October 22, 2014

Third Quarter 2014 Letter


For the third quarter of 2014, the dollar-weighted average return of our segregated equity portfolios was -0.7% (net of fees) versus -0.6% for the TSX Composite total return and +6.1% for the S&P500 total return (in $CAD). Year-to-date, portfolios have earned +5.3% (net of fees) versus +12.2% for the TSX and +14.1% for the S&P500 (in $CAD). While market volatility is back and the TSX swooned mainly due to resource and financial stocks, our returns were influenced by a variety of sources including energy related holdings.

On a dollar-weighted average basis, balanced portfolios returned between -0.3% and +0.4% (net of fees, depending on fixed income and equity allocations) versus +0.2% for a benchmark comprising 50% DEX Bond Universe and 50% TSX Composite total return. Fixed income portfolios were up +0.4% (net of fees) versus +1.1% for the DEX Bond Universe. Year-to-date, balanced portfolios are up between +4.2% and +5.9% (net of fees) versus +9.2% for the same 50/50 benchmark, while fixed income portfolios are up +4.3% (net of fees) versus +5.9% for the bond benchmark. High weightings in shorter maturity and low duration high yield corporate bonds caused us to lag the benchmark during the quarter and year-to-date.

Top gainers in the third quarter included:

  • Wi-LAN (+19.2%)
  • Logistec (+18.1%)
  • Transcanada (+13.2%)
  • Bell Aliant (+11.1% being privatized by BCE)
  • Asian Television (+10%)
  • CCL Industries (+9.1%)
  • Algonquin Power & Utilities (+7.5%)
  • Direct Cash (+7.4%)
  • Fortis (+6.6%) and
  • Park Lawn (+6.4%).

However gains were more than offset by declines in energy related holdings and several small cap stocks. Nevertheless, we have full confidence in the companies held in our portfolios.


During the third quarter of 2014, the Fund returned -0.4% (net of all fees and expenses) versus -0.6% for the TSX Composite total return (including dividends). Year-to-date, the Fund is up +6.2% (net of all fees and expenses) versus +12.2% for the TSX. The Fund owns most of the same stocks held in our segregated accounts and employs the same successful investment strategy implemented in July 2006. Since then, we have earned a cumulative return of +150.3% (net of all fees and expenses), more than double the +63.2% total return of the TSX and the +67.5% total return of the S&P500 (in $CAD). This represents an annualized compound net return of +11.8%, versus +6.1% for the TSX and +6.5% for the S&P500 (in $CAD) over a period of eight and a quarter years, ranking us among the top Canadian equity managers for the period.

OUR MACRO VIEW: Serial Disappointments

The mystery of why bond yields were falling earlier this year, while the threat of rising interest rates loomed large with the end of quantitative easing (QE) and stock markets roared ahead in anticipation of solid global growth has been solved. It was not, as it turns out, the Chinese conspiring to buy massive amounts of US treasuries to drive down interest rates so that US consumers had more money to shop for goods made in China. As usual, the bond market was correct, foreshadowing a slowing global economy and lower inflation.

For the umpteenth time since the crisis in 2008, world economic growth has been revised downwards. The reasons are numerous and include: slower growth in China due to a strained domestic banking system from excessive and questionable lending, falling real estate values, and manufacturing overcapacity; contraction in Japan from the fading effects of Abenomics and new value added taxes; deflationary pressures and relapse into recession of several European countries due to lack of stimulus and bank lending, combined with the crippling effects of austerity measures; a recession in Brazil exacerbated by uncompetitive businesses and collapsing resource prices; and damage to Russia’s economy from economic sanctions imposed because of the Ukraine conflict.

Since September, world stock markets, which were well ahead of themselves anticipating stronger global growth, have received a brutal “reality check”. While there were plenty of canaries in the coal mine, it was only when Germany’s imperial eagle squawked and shocked the world in early October with it collapsing exports and industrial output that markets really started to panic. At the time of this writing, many global stock indices are now well in the red year-to-date. Despite the collapse of oil prices over the past few months, Canada’s TSX is still the best performing stock market of the developed world in 2014. While most equities are cheaper now, caution is still warranted as central banks appear to be low on the ammunition required to stimulate growth and fight the growing specter of deflation.

THE US: Reaching Escape Velocity?

While the US economy has been recovering and job creation has been healthy, it is uncertain whether or not it has reached “escape velocity” (i.e. whether it has self-sustaining positive momentum without government stimulus). Several statistics continue to dog the Federal Reserve including lack of real wage growth, a 35-year low labor participation rate at 62.7% (high number of unemployed workers who have given up searching for a job), low inflation, and a rising US dollar. The housing recovery appears stalled, US consumers still prefer to save rather than shop, and multinationals face softening overseas markets and devaluing foreign currencies. Given the fragile state of the world economy and subdued inflation, the Fed will be hard pressed to raise interest rates any time soon. Raising rates would likely drive the US dollar higher versus other currencies negatively impacting the export and manufacturing sectors, as well as push the inflation rate perilously closer to the dreaded “D” word (deflation).

EUROPE: Divided We Stand, United We Fall

In trying to come up with a concise way to describe the current situation in Europe, we couldn’t think of a better way than the above. Bound and shackled by a common currency, there has been little progress by profligate EURO-zone nations in implementing the structural reforms needed to become more competitive and reduce wasteful government spending and over-indebtedness (unless forced to cleanse and restructure like Ireland). While the European Central Bank (ECB) has been trying to help governments and financial institutions by artificially lowering the cost of debt so that they clean-up their balance sheets and start investing again, little has been resolved. Unemployment remains high throughout Europe, banks are not lending, sovereign debt to GDP ratios have worsened in most countries, and the differences of opinion among EURO-zone members and among the general population have widened.

Italy is in its third recession since 2008, while Germany is finally showing signs that it can no longer be an island of prosperity unto itself amidst a group of sinking trading partners. As a result, tensions are building between Germany and France, the two architects of the EURO, with Germany hell-bent on austerity and balancing its budget, and France, along with Italy, seeking extensions in reaching their deficit targets as they argue that more government spending is needed to stimulate growth. Meanwhile, Greek and Portuguese government bond yields are rising again and geopolitical risks associated with the increasing popularity of anti-EURO parties are mounting. It looks like the EURO experiment may be coming to a head soon and that the ECB’s attempt to ease monetary policy is “too little too late”. Unfortunately, Mario Draghi relied too much on his “Super” powers of persuasion when he famously pronounced in July 2012 that he would do “whatever it takes” in the hopes that Europe’s problems would resolve themselves.

OIL: The Perfect Storm or The End of OPEC?

You may have noticed something strange lately; that it costs less to fill up your tank. In fact it is hard to remember the last time gas prices dropped in any substantial way. After climbing to about $1.50/liter several years ago, prices have remained stable at that level until the very recent decline. So, what’s new? Well several things and we’ll begin with the classic Economics 101 explanation, Supply and Demand:

The supply of oil is rising – How can that be when conventional knowledge was that the world’s oil production peaked in the 1970’s or 1980’s and that the price of oil by 2014 would be so prohibitively high that mass market alternatives would have been developed. Well, technology got in the way. All that fracking we hear about has enabled the recovery of oil from fields that was impossible before. As well, technological improvements in 3D seismic mapping and offshore drilling rigs have facilitated oil extraction from fields that were previously hidden or areas that were inaccessible. Consequently, the US, being by far the biggest benefactor of the technological innovations, has caught up with Saudi Arabia and Russia to   become one of the world’s largest producers of oil at around 9 million barrels/day.

Demand for oil is essentially flat – While China and some other countries emerging from third world status are still increasing their need for oil, albeit at a slower rate of growth than previously anticipated, it has lately been offset by diminishing demand from developed countries, notably the US and in Europe. Reasons for reduced demand include cars becoming much more fuel efficient and the introduction of electric cars which are now just starting to impact the market in terms of penetration, as well as lower consumption due to softness in the economy. Also, North America’s plentiful and cheap natural gas is starting to replace oil in some uses such as public transportation, heating, industrial and electricity production, and fossil fuel by-products.

The above issues associated with supply and demand are enough to put downward pressure on the price of oil, but they are gradual and have been well publicized over the past several months, and thus should now have largely been discounted by the markets. What is truly new is OPEC’s behavior of late. In the past, whenever oil moved down OPEC would cut production amongst its member countries and the price would recover. Conversely, if oil started to rise too sharply and threaten the world’s economy, OPEC would increase production. Thus, OPEC kept the price of oil in “Goldilocks” territory – not too hot or too cold, to maximize their profits over time. A couple of weeks ago, however, OPEC announced that they were going to pump away at full throttle regardless of the price and this is what has spooked the markets and caused the sell-off of oil related stocks. There is much speculation about why OPEC is doing this such as trying to force Putin to lower Russian production (not likely to happen) or doing this in concert with the US in order to apply more pressure, along with the economic sanctions, for Putin to back-off in the Ukraine. Trying to discourage the US from investing more capital in technological innovations and in developing more expensive oil resources is another possible motive. The most likely answer is that OPEC has lost control of some of its member nations, especially Venezuela. Regardless of the reason(s), markets do not like surprises or new developments and OPEC’s behavior certainly qualifies on both fronts.

Interestingly, Canadian oil producers have not been hurt as much as producers elsewhere for two main reasons. As per historical correlations, the Canadian dollar has gone down against the US dollar almost in step with the decline in the price of oil, and the spread (difference in price) between WCS (Western Canada Select) and WTI (West Texas Intermediate) has tightened. Thus Canadian producers are generally making as much profit in Canadian dollars as they were before the price of oil started its recent drop. This is why we are still happy to own shares in Canadian producers and are looking to add to those positions.


TINA is not Lester Asset Management’s newest employee, but rather is an acronym for “There Is No Alternative”. Traders have recently used this expression when there are limited choices available to earn positive returns. With most of the juice squeezed out of the bond market and the threat of rising interest rates looming, money was piling into stocks thanks to TINA. The attraction and instant gratification of continuously rising stock markets versus the fear of losing money with bonds lured investors to TINA and drove equity prices ever higher. In essence, there was no other place to go to have a good time….

In previous letters, we warned against investor complacency and overvaluation in equities, but had no crystal ball as to when the party would end or how bad it would be. Is it finally over? Our assessment of the recent market decline is that stocks are having a long overdue and healthy correction (akin to getting sloshed at a party with TINA and then stumbling and resting before recovering for the next leg). However, capital markets are also heeding warning signs that global growth is slower than anticipated and that serious economic problems remain unresolved, particularly in Europe. We tend to welcome corrections and buy selectively during down markets. Being aware of the macro risks helps guide us with respect to what companies and industries to invest in, and what to avoid. One can never predict which direction markets will go in the short term or when markets reach a bottom; however buying good companies when valuations are lower improves our chances of earning good risk-adjusted returns over the long run. This is the surest road to wealth creation and the one we are focused on for our clients.

Ken Lester, Stephen Takacsy, Peter Dlouhy