A Comment -- General Comments From an Expert (A Commentary)

Nice to have two very nice years, but there's a cost to everything. As prices go up, value tends to drop, and that's what we've seen. We're slightly overvalued on PE ratios against historical levels. 2025 will offer opportunity, but we have to be realistic. The Mag 7 contributed over half to S&P returns for 2024.

Those who have benefited from the momentum plays of 2023-24 should be quite careful, lots of air under those stock prices. Unlike quality companies that are well valued against their historical norms, the high flyers don't have that valuation floor you can rely on when markets get scared. 

Make sure we're grounded in our stock choices, in a risk-off mentality. You just have to do your work. It's pure stock-picking and factor analysis as to what's going to drive the market. 

He looks for earnings, earnings growth, positive earnings revisions, quality balance sheets, and strong moats.

He believes so. His small-cap portfolio had another good year. Valuations are quite a bit lower than those in the big-cap S&P 500, both in absolute terms and compared to historical norms. Lots of opportunity there. 

Much is due to smaller companies being more domestically based, so they don't face the huge headwinds of a strong USD. And the regulatory environment is positive. Changes to corporate tax policies will be most beneficial to domestic companies.

In general, try to exclude the political rhetoric and how it will impact individual companies, though you have to be prepared for what might come. With Trump, every 10 pounds of words leads to about 1 ounce of action. To try to react to the words will take you to bad places. Put your noise cancellation headphones on, and let the company do the talking.

Doesn't use them. He likes to invest in the economy and currency of the stock itself, sees it as an advantage. Just look at the past 6 months to see the benefit of having USD investments that come back to investors in Canadian currency.

If you're investing in US companies, but not in its currency, you have to go back to the premise of why you're investing in an economy you don't like. He likes the US market, the biggest in the world with many investment-grade companies.

It seems that good news is now bad news, with ISM numbers being a bit stronger. Now there's concern about rates potentially not coming down as quickly as we'd hoped. Rates can stay higher for longer, and inflation might be a bit sticky, but we're still far away from the 9% inflation we had a couple of years ago.

We're really in a Goldilocks-phase type of economy in the US. Steady GDP, with inflation relatively easing or stable, and consumer sentiment remaining pretty steady. Labour market still pretty stable as well. Earnings remain strong, and that's really the most important key.

Looking at 2025 and 2026, he sees ~12% earnings growth rate for the S&P 500. Mid-caps are even higher than that. Markets in NA, and in the US particularly, are primed to move higher again for the third consecutive year.

We've reached $6.75T USD in money market assets. If interest rates continue to fall, that will provide even more support for equities and a buffer to the economy as well.

In the equity component of client portfolios, he's roughly 70% US stocks and 30% Canadian. The US component has increased over the last few years for obvious reasons, as US markets have done really well and the USD has moved forward too.

Given the political uncertainty in Canada, he wouldn't be surprised if the loonie remained weak around 69-70 cents or even lower. The interest rate differential between US and Canada points to further weakness in the loonie relative to the USD.

With regards to holding cash, you really want to look at the opportunities that are prevailing at the time. He doesn't really make cash calls. The only time he might increase a cash position is before September, because it tends to be the worst month historically. 

What is the Private Equity playbook in the public market?

Firstly, Private Equity investors do not look for the “traditional compounders” of high-growth, disruptive businesses early in their life cycle and hold on for decades. The primary criteria the private equity industry tends to look for are businesses with a high degree of predictability and a low risk of disruption.

In addition, these investors constantly seek companies with a high degree of recurring revenue, low customer churn, strong pricing power, and consistent cash flow generation. The purest forms of such businesses are subscription-based businesses like software, consumables, consumer brands and other high-recurring revenue products/services, etc. These businesses tend to be highly durable, independent of access to the capital market and able to support a decent amount of debt on the balance sheet even during a tough environment.

One of the primary value-creation engines of private equity investors is to raise prices prudently, control costs efficiently and put a moderate to high level of the amount of debt on these companies’ balance sheets. The debt level tends to vary for different companies, as some are more well-equipped to carry a higher level of debt, but the target leverage levels usually range between 2.0x – 5.0x net debt/EBITDA. The purpose of the debt is to amplify the value creation of the business either through organic growth or cost management.

As the business can grow EBITDA, then the leverage levels naturally go down, and these companies can leverage up again to maintain the target leverage levels and use the proceeds to do some value-creating strategies like acquisitions, buying back shares or paying out special dividends. The model reinforces itself, making even a low, moderate-growth business in EBITDA become a double-digit total return investment over time.
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It was telegraphed that Justin Trudeau would resign as Prime Minister, such as Freeland resigning in December. He's not sure why he took this long. The markets reacted positively. 2025 outlook: so much capital has flowed into the US to bid up wonderful companies like Mag 7, but only 25 companies make up 50% of the S&P market cap. Be careful with valuations and avoid recency bias (the last 2 years returned over 20% annually). Analysts are projecting sky-high targets for the S&P. Valuations matter, and the market is not cheap.

The next earnings can't be okay but way above average to sustain current valuations. The US economy grew well in Q4, but must translate into earnings. A stronger US dollar will be a headwind for earnings, but expectations for the next few years is low/double-digit growth. He doesn't think earnings can maintain these levels. We've had two strong years in US stocks, but that won't repeat. Microsoft's announcement to spend on AI triggered today's rally. Trump: Canada won't be a 51 state, tariffs are disruptive and that's a headwind. Trump's platform will cost $5-7.5 trillion over the next 4 years and how will he pay for that? World governments have not done a good job with tax dollars, which may explain a shift to the right.

The Bank of Canada is cutting interest rates way faster than the U.S. because our economy has been weaker. So, the bond markets has done a lot better here. That said, everything is priced against what's happening in the US treasury market, and this creates upside pressure which therefore limits the Canadian bond market from getting too much stronger. Rates are decent now. We won't go back to very low rates. We could see a few more rate cuts ahead, but not change the 5-year yield that much.