March 11, 2022

An Update on Russia-Ukraine

We recently wrote to our clients to reflect our current thinking in regard to the Russia-Ukraine conflict and thought it might benefit those who hold our funds through intermediaries, so we have excerpted it in the letter, below.

While the focus of the note is to interpret the potential implications of the war on markets and investment portfolios, first and foremost we want to express our heartbreak for the people of Ukraine, and our sincere hope that the conflict can be resolved peacefully, and soon.

Leith Wheeler Client Portfolios

On the day of the invasion, Leith Wheeler clients had negligible exposure to the Russian market in equity and bond portfolios. Our International Fund is allowed to own emerging markets stocks and while Russia is in that universe, we have no direct exposure to Russian stocks. That is a positive given that the Russian market is currently inaccessible and its economy under significant pressure.

A modest number of holdings in other portfolios have indirect exposure to Russia, primarily through revenues. At the portfolio level, these indirect exposures are immaterial. For example, the two Canadian companies in the portfolio with the largest exposure to Russia, Onex and Saputo, still derive less than 1% of revenues from there. Similarly, in non-Canadian equities there are holdings with some revenue exposure to Russia, but the position size is relatively small, or the revenue impact immaterial, or both.

We do have a small but building position in a distinct emerging markets strategy (the Emerging Markets Fund), that on day one held two Russian companies for a total weight of 2% of that fund. That means clients with a 5% distinct allocation to emerging markets would have had 0.10% of the equity portion of their portfolio in Russia. We believe these companies – Alrosa, a diamond mining company and MOEX, the Moscow Stock Exchange – will still have value eventually, but to be prudent we have written them down to zero in the fund valuation and the intent at the time of writing is to eliminate them when trading resumes. Its benchmark, the MSCI Emerging Markets Index, has similarly eliminated Russian companies in recent weeks.

What Have Markets Done?

Stock markets around the world have certainly been more volatile in the period since Russia’s troops crossed the Ukraine border on February 24^th, but the net impact so far has probably been less than you might imagine.

Given Russia’s huge global oil production and both Russia and Ukraine’s dominant position in agricultural markets, these commodities have surged since the invasion. Oil spiked 39% to $128 per barrel and wheat futures rocketed 63% in the ensuing two weeks, before falling to end this past week down 15% and 27%, respectively, from those peaks. Clearly, it is a fluid situation in these markets.

North American indices have reflected a somewhat more sanguine picture, with the S&P 500 (USD) falling just -0.5% and the S&P/TSX Index (with its relatively large Energy component) rising 3.5% since the day before the attack. The MSCI World Index (USD) is also down slightly (-2.3%) but as expected, the MSCI Emerging Markets Index (USD) is down the most, at -10.1%. (All figures as of March 11.)

The key question that bond markets have wrestled with since the invasion is whether central banks would ease up on their aggressive plans for interest rate hikes this year and next. After a brief period of doubt, prices returned to reflecting a full expectation of hikes from the US Federal Reserve and Bank of Canada, certainly through the first half of this year and likely through 2022. The current expectation is 6-7 hikes of 0.25% each, this year.

What Have We Done?

As you might expect, very little has changed in our investing style or process. The core discipline to invest in companies with a defensible competitive advantage, capable management, serviceable debt levels, high potential to grow cash flows over time, and an attractive price, persists. What has changed is the set of variables that might determine the future path of those cash flows – and these paths have become a bit murkier, especially in Europe.

Similar to when COVID-19 first hit – roughly two years ago this week – our investment teams developed a set of scenarios that could play out in Ukraine, from the most optimistic (a rapid and complete retreat by the Russians) to the most pessimistic (a protracted and deadly conflict that expands beyond Ukraine’s borders). We then apply a probability to these scenarios and use these to assess the riskiness or opportunity within certain sectors or companies over the medium to long-term. We don’t profess to have a crystal ball of course, but it is helpful to be pragmatic in assessing the potential downside (and upside) of current holdings and be able to be nimble when opportunities present themselves. The exercise also helps us identify “tail risks,” or low-probability/high-impact events that may impact the financial fortunes of our holdings.

What Comes Next?

We know we don’t have an edge as investors with regard to the outcome of this conflict or its impact on markets. Ultimately, what we can do is position client portfolios based on our assessment of value over the next few years, and allow the geopolitical crisis to resolve in time. History can be a comforting thing at times like this, and the following chart does provide a modicum of this. 

This chart shows the experience of investors since the S&P 500 bottomed after the Credit Crisis, in the Spring of 2009. There were clearly many, many points in time where the crisis du jour would have presented a convincing “reason to sell” but while these crises may have felt earth- and market-shattering while you were in them, they did resolve, and oftentimes sooner than you thought.

As we watch the developments in Ukraine, we continue to manage our clients’ investments with care and caution.