January 30, 2015

Fourth Quarter 2014 Letter


In 2014, the dollar-weighted average return of our segregated equity portfolios was +7.6% net of all costs, versus +10.5% for the TSX Composite total return and +24% for the S&P500 (in $CAD). Depending on fixed income and equity allocations, our balanced portfolios rose on a dollar-weighted average basis between +5.8% and +6.2% net of all costs, versus +9.7% for a benchmark comprising 50/50 DEX Bond/TSX Composite. Weighted average fixed income returns were +3.8% net of all costs, versus +8.8% for the DEX Bond Universe. Low weightings in financial services, and in large cap consumer discretionary and consumer staples stocks, as well as high cash balances during parts of 2014, acted as a drag on our equity performance. Our underperformance in fixed income was caused by widening spreads on some higher yielding corporate bonds, a lack of long dated government bonds, and from holding high cash balances.

  • Our top performing Canadian large cap stocks (excluding dividends) during 2014 included:
  • CCL Industries (+58.9%): Canadian-based global packaging and label manufacturer.
  • Veresen (+28.7%): North American provider of extraction, processing and transportation of hydrocarbons.
  • Fortis (+28%): Leading North American supplier of hydroelectric power and gas distribution.
  • Emera (+26.4%): Supplier of electrical power and gas transmission in northeastern Canada & the US.
  • Shaw Communications (+19.3%): Western provider of cable TV services and broadcast media (since sold).
  • TransCanada (+17.6%): North American supplier of energy infrastructure, pipelines, and power producer.
  • Bell Aliant (+16.5%): Rural provider of telecommunications services (privatized by BCE).
  • BCE (+15.8%): Canadian-based provider of wireless telecommunications services and broadcast media.
  • Telus (+14.6%): Western Canadian-based provider of wireless telecommunication services.
  • Pembina (+13.1%): North American supplier of energy infrastructure, pipelines and marketing services.

Our top performing Canadian small and mid-cap stocks (excluding dividends) during 2014 included:

  • Neulion (+114.7%): US-based provider of live sports content video streaming services.
  • Velan (+66.4%): Canadian-based global manufacturer of industrial valves.
  • Logistec (+50.2%): North American marine cargo handling and environmental services provider.
  • Park Lawn (+44.7%): Only Canadian publicly-traded provider of cremation, funeral and cemetery services.
  • Algonquin (+31.3%): North American producer of renewable energy and provider of utility services.
  • Ag Growth (+30.3%): Manufacturer of grain handling equipment (acquiring Vicwest’s storage division).
  • Boralex (+18.8%): Producer of renewable energy in Canada and France.
  • Conifex (+18.4%): Producer of lumber and bioenergy in British Columbia.
  • Input Capital (+17.7%): Provider of financial services to the Canadian agricultural industry.
  • Questor (+17.2%): Canadian manufacturer of clean air equipment for the petrochemical industry.


Our returns continue to be generated by a diversified group of businesses operating in unrelated industries and that have low correlation to the global economy. As in previous years, we tended to outperform during months when equity markets were down. This defensive characteristic of our portfolio aims to protect our clients’ capital while still being able to generate attractive absolute positive returns.


For 2014, the Fund was up +8.8% (+10.7% gross of all fees and expenses) versus +10.5% for the TSX Composite total return. The Fund, which now represents 15% of our assets under management, holds most of the same stocks as our segregated accounts and employs the same investment strategy that we use to manage these accounts. The Fund’s performance differed from our segregated accounts due to additional stocks such as Ridley, Pure Technologies and DHX Media, and the timing of cash inflows and stock purchases. As in our segregated accounts, we took profits in several holdings such as Open Text, Bell Aliant and Shaw Communications and sold several laggards such as Transalta and VIXS Systems.

Since inception in July 2006, and including the Fund’s performance since January 2012, our equity strategy has generated a cumulative return of +156.3% net of all fees and expenses, over double the +60.8% for the TSX and more than one and a half times the +99.1% for the S&P500 (in $CAD). This represents a compound annual return of +13% on a gross basis and +11.7% net of all fees and expenses over an eight and a half year period, compared to +5.7% for the TSX and +8.2% for the S&P500 (in $CAD). These results continue to rank us among the top Canadian equity managers in the country over the period.

CANADA: A Crude Awakening

A weak global economy and a further slowdown in China continued to take its toll on Canada’s Materials sector (down -4.5% for the year), but the real story during 2014 was the swift reversal in the fortunes of oil & gas stocks mid-year, caused by a 50% decline in the price of crude oil. Despite a -7.8% decline in the Energy sector, the TSX Composite was still up +7.4% in 2014 (+10.5% including dividends) and finished as one of the better performing stock markets in the world during a volatile year. Excluding the commodity complex, most of Canada’s other sectors performed very well, as they did in 2013: Consumer Staples (+46.9%), Technology (+34%), Consumer Discretionary (+26.4%), Industrials (+20%), Utilities (+11.3%), Telecom (+10.5%) and Financials (+9.8%). The Loonie dropped a further 9% versus the US dollar in 2014, providing a further tailwind to Canada’s manufacturers and exporters. Despite continued dire warnings, Canadian housing prices and consumers held up well. However, energy companies are now slashing capital expenditure programs by the billions and laying-off employees by the thousands which will cause a sharp slowdown in western Canada. As a result, the Bank of Canada cut its overnight rate by ¼% on January 21 as a pre-emptive measure, further weakening the Loonie. A healthy US economy should continue to help Canada make up for slower growth in other parts of the world.

THE US: The End of Quantitative Easing

We attended a dinner presentation recently in Montreal with a panel discussion including Stephen Poloz and Ben Bernanke. The question was asked of Mr. Bernanke if he was surprised by how well quantitative easing (QE) has worked in the US, especially given that it had never before been attempted on such a scale. “Yes”, he said. “We have all been pleasantly surprised”. And then he went on to say: “It appears that QE is one of those things that works in practice but not in theory”. In the same vein, Ray Dalio, who is certainly one of the brightest hedge fund managers (Bridgewater), calls the unexpected success of the QE solution in the US as “beautiful deleveraging”. We share Bernanke’s and Dalio’s categorization of QE and marvel at the fact that other than savers and retirees who hoped to live off higher interest payments from their fixed income investments, there has been very little collateral damage, at least not yet. As a result, stocks in the US continue to hit new highs and the currency keeps strengthening. A big part of recent gains is coming from European money migrating to the US market in search of safety and stability. The concern here is that this type of opportunistic “flow of funds” is transitory in nature and can be reversed in a heartbeat. Other concerns we have going forward are the negative effect of the soaring US dollar on US exports and multinationals, and the large number of new jobs that were created by the energy industry in the US since 2008 which will likely be lost as a result of lower oil prices.

EURO-ZONE: The End of Quantitative Teasing

While the US Fed spent the last seven years inflating its balance sheet by effectively creating 1 trillion new US dollars some of which found its way into the economy and helped create new jobs, the European Central Bank (ECB) has done exactly the opposite (it actually raised rates in 2011!). Consequently, banks in Europe were not lending and unemployment has risen in most countries. Europe’s GDP is still below prefinancial crisis levels, and deflation has now taken hold in 16 of 28 member countries of the European Union. Mario Draghi, head of the ECB, who has been all talk and no action, finally launched a QE program on January 22, after years of flirting with the concept. Up to 1.1 trillion EUROs (US$1.3 trillion) of sovereign and corporate bonds will be purchased for an indefinite period to further suppress bond yields, weaken the EURO, spur inflation, and stimulate banks to lend and companies to borrow (eerily resembles Abenomics in Japan). With deflation pounding at the door, one has to wonder if introducing QE in Europe is too late, with the horses having left the barn long ago.

Meanwhile, tensions are still running high between those members who have been advocating German style austerity and discipline (so that profligate nations become more productive and pay down debt), and those members who are advocating more stimulus. This debate came to a head recently with the surprisenear majority election of the far left anti-austerity Syriza Party (it won 149 of 300 seats). As is always the case, bold and forceful election promises will morph into more reasonable and practical actions as the reality of actually being in charge takes hold. However, there is a distinctly different attitude among European voters now regarding the future of the EURO because of this election. At the time of Greece’s first bail-out, Europe’s tone to Greece was: “We really want you to stay in the European Union and keep using the EURO because we’re afraid that if you leave, a Pandora’s Box will open and other countries will follow. So if you want to stay in our club, this is what you have to do”. After some riots, strikes and general mayhem, Greece stayed in the EURO-zone, thus avoiding a “Grexit”, and reluctantly agreed to austerity measures. Since then, Greece has cut some costs but has done little in the way of structural reform. Revenues have been flat, and the country is not even close to achieving the debt targets imposed by the “Troika” (ECB, IMF, and EU). Now Greeks have just elected a party that “promises” tough negotiations with those who bailed them out and wants to reverse austerity measures they claim are choking their country’s ability to get back up on its financial feet. What really interests us about all this, is the recent change in rhetoric from Germany and other members of the EURO-zone. What they said to Greece just prior to the election was: “If you want to leave, go! We can survive without you”. We believe this bravado was an act and a game of chicken to try and scare Greek voters from electing the Syriza antiausterity party, and to keep the EURO-zone together, Greece and all. Stay tuned….

OIL PRICE COLLAPSE: What We Didn’t See Coming

The “story of the year”, if we had to pick one, was the breathtaking speed in the collapse of crude oil prices since June 2014. At the end of the day, and despite all the conspiracy theories out there, this is a classic case of a good old fashion price war, caused by an increasing oversupply of oil (from a variety of sources including the US and Canada) and OPEC’s resolve to re-establish its dominance which was quickly slipping away with America’s bid for energy self-sufficiency. At this point, it is far from obvious how long it will take to bring supply and demand back into equilibrium, or if OPEC will ever regain complete control and become the price setter again. It’s possible that the supply scale has finally tipped enough in favor of non-OPEC countries such that oil prices will from now on be determined by free market forces and not a cartel of Arab kingdoms. While low oil prices are bad news for investors and employment in the energy patch, it is good for some corporations and most consumers who will save money on gasoline, furnace oil, and natural gas. These cost savings should encourage spending in other sectors of the economy.

Like all natural resource commodities, the best oil & gas companies in the world have no control over the price of their finished product. Nevertheless, oil is known to be the fastest “self-correcting” commodity, as supply can be adjusted downwards much more rapidly than in the case of mining companies. The saying: “The best cure for low oil prices is low oil prices” means that the faster and deeper the fall in prices, the sooner unprofitable producers will shut down their wells and the quicker supply and demand will be rebalanced, leading to higher prices. So, let’s enjoy lower gasoline and energy bills while they last!

CHINA: Suffering from Indigestion

The commodity super-cycle that was mainly driven by China’s torrid growth rate seems a distant memory amid the continual decline in most global commodity prices from copper to iron ore to metallurgical coal. Years of overinvestment and lax lending practices in China have resulted in most heavy industry being awash with overcapacity, leading to nearly 3 years of declining manufacturing prices in the face of rising labor costs. Similarly, wasteful spending on infrastructure and overambitious real estate projects has left many regional governments and corporations overly indebted and saddled banks with bad loans. The rise of a massive shadow banking system, including the recent emergence of “entrusted” loans (whereby companies lend to one another using banks as the middleman), underscores the existence of a highly leveraged system of credit. With an unexpected interest rate cut by the Chinese central bank last fall and increasing regulations being imposed on financial institutions, China is clearly trying to avert a hard landing while deflating a credit bubble. Nevertheless, the rapid slowdown from a decade of double digit GDP growth to an expected rate of below 7% this year continues to send ripple effects around the world. Meanwhile, after years of underperformance, the Chinese stock market surged in 2014, however this has largely been attributed to an explosion of margin debt offered to retail investors by stock brokers. Chinese regulators are now busy cracking down on the securities industry, and we all know how that story ends….

IN SUMMARY: Driving On

In last year’s annual letter, we mentioned that we were scanning the horizon for financial danger signs and had identified a few, but we also wrote that: “Of course, there’s always the “other crisis” that we didn’t see coming: the one we didn’t know that we didn’t know.” While markets were busy dodging the bullets of conflicts in Syria and Iraq, the threat of a war with Russia in the Ukraine, deflation in Europe, slowing growth in China, Ebola in Africa, acts of terrorism and a host of other bogeymen, an “all-out war” in the price of oil was not on many people’s radar screen. Being conservative investors and adverse to volatility, we luckily don’t have a large exposure to commodities in general or oil & gas in particular, but still suffered “collateral damage” in our pipeline and infrastructure holdings, and some industrial companies servicing the energy sector. Being “value” investors, we have been sifting through the rubble for bargains in companies that have been unfairly or temporarily hit by the oil meltdown. However, this takes plenty of courage and can sometimes feel like catching a falling knife. It also takes patience before some of these investments pay-off in the long run.

Seven years after the great financial crisis, we are still writing about how the world is trying to recover. Like last year at this time, our list of financial market risks include a 1998-style currency crisis, a hard landing in China (caused by a credit crunch), chronic Japanese-style deflation in Europe, a “Grexit”, and of course the next one we didn’t see coming. On the fixed income side, a correction in high yield corporate bonds has created some attractive investment opportunities. Our equity portfolios continue to be anchored by stable dividend yielding stocks in growth sectors such as telecom, media, renewable energy, power generation and energy infrastructure, complemented by small and mid-cap companies operating in diverse business segments. However, with 5-year Canadian government bonds yielding 0.8% and 10-year bonds yielding 1.3% compared to the TSX Composite yielding 2.9% in dividends, it’s no wonder money keeps pouring into the stock market and valuations keep getting ever more stretched.

We’ll end with the same comments as last year at this time: We expect the current weak global economic backdrop to persist, underpinned by low interest rates and massive (yet diminishing) printing of US dollars, EUROs and YEN in order to keep stimulating growth in a fragile world. Such a climate will continue to provide some support for financial asset prices, although less so now for bonds, preferred shares and real estate which face the headwinds of higher bond yields, and less so for stocks where high valuations are questionable in relation to growth prospects.

Ken Lester, Stephen Takacsy, Peter Dlouhy