CVE:CC - 15% Expected Returns From A Simple Portfolio To Hold For Years

Summary

• S&P 500 or MSCI World are good things to hold, but there is zero chance for extraordinary returns, so it's hard to shake fears of missing out.
• A total market portfolio might not protect you from your specific risks.
• Humans have messed up their energy situation, resulting in risks and opportunities - I suggest some ways to profit from it.
• The suggested portfolio is likely to return 12-20% p.a. over the next 5-10 years and mitigates various kinds of risks. It comes with above-average volatility, though.
• I touch various aspects of portfolio construction that are of general use, and link a couple of useful resources that might potentially increase your understanding.

If I were to construct a simple equity portfolio that one can buy and then pretty much forget about (except perhaps some occasional rebalancing if something gets out of proportion too much), I would do something like this:

• 40% Brookfield Corporation ( BN ),
• 20% Apollo Global Management ( APO ),
• 20% Cenovus ( CVE ) or some oil & gas ETF,
• 20% XAIX ( XAIXF ) or some other AI and big data ETF.

I like it very much because it offers both high expected returns and at the same time protects against various risks. Consider the portfolio an inspiration, particular percentages are not overly important. Let's discuss in detail what the individual securities bring.

Brookfield

• Exposure to a fast-growing elite alternative asset manager BAM . If you don't know why that is great, read Alex Steinberg's introductory articles on alt managers and insurance (I'd say both are among the best on this topic, not only within SeekingAlpha).
• Exposure to net-zero carbon transition, primarily through solar, wind and nuclear energy generation and transmission (via BEP ).
• Owns critical infrastructure, so lots of long-term contracted cash flows indexed to inflation (via BIP ).
• Owns high-quality real estate at best locations (about 1/3 of the invested capital).
• Owns a fast-growing insurance business.
• Owns Oaktree, a famous alternative asset manager focused on credit, especially distressed debt, which tends to thrive in times of financial distress.
• Thanks to the uniquely crafted structure of the Brookfield empire, you not only own the invested capital in these attractive areas, but also earn tons of fees on hundreds of billions of third-party investments that Brookfield manages. Expect 15-20% annual growth of these fees over the next 5-10 years.
• Half of this position can be replaced by Blackstone ( BX ) or KKR if you don't like holding 40% in a single security. Both of them are attractive and have many similar characteristics.

Apollo Global

• Another alternative asset management with expected 15-20% growth.
• Focused on private credit and annuities, so highly complementary to BAM. Likely to benefit from an aging population.
• Benefits from higher interest rates: they have lots of long-tailed insurance liabilities on their balance sheet, offset by investment grade credit assets with floating interest rates.
• I highly recommend their 2021 investor day talks to learn about the industry and why Apollo is attractively positioned.

Cenovus

• Oil producer and refiner ( presentation ). Can be replaced by an energy ETF.
• Mostly oil sands in Canada, about 30 years of reserves. Once they got it running, operating costs are low; CVE has a break-even cost below $45 WTI.
• At $75-80 WTI, the free cash flow yield is ~15%. With oil at $100, FCF yield is ~25%.
• All free cash flow is used for dividends and buybacks.
• Almost no debt.
• If you need gasoline, there is no need to worry about its cost if you own CVE. Diesel? Even better thanks to the properties of Canadian heavy oil.
• Since 2015, not enough has been invested in oil & gas production (including the OPEC countries which have trouble fulfilling their quotas). U.S. shale is slowly running out, European shale is out of the question, and pretty much everything else is too expensive to produce, so over many years we are likely to experience prolonged periods of high oil prices or even fuel shortages. Since we can't produce anything without oil, I'd like to be protected against rising energy costs.

Artificial Intelligence and Big Data ETF

• XAIX is a European UCITS ETF focused on AI and big data. There are similar U.S. ETFs, e.g. [[AIQ]], or you can just buy [[QQQ]].
• Without a position in these areas, I'd always fret about missing out big time. The big software firms have lots of favorable characteristics and currently trade at modest valuations (compared to history).
• The advantage of XAIX is that positions are capped at 5%, so you are somewhat protected against holding too much of a single company at a sky-high valuation.
• Such an ETF is likely to capture future winners soon enough, so you won't have to worry whether ChatGPT is going to replace Google Search (GOOG) (GOOGL).
• The correlation of software to alt managers and energy is rather low and XAIX is mostly about growth, so adding it has potential to blunt portfolio drawdowns caused by value strategies of alternative asset managers.

Positives of the portfolio

• Expected returns. About 80% of the portfolio has expected returns above 15% over the next 5-10 years. I'm not so sure about AI and big data companies, but their valuations are down a lot recently, so expected returns are higher than usual and could be, say, 10%. Over the last ~10 years, the portfolio would have returned 17% p.a. (calculated by PortfolioVisualizer , a very useful tool for both learning from history and playing with possible future scenarios).
• Fear of missing out. If you invest in S&P 500, you are exposed to everything, but it is common to feel you are missing out something if you see headlines about current trends. This portfolio offers exposure to almost everything meaningful; renewables, net zero, aging populations, AI, big data, software, insurance, real estate...
• Inflation protection. Most of the businesses are fairly well protected from inflation. Asset managers get their fees on invested capital, so if money is worth less, it's because there is more money, and thus more fees. Also, Brookfield judiciously uses nominal fixed-rate long-term debt financing for its investments (most of which are the so-called real assets with values increasing with inflation over time). Software companies have little trouble raising prices, they tend to be monopolies or oligopolies, and switching costs are much higher than the rates they charge. Energy costs are typically a significant component of inflation; CVE protects you here.
• Value factor exposure is likely to provide some extra return in the coming decade (more on this in the section on factors below).

Negatives of the portfolio

• No direct protection from rising healthcare costs. I'm not sure if it is possible to specifically mitigate this risk. But with 12%+ expected returns and strong inflation protection, I am not worried.
• I've not identified other significant negatives, apart from general concerns like too much concentration in a single security. Please suggest some in the comments.

Volatility

Expect a lot of volatility from this portfolio. The prices of alternative asset managers' stocks routinely move more than twice the market average (2-4% price change in a day is common). For instance, on a memorable day when inflation came out 0.2% below expectations last October or so, S&P 500 was up around 5%, while BN was up 10% and BX even 14%. Oil stocks have high volatility too, although they are somewhat uncorrelated to the other positions. Over the last 10 years or so, the standard deviation was ~23%, about 1.5x more than [[SPY]]. The maximum drawdown was also 1.5x higher.

Volatility can be also viewed as an advantage; it allows one to buy more when stocks are down. That's especially beneficial for those trying to accumulate wealth over time.

Low yield

If you need dividend income, it is perfectly okay to combine this portfolio with BDCs like FSK , BXSL or OCSL , or even better, an interval fund like [[CCLFX]]. Exposure to private credit comes with risk diversification (it's preferable to choose BDCs that are not managed by the same alternative managers as you hold in the portfolio), returns are decent and defaults seem low .

Short-term treasuries are also nothing to scoff at a ~5% yield, and they can potentially be sold and the proceeds invested into more equities when markets are down (thus obtaining high dividend yield and income).

Energy

On this vast topic, just very briefly (but I encourage everyone to get more informed, e.g. Jack Devanney offers a good balance between technical details and high-level pictures). Human civilization develops thanks to energy consumption. Pretty much all progress of the last 200-300 years was achieved thanks to fossil fuels, first coal, then oil, then natural gas. It is highly unrealistic that people in either developed or developing countries can be ordered to consume less energy or stop increasing their quality of life by consuming more energy. As of now, we barely produce enough energy, hence prices are likely to remain high. Thus I am strongly in favor of a portfolio that would protect against energy cost increases, and the easiest way to get exposure is holding oil & gas producers (which are, luckily, promising investments on their own right now).

To get away from oil & gas eventually (though it will take decades), we need lots of electricity. There are only three big enough power generation sources available at present:

1. Coal. Pretty much everybody agrees that coal is dirtiest and would happily replace it with something else if it is cheap enough. It's also a less convenient source of heat than oil and produces more carbon emissions, so it is very likely to be phased out over time.
2. Solar and wind. Currently in favor of politicians, but does not really work without storage, and we haven't figured out storage yet. Requires tons of mined metals, i.e. tons of burned diesel, and tons of coal burned in China to produce steel and solar panels. IMHO not a way to achieve anything close to net zero, but likely to enjoy at least a decade of growth.
3. Nuclear. That's where we will end up IMO, but it will take many years.

Brookfield is positioned very well: whether the society decides it's solar, wind, or nuclear, they have lots of operating expertise, and thanks to their impressive track record are able to raise lots and lots of third-party capital for their transition and decarbonization funds (which includes opportunities outside of power generation, e.g. decarbonization of steel and concrete production). Many industries provide some kind of luxury and are thus in danger (e.g. fast fashion and beef producers), but energy will be required no matter what policies we agree upon or what particular technologies we use. If we are ever to replace oil in transportation and coal/gas in heating, we need to increase electricity production 2-3x, so the trillions Brookfield's CEO talks about are unavoidable, and the runway is very long.

Factor investing/smart beta

Exposure to certain sorts of stocks has historically provided returns above what would be expected from their volatility. This is not the topic of this article; I very highly recommend books from Antti Ilmanen or Larry Swedroe to learn more about these factors (one of them is even for free, so you have no excuse).

Thanks to the investment style of Brookfield and other alt managers, one would expect positive exposure to value and possibly quality and size, but with slightly negative exposure to low volatility and momentum (they are mean reversion guys). That can be confirmed by some factor regressions, but those are very unreliable for highly-concentrated portfolios. It suffices to say that the alt managers in the portfolio are creating their factor exposure in a way similar to W. Buffett, as described in the famous paper on his alpha .

While you should not be focused on timing these factors, it is still a good time to be exposed to value. And well-constructed factor ETFs like [[AVUV]] are a good addition to most portfolios. (Notice that such value ETFs have 15-20% allocated to the oil & gas sector. I consider the suggested portfolio good, not original.)

Berkshire Hathaway

This portfolio is similar to what you would obtain if you invested all the money in Berkshire Hathaway ( BRK.A , BRK.B ).

• An electric utility focused on wind generation, like BHE? You have BEP / BEPC within BN.
• A railroad, like BNSF, or some gas pipelines? You have BIP / BIPC within BN.
• Apple ( AAPL )? We have the AI and big data ETF.
• Insurance? Plenty of that in APO and soon in BN, too.
• Oil, like Chevron ( CVX ) and Occidental ( OXY ), constituting 5-10% of BRK's assets? We have CVE or an oil & gas ETF.
• If we remove the above-mentioned parts from BRK, there is not much left, so I'd say that Buffett would rather agree with attractiveness of the suggested portfolio.

There are, however, several major advantages the portfolio has over BRK.

1. Willingness to charge fees. Buffett works basically for free and does not charge his investors anything, while alt managers are much closer to the famous 2 and 20. Judging from the rapidly growing trillions of dollars they manage for top institutions, the fees are justified.

2. Ability to supply management. Berkshire has very few people at the top, and so has to buy businesses that already have good management in place (and those typically don't come cheap). On the other hand, Brookfield (and other alt managers) have tens or even hundreds of experienced professionals with operating expertise that can take a CEO role temporarily, or assist with lower-level decision-making. I can hardly imagine BRK buying the bankrupt Westinghouse, while Brookfield earned on it 60% IRR and a 6x multiple of the invested capital over 4 years .

3. Global mandate. Brookfield is willing to go wherever it takes to get better returns, while equities in the U.S. tend to trade at high multiples, so with low expected returns. That weighs on BRK quite a lot, especially since it is confined to investing in large-caps because of its big size. The competition for large deals in countries deemed less safe is much smaller - how many bidders would you expect for a 5 billion natural gas pipeline or a railroad in Brazil that has first to be carved out of Petrobras? And they don't do it haphazardly; they are selective in which countries to enter and move slowly and incrementally.

4. Ability to let go of assets. Buffett is focused on creating a permanent home for acquired businesses, and he behaves rather similarly with purchased stocks. This means he doesn't profit from selling if other people are willing to pay extra for what he owns. Alternative asset managers have no such problem, and coupled with the global mandate it can be very powerful (a great example of this is the story of Brookfield Infrastructure Partners: try to compare the assets they held in, say, 2011 and 2023).

Of course, there is no problem in combining this portfolio with BRK. And you can get some incremental return by opportunistically selling a sliver of BRK and buying the more volatile positions when they are down much more.

Personal concerns

You have to mix your portfolio to fit your personality, risk tolerance, etc. For me, it means having at least some cash available at all times, so that I can buy cheap. Investing even a thousand dollars into something attractive counters the negative feelings arising from having a portfolio down tens of thousands.

Also, it irritates me quite a lot to hold a total market ETF. Because there are always some close-to-zero-profit stocks trading at absurd valuations. Or no-growth stalwarts like [[KO]] and [[MCD]] with expected return perhaps around 6-7% (they have their dividend growth fans, but my view of what MCD has done over the last 10-15 years is borrowing lots of money to repurchase overpriced stock, while revenues did not grow at all). The suggested portfolio alleviates these concerns almost entirely.

I'd consider major changes only when something got overvalued, causing me discomfort.

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