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Fourth Quarter 2010


Market Review Fourth Quarter, 2010

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

Fourth Quarter (% Change in Cdn$)

8.7%

6.4%

0.6%

6.9%

13.5%

4.0%

Calendar Year 2010

14.5%

7.2%

-4.0%

8.5%

8.7%

4.4%

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

December 2010

1.00%

0.15%

3.13%

3.29%

September 2010

0.88%

0.15%

2.74%

2.51%

Commodities (in US$)

Oil

Natural Gas

Gold

December 2010

91.38

4.23

1420.78

September 2010

79.97

3.87

1309.60

Portfolio Management Strategy

What Worked

– Small Cap Stocks

– Japanese Stocks

– Forest Products Stocks

What Didn’t

– European Stocks

– Bonds

– Canadian Cable and Wireless Stocks

The Day of Reckoning Is Here-NL

Nine months ago, in our Commentary, I wrote an article entitled “It’s All Greek To Me”. In the article I referred to what have become affectionately known as the “PIIGS”, Portugal, Ireland, Italy, Greece, and Spain and how Greece was in dire financial straights and crying out for help from its Eurozone partners, and how it was only a matter of time before the others would need and demand equal treatment. Generally, I like to be right in my predictions, but this is one time when I wish I had been wrong.

Financial contagion refers to the transmission of a financial shock in one entity to other interdependent entities. As we feared, Greece’s problems have spread. Ireland has requested a massive financial rescue from the European Union (EU). Portugal, at the time of writing, appeared to be only days away from their own request. Who might be next? With 20% unemployment and a real estate market that makes that in the US look healthy by comparison, Spain is a likely candidate. Italy, Europe’s largest debtor, may slip from the eurozone’s stable core into the high-risk group on the periphery.

Why is it so easy for financial crises to jump from one troubled nation to another? And why are the more stable of the European nations so willing to come to the rescue? The answer is sovereign debt and who owns it – foreign banks. According to the Bank For International Settlements (BIS), German banks have US$540 billion of PIIGS debt, French banks have US$370 billion, and Italian banks have US$50 billion. British banks own US$350 billion and they aren’t even part of the EU. Therefore these countries have to support their neighbours or face the collapse of their own financial systems.

As we also pointed out in that previous Commentary, normally, when a country runs into financial problems, it would simply devalue its currency. This would have the effect of helping the country reflate and export its way out of trouble. This is not possible, however, with a common currency. What is happening, though, is that the common currency, the Euro, has been devaluing itself against most major world currencies. Unfortunately, it is not really helping the troubled countries as they are each others largest trading partners and are gaining very little competitive advantage.

There is one country, however, that is benefiting from its neighbours troubles and that is Germany. Germany is in the best fiscal shape of all the major European nations. It has the lowest amount of debt to GDP, the lowest unemployment, and the highest savings rate. It is also the most industrially efficient and has become an export machine, having the benefit of a weak Euro as its currency. In fact, if Germany were to abandon the Euro and return to the old Deutsche mark, it would face an immediate approximate 20% upward currency revaluation – and a totally uncompetitive landscape. No wonder Germany’s Chancellor, Angela Merkel, has come to the rescue of her neighbours. Her country’s banks and exporters cannot afford otherwise.

The Germans and, to a lesser extent, the French will keep Europe together even if a few other countries (eg. Belgium) follow the route of the PIIGS. They know they have to. It is in nobody’s interest for the Euro to disappear, but it will probably continue to decline in value.

What about governments on this side of the Atlantic? How smug can they be when looking across the pond?

Canada’s federal government has a debt-to-GDP ratio of 30%, the lowest of the G7. Adding in the provinces brings this to 53%. The US federal ratio, however, is at 62%. Add in the states and it is at a bone-chilling 94% – equivalent to some of the worst in Europe.

How as investors are we to use this information? One is to view the ratings of sovereign debt by ratings services with a grain of salt. Canada and the US each have a AAA debt rating but who is kidding whom? Canada and the US’s 10-year and 30-year bonds trade at the widest interest rate differential in their history – I mean Canada’s yields are much lower than those of the US. And why not. Based on the financial situation of both countries, which one would you rather own? No wonder the loonie is trading above par! Also, investors should not be averse to owning high-grade corporate debt as an alternative to government debt as many of those companies have much better balance sheets than the government, especially in the US. Would you sleep better owning debt issued by IBM or the US government? There have been times in history when AAA corporate yields were lower than US Treasuries. It is not beyond the realm of possibility that it could happen again. Governments around the world need to face reality. The day of reckoning is here.

Thoughts at year end – FB

This is the time of year when everyone expects the professionals in the investment business to predict the future with unerring efficiency. Predicting the future, as mentioned here before, is a losers game and we believe our time will be better spent sticking to our strengths – efforts evaluating investment opportunities.

The current economic environment, and by extension the market, appears to have a larger than normal number of cross currents and competing factors that are clouding future prospects and making the crystal ball more opaque than usual.

Some of the more negative include:
– The global de-leveraging process will continue. It shows every indication of being a long drawn out process and will feature negative flare ups similar to the recent round of Euro sovereign risk worries.
– The sovereign debt problems in Europe could migrate to North America by way of a troubled states (California & Illinois?) or could migrate to a developing nation.
– The bond market can be expected to go through some turbulence as bond investors realize they will have to spend more time analysing credit quality, not just the risk of inflation.
– Revenue growth in a de-leveraging environment will be tough to find. Thus profit growth will slow as cost savings are finite.
– Political problems in areas like North Korea and Iran.

Some positive factors:
– Recent information points towards a small reduction in the North American unemployment rate(s). There’s a long way to go but it’s a start.
– In Canada two of our larger economic contributors, big banks and the natural resource area, are prospering and should be significant contributors to economic progress.

I would like to thank all our clients for their confidence. Peter, Rhonda, Norm and myself along with our staff all work hard to meet your expectations and hopefully we can make some sense of the capital markets in these uncertain times. I would be remiss if I didn’t thank all those who referred someone to us over the past year. Our business is driven by those referrals and we very much appreciate the vote(s) of confidence.

Please note that while the RRSP contribution deadline is the end of February, it makes life much easier for all concerned if contributions are received before the last minute. And as always cheques should be sent to our office but made payable to TD Waterhouse.

December 31 2010 marked the retirement of Peter Walter and as many of you know he has been instrumental in driving our research effort for the past decade. Peter is not one for much fanfare but I would like to thank him on behalf of our clients, our staff and his partners for 10 years of wisdom, wonderful counsel, and for delivering all of the above in a friendly harmonious and supportive manner. It’s no wonder our replacement search is taking so long, Peter will be difficult to replace. In the meantime we will be well served by Rhonda’s skill and experience. They are both considerable and I’m very comfortable having her as our primary “investor”. Finally, Peter’s efforts cannot be separated from those of his wife Louise who very kindly “lent” Peter to us for a period that benefitted all of us, me not the least. Thank you both very much.

Why we added/sold – RD
Sold
Pembina Pipeline (PIF.U – TSX)

Despite yielding in excess of 7% we sold this name. We felt that investors thirst for yield had driven the stock price of many trusts to very high valuation levels. Investors appear to be focusing on income generation and overlooking capital preservation concerns. We worry about both and this led us to sell this highly leveraged name. Relative to its peers it was trading at a significant premium despite an over 100% payout. We are monitoring our exposure to high yielding names that happily enough have performed exceptionally well over the past year. We want to ensure we are not overly exposed here because although we are clearly not there yet, at some future time this party will also end.

Bought
Badger Daylighting (BAD – TSX)

Badger Daylighting is North America’s largest provider of non-destructive excavating services. In essence it moves dirt with water. Badger’s primary customers are contractors and facility owners in the utility and petroleum sectors. Its hydrovac trucks use pressurized water stream excavation with a vacuum system that removes soil and debris to expose underground facilities to daylight. The avoidance of digging helps prevent damage to underground infrastructure such as water lines and energy pipelines, thus saving costs and time. Aging municipal infrastructure and oil and gas activity provide good business growth. It will pay a monthly dividend which will be annualized at $1.02 for a 5.4% current yield.

Badger is the only player in the industry with national coverage. Smaller players find it harder to get on large corporate or municipal sites as BAD has the client relationships and can spend the money to pass safety programs and financial audits. Although cyclical because of its energy exposure (50%), it remains a very healthy business even in the down times because of the half of its business that is utility related. The 60% of its business that is in Canada is largely mature, especially in Western Canada through its focus on oil and gas facilities. The growth is really in the 40% of its business that is in the US where penetration of its services is still low. This stock was bought mainly for income accounts.

Rona (RON – TSX)

RONA is the largest Canadian distributor and retailer of hardware, home renovation and gardening products serving the retail, commercial and professional markets.

This stock is trading at depressed multiples due to a lack of sales growth. In fact, sales have not grown since 2008, first as a result of the economic downturn and then due to spending that was borrowed from 2010 and took place instead in 2009 to take advantage of a home renovation tax credit. This will have to change or the stock will not get rerated higher. Despite the well documented sales lag, the company has managed expenses well and we just await a resumption of top line growth. Once sales growth resumes, the lion’s share of the return is expected to be from a revaluation of its multiple to 14/15X earnings (Currently 12X). The stock is trading at close to tangible book value and is also trading at near low multiples relative to both Home Depot and Lowe’s trailing earnings.

Moving forward, a certain amount of maintenance on homes is required and cannot be postponed forever. The industry has significant consolidation opportunities ahead of it and Rona’s expertise in smaller size store formats gives it a competitive advantage in this avenue of growth. This is a well managed, financially sound market leader that is trading at depressed multiples. Once consumer spending picks up, given continued expense reduction efforts it should be a safe way to play a consumer recovery. In the meantime the company has announced a dividend for the first time (14 cents for a 1% yield) thus announcing its confidence in a positive outlook despite the sales slowdown. Although we may still be a couple of quarters away from easier comparisons, the stock is a compelling value with a longer time horizon. We believe its valuation reflects the recent lack of sales growth and low expectations.

December 2010


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