Market Call: Christine Poole's outlook on North American Large Caps

Key Concepts

• Big Tech Valuation Sentiment: The prevailing market sentiment regarding the valuation of large technology companies.
• MAG Seven: A group of seven prominent technology companies (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, Tesla).
• CAPEX (Capital Expenditures): Funds used by a company to acquire, upgrade, and maintain physical assets such as property, buildings, technology, or equipment.
• S&P 500: A stock market index representing 500 of the largest companies listed on stock exchanges in the United States.
• Earnings Per Share (EPS): A company's net profit divided by the number of common shares outstanding.
• Recession: A significant decline in general economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.
• Tariffs: Taxes imposed on imported goods and services.
• REIT (Real Estate Investment Trust): A company that owns, operates, or finances income-generating real estate.
• Dividend: A distribution of a portion of a company's earnings to its shareholders.
• Levered: Having a significant amount of debt relative to equity.
• Interest Rates: The amount charged by a lender to a borrower for any loan, expressed as a percentage of the principal.
• Political Risk: Risks associated with political instability or changes in government policy.
• Guidance: A company's forecast of its future financial performance.
• P/E Ratio (Price-to-Earnings Ratio): A valuation ratio of a company's current share price compared to its earnings per share.
• M&A (Mergers and Acquisitions): The consolidation of companies or assets through various types of financial transactions.
• Demographics: Statistical data relating to the population and particular groups within it.
• PBM (Pharmacy Benefit Manager): A third-party administrator of prescription drug programs.
• Medical Cost Trends: The rate at which the cost of medical services and treatments is increasing.
• AI (Artificial Intelligence): The simulation of human intelligence processes by machines, especially computer systems.
• TSX: Toronto Stock Exchange.
• NASDAQ: A global electronic marketplace for securities.
• NYSE: New York Stock Exchange.
• Operating Ratio: A measure of a company's operating expenses as a percentage of its revenue.
• Intermodal Operations: The use of more than one mode of transport for a single shipment.

Market Overview and Tech Sector Performance

The North American markets are experiencing a second consecutive day of decline, following a downturn the previous day. This pullback is attributed to the ongoing sentiment surrounding big tech valuations. Christine Poole, Co-Chief Investment Officer at Davis Ray, believes that the strong year-to-date performance, with significant gains since the April pullback, has led some momentum-driven names to get ahead of themselves, resulting in a natural correction.

Tech Earnings and CAPEX

Despite the market pullback, tech earnings are generally coming through as expected. The "MAG Seven" companies have reported their numbers, with the exception of NVIDIA. A key observation is that these companies have also increased their CAPEX for the current and next year, indicating strong demand. However, a lingering question is when companies will see a return on these substantial investments.

Broader Market Earnings

Looking beyond tech, the S&P 500 companies, dominated by large-cap names, are showing better-than-expected earnings for the third quarter, with an anticipated 14% increase. Fourth-quarter earnings are also expected to be positive, and for the full year, earnings are projected to grow by 12%, with a further 14% increase anticipated for the next year. This consensus suggests that the market is not heading into a recession, as a recession would typically lead to negative profit growth.

Performance of Other Sectors

Other sectors have also performed reasonably well. The full impact of tariffs has not yet been felt due to delayed implementation and companies' ability to mitigate these effects. Companies serving lower-income households are experiencing weaker consumer spending. However, industrial companies have seen their earnings come through. The growth in data centers and hyperscalers building them is providing significant growth opportunities for companies servicing this area, including component suppliers, semiconductors, power generation, and even utilities, which are essential for powering these facilities.

Stock-Specific Analysis and Investor Questions

The program then transitions to addressing specific investor questions.

Allied Properties REIT (AP.UN)

John inquired about Allied Properties REIT following a recent sell-off despite assurances about its dividend. The company reported numbers indicating that their target of 90% occupancy by year-end has been pushed out, with current occupancy in the mid-80s. The company is highly levered, and rising interest rates have increased refinancing costs. A comment from management suggesting consideration of a distribution cut, which would save cash flow, is believed to be the trigger for the stock's decline. Analysts are factoring in a potential 50% cut for next year. With a distribution yield exceeding 10% (closer to 12.5-13%), doubt about its sustainability is evident. Given the slow recovery expected in the office market, especially in their specific locations, Poole suggests that investors seeking income might need to look elsewhere for more sustainable options.

MDA Space (MDA)

Elliot asked about MDA Space, which experienced a significant drop after losing a contract and facing speculation about further contract losses, particularly the Globalstar contract, due to SpaceX's consolidation activities. Poole advises caution, stating that MDA is not a current holding. She recommends waiting for the company's upcoming report in the next week or two, which may provide more clarity on their outlook.

Zoetis (ZTS)

Rick inquired about Zoetis, a company in the animal health sector, which has seen its stock decline after cutting guidance. The issue is centered around their pain management drug, Librela, for dogs and cats. While the company believes it's a blockbuster drug addressing an underserved need, some vets and pet owners have reported adverse effects, including death, though studies suggest these are not direct side effects and regulatory authorities have approved its marketing. Slower uptake of the drug and a general slowdown in pet visitations due to economic conditions are impacting prescription demand. Despite these challenges, Poole recommends holding Zoetis, citing its leading position in the animal health space, its spin-off from Pfizer, the growing pet population, and a discounted valuation.

GoEasy (GSY)

Jim asked about GoEasy, a lender that has seen a significant price drop. Poole notes that GoEasy is not a holding and expresses concern about elevated loan losses reported by the company. Given their client base tends to be lower-income individuals who may not qualify for traditional bank loans, and the current economic strain on lower-income households, credit problems make future outcomes uncertain. Poole prefers sticking with larger, more diversified Canadian banks.

Thermo Fisher Scientific (TMO)

Chris asked about Thermo Fisher Scientific, a long-term pick in the life sciences and healthcare sector, and its potential to merge with Danaher. Poole confirms they continue to own Thermo Fisher, describing it as a "picks and shovels" provider to the healthcare industry, supporting drug development from inception to production. While Thermo Fisher experienced growth during COVID, its top line normalized, and it faced weakness in China and funding slowdowns in the biotech sector due to rising interest rates. However, the CEO believes the industry will grow 5-7%, and Thermo Fisher is expected to grow slightly higher, with potential for M&A. Poole views healthcare as an attractive long-term industry due to demographics. Regarding concerns about potential R&D funding cuts under the Trump administration, Poole believes Thermo Fisher's diversified client base and geographical reach make this manageable.

UnitedHealth (UNH)

Tony inquired about UnitedHealth. Poole states they do not own UnitedHealth and are not looking to add it. The entire PBM sector is facing issues with medical cost trends, where premiums are not covering actual costs, and increased patient utilization of services. While the company has brought back its well-respected former CEO to reset expectations, and repricing next year may help, the Trump administration's focus on medical costs and pricing keeps the industry under pressure. Poole remains on the sidelines for this sector.

Taiwan Semiconductor Manufacturing Company (TSM)

Henry asked about Taiwan Semiconductor Manufacturing Company (TSM) amidst a correction in the high-tech sector. Poole acknowledges TSM's benefit from data center build-outs and AI investment but notes that they typically do not invest in the semiconductor space due to its cyclical nature. While TSM is arguably a better investment for exposure, Poole finds valuations quite high and is uncertain about the sustainability of this growth. Therefore, they are not ready to invest.

Digital Payment Company (Unspecified)

Nick asked about a digital payment company, which he finds cheap based on its P/E ratio despite a guidance cut. Poole identifies the company as a payment processing firm with products like Clover terminals. A new CEO reviewed the business and lowered guidance, suggesting the previous CEO might have been artificially boosting growth numbers. The sustainability of future growth is uncertain. Poole recommends waiting for more clarity from the new CEO before entering the stock.

Past Picks Review

The program then reviews Christine Poole's past picks from October of the previous year.

CGI Inc. (GIB.TO)

CGI Inc., a computer technology and information consulting company, was down 24% from its pick date. Poole states they have owned CGI for many years and continue to like it. The sector has faced an overhang regarding AI's potential impact on demand for services, but CGI believes it will require assistance for AI integration. CGI has two businesses: managed services (55% of revenue, long-term contracts) and systems integration consulting. AI is being integrated into CGI's internal processes for efficiency. While demand for consulting has slowed, potentially due to economic uncertainty and AI investment allocation, Poole believes CGI's expertise will be needed for AI implementation. Government cost-cutting measures may also drive demand. CGI continues to grow its backlog, and its strong balance sheet and discounted valuation (forward P/E less than 14 times) make it attractive for M&A. Poole would buy it here.

Linde plc (LIN)

Linde plc, an industrial gas company, was down 13% with a 12% total return. Poole describes Linde as an oligopoly with global operations, providing industrial gases used in chemicals, healthcare, beverages, and electronics. While electronics are a growth area, 65% of their business is cyclical (chemicals, mining), impacting operations due to the industrial slowdown. However, Linde can grow even with slow or negative GDP growth. They have long-term contracts, benefit from scale, can implement price increases, and are effective at cost-cutting. Poole believes the company can still grow mid-single digits and is arguably under-earning. She considers it a defensive industrial company and would continue to buy it.

Microsoft (MSFT)

Microsoft, a "MAG Seven" company, was up 18% with an 19% total return. Poole continues to own Microsoft and finds it an attractive entry point below $500 after a recent pullback. They are well-positioned for future growth, with top-line growth of 23% and Azure (cloud computing) growing 40%. Microsoft is increasing CAPEX due to strong demand for cloud services. Their Office tools are subscription-based and recurring, with AI being embedded. Their investment in OpenAI is also a factor. Trading at about 30 times forward earnings, it's considered reasonable given their growth rate and outlook.

New Top Picks

Christine Poole then shares her new top picks.

Abbott Laboratories (ABT)

Abbott Laboratories is a diversified global healthcare player with four operating divisions: medical devices, diagnostics, established pharmaceuticals (branded generics for emerging markets), and nutritionals (e.g., Similac). Abbott benefited significantly from COVID-19 through its testing kits, generating $8.4 billion in sales in 2022, which reduced to $750 million last year. The company reinvested these funds into R&D to grow its pipeline and is well-positioned for future product launches. Poole expects Abbott to grow its top line in the high single digits and earnings in double digits. The company has also increased its dividend for 53 consecutive years, offering a yield just under 2%. Abbott is expected to benefit from the aging demographic.

CN Railway (CNR.TO)

CN Railway is favored over trucking and air cargo due to its deeply embedded networks across Canada and the United States, which are difficult to replicate. The valuation has dropped significantly, trading at a discount compared to its peers. Last year, CN had to reduce guidance multiple times due to a weaker economic environment, lower volumes, and disruptions from labor and port strikes. However, they have reinvested in their network, increasing capacity, and are now reducing CAPEX to a more normalized level (mid-teens as a percentage of revenues). They have reduced labor costs and are seeing improvements in their operating ratio. Poole believes CN is well-positioned, maintaining guidance and benefiting from a discounted valuation. Any pickup in volume will flow to the bottom line. She anticipates increased goods to transport due to government initiatives promoting investment and believes CN can gain market share from trucking through improved intermodal operations and on-time delivery metrics.

Otis Worldwide (OTIS)

Otis Worldwide, a manufacturer of elevators and escalators, was spun off from United Technologies in 2019. The elevator industry is attractive due to its two components: new equipment (low margins of 5-6%) and service contracts (high margins of 24-25%). Otis is an oligopoly with competitors Schindler and Thyssenkrupp, holding about 60% market share. The new equipment side has been weak, particularly in China, due to an economic slowdown and property overbuilding. However, the service side is growing, with China's service contract attachment rate increasing from below 40% to over 50% and targeting 60%. Approximately 40% of elevators are over 15 years old, indicating a need for modernization or replacement. Poole believes Otis is well-positioned to capitalize on the aging installed base.

Investor Questions and Expert Responses

The program concludes with further investor questions and Poole's responses.

IBM (IBM)

Regarding IBM, Poole notes that while it has performed well, she does not own it. She acknowledges its participation in the AI surge after separating its mainframe business from its consulting side. The multiple has expanded, and the market recognizes its improved growth outlook. However, Poole prefers CGI for exposure in the consulting space due to its valuation discount.

Brookfield Corporation (BN)

Poole likes Brookfield Corporation, the parent company, which they own. She highlights its strong positioning in renewables, uranium (via Cameco), and infrastructure, with cash flows backed by hard assets under long-term, inflation-protected contracts. Brookfield is also participating in the growing alternative asset management industry, now targeting high-net-worth individuals. Their acquisition of a partial interest and subsequent purchase of the balance of Oaktree Capital, a credit company, has opened up a new growth avenue. Poole believes Brookfield is well-positioned and recommends adding to positions on pullbacks.

West Fraser Timber (WFG.TO)

Poole does not own West Fraser Timber and typically avoids lumber stocks due to their cyclical nature. She notes weak demand for lumber, plant closures, and the impact of tariffs. While these stocks can be profitable in good times, prices can collapse, leading to overcapacity and mill shutdowns. She considers it too cyclical and would not buy it at current levels. If already invested, she would likely not hold it, especially with tax-loss season approaching, which could exacerbate declines.

Constellation Software (CSU.TO)

Poole has never owned Constellation Software but acknowledges its historical success. She notes the transition in leadership and questions about AI's impact on software companies. Constellation has primarily grown through acquisitions rather than organic growth, which is a preference for Poole. She prefers companies with a balance of organic growth supplemented by M&A. While Constellation has been successful in acquiring smaller software companies, the need to pursue larger transactions as it grows presents more risk. Poole prefers software companies with more recurring revenue streams and visible growth without relying heavily on M&A, such as Microsoft.

Arc Resources (ARX.TO)

Poole is unsure about the specific reason for Arc Resources' pullback but notes that it has performed relatively well. As a premier player in natural gas, it could be a good holding for exposure to the sector. She suggests that days like this, with general pullbacks, might be an opportunity to buy high-quality players experiencing unforeseen problems, but she would need to understand the reasoning behind any production forecast cuts. National Bank's lowered price target also indicates some headwinds.

Cargojet (CJT.TO)

Poole has not invested in Cargojet and would not do so now, preferring rails in the transportation sector. Cargojet is impacted by weak demand for deliveries due to the weakening consumer and potentially the impact of tariffs. The industry is capital-intensive, and reduced volumes significantly hit the bottom line. She suggests that the current lull might be due to goods being shipped ahead of time for the holiday season due to tariff uncertainty, and normalization may occur later.

Visa (V)

Poole owns Visa and has held it for years, liking its long-term outlook. The growth of digital payments, especially with the continued use of cash and checks in some parts of the world, presents an opportunity. E-commerce contributes to continued growth, and cross-border volume and travel have held up well, particularly with high-end consumers. Even lower-income households are transitioning to using credit/debit cards for everyday items, providing steady demand. Visa and Mastercard are also developing value-added services like cybersecurity, which now constitute a significant portion of their top line. Poole considers Visa a good entry point on pullbacks.

Conclusion

Christine Poole's analysis highlights a market grappling with big tech valuations while broader earnings remain robust. She emphasizes the importance of understanding company-specific fundamentals, managing debt, and considering long-term trends like demographics and digital transformation. Her investment philosophy leans towards companies with strong balance sheets, sustainable growth drivers, and attractive valuations, often favoring established players with diversified revenue streams and proven business models. She advises caution on highly cyclical sectors and companies with uncertain future growth prospects.