Category: Quarterly Investment Updates

Spring is in the air, stock markets are up and, as always, we face an uncertain future. This morning I am reviewing our quarterly newsletters written before the pandemic and hoping you will join me as I reflect with you not on the past three months but the past three plus years.

IF We’d Known Back THen What We KNow NOw…

• were hit by a global pandemic
• took on ballooning government deficits
• looked on in shock as a war started in Europe
• found ourselves in an inflationary environment not seen in 30 years
• endured sharp interest rate increases while the value of our homes declined
• witnessed bank failures including the 40-year-old Silicon Valley Bank and 167-year-old Credit Suisse

…and this list is far from complete. All this makes me wonder:

If we had known back then what we know now about the first three years of the decade, would we have kept our money invested in businesses or would we have moved to so-called “safe” investments?

The Results are In

In January 2020 I encouraged you to “look forward with planning in mind – and continue to be prepared for the uncertainty we face”. Weeks later we entered the pandemic. We were nervous for our health, for our communities and for our investments. You were steadfast and stuck to the plan. The results are in over three years later:

• Sticking to the Plan: A $100,000 investment in the S&P/TSX Index (the 250 largest Canadian businesses) made on January 1, 2020 would have been worth over $131,900 by March 31, 2023 (Source: Morningstar. Compound Annual Growth: 8.9%).
• Not sticking to the Plan: If you had invested in GICs over the same timeframe your $100,000 investment would have grown to $108,356 (Source: Ratehub.ca. Compound Annual Growth: 2.5%).

That’s a 23.5% difference in just over 3 years.

Are THings Looking Up for First-Time Homebuyers?

For many young Canadians, we see an opportunity to acquire homes at prices lower than they have been for some time owing to higher interest rates. We will also be recommending that many of our clients (or their younger family members/friends) set up Tax Free First Home Savings Accounts. For more information on this account I recommend you check out our blog post.

A new year with new investment realities to consider. The year 2022 brought headwinds in the form of ongoing COVID-related challenges especially in China, wildly fluctuating energy prices, skyrocketing inflation, the ongoing war in Ukraine and increasing interest rates that reversed a trend that dates back 40 years. The value investors placed on securities decreased over the course of the year 2022 as follows:

Our observations

1. Canadian businesses. Our thesis for years has been that Canadian businesses – many of which are in the energy and materials sectors – serve as a healthy part of a diversified global portfolio. This year portfolios with a Canadian equity component benefitted greatly.
2. Bonds. Which have long been considered a safe-haven for investors, experienced one of the most pronounced selloffs in modern history with the Canadian Bond Index declining by 14% over the course of the year.
3. Active management. Many active managers were able to substantially outperform their peers and passive investments over the course of the year. While this is small consolation for investors whose values went down in 2022, the capital protection provided by active management served many investors well in 2022.
4. Crypto-currency. Speculators in crypto-currency saw the value of their portfolios drop by 60% or more in 2022. FTX Trading Limited, a large crypto-currency exchange, declared Chapter 11 bankruptcy in the US and one of its founders, is facing charges that could keep him imprisoned for the rest of his life. The events of 2022 in this space serve as a cautionary tale on the perils of speculation of any kind.

Looking Ahead in 2023

Looking ahead, we are wise to consider the following:

1. Inflation and tax. Our goal is to invest in a manner that enables you to feed, clothe and house you and your family in the future. The greatest threat to achieving this goal is not short-term volatility but inflation and tax. Together we will continue pursue a strategy that enables you to manage and overcome these threats over the long term.
2. Investing in businesses. While income-generating investments such as High Interest Savings Accounts and GICs are generating much higher rates of return, they do not enable your purchasing power to keep pace with the cost of inflation and tax. Our investment priorities remain unchanged: we believe that a diversified mutual fund portfolio made up of quality businesses acquired at reasonable prices will enable your long-term financial success. Many businesses can adapt and thrive in an inflationary world. Think of it this way, when the price of doughnuts goes up would you rather be the one paying for the doughnuts or being an owner of the restaurant that serves the doughnuts?
3. There are benefits associated with higher inflation as follows:
   • Tax brackets announced for 2023 are substantially higher than 2022. This means that your taxes will be lower on the same income level. The OAS claw back threshold has also increased substantially for 2023.
   • OAS and CPP Retirement benefits have increased substantially for 2023.
4. Tax-Free First Home Savings Account (FHSA). The federal government will launch the FHSA this year. While this account may not benefit you, it is likely that a family member or friend could benefit. We will keep you posted on this as we learn more and as the account is launched later in 2023.

Hurricanes and Headwinds

The third quarter saw strong markets in July replaced with negative sentiment in August and September. In the aftermath of two hurricanes striking Canada and the United States in the past two weeks, I am reminded of the headwinds that push down the prices of the valuable assets we own in our investments:

1. Higher interest rates. The US Federal Reserve and Bank of Canada have continued their pursuit of higher interest rates to bring inflation back under control. The Bank of Canada overnight rate is now 3% higher than it was at the start of this year. These higher interest rates, while a good thing, raise borrowing costs and can impede the growth prospects of real assets. A $1,500 monthly mortgage payment in 2020 could finance a $350,000 mortgage. Today it can support less than half. (Source: Federal Reserve Economic Data)
2. Recession fears. Higher interest rates have already taken a bite out of global economic growth. Lower growth can lead to lower profits and compress the value of businesses we own in our mutual fund portfolios. 
3. Ongoing political uncertainty. As expected, the war in Ukraine lingers on. Uncertainty is the enemy of investment and prevents investors from deploying assets into businesses. Steps toward resolution will reduce uncertainty and market volatility.

Emotion Battling Our Beliefs

It is inevitable that these lower prices evoke an emotional response and may lead us to question the wisdom of our investment strategy. This is normal and to be expected – and it is (again) at times like these that we benefit by drawing on the things we know to be true and will continue to be true in the future. Here they are:

1. Active management can protect you on the downside. When markets are up, investors tend to prefer higher-risk investments such as a pure index ETF (S&P 500 index down 24% YTD), highly-leveraged growth stocks (NASDAQ index down 32% YTD) and/or speculative assets such as Bitcoin (down 57% YTD). We are never pleased when the value of your investments goes down in the short-term – and we are very pleased with many of our actively managed portfolios that have performed substantially better than these higher-risk investments
2. Our moment of greatest investment opportunity usually approaches when prices are low and uncertainty is high.  This is a very difficult truth to embrace for most investors because a decision to commit to a good investment at a great time is often a lonely decision and filled with uncertainty. At the same time, a decision to remain committed to a long-term investment plan is easy when markets are up, and difficult when they are down.
3. We are willing to adapt your investments to a changing environment. In this regard, we have a renewed appetite to use interest-bearing investments such as savings accounts to grow your capital. We have access to the CI high interest savings account that is now yielding over 3%. If you are holding a substantial balance in your bank account, I encourage you to speak to us about this investment.

Higher Interest Rates, a Looming Recession and High Uncertainty

During the second quarter of 2022 asset prices contracted through persistent uncertainty concerning inflation, economic growth and political unrest. 

On June 15^th, 2022 the US Federal Reserve increased the interest rate charged on federal funds by 0.75% which is the largest single increase since 1994 (Source: CNBC).  Interest rate hikes are expected for the next nine meetings till July 2023 (Source: CME Group).  The Bank of Canada will likely follow a similar path over the next year. These interest rate increases will continue until central banks are confident that inflation is under control. What this means for borrowers is that they can reasonably expect rates on 5-year fixed mortgage to be greater than 6% at this time next year.  

There are risks to our economy as these aggressive rate hikes could tip us into a recession – but slow rate hikes may allow inflation to remain. At a time like this we might be inclined to take our money and retreat to a safe place while things get sorted out. That would be a mistake and this is why it’s so important we lean on our investment discipline to guide our asset allocation decisions. This principle applies to both our behaviour and the investment approach applied by our investment partners. When we combine the discipline of these two the results are pleasing.

What helps us sleep at night

This is a question that people ask more frequently during down markets. EdgePoint Wealth recently published an article that explains in detail their investment approach and how it applies to specific investments and opportunities in their portfolios. We believe this is a worthwhile read for investors – and especially those who invest in their portfolios.

The Psychology of Money

Lesson #1: Timing is meaningless, time is everything. When Morgan published his book in 2020, Warren Buffett’s net worth was $84.5 billion. Of that, $84.2 billion (or 99.6%) was accumulated after his 50^th birthday. Although Buffett has enjoyed strong investment returns over the course of his life, it has been the time he has been investing that has had the greatest impact on the compounding of his wealth. If, for example, he had begun investing at age 30 (rather than 10) and stopped investing at age 60, his investing time horizon would have only been 30 years and his net worth would have been $11.9 million. This is a powerful lesson that investing is not about each year’s individual investment returns, instead it is about having an investment plan that you can stick with and that can be repeated over a long period of time – ideally over a lifetime

Lesson #2: You can plan for every risk except for those that are too crazy to cross your mind. These “crazy” events happen more than we think and avoiding them is impossible as they cannot be anticipated. It is, therefore, important to create redundancy in our financial plans. Housel referenced suspension bridges which are built to stand even with missing cables. In the same way that a suspension bridge does not rely on a single cable, your financial life should not rely on a single investment. We incorporate different holdings and different asset classes in financial plans (equities, bonds and cash) for this very reason. These alternatives provide safety not only for risks we anticipate but also for those we cannot. The cash and low-volatility assets can be accessed when disaster strikes or deployed into the market when opportunity arises.

Uncertainty and Market Volatility

Uncertainty goes hand-in-hand with market volatility – and political uncertainty offers no exception to this rule. Think back on the summer of 2015. The S&P 500 dropped by over 12% on fears that Greece would default on its debt and exit the European Union (Grexit). In the summer of 2016 markets again dropped as Great Britain initiated its own process to exit the European Union (Brexit). Later that year in November, the S&P 500 futures dropped by over 5% on the evening Donald Trump shocked the world by winning the US presidential election (it recovered overnight and was up by over 1% the next day). The Russian invasion of Ukraine did not come as a surprise to the world. The S&P 500, nevertheless, convulsed in the first quarter – dropping by over 13% by March 8. (Source: yahoo.ca/finance).

It is during these times of market volatility that we are well-served to check our convictions on why we own what we own. This is process is known in our industry as conducting due diligence. It is defined by the Oxford Dictionary as: a comprehensive appraisal of a business undertaken by a prospective buyer, especially to establish its assets and liabilities and evaluate its commercial potential.

Due Diligence

In our investing process we employ professional managers who are constantly conducting due diligence on our behalf. They ask questions such as:

1. Does the business solve compelling problems for its customers – and will it continue to do so in the future?
2. Is the business able to generate a solid stream of free cashflow from its operations?
3. Are the business managers competent, honest and hard-working? Do they have a successful track record?
4. Is the business well-positioned to survive a crisis?

I encourage you to ask the same questions too.  If for no other reason than to reassure yourself that you are holding shares in businesses that will provide for you and your family in the future. If you have a moment, look up the securities you hold in your mutual fund portfolios and ask yourself if these are the kinds of businesses you want to own in a volatile world. Search for the top holdings of your mutual funds (this information is publicly disclosed and updated each month).

Let’s take a quick look back at 2021 even as we shift our focus to 2022.

Year of Vaccination

2021 was largely defined by the rollout of vaccines to curb the spread and impact of COVID-19 in Canada and the world. In the developed world this was a remarkable achievement with a vast number of people being vaccinated. In Canada, we progressed from less than 1% of our population being vaccinated at the beginning of the year to over 77% by the end (Source: Our World in Data). Even as we recognize this achievement, we acknowledge that there are issues as poorer countries – especially those in Africa – have been unable to procure and distribute vaccines to large portions of their population. This challenge may lead to a prolonging of the pandemic as new variants mutate over time. We remain hopeful that 2022 will be the year we put many of the impacts of COVID-19 in the rear-view mirror.

Increased Tension with Russia and China

Inflation rearing its head

The pandemic and its effects have resulted in increased inflation. Canada’s inflation rate remained at 4.7% in November, the highest inflation rate we have seen since 2003 (Source: Economist). When inflation concerns were first raised earlier in 2021 much emphasis was put on inflation being transitory and likely to return to normal levels soon. Those predictions have been adjusted and it appears likely that higher inflation will remain for longer than originally anticipated.   

There is much that is outside of our control as we have experienced through the last few years. As such, we do not spend our time predicting the future but instead we focus on what is within our control with appropriate asset allocation, tax planning and estate planning.

---

Looking to 2022 we return to similar themes as we examine the forces that will influence your financial plan in the coming years.

Inflation and increased interest rates

As noted above inflation is a serious concern in Canada and around the world. As governments look to curb inflation it is likely that we will see multiple interest rate hikes in the coming year. Although the Bank of Canada did not raise the interest rate at the end of 2021, it is anticipating raising interest rates between April and September of 2022 (Source: Reuters). Economists anticipate that there could be as many as four rate hikes by the end of 2022. This situation again confirms our belief that owning good businesses that can weather change and adjust is the best investment. Our approach to fixed income remains focused on shorter duration (which measures the amount of time we lend our money to others) and higher-yielding corporate debt.

Canada’s housing Market

According to the Financial Post, Canada has the second-highest housing bubble ranking in the world and there is significant risk of a pullback. One source of risk to Canadian housing is higher interest rates. The market share of variable-rate mortgages increased to 51% in 2021 up from less than 10% in early 2020 (Source: Financial Post). As the bank of Canada raises rates these variable rate mortgages (and eventually fixed-rate mortgages) will become increasingly expensive. Many Canadians have stretched themselves to afford homes in the recent housing market environment and an increase in interest rates is likely to squeeze the budget of many Canadians. As mortgages become less affordable this could drive down the price of homes throughout the country. Due to this risk, we work to create retirement plans that are not dependent on continuous price increases and eventual downsizing.

Short-term vs. Long-term

It is no secret that attention spans worldwide are shortening. This phenomenon is infiltrating investor mindsets. In the 1960s the average holding period for stocks was eight years. In 2020 the average holding period dropped to below five months (Source: Reuters). This short-term focus works against investors as it encourages damaging behaviour from investment managers such as closet indexing and high portfolio turnover. We also find that a short-term focus may tempt investors to chase short-term investment returns. ARK Invest is a US-based investment management firm that invests solely in disruptive innovation. Their flagship ETF (ARKK) dropped roughly 31% in 2021 while the S&P 500 finished up. The average investor in their ETFs is now estimated to have lost money (Source: Financial Times). This is why we work with investment managers who are focused on long-term results. These managers have established investment processes that keep them from chasing the latest short-term investment idea, instead focusing on fundamentals and long-term performance of the businesses in which they invest.

2022 promises to be a year of change as we emerge from the pandemic. We remain focused on your long-term financial health and look forward to working with you through the changes this upcoming year has to offer.

China Rises

A Cautionary Tale

Ethical Investing, ESG and Greenwashing

We continue to cast a skeptical eye on so-called “green” mutual funds and ETFs.  Investors are increasingly concerned about how their investments are impacting the world and the future – and we think this is a good thing. At the same time, investment companies are using investor sentiment as an opportunity for profit without really helping the environment (this is a process called “greenwashing”). Helping the environment is a complex endeavour and serious solutions are needed. TransAlta, a Canadian power company, is in the process of converting from coal to natural gas power generation. This conversion will reduce the company’s annual carbon emissions by 30 mega tonnes which represents 14% of the target carbon emission reduction for Canada (Source: Edgepoint). We believe a typical “green” investor would be disinclined to invest in TransAlta, yet it is difficult to find a company that will contribute as much to the reduction in Canada’s carbon emissions moving forward as TransAlta.

We believe that investing continues to be a nuanced and complex endeavour where simplistic solutions are counterproductive.  We agree that making the world a better place through our investments is a good thing – and affixing simple labels to investments and/or people does more harm than good. 

Welcome Garrett Boekestyn

Crowds Slowly Building Again

The long-anticipated 2020 Summer Olympics will finally take place starting on July 23 in Tokyo. Crowds around the world are slowly building again as the organizers announced that 60,000 fans will be allowed into Wembley Stadium for the Euro Cup finals in July (Source: The Guardian). Foo Fighters, an American rock band, played to a full-capacity audience at Madison Square Garden on June 2. In a sign of what may be to come, attendees had to show proof of vaccination in order to gain entry to the concert.  

Strong Investment Returns Tempered with Higher Inflation

The value of the businesses in your mutual fund portfolios generally increased over the quarter. In our view, these higher values are to be greeted with caution because at the same time the values of our investments were increasing the prices we pay for things was also increasing. Year-over-year inflation in Canada was 3.6% in May (up from -0.4% a year earlier) and 5% in the United States (Source: Trading Economics, Statistics Canada, U.S. Bureau of Labour Statistics). The US Federal Reserve, who had previously indicated that they would leave interest rates alone until the end of 2024, now suggest that interest rates will be lifted twice in 2023 (Source: Economist).  If our main objective is to maintain and grow purchasing power over time, these inflation numbers remind us that this is not an easy task.

It Pays to be an Owner

Oil prices are up by over 53% since the start of 2021 (Source: Yahoo Canada Finance).  It should come as some consolation for you to know that when we invest in Canada through Canadian equity mutual funds, we benefit from these higher prices through ownership of energy businesses such as Enbridge, TransCanada, Canadian Natural Resources and Suncor.  Another reminder that ownership is a good thing – and potentially takes some of the pain away when the price of gas creeps up above $1.30/litre.

Finding Risk in Unlikely Places

Bond prices were significantly down over the first quarter and we believe this is important. We were again reminded how fragile our global supply chains are when a ship named MV Ever Given ran aground in the Suez Canal blocked over 12% of global shipments.  If it isn’t a pandemic, it’s something else that is reminding us that financial risk is everywhere. We are well-served to understand and manage (versus avoid) risk. 

Why Lower Bond Prices is a Big Deal

A decrease in bond-prices is important because bond prices represent the value of money we lend to others. From January 1 – March 31, the iShares Core Canadian Long-Term Bond Index ETF (this serves as a proxy for the value of long-term bonds in Canada) was down 11% (Source: Morningstar).

The graph below shows that interest rates have been more-or-less declining and bond prices have been more-or-less rising since 1981. Since 1981 it has made sense to borrow as much as we possibly could to buy assets that go up in value as the cost of borrowing goes down. The decrease we have seen this year is the first major pullback in bond prices in a generation. How much further bond prices decline and how much higher yields rise is anyone’s guess.

---

What Do We Do About It?

We want to remain vigilant as the investing landscape changes around us. What causes bond prices to fall and what does it mean? Bond prices often fall when investors require a higher rate of return on the money they lend to others. In many cases they require a higher rate of return when they believe the cost of things will go up. Why, for example, would I lend you my lunch money for 2% this year when I think the price of food will go up by 3% over the same timeframe? Lenders worldwide are expecting prices to rise at a greater rate in the future and have already priced higher interest rates into bond valuations.  

What can we do about this? Here are three ideas:

1. Be prepared for declining home values. I am concerned about the number of Canadian households with high mortgages and how they will manage when interest rates increase to 3%, 4% or 5%. I’m interested to know what will happen to the market value of my house when the pool of potential buyers is faced with higher mortgage payments. It is difficult for me to imagine a scenario where housing prices rise in the short to mid-term.

2. Keep our lending short-term. With a bond we receive a promise from borrowers to repay within a specified timeframe. Lending money to others for a longer timeframe in a period of rising inflation is risky. This is because borrowers typically don’t increase what they pay simply because inflation has gone up. With a bond they agree to pay you whatever they agreed to pay you, not a penny more. This is why we prefer to lend our money to others on more of a short-term basis. This strategy is reflected in the portfolios we manage for you. 

3. Invest in businesses that have the ability to increase the price of the goods and services they produce. These businesses are able to generate higher profits for investors. This is why we use mutual funds that invest in businesses that are industry leaders and have the ability to thrive while prices are rising. 

A Word About ESG Investing

ESG stands for “Environment, Social, Governance” and it is a hot sector in the investing marketplace. The above image shows the explosive growth in ESG assets since 2015. The promise of ESG is that we can use our investment dollars to nudge businesses to be more environmentally aware, socially conscious and better corporate citizens. We have not embraced ESG investing because we believe it is difficult to fulfill the promise that ESG investing makes. 

An opinion piece published in USA Today on March 16 by Tariq Fancy, former head of sustainability at BlackRock, the world’s biggest asset manager, tends to support our concern. Click here to read his article.