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Second Quarter 2014


Market Review Second Quarter, 2014

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

First Quarter (% Change in Cdn$)

5.7%

1.1%

-1.6%

2.7%

9.7%

4.7%

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

June 2014

0.90%

0.03%

2.24%

2.53%

March 2014

0.92%

0.05%

2.46%

2.72%

Commodities (in US$)

Oil

Natural Gas

Gold

June 2014

105.48

4.44

1328.20

March 2014

101.51

4.37

1284.80

Portfolio Management Strategy

What Worked

– Gold Stocks

– Energy Stocks

– Transportation Stocks

What Didn’t

– European Stocks

– Chinese Stocks

– Utilities and Telecom Stocks

Will The Fed Overstay Its Welcome Again?- NL

Canada’s stock market (as represented by the S&P/TSX Composite Index and led by energy, materials, and gold stocks) has continued to outpace other world markets and has shown the largest gain half way through the year. This is in sharp contrast to its relatively dismal performance over the previous three years. In addition, the loonie reversed course in the second quarter and became the strongest major currency in the world. As you might have guessed, there is a strong correlation between commodity prices and the Canadian dollar and so it is no accident that the stock market and the currency were strong together. In sharp contrast to the first quarter, Canadian investors in foreign stocks were hurt by the double whammy of many markets in Europe and Asia performing poorly and the strong Canadian dollar negating whatever positive returns those markets may have shown in local currency.

A recovering U.S. economy, combined with worries about supply disruptions in Iraq, gave rise to higher oil prices in North America. In addition, the extremely cold winter caused a drawdown in natural gas supplies, leading to high prices for the commodity. This in turn led to large share price gains for many energy stocks. Prices for materials, led by copper, began strengthening in the second quarter. Copper is often called the commodity with a PhD as the direction in which its price moves is often a precursor to how world economies perform. Reversing their excellent showing in Q1, utilities and telecom stocks were the laggards in Q2, perhaps being an early warning sign of a turnaround in interest rates.

On the topic of interest rates, one would have been hard pressed to find very many people (including ourselves) calling for bond yields to continue to decline in the second quarter. But decline they did, and the longer the bond, the more they declined. The quest for yield continues, aided and abetted by the major central banks in North America, Europe, and Japan.

While most people question whether world stock markets are overheated and due for a correction (we have been calling for one for quite some time and, as articulated in our Q1 edition of Quarterly, actually look forward to one), we are more concerned about a bond market bubble. We believe that a 10% or so decline in the price of equities would be a temporary situation within a continuing long-term bull market fueled by increasing economic growth and corporate profits. The corollary to that expectation would be that improving economies lead to higher interest rates, especially when they are being artificially kept at historic low levels.

Through three rounds of Quantitative Easing (QE), the Federal Reserve (Fed) in the United States (the European Central Bank is considering a similar policy) has been by far the largest purchaser of government bonds for almost six years in an effort to keep interest rates low in order to fulfil its mandates of stimulating both economic growth and employment. It’s dual mandate (unique in the world) is causing it to overstay its low interest rate policy as unemployment remains stubbornly high and the employment participation rate remains stubbornly low while the economy is showing reasonable growth (weather excepted). The fallout from this policy is that bond buyers, in search of bonds to buy in what has become a scarce environment, have bid up the prices (and bid down the yields) of bonds and other interest sensitive assets in their pursuit of yield. Quality is being thrown to the sidelines as buyers look for that precious little extra bit of yield. Disregarding quality usually leads to tears. Not necessarily right away but, eventually.

The Fed has historically overstayed its economic stimulus welcome. Its policies generally lag the economy. The result has been pent up inflationary pressures, which then cause interest rates to rise faster and further than initially intended. There is a fear that this could happen again in this current cycle which would prove quite painful for bond investors as even a 1 percentage point increase in bond yields would be quite large when 10-year yields are in the 2.5% range. Our economic consultant, Capital Economics, is forecasting 10-year U.S. Treasury yields to rise to 3.75% by the end of 2015. Ouch! Are bond buyers really prepared for this? We continue to minimize our clients’ exposure to higher interest rates by limiting the terms to maturity on our bonds to 5 years at most and by only buying high quality bonds and preferred shares.

On a different matter, The Wall Street Journal recently celebrated its 125th anniversary. In its anniversary issue it highlighted a number of articles and pictures from past editions. One quote from its ‘Review and Outlook’ column of April 21, 1899 caught my eye. “It is the experience of practically all operators in stocks that they do not wait long enough for profits.” It was short but sweet and articulated why our investment philosophy of buying shares in quality companies at reasonable prices and holding them for the long-term, while ignoring short-term noise, has been so successful for our clients.

Blood Sells – FB

Over the years as I’ve written pieces for our quarterly commentary, one of my pet peeves has been the business media blowing some events out of proportion. When that happens its usually bad for the market. The pieces I’m referring to are presented as “news” but are nothing more than a short term attempt to increase readership by sensationalizing what would otherwise be a third page story.

Recently the Canadian business media have been trumpeting the new all-time high reached by the S&P/TSX Composite index. The implied message in the articles is “now that a new high has been reached its OK for the public to come back to the market”. Last week I was at the dentist and he told me I’ve been grinding my teeth. Yes, I acknowledged, I know. And I know why.

It’s true that the TSX did hit a new high on June 4 as it closed that day at 15,215.00 bettering the mark of 15,073.10 set on June 18 2008. As value investors with cash reserves, we would rather the market was closer to the low of March 3 2009, being 7,631.60, as the lower prices inherent with a lower market average allows us to put capital to work at favourable prices. A business journalist looking to write a good long term article would have written about the 99.3% increase in the TSX average since the low in March 2009 and the difficulty that presents for value investors.

From the above you can surmise that we are viewing the market with some caution and to the extent that we have an opinion on the market at all, that is correct. Mostly we study values available at current prices and look to buy investments below our calculation of fair value and sell investments when prices rise too far above fair value.

By way of example(s) in November of 2008 we purchased shares in BCE Inc., the largest Canadian telecommunications company. The then current price earnings multiple (an industry standard value measure with a lower number indicating better value) was 10. Its currently 15. In May of 2011 we added shares in Badger Daylighting to client portfolios and the PE at the time was 8, its currently 20 which explains why we sold some in September 2013 and again in April 2014.

That value process is neither exact nor infallible but it does help us avoid some mistakes by staying too long at the party. Our current work shows us that the market is close to fully priced but not in nose bleed territory as valuations are “full” as opposed to “stretched”. In automobile terms the light ahead is amber meaning proceed with caution, which we are doing, as no one wants to give away recent gains through shortsighted greed.

On an administrative note we have recently experienced a staff change in the office as Susan Haydeman retired last week after 8 years at PMC. Susan was our office manager and many of you would have been familiar with her in March and April as she was responsible for the annual distribution of income tax information to our clients. Susan and her partner are retiring to Brighton, east of Toronto, and we wish them both a fabulous next chapter.

Every ending brings a new beginning and I’m pleased to advise that Bonni Rapoport has joined our admin team. Bonni will be in charge of our computer records as Finn Carroll has moved from that position to replace Susan. All very confusing but we are ecstatic to have added someone of Bonni’s character and look forward to a seamless transition.

As always if you have any questions, concerns, thoughts, something is missing or whatever as it pertains to your investments please call our office. We can’t help or fix it if we don’t know it’s broken.

Are We There Yet? – RD

It has been over 6 years since the market crash. There has been a steady recovery with many developed world markets gaining momentum particularly over the last couple of years. In the past year there has been a notable ramp up in the volume of U.S. mergers and acquisition (M&A) activity. Given the natural ebb and flow of the economic cycle and that past significant M&A waves have often preceded equity price declines, it makes us wonder if this is a bear market warning, something that sets itself apart from the more frequent hiccup that tends to present itself every now and then. There are several examples of a market decline being precipitated by a significant M&A wave. Think back to the late 1990’s feeding frenzy of acquisitions by technology companies. Both the number and value of M&A deals were significant warning signs of a market top in both 2000 and 2007. M&A tends to increase when equity valuations are high.

However, one can’t necessarily conclude that an increased level of M&A activity is rife with overvalued stocks. The recent increase in M&A has been in part due to U.S. accounting and tax rules rather than strategic reasons. The increase in M&A is also due to a desire to reduce corporate tax rates by acquiring an entity in a lower taxed country, a strategy more commonly referred to as tax inversion. Additionally, the U.S. has onerous taxation, which effectively strands cash outside the U.S. that is no longer able to fund domestic operations, or be used for dividends or stock buybacks. By incorporating in a more favourable tax jurisdiction, the companies acquire new flexibility on how to use this cash. This latter point is a strong motivation for the Medtronic acquisition of our holding in Covidien (domiciled in Ireland). Our belief is that we will be seeing more cost cutting types of M&A as growth becomes harder to attain for large well established companies in this low economic growth environment.

Despite all the recent news flow there has only been a modest increase in the number of deals. What is more prominent is that the value of the individual deals that have been announced is quite high (Time Warner Cable/ Comcast, AT&T/Direct TV, Medtronic/Covidien and Canada’s Valeant (hostile attempt to acquire Allergan) are each over $40B in value. Rather than signalling overvaluation it could point to management’s assumptions that bond yields are about to rise and so they want to lock in an attractive cost of debt. Importantly, management are just as apt at using cash and debt as to using stock. All stock deals point towards management taking advantage of a high priced stock.

The type of M&A we like to see most is that which is undertaken for the purposes of generating both revenue and earnings growth. That is essentially putting 2 entities together to provide more revenue growth than either of them separately could have attained. This is the rationale of SNC-Lavalin in purchasing Kentz Corp. (see below).

We do not see an equity financial bubble waiting to burst and the spate of M&A is not indicative of irrational exuberance. Valuations are full but not expensive so other than news of M&A, we may be in for a period of time where nothing much happens, like in most of the world cup soccer games (Brazil excepted).

July, 2014


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