July 29, 2012

Second Quarter 2012 Letter

Positive Year-To-Date

We are pleased to report that for the second quarter of 2012, the weighted average return of our equity portfolios was -2.7% net of all fees, versus -5.7% for the TSX Composite total return (including dividends) and -0.7% for the S&P500 (in $CAD). Year-to-date, we are up +3.5% versus -1.5% for the TSX and +9.6% for the S&P500 (in $CAD). Since our strategy’s inception exactly 6 years ago (July 2006), we have generated a cumulative return of +77.3% net of all fees, more than quadruple the +18.2% for the TSX and quintuple the +14.6% for the S&P500 (in $CAD). This represents a compound annual net return of +10.0% over the 6-year period, compared to +2.8% for the TSX and +2.3% for the S&P500 (in $CAD). These results continue to rank us among the top Canadian equity managers in the country. During the second quarter of 2012, our balanced portfolios declined between -0.2% and -0.8% on a weighted average basis depending on fixed income allocations, while year-to-date these portfolios are up between +2.7% and +3.8%. For more details on our historical results and investment strategy.

Our outperformance versus the TSX during the second quarter occurred during the market declines in April and May, when we protected the downside thanks to our defensive stance with low weightings in energy and materials. As importantly, we have been prudently redeploying cash received from the takeovers of Mosaid, Neo Materials and Viterra, into selective new investments which have performed very well during this turbulent quarter. These include:

  • Canadian Satellite Radio (+16.7%)
  • High Liner Foods (+6.6%)
  • Boralex (+6.5%) and Maxim Power (+4.7%).

Other top performers for the second quarter were:

  • Stella Jones (+25.6%)
  • Algonquin Power (+13.4%)
  • Direct Cash (+13.1%)
  • Northwest Health (7%)
  • Cineplex (+5.6%)
  • BCE (+4.9%)
  • Telus (4.8%) and
  • Logistec (+4.5%).


During the second quarter of 2012, the Fund was down -1.5% versus -5.7% for the TSX Composite total return. Year-to-date, the Fund is up +4.4% versus -1.5% for the TSX.  A few of our clients asked us recently why the performance of our Fund is higher than the performance of their own segregated portfolio that we manage. Indeed, the Fund’s performance for the last quarter is 1.2% higher than the weighted average composite of our equity portfolios (note that there are a few clients whose segregated portfolios may have outperformed the Fund for extraordinary reasons, however they have not called us). It is reasonable to ask whether or not the Fund holds the same securities held in our segregated portfolios, and if we like something should we not buy it for everyone? The answer is a qualified yes. There are several reasons why there may be a discrepancy in performance between the Fund and your account.

1)   To begin with, we certainly do buy the same securities for the Fund as we do for our segregated portfolios with some rare exceptions. However, keep in mind that the Fund only started in January 2012 with several hundred thousand dollars in cash and has been slowly growing to just over $5 million today, of which $700,000 is in cash. As new clients buy units of the fund, we take the cash and deploy it into our model portfolio over a period of time. In other words, we are still in the process of accumulating positions in our favorite companies. Thus the Fund has had higher cash weightings than the average segregated account in 2012 which benefited returns during the down months, and has also held stocks in different proportions than in the average segregated account.

2)   Note that the Fund is an all-equity fund with no bonds or preferred shares whatsoever that would tend to lower positive performance and limit negative performance.

3)   Some clients make special requests to either hold a security they like or avoid certain companies or industries. Also, we avoid or underweight certain securities for certain clients that we deem as unsuitable. For example, we may choose not to buy certain non-dividend yielding stocks or certain small cap stocks for older clients. These differences will impact returns.

4)   There are often tax considerations that shape the asset mix in a given segregated portfolio. For some of our high income clients who request it, we buy flow-through shares (tax shelters). As well, on request, we crystalize capital gains or losses at fiscal year-ends if it benefits the client. In both of these cases, performance may be hindered so that clients benefit by paying less tax.

Within several months, and depending on cash inflows, the Fund should be completely deployed into our model portfolio with weightings that are consistent with our segregated portfolios, and the discrepancies in performance should be reduced. One should then see a convergence between the performance of the Fund and the equity portion of your segregated portfolio, notwithstanding the other points above, if applicable, may continue to cause differences.


For the second quarter of 2012, the Lester Hedge Fund pulled back -5.9% net of all fees and expenses, versus -5.7% for the TSX Composite total return. Year-to-date, the fund is up +2.9% net of all fees versus  -1.5% for the TSX. Since inception in April 2007, the fund has produced a cumulative net return of +28.5%, more than 10 times the +2.4% 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: A World of Diminishing Returns and Lost Credibility

What have we learned since the financial crisis? Despite near zero interest rates in Japan, the US and Europe, growth in the advanced economies has been minimal over the past 12 months. Industrial production is still 8% below its 2008 peak, the steepest downturn since the 1930’s. Developed nations have run out of ammunition. It does not appear that more quantitative easing (QE) and “twisting again” will stimulate more growth. Governments are even less solvent, corporations are cautious and consumers are still deleveraging (or are unemployed). Interest rates can’t go any lower and have caused savers to earn negative real returns (i.e. not earning enough to even keep up with inflation). Brazil, the European Central Bank, China and South Korea, have all lowered interest rates in the past few weeks. The Danish central bank is now even charging a fee for banks that deposit money with it!  As economies stall or even contract from austerity measures, debt levels will rise further while tax revenues shrink and unemployment grows. The industrialized world appears to have indebted itself beyond its capacity to repay, and so the defaults have started (i.e. Greece). There appears to be only one solution left: debt monetization (repayment of debts with devalued currency). Expect printing presses to run for years to come in an Olympic marathon “race to the bottom”, as nations compete to devalue currencies in a bid to prop-up exports. No pun intended, but the gold medal may very well be won by….well, gold.

If this wasn’t bad enough, bankers, which were already on many people’s “most hated” list and had an opportunity to redeem themselves after the 2008 financial crisis, have just shot themselves in the other foot. JP Morgan’s CEO Jamie Dimon, the embodiment of Wall Street arrogance, who has been lobbying against more financial regulation, finally admitted to losing over US$5 billion from what was supposedly a hedged position. It seems bankers continue to gamble away shareholders money and pay themselves big bonuses. Barclays and other prominent British banks are caught-up in a LIBOR scandal whereby they lied about interest rates paid on money borrowed from other banks. One wonders whether or not the global banking system has any scruples or credibility left. In this kind of world, we prefer to continue avoiding leveraged financial institutions and to maintain a defensive investment stance.

EURO-ZONE: Germany Blinks

Much has happened since our last quarterly letter in April. As we expected, there were many twists and turns, including Nicholas Sarkozy being replaced by socialist president Francois Hollande in France, Greek elections that failed to produce a clear winner in the first go around, a bail-out of the banking system in Cyprus, and the announcement of a EURO 100 billion bail-out of Spanish banks. There is even talk of eventually having to bail-out the Spanish government itself, a thought that was unthinkable just a year ago as Spain (like Italy) is considered “too big to bail”. With unemployment at 24.4%, 10-year yields on government bonds near 7%, a real estate crisis and a 65 billion EURO austerity program which is causing much social unrest, Spain is clearly in trouble. Europe is indeed looking like a slow motion train wreck.

Also unthinkable was that the Germans would give an inch in their drive for strict fiscal discipline and austerity imposition on over-indebted nations. Unfortunately, it is too late for austerity alone to reduce sovereign debt levels in countries like Greece and now Spain. When a fire is raging, you have no choice but to turn on the hose and stop scolding those responsible for the blaze. At the June 29 EU summit, the Germans started to bend, accepting such taboo concepts as additional spending on growth initiatives and giving the European Stability Mechanism (ESM) the power to bail-out banks (rather than lending to governments who would bail-out their banks) and to directly purchase sovereign bonds on the secondary market. Eventually, we believe that Germany will need to accept some form of Eurobonds or the Euro-zone risks splitting-up. In return for these concessions, the Germans continue pushing for a “fiscal compact” to oversee national budgets and a central authority that would supervise and regulate the 25 largest European banks. Meanwhile, the German courts are challenging the legality of the ESM, which at this rate, will likely run out of funds before it is even implemented in late 2012.

The good news, if there is any, is that political leaders are acutely aware of the gravity and enormity of the sovereign debt crisis. The European Central Bank (ECB) stands ready to provide unlimited liquidity to the European banking system, and so in a way has “ring-walled” the financial system. The ECB also has the power to print unlimited quantities of EUROs and devalue the currency. We therefore do not expect any type of “Lehman moment” to occur, however, we should still expect the unexpected such as one or several countries leaving the EURO, hopefully in an orderly fashion. Meanwhile, parts of the Euro-zone will go through a painful recession and consequently the global economy will suffer a further slowdown.

THE US: Towards the Fiscal Cliff

As the November Presidential elections approach, all eyes will no doubt turn towards the US. The economy and employment have slowed to a crawl. Annual GDP growth has now fallen below 2%. Factory orders are shrinking as recessions in Europe and slowing growth in China take their toll. Retail sales have fallen for the 3rd month in a row, the longest stretch of declines since the 2008 recession, a reflection of a cautious consumer who is still deleveraging and worried about unemployment (which is still stuck at around 8.5%). And after 4 years, much of the US housing market is still trying to find a bottom….

With mentions of a possible QE3 and the extension of “Operation Twist”, the Federal Reserve is clearly running of out of stimulus and is suffering from the law of diminishing returns. The famous “fiscal cliff”, a lethal combo of tax increases and budget cuts worth around US$600 billion which is currently set to be implemented in early 2013, is projected to shave 4% off of GDP (the fiscal drag) unless Congress gets its act together. With the US still weak from the 2008 financial crisis, it is feared that the fiscal drag will throw the US into recession again. Depending on the outcome of the US elections, we expect a last minute compromise similar to the lifting of the debt ceiling last summer.

CANADA: Safe Haven Status

Continued evidence that Canada is seen as a safe haven is reflected in $26.1 billion of Canadian securities purchased by non-residents in May, the largest monthly inflow on record.  This also explains why the Canadian dollar has depreciated very little versus the US dollar this year, despite large declines in commodity prices, and why the Loonie has been outperforming other commodity currencies like the Norwegian Krone and the Australia Dollar. Reasons for Canada’s safe haven status include the fact that the domestic financial sector is among the strongest in the world, Canada was among the first to recoup all jobs lost in the 2008 recession and that it is also expected to be the first G7 nation to balance its fiscal deficit. Canada is also one of the few remaining countries with the coveted AAA rating on its sovereign debt, and as a result of demand, yields on 10-year government bonds recently hit a record low of 1.6%.

While the Canadian stock market (TSX) continues to lag the US market (S&P500) in 2012, this is more a reflection of its composition being heavily weighted with resource companies (oil & gas and mining). These sectors are more sensitive to foreign events and global economic news. Many other sectors have performed very well on the TSX this year such as consumer discretionary (+11.6%) and consumer staples (+7.9%), which are better representations of the domestic economy. No doubt, however, that Canada will be negatively affected should the economies of the US, China and Europe weaken further.

CHINA: Dubai Times a Thousand?

There continues to be much debate about whether there will be a hard landing in China. Some have gone as far as saying that China “is heading for a hard landing of epic proportions” or “Dubai times a thousand”. Annualized growth has slowed in China to just over 7%, the latest quarter being the second worst in a decade. Electricity usage and cargo volumes are declining and core inflation has wilted to 1.3%. A surprise interest rate cut was announced last week, the second in the past two months, prompting Chinese stocks to tank (normally a stock market would rise on news of such monetary stimulus). These are all ominous signs of a significant slowdown. At the root of China’s problems are shrinking exports courtesy of the fallout in Europe and a soft real estate market high on inventory of unsold properties. The People’s Bank has been trying to stimulate more lending since last fall, reducing bank reserve requirements three times. There is also evidence that China is ramping up infrastructure projects again. These are likely to be transitory fixes while the government hopes that a consumer based economy one day takes hold.

IN SUMMARY: Staying the Course

Over the past two years, our macro views have been largely correct. In our second quarter letter of 2010, we stated that “interest rates would stay low for a long time”. This is why we continue to hold high dividend yielding defensive stocks despite valuations appearing to be expensive in certain sectors. However, when one is earning 1.6% now on a 10-year government bond, a 4% dividend yield looks very attractive. In a world of low rates, it is not surprising that cash flow from dividends is valued more highly than ever by shareholders. Dividends will continue to be an important part of investment returns in this low-return world. Also, as individual investors continue to flee the stock market, bargains abound in the small and mid-cap sectors among which many solid companies are also paying attractive dividends.

With slowing global growth and a plethora of significant risks abroad, more predictable profits continue to be generated at home in domestic and non-cyclical sectors. We thus continue to be overweight the consumer discretionary and staples sectors, as well as utilities such as power and renewable energy, telecommunications, and pipelines and energy infrastructure. We remain underweight materials, energy and financials (owning no banks or insurance companies). And of course, we continue to hold some bullion and a basket of gold stocks which are grossly undervalued versus the price of gold.

Having been bought out of several positions over the past 6 months, we have higher cash balances than normal. We are redeploying this cash prudently in local companies that march to their own beat and which have contributed nicely to our positive returns in 2012. With respect to fixed income securities, we continue to selectively invest in high yield corporate bonds, as we consider government and investment grade bonds overpriced. More than ever, we are in a stock (and bond) pickers market. Beware of ETFs!

If the above sounds familiar, it is because we have stayed the course in positioning portfolios defensively for the better part of two years. During this period, we have managed to generate positive net returns for our clients in very difficult markets. It appears we will need to work even harder to continue doing so.

Ken Lester, Stephen Takacsy, Peter Dlouhy