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Second Quarter 2008


Market Review Quarter 2, 2008

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

Second Quarter
% Change

-8.4

-4.1

-6.6

0.5

17.2

-5.2

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

June 2008

2.45%

1.70%

 3.74%

3.96%

March 2008

2.12%

1.33%

3.61%

3.56%

Commodities (in US$)

Oil

Natural Gas

Gold

June 2008

140.00

13.35

928.10

March 2008

104.83

9.83

895.20

Portfolio Management Strategy

What Worked

– Mining Stocks

– Gold

– Energy Stocks

What Didn’t

–  China

– Consumer Discretionary Stocks

– Financial Stocks

Between a Rock and a Hard Place – NL

Pity the world’s central bankers. They are caught between a rock and a hard place. Economies are slowing, inflation is rising, and we are in the midst of a credit crisis. Do they lower interest rates to help stimulate their country’s economy, do they raise interest rates to fight inflation, or do they leave them alone and hope for the best? Then there is the political aspect. Try to find a politician (especially one already in office) who will face up to the truth and tell you their country (or province or state) is already in a recession or that inflation is becoming a major issue. It’s also an election year in the US. Woe to be the central banker who raises interest rates in the months before an election.

While every country (outside of Europe) has its own central bank, there are two that are vastly more important than the others. They each have different mandates. The European Central Bank (ECB) has but one mandate: to maintain price stability. In other words, fighting inflation is its sole raison d’ tre. The Federal Reserve Bank (Fed), however, has a dual mandate: the pursuit of price stability and full employment.

Inflation in Europe has accelerated to 4.0%, well above its target of just below 2.0%. Inflation in the US has also increased to 4.2%. In response, the ECB has raised interest rates by 0.25% to 4.25%, the highest level in 7 years. The Fed has done nothing. The Fed Funds rate remains at an easy money rate of 2.0%. The ECB hopes it is the only increase needed this cycle. That appears doubtful. The Fed hopes that by holding rates low, it will keep the US economy from sliding into a recession and that slow economic growth will keep inflationary pressures at bay. Hope springs eternal.

The increases in food and energy prices thus far this year have been relentless. Oil prices have increased nearly 50% so far this year while natural gas is up 72% and heating oil up 53%. On the food side, corn prices are up over 50%, while soybeans have increased over 30%. Companies have been reluctant to raise prices and have been eating most of the increased costs (pardon the pun). This appears to have been keeping reported inflation numbers artificially low. We are now seeing many companies finally crying ‘uncle’ and starting to pass along the costs. Dow Chemical, for example, has recently announced an across the board 25% price increase to take effect in August. This is on top of a 20% increase announced in June. It is only a matter of time before we see end user companies passing these costs on to consumers. Already we are reading about auto companies fighting against significantly higher steel prices. How long do you think they can continue the fight and who do you think will end up paying the cost? Right now auto companies are cutting prices to move their surplus inventories (helping keep reported inflation numbers low) but this will come to an end when their costs begin to climb sharply.

While prices are rising, economies are slowing. The US, according to David Rosenberg of Merrill Lynch, entered into a recession some time between October and February. The vagueness is due to the fact that reported economic numbers in the US are totally unreliable and are subject to numerous revisions before being considered accurate. Previously reported positive GDP data is expected to be massively revised into negative territory. According to Rosenberg, all four recession determinants (real sales, employment, industrial production, and real personal income) have peaked and rolled over. Economies in Europe remain healthier than in the US at present but recessionary worries abound. Higher interest rates will definitely put a damper on growth and may even tip the scales there to negative as well.

The worst of all evils is a combination of the above, stagflation, where economies stagnate or decline at the same time inflation continues to bedevil. The most recent example was in 1974-75. It was an ugly period. While we hope this will not be the case, we are becoming less optimistic.

History has shown that inflation is a far greater evil than slowing economies or recessions. The Europeans have begun their fight. The Americans have not. If they want to prevent stagflation, they had better begin soon.

A look back – Some thoughts for the future – PW

We are in the midst of a very unnerving time for investors. The litany of problems ranging from the mammoth losses of financial institutions, the US housing crisis, and soaring commodity prices has been analysed in depth by many respected economists and market strategists, resulting in different conclusions. There is no certainty how or when these problems will be unwound. Patience will be required to determine the correct course of action.

Some historical perspective is useful in developing investment strategy under current conditions.

Over the last 10 years we have witnessed the bursting of the bubbles in dot com equities, the U.S. housing market and the Chinese stock market. This makes one wonder if the current soaring commodity prices might be building up to the same conclusion. If this turns out to be the case, it would have a dramatic impact on the Canadian dollar and stock market.

Markets and companies seldom repeat their performance from decade to decade. Strategas, a U.S. economic consulting firm, has recently compiled some statistics that clearly demonstrates this.

The Canadian stock market has beaten all the major world indices so far in this decade, after mediocre performance in the 90’s and ranking last in the 80’s. The strong performance was driven by income trusts and the heavy weighting in resource stocks.

Conversely the U.S. market was the strongest in the 90’s and is ranked last so far this decade. The U.S. market has been dragged down by the performance of the large growth stocks which were the leaders in the 1990’s. Stocks such as GE and Coke are selling below where they were 10 years ago, despite having more than doubled their earnings and dividends over this period. Former leaders Pfizer and Bristol-Myers are at multi-year lows while paying dividends significantly higher than government bonds. These financially strong international companies could attract a lot of interest from conservative investors and cash heavy entities. The recent bid for Anheuser Busch indicates how attractive these companies are.

The Canadian market could also see a change in leadership. Many of our leading companies have disappeared. Others such as Bombardier, Nortel, Celestica and Loblaws have fallen on hard times. Some of these will recover, while others will continue to wither. Ten years ago, it would have been difficult to predict that Rogers Communications, CNR and Cameco would become industry leaders. Who had even heard of Research in Motion? The next 10 years will contain similar surprises.

The only style that consistently worked through the four decades studied by Strategas was value investing. This is not surprising because the discipline involved in value investing forces the manager to move from sectors and companies that are in vogue to more neglected areas.

Impact on Portfolio Strategy:
Although by no means exclusive, these observations will help set the framework for portfolio strategy in the months ahead.

Markets are resilient: As we emerge from these difficult times, equity markets will recover and produce healthy returns.

Value investing is the only style that shows consistent long terms results: High quality stocks selling at low Price/Earnings ratio or low price to growth will again produce superior results. At Portfolio Management Corp we are advocates of value investing and will continue to search diligently for attractive investments.

Timing is uncertain: Under today’s conditions patience is required. We will not try to anticipate when a change will come but will purchase selective equities as they meet our criteria.

Why we own them – PW and RD
Thomson Reuters Corp (TRI – T)

TRI is one of the leaders in the delivery of electronic information services, trading systems and news for financial services, legal, accounting and health care professionals. We are attracted to the favourable industry structure with high barriers to entry and the need for timely global information. Although the financial services industry that TRI serves in one of its business lines is under pressure, when the cycle turns TRI will be a prime beneficiary given its market dominance and geographic diversification. Until then the company has significant cost synergies available due to its acquisition of Reuters and its other electronic information business lines are stable and non-cyclical.

The uncertain economic environment has provided an opportunity to take a position in a company with excellent long term prospects with a healthy balance sheet, strong margins and good cash flow generation. The stock is trading at the low end of its historical ranges and yields 3.5%.

Kroger (KR – NY)

KR, founded in 1883, is one of the largest US grocery retailers and operates on a national scale. Our initial investing thesis incorporated several aspects. Firstly, although Wal-Mart was and is a formidable competitor, KR, was executing well on a basic strategy of offering good produce and grocery at attractive price points at convenient locations with good service. Recently KR has led the industry in sales gains due to its low prices and a strong private label offering. US consumers are feeling the economic pinch from a variety of places and are looking for a value offering. Not only is KR the lowest price grocer but close to half of its sales are now in its private label products which for grocers are more profitable items.

The stock trades at 14.5X 2008 earnings and given such an uncertain economic backdrop our investment in this stable non-discretionary business continues to make a lot of sense.

Teva Pharmaceuticals (TEVA – NAS)

Teva, headquartered in Israel, is a leader in the fast growing generic (non-branded) drug industry. It has a strong track record of growth and a full pipeline of new generic offerings. In addition, Teva is involved in developing active pharmaceutical ingredients and proprietary branded drugs. These include Copaxone, a major drug for the treatment of multiple sclerosis. Another one of their drugs, Azilect, has recently been demonstrated to reduce disease activity in Parkinson’s and multiple sclerosis. This could turn into a major drug for Teva. Selling at 15X estimated 2008 EPS (earnings per share ratio) and with an expected growth rate of 15%, Teva continues to be an attractive investment.

Syngenta AG (SYT – N)

Based in Switzerland, Syngenta’s principal activities are to discover, develop, design and market products to improve agricultural crop yields and food quality. Demand for its products have been spurred by accelerated modernization of farming in Eastern Europe, more intense agricultural usage in Brazil and a shift to preventative applications of crop chemicals. Crop protection chemicals make up 78% of SYT sales. Management expects sales to increase more than 20% this year and with world food demand rising, this trend should continue through the next few years. SYT is strong financially. It has little debt and earns 25% on equity. It uses its high cash flow for research, acquisitions and share buy-backs. Selling at 16X estimated 2008 EPS, the stock represents good value.

July 2008


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