The following is an adapted version of the 2020 Annual Address speech given by Executive Vice President and Director, Investment Research, Murray Leith in February.
Before Christmas, my fiancée and I got away to Cabo San Lucas for seven days, and it was wonderful. It was also the first time I’d been away from my boys for a whole week since they lost their mother to cancer seven years ago. My sons are 16 and 18 now, and it was great to come home and see that the house hadn’t burned down and nobody had starved.
I didn’t leave them alone like my eldest wanted. I told them we needed someone to stay and look after the dog, but frankly I was finding it hard to leave the boys on their own.
Nonetheless, with my kids getting older, I’ve been thinking a lot about the trade-off between protecting and letting go. All parents struggle with this. If we are too protective, kids don’t learn from experiences and mistakes, helping them to mature and grow.
In many respects, the balance I’m trying to get right for my boys is similar to the balance between protection and growth that we’re looking for in our investment portfolios. And, like raising children, it’s not easy sometimes.
In fact, in my 25 years at Odlum Brown, I don’t think it has ever been more challenging to protect and grow wealth. One of the reasons for this is extremely accommodative monetary policy – ultra-low interest rates, in other words.
The Dark Side of Easy Money
Ever since the financial crisis, central banks have been printing money and keeping interest rates low because they are trying to stimulate growth and stave off deflation. Deflation and the world’s excessive debt would not mix well, potentially setting in motion a deep economic setback. Consequently, central banks err on the side of caution and keep interest rates low.
Low interest rates help stimulate economic growth in a couple of ways. They encourage consumers and businesses to borrow and spend. They also cause asset prices to rise, which in turn makes people feel richer and more inclined to spend.
The strategy has worked well, but unfortunately it won’t work forever. There are two major adverse consequences of cheap and easy monetary policies.
The first, and most worrisome, is the fueling of inequality and social unrest in the world. The relatively small group of people who own the majority of the world’s financial assets are getting richer and richer, while the rest feel like they are falling further and further behind.
The other major negative consequence of ultra-low interest rates is that they are driving an even greater buildup of debt in the world. In that sense, we are treating the debt problem with medicine that is slowly killing us. It’s not a formula that is moving the world to a healthier and more stable state.
Unfortunately, central banks are like over-protective parents. Their policies make us feel safe in the short term, but they are not setting us up for success in the long term.
What the world really needs is better government and less easy money, but that is not likely to happen in the near term. That makes our job tough. On the one hand, we should be cautious because the world doesn’t have good leadership or a long-term plan to deal with social unrest and excessive debt. On the other hand, there is a good chance that central banks will continue to inflate asset prices because they fear deflation.
A Slower-Growth World
What makes matters even more complicated is that the world is not growing as fast as it used to, and stocks are not cheap.
I’ll address the sluggishness of global growth first. The current U.S. economic expansion has the dual distinction of being the longest (10.5 years and counting) and the weakest (lowest average annual growth) in post-World War II history. These characteristics have been mirrored around the world, and the contributing factors are fairly universal. The biggest contributing factor to slower global growth is demographics. Working age populations are growing a lot slower than they used to, and that will hamper global growth for the foreseeable future.
Excessive debt is also weighing on growth. Not only has overall debt increased, but much of it is not going to productive purposes. For example, many businesses are borrowing to buy back stock. That helps shareholders get richer but doesn’t do much for society. Consequently, it’s taking increasing amounts of debt to produce incremental growth in the world. That’s not a good trend.
The growth dampener that gets the most headlines is protectionist trade policies, principally tariffs. While there has been some progress on resolving the U.S./China trade war, we think trade friction will continue to be an issue that weighs on global growth and spooks the market from time to time.
Economics 101 – The Lesson on Trade Wasn’t Quite Right
The American view on globalization and free trade is changing, and we think it’s important to understand why. In university, we were taught that society benefits from trade because there are more winners than losers. The winners include consumers, who benefit from lower prices and more choice, and entrepreneurs and workers who benefit from selling the products and services in which they have a competitive advantage to the rest of the world. The losers include all those who lose their jobs to cheap overseas labour.
The one thing they didn’t tell us in university is that this conclusion is based on a key assumption that trade is balanced. Unfortunately, that is not what has happened in the real world. For 40 years, the U.S. has had a trade deficit, meaning that imports have exceeded exports. Consider that in the first of those years, there was a small group of losers, and over the next couple of years, a few more. Not a lot. But after 40 years, a huge number of unhappy people have lost their high-paying manufacturing jobs to cheap foreign labour. And you know what happens then? Trump happens!
In the 2016 election, Hillary Clinton’s Democrats won the coasts. The industries that have benefited disproportionately from free trade are on the coasts – Silicon Valley and Hollywood in the west, and Wall Street and the defense industries in the east. But Trump’s Republicans won the states in between. That’s where all the farmers and manufacturing workers who have suffered from freer trade live. There are a lot of angry people, and that is driving polarized politics in the U.S. and around the world.
The combination of unfavourable demographics, excessive debt and divisiveness will make slower global growth a reality for a long time to come. As a consequence, we should expect corporate profits to also rise at a slower rate over time.
Stocks can and have risen at a faster pace than corporate profits in recent years because valuation multiples have expanded as interest rates have fallen. In 2019, corporate profits barely increased, and yet the U.S. and Canadian equity benchmarks rose 32% and 22%, respectively.
While we believe there is still scope for valuation multiples to increase, it’s not realistic to expect double-digit returns from stocks when growth is slow and valuation multiples are already on the higher side of reasonable. We need to lower our return expectations. We used to expect stocks to generate average returns of 8-10% over the long term, but 5-7% is more realistic today.
Different Makes a Difference
Let me reflect on history to reinforce the point that elevated valuation multiples can have a dampening effect on returns. Over the last 20 years, the Canadian stock market has produced a total return, including dividends, of approximately 200%, or 6.3% compounded annually. That is not terribly inspiring, and that’s because the Canadian market was very expensive during the technology mania at the beginning of the 20-year period. Because of the ultimate demise of just one technology stock – Nortel Networks – and the Resource sector boom and bust in the 2000s, our stock market didn’t embark on a sustained recovery from its peak in 2000 until 2016.
Still, you might be surprised that the Canadian market did better than the U.S. market over the last 20 years. The American market returned 186% in Canadian dollar terms, or 5.5% compounded annually. It performed worse because overvaluation was more significant and widespread in the U.S. in the late 1990s. Not only were technology stocks stupidly priced, but America’s biggest and best companies also traded at ridiculous valuations.
Our Odlum Brown Model Portfolio* has performed considerably better than the Canadian and U.S. stock markets over the last two decades for two reasons. First, we didn’t own the over-hyped and overpriced stocks during the technology and resource manias. Second, there were plenty of attractively priced high-quality alternatives during those periods.
In the late 1990s, with the exception of a few technology stocks, we kept our money in Canada when investors were chasing overpriced American stocks. There were a lot of attractively priced high-quality businesses in Canada at the time. In the mid-2000s, during the resource mania, we shifted money out of Canada and into the U.S. because their biggest and best companies were out of fashion and therefore cheap.
Being different during those two important periods really made a difference. Our Model Portfolio has appreciated by 650%, or 13.0% compounded annually, over the last 20 years.
Everyone’s Chasing the Same Thing
The challenge in the market today is that everyone is chasing the same thing. The high-quality businesses we like are popular and pricey. And unlike during the mania periods I mention above, the crowd’s behavior is fairly rational; investors appreciate the uncertainties and risks in the world and are gravitating toward the businesses that are best positioned to thrive in that environment. There simply aren’t many high-quality businesses trading at great prices.
Most of the cheap stocks are cheap for good reason. They either have too much debt, poor management, operate in challenged industries or have some other problem. Earlier in my career, you could buy such unpopular stocks and count on a robust economy to lift profits and investor sentiment and drive impressive returns. But that strategy doesn’t work very well in a slow-growth world.
You might be wondering, if the best businesses are somewhat pricey, should you sell? I don’t think that’s the right thing to do, at least not yet. My experience and understanding of history and human nature cause me to believe that valuation multiples could be higher, and perhaps a lot higher, before the cycle is over. Trends often run a lot longer than you think.
Diversifying the Odlum Brown Model Portfolio
Having said that, we aren’t sitting on our hands. After making fewer than 10 trades in each of 2017 and 2018, we made 45 trades in our Model Portfolio last year. That’s the most trades in 11 years!
As part of this trading activity, we added cash (7%) and gold (3%) for diversification purposes. This has caused a bit of a stir, with people wondering if this is a sign that we are expecting a big correction. We are not! At least not any more than usual; we are always prepared for corrections, as they are something one has to live with to be a good investor. We also continue to own resource stocks, and energy stocks in particular, despite their horrible performance, because they are out of favour and extremely cheap, and also since they provide diversification. As they say, if some of the assets in your portfolio aren’t causing you some grief or controversy, you are probably not well diversified.
I love my Visa and Apple shares and a lot of other companies that have done well, but in investing it’s important not to be too greedy. We should hang on to the great businesses, but we should also diversify our risk and not be too concentrated in assets that are popular and pricey. That’s what we’ve done in the Model Portfolio.
We believe the major market indices will appreciate 5-7% over the long term, and we hope to do a bit better than that based on the composition of our portfolio today. Of course, we will be working hard to find opportunities to exceed that expectation. But until those opportunities present themselves, we think it’s best to take a more conservative posture.
The best way to protect and grow wealth is to own great businesses while at the same time ensuring your portfolio is adequately diversified. If central banks continue with their cheap and easy monetary policies, as we think they will, the price of great businesses will likely continue to go up. If we don’t hang on to our financial assets, we risk falling behind.
While great businesses are not immune to market corrections, we can be confident that they will survive adversity and thrive over the long term. The diversification into cash, gold, energy and other contrarian positions will help reduce volatility along the way.
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*The Odlum Brown Model Portfolio is an all-equity portfolio that was established by the Odlum Brown Equity Research Department on December 15, 1994, with a hypothetical investment of $250,000. It showcases how we believe individual security recommendations may be used within the context of a client portfolio. The Model also provides a basis with which to measure the quality of our advice and the effectiveness of our disciplined investment strategy. Trades are made using the closing price on the day a change is announced. Performance figures do not include any allowance for fees. Past performance is not indicative of future performance.
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