JANUARY 2018

From the reader’s perspective, this document should be read in conjunction with the “Pathfinder Portfolio Management Overview” report released on January 6, 2017 which explains our overall portfolio management process and investment thesis. Please follow this link here  for a copy of the report if you have not seen it yet.

CORE EQUITY & HIGH INCOME REVIEW

We were surprised this past year with how strong the global and, more specifically, the Canadian economies were. As you will see in the outlook section below, developed market Gross Domestic Product (GDP), employment rates and corporate sentiment have all been very strong. We had positioned the portfolio this year for a less aggressive Bank of Canada (BOC) based on a slowing GDP and a weaker dollar. This meant higher allocation to assets that had more bond like characteristics along with US$ revenues, non-Canadian assets and cash. With a more hawkish BOC and a stronger C$ dollar, our returns at the portfolio level lagged against what we would have expected, even with strong performance from our US stocks.

In our opinion, the Canadian economy is too focused on housing and commodities. Housing has driven household debt growth and commodities markets have been difficult. This is not a great combination. Over the years, much of Canada’s economic expansion has been driven by an increase in household debt, made possible by what seems like ever increasing housing prices. Indeed, our debt as a percentage of disposable income is one of the highest per capital in the world (please see chart to the right). Thus, we expected that the Bank of Canada (BOC) would not be able to raise rates aggressively. We felt that the second half of 2017 would be characterized by a slowing economy and low inflation. Therefore, we positioned the portfolio to be overweight Canadian stocks that would perform better with declining interest rate expectations. We also held cash in order to remain conservative and also opportunistically to buy good companies at lower prices. We expected our liquid position would be well positioned if the Canadian economy slowed and if the BOC pulled back on interest rate increases, causing investor expectations to change in kind. The strong performance of the Canadian economy in the second half of 2017 was particularly surprising to us, as was the reaction of the Canadian dollar. These were the two largest contributing factors to our portfolio, as the conservative stance that we initiated acted as a drag against the other strong performing part of our portfolio (US technology and Canadian & US financial stocks).

We present the table to the right, which shows the difference with respect to portfolio characteristics of the Core mandates to two large exchange trade funds. As you can see, the Core portfolios do not look like any common benchmark portfolio. We are more concentrated, less exposed to cyclicals, have better valuation metrics and strong company fundamental statistics. Over the years, our allocation to the sectors, geography and cash have changed dramatically. We take a real investment stance, move the capital opportunistically and, as a result, expect a more efficient return profile.

CURRENT INVESTMENT OUTLOOK

The global economy continues to expand. The table to the right presents the gross domestic product for each of the major global economies and Canada for the past year. As you can see, all have ended positive. You would have to go back 10 years to 2007 to find the same rise in unison. Even the smaller more emerging market type economies did well. Strong purchasing managers indices (PMI) which demonstrate business expansion expectations and Gross Domestic Product (GDP) were robust for most countries throughout the year.

Another item that remains strong globally, and in Canada specifically, is employment. Canada has recently reached record low unemployment (5.97%) and continued to post good job gains right into the end of the year. The US, Europe and even Japan have also been strong. One interesting item to note is that even with all the job creation in the US, the unemployment rate, while low on a relative basis, has remained somewhat stable (below 5% over the past 2 years). Another data point to note in conjunction with this is a strong Quit Ratio. This should drive unemployment lower given that workers are leaving existing jobs for better paying jobs, thereby opening positions for those that are unemployed. However, the Participation Rate has edged up somewhat from its low in the summer of 2015 as disgruntled workers, who had previously left the workforce began to rejoin. This has kept unemployment and ultimately wage growth relatively flat. Furthermore, the pace of rejoining has been somewhat stable, increasing in a somewhat similar amount each month, rather than a huge influx, which one might have expected. A large influx would have had an impact on the labour market (and wage growth) but the slower pace of change allowed for the “new” workers to be absorbed consistently. In our view, this slow and steady change has been much better for the economy, allowing the workers to rejoin in an orderly manner. It has also contributed to slower wage growth which means that inflation pressure has been lower. This, in turn, has lead the US Federal Open Market Committee (FOMC) to remain relatively dovish, as compared to other recovery periods, and allowed its monetary accommodation to be loose for longer. It was only this past year that the financial markets were faced with consistent increases in administered interest rates, which is much later in the economic cycle that normal. While we believe that FOMC members do not want an economy that runs too hot, which would include too much inflation, they also do not what to raise interest rates so quickly that they will pull the economy into recession. This is a strategy that would create the engineered (and coveted) soft-landing that you might have read about before. This is hard to do but it not impossible. For now, it is difficult to see much weakness in the global economy. Valuation, which we deal with below, is another question, but at this point, other than what looks like a peak in the JPM Global PMI, economic activity does not appear to be slowing in the near term.

Valuations are stretched. There is no doubt about that in our minds. They have expanded to as high as they tend to get before recessions and have done so in one of the quickest intervals in history. The problem with valuation prediction is timing. We know it will change but it is hard to know when. To add to the difficulty, in the last 10 years, we have had the largest globally coordinated financial stimulus in history and this tends to distort metrics that are used to price financial assets. No one really knows how long it will take to work through the impact of unwinding the stimulus.

There are two parts to standard valuation methodology: 1) how much one pays for cash flow (i.e. the multiple) and 2) how much cash flow an asset generates. Thus, the price of any asset will be determined by the amount of cash that flows off the asset and how much investors are willing to pay for that cash flow. As we noted above, multiples are high. We also noted that appears that there is little sign of a weakening economy at this point. The risk is that there is some event (i.e. a currency devaluation, a military or terrorist event, an unforeseen major bankruptcy) which causes multiples to drop or the global economy sputters quickly and sentiment changes. Unfortunately, we are not able to predict these, or the market’s reaction to them, with any consistency, so we will stick to our investment process which is to be disciplined about buying high quality assets at a fair valuation.

Our outlook for Canada continues to be less optimistic. Especially when compared to other parts of the world (chart to the right). A recession or valuation impairment in global markets will hit Canada harder in our opinion. For that reason, we will rely on our process of investing in high quality companies that generate cash flow (irrespective of what happens in the financial markets), as well as creating cash where those companies appear expensive or more broad macro concerns become readily apparent.

There were only minor adjustments to the Core 100 this past year as in the previous year we had refocused our universe of stocks towards non-Canadian companies in continuation of our outlook for more substantial investment outside our borders. We view this as one of the long-term trends that our portfolios should be positioned for on a strategic basis. The universe is now predominately non-Canadian based and is well-diversified across cyclical, defensive, technology and financial stocks. Some statistics are detailed in the table to the right.

We are always looking to improve the quality of the companies that we consider for the portfolios and currently have a number of companies that have passed our initial quality screen. Each day we run a screen that identifies new companies that fit the broad parameters of what we consider to be a “good” company. The list is continually evolving and over the coming year it will be reviewed to determine if they are a potential fit in the Core 100.