We’ve got a jam-packed e-mail for you this week. For one, we’ll speak on a stock from our Bull Lists that has run up in price quite a bit, and as such, we will remove it from the list.
Secondly, we’ll speak on the CET 1 ratio, why it’s on the rise, and what it means for the banks.
And finally, we’ll speak on US tech, which will lead us into some rebalancing in our model portfolios, and we’ll talk about some of the transactions.
Let’s get right into it.
We are removing Stella Jones (TSE:SJ) from the Bull List
It’s been one heck of a run for Stella Jones. The company’s stock is up by 78% since we first added it to the Bull List and ~34% year to date. When we first added Stella, the investment thesis was simple. We felt that the company was trading at a steep discount to intrinsic value considering its expected growth rates and valuation at the time.
Before we go any further, we must re-iterate that removing Stella Jones is not an indication to sell. We still think it is reasonably priced; we just feel it is no longer a deep-value play.
Also worth noting, it doesn’t seem like Stella Jones’s management does either. Stella Jones cancelled their automatic share repurchase plan. Why is this important?
In November, the company entered into an agreement with its broker to automatically buy shares for cancellation. However, with the cancellation, Stella will now rely on its normal course issuer bid (NCIB), where it can have more flexibility on the timing of buying back shares. As a reminder, Stella Jones renewed their NCIB in November and can purchase up to 9.6% of its float (5M shares) for cancellation.
We can’t help but feel that the company is being proactive here. Since their share price has run up quite a bit, being more selective when they decide to buy back shares is smart.
We still feel that Stella Jones is a solid long-term hold and provides decent value. Worth noting, Stella was in the overbought territory a couple of weeks ago and has since consolidated. Our discounted cash flow analysis of the company had a fair value in the high $60 range.
Our primary reason for removal is the fact the margin of safety has shrunk to a single digit level. If we see a correction in price, this company could easily make its way back on the list like many others have.
I (Dan) own Stella Jones and have zero intentions of selling the company.
There is often confusion here that when we remove a company from the Bull List, members think it is a sell signal or are given the idea that we don’t like the company anymore. This isn’t the case. It’s just gone from our original thesis, that being a deep value play, to a fairly valued company.
It is important to remember our Bull Lists are shortlists. So, we do like to stick to the name and keep them short.
If we had a large position would we consider taking profits, like we’re going to do in one of our model portfolios below? Certainly. However, that is much different than exiting a position.
CET1 Ratio on the Rise
This past week, the Office of the Superintendent of Financial Institutions (OSFI) announced that the Domestic Stability Buffer (DSB) was being raised by 50 basis points to 3.5%. Why is this important? The DSB is part of the Common Equity Tier 1 (CET 1) ratio calculation.
The DSB requires banks to build up capital that can be used to absorb losses and encourage lending even during poor economic conditions.
If you have watched our Big Banks Market Mindset episode (if not, click here to watch it), you would know that the CET 1 ratio is an important liquidity measure that was introduced in 2014 in response to help mitigate issues that preceded the 2008 Financial Crisis.
It measures a bank’s core equity capital as a percentage of its risk-weighted assets and is used to measure a bank’s capital adequacy.
Does this sound like gibberish or an entirely different language? Don’t worry; you’re not alone. As an investor, as long as you know the higher the number, the better, you’ll do just fine. Here is a quick example. A CET 1 ratio of 15% is better than one of 12%.
A strong CET 1 ratio is a strategic advantage as it provides financials more flexibility regarding capital allocation – think dividends, share buybacks and acquisitions. Those with strong CET 1 ratios are also considered to be in a better position to absorb losses caused by unforeseen events.
Given the rapid rise of interest rates, a raise to the DSB was largely expected. What caught the markets off guard was how quickly the rise came. The consensus was that a DSB announcement would not come until later in the fall. What does this all mean?
The DSB hike now means that Canada’s Banks must meet a minimum CET 1 ratio of 11.5% (vs 11.0% previously). It is also worth noting that banks usually target ratios ~50 bps above the minimum threshold, which means they will aim to get their ratios above 12%.
The good news is that the new DSB rate does not go into effect until November 1st, so the banks have time to build up their capital. As a reminder, here were CET 1 ratios as of the end of last quarter (make sure you have images enabled.)
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As you can see, only the Canadian Imperial Bank of Commerce is below that 12% mark and only by 0.1%. This is good news as it means Canada’s banks will unlikely require a capital raise to meet thresholds.
What it can mean, however, is less capital for dividend raises or share buybacks, and an increase in provisions for credit losses.
As mentioned, the expectation was that a DSB raise was going to come, but the timing came sooner than expected. As a result, management teams may need to slightly adjust their return to shareholders plans accordingly.
Overall, it will continue to be rough waters for Canada’s banks over the next year or more. However, we feel they’re still great long-term positions, and Mat and I continue accumulating.
US technology companies driving market returns
Many people are talking about the strong markets in 2023. And if you look on the surface, they’re certainly performing well. The NASDAQ is up by nearly 30%, and the S&P 500 is up by 13%.
However, you’re not alone if you feel your portfolio is not participating in this large runup.
Why? Well, for the most part, the runup is due to a surge in US technology companies, especially those with AI exposure.
As it stands, major technology companies are looking very expensive. In fact, on a price-to-free cash flow basis, Microsoft and Apple are more expensive now than at the absolute height of prices in 2021.
Nvidia is an entirely different story. Trading at 100 times free cash flow in late 2021, the company is trading at a mind-boggling 215 times free cash flow at this moment in time.
The meteoric rise in US technology companies is causing the index to show large gains when in reality, the bulk of companies and stocks are still struggling.
If we look at the S&P 500’s returns with big tech, they sit at 13.28%. Remove the major technology companies? The returns shrink to just 5%.
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As a result, we’re fine-tuning some of our model portfolios
We’re not ones to make transactions based on short-term price movements.
However, we’re unsure how major US tech companies can keep up these valuation levels. And as a result, we’re going to be trimming back positions in Microsoft (MSFT), Apple (AAPL), and Broadcom (AVGO) in our model portfolios.
Keep in mind, we will still maintain very healthy positions in all of these companies, as we do think they are strong long-term holds. However, taking some profits off the table here to deploy into other struggling companies is a strategy we think will be beneficial in the long term, considering how expensive US tech is. And if US tech continues to increase, we still have sizable positions to benefit.
High Yielding Model Portfolio
This portfolio does not contain the likes of Apple or Microsoft. However, it does contain what we considered a strong value play in the chip industry at the time of addition in Broadcom (AVGO).
The core position, which started at a 5% weighting, has risen to 6.6% at the time of writing, and we’re going to trim it down to 4%.
Dividend Growth Model Portfolio
The Dividend Growth Model contains both Apple and Microsoft, and these positions have grown from a 5% weighting to around 6%. Much like Broadcom in the High Yielding Model, we will trim our positions back to 4% in both companies.
In addition to these two technology trims, we will also trim back our position in Stella Jones. The company’s run has caused its position to grow to nearly 4% in the portfolio, and we’re happy to scale it back to its target allocation of 3%.
Why are we trimming tech stocks back an additional 1% below our target allocation, but Stella is simply back to target? Primarily due to valuation.
US Tech right now is so expensive that we feel lowering our total target allocations to these stocks until there is some consolidation or correction will be a long-term winning strategy.
And, as mentioned, if they continue to rise, we still have very healthy 4% positions in the companies, more than enough exposure to reap the benefits.
Where will the proceeds of the sales be placed?
Over the course of this week, we’re going to identify some strong options to place the profits into, and we’ll be filling investors in next Sunday on what we’ve decided to buy.
