“Be like a Duck. Remain Calm on the Surface and Paddle Like Hell Underneath.”
– Michael Caine


This quote from Michael Caine, while a little extreme, does translate well to investing in an uncertain market. The asset value of Avenue’s portfolios moved up a bit in the first quarter of 2023, and our investments were relatively stable, given the swings in interest rates, currency and many sectors of the stock market. At Avenue, we are staying calm and analytical and working hard to make sure we can stay invested while avoiding areas where profit margins might be under pressure. As the economic landscape shifts, there are many new opportunities as other investors pull back.

The economy is finally feeling the effects of short-term interest rates rising to levels not seen since 2007. Short-term interest rates are significantly higher than long-term interest rates, a situation known as an inverted yield curve. This situation occurs near the end of an economic cycle when a central bank raises interest rates to slow the economy down. Because interest rates are higher many individuals are making the simple decision to move their savings from bank deposits to short term treasury bills. Also, some investors are making the same decision to reduce risk in their investment portfolios. We would argue that much of this money always should have been invested in safe short-term securities, but because of zero interest-rate policies of the last decade, investors were encouraged to seek out more risk.



While stating the obvious, that many investors are seeking safety and lowering risks in their portfolios, the net effect on the financial system has been dramatic. In just the last month we have seen bank runs in the US leading to bank failures and rapid central bank intervention. (See Case Study: Is the Market Broken?). In times of turmoil, investors need to continue to be focused because while there are many businesses that should be avoided, there will be many that are unnecessarily discarded. As events unfold, we make sure we are actively getting our positioning right in a fast-changing market. Many of Avenue’s stock market investments made new highs this quarter and the businesses are doing very well.

Many of our investments also continue to grow their dividends and repurchase their shares. One such business is Andlauer Healthcare, which we were happy to see implement a share buyback program this past quarter. The Avenue team had previously advocated for this during our meetings with management.


Where we are seeing opportunity


We believe real estate, infrastructure and financial services are fundamental building blocks of a long-term compounding investment strategy, except for in this higher interest rate environment. Therefore, we have reduced our exposure in these three areas of the portfolio. The valuation of hard asset businesses should decline, and the cost of new construction is uncertain. We have moved our real estate and infrastructure investments to businesses where the current valuation is reasonable and where we do not have construction and financing risk. As well, we halved our exposure to Canadian banks over a year ago. Our latest effort to reduce risk and improve profitability was to sell TD Bank outright and replace it with National Bank because of its more isolated and quasi-monopolistic position in Quebec.


The intention of our investment strategy is to protect our current investments from potential losses and make new investments where we find the most opportunity. As money is coming out of parts of the stock market and the market breadth is contracting, we are finding high-quality businesses at fair valuations in the industrial and consumer areas, both in Canada and the US. This might seem like a contradiction given that the words ‘impending recession’ are everywhere. Once again, because there is a fear of recession, potential investments are trading at more reasonable valuations.


Slow motion contraction in money



We have been writing that we have been defensive for over a year. We have actively moved the portfolio to what we have characterized as essential businesses where profit margins can be maintained and where there is not a reliance on a need for raising money in financial markets. We are also maintaining a cash position and for many clients we have the Avenue Tail Hedging strategy.

When we look at the M2 Money Supply, we see it has now contracted for the first time since the 1930s.



The banking events of the past few months have further accelerated the decline in bank deposits, which are now contracting 5% year-over-year. From our historical research we have determined that the only other time this happened was 1930-32 and in 1921. Both were times that experienced major deflationary recessions.



We are observing a slow-motion correction of asset prices. The reason it is taking so long and why we have not had a major stock market drop is because we still have major competing economic forces. Short-term interest rates are being increased by central banks with the goal to slow the economy. However, the central bank balance sheet is no longer being reduced and the continuing deficit spending by government is providing plenty of liquidity to the economy and financial system. As a result, some of our industrial companies are experiencing record backlogs as a by-product of the fiscal policy spending on infrastructure in the US.

We would like to share with you some charts to illustrate the scale of the competing monetary forces at work in the last quarter. We live with the contradiction that what should be an end-of-cycle credit crunch, where business loans become harder to refinance, is set against the central bank raising interest rates while government deficit spending resulting in excess liquidity.

To illustrate the tension, we will start with the negative economic scenario caused by higher interest rates, then follow with the contrasting positive financial market scenario caused by central bank balance sheets expanding again. We will use the US figures as opposed to Canada’s as they are the main drivers of overall bond and stock market prices.

Interest rate hikes mostly over


Probably the most important data point is that central bank interest rate tightening is mostly over. The following chart shows expectations for the US short term interest rate decreasing from its highpoint in February of this year. When we assess our investments, we have to make sure they remain healthy when paying this level of interest on the money they have borrowed.


Source: John Aitkens, TD Securities Research

Yet another banking crisis


The banking crisis we have recently experienced was brought on by two factors and we would argue that while the crisis is fixed at the individual banks, the original problems remain. The first problem was the flight of deposits to short-term treasury bills that we highlighted earlier. The second problem is shown in the slide below whereas interest rates have gone up, the value of bond type investment held by banks has a negative value.


Source: FDIC


While the largest banks in the US are covered by legislation that protects them as ‘too big to fail,’ the policy for protecting smaller banks is ambiguous and arbitrary.

This next chart is more esoteric but worth showing because it best depicts the epicenter of the storm US banks just experienced. Banks make money by taking in deposits and paying what is usually a small interest rate and lending the money for longer terms and charging a higher interest rate. Most of the time this relationship remains stable. The following chart shows a histogram of weekly changes in the relationship between 2-year interest rates and 30-year interest rates in the US, otherwise known as the 2s 30s spread. After the effective bailout of depositors at Silicon Valley Bank (SVB) in California on March 10th, there was a 6 standard deviation weekly move in this relationship. It illustrates that financial institutions are navigating extreme interest rate volatility.



The economy is gradually slowing


Our conclusion is bank lending will become restrictive as deposits leave the banking system. Many bank loans which were made at low interest rates will take time to mature and interest rate volatility will discourage banks from taking risks. This is a classic set-up for a credit contraction which is already reflected in banks tightening their lending standards. We are worried about the ability of businesses to refinance existing debt. It is probable that regional or small businesses will be the most affected, but this tightening will incrementally slow the overall economy.


Central bank and government deficits provide liquidity


The US federal government deficit spending continues to supply financial markets and the economy with liquidity, despite the restrictive effect from higher interest rates and tightening credit. Because there is still lots of money in the financial system, we have not experienced a major decline in the US stock market index.

Of all the economic factors affecting the level of money in the financial system, it is the US Federal Government’s borrowing that eclipses any other influence. To truly fight inflation and inflation expectations, yes, interest rates had to go up. But taxes should have gone up too and government spending should have gone down. But nobody will vote for austerity, either in the US or Canada.

Even as we are writing this, we are aware that given the scale of federal pensions, medicare and defence spending in the US, this is not likely to happen. The US is now a $23.6 trillion economy where the federal government has borrowed almost $32 trillion. Having $22 trillion of debt just prior to the onset of COVID, the US has added over $10 trillion of debt in 3 years. This is new money that has been borrowed and spent into the economy. This is the main reason why we have seen higher inflation.




The US Federal Government’s borrowing supplies money to the economy and financial system, and for the time being there is lots of it. Structural deficit spending is likely to remain systemic no matter which political party is in power. With a sustained $1.5 trillion + annual deficit, $10 trillion more debt will be added in the next 6 years.

If you compare corporate profits to total debt you can see a similar pattern in the below chart. As more money gets borrowed and spent into the economy, it has the knock-on effect of making the economy and business profits look better in the short run. How should investors think about this relationship?




While this ever-increasing debt might seem alarming, it is better to be clear eyed about how it will impact asset prices. Bond and stock market prices are just as much influenced by the amount of money in the financial system as they reflect underlying earnings of a particular business.

To conclude, we remain cautiously positioned due to the slow-motion tightening of the credit cycle but hard at work knowing the only way to compound our money is to be invested in dynamic businesses over the long run.

A Case Study on Is the Market Broken?


In the last month we met with a client who spent their career in financial markets and before we even said a polite hello, they asked flat out, ‘is the market broken?’ After taking a moment to put together what was hopefully a thoughtful response, we answered, yes. However, we still need to be invested in high quality businesses to compound long-term to protect ourselves from inflation and currency devaluation.

The most obvious example directly impacting our Avenue portfolio strategy was the Bank of Canada supporting corporate bond prices in March of 2020. Buying high quality corporate bonds in a market liquidity vacuum was key to Avenue’s successful investment navigation of the 2008 financial crisis. However, in 2020 this opportunity was taken away from us as the financial risk was effectively nationalized. We are forever moving to a banking system where profits are privatized, and losses are socialized. More than ever it really matters what we own, and we must acknowledge that the rules are constantly shifting. The motivation to construct Avenue’s Tail Hedging strategy came out of this experience.

Since this conversation with our client, we have had yet another week where major financial institutions collapsed. Both are new examples of how established financial system regulations are fluid in the time of a crisis. In the case of Silicon Valley Bank (SVB) in California, there was no resolution process for winding up an insolvent bank. There was deposit insurance of up to $250,000 per depositor but this policy was ignored, and all depositors got their money back. This is an example of socializing losses.

In the case of Credit Suisse bank of Switzerland, which was founded in 1856, there was an insolvency resolution but then the Swiss regulators ignored it. About $3 billion of equity value was salvaged while $17 billion of ‘special insolvency contingent’ bonds had their value wiped out. The core belief of our financial system is that the equity holder gets to profit when the market is positive and is the first to take the loss when the business fails. Bond holders are limited to their interest payments, but they get to be converted to equity holders in the case of insolvency. If these fundamental rules of capitalism are not followed, then we start to question the system itself.

The following is now a notable March 16th exchange between James Lankford, the Senator for Oklahoma, and Janet Yellen, the Treasury Secretary, about the recent bank bailouts.

James Lankford:

Will the deposits in every community bank in Oklahoma, regardless of their size, be fully insured now? Will they get the same treatment that SVB just got or Signature Bank just got?

And Janet Yellen’s answer last week was “not necessarily.” That kind of extraordinary help would only be extended, she said, if it looked as if there were a danger of a more widespread bank run. Now, that worried a lot of community bankers because it might encourage their biggest customers to pull money out of small banks and move to a bigger bank where they might be more likely to get government help.

In summary, in normal times we are told everything should function just fine. The problem is that it is the ‘not normal’ times that we are worried about. What has made Western financial markets so successful is their predictability of the rule of law and fair regulation. The events of the last few weeks will definitely have an ongoing effect on who gets to borrow and who doesn’t. For Avenue it is yet another reason to focus on the quality of the underlying business and avoid unnecessary and arbitrary risks.


“The power of the population is indefinitely greater than the power in the earth to produce subsistence for man.”Thomas Malthus, 1798


At Avenue we believe we have entered into a period of scarcity like we have not experienced for some time. We face scarcity of capital, energy, food and labour. While this will be a challenge for all investors, we believe there is an opportunity to invest in what we think of as resilient quality businesses that can take advantage of scarce resources while also avoiding businesses where profits may decline.

It was over two centuries ago that Thomas Malthus predicted that the human population would always increase beyond its ability to feed itself. He was famously wrong as he did not account for human ingenuity and the subsequent global population boom from 1 billion to 8 billion souls today. It was only a few years ago, pre-covid, that food and metals were abundant, there was global excess manufacturing capacity in almost every industry, cheap labour, interest rates had never been lower and there was capital available for everyone. That world is behind us, and we now face shortages but not ones constrained by nature the way Malthus predicted, but shortages from self-imposed human choices.


Man-made Scarcity


The war in Ukraine is almost a year in and the Western response has been to arm Ukraine and isolate Russia. However, Russia and Ukraine are major suppliers of grain, and Russia is a major supplier of metals, oil and natural gas. The Western world is also a major supplier of oil and natural gas but to address climate change, governments are committed to limiting the supply. In this quarter’s Case Study, we have put together some charts that help demonstrate the scale of the challenge we face with the energy transition.

China has become the world’s manufacturing hub but the Chinese government has become increasingly authoritarian and hard to deal with. We believe the trend to get manufacturing out of China will continue even after Covid supply chain bottlenecks are resolved. Many finished goods that China produces will be harder to get and will cost more. This trend called reshoring and friend-shoring are happening at the same time as Western economies experience a mass retirement resulting in labour scarcity and higher wages.

Finally, interest rates are now higher, and capital is scarce. Again, this is not a bad thing as much of the excess speculation is being taken out of the market and stock market valuations are coming down to more reasonable levels. We can now evaluate our investments using a more rational cost of capital. However, this process is taking its time and there is a lot of excess to unwind.


The Hangover


It is truly impressive how some of the highflying stocks have declined. The posterchild in Canada is Shopify which is now down 80% from its highs. In the US, arguably the most controversial highflyer is Tesla, which is down 75% from its high. And amazingly both these companies are still expensive using traditional sales and earnings ratios. With the return to higher interest rates, we expect excessive speculation will continue to unwind.



The following chart of venture capital actively shows that it has fallen to a pre-pandemic level. However, we anticipate that given the scarcity of capital in the financial system, the number and size of venture deals will decline further and offset the excesses of 2021.




Investing 101 – Lower asset prices are better for long-term compounding


We usually discuss investment concepts in the quarterly Case Study and the Letter is used as a discussion of how we are adjusting our investments given the economic environment. However, reiterating the power of compounding is essential to how we see the next few years unfolding.

Buying low and selling high is ubiquitous to all investing but it can also lead to over trading and outright speculation. The overused phrase ‘buy and hold’ has come to mean buy the index of the overall stock market and overtime the overall stock market will go up. However, we believe this is a unique point in time where excess valuation must come out of many individual stocks and out of the broad stock market indices, like the S&P 500. So yes, buy and hold but it depends on what we buy.

For example, if we have invested $100,000 dollars in an essential type of business that has an 8% profit margin that it can maintain in a challenging economy, then there is $8,000 annual profit that can be reinvested. The business we own then has three choices. They can reinvest in their own business to grow future earnings. It can pay a dividend and we as shareholders reinvest that money. Or it can buy back its own stock, which is effectively like a dividend but in many cases more tax efficient. No matter how you look at it, the investor has $8,000 more at the end of the year.

We all like it when prices go up but if we are in the business of constantly reinvesting then by definition it is always better when we are accumulating more assets when prices are lower. Our $8,000 dividend buys us new investments at a lower price. Corporate share buybacks are able to buy more stock at a lower price. Reinvesting in your businesses is more profitable if these acquisitions are cheaper.

Wanting lower asset prices seems counter intuitive, but not when you think of the business of investing as being the business of accumulating assets. In this case, 8% is not a random number as it is the actual profitability target Avenue uses for our investments across the sectors of the economy. So, if this market weakness continues for a few more years, we will be accumulating more investments at a better price. In this example, over a three-year period, we will have 24% more in our investments or $24,000 ($8,000 x 3) more given our original investment of $100,000.

This outcome is all predicated on owning businesses that consistently make money even with all the challenges we are facing. This is why we have spent so much time talking about investing in businesses that provide an essential service or product in the economy, and that also do not rely on constantly issuing shares or bonds to grow.

Bonds and Stocks correlation unlikely to repeat


Investing is often counterintuitive. We would like to highlight again how unusual 2022 was when we look at the combined bond and stock market decline. However, once we experience a statistical outlier year like 2022, it is unlikely to repeat itself for some time.



Inflation should decline for the time being


There are several definitions of inflation, and investors often have a hard time getting their heads around them. We have on occasion used an example of the oil price to illustrate in a simple way how inflation is about percentage moves in price. If oil goes from $60 to $80 then the oil price component of the consumer price index (CPI) goes up by 33%. If the following year oil stays at $80 then the contribution to CPI is 0% or no inflation. But oil is still at $80 and expensive.

We believe most of the price increases in goods and services of the last year will stay, but they will not continue to increase at the same rate. Therefore, over the course of 2023, CPI as a measure of inflation will come down purely by the mechanics of how it is calculated. The accompanying chart gives an example of how this may play out.


If we look out beyond 2023, the main question we are thinking about is if the inflation rate will eventually return to higher levels than we experienced last year. If we enter a mild recession in 2023 which gets met by lower interest rates from Central Banks along with more expansionary fiscal policy into our current world of scarcity, one could reasonably argue that inflation will return to the upside. This is a scenario that few investors are expecting but we at Avenue will be on the lookout for. It is important to remember that inflation cycles generally occur in multiple waves. The 1970s highlight this well with the three phases of inflation shown below.


Avenue’s Bond portfolio remains defensive


Over the past three quarters, interest rates have risen dramatically from the lows of the past decade. As bond investors, now we can finally get a reasonable rate from higher interest rates. And for the time being inflation expectation should be coming down over the course of 2023.

However, Avenue’s bond portfolio remains defensive for two reasons. We feel there might be an oversupply of longer-term bonds and few people will be buying them. This is simply a technical supply and demand issue that we need to have more clarity on before we extend the maturity of the portfolio.

As well we are coming out of a period of very low corporate bankruptcies and the additional return we get for investing in corporate bonds has generally been low. We believe there is the potential for higher yields from corporate bonds at some point this year and we would like to maintain our ability to invest in these opportunities if presented.


Avenue’s equity portfolio remains defensive


We have worked hard at Avenue to build an investment portfolio of high quality and resilient businesses that we believe will survive and hopefully even thrive in this challenging environment. That said, we still continue with our defensive strategy with the types of businesses we own and the amount of cash we keep on hand.

We are expecting that financial liquidity will continue to contract, at least for the first half of the year. We will be better able to determine investment opportunities for our cash when we see how valuations are affected in each sector. An example of the contraction in liquidity would be looking at M2 Money Supply in the United States, which has contracted to the lowest year over year change ever recorded.



We believe that many of the businesses in our portfolio can raise prices and maintain profit margins even as their costs increase. This is a crucial concept to understand and is why we see many companies as still being able to thrive in the current environment. This will be a year to keenly watch profitability and how rising costs affect stock market earnings. The following chart is a reminder that we are starting from a historical high point for US profit margins, mostly driven by the influence in the index of big technology companies’ outsized profit margins.




Hording Gold


Previously in this letter we wrote that when we are accumulating income producing assets, we would like them to be cheaper for longer. However, in the case of being a gold investor, at some point we would like the price of gold to go up. The chart below shows what is essentially non-Western central banks buying physical gold and tightening the open market. While this buying is positive for the gold price, we don’t know why there has been a noticeable increase in buying. Often what is good for gold is not good for everything else, which is why we have it as a diversifier. In Avenue’s equity portfolio we have primarily invested in royalty companies because they are unaffected by the rising cost of mining.






“Stay the course.”Ronald Reagan

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

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

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

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




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

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


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



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



Avenue’s Bond Portfolio


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


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


Avenue’s Equity Portfolio


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


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



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






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

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


The Great Unwinding


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

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


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


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


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


An Orderly Decline, Not A Panic


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


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


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



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


KISS – Keep It Simple, Stupid


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

The simple answer will likely be the right answer.

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

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


Avenue’s Bond Portfolio


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

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

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


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


Avenue’s Stock Portfolio


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


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

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

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






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


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

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

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

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

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


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

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



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

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


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


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

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





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

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

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

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















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

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

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

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

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


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



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

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

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

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

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

Chart Section

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


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

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

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



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

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





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















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

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

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

Supply disruption leads to demand destruction

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


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



Avenue’s Equity turnover and Canadian exposure

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

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

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


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

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

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


Not all stocks are expensive

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

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


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




Remember the Tail Hedge

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



Avenue’s Bond Portfolio remains defensive

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

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

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



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