Good Morning. In today's newsletter, we explore the swing of interest rates and inflation in Canada, examining why Loblaws customers are frustrated despite a drop in inflation rates. We discuss the impact of the consumer-led boycott on Loblaws and small businesses. Additionally, we analyze the rise of AI-powered investing, its implications for retail brokerage, and the major industry-shaking merger between Capital One and Discover. Lastly, we spotlight the financial concept of the month, Beta, and its significance in evaluating market risk. Join us for a concise exploration of these pivotal topics shaping our economic landscape.

ECONOMIC UPDATE

THE SWING OF INTEREST RATES AND WHY LOBLAWS CUSTOMERS ARE FRUSTRATED

Where does inflation currently stand in Canada?

In Canada, the inflation rate decreased to 2.7% in April, down from the previous March rate of 2.9%. Although this is a positive sign for Canadians and was a strong indicator for the interest rate cut in June, many Canadians are still concerned about the rising rates of groceries. As of April, inflation on groceries decreased from 1.9% to 1.4%; however, despite this low inflation rate, prices are increasing. In the past three years, grocery prices have risen 21.4%. Many Canadians believe that grocery stores drive this large increase in desire to increase profit margins rather than as a reflection of the economic landscape.

The Loblaws boycott: How Canadians are combating grocery prices

In repetitive fashion, Canadian consumers have focused their pricing frustrations at the blue-chip grocery chain Loblaws for their prices on groceries through a boycott of all subsidiaries, including No Frills, Shoppers, and all Presidents Choice businesses. This movement was driven by the company's 2024 first quarter performance, which displayed that out of the company's $13.6 billion total revenue, $9.4 billion (69%) came from grocery sales. Amidst this, the company's shareholders retained $460 million in profits, which is a 10% increase from the previous year's first quarter. As Loblaws continues to grow and become more profitable, about 18% of all Canadian households face a level of food insecurity in comparison. Rising concerns for consumers has derived action, price cap demands, and increased pricing transparency to ensure necessities are accessible to all Canadians. 

How has the boycott impacted Loblaws?

Despite growing a massive audience of supporters, only about 18% of Canadians actively participated in the boycotting of the grocery giant. Loblaws has remained largely unphased as the stock price continues to hit all-time highs throughout the month of May and currently sits at $156.66, which is about a 2.5% increase since the beginning of the month when the boycott started. Despite this, boycotters plan to continue to extend their movement. 

How has the boycott impacted small businesses?

As a result of Canadians boycotting, many family-run grocery stores have become the next best alternative. Amidst the boycott, many independent grocers have noticed significant boosts to their sales in the month of May, some even recording up to a 57% month-over-month increase. As pricing is comparable at smaller stores as it is to Loblaws, consumers have become more inclined to support local businesses in their area, proving that even the fraction of those participating in the boycott have greatly impacted community business.

Bank of Canada likely to cut rates before the Fed

As general inflation in Canada slows, moving closer to the 2% target, and the economy is stabilizing, the Bank of Canada is predicted to use monetary policy to continue to cut interest rates throughout 2024, following the June meeting. However, in the U.S. market, signs of an interest rate cut are less promising. As inflation rates in the U.S. stand around 3.4%, the 2% target is quite far away. Interest rates in the U.S. have remained stagnant since 2023; however, despite this, it is predicted that rates will not move until March 2025.

What does the interest rate cut mean for Canadian consumers?

As interest rates fall off, the cost of goods and services reduces due to a lower cost of borrowing. This means there will be a likely increase in general spending, mortgages, and loans. In tandem, savings will likely be reduced as interest on savings accounts decreases. Ultimately, the rate decrease will stimulate the economy and allow for increased growth and consumer purchasing power. However, the widening gap between Canadian rates and U.S. rates will weaken the Canadian dollar, causing the costs of imports from the U.S. to increase. However, this will not impact imports from other geographical locations besides the U.S.

MARKET TREND

AI POWERED INVESTING; THE RISE OF INDEPENDENT INVESTORS AND FALL OF RETAIL BROKERAGE

In an era where financial stability is paramount, Canadian banks are making significant moves in the credit market with an innovative approach: Synthetic Risk-Transfer Tools (SRTs). These financial instruments, reminiscent of the complex securities that preluded the 2008 financial crisis, are gaining momentum, highlighting a strategic pivot in risk management and regulatory compliance.

Should you let AI choose your investments?

As the AI boom continues, investors are turning to AI-powered ETFs to leverage artificial intelligence in their investment strategies. An AI-powered ETF is an exchange-traded fund that uses AI and machine learning to research, select, and trade stocks or other investments in pool-based allocations. In some cases, AI actively manages the fund's portfolio, often with limited human oversight. These funds don't necessarily invest in AI companies but use AI technology to analyze data patterns and select which stocks to buy. They differ from AI Sector ETFs, or simply AI ETFs, which invest in companies that are positioned to benefit from growing AI adoption.

AI will typically gather public data points from social media, news, financial statements, analyst reports, and more to help determine the market’s sentiment on stocks. AI models can simplify the process of finding promising investments by examining financial data and identifying traits correlated with outperformance. Based on this, it can predict which businesses are likely to continue performing well and transform this research into a list of stocks for fund managers, increasing their productivity. Some AI models may also use this research to recommend how much of a stock to buy. Some ETFs, like the Amplify AI Powered Equity ETF (AIEQ), give their AI more freedom to choose a variety of stocks. Others, such as the WisdomTree U.S. AI Enhanced Value Fund (AIVL), focus on specific types of stocks, like undervalued stocks in AIVL's case.

Top-performing U.S. AI-powered ETFs include the BTD Capital Fund (DIP), with a YTD performance of 10.65%, and the QRAFT AI Enhanced U.S. Large Cap Momentum ETF (AMOM) at 9.91%, which is still underperforming the S&P 500 at 11.21%.

Implications

The rise of AI-powered ETFs brings significant implications for individual and institutional investors. For individual investors, this would increase the variety of actively managed ETFs, which would also be cheaper to operate than those by certified portfolio managers. Inherently, this begs the question once again, of AI’s grip on the labour force. Considering that these ETFs can be programmed to specialize in certain sectors or types of stocks, this can help investors create actively managed portfolios that align with their beliefs/styles without needing investing expertise. This development may pose a threat to current wealth management firms that specialize in public equities investing, however this would take years to materialize as investors may remain skeptical of AI-powered ETFs until they establish a successful track record. This may be difficult as the low AUM of these ETFs make them particularly volatile, however as they reach wider adoption, this would pose less of an issue.

Institutional investors may also increasingly consider special situations investing strategies to outperform the market. While AI-powered ETFs may be able to better predict short- and long-term earnings growth using economic and historical trends analysis, it’s unlikely that they can make accurate predictions of critical events like accounting fraud leading to bankruptcy or the loss of a crucial C-suite executive. These are events that are more closely predicted by analyzing subtle signals from management teams, employees, or customers, which are often unique to the circumstances, thereby limiting the potential for AI to effectively predict them.

AI-powered ETFs may have a long way to go till they are trusted by the public, but their introduction and accelerating adoption points towards a future which further lowers the cost and accessibility barriers of investing in the markets.

MERGER AND ACQUISITION

CAPITAL ONE & DISCOVERY SEND SHOCKWAVES THROUGH INDUSTRY REGULATIONS AND NORM’S

Firm(s) Background:

Capital One Financial Corporation serves as the holding company for Capital One, National Association, offering a range of financial products and services in the United States, Canada, and the United Kingdom. It operates through three main segments: Credit Card, Consumer Banking, and Commercial Banking. The company accepts various types of deposits including checking accounts, money market deposits, negotiable order of withdrawals, savings deposits, and time deposits. Its loan portfolio includes credit card loans, auto loans, retail banking loans, commercial and multifamily real estate loans, and commercial and industrial loans. Additionally, Capital One provides credit and debit card products, online direct banking services, as well as advisory services, capital markets solutions, treasury management, and depository services. The company caters to consumers, small businesses, and commercial clients through digital channels, branches, cafés, and other distribution channels throughout many states across the United States. Founded in 1988, Capital One is headquartered in McLean, Virginia.

Discover Financial Services, through its subsidiaries, provides digital banking products and services, and payment services in the United States. The Digital Banking segment offers Discover-branded credit cards to individuals; private student loans, personal loans, home loans, and other consumer lending; and direct-to-consumer deposit products comprising savings accounts, certificates of deposit, money market accounts, IRA certificates of deposit, IRA savings accounts and checking accounts, and sweep accounts. The Payment Services segment operates the PULSE to access automated teller machines, debit, and electronic funds transfer network; and Diners Club International, payments network that issues Diners Club branded charge cards and/or provides card acceptance services, as well as offers payment transaction processing and settlement services. The company was incorporated in 1960 and is based in Riverwoods, Illinois.

Deal Breakdown:

Capital One Financial Corporation (NYSE:COF) entered into a definitive agreement to acquire Discover Financial Services (NYSE:DFS) for $35.3 billion on February 19, 2024. Under the terms of the agreement, Discover shareholders will receive 1.0192 Capital One shares for each Discover share, representing a premium of 26.6% based on Discover's closing price of $110.49 on February 16, 2024. Transaction is 100% stock consideration. At close, Capital One shareholders will own approximately 60% and Discover shareholders will own approximately 40% of the combined company. representing a premium of 26.6% based on Discover's closing price of $110.49 on February 16, 2024. Transaction is 100% stock consideration.

The proposed acquisition comes at a time when consumers are shifting more of their payments from cash to credit cards. Cash payments in retail stores declined 25 percent from 2017 to 2022, with shoppers now paying for 70 percent of all retail purchases—including in-person and online—with credit or debit cards.

Deal Implications:

The proposed combination of two major players has drawn scrutiny from regulators. If approved, Capital One would become the sixth-largest bank in the United States, with more than $450 million in deposits, while owning the fourth-largest credit-card payment network.

Thanks to a unique loophole in the credit card industry, Discover is allowed to give consumers something that Visa and Mastercard are not: cash-back rewards on their debit cards. This is courtesy of the 2010 Durbin Amendment, passed as part of the Dodd-Frank reforms in the wake of the financial crisis.

The amendment capped the interchange fees on debit cards for large banks. With those fees capped and profit margins crunched, banks stopped giving debit-card customers rewards for purchases. But the law only applies to open networks like Visa and Mastercard that work with many banks and not to proprietary networks like Discover and American Express. So, Capital One could conceivably issue rewards debit cards through Discover, which would make Discover more attractive to a new customer base.

FINANCIAL CONCEPT OF THE MONTH

BETA

Background:

Beta measures a stock's volatility relative to the market. A beta of 1 indicates that the stock moves in line with the market and lacks any variance. A beta greater than 1 signifies that the stock is more volatile than the market, while a beta less than 1 indicates that the stock is less volatile than the market.

Unlevered Beta:

Levered Beta/ [1+(1-Tax rate)*(Debt/Equity)]

Unlevered Beta measures market risk without the impact of debt. This isolates the risk solely due to company assets and operations. Unlevered beta removes any beneficial or detrimental effects of adding debt such as bankruptcy risk which would in theory increase the cost of debt. Debt levels can affect sensitivity to stock prices. Removing the debt can give a clearer picture of a company’s operating volatility. This makes unlevered beta a useful metric for comparing the risk of different companies in the same industry, as it provides a pure measure of business and equity risk.

Levered Beta:

Unlevered Beta*[1+(1-Tax Rate)*(Debt/Equity)]

Levered Beta measures the market risk but this time it is affected by the company’s debt. This type of beta reflects both business risk and financial risk. Financial risk comes from the company's capital structure, particularly the use of debt financing. A company with higher leverage (more debt) will have a higher levered beta, indicating greater risk to equity holders due to the obligation to service debt. This type of beta is used to calculate the CAPM formula to determine the cost of equity.

Examples of low Beta companies/industries

Utility companies

Explanation: In the age of modern house development, global warming, and population growth, the need for utilities also grows quite inevitable but never experiences R&D booms or makes irrational liquidation decisions for CapEx.

Walmart

Explanation: Discount wholesale grocers are an essential service for almost 11% of the Canadian population (low-income consumers), creating stable operating cashflows.

Examples of high Beta companies/industries:

Technology

Explanation: High levels of innovation, R&D and thus Capital Expenditures that may exceed cash inflows

Discretionary spending(travel)

Explanation: Cyclical demand and thus earnings, combined with it’s classification as a non-essential service make it extremely difficult, especially when paired with necessary government intervention (COVID-19)

Oil and Gas

Explanation: Political tensions (OPEC+) and its designation as a fossil fuel make company cashflows extremely volatile

RECRUITING QUESTION

How can you use un-levered and levered beta concepts to find the beta of a company?

Once again, Beta can be thought of as the “riskiness” of a company. That risk can be broken down into company risk and capital structure risk. Company risk represents the risk that is inherent to the company's operations and the industry in which it operates. Capital structure risk refers to the risk created by the structure in which the company is financed (debt vs. equity).

When trying to find the beta of a company, a technique often used is to look at comparable company’s betas to find a median and use that to estimate what our beta might be. The problem with this is that we are finding companies that are comparable from an operating perspective (eg. size, industry, geography). This does not necessarily mean that the companies have similar capital structures.

Therefore, we need to un-lever our comparable company's betas before finding their median. This gives us our companies un-levered beta and we can proceed to re-lever it with our own capital structure using the formula: Remember...

Levered Beta = [Unlevered Beta] x [1 + (D/E) x (1 - Tax Rate)]

How do you treat Preferred Stock in the formulas for Beta?

You should treat preferred stock as equity for the purpose of this calculation. This is because the dividends paid out from preferred shares are not tax deductible, unlike the interest paid on debt.

How do changes in taxes affect beta and WACC?

Effect of Taxes on Beta

To understand the impact of taxes on beta, we can refer to the formula for levered beta:

Levered Beta = [Unlevered Beta] x [1 + (D/E) x (1 - Tax Rate)]

Mathematically, an increase in taxes decreases levered beta, while a decrease in taxes increases levered beta. For example, consider the following:

Unlevered Beta = 1.7; Debt/Equity Ratio (D/E) = 2; Tax Rate = 30%

Using these values:

Levered Beta = 1.7 x [1 + 2 x (1 - 0.30)] = 4.08

If the tax rate increases to 50%:

Levered Beta = 1.7 x [1 + 2 x (1 - 0.50)] = 3.4

Impact of Changes in Beta on WACC

When using the Capital Asset Pricing Model (CAPM), an increase in beta results in a higher cost of equity, while a decrease in beta leads to a lower cost of equity. This, in turn, influences the Weighted Average Cost of Capital (WACC).

WACC = [Cost of Preferred x % of Preferred] + [Cost of Equity x % of Equity] + [Cost of Debt x % of Debt] x [1 - Tax Rate]

If beta increases, the cost of equity rises, increasing the overall WACC.

If beta decreases, the cost of equity falls, lowering the overall WACC.

Conceptual Understanding

Conceptually, a decrease in the tax rate reduces the tax shield, thereby increasing the effect of interest and making equity riskier. Conversely, an increase in the tax rate enhances the tax shield, reducing the effect of interest and making equity less risky.

BONUS: Effect of Taxes on the Cost of Debt

Taxes also affect the cost of debt in the WACC calculation. An increase in taxes will typically increase the cost of debt, while a decrease in taxes will decrease the cost of debt, due to the impact of the tax shield on interest expenses.