Third Quarter 2012

Market Review Third Quarter, 2012

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 2012





June 2012





Commodities (in US$)


Natural Gas


September 2012




June 2012




Portfolio Management Strategy

What Worked

– Gold

– German Stocks

– Oil Service Stocks

What Didn’t

– Chinese Stocks

– Coal Stocks

– Japanese Stocks

The Only Thing We Have To Fear is… Fear Itself – NL

Equities continue to be macro-economically driven and pushed upward post European Central Bank (ECB) President Mario Draghi’s announcement. This brought troubled European bond yields back from the brink of disaster. While commodity shares, such as energy and precious metals enjoyed particularly strong results, so did European stocks, led by Germany, and Asia/Pacific shares, excluding China & Japan. Laggards were defensive stocks such as utilities, along with bonds and preferred shares. This was a turnaround from the first six months of the year when defensive stocks ruled the day and investors fled European and commodity stocks and bond yields were driven to all-time lows. A weak U.S. dollar and a strong Canadian dollar and Euro helped shape the results for the quarter.

Canadian investors can relate to a strong dollar as major commodities such as oil, natural gas, and gold strengthened during the quarter. As much as we like to think our economy is diversified, the world still views us (probably correctly) as hewers of wood and drawers of water. A weak U.S. dollar? Yes, investors can understand that as America’s debt spirals out of control and its politicians (both sides are equally guilty) watch the country dance towards a fiscal cliff at the end of the year, putting bull-headed partisan politics ahead of sensible compromise. But a strong Euro? Who in their right mind would have thought that the Euro would emerge as one of the strongest currencies during the quarter? Isn’t Greece about to default on its debts and leave the European Union (EU)? Isn’t Spain going to follow closely behind?

In his first inaugural address in March of 1933, at the height of the Great Depression, Franklin Delano Roosevelt stated: “…let me assert my firm belief that the only thing we have to fear is…fear itself — nameless, unreasoning, unjustified terror, which paralyzes needed efforts to convert retreat into advance.”

Since the market bottom in March 2009, individual American investors (for whom the most accurate statistics are available) have, according to the Wall Street Journal, poured almost U.S.$1 trillion into U.S. bond funds while redeeming a net U.S.$138 billion from equity funds. If one were to add in the amounts moved by investors who invest directly and not in mutual funds or Exchange Traded Funds, the numbers would balloon. Fear dominates the psyche of the individual investor. During that time period, the yield on 10-year U.S. Treasuries has declined from 2.1% to the current 1.6%. A pretty good total rate of return if you sold the bonds and pocketed the capital gain along with the very modest interest paid. Individual investors, however, don’t trade bonds or funds. They keep their money in those funds or hold the individual bonds until they mature. In that case, they are sleeping well but earning a paltry 2.1%, below the rate of inflation and well below a rate of return that is needed to retire or live off. One wonders why they sleep so well.

Investors, who chose to buy or stick with equities since they bottomed, have more than doubled their money in that same time period. In addition, they have collected dividends throughout that period, currently about 2% on the S&P 500, higher than what bonds currently yield! And those dividends will continue to grow while bond interest payments remain the same until maturity.

While I have an actual crystal ball on my desk, it remains (as it usually does) foggy, as predicting the future is impossible. However, we manage our clients’ assets on a very conservative basis, buying equities with strong balance sheets and good earnings futures, at what we consider to be attractive valuations. We also favour companies with good dividend yields. Our portfolios remain defensive in the companies and industries in which we are currently invested. When we think times are good, we reduce the cash in the portfolio and become fully invested. When we think things could be iffy, we increase the cash (we were as high as 35% in 2008) and guard our clients’ assets. Currently, we believe the equities markets have had a good run and could see some profit taking. Nothing goes straight up. That is what we have the cash for – to take advantage of opportunities.

At present, we believe the strongest sign that the U.S. economy is better than many pundits (and the press) predict is the state of the housing market. While not robust, there is finally activity going on. In many cities, prices seem to have bottomed and even increased, sales have picked up, and new homes are finally being built. Lumber prices (an excellent barometer of housing health) are up substantially from their bottom. We believe that politicians in the U.S. will come to their senses to avoid falling over a cliff. Some sort of sanity will prevail. Canada will benefit from an improving U.S. economy, especially one led by the housing sector. While we have uncertainty due to the futures of the Keystone XL and Northern Gateway pipelines, as well as the election of an anti-business, tax and spend government in Quebec, Canada remains an attractive country in which to invest. As for Europe, we believe their economy will be in the doldrums for some time but that sanity there too will prevail and prevent the worst case scenarios from occurring.

Rising interest rates are the inevitable result of improving economies. They are also the enemy of bonds. Bond prices fall as interest rates rise. Bad news if you plan to sell bonds before they mature or redeem your bond funds as rates increase. If you hold your bonds until maturity you don’t lose any capital but you are left holding an investment with a paltry yield for many years. Me, I prefer to hold some bonds for the guaranteed income but the majority of my money is in equities. Generally, rising interest rates, while bad for bonds, are good for stocks. They mean that the economy is doing better and therefore corporate profits are increasing. One notable exception is when interest rates rise due to credit risk issues, e.g. Greece and Spain. Rising corporate profits eventually translate into higher stock prices. Not a straight line, for sure. Not without risk. We are over twelve years into a volatile but largely flat market since the tech bubble peaked in 2000. Much closer to the end than the beginning. If you are fearful and you want risk free – stick with bonds. A great investment strategy in 1981 when bonds yielded in the high teens. At current rates, you will be a loser in the long run.

Green Shoots, Burnt Grass & Cry Me A River – DS

Recessions are tough, mentally tough. The constant negative noise coming from market analysts, CNBC or the other talking heads on the business channels, make an appreciation of what’s really happening in the economy very, very difficult. However, if you step back and take a value approach, the noise is less relevant and the fundamentals become the key focus.

Looking at the U.S., I continue to see many positive signs or so-called Green Shoots. The fundamentals are improving! The unemployment rate is improving and has fallen to 7.8%. In some pockets of the U.S., notably economically hard hit areas like Arizona and parts of Florida, outbreaks of real estate bidding wars are occurring. Imagine that! Housing starts are up, which is a positive sign for the construction industry, hardware retailers, forestry and material companies and for banks that provide the mortgages. Best of all, the large tracts of Shale Gas discovered in places like the Marcellus Shale in Pennsylvania and the Eagle Ford Shale in Texas should eventually lead to energy sustainability and a net energy export status for the U.S. On balance, it is difficult to be overly negative (a view which is at odds with the conventional press) about the U.S. when a housing recovery will eventually strengthen city and municipal tax takes, continued declining unemployment will be positive for consumption and net energy exports mean the outlook for the U.S. balance of payments is not nearly as dire as media pundits suggest.

Europe, on the other hand, continues to be the proverbial Greek Tragedy or perhaps a Burnt Grass analogy is appropriate. Fiscal brinkmanship continues to dominate and during the quarter we saw the future of Eurozone and the future of the Euro (the region’s currency) hinge on a single German lower court ruling in respect of inflation. Greece is now in the midst of asking (think negotiating) for more money, Spain continues to teeter on the edge with its banking system surely broken, unemployment is rising both in the Eurozone and across the European periphery, business confidence is at very low levels and the Euro has fallen substantially relative to most global currencies since the beginning of the year.

The outlook for China was best summed up by a friend of mine who previously worked for Teachers Pension Plan here in Toronto but now works for CITIC, the Goldman Sachs of China. “True, China’s GDP is not growing at 10% any more but Cry Me A River…. it’s still going to grow at 6%”. From a practical perspective, this means China will still grow its GDP 8% faster than the Eurozone (economists currently forecast a GDP decline of 2% for the next couple of years) and 3x faster than the 2% growth estimates for the U.S. economy. Companies with exposure to China and the broader Emerging Markets (“EM”) will continue to benefit from the out-sized growth rates of their host countries.

Combining the fundamentals mentioned above into a cohesive world view is difficult and challenging. The U.S., which is now on a secular energy growth path, is making slow but steady progress out of recession. Consequently, over a longer term timeframe, the U.S. should be a positive place to invest. In the near term, the fourth quarter will likely be buffeted by market volatility surrounding the election cycle. The post-election hubris could likely see a rally into the second quarter with more sanity returning sometime thereafter.

In Europe, while the fundamentals are deteriorating, the recent lower German court ruling on continued European Central Bank financial support for the Eurozone region was critical if not a pivotal moment for the monetary union. It was the “come to Jesus moment” for the Germans. George Soros, a well-regarded, billionaire, global fund manager, when commenting on macro uncertainty in Europe, recently noted that Germany needed to either take a more active role in the Eurozone and be prepared to lead the region going forward or it should leave the economic union and move forward on its own. While it may be still too early to tell definitely, the Germans through the supportive decision handed down by the lower German court, appear to have taken Soros’ first suggestion. Consequently, we should expect continued financial support for the regions weaker economies (moaning and grumbling from Germany will continue), a higher level of inflation, possibly the departure of Greece, and a gradual reduction in European debt and equity market volatility. The region should now move orderly through a recessionary phase and, in three to four years, will emerge in a stronger, more secure financial position. Given this backdrop, the flight to quality that has driven up German, Swiss and Nordic equities should subside or weaken and lower equity prices across the region should develop. Deploying capital, post an equity price correction should be good for our clients over a three to five year timeframe.

Like the U.S., the macroeconomic picture for China and the broader EM is fine. China and most large EM generally have good balance sheets, will continue to grow over the next five years and growing real incomes will lead to higher levels of consumption. However, growth is not a linear, uninterrupted line and bumps along the growth curve should be expected. China elects senior members of its legislative executive for a ten-year tenure in the fourth quarter of 2012. Junior executives, who will serve five-year terms, were cycled in the early part of the year. I don’t expect China’s new government ministers will depart from the export driven growth strategy, which was successfully employed first by Japan and then later with similar effect by Taiwan, Singapore, Korea and Hong Kong. However, now with greater financial reserves, higher GDP per capita than in prior government changes and a widening economic disparity between the rich and poor, the introduction of universal healthcare, pension schemes and programs designed to deliver affordable housing will likely change the nature of the goods and services the developed world sells China. Drug companies, tourism operators, and aircrafts manufacturers are a few examples of industries that will likely be positively impacted by China’s continued modernization. So, for the foreseeable future, EM will remain a profitable destination for investment.

With the above in mind, I would like to remind our clients we like to invest in Green Shoots. We are still waiting forBurnt Grass valuations to fully reflect the underlying fundamental realities before committing more capital to Europe. We will not Cry A River over the slowdown in China and the other large EM as these nations will continue to achieve growth rates substantially above the pace of economic growth achieved by developed economies. Continued exposure to these fast growing economies is therefore desirable from an investment perspective.

Waiting to “cash out” – FB

I recently read an interesting piece on Warren Buffet and his thoughts on holding cash. As most of you know, our cash holding has been higher than normal for a while as, in short, we have not found enough compelling purchase ideas. The article, which is reprinted below with the permission of the Globe and Mail, reinforces the thought that the market doesn’t care if you have cash to spend or not. The market will do its thing regardless of your position and it’s the investors’ job to make a purchase only when the odds are in his favour. By my translation that means when the purchase price of the investment is low enough such that the potential future return at least matches and hopefully outweighs the risks involved. We will happily “cash out” our reserves when our research uncovers attractive opportunities. Until then we will wait patiently on the sidelines.

On an administrative note we have a new client services manager, Carol Williams (ext. 3501) who is now handling all day to day client inquiries. If you haven’t already met or spoken to Carol please introduce yourself on your next visit to the office or your next phone call.

September 24, 2012

For Warren Buffett, the cash option is priceless


The Oracle of Omaha’s company has $41-billion sitting around earning negligible interest. But his method of investing does not make this a waste of funds.

If holding cash in your portfolio for little return is driving you crazy, maybe it’s time to look at it the way Warren Buffett does.

Mr. Buffett, the world’s most successful (and richest) value investor, is sitting on almost $41-billion (U.S.) of cash at his Berkshire Hathaway holding company, the most in a year. Partly, that heap of greenbacks is a safety blanket. But it’s something more. As with most matters Buffett, the strategy is more complicated than it looks, Alice Schroeder says.

She should know. The former Wall Street analyst may know more about Mr. Buffett than anyone outside his family and inner circle: She spent more than 2,000 hours with him while writing The Snowball: Warren Buffett and the Business of Life.

Ms. Schroeder argues that to Mr. Buffett, cash is not just an asset class that is returning next to nothing. It is a call option that can be priced. When he thinks that option is cheap, relative to the ability of cash to buy assets, he is willing to put up with super-low interest rates, said Ms. Schroeder, who followed Mr. Buffett for years before she became his biographer.

“He thinks of cash differently than conventional investors,” Ms. Schroeder says. “This is one of the most important things I learned from him: the optionality of cash. He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.”

It is a pretty fundamental insight. Because once an investor looks at cash as an option – in essence, the price of being able to scoop up a bargain when it becomes available – it is less tempting to be bothered by the fact that in the short term, it earns almost nothing.

Suddenly, an investor’s asset allocation decisions are not simply between earning nothing in cash and earning something in bonds or stocks. The key question becomes: How much can the cash earn if I have it when I need it to buy other assets that are cheap, versus the upfront cost of holding it?

“There’s a perception that Buffett just likes cash and lets cash build up, but that optionality is actually pretty mathematically based, even if he does the math in his head, which he almost always does,” Ms. Schroeder said last week in Toronto, drawing on knowledge gained during the five years she spent working on The Snowball.

Much of that time was spent on the couch in his office in Omaha, Neb., where she said nothing much happens but a lot of reading and thinking. In that time, and the hours spent digging through his files, she said she discovered that while Mr. Buffett likes to speak in folksy aphorisms, in fact, his investing is very complicated.

For someone driven by a quest to find things that are undervalued, as Mr. Buffett is, knowing the price of cash as a call option is the key. The “call premium” on the cash option is essentially the opportunity cost. It is the difference between what he can earn somewhere else and the nil return on holding cash, said Ms. Schroeder, addressing the crowd at the annual Investment Industry Association of Canada conference, after which she sat down for a Canadian exclusive interview.

“There are times when he feels like that option premium is really cheap, compared to the intrinsic value of the option itself,” she says.

The option theory of cash is something Mr. Buffett does not tend to get into when he is up on stage at his annual investor meeting, dishing out his homespun take on life and investing. That’s probably because Mr. Buffett views himself as a teacher, and he wants to reach a broad audience, she says.

“Generally speaking, he likes to keep concepts simple,” Ms. Schroeder says. “He says, ‘I like to have all that cash around because you can use it.'”

However, it is a lesson that Ms. Schroeder said she wishes more people would learn. For many investors, there is a sense that holding cash is a cop-out. Investors who see their fund managers holding a lot of cash tend to think that they are not getting their money’s worth, which is wrong, she says.

“If investors would realize that what they are paying for is someone to have the expertise to know when to buy a call option called cash, and move in and out of that, then perhaps there might be more value placed on that service.”

The Globe and Mail, Inc.

Reprinted from The Globe and Mail, in the “Streetwise” section.

September 2012

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