Avenue 2020 Vision

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

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

Bonds

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

Source: St. Louis Federal Reserve

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

Avenue’s Equities = Lower Risk

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

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

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

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

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

Where We Now See Risk

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

Source: RBC Dominion Securities

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

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

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

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

There are three distinct themes emerging that separate the world of investing and define our times.

The first is the phenomenon of low interest rates and their impact on what can most easily be described as the slow growth, pre-digital, old economy.  The second is the rapid change brought about by the digital revolution and the amount of money directed towards it.  And finally, the emergence of environmental and social issues against which companies will be judged. When investing we must clearly separate these complex themes to understand which of these are risks and which are opportunities for our portfolios.  

As an example, the current headline-grabbing topic is: Are we heading into recession in 2020?  At Avenue, we feel this is too broad a question and all investments need to be broken down into the three themes mentioned above. We are asking ourselves, what does a recession look like when money is almost free because we are already in a global ‘industrial’ recession and these types of industrial stocks are already inexpensive? Will there be a contraction in the digital revolution? This is unlikely due to the pressure of all businesses to evolve and compete but perhaps there will be a pullback in valuation and the price of technology stocks will decline. Has Canadian productivity stalled as a result of self-imposed environmental and social policy?  Here we must make sure our investments are aligned with positive social impact so that projects can get built, on time and on budget.

The Old Economy

While a recession has an important influence on stock market prices, it is also by definition temporary.  The bigger issue for us as investors is the very low level of interest rates and how that affects the valuation of bonds and stocks.  In last quarter’s letter, we described how an estimated $12 trillion of global government bonds were trading with negative interest rates.  Now, just three months later, that number has grown to $17 trillion, which is almost half the global bond market.   The US has the highest 10-year interest rates in the world at 1.65% and Canada is second highest at 1.40%.

Country10-Yr Rate30-Yr Rate
United States1.65%2.16%
Canada1.40%1.59%
Japan-0.21%0.36%
Germany-0.47%0.02%

To better describe what a negative interest rate is, if you put $100 in the bank, next year the bank will give you $99 back.  For 5,000 years, humans have produced written records of people lending money to each other in an organized contractual fashion for profit.  Negative interest rates are not supposed to happen.  In no economic textbook is there a formal theory where money is lent to get less in return.  For the last decade Japan was the only country with such abnormally low interest rates, but the belief was that Japan would normalize at some point. But what has happened is that the rest of the world is slowly becoming Japan and being pulled towards the black hole of negative rates.

5000 Years of Interest Rates

There was a great quote this summer from past US Federal Reserve Chairman, Alan Greenspan.

“I wouldn’t be surprised if yields on U.S. bonds turned negative and if they do, it wouldn’t be that big a deal.”

– Alan Greenspan, CNBC Interview, September 2019

Mr. Greenspan’s comments reflect a central bankers concern with inflation and funding government debt.  What is ignored is that the banking system, which is effectively our financial plumbing, would stagnate with negative yields. And most importantly, the retirement funding for an entire generation of baby boomers gets a whole lot riskier.  

Our conclusion at Avenue is that there is now a real risk that, over time, financial assets will be monetized.  Monetization of debt is an obscure economics term which can be explained more clearly by saying, big borrowers like the US Government will have no way to pay back their lenders. Government debt is increasingly likely to be paid back with printed money and outright monetization. 

Having a defined investment strategy is more important than ever.  At Avenue, we believe that if income is needed from a portfolio, then a certain amount of bonds is still appropriate. But we must temper our return expectations.  The absolute level of interest rates is just so low.

Investment savings that can be allocated to longer time horizons need to be invested in businesses that have hard asset value and predictable income streams.  You have heard us say this many times before. What is different this time is that hard asset investing must be a core strategy to maintain wealth in a world where paper or financial wealth may slowly resemble the analogy of the frog in the pot of water that comes to a slow boil.

The New Economy

Talking about technology stocks is a completely different conversation from what we have been discussing so far.  The digital revolution has created the ability to turn the internet and internet connectivity into a useful tool for everyday life.  Most of these technology companies don’t borrow money from banks.  Most of these companies are venture capital funded until they are mature businesses and have large valuations even before they become public companies. Really what we are saying is that you can’t throw out a line like “the stock market is expensive” or “a recession is going to impact the market in 2020” unless you clearly define which market you are talking about.   

Every corner of the economy from media to transportation to banking is being disrupted.  Avenue’s problem with investing in technology disruptors, that are purely internet based, is that by definition their businesses and underlying incomes are not consistent.  Given the level of competition, it is nearly impossible to create a useful earnings model for these companies that looks ahead five years from now.  Where we can observe industry leadership with barriers to entry, for example cloud computing, we find the stocks are very expensive. (See our Case Study for a more detailed story of WeWork.)

What Avenue does look for is establish businesses that use these digital tools to improve their existing business.  Like Boardwalk REIT making it easy to get renters into apartment units in Alberta. Canadian Natural Resources using driverless trucks in the oil sands. BCE creating the network for 5G in Canada. Enbridge using drones to monitor pipeline integrity.

Environmental Sustainability

The mention of pipelines above, leads us right into the importance of environmental and social issues.  The level of environmental scrutiny of all public companies is only going to increase. So far, the biggest effect on Canadian companies is that the building of infrastructure, be it pipelines or ports, has completely stalled.  What we have witnessed is that companies we have already mentioned, like Enbridge, are making their new investments in the US.  Also, we see foreign investors standing back from making any investments in Canada, for now.  The net result is that perfectly solid and profitable Canadian businesses are being neglected because of this overall negativity and we can make new investments at very attractive valuations.

To finish off this quarter’s letter, here is an example of how valuing a business like the oil sands has changed over the last 20 years. To value an oil sands project, you initially estimate the amount of money needed to build the mine and then determine how much that money will cost to borrow.  Then once built, you estimate how much cash can be generated to repay the original money borrowed, plus the accumulated interest.  The excess profits determine the rate of return of the investment.  For example, 20 years ago $3 billion for pipeline construction was borrowed at 6%. Here 6% is the cost of borrowing money. If when built, the project makes $500 million of operating profit the original money borrowed plus the accumulated interest can be paid off in 7 or 8 years, and the excess profits will deliver the rate of return that shareholders receive. Borrowed money plus interest to build and operate the pipeline were the inputs and up until now, air and water were considered free.

In one generation, the inputs have completely reversed where borrowing money is effectively free at these low interest rates, however air and water have become priceless because of environmental and social concerns.  It is very difficult to use traditional valuation tools as all businesses have some amount of carbon footprint.  We must be very mindful of what we own and how we profit from our investments.

We are now in record territory; a full decade of economic growth and stock market expansion has many investors fearful that we are overdue for a correction.  In this quarter’s letter we make the case that the investments we hold in Avenue’s portfolios remain compelling, but at the same time we need to actively avoid certain stocks and sectors where there is excess valuation. 

While negative headlines like US – China trade, Brexit, and Canadian pipeline politics rattle investors, the primary driver of our portfolios remains the low and relatively stable level of interest rates.  We would also like to comment on the esoteric topic of liquidity, driven by what have become astoundingly large pools of money around the world and the implication for all investors.

We just surpassed the previous record of economic growth, which was the 120 months from 1991 to 2001, which ended with the bursting of the dot-com bubble.  However, there have been a few key differences with our current expansion. The main variant is that economic growth has been consistent but weak by historical standards. Our economy has not built up excess over-investment in manufacturing or construction.  There have also been many mini bear-markets in various sectors which always present opportunities to sell investments that get expensive and reinvest where we find value.

The Canadian TSX Index is making new highs. But there is opportunity with many stocks that are not at their highs.
We recently made an investment in ARC Resources. A Western Canadian natural gas producer that is trading at a twenty year low.
Earlier this year we invested in Barrick Gold, Canada’s largest gold producer. The stock has recently risen off multi year lows.

The only consistent trend in the markets over the past several years has been the dominance of the technology sector.  What is new in this economic cycle is that the technology sector does not borrow money in the way traditional businesses do.  When a tech company wishes to increase its supply of software or its technology services it does not need to make massive investments in a new plant and equipment, for example, in the same way the auto sector does.

Avenue continues to invest in technology.  We currently own Apple and IBM.  We also view BCE as a technology investment as it will be a key beneficiary of 5G mobile internet. Our challenge with technology is that most companies are not consistently profitable, given that they are disruptors.  It is not easy to pin down which companies will be industry leaders in the years to come. (It is much easier to project something like Canada is unlikely to build a new railway from scratch.)  Another challenge for Avenue is that technology valuations are once again extreme because of the level of interest in the technology sector.

Because Avenue’s portfolios are made up of businesses that have consistent income streams, the primary influence on valuation remains the level of interest rates.  The media highlights the potential chaos of US – China trade talks, a hard Brexit, and the perception that Canada is un-investable since we cannot get new infrastructure built, like pipelines and ports. All these events have the effect of dampening economic activity.  Lower economic activity means lower interest rates than there would have been without these events.

A slow growth economy with low and relatively stable interest rates are good for Avenue’s portfolio.  Until last November of 2018, we didn’t know the limits of how high interest rates might go when normalizing, after eight years of very low rates.  Our view was that if interest rates went too far beyond 3%, it would likely trigger a consumer recession.  We use the example below of the US 2-Year Treasury Bill to show how interest rates have moved.  We believe 3%, to maybe 3.5%, is confirmed as an upper limit and 1.0% to 1.5% may be now too low on the downside.  But we believe we are in a band of lower interest rates within these levels for the foreseeable future.

Our last topic is the underpinning of all asset prices by big investment funds constantly looking for a place to invest their money.  The big pools of money are getting bigger and they all need to put it somewhere.  Anytime the market goes down there is a deluge of money looking to take advantage of the opportunity. We will try and attempt to show the scale of this dynamic by way of a few examples.

As a reference point, the value of all Canadian publics stocks is approximately $2.6 trillion.

Canada Pension Plan has grown over the last ten years from $100 billion to $400 billion. The latest internal estimate is that the plan will have assets of $2.5 trillion by 2050.

Norway’s sovereign wealth fund has grown from $300 billion to $1 trillion in ten years.

The combined Middle Eastern sovereign wealth funds of UAE, Kuwait, Qatar and Saudi Arabia have increased from $800 billion to $2.1 trillion.

Vanguard is the largest fund management company in the U.S. and they mainly use an index or passive strategy. Over the last ten years the values of assets they manage has grown from $1 trillion to almost $6 trillion.

Historically big pools of money that are risk adverse use the bond market as a core investment.  In today’s low interest rate world, there are now over $12 trillion invested in bonds with negative interest rates. With the Japanese 2-Year bond yielding -0.2% and the German 2-Year bond yielding -0.75%, this is truly the investment anomaly of our time. All investors are motivated by the need for returns and certainly some of this money will be looking to get better returns by taking on more risk.

Also important to note is that most of these assets from the Canada Pension Plan to Norway to the Middle East are looking to make investments that diversify them away from their smaller domestic market. This adds to the concentration of investment dollars in safe jurisdictions where there are established private property rights and the rule of law like North America and Europe as a whole. 

What we are experiencing is that when some investments are out of fashion or are too hard for big pools of money to invest in, they become inexpensive.  We can use the example of how many medium sized companies in Canada have compelling long term value, yet their stock prices languish. 

However, if they become inexpensive enough, big private pools of money will show up only to buy the whole public company outright.  Recent examples are WestJet and Hudson Bay Company which have pending purchase offers using private equity money.  We will now likely lose these companies as potential public investment opportunities.

Also, we saw ARC Financial, the largest private equity player in Alberta just raise $780 Million to buy up inexpensive and neglected Western Canadian energy companies.  (ARC Financial is a sister company to ARC Resources, in which we recently invested.) At Avenue, if we keep our focus on quality businesses that consistently make money, the investments will either grow on their own or alternatively there is lots of money that will show up to buy them from us.

We have experienced good performance in the last three months in both Avenue’s Equity Portfolio and Bond Portfolio.  The key reason is an extraordinary reversal in interest rates.

Our repositioning of the Equity Portfolio over the fall and winter have us well positioned for what we believe will be a continued slow growth economy with interest rates remaining in this band certainly for the next year.

There was a great deal of nervousness into December that interest rates would continue to rise given the strength of the US economy.  In last quarter’s letter we forecasted that interest rates were unlikely to go any higher, simply because any further increase was likely to trigger a consumer-led recession. Even though sentiment was positive on the economy, we saw there were signs of a slowdown.

This is the odd and often perverse logic of the stock market.  Interest rates moved up to the point that the economy looked like it was going to stall.  Wouldn’t that be bad for stocks? Actually, a stall in the economy generally results in a dramatic drop in interest rates, and lower interest rates propel stock valuations higher.  I can pay more for a stock because the cost of borrowing money is lower.  It is the same idea as when housing prices go up when the cost of a mortgage goes down.  We have benefited from our recent re-positioning of the equity portfolio where we sold expensive US holdings and reinvested back into Canadian companies with lower valuations and higher yields.

Table: Government 10-Year Bond Yields

CanadaUSAGermany
Nov 6th, 20182.55%3.45%0.54%
Mar 31st, 20191.60%2.85%-0.05%
Government of Canada 10-Year Bond Yield Over the Last 2 Years
Chart: Government of Canada 10-Year Bond Yield Over the Last 2 Years
Chart: Enbridge Share Price Over the Last 2 Years

The table on the previous page shows how much interest rates have fallen over the first three months of 2019.  The chart at the top of the page shows the Canadian 10-year Government bond yield over the last two years.  We then compare this to the stock price chart of Enbridge, and we can see that as interest rates come off, the share price of Enbridge goes up.

The yield curve and what is called ‘the shape’ of the yield curve is also at an important juncture.  After 10 years of aggressively lowering interest rates to stem the 2008 financial collapse, short term interest rates have risen and long-term interest rates haven’t, so the shape of the yield curve is what is called flat.

Chart: Canadian Government Bond Yield Curve – 3 Month to 30 Years

This is not great if you run a bank; you borrow money from depositors and lend it longer term.  Therefore, we are now out of our US banks and we are just holding our core positions in TD Bank and Royal Bank.  Both our Canadian bank stocks yield 4% and we think much of the negative sentiment is in the stock price.

The other extraordinary anomaly is that the price the Canadian energy companies get paid for selling their oil has recovered but the stocks have not. We believe the stocks will eventually go up but because we can only guess the timing, our investments in Canadian Natural Resources, Vermilion and Prairie Sky all pay us a nice dividend while we wait. Also, there is finally an argument for the Canadian dollar to strengthen given the doubling of the demand for Canadian dollars just from Americans buying our Canadian energy exports.

In last quarter’s letter we wrote that as interest rates rise, they will likely cause a stall in the economy given the level of consumer and corporate debt.  It is always hard to predict the timing of when the market will react to a slowdown, but that reality finally happened in December.  What is unusual is that this was a global phenomenon where almost all asset classes were down worldwide in 2018.

Now we are faced with a paradox: interest rates are likely to stay at this low level which implies stock market valuations should remain high, but the stock market keeps falling. Our conclusion is that parts of the stock market are now oversold so we will focus our investments on high cash-generating stocks. As dividends are constantly building up in the portfolio we can keep adding to our investments, even if we are faced with a prolonged period of stock market weakness.

After eight years of low interest rates, where borrowing money was basically free, financial assets have shot up in value almost everywhere. However, throughout 2018 we observed that most global markets were weakening.  The US was the lone holdout with a strong economy; earnings had benefited from a onetime corporate tax cut and there was a continuing bull market in tech stocks.  All that changed in December with the resetting of asset prices and the assumption that money will have a cost going forward, combined with a global economic slowdown and unresolved trade disputes.

The following two charts are a good way to visualize the magnitude of the interest rate change (1) and the resetting of global asset prices (2).  The first chart is the yield on 1-month US treasury bills which currently sits at 2.4%.  You can think of it as the cost of money for the world’s reserve currency.  The second chart shows that over 90% of all asset prices, measuring 200 categories, were down in 2018 for the first time in almost a hundred years.  2018 was truly an unusual year.

(1) US 1-Month Treasury Bill Yield
(2) Asset Prices

Here is the paradox. Interest rates are hitting a point where they have caused the consumer to slow down. We now have higher confidence that interest rates will stay at the current low levels for some time. If interest rates remain at this low level, then the valuation on stocks should remain higher.  But as the stock market continues to fall, stocks are getting cheap by historical measures.

So, either stocks are great value, which is what we have been waiting for, or maybe something else is wrong and we are entering an earnings recession and we don’t know it yet. The following chart shows that the Price to Earnings relationship for the TSX index is now close to the lows of the past 30 years. To phrase this another way, Canadian stocks have only offered this much value three other times in the last 30 years.

An important part of Avenue’s strategy is to minimize losses and more importantly to get through and take advantage of periods of weak markets.  We try to avoid areas of overvaluation.  Also, if there really is something wrong with the greater economy, which we can’t see yet, we try to avoid economically sensitive and cyclical businesses. We keep our core portfolio investments, which generate lots of cash, and it is the income from these businesses that we use to keep adding new investments to the portfolio to take advantage of a weak stock market. 

A volatile market gives us an opportunity to shift the portfolio around more than usual.  Starting in September we lightened our exposure to parts of the portfolio that we felt had become overvalued and added to investments where the underlying businesses were more stable, the valuations were lower, and we could get a better income stream. And again, it is the income stream that gives us the ability to keep adding investments to the portfolio in a weak stock market 

For example, we have now lightened or sold outright Amgen, Apple, Blackstone, CN Rail, Johnson and Johnson, and Microsoft.  We have added to our existing investments in Baytex bonds and BCE, bought Slate Real Estate and reinvested in Blackstone at a lower price. As of the time of writing this letter, our cash position in the equity portfolio, which includes the Canadian government bond, is 12% and the yield on the investments within the portfolio is the highest it has ever been at 4.7%.  This gives us cash to spend when we find good companies trading at attractive levels.

Given the particular weakness of our energy investments, we would like to make a more detailed comment about this part of the portfolio.  A global slowdown has dropped the global price of oil from $80 US dollars in October to under $60 US dollars today.  However, our investments are influenced by the Canadian sector where we believe market sentiment has given up on Canadian oil stocks after a decade long slump.  We now have three investments in what we believe are the highest quality companies which are trading at compelling valuations.  With patience, pipelines will be added, and we will have an opportunity to sell these investments a few years from now when we believe the Canadian energy market will recover.

We have also added to gold with our investment in Barrick.  With almost all asset classes weak, gold is again a useful hedge and we feel most investors have little or no exposure. Also, cryptocurrencies don’t look like they are replacing gold any time soon.  Barrick is Canada’s largest gold company and it has spent the last five years restructuring financially.  It has now merged with Randgold and has acquired the best operating team in the industry.  The Randgold people are now in charge of getting the most out of Barrick’s operations.  We are positive on gold and positive on Barrick but we will use careful risk management for this holding where valuation is more important than the income stream.  It will not likely be a long-term investment.

The last three months have seen the continuing trend of gradually rising interest rates in both Canada and the US. In this quarter’s letter we will elaborate on Avenue’s bond portfolio strategy where the majority of our investments are in shorter maturity Canadian corporate bonds.

The shorter maturity helps us get through a period of rising interest rates.  In Avenue’s equity portfolio we have taken profits from some stocks that have done well and reinvested into stocks where we believe valuations have been depressed as a result of rising interest rates.  In Avenue’s equity portfolio we will also discuss why we have added to our energy holdings and we will comment on our one remaining gold investment.  

Interests rates should move in a close relationship with inflation, over time.  Inflation in Canada has been relatively stable for the last decade hovering around 2%.  The perception was that while inflation was at 2%, the only likely direction was down to 1%.  What has changed over the course of 2018 is that while current inflation is still 2%, the next level might be a rise to 3%. Therefore, bond yields are rising and bond prices are falling.  Avenue’s bond strategy is not to make a big short-term trading call on the direction of interest rates.  We capture the higher return from investing mostly in Canadian corporate bonds. In today’s environment where interest rates are rising, we keep our average maturing of the portfolio exposed to shorter term bonds.  Currently the average maturity is roughly three years. 

The purpose of Avenue’s bond portfolio is not to hit a target rate of return. The money that is invested in Avenue’s bond portfolio is money that needs to be there no matter what.  For many clients this is the money they need to live on.  We view it much more like a safe bank account but where you will get a better rate of return over time. To state this choice more clearly, you can either have this money in the bank or get a better rate of return from Avenue’s Canadian corporate bond strategy. Consequently, it is not appropriate to use this money for investments in the stock market with its inherent risks.

There will be points of time when bank issued Guaranteed Investment Certificates (GICs) or bank savings accounts will have competitive rates. There are also times when short-term interest rates can be higher than long-term interest rates.  That doesn’t change our belief that if we stay with Avenue’s strategy of investing in Canadian corporate bonds over the long term, we will get superior returns. The key investment decision we make is to keep the average maturity low when interest rates are rising and to have a longer average maturity in the portfolio when interest rates are falling. 

In this month’s Case Study we have put in a chart of Avenue’s bond portfolio which shows each bond we own by issuer (who we are lending the money to), the term to maturity on the X axis and the current yield on the Y axis.  If we did nothing more to this portfolio and we let all the bonds mature, we would get a 3.5% rate of return over the next five years or so.  But in the short term we have to be patient. 

We do have a view that there is a limit to the rising rates. In simple terms, if the interest rate for 10-year Government bonds in the US rises to 4%, this will trigger a consumer recession.  Once we are clearly into a recession then interest rates will come down again.  Therefore, with current US 10-year Government bond yields at 3.25%, we feel the majority of the move has already happened.

Avenue’s equity portfolio strategy has a different way to take advantage of rising interest rates.  We have reduced the size of some of our holdings that have done well and which are now a bit expensive, and we put that money into sectors like Real Estate and Utilities that have been depressed by rising interest rates.  Yes, the news headlines read that the US market is at all-time highs and we are now almost 10 years into this bull market, which implies we should be cautious.  However, that characterization is a bit simplistic. Most of the gains in the US are in just a handful of technology stocks. 

There are other parts of the stock market where we find good consistent businesses, and the valuations are reasonable.  We have bought WPT industrial real estate which owns warehouses across the United States and we have made a second attempt to invest in AltaGas.  In January we sold AltaGas because interest rates had just started to rise and given their high level of debt. At today’s stock price we think the stock market is already pricing in all the negative news, which has given us a good opportunity to buy shares.

Canadian energy stocks are another area where we believe we can invest in good companies and the valuations are reasonable.  As with interest sensitive stocks, the headline news for the Western Canadian energy sector is alarmist.  There is a fear that Canada will never get another pipeline built so the price for Canadian oil and natural gas will remain low for a long time.  We believe enough pipeline capacity will get built in the next two to three years to help the Western Canadian oil price recover.  Also, Shell’s newly announced West Coast project to export liquefied natural gas will improve the sentiment for natural gas pricing, again in the two to three-year time frame.  We have added an investment in Arc Resources and added to our position in Vermilion.

A closing comment on our one gold investment in Roxgold which has not done well this year. We know the company well and we added more shares at $1.09 on the way down.  The company has a uniquely profitable gold mine in West Africa.  However, the company lacks a catalyst for what will happen next.  We believe that either the profits will get returned to shareholders or the company will get bought in the near term.  If either of these events don’t materialize, or the corporate strategy changes, we will likely sell the position.

In investing it is important to directly address the challenging and ever-changing economic environment head on.  It was only last quarter when there was a real fear of inflation and surging interest rates.  Now escalating trade wars are threatening a global recession. In this quarter’s letter we will discuss how we see these challenges playing out and what we are doing about it within Avenue’s fixed income and equity portfolios.

Where we spent most of last quarter’s letter discussing interest rates, we can give a briefer update this quarter.  The all-important US 10-year bond yield reached a high of 3% in the quarter and has now fallen to 2.8%.  The US economy is strong and unemployment is low.  However, the structure of employment has not resulted in overall wage pressure.  Trade tensions which started with NAFTA, affecting Canada and Mexico, have extended to Europe. And now more importantly, China has been added to the mix. 

Trade wars are easy to start but hard to finish, or rather resolve. The likelihood of a mild tariff-induced recession is now a realistic possibility.  Avenue’s conclusion is that interest rates will not be going up significantly from this level given a global economic slowdown and will stay range bound at these levels, meaning that rates will move within a relatively tight range for a certain time period.  To be clear, to give markets room to breathe, interest rates could easily be range bound between a full percent higher or a percent lower from this current level.  However, we believe there is unlikely to be a step change where 10-year bond yields rise to 5% or fall to 0%, as has been experienced in Europe. 

Avenue’s bond portfolio continues to focus on Canadian corporate bonds where initial investments are made for 5 to 7-year time frames.  However, the average term to maturity of the portfolio is 4 years and we expect the portfolio to average a 3% to 4% rate of return over time. We also feel that it is important not to ‘reach for yield’ at this point in the economic cycle.  We see other investors taking on more risk to get a limited improvement in return. It is very difficult to predict the timing of a credit event where corporate interest rates rise dramatically due to potential default risk.  Therefore, one of Avenue’s core rules is to be cautious when it looks like the market is getting greedy.

So, with the level of interest rates at a reasonable level and the North American economy doing fairly well, we now get President Trump-induced trade battles on multiple fronts. The US, Canada, and Mexico have imposed tariffs on a number of items with the idea that this pressure will force all parties to resolve their respective NAFTA trade issues faster.  Europe is also being targeted with steel tariffs, but the specific trade issues are less clear.  Now more importantly, China is being asked not to be a trade cheat and an intellectual property thief.  All these issues are very complex and not easily resolved.

But the tariffs are very real and they can gum up the economy very quickly. These multiple tariffs will slow global growth.  We just don’t know if it is a slowing or a stall at this point. The one thing we know for sure is that the stock market does not like uncertainty.

From an investment perspective we have lots of maneuverability.  The North American economy is described as a consumer industrial economy.  Industrial implies that we make things and consumer implies that we buy things.  But really what the consumer economy has evolved into is services as well as products. The trade of goods can stagnate and we don’t want to own investments in companies that make tradable products.

Ironically, but for different reasons, Avenue had already come to the conclusion not to invest in Canadian companies that make things for export.  Over the last decade in Canada we have witnessed an all-out government driven assault on making Canadian export products uncompetitive.  Please see this quarter’s Case Study which details specifics of what Canada exports globally.  While NAFTA makes an extreme case to avoid certain manufacturing sectors of the economy, we would say these businesses were already largely un-investable a long time ago, given government policies of inhibitive tax levels and regulations.  Canadian policies were already hurting our businesses long before NAFTA tariffs.

We have seen the stock market sentiment rotate away from manufacturing and global multinationals to local businesses that focus on services and rents.  These are the types of business where Avenue already has the majority of our holdings.  But it is never quite that simple.  We are positioned for how the market is shifting but many multinationals have now sold off.  This gave us the opportunity to buy back Johnson and Johnson at a good valuation that we have not seen in years.

We will finish this letter with the comment that the current economic climate is harder to predict and therefore we will run Avenue’s equity portfolio with a slightly higher cash cushion. This extra cash gives us the flexibility to take advantage of opportunities when they arise.  We also might expect to have a bit more turnover than usual.  Turnover is an industry term for selling what is not working.  In the current environment we will be less forgiving of companies that are not meeting our expectations.