Third Quarter 2011

Market Review Third Quarter, 2011

Equity Markets

S&P/TSX Composite

S&P 500


MSCI/Far East

TSX Energy

TSX Financials

Third 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

September 2011





June 2011





Commodities (in US$)


Natural Gas


September 2011




June 2011




Portfolio Management Strategy

What Worked

– Telecom Stocks and Utilities

– Bonds and Preferred Shares

– Gold

What Didn’t

– Small Cap Stocks

– European Stocks

– Energy Stocks

A Bandage Instead of an Amputation – NL

Stock markets around the world, led by the most economically sensitive stocks, were in broad decline during the third quarter although Canadian investors in non-Canadian stocks were somewhat cushioned by the drop in the value of the Canadian dollar versus major world currencies. In addition, fixed income investors (both bond and preferred shares) made out like bandits as interest rates in Canada and the US collapsed to record lows during the quarter, sending the value of government and high quality corporate bonds and preferred shares higher. Investors in utilities, pipelines, and telecom stocks also did well in recent months. Many have been the times when clients and prospective clients have questioned the value of owning fixed income securities when interest rates have been perceived to have been low. They now have their answer. Equities and interest rates usually mirror each other. That which makes stocks go up, usually causes interest rates to rise and fixed income values to decline, and vice versa.

As we noted in the second quarter Commentary, the majority of so-called “experts” have been calling for higher interest rates and higher inflation, totally ignoring the fact that world economies are fragile and that it is difficult or impossible for interest rates to go up when economies are going down. Just ask The European Central Bank (ECB). It chose to raise rates as recently as July 13 of this year, even as its weakest members were falling off economic cliffs, all in the name of preventing inflation in Germany and France. While I fully understand the Golden Rule of “he who has the gold makes the rules”, common sense must prevail at some point.

The major problem in Europe is denial. While the European Union (EU) was a great idea on paper, it just doesn’t work in reality. There are 17 countries in the European Union. Any new policy must be passed by all 17 or nothing happens. Government by committee. As in the corporate sector, it does not work. EU officials continue to fool themselves that their band aid solutions will hold the EU together when the truth is amputation of the weak countries is really needed. While there is no mechanism for a country to leave the EU, one must be found or created. Greece will default. It is a matter of when, not if. The other PIIGS (Portugal, Italy, Ireland, Greece, and Spain) are also at risk. Hampered by the inability to set their own monetary policy or devalue their own currencies, these countries have been set up to fail. And when they fail, as we pointed out in our last Commentary, major European banks will fail and/or need to be recapitalized. That is the main worry of the EU. The banks, not the countries. Dexia of Belgium is the first major casualty. More will follow.

Ouch! Who Knew Debt Repayment Could Be So Painful? – FB

The three months ended September 30 are an excellent example of what can happen in an environment where the man on the street has shifted his priorities from asset accumulation to debt repayment. Since the summer of 2007 when the US housing market finally rolled over, the North American consumer has tried to move steadily away from financial risk, primarily by restricting spending, and the result has been a slow growth economy that has resisted any and all government stimulus attempts.

Not surprising then, as the summer of 2011 progressed and the effects of Quantitative Easing 2 (being the most recent economic stimulation effort in the USA) wore off, the economy showed signs of weakness and the capital markets which were already spooked by the Euro debt problems reacted negatively. Going forward I would expect that the North American economy will remain in a slow growth mode until consumers payoff enough debt such that they feel confident enough to move their spending back towards historic norms. The result will most likely be minimal economic growth, and continued volatile equity markets.

The market’s recent violent swings – its volatility – would appear to stem from a combination of highly levered hedge funds trying to anticipate short term changes in market sentiment and longer term investors realizing that the mature economies of Europe and North America are headed for a period of slow (at best) economic growth. It seems as if many current market participants have forgotten that Rome wasn’t built in a day – that the debt repayment necessary to loosen the consumer’s tight grip on his wallet won’t happen in the next thirty days. By way of example, as I write this piece one of this morning’s headlines is “Foreclosures continue to plague housing market”. If the health of the US housing market is indeed the driver of consumer spending then that headline underlines that time is needed before housing prices hit bottom.

We would expect to keep emphasizing investments which offer safety and capital preservation along with an attractive income. We have been, and will continue, to sell – those investments which aren’t performing well and those investments that would appear to be disadvantaged by changes in the economic outlook. We will continue to employ capital in investments that offer attractive income, stability, and in the long term can best be expected to provide a return of capital as well as a return on capital.

One of our primary objectives is to best match client risk tolerance with appropriate portfolio risk – so if recent market events have caused you some angst and or you’d like to discuss your risk profile in light of recent and possible future volatility please do not hesitate to call our office and speak directly with your portfolio manager.

Volatility, Valuations and Risk – RD

Taken from recent press headlines – ‘stocks soar the most in 3 years on expectations Europe will manage its debt trouble’ and ‘ stocks plunge on fears of Greek default and contagion’. As you may have noticed these two types of duelling headlines have permeated the market since the end of July. The interday and even intraday volatility has been nonsensical for the most part. Unfortunately, no matter what sentiment the daily headline has engendered, the fact is that there is no quick fix for what ails the European and US economies. Debt is an insidious foe. The remedy is a painful and slow deleveraging process. However, we are executing on a plan of action.

Risk to the system is clearly high. Seventeen European countries managing by committee is simply ‘too many cooks in the kitchen’. It is difficult enough for my family of three to agree and we clearly have much lesser issues of state. Assuming some agreement is forged in Europe, execution is likely to be messy and drawn out.

So back to managing money in this environment. We have companies on a watch list. This watch list is comprised of companies we would love to own but can’t justify the current valuation. Great companies often have lofty valuations that present difficult buying decisions for a value manger. In good times these stocks continue to do well but in questionable times, like now, they typically fall further given they have been more expensive. We have taken the opportunity provided in the last quarter to add three of these high quality companies, what we would call keepers. Companies we plan to hold for the long run. The opportunity presented itself because the near term outlook is so fraught with risk. However, 5 years from now these franchises will continue to be sound.

No worries. Well actually we worry, a lot. But that is our job. We worry when the markets run up (too expensive) and we worry on the way down. The difference is the valuations are significantly more attractive now than at the beginning of the year.

Why we added/sold – RD/DS

For most of the last decade, Cisco has been a high conviction, go-to investment for growth investors. However, the company and the industry it serves have matured and Cisco is no longer a high growth company. The corporate culture has changed in response to changes in its industry and Cisco has now become more shareholder-friendly i.e. more share buybacks and the introduction of a small dividend. Over time, the dividend will likely grow and share buy backs (given the large cash reserves) should continue. A change of CEO is a high probability, as the growth-oriented John Chambers is likely no longer appropriate. While we applaud management’s efforts to transform the company and its culture, given the continued macro economic weakness, we now expect the transformation will take significantly longer than we initially expected. We also believe the next three to five years will be difficult for investors, as management’s efforts to rectify its problems through right-sizing and business optimization will likely result in the shedding of underperforming assets, exiting low growth markets and a deeper penetration into the company’s core networking market. Given the changes outlined above, the company’s shareholder base will likely transition from growth oriented to dividend-focused investors and the stock should continue selling off.

Vale SA – VALE (NYSE) (appears on statements as it was sold at quarter-end)

Vale performed strongly in the last five years due largely to the commodity boom that has supported the urbanization and modernization initiatives of China and other leading emerging market countries. However, China has officially lowered its long term GDP growth target from the 10% range it maintained over the last 20 years to a more moderate 7% – 8%. The government has also tightened the lending limits on its banks in an attempt to lower inflation to a more manageable level. While the fiscal and monetary policy cocktails currently being applied by Brazil, Russia, India and China to slow inflation and cool their overheated economies will eventually work, the near term consequences for the commodity sector is not good. Vale and its large-cap peers will most likely experience a slowdown in growth rates due to a fall in demand. Consequentially, we expect Vale and its peers to either sell off further or for the stock to trade in a fairly narrow band over the next couple of years. Once valuations for commodity companies fall back to value-oriented levels we will likely re-invest in the sector. Based on current information, we would not re-invest in Vale as the Brazilian government is now interfering in the company and if we chose to invest in a large miner we would probably look to the likes of BHP, Rio Tinto, Xstrata or Glencore.

Teva – TEVA (NYSE)

Following the sale of half of our Teva holdings in the 4th quarter of 2009 we have now exited the position entirely. Copaxone, its multiple sclerosis (MS) drug, represents about 35% of Teva’s profits (2014 patent expiry). Initially we were concerned about an alternative medical procedure to treat MS. Now, however, we do not want to be exposed to these shares ahead of clinical trial results from a newly developed drug manufactured by Biogen, a competitor in the MS space. We expect positive results from Biogen will pressure Teva’s stock price as this new drug has the potential to take market share away from Copaxone. Unfortunately Teva’s own follow-on compound to Copaxone appears inferior to Biogen’s. The company has been active on the acquisition front in order to offset earnings from Copaxone but we will sit this one out until the competitive playing field in MS gains clarity.

ThomsonReuters – TRI (TSX) (appears on statements as it was sold at quarter-end)

We purchased TRI in 2008 as we felt the earnings would hold up in an uncertain environment given cost synergies with Reuters. That indeed played out in 2009, with earnings flat over 2008. However, now the financial services horror show is being replayed in Europe with asset sales and rising headcount reductions not boding well for the company’s business trends. TRI is selling off its health care business and the replacement for this earnings stream has yet to be determined and this time around the lion’s share of cost synergies from the Reuters acquisition has been realized. Thus, without a boost in business fundamentals, the stock is likely to be a range bound and hence the decision to exit this investment.

Taiwan Semiconductor Manufacturing Co. Limited – TSM (NYSE)

TSM is the leading semiconductor contract manufacturer by market share, size (10x closest rival), profitability, research budget and technology leadership. The company has a strong balance sheet and negligible debt. Other positives include a two-year technology leadership which positions the company for a dominant market share of the semiconductor chips used in high margin communication products and smart phones. The company sells into a broad group of markets, has a diverse client portfolio, will benefit from a recovery of the automotive industry and continued growth of large-cap industrial companies like General Electric and ABB Limited, which are also in our portfolio. The company recently expanded into China and should experience lower labour costs and reduced non operating expenses such as rent, water and electricity moving forward. TSM has a 4.4% dividend yield.

Kone Corporation – KNEBV (OMX Helsinki)

Kone is the fourth largest elevator company in the world. The company has been controlled by the Herlin family since 1928 and is managed for long term growth by Anti Herlin, (current Chairman of the Board). Kone is leveraged to China and recently invested additional capital to gain control over its Chinese subsidiary. The emerging markets are typically driving double digit growth for the company. Due to the regulated regimes surrounding elevators, Kone’s installed base of elevators produce a highly predictable, recurring services revenue stream. Consequently, the company is an active acquirer of elevator servicing companies in the America’s, Europe and Asia as these companies typically control the maintenance contracts and will typically get the first call on elevator refurbishments. Kone has a strong balance sheet and has a 2.4% dividend yield.

Pall Corp – PLL (NYSE)

Pall Corp is in an attractive industry with a good runway for growth. After the stock dropped by over 20% from its yearly, high we initiated a position. It is the largest pure-play filtration company remaining in the public arena. As the world heightens its quest for pure water, Pall is well positioned to benefit from its high-profit replaceable filter business. As water supplies tighten and governments impose more onerous requirements concerning the treatment and disposal of water, filtration systems and procedures gain more importance in the processing of water. Pall creates a high-value-added component to filtration systems and helps industrial end users lower operating costs. Similarly, it has helped health-care facilities lower the risk of diseases contracted while patients are in the hospital. Filtration products have high switching costs so customers are sticky, albeit still economically sensitive. Pall is well diversified with 69% sales outside the US and the company serves a variety of end markets. It has high returns on capital and a strong balance sheet. The shares yield 1.5%.

September 2011

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