In Avenue’s equity portfolio, Enbridge is a great example of an investment which demonstrates the current valuation paradox.

Below is a chart of Enbridge’s share price over the last 10 years and a table showing the increase in dividends and yield over that same period.  You can see that today’s 6.7% dividend yield makes the shares the cheapest they have ever been, but still the stock market sentiment is negative on the shares.

We like Enbridge because it has the best pipeline infrastructure in North America.  The company that produces the oil pays Enbridge a fee to transport the oil to a refinery.  It is a very simple business. The problem for Canadian oil producing companies is that there is more oil than there is pipeline capacity to move it. The handful of projects to add pipelines are stalled, for a number of reasons. This does not change the fact that Enbridge has lots of existing pipelines and they are all full and making money.  We as investors get a great long-term income stream from what is a comparatively stable business.

The criticism for owning Enbridge is that the company cannot grow and therefore cash flow and the dividend will not grow either. This argument ignores the fact that the dividend has grown from $0.74 per share annually in 2009 to $2.95 annually for 2019, an increase of 300%.

With the current 6.7% dividend, the company doesn’t have to grow that much for us to hit Avenue’s 8% compounding target.  Again the 8% rate of return allows us to double the value of the investment every 10 years.  The more important part of the compounding equation for us is that Enbridge remains profitable and this is what we will be monitoring carefully.

We would also like to point out that we have reduced the holding once over this 10-year period when we believed the stock was expensive.  A little too soon as you can see.  We then doubled the position in late 2017 at a price where we felt the underlying value had caught up to the share price. We don’t see any signs that the profitability of Enbridge is deteriorating.  We are happy to own it at this level and capture the income stream that can then be used to reinvest into other holdings and compound the portfolio.

In a rising interest rate environment there are times like the last nine months when it seems like nothing is happening.  We have had a few questions from clients about why we own bonds at all. We believe it is helpful to lay out Avenue’s bond portfolio, so you can see all the individual bonds and you can better understand the return profile of the entire portfolio.

In the chart below of Avenue’s bond portfolio we can see each bond we own by issuer, (who we are lending the money to) the term to maturity on the X axis and the current yield on the Y axis.  If left untouched this portfolio will compound at 3.5% over the next five years or so.

However, as the current bonds mature and are reinvested into this rising interest rate environment, the future bond portfolio will be invested at higher interest rates.  Avenue’s bond portfolio, going forward will have a return greater than 3.5%.  We are not going to predict at exactly what level interest rates will top out for this cycle.  This is simply an exercise to help present Avenue’s bond portfolio in a different way.

It seems many Canadians are in denial of what we actually do as a county to create wealth.  A majority of the Canadian population have voted for federal politicians to extract us from the carbon economy. This may sound like a good idea except we don’t really have a substitute non-carbon economy ready to replace it, just yet.

Our conclusion is that the sum total of these taxes and regulations is increasingly making it too expensive to manufacture products in Canada.  Our only remaining competitive advantage will likely come from having a weak currency.

Here is the list of the top ten items Canada exports:

The top ten categories represent 63% of our total exports that we sell to other countries to create wealth. These top ten categories total $265 billion in export value, or 14% of the Canadian economy. This is the wealth which can then be taxed to pay for our generous social welfare system.  However, looking at the list, all of these goods require a carbon footprint. Also, all of these items can be bought from someone else. You will notice that wheat does not even make the list.

It feels like the government didn’t even look at the list of what we sell before introducing rules and complexity that will surely put Canada out of business. These costs to manufacturing include: the high cost of electricity (in Ontario, this is a big one), the overall level of tax, density of regulations and permits, social license, minimum wage, and carbon tax.  If we keep going down this road, we are not going to have anything to sell. 

When we are looking for Canadian public companies who are making money, other than energy and lumber, we rarely invest in Canadian exporters.  It is service businesses and transportation companies that have much better and consistent margins.  Also, we have argued that owning an existing pipeline is probably a profitable asset given that it is almost impossible to build a new one.  There are lots of individual investments in Canada that will do well but as a whole, Canada as an exporter of goods is in trouble.

Given Canada’s overall lack of competitiveness, our economy will likely lag behind the US.  This is the core argument for why we believe the Canadian dollar will remain weak versus the US, even with the benefit of a higher oil price.  This is why we continue to maintain a core position in US dollar stocks.

Sometime a picture can relay information more clearly than a long-winded description.

This chart called “Ten-year US Treasuries: the end of the long decline in yields?” came to us from the Financial Times of London. Avenue’s conclusion is ten-year US rates can easily trade in the 3-4% range and not cause too much disruption. A move to the 5-6% range would be disruptive, but a move of this magnitude would be enough to trigger a recession and therefore an adjustment to lower interest rates.

This time line of ten-year US Treasury yields is a great way to visually measure the magnitude of today’s concerns of rising interest rates.

A new investment mania is always just around the corner.  All you need are the right ingredients of hope, unquantifiable potential and greed.  Cannabis stocks and Bitcoin qualify for this distinction as we observe them both dominating the headlines.  So, we thought we would take this quarter’s Case Study to discuss why a speculative craze does not fit with Avenue’s strategy of investing in consistent and profitable businesses.

As a refresher, at the core of Avenue’s investment philosophy is the idea that we invest in businesses.  We ask ourselves, does the company have a good product or service which can be sold to earn a consistent profit margin. Then can we invest in this business at a fair price.  Sticking to this plan is the best way we know to avoid big investment losses. If we own a diversified portfolio of businesses which all have about an 8% profit margin, we should compound at about 8% over time, with more consistency than the overall stock market.

So now let’s looks at Cannabis stocks with this filter.  The business should be easy to analyze because it is simply a traditional agriculture commodity turned into a consumer product.   Why it is exciting is because the market is expected to be large.  The argument goes that whichever company can get market share early will be able to make a killing.  Likely there will emerge a few dominate players.  But at the start it is hard to tell which ones they will be.  There is no track record or financial data to analyze.  You are making an investment decision based on proposed business plans run by people who have never done this before. 

Now, when we look at the financials we see they are already pretty crazy and don’t come anywhere near Avenue’s criteria.  The largest company, Canopy (Ticker symbol: WEED) has a $6 billion market capitalization and this year they are expected to have revenue of $40 million, negative operating profit, and no earning for years to come.  Disregarding any moral or legal challenges, a potential outcome will likely be that too much money will get thrown at the investment opportunity. This will result in overcapacity and an industry where there is a lot of cannabis but not much profit.

So far Bitcoin, the world’s first and most successful cryptocurrency, is not in any way a traditional investment.  Straight out, it is not a business. Also, it is not really a currency because it has limited uses at this point.  It is being characterized as an asset class, similar to gold.  However, from Avenue’s perspective, gold is still a business where we look for companies where the mining costs are less than the price the gold can be sold at, and where we can generate a healthy profit margin in the business of mining gold. We will mention that there is such a thing as mining Bitcoin and it is a very technical, high capital cost, and energy intensive exercise with low profit margins.

The key ingredient to an investment mania or craze is that, whatever the opportunity is, it is new and very few people own it at the start.  The upside seems to offer unlimited potential. Speculators feel they are going to be left behind if they don’t get on the band wagon. We have no idea how much higher in value Cannabis stocks and Bitcoin can go.  What Avenue’s discipline requires is that until such time where we can identify a good business, we will ignore the mayhem.  The get-rich-quick payoff will elude us but we will also avoid the possibility of catastrophic failure.  

Compounding investment savings using bonds requires a grasp of a few simple concepts.  However, it is amazing how complicated the financial industry makes it sound.  What tends to get lost in the noise of interest rates going up and bond prices going down is the far more important result that bond interest and maturities can be reinvested at a higher rate.

Working at TD Asset Management in the 1990s, our head of fixed income investing taped a cartoon on the trading room door. It showed dinosaurs listening to a misinformed T. Rex above the caption: How Dinosaurs Became Extinct.  It was a fun little prompt of how simple our investment task was, as well as a clear reminder of what our fate would be if we messed up.

In the short term, as interest rates move up and down, there is always an opportunity of capital gains but also the risk of capital loss.  When interest rates fall there is the immediate financial reward of capital gains as bonds prices move higher.   More money sooner is always a good thing when investing. 

However, there is one major drawback: after interest payments are made and when the principal is repaid upon maturity, this money has to be re-invested at a lower interest rate.  Getting the short benefit of lower interest rates feels good today and at TD we got to keep our trading jobs.  However, at Avenue we use the bond market to compound our investments over 20 to 30 or 40 years.  Higher interest rates, for reinvestment purposes, are always more important than short term capital appreciation.

Using this year’s Canadian interest rate rise as an example, interest payments have been roughly offset by capital losses as bond prices fell and returns are slightly positive.  So, the inevitable question comes up, “Why am I invested in the bond market when I’m not making any money?  I could have got a better return from a bank account.” While true, this implies a trading strategy with perfect insight for when to be out of the market whenever interest rates rise.  We might be right sometimes but we also can get the timing wrong.

Avenue’s strategy is to capture the benefits of long term compounding in the bond market and not trade interest rate moves.  We currently own a portfolio with a majority of shorter term bonds so we have bonds constantly maturing and needing to be reinvested.  Investment returns will occasionally take a short-term pause, but it is far more important to have our money available for higher interest rates so we can benefit from higher compounding over the decades to come.

The stock market of 2017 is starting to feel a lot like 1997.  It is now a full 20 years after the first stock market internet bubble. The peak of that market phenomena was in 2000, but it was two and half years earlier when the market started to differentiate between those businesses who used this new phenomenon called the internet which could attract millions of ‘eyeballs’ and those businesses who did not. The world was never going to be the same.  Owning your Mum and Dad’s stocks was as sexy as wearing a one-piece wool bathing suit.

“History never repeats itself but it rhymes.”

– Mark Twain

Back then the promise that enticed the investor was real but the market ran out of gas because for most of these companies the internet was great at making access to their business offering free, and the few successful business models like eBay and Amazon had a stock valuation that was way ahead of future earnings. Twenty years later the earnings have arrived.  Amazon dominates retail while Google and Facebook attract the lion’s share of global advertising dollars, and software has become an annuity as a subscription service which is constantly updated and living on Amazon and Microsoft’s ‘cloud’.   

The very nature of the stock market creates trends that lure everyone in.  The reality and the dream usually have a solid base to start with but then human enthusiasm propels the idea to unsustainable heights. Millennial investors and the media now like to state that the onset of disruptive technology was so unbelievably obvious that you are a dinosaur if you couldn’t figure out that it was going to happen. However, the stock market is made up of only a handful of $100 billion dollar ‘Super Cap’ stocks, with a few getting close to capitalizations of a trillion dollars for the first time. Many disruptive technology business models didn’t survive.

The next logical push in the stock market will be fueled by a wave of paranoia, where investors ask themselves why would I own anything else. Bank and pipeline stocks start to feel like they might not evolve fast enough to survive. Again, this perpetuates the disruptive technology trend and great companies that are basically boring get neglected.

This is really the point we at Avenue would like to make.  Our strategy of looking for consistent and, yes, boring companies might become even more out of fashion for a time.  However, if we stay focused on the cash, we will be able to compound our investments regardless of trends and we can avoid a wild ride driven by excessive valuations.  Many of the dominant tech stocks are already expensive and remember, disruptive technology has the ability to disrupt itself as well.

The reality is that all companies are dealing with disruption.  At Avenue, we spend our time making sure our companies are actively using these technology tools to make themselves better and to maintain their market share in their respective industries.  Will Royal Bank inevitably buy up and dominate ‘fintech’ in Canada? Will Enbridge cut its maintenance costs in half by using infrared drones to continually scan their pipeline network?  We have to make sure we are never standing still but we also have to protect ourselves from what has started to feel like tech bubble 2.0, in the making.