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The emergence of the delta variant and ongoing inflation concerns has likely dampened earnings expectations for more economically-sensitive companies. On the other hand, secular growth companies that have thrived during the pandemic, may have higher hopes. This episode, Stu Kedwell, Co-Head of North American Equities, shares his key considerations as companies roll out their second quarter earnings reports. [9 minutes, 42 seconds] (Recorded July 14, 2021)


Hello and welcome to The Download. I'm your host, Dave Richardson, and we took a couple of weeks off. It is summertime here in Canada and it's a good time to take a bit of a break. Hopefully, everyone listening to the podcast has an opportunity to take a break, spend some time with loved ones as we start to open up a little bit in different parts of the country. Joined today for (S)Tuesdays, on Wednesday, Stu Kedwell, co-head of North American Equities at RBC Global Asset Management, who had a chance to take a bit of a vacation. Stu, you had a good time?

We did, Dave. We were down in Prince Edward County, which is a beautiful spot of the world. And great to be back. Thanks for having me.

Yes, I think one of the great things about being restricted is that we still have this big huge country to travel around, in Canada. To get out to some of the great places like Prince Edward County is a really nice opportunity this summer. Again, I hope everyone has a chance to enjoy themselves. And fortunately, this is not a video podcast; this is just audio. You can’t see that Stu and I have been enjoying ourselves already this summer. A little bit of growth for us. That ties into our topic for today, as we're starting to look at earnings. Of course, we're always looking for growth when we're looking at earnings coming out. Companies in Canada, the United States, all around the world, starting to report this week for the second quarter. Stu, is there anything in particular that you're going to be looking at or keying in on, given some of the things that we've been talking about on the podcast? Along with the different variants, the progression of vaccination in Canada and in the U.S., what are the things that you're going to be looking for as these companies are reporting?

Yes. So let's maybe just revisit some of the key points that we've talked about and continue to evolve in the markets today. Stock markets have made new highs, which is obviously a positive and is reflective of an economy that is gradually getting better. Underneath the surface, a couple of things are quite noteworthy, though. The breadth of the market is not quite as good as it used to be the last time around when we had very strong markets, which means that not as many stocks are making new highs as they had in the past. The second thing is, away from the equity market where the slope of the yield curve has compressed, the difference between long rates and short rates is smaller than it was earlier in the year. As the basis of discussion, the economy was quite strong, generating levels of inflation that we don't know if they're transitory or not— likely transitory, but we'll see. A lot of stimulus. The next chapter of the economy, which still has quite a bit of pent-up demand, and we can see that when it comes to travel and what have you, but with the delta variant out there, people are a little bit uncertain as to how strong the strong economy will be in the back half. As a result, you've had more conversation around certain companies, maybe economically sensitive, about how strong will their earnings be from here, and that's why the breadth of the market has narrowed. So, when we come in earnings season, there's a couple of things that we need to really think about. First and foremost, some of the more economically sensitive companies, their share prices have rolled over a little bit. So, this quarter will be important to see the numbers that they actually produce, but we'll be looking for conversation around what do you think the impact of the Delta variant could be on your business? This type of things. Is the economy as strong as you thought it was? Any change you're doing? Another big thing that comes out from many of these companies is the impact of inflation that we've seen, and if it’s transitory. Do you have the ability to pass on costs? These things all become very important discussion points. For many companies, because they're not at all-time highs, expectations are a little bit more subdued than you might think. Versus another group of companies where they have participated quite meaningfully— these are some of the secular growth companies that were very strong right in the midst of Covid— they've done very well and I would say, going into this quarter's earnings, expectations are quite high for them. They need to really deliver not just strong earnings this quarter, but also give confidence that growth is going to continue at that high level. So when we think through the portfolio, we're not big fans of the value-to-growth and growth-to-value argument. Every company has a set of cash flows that they're going to deliver into the future. We need to basically agree or disagree with the assumptions that each share price might be making. So, we find the portfolio filled with companies from both buckets. We're not sitting there necessarily trying to rotate from one to the other. But when we sit here today, some of the companies, where there's been a little bit more of a discussion about how robust the growth will be, are priced that way, so they may be a little bit more attractive. Some ones where it has to be just right on the screws for a very long period of time to justify the current share prices— even great businesses—, we’re maybe a little bit more cautious about some of those in the near term.

Yes. So, we've seen some of those big tech names, again, continue to perform very well, and many of them are sitting at all-time highs. That's where you're saying you're looking almost for perfection in terms of those results and not just perfection for this quarter, but forward guidance that you're going to continue to see strength in results. Then you've got some other areas, and when we focus on Canada, for example, that would be the energy sector, which actually had pretty soft performance over the last couple of months. Again, some fears that maybe growth isn't going to be as robust as thought of before and perhaps the expectations are lower there. And so, there's an opportunity for them to exceed those expectations. Is that what you're talking about, this dichotomy between the different parts of the market?

Exactly right. Warren Buffett used Aesop's Fable, which is, how many birds are in the bush and when are they coming out. The way that you think about that from an investing standpoint is how much cash flow is the business going to generate and what multiple do we have to pay for it? So when we have a set of businesses where the cash flow might be a little bit variable, but the multiples are quite compressed, and we see that in some of the more cyclical areas, like energy today, where the price of the underlying crude oil has been quite strong, yet the stock market's not quite willing to believe it in the share prices as of yet. You have multiples that are lower. You have companies that are pretty quickly delivering and generating a lot of excess free cash in this environment. There's a lot of stocks in the market that look that way. When we go back to the surface, markets are at new highs, which always gives a bit of a pause, but then getting underneath the surface and looking at which companies are doing what and what have you is very important. So, if you're going to pay a big multiple of sales or a very large price to cash flow, then that just needs to be just so, to keep that investment going, versus where there is a discussion and there's a two-sided discussion that's taking place; that's ironically a little bit more comforting sometimes.

Is this the kind of market Stu that you'd characterize, just for lack of a better term, as a stock pickers market, just for that reason?

Yes, it's a great analogy. Sometimes it's a stock market, sometimes it's a market of stocks. When we think through the discussions that we've had on this podcast, even the last time, markets were very broad and strong in March. Then some of the more secular growth companies had lagged for a period of time and looked reasonably interesting against that construct, because people had started to doubt how long the growth could last, what could be a change in valuation if things had broadened. In the last 12 weeks, that debate has swung quite significantly. Today we have a bunch of other kind of very high-quality businesses that are a twitch more economically sensitive and some uncertainties have presented themselves there. So, that's a pool of stocks that we're spending a lot of time with right now.

Well, that's a great preview of earnings. We're going to start to see them roll out. It'll be fast and furious over the next three or four weeks with all the different companies reporting. And now that we've had our little break, we will give you frequent updates on this podcast on (S)Tuesdays of what's going on in earnings season. Stu Kedwell, thanks again for joining us.

Great. Thanks for having me, Dave.


Recorded: July 14, 2021

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