Brendan Caldwell, President and CEO, Caldwell Investment Management
FOCUS: North American Stocks
MARKET OUTLOOK:
In a recent commentary on the markets, the US Federal Reserve said it was willing to tolerate a recession – hopefully mild – rather than allowing continued high inflation. As a result, rising interest rates helped push the US into recession (technically defined as two consecutive quarters of negative GDP growth) in the second quarter of 2022. Inflationary pressures from higher wages and other inputs (e.g. raw material prices, shipping costs) have led companies to pass on higher costs, putting pressure on consumer spending on a real basis. Spending in ‘re-opening’ categories such as travel and leisure seems robust, but consumers are making trade-offs in other commodity-based categories (eg electronics, furniture, cars and even everyday household products). This leaves investors wondering what will happen to the economy if, and when, growth in service-based categories starts to slow down. In addition, as consumers’ willingness or ability to deal with higher prices declines, firms’ ability to maintain margins, and thus profits, may also come under pressure, which is in stark contrast to the strong earnings growth over the past two years.
Given all the uncertainty, it’s no surprise that nine of the 11 sectors in the S&P 500 have fallen year-to-date, with an overall market decline of more than 10 percent. As far as our outlook is concerned, predicting the future is extremely challenging in the best of times and increasingly in today’s environments. We will continue to focus on identifying high-quality, well-run companies with a proven history of navigating difficult environments and believe that professional investment advice can be invaluable in times like these.
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TOP CHOICES:
Costco (COST NASD)
Most recent purchase – July 22, 2022
Leading operator of supercenter, multi-category retail warehouses; third largest global retailer with 830 warehouses worldwide serving 64 million households.
Why do we like it? (more specifically, why now?)
- Despite the huge demand for COVID-19, they continue to see strong growth and consistent traffic numbers. Renewal rates for new members are trending well above pre-COVID-19 levels, suggesting that demand at these higher levels may be sustainable.
- COST is a price leader, but not heavily exposed to lower-income consumers – they haven’t seen any trade-off activity yet, but would likely still benefit in that environment.
- The conversion from executive membership is robust. As they exited the pandemic, executive members accounted for 55 percent of paid memberships in the US and Canada, 17 percent internationally, indicating long membership conversion opportunities.
- Executive membership builds customer loyalty and they spend more than basic members.
- Prices are still lagging behind competitors in some categories, so COST can pull that lever if necessary without significantly impacting demand. New programs such as grocery delivery also create customer stickiness. The strong gas sales stimulate the visits of attachments in the store. Geographical Expansion Opportunities in China.
LKQ (LKQ NASD)
Most recent purchase – July 21, 2022
LKQ is the leading supplier of aftermarket (AM) auto parts in North America and Europe; 20x bigger than its number two competitor in NA; 2-3x larger in Europe.
In North America, it mainly sells to independent and large pile-up repair shops; the company is driven by total vehicle kilometers driven and vehicle safety standards.
- Note that bodyshops are customers of LKQ, but insurance ends up paying 80-90 percent of repairs. Since AM parts are 40-50 percent cheaper than OEM parts, insurers are incentivized to use cheaper parts to lower their costs (especially relevant in an inflation environment).
- This company should benefit from the reopening, the return to work, the lower gas prices, etc. as the mileage is still below the 2019 level.
- Consumers are also more likely to opt for repair than replacement in the next 1-2 years. Given the high prices of new and used cars, the average age of vehicles supports repair activity.
- It also sells specialty parts to truck, RV and marine markets – this category is more discretionary.
In Europe, LKQ sells to collision and repair shops with a greater focus on mechanical replacement parts (windshield wipers, belts, air filters) versus collisions.
- Regulations passed in recent years have opened up European markets to non-OEM parts; Europe is still catching up with North America in AM component penetration.
LKQ is undergoing restructuring to improve margins; focused on sustainable EBITDA margins of the DD segment versus 8% historical
Electronic Art (EA NASD)
Most recent purchase – July 29, 2022
Electronic Arts is a leading game developer whose content and services can be played and viewed on game consoles, PCs, smartphones and tablets.
Its portfolio of games includes wholly owned properties – such as Battlefield, The Sims, Apex Legends – and licensed brands such as FIFA, Madden NFL, NHL and Starwars.
Why do we like it?
- The global gaming market is huge and growing well above GDP.
- There are high barriers to entry, as development costs, regular customers, and licensing agreements with major sports brand franchises give major developers the upper hand.
- EA’s marketing and research and development base also serves as a competitive advantage over smaller game developers, allowing for faster development schedules.
- Strong growth in live services revenue has made the business model less risky over the years; single game releases have much less impact, as live services account for about 70 percent of total revenue.
- Live services include the sale of additional content for console, PC, and mobile games, licensing income from third-party publishing partners who digitally distribute our games, subscriptions, and advertising.
- Engagement with EA’s games remains strong despite the reopening, as gaming has more of a social aspect than a mere solitary pursuit that most think of – this is driving the growth of active accounts and thus bookings.
- EA’s relatively recent acquisitions of mobile gaming studios help drive growth and strengthen EA’s position in a market where they have typically lagged.
- EA is also leveraging the expertise of mobile gaming studios to roll out mobile versions of its blockbuster franchises such as Battlefield and F1.
PAST CHOICES: March 30, 2022
CME Group (CME NASD)
- Dan: $241.80
- Now: $200.63
- Yield: -17%
- Total return: -17%
Quanta Services (PWR NYSE)
- Dan: $132.16
- Now: $134.81
- Return: 2%
- Total return: 2%
Micron technology (MU NASD)
- Dan: $79.16
- Now: $62.66
- Return: -21%
- Total return: -21%
Total return Average: -12%
| CME NASD | N | N | Y |
| PWR NYSE | N | N | Y |
| MU NASD | N | N | N |
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