December Market Update

Record-high profit margins

Aside from the Canadian Banks, the majority of Canadian and U.S. companies have now reported their quarterly results. The Canadian banks will be begin reporting their fiscal year-end results during the last week of November. It has been a terrific recovery for the sector in 2021 and shareholders essentially have received more than two years worth of returns in one-year, after a largely flat year for bank share prices in 2020. Credit surprises have been positive as well as loan growth and banks are now sitting on approximately $45 billion of excess capital as of Q3/21. Too much capital on a balance sheet does curtail the sector’s return on equity (ROE) so with the Banks receiving the green light from regulators earlier this month, they will be in a position to restart dividend increases and share buybacks.

A surprise for analysts in the Q3 reporting season was that analysts were expecting Q3 margins to be well below Q2. However, the net profit margin for the S&P 500 during Q3 was at 12.9%, which was well above the five-year average of 10.9% and just barely below the record high of 13.1% in Q2. The reason for the strong margins were “the result of effective corporate management working to offset continued macro and micro uncertainty,“ according to DataTrek’s Nick Colas. Efforts such as cost cuts, tech upgrades, and working-from-home surely helped a lot of companies benefit from operating leverage, or the degree to which a company can increase sales without increasing.

Another factor helping profit margins was the fact that with companies increasing prices, customers went along (so far) with the price hikes and continued to shop and not curtail their spending. Whether it was restaurant, grocery or other items, and even businesses have ramped up spending to keep up with increased demand. This trend is also expected to continue into 2022, until supply chain and price increases have fully worked through the system.

Target Prices

Looking at estimates from the start of the year, Canadian Banks have provided about 2.5x the expected returns above January analyst forecasts! This is a huge disparity but also highlights the challenges for analysts in forecasting the future. There are many variables to consider starting with the company fundamentals even before one considers all the macro factors which is very difficult and some would say, impossible to predict. Interest rates will have a big impact on company multiples, investor sentiment and fund flows as well will drive share prices. Additionally, analysts cannot model in acquisitions that can be accretive and lead to strong returns, until they occur. But companies with a good track record of acquisitions will continue to add value and find strategic opportunities – an investor can’t wait for these deals to occur. While target prices are a much talked about topic in the media, for an investor that may hold companies for many years, a one-year target price is not very helpful. Some companies have started to provide a five-year corporate strategy and analysts have also periodically provided longer term upside forecasts for companies. Investors buy companies for future growth, not the past. So the bigger a company’s addressable market and their ability to grow their market share and maintain margins, investors will pay up for such companies.

I do think there tends to be too much focus on quarterly results and the instant reaction to a good/bad quarter. We have held companies in our portfolios for 5-10 years, or even longer in some cases. That means those companies have reported 20 to 40 quarters of results! Some good quarters, some below expectations but each are just a snapshot in time. I remember well that Constellation Software (CSU) ‘missed’ their second quarter results in 2018. The shares traded down 16% in early August, from the 52-week high on July 19 that year and a Globe & Mail article said the company ‘may have to revisit its retreat into silence’ as the company had decided that year to no longer hold quarterly conference calls, as the company’s President and CEO Mark Leonard said, “for competitive reasons we are limiting the information that we disclose about our acquisition activity. We believe that sharing our tactics and best practices with a host of Constellation emulators is not in our best interest.”

Ironically, the Globe wrote at the time that the short-term shareholders “are probably not the ones responsible for the recent swoon.” With the shares up 135% since that time, I would argue those were exactly the type of shareholders that were most likely sellers, who were jumping ship and not willing to give a company with a terrific long-term track record of excellent shareholder returns, the benefit of the doubt and focus too negatively on ONE quarterly result. While it’s never easy to discern in real time if this is just a pause in a company’s business or a larger sea change, the great companies I believe have earned investor’s patience to ride things out, so long as management’s vision for the business has not waned. Periodically there will be events, such as some we are seeing recently, particularly labour or supply chain challenges, that great companies will overcome. The reality is that many companies are actually having unexpected ‘demand challenges’ which is a good ‘problem’ to have. Often, it’s not as quick as the market wants, but in time, those companies should continued to reward their patient shareholders.

There’s always the 2017 quote from Amazon’s founder, Jeff Bezos, on what he thought about being complimented on a good quarter:

“When somebody… congratulates Amazon on a good quarter… I say thank you. But what I’m thinking to myself is… those quarterly results were actually pretty much fully baked about three years ago… Today, I’m working on a quarter that is going to happen in 2020, not next quarter. Next quarter, for all practical purposes, is done already and it has probably been done for a couple of years. And so if you start to think that way, it changes how you spend your time, how you plan, where you put your energy. And your ability to look around corners gets better. So, many things improve if you can take a long term. By the way, it's not natural for humans. It's a discipline that you have to build.”

Demographics

Demographic trends do not receive as much attention as they should as many shifts tend to happen over years or decades. But an important shift is occurring now that has significant investment implications as Millennials are in their spending years. The oldest Millennial turned 35 in 2016. Peak earning and spending years are between age 35-55 which can lead to economic booms and secular bull markets. The oldest Boomers turned 35 in 1981 and left their peak spending years in 2000 – which was also a terrific period for stock market returns. Think of the home buying strength we have seen over the last few years, which leads to consumers filing their homes with furniture and the positive implications for many industries such as home building, retail, restaurants etc. This trend can influence markets for many years still to come.

Source: Demographics Say Bull Market Could Have Years to Run - Ciovacco Capital