How do we avoid the instant gratification trap? By owning, not renting
We delivered positive results for the last three months ending October 31st. However, the markets were mixed. The S&P/TSX Composite Total Return Index was up 2.1% while in the US, the S&P500 Total Return Index was off 1.7%, not great but not bad. The portfolios recent strength is coming from the long awaited but still slight rise in longer term interest rates which has improved the financial service stocks where we are heavily invested.
Investing for the long-term
A recent study came out showing that the median life expectancy for those born in 2007 in G-8 nations (US, Canada, Japan and most of Western Europe) was over 100 years old. People are living longer and healthier. If you are 65 today, you will probably live another 25 years. But what happens if you treat that actuarial expectation as a certainty, spend too much each year, and end up healthy and vigorous at age 90 with no assets left? The prudent course is to plan on a longer than normal life.
It follows logically that your investment time horizon should be longer as well. Just as a sailor sees, but never reaches the horizon, the same is true for nearly all investors. We cannot emphasize enough that investing is about at least maintaining, or better increasing, your purchasing power over the life of your spending. It should follow that with safe (10-year bonds rated A or better) fixed income investments averaging about 2% after taxes and a core inflation rate that is now just over 2%, these bonds continuously erode the purchasing power of your portfolio. With long bonds you are at the mercy of the inflation gods: if inflation is low enough, you can win big; if it is high enough, you get burned.
Many investors have been pushing into higher risk or lower quality fixed income with higher yields. Today the iShares Emerging Markets Corporate Bond ETF yields 4.7%. This is investing in the debt of companies domiciled in third world countries that do not have the same legal and in many cases economic infrastructure that we enjoy in North America. If this investment yields less than 5%, what risks are people taking when stretching for 7% or 8% yields? It is very important not to confuse volatility with risk.
The point of accumulating assets is not so that you can spend them down quickly in retirement. Ideally, it is to rely on the income they produce. Of course, income does not mean simply nominal income, but real inflation-adjusted income. And in this regard, equities do best.
The last decade was one of most volatile on record, and even in that difficult period the Kingwest Avenue Portfolio not only produced attractive capital appreciation, but also saw dividends grow by over 10% per year — the dividend yield on the original investment of ten years ago is now over 5% (with the tax benefits on Canadian dividends this is equivalent to a 6.5% bond). Both income and capital have grown during a tough environment. The portfolios will provide increasing purchasing power over the next 10 years and will generate a growing stream of dividend income.
Do not worry about the volatility of the market. True enough, sometimes you will be selling when the stock market is depressed, but at other times you will be selling when the stock market is elevated. On average, it averages out. Patience is a virtue that will be rewarded.
The upshot is this: both the historical record and logic argue very strongly for stocks over bonds. Yes, stocks are more volatile, but if you recognize that the ‘investment horizon’ is always long and always receding into the future, the best bet, contrary to conventional wisdom is that even the average senior citizen should have the largest portion of their portfolio in equities.
A long-term approach is important on the investing side as well.
Companies create real value by investing in opportunities to earn attractive rates of return on the capital they have available to them. The more of those opportunities that they see and invest in the more value they will create for the company and for society as a whole. All this does not happen overnight. It takes time, not weeks or months but years. And so investing to create value, as is our purpose, also requires an outlook over a longer timeframe.
That is one of Kingwest’s real competitive advantages; we invest with a long-term perspective that looks beyond short-term market pressures to make investments that are based on the value of the business.
You can see it in our portfolios. On average, we have held our investments between 4 and 5 years. Most investors have much shorter timeframes. The average holding period for a stock listed on the New York Stock Exchange is 11 months and the turnover of Canadian mutual fund portfolios is similar. Most investors are renters, not owners. Our view is that an ownership culture is more effective and our longer term view gives us a leg up on the vast majority of investors who are looking for instant gratification.
Quality companies are key – but at what price?
Many commentators point to the fact that the stock market is overvalued with the S&P500 trading at 25 times earnings. The story is different on a closer inspection. The market is two–tiered in the US. There are some very expensive companies as well as some very cheap ones. There are still many pockets of value and opportunity.
Much has been made of the sky high valuations of Facebook (62x P/E) and Amazon (179X P/E). But the over extended value of some of the “quality consumer staples companies” is being overlooked. For example Kraft Heinz, Molson Coors and Colgate Palmolive all trade at over 45X earnings. In contrast, we have three big brand name companies in our US portfolio – American Express, Ingersoll Rand and Time Warner – that trade at much lower valuations. In investing it is the price you pay that is a key determinant of future return.
Recent Purchase: DuPont E I de Nemours (DD)
Dow Chemical and DuPont E I de Nemours agreed in December 2015 to combine in an all-stock merger. We are invested in DuPont (share prices prior to the announcement: DD $67.50; DOW $53).
The deal is a first step toward breaking into three separate businesses: an agriculture company to have DuPont in its name; a material sciences company to have Dow in its name, and a specialty products company, as yet unnamed. The deal is expected to close late this year or early next year.
We believe there is potential for operational improvement that mightgreatly exceed the announced savings of $4 billion per year, by expanding operating margins, driving organic growth, and increasing capital efficiency. DuPont is in the process of laying off about 10% of its staff worldwide and also it has spun off its performance chemicals business into a separate company.
A share in DuPont could reach $85 at the end of 2017excluding dividends, based on our view that the combined company is capable of generating earnings of $5.50 – $6.00 in 2018. Pro forma combined net revenue in 2014 was $74 billion, operating earnings were $15 billion, net debt was $13.5 billionand the company had an initial combined market value of $130 billion.
Given that these earnings will consist of contributions from several spin-offs, we believe it is likely that these more focused entities that remain will have earnings over 33% higher after the merger. This should cause them to trade at much higher valuations, providing us a return of 40%. We have owned DD for only a few months and are already up about 10%.
The strong businesses in our portfolio and their growing free cash flow over the next few years should continue to drive their underlying values higher. The capable managements continue to productively re-invest the cash flow of their businesses, successfully monetize assets, and prudently steward their balance sheets for the long-term. In sum we are very positive for the outlook for our portfolio.
This positive outlook shows up in the value of the companies in our portfolio in relation to their current price. For a stock to enter the portfolio it must have a substantial divergence between price and value. We continually monitorthe divergencebetween price and valuefor the portfolio as a whole – the ‘Value Gap’. Today our portfolio has a Value Gap of 42% so we see potential for some very good returns in the next couple of years.
We believe this strategy differentiates us in a meaningful way from other investment managers, even those that share a value approach to investing. Our performance history confirms not only that we are different, but that this difference is meaningful to you by generating more wealth. And it is sustainable. We have delivered superior returns for over 20 years and through 7 market cycles. The next few years should be even better.
As we look to the end of 2016 and into 2017, we see a business environment that poses continued challenges and uncertainties, but also exciting opportunities. Kingwest is in the strongest position in our history to seize these opportunities, with our entrepreneurial spirit, an exceptional team, and a rigorous investment process. These strengths will enable us to continue our consistent record of top-quartile performance for you.