2023 Q1 Coleford Quarterly Commentary

The confluence of powerful, market-moving currents has been a defining characteristic of the global financial landscape in recent years.  In this context, the first quarter of 2023 was no different. This time around, capital markets were moved by the failures of Silicon Valley Bank and Signature Bank in the United States and the emergency lifeline needed to support depositors in Credit Suisse in Switzerland.

However, intervention by central banks was swift. The U.S. Federal Reserve created a program through which banks could access additional liquidity – a confidence-restoring move – while the Swiss central bank came to Credit Suisse’s rescue with $54 billion of liquidity. At the time of writing, these moves appear to have contained the threat of a larger contagion.

Meantime, continued monetary policy tightening – in the form of higher interest rates – created another headwind (or “current” to sustain the metaphor), and added more market volatility. Moves by the Bank of Canada in January and the U.S. Federal Reserve in January and March were seen as necessary steps to contain a different type of contagion: the threat of runaway inflation.

Despite these new disruptions to contend with, the quarter also saw – somewhat incongruously – the arrival of a risk-on trading environment. This was best illustrated by the performance of two formerly high-flying stocks. After declining in value by over 70% in 2022, Tesla and Shopify flipped the script. Telsa’s market value almost doubled in the first six weeks of the year. (For evident reasons, Coleford’s Equity Model Portfolio does not participate in these issuers.)

How did the indices respond to these most recent currents? After the final bell rang on March 31^st, the Nasdaq 100 was up 20%, the S&P500 rose 7%, and the S&PTSX climbed 3% from December 31^st.

Canada vs the World: Comfort in Banking

While banking failures created angst in the United States in Q1, Canada’s banking system stood fast. The difference is worth exploring – and the difference is stark.  In the past 23 years, there have been 565 bank failures in the United States and ZERO in Canada. The last time a Canadian financial institution failed was in 1996 when Security Home Mortgage collapsed. At the time, Canadians shrugged it off and the corporation’s 2,600 customers received funds on their insured deposits within three weeks. Contrast that with the failures of Silicon Valley Bank and Signature Bank – a top 20 and top 30 institution in the U.S. based on assets.

This poses the question: why is Canada’s banking system so much safer than the U.S.? There are two fundamental reasons.

First, the regulatory framework is different. While both countries have deposit insurance schemes – and perhaps fittingly U.S. Federal Deposit Insurance coverage is higher than that offered to Canadians by CDIC – American banks are regulated by several federal agencies. This includes the Federal Reserve and the Office of the Comptroller of the Currency. In Canada, 400 financial institutions and 1,200 pension plans are  regulated by a single, independent federal agency: the Office of the Superintendent of Financial Institutions (OSFI). As a prudential watchdog, OSFI’s powers are impressive: it advances a regulatory framework designed to control and manage risk; it supervises the financial condition of the institutions under its purview (requiring them to maintain appropriate levels of capital); and, it takes corrective measures (or requires that institutions take such measures promptly) if it spots financial deficiencies. In short, it acts to protect the rights and interests of depositors, policyholders, financial institution creditors and pension plan beneficiaries and does a good job at it.

Second, the structure of our banking system is different. The U.S. banking system has over 11,000  players, including dozens of small community banks and credit unions. In contrast, the Canadian system is dominated by six large banks that control over 90% of the market. This concentration of power has led to concerns about the lack of competition and potential risks to the financial system but has proven to work well from a stability perspective for decades and during this most recent period.

EQUITIES

During the quarter we added Intact Financial (ticker IFC on the S&P/TSX) to the Coleford Equity Model.  Originally founded as the Halifax Fire Insurance Association in 1809, Intact is the largest provider of property and casualty insurance in Canada with an estimated 20% market share, and a leading insurer in the United Kingdom.

Intact has grown organically and through successful acquisitions such that today it generates over $20 billion of total annual premiums. Acquisitions have been part of its growth story since 1988 and included the addition of RSA in 2021 which brought it with ready access to customers in the U.K. and Ireland.

Its disciplined approach, scale advantage, and in-house claims expertise are some of its sustainable competitive advantages.  In analyzing the company, we were also impressed by its multi-channel distribution strategy. This strategy enables the company to appeal to different customer preferences and respond effectively to change.

Intact aims to outperform the industry’s return on equity by at least 500 basis points every year and targets net operating income growth per share of 10% per year over time.

Of particular relevance to us, the company has a record of strong capital generation and disciplined deployment that allows it to pursue its growth objectives while returning capital to shareholders. As a result, since its stock exchange listing in 2005 Intact’s dividend has grown at a compounded rate of 11%.

Intact’s conservative approach to establishing and managing claims’ reserves reflects its prudent approach. Of note, it also has a reputation as a purpose-driven company that values its people.

FIXED INCOME

U.S. banking sector issues had a dramatic impact on fixed income markets in Q1. Daily volatility in bond markets reflected competing theories about the trajectory of the economy and interest rates. Some market participants keyed in on cracks that may be emerging in the economy due to rising rates, tighter lending conditions, and shrinking liquidity and postulated that banking system woes might be the catalyst that leads to a cut in interest rates.

Meantime, and as expected, the U.S. Federal Reserve raised the federal funds rate by 25 basis points in January and March.

For his part, Federal Reserve Chair Jerome Powell acknowledged the costs of bringing inflation down to the Fed’s 2% target, but also highlighted the more severe costs associated with allowing inflation to remain high. He even suggested at one point that the Fed might need to raise short-term interest rates even higher than expected to fight inflation.

After digesting these competing viewpoints, markets now expect cuts to the federal funds rate in the second half of the year, even though Chairman Powell reiterated during a press conference that cutting rates in 2023 is not the Fed’s baseline expectation. This disconnect between market expectations and the Fed’s plans will likely contribute to more volatility in the future.

That’s because the question remains: what will the central bank do next as it tries to balance the threats associated with the banking crisis with the threat of high inflation?

CLOSING THOUGHTS

As investors wrestle with competing views of the near-term future and the volatility created by differing interpretations of economic and market data, it reminds us of the importance not just of taking a long-term perspective but investing with a sound plan in structurally advantaged companies.

While so-called black swan events seem to be occurring more often these days than they used to and market cycles appear to come and go faster than ever, companies with strong balance sheets and proven, shareholder-oriented methods of deploying capital always prevail. Intact Financial and other names in the Coleford Model Equity Portfolio are living proof and we take comfort in their resilience and value creation track records.

We also find confidence in the Canadian bank system, which has stood the test of time due to its structural advantages.

After 30+ years of investing, we know that there will always be challenges and disruptions in the world, which is precisely why as stewards of your capital, we are conservative, consistent and committed.

I know that history is going to be dominated by an improbable event, I just don’t know what that event will be
– Nicholas Taleb –