We have been getting lots of questions about how our investments are faring in the face of this historic market decline. We have attempted to lay out our comments in a question and answer format. And please continue to reach out to our Avenue team at anytime with your questions and concerns.
Q: What exactly is happening in financial markets?
This has been the largest flight-to-cash in economic history given the unprecedented nature of the global economic shutdown we are witnessing to confront the spread of the virus.
There has been a particularly strong demand for U.S. cash because of the trillions of global debts denominated in US dollars. Individuals, companies, and governments need cash now to cover expenses while the economy remains shut down. These entities will be starved of revenue as long as the economy remains shut down and this will create issues servicing their debts.
80% of global payments are conducted in US dollars even though the US economy reflects less than 20% of the global economy.
The virus continues to be highly contagious, and we are only beginning to grasp the scale of transmission in Western populations in the last week. To state the obvious, the capitalistic system isn’t designed to be shut down like this, in an abrupt manner.
In the past two weeks we witnessed significant deleveraging from the unwinding of certain leveraged financial products. This action hurt the sectors that are more often held by retail investors including financials, real estate investment trusts, and utilities.
We view this selling pressure as the unwinding of leveraged market players which is a temporary action and we are comfortable with the stocks we currently own in the real estate and utilities sectors. Avenue continues to be very underweight in our exposure to Canadian and U.S. financials which we expect to remain under significant pressure.
Q: What has Avenue done leading up to today?
We entered this period of market uncertainty with a very defensive portfolio. We felt we needed to protect ourselves from stretched valuations and from a U.S. equity bubble being created by an accommodative Federal Reserve.
Keeping track of the proportionality of the numbers is straight forward when you look at the Dow Jones Industrial Average, because it started at a round number. The Dow Jones has fallen from just shy of 30,0000 in February to a low on Monday of 18,500, losing over a 1/3rd of its value. The Dow has rebounded over the last three days to just under 22,000. The TSX fell by roughly a 1/3rd as well during this month.
Since the end of 2019 we have repositioned Avenue’s portfolio having sold and bought over 40% of the current holdings since January 2020.
- 16% of holdings were repositioned from January 6th to February 4th to protect the portfolio from overvaluation and to lock-in profits on certain investments.
- 14% of holdings were repositioned from February 24th to March 11th, given the evolving market backdrop and uncertainty around the virus.
- 11% of holding were transitioned between March 12th to March 19th using risk management, selling positions that we viewed as non-core and adding to more favourable investments.
The transactions are a function of our active risk management as we reposition the portfolio and upgrade our assets while everything in the market is on sale.
We expect that in time our portfolio turnover will decrease significantly.
Q: What do we expect the market to do going forward?
The low in a stock market panic usually coincides with maximum uncertainty and a period of forced liquidation of market participants. If in three weeks the economy is terrible, but we can understand where we will be in September, then we likely have seen the low in the market.
But, if in three weeks the economy continues to deteriorate and there is no clarity on the outlook, we could have further weakness in stock markets around the world.
Importantly, we are now getting further policy action on a few key issues:
The US Federal Reserve has described its monetary policy stance as willing to provide an ‘infinite’ amount of cash. The US treasury market, which is one of the most important and liquid markets in the world was acting dysfunctionally last week. It has since improved given the policy intervention from the Federal Reserve.
The Federal Reserve increased their balance sheet by over $1 trillion dollars over the past 3 weeks. A staggering sum.
Additionally, a US fiscal spending bill worth $2 trillion is in the final stages of voting in the Congress. This will put money into the hands of individuals to keep them solvent during this economic shutdown.
This is what we once described as “Helicopter Money” only a few months ago.
Yesterday morning the US unemployment benefits added 3.3 million people in one week, which is a record. Our view is that the numbers in future weeks will be significantly higher.
Canada has taken similar action on monetary and fiscal policy and government unemployment protection. We also believe there will be relief from rent and bank loans for the next few months.
Historically, the markets have recovered in an average time period of 6 months to 2 years and previous crisis situations have represented great long-term buying opportunities for quality assets.
Q: What is Avenue’s equity strategy going forward?
As of today, we have approximately 55% of the portfolio in cash, gold, high quality mortgage corporations, real estate and utilities. Over half the portfolio is generating significant income to be reinvested into the portfolio during this volatile period.
We will continue to be patiently buying as we go through this steep market correction. We are focused on the highest quality large businesses, with a tendency for owning hard assets where we can find them.
Earlier this week we bought back Bell Canada, added to Enbridge and Brookfield Asset Management, and made an initial investment in Kirkland Lake Gold and Inter Rent Apartment REIT.
Our plan is to maintain a minimum cash buffer as insurance given that the length of the economic shutdown is still unknown.
Q: Are any of our portfolio investments at risk of insolvency?
This is by far the most important question and why we have been working around the clock for the last few weeks. We believe all the businesses we have invested in have a defensive and or essential nature to them. As we regularly discuss, we prefer hard tangible assets that produce consistent income streams.
We continue to ask ourselves, are our dividends likely to get cut and do any companies have too much debt. Given our repositioning, we think we are in good shape to weather this storm and emerge stronger.
Avenue focuses our research on the profitability and consistency of a business. It just so happens that many of these types of businesses pay a dividend. So far, we do believe almost all our dividends will be maintained. Historically, it has been very rare for the Avenue portfolio’s underlying companies to experience dividend cuts.
There will be weakness in Canadian banks and for this reason we have a much smaller exposure to the banks than usual. We believe the government will provide a backstop for bank loans, but it could still get messy. We are hoping we might get a chance to add to our holdings at a much lower price.
Q: What has been happening with the bond portfolio?
Avenue’s bond portfolio has investments in corporate bonds and a few publicly traded mortgage corporations and real estate companies.
In extreme market declines we know there is always a potential that the bond market will freeze up because of illiquidity and the lack of bond trading desks willing to take on bond inventory.
Whenever we make these corporate bond investments, we know the company will be solvent and we will mature the bond and collect our coupon income. Our bond portfolio is not a trading strategy.
The bond portfolio was very defensively positioned for the last 6 months waiting for an opportunity to buy corporate bonds. But as of today, we have not seen anything that offers compelling value.
Liquidity in the bond market is in the process of being restored by central banks and the majority of the portfolio is of very high credit quality with much shorter maturities than the broader bond index.
Q: Are financial markets telling us anything about the timeline of the virus?
This really is the only question that matters, and we don’t believe anyone knows the answer at this point. South Korea and Italy are quite geographically contained spaces when compared to the size of the United States and Canada.
Our best estimate is that the economy is back up and running in May or by the latest the summer months, but we expect travel restrictions will continue for some time.
Q: Where will we be in six months to a year?
We truly hope we will know how our healthcare system can handle a new highly infectious seasonal virus over the coming weeks. As in 2008, today’s rush to US cash is being solved by printing money. The policy makers have been much quicker to respond this time around. There is a staggering amount of money being printed.
We started the year with an outlook that for the next decade we need to make sure we own hard assets and essential businesses that can generate consistent income. After the markets are settled down this will be more important than ever.
It is understandable that businesses that need cash now must raise it where they can. However, all those people who feel safer with cash under their mattress are at real risk of a significant devaluation in the purchasing power of paper money because of the actions of central banks.
Q: Why would I ever own a Canadian oil stock?
We believe Saudi Arabia’s decision to abandon supply restrictions after 47 years had a lot to do with trying to hurt the U.S. shale oil producers. This will have a significant knock-on effect on the high-yield corporate bond market. About 20% of the US corporate bond market is energy related.
We believe the Saudis are taking advantage of the extreme demand destruction to use market forces to get the US to stop drilling oil on such a large scale. We have seen estimates this week that there might be 8-10 million barrels a day less demand when global supply is still running at 100 million barrels.
In this situation we will only own one stock which is Canadian Natural Resources. Their oil production is very low-cost, the oil sands can operate for fifty years without declining and their debt is manageable.
Q: Are gold stocks no longer a hedge?
We believe in investing in gold stocks as opposed to just owning the metal. If we own a good mining business, we will have more gold in the future than we do today. We are very selective with the gold companies we own.
However, in the short term where investors value cash above everything else, gold stocks become just another stock on the stock market. We are now writing this note on the other side of last week’s panic and gold share prices have already rebounded dramatically. Gold fits into our overall theme of wanting to own hard assets.