Second Quarter 2018

Market Review Quarter 2, 2018


 What Worked                                                               What Didn’t

Energy Stocks                                                                      Utility Stocks

Canadian Stocks                                                                  Emerging Market Stocks

Technology Stocks                                                               Gold



                                                                                Second Quarter 2018                  

Equity Markets                                                        % Change (in Cdn$)                   

S&P/TSX Composite                                                                     6.8%

S&P 500                                                                                        5.5%

MSCI/EAFE                                                                                   1.0%

MSCI/EM                                                                                      -5.0%

TSX Energy                                                                                 15.8%

TSX Financials                                                                              2.1%


                                                                              Second Quarter 2018           

Bond Markets                                                        % Change (in Cdn$)                   

FTSE TMX Cda Bond Universe Index                                        0.5%


Thank Goodness for Oil – NL

Following a bleak 2017 and an even worse first quarter of 2018, the Canadian stock market, as represented by the S&P/TSX Composite Index, staged a strong turnaround and recorded one of the best results in the world during the second quarter of 2018. While technology and healthcare stocks (read: marijuana stocks) contributed to this gain, it was really the almost US$10 increase in the price of crude oil that really propelled the Canadian market.

It wasn’t just the improvement in the world price. Much of Canada’s oil is heavy oil as represented by Western Canadian Select. Being heavy (thick) oil, it has always traded at a discount to West Texas Crude, as it should, as it is more difficult to refine. However, in recent times, the discount has widened dramatically due to the imbalance between supply and deliverability options. In other words, lots of heavy oil is being produced, but no new pipeline capacity has been created to get that oil to market. There were also some temporary bottlenecks with some existing pipelines. Producers were forced to cut capacity until pipeline repairs were completed. Also, oil delivery by rail was not as robust as hoped due to poor winter weather and a shortage of rail cars. Thus, producers were forced to take much lower prices on their oil. Supply and demand. However, during the quarter, the pipelines that had been “down” started returning to their normal capacity and rail shipments increased. Both helped narrow the price differential, just as the price of oil in general was increasing. A win-win for Canadian oil companies. Looking forward, Enbridge’s Line 3 replacement project has been approved, which will lead to further delivery capacity for Canadian oil exports to the U.S. And then there is Trans Mountain.

In addition to the increase in the price of oil, world economies and markets have been subject to the bombast over tariffs and trade wars. The United States has been the principle protagonist on trade, with President Donald Trump playing to his base, calling for more factories to be built in the United States and for other countries to stop ‘dumping’ their goods into the U.S. market. The fact that, for the first time in my memory, there are currently more job openings available in the U.S. than there are unemployed workers seems not to be part of his equation. Trump can try and coerce companies to locate plants in the U.S., but if the companies cannot find workers to work there, they will simply not be built, no matter the rhetoric.

I believe the tariffs so far imposed, and potential others talked about ad nauseam, are not really meant to bring more factories and jobs to America. I believe all the talk and so far, limited action, is designed to shore up votes for Republican candidates in the upcoming mid-term congressional elections. Trump and his advisors are all well aware of history and how genuine trade wars are devastating for the economies and stock markets of all countries involved. Rhetoric about tariffs and trade wars, however, can be just as powerful as the actual implementation of them. Take Canada, for example. Even though nothing on the trade front has happened yet (and hopefully never does), there is a huge chill in the Canadian auto sector. Canadian auto parts companies are trading well off their highs and there don’t appear to be many companies currently willing to devote new investment capital to the area in Canada as long as the uncertainty continues.

President Trump has stated that there is no way the United States can lose a trade war. Actually, in a real trade war, nobody wins and everybody loses. But so far, in this tariff ‘skirmish’ with China, the U.S. is clearly winning. The U.S. exports to China a very small percentage of its total exports. China, however, exports a very large percentage of its exports to the U.S. As the chart below (courtesy of Strategas) shows, using stock markets as a proxy, the U.S, is clearly winning what is currently mostly a war of words with China, and we don’t see that changing anytime soon.

Shanghai Composite Q22018

One final comment from me, and that concerns marijuana stocks, which Anish will be visiting in greater detail below. In my career, I have owned all kinds of ‘sin’ stocks: tobacco, liquor, beer, and casinos (I drew the line at brothels!) and have mostly made money on them over the years. They all have a few things in common that have made them winners. 1) They all have huge profit margins; 2) There are limited major players in each product category; and 3) Their customers are generally addicted to their products. In addition, like almost all other businesses, investors have been able to predict with a reasonable degree of accuracy what each company’s sales, margins, and earnings would be in the upcoming few years. In the case of the marijuana industry, at present, little is known about how the market will evolve over the near term. Who will be the sales leaders and will they be gaining or losing market share, who will be profitable, will that profitability continue, will margins be increasing or decreasing, what if any brands will dominate, what about the Black Market and home growing? All these questions, and more, need to be addressed before we would consider investing in the industry. For now, the marijuana industry remains a speculation, not an investment.


Why haven’t we invested in cannabis? – AC

Being at the dawn of an industry, especially in a non-tech sector, is an alluring prospect for any investor. Dreams of large gains dance around investors’ minds. When we look at Canadian stock market sector returns, certainly, cannabis equities have been a stand-out over the last while.

It is hard not to have run across stories of individuals who have invested in this area and have made many times their money. We have looked at the area as well but have come to the conclusion that in general, investing in cannabis stocks is more akin to speculation than investment. In other words, the price action of the stocks is where speculators derive their profits whereas for investors like us, our profits are derived from the cash flows of the business which are then reflected in stock prices. In addition to expensive valuations, there are a large number of unknowns, but for now, let’s focus on the lack of predictability of sales for the cannabis growers.

The speculative story on Canadian marijuana stocks relates to the legalization of cannabis and how current illegal demand will shift to legal demand starting in October 2018. Another aspect of the potential investment appeal is that once cannabis is legalized, demand will increase. These areas of demand are summarized in Table 1 with further discussion below:

Table 1 – Sources of Demand Growth for the Legal Cannabis Market

a)      Current illegal demand becoming legal
b)      Overall demand growing as a result of legalization


      a) Current Illegal Demand Becoming Legal

Quantifying the demand shift from the black market to legal retail stores this fall is difficult to determine in advance. It does seem obvious that illegal demand should move almost entirely to retail stores (why transact in a dark alley somewhere?), but it is complicated by the pricing structure as seen in Table 2:

Table 2 – Cannabis Pricing – Legal Market vs Black Market (estimates only)

Legal Market Black Market
Price per gram including taxes $11 $7
Price per gram excluding taxes $10 $7
Approximate cost of production $2 $2
Gross margin $8 $5


Purchasers may be able to buy cannabis for $11 per gram (including taxes) at a retail outlet, or they can save over 35% by buying in the black market for $7 per gram. The investing question here becomes how much of the current black market demand will become legal demand given the pricing advantage of the black market? This is a difficult question to answer. Another investing question is if enough demand moves to legal retail stores, will the black market react by dropping prices? There does appear to be sufficient profitability in the black market ($5 per gram) for prices to be cut in order to offset a drop in sales.

       b) Overall Demand Growing as a Result of Legalization

There appears to be an assumption made by investors that if cannabis is legalized, demand will grow beyond that of the current black market. So, a further question is can an investor reliably estimate how much demand will grow given legalization? This is another difficult question to answer.

Table 3 – Summary of Investment Questions and Answers

Investment Question                Potential Answer
How much of the current black market demand will become legal demand given the pricing advantage of the black market?                 Hard to know
If sufficient demand moves from the black market to legal retail stores, will the black market react by dropping prices?                  Maybe
How much will cannabis demand grow beyond its current size given legalization?                 Hard to know

The market capitalization of the cannabis sector reflects very positive answers to the above three questions (see Table 3). Note that our answers to these questions are not very comforting (see Table 3 as well). Also, we have not talked about other questions regarding the industry such as competitive dynamics, individual company cost structures, future changes to regulation, additional supply, etc. The stock market, however, seems to have positive answers to these additional difficult-to-answer questions as well. We believe that the market is making very rosy projections about the cannabis sector that are unlikely to pan out as speculators hope. For us, investing in cannabis has been a no-go.

I can’t help but make a final observation – cannabis is essentially an agricultural product. Over time, agricultural product pricing, as a result of supply growth, moves to the cost of production (think cucumbers, wheat, carrots, etc.). In other words, could the cannabis price get closer to $2 per gram in the future as supply grows? Though a decline in sales prices may not happen rapidly, cannabis would be the exception to this rule of agricultural sales prices coming down closer to the cost of production over time. Do cannabis stock prices reflect this potential reality? Certainly not.

Summer reading – FB

I found an article as I was ploughing through some of my father’s old papers. He was born in 1903, toiled in the investment industry for the majority of his working life and tended to squirrel away articles he thought were either interesting or important. The article was published in The Outlook in 1928 shortly before the market crash in October 1929. I’m not predicting anything similar “now” but I found the general tenor of the article interesting and thought those readers who enjoy some summer reading (see link below) might find it of interest as it illustrates beautifully the fear of missing out.

We will be maintaining our conservative stance for the foreseeable future as equity valuations remain stubbornly high in the face of rising interest rates and a US President who seems to become more unstable with each passing day.

Article: In Defence of a Bull Market


Other Markets


Fixed Income                                                         June 2018                               March 2018

Cdn 91 day T-Bills                                                          1.25%                                           1.09%

U.S. 91 day T-Bills                                                          1.94%                                           1.76%

Cdn 10 year Bond                                                           2.13%                                           2.11%

U.S. 10 year Bond                                                           2.85%                                           2.74%


Commodities (in U.S.$)                                       June 2018                                March 2018

Oil                                                                                       74.15                                           64.94

Natural Gas                                                                          2.92                                             2.73

Gold                                                                                1254.50                                       1327.30


Currency                                                               June 2018                                March 2018

Cdn/USD                                                                         1.3133                                          1.2885

Cdn/Eur                                                                           1.5336                                          1.5853




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