In what is a time-honoured tradition here at Purpose, we recruited a handful of our favourite portfolio managers and asked them to reflect on 2022 and what they anticipate for the year ahead.
Read on for their thoughts on the Fed, this chilly crypto winter, the future of the energy sector, the fate of the FAANGs, what sectors and asset classes were on the good and bad list this year, and more.• Investment Strategies and Portfolio Construction
• Reflections on the Crypto Winter
• Comments on the Tech Sector
• Analysis of the Energy Sector
• Discussion of Post-Covid Real Estate
• Notes on the Fed and Market Wish Lists for 2023
Craig Basinger Talks Investment Strategies and Portfolio Construction
Did any asset classes or sectors make the nice list this year, or does everything deserve a big lump of coal? Do you expect the same trends to continue in 2023?
2022 has certainly been a challenging year for portfolios, and clearly for the owners of those portfolios and the managers of those portfolios. Given the sudden need for global central banks to fight inflation, overnight lending rates were ratchetted up very quickly. In Canada, this was from a paltry 0.25% to 4.25% while for the all-important U.S. Fed, it was from 0.25% to 4.5%. The speed of this action raised the discount rate that goes into valuing any asset…so stocks fell, bonds fell, and real estate fell. This really neutralized the normal benefits of portfolio diversification. Overall, coal appeared to be the norm.
But coal isn’t always bad. In a pinch, it can heat your home or given enough time and pressure can turn to diamonds. 2022 brought a massive reset of valuations and while the journey was not pleasant—and may very well not be over—the markets are getting to a much better place. The Canadian bond universe spent 2020 and 2021 with a yield of less that 2%. Today it carries a yield of almost 4%. Global equities started 2022 with a valuation of 18x earnings, today it is 15x and well below that if you look outside the U.S.
Despite the pain in 2022, there were some things that worked. Some alternatives navigated this unique market well, notably momentum-based futures strategies, and the value factor among stocks did well, or at least fell materially less. Perhaps this good news was long overdue for both, given growth had trounced value in just about every year in the past decade and God only knows how many investors have been disappointed by futures-trading strategies in years past.
2023 has one thing going for it: a much healthier starting point. But we caution against simply extrapolating 2022 into 2023 the same way we cautioned extrapolating 2021 into 2022, as we believe this is a market-cycle-ending bear that will see a change in leadership. Some changes have already started, some are still to come. With certainty, 2023 will not look like 2022. Overnight lending rates can only go from near zero to 5% once. Next year will likely see inflation continue to gradually fade and the risk of a recession continue to mount. It’ll be very different year, assuming the market even cares about the Gregorian calendar.
When analyzing their portfolios for the year ahead, what should investors be sure to check twice?
In our recent publication, Preparing for the Next Bull, we outlined a number of important portfolio construction implications for the next cycle. Now we do not pretend to know if the next bull has started. We do believe the end of this bear cycle is closer than the beginning, given recession risk and likely slowing earnings ahead, but it probably ain’t over yet. Still that does not mean it’s too early to start considering positioning.
As we head into the new year, these are some of the more pressing portfolio considerations:
- Go global – There is no denying that the U.S. equity market and U.S. currency were the stars of the last bull cycle. But it’s very rare for that to repeat. Given the combination of relative valuations in markets and relative valuation in currencies, consider less U.S. and more global equity.
- More value – While somewhat related to going more global, the next cycle appears to be more ideal for the value over growth as greater cyclicality in economic growth, inflation, and less central bank support all favour value.
- Duration is not a four-letter word – Perhaps the most crowded trade among portfolios today is underweight bonds, low duration, and high credit among fixed-income allocations…perhaps even spreading into income alts. There’s no denying this was the ideal position for the past few years as yields were super low and started to rise. But they have risen. Maybe there’s more to go, but the risk/reward of duration and normal bonds is now much more balanced. If a recession is ahead, duration will once again become a portfolio’s friend.
Nawan Butt Talks Crypto Markets
Crypto markets have been quite volatile this year. What North star should people keep in mind as they look to navigate 2023?
It’s always been difficult to measure valuation via fundamentals for the world of crypto. The possibilities associated with crypto are far removed from the tangibility of the current state of crypto technology. As we move into the latest crypto winter, focus for investors should shift from potential to application.
And as the smoke clears and the dust settles, it will be up to incumbents to use the funding gained over the last few years to create technologies for the next many years. With that context, we actively await and watch for technological developments that have real-world applications. We have seen such progress before, but an acceleration in development is required to validate the concerns regarding the viability of crypto technology. So, with the majority of price discovery behind us, watch out for proof of concept going forward.
Who would be at the top of your naughty or nice list this year in crypto?
The nice list is very short and the naughty list is very long. The chief culprit is very much SBF [Sam Bankman-Fried] and this is well covered by all news outlets. As far as tokens are concerned, we remain focused on Bitcoin and Ether as the keys to crypto success in the long term.
Nick Mersch Talks Tech Investing
Many people feel that tech stocks deserve a lump of coal in their stockings this year. What's your take on how tech has performed over the past 12 months?
Technology stocks have been firmly placed on investors’ naughty list this year, as growth equities have been punished across the board and there are no “growthier” equities than tech stocks. Historically, these businesses have forgone cash flow in pursuit of rapid growth in order to benefit from economies of scale and steal market share so that they can reach a point of exit velocity.
Over the last decade, the Nasdaq-100 has grown from a market cap of $3.2 trillion in 2013 to $20 trillion at its peak to the $13.9 trillion it stands at today. This marks one of the single greatest wealth creation events in the history of capital markets. But the party is over.
Interest rates hikes mean that yield is now everywhere in the market. Technology went from TINA (“there is no alternative”) to TAMA (“there are many alternatives”) as capital rotated violently out of growth. When it comes to flow of funds, capital has been piling into other pockets of the market as value factors and fixed income look increasingly attractive on a risk/return basis.
We know that stock prices are broken down into two components: fundamental (earnings/sales) and sentimental (multiple). The technology rally from the 2020 trough to the 2021 peak was fuelled by rapid multiple expansion. It was not unusual for some of these high-growth names to be trading at 40x+ EV/Revenue. Then the reverse occurred, snapping back like a rubber band over the course of 2022. Longer-duration assets get hit relatively harder when rates rise, and we saw this in spades through the 70-80% multiple contraction amongst the high-growth software cohorts.
From a fundamental perspective, the bull narrative was that technology companies are much more insulated from a downturn because they have flexible cost structures and have strong operating leverage. But, what we got over the course of mega-cap earnings last quarter was a narrative violation because, amongst the majors, it was really only Apple that didn’t disappoint as we saw margins squeezed across the board.
However, as we start to find a bottom on multiples, we will see the best-of-breed companies emerge stronger on the other side. We favour companies that are free cash flow generative, have defensible moats, are mission critical, and can expand their TAM through synergistic acquisitions as acquirees are at discounts.
When private equity firms like Thoma Bravo start to heavily acquire, you know there are long-term intrinsic value discounts in the market. Everything happens in cycles, and we believe that over the course of 2023, we will see the bottom of this cycle. Come the latter half of 2023, we should see the Fed pausing hikes after rapidly deteriorating economic conditions, we will finally be able to admit we are in a recession, and we will see an earnings trough. History tells us that the combination of these factors is one of the best entry points for the next long-term secular bull market.
Much has been made about the fall of the FANGMAN stocks in 2022. But who have been the three wise men? Give us your top three companies that have impressed you this year.
The market loves acronyms, but there’s danger in grouping companies together. In the case of the FANGMAN, the fundamental business structures, operations, and exposure vary widely across all the catchy company acronyms.
For example, while Apple is down ~20% YTD, Meta has fallen ~65%. These companies were directly engaged in a war with each other over the course of 2022. Apple made a change to its privacy terms that greatly lowered the efficacy of Meta’s advertisement model. Meta could no longer serve ads that target hyper-specific groups because Apple was not allowing Meta to collect this information. Add in overspending on the VR/metaverse opportunity, and you’ve got an incredibly difficult year for Meta.
Here are the YTD returns as of writing:
- Facebook (-65%)
- Amazon (-46%)
- Netflix (-49%)
- Google (-33%)
- Microsoft (-27%)
- Apple (-20%)
- Netflix (-49%)
While a tough year for all, here are the three that had the best relative performance of 2022:
- Google: Google has a near-monopoly when it comes to search on the internet. By having an extremely deep moat at extremely higher margins, Google can drop a lot of its revenue to free cash flow. Since it trades at a lower multiple, it’s inherently more insulated from downturns and less reflexive to changes in interest rates. Google also currently scans closer to value metrics than growth, trading below 10x EV/EBITDA and below 5x EV/Revenue. Looking forward, Google will continue to face low growth because advertising budgets have drastically pulled back in the anticipation of a recession. There are better names for next year, but Google proved to be an okay place to hide and did not drop as much as other peers.
- Microsoft: Microsoft is still the king of the office. When it comes to productivity tools, the O365 Suite of products remain to be table-stakes in any organization. Can you imagine not having access to Word, Excel, and PowerPoint? Microsoft is also one of the few legacy companies that has been able to innovate instead of fall into irrelevancy. Under Satya Nadella, Microsoft has grown rapidly in the cloud, with their Azure platform giving AWS a run for its money. When it comes to free cash flow compounders in the technology space, few have provided investors with more attractive returns than Microsoft.
- Apple: Apple was the best of the bunch in 2022. They proved that the power of a brand has enormous value throughout any stage of the economic cycle. While on the surface, it looks like they just keep adding n+1 to their top-selling product, they also quietly built another empire in another product category – Airpods. If you look at revenue – AMD, Nvidia, Uber, Square, and Adobe all did close to $16B in revenue in 2021. Airpods alone had a product category revenue of $12B. While some tech investors consider “hardware” a bad word because of gross margins and lack of a recurring component, Apple’s product has bucked the hardware trend by being both high margin and highly recurring. Strength in selling adds and owning the end consumer has also proved a winning strategy.
Mega-cap companies aside, we believe into 2023 there will be many opportunities for pure-play direct exposure to emerging themes such as database warehouse management, cybersecurity, DevOps, and cloud platforms. Names we like in these spaces include Snowflake, Datadog, Crowdstrike, Zscaler, and Atlassian– all of which we hold in the Purpose Global Innovators Fund (TSX: PINV).
Jeremy Lin Talks the Future of Energy
As countries like Germany and Japan softened their stance on nuclear energy, uranium prices basked in a warm glow earlier this year. How do you see this sector evolving in 2023?
Nuclear energy will continue to be a key tool in our fight against climate change, and we see 2023 as a year where we’ll see more long-term contracting of uranium as nuclear operators start to run low on inventories. In many countries not abundant in natural resources (e.g., China, India, and Japan), the nuclear debate is already over—they all recognize that nuclear is absolutely key to generating enough energy to keep the lights on, let alone reducing greenhouse gas emissions.
There is also an underlying theme to re-shore uranium production as western countries look to shift away from Russia’s uranium value chain, where they have 8% of world's primary production as of 2021 but also 40% of global conversion capacity and 46% of enrichment capacity.
The global primary uranium supply of Kazakhstan, a major supplier of uranium at 46%, is increasingly at risk as the majority of their products need to be railed through Russia to St. Petersburg, where the risk of "sabotages" on the rail tracks is not zero. Historically, nuclear operators that have contracts with Russian entities are all looking for alternative solutions past their current term contracts, which will further drive incremental demand for western uranium production and conversion and enrichment capacity.
The Purpose Global Climate Opportunities Fund (TSX: CLMT) continues to perform better than almost all of its peers. To what do you attribute this stand-out performance?
The most significant factor driving our outperformance this year was the fundamental understanding that any viable energy transition movement would require traditional fossil fuel. Our portfolio was already positioned to capitalize on the energy crisis within cleaner fossil fuel space before the full-on Russian invasion of Ukraine. As we headed into the summer, we saw a shortfall in energy across the world, whether it was a lack of electricity because people were turning up their air conditioners from the record heat waves or record high gasoline/diesel prices because of shortfalls in supply from a lack of investments during Covid under the false hope that everyone will soon be driving an electric vehicle.
Going into 2023, the energy transition theme is now more mainstream, with many more sensible investors accepting the fact that we need fossil fuel as part of any sound energy policy and a balanced portfolio, so we've definitely seen a re-rating in the space to the upside.
We see 2023 as the year where we need to be more selective with names in the space as the energy trade becomes more consensus and recession and rate risks still loom in the market. We are more constructive on many renewable operators and critical mineral producers as companies start to ramp up their production to take advantage of tax credits from the Inflation Reduction Act, the single biggest climate legislation in U.S. history.
Michael McNabb Talks Real Estate
With inflation still rampant and the Bank of Canada raising its rates yet again this year, what impact is this having on the real estate sector? How significant will this impact be on housing prices in 2023?
The Bank of Canada continues to raise its benchmark rates in an effort to cool inflation. The velocity with which rates have moved has stalled both the commercial and residential real estate markets, and the market is now in price discovery mode. Canada’s benchmark lending rate has moved from just 0.25% to 4.25% in 10 months – that sort of move is bound to have a cooling effect on Canada’s hot housing market.
It’s clear that some overheated suburban markets are due for a bit of a correction after the free money, pandemic-fuelled run-up. The national average price of residential real estate was down 12% year-over-year as of November 2022. It is always tough looking at the pricing stats of residential real estate as you don’t know if you are really comparing apples to apples. With transaction volumes down almost 40%, year-over-year numbers can easily be skewed if not much high-end real estate was traded in the period.
Longer term, the laws of supply and demand should keep the housing market afloat. The Canadian government has committed to welcoming nearly 1.5 million new residents by 2025, and there currently is not enough housing or rental stock supply for that population influx.
Since Covid, many companies have been looking to scale back their office presence. What impact is this having on commercial real estate?
The office is the one asset class that has been hurt the most in the post-pandemic world. The way companies are thinking about space has changed, and many employees are demanding flexible work options. So, while the office is not dead by any means, it has definitely changed.
The national vacancy rates are hovering at a 10-year high of over 16% – not accounting for the substantial amount of sublease space available on the market. Interestingly, rental rates on a per-square-foot basis continue to grow and are also at 10-year highs. Much of that has to do with the length of office leases, which tend to be longer in nature, and landlords have still been able to get rent upticks upon release. The office is also an asset class that would struggle if we were to enter a prolonged recession, which is another reason investors continue to shy away from it. We continue favouring recession-resistant asset classes with better supply-demand imbalances like multifamily and industrial warehousing.
Greg Taylor Talks the Fed and Forecasts
This year, the Fed was front and centre as it began rising interest rates and implementing quantitative tightening measures. What’s your take: were they being a bit Grinchy or was this long overdue? What do you expect to see from central banks next year?
The Fed was behind the curve and spent 2022 needing to play catch up by aggressively hiking interest rates. After all the money printing to support the economy during the pandemic, we knew it would be tricky to get inflation back under control. But we are starting to see some positive signs of late, even though we still don’t know how long it will take to get inflation back to their target, as it’s probably easier to move CPI from 8% to 5%, than from 5% to 2%.
Next year the Fed will become much more data dependent as they walk the line to balance the fight against inflation vs the risk of a recession. However, an optimist would look at this and think that most of the heavily lifting is done, multiples have contracted, and that investors can get back to a more normal market environment in the year ahead.
What’s on your holiday wish list for the markets next year?
A wish for 2023 would be to avoid a major recession. If the central banks can create a soft landing for the economy, we could be setting markets up for a very nice year. The fear entering 2023 is that earnings are too high and will need to be lowered substantially. Given multiples have already contracted back to more normal levels, if earnings keep growing, markets will move higher.
On the global front, the relaxation of Covid restrictions in China should present the opportunity for a boom in commodities. If commodities run, it could be a great year for the TSX and remind many investors of the period post the dot.com crash in which cyclicals and value outperformed for many years.
Sources: Charts are sourced to Bloomberg L.P. unless otherwise specified.
The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.
Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. Certain statements in this document are forward-looking.
Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.