Caisse Warns of Headwinds Ahead?

Paul Delean of the Montreal Gazette reports, Caisse posts 6.7% return, prepares for challenges ahead:
A first-half return of 6.7 per cent for the Caisse de dépôt et placement du Québec in 2014 is “solid right down the line” but may not be matchable in the final six months of the year, chief executive Michael Sabia said Friday.

“I’d like for it to be the case, but I don’t think it will happen,” Sabia told reporters in a conference call unveiling the Caisse’s mid-year report card.

Economic conditions around the world are growing more challenging, there is geopolitical instability in places like Russia and Syria and the five-year boom in stocks already has lasted much longer than the usual bull market, Sabia noted.

As is his custom, he took pains to emphasize that short-term returns are not a priority for Caisse management, which treats long-term results and the relative needs of its depositors as top priority.

In that context, a rate of return on assets over four years of just over 11 per cent, relative to depositors’ needs for a return of 6 to 6.5 per cent, is more than satisfactory, and slightly above the benchmark index, said Sabia, who took the helm at the provincial pension-fund manager in 2009 after it stumbled badly during the economic crisis of 2008-2009.

The Caisse, which oversees more than $214 billion in assets, is continuing to reshape its investment style in a quest for more stable, long-term assets, Sabia said.

Infrastructure investments, for instance, account for $36 billion of its portfolio, double the amount five years ago.

It’s also increasing its presence in emerging markets, the expected growth motors of the future. Next week, the Caisse will announce the chosen candidate to oversee its operations in Asia, and the search is on for a candidate in Latin America.

With interest rates so low and modest returns projected over the next five years for stocks in developed markets, “we’re going to have to try harder, go to places in the world where growth is,” said chief investment officer Roland Lescure.

Russia’s not one of them, though. Sabia said the Caisse’s Russian holdings were “as close to the mathematical concept of zero as you can get, and that’s how we want it to be.”

Mexico and India, however, are on its radar.

Sabia said the Caisse had invested about $830 million this year in Quebec companies, mostly small businesses, and the addition of former Coalition Avenir Québec finance critic Christian Dubé will further boost its expertise in that area.

Asked about specific names that it already has in the portfolio or might be considering, he said it was closely following events at Bombardier, not at all interested in the troubled construction company Hexagone, and very impressed with the turn of events at SNC-Lavalin, which it took some heat for backing during its crisis two years ago.

SNC-Lavalin “is in a hell of a lot better shape than two-and-a-half years ago, when everybody was heading for the exits,” Sabia said. “That company’s moving and moving in a good direction.”

Stocks in general, and Canadian stocks in particular, were a major contributor to the Caisse’s six-month returns, rising 9 per cent. The fixed-income portfolio contributed 4.7 per cent, thanks mainly to a drop in interest rates.

As of June 30, the portfolio allocation was 48 per cent stock, 36 per cent fixed income and 16 per cent “inflation-sensitive” investments.
In her article, Janet McFarland of the Globe and Mail reports, Smooth sailing for investors can’t last, Caisse CEO warn:
The head of Quebec’s giant pension fund manager is warning that headwinds are starting to form that will slow investment returns in the global economy in the coming months.

Michael Sabia, chief executive officer of the Caisse de dépôt et placement du Québec, said Friday numerous factors are confronting the markets – including mounting geopolitical risks and lagging global growth outside of the U.S. market – that will make it difficult for investors to earn the same returns they have seen in recent years.

He said he would “like very much” if the Caisse’s returns in the second half of 2014 could duplicate its 6.7-per-cent investment return for the first six months, when total assets grew to $214.7-billion from $200.1-billion.

“But I don’t think that will happen,” Mr. Sabia told reporters on a conference call. “The global investment environment is becoming more demanding.” A key challenge, he said, is that the U.S. economy is virtually the only large engine powering economic growth because of China’s slowing growth rates and persistent concerns that Europe is “extremely fragile.”

“In China and emerging markets, we’re not suggesting there’s a crisis and things are going to become unstuck, but their capacity to motor the global economy forward is not what it used to be a little while ago,” he said.

“And hence with a single motor working in the global economy – that being the United States – we think there is a lot of fragility there.”

Mr. Sabia also said he agrees with a comment in July by former U.S. secretary of state Madeleine Albright about the global geopolitical position when she bluntly concluded “the world is a mess.”

He said upheaval in Ukraine, Iraq, Gaza and Syria add “a further weight and a further headwind for the global economic growth.” He noted the Caisse has no investments in Russia – “as close to the mathematical concept of zero as you can get.”

Mr. Sabia also warned the recent pace of growth in global stock markets cannot continue indefinitely. He said that historically, the average bull market lasts for 45 months, but global markets have now expanded for 66 months.

“There are a lot of reasons why you might expect this one to be longer than the average of 45, but at some point this is going to slow down, and we think we’re seeing signs of that now.”

Public equity market returns are likely to be in the range of 5 per cent to 7 per cent annually over the next four to five years based on current forecasts, Mr. Sabia said, which is “a far cry from where we’ve been.”

It won’t help, he added, that the U.S. Federal Reserve is in “unknown territory” as it tries to plot a strategy to withdraw stimulus from the economy and figure out how to begin raising interest rates.

The result, he predicted, is likely to be either Japan’s experience where interest rates remained extremely low for a prolonged period, or a scenario where interest rates inch up extremely slowly.

“In either case, it’s hard for us to see how that’s something that contributes positively to the investment environment,” he said.

Given low interest rates and volatility in public equity markets, Mr. Sabia said the Caisse is increasing its emphasis on seeking growth in private investments and in emerging markets with potentially higher growth rates.

He said the fund manager is “very focused” on finding investments in Mexico, which he called “a very interesting country at a very interesting time in its history.”

He also said there are good opportunities in certain sectors in India, and said the Caisse is also interested in investing in Australia because it offers a “surrogate” way of gaining exposure to opportunities in Asia.

The pension fund has also invested $25-billion in a portfolio of global equities focused on major companies positioned for growth in emerging markets, including Procter & Gamble Inc., Unilever Group and Nestlé SA, he said.

In the first half of the year, the Caisse reported equities climbed by 8.8 per cent, while fixed-income investments earned 4.7 per cent and inflation-sensitive investments such real estate and infrastructure earned 3.5 per cent.

The Caisse now has 48 per cent of its holdings in public and private equities, while fixed-income holdings are at 36 per cent and inflation-sensitive assets account for 16 per cent of the portfolio.

Also Friday, the Caisse announced it has appointed Christian Dubé as executive vice-president for Quebec, a newly created role dedicated exclusively to overseeing the fund’s Quebec investment holdings. Mr. Dubé, a former forest products industry executive, was elected to Quebec’s legislature in 2012 and served as finance spokesman for the Coalition Avenir Québec party.
The news in Quebec is all about Christian Dube quitting political life and going to work for the Caisse. I personally couldn't care less and if it were up to me the Caisse wouldn't invest one penny in Quebec's small & medium sized enterprises. 

Why? Because I fundamentally believe if you're a great company, you don't need the Caisse or anyone else to grow. How much money did Dollarama's founder, Larry Rossy, accept from the Caisse or other government or Crown agencies? I'm tired of subsidizing Quebec companies with pension money. I understand the Caisse has a "dual mandate" but the opportunity cost of that $800 million+ portfolio is to invest it elsewhere with bigger returns and less potential conflicts of interests.

As far as SNC-Lavalin Group Inc. (SNC.TO),  I personally wouldn't touch it (I only invest in U.S. stocks), but Sabia is right that's it's in much better shape now after it cleaned up from all the scandals and that's reflected in the appreciation of shares over the past year (click on image):

Still, let's forget about Quebec companies because that's not where the engine of growth will come from in the future. There are some great companies in Quebec but they represent peanuts in terms of the Caisse's portfolio.

I want to focus more on Michael Sabia's comments. In particular, he's right, the only real engine of growth right now is the U.S. economy and it's fragile growth at best. Employment growth is picking up but too many U.S. consumers are still saddled with unprecedented debt. The euro deflation crisis will drag Euroland into a protracted period of subpar growth. Japan is pulling out all the stops to lift inflation expectations but that country is not out of deflation yet. And if Abenomics fails, watch out, it's headed for an even worse bout of deflation.

What about emerging markets? They have staged a comeback in recent months, but growth prospects remain uneven in various countries and the threat of geopolitical turmoil, Fed tapering and lower oil and commodity prices can wreak havoc in these markets. And despite the secular trend of growth, it's still unclear how this growth will develop and what pitfalls investors will endure along the way.

I'll admit, however, I never bought into this emerging markets hoopla. I did my Masters thesis on Galton's fallacy and the myth of decoupling (1998), which is why I remain biased toward the U.S. economy and U.S. stocks. If there is global growth going on, I'd rather play it by investing in U.S. markets.

As far as markets, I'm definitely not in the crash camp, but I agree with Michael, stocks can't go up forever. Having said this, with rates at historic lows and declining because of flight to safety and more importantly, fears of global deflation, this bull market in stocks can last a lot longer than any previous one. Michael Sabia, Leo de Bever, Ron Mock and Mark Wiseman should post John Maynard Keyne's famous quote in their office: "Markets can stay irrational longer than you can stay solvent."

I happen to think that despite Fed tapering, there is an unprecedented amount of liquidity out there which will drive stocks much, much higher. You will see multiple expansion because rates are at historic lows and there is no real threat of them rising anytime soon. In fact, I agree with Michael, rates will stay low for a very long time and if you ask me, they're heading lower because deflation is the ultimate endgame.

Maybe that's why the Caisse is retrenching somewhat on risk and investing $25 billion in this global portfolio made up of major companies positioned for growth in emerging markets, including Procter & Gamble Inc., Unilever Group and Nestlé SA. I'm highly skeptical on this approach and think it's a bit of "safe approach" to cover the fact that they're not taking enough risk in public markets.

I would much rather see the Caisse follow others and co-invest with top hedge funds they're investing with or just track my quarterly comments on top funds' activity and take smarter risks in public equities as opportunities arise. The Warren Buffett approach is great for the Oracle of Omaha, not so much for the Caisse which has access to great information from top hedge funds across the world.

But it's true, if deflation is coming, there is an argument to be made that you're better off sticking with solid companies growing their earnings carefully throughout the world. I'm more of a risk taker and think a lot of pension funds lack market savvy to jump on opportunities as they present themselves.

What else should the Caisse be doing in public equities? They should be investing thematically based on demographics and major secular trends in energy. I was laughed at Zero Hedge when I recommended buying solar shares (TAN) and biotech shares (IBB and XBI) and yet these two sectors are still on a secular uptrend.

When I was studying at McGill, I took all my pre-med courses as electives (on top of my major in Economics and minor in mathematics). That was a crazy workload but it helped me cope with my diagnosis of Multiple Sclerosis in the summer of 1997 when I was writing my thesis. It helped me understand new treatments and which pathways they are targeting, giving me some comfort during a difficult time. And treatments for MS and other diseases have exploded since then.

I actually think we're just getting underway in terms of a major biotech revolution and far too many pension funds are under-invested in this space. The problem is it's a tough space to understand and you need specialized knowledge to understand the pipeline treatments of all these biotechs treating everything from cancer, to autoimmune and other diseases. That's why the few pension funds that do invest opt to do so through funds but others are investing directly (like CalPERS).

Anyways, let me end by stating that there is nothing major to report from the Caisse's mid-year update. From my private conversations with former Caisse employees, they have a lot of work to do to attract and retain qualified people in private equity to ramp up direct investments there. Unlike in real estate, the Caisse is weak in terms of direct investments in private equity. Their new head of private equity and infrastructure, Andreas Beroutsos, is very keen on direct investments but he lacks the proper staff to ramp this activity up (he should get in touch with me so I can recommend top-notch people to him but the Caisse has to pay and keep them, which isn't their strength!).

I don't really like these mid-year updates from the Caisse or quarterly updates from CPPIB. They're pension funds with very long-term liabilities. Who cares about the six-month or annual performance? But following the big debacle in 2008, there is more of a focus to report performance on a more timely basis and be more transparent, which is fine as long as people remember it's the very long term that really counts.

By the way, the Caisse's 2013 Annual Report is available here. Let me just show the compensation of their top brass (click on image below from page 101):

As you can see, Michael Sabia, Roland Lescure and Normand Provost (former head of private equity) all received a little over $1 million in direct compensation, which is nothing to scoff at, but certainly nothing compared to the hefty payouts doled out at PSP in FY 2013 and FY 2014. In fact, one can argue the Caisse is underpaying their top people and other employees (they attract good people but they also attract far too many civil servant types who are happy to coast by and collect a decent salary and pension. Those people drove me nuts!!).

Once again, if you have any comments, feel free to reach me via email ( or post them below. I have my opinions on the Caisse and I'm sure many of you have yours.

Below, Michael Sabia, CEO of the Caisse, participated in a discussion group of experts at the Milken Institute Global Conference, on April 30, 2014, in Los Angeles. Among other international institutional fund managers, Michael presented his perspective on long-term investing in the current global economic context.

Great discussion, well worth taking the time to listen to it. You should also read a previous comment of mine on life after benchmarks, which discusses the Caisse's long-term view on equities and absolute return focus.