Quarterly Report - Mackenzie Bluewater Team

From the desk of the Mackenzie Bluewater Team Q2, 2024

Market commentary

Markets continued to show strength during the second quarter as the rally that began in the fourth quarter of 2023 continued into the first half of 2024.  Equity markets have been buoyed by optimism that the Central Bank tightening cycle is behind us, and that a more accommodating monetary policy stance is forthcoming, with recent interest rate cuts from the Bank of Canada and the European Central Bank as evidence.  We believe that path forward for monetary policy is more uncertain.  The combination of sticky services inflation and global conflicts, which continue to support energy prices, suggest that monetary policy will remain tighter for longer than the market anticipates. 

From a global GDP standpoint, economic growth continues to be uneven, with the United States showing mixed signals but still overall relatively healthy, while Canada, Europe, and Asia are generally softer.  The economic health of global consumers also remains challenged, as we continue to see some strain from low-income level consumers, along with evidence that all income cohorts have been trading down for value as a result of years of inflationary pressures and higher interest rates. Canadian consumers face additional vulnerability 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.

The healthier economy in the United States also suggests that monetary easing will be slower than markets expect, as the Federal Reserve sees less pressure to materially cut rates to stimulate growth.  Our view is that the economic boost from people returning to work post a recession-driven spike in unemployment is the single largest driver of above trend economic growth rates during the expansion phase of the economic cycle.  With unemployment in North America at very low levels, that boost to growth will not be forthcoming.  Instead, the team anticipates that global growth will continue to be fairly anemic which is an environment that tends to be supportive of the Bluewater investment process. 

Energy Markets

OPEC+ held a meeting in early June and decided to maintain current output cuts while creating a timetable for the resumption of full production.  Oil sold off briefly on the news before rebounding.  From a medium-term perspective, the original goal of the OPEC+ oil output cut was to push global markets into a supply deficit, leading to higher prices.  So far, the strategy has met with limited success, with rising non-OPEC+ production (US, Canada, Brazil, Guyana) and softer than expected oil demand leading to a more balanced market.

Looking forward, the OPEC+ cartel faces a growing number of challenges.  On the supply side, the post-Covid market consensus was that with reduced spending on exploration and development, the world would begin to see falling oil supplies from non-OPEC+ sources.  Instead, the opposite has been true.  US shale oil production in particular has ramped up with production above pre-Covid levels.  Current oil prices remain well above shale break-even price requirements, which continues to drive supply. 

On the demand side, there are two significant headwinds.  The first is the structural change in energy markets driven by the global energy transition.  Management consultant McKinsey & Company estimates that US$275 trillion will need to be spent by 2050 if the world is to transition to net zero, with much of this spending aimed at reducing the global usage of fossil fuels.  As a result, this transition is expected to create a steadily rising headwind to global oil demand.  The second is demand growth from China.  There is a wide divergence in views on the path forward for Chinese oil demand.  OPEC+ recently projected that China would continue to grow demand until at least 2045.  Sinopec, which is both China’s and the world’s largest petrochemical conglomerate, recently projected that China’s oil demand will peak in 2026, due to rising EV adoption and slower economic growth.  China has been the single largest driver of oil demand growth for the past two decades, accounting for roughly half of the global increase.   The evolution of China’s demand for oil will be a key factor for oil prices over this decade.

In our view, OPEC+ is in a somewhat precarious position.  Bringing oil barrels back into the market appears likely to unbalance the market, which historically has resulted in a significant drop in oil prices.  But with oil sales a major component of many OPEC+ member’s GDP and government income, keeping barrels off the market pressures internal finances while creating an umbrella for further growth of non-OPEC+ supply.  In a world with steady oil demand growth—which has been the environment for the past 4 decades—OPEC+’s dilemma would resolve itself:  simply wait until demand growth creates a need for more barrels. In a world of low demand growth, this process will take considerably longer, and if projections (again, highly disputed) for a peak in global oil demand later this decade prove correct, the problem may prove intractable.

Market concentration

The past decade has witnessed a dramatic rise in stock market concentration. The weighting of the top 10 stocks in the S&P 500 has nearly doubled, reaching 28% earlier this year versus 14% in 2014.  While this sort of concentration is not without precedent, it represents the highest level of concentration since the 1960s and is above the last spike in concentration that was experienced in the US in 1999.

To illustrate this level of concentration further, we provide the following stats below:

• 2023 was the worst year for equal weighted indices vs market weighted indices in over 20 years. Historically, the last time we experienced a spike in concentration of this size was in 1999.
• In 2023, the Magnificent 7 contributed 65% of the S&P 500 return. Three names (MSFT, AAPL, and NVDA) contributed 37% of benchmark return with Nvidia up 230% in 2023 alone.
• 2024 has continued this trend and the level of concentration has continued to narrow around one specific name (otherwise known as Mag1 or Nvidia) that has appreciated 129% YTD and accounted for 26% of the benchmark return.

This level of concentration is not unique to the US, with several other markets globally also with high level of concentration (i.e., Canada, Switzerland, France, Australia). That said, what is unique to the US is the outsized impact its concentration has on other Global Indices such as the MSCI World where the US represents over 70% of the global country weight.  The US weight has increased by 15% over the past two decades, with much of the increase driven by a handful of large technology companies. Further, by comparing historical time periods, the largest companies in the world today are based on a set of intangibles that are technology based, as opposed to businesses during the pre-Internet era that required investment in physical manufacturing facilities to grow production such as GM, Exxon, and GE. This compares to the large mega-cap tech names today that share a common set of characteristics such as infinite scale and network effects (Google today has nine products with over one billion monthly active users) that never existed previously.  

Given the market concentration of the mega-cap tech names, it presents a very challenging environment for active manager to outperform their respective benchmarks.  While calling an eventual top on these names such as Nvidia is highly uncertain, what we do know from history is extrapolating out current growth rates is never linear, and when it stops, the level of concentration comes in and we would expect returns to broaden out, creating a large tailwind for our investment style.

Recent Developments - Apple showcases its R&D prowess with Artificial Intelligence

With many of the Mag 7 stocks being driven higher by excitement around AI, we continue to follow recent developments closes.  While most of the news around AI has been focused on ‘large language models’ provided by ChatGPT (OpenAI), Google Gemini, Perplexity, and many others, in June, Apple debut its AI product strategy at its Worldwide Developer Conference. Given the narrative around Gen AI and its transformational use cases, this was an important event for Apple to showcase its future innovation.

While most consumers have yet to fully grasp the full potential of AI, Apple illustrated once again its R&D prowess with ‘Apple Intelligence’ as a more personalized intelligence system along with relevant consumer use cases. While LLMs are increasingly becoming commoditized, Apple’s powerful chips and on-device processing capabilities positions the company to cost effectively provide AI functionality differently.  In our view, as users become increasingly accustomed to more natural language interactions with their phones, the iPhone becomes an even more integrated extension of oneself, thus expanding company’s competitive moat and mission critical nature to its customer base.

This strategy is particularly unique from the rest of the ‘mega cap tech’ names where Apple can fund their AI endeavors from its income statement, minimizing any step up in capex which is intrinsically lower risk. This "capital-light" approach makes them less vulnerable to potential downturns in the AI development cycle compared to GPU cloud vendors or enterprise AI hardware providers. Overall, Apple's WWDC 2024 showcased their multi-pronged attack on the AI frontier: leveraging powerful chips, promoting an exclusive on-device AI experience through the iPhone 15 Pro and above, and strategically positioning themselves within the AI ecosystem. This strategy has the potential to further strengthen Apple's position in the market and drive an iPhone upgrade cycle.

Portfolio Changes

During the quarter we initiated a position in Alphabet Inc., a longtime holding in our US and Global portfolios.   Alphabet (formerly known as Google) has been one of the most successful companies of the internet era, as they have come to dominate internet search – a business that has been extremely profitable with substantial growth over the past 20+ years.  While search use cases have broadened out from the world wide web to more dedicated platforms and apps such as Amazon, Facebook and other social media platforms where Alphabet does not directly benefit, Alphabet’s search business has doubled over the past five years.   Despite concerns that search has become a mature business, it nevertheless is on track to grow in the mid-teens this year.  Despite the tremendous success of their search business, search as a percentage of Alphabet’s total business has actually decreased from a peak of just over 75% to under 60% today due to the success of other businesses within Alphabet such as YouTube and other Google services.  In fact, Alphabet has over 9 products with more than 1 billion users.

One business that has enjoyed considerable success over the past few years is Google Cloud Platforms (GCP), which despite being a distant third place to AWS and Microsoft Azure has now reached a revenue run rate of close to $40bn with increasing profitability.  While the narrative around Google has been of a laggard with respect to AI, Google was in fact a pioneer in the space with Google search and other products using Artificial intelligence for many years in their algorithms, while acquiring Deep Mind in 2014 and developing Alpha Fold to revolutionize protein structures for biology and drug discovery.  Google’s unique vertical integration across all aspects of the AI value chain positions the company in an advantageous position to help companies develop and implement AI workflows into their businesses through GCP.

In Canada, we recently initiated a position in Loblaws, the leading grocer in Canada.  While the grocery sector tends to exhibit resiliency through economic cycles, given Loblaws’ skew towards discount, they are seeing increased traffic into their stores as value conscious consumers retrench and trade down.  This is a key growth area for the company, where they continue to roll out new discount stores and convert conventional stores into the discount format.  What is even more exciting is their Shoppers Drug Mart franchise, which comprises 45% of their retail profitability and exhibits superior growth and profitability.  There are a few reasons for this:  first is the expanded scope of care for pharmacists, which now allows them to prescribe medication for non-chronic illnesses.  This is proving to be a win-win situation for both consumers and Shoppers Drug Mart and they continue to open new clinics to address this new opportunity with 70 clinics opened last year and another 140 slated for this year.  The second growth driver is specialty drugs, which includes the new blockbuster GLP-1 drugs among others.  More broadly, specialty drugs continue to see outsized growth as existing specialty drugs get additional indications to treat unmet needs and also due to the rich pipeline of products coming to market from the increased innovation within healthcare.  The average prescription value is $700 for specialty drugs compared to $40 for traditional drugs, resulting in significantly higher profitability.  With these opportunities, we think the Shoppers Drug Mart franchise should steadily become a larger mix of the overall business, driving higher margins and growth rates for the overall company.  Historically, Loblaws has been able to grow at 8-10% through a cycle, driven by a balanced mix of organic growth, margin expansion and share buybacks.  Looking ahead, they should be able to deliver faster growth rates given the success of their discount proposition as well as the opportunities within Shoppers Drug Mart.    

Following the transformational acquisitions by Rogers and Quebecor, we think there have been structural changes to the competitive landscape within the telecom space.  We think both Quebecor and Rogers will likely pursue a strategy of volume over price, effectively eliminating the pricing discipline the industry has come to enjoy.  Exacerbating this is the unfavorable regulatory environment, which is adding to the pricing pressure. What does this mean for the sector?  Historically, growth within the telecom sector has been a combination of subscriber growth and pricing.  We think we may now be entering a low to no growth pricing environment.  In terms of volume, carriers have certainly benefitted from high levels of immigration over the past few years.  However, current immigration levels appear unsustainable.  Therefore, we think the entire sector is moving from a historically growthy area, to one that resembles a utility—becoming uninvestible from our perspective.  While we think Telus is the best operator, they are not immune to these dynamics and we have eliminated our position. 

Positioning of Bluewater portfolios

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.  This has translated into superior risk-adjusted returns over the long term. 

The team 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.  On a consolidated basis, the fund should be able to compound free cash flow per share at 10-12% through a cycle and that is reflected in the long-term absolute returns the fund has achieved. 

The team has added value by preserving capital through market drawdowns, while at the same time compounding returns for clients.

In summary, while there have been many exciting developments occurring with respect to AI over the past year, there is still much uncertainty.  This is why we continue to focus on companies who are enablers of this important secular change.  These companies benefit from being global leaders in their respective business areas and are in a strong position to benefit from serving new applications and uses to their clients.  We believe that this is a prudent way to invest in these important changes, without subjecting the portfolio to the uncertainty and extreme volatility that often comes with emerging technologies.

For Investor Use.

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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 June30, 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.