Q&A From Our Quarterly Investment Review
October 25, 2021
Image used with permission: iStock/mattjeacock
Q&A From Our Quarterly Investment Review
Your Nexus investment team participates in many meetings where a company’s CEO or CFO presents to a group of investors. These meetings often have a question and answer (Q&A) session at the end. Personally, I like a good Q&A because it allows me to ask the questions that are on my mind, as well as to open my thinking to the questions that are on my fellow investors’ minds. And, of course, it’s always good to get answers.
But I’ll admit that sometimes Q&A can be tedious: having to listen to endless questions and answers that maybe you just don’t find that relevant.
There’s a parallel here with our own Q&A that Nexus hosts for our clients at the end of our quarterly presentations. Feedback from our clients tells us that the Q&A at the end is very popular. But from personal experience, I’d guess that not everyone cares about every question.
To relieve any potential tedium from your day, here are some of the questions we’ve been fielding lately. Feel free to peruse those that interest you and skip over the rest.
Of course, if you have other questions on your mind, please don’t hesitate to be in touch.
How are you looking at the technology sector? How do you think about changes coming down the road in terms of innovations like artificial intelligence (AI)?
We have a number of tech investments in our portfolio and have been keen investors in the sector for a long time. In the past few years we have sold a few of our positions, including Apple and HP, but we continue to own others like Cisco, Microsoft, and Western Digital – as well as Alphabet (Google) and Facebook that are tech-like, but classified as communication services.
One way to look at the sector is that, while there are many tech companies out there, you can divide them into roughly two buckets.
The first bucket is filled with high-growth companies with tons of future potential, but that aren’t necessarily profitable today. Many of these companies are fascinating and are making big inroads with new customers (a good example is Zoom). But with some of these high-potential companies, we often feel that their valuations are simply too high. We understand that some of them will work out and become huge successes, but if you look back in history, those tend to be the proverbial “needles in a haystack”. Many of these companies will turn out to be wildly overpriced for what their future performance actually delivers.
The second bucket is comprised of the “Steady Eddies”. These are technology companies that generate good cash flows, have stable, diversified businesses with manageable risks, and are available at a good price. These are the characteristics we look for in our technology holdings. Of course, we also follow new developments in tech, including artificial intelligence (AI), and we are keen to make sure that these developments are reflected in the portfolio.
Not everyone realizes it but AI, for example, is front and center of what Alphabet is pursuing. Google has a strong core advertising and search business, and it’s using AI in these parts of its business. But it’s also investing in a number of early-stage growth businesses, from self-driving cars to healthcare technology, and is applying AI in these longer-term bets as well. And Alphabet is not alone in integrating AI into its business – many of our portfolio companies are investing in AI in recognition that it will be a major force for innovation and change in the years ahead.
How are extremely low interest rates affecting our bond investing strategy? What are the implications for the Nexus Income Fund?
The key challenge of ultra-low interest rates is that they present an impediment to our clients being able to incorporate what would have historically been normal fixed income allocations in their portfolios.
To put the situation in context, governments around the world have intervened in markets using zero interest rate policies. These actions have kept interest rates below the rate of inflation, and even below zero in many parts of the world.
As investors, we think that this intervention has made today a great time to be a borrower, but not a great time to be a fixed income investor.
In response to this situation, we have maintained an average maturity that is much less than the bond market as a whole, and our benchmark. If interest rates go higher (which, although not certain, we expect will happen), any capital loss in our portfolios will be modest. In addition, we’ve maintained a high-quality approach in our bond holdings.
For the Income Fund, this low-duration, high-quality approach with the bond investments has worked well. The Fund has also benefitted from our decision to be fully invested in equities (our equity allocation is close to our limit of 20% of the Fund’s assets). We currently own shares in 19 companies which pay solid dividends and provide important inflation-beating potential to holders of the Income Fund.(1)
Despite the low interest rate environment, for many people it still makes sense to maintain some allocation to fixed income in your investment objectives. Were we to go through another round of equity market weakness, holding some bonds provides an insurance effect that will partly offset the downside risks that come along in the equity market.
What’s your take on inventory shortages in the auto sector?
There have been all manner of headlines about the global shortage of semiconductor chips, and that shortage has had big implications for the auto sector.
In the beginning, the cause of the chip shortage was simply that semiconductor factories just weren’t producing them as quickly as demand was rising. More recently, however, the shortage has been exacerbated by many transportation bottlenecks, such as clogged shipping ports in South-East Asia and elsewhere. Coronavirus has snarled the operations of these ports.
These problems in the semiconductor supply chain have caused a slowdown in the production of vehicles and we’ve seen GM and others announce extensions of their auto manufacturing plant shutdowns. Obviously, this is not good news in the short term for GM or Magna in that they can’t sell or assemble as many cars as they otherwise would have. However, we see this as a temporary phenomenon and don’t believe that demand has been permanently impaired.
How will the situation with Chinese property developer Evergrande evolve?
This is another story that has dominated headlines of late. Evergrande Real Estate Group is the second largest property developer in the world. The company carries a massive amount of debt (~US$300 billion) and, while it has lots of assets to back that debt, it has felt enormous pressure from a Chinese policy decision to rein in the property sector and tamp down on real estate speculation.
Evergrande owes enormous amounts of money to its lenders, suppliers, as well as its customers (homebuyers), most of whom are in China. If it does need to reorganize, there will be a ripple effect through the Chinese economy because that is where most of the debt is owed.
The larger worry is there could be a wider “contagion” from the Evergrande fallout. Some concern exists that the impacts may ripple out globally into parts of the economy that Evergrande is so involved in, such as iron ore which goes into steel, or cement that is used in all forms of construction that Evergrande is so involved in. Despite these concerns, we think the problems will be contained. The Chinese government is acutely aware of the negative second and third order effects that could occur and will likely intervene to ensure a managed default is arranged.
How big of a risk are rising rates, stimulus tapering and the housing market bubbling to your thesis of a strong consumer in North America?
Before COVID, we were quite concerned about the state of the North American consumer, particularly in Canada where savings were low, debt was high, and there was significant risk if interest rates rose sharply.
However, that story has shifted for the better over the last 18 months, mostly because consumers have saved a lot of money. With more money in the bank, consumers have more capacity to handle small shocks to their expected expenses. And, while mortgage debt remains high, people have used the savings windfall from COVID to pay down their credit cards and other forms of debt. In short, many consumers are now in better shape.
Rising rates are a risk, but not an immediate one. The chair of the Federal Reserve has said recently that the U.S. is not likely to raise rates until the Fed has ended all its bond buying programs. That’s likely a mid-2022 event at the earliest. Canada is unlikely to raise rates at a materially different pace than the U.S. In addition, it’s important to remember that rates are at very low levels, and we expect any increases to be slow and methodical. There is not a big concern that rates will shoot higher and cause problems for consumers.
On the housing front, there is room for debate as to whether there is a housing bubble in Canada or the U.S. Certainly, housing prices have gone up aggressively and there has been a boost in demand from COVID. The recent rapid increase has been surprising after the price escalation that preceded COVID. Nevertheless, we don’t anticipate a crash in housing prices. As rates rise slowly, we think the more likely scenario is a soft landing. There is a well-known shortage of housing in big cities in Canada and there doesn’t seem to be any resolution to that situation in the near term, so this will support demand.
What are the implications of the recent Canadian election? What do you make of all the spending promises?
Coming into the election, people expected a Liberal minority would likely be the outcome. And that’s exactly what happened. So in some respects not much has changed.
After spending plenty of money during COVID, politicians have made promises for even further spending post-COVID. With all of these promises, it seems likely that there will be a time when taxes are increased.
Higher taxes in various parts of the economy can be a double-edged sword. One of the negative implications is that the more taxes a government takes, the lower people’s personal consumption expenditure is and that can constrain future economic growth.
Its unclear what form any future tax increases will take. They could be for individuals, or they could be for corporations. They could be income taxes, taxes specifically targeted at the wealthy, taxes on banks, or perhaps a higher capital gains inclusion rate. It could be all of these, but the bank tax seems the most concrete and we feel that the banks’ stock prices have already discounted a bank tax. Time will tell, but eventually the piper must be paid.
The other implication of so much debt in place after the election, and no clear commitment to rein in borrowing, is that at some point, foreign investors may demand higher rates as compensation for the worsening risk profile of Canadian government debt. If rates do go up, that will have consequences for bond investors that are worth considering.
Are there implications for your emerging market investments as different countries emerge from COVID at different times?
It’s clear that different emerging market countries will recover at different paces, depending on how well they are able to get on top of COVID. The big unknowns are how quickly vaccine rollouts happen and how soon some level of herd immunity is reached. As we know, vaccine rollouts have been swift in the wealthy nations of Europe and North America, but much slower in the less developed parts of the world.
From an investing perspective, while taming COVID may happen in fits-and-starts, we remain optimistic about the long-term prospects for emerging markets. With young populations, economies that continue to mature and a growing number of people joining the middle class, many emerging market economies have tailwinds that will propel growth for decades to come.
(1) One of these holdings, GM, has suspended its dividend.