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Third Quarter 2008


Market Review Quarter 3, 2008

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

Third Quarter
% Change

-18.8

-5.2

-18.0

-15.7

-33.7

 2.9

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

September 2008

  1.85%

  0.76%

  3.77%

 3.78%

June 2008

  2.45%

 1.70%

3.74%

 3.96%

Commodities (in US$)

Oil

Natural Gas

Gold

September 2008

100.45

7.17

 863.05

June 2008

140.00

13.35

 928.10

Portfolio Management Strategy

What Worked

– Cash

– Government Bonds

– Canadian Financial Stocks

What Didn’t

– Emerging Markets

– US & European Financial Stocks

– Small Capitalization Stocks

Challenging Times – FB

Watching the market’s gyrations over the past month I found myself thinking that we must be having the same thoughts as a Nebraska tornado chaser as he watches the sky during a thunder storm – fascinated by the display of volatility, just keep me out of the way of the nasty bits. And I think we have avoided the nasty bits, with one exception which I will discuss shortly, as our long term caution has been vindicated recently. We had begun to raise cash in our client portfolios in early 2007. Even with being cautious, portfolio values are down but we feel confident that our value process will be rewarded in the long run.

The crisis that started off as a US centric housing and credit bubble has become a bonafide global liquidity crisis. While money is available (re Warren Buffet’s Berkshire Hathaway and other well capitalized corporations), steadily falling asset values has made it painful to step into what appear to be intriguing investment opportunities. There is panic in the market place, assets are being sold (at any price) in order to have cash at hand given that banks have virtually stopped lending. Valuation metrics are not particularly helpful as rather than trading off investment fundamentals, stock prices are being hijacked by the credit crisis. Ultimately however, it is important to remember that investing should be about values not prices. The difference between those two numbers is the heart of how we make investment decisions. In short, value is our calculation of what a company is worth and price is the level that the market will pay. The difference between the two is usually modest but can become extreme when investors become overly emotional. Currently negative emotions are running wild and we are starting to see some interesting bargains appear as short term emotional thinking trumps the rational long term process of business valuation. It is for times like these that we hold cash reserves. Not only do they cushion the impact of falling prices on portfolio valuations but they also provide liquidity for distress purchases.

The road ahead is always uncertain, now more than ever if one is to believe even a fraction of the dire predictions made by commentators in the financial press. As our former colleague Robert McInnes wrote in a prior quarterly ‘The market always does what it is supposed to – but never when’. That old market adage is as true today as ever. Therefore we have and will continue to be cautious as we work to maintain and grow your capital and its ability to provide income. This cycle will be broken but as global investor John Magee is reputed to have said ‘don’t tell me what to buy, tell me when to buy it’. The companies to survive this crisis are those with solid market positioning and a strong balance sheet that can carry them through until the crisis subsides.

We have avoided the worst of the crisis in the US by steering clear of their banking and brokerage system but we can’t say our record is spotless as we have holdings in two banks in Great Britain: Lloyds TSB Group and Barclays PLC. Their share prices have declined since the start of the year but we feel confident that each has a solid franchise and solid long term prospects evidenced by Barclays’ recent purchase out of bankruptcy some of Lehman’s North American business and Lloyds’ purchase of foundering HBOS (UK’s biggest mortgage lender and savings bank).

It is also important to remember that the Canadian experience is not the American experience. On a personal, corporate and government level our borrowing practices are more conservative, our economy is in better shape and, as frightening as it may seem to some, our political leadership is noticeably better. We remain committed to value investing as it has and will continue to be the most appropriate way to invest for the long term.

Why we own them – PW
Government Bonds

Due to their high quality, Government bonds, whether Treasury Bills or issues with longer maturities, are held to protect a portfolio from loss if the economy falls into a prolonged recession or if deflationary pressures mount. The risk of both of these events occurring is increasing as the US faces a continuing housing meltdown together with rising unemployment. The ongoing question is the extent to which the Canadian and global economies will be impacted.

The financial crisis that is unfolding is more likely to be deflationary than inflationary. Banks, corporations and individuals will become more cautious until their balance sheets are repaired. There is some fear that the large increase in the US government deficit will spark inflation but there are numerous examples that interest rates can fall under these conditions. Japanese rates fell dramatically in the face of massive government deficits and even today their 10 year government bonds yield only 1.5%.
Why we own them – RD

Berkshire Hathaway BRKB – NY

We are revisiting our rationale for holding this company given recent newsworthy actions taken by its Chairman and CEO, Warren Buffet. He is arguably the most successful investor of all time and is especially famous for his truly long term approach. His investing style is value based and while it may appear boring and old fashioned, it has produced a stellar annual growth rate for over 40 years.

Berkshire Hathaway Inc. is a holding company and its subsidiaries are engaged in a number of diverse business activities. The most important of these is insurance, conducted on both a primary basis and a reinsurance basis. Berkshire also owns and operates a number of other businesses engaged in a variety of activities, and holds large stock positions in blue chip companies such as Coke, American Express, Wells Fargo and Proctor & Gamble.

Buffet is known for his patience and discipline and as a result has the ability to skirt short term investment philosophies that often get managers into trouble as they chase the latest ‘must have investment’. His long term investment time horizon allows him to shut out the short term noise that results in panic and emotion driven trading. Over the last few years with limited exceptions, (Anheuser Busch, Mars – Wrigley), he has been building and storing a war chest of cash that has grown to over $40B. Over the last several weeks his company has taken significant positions in both Goldman Sachs (US brokerage firm) and General Electric (US multi-industrial/ financial). That such an astute investor is putting some of his capital to work in this environment is telling on current valuations and the return he expects to generate on his investments over time.

The shares are not inexpensive trading at approximately 22x current earnings, however, the enormous cash stockpile is a significant advantage and the company should be a clear winner in the current environment where cash is king.

Essential Energy Services ESN.U – T

Essential Energy Services is a unit trust that provides well services for oil and gas producers in Western Canada and offers the 6th largest fleet of service rigs in Canada. Approximately 40% of the equipment is related to the drilling of new wells and the other 60% is for the maintenance of existing wells. As a response to the 2011 trust taxation rules the company merged Essential Energy Services Trust and Builders Energy Services Trust in April 2008, cut its distribution to 18 cents annually (from 93 cents) and on July 2, 2008 sold its transport division for $135M. The company is now set to benefit from cost synergies between the two companies, has a payout that is sustainable post the 2011 trust tax and has virtually no debt.

The company will benefit from a lift in natural gas prices but until then it has a pristine balance sheet that gives it the flexibility to stay the course until drilling activity resumes. The stock is trading at levels substantially below its replacement value (valued as recently as April) and the current yield of 10% will be a support until the market recognizes the inherent value embedded in its asset base.

Morgan Stanley MS – NY

Morgan Stanley has a world-class investment banking franchise and is one of the most diversified of all the US investment banks with leading positions in securities, retail brokerage and asset management.

We made our purchase after MS announced Mitsubishi UFJ Financial Group (MUFG) of Japan was purchasing 21%. This additional $9B capital plus the Fed announcement that it would purchase distressed assets from financials reduced the risk substantially. It is expected that MS will use this capital to buy distressed assets or to build a retail deposit base through acquisition. Co-incidentally at the same time Berkshire Hathaway announced a sizeable acquisition in Goldman Sachs, the only other major investment bank left standing.

We made our purchase after MS announced Mitsubishi UFJ Financial Group (MUFG) of Japan was purchasing 21%. This additional $9B capital plus the Fed announcement that it would purchase distressed assets from financials reduced the risk substantially. It is expected that MS will use this capital to buy distressed assets or to build a retail deposit base through acquisition. Co-incidentally at the same time Berkshire Hathaway announced a sizeable acquisition in Goldman Sachs, the only other major investment bank left standing.

October 2008


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