August 2018 Update

Our value stocks performed well in July. Notable performers include Canadian natural gas companies and US pipelines, along with AGT Foods which received a management buyout offer only weeks after we purchased shares. At the same time, glamour stocks began to unwind from peak territory as I’ve been expecting for some time. Notably, Facebook and Netflix each sank over 20% after falling short of their earnings expectations.

With value stocks finally seeing positive momentum and glamour stocks missing their marks, I believe we are witnessing the beginning of the most important shift in investor psychology since 2008.

Over the last ten years, expensive glamour stocks have massively and uncharacteristically outperformed their cheap value counterparts by a wide margin. This stands in sharp contrast to market history and common sense, where the cheapest stocks earn the best return, not the most expensive. At this point the vast majority of investors have become enamoured with the glamour trade, making it ripe for a turn.

The principal catalyst for this turn, for value to outperform glamour going forward, is higher interest rates.

Glamour stocks have little cashflow today, with most of their cashflow anticipated in the future. Higher rates make glamour stocks less attractive because they shrink the value of all that future cashflow, causing a lot of pain for stock holders who must, in turn, lower their expectations.

For value stocks we observe the opposite. Since the cashflows and asset value of cheap value stocks is immediate and in the present, value stocks become relatively attractive and tend to produce strongly positive returns as investors seek out safer habours.

Cheap value stocks today are found in all the usual places: amongst the unloved, the ignored, the downtrodden, and the disappointed. Here we’ve purchased companies for 50 to 60 cents on the dollar including precious metals producers, energy producers, food processors and distributors, and bricks and mortar retail. With patience, we’ll realize full value on our companies and earn a good return for our efforts. But patience isn’t easy, if it was, it wouldn’t be so rewarding.

It goes without saying that I think the experience of glamour stock investors henceforth will be less rewarding – more akin to technology investors following the year 2000. Chasing trends without fundamental company research has never been a path to long term success.

In a world of glamour investors, value is the underdog. Growing up I always enjoyed rooting for the underdog, and still do. Not only was there more satisfaction in the win, but the payoff was always better too. Our portfolios are heavily aligned to benefit from our emerging value underdogs and I anticipate significant upside ahead for our holdings.

Interesting links

More on value versus growth investing https://www.marketwatch.com/story/after-a-decade-of-wins-the-end-may-be-near-for-one-of-wall-streets-best-stock-trades-2018-07-30

A look at global housing leverage https://latest.13d.com/boom-global-megacities-bust-contagion-economy-real-estate-30d0951e21bc

Cordially,

Ben W. Kizemchuk
Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth

July 2018 Update

The broad investment themes supporting our companies are playing out as expected. Low supply is driving up the cost of energy resources, inflation is starting to wake up precious metals and food prices, and global economic deceleration is pushing high quality bond prices higher. When appearing in concert as they do today, these elements point to a late stage in the economic cycle. Remember that the best economic news comes at the top of the cycle, while the worst economic news comes at the bottom.

Whereas exciting “growth” stocks have outperformed boring “value” stocks over the last decade, the reverse is more likely to be true going forward. Sentiment is shifting to favour the real economy over the digital, and higher short term interest rates are pinching lofty valuations. Our portfolios are heavily aligned to benefit from this emerging trend towards value and the return of real asset and resource investing. I anticipate significant upside ahead for our holdings.

Interesting links
Some investors says an “inverted yield curve” will predict the next recession. Not so. https://www.variantperception.com/2018/06/13/will-there-be-a-yield-curve-inversion-before-the-next-recession/
Economic news is best at the top http://www.kesslercompanies.com/last-time-unemployment-3-8/
Peeling back the layers of Canada’s subprime lending https://betterdwelling.com/canada-has-a-subprime-real-estate-problem-you-just-dont-know-it/
Deeper dive on the economy https://vintagevalueinvesting.com/is-the-economy-overheating/
Perception and placebos http://slatestarcodex.com/2018/01/31/powerless-placebos/

Cordially,

Ben W. Kizemchuk
Portfolio Manager & Investment Advisor

June 2018 Update

Our largest portfolio positions continue to benefit as expected. Our energy companies received good news in May with the Canadian government’s support of the Trans Mountain Pipeline, along with improving natural gas and crude prices. Our precious metals companies benefited from increasing government support in their mining jurisdictions, along with support from higher commodity prices. Our bonds saw significant appreciation as global economic conditions decelerate, as I’ve been expecting for some time. In all cases, a combination of low purchase prices and low consensus expectations setup a promising foundation for our investments. I anticipate more upside ahead for our holdings.

The consensus investor today holds the largest position in growth stocks, high yield bonds, credit, and real estate in history, while holding the relatively smallest position in government bonds, gold, energy, and cash in history. This reflects the tendency of the public to invest by looking in the rear view mirror, chasing short term performance and naïve trend following instead of judging a security based on it’s intrinsic value. Our positions stand to benefit as the tide shifts back towards reality. 

Interesting links

Stocks aren’t the only inefficient market: https://www.bloomberg.com/news/features/2018-05-03/the-gambler-who-cracked-the-horse-racing-code

There will be stories for decades: https://betterdwelling.com/boc-8-of-canadian-households-owe-more-than-20-of-the-2-1-trillion-in-debt/

Value stocks emerging as the new heroes: http://eastwestfunds.com/research/value-vs-growth-a-decade-long-pause-provides-great-entry/

What do google search trends tell us about the health of the economy?  https://twitter.com/jessefelder/status/999307524674392064/photo/1

The next big market mistake: https://latest.13d.com/liquidity-new-leverage-regulation-algorithmic-investing-qt-bond-equity-markets-7b7f97c57cc5

Cordially,

Ben W. Kizemchuk
Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth
www.growthandincome.ca
www.wellington-altus.ca

(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
M5E 1J4

May 2018 Update

April was one of our best months on record for the Growth Portfolio. Our largest holdings, gold and energy producers, saw significant price appreciation. A combination of low purchase prices and low consensus expectations setup a promising foundation for our investments, so when several pieces of good news came out in April, buying interest sparked up quickly. Consensus expectations for our companies are still far too low, so I anticipate more upside ahead.

In regards to our defensive bond position, the economic slowdown that I’ve been anticipating is taking hold. Short term interest rates have been rising, making loans more expensive for borrowers. Consumer loan delinquencies are rising, including credit card receivables, auto loans, and some lines of credit. Applications for consumer proposals are now rising. Historically, once these types of loans start experiencing trouble after a long period of calm, recession is not far away. The Income Portfolio’s bonds protect and benefit as the economy slows.

Most people believe interest rates are rising because of economic growth. What they misunderstand is that rates are rising in spite of a slowing real economy. What looks like economic growth and inflation to the general public is tomorrow’s consumption being pulled forward to today by debt-fueled spending. When tomorrow’s dollars are borrowed and spent today, there is less demand left for tomorrow. If we net-out the effects of tax-cut deficit spending by the US government, economic activity is meager at best. Therefore, hiking interest rates will likely weaken conditions into a recession faster than expected.

Such was the case in 2007, when central banks hiked rates to combat what they thought was inflation at the time, all the while steering the economy into recession.

While rising interest rates garner most of the attention in the news, few investors notice there are even more meaningful central bank policy actions on the horizon. Central banks are now slowing their purchase programs of stocks, bonds and mortgages (called “quantitative easing”). These programs have been in place since 2009 to help support economic recovery by providing liquidity. By this time next year, central banks will have started to sell off those stocks, bonds and mortgages, withdrawing liquidity from the economy. This amounts to a coordinated and synchronized global deflation.

Most investors are not adequately prepared for this outcome. The consensus investor today holds the largest position in stocks and real estate in history, while holding the relatively smallest position in government bonds, gold, energy, and cash in history. This reflects the tendency of the public to invest by looking in the rear view mirror, impressed by short term outcomes and naive speculation. Whereas they characteristically ignore the warning signs of excess, we are prepared to benefit from what comes ahead.

Interesting links
Good news for energy stocks: http://blog.knowledgeleaderscapital.com/?p=14069
Consumer proposals are on the rise: https://betterdwelling.com/canadians-seeking-early-intervention-from-bankruptcy-spikes-to-a-new-january-record/
Canada’s housing market dominos: https://www.thestar.com/business/2018/04/04/they-bought-their-prebuilt-homes-at-the-markets-peak-now-they-face-financial-ruin.html
The risk hidden inside today’s most popular investment strategy: https://latest.13d.com/big-tech-passive-algorithmic-investing-more-pain-market-action-threats-8e25503fd1e4
Hunter S Thompson on leading a good life: https://www.fs.blog/2014/05/hunter-s-thompson-to-hume-logan/

Cordially,

Ben W. Kizemchuk

Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth
www.growthandincome.ca
www.altusinvest.ca
(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
M5E 1J4

All opinions and estimates contained in this report constitute the judgement of Ben W Kizemchuk of Wellington-Altus Private Wealth as of the date of this report and are subject to change without notice. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.

April 2018 Update

We continue to maintain a defensive position across our portfolios. We are holding a larger than usual amount of cash, government bonds, and commodity producers, with a reduced exposure to equities.

The five charts below illustrate my thoughts about the market, and how we are positioned to take advantage.

The first chart measures stock market valuation -- how much investors are willing to pay for $1 of corporate earnings. Valuations match levels seen only before the Great Crash of 1929 (stock market then fell 90%), and the DotCom Crash of 2001 (stock market fell 46%). The average stock is too expensive, hence risky. That makes the best performing stocks of the last year even riskier. Hence, I view the market and consensus growth expectations with a fair amount of skepticism and caution.

The second chart measures investor euphoria – how excited investors are about owning stocks. We can measure this by observing the amount of cash in US brokerage accounts relative to the size of the stock market. When the blue line is low, there is less cash because investors have spent it on stocks. Today’s current level of excitement has coincided with investors going “all-in” at past stock market peaks. As a countermeasure against this euphoria, 30% of our Canadian Growth Portfolio is in cash, 12% of our American Growth Portfolio is in cash, and 22% of our Small Cap Value Portfolio is in cash.

The markets are expensive, and investors can’t seem to own enough stock – a perfect recipe for a tidal wave of risk in my opinion.

When it comes to stocks, not all of them are expensive, just most of them. We always want to be defensive with our stocks by owning what’s cheap. The third chart below shows the relative value between stocks and commodities. When the blue line is low, commodities are relatively cheap, and when the blue line is high, stocks are relatively cheap. The chart shows that commodities are at their cheapest value since 2000, and match the early 1970s before that. I expect commodities to significantly increase in price as they did after both prior occasions. Our Canadian stock portfolios own large interests in gold, silver, oil, and natural gas producers to take the advantage.

The fourth chart below highlights our particular interest in precious metals, with an emphasis on silver. The high price of gold bullion relative to silver bullion has reliably marked the start of strong periods of outperformance by precious metals. Our largest individual position in the Canadian Growth Portfolio is a silver miner.

Our fifth chart shows another place to find shelter. This chart measures investor sentiment for 10-year government treasury bonds, which tend to act as a safe haven in times of market turmoil. When the blue line is high, treasury bonds are unpopular and cheap, and when the blue line is low, treasury bonds are popular and expensive. The chart shows bonds haven’t been this unpopular and cheap since the mid 2000s. Most of our Income Portfolio holds long term government bonds, which I expect to increase in price. Of note, we hold zero so-called “blue chip” dividend stocks – they are too risky at this time due to excessive valuation, as per the first chart.

The final bonus chart is the most important of all. Investing obeys two of life’s core principles: there is no growth without pain, and everything moves in cycles. With commodity stocks and bonds so cheap and out of favour, our portfolios are at the point of maximum financial opportunity for intelligent investors.

Interesting links

Higher interest rates are slowing the economy: http://business.financialpost.com/personal-finance/debt/these-charts-show-higher-canadian-rates-are-starting-to-bite

Canada has too much debt to escape a major recession: https://www.bloomberg.com/news/articles/2018-03-13/consumer-debt-binge-draws-moody-s-warning-for-canadian-banks

Detachment from the outcome is a key attribute of successful investors: https://intelligentfanatics.com/forums/topic/the-power-of-detachment/

A list of powerful ideas: http://www.collaborativefund.com/blog/ideas-that-changed-my-life/

Cordially,

Ben W. Kizemchuk

Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth
www.growthandincome.ca
www.altusinvest.ca
(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
M5E 1J4

All opinions and estimates contained in this report constitute the judgement of Ben W Kizemchuk of Wellington-Altus Private Wealth as of the date of this report and are subject to change without notice. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.

March 2018 Update

We continue to maintain a defensive position across our portfolios. We are holding a larger than usual amount of cash, government bonds, and commodity producers, with a reduced exposure to equities.

Warren Buffett’s company Berkshire Hathaway released their annual shareholder letter last weekend to the delight of many value investors. Buffett mentioned that he was a net buyer of securities throughout the year, but expressed a cautious tone about today’s valuations. I agree with his perspective that while there are many well run companies, their trading prices are generally too high to ensure an adequate margin of safety. In other words, higher prices have increased risk. At present, Berkshire’s portfolio is invested about $191 Billion in stocks and $116 Billion in cash, a roughly similar composition to our Growth Portfolio’s 30% cash position. And like Buffett, I too await lower prices so we can make lower risk purchases.

As illustrated in the graph below, stock prices relative to earnings match levels seen only before the Great Crash of 1929 and the DotCom Crash of 2001. With nine years since the last major downcycle in stocks, it bears reminding that all markets are cyclical, and sticking to defensive principles is the only way to win the long game. In the short run when prices are elevated as they are today, that means we underperform because we will not do the risky things everyone else believes are normal. In the long run, it means we survive and protect capital.

In early February we saw the first signs of a large (and anticipated) increase in market volatility. Investors should remember that the market is here to serve us, not guide us. Often times market prices over and under-react to various news items, and we will take advantage of that volatility to buy companies with strong operations and valuable assets at a cheap price. Just because someone is willing to sell us a share of a business at a low price doesn’t necessarily mean that’s what the share is actually worth to a more prudent long term buyer. We should be quite happy to see more volatility, because it allows us to deploy our cash into bargain purchases, investing for the long term.

Interesting links

More of today’s best investors raising cash: http://business.financialpost.com/news/fp-street/brookfield-selling-assets-to-build-war-chest-for-next-downturn

Investor discipline and sticking to your style: http://mebfaber.com/2016/01/05/how-to-beat-98-of-all-mutual-funds/

Stop reading the news: https://www.fs.blog/2013/12/stop-reading-news/

Natural gas bull market: https://latest.13d.com/natural-gas-longest-bear-markets-greatest-over-supply-always-leads-long-bull-markets-2a5e8e85f1ad

Toronto is not even close to running out of land: https://betterdwelling.com/city/toronto/researchers-destroy-narrative-greater-toronto-running-land/

Cordially,

Ben W. Kizemchuk

Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth
www.growthandincome.ca
www.altusinvest.ca
(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
M5E 1J4

All opinions and estimates contained in this report constitute the judgement of Ben W Kizemchuk of Wellington-Altus Private Wealth as of the date of this report and are subject to change without notice. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.

February 2018 Update

We continue to maintain a defensive position across our portfolios. We are holding a larger than usual amount of cash, government bonds, and commodity producers, with a reduced exposure to equities.

Incoming data suggests the Canadian and US economies will grow, but at a slower pace than consensus estimates. With market valuations now stretched to levels beyond historic comparison, slower than anticipated growth poses a significant risk to the popular rosy outlook for stocks. Although stock prices may continue higher, I believe the short-term reward of chasing such gains is not worth risking capital. My focus remains on protecting capital by reducing the risk of permanent loss, and secondly on maintaining upside potential through holding undervalued securities.

Over the past year we recorded a 25% gain in the American Growth Portfolio, while the Canadian Growth Portfolio was flat. On the topic of relative performance, one client asked me a good question that illuminates an important aspect of our value investing strategy: how could two exactly similar strategies (apart from a Canadian versus US focus) deliver such different results in a year?

In the short term, any investment outcome is the product of many factors that we cannot control. In other words, luck plays a big part in which stocks move up or down in a year. In fact, most often when we establish a new position in an out-of-favour stock, it moves down before it moves up. However if we measure over longer periods of time, we know that various short term factors lose influence, and a stock’s price reflects the long term growth earned by the business. In our strategy, I focus only on the factors that I can control, such as only buying businesses with steadily growing profits, or businesses with valuable assets, or businesses mispriced by emotional investors. By concentrating on factors under our control, our view is necessarily on the long term, which allows us to earn above average long term returns.

While most investors form a judgement about a stock or fund based on what it did over the last 365 days, I believe the growth prospects of a company have nothing to do with arbitrary astrological timing, and everything to do with that company’s intrinsic value. Sometimes that value is realized within one year, sometimes longer. In any case, we can rest assured that the availability of one year performance numbers has no bearing on a sound investment process.

This means that our Canadian and American Portfolios will produce yearly variations in performance (as demonstrated in 2017). Over longer periods these variations will average out to the long term growth rates of the businesses we own. If we do a good job in our business valuation, and buy our businesses for less than they’re worth, we have a good idea of what the long term results are likely to be -- only we don’t know when those results will be delivered. We know the destination, but not how fast we’ll get there.

If all of our businesses reached their estimated fair value tomorrow, the Canadian Growth Portfolio, American Growth, and Small Cap Value would each be up healthy double digits. Therefore, what’s more important than measuring the ebbs and flows of short term performance, is to condition and accept that we must be patient for the process to work in its own time. This is what Warren Buffett’s partner, Charlie Munger, refers to when he talks about “sit on your a** investing”. Do good valuation work, buy the company at a discount to what its worth, and then wait.

Interesting links:

“Expected value” will change your life: https://www.fs.blog/2018/01/expected-value/

Management insights from Jeff Bezos: https://www.youtube.com/watch?v=fpDUiDQigO8

More from the incomparable Charlie Munger: https://youtu.be/BLctqhNClqY?t=19m5s

 

Cordially,

Ben W. Kizemchuk

Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth
www.growthandincome.ca
www.altusinvest.ca
(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
M5E 1J4

All opinions and estimates contained in this report constitute the judgement of Ben W Kizemchuk of Wellington-Altus Private Wealth as of the date of this report and are subject to change without notice. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.

January 2018 Update

We continue to maintain a defensive position across our portfolios. We are holding a larger than usual amount of cash, government bonds, and precious metals and energy producers, with a reduced exposure to equities.

Over the past eight years we’ve witnessed a gradual shift in investor psychology, culminating in the “no fear” market of 2017. Over that time pessimism and doubt gave way to optimism and faith. Concerns about being over-invested in stocks gave way to concerns about being under-invested. Security valuation gave way to buying at any price. Due diligence gave way to companies adding “blockchain” to their names rallying +100%. Reducing debt gave way to a borrowing binge. Prudent capital ratios at the banks gave way to increasing leverage. Volatility gave way to a US market that climbed without so much as a 3% drawdown in the year. Top performing conservative money managers gave way to shutting down their funds after client withdrawals to chase the market higher. Concern about risk gave way to concern about reward. Simply, fear gave way to greed.

It is precisely in these moments of no fear that stocks, real estate, high yield bonds, and other “growth” assets are at their riskiest. Investors must always remember that no asset class enjoys the birthright of permanently high (or even positive) returns because all things move in cycles.

In 2018, it is my opinion that Canada will contend with a continuing decline in house prices, eroding household wealth and, slowing housing investment. I anticipate this will cause Canadian GDP growth to slow by about half, from 2.9% to 1.5%. In the US, tax reform will deliver a short term boost to GDP growth, yet long term effects will be muted as corporations use tax-windfall gains to buyback their shares and pay one-time dividends instead of buying capital investments. Few people remember that after the largest US tax cut in history in 1981, US stocks fell 23% over the next year as investors bought the rumour, and then sold the news. On both sides of the border, I anticipate higher short-term interest rates will slow credit growth and personal consumption. In sum, 2018 faces the double hurdle of rising short term rates and inflation plus lower long term growth – also known as stagflation. Without additional fiscal or monetary intervention, these conditions eventually lead to recession.

My focus coming into 2018 remains foremost on protecting capital by reducing investment risk, and secondly on maintaining upside potential through holding undervalued securities. Our holdings including cash, government bonds, commodities, and select “recession-proof” companies reduce risk in a rising-inflation-low-growth economy. Energy and precious metals companies benefit from rising short term interest rates and inflation. Long term bonds benefit from lower economic growth. Our “recession-proof” companies have demonstrated sustainable profit growth through past periods of economic contraction. A large cash holding gives us plenty of flexibility to take advantage of lower equity prices and better values ahead. I believe we are ideally positioned to thrive through these economic changes, and capture upside to make the best of the situation.

Interesting links:

The obstacle is the way https://www.farnamstreetblog.com/2013/01/the-path-of-amateurs/

How slower growth can produce a better result https://intelligentfanatics.com/forums/topic/yvon-chouinard-patagonia-controlled-growth/

Canadian shadow lending https://www.bloomberg.com/news/articles/2017-12-13/risk-shifts-to-shadows-in-canada-s-whac-a-mole-housing-market

Prepare for weaker bank results http://business.financialpost.com/investing/for-canadas-big-banks-a-housing-hangover-may-loom-in-2018

Investors are euphoric http://www.investmentnews.com/article/20171214/FREE/171219944/rias-struggle-to-keep-clients-grounded-amid-stock-market-euphoria

 

Cordially,

Ben W. Kizemchuk

Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth
www.growthandincome.ca
www.altusinvest.ca
(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
M5E 1J4

All opinions and estimates contained in this report constitute the judgement of Ben W Kizemchuk of Wellington-Altus Private Wealth as of the date of this report and are subject to change without notice. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.

December 2017 Update

We continue to maintain a defensive position across our portfolios. We are holding a larger than usual amount of cash, government bonds, and commodity producers, with a reduced exposure to equities.
 
I’m having a hard time finding Canadian companies worth buying. While the companies we do hold present a good opportunity for double digit returns, most Canadian companies are priced too high to deliver an adequate margin of safety. As an owner of businesses rather than stocks, I find today’s prices aren’t reasonably discounting future earnings growth nor asset value. Perhaps value investing is permanently broken so that earnings and assets don’t matter, or there is a correction approaching that will remedy market prices to a more reasonable and justifiable level.
 
For example, it appears to me that the stocks of the thirty largest public companies in Canada could easily lose money for their owners. As a group, these companies have been growing earnings on average about 10% per year and growing dividends by about 7% per year. Let’s assume that in the future these companies will trade at 22 times their earnings, as they do today (giving today’s owners the benefit of the doubt, since 22 times earnings is historically very high). If we compound earnings at 10% per year for the next five years and apply the 22x multiple, and then add up the dividends received along the way, we would find that the intrinsic value (what these businesses are worth) is lower than what they’re trading for today. In other words, today’s stock prices are so high that they’ve already discounted over five years worth of generous earnings growth, leaving no room for error. If future earnings growth comes in even slightly below average over the next five years, or investor sentiment even a little less rosy, these stocks could be valued significantly lower.
 
What might cause below average earnings growth? The companies together are significantly leveraged, owing $0.80 of debt for every $1 of equity. Canada is now the most leveraged of developed countries, and the third most leveraged of all countries. Recessions are inevitable, and when the next one arrives, it’s reasonable to assume it will be amplified by this historic amount of leverage. Just as leverage boosts returns on the way up, it compresses economic activity on the way down.
 
In my opinion, the average Canadian investor faces the possibility of a permanent loss of capital at today’s prices. With such a high degree of risk in the general market, I have no interest in allocating my own or your capital in the fashion I see most amateurs and professionals investing today. I believe protecting capital is far more important than the fear of missing out on short term speculative gain.
 
As Noah can attest, building arks is more important than predicting rain, so I have been spending most of my time evaluating the downside risks of our companies. I believe our holdings including cash, government bonds, energy and precious metals producers, and select “recession-proof” companies are the most reasonable way to reduce risk while maintaining upside potential.

In depth portfolio and company-specific notes are available for clients only.

Interesting links:

Investors today have unrealistic return expectations http://www.schroders.com/en/insights/global-investor-study/investors-expect-returns-of-10.2-with-millennials-hoping-for-more
 
For an investment to outperform, it must be perceived as hard to own https://blog.thinknewfound.com/2017/10/frustrating-law-active-management/
 
Yale’s Swensen warns on “low volatility” investing https://www.bloomberg.com/news/articles/2017-11-14/yale-s-swensen-says-low-market-volatility-profoundly-troubling
 
Investor cash holdings are at an all-time low https://finance.yahoo.com/news/investors-running-cash-apos-terrible-100100643.html?soc_src=social-sh&soc_trk=tw
 
Warren Buffett’s first TV interview, he describes a simple & winning investment strategy https://www.youtube.com/watch?v=LFWj0ps9DqA&sns=em

Please let me know if you’d like to chat about financial planning, long term investing, or private investment opportunities.

Cordially,

Ben W. Kizemchuk

Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth

November 2017 Update

We continue to maintain a defensive position across our portfolios. We are holding a larger than usual amount of cash, government bonds, and commodities, with a reduced exposure to equities. At this time, we seek to protect our wealth rather than engage in excess risk taking.

Canada is possessed by a debt bubble of epic proportions, posing the largest risk to Canadian investors since 2008. The debt bubble has distorted investor return expectations across Canadian equities and other assets classes.

From the perspective of a value investor who enjoys reading financial statements, I find a general character of inflated earnings expectations, overvalued assets, and unsustainable revenue growth rates among today’s “top stocks”. These are the time-tested hallmarks of greed and overconfidence. The situation parallels valuations last seen in some respects before the 2001 stock market decline, and in other respects before the 1990 real estate decline. This is not to say that the timing of a similar decline is imminent, only that the odds are materially increasing.

I could talk about the real estate bubble, suspect bank earnings, tech stock castles in the sky, bitcoin, record low volatility, or how government bonds are now priced to earn more than equities over the next decade… but at the highest level there is only one factor driving this risk-blind behaviour. Investors have become accustomed to a coordinated effort by central banks to re-liquidate markets, a period lasting from 2009 until present.

Eight years of liquidity injections have rendered investment analysis largely obsolete. After all, why bother analyzing a company’s financial statements if a rising tide lifts all ships? The key to our success has always been a steady commitment to owning quality companies at a good price, and in a rational environment, that guiding principle has rewarded us well. But in an irrational market focused on short term performance, it doesn’t count for much. Conventional wisdom today is that dividends, cash flow, earnings power, and asset value aren’t very relevant to stock prices. One simply buys stocks today because they are going up.

This too shall pass. Like most things in life, just as the rules become obvious, the game changes.

2018 marks the beginning of a new phase of bank action, the reduction of global liquidity by about $1 trillion per year. This has already started in several forms such as increasing short term interest rates and the slowing of asset purchase programs by central banks (also known as quantitative easing, or QE). In the same way a rising tide lifted all ships, draining the pool means summer is over. It is my opinion that the reduction in liquidity will cause investors to re-evaluate risk, and materially change stock valuations, resulting in higher market volatility.

You will notice no alarm bells are going off and few are talking about these changes. Most people judge success through the rear-view mirror, where markets are up for the year, and Canada lead the pack in economic growth in 2017. From that perspective, a rear-view driver would naturally find nothing of concern. But the inescapable fact remains that the worst investments are made in the best of times, and this cycle will be no exception.

Although the market can carry on this untethered course for some time, the potential for a lasting gain becomes limited the higher prices go. With safety of principal my number one priority, I will not risk capital unless the odds in my favour. By reducing risk exposure and increasing cash, the long term advantage is ours. Time is on our side as the leverage bubble unwinds.

For the select few assets I do choose to hold, it is my view that there is a period of substantial appreciation on the horizon. Government bonds, energy, gold, and our other holdings have demonstrated real growth through historic market declines and economic contraction. As an investor who has personally and financially lived every good day and every bad day since starting the Growth and Income Portfolios, I hope you await the appreciation with the same solid confidence and anticipation as I do.

In depth portfolio and company-specific notes are available for clients only.

Interesting links:

Five star funds aren’t what you think https://www.wsj.com/articles/the-morningstar-mirage-1508946687

A simple explanation of faith http://monevator.com/patient-investing-faith/

Must read about making better decisions https://machinelearnings.co/why-are-we-so-confident-2c3151a6d5d0

Something I look for in interesting people https://waitbutwhy.com/2014/06/taming-mammoth-let-peoples-opinions-run-life.html

Please let me know if you’d like to chat about financial planning, long term investing, or private investment opportunities.

Cordially,

Ben W. Kizemchuk

Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth

September 2017 Update

We continue to maintain a defensive position across our portfolios. We are holding a larger than usual amount of cash, government bonds, and commodities, with a reduced exposure to equities. At this time, we seek to protect our wealth rather than engage in excess risk taking.

Short term interest rates in Canada and the US have been moving higher over the past months, increasing interest costs and tightening the availability of credit. With leverage at an all time high in Canada, this poses a risk for many of our country’s borrowers. History tells us expanding credit is an important ingredient for economic growth, while contracting credit tends to be an important precursor to economic recession. Sometimes credit begins to contract a year before recession, while other times only months.

With that in mind, the latest Canadian GDP report showed an abrupt halt in economic growth in July, driven primarily by real estate, construction, and banking. We therefore maintain a sense of caution.

Portfolio construction and company-specific notes are available for clients only.

Interesting links:

The economics (and tax advantages) of owning a sports team https://www.bloomberg.com/view/articles/2017-09-08/buy-a-sports-team-get-a-tax-break

How our perspective influences our success https://www.farnamstreetblog.com/2017/09/open-closed-minded/

Dividends aren’t what you thought http://www.etf.com/sections/index-investor-corner/swedroe-vanguard-debunks-dividend-myth

Please let me know if you’d like to chat about financial planning, long term investing, or private investment opportunities.

Cordially,

Ben W. Kizemchuk
Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth
www.growthandincome.ca
www.altusinvest.ca
 

(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
M5E 1J4

August 2017 Update

We continue to maintain a defensive position across our portfolios. Valuations of the largest sectors of the Canadian and US markets remain at historic highs. We have countered against this environment by increasing exposure to cash, government bonds, and commodities. At this time, we seek to protect our wealth rather than engage in excess risk taking.

It has been said the riskiest thing in the world is to believe there is no risk. In that light, 54% of Canadians recently polled by Angus Reid believe “house prices will never come down”. The most unanticipated and therefore significant risk to Canadian investors is an unwinding of the Toronto housing bubble. Housing has become the top driver of employment and economic growth in Canada, accounting for the bulk of GDP gain last year. Such gain cannot be expected to continue indefinitely.

It is reasonable to believe the unwind has already started. Demand for GTA homes, as measured by the sales-to-new listings ratio, continues to drop from the Spring high. This measure usually leads price by 4-6 months, and suggests further price weakness ahead.

A material decline in prices could present two key risks for investors. First, bank earnings could be impacted as new mortgage growth slows, and loan losses rise. Canadian banks on average have reserved only 0.25% of the total value of their mortgage books for losses, a historically (too) low amount. While it is true mortgage arrears today in Ontario are 0.10% (matching the 1990 low), historic data show arrears rise to about 0.50%-0.70% as a bubble unwinds, a 5x-7x increase from the current level.

The larger risk is to general employment. The number of realtors in Toronto has surged 77% since 2009 to more than 48,000 people. By comparison, there are only 13,500 realtors in Chicago, a city with similar population. Over the last year, sales commissions from real estate totalled about 2% of Canadian GDP, a historic high. As experienced during prior real estate cycles, realtors and other ancillary service providers (construction being the largest) could see demand for their services decrease, leading to a rise in general unemployment and further loan arrears.

These issues are compounded by household leverage, primarily in the form of home equity lines of credit (“HELOC”) and second mortgages. Ontario’s largest debt consultancy Hoyes-Michalos points out that over recent months they’ve noticed an increase in the number of Canadians borrowing against their homes to avoid filing bankruptcy. They add, “this is a temporary fix that will become much more complicated in the very near future.” Rising short term interest rates are the primary motivator.

For the sake of comparison, we can look at global housing bubbles of the past fifty years, looking for commonalities, signposts and benchmarks. We observe an average price drop of 35% from the peak, with most of the drop occurring within 3 years of the peak. Bonds, precious metals and cash (our largest holdings) tend to appreciate in real terms through these historic periods. Should a similar correction materialize in Toronto, we have taken the early and precautionary steps to protect our wealth.

Portfolio construction and company-specific notes are available for clients only.

Interesting links:
Toronto has more housing than you thought https://www.bloomberg.com/news/articles/2017-08-14/toronto-has-more-housing-than-you-thought-canada-eco-watch

The retail renaissance is underway https://latest.13d.com/has-disruption-from-ecommerce-run-its-course-6222c9544fd9

As always, please let me know if you’d like to chat about financial planning, long term investing, other private investment opportunities.

Cordially,

Ben W. Kizemchuk
Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth
www.growthandincome.ca
www.altusinvest.ca

(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
M5E 1J4

July 2017 Update

Equity markets are at their highest valuation in history by some measures. The S&P 500 is selling at 25 times earnings compared to a long term average of 15, a level only exceeded in 1929 and 2000. Warren Buffett’s favourite valuation measure, total US stock market capitalization divided by GDP, is at an all-time high of 145, compared to a long term average of 100. In the past when valuations were this high, subsequent ten year returns have been single digits or negative.

Investors seem to believe there’s no price too high for the largest US stocks, responsible for driving most of the rally this year. These FAANG stocks (Facebook, Amazon, Apple, Netflix, Google) are trading at over 30 years worth of current earnings. They have performed well, but given their valuations, are they safe investments?

Few seem to care about the answer to that question. Over a trillion dollars are now deployed into passive investment funds, of which the FAANG stocks make up an increasing percentage of holdings. By definition, the passive investment philosophy ignores company valuation, buying instead on the basis of popularity: buy more of what’s popular, and sell what’s unpopular. If that sounds like the opposite of buy low, sell high, it is. It should concern investors that over one trillion is now invested in this way, with no attention paid to analysis or valuation.

After years of low interest rates, investors have been encouraged to view this excess risk taking as normal, and even welcomed. Hand in hand, the amount of leverage deployed in stocks, bonds and real estate shows there is more worry today about being under-invested than being over-invested. When so many are willing and excited to bear excess risk, we do the opposite.

Portfolio construction and company-specific notes are available for clients only.

Interesting links:

Uninsured mortgages in Canada pose a risk http://business.financialpost.com/personal-finance/mortgages-real-estate/uninsured-mortgages-are-greatest-risk-for-canadian-financial-institutions-dbrs-report-says/wcm/4c169bd0-473a-46e0-966e-dec0f678aaa5

The effects of Indexing on the market https://www.bloomberg.com/view/articles/2017-07-06/the-stock-market-has-entered-bizarro-world

Cordially,

Ben W. Kizemchuk

Portfolio Manager & Investment Advisor
Welling-Altus Private Wealth
www.growthandincome.ca
www.altusinvest.ca
(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
M5E 1J4

June 2017 Update

May was a relatively quiet month in the markets. Our Growth Portfolio earned a solid gain, benefiting from a number of consensus-beating earnings reports issued by our companies. The Income Portfolio earned a solid gain as well, with investors continuing to buy more high quality bonds. Small Cap Value also saw a sizeable increase in return. That contrasted with American Growth which saw a decline due to a couple companies not meeting earnings report expectations.

Our outlook continues to follow themes we established earlier in the year: we believe economic growth in North America will be lower than generally anticipated (but not negative) through 2017. We believe defensive value companies and bonds are the best places to realize a return and protect capital in such an environment. We believe that although the large cap market indices are fully valued, there are sizeable pockets of cheapness outside of the most popular stocks. Investors must be extra-choosy to avoid the over-valued companies. Thus, we believe the anticipated returns of index and passive investment strategies do not provide adequate compensation for risks assumed in a fully valued market.

Company-specific notes and target estimates are available for clients only.

For more detail please visit: Growth PortfolioIncome PortfolioAmerican Growth PortfolioSmall Cap Value Portfolio and Financial Planning.

Interesting links:

In a field where most people look for corroborating evidence, it’s far more effective to disprove you’re thinking than prove it https://www.farnamstreetblog.com/2017/05/confirmation-bias/

Canadian banks are exposed https://www.theglobeandmail.com/report-on-business/economy/imf-praises-infrastructure-bank-plan-flags-housing-market-concerns/article35160977/

 

Cordially,

Ben W. Kizemchuk

Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth

www.growthandincome.ca
www.altusinvest.ca

(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
 M5E 1J4

May 2017 Update

In contrast to the woes of the mortgage and banking sector, our defensive companies are performing well, up over 7% on the year. American Growth is up 15%, and the Income Portfolio is up 12% on the year. With purpose we have avoided most companies on the TSX and especially the banks. Instead we’re focusing on unique opportunities where we can demonstrate our edge in judging intrinsic value and business quality. Our strategy of buying good companies on the cheap continues to work, and I expect more runway ahead for our ideas.

Although it is true we’ve taken a more defensive tone than usual, and that defensive tone has cost us a couple points of upside relative to the general market this year, we also believe that taking excess risk just because everyone is doing it is not a good idea long term. While bull markets cause the average investor to sacrifice things like quality and value for the mirage of short term gain, quality and value form the very bedrock of what we do.

Company-specific notes and target estimates are available for clients only.

For more detail please visit: Growth Portfolio, Income Portfolio, American Growth Portfolio, Small Cap Value Portfolio and Financial Planning.

Interesting links:

Possibly the best half hour investment lesson ever recorded: https://www.youtube.com/watch?v=bZfPJCAVQg0

How to make better decisions: https://www.farnamstreetblog.com/2017/04/get-smart-brian-tracy/

54% of Canadians think house prices will never drop: https://twitter.com/jamesmcuddy/status/851445900161556482/photo/1

The truth about investing: https://www.cfasociety.org/india/Newsletters/Howard%20Marks_The%20Truth%20about%20Investing.pdf

High risk mortgages are growing too quickly: https://betterdwelling.com/sorry-vancouver-toronto-king-risky-mortgage-debt/

Cordially,

Ben W. Kizemchuk

Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth

www.growthandincome.ca
www.altusinvest.ca

(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
 M5E 1J4

April 2017 Update

In a land far away a long time ago, a monk wanted a cigarette. He approached the monastery’s Abbot asking, “Abbot, while I am praying, is it ok if I smoke?” The Abbot replied, “No my dear monk, praying is a sacred act, so you should not smoke while praying.” A week later the monk returned to the Abbot, asking this time, “Abbot, while I smoke, is it ok if I pray?” The Abbot replied, “Yes, God always welcomes prayer.”

In many aspects of life, success is only a matter of holding the right perspective.

A simple look at Toronto real estate, bank stocks, and index-tracking funds/ETFs (all three deeply intertwined), illustrates just how many people are looking for something to be excited about. Enthusiasm is in high demand and high demand equals high prices. And yet we know that anyone who arranges their investments to maximize enthusiasm ends up disappointed in the long run – enthusiasm for high prices doesn’t make for high returns. Instead, a perspective towards endurance is far more likely to accrue long term gain. But while enthusiasm is commonplace, endurance is rare.

With that in mind, a good defense is a good offense. As you read in the March note, Canadian banks are expensive based on their economic fundamentals and comparisons over the past twenty years. Tech stocks and materials companies are up there too. Where are risk-conscious investors to turn?

The good news is that while the “enthusiasm stocks” are through the roof, endurance stocks are the cheapest they’ve been in a decade. These are the defensive sectors, named so because they are less dependent on economic cycles and the mercurial whims of capitalist fancy.

Within the consumer staples, consumer discretionary, retail, energy (now that earnings are coming back up), and healthcare sectors I’m seeing some companies trading at valuations comparable to the lows of 2008. The strange thing is these companies are doing everything right -- growing income, growing cashflow, growing book value, and growing sales. Yet many investors are too busy building castles in the sky to notice these diamonds in the dirt.

Perhaps the preoccupation with “banks never go down” or “Trump trade” will last forever and our defensive stocks will stay forever low. Or more reasonably, it seems far more likely that investors will readjust expectations for growth in the real economy. Common sense always has a way of creeping back in after asset prices move too far out.

To take advantage of the current polarity in prices we see three avenues to success. Over the next while we plan to 1) take profits on companies successfully meeting our estimates of fair value, 2) raise cash to reduce general risk, and 3) add defensive companies priced well below fair value.

Company-specific notes and target estimates are available for clients only.

For more detail please visit: Growth Portfolio, Income Portfolio, American Growth Portfolio, Small Cap Value Portfolio and Financial Planning.

Interesting links:

Views from Toronto’s Real Estate Expo: http://torontolife.com/real-estate/think-going-go-even-sky-high-wealth-expo-attendees-talk-torontos-housing-market/

Two great investors share this in common: https://www.forbes.com/sites/antoinegara/2017/03/16/from-equities-to-bonds-howard-marks-and-joel-greenblatt-preach-the-gospel-of-patience/#67f9df5262a3

Seven things good investors do well: http://jimoshaughnessy.tumblr.com/post/158366040139/successful-active-stock-investing-is-hard-here

“Become more humble as the market goes your way”: http://awealthofcommonsense.com/2017/03/how-bull-markets-affect-your-intelligence/

As always, please let me know if you’d like to chat about financial planning, long term investing, and other investment opportunities.

Cordially,

Ben W. Kizemchuk

Portfolio Manager & Investment Advisor
Altus Securities Inc.

www.growthandincome.ca
www.altusinvest.ca

(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
 M5E 1J4

March 2017 Update

Growth Portfolio and American Growth Portfolio Commentary

Mean reversion is constantly working in the background of our everyday lives, responsible for everything we consider to be normal. It describes how things evolve over time towards a long term average value. It’s important because it’s a primary driver of the long term risk and return of investment portfolios.

For a simple example of how mean reversion works, we can look at height. If you’re a tall person, it’s likely your children are also tall, but not as tall as you. Your children’s children might be tall, but are more likely average height. Mean reversion balances out all the tall and short people over time towards an average height. It turns out nature wants just about everything to fluctuate around an average.

The idea is deceptively simple. “Simple” because we all intuitively understand how this process works, but “deceptive” because our behaviour does not always match our understanding.

Two finance professors, analyzed how 3,700 retirement plans, endowments and foundations hired and fired investment managers over a ten year period (1). They found that the institutions tended to hire new managers that had outperformed the market over the prior three years. The number one reason they fired managers was poor recent performance. Consistent with reversion to the mean, the professors noted that in subsequent years, many of the fired managers went on to outperform those who were recently hired.

Individual investors show similar behaviour. Research firm Dalbar found that most investors consistently buy stocks in hot markets and yank money out after a drop (2). That buy high, sell low behaviour is why the average equity investor earns about 50% less return than the S&P 500 over time. In professional and individual cases, ignoring mean reversion substantially limits long term return.

The downside of mean reversion is clear, but what about the upside?

In a seminal paper published in 1987, professors Debondt and Thaler showed that companies with higher than average earnings today tend to earn lower returns in the future, and companies with lower than average earnings today tend to earn higher returns in the future (3). This surprising result confirms a fact that’s confounded investors for decades: the largest returns come from companies recovering from lower than average earnings.

A real life example of mean reversion was recently brought to my attention over lunch with Mike Philbrick from Resolve Asset Management. In June 2000, going into the peak of the tech bubble, Warren Buffett’s Berkshire Hathaway had underperformed the S&P 500 by 60% over the prior two years. Buffett was down 31%, while the S&P was up 28%. Just about everyone thought he lost the magic touch. This 1999 article from Barrons might be one of the best foot-in-mouth lessons ever recorded: http://www.barrons.com/articles/SB945992010127068546. Two years later, in June 2002, Berkshire Hathaway was up 24% while the market was down 32%. Four years later, Berkshire was up 65%, the market still down 22%. 

Buffett was not the only one riding the mean reversion wave. The chart below is from investment firm Euclidean Technologies (4). Euclidean came to the same conclusions we did in our February Commentary about expectations for value strategies. Their chart illustrates what’s happened to value investment strategies following periods of underperformance. The results speak for themselves -- Buffett is not an outlier.

The evidence is clear: the higher the current performance of an investment strategy, the less we should expect over the future. And the lower the current performance, the more we should expect over the future.

So where does that put us today?

After a huge rally in Canadian banks and energy companies, top performers by a country mile, the TSX Composite Index is vulnerable to mean reversion. The top ten companies in the TSX are mostly banks and energy, accounting for 40% of the total weight of the Index. Those companies are trading within 93% of their highest valuations of the last ten years.

We can take a closer look at Royal Bank as an example. Royal is the largest company in the TSX, making up 7% of the Index, and currently trades at about 14 times earnings. That puts Royal within 91% of its highest valuation of the last ten years.

In the chart below, I’ve illustrated Royal’s share price in the top pane, and Royal’s price-to-earnings (PE) ratio in the bottom pane. You can see that levels above 13.75 times earnings (red circles) have reverted to the mean in the past. Five instances record an average subsequent share price decline of 21% (the average of the red boxes). Other banks show similar histories.

The chart is visually compelling, however we can’t rush to conclusions. Nothing is carved in stone preventing a fully valued company from becoming even more fully valued before mean reversion takes hold. Although we can always count on reversion, its timing can be unpredictable over the short term. That said, when faced with a choice between owning a fully- or under-valued company, sensibility sways me to the latter.

The TSX appears fully valued, but perhaps Canada’s biggest fund managers are positioned differently?

Surprisingly, two of the largest mutual funds in Canada have invested even more client money in banks and energy than the Index. One fund has 38% in financials and 22% in energy, while another has a whopping 63% in financials and 13% in energy. It turns out that many popular Canadian mutual funds and ETFs are concentrated along similar lines. So much for diversification…

Economist John Maynard Keynes said it is better to fail conventionally than to succeed unconventionally. I’m not so convinced.

The reputation of the Growth Portfolio is staked on independent thinking, deep research, and ignoring the investment beauty contest. I believe that’s what makes our investors more level-headed than the average. We zig when others zag, looking for opportunities ripe for reversion. Yes, we end up kissing some toads along the way, but we meet more than our fair share of princes.

Independent thinking, especially when it’s producing less than average short term results, is difficult. The patience required can make me look wrong, dumb, stubborn, and sometimes all three.  The truth is I am far more comfortable relying on a proven long term value approach and putting up with periods of lower than usual performance than I am chasing hot stocks into near-record valuations with your wealth.

Sometimes that means Index investments and other funds will produce brighter and more exciting flashes of return than us from time to time. That’s ok. Mean reversion is a far more powerful corrective force in the long run.

Sources
1: https://papers.ssrn.com/sol3/papers2.cfm?abstract_id=675970
2: https://www.thebalance.com/why-average-investors-earn-below-average-market-returns-2388519)
3: http://fac.comtech.depaul.edu/wdebondt/Publications/FurtherEvidence.pdf
4: http://www.euclidean.com/value-rebound

 

Income Portfolio Commentary

We’ve spent the last several months adjusting towards a more neutral position relative to income portfolios held by other Canadian investors. Our conservative focus on reducing risk has meant our performance has lagged in relation to many popular funds over the past year. While still producing a very decent return of just under ten percent on the year, I see other income funds showing in the twenties – a strange, rare, and somewhat concerning sighting. Most dividend-focused funds find themselves today making concentrated bets on just two fully-valued sectors of the Canadian economy (financials and energy) that have demonstrated considerable cyclicality in the past. That type of cyclicality is what we’re trying to avoid in managing long term capital for our investors.

Our systematic approach is telling us that capital preservation is a more worthwhile goal near-term goal than chasing return. We are far more diversified than most Canadian income investors, both by geography and sector, which provides good comfort.

We will continue to manage the Income Portfolio to preserve capital, grow conservatively and reduce risk.

 

For model portfolio performance please visit Growth PortfolioIncome Portfolio, and American Growth Portfolio.

 

Interesting Links

The role of sentiment: https://blogs.cfainstitute.org/investor/2017/02/20/gauging-market-sentiment-selling-greed-is-harder-than-buying-fear/

The roots and causes of human irrationality: http://www.newyorker.com/magazine/2017/02/27/why-facts-dont-change-our-minds

Some interesting properties for sale in Toronto these days: https://twitter.com/RobynUrback/status/834426411687542784/photo/1

As always, please let me know if you’d like to chat about financial planning, long term investing, and other investment opportunities.

Cordially,

Ben W. Kizemchuk
Portfolio Manager & Investment Advisor
Altus Securities Inc.

www.growthandincome.ca
www.altusinvest.ca
(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
M5E 1J4

February 2017 Update

Growth Portfolio and American Growth Portfolio Commentary

People buy investments for all sorts of reasons. As strange as it sounds, I’ve found that making money is not always at the top of the list. Everyone will tell you they invest because they want to make money, but often the real reason can be something different. Some people buy investments because their friends and neighbours are buying them. Some buy for a rush of excitement. Some buy to fulfill the wishes of someone else. Some buy because it gives them a feeling of control over their destiny. Some people buy out of altruism -- they feel a certain company is changing the world for the better. But if you buy a stock for any reason other than its value, it’s not investing.

The reason I bring this up is because I’ve noticed some interesting data recently about people doing strange things with their money. Particularly, I mean that people are buying index funds at a rate never before seen in history.

First a quick review: index investing (also called passive investing or benchmark investing) is when an investor’s portfolio is directly tied to that of the whole market. Indexers believe that earning a better return than the market is impossible, if not too hard to bother with, so they favour earning the market’s average return over time. The premise is that if you can hang on through the highs, and the lows, then you get the long term average return. Indexers buy exchange traded funds (ETFs) or mutual funds that directly track the largest stock indices. Looking inside these ETFs and mutual funds, you’ll see that the largest company holdings are held in proportion to their size in the market (geek speak: market capitalization). So indexers hold lots of the largest stocks in a market, and little to none of the other stocks in a market. Because of this, indexers tend to participate in a momentum effect, holding increasingly large positions of companies that everyone who came before them already bought.

In contrast, active managers apply investment strategies or techniques in an attempt to perform better than the general market. Some try to earn a higher return, some try to minimize risk, and some try for both.

Active managers and indexers have been in an eternal struggle since the first Investment Trusts were started in the 1920s. The chart below compares the performance of actively managed funds in the US to a passive investment in the broad US index over the last 50 years. When the blue lines are high, actively managed funds are doing better than the index. When low, the index is doing better than most active investment managers. Over the last five years, index portfolios have been winning out over most active managers.

This chart illustrates two important points. First, we recognize the cyclical nature of active/passive style over short time frames. We tend to move in broad multi-year cycles of one style leading the other. Second, and more importantly, this chart illustrates that only 10% of active managers did better than the index in 2016. That compares to other historic lows in 1999, the late 1980s, and the mid 1970s (red arrows). Each of those arrows marked the start of long periods of outperformance for active strategies. Although I cannot find a comparable chart for the Canadian market, it would be reasonable to believe it looks similar. And yes, the Growth Portfolio finds itself in the minority of managers outperforming the index over the last five years (12.3% average return per year vs 4.3% per year from the TSX Index).  

Based on the chart above, if we believe that active strategies might outperform the general market going forward, the next question to ask would be what type of active strategy could work best? Broadly speaking, active strategies can be divided into two groups. One group would buy “value” stocks (those with low price-to-earnings/book value/revenue multiples), while the other group would buy “growth” stocks (those with high price-to-earnings/book value/revenue multiples). Typically, value stocks have a reputation for being cheap, unloved, and discounted, while growth stocks are the most popular, broadly followed companies.

The chart below compares the relative return of global value stocks and global growth stocks since 1984. When the blue line is moving higher, value stocks are performing better, and when the blue line is moving lower, growth stocks are performing better.

This chart illustrates two important points. First, the relationship between growth and value is cyclical, in context of value performing better than growth over the long term. Second, we see that growth stocks have performed dramatically better than value stocks from 2009 to present. It also appears, starting in the final months of 2016, that the tide is turning in favour of value, away from growth. While it’s too early to tell how long this lasts, it would be reasonable to expect, based on reversion to the mean, that value stocks stand a good chance of outperforming over the years ahead. That would bring value back in line with its historic better-than-average performance.

So if we expect active to outperform passive, and we also expect value to outperform growth, then it stands to reason that value investing is likely to outperform the general market over the years ahead. It also stands to reason that expensive growth stocks today comprise most of the passive index. In simple terms, this means that the cheaper value stocks being ignored by investors are likely much safer investments than the most popular stocks loved by investors. While it sounds rather common sense to say that cheap stocks are safer than expensive stocks, this idea is directly at odds with the prevailing trend towards indexing, whose buyers increasingly own greater amounts of expensive stock.

With that in mind, I return to my first point. If you’re not investing on the basis of value, you’re not really investing at all. As a matter of conjecture, I believe indexers tend to focus mostly on the upside of risk by putting too much faith in a safety-in-numbers approach. While herding worked as a survival mechanism thousands of years ago, it is not a useful skill in a market-based economy. As for value investors, they tend to focus mostly on the downside of risk by trying to reduce what they might stand to lose. I’ve found that if you spend time managing what you stand to lose, the upside tends to take care of itself.

It is reasonable to believe things might continue on the current path for a while. It is also reasonable to believe a renewed preference for value is already underway. The ability to accurately time when the psychology shifts from growth to value is unknowable (not just by me, but anyone). Regardless of when this happens, we can be assured it will happen. The balance of history is on the side of high quality companies purchased at cheap prices – in other words, value.  

 

Income Portfolio Commentary

We noted in last month’s review that we were becoming sceptical of the US Dollar’s ability to continue trending higher. Our systematic investment process supports this outlook, and so this month we will take additional steps to reduce our exposure to US companies. We will sell our US dividend ETF at a good profit. We will reduce risk by investing the proceeds in a Canadian dividend-growers ETF that will boost overall portfolio income, as dividend rates are higher in Canada than in the US at this time. We will keep a small holding of US dividend payers for now. Our currency exposure is now fully hedged (our holdings will not be affected by shifts in the foreign exchange rate). On the whole, after a year spent abroad, we are now slowly returning to a preference for Canadian dividends, offering higher yields and more cheaply valued than foreign counterparts. There is no place like home.

We will continue to manage the Income Portfolio to preserve capital, grow conservatively and reduce risk.

 

For model performance please visit Growth Portfolio, Income Portfolio, and American Growth Portfolio.

 

Interesting Links

As always, please let me know if you’d like to chat about financial planning, long term investing, and other investment opportunities.

Cordially,


Ben W. Kizemchuk

Portfolio Manager & Investment Advisor
Altus Securities Inc.
(416) 369-3024

55 Yonge Street, Suite 1100
Toronto, Ontario
M5E 1J

2016 Year End Review

Model Portfolio Returns (%)

These returns represent the model portfolios only. They may differ from actual client results due to rounding, cash balances, the timing and amount of deposits and withdrawals, the timing and amount of dividends and other income, and fees and other costs. Please see your official client statement for complete reporting.

Growth Portfolio and American Growth Portfolio

2016 proved our most difficult year to date for the Growth Portfolio and American Growth Portfolio. After a rough first quarter, not much happened until the early summer, when a recovery unfolded into the end of the year. While the prices of our companies did not deliver gains, the financial results reported by our businesses were impressive. Over 2016, our Canadian Growth businesses increased cashflow by 12%, earning a collective 18% return on invested capital, while our US Growth businesses increased cashflow by 14%, earning about 22% return on invested capital. Our holdings are among the top 10% of public companies in terms of businesses quality. That their prices did not deliver stronger results this year is highly irregular, but not without precedent.

We underperformed 2016 for two reasons.

First, we encountered some bad luck. Usually the market rewards high quality value companies and ignores junk stocks. That was reversed in 2016 as the securities that saw the largest increases in price were of remarkably low quality. Businesses with high valuations, low or negative cashflows, high debt, high dividend payouts, and low or negative earnings growth became darlings. Meanwhile good businesses, those with cheap valuations, positive cashflows, low debt, reasonable dividend payouts, and positive earnings growth were ignored. This strange preference for junk has only occurred three times in the last thirty years, including 2016. While we firmly believe that one person’s trash can be another’s treasure, we also believe that one person’s toxic waste will be their eventual undoing. Making a habit of holding junk companies would have produced a loss of 9% per year since 1985. In comparison, a value approach similar to our own would have produced gains of about 15% per year on average. So even though we did not receive the expected outcome in this one year, our value investment process remains sound. Value investing works most of the time but not all of the time. Nothing does.

The second reason we underperformed was related to diversification. Towards the end of 2015 we correctly understood that the market was over-valued. This meant that only a few companies met our investment criteria. In the past, concentrating our capital in few companies worked very well through periods of over-valuation. However 2016 featured something rare: a series of separate and repeated market shocks (Yuan revaluation, oil volatility, Brexit, US election) that overwhelmed our model strategy. While it is normal to see one or maybe two such events of stress in a year, four in quick succession are quite rare. In the future when we cannot find a larger number of adequate investment opportunities meeting our criteria we will hold more cash instead of plugging more capital into fewer companies. This will allow us to navigate a wider spectrum of markets without giving up on long term returns. This will also provide a source of funds to purchase new holdings when cheaper securities avail themselves.

In every underperformance there is an opportunity. In that light I’d like to recognize 2016 to reaffirm an important point about investing, expectations, and dealing with disappointment. By the end of 2015 we earned about 25% more than the TSX in Canadian Growth, a gap as wide as ever. We outperformed the S&P500 by about 10% in American Growth. This naturally produced a degree of giddiness and popularity that I will henceforth take as a warning sign. In hindsight, it occurred to me that some investors joined because they fell in love with the profits over the process.

While I understand that many investors don’t like negative years, I do not agree that they should be surprised by them. Negative years are entirely normal, and to be expected in the course of our work together. There exists no investment strategy that delivers gains year-in year-out (even Buffett’s Berkshire Hathaway has its down years). Further, since we hold different securities than the market average, our returns will not be correlated to the market average. So if your expectation is similar to mine, that no one including us can possibly outperform every single year, or even produce a positive return every single year, then we have a good chance of realizing higher than average returns over the long run together. Since the short term results do not matter as much as the long term results, our focus remains solely on doing things that earn good long term results.

Now onto some good stuff. While 2016 had been a year of negative anomalies, today I see positive ones.

First, cash balances in public investor portfolios are elevated. Notably, while professionally-managed portfolios have more cash than usual, most of the extra cash is found in retail (mom and pop) investment accounts. This has proven to be a reliable contrarian indicator in the past. Such high cash balances have led to periods of positive stock market performance.

Second, since 2012 investors have been abandoning value strategies en-masse in favour of passive investing, also known as index investing or benchmark investing. Although this may seem a recent fad, the active vs passive pendulum has been swinging since the early 1920s. The passive trend has swung so far this time that it has created one of the largest distortions in history. As of 2016, the spread between the most expensive stocks and the cheapest stocks is historically wide. In the past, such a large spread has created significant opportunity and value for active strategies, a level from which value investing has come strongly back into favour. From a contrarian perspective, the more people that believe value investing won’t work, the better it turns out to work in the future. By the same token, the more people that believe index investing works best, the worse it turns out in the future. And that is good news for cheap stocks like ours. As of December, our Canadian Growth stocks are collectively undervalued by about 18%. The top stocks making up the TSX Index are collectively over-valued by about 10%. The disparity is not as wide in US markets, where our American Growth stocks are undervalued by about 20%, and the S&P500 at about fair value.

Finally, 2016 marked an important turning point in North American demographics: Millennials are now the largest living cohort in America, overtaking the Boomers. This demographic shift poses a key driver for economic growth because Millennials are now entering their household formation and spending years (Lauren and I happily attest). This should be welcome news for economic growth enthusiasts, refuting the idea we are drifting into a Japanese-style deflation. In the long term it would be reasonable to expect that interest rates are not likely to go any lower. That is not to say they are immediately heading higher either.

Although my outlook is constructive, by no means am I suggesting that any particular outcome is certain for the year ahead. Instead of relying on forecasts and predictions, our edge has always been in a disciplined rules-based value investing process. As always, we will follow our process to identify high quality investments at bargain prices. Through 2017, we will stand by the following principles, and welcome the results that come our way.

Control risk -- We minimize investment risk in three ways. First, by investing in high quality companies, and second, buying them at a discount to their intrinsic value. Third, we set an alert level if the price of a security moves beyond a certain threshold.

Seek consistency -- We search for investments that have demonstrated fundamental growth through various market cycles. 

Markets are inefficient -- The price of a stock does not always reflect the value of the underlying business. This gap between price and value creates profit opportunity.

Know what you know -- Making consistently successful macro forecasts or predictions is impossible because the future is inherently unknowable. Understanding market history can provide useful information with which to compare the present. Our evidence-based process concentrates on knowing businesses, which are more predictable than broad markets over the long run.

Avoid market timing -- Our goal is to remain fully invested throughout the market cycle by investing for a range of outcomes. When investment opportunities are few, we will hold more cash. 


Income Portfolio

The Income Portfolio earned a positive return in 2016. We experienced the same trials and tribulations as the general stock market, but with reduced volatility, making for a smoother ride. Capital gains and dividends contributed equally to a satisfying result.

Throughout the year we maintained positions in international and US dividend payers that not only saw their stock price appreciate, but also provided positive exposure to a strengthening US dollar. Canadian dividend payers experienced larger than average volatility through 2016, so did not meet our investment criteria. Our broadest exposure in the Income Portfolio remains to US dividend paying stocks at this time.

At some point the positive effects of the US dollar will reverse course, turning from a tailwind to a headwind for Canadian investors in the US market. Predicting when this will happen is impossible, so we will likely maintain a more balanced approach in currency exposure for 2017. We see potential early indications, but make no firm assertions at this time, that the strength of the US dollar trend is starting to wane. In recent months we have hedged some of our US dollar exposure in the portfolio, allowing us to participate in the market while reducing the effects of currency. Broadly speaking, the US market appears reasonably valued at this time, while the Canadian market is showing pockets of over-valuation.

In 2017 our investment process will continue to search for high quality income streams at reasonable prices. We will manage the Income Portfolio to preserve capital, grow conservatively and reduce risk.

Good advice rarely changes

Jason Zweig, writer of the Intelligent Investor column at the Wall Street Journal, once said:

My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself. That’s because good advice rarely changes, while the markets change constantly.

From here on in I’m going to be incorporating these weekly updates into my monthly letters. I’ve enjoyed every moment of writing them over the years and I appreciate every reply, critic, and comment received. Things have been getting busier around here, business is growing, and I think my Friday mornings will be better spent on managing our portfolios and advising our clients. Thank you for reading and I hope you’re looking forward, as I am, to the next monthly update.  


What I’ve been reading this week

Andreesen Horowitz on what comes after mobile: http://a16z.com/2016/12/09/mobile-is-eating-the-world-outlook-2017/

Can you teach a computer to invest like Buffett? https://www.bloomberg.com/news/articles/2016-12-07/buffett-soros-and-the-role-of-robotic-logic-in-investing-riches

Advice on making better decisions: http://www.basonasset.com/slow-down-to-go-faster/

Nat Geo’s best photos of 2016: http://www.nationalgeographic.com/photography/best-photos-2016/

 


Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc offering investment management and planning for high net worth Canadians. Ben focuses on the Growth and Income Portfolios and reducing tax.