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.

For long term use only

When you eat a chocolate bar, you expect the sweetness to last about 5 minutes.

When you watch a movie, you expect to be entertained for 2 hours.

When you buy fresh groceries, you expect to eat over the next 7 days.

A tube of toothpaste does its job for about 2 months.

The batteries in your remote will get you through the next 9 months.

A smartphone will get you about 3 years of use.

When you drive a car, you expect it to last about 10 years.

Owning a house, you’re generally happy with about 25 years.

Whenever we buy something, we make an assumption about how long it takes to get the full enjoyment out of the product. If you expected a movie to get to the good part in the first half hour, you’re going to be disappointed. If the best part of owning a car was the first 100 miles, it’s not going to work out. Different products need different amounts of time to do what they’re supposed to do.

A stock portfolio is no different. If we treated it the way we treat groceries, toothpaste or the batteries in a remote, not much is going to come of things. Stocks represent ownership in business, and business conditions just don’t change that quickly. So if you’re ok with waiting three years in between smartphones, at the very least you might consider the same amount of time for a stock portfolio. Stocks are wonderful products, as long as we keep in mind the instructions on the label: for long term use only.  


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. 

The law of supply and demand

How much oil will people consume next year? How many iPhones will people buy? How many movies will people go to?

These are the types of questions many investors rely on in deciding what makes a good investment. But can you spot what those questions all have in common? There’s a little something hidden in there that tends to trip up budding Buffetts.

Look closely and you’ll find that each of those questions is focused on predicting demand. The last time I checked it’s incredibly hard to figure out where and how people will want to spend their money in the future. But as you already know, it’s called the law of supply and demand, not the law of demand. And it turns out that one of these things is much easier to guess than the other.

I don’t know how much oil will get consumed, but we can get a good estimate of how much oil will get produced.

I don’t know the whims and wishes of iPhone buyers, but we can figure out how many iPhones will get made.

I don’t know how many movies people will watch, but we can find out how many movies theatres will be open for business.

The supply is easier to understand because it deals with the here and now. For big businesses and industries, the supply tends to change much more slowly than demand. Based on the limits of production, service standards, and supply chains, we can’t all of the sudden make more oil appear, or movie theatres open, or even produce 10 million new iphones overnight (as much as Tim Cook would love otherwise). So by focusing on supply, we have a steadier barometer for what the marketplace is able to bear (without having to guess what it wants).

A similar concept is at work with financial capital as well. When you see a lot of money being raised (supplied) in a particular sector, it’s doubly important to keep an eye on how much new production will be coming online. Flooding the market with new supply is rarely a good thing for prices. On the other hand, when you see capital leaving a sector or plants and machinery being shut down, it usually means supply is coming offline, and financing being withdrawn. That’s one of the reasons we often hear that the cure for low prices is low prices.

Following the trend of supply instead of trying to predict the vagaries of demand can help investors better understand the risks to their companies through the capital cycle. 


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. 

Low risk thinking

When I was starting out as an investor my primary goal was earning the highest return possible. Following this path I got into all sorts of troublesome stuff like options and other high risk strategies in pursuit of the golden goose. Needless to say, none of these approaches worked out. There were brief spurts of joy, and a couple +100% gainers in the mix, but overall it was a bust. What I later discovered was so counterintuitive that I literally had to rebuild the entire way I looked at investments. I found out that you don’t get better than average returns by trying to get better than average returns. That was the fool’s way of building temporary wealth. It turns out that earning better than average returns is only a by-product of seeking out lower than average risk.

There’s this mythical investing paradigm that says high risk equals high reward and low risk equals low reward, I’m sure you’ve heard it. But what they don’t tell you is that relationship has never actually been proven. Instead, the evidence points in the other direction – it is the lower risk stocks that produce the higher returns, and higher risk stocks that produce the lower returns. Intuitively, this makes a lot of sense. There are old investors and there are bold investors, but there are no old bold investors. That’s because as you get more of it, you realize that capital is a responsibility and not a reward. So if you have a lot of capital, and you need to find something to do with it, lowering your risk is not just a choice, it’s the only choice. That’s one of those common sense ideas that’s not so common.

So how does one go about lowering risk? Below are some ideas that have worked around here:

First off, the simplest idea: be careful with cash. For many people, cash might appear to be the lowest risk investment around. But earning near-zero percent interest while inflation ticks along at over 1.5% per year is actually a guaranteed loss. You don’t have to get fancy with cash, but there are plenty of options that can be competitive with the rate of inflation.

Be selective and say “no” more. I’ve never tracked it, but I would guess that I say no to about 99% of the investments I look at in a given year. If I get a call out of the blue from a stock pitcher or a mutual fund salesperson, the automatic answer is no. A close friend of mine sent me an email recently about the hidden powers of no -- say no to everything. That way you can easily tell who’s passionate and who isn’t – the passionate ones will spend the time to follow up. Whether its investing or life, without passion, there is no return.

Buying companies with growing cashflow reduces risk. Growing cashflow allows more wiggle room on your mistakes, so if you buy something at too high a price, the cashflow growth will eventually make up for the gap. For this to work the company should have a long history of sustained cash flow growth that you can see in the financial statements. History is only half of the future, so you should also have an idea of the sustainability of that growth. Could you see people still using the company’s products in their current form five years from now? Usually only the most boring and run of the mill products pass this test. These companies are the ones with staying power and make good long term holds.

Buying companies that are cheap also reduces risk. No secret sauce here, just a lot of statistical evidence showing that if one makes a habit of buying unloved stocks, they will likely earn better than average results. Of course the main issue with this approach is you need guts of steel to buy companies that everyone else is getting rid of, and sometimes cheap stocks can get even cheaper. Goes without saying this route is not for everyone, which is one of the reasons it works so well. Another thing to keep in mind is these companies usually have very short staying power, so once they revert back to normal it’s time to sell and find the next one.

By combining the previous two ideas of growing cashflow with cheapness, you get a twofer. These unloved compounders are the things low risk dreams are made of.

One of my first clients, a very wise man, once told me, “Ben, don’t lose my money”. His success has inspired me many times over, and so in heeding his advice, I avoid situations that can result in the permanent loss of capital. If the economics become dim enough, any individual company can go bankrupt and any individual trade can result in a loss. But it’s quite rare, even in the dimmest of times, that a basket of companies all go bankrupt, or that a basket of companies fail to recover from a bad market. This is not an argument to put fifty stocks in a portfolio, but it’s not an argument to put only two stocks in a portfolio. Like jam on toast, spread it out but not too thin.

The final point is something I found out from a CEO with a reputation for building good teams. Before hiring a new person, consider if he or she brings the team’s average knowledge up or down. In similar terms, before adding a new company, consider how its risk compares to the risk of the existing portfolio. Add a new company only if it lowers the average risk of your holdings, otherwise keep what you have.


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. 

How to think about the future

Stanley Druckenmiller is not a household name. Even if I told you he was the guy that came up with the idea to short the British pound in 1992, you’d likely be scratching your head. But if I added that his partner George Soros encouraged him to invest in that idea so heavily that it literally broke the Bank of England, you’d likely recognize the famous story. Druckenmiller and Soros earned over $1billion on that trade. Druckenmiller has one of the best track records in the business, compounding by 30% per year over his career. How did he do it?

In an interview (YouTube) with the University of Southern California, Druckenmiller explained his investment approach. He says “too many investors think in the present. The present is already in the price. You have to think out of the box and visualize 18 to 24 months from now what the world is going to be and what securities might trade at.” Is one of the world’s best investors really suggesting we turn into fortune tellers? I’ve written many times about why forecasting is one of the cardinal sins in investing, yet here’s a fellow who’s shown it’s not impossible. How did he do it?

Thinking about the future is tough stuff -- almost impenetrable. In their book Superforecasters, Philip Tetlock and Dan Gardner illustrate the techniques of the world’s best forecasters. By no means am I suggesting that we should all try to be Superforecasters (or put our life savings into it!), but it is instructive in helping form an opinion about the world. It’s for people that believe making an educated guess is better than making a random guess. The best news is that you don’t need a rocket science IQ to think about the future. Just a bit of curiosity and willingness to think in terms of probabilities, not certainties.

Generally all of the Superforecasters follow the same approach: break down the big hard question into smaller easier data-driven questions. By piecing together answers from the smaller easier questions, we can obtain a better informed estimate to help us answer the big question.

For example, let’s start with the big question: is the US stock market going to be higher or lower one year from now? There are as many answers to this one as there are investors, making it way too tough to consider this question on its own. So what are some smaller questions where we can find an answer?

Let’s start with this one: How many years has the US market increased? We know that on average the US market goes up about 65% of the time on an annual basis. So we can use 65% as our baseline probability that the market will rise. That’s way better than a random guess. Now to refine our 65% up or down, let’s think about some additional smaller questions:

  • What is the current sentiment of investors? We can find survey data going back decades that tends to show investor sentiment is a contrarian signal. So if sentiment is low, we should boost our 65% estimate higher. But if sentiment is high, then we should reduce from the 65% baseline.
  • What is the shape of the yield curve (for non-geek-speakers, the yield curve compares short term to long term interest rates)?  Decades of data suggests a flatter yield curve tends to be worse for the stock market than a steeper yield curve. Same as above, use this info to boost or reduce from our baseline.
  • How much cash are professional money managers holding as a percentage of their portfolios? We can find evidence that shows professional money managers tend to increase cash before positive stock market performance, a contrarian signal.
  • Is the stock market already in an uptrend? Data shows that on an annual basis a rising market tends to keep rising.

The list is by no means exhaustive, but is a good place to start assembling a superforecast. You’ll notice also these are all questions that can be backed up by real data. Since the answers to these questions are knowable and have a testable track record, we can combine their individual probabilities to build a better estimate of our big question. Stay away from small questions where we don’t know an answer, or the answer is not measurable or verifiable.

So is the market going to be higher or lower a year from now? We’ll never know the answer for certain, but we might be able to get reasonably close. 


Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on the Growth and Income Portfolios and reducing tax.

Volatility is not risk

Bad things happen when investors confuse risk and volatility. My clients have heard me say this several times over, and I’ve written about it in previous notes, but this is a very important topic we should periodically revisit. In my opinion, understanding the difference between risk and volatility is one of the most important things that separate the average from the above average investors.

Risk is what happens when you compromise your ability to reach your investment goal. At its best, too much risk means you don’t get the return you need from your investments. At its worst, it represents the chance of permanent loss of capital. Volatility, on the other hand, is a very different concept. It is the ups and downs on the way to achieving your goal.

Some investments can be volatile with low risk, while others can be highly risky with zero volatility. Sounds confusing, so here’s an example:

Let’s say an investor, 50 years old, needs to earn five percent per year to live the retirement of their dreams. Investing in the stock market to earn that five percent will certainly bring some volatility over the years, but it’s likely that over the long run that investor will earn the five percent per year they came for. So while the stock market can be volatile at times, investing for the long term is not a risky venture – with reasonable expectations it’s highly likely that the investor’s needs will be met. On the other hand, let’s say that same investor instead buys GICs or term deposits earning only two percent per year. Although there will be no volatility along the way, the investor is taking on significantly more risk than a stock market investment -- they will not meet their retirement obligations, falling short by three percent per year. Compound that three percent over the long run, and you have a very serious capital shortfall on your hands. Sometimes things that seem less volatile can make for the most risky investments of all.

The reason this is so important is that just about every investment will experience volatility at some point. Assuming that volatility equals risk encourages investors to bail on otherwise good investments at the wrong time. Just because an investment is lower than the purchase price does not necessarily make it more risky. In some cases, a lower price actually reduces risk when purchasing a high quality company because it increases the margin of safety or economic value. To reduce risk, the best thing investors can do is periodically revisit their long term needs and expectations. Those are the real drivers of investment satisfaction, and also the greatest opportunities for reward.


Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on the Growth and Income Portfolios and reducing tax.