Following up on the May presentations

Quarterly Letter

During the month of May, Claret made seven presentations where several of you were present. We would like to thank you for your support and questions. We hope our answers have been straightforward, candid and transparent. For the benefit of all, especially those who could not attend, we will use this quarterly letter to expand our answers to some of the questions that arise from the presentations.

QUESTION # 1

Trump, NAFTA, Free Trade and protectionism

The most asked question during the presentations is obviously Trump’s attitude towards trade issues and his protectionist penchant. As you may not know, history shows that protectionism was America’s policy for most of the 19th century (1800s) and the first half of 20th century (up to the end of World War II). More open trade policies were only introduced in 1945.

While everyone has an opinion about Trump and his “tweets”, we look back at financial markets during the periods where protectionism was the strongest and this is what we find:

  • World War I ignited an isolationist trend in America and Congress passed a Tariff Bill in 1922 in the name of protecting farmers and creating jobs for the returning servicemen. Meanwhile, the stock market, Dow Jones Index, started a bull run in 1922 which peaked in 1929…
  • In 1981, protectionist measures were installed to help the automobile industry. As Detroit was decimated by hard economic times, the biggest bull market in history started in 1982 and lasted for almost 20 years…
  • There are no periods where protectionism was the driving motivator for a bear market.

We cannot say for sure what trade wars entail in the short term but we believe that in the long term, they will be detrimental to global economies. However, trying to figure out how protectionism impacts financial markets is a futile exercise -- valuation is by far more important.

QUESTION # 2

Claret pooled funds and their benefits

Pooled funds, or mutual funds, are an investment structure where a trust is created to hold a portfolio of securities. That trust is divided into shares that represent an individual portion of the entire portfolio. So, each time you trade in shares of that trust you sell all of the positions held in equal proportion to what is in the entire portfolio.

The concept of pooled funds or mutual funds in general is good: they offer the benefits of diversification, within industries, countries and assets classes, all with a very low cost. Unfortunately, many financial institutions choose to make their structure opaque and many types of fees they charge to the investors are not easily visible, ranging from high management fees, trading fees, price spreads, custodian fees etc. Sometimes, these fees are paid to different departments of the same institutions that are selling investors the funds and often the fund platforms are controlled by very large institutions, such as banks and insurance companies. There is therefore an obvious potential conflict of interest that is never addressed.

Claret’s set of funds are created with the sole objective to serve our clients’ needs in terms of diversification and cost efficiencies:

  • There are no management fees within the funds since you already have given us a management mandate and pay us a fee for that;
  • There are no administrative fees or audit fees charged to the funds because Claret absorbs all costs except for trading costs;
  • All funds are based on Claret’s research processes or back tested results in term of performance over the long term;

We have created several equity funds, a fixed income fund and an alternative-assets fund. Therefore, your manager can easily design, even in smaller accounts such as TFSAs and RESPs, a portfolio that fits your investment objectives in the most efficient way possible.

As our research evolves, we will endeavor to improve the existing funds and create new ones that meet our criteria of performance and risk exposure.

Many questions have been asked during the presentations regarding clients’ upcoming retirement, conversion of RRSP to RRIF and our strategy toward managing the frequent withdrawals without jeopardizing the long-term objectives of obtaining a reasonable return without taking unduly higher risks.

As you know, RRSPs are designed for accumulation of funds for pension purposes and RRIFs are designed for withdrawals.  While you can transfer your RRSP into a RRIF anytime (it is generally done only when you know you will require annual cash flow from the account), it must be transferred to a RRIF at the age of 71. For most of our clients, the time horizon is still considered long-term since most of you will live another 15 to 20 years if you reach 71 years of age. However, even if the investment objectives have not changed much, the need to manage the outflows becomes important.

One of the biggest challenges is to stay well diversified: as the funds are withdrawn, we have to sell a small portion of each position at a time. This creates a very inefficient way of managing the balance of the account, especially as far as fixed income is concerned. Even with equities, it will become a challenge to manage ever smaller positions in terms of trading costs and bid-ask price per share spreads. In order to be able to stay with a well-diversified portfolio, your manager will now have a choice of including the use of the series of “pooled funds” Claret has created in the overall strategy to meet your objectives as efficiently as possible.

QUESTION # 3

How do we deal with an environment of rising interest rates?

As many of you have made the observation, interest rates seemed to have bottomed and are on their way up, albeit from a very low level and at a very slow pace. The question thus becomes: how do we manage your portfolio in this environment?

Let us put several points in perspective:

  • Although rates seem to be going up, it is not at a level where the economy will feel the impact of the rising financial costs they generate. The 10-year treasuries (bonds issued by the US government) are yielding barely 2.9%. Furthermore, governments around the globe have manipulated the interest rate for the last 10 years, so much so that we don’t actually know where the natural rate should be;
  • Except for the US Treasury, most governments are still in the money printing mode, i.e. creating more money by buying their own bonds. These actions put downward pressure on rates;
  • One way to evaluate the bond market and the stock market is to calculate the “Price to Earnings” multiple (P/E) for both markets. The P/E multiple is basically the number of years needed to repay your investment with the income generated:
    • The S & P 500 trades at a P/E multiple of 20X today, meaning 20 times current earnings;
    • As for the bond market whose proxy is the 10-year Treasuries, it is yielding 2.9%, i.e. for $100 of investment, it is paying $2.90 in earnings (interest income here). That would be a P/E of $100 divided by $2.90, 34.5 times earnings, twice as expensive as the stock market, without the benefit of growing earnings.
    • Most investors are focused on government bonds when they talk about interest rates. While we don’t want to dismiss their importance, there are a lot more fixed income products that should be considered when managing a portfolio: investment-grade corporate bonds, high yield corporate debentures, convertible debentures, preferred shares etc. If used judiciously, not only can they enhance the income portion of a portfolio, they can even offer a capital gain potential over the long term.

In summary, the best way to manage through a rising rate environment is to stay flexible and open-minded, avoid buying fixed income with too long a maturity, focus on yield-to-maturity and make sure to diversify to the extreme (i.e. the more securities you can buy, the lower the credit risk you will be exposed to on each security, the better). On the equity side, it is best to avoid interest sensitive sectors – utilities, REITs etc... We should all remember that one reason rates are going up is the growing strength of the economy. Therefore, we should expect rising earnings and lower P/E for the stock market, making it more attractive versus fixed income in general.

At some point, if rates rise too much, fixed income products will compete with equities in investors’ portfolios, creating headwinds for the stock market. It is then that we will become more defensive.

QUESTION #4

Are we in another tech bubble?

It is quite difficult for most investors to perceive bubbles as they occur. In fact, most will not realize they are in one until it bursts. The simplistic definition of a bubble is when the price of a specific asset (be it companies, a sector or the broad market) rises to a point when even with the most optimistic projection far into the future, its profits cannot justify its elevated level. Usually by then, people are buying because they think somebody will be willing to pay more in the future – the “Greater Fool Theory”.

We believe the financial markets constantly create micro-bubbles:  some of the potential current ones could be Tesla, Bitcoin and other crypto-currencies, and the Cannabis sector. As for the technology sector today, we are not sure whether it is a bubble or just a case of slightly elevated valuations:

  • Different from the bubble of 2000, the top tech names are actually making money. Some of them even enjoy a position of quasi-monopoly, generating extremely high profit margins and cash. Think of Apple, Google, Facebook. If you are wondering why these may not be in your portfolio, they are currently trading at quite high multiples and may not fit all risk and objective profiles;
  • We are not sure whether they are pure tech companies or consumer and telecom companies with technology expertise. Even the S & P has reclassified Google and Facebook to the telecom sector and Amazon to the retail sector. We are not sure why Apple has not been reclassified as clearly it is no longer a tech company but a consumer products giant.

However, we are mindful of the historical performance of equities during bubbles. At the beginning of 2000, the top large market-cap tech stocks in the US represented 25% of the S&P 500 index: Microsoft, Cisco, Intel, IBM, AOL, Oracle, Dell, Sun, Qualcomm and HP. Over the next 18 years, not a single one beat the market. 5 had positive returns, averaging 3% a year, 2 failed outright and 5 had annual negative returns of 7%, underperforming the market by 12% a year.

Today, the 7 largest-cap stocks in the world are: Alphabet (Google), Apple, Microsoft, Facebook, Amazon, Tencent and Alibaba, the last 2 being Chinese companies. Can all of them succeed to sufficiently justify their combined US$4.3 trillion market capitalization? Although they carry multiples that are far lower than ones we witnessed 18 years ago, it is still a monumental task for them to achieve the robust continued growth required to justify their market cap. Furthermore, these companies compete with each other, in some cases directly, for market share. There will be winners and losers and their respective market cap will reflect that. History also shows that the ultimate big winners are not the technology companies but the end users who benefit from the increase in productivity.

Not only are bubbles difficult to identify, it is even more difficult to take advantage of them because of the timing issue. We should never forget the following quote from John Maynard Keynes: “markets can stay irrational a lot longer than you can stay solvent”.

We therefore focus on staying disciplined, diversified, and limiting exposure to stocks with sky-high multiples.

 

Wishing you a wonderful warm summer.

The Claret Team