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Fourth Quarter 2011


Market Review Fourth Quarter, 2011

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

Fourth Quarter (% Change in Cdn$)

2.9%

8.8%

2.7%

-5.0%

10.6%

0.1%

Calendar Year 2011

-11.5%

2.3%

-11.9%

-14.9%

-12.7%

-6.6%

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

December 2011

0.83%

0.01%

1.94%

1.88%

September 2011

0.82%

0.01%

2.15%

1.91%

Commodities (in US$)

Oil

Natural Gas

Gold

December 2011

98.83

2.98

1563.70

September 2011

79.20

3.67

1623.50

Portfolio Management Strategy

What Worked

– Small Cap Stocks

– Oil Stocks

– Industrial Stocks

What Didn’t

– Chinese and Japanese Stocks

– Life Insurance Stocks

– Gold Stocks

Fear Breeds Opportunity – NL

After a dismal nine months, world stock markets said enough was enough and rallied in the fourth quarter. It was not, however, enough to save the year and it was the rare market, indeed, that showed positive returns for the full year. Canada, not surprisingly, broke its string of outperformance while the US, to most people’s surprise, was the best performing major market in the world. Canada had been the best major market for over ten years. Canada’s run was defined by ever stronger commodity prices and a weak US dollar. It was a great run, but nothing goes on forever. Stein’s law states, “If something cannot go on forever, it will stop”. And stop, it did.

At the beginning of the year, fear of the US was overwhelming. People were questioning our sanity in owning US equities. Their concerns over the out of control level of debt in the US and the declining value of the greenback was magnified by the ever-present American media. Worries about another recession, so soon after the last one, were on everyone’s mind. They were omnipresent. We, however, were more concerned about Europe and fears of financial contagion sweeping the continent. The problem in the US was, and still is, debt that is not being addressed due to political partisanship. Europe, on the other hand, was a financial problem in a hugely imperfect economic union and showing signs of growing like an out of control virus.

In Canada, commodity stocks were priced to perfection. Canadian financial stocks were the envy of the world. Money poured into them as they were viewed as pillars of strength in a world where bank safety was properly treated with scepticism. Very full valuations meant that these stocks faced huge headwinds. With about 80% of Canada’s market capitalization comprised of resource, material, and financial stocks, it was inevitable that our market would have a tough time. As a result, Canadian stocks are relatively expensive compared to stocks in many other countries. While we by no means intend to abandon the Canadian equities market, in all likelihood we will be reducing are holdings in Canadian stocks over the coming year and investing the proceeds in more attractive markets.

Not so in the US where expectations were rock bottom, and so were the valuations on equities. Fear breeds opportunity. Corporate America (outside of the financial industry) was in great shape. Debt levels had been pared back and many companies were flush with cash. Some, such as Apple, had more cash on hand than the US Treasury. As we stated in our Q4/10 Commentary, we were more comfortable owning debt of corporations than that of the US government. When employment numbers began to improve and corporate profits did not tank, optimism over a slowly recovering economy began to influence investor psychology. It even allowed investors to look at the problems in Europe and say yes, their economy is headed into recession and they have huge problems, but its impact on this side of the Atlantic is much less than many originally feared.
Now Europe is the centre of attention. Its markets were among the world’s worst in 2011 and the Euro has been sliding almost non-stop since April. Investors continue to flee to the “security” of the US dollar, pushing the greenback and US equity markets higher while sending interest rates on Treasury bonds to historic lows. The selling of European stocks has been relentless and pretty much across the board. Investors are giving little consideration to the distinction between the shares of mainly domestic companies that get almost all their revenue and profits from within the continent, and shares of multinational companies who generate most of their revenues outside of Europe but happen to have the (current) bad luck of having their headquarters there. European based? Sell! Fear breeds opportunity. We have already begun the process of increasing our exposure to European multinationals. Recent purchases have included Kone of Finland and Carlsberg of Denmark. These have been added to our existing holdings of Boskalis of the Netherlands, Diageo and Vodafone of the UK, Covidien of Ireland and ABB and Syngenta of Switzerland. Many will again be questioning our sanity, but don’t be surprised to see more European names in our portfolio in the coming months.

Fixed income markets continued to defy the experts as interest rates again ploughed through old lows. In Germany, short-term government securities currently have negative yields, meaning people are willing to lose money just for the security of the German guarantee. Return of principal is more important at this time than return on principal. In Canada, the year ended with 30-year Government of Canada bonds yielding 2.5%. In the previous issue of Commentary, I suggested the possibility of us buying long bonds due to our belief that the yield curve would flatten. Well, flatten it did, but without us. We couldn’t quite get our heads around interest rates going even lower than they already were. I wouldn’t loan my money out for 30 years at 2.5%, so I sure as heck wouldn’t loan yours out either!

While the “safety” of owning fixed income is alluring to many investors, there are two facts to keep in mind. First, interest rates on investment grade bonds are lower than the level of inflation, so holding a bond can be a losing proposition. Second, at some point rates will rise and the “safety” of owning bonds is going to be overwhelmed by the decline in their value as their prices adjust to the rising level of interest rates. Dividend yields on common stocks are generally higher, in some cases significantly so, than bond yields. In addition, dividends from most companies increase over time, some on a quite regular basis. This greatly increases the yield received on your original purchase value. Don’t be surprised if sometime in the next year or so we lower our weighting in fixed income and increase our equity exposure as we face the coming reality.

More of the Same, But Different – FB

The start of a new year and it seems all the eyes in the market are pointed towards the future. What it will bring and how this year will be different from the past few? I would expect the longer term trends we have mentioned in previous essays to remain in play. Notably, weak consumer spending, low rates of inflation, irresponsible media using their pulpits to exacerbate swings in market psyche and thus market volatility, and most importantly, the trend towards debt repayment. In addition to those long term trends, 2012 will likely contain some shorter term swings in economic and market direction. These will likely include: European economic weakness and political discord; slow strengthening in the US economy; and inflationary worries. Those variations should not be too dramatic as we expect the long term trends to dominate.

If we can do a decent job of noticing the differences between short and long term trends our value approach to investing should allow for solid results. The trick to being a successful investor is to not just blindly project the recent past into the future but to apply independent thought to the problem(s) and then make investment decisions independently of the thundering herd. I think our team has shown some strength in that area but assuming that strength will continue “just because” is a dangerous road. We will be working hard to make sense of the markets and to make sensible investment decisions with the goal(s) of maintaining and enhancing your capital.

Every January its been my habit to thank those clients, readers of our commentary and friends of the company who have referred business to our firm over the previous year. 2011 was no exception – Thank You – as we were blessed with an abundance of referrals. We still have plenty of room to properly handle additional business so if you know or hear of anyone who might be interested in our firm we would love to hear from them.

On an administrative note the 2011 RRSP contribution deadline is February 29th, but to be safe please have any RRSP payment arrangements made by, or RRSP contribution cheques to us by, no later than February 27th.

Expect More of the Same in 2012 – DS

My views on the global economy in 2011 were largely accurate. The BRIC countries (Brazil, Russia, India and China) were the main engines of growth of the global economy and the U.S. continued to progress (a somewhat controversial view last year). However, I was a little more optimistic at the start of 2011 on Europe and was not alone in underestimating the ability of Eurozone politicians to magnify their problems through feet dragging, name calling and political grand-standing.

In 2012, I expect to see slow, continued progress from the U.S. The key drivers are likely to be a better fiscal position due largely to the conclusion of U.S. activity in Iraq and therefore a lower military spend. A flow on effect will be more federal budget flexibility and consequently the lower likelihood of sizable and continued public sector lay-offs. Second, continued private sector payroll growth as more nimble, small-medium-sized-businesses which have adapted to the new lower growth environment, add employees as they have done for the last 23 consecutive months. Offsetting these positives will be 1) a lame-duck pre-election year for Obama and therefore minimal policy changes should be expected in 2012; 2) continued housing market weakness; and 3) a banking sector, that although now well capitalized and largely stabilized, is plagued by uncertainty surrounding the implementation of new regulatory changes such as Dodd Frank (proprietary trading & investment banking activities), the Durbin Amendment (credit cards) and Basel III (capital adequacy).

The BRIC countries will again be a source of strength in 2012. However, their higher relative levels of growth vis-a-vis developed nations over the last 24 months has taken its toll in the form of high levels of inflation and, in the case of China, heightened levels of bank exposure to a slowing export sector. Consequently, China’s growth should slow to 8% or down two percentage points from its 20-year historical average growth rate of 10%. Brazil, Russia and India will also grow at substantially faster rates relative to developed economies. Based on current data, I am a little concerned with Brazil’s inflation rate and will be watching it closely. Russia will continue to grow and should benefit from its 2010 – 2011 efforts to curb inflation. India could surprise to the upside, as in January 2012 it opened its stock market to foreign investors and this initiative should drive higher levels of foreign direct investment and a higher, sustainable level of economic growth moving forward.

Europe continues to be the proverbial Greek Tragedy. Common sense will eventually prevail. In the interim, a summer holiday in Greece, Portugal or Spain should be a low cost alternative for Canadians in 2012. Until the European “risk-off” sentiment reverses, high quality, Eurozone-based companies that benefit from a lower Euro and access to high growth Asian markets will become increasingly attractive.

Given the above, Asia (particularly developed Asia) will continue to offer attractive investment options and we will likely increase our exposure to this geography over time. Europe, particularly the more stable Nordic region, will also continue to generate attractive investment opportunities for the next 12 – 36 months and where appropriate, we will selectively add assets in this region. The U.S. also continues to offer a number of deeply discounted, high quality investment opportunities and best-of-breed American companies with exposure to higher growth products or the faster growing Asian markets would be logical additions to our portfolio.

Why we added/sold – RD/DS
Sold
FP Newspaper (FP – TSX)

This newspaper publisher was sold in the quarter. Positively, for holders since 2005 the stock has given back over $7.00/share in interest (trust) and dividends. Unfortunately this has not offset the capital loss. The purchase has performed poorly since 2008 as a result of 3 cyclical or one off events and one secular issue. Firstly, the economic downturn in 2008 & 2009 resulted in a severe drop in revenue as advertisers (especially auto companies) pulled back and classified ads also took a tumble. Secondly, FP Newspapers printed the Financial Post for Manitoba and Saskatchewan. The Financial Post pulled out of these markets during the recession leaving a hole in revenue and assets (printing presses) lying idle. Thirdly, the company printed the Globe & Mail for the province of Manitoba but the Globe consolidated its suppliers and gave that contract to a competitor who already did the printing for the rest of Canada. Not surprisingly the secular issue here is one of declining readership and advertising revenues given the increased use of the internet. This company is not in an attractive industry and so while the dividend yield is high and seemingly appealing it may not be sustainable. Our overarching concern with the industry led us to exit the position.

EL Financial (ELF – TSX)

EL Financial is a property, casualty and life insurer and is the owner of Empire Life and The Dominion. The low interest rate environment continues to be a headwind for this life and auto insurer. Yielding a paltry 0.1%, we were not being paid to wait until industry fundamentals improve, hence, the decision was made to exit this illiquid name.

Added
Wright Medical (WMGI – Nasdaq)

Wright Medical is global orthopaedic device company. WMGI is the 6th largest player in a consolidating orthopaedics space dominated by large players. However, despite its relatively small market shares in knees and hips, it has strong market shares in the higher growth extremities (foot, ankle, hand, elbow) business. Profitability has trended steadily downward, primarily as a result of an abnormally high expense structure. In mid September of 2011 the company replaced its CEO with a well respected veteran of the medical device industry. His track record has demonstrated that he has cost cutting expertise that will benefit WMGI going forward.

We see a couple of ways for this investment to work. First, the sector has been on a multi-year slide from what was probably an unsustainably high relative P/E premium to one that has been discounted to an extreme on the downside. While there was a greater negative impact on medical procedures in the recent downturn than what was anticipated, those procedures cannot be postponed forever. We believe it is a matter of time before orthopaedic growth rates start to move back toward average historical mid single digit growth rates from negligible rates of growth that have persisted the past couple of years. Secondly, the new CEO can right size the franchise and has stated that the extremities business is where he will be directing future investment moving forward. The outcome should be an uptick in earnings growth and a commensurate expansion in P/E multiple. The company has a strong balance sheet with low debt and cash representing 23% of its assets. The company does not pay a dividend.

Carlsberg A/S – CARL’B-KO (OMX Copenhagen)

Carlsberg A/S is a Denmark-based company primarily engaged in the production, marketing and sale of beer. Carlsberg’s portfolio consists of more than 500 beer brands, including international premium brands such as Carlsberg, Tuborg, Baltika and Kronenbourg 1664, and local brands such as Ringnes (Norway), Feldschlosschen (Switzerland) and Wusu (Western China). The company has operations in Northern and Western Europe, Eastern Europe and Asia.

We purchased Carlsberg following a major share price decline as a result of weak operating results in Russia (40% of earnings). The weakness in Russian beer volumes was largely driven by a 30% price increase as the company sought to counter high inflation in the Russian market. A second driver of weaker year-over-year volumes was a one-time regulatory change which targeted the restriction at the sale of beer with an alcohol content of greater than 6% from mobile vendors like the hotdog stands we have here in Toronto.

However, following our analysis of the company we concluded the market had over reacted to the weakness of Russian beer volumes. Specifically, the Russian economy, much like its BRIC (Brazil, Russia, India and China) peers, is experiencing high GDP growth rates. Consequently, price increases will occur but over time they should be easily absorbed as the average Russian citizen is experiencing an annual increase in their standard of living.

The restriction on the sale of high alcohol content beer from mobile vendors extends only to beer above 6% and not to beer with alcohol content below this threshold. Consequently, if Russians want to drink higher alcohol content beer, they will find other alternatives.

Reduced
TransCanada (TRP – TSX)

Recall from our first quarter commentary that we added to our TRP position given it had lagged. Three quarters later we were up 10% on the trade in what has been a very volatile year. With the stock at higher levels we felt it prudent to reduce the risk in the portfolio by trimming the position back as concerns on its expansion no longer justified an outsized position. One of the key platforms for TRP’s next leg of growth involves transporting oil through a proposed extension to its current pipeline into the central US. The extension is called the Keystone XL pipeline and if approved will transport oil from Alberta to Oklahoma and then ultimately the Gulf of Mexico. This pipeline has become a focal point for both environmentalists and for political favour. We felt that given its importance to TRP and the questionable timing of its completion, that we should lock in some profits. We viewed our position in light of the risk that Keystone XL would be turned down or delayed given ongoing legal and environmental protests. Shortly after our sale the US federal government indeed announced it would delay a decision on a federal permit for the project. Subsequent to this news TRP agreed to reroute the part of the pipeline going through an environmentally sensitive area of Nebraska. We believe this pipeline will be built but the timing of this project, should it be ultimately approved, is still unknown. This is an important pipeline for TRP to diversify its earnings stream.

Constellation Software Inc. (CSU – TSX)

Our investors have had a great run with CSU as it has been a core holding since its initial public offering at $17. However, in the summer of 2011, the company embarked on a major strategic initiative which likely targeted the sale of the company to a strategic buyer. Birch Hill Equity Partners and OMERS Capital (which have been long-term investors and own 20% and 21%, respectively of the company and hold seats on the board of directors) were likely drivers of the strategic initiative as they are now widely understood to want to divest their holdings in CSU. During the strategic initiative process, the shares were bid up from $55 to the $70 range as the broader market became aware of the possibility of a strategic acquisition of the company. Consequently, the share price ran to a level we felt was no longer justified by the underlying fundementals of the company. We were also concerned that a failed divestiture could result in a dramatic share price fall. Therefore, in Q4/11 we halved the CSU position.

The strategic initiative ended unsuccessfully in Q4/11. However, management has subsequently announced a quarterly dividend of $1/share (4.9% dividend yield) which should cushion the downside risk.

December 2011


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