The Goodreid Gauge Winter 2019
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Goodreid Investment Counsel Corp. 1 The Goodreid Gauge Winter 2019
Goodreid Investment Counsel Corp. 2
The Goodreid
Gauge
Winter 2019
2018 came to a sombre and dramatic on this somewhat maligned and misun- the stock markets through this de-risking
close with sharp losses in both the Cana- derstood asset class to -8.6%. Corporate process and by re-balancing portfolios to
dian and U.S. stock markets, as festering bonds stood alone among our four major their agreed upon asset mixes, we have
concerns about waning economic asset classes in booking gains for the steered the majority of our balanced ac-
growth, rising interest rates and dysfunc- quarter and for the year, with the FTSE counts to a somewhat disappointing, but
tional government finally came home to TMX Canada Short Term bond index not crippling, annual loss of 2% or so,
roost. The S&P TSX Composite index earning a total return of 1.4% for the whereas the average North American
incurred a loss of 10.1% during the quarter and 1.9% for the year. Clearly balanced fund dropped almost 7% in
fourth quarter, erasing the year’s gains as this is nothing to jump up and down 2018. This is exactly what active and
the ink dried on 2018’s total return of - about, but then again, nor should it professional investment management is
8.9%. The S&P 500 Index, which be….bonds are “boring” to some, per- supposed to do. Take comfort in know-
throughout the first nine months of the haps, but we have long advocated that ing that as exchange traded funds (a pop-
year had been bulletproof and largely the role of bonds in a balanced portfolio ular form of passive investment) garner
immune from broad-based stock market is to generate reliable income, to act as ever greater inflows and now manage by
weakness around the world finally an uncorrelated diversifier and an offset some estimates nearly half of all equity
“caught down” to the rest of the world to an otherwise all equity portfolio and to assets, and as their purveyors loudly
with a steep 13.5% loss. This dragged provide capital security, thus dampening trumpet their virtues: transparency, sim-
2018 into the red to the tune of 4.4% af- the raw downside volatility that an all plicity, liquidity and most notably their
ter an unprecedented and uninterrupted equity portfolio incurs from time to time. low fees, all of this has been shown to be
nine-year string of annual gains for U.S. a false economy with the typical Good-
stocks. Canadian investors in U.S. While we were disappointed by the eq- reid balanced account ahead of its peer
stocks however fared better, as a uity market weakness late in the year, we group benchmark by hundreds of basis
strengthening US$ actually pulled the were not entirely surprised by it and had points. But also be aware that active
S&P 500 Index into positive territory been taking steps proactively and itera- management is by definition active,
when measured in C$ for the full year tively to de-risk portfolios over the meaning both that our portfolios will dif-
(+4.1%). This Canadian currency weak- course of roughly the last five quarters to fer meaningfully in composition from
ness took some of the sting out of the position for the late cycle stages of the their benchmarks and that periodic trad-
fourth quarter’s loss, with the C$ total re- economic cycle. By and large these ef- ing will occur to adjust portfolios and to
turn of -8.6% still disappointing, but forts were rewarded, although it may not rebalance to target asset weights. This
meaningfully better than a US$ investor be intuitive to most that the rewards were makes the Canada Revenue Agency in
would have fared. The Solactive Lad- evident after a quarter like this one. But some sense your partner as trading real-
dered Canadian Preferred Share Index we firmly believe that a dollar saved is izes capital gains upon which taxes need
was extraordinarily weak during the equivalent to a dollar earned, and in in- to be paid. This year clients will have re-
fourth quarter with a total return of - vestment terms a loss avoided is as good alized somewhat higher than usual capi-
11.1%, which brought the full year loss as a gain that is actually earned. By side- tal gains as we, for instance, took partial
stepping some of the bigger landmines in profits in the FAANG (U.S. tech) stocksGoodreid Investment Counsel Corp. 2
early in the year and sold companies like Because the economy grows over time, faces odds of success of just 55% in
Shopify and Magna later in the year. and with it grow profits, stock prices rise Canada and 53% in the United
While writing cheques to the taxman is inexorably over time, albeit in an irregu- States….somewhat better than a coin
no one’s favorite pastime, it is a neces- lar zig-zag fashion. Over the past one toss, but a far cry from the near certainty
sary and recurring side effect of a suc- hundred years an investor in American of success that the long term investor en-
cessful investment strategy and in effect stocks with a five-year time frame has joys. While the explanation may be
it is the proof that the process is working. earned positive returns in 89% of all somewhat belaboured, the point cannot
five-year periods ending December 31st . be overemphasized: time in the market
Devil’s advocates might ask why, if we An investor in Canadian stocks has also is the investors’ friend whereas timing
weren’t entirely surprised by the stock earned positive returns in 89% of all the market is a glorified coin toss. Like
market rout during the latter part of the such five year periods. An investor with it or not, we know that periodic losses
year, didn’t we fully de-risk portfolios by a one-year time frame over the past 100 are a normal and recurring risk in the
going to 100% cash? At the risk of years has seen annual gains 67% of the market, although they are outnumbered
sounding like a broken record, we ada- time in Canadian stocks, and 72% of the and significantly outweighed by gains,
mantly refute any and all claims and si- time in U.S. stocks. An investor with a particularly as the benefits of compound-
ren songs of those pretending they can three month time frame sees those odds ing accrue over a long span of time. We
successfully time the markets. With of success slip to 64% in Canada and strive to be “less bad” in difficult mar-
many decades of combined experience 66% in the United States. An investor kets and “better” in strong markets and
managing portfolios, we have heard with a one-month time frame sees the we know that over time if we succeed in
many such claims…some elegant, some odds of gain slip further to 58% in Can- doing so, we will leave passive invest-
elaborate, some even downright alluring, ada and 60% in the United States. And ments and ETFs behind.
but none validated by a consistent track the day trader with a one day time frame
record of success in executing what
amounts to not one, but two binary (“all
in” and then “all out”) decisions. We do
know that sentiment is a contrarian indi-
cator though, meaning that when the hue
and cry is loudest to be “all in”, the pro-
spective returns are lowest. This would
have been approximately the prevailing
condition in U.S. equity markets around
late January of 2018. Conversely, when
greed has gone into deep hibernation and
fear is in the driver’s seat, prospective re-
turns are most promising. This would
have been roughly the prevailing condi-
tion in Canadian and U.S. markets in
early 2009 or in January/February of
2016, for instance. We can measure cor-
porate profits and margins, we can ob-
serve interest rates and we can estimate
earnings growth rates and derive compu-
tationally elegant estimates of the fair
value of any single stock or even a whole
index of stocks. But we know that fear
will push market prices well below their
theoretical fair value from time to time
and greed will push market prices well
above fair value from time to time. Ra-
ther than try to gauge nebulous and diffi-
cult to forecast investment sentiment by
making “all in” and “all out” binary mar-
ket timing decisions every few years, we
simply recognize that equity investors
supply the risk capital in the economy
and thus own the profits in the economy. Table 1Goodreid Investment Counsel Corp. 3
The other obvious implication after a original investment via share price ap- Canada may pause its rate hike campaign
quarter like this is that the horses have preciation. at some point in 2019, we don’t expect
run out of the barn already…that is to them to go into reverse as they did in
say, prices, valuation and sentiment are Understanding this hierarchy, there are 2015.
all markedly lower and thus prospective basically two factors that can meaning-
returns are correspondingly higher, as fully move the price of a rate-reset pre- As to credit concerns, we note that the
the above table which shows the 22 other ferred share: changes in credit risk and preferred shares we own are all issued by
instances since 1928 (out of 364 quar- changes in interest rate expectations. investment grade credit rated companies.
terly results) during which the S&P 500 Changes in credit risk reflect investors’ Investment grade credit bonds, as meas-
Index fell by 13.5% or more during a assessment of the risk of a preferred ured by the FTSE TMX Canada Short
quarter clearly demonstrates. Outside of share issuer encountering financial dis- Term Bond index, actually made modest
big quarterly losses incurred the Great tress as preferred shares hold the second gains this quarter (+1.2%) despite some
Depression in the 1930s, stocks have lowest priority claim on corporate assets. modest widening of credit spreads, so it
only once failed to rally the year after a Small changes in perceived credit risk does not logically follow that any severe
big loss and have never failed to rally can drive significant changes in the price credit degradation occurred this quarter.
over the subsequent 3 and 5 years. of a preferred share, particularly if a
company’s credit rating is formally Ruling out both of these factors as the
Turning now to the smallest and most downgraded as this can trigger forced explanation for the decline leaves only
“niche” exposure among our four asset selling by passive investors and ETFs the conclusion that the market has over-
classes, let’s explore the role and the per- with prescribed minimum credit quality reacted, creating a timely opportunity for
formance of preferred shares in balanced thresholds. Changes in expected interest investors to capture a tax-advantaged
accounts, which we freely concede was rates can also impact the prices of rate- dividend yield of 4-5% in the preferred
dismal and rather perplexing this quarter. reset preferred shares, as the terms of share market currently, as well as scope
these shares include a dividend reset fea- for modest price appreciation as the $25
First, we step back to demonstrate where ture at five-year intervals, with the divi- par value of the preferred shares asserts
preferred shares sit in the capital struc- dend reset to a level indexed to the then its gravitational pull via the dividend re-
ture of a company, since this asset class prevailing five-year Government of Can- set mechanism.
in not well understood by most investors. ada bond yield plus a prescribed credit
In the diagram to the right, the lowest spread. In our view, the 11.1% decline In the bond market, we continue to hold
risk and the lowest expected reward po- in the preferred share index this quarter the view that the secular bottom in inter-
sition is at the top of the triangle, and is a dramatic overreaction to changes in est rates occurred in mid-2016 and we
stepping down the rungs successively in- credit risk and/or changes in interest rate are in a long, long cycle of rising interest
creases both the risk and expected return. expectations. The preferred share mar- rates. This is the reason why we own
Employees and creditors get paid first in ket is small and thinly traded and is over- predominantly short and medium term
the event of financial distress and thus whelmingly dominated by retail inves- maturity bonds, so as to side-step the se-
their position is most secure, but this se- tors, many of whom are “once bitten, vere interest rate risk associated with
curity comes at a price as they are not twice shy” after the severe weakness that long dated bonds. Within this long secu-
entitled to share in the profits or assets of unfolded in 2015 when the Bank of Can- lar rising interest rate environment, we
their company whatsoever. Bondholders ada unexpectedly cut interest rates three will have a number of rising and falling
are due periodic contractual interest pay- times causing widespread pain to pre- bond yield cycles, and it’s reasonably
ments and at maturity are owed the “par ferred shareholders. While the Bank of likely that the first one, from summer
value” of their bond, but no more and no
less than that. Preferred shareholders are
entitled to the dividends declared on
their shares, in formulaic amounts, but
cannot expect regular dividend growth or
significant capital gains beyond the $25
par value of their shares. Common
shareholders as noted previously supply
the risk capital in the economy, which is
to say they are left holding the bag
should the enterprise fail, as the last peo-
ple to get paid. Their reward for doing
so is dividend growth over time and the
potential for many-fold increases in their
Figure 1Goodreid Investment Counsel Corp. 4
2016 through October 2018 has come to goosed significantly by corporate tax re- ultimately creates a more target rich en-
a close, and a new medium term cycle of form in 2018. A divided Congress will vironment with more viable acquisition
falling yields has been ushered in. This pose new uncertainties and likely creates opportunities at better prices for these
is, of course, a double edged sword, as a more volatile and fractious environ- companies. And while as strong propo-
on the one hand falling rates push bond ment, particularly as it relates to key is- nents of trade and globalization we la-
prices higher, as we saw in the fourth sues like NAFTA (a.k.a. USMCA), the ment the ongoing rise of nationalism
quarter, creating welcome ballast for be- southern border wall, the China trade worldwide and the dangerous brinks-
leaguered equity portfolios. On the other war and of course the ongoing saga of manship at play in the U.S./China trade
hand, as existing bonds mature, reinvest- the 2016 election irregularities. But war, we can’t help but note that compa-
ment opportunities occur at lower inter- amidst the confusion and mudslinging, nies like CVS Health, Home Depot and
est rates, limiting income potential. We some common ground will surely be Waste Management derive the over-
don’t expect interest rates to once again found, and achieving clarity on key is- whelming majority of their revenues in
plumb the lows we saw in 2016, but they sues like the China trade war and the rat- the United States and thus remain not
could fall modestly further from current ification of USMCA would go a long only largely insulated from these trade
levels as economic growth cools off and way towards narrowing the political risk wars, but in some cases actually stand to
the final innings of the Federal Reserve discount that has undeniably opened up benefit as the ultra-strong US$ drives
and the Bank of Canada’s current tight- in stocks over the last few months. In- down their costs of imported goods. In
ening campaigns come into sharper fo- cremental upside could yet come from our view, great companies and great
cus. For this reason, we intend to con- more fiscal stimulus, perhaps in the form franchises are like great athletes…they
tinue to maintain and manage well diver- of an aggressive and well thought out in- snatch victory from the jaws of defeat
sified portfolios of creditworthy Cana- frastructure buildout plan, although we and they find ways to win even against
dian bonds, effectively walking the mid- wouldn’t count on this in a base case very long odds sometimes. We are very
dle ground between interest rate risk and scenario. confident that we own just such a portfo-
credit risk, neither straying too far into lio of companies.
the realm of interest rate risk via owner- Finally, on a “micro” level, we see silver
ship of long dated bonds, nor straying linings for many of the companies we We know the final months of 2018 were
too far into the realm of credit risk via own amidst a generally more difficult nothing if not unsettling to many inves-
ownership of risky non-investment grade economic environment. This isn’t tors, many of whom were rudely re-
bonds. merely wishful thinking or analysis minded of downside volatility which had
through rose-colored glasses, but rather been in hibernation for much of the last
Broadly, as we think about the major this a deliberate and intended conse- decade. It was dormant - not dead, and
forces at work in the Canadian and U.S. quence of striving to construct a “best- we’ll see it again, but it will not scuttle
economies in 2019, we see a number of of-breed” portfolio…which is subtly but the long term planning we have put in
puts and takes. On the positive side of crucially different from a purely defen- place for our clients via well thought out
the ledger, we have essentially full em- sive portfolio. A best-of-breed portfolio asset allocation targets and well-diversi-
ployment in both countries, with unem- is diversified by sector, and is comprised fied best of breed portfolios within each
ployment at or near record lows, all of companies with pricing power, high asset class. We are comfortable with our
while wage inflation remains at healthy margins, high returns on capital, a long positioning and portfolios and continue
but not unduly inflationary levels. In track record of success, one or more sus- to keep our eyes on the horizon.
Canada, we have some stirrings of ur- tainable competitive advantages, strong
gency as it relates to business competi- management teams and a dominant posi-
tiveness, particularly in Alberta where a tion within their industries. To offer up
plan is taking shape to alleviate crisis just a few examples of companies mak-
level pricing that Canadian oil producers ing lemonade when life gives them lem-
are receiving for their product. In On- ons, note that companies like CGI
tario, the newly elected premier is mak- Group, Alimentation Couche-Tard and
ing strides in pushing back on federal Intact Financial are consolidators of frag-
carbon pricing. Federally, Canadians mented industries and thus they rely sig-
will vote in October, and in our view, nificantly on acquisitions to bolster their
business competitiveness will be a topi- organic growth prospects. Rising inter-
cal issue in the campaign. In the United est rates and rising credit spreads drive
States, business confidence surveys con- up the cost of capital for leveraged buy-
tinue to indicate expansion although the ers of assets, which in turn drives down
pace of growth in corporate earnings the price private equity funds and other
necessarily will moderate after being non-synergistic buyers are willing to pay
for targets within these industries, whichYou can also read
