We are experiencing a continuous stream of crises, with the latest being Brexit.  The results from all these events (the Greek debt, the slowing Chinese economy and Brazilian corruption) are causing ongoing pressures to lower inflation and subdue growth, which hold down interest rates to very low yields.  The world is awash in surplus money that needs to go somewhere and any income generating business, asset or higher yielding bond should become increasingly valuable.  However, as investors we will always have to live with short term volatility.

As we write this letter, Brexit is still being digested by the market.  Brexit is the term given to the United Kingdom’s majority vote on June 23rd to leave the European Union.  Whatever the long term consequences for the economies of England and Europe, the near term result will be to further depress inflation and constrain growth with the result that interest rates will remain low.

Constrained global growth and an excess of saving is affecting all major financial markets.  In light of Brexit, it is not likely that the US Federal Reserve will raise interest rates this year.  The US 10-year Government bond is now yielding 1.45% having dropped 0.4% in the last month. Between Japan and Europe there are now estimated to be $10 trillion of government securities trading with a yield of less than zero. 

The link below will forward you to a unique 3-D image of the major world interest rate curves over the last 20 years.  These images are not necessarily predictive but they do illustrate the magnitude of the shift to lower interest rates around the world.

Click here to go to the New York Times page

All savings or investment dollars are looking for the best return with the least amount of risk.  So the truly confounding fact of our times is that $10 trillion worth of investors happen to believe a negative return is the best risk adjusted return they can get.  The reality is that there is a global excess of saving with few places to save and invest it.  A safe legal jurisdiction with a reliable currency obviously is the desired investment and a negative interest rate has become the cost of parking money in a deemed safe destination. 

We argue that regardless of the US and European Union central banks dropping short term interest rates to zero post the 2008 financial crisis and then instigating quantitative easing, yields were going to drop dramatically regardless.  There is too much consumer and government debt for low interest rates to stimulate more borrowing to drive growth.  On top of this, ironically there is also a surplus of savings versus income generating investment opportunities.

With this as our background, investing in bonds has become much more complicated.  We often get asked the fundamental question, “why invest in bonds at all”? A high interest savings account at a bank like Tangerine yields 0.8%.  We have put together a slide of Avenue’s bond portfolio to show that investing money in a portfolio where a majority of the investments are Canadian corporate bonds will still give us an annual return of 3-4%.

In the chart above you can see Avenue’s individual bond investments and their maturities. (Maturity means the number of years we have lent money to a company).  Investing in bonds with shorter to medium term maturities reduces risk and volatility compared to ‘stretching for yield’ by owning a portfolio of longer term bonds. There are a few investments in Government bonds but the majority of the investments are Canadian corporate bonds which gives us our higher rate of return.  We feel a 3-4% annual return is realistic and accomplishes the goal of income with security. 

Investors’ search for income also translates directly to stock market equity investments.  If a company can demonstrate the ability to generate a consistent income stream, then this is very valuable.  With stock market jitters, from events like Brexit, certainly most stocks will sell off, but we observe that stable income producers and dividend paying securities bounce right back. Our job at Avenue is to find good consistent businesses that make money.  We added TransCanada this quarter and took advantage of the Brexit decline to add to our investments in TD and Royal Bank.

Oil is still very much a factor in the Canadian stock market and exercises a major influence over the value of the Canadian dollar. So far this year we have had a strong rally in the price of oil and the Canadian dollar.  In the short term the oil price and the Canadian dollar might have recovered too quickly. However, over the next year global supply and demand will come back into balance and we believe a long term oil price of $60 – $70 Canadian per barrel is possible.  This is a good price for our energy investments and should underpin further strengthening of the Canadian dollar.

On a final note, we have written that liquidity has become a real problem with companies that have a market capitalization below $1 billion. In the 2015 Q4 letter we wrote that we had three investments in our portfolio with yields, at that time, of over 10%.   However, in the stock market, value has a way of fixing itself.  Sirius Satellite Radio is now engaged in a parent buy out, BTB REIT rallied nicely and the two TimberCreek listed pools are now merging to form a more market friendly $700 million market capitalization entity.

In the first three months of 2016 we experienced a dramatic stock market sell-off followed by a rapid recovery.  At Avenue, we have argued that along with low interest rates, and higher stock market valuations, comes increased volatility.  Just a small change in investor perception of the future can trigger a pronounced stock market move in either direction.  An important part of Avenue’s investment strategy is to be ready for the unexpected and to take advantage of it.

We would like to discuss the last few months to illustrate how volatility can be magnified as a consequence of very low interest rates.  Most of January’s stock market and corporate bond sell-off was caused by a heightened sensitivity to increasing short-term interest rates in the US.  At the beginning of January expectation was for the US Federal Reserve bank to increase short-term interest rates to 0.75% later this year from where they stand today at 0.25%. Taking the US economy in isolation, an increase in interest rates of this mild a magnitude would not seem like it warranted a crisis.  However, on a global scale it created the potential major interest rate imbalance.

At the root of this mild market shock is the reality that there are trillions of dollars of surplus global savings washing around the financial system looking for a safe short-term investment with a positive rate of return.  Most places for people to invest their savings are viewed as poor choices this year.  China’s economy is slowing, most of the large emerging markets are in recession and parts of Europe, as well as Japan, have negative interest rates. A further increase in US interest rates would make a US short-term bond investment even more compelling compared to the alternatives.

This interest rate trend is a problem because higher interest rates restrict lending and a higher US dollar exchange rate stifles US exports.  Also, imports become cheaper which is deflationary.  The US dollar has already appreciated 25% against a majority of America’s trading partners in the last year and a half and the domestic impact is only now being felt in lower corporate earnings. Continuing to raise interest rates would result in a higher US dollar exchange rate and put a further drag on the US domestic economy which is only expected to grow by 2% this year.      

All of this played out in a matter of weeks and the US Federal Reserve as of March 16th stated that given the impact of previous currency appreciation and the economic dampening effect, US short term interest rates will stay where they are at 0.25% for the foreseeable future. As a result, the US stock market bounced right back up again.

To summarize the first quarter of 2016, at the beginning of January interest rates were expected to go up 0.5% from 0.25% to 0.75%.  The S&P 500 (US stock market index) fell a dramatic 13% in a few weeks in anticipation of higher interest rates and the potential of a stronger US dollar.  Fearing the economic consequences, the US Federal Reserve announced a hold on future interest rate increases keeping short-term interest rates at 0.25%.  Consequently the US stock market rebounded by 14%, which is back close to its all-time high. So in actuality US interest rates didn’t move at all and the US dollar exchange rate didn’t move by much. It was just the investors’ perception that created the big moves in places like the stock market and the corporate bond market and this is what Avenue argues is the new norm of magnified perception-based volatility. 

We have to incorporate this volatility into our investment strategy and be ready for it.  This means vigilant risk management where we will sell investments that are not playing out as we would have hoped. Then, we need to not miss the opportunity to reinvest in businesses that offer a better risk reward.

In Avenue’s equity portfolio we have held individual investments for an average of five years, which in industry jargon is a turnover of 20%.  However, when there is a big stock market movement, we get the chance to increase the quality of our investment. Often, there are more Sells and Buys in that period.

In Avenue’s equity portfolio in Q1 we sold our underperforming investments in Barclays, Regions Financial, Crescent Point Energy and PHX Energy.  We were able to reinvest these funds in J.P. Morgan Chase, BMW, Allied Properties and Potash Corp.

In Avenue’s Bond portfolio we had accumulated cash so were we able to make a new investment in Canadian Natural Resources bonds maturing in 2020.

2015 was a hard and stressful year.  At times it felt like mini-crisis after mini-crisis.  By year-end, Avenue’s bond portfolio was up a bit and Avenue’s equity portfolio was down slightly.  Low interest rates continue to be a challenge for returns in the Bond portfolio. However, the equity portfolio is faced with multiple challenges from currency, from commodities, and from investors’ perceptions of the future direction of interest rates.  On the positive side, the high yielding stock investments that we favour are now at decent valuations and we believe they should offer better returns this coming year.

During this quarter we experienced the first interest rate increase in the US in nine years. This rate increase had a chilling effect on the higher yielding sectors of the stock market, but the Canadian bond market was little affected.  The Canadian economy continues to slow. Stephen Poloz, the Governor of the Bank of Canada has indicated that he likes short-term interest rates where they are and has a bias towards lowering them again. However, our expectation is that we can earn a 3% to 3.5% rate of return over time in this environment given our exposure to medium-term Canadian corporate bonds.  We are also looking for opportunities to make investments in higher yielding corporate bonds, which are currently experiencing a sell-off.

In past letters we have touched on the various global crises, like war in the Middle East and the stalling of the Chinese economy, to show how slowing growth affects commodities and the financial markets in general.  The decline in interest rates and commodities is well documented but we must not forget that the consequenceof global bad news is frequently a rising US dollar as a safe haven in an uncertain world.  The Canadian dollar is trading down in tandem with other commodity based currencies like those in Mexico, Australia and Brazil.  This rising US dollar, as a reaction to bad news, is now a well-established trend and trends tend to continue and may reach an extreme.  

From a Canadian investor’s point of view we are starting to see a panic reaction much like the last time the Canadian dollar was in the 60 cent range in 2001. Yes, in retrospect, when the Canadian dollar was even with the US we should have taken all our money and just bought Amazon.  In reality, it is very hard to predict the timing of world events such as a Chinese financial crisis or an Arab spring. 

When valuing the Canadian to US dollar relationship, we like the concept of purchasing power parity, which is when an identical item, sold in either the US or Canada, would be of the same value.  Currently using this method, the Canadian dollar’s purchasing power parity with the US dollar is about $0.85.  The purchasing power parity between America and Canada has been an amazingly stable relationship over the last 50 years.  So at one point in the recent commodity boom when the Canadian dollar went almost to $1.10, this relationship said that the Canadian dollar was 30% overvalued.  Now that the Canadian dollar is close to $0.70, the currency is 20% undervalued.  As we have already discussed, trends can go to an extreme and a 30% oversold situation is possible.  But we can say, the Canadian dollar is undervalued and we have good businesses in Canada that we would like to own at these stock prices.

For about a year now, we have been writing that there is relative value in the Canadian dollar and we have been gradually moving investments back from the US, while the Canadian dollar has been losing value.  This is much the same way we were gradually increasing our investments in the US when the Canadian dollar was high versus the US.  Below, we have made an attempt to break down the portfolio by currency exposure.  We would also strongly argue that we have true US dollar exposure in Canadian, TSX listed companies like Element Financial which has large leasing businesses across the US.  The business and assets of the company are in the US and the income stream is in US dollars.

Avenue’s Equity portfolio’s currency exposure as of January 9, 2016.

20%Direct US Listed Companies
13%Indirect US Exposure Through Canadian Listed Companies
3.5%Other International Companies
36.5%Total International Companies
5.8%Gold Companies
42.3%Total International Companies & Gold Companies
vs.
31.8%Direct Canadian Companies
25.9%Cash & Canadian High Yield Bonds & MICs
100%

First, a brief explanation that the Cash and Canadian high yield bond and Mortgage Investment Companies (MICs) position is kept as an insurance policy within the portfolio, where we try to maintain a 20% weighting.  If there is an extreme market decline, we can use this money.  But for the most part it returns a less volatile income stream.  This is a very effective strategy which helped us get through 2008. 

We do have cash at the moment which is the un-invested 5.9% above our 20% target weight in the Cash and Canadian high yield bond portion of the portfolio.  Excess cash is kept in Canadian dollars.  We have been asked if the excess cash can be kept in US dollars and the answer is no. We could view this as a limitation of how we are structured, given that many of our portfolios are RSPs.  The reality is that multiple currency cash strategies are expensive and more importantly we feel that keeping the cash in Canadian dollars lowers risk.  For the most part, our clients live in Canada and therefore their expenses are Canadian based.  With long-term pension type investing, the simple answer is to match assets and liabilities.  However, if a client spends significant time in the US, then this is a different matter and can be addressed individually.

So when we look at our equity exposure we see a Canadian weighting of 31.8% versus a non-Canadian weighting of 36.5%, with 5.8% in Gold.  Much of the US exposure was purchased when the Canadian dollar was above $0.90.  Today we have excess cash and we see value in good Canadian businesses that pay a dividend. The yield on our 31.8% weighting to Canadian stocks is about 5.2%.  As a comparison, the TSX index yields 3.4%.

Why wasn’t Avenue’s equity portfolio’s return better in 2015 given the US dollar exposure? The simple explanation is that the 7% return which we made on the US currency was offset by a decline in the Canadian holdings which fell about 10%.  This was a negative year for utilities, real estate, energy and small cap stock which are the core of our Canadian exposure.  On a positive note, we had previously reduced our exposure in many of these sectors.  In the Fourth Quarter of 2015, we started to buy some positions back. We doubled our holdings of Enbridge Inc. and added AltaGas Ltd. 

One of the harder decisions was to reduce our weighting to smaller companies.  We think they offer exceptional value. But right now we would argue that any stock with less than a billion dollar market capitalization is experiencing a liquidity crisis.  In plain language, there are no buyers.  If an individual needs some money and the stock has to be sold, then the price goes lower until a buyer can be found.  This is actually a complicated topic so we have expanded on this discussion in this quarter’s Case Study on a Liquidity Crisis found on the next page.

The hard part of investing is often doing things that make us feel uncomfortable. The Canadian dollar looks and feels horrible yet we know the theory tells us the Canadian dollar is now good value.  Also, the type of Canadian dividend paying stocks that we favour for their consistent income, offer attractive yields again, whereas over the last2 to 3 years these stocks have been expensive.  So as we enter 2016, we will look to gradually add investments in Canada where we can find a consistent business trading at a fair price.

We have spent the last three quarterly letters saying that not much has changed. Now, almost every corporate bond, stock and asset is being repriced and the rate of change or volatility is up significantly.  We believe this environment to be another symptom of low interest rate policies. However, this current sell-off improves our opportunities to invest in quality income-producing securities, which is Avenue’s core investment strategy.

To solve the 2008 financial crisis, interest rates were lowered to encourage higher prices on hard assets like real estate and to promote more debt (or cause existing debt to be affordable).  At present, monetary stimulus has run its course.   The current trend is that few investors or companies want to borrow more than they already have.  So the natural question is, if there is no more borrowing, where is the next buyer going to come from?  And more important, is a buyer going to be there if we need to sell?

Last quarter’s case study dealt with liquidity risk as it relates to bond exchange traded funds (ETFs).  If everyone wants to sell a bond fund all at once and the fund owns illiquid bonds, then prices for those bonds will move dramatically lower until a clearing price can be found.  Illiquidity and herd selling create their own self-fulfilling market mini crash.  The hypothetical scenario we discussed in the Q2’sCase Study became a reality across many markets in August.

In a market where many players have borrowed heavily, they are actually short-term speculators, not investors.   A more tangible example is to compare selling a stock to selling a house.  If you want to sell your house and similar houses on your street have sold for a million dollars, but you have only been offered $900,000, then you are likely to wait a few weeks to see if the current soft market, is just an aberration. You hope that someone will come along and offer a million dollars for your house as well.

The stock market doesn’t work like this.  If you have borrowed a lot of money to buy bank shares and then the immediate future becomes less certain, you simply sell at the current market price so that you don’t have any debt and then stand on the sidelines.  You might miss a rally but you absolutely get to keep what money you had.  In fact, you might be happy to knock the stock down $2 dollars just so that you can sell all your stock by 9:35am, just minutes into the trading day.  Debt creates instability. This is what we believe we saw the morning of August 24th when the Dow Jones stock market index opened down 1,000 points. In industry jargon this is referred to as a ‘loss of risk appetite’.

By late August three negative factors appear to have converged to cause the market to drop.  The first is the consensus that interest rates in the US will be going up. That means that borrowing costs will increase for all those leveraged stock speculators.  So to lower debt levels, stocks need to be sold. Since the level of borrowing is at a record high when those speculators sell there are incrementally more sellers than buyers. Another result of higher US interest rates is that the US dollar continues to appreciate and earnings for America’s global businesses will be reduced, from a US investor’s point of view.

China is the second negative factor. The Shanghai index collapsed by 41% this summer.  But the real trigger for the US stock market weakness was the devaluation of the Yuan versus the US dollar on August 13th.  It was a direct Chinese government acknowledgment that their economy was weak.  Again if you had borrowed money to speculate on stocks that will benefit from continued global economic health, you might be willing to wait on the sidelines for a bit to see the true state of China’s economy unfold.

The third factor would be the Middle East.  This would include a lower oil price shock and a civil war which has resulted in a massive destabilizing refugee crisis.  One result is that the Saudi Arabian budget deficit has been reported to have prompted sales of $73 billion in securities in the month of August.  The sales included everything from shares in Apple and Johnson & Johnson to German utilities. This is another example that there are more sellers than buyers and the selling has nothing to do with the health of the underlying investment.  It is just that today, for the seller, it is more important to have cash in hand.

In our estimation, we are in a liquidity crisis.  There is always potential for this type of event but what is new is the scale because of the ability to borrow large amounts of money at relatively little cost.  Building up leverage is gradual but unwinding leverage can cause a sudden drop in prices.  So we can predict with relative certainty there will be a liquidity crisis, the hard part is predicting when. 

Avenue’s strategy requires patience, we prefer to wait for a crisis to hit and then we can make investments in securities we have been waiting to buy.  When the market is doing well, we try to maintain a cushion of cash that we hold in reserve to use when the market slumps.This eliminates the need to predict or time market events. For the most part, the purchase of stocks is done through valuation.  An example is that we recently added to our investment in Inter Pipeline.  The security now has a 6% dividend yield and the company should grow by 2-3% over time.  This satisfies our 8% return target.  Inter Pipeline owns and operates many of the interconnecting pipelines within the Alberta oil sands.

The portfolio has fallen slightly through September but we think the valuations of our core holdings look good.  Another example is Royal Bank where the dividend yield is over 4% and its dividend payout is less than 50% of earnings.  When one combines the dividend and the retained earnings, our investment will be compounding internally at over 8%.  There is a fear that earnings will not hit analyst expectations for growth.  But for now, analysts do not believe earnings are going to go lower, just not grow as quickly. So the Royal Bank is compounding at 8%. The returns are gradual and Avenue is thinking long term so this is exactly the type of investment that we look for. However, a return is not guaranteed enough for the leveraged investor who worries about the next few weeks. All the negative issues we have just discussed out weight the long term view.  Avenue owns unleveraged positions and thinks about the long term value of the company not the value of its stock on a short term basis.

A further example of an investment we own but where the outlook is actually negative for their industry is MainStreet Equity.  The company buys and renovates old apartment buildings in B.C and Alberta then rents out the refurbished spaces. Layoffs and wage reductions are very real in Alberta but we feel this is already reflected in MainStreet’s stock price.  The shares trade at a 40% discount to the breakup value of the underlying real estate.  So far revenue has not declined and the company hopes to make opportunistic acquisitions of over $100m in this depressed market.  Once again our assessment is that if we didn’t already own it we would want to buy it at this price.

PHX Energy Service is the big percentage loser this year in our Equity Portfolio. We bought the shares believing this energy service company has the flexibility in their business plan to ride out impacts of the low oil price on the Western Canada industry.  So far the company has done what it said it would do and we see positive cash flow this year and we expect to eke out a gain next year while most in the industry are losing money.  What we didn’t expect is that investors would completely walk away from this oil and gas service sector.  We have doubled the position to lower our overall book cost.  We will be closely monitoring the health of this investment and it is only 1.8% of the portfolio.

In terms of the Canadian dollar, our opinion remains the same that we will incrementally sell foreign securities and invest that money back in solid Canadian companies when given the right opportunity.  We have already reduced our direct foreign holding to 24% where at one point it was well over 30%.  But just a reminder, we still have plenty of indirect foreign exposure through investments like TD Bank’s American operations and Canadian National Railway’s US track.  The addition of indirect exposure brings the foreign holding closer to 36% of the portfolio.

We don’t want to leave this quarter without touching on Avenue’s Bond Portfolio.  Continuing with the theme of illiquidity, the lack of liquidity has resulted in a slight price decline in the corporate bond market this quarter. However Avenue’s bond portfolio is still up 2% year to date.  For the most part, our portfolio of shorter-maturity investment-grade bonds are not that affected.  The real weakness in the market is in high yield bonds, what used to be called the junk bond market.  We have spent time analyzing industrial and resource company debt but so far we have not made any investments as the risk return does not look to be in our favour.

The main financial event in the second quarter was the rise of short term interest rates.  As a result, the price of bonds fell but this did not result in a stock market selloff.  Therefore, not much has changed since we last wrote three months ago and the equity portfolio has been unusually stable. There are two popular concerns that we would like to address in this quarter’s letter: the risk to corporate profit margins and the danger of illiquidity in some markets.

When short-term interest rates are this low, there has to be a reversal of some kind eventually. Some interest rates in Europe actually went negative for a few weeks.  We have written in previous letters about how a 0% interest rate policy (ZIRP) by the central banks is not in the text books.  We are all learning as we go.  To state the obvious, until interest rates recently tipped up, one could give the German government $100 dollars and expect to receive back $99 dollars in a few years’ time. 

Our Avenue bond strategy remains the same.  The majority of the portfolio is invested in short to medium-term Canadian corporate bonds.  We are getting the extra return that a corporate bond gives us but not taking on the risk of buying long-term bonds, in spite of their extra yield.  So as interest rates went up in the last few months, Avenue’s bond portfolio did not go down in price as much as the Canadian bond index.  We believe our portfolio should still be able to return 3% to 4% per year on average if, as we expect, inflation stays low and stable.  

Even with this significant rise in interest rates, there was not a corresponding drop in the stock market. It has felt more like a holding pattern.  In fact, the US stock market has now had over 1,350 consecutive trading sessions without a 10% correction.  Many stock market watchers are now looking for reasons why stocks should go down, simply because the market has gone up for so long.   

There is general concern that the current level of record profit margins cannot last.  We have written in the past that as interest rates, which are the costs to borrow money for companies, have declined and wages stalled the result is record profit margins.  We have even referred to our current investment climate as a golden age of corporate profitability.  Conventional wisdom is anticipating that the cost of borrowing will soon be going up in the US and wages will finally have to increase as the labour market tightens.  The conclusion is that profit margins will have to fall and the stock market will fall with them.           

At Avenue we make a distinction between the impacts of different interest rates.  We believe that short-term interest rates in the US should rise over the next two to three years.  This will have an impact on parts of the economy that borrow short term, like housing.  However, companies borrow for medium terms, like 10 years, and the stock market reacts more to these corporate medium term borrowing rates. Here we would expect that interest rates might go up by 1% but this is not enough to either destabilize markets or dramatically revalue asset classes like pipelines or commercial real estate.

Unemployment in the US has gradually fallen to the 6% level and the expectation is that wages will finally face some pressure to increase.  So far we have seen this to be true in some specialty areas like high tech and health care.  However, because we are in a debt heavy and slow growth economy, many companies still prefer cutbacks and efficiency compared to growth to maintain profits.  The result is a constant supply of surplus labour.  In Canada we have also had the shakeout in the Alberta energy sector which has shed workers and lowered wages for those who have kept their jobs.     

The other hot topic of concern is a very technical argument about bond index funds and liquidity.  We will expand this discussion in this month’s case study.   In summary, if everyone who owned a bond index fund felt that interest rates were going up and put in a simple order to sell the fund, the manager of the fund would then go and sell the actual bonds into the market.  However, because of various factors, one being new bank capital regulations, what is called the depth of the bond market is not as deep as it used to be.  In plain language, there is no buyer for the bond. The result is a bond market panic instead of an orderly selloff as interest rates rise.

At Avenue we are positioned to weather a bond panic and we plan to maintain our bond portfolio strategy.  We always intend to mature our bonds.  (Although sometimes we don’t let the bonds mature for technical reasons).  If a bond market collapse occurs, we have cash and constantly maturing bonds that we can then reinvest to take advantage of the higher rates.  It is no more complicated than that.  However, bond trading can become much more complicated and one can end up really losing money if one tries to time the market using a trading strategy in a volatile market.

We will also mention that there is always the risk of political shock. This is very topical since Greece teeters on the edge of default as we write this letter. Bond and stock markets could react negatively to this event given its deflationary impact.  But we would argue that the bulk of this negative news is already reflected in the prices of bonds and stocks.  Also, Greece is not such an important economy globally.  So it is more important to look through a Greek collapse and imagine the world in a few months’ time.

When we look at our existing investments, we ask if their underlying businesses can meet our target return of 8%.  For the most part the actual business environment is good and quite stable. We would now argue that stock market multiple expansion is likely after this uncertainty with interest rates and Greece clears. 

Interest rates can go up but not to a level where we would say we don’t want to be invested in the stock market because we get a higher return from bonds.  If stocks are still the only place to get 8% rates of return then we believe money will continue to flow into the stock market.  Today’s valuation is about 17 times earnings for consumer and industrial companies but we feel a price earning multiple close to 20 is possible.  Earnings don’t need to go up for the stock market to go higher.  A higher multiple on existing earnings will be the next driver of higher stock prices. The one caution is that with higher valuations comes more volatility, which means bigger price swings in the months and years ahead.

We wrote about the oil cycle last quarter and we can talk this quarter about other mini cycles going on in other industries, like mining.  We have had a bull market in stable companies but a collapse in mining over the last two years.  We have watched and waited to buy Labrador Iron Ore Mines until it was finally down by 60% from its high.  It is a debt free royalty stream from Canada’s largest iron ore mine operated by Rio Tinto and it sells a high value product into the global specialty steel market. We feel we can get our 8% rate of return over the next few years with the possibility that the iron ore market recovers in the future.  To buy it, we sold our diversified mining investment in BHP.

Our investment in John Deere is doing well and acting as we had hoped in a counter cyclical way.  The corn price is terrible but the stock market has a way of looking through this.  It is another example of having a very different return profile within the portfolio that offsets the impact of our previously discussed theme of higher interest rates.  This leads to a final comment that higher interest rates are good for US banks.  This is what we have been waiting for to propel our returns in Bank of America.  Higher interest rates will have a negative effect on the valuations of tangible assets but there are a lot of diversified investments in Avenue’s equity portfolio to smooth the return.

There is no dramatic difference between the strength of the US economy and that of a core European economy like Germany.  However, ultra-low interest rates are magnifying the subtle differences and we are now seeing a large flow of money from Euros to the US dollar as well as the continued rise of asset prices. Avenue has started to incrementally move investments back to Canada.

We have argued for five years now that interest rates will be low for much longer than what the majority of investors have anticipated.  However, we are now in a world where we compare one country’s low interest rates to another’s.  At present, the US economy is doing relatively well; therefore, the US Federal Reserve would like to start raising short term interest rates.

However the 10 year US Government Bond yield is 1.96% and the 10 year German Government Bond yield is 0.16%.  The US return of 1.96% is not ideal, but it is more attractive than the arguably punitive German return of 0.16%.  We have seen a massive flow of money and consequently a 23% rise in the US dollar since mid-2014.  When money flows rapidly to the US, the Canadian dollar can be marginalized. The Canadian dollar has also suffered due to the drop in oil price and the fact that our 10 year Government bonds, which yield 1.37%, are now well below US rates.

The knock-on effect from a stronger US dollar is that US corporate earnings will not grow in 2015 for the first time in five years.  Almost 40% of public company earnings in the US come from global operations.  Any earnings growth will be offset by the strength of the US dollar.

As Canadian investors, we now have the stimulative effects of a much lower currency compared to our major trading partner.  In addition, a lower oil price benefits those who use energy on a daily basis compared to the fewer people, mostly in Alberta, who are in the business of producing it.  The resulting positive impact will take time to flow through the system, and it may be a year before it can be measured through statistical analysis. This argument can be read thoroughly in the article written by Paul Gardner for the Globe and Mail on March 11, 2015 (see our website). 

The fundamental issue remains that there is no inflation of either type.  Demand pull inflation is described as when too much money is chasing too few goods. The problem is that we have too many goods and the capacity to make everything we need.  Alternatively, cost push inflation is described as when the swelling of input costs results in overall price level increases.  However, the input costs of wages have not gone up and the input costs of raw materials are in steep decline. Ultra-low interest rates are meant to encourage the virtuous cycle of borrowing and investment for growth, but it remains that we don’t need any more debt and there is excess capacity in almost every industry.

Asset price increases and even potential asset price bubbles are now common investor worries, but we do not believe we have reached this point yet. The prices of Canadian houses are quite rational given the low level of interest rates.  Where borrowing $350,000 at 8% in 1990 cost $28,000 per year in interest, borrowing $1,000,000 in 2015 at 2% will cost $20,000 per year in interest. A drop in interest rates by 6% may have the effect of house prices increasing by 200%. This is not a bubble.  A bubble is created if the house price increases beyond what people can afford to cover in interest costs. The cost of Canadian housing is quite rational, with perhaps the exception of Vancouver, which is dealing with limited supply and a hot Asian buyer’s market.

We would also use this same argument to view price earnings (PE) multiple expansion in the stock market.  A few years ago when stocks were trading at 14 times earnings, we made the case that in this low interest environment stocks should trade at a PE of 18 times.  This is where we are today.  However, the pressure for investment returns is only increasing.  A recent survey by State Street of large institutional money managers in 15 countries found that “plan sponsors will increase their risk appetite over the next three years”.  This has only recently occurred and is a polite way of expressing that large investors are finally acknowledging that they cannot meet their return expectations from large weightings in bonds.

A great example is our investment in Royal Bank.  The stock currently has a dividend yield of 4.1% which compares favorably to a 10 year Canadian Government bond yield of 1.3%.  Royal Bank only pays out 45% of earnings in the form of dividends.  Barring a major financial disruption, it is unlikely that the stock will fall in price.  However, we have also just demonstrated that there is not a housing bubble, and the high prices are really a rational appreciation given low interest rates.  We believe it is more likely that the stock will go up regardless of earnings or dividend growth.  Investors need the income.  At the overall stock market index level, the current PE multiple of 18 times could easily go to 20 or 22 times.  

At Avenue, one of our core beliefs is that we have to stay invested and capture the long term compounding offered by owning a variety of stable income streams through investing in public companies.  The case study this month is a discussion based on an excerpt from this year’s Berkshire Hathaway annual report, authored by Warren Buffett.  His argument is that being a long term shareholder in a good company is much less risky compared to treating cash or bonds as long term investments.  The tradeoff is that in the short term, cash and bonds can be necessary to reduce volatility but volatility is not an ideal way of measuring risk for investments over decades.

Bringing this all back to Avenue, our bond portfolio is committed to getting the best return we can out of the bond market for those clients that need income and stability.  The largest part of the return is coming from our investments in medium term Canadian corporate bonds.

Our equity portfolio is committed to staying invested but being careful about inevitable valuation increase.  This quarter we have shifted our exposure within the energy sector to two companies that are better positioned to get through the downturn and hopefully we will take advantage of today’s lower energy prices.

Measured by asset exposure, the Avenue equity portfolio has benefitted by being over 50% invested outside of Canada. Most of these investments are in the US through direct investments like Bank of America, Deer and Amgen.  However, we also have to factor in that our investments in Canadian listed companies, such as Brookfield Asset Management, have most of their assets in the US. In addition, TD Bank and Royal Bank now have a third of their operations in the US.  With the Canadian dollar now at this $0.80 level we will be looking to incrementally sell some of our US investments and bring the money back to Canadian opportunities.

We continue to believe that there are few better substitutes for our investable savings than owning quality stocks for growth and certain selective bonds for income and safety.  Again, we witnessed two rapid recoveries in the stock market following volatility in October and December.  Moreover, corporate share buybacks and acquisitions reinforced the dynamics of the equity bull market. However, potential big risks to North American equity investors are a potential rise in wage inflation and increased geopolitical unrest.

These constantly changing dynamics give us opportunities to make adjustments within the portfolio to take advantage of a lower Canadian dollar, a much lower oil price, and insulate ourselves from a rising interest rate environment.

2014 Returns

Avenue Composites 2014Percentage
Bond Portfolio4.4%
Equity Portfolio9.8%
Indices 2014
Canadian Consumer Price Index1.9%
DEX Canadian Bond Index8.8%
S&P/TSX Composite Index7.4%
S&P 500 Composite Index (CAD)21.9%

Note: 2014 percentage change returns, pre-audited, net of fees.  Individual performance may differ due to size and timing of investment.

In our Q3 2014 letter, we raised a concern that the stock market could continue to fall due to repercussions from a stronger US dollar, since all world markets in bonds, stocks and commodities would likely adjust.  Avenue’s Equity Portfolio is built with the intention of being more stable than the overall stock market, so we are very interested in how our equity portfolio holds up in the periods where there are rapid declines in the stock market. The TSX Index fell 13% between the September high and the October low, whereas Avenue’s Equity Portfolio declined 7% through this period.  Because of greater diversification and a focus on higher quality investments, or lower relative valuations, Avenue’s Equity Portfolio continues to perform with less volatility than the TSX Index.

Since last summer’s stock selloff was followed by a rapid recovery, we were not surprised to experience two more rapid recoveries in the price of high quality cash-flowing stocks from both the October and December stock market corrections. Avenue has been quite repetitive about pointing out that given the present low interest rates, investors are forced to look to stock dividends as an income substitute.  As a reminder, at the start of 2014 the Canadian 10-year Government Bond yield was 3% and today those same bonds yield 1.8%.  Compare this to Royal Bank’s dividend of 3.8%.

Stockmarket values have also risen because companies are buying back their own shares.  Last year in the US, total share buybacks were worth roughly $450 billion which is the equivalent of a 3% dividend yield.  However, the actual dividend yield was 2%, so the dividend added to the stock buyback combined for a total cash return to investors of 5%.

In past newsletters we have discussed that when companies continue to make money, but don’t have a need to reinvest it in their own business, a merger and acquisition cycle can develop. In the fourth quarter of 2014 the US public equity market was back to the same level of takeover activity last seen in the frenzied days of 2007.  Takeovers have the effect of pulling assets out of the stock market with the result that there is more cash to invest in fewer listed companies.

When we assess risk to corporate profitability, a key variable is the cost of production and the largest component of costs is wages. So far, the pace and nature of the economic recovery after the 2008 financial crisis has not resulted in increased labour costs in North America.  We have referred to our current economic period as being a golden age of corporate profitability where taxes have come down, interest costs are low and wages are stable.  However, wage pressure might start to appear as US unemployment has now come down to 5.6% and the US economy is estimated to grow at 3% for 2015. Not all wages will go up, but many businesses are starting to notice a skilled labour shortage.We don’t expect rapid wage inflation, but rather we are watching closely for incremental change.

The list of geopolitical risks is getting longer: countries that run a real risk of default include Russia, Greece, Venezuela and Nigeria; there is limited economic growth in Europe and slowing economic growth in China; and the conflict in Syria and Iraq continues unabated.  World events will likely have a short term shock effect on the bond and stock markets, but hiding our money under the mattress will not help us either.  Avenue aims to be invested in stable, profitable businesses and the North American economy continues to make slow but steady progress in spite of all these problems.

Avenue’s Bond Portfolio remains more weighted to Canadian corporate bonds with shorter term maturities.  At this time we wish to be defensive to protect against a potential increase in interest rates or a surprise credit event that would weaken the corporate bond market. The primary function is safety and providing an income for Avenue’s clients where this level of risk is appropriate.  

Avenue’s Equity Portfolio has made some minor adjustments due to the changes in interest rates, the currency, and the price of oil.  With interest rates this low we will continue to underweight hard asset classes like Real Estate and Infrastructure. We don’t see any imminent reversal to dramatically higher interest rates. Rather, we feel the move will be gradual to a more normal level over the next 3 to 5 years, given inflation of 1.5% to 2%.

The Canadian dollar has now reached the $0.85 level in US dollar terms, which encourages us to look at Canadian opportunities first when making new investments.  Remember, we are now benefiting from those international investments we made when the Canadian dollar was at par or higher with the US dollar.  Lastly, we see the collapse in the price ofoil as an opportunity to increase our exposure, having been significantly underweight in the energy sector going into this fall’s correction.  We believe today’s oil price of $50 may not be the absolute low needed to clear the oversupply, but with a 12 to 18 month time horizon, the oil price should get back to the $75 to $80 per barrel level.