A Comparative Look at the Intrinsic Value Portfolio
Back in the third week of March, as our world was collapsing all around us, it would have been unthinkable to predict a 17.0% in appreciation in the portfolio by year’s end. And yet, as the global financial markets pulled out of the deep pit of horror that we collectively witnessed, our Global Intrinsic Value portfolio followed suit.
The portfolio benchmark (70.0% MSCI World Index and 30.0% Canadian Bond Index) gained by 11.9% in 2020, while the S&P 500 ended the year 16.2% higher. From the severe correction in global financial markets in March 2020, to the sustained recovery from then, to new all-time highs, the key theme is one of synchronized global recovery. The Japanese Nikkei index at year-end is at a 30-year high as is the MSCI All Country World Index, that gained 14.4% in 2020. Canadian equities, however, lagged global peers, gaining a total return of 5.8% for 2020.
While the Vulcan Intrinsic Value Portfolio outperformed major domestic and global indices, the foundation for the recovery in the portfolio was put into place the previous year, which allowed the portfolio to react favourably to the new economic and financial market conditions. From the middle of 2019 we positioned the portfolio away from Canadian mid and small caps and instead focused on US large caps, with a mix of value and growth.
A sharp rise follows a sharp fall
After a 28.0% fall in the S&P500 in a late March, the financial markets responded to the speedy and enormous stimulus from governments and central banks the world over. Having learnt a very painful lesson during the aftermath of the financial crisis and recession in 2007-08, governments and central banks in a globally co-ordinated move introduced a massive fiscal and monetary stimulus that is unprecedented in the economic history of mankind. Over $3 trillion was pumped in the US economy, with much more globally and much more coming by all indications.
The mechanism of the financial system will ensure that a substantial portion of these newly created fund flows will find their way into the asset market, particularly equities. The last time this happened in 2008-09, a 10-year bull market followed, which was interrupted only by the pandemic in early 2020.
Risks to the Rally: Interest rates, over-speculation and rising margin debt levels
We ended 2020 at an all-time high in equities. Other asset markets are at all-time highs everywhere as well. We may well get one or more corrections in 2021 (10.0%+ pullback). These pullbacks will be opportunities to buy, as cost of money is nearly zero and few investment avenues remain relevant (just look at the rush into Bitcoin and assorted IPOs!). The reality is that short term interest rates will stay low for some time to come even as the yield curve normalizes. The point of caution for us will be signs of rising interest rates, especially at the shorter end of the curve, as well as a weakening US dollar. Margin debt (short term debt provided by brokers to their clients to speculate in stocks) is close to a record high, though that in itself is not unusual as the market indices are already at record highs. Demand for margin debt trailed the high in indices, and, despite the jump in speculation through the online discount brokers, the level of margin debt is still not considered to be at alarming levels.
Positioning the portfolio for future trends
Within the global recovery in 2020, the key trend emerging is digitization. So far the focus has been on tech stocks that own the proprietary software that enables digitization. But over time the focus must shift to companies that use these digital tools effectively. The emerging winners in the future will be from these companies. This view is reflected in the recent addition of GAP Inc stock to the portfolio. GAP Inc has emerged as a strong player in the digital transformation of its corporate and marketing profile and its ability to migrate its customers to the web allowing it to close down stores, rationalize its brands and grow revenue with better margins.
We retained our investments in a small handful of energy, metals and mining companies, covering oil, gas, natural gas liquids, energy transportation, copper (our largest exposure in this category, which is at its highest level since 2011) and uranium. We hold a slightly different perspective with respect to the energy market and expect that the new US administration’s energy policies will be detrimental to production volumes but favourable for prices, as supply is reduced dramatically. Crude production data shows decline in global production by 10.0% already and that is likely to decline even more. We expect equity pricing in the energy sector to improve over time even with delayed liftoff in air travel. Air travel impact on oil demand is less than 20.0% of that of road travel.
We had built a substantial position in gold and silver from late 2018 as the trade war rhetoric heated up between the US and China. This position was built to between 10-12% of the portfolio. The rally in gold and silver through late 2019 and in 2020 (particularly in silver where we deployed 5.0% of the portfolio) gave us a significant boost as the portfolio recovered from the pandemic-induced meltdown.
We have built meaningful investments in pharmaceuticals, covering a variety of therapies across large multinationals and specialty businesses. In addition, we built positions in specialty financial services, aerospace (which we will likely continue to add to), entertainment, streaming services and big data-based consumer and business services companies.