It is our custom to use this quarterly letter to address some questions we have heard from you regarding different topics that are currently in the news. We would also like to update you regarding our views on the financial markets in general.
Out goes Bitcoin, in comes Cannabis
There were many questions regarding the value of Bitcoin as a currency a year ago and we did address them in our 2017 year-end letter: it is doubtful that any serious business would like to be paid in bitcoins. Now that the bitcoin bubble has deflated, another one just appeared in recent months: cannabis.
We don’t know to what extent people will smoke, drink and eat cannabis related products but we believe, to quote the former Fed chairman Alan Greenspan’s famous line, that “irrational exuberance” is certainly present. Judging by the market capitalizations of all the cannabis related companies listed on the stock exchanges, we believe that, as in the bitcoin story, it will end badly for most investors/speculators.
However, we will quote John Maynard Keynes again: “markets can stay irrational a lot longer than investors can stay solvent”. Therefore, “buyer beware”. We will also quote Warren Buffett: “We would rather skip the ride” and stick to our circles of competence: when the numbers don’t make sense, don’t get involved.
Update on the interest rate environment
Many of you might not have noticed this but long-term interest rates, using the 10 year US treasury bond as the benchmark, have been moving up for a while albeit very slowly – from near zero to slightly over 3%. We believe that the level of long term interest rates is one of the most important factors affecting the valuation of stock markets and financial assets worldwide, if not THE most important one. At this level, currently 3.25%, the bond market is trading at 31 times its earnings equivalent whereas the stock market is trading at about 20 times.
Anecdotal evidence tells us that inflation is making a comeback sooner rather than later: Amazon just raised their minimum wage to $15 per hour; the unemployment rate is at 3.9%, a 50-year low; skilled labour, or apparently anyone willing to work, is tough to find.
We will not be surprised to see interest rates moving higher over the next year or two. Eventually, it will create a headwind for the stock market. For now, the economy seems to be humming along on all cylinders and so are corporate profits. However, we will be diligent in watching interest rate levels.
Interest rates and real estate
While real estate prices are booming everywhere in Canada, making Vancouver one of the most expensive cities in which to live in the world, people tend to forget that even housing prices are dependent on interest rate levels: mortgage rates move in tandem with long term interest rates and as the latter go higher, so will the former. At some point, as mortgages get renewed at a higher rate, mortgage payments will become a drag for some owners/speculators with large mortgages. There will then be more houses and condos for sale, putting downward pressure on prices. For the people who need to sell, it will be problematic. Furthermore, one thing needs to be remembered: Canada did not live through a painful adjustment on housing prices during the Financial Crisis of 2008-2009.
Investment philosophy and decision process
Throughout the presentations in May, we discovered that the themes that came up the most were about our philosophy and our investment process. So, using the simplest words possible, we would describe our philosophy as one that focuses on buying “profitable” companies. Combining this with the principles of investment and some understanding of human behavior, we arrive at a decision-making process that emphasizes patience, discipline, rational thinking and diversification.
- We define a profitable company in a business sense and NOT necessarily in an accounting sense.
- Principles of investment include:
- Diversification (do not put all the eggs in the same basket);
- Asymmetry of returns (a stock can only go down 100% but can go up a lot more, many times your investment);
- Existence of momentum in the markets, driven by human behavior;
- Concept of “return to the mean”;
- Rebalancing of portfolios.
- Investors’ behavior is defined by fear and greed, behavior that is toxic for the returns on their portfolios. Fear and greed are the origins of all the examples we talked about in our presentation in May and then some. Unfortunately, knowing their existence does not mean you can change them. The only solution is to have a trusted process that puts you in a rational autopilot, so you don’t fall prey to your irrationality.
Our on-going research has helped us develop different approaches to our investment process that are complementary to each other. Based on these insights, we have launched different pooled funds that can be used efficiently to manage your portfolios.
As markets have moved higher since the beginning of 2018, interest rates have also moved higher, albeit slowly and from a very low level. We are now approaching levels where markets could be more volatile. While the economy is still expanding nicely, and inflation has not yet shown its ugly head, we need to be more vigilant as more speculation (the bitcoin kind or the cannabis kind) will make the markets more vulnerable to a meaningful correction.
The Claret Team