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Third Quarter 2013


Market Review Third Quarter, 2013

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

Third Quarter(% Change in Cdn$)

5.4%

2.4%

10.7%

3.8%

5.7%

6.4%

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

September 2013

0.99%

0.02%

2.54%

2.61%

June 2013

1.03%

0.06%

2.44%

2.49%

Commodities (in US$)

Oil

Natural Gas

Gold

September 2013

102.21

3.56

1329.10

June 2013

96.56

3.57

1223.70

Portfolio Management Strategy

What Worked

– European Stocks

– Forest Products Stocks

– Mining Stocks

What Didn’t

– Real Estate Investment Trusts

– Preferred Shares

– Utilities

Don’t Sell In May and Go Away – NL

Stock markets around the world continued their upward march during the third quarter and this time, Canadian stocks were invited to the party. While their gains remain modest so far this year, Canadian stocks, as measured by the TSX Composite Index, are finally in positive territory. This is in marked contrast, though, to stocks in most other major markets, which are up double digit percentages year-to-date when measured in Canadian dollars. As we noted in last quarter’s Commentary, lackluster commodity markets are almost entirely to blame, although the Federal Government’s attempted interference in Canada’s wireless telecommunications industry hasn’t exactly helped either. During the quarter, commodities did experience some nice gains although it remains to be seen if their strength has any legs. Not exactly ones to just sit back and watch, we have been quite proactive in repositioning our portfolios over the last couple of years to where we now have, in many cases, more of our equity investments outside of Canada than inside Canada, a situation I have never before experienced in my 38 years in the investment industry. It is a trend we expect to continue for the foreseeable future.

Fears of rising interest rates led to poor performance again from interest sensitive stocks such as pipelines, utilities and real estate investment trusts (REITs). These are all stocks that are greatly affected by their yields and investors reset their prices lower to reflect current yield expectations. Also greatly affected were preferred shares and, to a lesser extent, bonds. Preferred shares trade like long-term bonds, so it is understandable that they were once again weak, as long-term interest rates continued to climb for much of the quarter. The DEX Universe Bond index, however, actually rose during the quarter, by 0.11%, as slightly lower short and mid-term interest rates more than made up for higher long-term rates. Our longest maturity, broadly-owned bond, is less than 6 years in length so our bond portfolios are fairly well protected from rising long-term interest rates. As dividend yields on preferred shares are significantly higher than yields on bonds and are taxed at a much lower rate, we have been more reluctant to part with them than we have with our bonds.

Fear of the Federal Reserve (The Fed) beginning to taper (the trendy word in our world these days) their purchase of bonds caused interest rates to shoot up near the end of June, and 10-year U.S. Treasuries actually touched 3% in early September. FYI, taper refers to the Fed easing up slowly on its bond purchases, rather than stopping cold turkey. Since then, they have eased (2.65% at time of writing) as tapering seems to be off the table for now and investors have switched their concerns to the U.S. budget standoff and the fear (at time of writing) of the U.S. defaulting on its debt. We won’t opine on either of these topics but will say that while we think interest rates are ultimately going to continue to trend higher, we believe they have seen their highs for a while and think that the damage done to the above-noted interest sensitive stocks is probably overdone, for now.

“Sell in May and go away” is an oft sighted term used by market timers. It implies that investors should sell some or all of their stocks at the beginning of May and repurchase them at a later date, usually after the end of October. This trading adage is based on studies that show stock markets tend to have higher returns from October to May than they do from May to October. While that is generally true over a period of many, many years, it is also true that most years that adage does not work. As Don Vialoux pointed out in a Globe and Mail article earlier this year, markets gained in far more years in the May to October period than they lost. However, the magnitude of losses in bad years were larger than the gains in good years, hence the quoted data. One need only think of the market crashes in October of 1929 and 1987 to see where the skewing comes from.

If the evidence is so compelling (as proponents allege), why do we not greatly reduce our equity weightings in the spring and replace them in the fall? First, one must be a trader and market timer to follow the adage. I dare anyone reading this Commentary to let me know of anyone they know who successfully trades the market over the long-term. We can all name someone who has done it in the short-term, but I know of no one with a successful long-term trading record, myself included. Second, at time of writing, sell in May and go away has not worked this year, nor did it work last year. Do you know in advance in which years it will work and in which years it won’t? You can miss some great returns by blindly following this rule. Third, how do you know which stocks to sell and which to keep? This year, had you sold them in May to repurchase in November, you would have missed out on fabulous moves by stocks such as Badger Daylighting, International Forest Products, Suncor, BankUnited, Deutsche Telecom and Vodafone, to name a few. Fourth, returns quoted use indices such as the TSX Composite or the S&P 500. What if you are like us and don’t invest like an index? In any given period, our stocks can do much better or worse than an index so we shouldn’t be expected to perform like one and therefore our returns could be totally different than other investors during the May to October periods. Maybe our experience is the opposite? Who knows? More important, who cares? What matters is how we do for our clients over the long-term, not how we do in any given six months. We are long-term investors who like to make money for our clients. If you want to generate lots of commission dollars for your broker, by all means sell in May and go away. If you want to make money for yourself, just ignore the rule.

Price Is What You Pay, Value Is What You Get – FB

I was in a client meeting recently and found myself explaining our investment process to someone who I thought would already know our philosophy. That brings me to the usual quarter end dilemma… what to write about for our Commentary? To that end I thought I’d produce a short summary of how we choose equity investments, so hopefully, everyone is on the same page and understands what we do before we make a purchase or a sale. As a reminder we are a “value” shop meaning our starting point is the premise that a business has a value. It follows that if we can determine that value our buy, sell or hold decision becomes noticeably easier when compared to the price the shares are trading at on the stock exchange.

The first step in the process is looking for a good company. That’s not too difficult as there is a ready supply of those. Especially if the search is not restricted to Canada, which is why we look for potential investments not just in Canada or the U.S. but globally. Finding a good company at an attractive price is another matter and requires an extensive amount of investigation.

The calculation of business value is a somewhat of a black art that varies according to the type of business being investigated. However, all businesses have a current worth; their total assets less any debt or lease obligations and an expected future worth; being the present value of any future profits net of any capital expenditures. Add those two values together, divide by the number of shares outstanding and one arrives at an estimation of a company’s value per share.

No one, least of all a security analyst, has a crystal ball so by definition calculation of contributions to current value from future operations involves estimates, projections and in some cases best guesses. Thus the calculations are fraught with uncertainties and errors and its why most value investors discount future contributions when calculating the value of a company.

Once we have our estimate of a firm’s per share value we then compare that figure with the price as quoted on the stock exchange. If our estimate is a value per share of $20 we will not initiate a purchase unless and until the share price is sufficiently below $20 to provide a margin of safety. That’s a fancy way of saying we won’t purchase until the price is far enough below our estimate of value to cover our backside if our calculations are incorrect or if some future event (a recession for example) reduces the firm’s expected profit stream.

To complicate matters some firms pay dividends, we tend to favour those, and some don’t. Some firm’s operate in an industry that lends itself to stable long term results, utilities and pipelines among others, while some businesses defy even short term estimates. High tech communications fall into the latter category with Blackberry being a well-known example. Some months ago their equipment was all the rage, now, not so much.

It is also important for the investor to remember that a company’s value usually changes slowly over time while the share price in the market can change quickly over short periods. The reason for that divergence is the emotion of the investing public which swings between fear and greed. Predicting those emotional swings is, in my opinion, impossible though many people have tried and will no doubt continue to try in the future to solve that riddle.

I have no idea how I will view the world tomorrow, never mind how the millions of other investors in the Canadian equity markets will feel. So we stick with the old standby, value investing, and do our best to use the emotional swing to our benefit by buying when fear is rampant and selling when greed is in the van.

That brings me to “today”. The headlines have been full of fear recently as top U.S. politicians act like young children holding their breath in the school yard. The predictions in the papers are for doom and gloom unless the deadlock is solved quickly. They sound like Chicken Little to me and with journalists behaving that way it’s no wonder that investors alternate between fear and greed. All the more reason to stay with what we understand and what we can demonstrate has worked in the past. Value Investing for this kid.

October, 2013


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