Second Quarter 2020

* Index returns are total returns, including dividends.

AN EVENTFUL LAST FEW MONTHS

Months after lockdowns were first imposed in response to the COVID‐19 pandemic, countries around the world have slowly begun to emerge from hibernation. While the public health consequences of the virus have gradually become somewhat clearer, the economic fallout of the actions that have been taken are still very much unknown. There is no doubt that the global economy faces tremendous near‐term uncertainties. However, as we mentioned in our last quarterly letter, we take comfort in the knowledge that humankind has weathered countless calamities in our history and has emerged from every one of them stronger. We believe that this will be no different.

To counteract the virtual shutdown of their economies, the world’s governments and central banks introduced fiscal and monetary stimulus packages at a scale and speed never seen before. The unprecedented force and quickness with which they acted helped buoy households and businesses and kept liquidity flowing as the world economy began to emerge out of stagnation. It cannot be overstated just how important these interventions were in helping to avoid a worst‐ case scenario. They may well have prevented the loss of confidence that began in March from spiralling further out of control.

Such interventions come at their own cost, the extent of which may not be fully revealed for years to come. In the meantime, however, the huge influx of liquidity has played a noticeable part in the dramatic recovery in prices of practically all asset classes. This recovery started with the safest securities – government bonds – and continued to move down the chain to the rest of the credit markets. Corporate bond spreads have since narrowed considerably, allowing companies once gasping for liquidity the ability to raise significant amounts of new debt at far lower rates than what was available at the height of the panic. In fact, the months of April and May have set consecutive records for new corporate bond issuance.

As credit markets tightened, fears of a liquidity crunch like the one that led to the financial crisis of 2008 began to lessen. Investors realized that even companies most vulnerable to the downturn would be able to tide themselves over for a sustained period. Confidence and optimism returned and investors, faced with near‐zero return prospects for the safest securities (government bonds), were obliged to look farther afield for adequate returns. Equity markets thus followed in rapid succession, turning the sharpest fall in recent memory into the quickest recovery.

A TALE OF TWO CITIES

From the nadir in March to the end of June, the S&P 500, TSX Composite and MSCI EAFE indices rose 39%, 40% and 33% respectively. Though these equity indices have made impressive gains from the troughs, the recovery so far has been anything but evenly distributed. The stock prices of companies in some sectors have recovered relatively little of what they lost, while others have soared to levels that have become grossly detached from any reasonable appraisal of their fundamental values.

Technology stocks have been the latter. The information technology sector of the S&P 500 has returned 15% year‐to‐date compared to an average year‐to‐date return of ‐11% for all the other sectors comprising the S&P 500. Specifically, the market capitalizations of the six largest technology stocks have collectively risen by 28% year‐to‐date, while the market capitalization for the rest of the S&P has fallen by 11%. As a group, the returns from these six stocks so far this year have raised their weighting in the 500‐company index to a full quarter from 18% at the beginning of this year.

Closer to home, the divide between the price performance of the information technology stocks in the TSX and that of everything else has been even wider. Year‐to‐date, the TSX’s information technology sector is up an astounding 62%, thanks largely to one company (Shopify) which now makes up more than half the entire sector; this is compared to a decline of 14% for all the rest of the TSX. The price for this one company has risen to such a degree that it has nearly tripled its weighting in the TSX, accounting for more than 5% of the index.

The influence of a few large technology stocks has been the key determinant in driving returns of stock markets globally and thus it should come as no surprise that U.S. equity indices, which have the highest weighting in this sector by far, have significantly outpaced returns of their international counterparts in recent years. Since the beginning of 2015, the S&P 500 has returned a cumulative 68%, compared to 25% for the TSX and 21% for the MSCI EAFE in local currency terms. However, if one excludes the six largest U.S. technology stocks, the S&P 500’s market value would have grown less than 15% in that time span.

TREES CAN’T GROW TO THE SKY

At first glance, the glaring divide in the price movements of large capitalization technology stocks this year versus those of everything else makes sense. As a group, they are less affected by the impacts of the pandemic and the economy’s lockdown and may even benefit from the trends caused by them. This perception of the sector’s “defensiveness” has enticed investors to buy these stocks, pushing their prices up and further confirming their safe haven status in a positive feedback loop. However, while the prices of stocks in the short term can be driven by such sentiment, the values of stocks in the long term can only be determined by the earnings of the underlying business itself.

As an illustration, consider that the aforementioned six largest technology companies in the U.S. are collectively valued at $6.5 trillion. This surpasses the GDP of every country except the U.S. and China. For an investor to expect a 10% rate of return (roughly what stocks have returned over the last century) from buying this collection of companies at a price of $6.5 trillion, he or she would need to see $650 billion in earnings in perpetuity starting today. This is roughly quadruple the $162 billion that the six companies actually earned last year. Keep in mind that this $650 billion averages to $108 billion in earnings per company, which is more than any single public company has ever earned in a single year.

Some may believe that these companies will grow at such a rate that ultimately justifies the enormous original price tag. But every year that goes by in which earnings do not meet that $650 billion threshold means that earnings in future years need to be even higher than $650 billion to reach the investor’s desired 10% return. Consider the math of such growth: the earnings of these companies will need to grow (with no additional reinvestment of capital) six‐fold over the course of the next decade, reaching $1 trillion by 2030, and remaining at that level until kingdom come in order to earn a 10% return.

It is difficult to comprehend such large numbers fully. For many of the buyers of companies that trade at exorbitant prices in relation to their earnings, we doubt that math even seems to be a factor. A 10% return would likely seem meagre to them, considering the returns that they have seen in recent past. But the law of very large numbers quickly makes such return expectations increasingly bizarre: to generate another 28% return like they have returned year‐to‐date, these six companies would need to add another $1.8 trillion on top of their market capitalizations, the equivalent of adding nearly five Berkshire Hathaways (which itself is one of the 10 most valuable companies in the world). Indeed, the seemingly perpetual rise in stock prices of many of these companies have now reached levels that have rendered some of these investments decidedly un‐ defensive.

ECHOES OF THE PAST

Today, the disparity between how value stocks are priced compared to their growth counterparts has created the widest divergence in performance between the two categories that we have seen in decades. Over the last year, the Russell 1000 Value index has returned ‐9% compared to 23% for the Russell 1000 Growth index, widening a 10‐year lead that has now expanded to 120%. Although the market prices for the stocks in vogue today may seem baffling, we know from experience that market prices have in the past deviated widely from any rational judgment of a company’s business fundamentals or even logical mathematics in a finite world. In the following, we note two past examples of periods in which price and value became wildly decoupled.

In the early 1970s, investors, having been burned by stocks in smaller companies in the late 60s, started to flock to the largest companies, believing them to be safer investments whose stock prices were far more stable. This pervasive belief in the safety of these large companies gave rise to the “Nifty Fifty”, so named after the fifty largest and fastest growing American companies. The Nifty Fifty became thought of as “one‐decision” stocks; companies so appealing that they should always be bought, no matter the price.

At the peak in 1972, blue chip favourites of the Nifty Fifty such as Xerox, Avon and Polaroid traded at price‐to‐earnings ratios of as high as 91 times, the equivalent of a 1.1% earnings yield – in a period when risk‐free long‐term government bonds yielded more than 8%. The belief that the Nifty Fifty would forever deliver outsized returns held for a few years, but eventually heady enthusiasm was met with reality. As the actual performance of these companies fell far short of their lofty expectations, their stock prices fell in tandem. From their peak to their 1974 lows, the stock prices of some constituents of the Nifty Fifty fell as much as 91%.

A similar story played out in the late 1990s when the prices of dot‐com and information technology stocks soared above any sensible appraisal of their business models or earnings power. Once again, the prevailing thought was that the investing paradigm had shifted, but this time buyers piled into fast‐growing companies that were making their mark on the newly created internet. Traditional measures of a company’s value, such as earnings, no longer mattered and were promptly replaced by new measures such as “eyeballs”, “website visits” and “potential market size” to justify stratospheric prices.

Most of the high‐flying dot‐com companies of the 90s era have long since disappeared, but a few of the largest companies by market capitalization that exist today can trace their origins to that period. Many of these companies were excellent businesses and, in some cases, have become even stronger today. One such example is Cisco – a company that we own for some client accounts – whose revenues have grown more than four‐fold and earnings per share more than six‐ fold since 2000. However, Cisco’s stock price is still only half what it was at its all‐time peak in 2000 when it was valued at $500 billion, or 100 times its earnings for that year. Even the best of businesses can be poor investments at the wrong price.

A SAMPLE OF OUR HOLDINGS

Buying with the hope of selling in the near future at a still higher price is speculation, not investing. As long‐term investors, we understand that the return we obtain from an asset can only be determined by what the asset itself actually delivers, rather than what another speculator may pay for it. In the following, we highlight a few of our largest holdings1 and why we believe they are priced significantly below their intrinsic value.

Berkshire Hathaway: Berkshire’s current market capitalization is $440 billion, and its stock and cash holdings alone amount to over $300 billion; this means that the conglomerate’s operating businesses are being offered for less than $140 billion. These operating businesses include what we believe to be a superior collection of insurance companies; the largest freight railroad in North America; and a host of other industry‐leading businesses. Together they generated $18 billion in operating earnings last year. We believe that Berkshire’s current price dramatically discounts the earnings power and growth potential of its operating businesses.

Morguard Corporation: Morguard’s real estate assets, after netting liabilities, would likely be valued in the private market in the $300 per share range, yet its stock price currently trades at just $120. We take additional comfort from the fact that the company has modest leverage, at a debt to gross asset value ratio of just 50%. Moreover, the company’s CEO, Rai Sahi, owns nearly 60% of the company and has a long history of solid capital allocation, having grown the company’s net asset value per share nearly three‐fold over the last decade.

Softbank: Softbank’s chief asset is its 28% ownership interest of Alibaba, China’s largest e‐ commerce company; this alone is worth $150 billion, more than Softbank’s current market capitalization of $120 billion. In addition, Softbank also owns one of the largest mobile telecommunications companies in Japan, has part ownership in one of the largest mobile telecommunications companies in the U.S., and a collection of fast‐growing technology companies around the world. We view Softbank as a large conglomerate of different companies that collectively have a value more than twice that of its current market capitalization.

CONCLUDING REMARKS

In the span of a few months, marketplace sentiment dramatically shifted from overwhelming fear and panic to sudden anxiety about missing out on a broad‐based rally. If recent events have taught us anything, it is the folly of using short‐term stock price movements to draw inferences about long‐term value. Throughout the crisis, stock prices have jumped around sharply day‐to‐ day, their capricious movements dictated more by speculative traders than by long‐term investors.

We generally see price declines not as something to lament, but as opportunities to buy stocks that we like at even better prices. As long‐term investors, we strive not to let the emotions of others interfere with our evaluation of businesses and their suitability as investments, no matter the recent scorecard. Over long enough periods of time, there are only two things that determine the return that an investor gets: 1) what the business itself produces; and 2) the price the investor paid for it.

Lastly, we wish to inform you that Keith Martin, an analyst and portfolio manager at the firm for 20 years, has decided to retire. We will miss him greatly. Keith’s professionalism and integrity were at the core of everything he did. He was passionate about the business and especially the value investing process. He worked tirelessly to make the firm better.

Keith believed in lifelong learning and was constantly reading and learning from the investment greats and from others in business. Above all else, he was focused foremost on the preservation of capital and margin of safety. He understood that clients had entrusted him with their hard‐earned life savings. He did not take this responsibility lightly.

Keith believed very strongly, along with Howard Marks, that returns over the long term should be achieved by taking far lower risk even if it meant foregoing shorter‐term rewards. Keith’s philosophy, approach to investing and above all ethics and integrity have been pillars of our firm, not only in driving our long‐term performance but also our firm’s culture as well.

Today, Keith wants to spend more time with his family and his seven grandchildren. We thank him for his tireless efforts and wish him nothing but the very best and good health as he enjoys his family and turns to this exciting new chapter in his life.

Very sincerely,

The Evans Team