Second Quarter 2016

In late June, voters in the United Kingdom (UK) voted 52% in favour of leaving the European Union. This result defied the polls and surprised investors. Global equity markets evoked an immediate negative response, driving two downward days of trading. This initial response signalled the market’s general dislike of uncertainty. The downturn was short-lived, however, as markets recovered just prior to the quarter end.

The Brexit vote served to immediately destabilize the UK government, and threaten the longer term viability of the European Union itself. If the British could leave, would others follow? It appears that the vote embodied two different issues: free trade and immigration. We believe that free trade is essential to the economic development, efficiency and productivity of a global economy. For a modern and developed country such as the UK to turn its back on free trade is a mistake. If immigration is the real issue, then it is a shame that it could not be dealt with on its own.

The Brexit vote is not a material event for the types of North American companies we invest in. In addition, the UK economy is a relatively small one, contributing only 1.4% to global GDP. Further, US based companies that make up the S&P 500, derive less than 3% of their revenues from the UK. Lastly, we are not currently invested in any public companies that are either domiciled in the UK or derive a significant amount of revenues from its economy.

Having said all this, the Brexit vote is an important one from a philosophical perspective. Over the past 30 years, countries in the developed world have sought a number of free trading agreements amongst themselves, resulting in positive economic results. Free trading agreements have also spread to some aspiring developing countries, such as Mexico, who have also benefitted. The European Union has been an ambitious attempt to create a western and central Europe as a zone allowing for the free trade of both goods and labour. Attempting to undo this arrangement is to go backwards.

As we noted above, there are few, if any, implications to the companies that we are invested in. Evidence points to a North American economy that will continue to grow and may well accelerate during the second half of 2016 and into 2017. Signs of margin expansion for our U.S. companies will lead to further earnings and cash flow growth. The sole negative that we anticipate is a strengthening US dollar (while the British pound weakens) that will cause some minor headwinds for US exports.

On the domestic front, the Canadian economy has recovered modestly during the first half of 2016. This is largely on the back of a recovering oil price. While this may not create any new employment in western Canada, it does seem to signal that the worst of this recent downturn is over.

Our philosophy for investing in public companies for you remains unchanged. We continue to pursue entities with growing cash flows from operations, accompanied with the wise allocation of free cash flow. While 2016 has seen relatively flat equity market performance, we believe that improving corporate fundamentals that we track could lead to better market performance during the remainder of the year.


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