The wrong question – 4th quarter, 2013
How many times have you heard an investor ask: “How will next year be different?”
Most financial firms are always trying to sell you something so coming up with an “intelligent” answer to that question is an easy way to gain your trust and encourage you to invest. The partners at EdgePoint get asked that same question on a regular basis, but to the disappointment of some, we explain that we’re not smart enough to come up with an insightful answer. What we find more interesting but rarely get asked is what won’t change in the future. We would argue that’s the more important question, because history has shown that investing your hard-earned savings based on short-term forecasts is a fool’s game.
Imagine we pulled you aside on January 1st, 2013 and whispered in your ear that the following list of things would occur over the next 12 months:
The U.S. Federal Reserve will begin to reduce its economic stimulus measures.
The yield on the 10-year U.S. Treasury note will rise from 1.7% to 2.8%. (Source: Board of Governors of the Federal Reserve System)
GDP growth in China will decline for the third consecutive year (from 10.4% in 2010 to an estimated 7.5% in 2013). (Source: Bloomberg; The World Bank)
Inflation will rear its ugly head in markets such as India and Brazil, causing pain for citizens and dislocations in currency markets.
The price of gasoline will stay high and natural gas prices in North America will rise by more than a third, creating headwinds for consumer spending.
Europe will face an unemployment crisis. The European Union (EU) will see unemployment levels hit 10.9% by the third quarter, while those of individual markets such as Spain and Italy will reach 26.7% and 12.5%, respectively. (Source: Wikipedia)
Youth unemployment across the EU will rise above 23%. (Source: Wikipedia)
Deflation will take hold in markets such as Spain, Ireland and Greece. (Source: The Guardian U.K.)
Aluminium, copper, nickel, corn, wheat, sugar, silver, gold and other commodities will fall in price.
The Canadian dollar will decline by more than 7% compared to the U.S. dollar, causing U.S. import prices to rise materially for the average Canadian.
These things actually happened during the year. On hearing these predictions, would you have guessed most global equity markets would be up strongly over the same timeframe? It’s likely that you would have been less optimistic or even pessimistic after hearing the list. That’s the problem with trying to answer the question of how the future will be different. It incorrectly presumes that people can actually forecast short-term price movements in the stock market or the events that might drive them.
Rather than try to make short-term forecasts, we think about the more important question of what will be consistent in the future. Our goal is to build wealth for you over a material amount of time, which we define as 10 years. To achieve that goal, we spend a lot of time analyzing aspects of our investment approach and investing environment that we think shouldn’t change.
Here are some things we believe won’t change:
The quest for low returns will continue
The average investor will continue to believe in the most peculiar of things, mostly at the wrong time and mostly at the wrong price, only seeing what they want to believe. This peculiarity means they'll continue to earn unsatisfactory returns. Most "investors" jump in and out of their investments at precisely the wrong times, sabotaging any potential for satisfactory long-term investment results as shown in the chart below. If history is a guide, this self-destruction will continue.
20‐year annualized returns by asset class
(1992 – 2012)
Source: Bloomberg. Bonds: Barclays Capital U.S. Aggregate Bond Index; Oil: Bloomberg WTI Cushing Crude; Gold: Bloomberg Gold Spot Price per Troy Ounce; Homes: S&P/Case Shiller U.S. Home Price Index; Inflation: U.S. Consumer Price Index; Average Investor
Returns: Calculated using Dalbar fund flow information. The average investor return is the average of Equity, Fixed Income and Asset Allocation investor returns. S&P 500 Index is a broad-based, market-capitalization-weighted index of the 500 largest and most widely
held stocks in the U.S. All returns annualized and in US$.
Source: Bloomberg. Bonds: Barclays Capital U.S. Aggregate Bond Index; Oil: Bloomberg WTI Cushing Crude; Gold: Bloomberg Gold Spot Price per Troy Ounce; Homes: S&P/Case Shiller U.S. Home Price Index; Inflation: U.S. Consumer Price Index; Average Investor Returns: Calculated using Dalbar fund flow information. The average investor return is the average of Equity, Fixed Income and Asset Allocation investor returns. S&P 500 Index is a broad-based, market-capitalization-weighted index of the 500 largest and most widely held stocks in the U.S. All returns annualized and in US$.
The average investor will still be fooled by sales and marketing companies masquerading as investment managers
Investors will continue to get lots of “help” from the average mutual fund company hawking whatever product becomes popular and inappropriately priced.
This allure to the artificially high price will allow investors to become easy prey again. Look no further than all of the funds hawked during the past five years with “commodity”, “bond”, “emerging market bond”, “income”, “dividend” and "low volatility" in their names and the resulting low returns relative to the better-performing, lower-priced alternatives that were far more ignored.
The industry played to the average investor’s fear during the past five years. With rising markets during the past many years, perhaps the industry will start preying on investors' greed. Either way, the end result for the average investor will likely be the same.
We believe our industry does a great job selling "cure-all" solutions, insinuating the promise of great results without acknowledging the possibility of bad ones.
From day one, we've endeavoured to build strong relationships of trust with a small group of advisors and investors who understood how we are different. Our communications with you are unbiased because we don't have to worry about offending sister funds or brands that could betaking a different approach.
For example, in our Q3-2013 commentary, we had a section titled, "The markets will go down”. How's that for putting a downer on things? But shouldn't we be honest if we're to have a mutually profitable relationship?
In the same commentary, we also said "although we're not allowed to promise investment returns … we can without a doubt promise volatility”. Why are we promising volatility when our industry typically tries to avoid it at all costs? While being honest can prove difficult when the truth hurts, truth and trustworthiness go hand in hand.
The truth is, making money in the investment world can be very hard. If it were easy, we'd all be rich. It's not as easy as buying the popular funds because throughout history investors have been generally unsuccessful following this herd mentality. It's not as easy as buying great companies because great companies can be disastrous investments. And it's certainly not easy if you're unwilling to embrace market volatility.
Volatility will continue in 2014
Price fluctuations will be inevitable this year, as they are every year. We experienced almost nothing but upwardly sloping price fluctuations in 2013, but that's unlikely to continue with such abandon into eternity. Remember, volatility isn't risk. It just creates bumps on the road. Since our inception in 2008, we've seen three significant market dips. Look at the negative returns of our portfolios over those periods:
EdgePoint Global Portfolio Decline EdgePoint Canadian Portfolio Decline January 6, 2009 – March 9, 2009 -22% January 6, 2009 – March 9, 2009 -14% April 29, 2010 – August 24, 2010 -16% April 26, 2010 – July 5, 2010 -11% May 10, 2011 – August 8, 2011 -20% July 5, 2011 – October 4, 2011 -17%Annualized returns as at December 31, 2013: EdgePoint Global Portfolio, Series A
YTD: 44.52%; 1-year: 44.52%; 3-year: 16.05%; 5-year: 16.70%; since inception: 18.55% EdgePoint Canadian Portfolio, Series A
YTD: 26.27%; 1-year: 26.27%; 3-year: 8.21%; 5-year: 17.28%; since inception: 17.93%
This is the third commentary in a row where we've highlighted these charts. We do this to remind you that volatility is a consistent force in the stock market. Just because it was a little quieter in 2013, doesn’t mean it won’t be louder in the future. As bad as they may look, we're proud of these periods because of the actions we took. Down markets don't impair performance. In fact, over the long term, they generally help. Down markets are simply opportunities to purchase businesses at more attractive prices. Embracing price movements with the right attitude and investment approach can be financially rewarding. It might not be easy, but that's why making money is hard - much harder than mutual fund ads or mutual fund wholesalers make it out to be.
The importance of having an Edge
Investing will continue to be about mistakes. You’re either making one or you’re capitalizing on one. The right investment “Edges” help you avoid contributing to someone else’s success at the expense of your own.
At EdgePoint, our greatest Edge is our investment approach which is based on being long-term investors in businesses. We view a stock as an ownership interest in a company and endeavour to acquire these ownership stakes at prices below our assessment of their true worth.
We believe that the best way to buy a business at an attractive price is to have an idea about the business that isn't widely shared by others – what we refer to as a proprietary insights.
Proprietary insights revolve around identifying how a business will look different in the future and understanding that the market’s view is unlike yours. If you believe a company will be bigger and you’re not being asked to pay for that growth, you have to ask yourself why. If you have a good answer, then you may have a proprietary insight.
Proprietary insights typically evolve from meaningful research acquired over time. There’s no way to filter for them and no simple formula to nurture them. Their development is unpredictable and can often be an unconscious act. We generate insights by accumulating facts and applying reasoning to those facts. The reality is that the majority will prove worthless in fostering a proprietary view. They may help you know what others know, but no more than that. The rare time you can logically connect the facts that really matter, you gain a unique insight.
During the past 12 months, we sold 12 businesses from EdgePoint Canadian Portfolio and 10 businesses from EdgePoint Global Portfolio where our proprietary view played out and the share prices appreciated. One of these was SHFL Entertainment Inc. (SHFL).
When we first purchased SHFL in March 2011 in the global portfolios, we saw a business that was quickly evolving, but whose progress was largely unnoticed. The company was and continues to be the market leader in automated card shufflers, machines that automatically shuffle cards for dealers in a casino. Card shufflers help prevent people from counting cards and dealers from cheating. They also speed up the game so more hands can be played.
Just prior to purchasing SHFL, the company changed from selling machines to leasing them. This meant revenue would be negatively impacted in the short term, but longer term, SHFL would be more profitable. The company also decided to spend money to expand into new areas of gaming, specifically slot machines, proprietary table games and electronic roulette. All three areas represented attractive long-term opportunities but required short-term investments.
The stock market doesn’t like uncertainty and during the first part of 2011, SHFL had a fair amount of uncertainty surrounding it. There was concern about its transition to a lease-based model, as well as the amount of money it was spending on new business areas that wouldn’t see a return for several years. However our analysis led us to believe these changes could result in SHFL doubling its earnings over the following five years. At around $10 per share (the approximate price we initiated our position), we didn’t feel the market was asking us to pay for that growth. We had a proprietary view and invested behind it. Our view was recognized in 2013 by a competitor named Bally Technologies, which saw the same potential for growth that we did and offered more than $23 a share for the company. We were happy sellers.
Your portfolios continue to be populated with proprietary ideas generated from collecting facts and applying reasoning to those facts. To illustrate our thinking, we thought we’d share the information that helped shape our insights about the businesses you own. On its own, this is simply a list of facts and ideas. Collected over time and with reasoning applied, information like this forms the foundation for our proprietary insights.
* Today, chronic disease accounts for more than 60% of deaths worldwide, but 75% of cases can be prevented through effective behaviour change programs. (Source: Alere Inc.)
* A modern Airbus A-380 or Boeing 747 requires five times the specialty alloy components as the older and very popular Boeing 737. (Source: Carpenter Technology Corp.)
* OECD countries consume 48% of the world’s energy today but are expected to consume 41% by 2035. (Source: Dresser-Rand Group)
* Global infrastructure spending should exceed one trillion dollars in 2014, with the U.S. representing 25% of that spending. (Source: Jacobs Engineering Group)
* Insurance catastrophe losses in Canada were close to $3 billion in 2013. That’s the highest on record and more than three times the average since 1991. (Source: Intact Insurance)
* McKinsey & Company says that by 2025 the “Internet of Things” will create somewhere between $2.7 trillion and $6.2 trillion of economic value, which is defined as either $1 of revenue created or $1 of cost avoidance. That’s 10 times larger than what 3D printing is expected to create. (Source: PTC Inc.)
* The electrification of cars is accelerating. Over the next eight years, the sensor, alternative power system, infotainment and in-car lighting markets should more than double in size.
* The so-called rule of thumb known as Moore’s law is being undermined. The belief that the number of transistors per computer chip will double every two years and result in greater computing power is no longer economically attractive.
* Natural gas prices in North America are approximately US$4.30 compared to US$8.01 in Europe and US$10.91 in Japan. (Source: Quandl)
The importance of authentic ability
An investment approach is only as good as those who practise it. This has and always will be true. You should breathe a deep sigh of relief that it’s no longer just Geoff and Tye managing your money at EdgePoint, as it was at the beginning. Since 2008, the Investment team has grown from two to five members. Ted Chisholm, Frank Mullen and Andrew Pastor work shoulder-to-shoulder with us every day to grow your wealth and your savings are better off for it.
In addition to their authentic investment ability, they’re also liked, trusted and admired by their partners at EdgePoint. This may sound a little touchy feely for some, but it’s of the upmost importance to us, since the biggest risk that EdgePoint faces as a firm is the people we partner with.
The governing principles of math don’t change. Inflation will cause things to be more expensive in the future. You must invest to protect yourself from it or you’ll slowly become poorer. For example, if inflation averages 3% a year for a decade and you simply own cash earning 0.5% a year, you’ll be over 25% poorer a decade from now. If instead you own a 10-year government bond paying the current rate of about 2.75%, you’ll still be poorer in a decade. To avoid this, you have to buy growth and not pay for it. That’s where proprietary insights come in.
You may be 65 years old and think your investment horizon isn’t that long so you don’t want to subject yourself to volatility. But here’s some math to consider. If you and your spouse are lucky enough to be alive at 65, then there’s a one in two chance that one of you will live to 90. That means one of you has a 25-year investment horizon. In 25 years, $100 won’t buy you what $50 does today if inflation is 3%. Even if you’re 65, you need some growth in your portfolio.
We’ll make more mistakes
We’ve made at least one costly mistake every year. Unfortunately this will likely continue. Our investment results since inception have been pleasing in spite of mistakes such as GameStop Corp., Connaught PLC, Blackberry Ltd. and Western Union Co. because we’ve been successful at diversifying the Portfolios by business idea. The obvious benefit of a well-diversified portfolio is that one mistake won’t pull the entire portfolio down in a meaningful way.
In a year like 2013 when almost every company we owned was up strongly, it’s tough to identify mistakes. Last year, our most costly mistake however was our cash balance. We were very active in 2013, both buying new companies and taking profits in others. On balance, we were more aggressive in taking profits and as a result, our cash balances averaged approximately 13.6% in EdgePoint Global and 9.5% in EdgePoint Canadian. With EdgePoint Global Portfolio up 44.5% in 2013 and EdgePoint Canadian up 26.3%, we could have achieved another 7.0% and 2.8% in performance respectively had we’d been fully invested.
Are we allowed to promise lower returns?
In the spirit of not just spinning good news without the mention of possible bad results, we should also promise lower returns next year on top of the volatility we’ve already promised. Of course we'll endeavour to do better, but the reality of that happening is not a high probability.
As we stated earlier, making money can be hard work. At first glance, 2013 looked way too easy (and it was), but a lot of hard work preceded it. In other words, the seeds of success were planted long before the year started. For example, at the start of the year, EdgePoint Global Portfolio had owned seven of the same companies since its inception. It had held another six since 2009, six others since 2010 and nine since 2011 on top of the 11 added in 2012.
That said, the magnitude of the returns in 2013 surpassed our wildest expectations and was much greater than the underlying annual growth in value our holdings typically experience. Some of this was companies catching up from the undervaluation we vigorously counselled about during the past five years. Now that the significant “catch up” has occurred, we’re unlikely to experience the same level of returns next year, though who would’ve guessed the developments this year! This should also mean that returns over the next five years will likely be lower than over the previous five.
We continue to approach investing in these markets with measured confidence, value your trust in us and look forward to working towards building your wealth in an effort to be worthy of that trust.