More volatility, lower returns in 2022

Odlum Brown’s model portfolio is well-diversified with reasonably-priced, high-quality stocks that have the ability to grow and raise prices to offset inflationary pressures.

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Odlum Brown’s Murray Leith wonders how long the market can keep this party going.

Twenty-seven years ago, on Dec. 15, 1994, our research department launched the Odlum Brown model portfolio with an initial investment of $250,000. The purpose of this hypothetical, all-equity model was, and still is, to showcase how we believe stock recommendations may be used in client portfolios, and to measure the quality of our advice and the effectiveness of our disciplined investment strategy.

The objective of the model is to achieve better performance than the Canadian equity benchmark, the S&P/TSX Composite Total Return Index, while limiting risk and preserving capital. Typically, the model holds 40 to 45 stocks. It is well-diversified across economic sectors, with an emphasis on high-quality companies with sustainable competitive advantages, conservative financial leverage and strong management. In recent years, we have felt that foreign diversification is both prudent and essential to achieving good long-term returns. The Canadian market lacks diversity and has a limited number of world-class businesses. Thus, roughly half of the portfolio is currently invested in US stocks.

In November 2021, the value of the model breached $10 million, marking a 40-fold increase since inception. That represents a compound annual return of 14.7 per cent.

While we are proud of the achievement, credit for the pace by which we reached this milestone this past year really belongs to the governments and central banks that supercharged the economic recovery with unprecedented amounts of fiscal and monetary stimulus. For the year through to mid-December, the model appreciated by 25.6 per cent, roughly in line with a blended 50-50 Canada-US equity benchmark.

“Laissez les bons temps rouler”

The question on everyone’s mind is, “Can the good times continue?” From an economic perspective, there are reasons to believe global growth will slow materially from the impressive rate achieved in 2021. While stocks still have good long-term prospects, increased volatility and lower returns are likely in 2022.

As of writing, it appears that the Omicron variant may accelerate the already established winter-wave of COVID-19 cases and undermine economic activity. Although there are indications that Omicron is less deadly than the Delta variant, it’s proving to spread much faster. Travel restrictions and lockdowns are becoming common once again, and this time they are happening as extraordinary government support programs are ending and central banks are starting to dial back cheap and easy monetary policies.

Investors are obsessed with inflation, and for good reason. It is running at its highest level in decades, and that is creating hardship for individuals and businesses alike. Many companies are struggling with supply chain issues and labour shortages, and the lack of investment in the traditional energy sector has caused energy prices to rise meaningfully in parts of the world.

The rich get richer

Nonetheless, we don’t fear an economic recession in the near term because there is so much fiscal and monetary stimulus in the economic pipeline. It normally takes 12 months to 18 months for stimulus to work its way through the system, and it’s more likely that economic growth will merely revert to the slow, muddle-through pace that existed prior to the pandemic.

Social unrest due to rising wealth and income inequality has long been a major concern, and the US Federal Reserve and other central banks have exacerbated the worrisome trends by buying bonds and maintaining interest rates at such low levels. While these stimulative activities were absolutely necessary in reviving the economy, they also served to inflate the value of financial assets, thereby increasing income inequality given these assets are disproportionately owned by the wealthy.

Wages are rising at a decent rate, but unfortunately they are not keeping pace with consumer price inflation. From a purchasing power perspective, the average worker’s inflation-adjusted income is falling. That likely explains why consumer confidence is extremely depressed.

While some businesses have been hurt by the pandemic and its effect on supply chains, labour availability and prices, most of the big companies that dominate the equity market benchmarks have been helped by inflationary trends. They have been able to raise prices at a faster rate than their costs have increased, which has fuelled record profit margins and outstanding profit growth.

The Canadian and US equity benchmarks were up 22.2 per cent and 28.5 per cent, respectively, in 2021 (as of Dec. 15) because the growth in earnings overwhelmingly offset a modest contraction in valuation multiples. What’s unclear is whether corporations will be able to maintain these sizable profit margins in 2022.

Will the punch bowl disappear?

There is a risk that the monetary authorities will take the proverbial punch bowl away just as the economy is slowing, which could put pressure on corporate profit margins and undermine the overall demand for stocks.

High prices are already starting to take a toll on demand for homes, automobiles and other high-priced items, and central banks have started the process of reducing monetary accommodation to tame inflationary pressures. In particular, the US Federal Reserve is expected to unwind its US$120-billion monthly bond-buying program over the next few months and start raising interest rates. That means there will be less liquidity in the market—that is, money looking for investments. In other words, there won’t be a liquidity-driven rising tide lifting all investment boats.

The big companies that dominate the major North American stock market averages are generally holding their own, yet that masks the fact that many stocks are not doing well. Many of the more exciting, faster-growing businesses—those that benefited from the pandemic, and also those with the most extreme valuations—have seen very significant corrections in their share prices (again, as of Dec. 15, 2021).

For example, the share price of the popular video conferencing company Zoom Video Communications Inc. (NASDAQ—ZM) is down 67 per cent from its high. It’s an awesome business and platform, but it’s also a very expensive stock. Peloton Interactive Inc.’s (NASDAQ—PTON) exercise bikes are similarly impressive, but its stock is down 77 per cent from its high. Shares of DocuSign Inc. (NASDAQ—DOCU), whose product has been invaluable in helping us get paperwork completed while working remotely, are trading at a 51 per cent discount compared to their peak valuation.

Price matters when money gets tight

Investors are learning that price matters. Shares of unprofitable businesses, or those whose share prices are hard to justify based on underlying fundamentals, have performed poorly lately. Large companies have fared better than small, and developed markets have outpaced those that are still developing. These patterns typically unfold when monetary policy becomes tighter or less accommodative, which seems likely in 2022.

It’s quite possible that markets will be volatile in the near term as investors fret over the fallout from the Omicron variant and the extent to which central bankers will tighten monetary policy.

Still, we have been humbled and surprised, both positively and negatively, too many times to make bold predictions about the economy or the stock market over the next six to 12 months. While a meaningful market correction is certainly possible, it’s also conceivable that the authorities will reverse course and crank up monetary accommodation, as they did in 2019.

Our focus is always three to five years out, and over that horizon we expect economic growth and inflation to moderate. Against that backdrop, we believe we own a great complement of businesses with meaningful potential to be bigger, stronger and more valuable.

We are managing the heightened near-term uncertainty of COVID-19, inflation and the general economic outlook by ensuring our model portfolio is well-diversified, and that we own reasonably priced, high-quality businesses with the ability to grow and raise prices to offset inflationary pressures.

Murray Leith is an executive vice-president and director of investment research at Odlum Brown. He is based in Vancouver.

This is an edited version of an article that was originally published for subscribers in the January 21, 2022, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.

Investor’s Digest of Canada, MPL Communications Inc.
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