As we have written in many of these essays, in times of inflation holding cash for long periods is not a good financial option. We own businesses to protect and grow our wealth but given today’s valuations and interest rate risks, we would like to emphasize that Avenue builds in a margin of safety. In this case study we would like to discuss our margin of safety in terms of the type of quality businesses we are invested in and how we can still find good stock market valuations.
Let’s start by giving an update on inflation as this is the main driver of interest rates and subsequent stock market valuations. As a reminder, the central bank determines short-term interest rates, but longer-term interest rates are determined by the free market. We currently have three drivers which are all inflationary: US government budget deficits, US tariffs on imports, and wars in the Middle East and Ukraine. These three factors seem set to continue for a while.
US Government Deficit + US Tariffs + War = Inflation
In addition to these three factors, we added a Data Centre construction boom. What is new is that these big tech companies, referred to as hyperscalers, are now starting to finance their construction projects with debt. This extra demand for borrowing also pushes up interest rates.
With all this inflationary pressure, why is US inflation only slightly above 3%? The reason seems to be that despite low unemployment there is very little wage inflation. The things that are increasing price inflation in goods are also dampening expectations for wages. With all this tension there is a risk that something breaks.
To protect ourselves from an interest rate shock, either higher or lower, we can use the example of our infrastructure investments. We like Canadian energy infrastructure businesses for their consistency and how they return profits to investors. However, we believe some companies are better than others in terms of riding out an interest rate shock.
In the chart below of seven companies, we would like to highlight that Avenue owns the bottom three, which have the least debt. More importantly, Pembina, South Bow and Gibson are living within their means. At Avenue, we like to focus on the measure of capital spending plus dividends and have that number be within the amount of money or cash flow their current businesses are producing. For the most part the stock market will not notice the difference. As we like to say, it doesn’t matter until it matters. At Avenue, we define a quality business as one where the numbers make sense, and this gives us the added margin of safety.
The other margin of safety we would like to highlight is looking for new investments that do not have expensive valuations. The historical average price earning ratio for the US S&P500 is 16 times earnings. The chart below breaks out the valuations for the largest big US tech companies by US large cap, mid cap and small cap stocks. What we see is that a few large tech stocks are expensive, but the majority of stocks are trading at average to lower than average valuations.
Source: Ed Yardeni Research
If we can find great businesses at a fair valuation, then this is building in a margin of safety for our investment. The alternative of buying a great business at a high price is that the business must execute perfectly to make the return worthwhile as there is little room for error.
Bill Harris
October 2026
