The question many investors are asking is, given this increase in money supply, is a period of higher inflation upon us? While we at Avenue believe higher inflation is likely this year, we will soon revert back to an economy with low growth and low consumer price inflation.

Velocity of money is an esoteric economic term that we have mentioned in past letters at the risk of being too technical and quite frankly, pretentious. At Avenue we are always attempting to write about investing in as clear and understandable a language as possible. However, velocity of money is now an extremely important concept to grasp, and we feel most investors are missing it. One cannot understand where economic growth and inflation are going without understanding the historic decline in the velocity of money.

Velocity of money is described by the Equation of Exchange which economic students bump into in university level macroeconomics then promptly forget. It just has not been relevant until this last decade. Many classical economists believed it was a constant and something you could disregard. And this was the case for most the 20th century.

The Equation of Exchange : GDP = Money Supply x Velocity of Money.

The concept is that the value of a country’s Gross Domestic Production is simply a function of how much money is in the economy multiplied by how fast that money circulates between people and businesses. We can see that the money supply has increased through 2020. But is this inflationary?

What is clearly revealed by calculating the velocity of money is that for every increase in the money supply there has been a commensurate decrease in the velocity of money. The money in the economy is circulating at a decelerating rate. There are all sorts of reasons for this. The main one being that there is just too much debt in our modern economy. But the conclusion is the same, it is really hard to get any lasting inflation if we can’t get the velocity or the speed with which money changes hands to increase. Velocity can only come from making productive investments that generate an income stream to pay back both principal and interest, or from a complete loss of faith in a currency.

While we will have a temporary increase in inflation as the economy recovers from the pandemic, we believe inflation will return to the 1 to 2% level over the next few years. Therefore, bond yields will remain low, and the stock market multiple will remain high by historical comparisons.

After a forty-year bond market rally from a high of 18% in 1982 to the current 0.70% low today, we struggle to get excited about bonds in the short or medium term.

Now What to Do?

Bonds have always been there to diversify from the volatility of the stock market.  The idea was, and is, when stocks go down, bonds go up, and vice versa.  In 2020, we saw that historical relationship break.  When stock markets crashed in March, the Bond Market went down as well until the Federal Reserve and Bank of Canada “saved” the Bond Market.

Another attribute is that bonds are there for capital preservation despite having little yield, which is a very important attribute to have when dealing with risk or asset allocation of clients’ wealth.

When we look beyond those two benefits, we struggle to find many opportunities in the credit or interest rate market due to historically low interest rates. As well, we have seen the central banks’ interventions into the credit markets suppress credit spreads.

Where Do the $300 Trillion in Global Debt Markets Go From Here?

For the past two decades, analysts, economists and central banks have forecasted incorrectly that global bond yields should yield at higher levels. The ongoing combination of technological disruption, global free trade expansion and our aging population has caused deflationary pressure, therefore causing yields to be suppressed.

Why It’s Different This Time

For the past decade, central banks have “pumped” the system with a massive injection of money for two reasons.  Firstly, for the public markets to function properly.  Secondly, they are trying to keep businesses afloat (large and small).  The former worked wonderfully, the latter not so much.

When central banks increase liquidity, they release funds to the banking sector. The problem has been that this money doesn’t leave the bank and get lent out into the economy. The banks are too scared to lend or it is too expensive (from a capital perspective) for them to lend. So, the money never gets into the hands of main street and the commercial banks just buy government bonds to keep on their balance sheets.

For the economy to recover, the commercial banks need to get money into people’s hands. This could happen.  More on that later.

The Central Banks are also trying to reflate the economy. To get inflation, you need several conditions in place. Or to say it differently, you need specific ingredients to bake an inflation cake:

1. Central Banks Are Slowly Losing Their Independence

With record amounts of sovereign debt, there is very little chance that central banks will not be influenced politically. There is a view that the only way out is to inflate the debt away.  This occurred in 1948.  After WWII, the Allied countries were left with a massive amount of debt.  They had little chance of paying it back.  So, they used inflation as a monetary trick.  After the war, there was tremendous pent-up demand resulting from rationing, consumer high savings rates and European rebuilding (Marshall Plan). All this caused inflation over several years. They used higher inflation to lower the outstanding debt since future dollars are worth less than present dollars, thereby dropping the real debt ratios.

2. Labour Market and Class Division

There will be a new agenda focusing on closing the divide between the upper class and the middle class.  We have started to see wage increases. As an example, minimum wage workers have seen their wages double. We believe we are going to hear more of new labour union creation for the working class to extract more profits from their companies. An example is the organizing of Amazon workers.

3. Global Trade

a) Modern Trade Agreements and Reshoring

We have seen so much deflation coming from global trade agreements set in the 1990s and 2000s. The Agreements in place are starting to unwind.  We are seeing western countries renegotiate trade deals that encompass not only economic benefits but must have social benefits as well, which will lead to higher prices for goods.  Manufacturing is also looking to bring back their production to their own country, which is called reshoring. Goods will be more expensive.

b) Cold Trade War with China

Western economies are starting to re-evaluate their relationship with China due to trust issues. Cybersecurity, political intervention by the Chinese state and uneven access to their markets is causing the West to re-evaluate our relationship.  This will mean that companies will try to find other options such as reshoring manufacturing.  This will lead to higher prices.

4. ESG (Environmental Social Governance), Social Lending, Justice and Green Programs

This type of policy is now in vogue. Even though it is just and honourable to consider these social lending polices, from an economic perspective the policies will force higher prices since these policies have a cost which must be shared throughout society.

5. Central Banks’ Policies Mandate Inflation

Most central banks have abandoned low inflation policy.  The US Federal Reserve has now installed a policy where inflation targets should be at minimum 2%.  Central banks have said they will not tighten monetary policy until they see a complete recovery.

6. Asset Prices Are Now Inflationary

Whether it is housing, the stock market or bitcoin, all asset classes are now reaching bubbling levels that will trickle down into the Consumer Price Index (CPI) inflation calculation.

7. Interest Rate Curve Suppression (Not Happened Yet)

There has been recent discussion on central banks trying to control and pin down long-term interest rates by purchasing unlimited amounts of bonds to keep the interest rate curve low. If this does happen, inflation will certainly rise.

8. Macro Prudential Regulation (Not Happened Yet)

As previously mentioned, central banks will be pressured politically.  The main issue is that money expansion is not getting to the consumer or small business. There is early talk that governments could force banks to lend by guaranteeing all loans to their customers.  Or governments could force their central banks to buy outstanding federal debt, thereby creating money by fiat.  (Most modern currencies are fiat or paper currencies that are not based on a commodity such as gold.) Regardless, if this does happen, inflation becomes a real issue.

In Summary

We do believe reflation is on the horizon.  We believe that inflation will easily move from 1.5% to potentially 3.0% in six months. Over time, we think that higher inflation is a bigger risk than lower inflation. If that occurs, it is a headwind for the bond portfolio.

With this in mind, we have been in a defensive mode since mid-2020 with our bond portfolio by doing the following:

  • Lower term-to-maturity (shorter duration):  3.5 years versus 7 years for the index
  • Credit exposure primarily in the 1 to 3 year area
  • Larger weight towards REITs – sector trades at a discount to its Net Asset Value
  • Lower weight to High Yield – sector shows little value versus risk.
  • Possible purchase of inflation index-linked bonds in near future.

(As a reminder we can own 20% of the bond portfolio in higher risk assets such as convertibles, real estate investment trusts, preferred shares, and non-investment grade bonds.)

An examination of the valuation of Apple’s shares is an excellent way to demonstrate the extreme divergence that has taken place in the stock market in the last six months. Not much has changed in the underlying profitability of Apple. What has changed is that investors are willing to pay a mania-type multiple not seen since the 2000 dotcom bubble.

To be fair, the present era is different from the dotcom era. Apple and its ‘Mega Cap’ siblings are very profitable. More importantly, Apple is an essential provider of smart phones and services which are helping us get through this global pandemic. As we have discussed in our Q3 Letter, financial markets are awash with money looking for a safe place. Apple fits the bill as a low debt company with a consistent and slightly growing income stream. But we argue that the valuation is now extreme.

Looking back at our internal estimate of Apple’s future earnings from four years ago, we believed that then current earnings of $9.00 per share could rise to $14.00 by the year 2020. This has turned out to be exactly what has happened and for the most part this was a consensus view among Wall Street analysts. When we initially purchased Apple in 2015 at around $100 (split adjusted $25) we were paying roughly 10 times 2016 earnings with our expectation that earnings would grow to $14 in 2020. We made our purchase with a good margin of safety in the valuation.

Since that time the stock has delivered great returns, but it is not because the business is growing. Rather the business has been consistent in that it has a high profit margin and then it takes that excess profit and buys back its own shares. Revenue and profit have increased slightly but earnings per share have gone up over 50% because the numbers of shares outstanding have been reduced.

What has happened since then is the multiple that investors are willing to pay for Apple has increased dramatically. Last month at its recent high share price of $535, Apple traded at 38 times this year’s earnings of $14.00 per share. And now the market capitalization for Apple is $2 trillion dollars. This is the highest value that any company has ever traded at and is closing in on the value of the entire Canadian Market. Yes, you can either have an entire country the size of Canada or a company that makes a cool phone.

When we made our initial investment at 10 times earning a lot could go wrong with the business and we were still ok with our decision. Now at a multiple in the high 30s, a lot must go right for us to be comfortable owning Apple. A stock that trades at a multiple of earnings this high implies that the future must be better than today. We argue that Apple’s earnings need to double to justify its current share price. Apple’s business is not perfect. China makes up 15% of sales and the US and China are embroiled in a tepid trade war. Much of Apple’s supply chain is China dependent. There is also a battle being fought over fees paid by app developers to access Apple’s App Store, where there is threat of margin erosion.

Our point here is not to say that Apple’s stock cannot continue to go up or that collapse is imminent. Rather it is an effort to make sense of what has been an extreme run up in the share price, and because of Apple’s relative size, this has created a distortion affecting the valuation of the entire stock market. As investors we are trying to avoid taking unnecessary risk. We can find other equally profitable and growing businesses where the stock is trading at a much better multiple. We have now sold our shares in Apple and have added to our existing technology investments that trade at a more reasonable multiple of earnings.

The level of US Government debt was an issue before this recent crisis. Now we believe excess debt will come to define financial markets in the coming years.

Our conclusion is that there is simply too much debt to be paid back in real terms. In the case of the US, being a reserve currency, they will not default on their spending obligations but rather devalue the purchasing power of the US dollar over time. Being invested in businesses and hard assets is the best way to protect our wealth in a world where cash and bonds lose their purchasing power over time.

When the central bank starts printing money to pay for government spending, crazy things can happen. Historical examples include Weimar Germany, Zimbabwe, Venezuela, and Argentina. We have a few charts which show the recent currency devaluation in Argentina to illustrate what this can look like in an extreme version.

The first is showing gold. The gold price in US dollars during this period was relatively stable. This is not a chart of gold going up, but rather the Argentinian peso going down. This requires real mental gymnastics because it is just not what we are used to seeing. Gold looks like it has gone up 500% in Argentina pesos since 2018, when actually the purchasing power of the Argentine peso has gone down.

While we want to have a certain amount invested in gold, there are still lots of things that can go wrong. A portfolio made up of a mixture of hard assets and income producing businesses is ideal. Real estate or a power plant retain their intrinsic value while the value of the currency declines.

However, as we see in the case of Argentine stocks, returns are not linear. A portfolio of stocks accomplished about half of the same protection as gold, but there are big 50% or more swings along the way that test the resolve of investors.

While it will be tempting to jump from stocks to cash and back, getting the timing right on this type of move will be impossible to do consistently. Our discipline is to stay invested. We will continue to be cautious when the market is up, and sentiment is positive. And by that same token, we will buy when the market is down, and sentiment is negative.

The case study is where we discuss specific details of our investment process. Today we will tackle stock market multiples and how it relates to risk. I wish I could say we can also make it entertaining, but the subject matter probably precludes this.

To ‘beat the stock market’ investors often take excessive risk and make no attempt to measure it. In investing, measuring returns is the easy part and measuring risk is complicated. At Avenue we are not spending our days trying to figure out how to beat the market. We prefer to ask the question: Can we get a fair rate of return from our individual investments with a high degree of confidence? This is the same as saying we wish for a fair rate of return with low risk, or limited loss.

If a company grows consistently on a per share basis then this is a great way to make money. At the moment, however, the economy is growing slowly and sometimes not at all. There are a few rapidly growing businesses but because they are an anomaly, they attract disproportionate global investor interest and subsequently trade at extreme valuations. We think a much safer way to compound at a reasonable rate is to focus on stable and growing, moderate-sized businesses that trade at lower multiples compared to mega-sized businesses that trade at a high multiple and have high index concentration. For this Case Study exercise we choose to compare Leon’s to Microsoft.

Leon’s is an Avenue portfolio investment that trades at approximately a 10-times earnings multiple – or at least it did for most of 2019. We don’t factor in significant growth in earnings for Leon’s over the next 10 years. But the company is consistently profitable. More importantly, it returns this profitability to us, by way of dividends and share buy backs. By capturing and compounding these returns, we hope to safely double our original investment over the next ten years.

In contrast, Microsoft pays a small dividend but mostly reinvests the money it makes back into its own business. The problem is that the stock market has bid up the price of Microsoft’s stock so that it now trades at a 30-times earnings multiple. Now let’s use actual numbers to assess the probability of our expectations. Microsoft has a market capitalization today of $1.2 trillion and earnings of $40 billion per year. Let us emphasize that earnings again must double to $80 billion and in 10 years’ time, growth must be just as strong so that the stock still trades at 30 times earnings; or if Microsoft’s earnings slow and the stock trades at just 20-times earnings, then earnings must triple to $120 billion.

What you are asking Microsoft to accomplish is possible, but it has never happened in investment history before. Whereas, what we expect Leon’s to accomplish did happen last year, and the year before that, and the year before that… At Avenue, we believe we have a high degree of confidence that we can double our money by investing in Leon’s. Whereas doubling our investment with Microsoft would be super cool, but the risk is more comparative with wildcatting for oil or exploring for diamonds. Take note that if Microsoft did double its present stock market value, that company would be similar in size to the current value of the entire Canadian stock market, which is about $2.4 trillion.

Avenue’s stock market investment strategy is to find business that have consistent earnings and trade at a fair price. Technology is difficult to fit into these parameters because technology companies by nature have disruptive business models which don’t always result in consistent earnings.  Our topic today is to show just how expensive and erratic many of these technology companies have become.  We will examine the influence of Softbank’s Vision Fund and WeWork on tech venture investing.

Softbank’s Vision Fund is a pool of $100 billion dollars which has emerged as one of the biggest global venture capital investors.  It is the largest investor in household names like Uber, Slack, Didi (the Chinese equivalent of Uber), and WeWork. And it is the withdrawing of WeWork’s initial public offering (IPO) and the trail of wild valuation swings that make it a timely example of extreme valuation in technology investing.

Who is behind Softbank’s Vision Fund?  Is it run by an autocratic portfolio manager named Masayoshi Son. At 16 years old he emigrated from Japan to California and became interested in technology. Through smarts and luck he was an early investor in Alibaba. Alibaba is the Chinese equivalent of Amazon, eBay, and PayPal rolled into one. His initial $20 m Alibaba investment in 1999 has propelled him to the 43rd largest billionaire in the world.  He is back living in Tokyo and seen as a technology visionary. 

His Vision Fund’s business model is to seed emerging disruptive internet businesses with enough money so that they can become global category killers before they come public.  The problem is that in their enthusiasm and early success, valuation and profit are things that don’t seem to matter. The question raised is Softbank actually “smart money”?

Uber is now a public company and it trades with a market valuation of $50 billion.  It has revenue of $11 billion and seems to have a hard time making money. Also, it looks like there is plenty of competition.

In the last few weeks WeWork was expected to become a public company, however, the cancelation of the IPO revealed an extraordinary example of private market overvaluation.  WeWork is a global commercial real estate company that provides shared workspaces for technology startups. In summary, WeWork’s most recent private valuation where private investors put money into the company valued it at $47 billion.  The company then tried to realize this valuation in the stock market by going public.  The initial valuation for their stock was set around $20 billion by investment bankers at the end of the summer. When the bankers actually went to market the company to potential investors, they found that the highest valuation they could get was $10 billion.

WeWork Valuation

How can the private and the public valuation be that different? And more importantly, who’s money is it in the Vision Fund investing to create these crazy valuations and get it that wrong?  Well, one third is Masayoshi Son and Softbank’s money and the other two thirds are Saudi Arabian and Abu Dhabi sovereign wealth funds. Connecting these dots, it looks like Masayoshi Son’s vision doesn’t really care about hard numbers and with his level of wealth he doesn’t really have to worry. If he loses 90% of his wealth, he will still be worth $2.5 billion.  And to be generous, it looks like the richest guys on the block who most want to diversify their wealth away from oil and into the new economy got duped into believing this one guy in Tokyo had all the answers.

WeWork is just today’s example of wild valuation.  It really is the scale of money flows that we as investors have to be aware of. Technology investing today is just as crazy as it was in the era of 2000.  Great businesses will be created but quite often more money is being poured into technology businesses than will be ever returned to investors in profits. While the lucky tech titan Masayoshi Son and Saudi Sheikhs can afford to make this scale of mistake, we would prefer not to.  At Avenue we will continue to look for investments underpinned by hard asset values and profits.

With Canadian bond yields dropping below 2%, these are dark days to be a bond investor.  Gone are the days when one could hope for 5-7 % annual returns from the bond market. With global central bank policy using quantitative measures to lower interest rates close to zero, the global $40 trillion-dollar bond market is searching for a “normal” return.

The Canadian bond market is no different, and a disturbing trend has recently surfaced here.  As an independent portfolio manager, Avenue is privy to many retail portfolios and we see a persistent trend of reaching for yield without understanding its consequences.

Specifically, attempting to reach a high yield often means investing in preferred shares and private mortgages.  The concern is the higher risk that investors are adopting, especially senior citizens, and the regulators seem not to care.

It is now common to see investment advisors using preferred shares as the building blocks for creating a so-called fixed income portfolio for their clients. Most investors are told these shares are fixed income.  They are not.  Although preferreds are higher on the capital structure than pure equity, they still have inherent risk and they are much riskier than the traditional corporate bonds if one needs to rely on the income they provide. During a company’s restructuring, preferreds are usually “wiped out” with the common equity.  Only creditors (i.e. bond holders) hold the cards in the restructuring or bankruptcy process.  If there is any inherent value left in the company, the bond holders get the lion’s share of the remaining assets.

Recently, a more important issue has reared its head for preferred share investors. Here we are talking about preferred shares that have a dividend reset policy. Over the past few years, bank underwriters have issued billions of these shares, close to $5 billion worth of preferreds in 2018 alone. Critically, these issues have a rate reset policy. These were issued as rate-reset preferreds because most analysts believed interest rates would go back up in 2018 and 2019.  Therefore, the dividend yield would reset at higher coupon levels since interest rates would increase in both Canada and the US. This obviously did not happen.  Dividends are being reset at much lower yields. When that happens, the value of your preferred shares will drop significantly.

Now let’s go back to advisors that are recommending these preferreds. Investors that have these resets are now down between 15-30% depending on the issue. For a retired investor that is looking for fixed income, this is not it.  A fixed income portfolio is not supposed to drop 20 – 30%.  From an asset allocation perspective, fixed income is about providing stability and preservation of wealth while giving you a stable rate of return.  Yes, interest rates are very low by historical standards. Investors will have to accept this fact.  What they must not do is chase yield at this point in time.

The same rule applies for mortgages.  Many private mortgages that investors hold give some enhanced yield, but the problem is that there is inherent risk with this product. Not only is it illiquid, but in a downturn in the economy these types of investments can drop to close to zero.  (Just look at the recent collapse of a prominent mortgage lender where investors lost everything.)  Once again fixed income portfolios are not supposed to have these risk profiles.

Please do not misunderstand, preferred shares are a relevant product.  Preferred shares have low correlation to fixed income securities and the inherent tax advantage can be compelling in certain situations. The problem arises with the individual investor’s asset allocation and risk tolerance.  Many retired investors have these types of products which is fine when you have a 10-20% weighting under normal diversification rules. However, we believe this is frequently not the case.  When looking through prospective client statements, we are seeing weightings that are far higher and are inappropriate given the risk tolerance of the investor.

The investment community will have to deal with this fallout. As the chase for yield marches on, investors are looking to alternative investments that have inherent hidden risks. Investors will need to understand the real risks involved and should always be prepared to ask the question – “Why do I own this?”