Market Review Quarter 4, 2015
Fourth Quarter Calendar Year
Equity Markets Total Return (in Cdn$) 2015
S&P/TSX Composite -1.4% -8.3%
S&P 500 10.9% 21.6%
MSCI/Emerging Mkts. 4.4% 2.4%
MSCI/EAFE 8.5% 19.5%
TSX Energy -1.6% -22.9%
TSX Financials 1.7% -1.7%
Interest Rates December 2015 December 2014
Cdn 91 day T-Bills 0.50% 0.91%
U.S. 91 day T-Bills 0.26% 0.04%
Cdn 10 year Bond 1.41% 1.79%
U.S. 10 year Bond 2.27% 2.17%
Commodities (in U.S.$) December 2015 December 2014
Oil 37.15 53.71
Natural Gas 2.35 2.91
Gold 1060.20 1183.20
Portfolio Management Strategy – Year over Year 2015
What Worked What Didn’t
– Asian Stocks – Commodities
– U.S. Dollar – Preferred Shares
– European Stocks – Canadian Dollar
Diversification and Canada – an Oxymoron – NL
As 2015 came to an end, one thing we could say with conviction was: Thank goodness we are global investors and had over half our clients’ equity money outside of Canada during the year. Even though Canada is our home market and there will always be a home country bias to some extent (as there should be), Canadian equity markets represent only 3% of the world’s total and, as we have pointed out in previous issues of Commentary, are quite undiversified as to companies and industries available for investment. With that in mind, late last year I wrote an article for The Huffington Post Canada (http://www.huffingtonpost.ca/), the gist of which I have provided below.
It’s an adage almost literally stenciled onto sticky notes on computer monitors and bulletin boards of investment professionals everywhere: Diversification is key.
And it absolutely, unequivocally is. While few have made a career out of putting it all on black or red, history has proven time and again that a well-diversified basket of investments typically outperforms a portfolio that holds similar types of securities.
The problem, as most in the Canadian investment community know all too well, is that true diversification – not only being in different types of investments beyond stocks and bonds but true diversification among sectors, companies and even geography – is a tall task in the Great White North.
Indeed, the reality is that the majority of Canadian investors have little choice but to invest in the same sectors that the rest of us do: Energy and Financial Services.
The reason is fairly simple: The Toronto Stock Exchange is by far the dominant market in the country. And the publicly traded sectors that dominate its makeup are those just described: resources and financials, including banks and insurance companies with close ties to the resources sector.
The answer to this is to look abroad, with the most obvious place to start being the United States. As the largest and most diverse market in the world, it makes sense to look at various publicly traded companies that not only look and act differently from Canadian stocks but also operate in a very different economic environment.
The issue here is the value of the Canadian dollar relative to the U.S. currency, and the kind of premium investors must now pay to buy a U.S. dollar-denominated asset. A few years back when the Canadian dollar was on par with the U.S. greenback, it made a lot of sense to scoop up U.S. investments. And over the past few years, investors have been paid handsomely simply by having the value of the U.S. dollar become worth more in Canadian dollars as the former has gone up and the latter down.
The problem now is that while there are likely more U.S. opportunities to be found from an investing standpoint, the odds of the Canadian dollar continuing its descent are significantly lower than what they used to be. In other words, the major decline in the Canadian dollar relative to the U.S. dollar is likely behind us, having declined from a high of about US$1.06 in 2011 to its current US$0.70 at time of writing. While there is still a high probability of some downside in the loonie in the future, at some point it could reverse – which would see the Canadian dollar heading back up again, which in turn would erode some but probably not all gains made in U.S. dollar-denominated stocks or other assets.
Of course, there are lots of opportunities to purchase equities and other assets right here at home without worrying about getting nicked by the exchange rate, or investing in a non-Canadian company that may or may not perform well. Indeed, the crushed Canadian dollar should eventually provide a boost to corporate earnings and trade, helping boost the value of Canadian securities. What’s more, for anyone with U.S. dollars to spend and a good cross-section of other securities already in their portfolio, Canada is looking more attractive from a currency standpoint. If resource prices find a bottom and rebound, then there could be even more upside to be had in Canada.
But for investors here at home, the bottom line is that if you’re looking to diversify your portfolio, there are still other regions that offer strong upside potential and portfolio diversification benefits without such a large exchange rate differential: namely Europe, where the value of the Euro has declined slightly less dramatically against the Canadian dollar, and where stocks have generally not performed as well for a variety of economic, political and geopolitical reasons. Parts of Asia as well offer the same kind of potential as well as diversification – without a currency hit.
To be sure, the U.S. is still an attractive market, and if played correctly can provide both diversification and upside irrespective of the exchange rate. While it may not make sense to buy U.S. equities with Canadian dollars, trimming existing U.S. dollar investments and re-allocating them to other types of U.S. dollar securities that have growing dividends and additional upside potential can also help enhance returns and provide diversification.
The bottom line is that most Canadians feel they have little choice but to invest in Canada – especially with the Canadian dollar not stretching very far. The reality is that diversification can only happen one way: by investing abroad and by doing it in such a way that, irrespective of the value of the Canadian currency against the U.S. dollar and others, your overall investment portfolio will perform well – especially in more volatile times.
Cash was King – FB
In preparation for writing this piece I reviewed some of our recent commentaries. As I moved through them several themes were easily evident. First, as value investors we seem to accumulate larger than normal cash reserves as prices climb and leave valuations behind. Secondly, patience is important and thirdly, don’t deviate from the path of understanding that values are long term and prices are temporary.
As this piece is being written the inevitable is occurring in the markets. Share prices, after an extended period of unwarranted strength, have been declining sharply. We style ourselves as patient long term investors but; “it’s about time!” as we have been talking about inflated prices for two years. The decline has been caused by falling oil prices, the strain of carrying too much debt at all levels of government, and excessive optimism among equity investors.
As regular readers will know we have been carrying larger than normal cash reserves for the past several years in expectation of a period of falling prices. We won’t be trying to time the bottom as that’s a fools game best described as trying to catch a falling knife but we have been on the lookout for good companies at bargain prices and we very much expect that as prices continue to fall so will client account cash reserves as we step into some of what we hope will be bargain basement prices.
So, cash was king over the past several years and I’m sure our clients shared our frustration with holding a large cash position that was earning very little. I don’t know when and I don’t know into what but that cash is closer to being spent than previously and patience has again shown its virtue as while it doesn’t earn much in today’s interest rate environment cash has one positive trait … it doesn’t go down.
The turmoil in the equity market has also been present in the debt markets as bonds and preferred shares have had a rough ride over the past year. Since the start of 2015 the Bank of Canada has lowered interest rates to stimulate the Canadian economy while the Federal Reserve in the US, being the American counter- part to our Bank of Canada, has raised interest rates to avoid a perceived large inflationary threat. The poor debt market investors have been confused and I would postulate that more confusion is likely.
Looking forward I do not think inflation will be a problem in North America as the globalization of manufacturing has, and will continue to, put a lid on costs and prices. Domestic only goods and services, think; education, healthcare, government and financial services, will be subject to inflationary pressures but the aging population in most of our continent will, in harmony with cheap global labor keep inflation under control. That means I think interest rates will stay lower rather than higher which also means I think the Canadian dollar will stay lower rather than higher and that the strength of the North American economic recovery will be weaker rather than stronger.
The above brings me to the position of pointing out what I think should be obvious. North America is, and has been for a while, living beyond its means. Debt levels are rising such that most governments have little if any chance of regaining firm ground, many individuals have financial problems beyond their ability to cope and quite a few companies are in the same situation. By definition our clients are likely well insulated from excessive debt but as “we” are in the minority I wanted to congratulate you and remind you we will be doing our utmost to manage your resources in such a way as to minimize your exposure to poor balance sheets unless the potential reward is significant.
As always at the start of a calendar year I would be remiss if I didn’t thank all of those clients and readers who gave us a positive reference last year. Many of those referrals turned into clients over the past twelve months and we are very grateful for your support.