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First Quarter 2011


Market Review First Quarter, 2011

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

First Quarter (% Change in Cdn$)

5.0%

3.0%

3.5%

-7.2%

10.5%

8.5%

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

March 2011

0.91%

0.09%

3.34%

3.46%

December 2010

1.00%

0.15%

3.13%

3.29%

Commodities (in US$)

Oil

Natural Gas

Gold

March 2011

106.72

4.31

1432.77

December 2010

91.38

4.23

1420.78

Portfolio Management Strategy

What Worked

– Energy Stocks

– Real Estate Investments Trusts

– Forest Products Stocks

What Didn’t

– Japanese Stocks

– Bonds

– Gold Stocks

It’s All Greek To Me – NL

It has been quite a ride since equity markets bottomed in March, 2009. Major North American markets are up 85-90% from their lows. Sounds impressive until you realize that most stocks have yet to return to where they were in late 2007 or early 2008. Of the major indices, only NASDAQ is really close and that reflects its more speculative nature as it has been mostly mid-and small-capitalization stocks that have led the rally.

There is much to be negative about around the world. Parts of Europe (as we have written about extensively over the past year) are either bankrupt or very close to the edge. Large parts of the Arab world are or have been on fire as the people there begin to demand freedom and democracy – some, so far successful, some not. Japan was hit by a monstorous earthquake and subsequent tsunami that has resulted in a tragic loss of life and property destruction that has caused economic stagnation. At the time of writing, oil is US$112 per barrel and rising. Finally, the United States is up to its eyeballs in debt and the deficit is out of control as a result of the real estate inspired economic problems of the past few years. Many states and municipalities are in similar shape. Politicians insist on playing petty politics rather than being realistic and making the major economic decisions that are required. Like Nero fiddling while Rome burned.

It is said that markets often climb a wall of worry. What that means is equity investors tend to shape their investment outlook on the future, not the present, even when the present environment is not hospitable. If that is the current case, then this has been one large wall that has been climbed. And we wonder what there is in the future that is causing investors to be so optimistic.

Ben Bernanke, Chairman of the U.S. Federal Reserve (Fed), is a student of The Great Depression and scared to death of the United States repeating history, especially under his watch. It is primarily for that reason that the Fed has flooded the U.S. economy with liquidity, meaning it has been a major buyer of U.S. Treasury bonds, and has been keeping short-term interest rates as close to zero as possible in order to stimulate the economy. Its massive bond purchases, which have come in two tranches, have been labelled Quantitative Easing and Quantitative Easing 2 (QE2).

The result is investors have sold their bonds to the Fed and have lots of cash to invest and the government controlled ultra low interest rates have caused investors to do one of two things. One is to buy risky assets. The other is to chase yield wherever they can find it. Both routes have helped send equity markets higher.

Basic Investing in a Low Interest Rate Environment – FB

As mentioned in Norman’s column, the equity markets have been quite strong over the past few months yet we are maintaining a considerable horde of cash and fixed income securities. Why? There are several good reasons. Some clients’ investment objective(s) are such that fixed income investments are almost always going to represent a significant holding as the stability and income inherent are appropriate. But more importantly, as the market averages rise, share prices often increase at a faster rate than the rate of increase in the value of the underlying investments. That’s certainly been the case over the past year and this uneven advance, which is quite common in equity markets, has created an imbalance between share prices and the values in the underlying companies. Thus the advance in the market averages comes with the attendant worry for us i.e. if share prices go too far, the advance will end badly. That’s the lot of value investors, never satisfied and always worried about something.

Our value equity philosophy hasn’t changed in the twenty years I’ve been at PMC and I don’t see it changing as long as I’m here. On the other hand our fixed income philosophy is changing/has changed modestly over the past few years. When I joined PMC in 1990 (that sure makes one feel old!), Bob McInnes and I decided that the best bond strategy was to lend to the top credits for the long term. In practice that meant buying government bonds, mostly Canada bonds and Canadian provincial bonds, with very long maturities. Issues of that type do very well when rates are falling and those readers who were clients during the 1990’s and 2000’s will remember some very nice returns over the years. But that was then, this is now and the landscape has changed. Not only are interest rates so low as to make further reduction difficult, many governments are now so indebted that informed investors are treading carefully. That’s why some corporate bond issues are appearing in your portfolio(s) as its very possible to make a strong argument that corporate balance sheets are in better condition than many government balance sheets.

Just last quarter I wrote about Peter Walter’s retirement and how the search for a replacement could take a while. That search started two years ago and I’m pleased to report that it ended in March as Darren Sissons has joined us. Darren’s primary responsibility will be analyzing the international equity markets and he will also lend his expertise to our research efforts in North America and the bond market. Darren has spent most of the last 5 years at Scotia Bank managing a portion of the bank’s capital. Before Scotia he worked for Royal Bank as an investment analyst and was a partner at Osprey Capital Partners. I would encourage anyone who visits the office to introduce themselves to Darren. His New Zealand heritage is evident in his accent, though according to Darren its everyone else in the office who speaks “funny English”.

Why we added/sold – RD
Added
CISCO SYSTEMS (CSCO – Nasdaq)

Cisco is not the same company of 10 to 15 years ago. Gone are the days of super charged earnings although the company did grow revenue by 10% last year. Similar to other very large and successful companies, it is transitioning itself into a dividend paying (1.3% yield) and more moderate earnings grower. Cisco is the global market leader in enterprise routing and switching and this business line generates over 50% of Cisco’s revenue. Think of these businesses in terms of a traffic cop managing the speed and direction for data and video delivery across the internet. Data and video streaming over the internet is projected to continue to grow rapidly and although Cisco is facing strong competition it is well positioned to compete effectively going forward. The other 50% of revenue is comprised of new products and services. The company has broad geographic exposure which will be an advantage given the weakness of the US dollar.

Given the transition to a maturing business model, noted above, John Chambers, Cisco’s CEO, has affirmed continued cost cutting strategies, continued tuck-in acquisitions and the continued improvement of the company’s portfolio of products and services. Collectively, we believe these initiatives will allow the company to grow accretively over the next three to five years.

The stock was off significantly last year as government related belt tightening and the European crisis caused the delay of new projects. We believe that this is a temporary condition as the efficiency arguments are too strong to delay the build out of technology upgrades that are required by the public sector. Granted, the upheaval in the Middle East and the recent supply shock related to Japan will probably result in lower than historical revenue growth in the near term. However, with many cost levers yet to pull we think the company can grow earnings between 8% to 10% with the resulting P/E of 10X next year’s fiscal earnings looking quite inexpensive. We expect the dividend to continue to grow and share buybacks to become a more significant use of its considerable cash hoard.

PEPSICO (PEP – NYSE)

PepsiCo is one of the world’s major food and beverage companies. It operates in two distinct categories, each comprising about half of revenue. Its beverage category includes Pepsi, Gatorade, Tropicana, and Mountain Dew and its snack food brand Frito Lay includes Ruffles, Lays and Doritos.

This year the company is investing in its health and wellness businesses (more natural ingredients and reduced sugar) while at the same time facing higher commodity costs (sugar, corn etc). This has resulted in some recent negative earnings news that has provided an opportunity to invest in this premium food and beverage company at an attractive price. Pepsico is a high quality company with strong market shares in the vast majority of its products. Growth is expected to come largely from its emerging market exposure that is approx. one third of revenues and 25% of profits. Testament to its stability is the fact that it has boosted dividends 38 years in a row and at our entry price yields 3%.

Looking forward the company has stated that beyond 2011 the investments in nutrition will be more measured and while commodity prices have escalated they have hedges in place. Just as important is that management is experienced in the volatile supply and demand driven world of commodity prices and has operating levers in place to mitigate the cost pressures.
Relative to the large food companies, PEP at 13X 2012 estimated earnings, is trading similar to other food companies despite having higher long term growth potential due to its emerging market sales mix. Additionally, its valuation discount to Coca-Cola is much wider than historical levels and should normalize over time.

Added to
Pfizer (PFE – NYSE)

We added to our Pfizer position early in the quarter when its new CEO, Ian Read, embarked on a long awaited strategic change. The CEO announced that he would be evaluating all business units as to whether they make strategic sense and will be narrowing the companies focus. Rather than continuing with the mantra of bigger is better, the company now appears ready to downsize to a more manageable level. Consequently, success with new drug discoveries and smaller tuck-in acquisitions can make much more of a positive difference in a more concentrated portfolio of assets and will likely benefit shareholders more than in prior periods.

Valuation has appeared inexpensive for some time but now the 9X 2012 expected earnings and 4% dividend yield have been combined with a catalyst for change that we feel will finally result in a sustained move up in the stock price, despite the well understood patent expiration in 2012 of its largest drug Lipitor.

TransCanada (TRP – TSX)

We added to our TransCanada position in the quarter. Our view is that the negative performance differential between it and its peers has become too wide. TRP stock has lagged the substantial gains of its peers for several reasons. Firstly, its no growth Mainline pipeline (transporting natural gas across Canada) has suffered from low volumes as low natural gas prices have led to reduced drilling in Alberta. We feel that concerns are overdone now that the National Energy Board has ruled for higher toll rates. Secondly, investors have punished TRP for coming to the market multiple times with additional shares to sell in order to fund large capital expenditure programs. While that is certainly a fair response, TRP management states that it is now funded through 2013. Lastly, the stock has been hampered by the uncertainty surrounding approval for its U.S. Keystone XL pipeline extension going through the U.S. Midwest and down to the Gulf of Mexico. We believe uncertainty as to supply out of the Middle East and the U.S.’s stated desire to reduce its dependency on petroleum coming from unstable areas of the world will ultimately lead to the approval of this project. Hence, all combined, the potential for reasonable upside should our assumptions be correct warranted an increase in our position.

Sold
Verizon (VZ – NYSE))

We continue to be attracted to the Verizon story but believe better value and more accretive investment opportunities lay elsewhere. Specifically, over the last 12 months the company has rallied from US$29.54/share (6.4% dividend yield) to US$38.61/share (5.2% dividend yield) due largely to investors hunger for yield. However, now, with the U.S. economy transitioning into recovery, growth oriented technology companies such as Cisco Systems, which was added to the portfolio, offer a better blend of risk and reward moving forward. Additional considerations for the Verizon divestiture included consideration of our investment in Vodafone, which already owns 45% of Verizon Wireless (the fastest growing and most highly valued portion of the Verizon franchise) and the intent to execute on the thematic strategy of investing in U.S. companies with significant international exposure in order to take advantage of the weak U.S. dollar.

Fortis (FTS – TSX)

Fortis is a good low risk stock given that it owns and operates largely regulated utilities. Last year a number of our high yielding and low risk names performed exceedingly well making us question the potential for future upside. At this juncture, investors have been attracted to low risk situations where they can have a decent assured yield given bond yields and cash have underwhelming returns. However, investors thirst for yield has driven the stock prices of many dividend income producing stocks to high valuation levels as they appear to be focusing on income generation and overlooking capital preservation concerns. We continue to pare back exposure in this area and we viewed Fortis’ valuation as expensive at 18X 2012 estimated earnings (5% growth) with a 3.5% dividend yield. Compared to our newer positions, we feel that better risk/reward lies elsewhere.

Genuine Parts (GPC – NYSE)

While we like this company, the industry fundamentals are deteriorating. A recovery in new car sales and increased gas prices will at the margin result in fewer, older, in need of repair cars on the road and a decline in miles driven given the added expense of gasoline. This one two punch delivery combined with valuation metrics at the high end of historical averages are not a good combination. We expect sales to decelerate and comparisons with the rebound year in 2010 are tough. This is a good quality name but given the above noted concerns we have a preference towards US companies that have more international sales exposure due to the benefits associated with a weak U.S. dollar.

Update
Badger Daylighting (BAD – TSX)

In record time and before we had a chance to build up a full position in this name we had it taken away from us as U.S. based Clean Harbors made an agreement to purchase Badger for $20.50 in cash. We had liked Badger for its income producing characteristics and 6% yield. Additionally, the take out premium was less than what we would have received collecting the annual dividend. We have voted against this deal as we believe it gives the upside from its U.S. expansion strategy to Clean Harbors shareholders. However, should our wishes not prevail; the deal could be approved and closed during the second quarter of this year. Until then we will continue to collect the monthly dividend of $0.085/share.

March 2011


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