Shane Obata, portfolio manager, Middlefield Capital

FOCUS: Global and U.S. large-cap stocks

MARKET OUTLOOK:

We are entering a seasonally strong period for stocks. November to January is historically one of the strongest consecutive three-month periods of the year for returns. Potential tailwinds supporting this strength include:

(1) The upcoming mid-term elections in the United State.

(2) Acknowledgement by global central banks that rapid monetary tightening is starting to produce slowdowns in certain sectors of the economy, suggesting that the federal funds rate incorporated into the current dot plot will be sufficiently restrictive.

(3) A rebound in economic sentiment toward China, assuming the authorities begin to dial back stringent virus controls by the spring of 2023.

In our last monthly commentary, we discussed conditions that needed to be met before markets could form a bottom. A few, but not all, have started to move in the right direction. A pullback in the U.S. Dollar Index and benchmark two- and 10-year yields were key factors behind the strength in equities during October. However, we are still looking for evidence of a softer labour market and a comfortable bottom in forward earnings estimates, the latter based on anticipated lower profit margins going into 2023.

For the current rally to be sustainable, we need to see a clear change in U.S. dollar and interest rate dollar trends as well as valuations based upon more realistic earnings expectations. While encouraged by improvements in the various momentum indicators and market breadth, we continue to view the current gains as a relief rally.

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TOP PICKS:

Amazon (AMZN NASD)

Purchased at US$101.26 on Oct. 28, 2022

While the recent quarter was disappointing – mostly from a margin and outlook standpoint – it did not change our long-term investment thesis for Amazon (AMZN). We continue to view AMZN as the best logistics company in the world and expect that it will show a significant step up in profitability and FCF generation in 2023 as Amazon Web Services and advertising become larger parts of the business. In addition, we expect that the retail division will show capital expenditure moderation after doubling the size of the fulfillment network during the pandemic. AMZN still trades at a premium to the market, but we think this is justified by its leadership positions in both e-commerce and cloud.

PepsiCo (PEP NASD)

Purchased at US$176.61 on Nov. 1, 2022

One of our preferred names in the staples sector. Pepsi (PEP) is not cheap; however, we believe that it can generate durable earnings growth for years to come. PEP has demonstrated impressive organic sales growth, mainly attributable to pricing power. As a result – and thanks to other cost-saving initiatives – the company has done a great job protecting operating margins. Given the extremely strong price realization we have seen in 2022, forward organic growth will need to come from a more balanced mix of price and volume. This combined with moderating input costs and productivity gains should allow Pepsi to achieve high single digit EPS growth in 2023 and beyond. Finally, we would note that PEP is expected to return nearly $8 billion (> three per cent of current market cap) to shareholders through dividends and buybacks in 2023.

Deutsche Telekom AG (DTE ETR)

Purchased at 18.19 EUR on Oct. 20, 2022

While we appreciate the stability of Deutsche Telekom’s (DT) local / German network, the key driver of our long thesis is DT’s majority (>50 per cent post-buyback) stake in leading U.S. operator, T-Mobile (TMUS). We believe that TMUS has the best network and value proposition, thus it is best positioned to continue benefiting from the 5G rollout in the U.S. Moreover, it is expected to enjoy a significant boost to FCF in 2023 due to lower capital expenditures (following Sprint integration) and the end of merger integration costs. We have chosen to access TMUS through DT because the latter has a very attractive valuation and pays a dividend, which currently yields over three per cent and is expected to grow at a greater than 10 per cent CAGR through 2024.