January 12, 2012

Fourth Quarter Letter 2011

Positive Returns in 2011

We are proud to report that in 2011, we generated positive equity returns in very difficult markets, marking our 5th year of outperformance out of the past 6 years versus the TSX Composite total return. For 2011, the weighted average return of our equity portfolios was +4.5% net of all fees, versus -8.7% for the TSX Composite total return (including dividends) and +4.4% for the S&P500 (in $CAD). Since our strategy’s inception in July 2006, we have generated a cumulative compound return of +71.4% net of all fees, more than triple the +20% for the TSX, and far ahead of the +1.5% return of the S&P500 (in $CAD). Over the past 5 and a half years, this represents an annual compound net return of +10.3%, more than triple the +3.4% annual return of the TSX and 35 times the +0.3% annual return of the S&P500 (in $CAD). This performance places us at the very top of Canadian equity managers in the country.  For more detail regarding our historical results and investment strategy, please visit our website at www.lesterasset.com.

Our performance in 2011 was driven by specific stock selection and exposure to defensive sectors. As mentioned in previous letters and during our television appearances on Business News Network (BNN), there are always opportunities to make money, even in turbulent markets. This meant avoiding banks and life insurers as well as resource-based companies, and instead, investing in high yielding defensive growth industries such as telecom, broadcasting, renewable energy, utilities and energy infrastructure. Specific stock selection in other sectors such as consumer staples, industrials, technology and healthcare also contributed to our positive returns. It is important to note that in 2011 we generated positive returns during five months when equity markets were down, helping to protect capital for our clients and dampen portfolio volatility. For 2011, our balanced portfolios rose on a weighted average basis between 3.6% and 4.6% depending on fixed income allocations. Our top performing holdings during 2011 included:

  • Asian TV Network (+158.1%): Fastest growing broadcaster of ethnic specialty TV channels in Canada.
  • Mosaid (+54.7%):  Technology patent licensing firm (acquired for $46 per share by Sterling in December).
  • Algonquin (+27.9%): North American renewable energy producer and utility (owned 25% by Emera).
  • Telus (+26.3%): One of Canada’s leading fixed and wireless telecom operators.
  • Provident Energy (+24.5%): Natural gas liquids extraction, processing, storage and transportation.
  • Stella Jones (+21.7%): Leading North American manufacturer of utility poles and railway ties.
  • BCE (+20.2%): Largest Canadian telecom operator and broadcaster (acquired CTV and Maple Leaf Sports).
  • Highliner (+18.7%): Leading North American processor/marketer of frozen seafood (acquired Icelandic).
  • Transcanada Corp (+17.2%): One of the largest pipeline operators and power producers in North America.
  • Viterra (+15.7%): Leading grain handler and agricultural products marketer in Canada and Australia.


For 2011, the Lester Hedge Fund was down -4.3% net of all fees and expenses, versus -8.7% for the TSX Composite total return. This marks the 4th year out of 5 that the fund has outperformed the TSX. Since inception in April 2007, this fund has produced a cumulative compound net return of +24.8%, more than 6 times the +4% for the TSX Composite. It is managed by one of our partners, Peter Dlouhy, 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.

LESTER CANADIAN EQUITY FUND: Launched on January 3, 2012

We are pleased to announce that we have launched the Lester Canadian Equity Fund. Smaller accounts will achieve better equity diversification by owning units of the fund than if managed in a segregated account. This vehicle also permits outside investors such as institutions and retail clients of investment advisors, brokers and financial planners to invest in our portfolio strategy. The fund holds the same stocks that are held in our segregated equity accounts and is managed with the same strategy that produced our +71.4% returns since July 2006. The Fund is structured as a Mutual Fund Trust (MFT), and National Bank Financial is acting as the Fund’s custodian while Computershare is the Trustee. The minimum investment is $25,000 and the Fund is eligible for registered accounts such as RRSPs, RIFs and RESPs. Unlike the mutual fund industry, Lester Asset Management will pay the operating costs of the Fund such as fund administration, accounting and audit expenses in order to keep the management expense ratio (MER) as close as possible to our management fee. The MER will therefore be 1.5% plus minimal custodial and trading commission costs. Notably, all three partners are investing in the Fund including our lead portfolio manager, Stephen Takacsy, who has invested 100% of his equity allocation in the Fund. Existing clients who would benefit from the Fund will be contacted, and clients who aren’t contacted or are not yet clients should feel free to get in touch with us should they have any questions or interest in the Fund.


In our 2010 year-end letter and throughout 2011, we warned that global macro risks were rising, mainly as a result of the European debt crisis and economic weakness in the US, and that a defensive posture was justified; this view served our investors well. A confidence crisis has infected global capital markets as a result of political inaction in the world’s two most important developed regions. Until we see evidence that meaningful decisions are being made and implemented to improve finances in Europe and the US or that the global economy is not threatened, little change in our defensive stance is warranted.

Just to be clear, our definition of a defensive stance is still well within the boundaries of a fully invested portfolio. In other words, we are avoiding or underweighting certain industries that we feel will underperform due to the global macro problems we have identified and overweighting industries and companies that we feel can benefit or at least continue to perform well in this environment. It is conceivable that our view could become more bearish. This could cause us to become so defensive as to significantly increase our cash weighting or purchase hedges. However, we have never felt that bearish before (although it would have helped in 2008) and, if we did, we would make sure clients are made aware of any major structural changes to their portfolios.


During 2011, the sovereign debt crisis in Europe spread like wildfire including to countries that are “too big to bail”. Greece and Italy are now under “financial stewardship” by unelected technocrats in order to stay afloat, and France has been threatened with a credit downgrade. Austerity programs to bring down debt loads are creating recessionary conditions throughout the Eurozone, leading to social unrest and political instability, and potentially worse finances if economies shrink too much. European banks are undercapitalized and no longer trust lending to one another. They borrowed a staggering EURO 489 billion from the European Central Bank (ECB) in December, which still sits in deposits at the ECB. These banks require massive capital injections in addition to rolling over hundreds of billions of EUROs worth of debt in 2012, and are in the process of deleveraging by shrinking their assets (loans) to the further detriment of local economies or issuing shares at massive discounts via rights issues. With many countries reporting declining real estate prices and rising unemployment, the future of the Eurozone looks bleak indeed.

After having tried every trick in the book to get other parts of the world to help fund Europe’s debt problems (via a leveraged Financial Stability Fund or the IMF), Germany and France are now spearheading complex Maastricht and European Union (EU) treaty changes to achieve some form of fiscal union (“fiscal compact”) involving budgetary discipline and debt limits entrenched in national constitutions policed by EU institutions, and sanctions for violators. Already, several non-EURO currency members of the EU have vetoed any such reporting to Brussels or loss of sovereignty (England and Hungary).  Such complex treaty changes risk becoming entangled in upcoming national elections (France and Greece) further delaying resolution of the debt crisis and increasing the chances of a dreaded “Lehman moment” such as the bankruptcy of a country and/or large bank failures.

No matter how much Germany refuses, the European Central Bank (ECB) will need to further lower interest rates, print trillions of EUROs and issue Eurobonds and/or increase purchases of sovereign debt. There is no other way out of this debt trap. Italy alone must raise EURO 450 billion in 2012 just to cover maturing bonds and cannot afford to pay the going rate (7%) on such an amount (around EURO 30 billion in annual interest payments!).  The EURO has provided Germany with a much more competitive currency than the Deutschmark and has helped its exports boom, and in turn, other countries have benefited from (and unfortunately abused) lower borrowing costs. In the end, the EURO will need to be devalued, which will further benefit the uber-productive and export-driven Germans, despite their inflation paranoia.

An interesting aspect in all of this is how Germany has found itself in the role of driving the Eurozone bus and how they are dealing with the responsibility. In a recent speech, former German chancellor Helmut Schmidt reminded his countrymen that the rest of Europe is justifiably concerned about Germany’s growing strength. He also pointed out that Germans owe the rest of Europe for allowing Germany to get back on its feet after WWII. It is clear that Schmidt is attempting to mitigate strong feelings of frustration and anger Germans have towards their southern European neighbors who underworked and overspent themselves into insolvency while Germany was busy rebuilding and saving. (Thanks to our friend Rolf Speilmann at Blue Bridge International Wealth Solutions for alerting us to this speech.)

THE US:  Stuck in the Muddling?

Problems in the US took a back seat to the much more serious sovereign debt crisis in Europe. Despite sporadic encouraging economic statistics emanating from the US, the ugly truth is that after two rounds of quantitative easing and record low interest rates for nearly 3 years, the recovery in the US has been anemic at best. This is indeed “paranormal” (to borrow an expression from PIMCO fund manager Bill Gross). Housing prices continued to decline in 2011 (now down 33% from the peak), and foreclosures and unsold inventory of homes remains near record highs. Weak municipal and state government finances continue to warrant downsizing and lay-offs. Unemployment, including those that have given up the search for full time jobs remains stubbornly high at over 12%. The gap between rich and poor has widened dramatically, and social unrest is rising as evidenced by the Occupy Wall Street movement. The US consumer and the US financial system continue to deleverage which is deflationary. Corporations, America’s bright spot, remain highly profitable and flush with cash, yet distrustful of government and a broken financial system, and so are hesitant to hire and make aggressive investments for the future.

With the presidential election in November looming, the investment landscape promises to get even more interesting (note: as investors we hate “interesting”, such as when politics trumps policy as it has regarding the Keystone pipeline project). The surprising results of the Iowa primary this month show how discombobulated and indecisive the American public is right now. The Republicans are now experiencing the negative consequences of getting into bed with the far-right religious fundamentalists, who recently have risen in power from fringe lunatics to actually dictating Republican policy. Romney’s somewhat unexpected strong result in Iowa is hopefully a sign that some sanity is returning to the Republican party, but as they say in Quebec “ça reste à voir”.


2011 was another tumultuous year for emerging/developing/Asian markets: China (Shanghai -21.7%, Hong Kong -20%), India (Mumbai -24.6%), Russia (RTS -22%), and Japan (Nikkei -17.3%). We also witnessed a multitude of Chinese related North American-listed companies being investigated for fraudulent business and accounting practices, including the dramatic unraveling of Sino Forest, a $6 billion Canadian-listed company operating in China. These unfortunate episodes highlight the risks of investing in companies operating in less developed foreign markets. Also, rumors are that many Chinese banks are saddled with bad loans and that municipalities formed “special purpose vehicles” that have piled-up massive amounts of unserviceable debt from overbuilt real estate and infrastructure projects (entire neighborhoods and shopping malls are empty).

With China having raised interest rates in early 2011 in order to curb runaway bank lending and tame inflation (courtesy of China’s currency being pegged to a declining US dollar and strong yet unsustainable internal demand for commodities), the impact on the global resource sector has been severe. An economic slowdown in Europe, one of China’s largest export markets, will only exasperate the problem. Tragedy and scandals (i.e. Olympus) also rocked Japan, the world’s most heavily indebted nation whose aging demographics are negative for economic growth. Clearly the bloom is off the rose in such exotic lands, and many emerging markets will begin to feel the ripple effects of a likely slowdown.

CANADA: A Safe Haven in an Uncertain World

We have consistently advocated that for the foreseeable future (i.e. the next 5 years at least), investing closer to home would be the most profitable and safest route, as it has been for the past decade. Once again foreign investors agreed and poured record amounts into Canada, mainly in the form of government and corporate bonds. As a result, Canada’s bond market again outperformed the global benchmark. With the unraveling of the EURO, money flows into Canada have accelerated from abroad. Recent strength in the US dollar as a result of foreigners seeking refuge in the world’s most liquid asset (US Treasury Bills) should prove to be transitory with the ebbing and flowing of “risk on, risk off” trading, unless US politicians are finally able to start tackling America’s gargantuan debt burden.

It should be clarified that when we say that we prefer to invest in Canada, we do not mean the TSX index. Canada has a stable and diversified economy which is not necessarily reflected in the basket of publicly traded companies listed on its stock exchange. Over 75% of the TSX Composite index companies are in the capital hungry energy, materials and financial sectors. Then there’s Research in Motion which was responsible for half of the TSX’s -8.7% decline in 2011. So while the energy, materials and financial sectors were down -16.8%, -21.8% and -7.5% respectively on slowing global growth concerns, other industries (more local in nature) fared much better including telecom, consumer staples and utilities up +17.1%, +4.8% and +1.5% respectively. It is thus important to distinguish between individual companies, sectors and the overall market. Canada’s stock indexes can seem volatile at times due to heavy weightings in the resource and financial sectors, however there are many other industries and companies with which to generate strong risk-adjusted returns. Canada’s healthy employment level, sound finances and stable politics look very attractive relative to the uncertainty facing the rest of the world today. We therefore continue to favor investments in Canadian companies that are primarily dependent on our domestic economy, or that operate in markets with low sensitivity to the global economy.


Interest rates will remain at historic lows throughout the developed world while the US and Europe undertake a long and painful deleveraging process. This is supportive of higher yielding investments such as corporate bonds and dividend paying stocks. The ratio of money invested in equity funds continues to plummet in relation to bond funds and has now reached a low not seen since 1994 (a record US$140 billion was withdrawn from US equity funds in the past 8 months). This “under-ownership” of stocks is a bullish sign for equities.  Government and investment grade bonds have little upside, and are overbought and vulnerable to inflation and rising rates compared to equities. The TSX Composite dividend yield is around 2.8%, almost 1% higher than 10-year government bond yields which are at a lowly 1.9% (“du jamais vu” as they say in Quebec). Many well managed corporations are generating record profitability and are full of cash allowing them to take advantage of attractive investment opportunities and acquisitions of weaker players, and their shares can arguably be seen to be less risky than many government securities. We thus continue to favor investing in profitable domestic companies trading at reasonable multiples and paying attractive dividends, while keeping low weightings to volatile sectors such as financials and resources. However, we still advocate exposure to oil as a hedge against supply disruptions in the Middle East and gold as a hedge against currency debasement and eventual inflation. In fixed income, we continue to look for value among non-investment grade corporate bonds with maturities of less than 10 years.

POST-SCRIPTUM: Stock-Picking Matters

Last year we concluded with arguments about why stock-picking is not dead, and our performance during the past 6 years, and particularly in 2011, is perhaps evidence to our point. In a world that is increasingly globalized in terms of trade, economic interdependence and capital markets interconnectedness, it is no wonder that correlation amongst stock indexes and other asset classes has increased. High-frequency computer trading and the proliferation of Exchange Traded Funds (ETFs) have compounded the problem causing large baskets of securities (represented in indexes and ETFs) to go up and down together. However, as discussed there were many positive performing sectors and companies in Canada in 2011 (i.e. telecoms, renewable power, energy infrastructure). The key is to grasp the “macro” forces at work (which often tell us what sectors to avoid such as financials now), and search for long term investments that offer good value and for which the “micro” is well understood and can be easily monitored.

We continue to believe that times are good and improving for stock-picking, as more investors give up on individual securities selection. To repeat what we said last year, the more that index and ETF investing is in vogue, the less attention is paid to companies and sectors that are not well represented in the capital markets. These include sectors that are out of favor or misunderstood, small/mid-cap companies (which tend to be less liquid) and non-investment grade corporate bonds. Investments that are not driven-up in price by the herd mentality represent better value and lower risk for us and our clients. We cannot promise to beat the TSX every year, especially when overrepresented sectors such as resources and financials outperform, however, we will always strive to generate strong risk-adjusted returns for our clients over the long run and use our “home town advantage” in exploiting opportunities in Canada to the best of our abilities.

We wish you a healthy, happy and prosperous 2012.