The House Always Wins

Understanding the House Advantage

How do casinos and 'the House' factor into today’s investment climate? To start, it's crucial to acknowledge that casinos operate on a business model crafted to ensure profitability. In any casino game, the rules inherently favour the House. Casinos meticulously calculate an expected return, known as the “House edge,” for each game. Let’s take roulette as an example, with a House edge of 5%. This signifies that for every $1 million wagered on the roulette wheel, the casino anticipates earning $50,000, while the remaining $950,000 goes back to the bettors. Although a gambler might experience short-term success, the House edge inevitably erodes profitability over time. This gradual decline is why casinos are notorious for their absence of clocks and windows, as well as their provision of complimentary drinks. Time, coupled with the law of large numbers, invariably favours the casino. 

Many individuals are aware of the House advantage and are familiar with House odds, but they often fail to grasp the full extent of its implications. Suppose they believe that the casino holds a 5% advantage in roulette and enter with $100 in their pocket for playing. They might calculate that they'll only lose $5. However, what they overlook is that the House edge applies to the total amount wagered, not just their initial bankroll. 

For instance, if a gambler consistently bets $10 on every spin of the wheel, and the wheel spins 50 times within an hour, they're effectively placing $500 worth of wagers. Consequently, the expected loss would amount to $25 per hour, not $5. 

The downside risk we calculate often exceeds many people's expectations. Prioritizing downside protection enhances the likelihood of profitability. Understanding the odds shields us from succumbing to FOMO, or the "Fear of Missing Out." During market surges, investors observe rising stock prices and may perceive others as having more fun, earning more money, or enjoying better experiences. This perception can evoke envy and even impact self-esteem. However, adopting the perspective of the House entails analyzing the numbers, tipping the odds in our favour, and setting aside emotions, which are traits more fitting for gamblers on the casino floor. Each individual has the option to be either the gambler or the House. We opt for the latter. 

About That Valuation of the U.S. Market… 

Every few years, we witness a surge of enthusiasm for trendy themes that captivate the market's attention. A couple of years back, it was cannabis, followed by the SPAC/IPO and meme stock frenzy during the COVID-19 pandemic when day traders emerged, using stimulus money for speculative trading. Most recently, with the launch of ChatGPT in November 2022, the AI craze ignited. It appears that every management team across various industries, not just in tech, is touting how they leverage AI to enhance their businesses. Investors, too, are becoming overly excited — investing in companies with a hint of AI "pixie dust" about them. 

While we believe that AI's benefits will yield productivity gains in the long run, we must exercise caution. Just as the internet was overhyped in the 1990s, we need to be mindful of the economic implications of AI and its profit potential in the companies we choose to invest in. 

The momentum behind AI, coupled with the Fed's pause in the summer of 2023, has injected new life into the market following a significant decline in 2022. Now, investors are growing increasingly concerned about the elevated valuations in the U.S. market, and we share this concern, particularly when considering the index level. However, upon excluding the top five stocks by market capitalization, the median valuation for the S&P 500 appears more reasonable. 

The U.S. market is currently propelled by widespread enthusiasm surrounding all things related to AI, with the biggest tech-related players exerting significant influence on the S&P 500. Referred to as the "Magnificent 7," these stocks—Amazon, Apple, Nvidia, Meta Platforms, Microsoft, Alphabet, and Tesla—collectively account for 29% of the S&P 500 market capitalization and an astonishing 47% of the Russell 1000 Growth Index. To provide some context, the combined market capitalization of the Magnificent 7, totalling approximately $15 trillion, surpasses that of all listed stocks in China, the world's second-largest stock market. 

Market Cap - MAG Seven and U.S. Equities

China's Market Capitalization

To emphasize further, the collective value of Microsoft's shares is nearly equivalent to the total value of all companies' shares in the S&P/TSX Composite. 

Examining historical parallels can provide insight into the current market concentration and excitement. In 1999, the top 10 companies in the world by market capitalization were Microsoft, GE, Cisco, Exxon, Walmart, Intel, NTT, Lumen Technologies, Nokia, and BP. Notably, only one of these companies (Exxon) maintained a higher market capitalization a decade later. 

Indeed, Microsoft stands out as the sole survivor from the 1999 top 10 list, now part of the Magnificent 7. Notably, its valuation on December 27, 1999, was over 70 times its earnings. If one had purchased the stock at that time, it would have taken nearly 17 years to recoup the initial investment. This serves as a reminder that the higher the valuation you pay, the lower your potential future returns are likely to be.   

Valuations for the S&P 500 are currently elevated compared to historical levels. When the index trades above 20 times earnings, historical data suggests that forward returns tend to be subdued. This doesn't necessarily imply an imminent market crash. However, we believe that the pace of price appreciation should slow down, and earnings growth will be crucial to justify the current valuation. 

Investing in the index at this juncture entails risks associated with sector concentration and valuation. Drawing from historical patterns, it doesn't appear to us to be an opportune time to invest in the index, as the likelihood of achieving above-average returns seems diminished.

S&P 500 TTM P/E with Long-Term Average

Average Forward Return by TTM PE Tranche

Seeking Opportunities Amid Market Trends

As mentioned previously, individuals have the option to either gamble or adopt the role of the House when investing in markets. Our objective is to selectively achieve superior risk-adjusted returns compared to simply investing in the entire market. We prefer not to speculate on high valuation stocks that rely on unrealistic growth projections or unproven technologies. We've observed similar situations in the past, such as the Dot-Com bust in the late 1990s, which often resulted in losses for investors. 

We believe that the mega-cap companies driving the S&P 500’s valuations higher do not fully represent the entire market. There are numerous other opportunities available to identify quality businesses at reasonable prices. Our strategy focuses on seeking out these opportunities to enhance returns while managing risk effectively. 

If we were to adopt the role of the House, our aim would be to tilt the odds in our favour, thereby increasing our chances of success. Our investment philosophy is grounded in the following principles: 

• Focus on Quality: We prioritize quality businesses that boast strong competitive advantages, deliver high returns on capital, and exhibit sustainable growth prospects. 
• Value Investing: We aim to acquire these quality businesses at reasonable prices. This means we avoid overpaying for future growth expectations or relying on speculative assumptions. 
• Diversification: We diversify our portfolio across various sectors, industries, and geographical regions to mitigate concentration risk. We steer clear of overexposure to any single name or theme. 
• Rigorous Analysis: Each potential investment undergoes thorough fundamental analysis and due diligence. We continuously monitor the performance and valuation of our investments to ensure alignment with our criteria. 
• Long-Term Perspective: We are long-term investors, characterized by patience and discipline. We refrain from chasing short-term fads or reacting impulsively to market fluctuations. 

Our primary philosophy revolves around investing in exceptional companies at fair valuations, echoing the principles of Warren Buffett and other value investors. We diligently seek out businesses endowed with enduring competitive advantages, robust growth prospects, impressive returns on capital, and exceptional management teams. Additionally, we strive to acquire these businesses at reasonable valuations, incorporating a margin of safety to safeguard against the risk of permanent capital loss. Through this rigorous and disciplined approach, we aim to generate superior long-term returns for our clients, irrespective of short-term market fluctuations or trends.  

We anticipate that the Nicola U.S. Equity Income Fund return profile may lag during periods of narrow or speculative markets that favour low-quality stocks. Conversely, we expect our approach to outperform during market corrections or drawdowns that favour high-quality stocks. This outlook aligns with our track record of performance over the past four years, as illustrated in the charts below. 

The Nicola U.S. Equity Income Fund has delivered consistent returns and lower volatility compared to its benchmark, the S&P 500 Index, during this timeframe. This performance underscores the effectiveness of a quality and value-based approach.

Where We See Value

The performance of U.S. mega-cap stocks has undeniably dominated global equity performance in recent times. This trend has become so pronounced that diversification and investing outside of these mega-cap stocks may now seem like a contrarian approach rather than prudent risk management. While adopting a contrarian stance can be challenging, especially when FOMO (Fear of Missing Out) is rampant, we are cautious about chasing returns in crowded areas where valuations significantly exceed historical norms. 

Conversely, we are drawn to opportunities where good quality companies trade at valuations well below their long-term averages, presenting meaningful upside potential if sentiment rebounds. Here are a few situations that have caught our eye: 

Canada

When we examine Canada, we find that the current P/E ratio as measured by the S&P/TSX stands at a very reasonable 13.9x, both in absolute terms and relative to historical valuations. Part of the underperformance of the Canadian market and the lower P/E multiple for Canada is justified by Canada's heightened sensitivity to interest rates and its weakened economy. However, the current pessimism could transition into optimism in the latter half of 2024 as growth re-accelerates. Crucially, this optimism may be fueled by the Bank of Canada's anticipated reduction of the overnight rate from the current 5% to around 4% by the end of this year, and possibly down to 3% by late 2025. When inflation and interest rates are low, there exists a greater opportunity for higher real earnings growth, which supports investors paying higher P/Es, and vice versa. 

Part of Canada’s underperformance compared to the US can be attributed to differences in the composition of the indices. A significant portion of the Canadian index is allocated to income-generating sectors such as Banks, Utilities, Communications, Real Estate, and Pipelines, all of which have experienced poor performance, primarily due to elevated bond yields. While dividend yield and dividend growth strategies have recently underperformed, dividends constitute a significant portion of total returns over the long term, with dividend yields currently higher than at any point in the past decade. 

If you have any doubts about the importance of dividends in relation to total returns, consider this: from February 2014 to February 2024, the price appreciation of the S&P/TSX was +50%, resulting in a 4.2% annualized return. However, when you factor in the impact of dividends, the total return increases to +104%, equating to a 7.4% annualized return over the same time period. While Canada may lack exposure to high valuation AI sectors, it has historically compensated with strong and stable cash flow generation. 

For many companies that we own in the Nicola Canadian Equity Income Fund, the yields currently sit at or near the top of their long-term range. 

International Markets

On the international front, we perceive the most promising opportunities in Europe, which remains one of the Nicola International Leaders Fund’s largest overweight positions. The Eurozone currently boasts a P/E ratio of 13x, presenting a nearly 40% discount relative to the US and marking its lowest valuation in over 30 years. We believe this favourable valuation environment has enabled us to acquire industry leaders with robust competitive advantages at more appealing prices than those available in the U.S. market. 

Despite Europe's underperformance over the past year, largely attributable to weak economic momentum in the region, some economists are forecasting a rebound in Europe's economy for 2024 as the impact from the energy crisis subsides. Since the start of the year, there have been signs of improving economic momentum in the region. 

Similar to Warren Buffet's perspective, the Nicola International Leaders Fund also identifies investment opportunities in Japan, which represents 14% of the Fund's holdings. The Japanese economy seems to be on a path towards sustainable growth, particularly as the Bank of Japan has ceased its negative interest rate policy. Furthermore, corporate reforms have enhanced the potential for improved capital efficiency and higher shareholder returns for equities in the region. 

We have used the analogy of "Be the House" to explain investing in the past. This concept highlights the importance of understanding the probabilities associated with your investments and avoiding scenarios where the odds are against you. Instead, we actively seek opportunities and strategies where we can tilt the odds in our favour.  

It's unlikely that the largest stocks, which have been driving performance, will maintain the same momentum going forward. As this momentum slows, investors will start looking for other opportunities. Currently, we believe that investing in areas within the U.S. that are currently unloved, as well as in inexpensive countries/regions like Japan, Canada, and Europe, offers favourable odds.  

The House knows that it is only a matter of time.