During the first half of 2018, higher inflation, higher interest rates, and new trade tariffs limited returns across multiple asset classes. In Canada, the TSX Composite Total Return Equity Index was up 1.3%, Teranet’s Real Estate Index was up 1.7%, and the total return of a 10-year treasury bond was 0.3%. Globally, the MSCI All-Country World Equity Index was up 1.1% in USD or 4.0% when measured in CAD.

Over the last few years, we have been positioning the portfolio to be defensive against the possibility of higher inflation and higher interest rates. Ironically, this meant avoiding investment in “defensive” assets like bonds, real estate, and infrastructure. While these assets are defensive against economic recession, they are negatively exposed to an environment of rising inflation and higher interest rates.

While we benefitted from this general portfolio positioning, performance was primarily driven by the fundamental progress of the companies in which we’ve invested. We were generally pleased with the fundamental progress of our companies and we provide updates on some of our core investments below:

ASSET ALLOCATION

COMPANIES: 84% WEIGHT

Our fund remains substantially weighted to equities.

• Great Canadian Gaming Corp. (TSX:GC, +38% in CAD) announced initial operating results from its new gaming properties in the Greater Toronto Area. These results exceeded expectations which sent shares of the casino operator higher. Shares of GC have more than tripled over the last two and a half years and while we remain constructive on the long-term outlook for GC, we used recent share price appreciation as an opportunity to sell some of our position.

• Last year, we reinitiated an investment in Nike Inc. (DJ:NKE, +34% in CAD). At that time, the company was being scrutinized for slowing North American sales growth and falling gross margins. Our opinion was that sluggish North American sales were not a reflection of deterioration in NKE’s product or brand.  Instead, NKE’s North American business was transitioning to a direct/digital sales platform from its traditional wholesale network. This transition was causing near-term noise but we believed it was actually supportive of NKE long-term growth and margin profile. More recently, the company reported recovering North American sales and improving gross margins.

• Alimentation Couche-Tard Inc. (TSX:ATD.B, -12% in CAD) has been a long-term investment of the fund. The company owns and operates retail gasoline stations (and the associated convenience store) in North America and Europe. The recent spike in crude oil prices has put some pressure on the company as higher gasoline prices usually equal lower store traffic and lower short-term gasoline margins. In addition, dollar stores and quick-service restaurants have begun competing with some convenience store offerings. Retail gasoline has always been a challenging industry but ATD.B has always excelled in its operation. We believe ATD.B remains an incredible operator and is well positioned to manage through these headwinds. We remain constructive owning ATD.B as it continues consolidating this fragmented industry.

HARD ASSETS: 14% WEIGHT 

We slightly added to oil within the hard asset segment of our portfolio.

• Badger Daylighting Ltd. (TSX:BAD, +18% in CAD) was subject to short seller accusations last year. We felt the accusations contained false information and after meeting with management to confirm our views we were happy adding to our investment last year. BAD designs, assembles, and operates hydro excavation trucks for service rental in North America. BAD’s biggest customer is the energy industry and we believe BAD is a high quality way to participate in the recovery of oil. Recent operating results have been strong as oil activity has picked up in North America.

CURRENCIES/CREDIT: 2% WEIGHT

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

INVESTMENT OUTLOOK

CONSTRUCTIVE BUT WITH INCREASED CAUTION

We remain generally constructive of the current investment environment but with a higher level of caution versus previous years.

The equity bull market of the last approximately 9 years has either coincided with or been driven by a consistent environment of low inflation, low interest rates, expanding globalization, and, to a lesser extent, fear of investing in equities.  Our opinion is that these factors are beneficial to business operations and businesses valuations. Thus, we believe they have been drivers to the equity bull market:

• Low inflation is beneficial; it keeps corporate expenses low and capital expenditures on budget.
• Low interest rates are beneficial; it decreases a business’s cost of capital while increasing its valuation.
• Globalization is beneficial; businesses can source materials globally and sell their products globally.
• Fear of investing in equities is beneficial; it allows investors to buy businesses at discounted valuations.

What gives us increased caution are the changes that are occurring in inflation, interest rates, globalization, and investor sentiment. Inflation has accelerated and a tight labour + oil market may mean it continues. Interest rates have risen and central banks have stated they expect to continue raising rates. Our global leaders are implementing trade tariffs which, if continued, may reverse the multi-decade trend of globalization. Retail investor sentiment has turned more bullish, likely as a result of 2017, a year that saw the lowest equity volatility in 50+ years. Combined, the constructive investment environment of the last approximately 9 years may be shifting.

However, while we acknowledge these changes, we remain generally constructive of the current investment environment.  While higher, inflation and interest rates are still low by historical standards. Trade tariffs are not widespread and we are not in a trade war at this time. While improved, equity investor sentiment is nowhere near the euphoric levels we saw in other assets like bitcoin and local real estate. In fact, the increased volatility of 2018 has already made many investors again pessimistic of equities. Combined, we believe the overall investment environment remains generally supportive of investing in equities.

In conclusion, we remain generally constructive of the current investment environment but with a higher level of caution versus previous years. Over the last few years, we have been positioning the portfolio to be defensive against the possibility of higher inflation and higher interest rates. An all-out trade war is harder to hedge against but we view this as an unlikely scenario. These macroeconomic shifts are hard to forecast and as legendary investor Peter Lynch said, “nobody can predict interest rates, the future of the economy or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested”. This remains our focus: we own high quality businesses that are exceptionally managed at a reasonable price. Most often, that is our greatest defense.

FINAL REMARKS

In 1967, the American Basketball Association (ABA) introduced the three-point shot to basketball. At that time, ABA commissioner George Mikan stated that the three-pointer “would give the smaller player a chance to score and open up the defense to make the game more enjoyable for the fans”.  The three-point shot was a regulated response to the natural dominance of big men in basketball.

Like economic regulations, entrepreneurs find a way to adjust and excel in a new environment.  Today, three pointers are being launched and made at an unprecedented pace. More importantly, they are being launched and made by the most successful teams. The Golden State Warriors (NBA) and Villanova Wildcats (NCAA) recently set records for three pointers made in their respective leagues. Both teams won their championship this year and both have won two of the last three championships. The basketball entrepreneur has innovated to excel in the three-point era and the most successful teams have embraced them.

Previously, the post-up center and the guard who mastered the mid-range jump shot dominated basketball.  Today, they are discouraged by coaches and analysts.  With the current level of shooter, why take a shot that has 33% less value and similar odds of going in? Compounded over time, two-point shots are a waste of time versus three-pointers. I recently read that Steph Curry, the NBA’s most prolific three-point shooter, has a 70% chance of making a wide-open three point shot and a 99+% chance of making a wide-open layup. That means that on a breakaway, Steph should pull-up for three (expected point value of 2.1) versus making a lay-up (expected point value of 2.0). With shooters this good, player spacing would occur even if long-distance shots were worth just two points. With the pure big man and the art of the mid-range jumper on the verge of extinction, it begs the question:   Is it time to remove the three-point shot?

Thank-you for investing and have a great summer!