Nancy - well, how did the second quarter (2Q16) go? I am preparing the financial statements so I know it is that time again for me to check in and see how much money you are making for us
Paul - good memory. It went very well in fact
Nancy - how well? How did our clients make out first?
Paul - quite well. Remember that Scott and I structured the Private Client business to appeal to pretty much any investor...my 83yr old parents, us, our boy's RESP, Scott and his family and everyone in between. In fact, in March we took on a special mandate for a client of ours as he wanted a very specific portfolio that he and I structured. Given our three models and our unique skill-set managing money across the entire capital structures of companies, we can create a model for most people and most mandates
Nancy - sounds complicated
Paul - well all that to say that when we do a Wealth Forecast (the first thing we do when a client comes on board) it effectively tells us what percentage to allocate to each of the three models: Fixed Income, Global Equity and Tactical. So we have three models but then we structure models of models. For instance, Scott's household is in 40% Fixed Income, 50% Global Equity and 10% Tactical. Our household is in 50% Fixed Income, 25% Global Equity and 25% Tactical. We have about 8 of these models of models to accommodate clients according to their Wealth Forecast and their Investment Policy Statement.
Nancy - can we get to how the quarter or year is going so far?
Paul - sure, sorry. I can only give you actual client performance (as per OSC rules) so I will use Scott's performance and our own performance because as I said, we have different exposures or weights to the three model but we are clients and invest in the exact same securities and models as our clients and all at the same price and timing. The difference between an Advisor and a Manager?...one "advises" clients what to do and one "manages" money for himself and those clients who see the benefit in having him do so for them,
Nancy - OK so how did Scott do first?
Paul - he did quite well. For the year to date (YTD) he was +4.8%. But, to be fair, Scott and we do not pay management fees so we should deduct about .6% from our returns. So comparing that to our other clients, he would have been +4.2% net of fees. Very solid YTD numbers but if we layer in the fact that Scott was sitting on 45% Cash over that period, the returns are spectacular.
Nancy - ah yes, I recall, he had strong risk-adjusted returns then, right?
Paul - that's right. Every time we buy and own an asset, there is risk of the asset going up or down. Some are more volatile than others. Something I do, that I doubt anyone else does, is run regression returns to calculate how much risk we are taking for how much return. This also flows into another calculation on how various asset classes correlate with each other. To not do this would be the definition of insanity as you could not possibly manage the inherent risk in a portfolio without knowing what the risk/return is over time. In fact, it wouldn't be a portfolio...it would be a pile of securities. So if we are getting "good" returns and we are doing so while sitting on large cash weighting, we are creating excellent risk-adjusted returns.
Nancy - and us?
Paul - well we had even better performance because of our much higher weighting to the Tactical model. Remember Scott has only 10% while we have 25%.
Nancy - percentage number please?
Paul - sorry, +9.1%. But again, we need to deduct the Management Fee that we don't pay but our clients pay which would have been just under .6% so that would have given us about +8.5% YTD. Not bad eh? And on top of that, we were sitting on 37% cash so extremely strong risk-adjusted returns for us too.
Nancy - so we are up a fair bit more than Scott? How come?
Paul - well primarily because we have a 25% weight in the Tactical model while Scott (and many clients) have a 10% weight to the Tactical. Also, we have a slightly larger weight in Fixed Income at 50% vs Scott at 40%.
Nancy - so did the Tactical and Fixed Income do really well YTD?
Paul - yes they did. In Fixed Income, we took a contrarian bet based on our ions of bond trading experience and current research and were long a good weight in 10yr and 30yr Government of Canada bonds along with two 30yr Investment Grade corporate bonds that have about an 80% correlation to 30yr Government of Canada bonds (remember the regression models I run? I know these Investment Grade 30yr bonds are 80% interest rate risk and 20% credit risk). All four of those bonds did quite well as did some of our High Yield bonds. Within the Tactical, we had a great YTD. We had a triple in Paramount Energy stock and a double in Rona when Lowes came in to acquire them. We also had some impactful trades in some very specific, special situation high yield energy bonds (these are not included as part of our fixed income models) that I have a long history with and do a lot of fundamental research on. I won't name them because we are still trying to buy more and we still have the positions on. There were a few trades that also added some decent value but we still have those positions on so I will not tell you what they are.
Nancy - and so because we had more exposure to the Fixed Income and Tactical, we are up more?
Paul - yes but remember, this is only over 6 months. Anything can happen the next 6 months. Don't get too excited.
Nancy - well why don't all clients move to the same weights as we have in our house?
Paul - good question. The simple answer is that a client's portfolio is designed with a purpose in mind based on the outcome of their Wealth Forecast and their Investment Policy Statement. If we can meet a client's future goals without taking a ton of risk, we will do so. Then we look at all kinds of asset classes and individual stocks on that regression basis to ensure we are always taking the least amount of risk possible to meet our collective goals.
Nancy - sounds nice and all but you always say that is is not enough to be up money, that you need to compare your performance to some benchmark or something like that. So how did you do versus the benchmark thing?
Paul - we did pretty well versus the benchmark thing too! If we look at the YTD performance of the Canadian Bond Universe ETF XBB with a 40% weight (Fixed Income) and the ACWI ETF (Global Equity) at 60% (Source: Bloomberg, Dec 31, 2015 to Jun 30, 2016) we would have seen a return of 2.79%. So compare that to Scott's performance of 4.2% PLUS he is sitting on 45% cash so you can see he outperformed our benchmark thingy by 1.4%. Very good. And our household at +8.5% vs 2.79% for the benchmark thingy means we outpaced the benchmark by 5.7% PLUS we did so sitting on 37% cash. Very good as well. Measuring our performance against a relative benchmark is important because this too helps us ascertain what kind o risk we are taking. Rick Management is easy to talk about but harder to put into action.
Nancy - getting complicated. Keep doing what you are doing and make sure those performance numbers don't have minus signs in front of them.
Paul - always our goal my dear, always our goal
(Past performance is no guarantee of future performance. Client portfolios can vary slightly depending on their model weights and when they began to invest with High Rock Capital)
Open Letter to Prime Minister Trudeau and Finance Minister Morneau on the state of the housing markets in Toronto and Vancouver:
Open Letter to Prime Minister Trudeau and Finance Minister Morneau on the state of the housing markets in Toronto and Vancouver:
July 7, 2016
Recently, there has been a lot in the press about the housing market in Canada, mostly directed at the Toronto and Vancouver markets. Even the federal government has begun to opine that “this is a significant crisis” and adds, “We know that we need to take measures so that the affordability of a home is accessible for more Canadians who increasingly look at markets like Vancouver and Toronto as significant barriers to achieving their dreams and their successes”.
So taking the Prime Minister’s comments as a harbinger of a policy measure to come, I thought I would state my own personal views in the hopes of helping you avoid a policy error.
I think we all understand that your intentions are pure but perhaps a number of items should also be considered to help us avoid complete and utter economic disaster for the entire country.
Firstly, in Portfolio Management Theory 101 (CFA Level I) they teach every budding finance student that there are four main asset classes: equities, bonds, cash and…real estate. That’s right; real estate is an asset class. Just like equities and bonds, real estate has valuation metrics but, to be sure, they are much more nebulous to calculate and base investment decisions on than stocks or bonds, not that either of those are easy either. The point is, real estate is an asset class and what makes you believe that residential real estate in Toronto and Vancouver is overvalued? Is the stock market overvalued because it is trading near all-time highs? Is the bond market overvalued because it is trading at all-time low yields? Actually, I think both of those reasons are part of the reason why real estate has done what it has done. There are a host of other reasons why Toronto and Vancouver real estate have increased in value. Take for instance, Toronto, which happens to be the financial capital of Canada and the fastest growing city in North America, if not the developed world. Houses in Toronto are cheap versus other financial centers around the world like London, Frankfurt, Paris, Rome, New York, Tokyo, San Francisco, Los Angeles, etc…and there is about a 10-20 minute commute to the downtown financial core for a house with four bedrooms, a decent size yard, a driveway and maybe a garage. Try to find a deal like that in any of those other financial centers. To get that type of house in NYC would be a 1:30-2:00 hour commute (one-way) and the cost would likely be double.
Secondly, it is not a constitutional right that every Millennial should own a house down the street from their parents and the family home they grew up in in Toronto or Vancouver. These were, are and will likely continue to be the most expensive cities in the country. Who says young professionals need to have guaranteed affordability of a home in these so-called “affluent” neighborhoods within Toronto and Vancouver? I think we understand the “social” aspect to your thinking that the Millennials will be priced out of the real estate market in these two cities. There are two solutions on this front: 1) if we had better high-speed transportation, many could live in Barrie and be downtown Toronto in a heartbeat and 2) they will live like they do in every other large metropolitan city around the world…in condos. Do they need to live and raise a family in a 6 bedroom house in Lawrence Park? No, they will do what other Millennials in large cities around the world do and live in multiple units that stretch upwards into the sky, not across a 50 x 150 foot lot with a two car garage and a swimming pool.
Thirdly, on the matter of valuation, one could draw the argument that many other asset classes are equally as inaccessible for Millennials. Take Royal Bank (RY) stock for example: it has gone up so much since 1996 that my children can’t afford to buy it. In 1996, it was around $7.50 and today it is up ten times that at around $77. That is a “ten-bagger” over the past 20 years or up about 927% excluding dividends. And if we take a total return (including dividends and the reinvestment of dividends) into account it is up 23% per year on a compounded basis (Source: Bloomberg). 23% per year!! Now taking the Toronto average sales price of a home in 1996 of $203,028 vs 2016 of $750,000 (Source: TREB) we get a total appreciation in price of about 279% or 6.75% per year on a compounded basis, excluding property taxes and associated costs (like home improvement expenditures that clearly would have been spent over a 20 year period). So let’s compare these two asset classes: 1) RY stock is up 927% over the last 20 yrs (excluding dividends) or 23% CAGR (including dividends) and 2) Toronto real estate is up only 279% and 7% CAGR (excluding all the taxes and home improvement costs). As I said, I am very worried my children can’t afford to buy any RY stock because it has appreciated so much over the last 20 yrs. Something needs to be done to make it more affordable so they can live the dreams and have the same successes like their parents did by owning this stock. The bottom line on valuation is that because interest rates are low (and negative) in many parts of the world, there is asset price inflation across all asset classes: equities, bonds, and even real estate…this should be no surprise.
Fourth, is the Economics 101 theory of Current Account/Capital Account Parity. Canada runs a substantial current account deficit, which means we need to run a capital account surplus…which effectively means we need to attract foreign capital investment into our country to fund the current account deficit. So here we sit, in a global world where over $10 trillion worth of government bonds are in negative territory. Money is flowing into US Treasury bonds and Government of Canada bonds as a store of value, a safe haven if you will. It is a good thing too because we need that money. It is also flowing into Canadian housing for much the same reason. Can we afford to say to every Chinese, Middle Eastern, European buyer, “No thanks, we can’t allow you to invest in our country?” You can’t suck and blow at the same time and that is why the Current Account/Capital Account must be in Parity at all times. We need that foreign investment to survive. Are you worried our Millennials won’t be able to afford a house? See what happens if we deny foreign investment in our great nation. And on the matter of immigration, the government purports to want to support immigration on many levels and, to be sure, for social reasons, there a host of reasons to want to do so. We may “want” to allow some immigration for valid social reasons but we also “need” some immigration for economic survival reasons. Let’s not discriminate too much. Economics aside, the B.C. government just released preliminary data stating that only 5% of the value of all Vancouver homes sold were sold to foreign nationals. 5%...that's it?? Is it really foreign money driving up prices or could it be something else? Hmm, I wonder.
The fifth consideration should be the level of household debt to disposable income in this country which hit a record of 165% as of late (Source: Bloomberg). That is up substantially from 2007 (pre-credit crisis) where it was about 125%. Unlike our cousins to the south, Canadian households were in great shape in 2007 at 125% vs the USA at 160% so we were able to spend our way out of the Great Recession. Today we are at 165% and the USA is at 138% showing a reversal. The bottom line is the Canadian consumer is sitting on a ticking time bomb of debt, not unlike every sovereign in the world. That debt is largely based on the asset value (the consumer’s house) holding up that debt. What happens if interest rates go up (we don’t think they can because there is so much structural debt in the world that it is impairing growth and inflation and servicing an ever-increasing amount of debt)? What happens if the asset price falls and many first-time house buyers are suddenly “offside” or in a negative equity position? Some of us had front-row seats and lived through it in our professions but most have read the book or seen the movie and know how it ends.
Sure there are policy measures you think you can come up with but what happens if, just if, you have a policy error? You attempt to put a tiny pin prick in the balloon but you end up slicing it with a hunting knife – then what? With the consumer at 165% debt to disposable income, I think it is fair to say it will not end well. I think a severe recession, arguably worse than 2008 was in Canada, would be the result. The consumer most certainly will not be able to drag us out this time at 165% debt to disposable income.
So if there is a policy error on your part, who is it you hurt…foreign money? Probably not, as they will just move to another safe jurisdiction that will willingly accept their capital (like USA for instance) to help fund their own current account deficit. It is highly likely you hurt the very people, the Canadian voter, you are trying to protect.
Be careful what you wish for.
Paul Tepsich, CFA
Managing Partner and Portfolio Manager
High Rock Capital Management Inc.
1 Toronto St., Suite 210, P.O. Box 4
Toronto ON M5C 2V6
Tel: (416) 642-5707
Cell: (416) 509-4543
I remember sitting at my desk at Merrill Lynch as the Head of Canadian Credit Trading ( a front row seat to watch the world unwind) in the summer of 2007. Most people recognize Sept 2008 as the "financial collapse" and, to be sure, that is when things really went pear-shaped. But our job as portfolio managers is to do the research and spot these pear-shaped events before they happen so we can avoid big losses or draw downs.
So in the Summer of 2007, there was great weather, sunshine, candy floss and unicorns but behind all that utopia were a few lurking issues in the financial markets.
The first, were two Bear Stearns hedge funds that were largely comprised of Collateralized Debt Obligations (CDO's) that were filled with residential mortgage backed debt. After the typical management oversight shuffle in June 2007, the funds were effectively "Gated" (investors cannot redeem) and then ultimately by August 2007 they were bankrupt.
The second harbinger of the beginning of the financial crisis also began in the Summer of 2007 and this one I did really have a front row seat to watch. There was a local firm in Toronto called, Coventree Capital. Coventree was what was called a "conduit" but they were basically a fund that borrowed very short term debt, like a lot of overnight money, and invested in...you guessed it...US residential mortgages. Great gig, until it isn't. Now, the funding of the assets was critical because Coventree was relying on all kinds of domestic and foreign banks to help them receive overnight funding should the commercial paper market not grant them funding, which was called a "liquidity event due to a market disruption clause". The banks were supposed to step in and lend to Conventree if such a market disruption occurred. While on Aug 13, 2007, Coventree couldn't "Roll" or "Refinance" its commercial paper so they went to all of these banks to declare a market disruption clause so that the banks would provide funding. But the banks said, "we didn't have a problem rolling our overnight commercial paper so there is no market disruption clause and liquidity provided". Coventree got the same answer from each bank. Given my position at Merrill, I, along with a couple of other folks, were called into the President's office (Lynn Patterson who was my direct boss at the time and is now a Deputy Governor at the Bank of Canada). "What are we to do?" Well the rest is history as the late, great, Purdy Crawford had to unwind the mess over several years. When Coventree broke, I took phone calls from my Merrill colleagues from all over the world, Frankfurt, London, Tokyo, NYC, asking who the hell they were and why there were specific "outs" in the Canadian Liquidity Providing Market. Very interesting.
So when people ask me about the financial crisis, I am sure to tell them it actually started in the Summer of 2007, especially if you were involved and paying attention to the tell-tale signs.
Fast forward to today and we can see over the past 24 hours that two UK-based Life-co funds have been "gated" in the same way. First, Standard Life Investments gated a 2.9bln Sterling commercial real estate open-end fund. Redemptions were so great that they gated it for 28 days and marked the net asset value (NAV) by 5%. Intuitively seems like a joke to me...5% cut in NAV.,..that is all? Same as all the dealers and banks back in 2007; no one wanted to write the portfolio down in one swoop...they inched it down. Like the market will run right back up. I have been trading my entire career and that never happens. And today, Aviva Investors Property Trust also gated a closed-end fund. Same story.
Probably pays to pay attention to news like this.
While Brits were busy voting to Leave the EU, and the world watched, China continued to quietly devalue their currency, the renminbi/yuan. Why are they doing this? To spur exports of goods to the USA, just like every other nation on earth. To be sure, these don;t look like big percentage moves because the yuan is theoretically "fixed" to the US$, however, remember what happened when they started moving further from their "peg" (to the US$) last August...mayhem. The fact they continue to devalue the yuan is not a good sign for global inflation and economic growth prospects.
(Higher is stronger US$ and weaker yuan)