Real Fund Semi-Annual Report
June 30, 2022
The Real Fund invests in assets exhibiting specific qualities that allow for long-term growth beyond inflation.
The Real Fund had a net return of -14.9% in the first half of 2022. Inflation was 15.2% as measured by our custom cost of living index and 5.0% as measured by the Canadian Consumer Price Index (CPI).
The first half of 2022 saw a significant correction in asset prices. Directionally, global equities were down ~20%, global bonds were down ~15%, and popular new assets like cryptocurrencies and NFT’s were down over 60%.
Investor sentiment turned negative on several factors: 1) High inflation caused by disrupted supply-chains from the pandemic; 2) Even higher inflation caused by the sudden war in Ukraine; 3) A spike in interest rates caused by central bankers aggressively raising interest rates to combat inflation; and 4) Recession fears caused by the perceived impact that higher interest rates may have on economies.
The Real Fund was not immune to the global decline in asset prices and our first half-year return was well behind inflation. Many of our assets declined based on the macroeconomic events noted above. When markets obsess over macroeconomic headlines, they tend to ignore bottom-up business fundamentals which can lead to individual asset mispricing. We believe this is the case today and we are finding attractive pricing for many of our companies. We comment on some of those companies below.
COMPANIES: 87% WEIGHT
Below, we highlight the two portfolio companies that have declined the most in price this year. We also describe why we believe they are compelling opportunities today.
- Goeasy Ltd. (-43% in H1/2022) provides leasing and lending services to non-prime Canadian borrowers. Shares have traded lower on concerns that the company will see much higher credit losses given the current economic headwinds. However, we believe GSY’s credit portfolio has some immunity to the current environment: higher interest rates do not impact non-prime borrowers (they already pay very high rates), high job vacancies greatly benefit non-prime borrowers (easy to get employment income), commodity inflation is generally good for commodity producing countries like Canada, and overall non-prime lending standards have greatly improved since 2007. With this view, we see shares as attractively priced, a view shared by the company given aggressive recent share buybacks.
- AutoCanada Inc. (-42% in H1/2022) is a multi-brand automotive dealership group operating in North America (Canada mainly). Shares have traded lower on concerns that current economic headwinds could drive much lower vehicle sales. However, new vehicle sales have already been low for a year given restrictions in producing new cars. Instead ACQ has been excelling in their repair/service, finance/insurance, and used vehicle divisions. We recently met management and believe that they have done a good job turning around operations, focusing on market competitiveness, recurring revenue, and profitability. While we share concerns on slower vehicle sales, we believe that risk is more than priced into shares, a view shared by the company given their recent proposal to buyback 15-17% of the company.
HARD ASSETS: 6% COMMODITIES + 4% REAL ESTATE
We have seen commodity inflation since the pandemic but none greater than natural gas. Natural gas prices are more than triple pre-pandemic levels in North America and 10x pre-pandemic levels in Europe and Asia.
- We own natural gas producers Peyto Exploration & Development Corp. (+30% in H1/2022) and Advantage Energy Ltd. (+24% since Feb 2022 initiation). These are the two lowest cost producers of natural gas in North America given the quality of their wells and the ownership of their infrastructure. While shares have significantly appreciated over the last two years, we still find them attractively valued.
CURRENCIES/CREDIT: 0% CASH + 0% BONDS +3% MERGER ARB
- Activision Blizzard Inc (+19% in H1/2022) is in the process of being acquired by another portfolio company Microsoft Corp (-20% in H1/2022). There is concern the deal may not close due to anti-trust issues. For this reason, ATVI shares trade at a discount to the proposed acquisition price, a discount we believe is too large. As a result, we have maintained our ATVI position (we owned before the proposed acquisition), a thesis shared by Warren Buffett who recently bought 10% of the company.
THE INFLATION, INTEREST RATE, AND ASSET VALUATION SHIFT
What we saw in the first half of 2022 was the emergence of an economic scenario we feared: structurally higher inflation, leading to structurally higher interest rates and structurally lower asset valuations. A scenario where all assets rationally decline in price and where there is little or nowhere to hide. It’s important to reiterate how we have been describing the investment environment:
- All assets are expensive relative to history. Interest rates are inversely correlated to asset valuations (lower mortgage rate = higher house price), interest rates have dropped from a secular high of 40 years ago and have been at historic lows for a prolonged period. This means that all assets trade expensive relative to history: Equities trade at higher P/E’s, bond’s yield less interest, and real estate have lower cap rates.
- We’re (likely) about to find out where interest rates will go. With inflation high for the first time in decades we’re (likely) about to find out where long-term interest rates will go. Structurally higher inflation could lead to structurally higher interest rates and structurally lower asset valuations. On the other hand, if inflation turns out transitory and we survive all this chaos, it likely means low interest rates are here for a long-time.
While we feared a shift to this environment, we had no idea if, when, or how it would happen. It took a global pandemic, a ~2-year shutdown of productive capacity, and a war between commodity rich countries to spark inflation, not the most predictable of equations. The relevant question now is: where do we go from here? Looking forward, we are more optimistic than most:
- Many of the macroeconomic risks are now well known and priced into valuations: we have already seen a major correction in prices across multiple asset classes.
- We are finding attractive pricing for many of our companies, many of which have not seen a deterioration in business fundamentals.
- Those same companies are buying back shares at the most aggressive pace we have ever seen, meaning they agree with our assessment of the value embedded in their shares.
- The above is typically a good setup, and our outlook is more positive than it was six months ago.
When investing for the long-term, recessions and bear markets are normal, healthy, and usually unpredictable as to when they will occur. They typically represent valuation resets that setup healthier returns for the future. We work with clients to immunize short-term spending requirements so that invested capital can retain a long-term and unemotional outlook, and stay the course.
While our financial outlook is optimistic, it is important to highlight that there are global scenarios for the world that are quite undesirable. We highlight some of these scenarios below:
- Global high or even hyperinflation: Supply-chains and global trade are in stress; labour is scarce, and people are trending to be less productive. An environment where many products and services become unavailable is not out of the question.
- Civil War/Wars: Current politics are extremely tribal. An environment where citizens are at war with each other is not out of the question.
- World War 3: Global tension has been heightened by the pandemic and Russia’s invasion of Ukraine.
- Return of 10%+ interest rates: Central banks may have to keep aggressively raising interest rates to combat inflation. If we return to early 1980’s interest rates, it would be an ugly scenario for many industries and people who have become reliant on low interest rates.
We consider the above scenarios unlikely and certainly unpredictable. However, while these were previously thought of as impossible outcomes, the current odds of occurrence are not 0%. We should all do our part to aide in the avoidance.
Thank-you for investing!
“You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets.” – Peter Lynch
National Instrument 31-103 requires registered firms to disclose information that a reasonable investor would expect to know, including any material conflicts with the firm or its representatives. Doug Johnson and/or Pathfinder Asset Management Limited are an insider of companies periodically mentioned in this report. Please visit www.paml.ca for full disclosures.
*All returns are time weighted and net of investment management fees. Returns from the Pathfinder Partners’ Fund and Partners’ Real Return Plus Fund are presented based on the masters series of each fund. The Pathfinder Core: Equity Portfolio and The Pathfinder Core: High Income Portfolio are live accounts. These are actual accounts owned by the Pathfinder Chairman (Equity) and client (High Income) which contain no legacy positions, cash flows or other Pathfinder investment mandates or products. Monthly inception dates for each fund and portfolio are as follows: Pathfinder Core: Equity Portfolio (January 2011), Pathfinder Core: High Income Portfolio (October 2012) Partners’ Fund (April 2011), Partners’ Real Return Plus Fund (April, 2013), and Partners’ Core Plus Fund (November 2014).
Pathfinder Asset Management Limited (PAML) and its affiliates may collectively beneficially own in excess of 10% of one or more classes of the issued and outstanding equity securities mentioned in this newsletter. This publication is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author has taken all usual and reasonable precautions to determine that the information contained in this publication has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze such information are based on approved practices and principles in the investment industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, neither the author nor PAML can make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your portfolio manager, who can assess all relevant particulars of any proposed investment or transaction. PAML and the author accept no liability of any kind whatsoever or any damages or losses incurred by you as a result of reliance upon or use of this publication.