“Use only that which works, and take it from any place you can find it.”

– Bruce Lee, Martial Artist

Warren Buffett has been one of the most successful investors of our time.  He is equally good at distilling complicated investment concepts and explaining them in a way that is accessible to everyone.  In this year’s Berkshire Hathaway annual report, he presents a clear and simple argument for long term stock investments being more stable and less risky than long term bond investments.

The core of the argument is that bond investments are fixed to a currency and that paper (fiat) currencies, over the long term, erode in value due to inflation.  The purpose of stock market investments is to protect your purchasing power over longer periods of time, such as a retirement of 30 years or more.

We have played with some numbers to demonstrate this investment concept using the 50 year time period that corresponds to the time Warren Buffett has run Berkshire Hathaway.  These numbers are all in US dollars to demonstrate the concept.  It is harder to replicate in Canadian dollars, since the TSX index did not even come into existence until 1979.

For every $1 you had in 1965, it would take you $7.69 in 2015 to have an equivalent level of purchasing power.

Likewise for every $1 you invested into the stock market in 1965, your investment would have grown to be worth $52.43 – assuming you held your investment and reinvested your dividends over that period.

The idea is that if you used the stock market to improve your purchasing power for 50 years, you can now afford 5 Ford Mustangs (at today’s base price of $23,800) for every one you could have purchased in 1965.  Today’s car is also a fair improvement in comfort and safety. 

Food items, which are commodities, should closer reflect inflation. We can now get 14 dozen eggs for every one dozen bought in 1965.  Here, we would point out that 50 years ago eggs were likely more organic than today’s industrial variety, so conceivably we should be using the $5.00 per carton variety found at Whole Foods. Regardless, the concept still holds.

We have included below a full excerpt of page 18 on the Berkshire Annual Report, so you can read Warren Buffett’s own words.  It would be hard to write any better about the essence of the core relationship between balancing exposure between stocks and bonds and understanding their comparative risks.

At Avenue, this long term understanding of risk is exactly the key concept behind our asset allocation decisions process for each of our clients.  The starting point is that every one of our clients should be 100% invested in the stock market for the long term.  However, if you need some of your money to live on in the near term, we like to have at least 5 to 7 years of fixed income to cover annual income needs. Alternatively, if an individual is uncomfortable with the fairly common stock market swings of 25% or more that the stock market inherently will produce, we can allocate to bonds, but the individual needs to understand that there will be a loss of purchasing power over time.

“Our investment results have been helped by a terrific tailwind.  During the 1964-2014 period, the S&P 500 rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196%.  Concurrently, the purchasing power of the dollar declined a staggering 87%. That decrease means that it now takes $1 to buy what could be bought for $0.13 in 1965 (as measured by the Consumer Price Index).

There is an important message for investors in that disparate performance between stocks and dollars.  Think back to our 2011 annual report, in which we defined investing as “the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future.”

– Berkshire Hathaway Inc. annual report 2015 (pg. 18), Warren Buffett

The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to the American currency.  That was also true in the preceding half-century, a period including the Great Depression and two world wars.  Investors should heed this history.  To one degree or another it is almost certain to be repeated during the next century. 

Stock prices will always be far more volatile than cash-equivalent holdings.  Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolio that are bought over time and that are owned in a manner invoking only token fees and commissions.  That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk.  Though this pedagogic assumption makes for easy teaching, it is dead wrong: volatility is far from synonymous with risk.  Popular formulas that equate the two terms lead students, investors and CEOs astray.

It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents.  That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets.  Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

For the great majority of investors, however, who can – and should – invest with multi-decade horizon, quotational declines are unimportant.  Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar based securities.

If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things.  Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in “safe” Treasury bills or bank deposits.  People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement.  (The S&P 500 was then below 700; now it is about 2,100.)  If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividend would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure)…”

Avenue believes that with time, the price of oil should recover to the $75 to $80 price level. However, lower prices might be needed in the short term to reduce the excess supply from the global oil market.

We have described Canada as a developed consumer and industrial economy, with a resource heavy stock market. This is compared to the US which is a developed consumer and industrial economy, with a consumer and industrial stock market. The difference is important because a falling oil price is a net positive for the Canadian economy, but definitely a negative for the Canadian stock market performance. At the height of the mini energy bull market this past summer the TSX Index was 26% weighted to the energy sector.  As a Canadian-based investor, having an understanding and a view on the oil price is important.

Commodity price forecasts are rarely accurate although, ironically, many analysts are paid to make them. At Avenue, we do not try to predict the future.  Our strategy is to understand the marginal cost of production, which in today’s market is roughly $80 US per barrel. We then put a fairly wide $20 price band around $80.  This gives us our high price of $100 per barrel where we would underweight the energy sector in our portfolio and our low price of $60 per barrel where we would overweight the energy sector.

The marginal cost of production is a theoretical price.  An absolute price is hard to nail down because it is always adjusting to the level of demand and the cost of supplying the commodity. To use the oil market as our example, the World consumes 93 million barrels of oil per day, so the marginal price is where the cost of bringing on the final well to produce 93 million barrels per day basically breaks even.  Today, this price is about $80 per barrel.  There is much more oil to drill for in the World but the costs are above this break-even point, therefore these wells will not be drilled until either demand goes up or costs come down.

This chart is a great depiction of why the marginal cost of producing oil is likely around $80 per barrel.

Oil was at $100 per barrel as recently as this summer because there were real supply concerns until US shale oil production surged.  In the last three years the US increased their domestic production by 4 million barrels per day, thereby pushing the oil market into oversupply. We believe the world is likely oversupplied by about 1.5 million barrels per day, so as long as oil stays at this price of around $50, it will knock out the high cost supply.  This is not just higher cost US shale, but many other high cost projects around the World, including some Canadian oil sands development projects.

Having patience is often the hardest part of investing. The oil price can stay above or below the marginal cost of production for years.  However, there are always opportunities to invest in money-making companies at both high and low commodity prices.  It just makes it a little easier when we get the chance to buy a great company at low valuations and when the next direction for the oil price is heading up from a cyclical low.

We have written about Avenue’s theory regarding equity portfolio volatility, or risk, over the last 10 years in several case studies. Now that we have completed our first decade, we are happy to share with you that the results were much better than what we had hoped for.

Our stated goal was to capture the long term stock market compounding of 8% but do it with as little risk as possible. We had hoped that we could reduce volatility by as much as 25 to 30% and still meet our return targets. We are off slightly on our return target of 8% as the average Avenue portfolio has compounded at 7.2% over the last 10 years. Nevertheless, we managed this in a decade where we experienced the worst stock market crash since the 1930s.

Our constant focus on risk reduction resulted in the volatility of Avenue’s equity portfolio coming in roughly 44% lower than the TSX Canadian stock market index. Volatility is calculated by comparing the amounts that Avenue’s portfolio and the TSX index swing up or down monthly to their long term average returns. This is the standard way that the investment industry measures risk.

We accomplished this low volatility by a commitment to invest in high quality businesses and other consistent income streams. If our companies are established and profitable, with reasonable levels of debt, they usually have a more predictable stock price.

The Avenue Equity Portfolio is also slightly more diversified across uncorrelated asset classes than the major Canadian and US indexes. The TSX index has a high concentration of resource stocks and the US S&P500 index is predominantly a mix of financial and consumer/industrial businesses. Avenue’s portfolio has a much more balanced exposure to the securities in both those indexes and also includes meaningful positions in utility and telecom businesses, real estate and high yielding bonds.

Our investment process continues to be driven by searching for securities where we can lock in an 8% return with limited downside. If we find one, we grab it. This sounds simple enough but it is not that easy in practice. Today’s very low interest rate environment makes it much more difficult to find quality securities and means we must consistently maintain our disciplined approach.

Avenue’s Equity Portfolio is designed to accomplish consistent compounding in a diversified mix of assets and not simply to replicate or beat an index. The fundamental reason for creating a portfolio this way is to drive down the overall risk or volatility as it is called in the financial industry. We address this issue occasionally in this part of the letter because there are times that our portfolio does not reflect what is happening in the broad market indexes and we get questions as to why this is the case.

The first question we ask of the market is can we compound in bonds or income generating securities and receive an 8% to 10% rate of return with as little risk as possible. Right now we own Yellow Media Bonds and Timbercreek Mortgage Investment Corp which fit this description. This is all we can find at this time but we are patiently waiting for an opportunity where we would like to have at least 20% of the portfolio invested this way. As a reminder, in 2009 the Avenue equity portfolio was over 35% invested in bond and other bond like securities. There is no exposure to these types of investments in the TSX index.

After building in some consistent income streams, we always look for consistent income generating companies. Many of these public companies fall into sectors like Real Estate and Utilities. We think these are quality hard asset investments to have over the long term so we will try and have roughly 10% invested in Real Estate and another 10% invested in Utilities. However, the TSX index only has 3% exposure to Real Estate and 2.4% exposure to Utilities.

To summarize, Avenue likes to first build the Equity Portfolio with 20% invested in higher yielding bonds and another 20% in Real Estate and Utilities for a total of roughly 40%. This makes a big difference to how our portfolio moves when compared to the TSX Index where only 5.4% is invested in comparable securities.

We would also like to be clear that we are not always fully invested in these sectors. Right now we are underweight in high yield and Utilities given where we are in the interest rate cycle. Our preferred investment while underweight will usually be cash not another asset class.

There are also big differences between the major Canadian and US indexes. The TSX index is 23.8% in energy stocks and 31.3% in financial stocks. Whereas the S&P500 index in the US is 10.2% in energy stocks and 17.5% in financial stocks. Avenue’s Equity Portfolio lives in between these two indexes with currently 17% in energy stocks and 23.2% in financial stocks.

The point we are trying to make clear is that Avenue’s equity portfolio’s performance is derived often very differently than the returns of the established indexes. Why we go out of our way to do this is to lower the volatility or risk of the overall investments and increase the consistency of the compounding within the portfolio.

Over the last ten years Avenue’s equity portfolio has had volatility of approximately 11.5% vs. the TSX index which has had volatility of 18%. We have compounded at times with roughly the same rate as the index but Avenue’s equity portfolio was compounded with 36% less risk.

We are at a unique point in time that clearly demonstrates a universal investment fallacy where growth in Gross Domestic Product (GDP) will somehow translate to positive stock market returns. The performance of the Chinese stock market clearly exposes how simplistic this assumption is in reality.

Common folk lore, constantly regurgitated by the media, would have us believe that GDP growth is almost essential to stock market returns. We might never have a clearer example to clarify that the stock market does not measure growth in the economy by growth in profits.

The Chinese economy has grown 240% in the last 5 years, from $3.5 trillion dollars to $8.5 trillion dollars. There are few examples in human history to compare to this phenomenon of advancement. However, the stock market (here we use the Shanghai Composite Index) is down 68%.

We have to go back 14 years to 1999 before we can calculate a positive investment return. In that time frame the Chinese economy has increased in size 670%.

An explanation for this unique phenomenon is that the Chinese economy grew but profitability did not emerge as fast as anticipated by investors.

The core of our investment strategy at Avenue is focusing on the profitability of our investments. The reason we care so much about profits is because that is what drives stock prices. All our investments have to be profitable businesses or assets. We have to make sure we don’t pay too much for them. But if the profits grow, that is even better.

We would like to share a couple of recent developments which confirm our belief that investing Safely in today’s world is best served by owning a hard asset or business in a sound legal jurisdiction.

This month’s economic event of interest is the unwinding of the tax haven of Cypress. The two-state island exists inside the umbrella of the European Union but there are many complicating issues. The overleveraged banking crisis has now hit the island in such a way that a traditional bailout is not possible. At this time it looks like basic bank deposits will take a hit.

When you put money in a bank and the bank lends the money and loses it, in this case by lending it to Greece, the bank shareholders lose first, then the bank bond holders and finally the bank depositors.
Usually the government comes in to save deposits because a run on a bank is bad for everyone. However, in the case of Cypress where the majority of depositors are wealthy Russians, it seems to only be bad for tax evaders. The bank is going to fail and foreigners are going to have to find another place to put the remainder of their money.

What is important about the events in Greece and Cypress is that the traditional view that cash and government bonds are the safest assets no longer holds true. We believe that owning a good business is the safest way to maintain and compound your wealth. We also believe a few more Cypress savers and investors now share our view.

The second argument is that you have to own the business in a sold legal jurisdiction. China now has many inter-listed public companies in Canada and the US. However, we would not recommend owning them given the lack of accountability.

Recently uncovered fraud in inter-listed Chinese public companies has prompted the US Securities Exchange Commission (SEC) to demand domestic audit documents for these companies. The Chinese auditors have refused to cooperate because they fear that releasing Chinese audit documents might accidentally pass on “state secrets”, which of course is illegal. Amusingly, the answer to the SEC’s request for records is that they will not be getting any and nor will shareholders.

Our conclusion here is that in this age of global investing, the importance of where your business is located and if it is supported by a high quality legal structure is under appreciated. We certainly prefer to invest in Canada first and we have observed that more and more individual Chinese citizens share our conviction as their personal money is landing on our shores every day.