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Market Update – July, 2022


Securities markets are experiencing a difficult moment. Many great businesses are now significantly undervalued. When will the market turn? We do not know.  But the long-term outlook is attractive. We have a substantial cash hoard to invest at these hugely discounted prices and expect this will prove to be very profitable over the next few years. This is the best opportunity in the stock market since March 2020.


Abroad indicator of the US stock market, the S&P 500 index, declined 20.6%, the worst first half year since 1970. All sectors dropped apart from energy, which ended 32% higher as oil prices jumped. The Nasdaq index which is heavily weighted to technology companies fared even worse, falling 29.5%.

Other global markets have also pulled back sharply this year. In US dollar terms, Europe’s Stoxx 600 was down 21%, and the MSCI Emerging Markets ex-China index slumped 18%.

The bond market was no safe haven. Bond prices plunged 12%. Over the last decade bonds have delivered a meagre 1.7% annual return. What was widely expected to be ‘no risk, high return’ turns out to be ‘high risk, no return’.

US stocks had the worst first 6 months since 1970

                                                                                                                                                                                 Source: Financial Times

The S&P/TSX index was the best performing index in the developed world, but was still down 9.9% including dividends. Surges in oil and commodity markets in which the TSX is very heavily weighted saved it from the fate of the other world exchanges.

As you know, our portfolio has almost negligible investments in those commodity oriented sectors. Nevertheless, at the time of writing, our Canadian portfolios are off around the same as the index. Why? The businesses we invest in are performing well.

We invest in businesses that are building sustainable cash flow — the cash a company will generate in a normal economic environment — thereby increasing the value of the business. While the market is soft,

our businesses continue to increase in value. When will the stock market reflect that increase? As we have seen all too often, timing the stock market is a random, unpredictable event. What is predictable is that the market will reflect economic values in ‘normal times’ and those businesses building real value will be rewarded.

During the past year the earnings of the TSX index were buoyed by the price of oil and metals which skyrocketed as a consequence of the Ukraine war. But those earnings do not translate into long term sustainable earnings. They are cyclical. You can see in the chart below that the big profit increases were not generated by comparable revenue increases.

The earnings in the companies we own are sustainable. They come from building the business, increasing revenue and in turn increasing profits.

We acquire fractional shares in businesses which offer attractive potential returns on our investment. It is not enough for the businesses to increase in value. Over many years of experience, we have found that profit opportunity is greatest when dislocations in the market cause stock prices to disconnect from their value. This is particularly true for businesses that are building value.

For many years we have been telling you about what we call the Value Gap. That is the difference between our estimates of the value of the businesses we own and their current stock price. The business value is the price an arm’s length purchaser would pay to acquire the entire business. The disconnect between those values and their price in the market is our opportunity to really accelerate returns in your portfolio.

The Value Gap is indicative of the returns we should expect from the portfolio over the coming few years. Currently the Value Gap is near a historical peak: 59.9% in Canada and 74.3% in the US.

The uncertainty in the market has come from the possibility of a looming recession in North America and Europe. Early indications from the Federal Reserve Bank of Atlanta suggest that the US economy may already be in a recession. That concern is heightened because the days of relying on central banks to ease monetary policy and support the economy are behind us. The Fed is tightening policy to combat inflation.

Investors frequently obsess over these near-term uncertainties and ignore longer-term trends. This shortsightedness sometimes causes a significant gap between business value and stock prices. While uncomfortable, this process is where the most money is made in public markets because the economy will recover as it always has, businesses will again have upward momentum and stock prices will climb to new heights. This is a certainty. Only the timing is in question.

The unique opportunity of public markets is the opportunity to arbitrage the disconnect between stock prices and business values.

Has the market reached a bottom? We cannot say. What we can say is that looking over the valley, the stock prices of many companies are very cheap. They will not stay cheap forever.

Take the Canadian banks for example. The strength of banks is easily measured by referring to the three C’s: capital, credit and conditions. As we just said the economic conditions are uncertain in the near term. Longer term the outlook for the North American economy looks robust.

Mortgage loans account for 65% of total loans. Even in what appears to be a slowing housing market, the bank’s mortgage portfolios are in very good shape. Five-year mortgage rates have risen considerably from 1.87% on February 23, 202l to around 5.25% today.

Only a small portion (3%) of Canadian mortgages have variable payments and therefore are vulnerable to these higher rates. The balance have fixed payments. Mortgages taken at the low rates of the last couple of years do not renew until 2025. The mortgages that will renew this year had rates of roughly 3.5%, and they are associated with the much lower housing prices of 5 years ago, leading to little risk. 

Corporate credit is also strong. Corporate balance sheets have improved over the past year. Total cash to debt is an all-time high. This share of corporate debt accounted for by firms at risk is also noticeably smaller than it was earlier in the pandemic (3% in the fourth quarter of 2020).

Finally, the capital position of Canadian banks has never been stronger or more resilient. They can easily withstand an economic downturn, should one occur.

Nevertheless, Canadian bank stocks have fallen 20% from their record high in early February as recession fears set in. If a recession is on the horizon, profits may soften, but they will recover as the economy recovers. The Canadian bank stocks yield between 4.2% (Toronto-Dominion Bank) to 5.3% (Bank of Nova Scotia and CIBC). None of the five major banks have cut their dividend in over a century.

Higher rates are not negative for banks. Banks profit from the interest spread — the difference between the rate at which they lend money and what they pay for it. It is difficult to make a 2% spread from a 1% interest rate. Now that rates are normalizing, banks can go back to earning a normal spread which should drive profits higher.

With high and secure dividends, depressed stock prices and strong fundamentals, Canadian bank stocks are cheap.

We focus on results, not activity. We buy businesses when they are undervalued. Ones that create value which has not yet been reflected in their stock price. We have owned some companies for over a decade. In total they aggregate about 25% of the portfolio: BCE, FirstService Corporation, Manulife Financial, Quebecor, TMX Group, TELUS, Toronto-Dominion Bank, Howard Hughes Co, Ingersoll Rand, and Morgan Stanley.

In addition, there are a number of businesses we sold when their stock price reached full value. When their stock price subsequently retreated, we took the opportunity to buy them again: Canadian Imperial Bank of Commerce, Equitable Group (EQB Inc), Cenovus Energy (Husky Energy), Citigroup, General Electric, JP Morgan Chase, and Las Vegas Sands.

We do not buy and hold forever. Our process requires continuous work to ensure the companies we purchase are preforming as expected. When share prices exceed the business value we sell.  For example, we purchased First Quantum Minerals about 3 years ago in the low teens with the expectation that the planned expansion of their copper production over the following years would drive sustainable cash flow and thereby push the share price higher — our valuation was $30.

It came to pass, albeit slower than originally anticipated, but relatively on target. Early this year we sold the shares around $30. The stock price subsequently traded as high as $44 but has now retreated to $23.

We are not able to judge “the madness of crowds”. We are able to reasonably assess business value. If we stick to what we can know, and avoid the games others play, we are confident that we will continue to deliver the attractive long term investment results you seek.