October 14, 2011

Third Quarter 2011 Letter


For the third quarter of 2011, the weighted average net return of our all-equity portfolios was -3.5% versus -12.1% for the TSX Composite total return and -6.4% for the S&P500 (in $CDN). Our conservative stance since the start of the year helped cushion the blow during the worst quarter since 2008. Our outperformance was mainly due to overweighting defensive sectors such as telecom, cable & media and utilities, underweighting resources and financials, as well as exposure to gold and contributions from several small/mid cap stocks which rose on take-over news. This is evidenced by our top 10 gainers for the quarter which included:

  • Mosaid Technologies (+35%)
  • Asian Television Network (+20%)
  • Score Media (+13.7%)
  • Transalta (+10.8%)
  • iShares Global Gold (+8.2%)
  • Claymore Gold Bullion (+8%)
  • Caribbean Utilities (+7.4%)
  • BCE (+3.9%)
  • Shoppers Drug Mart (+2.9%)
  • and Emera (+2.2%).

We are also pleased to report that, on a year-to-date basis, our weighted average all-equity return is positive 0.5% versus a decline of 11.9% for the TSX Composite and -3.9% for the S&P500 (in $CDN).

Our balanced portfolios returned on average between +0.1.% and -2.7% during the quarter, depending on fixed income weightings, helped by lower Canadian government bond yields which was offset by wider spreads on corporate bonds. Year-to-date, balanced portfolios are up between 0.5% and 2.3%.

We now have a 5-year plus track record since our new team implemented its investment strategy in July 2006, and are pleased to have generated a cumulative return on our all-equity portfolios of 64.8% net of all fees, quadruple the 16% for the TSX over the same period, and far ahead of the -6.4% for the S&P500 (in $CDN). Our performance equates to an annual compound net return of 10%, versus 2.9% for the TSX and -1.3% for the S&P500 (in $CDN). This result places us at the top of Canadian equity managers over the period. For details on our historical results and investment strategy, please visit our Inestment Reports Archive.


We are pleased to announce that we will be launching a Canadian Equity Fund, which will be structured as a Mutual Fund Trust. The reason for launching this fund is twofold. Clients who have more modest amounts allocated to equities will be better served by owning units in our fund. Investing in the fund will facilitate proper diversification versus having stocks purchased directly for clients. Those who choose to own units in the fund will have the appropriate weightings to all of our equity holdings at all times, which is more difficult to achieve when managing individual accounts on a segregated basis. Also, we have been approached by third party financial institutions wishing to access our investment strategy for their clients but can only do so by purchasing units in a fund. By  eating a fund that is opened to third parties, our clients will benefit from increasing economies of scale and efficiencies as the fund grows.


For the third quarter of 2011, the Lester Hedge Fund is down 5.1% net of all fees and expenses, versus a decline of 12.1% for the TSX Composite total return. Year-to-date the Fund is down 8.4% versus -11.9% for the TSX. Since inception in April 2007, the Fund has produced a cumulative compound net return of 19.4% versus 0.4% for the TSX. This fund is managed using alternative strategies, including short selling and merger arbitrage, and is a good complement to our core portfolio management expertise.


Stock markets worldwide have plunged for 5 consecutive months due to a convergence of factors. These include fear that European leaders will be unable to prevent a catastrophe triggered by sovereign debt defaults, concerns that the US has run out of ammunition to solve structural issues such as high unemployment and deflating housing prices, as well as evidence that major economies including China’s are slowing down. While certain economies undergoing severe austerity measures are indeed contracting, the stock market’s recent behavior is reflecting more than just a global recession. Investors appear to have lost confidence in politicians, financial institutions and capital markets. And who can blame them?

Most of today’s problems stem from governments, banks and borrowers taking on too much debt and squandering the funds. The irresponsible behavior of politicians and bankers is now testing the patience of the average person on the street who refuses to bear the burden of more bail-outs. The developed world appears to have reached the boiling point where populist movements are rising against a flawed financial system, from Greece, where demonstrations are turning violent as a result of harsh austerity measures being imposed on its citizens, to the USA, where Occupy Wall Street is spreading like wildfire as Americans protest against financial greed and lack of accountability.

Investors rightfully fear a repeat of the 2008 financial crisis, and are voting with their wallets by bailing out of stock markets before governments have a chance to react. Volatility rules the day amplified by huge volumes being traded by computers and momentum funds, causing investors to endure gut wrenching swings in the valuation of their holdings. Savers are earning negative real rates of returns on certain fixed income investments as interest rates are held artificially low, while real estate values continue to sink in many places. There is clearly a crisis of confidence in the institutions that were supposed to protect investors. This is the macro and psychological environment in which we are investing today.

THE US: Twisting in the Wind

During the quarter, all eyes were on the US government’s battle to increase its borrowing limit, which was tapped out at $14.3 trillion. As expected, a last minute deal was reached in August and the ceiling was raised, however the protracted process exposed a constipated political system and a country deeply divided between cutting costs and reducing deficits, increasing taxes, or providing more stimulus spending. As a result, the US lost its coveted triple A rating from S&P and continues to pile on more debt.

Meanwhile, Ben Bernanke announced “Operation Twist”, which is essentially another attempt to flatten the yield curve (i.e. to lower long term interest rates) without expanding the US balance sheet (i.e. without printing more money). Although positive for mortgage holders and other long term borrowers, it is not obvious that lowering interest rates further will encourage more borrowing and stimulate the economy. Homeowners are still in a “balance sheet recession” from 2008, meaning that they continue the deleveraging process of reducing the debt that got them into trouble in the first place. With housing prices continuing to decline overall and job prospects looking bleak, Americans continue to save and adjust to a more frugal lifestyle.

While most US corporations have healthy balance sheets and are generating decent profits, the high level of anxiety at home and abroad is causing companies to refrain from expanding aggressively. Thus capital spending and new hiring remains muted, dampening the US economy and keeping unemployment levels high. It appears that the US is running out of monetary tools to stimulate economic activity and generate real job growth, while ill winds are blowing from Europe to the East. With political paralysis in Washington, a hunkered-down US consumer, a hesitant corporate America, ballooning debt levels, pending budget cuts, and a higher dollar (courtesy of Europe’s deepening crisis) which will hurt US exports if it persists, the US economy will be left twisting in the wind for now.

EUROZONE: Another Lehman Moment ?

In our last letter, we mentioned that European leaders have been in denial and were playing a waiting game in dealing with the sovereign debt crisis and its repercussions on the banking system. As a result we warned investors to avoid global bank stocks, and the market has since agreed. European and US bank shares have been decimated since the summer. Just a few days ago, the crisis took its first victim; Dexia, the biggest bank in Belgium, announced that it needed to be bailed-out by the governments of France and Belgium to the tune of $126 billion. And this may just be the beginning…

As we have stated in previous letters, no one knows the true extent of how Europe’s debt crisis will impact the global financial system. Banks are watching each other with increasing suspicion as inter-bank lending is becoming expensive if not impossible. Potential liabilities from credit default swaps and other derivatives amongst entangled financial institutions are difficult to quantify, but are surely enormous. The only bit of recent good news is that it appears that Eurozone leaders have finally understood the severity and urgency of the situation, and will do whatever it takes to prevent “another Lehman moment”.

One thing is certain, European banks will need to be recapitalized quickly prior to any sovereign debt restructuring. Shareholders, bondholders and taxpayers alike will need to share the pain prior to writing down any debt of profligate member countries like Greece. The European Financial Stability Facility will also need to be beefed-up to over $1 trillion and given more powers to intervene in the bond markets and bail-outs. This process risks being extremely complex and lengthy as it needs to be coordinated between 17 separate governments whose members are elected by their respective citizens. We expect the battle between the private and public sectors to rage on as European tax-payers revolt.


Gold is a very interesting phenomenon on many levels beginning with its history. Due to its unique qualities of never tarnishing or corroding, of being shiny and malleable, and because it can be found on every continent, gold has been a fascination for mankind for nearly 10,000 years. In fact, gold mining predates iron and bronze. Empires have been built on gold and many have fallen because of it. Due to the fact that gold is indestructible, all the gold that has ever been mined over the last 10,000 years still exists. If you assembled it all together, it would fit into a room measuring 60 ft. by 60 ft. by 60 ft. high. It doesn’t sound like much, but the US dollar value of that cube of gold is about $8.3 trillion today.

Gold has certainly been in the news lately due to its meteoric rise in price over the last few years. In the September 17 issue of Barron’s, Jim Grant, a legendary investor, whom we hold in high regard, was asked: Barron’s: “Is gold in bubble territory?”
Grant: “A bubble is a bull market in which the user of the word ‘bubble’ has not fully participated”. We love this quote, and Grant goes on to explain that valuing gold is a mystery due to the fact that it has no intrinsic value, earns nothing, never pays a dividend and actually costs money to store and insure. He goes on to say that gold is “the reciprocal of the world’s faith in the institution of managed currencies”. It’s hard to argue with this statement, especially in light of how gold has behaved recently against the backdrop of the fiscal insanity most bankers in the developed world have demonstrated of late. Indeed, the future of our fiat (paper currency) system has again been called into question (the last time being during the subprime debacle of 2008). Thus, it doesn’t surprise us if concerned clients call and say that they are scared, and ask if we would object to selling everything in their portfolios and purchase only gold. Many refer to articles by “gold experts” (we aren’t sure how to qualify as one) claiming that gold is going to $5,000 or $10,000 an ounce and that paper money will be useless. If this happens, we don’t want to live in such a world let alone invest in it. In other words, if gold is trading at those levels within a few years, we may all be running for the hills with a shotgun and a bag of wheat, and gold will also be useless (except perhaps if used as a projectile to be thrown at an enemy).

As mentioned earlier, we hold roughly 5% in bullion and senior gold producers in most portfolios because we believe that the rest of the world sees gold as an alternative currency, an insurance policy, or a store of value. Gold should fulfill this role as long as there is uncertainty and that the world’s problems are not so serious that all asset values collapse including gold. Like insurance, we hope to never make a claim. In fact, we hope not to make too much money on our gold investments because this would mean that things are getting better elsewhere.

IN SUMMARY: Let Volatility Be Your Friend

Until a credible plan is firmly in place to protect the Eurozone’s banks, we remain very cautious of the systemic risk which exists in the global financial system. This implies that we maintain a low exposure to more volatile sectors of the market, such as resources and financials, as well as avoid companies that are overly dependent on industries or on economies that are struggling. We also continue to hold defensive stocks such as telecoms and utilities, as well as gold and gold stocks as a hedge against currency debasement. This approach has served us well and as a result we have been asked six times since May to appear on television’s Business News Network (BNN) to discuss our successful investment strategy.

Despite being conservatively positioned, we are cognizant that all equities can get dragged down during prolonged market declines. Such declines however present good opportunities to seek out attractive investments which will enhance client returns over the long run. Warren Buffett often states: “look at market fluctuations as your friend”. It is thus important for portfolio managers to exploit volatility, not necessarily in order to trade in and out of the market, but to purchase shares in profitable, growing and well-managed companies at low prices during major corrections. This is how long term wealth is built.

As stated in our last letter, the one certain thing is that interest rates will remain low for the foreseeable future. Therefore, we continue to hold high dividend yielding stocks in order to maximize returns and mitigate some of the downside risk. Dividends have historically been an important component of overall investment returns, and more so in an ultra-low interest rate environment like we are in today. Low rates are generally beneficial for corporations and supportive of stock and bond markets, and dividend yields are at historic highs versus 10-year Canadian government bond yields which are now below 2.5%.

Ken Lester, Stephen Takacsy, Peter Dlouhy

POST SCRIPTUM: Other Company News

As most of you know, I am a teacher by training and am entering my 20th year as an Adjunct Professor at McGill. In 2008, McGill asked me to be in charge of the Honors Program in Investment Management. I accepted this wonderful opportunity to teach and work with some of the most gifted B. Com. and MBA students in all of Canada and have never regretted it. As time goes on and the program grows, my duties have increased as has my time away from the office. In terms of replacing some of my duties at LAM, our approach is two pronged. First, my partners Stephen and Peter have been successfully managing the company with me for over 5 years and have taken on most day to day responsibilities. Even so, we recognize the need to add some depth, especially with all the new clients we have been signing up lately thanks to our great performance. That said, it is our pleasure to introduce our latest hire; Jordan Steiner. Jordan is a McGill graduate (of course) who just completed all three levels of the very difficult CFA program. He spent the summer with us as an intern (another benefit of my relationship with McGill) and impressed us all with his knowledge, abilities and disposition. It was an easy decision to ask him to officially join us as Research Analyst. As an interesting personal note, Jordan’s father is a psychiatrist working in Montreal who studied under my late mother who was also a professor at McGill.

Ken Lester