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A reason for optimism


There are both bright spots and holes in the economic recovery but on balance the outlook is very positive and that will drive stock prices higher over the coming year.

Our portfolios have underperformed so far this year. This is not the first time this has happened. In fact, it has happened once every decade since we formed our firm 38 years ago. Nevertheless we have outperformed by 3% compounded per year over that whole period. Over time, stock prices reflect the inherent value of companies, and our portfolio today is trading at a very large discount to the inherent value of its businesses. We are very optimistic over the course of the next year.

Winston Churchill said: “A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.”

Our business model has proven very resilient in past periods of disruption. This time will be no different. We have a simple belief that we should only expect to make money in things we understand. By ‘understand,’ we are not talking about what the product does or anything like that. We mean understand the economics of the business; the competitive aspects of the business, and what it will likely look like in the foreseeable future. Every one of our investment decisions is informed by extensive research, a long-term focus, and the expert insight of our professionals. All focused on coming up with a reasonable value for what each business is worth.

The economic environment is improving

We are all aware of how much the economy suffered during the first half of this year. The U.S. economy declined at an annual rate of 5% in the first quarter followed by a 31.4% drop in the second quarter, by far the most severe drop on record. The largest previous decline was 10% in the first quarter of 1958; during the Great Recession the biggest fall was 8.4% in the December 2008 quarter.

But focusing on annualized numbers distorts the true nature of what is happening. In simple numbers for the first six months of the year the economy was down 10.1% . Over the last few months the economy enjoyed unprecedented growth as it began to re-open. The range of forecasts are that the U.S. economy grew somewhere between 15% and 35% in the recent quarter. An unheard of disparity! For the year the economy will probably be down around 4.5%, not so terrible given where we have come from. The rosiest forecast comes from the Federal Reserve Bank of Atlanta that expects only a 1.25% decline this year.

Happily, the economy is expected to continue to expand next year as the health crisis continues to ameliorate. The consensus is for growth to rebound by 5% or 6% in 2021. So by the end of 2021, the economy should surpass where it started 2020.

The Canadian economy is following a similar trend. Economic activity dropped 11.7% in the first six months and will probably end the year around 5.5% below last year. Our government has committed to substantial fiscal support and signalled more is to come which together with the booming housing market suggests that consumption could rebound a relatively quickly. Given that, our economy should be 5% to 6% better next year, and improve a further 3.5% in 2022.

Interest rates will be lower for longer

Interest rates collapsed in March as both the Bank of Canada and the U.S. Federal Reserve tried to counter the economic catastrophe caused by the pandemic. Today 3-month Treasury Bills yield 0.11% in Canada and 0.09% in the U.S. bond yields are similarly low. Canada 5-year bonds yield a paltry 0.37%; and 0.61% for 10 years. The U.S. 5-year bond yields 0.33% and the 10 year yields 0.78%. In effect, the government pays nothing to borrow our money.

The Bank of Japan and European Central Bank, two key central banks, also took on massive stimulus campaigns to help out their economies. The ECB, for example, is running a crisis bond buying programme worth more than 1.3 trillion euros. The BOJ, meanwhile, has pledged to buy an unlimited amount of bonds to keep borrowing rates low. China’s central bank, the People’s Bank of China, has cut its one-year loan prime rate to 3.85% from 4.15%. 

If we listen to, and believe, the briefings coming from the Federal Reserve and the Bank of Canada, it appears that this extremely low interest rate environment will continue for a long time to come.

And equity markets will continue to rebound as the environment improves

In Canada the S&P/ TSX is off 5% in the first 9 months. This number is understates the decline in the average stock. For example one company alone accounts for 3 percentage points of positive return of the index. Shopify stock has soared 2.7 times since the beginning of the year and has seen its market value grow to $170 billion, approximately $35 billion more than the Royal Bank of Canada (the second most valuable company in Canada). This company sells for 62 times revenues yet had an operating loss of $63 million for the first half of the year. Yes, revenue is growing very fast, but this price requires growth to continue for many years just to justify the current price. Who can know what will happen so far into the future in an ever changing business? Excluding  this one company, the average stock is down well more than the Index.

The story is the same in the U.S. The S&P500 index is up 3% since Dec 31st. Five companies, Facebook, Amazon, Apple, Netflix, and Microsoft, comprise almost 25% of the Index and each has benefitted from the COVID-19 pandemic. Historically the largest five companies account for around 12% and they have never previously exceeded 17%. This index gives a poor picture of the behaviour of the average stock. You get a clearer picture by looking at the S&P index with each company equally weighted. When you look at the index this way, the stock price of the average U.S. company is down 6.4%.

The good news is that the economy looks like it will continue to improve for quite a while. In the U.S., businesses are still rehiring workers but the gusher of government assistance which ended July 7th may have run its course.

U.S. employment rose by 661,000 in September, but was well below the 1.1 million expected. Local and state governments reduced jobs by 216,000 due to a drop in education as many schools maintained at-home instruction due to the virus. A reduction in Census workers also pulled 34,000 from the total.

Nevertheless, the unemployment rate improved to 7.9% from 8.4% in August. The number of  discouraged workers and those working part-time for economic reasons also saw a notable decline, falling from 14.2% to 12.8%. In sum, the labour market continues to recover but there is still a ways to go. Higher employment will push consumption expenditures and economy higher.


Monthly job growth


The employment situation in Canada is steadily improving with 378,200 jobs, +2.1%, added in September. The unemployment rate fell to 9.0%, down 1.2% and down from 13.7% in May, as children returned to school and the economy continued to reopen. The number of Canadians who were employed but worked less than half their usual hours for reasons likely related to COVID-19 fell by 108,000 ,-7.1%, in September. Roughly 76% of the three million jobs lost in March and April have been recovered; the U.S. has recouped only 52% of its lost jobs.


Strong Employment growth in  September

Source: Statistics Canada The Daily Labour Force Survey, August 2020


Where do we go from here?

The portfolio is very well structured. One way we measure that is with the “Value Gap” — the divergence between what we believe the businesses we own are worth and their stock prices, weighted consistent with our portfolio.

The “Value Gap ” is near its highest level ever. This means to us that the opportunities are as good as they have ever been. We are very confident about the potential for strong returns from the portfolio.

So why are we behind the market? We have a few companies which have been hurt by the COVID pandemic but have not yet recovered.

The financial stocks have been hurt and have stayed hurt. Yet the businesses are as strong as they have ever been. In Canada the negative story on the banks has been worry about the housing market. Despite the coronavirus pandemic, house prices continue to rise reducing the risk of problems in the mortgage market. Nevertheless, the share price of the average bank stock is down 15% since the end of the year. The big five banks sell at single digit price to earnings ratios with dividend yields that range from 5.1% at the TD Bank to 6.4% at the Bank of Nova Scotia. These stocks are very cheap, but not glamorous.

Outside of the big banks we own Equitable Group, a growing Canadian financial services business that operates through its wholly-owned subsidiary, Equitable Bank, Canada’s Challenger Bank. This is the country’s ninth largest independent Schedule I bank with a proven branchless approach and exceptional customer service focused on providing residential lending, commercial lending, and savings solutions to Canadians. The digital banking platform provides state-of-the-art digital banking services, and is at the forefront of this business. The company has a book value of $84.89 per share, up 10% from a year ago, compared to its $77 stock price. And the earning power is very strong and growing; Equitable is earning $3 per quarter ($12 per year). This business is substantially mispriced.

We have been asked why we have such a heavy weighting in real estate. Our real estate portfolio in aggregate is up about 2% so far this year.

We own very different kinds of what are deemed real estate. FirstService, for example, is a company with long term recurring contractual earnings that neither owns nor develops property. Rather it sells its services into the real estate market. It is not what you think of when you talk about real estate. Yet it is included in the real estate index.

The company continues to do very well throughout the pandemic and the stock price reflects that. It was $120 at the beginning of the year; it is $175 today.

Brookfield Properties owns some of the highest quality office buildings in major cities in the world. It is the second largest owner of high quality shopping centres in the U.S. The office portfolio is receiving 96% of its contracted rent and has throughout this disturbance.  Furthermore, Brookfield is in the midst of the sale of an office building in London at a peak valuation, well above what is implied by the share price. The company is also the second largest owner of high quality shopping centres in the U.S. While that income has been hurt by the closedown of centres in the U.S., almost all of their centres are now open, the occupancy remains high, and the rental rolls are on their way to returning to normal. The stock yields 10.8% and the dividend is secure. The underlying properties are worth around $40 per share; the stock price is $17. Certainly it will take some time for the stock to reflect that value and the economy will have to be getting back to “normal”, but with a very high dividend income and very cheap real estate, this stock offers superb capital appreciation potential.

Our newest investments made since March have all done  well. In Canada, GFL Environmental is up about 10% in just a few weeks, Empire Company is up 35%, and SmartCentres is up over 10% and we have earned an additional 5% from dividends since we bought it.As the virus worries subside and people can get back to their lives, these companies will enjoy exceptional success and the portfolio will do extremely well.

The story is similar in the U.S. The other newest investments Alphabet, Facebook, MasterCard, and Sonos are each up over 30% each.

In summary, we are optimistic. Like all cycles, this one too will come to an end. Panic and depression will be replaced by hope and optimism. The catalyst will be the end of the global health crisis. As economies open back up, which we are beginning to see, and investors realize that we are in a lower for longer interest rate environment, our portfolio which trades at a substantial discount to its value, should provide ample returns over the next two to three years.