SECOND QUARTER 2024

* Index returns are total returns, including dividends.

CAN IT END?

“All good things must come to an end.” – Geoffrey Chaucer

Deep within the Ancient Forest/Chun T’oh Whudujut Provincial Park in British Columbia there are groves of ancient cedar trees, some over a millennium old. These majestic giants had weathered centuries of storms and nurtured countless ecosystems. However, despite their resilience, some of the trees began to show signs of stress as climate change and human impact took their toll. One by one, cedars started to succumb to disease and environmental pressures, their towering trunks eventually tumbling to the forest floor. Their end is a somber reminder of the impermanence of even the oldest living organisms.

In nature, and throughout history, we are constantly reminded that great things eventually end. Prospering civilizations. Massive stars. Our favourite TV shows (although Grey’s Anatomy is having an incredible run).

As investors, it is important to remind ourselves that things can end. Bull markets can run their course. Indebted companies can go bankrupt. Great companies can be beaten by better competition or regulatory change. At Evans Investment Counsel, we don’t pretend to believe that we can predict the timing of these types of events, but it is important to acknowledge the possibility. And because we acknowledge that something can end, we stay disciplined on the price we pay for a company.

Consider the fact that, as a recent McKinsey & Co. study showed, the average S&P 500 company has only been included in the index for roughly 20 years. In his book Antifragile Nassim Taleb mentions “The Lindy Effect”, a school of thought that suggests the longer something has been in existence, the greater the odds of its continued existence. Most of the so-called “Magnificent 7” stocks (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA and Tesla) were founded less than 30 years ago and have only been dominant in their niches for the past 10-20 years.

Although these are clearly dominant companies today, we recognize that technology can change rapidly and thus we continue to protect downside risk by only buying companies at prudent prices. We look for opportunities where we don’t need the next 20 years to be as prosperous as the past 20 to achieve our desired return. As the chart below shows, this should tilt the odds in our favour.

A NARROW MARKET

For the past two years, market returns have been dominated by a small handful of companies. Make no mistake, these are companies that are currently strong and growing, and they may continue to win for decades to come. However, we would argue that this assumption is already reflected in today’s market prices.

Year-to-date, the S&P 500 gained 15.3% (US$ terms). The Magnificent 7 alone accounted for over 60% of that return. NVIDIA is solely responsible for roughly a third of the S&P 500’s performance this year. In contrast, the S&P 500 index excluding the Magnificent 7 is up only 5% this year. Market concentration of the top 10 stocks is now at a staggering 37% of the U.S. index. Furthermore, the percentage of stocks outperforming the overall S&P 500 over the past two years is at its lowest point since the Dot-Com Bubble (see charts below).

It would be naive to suggest with 100% certainty that this bull market, or the dominance of the top few companies, will end any time soon. According to Morgan Stanley, market concentration among the top 10 stocks in the early 1960s was similar to what it is today, with solid subsequent returns. However, as mentioned above, it’s important to acknowledge that it could end. Looking at the valuation levels at which some of the Magnificent 7 stocks trade today, if their dominance were to end, it could result in a meaningful loss of capital for those who had put all their eggs in that basket.

We tend to focus instead on the overlooked areas of the market and look beyond the market leaders that have had such an incredibly strong two years. We remain disciplined on price and believe there are plenty of opportunities to compound capital steadily without taking on the high valuation risk of the dominant technology giants.

OPPORTUNITY IN UTILITIES

ATCO Ltd.¹ is a prominent Canadian company with a rich history dating back to 1947 when it was founded by S.D. Southern and his son R.D. Southern as Alberta Trailer Hire. Originally focused on renting and manufacturing trailers, ATCO quickly diversified into modular construction, logistics, and energy services. Over the decades, ATCO expanded both domestically and internationally, establishing a strong presence in sectors as diverse as utilities, infrastructure, energy and transportation. The company’s growth over the years has been marked by strategic acquisitions and partnerships, enabling it to evolve into the global conglomerate it is today, known for its innovative solutions in delivering essential services and infrastructure.

Today, ATCO operates as a diversified corporation with significant operations on five continents. The company is structured into two main business units: Structures & Logistics, and Utilities. ATCO Structures & Logistics specializes in modular construction, workforce housing and camp services, providing critical infrastructure solutions worldwide to industries such as mining, energy, and defense. ATCO Utilities, meanwhile, operates regulated natural gas and electricity distribution, transmission, and generation assets in Canada and Australia. The company continues to innovate and grow in renewable energy, sustainable infrastructure, and customer-focused utility services, reinforcing its commitment to delivering reliable, safe, and efficient solutions to communities globally. ATCO may also benefit from the increased demand for electricity from the AI frenzy.

ATCO trades at an inexpensive 9.5x next-twelve-months (“NTM”) price to earnings (“P/E”) ratio compared to the S&P/TSX Composite Index (Canada) which is currently sitting at 14.8x NTM P/E. In addition, ATCO is below its 20-year historic average NTM P/E of 13x. We expect the company can grow its book value approximately 4% per year through further project expansions. Combined with a 5% dividend yield, we expect a minimum 9% annualized return excluding any multiple rerating which would provide additional upside. Beyond its attractive value, we appreciate ATCO’s large holding of Canadian utilities for its defensiveness, our expectation that interest rates will continue to decline in Canada (which in turn will help utility valuations overall), and as a diversifier in our portfolios.

A DISCIPLINED APPROACH

It’s always been part of our DNA to be value investors. In today’s rather expensive and narrow U.S. equity market, we remind ourselves to stay disciplined on price and note that nothing is forever, especially in the rapidly changing technology space. We will continue to seek out good value opportunities to put our clients’ hard-earned money to work.

Thank you for your continued confidence and support.

The Evans Team

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