Why should one invest with Avenue as opposed to an index and why does Avenue not use index funds to gain exposure to some harder to invest in sectors?

The simple answer is that the goal of Avenue’s Equity strategy is to be more consistent than the index. We might not do as well in a strong stock market, but we will still do just fine.  However, our strategy should do much better relative to the index over a full bear market cycle.

Index investing has been around for decades but its popularity has exploded in the last few years.  The Financial Times of London reported that 80% of new retail investment went into index funds in 2016 and globally $1 trillion flowed out of traditional mutual funds and into index funds. 

The argument for indexing is compelling. There is a 100% certainty that you will get the market rate of return.  By simply investing in the broad market or a specific sector you are eliminating making mistakes by owning individual investments.

The problem is that the stock market is volatile.  This is fine for most investors when the market is going up, but there are also sharp corrections.  The bigger issue to us at Avenue is that there are also lost decades.  This was most recently experienced by investors in the decade from 1998 to 2008 where the stock market compound return was negative. If you were retired and living off your investment portfolio, there was no benefit to taking on the extra risk of stock market investing for fully ten years. This is too long a time period for most people and the temptation will creep in that maybe investing was not a good idea in the first place.

Avenue’s portfolio is not comparable over this time period given that we started in 2003. Our strategy is designed to be more consistent than the market but we only have the experience of the 2008 financial crisis to prove this. Avenue’s equity portfolio performance over the 2008 financial shock was significantly better than the stock market index.  Also, because of the cash flow within the portfolio, we had the flexibility to add to our investments at great prices as we went through the stock market decline.

To be more consistent than the index, what we do at Avenue is examine all available public companies to find the businesses that are more consistently profitable than the average company.  Historical profitability is measurable and usually identifies which company has a better business.  Avenue’s job is then to understand if this business and its profits are sustainable and do they have the ability to gradually grow over time.  This sounds simple but the challenge is to stick to the strategy and not get pulled off purpose by trends and emotion.

Usually politics grabs the news headlines but does not have much effect on investments.  Profit margin cycles and the direction of interest rates evolve gradually over decades and are the real long term drivers of investment returns, unless you experience a dramatic and sustained political interference.  So while US politics dominates our news cycle and we would argue that the current US election would have some negative consequences from either candidate, it is important to look beyond this noise and fully grasp how intrusive and stifling domestic politics has become.

We use these case studies to discuss investment concepts and what we believe to be basic principles of investing.  So, not to get bogged down in a discussion of the US election, let’s just use what we know of Donald Trump’s proposed policies to illustrate our argument. Some of his economic ideas are not well thought out.  Tearing up trade agreements is bad for business and will make international borders more impenetrable for trade and people.  Nations specialize in what they choose to produce and then trade to their mutual advantage; it is really the one pure economic concept that we can definitively prove to be true.  Also, if the world works together it tends to be a safer place. 

On the other hand, if Donald Trump, working with a Republican congress, had any success at tax reform, this could have positive investment ramifications for decades.  It is ironic that the real economic time bomb in the US is entitlement spending and the topic has hardly been addressed by either candidate.

So instead of shaking our Canadian finger at how crazy the US electoral process has become, we think a little self-criticism is in order.  In Canada, a majority government does not face the same checks and balances that, for the most part, would put limits on Donald Trump.  So let’s look at Ontario and what the Provincial Liberal government has been able to achieve after 13 years in power.

In Ontario, the main provincial policy to promote growth has been a determined effort to build infrastructure; if you build it, business will come and economic prosperity will ensue.  In reality very little new infrastructure is being built since most of the billions are being spent on repair that should have been part of the budget already.  Repair does not have the same multiplier effect on growth.

So what if you were thinking of moving to or increasing the size of your business in Ontario.  How would you analyze Ontario versus other locations?  In the past 13 years the price of power has gone up 200%.  It is now the highest in North America and it is scheduled to go higher still.  In this same time period, the minimum wage has risen from $7.25 to $11.25 and it is about to go up again. Having a minimum wage is decent social policy but raising it at this speed it what makes it hard for small and medium size businesses adjust.  Also Canadian Pension Plan contributions are to be increased. This affects all Canadian and higher contributions act as an effective increased cost on business.

Every year in Ontario more rules are added for businesses, regulation is increased and permitting restrictions are greater and more time consuming. Now, Ontario plans to price carbon using a cap and trade system.  Cap and trade is the worst way of limiting carbon. It is very arbitrary, cumbersome, bureaucratic and open to manipulation and fraud.  In comparison, BC uses a simple to calculate, revenue neutral carbon tax.

In Ontario, the highest personal tax rate has risen from 46% to 54%, for anyone successful enough to earn over $220,000.  And now the Liberal government is in the process of drafting the most union friendly labour legislation in North America.  Collective bargaining is a well-established cornerstone of our economy with clear processes in place.  However, the nature of the new rules of association will have the effect of gluing up the flexibility needed to evolve in a rapidly changing global economy.

Ontario does need repaired roads and new transit.  However, all of the above government interference dwarfs any benefit from infrastructure spending.  This list is so long and complicated that the collective pressure on the economy gets lost on the average voter. So if we bring it back to the question of would you expect businesses to actively grow in Ontario? The answer is no.  There is no manufacturing boom coming, even though the Canadian dollar is favourable versus the US dollar.  Ontario is a great place to live but we expect the economy to bump along at the status quo.

The annual proxy season can be a tedious time for money managers as public companies send out their annual reports and proxy materials. Tedious as it is, proxy season is an important time of year, when shareholders are given the opportunity to vote for board members, management compensation, as well as other corporate matters. However, aside from the occasional contentious vote, usually the general consensus towards proxy season amongst investment managers is a collective yawn.

This year was going to be different for me. Knowing that I would be attending the Berkshire Hathaway annual meeting in Omaha, Nebraska meant that I was going to be one of the few portfolio managers for whom proxy season couldn’t have come sooner.

Berkshire’s chairman, Warren Buffett, is the most renowned and well respected investor the world has ever seen. At 85 years of age he still tap dances to work every day doing what he loves to do. Buffett runs Berkshire out of a small unassuming office in downtown Omaha with his long-time business partner Charlie Munger, age 92, and their 24 employees.

The story begins in 1956 when Buffett formed an investment partnership and began managing money for family and friends. His investment philosophy was formed under the tutelage of Ben Graham at Columbia University, where he first learned the idea of purchasing stocks in companies whose share prices were trading below intrinsic value.

Today, Berkshire is everywhere — contributing revenue to this conglomerate is as simple as cracking open a can of Coke or using Heinz ketchup on your next burger. Currently, Berkshire and its subsidiaries employ over 367,000 people worldwide (78% of that number in the US) and is the largest shareholder in companies that include Coca Cola, AT & T, Wal-Mart, and Kraft Heinz, to name a few.  

The hype surrounding the Berkshire annual general meeting weekend is well known through investment circles. The aura around Buffett and Berkshire has created a loyal following that flocks to Omaha each year from around the world. Hotels and flights are booked months in advance, and restaurants in downtown Omaha are abuzz all weekend long. On meeting day I sat sandwiched between a retiree from Cape Town to my right and a hedge fund manager from Tokyo to my left, both long time shareholders of Berkshire.

Rather than a direct flight from Toronto, my pilgrimage to Nebraska included stops through Minnesota, South Dakota, and Iowa before arriving in Omaha on Friday. I wanted to take the time to experience the American Heartland and gain further perspective on what life is like in this part of the country. Through my experience I have come to see that the American economic engine is still as dynamic as ever. In my view, the quintessential American ethos in the people and places in these parts of the country cannot be experienced in cities like New York or Chicago. For money managers based in financial centres like Toronto or New York it is often too easy to get caught up in our own big city viewpoints and lifestyles and lose touch with places not immediately in our sight. It is important to look outside this perspective when evaluating the state of the American economy.

In effect, the genius of Warren Buffett is that he recognized the dynamism of the American economic engine early in his life and tied Berkshire Hathaway closely to it. As the American economy prospered, so did Berkshire. His performance record is staggering – delivering total returns of 1,598,284% (20.8% annualized) since 1965. If you had been lucky enough to give Buffett $1000 in 1965, today your investment would be worth over $15 million dollars!

In this year’s annual letter to shareholders Buffett takes aim at the critics who say the American economy is now doomed, mired in a slow growth world of 2% with bloated debt levels at the state and federal level. If one were to look at the state of America through the lens of the political rhetoric we are hearing this election season, it would be easy to understand where the pessimism is coming from.

Using simple math Buffett reinforces his case as to why it is a mistake to bet against the American economy. At 2% real GDP growth and population growth of 0.8% annually, America would realize 1.2% per capita growth annually. Over a 25 year span, this will produce a staggering $19,000 increase in real GDP per capita, or $76,000 for a family of four. The aggregate pie that the American economy will produce will be 34.4% larger in real terms in 25 years using this math. For an economy that is already over $16.7 trillion in size, the growth America will see over the next 25 years will be staggering.

Although the American economic pie will be far larger in 25 years, Buffett is right in stating that how it will be divided between investors, workers, retirees, and corporations will remain fiercely contested in the halls of Congress, and between Wall Street and Main Street. There will always be winners and losers in a market economy, but nothing will ever rival the capitalist market system in producing what people want.

The American economic system remains as dynamic as ever, and surely we will experience ups and downs over the coming years and decades. Reflecting on my time in Omaha I have decided it’s best to side with Mr. Buffett and say that it has been a mistake to bet against the American economic engine for the last 240 years, and now is no time to start.

Tax rates are going up in Canada for the wealthy and the moderately wealthy.  This has a significant impact on after-tax investment return when Avenue does retirement projections for many of our clients.  It is an obvious statement but one we haven’t had to formally address because for the most part the previous federal conservative government had spent the last ten years lowering various tax rates.  This is important because we need to make sure we use realistic expectations for planning retirement income.

Who are the wealthy Canadians being targeted? The numbers tell us that they are the top 10% of the population.  In Canada the top 10% own roughly 35% of the total value of investments and property.  What is interesting is that the average wealth of the top 10% is $1.3 million from combined savings and real estate.  So by way of higher house prices and moderate savings, most people who live in Canadian urban centers are in the top 10%. 

With provincial Liberal governments in BC and Ontario plus the new Liberal government in Ottawa, overall taxes are up 2% to 6% in many cases for 2016 income. Alberta is going through a transformational change with the new provincial NDP government.  In one year, Alberta’s taxes went from being the lowest income taxes in the country to closer to the Canadian average.

Taxable income for most retired Canadians is a combination of Old Age Security (OAS), Canadian Pension Plan (CPP), Private Pension payments, RRIF withdrawals and investment interest income.  Higher tax brackets start at about $60,000 of income per individual. Thankfully, mandatory RRIF withdrawals were lowered last year and income splitting for seniors will remain for the time being. 

Moving the overall tax rate by a few percentage points doesn’t sound like much.  However, planning a 30 year retirement can be very sensitive to the after-tax rate of return on investments.  We would encourage all our clients who are interested to check in with us if you would like to work through an up-to-date financial model to calculate what an appropriate level of spending might be.

As for the cost of living and how much you can buy with your savings, we will save that for another Case Study.  Higher HST or GST anyone?

A very real challenge we face is a lack of liquidity in both the bond and stock market for smaller investments.  We see three reasons for this liquidity crisis; two are global issues and one is unique to Canada.

The first issue is the increased capital and the quality of the capital held by global banks as a safety cushion against bad loans, as well as restriction on their ability to speculatively trade with this capital. Anecdotally, global banks have had to increase capital by $2 trillion dollars to protect against the potential of future bad loans.  As a result, banks have to hold these new assets of $2 trillion, not trade them, which takes $2 trillion out of the market thus reducing liquidity.  Keep in mind that the entire Canadian economy is worth about $2 trillion dollars and $2 trillion dollars is also the size of the entire Canadian stock market.

The second issue is the near universal acceptance of index investing. There are many good reasons why indexing is popular but the result is that most investment money isconcentrated in the main broad market indexes and these by definition invest mainly in the biggest companies.  Also, high frequency trading is on the rise and this type of trading concentrates only on big and active securities. What we are finding is that there is almost no trading volume in any security that is below $1 billion in market value. 

Finally, we have the home grown development called CRM2 which is an acronym for Client Relationship Model Phase 2.  CRM2 are amendments to theregulations for all Canadian stock brokers imposed by the Canadian Securities Administrator (CSA).  By this coming July every stock broker in Canada will have to report performance and fees to their clients.  This is what Avenue has always done but stock brokers have never been held to account before. The result is that the market in smaller and creative investments has all but dried up as brokers seek to retain the trust of their clients. In other words, there is no appetite for risk.  As an aside, the measurement the CSA picked to report performance is faulty and in reality not all fees are going to be disclosed.  This topic might be better addressed in a future case study.

So in 2015 we have done our best to retain our wealth in this liquidity vacuum. But now that we have lived through what we hope is the majority of the downward move in stock prices, we find ourselves in a position with favourable risk reward.  Three of our investments, BTB Reit, Timbercreek Mortgage Investment and Sirius XM, all have consistent income streams and now yield over 9.5%. Because of this liquidity problem in the stock market, we believe these investments are being given away and that is good for us.

“Be like water making its way through cracks. Do not be assertive, but adjust to the object, and you shall find a way around or through it. If nothing within you stays rigid, outside things will disclose themselves”

Bruce Lee, Martial Artist

This is absolutely the Last Bruce Lee quote we will use but we found it while looking up the one used in our Q1 letter about keeping an open mind.  This month’s topic, in light of a market sell-off, is about sticking to our strategy when faced with adversity.  Again we feel Mr. Bruce Lee is spot on in his Zen approach to conflict, which can also be applied to the mental challenge of stock market investing.  

What we know about the stock market is confirmed by the Dalbar market research group in their report titled Qualitative Analysis of Investor Behaviour 2015. In summary, over the last 30 years the S&P 500 had compounded annually by 11.1%.  But the average investor has only compounded at 3.8%.  Through this period inflation was 2.7% so the average investor’s real return was only 1.1%.  The conclusion of the research is “The overwhelming driver of this poor performance is bad timing by investors. This is worst during extreme events”*

The usual approach to short term stock market investing is to guess whether the security is going to go up or down.  In a sense you are really only telling the stock market what you think it should do,and the stock market doesn’t have ears. Given all the factors involved, predicting is almost impossible to do successfully over time.  Many people can get it right for a while but then fail to notice a major change in the market direction.  By the time one can acknowledge that the direction has, for arguments sake, turned down and that a decline in earnings is obvious, the opportunity to sell is lost and that is often the time when you should be thinking about buying.

Instead, at Avenue we ask two simple questions:  is this a good consistent business and are the shares trading at a reasonable price? For us, a reasonable price gives us a fair chance of compounding at 8 to 10% over the next ten years.  If markets run up, we can sell a bit and if they come off we can add.  The key idea behind getting a consistent return is to own consistent businesses throughout the up and down cycles.  You cannot capture the compounding 8% if you do not own the stock for a long term.

* John Authers, Emotions get in the way, Financial Times, 23 April 2015 Dalbar, Qualitative Analysis of Investor Behaviour 2015

That we are even talking about this kind of truly esoteric ‘systemic risk’ shows how far markets have progressed since the 2008 financial crisis. We will do our best to explain what this risk is and why it is a hot topic.  But first we will start with a few definitions.

A bond ETF refers to a mutual fund which pools investors’ money and holds bonds on their behalf and is traded on the stock exchange.  ETF stands for exchange traded fund.  You can buy and sell these funds in seconds and it is estimated that the total size of this market is just under $2 trillion dollars.

Bond ETF’s have become popular because they solve a few key problems with owning bonds.  The primary problem is that buying individual bonds is fussy.  For the average investor the quote is controlled by their broker and pricing is opaque which means you are at an immediate disadvantage.  Also choosing which bond to own is too time-consuming given the investor is just trying to make an interest rate bet.

So the mismatch comes because the investor wants interest exposure but without the individual distinction of comparing which bonds they want and at what price.  As interest rates go down and prices go up this is a gradual positive self-reinforcing process.  However, if the ETF market collectively hits sell, as a possibility, there is no distinction on price and what gets sold.

Liquidity refers to the depth of the bond market.  We will use this bit of financial jargon only to demonstrate that the financial market can actually be quite poetic.  In clear language this means, if I want to sell a bond, is someone there to buy it? Regulation designed to make the banking industry more stable now requires banks to restrict their market making which means a bank cannot be a buyer to create liquidity.  Often in the past a bank would buy a bond and wait for a buyer to show up. 

Government bonds are easy to trade but most other bonds are not.  So in the scenario that there is a one sided selloff, government bonds can fall, but at some point pension plans and insurance companies will come in to buy the bonds. The root of the panic argument is that many non-government bonds do not have a deep liquid market. If selling is truly one sided, because it is an interest rate bet, there is no one to buy the actual individual bonds.    

The irony with the bond market is that if the company does not need to issue debt then they can wait for the panic to pass.  If, however, the company needs to issue debt or roll over their existing debt then they can get caught paying a much higher interest rate for new debt.  This is simply to say the consequences are real for many companies.

Avenue’s bond portfolio strategy has always embraced the shortcomings of the bond market head on.  We get the best institutional pricing we can by using a simple strategy of patience and multiple dealers.  We also believe there is real value to evaluating and buying individual bonds.  The broad industry term is called credit analysis.  If a bond panic selloff occurs, there are bonds of many completely solvent companies that we would be happy to own at higher interest rates. We believe Avenue has the capability to take advantage of any potential bond ETF illiquidity shock.