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.
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.