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Rarely does life go as planned….
It may be hard to remember, but 2020 started well. The stock market reached a new high on February 19th in both Canada and the US. It looked like 2020 was going to be a good year. By March 23rd that was a distant memory. The North American markets had fallen over 35% in the previous 33 days, the steepest slide ever in such a short period. Almost no companies had gone unscathed. The future looked bleak indeed.
The change that happened thereafter was almost unfathomable. The stock market started to rise. But the rising tide did not lift all boats. Only those stocks in companies which might benefit from the “stay-at- home” economy improved. A number of industries benefited tremendously from the pandemic, unlike a typical economic recession when almost everyone gets hurt. The largest firms also performed well or better than their smaller rivals, as they had better resources to adapt.
Then as the prospects for a vaccine to end the pandemic became more real, the tide shifted, the stay-at-home stocks lost some of their mojo and the stocks that would benefit from an economic recovery rose. By year end the tech heavy NASDAQ and S&P 500 had risen double digits, the Dow Jones Industrial Average (DJIA) gained a more modest 6.9% (+5.0% in Canadian dollars) but the S&P/TSX improved only 2.2%.
That climb has continued through today even though the pandemic that caused it all has raged on. Two vaccines have been approved in Canada and the US and the end of this horrific pandemic might be in sight.
Rarely does life go exactly as planned. If you convince yourself that you know exactly how it is going to play out, you are setting yourself up for certain failure.
At Kingwest, we do not make forecasts of the economy or of the market. Why not? We cannot do it consistently, and we do not know anyone who can. So, forecasting seems a weak foundation on which to sit one’s financial future.
For information to be valuable, it must be both important and knowable. Knowing what will happen in the future is clearly important, but the future is unpredictable — unknowable. Our crystal ball is no better than anyone else’s. In other words, it is useless at best. It is not that these macro factors do not matter, but rather that they are virtually impossible to consistently predict with any accuracy. Forecasts of the future are little help in achieving investing success.
John Kenneth Galbraith put it well, “The only function of economic forecasting is to make astrology look respectable.” (Tim loves quotations, and this is one of his favourites).
At Kingwest, we spend our time instead trying to understand the environment, not forecast it. By observing the path of the economy and by studying industries and companies, we hope to be able to put together a portfolio of companies trading at large discounts to what they are worth. If we are right, over time the market price will converge on business value.
How to respond to the challenges presented by the pandemic is about facing an uncertain future. This is similar to the problem in investing.
In their recently published book, “Radical Uncertainty”, John Kay and former Bank of England Governor Mervyn King describe what is required for decision making for an unknowable future is not rocket science. It is common sense.
Complex mathematical models are not useful guides to action due to a lack of accurate data. There are too many of what former US Secretary of Defense, Donald Rumsfeld called “unknown unknowns”.
In an uncertain world, the greatest challenges are unique. People frequently overreact to dramatic and unexpected negative news. To complicate things even more, these behaviours are reflexive: the action itself can cause the reality to change, keeping the reality in constant motion.
Just because we do not have accurate data on which to base decisions does not mean people will stop acting as if they had — this is particularly true in the world of finance, where number crunching is addictive.
At the onset of the global financial crisis, the CFO of Goldman Sachs, David Viniar, notoriously referred to the markets experiencing a 25-standard deviation event. Kay and King describe the “Viniar problem” is “the mistake of believing you have more knowledge than you do about the real world from the application of conclusions from artificial models.”
The current approach to the Covid-19 outbreak is another example of this problem in action. Just as Wall Street had its financial risk modelers, politicians have become excessively dependent on mathematical epidemiologists. The high death rate forecast produced by modelers at the University of Washington is said to have prompted the American government to adopt a lockdown.
Nonetheless each forecast is wildly different from the last. What good is a forecast that is never right? The problem is that nobody knows how much of the population is already immune to Covid-19. And the spread of the disease has changed peoples’ behavior which causes the data to constantly change, that is, it is reflexive.
Kay and King suggest that when faced with uncertainty the best response is to ask a simple question: What is going on here? Rather than jumping at a fixed answer, remain open-minded. What is on will adapt and change as new information becomes available. While models can help to frame problems and examine scenarios, decision makers should never be tied to their predictions. That is a route to failure.
Since the coronavirus pandemic, however common sense has played second fiddle to mathematical models. Over time it has become evident that Covid-19 contraction and fatalities are largely confined to hospitals and care homes. Had policy makers not been so obsessed with the models; would so many infected patients have been moved from hospitals into nursing homes with such tragic results? Perhaps it is worse because it is made to sound like science.
Someone wise once said that all the problems of capitalism are agency problems. Agency costs arise when people act like a renter not an owner. Do you take better care of a home you own or one you rent? This agency problem has no easy solution — but investors could be quicker to ask searching questions.
That is why we emphasize our “owner’s” approach. We are accountable for our actions and we provide your returns at the top of each of these reporting letters. Most managers report returns when they are good, avoiding them when bad. As Mr. Justice Louis Brandeis said, “Sunlight is said to be the best disinfectant.” Transparency goes a long way to alleviating the agency problem.
To provide the superior sustainable long-term returns quarterly returns will sometimes lag. Time is the ultimate test. For almost forty years we have been able to prevail.
Wither the economy now?
The continued rise of equity prices rests on three pillars 1) the extraordinary monetary policies unleashed by the world’s central banks, 2) optimism that Covid-19 vaccines will eradicate the disease relatively soon and let us live “normal” lives again, and 3) continued fiscal stimulus combined with historically high cash balances in both consumer and corporate hands will boost economic growth.
Investors seem to have concluded that, after a more than decade long bull market fueled by cheap money, that there is little to be gained by standing in the way of the Fed. Furthermore, low interest rates make valuations at the high end of the historical range seem to make sense. And Fed officials continually reinforce that these near-zero interest rates will remain until at least 2023.
There is a genuine case for optimism. Following Democratic candidates’ victories in the Georgia senate run-offs, the prospects for more fiscal stimulus has increased. This caused 10-year bond yields to bump up a bit following the results — the US 10-year yield rising to 1.1% (it was 1.8% last January) and the Canadian 10-year bond rose to 0.9% (1.6% last January). Control over the presidency and both houses of Congress will allow the Democrats to pursue a bigger fiscal stimulus, this combined with mass inoculations, this will drive a swifter economic rebound.
We have recently added a few companies to the portfolio. So far, they are doing quite well.
GFL Environmental is new to the public markets; the company came public in February last year. GFL is North America’s 4th largest waste operator providing solid waste management, infrastructure and soil remediation and liquid waste services. GFL has developed through an acquisition strategy. It has strong barriers to entry, enjoys strong pricing power, the industry remains fragmented despite years of consolidation and is resilient in tough economic times. Currently, GFL is integrating two very large platform acquisitions that we expect will increase margins and free cash flow. Given the company’s past success of buying smaller companies we see these two platform assets adding years of densification value-enhancing acquisitions ahead. Additionally, GFL’s existing collection routes have industry leading opportunities to raise prices. Over the coming years we expect these actions to drive free cash flow while helping to bring the company’s debt levels to industry averages.
Comcast was added to our portfolio late last year. Comcast is a communication and media company. It owns the Comcast cable business, which includes broadband for residual and business clients, video, and wireless, as well as content such as NBCUniversal, cable and broadcast stations, theme parks and the UK-based Sky, Europe’s leading direct-to-consumer media and entertainment company. The crown jewel within Comcast’s portfolio is the company’s broadband services which enjoys enduring competitive advantages. The company’s fast broadband speeds, along with increasing demand for broadband usage and Comcast’s local monopolies ensure staying and pricing power. Additionally, Comcast is able to leverage these broadband relationships and offer a compelling wireless product which we view as a great value to customers. The cable division is well positioned to handle the continued video cord-cutting and at the time of our purchase our assessed value of Comcast’s cable equaled the share price. In other words, NBCUniversal including the content, cable and broadcast stations, theme parks as well as the Sky operations were free options. Collectively these divisions contribute 35% to Comcast’s total cash flow. Comcast has historically been family controlled and that is no different today with Brain Roberts, son of founder Ralph Roberts, the company’s CEO and Chairman. This founder-family control has allowed Comcast to make strategic, value enhancing decisions, potentially at the expense of short-term profits. Ultimately, we believe the non-cable assets will be worth more in the future either through internal developments, divestures or further consolidation.
We are optimistic about the prospects for the portfolio. We will proceed through this pandemic at some point, hopefully in the next few months, that will drive the economy as we all get the opportunity to return towards more normal activities. That will spur the economy from the COVID induced slowdown, and it should improve the stock market as well. The other main driver of the market is interest rates, and the leaders of central banks in North America consistently say interest rates are not going up until 2023, at the earliest. If those conditions prevail, we should enjoy a good environment for stock investments.
Take care and stay well.