Chris Blumas, portfolio manager, Raymond James Investment Counsel

FOCUS: North American large caps

MARKET OUTLOOK:

It’s been a roller coaster ride for investors so far this year. Equity markets sold off to start the year then rebounded somewhat and have sold off again. Last month, the U.S. Federal Reserve shocked financial markets with its plans to increase interest rates more significantly 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 and increases the odds of a hard landing. However, real-time data shows that commodity and home prices are deflating. These price declines should help to shorten the current cycle of inflation and increase the possibility of interest rate cuts in the second half of next year.

In prior tightening cycles, the Fed has had to push interest rates above the rate of inflation and create positive real interest rates. With U.S. inflation running around eight per cent year-over-year, there is a way to go before real rates turn positive. Overall, I think it’s unlikely that this will occur because there is too much debt in the system. 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 volatile environment can be daunting, equity market valuations have compressed significantly and the valuation risk embedded in the markets is much lower. With low nominal interest rates and negative real returns, investors holding cash and low-yielding fixed-income securities risk a loss in purchasing power over time. Going forward, I think investors should remain well diversified and defensively positioned 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 $96.76 on Sept. 29, 2022

 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 ads 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 at 16.5x forward earnings. However, this valuation doesn’t account for the excess cash on the company’s balance sheet ($110B or $8 per share) or the hidden value associated with its cloud services business and its early-stage technology investments that generate negative operating income.

Artis REIT (AX.UN TSX)

Most recent purchase at $9.13 on Oct. 7, 2022

Artis is a diversified REIT with a mix of office, industrial and retail properties. The trust currently generates around half of its operating income in Canada and half in the U.S. Diversified REITs are very out of favour and trade at dramatically lower valuations than other real estate subsectors. In early 2021, Artis reconfigured its board and appointed a new chief executive officer with the aim of improving capital allocation and maximizing value for unitholders. The end goal of the new management team is to create an asset management platform with the optionality to invest in public and private real estate markets on a value basis and grow NAV at an above-average rate. The units currently trade at 6.8x current year funds from operations and have a distribution yield of 6.6 per cent. At the second-quarter of 2022, the IFRS NAV per unit was more than $19 and the current discount to NAV of more than 50 per cent is among the largest discounts in the Canadian real estate universe.

Constellation Software (CSU TSX)

Most recent purchase at $1934.71 on Sept. 30, 2022

Constellation Software is an enterprise software consolidator with a global presence. Last year, the company generated almost 90 per cent of its revenues outside of Canada. Constellation has six operating subsidiaries that function as independent businesses with a common capital allocation framework. This decentralized operating model has allowed the company to complete hundreds of acquisitions since its initial public offer in 2006. Constellation typically targets smaller companies that are too small to attract the interest of other IT conglomerates or private equity firms. Over the years, the company has expanded its operating infrastructure so that it can continue targeting smaller acquisitions and continue compounding cash flows at an above-average rate. Over the last three years, the compound annual growth rate for cash flow per share is 25 per cent. The shares currently trade at 24x trailing cash flows and have a dividend yield of 0.3 per cent.