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First Quarter 2012


Market Review First Quarter, 2012

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

First Quarter
(% Change in Cdn$)

3.7%

10.0%

8.0%

9.1%

-1.2%

 9.8%

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

March 2012

0.92%

0.06%

2.11%

2.21%

December 2011

0.83%

0.01%

1.94%

1.88%

Commodities (in US$)

Oil

Natural Gas

Gold

March 2012

103.02

1.98

1668.35

December 2011

    98.83

 2.98

1563.70

Portfolio Management Strategy

What Worked

– Life Insurance Stocks

– US Stocks

– European Stocks

What Didn’t

– Natural Gas Stocks

– Bonds and Preferred Shares

– Gold Stocks

Nothin’ Stupid – NL

It’s amazing what lots of cheap money and hopes for a better economy can do for equities. Stock markets around the world rallied in the first quarter in response to continued low interest rates, brighter economic news, and the hope for additional monetary stimulus by the world’s major central banks. While Canadian stocks rose during the quarter, the increase was rather anemic, beating only Chinese stocks when compared to major world markets, when measured in Canadian dollars. This should not be much of a surprise, as we noted in last quarter’s ‘Commentary’ that Canadian stocks were relatively expensive compared to those in many other countries. We also pointed out that the heavy weighting of resource and material stocks certainly helped stock prices for the first decade of the current millennium when commodity prices were rising. But the sword is double edged. If investors perceive that commodity prices have peaked (as they seem to have in the latest quarter) then commodity stocks will decline and hold back the Canadian market.

Fixed income investors did not fare well in Q1. Prices fell for both bonds and preferred shares as yields increased and investors pondered the question of whether the 30-year decline in interest rates had come to an end. Our feeling is that it is too early to tell for sure but, when bond yields have gone from 18% to 2%, you can be sure the end is nigh. Besides, who would want to loan their money out for 10 years at 2%? How can that be a rational move when inflation and taxes guarantee your return will be negative? The average stock yields more than that. And dividends tend to grow over time, increasing the yields on your purchase price. We hold only short and mid-term bonds for our clients. Nothing longer than 8 years to maturity. If rates start to rise, we will probably sell those to shorten our time to maturity even more.

We know for sure that higher interest rates are bad for bond prices but common wisdom (which is not the same as ‘knowing for sure’) has it that lower interest rates are good for stocks and higher interest rates are bad. Common wisdom is quite often wrong. For the past ten years interest rates have dropped relentlessly. However, the S&P 500 (the best proxy for the U.S. stock market) increased only 2.1% compounded over that time period. Not enough to offset inflation. World stock markets as a whole were only slightly better, increasing 2.7% compounded over that same decade. In Canadian dollars, those results were actually negative. Looks like common wisdom was wrong. Maybe higher interest rates would be better for stocks.

Ben Bernanke, Chairman of the U.S. Federal Reserve, recently made a speech signaling that the likelihood of QE3 (the hoped for third round of quantitative easing, better known as flooding the market with liquidity to keep bond interest rates down) was less likely to occur than previously expected because the economy was starting to do better. This was not taken well by either equity or bond investors. It was like telling a crack cocaine addict that they were going to be cut off. Interest rates went up and stock markets went down. We’ll show them! Wrong. Equity investors should welcome higher interest rates, within reason. Why? Because (unless you are a Mediterranean country in dire financial shape) higher interest rates means the economy is doing better and a better economy usually means higher sales and higher sales usually means higher earnings and higher earnings usually means higher share prices.

Risk on, risk off… sounds familiar but patience and discipline win longer term – DS

Shares of the higher risk sectors of the economy ran in the first quarter of 2012 as they have done in the last three years. Euphoria gripped the markets as investors ran head long into cyclical stocks and higher risk equities (risk on) many of which reached 12 month highs during the quarter. The less sexy, consistent performing, dividend paying stocks (risk off) we typically hold were left behind in the rally and did not generally perform as well. Consequently, during the first quarter, I often found myself wondering if anything had fundamentally changed since the fourth quarter of 2011 and whether North America and Asia had completely exited from the grip of the worst economic recession since the Great Depression?

True, the U.S. economy is now no longer in intensive care but given its 8% + unemployment rate, the good doctor Bernanke from the Federal Reserve is watching closely and has recently been talking down the prospects of the U.S. economy. China continues to show signs of stress. Its export-led economy is continuing to weaken if the sizable fall in its trade surplus recently is any indication. Its housing market is also rumoured to be vulnerable. The recent Long Term Refinancing Operation (“LTRO”) which is the Eurozone mechanism for injecting vast quantities of capital into the financial system to create liquidity and to reduce the risk of a catastrophic financial meltdown, has so far been a success at stabilizing the European financial system. However, many major European banks now have an identical three year debt maturity profile rather than a conventional maturity profile which features staggered debt maturities across a number of years. Naturally, the LTRO has dramatically increased the systematic risk for the European financial sector three years hence. Also, a normal European bond market (which dwarfs its equity markets) would not currently be possible without the continued intervention of the European Central Bank. Greece remains a worry as do many of the PIIGS (Portugal, Ireland, Italy, Greece and Spain). Europe is now entering a period of fiscal austerity, which given the depth of government involvement in the Eurozone economy will surely lead to a weaker economic performance across the region. Moving forward, slow or negative economic growth should be expected for many companies with European exposure. At the time of writing, the price of oil, or perhaps the oil tax as it should hence forth be known, has risen to $125 a barrel and it now equates here in Toronto to gas at $1.40 a litre! Given a few of the macroeconomic headwinds facing the global economy which I have noted above, I continue to see little if any support for a bull market but rather expect a slow and steady recovery for North America.

Looking across the investment landscape, Asia and the Emerging Markets have generally bounced back from a disastrous 2011 sell-off. Higher prices now make increasing our Asian exposure more expensive. Some pockets of the Eurozone, particularly marquee German companies, have rallied, due primarily to the weak Euro. However, I expect earnings revisions over the second, third and fourth quarters of 2012 and the slow and steady bite of Eurozone fiscal austerity to correct German equities and to drive other European markets lower. Latin America, like the Eurozone, is at risk if the continued weakness in commodities and foodstuffs persist. Inflation remains a concern in Brazil. Australia, like Canada, is catching cold due to the slowdown in China’s commodity demand.

Given the above, growth and momentum investors had a great start to the year but for value investors like our firm the first quarter was a difficult time to deploy capital. However, for the reasons noted above, I fully expect 2012 will follow a similar pathway as the three prior years and for higher risk stocks to now sell-off. Should this thesis be proven correct, the RRSP (Canada) and the 401K (in the U.S.) seasons could represent calendar highs for many companies’ share prices. For patient, value-oriented investors like our firm, the later part of 2012 should be a good time to deploy capital at reasonable prices.

Why we added/sold – RD/DS
Sold
Loblaw (L – TSX)

The company released its 4th quarter earnings and missed expectations by 6 cents per share. Although this was bad enough the company also guided for negative earnings growth for 2012. The 5 year revitalization plan that began in 2007 has gotten long in the tooth and will be lengthened to 6, possibly 7 years. We attended the analyst day presentation and heard nothing that would provide a positive catalyst for the share price and continued competitive store openings will add risk to its strategic initiatives. We fear the cost efficiencies from the first 5 years of its revitalization plan have already been harvested and hence they now require even more substantial cost efficiencies to generate earnings growth going forward. This is not without major execution risk so, given the risk reward was no longer favourable, we exited this stock.

Added
BB&T (BBT – NYSE)

Winston-Salem, N.C.-based BB&T Corporation is the 9th largest financial holding company in the U.S. Founded in 1872, this regional, mainly east coast focused bank has a diversified stream of revenue with net interest income approximating 60% and fee income 40%.

Bank valuations in the U.S. have been at a discount to Canada since the real estate / subprime debacle. However, we have held off purchasing until now given uncertain regulatory and profitability metrics. Recently, uncertainty has declined as regulatory changes have become clearer. Credit metrics are on the upswing and the U.S. economy appears to be improving. Importantly, commercial and industrial loan growth have started to move up. BB&T is in attractive geographic markets and the shares are attractively valued. It is one of the best capitalized large cap regional banks. It does not hold any European government debt. BB&T did not want to accept TARP (Troubled Asset Relief Program) but was one of the first to repay 7 months later after passing the government stress test. Due to increasingly stringent capital requirements the TARP repayment was funded by a dividend cut after 37 consecutive quarters of raising it and through a stock issuance. However, BB&T has paid a dividend to shareholders since 1903 and it was one of the first U.S. banks to raise its dividend after finishing a second round of stress tests by the Federal Reserve. Subsequent to our purchase the bank increased its annual dividend again, in this case by 25% over the prior year’s level, for a 3.0% dividend yield at our cost.

Sun Life Financial (SLF – TSX)

Sun Life is one of Canada’s leading financial services companies. It provides life and health insurance, group employee benefits (life, dental, drug, disability etc) and retirement products (protection and wealth accumulation). It has a strong insurance brand and has become stronger in asset management within its MFS (money management) division. It is now the 4th largest asset manager in India. Its sales are roughly evenly split in wealth and protection between Canada and the U.S. at 40%, Asia and the UK at 6% and 5%, respectively and MFS at 8%.

The life insurance industry has had a difficult few years. The level and volatility of equity markets and the level of interest rates are important variables that have been headwinds for this group. Low rates hinder profitability as many fixed income investors can relate to. Higher interest levels would allow for reinvestment of its premiums at a more profitable higher rate. Although the banks and insurers traded at precisely the same multiple for the five-year period from late 2002 to October 2007, beginning with the equity market recovery in 2009, the insurers have lagged the banks in spectacular fashion given the higher sensitivity to those aforementioned variables.

While Sun Life has not cut its dividend, like one of its peers, it has not increased it either since 2008. By comparison, the Canadian banks were able to revive their pattern of dividend increases in 2011. The life insurance industry is now many years into an environment of depressed interest rates and volatile equity markets. Its valuation spread relative to the Canadian banks (that we find expensive relative to other areas of interest) is due for an eventual reversion to the mean and meanwhile we posit that its 6% dividend yield is sufficient to warrant a position now as we wait for interest rates to move up from an extended period of low levels.

SNC Lavalin (SNC – TSX)

SNC is an international leader in engineering and construction and a major player in operations maintenance and infrastructure concession investments. Diversified by industry, it has been involved in the construction of projects from refineries, water treatment and power plants to hospitals and concert halls and while Canada makes up roughly half of revenues, it has been active internationally for over 50 years and has projects in over 100 countries. The company also makes selective investments in concessions, the largest being its 17% stake in the 407 toll road highway in Toronto. We expect it to continue to be active in this area as the trend of infrastructure privatization and public/private partnerships continues to grow taking pressure off of cash strapped governments.

The stock price declined 20% this year into attractive value territory after the company missed earnings expectations and became embroiled in ethical and business practices violations. SNC’s well respected board commissioned an independent investigation which resulted in the CEO and two other high ranking employees who were directly responsible for the questionable transactions leaving the company voluntarily or otherwise. Similar to our purchase of Wright Medical which ran afoul of FDA regulations and had a house cleaning up to the CEO level, we see a similar value situation at SNC. We believe the business fundamentals are still intact. Despite dragging the loadstone of prior unethical behaviour along for a while, the company will continue to generate solid cash flow from construction and engineering earnings and from its stable concessions businesses. We expect, again similar to Wright Medical, monetary fines and reputational fall out for a short period but ultimately the company’s expertise in its fields will dominate the business fundamentals once again and a share price recovery should ensue. Roughly half of the stock’s current valuation is made up of its steady cash flow generating concession investments. The company has a solid balance sheet and recently raised its dividend to yield just over 2%. Due to its slightly riskier investment profile, SNC was purchased only in growth and balanced portfolios.

Corning Inc. (GLW – NYSE)

Corning Inc. (“Corning”), which was founded in 1936, is a technology-based company primarily focused on glass and glass-like products.

We purchased Corning as the company should grow over the next three years based on: i) the U.S. economy is exiting recession and beginning to grow which should positively impact the sale of televisions, smartphones and flat panel displays; ii) supply rationalization is beginning to occur across the display industry which should lead to improved profitability for all participants; iii) a fortress balance sheet and no significant near term debt maturities; iv) the company’s preference for continued tuck-in acquisitions; v) further buybacks should be expected ($750 million through the current $1.5 billion authorization); and vi) continued dividend increases are likely.

Increased
Kone Corporation (KNEBV – OMX Helsinki)

We increased our position in this Finnish company from a half weight to a full allocation. The initial position was a half weight as we believed a continuing slowdown in European would provide better entry levels and we were not optimistic on European currencies in the near term.

We continue to like the prospects for the company and believe the recent expansion of the Giant Kone ownership stake (Chinese subsidiary) to a controlling interest will prove to be a smart decision over time.

March 2012


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