Annual Letters

Politically Polarized

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As we enter the new decade, a few random thoughts on the past year and the path we may tread in the months to come.

“Beware of my partisanship, my mistakes of fact and the distortion inevitably caused by my having seen only one corner of events.”

George Orwell

We live in a politically polarized time. The internet abounds with passionate defenses and vociferous criticisms of each presidential candidate. Relationships can be fractured because of it. Rancour continues to worsen. The divisiveness is pervasive.

The key element here is that most partisans see their “side” as not just true, but obviously true. It’s a by-product of a blind spot bias. We tend to see bias in others but not in ourselves. Therefore, our strongly-held positions aren’t really debatable — they’re objectively and obviously true. After all, if we didn’t think our positions were true, we wouldn’t hold them. And (our thinking goes) since they are objectively true, anyone who makes the effort to try should be able to ascertain that truth. Our opponents are thus without excuse.
If they disagree with me, they are denying reality.

As it relates to politics, few partisans accept that their opponents are generally people of goodwill who simply disagree about what is best for the country. They are deemed as necessarily being engaged in denialism. To hear the Republicans tell it, Democrats will intentionally try to ruin America. Similarly, Democratic ideologues insist that the Republicans’ primary goal is simply cutting taxes for the rich to stick it to the middle class and the poor. Because the assumption — steeped in bias — is that the “other side” is not generally acting in good faith, the necessary conclusion is that they must be stupid, delusional or dishonest to take the positions they do.

Sometimes it’s true that the “other side” is irrational with intent. But it’s not the usual case. We should never underestimate the power of confirmation bias – that is, wanting a certain idea or concept to be true, thereby believing it to be true. If we are to have any hope of seeing leaders with different viewpoints working together to solve problems, it ought to start with the idea that those who disagree are generally people of goodwill, acting in good faith. In other words, they may be wrong, but they aren’t necessarily (or even likely to be) stupid, delusional, or evil.

Recognition of the reality and the power of our behavioural biases would provide a good start toward making some real progress in that direction.

Populism has taken hold of the political agenda. Thanks to Donald Trump, Brexit, and a string of anti- establishment leaders and parties in Europe, Latin America and Asia, everyone is talking about populism. The two core principles of populism – claiming to speak on behalf of ordinary people, and positioning in opposition to an elite establishment – are combined in different ways with different populist parties, leaders and movements. For example, left-wing populists’ conceptions of “the people” and “the elite” coalesce around socioeconomic grievances, whereas right-wing populists’ conceptions of those groups tend to focus on socio-cultural issues such as immigration.

Populists seek to transform the status quo, ostensibly in the name of the people, meaning they can appear threatening to the norms of democracy and societal customs that many people value. And the very construction of “the people” plays a large part in populists being perceived as “bad”, because it ostracises portions of society that don’t fit in with this group.
Populist policies generally appear to be good for investors – simply measure the reaction of equity markets following the election of Donald Trump or the Brexit votes. However, the economic benefits of populist policies tend to be short-term in nature (Trump’s tax cut policies inflating equity prices being a clear example). Longer term, isolationism restricts trade growth as barriers and tariffs cut off opportunities.

As we’ve seen recently with the tariffs in negotiations between the US and China, growth can be badly damaged by protectionist policies. While the rise of populist politics was likely due to the pain felt following the global financial crisis in 2008, it also reflects the long-simmering resentment of the living standards of the “elites”. Donald Trump won the US presidency on a platform of trade protectionism and migration controls. As his agenda has played out, so has the market impact.

Referring back to my December 2015 letter, I quoted Janet Yellen’s opinion that economic expansion does not die of old age, but it has to deal with shocks – both positive and negative. Clearly Trump’s tax reduction “shock” had positive implications for markets, as has the benign Fed policy of keeping interest rates low. We’ve spoken at length about this in our various communications since that letter.

And we have just completed a year where equity and bond markets worldwide have soared though, arguably, from a low base caused by the fourth quarter correction in 2018.

Yet there are signs of difficulty ahead. Like populism, environmentalism is in its ascendency. Like the prophets of the Old Testament whose predictions foretold that God would be displeased if people did not change their ways, environmentalists warn that our abuse of our environment threatens the balance of our ecosystems.

Change is certainly becoming more visible, and not only through the activities of the fair-haired Greta Thunberg.

Mark Carney, who will step down as Governor of the Bank of England in January 2020, has taken on a new role as the United Nation’s special envoy on climate action and finance. Carney is an advocate of institutional investors curbing investment in fossil fuels. This has plenty of implications to Canada’s economy (in 2018, 23% of our exports were fuel-based) but the succession of alternative energy to fossil fuels will be slow without the existence of necessary infrastructure.

Global advisory firm NMG Consulting, in a 2019 US survey, found that institutional investors want to integrate environmental, social, and governance (“ESG”) factors into their portfolios but view a lack of acceptable policy frameworks and supporting data as the primary roadblocks to full implementation. The survey indicated all respondents desired comprehensive data for ESG-related investment decisions. Which means the current data void will eventually be filled.

Here at home, a recent study by the Edelman Trust Barometer concluded that 91% of Canadian institutional investors agree that maximizing shareholder returns can no longer by the primary goal of a corporation. The report goes on to conclude that business leaders must balance the needs of shareholders with those of employees, customers, suppliers and local communities to drive long-term business success and lower the risk of multi-stakeholder activism. A shocking conclusion to those of us with decades of service to institutional investors, but indicative of changing ideals surrounding use of capital investment.

The new decade will bring changes to the investment process to incorporate environmental and ESG principles. However, like conversion to alternative fuels, the process will take time.

In October 17, 2018, Canada became the second country (after Uruguay) to federally legalize the recreational use of cannabis. New ventures formed to enter the market, hoping to take advantage of what they saw as a big opportunity, and excited investors rewarded them with large market capitalizations. Coming into 2019, the conventional thinking was that the cannabis market would be huge, in terms of users and revenues. Conservative expectations predicting that global revenues from marijuana sales would increase to $70 billion in 2024, triple the estimated sales in 2018.

On October 2018, the cannabis market was young and evolving. Many of the firms were small, with little revenue and big operating losses; and most were privately owned – though a few of these companies had public listings, primarily on the Canadian market. Generally, all of them traded at astronomical multiples yet, for each company, the high market capitalization relative to any measure of fundamental value was justified using the rationale that the cannabis market opportunity was so big.

By October 2019, assumptions regarding growth and profitability were being universally scaled back, business models were being questioned, and investors were reassessing the pricing of these companies.

Within a period of approximately one year, cannabis stocks declined more than 50%. Tilray and Canopy Growth, the two largest companies, saw their market capitalizations decline by 81% and 39% respectively. There was no significant shift in fundamentals, investors just came to realize that the “big opportunity” was not going to deliver the previously expected growth rates or profitability.

We never bought into the speculative marijuana-stock story. But in retrospect, the cannabis story does offer investors three good lessons:

  1. Be skeptical of predictions based on hyper-optimistic projections of potential market size. When asked to justify the pricing of a company in the market, especially young companies with little to show in terms of fundamentals, entrepreneurs, managers and investors almost always point to macro potential, i.e. that the cannabis markets were huge.
  2. Recognize that the prospect of big profits is a magnet for competition. Typically, when these big opportunities present themselves existing competition is generally downplayed, thus failing to factor in the reality that growth will have to be shared with both existing and potential new entrants.
  3. Be cautious of valuations disconnected from economic fundamentals. If you combine a focus on growth as the basis for pricing, with an absence of concern about business models, you get pricing that is disconnected from the fundamentals.

With cannabis stocks, the rise and fall were both precipitous. Any pricing delusion – the dot com bubble would be another example – will eventually correct itself, though the pattern of correction may vary.

In May 2019, Laurus celebrated its fifth anniversary and by any measure, 2019 has been another success. We have seen healthy growth in our assets under management over the past twelve months. We ranked 62nd in the Globe and Mail Top 400 Growing Companies over the three years ending June 2019. We successfully launched our Global Small Cap Fund at the end of February – with respectful thanks to two existing clients for their support. And special mention should be given to the investment team for the spectacular US small cap equity performance – this concentrated portfolio has surpassed virtually all of the 475 peers in the MercerInsight over the past year (ranking 5th percentile) and the longer term record
is enviable by many.

None of this would be possible without the confidence of our extraordinary clients and their trusted advisors. On behalf of the Board, my partners, and all the employees of Laurus, we humbly thank you.

Over the past five years I’ve had the joy of making many new friends across Canada and the US. Each of you has given us fair time to explain our philosophies and process, and many remain in regular contact. We look forward to further dialogue in the coming years in the hopes that our services, in some small way, may enhance your goals.

As we turn to the new decade, on behalf of everyone at Laurus I wish you the courage, faith, and strength of spirit to walk the difficult road ahead – along with the tenacity and patience to achieve everything you desire.