Overview
- Office Update
- Market and Portfolio Performance
- Portfolio Update
- Company News
- Market Outlook
Website Update
We’re excited to share that our newly revamped website is live! You can now find monthly newsletters, webinars, helpful reading resources and quarterly investment strategy fact sheets, all in one place. We will continue to update the site to keep you connected with everything happening at the Hale Investment Group.
https://advisor.wellington-altus.ca/haleinvestmentgroup/
Market and Portfolio Performance (total returns in Canadian dollars unless otherwise noted)
Year-to-date performance as of June 1, 2023:
- TSX 60 Index (C$): 2.1%
- S&P 500 Index (US$): 9.7%
- NASDAQ (US$): 24.1%
- DJIA (US$): 0.25%
The Conservative Equity Portfolio has returned 16.2% year to date, 9.2% over three years, 9.6% over five years, and 11.9% since inception (October 2015).
The Diversified Income Portfolio, which is our balanced portfolio used for many of our clients’ registered accounts, returned 5.3% year to date, 9.4% over three years, 8.7% over five years, and 8.9% since inception (July 2017).
The Focused Total Return Portfolio, designed for TFSAs, returned 27.1% year to date, 13.3% over three years, and 18.2% since inception (April 2020).
Your returns will vary depending on the amount of fixed income held, cash flows in and out, and management fees.
Portfolio Update
Amazon
In the Conservative Equity Portfolio, we trimmed 1% off our Visa Inc. position and purchased Amazon.com, Inc., while in the Focused Total Return Portfolio, we cut 1% off our Berkshire Hathaway Inc. Class B position and also purchased Amazon.
We’ve owned Amazon in different portfolios for over five years. Before that time, we appreciated the business, but it took us a few years to determine how to value it because its stock price always traded for a high price-to-earnings multiple. We began to understand why when we took a deeper dive into Amazon’s income statement and cash flow. Because the company was growing so fast, they would invest all their free cash flow back into the business to grow, so although the business showed very little profit and sometimes traded for 200–300x earnings, on a price-to-cash flow basis, it was much more reasonable trading at roughly 20–30x cash flow for the last decade while growing at 25–30%.
After the tech selloff last year, Amazon declined by roughly 50% and was trading for 10x cash flow by December—a valuation we have never seen before. That did not last long, and since then, the stock is up almost 50% and now trades for 16x its 2023 cash flow. We believe Amazon’s value is closer to 25x cash flow, and in our opinion, it’s still undervalued. Frankly, we’d be happy if the multiple stayed at 16x and the company grew at 25%. However, we suspect the multiple will expand in the coming months.
We all know Amazon as the place where we can buy stuff online. But when we are talking about making money, its online stores are just the tip of the iceberg and represent almost none of the profits. The real money is what you don’t see. The things that don’t have Amazon’s name on it.
Amazon makes money a few ways. The first is by renting out computers and software to other companies. This is what people call the ‘cloud’ and is under the name Amazon Web Services. They run computers and software for a huge number of institutions, governments, and companies around the world. Some of these clients include the U.S. government, Netflix, and Apple.
Amazon got into this business more than two decades ago. They were building computers to run their own business and needed a lot of computer system resources for peak seasons like Christmas. But they were not required the rest of the year. So, they started renting out the cloud to other companies.
The second way they make money is by running other companies’ stores. They call this ‘Third Party Reseller services’. While the products and sales are run by other companies, Amazon will store, ship, and provide all kinds of services for those selling something online. In many cases, you will have no idea that it was Amazon that stored and shipped your purchase to you.
Both divisions grew dramatically over the last three years and represent some of the largest growth in our economy. Because they’ve grown so quickly, Amazon has spent a lot of money to ensure they can still take on more business and keep up with demand. The number associated with this cost is something called Capital Expenditures or Capex. This represents the money a company is spending on the physical stuff they need to run their business, tools, buildings, etc.
For Amazon, the money they spent on equipment and property went up from about $12 billion per year in 2019 to around $60 billion per year today. This is also why the stock always looks less profitable than it could be because they spend so much money for future growth, making their earnings appear much lower than they could be.
This equates to operating leverage, meaning their earnings can grow much faster than their sales over the next five years.
Why do we think Amazon will see a significant return over the next three to five years? We think that Amazon is an extremely efficient operator and will continue to run the digital infrastructure of a portion of our economy. That infrastructure is growing, not shrinking. How does all this talk about AI affect their business? Well, the number of computers and software companies will need going forward will be much greater than the growth we’ve seen in the last five years.
Sure, Amazon will also talk about their virtual assistant, Alexa, and how better AI will make her more relevant than ever. Still, most people don’t understand that the real profits are in what Amazon does for other institutions already and how that positions them for huge growth as the digital landscape expands.
Bonds
We have made some changes to the way we manage fixed income. When interest rates were low, we found it difficult to find value in the Canadian bond market. So, we relied on exterior managers, primarily Pimco and Fidelity, to manage our fixed income. We can find better value now that rates are higher, especially in government bonds.
Our new bond allocation is 60% government, 20% investment grade corporate ladder, and 20% managed by Pimco and Fidelity.
We began by investing 35% in the US$ Intermediate Treasury ETF. This ETF invests in U.S Treasury bonds with maturities ranging from five to ten years. This is very liquid and safe and has a total internal cost of just 0.04%. Treasury bonds will act as protection against a recession or tough economic times.
Then we invested 25% in the one to 10-year Canadian Government Bond ladder. Again, it’s very liquid, safe, and low-cost.
Both government bond ETFs should hold up well in times of turbulence.
Next, we invested 20% in Canadian investment-grade bonds through the RBC Target Maturity Bond ETF. We built a bond ladder from one to five years, with an ETF maturing annually.
These bond ETFs hold a basket of investment-grade Canadian corporate bonds that all mature in the same year.
So as an example, the 2024 ETF holds a total of 46 different bonds, all investment grade, all maturing sometime in 2024. We receive monthly interest payments from the bonds, and in September 2024, the ETF matures and pays out the total balance.
The interesting thing about these target ETFs is that they are all trading below par after last year’s dramatic interest rate increases. For example, the 2024 ETF is trading at roughly $19.82, pays 2.73% interest, and matures at $20.26 for a total return of 5.51% on a one-year bond, with an interest equivalent of 7.1%.
Because the capital gain is much more tax efficient, you would have to purchase an interest-bearing GIC that paid 7% to net the same after-tax return as this one-year bond ETF.
As all the bond ETFs are trading at a discount right now, it’s very tax efficient when half of our return comes from capital gain.
Another benefit to this strategy is that we have separated the corporate and government bonds. At the beginning of the pandemic, there was a liquidity crisis, and it was difficult to sell most assets and get a fair price. The only asset that held its value was government bonds. However, because we held ours in bond funds along with many other kinds of bonds, we were unable to sell them.
We also believe that owning government bonds now will help lower the volatility of the overall portfolio going forward.
Company News
NVIDIA
NVIDIA Corporation reported impressive earnings and surprised the market this past month. The stock shot up about 25% after announcing earnings were up about 40% last month, around 160% for the year. It is the best-performing company in our portfolio for 2023 so far.
We can confidently say that this has been one of the more difficult companies for us to own the last few years. We originally purchased our position in 2021 at $125 a share. It went up to $320 a share, then down to $120 last October and is now back above its previous high at $387. While the business has continued to execute and grow reliably, the share price has been all over the place.
What drove the recent share surge is that instead of selling fewer chips because people already bought a new computer with a graphics card during the pandemic, it turns out that segment doesn’t matter very much because the number of chips NVIDIA was selling for cloud computing, in particular ones specialized in artificial intelligence (AI), blew past expectations.
For example, while NVIDIA is projected to sell $10 billion in graphics cards next year, it will sell about $30 billion in AI and cloud-related chips. So, 80% of their business is now in one of the fastest-growing sectors of our economy. The beat was huge, and people vastly underestimated demand. Now, rather than a company with relatively flat sales, we have a company that is growing sales by 25% per year.
NVIDIA is selling as many of these chips as they can make. Interestingly, the company was negatively affected last September when the U.S. government banned the sale of A100 and H100 AI chips to China. NVIDIA’s sales took a hit, but now all those chips and more have found a home.
We saw some of this in many large technology companies. For example, we questioned why Facebook’s capital expenditures had grown from about $18 billion two years ago to $33 billion this year. We thought it was a lot of money, but now we know what they’ve been spending it on.
Many people are talking about a bubble; some who don’t know the company thought NVIDIA’s stock moves were crazy. When we went through the numbers, and from a fundamental perspective, we could see where the current share price is derived from. For example, the company was actually more expensive from a valuation perspective before it went up 25% on their earnings announcement.
Is it an expensive stock? Absolutely. Is it trading at a historically crazy valuation? We don’t think so. We believe the forward earnings estimates are severely underestimated, and the sale of chips will begin to accelerate once all of the products that are currently in development are released.
Remember also that the chip market is generally a leading indicator, meaning when chip sales spike it’s ahead of the commercial spike because chips must be ordered well in advance.
AI Investing
Are we in a bubble? We are still in the early stages here, but there is definitely some hype. Will we get into a bubble eventually? We think the sheer size of the potential opportunities in the space could drive the kinds of greed and hysteria that usually fuel bubbles. We aren’t there yet as the commercial applications are still in development and not widely used.
We are invested in a big way—microchips through NVIDIA and Advanced Micro Devices, Inc., cloud services through Microsoft Corp. and Amazon, software through Microsoft Corp. and Alphabet Inc. Class A, and hardware through Apple Inc. and Tesla Inc.
We should probably differentiate the types of AI because they do different things. For example, the one most people are talking about today is Chatbot AI-based language processing. Spatial AI is a system that can react to its physical environment rather than words. Computer Vision is the ability for a computer to essentially see, so it takes the information from a camera and understands what it’s seeing on the screen. Then it can take this information and make decisions.
The latter two items, while they have vast amounts of resources working on them, right now Google, Tesla, Uber, and even the Canadian car parts manufacturer Magna, are not being talked about but obviously have broad applications as they relate to real-world tasks.
We are going to see a lot more AI talk in business software and consumer products over the next few years.
Market Outlook
Debt Ceiling Resolution
Since 1960, the U.S. Congress has acted 78 times to raise the debt ceiling. This time was no different, however instead of raising the limit, they suspended it entirely until 2025. This allows them to pay their bills until that date and know that the next fight over raising the limit will not interfere with the presidential election.
The markets hate uncertainty, and until a resolution on this was met, the markets were stuck in a trading pattern. Now that we can put this behind us, or proverbially kick it down the road, the markets have broken out and continued their upward trajectory. Now many Wall Street analysts are raising their year-end price target on the S&P500 to 4,600–4,800. That would imply another 10–15% from here.
We tend to agree as most institutions are under-invested in equity and we still have record amounts of cash on the sideline—$5.3 trillion, to be precise. That’s up from $3 trillion pre-pandemic.
During a bear market, like we experienced last year, stocks went down regardless of their fundamentals. And 2023 is the year where markets are driven by technicals. First you have mega-cap quality moving up in the early stage; think Apple, Microsoft, Google, and NVIDIA, who were the first to move. And now you have others playing catch-up, like Amazon, AMD, and Tesla. Most of these quality names could reach their all-time highs before year-end as money on the sideline piles into equities.
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We wish you a wonderful start to your summer.
Simon & Michael
Simon Hale, CIM®, CSWP, FCSI®
Senior Wealth Advisor,
Portfolio Manager
Wellington-Altus Private Wealth
Michael Hale, CIM®
Senior Wealth Advisor,
Portfolio Manager
Wellington-Altus Private Wealth
Hale Investment Group
1250 René-Lévesque Blvd. West, Suite 4200
Montreal, QC H3B 4W8
Tel: 514 819-0045
Returns for the Conservative Equity Portfolio, Diversified Income Portfolio and Focused Total Return Portfolio represent the returns of model portfolios only and do not represent the returns of any client. Individual account performance may differ materially from the representative performance history, due to factors including but not limited to an account’s size, the length of time the strategy has been held, the timing and amount of deposits and withdrawals, the timing and amount of dividends and other income, trade execution timing and pricing, foreign exchange rates, and fees and other costs. This is not an official statement from Wellington-Altus Private Wealth (“WAPW”). WAPW cannot verify the accuracy of these performance numbers. Please refer to your official WAPW statement for your specific performance numbers.
