Brendan Caldwell, president and CEO, Caldwell Investment Management

FOCUS: North American equities 

MARKET OUTLOOK:

In a recent commentary to the markets, the U.S. Federal Reserve signalled a willingness to tolerate a recession – hopefully mild – rather than allow persistently high inflation. As a result, rising rates helped push the U.S. into a recession in the second quarter of 2022 (technically defined as two consecutive quarters of negative GDP growth). Inflationary pressure from higher wages and other inputs (e.g. commodity prices, shipping rates) have led corporations to pass along higher costs which have pressured consumer spending on a real basis. Spending in “re-opening” categories such as travel and leisure seems robust but consumers are making trade-offs in other goods-based categories (e.g. electronics, furniture, cars and even everyday household products). This leads investors to question what happens to the economy if, or when, growth in service-based categories begins to slow. Additionally, as consumers’ willingness or ability to handle higher prices wanes, companies’ ability to maintain margins, and thus earnings, may also come under pressure which is a sharp contrast to the strong earnings growth seen over the past two years.

Given all the uncertainty, it’s no surprise that nine of 11 sectors in the S&P 500 are down year-to-date, with the market down above 10 per cent overall. As far as our outlook, predicting the future is extremely challenging in the best of times and increasingly more so in the current environments. We will continue to focus on identifying high-quality, well-managed, companies with proven histories of navigating through tough environments and believe professional investment advice can be extremely valuable in times such as these. 

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TOP PICKS:

Costco (COST NASD)

Most recent purchase – July 22, 2022

Leading operator of supercenter, multi-category retail warehouses; third largest global retailer with 830 warehouses worldwide serving 64 million households.

Why we like it? (more specifically, why now?)

• Despite the huge COVID-19 surge in demand, they continue to see strong growth and consistent traffic numbers.  Renewal rates for first-time members are trending well ahead of pre-COVID-19 levels suggesting demand may be sustainable at these higher levels.
•  COST is a price leader but not highly exposed to the lower-income consumer – they haven’t seen a trade-down activity yet but would likely still benefit in that environment.
• Executive membership conversion is robust. Exiting the pandemic, executive members represented 55 per cent of paid memberships in U.S. and Canada, 17 per cent internationally, highlighting long membership conversion opportunities.
• Executive membership drives customer stickiness and they spend more than basic members.
• Pricing still lags competitors in some categories so COST can pull that lever if necessary without significantly impacting demand. New programs such as grocery delivery also create customer stickiness. Strong gas sales are driving in-store attach visits. Geographic expansion opportunities in China.

LKQ  (LKQ NASD)

Most recent purchase - July 21, 2022

LKQ is the leading supplier of aftermarket (AM) auto parts in North America and Europe; 20x bigger than its number two competitor in NA; 2-3x bigger in Europe.

In North America, it primarily sells to independent and large chain collision repair shops; the business is driven by total vehicle miles driven and safety standards on vehicles.

• Note that collision shops are LKQ's customers but insurance cos ultimately pay for 80-90 per cent of repairs. Given that AM parts are 40-50 per cent cheaper than OEM parts, insurers are incentivized to use cheaper parts to lower their costs (especially relevant in an inflationary environment).
• This business should benefit from the reopening, return to work, lower gas prices, etc. as miles driven are still below 2019 levels.
• Consumers are also more likely to choose repair vs. replace over the next 1-2 years. Given high new and used car prices, the average age of vehicles supports repair activity.
• It also sells specialty parts to truck, RV and marine markets - this category is more discretionary.

In Europe, LKQ sells to collision and repair shops with a greater focus on mechanical replacement parts (windshield wipers, belts, air filters) vs. collision.  

• Regulation passed in last few years opened up European markets to non-OEM parts; Europe is still playing catch up to North America in terms of AM part penetration.

LKQ is undergoing restructuring aimed at improving margins; targeting sustainable DD segment EBITDA margins vs. eight per cent historically

Electronic Arts (EA NASD)

Most recent purchase - July 29, 2022

Electronic Arts is a leading game developer whose content and services can be played and watched on game consoles, PCs, smartphones and tablets.

Its portfolio of games includes wholly-owned properties - such as Battlefield, The Sims, Apex Legends – and licensed brands such as FIFA, Madden NFL, NHL and Starwars.

Why we like it?

• The global gaming market is massive and growing well above GDP.
• There are high barriers to entry given development costs, sticky customers and licensing arrangements with major sports brand franchises give large developers the upper hand.
• EA’s marketing and research and development base also serves as a competitive advantage vs. smaller game developers, allowing faster development schedules.
• The business model has de-risked over the years given strong growth in ‘live services’ revenue; single game releases have much less impact as live services are ~70 per cent of total revenue.
• Live services are sales of extra content for console, PC and mobile games, licensing revenue from third-party publishing partners who distribute our games digitally, subscriptions, and advertising.
• Engagement with EA’s games remains strong despite the re-opening as gaming has more of a social aspect than a purely solitary pursuit that most think of – this is driving growth in active accounts and thus bookings.
• EA’s relatively recent acquisitions of mobile gaming studios help drive growth and strengthen EA’s position in a market where they’ve typically lagged.
• EA is also leveraging the expertise of mobile gaming studios to roll out mobile versions of its blockbuster franchises like Battlefield and F1. 

PAST PICKS: March 30, 2022

CME Group (CME NASD)

• Then: $241.80
• Now: $200.63
• Return: -17%
• Total Return: -17%

Quanta Services (PWR NYSE)

• Then: $132.16
• Now: $134.81
• Return: 2%
• Total Return: 2%

Micron Technology (MU NASD)

• Then: $79.16
• Now: $62.66
• Return: -21%
• Total Return: -21%

Total Return Average: -12%