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Second Quarter 2012


Market Review Second Quarter, 2012

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

Second Quarter
(% Change in Cdn$)

-6.4%

-1.4%

-7.3%

-5.3%

-8.1%

-5.9%

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

June 2012

0.88%

0.08%

1.74%

1.64%

March 2012

0.92%

0.06%

2.11%

2.21%

Commodities (in US$)

Oil

Natural Gas

Gold

June 2012

84.96

2.74

1597.55

June 2014

103.02 

1.98

1668.35

Portfolio Management Strategy

What Worked

– Bonds

– Telecom Stocks

– Forest Product Stocks

What Didn’t

– Small Cap Stocks

– German Stocks

– Metal and Mining Stocks

What worries us – You might be surprised- RD

I am not going to dwell on Europe as its issues are well written about. My main observation is that, contrary to the markets daily despair (or indeed euphoria depending on the day), the financial problems in Europe will not be resolved quickly. The markets have been highly reactive – both in the up and down directions – with the smallest of positive or negative news. The ‘trial and error’ problem solving of European leaders should not warrant daily bouncing markets. Accordingly, although we are aware of the daily moves we do not use weekly timeframes to assess whether our investments have performed well. The healing process will take some time and that is where Europe is at.

From our vantage point there are many positives. Despite having been in a low return environment for the past decade or so, interest rates hitting record lows have kept bond prices moving up and so our fixed income investments have continued to be star performers. The equity side is not as homogenous. Our portfolios are comprised of shares in companies that are in varying stages of development. Currently a large portion of the portfolios are invested in companies where the business, and hence the stock, is performing well. Right now this category is not surprisingly comprised of mainly non-cyclical stocks the likes of Diageo, Bristol Myers Squibb and Morneau Shepell (up 26%, 24%, and 15%, respectively, over the last 12 months). These are just 3 examples but our portfolios have ample exposure here.

We have another segment of the portfolio devoted to companies that are ‘works in progress’, either because they have been newly added, or because there are some business issues that are impeding near term earnings growth. We believe these shares to be attractively discounted compared to their long term potential. These are expected to perform over the next 12 to 24 months and we do not fret about them on a quarterly basis.

This leads me to discuss what does worry us. The day will come when the world’s business and economic issues will not seem as bleak. Potentially, Greece will have left the Euro, China’s slowing GDP will have reversed, the U.S. will continue its slow and steady resurgence and corporate scandals will have ceased (OK, maybe not that last one). In that environment there will be a case to be made for increasing the number of economically sensitive stocks in the portfolio and/or reducing our fixed income exposure. We worry we will miss what will be working later if we focus too much on the ground immediately beneath our feet. We need to have our eyes on the horizon.

Given you have entrusted us as stewards of your capitol over the long haul we need to look forward to what is likely to work when the current crisis has abated. At the moment, investors continue to have a strong demand for income yet, with interest rates as low as they are, there is not much more oomph left in fixed income. In fact, there has been such a demand for safety that investors in some cases have been willing to accept a negative return on their money just for the assurance of getting their money back. As Mark Twain is attributed to have said:”I’m not as concerned about the return on my money as I am in the return of my money”. This state of affairs cannot persist indefinitely and, coupled with the fact that investors have been shying away from equities, has left some stock prices languishing from fear or neglect. Economically sensitive stocks that are already factoring in a slowdown and stocks already battered in Europe are areas we are analyzing closely. We don’t foresee any near term upside catalyst and so don’t think the time is yet right to add those types of stocks to the portfolio; however, we are scanning the horizon to be prepared for when the time is right. What keeps us up at night is that no bell will ring, no red sale light will flash to let us know when to put the buy order in. So at least I know what I don’t know.That’s a start. In the meantime our dull and boring conservative stocks are winners and we will continue to wait for our experience to nudge us to determine when to shift the mix.

Other People’s Money – NL

Once again, led by energy and mining, metal, and materials stocks, Canadian equities underperformed most major markets in the second quarter. It was a quarter when equities markets in all large economies posted negative returns. As we pointed out in the most previous issue of ‘Commentary’, the sword is double edged. These same poor performers were the stars for ten years as commodity prices rose relentlessly, feeding China’s insatiable appetite as its economy became the world’s factory. Unfortunately, China’s economy is slowing as its great success is built mainly on exports, not domestic demand, and Europe’s problems have become China’s problems. Exports to Europe, and to a lesser extent North America, have shriveled. Fortunately, we don’t have a lot of exposure to commodities in our portfolios. Not very Canadian of us, eh?

All was not negative, however, as defensive stocks (with their attractive dividend yields) were largely up in the quarter. Fortunately we do have lots of those. Another thing we have lots of, is fixed income. Boring bonds and preferred shares had a great quarter as money flew out of stocks and into fixed income, driving interest rates to exceedingly low levels. Last quarter we wondered who would want to loan their money out for 10 years at 2%. Well, with 10 year Canada’s closing the quarter at 1.74% and 10 year U.S. Treasuries at 1.64% (and even lower since then), we now pine for that 2% bond. The problem is that people aren’t buying these bonds to own for 10 years, or 30 years, as the case may be. They aren’t ‘owning’ bonds at all, they are ‘trading’ bonds. You would be hard pressed to find anyone expecting to hold these bonds to maturity. They want to own them as a place to hide, either until equities begin a sustainable advance or until interest rates reverse course and start increasing. Those two events are probably highly related and will most likely happen at the same time. That makes the bond market a big game (the bond market is multiple times larger than the stock market) of musical chairs because when everyone decides it’s time to trade those bonds in for stocks, everyone will be scrambling for a seat. The answer will be: Sell them. The question will be: To whom? We are in the investing business, not the trading business. That is why we still do not own any bonds longer than 8 years to maturity, and the majority are dated much shorter than that. We do not want to be left holding the bag when interest rates start to rise.

Margaret Thatcher, the former Prime Minister of The United Kingdom, most famously said, “The problem with socialism is that eventually you run out of other people’s money”. While most countries in the developed world are not Socialist, they are all what we would call Social Democratic. That means that they have all the social services benefits of socialism while still operating as capitalistic economies. And that, I believe, is one of the main causes of the current economic problems in Europe, as well as the growing budget problems in the US, Japan, and Canada – especially in many of the provinces.

As the baby boomer cohort moved through society, tax revenues bloated as this generation became employed and formed families. At the same time, boomers began demanding more services from their governments: universal health care, daycare, subsidised higher education (never enough subsidy in Quebec, apparently), eldercare for their parents, generous guaranteed pensions, retirement benefits, and a whole laundry list of ever growing other social services. To get elected, politicians fought to one up on the opposition in dreaming up more services. People loved being bought with their own money.

Unfortunately, relatively early on in the process, all those promises and new services ended up costing more than the tax revenues that were being generated. What to do? Raise taxes? Are you kidding? I need that money for all the goodies I want to buy. I’m a consumer. My parents saved. Not me. I spend. I want my toys and what my neighbour has.

What was the answer? Borrow money. Let the next generation pay for what we want. Politicians quickly realized that the next generation doesn’t know to complain and they can’t vote yet. And so began the era of government deficits and bloated government debt. Unfortunately, those baby boomers didn’t have as many children as their parents did so there are fewer people in the next generation to pay for all the goodies that the baby boomers have now deemed to be necessary and unwilling to give up.

What about raising taxes? Everyone from Barack Obama to Dalton McGuinty to Francois Hollande want to, or already are, increasing taxes. They hope to raise enough money to offset the rising costs. It remains to be seen how successful this will be.

The populations in many countries are aging quickly. Their finances are in ruin as expenditures far outrun revenues. They can’t borrow anymore. What is the answer now? Cut back on services? Are you kidding? These aren’t services anymore. They are entitlements and few politicians are willing to tell their voters that they have to give something up. They want to get re-elected. In Europe, people are voting out governments that preach austerity.

Governments in Europe need to face reality. Continually kicking the can down the road is not solving the problem. It is only making it worse. Europe, especially southern Europe, needs to become realistic about what it can afford. What it can’t afford is to keep offering all its services and employing all its civil servants and paying exorbitant interest rates to finance it. Countries like Germany have benefited from the problems in other parts of Europe as it has kept the value of the euro low, enabling Germany to become an export machine and have the strongest economy on the continent. It must help its suffering neighbours or it risks being dragged down, as well. There is no free lunch. And it can no longer be accomplished with other people’s money.

Cucumbers – FB

People are for the most part emotional. And emotions can be wonderful as they help us to more fully experience some of life’s highs and lows. We are all familiar with the emotions associated with love, friendship, “the thrill of victory and the agony of defeat”. Those emotions are quite often the largest single piece of our day to day experience. And almost always the most remembered piece.

However, in business and especially in the business of making investment decisions, emotions are a significant hindrance to rational decision making. Twelve years ago the news was full of pieces commenting on the Internet and how it was going to revolutionize everything around business and how business was conducted. With the benefit of hindsight it’s easy to see that the hype generated led to an unsustainable advance in any and all technology investments, and resulted in what we now call the technology bubble. That bubble ended badly (they all do) when common sense finally caught up with the emotionally charged technology prices of the day.

Fast forward to today and the news is full of Europe’s troubles with its debts and, according to some pundits, its pending doom. I have no idea how far the negative hype will go, and no idea how Europe’s troubles will be resolved but, using history as a guide, I think it’s reasonable to expect further turbulence in the various capital markets. If we can leave our emotions at home and be as cool as cucumbers while remaining detached observers, then the coming turbulence might well provide some attractive opportunities.

Over most of the past ten years the Canadian economy and the Canadian capital markets have been very strong. That strength helped move our Canadian dollar all the way to a small premium when compared to its US counterpart. I’m a proud Canadian and I’m pleased the world thought enough of all things Canada to bid up our dollar but, unemotionally, the law of averages strongly suggest that Canada’s time in the sun is coming to an end. That’s why Darren Sissons and Rhonda Dalley, in conjunction with Peter Walter before them, with their expertise in international capital markets are so important to our ongoing investment efforts. I believe that if we were restricted to only making investments in North America, our clients would not be as well served as possible given that the best opportunities might well arise in the wake of the European turbulence.

As always we remain value investors. We feel our goal is to use the value process to identify, purchase, hold and ultimately sell investments in such a manner that will give our client portfolios the best chance to deliver on the objectives as outlined by each client.

Would you like cucumbers with that order sir?
Why we added/sold – RD/DS

Sold
Constellation Software (CSU-TSX)

Constellation Software Inc. has been a great investment for our investors. We initially purchased the position at $17/share during the IPO. Over the intervening four and one half years we have trimmed the size of our holdings. We recently sold the remaining portion for $92 per share.

In 2011, CSU’s share price rose 60%, versus a 10% decline for the TSX, and the company initiated a 5% dividend. Despite the recent success, management has been highlighting the increasing difficulty of acquiring a sufficient volume of software companies at attractive prices in order to continue the company’s growth. Moving forward, we expect management will eventually be forced to either accelerate its already high volume acquisition program (which could lead to integration errors, poor investment decisions and or management attrition) or more likely that the company will begin acquiring larger, more complex software companies at higher prices as a means to continue growing. Both options are fraught with difficulty. Given CSU’s 70% out-performance relative to the TSX last year (which is unlikely to be repeated in 2012), we feel our clients will be better served by deploying the capital into higher potential alternatives.

Syngenta AG (SYT-NYSE)

Syngenta has been a solid performer. There is currently no fundamental issue with the company and it is performing well. However, looking forward, the company’s profitability will become under increasing pressure due to the generic threat from Chinese competitors, which we expect to intensify over the next 12 to 24 months. Additionally, due to the macro risks currently facing Europe, institutional investors are now typically net sellers of quality European stocks such as Syngenta. We recognize we are early in our disposal of the Syngenta position. However, we believe it is now prudent to raise some capital for opportunities that will develop in Europe post a successful conclusion to the region’s banking crisis.

Atrium Innovations (ATB-TSX)

This manufacturer and seller of health and nutrition products failed to live up to our expectations. The focus on wellbeing and healthy living put the company in an attractive industry segment and yet it has not been able to capitalize on its potential. Internal and regulatory hiccups have prevented the earnings from growing as we had anticipated and while they have put a new management team in place, at this stage there are othe more compelling opportunities opening up as the market trades off.

Switched
Sold: Newmont Mining (NEM-NYSE)
and
Bought: SPDR Gold Trust (GLD-NYSE) / Royal Canadian Mint (MNT-TSX)

We have replaced the gold miner Newmont Mining with pure play gold commodity trusts in order to eliminate the effects of company specific incidences such as mine accidents. Our overall gold exposure remains unchanged. Our gold position in the portfolios is for diversification purposes, a hedge against further global shocks to the economic system. Gold and gold stocks do not lend themselves to traditional valuation analysis as the value of gold is based upon macro-economic events and not on traditional supply and demand metrics. For this reason we will never have a significant exposure to this area. However, current concerns over paper currencies and global debt levels makes us believe that in the current environment, it remains prudent to continue to have exposure to this metal. We indeed hope that gold does not do well as that should mean that global fears have waned and other investments, of which we have much more exposure to, will strengthen accordingly.

June 2012


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