“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.

If you had the good fortune last January to take a year-long sabbatical in the South Pacific, cutting yourself off from the world, you would be arriving back on an empty flight, landing into quarantine and economic lockdown. After checking in with your family and friends about their health, you might be emailing or calling Avenue to see how bad a global pandemic is for your investment returns. Remarkably, Avenue’s equity portfolio was up a bit for 2020, after having a good year in 2019. Avenue’s bond portfolio also had a good year in spite of a continuing low interest rate environment. As an added plus, your sojourn abroad would have ensured you avoided the gut-wrenching experience of global market selloff and subsequent recovery.

Looking at the year ahead, we will try and make sense of what seems like major contractions in financial markets. Markets are progressively more fragile, yet we believe it is a greater risk not to be invested. While many stocks are expensive, we have built a portfolio of high-quality businesses that trade at much fairer valuations. Also, we would like to celebrate financial innovation at Avenue in 2020 with the introduction of our Tail Hedge Portfolio to protect our wealth against future systemic shocks.

The Impact of Low Interest Rates

In previous letters, we have termed this current era of financial markets “the great distortion”. This term describes the transformative effect on all assets prices from low interest rates. The US central bank is committed to maintain a low interest policy for the next few years until the economy has recovered from the loss inflicted by the pandemic. However, growth will accelerate during 2021 with the global rollout of vaccinations. But as supply bottlenecks continue, there will be higher consumer price inflation for the first time in a decade. We are already seeing 10-year and 30-year interest rates rising, but arguably from a very low base.

In addition to low interest rates, corporate bond spreads have fallen to very low levels. The corporate bond spread is the amount of extra return you get above what a similar government bond would return. For example, if a 10-year Canadian government bond is yielding 1% and a 10-year Bell Canada bond is yielding 2.5% then the added yield for taking on the risk of Bell Canada is 1.5% more than owning a similar term government of Canada bond. Avenue’s bond portfolio invests in Canadian corporate bonds as a core part of the strategy.

Because of the risk of increasing consumer price inflation and the fact that the absolute level of corporate bonds is so low, Avenue’s bond portfolio is again defensively positioned. We have a higher level of cash and the average term to maturity of the bonds in the portfolio is 3.5 years. While we do not anticipate that the last two years of favourable returns will continue, the bond portfolio continues to serve the important role of diversification and stability for many clients. We also have the flexibility to take advantage of any opportunity to reinvest at higher rates.

Avenue’s view of the stock market in January 2021 is very similar to where we were in 2020. Asset prices and valuations are priced as if central bank zero interest rate policy will continue indefinitely. As well, liquidity continues to be added to the financial system. The term liquidity is financial jargon for cash being available or added to the overall market either through suppressing interest rates or issuing more government bonds.

In the short term, if we can agree that there is a fixed amount of assets in the economy, when you add money that needs to be invested then the price of existing assets will be driven up. Last year the rough amount of new money added to help North America get through the pandemic was roughly $7 trillion for an economy that is slightly bigger than $20 trillion. With the Democratic party elected to all three federal branches of government in the US, the expectation is that the stimulus in the first half of 2021 may be up to an additional $3.0 trillion.

Source: CBO: The 2020 Long Term Budget Outlook

Further to this sum, many businesses listed on the stock market have been very profitable during the pandemic. A good example is Walmart which has thrived while corner hardware stores have been forced to close. But at the same time Walmart is not using their cash, it is just accumulating money until the economy fully opens again. The total cash held by the 3,000 most valuable non-financial businesses globally has gone up this year from $5.7 trillion to $7.6 trillion. Most of this money will be recirculated into the financial market as the global economy is restored to normal.

Then there is the global bond market which is valued at about $300 trillion. With interest rates so low it is hard to get a satisfying absolute rate of return investing in bonds. Each day there are more investors moving money out of the bond market and into the stock market in search of higher returns.

Finally, we need to acknowledge and understand the magnitude of index driven stock market investors and historic retail participation. The majority of new stock market investors are buying index funds which do not distinguish between relative valuation or weigh an individual stock’s future prospect. Buying a stock index drives up all stock with the most money going to the biggest stocks. The largest 6 stocks in the US SP500 index now comprise over 25% of the total value of the index.

Source: Yardeni Research

As we look to the coming year, a sustained low interest rate policy with waves of additional money will continue to drive up asset prices. But as prices go higher, the more vulnerable and fragile the market becomes. Any rise in interest rates or any future contraction of liquidity would ultimately cause a big reversal in financial markets.

Moving to the sideline and waiting out a potential mania is not really a solution either. First off, we do not know how long current liquidity conditions will last. Also, as we have discussed for most of this past year, because the government has so much debt, there will be real pressure to devalue the currency over the coming decades. Sitting on cash is actually the dangerous place to be, longer term. And there is not really one currency that appears better than the others.

Our conclusion is that the best strategy to protect and yet still grow our wealth is to make sure we stay invested and sidestep the obviously frothy, or overvalued, stocks. Because of the fragility of the market, you can understand the importance of having Avenue’s new Tail Hedge Portfolio which is a complementary strategy when combined with the equity portfolio.

What we own in the stock market is also very important. We believe the safest portfolio is a broad mix of businesses with representation from all 10 major sectors of the economy. All our companies are profitable today, we have not paid too much for them, and we can understand why they will be more valuable in the future. This protects us from sector concentration or the risk from individual companies where profits fail to materialize.

Investments in technology are an important part of the portfolio but this is the sector where some of the stock market mania is materializing. Technology stock outperformance has driven index returns for some time. However, as we have seen in the second half of 2020, what were already expensive stocks are now very expensive stocks. The risk is that all the future growth of profits is already in today’s price. One of the most extreme examples is Tesla. The stock trades at a multiple of 1,600 times earnings compared to the comparative stock market index that trades at 22 times earnings. Today’s valuation of $700 billion is discounting that the company will have a 30% share of the global electric vehicle market in a few years’ time. In this case there is a lot of execution risk on behalf of management to deliver what investors are expecting.

Source: Yardeni Research

We will try and stay away from stocks that are in the spotlight. Doing so gives us a better chance of finding and being invested in high quality businesses but where the risk reward is much more in our favour. Protecting against losses is just as important as the potential upside in any investment. And it may be more important now, given the fragility of the stock market.

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Benjamin Graham, Economist

This pandemic period we are living through has been described as The Great Distortion for financial markets. Central banks are intervening to support the bond market and Government spending is injecting enormous amounts of money into the economy with much of it finding its way into the stock market. We know we must own stocks now more than ever to protect our wealth, given the fragility of the financial system built on too much debt. Avenue’s equity strategy allows us to stay invested but avoid stocks that are too expensive. We must also avoid stocks that might be inherently weak. We are continually building a portfolio of high profit margin companies that still trade at a reasonable valuation and do not need to rely on financial markets to raise money.

The frequently used quote above, is attributed to Ben Graham, often referred to as ‘the father of value investing’. What he is observing is that in the short term many stock prices will swing wildly as a reaction to the flow of money and perpetuation of fads and tends. However, in the long term all stock prices must reflect the earning power of the underlying business. Substance eventually wins over popularity.

We feel this statement is very relevant today. The pandemic’s impact on the economy and the stimulus impact on financial markets, has resulted in pronounced stock price moves. We see stocks trading either well ahead of their fundamentals or at a deep discount to their asset value. As we wrote in our Q2 letter, we are trying to come up the middle and not overpay for the future nor get caught in what is called a value trap, where the stock is cheap but stays cheap.

COVID-19 Consensus

Before we go any further, let us weigh in on what we believe is the consensus estimate for the length of time until we have a vaccine. While this changes day to day, it gives us a benchmark for what we believe is priced into the market. Currently the average opinion is that there will be a vaccine and it will be ready by next spring and then available to most people by this time next summer. If that timeline changes for the better or for the worse we can gauge how parts of the market, like banks and energy stocks, will react.

The Economy vs. Financial Markets Distortion

There is still a general feeling that there is a disconnect between the recovering financial markets and an economy in recession with high unemployment. Since our last Q2 letter we are now able to detail some hard numbers comparing the economic slowdown to the stimulus. In this case we will use US numbers because they highlight the massive scale of what we are talking about.

In the first half of the year, US wages and salaries decreased by $680 billion with a further decline of $175 billion in other types of income. However, US government transfers to individuals totaled $2.4 trillion in this same period. For the first half of the year, the average personal income in the US actually increased by 33% because of government support, while spending declined by 35%. Money that would have been spent on travel, restaurants and other entertainment has gone into home improvements, personal debt repayment and stock market investing.

The US gross domestic product for Q2 was $4.85 trillion and total stimulus spending was $5 trillion. The pandemic has created a massive hole in the economy but between central bank borrowing and deficit spending by the federal government, the hole has been filled, and then some. The numbers in Canada are not quite as dramatic but they are not far behind.

Low Interest Rates & Corporate Bond Market Distortion

Low interest rates are the intention of central bank policy but also the casualty of a low growth environment. With high household and government debt levels, low interest rates are essential for avoiding a deep and painful recession. Also, there is the theory that low rates will encourage people to borrow and build new businesses. But that notion has not held true. The pandemic has instigated a decline in traditional bricks and mortar store front businesses that borrow from a bank. Dynamic new economy technology companies don’t get any advantage from low rates because they can’t borrow from a bank even if they wanted to.

The central bank has borrowed money and given it to the banks to lend. The banks have money to lend but no one to lend it to. We now have more debt but no increase in economic activity, the result being low interest rates that reflect a stagnant economy with no inflation in goods and services.

Too much debt makes our financial system fragile. There is now incentive for the Federal Governments in both Canada and the US to never pay this money back. Our conclusion is that, over time, all currencies will be depreciated. This is why Avenue fundamentally believes owning high quality businesses and hard assets is the best way to protect and grow our wealth in the next decade compared to the alternative of not owning stocks and hard assets. Cash in the bank or under the mattress is the riskier choice.

However, Avenue’s bond portfolio still plays a role for people who need income and can’t take on long-term stock market risk. As we have again experienced, the stock market can swing wildly in the short term. Absolute levels of interest rates are now very low. The 10 year Canadian Government Bond yield is 0.55%. At this level many investors feel the pressure to look for higher returns.

The core of Avenue’s bond portfolio strategy is to invest in Canadian Corporate Bonds. We were able to take advantage of the sell-off in corporate bonds in the spring and we are having a decent year for returns in a low rate world. But this pressure for higher returns means that money that might have been invested in government bonds has now moved to buy corporate bonds. Canadian Corporate Bond prices have benefitted from money looking for higher returns but now the market is expensive. For example, a 7-year bond issued by Canadian Natural Resource, where you take on the risk of the oil sands, will pay you a 2.2% annual return.

We believe Canada’s central bank’s coordinated effort to lower interest rates is fully reflected in the bond market. Any surprise move in the bond market will likely come from a rise in longer term interest rates. Therefore, Avenue’s bond portfolio is again positioned conservatively while we wait for economic recovery to restore more rational interest rates.

Stock Market Distortion

Following through on this last point, some of this money that has historically been invested in government bonds is being forced to take on even higher risk found in the stock market. Just knowing that this is the intention of central bank policy should be taken as a warning not to take too much risk. There is always an element of musical chairs in the stock market where the game is chasing returns when there is too much money and only so many seats. Returns are always better when the game has lots of seats and fewer players.

Identifying the excesses in the current stock market is easy to do. Please see this quarter’s Case Study on the valuation of Apple. Investors are forced to take on more risk and go into the stock market, but they still want safety. Safe investments in the second half of 2020 are companies with little debt and those that dominate the new tech economy. A new acronym has evolved over the summer: FANG MAN. This acronym stands for Facebook, Apple, Netflix, Google, Microsoft, Amazon and Nvidia. The combined market capitalization of these relatively recently created businesses is $7.5 trillion dollars. Their combined weight in the US’s main index, the S&P500, is 27% of an overall valuation of $27 trillion dollars. That is up from 21% when we described this phenomenon in our Q2 letter.

The distortion is caused by the flow of money pushing up valuations based on the perceived safety of these businesses. Back to our Ben Graham quote, current FANG MAN stock prices are reflecting many years of future growth that now must happen to sustain today’s price level. We are not predicting that these stocks must fall. But it a riskier bet to say that these companies will continue to compound at the same rate given today’s high valuation as a starting point. It is more likely that the stock market returns will broaden out to other parts of the market as the economy slowly recovers over the next year.

We have showed this back of the napkin valuation exercise before. Again, we will use the S&P 500 Index. The two inputs are a rational stock market multiple and an estimate of next year’s earnings. Historically the stock market has traded at a multiple of 16 times earnings. However, that was in a higher interest rate world. With lower interest rates we are forced to accept a higher multiple and here we argue that a multiple of 20 is reasonable and in reality, next year, it will likely be higher. The S&P 500 consensus earnings estimate for 2022 is $200 per S&P 500 unit. Embedded in this estimate is that the dominant FANG MAN earnings will be stable, and the broad economy will recover. A multiple of 20 x $200 in earnings = 4,000 units for the S&P 500 Index, which is over 20% higher than today’s level.

What do we know that will help us make sound investment decisions? We know we must own stocks because holding cash and sitting on the sidelines is risky. We also have a positive bias for the overall stock market. We know a handful of mega-cap stocks are overvalued. But we also know many traditional businesses in retail, travel and entertainment are distressed. As we stated at the beginning, we try not to overpay for the future nor get caught in what is called a value trap, where the stock is cheap but stays cheap. This knowledge helps us to build a portfolio of businesses that we have determined to be economically essential and which continue to operate in line with our expectations. We make sure to reduce risk by maintaining balanced exposure, in the best businesses we can find, across the various sectors of the economy.

We have always said that we go into the stock market to look for consistently profitable companies, with a high return on their capital, that trade at a fair valuation. What we find is that companies that fit this description are more mature and have well established businesses which often pay a dividend. We do not intentionally plan to build a portfolio of high dividend companies but often that is the result. For the last few years, the equity portfolio has had a dividend yield of about 3.5 – 4.5%.

With the new investments that we have made over the year the equity portfolio’s dividend yield has fallen below 3%. Partially this is due to increasing our gold exposure with companies that pay small or no dividends. But what has changed is that there are many high yield stocks trading in the market and we own a few of them. However, when we dig into the numbers, many high yield stocks are trading that way because their underlying business is distressed. We are finding it is better to invest in healthy businesses that pay a smaller dividend and have a clear path to increasing that dividend over time.

Canadian Stock Market’s Negative Perception is More Distortion?

Is Canada still out of favour? This is still a major investment theme. Canada’s image was not helped by the Liberal Government’s throne speech on September 23rd. Attracting investment to a ‘new and improved’ economy is seen as essential as long as your goal is to not make money. With all that is happening around the world we must recognize that Canadian’s are blessed to live in a country such as ours. At the same time, a thriving and prosperous economy is what pays for the things we value such as education, healthcare, and generous social spending.

The green economy is growing but it is not big enough to make an impact and it will not pay the bills for the country. Much needed toll-type infrastructure like pipelines and ports cannot get a building permit. Taxes are high and there is a lot of red tape because of government regulation. On the other hand, there is a big desire for transit or high-speed rail, but these projects do not operate at a profit.

Here is the problem. Canada’s electricity sources are already carbon-friendly green from our hydro and nuclear plants. Transportation is still awaiting a revolution because at this time Canada is cold and we live far apart so we are not suited for the current types of electric vehicles.

When we look at Canada’s top 10 exports, where Canada makes most of our money, we sell carbon-based energy to the world as well as heavy equipment. Wheat exports do not even make it on the list. Investors’ negative perception about Canada is real and it comes from observing a Federal government and a majority of the Canadian voting public that wants to shut down our carbon-based extractive industries before there are substitute industries. If Canada is to succeed in the years ahead we need a more rational and balanced approach.

We find by digging into the Canadian stock market that many dynamic Canadian businesses have evolved to lower their environmental footprint and increase their reach across North America. Companies like Cargojet, CP Rail, and Superior Plus are businesses that are having a great year despite not being widely owned by index investors. Because of investors’ antipathy to Canada, these companies trade at a lower valuation to their US peers. This gives Avenue lots of choice for investments in good Canadian companies. We can end this quarter’s letter by repeating what we wrote earlier, returns are always better when the game has lots of seats and fewer players.

“Face reality as it is, not as it was or as you wish it to be.”

Jack Welch, Former CEO of General Electric

In this quarter’s letter we would like to give our assessment of the many contradictions of financial orthodoxy in which we now find ourselves. The economy is in terrible shape and yet the stock market has had a strong rebound from the March 23rd low. Central bank intervention in the bond market means businesses can still borrow easily but this intervention by central banks is sacrificing the usefulness of investing in bonds because of how low interest rates are. There is a rush to ‘global’ investing which isn’t really global, but more like a second technology bubble. And cash is not a safe place to ride out stock market turmoil now that central banks are under pressure to devalue their currencies. Our conclusion at Avenue remains, to protect and grow our financial wealth we must be invested in a mix of hard asset and high-income producing businesses.

Avenue’s Bond Portfolio

The stock market remains the focus of most investors’ attention. It seems like a contradiction that the stock market is rebounding in the face of the worst economic crisis since WWII. But to get the progression in order of importance, let us discuss the current state of the bond market. To stave off financial panic in March, the US and Canada’s central banks aggressively purchased bonds in the open market. Our central banks started by buying government bonds, and now buying has extended to purchases of corporate bonds as well. This process of buying bonds keeps interest rates suppressed and frees up cash to be invested in other things, like stocks. This manufactured liquidity is easily the most important factor in turning around financial markets.

We were able to take advantage of the initial sell off and make several timely purchases in Avenue’s bond portfolio. However, where we were hoping for more higher yielding purchases, any further opportunity was taken away by the swift and overwhelmingly large central bank intervention. Despite the bond selloff in March, to look at the price level of corporate bonds today, you might well conclude that the bond market is not reflecting any stress in the real economy.

A major part of Avenue’s bond portfolio strategy is to invest in Canadian corporate bonds and we believe the portfolio is in much better shape because of the crisis. We were conservatively positioned going into March which gave us the ability to buy as the price of corporate bonds sold off. We expect the bond portfolio to return between 3 – 4%, at a time when the government of Canada 10-year bond currently yields 0.5%.

There are far reaching implications for this scale of central bank bond purchases. So far, our central banks have not printed money, they have borrowed it. Which implies that they have an obligation to pay it back. For this reason, the current actions are technically not yet inflationary, but that might change in the next few years. More on this later in the section: Cash isn’t Safe.

Central banks have the singular power to un-glue financial markets so that good businesses that borrow money have access to financial markets. But it also sustains the life of many marginal businesses that have too much debt and, perhaps, should have failed or been restructured. The creative destruction that occurs in a capitalist system can at times feel harsh, but it allows for capital and investment to be directed to (hopefully) productive uses. At least that is how the economic system is supposed to work. This past decade of artificially low interest rate has filled the economy with ‘zombie’ companies which has reduced the economy’s ability to rejuvenate itself. When the hurdle rates for investment decisions are today’s government bond rates, then it is easy for capital to be misdirected and misallocated to unproductive uses and financial speculation.

Central banks have created an environment where most businesses can borrow money and are solvent for the time being. But the core idea of capitalism, where financial markets find the right price where a lender is willing to lend and a borrower is willing to borrow, has been taken away. Rightly or wrongly, bond investing for the moment is an act of anticipating central bank policy. This is reality as it is, not as it should be.

The main implication for long term investors is that interest rates continue to be suppressed which leads to effects on investors’ behavior.

Historically most pension funds, insurance companies, and retirees had invested the majority of their money in the bond market and some smaller allocation was invested in the riskier stock market. For most of our lifetime if an individual investor was nervous, they had a choice of limiting their stock exposure and have say 70-80% in bonds for safety. Even in the crisis of 2008 you would have been able to get out of the stock market and buy a 10-year government of Canada bond with a 3.5% yield.

Using the government bond market for safety no longer gives the same return. Or it has been said that long term bonds now provide “return-free risk”. It is difficult to comprehend the scale of this shift where a vast sum of institutional investors’ former bond money is now forced to seek a new home in cash or the stock market.

Avenue’s Equity Portfolio

Living through the panic in March we were still confident in the long-term value of our investments. We just thought the stock market would take longer to recover. We now have a clearer picture of why the stock market has rebounded with such speed in the last quarter. The phrase being used is that the US central bank has the ability to save Wall Street but not Main Street. Low interest rates make bond investing unattractive and pushes money toward a potential higher return in the stock market.

We also have the additional liquidity, generated by central bank purchases of bonds, which also finds its way into the stock market. We are currently using a rough number of about $5-trillion dollars of newly created funds in the US, which is about 25% of the entire economy. This includes both central bank asset purchases and the fiscal deficit. A further anomaly of this crisis is that many people are saving money at the highest rates in generations with a savings rate of 30%, and so there is even more money available for investing.

In our last letter we explained how the stock market has a way of looking through to the other side of the pandemic. We focused our investments on businesses that have stayed open through the crisis and can be termed as essential to the economy. This pandemic will pass. At the moment the consensus priced into the market is that there will likely be a vaccine available sometime in 2021. We have built the portfolio to survive this crisis, but these businesses are also ones that we want to own in the years ahead.

Global Isn’t Global

A post-panic trend is to encourage investors to get their money out of Canada and own a broader global portfolio. This idea was fashionable before the crisis but now the noise has become even louder. Avenue’s strategy is always to go find consistently profitable businesses, regardless of where they are, and be careful not to pay too much for them. So, we ask the question, are we missing something? On closer inspection what is making up these global portfolios is just the same handful of big US technology stocks.

When the term “global investing” is thrown around you do not hear many investors talking about wanting to own German banks or Japanese bonds. Deutsche Bank for example has a stock price still sitting at close to a 15 year low.

It is the success of the big tech stocks like Microsoft, Amazon, Apple and Google which is completely overwhelming the investment industry’s ability to make clear decisions on diversification. They are all good businesses, but for the most part they trade at high valuations and there is increasing risk over coming years that they will face anti-trust issues. There is real concentration risk because everyone, globally, owns the same few stocks. In Avenue’s equity portfolio we have 10% exposure to technology, and we have an investment in Apple where we think the valuation is reasonable. But to make sure we do not get side swiped by another tech wreck like we had in 2000, we have diversification with similar weightings in healthcare, consumer service companies, real-estate and utilities.

While many investors are still concerned about a second stock market crash, what we are actually seeing is a bit of a mania unfold in story stocks like Tesla and Shopify. Both these companies have revolutionary business models and could very well change the world, but they don’t currently make money. Excess liquidity from central banks is creating a bubble even while the economy is in recession. So, we must position ourselves to cautiously steer around this new obstacle as well.

Cash Isn’t Safe

Many investors have gone to cash to wait out the current economic crisis. We argue that the perceived safety of cash is no longer as useful as it was. We spoke earlier in this letter about the central bank borrowing money to create liquidity. This has had the effect of stabilizing the bond market, but it has also sown the seeds of the next financial crisis. There is now simply too much debt in the world which cannot be paid back through economic growth or taxation. The only practical way out is to gradually devalue the purchasing power of fiat currencies.

There is a staggering amount of money that has been created in the United States, with M2 money supply growing at over 20% during the last year. As you can see on the chart, this number well exceeds the growth in money supply that occurred during the inflationary period of the 1970’s.

The tricky part is that most governments are in the same situation. The relationship between the Canadian and US dollar might appear to be stable but they are both declining in value at the same rate relative to the price of a hard asset like gold.

In this month’s case study, we give a description of what an extreme devaluation looks like. While our current situation is less severe, it highlights the fact that maintaining investments in real cash generating businesses and hard assets is essential to retaining financial wealth. An important observation from past episodes of devaluation is that the path can be bumpy and test the resolve of investors.

Avenue’s investment strategy is designed to get us through these big challenges and protect our wealth. We diversify to shield ourselves from individual sector shocks. And our focus continues to be on businesses with income streams we can reinvest, hard assets and yes, gold. We believe this approach is more important now than even.

We have lived through an extraordinary few weeks. Across the country Canadians are now bracing for the full impact of the virus. Hopefully all our collective efforts at social distancing will pay off. Currently, we don’t know of anyone within our Avenue network who is ill with the virus, and we truly hope it stays that way. We give our thanks to all of you who are on the frontlines in the medical and support professions as you work tirelessly to keep Canadians safe.

With the wonders of modern technology, the full Avenue team continues to operate smoothly and without interruption. Periods of time like this are why we test our offsite systems and technology annually to ensure for smooth operations during potential events like we are currently experiencing.  

With regards to the state of the economy, the best analogy we have heard compares our current state of quarantine to the economic world being stuck in a plane on a runway with the message that there is a ‘flight delay’. It is an incredibly frustrating and helpless feeling for anyone who has been in this situation. In the interim, you are not allowed to leave your seat and there is unclear information as to how long this situation will last.

This is where we find ourselves today. We know there will be a time in the future when our outside lives will get back to normal. However, we now know the economy will be shut down for longer than a month, but we don’t know how long it needs to remain closed to contain the virus.

When we look at our portfolio investments, we need to weigh many rapidly changing factors. We understand the most immediate issue is the uncertainty around how long the economic paralysis lasts. As time passes there will be more damage done to the consumer and services industry which are the largest parts of the economy.

On the other hand, we must weigh this short-term economic shutdown against the unprecedented amount of government and central bank stimulus that is being injected into financial markets and the economy. We have already seen the results in the strong rebound in the stock market after the panic low on March 23rd. As we wrote in our last mid-month update, the stock market has a way of looking through the global economic shut down and will attempt to measure what the economy will look like at the end of the year and beyond. 

While we have witnessed a breathtaking market decline in both speed and severity, we have done our best to transition the portfolio to have a much larger weight in what we describe as essential businesses. These are the types of businesses that will remain strong through this economic downturn.

Businesses like BCE are well positioned as people continue to keep paying their phone and internet bills. 

Canadian Pacific Rail and Superior Plus (propane distribution) both have an element of essential service and a soft monopoly on their respective markets.

If you have purchased any items through online shopping over the past month it was most likely delivered overnight on a Cargojet plane. They have a virtual monopoly on overnight air cargo delivery throughout Canada and have a unique partnership with Amazon. 

Enghouse Systems and Constellation Software are new positions we added and are both Canadian technology success stories. They provide critical technology services to businesses all around the world.

Other businesses like Emera (regulated utility) and Brookfield Infrastructure will also remain as essential businesses during this period. Many of the companies discussed above have already seen sizable increases in their stock prices over the past two weeks.

During volatile periods in the stock market, such as the one we currently find ourselves in, we often think of our favourite quote from famed investor Warren Buffett:

“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.”

Your Avenue team channeled this investing mindset through the month of March as we actively purchased shares in great businesses that we believed were being unfairly punished. We have always explained Avenue’s strategy as investing in consistently profitable businesses that generate stable income streams. And then we make sure not to pay too much for them. 

Over time, these types of businesses are less volatile than other less profitable parts of the stock market that trade off “themes” and not the underlying profitability or cash flow. We have never experienced a period in the market, in this case a global pandemic and economic shutdown, that has sharpened our perspective so fast on what qualifies for this characterization. 

We also emphasize the diversification of Avenue’s portfolio when compared to how concentrated the stock market indexes have become.  In this stock market sell-off all sectors were punished. In the liquidity vacuum that the markets experienced in March, investors stopped viewing stocks as small pieces of great businesses. Rather everything became just another stock on a stock exchange and got sold to raise cash.  This occurred in all asset classes. We now are seeing that over the past two weeks the market is beginning to sort out which companies offer long term value and which businesses are going to remain distressed.

The other phenomenon that exacerbated the volatility throughout March was the rise and ubiquity of the Exchange Traded Fund (ETF) as an investment vehicle for many investors over the past decade. We have long been discussing the impact that ETFs were having on the market structure, and that the impact they would have on markets during periods of extreme stress were still unproven.  Well, now we know.

There were several earthquakes that went off in the bond ETF market during the month of March. We thought it would be insightful to highlight a few of them.

Below is a chart from the Financial Times highlighting the disparity between the net asset value (NAV) of the iShares corporate bond ETF product, and the price that the ETF was trading at during the period of extreme market stress in March.

This bond ETF is supposed to trade at the net asset value of the underlying bonds. The far-right side of the picture is not supposed to look like that.

When looking at the price of this underlying corporate bond ETF (ticker: LQD), shown below, it is clear by looking at the price action in March that investors in this product all ran for the exits at the same time.

Think of corporate bonds as individual loans to different businesses. One great example is of a company that we should all be familiar with, Ford Motor Company (The Avenue bond portfolio DOES NOT own these bonds). Ford bonds paying 3.81% annual interest and maturing in 2024 were trading at a price of $102.30 to par on March 9th. If you purchased these bonds at this price you would receive an interest rate of approximately 2.8% for 4 years.

These Ford bonds became distressed during the month of March and closed at a price of $61.40 on March 20th, or down about 40% in 10 days.  

Within bond ETF products like the iShares Investment Grade ETF (LQD) there are hundreds of individual corporate bonds, like these Ford 3.81% 2024 bonds, that get packaged together and are traded by investors on the stock exchange.

The corporate bond market was not meant to function like this.

The U.S. is now sitting with a record $13 trillion of corporate debt, much of which was issued over the past decade and used to buy back shares to boost stock prices. As a result of the significant dislocations in the bond market in March, the U.S. Federal Reserve announced that they would be stepping in to start purchasing corporate, municipal, and high yield bond ETFs to help alleviate the stress in these markets.

There are now market participants who try to ‘guess’ which assets the central bank will buy next – and then ‘front-run’ those central bank purchases to earn a profit. If you had correctly guessed that the US Federal Reserve would start purchasing junk bonds, you could have made a handsome profit on the 2024 Ford bonds which are now trading back at $94.65.

The Avenue team cannot in good conscience make investment decisions like the one mentioned above. This is not investing. We live in unprecedented times.

Another similar dynamic occurred in Canada during the month of March with a series of investment products from one of the Big Six Banks. We know from our conversations with our contacts in the financial sector that one bank trading desk was forced to sell $8 billion worth of pipeline, real-estate, and bank stocks over the course of two days in March because the leverage and options positioning in some of their structured investment products blew up. This forced selling action then caused significant losses for any investors who bought those same shares on margin, which led to more forced selling. Skittish investors then panic and sell their shares because they simply don’t know what’s going on. Rinse, wash, repeat. The unwind of leveraged positions can be very messy as we witnessed throughout the month of March.

The market structure has been significantly altered over the past several years as we continue to move through this period of effectively 0% interest rates along with the growth of new financial products. These dynamics have created associated risks, but also opportunities.

One of the great opportunities we saw in March was in real estate stocks. We believe the real estate sector was unfairly punished during the quarter, so we have added to our holdings. Although rents may decline over the short term as tenants wait to go back to work, we believe apartment focused Real Estate Investment Trusts (REITs) have sold off disproportionately to their long-term value.  These buildings aren’t going anywhere. 

The value of an apartment REIT should be based on accumulating rents over the next ten to twenty years. Apartment REITs have access to Canadian Mortgage Housing Corp backed financing at very low rates.  The government’s income support measures have been designed to get money directly to helping renters. We added to our holding of Boardwalk REIT which focuses on Western Canada and added a new position in InterRent REIT which owns apartments in Ontario and Quebec. This is a good example of how we can look through this crisis and take advantage of long-term assets trading at a good value.

During this period, we have made more trades than usual, and this is in the effort to transition the portfolio to weather this storm and to emerge stronger than ever.  There is always the possibility the stock market might do a ‘re-test’ of the March 23rd low before this is over, sometime later in the spring or summer. However, nothing is certain or absolute. For this reason, we are holding a slightly higher cash position and as dividends come in, we will continue to patiently pick away at new investments as opportunities are presented.

With many people and businesses having no income currently, we understand the need by many market participants to sell securities to raise cash. That this move to cash is happening on a global basis explains the continued strength in the US dollar. This has been dramatically impacted by the many trillions of dollars in global debts which are denominated in US dollars. Many global companies may have zero revenue for the time being because of the shutdown, but they still must make their interest payments on their U.S. dollar debt. We discussed this phenomenon in a recent podcast which is also now up on the Avenue website.

Herein lies the biggest investment dilemma going forward. The United States is on pace to run a deficit of $3.5 to $4 trillion for the current year, or up to 20% of GDP. Most of this new debt will be purchased by the central bank. A period of outright debt monetization, where the central bank prints money to pay for government expenditures, has now arrived.

We believe that the incredible amount of stimulus and money printing will eventually weaken the US dollar, potentially quite significantly. To protect ourselves from future inflation our best answer is, more than ever, that we need to maintain investments in good businesses that can navigate the changing world, along with owning investments in hard assets like real estate, gold, and utilities. We will talk a lot more about this strategy in the coming quarters.

The Avenue team wishes everyone a safe and healthy next few months.

Avenue 2020 Vision

This past year was a year to celebrate Avenue’s unique equity strategy where the foundation of the portfolio is built on limiting the risks we take, instead of trying to ‘beat the stock market’ in any given year. For 16 years we have developed our brand and place in the Canadian investment industry where when you think of Avenue, you think of stability. Investment stability is achieved by diversification of the portfolio, the stability of the underlying investments, and rigorous attention to avoid owning securities that we believe are overvalued.

This past year, Avenue’s equity portfolio performance clearly demonstrates that a conservative investment strategy does not have to sacrifice capital gains appreciation. In this letter we will highlight the key features of this strategy and why it is best to first care about protecting the downside, which then makes it easier to stick with our investments in the face of frequent pessimistic forecasts. Also, we will explain possible investment risks in the year ahead and where we see opportunities for Avenue’s equity strategy.

Bonds

First, we would like to discuss Avenue’s bond portfolio and the current level of interest rates. For the past several years we have maintained our view that we are in a very low and range-bound interest rate world. Then came 2019 where almost every financial sector and asset went up in value. A year ago, our year end letter for 2018 conveyed that almost all investment sectors were down. Markets where everything is down, and markets where everything is up, are both extremely unusual. We believe both can be explained by the US Federal Reserve’s tight monetary policy at the start of 2019, then its swing of 180 degrees mid-year to its present easy monetary policy.

Source: St. Louis Federal Reserve

The US Federal Reserve monetary policy is shown to be overwhelmingly important on a global scale. Because of the overall level of debt in the North American economy, interest rates can only go so high and we expect an easy monetary policy should allow the economy to expand. But our expectations for returns from Avenue’s bond portfolio will remain in the 3% to 4% range over time. However, because last year’s bond return was so good, we wouldn’t be surprised if returns were slightly less near term. We recommend Avenue’s bond portfolio for people that absolutely require their money and income to be there when they need it. Where more risk can be tolerated, and with a longer time horizon, we believe the better value is currently in Avenue’s equity portfolio and its diversified group of income producing stocks.

Avenue’s Equities = Lower Risk

We often describe Avenue’s equity strategy as limiting the downside risk. But in so doing, we can’t always expect to get huge returns from the upside in great stock market years either. One of the most important tenets of long-term investing is to win by not losing. If we can limit our downside in bad markets, we maintain the value of our portfolio and can take advantage of good markets, like last year’s. Also, if we have stable businesses, with limited downside, generating income, it gives us the peace of mind to stay invested through weaker stock market.

This past year, 2019, was a great example of many pessimistic forecasts from market participants, many of which have been detailed in previous letters. Let us remember the China-US trade war and tariffs, the Canada-US trade renegotiation and tariffs, and Brexit, all of which still exist. At the start of 2019, we were recovering from a severe market decline where forecasters predicted impending recession and by last August, it was expected that we were headed into a recession within months. The recession didn’t happen. But there were multiple opportunities where the temptation was to get out of the stock market and sit on the sidelines until there was more clarity. Removing ourselves from the stock market would have resulted in missing out on one of the best years for returns this decade.

How do we approach and define low risk at Avenue? We evenly distribute and diversify our investments in publicly traded companies across the many vibrant sectors of the economy. In Avenue’s case we use eleven distinct categories from real estate and infrastructure, to financials, technology, and healthcare. Within these sectors we try to find and invest in the companies that are the best stable income generators. Unlike other investors, we do not try to guess if a stock is going up immediately or if a currently unprofitable business will make a lot of money in the future. At Avenue, we stick to investing in businesses that are making money now, where we can capture that income stream by being patient investors. Then most importantly, we must be disciplined on valuation and not overpay for the amount of income the businesses generate.

Avenue always likes to start by looking at ‘Canada First’, which is an important advantage overlooked by other managers. Right now, and this might change, there is a real opportunity to invest here in Canada. Canada is totally out of fashion as an investment destination and out of fashion is a good thing. If we had tens of billions of dollars and needed our investments to go up immediately, then we would agree that Canada is harder to get excited about. But we believe there are many businesses here in our stock market that have a North American business footprint and are being ignored by investors. The businesses we like generate consistent income, which gives us the opportunity to be patient. The Canadian dollar is also low compared to the recent strength of the US dollar. We feel there is a potential reversal to this trend in the coming years given the United States’ spiraling debt and deficits which are now in the trillions of dollars.

The last major differentiator in Avenue’s equity portfolio is our 20% allocation to higher income producing bonds and mortgages. Our current mortgage exposure is not directly in individual mortgages but in two MICs, or Mortgage Investment Corporations. In this part of the portfolio we get a consistently high-income stream that can be reinvested over the course of the year, when we find opportunities.

Where We Now See Risk

Interest rates are so low that money that has traditionally been invested in bonds is now being pushed into riskier investments. Where we see distortion in valuation is in the US corporate bond market, private equity, venture capital and the indexing of over half of today’s new money allocated to the stock market by investors. In the face of all this momentum elsewhere, we believe our commitment to finding value in Canada is a real opportunity. As shown below, the positioning in the US equity futures market is now at euphoric levels.

Source: RBC Dominion Securities

Let’s start with stock market indexing. What was a novel idea in 1975 and statistically correct at the time, has morphed into a dominant and distorting force in today’s stock markets. The original idea was that if, up to 10% of average investors became ‘passive’ index trackers then many poor, buy high and sell low decisions would be avoided. Forty-five years later and we are now in the age of the index and the result is an extreme concentration of risk. Last year in the US, 80% of the return in the technology heavy NASDAQ came from just four stocks: Apple, Microsoft, Facebook and Google. We owned Apple for several years but as of the time of writing we have recently sold our position.

We believe the distortion caused by this concentration is the modern-day version of the Emperor’s New Clothes. The concentration of wealth into the top companies in the index will continue until some innocent observer declares to all involved that the valuation is crazy given the underlying business. While all these businesses are very successful, no company has an indefinite lock on cloud computing or internet advertising. We have made an attempt in this quarter’s case study to show how hard it will be for Microsoft to continue to outperform as a stock, just because they are now so big. We have owned Apple and Microsoft shares until recently, but we can no longer justify the high valuation.

As an aside, an Avenue team member was in the Harvard University bookstore over the holidays and commented that on an entire wall of books dedicated to business, there was only one on stock market securities valuation. And it was an Economist publication equivalent to ‘Stock Analysis for Dummies.’ This is a stark reminder that Avenue’s commitment to be traditional investors who own and hold on to shares because we believe in the underlying business, is seen as being amusingly antiquated. As we stated earlier, being out of fashion is good and stock market valuations have to come back to underlying earnings at some point.

This has been a longer than usual letter and we want to keep it to an easily digestible size. We tackled the topic of venture investing in last quarter’s Case Study on WeWork, which you can find on our website. Later in the year we will discuss the US corporate bond market and private equity boom and why we should avoid them. We imagine we will be in this odd investment climate for a while longer and we haven’t even had time to touch on the brave new world of ESG investing yet. ESG stands for Environmental, Social and Governance and it is changing professional investors’ behavior everywhere.