Chris Blumas, portfolio manager, Raymond James Investment Counsel

FOCUS: North American large caps 

MARKET OUTLOOK:

Earlier this year, the U.S. Federal Reserve shocked financial markets with its plans to increase interest rates more aggressively than prior indications. Higher interest rates and the threat of lower liquidity have pressured equity markets and other risky assets, including home prices. This ultra-aggressive policy stance virtually guarantees a recession of some sort and increases the odds of a hard landing.

While the headlines are overwhelmingly negative, real-time data show that commodity and home prices are deflating. Going forward, these price declines should help to shorten the current cycle of inflation and increase the possibility of interest rate cuts in the back half of next year.

If you look at the monthly inflation data in the U.S., headline inflation looks to have peaked several months back (June 2022) and the year-over-year comparisons get much tougher in the second half of 2023. Overall, this sets the stage for monthly inflation to continue rolling down from around seven per cent currently to something around three per cent by the end of next year, if the current price level remains relatively stable.

The modern economy is built on credit and higher interest rates hurt governments, businesses and consumers. With U.S. national debt reaching an all-time high of US$31 trillion, significantly higher interest rates are likely to crowd out crucial public programs and critical defence spending.

While putting investment dollars to work in this uncertain environment can be daunting, equity market valuations have compressed significantly and the valuation risk embedded in the markets is much lower. Equity markets are likely to bottom before the economy rebounds and this setup may provide investors with an opportunity to enhance longer-term returns. Going forward, I think investors should remain focused on earnings and cash flow and avoid the temptation to exit the markets and wait on the sidelines.

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TOP PICKS:

Alphabet (GOOGL NASD)

Most recent purchase at $94.00 on 2022-12-09

Alphabet is an investment holding company. The company’s main asset is Google which accounts for more than 90 per cent of Alphabet’s revenue. Google generates around 90 per cent of its revenues from online advertising and generates the remainder from the sale of apps and content. As advertising dollars continue to move online, Google is uniquely positioned to continue growing revenues and cash flow. On the negative side, Google continues to face greater regulatory pressure to safeguard user privacy and to lessen its online dominance. The shares currently trade around 17.5x forward earnings and have a trailing free cash flow yield of almost 5 per cent. However, these valuation metrics don’t account for the excess cash on the company’s balance sheet (~$100B or ~$7.25 per share). The metrics also don’t account for the hidden value associated with its rapidly growing cloud services business and its portfolio of early-stage technology investments all of which currently generate negative operating income.

Brookfield Corporation (BN TSX)

Most recent purchase at $61.27 on 2022-11-28 (pre-spinoff price)

Earlier this week Brookfield Asset Management successfully completed the spin-off of a minority stake in its asset management business to existing shareholders. As part of this process, the parent company (formerly Brookfield Asset Management) changed its name to Brookfield Corporation and changed its ticker to “BN” on both the TSX and NYSE.

Brookfield Corporation is a direct investor and third-party asset management firm with a unique focus on real assets and private equity. The company has a controlling interest in each of its publicly traded affiliates and a portfolio of other private investments. Brookfield is one of a handful of global private equity players that are uniquely positioned to raise large amounts of capital from institutional clients as it shifts its portfolios toward higher-yielding asset classes.

While the company has four publicly listed operating subsidiaries (BAM, BBU, BEP, BIP), the parent company has the unique ability to allocate capital across its platform and operate in a counter-cyclical manner. Brookfield has more than $100 billion in capital available to deploy across its platform and is uniquely positioned to benefit from weakness in the global macroeconomic environment. The shares currently trade at less than 12x trailing funds from operations and have a core free cash flow yield of around five per cent.

Chartwell Retirement Residences (CSH.UN TSX)

Most recent purchase at $8.33 on 2022-12-07

Chartwell owns and operates retirement residences for seniors. The trust’s main business is its private pay retirement operations which account for around 90 per cent of profits. Demographic trends and fiscal constraints on governments should lead to significant private pay demand over the long-term. So far this year, growth in funds-from-operations has been weak as the pandemic has reduced occupancy levels and increased expenses. Going forward, occupancy levels are expected to normalize and the trust has a solid development pipeline that should help enhance its growth profile. The trust currently trades at around 12x forward funds from operations and provides investors with a distribution yield of around 7.5 per cent. The current distribution is paid monthly ($0.051 per share) and translates into a funds from operations payout ratio of ~93 per cent based on forward estimates for 2023.