Technology update.  The final big data point in 3rd quarter corporate profits also came out in November as the world’s largest company by market capitalization, Nvidia, reported earnings.  The stock traded down slightly following the release despite another strong beat on earnings and revenue and an increase in guidance.  Clearly expectations were so elevated that ‘great was not good enough!’  What’s troubled investors this time was a quarter-on-quarter decline in gross margins, with guidance for them to fall further in the coming quarter and weaker-than-expected forward guidance for revenue.  We sold our remaining position in client accounts going into the print.  While momentum will be strong for at least the next year as data centre build out continues at pace but our concern is that investors will ultimately need to see the ‘monetization of this AI spending’ and we see little evidence of it thus far outside of the hyperscalers where we see Microsoft packaging ‘Copilot’ with their 360 offering at $35 month.   For now, demand for Nvidia’s Hopper and Blackwell graphic chips far exceed supply but as either demand slows or production increases to meet this demand, prices and margins will come down.  While the hyperscalers (Amazon, Meta, Microsoft, Alphabet) continue to spend on the AI infrastructure rollout at $40-60 billion annual rates, the bigger risk going forward will be the profitable uptake of these new AI services on a broader scale.  The recent results from Dell Computer, Hewlett Packard and Intel all suggest that this uptake could be slower than expected given the reductions in forward guidance on recent earnings releases.  We should pay close attention to the semiconductor group in general as this market-leading industry has been under pressure, with the group now down more than 14% from its July highs, despite the positive impact of Nvidia, which is up 6% during that same period and represents more than 25% of the semiconductor index.  This means that the rest of the semiconductor group exlcuding Nvidia is down over 18% from its peak.  The relative strength ratio of the group to the broader market has also broken down through the 200-day moving average for the first time since the bear market of 2022.

Donald Trump’s nomination of Robert F. Kennedy Jr. and other healthcare skeptics has caused investors to flee the sector, which may mean it’s time to pay close attention to the stocks.  The reaction to Trump’s election has been generally celebratory, with the S&P500 up 5% in November alone.  But not the healthcare stocks, whre the Health Care Select Sector ETF has fallen about 2% this month on worries about tighter restrictions on new drug releases and less overall government support for vaccines and other health care initiatives.  Though nothing specific has been released so far, the plethora of names of indiviudals with questionable industry experience and some ‘unique’ views has prompted shareholders in the group to mostly hit the ‘sell button.’  But sometimes the reward more than makes up for the risks, and healthcare stocks are trading cheaply enough to start looking interesting.  The Health Care ETF trades at 17.8 times earnings, down from 19.9 times at the end of August and near its cheapest level of the year.  We added to positions in Pfizer (PFE) and the Biotech small company ETF (XBI) on weakness and also established a new position in CVS Health. 

Bitcoin conitnued to hit new highs following the U.S. elections and the ‘cyrpto friendly’ incoming president helping to set sights on $100,000.  The renewed excitement around Bitcoin comes on hopes that Trump will usher in a golden age of crypto, which would include more supportive regulation for the industry and a potential national strategic bitcoin reserve or stockpile.  Bitcoin’s recent moves higher also triggered a wave of short liquidations – more than $100 million according to CoinGlass – sending the price even higher.  Another Trump term also implies larger budget deficits, potentially more inflation and changes to the international role of the dollar, which are all things that would have a positive impact on the price of Bitcoin.  While price momentum and new buying is clearly positive, we question the ability to push through wide scale adoption of the technology and the currency, which would seem to be a necessity to sustain the interest.

Elevated risk-taking has not been confined to Bitcoin and the stock market.  We have also seen tighter corporate bond spreads than we have seen in decades, indicating that bond investors are also taking higher risks despite some deterioration in the background.  The median interest expense ratio across S&P500 companies is challenging the highest levels since the dotcom bubble, while the median coverage ratio has fallen to 2.2x (lowest since 2009 and well below the historical 3.5x average). Yet, credit spreads sit at multi-decade lows, failing to reflect rising default risks that are not priced into the corporate bond market right now.

So how do we invest in that ebullient environment?  With sentiment running so high at the same time as valuations are at record highs and the tailwind of falling interest rates could be put on hold, we see no benefit in increasing the risk levels in client portfolios by taking stock weightings higher, particularly in the more economic sensitve sectors that have already rallied sharply without a supporting increase in earnings projections.  We are retaining relatively high cash levels in portfolios, where we are still seeing positve real rates of return on short-term paper.  We are slowly starting to add to longer-term U.S. bond exposure as yields push up into the 4.5% range.  In the stock market we still like the high yield group with overweight positions in the telecom, electric utility, energy and pipeline stocks.  We have reduced bank stocks in both the U.S. and Canada on the recent strength and will re-evaluate once we see the upcoming 4th quarter earnings reports from the Canadian banks.  We continue to have healthy weight in the technology sector (not the 44% weight in the S&P500 Index but above the 12% weight in the TSX Composite) with an ongoing focus on the large hyper-scalers (Amazon, Alphabet, Meta) and other software names (Shopify, Lightspeed POS) and Celestica in the equipment group.  But we have reduced our weights in the semiconductor space, with memory chip maker Micron being our remaining holding.  With year end tax loss selling mostly out of the way be now, December does have a history of being one of the stronger months of the year for stocks, so it would not surprise us to see this ‘post election euphoric’ rally continue.  But the overall risk-reward profile in the stock market looks unfavourable, so we continue to have a slightly underweight position in stocks with a focus on defensive, high-yield sectors and a healthy allocation to cash and short-term paper.

 A few of the top names in our portfolios and some background on each as follows:

Atkinsrealis Group Inc.  (ATRL-TSX)  The former SNC-Lavalin is a professional services and project management company.  It delivers end-to-end services across the whole life cycle of an asset including consulting, and advisory and environmental services.  ATRL’s core Engineering Services Regions and Nuclear segments are well positioned to continue realizing strong organic revenue growth and margin expansion. Top line growth is supported by robust backlogs and favorable demand trends, while management is focused on driving margin improvement in Engineering Services.  But the real gem is the nuclear segment, which is underappreciated in the current valuation as it helps to refurbish reactors globally.  Risks include possible cost overruns and/or cash outflows associated with LSTK Projects work, a weakening of end-market conditions or failure to deliver improved margins.   But the valuation is attractive at under 10 times 2025 expected EBITDA, a discount compared to Canadian engineering peers.

Pfizer Inc.   PFE-US   The stock has fallen more than 60% from its 2022 high due to the fall-off in COVID19 vaccines as well as the recent appointments of health industry leaders by the incoming US administration that are viewed as ‘unfriendly’ to the pharmaceutical industry.  But the sell-off has created opportunity as the company has done a great job of using the ‘windfall’ Covid vaccine revenues to add to its pipeline of growth, including promising diabetes and oncology drugs.  There has also been activist investor interest in the company which could jumpstart shareholder friendly moves.  The stock has a dividend yield of over 6%, trades around 10 times forward expected earnings and should have annual earnings growth of over 12% over the next five years, which should give it downside valuation and dividend support as well as the potential for re-valuation due to a more favourable growth outlook.

Meta Platforms Inc (META-Q)  Meta builds technology that helps people connect and share, find communities, and grow businesses. The Company’s products enable people to connect and share with friends and family through mobile devices, personal computers and devices.  It operates through two segments: Family of Apps (FoA) and Reality Labs (RL).  The stock has rallied sharply in the past 18 months but still trades below a market multiple.  Meta is one of the best ways to participate in the monetization of AI services as the perversity and penetration of their apps will allow them to effectively bundle AI products for their customers.  Also, its mobile advertising business is one of the best targeted methods of reaching customers and improving productivity.  

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