Q1 - 2022 Investment Commentary: "Stay Patient and Stay Focused"

The first quarter of 2022 was the most successful to date for our Newhaven portfolios.?At the same time, the world appears to have moved from one crisis to the next during the last three months.?Financial markets correctly forecasted the rapid rise and fall of the less severe Omicron driven wave that brought significant policy changes across much of the globe, leaving society much closer to normal today than at any point during the last two years.?This positive development has largely gone unnoticed due to the stunning invasion of Ukraine by Russia.?Inflation, which had appeared to have a path to de-escalation as 2022 progressed owing to base effects and slowing demand, has instead been stoked to alarming levels by the conflict.?This has led to a rapid change in interest rate expectations among investors and central bankers alike.?Despite the turmoil, equity markets navigated the first quarter remarkably well; however recent gains in broad indexes were produced with weak underlying metrics and are unlikely to last.

Outside of Australia, the Canadian stock market has been the best performer in the developed world in 2022 and would have been the clear winner if not for Shopify’s dramatic collapse.?The S&P TSX Composite Total Return Index has gained 3.8% so far this year.?The S&P 500 Total Return Index dropped well into correction territory (down more than 10%) in February before staging an impressive rally to end the quarter.?The broad US market is down 5.8% so far in 2022 while the tech heavy Nasdaq Composite is down 10.5%. (All figures are calculated in Canadian dollar terms and include dividends)

At the end of Q4 I wrote “I remain cautious on technology valuations and thus broader market indexes owing to their high concentration in technology companies. At the same time, I remain very upbeat on our portfolio positioning given strong fundamentals reinforced by dividend growth.”?Not all predictions come true, but the confidence in our positioning has been validated with emphasis so far this year.?Our Newhaven portfolios have significantly outperformed all North American markets in 2022 as investors have frantically repositioned portfolios to withstand geopolitical uncertainty and inflation.?Commodity producing sectors including Energy and Materials (Agriculture, Mining, Forestry, and Precious Metals) were the best performing sectors during the quarter, an obvious outcome given the circumstances in Europe. ?Interestingly, defensive sectors like Utilities and Telecommunications also performed well as investors started to recalibrate risk in portfolios.?Not surprisingly, Technology and Health Care (largely marijuana companies) were, by far, the worst performers during Q1. The following chart depicts year-to-date performance for each sector in Canada to March 31st.?Note - The yellow bars indicate sectors where our portfolios have significant (>5%) weightings:

As mentioned earlier, we were positioned in advance for the shift in investor sentiment depicted above.?The biggest advantage of our active approach is to be able to select specific investments that match our long-term objectives regardless of what is in favour in the moment.?This has been made even more important in recent memory due to the lack of guaranteed (fixed) return available on bonds or GIC’s, and thus the need to structure an increasingly equity-based portfolio conservatively.?In recent years, passive (indexed) investing has risen in popularity with the desire to reduce fees without sacrificing performance.?Unfortunately for those that have made the switch, we seem to be coming to a point in the market cycle where indexed investing struggles to perform. Index concentration levels have reached extremes not seen since the .com bubble in 2000.?Additionally, the sheer size of the passive pool has grown to the point where professional investors and traders can take advantage of a passive owner of a mechanical index.?This is best explained using the case study below:

?Passive Investing – A Case Study:

Many investors have made the switch to passive (indexed) investing in the past two decades as fees on Exchange Traded Funds, commonly known as ETF’s, have dropped while many financial advisors using active mutual funds with higher fees have chronically underperformed during a decade of excess liquidity.?Passive investing involves purchasing investments that track one or more stock indexes and holding indefinitely.?Like anything there are pros and cons to this strategy.?The pros are widely known and understood, namely the lower fee and adequate diversification associated with broad market ETF’s like the S&P 500 ETF in the US (TICKER: SPY) and the S&P TSX 60 index in Canada (TICKER: XIU).?The cons of indexed investing are less clear and stem from the construction methods of the indexes themselves.?A recent example of index inefficiency involves Canopy Growth, the standout Canadian marijuana company known more commonly by its ticker WEED.

First some background:?The S&P TSX 60 index is meant to reflect the 60 largest companies in Canada.?An index committee meets regularly to make adjustments to the index usually on the basis of a company’s size, but the committee has some discretion as to what companies get added and when.?Once a company is added to an index, the only way for it to be removed is for it to no longer meet the index’s eligibility criteria, usually following a collapse in share value.?In this way it is harder to get added to an index than to be removed (this is exactly what happened with Canopy Growth).?Additionally, active investors and high frequency traders are aware of when a stock is being considered for index inclusion and can bid up a company’s share price prior to inclusion, raising the price the index “pays” for the position.?This matters if you own an ETF as they must purchase AFTER the announcement that stock has been officially included in the index.

Now to Canopy.?After years of aggressive equity issuance funding a plethora of acquisitions, Canopy Growth was added to the TSX 60 index in April of 2018 with a market capitalization of just over $20 billion, a significant index weight at the time.?Canopy’s market capitalization peaked later that month at just over $24 billion (up 20% from purchase for indexed ETF owners) and again during the worst of the COVID lockdowns in 2021, before plummeting to $3.5 billion where it remains today.?The stock was removed from the TSX 60 index this March, nearly 3 years after its addition. Indexed investors received an 85% loss on their 3-year investment in Canopy before fees.?Remember too, that just as traders know when a stock is being included in an index, they also know when one is likely to be deleted meaning both the price paid AND received can be manipulated in ways that are adverse for the indexed buyer.?As indexed investing has become more popular, trading around index rebalances has become more prevalent and lucrative for professional traders at the expense of ETF holders.

To be fair, technology success story Shopify was added to the TSX 60 a month before Canopy and remains up ~300% from purchase for indexed investors, however the jury is still out on whether those gains will be sustainable, as the index will either hold the company forever or sell it if it collapses at some point in the future.?Given neither Canopy or Shopify produce any dividend income, their gains within the index ETF are purely paper based and are likely to erode over time for passive holders without dividend flow to underpin their long-term value.?

Fortunately for indexed investors, indexes also hold many of the same companies we own that produce steady returns and dividends like Royal Bank, Enbridge, Canadian Natural Resources and Fortis as examples. Over the long term it is these companies that do the heavy lifting for the long-term indexed (ETF) investor and cover for the sins of companies like Canopy, Research in Motion, Nortel, Valiant Pharma and numerous others that have eventually gone bust over the years.?

This begs the question: “What if I just bought the sustainable companies that do the heavy lifting and avoid the catastrophic losses like those in the companies mentioned above?”?My answer: This is exactly our goal when managing your money.?By staying concentrated in sustainable names, we will miss the odd shooting star that puts up incredible returns for relatively short periods of time (although not everything fails as quickly as Canopy), but we also will not be left holding a withering asset as it declines.?We are building a return profile for your diversified, yet concentrated, portfolio designed to last decades, not years, and thus we cannot be taken off task with shorter term trends.?Additionally, because we are not reliant on index criteria to buy or sell, we can actively invest in companies before they become popular and exit while they still are, although this timing element is far less important than the selection of sustainable compounding companies for the long-term.?We certainly do not get each investment correct, however the longer we remain disciplined in our approach the better chance we have of exceeding an ETF’s return by avoiding the worst companies, and we do it with less volatility and more dividend income. Canopy was a bust you could see coming the day it entered the index, it was easily avoided by intelligent active investors.

Looking ahead, we seem to have an inordinate number of unanswerable questions.?The most pressing of which with regard to our portfolios are:

• How long will the conflict in Ukraine last and will it escalate further before its conclusion?
• What are the short, medium, and long-term effects of the conflict in Ukraine?
• Will China be emboldened by the actions of Russia regarding Taiwan?
• When will we see a supply response to higher commodity prices?
• How high can interest rates go before the financial system shows significant stress?
• Will central banks do what is necessary to tame inflation, even if it causes a significant recession?
• Will governments allow central banks to act independently?
• How will the consumer fare in the face of higher food, energy, and housing costs in the form of higher mortgage interest payments?
• How will financial markets cope with an extended period of falling bond prices and higher discount rates for equities?
• Will labour inflation prove stubborn given flagging demographics and supply chain reorganization?

Clearly we do not have definitive answers for any of these questions, but at this moment I have the following views about the future:

• The conflict in Ukraine has changed the game for inflation and thus interest rates in the short to medium term.?The inflation we have dealt with over the past few quarters is a result of the pandemic and was set to ease. The food and energy inflation we are dealing with now is likely to prolong this inflationary cycle and elicit a stronger response from central banks, even though monetary policy tools are not ideal for combating commodity price (cost push) inflation.
• Go forward supply chain and energy infrastructure decisions will be made with a very different calculus.?Decision makers can no longer rely on a relatively frictionless global system allowing for the production of essential goods to fall to the lowest marginal cost producers.?Resiliency and reliability are poised to trump efficiency in the years ahead.?This will add cost to nearly everything we need and bodes well for many of our portfolio holdings.
• Consumers are likely to be challenged for an extended period by the increases in food and energy prices we are experiencing now and the increases in mortgage payments from the interest rate increases we are likely to see in the next 12 months.?Additionally, durable goods consumption was pulled forward during the pandemic leaving even less cushion for consumer demand to prop up the economy going forward.
• Liquidity flows resulting from 0% interest rates, low energy prices, and emergency government assistance helped push asset prices (stocks, bonds and real estate) to new highs despite the economic turmoil we endured over the past 2 years.?These former liquidity sources have either stopped flowing or in the case of interest rates are now contracting credit availability.?The draining of liquidity from the economy and financial markets could expose excesses of the past decade.
• Investors have begun to reposition portfolios with a focus on safety of capital and inflation protection, paying more for the types of companies we already own.?As financial markets and the economy digest higher interest rates the prospects for share price volatility and recession increase.?We should be prepared for both in the months ahead.
• Ultimately, I believe that increases in interest rates will be constrained by high absolute debt levels and lack of political will.?This should allow for a reasonably soft landing for the economy but a recession of some duration seems like a high probability in the next 24 months.

Given the view articulated above, I feel we are well positioned for what is ahead of us and we are seeing that demonstrated by the resiliency of both capital and dividend income in our portfolios relative to other avenues of investment at present.?Returns over the past few quarters are unlikely to repeat and we need to be prepared for a temporary regression if fear or panic sets in.?Dividend income, however, continues to grow steadily and dividends will be paid regardless of what happens in the short term.

In summary Q1 was a very successful quarter for our portfolios on an absolute, and especially relative, basis.?This is the point in the cycle where our careful positioning shines as the tide of liquidity begins to recede, exposing investments of lower quality and sustainability.?The inflation protection built into our portfolio is safeguarding the value of our hard-earned capital when we need it to the most.?I remain very cautious on the go forward prospects for both equity markets and the economy in the short-term and have taken steps to insulate portfolios by allowing dividends and profits from the redemptions and trades discussed above to add to cash positions temporarily.?I will look to redeploy these funds in the quarters ahead but will be patient to see how the first few interest rate increases are digested in the coming months.?Longer-term the prospects for increased in power demand in North America have been significantly bolstered by the conflict in Ukraine as companies re-evaluate supply chains (Intel building a semiconductor plant in Ohio as a key example).?Any re-shoring of manufacturing activity will require infrastructure to support these facilities and our portfolio is filled with companies that can satisfy this demand. It is my hope that the experience over the last 24 months has served to strengthen our clients' confidence in the strategy they have chosen Newhaven to execute. ?Our ultimate goal is to provide adequate investment returns with the understanding necessary to allow our clients to enjoy life with less financial stress.