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From the desk of the Mackenzie Bluewater Team Q3, 2024
Market commentary
Markets continued to show strength during the third quarter as the rally that began in the fourth quarter of 2023 continued into the first nine months of 2024. Equity markets remained buoyant in response to more accommodative monetary policies from the Bank of Canada (three rate cuts that began in June), the European Central Bank (two rate cuts with the first occurring in June), and most recently from the Federal Reserve, which cut rates by 50 bps. While the combination of cooling inflation and labor markets motivated central banks to cut rates from excessively restrictive levels, we continue to believe that the path forward for monetary policy is more uncertain given the combination of sticky services inflation and two geopolitical conflicts, which continue to support energy prices.
While some market participants are excited by the prospect of lower interest rates, significantly lower rates likely imply that economic conditions have deteriorated beyond current expectations. While there inevitably will be considerable ink spilled about the ‘average return’ after policy rates begin declining, it is important to remember that the economic environment around rate cuts tends to be highly idiosyncratic, making the usefulness of these statistics less than useful. There have only been 3 easing policy rate cycles in the past 25 years in the US, and they were marked by a historic stock market bubble bursting, a global financial crisis and a global pandemic, none of which even faintly resemble the current environment, which poses a large challenge for looking at the past as a guide to the future.
From a global GDP standpoint, economic growth continues to be uneven, with the United States showing relatively healthy levels, while Canada, Europe, and Asia are generally softer. China remains challenging driven by numerous structural issues that we have written on previously such as demographics and a decline in the working age population, maturing urbanization trends, overbuilding, and a slowdown in global outsourcing. While recent stimulus announcements from the Chinese government may help from cyclical perspective, the challenges that we have highlighted are all structural in nature and are unlikely to be solved through financial stimulus.
With unemployment in North America rising from very low levels, we are not anticipating the beginning of a new economic cycle. Rather, we anticipate one of two scenarios: either a standard slowdown propelled by rising unemployment (4.1% currently, up from 2023 lows of 3.4%) or a prolonged period of stable, albeit anemic, economic growth. In either case, we anticipate that global growth is likely to be at levels that are below average for the next several years, which is an environment that tends to be supportive of the Bluewater investment process, focused on identifying resilient businesses that can grow their free-cash-flow at higher rates than the market and are less reliant on the broader economic landscape for such growth.
Challenging consumer environment
The economic health of global consumers also remains mixed and challenging, evidenced by numerous quarterly company conference calls in the consumer space that have highlighted continued strain from low-income level consumers and consumers trading down for value due to years of inflationary pressures and higher interest rates. In Canada, consumers face additional challenges due to mortgage structures that are of shorter-term duration, raising concerns about how consumers will adapt to significantly higher borrowing costs as ultra-low-rate mortgages come up for renewal in 2025 and 2026.
Despite these challenges, many consumer companies have performed well in recent years as high inflation drove strong top-line growth as companies were able to pass through an increase in input costs to consumers. With goods inflation now having rolled over, focusing on idiosyncratic names that can grow regardless of the economic environment has become increasingly important.
Over the last year we have aligned our portfolios to focus on consumer facing companies targeting either the very high-end consumer, those that are virtually unimpacted by macro economic conditions, or those companies that offer a unique value proposition.
At the high end, extreme luxury brands like Hermes and Ferrari (held in Bluewater Global Growth and Bluewater Next Gen Growth Portfolios) remain highly resilient. Founded in 1837, Hermes is a European luxury business known for its signature handbags and luxury items and a business model that is based around scarcity value and desirability of its hand-crafted leather goods. This unique value proposition has resulted in methodical scaling of its hand-crafted artisanal production while maintaining considerable pricing power, allowing the company to compound its revenues at 12% since 1991, virtually unheard of in an industry known for its cyclicality and fads that come in and out of favour.
At the other end of the spectrum, companies such as Dollarama and Loblaws (held in Bluewater Canadian Growth), as well as Costco and Amazon (held in all US and Global funds) all benefit from unique strategies that provide real value for consumers. We have avoided traditional retail companies targeting the middle market consumer. In our view, this large segment of the market faces increasing risks from large industry players such as Wal-Mart and Amazon that compete by providing value, selection, convenience and speed, all at massive scale, giving them a growing logistics and shipping competitive advantage.
Furthermore, in light of the weak consumer backdrop in Canada, we have maintained an underweight position in Canadian banks. While the Canadian consumer has proven to be far more resilient than generally expected due to excessive savings built up through COVID, as well as strong employment and wage growth trends, there is mounting evidence that the impact of higher rates are being felt as the consumer retrenches. We have been concerned about deteriorating credit conditions as consumer trends and hiring trends continue to weaken more broadly. Rather, within financials, we recently initiated a position in TMX Group, which is a business less tied to the consumer and the underlying economy. TMX is a global exchange, technology, data & analytics provider facilitating the funding, growth and success of businesses and investors. TMX’s main trading platforms include the Toronto Stock Exchange (TSX), TSX Venture Exchange (TSXV), TSX Alpha Exchange (Alpha), and the Montreal Exchange (MX).
The business has undergone significant transformation over the last several years, transitioning from effectively a regional infrastructure company with declining organic revenue and margins to becoming a global technology solutions provider with a diverse and recurring revenue base. Today, over half of TMX’s revenue are now recurring compared to the low to mid-30% range for most of the last decade and half, approximately a third of their revenues are derived from international markets, and revenue and earnings growth objectives of mid single digits and double digits now approximate that of US exchange peers. Certainly, an increasingly balanced mix of recurring and diverse transactional revenue is a key factor in reducing shorter-term volatility and cyclicality of earnings.
AI hype beginning to come off….
Digitization encompasses a broad range of technologies, including cyber security, cloud computing, communication advancements, and artificial intelligence (AI). AI represents a significant continuation of these digitization trends, driving innovation and transformation across various sectors.
To appreciate the current state of AI, it is instructive to look back at the last major technological breakthrough: the internet. During the internet boom, we witnessed a huge investment cycle that led to a massive physical buildout, benefiting hardware providers like Cisco. While the internet did indeed prove transformational to the economy, the tech industry and society, the use cases took a much longer time to develop than initially expected, and in many cases were different than what was anticipated at the time. For example, while e-commerce did indeed become an important industry built on the back of the internet, it took many years for the delivery logistics to be in place to allow this to happen. The iPhone, which revolutionized mobile computing, didn’t debut until 2007, and Amazon Web Services (AWS) didn’t launch its cloud services business until 2006, this was several years after the tech bubble burst. Today, we have several large companies spending hundreds of billions of dollars on the building of datacenters to compute AI workloads. The beneficiaries of this spending have thus far been those companies that provide the semi conductors and other equipment, such as Nvidia.
Despite this influx of capital, the practical use cases for AI remain early and unclear. While we believe the technology holds immense potential, many companies and industries are still figuring out how to effectively integrate AI into their operations and have yet to figure out how to generate significant revenue or productivity gains from it.
Further, industry leader Nvidia approached FY24 with $30 billion in revenue expectations only to end with over $60 billion in actual results. Given that spending on datacenters is expected to continue at these high levels for the next few years, expectations for NVIDA’s revenue have increased to $280 billion in FY29. In our view, these high expectations and thus far limited adoption, we would not be surprised to see the industry go through a period of “digestion” in which growth moderates considerably. This is a key reason that we have avoided directly investing in the hardware chip focussed names tied to the semi-industry.
Bluewater culture
At Bluewater, our investment culture is built on intellectual curiosity, constant learning, accountability, candor, and a complete openness to feedback in a world that is constantly changing. This foundation ensures that every team member is aligned with our core values and mission of compounding client capital at above market rates within the Bluewater philosophy.
One of the unique aspects of Bluewater’s culture is our flat organizational structure. Unlike the typical hierarchical triangle seen at other asset managers, we operate with a flat hierarchy where everyone contributes equally. All portfolio managers also contribute as analysts. Investment decisions are made as a team and we do not divide our coverage by sector, which means we are ALL deeply involved in analyzing our portfolio holdings and future positions. This structure of openness and candid communication eliminates ego and promotes an environment that fosters high-level debates to truly optimize the investment decision making process. This approach not only enhances decision-making but also builds trust within the team and with our clients. Where our clients see Bluewater as a cohesive and principled investment boutique which deepens their trust and leads to long-term partnerships to achieve investment success.
We are often asked how we manage to run Canadian, US, and Global portfolios with a relatively small team so efficiently and in an effective manner. The answer lies in our common alignment around a shared investment philosophy and our focus on owning a “small collection of elite businesses” that fit the Bluewater investment philosophy. In summary, the culture within an investment organization like Bluewater is a foundational element that influences every aspect of our investment decision making and is the bedrock upon which long-term investment excellence is built.
This not only extends to Bluewater, but also to our portfolio holdings where we typically find many of the greatest compounding businesses have a distinct culture that is focused on their investment objectives. Roper Technologies (held across all Bluewater portfolios) epitomizes this with a decentralized hierarchy, alignment, full transparency and accountability among employees, a mindset of constant improvement and focussing on a small number of objectives that the team is united behind. This set of guiding principles has been instrumental to the success of Roper and its ~17% share price CAGR over the last 20 years.
Conclusion
In summary, Bluewater focuses on conservative growth, seeking companies that are growing at or above market rates but not at extremely fast rates. In Canada, we are targeting businesses that grow their free cash flow in the high single digit to low double-digit range through a cycle. On the foreign side, the businesses are typically superior and deliver faster growth rates, in the low to mid-teens.
Bluewater focuses on a small subset of global businesses that are truly unique – global leaders in attractive industries with defensible moats that have secular growth tailwinds. These characteristics allow the companies we target to grow their free cash flow at above market rates in a more stable fashion compared to the overall market through a full cycle. Acquiring such high-quality businesses at reasonable valuations imparts downside protection to the portfolios, allowing them to more effectively navigate through economic cycles, and the inherent drawdowns and volatility along the way.
The team has added value by preserving capital through market drawdowns, while at the same time compounding returns for clients that has resulted in superior risk-adjusted returns over the long term.
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This document may contain forward-looking information which reflect our or third party current expectations or forecasts of future events. Forward-looking information is inherently subject to, among other things, risks, uncertainties and assumptions that could cause actual results to differ materially from those expressed herein. These risks, uncertainties and assumptions include, without limitation, general economic, political and market factors, interest and foreign exchange rates, the volatility of equity and capital markets, business competition, technological change, changes in government regulations, changes in tax laws, unexpected judicial or regulatory proceedings and catastrophic events. Please consider these and other factors carefully and not place undue reliance on forward-looking information. The forward-looking information contained herein is current only as of September 30, 2024. There should be no expectation that such information will in all circumstances be updated, supplemented or revised whether as a result of new information, changing circumstances, future events or otherwise.