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Stocks continued to work their way higher in December despite record-setting daily increases in COVID-19 cases and deaths, increased state and provincial lockdowns across North America, further delays in implementing the next round of U.S. stimulus and even the continued denial of U.S. election results by President Trump, with risks that he takes on a more ‘scorched earth’ policy during his last month in office. But the approval and rollout of three different vaccines, continued unwavering support from central banks and the belief that new economic stimulus will eventually pass all helped stocks push to slight gains, adding to the sharp rise in November. Stock sectors tied to the recovery trade were the clear winners in December, with the Dow Industrials and the ‘small cap’ Russell2000 Indices leading the charge. The Dow features many of the largest multinational conglomerates (3M, Disney, Apple, Visa, Microsoft) that benefit from a global recovery while the Russell2000 benefits from a recovery in the U.S. domestic economy and many of the smaller companies that have been most negatively impacted during the pandemic, including many financial industry stocks. In Canada, the defensive health care, consumer staples and telecom sectors were laggards in December while the energy and consumer cyclical (i.e. autos, airlines) sectors lead the gains on recovery hopes and lower valuations. Bond prices were mostly unchanged as a slight rise in long-term rates was offset by an improvement in corporate bond spreads.
We head into 2021 with the most widely-held consensus on both economic activity and stock market performance we have seen in decades. That alone tends to make us a bit nervous, especially with stock market valuations at record levels, investor sentiment ragingly bullish and speculative activity continuing to surge (think Tesla, SPACs, Bitcoin and IPO fever -AirBNB, Doordash). Investors expect economic growth to rebound, which makes sense given that millions of Covid-19 doses are on track for distribution, new fiscal stimulus packages are on the way and central banks remain adamantly supportive. In our view, economic growth will meet these expectations, with continued manufacturing recovery boosted by a pent-up demand for service spending in areas such as travel and entertainment.
The ‘fly in the ointment’ for stock markets could be a reversal of the interest rate declines that have been so supportive of valuations. Few investors expect any inflationary pressure, but we have never before seen the amount of monetary expansion we have seen in the past year in any industrialized economy. If growth does indeed recover as expected, we would almost certainly see some upward pressure on goods prices. While central banks are adamant that they will keep interest rates at these record low levels right through 2023 (famous Fed quote, ‘we are not even thinking about thinking about raising interest rates’), we wonder how they could maintain that stance if we suddenly see the economic growth back in the 3% range and inflation running at a similar rate. The biggest market risk, in our view, is that 2021 ends of looking a lot like 2018 where, post the massive tax cuts in late 2017, profits and growth soared, but along with that so did interest rates, which proved too much for a stock market which had been levitated on low interest rates. Despite this risk we remain overweight in stocks as they still represent the best alternative to bonds or cash. Within the market though, we are avoiding the high growth, high valuation sectors and focusing instead on recovery sectors that can still work in a higher interest rate environment. Financials in both the U.S. and Canada lead that list, but we have also added to energy, industrials, base metals, autos and even some airlines. The biggest focus in our portfolios is on the stable dividend payers such as pipelines, telecom stocks and banks, where yields exceed 5% and valuations are relatively depressed. We have also added to preferred share portfolio as rate reset risks have diminished.
In terms of some specific recent portfolio additions and rationale, we continue to favour Shaw Communications. In our view, the telecom sector provides the best risk-reward combination for investors with low volatility, positive free cash flow, reasonable valuations and high dividend yields with growth. Less appreciated are the benefits of owning all the long-life spectrum and communications infrastructure assets, at a significant discount to other long-term capital assets. Shaw trades below 6 times EV/EBITDA, generates significant free cash flow and has paid down acquisition debts. Results in 2020 beat expectations as the growth of Shaw/Freedom wireless was better than the incumbents and they have a relatively stronger balance sheet with lower expected spectrum cost. COVID-19 impacts (store closures, subdued subscriber activity and reduced Roaming fees) have been managed well and broadband trends are improving with the growth of 5G and streaming expected to increase further.
Within the banking sector we have added to CIBC. Financial stocks lagged the overall market in 2020 as fears about substantial loan losses, economic risks and record low interest rates hampered expectations. But the banks delivered solid results with strong capital ratios, continued growth in wealth management and surprising strength in capital markets and trading. CIBC has excess capital and has probably over-provisioned for potential loan losses so we expect those reserves may come back into earnings and dividends could be increased again, along with the reinstitution of share buybacks. CIBC’s expansion into the US is now contributing to net earnings yet the valuation gap to the rest of the bank group remains wide, and we expect that differential to narrow. Meanwhile the bank dividend yield is over 5%.
While energy has been one of the biggest laggards in 2020, we have added to a quality name in Tourmaline Oil. We see a bullish backdrop for natural gas pricing fundamentals over 2021, and Tourmaline is the best way to play the gas-weighted producers. The company has one of the best balance sheets in the industry, a low-cost asset base and one of the strongest management teams, who have a history of creating value in prior positions and also have been aggressive buyers of their own stock. Strategic corporate acquisitions and dispositions have added value including recent purchase of Modern Resources and Jupiter Resources, which provide an additional 76,000 bpd of current production. These transactions are immediately accretive on virtually all relevant metrics as the Company ramps-up production on the acquired lands and fully captures what could be some significant cash flow and free cash flow. The recent spinout of Topaz Resources as a separately-traded entity has also crystallized value for that asset and becomes a source of funding for future acquisitions.