What 2017 turned out to be

  • The US stock market gained 17% in Canadian Dollar terms. The technology sector, driven in part by the FAANG Stocks (Facebook, Apple, Amazon, Netflix and Google) is the big contributor to the performance. Today, it comprises 23.8% of the S & P 500, the third highest weight of any sector after Tech in 1999-2000 and Energy in 1980-1981;
  • While growth stocks have had a great performance, value stocks have lagged the indices by quite a wide margin;
  • The US Dollar Index posted its worst year since 2003, down 10%;
  • Europe is up 13.7% (also in Canadian Dollar terms);
  • Most of Asia is up anywhere between 8 to 20%;
  • Canada, unfortunately, is only up 6%.
  • Bitcoin is up 1403%. There are few historical comparisons, silver being the closest one in the early 80s.

What ‘s next?

Let us address several questions that have probably crossed your mind if you have read some of the headlines in the news in 2017….

Is President Trump out of control?

Maybe, maybe not. Without getting into a lengthy debate where nobody really wins, let us just state that as investors, we must differentiate between policies and politics: whereas the former (fiscal, monetary and other) do drive businesses by emphasizing incentives, politics is just noise and truly belongs to the world of Hollywood, the entertainment business. In 2017, the Trump administration has achieved 2 things: cut down dramatically on regulation and pushed through congress a huge tax cut package for corporations. These are policies that are very bullish for business and, consequently, shareholders. So as money managers, we are bullish.

Is the market too expensive?

  • The first question to ask would be: compared to what?
  • if we are willing to buy US government bonds at an annual rate of return of 2%, i.e. we would receive $2 for every $100 invested, we are basically valuing this investment at 50 times earnings ($100 of capital divided by $2 of earnings);
  • we are also willing to accept the fact that these $2 of interest will never go up for the duration of these bonds;
  • how does it compare to the S & P 500? As of today, it is trading at 22 times earnings with earnings probably growing at 3 to 5 % per year in the foreseeable future.

The Federal Reserve Board has an inflation target of 2%. Yet, the government bond is paying around 2% before taxes and inflation. It would not be very sensical to get into an investment where it is guaranteed that you would lose purchasing power over time.

Our conclusion is pretty straight forward: The stock market is not expensive compared to bonds.

  • The second question would be: what is the impact of the corporate tax cut?
    • As Warren Buffett put it so well: if you have a partner who used to get 35% of the profit of your business come to you one fine day and says that he is willing to only get 21% of the profit and leave you with the balance without any condition, what do you think will happen to the value of your business?

The corporate tax cut should therefore be bullish for the stock market.

Why not more Chinese stocks?

Let us quote a short article from Craig Mellow in Barrons on January 1st, 2018 and you’ll understand why we are a little cautious regarding Chinese stocks:

(we bolded the relevant sections and added some contextual explanation in brackets)

“… More than 80 Chinese firms have issued shares on U.S. exchanges using a legal structure called a variable interest entity (VIE), according to the Council of Institutional Investors in Washington, D.C.  Most of them are in the internet space.  With 20 announced initial public offerings of VIEs, 2017 set a record.  That prompted a CII report in December titled “Buyer Beware”, which warns that “investors’ participation in China’s emerging companies is precarious and may ultimately prove illusory.”

The root of this precariousness is Chinese law, which prohibits foreign owner-ship of internet companies.  Resourceful investment bankers hit on the VIE work-around in 2000 when Sina (SINA), which controls China’s Twitter equivalent Weibo, wanted to tap the Nasdaq for investment capital.  Generally speaking, (Step One) the Chinese company creates a VIE, which (Step Two) establishes a “wholly foreign-owned enterprise,” to which it pledges its cash flows and profits.  Step three:  set up an off-shore shell company that titularly owns the WFOEForeign investors buy shares in the shell, which is usually based in the Caymans or British Virgin Islands.

What could go wrong with this two-arms-length relationship?  Plenty, says Steve Dickinson, a Chinese law specialist with Seattle-based firm Harris Bricken.  “Why anyone would invest in a vehicle that the Chinese government states is against their law is a mystery to me,” he says.

One faction in the Chinese leadership wanted to eliminate VIEs outright in 2015, Dickinson says.  But (Jack) Ma (Alibaba’s CEO) and other tech titans beat them back, and the structure seems safe for now.  “The uncertain status of these companies allows the government to control them, plus you have money coming in from naive foreigners,” Dickinson says.  “It’s a beautiful thing.”

But a spike in taxation is a threat, the CII warns.  And foreign shareholders’ tenuous legal footing leaves them open to abuse by Chinese managers.  Alibaba ignited a firestorm in 2011 when Ma (Alibaba’s CEO) removed its payment service Alipay from the parent over objections of investors Yahoo! And Softbank.  Last autumn, Sina cold-shouldered U.S. hedge fund Aristeia Capital’s push for board seats and restructuring the relationship between Sina and Weibo (WB), whose shares had outperformed those of the parent.  Some VIEs, like China’s Google, Baidu (BIDU), and online retailer JD.com (JD), don’t meet investors at all, at least not through annual meetings. The CII says more than 80% pay no dividends.”

How about bitcoins?

We know very little about bitcoins. We are told that it can be used as a currency. However, we cannot figure out which merchants in their right minds would accept it as a currency payment? If you own a business, would you accept a currency that could fluctuate 20% a day as payment for goods that you have to sell? Export companies hedge their currency exposure when it fluctuates only a few percentage points. They certainly will demand that clients pay them a currency that is related to their cost in order to avoid the fluctuation risk.

As John Maynard Keynes said so many years ago: “the market can remain irrational longer that you can remain solvent”, and that is why we choose not to participate in this folly, it is almost a certainty that the whole thing will end badly. We just don’t know when and how.

To quote Buffett again, we can get into enough trouble already with things we know something about, why would we choose to get into something we know nothing about?

What about the economy?

We have given up a long time ago trying to predict the economy and we think you should too.

Knowing that it is mathematically impossible to solve a set of equations where the number of variables exceed the number of equations, don’t you find it ironic that economists can manage to give a fairly precise answer regarding the global economy where there are an undetermined number of variables with an undetermined number of equations?

Ask yourselves the following questions:

  • If somebody told you in 1920 that the US debt will multiply by 730 times over the next 100 years, would you have believed that the US could stay solvent with a vibrant economy?
  • If somebody told you in 1990 that Japan would see its interest rate go from 9% to close to 0 by year 2000 and stay there for the following 17 years, would you have believed it?

Yet, these events happened and no economists managed to predict it. Unfortunately, economics is not physics; whatever prediction tools that used to work 10 years ago may not work the next 10 years.

We believe investment decisions should be made based on business fundamentals. Introducing macro-economic prediction in the analysis process is asinine and will potentially lead you to overlook the actual strength of the business itself.


Happy New Year.