Navigating Complexity: A Catalyst for Growth

On February 27th, Nicola Wealth Management Ltd. (Nicola Wealth) celebrated its 30th anniversary at the annual Vancouver Outlook event, drawing nearly 1200 attendees despite the West Coast "Blizzard." Nicola Wealth has firmly established itself as one of Canada’s fastest-growing private investment counsel firms, catering to affluent families across the country. As we reflect on this journey, we recognize the profound changes that have shaped both our company and the global landscape. From transitioning from Netscape to Google Chrome, NAFTA to The United States-Mexico-Canada Agreement, and Amazon's primary focus on books to its diversification into a comprehensive marketplace. Nicola Wealth, too, has undergone substantial evolution, progressing from its humble beginnings as a seven-employee firm managing $80M to a formidable institution boasting over 500 employees and $15B of assets under management (AUM). Amidst these changes, our commitment to providing exceptional service and guiding clients through evolving markets remains unwavering.

Given the prevailing uncertainty, it can be prudent to seek an all-weather approach to one's investment portfolio and an advisor who can adeptly navigate the complexities of our ever-changing world. Nicola Wealth has been a trusted solution for many families, offering a portfolio that extends beyond traditional stocks and bonds, coupled with financial planning that transcends the ordinary.

To underscore the importance of safeguarding against investment downside, let's compare the Nicola Core Composite, comprising all client funds invested in portfolios with a Nicola Core mandate, with the Morningstar Canadian Neutral Balanced index, serving as a proxy for an average Canadian balanced mutual fund. Across 2022 and 2023, Nicola Core Composite achieved returns of 6.58% and 5.18% respectively. In contrast, the Morningstar portfolio experienced a loss of 8.75% in 2022, followed by a gain of 7.98% in 2023. It may come as a surprise to some that the aggregate difference in returns over this period was nearly 14%, highlighting the significant impact even short periods of negative returns can have on the overall outcome.

Five Key Areas Impacting Investor Portfolios

In his keynote address, Nicola Wealth Chairman, Chief Executive Officer and Chief Investment Officer, John Nicola, provided valuable insights into the five critical areas impacting investor portfolios: inflation, demographics, trade dynamics, geopolitical risks, and evolving asset classes. These insights serve as a compass in navigating complex market environments and making informed investment decisions.

Inflation

Inflation has been a pressing concern since the COVID-19 pandemic, reaching highs of 5-10% in some economies before recently stabilizing. Only recently have we begun to see inflation return to the normalized range of 2-3% that we would expect. While this trend is positive, it's crucial to remember that tilting the scales too far in one direction can lead to a different problem: deflation, as witnessed in China over the past 6-9 months. Deflation occurs when falling demand and lower production costs decrease the value of goods and assets, posing a challenge for borrowers who must repay their debts in dollars that are now worth more than when they were borrowed. With $7.3 trillion of debt coming due over the next 36 months, this presents a significant risk to financial markets.

Demographics

Aging demographics is a pressing issue, particularly evident in China but increasingly prevalent worldwide. The United Nations projects the world population to peak around 10.4 million people in the mid-2080s. With people living longer lives, this demographic shift will strain governments and social benefits as retirees require support throughout their post-work years.

Trade Dynamics & Geopolitical Risks

Trade has historically been a driver of global growth. However, the current political climate, characterized by deteriorating relations between the United States and China, the Russian-Ukrainian conflict, and tensions in Gaza, has negatively impacted global trade. Countries are focusing more on domestic production and local trade, leading to a decline in international trade. Illustrating this trend, China has slipped from its position as the largest importer to the U.S. for the first time in 15 years, being overtaken by Mexico.

Evolving Asset Classes

Amidst this uncertainty and volatility, the importance of financial advice has become paramount for families seeking to secure their future. Engaging a trusted advisor to navigate changing market environments can have a significant impact on long-term portfolio success. While investors are often enamoured with the allure of the next big thing, such as AI, cryptocurrency, or miracle drugs, it's crucial to recognize that many overlooked industries can offer better risk-adjusted returns. Our focus extends beyond headline-grabbing sectors, recognizing the enduring value of asset classes that have historically delivered consistent returns. Mark Twain famously said, “When everyone is looking for gold, it’s a good time to be in the pick-and-shovel business.”

Focus on Fixed Income Strategies

In the fixed-income sphere, Nicola Wealth has shifted its focus to the investment-grade bond market, as high-yield bonds have become increasingly pricey. The default rate on high-yield bonds has risen to approximately 3.7%, a level that we believe will not be reached in the investment-grade space. To bolster returns, we employ judicious leverage, acquiring bonds from established entities such as Microsoft, Royal Bank, and McDonald's.

Over the past decade, the Nicola Bond Fund has excelled in three distinct environments: during the low-interest-rate period from 2014 to 2019, throughout the COVID-19 pandemic in 2020, and in the current high-rate environment spanning 2021 to 2023. To contextualize this performance, over the past ten years, the Nicola Bond Fund has been profitable in 78% of months, aligning with our overarching strategy of prioritizing downside protection, as outlined earlier in the presentation.

The Power of Private Assets

When assessing the investment strategies of the average high net worth investor with $1-5 million in investible assets, it becomes evident that their portfolio typically allocates around 2% to private assets. However, this pales in comparison to the allocations made by larger institutional managers responsible for billions of investment dollars. For instance, Canadian pensions tend to dedicate an average of 50% of their investment base to private investments, while ultra-high net worth families with $30 million or more in investible assets allocate an average of 20% to private assets.

There are several reasons why the average investor may shy away from private assets. This reluctance could stem from a lack of readily available information, limited name recognition of private investment opportunities, or simply the historically challenging access to such assets. Traditionally, committing to and enduring lock-up periods for private assets have been daunting, with investors required to commit millions of dollars for indefinite periods to reap the returns associated with these investments. However, Nicola Wealth offers clients access to these assets without imposing such minimums or requiring multi-year lock-up periods.

But why should investors care about gaining access to private assets? Simply put, private assets have demonstrated the potential to yield relatively better returns, often outperforming their public counterparts by as much as 2%, all while exhibiting reduced volatility. Moreover, considering the investment landscape, there is a substantially larger pool of private companies available for investment compared to public ones, thereby enhancing the diversity of assets within investors' portfolios.

In the backdrop of 2023's environment, characterized by persistently high interest rates, private equities encountered headwinds as merger and acquisition activity dwindled, and financing costs remained elevated. Conversely, this elevated rate environment served as a tailwind for private debt and mortgage investments, with yields increasing by 3-4% in the private debt space and by 2% in private mortgages. As long as rates remain high, private credit is poised to remain an attractive investment avenue. However, with the potential for rates to decline, possibly later this year, we anticipate a resurgence in private equity activity and returns.

Real Estate Dynamics in a Shifting Market

As Nicola Wealth's real estate division commemorates its 20th year, valuations across the market face challenges stemming from increasing capitalization rates triggered by a recent upswing in interest rates. In this environment, the composition of investment funds plays an instrumental role in determining the success of ventures in commercial real estate. With a seasoned team of over 65 professionals at the helm, Nicola Wealth’s real estate division manages a portfolio comprising 340 assets and boasting over $10 billion in gross asset value spread across North America. This portfolio encompasses over 20 million square feet across diverse asset classes, including industrial, multi-family, self-storage, office, development, retail, and senior living.

While navigating the real estate landscape in 2023 presented challenges in realizing the returns our real estate funds are capable of delivering, we discern opportunities emerging on the horizon, particularly with buyers remaining on the sidelines. Positioned at what we perceive to be the bottom of the cycle, we recognize a window of opportunity to capitalize on acquiring properties below their replacement cost and propelling returns into the next gear. As aptly articulated by Mark Hannah, Managing Director of Real Estate, "You make your money when you are buying, not selling." This sentiment encapsulates the overarching theme of seizing opportunities for those willing to capitalize on them.

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