Avenue Investment Management has now been looking after client money for 10 years. In this quarter’s letter we will revisit our original purpose and discuss our present challenges. This will be followed by our usual discussion of the current investment climate and how we are positioning our investments for 2014.

Reflection on Avenue’s First 10 Years

Avenue was started with two simple ideas that we felt were not being properly addressed by the investment industry. First, we believed that all Avenue clients should be treated as well as we would like to be treated ourselves. Second, we decided that Avenue’s investment strategy was to capture the long term compounding from the stock market, which has historically been approximately 8%, but try to accomplish this with as little risk as possible.

The bond portfolio’s strategy is to enhance a traditional government bond portfolio with the higher rate of return offered by meaningful exposure to Canadian Corporate Bonds for our clients who need certainty of income.

Recently, Avenue’s partners spent a day off site reviewing the last ten years and determining which factors have had the biggest impact on our success. We concluded that Avenue has reached this sound position from clearly executing the above two simple ideas. It has been a very hands-on process since we take responsibility for doing all the work ourselves. As the number of our clients has grown and we have added a few people to the team, our challenge is to maintain that same level of care and attention to detail. This is a human industry and errors can happen, but our commitment is to directly address any and all problems as soon as they come up as transparently as possible.

The tangible ways we commit to being client friendly seem to distill down to three factors. We can legitimately claim to care about how our clients’ money is invested because 100% of our own money is invested the same way in Avenue’s portfolios. We also cut our management fee in half for the following year when equity returns are negative. As well, Avenue still has just one phone number and all questions and requests for assistance will be responded to promptly. These three factors all seem quite simple but it is amazing how our competitors are not accountable in the same way.

We continue to enhance our client services. Over the last few years we have refined our ability to maintain an individual or family financial plan based on our own software that assesses overall assets and liability risk for any client that is interested.

Our investment strategy is slightly more novel. We ask the question: Can we capture the long term stock market compounding of 8% but do it with as little risk as possible? We try to do this by investing in a diversified portfolio of high quality companies where we look for profitability and stability. The focus of Avenue’s research is to find investments where we can limit losses or, to use a sports analogy, win by not losing. We are very happy with the results.

Avenue’s average equity portfolio has compounded 7.2%, even accounting for 2008, but we have done this with 44% less volatility than the TSX stock market index. We will go into more detail in this quarter’s Case Study.

Bond Yields Now at a More Rational Level

This is a great lead-in for where we see risks and opportunities for the year ahead. For Avenue’s Bond portfolio, 2013 was a year where the effort was put into not losing money.

We now believe interest rates are at a more appropriate level. If we use the US 10 year treasury bond as an indicator of rates in general, the yield has now risen to just around 3%. What has changed is that US inflation has fallen to just above 1%. So the real yield after inflation is about 1.7% which is exactly the historical average.

For all the reasons we have discussed over the last few years, we just don’t see how inflation can dramatically increase in the near to mid-term.

Avenue Composites2013
Total Return Equity Composite Portfolio10.6%
Bond Composite Portfolio1.9%
Canadian Consumer Price Index0.9%
DEX Canadian Bond Index-1.2%
S&P/TSX Composite Index9.6%
S&P 500 Composite Index (CAD)38.7%

In the Avenue Bond Portfolio we have bought more mid-term bonds to increase the overall term to maturity of the portfolio, from very short to a more neutral 7 years. We are also still getting paid a reasonable rate of return above government bonds to own Canadian investment grade corporate debt. Higher yielding non-investment grade bonds are harder to find. If we can’t find anything that meets our return objective, we will wait until such an opportunity presents itself. We feel a conservative return expectation for the bond portfolio is now 3 to 3.5%.

Equity Returns Focused on Reducing Risk

The U.S. equity market did very well in 2013 in contrast to the resource heavy Canadian market. Profitability did not actually change much for North American consumer and industrial companies. However, investors came to the conclusion that there was no alternative to these types of investments and prices of stocks were driven up. We would argue that if we didn’t love these businesses a couple of years ago, why would be buy them now but at a higher stock price.

As part of our core investment strategy, we would like to emphasize that we have owned many of our companies for most of the last 10 years. These are the same investments that did not fall dramatically in 2008 so there was not that same springing back effect in their stock market prices. We have participated in the overall consistent compounding of their profitability. We are careful to limit dramatic downside risk, but that does limit dramatic upside potential.

We have investments like Timbercreek Mortgage Investment Corp., BTB REIT and Yellow Media Bonds where the cash flow contribution to the Avenue Equity Portfolio was going to be 7- 8% no matter what happened to the stock market. Wherever we can, we are locking in a consistent return and limiting risk.

We actually have significant foreign exposure compared to past years. Direct investment in foreign companies is at 18.2%. It is also important to monitor indirect foreign exposure. As an example, TD Bank and Royal Bank have about 50% of their respective businesses in the US. This is a much more grey calculation, but our total exposure to businesses and assets outside of Canada is closer to 30%.

While resources have done poorly for the last three years, we have maintained our exposure because we believe we own good companies. As long as we are limiting our losses, we need to be building positions in high quality income streams which are being ignored by other investors. For example, we have done very well in Tourmaline in what has been a terrible pricing environment for natural gas producers.

A Cautious Approach For 2014

A very unusual development in the last few weeks is that one major indicator of investor sentiment has now fallen to 14% bearish. Neutral and bullish sentiment are equally split at 43%. How we interpret this is that investors don’t necessarily think the market is going to continue racing up, but that almost no one is left believing that the market can go down.

Traditionally, when most investors believe nothing can go wrong, market shocks are more likely to happen. We have been building conservatism into your portfolio in the form of cash and making sure the valuations of our investments are not stretched. In a down market we try to stay fully invested, but now that we have had a significant up market we will be more cautious going into 2014.

Avenue Investment Management has now been looking after client money for 10 years. In this quarter’s letter we will revisit our original purpose and discuss our present challenges. This will be followed by our usual discussion of the current investment climate and how we are positioning our investments for 2014.

The 10 year and 30 year Government of Canada bond interest rates have risen to a level where we believe they will now stabilize. We are again increasing our exposure to interest sensitive stocks and REITS. As global growth returns, resource stocks look like they have bottomed. We can make a rational case for why the stock market will go higher in price but the seeds for the next market correction are being sewn, and again the problem is too much debt.

Avenue’s last Q2 2013 report tried to capture how interest rates needed to go up but because of the weight of government debt, rates were not likely to exceed 3% to 3.5% for 10 year government bonds. Following this argument, the growth rate of Gross Domestic Product (GDP) will remain stuck at about 2.5%. The policy conundrum remains that the U.S. economy cannot hit the magical ‘escape velocity’.

Escape velocity is where the economy can grow at a rate where unemployment can come down to the 5% to 6% level and enough tax revenue can be generated to start to pay down the accumulated government debts. Simply put, if the economy would just grow at 4%, politicians will not need to make any hard decisions to cut previously committed spending.

Interest rates are up significantly since April. However, rates are not that much higher as seen from the perspective of what a company has to pay if they choose to borrow money. We would argue that 80% of the move in interest rates has already taken place. We have started to move our weighting to a more normal level in interest sensitive investments from being underweight. REITS look the most attractive and we have added First Capital which operates outdoor shopping centres across Canada.

From the perspective of Avenue’s Bond portfolio, we are now gradually increasing the term to maturity of the overall portfolio. Up to this point the Bond portfolio has been about as defensive as possible with the average term being 4 years. We have already increased the term back to 6 years and we will consider increasing duration further if interest rates go higher.

After interest rates, the next theme in order of importance would be a return to global growth for the world’s major economies. The US is now in the rhythm of 2.5% GDP growth. Europe has bottomed and next year will be better than this year. Also, China’s economy looks like it continues to grow at 7.5% which is much better than the credit-starved economic stall anticipated only a few months ago.

All governments are concerned that growth is not stronger. However, for resource investments we just care that the absolute growth number is positive.

A great deal of the rise in oil price is being attributed to the continuing conflict in the Middle East. We believe the price of oil was going to go up regardless. Demand for basic commodities like oil and copper will be 1% to 2% higher next year. We then see a return of investor interest to resource stocks.

We don’t expect it to be as broad based as before but a high quality cash flowing company should be attractive to investors. We have recently fine-tuned a few of the energy investments by selling Cenovus and Baytex to buy Suncor and Crescent Point. We have also added BHP Billiton, a global diversified mining company.

We have just highlighted that the Avenue Equity Portfolio’s investments in interest sensitive and resource stocks should do well. But there is also a strong argument that the overall price earnings market multiple should move higher. With interest rates staying at today’s level, investors will still need to be invested in stocks to accomplish their need for decent returns. So the market price earnings multiple of 15 times earnings that we have had over the last few years should rise to what has historically been a multiple of 18 times earnings in periods when interest rates are this low.

The multiple goes higher because there is no better alternative place to invest. To illustrate, we take next year’s earnings estimate for the American S&P500 index of $110, times a market price earnings multiple of 18 = 1,980 for the index. So the S&P500 Index can still go 19% higher from today’s level.

If we dig a little deeper we will find two more arguments to back up our simple 18 times multiple forecast. North American companies have done a good job paying down debt. For US companies, the debt to cash flow multiple has fallen to 1.7 times today from a high of 3.4 times in 2007. So we now have the healthiest balance sheets that we have seen in a generation.

Again, we can pay more for a company’s earnings when we know the business has borrowed a conservative amount of money. As well, dividend increases have not kept up with the increase in earnings. While earnings are not likely to increase dramatically from here, dividend payouts as a percent of earnings should return to more like the historic 50% level. This increase in overall stock market yield will also drive prices and justify an 18 times multiple.

In summary, we continue to have a positive outlook for the businesses we own and we can see that the stock market can move the share prices higher. However, we are now starting to see small pockets of excess that could be the seeds of the next market downturn.

We have noted that companies are conservatively financed, while retail investors are not. Individual investors are now borrowing record amounts of money to invest on the New York Stock Exchange.

Record margin debt does not mean the market is going down tomorrow. How we would interpret it is that when there is the next global destabilizing event, the stock market now has an internal dynamic that will cause the NYSE to go straight down quickly because all the highly leveraged investors will scramble to get out at the same time. When you borrow a lot of money you cannot afford to be a long term investor.

At Avenue, we incorporate the potential for a dramatic market fall into our strategy and make sure we always have cash on the sidelines so we can take advantage of this volatility when it comes. We like the businesses we own but we have to acknowledge that the market is getting inherently more risky and that we have in place a strategy to take advantage of it.

It is our belief that the American stimulative monetary policy will be coming to an end. We are witnessing an active realignment of bond and stock prices. We will do our best to describe how this impacts the various parts of our portfolio and how this creates an opportunity for additional investments.

Four and half years of ultra-easy monetary policy looks like it is coming to an end. This should not be big news given the undeniable health of the US economy. However, the bond and stock markets seem to be treating it as a revelation, for the moment.

The US 10 year Treasury bond had a low yield of just 1.66% on April 26th of this year. The yield for that same bond hit 2.6% at the end of June. So while in absolute terms a 2.6% yield is still not that exciting as a total return, given persistent inflation, the percentage move is 55% higher.

As Canadian investors we will focus on US monetary policy because for now that is what moves Canadian policy. Also to be clear, the US Federal Reserve has only barely acknowledged that the US economy is doing well and that quantitative easing will be reduced sometime next year. Quantitative easing is the Federal Reserve’s policy of creating money by buying bonds and mortgages in an effort to lower longer term interest rates. No mention has been made as to when the 0% interest rate on Treasury Bills will be increased.

A Year to Tread Carefully in the Bond and Stock Market

At our Avenue Spring presentation in Toronto we summarized the main themes of our quarterly letters. We also added one new theme: we now needed to be careful in the bond and stock markets. While we think interest rates will stay lower longer, they still need to be higher than present levels. Ten year yields need to be 2.5% to 3.5% longer term but they should not stay at 1.8% as they have been for the last six months. Our warning came with an explanation that we had already adjusted our investments to allow for this increase in rates.

We argue that interest rates in a normal economic environment would end up much higher than 3.5%. But because the Government’s debt is now so large, the social welfare state has to be rolled back which is having a real -1% drag on GDP. So the private economy is growing at 3.5% but the government is contracting at -1% with a net effect equal to GDP growing at 2.5%.

There is nothing that wrong with 2.5% GDP growth. The problem is that this amount of growth does not generate enough prosperity to pay off the accumulated Government debt load. The conclusion to this tidy argument is that monetary policy remains accommodative with low short term interest rates for years to come. To try and define low in more relatable terms, we would not be able to create a healthy retirement income by just investing in government bonds with a 2.5% yield.

So we know we have work to do finding higher consistent rates of return than offered by government bonds while still avoiding market disasters. We have been waiting for an increase in longer terms yields and now we are in the middle of that correction. However, the knock-on effect is dramatically different depending on which investments we are talking about.

A 55% increase in 10 government yields would confirm that there was a bubble in long maturity government bonds. A great deal of the excess money supply went into emerging markets as well. The effect of probable tighter money days in the near future has the Emerging Market Index down 22% in the last month.

First off we do our best to avoid investments where the return or the risk cannot be justified. Where our core strategy is impacted, we still have ways to reduce the risk.

The Positive Impact of High Interest Rates

The Avenue Bond Portfolio has not owned long maturity Government bonds since 2010. The average maturity has been lowered to a very conservative 4 years. While Government yields have gone up, the extra return we get from corporate bonds, called credit spread, has not been impacted. We are now in a position to buy longer dated bonds at higher rates and take advantage of the market turmoil.

The Avenue Total Return Equity Portfolio has groups of investments that will move differently to this change in interest rates. Higher rates are important but in the opposite way to our bond investments. The companies, in which we own shares, borrow money and now those companies have to pay higher interest so by definition corporate earnings will be lower.

Our utility and REIT investments would be the most directly impacted. Here we have felt that high valuation was already a concern so we have sold half our holdings over the last year. We are now in a good position to add to these sectors if the market was to decline.

The financial service industry is probably the most complicated industry to assess. Simply put, as interest rates go up, asset prices fall. However, higher interest rates are very healthy for the basic business of lending money. The Avenue portfolio is heavily weighted to commercial lending banks so we feel these higher rates will have a positive impact on earnings. Also, our investment in non-financial services, like Shoppers Drug Mart, was not impacted at all.

The portfolio’s resource investments are still more impacted by China and the internal supply and demand dynamics of the North American energy market. We are already trading at what we feel are depressed valuation levels. Gold is the outlier and here we have been wrong so far. We sold half our position in Yamana Gold close to the top but bought it back too early. We will maintain 5-6% exposure to gold as intelligently as we can. Yamana Gold remains a very profitable company right down to a $1,000 per ounce gold price.

In summary, this significant rise in interest rates has given us an opportunity to make bond and stock investments at levels we have been patiently waiting for. But to be ready, we had to be positioning ourselves over the last six months. There even might be an opportunity to get fully invested again but this would take an additional back up in higher yielding securities from today’s levels.

Recovery Continues

The recent US federal budget cuts of $85 billion confirm our belief that interest rates will remain low for some time. Stock market investors continue to buy consistency and sustainability where they can find it. However, both Avenue’s Bond Portfolio and Avenue’s Total Return Equity Portfolio have slightly increased weightings in cash given the higher prices and unsustainably high positive sentiment.

We are officially in the next phase of this low interest rate and overleveraged cycle. The US federal reserve chairman, Ben Bernanke, has acknowledged that there is healing in the property market and a recovery in the private sector. He agrees that in a normal cycle short term interest rates should gradually increase. However, he concludes that since the US Federal Government has been hit with automatic spending cuts of $85 billion, interest rates will not be going up any time soon.

Spending Cuts Equal Job Cuts

The way the $85 billion in spending cuts works is that it directly hits the operating budget of the US federal government. Health care and pensions are unaffected, so the only way to reduce spending is to cut jobs. Herein lies the core of the conflict. Ben Bernanke has stated that interest rates will not be going up until unemployment falls to 6.5%, down from today’s 7.7% level. This is a difference of about 1.9 million new jobs.

The US private sector is growing at roughly 2%, but the public sector is now contracting. Although we cannot yet calculate how many government jobs will be cut, it will now take several more years to get to 6.5% unemployment due to this new burden of constant government job losses.

The perception is that consumer demand in the US economy will remain slack and therefore interest rates should stay accommodative. Without addressing pension and healthcare reform, there is no way to overcome the economic drag created by reducing the public sector. Effectively, one major piece of the economy is deflationary and holding down what would normally be much higher interest rates.

Low Interest Rates For The Long Haul

This view of low interest rates for a longer period of time underpins our investment strategy for the Avenue Bond Portfolio. We will remain conservatively positioned for the foreseeable future by holding more cash and waiting for security-specific opportunities. Even at these incredibly low yields, we still believe we can get a 4% rate of return by having the majority of the portfolio invested in shorter maturity Canadian corporate bonds.

In terms of the stock market, getting the level of interest rates and wage inflation correct is very important because they are two of the major factors in determining corporate profitability. We have written in past letters that the strong stock market run in non-commodity businesses has been underpinned by the current record level of profitability. Corporate profitability is unlikely to grow dramatically from here, but it is not likely to collapse given that borrowing will remain inexpensive and excess labour will mitigate wage gains.

Stock market investors have caught on to this trend and money continues to flow into conservative equity and dividend funds which then buy the handful of profitable and sustainable publicly listed businesses. Shares of slow growth utility companies would be a good example. However, we believe that most of this good news is already in the share prices. The valuations are now expensive and broad measures of sentiment are now high.

Conservative Risk Management

Our risk management for the Avenue Total Return Equity Portfolio is to build some conservatism into the portfolio in two ways. The first is, raise more cash and wait for better opportunities in the future. The second is to incrementally sell shares in our more expensive utility and real-estate stocks and buy shares in companies with better valuations. Many of Canada’s commodity businesses are inexpensive for the first time in a long while.

The Canadian dollar is also caught up in the same investment theme. As the Canadian price of oil has deteriorated and the relative health of the US economy has improved, the Canadian dollar has decreased in value compared to the US dollar. We looked for investments outside of Canada when we had a strong dollar. Now we are focused on inexpensive investment opportunities at home.

Gold Update

We would like to finish with a gold update. The metal is now trading lower at about $1,600 but the stocks of the gold producing companies have fallen dramatically. This industry has all sorts of problems with profitability, growth and political risk but we believe we can own one or two of the better companies in the sector and accomplish our investment return objectives. We have taken advantage of the recent weakness and added to our investments in Yamana and Roxgold.