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First Quarter 2009


Market Review First Quarter, 2009

Equity Markets (in Cdn$)

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

First Quarter (% Change in Cdn$)

-3.0

-9.1

-12.7

-13.5

0.0

-7.5

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

March 2009

0.36%

0.20%

2.78%

2.66%

December 2008

0.85%

0.11%

2.68%

2.21%

Commodities (in US$)

Oil

Natural Gas

Gold

March 2009

49.00

3.59

918.33

December 2008

44.60

5.63

880.70

Portfolio Management Strategy

What Worked

– Mining Stocks

– Emerging Markets

– Gold

What Didn’t

– Insurance Companies

– Oil and Gas Service Stocks

– Utilities

Buy Now … Pay Later – FB

After 25 years of rising markets – from August of 1982 to October of 2007- most investors have been programmed to expect constant price increases and as a result have been asking “when will this market hit bottom and start back up?” I thought a short look back might help illuminate the current situation and what will likely be required before the economic clouds retreat and the market reaches that elusive bottom.

In the 1970’s the North American economy was battling inflation caused in no small part by a huge shift in demographics now known as the post war baby boom. As the boomers were being added to the population they put a strain on the production side of the economy to provide an ever increasing supply of homes, schools, roads, automobiles and all the various bits and pieces required of a growing population. In the short term the economy couldn’t keep up so prices started to increase. This inflation was “broken” in 1981 after the US central bank raised interest rates to previously unseen levels. Remember Canada Savings Bonds at 17.5% in the fall of 1981? Paul Volker, the head of the US central bank, was the man most responsible for those high rates and he received the lion’s share of the credit for taming inflation even though it would have happened on its own shortly thereafter as the majority of boomers finished school, entered the work force and became economic “contributors” as opposed to economic “takers”.

By now I’m sure you are asking what does a bunch of aging baby boomers have to do with today’s economy and today’s markets? The answer is surprisingly simple.

When I was growing up in the 1960’s and 1970’s I remember hearing advertisements urging consumers to “Buy Now and Pay Later”. At the time those advertisements stood out as most households, remembering the depression, were reticent to borrow money for anything other than buying a house. How times have changed!

Interest rates which peaked in 1981 started their long decline to current levels in concert with falling inflation rates. Too, as the baby boomers entered the workforce in large numbers their productive efforts improved their financial status and their desire to accumulate material goods was stoked by continued messages exhorting “Buy Now … Pay Later”. Gradually the pendulum started to swing and the mind set of a whole generation changed. Financing a purchase, any purchase, became not only acceptable practice but almost required if one wanted to keep up and get ahead. In today’s world buying groceries with a credit card is standard practice!

The pendulum reached the borrowing extreme as the acceptance of “Buy Now … Pay Later”, coupled with low rates, easily available financing, asset inflation (rising prices in both the real estate and capital markets) fueled an enormous debt accumulation that peaked in the summer of 2007 when the housing market in the US topped out. Since then similar to the demographic shift in the early 1980’s I believe enough of the baby boomers have realized that their retirement is looming and they had better deal with their debts if they ever want to stop working. In short, “Later” started eighteen months ago.

Looking forward, in the short run, the North American economy is in recession caused by the sudden decline in consumer spending. I would expect that recession to end in the relatively near future as the economy adjusts to the new spending reality (helped by the various government stimulus dollars). In the longer term consumer spending will be restrained, governments will be increasing taxes and corporations will be struggling with those issues and some of their own as well – higher pension contributions spring to mind. So I would expect slower corporate earnings growth which means further adjustments for both markets and investors.

Where’s the good news? For the first time in a decade security prices, both equities and some parts of the bond market, have reached levels from which long term return expectations look attractive. As value investors we will be playing to our strength which is identifying good investments and purchasing them at attractive prices. The issue of course will be “Where is the bottom?” but even if we get in early we have the comfort that falling prices have increased the yield on many of our potential targets such that we will be well paid to wait.

It Ain’t Over Till It’s Over – NL

Investors are optimistic by nature. They like it when markets go up and, even in the midst of prolonged bear markets, are eager to pronounce the mighty bear dead every time equities stage a rally. We too like to be optimists. We like it when our clients are making money. But we are also realists and students of history. Bear markets historically end with a whimper, not a bang, and are characterized by extreme volatility and huge rallies that end up leaving ever-optimistic investors in tears. This great bear will end, but we don’t think it is ready yet. All kinds of prognosticators (those same ones who never warned you we were entering a bear market) are falling over themselves to tell you the bear has ended. In fact, it will probably end quietly when everyone least expects it. We are getting closer but we’re not there yet. In the immortal words of that great sage, Yogi Berra, “It ain’t over till it’s over”

As of the end of February we have seen the worst 6 month decline in world markets since 1932. March, however rebounded and gave us one of the best months ever, highlighting the continued volatility of equity markets around the world.

We expect a very weak first quarter earnings season. This should not take investors by surprise.

The decline in economic activity in the last two quarters has been dramatic. So dramatic that the massive stimulus policies enacted by governments around the world should provide a floor or even a modest boost to economic activity. It is very early in the game, however. Most of the stimulus projects and packages approved by governments have yet to be implemented. Many will never see the light of day. Markets will rise when the stimulus appears to be working and will fall when fears resurface.

Central banks are doing everything they can to take care of the supply of credit to boost consumer and corporate spending. Even with record low interest rates and a rapid increase in money supply, credit to consumers and business is severely constrained. The demand for consumer credit is likely to experience a persistent decline given the enormous loss of wealth many have experienced. Consumer spending, the largest driver of the US economy, is weak as households attempt to rebuild their balance sheets. In the United States, the personal savings rate has increased from virtually zero in January of 2008 to 3.8% by year’s end. For perspective, the personal savings rate averaged 8.3% in the 1960’s, 9.6% in the 1970’s, 9.1% in the 1980′, 5.2% in the 1990’s and 1.6% thus far in this decade. It should continue to rise towards its long-term norm of 8-10%.

The housing market is not going to revert to its previous froth where homeowners treated their homes as their personal ATM. There is substantial excess inventory of new and resale homes.

We believe government’s ‘hair of the dog’ solutions to get consumers spending again are not sustainable although in the short run they can provide fodder for optimism. Over the long run ultimately these stimulus measures will have to be paid for through higher taxes. Though no politician wants to talk about it at this point, eventually the piper must be paid.

One thing to especially watch out for is the growing tide of protectionism around the world. While it is natural and politically expedient for politicians to want to protect jobs in their own country, history shows that slowing trade caused by protectionism (both overt and covert) does not solve economic problems – it prolongs them.

Economic recovery around the world, when it arrives, will be tepid for a prolonged period of time. Corporate profit margins will remain under pressure with taxes rising, regulations increasing, and sales growth continuing to be subdued. Balance sheets (government, corporate, and individual) have been devastated. Rapid recovery is unlikely in a deleveraging world.

Individuals and corporate pension funds will be searching for sustainable yield to help restore their liquidity. Risk tolerance will be reduced. Dividends and income will become much more important than in recent years. This is nothing new to our clients. We have been preaching this mantra for some time.

Our clients’ accounts contain historically high percentages of cash. This has served our portfolios well during these troubled and volatile times. Conditions, though, will improve and it is important that we begin reducing these positions over the coming months.

For Balanced mandate accounts, we will be building up holdings in high quality mid-term corporate bonds. Interest rate spreads available from these bonds versus government bonds are at record and we feel unsustainable levels. Taxable accounts may also see purchases of high-yielding quality preferred shares as their dividends are particularly attractive on an after-tax basis.

In addition, we will selectively add to attractively valued common shares, especially those with the potential of increasing their dividends.

For Growth mandate accounts, we will selectively increase our holdings in attractively valued common stocks, anticipating significant returns over the next 3-5 years.

Why we sold them: – RD

Teck Cominco – TCK.B – T

The rapid deterioration in economic activity is a dangerous turn of events for companies with a high degree of leverage. Unfortunately for Teck Cominco they have just finished adding on a significant amount of debt in order to pay for Fording Coal. This acquisition is proving to have been very ill timed as credit conditions, economic conditions and commodity prices have all
spiralled down putting the company’s ability to pay its debts at the mercy of factors largely beyond its control. As a result our investment had taken on a speculative nature. While the company is taking measures to reduce its cash outflows, the financial risk in this name is high should conditions continue to deteriorate. The cycle will eventually turn but in the meantime those companies with high levels of debt are in a precarious position.

Parkland – PKI.U – T

We trimmed half our position in this Western Canada rural gas station operator as we feared a distribution cut could be in the offing. This turned out not to be the case. Its earnings and hence distributable cash were boosted by a one off contract cancellation fee and also by a series of acquisitions. Recent maintenance shut downs by refineries will continue to benefit the company by increasing its refining margins for the 1st quarter. This will help to offset declining volumes of gas and merchandise sales at its gas bars as the result of slower economic activity in the West.

The company remains on watch with us given its high payout ratio and hence high distribution risk.

Manulife – MFC – T

A previously well regarded life insurer got itself into major trouble as the equity market dropped. MFC wrote variable annuity business that guaranteed investors’ capital in the event of a market decline. This was great business in buoyant markets and can still be an OK business if the risk of a market decline is properly hedged. Inexplicably MFC chose not to hedge and the stock became a trading play on the equity market, trading down when the market declined as its client obligations became more onerous. Without a strong rally in the markets MFC was going to be in dire shape. We don’t hold companies whose health is premised on hope – hope that the market recovers or hope that they can get additional capital to support their financial obligations.

UK Banks Lloyds, Standard Chartered, and Barclay’s (4Q08)

We held these banks as our analysis indicated that they were among the strongest and best regulated banks outside of Canada. Unfortunately we were only partially correct, both Barclay’s and Standard Chartered have remained independent. Regulation turned out to be much more lax than expected and the corrective measures the UK government has enacted have been extremely costly to the strong banks. Lloyds Bank, one of the strongest going into the crisis was forced to merge with a bankrupt mortgage bank which proved disastrous. With the combination on the verge of nationalization, we reluctantly sold our Lloyds holding. Barclay’s which so far has escaped being saved by the government has had to raise costly equity and is selling the family jewels (Ishares) to remain independent. The sale of Standard Chartered Bank was the most difficult decision. It avoided much of the sub prime problems but, faced with rapidly deteriorating economic conditions in its markets such as South Korea, Pakistan and Hong Kong, we decided that it was prudent to watch from the side lines.

Added

Morneau Sobeco – MSI.U – T

Morneau Sobeco is a pension plan and benefits consulting/workplace health management company with a market leading position in Canada. Its blue chip clientele includes CN, TD Bank, McCain, and CBC. The company is recession resilient as employment turnover (rising unemployment) results in increased business. This is generally because a shifting workforce requires continuously updating actuarial assumptions and pension liabilities. The 2008 acquisition of Shepell (employee assistance programs) effectively doubled the size of the company and introduces a significant cross selling opportunity. Additionally, employee assistance programs are a growing area in the corporate world in order to reduce employee stress and get them back to work faster. Once a company contracts with Morneau Sobeco it becomes very expensive and time consuming to switch. As a result this defensive position was taken to provide our clients with a steady, stable 11% distribution in uncertain economic times. We do not anticipate much if any capital gains in the near term.

April 2009


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