC™, alerted us to a pending one. We remain wary of lower market prices that accompany economic declines. Markets are fully valued and appear too high relative to interest rates. Though we foresee a recession, we are open-minded about a muted, low-growth scenario, given the uniqueness of this cycle (Covid, massive stimulus, historically low unemployment) and the fact that we’ve already had a recession rolling through various sectors. However, something will have to go off-the-rails before central banks lower rates since they are concerned about refueling inflation, as in past cycles.
Complacent government officials, businesses, employers, employees, and investors will mostly be caught off guard by a recession, which should create job losses, weaker profits, bankruptcies, and declining share prices. While most believe a slowdown is upon us, they don’t see a recession, nor have they reacted yet. Sectors that are usually down as a recession is approaching, such as Industrials and Materials, have barely declined.
As such, we will continue to hone our short game—hedging portfolios—while playing the long game—owning high-quality companies we expect to grow their earnings and underlying valuations. A 7-page letter. Not quite short and sweet. But we’re trying.
Randall Abramson, CFA
All investments involve risk, including loss of principal. This document provides information not intended to meet objectives or suitability requirements of any specific individual. This information is provided for educational or discussion purposes only and should not be considered investment advice or a solicitation to buy or sell securities. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. This report is not to be construed as an offer, solicitation or recommendation to buy or sell any of the securities herein named. We may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities named in this report. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. E.&O.E.
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