“History doesn’t repeat itself, but it does rhyme” – attributed to Mark Twain
Financial market participants spend much of their time fretting over various factors, events or outcomes that could upset their investment thesis. This is readily apparent as we see trade wars causing concern as well as negative interest rates and inverted yield curves signalling economic slowdowns.
The abrupt change in how the United States views trade with the rest of the world has added an extra level of
uncertainty to financial markets. Trade concerns between China and the U.S. began in 2018 and have progressively worsened, as each country has dug in its respective heels. At the recent G20 meetings in Japan, there was some hope among investors that a grand deal would be struck and global trade between the two largest economies would resume in a more familiar fashion. However, a comprehensive agreement is very
unlikely in the near term, and quite possibly in the medium term depending on the 2020 U.S. Presidential election outcome. The reason behind this is that Robert Lighthizer, the U.S. Trade Representative, will only agree to a deal that provides significant advantages for the U.S. China, on the other hand, is unlikely to agree to any severe concessions based on a growing economy and the chance that a less confrontational leader is elected during the 2020 Presidential election.
Interest rates continue to provide classic signals that have previously foreshadowed bear markets, or declining stock prices. Bond markets are pricing in significant trouble ahead as yields are negative in many economies throughout Europe. As shown in the table below, negative yields exist from 6-month maturities all the way out to 15 years for Switzerland and Germany. This is a combination of extraordinary monetary policy implemented by the outgoing European Central Bank president Mario Draghi, and persistent economic weakness in Europe.
Inverted yield curves are another concern for market participants, as they generally precede recessions and bear markets. Both Canada and the more important U.S. Treasury market are experiencing inverted yield curves, with the benchmark short-term T-bill rates higher than 10-year government bonds.
Several other issues are creating worry. Britain seems likely to leave the European Union without a trade agreement before the end of the year. Meanwhile margin debt on the New York Stock Exchange, remains elevated (see Yardeni® graph). With hindsight, we can see that prior peaks in margin leverage in 1999 and 2007 foreshadowed difficult years for the stock market as credit unwound. Corporate profit growth is slowing while corporate debt offerings have expanded rapidly over the last decade given low and attractive interest rates. This is potentially a bad combination in the long term, but for the most part, investors seem to be ignoring this. For instance, “in the second quarter, over 60 IPO’s raised $25 billion on the U.S. market, the most active quarter by deal count and the most capital raised in the U.S. in five years. The average return was an eye-popping 30%” according to Renaissance Capital. Technology IPO’s were leading the charge with strong risk-taking behavior. In the unlikely event that this IPO pace was maintained, “we could hit the all-time record of $96.9 billion raised on U.S. markets in 2000, which was the height of the internet bubble” according to CNBC.
While the Global stock market is giving us some potentially worrying signals at present, a close look at the North American companies within our investment strategies doesn’t provide the same conclusions. In fact, some divergences in the market highlight attractive differentials on a relative and absolute basis. In the Scotiabank GBM® graph to the right, one can see the valuation differential expanding between the U.S. technology and financials sectors over 25 years. The rising blue line shows technology stocks becoming richly valued versus financial stocks. We invest in certain technology companies and have large positions in financials that are relatively inexpensive on both sides of the border. All else being equal, we will choose to invest in more of the less expensive company with dividend growth. Our focus is to generate sustainable long-term returns through all market cycles.
While we are fully aware of the potential troubles facing Global capital markets it is important to remember that what we refer to as ‘the stock market’ is a collection of businesses, not one large homogeneous entity. At BCV, we continually research and follow select North American companies to ensure we are investing in those that are resilient and can manage through difficult environments while growing their dividends. In fixed income allocations, we continue to avoid sovereign bonds with negative or negligible yields and buy bonds of credit worthy companies with relatively attractive yields.
Capital preservation, investment appreciation, dividend growth, and downside risk mitigation are aspects we strive to achieve daily for our clients. We look to understand Global and North American risks within capital markets and make educated investment decisions in our investment strategies. As a client, you have trusted us in the management of your investment portfolio and your future; something that we do not take for granted.
As North American markets close in on attaining new highs, investors may begin asking, “is it a good time to invest more capital into the market or sell?”, also know as “Timing the Market”.
No one can accurately predict the market on a consistent basis, especially over the long term. A market timer would have to be correct in their trading habits more than 74% of the time to beat the performance of a fully-invested portfolio according to research by Nobel Laureate William Sharpe. This then begs the question of why do investors, and more specifically, why do professional investors continue with this ill-fated pursuit of timing the market?
We believe there are two potential reasons: 1) a lack of conviction in their own investment strategy; and/or 2) they have an overconfidence bias (having the tendency to be more confident in one’s own abilities than what is objectively reasonable).
Even if an investor is correct in exiting at the market high point, they would have to enter back in at the correct or appropriate time. The following chart by Morningstar (a global financial services and research firm) puts this theory into perspective, highlighting that missing a handful of the best days can hinder a portfolio’s performance dramatically. For example, missing the best 10 market performing days reduces a portfolio’s performance by over half of what it would have been had the investor simply remained fully invested.
At BCV, since we remain fully invested, our clients have benefited from the bullish market performance. With the market biased towards monetary easing, both the fixed income and equity markets are thriving.
The two charts below break out investment performance over the past 10 years and 2019 year-to-date as of Q2, 2019 (by asset class) for both Canada (Chart 1) and the United States (Chart 2). The top tile in each column, represents the best performing asset class for that year, while the bottom tile in the column represents the worst performing asset class. Asset classes are color coded to provide an easy visual reference when reviewing the charts.
Large Cap companies (yellow tiles), which are companies with greater than $10 billion of market capitalization, are an asset class that represents BCV’s equity investment philosophy and strategy, while Canadian corporate bonds represent BCV’s Canadian fixed income strategy.
In the U.S. markets, Large Cap stocks (yellow tiles) perform well again – mainly in the upper two-thirds of the universe. Year-to-date this asset class is up 18%!
What does this all mean? Timing the market is ineffective and extremely difficult; a large capitalization strategy for equities has generated very reasonable returns over time; and generally, the markets have been performing well recently. But you are “still nervous about the markets”. Clients can take comfort in our process of building concentrated portfolios of high-quality securities. This means that client portfolios are not “the market”, but a portion of the market. In the Canadian S&P/TSX Composite Index, there are approximately 250 companies; our model portfolios own 21 of these companies. In the United States, the S&P500 there are approximately 500 companies; our model portfolios own 19. These are a small sub-set of high-quality businesses. Ignore the macro headlines. At BCV, we are bottom-up focused Portfolio Managers.
Why own the market when you can own high quality at an attractive price? We follow and conduct research on our companies regularly, evaluating their fundamentals and valuations, and deliberate this within our team of investment professionals to decide what is best for you, the client. In other words, adhering to our Fiduciary Duty, which is an obligation to act solely in the best interest of our clients and a requirement of our registration as Portfolio Managers. Regardless of what the market is doing, we will make changes to portfolios when
attractive opportunities are available to purchase high quality businesses. The same that we did in late 2018 and early 2019 and the same that we will continue to do so in the future.
At the end of Q2 2019, the S&P/TSX Composite Total Return Index is up 16.2%, and the U.S. Equity market as measured by the S&P500 Total Return Index is up 18.5% (Source: Factset).
“Some people are making such thorough preparation for rainy days that they aren’t enjoying today’s sunshine”
– William Feather
I was thinking about uncertainty today, shortly after rainfall accumulated in the front seats of my Jeep. With the top off, I was taking a risk that it wouldn’t rain; but alas, the 10% probability soared to 100%.
Uncertainty is a fact of life. It is particularly evident in financial markets, where it is the norm rather than the exception. Lately though, it seems to have become much more prevalent. Whether it’s U.S. Federal Reserve policy, potential impacts from trade tariffs between two super powers, or forecasts of economic growth, market participants are regularly subjected to countless uncertainties. The Board of Governors of the U.S. Federal Reserve mention the term “uncertainty” over 300 times in their latest annual report. These uncertainties can have immediate, and in some cases significant impacts on equity prices. So how do you go about managing investment portfolios in such an environment and is there a way we can reduce the effects of unknown events?
All businesses face uncertainty. These uncertainties can’t be eliminated completely, but they can be managed or mitigated. One of the key ways that BCV manages and mitigates uncertainty is by investing in companies that have certain characteristics, either financial or non-financial. The three broad areas we consider are strategy, financial strength and operational.
Some businesses have strategies that can successfully counteract the effects of uncertainty. Suncor Energy (TSX) is an example. Oil prices are notoriously difficult to predict. This makes it challenging for oil producers to forecast production and financial results. Suncor; however, has vertically integrated refining into its business strategy. When oil prices fall, the impact to the producing operations is offset by their refining which benefits from reduced input costs. As a result, Suncor is partially protected or hedged from fluctuating oil prices.
Financial strategies are another tactic that can be used when facing an uncertain economic environment. When faced with an economic downturn or reduced demand for a product, companies that have low levels of debt, high cash balances, and flexibility will be the ones that succeed through the difficult times. Apple Inc. (NASDAQ) is a case in point. During its most recent quarter end, Apple reported approximately 80 billion dollars of cash and short-term investments on their balance sheet. To put that in perspective, Apple’s quarterly operating expenses were around 8.5 billion dollars. Without selling a single iPhone or MacBook, Apple could sustain their operations for almost two and a half years with just their cash on hand.
Operational flexibility is also key in how companies manage uncertainty. The ability to adapt during down times is critical in maintaining cash flows and profitability. Companies that have a low proportion of fixed assets relative to labour can often transition through rough periods with less stress. Stantec Inc. (TSX); an engineering and design firm, can reduce their engineer headcount if business slows dramatically, keeping cost reductions in line with revenues. Businesses with larger fixed costs, such as Canadian National Railway (TSX), can still manage downturns, largely because they operate an asset that can’t easily be replaced or replicated in an industry with high barriers of entry.
There will always be clouds of uncertainty on the horizon; particularly in the financial markets but know that these are normal and expected. Our focus will continue to be on researching quality businesses that have the financial strength and operational flexibility to survive even the harshest economic conditions. You can rest assured that your investment portfolio comes with an umbrella (or at least a Jeep with the top on).
Canada
First Quarter 2019:
Bank of Montreal: 100 cents (96 cents)
Brookfield Asset Management Inc.: 16 cents (15 cents)*
Brookfield Property Partners LP: 33 cents (31.5 cents)*
Canadian National Railway Company: 53.75 cents (45.5 cents)
Canadian Western Bank: 27 cents (26 cents)
Enbridge Inc.: 73.8 cents (67.1 cents)
Intact Financial Corporation: 76 cents (70 cents)
National Bank of Canada: 65 cents (62 cents)
Suncor Energy Inc.: 42 cents (36 cents)
Second Quarter 2019:
Bank of Nova Scotia: 87 cents (85 cents)
Canadian Imperial Bank of Commerce: 140 cents (136 cents)
Canadian Natural Resources Ltd.: 37.5 cents (33.5 cents)
Open Text Corporation: 17.46 cents (15.18 cents)*
Power Financial Corporation: 45.55 cents (43.3 cents)
Royal Bank of Canada: 102 cents (98 cents)
Sun Life Financial Inc.: 52.5 cents (50 cents)
Stantec Inc.: 14.5 cents (13.75 cents)
Toronto-Dominion Bank: 74 cents (67 cents)
TransCanada Corporation: 75 cents (69 cents)
Third Quarter 2019 (Pending):
Algonquin Power & Utilities Corporation: 14.10 cents (12.82 cents)*
National Bank of Canada: 68 cents (65 cents)