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First Quarter 2010


Market Review First Quarter, 2010

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

First Quarter (% Change in Cdn$)

2.5

1.8

-5.2

3.2

-2.8

7.1

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

March 2010

0.28%

0.15%

3.56%

3.83%

December 2009

0.17%

0.05%

3.61%

3.83%

Commodities (in US$)

Oil

Natural Gas

Gold

March 2010

83.76

3.87

1113.30

December 2009

79.36

5.57

1096.20

Portfolio Management Strategy

What Worked

– Mining Stocks

– Financial Stocks

– Small Cap Stocks

What Didn’t

– Gold Stocks

– Euros

– Sterling

It’s All Greek To Me – NL

Equity markets in North America (and many other parts of the developed world) continued their march upward during the first quarter. Around the world, though, results were very mixed. Emerging Asian markets such as China, Taiwan, Korea, and Singapore were negative. Mainline European markets were positive, some substantially. However, their gains were overshadowed by those European markets whose government finances are highly questionable. Affectionately referred to as the “PIIGS”, Portugal, Ireland, Italy, Greece, and Spain all have runaway budget deficits and massive amounts of debts. Of the group, only Ireland’s stock market was able to show positive returns for the quarter. Greece and Spain declined substantially.

They are all members of the European Union. Unfortunately, the European Union works better in principal than in reality. It is more of a currency union than an economic union as, while it operates under a common currency, each country is responsible for their own economies as long as they operate under Union guidelines. The great advantage of the Union is that there are no tariffs on goods or services between members. This was a great inducement for countries to join. The great disadvantage is the lack of wiggle room for a country in economic trouble.

It doesn’t matter whether you are economically strong like Germany and France or weak like Greece and Spain. Your currency is the euro. In pre-Euro Europe, if a country got overextended it simply devalued its currency. This had the effect of helping the country inflate and export its way out of trouble. With the advent of the Euro, however, all countries use the same currency regardless of its economic strength. This is a huge problem for the economically weak.

Greece had no business joining the European Union. It has a long history of fiscal promiscuity. According to economists Carmen Reinhart and Kenneth Rogoff, Greece has spent 92 of the past 184 years in default on its sovereign debt. When it joined the Union, its debt was 12 times as much as it disclosed in its statements and its citizens and companies have a very poor history when it comes to paying taxes. The recent recession has caused all of Greece’s warts to be put on full display and now it is crying out for help from its fellow Eurozone partners. Unfortunately, as Dennis Gartman is quick to point out, Germany, the strongest country in the Union, is loathe to help as its citizens have just emerged from the painful and very expensive experience of merging East and West Germany together. They were family. Greece is not. Germans pay their taxes, work harder, get fewer vacations and retire later than the Greeks. They are in no mood to help their slothful neighbours. Besides, if Greece is rescued by the Union, then Portugal, Ireland, Spain, and possibly Italy will demand equal treatment. Even the United Kingdom could be in line for help.

Things are likely to get uglier in Europe before getting better. We are not in a position to guess as to how things will work out or how long it will take. However, we are being constantly vigilant as to how events will affect us as Canadian investors.

Currency changes are one thing that are working favourably for Canadian investors. People still ask our opinion about the weak US dollar but we have to ask, “Weak against whom?” Despite its many problems, the US dollar is showing great strength against European currencies (be it the Euro, Pound, Kroner or Franc) as well as the Japanese Yen. Its turnaround has gone largely unnoticed in Canada as our dollar has been even stronger, being a beneficiary of the problems in Europe and the US as well as being viewed by the world as a commodity currency. This led to the Canadian dollar being the second strongest major currency in the world during the past quarter, behind only the Mexican Peso (who knew?!).

While headline writers fret about the many perceived negatives of a strong Canadian dollar, we look upon a strong currency as a gift. Not only does it help mute inflation, keep interest rates lower, and make imports and foreign travel cheaper, it also forces our manufacturers to become more productive. Most important to us, though, is it makes foreign investment very attractive. Currencies move up and down constantly and the best time to invest outside your home country is when your currency is strong as you are able to buy more assets for the same amount of money.

We have no idea how high the Canadian dollar will rise or for how long it will remain strong. We do know though that it will not stay strong forever. We are a commodity currency. Live by the sword and die by the sword. Commodities do not just go up. Commodity prices peaked in January and yet our dollar continues to strengthen. Either commodities resume their upward trend (much more difficult now with a strengthening US dollar) or our dollar becomes vulnerable.

A Greek tragedy is unfolding. For a Canadian investor, it is causing European assets to go on sale. The financial crisis in the US has caused their assets to go on sale relative to ours. Japan’s coming demographic catastrophe will have the same effect on its assets. Companies are not countries. Strong companies (especially international ones) can reside in weak countries. We have always been big believers in international investing. We will be emphasizing it even more in coming months.

Withdrawal Symptoms – PW

The world economy, over the last few years, has been supported by massive stimulus actions from central banks and government fiscal policies. These actions have prevented a major world wide depression. There is a cost to these actions, however, that must be paid. Governments are running unsustainable deficits. The main problem now is how to withdraw this stimulus without throttling the economic recovery.

Fortunately Canada has performed well through this period and its debt is relatively low compared to most other countries. The problems will be less in Canada but it will be a painful struggle for all levels of government to reduce their deficits.

The timing and methods of reducing this stimulus will differ from country to country. China, after a huge increase in its money supply, has taken severe measures to restrain bank lending to prevent bubbles in its Real Estate and Equity markets.

The Bank of Canada has removed most of its support mechanisms and has indicated that interest rates will be raised later this year.

The US and UK, because of the size and complexity of their stimulative policies will have the most challenging time trying to reverse their policies. Mr. Bernacke has outlined measures that the Federal Reserve Board could take to prevent inflation and reduce the billions (or is it trillions?) of dollars that they have injected into the system. Many of these measures are untested and to many, including ourselves, incomprehensible. They basically include the Federal Reserve raising interest rates, selling assets and altering bank reserve requirements. The US government has two options to control its spiralling debt. It must reduce spending or raise taxes, neither of which are popular choices.

The focus currently is on reducing stimulation. No one is talking about what happens if the patient has a relapse. Japan sets a worrying example.

First some conclusions that can be drawn from the events of the last few years:

A. It has become clear that the economies of countries such as China, India, and Brazil will be the engines of growth for the foreseeable future. It will be these countries that will drive demand for energy, industrial, and agricultural commodities.

B. Unemployment will remain high, limiting the growth in consumer spending and the recovery of the US Real Estate markets.

C. Because of rising taxes, increasing costs of healthcare, and environmental protection, Corporate profit margins will be squeezed. Growth will be scarce.

In determining this strategy it should be realized that withdrawing the stimulus will not be simple and will lead to volatile markets for stocks, bonds, commodities, and currencies. More difficult will be the task of restoring to health the balance sheets of debt laden governments and underfunded pension funds. This will be a prolonged process and will constrain investment returns for many years.

Our foremost strategic priority is to emphasize high quality investments that produce secure income. This is not a new theme but needs to be strongly restated.

The spectacular rebound of low quality bonds and stocks will not be repeated. Income generation is not a new theme either but becomes increasingly important in a slow growth environment.

Since it is far from clear which will be the greater issue, fighting inflation or continuing to stimulate the economy, a flexible approach to fixed income investing is necessary. This will entail maintaining a high level of government bonds that provide the liquidity to quickly react to interest rate trends. In order to generate more income for the portfolio, greater use will be made of high grade corporate bonds. Strange as it may seem the soundest approach to adding income to a portfolio may be to increase the holdings of quality stocks that continuously raise their dividend. This leads to one of our major equity themes. Today large global companies offer relatively good value. With their strong balance sheets and easy access to capital they have a strong competitive advantage over their smaller, weaker rivals. Many of these also have significant exposure to the faster growing emerging markets. In a world where growth is scarce and bond yields low, this type of company looks very attractive.

Our portfolios are well represented in this type of company but as we put cash to work we will search for more.

This continues to be a high risk investment environment. As well as the economic risks, the geopolitical risks remain high. It is worthwhile to remember the old investment adage that it is the return of capital not the return on capital that is most important. The withdrawal from any addiction is difficult. The hangover is long lasting.

Why we added/sold – RD
Added
Volkswagen – VOW3.DE – XETRA

Porcshe SE’s auto manufacturing unit. Despite the well publicized travails of the auto makers in general we are attracted to VW given that it is one of the best positioned auto makers with 45% of unit sales in emerging markets. VW sold more vehicles in China last year than it did in Germany. While we feel the developed world in general will face a slow economic recovery, we are optimistic that wealth creation in the developing markets will spur better levels of consumption. VW’s geographic diversity should give them a strong offset to the more mature developed markets. Additionally, a healthy balance sheet, a strong brand and low valuation adds to its attractiveness.

Sold
Student Transportation – STB – TSX

After reaping close to 50% returns (including dividends) from our $3.50 initial purchase price the stock began to have a risk to return profile that made us uneasy. Attributes such as a large payout of earnings for what is still a growth company were easy to overlook at $3.50 but not so closer to $5.00. We exited the name feeling strongly that this dividend paying name will change their capital structure before too long and that the reaction will not be favourable. Given that this company is not a trust, a dividend cut will be felt directly as such by the shareholders. Having said that, we continue to like the school bus business and will keep the name on our watch list and revisit it after the dividend is reset.

Income Trusts
Morneau Sobeco – MSI.UN – TSX

This was a good business structured as a trust and will continue to be a good business structured as a tax paying corporation in 2011. In the case of MSI the yield will be reduced from 9.0% to 7.6% (from $0.94/year to $0.78/year) as the trust structure is eliminated in 2011. In this case it will continue to pay its shareholders monthly. For many investors the after tax income will be similar and for those in the highest tax bracket will work out to being an effective after tax increase. This is because the tax rate paid on dividends is lower than that paid on interest. While some trusts can utilize tax loss pools for a period of time, sooner or later all will be subjected to paying corporate income taxes and will need to make a decision on the sustainability of the current distribution. Now that the dividend/distribution decision is out of the way for MSI we can go back to looking at the health of the business and its industry, both of which we view favourably.

April 2010


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