Opportunity Knocks – Part 2

Part 2: What’s in a name? – Value is Growth


We have received quite a few inquires about our Vertex Value Fund and how it has managed the out-performance it has over the last year (see below chart).

Vertex-Value-Fund-B-1-year1 Vertex Value Fund Class B: 1-year comparison to S&P/TSX Total Return Index

There are many contributing factors which have been driving returns in the fund. However, generally speaking, secular changes in the market are unlocking value in the positions and underlying themes within the portfolio. The good news is that these are long term trends which will play-out over the next decade and despite the fund’s almost 30% return year-to-date, the securities remain massively undervalued. The portfolio currently trades at 0.9x book value. The following is our opinion for what should and should not be core holdings for any investors portfolio over the next 5-10 years.

Where to be?

US Housing – Below is a recent chart of US Housing Starts, including September’s number of 872,000 units. When the US housing market turns following a recession, it tends to be an unstoppable machine that provides years of productive output. This time should be no different. In fact, because of the great-recession in ’08-’09, there have hardly been any new homes constructed as people have held off on purchases. The number of people per new house has skyrocketed from a 50-year average of 200 per house to over 700 people per new house. That’s a lot of kids still living at home . . .


The US population continues to increase and as demand returns people’s wants are for new or newly renovated homes not old, foreclosed homes. So, what investments stand to benefit?

Forestry Products (30% weight) – Canadian forest stocks are a great way to invest in the US housing recovery. Without a doubt, softwood lumber is the best commodity to own today. This sector is one of the few bright spots in the Canadian economy where there is growth. Albeit small, we’ll admit, but so was the Gold sector in the year 2000. The lumber market was decimated following the housing crash and ensuing recession, as US demand evaporated. As a result, many companies closed, with the remaining few cutting costs so that they now have great earnings potential and little competition. Compounding the situation is the damage done to lumber supplies by the Mountain Pine Beetle. Forests throughout the Pacific Northwest were drastically reduced because of the infestation. So, not only do we have favourable demand conditions but we also have tightened supplies.

pine-beetle Forest destruction caused by the Mountain Pine Beetle

Because we’re so focused as Canadians on the resource and mining sector we often forget about one of our most patriotic commodities: trees. Only 0.20% of the TSX Index is weighted in forestry products.

The beauty of trees as an investment is they provide a hedge against inflation. During America’s last major inflationary period – from 1973 to 1981, inflation averaged 9.2% – timberland values increased by an average of 22% per year! Almost every dollar in the gold sector that has been raised in the last ten years has been destroyed. If you need some inflation protection – buy trees. They are a non-depreciating asset that grows while you wait and we have yet to witness a gold bar grow . . .

Timber also has a low correlation to other asset classes. Importantly for Canadian investors, one of those asset classes is commodities. The below chart illustrates the spread between the General Commodity Index (CRB) to Softwood Lumber prices (LB1) since 1990. Following the last housing slump, the savings and loan crisis, lumber prices outperformed commodities for 10 years (in red) before the opposite occurred (in green).

forestry-prices-vs-commodity Spread of Commodity Index over Lumber Index

There have been telling signs that the decade long commodity boom may be stalling (see below chart) and with new housing starts picking up similar dynamics to the 1990s may occur again.

sp500-vs-commodities Source: Shiller / S&P stock index data. Commodities 1870-1890: Warren & Pearson U.S. commodity index. 1891-1913: Wholesale Commodities Price Index from the BLS and other agencies.1914-1956: PPI for All Commodities.1957-present: CRB Continuous Commodity Index.

In a sign that things are heating up, PRT forest regeneration was taken over this morning for $4.45 a share. A bit of a bummer as we liked it as a long term hold, but who’s complaining? We’ve owned it for about 3 years, with an average cost base of $1.60 in the Managed Value Portfolio and $2.20 in the Vertex Value Fund.

US Regional Banks (18% weight) – US Regional banks trade at book value and are now lending money to qualified borrowers with home equity rising in the lender’s favour. Canadian Banks trade at two-times book value and are lending into an unsustainable housing bubble, where Canadians are leveraged to the hilt. It seems to be going unnoticed that the US economy is strengthening while Canada is weakening. US Regionals are a great way to take advantage of the housing recovery gaining momentum south of the border. The chart below illustrates the US Regionals (KRE ETF in green) out-performance to the S&P/TSX over the last two years.

regional-banks-vs-tsx US Regional Banks ETF (green line) compared to S&P/TSX Index

P&C Insurance Companies (26% weight) – Reinsurers continue to buy back stock and raise dividends rather than write unprofitable policies. These companies are trading at 52 week highs and have only climbed to a whopping 90% of tangible book value! When will the market realize these are awesome stocks and should trade well above book? Maybe it will be about the same time investors realize Canadian banks are now some of the most leveraged in the world and are not worth two-times book. Or maybe the tailwind of increasing insurance rates which are not only trending up but net increasing for the first time in half a decade will continue to push these stocks higher.


BioPharmaceuticals (10% weight) – Like Reinsurers, BioPharma companies are buying back stock and increasing dividends. Their dividends are some of the best available. They also happen to trade a very reasonable earnings multiples and have solid underlying fundamentals. Not only is the global population steadily increasing but it is also getting wealthier. The wealthier individuals become the more they demand of their personal health and drugs are the main benefactor. Not to mention, the demographic sway of baby boomers entering their golden age. We’ve all seen what the ads on Jeopardy are selling!


Where not to be?

The Canadian dollar – There are quite a few risks on the horizon for the Canadian economy. Canada is facing negative GDP growth, decreasing revenues, rising debt levels and a fragile housing market. It’s currency’s parity with the US dollar will be tested over the next few years. As the US economy powers forward, while the Canadian economy stalls, it will be hard to justify an equal exchange of currencies. Furthermore, the Canadian dollar has historically not traded at parity or better for extended periods of time. We do not hedge our exposure to the US dollar through our US security holdings (about 60% of the fund).

usd-cad USD depreciation against CAD over the last decade

Investment Grade/Government Bonds and Cash – You only need to glance at the yield curve of world bond markets to see how puny the available yields are. 1.817% for a 10-year US bond will barely cover today’s inflation; imagine what will happen if inflation increases! Over a 10-year period investors are much safer owning stocks with higher dividend yields and the opportunity for significant capital appreciation. We believe low yield is high risk.

Within our portfolios we have NEVER held cash. We’d like to tell you that we were smart enough to “go to cash” and that’s how we got through 2001/2002 and 2008 with positive returns in the Vertex Managed Value Portfolio but it would be a fabrication. What has worked for as long as we’ve been in the investment business is to run away from any investment that everyone is talking about. Consensus is usually a harbinger for impending disaster. Consensus has it that oil, mining and banks are the most valuable properties in Canada. This is evidenced by TSX index weightings of the latter being 70%. Everything else is an afterthought. This leftover 30% is our playground and where there’s nothing interesting in the afterthought, we head south. The pickings are target rich beyond imagination down south, providing one looks beyond the usual candidates.

Please give us a call to chat about why the Vertex Value Fund should be one of your core portfolio holdings.

Further Reading:

until next time. . .
@The Vertex Team

For information on this update or the funds we offer, please contact a regional VP of sales:

Noel Dattrino
(Western Canada)

Michael Lindblad
(GTA & Eastern Ontario)

James Wilson
(GTA & Western Ontario, Maritime Canada)