Q1-2021 Comment: Patience Prevails

As we lap the first anniversary of the onset of the global COVID 19 pandemic we should all take a moment to be thankful for our health and privilege. Looking back, it is amazing that the pandemic has been more destructive than all but the most dire initial predictions from a year ago and yet we remain resilient. The journey for our portfolios has been similarly unexpected and privileged.  A year ago today we had just endured the most rapid drawdown in history, with equities shedding more than 30% of their value in only a few weeks. Volatile financial markets were showing generational signs of stress requiring dramatic intervention from the US Federal Reserve and other central banks to quell panic and restore order. Over the summer, a seasonal ebb in viral transmission combined with massive fiscal stimulus enabled by central banks was enough to restore consumer confidence and the effective vaccine trial results released in November sealed the recovery for equity markets. None of this minimizes the physical and economic devastation brought on by the pandemic, nor does it mean that we are even close to putting it behind us. The effect of the pandemic will surely be felt for years and maybe even decades to come, especially with respect to government finances. Few could have predicted the sequence of events that occurred last year, even fewer could have predicted that even after all those events that portfolios would be making new all-time highs. I’ve had many clients, friends, and acquaintances express their amazement at how well their investments have performed given the circumstances. Many of these people have expressed caution and/or concern about the prospect of another downturn. While I agree that the current state of markets seems out of step with the reality of the ongoing pandemic, it is imperative that we remain invested given the prospect of further currency devaluation by governments and central banks. With interest rates near zero, and inflation expectations climbing, we need to protect our hard-earned capital by investing it without taking undue risk. Our infrastructure focused, dividend paying portfolio represents a reasonable tradeoff between risk and return on a short, medium, and long term basis and I am pleased to report that recent strong performance would indicate that this view is growing in popularity.

The S&P TSX Composite Total Return Index appreciated 8.1% during the first quarter of 2021, nearly doubling the S&P 500 Total Return Index which returned 4.2% in Canadian dollars. Technology and Materials (mining) were the worst performing sectors on both sides of the border while Energy and Financials led. Newhaven’s equity portfolios enjoyed a second consecutive quarter of outperformance as we are positioned favourably for the current shift in market sentiment. Our equity portfolios were up more than 11% for the second straight quarter and are up nearly 25% on average since the US election. All Newhaven portfolios made new all-time highs in Q1 and, more importantly, dividend income has already grown by 2.8% so far this year with many more dividend increases ahead.  Recent strong performance confirms that staying invested and making necessary adjustments has preserved and grown our capital while providing a steady stream of dividend income, even in a very uncertain and challenging time. This particular crisis remains unresolved as do others we will undoubtedly encounter in the future, but it is crucial to hold valuable equity assets through occasional periods of heightened volatility in a low interest rate world.

Going forward, the backdrop is broadly constructive for our portfolios. The rotation from richly valued technology stocks, and the US equity market more generally, to other sectors and markets has only just begun. Apple alone is significantly larger than the entire Canadian market so even marginal dollars flowing out of technology behemoths can have a significant positive effect on performance elsewhere. Additionally, governments around the world have passed unprecedented amounts of fiscal stimulus at a time where many households have excess savings due to avoidance of travel and leisure activities caused by the pandemic. Finally, and perhaps most importantly, central banks are buying trillions of dollars of government debt annually through quantitative easing programs, pushing more and more investment savings up the risk curve into equities. All of these factors position the equity market broadly, and our portfolios specifically, as beneficiaries of continued inflows of capital seeking to avoid negative returns after inflation by sitting idle. The 4.0-4.5% dividend yield on our portfolios remains nearly three times higher the comparable Government of Canada 10-year bond yield at ~1.5% and significantly higher than market indexes as well. Infrastructure investments are an attractive and relatively safe place to preserve and accumulate wealth. The supply of dollars has been increasing dramatically while the options to invest those dollars safely have been declining.  This reasoning, while not exhaustive, is the basis for remaining optimistic in the short, medium, and long term with regard to our portfolios.

Of course, all investments and outlooks also involve risks. The two key risks at present are the pandemic and the prospect of inflation. The pandemic’s impact has become easier to address but remains impossible to predict. The current market outlook for 2021 and beyond is predicated on vaccines eventually overpowering the variants of concern in a race against the clock. The risk for markets is no longer the pandemic as it stands today, but rather the expectation that the pandemic will be brought under control in relatively short order. Unfortunately, the virus is a moving target that is evolving in a dangerous direction in terms of severity and ease of transmission. Vaccines will no doubt be tweaked and improved, but the virus will constantly evolve as well. The present circumstances in the UK are giving markets hope that the vaccines can win the race given Britain has vaccinated more than half their population and are seeing cases steadily fall even in the face of new variants. The next six weeks will be a crucial test for vaccine efficacy as the US will assume the lead in vaccinations with ongoing lax social distancing behaviour and variant spread. Any sustained negative change to the trajectory of vaccine production or efficacy has the power to dramatically downshift market sentiment, at least in the short term. 

The risk that inflation poses is more nuanced and has potential positive and negative implications for the economy and equity markets. Clearly the actions of governments and central banks are inflationary. Giving additional liquidity and lower interest rates to consumers who are broadly already saving allows them to pay higher prices for durable goods like homes, bicycles, patio furniture and other household goods. Additionally, the supply chain for many of these goods has been disrupted, limiting the ability to increase production, resulting in price increases for goods and potentially wage increases for the workers that produce them. This is textbook inflation, and we are living it in 2021 in a way we have not seen for many years. At the same time, we continue to battle the same powerful deflationary forces that have been entrenched throughout the 21st century, namely: high debt, technological innovation, globalization of labour and an aging population hoarding savings. The ability for inflation (and interest rates) to rise too far before cheaper labour (or technology) pushes down costs and/or increases production is limited. The outcome of the inflation debate is uncertain and highly dependent on the path of the pandemic combined with government response. Our portfolios are well positioned to handle inflation given the ability for our companies to pass through, and even benefit from, rising prices. At the same time our portfolio is designed to protect capital from a potential deflationary shock in financial markets due to the essential nature of the assets our companies own and operate.

Over the past year financial markets, and consequently this newsletter, have been dominated by the macro themes and events impacting our lives. Q1 provided several noteworthy developments amongst the companies we own allowing for a welcome shift in focus back to our portfolio of businesses and important work their employees do every day (owned companies in bold):

• CAE Inc is a global leader in the production and operation of flight simulators and pilot training schools for both commercial and defense aircraft, headquartered in Montreal. At the onset of the pandemic, they were an early mover into emergency ventilator production. CAE was added to portfolios last fall prior to the positive vaccine news at very attractive levels. During the first quarter of 2021 CAE purchased L3Harris Inc., a leading defense pilot training company in the US, which was very well received by investors. I expect CAE’s dividend to be reinstated at some point within the next 12 months and the business to grow to new heights if/when global air travel recovers. In the meantime, their emphasis on business jet and defense training will continue to help them weather the storm.

• Shaw Communications agreed to a friendly takeover by long-time rival Rogers Communications. This was not surprising following the passing of patriarch J.R. Shaw last summer, however the $40.50 per share offer price exceeded expectations. Clearly there will be significant opposition to the deal by government and consumers, however precedent transactions have been allowed in Canada (BCE/Manitoba Telecom) and in the US (Sprint/T-Mobile). Given Rogers is prepared to divest Shaw’s wireless business in whole or in part, it seems that the transaction has a path to closure. Significant upside from Shaw’s current ~$35 share price remains to Rogers’ offer and as such we wait patiently for more developments

• Telus completed a highly successful IPO of Telus International for nearly $1 billion in proceeds while retaining a majority stake in the business. Surprisingly Telus’s share price has dropped despite the fact that the IPO of Telus International has traded up by as much as 60%. Telus retains a majority stake and they have at least two more standalone businesses that could surface additional value at some point in the future (Telus Health and Telus Agriculture)
• InterPipeline was approached in a hostile takeover from Brookfield Infrastructure at $16.50 per share. Oddly, we own both companies involved in this transaction and as such are relatively agnostic as to the outcome. Clearly Brookfield sees untapped value in the Heartland Petrochemical Complex that is scheduled to be completed by InterPipeline late next year. The complex will produce plastic pellets to be used in durable plastics from discounted Canadian propane feedstock. Importantly these plastics are not used in single use packaging, but rather more durable and recyclable applications like automotive parts and computer housing. InterPipeline’s shares have traded well above Brookfield’s offer price and as such a higher bid is expected. If Brookfield were to walk away it might represent our best long-term outcome as we would then be able to more directly realize the potential earning power of this project.
• Savaria is another new holding purchased mid last year that produces stairlifts and other home accessibility products catering to an aging population wishing to stay in their homes. Clearly the trajectory for the business was positive even before the pandemic and is even more assured now. Savaria acquired Swedish competitor Handicare in Q1 leading to a jump in the share price as investors anticipate significant synergies to result from the business combination.

• Finally, Arc Resources and Seven Generations Inc agreed to a merger of equals, creating only the third investment grade natural gas producer in North America with world class resources. Arc Resources is one of the most environmentally responsible natural gas producers in the world and is now operating at a scale that is likely to attract a broader investor base as LNG Canada progresses toward completion in the middle of this decade.

In total, seven of our companies were involved in transformative transactions during the quarter and nearly all of them were well received. Despite strong performance over the past 5 months our portfolio remains attractively priced relative to richly valued technology stocks, and other speculative investments that made headlines in Q1, while remaining conservative. The market has expressed some bold assumptions about the future path of the pandemic as well as the future of certain companies and industries in what appears to be several bubbles. As 2020 progressed I found myself coming back time and again to the famous Mark Twain quote:

 “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”.

We are not making bold assumptions about the future in our portfolios. In fact, we are attempting to forecast as little about the future as possible other than the view that our essential needs will continue to be satisfied by companies with entrenched infrastructure. Our approach from here can best be described in a quote oft repeated by veteran investor Howard Marks of Oaktree Capital:

“Move forward but with caution”.   

We will continue to invest money prudently on our clients' behalf in a way that minimizes the risk of loss while avoiding the risk of standing still.