Brian Madden, chief investment officer, First Avenue Investment Counsel

FOCUS: North American equities 

MARKET OUTLOOK:

Markets are locked in a tug-of-war between earnings and interest rates. Profits for U.S. companies have been very robust. Conversely, interest rate relief remains elusive with inflation still too high for policymakers to cut rates. At the index level, earnings are winning the tug-of-war, propelling the S&P 500 Index and Nasdaq Composite to all-time highs. However, the market remains bifurcated between growth and value, with growth stock returns roughly double those of value stocks. The Russell 1,000 Growth Index return of 10.5 per cent and the Dow Jones Canada Growth Index return of 6.4 per cent this year handily surpass their value counterparts’ returns of 5.4 per cent and 3.4 per cent.

Income investors are caught up in this crosswind as well, with dividend aristocrat indices returning just three per cent and one per cent in the U.S. and Canada. Knowing sentiment is fickle and contrarian and that it is currently heavily bullish, with the latest American Association of Individual Investors survey reading 47 per cent bullish versus 21 per cent bearish. We practice a style-diversified approach with a fund oriented towards growth as well as a fund that is more income-oriented. Both approaches work, but at different times, and we continue to find compelling investment opportunities in both style disciplines, with notably more opportunities in the U.S. in both portfolios. Risks we remain mindful of are the lagged effect of the 2022-23 interest rate hikes, as credit losses invariably follow rising rate cycles, as well as the risk of a reversal in currently stretched investor sentiment, but all in the context of a durable bull market. 

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TOP PICKS:

Pool (POOL NASD)

Pool Corporation is the world’s largest distributor of swimming pools and related equipment and supplies and is a leading distributor of irrigation and landscaping supplies in the U.S. With 400 sales centres, mostly in the U.S., and to a lesser extent Canada and Europe it is by far the dominant player in this category with regional/metro market shares ranging from 33 – 45 per cent, with the only other competitors very fragmented mom and pop type operations. With high operating margins in the mid-teens, decent asset turns and a capital-light growth model, the company earns 40 per cent plus returns on equity allowing them to grow earnings per share and dividends at a 19 per cent compound rate over the past decade. Longer term, climate change and southward/westward migration patterns should continue to be tailwinds to the current installed base of 5.5 million swimming pools in the U.S., all of which incur significant maintenance and consumables costs and potentially over longer usage seasons, adding visibility and stability to the 60 per cent of POOL’s sales that address maintenance, repair and consumables needs for pools and spas. The shares have generated a compound total return of 23 per cent over the last decade and 17 per cent over the past twenty years.

Hershey (HSY NYSE)

Hershey is the largest chocolate producer in North America, with a 45 per cent market share across well-known brands like Kisses, Reeses, Twizzlers, Kit Kat, Brookside and Almond Joy among others. Hershey has a smaller but fast-growing salty snacks business with brands like Dots Pretzels and Skinny Pop popcorn as well as a small international business selling into developed and emerging markets. Hershey earns best-in-class margins 10 points above its peer group average and leads all of its peers in profitability with a 23 per cent return on invested capital and is also the best-rated consumer packaged goods company on ESG metrics. The stock has corrected 30 per cent off the May 2023 peak, affording an excellent entry point with the shares trading at 20 times earnings – well below the five-year average multiple of 24 times.

Shopify (SHOP TSX)

Shopify offers e-commerce enablement services primarily to small/mid-size enterprises via a recurring subscription model and ancillary merchant solutions such as payments, working capital financing, inventory management, etc. E-commerce continues to benefit from long-term secular tailwinds, but in the near term, Shopify should also continue to benefit from robust earnings momentum with the divestiture last year of its fulfillment business, which was a strategic mistake and a big drag on profitability. Some fairly recent new arrivals in its C-suite and boardroom have helped to refocus Shopify’s strategy on profitability and growth. Consensus estimates forecast an 48 per cent improvement in profit this year and a further 35 per cent next year in light of its meaningful workforce reduction and the elimination of the large fulfillment centers, coupled with a recent 33 per cent increase in its monthly subscription price, which has been well accepted by merchants – a strong endorsement of how differentiated, “sticky” and mission-critical its offering is to e-tailers.  

PAST PICKS: MAY 18, 2023

Open Text (OTEX TSX)

• Then: $56.05
• Now: $52.35
• Return: -7%
• Total Return: -4%

TMX Group (X TSX)

• Then: $145.29
• Now: $34.50
• Return: 19%
• Total Return: 21%

Arista Networks (ANET NYSE)

• Then: US$141.46
• Now: US$284.41
• Return: 96%
• Total Return: 96%

Total Return Average: 40%