Real Return Plus Fund Semi-Annual Report
December 31, 2017
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%.
In 2017, our fund delivered a net return of 12.2%. Inflation was -2.6% as measured by our custom cost of living index and 1.8% as measured by the Canadian Consumer Price Index (CPI). Global estimated purchasing power increased 15.2% and has increased 7.1% annually since inception.
Inflation remained low but saw modest acceleration in most places of the world. Generally, real estate, consumer product, energy, and education costs increased, while food remained deflationary. However, many of these costs were down in Canadian dollars. This was due to the appreciation of the Canadian dollar after the Bank of Canada unexpectedly raised interest rates last year.
Our fund benefited from being overweight in equites versus other assets like bonds and real estate. The value discrepancy we see between these asset classes is something we have written about at length and it has led to our fundamental overweight in equities. Equities strongly outperformed other asset classes in 2017.
In regards to the equities we own, we are generally pleased with their fundamental progress. Over the last year, many of our businesses met or exceeded our expectation for earnings growth. Specific highlights are in the asset allocation section below.
COMPANIES: 87% WEIGHT
Our fund remains substantially weighted to equities as we continue to believe that equities are undervalued relative to other assets like bonds and real estate. Equities strongly outperformed other asset classes in 2017.
- Visa Inc. (NASDAQ:V, +48% in USD, +38% in CAD) continues to benefit from its strategic position in a digital payments industry that is growing rapidly. Digital payments are becoming increasingly adopted thanks to growing E-commerce (think Amazon) and the ease of “card-tap” payments in-store. Competition is emerging but Visa is entrenched in the ~200 countries it already operates in; most competition accelerates digital adoption and is actually beneficial to Visa. The integration of recently acquired Visa Europe is also exceeding expectations.
- Great Canadian Gaming Corp. (TSX:GC, +35% in CAD) achieved significant milestones last year. In January, the company opened its new Shorelines casino in Belleville, Ontario. In August, the company was awarded the Greater Toronto Area gaming package from the Ontario government, the most coveted package in Ontario’s gaming privatization. In December, the company was awarded the West Greater Toronto Area gaming package, another significant package. Moving forward, we expect the company to benefit from its new and existing regional gaming monopolies; including exciting expansion opportunities.
- Shares of Pepsi-Cola Products Philippines (PSE:PIP, -31% in PHP, -37% in CAD) were by far our worst performer last year. The new Philippine government announced a significant new tax on sugared beverages which is expected to pressure PIP’s sales and margins. Today, we believe PIP represents a significant value opportunity: trading >15% below the tangible value of its manufacturing equipment and inventory. While the new tax is significant, we believe PIP will continue as a profitable company.
HARD ASSETS: 12% WEIGHT
We generally maintained our hard asset investments in real estate, infrastructure and energy.
- Mainstreet Equity Corp. (TSX:MEQ, +33% in CAD) acquires, renovates, and operates low-end middle class apartment buildings in Western Canada. After the 2014-2015 downturn in Alberta and Saskatchewan, the company has been actively acquiring buildings in these regions. Last year, we were rewarded as these regions saw improving same building operating profits. We believe there is more improvement to come as vacancies remain high and the economy continues to improve.
CURRENCIES/CREDIT: 1% WEIGHT
We remain significantly underweight in bonds. After tax and inflation, we believe bonds are priced for prospective losses.
HEDGING ASSET VALUATION RISK
This marks the 10th investment outlook for our fund. Over that time, we have touched on many philosophical topics but have maintained two opinions on the current investment environment: 1) equities seem undervalued relative to other assets like bonds and real estate; and 2) all asset classes seem expensive relative to history. In this outlook, we elaborate on our second opinion, a few facts and concepts to understand:
- Interest rates set the base valuation for all assets.
- Interest rates are inversely correlated to valuations; i.e.. Lower mortgage rate equals higher house price.
- Interest rates have dropped from a secular high reached 37 years ago.
- Interest rates have been at historic lows for a prolonged period.
By understanding the above, we have insight into the current investment environment: historic low interest rates equal historic high asset valuations. Equally important, we understand that if interest rates rise significantly, asset prices should fall.
This encompasses our primary economic concern today: the potential for much higher interest rates. Interest rates are set by central banks and they typically rise when there is strong economic growth and/or high inflation. With economic growth accelerating, central banks have been raising rates and it begs the very important question: to what level do they raise rates too? Warren Buffet recently said that if he could know one macroeconomic event for certain it would be the rate at which long-term interest rates settle at. Equally, it is the macroeconomic event we would most like to know.
Let’s cut to the chase, we don’t know the answer. In our 2016 investment outlook entitled “know what you can know”, we describe the difficulties in predicting macroeconomic events with any type of consistency. That year, the experts were certain that the US would have a recession, Britain would stay in the European Union, OPEC would not cut oil production, and Hilary Clinton would be elected President. The experts were wrong on every event. It really highlighted that macroeconomic events, like interest rates, are impossible to predict consistently.
However, this does not mean that we should ignore the risk of higher interest rates. It just means we should not act as if we know for certain of that or when interest rates will go higher. There is a difference between positioning the portfolio for the certainty of much higher interest rates and defending the portfolio against the possibility of much higher interest rates. Our fund has chosen to do the latter; we have done this by:
- We own almost no bonds, they are highly and directly inversely correlated to interest rates;
- We have very low exposure to real estate and infrastructure. These assets are bond-like and are typically owned on leverage, making them considerably prone to higher interest rates;
- The real estate we own involve special situations, like closing vacancies, that can offset higher interest rates (see Mainstreet in the asset allocation section);
- Our investments today are focused on businesses; whose earnings growth can offset higher interest rates;
- When we invest in a business, we value it under a higher interest rate scenario;
- We have increased exposure to businesses that can benefit from higher rates;
- We are considering increasing investment in assets that are correlated to higher inflation; and
- We are considering shorting highly rate sensitive assets.
In conclusion, higher interest rates are a risk to asset valuations. We don’t know the direction of interest rates for sure but we have chosen to hedge the portfolio against the possibility of much higher rates. However, as we always say, our core outlook places a greater emphasis on individual asset valuation, industry study, and business progress. For that our outlook remains constructive.
At Pathfinder, all employees take an in-depth personality test used by the US Marine Corp. The Marine Corp Generals read the results so that they can understand their Lieutenants. At Pathfinder, we all read each other’s results so that we can gain perspective working with one another as a team. My test highlighted that I focus strictly on ration and facts while paying little attention to human emotion. While this is likely ideal in managing an investment portfolio it can be tough in forming relationships. So, here goes an attempt at being more emotional.
I’ll remember 2017 as one of my favourite years:
- We made significant strides as a team at Pathfinder;
- I became an uncle for the second time;
- Some close friends became engaged, including a couple I introduced;
- Family from Canada, the US, and the Philippines were together over Christmas; and
- My alma mater made its first Final Four and was a rebound away from the National Championship, an experience I shared with close friends and family
Thank-you for investing and all the best in 2018!
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.