Second Quarter 2013

Market Review Second Quarter, 2013

Equity Markets

S&P/TSX Composite

S&P 500


MSCI/Far East

TSX Energy

TSX Financials

TSecond 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 2013





March 2013





Commodities (in US$)


Natural Gas


June 2013




 March 2013




Portfolio Management Strategy

What Worked

– U.S. Stocks

– Japanese Stocks

– Life Insurance Stocks

What Didn’t

– Gold & Mining Stocks

– Fixed Income

– Interest Sensitive Stocks

Shoot First Ask Questions Later – NL

Stock markets in Canada suffered through another tough quarter as Canadian equity returns were negative once again. This was in sharp contrast to most of the rest of the world, which generally showed modest gains.  In Canadian dollar terms, the United States and Japan were the top performing markets in the world.  Once again, declining commodity prices were the main culprit in Canada, although the lackluster performance of the Canadian banks contributed to the market’s malaise.  Gold, copper, natural gas, oil, and even lumber, showed price declines in the quarter.  It is important to remember that the S&P/TSX Composite Index is about three quarters composed of resource, materials and financial stocks.  Not very diversified and not an index we would ever attempt to mirror (not that we would ever attempt to mirror any index).

Interest sensitive stocks fared poorly in both Canada and the United States.  Not surprising, due to the fact that yields on bonds shot up almost overnight following Federal Reserve (The Fed) Chairman Ben Bernanke’s statement on June 19 that the Fed might start winding down its buying of bonds by year end and might stop buying bonds in about a year.  The end of easy money.  I emphasized the word might as it is highly dependent on the state of the U.S. economy and its employment levels.  Please remember that The Fed, unlike the Bank of Canada, has the dual mandate of monetary policy and jobs.

Despite the fact that Chairman Bernanke opined that interest rates should remain low even if the Fed ‘tapers’ or even stops its purchase of bonds, market participants decided to shoot first and ask questions later.  The interest rate on 10-year government of Canada bonds leapt from 1.76% at the end of March to 2.44% at the end of June.  U.S. 10-year Treasury yields similarly jumped from 1.85% to 2.49%.  While not large in absolute numbers, in percentage terms the moves were humungous – up 39% in Canada and 34% in the U.S.  And that was in only one quarter!  Longer dated maturities fared even worse.  Thankfully the longest bond we own is only seven years and most are even shorter.  When interest rates are very low, small absolute movements can mean large percentage moves in bond prices.  The average Canadian bond (combines short, medium and long-term bonds) as measured by the DEX Universe Bond Index, declined 2.4%, with most of that decline occurring rather quickly in the latter part of June and most of the damage being recorded by the long end of the bond market – an area where we do not currently participate.  Preferred shares suffered an equal fate as they too are tied to interest rates.

But it didn’t end at just the fixed income markets. Utilities, real estate investment trusts (“REITs”) and telecoms are all viewed as having negative correlations with interest rates.  Their share prices generally go up when interest rates decline as investors are in yield seeking mode, and their shares generally go down when interest rates rise as investors demand higher yields to compensate for higher interest rates.  During the quarter, utilities declined 5.5%, REITs 8.3% and telecom stocks 11.6% (rumors of Verizon’s potential entry into Canada didn’t help that group), all in quick response to Bernanke’s speech.  One area that fared well, however, was life insurance companies, up 9.4%.  They are the anti-bond as they earn more money as interest rates on bonds rise

In previous issues of Commentary this year, we talked about reducing our exposure to rising interest rates over the course of the year.  While we have made some strides in that goal, the speed and veracity of the move in June took us and almost all market participants by surprise.  While we still think interest rates are headed higher, we believe that the most recent leap in rates was excessive and that some back-filling is due.  We will use that opportunity to continue reducing both our fixed income exposure and the duration of the bonds we hold.

As for the interest sensitive stocks that we own, many of them were purchased at much lower levels than current prices and the yields our clients receive on those stocks, on their purchase prices, are extremely attractive, especially when one remembers that these companies tend to raise their dividends on a regular basis.  Therefore, we will be more reluctant to part with these securities at this time.

When what’s working stops working – RD

I began my career as a junior analyst in international investing.  Fortunately for me it was the mid- 1990’s and international and emerging markets (ex China!) were ‘hot’.  Life was good, capital inflows to emerging markets surged.  I was keenly demonstrating the efficient frontier hypothesis that demonstrated the wisdom of adding emerging markets to increase returns. The data was undeniable – at least at the time

But then….along came the currency and debt crisis in Thailand, followed by a similar crisis in Russia and in other emerging markets.  Stock prices in the emerging markets fell like dominos.  Lo and behold the same analysis with this ‘new’ data soon demonstrated the opposite – better returns without emerging markets exposure.  Not good for job security given I worked in this group.

But then….along came the currency and debt crisis in Thailand, followed by a similar crisis in Russia and in other emerging markets.  Stock prices in the emerging markets fell like dominos.  Lo and behold the same analysis with this ‘new’ data soon demonstrated the opposite – better returns without emerging markets exposure.  Not good for job security given I worked in this group.

So on to my next endeavour, analyzing U.S. stocks. I watched from afar the technology bubble grow and subsequently burst while I toiled away looking for value.  Some exposure here made sense but it seemed that I could never recommend enough of these ‘hot’ stocks.  There were undoubtedly good companies but when unbridled enthusiasm takes hold, valuations can get stretched.  This does not only apply to tech stocks.  After a few years, the hot stocks tanked under the weight of accounting scandals and over valuations.  I persevered through the ensuing carnage and surveyed a whole host of very compelling valuations in the U.S.  However, little did I know that the Canadian dollar was going to go on a long run of strength versus the U.S. dollar, minimizing my returns once translated into Canadian dollars.  The Canadian dollar was now ‘hot’.  As a Canadian I was truly impressed.  As a U.S. investor, not so much.  I wasn’t invited to client meetings and no one dropped by my office anymore.  It was a lonely time.

As you know I was fortunate to join PMC in 2007 and clearly have seen many a trend end.  To that end we might now be experiencing the finale of a bull run in bonds and other similarly interest sensitive equities like preferred shares and REITs.  The last several years have witnessed huge demand for interest sensitive vehicles because of their perceived safety and returns were very good.  While some exposure can be prudent, the real deals have been elsewhere.  Now a calamity is not about to befall this asset class but better returns are likely to be found in other areas.  The love affair investors had for Canadian stocks started to wane about a year ago.  Again what was hot is becoming ‘not’.

Currency has moved in the opposite direction and now our portfolios are benefitting from a weak Canadian dollar. We now hold our highest non-Canadian equity weight ever. We embarked on reducing our bond exposure a while ago and importantly we invest globally, Canada, U.S., Europe, emerging markets, where ever we see value. We could be invested in what’s ‘hot’ but we endeavour to have a good quantity of ‘what’s not’ as well because we know what eventually happens. Historically we have been years early to a show but we usually get a good seat.

BCE: Validity of Verizon Market Entry & Higher Interest Rates – DS

Recently, Verizon Communications Inc. (“Verizon”), a leading American telecom operator announced plans to enter the Canadian market. This announcement was greeted by a sell-off of Canadian telecommunications companies. While an interesting development, I am doubtful the long term future of the Canadian market place includes a foreign telecom carrier with a significant market share. This view is essentially based on the sheer magnitude of capital that must be invested to develop a competitive telecom network. Additionally, without a competitive network, a new entrant cannot expect to attract and retain a sufficient number of customers in order to drive an appropriate return on the investment in a network. The doubt Verizon can build commercial scale also assumes the incumbent Canadian operators will use price and scale (like they did against Public Mobile and Wind Mobile) to compete against a new market entrant and will endure near term margin pressure as a means to eliminate a competitive threat. While the wholesale market provides some merit, that market is very competitive and suffers from poor economics. Consequently, average telecom prices will likely fall in the near term and the growth rates of BCE, Rogers and Telus would slow if Verizon entered the Canadian market in 2015/16. However, poor economics will likely lead to the eventual departure of Verizon. A reversion to the current oligopolistic structure should then be expected over time.

While considering headwinds for the Canadian telecom sector it is worthwhile pondering the impact of rising interest rates. The telcos have been widely used by investors as a bond proxy with capital appreciation since the onset of the recession in 2008. Hefty sustainable dividend yields drove scores of investors to all things telecom and share prices rose substantially across the sector. Surely, as the U.S. begins to grow again, the light at the end of the recessionary tunnel (at least here in North America) appears less dim. In the context of an economic recovery will telecom stocks fall? We should expect a small decline in price as interest rates eventually rise but the more likely outcome is the telecom sector will be range bound for a period until growth and yield increases resume.

However, despite the above near term negatives, our Canadian telecom operators are all well capitalized. Generally, across the entire sector companies have good balance sheets and they grow at a slight premium to the Canadian GDP rate. Dividends will continue growing albeit not as quickly as they have in the recent past. Given the above and in light of the low cost base of our BCE investment and the corresponding dividend yield on cost, we will be unlikely sellers of the company in the near term.

July, 2013

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