OB Report
May 2023
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Don’t Get Caught Swimming Naked

 By Murray Leith, CFA Executive Vice President & Director, Investment Research

Stocks have recovered impressively following the downdraft in the wake of the recent U.S. bank failures. As of mid-April, the Canadian and U.S. equity benchmarks were both up 7.2%, year to date. The Odlum Brown Model Portfolio gained 4.3% over the same period.


While we are always disappointed when we don’t keep pace with the general market, it’s not unusual for our Model to underperform in a fast-rising market. In fact, we have outperformed the benchmarks over the long term by modestly underperforming in rising markets and losing meaningfully less during the inevitable corrections. By preserving capital in the tough times, we have more money to compound during the good times.

Last year, our Model was down 4.5 percentage points less than the average decline in the Canadian and U.S. benchmarks. This year, we have given back 2.9 percentage points of that advantage.

Our job is to both protect and grow wealth, and we are currently focused on the protection aspect of that equation. The Model is purposely positioned defensively relative to the general market, and we believe that posture will ultimately produce market-beating results.

The accompanying attribution table highlights our sector weights and year-to-date returns and compares them to a blended 50/50 Canada-U.S. benchmark. Our comparatively weak performance this year is a consequence of being underweight the best-performing sectors and overweight those that haven’t performed as well. Our stock-picking batting average has been reasonably good, with better-than-benchmark performance in seven of the 11 sectors.

The table is sorted by the year-to-date sector returns for the blended benchmark. Notably, we have less exposure to the three best-performing sectors: Technology, Communication Services and Materials. The first two have performed particularly well, with gains of 22.5% and 15.4%, respectively, because they contain a lot of growth stocks that investors believe will do well if the economy slows and central banks lower interest rates. We are not convinced that will hold true, as growth stock earnings may suffer more than expected if we have a recession. The strong performance in the Materials sector has been fueled by sizable gains in gold company stocks.


We own high-quality businesses, and we have greater-than-market exposure to defensive sectors like Health Care, Utilities and Consumer Staples. Most of those businesses are less economically sensitive, and many have above-average dividend yields. We believe investors will value these attributes more dearly as the economy slows.

The authorities handled the bank failures well, and fears of a systemic banking crisis have appropriately passed. Still, the sudden demise of a few banks is a reminder that there are negative consequences of a long period of cheap and easy money.

As we discussed at our Annual Address earlier this year, ultra-low interest rates encourage excessive risk taking and debt leverage. While the drama and details surrounding the failure of Silicon Valley Bank and others may have been shocking, it’s not surprising that there were some poorly managed banks that made bad investments and loans.

As Warren Buffett said in a recent CNBC interview, “It gets back to that old story,… when the tide goes out you learn who’s been swimming naked.” It’s what usually happens after central banks take away the proverbial punch bowl following a long period of stimulative monetary policy.

Taming inflation requires extinguishing the excesses that fueled higher prices. Bank failures and business and consumer bankruptcies are necessary and inevitable parts of the process.

U.S. bank-lending standards had already tightened meaningfully prior to the bank failures, and we have little doubt that they will tighten further. The U.S. regional banks, in particular, will need to dial back lending to enhance their financial strength, which will take a toll on consumers and businesses. Canadian banks are similarly becoming more conservative. The least credit-worthy borrowers will be unable to refinance loans. There will be more casualties, as that’s what happens when credit conditions tighten.

While the process is unpleasant, and the possibility of recession is real, unfortunately it’s necessary to arrest inflationary pressures, put the economy on a healthier footing and set the stage for the next expansion.

There are reasons to believe that an economic setback, if indeed one arrives, will be relatively mild. The overall banking system, in North America and globally, is considerably better capitalized than it was prior to the 2008 financial crisis. Back then, it was low-quality, sub-prime mortgages that caused the crisis. Today, it’s high-quality government bonds and agency mortgage-backed securities that are the problem. The former fell in value as the 2008 crisis unfolded, fueling a vicious self-feeding cycle. The latter securities have risen in price this time around, as longer-term interest rates have trended down on the expectation that the U.S. Federal Reserve will lower administered, short-term interest rates later this year in reaction to a weaker economy.

The U.S. is the most important consumer cohort in the world, and, as a group, they are in much better financial shape than they were prior to the 2008 crisis. They have learnt important lessons from that era and have reduced their collective debt leverage considerably in the ensuing years. Moreover, they’ve developed a strong preference for fixed-rate 30-year mortgages after getting burned by variable-rate mortgages the last time the central bank raised interest rates meaningfully. That, together with savings accumulated during the pandemic and a strong job market, makes U.S. consumers better positioned to weather higher interest rates and economic turbulence.

The possibility of a recession has been widely telegraphed by the media and investment pundits, and, because of that, we believe much of the risk is already discounted in stock prices. That doesn’t mean we don’t expect volatility – we do – but it also implies that we are constructive regarding the prospects for pleasing returns over the next few years.

We own businesses that have strong competitive advantages and the financial wherewithal to survive. In other words, they aren’t “swimming naked” and at risk of being exposed as the tide goes out. On the contrary, they have the strength to invest in the face of adversity, gain market share and ultimately thrive. Their share prices may fluctuate as we navigate these uncertain times. But, like Warren Buffett’s attitude towards Berkshire Hathaway, we will be more enthusiastic if share prices temporarily go on sale. 

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