July 29, 2013

Second Quarter 2013 Letter


We are pleased to report that for the second quarter of 2013, the weighted average return of our segregated equity portfolios was down only -0.9% net of all fees, versus -4.1% for the TSX Composite total return (including dividends) and +6.4% for the S&P500 (in $CAD). Year-to-date, portfolios are up +4.9% versus -0.9% for the TSX and +20% for the S&P500 (in $CAD). This marks 7 years of outperformance versus the TSX since we implemented our Canadian equity strategy on July 1, 2006. Depending on fixed income allocations, our balanced portfolios declined during the quarter between -0.7% and -1.1% on a weighted average basis versus a benchmark of 50% DEX Mid Term Bonds/50% TSX which was down -3.4%. Year-todate our portfolios are up between +0.8% and +3.6% versus the same benchmark which was down -1.2%.

Our equity outperformance versus the TSX occurred largely during the market declines in April and June, when we protected the downside thanks to our low weightings in energy and materials. Top gainers during the quarter included:

  • Open Text (+19.7%),
  • Wi-LAN (+17.7%),
  • Eagle Energy (+15.1%),
  • Andrew Peller (+14.5%),
  • Shoppers Drug Mart (+11.6%),
  • Logistec (+11.1%),
  • FP Newspapers (+9.1%),
  • CCL Industries (+8.3%),
  • Sirius XM (+8.1%),
  • Manitoba Telecom (+8%) and
  • Bell Aliant (+4.9%).

On the fixed income side, we also outperformed the bond benchmark thanks to our lower duration and higher yielding corporate bonds which did not drop in value as much as long government bonds did on the back of rising yields.


During the second quarter of 2013, the Fund was down -0.8% versus -4.1% for the TSX Composite total return (including dividends). Year-to-date, the Fund is up +5.2% versus -0.9% for the TSX. The Fund mostly owns the same stocks held in our segregated accounts and employs the same successful investment strategy implemented in July 2006, exactly 7 years ago. Since then, we have earned a cumulative net return of +110.5% (net of all fees and expenses), more than quadruple the +27.6% return of the TSX and more than double the +42.4% of the S&P500 (in $CAD). This represents a compound annual net return of +11.2% versus +3.5% for the TSX and +5.2% for the S&P500 (in $CAD). These results rank us among the top Canadian equity managers in the country over the 7-year period.


For the second quarter of 2013, the Lester Hedge Fund pulled back -2.8% net of all fees and expenses, versus -4.1% for the TSX Composite total return. Year-to-date, the fund is down -4.9% net of all fees versus -0.9% for the TSX. Since inception in April 2007, the fund has produced a cumulative net return of +27%, versus +11% for the TSX. It is managed using alternative strategies not available to most investors, including merger arbitrage, index arbitrage, pair trading and short selling.

OUR MACRO VIEW: Withdrawal Symptoms

The second quarter of 2013 witnessed our first taste of stimulus withdrawal, and it was nasty. When Ben Bernanke casually mentioned that he might slow down the Federal Reserve’s bond buying program and possibly end it by next year, the bond market saw a violent reaction, with yields on 10-year treasuries rising from a low of 1.6% in May to around 2.5% in June. This not only crushed fixed income markets, but it also spooked stock markets worldwide. High dividend yielding sectors such as real estate investment trusts and utilities, which are hyper sensitive to rising interest rates, declined sharply. With anemic GDP growth in the US, deep recessionary conditions and high unemployment in Europe, China slowing down, and Japan waging an all-out war on deflation, Bernanke’s comments seemed out of context. Capital markets correctly feared that the Fed would prematurely remove monetary stimulus and that interest rates would start to rise while the world economy is still very fragile. Bernanke then toned down the rhetoric in July, clarifying his stance, and the liquidity fueled party resumed (see US commentary below). As we have previously stated, we expect interest rates to remain low for years to come, as manufacturing overcapacity, low inflation, high unemployment, over indebted governments and slow growth persist.

EURO-ZONE: PIIGS on the Rise Again

Hot on the heels of the Cyprus crisis, Slovenia is now scrambling to avoid a bail-out of its troubled banks. Just recently, the Portuguese finance minister resigned due to growing unrest over tax hikes and austerity measures aimed at meeting its $102 billion bail-out terms, causing bond yields to soar. Ireland, the poster child of successful austerity measures announced that it had fallen back into recession just as it is due to exit its bail-out program. Italian companies continue to struggle with bankruptcies reaching 1,000 per day! Greece continues to be mired in depression and its government has been teetering on the verge of collapse as it moved to shutter the state owned TV broadcaster. Spain’s unemployment rate hit 27% in May, and is now as high as in Greece. With German elections fast approaching, Angela Merkel is careful to keep a low profile and not raise attention to the collapsing house of EURO cards around her. Meanwhile, European banks remain highly vulnerable and are as leveraged as they ever were prior to the collapse of Lehman Brothers, having procrastinated in cleaning-up their balance sheets which is a critical condition for any economic recovery. The only thing holding up Europe appears to be the ECB’s Super Mario (Draghi) and his continuing pledge to “do whatever it takes” to keep it all afloat.

THE US: When Good News is Bad News

As mentioned above, Ben Bernanke’s suggestion that the US economy was recovering to such a point that a “tapering” of quantitative easing (QE) was foreseeable caused the market to react violently on the downside. When GDP figures were released soon after showing the US economy growing at only 1.8%, Bernanke quickly responded that perhaps he was too early with his comments and that he is cognizant of the damage that can occur with premature central bank tightening. Equity markets have come back, but bond markets in Canada and the US are still trading lower after a partial recovery.

This recent episode brings up an interesting theme: When good news is bad news and bad news is good news. To be clear, QE, as discussed in earlier letters, is a euphemism for printing money. Central banks print new money to buy back their own bonds thereby driving down interest rates when they want to boost the economy. Conversely, they tighten the money supply by hiking rates when they want to put the brakes on an overheating economy. The thinking is that if you let the economy grow too much too quickly, it will crash that much harder, whereas if central banks control the money supply properly then economies could theoretically enjoy long periods of slow, steady growth. In normal times (we are starting to forget what that feels like), central banks tweak the money supply both ways as needed. Since the subprime debacle, however, the US central bank has printed new money on an unprecedented scale (as have central banks in Europe and Japan), thus any whiff of monetary withdrawal is causing wild volatility.

Thus when the Fed recently saw good economic numbers and concluded that the need for printing new money is diminishing, the markets should have rejoiced and gone up as a result of positive economic news. Instead, the markets sold off. We have seen this reaction before because investors suffer from short-termism rather than thinking long-term. So, even though the reasons for announcing that QE may be curtailed shortly are good for the economy, the market sold off because in the short term it means that there will be less new dollars chasing assets. Even though everyone knows that QE is unsustainable in the long run and would certainly lead to hyperinflation, investors like it because it makes their assets go up in the present. It is like a doctor telling a patient: “Good news, your recovery is progressing ahead of schedule and we’ll be able to reduce your medications and send you home soon so that you can get back to your normal life”, and the patient reacting like it is bad news because he or she is now so dependent on the comfort of the doctor’s drugs and doesn’t want to go home and deal with real life.

CANADA: Metals Meltdown Steals the Show

China’s slowing growth has had a dramatic impact on Canada’s resource sector, particularly mining and metals which have suffered a huge meltdown, exasperated by the retreat of hot money from gold. The Materials sector is down a massive -31.5% as at June 30, which has been the main culprit causing the TSX to have declined by -0.9% year-to-date. This of course makes the Canadian stock market look bad from an international perspective, although Emerging Markets and the much hyped BRIC countries like Brazil, Russia and China have fared much worse. Nevertheless, Canada continues to surprise with strong employment, brisk retail sales, rebounding housing starts, and positive wholesale and manufacturing statistics. This is reflected in healthy stock market gains in sectors such as Consumer Discretionary (+20.7%), Consumer Staples (+14%) and Industrials (+13.3%). The death of the Canadian consumer and the impending collapse of our real estate market have been greatly exaggerated by US hedge funds, and Canada remains a safe place to invest, barring certain segments of the commodity complex. While the energy sector has also lagged, we have seen a pick-up recently as oil prices normalize from resolving distribution bottlenecks in the US and as tensions in the Middle East flare up again.

CHINA: Credit Crunch

We have been writing about China’s reckless lending habits for years, and it seems that this is finally coming back to bite. Interbank lending rates, a measure of the level of trust among domestic banks, soared to 13% in June. Normally, central banks intervene and try to lower the interest rate that banks charge one another. However, the Chinese government appears so concerned by the torrid pace of corporate banking that they actually welcomed a freezing up of interbank lending in order to slow down loan growth. This is a very worrisome development and suggests that there is a massive amount of potentially bad loans on Chinese bank balance sheets, particularly in the real estate sector and municipal infrastructure. The curtailing of bank lending to larger corporations will have a negative impact on economic growth which is already faltering, as companies will have a more difficult time accessing credit. The government crackdown on the shadow banking system will also affect businesses, particularly smaller ones. China’s transition to a domestic led economy will be a difficult one and continue to have global repercussions on commodities impacting Canada’s resource sector.

JAPAN: A Wild Ride

Since Japan’s new government announced aggressive measures to combat debilitating deflation which has plagued the country for decades, the Bank of Japan has embarked on massive quantitative easing to double Japan’s monetary base, quadruple purchases of domestic government bonds and expand the types other assets it would acquire (such as real estate and stocks). As a result, the Nikkei rose as much as 48% since the beginning of the year to May 21, then plunged 18%, and finished the quarter up nearly 32% year-to-date. Of course, the YEN has been majorly devalued, and in US dollars, foreign investors are only up 15%, hardly worth the gut-wrenching volatility. This wild ride of course has been somewhat artificial given that the extent of government involvement in supporting the stock market is unknown. The recent run up in government bond yields presents a major headache, because domestic banks own such a large amount of Japanese government bonds that the slightest increase in yields causes huge losses for them. Rising yields on Japan’s soaring public debt, now a dizzying 230% of GDP, risk bankrupting the country sooner.

IN SUMMARY: Celebrating Our 7 Year Anniversary

This month marks the 7th anniversary of the newly formed Lester Asset Management. In July 2006, we took on additional partners forming a new team, and decided to focus on where we could add value for our clients: Canadian equities and Canadian corporate bonds. Our philosophy became one of bottom-up fundamental in-house research, with a focus on value investing and event-driven opportunities in small, mid-cap and large capitalization companies either not included, or in sectors that are underrepresented, in the TSX index. This strategy has served us well, as a recent report by pension fund consultants Pavilion Financial shows that we are one of the top Canadian Equity managers in the country, with a compound gross return (before fees) of over 12% per year during the 7 year period (copies available upon request).

Thanks to our strong performance and lower than market volatility, we have attracted a considerable amount of new clients and additional funds from existing clients, for which we are very appreciative. Rest assured that our size is still modest enough to be able to continue executing our investment strategy for many years to come. Our view is still that low interest rates will persist, and that dividend yield will remain an important part of equity returns for the foreseeable future. Fixed income markets are overpriced, and we are very selective about what bonds we purchase. We will continue our hunt for good value in both the stock and bond markets, and invest in opportunities where we can generate higher than market returns with lower than market risk. We remain focused on protecting the downside while trying to achieve acceptable absolute returns for our clients with the funds they have entrusted to us.

Ken Lester, Stephen Takacsy, Peter Dlouhy

Another reason to celebrate from Ken:

For those who have not heard already, I am extremely proud to announce that my wife Trudy and I became first time grandparents on June 7th. Our lovely daughter Allison gave birth to a healthy and beautiful 7.25lb baby girl, Raya Belle Curtis.