Observations from 2018, Optimism for 2019

Quarterly Letter

As 2019 starts, the market continues its gyrations that began in September 2018. Volatility has indeed increased over the last 3 months but only relative to the last 2 years where it has been quite subdued. We go back 100 years (i.e. since 1920) and look at the day-to-day and intraday volatilities and our conclusion is that markets exhibit nothing more than normal volatility. However, investors have been more conscious of every small move thanks to the internet and the media, making it feel like things have changed. In fact, financial news reporting has changed, not for the better but for the worse.

In times like these, we urge our clients to stay put, keep their eyes on the horizon and avoid looking at the waves in front of them. Here are a few reasons we should stay calm:

  • We don’t know of any correction or bear market that is not followed by another bull market;
  • Price is what you pay, value is what you get. In other words, market valuation is what you pay, earnings and dividends are what you get. We rarely get questions regarding how much dividends a portfolio is generating…. It should be by far the most important question, don’t you think?
  • For most investors still in the accumulation phase, market corrections should be welcomed as they are opportunities to buy cheap. Wouldn’t anybody want to buy when stocks are cheap? As Warren Buffett says, you should buy when everybody is fearful.

A basic strategy that has stood the test of time is one of Dollar Cost Averaging: instead of trying to time the market, most investors should buy the same amount of money in equities in regular intervals in time: for example, investing $2,000 every month over a long period of time. This strategy fulfills several sound principles of investing:

  • Over the long term, free market economies tend to grow and so do their related stock markets, albeit punctuated by sharp declines and recoveries. In fact, we looked back through 100 years of data and the annual growth rate of the US stock market has been around 8% including dividends. Based on the last 50 years of data, the US market has grown at a rate of 10% including reinvested dividends whereas the rest of the world came in at around 8% comparatively. In conclusion, not only does it not pay to be bearish, it certainly does not pay to bet against America.
  • The same amount of money buys more units of equities when markets are lower and less when they are higher. Therefore, as markets ebb and flow, you end up taking advantage of market weakness by buying more whenever it is cheaper.

Lots of questions have been asked related to our fixed income strategy. While we have not re-invented the wheel, we do manage it in a very different way because we define the objectives of our fixed income portfolio very differently:

  • First, since it is called income portfolio, we believe that generating income should be the most important objective. Therefore, investment vehicles used here are all types of bonds, corporate debentures, preferred shares and any type of securities that are ranked ahead of common equity, pay an income that is based on a fixed or floating rate and have a nominal value;
  • Second, we pay attention very much to yield to maturity (YTM). Since our main objective is to buy and hold until maturity, it is important that the YTM is worth our while. You must have heard us saying for a long while now that owning government bonds at 2.5% for the next 10 to 30 years is not the best alternative. Unless you benefit from divine intervention letting you know which direction interest rates would move, you would have to speculate on price movement in order to get a return that is higher than the coupon of 2.5% annually;
  • Third, in order to compensate for the different risk/reward relation inherent to fixed income vehicles, we use what we call an extreme diversification strategy, i.e. owning as many securities as possible, in small quantities each so no one negative position can affect our long term return significantly;
  • Fourth, while we can estimate the safety of the income on securities we purchase, we do not control their price movement, which is driven by fear, greed and liquidity issues, very much like the stock markets.

Our strategy is not unknown to other managers. There are plenty of empirical studies that prove our point. However, scalability is the biggest problem when funds under management become too large. Liquidity, availability and sourcing of products become problematic and since most of our competitors are mutual funds managed by big financial institutions, management costs become prohibitive relative to simply buying government bonds or highly liquid corporate debentures.

For now, we do not have a size problem as bond markets worldwide are large enough for us not to have to worry for a while.

How cheap or expensive are the markets worldwide anyway? Here are some statistics:

 

Geography Representative indices P/E multiple
US MarketS&P 50017.1x
Canadian MarketS&P/TSX 15.6x
Rest of the WorldMSCI EAFE13.4x
Emerging MarketsMSCI  EM11.5x

 

Compared to worldwide interest rates:

 

CountryRepresented byRatesP/E multiple Equivalent
USAUS 10-year treasury2.80%35x
EuropeGermany 10-year bunds0.15%666x

 

As you can see, while equity markets worldwide are no longer at bargain levels of 2009, compared to interest rates, they are far from being expensive. As central banks try to “normalize” their monetary policies, markets could stay volatile for a while. Economic growth might stall for a period of time but unless a nasty recession shows its face, equity markets are expected to perform in line with history.

Happy New Year!

The Claret Team