Market Commentary


A Tech Rally but What's Next?

Hopes for an end to the current cycle of rate hikes spurred a strong start to equity markets in 2023.  Much of the rally was due to a resurgent Information Technology sector which contributed more than two thirds of the first quarter index move in the S&P 500 and roughly one third of the return for the S&P/TSX.  Considering the economic effects of inflation and the interest rate hikes already in place, we expect further volatility over the remainder of the year. 

A quick look at the IT contribution highlights the narrow breadth of the first quarter rally. We calculate that:

  • IT contributed more than two thirds of the 7.5% first quarter S&P 500 return:  With an average index weighting of 27.1%, the Information Technology (IT) sector returned 21.9% in Q1; the rest of the index gained 2.2%. 
  • IT contributed more than one third of the 4.7% first quarter S&P/TSX return:  In the Canadian index, with an average IT weighting of 6.2% the Information Technology (IT) sector returned 27.9% in Q1; the rest of the index gained 3.1%. 

The IT rally also looks to be based more on speculation than fundamentals.  We note that:

Optimism for IT overlooks a YTD decline in 2023 earnings estimates:  Sector estimates of 2023 operating earnings have declined since the start of the year, down more than 5% to $101.  In the process, the S&P sector multiple for IT has increased to a P/E of 25.6x to operating earnings, up ~26% from 20.3x entering the year.  The sector is no doubt looking past this year to anticipated growth of more than 17% in operating earnings in 2024, to $119. 

The IT sector consensus also sets a very high bar for 2024:  Getting to the current 2024 operating earnings estimate of $119 requires much stronger performance than we have seen historically, even during the bull market that preceded the pandemic. Therefore either:

  • Stronger revenue growth and stronger margins:  10% sales growth this year and next with a 200 bps expansion in 2024 operating margins versus 2022 levels. 
  • Or spectacular growth, same margins:  15% sales growth this year with no expansion in 2024 operating margins, also sums to $119.

Both possibilities look unlikely because IT sales growth would need to be well above historical trends and face a softening economic outlook. 

For reference, S&P IT sector sales per share have grown at a 7.8% CAGR since 2012 and grew at 6.8% year-over-year in 2022.  As reality sets in, we see a significant risk of reversal for the sector over the remainder of the year.

If the IT sector looks risky and Financials are flashing caution signs because of funding pressures and emerging credit risks, how should investors approach the rest of this year?  We have a few thoughts:

  • Energy is looking up:  Energy has seen underinvestment in the current cycle and typically experiences a seasonal rebound in demand in the second half of the year.  OPEC, with a million-plus barrel a day cut, is signalling it will move quickly to counter potential softness in demand.  Even with the prospects of a global slowdown, we are seeing greater discipline in the oil markets and expect significant cash flows for producers.  Our top picks include Canadian Natural Resources (TSX, NYSE: CNQ) and Suncor (TSX, NYSE: SU).
  • Utilities:   The transition to a lower carbon economy has the Utilities sector directly in its sights, imposing costs, but also creating opportunities.  The retirement of legacy coal plants has raised power prices for existing producers and governments are increasing their funding for green energy programs.  Because the transition drives additional investment activity, we have identified a number of companies with strong capital discipline, established operational expertise, and decent cash flows.  Our top picks include TransAlta (TSX: TA), Capital Power (TSX: CPX) and Hydro One (TSX: H)
  • Targeted Discretionary names:  While Restaurant Brands (TSX, NYSE: QSR) and Dollarama (TSX: DOL) are classified as discretionary stocks, based on past cycles, we view these names as well positioned to produce growth and strong cash flows, even in a potential slowdown.
  • Industrials:  Despite being a cyclical sector, we continue to see opportunities in Industrials for companies that are able to grow and their operational efficiencies. Our core holdings include Canadian Pacific (TSX, NYSE: CP), which recently won approval to combine with Kansas City Southern, increasing its scale and generating network economies; and TFI International (TFII: TSX, NYSE), which continues to benefit from targeted tuck-in acquisitions and growing market share.
  • Materials:  Generally speaking, mines are operationally complex and carry long investment horizons.  While these features create short-term volatility in output, costs and earnings, they also form barriers to entry and make supply slow to respond to higher prices.  When prices rise, operating leverage kicks in and the best operators are rewarded.  In the near-term, market uncertainty and the eventual weakening of the U.S. dollar should favor gold prices and producers.  Our top picks include Agnico Eagle Mines (TSX, NYSE: AEM) and SPDR Gold Shares (NYSE: GLD), a U.S. gold ETF.

We expect market volatility over the remainder of 2023 to generate opportunities to purchase well-priced companies with strong free cash flows, clean balance sheets and capable management teams. 

To this end, our affiliate Veritas Investment Research continues to provide us with compelling investment ideas by combing through the financials and asking tough questions of management.

Year-to-date through March 31, 2023, the S&P/TSX is up 4.6%, the S&P 500 +7.5% and the NASDAQ 17.1%.  Over the same period, our Canadian Equity Fund rose 2.2% and our Absolute Return Fund was 2.7% lower.  (Performance based on F series).  Year-to-date returns in both our funds reflect underweight positions in Information Technology names. 

Admittedly, we are not rally-chasers at Veritas.  Our picks are based on bottom-up analysis, due diligence, and our long-term views.  We continue to manage our funds to lower risk and generate attractive returns for unitholders. 

We thank you for your continued support.

Your fellow investors,

Anthony Scilipoti
Sam LaBell

Veritas Absolute Return Fund April 2023 Performance Sheets
Veritas Canadian Equity Fund April 2023 Performance Sheets

Source: Refinitiv, S&P Global, Veritas Asset Management estimates as at March 31, 2023. Past performance is not indicative of future performance. The S&P/TSX Composite Total Return Index is a Canadian dollar denominated, capitalization-weighted index that includes the largest float-adjusted stocks trading on the Toronto Stock Exchange, subject to inclusion criteria. The index provides the broadest representation of market-weighted returns for large capitalization Canadian-listed stocks, including reinvested dividends, making it an appropriate index for diversified portfolios that invest primarily in Canadian stocks, such as the Veritas Absolute Return Fund and the Veritas Canadian Equity Fund. While our funds are benchmarked against the S&P/TSX Composite, we may reference returns for the S&P 500 and NASDAQ Composite, as well as yields on U.S. ten-year Treasury bonds, which we view as relevant investment benchmarks for investors in North American equities. The S&P 500 represents approximately 80% of the total market capitalization of U.S. stocks and remains the most broad-based indicator of large-cap U.S. equity returns. In contrast, the NASDAQ has a greater proportion of technology and growth stocks, which we view as providing additional insight into investors' risk appetite. Where applicable, the ten-year U.S. Treasury rate is referenced as a measure of the lowest-risk investment alternative to equities (‘the risk-free rate’). Contact Veritas Asset Management Inc. ("Veritas") for more information regarding comparative indices. 

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