April 23, 2012

First Quarter 2012 Letter


We are pleased to report that for the first quarter of 2012, the weighted average return of our equity portfolios was +6.3% net of all fees, versus +4.4% for the TSX Composite total return (including dividends) and +10.4% for the S&P500 (in $CAD). Since our strategy’s inception in July 2006, we have generated a cumulative return of +82% net of all fees, more than triple the +25.4% for the TSX, and well ahead of the +12.1% return of the S&P500 (in $CAD). Over the past nearly 6 years, this represents a compound annual net return of +11%, compared to +4% for the TSX and +2% for the S&P500 (in $CAD). These results rank us among the top Canadian equity managers in the country. During the first quarter of 2012, our balanced portfolios rose on a weighted average basis between 1.7% and 6.5% depending on fixed income allocations. For more details on our results and strategy.

We are pleased to report that for the first quarter of 2012, the weighted average return of our equity portfolios was +6.3% net of all fees, versus +4.4% for the TSX Composite total return (including dividends) and +10.4% for the S&P500 (in $CAD). Since our strategy’s inception in July 2006, we have generated a cumulative return of +82% net of all fees, more than triple the +25.4% for the TSX, and well ahead of the +12.1% return of the S&P500 (in $CAD). Over the past nearly 6 years, this represents a compound annual net return of +11%, compared to +4% for the TSX and +2% for the S&P500 (in $CAD). These results rank us among the top Canadian equity managers in the country. During the first quarter of 2012, our balanced portfolios rose on a weighted average basis between 1.7% and 6.5% depending on fixed income allocations. For more details on our results and strategy.

While we lagged the TSX during January and February due to our defensive stance, we more than made up for the shortfall in March. We are proud to have generated a positive return of +1.3% during a month when the TSX was down -1.6%, thanks to low weightings in energy and materials, and a plethora of news related to the acquisition of several of our largest holdings. In March, Neo Materials received an offer from Molycorp worth over $12 per share, while Viterra accepted an offer of $16.25 per share from a consortium comprising Glencore, Agrium and Richardson. Also, BCE launched a take-over bid for Astral which boosted the value of Corus, one of our largest media holdings. Finally, shareholders of Provident Energy, another of our top positions, approved Pembina Pipeline’s offer received earlier this year. Our top performers during the quarter include:

  • Neo Materials (+53.1)
  • Viterra (+48)
  • Vicwest (+34.1%)
  • Encanto Potash (+26.4%)
  • FP Newspapers (+23.7%)
  • Provident Energy (+22.2%)
  • Manitoba Telecom (+17.8%)
  • Corus Entertainment (+15.1%)
  • High Liner Foods (+14.8%)
  • and Glacier Media (+14.8%).


We are also pleased to announce that we launched the Lester Canadian Equity Fund in January. During the first quarter of 2012, the Fund was up +6% versus +4.4% for the TSX. The Fund owns the same stocks that are held in our segregated accounts and employs the same successful investment strategy that has generated the returns described above. Smaller accounts will achieve better equity diversification by owning units of the Fund than if managed on a segregated basis. The Fund also allows 3rd parties such as institutions and retail clients of advisors/brokers and financial planners to invest in our strategy. Should you have an interest in the Fund please feel free to call us.


For the first quarter of 2012, the Lester Hedge Fund was up +9.4% net of all fees and expenses, versus +4.4% for the TSX Composite total return. Since inception in April 2007, this fund has produced a cumulative net return of +36.5%, more than 4 times the +8.6% for the TSX Composite. It is managed using alternative strategies not available to most investors, including merger arbitrage, pair trading and short selling, and is a good complement to our core portfolio management expertise.

OUR MACRO VIEW: No Time for Complacency

For the past two years, we have been warning that global macro risks were in fact rising, mainly as a result of the European debt crisis, and that an increasingly defensive posture was justified. This conservative view has and continues to serve our investors well. The biggest developed nations in the world have more debt than ever before and their economies remain weak and vulnerable.  Despite a strong rebound in stock markets from the panic lows of last fall, we believe that now is no time for complacency. Too many macro risks remain, including recessionary conditions, elections and social unrest in Europe, fears of a hard landing in China, a weak economy and government gridlock in the US, and political upheavals in the Middle East and North Africa. This implies that Interest rates will remain near historic lows while the developed world continues its long and painful deleveraging process. So for now, we prefer to err on the side of caution and remain defensive.


Since last December, the European Central Bank (ECB) has showered European banks with EURO 1 trillion (US $1.3 trillion) in order to stave off a financial meltdown. These once infallible institutions, loaded with sovereign bonds which have declined in value, no longer trust one another and are unable to borrow on the interbank market. The ECB’s cheap 3-year loans (known as LTRO or Longer-Term Refinancing Operations) are aimed at helping relieve these banks from their liquidity problems and buying them time to recapitalize. These emergency funds were either immediately put back on deposit with the ECB or used to purchase high yielding sovereign debt (to profit from the huge spreads) instead of being put to good use by lending to deserving corporate borrowers in the real economy. In other words, European banks are in repair mode, deleveraging by shrinking their balance sheets, thereby withdrawing liquidity from the market.  While a European banking crisis has been averted for now, loans to the non-financial sector are contracting, threatening to further slowdown the Eurozone economy which is already in recession.

On March 30, a trillion dollar “firewall” was announced by the 17 finance ministers of the Eurozone in the form of a EURO 800 billion (US $1 trillion) permanent rescue fund called the European Stability Mechanism (ESM), which is to replace the temporary European Financial Stability Facility (EFSF). However, upon close inspection, EURO 300 billion of the total was money that had already been pledged to bail-out Greece, Ireland and Portugal. A further EURO 100 billion is to come from existing special bilateral pledges. So in effect, only EURO 400 billion of the total is “new” money, and even this amount is restricted. Christiane Lagarde, head of the International Monetary Fund (IMF) hailed the announcement as key to getting additional financial support from other G20 countries. However, our own finance minister Jim Flaherty was quick to dismiss the adequacy of the “new” permanent rescue fund and mentioned that Eurozone countries were undeserving of international aid. Canada, like the US, opposes helping European countries by using funds from the IMF which was created to help poorer countries of the world.

Despite this flood of liquidity, the fires still burn. Yields on Spanish and Italian government bonds are rising again to uncomfortable levels (Italy and Spain alone have funding needs of EURO 800 billion over the next 3 years). Concern is mounting about Spain’s inability to control its fiscal deficit for which it recently revised its target upward to 5.8% of GDP without EU permission. Spain’s unemployment rate has now reached a record 23.6%, its debt is soaring despite severe austerity measures and its weak banking system is infected with toxic real estate loans, now estimated at Euro 136 billion (7.6% of all loans are at risk of default up from 1% in 2008). With upcoming elections in France and Greece, and a referendum in Ireland (Irish bail-out funds run out in 2013), the geopolitical landscape in Europe is vulnerable to unexpected and potentially gut-wrenching twists and turns. Growing unemployment (now 10.8% in the Eurozone), the rise of fringe parties and heightening tension among European nations are likely to lead to political instability.

THE US:  Still on Steroids

Weakness in the US continues to take a back seat to the much more serious risks in Europe. Despite encouraging economic statistics, given the amount of steroids the Fed has pumped into the US economy including ultra-low interest rates, two doses of quantitative easing and “Operation Twist”, the patient from the 2008 crash is still limping along. Annual GDP growth is barely above 2%, and the housing market (down 34% since its peak and still saddled with foreclosures and unsold inventory) remains in the doldrums. Much of the decline in the US unemployment rate to 8.3% is due to people dropping out of the work force after having given up looking for a job (real unemployment remains near 12%). Of those that are employed, “real” disposable income (after inflation) has dropped sharply over the past 2 years, a very negative trend for an economy which is 70% domestic consumer driven. Ronald Reagan is the only president to have ever won another term with an unemployment rate over 7%, and so the elections later this year promise to be interesting (remember, as investors, we hate “interesting”).

CANADA: Still in Good Shape

The media has recently been making a big deal about the US equity markets finally outperforming the Canadian markets after a lost decade; however one needs to carefully examine the details. While the US S&P500 was up 12.6% versus 4.4% for the TSX Composite during the first quarter of 2012, a closer look reveals that the difference is not so pronounced. Without Apple (which nearly single handedly lifted the technology sector in the US) and the US banks (which rose on the back of having “passed” a new round of stress tests), the S&P500 would have only risen 5% during the quarter. In Canada, if one excludes the poorly performing resources sector (energy and materials), the TSX would have risen over 5%. Herein lays the danger of associating the performance of an index with all sectors of the economy. In fact many areas of the Canadian stock market performed well such as the Consumer Discretionary (+14%) and Consumer Staples (+7%), two sectors in which we hold large weightings. As we mentioned in our last letter, over 75% of the TSX Composite companies are in the energy, materials and financial sectors, and thus the TSX lacks diversification and is very sensitive to macro-economic news, inadequately reflecting Canada’s other industries and its overall economy. Canada’s healthy employment level, sound finances and stable politics remain a bastion of strength in today’s uncertain world.  Evidence of this is reflected in the fact that foreign investors once again purchased a record amount of Canadian bonds so far in 2012.

CHINA: Fasten Your Seat Belts and Prepare for Landing

There is much debate about whether the slowdown in China will cause a “hard landing” or not. Residential real estate prices have been falling in most mid and large Chinese cities for 4 months now, and are expected to decline by 20% to 30% due to a glut caused by overbuilding. Commercial real estate appears to be facing a similar fate. This is an ominous sign if one compares it to the devastation caused by bursting real estate bubbles in developed economies (think Japan, US and Spain). Also, China recently announced a drop in manufacturing output and the largest trade deficit ever as exports have been slowing. Europe, which represents over 20% of China’s exports, has been the main culprit. Based on the Eurozone’s contracting economies, exports from China are expected to decline further. The last “hard landing” in China occurred in 1989-90 when growth dropped below 4%. China’s recently lowered GDP growth target of 7.5% (its lowest target since 1990) and its desire to refocus growth on a consumer driven domestic economy may be difficult to achieve in light of declining manufacturing (i.e. jobs) and plunging residential real estate prices (i.e. household wealth). Given that China consumes 40% of the world’s industrial metals, 20% of its grain and 11% of its oil, commodities remain a risky investment for now which is why the resource sector has performed so poorly in Canada. Nevertheless, we believe high oil prices are here to stay due to ever rising development costs and protracted tensions in the Middle East and North Africa.

IN SUMMARY: Combining the Macro with the Micro

Our macro views dictate that we continue to hold high dividend yielding defensive stocks, growth companies focused on the domestic economy, oil producers with long life reserves, exposure to gold and plenty of cash. On the fixed income side, we prefer high yield corporate bonds maturing within 10 years, as government and top rated corporate bonds are overvalued. Our micro views (i.e. company specific) continue to focus on using our “home town advantage” to seek out high return opportunities with low risk. On this front, we have had a series of successes lately with several of our core holdings being the subject of take-over offers, providing the ultimate value maximization event for our investors.

Have we been lucky or smart? Nassim Taleb is well known in the world of finance as a cynical, glass half empty polemicist (uber bear) who wrote The Black Swan in 2007, which became a best seller because it seemed to predict the sub-prime crisis the following year.  While The Black Swan is essential reading for students and industry practitioners, we prefer Taleb’s Fooled By Randomness.  The central theme is that investors often confuse luck and skill, not knowing which is responsible for a series of successes.   The first chapter entitled: “If You’re So Rich Why Aren’t You So Smart?” captures that concept well.  As professionals, we ask that question all the time, especially during periods of under or out-performance.  As human beings, we tend to blame under-performance on bad luck, and claim skill for out-performance.

As responsible fiduciaries, we must analyze our results to determine whether luck or skill (or a combination) was at play, so we know whether our strategy is really working or not.  A manager who is consistently under-performing a benchmark should revisit his or her strategy, and/or adjust the portfolio.  If the manager’s thesis is still valid, then one needs to consider if unforeseeable events were responsible for the poor performance.  Poor timing can also be responsible for under-performance.  Investors can be “right” and still lose money if they are too early with their strategy or apply it for too long.  Prior to the sub-prime debacle, many fund managers predicted the US housing collapse, but started shorting housing and mortgage companies too early and lost fortunes before the market  imploded.

When a manager is out-performing, it is just as important to determine why. Macro views can be time tested by reading past investment letters and reports to see if a manager was correctly assessing the market and properly positioned. In addition, individual securities selection is critical since, even if one gets the macro view right, investing in the wrong companies (the micro) can lead to poor performance.  It is the consistency of correctly applying these two factors (macro and micro) that determines a manager’s out-performance and whether he or she is just lucky or smart. Academics have come up with useful statistical analysis to measure the consistency of risk adjusted returns, and we invite those interested in this topic to contact us (of course, we would not mention this if we did not score highly in this area!). Thus investors do have tools for judging the results of their current portfolio manager or when shopping for a new one.  Many make the mistake of looking only at short term results for determining success or failure.

Ken Lester, Stephen Takacsy, Peter Dlouhy

POST SCRIPTUM: Other Company News

Consider what happened to some of my students at McGill a few years ago.  Twelve groups of 5 students each ran $250,000 portfolios of McGill’s endowment fund.  One group put in an order to buy shares of a company but got the symbol wrong and ended up with shares in another company which was taken over at a 100% premium. That group of students made a terrific profit.  Had they bought the stock that they really wanted, they would have lost 10% over the same time period.  As it turned out, this erroneous trade catapulted them into the highest performing group for the year.  However, not only did they not get credit for the undeserved performance, they were actually penalized for the error.