Fourth Quarter 2013

Market Review Fourth Quarter, 2013

Equity Markets

S&P/TSX Composite

S&P 500


MSCI/Far East

TSX Energy

TSX Financials

Fourth Quarter (% Change in Cdn$)







Calendar Year 2013







Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

December 2013





December 2012





Commodities (in US$)


Natural Gas


December 2013




December 2012




Portfolio Management Strategy

What Worked

– Non-Canadian Stocks

– Forest Products Stocks

– Transportation Stocks

What Didn’t

– Gold and Gold Stocks

– Metal and Mining Stocks

– Interest Sensitive Stocks

Woe Canada – NL

Most stock markets around the world continued their winning pace in the fourth quarter, earning returns for the year far in excess of what anyone predicted at the beginning of the year (a good lesson in why you should take any prediction with a grain of salt, even mine). Held back by declining gold and mining stocks, Canadian equities lagged most major markets again in 2013, but were still up 9.6% as measured by the S&P/TSX Composite index. Its returns paled, however, in comparison to huge gains made in other major markets such as the U.S., Europe, and Japan.

Four and five years ago, Europe was a basket case and its markets were in deep trouble. For the past few years, the continent’s economies, both major and minor, were almost all in recession. Today its economies are slowly recovering and its stock markets are at levels not seen since 2008. Almost every day I am asked by potential clients whether we invest in European stocks. Yes, I answer. We have been there for a few years. We were there when people thought we were crazy. Investing there is now quite fashionable. Personally, as most of you know, I like to be fashionable in how I dress, not in how I invest. There, I (and my partners) prefer to rummage through the bargain bin in search of the next investing fashion trend.

Asian and other emerging markets were the laggards this year. They were mostly flat or down for the year. China, contrary to all the hype a number of years ago, has generally been a horrible place to invest for the past five years. Nobody is interested in investing there now. That’s not where the action is. Just like Europe four and five years ago. Not fashionable to be investing there. We are watching closely and are getting keenly interested.

With central banks keeping their administered interest rates near zero in order to continue stimulating their fragile economies, bond markets responded to improving economic signals by moving interest rates up significantly, causing all but the shortest duration fixed income returns to be negative for 2013. While we see bond yields continuing to work their way higher during 2014 as economic recoveries continue to take hold, the magnitude of the increases should be less severe than last year and much more gradual. Inflation, the biggest enemy of interest rates, remains tame and in some European countries the threat of deflation remains a bigger concern. In response to our interest rate outlook, we continue to favour corporate bonds and avoid issues with maturities longer than 5 years. We are also favouring rate-reset preferred shares over perpetuals, where possible. Unfortunately, the preferred market is relatively illiquid so one cannot change holdings quickly, as one can in the bond market.

At time of writing, the Canadian dollar (the Loonie) is trading below US$0.92, its lowest level since 2009. Back then, the Loonie was recovering from the huge hit it took in 2008, where it declined from US$1.10 to US$0.76 in a matter of months. The circumstances, however, are significantly different. Back then Canada was an island of safety when the rest of the world was in economic hell. Our banking and financial system was the healthiest on the planet and the financial strength of our federal and provincial governments were the envy of the world. In addition, our housing market was quite healthy. Our currency didn’t go down because we were beset by problems. It went down simply because there was a rush to safety in the currency markets, and, in that market, safety means the U.S. dollar. All currencies declined relative to the Greenback.

Now, the situation is quite different. Today, the Loonie deserves to be weak.

Where investors flocked to buy shares in Canadian bank stocks during the financial crisis, their attractiveness to foreigners is now far less. While Canadian banks are still highly profitable, the best years for earning growth seem behind them as Canadians are overleveraged and it will be difficult for the banks to continue to grow loans at the same pace as in the past. Foreign investors now view the potential earnings and dividend growth in their home banks to be superior as these banks recover from their near-death experiences.

Canada was in the middle of a commodity supercycle just a few years ago. This was highly beneficial for the economy as it generated jobs, taxes, and exports. Unfortunately, the worldwide recession and resulting mild recovery has taken the wind out of commodity prices and demand. This has caused Canada’s economy to be much less robust than previously expected. Also, a shortage of infrastructure in the energy field is proving to be expensive to the economy. Western Canada is blessed with huge reserves of natural gas and oil, much of that being in the Alberta oil sands. Unfortunately, a dearth of pipelines needed to move the oil and liquefied natural gas (LNG) facilities needed to export our gas is causing our energy to be sold at a steep discount to world prices. No matter whether you support the building of these pipelines and facilities or not, the economic reality is that without them or until they are built (and I have no idea what will ultimately happen), the Canadian economy will suffer.

Foreign investors have also been huge players in the Canadian bond market, attracted once again by the country’s financial stability and strong currency. Unfortunately, actions by many of our governments in the past few years (both federal and provincial) have eroded the Canadian mystique. Profligate government spending and just plain dumb government policies, especially at the provincial level (and it matters not if the government is Conservative, Liberal, Parti Quebecois or New Democrat), has caused bond investors to look much less favourably upon Canadian credit than they have for many years. Foreign money that once poured into our bond market is just as quickly now pouring out.

Finally, our manufacturing sector is in disarray as cheap overseas labour, poor productivity, high electricity prices, a strong currency (up until very recently), high provincial taxes and unrealistic union expectations have combined to cause a massive decline in manufacturing capacity and jobs in Canada, especially in Ontario.

How is this affecting our investment strategy and outlook? On the fixed income side, we only own the debt of provinces that are more fiscally responsible (the western provinces and Newfoundland) and avoid the provinces in between as their fiscal situations argue for downgrades by the rating agencies.

In equities, we currently have more of our client’s money in companies outside Canada than within and we see this trend continuing for the foreseeable future. We are not by any means abandoning Canadian equities but as about three quarters of the Canadian stock market is comprised of resource, materials, and financial stocks, we find it difficult to find good new ideas at this time. It is much easier to find attractive companies elsewhere right now.

As I said earlier, we don’t like to invest where it is fashionable. Canada is certainly not currently fashionable. Eventually, circumstances will change and we will see things in the horizon that will again attract us to move money back into Canada. It is just much too early at the moment.

Approaching Light – FB

At the end of every year investors of all disciplines take stock of the previous twelve months and try peering into the future with a view to understanding what might happen. The future is, however, always a difficult study and the coming year appears to be that in spades. Will the market strength of 2013 be repeated, or will long building government debts overwhelm the bond market and send interest rates soaring.

We have written on the fragility of the current situation previously. I don’t intend to revisit that topic other than to remind our readers that as debt levels increase, as they did last year, the possibility of significant damage to the capital markets if/when something goes wrong has also increased. That leaves me wondering whether the light at the end of the tunnel is the sun, or an approaching train.

Some possible happenings in 2014 include:

Rising interest rates

Over the past twelve months interest rates in the bond market started to rise and showed signs that lenders were demanding a larger return to compensate for the increasing risks in what is an increasingly debt heavy environment. If those rate increases persist it’s only a matter of time before prices are affected. Warren Buffet said it best when he postulated that “interest rates affect securities prices the way gravity affects matter”.

In other words a market downturn is distinctly possible should rates rise rapidly and or significantly.

Strength in the U.S. dollar

After the better part of a decade in which the U.S. dollar was weak, confidence has returned to the world’s reserve currency over the past year. Until the lenders of the world dramatically recalibrate their risk meters I would expect the U.S. dollar to remain “stronger” as opposed to “weaker”. The result will be downward pressure on commodity prices including the price of gold as those items are denominated in U.S. currency

Slow economic growth

The U.S. administration, in conjunction with the U.S. Federal Reserve has been pulling out all the stops to reignite the U.S. economy. Open market operations that a few years ago would have been viewed as lunacy now seems standard practice. I’m referring to the Fed’s (U.S. Federal Reserve) monthly expenditure of $85 billion to buy back bonds and flood investors with cash. Their ultimate hope is for all that cash to find its way into the wallets of consumers whose spending will improve economic activity, producing an increase in both employment and tax revenues. To date the U.S. economy has not rebounded strongly though there are some signs that additional strength is on the way. I’m from Missouri on this issue, I’ll believe the economy “is back” when that’s evident in current, not future, numbers. ion of income tax information to our clients. Susan and her partner are retiring to Brighton, east of Toronto, and we wish them both a fabulous next chapter.

Lots of other things could, and likely will, happen in 2014 but those are the issues we will be focusing on when we attempt to assemble the pieces of the economic and capital market puzzle, and when we are making capital allocation decisions.

On an administrative note, the deadline for making RRSP contributions that qualify for inclusion as deductions against 2013 income is Monday, March 3, 2014. As always the last few days can be hectic so if you are intending to make a contribution if you would please arrange to have your cheque, payable to TD Waterhouse, in our office by Wednesday February 26th – it would be most appreciated.

As per usual at the end of the year it’s my habit to write and thank those clients who have passed our name along to a friend, neighbour or relative. Last year we received many inquiries from potential clients and I wanted to pass on a very sincere “Thank You” to all involved. Those referrals are a significant source of new business, and we are truly grateful.

2014 will no doubt produce its fair share of challenges but we will remain steady in our value investing beliefs and with the continued support of our clients I’m hopeful we will all have a successful year.

Observations from China – DS

In November 2013 I attended an investment conference in China. Having lived in Asia for five years from 1993 to 1998 and having travelled frequently throughout the region, I had pre-conceived notions of what to expect from China some of which were reinforced while others were completely obliterated.

At the conference I met with a range of companies some of whom are in our portfolio and others I wish we owned. I saw Chinese macro-economic data and talked extensively with investment analysts and other investors. On reflection, my general conclusion is that China will continue to develop but at a slower pace than in prior years (no real news here). Previously the big winners from the China growth story were autos, commodities, energy, freight, machinery and transportation companies. Post the November 2013 Third Policy Plenum (it sets Chinese industrial and consumer policy for the following decade) the situation has changed. The Chinese economy is now more likely to favour consumer, industrial, technology and telecom companies. Given the size of the population, energy and transportation remain big stories. Food quality is also a major theme as Chinese consumers look to high grade their diets in line with their rising standard of living. Perhaps most importantly, pollution is becoming a major theme as the heavy yoke of coal-fired power generation emissions and the toxic residue of factory production are taking a heavy toll on air quality and the environment.

Now to the important points. It is popular in the western press and some academic circles to base the continuing success of the Chinese economy on easy credit, a high savings rate and a housing bubble. While these views are perhaps loosely correct there is definitely not a linear relationship amongst high Chinese GDP growth rates, high capital investment and a high savings rates. What the current Sino-bashing rhetoric misses is that in order to make an investment, a company must first be financially successful, otherwise known as profitable. Growing, profitable companies hire more workers. When companies grow, salary growth and disposal incomes rise for their workers, which then enables the workers to invest. The simple relationship between profit, rising worker incomes and investment are a key foundation of modern economic theory. Sadly, in the case of China, the negative rhetoric is drowning out the simple facts that China is growing and still at a much faster pace than the developed world.

The Chinese housing bubble argument, another piece of Sino-bashing rhetoric, is also loosely accurate but perhaps more appropriately the concept of a real estate bubble in China captures the essence of what is occurring globally in real estate markets. However, in China, as is generally the case, the story is a little different from the one we are experiencing here in Toronto. Young kids of 30 something (I shall call them that as I am older than them) from middle class families, with good educations have good-to-excellent prospects in a growing China. Many of these kids in the larger metropolitan cities are the recipients of apartments purchased free and clear of debt obligations by their parents. Their parents typically own an apartment free of any debt (purchased at much lower price levels) and may have purchased a second apartment for rental purposes frequently without debt or with little debt financing. Here’s the interesting point relative to Canada. When these 30-something kids marry, they are frequently marrying peers from their own economic class. In terms of the coming inter-generational asset transfer of baby boomer wealth, one young 30 something couple could accumulate (due to the one-child policy most families only have one child) six apartments i.e. two each from mum and dad plus an apartment from each spouse. Now for the Coup d’état: Given the gradual wealth accumulation experienced by the Chinese population, middle class apartments in desirable neighborhoods in large metropolitan cities such as Beijing are now valued up to C$1.5 million. This then implies the 30 something generation of China’s middle class will see a massive increase in their net-worth over the next two decades. Their buying power will also rise dramatically as most assets are owned out right, free of debt repayment commitments. Unfortunately for our 30 something generation, this is clearly not the case in Canada.

I wonder, do we have enough exposure to China?

January, 2014

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