Paul Harris, partner and portfolio manager, Harris Douglas Asset Management

FOCUS: North American and global large caps

MARKET OUTLOOK:

The second-quarter of 2022 began with hope and ended in despair. After a strong rally in equity and bond markets in July, both sold off sharply in August and September. The rally began as markets started to price in interest rate cuts and hopes of a mild recession. However, in August, the U.S. Federal Reserve and other central banks reiterated that the priority remained the fight against inflation rather than the support of economic growth.

On the inflation front, inflationary pressures moderated somewhat over the quarter on the back of lower oil and food prices. Nevertheless, core inflation generally remains well above central bank targets in most countries, which is why markets are pricing in further rate increases in the coming months.

On a positive note, equity market valuations have now generally fallen. For example, in the U.S., the market is currently trading on a price-to-earnings (P/E) ratio of 15.6 vs. a long-term average of 16.6. However, these valuations are based on current consensus analyst forecasts for earnings growth, which have barely fallen. From Dec. 31, 2021, to Sept. 30, 2022, consensus earnings have decreased by less than five per cent. 

Overall, while the growth outlook remains challenging, many stocks and bonds are now already priced with a relatively high probability of at least a moderate recession. Government bonds are now also pricing in a significant amount of further tightening. So, after a very difficult year thus far, both stock and bond valuations now look more attractive.

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TOP PICKS:

Alphabet (GOOG NASD)

It is a top search destination on the web and provides a leading search marketing platform for advertisers and merchants. The company continues to see growth in YouTube and its ability to monetize advertising. The stock trades at 20 times earnings. It will generate $50 billion in free cash flow in 2022 and has no debt. It has significant secular growth from internet advertising, a strong market share in search and other internet advertising segments. Google has 30 per cent share of U.S. digital ad revenue and global ad revenue is expected to reach well over $400 billion in 2024 and digital advertising accounts for more than 50 per cent of total ad spend. The restrictions that Apple has put on iPhone helps Google. The stock trades at 16.4x 2023 earnings and has no debt.

Zoetis (ZTS NYSE)

Zoetis is the largest public animal-health company. Zoetis was spun off from Pfizer in 2013. In 2018 U.S. pet owners spent 15.5 billion on over-the-counter medicine and supplies; double 6.2 billion in 2001.

Health care for animals has a certain advantage over health for humans. The industry doesn’t have content with pricing pressure from the insurance industry as most medical expenses are paid out of pocket.

Developing drugs for pets, compared with humans, is generally faster and less expensive since it requires fewer clinical studies involving fewer subjects. Most companies try to find compounds that have worked in humans, so we don’t have to start from scratch.

Generic drugs are less of a threat. The company has strong free cash flow growth, generating two billion dollars in 2022, a strong balance sheet and covers interest on debt 14x and high conversion rates in free cash flow to net income.

FirstService (FSV TSX)

The company focuses on residential property management and services(California Closets). It has room to grow market share in the U.S. in what remains a very fragmented business. The company has grown through acquisitions and organic growth. Trades at 26x next year’s earnings and yields 0.80 per cent.