Jonathan Wellum is CEO of RockLinc Investment Partners
Update: This post was included in the Carnival of Personal Finance and the Best of Money Carnival
Biography: Jonathan Wellum has a distinguished career in the financial industry, holding various positions including his present role as the CEO and CIO of RockLinc Investment Partners Inc. He was formerly the CEO and CIO of AIC Limited. He has twice been recognized as Fund Manager of the Year and in 1999, was recognized as one of the “top 40 under 40.”
Mr. Wellum holds a Bachelor of Commerce and a Master of Business Administration degree from McMaster University, and a Bachelor of Science degree from the University of Waterloo. He completed his formal education with a Master of Arts degree in Theology from Trinity Seminary. He also holds the designation of Chartered Financial Analyst (CFA).
Q: We were recently notified that the U.S. had 2% real GDP growth in Q3/10. In response David Rosenberg of Gluskin Sheff pointed out that at this point of the post-recession recovery, the economy is usually humming along at a 4.3% clip and on a lot less government stimulus. Mr. Wellum, what do you make of the current economic environment in the United States after taking into account the results of the recent mid-term election? How do you see the next year or two unfolding?
A: When we look at the United States, as well as most developed nations, we see the following challenges: budget deficits, excessive and growing debt (public and private), outrageous entitlement promises, aging populations, dishonest accounting and currencies that are dropping in value when compared to hard assets or real assets due to excessive printing of money and or easy money policies. The developed nations of the world face massive structural problems that have been created over more than four decades and will certainly take some time and pain to at least partially fix. It is very hard to take most economists seriously as they talk about a recovery in the United States when the federal government is running a budget deficit well in excess of $1.2 trillion per year and the financing of the housing market has been essentially nationalized with an unfolding foreclosure problem throughout the country.
In terms of QE2, we like to be honest and refer to Quantitative Easing as Quantitative Oppression. The bottom line is that there is no correlation between the excessive printing of money and wealth creation in real dollars. We believe that QE2 and probably QE to infinity, is the last desperate gasp emanating from our Ivy League School economists who, unfortunately, control our economic policies and central banks. At the end of the day, they do not know what else to do, now that their beloved Keynesianism and easy money piled on debt policies have taken the developed economies to the point of insolvency. There really is no exit from the current debt crisis without a global debt restructuring. We must return to an equity driven economy and a fundamental belief that wealth is created on Main Street by the private sector, not on Wall Street, and, certainly, not by our governments who now represent more than 40% of our economy.
On balance, we view the mid-term elections as a positive but, given the severity of the situation, we do not believe they will prevent the United States and other developed nations from needing to restructure their economies, including their debt and entitlement promises. We believe very strongly that during the next two years we will have to live through some substantial sovereign defaults. As far as we are concerned, “printing money” is an implicit default, and morally reprehensible despite that fact that “everybody’s doing it.” All the foregoing points, in our opinion, translate into very little real growth in the United States and throughout the developed world for the next decade. This is why our stock selection and discipline will be critical for our clients.
Q: Closer to home, with the Canadian dollar nearly at par with the US dollar, what are your thoughts on the Canadian economy? The topic of trade has been outlined as one of the weak spot in Canada’s economy, how large an obstacle will this play in terms of hampering growth going forward?
A: The Canadian economy is in much better shape than many of our trading partners, including the United States. This does not mean we can be complacent. Although our banking system has remained relatively strong and our Federal debt is much lower than most of our trading partners, we still have some serious structural challenges that will be stressed by the weakness in the United States and Europe. Three key issues we continue to factor into our investment paradigm are: the loss of manufacturing jobs in Ontario and Quebec (hollowing out of our core), the unsustainable level of debt in two of our largest provinces (Ontario and Quebec) and our national trading dependence on the United States. It is important that we continue to diversify our trading activities so that a larger portion of our exports find their way into more of the world’s creditor nations. In the meantime, we need to continue working with the Americans in order to maintain the freest flow of goods and services as possible. The United States is still the world’s largest economy by far and, despite the challenges, currently will remain our most important trading partner for a very long time.
One of the challenges we will continue to face is the higher value of our currency versus the greenback. Given the loose monetary policies in the United States we would expect our dollar to remain at par or even go higher in the next two years. This means we need to factor this reality into the types of businesses we are buying to ensure they are not unduly harmed by a high Canadian dollar. The smartest companies are using this opportunity to continue to invest in their businesses and look for market share growth opportunities. Ideally we look for companies that can earn money in as many currencies as possible which is the best diversification and protection from the risks of any one country.
Q: In Canada, a number of recent studies and surveys have revealed that household debt as a percentage of GDP has been on a sharp uptrend since 2000. What are your thoughts on these observations? To follow up on the previous question, does this borrowing binge need to be curbed? If so, how can it be curbed without sparking a debt-service squeeze or even worse, a run of defaults, when interest rates rise?
A: We are very concerned with the overall debt levels of Canadians. The debt to equity ratio is simply too high, particularly in the context of an aging population, cash strapped governments and a very indebted world. We must encourage Canadians and indeed people within the developed nations to safe more, invest more and expect much less from government. We must substantially reduce the size of government and the extraordinary amount of regulations that businesses face each day if we are to begin to turn things around. Borrowers need to stop borrowing and begin repairing their balance sheets. This is critical when we consider the amount of debt outstanding and the fact that we are currently servicing this debt at some of the lowest interest rates in the last 400 years. A slight uptick in interest rates will have a profound impact on most borrowers.
There is no way we can expect to maintain interest rates at the current levels throughout North America. Eventually, interest rates will reflect the underlying risks in our economy which have never been higher, post World War II. The super low rates we are experiencing now are an artificial construct forced on us by the central banks. This artificiality is leading to another bubble, a debt bubble that when it breaks will shake the foundation of our global economy. The worst offenders when it comes to the abuse of debt are governments. Eventually, governments will have to default which is nothing unusual for those of us who are students of history. Default can take two forms: implicit default known as printing money (paying people back with cheapened money) or explicit default, the direct restructuring of debt. Either way, expect money spreads to widen significantly in the future which will only expedite the money problem. A good look at Greece or Ireland is simply a precursor or warm up for what to expect in many more countries. Even if the European Union steps in and decides to copy the US Federal Reserve by printing Euros to paper over the debt of their weakest member countries, it is still a default and will result in devalued Euros leading to inflation and, eventually, higher rates! There is no easy exit, and kicking the can down the road only makes the forced exit worse. We as investors must be prepared or we will be hit very hard. Japan which has been able to keep its interest rates very low by running a massive Ponzi scheme with its citizens is about to find out that even they won’t be able to keep their rates low for ever. Presently, Japan is now at the point where they must raise new debt outside their country now that their savings rate (given their aging population) has fallen below their budget deficit. If they decide to simply print Yen to make up the difference, they will run the real risk of hyperinflation.
Q: How are you positioning your fund/client portfolios (in terms of asset allocation) to take advantage of your aforementioned views?
A: The situation we find ourselves in means that we must be vigilant in our assessment of risk and in the execution of our investment strategy. Despite the challenges, if we stay focused on the strongest companies, operating in the best industries and buy them at compelling prices we should not only maintain the purchasing power of our client’s portfolios but increase the real capital value of their portfolios. I have provided a very brief outline of how we are approaching each of the major asset classes.
Bonds: Focus on high quality yield from the strongest corporate bonds (largely non-cyclical industries, well capitalized and liquid balance sheets with minimal refinancing needs). Given the low level of interest rates we continue to focus on bonds with maturities of less than 4 years. We are very concerned about a brewing bond bubble, particularly in the face of the competitive devaluation of the world’s major reserve currencies (Japanese Yen, US Dollars, Pound Sterling and Euro Dollars).
Equities: Focus on sustainable dividend growth and yield. This provides consistent cash flow into client portfolios for either reinvestment opportunities or supplemental income.
Independent of whether the investment is in bonds or equities we focus on businesses that have very low leverage, significant liquid assets and transparent balance sheets. We are particularly concerned with financial stocks and have limited our exposure to the sector. In particular we would not invest in any long duration financial businesses (ie. life insurance firm). Clients should be highly skeptical of annuity products or any fixed dollar payout scheme in light of the monetary policies of debasement being pursued by our central banks. The accounting for sovereign debt within the capital of many banks is really fraudulent. Banks should be forced to post significant capital against sovereign debt (especially countries such as Greece, Ireland, Italy, Portugal and Spain) and mark them to market. Since this is not occurring we have chosen to avoid all banks outside of Canada at this time.
Focus on sectors in the economy that are essential and scarce and can re-price their product or service in the face of a changing cost structure and volatile exchange rates in the global currency markets. This leads us to focus on businesses with lower fixed costs, high barriers of entry (preferable if business operates in an oligopolistic industry), inelastic demand such as utilities, agriculture, and water.
Precious metals: Gold and silver mining businesses provide a hedge or insurance against the quantitative oppression whereby the central bankers operating with the politicians are undermining the value of our paper money. Over thousands of years gold and silver have effectively operated as wonderful stores of value and protected investors from the money printing, currency devaluations, trade frictions between countries and confiscatory government policies.
For anyone who doubts the staying power of gold should take a moment to consider that the price of gold in 1913 was approximately $20.00 per ounce. This was the year the Federal Reserve Bank was created. Note that the mandate of the Federal Reserve was to maintain pricing stability! Today gold trades for approximately $1,400 per ounce. Note, gold has not gone up in value, rather, the dollar has plunged by over 98% since 1913. Beginning with 1971 the dollar has dropped approximately 97% against gold. Let’s be serious, there are absolutely no reasons why we should trust our central bankers. Our view is simple, take the other side of the trade when it comes to the central bankers today, their gunpowder is all but gone.
Q: Can you talk about a couple of the investments that comprise your portfolios?
A: Two examples of businesses we own that we believe meet our criteria and will protect our clients’ purchasing power over time as well as produce a decent return include Canadian Oil Sands Trust (COS.UN:TSX) and Nalco Holding Company (NLC:NYSE). Most investors are very familiar with Canadian Oil Sands Trust which we believe is the best pure play oil company in North America. In a nutshell, we believe oil as a source of energy will remain a vital and strategic resource for many years to come. Global demand for oil remains very strong, despite recent economic weakness and the ease by which we can produce 85 million barrels a day to meet the needs of the global economy is getting harder and more expensive with each passing day. As the marginal cost of production continues to rise, we are increasingly comfortable with the cost structure of the oil sands. We also like the fact that, at current levels of production, their oil reserves will last more than 50 years. Their reserves are also located in one of the safest places in the world. Looking forward, the Syncrude operation of which Canadian Oil Sands is apart will continue to expand its output in what we believe will be increasing oil prices, exacerbated by the devaluation of our paper currencies. For investors looking for a decent yield Canadian Oil Sands even after conversion back to a corporation should be able to sustain a dividend yield well in excess of 4% per year. The management and board have proven to be exceptional stewards of this world class asset. We continue to add to our positions below $27 per unit as client mandates warrant.
The second company I will mention today is Nalco Holding Company. Consistent with our themes of investing in scarce assets that can survive the global debt restructuring we believe the water industry is a wonderful place to hide and make some money. In terms of the industry itself, according to the OECD, nearly one in every two people will live in water stressed areas by 2030. Structural problems in the management of water resources have led to broad under pricing, which in turn has caused waste, pollution, and overuse. water scarcity poses considerable economic, environmental, and social challenges throughout the world and, in particular, for almost all of the fast growing emerging markets. Most investors are unaware that only 2.5% of the world’s water supply is freshwater, and most of this is frozen. The other important point is that the very limited freshwater resources are unevenly distributed across countries and regions. In Canada, we are blessed with significant freshwater resources, but for many of the fastest growing countries in the world they are faced with significant shortages of freshwater. Shrewd investors will quickly recognize that where there is scarcity and need, there are often great investment opportunities.
Nalco is a company that can take advantage of the increasing need and importance of water globally coupled with water’s scarcity. Nalco is the world’s largest sustainability services company, focused on industrial water, energy and air applications; delivering significant environmental, social and economic performance benefits to their commercial customers. Nalco works very closely with their clients to increase the productivity of their businesses helping them to be more efficient with the use of key inputs such as water, energy and air. With growing water shortages, increasing energy costs and the need to limit air pollution, Nalco’s services are in high demand around the world with the greatest amount of growth coming from the emerging economies of the world. In order to execute on their business plan, Nalco has over 7,000 technically trained experts serving over 50,000 customer locations in over 150 countries around the world. In the world we envisage over the next decade, we believe companies such as Nalco will grow in importance.
We started buying the company over two years ago in the midst of the debt crisis. Our first purchases were around $12.00 per share. With the stock trading at $30.00 today, we would not be adding to our positions. We would add to our positions below $26.00 per share. At $26.00, you could buy a very strong global franchise operating in essential areas of the economy, growing at high single digits and trading at a free cash flow yield of approximately 7.5%. Given that many of Nalco’s largest customers are commodity and manufacturing businesses, the stock can be volatile and offer investors the opportunity to slowly build a position over time as the market provides great entry points.
We live in demanding days but this in no way deters us from our job of capital allocation. Despite all the debt, which we have ignored for too long, the world will continue. We want to ensure we own long-term strategic assets that are essential to everyday life for the world’s inhabitants. And, we don’t want the government as our counterparty!
Thank You, Mr. Wellum!
{ 7 comments }
