(An audio version of this letter can now be found as Episode 24 of The Unlimited Podcast by Ginsler Wealth. Use the link provided or find us on your favourite podcast app.)
To Ginsler Wealth’s Clients:
The first half of 2023 has been a scary one.
Not because inflation continues to be more persistent than expected, or because central governments have continued to raise rates and will likely do so again, or because of the ongoing Russian war with Ukraine, or that in the face of all of this, U.S. technology stocks, especially the largest seven of them, seem to be in their own bubble.
No, the first half of 2023 has been a scary one for me because my sixteen-year-old daughter got her G1 driver’s license permit at the beginning of the year.
Because I am now in “driver training mode”, I’ve become more attuned to my own driving actions that have become second nature to me – in order to help teach my daughter how to become a good driver.
It dawned on me that beyond the basic skill of controlling the vehicle, safe driving is all about math, or more specifically, probability: the actions you take to drive from A to B to maximize the probability of arriving safely at your destination.
- This is why I adjust my speed (up or down) to get out of another car’s blind spot = lower probability of that car turning into me,
- This is why I stick to major streets versus taking the highway if the travel time isn’t materially different = avoid the higher probability of major injury if something goes wrong on the highway, and
- This is why I take an extra few seconds to start driving after the traffic light turns green = minimize the probability of getting hit by a driver running through their newly-turned red light.
With my newfound focus around probability as it relates to driving, over the past quarter I’ve been similarly attuned to how we use the same concept when managing your investment portfolios. Given some of the scary items listed above, we have been particularly active this quarter adjusting client portfolios and introducing new strategies; actions we believe should increase the probability of (a) protecting capital,
(b) minimizing volatility, and (c) generating attractive returns.
In one of my early client letters I stressed that “uncertainty is the only thing I know with certainty”. We acknowledge this uncertainty and combine it with facts and probabilities to arrive at what we believe are the best investment decisions.[i]
LET’S START WITH FACTS
The most important fact to reiterate is that interest rates have increased dramatically and rapidly since early 2022.
Increased interest rates make borrowing more expensive for companies and homeowners, among others. A few months ago, I attended a lunch featuring Tiff Macklem, Governor of the Bank of Canada. He was extremely clear that unless and until inflation returns to 2%, he will not cut rates and may, in fact, continue to raise rates. His goal, like other central bankers around the world, is to inflict sufficient pain on companies and individuals, until they dramatically reduce spending. That is a fact.
However, it shouldn’t be a surprise that these initial and swift interest rate increases have yet to achieve Mr. Macklem’s goal. Companies and individuals with floating rate debt can handle increased interest costs for a period of time. Those with fixed rate debt maturing soon will face a harsh reality in the form of dramatically higher borrowing costs upon renewal.
It is our view that interest rate cuts will not be coming soon. This means there is an increased probability of companies’ earnings being lower for some time.
EQUITY MARKETS AND LOWER PROBABILITY
With the above fact(s) stated, clearly the probability of strong equity returns should be lower. So, what happened so far in 2023? The equity markets rallied of course! More specifically, technology stocks rallied, with the NASDAQ Composite Index up 32% and the S&P 500 up 16%, both dominated by the seven large tech giants[ii].
Was this outcome a highly probable forecast on January 1 of this year. Definitely not; and it may not last.
If not for the current excitement around artificial intelligence (AI), equity market performance would likely have been far more in line (and in fact, below) the equal-weighted S&P 500 return of 6% (as opposed to the “regular” S&P 500 that gives more weight to its larger constituents) and the S&P/TSX here in Canada, which was up 4%.
While investors and the media often focus on the latest exciting news (markets up in 2023 – yay!), it is important to remember that equity markets still have quite a way to go to make up for a dreadful 2022. See chart below.
The last point is a great reminder of why it is so important to minimize losses and protect capital when investing. Climbing out of a hole is much harder than avoiding it. The NASDAQ requires a positive 50% return to recoup its 33% losses in 2022. Even its blistering 32% performance so far this year won’t cut it.
We believe the short-to-medium term outlook for equities remains rocky with a higher probability of weaker performance.
FACTS & PROBABILITIES: ACTIONS WE ARE TAKING
Most of our clients are long-term focused investors. When we look at the long-term performance of equities and of the many equity managers we review on an ongoing basis, we find that (good) long-term results tend to all coalesce around the very high-single-digit range. However, in the current environment where we believe equity returns may fall short of this long-term average, and do so with elevated volatility, we have been focused on (and initiating or increasing allocations to) strategies with many of the following characteristics:
- Lower volatility = higher probability of generating the target return with smaller fluctuations
- Downside protection = higher probability of not losing capital, or losing less capital
- Owning higher-ranking securities = higher probability of recouping capital and collecting all interest
- Asymmetric return profiles = lower probability of downside relative to the upside potential
- Tax-effective = focusing not just on pre-tax returns, but after-tax returns as well
- Capitalizing on distress = more specific to the current higher interest rate environment
Interestingly, we continue to uncover opportunities that have many of the characteristics noted above and can also generate pre-tax investment returns similar to, or greater than, equities[iii]. Some examples you may see (or may soon see) in your portfolios include:
Canadian Mortgage Strategy
This strategy has generated a consistent 9%+ return each year since its inception and since we started adding it to client portfolios. It has zero negative months in its history. It issues shorter-term (generally less than one year) mortgages at conservative loan-to-values. The principals who own and run this mortgage lending business have committed $15 million of their own money to absorb any losses that may occur (there have been no losses so far). Has characteristics 1, 2, 3 and 4 listed above.
One of the best examples of an asymmetric return profile. Listen to our recent Unlimited Podcast episode: What is SPAC Arbitrage with Jamie Wise to truly understand this strategy. It exhibits downside protection characteristics with upside opportunity. Has characteristics 2, 4 and 5 listed above.
Bank-Issued Structured Notes
Securities that pay a high contingent income (generally between 9%-11%) as long as a reference portfolio (typically the performance of the Big Six banks) doesn’t fall more than 30%. Has characteristics 1, 2, and 3 listed above.
Preferred Equity Issued by Asset Based Lender
A unique find, this specialty finance company with a ~$2 billion loan portfolio and over 6,000 business borrowers, issues preferred equity to investors that pays 12% per year[iv] in the form of dividends, which are taxed more favourably than regular interest income. This equity ranks as the most senior obligation of the company after its senior bank debt. Has characteristics 1, 2, 3, and 5 listed above.
Stressed and Distressed-Focused Strategy
This is perhaps the most “tactical” new addition to our roster based on our view of the coming stress for companies caused by higher interest rates and lower customer spending. This $100+ billion global fixed income manager has a smaller, dedicated strategy aimed at capitalizing on stressed and distressed corporate bonds. Has characteristics 3, 5 and 6 listed above.
What do all the above strategies have in common? In our view, they offer a higher probability of helping our clients arrive safely at their investment destinations, with a lower probability of getting into an “accident”[v].
Following on the driving theme of this letter, in our efforts to constantly bring you more value, our Ginsler Wealth Partners Program has been expanded to include an exclusive offer on a specialty, high-end car-detailing service, along with offers/discounts from a few other new partners. Your private weblink was in our client only email communication (or reach out to us directly).
Wishing you a wonderful summer. And please wish me luck as the driver training continues.
Thank you for your trust, support, and confidence. We are available 24/7 should you need us.
President & CEO
[i] For the balance of this letter, please recall that our clients have different investment goals, objectives, and risk tolerances, and therefore will have different portfolios, which may not include some of the strategies detailed herein.
[ii] Apple, Microsoft, Alphabet (Google), Amazon, Nvidia, Tesla, and Meta (Facebook) comprise approximately 27% of the weight of the S&P 500 Index and 45% of the weight of the NASDAQ Composite Index as at June 30, 2023.
[iii] Represented by the longer-term performance of equities, past performance of the strategies under review and Ginsler Wealth’s expected target returns for these strategies. Specific results are not guaranteed.
[iv] The precise securities issued are Common Shares of the company’s Canadian funding entity. 12% is the current dividend rate, which we expect, but is not guaranteed, to continue.
[v] All investments come with risks and uncertainties, and nothing herein should be taken as a guarantee of future results or returns. Past performance is no guarantee of future results. Some or all of these strategies may not be appropriate for certain client portfolios and some of these strategies are only available in non-registered accounts or at certain minimum investment amounts.