Market Forces 009
December 5, 2022
Stock Market Update
The latter part of 2022 to date, not unlike most of the year, continues to be characterized by high levels of volatility, though, unlike most of the year, for the fourth quarter to date this has been volatility of the upside variety.
Quarter to date, equity markets have put in a strong performance across the board (the NASDAQ being an exception) whilst the bond market moves have been mixed, though yields have compressed significantly (in the 50-60bp range for 20- and 30-year Treasuries) from October highs.
Whilst most investors generally dislike volatility, unsurprisingly, this view does not extend to strong upward moves, and this rally has undoubtably gone some way to reduce investor discomfort, in what has been a challenging year so far.
To re-iterate our view, the transition from cheap money/low inflation to money having a cost and less benign pricing pressures, and its consequences, is clearly underway, but is by no means complete.
Investors need to prepare for continual volatility, in what on aggregate still appears to be a market searching for direction.
Inflation appears to have peaked, but the issue of the degree, and timeframe, over which it can be brought down to targeted levels remains (the services component of inflation continues to accelerate driven by high wage growth levels).
Markets for much of 2022 have been in our view primarily driven by the valuation impact of increased rates. Going forward rates, and inflation, will continue to be items to monitor, but the impact that rates have on the real economy (economic growth, corporate profitability, employment rates, etc.) will increasingly come into focus.
This process is already underway, as we continue to see earnings estimates ratchet down, a risk we have been flagging for months now. It is also worth noting that changes in rates have a lagged effect on the economy, generally viewed as being in the six-to-nine-month range.
He Gets On Base (focusing on what matters)
The “phrase he gets on base” is likely one that is familiar to most. Popularized by the book “Moneyball”, authored by Michael Lewis, and brought into even wider prominence by the movie of the same name (great movie, even greater book in my opinion).
As an aside, Michael Lewis is my go-to, when anyone, irrelevant of profession, ever asks for an author recommendation; his books are exceptionally well-written, highly researched, and incredibly insightful.
At the risk of turning this into a book or movie review, the point (at least the one I came away with) from “Moneyball” was the success enjoyed by the baseball major league Oakland A’s (a smaller market team with the accompanying constraints) due to them embracing analytics. This approach is now commonplace, but at the time was anything but, especially in the old boys’ club of baseball.
Talking baseball or movies, is definitely not the topic of choice for “Market Forces”, but if you bear with me, I assure you we will get to the investment relevance.
You will have to pardon the gross oversimplification here, but in essence one of the key analytical data points that the Oakland A’s figured out/calculated had ‘value’ was something called “on base percentage” or OBP. In essence how often a player gets on base per plate appearance.
The Oakland A’s wanted a player who got on base…period. How good their swing, stance, etc. “looked” meant nothing, all that mattered was the outcome… getting on base.
OK, now to the point of relevance. Investors should care about only two things*, their portfolio rate of return (%) and the risk taken to achieve that return, or more eloquently, the risk-adjusted return. Not whether a stock is popular (the baseball batter has a visually appealing swing), not whether the stock has some sentimental tie to where they grew up (the baseball batter has a strong stance); only how that stock impacts the risk-adjusted return of the portfolio (i.e. the batter gets on base!).
* This is predicated on the basis that the underlying portfolio is suitable given the unique situation of each individual investor, namely, their investment objectives, risk tolerance, etc, etc.
Investors may get some non-financial benefit from owning a popular stock, be it, the ability to talk about their portfolio over a beverage of their choice, a perceived level of comfort of owning a company they understand in some way in terms of product or other familiarity. However, when it gets down to brass tacks, all that matters is risk and return. All that matters is that their portfolio “gets on base”.
The risks inherent in investing in “popular” stocks, often referred to as “crowded trades” have been made evident this year. These are clearly evidenced in the dramatic underperformance of the NASDAQ (>10% and >20% underperformance versus the S&P 500 and DJIA respectively), with its greater concentration of tech darlings, versus the other major indices.
To be clear, we are not advocating avoiding (or selecting) stocks based on their level of popularity, quite the contrary, we are highlighting the risks of using that metric as a primary basis for investment decisions as opposed to what really matters, i.e., determining the stocks’ impact, in terms of risk-adjusted return, on the investor’s overall portfolio.
On a related note, the use of analytics in baseball that is referenced in “Moneyball” flow from the same branch of mathematical techniques that underpin the Modern Portfolio Theory which drives and shapes the asset allocation component of the portfolio construction we employ. In the case of baseball, it’s about squeezing out maximum player production relative to market value (player cost), and in the case of modern portfolio theory it is about extracting the maximum return per unit of risk.
Putting Our Words Into Action
Recent transactions would have drawn the attention of our discretionary clients to the sale of a long-held position, replaced by a new name. The replaced company has much less brand recognition than the exited position, which has performed well for clients and is a relatively well-known name. However, and this is crucial, we believe that the new holding’s risk-reward ratio is significantly better than the one it replaces.
Regarding the new position, the stock may not be as well known in the markets, however the company is well known as one of the leaders in its industry. The core business is highly defensive and augmented by some positive legislative actions, the current environment, namely, one of more attractive valuations (the group has an acquisitive growth strategy), plays favourably into this strategy, which it has ample liquidity to execute on. The company generates significant operational cash flows and all of this at valuations we deem highly advantageous.
We could expand on this more and are happy to do so (give us a call), but essentially, it gets on base.
In a prior commentary (“Market Forces 007”), we spoke of our view that this market environment would create significant opportunities. This new holding fits the bill. Whilst the underlying nature of the business is unrelated to the state of the market, it is highly unlikely we would have been able to acquire a business of this caliber at valuations this favourable, absent the volatility we have experienced in markets.
As always, please see performance attached below.
On behalf of McIver Capital Management
P.S. We are pleased to share that Neil McIver has been recognized as one of Canada’s Top Wealth Advisors (Best in Province) for 2022 by Globe and Mail’s Report on Business and SHOOK Research.
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The comments and opinions expressed in this newsletter are solely the work of McIver Capital Management, not an official publication of Canaccord Genuity Corp., and may differ from the opinion of Canaccord Genuity Corp’s. Research Department. Accordingly, they should not be considered as representative of Canaccord Genuity Corp’s. beliefs, opinions or recommendations. All information is given as of the date appearing in this newsletter, is for general information only, does not constitute legal or tax advice, and the author McIver Capital Management does not assume any obligation to update it or to advise on further developments related. All information included herein has been compiled from sources believed to be reliable, but its accuracy and completeness is not guaranteed, nor in providing it do the author or Canaccord Genuity Corp. assume any liability.
CANACCORD GENUITY WEALTH MANAGEMENT IS A DIVISION OF CANACCORD GENUITY CORP., MEMBER-CANADIAN INVESTOR PROTECTION FUND AND THE INVESTMENT INDUSTRY REGULATORY ORGANIZATION OF CANADA (IIROC).
CANACCORD GENUITY GESTION DE PATRIMOINE EST UNE DIVISION DE CORPORATION CANACCORD GENUITY, MEMBRE DU FONDS CANADIEN DE PROTECTION DES ÉPARGNANTS ET DE L’ORGANISME CANADIEN DE RÉGLEMENTATION DU COMMERCE DES VALEURS MOBILIÈRES (OCRCVM).
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