Sensible Investing for Turbulent Times


In the past twelve months, equities are up almost 5% in Canada, just over 2% in the U.S. (S&P500), about 3% in China, but the FTSE All-World index is down about 0.6%, expressed in their home currency. Canada is doing better relative to the rest of the world.

We are cautiously optimistic for the near term for securities markets both in Canada and the U.S. The underlying fundamentals of both economies are positive. But as a consequence of the long running economic expansion and the rise of share prices, it is becoming increasingly challenging to find new investment ideas.

As a result, we are becoming even more careful about making new investments. We want to ensure that the companies we invest in are building value and will continue to get stronger even if a slowdown were to occur. As you know, we invest with a longer term perspective. We do not concern ourselves too much with the short term gyrations, but rather we focus on the ability of a company to build its business and create value for us over a 3 to 5 year period. Nevertheless, we are very cognizant that we are in the later stage of this business cycle.

The companies that make up the S&P500 increased their expected 12 month earnings by 10% over the past year. Improved earnings are a key driver of the steady climb that equity markets enjoy over time. Throughout October, companies will be reporting third quarter revenues and earnings. The companies we own did better than had been expected in the second quarter, and we expect a similar result this quarter as well.

The first of our companies to report was Citigroup. Citigroup reported earnings of $1.97 for the quarter, slightly better than expected, versus $1.74 last year. The company has bettered the expectation every quarter for the past seven quarters, and it was no different this time. These results confirm that Citi is one of the cheapest major banks in the world, even while it is enjoying substantial improvement in its business. We continue to believe that this stock will trade at over $100 per share compared with $70 today.

The Environment

The Canadian economy is chugging along nicely thanks to a healthy labour market. The rise in employment in September dropped the unemployment rate to 5.5%, its best showing in forty years. Not only is employment growing, but so are wages. Hourly pay rose 4.3% in September over the last year. The recent few months have enjoyed the strongest year-over-year wage increases in a decade. Good news for Canada.

Similarly, the U.S. economy is reasonably robust and the professional prognosticators at the International Monetary Fund feel it will continue to grow at, or near, a modest 2% rate for the next five years — well below Trump’s promise to maintain expansion above 3% a year. While manufacturing data released for September showed the lowest reading in over 10 years, manufacturing accounts for a mere 11% of U.S. economic activity. The consumer sector accounts for 70%, and the consumer is doing fine.

Why? The U.S. has full employment. The unemployment rate is 3.5%, the lowest level since 1969. Just about everyone who wants a job has a job. A shortage of labour in many sectors has been pushing up wages. Since last year, average hourly earnings have increased 2.9%. When Americans have additional money, they spend it.

There are only three things that could potentially disturb the expansion. First, the economy could overheat — this is the normal way for an economic expansion to end. That is highly unlikely in the near term because growth has been sluggish relative to its potential to grow 3% per year. With the economy operating nowhere near its full potential, the probability of a downturn next year is less than 50%.

Second, if wages were to rise at a rate sufficient to push inflation above the 2% target of the Federal Reserve, then the central bank might feel forced to tighten monetary policy to temper the rising inflation. This could slow the economy. Again, the probability of this occurring in the next year or two seems quite low.

Third, some kind of geopolitical problem could weaken the world economy. With the kind of behaviour we see in the White House, this is the most probable source of trouble. We have already seen how that could come about. David Malpass, the president of the World Bank, has warned that global growth will probably fall short of the 2.6% rate predicted in June, due to “Brexit, Europe’s recession, and trade uncertainty”. This will be the slowest rate of expansion since the global recession of 2009. Slower growth is markedly different from a recession. This is not a problem at this point, but it is something to keep one’s eye on.

The eurozone economy risks entering a period of prolonged economic stagnation, similar to that experienced by Japan since 1990. Given the weakness of the German economy, which is suffering from deep stress in its automotive sector, the eurozone is expected to expand only around 1.2% this year and the next.

Negative European interest rates appear to be seen as a panacea. The European Central Bank’s (ECB) most recent policy decision was to launch a substantial package of quantitative easing and further reduce its main deposit rate by 10 basis points to -0.5%, a new record low. Negative interest rates in Europe are making it increasingly difficult for insurance companies and banks to make money. ECB policy is to alleviate some of the pressure from negative rates on bank balance sheets, as it has been encouraged by the heads of various major European banks.

That matters. If these institutions are not making money, they cannot increase their capital. If they cannot increase their capital, they cannot make more loans to people and to companies. If they cannot make more loans, they cannot grow their economy. You need to have credit expansion to grow economies. While this impacts all banks operating in Europe, our North American bank investments should do better as the European banks focus on dealing with their problems in their home markets.

Turning east, the U.S. is calling for fundamental and dramatic change in China. Forty years ago, China was a lesser developed country. The Gross Domestic Product (GDP) was a few hundred dollars per person. Today, GDP is $10,000 per person. China is one of the greatest economic miracles in history.

The country has become economically successful, in no small measure by staying behind big tariff walls, taxes, closed markets or selectively open markets, government subsidies, and by seizing intellectual capital created elsewhere — a variety of things that we consider unfair in the West.

Trump started a trade war with China to change the status quo. After five months of constant escalations in this dispute, the two countries announced that they had reached a truce on October 11th. The terms are vague and one-sided. Chinese officials have only acknowledged progress in the talks, while Trump said “Phase One” was the “greatest and biggest deal ever” for the American farmer. In return for some modest concessions, most of which China had offered previously, Trump agreed to put on hold higher tariffs on $250 billion in Chinese goods that were due to take effect on October 15.

The two sides made no progress whatsoever on the most significant and contentious issues; Chinese government support for strategic industries and state-owned enterprises and intellectual property theft, which Trump had hoped to achieve before his 2020 re-election campaign kicks off in earnest.

But this respite does set the stage for high stakes negotiations after a planned meeting between president Xi Jinping and Trump at the Asia Pacific Economic Conference on November 16-17 in Santiago de Chile. The two countries will finalize the October 11th agreement at that meeting.

This agreement is probably good for financial markets in general, and it is certainly good for us. One of our largest U.S. positions is Las Vegas Sands (LVS), a gaming company with extensive China operations — 62% of the company’s revenue comes from its operations in China. The calming of relations between these two countries can only benefit this wonderful company.

The coming of the 2020 election season will probably restrict Trump’s ability to act up — a good thing for financial markets.

Growth stocks vs. value stocks

We have talked before of a two-tiered market; one of overpriced growth stocks and safe but underpriced, value stocks. The growth crowd has been the decided winner for the past few years.

The Russell 1000 Value index has trailed the Russell 1000 Growth index by no less than 21% over the last three years. The exact reasons are unclear. However in 2018, 81% of firms that went public lost money. So far in 2019, 74% of companies debuting in the public equity market have been making losses. Historically, the majority of IPOs have been profitable. The last time 80% of companies that went public were unprofitable was in the tech bubble of 1999-2000. When that bubble burst, from mid-2000 to mid-2003, North American markets declined by over 30%. But value investors in general, and Kingwest in particular, enjoyed positive returns. It has been miserable being patient but it may be about to pay off.

You only have to look at WeWork – it was the darling of growth investors a few weeks ago even though it lost $1.6 billion in 2018 and a further $2.4 billion in the first six months of 2019. WeWork will continue to lose money at a similar rate for at least the next few years. SoftBank, a hugely successful growth investor, has invested $10.4 billion in WeWork over the last few years. Today, the value of the whole business of WeWork is less than $10 billion, at best. Softbank has lost over 70% of its investment. These high priced companies are dangerous when their growth rate falters, even a little bit.

We opt for the safer route. We do not invest in businesses with high share prices that can crater badly if the company slips up. Safety of capital may be out of fashion, but that does not mean that it is no longer the most sensible strategy.

We prefer to make sensible investments in companies that are building lasting value. This has proven over years and decades to be the most prudent and most profitable strategy, and we are confident that it will be again. We will not have to worry about the big WeWork-like decline.

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