October 12, 2012

Third Quarter 2012 Letter

A Strong Quarter

We are pleased to report that for the third quarter of 2012, the dollar-weighted average return of our segregated equity portfolios was +6% net of all fees, versus +7% for the TSX Composite total return (including dividends) and +2.7% for the S&P500 (in $CAD). Year-to-date, our weighted average return is +10.5%, versus +5.4% for the TSX and +12.6% for the S&P500 (in $CAD). During the third quarter of 2012, our balanced portfolios rose between +1.5% and +5.2% on a dollar-weighted average basis depending on fixed income allocations, while year-to-date, balanced portfolio returns are between +4.5% and +8.9%. For our historical results and investment strategy, please visit our website at www.lesterasset.com.

Our performance lagged the TSX Composite slightly during the third quarter as we are underweight materials, energy and financials which represent 75% of the TSX. It was mainly the gold sector and to a lesser degree the energy sector that propelled the TSX upwards, sectors in which we have lower than market exposure. Nevertheless, many of our small cap holdings performed well and made up most of the difference. Of note, we again benefited from several takeover offers during the quarter, namely Score Media which rose by +95.5% on news that it would be acquired by Rogers Communications, and Arbor Memorial which increased by +40.1% on the announcement that it would be taken private. Other strong performers during the quarter include:

  • Vicwest (+21.4%),
  • Canadian Satellite Radio (+21.4%),
  • High Liner Foods (+19.2%) which was added to the TSX Small Cap Index,
  • iShares Global Gold (+14.8%),
  • Stella Jones (+12.2%),
  • MTY Food Group (+12.2%),
  • Retrocom (+11.4%),
  • iShares Gold Bullion (+11%),
  • Wi-Lan (+9.3%) and
  • Logistec (+8.6%).


During the third quarter of 2012, the Fund was up +6.6% (net of all fees and expenses), versus +7% for the TSX Composite total return. Year-to-date, the Fund is up +11.3%, versus +5.4% for the TSX. The Fund holds the same stocks as our segregated accounts and employs the same successful investment strategy that we use to manage these accounts. Since our equity strategy’s inception over 6 years ago, our dollar-weighted average composite equity return (from July 2006 to December 2011) plus the return of the Fund (since January 2012) has generated a cumulative return of +90.7% net of all fees, more than triple the +26.5% for the TSX and quintuple the +17.7% for the S&P500 (in $CAD). This represents a compound annual net return of +10.9% over the 6-year plus period, compared to +3.8% for the TSX and +2.5% for the S&P500 (in $CAD). These results continue to rank us among the top equity managers in the country.


For the third quarter of 2012, the Lester Hedge Fund rose +2.9% net of all fees and expenses, versus +7.0% for the TSX Composite total return. Year-to-date, the fund is up +5.9% net of all fees versus +5.4% for the TSX. Since inception in April 2007, the fund has produced a cumulative net return of +32.2 %, more than triple the +9.6% for the TSX. It is managed using low volatility/low market correlation 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: Buying Bonds = Buying Time

In our last quarterly letter, we mentioned that the European debt situation was so dire and the US recovery so anemic, that the printing presses would be turned on full blast causing gold to be the big winner (and not just at the London Olympics). We were right. In August and September, gold rebounded to nearly an all-time high in anticipation of and in response to the massive monetary stimulus by the US Federal Reserve and the European Central Bank (ECB). Specifically, the US announced a $40 billion per month mortgage bond buying program for an indeterminate amount of time until the employment situation improves, as well as the extension of “Operation Twist”. In addition, “Helicopter Ben” announced that interest rates will be maintained at rock bottom levels until at least 2015. In plain English, this means that the US will keep printing unlimited amounts of US dollars until the economy improves such that enough people are hired back into the workforce. Massive printing also helps America devalue its dollar to better compete in export markets and to monetize its $16 trillion in outstanding debt.

In Europe, the precarious financial situation in Spain has forced the hand of Europe’s central banker. The ECB announced that it would start a new and unlimited sovereign bond buying program called Outright Monetary Transactions (OMT) to help lower onerous interest rates of troubled countries like Spain. Not to be outdone, Japan joined the quantitative easing party by announcing a Yen 10 trillion (US$ 124 billion) increase in its bond buying program shortly after the US and European announcements. In essence, the US, Europe and Japan have run out of ammunition (they cannot lower short term interest rates below zero) and are simply buying time until real structural solutions are found to revive growth in their stagnant economies. But time is ticking away and the mountains of debt keep piling up…

EURO-ZONE: The Last Resort

As we said in our last letter, the good news is that political leaders in Europe are acutely aware of the gravity and enormity of the sovereign debt crisis, and the ECB stands ready to provide unlimited liquidity to “ring wall” the European banking system. The bad news is that austerity programs are failing in the periphery making it impossible for governments to pay down debt. And so the ECB has formally assumed the role of lender of last resort, ready to buy an unlimited amount of bonds of any country that asks for a bailout and accepts certain conditions to be imposed on it. Spain, long considered too big to bail, is expected to seek a bailout in exchange for implementing harsh austerity measures and structural reforms to reduce debt. Meanwhile, the ECB nervously waits for Spain to officially ask for a rescue. With unemployment hovering around 25% and protests becoming more frequent and violent, the dilemma as in Greece, is that it may be too late for austerity without Spain’s social fabric unraveling.

Meanwhile, Greece is struggling to meet the terms of its bailout package amid increasingly violent protests as the rest of the Euro-zone is entering recession. Even France is feeling the pinch, with unemployment reaching 3 million people, a 13 year high. Although the “fat tail risk” has been averted for now (i.e. we don’t expect any Lehman-style bank failures), financial institutions remain seriously undercapitalized and there are still plenty of unexpected political and social events that could derail efforts to the save the Euro-zone and the EURO. Left with little choice, Germany continues to soften its stance, its courts having recently approved the legality of the European Stability Mechanism (ESM) which plans to fund bank bailouts and buy sovereign bonds. There is even talk now of the ESM “guaranteeing” up to 30% of newly issued Spanish bonds, so as not to drain the entire rescue fund on a Spanish bailout. As mentioned previously, we expect that ultimately, the Germans will have to accept some form of Eurobonds (jointly and severally guaranteed by all Euro-zone members) in return for members accepting a central authority (“fiscal compact”) to oversee national budgets and empowering the ECB to supervise and regulate European banks. That is, if Angela Merkel can hang on to power in 2013…

THE US:  Uncertainty and Paralysis

At the time of this writing, we are one month away from the US Presidential election and things are starting to heat up.  October 3rd was the first of three televised debates between Obama and Romney, and Romney appears to have been the consensus victor.  According to the London Evening Standard, the odds with bookmakers (who are much more accurate than the polls) on Romney winning went from 5/1 to 11/4 on the outcome of that debate. The debate reminded us of a boxing match where one combatant has a clear lead and his strategy in the last round is to play it safe hoping not to get hit by a lucky punch.  In other words, lose the final round but make sure you win the fight.  The risk Obama is taking by looking weak at the end is that more of his previously committed voters will switch over to Romney than anticipated.  The subsequent debates should be very interesting.

How the US election pertains to the world’s economy, the investment industry and our portfolios is our main concern.  As social liberals who work in the investment industry, we have traditionally been torn between cheering for the Democrats for the sake of most aspects of our lives and cheering for the Republicans for the sake of our portfolios.   This is because, up until recently, the markets had a very predictable, knee-jerk reaction to elections; Republicans are good for business because they want lower taxes, less business regulations and do not want to “waste” money on the poor.  Democrats, on the other hand, simply put, want to take from the rich and give to the poor.  Thus, markets mostly went up when the Republicans won and went down when they lost.

That was then.  Today this dynamic distinction, although still somewhat in evidence, has diminished.  Indeed, the last two Democratic Presidents, Clinton and Obama, acted fiscally more like Republicans  (especially Obama, who, upon election, immediately surrounded himself with Republican type financial advisors and let them drive the bus out of the sub-prime debacle).   Meanwhile, recent Democratic presidents have been leaning towards center, while the Republicans have become more conservative as right wing fundamentalist religious fringe groups have gained power within and are dictating party policy.  While the two parties may be closer fiscally, they have drifted apart socially, explaining the enhanced polarization.  Although the two parties seem more confrontational and apart in their views, they are fiscally closer.  Note that markets are increasingly discounting the probability of important events, and in this case, an Obama victory is already baked into prices in the capital markets.

Now while the two parties are closer in term of making financial decisions, the increased polarization due to social policies is causing more and more concern in markets worldwide.  Remember the fight over the debt ceiling last summer and how markets plummeted while this went on? Republicans, for purely partisan reasons, recklessly chose to dig in their heels and threatened to bring down the entire country, all because they thought it would hurt the Democrats and raise their own profile.  To put this lunacy into perspective, the debt ceiling has been hit and lifted 78 times since 1960 (49 times under Republicans and 29 times under Democrats).  During Reagan’s Presidency alone, the debt ceiling was hit 17 times.  So now the markets seem more concerned that the American political system may fail due to infighting, than they are about whether it’s a Democrat or Republican president sitting in the White House.

This time, we worry that both parties will lead us to the edge of the “fiscal cliff”, a combo of tax increases and budget cuts that is projected to lower GDP by 4% (the fiscal drag) and throw the US into recession. The US economy has slowed to a crawl with annual GDP growth well below 2%. Factory orders are falling while recession takes hold in Europe and growth slows in China. Retail sales are weak due to a cautious consumer who is still deleveraging and worried about work. The decline in unemployment is mainly due to people dropping out of the workforce, while corporations hesitate to hire or invest due to the uncertainty caused by political paralysis. One bright spot is that after 6 years, the US housing market appears to be bottoming out, but is far from foreshadowing a construction boom. The recently announced QE3 and extension of “Operation Twist” will likely fail to create the number of jobs needed to stimulate enough consumption to get the economy humming again.

CANADA: Refugee Camp for Foreign Investors

Canada continues to be seen as a safe haven as reflected by the record buying of Canadian fixed income securities by foreign investors. In particular, European investors, fearing an increasing tax burden at home, are setting up camp in Canada and transferring wealth here. As a result, bonds and other high yield investments have received a big boost again in 2012. This flow of funds has also supported the Canadian dollar much to the chagrin of manufacturers/exporters, but is increasing our purchasing power abroad. Ironically, and as a result of slowing global growth and in particular China’s reduced appetite for commodities, the resource-heavy Canadian stock indices have lagged US indices in 2012, as foreign investors sold-off holdings in the materials and energy sectors. However, other sectors more representative of the Canadian economy have fared very well year-to-date such as consumer discretionary (+13.1%), consumer staples (+10.7%) and real estate (+10.3%). We expect the foreign flow of funds to keep gravitating to these non-resource sectors which is where we have concentrated our investments and one of the reasons why we have outperformed the TSX. Nevertheless, we remain vigilant as to how different sectors of the Canadian economy and how our holdings might be affected by the global economic slowdown and rising Canadian dollar.

CHINA: Losing its Appetite for Commodities?

China accounts for around 40% of the global consumption of industrial metals. Any slowdown from double-digit growth to mid-single digit growth in the world’s fastest growing economy has an enormous impact of the marginal demand of such commodities and their prices. With slowing exports, slowing manufacturing, and more modest infrastructure spending, China is losing its insatiable appetite for materials such as copper, lead, zinc, aluminum, steel, iron ore, etc… resulting in a commodities slump. On the other hand, agricultural products, considered more as global staples and weather dependent, have held up better. China consumes only 13% of the world’s oil (the US is still the largest consumer at 20%), thus the impact of a slowdown there has a less pronounced negative impact on the energy sector. Tensions in the Middle East, increasing production costs, and a devaluing US dollar have kept the price of oil high (gas remains in a glut). As for gold, it has resumed its role as an alternative currency and inflation hedge, and is also benefitting from net buying by central banks and large purchases by India and China.

IN SUMMARY:  Slow and Steady Wins the Race

Much has been said over the past few years about the end of the “buy and hold” investment strategy. Volatility, the “lost decade” and the recently coined “risk-on risk-off”, have the financial industry and media making investors believe that the only way to make money is to “trade the market” or buy ETFs.

We beg to differ. In the past 6 years, we have proven that “buy and hold” can generate far superior results than the market indices. Most importantly, we have done so with lower volatility and lower risk than the market. We did not achieve these results by making big bets or timing the markets. We have simply correctly assessed the macro environment, allowing us to better understand the context in which investments must be carefully selected. Portfolios are positioned accordingly in well run, profitable, and growing companies using solid bottom-up research and fundamental analysis, and these are then held until value is maximized. The main way to make serious money is by making good choices and sticking with them. This means that by being diligent and patient, slow and steady wins the race.

To conclude, we expect the current investment environment to persist for the foreseeable future. That means low interest rates, slowing global growth, and the monetization of debt (currency debasement). These are not necessarily all negative for equities as witnessed by recently rising stock markets, but at the risk of repeating ourselves, we will need to be selective and prudent to keep generating attractive returns.