In the first quarter, Avenue’s Equity Portfolio experienced its first decline since January of 2016. The Avenue bond portfolio’s performance also had a small decline.  Both portfolios were affected by the market’s reaction to rising inflation expectations as interest rates rose and the added new risk of a global trade war reduced the outlook for corporate profits. We were conservatively positioned ahead of this market move and we argue that a significant amount of the correction has already taken place.

In Avenue’s equity portfolio, we have already taken advantage of a few compelling valuations and we have trimmed some investments where the company’s debt level may be perceived as a problem in a higher interest rate environment.

Avenue’s bond portfolio strategy is not about trading bonds.  For most of the bond investments, we buy the bonds then hold them to maturity.  We still have to make one fundamental forecast as to the level of interest rates in the medium term. The bond investments will have shorter maturities if the outlook is for higher interest rates or longer maturities if the outlook is for lower interest rates.

Currently, much of the discussion around the level of interest rates is centered on the US 10-year government bond yield.  Currently the yield is 2.8% and the fear is that interest rates will continue to increase to 3.5% and maybe even 4% level.  Interest rates are rising to offset the strength in the North American economy.  The North American economy may finally have some inflation, given the economy is close to full employment.

A further interest rate rise of this magnitude is possible but will not likely be that disruptive to the bond market.  It is true that a 10-year US government bond yield rising to the level of 5% to 6% would dramatically affect all markets.  This is the level where large sums of money would switch from stocks to bonds. However, we don’t believe this is likely because if interest rates rise above 4%, it would trigger a consumer recession.  Avenue’s position is that interest rates can move slightly higher but most of the move and psychological impact has already happened.  Avenue’s bond portfolio will mark time as interest rates increase in the short term, but returns will resume as soon as interest rates stabilize. 

This quarter’s Case Study includes a relevant and descriptive picture titled: “Ten-year US Treasuries: the end of the long decline in yields?”

This interest rate change is playing out in the stock market as well.  As we have written many times, Avenue’s equity portfolio looks to invest in consistent, profitable businesses.  These types of businesses usually borrow some money so an increase in interest rates will decrease their profitability over time as bonds are re-issued. So as interest rates have increased, the stock prices of some of our investments have declined.

In last year’s Avenue cocktail party presentation, we showed a slide of the two pullbacks in Avenue’s equity portfolio over the last 10 years. The first one in 2012 was of 5.6% and one at the beginning of 2016 was 7.9%.  So far Avenue’s portfolio is down roughly 6% from the November 2017 high.  We believe most of the pullback has already taken place for our type of investments and our core long-term holdings are trading at much better valuations.  

Given the volatility in February and March, we have much higher activity than normal.  We pared back, selling partial amounts in areas where we felt there could be higher risk of a pronounced correction and added to existing investments where we felt the valuations were already compelling.  All the trades where the security is completely new or where the security has been totally sold are listed with a description in the trading section of this quarter’s letter.

Of course, we ask ourselves if there are further risks out there.  Two risks are that higher interest rates might tip the economy into recession and a trade war would slow the entire global economy. To protect ourselves, Avenue’s equity portfolio is still conservatively weighted with an 8% cash position.  Also, many of our investments are more insulated from the economy as they are what are called consumer staples as opposed to consumer cyclicals. Plus, as new money from dividends continues to flow into the portfolio, we actively look for new opportunities to invest.

2017 was a challenging year for bond investors as interest rates rose in Canada.  That challenge contrasted with what was a decent year for Avenue’s equity portfolio where the return was roughly in line with our expectations. However, within the portfolio there were certainly plenty of variables which we will discuss in this quarter’s letter.  Also, we would like to reaffirm how Avenue’s portfolio strategy is always looking to lower risk given our view that there are now parts of the stock market that we would describe as overvalued.

Last year we experienced rising interest rates in Canada. In last quarter’s letter we went into detail about how bond prices are affected in a rising interest rate environment and how we can protect ourselves from losses.  Avenue’s bond portfolio has a majority exposure to higher yielding Canadian corporate bonds and the overall portfolio has a medium term to maturity of roughly six years. So, when interest rates went up the prices of the bonds went down but with the higher interest payments we were still able to have a positive return of 1.5% for the year.

Also discussed in last quarter’s letter, it is always better to have higher interest rates going forward.  We are constantly receiving interest income into the portfolio as well as bond maturities which can then be reinvested at today’s higher interest rates. We maintain our belief that we can compound in the bond market at between 3% and 4%, even in this low interest rate environment.  

We try to avoid making broad investment predictions, preferring to stick with the fundamentals of our individual holdings.  However, we still have a forecast that interest rates will remain low for the foreseeable future given that Canadian inflation will remain in the 1.5% to 2% range.  While this is important for how we invest the bond portfolio, it is equally important for how stocks are valued by investors. 

Monitoring inflation will certainly be critical in the year ahead, as 2018 is set to be the first year in this decade where all major economies are positioned to grow.  Overall inflation in Canada will likely be muted because we already carry high consumer debt but there will likely be pockets of higher prices as some global markets tighten.     

When analyzing Avenue’s equity portfolio, the rise in interest rates also resulted in a decline in price for our investments in pipelines and utilities. This was certainly the main drag on our returns in 2017.  However, we believe this hit to the sector is now behind us and dividends will continue to increase.  We have taken this stock market weakness as an opportunity to increase our investment in Enbridge, which we feel offers great value for the long term.

Energy was the other major sector that stalled last year.  The global oil price has recovered but the oil price that Canadian companies receive is still much lower due to insufficient pipeline capacity to move the oil out of Alberta.  We believe pipeline capacity will increase in the next few years and investors will come back to invest in Canadian producers.  Meanwhile, this market sector pessimism gave us the opportunity to invest in Cenovus at the end of the previous quarter.

The Amazon effect became a major theme over the course of 2017.  The Amazon effect basically postulates that Amazon will take over all retailing one day.  This has put pressure on the stocks of many traditional retail businesses. Amazon itself is a very expensive stock, therefore it does not meet Avenue’s criteria to purchase based on the extreme valuation of its share price.  CVS came under pressure in 2017 when it was believed that Amazon was going to enter the drug retailing business. However, when we spent time researching CVS, one of the largest drug stores in America, we felt the stock market was being too pessimistic. CVS is also more than just a drug store. With its new acquisition of Aetna it is transforming the company into a comprehensive healthcare benefits provider, in addition to its retail pharmacy business. We believe this investment is a great example of investing in a good business at a compelling valuation, but it will likely require some patience.   

In conclusion, many stocks have gone up significantly in the last few years.  2017 was yet another year where we would characterize some large technology stocks as going from expensive to very expensive.  We believe there is now real concentration risk in the stock market where investors have greatly increased their exposure to only a handful of companies. 

Avenue believes we can greatly reduce the risk of our equity portfolio by being broadly diversified and making sure we stay away from expensive investments.  We picked these few examples to demonstrate why, as dividend income comes into the portfolio or we sell stocks that have done well, we try to reduce the risk of the portfolio by reinvesting in good businesses with relatively limited downside.  As long as each investment meets our return criteria, with patience, we hope to continue to compound at our target rate of 8-10%. As always, our stated goal is to double our portfolio every 10 years with as little risk as possible.  

Avenue’s fixed income and equity portfolios historically have little turnover of the individual securities from year to year and 2017 has been no exception.  However, this year has been notable in terms of big moves in interest rates, the Canadian dollar and many stock market sectors and individual stocks.  In this quarter’s letter we would like to discuss where our portfolios stand in relation to these many moves.

Probably the biggest news in the financial world has been the decision of the US Federal Reserve Bank and the Bank of Canada to raise short term interest rates. A decade has now passed since the financial crisis of 2008.  Raising rates was always going to be big news and this is not to say that raising interest rates was not expected, but that the timing was uncertain.  We have been positioning the Avenue bond portfolio over the last few years for just such a change in interest rates.   

Bond investing is really quite simple.  See this month’s Case Study on compounding in the bond market for more detail.  When interest rates go up, bond prices go down. So, Avenue’s bond portfolio is up only 0.4% in 2017.  We have received 3% in interest income but that has been offset by the fall in the market price of the bonds.  With perfect timing, we would sell all our bonds, wait for interest rates to go up then buy back the bonds.  However, we run a real risk of not guessing the timing right of such an interest rate move.  Also, it is very expensive to get the timing wrong because when we don’t own the bonds, we don’t get paid any interest income either.

We have positioned Avenue’s bond portfolio to address the challenge of timing a rising interest rate environment by owning bonds with a shorter term to maturity. We still get paid interest but as the bonds mature faster, we are able to reinvest sooner at the new higher interest rate. So, while total bond returns have paused for a bit, we are in much better shape to capture higher returns going forward. Many Avenue clients will have and will need bond portfolios for years into the future. Higher interest rates will have by far the biggest impact on future returns compared to any short-term losses.

The strong Canadian dollar is the next big story of 2017.  We have discussed several times in previous letters that we believe a $0.85 Canadian dollar is a level where we would be indifferent between making a Canadian investment versus a US investment.  We don’t have to make a call as to where the dollar is going.  We simply have to acknowledge where value is and adjust our new investments incrementally. 

For that brief period where the Canadian dollar was at par with the US, we actively looked to make investments outside of Canada.  For the last two years, with a Canadian dollar in the low $0.70 area, we looked to bring money back to Canada and invest in domestic businesses.  As the Canadian dollar gets closer to $0.85 to the US dollar, the currency is a less important consideration for a new investment.  Avenue’s equity portfolio is currently 26% invested in companies outside of Canada.

Finally, we would like to discuss the stock market from a Canadian investor’s perspective.  The headline has been “Canada is the worst performing stock market in the world”. Here we can accurately use the term disingenuous analysis as there is a lot more going on inside the Stock Market Averages as represented by the indexes.  Yes, the main US S&P500 stock market index is up 14% year to date, but that is only a 5% gain when converted back to Canadian dollars.  The Canadian TSX Composite is up 3% in 2017, which makes the comparison between the US and Canadian returns not that dramatically far apart.

More importantly, the performance of the US S&P500 Index is now being completely skewed by a handful of mega-cap technology stocks.  Here we are referring to the Google, Facebook, Apple and Amazon effect.  The 10 largest stocks in the S&P500 are now 20% of the index. The 20 largest stocks are 1/3rd of the index. The bottom 100 stocks of the S&P500 represent only 3.6% of the index which is the same size as Apple on its own. Therefore, big tech is having a good year and driving up the index, but most stocks in the US are flat.

Why this is so important is because index investing has become the norm for most individual investors, as they are all basing their savings and retirement on the same handful of very big, mostly tech companies. Buying the index makes investing simple and accessible for many people.  However, diversification, which is the core principal of risk management, is being completely ignored, mostly because it makes the story too complicated.  If we are looking for the next bear market crisis, index concentration is certainly on the list of major emerging risks within the financial system.

When we dissect the Canadian TSX Composite index we have always been faced with a concentration problem but here it is different from the US.  The TSX Index is roughly 30% financial stocks, 15% energy stocks, 15% Mining stocks and 40% everything else.  We have argued many times that given the importance of diversification, you would never use the TSX index as a framework for a long-term retirement type portfolio.  You can also see why the Canadian index has lagged in 2017.  Banks stocks stalled when interest rates went up.  Energy stocks stalled, until just recently, as the oil price continues to be in the $50 area. And mining has been a mixed bag.

When discussing the stock market in this way we are trying to highlight what we at Avenue are not.  Avenue’s equity portfolio is diversified with a various mix of sectors, business type and currency.  We also believe we have the ability to withstand a rising interest rate environment.  But similar to the bond portfolio, Avenue’s equity returns seemed to pause for most of 2017.

However, by mid-August it was apparent that although the stock prices were not moving, our underlying investments were fundamentally sound and improving.  For example, in terms of simply capturing the return from dividend income, the Canadian bank stocks were yielding 4%, two of our pipeline stocks were yielding 7% and two of our real estate stocks were yielding over 6%.  When September arrived, we were rewarded for our patience as the Avenue equity portfolio is up 4.4% for the year to date.

The Avenue Bond portfolio is up 1.3% for the first half of 2017 as the expectation of higher inflation and a sell-off in the bond market has not materialized. The Avenue Equity portfolio is up 1.0% for the first half of 2017. While we have not had a market pull back this year, after a good performance in 2016, the type of income producing stocks that Avenue invests in seem stalled as investors’ attention remains on technology and more specifically disruptive technology companies. We believe that stock market investors will come back to focus on income at some point, but we need to be patient.

Interest rates seem to reflect a contradiction with traditional investment theory. The North American economy continues to grow at about 2%, unemployment is now low and yet there is no sign of general price inflation.  We might get inflation at some point but for now the picture is more complicated.  The overall debt level of governments and individuals remains high which limits the ability to accelerate spending.  Also, disruptive technology continually makes the economy more productive at the expense of traditional jobs.  So, while GDP growth of 2% and inflation of 2% has the appearance of stability, inside every sector of the economy there are a great many winners and losers. They just seem to cancel each other out.   

We have observed that investors have lost some of their interest in securities that generate income.  As we have written many times, Avenue’s aim is to generate less volatile returns than the overall market. Our strategy is driven by focusing our investments on companies that produce consistent profits.  In an environment where the 10 year Canadian Government Bond offers a return of 1.4% we would normally expect investors to be attracted to stocks with higher dividends.  However, we now have two infrastructure investments in AltaGas and InterPipe that yield almost 7%.  With that amount of income difference, we have to ask ourselves if there is something wrong with these companies since the yield is relatively high.  However, our research indicates that these businesses are actually getting stronger, which means we can expect higher dividends in the future.

In the stock market, investor interest is focused on technology and disruptive technology seems to be the new mantra; if you are not disrupting then you really have no place in the new economy. This month’s Case Study presents a more detailed discussion. Why this argument is self-perpetuating is that it is very hard to argue against the success of a company like Amazon, which truly is making many business models obsolete.  If you are not invested in Amazon, then it looks like you have your head in the sand.

As investors who are seeking consistent income, we believe we are faced with three decisions.  First, if all businesses are getting disrupted then we need to get out of the way of obvious train wrecks.  The Hudson Bay Company is a good example. A few years ago, The Bay was a decent business that happened to have a lot of real estate value in the stock.   Today we see that their core retail business is struggling as the internet age progresses. 

Second, if we acknowledge that this is the new age of technology, then why don’t we buy stock in tech disrupting companies such as Amazon, Google and Facebook and be done with it. However, this would conflict with our investment strategy because these fantastically successful businesses trade at a very high multiple to earnings in the stock market.  The problem is if technology shifts again or profits don’t materialize, then there is no inherent value and the stock prices can go down significantly.

Third, we can embrace disruption and find companies that are hard to replicate. We can make sure our traditional businesses are evolving as users of disruptive technology or, where the valuation is compelling, we can own a few of the direct disruptors themselves. 

Referring back to our investments in infrastructure, no matter what the internet can accomplish, it would be very difficult to replicate the pipeline network that InterPipe has already built.  Having already given the Hudson Bay example, we do have an investment in Leon’s.  It is still hard to sell bigger house hold items online, as buyers like to sit on a sofa before making a major purchase. Also, Leon’s is spending a great deal of money on inventory and distribution management systems to maintain their position in the industry. Another example is Canadian National Railways where driverless trains are a near-term reality, well ahead of driverless cars.   A driverless train does not require a pension plan, which will significantly reduce costs.  Lastly, we took the opportunity to invest in Microsoft and Apple at points in time where the valuation was compelling and where the market was less sure of future earnings.

To summarize, these investments all share common characteristics: the underlying profitability of the business, our understanding that each company is a technology leader in their sector, and most importantly our assessment that we did not pay too much for the underlying cash flow.  If we focus our investments on the income generated by the business, at some point the stock market will reflect the value, no matter how unfashionable the sector might appear.

In this quarter’s letter, we would like to review Avenue’s bond portfolio strategy and performance. We will then give an update on why Avenue’s equity strategy is well suited to approaching today’s investment uncertainties. We will conclude with our view on current stock market valuation, given this has been the focus of many client questions over the last few weeks.

Last quarter’s Case Study gave an updated summary of Avenue’s bond portfolio strategy. We thought this was timely given the current concern that interest rates might start to rise.  The point of the Case Study was to explain that not all bond strategies are the same.

We discussed that the majority of Avenue’s bond portfolio is made up of medium term Canadian corporate bonds. Avenue’s bond portfolio has a different level of risk compared to a government bond portfolio or to a bond strategy based on trading short term moves in interest rates.  Often very different strategies will randomly have the same return so it is hard to distinguish why they might be different or what risks are actually being taken.

Looking at the current one year performance truly reveals how different Avenue’s bond strategy is compared to investing in the bond index. Here we will use the Canadian bond index as a proxy for what many investors simply refer to as ‘the bond market’. For the last 12 months, long term interest rates have experienced a few dramatic swings but the net result is that the Canadian bond index had a return of 1.5%.  This compares to Avenue’s return of 4.8% from a portfolio of predominantly Canadian corporate bonds.  The extra return was achieved by taking on credit risk by lending money to corporations for a short to medium period of time.  The Canadian bond index has a higher proportion of government bonds with longer maturities, which is a riskier portfolio at these low interest rates.

At Avenue, we believe our bond strategy has a universal or all-weather appeal to it.  If interest rates stay at these levels, we will continue to benefit from the higher income generated from investing in corporate bonds.  If interest rates rise, the shorter term to maturity of the portfolio means as our bond investments mature sooner, this money can be reinvested at the higher rates.

We also believe that Avenue’s equity strategy has a similar universal appeal to it. However, we usually describe it as an internal insurance policy.  There are two parts to our policy: the first is our focus on investments that generate consistent cash and the second is a 20% allocation to higher yielding securities which are usually bonds.

Before we outline the benefits of our insurance policy, we need to always remember why we are investing in the first place. Compounding in the stock market as a long-term investor requires staying invested, usually over decades. So, the decision to sell all stocks and sit on the side line is actually a big deal.  The irony is that although it seems safer to not be invested, this decision comes with a great cost of lost opportunities.  If you sell everything and sit on the sidelines, the market ‘has to go down’ within a relatively short time period of months, because as a long-term investor you know you need to be buying back in at some point.  Another approach, trading on short term swings in the market, is the definition of what is called speculating, and again the long-term speculator must be consistently right over and over again.

Yes, the stock market can have dramatic short term declines, usually when most people least expect it, as we recently experienced in 2008.  Therefore, at Avenue we believe the money you need to live on in the short term should not be in the stock market. This allows us to take a ten-year view when making an investment in individual stocks with money that is available for the long term.

Let us look at Avenue’s equity strategy and why consistent cash flow and bonds are important given three stock market scenarios.  First, if the stock market shoots up in the short to medium term, Avenue’s portfolio of more consistent cash-generating investment will likely underperform the overall market. However, we will hopefully still get a decent return for the level of risk taken.

Second, there is always a legitimate risk that the stock market will stall for a long period of time, possibly even a decade.  Avenue’s portfolio of income generating businesses will be kicking out money that can be reinvested over the period that the market is flat.  Again, this highlights the important part of the strategy that the money cannot sit on the sidelines.  The cash that is coming into the portfolio needs to be constantly reinvested into the stock that has the highest income generation at that point in time.  So even though the overall stock market is flat, Avenue’s equity portfolio should be able to have a positive return.

The third scenario is the one that we all worry about the most, which is a significant and sustained short to medium term decline.  In this situation, guessing that the market was going to go down and being on the sideline is obviously the best place to be. However, as stated previously, one really must be accurate with the timing and again this implies an expectation of perfectly timing an event that most people don’t expect to happen.  You can see the paradox.

The second part of Avenue’s internal insurance policy is very important if we experience a market correction. The equity portfolio’s 20% bond and cash holdings can be used to buy stocks that are now at much lower prices.  Also, there is constant cash coming into the portfolio by way of dividends.  So over 12 to 18 months, we should be able to reinvest up to 25% of the portfolio to take advantage of high quality investments that are selling at much lower prices.  If lower prices or a bear market is sustained, we should be able to fully reinvest a third of the portfolio over two to three years. This strategy has an incredible advantage when compared to a much less flexible, fully invested equity strategy which owns primarily growth stocks that do not pay dividends.

Avenue’s equity portfolio’s stated goal continues to be ‘to double the portfolio in 10 years with as little risk as possible’. This goal requires a compound rate of return of a bit more than 7% annually.  But as you can see from the previous three scenarios, creating consistent returns in the stock market is always relative to a stock market that is anything but stable. Taking a conservative approach works well over time.

Finally, we would like to discuss our view on the current stock market valuation, with stocks having risen 10% after the election of Donald Trump.  Here we will use the S&P500 market index as a much better indicator of the broad market compared to the Canadian TSX Index.  Currently the S&P 500 trades at 18 times earnings.  This is only slightly more expensive than the historical price earnings average for the S&P500 which is 17 times.  We believe the stock market should be more expensive than the historical multiple because companies are able to borrow money at such low interest rates.

The stock market is now at a fair valuation and there is a risk that it can go significantly higher given that a multiple of 20 times earnings is not unreasonable. The risk on the down side is that earnings do not materialize as costs increase and interest rates rise.  That profit margins will contract is always a concern but for the time being we view this scenario as less likely.  We will be monitoring our individual companies closely and more likely we will lighten securities on a case by case basis if valuations become too expensive or margins become less predictable.

Politics and subsequent government policy normally affect the level of interest rates, the economy and the stock market gradually, over time.  However, the election of Donald Trump as president of the United Sates is a rare exception where market perceptions dramatically changed overnight.  In this quarter’s letter, we will discuss what are the most likely US government policy changes and the potential positive impacts on our Avenue Fixed Income and Equity portfolios going into 2017.

First let’s step back and review the economic ‘big picture’ at the beginning of last November.  We will focus on the United States because of its oversized impact on financial markets compared to Canada.  The US economy has become so predictable that most people have stopped paying attention to the big picture and simply nitpick at small details. For the last five years in a row the market expectation was 2% inflation and 2% economic growth. As predicted, for each of those five years inflation came in at slightly less than 2% and the economy actually grew at about 2%. Again, before the US election in November, the expectation for 2017 was 2% inflation and 2% economic growth. 

As an investor, inflation is right in line with expectations. The economy could be better, but 2% growth is fine since Avenue has always said that we are looking for stability. However, in this golden age of predictable economics, anxiety is still prevalent due to the real-world experience caused by the debt overhang and the dislocation of the work force due to globalization. This brings us to Avenue’s core investment argument since 2009 which has been, due to too much debt and the efficiencies of globalization, that interest rates will be low and stay low for a long time.  We are eight years into this low interest rate world and the questions is, with the election of Donald Trump, have we hit an inflection point and will inflation, interest rates and economic growth materially change from here?

Since Donald Trump’s election, the US 30-year bond price has fallen 8% and the stock market is up 15%. Markets are often good predictors of economic change.  However, in this case the potential government policy changes have a far bigger impact on the price level of bonds and stocks than an actual change in the real economy.  The three big proposed policy changes are lowering the corporate tax rate, allowing for the return of stranded foreign profits and reducing regulation. 

Very simple math can determine the potential impact on the stock market of lowering the US corporate tax rate.  The basic corporate tax rate is 35% but because there are so many loopholes the average tax paid is 25%.  One scenario has Donald Trump proposing that the corporate tax rate be lowered to 15% for a practical reduction of 10%. So for example, the S&P500 index earning of $120 would instantly jump to $145 at that lower corporate tax rate.  At today’s 18 times price earnings multiple, this means the S&P500 can trade at 2,600 ($145 x 18) which is 15% higher than today’s index price of 2,250.

The second boost to the US economy would be from encouraging repatriation of the corporate profits of US companies overseas subsidiaries.  The overall number of stranded offshore profits is getting close to $1 trillion dollars which is 6% of the annual US economic output. For example, the technology firm Apple has over $200 billion in cash which they have not wanted to bring home to the US because of the punitive 35% corporate tax rate. 

And thirdly, Donald Trump has challenged government to eliminate two regulations for every new regulation.  It costs roughly $2 trillion dollars a year for US companies to comply with government regulations, and from our previous point in the above paragraph, we know $2 trillion is equal to 12% of the annual US economic output.  In practice, it might not be so easy to reduce regulation but any progress in this direction can be a boost to economic activity.

In summary, due to proposed policy changes that may lower corporate tax rates, return stranded foreign profits and reduce regulations we have a potential boost to profits and cash on corporate balance sheets.  However, we don’t know if this money will be reinvested in a low growth economy because business leaders are worried about the other side of Donald Trump’s agenda which is clearly isolationist and bad for growth.

Bond yields have quickly moved up in the anticipation of improved growth potential and the expectation of a shift to higher inflation. We argue that we have already had a large move in interest rates and that yields would better be described as normalizing.  The low interest rates back in July of 2016 were the result of an almost universal panic that there might be no inflation.  Now inflation is much more likely to be, you guessed it, around 2% with a normal interest rate spread between short maturity bonds and long maturity bonds.

Avenue’s bond portfolio has been conservatively positioned for the last two years not because we anticipated an increase in yields but because we felt we were not getting paid enough to take on the risk of owning longer maturing bonds.  Given our emphasis on owning corporate bonds, Avenue’s bond portfolio was up 4.3% in 2016 despite the recent drop in bond prices and increase in yields.  We are now looking for opportunities to gradually buy longer-maturity bonds.

So far, the stock market has moved up sharply to reflect that companies will get to keep more money due to lower taxes and less regulation.  The implementation of these policies will take time and so measurable results could be a year or so away. We expect that economic growth in the US could increase from 2% to 3% for a period of time, given the cash washing around in the system. To expect growth beyond 3% would require too many unknowable events.  In summary, we have a better outlook for growth in the economy, inflation and interest rates are within expectation and overall stock market valuation is reasonable.  We believe we have to stay invested in our diversified portfolio of businesses.

Avenue’s equity portfolio was up 16.2% in 2016 having clearly benefited from this rerating of our investments. The best example of who benefits immediately are US banks where we have holdings in Bank of America and JPMorgan.  Higher interest rates mean banks can earn more in interest income.  Banks make significant taxable income compared to many businesses so a drop in corporate taxes will result in a direct increase in earnings.  And rolling back some of the more stifling parts of post 2008 banking regulation might be one of the easiest acts for the new legislators to enact.

We don’t believe Avenue’s equity portfolio needs many changes.  We believe our investments in financial stocks are appropriate and our energy investments are playing out as expected. Utility stock prices are the most vulnerable to increases in interest rates but our infrastructure investments are more geared to the improving energy sector.  Two new investments were made in areas that we feel are being overlooked.  We invested in AutoCanada which owns 54 car dealerships across Canada and has been recently restructured.  Also, we bought Western Forest Products which harvests and mills cedar and hemlock on Vancouver Island.  We believe this company is out of favour given the unresolved softwood lumber agreement but the business should do well over the next few years.

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.

Over the course of the year a handful of big Canadian companies have become even bigger by acquiring American companies and this has dramatically changed the character of the Canadian stock market and the Canadian TSX Index.  Most of these big acquisitions are taking Canadian expertise into the United States.  When we think of our investments in these large Canadian companies we have to understand that they are now North American businesses.  It is these big companies that have the scale and geographical diversity to produce the consistent returns that Avenue prefers, however, this has led to a change in the makeup of Avenue’s equity portfolio.

Growth, through expansion into the US, is a well-established Canadian trend over the last twenty years led by the Canadian Banks. The Royal Bank and TD Bank now have market capitalizations of over $100 billion and each has about a third of their earnings coming from outside Canada.  By comparison, the largest bank in the US is JP Morgan with a market cap of $300 billion. JP Morgan is also one of Avenue’s investments.

The list of Canadian companies getting bigger in the US this year includes Fortis buying a central US electric grid, Emera buying a large electric utility in Florida, TransCanada buying a big Eastern US pipeline business and Enbridge buying a similar but complimentary energy infrastructure business that is also North American in scale. Enbridge, which we consider a core holding at Avenue, will have a market capitalization of almost $100 billion after their merger is complete. As well, Alimentation Couche-Tard is buying a large convenience store chain in Texas, while Potash and Agrium are trying to merge into an agricultural industry giant with a big US farm retail distribution business. 

We would like to say that these deals into the United States are driven by optimism and opportunity.  But going through the details we find the same story every time. Many Canadian companies express that they actually can’t get anything done in Canada.  Whereas in the United States, projects can get permitted and built in a much timelier fashion.

For an investor, it is the dynamic of a project getting built on time and on budget that drives the investment return.  For companies that build ‘things’, the math is very simple.  If a project needs a hurdle of 10% internal rate of return to take on the amount of associated risk, and then the project gets delayed 2 years, the result is the rate of return can drop to say 5% and it is not worth taking the risk. The project does not get built.

The top 10 companies in the Canadian stock market by market capitalization:

CompanyMarket Cap ($ Billions)
Royal Bank121
TD Bank108
Bank of Nova Scotia84
Canadian National Rail68
Bank of Montreal54
Canadian Natural Resources47

The table shows the top 10 largest companies in Canada by market capitalization.  In the Avenue equity portfolio, we own 7 out of the 10.  Of these 7 companies, only Suncor and BCE are mostly Canadian businesses.  But even here, Suncor owns and operates a refinery in the US and BCE’s business may be all in Canada but it certainly relies heavily on delivering US programming to Canadians.

We find that these large Canadian companies have a great advantage by way of their commanding presence in their respective competitive industries. For the most part, it is the Canadian customer that is driving the profitability. We Canadians use big banks because we want our money to be safe.  Also, we like to use a dominant cell phone carrier because we want a consistent signal wherever we go.  As for energy, once an oil sands project is built, it is comparatively low cost to operate and there is no production decline rate.  The world may change but at this point in our economic development big companies have the advantage.

Avenue’s exposure to large cap stocks has increased as this stock market trend has unfolded.  Where last year Avenue’s equity portfolio was 30% weighted to smaller companies, that exposure has fallen to about a 13% weighting today. Not only are the larger companies profitable but we are able to find investable businesses where the valuation is appropriate.

We easily could have spent this entire letter on risk analysis of the many looming disruptive events.  We are not ignoring world events, we just wanted to discuss what we feel is an important topic that is not front page news.  Now, this letter will address the current hot topics. Brexit continues to unfold and the property market in London and New York is starting to be marginally softer.  The Vancouver property market has stalled given the 15% foreign-buyer tax.  In Europe, Italy is to vote in a referendum similar to Brexit, while Deutsche Bank, Germany’s largest bank, might be insolvent. The US federal reserve bank seems determined to increase short term interest rates in the US over the next six months. The US election, say no more…

It is common to have one or two disruptive events at the same time but not six at once.  With the current high level of stock market valuation, in combination with the nervousness of investors, we could easily see a drop in stock prices.  We conclude that the result of any of these disruptive events may be a stalled economy, which then perpetuates this world of lower-for-longer interest rates.

Given this outlook, we feel well positioned due to the defensive nature of Avenue’s existing equity portfolio.  Our cash position is about 12%, dividends are constantly coming in, and we have a few investments coming to a natural end and becoming cash, like Sirius Satellite Radio. We will add to our list of high cash flowing investments if an opportunity is presented.