Second Quarter 2017



Market Review Quarter 2, 2017

                                                                                                                                           Second Quarter

Equity Markets                                                                                                            % Change (in Cdn$)

S&P/TSX Composite                                                                                                                          -1.6%

S&P 500                                                                                                                                               0.4%

MSCI/EAFE                                                                                                                                          3.6%

MSCI/EM                                                                                                                                              3.6%

TSX Energy                                                                                                                                         -8.3%

TSX Financials                                                                                                                                    -0.9%


Interest Rates                                                                              June 2017                   March 2017

Cdn 91 day T-Bills                                                                                0.68%                            0.52%

U.S. 91 day T-Bills                                                                               0.95%                            0.79%

Cdn 10 year Bond                                                                                1.73%                            1.63%

U.S. 10 year Bond                                                                                2.13%                            2.39%


Commodities (in U.S.$)                                                             June 2017                   March 2017

Oil                                                                                                           46.32                            50.81

Natural Gas                                                                                              3.04                              3.19

Gold                                                                                                    1241.50                        1251.10



Portfolio Management Strategy


What Worked                                                                                      What Didn’t

– Emerging Market Stocks                                                                    – Energy Stocks

– EAFE Stocks                                                                                      – Canadian Stocks

– Canadian Dollar                                                                                  – Mining Stocks



Ready Or Not, Here They Go — NL

It was a tough time being a Canadian investor in the second quarter of 2017.  We had the worst of both worlds.  A poor stock market and a rising currency. The Canadian stock market, as represented by the S&P/TSX Composite Index, declined by 1.6% (total return), making it one of the worst performing major markets in the world.  We did, however, manage to beat markets such as Russia, Qatar, and Brazil.  Not exactly rarified company.  How did this underperformance happen at the same time we are being told the Canadian economy is one of the best performing in the world?  As I have pointed out in previous editions of Commentary, the S&P/TSX Composite Index bears little resemblance to the Canadian economy.  As so many companies and whole industries in Canada are either privately owned or are owned by foreign companies, the Index is dominated by resource and financial stocks.  If they are doing well, so is our stock market. If they are doing poorly (as they have done most recently), so is our stock market, regardless of the health of the economy in general.  This is a definite warning to investors (and unfortunately there are quite a large number) who invest almost exclusively in Canada without thought to proper diversification.  Proper diversification involves owning a number of companies in different industries based in different countries.  We will typically own, for our clients, 35-45 different stocks and they will be based in Canada, the U.S., and internationally and while there may be, from time to time, some small industry concentration, they will encompass quite a number of different industries.

Also not helping Canadian investors was the Canadian dollar as it advanced versus the U.S. dollar during the quarter, eradicating almost all of the gains realized in the U.S. stock market.  Great if you were a traveler, not so much if you were an investor.  Long bond and rate/reset preferred share investors fared well.  Long bonds benefitted from the flattening of the yield curve (short-term interest rates rising while long-term interest rates declined while rate/reset preferreds were helped by expectations of the Bank of Canada imminently raising interest rates.

Speaking of interest rates, The Bank of Canada (BOC) has finally decided that its emergency measures are no longer necessary and Canadian interest rates can begin to reflect the reality of the current Canadian economy.  As you know from my comments in previous issues of Commentary, we have felt that interest rates at crisis levels were too low and were overdue to be increased.  The oil shock experienced in late 2015 and early 2016 caused the BOC to reduce its already low Bank Rate to 0.50% and it has remained there ever since, despite oil recovering somewhat from its panic bottom and the ongoing positive numbers being recorded recently in both job growth and economic expansion.  For the first time in almost seven years, administered interest rates have finally increased.  The BOC has raised its Bank Rate by 0.25% to a still ultra-low 0.75%.  As a result, all borrowing rates (Prime, mortgage, etc.) have been raised by the Chartered banks. Savers, however, should not be showing too much excitement.  As banks feel the need to pad their already huge profit margins, savings rates will not be raised. At least, not at this time.

Individual Canadians are the most indebted in the world (much like their provincial governments).  Spurred on by unnecessarily low interest rates and banks that are more than happy to shove money on to their personal banking customers (corporate borrowers have been less inclined to borrow so the banks felt they had to lend money somewhere to keep shareholders happy), Canadians have racked up historically unheard of debt loads from both spending and purchasing real estate.  Home equity lines of credit (HELOC) and mortgages, both tied to the housing market, are the main avenues banks have used to funnel money to their customers.  HELOCS are all at floating rates, as are many mortgages.  Those borrowers will immediately feel the effects of the higher interest rates. Those with fixed mortgages will feel it upon renewal.  The result of this ‘easy money’ in Canada has been, as noted above, a heavily indebted citizenry and real estate bubbles in certain markets such as Greater Vancouver and Toronto.

We do not believe the BOC will stop at just one rate increase.  It appears that interest rates around the world have bottomed and are either poised to rise, or are already doing so.  A whole generation of people in most developed nations have never experienced rising interest rates and, in Canada at least, are not prepared for its potential ramifications.

Rising interest rates are not bad, except when borrowers are overextended.  Interest rates generally rise when economies are expanding, when the demand for credit grows, and when inflation increases.  This is normal economics and is healthy.  Usually central banks are late responding to these signals (called being behind the curve). At this point in time we believe the BOC is behind the curve (more so than the Fed in the U.S.) and will raise rates at least a couple more times in the next year in an effort to catch up.  Rising rates are a problem when central banks are too slow to respond and growth, and especially inflation, gets out of hand due to credit being too cheap.  We aren’t there currently but the risk is there.  Commodity prices are under pressure and are probably closer to a bottom than a top.  Wages and their influence on inflation is something we will be watching closely.  A combination of low labour slack in Canada (especially when compared to the U.S.) and pending huge increases in minimum wages in some provinces (and the resultant pressure on other wages) could also become worrisome.  The degree of offset in deflationary impacts of technology remains to be seen.

What does this mean for investors?  We believe it means that yields on fixed income (especially bonds) will be going up.  That’s great for investors once they get there but painful in the meantime, as prices on currently owned bonds will decrease to allow for yields to adjust to rates available on newly issued bonds. Because of that, we will continue to have a less than typical allocation to bonds for the foreseeable future.  Many of our clients also own preferred shares. As noted in previous issues of Commentary, there are mainly two types of preferred shares.  Perpetual preferreds have a set dividend that never changes. While these shares do respond somewhat to changes in interest rates (not as much as most investors believe, except in extreme situations) they actually respond more to changes in the perceived credit paying ability of the issuer. We own them in most fixed income portfolios because of their very attractive yields and the favourable tax treatment of their dividends in taxable accounts. Rate-reset preferreds recalculate their dividends every five years, based either on the current prime rate or the interest rate on 5-year Canada bonds.  This means they hurt investors when rates go down and reward them when rates go up.  Their dividends also receive favourable tax treatment.  Since they were first introduced about ten years ago, they have mostly hurt investors as rates declined relentlessly but, if we are correct in our interest rate outlook, their day in the sun may finally be arriving.  Once again, many of our fixed income portfolios own rate resets but unfortunately preferred shares do not have a lot of liquidity and are therefore difficult to trade.

We are happy that the Canadian economy, along with other economies around the world, are doing better.  This should have long-term positive ramifications for stocks as their earnings increase along with economic growth. However, current stock prices are probably ahead of earnings and we will be awaiting better valuations to increase our commitment to them.  Patience, while difficult, is important.


It Takes Longer Than You Think – RD

I have found myself mulling about the latest business and stock price disasters in the retail sector.  The problems stem from changing consumer habits and the lagging transformative shifts in business models to keep up.  However, I have been hearing the arguments to explain the current retail store woes for a long time.  The predictions are so familiar.  My recollection is that at the end of the last millennium I was going to be able to bypass the mall and click on my TV display to buy the coffee table on the screen or clothes a certain actor was wearing.  Similarly, back then, grocery stores were going to have to shrink given that upstart on-line grocery stores were going to eat their lunch (I couldn’t resist).  In fact, in the early 2000’s I gave on-line grocery shopping a try with Grocery Gateway.  After a couple of deliveries I stopped as it didn’t prove to be a better way of filling up my pantry after time, selection and cost was factored in.  Many on-line shopping formats weren’t actually very profitable, if they made money at all, and seemed to settle into the background or were purchased by a large traditional company.

On-line was expected, back then, to devastate retail stores.  “All with a click of a button” and that’s the story that surrounded the internet at that time.  Now, so many years later, it seems that the forecast decline of some traditional brick and mortar retail stores is finally at hand, only it has taken much longer than thought previously. But I have still been perplexed with how ‘sudden’ the retail dominos have fallen to the internet. This past year we have read countless stories of retail store challenges.  Store closings and or job cuts happened at Hudson Bay, Sears, Staples, Radioshack, Gymboree, Payless ShoeSource, Target, BestBuy (and the list goes on and on).  It would appear that we have reached a tipping point, only over 17 years after the first shot across the bow.   Other factors needed to be in place before this tipping point occurred.  What these factors are is in debate.  Faster internet speeds have helped but so too has the building of more efficient distribution networks,  improved speed of delivery and lower delivery costs that were not available ‘back then’.

In a case of back to the future, a company called Blue Apron came to market this last quarter issuing new stock.  There was much hype (in my stock world) surrounding this company whose service is providing ready-made meal packages. Similar to former internet bubble stocks, this company does not make a profit.  I was initially confused about the level of interest in Blue Apron but I thought if I did some research I would understand its appeal (and possibly even become a potential customer because I am all for making my life easier).  However, the cost at $10 per meal soon stopped me short.   An ongoing subscription with a thirty dollar cost for my family of 3 to eat one meal that I still have to cook is a non-starter, for me.  Stocks need earnings growth or, in this case, actual earnings.  The Blue Apron concept is likely to be used by a small slice of the population at best and this leads me to another area of perceived rapid adoption.

There was a splashy headline recently that car manufacturer Volvo was no longer going to manufacture internal combustion engines after 2019 in favour of electric.  Wow!  In full disclosure the Oldsmobile I am driving will be able to hang a heritage licence plate in a few more years so I am clearly old school when it comes to my ride.  Having said that, this new technology will take longer to roll out than people anticipate.  Traditional car companies have watched Tesla (electric car maker) stock rocket 60% this past year even though Tesla has not shown a profit.  Yet, the traditional car companies have put their own electric plans into place.   The big auto manufacturers are planning on selling millions of electric-only cars by 2025.  This has huge implications, not just for Tesla and the other auto companies, but, eventually, for Canada’s resource driven economy.  But for all the ambition, subsidization and environmental arguments, given current battery life constraints and infrastructure requirements, I suspect it will roll out slower than people currently anticipate.  Less than 1% of all vehicles sold in the US last year were all-electric. The next mass market step, including Volvo’s, will be hybrid electric-internal combustion engines (and don’t be surprised if current favourite lithium-ion batteries are supplanted in 10 to 15 years by something different before the fully electric car reaches a tipping point).

Companies have time to adjust if they are watching the shifts and have the corporate culture in place for change.  Pepsi and Coke adapted to the decline in soda pop by becoming one of the top sellers of water in the world.  GE is selling the consumer light bulb business it helped found 125 years ago. It has been undergoing a significant reconstruction from appliances and light bulbs to power turbines, medical equipment such as CT scanners and energy services, digitization and locomotives.  Whole Foods (seller of expensive healthy and organic food) on the other hand couldn’t adapt to the competition and has recently sold itself to Amazon.  The changes these companies faced have been years in the making.

Just like ours is a different world than our parents, our kids will experience a different technological and consumer world than we lived through.  My point is that the adoption of transformative goods and services usually takes longer than people think and the root causes of the tipping point will only be able to be interpreted by historians.


“It’s Not What You Don’t Know That Hurts You, It’s What You Know That Just Ain’t So” – AC

I recently joined Portfolio Management to oversee global equities and fixed income.  I am pleased to assume the portfolio from Peter Walter and wish him well in retirement.  I would also like to thank him for the smooth transition and support that he has provided to me.  I look forward to continuing the strong track record that PMC has built over time.

Most equity markets have done quite well in 2017, with the notable exception of Canada, and we continue the search for solid companies in which to invest. Economies in both Europe and Asia have started to recover nicely and this is reflected in market prices.  If we look at fixed income markets, they have also performed solidly with long-term yields falling and bond prices rising.  Is this a Goldilocks scenario with low but stable economic growth and continuing appreciation of stock and bond prices?  It is hard to know for sure, which brings me to some thoughts on some of my recent reading.

There was an article in the Financial Times entitled “You are not as clever as you think you are” by Anjana Ahuja, an award-winning science journalist.  The point of the article is that in a world where information is easily available and can lead to overload, people tend to use intuition to make decisions.  However, even intuition has its shortcomings.  The article highlighted an interesting paper on “cycology” where psychologist Rebecca Lawson asked a simple question: could people draw the basics of a bicycle?  This task is more complex than it seems.  I tried it and encourage you to do so as well.  How is the frame structured, how does the chain work, where do the wires from the hand brakes go?  In fact, according to the study, around 40% found it almost impossible to draw a bicycle. What I found interesting was that many people in the study had ridden and seen bikes over many years, yet still had difficulty drawing the basic of a bicycle.  However, if asked beforehand, many people would confidently say that they could draw a bike.  The main lesson here is that a little knowledge can be a dangerous thing.

How does this all relate to investment management?  Many people can have an opinion about a company, but it takes years of experience and understanding and a lot of diligence and hard work to uncover a solid investment idea. Deep fundamental research is essential in the investment process.  I am delighted to join a firm where excellence in fundamental research is embedded in the culture.

Taking it one step further, this lesson of overconfidence in your level of knowledge can be extended to investing in international equities.  Investors are able to identify, understand and appreciate the subtle and not-so-subtle issues when investing in markets they know.  For example, investors who live in Canada or the U.S. are comfortable investing in their home markets.  They look for companies that have strong management teams, solid balance sheets and high returns on capital.  However, these investors may take for granted issues like robust corporate governance, transparent accounting and the rule of law because that tends to be the general backdrop in those North American markets.  When you invest internationally, these issues can’t be taken for granted.  At PMC, a critical part of the investment process is to ensure that we aren’t making subtle assumptions about companies we invest in that could hurt our performance down the road. Sometimes, “it’s not what you don’t know that hurts you, it’s what you know that just ain’t so”.

June 2017


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