Fourth Quarter Letter 2019

While we expected a strong year for equity markets in 2019 given the overblown sell-off toward the end of 2018, we were surprised by the magnitude of the rally. Profit growth of U.S. corporations has been anemic as tariffs imposed on imports from China and other countries have cost U.S. companies US$46 billion, while U.S. exports of goods hit by retaliatory tariffs have fallen sharply. So what drove the markets to record levels? Fears of an impending recession faded quickly early in the year, followed by a series of interest rate cuts in the U.S. and elsewhere, capped-off by hopes of a partial resolution to the U.S. trade war with China. Record share buy-backs also helped. The Bank of Canada resisted lowering rates and consequently the Loonie was the best performing G7 currency rising nearly 5% versus the U.S. dollar. Lower interest rates also drove bond markets higher than even the most bullish investor anticipated and inflated other asset classes such as real estate.

There’s no doubt that valuations are stretched in the most liquid markets such as North American large cap equities (particularly tech stocks), as well as in fixed income where, in some countries, government bond yields are negative. The increasing domination of electronic trading and flood of money going into ETFs have only amplified the situation. The biggest overvaluation of all however appears to be in private equity, particularly in the tech sector. Investors are pumping in so much money that “pre-IPO bubbles” are forming whereby private valuations now exceed what public markets are prepared to pay. Witness the poor stock price performances of recent IPOs of money losing companies like Uber, Lyft, and Slack, and the catastrophic meltdown of WeWork as it attempted to list its shares on the stock market at a valuation of $47 billion only to be valued months later at $8 billion. Private equity investors will likely be disappointed by future returns.

Nevertheless, there are still areas where valuations are not only reasonable, but downright cheap simply because they are unpopular. For example, small cap value stocks are out of favor having trailed large cap growth stocks for several years since they benefit less from fund flows into index funds like ETFs or from computerized momentum trading. The valuation gap between these two segments has never been wider. In a recent study by academics at the London Business School who ran 2.25 quadrillion simulations to evaluate 51 factors that have the most impact on driving asset returns, only a few factors emerged as significant determinants. Not surprisingly, valuation was one of them. To outperform the market, you need to invest at cheap valuations (i.e. buy low). Another was company size. Small companies often outperform large ones (as they can grow faster and eventually become large caps). This may not occur every year, but over long periods of time, this should mostly hold true. Successful investing requires a rigorous research process and patience.

On another note, we would like to welcome Marc Dansereau to our team. Marc formerly worked at a large money manager and was hired as our new Senior Manager Operations, Technology and Compliance. This role was created to help us separate operations from money management so that Jordan, Martin and I can spend our time researching companies and managing portfolios. This is also part of our continuous improvement to meet the more stringent requirements of institutional investors such as foundations and pension funds following the Quebec Emerging Managers Program having awarded us the management of a Canadian Bond Fund. These improvements will benefit all of our clients. As always, our administrative team comprising Lorie, Patricia, Peggy and Celine do an excellent job of making sure everything runs smoothly throughout the year.

CANADIAN EQUITY

During the fourth quarter of 2019, our Canadian Equity Fund rose +5.4% on a gross basis versus +3.2% for the TSX Composite Total Return. Despite our low weightings in the Gold and Energy sectors which rose sharply, our outperformance was driven by strong returns from a diverse mix of small (Tecsys, K-Bro Linen), mid (Kinaxis, ATS Automation) and large cap (Enbridge, Blackberry) holdings. We are happy with these results and continue to generate strong returns thus far in 2020, up over +4% as of the writing of this letter. Note that our commentary and newly formatted Canadian Equity report now refers to gross returns before fees (but after other expenses such as trading and custodial charges), which is more in keeping with industry standards given the different fee structures applicable to individual investors, charitable foundations and institutions, and provides a more direct “apples to apples” comparison of our return performance versus indices.

For the year, the Fund was up +18% on a gross basis versus +22.9% for the TSX Composite Total Return. A 40% surge in the Gold sector contributed around 2.5% to the TSX’s rise during the year. Our investment process avoids volatile and unpredictable sectors such as precious metals and mining, so we did not participate in this speculative trade. We also took a more conservative stance in light of the U.S.-China trade wars by maintaining a high average cash balance of 8% which cost us roughly 1.5% for the year. While we lagged the TSX, it is important to note that our still high return was achieved with less risk than the market.

Top contributors in 2019 featured several technology stocks such as Solium Capital (+62%) which was acquired by Morgan Stanley, Tecsys (+57%) and CGI Group (+30%), as well as utilities in renewable energy such as Boralex (+45%), Innergex (+34%) and Algonquin Power & Utilities (+34%). Other winners included real estate services provider Altus Group (+60%), manufacturing systems integrator ATS Automation (+49%), natural gas mid-streamer Keyera (+32%) and discount retailer Dollarama (+37%).

During the latter half of 2019, we gradually deployed our high cash balance by adding several new positions such as Calian Group, Tecsys, Enbridge, Kinaxis, Quorum Information Technologies, Hamilton Thorne, and Mediagrif Interactive. Many of these happen to be in the technology sector and most are smaller companies. Our search for compelling value often leads us to smaller lesser known firms with good growth prospects. As per the findings of the London Business School study mentioned earlier, our value-based investment process has and should continue to result in outperformance over the long run. As valuations are stretched, we continue to exercise caution when seeking attractively priced stocks with low exposure to economically sensitive sectors and remain confident that our portfolio is well positioned for strong long-term returns.

U.S. EQUITY

In the fourth quarter, U.S. markets continued to hit all-time highs, as did our U.S. strategy. We were not able to keep up with the market’s torrid pace however. The strategy and positioning of our portfolio, which worked so well in 2018 and led to our outperformance, cost us in 2019. For the year, we finished up +20.3%, behind our two benchmarks of the S&P500 Total Return (+31.5%) and the Russell 2000 (+25.5%). It is worth mentioning that we are already up +4% over the first two weeks of the year, and that December 31st is simply a point in time, while investing is a lifelong journey. We are happy to continue with our strategy of focusing more on small and mid-sized companies, with a slant towards value. While simply buying the biggest and growthiest names in the world has been a winning strategy this past year, we are reminded of a different time when names like Cisco, AOL, Nokia and Lucent could also do no wrong. Markets and styles tend to revert to the mean, and in the interim we continue our work of finding undervalued companies that are misunderstood by the market. We believe we have recently found two such investments.

The first one is Pinterest, which also goes to show that we are not only buyers of traditional value stocks but are looking for businesses with attractive characteristics and large moats. Pinterest is the social media site where users can share their pictures (pins) with one another and create boards of their top ideas. It’s quite useful for those of us who respond better to a visual idea than text. It’s popular for sharing fashion ideas, cooking recipes, workout regiments, travel lists, home renovations and décor. The company went public in the spring of 2019, and despite having over 250 million active users around the world, is only just starting to monetize their platform. The reason we like Pinterest is that the ads on its platform are not a nuisance like on Facebook or Twitter. Instead they are helpful ways users can act on their ideas. For example, when seeing a dress that a user likes, the user can click on it and get linked straight through to the vendor’s site. The ads improve the user experience instead of detracting from it. This leads us to believe that Pinterest can increase the revenue they generate per user far above competing platforms and eventually grow their revenue rate closer to the social media king, Facebook. With this investment, we are looking into the future and believe that the price paid today will look quite cheap in a few years.

The second investment in which we initiated a position is a traditional media name, Viacom CBS. The two entities merged in December and we bought shortly thereafter. The combined entity comprises CBS, Showtime, Paramount Pictures, as well as the legacy Viacom specialty TV channels. While some of these businesses (like the specialty TV channels) are shrinking, others such as Showtime, CBS and Paramount are still growing. It also has a massive intellectual property library that can be used to develop new shows and movies. This collection of content will continue to grow over time through in-house development and through accretive transactions like the recent deal whereby Viacom CBS acquired a 49% interest in the beleaguered Miramax. The new company will spend as much as Netflix does on content that it develops for in-house use or to sell to third parties. Basically, it has the scale to matter and, contrary to popular opinion, is not going away overnight. The company is currently trading for just 7x earnings, similar to retailers who look like they are headed for bankruptcy. We think this is too cheap and while we aren’t expecting to double our investment, it should gain in value as the company reports stable results or better yet grows overall.

CANADIAN FIXED INCOME

Our Fixed Income portfolios performed well in the fourth quarter, returning +0.9% versus -0.9% for the Canadian Universe Bond Index and +0.4% for the Canadian HYBrid Corporate Bond Index. The main driver of our performance was movements in interest rates. When rates rise, we should outperform since our bonds have shorter maturities than the overall bond market. When rates fall, we are likely to underperform the indices. In 2019, rates dropped substantially, and we did lag, returning +6.0% versus +6.9% for the Universe and +9.1% for the HYBrid. Given that we mentioned our shorter duration strategy before, we should explain why we made that choice.

When corporations issue bonds, they tend to do so over a wide time period. The maturities of their bonds can range from 3 years to as long as 30 years. We tend to only buy bonds in the 3 to 10-year time frame. Why? Because we feel more comfortable doing our research on an individual company’s credit worthiness rather than trying to guess where interest rates and government bonds are going. Even safe bonds can be volatile if they have a long time until maturity. A 30-year utility bond for example that yields 3% (the going rate today) can swing up or down 20% with a mere 1% move in government interest rates. So while there is virtually no risk of bankruptcy in that scenario, there is a risk of a large drop in the value of the bond from rising rates. This means that in the short run we may over or under perform based on how interest rates move, but in the long run our performance will be driven by our credit analysis of the corporations we are lending money to. Given our superior track record of generating an annualized return of +7% versus +4.6% for the Canadian Universe Bond Index since January 2008, it’s a strategy that works.

Turning to the portfolios themselves, preferred shares had a comeback in the fourth quarter contributing to our positive return. We still see good value in that space, with dividend yields north of 5% being paid by high quality issuers. In today’s market that’s quite attractive. We also continue to have a larger allocation to investment grade bonds than in past years. That may change at some point, but for now we aren’t seeing appropriate levels of compensation to own many high yield bonds. When these go on sale after a decline, as high yield bonds invariably do at some point, we will be ready to rotate out of some of our safer securities. Overall, this balanced approach is still resulting in total portfolio yields that are 2% to 3% higher than the Canadian Universe Bond Index, and we will continue to be patient before adding new high yield positions.

THE MACRO ECONOMIC ENVIRONMENT

Global economic growth was quite weak last year at 2.9%, the worst since the Great Recession. China, Japan and Germany (the locomotive of the Eurozone) faced manufacturing and export contractions which led to a global manufacturing recession. U.S. growth was also anemic. Yet, global equity markets rose sharply in 2019. After such a rise, there is always the risk of a correction. What explains the large disconnect between the weak economy and the strong stock market? It is important for investors to keep in mind that trends in money, credit and liquidity lead and drive stock prices. The daily drumbeat of news tends to focus on economic conditions which continue to be lackluster internationally. If investors had been focusing only on the negative economic indicators, they might have missed much of the rise in stocks last year. Liquidity trends, on the other hand, improved significantly in 2019 and continue to be very positive, as no less than 49 central banks lowered interest rates. This expansion in liquidity will play an important role in pushing the global economy onto stronger footing and support rising profits and stock prices.

However, the fundamentals of low inflation and accommodative central banks create a “Goldilocks scenario” or a “sweet spot” for asset prices to rise and for bubbles to form. So, in spite of the improving prospects and buoyant stock markets, many investors have serious concerns. These center primarily on three things:

The third area of concern has been China’s economic slowdown and the U.S./China trade war. In recent days, China and the U.S. have concluded a Phase I deal to end the current stalemate. The U.S. appears to have reaped some gains, and the ending of current tensions combined with stimulative Chinese policy should lead to a stronger Chinese economy and help reverse weakness in global manufacturing. However,we do not expect this economic and technological cold war to end any time soon.

First, the record-long economic expansion and bull market since March 2009 suggests to some that a recession is imminent. However, evidence shows that bull markets don’t die of old age. As the expression goes, they are “murdered by the Federal Reserve”. There are no signs that the Fed will tighten in the short run, particularly with President Trump entering an election year and measuring his success on the stock market’s performance. In fact, we have already had several industry specific recessions and two bear markets: 2015-16 and 2018-19. We are coming out of the second of these slowdowns, paving the way for a new upswing, just as in 2015-16. We are just as likely to be in a “mid-cycle” expansion than in a “late-cycle” bounce.
Second, massive central bank liquidity expansion since 2008 leads one to assume that there has been excessive speculation and economic distortions, making the financial system fragile and vulnerable to a rise in rates, which in turn, could trigger another financial crisis. Every economic expansion involves some degree of speculation, excesses and overborrowing. This one is no exception as valuations have increased sharply in almost every asset class, corporate debt has risen to record levels and investors have pushed into riskier assets. However, there is little evidence that the magnitude of the excesses is anywhere near the scale of previous episodes that led to burst bubbles and crises. The key question is: what would trigger a crisis? Inflation would have to pick up considerably and interest rates rise sharply, however this is unlikely, given that we live in a deflationary world awash with liquidity and that central banks are not inclined to tighten monetary policy in the short term.
The third area of concern has been China’s economic slowdown and the U.S./China trade war. In recent days, China and the U.S. have concluded a Phase I deal to end the current stalemate. The U.S. appears to have reaped some gains, and the ending of current tensions combined with stimulative Chinese policy should lead to a stronger Chinese economy and help reverse weakness in global manufacturing. However,we do not expect this economic and technological cold war to end any time soon.
Such concerns thus appear to be overblown for the time being; however we do not recommend complacency. There is always the possibility of a bad surprise, particularly given recent geopolitical risks. The world is also going through a massive transition, driven by several megatrends: China’s growing influence, technological disruptions (the Fourth Industrial Revolution), rising global populism and growing wealth inequality, trade protectionism, climate change (and the green movement), and the prevalence of zero to negative interest rates in parts of the world (i.e. “lower for longer”). The sheer complexity of this new world suggests that, in spite of our optimistic view, portfolios need to be conservatively positioned and focused on value.

Conclusion for Canada
Economic and financial prospects continue to be favourable for Canada which also experienced a strong stock market and a strong currency in 2019, despite flat commodity prices which held back parts of the Canadian economy. From 2002 to 2012, Canadian stocks outperformed U.S. stocks by almost 200%, after adjusting for the currencies. It was the U.S. stock market’s “lost decade”. Since then, the Canadian market has given back those relative gains, caused in good part by weakness in energy and other commodity prices, and a sharp fall in the Canadian dollar. The cycle of underperformance is now eight years old and Canadian stocks and the Canadian dollar are cheap. The 12-month forward P/E ratio in Canada is under 15X versus 18.5X for the S&P500, the largest discount since the 2001 U.S. recession.

With the world economy anticipated to improve in 2020, commodity prices and the Canadian economy should strengthen, as should the Canadian dollar. As a result, a reversal in the recent downtrend in Canadian stocks relative to the U.S. is likely, with the added kick of a pick-up in the Canadian dollar which began in earnest last year. In short, we believe that this is the time to be bullish on Canadian stocks. The decline in currency adjusted relative performance is yesterday’s story. Interest rates are likely to firm up in 2020 as the world and Canadian economies strengthen. The yield curve is likely to continue to steepen. Credit spreads are tight, but a better economy should reduce fears of major credit stress. Nonetheless, it remains prudent to keep duration relatively short to minimize interest rate risk and to focus on credit quality to mitigate credit risk.

Stephen Takacsy, Jordan Steiner, Tony Boeckh