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Second Quarter 2009


Market Review Second Quarter, 2009

Equity Markets (in Cdn$)

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

First Quarter % Change

19.0

6.3

13.4

15.0

22.2

33.8

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

March 2009

0.23%

0.18%

3.36%

3.58%

December 2008

0.36%

0.20%

2.78%

2.66%

Commodities (in US$)

Oil

Natural Gas

Gold

March 2009

69.89

3.72

927.65

December 2008

49.00

3.59

918.33

Portfolio Management Strategy

What Worked (The return of risk)

– Corporate Bonds

– Energy Stocks

– Financial Stocks

What Didn’t

– Government Bonds

– Gold Stocks

– Telephone Stocks

Green Shoots, Golden Crosses, and the Law of Unintended Consequences – NL

Two business catch phrases have quickly become lexicons in the North American English language vocabulary.

First used by British Chancellor of the Exchequer Norman Lamont in the 1991 recession, but more recently and more famously used by Federal Reserve Chairman Ben Bernanke in a 60 Minutes interview in March, “green shoots” is a term used colloquially to describe signs of economic recovery during a recession. It is a phrase born of hope. Green shoots are being reported everywhere, especially by the press. Unfortunately, these sightings appear to be premature as they appear to be one-offs rather than the beginnings of trends.

A “golden cross” is a term used in technical analysis. Widely used by traders and investors but disdained by academics, technical analysis is the forecasting of future financial price movements based on an examination of past price movements. It uses a wide variety of charts. Generally viewed as a bullish signal, a golden cross occurs when a securities’ (or market’s) short-term price moving average (such as its 50-day moving average) breaks above its long-term price moving average (such as its 200-day moving average). It is especially positive if it is coincident with rising share volume in the stock. People who have never dreamed of using technical analysis to predict share prices are now on the lookout for golden crosses. You will be seeing this term used widely in the press as well. Such is the desire for positive signals. Unfortunately, the global stock rally that began in March has featured low and mostly declining volume. More like a bear market rally than the beginnings of new bull market.

We are optimists by nature, and would very much like to see green shoots and golden crosses everywhere we look. Unfortunately, while we may see the odd flicker, there are abundant signs that any economic recovery we are looking at will be protracted and bumpy, and there is little that governments can do. In fact, there is much evidence that, good intentions aside, they may be making it worse.

Governments around the world have established stimulus plans to rescue their economies from recession and get them growing again. Over a trillion dollars has been pledged. Canada’s part is $35 billion. The US is in for $787 billion. Most other major countries have pledged varying amounts. And what have they got for their money? Not much to speak of as much of the money has yet to be spent. In Canada, the government claims that over 80% of their pro-growth stimulus projects have been implemented, but no proof has been provided. In the US, none of the $787 billion was spent in the first quarter of 2009, $14.5 billion was spent in the second quarter, and about $40 billion is expected to be spent in the third quarter. The goal of the Obama administration is to have about 70% spent by the third quarter of 2010. By that time it is hoped the economy will have righted itself on its own. And yet, there are calls for a second stimulus package.

At the same time, governments are projecting that they will amass huge budgetary deficits in their attempt to fight the recession. In the US, the deficit has passed $1.0 trillion for the first time, nine months into its fiscal year. It is no longer certain that the US will be able to keep its coveted AAA rating in light of the huge amount of debt it is amassing. In Canada, it is projected that we will have a budget deficit of $50 billion this year. Stimulus at the federal levels are being offset by cuts and higher taxes at state, provincial, and municipal levels. California is close to bankruptcy and is issuing IOU notes.

In Canada, governments are holding the line on taxes or, like the federal government and some provinces, even cutting them in the hope that lower taxes will spur spending and investment. They are also taking a pro-business attitude to spur growth. Not so in the US.

The people of the United States were fed-up with the Bush administration and many of its policies. They also blamed it for much of the economic problems caused by the real estate, banking and investment industries. Americans wanted change and in Barack Obama, they were promised an administration dedicated to change. Strongly backed by the union movement, Obama was elected to bring change not only in foreign policy, but on domestic issues as well, mainly the economy and health care. And change they are getting. However, one must be careful of what one wishes for – especially when dealing with the law of unintended consequences.

The law of unintended consequences, often cited but rarely defined, is that actions of people-and especially of government-always have effects that are unanticipated or unintended. The US is learning about this law first hand. The Obama administration is taking a populist big government, anti-business and pro-union attitude that may be popular on Main Street today but will probably come back to bite it in the future.

Taxes, especially on the “rich”, are being raised at a time of economic decline in order to raise revenue to pay for the large increase in government spending. This totally ignores the fact that the top 1% of income earners already pay 33% of taxes collected, the top 5% pay 52%, and the top 20% already pay 86.3%. Tax increases slated for the “rich” include surtaxes to cover universal healthcare and the deficit. History shows that the rich, their money, and their companies are much more mobile than the general population and that money and capital could leave the US in search of lower-tax countries and not provide the much needed hiring of additional workers or the buying of equipment – an unintended consequence of higher taxes. Tax rebates to lower-income Americans are being saved, not spent -an unintended consequence that may be repeated in the future. Auto companies are being “saved” at huge taxpayer expense, with bondholders losing their contractual rights and executives losing their jobs by government fiat while governments and unions are given control of the companies. At the same time, fuel economy standards are being strongly tightened. Unintended consequences here are many. Investors are fleeing the US in search of friendlier pastures where contract law is observed and where boards of directors (not governments) dictate who runs companies. This is causing the US dollar to weaken and interest rates on bonds and mortgages to be higher than they would normally be, which is undercutting the nascent housing recovery. As for the auto sector, the unintended consequences are that thousands of jobs at car dealerships and auto parts companies are being sacrificed to save Chrysler and GM workers; Ford (which has survived without a nickel of government largess) is forced to compete on an unlevel playing field as it cannot borrow at ultra-low government interest rates like Chrysler and GM; and auto companies are about to be forced to produce small, fuel efficient cars that consumers have shown they will not buy, bringing the whole auto company rescue into question. As John E. Silvia, Chief Economist at Wells Fargo Securities says, these policies look great at the 40,000- foot macro level but not so great on the ground floor.

In our last quarter’s Commentary, we noted that investors will be searching for sustainable yield. We also predicted that risk tolerance will be reduced. We still believe this to be true, although markets in the second quarter were highlighted by a craving of risk by investors, hoping for a V-shaped recovery. As cash returns virtually nothing at this time, we have reduced cash positions in most accounts without assuming much additional economic risk for our clients. We have, in many cases, purchased investment grade corporate bonds which feature attractive current yields. In addition, as described below in Rhonda’s comments, we have purchased shares in high-yielding companies that do not have much in the way of economic sensitivity.

When we believe the time is right, we will be increasing the economic sensitivity of our client’s portfolios and further drawing down cash reserves. We are building a list of companies we will want to own when we feel the opportunity is at hand. Canada remains a very attractive place for us to invest. As far as foreign equities are concerned, we will continue to emphasize non-US companies and US companies with large foreign exposure.

Why we added / sold – RD
Added:

Inter Pipeline Fund – IPL.UN TSX

Inter Pipeline operates approximately 5,900 kilometres of petroleum pipelines and 3.6 million barrels of storage in western Canada. These systems transport oil sands bitumen, conventional crude oil and gas plant condensate, representing approximately 18% of total western Canadian conventional volumes and approximately 40% of oil sands volumes. In addition, Inter Pipeline is one of North America’s largest natural gas liquids (NGL) extraction businesses with ownership in three major extraction facilities located in southern Alberta. Inter Pipeline’s NGL business currently processes approximately 40% of the natural gas exported from the province of Alberta.

Key to this investment is the expansion of the oil sands pipeline assets that are slated to come on line in late 2010 in time to provide extra cash flow for the tax change in 2011. Critically the expansion project is on time and on budget with 90% of the price risk now having been expended so exposure to cost overruns has essentially been mitigated. This expansion will shift the oil sands component (which has no volume or commodity price risk) of its business from 25% to 50%. Hence the overall risk profile of the Fund will be significantly reduced yet we don’t believe the market is pricing this in.

Student Transportation of America – STB TSX

Management has stated that they will ‘keep the distribution ($0.07 monthly distribution, $0.84 yearly) when the company becomes taxable in 2011 and for years beyond’ as well. At purchase the units yielded 10%.

STB is a small company, yet is the fourth largest school transportation company in North America. It has experienced rapid growth since its formation, doubling in size over the last 3 years.

The company grows by buying other smaller bus companies, winning contracts for student transportation services and by the privatization of municipal school bus fleets as government budgets become pinched. The backlog in privatizations has never been higher and an inability to obtain financing is spurring smaller private operators to sell. We like the management as the company was founded in 1997 by Denis Gallagher who has literally grown up in the business working his way up in the bus company his grandfather founded in 1922. That company was ultimately sold to Laidlaw where Mr. Gallagher went to work until forming STB.

The business, while seasonal, is economically insensitive as kids need to go to school. The company has a stable and diversified contract base. The average contract runs for 5 years and the company has a 97% contract renewal rate. Its focus on rural and suburban markets results in lower operating costs, reduced competition and increased safety. The company has a proven ability to acquire and integrate school bus contractors. For a rapidly growing company the stock pays an uncommonly large dividend yielding about 15% at the time of purchase. We believe the dividend is secure although is not expected to rise. We anticipate that the company will continue to offer additional shares to fund future growth opportunities as they become available. We believe this investment gives us exposure to a stable business with good management in a rapidly consolidating industry while simultaneously providing investors with a healthy income stream.

Administrative Item – FB

The Federal Court of Appeal recently upheld a decision by the Tax Court of Canada that might well have ongoing consequences for clients of discretionary investment management firms. In The Queen vs The Canadian Medical Protective Association (CMPA) the tax court found that “discretionary” investment management services are a “financial service” and thus are exempt from GST.

Clients will have noticed that we have been charging GST when calculating their fees but the recent decision raises two issues. First, should we charge GST going forward? After consulting with various tax and GST experts we feel that as the issue is still before the courts that we should continue to collect GST and remit it to the Canada Revenue Agency (CRA). To that end you will see that we have charged GST, where applicable, on the most recent quarterly invoices. Second is the issue of claiming back from the CRA GST previously collected. That issue is still open for debate as

We have been monitoring the situation through our industry association, The Investment Counsel Association of Canada, and have been consulting with our legal and accounting contacts and will be providing clients with the information required to reclaim GST should that prove to be the path recommended.

The short version is the situation is still fluid, we feel we are on top of it and clients will be hearing from us re reclaiming previous year’s GST payments just as soon as we have something concrete to report.

July 2009


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