July 24, 2014

Second Quarter 2014 Letter


For the second quarter of 2014, the dollar-weighted average return of our segregated equity portfolios was +3.2% (net of fees) versus +6.4% for the TSX Composite total return and +1.6% for the S&P500 (in $CAD). Year-to-date, portfolios are up +6% versus +12.9% for the TSX and +7.5% for the S&P500 (in $CAD). Our low weighting in the energy sector, lack of gold stocks and cash balances caused us to lag the TSX during the quarter and year-to-date.

Balanced portfolios rose on a dollar-weighted average basis between +1.9% and +3.2% (net of fees, depending on fixed income and equity allocations) versus +4.2% for a benchmark comprising 50% DEX Bond Universe and 50% TSX Composite total return. Fixed income returns were +1.9% (net of fees) versus +2% for the DEX Bond Universe. Year-to-date, balanced portfolios are up between +3.8% and +5.8% versus the DEX benchmark which was up +8.8%, while fixed income portfolios are up +3.8% versus +4.8% for the DEX benchmark. High weightings in shorter maturity and lower duration corporate bonds, and high cash balances caused us to lag the DEX during the quarter and year-to-date.

During the second quarter, positive equity returns were led mostly by various industrial and energy related companies including:

  • Logistec (+23.4%) which announced a special dividend and a stock split,
  • Velan (+22%)
  • Suncor (+17.9%)
  • NeuLion (+17.8%)
  • Vicwest (+17.7%)
  • Veresen (+12.4%)
  • Com Dev (+12.4%)
  • Maxim Power (+10.2%)
  • Pembina Pipeline (+9.4%) and
  • Innergex (+8.4%).


During the second quarter of 2014, the Fund was up +4% (net of fees) versus +6.4% for the TSX Composite total return. Year-to-date, the Fund is up +6.7% versus +12.9% for the TSX. The Fund holds mostly the same stocks as our segregated accounts do and employs the same investment strategy used to manage these accounts. Since inception in July 2006, and including the Fund’s performance since January 2012, our equity strategy has generated a cumulative return of +151.5% (net of fees), more than double the +64.2% for the TSX and the +67.5% for the S&P500 (in $CAD). This represents a compound annual return of +12.2% (net of fees) over the eight year period, compared with +6.4% for the TSX and +6.7% for the S&P500 (in $CAD). These results rank us among the top Canadian equity managers for the period.

CANADA: Full of Energy

The TSX continued to steam far ahead of most foreign stock markets this year, led by the Energy sector (+22.4%) and Gold sector (+25.6%). Even the Canadian dollar, left for dead by most economists just a few months ago, performed better than most currencies, rallying by +3.5% versus the US dollar during the quarter. Oil and gold continue to benefit from increasing geopolitical tension in Eastern Europe and the Middle East. Numerous projects aimed at getting crude out of Western Canada into the US, and getting LNG to Asia, continue to drive energy-related infrastructure and transportation stocks. High dividend yielding stocks such as utilities and financials benefitted from sinking bond yields.

THE US: Getting High With a Little Help from China

While the US hit a rough patch in the first quarter due to extreme weather with GDP declining a whopping 2.9%, it continues to make good progress on the job creation front. The unemployment rate is fast approaching the Fed’s targeted 6%. This does not account for millions who have stopped looking for work, which has caused the participation rate to reach its lowest level in 36 years. Janet Yellen, the new head of the Federal Reserve, announced the end of quantitative easing (QE) by year end with little market reaction. Nevertheless, she vowed not to raise interest rates any time soon, yet warned that certain sectors of the stock market are becoming overvalued such as social media and biotechnology. Clearly she is concerned about the quality of job creation while fearing the creation of market bubbles.

The biggest surprise this year is no doubt the new highs being made by the US bond market. Most pundits and investors had forecast that bond yields would rise (and thus bond prices would fall) as the US economy improved and QE asset purchases wound down. Yet, the yield on 10-year US treasury notes has plunged to 2.54% from 3% fuelling a huge rally in the bond market. How can this be? One sure reason is that the Chinese government has been buying US Treasuries this year at the fastest pace on record. Besides investing its massive foreign exchange reserves in the world’s most liquid market, China’s purchase of US bonds serves to weaken the yuan helping to stimulate its export-driven economy, and also suppresses US bond yields which in turn helps to keep mortgage rates down thus benefiting the US consumer who might do more shopping and buy more goods made in China. Funny how that works…

EURO-ZONE: Below Zero

With Europe’s inflation rate stuck in the “danger zone” at 0.5%, European Central Bank head Mario Draghi cut the ECB’s deposit rate to minus 0.10% in June, effectively charging banks a fee for parking their money in a bid to try to stimulate bank lending. It also lowered its benchmark rate to 0.15% for an “extended period of time” and may yet implement a program of US style quantitative easing (asset purchases). With huge sovereign debt loads sustained by artificially suppressed interest rates and high unemployment levels in many countries, Europe’s teetering on the edge of Japan-style deflation is a serious cause for concern. Portugal, which proudly exited its international bail-out program two months ago, announced that it is auditing Banco Espirito Santo, the country’s second largest bank, and has replaced its CEO as a result of financial strain on the bank’s holding company which recently missed a short term debt payment. These problems illustrate that a large swath of the global economy is still suffering from the financial crisis six years ago. Geopolitical tensions in the Ukraine risk making matters worse as trade sanctions will eventually slow down economic activity between Europe and Russia.


The concept of “cash as an asset class” is hard to grasp, especially for those who pay a fee to professional money managers based on assets under management (AUM). Cash in a portfolio looks like inactivity by the manager, so why have any cash in a portfolio? Cash can be an important asset in that it allows managers to act quickly and opportunistically when undervalued securities become available. It also acts as a buffer in down markets. Indeed, many were envious of those who “sat on cash” during the 2008 financial crisis as short term instruments such as commercial paper, asset-backed securities and money market funds “froze-up”. The opposite is true in an up market as cash drags down a manager’s returns. For this reason, and for not wanting to appear indecisive, managers are often reluctant to hold cash.

There is a good reason why “cash as an asset class” is a new phenomenon. In a normal interest rate environment, managers routinely place the cash portion of a portfolio in money markets, T-Bills or other short term debt instruments that would pay small but still meaningful interest rates. Since 2008, traditional low risk money market instruments are either non-existent or pay next to nothing. While some wealth management firms do not charge for cash, they generally charge higher fees on the balance of the portfolio. Clearly, this can bias a manager towards constantly deploying all the cash in stocks or bonds in order to maximize fees. Having said all this, we are currently working with our main custodian National Bank to see how we can earn more than just a few basis points on cash.

IN SUMMARY: The Vanishing Safety Net

As we mark the 8th anniversary of Lester Asset Management, we note that the VIX Index, a measure of market volatility, is reaching lows not seen since just before the 2008 financial crisis. This appears to indicate investor complacency and lack of concern despite stretched valuations, tensions in the Ukraine and Middle East and a still fragile global economic recovery. Is this the calm before the storm? Be assured that we are not taking anything for granted. Prudence has its cost as we have lagged Canadian indices lately. However, when volatility returns (and it will), our investments should fair relatively well.

The table below, prepared by pension fund consultants Pavilion Advisory Group, illustrates how we have kept risk low while generating above average returns. This risk/return analysis shows our 5-year annualized equity returns (net of fees) and standard deviation versus a basket of known Canadian portfolio managers. We have been able to generate higher returns (20.2% annualized versus the TSX at 11%) with lower volatility (standard deviation of 7.1 versus the TSX of 10.6) compared to all other managers in the sample.

We believe that low interest rates will persist as global growth disappointed at 1.6% in the first half of the year and inflation remains subdued. Therefore, central banks will not be raising interest rates any time soon. Low rates in the developed world are propping-up financial assets, but as their values keep on rising for reasons other than fundamentals, the safety net is quickly vanishing. Fixed income securities are fully priced, and we continue to be selective when purchasing bonds for our clients. We remain focused on protecting the downside with a margin of safety, by holding higher cash balances, dividend paying stocks and being prudent when adding new equity positions as bargains are few and far between.

Ken Lester, Stephen Takacsy, Peter Dlouhy