The past year was unique in that equities, fixed income (corporate and long-term government), real estate, and commodities all had negative returns. This made cash the top performing asset class for the first time in multiple decades!  We expand on this topic in our “Final Remarks” section.

While the majority of our fund (>90%) is invested in equities listed on the TSX Composite Index (TSX), the overall composition of our fund doesn’t look anything like the TSX. This is because we take concentrated positions in investments we like while avoiding entire sectors if we don’t like their fundamentals. This active approach to management can lead to differentiated returns versus an index. In that regard, we would highlight that the total return of the TSX was -8.9% in 2018.  The TSX (and other equities) were especially volatile in the fourth quarter.

However, our objective is not to beat an index; our objective is to generate a long-term real return by investing in quality assets whose cash flow grow beyond inflation. While markets priced some of our assets lower last year, we were generally pleased with the fundamental cash flow growth of our companies. We believe cash flow growth is a key quality in generating long-term real returns.  We provide updates on specific investments below:

ASSET ALLOCATION 

COMPANIES: 84% WEIGHT

Our fund remains substantially weighted to equities.

• Great Canadian Gaming Corp. (TSX: GC, +42% in CAD) had an eventful year that included initial operating results from new gaming properties in Ontario and initial operating results under new gaming regulations in B.C.. Ontario operating results exceeded consensus expectations while the negative impact of new B.C. regulations was less severe than expected. As a result, GC’s overall cash flow growth well exceeded expectations.

• CGI Group Inc. (TSX: GIB.A, +22% in CAD) is one of the largest global IT and business consulting services firms in the world. Organic growth and margins have been expanding as businesses and governments’ transition to technology platforms that use more IP under the Software as a Service (SaaS) structure. CGI previously structured itself to take advantage of this shift and is now reaping the benefits. We expect this to be a long-term trend that should benefit the company’s long-term cash flow growth.

• Richelieu Hardware Inc. (TSX: RCH, -33% in CAD) designs specialty high-end products used in furniture construction; for example, the knob or hinge in a kitchen cabinet. A severe slowdown in Canadian housing has led market participants to believe there will be a severe slowdown/ decline in RCH’s growth. While RCH has exposure to Canadian housing, we have reason to believe the impact will be less than expected. Firstly, RCH products aren’t used in new home or condo construction as their products are too high-end and expensive. Secondly, RCH’s revenues are more sensitive to home improvement then overall housing. Thirdly, RCH has meaningful exposure to the US home improvement market. Finally, RCH’s market share gains could offset an overall industry slowdown. While we do expect Canadian housing to have a negative impact, we believe the impact is already reflected in the current share price.

HARD ASSETS: 14% WEIGHT

Our overall allocation to hard assets didn’t shift much through the year.

• Canadian Pacific Railway Ltd. (TSX: CP, +7% in CAD) was an investment we made towards the end of 2017. While CP has is an operating business, we include it as a hard asset because we believe its intrinsic value is anchored in its infrastructure-like rail network (a hard asset) that has extremely high barriers to entry. In our opinion, the biggest near-term upside for cash flow growth is Crude-by-Rail. Canada needs incremental pipelines to move oil from Alberta to the Gulf Coast and the current pipeline shortage may have a significant duration due to regulatory issues. This leaves crude-by-rail as the next optimal option. We identified this potential in 2017 and it was a driving factor behind our CP investment.

CURRENCIES/CREDIT: 2% WEIGHT 

We remain underweight bonds. After tax and inflation, we believe bonds are priced for prospective losses.

INVESTMENT OUTLOOK 

CONSTRUCTIVE WITH A LITTLE MORE OPTIMISM 

Today, we remain cautiously constructive of the current investment environment but with a little more optimism than 6 months ago.

Our increased optimism certainly isn’t consensus. Recent media headlines are rampant with negativity:

• The global recession is just around the corner
• A global trade war is coming; Europe is slowing
• Equity markets are in free-fall
• Trump, Trump, Trump

These headlines certainly aren’t inspiring and a heavy amount of emotional control is required to maintain a rational view. With a rational view, we don’t believe too much has changed in the economic landscape: there are still many things that worry and encourage us. What we have noticed is that investors have shifted their focus to the things that worry us (like trade wars) from the things that encourage us (like corporate tax cuts).  Sudden shifts in sentiment typically cause sudden shifts in asset prices and this was the case in the fourth quarter. However, are any of these issues/headlines really new? Corporate tax cuts and a China trade war were the cornerstones of Donald Trump’s Presidential campaign. Shouldn’t these issues have been factored into analysis when he was elected in 2016?

In our last report (June 2018), our thesis was “move forward with increased caution”. What gave us increased caution were higher interest rates, higher inflation but also improving investor sentiment and resulting higher asset prices.  Equities were by no means excessively expensive (especially relative to other asset classes) but were becoming potentially stretched. It was a factor in our increased caution.

So what gives us a little more optimism now?  It is the fact that we believe the fundamentals of most of our assets have not changed while we now own these assets at mostly lower prices. For the equities we own, valuations have moved from, in some cases, stretched to, in most cases, attractive. In our last report, we stated that we own high quality businesses that are exceptionally managed at a reasonable price.  In this report, we can now say, we own high quality businesses that are exceptionally managed at an attractive price. That alone is what gives us increased optimism.

Finally, it is important to highlight that while we are more optimistic, we remain just cautiously constructive overall. There are still many things that can derail the global economy and negatively impact corporate earnings.  Also, there are things that can impair how we value corporate earnings; like a booming global economy and resulting higher interest rates. So we worry about the consequences of an economic crash but also of an economic boom. The point is there are always things to worry about but not investing because of persistent worries is a mistake. The stock market climbs a Wall of Worry and as one of my favourite investors says “realizing that is one of the keys to successful investing”.

It is important to stress that the last 38 years have operated against a backdrop of declining interest rates. As we have stressed in our prior investment outlooks: interest rates set the base valuation for all assets and 38 years of secular declining interest rates typically means an asset other than cash is outperforming, as has been the case.

However, as we have also stressed in prior investment outlooks: if interest rates reverse and begin a secular incline we could see a unified decline in the value of all non-cash asset classes. We don’t know if this will happen (no one does) but 2018 was a good reminder of its potential.

Thank-you for investing and have a great 2019!

“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”– Warren Buffett