Richard Feynman was a genius, Nobel Prize winner and one of the greatest physicists of all time. During his years of teaching at Caltech, he was always striving to make the most difficult concepts accessible and understandable to the widest possible audiences. He famously said that no professor fully understood a subject until she or he could explain it to a reasonably intelligent eight year old.
I am happy to say that what we do at Baskin Wealth Management is not theoretical physics, and we don’t need to be geniuses to be pretty good at it. However, I think it is worthwhile at the start of 2019, after a disappointing 2018, to make sure that we understand our process and thinking well enough to explain it to our clients, all of whom are significantly more intelligent, we believe, than the average eight year old.
What We Are Trying To Achieve
Every investor wants to make money, but wealth management goes beyond that. Our aim is to invest for each client family based on its own goals and needs, taking into account their individual risk preferences and time horizons. For all of our clients, we have always had an emphasis on protecting capital. We recognize that the possibility of higher returns comes with higher risks, and that prudent wealth management requires us to balance the risks and rewards of various strategies. We design our client portfolios with a view towards “Upside Capture” and “Downside Capture”. Upside Capture is the answer to the question: If the stock market goes up 10% (or some other number), how much will my portfolio likely go up? Downside Capture asks the opposite question: If the stock market goes down 10%, how much will my portfolio likely go down?
Our investment bias is to protect the downside and the steps we took to reduce risk proved effective in 2018, a year in which virtually every market and asset allocation category showed negative returns.
What Worked in 2018
Nothing worked very well in 2018, but some things worked better than others. The following strategies helped keep our losses to reasonable levels:
In 2009, after the great financial crisis, our client stock holdings were 100% in Canadian stocks. Over the next nine years we systematically decreased our Canadian holdings and increased our exposure to the U.S. stock market in particular. This proved very effective in 2018, as the sharp drop in the CDN$ vs. the US$ resulted in essentially flat returns on the U.S. securities in our portfolios, in spite of a drop of over 6% in the S&P 500 for the year.
We kept our bond maturities short, averaging about 2.5 years, compared to around 7 years for the broad bond index. As interest rates rose in 2018, bond prices fell and the longer the time to maturity, the steeper the drop. This resulted in a mediocre return of about 1.5% for the Canadian bond index. Our bonds held their value well and produced positive returns.
We remained diversified across sectors and across companies. We took profits when we thought advisable (and as a result some of our clients will have significant capital gains for 2018) and reduced our over-weighted positions in some stocks that had gone up a lot. As a result, the very sharp drop in value for stocks such as Apple and Facebook impacted our clients less than would have been the case in a market- weighted index fund.
We avoided disasters in bitcoin and other cryptocurrency products, most of which fell by between 80% and 99% in 2018.
We avoided the temptation to get into cannabis stocks. Canopy Growth opened the year at $30 and rose to over $76 at its peak. It closed the year at $36.60. Late buyers had huge losses. BC-based Tilray briefly rose to $300 before closing the year at $70, a stunning 77% loss for those who bought at the top.
We delayed our planned entry into foreign markets. This proved wise. Most foreign markets under-performed North America, with losses ranging upwards from 13%. This is an asset class we expect to add to our portfolios, but our decision to wait looks good for now.
Two companies held by some of our clients, Enercare and Dr. Pepper, were taken over at nice premiums. We don’t shop for companies based on their potential to be purchased by rivals, but sometimes acquisitive firms are attracted to the same kind of value stocks that caused us to become investors, and it is usually a welcome surprise when it happens.
We sold underperforming stocks such as General Motors, High Liner Foods, KP Tissue, Oracle, Molson Coors and Zimmer Biomet, and reinvested the proceeds of sale into fixed income products. We also trimmed over-weighted positions and took steps to reduce equity exposure for many clients. These actions reduced the negative impact of the stock market sell-off in the fourth quarter.
Finally, we maintained our zero-weight position in primary energy and metals explorers and producers. This worked out very well, as oil had a horrible year, falling over 25% for West Texas crude, and much more for Canadian oil which is stuck in Alberta due to lack of transportation infrastructure.
What didn’t Work in 2018
Lots of things didn’t work very well. Among the more disappointing for us:
Banks and other financial services companies had a dreadful year. Bank of Nova Scotia increased its earnings by 5% and increased its dividend by 8%, and the stock fell by 15%. U.S. banking giant JP Morgan had a slight increase in earnings and raised dividends by 18%, only to see a 7% drop in its stock. On average, our financial services holdings fell 11.8%.
Conservative stocks which we buy chiefly for dividend yield and steady value also had a bad year. TransCanada Corp. fell by 20% and Power Corp. fell by 25%, in spite of steady earnings and dividends. The yields on these high-quality holdings are now at 5.7% and 6.3% respectively, compared to a yield of about 1.9% on the 10 year Canada bonds. BCE yields 5.6% and Bank of Nova Scotia yields 5%. If the Bank of Canada and the Federal Reserve in the U.S. are finished raising interest rates, we would expect to see major upward moves in the interest sensitive sectors.
Companies that disappointed the market by missing the consensus forecast for earnings were crushed. Companies like Facebook (down 24%), Cineplex (down 32%), and Keyera (down 28%) were shown no mercy. When markets are nervous, short term fear always dominates over long term value.
Canadian preferred shares sold off sharply in November and December, partly for tax-loss related reasons and partly due to fear of higher interest rates. We started to see prices for these securities recover in the last week of the year.
Multiple Compression and Fear of the Future
We buy shares of companies that we expect to make money, not only in the current year, but for years to come. Shares are valued based on the amount of those expected earnings over time, which we think of as a stream of income. There are two major factors that go into putting a value on that future income stream:
How certain can we be that the earnings will in fact be realized? Forecasting the future is somewhere between difficult and impossible, and the longer out one tries to look, the hazier and more uncertain the forecasts. Analysts get around this by assigning a “discount factor” to future earnings. For example, if we expect Bank of Nova Scotia to earn $7.25 in 2019 (it made $6.90 in 2018) we can assign a reasonable level of certainty to that estimate. But beyond 2019, there are too many variables to deal with. So we might say that we value the expected earnings for 2019 at 100 cents on the dollar, but the expected earnings for 2020 at only 85 cents on the dollar, a discount of 15%, and the expected earnings for 2021 at only 72 cents on the dollar (a further 15% discount), and so on.
What will be the prevailing level of inflation and interest rates in the future? We all know that a dollar today is better than a dollar a year from now, since we can invest the dollar we have now or spend it at current price levels. If there is high inflation, next year’s dollar might only be worth 95 cents by the time we get it. When we assign a value to a stream of future income, discounting for the possibility of higher inflation and interest rates is a key part of the process.
In practical terms, these two factors are combined into a number familiar to most investors, the price to earnings (or P:E) ratio. A high P:E shows a high degree of confidence in the future, and likely an expectation of pretty low interest rates and inflation. A low P:E ratio reflects a higher amount of uncertainty, and perhaps the belief that interest rates will rise going forward.
How is it that Bank of Nova Scotia could increase its earnings in 2018 and still fall 15% for the year? The answer is that the market chose to value its future stream of earnings at a higher discount rate than was previously the case, and perhaps also added in a higher expected inflation rate.
A year ago, the market valued Bank of Nova Scotia at about 12.5 times its current earnings, demonstrating high confidence that earnings would increase in the future. A year later, it is valued at only 10 times its current earnings. In other words, the market is attributing 20% less value to the future earnings than it was a year ago. This phenomenon is known as “multiple compression” as the price to earnings ratio has been compressed. When this happens, even a company with rising earnings can have a falling stock price. During 2018, the P:E ratio for the combined S&P 500 fell from 21.8 to 19.6 times earnings, a compression of 10%.
Why the Markets are Fearful
There is a popular expression that stock markets “climb a wall of worry”, and in truth, there is always something to worry about. Sometime in the fall of 2018, the number of things to worry about seems to have built up and caused a general convulsion throughout the equity markets. The result was a very sharp drop in stock prices that started in late September and continued until late December. During that period the S&P 500 fell from its all-time high of 2941 to a low of 2346, a drop of 20.2% from peak to trough. The NASDAQ fell 23.9% and the TSX fell 16.9%. All the gains in the first three quarters of the year were erased, and portfolios fell into a loss position. December, 2018, saw the worst stock market performance for that month in over 70 years. So, what are market participants so worried about? In no particular order, here are the main concerns:
In spite of high employment, low inflation and record corporate earnings, there are signs of weakness in the U.S. economy. Housing starts appear to be weak, corporate profits, after adjusting for stock buy-backs and lower corporate taxes, are less robust than might be expected, and exports are suffering. Retail sales growth is anaemic and consumer confidence is falling. Most interestingly, in spite of very low unemployment, wages remain stubbornly low, restricting buying power for a significant part of the population and making growth more difficult.
Trade relations with the largest U.S. trade partners (China, Mexico and Canada) are strained as the White House continues to pursue a policy of import tariffs and aggressive executive actions in an attempt to reduce the U.S. trade deficit. The tariffs have not only hurt exporters such as Canadian manufacturers of steel and aluminum, but they have also hurt American users of these products. General Motors reported that its steel costs rose $1 billion in the last quarter due to tariffs. American exports of soybeans to China, once the largest market, fell to zero in November; the U.S. government is now providing direct subsidies to soybean farmers in partial compensation. As I write this, we have learned that Apple’s sales in China were hurt over the holiday period due to a weaker Chinese economy, a direct effect of the “Beggar your neighbor” Trump trade policy.
The U.S. Congress will be under divided leadership starting this month. The possibility of impeachment proceedings against President Trump appears to be high, and a deadlocked Congress is seen as unlikely to take actions to help the economy.
The recovery after the great financial crisis of 2008-09 is long in the tooth by any measure. Some economists (David Rosenberg prominent among them) are forecasting a recession as early as the 2nd half of this year. Recessions are notoriously difficult to forecast accurately, but certainly there are causes for concern.
Oil prices are at multi-year lows. This is particularly worrisome for Canada, which relies heavily on oil exports to earn foreign exchange and provide employment in western Canada.
Debt levels are at record highs for governments, companies and consumers. Any increase in interest rates will increase the amount of money needed to service debt, taking it away from consumption, corporate investment and corporate profits. In spite of this, the US Federal Reserve and the Bank of Canada continued to raise rates during 2018. Those with long memories know too well that more than one recession was preceded by quick increases in interest rates.
Full Speed into 2019
The best asset category in 2018 was 90 day treasury bills, essentially, cash. In other words, the only winners in the investment game were those who refused to play. This last happened in 1994, and history shows that the odds of it happening two years in a row are very small indeed (although the period of the late 1970’s when short term rates exceeded 18% provides a one-off example of cash being king for an extended period). We will not play the game of forecasting the level of the market indexes for the end of 2019. Currently, we do see lots of bargains in beaten-down high quality companies, some with dividend yields last seen 10 years ago. Experience has taught us that such opportunities should not be ignored. We also know that the stock markets and the real economy are not the same thing, and do not always move in the same direction. A falling market does not always portend a recession; and a recession does not always result in falling markets.
One of Richard Feynman’s colleagues on the Manhattan Project, which resulted in creation of the atom bomb and the dawn of the nuclear age, was the physicist Enrico Fermi. After hearing a lecture he commented: “Before I came here I was confused about this subject. Having listened to your lecture I am still confused. But on a higher level”. We hope you found this essay helpful, and we hope, not confusing. As always, our account management team is only a phone call or email away and would be happy to discuss matters with you at any time.
Best wishes for a happy, healthy and prosperous New Year.