Bullish on the Canadian grocers: Horan

Key Concepts

• Canadian Market Bullishness: Constructive outlook on the Canadian market due to its recent participation in the bull market and the cheapness of its cyclical and value sectors.
• US Market Euphoria: Concern about potential overvaluation and euphoria in the US market.
• Grocers as a Short Position: Negative view on Canadian grocers, citing high valuations, increased competition, and the end of the low-interest-rate "safety trade" environment.
• Constellation Software and Thomson Reuters as Short Positions: Skepticism towards these companies due to their extremely high valuations, despite their strong business models and moats.
• AI's Impact on Barriers to Entry: Potential for Artificial Intelligence to lower barriers to entry for new competitors, impacting companies with established moats.
• Valuation Multiples: Discussion of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) multiples and their justification based on growth.

Canadian Market Outlook

Patrick Hand expresses a bullish stance on the Canadian market heading into the year-end. This optimism stems from the fact that the Canadian market has historically lagged in the recent bull run of the past seven to eight years, but has recently started to participate. Hand believes that the TSX (Toronto Stock Exchange) has a significant number of cyclical and value stocks that are currently undervalued. These sectors were particularly affected when the consensus was that interest rates would remain low. Despite recent good performance, especially through the end of October, Hand argues that these cyclical areas still represent good value, with strong earnings and benefits from inflation. He anticipates that the Canadian market has more room to grow and is likely to outperform the US market.

Concerns Regarding the US Market

In contrast to his positive outlook on Canada, Hand expresses concerns about "euphoria" in the US market, suggesting it might be overvalued.

Short Position: Canadian Grocers

Contrary to a potential perception, Patrick Hand clarifies that Agelith Capital is actually short Canadian grocers, meaning they are betting on their prices to fall. The reasoning behind this bearish view includes:

• High Valuations: Grocers, particularly Loblaw Companies Limited (LAS), are trading at high multiples, around 19-20 times earnings.
• Benefit from Past Regimes: Grocers have benefited from food inflation and the "safety trade" associated with ultra-low interest rates. However, this low-interest-rate regime has ended, and the market is now in an inflationary environment.
• Weakening Competitive Advantages:
  • Currency Impact: A strong Canadian dollar (weak US dollar) will reduce the ability of grocers to pass on food inflation to consumers, forcing them to compete more on steady prices.
  • Increased Competition: US grocers are expanding their presence in the Canadian market, intensifying competition.
• Not as Defensive as Perceived: Hand argues that grocers are not as defensive as they are often considered to be.
• Historical Valuation Reversion: Hand, with nearly 40 years of experience, has seen grocers trade down to multiples as low as 11 times earnings, and currently, they trade significantly above that. He expects a "round trip" of these multiples downwards.

Short Positions: Constellation Software and Thomson Reuters

Agelith Capital has also initiated short positions on Constellation Software and Thomson Reuters, which are relatively new additions to their short portfolio, having been layered on over the past couple of months.

• Investment Thesis for Owning (and why it's being shorted):

  • Fantastic Moats: Both companies possess strong and resilient "moats" (competitive advantages) that make it difficult for competitors to penetrate.
  • Artificially High Margins: Their leverage over customers results in artificially high margins.
  • Constellation Software's Model: This company is a serial acquirer, aggregating businesses, benefiting from cash flow, and integrating them into existing systems to create positive leverage.
  • Fantastic Business Models: Both are acknowledged as having excellent business models.

• Reasons for Shorting (Valuation Concerns):

  • Unbelievable Valuations: Both companies trade at extremely high EBITDA and earnings valuations. Hand compares these valuations to the dot-com bust era, a period he vowed never to repeat.
  • Growth vs. Valuation Mismatch:
    • Thomson Reuters recently reported 7% revenue growth, which Hand argues does not justify a 22 times EBITDA multiple. He believes significantly more growth is required to support such a valuation.
    • A free cash flow analysis suggests that these companies need substantial future growth to justify their current multiples.

• AI as a Risk Factor:

  • Uncertainty of AI: The unfolding impact of AI is unknown, but Hand views it as a productivity tool.
  • Lowering Barriers to Entry: More importantly, AI could provide a cheap way for new entrants to access customers, potentially eroding the high barriers to entry that Constellation Software and Thomson Reuters currently benefit from.
  • Delayed Impact: While the impact on results might not be visible for about a year, Hand believes that when expensive stocks face such risks, they tend to decline.

Conclusion

Patrick Hand's perspective highlights a contrarian view on certain segments of the market. He is bullish on the Canadian market, particularly its undervalued cyclical and value sectors, while expressing caution about potential overvaluation in the US. His firm is actively shorting Canadian grocers due to high valuations and increasing competitive pressures, and also Constellation Software and Thomson Reuters, despite their strong business models, due to what he considers unsustainable, extremely high valuations, with AI posing a potential future risk to their moats.