This week's interesting finds

October 19, 2019

What's your vintage year?

When did you become an EdgePoint partner? Let's take a walk down memory lane as we recall the major events and fun facts from your vintage year.

Focusing on best ideas

CFA Institute recently released a blog post looking at active managers’ returns by position sizing relative to benchmark. Looks like there’s a relation between best ideas and performance. Another reason it makes sense to run concentrated portfolios of high conviction ideas. 

Negative interest rates are nothing short of a mystery

Negative interest rates are likely to throw off whatever we knew about the financial world and how things worked in the past. Howard Marks discusses why negative rates have become prevalent, what implications they might have, whether they will reach the U.S., and what investors can do as they navigate these uncharted waters.

Why would anyone want to buy a negative-yield bond?
• Fear about the future that causes investors to engage in a flight to safety in which they elect to lock in a sure but limited loss
• A belief that interest rates will go even more negative providing a profit on bonds when they do (as bonds appreciate in price as they would with any decline in rates)
• An expectation of deflation causing the purchasing power of the repaid principal to rise
• Speculation that the currency underlying the bond will appreciate by more than the interest rate

What is there to do?
The most reliable solution lies in buying things with durable and hopefully growing cash flows. Investments with the likelihood of producing steady earnings or distributions that reflect a substantial yield on cost seem like reasonable responses in times of negative yields. The challenge lies in accurately predicting the durability and growth of cash flows and making sure the price you pay allows for a good return. In today’s environment, assets with predictability are often priced too high and investors are unusually willing to extrapolate growth far into the future. While simple in concept, investing is far from easy, especially today.

Leveraged Loans

Barely noticed in a corner of the financial markets, leveraged loans originally worth about $40 billion are staging their own private meltdown.

Loans tied to more than 50 companies have lost at least 10% of face value in just three months. Some have dropped a lot more, with lenders lucky to get back just two-thirds of their investment if they tried to sell.

Morgan Housel on behavioral biases and pitfalls

In January this year Morgan Housel- Partner, Collaborative Fund- gave a presentation on behavioural biases and pitfalls faced by ordinary investors at the India Investment Conference. Through five stories and various examples, he conveys that investing is not just about what you know but also about how you behave and that stocks become less risky the longer one holds them.

“The goal of investing is not to minimize boredom, it is to maximize returns! If you want clients to stick around, then do things simply.”

This week's interesting finds

October 12, 2019

Our Q3 commentaries are available now

This quarter, portfolio manager Geoff MacDonald explains why it's important to invest like a rational business owner, while fixed-income analyst Derek Skomorowski discusses why relying on others to do your credit work doesn't pay off.

America’s middle class can’t afford its cars

Car loans that are increasingly stretched out are a pronounced sign that some American middle-class buyers can’t afford a middle-class lifestyle. For many, the availability of loans with longer terms has created an illusion of affordability. It has helped fuel car purchases that would have been out of reach with three-, five- or even six-year loans. Low rates in effect served as a bailout for the auto industry over the last decade. 

A growing share of car buyers won’t pay off the debt before they trade in their cars for new ones, either because the car is in need of repairs or because they want a newer model. A third of new-car buyers who trade in their cars roll debt from old vehicles into their new loans. 

Americans have been borrowing to buy their cars for decades, but auto debt has swelled since the financial crisis. U.S. consumers held a record $1.3 trillion of debt tied to their cars at the end of June.

So far this year, dealerships made an average of $982 per new vehicle on finance and insurance versus $381 on the actual sale. 

Momentum. After one year of outperformance, the next 9 are usually bad
Momentum strategies show a tendency towards long-term reversal. Starting from around the one year point onward, they underperform. The green column shows the initial one-year annual excess returns of Winner portfolios over Loser portfolios. The blue column shows the excess returns of those same portfolios from the end of the 1st year to the end of the 10th year. 

Free cash flow as a % of GDP is at a record high in the U.S.

There have NOT been big investments by either households or businesses that create misallocations of capital.  Misallocations usually precede/cause a recession.

Source: Empirical Research Partners

Paying for stability

Stable stocks have been more expensive only 4% of the time since 1976. Bank stocks have been less expensive only 5% of the time since 1976.

Source: Empirical Research Partners


Demographics

Artist Profit Sharing

Don't go chasing waterfalls...

…unless you can take a photo of it like this spectacular shot. Our Q3 Photo Contest winner is Ted Chisholm.

This week's interesting finds

October 5, 2019

Warren Buffett's first television interview

Invaluable lessons about investing that haven’t changed to this day. 


Paying for stability

The valuation gap between stocks with stable growth and volatile growth is larger today than at any time in at least the last 35 years. The 20% of S&P 500 stocks with the most stable EBITDA growth during the past 40 quarters currently trade at a median forward P/E of 21x. This represents a 23% premium to the median S&P 500 stock's multiple of 17x. Since 1985, this premium was only exceeded in early 2000 at the peak of the Tech Bubble. The 25% discount carried by the stocks with the most volatile earnings growth (13x vs. 17x) has been deepening for a decade and is now the largest on record.

BUT…
While the valuations of stable growth and volatile growth companies look extreme relative to history, valuations have generally not been a useful signal for predicting the forward returns of these stocks in the past. Exhibit 14 below shows the weak historical relationship between the valuations of stable growth stocks and their forward 12-month returns relative to volatile growth stocks. In the past, large valuation spreads have not indicated above-average risk of a reversal in valuations and performance. In fact, the times in the past when stable growers carried the largest valuation premia relative to volatile growth stocks were often been followed by further stable growth stock outperformance. 


Ever seen a 0.00% R squared before?*
*R-squared is a statistical measure that explains to what extent the variance of one variable (valuation premium in this case) explains the variance of the second variable (forward 12-month excess returns in this case).  

Bond and dividend yields since 2005

Tech IPOs aren't working for the masses
Many of the seemingly hot debuts this year have been much less so for most ordinary investors. Most big new tech issues from this year are trading below their opening prices from their first day of trading. For most new tech issues, the biggest gains come upfront. Relatively few investors get access to new shares at the listing price. But for the majority of investors who have to wait for trades to open, the returns aren’t so glamorous. 

Shale boom is slowing

This week's interesting finds

September 28, 2019

EdgePoint Partners' back to school reading list
Over the past few weeks, we have been collecting some of the reads that have caught your attention lately. The results are in! Here are some of the books that come highly recommended by EdgePoint partners: 

• Simple Wealth, Inevitable Wealth by Nick Murray. It’s a book for advisors to give to clients, in order to establish two great, complementary investing truths: (1) that equities are essential to long-term wealth-building and to a solidly rising income in retirement; and (2) that no one will ever be able to hold equities through all the fears (and fads) of the market cycle without you – the empathetic but tough-loving Behavioral Investment Counselor.
• The Code: Silicon Valley and the Remaking of America by Margaret O’Mara. The true, behind-the-scenes history of the people who built Silicon Valley and shaped Big Tech in America.
• The Power of Habit: Why We Do What We do in Life and Business, by Charles Duhigg. It explores the science behind habit creation and reformation. The key to exercising regularly, losing weight, being more productive, and achieving success is understanding how habits work.
• Sell or Be Sold: How to Get Your Way in Business and in Life, by Grant Cardone. Whether it's selling your company's product in the boardroom or selling yourself on eating healthy, everything in life can and should be treated as a sale. Cardone breaks down the techniques and approaches necessary to master the art of selling in any avenue. You will learn how to handle rejection, turn around negative situations, shorten sales cycles, and guarantee yourself greatness.
• The Talent Revolution: Longevity and the Future of Work, By Lisa Taylor and Fern Lebo. The definitive guide to maximizing workforce value, The Talent Revolution exposes work-life longevity as the most influential driver transforming today’s workplace – a competitive edge for organizations smart enough to capitalize on it.
• Talking to Strangers: What We Should Know About the People We Don't Know, by Malcolm Gladwell. The book offers a powerful examination of our interactions with strangers--and why they often go wrong.
• A Higher Call, by Adam Makos. This is the true story of the two pilots whose lives collided in the skies one day. An incredible story of a brotherhood between enemies, that emerged from the horrors of World War II.
• The Fifth Risk: Undoing Democracy, by Michael Lewis. A 2018 political book by Michael Lewis. It examines the transition and political appointments of the Donald Trump presidency, especially with respect to three government agencies: the Department of Energy, the Department of Agriculture and the Department of Commerce.
• When Breath Becomes Air, by Paul Kalanithi. A profoundly moving memoir by a young neurosurgeon faced with a terminal cancer diagnosis who attempts to answer the question “What makes a life worth living?”

S&P 500 Return: Earnings Growth vs. Multiple Expansion

The amount of IPO capital raised by unprofitable firms keeps climbing

During the dot-com bubble, investors flocked to bet on the purported next big thing. A similar theme can be spotted in today’s IPO market, with some companies asking buyers to bet on unproven technology and untested revenue models. Many winners have emerged, but this deluge of disruptors has also laid down a minefield.

Historical market returns vs. ISM manufacturing index

The left chart shows the correlation between ISM manufacturing index and 10-year Treasury yields since 2010.  A PMI index above 50% indicates that the manufacturing economy is expanding, and a PMI index below 50% indicates that the manufacturing economy is declining.  The right chart shows the correlation between S&P 500 returns and ISM readings over or under 50.

Mixed signals from bond yields 

According to government bond yields, we are making a bee-line for Armageddon. According to credit spreads, clear skies on the horizon.

Stock market returns are inconsistent.

Maybe the best and worst part about the markets is the fact that two investors can look at the same exact data and come to completely different conclusions. Looking at the two stats below many might say that “buy & hold doesn’t work” or “this is why I time the market”.

$10k invested in the S&P 500 in Jan 2000 would be worth $29,181 by the end of Aug 2019

$10k invested in the S&P 500 in Jan 2010 would be worth $32,100 by the end of Aug 2019

The first situation invested at the height of the dot-com bubble which might have been the worst entry point in U.S. stock market history. The dot-com bubble soon burst leading the S&P 500  to fall by 45%; 10 years later the financial crisis hit and the S&P 500 fell again, but this time by 51%. Despite this, the investors still managed to triple their money and earn 5.9% annually as of August 2019. How many investors would sign up for 5.9% annual returns today for the next 20 years?

Stock market returns are inconsistent. Sometimes returns are front-loaded, sometimes they’re back-loaded and sometimes they’re not great, even over longer time frames. One period of inconsistent or poor returns isn’t a reason to give up on the stock market. That’s how it works.

This week's interesting finds

September 21, 2019

Earlier in the summer, we presented our Investment team’s top literary picks for the season. We hope you enjoyed them! Now, in the spirit of sharing interests, we’d love to hear which books and podcasts have caught your attention lately. Share your recommendations HERE and we may feature them in an upcoming edition of Inside Edge! 

Video: An investor's journey with EdgePoint

We’re proud of how we’ve been able to help our partners and end clients by building their wealth during the first 10 years of our existence. To help build for EdgePoint’s second decade, we’ve made a video to remind people that the first one wasn’t always a smooth ride but that it paid to be patient during the tough times. Volatility is a constant in the market, how our clients react to it however will determine if they can get to their Point B. 

More on negative-yielding bonds

According to Jeff Gundlach: “79% of all negative-yielding bonds are held by central banks.”

With $14 trillion in negative-yielding debt globally, that means that $3 trillion was bought by actual investors.

Saudi oil reserves

Members of the International Energy Agency are required to hold emergency stocks of oil that could cover 90 days’ worth of lost imports. They can deploy these reserves in unison to avoid an oil shock, as in June 2011, when the U.S. and 27 other countries acted to release 60 million barrels of oil from strategic reserves to drive down prices during the disruption caused by the civil war in Libya. The U.S. holds around 600 million barrels of oil in reserve and other governments have a further 1.2 billion.

Saudi Arabia’s own oil reserves have fallen in recent years, but remain sufficient to ensure the kingdom’s customers don’t experience shortages. The only stipulation is that the disruption must be short-lived. The nation holds enough to cover the country’s exports for around 35 days.

A look at what countries are dependent on Saudi oil.

The chart on the left shows total crude exports from Saudi Arabia by destination country with Japan, China, US, South Korea & India making up the bulk of their exports. The chart on the right shows Saudi Arabia’s share of each nation’s crude petroleum imports with Japan and South Korea being the most dependent.

How Buffett's Brain Works

Here are some key factors Warren Buffett considers when looking at potential opportunities:

Simplicity - Is the business easy to understand?
Operating History  - Has the business been around for a long time, with a consistent operating history?
Long-Term Prospects - Is there reason to believe that the business will be able to sustain success in the long-term?
Rational Decisions - Is management wise when it comes to reinvesting earnings or returning profits to shareholders as dividends?
Candidness - Does the management team admit mistakes? Are they honest with shareholders?
Margin of Safety - What’s the chance you’ll lose money on the stock, in the long run, if you buy it at today’s price?

This week's interesting finds

September 14, 2019

Earlier in the summer, we presented our Investment team’s top literary picks for the season. We hope you enjoyed them! Now, in the spirit of sharing interests, we’d love to hear which books and podcasts have caught your attention lately. Share your recommendations HERE and we may feature them in an upcoming edition of Inside Edge! 

The worst day for momentum since 2009

Earlier this week many growth stocks (generally companies that are seeing rapid profit increases) took a dramatic turn downward as measured by Bloomberg’s Pure Growth Portfolio. In essence, many of 2019’s hottest stocks took a large hit, while the year’s most unloved stocks have enjoyed a rally.

This sudden reversal is what drove US momentum to have its worst single-day decline since 2009.

Can you stomach the next big market swing?

The quiz that your financial adviser may have given you isn’t really a good way of understanding your tolerance for risk.

If I ask you in a questionnaire whether you are afraid of snakes, you might say no. If I throw a live snake in your lap and then ask if you’re afraid of snakes, you’ll probably say yes—if you ever talk to me again.

Investing is like that: on a bland, hypothetical quiz, it’s easy to say you’d buy more stocks if the market fell 10%, 20% or more. In a real market crash, it’s a lot harder to step up and buy when every stock price is turning blood-red and your family is begging you not to throw more money into the flames.

This is why financial advisors use risk tolerance questionnaires to help determine how much risk their clients should be exposed to. Unfortunately, imagining your future behavior or accessing that behavior from a risk questionnaire isn’t as easy. New research shows financial advisers create drastically different portfolios even when clients appear to have the same tolerance for taking the risk.

Professionals in many fields are vulnerable to what the Nobel prize-winning psychologist Daniel Kahneman calls “noise,” or variation in judgment driven by such irrelevant factors as emotion, time of day or the weather.

To do better, think about how your past experiences might shape your future expectations. Did you buy your first stock at the beginning of a bull market? That could skew you toward taking more risk. Did you start a business during a recession? That could make you more gung-ho if it thrived or gun-shy if it failed.

One researcher suggests that the best guide to whether you will dump stocks in the next financial crisis is whether you did in the last one.

Your perceptions of risk are only part of the puzzle. At least as important is your risk capacity. Think of your spending habits, your non-financial assets and how easily you could sell them in a pinch. Also vital are your goals. You can’t know how much risk to take until you estimate when and how much you’ll need to spend in the future.

Ultimately any good adviser should devote more time to your risk capacity and your goals than to your risk tolerance.

A behavioral prescription

There have been 17 separate 5% pullbacks since stocks bottomed in 2009. Each one of them felt like the top. The chart below shows some of the headlines and quotes you might have read during these market declines. 

It’s hard to see headlines like this and not act on them. We know now that our worst fears did not come to pass, but there was no way to know at the time that each and every one of these pullbacks would resolve themselves to the upside.

One of the worst things that investors can do is overreact to market volatility. It’s perfectly normal to feel something, but adopting an all in or all out mentality when the market goes up and down is destined to fail.

How the invention of spreadsheet software unleashed Wall Street on the world

At one point or another many of us have had to use spreadsheets for school, work, or personal use. This article points to some interesting correlations between Wall Street and the rise of the spreadsheet.

In 2010, a pair of researchers published a controversial economics paper. It was cited by UK politicians to justify austerity measures that sparked economic and employment crises, and anti-austerity protests—measures that the UN later called “punitive, mean-spirited, and often callous” inflicting “great misery.” In 2013, however, this widely influential paper was found to have been substantially off in its estimates, thanks in part to a simple spreadsheet error: specifically, “a few rows left out of an equation to average the values in a column,” the Guardian wrote at the time.

This famous foul-up is just one of many instances when digital predictions have let us down, creating a sharp contrast between the reality of things and what the numbers foretold.

Rock-bottom bond yields spread from Japan to the rest of the world

When the Bank of Japan’s board meets on September 19th, it is not expected to reduce its main interest rate, currently at -0.1%. But any increase in interest rates seems a long way off. And as long as rates are at rock-bottom in Japan, it is hard for them to be raised in other places. Bond-buying by desperate Japanese banks and insurance companies is a big part of what keeps a lid on yields elsewhere.

Japan is already the world’s biggest creditor with its net foreign assets (Japans assets minus what they owe to foreigners) at around $3 trillion, or 60% of its annual GDP. This chart shows how since 2012 both sides of its national balance-sheet have grown rapidly as Japanese investors borrowed abroad to buy more and more assets.

Globally, Japan’s impact is felt most keenly in corporate-credit markets in America and Europe. Japan’s pension and insurance firms are in a pinch to make regular payments to retirees so they look abroad for yield. Some see Japan as a template: its path of ever-lower interest rates is one that other rich, debt-ridden economies have been destined to follow and will now struggle to escape.

This week's interesting finds

September 6, 2019

EDGE-ucation camp
Since 2013, EdgePoint has been organizing EDGE-ucation camps for the children of our partners. These one-day events are aimed at kids ages 13 to 18 and cover the foundations and importance of investing and building long-term wealth. 

The camp has grown every year. As more kids attend these events, we’ve been adding more camps in more cities. 

Over the last 2 years, EdgePoint partners have visited 13 cities across Canada to share their knowledge and experience about things that can hurt savings and what people can do to reach their financial goals. Our hope is that with this program we can teach future generations about investing and other concepts that will help foster good future decision-making, financial independence, and self-confidence.

We sent out a survey to see how these lessons have impacted the attendees of the camp. Here are the results.

We were excited to see two campers select “Other” because it means they took the lessons to heart and looked for new ways to apply them. The answers were:

• Opened a savings builder account with a higher interest rate
• Want to buy a stock

Is Your Stock Portfolio A Museum or A Warehouse?

You don’t make a great museum by putting all the art in the world into a single room. That’s a warehouse. What makes a museum great is the stuff that’s not on the walls. Many items don’t make it to the walls so there is an editing process. There’s a lot more stuff off the walls than on the walls. The stuff on the walls is the best sub-subset of all the possibilities.

When you apply this crucial lesson to building your stock portfolio, it means that you are likely to succeed as an investor not just by the stocks you own, but also by the ones you don’t.

People buy stocks for all kind of reasons – they like them, their neighbours like them, their friends are making money on them, someone on Twitter is shouting about them, their prices have risen sharply in past few months, someone recommended them on TV, someone wrote about them on online forums, someone is boasting about them on WhatsApp groups, etc.

Often, we end up building warehouses of our portfolios, not curated museums. Some people even maintain multiple portfolios, and each looks like a zoo of mismanaged, rowdy animals. You will do yourself a world of good by saying no to most things and not adding a lot of unwanted stocks to your portfolios. In other words, be a curator of stocks, not a warehouse manager.

Skin in the game matters, especially for riskier, leveraged investment approaches

In Norway, tax returns are publicly available making it possible to collect data on asset managers’ taxable wealth.

Three researchers conducted a study on 120 private equity professionals in Norway. The main objective was to test whether or not co-investment had a meaningful impact on manager choices. The researchers found that managers with more skin in the game tend to select investments with less risky cashflows and took on more debt to finance purchases as their purchases were generally of lower risk. The research suggests that outside investors in private equity funds could incentivize their managers to take less risk by requiring them to invest their own capital.

Over $1 trillion in negative yielding corporates outstanding

























Maybe everyone is buying negative yielding bonds because some of them are up 35% YTD...