April 15, 2013

First Quarter 2013 Letter


We are happy to report that for the first quarter of 2013, the weighted average return of our equity portfolios was +6% net of all fees versus +3.3% for the TSX Composite total return (including dividends) and +12.8% for the S&P500 (in $CAD). Our balanced portfolios rose on a weighted average basis between +1.4% and +5.5% depending on fixed income and equity allocations. During the first quarter, strong returns were generated by a diverse group of companies including new positions initiated during the past year such as:

  • Redknee Solutions (+62.5%),
  • CCL Industries (+39.3%),
  • Boralex (+16.1%),
  • Maxim Power (+14.8%) and
  • High Liner Foods (+12.9%), as well as long time holdings such as
  • Guardian Capital (+28.6%),
  • MTY Food Group (+20.7%),
  • TVA Group (+16.2%),
  • FP Newspapers (+13.3%) and
  • Pembina Pipeline (+12.8%).

Our high weightings in the Canadian telecom and media sectors, and our low weightings in the energy and materials sectors, contributed to our outperformance versus the TSX.


During the first quarter of 2013, the Fund was up +6.1% net of all fees and expenses versus +3.3% for the TSX. The Fund owns the same stocks held in our segregated accounts and employs the same successful investment strategy implemented in July 2006. Since then, we have earned a cumulative net return of +112.3%, more than triple the +33% return of the TSX and the +33.8% of the S&P500 (in $CAD). This represents a compound annual net return of +11.8% versus +4.3% for the TSX and +4.4% for the S&P500 (in $CAD). These results rank us among the top Canadian equity managers in the country over the period.


For the first quarter of 2013, the Lester Hedge Fund was down -2.1% net of all fees and expenses versus +3.3% for the TSX Composite total return. Since inception in April 2007, this fund has produced a cumulative net return of +30.6%, twice the +15.2% for the TSX Composite. It is managed using alternative strategies not available to most investors, including merger arbitrage, pair trading and short selling.

OUR MACRO VIEW: Where No Man Has Gone Before

World GDP growth continues to be anemic and so global monetary expansion continues unabated. From the European Central Bank (ECB) pledging to do “whatever it takes”, the recent statement by the Bank of Japan (BOJ) to do “everything possible” and the Fed’s commitment to extend quantitative easing into “the indefinite future”, one would think that central bankers were running out of rhetoric and deflation fighting ammunition. It appears that, since adding US$8.5 trillion in liquidity as of 2007, governments are increasingly “pushing on a string”, and unwinding the debt super-cycle still has a long way to go. For these reasons, we don’t see inflation or interest rates rising anytime soon, and thus remain cautious while we continue to ride the tsunami of liquidity flooding capital markets which has helped prop-up financial assets such as stocks, bonds and real estate. However, the lingering question remains about how this will end. There will most certainly be unintended consequences from this massive reflation effort that has never before been tried on such a massive and worldwide scale.

EUROZONE: From Cyprus with Love

Just as the debt crisis seemed to be calming down in Europe, it reared its ugly head once again. Three years ago it was Ireland and Portugal. Two years ago it was Greece. Last year it was Spain. And now, it’s Cyprus, a Mediterranean island nation of less than one million people. Once again, the folly of bankers has caused a country’s economy to collapse and billions more in European taxpayers money to be directed towards bailing-out a profligate land far away (the latest rumor is that Slovenia is next).

Since joining the EURO-zone, Cyprus has tried to build an off-shore banking center through secrecy laws (mainly attracting Russian tax evaders) and offering higher rates on deposits which were foolishly invested in higher yielding Greek debt. It was a “Cypri-idiotic” strategy indeed. As Greek sovereign bonds plunged in value and Greek banks teetered, so were Cypriot banks bound to crumble. And so now the Troika (EU, ECB and IMF), the 3 horsemen of the apocalypse, have descended onto the island with a 10 billion EURO rescue package conditional on Cypriot banks imposing a levy of at least 40% on depositors (on deposits over 100,000 EUROs) in order to raise another 13 billion EUROs! This has necessitated the government to impose capital controls to stem the tide of funds being withdrawn from local banks, which has led to the notion that not all EUROs are equal (i.e. in Cyprus they are worth less since one can’t access them freely).

Let this be a lesson learned by nations that have created highly leveraged banking systems built on secrecy laws and poor lending practices. Who’s next: Luxemburg, Malta, Austria…France? The Cyprus experience has increased the risk of a run on banks throughout the EURO-zone, since future bail-outs may involve not only the shareholders and bondholders being wiped-out, but depositors losing some of their savings as well. Meanwhile, Europe is mired in a deep recession which has caused unemployment to reach another record high of 12%, including in France where joblessness has risen to its highest level in 15 years.  If Italy’s recent election of anti-austerity politicians is any indication, expect the chasm to widen between European nations in the north who espouse discipline and competitiveness and those in the south where the stench of entrenched entitlement and inefficiency still permeates.

THE US: Cause for Optimism?

When reading the headlines, it would appear that the U.S. economic recovery is gaining ground, albeit at an uneven and modest pace. To be sure, housing prices have finally bottomed, consumers have made good progress paying down debt and refinancing mortgages at lower rates, corporate balance sheets remain flush with cash and the stock market is back up to pre-recession levels. This is all helping to boost consumer confidence through the “wealth effect”. And while the unemployment rate is declining, the proportion of the “labor force” (i.e. people that can work) that are actually employed has been static. This implies that Americans keep dropping out of the workforce. This and the continuing decline in real wages are distorting the true picture and remains of concern. The weak job market in the US has driven down labor costs and the share of GDP in the U.S. that is attributable to labor income is now at its lowest level in 50 years.  There are still millions of people out of a job since the 2008 recession, and corporations remain reluctant to hire, focused still on cost cutting to maintain record high profit margins and trying to compete in a slow growth world where currencies like the EURO and YEN are in devaluation mode.

Interestingly, the top performing sectors in the U.S. stock market so far in 2013 have been high yielding defensive ones such as healthcare (+16.4%), consumer staples (+13.7%) and utilities (+11.7%). These are hardly the industries that would foreshadow a strong economic recovery. And while sequestration (tax hikes and budget cuts) is creating headwinds on the fragile recovery, the trend is nevertheless positive and the U.S. economy remains the best of a bad lot.

CANADA: Dr. Jekyll and Mr. Hyde

While the Canadian stock market measured by the TSX Composite continues to lag US markets, the heavy weighting of the poorly performing resource equities on the TSX has been the main culprit. As we have mentioned in previous letters, the composition of companies listed on the TSX bears little resemblance to the Canadian economy. The mining and energy sectors together represent 12.7% of Canada’s GDP, yet a huge 41% of the TSX. Financials make up 33% of the TSX, while contributing only 21% to GDP. The reason for this is simple. The stock market is mainly a capital raising mechanism, and so, resource companies which have an insatiable appetite for money, naturally have a very large representation in the index. Thus, most other “everyday” sectors, such as consumer discretionary, utilities, telecommunications, retailing and manufacturing are grossly underrepresented in the Canadian stock market.

Clearly, the TSX is a tale of two markets. While the Materials sector was down  -10.7% in the first quarter of 2013, Industrials were up +14%, Consumer Discretionary rose +11.8% and Telecommunications increased +9%. These gains are similar to those registered on the more widely diversified U.S. stock markets. However, slowing growth in China, the largest marginal buyer of commodities in the world and Canada’s second largest trading partner, continues to hurt the fortunes of resource companies and affect the overall returns of the TSX, which is why we prefer to invest in sectors less weighted in the index.

CHINA: Debt Reckoning

After years of torrid growth, China now has one of the most highly leveraged corporate sectors in the world as a percentage of GDP, a staggering 122%. This has led the government to impose caps on mainstream lenders limiting their exposure to risky off-balance sheet products such as repackaged corporate loans which were sold to investors through wealth management channels because caps on official deposit rates encouraged savers to buy these higher yielding products. At the end of 2012, there were US$1.16 trillion of such products outstanding, 80% of which are not on bank balance sheets. This represents 4% of Chinese bank assets (which is coincidentally the new limit prescribed by regulators). This situation is eerily reminiscent of the packaged sub-prime mortgages in the U.S. which triggered the global financial crisis. While lending limits are meant to protect the health of Chinese banks, loan quotas will hurt the stretched corporate sector and help continue fuelling China’s runaway shadow banking system.

JAPAN: Let’s Get This Party Started

Following the recent election of pro-stimulus Prime Minister Shinzo Abe, the Bank of Japan (BOJ) announced in April that it would launch a massive reflation program in order to stimulate its economy. It plans to purchase a staggering YEN 7.5 trillion of bonds per month over the next 2 years (US $1.4 trillion in total) while doubling the average maturity of its purchases by buying bonds with terms up to 40 years. It would double its monetary base with the aim of achieving an inflation rate of 2% by 2015. The BOJ even plans to purchase exchange traded funds (ETFs) and real estate investment trusts (REITs) on the stock market! The result of this unprecedented monetary expansion is to create asset and price inflation, and of course devalue the YEN. By creating inflation or at the very least the expectation of inflation, the hope is that the Japanese will go out and invest and spend money now before values and prices rise. By devaluing its currency, Japan hopes to boost its export driven economy by making goods priced in YEN cheaper for foreigners to buy.

However, these extraordinary measures are not going to go unnoticed and are bound to trigger retaliation in the form of competitive currency devaluations by other countries. Skeptics abound, doubting that such inflation targets can be met without inflation-adjusted GPD growth of at least 4% per year, a near impossible task in such a slow growth world. Even BOJ governor Haruhiko Kuroda called the scale of the stimulus “large beyond reason” and stated that this was “an entirely new dimension of monetary easing”.

The so-called “Abenomics” have already caused the Japanese stock market to rise by around 30% and the YEN to devalue nearly 20% versus the US dollar. But what Japan really needs is broad structural reforms to improve its productivity and competitiveness, not more debt which already stands at over 200% of GDP, the highest level of any developed nation (Japan also has the fastest aging population on earth, so imagine what this lethal combination of higher debt and less people might result in). Decades of well-entrenched consumer and corporate behavior based on a psyche of savings rather than spending won’t be so easily changed. Time will tell whether this last ditch effort to shake off decades of deflation and recurring recessions succeeds or whether this is Japan’s final act of committing hara-kiri.

NORTH KOREA: Sabre Rattling or Act of Desperation?

As foolish and absurd as the recent threatening rhetoric from the “leadership” of North Korea is, it would be imprudent to completely ignore it. Armies around the world are on full alert, as they should be.  While the threat of a thermal nuclear war remains remote, the real concern is what to do with 25 million of mostly poverty stricken North Koreans after their government is defeated.  That is the real reason that China, Japan, South Korea and the US have tolerated Kim Jong-un and his forefathers.  Stay tuned.


The general public has always had a hard time reconciling the differences between what goes on in the stock market (Wall St.) versus what is happening in the economy (Main St.).  A common sentiment heard, especially lately with the DOW and the S&P 500 hitting new highs, is:  “How can the stock market be doing so well while my neighbor and sister have recently lost their jobs and there are so many structural problems throughout the world”? There are several explanations for this phenomenon.  Some of the more material ones are: 1) the stock market is a forward looking entity predicting earnings usually 12-18 months into the future; 2) the stock market is a gauge of expectations (i.e. a company comes out with worse earnings than the previous year and yet the stock goes up because the market was actually expecting even worse results; 3) companies generally thrive in extended periods of high unemployment because nothing keeps corporate profit margins up more than a pool of unemployed workers eager to fill job openings at lower salaries. Currently, the disconnect between Wall St. and Main St. is further exasperated by rock bottom interest rates, as bond holders are migrating to equities in search of yield.

IN SUMMARY: Staying Focused

As interest rates and inflation are anticipated to stay low, investors will need to temper their return expectations going forward. This is particularly true of fixed income investments for which there is no upside left (unless we go into deflation) given that gains since 2008 have been artificially driven by the suppression of interest rates by central banks. Pre-tax yields in the 1% to 2% range are now the norm for government bonds (generating negative real returns after inflation and tax), while investment grade corporate bonds are yielding between 2% and 4%. Given these meager returns, we continue to favor higher yielding corporate bonds in solid mid-sized companies that we are already familiar with, yielding in the 4% to 7% range with 5 to 10 year maturities, although choices are limited.

Regarding equities, low interest rates have driven up valuations to expensive levels, but there are still ample money making situations by investing in companies that have little or no presence in the main indices. Given our macro-economic views, we continue to remain “defensively invested” as we feel that global stock markets are anticipating too optimistic a scenario. Approximately 35% of our typical equity portfolio remains in high yielding dividend stocks of growing companies in stable sectors such as telecom, cable and media, energy infrastructure, renewable energy and power generation. We believe that dividend yield will continue to be an important part of investment returns for the foreseeable future. Roughly 10% is in cash awaiting better opportunities and 5% is in bullion and gold equities as a hedge against currency debasement. The balance, or around 50%, is invested in a well-diversified group of small, mid-sized and large companies that offer good growth prospects and still trade at reasonable valuations, many of which also have generous dividend yields. We thus continue to stay focused on our strategy of protecting the downside while still aiming to achieve acceptable absolute returns for our clients.

Ken Lester, Stephen Takacsy, Peter Dlouhy