Equities staged a strong recovery rally in the fourth quarter of 2022, with peaking inflation and falling interest rates helping drive stocks higher. However, tough talk from U.S. Federal Reserve (Fed) Chair Jerome Powell and other central bankers around the world put a dent in the typical year-end rally. Services-related inflation seems set to remain stubbornly high for some time and the Fed appears determined to avoid seeing higher inflation become entrenched in longer-term inflation expectations. Our equity and hedged equity strategies produced positive returns over the quarter.
Holdings that contributed to absolute performance:
Trisura Group Ltd performed strongly during the period as they delivered strong quarterly results led by exceptional growth in their US fronting business.
Entering the quarter, Mastercard Incorporated (MA) forward P/E relative to the market was trading at its bottom decile of its 10-year valuation range. This created a fantastic opportunity for strong returns in Q4 as we witnessed a continued recovery in cross-border travel. Through November, cross border travel revenues were running at 117% of 2019 levels.1 Had the pandemic not occurred and assuming prior growth trends, by 2022 it should have been running at 135-145% of 2019 levels so in our view, there is still a lot of recovery potential here. Moreover, MA is considered a beneficiary of inflation with a significant portion of their revenues linked to purchase volumes. Finally, with 0% interest rates no longer a reality, many of the “disruptive” fintech companies that were once seen as threats to the incumbent network players like MasterCard Incorporated, have seen their funding dry up and their longer-term viability brought into question. With their leadership position no longer brought into question, we expect multiple compression of the recent past to change towards multiple expansion.
Holdings that detracted from absolute performance:
AltaGas Ltd reported weaker-than-expected Q3 results due to volatility in their midstream export business.
In our view, Amazon.com, Inc. has traded off for two reasons: 1) clearly the company misjudged future demand in its retail division during COVID and this resulted in a significant overbuild of capacity in the business and hence a lack of operating leverage in its retail segment. 2) its crown jewel, AWS, decelerated more in the last quarter than many had expected. A similar cloud deceleration was noted at Microsoft’s Azure division creating concern of an overall category slowdown. AWS has never gone through a recession as a more mature business and thus we are left to wonder how fast the business will decelerate from here. Given a large portion of revenues are tied to consumption/seats and with the potential for the onset of a tech recession with companies slowing both hiring and spending it is unclear what normalized growth will look like for this division.
In 2022, there were three major headwinds for global equities: Rising inflationary pressure/Central Bank interest rates concerns, geopolitical uncertainties (Russia/Ukraine conflict, China/Taiwan rhetoric), and China’s zero COVID policy. As we move into 2023, we have gained the most visibility on China’s COVID front. Prompted by growing civic unrest and decelerating economic prospects, China has started to pivot away from its zero COVID policy. This comes at a time when investors’ sentiment and positioning are extremely poor and valuations are at/near all-time lows. While the near-term economic data/news flow will likely be volatile and we expect spikes in COVID cases, we believe that pent-up consumer demand will drive China’s economic growth later in the year. In anticipation of this, we have increased our weight in both Chinese stock holdings and Chinese-exposed stocks, especially in the consumer discretionary space.
Small Cap Spotlight
We would like to highlight our position in Pet Valu Holdings Ltd (PET) – We are positive on shares of it. PET is a relatively new name to Canadian markets, having completed their IPO in June 2021. PET is Canada’s largest retailer of pet food and pet-related supplies with over 600 locations nationwide and growing quickly. New store unit growth is being complemented by very strong Same Store Sales (SSS) numbers, with 2022 expected to drive +16% SSS growth for the year, which is above industry growth which indicates PET is gaining market share despite their leadership position.2 This growth is also driving margin expansion as the company focuses on leveraging their scale and expanding their private label offering. We see a long runway of continued growth for the company and view it as a high-quality earnings compounder over time. Valuation reflects the strong execution the company has displayed, but we see further upside from continued earnings growth and some multiple upside.
