Panorama —

ETF Achilles’ Heel Exposed

Scott Morrison

Scott Morrison

Founder & CIO


The Other Shoe Dropped.

It finally happened. After a seemingly never-ending bull run, the market has finally passed an apex and the roller coaster is on its way down, fast. With what we are seeing happening to the stock markets in general (S&P 500 is currently down ~25% and the Dow is down ~29%), we are left wondering how the average investor is feeling about their Exchange Traded Funds (ETFs)? Luckily for us, preparing for the next market disaster is our bread and butter. Our investors can breathe a sigh of relief knowing our funds are currently outperforming the market. The protection tools we have set up have been put to action, guiding each of our funds through the mayhem.

At the core of our thesis, we strongly believe interest rates are lower and will be so for longer for many economic, technological, and demographic reasons we have discussed in the past. As someone who has met the management team of almost every major bank during my career, from developed to emerging economies around the world, I can tell you that in geographies where interest rates are low, you would have seen their financial service stocks struggle from a profitability perspective. Unfortunately, we believe we are about to cross the same Rubicon crossed by Europe and Japan here in Canada and south of the border in the U.S. Stay tuned!

30-YEAR U.S. BOND RATES
CURRENT (1.53%) VS 2020 HIGH (2.39%)
Source: Bloomberg 13 MAR 2020
30 -YEAR CANADA BOND RATES
CURRENT (1.15%) VS 2020 HIGH ( 1.76%
)
Source: Bloomberg 13 MAR 2020

In our opinion, these are the times that will reveal one the major flaws of ETFs. My mentor in the 90’s once said to me: “Scott, people will always have the most money in the wrong sector at the wrong time”. At present, Canada has five big banks and three big insurance companies. They comprise almost one-third of the TSX index. They have been a true oligopoly and had above-average returns on equity (ROE). In my opinion, they have grown complacent by copying each other’s strategies and buying each other’s stocks/debt within their asset management divisions. They did this in order to grow their Assets Under Management (AUM) and charge fees, with very little regard for the liquidity risk for their clients.

Before the 2008 financial crisis, Canadian bank ROEs were in the 20’s percentage level and then as of late, they have recovered to slightly above the mid-teens. However, moving forward we believe their ROEs are likely going to settle in the high single digits and they will see their net interest margins (NIMs) compress. Simply put, the primary job of a bank is to gather assets in the form of deposits and lend that money out to collect a spread. With rates crashing down so far this year, we passionately feel you do not want to own an industry where falling NIM’s are going to lead to declining ROEs. As such, if you own a market ETF in Canada you are going to be forced to own these companies with deteriorating fundamentals. We feel this is a multi-year problem and that they are classic value traps in light of the interest rate levels shown above.

This past week, I went off for my annual research pilgrimage to San Francisco for a technology media and telecommunications conference. This year had a unique feel to it since the coronavirus had just spread to Seattle, where a lot of tech companies attending the conference were arriving from. All of a sudden, in the days leading up to the conference, I was being asked if I had recently travelled to China, South Korea, Iran or Italy. If so, I could not attend. One positive side effect of the fears around the virus was that there were less attendees and I was able to get in more questions with senior management teams. At the tail-end of the conference, the semiconductor company AMD that designs semiconductor chips that go into personal computers, data centers and video game consoles, held an analyst day down in San Jose which I attended. The big takeaway from discussions with their management team was that they will steadily take market share from their bigger and slower-moving rival, Intel. The other macro takeaway is that their innovative use of technology will cause further deflationary forces across society. Here is a quote from AMD on their computer power innovation:

“The average lifetime of a notebook is about 4.8 years, so let’s just call it five years. If you go back five years and look how far we’ve come, we’ve increased the compute power by six times, we’ve increased the graphics by three times and the battery life of a notebook is now three to four times longer. So just tremendous progress telling you where we’re going to be five years from now as well.”

One of my fondest memories as a young analyst back in the 90’s was getting to meet Gordon Moore. For those who may not know of him, he was one of the founders of Intel. I met him at a tech conference at the Arizona Biltmore. I can remember it like it was yesterday. At that meeting I clearly remember the man who created “Moore’s Law”, mapping out how the shrinking computer chip dye sizes would change computing power moving forward. AMD’s management team reminded me of the innovative Gordon Moore. I was fortunate to meet them as they were fresh off winning a key super-computer design win. These design wins based on innovation leadership captures the attention of the industry customer base and allows them to take market share away from the incumbent Intel. And once again, while I am speaking negatively of ETFs in this write-up, you should know that Intel is a much bigger stock in the semi-conductor ETF or S&P 500 ETF. We believe if you buy either of those ETFs, you will own the market share loser of the future.

As the market sells off, I believe it is important to ask yourself if you want to buy and hold an ETF for the long-term which also consists of companies with cruise ships, airline or hotel company at risk of running out of cash if this virus issue doesn’t go away? Or do you want to own the bank that lent a lot of money to developed market oil and gas companies? These companies are caught as a casualty of the oil price war started by the failure of an OPEC and Russian agreement on supply curtailment to try and balance the demand destruction happening from the virus impact on fuel demand, as you can see illustrated in the chart below. (Please note that this chart is taken before the ban on flights to and from Italy and flights between the U.S and Europe. Thus, the fuel demand collapse will be worse than that seen in the “Great Financial Crisis” of 2008/2009 (the “GFC”). It’s a horrible set-up to have a scenario where supply is going up while demand is going down for a large group of high-cost companies with a lot of leverage. If the Saudis and Russians do not decide to play nice in the Saudi Sandbox, then it will be very painful for our fellow countrymen in Alberta. And, we continue to be surprised how few fellow Canadians across the country appreciate that Alberta’s economic pain is Canada’s economic pain since energy is still our largest GDP contributor.

Source: IEA, ICAO Bernstein Analysis

Herein lies the real side effect of the virus crisis. As you can see in the chart below, the travel industry has grown to a $6 trillion dollar industry. That’s real money that drives a lot of cash-flow and salaries for a lot of businesses and workers. Back in the GFC, we used to say that the world was in “Red Light Mode”. Businesses and consumers stopped buying houses and cars, etc. Businesses stopped hiring and investing, etc. Then in 2008, this Fund looked nothing like an index fund because we wanted to avoid the areas where consumers and businesses stopped spending. Well, here we go again. This time though, we do not feel it will be a collapse in spending in the housing sector. Instead, it is now in the travel and leisure sectors. We are actually very bullish on holdings in the housing-related sectors since interest rates are at such a low level and all our research tells us that supply is low and demand is high.

GLOBAL TRAVEL ~$6T IN 2019 WITH ~21% CORPORATE TRAVEL (INCLUDES DOMESTIC)
Source: World Travel & Tourism Council, Bernstein analysis

One thing we like about Wealhouse’s position in the investment world is that we don’t manage tens of billions or hundreds of billions of dollars. As a result, we do not have to buy 5-10% stakes in companies to make it matter as a weighting in our diversified portfolios. As we have said over and over again during the last few years, “more and more money is being run by fewer and fewer firms.” Therefore, if the portfolio managers at Wealhouse need to adjust to a change in fundamentals, we can do it quicker than our larger peers. For example, last month we told you we were nibbling on best of breed travel and leisure businesses with rock solid balance sheets in Europe. We figured that people would pivot their travel plans from Asia to Europe. Oops! When we woke up and heard how the virus was spreading in northern Italy a few weeks ago, we were out of those investments as fast as an Italian Ferrari can go from zero to a 100 miles per hour. At Wealhouse, when we make a mistake, we can quickly correct it. At some larger firms they are stuck. We believe we live in a business world, where thanks to technology disruption, there are more winners and loser scenarios than ever before.

In our opinion, most consumers and businesses do not know it yet, but we are already in a recession. Hopefully, it will not take our politicians and central bankers much longer to realize this as well. Fingers crossed, the politicians in my experience have been the slowest to recognize recessionary economic risks, i.e. the GFC! You can see in the below chart, as soon as the Federal Reserve balance sheet started to expand again after the severe sell-off across assets classes in 2018, the market went up in 2019. I do not feel this is 2008 but there are similarities. As Mark Twain once wrote “history does not repeat itself, but it often rhymes”. As I said before, this time around it will not be the housing market that crushes a ridiculously over-levered banking system since the banking system is not as poorly capitalized as it was in 2008. Instead it will be a travel and leisure sector combined with an over-levered and high cost energy complex that will force the central banks and governments hands.

What I have learned in my career is to always track where the big pools of debt are in the world. And when something goes wrong do not be long those over-levered sectors and companies to help manage downside risk for your investors. This strategy did not matter while the economy was expanding at a regular clip and central banks in Europe and Japan were monetizing their debt. In my opinion, the U.S. and Canadian central banks will have no choice but to step in and monetize debt as we have seen happen in Europe and Japan. And maybe as we have seen in Japan, the central bank will buy stocks too.  If not, I am sorry to say, this will be a very, very deep recession. And that is why unlike ETFs, we are balanced between businesses that we believe will win and avoid ones we feel will lose – that we have identified through old fashion bottom-up proprietary research which are at risk of seeing the values of their businesses collapse since free cash flow will quickly evaporate as we hibernate in our homes to avoid the virus.

FED BALANCE SHEET FLATTENING ENDS THE LIQUIDTY-DRIVEN BULL MARKET
Source: Bloomberg, Morgan Stanley Research

Our thoughts and prayers go out to all being affected by this terrible pandemic and the subsequent job losses and family hardships this will cause to many. We know these are nervous times for investors. In my experience these uncertain times are when you get the best investment opportunities. Feel free to call with any questions.

These comments are a little less lengthy than normal because the whole world has gone on sale and I am spending more time with our team updating ourselves on the many moving prices around our approved lists of companies. We believe we are in the valley of panic-related selling in the equity markets. It is tough to know how long this panic will last since no one knows the extent to which this virus will spread. We are very excited to have an opportunity to invest in awesome companies with solid capital structures that are on sale at present. My mentor taught me in the 90’s to take the balance sheet out of the equation in times of uncertainty in order to better manage risks. Therefore, we will only invest in very well-capitalized companies. We are encouraged to see executives of the companies we own stepping up to buy their stock in recent days. In total, we’ve seen insider buying from over 50 CEOs and CFOs in the U.S. since the start of March, including $1.25mm from multiple executives in our holding in Home Depot. We look forward to updating you on the great deals we seized for you and our families in the commentaries to come.

Stay Safe.

Panorama

Panorama

Panorama Fund strives to maximize capital appreciation by investing only in securities that we believe offer above-average returns on a risk-adjusted basis. The fund employs a variety of strategies including investments in equity, bonds, currencies, commodities, and publicly traded real estate. The fund also makes prudent use of derivatives to generate yield and enhance or protect our positions.

As Wealhouse Capital’s flagship fund, Panorama takes advantage of market inefficiencies across different geographies, industries, market capitalizations and asset classes to build a balanced portfolio. We actively analyse different risk factors in the markets to better diversify and safeguard our clients’ capital.

View Fund