January 31, 2013

Fourth Quarter 2012 Letter

An Exceptional Year

We are pleased to report that for 2012, the dollar-weighted average return of our segregated equity portfolios was +14.9% net of all fees (over 16% before fees), versus +7.2% for the TSX Composite total return (including dividends) and +13.5% for the S&P500 (in $CAD). This marks the sixth year out of seven that we have outperformed the TSX. For 2012, on a dollar-weighted average basis, our fixed income portfolios rose +5.9% (net of fees), and our balanced portfolios rose on average between +9.5% and +12.4% (net of fees) depending on fixed income allocations.

Our outperformance over the TSX during 2012 was mainly due to three factors:

  1. The takeovers of five of our core holdings.
  2. Low weightings in Energy and Materials, two sectors which generated negative returns on the TSX.
  3. Strong returns in several recently purchased small/mid cap holdings.

Our top performing investments during 2012 were:

  • Canadian Satellite Radio (+106.7%):  Merger of Sirius and XM (initiated a quarterly dividend)
  • Score Media (+100%): Specialty TV broadcaster of sports content (acquired by Rogers Communications)
  • High Liner Foods (+92.8%): Leading North American processor and marketer of frozen seafood
  • Maxim Power (+54.7%):  Alberta power producer with coal reserves and assets in the US and France
  • Redknee Solutions (+51.5%): Converged billing software developer (acquiring Nokia’s software division)
  • Viterra (+49.9%): Leading grain handler and marketer of agricultural products in Canada and Australia (acquired by Glencor, Richardson and Agrium)
  • Neo Materials (+47.3%): World’s leading rare earth processor (acquired by Molycorp USA)
  • MTY Foods (+47%): Leading Canadian franchisor of quick service restaurants
  • Stella Jones (+46.9%): Leading North American manufacturer of railway ties and utility poles
  • Arbor Memorial (+39.1%): Canada’s leading owner of cemeteries and funeral operator (privatized)
  • Vicwest (+37.9%): Manufacturer of agricultural storage systems and steel building products
  • Provident Energy (+26.9%): NGL extraction, processing, storage and transportation (acquired by Pembina)

Generating these kinds of returns in such a diversity of sectors demonstrates that it’s possible to find good opportunities no matter how the “market” is performing. Equally as important in 2012, were our positive returns during months when equity markets were down, helping to protect clients’  capital and showing that we can generate higher returns with lower risk (as measured by lower volatility).


For 2012, the Fund was up +16.8% (net of all fees and expenses) versus +7.2% for the TSX Composite total return. The Fund holds the same stocks as our segregated accounts and employs the same investment strategy that we use to manage these accounts. Since our equity strategy’s inception in July 2006, we have generated a cumulative return of +100.1% net of all fees, more than triple the +28.5% for the TSX and quintuple the +18.7% for the S&P500 (in $CAD). This represents a compound annual net return of +11.3% over the six and a half year period, compared to +4% for the TSX and +2.7% for the S&P500 (in $CAD). These results continue to rank us among the top Canadian equity managers in the country.


During 2012, the Lester Hedge Fund rose +6.9% net of all fees and expenses, versus +7.2% for the TSX Composite total return. Since inception in April 2007, the fund has produced a cumulative net return of +33.5%, approximately 3 times the +11.5% for the TSX. It is managed using alternative strategies not available to most investors, including merger arbitrage, index arbitrage, pair trading and short selling, and is a good complement to our core portfolio management expertise.

OUR MACRO VIEW: Comfortably Numb

In 2012, investors held their collective breath watching the Euro-zone nearly break apart. They also stared over the US “fiscal cliff”, and witnessed Japan’s ongoing battle with deflation. With recessions worsening in Europe, a triple-dip in the UK, a quadruple-dip in Japan, anemic growth in the U.S. and a slowdown in China, central bankers have had to keep injecting massive amounts of liquidity into the lifeblood of the global financial system by way of trillions more in monetary stimulus. The result is that interest rates are being kept at artificially low levels.  While this financial medicine may have sedated capital markets by helping avert sovereign debt defaults, bank failures and even depressions, it has not had the desired effect on economic growth or job creation.  As well, government debt/GDP ratios keep rising towards a point of no return as economies wither and debt continues to pile up.

Such aggressive monetary policy, never before seen on such a massive world scale, acts like a drug on investors. Bond prices have risen to such a high that many are offering negative real interest rates (i.e. can you say bubble?). With few alternatives, money is now finally flowing back into equities in search of real returns. Real estate prices are also being pumped-up by artificially low mortgage rates (although in much of Europe they are sinking). For borrowers, it’s Alice in Wonderland. For savers and job seekers in countries where austerity measures are being implemented, it’s Nightmare on Elm Street. For investors, central banks’ policies have induced global stock and bond markets to rise on the magic carpet of easy money, providing multiple doses of pleasure in an otherwise unstable and uncertain world. Have investors become comfortably numb in this paranormal environment of continuous financial stimulus? While we have been able to adeptly surf this tidal wave of liquidity and generate higher than market returns for our clients, we remain defensively positioned for when it breaks.

EURO-ZONE: A Year Of Living Dangerously

During 2012, Greece, Spain and Italy each took turns teetering on the edge of disaster. In the case of the latter two countries, their respective bankruptcy and insolvency would have surely meant the downfall of the EURO. Greece, which was on the verge of a “Grexit” (i.e. exiting the Euro-Zone), managed to squeak through a series of close elections and reform bill votes, eventually securing a 2-year extension and a third bail-out of EURO 44 billion which had originally been withheld by the Troika. However, this was not without more pain to sovereign bondholders (including Greek Banks) who had to accept another EURO 40 billion haircut selling bonds back to the Greek government at a discount. Spain and Italy, who were suffering from unsustainably high bond yields, were given some respite  by “Super Mario” (Draghi), head of the ECB, when he announced that he would do “whatever it takes” to save the Euro-Zone (i.e. print as many EUROs as it takes to bail out governments who ask for assistance). This helped lower bond yields of all Euro-zone countries while capital markets stabilized. Spain secured EURO 39.5 billion to bail-out its troubled banking system, and may still require more funds in exchange for a formal austerity program. And finally, Cyprus raised the white flag seeking a EURO 17 billion bail-out as its banking system collapsed.

In reality, little has been resolved in Europe, other than the “EURO-crats” flexing some muscle and buying time. In the case of Greece and Spain, like Portugal and Ireland before them, severe austerity measures are being implemented to secure funding for their survival. Unemployment rates in Greece and Spain are at depression levels of over 25% and rising, while their economies are still contracting.  Their debt to GDP levels are worsening, making it virtually impossible for them to deleverage. Meanwhile the entire Euro-zone is being dragged into a recession which is expected to worsen. Even France and Germany are now losing jobs. The European banking system remains very fragile, still living on life support from the ECB’s cheap loans, and is expected to eventually be subject to centralized oversight by the ECB. 2013 will surely hold more surprises. Watch for the Italian elections in March in which Silvio Berlusconi, who helped put Italy into its current mess, attempts to make a come-back, followed by Germany elections this fall in which the still popular Angela Merkel hopes to hang on to power. And expect the tug-of-war between the dismantling of Europe’s expensive welfare state and social unrest among the unemployed to escalate.

THE US:  Haven’t We Seen This Movie Before?

Now that the so call “fiscal cliff” has been averted with a Y2K-like whimper by an 11th hour and 59 minute so-called “compromise”, the US is now on a trajectory which can better be described as the ”fiscal slippery slope”. Indeed, a deep recession may have been averted, but raising taxes on the highest income earners hardly deals with the tougher long term structural issues like slashing the expenses of a bloated government and curtailing budget deficits which are adding $100 billion per month to a staggering $16.4 trillion debt load. While an extension to May 19th has been negotiated allowing the US to breach its debt ceiling, expect a sequel to the jitters of summer 2011 when US bonds were downgraded by S&P. Meanwhile, kicking the can down the road once again seems to have lulled investors into complacency.

Nevertheless, one should expect some volatility as the battle over real issues such as tax reform, entitlements and spending cuts heats up over the next few months.  Most economists agree that weak spending in the US by households, who are still trying to reduce debt from the 2007/09 recession, will be further held back by new tax hikes. Similarly, most analysts feel that record profit margins by US companies will start to decline and that meanwhile, businesses will continue to hold off hiring, spending and investing amid such uncertainly. The anemic sub 2% GDP growth in the U.S., despite trillions in monetary stimulus, will be dragged down by lower government, corporate and consumer spending. The lack of real net job creation has been so worrisome that the Fed has now linked its interest rate policy to reaching an unemployment rate of 6.5% rather than to achieving an inflation target. It is widely known that declines in the joblessness rate to 7.8% is misleading, as millions of discouraged Americans quit looking for jobs and drop-out of the unemployment statistics. Is staying at home collecting welfare better than digging ditches and filling them up again? The problem is that the US government can’t afford either.

Despite low inflation, Americans’ standards of living have been on the decline as real wages have been dropping. Lower pay, longer hours, and higher productivity have taken their toll on the US consumer, although this has been good for America’s competitiveness.  While housing prices are firming up, there are still huge numbers of empty and unsold homes. The Fed’s low interest rate policy is expected to extend through 2015 allowing millions more home-owners to refinance their mortgages at historically low rates. Once this refinancing cycle is over, there is little else that can be done to help households relieve their debt burden and revive domestic consumption, other than job creation and the Fed knows this.

CHINA: The World’s Aging Factory

The world’s second largest economy slowed down last year to its lowest rate of growth since 1999. Still, 7.8% GDP growth isn’t bad when compared to most other countries. However, China’s economy has been thriving for decades on cheap labor acting as the world’s factory. With major developed economies in a fragile state (Europe is China’s largest trading partner), China is vulnerable. Rising labor costs are also starting to drive manufacturers to lower cost countries like Vietnam. And, for the first time ever, China’s workforce has started shrinking as it ages, the result of a three decade, misguided one-child family policy. Chinese officials have also finally let the “Gini out of the bottle”. The Gini Coefficient, which measures income disparity, shows that the urban middle class is earning $4,279 per year or nearly 4 times more than the rural poor class. A ratio this high (academics believe it to be much higher in fact), usual leads to social unrest. Finally, there are still rumors of massive bad debts plaguing the official and shadow banking systems from government stimulus programs deployed during the financial crisis. It will be interesting to watch, as China continues to look for ways to transition from an export led economy to one driven by domestic consumption. However, with a potential demographic crisis down the road, not unlike Japan, it may end up being too late as China becomes “old” before it ever becomes fully “developed”.

JAPAN: The Vanishing Race

Japan recently elected the Liberal Democratic Party on a mandate to implement more aggressive monetary policies to dig itself out of deflation, devalue the YEN, boost Japan’s export driven economy and create jobs. It recently announced a US$117 billion stimulus package, Japan’s biggest since the financial crisis. The money is to be used mainly for public works projects, corporate investment incentives and to help small businesses. The Bank of Japan (BOJ), which had previously announced US$124 billion in US-style quantitative easing (i.e. purchases of government debt to keep interest rates near zero), is now under intense pressure to raise its inflation target to 2%, double the current level. This “pressure” has many questioning the BOJ’s independence. Japan has even started purchasing EURO denominated debt in a disguised effort to make the YEN more competitive by pushing-up the value of the EURO (welcome to the ongoing currency wars!). With inflation in Japan having disappeared decades ago, bond yields just about non-existent, the next thing to vanish is Japan’s own people. With a shrinking population, in which there are now more adult diapers sold than baby diapers, Japan’s aging demographic poses a major dilemma. How will Japan ever repay its massive debt to GDP of 230% (and rising), the highest in the developed world? Default and devaluation presents a major risk to global capital markets. Japan’s saving grace is that most of its government bonds are held by the Japanese people and its domestic banks, implying that they will eventually all go down with the ship together. And by 2060, with one-third of Japan’s population gone, the other two-thirds will be left holding the bag.

CANADA: Not Only About Resources

Much has been said in 2012 about the US stock market as measured by the S&P500 outperforming the Canadian stock market as measured by the TSX Composite. One must be careful when referring to a specific basket of stocks in an index. The Canadian market, represented by the TSX, is not an exact representation of the Canadian economy. The TSX is a very concentrated basket made up of over 25% in financial companies and about 50% in resource stocks. With China’s reduced appetite for commodities, it was no surprise that the Materials and Energy sectors generated negative returns last year. On the other hand, the two best performing sectors of the TSX, Consumers Discretionary and Consumer Staples, were each up around 20%. Industrials, Real Estate and Financials also posted strong double digit returns. Thus, Canadian stocks, on a broader basis, faired as well as or better than those in most other markets.

Once again last year, Canada experienced record inflows by foreigners into Canadian fixed income securities. This is a major vote of confidence in our currency and coveted AAA credit rating, as well as our sound finances, stable politics and healthy employment level. The Canadian consumer remains resilient in the face of record high personal debt to net income levels (most Canadians have lots of equity in their homes, have low fixed mortgage payments and secure jobs). During 2012, the Canadian dollar was also given official reserve status as central banks diversify away from the US dollar, EURO and YEN. These currencies continue to be subject to ultra-easy monetary policy aimed at monetizing government debt and are thus in a devaluation mode. The Canadian dollar, along with gold, oil and other hard assets should provide investors with protection against foreign currency debasement and eventual inflation.

IN SUMMARY:  Thinking Outside the Box

Remarkably, despite all the high-fives about world equity markets being up in 2012, the S&P500 has only just now reached the level it was 12 years ago (in Canadian dollar terms, investors are still underwater due to a 60% appreciation of the Loonie during that period). Why is this? As we have stated on previous occasions, companies that form part of main stock indices such as the S&P500. have become increasingly overvalued over the past decades with the rise of index funds, traditional mutual funds (whose performances are tied to indices instead of measured in absolute returns), and more recently the explosion of ETFs and high frequency computer trading (which are totally unconcerned with the high price paid for liquidity). The increasing ownership of and correlation between baskets of the largest and most liquid stocks leaves little upside for investors to make real money over the long run, since almost every investor already owns them. In order to add real value, portfolio managers need to think outside the index box and not follow the herd. For the sixth year out of seven, we have shown that bottom-up fundamental research and analysis, combined with a “buy and hold” strategy focused on companies and sectors that are either underrepresented or not included in the TSX index, can handily outperform it.

With government bonds yielding negative real returns and investment grade corporate bonds earning next to nothing after fees, taxes and inflation, portfolio managers need to look much harder to find acceptable risk adjusted returns from fixed income securities. After a 30-year run and diminishing returns heading to zero, most bond prices are now over-inflated by ultra-low interest rates that are being artificially suppressed by central banks. Fortunately, our stock picking skills can be extended to the bond market. Over the past year, we have managed to unearth some very attractive non-investment grade (high yield) corporate bonds. Such bonds are often mispriced due to inaccurate credit ratings or improving prospects. Examples of issuers of bonds with maturities of less than 10 years yielding between 5% and 10% that we have purchased recently include Quebecor, Videotron, Precision Drilling, Sherritt, Direct Cash and Canadian Satellite Radio. After all, if we are willing to buy stocks in these companies after doing thorough research on them, we should be even more comfortable buying their bonds since these are higher ranking securities. Nevertheless, these opportunities are few and far between.

In conclusion, our equity portfolios remain well buttressed by stable yet growing high dividend yielding sectors such as telecom, media, renewable energy, power generation and energy infrastructure. These holdings are complemented by a diverse group of profitable well-managed small/mid cap companies which are generating solid results and great returns for us. In fact, many of these companies march to their own beat irrespective of what “Mr. Market” is doing. We also continue to hold higher than normal cash balances and a dose of gold bullion and gold stocks. We expect the current investment environment to persist: a fragile global economy with unlimited printing of US dollars, EUROs and YEN to keep interest rates low in order to stimulate job growth and minimize debt service costs. Low interest rates have certainly helped boost financial asset prices like stocks, bonds, and real estate, but we must not become complacent and need to continue working hard to generate attractive returns for our clients.

Ken Lester, Stephen Takacsy, Peter Dlouhy