How to invest in uncertain times: Keep calm and carry on


We are pleased to report that the performance, which lagged early in the year, was much better in the final quarter of the year. The portfolio was ahead of the respective benchmark in each of Canada and the US. The S&P/TSX Composite TR (Total Return) Index was up 4.5% while in the US the S&P500 TR in USD was up 3.8% over the last three months.

The return this year has largely been driven by strong performance from our portfolio after the US election.

We think it is fair to say that the economic narrative has changed with the US election. Since the end of the financial crisis in 2009, we have been in an environment where economic policy focused on austerity — low growth, low inflation, and low interest rates. And it appears we all got pretty used to that. The chart below shows how much more slowly the economy has grown in the last 8 years than at any time in the past 30 years. 

growth rate


Has the environment changed to emphasize pro-growth policy initiatives?

While Donald Trump made some inflammatory comments during the election campaign, his victory has served as a catalyst for a rally in stock markets around the world. This comes amid expectations that his plans for lower tax rates, more infrastructure spending, looser regulations, and incentives to induce American companies to bring home more than $2 trillion trapped overseas will stoke higher economic growth, inflation, and corporate profits.

The policies that will be enacted early will be those things that are common to the President, Paul Ryan, the majority leader in the House of Representatives, and Mitch McConnell, the majority leader in the Senate. At least for a bit, sanity may prevail.

The first order of business in the House will likely be comprehensive tax reform. The US tax code has not had a significant overhaul since 1986 (prior to that: 1954) and tax reform would be on the agenda whether Trump or Clinton won.

Lower tax rates should have a profound effect; not just on the rich but throughout the economy: more jobs, better jobs, and higher wages. It should make the US a friendlier place for foreign capital.

While it is highly probable that heightened infrastructure spending will happen, it will not happen as quickly as one would like. It takes years to plan large projects before a shovel hits the ground so do not look for significant spending for 4 years or so.

Finally, less regulation. President Trump can easily reverse all of the executive orders of President Obama that resulted in a heavy regulatory burden on business. That can be done quickly and Trump says he intends do it. To remove certain other Regulations requires Hearings in the House of Representatives. That could take 6 to 9 months. To enact these policies will take time and therefore the market may be a bit ahead of the facts on the ground. However, it is highly probable that there has been a definite transformation in attitude toward a pro-growth policies. That should lead to a stronger economy, more jobs, higher wages, and higher corporate profits.

On the flip side if the US starts running significant deficits and significant tariffs are put in place, you could end up with some uncontrolled inflation. If the results are stronger growth with moderately higher inflation, that is very positive for the economy. If you get the opposite effect, inflation with more limited growth, that is negative. Everyone is trying to figure out what will happen. We will not know with any certainty until after we see the bills that are proposed and what passes. But we do think there will be a transformation here and the potential for higher economic growth exists.

The road ahead for Mr. Trump is not without its bumps. Income inequality is higher than it has been in decades, and the federal deficit is larger than it has ever been, at over $19 trillion.

The economy is looking healthier: unemployment is at a nine-year low, housing is still in the early stage in its recovery, the banking system is now well capitalized, lower oil prices have helped, the S&P500 snapped a five quarter profit recession in the third quarter, and the economy grew at a 3.5% rate in the third quarter period, the fastest since 2014.

Wall Street analysts reckon S&P500 profits will accelerate further in 2017, helped by a rebound in earnings among energy companies. So prospects appear bright for the stock market. The Canadian market is poised to follow suit and benefit from the positive economic developments in the US.

Interest Rates

Interest rates look like they are going higher. Since the election US bond yields have gone up a lot. For the past few years, we have maintained very short bond positions in the face of what were declining yields because we believe the first priority of fixed income investments — bonds and preferred shares — is

to stabilize a portfolio, not to speculate, and we were worried that when interest rates rose it would be quick and painful. This happened after the US election and all of the profits of earlier this year plus some, vanished in a few weeks. Our portfolio pretty much maintained its value in this period.

US government bond markets were jolted when the US central bank outlined a more aggressive path for tightening than had been anticipated. In its release from the December meeting, the Federal Reserve said that it expects to raise interest rates three more times in 2017, spurring a sharp climb in Treasury yields. The yield on the 10-year Treasury bond climbed above 2.5% for the first time since September 2014. The policy sensitive two year yield approached 1.3%, its highest level since August 2009, after hefty selling in the wake of the central bank’s meeting.

Beyond 2017, the Fed policymakers lifted their long-term view of where interest rates will settle. The mid-point estimate of the Federal Reserve Governors is for the Federal Funds rate to rise to 4% by 2019 – this is a dramatic turn of events.

Credit markets are becoming more challenging. Near term interest rate moves could affect longer-duration assets. We favour short-term bonds, and floating rate debt and preferred shares which effectively have zero duration exposure.

A remark Shelby Cullom Davis, a Wall Street icon made long ago, seems bang on today: “Bonds promoted as offering risk free returns are now priced to deliver return free risk.”

The Stock Market Is Improving

Our US portfolio reversed most of the underperformance of early in the year after the election as the financial services sector; one of the best value groups — read safest — is now one of the darlings of the market, post election. The portfolio is exceptionally well poised for future gains.

It has been widely reported and it is true that US banks are better capitalized than they have been in recent memory. What has not been said is that bankers from Jamie Dimon at JP Morgan Chase to John Gerspach at Citi say that their loan book is stronger than it has ever been in every category. Yes loan losses will rise in the next downturn but nothing like the problems of the recent past. The banking business has dramatically de-risked. Safer banks make better investments.

Financial stocks should keep rising as Mr. Trump appoints regulators more sympathetic to the banks and as the Fed allows interest rates to drift higher. A wider gap between what banks earn on their assets, and what they pay for deposits leads to increased profits. Higher profits drive higher share prices.

Las Vegas Sands Corporation (LVS)

Las Vegas Sands Corp. is a developer and operator of world-class integrated resorts that feature luxury hotels; best-in-class gaming; lodging, retail, dining and entertainment, and convention facilities.

Its facilities are concentrated in the far eastern market: 49% in Macao (offshore China), 37% in Singapore which also caters to the Chinese market, and 14% in the US. Their diversified convention based offerings appeal to the broadest set of customers and comprises a unique competitive advantage in the Macao market.

The company is uniquely positioned to deliver long-term growth in Asia, with its unmatched track record, powerful convention based business model and the industry’s strongest balance sheet. It is committed to maximizing shareholder returns by delivering long-term growth while continuing the return of capital to shareholders through recurring dividend and stock repurchase programs with the industry’s most experienced leadership team dedicated to increasing long-term value.

LVS continues to invest for the future. The Parisian Macao is a $2.7 billion themed, iconic destination expected to open at the end of 2017. The development includes approximately 3,000 hotel rooms and suites, gaming capacity of 450 table games and 2,500 slot machines, a retail mall, a 50% scale replica of the Eiffel Tower, substantial convention space, diverse food & beverage options and entertainment.

For all new developments, LVS targets a minimum of 20% return on total invested capital, with 25 ‐ 35% of total project costs to be funded with equity. Historically the company has earned 28% on equity yet the shares sell at only 10 times cash flow, roughly half the price of less successful, slower growing real estate companies. And LVS pays substantial dividends yielding 5.2% with strong dividend growth.

We have owned this company for a while with excellent results and expect even better results the next couple of years as they continue to expand their business in fast growing markets and enjoy a cyclical upturn in the Chinese market. The stock continues to undervalue the business by over 45%.

We believe that the qualitative and financial strength of our companies will continue to produce outsized returns over time. We are optimistic about the outlook for equities over the next few years.

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