“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:

https://www.usdebtclock.org/

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.

US CONSUMER GOODS SPENDING

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.

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.