FIRST QUARTER 2024

* Index returns are total returns, including dividends.

AN OPTIMISTIC CROWD

After a strong rally in 2023 fuelled by optimism about Artificial Intelligence (AI)’s potential to enhance business productivity and profitability, the stock market continued its upward trajectory, reaching new highs this quarter. As equity market participants reach for returns, the market is broadening in its climb, with financials, energy, and consumer discretionary stocks all benefitting. However, these returns have broadly been sentiment-driven, with no meaningful increase or expected increase to company earnings (see chart below). The excitement is most clear in AI stocks.

Popular AI beneficiaries soared in Q1: Nvidia +86%, Super Micro Computer +270%, and MicroStrategy +148%. Bitcoin also surged +54% in the first quarter. As we have discussed numerous times before, we believe trying to pick winners in an excited and expensive emerging space is historically a fruitless effort. We usually liken this to the internet bubble, but as Peter Lynch highlights in One Up on Wall Street, there have been multiple points in history where exuberance

pushed prices higher for investors while competition flocked to the space. Examples include the carpet industry, oil services sector, disk drives, and many more. Ultimately this led to poor investments for all except the lucky few companies that survived.

In 1886, a new marvel in engineering captured the imagination of the masses: the gasoline- powered car. This led to the creation of the brands we see on our commutes today: Ford, Mercedes-Benz, Volkswagen, etc. Do you remember the other notable automobile companies of the once-emerging industry? Pierce-Arrow Motor Car Company? Or Studebaker Corporation? What about Hupmobile, or perhaps Willys-Overland Motor Company? Of course not. They all ceased production in the 1900s as they lost to stronger competitors. Competition flocks to innovation, and predicting who will win 50, 20, or even 10 years from now is notoriously challenging.

Instead, we hope to benefit in two ways: 1) wait for proven business models to show a sustainable competitive advantage and buy those businesses at inexpensive valuations; or 2) buy companies that will benefit tangentially from the innovation. For example, in 1886, it might have been difficult to predict which car companies would stand the test of time, but a safe bet was buying oil and gas producers. Today, we own companies we expect will benefit in these ways from AI. Just a few of these expected beneficiaries are Meta, Google, Samsung, Alibaba, and Naspers (discussed below).

QUALITY ASSURANCE?

As equity markets continue to rise, we are becoming more cautious about “paying up” for quality companies. In practice this is sensible. Who wouldn’t pay a bit more money for more durable tires or better-quality appliances? However, when it comes to many high-quality stocks, we find to own them these days is not just a question of paying “a bit more”. It’s expensive! After years of investors piling into quality names because it has worked well, we expect the returns of many of these stocks moving forward as subpar.

This isn’t to say that we don’t love owning high quality companies with defensible competitive advantages. We do. Comcast is a great example. Comcast is a strong company in a sector with significant barriers to entry stemming from the considerable financial investment needed to replicate its nationwide cable network infrastructure. Comcast trades at a price to earnings ratio (P/E) of 10, meaning each year the company earns 10% of the price we paid, excluding any growth Comcast achieves.

Compare this with Costco. We all know Costco is a phenomenal brand with low costs for consumers in another sector with high barriers to entry. It’s a high-quality business on many counts. However, Costco currently trades at a 45 P/E ratio (very expensive compared to the S&P 500 historic average of 16 P/E). Therefore, Costco only earns 2.2% of profit on the price of the stock. As such, to attain the 10%+ return we strive to achieve, Costco needs to consistently grow earnings at least 7.8% annually (without the P/E ratio decreasing, which could happen if it is thought that growth may slow, as was the case with Dollar General highlighted last letter). Although they have achieved that in the past 5 years, the company is likely reaching saturation in North America and has only grown its store base by 2.5% annually over the past 5 years. They will probably continue to open stores

and win market share, but at the current price, it’s hard to see remarkable future returns for investors.

A Toyota is a durable, quality car that will reliably get you from A to B. But would you pay $300,000 for one? We wouldn’t either. It’s not good value. When buying quality companies, we would much prefer to wait until they go on sale. This tilts the probabilities of great returns in our favour and provides a margin of safety so we don’t break Warren Buffett’s cardinal rule: don’t lose money.

 A RESILIENT ECONOMY

The U.S. economy has remained incredibly resilient in the face of higher interest rates. Unemployment is still well below historic averages. Real Gross Domestic Product (“GDP”) continues to grow. Consumer and investor sentiment is elevated. The U.S. economy is humming along.

Against this backdrop, equity markets were strong in the first quarter. However, we aren’t ready to crank up the music and start dancing quite yet. We remain cautious in our approach. Global economies and companies still face several headwinds: a) increased input costs due to inflation; b) greater interest expenses due to higher interest rates; and c) less consumer spending as more discretionary spend shifts to higher debt servicing costs. In addition, with equity prices generally elevated there is less margin of safety when buying them. Our goal is, as always, to find companies trading at attractive or bargain prices that have stronger tailwinds than headwinds – the opposite of how much of the broader stock market appears today. That philosophy is as important as ever in today’s environment.

Interestingly, since the U.S. economy is showing strength, current expectations are that interest rates will remain higher for longer. As such, bond prices pulled back slightly in Q1. We are still finding better value in bonds now than we have in the past decade but are not confident rates will go back below 2% that quickly. Therefore, we continue to hold shorter duration bonds in client portfolios until such time that we feel investors are well-compensated for buying longer-dated bonds.

It is worth noting that there are differences between the Canadian and U.S. economic outlooks. Data would suggest that the average Canadian is struggling more than the average American. Canadians may be disproportionately hurt by higher interest rates due to higher average personal debt. In addition, our real GDP per capita has effectively been flat since 2017, compared to that of the U.S. which has steadily risen during that time (excluding 2020). Overall, we continue to remain fully invested, as timing the market tends to be a fool’s game. However, we also are ensuring we build margins of safety into the prices we pay for companies as we are cautious about the economic outlook and many asset prices today.

FINDING VALUE IN DOMINANT TECHNOLOGY

Founded in 1915, Naspers is a multinational conglomerate based in South Africa. Naspers began as a newspaper publisher, but steadily diversified its interests over the decades. However, its

transformation truly accelerated in the late 20th and early 21st centuries under the leadership of CEO Koos Bekker. Bekker, who served as CEO from 1997 to 2014, orchestrated Naspers’ pivot into the digital realm, most notably investing a large stake in Tencent Holdings, the Chinese tech giant behind WeChat. This move proved to be immensely lucrative, turning Naspers into one of the world’s largest technology investors.

Naspers owns 10.5% of Tencent via different holding companies, a stake worth US$40 billion with Tencent’s current market valuation. Naspers itself trades at a market value of US$32 billion. What makes this investment so attractive to us is not only that Naspers trades at a discount to the value of its stake in Tencent, but also that we believe Tencent itself is undervalued today, effectively providing a double discount.

Tencent Holdings, a Chinese multinational conglomerate, is one of the world’s largest and most influential technology companies. Renowned for its diverse portfolio of internet services and products, Tencent operates in multiple sectors, including social media, gaming, entertainment, e- commerce, and fintech. Its flagship platform, WeChat, serves as a super-app, offering messaging, social networking, payment services and more, with over a billion monthly active users. Tencent’s success is defended by a formidable economic moat, primarily driven by network effects, brand recognition, and scale. As previously mentioned, Tencent’s valuation is also reasonable. The company trades at a 13 P/E ratio with an expected revenue growth rate in the high single digits. Its historic 5-year revenue growth is 14% annually. In addition, the company has a fortress balance sheet with US$53 billion in cash and investments versus US$52 billion in debt.

Our expectation is that as Tencent continues to succeed, Naspers will benefit. We hope the valuation will also increase as the market recognizes the strength of Tencent and the meaningful discount in Naspers versus its holdings. However, even if this does not occur, we are pleased to see that both Tencent and Naspers recognize their discounts: both companies are currently buying back their own stock to close the valuation gaps.

In addition to its stake in Tencent, Naspers owns investments in numerous venture technology companies in food delivery, payments and fintech, education technology, and more. All these additional investments are currently valued at US$10 billion. By buying Naspers’ stock at a price less than just its Tencent stake, we are effectively getting these other investments for free. Who knows? One of those companies may turn out to be the next big winner.

By allocating clients’ capital with a disciplined approach while remaining invested in good value companies, we expect to perform well in the long term. With investments we hold in client accounts¹ in the AI-beneficiaries we mentioned – Comcast, Naspers, and others – we believe we are well on our way to accomplishing that mission.

Thank you for your continued confidence and support.

The Evans Team

1 Some clients may not hold these securities in their accounts due to asset mix or timing.