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Second Quarter 2011


Market Review Second Quarter, 2011

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

Second Quarter (% Change in Cdn$)

-5.8%

-1.2%

0.0%

-0.9%

-9.1%

-3.6%

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

June 2011

0.92%

0.01%

3.12%

2.16%

March 2011

0.91%

0.09%

3.34%

3.46%

Commodities (in US$)

Oil

Natural Gas

Gold

June 2011

79.20

3.67

1623.50

March 2011

95.42

4.28

1502.80

Portfolio Management Strategy

What Worked

– Telecom Stocks

– Bonds

– Japanese Stocks

What Didn’t

– Small Cap Stocks

– Forest Products Stocks

– Energy Stocks

You Can Pay Me Now Or You Can Pay Me Later – NL

Led by commodity stocks, the stock market in Canada took it on the chin in the second quarter whereas US and international stocks fared somewhat better when measured in Canadian dollars. Fixed income investors actually made money as interest rates declined, contrary to the expectation of many “experts” who see inflation and higher interest rates around every corner. With unemployment remaining stubbornly high, the US housing market still on its back, growth in China showing signs of slowing, and large parts of Europe fighting for economic survival, it is hard to see where this supposed inflation is going to be coming from.

Of course the European Central Bank (ECB) worries about every 1/10% change in inflation and has been raising interest rates of late, despite that fact that many of its member countries are economic basket cases. Since none of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) can borrow at anywhere near market rates anyways, it really doesn’t matter to them what the administered rates are.

In Canada, through a combination of luck (strong commodity prices) and good fiscal management (at least at the federal level, amazingly during a minority government), our growth remains relatively strong, our debt level quite manageable, our currency not far off its highs, and our inflation in check. While the Bank of Canada is dying to raise rates, it dares not as that action, if done today, would send the loonie through the roof and destroy whatever manufacturing base remains in the country. That is why we are quite comfortable owning quality Canadian government and corporate bonds as well as preferred shares in our clients’ portfolios. While we expect short-term interest rate fluctuations, the range should be narrow and the trend flattish.

Greece, at the time of writing, edges ever closer to default. This should not be viewed as a surprise to anyone. According to the Wall Street Journal, Greece has been in default five times since it gained its independence in 1829 and has spent 50.6% of that time either in default or restructuring. The European Union (EU) and the ECB are ostensibly trying to keep the country solvent for the good of the Greek people. Nonsense. They care not a whit about Greece. What they care about are the French, Italian and German banks that own the lion’s share of Greece’s foreign sovereign debt. If (when) Greece were to default, the capital of many of these banks would take large hits. The ECB will be active in aiding these banks in the same way the TARP program came to the aid of US banks in their time of need.

Portugese and Irish bonds are rated as junk bonds. Italy is experiencing a liquidity crisis as its combination of high debt, slow growth and political dysfunction is scaring investors from owning its bonds for fear that it (Europe’s third largest economy) may be next.

Things are going to be ugly in Europe for quite a while. According to Capital Economics, our economic consultants, it is likely that if one country defaults, it is likely that a group of countries will, as well. Everything points towards the euro-zone taking many years to resolve its problems and that ultimately peripheral euro-zone countries (such as the PIIGS) will be forced to leave the euro in order to devalue their currencies as default without devaluation only prolongs the agony. The piper must be paid. He can be paid now (and minimize the pain) or he can be paid later (at a much higher cost). While this should lead to continued weakness in the euro in the near term, we believe it could lead to a higher euro in the long run as the remaining countries will be the economically strong ones.

The problems in the United States are of a different nature. There is only a small chance of the US defaulting on its debt. It will lay off hundreds of thousands of federal employees and temporarily cut services if the debt ceiling (the total amount of debt the US government is allowed to borrow) is not raised, but we believe it will not miss an interest payment or a bond redemption. The US needs to raise taxes and cut spending. Their politicians have a problem. In fact, they themselves are the problem. Raising taxes is anathema to the Republicans and cutting spending is like poison to the Democrats. They all want to get re-elected and don’t want to be seen as giving ground to the other side. Partisan politics is getting in the way of common sense. Some sort of common sense will ultimately prevail.

In our last Commentary, we talked about our cautious stance towards equities. While we continue to have one eye on the problems we detailed above, we have the other eye on equity valuations. While corporate earnings have been growing nicely, stocks have not been keeping pace. Much of this is due to the huge run stocks had off their March 2009 bottom but some is due to the economic uncertainty. As equity markets take a much needed breather, our inclination is to begin to take advantage of share price weakness and begin to buy shares of quality companies that have good growth prospects and good dividend yields.

The International Outlook – DS

I joined Portfolio Management Corp. on April 1st and as I reflect on my first quarter with the firm and our current international holdings I believe our portfolios are well positioned.

Looking into the international investment landscape, I see reasons for both optimism and pessimism but on balance believe the world economy will continue to recover from the nasty 2008 – 2009 recession and further growth will be achieved over the 2011 – 2015 period.

Areas of concern include the inflation rates in Brazil, Russia, India and China as these large emerging economies have been the main engines of global GDP growth over the last 24 months. However, I am encouraged by the recent tightening of monetary policy in China and the reduction in annual GDP growth rate targets from 10% to a more moderate and sustainable 7% – 8%. Additionally, China’s efforts to increase the equity component of real estate purchases by individuals and its efforts to increase the capital adequacy of its banks should help alleviate some of the speculative (and inflationary) aspects of the Chinese economy. These steps should also position the country for more sustainable long term growth. While China was the first of the larger emerging economies to take steps to slow growth and focus on inflation, Brazil, India and Russia are now all actively targeting lower inflation and a growth rate more appropriate to the lower rates of global growth we should expect over the next couple of years.

In Europe I am concerned by the debt levels notably Greece but also Portugal, Ireland, Italy and Spain (“PIIGs”). While efforts to reduce debt will ultimately be a positive, in the near term lower eurozone growth rates will continue to be the norm. However, given the inclusion of the weaker PIIGs in the Euro, the currency has traded at attractive levels and exports from Germany and the Nordic region have generally performed well. GDP growth rates in these countries have been good, unemployment is falling, domestic consumption and investment is rising. Looking out 12 – 24 months, I suspect more eurozone countries will experience export-led growth, falling unemployment rates and rising domestic consumption. A stronger Europe will be positive for the portfolio holdings and for Canada.

I am more optimistic on the U.S. economy than I was a quarter, six months or even a year ago. The U.S. was the first major economy to feel the bite of the recession and it was the first country to take steps to counter its negative impact. While unemployment has seasonally moved back to 9.2% we note the broader measures of unemployment have continued to improve for the last 12 months. Smaller companies, typically the first companies to hire post a recession, are now hiring and the U.S. economy appears to be in a sustainable (albeit slow moving) job creation cycle. Continuing improvements to the health of its banking sector will also be a plus. I also note that no sitting President has won a second term when the U.S. unemployment rate was above 7.2%. Consequently, while high debt levels will continue to challenge the U.S., I believe it is currently experiencing a positive mix of growth drivers that should support higher employment, increased domestic consumption, higher levels of corporate investment and rising corporate profits moving forward. Key drivers I would point to include: a population with limited welfare or healthcare outside of paid employment, a heritage of entrepreneurialism coupled with a general desire to overcome economic adversity and a desire to work, a stable banking system with the capacity to lend and a political dynamic that is targeting growth and employment.

The slowly improving global economy should continue to offer value investors like our firm a number of new and interesting international investment opportunities. I am currently spending my time investigating companies with sizable growth opportunities in emerging markets due largely to new product cycles or to support geographic expansion. We typically like attractively priced or inexpensively-priced companies with low debt, a high degree of recurring or repeatable revenue, management teams with a significant ownership stake in the companies they run and firms with a consistent track record of earnings growth.

I would conclude by noting the excellent portfolio I inherited from Peter Walter is continuing to perform well. I am thankful for the support and mentoring Peter has provided to date and I look forward to building on the strong track record of success he built with our firm over the years.

Why we added/sold – RD
Added
Badger Daylighting (BAD – TSX)

Before we had finished buying our position, as we stated in the prior quarterly, Badger became the subject of a takeover offer from Clean Harbors for $20.50. We were unhappy with this deal as the premium offered was less than the yearly dividend and also gave away the upside from its US expansion plans to Clean Harbors shareholders. We are pleased that we successfully voted against this deal as did the majority of shareholders and took the opportunity after the deal was scrapped to purchase the balance of the position. We are happy to hold this company for the long-term and continue to collect the monthly dividend of $0.085/share yielding 5.4%.

Added
Tuscany International Drilling (TID – TSX)

During the quarter we purchased this leading oilfield services company but only for our more aggressive accounts. We bought it when it issued additional shares to acquire a privately held Brazilian drilling company. Subsequent to our purchase the company acquired the African and Latin American drilling rigs of a French company called Maurel & Prom. It now has 80% of revenues coming from Latin America where it has significant positions in both Columbia and Brazil. It has a close to 20% market share in each country. The shares traded down on the latest acquisition and is now valued close to the liquidation value of its assets in the field. This management team has a proven, well established record of growing startup businesses into strong operations and the opportunities for growth are readily apparent as further oil exploration in the area is being encouraged by government leaders. We believe the business opportunity in Latin America is sound and will allow this team time to build up the business in Latin America.

Eliminated)
Nokia (NOK – NYSE)

We eliminated Nokia after a painful journey. Prior management had allowed the company to lose its technological edge yet it had/has all the resources necessary to rise again. The company had and continues to have leading market shares and a significant cash position. However, when a new CEO was hired and a decision was made to partner with Microsoft and abandon its operating system it was clear that the path forward was murky at best. We cannot elucidate what the new strategic path will look like as we go forward. Hence, given this rather major unknown we felt it best to exit from what is a questionable multi-year transitional period for the company.

June 2011


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