Q4 - 2022 Investment Commentary: Looking Back and Forward

At the end of each year, it is a useful exercise to look back before looking ahead.?When examining the last twelve months it is incredible to think about all that society and financial markets have digested.?Just one year ago we were still in the throes of the omicron wave of the Covid 19 pandemic, schools were closed and Intensive Care Units were overflowing.?Shortly thereafter, the wave of infections thankfully receded and imparted enough herd immunity that the western world has been able to remain open and live with the virus in a more normal fashion over the last 10 months.?Russia invaded Ukraine in late February, sending commodity prices spiraling upward, eliminating any remaining hope that the inflation we were experiencing would indeed prove to be transitory.?Central Banks were forced into action, reversing the low interest rate policy they had been committed to less than 12 months earlier. Starting in March, we embarked on the second fastest pace of interest rate increases on record, exceeded only by the legendary cycle in the early 1980’s led by Paul Volker.??The year closed with inflation not yet tamed, the Russia/Ukraine conflict not yet solved and a marked deterioration in Sino-US relations just as China finally, and abruptly, abandoned their controversial zero covid policy.

The points above are just a brief sampling of the turmoil endured in 2022, and financial markets were forced to adjust to the rapidly changing landscape.?The tech bubble and the bond bubble simultaneously burst leading to the worst combined year for US stocks and bonds on record dating back to WWII.?The TSX fared better owing to the lower concentration of technology stocks and high concentration of energy companies in the Canadian index.?The charts below from Scotia Global Equity Research are an excellent depiction of how rare an outlier 2022 was relative to the last 6+ decades of returns for equities and bonds combined:

The S&P TSX Total Return Index increased 6.0% in Q4 but lost 5.8% for the full year.?The S&P 500 index in the United States also had a solid Q4, with a 7.2% increase, but declined 18.1% for the year in US dollar terms.?The Nasdaq was down 33.1% on the year as technology shares drove the majority of the negative performance in the broad US market.?Every equity sector globally had decidedly negative performance outside of energy.?Long duration bonds had the worst year ever recorded, with 30-year government bonds down 27.9% in Canada and 32.1% in the United States. 10-year government bonds declined 12.5% and 16.5% respectively in Canada and the US.?The digital asset space endured a near complete collapse in 2022.?Bitcoin fared the best, losing nearly two thirds of its value, while owners of several alternative tokens, digital asset exchanges, and virtual art/real estate assets lost almost the entirety of their ill-conceived investment. ??The pain in financial markets was widespread and generally increased as you progressed along the risk spectrum.?

Our Newhaven portfolios performed admirably in 2022, significantly outperforming most major benchmarks and peers.?Following an exceptionally strong 2021, portfolio declines in the low single digits are encouraging in the context of the widespread downdraft experienced across virtually all asset classes globally last year.?So many investors were ill prepared for the shifts that occurred simply by following a passive asset allocation and indexed strategy.?We were actively positioned to preserve capital by owning companies with durable businesses that produce steady cash flows at reasonable valuations.?The discipline to avoid technology shares, high yield bonds, digital assets, real estate, and private equity in the face of a stimulus aided melt-up over the past few years is proving worthwhile as shown in the chart below. Valuations of riskier asset classes likely have further to fall in 2023, absent a substantial change in interest rate policy, an unlikely probability in our view.?

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The most encouraging sign from our portfolios in 2022 was the dividend growth performance.?Nearly 80% of portfolio holdings increased dividends in the last twelve months. Portfolio income (interest and dividends deposited into accounts) increased by ~20% year over year excluding the impact of cash flows.?(Note this figure was calculated by summing interest and dividends paid into actual client portfolios with zero external cash flows in or out for the period from Jan 1, 2021 to Dec 31, 2021 and comparing it with the period from Jan 1, 2022 to Dec 31, 2022).?The marked increase in portfolio income was driven by substantial dividend increases as well as the uptick in short term interest rates available on cash holdings.?Dividend increases are the best available signal of portfolio health as they reflect past performance AND confidence in the future profitability of the business simultaneously.?Portfolio income is set to grow again in 2023.?We have already registered dividend increases from a few core holdings this year and higher interest rates on cash will be paid for the full 12 months in 2023 as well.

Unfortunately the broad market outlook for 2023 is not as positive as you would normally see following a decidedly negative year.?Since the inception of the S&P TSX Composite Total Return Index (includes dividends) in 1957, there have been 19 calendar years with a negative return (29% of years were negative).?The average return in those negative years is -9.8% and in the year following a negative year the average return has been +17.2%.?This makes sense intuitively; the market goes up more years than it goes down and the years following a down year are typically better than average.?However, there have been two instances where a full year market decline was followed by another and interestingly they both have parallels to the present environment.?A -0.8% return in 1969 was followed by a -3.6% return in 1970 while a -12.6 return in 2001 was followed by a similar -12.4% return in 2002.?The prolonged downturn in 1969/70 resulted from stagflation (inflation with stagnant economic growth) while the 2001/02 period coincided with the collapse of internet technology stocks.?The current downturn shares similar characteristics with each of these time periods but with comparatively higher debt levels, poorer demographics, and heightened geopolitical risks, adding complexity going forward.

Last year started with a cautious near-term outlook and 2023 is very much the same.?Increased interest rates have only begun to filter through to consumers who are already feeling the pain from food and energy inflation.??With each passing month, more debt comes up for renewal at higher interest rates.?This will be a headwind for the foreseeable future as, even in the most optimistic scenario, interest rates are not returning to the extremely low levels of 2020/21 anytime soon.?House prices and asset prices have declined significantly in the last twelve months which will further reduce consumer confidence and likely spending as well.?Equity markets declined in 2022, mainly resulting from the impact of higher interest rates, which impacted the S&P 500 more than the TSX Composite as expected. ?There is further downside for equity indexes in 2023 if earnings deteriorate as anticipated due to the factors above. ?????

Fortunately, our Newhaven portfolios remain defensive with little exposure to the areas of the market likely to see the greatest contraction in earnings relative to valuation levels.?Consumer and Technology companies are still richly valued on a relative basis and are at risk of further multiple contraction and falling earnings.?Conversely, the utilities, infrastructure, and energy companies we hold are likely to see modest growth in earnings and valuation multiples as investors seek stability.?Recently there has been an influx of market strategists on TV extolling the virtues of dividend stocks with stable cash flows and meaningful dividend yields, an indication that the rebalancing of investor risk appetite in our favour has further to go.

We build our portfolios for the long-term and the opportunity for our portfolios looking out a decade or more is extensive.?The need for our country’s resources, and infrastructure to deliver them, was brought back into focus in 2022.?The energy transition continues as does population growth on our continent.?The paradigm of abundant resources, historically cheap capital, and geopolitical cooperation appears to be shifting such that scarce resources and manufacturing are needed closer to home.?With the anticipated completion of the Transmountain pipeline in 2024 and LNG Canada in 2025, our country will significantly diversify our opportunity to supply energy to the world.?This in turn, should spur more investment in Canada and require more infrastructure to support that investment.?The United States has already passed a series of legislative acts that will provide infrastructure investment opportunities for our holdings with cross-border businesses.?Finally, the era of ultra-loose monetary policy that fueled a speculative bubble in companies that produced little if any lasting value to society appears to be firmly in the rear-view mirror. Scarce capital is now seeking safer investment opportunities in things we need providing a tailwind to the valuations of the companies we own.

In summary, 2022 was a difficult year for financial markets and 2023 is shaping up to be another challenging year.?Despite the turmoil in 2022, our Newhaven portfolios performed exceptionally well, owing to our discipline to avoid investments with permanent capital drawdown risk.?Though a few holdings experienced significant declines in 2022, we have long-term confidence in the underlying businesses of these companies. We view downturns in share prices for viable companies as buying opportunities to enhance our long-term returns.?Conversely, investments made during bubbles such as a 30-year bond yielding less than 2%, or a risky technology stock at a stretched multiple, are unlikely to recoup drawdowns experienced in 2022.?Looking ahead to 2023 and beyond, Canadian equities, and specifically the sectors where we have material exposure are poised to prosper in a world where the pendulum is swinging back to tangible needs and a more normal cost of capital.?Our eyes remain fixated on the horizon, not the waves immediately in front of us.?