Monthly commentary - Mackenzie Ivy Team

Portfolio Manager Monthly Insights

Adam Gofton, CFA
Vice President, Portfolio Manager
Mackenzie Ivy Foreign Equity Fund

After holding Costco for well over ten years, we made the decision to exit our holding in late Q2 of 2024. Our view was that Costco’s share price level at the time would make it difficult for shareholders to earn an attractive go-forward rate of return. Despite selling our position, we continue to view Costco as a very high-quality company. Below, we explain why, providing insight into how the Ivy team assesses quality. The decision also highlights an important component of Ivy’s investment philosophy, valuation discipline. Long-term share price returns can be broken down into earnings growth and changes in earnings multiple. Valuation discipline ensures the benefits of earnings growth are not overwhelmed by paying a too demanding share price.

Why Costco is high quality

One of the foundational elements of quality for Ivy is a company that has an identifiable competitive advantage and continually invests to maintain that edge over the long term. Costco has been exemplary in that manner.

The root of Costco’s advantage is its low-cost business model that allows the retailer to offer the best prices to consumers on a limited selection of merchandise. All of Costco’s processes are oriented around its low-cost position. For example:

• Sourcing: Costco carries about 4,000 products, compared to other retailers’ 40,000+, focusing its negotiating power on a limited subset.
• Distribution: The warehouse doubles as the sales floor, with many items being “club ready,” meaning consumers are the first to touch individual products.
• Labour: Costco pays higher wages than typical retailers, resulting in lower turnover, reduced training costs, lower employee theft, and happier employees who provide better service. Additionally, restricted store hours reduce labour intensity.

Costco’s low-cost business model is also reinforced with cultural practices. Costco limits the mark-up that its merchants can make to 14% on branded products and 15% on private label products. A story used to reinforce this practice is of a buyer who found several thousands of Calvin Klein jeans for a unit price of $22 that were selling for $40 elsewhere. The buyer wanted to mark them up to $28, noting they would still sell out quickly given the price gap, but the Costco CEO insisted that they not be marked up beyond $25 to help reinforce the reputation of Costco offering extreme value to consumers. Beyond pricing, frugalness also pervades the culture, which finds its way back to consumers in the form of lower prices. On a headquarter visit, we were surprised to see the cost saving measure of pushing six small tables together to form a large board table that could seat 30 people.

Costco does not rest on its laurels and continually invests in its competitive advantage centered on offering extreme value to consumers. One example is through vertical integration into chicken processing and nut roasting where Costco can use its scale to help plants operate more efficiently (which then gets passed through to consumers in the form of lower prices). Another example is the continued expansion of Costco’s Kirkland Signature private label offerings where Costco insists on a quality level that meets or exceeds national brands while offering a lower price point.

Why we sold our position in Costco

When we are asked to sum up our investment philosophy in a single line, we usually say “high-quality companies at reasonable prices.” And while Costco has the high-quality piece in spades, the “reasonable price” aspect of our philosophy became increasingly challenged to the point that we ultimately exited our holding late in the second quarter of 2024. Due to Costco being of such high quality, we maintained a holding in the company for an extended period at a valuation level that would typically make us shudder for companies of only average quality. Our expected return for Costco declined to such a low level relative to our other holdings that even holding a lower-than-average weight became no longer tenable for us.

Making decisions based on low expected return can be frustrating as share prices often defy gravity and trade based on sentiment in the short term. In fact, since our sale, the Costco one-year forward P/E multiple according to Bloomberg has indeed expanded from 47x to 50x and the share price has increased further. However, over the long term, we are of firm belief that share prices ultimately reflect underlying business fundamentals. We expect it will be difficult for Costco shareholders to earn an attractive return unless business growth accelerates meaningfully from historical levels (with added difficulty points from margin levels at Costco also being higher than historical). Simply put, great businesses are not always great investments.

We also note that high valuations can signal high expectations, and that small hiccups are more likely to cause violent share price reactions to fully valued stocks. Assuming our assessment of business quality remains stable, Costco may be a candidate to re-enter the portfolio, but such a decision would be dependent on a share price that represents an attractive expected return and quality profile relative to other holdings. We will be patient and exercise valuation discipline; two of the Ivy team’s core principles.

Broader implications

The slowing global growth trajectory and related central bank actions have been key items in the news headlines year-to-date in 2024. In response, the market appears to be putting more demanding price levels on securities where recent results have been uncontroversial and where there is limited exposure to a slowing economy. As is typical when certain securities become dearer to the market and price levels rise, Ivy incrementally reallocates capital into more attractive opportunities. Such opportunities typically present themselves when there is some near-term uncertainty the market is grappling with, but where we remain confident in the long-term prospects for the business.

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This document may contain forward-looking information which reflect our or third party current expectations or forecasts of future events. Forward-looking information is inherently subject to, among other things, risks, uncertainties and assumptions that could cause actual results to differ materially from those expressed herein. These risks, uncertainties and assumptions include, without limitation, general economic, political and market factors, interest and foreign exchange rates, the volatility of equity and capital markets, business competition, technological change, changes in government regulations, changes in tax laws, unexpected judicial or regulatory proceedings and catastrophic events. Please consider these and other factors carefully and not place undue reliance on forward-looking information. The forward-looking information contained herein is current only as of September 23, 2024. There should be no expectation that such information will in all circumstances be updated, supplemented or revised whether as a result of new information, changing circumstances, future events or otherwise.

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