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First Quarter 2008


Market Review Quarter 1, 2008

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

First Quarter % Change

-3.5

-6.3

-6.6

-5.5

17.2

-5.2

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

March 2008

2.12%

1.33%

3.61%

3.56%

December 2007

3.77%

3.24%

3.97%

4.25%

Commodities (in US$)

Oil

Natural Gas

Gold

March 2008

104.83

9.83

895.20

December 2007

95.98

7.48

838.30

Portfolio Management Strategy

What Worked

Agricultural Stocks

Gold

Bonds

What Didn’t

– Far East Asian Stocks

– Small Cap Stocks

– Financial Stocks

Let History Be Your Guide – NL

I always thought that history was history but I have come to the conclusion that history depends upon your age. As a student of market history, and a participant for over 35 years, I have learned to look back at over 100 years of stock market activity to try to use those experiences to help predict what may be happening currently and in the future. While history may not exactly repeat itself, it sure does rhyme a lot.

If you have been watching capital markets for the past ten years, you remember the last two years of the technology bubble (where "buying the dips" was the dominant investment strategy) followed by its very ugly bursting. You also remember the quick recessions and bear markets in 1998 caused by the Asian financial crisis and the financial collapse of Russia and Long-Term Capital Management, and in 2001-2002 caused by the events of 9/11, and the subsequent five year climb in equities.

If you have been watching capital markets for the past twenty years, you also remember the crash of 1987, the Savings and Loan crisis, the short recession of 1990-91 caused by the large spike in oil prices due to Operation Desert Storm and the subsequent bear market.

If you have been watching capital markets for the past thirty years, you also remember the last commodities bubble (oil at US$41, gold at $US875) and inflationary and interest rate spikes (inflation at 14% and the prime rate at 22.75%), the 1981-82 recession and bear market caused by the determination of central banks to break the back of inflation, and the beginning of a twenty-year stock market rally following economist Henry Kaufman’s statement in August of 1982 that the worst was over and interest rates would begin to fall.

But if you want to compare what is going on now in the economy and capital markets around the world, you have to go back 35 years to 1973-74 and its recession and deep bear market. As David Rosenberg of Merrill Lynch recently pointed out, the similarities are many. They include: a sustained oil shock combined with rampant food inflation; real estate deflation coupled with an almost two year long bear market; a dollar bear market and consumer spending going through the floor.

Why do I go back so far to look for a comparison to today’s market? Because history tells me to. The media is full of prognostications telling us that the worst is over as the Federal Reserve Board’s interest rate cuts and bailout of Bear Stearns were the market’s capitulation bottom. Maybe. Some are still debating whether the US is indeed even in a recession. There is too much complacency and optimism right now. It is like Wile E. Coyote chasing the Road Runner and running off a cliff and into the air before stopping in mid-air and realizing there is nothing below him.

The downturn in housing and consumer spending is going to be a long, slow process to unwind. Consumers are tapped out and will be much more conservative for some time. The credit crisis has long-term implications and will change lending patterns for a long time. This will continue to affect private equity and leveraged buyouts (LBOs) as their activities will be largely curtailed for the foreseeable future. The elections in the US will not bring good news, no matter who wins. Protectionism, higher taxes, and increased regulation will lead to slower growth.

Inflation, particularly food inflation, has moved from page 16 to page 1 in the media. China, once an exporter of deflation to the developed world, is now beginning to export inflation as its costs for food, fuel, and labour are rising quickly. Wal-Mart will soon not be known for slashing prices but for raising them. The desire of third-world countries to raise their citizens’ standard of living is commendable. The resultant effect on the rest of the world may not be so pleasant.

With this gloomy outlook, what is an investor to do? Using history once again and looking back at previous recessions and bear markets, what one learns is that troubled times present opportunities for investors. For example, from the depths of the 1973 -74 bear market, the Standard & Poors 500 rallied 65% within 20 months. I use US examples because the historical data goes back further than in Canada. There was a short bear market from 1976 to 1978. From its depths, the S&P 500 rallied 58% in 36 months time. Following the crash of 1987, the next 33 months provided a rally of 70%. Finally, following the bear market of 1990, that same S&P 500 provided returns of over 300% in the next eight years. What did these examples all have in common? Investors were exceptionally pessimistic not only well before the markets bottomed, but well afterwards as well. Why? Markets lead economic trends and whatever makes an investor scared or negative tends to keep him that way well after the market recovery is in place. By the time something is in the news, it is probably old news. That is why investors should not try and time the market. Nobody can. Some get lucky once and are considered geniuses (remember Elaine Garzarelli) but have trouble repeating the feat. The key is to own quality stocks you are comfortable with and have a cash cushion available for opportunistic purchases, when they arise. That is the key to generating long-term returns.

Strategy: Yesterday, today and tomorrow – PW

The problems in the U.S. housing market, consumer spending and the financial industry did not come as a surprise. We have been writing about these concerns for some time. However, the severity of the problems has turned out to be more than anticipated. Our investment strategy has been conservative. At times like this we wish that it had been more so.

Our emphasis on high quality securities, bonds, stocks and money market investments has enabled us to avoid major disasters. In our bond portfolios, we have concentrated on Government of Canada bonds, which have worked well. Under the deteriorating economic conditions, we should have owned more long term issues. Our equity portfolios emphasized global diversification, strong balance sheets and a good dividend yield. For the most part, this has worked well. Last year most of the companies in the portfolio raised their dividend. We anticipate that this trend will continue this year. This bodes well for long term returns. Many of our global holdings provided outstanding results. Our U.S. returns were penalized by the unsustainable strength in the Canadian dollar.

Portfolios have been hurt by the sharp decline in financial stocks. Although we had limited exposure to Canadian banks, we owned the wrong ones. We have been surprised by the negative performance of the insurance stocks and they currently represent excellent value and will remain core holdings.

The international banks in the portfolio have weathered the storm operationally and have all raised their dividend this year.

As Norm discusses in his article, the problems facing the economy will take some time to work out. Here is how we are going to try to cope with the upcoming challenges:

We remain steadfast in our belief that a high quality, well diversified portfolio will provide sound long term results. We currently hold well above normal cash reserves in our portfolios. In the coming months or quarter, we hope to be able to put this to work. In periods of market distress, all stocks go down together. We will be looking to purchase excellent companies at marked down prices. A second phenomenon that occurs during periods of economic weakness is that, because of the huge amounts of money in the financial system not being used for real estate, construction, or capital expenditure, the stock market becomes very volatile. We hope to be nimble enough to generate some capital gains in this environment.

A major uncertainty is the direction of inflation. Whether the high commodity prices and government’s stimulative efforts will push inflation higher, or the impact of the recession will drive prices lower, is unknown at this time. We are watching carefully.

This will have a significant influence on the structure of both bond and equity portfolios. Higher inflation would indicate the need for inflation linked bonds and higher weights in community oriented stocks. Lower inflation would call for more bonds and high yielding defensive type stocks.

We expect that we are facing a period of below normal portfolio returns. Preservation of capital will be the number one objective. We will also be constructing portfolios in such a manner as to ensure that they will prosper when conditions eventually improve.

Why we own them – PW and FB

Manulife Financial Corp (MFC – T)

MFC is Canada’s largest life insurer and by market capitalization the second largest in North America and the sixth largest in the world.

Asset quality remains exceptionally strong allowing MFC to weather this financial crisis relatively unscathed. It has a longstanding and profitable operation in Asia, which now contributes over 20% of the company’s earnings. Longer term, MFC has an objective of earning 16% on equity and increasing its earnings by 16% a year. Selling at 13 x expected 2008 eps, the stock continues to be an attractive investment. Under current conditions MFC’s financial strength may give it the opportunity to make its next significant investment.

Diageo plc ADS  (DEO – NY)

DEO is the world’s leading premium drinks’ business with an outstanding collection of brands across the spirits, wine and beer categories. These brands include Smirnoff Vodka, Johnny Walker scotch, Guinness beer and Tanqueray gin. Its size and leading position gives DEO the ability to heavily promote its products while maintaining high profit margins. There is the opportunity for western spirit brands to expand rapidly in the fast growing markets of China, Russia and India.

DEO is consistently extremely profitable, generating large amounts of free cash flow which it uses to increase dividends and buy back stock. Earnings are expected to increase in the 10% range over the next two years and the dividend by the same amount. This largely recession proof stock seems attractive at less than 15x next year’s earning.

Genuine Parts Co. (GPC – NY)

GPC engages in the distribution of automotive and industrial replacement parts and electrical materials in the U.S., Canada and Mexico. It also retails auto parts under the NAPA brand. GPC is struggling currently because of the weak automotive market and sluggish U.S. economy. Nevertheless, earnings are expected to increase moderately. The company has a very strong balance sheet and will use its cash for acquisitions, share repurchases and higher dividends. GPC has raised its dividend in each of the last 52 years.

The stock sells at about 13x 2008 eps and yields 3.9%. It will be a prime beneficiary from the eventual recovery in the U.S. economy.

Vodafone Group plc ADR (VOD- NY

VOD is a leading international mobile communications provider ie cellular, paging and personal communications’ systems. It has a significant presence in Europe, the Middle East, Africa and Asia. It owns 45% of fast growing Verizon wireless in the U.S.

Although traditional wireless telephone business is under pressure in its main Western European markets, this is being more than offset by the growth in mobile broadband. The real interest in VOD comes from its fast growing operations in emerging markets, particularly India.

Its holding in Verizon wireless is expected to begin paying a substantial dividend within the next few years and become a public company exhibiting its true value.

VOD sells at a discount to its European competitors and has a dividend yield of 4.6%.

April 2008


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