Real Return Plus Fund Semi-Annual Report
June 30, 2018
The Real Return Plus Fund was created to protect and grow purchasing power. The objective is to earn a long-term, annualized, real return of 2-10%.
For the 6 month period ending June 30th, 2018, our fund delivered a net return of 6.6%. Inflation was 3.2% as measured by our custom cost of living index and 1.1% as measured by the Canadian Consumer Price Index.
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:
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.
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.
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!
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 fees. Performance returns from the Real Return Plus Fund are presented based on the Class C Master series. Inception and 2013 returns include the 10 months from inception in March 2013. Returns greater than one year are annualized. The custom cost of living and CPI provide general information and should not be interpreted as a benchmark for your own portfolio return. The custom cost of living represents an equally weighted (at inception) basket of Teranet-National Bank National Composite House Price Index™, UBS E-TRACS CMCI Food Total Return ETN ETF (FUD:NYSE), United States Gasoline ETF (UGA:NYSE) and Canadian import prices from Statistics Canada in Canadian dollars. We created the custom cost of living index to give investors another way to measure their cost of living. It has some differences versus CPI; for example, CPI measures shelter costs as the cost of renting a home versus the custom index which measures it as at the cost of purchasing a home. A bachelor may view renting as an accurate gauge of shelter costs. On the other hand, a mother and father who want to raise their family under the security of the same roof without the risk of forced relocation likely views home ownership as a more accurate gauge of shelter costs.
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.