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Third Quarter 2010


Market Review Third Quarter, 2010

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

Third Quarter (% Change in Cdn$)

9.5

7.5

15.4

3.9

4.8

5.7

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

September 2010

0.88%

0.15%

2.74%

2.51%

June 2010

0.52%

0.17%

3.09%

2.94%

Commodities (in US$)

Oil

Natural Gas

Gold

September 2010

79.97

3.87

1309.60

June 2010

75.63

4.53

1242.00

Portfolio Management Strategy

What Worked

– Mining and Material Stocks

– Euro

– Bonds

What Didn’t

– Japanese Stocks

– U.S. Dollar

– US Financials

Oh Canada! The True North Strong and Free? – NL

With the exception of the Nikkei in Japan, all major world equity markets had a positive quarter, thank you very much. And, if you were a Canadian investor, the unbelievable strength of the Yen turned even the Nikkei positive. Despite the fact that Mark Carney and the Bank of Canada continued to raise administered short-term interest rates on a regular basis, the bond market also had a good quarter as yields on bonds declined to rates not seen since the height of the financial crisis in early 2009. Good news, bad news.

It is highly unusual, but not unheard of, that stocks and bonds go up at the same time. Equity investors like good news as it generally moves stock prices higher and fixed income investors like bad news as it generally moves interest rates lower.

The good news for fixed income investors (bonds and preferred shares), is that investments appreciated to reflect current interest rates. The bad news is why. Interest rates are being driven down for two reasons. The first is that bond investors worry the economy will either remain quite weak or slip into another recession (especially in the US). The second reason is that the US government, which is desperate to get its economy rolling again, is embarking on a second round of Quantitative Easing (commonly referred to in the media as QE2). This means that the Treasury is buying up mortgages and government bonds in order to drive down interest rates on bonds (it can’t do much about the administered Federal Funds rate as it is already effectively zero) with the hope that lower rates will stimulate demand and economic activity. If only it was that easy. According to Capital Economics, the cost of borrowing is not the problem. The problem is that half of all mortgage borrowers don’t qualify to refinance their homes at lower rates because they don’t have enough home equity and businesses are already sitting on stockpiled cash, but are too cautious to hire or invest. They are not borrowing or interested in borrowing. They need a better macroeconomic environment, not lower interest rates.

out of its funk and rekindle the established economies. Also, Quantitative Easing frees up a lot of money that then looks for a new home and equity markets attract a considerable amount of that capital. That is the good news. The bad news is that it is unrealistic to expect that demand from emerging markets will be enough to stimulate economies in the rest of the world. Consider that 70% of GDP in the United States is consumer consumption while in China that number is 35% and that the Chinese economy is a fraction the size of the US economy. And China is by far the largest economy in the developing world.

In the end, the bond market and the stock market cannot both be right. While there historically have been many exceptions, usually the bond market is more prescient than the stock market.

What about Canada? We have been an island of relative tranquillity in a sea of turbulence. Our economy is still very much commodity based and demand for most commodities remains strong. At the same time, a weak US dollar has contributed to rising commodity prices. While our manufacturing base has been decimated in recent years, the service economy has not only held up very well but picked up much of the slack from manufacturing, with the result that our unemployment rate of about 8% is 2% better than in the US and far better than rates in Europe. Consumer spending remains healthy and the housing market has been quite buoyant.

With worldwide economic growth under pressure, no country wants their export competitiveness hurt by seeing their currency appreciate and no country wants its domestic market flooded by what they consider cheap imports from countries that are artificially keeping their currencies undervalued. This has caused massive intervention and government mandated manipulation in many of the world’s currencies. In Canada’s case, strong commodity prices have combined with increased interest rates to draw money into our country. This has caused our dollar to hover just below par with the US dollar. While this may be great for those of you headed south for the winter, having the Canadian dollar overvalued is a huge detriment to economic growth and we are beginning to see the economy falter as a result. Most Canadians are complacent about the level of our dollar but their complacency may be misguided.

In 2003, the Bank of Canada raised interest rates independent of the Federal Reserve as Canada’s economy was faring better than that of the US. It quickly had to recant and reverse the rate hikes as our economy began to falter. Canada’s economy is inextricably linked to that of our southern neighbour and it is foolish to think that we can prosper while it suffers. Mark Carney seems to have forgotten that lesson, raising rates here three times this year as our economy has outperformed the US. In his most recent speech, on September 30 in Windsor, however, he strikes a very different tone from those earlier this year. Carney is now suggesting that the global economic outlook (including emerging markets) may be compromised and that Canada’s economy will be negatively affected by the end of government stimulus. He also notes that our superior employment picture is masked by growth in government and part-time jobs as opposed to full-time jobs in the private sector.

In addition, he worries about Canadian household debt relative to disposable income dangerously nearing levels found in the US at its worst. What he doesn’t address is the desperate shape of government finances: federal and provincial. The combined debt of those two sources will represent 76.4% of Canadian GDP by the end of 2010. Municipal debt takes this percentage even higher. When you look at these all together, we start to look like some of those European countries whose debt you wouldn’t touch with a ten foot pole. Per capita, our federal and provincial debt totals almost $30,000. And it is growing quicky as government spending, especially at the provincial level, remains out of control.

As investors, we hope that Mr. Carney realizes his mistake and not only stops raising short-term rates but reverses himself and starts to lower them again. In order to prevent a housing bubble in Canada, this must be matched with the Federal government tightening lending requirements on mortgages. Governments of all levels must begin to curb their spending. It is unsustainable without raising taxes and voters are showing they are not in the mood for that.

Under this scenario, we will remain prudent and cautious in our investments. While we will emphasize earnings growth and dividends, as Fred points out in his commentary below, we will also be vigilant concerning valuations, as investors chase income and yield in much the same way they chased technology stocks ten years ago and then financial stocks until three years ago. The results are rarely pretty.

Where from here? – FB

Since the markets peaked three years ago in the summer of 2007 the financial crisis has come and, for now, gone. That crisis caused a steep decline in investor confidence and the North American stock market averages hit a bottom in March of 2009. They rallied for a year as it became apparent that the economies of the developed world were not going to fall apart and since March of 2010 the markets have appeared confused. Investors seem to be looking for a new theme, new leadership or something to give them a hint as to the direction of both the economy and thus the markets.

The current situation encompasses low interest rates and stubbornly slow economic growth which appears impervious to government stimulus. We would expect both the market and the economy to continue its recent form; more “toing” and “froing” as the market and investors come to grips with a period of slow growth.

Our ongoing concern is how to profit in this environment. As mentioned in previous commentaries we feel income will be an increasingly important component of investors’ total return as interest rates are low and income is scarce. That theme has already born some fruit as income sensitive investments produced solid returns over the past quarter. We feel that an interesting source of income in the future could well be companies that previously thought of themselves as growth companies and who, as a result, retained most if not all of their profits to fund future expansion. In a slow growth environment, the senior managements of these firms will be challenged to employ the cash stored for future expansion and, assuming management’s egos don’t get in the way, could well decide that the best use of these reserves would be to pay them out to shareholders.

Trotting out that theory several years ago would have been met with derision but recently Cisco, a large US firm that falls into the category of “challenged to employ cash at good rates” and a firm that had not previously paid a dividend, announced on September 14th that they would start dividend payments by year end. Perhaps it’s only one company but we will be searching for similar situations as Cisco could well be the canary in the mine.

As previously mentioned the past three months have been good ones for investors holding income producing assets. Its worth noting that since quarter end we have sold one of our income holdings as not only do we have a large representation in that area but as the “rush to income” has started, its prudent to take some profits and not try to get off at the top. We’ll let others play that game as its rarely successful: see Nortel, autumn 2000.

As always we will continue to look for good investments at fair prices and ones which pay, or can be reasonably expected to pay, a good income.

Why we added/sold – RD
Added
Goldcorp (G – TSX)

Goldcorp is one of Canada’s largest and fastest growing senior gold producers. Our unease with the current macro-economic backdrop found us adding to our gold exposure when the price of gold pulled back in mid-summer. Concern over paper currencies and global debt levels combined with anaemic growth in the developed world led us to seek additional portfolio insurance in the form of gold. If governments manage their economies and fiscal burdens successfully then this insurance is not likely needed. However, we think it prudent not to count on this. We chose Goldcorp specifically as it has low cost gold production in safe jurisdictions in the Americas and it has above average growth making it more than just a play on investor guesstimates of how high gold prices can go. Subsequent to our purchase, Goldcorp added to its gold production pipeline by buying Andean Resources, a miner with an exploration focus in Argentina.

Covidien (COV – NYSE)

Covidien is a medical device company that was spun out of Tyco in 2007. It has 3 Divisions: Medical Devices, Pharmaceuticals and Medical Supplies. The company has global reach with 40% of sales outside the US and strong free cash flow generation with $1.6B expected/year. In the last 3 years COV has reinvented itself through significant acquisitions and divestitures. Its largest division is Medical Devices, where it supplies a wide array of instruments used in operating room procedures. Earnings estimates for 2010 and 2011 have declined, for reasons stated below, causing the stock to drop over 20% since January. At 10.5X lowered 2011 earnings and a 9% FCF yield it became compelling from a risk reward standpoint.

Negatively impacting the shares this year has been significant earnings dilution from its portfolio shifts, unexpectedly rapid price and volume declines in its generic pain medication business, lower shipments of acetaminophen due to Johnson and Johnson’s Tylenol problems, nuclear reactor shutdowns (radiopharmaceutical and contrast agents) and an overall decline in medical procedures due to the economic recession and high unemployment. The positives as we see them now are that the portfolio restructuring is now largely complete so no further dilution is to be expected. Nuclear reactors are back up and running. The Tylenol situation is not expected to worsen and will ultimately resolve itself and lastly, and most importantly, is that the vast majority of medical procedures cannot be postponed forever.

Covidien is a medical device company that was spun out of Tyco in 2007. It has 3 Divisions: Medical Devices, Pharmaceuticals and Medical Supplies. The company has global reach with 40% of sales outside the US and strong free cash flow generation with $1.6B expected/year. In the last 3 years COV has reinvented itself through significant acquisitions and divestitures. Its largest division is Medical Devices, where it supplies a wide array of instruments used in operating room procedures. Earnings estimates for 2010 and 2011 have declined, for reasons stated below, causing the stock to drop over 20% since January. At 10.5X lowered 2011 earnings and a 9% FCF yield it became compelling from a risk reward standpoint.

Sold
Volkswagen (VOW3.DE – XETRA)

Volkswagen is a solid name within the auto industry. We purchased this stock in the 1st quarter of this year as we felt its stock price was overly depressed from an upcoming financing to purchase Porsche and did not reflect its strong position in China. This is a volatile market environment and the stock quickly rose to levels where investors were not discounting risk from the company’s many moving parts. While the stock is prized for its exposure to fast growing emerging markets, it is still in the process of acquiring Porsche and has a desire to add more names to its stable of brands. With the stock up close to 50% in a very short period of time, we felt it prudent to lock in these gains as the risks of being invested in this cyclical auto maker were no longer embedded in the stock price.
July 2010

October 2010


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