Smart Money

Our regular summary of the capital markets. Check back each month for new updates.

Smart Money

October 31, 2019

Hard Work and High Wages

Smart Money

For good reason, team captains are well paid. The approval of teammates and management is a reward in itself, but the player’s contract also provides compensation for the added responsibility. Whether the big money arrives before the “C”, or after, there is a strong relationship between the pay cheque and the designation. As we have illustrated in the attached exhibit, NHL captains ea...

For good reason, team captains are well paid. The approval of teammates and management is a reward in itself, but the player’s contract also provides compensation for the added responsibility. Whether the big money arrives before the “C”, or after, there is a strong relationship between the pay cheque and the designation. As we have illustrated in the attached exhibit, NHL captains earn 370% more than skaters who are without a letter.

Leadership Earns a Premium

October 29, 2019

WeWork-ing to Crush the IPO Market

Market Recap & Box Score

The S&P 500 and MSCI World Indices printed strong gains in consecutive months.  October is closing in on 2.6% improvement as progress on the Chinese and US trade deal has invigorated the equity markets.  The “Phase 1” announcement involves Chinese purchases of $40-50 billion of agricultural products from the US.  In exchange, the US would cancel the tariff increase on $250 billion...

The S&P 500 and MSCI World Indices printed strong gains in consecutive months.  October is closing in on 2.6% improvement as progress on the Chinese and US trade deal has invigorated the equity markets.  The “Phase 1” announcement involves Chinese purchases of $40-50 billion of agricultural products from the US.  In exchange, the US would cancel the tariff increase on $250 billion of Chinese imports that was scheduled to take effect on 15-Oct-19. Chinese President Xi and Trump are scheduled to meet on 17-Nov-19 where it is expected that final details will be put to paper.  It’s important to understand the hot and cold nature of these trade negotiations.  Since Chinese hacking/IP theft is not included in this phase, it seems to be a stopgap to show headway.
The TSX took a step back, down 1.6% for the period.  Once again, the energy sector led the benchmark to the downside, by falling 8.6%.   However, there were no sectors on the TSX that registered a gain for the month.  Canadian energy names decoupled from oil before and after the Canadian election. In August, the energy sector climbed 13% as momentum began to build for the Conservative party.   As it became clear that a Liberal minority was the most likely outcome, the trend reversed, along with Canadian oil as measured by Western Canadian Select.  WCS tumbled 9.9% while West Texas Intermediate (WTI) slid just 1.1%.  Outside of the preliminary move in oil, most markets were unaffected by the election, and the Loonie strengthened 0.4% versus the greenback.
Gold weakened during the month, down 1.1%.  Some of the softness could be attributed to a reversal in the trend of falling yields globally, as both the US and German 10-year yields rose 17 and 23bps, respectively.  Rising yields and a 3.1% lift in copper prices made for an interesting month on the macro front.  Despite the short-term nature of the signals, the implications for inflation are intriguing.
One of the more interesting trends so far in 2019 has been the evolution of the IPO market in the US.   As illustrated in the adjacent table, many of this year’s initial public offerings are trading significantly below their high or list prices. This weakness signals a major shift in investor expectation.  The focus may be shifting from growth-at-any-cost to one where companies are expected to run a profitable business.
To put this in perspective, the five companies listed above are expected to lose a combined $4.4 billion in EBITDA in 2019 vs. revenues of $22.6 billion.  Pinterest is the least egregious offender, responsibly burning through only $32.9 million in EBITDA.  While public market prices revealed the change in sentiment, the spark was more likely related to a company still operating in the private market space, that being WeWork.  Now it is clear from the numbers cited previously that investor penchant for due diligence has been severely compromised of late, but WeWork seems to have been the shot of adrenaline that the market needed to wake up to the reality.  It doesn’t take a CFA designation to understand that the business model would not work. But, the public disclosure in WeWork’s S-1 provided the necessary awakening. This realization and the subsequent rejection by public markets slashed the company’s valuation from a reported peak of $47 billion to just $20 billion.  Furthermore, the largest investor in the company, Softbank’s Vision Fund, seems to be the only bidder for the company. Without another suitor or an alternative source of funding, that $20 billion valuation may still seem exceptionally high.  Moreover, the yield on WeWork’s bond (due in 2025) has spiked from a low of 6.8% in Aug-18 to a high of 13.0% in Oct-19. This signals that investors are not eager to continue to provide any debt funding.
The consequences of  this failure extend beyond WeWork.  Softbank is the largest investor in Uber, Slack, and DoorDash, and a 26% holder of Alibaba, among others.  Additionally, WeWork has approximately $50 billion in office leases, which represents the largest tenant in New York, London and San Francisco.  Global property markets would be impacted if this occupant failed to meet their obligations.

October 15, 2019

Positioning For A Game Changer (Part II)

Third Quarter 2019 Newsletter

Up and Down, then Up Again – US equity markets registered new all-time highs in July, fell in August as risk-off price action took hold and ended the quarter back near their peaks. Similar themes caused the roller-coaster quarter.  The on-again/off-again US-China trade war dominated the headlines as well as weak global growth, recession fears and central bank monetary policy. Canada’s...

Up and Down, then Up Again – US equity markets registered new all-time highs in July, fell in August as risk-off price action took hold and ended the quarter back near their peaks. Similar themes caused the roller-coaster quarter.  The on-again/off-again US-China trade war dominated the headlines as well as weak global growth, recession fears and central bank monetary policy. Canada’s S&P/TSX Composite continued its strong 2019. However, energy stocks persistently underperform as crude prices slipped 8.5% during the quarter. Outside of North America, markets struggled to combat a slowdown in China that is reverberating through much of the globe.

The Federal Reserve embarked on a new easing cycle with two rate cuts. The long-end of the US yield curve fell dramatically, causing a temporary inversion of the 10-year and 2-year spread.  The Canadian dollar slipped during the quarter, but still remains approximately 3% higher than at the beginning of the year against the US dollar.

Paradigm Shifts & Turning Points – Following-up on our July 2019 issue, we continue to evaluate investment opportunities that are expected to outperform or at least be prevalent over the next decade. To recap, structural shifts in consensus beliefs appear to occur every ten years or so. This time frame applies to the formation of a championship hockey team and to investment allocation strategies. The transition often rewards early adopters. Eventually excessive optimism of the “New Paradigm” forms and mimicking becomes widespread. Ultimately, profits erode and the bubble bursts.  This cycle was coined by George Soros as the theory of reflexivity.

The current investment views have been formed by events over the last decade. This period witnessed the failure by the US Federal Reserve to sustain inflation above its 2% inflation target, while wage growth has been 180 basis points less than the decade previous. Meanwhile since 2010, the S&P 500 Index has outperformed the MSCI World-Ex US Index by an average of 70 basis points per month. The Technology sector has been the leader with a 15.2% average annual return. Finally, the trade-weighted US dollar index is at its highest levels since tracking began, up over 30% over the trailing 10-year period.

Inflation

  • Consensus

US core inflation rate has not breached 3% since the mid-90s. Debt, demographics and tighter monetary policy in developed economies will lead to a continuation of the current deflationary environment

  • Contrarian View

Low labour costs (China and excess workers in US) along with falling commodity prices have masked inflationary pressures. If inflation picks up, long-term bonds are most at risk while commodity equities have both relative and absolute upside.

US Equities & Dollar

  • Consensus

The US economy will continue to outperform, perhaps due to more desperate issues around the world. A shortage of US dollars will send the greenback higher eliminating the need to hedge currency risk.

  • Contrarian View

The twin deficits in the US may come in to focus causing an outflow from the dollar should there be a sustained loss of confidence in US growth or fiscal prospects. International equities appear better relative plays while gold could stabilize a portfolio if economic uncertainty persists.

Technology

  • Consensus

The top seven companies by market capitalization are technology firms. With near zero cost of capital and operating within oligopolies, technology giants will continue to expand their empires and profits.

  • Contrarian View

Sheer size alone warrants caution as bigger organizations face more bureaucracy and government scrutiny. Meanwhile, China and the US now appear to have chosen technology supremacy as a matter of national security. Underweight US technology while focusing on smaller, more disruptive companies.

While positioning does not ensure annual outperformance, the probability of success increases due to a commitment to the process. A well diversified portfolio has an objective of long-term wealth creation rather than outperforming in any single year.

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