Manager’s Quarterly Commentary – Felix Narhi – Q4 2016

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“Headlines, in a way, are what mislead you, because bad news is a headline, and gradual improvement is not.”
 – Bill Gates, Microsoft Co-Founder

Last year served as another vivid reminder that the future is always uncertain. Undoubtedly, 2016 will be remembered by many investors for the surprising victory of the Brexit camp in the UK and Donald Trump’s unlikely march to the White House. These were widely heralded as the first markers of the “Age of Populism”. It seems everyone has an opinion, particularly about Trump, where punditry has become a new national pastime. While important, given how much has been said and written about these subjects, we don’t think we can add much more value to this echo chamber. One thing is certain: It’s not business as usual. It’s not surprising these highly visible events have dominated the headlines, but in this commentary we will focus on other developments which may be under appreciated by many investors, but which could have equally significant, if not greater ramifications than recent political events. These developments include the implications of a potential new secular interest rate cycle and the impact of fast-developing artificial intelligence technologies. Both of these forces will continue to shape society, including political and business strategies, well after Britain presumably leaves the European Union and Donald Trump is no longer in office.

Forecasting Turning Points in Secular Interest Rate Cycles – Are We There Yet?
Only hindsight will confirm, but we surmise there is a decent chance that the great 35-year bond bull market ended last summer. If true, this will turn out to be one of the most significant moments of 2016 to never make a single headline. In July 2016, long-term US government yields hit all-time lows. The US 10-year and 30-year treasury yields bottomed at 1.37% and 2.09% respectively. Interest rates were not just low within the context of American history. According to Bank of England Chief Economist Andy Haldane, global interest rates hit their lowest levels in the last 5,000 years of civilization. As value seeking investors, we become more intrigued when assets trade at the extreme ends of their typical trading ranges. But we never imagined that we would live through a period where one of the most important global asset classes would hit multi-millennia lows! Since last summer, US and global interest rates have gradually risen which has led to speculation that the long secular down cycle may have finally bottomed. The yields on the 10 and 30-year US treasuries have both gradually edged higher. European markets have expressed their opinion that negative rates cannot go on forever as the amount of negative yielding bonds has fallen from more than $10 trillion to less than $5 trillion. If last summer indeed marked a historic inflection point, it will have profound long-term implications on asset values and investment strategies.

All that being said, we are reminded of the old economist’s joke, “If you really want to be right about your forecast, you should restrict yourself to predicting what will happen, or when something will happen, but never both”. When it comes to predicting what the next few months will bring, only the foolish (or the brave) need apply. After all, the bond market has experienced numerous cyclical bear markets at various points during its multi-decade bullish trend. Yet after each temporary reversal, it has reverted to its original downward trajectory. Countless analysts’ reputations have been tarnished by their early calls for the bottoming of this secular interest rate cycle. As such, we need to keep in mind that last summer’s all-time low could just be another temporary turn and a reminder of the folly of predicting “when”. As we have seen lately, markets are unpredictable, particularly over the short term, and momentum does not somehow magically stop at previous all-time extremes. In the case of global interest rates, the markets had been busy creating fresh all-time extremes for some time. As is often the case in history, inflection points are only obvious in hindsight once they are clearly visible in long-dated historic price charts.

Nonetheless, it is essential to remember that just about everything is cyclical. How much lower can interest rates go while already hovering near 5,000 year lows and with market yields already negative in large parts of the market? In baseball parlance, are we closer to the beginning, middle or late innings of this cycle? Or is it possible that the previous game has already ended and we are in the initial innings of the next game? The most probable answer will determine the suitable course of action. The obvious question is what happens to securities when interest rates rise? As American economist Herbert Stein rightly observed, “If something cannot go on forever, it will stop”. As the cycle becomes increasingly extended, the closer it gets to the point when the trend must stop (and reverse). Yet, investors continue to bid up certain crowded asset classes to lofty levels that can only be justified if the current trends are permanent.

A wry comment by famed investor Shelby Davis made long ago appears increasingly fitting today: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk”. The closest equity equivalent to the return-free risk of long bonds are the blue chip equities trading as “bond proxies”. For several years one of the most profitable strategies for equity investors has been to buy shares in blue chip companies that possess bond-like characteristics. Faced with seemingly ever-lower yields, investors have crowded into “safe” dividend-paying blue chip equities. The trade benefited from a feedback loop of sorts as momentum begets further momentum. Over time, this caused prices to detach further and further from their underlying fundamental values. Eventually this loop sows the seeds of its own undoing because fundamental value and prices ultimately converge. As a result of these dynamics, the large cap S&P500 index is trading at historically elevated valuations which can only be justified if interest rates stay ultra-low indefinitely. We believe reaching for a little extra return after an extended bull run is not worth the potential downside risk. Forewarned is forearmed and caveat emptor.

Artificial Intelligence, Automation and the Second Half of the Chessboard
We believe recent advancements in Artificial Intelligence (AI) foreshadow a potentially profound impact on society in the years ahead. AI-related technologies are nearing an inflection point that will likely reshape many, if not most, industries. We believe AI’s gradual rise has escaped the notice of much of the general population. Until very recently, even many of the world’s leading AI technologists underestimated its pace of progress.

While speaking at the World Economic Forum in January 2017, Google co-founder Sergey Brin noted that artificial intelligence is growing at a much faster rate than even he expected. Brin observed “This revolution has been very profound and definitely surprised me even though I was right in there and could throw paper clips at [my team]”. The artificial intelligence technology developed by Alphabet Inc’s research group (Google’s parent) and operated by a division called Google Brain is involved in nearly all facets of its business, including photography, advertising and translation.

How transformative could AI be? Andrew Ng, chief scientist at the Chinese Internet search giant Baidu, co-inventor of Google Brain and one of the more insightful AI leaders, offered his perspective: “We’re making this analogy that AI is the new electricity. Electricity transformed industries: agriculture, transportation, communication, manufacturing. I think we are now in that phase where AI technology has advanced to the point where we see a clear path for it to transform multiple industries”.

The potential disruptive impact of AI is hard to conceptualize today. Simply put, our brains are not well equipped to understand the fast-paced progression of technologies like AI. In particular, we severely underestimate how big the numbers can get when exponential compounding takes over. To make the power of compounding more vivid, technologists sometimes use an analogy out of India about the inventor of chess who presented his creation to the Emperor. The Emperor was so impressed with this invention that he offered the inventor a reward. The inventor asked for “some rice to feed my family” and suggested they use the chessboard to determine the amount of rice he would be given. Starting with a single grain of rice he proposed that each square received twice as many grains as the previous.

Intuitively, this seems to be a very humble request. But understanding the math of the exponential function allows one to see what the Emperor did not: 63 instances of doubling yields a fantastically big number, even when starting with a single unit. After 32 squares, the Emperor will have given the inventor about 4 billion grains of rice, however, in the second half of the chessboard, the numbers first climb to trillions, then quadrillions, and finally quintillions. Our limited human intuition can’t cope with the constant doubling after the 32nd square of the board. By the 64th square of the chessboard the inventor would wind up with 18 quintillion grains of rice, or about 210 billion tons, and enough to cover all of India with a meter thick layer of rice! No wonder renowned futurist Ray Kurzweil noted that “things only get crazy in the second half of the chessboard”.

Likewise, the ballooning computer revolution which is fueling AI is happening at speeds that no other previous technical innovations have reached. Google’s AI machine, known as AlphaGo, is already pushing its way into real-world applications, many of which were considered impossibly futuristic just a few short years ago. Some applications help drive services inside Google and other providers, such as helping to identify faces in photos, recognizing commands spoken into smartphones and providing translation services for languages. Other techniques at the heart of Google’s AI efforts are poised to transform everything from scientific research to robotics. As the chess story reminds us, the potential transformative impact from AI could be just beginning.

The old adage “May you live in interesting times” has rarely seemed so appropriate. Recent political developments are noteworthy, front-of-mind for many and, not surprisingly, dominate today’s news coverage. However, we think investors should consider the long-term consequences if interest rates have in fact hit generational lows and are now gradually trending higher. The potential impact will vary depending on asset class and securities. We are also increasingly vigilant about the opportunities and threats presented by AI and other disruptive developments.

We are often asked what we think about “The Market”. This is usually another way of asking whether we think the S&P500 or TSX will be up or down over the next three to six months. First, we believe making useful predictions about the market over short time horizons is not possible. Second, we don’t think about “The Market” because we are not index investors. To us, “The Market” is not a monolithic entity, but rather a universe of many individual stocks which includes securities outside the popular indices. As a group, it clear that US large cap stocks have relatively modest growth prospects, yet trade at historically high valuations. The prospect of higher interest rates and potential disruption to legacy incumbents from disruptive technologies like AI are real risks to this long favoured asset class. Instead, we currently own and are seeking investments in idiosyncratic, small and mid-sized companies which we believe have been largely ignored and underappreciated by investors. We believe our portfolios are well positioned if the trends mentioned in this commentary continue to play out.

Felix Narhi, CFA
March 2, 2017

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