April 17, 2014

First Quarter 2014 Letter


The dollar-weighted average return of our segregated equity portfolios was +2.7% (net of fees) versus +6.1% for the TSX Composite total return (including dividends) and +5.8% for the S&P500 (in $CAD). Our low weighting in the energy sector, lack of gold stocks and high cash balances caused us to lag the TSX. Balanced portfolios rose on a dollar-weighted average basis between +2.1% and +2.7% (net of fees, depending on fixed income and equity allocations) versus +4.4% for a benchmark comprising 50% DEX Bond Universe and 50% TSX Composite. Fixed income returns were +1.9% (net of fees) versus +2.8% for the DEX Bond Universe. High weightings in shorter maturity and lower duration bonds, as well as high cash balances caused us to lag the DEX.

During the first quarter, positive equity returns were led by a diverse group of companies including:

  • NeuLion (+65.6%)
  • Boralex (+20.1%)
  • CCL Industries (+19.6%)
  • Velan (+18.9%)
  • Input Capital (+18.3%)
  • Veresen (+16.9%)
  • Newalta (+15.6%)
  • Emera (+12.6%)
  • Pembina Pipeline (+12.1%) and
  • QHR (+10.2%).

Newalta and Pembina were added to the TSX Composite and TSX 60 respectively. Boralex declared its first ever quarterly dividend, while Veresen received key approvals for its Jordan Cove LNG project.


During the first quarter of 2014, the Fund was up +2.7% (+3.2% gross of fees) versus +6.1% for the TSX Composite total return. The Fund holds mostly the same stocks as our segregated accounts do and employs the same investment strategy used to manage these accounts. Since inception in July 2006, and including the Fund’s performance since January 2012, our equity strategy has generated a cumulative return of +141.9% (net of fees), nearly triple the +54.3% for the TSX and more than double the +67.5% for the S&P500 (in $CAD). This represents a compound annual return of +12.1% (net of fees) over the seven and three-quarter year period, compared to +5.8% for the TSX and +6.9% for the S&P500 (in $CAD). These results rank us among the top Canadian equity managers in the country for the period.

After lagging in 2013, the TSX is leading most other stock markets this year with a +6.1% return. Canada’s strong performance so far is due to a narrow group of sectors: Gold, Energy and Utilities. Gold stocks have rebounded somewhat after a disastrous meltdown in 2013, while the Energy sector has been boosted by robust oil & gas prices, a strong US dollar, and numerous infrastructure projects aimed at unlocking crude oil supply constraints affecting Western Canadian producers. Utilities on the other hand, have benefitted from defensive characteristics amid recently volatile markets. While the threat of higher interest rates resulting from the Federal Reserve’s tapering of bond purchases punished high yielding stocks in 2013, the current expectation that interest rates will continue to remain low for the foreseeable future has diverted funds back into companies that will be able to grow dividends going forward. A weak global economy, particularly slower growth in China, continues to hold back parts of the Materials sector. While the Canadian dollar has dropped another 3.8% versus the US dollar this year, a low Loonie bodes well for manufacturers and exporters whose costs are mainly in our domestic currency.

THE US: The End of Quantitative Easing

Janet Yellen, the new head of the Federal Reserve, declared in no uncertain terms that the end to quantitative easing (QE) will be gradual. When Ben Bernanke mentioned tapering QE last year, capital markets panicked as bond yields soared and stock markets tanked. After some initial turbulence this January, mainly relating to the impact of higher US bond yields on Emerging Markets, calm returned to global stock markets. This was followed by what appeared to be euphoria in February as Yellen clarified matters by committing to low interest rates for a longer period (likely until 2016) to address the jobless. The Fed scrapped its plan to keep rates low only until the unemployment rate reached 6.5% (it’s now 6.7%) since this rate does not account for those who have given up looking for a job. The Fed is concerned that the US labor participation rate is down to 63%, its lowest level since 1978, and wage gains have proceeded at a “historically slow pace”. Not surprisingly, April is off to a rough start as some of the froth comes out of the market. Our view remains that after such a big run over the past few years, the US stock market is expensive in relation to growth prospects. Downward earnings revisions by corporations and analyst downgrades are proving this point. Although we don’t see any panic on the horizon from rising inflation or interest rates, this eventual threat makes overvalued stocks that much more vulnerable.

EURO-ZONE: Mired in “Low-Flation”

Irish government bonds are now yielding less than US treasuries. How can this be possible? It is certainly not because Ireland has a better credit rating than the US nor because investors perceive the US as being riskier than Ireland. Low yields on Irish, Spanish, Greek and Italian sovereign debt is not only the result of the European Central Bank (ECB) being ready to do “whatever it takes” to avert a credit crisis in these countries, but is a reflection of ultra-low inflation expectations. In fact, the EURO-zone is flirting perilously close to deflation (annual inflation was a mere 0.5% in March). Christine Lagarde, head of the International Monetary Fund, carefully avoided the “D” word recently, preferring to use the new term “low-flation” in heeding her warnings about the need for more monetary easing to achieve price stability in the 18-country EURO-zone. Greece, Cyprus, Slovakia, Portugal and Spain are already in deflation and the fear is that this will spill-over to other countries resulting in a Japanese-style long term deflationary spiral. The ECB has little room to maneuver with its benchmark rate already at a historic low of 0.25%. Rising geopolitical tensions in the Ukraine will only make matters worse as trade slows down between Europe and Russia. Hence, the IMF is preparing a $27 billion bail-out for the near bankrupt country. Ironically, as the US is finally putting an end to its bond purchase program, it appears that the ECB may soon need to resort to unconventional measures such as quantitative easing before it’s too late.

CHINA: Till Debt Do Us Part

It’s finally happening. China’s lending system is showing some cracks. The Chinese government is refusing to bail-out some domestic financial institutions and allowing selective companies to default on their bonds, thus imposing losses on individual investors who purchased corporate bonds and asset-backed securities (sound familiar?). There have even been runs on a few rural banks and cooperatives sparking the need for China to urgently put in place a deposit insurance program. After decades of torrid growth, China is trying to curtail poor lending practices by banks to local businesses that are either unprofitable, in sectors plagued by overcapacity (solar cells, steel, cement) or exacerbating problems such as pollution like coal fired industries (in China the term GDP is now referred to as “Gross Domestic Pollution”). The reduction in domestic lending, combined with crackdowns on corruption, will cause a further slowing of China’s economy which is forecast to grow at around 7.5% this year. There is a contradiction between deleveraging the domestic banking system and achieving GDP growth targets. China is currently running a “credit gap” for which it needs $3 to $4 of new lending to create $1 of growth (much of China’s growth since 2008 has been domestically driven and locally financed). Sharp year-over-year drops in both imports and exports in March suggest that China’s growth target seems optimistic. While still healthy for the world’s second largest economy, any further reductions in GDP growth will have repercussions on its trading partners. We expect China’s slowdown to persist and continue to weigh on certain commodities.

A Note on High Frequency Trading

During the past few years we discussed high frequency trading (HFT) and expressed our concern about how HFT affects investing and our ability to trade optimally for the benefit of our clients. The meteoric proliferation of HFT in the last several years, gave us another reason to minimize our exposure to large cap stocks, especially in the US. One of our favorite authors on financial issues, Michael Lewis, just published a new book called Flash Boys, which exposes HFT. We are encouraged by the tremendous press the book has garnered, and hope this will lead to regulation that will curtail the obscene profits HFT firms have made off the backs of traditional investors. It would be hard to fully explain HFT here, but we will try to give you a primer on it. Those interested in learning more are encouraged to read Flash Boys.

Simply put, HFT firms have spent hundreds of millions of dollars building infrastructure that allows them to detect and act on trades before the rest of the world can. By either placing themselves physically closer to where the trade signals emanate or by building faster connectivity, HFT firms can “front- run” other investors. For example, when a “market” buy order is first sent, an HFT firm can detect it first and is able to step in front to buy the same shares at the lowest price being offered and then immediately re-sell those same shares to the original buyer at a higher price than that buyer would have otherwise paid, thus making risk free profits. The buyer of the stock doesn’t even know what happened since all is done in millionths of a second, and the higher price, if ever detected, is attributed to bad luck (i.e. a traditional investor’s order arrived first). Thus the system is currently set up to allow companies with a technological advantage and extraordinary sums of money to have the capability to earn extraordinary risk-free profits.

How does this affect you, our valued client? The short answer is – it doesn’t for two main reasons: First and foremost, HFT firms generally target highly liquid large cap stocks that have huge volumes of daily trades, particularly the more volatile ones. In fact, only several large Canadian companies would be worthwhile for HFT firms to trade. One of the cornerstones of our strategy is to find underpriced small to mid-cap Canadian companies. This category of public companies is not only ignored by HFT firms, but by most investors such as mutual funds, ETFs and large institutional investors like pension funds for the same reason (too small to invest in). The second reason why our clients need not worry that they are being “taxed” by HFT firms is because we are professional traders who have the skills to thwart those who would try to benefit from our orders. For example we generally place “limit” orders rather than “market” orders. There are other strategies that we deploy and are happy to discuss these further in person. We hope this helps explain the complex, yet critically important phenomenon of HFT. As well, we hope this discussion allows some of you to sleep a little better at night.

IN SUMMARY: Fingers on the Pulse, Feet on the Ground

In our 2013 year end letter published in January, we wrote of the risks that we saw on the horizon (except for the ones that we could not see!): vulnerable Emerging Market currencies, YEN devaluation, slowing growth in China, the threat of deflation in Europe, and overvalued stock markets in general. These risks have been re-surfacing since and are still very much present, in addition to geopolitical risk in Ukraine. After more than six years, the world continues to feel the after-effects of the financial crisis in the form of high sovereign debt levels, artificially suppressed interest rates, low inflation, overcapacity and high unemployment. Our equity portfolios remain defensively positioned with a healthy dose of high dividend yielding stocks (in sectors such as telecom, media, renewable energy, power, and energy infrastructure) which are able to raise dividends on a regular basis. While some of these held back our performance during months when stock markets were strong, they act as ballasts when markets decline sharply.

We also continue to hold higher than normal cash balances and are being more selective in adding new securities to our portfolios as attractive valuations have been hard to find. We continue to expect weak global economic conditions to persist, underpinned by low interest rates in the developed world. While this provides some support for financial assets, most of the heavy lifting by central bankers has already been done, and returns will be much harder to come by unless growth picks up.

Ken Lester,  Stephen Takacsy,  Peter Dlouhy