Second Quarter 2010

Market Review Second Quarter, 2010

Equity Markets

S&P/TSX Composite

S&P 500


MSCI/Far East

TSX Energy

TSX Financials

Second Quarter (% Change in Cdn$)







Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

June 2010





March 2010





Commodities (in US$)


Natural Gas


June 2010




March 2010




Portfolio Management Strategy

What Worked

– Gold Stocks

– US Dollor

– Small Cap Stocks – Government Bonds

What Didn’t

– Mining Stocks

– Financial Stocks

– Chinese Stocks

We are not all Keynesians now – NL

Throughout the world, the second quarter was not kind to equity investors. The number of major markets with positive returns could be counted on one hand, with a few fingers left over. As worries about government finances took stage front and centre, stock markets began to rethink their previous assumptions that economies in the developed world would have a ‘V-shaped’ recovery and that vigorous government stimulus programs would rescue their economies. Richard Nixon once said, “We are all Keynesians now”, and many governments have embraced his philosophy of applying large amounts of stimulus in an attempt to restart growth and reduce unemployment. (They all have chosen, in the past, to ignore the second part of his philosophy which was to reduce spending when times were good).

It didn’t work for Nixon and it isn’t working now. Unfortunately, Keynes’ philosophy makes for good headlines for populist politicians aiming to look like they are doing something in the eyes of their voters, but it makes for lousy economics. As we pointed out in our commentary last quarter, there is a cost to throwing huge amounts of money around and, and after seeing that all that cash has yet to generate much economic activity, governments are now starting to realize that the piper must be paid. The United States is a very large exception, as President Obama (very much a populist politician) is still very interested in renewing his massive stimulus program despite having little evidence that much in the way of long-term results were accomplished with the first round.

In a recent Forbes article, economist Michael Pento states that the cause of the Great Depression in the 1930s and the recent Great Recession, which began in 2007, was one and the same: an overleveraged economy. The private sector and individuals in the United States are going through a necessary and painful deleveraging, resulting in slower economic activity now in return for stronger economic activity once the process is complete. The US government, however, is going in the opposite direction, with gross national debt to GDP of 90% for the first time since World War II. We hope this massive amount of public debt does not crowd-out the private sector, just when its growth is needed the most.

The problems in Greece have multiplied, even though the European Union is in the process of throwing hundreds of billions of euros at the country. Greek workers refuse to change their slothful behaviour and expectations and are resorting to general strikes and refusing to let cruise ships dock at their ports, thereby destroying its tourism industry and denying the country its main source of revenue. The government has responded by raising taxes ( a doubtful measure as nobody pays them and so more of nothing is still nothing).

Greece, however, is not alone anymore as the economic problems in the “PIIGS” (Portugal, Ireland, Italy, Greece, and Spain) continue to deteriorate and spread to other countries. Spain, too, is experiencing general strikes. Fiscal prudence is now becoming the order of the day. European governments are all pledging (to various degrees) to cut spending in order to reign in their debt. The recent UK budget is a good start. Unfortunately, they are also mostly pledging to raise taxes (once again making for good headlines but lousy economics) when cutting taxes to put more money in the hands of consumers and businesses would be a wiser course to take if economic stimulation is their goal. Here, Canada stands out as a beacon, and the results speak for themselves.

Where does this leave us from an investment prospective? As shown above, the financial crisis is far from over. This will keep pressure on governments (especially the European Central Bank and the Fed in the US) not to raise interest rates. The shift from stimulation to debt reduction is deflationary. Falling energy prices, high unemployment and lower commodity prices due to a slowdown in China’s economy, will limit inflation.

Reactionary government policies will create uncertainty in all markets. In response, market volatility will remain high and equity markets will have no clear direction, resulting in a wide trading range. While the economic and political outlook remains uncertain, corporate balance sheets and earnings are strong. Companies are hoarding cash. This bodes well for dividend increases and share buybacks, which should limit downside risk in equity prices.

For now, we aim to generate stable income from high quality investments. Bonds look attractive, as interest rates are likely to remain low and the yield curve is expected to continue to flatten. Quality stocks will provide secure and increasing dividend income. It is our intention to remain fairly defensive at this time, with the intention of becoming more aggressive when we become more confident about the economic outlook.

Volatility – FB

Three years ago on June 30, 2007 the S&P 500 index in the US closed at 1503.35. Several days ago on June 30, 2010 the same index closed at 1030.71 or a decline of 31.4% over three years. That’s a big move but it hardly tells the complete story as the S&P bottomed at 676.53 on March 9, 2009. That’s almost a 55% decline from top to bottom followed by a 52% recovery through the end of last month. Volatility indeed. As an aside, those numbers remind us that large declines must be followed by exceptionally large rebounds just to return the index to its starting point, as the S&P 500 will need to increase by another 45% from its June 30, 2010 close to get back to the June 30, 2007 level.

So, what has caused all this volatility? What does the future hold and what are we planning to do in the coming months and quarters? We believe the recent volatility resulted from a number of factors including: a sea change in economic activity from consumption mode to savings mode by the majority of the participants in the economy, massive government bailouts and stimulus packages and multiple layers of leverage.

We’ve mentioned in previous writings the demographic underpinnings that resulted in the consumer’s change from consumption mode to savings mode but the effect on the economy, and by extension the capital markets, has been a sudden realization was the growth slows. That realization was the primary driver behind the equity markets decline from the highs of 2007 through to March of 2009.

As the decline progressed through the fall of 2008 with multiple failures in the financial arena, governments were spurred into action, initially to backstop the financial industry. If governments had stopped at saving the banks and insurance firms they would have, in my mind, been prudent. However, political leadership being what it is, governments didn’t stop there. Rather they opened the spending taps further in an effort to stimulate the economy (see Norman’s piece above) and all that really accomplished was a false sense of euphoria, a large market rally and large government deficits.

Financial leverage has also been a prime contributor to the market’s three year roller coaster ride. At the top of every debt/consumption/investment cycle all the market participants have been conditioned that capital market participation equals profit. The natural reaction then is to increase participation and the easiest way to do that is borrowing to invest. Couple all that borrowing by investors with all the borrowing inside the fancy investment vehicles dreamed up to accept the flood of dollars heading into the markets, hedge funds and their ilk,and its no wonder that the party ended badly for anyone with their neck stuck out.

Volatility is produced by the herd instinct of investors. The type of people who do their thinking after their trades are completed and who rarely do sufficient homework, a.k.a. research, to allow them to act independently are those who cause volatility by following the herd. That behavior was on display in spades over the past few years and was exacerbated by the financial media who breathlessly fill every minute and every page with noise which, in hindsight, seems perfectly designed to increase investor activity and thus volatility.

Looking ahead, always a dangerous exercise, we would expect volatility to remain high unless and until significant progress is made in debt reduction across the board. As the deleveraging process takes its natural course we will be trying to use volatility as out friend by paying distressed prices for good investments. As always we will put safety first and will do our homework before employing your capital.

Why we added/sold – RD
Baxter International (BAX – NYSE)

BAX is a medical device company with products that treat chronic, life threatening disease. The company has world leading positions in the majority of its product lines. It is large and internationally diversified with 60% of sales outside the US and is well positioned to benefit from the Westernization of medicine in the developing world. BAX is able to be present from an early stage of health care ie vaccines, IV solutions and anaesthetics and can progress with a developing country to more specialized treatments of chronic states such as kidney disease and hemophilia. The stock has traded off 30% over the past 10 weeks as it has taken a credibility hit due to a series of negative news announcements, none of which we feel alters its solid long term business fundamentals. It is generating about $2B annually in free cash flow, has an interesting pipeline of new products, a flexible balance sheet and an ability to generate earnings growth. The company is inexpensive on several measures notably trading at 10X 2011 estimated earnings and yields 2.8%.

Bell Aliant (BA.UN – TSX)

BA is one of Canada’s largest regional communications providers servicing the Maritimes and largely rural areas in both Ontario and Quebec. Although certainly in a very competitive industry its rural focus provides a cushion. During the quarter it announced its dividend policy post the 2011 trust conversion targeting a payout of between 75% to 85% of free cash flow. The new dividend will be set at $1.90 down from $2.90/annually, and will yield 7.5% given the current stock price. In taxable portfolios the lower dividend is mitigated by the fact that dividends are taxed at a lower rate than the distributions paid by the income trust. While the company will not actually have to pay cash taxes until 2013, as a result of its tax shelter, it will be using the money otherwise destined to the government to accelerate its fiber-to-the-home (FTTH) build out, a positive longer term. This is a critical component in competing with the cable operators. The company has done an exceptional job in reducing its cost structure and a continuation of this trend is key as the company substitutes wireline revenues with internet and video services. Until late 2011 when the success of the FTTH initiative becomes clearer the market will focus on its solid free cash flow generation and its attractive yield. We continue to like this stable company’s ability to generate healthy cash flow in today’s volatile equities market.

Thomson Reuters (TRI – TSX)

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. The industry has high barriers to entry and customers with a need for timely global information. We added this name in the 2Q of 2008 despite the very uncertain economic environment because we felt the company had excellent long term prospects, a healthy balance sheet and dividend yield, strong margins and good cash flow generation. Since then the significant cost synergies available due to its acquisition of Reuters have exceeded initial expectations and during the financial upheaval the company continued to invest in next generation product improvements. Integration and rationalization efforts continue to buoy margins and this year the company will benefit from the roll out of a number of new higher margin products. We continue to view this investment favourably.

July 2010

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