“Stay the course.”Ronald Reagan

The saying, ‘stay the course’ has a long military history but it is Ronald Reagan who repurposed ‘stay the course’ as a catch phrase for resetting the economy post 1970s inflation. At Avenue, we have a strategy that incorporates bad markets as well as good and we plan to come through this current weak period stronger than when we started.

The message we would like to convey is a positive one. While 2022 has been hard for investors, we believe a significant amount of damage has already been done. Bond and stock prices are at a much better level for us to accomplish long term compounding. But we caution that the central banks have no quick fix so our expectations of recovery will be gradual and accompanied with larger short-term price swings.

As long-term investors, we know that while there are strong markets, there will also be weak markets. As we have written in our last three quarterly reports, 2021 was about excess financial stimulus and 2022 was the year stimulus was taken away. We have been positioned defensively in terms of what we own and how much cash we have raised for most of the year. Now interest rates are at a level where we can build a bond portfolio which gives us a decent return. As well, while we believe many stocks are still too expensive, Avenue’s portfolio of stocks are trading at a good level relative to the cash flow these businesses produce.
We are going to share with you a few charts which show how weak the bond and stock market has been this year. But what we take away from these statistics is that because prices have been bad, we should be closer to a bottom, and going forward the returns will be better. While our strategy has been defensive throughout 2022, we must start thinking offensively and look for high-quality businesses we can invest in.

This year feels particularly bad due to the combined effect of weakness in both the bond and stock markets at the same time, while the cost of living is going up. For the last forty years, when stocks fell due to the financial crisis of the day, a central bank was able to lower interest rates and the bond market was seen as a safe haven for investors. So, if stocks went down, bonds went up. A balanced portfolio with a mix of bonds and stocks would counterbalance each other.




What we can see in this chart is how unusual an event it is that bonds and stocks went down in the same year together. Above all, this year has been about interest rates going up. With higher interest rates, stocks valuations came down. Again, as you can see from the chart, returns have been bad, and under these circumstances, history predicts that positive returns are more likely sooner rather than later.

Inflation is commonly expressed by the consumer price index (CPI). In our last letter we laid out how CPI is a complicated term often describing conflicting economic concepts. For simplicity’s sake, this quarter we would like to focus on the rise in prices for food, fuel and rent. To point out the obvious, the rise has been dramatic as this year’s CPI increase is coming off a low base. While the CPI headline number is jarring, central bank behavior and economic weakness tells us the CPI will be much lower this time next year.


Our current economic circumstances are unique and so is the behaviour of the central banks. It is very unusual, if not unprecedented, to have 28 central banks all tightening interest rates at the same time. The result is that globally there is less money and liquidity in the financial system. From having too much liquidity a year ago, we now have very little. But we anticipate that the next swing will likely take us back in the other direction.



When global financial markets have stress, the safe haven remains the US dollar and short-term US treasury bills. The Canadian dollar relative to the US dollar has fared better than most major currencies, because Canada’s main exports are commodity related. While US dollar cash is not part of our strategy at this time, we do maintain US dollar exposure through our stock market investments which make money from their businesses in the US. Currently we measure that exposure as 45% of the cash flow of our equity portfolio. As well a Canadian business like Canadian Natural Resources produces oil with their costs in Canadian dollars and sells their product in US dollars. Currently the Canadian price per barrel of Edmonton Par is $118 Canadian. The last time we had high oil prices the Canadian dollar was valued at one to one with the US dollar. Our current period of high oil prices is accompanied with a Canadian to US exchange rate of $0.73, as of this writing.



Avenue’s Bond Portfolio


Our conclusion from the chart below on the historical return of the global bond index is that this might be the worst annual return in our lifetime. We have described 2022 as the year where we have experienced the tearing off of the band aid of low interest rate policy. It is the speed measured in months and the magnitude measured in percentage terms that is so extreme. Over the decade of the 1970s, the last time interest rates went up dramatically, yields started at 4% which then doubled to 8% which then doubled to 16%. With today’s much higher level of debt and a more mature economy we have just experienced the same impact where 1% interest rates doubled to 2% which then doubled to 4%, but within the space of a several months.


The benefit of having bond prices fall this past year has been the resetting of bond yields to level where we can receive a more rational return. We expect inflation to come down from our current elevated levels but remain higher than the past few years where inflation sat at only 1.5%. If inflation was to average 3% for the next decade, Canadian government bonds should offer an added return of 1% for a total of 4%. Corporate bonds should offer an additional 1.5% for a combined yield of 5.5%. Historically, Avenue’s bond portfolio has had a majority weighting in corporate bonds. At this time, we are still being patient as the stress in the credit market might still affect credit spreads between corporate and government bonds. If credit spreads widen, we would like to take advantage of the opportunity to invest in higher yields. The main point we wish to make is that Avenue can build a bond portfolio that gives us a decent return, now that we have a break from the era of ultra-low interest rates.


Avenue’s Equity Portfolio


Stock market pricing is the result of two simple components: the amount of earnings and the multiple that investors will pay for those earnings. Let’s start with the stock market multiple which itself is a function of liquidity. Liquidity is the financial term for how much money is floating around in the system. As interest rates have risen this year, liquidity has dried up. As a simple example, investors are less likely to borrow money to buy stocks because the cost of borrowing has risen. Less liquidity, by definition, means that investors have less money to buy stocks with. The term used in the financial industry is ‘the market multiple will compress.’


The good news is that much of this compression has happened. While many stock valuations still can come down, we just need to focus on the ones we own. We have worked hard over the last year to make sure we don’t have any investments where the valuations are overly expensive. As well, we are keeping a cash position in case we get an opportunity of a further sell off. However, we need to be aware to the potential that much of this stock market weakness may have run its course. We showed the chart below of financial market liquidity in our Q1 letter in April, when global liquidity was at its peak and beginning to fall. This key indicator is now closer to the bottom. We don’t have a time frame for how long it may take to get to the bottom as it might take months or even a year. That doesn’t mean we run out and spend our cash, it just means we are now looking for opportunities as opposed to forcing ourselves to sit on our hands.



Stock market earnings, and thus profit margins, are very hard to generalize when inflation rises to this degree. The chart below shows how historically inexpensive the Canadian TSX index is based on analysts’ estimated earnings for 2023. To be clear, the price earnings multiple might increase from this level, not because stock prices go up but because profitability may start to fade in coming months. While this valuation gives us a general view on the overall Canadian stock market, it is much more important to focus on the earnings of each individual business. As we have stressed this year, we are focusing our investment strategy on simple and essential businesses that can maintain margins and do not need additional stock market financing. Whether the company we have invested in continues to pay a dividend or buys back stock, Avenue’s underlying portfolio will become more valuable as we go through what we believe will be an extended period of economic weakness.






“The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function.”
– F. Scott Fitzgerald

We will get through this financial market weakness remembering that the last few years have been a positive environment for investors. But right now, it seems like all prices need to find a new level. While we anticipated that 2022 would be a year of financial market headwinds, investors are faced with almost too many problems all at the same time. There are now so many negative issues: financial, economic, environmental, and geopolitical that they seem too many to list. Hence one could say there are many spinning plates, and it is just a question of which plates fall first. But what we know about investing is that when everyone is universally negative, this pessimism may already be reflected in the prices of bonds and stocks. We must force ourselves to think positively and look for opportunity.


The Great Unwinding


Our current financial market weakness is first and foremost due to rising interest rates on the back of a resurgence in inflation. We have experienced a decade-long period where interest rates were kept artificially low for too long. Historically, in very simple terms, if the stock market goes down then the bond market usually goes up. This has been the underpinning of balanced portfolio construction for over 50 years. In our current situation, low interest rates resulted in elevated prices of both bonds and stocks. Now that interest rates are going up, bond prices and stocks prices are declining at the same time.

The Bank of Canada is raising short term rates to fight price inflation in an economy where unemployment is at a historic low. We would like to distinguish that there are two types of price inflations, which have distinct identifiers but confusedly are both called inflation.


One type of inflation happens when new money or credit is pumped into the financial system, as per our Government’s COVID response; asset prices go up as the money must go somewhere. This is commonly called monetary inflation. The sustainability of the monetary inflation can vary depending on how much money or credit has been created, and whether it is done by the government or by the commercial banking system.


The other type of price inflation happens when there is an increase in the price of a specific commodity or a product. This increase can be caused because demand remains constant, but supply becomes constrained. Businesses are incentivized to respond to these higher prices by allocating resources so they can produce and sell more of that product and earn a profit. Competition for these profits then creates more supply from other businesses, which brings economic harmony and prices back into balance. If there is no supply response, then prices will rise until consumers reject the new prices and demand destruction occurs. Only new supply or demand destruction will bring down this type of price inflation.


The challenge in the current environment is that we have both monetary and supply/demand inflation at the same time. We are forced to take both types into consideration when we make rough approximations of what price levels will be in the future. We need to try and determine the direction of consumer price inflation (CPI) in a year from now. It is CPI that sets the tone for the level of interest rates. The level of CPI inflation also elicits a certain response function from Central Bank policy, which can impact investor sentiment and financial market liquidity. To reiterate our underlying theme, as interest rates rise from near zero, the price of almost everything must find a new level. Higher interest rates serve as a form of gravity on asset values.


An Orderly Decline, Not A Panic


One point we would like to highlight is that the bond and stock market weakness so far have not been accompanied by a rapid collapse in the major indexes consistent with a market panic. Individual securities have experienced large single day declines, but the overall weakness in the market is being popularly described as ‘an orderly decline’.


At Avenue, we wrote in our quarterly letters as early as last September that we were repositioning our bond and stock portfolios to be defensive. In our December letter we described how 2022 was going to be the year where ‘financial liquidity’ would be gradually drained from the system.


While we might have been early by a few months, this view is now more common among institutional investors. For example, stock market sentiment is close to an all-time low with professional investors because they have already adjusted their portfolios. Strangely enough there has been no stock market panic because private investors are still net buyers of securities.



This private investor behavior may still be interpreted as a short-term negative. As a rule of thumb, private investors are usually bullish at the top of the market and bearish when stocks are at the bottom. For these reasons we are still taking a cautious outlook.


KISS – Keep It Simple, Stupid


KISS is a well-known marketing acronym which helps guide marketing campaigns to not overcomplicate their message. We believe KISS can also be a guiding principle for constructing a portfolio to see us through what we have anticipated to be a challenging year.

The simple answer will likely be the right answer.

During the quarter we increased cash levels in all the portfolios. The most obvious decision is to avoid stocks where the valuation is excessive. Most of the stock market decline so far has been due to overpriced stocks falling to more reasonable values. As well, we have avoided or sold all corporate bonds and stocks where the business model is complicated or requires liquidity from the financial market. The best examples of this would be selling our position in Brookfield Asset Management and Onex, which are both global asset management companies with lots of exposure to leveraged real estate and private credit.

Avenue’s portfolio strategy at this time is to invest in simple and essential businesses. As always, these businesses need to be consistently profitable and the valuations we pay have to be reasonable. While this strategy does have an element of an analyst’s opinion, if broadly applied, we should be able to reduce our risk and have capacity to take advantage of opportunities to invest at good valuations as we go forward.


Avenue’s Bond Portfolio


Avenue’s bond portfolio has been positioned defensively for several years anticipating a return to higher interest rates. It seems too obvious to state but in a bond portfolio we still have to own bonds. To be defensive, we have held higher cash levels, kept the maturities shorter and avoided more speculative corporate bonds.

We also manage the bond portfolio with a view to compound returns over the longer term. In what has been an extremely low interest rate environment over the previous three years, Avenue’s bond portfolio was up +14.5% from 2019 to 2021.

This last six-month period is akin to ‘tearing the band-aid’ off the world of interest rate suppression. Going  forward we will continue to collect our interest income. Most importantly we can invest our cash and re-invest our maturing bonds at higher interest rates. We absolutely need these higher interest rates so that we can compound at a decent rate of return in the years to come. The rise in interest rates, although painful in the short term, creates a better environment over the long term for bond investors.


Now that 10 year government bonds are yielding just over 3%, Avenue’s bond portfolio is neutral in its positioning relative to the bond index. This is simply a way to relate our thinking in relationship to an industry benchmark. At some point in the next few months or maybe as long as a year, there may be an opportunity to be more aggressive. For now, our stance remains cautiously neutral.


Avenue’s Stock Portfolio


Avenue’s stock portfolio has been positioned defensively since last fall, anticipating the impact from a withdrawal of financial liquidity and a gummed up global supply chain. To be defensive, we have held higher cash levels. While we try to avoid overtrading, we have sold any stock that relied on financial markets for support. Maybe it is easier to think of the opposite type of business which is one that is an essential part of the economy that continues to make money through bad times. In Canada the valuations remain very fair.


We can be defensive, but we still own stocks in the stock market. We also manage the stock portfolio with a view to compound returns over the longer term. In this period of low interest rates, we have had good financial returns. 

One might argue that given the extreme pessimism in the market, a good part of the decline may have already happened. If there is another shoe to drop, it will likely come from a decline in earnings in various sectors of the economy. Although it may prove painful in the short run, we think this scenario would see many great investment opportunities emerge.

Again, we describe our current position as cautiously neutral. We will still avoid businesses that are termed ‘financialized’ and focus on simple essential businesses in the economy. Any further weakness may be an opportunity to get more aggressive but for the time being, we will watch and wait.






“The key is not to predict the future but to prepare for it.”
– Pericles, 494 to 429 BC, Athens


This famous quote from Pericles was made in the context of readying the Athenian people for the unpredictability of war. During the last two months we are witnessing what seems like a throwback to a past where despots were intent on brutal conquest. This behaviour seems completely irrational within our globally integrated world of business and finance.

At this point in early April, we don’t know how long the conflict in Ukraine will last and we can’t predict the outcome. This is the point Pericles is making: the future is always unpredictable. The investment industry attempts to forecast the level of an interest rate or the price of a stock in six months’ time, but really there is not any way to know for certain. We need to focus on being prepared for whatever environment we find ourselves in.

In our last quarterly letter, we described a tapering pandemic and how we have positioned our portfolio for a very complicated economic recovery. Excess money and gummed up supply chains have resulted in surging inflation. Adding a war in Ukraine is a completely different geopolitical challenge, but it exacerbates the same investment themes exposed by the pandemic. In summary, our investments remain oriented towards businesses who can maintain pricing power and we are avoiding businesses where margins are at risk of shrinking.

Geopolitical events usually affect bond and stock prices in the short-run, but the long-term prices are much more affected by major financial and economic trends. We have adjusted the portfolio for a financial system where liquidity is now declining and a global economy is contracting.

Only a few months ago, we wrote that asset markets would change if interest rates rose above 2%. Central banks have only just started to increase short term lending rates, but it is expected that short term rates will be 2.5-2.75% by this time next year. Subsequently, we have seen a sell-off in bonds and a real shift by stock market investors from growth stocks to more stable businesses of the type we like at Avenue.


In the face of the highest inflation in decades and rising interest rates, Avenue’s bond portfolio remains defensive. We have a higher cash weighting and our bonds have a shorter average term to maturity. From a long-term compounding point of view, higher interest rates are always better. It was going to be very hard to get a reasonable rate of return when interest rates were so low. We believe that in the next few weeks or months interest rates will reach a level where we can invest our cash and reinvest as our bonds mature, at much better rates.

What we don’t know is how much central banks will actually move interest rates to combat inflation. Even though the market is anticipating 2.5% to 2.75% interest rates next year, this has not happened yet, and a lot can occur over the course of a year. One of the indicators of economic health is what is called the shape of the yield curve. When we put all the current interest rates on the same chart (3-month, 2-year, 5-year, 10-year and 30-year interest rates), we look at what the relationship is between the interest rates over the different time periods.



Currently, the yield curve in Canada and the US is unusually flat. The consensus of many investors is that they anticipate short term interest rates will have to go up to a level where inflation is contained. This is a polite way of saying our central banks will have to raise rates to a level that creates an economic slowdown. This in turn, is keeping the longer maturities like the 10-year bond interest rate from going up because investors are anticipating a recession. As the year progresses the shape of the yield curve will give an indication of how big a future slowdown might be.

Declining liquidity will be a continuing theme throughout 2022. Interest rates are going up. Central banks will not be buying their own bonds, which is now being referred to in financial language as quantitative tightening. As well, direct Covid subsidy cheques are no longer being handed out.


We are already seeing indicators that point to much less liquidity in the financial system. There has also been a commensurate amount of damage in the high valuation growth stocks as the market digests this information.


For example, last November the e-commerce stock Shopify was the largest company in Canada with a valuation of $275 billion, compared to the next largest which was Royal Bank valued at $190 billion. Shopify in now down 70% in just the last four months.

At the beginning of the year, we were nervous that the entire stock market was vulnerable to a price decline. But what we have experienced is investors shifting from high valuation growth stocks like Shopify to more traditional stable businesses like Bell Canada. Avenue’s equity portfolio has held up well given the repositioning we did last year with the view that certain traditional businesses are able to cope with inflation better than others.





Global supply chains remain a problem. China is still locking down major cities and ports. Shipping is getting easier but that might be because there is less to ship. We are seeing signs in North America that trucking is slowing. This could be an indicator that the overall economy is not as strong as investors are expecting and we should be cautious.

A Cold War II scenario is a much bigger and longer lasting risk affecting investing. It appears just-in-time inventory management on a global scale will contract to a level more typical of previous decades. Russia is a source of raw material and China is the global supplier of manufactured goods. What is being called reshoring, bringing back manufacturing to North America and Europe, will have a negative impact on economic growth and the margins of many businesses.

To give some perspective, during the height of the Cold War in the early 1970s, the Global population was 3.5 billion people. However, due to the constraints of the Iron Curtain and China’s cultural revolution there were only about 1 billion people participating in what we describe as the Western economy.

Globalization exploded shortly after the fall of the Berlin Wall in November of 1989. Today, the global population is closing in on 8 billion people. But what is significant is that it is estimated that about 5 billion people now participate in the global economy. This is a 500% increase in the global participation rate in just 30 years and all the prosperity that goes along with open trade. Now, businesses are facing higher costs with less supply availability and less efficiency. As investors, these are very important points to study when we consider where to put our money.














“John Bull can stand many things, but he cannot stand 2% interest”
– Walter Bagehot

Walter Bagehot was the famed English financial writer and editor of the Economist through the 1860s and 70s. In the quote above, Bagehot refers to John Bull as the British everyman who would never accept anything less than a 2% return on his savings. This attitude was the standard for well over 300 years. Ironically, today this aphorism is flipped on its head, where the average debtor, governments included, could not stand an interest rate greater than 2%. We are clearly in a new financial age.

In our Q4 Letter, we will start by giving our view on how financial markets are interpreting the possibility that the Omicron variant will evolve to being endemic. This past year, 2021, was the second year where the virus drove central banks and governments to dramatically increase liquidity, resulting in consumer price inflation. We will discuss our view that regardless of inflation, longer term interest rates can only go up so much. The big theme for 2022 is the deceleration of liquidity as central banks tighten and governments no longer hand out cheques. Liquidity has been the main driver of the financial markets so pricing of all assets will be affected. This is why we have worked hard over the past quarter to build resiliency into Avenue’s equity portfolio.

A few days before Christmas, European and American newspapers simultaneously started to write about how South Africa was willing to approach the Omicron variant as endemic. Given the speed of transmission and how many infected people were asymptomatic, the South African government has concluded there is no way to control Omicron in an active economy. Yes, there seem to be ever evolving twists with this virus, but for this iteration, the stock market is looking through the current dramatic spike in infections and is predicting that the worst for the economy is over.

While we would all like to breathe a sigh of relief that our restricted living might be coming to an end, this opening up will have a dramatic and complex impact on financial markets. If Covid becomes endemic, like the flu virus, there is no need for further stimulus. Quantitative easing can be withdrawn, and interest rates can go up to cool consumer price inflation. We have already had a big move in 2-year interest rates from the levels seen early last year.

The first big contradiction is that because of the absolute size of our collective debt levels, interest rates can only go up so much before they trigger an economic slowdown. We may end up going into a potential economic recession before we even emerge from our Covid induced economic slowdown. We are not seeing longer term interest rates going up very much. As we have highlighted in past letters, businesses, and therefore the economy, care the most about the US 10year government bond yield. To refer to our Walter Bagehot quote, we believe as interest rates rise closer to 2% this will have a massive cooling effect on asset prices and even slow the pace of private money creation by the banks.

Avenue’s bond portfolio had an exceptional relative return in 2021. We were, and continue to be, defensively positioned given a rising interest rate environment. We also believe we are in a position to take advantage of any corporate bond weakness if prices deteriorate.

A deceleration of liquidity is the head wind facing financial markets this year. We try not to use financial industry jargon in our quarterly letters. However, there really isn’t a substitute for the term liquidity so let’s try a simple definition. Liquidity is the term used to define the speed with which an asset can be turned into cash. If we want to sell an asset, receive cash, then buy another asset and it all takes 30 seconds, that is a liquid market. If that same transaction takes days, then that market is less liquid.

Financial liquidity increased significantly over the course of the pandemic in three ways. Central banks accelerated already established quantitative easing, where the government issues bonds to financial institutions then buys the same bonds back, leaving newly created money in the financial system. Central banks lowered interest rates to basically zero. And the federal governments in Canada and the US wrote cheques to people and companies to tide them over while getting through the pandemic.

Ever larger amounts of money, even if borrowed, drive financial markets in the short term. Money will continue to increase in 2022, but the rate of change is slowing. First, the US central bank is committed to slowing their purchases of bonds. Next, it is anticipated that the US central bank will increase short term interest rates. Even if the absolute level of interest rates remains below the rate of consumer price inflation, liquidity will be tighter than what it has been. As well, government direct income supports will not continue. In 2022 there will be less liquidity and speculative financial markets will have less fuel.

Anticipating this loss of liquidity, we have actively repositioned the Avenue equity portfolio. We have made more trades than usual, but we feel this was important to get us in a more defensive position and build more resiliency into the portfolio. The coming year might offer buying opportunities and we need to be ready in advance. Many parts of the stock market that benefited from this excess liquidity in 2021 are already beginning their unwind, but we believe high quality businesses will continue to be the best source of long-term returns.

Chart Section

For a slightly different format, we would like to share with you some charts that best tell the story of what Avenue finds interesting about the economy and financial markets at the outset of 2022. The US economy has recovered and surpassed its pre Covid level and is expected to grow again this year.

Financial markets have been buoyant because governments have taken on a massive amount of debt to fill the gap caused by the pandemic shutdowns. In 2019, the US had roughly the same amount of government debt compared to the value of its economy (GDP). In 2022, the US economy is a little bigger than it was at the beginning of 2020, but the government debt is approaching $30 trillion which is now 127% of GDP.

Looking at the US debt clock can be mesmerizing and unsettling at the same time. If you click the link below, in the top right corner there is a time machine button which projects US debt levels out five years to 2026.

US National Debt is approaching $30 trillion. Click the link:


Borrowing this amount of money to bridge the economic gap does not tell the whole story. The pandemic created a situation where money that has been borrowed is spent more on goods and less on services. When people want to buy goods, supply disruptions due to Covid make goods less available, resulting in consumer price inflation. The goods economy continues to run far ahead of its pre-pandemic growth trend.

We added this chart because it really illustrates the incredible surge in consumer demand. The U.S. consumer purchased as many goods in the last 18 months as it had in the previous 10 years.
You can also extrapolate what it will look like 12 months from now if spending returns to its long-term trend.


Finally, we would like to highlight that many speculative stocks are already off from their highs. It is just the dominant technology names that are holding up the index. A lot of the liquidity excesses are already being unwound and liquidated throughout the stock market.

“Successful investing is having everyone agree with you…… later”
–       James Grant

We will start this quarter’s letter with our view on how the lingering pandemic is having a significant effect on the operations of all corporations.  The economy and the stock market are changing at a fast pace, and we have seen our equity portfolio turnover increase this year. As well, we have made an incremental shift back to Canadian companies for the time being because we are finding better opportunities here.  We will also discuss the bond portfolio and how we have protected it against the uptick in Consumer Price Inflation (CPI).

Every conversation between two people still seems to start with an update on how the pandemic is affecting them both and how they feel about the continued restricted living.  While most people hope we will be back to some sort of normal in our everyday lives soon, Avenue believes there is no back to pre-pandemic normal for business or investing in the near future. 

Supply disruption leads to demand destruction

In our Q2 letter we described how the level of Consumer Price Inflation has jumped in the US and Canada. Initially, this is a natural result of year over year statistics where the summer shutdown of 2020 is compared to the summer recovery of 2021.  However, we are now seeing real supply disruption everywhere with the global supply chain massively backed up.  In 2019 there was global oversupply of almost all goods and the manufacturing capacity to make them. Fast forward to today and we find that raw materials can’t get to the manufacturer, finished goods can’t get to the wholesaler, and retailers can’t find enough people to work on their sales floors. 

To use a simple example, if there is only one bicycle and two people want it, the price goes up until one person owns the bike and the other person decides they don’t want to spend that much money anyway.  The prices of goods are increasing but because fewer goods are being sold, the economy is stalling. Supply disruptions have led to price increases of basic materials, finished goods, and labour costs, which in the absence of an overall boom in wealth, has resulted in demand destruction.

Avenue’s Equity turnover and Canadian exposure

As usual we ask the question, what are the consistently high profit margin businesses trading at reasonable prices?  But now the answer is changing slightly.  We want to make sure we have investments in raw materials where the prices are rising.  We can maintain our investments in hard asset businesses like real estate and infrastructure where the asset is already built. Software and many services operate seamlessly across borders in the digital age.  What we want to avoid in the current market are businesses which rely on many inputs and have a long sales cycle.  To adjust to this changing business dynamic, our portfolio has been more active than what we normally plan for. 

Historically, Avenue’s equity portfolio has on average a five-year hold period per investment, which means the portfolio has a turnover rate of 20% per year.  So far this year Avenue has a turnover rate of 40%. Some of the turnover was a welcome surprise in that WPT Industrial REIT and Roxgold were effectively acquired.  But most of the turnover has occurred because stock prices have moved up and business outlooks have changed rapidly in the industrial and healthcare sectors of the portfolio. We are hoping that the high turnover rates, this year and last year, were an anomaly and what we currently own can be held for the foreseeable future, with the exception of a few cyclical commodity investments.

The other incremental shift in the portfolio has been an increase in Canadian business exposure, driven by value opportunities.  Historically, Avenue’s equity portfolio has had direct foreign investments ranging between 25% to 30% of the portfolio.  We have always argued that if we can find a great business in Canada, we don’t need to take on the extra currency risk of investing outside the country.  However, there have not been many good choices, given Avenue’s criteria, in the Canadian stock market in terms of technology and healthcare businesses. Thus, if we could not find Canadian stocks, we went outside the country to find high quality investments.

What we have found over the course of 2021 is that US healthcare and technology stocks are becoming increasingly expensive or are facing uncertain business risks.  At the same time, several Canadian businesses have emerged that fit our criteria of a good business at a fair price.  For example, in healthcare we have made an investment in DentalCorp and in technology we made an investment in Topicus.  Avenue’s equity portfolio is currently invested 17% in direct foreign listings because we have found that comparatively more opportunities are here in Canada where fewer people are paying attention. 

We still have foreign cash flow exposure. However, the exposure is through Canadian companies where the valuation is lower and we can pay less for an equal amount of cash flow.  For example, Lundin Mining is a copper mining company with over half its production in Chile.  We have ownership in a Canadian mining company that sells copper at the global US dollar price, but the profit margin is determined by the local production costs in Chile. 

Another example is Topicus.  The company is Canadian listed but with a European management team that buys and operates technology businesses in Europe. When we add up where the cash is made by the underlying businesses in the portfolio, fully 47% of the cash flows come from outside Canada.  We want to have foreign asset exposure in Avenue’s equity portfolio but currently the most cost-efficient way to get it is through Canadian listed companies, which make money from their foreign subsidiaries.

Not all stocks are expensive

‘Stocks are really expensive’ is the oft-repeated phrase lately.  We just said the same thing in the previous section, when referring to the valuation of healthcare and technology stocks in the US. We would like to make our case that this catch-all phase requires a bit of nuance.  At Avenue we argue that it is US technology and index leading mega-capitalization stocks that are expensive.  In our Q2 letter we presented a chart showing the incredible inflow of money into the US equity market in the first half of this year.

Running with the crowd has historically not been the best place to be when investing in the stock market.  In the following chart, the SP500 US Index price/earnings ratios are broken into growth companies and value companies.  While the growth companies are expensive by historical comparison, the value companies, with a price earnings ratio of 16, are trading at about their historical average. 

Again, in Canada we find that valuations are generally not high.  This next chart is a bit more esoteric, but it makes the point that Canadian stock valuations are a bit above their historical average relative to interest rates, but not by much.  We find that there are many opportunities to find good businesses and the valuations are not excessive.

Remember the Tail Hedge

We have made the case that we are able to build an equity portfolio of high-quality businesses at a reasonable price.  However, the risk remains that there are excesses in the broad stock market indexes like the US S&P500 Index.  Money flows are at all-time highs, margin debt is at all-time highs, initial public offerings are soaring, and retail trader participation is described as a mania. Our strategy is to acknowledge this systemic risk and hedge our portfolio of high-quality companies against any potential stock market shock using Avenue’s Tail Hedge strategy.   

Avenue’s Bond Portfolio remains defensive

Avenue’s bond portfolio performance in 2021 continues to demonstrate the difference between Avenue’s strategy and the overall Canadian bond index.  Avenue’s bond portfolio is up 2.2% year-to-date versus the Canadian bond index return of -3.9%.  Avenue’s portfolio out-performed the Canadian bond index by 6.1% and more importantly had a positive performance in what has been a bad year for bonds.

We have written previously about the effect on reducing interest rates by central bank activity called quantitative easing.  A few papers recently have tried to quantify the impact of this act of yield suppression on the level of interest rates.  The consensus is that interest rates have been artificially reduced by central banks by about 2%.  So, if we back calculate this with our current yield, this implies that the US 10-year yield of 1.5% should in fact be 3.5%.  If we add a historically normal corporate bond spread of 1.5%, this would imply a corporate bond yield of 5%.  Avenue would be very happy to build a corporate bond portfolio which has a 5% yield in a 2-3% inflationary world.  This gives us a sense of the scale for how far we are away from a properly functioning interest rate market.

We can now see the consequences of interest rates being this low.  There are very few if any corporate defaults because borrowing is so cheap. This is bad news for keeping the economy fresh because defaults and bankruptcies remove inefficient businesses from the market.  The following chart is not supposed to happen and demonstrates how yields have dropped to an extremely low level.  About 85% of high yield bonds or what are called ‘junk bonds’ in the US are trading below the rate of inflation. 

Given the extremely low corporate bond yields, Avenue’s bond portfolio remains defensively positioned. As well, 15% of the bond portfolio is invested in TIPS or Government Inflation Protected Securities.  In our next quarterly letter, we will take some time to dig into this topic in more detail.

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
–       Milton Friedman

In this quarterly letter we would first like to discuss Avenue’s view of inflation, which has quickly become the main topic for investors.  Leading from our view on inflation is our broader thinking about how nothing is normal in our current financial world. But we believe we need to get used to it; we are living in a new normal. Our conclusion continues to be that we have to stay invested, but more than ever it matters what we own and it certainly will always matter how much we pay for our investments.  Lastly, we would like to give an update on the Avenue Tail Hedge portfolio now that we have been incorporating this strategy for a full year.

Goods Inflation is Temporary

At Avenue we went into the year expecting inflation to increase as the economy recovers from the pandemic. We are halfway through the year 2021 and the headline consumer price index (CPI) measure of inflation is at 3.6% for Canada and 5% in the US. Now that inflation has arrived, there is an active debate about whether inflation is permanent, or will it at least continue at an elevated level from the less than 2% we experienced for the last decade.  This is a central issue because the level of inflation sets the tone for the level of interest rates which in turn underpins the valuation of all financial assets. 

It is our observation that most of the recent price increases are due to disruption in supply chains and shortages of labour caused by the pandemic.  We are emerging from lockdown and most industries are up and running, but it will take at least another year to smooth out raw material production and distribution, transportation networks and global trade links.  Here is where we make the argument that higher prices, caused by more demand than supply, are not inflationary as long as the pool of money is not increasing. If there really is no excess money in the economy then as goods become more expensive, consumers will be forced to cut back and consume less.

The next part of this argument is to address what is often described in the media as trillions of dollars of ‘money printing’ to help sustain the average person through the last year and a half.  As we have outlined in previous letters, the reality is that the trillions of dollars of stimulus in Canada and the US have not been printed but borrowed. For the time being, this implies that this money will be paid back and yes, it is stimulative but not in a conventional way. This is where central bank policies like quantitative easing get complicated. Money is created but because of the mechanics of the banking system, this money is not loaned out to create the positive knock-on effects from productive capital investment. Or as we mentioned earlier, this money does not make it into the economy and does not get used to build businesses.  The money effectively gets trapped in the financial system where it seeks out returns from financial assets.

There are two important results of this central bank policy of quantitative easing, where government bonds are issued but then bought right back again by the central bank.  There is new money in the financial system that has to be invested somewhere but now there are fewer bonds available because of the central bank purchases. The interest rate levels are lower than they would have been otherwise.  All investors, from individuals to pension plans and insurance companies, are seeking a decent return which government bonds no longer offer.  The new money is compelled to find higher risk investments like mortgages, corporate bonds, and stocks. 

Asset Inflation Will Continue

While we have anticipated that money should be flowing into financial markets, we are now witnessing unprecedented waves of money coming into the stock markets around the world, particularly in the US. Year to date inflows into global equities are on pace to surpass the last 20 years combined.   

A large amount of the money that is chasing global stocks is going into US equities. As seen in the chart below, the foreign ownership of US stocks is now over $10 trillion dollars, a record amount.  The newspaper headline on the right is from a copy of the Philadelphia Inquirer in 1929. A similar dynamic was occurring in the late 1920s when Wall Street was serving as a suction pump for capital from all over the world. At that time investors were speculating in stocks like General Motors, RCA, and Montgomery Ward. Today it is the FAANG stocks: Facebook, Apple, Amazon, Netflix and Google. Every generation of investors that comes along thinks they have found their version of the philosopher’s stone which will bless them with unlimited easy riches and prosperity. But in investing, like human nature, there is nothing new under the sun.

Source: St. Louis Federal Reserve, Philadelphia Inquirer

Warren Buffett has a famous saying to ‘be greedy when others are fearful and fearful when others are greedy’.  Therefore, we were aggressive when the stock valuations were lower last summer, and now we are building more caution into our investment portfolio given the current, almost universal, positive sentiment. This means selling individual investments when they reach our return targets and recycling this capital back into other new businesses that provide more attractive risk/reward opportunities. Because of this strategy the first half of the year had more turnover in the portfolio than normal.

A lot of money is being invested quickly and much of this money is being invested in passive index funds, which distorts individual stock prices. To understand the lure of index funds the argument goes like this. If you buy an individual stock and something goes wrong with the underlying business, then the stock will fall.  However, if you buy the broad market index, if the index falls then the central bank will come in and support the overall market. There is a win-win mentality that has seeped into index investing that is getting close to a tipping point of altering how the stock market functions. For instance, stocks like Apple are trading as if they are safe and defensive places for investors to hide, even when the stock is trading at 40 to 60 times their true accounting profits.

Source: Russell Investments

There is a great article written by Bloomberg on July 2nd that covers all the main problems with index investing on this scale.  Instead of reproducing what is already a thorough article, we have added it as this quarter’s case study for anyone who would like a deeper read.

When large amounts of money flow into index investing, sectors of the stock market become dominant precisely when they are at their most expensive valuation. For any long-term investor this creates a perilous future investment return.

Index funds are threatening the core purpose of the stock market which is to allocate savings efficiently. As long as the money keeps coming in, stocks will keep going up with the biggest stocks going up the most.  The problem we have as investors is that we know this is not sustainable, but we also do not know how long this excess financial stimulus will last.  It might continue for a week or years.  As we have discussed in previous letters, waiting on the sidelines for excesses to pass is risky as well.  To sit in cash on the sideline is fine for a month or two but there is little interest income from short term bonds.  Long term, the currency may devalue or the risk of an overheated market may be too great. We know we cannot compound our investments if we are not invested.

For most professional investors this is a period in time when “career-risk” becomes a driving force for making investment decisions. If you are managing a large mutual fund or institutional portfolio, you feel pressure to chase the market and really go for it. If you do not do this, you worry that your clients or fund company is going to fire you because you did not win big enough in a rising market. This is why alignment of interests between investment manager and client is so crucial for long term successful investing.

Fortunately, at Avenue we do not feel this pressure in the same way and that is a core reason why we are independent. Our equity portfolio has had a strong start to the year however our portfolio does not look like the index. We believe we are finding opportunity in investments that other people have missed. At Avenue, we do not speculate or chase expensive stocks. Our client’s place their utmost trust in us, otherwise they would not be invested alongside us.

The New Normal

We now find ourselves in a financial climate that is not normal or stable. Avenue is willing to project that this environment will continue for a while. In which case we need to get used to it and treat it as the new normal. How do we still accomplish our return goals and stay invested in what is becoming an uncomfortable and fragile market?

In summary, Avenue believes that government debt levels are far too high for the size of the economy. Hence, the productive economy will grow at a lower rate, somewhere closer to 1%. Interest rates on government bonds will remain low. Asset prices for things like stocks and real estate will remain high.

What do we do to structure a long-term portfolio given this environment? We know we have to have our money invested. Either in tangible things or high cash flowing businesses to protect us against the increasing cost of living, asset inflation and potential economic stagnation. 

But given the excesses of the stock market, it now very much matters what we own. At Avenue we focus on consistent and essential businesses. And more important than ever, it very much matters what we pay for our investment.  Reasonable valuations are an essential buffer for protecting the downside of our investments.

It matters what we own.

It matters how much we pay.

There Are Still Opportunities

The Canadian dollar has strengthened significantly over the last year to a point where our bias from a year ago towards investing in Canada has been reduced.  However, it is important to highlight that with a Canadian dollar now in the mid to low $0.80 range we are somewhat indifferent to where investment opportunities are located. If the Canadian dollar moved closer to $0.95, we would definitely look at investing our appreciated Canadian dollars outside of Canada.

At this level of the Canadian/US exchange rate we are country neutral, and we let the return opportunities dictate where our incremental investments are made. For example, our healthcare investments have primarily focused on the US because of the size and depth of their sector. However, this quarter we made an initial investment in DentalCorp, which is a Canadian business that owns over 400 dental practices across the country.  We really like the consistency of the underlying cash flow. The valuation was compelling which is the basis for achieving our rate of return objective.

Avenue Tail Hedge Strategy

The biggest change at Avenue over the last year was the introduction of our tail hedge strategy.  Roughly 2% of the equity portfolio each year is used to buy hedges on the overall stock market index.  These investments act as protection and have a positive return if the stock market falls significantly.  We feel even stronger about the importance of this strategy as the market continues to climb.

Having the hedge has a strong psychological effect of keeping us more fully invested. We are not always looking over our shoulders worrying about every little daily bump in prices.  We can focus on the longer term and make rational decisions about the valuation of economic sectors and individual stocks.

What we know about financial markets is that major market falls happen without any advanced notice.  Major declines happen when most people are positive about the future, because to get a big stock market drop most people have to be already all in.

We now have a way to patiently own our high-quality core investments but profit from our hedge given a sharp market decline.  If the stock market decline is significant enough, we will cash in our hedges and with the returns, reinvest in our favourite stocks at good prices.

“A bird in the hand is worth two in the bush.”
John Ray’s handbook of proverbs, 1670

In this quarter’s letter we would like to discuss Avenue’s investment strategy in relationship to the current strong overall performance of the stock market. We believe a balanced portfolio of high-quality consistent businesses is more important than ever. While interest rates may rise further, proportionally most of the move has likely already happened.

One of the obvious challenges with investing is that it is easy to make mistakes. The stock market prices are set by all investors collectively guessing what a company’s profitability will be at some point in the future. In hindsight, it seems easy to have predicted that Central Bank interest rate policy and government stimulus spending throughout 2020 would bail out the stock market. The big mistake we could have made last year was to be overly cautious in April. Any money on the sideline from that period has experienced a significant opportunity cost.

‘A bird in the hand’ is at the core of Avenue’s investment strategy. This age-old proverb expresses the idea that it is better to have a lesser yet certain profit, than the possibility of a greater one that may come to nothing. At any point in time, there are always many future outcomes. It is very difficult to continually guess which stock or sectors within the stock market will outperform all the others.

We believe that we have built a portfolio to achieve our goals no matter the economic environment. Our strategy at Avenue starts with putting constraints on the types of businesses we like to invest in. These constraints are designed to keep us out of trouble. We never start looking at a company and how much money we can make without first considering how much money we can lose if we are wrong. We look for assets or circumstances that can minimize the downside when we assess the underlying business. As we have repeated many times, we like to find investments with a consistency of profitability where the underlying business can compound on its own and then, of course, we don’t want to pay too much for it.

Building a portfolio of profitable businesses with balance across all parts of the economy protects us from the random collapse of any one sector. As we also pointed out in last quarter’s letter, there is now extreme concentration risk in a handful of technology stocks. These are certainly all amazing companies but their stocks’ valuations are now very expensive. And one thing we do know is that technology is always evolving. But more on that topic a bit later.

Lastly there is the constant reality that the stock market is prone to the occasional swoon. With low interest rates, high valuations and herd mentality the risk of another drop is increasing. Waiting for the drop to invest is also not a viable strategy given that it can be years if not decades between events. We will miss out on all the compounding of dividends. So that is why we introduced the Avenue Tail Protection portfolio last year as a perfect complimentary strategy to combine with Avenue’s portfolio of long-term investments. We believe we will make money with the hedge in a down market and be able to use these profits to increase our position in our favourite companies when they are trading at depressed prices.

2020 Hindsight

While we want to spend most of this quarter’s letter discussing where we are going, we think it is still worth understanding what happened economically in the last 12 months. It is not an exaggeration to state that we have never seen anything like this before. 2020 was something very different than a recession or depression. A portion of the economy, estimated at about 15%, was completely shut down, while the rest of the economy functioned more or less as normal.

We were able to make this argument last year, but now we can now see it in the numbers. Canada has a modern industrial and service economy. Throughout 2020, industry kept running and services like lawyers and accountants were able to pivot into the digital age. Consumption of home items surged. It is the services where we spend our disposable income, like restaurants, concerts and travel that took the hit from an economy in lock down. The result was a dramatic increase in personal saving. Savings don’t go up in a recession. We don’t, as of yet, have a definition for this type of economic outcome created by the pandemic.

Will this be the roaring 20s again?

2021 has many qualities that could result in a continuing surge in stock market speculation. Most households have excess savings and pent-up demand while Central Bank policy intends to keep interest rates low for at least the next two years. While we need to stay invested, we also want to avoid what have become obvious pockets of excess.
There is now a feeling among investors that the recovery was inevitable and asset prices will keep rising. The suppression of interest rates has also suppressed two fundamental parts of capitalism: price discovery for the level of interest rates and moral hazard where now it is unacceptable for businesses to fail. The view that the stock market only goes up has become imbedded in investor psychology. While the trend and fundamentals point to higher prices, we still need to have an eye on the horizon to see if there is a storm coming.

One such decade-long tailwind for corporate earnings will become a head wind in 2021. We wrote optimistically in 2009, coming out of the 2008 financial crisis, that there existed the best fundamentals for stock market bottom line earnings. We felt, at that time, that the economy would recover, costs were contained, the cost of borrowing would stay low for longer and taxes were going lower. At this time period, when we assess the earning recovery post pandemic, revenue will recover but operating costs like raw materials are up, the cost of borrowing is going up, and taxes look like they are going up as well. The result is margins that are lower than investors might have forecast. We must be mindful of the type of businesses we invest in and assess whether they can navigate these changes. Most importantly, this will be a headwind for stocks with expensive valuations.

As well, Central Bank and Federal Government stimulus have had a dramatic and distorting effect on asset prices. When interest rates are this low, investors are willing to pay more for earnings that might happen in the distant future. What are commonly called growth stocks will get a high valuation based on the expectation of future earnings. It is just a reflection that since interest rates are so low, borrowing money has little cost.

With interest rates going up in the last few months, this trend has reversed slightly. Companies that have stable earnings today become more valuable than companies that might make a lot of money in the future. We believe our portfolio of businesses with quality earnings, which still trade at reasonable valuation, is in a sweet spot.

Is inflation coming back?

In Avenue’s year end letter, we wrote that we had positioned the bond portfolio defensively given the need to protect our good return in 2020 and given our view that interest rates might go up. We even stuck our neck out with a forecast that inflation expectations might increase to 3% by the end of 2021. Three months later, 3% consumer price inflation is now the consensus estimate for the year.

The benchmark US 10year treasury bond has gone from a yield of 0.5% to 1.7% in three months. And while 1.7% is still a low interest rate in absolute terms, financial markets are very sensitive to the rate of change. The way financial markets see it, the US 10year treasury bond’s yield increased a record 240% in just three months.

Avenue’s bond portfolio was down in Q1 but only by -0.5% compared to the Canadian bond index which was down -5%. Yields are now at a level where we have started to invest some of the cash in the portfolio. We are focusing on provincial bonds first. We are holding off on buying new investments in corporate bonds given the current prices are still expensive relative to historical levels.

For a more detailed analysis of our inflation expectations, please see this month’s Case Study on Inflation vs the Velocity of Money.

Why is technology investing difficult?

Technology businesses are fantastic investments because they are what is called asset light. Once you have your computer code and defined purpose it is easy to replicate at scale. In contrast a lot more plant, equipment, steel and labour must go into building cars and planes.

However, technology businesses are difficult to predict because it is hard for a company hold on to a dominant market position in a hyper competitive market with access to what seems like unlimited investment capital. Additionally, high margin and asset light companies now trade with high valuations which don’t given us any room or margin of error if the future is not as bright as expected.

This time last year, we would certainly not have argued against the idea that big technology stocks like Apple and Microsoft could go to new highs. But to be clear, such a forecast would be saying: this expensive Apple stock is going to become a really expensive Apple stock. A likely possibility, but then what do we do next? You can then see how easy it becomes to start jumping from expensive stock to expensive stock while speculating on where the flow of money is going to go to next. Instead, we believe it is more productive to concentrate our research efforts on finding technology businesses that have lots of room to grow and have a reasonable valuation. Buying a technology stock at a reasonable valuation is no different than buying any other stock; a reasonable valuation protects our downside if there is an unanticipated business disruption.

We would like to point out that at this time two years ago, Avenue’s technology investments were BCE, Apple and Microsoft, and made up about 7% of the portfolio. (BCE is now considered technology where previously it was categorized as telecommunication.) Now Avenue’s investments in technology are focused on North American and European software applications comprised of Constellation, Topicus, Enghouse, Roper, CDW and Citrix. These investments make up 12% of the portfolio. Our holdings were slightly higher, but we recently sold our successful investment in the Canadian software services company Dye Durham.

Crypto currencies go mainstream

We are experiencing a profound development in technology and finance. The market value of all crypto currencies is now the equivalent of about $2trillion US dollars. We feel, as do most investors, that we need to understand this emerging asset class and so here are our thoughts.

Crypto currencies like bitcoin, are encrypted lines of computer code that can be exchanged and in bitcoin’s case there is a finite amount. As long as there is perceived value between a buyer and seller, then it is a real thing. It is a basic human trait that we like to collect scarce assets, seemingly even if it is just digital code.

Looking at crypto currencies as a mainstream investable asset is more problematic. Yes, there is a perceived value, but a bitcoin is essentially a thing, more a collectable, like gold or a rare wine. At Avenue we invest in businesses. Again, if we can find a good bitcoin-based business trading at a fair price, we will absolutely investigate it. You can put the equivalent of silver bars or pounds of uranium in your RSP, but then you are purely speculating on the price of the object. At Avenue, our returns are underpinned by the profits of productive businesses.

We would also like to remind ourselves of the two pillars of investing in Western democracy: the importance of private property and the rule of law. It feels like we are moving into an era where these pillars are being taken for granted. At Avenue, our first exercise for assessing any business is if things go badly what hard assets does the company really own that are tangible and of value to someone else. Is there an asset that can be repossessed by the courts?

You can now buy bitcoin quite easily on many exchanges. But Bitcoin is not registered security (Which is the fundamental point of it.) and they do not come with benefits and safeguards like custody and a fully developed legal system. It is unlikely you will be able to go to court and say “hey that North Korean guy took my decentralized string of computer code and I want it back.” And if you do decide to take your code off an exchange, please don’t lose it, but don’t tell anyone your 24 word random password either.

Crypto currencies are exciting to talk about and many businesses might be profoundly changed by the underlying block chain technology. Please reach out to your Avenue team member if you have curiosity about the space.