October 23, 2013

Third Quater 2013 Letter


We are pleased to report that for the 3rd quarter of 2013, the weighted average return of our segregated equity portfolios was up +4.3% net of all fees, versus +6.2% for the TSX Composite total return (including dividends) and +3.1% for the S&P500 total return (in $CAD). Year-to-date, equity portfolios are up +9.1% versus +5.3% for the TSX and +23.7% for the S&P500 (in $CAD). Depending on fixed income allocations, our balanced portfolios rose between +1.0% and +3.3% during the period (on a weighted average basis), versus +3.2% for a benchmark (50% DEX Bond Universe/50% TSX Composite). Year-to-date, balanced portfolios are up between +2.4% and +8.0% versus the same benchmark which was up +1.9%. Our equity underperformance versus the TSX during the quarter occurred largely during July and August when high dividend yielding sectors such as Utilities, Energy Infrastructure, Telecoms and REITs lagged due to the fear of rising interest rates, and also because of our underweighting in the Energy sector. Top gainers were from various industries and included:

  • Redknee Solutions (+58.1%)
  • Opmedic (+27.2%)
  • Shoppers Drug Mart (+22.6%)
  • Maxim Power (+22.5%)
  • Sirius XM (+22.3%)
  • Suncor (+20.4%)
  • High Liner Foods (+17.1%)
  • Logistec (+16.1%)
  • FP Newspapers (+15.9%)
  • Eagle Energy (+12.8%)
  • Telus (+12.4%) and
  • Newalta (+11.7%).

Both Shoppers Drug Mart and Opmedic benefitted from take-over announcements, the former to be acquired by Loblaw and the latter which management plans on taking private. In fixed income, we outperformed the bond benchmark due 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 3rd quarter of 2013, the Fund was up +4.0% versus +6.2% for the TSX Composite total return (including dividends). Year-to-date, the Fund is up +9.4% versus +5.3% 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, over 7 years ago. Since then, we have earned a cumulative net return of 118.9% (net of all fees and expenses), more than triple the +35.6% total return of the TSX and almost triple the +40.8% total return of the S&P500 (in $CAD). This represents an annualized compound net return of +11.4%, versus +4.3% for the TSX and +4.8% for the S&P500 (in $CAD) over a period of 7 years and 3 months, continuing to rank us among the top Canadian equity managers in the country.


During the 3rd quarter of 2013, the Lester Hedge Fund increased +3.9% net of all fees and expenses, versus +6.2% for the TSX Composite total return. Year-to-date, the fund is down -1.2% net of all fees versus +5.3% for the TSX. Since inception in April 2007, the fund has produced a cumulative net return of +32%, almost double the +17% return of the TSX. After much deliberation we have decided to wind up the Lester Hedge Fund, despite having outperformed both the TSX and the Canadian Hedge Fund Equal Weighted Index since inception. As our firm grows, we feel that our resources can be better utilized in our core portfolio management strategies.

OUR MACRO VIEW: The Fed’s Volte Face = Economic Fragility

The most significant events in the third quarter of 2013 were no doubt the surprise move by the Fed not to begin tapering its $85 billion per month long term bond purchases and the debt ceiling debate (addressed in the next section). In May, Ben Bernanke spooked capital markets by suggesting that the third quantitative easing program (QE3), which was nicknamed “QE Infinity”, would be coming to an end.

This was presumably because the US economy was doing well enough to start withdrawing stimulus. The knee-jerk reaction to this was that bond yields rose sharply and world stock markets dropped fearing that removing liquidity was premature. In our second quarter letter, we stated that Bernanke’s comments seemed out of context and that we expected interest rates to remain low, particularly in light of sub-par US economic growth, recessionary conditions in Europe, a slowdown in China, and an all-out war by Japan to tackle deflation, devaluing the YEN in the process.

Sure enough, in September, the Fed decided to continue its indefinite bond purchases mainly because of the fragility of the US recovery, high real unemployment (based on the “participation rate” which factors in all those who have given up looking for a job), a weak world economic backdrop, and Bernanke’s extreme fear of deflation. In addition, the appointment of Bernanke’s replacement, Janet Yellen, who is reputed to be even more “dovish” than Bernanke, appears to be further evidence that rates will stay lower for longer and that the Fed will be focused on job creation. As a result, the bond market has stabilized and stock markets have resumed their liquidity fueled ascent. For the same reasons we have mentioned time and again (manufacturing overcapacity, low inflation, high unemployment, over indebted governments and weak world economic growth), we still see interest rates remaining ultra-low for the foreseeable future. However, increasing caution is warranted as financial asset valuations rise further.

THE US: Kicking the Debt Can Down the Road… Again

Winston Churchill is credited with an often quoted pearl of wisdom that seems perfectly appropriate for the current debt ceiling debate in the United States: “You can depend on the Americans to do the right thing, but only after they have exhausted every other possibility”.

As expected, a last minute deal to postpone the budget/debt ceiling debate for a couple of months was accepted by both parties, and the markets have continued to trend higher. We again question the apparent euphoria of simply “kicking the can down the road”, but that, alas, is another example of the very short term focus of the markets these days. Actually, Wall Street’s reaction to all this has been relatively muted, in effect saying that it cares less about such silly posturing, knowing that at the end of the day the US will do what it always does: postpone the problem. In addition, polls indicate that a large majority of Americans from both sides of the political spectrum place the blame for this on the Republican Party and more specifically on their extreme right wing members, the Tea Party.

Indeed, many Republicans are infuriated with their own party, as well they should be. Republican senator Lindsay Graham stated that “we went too far”… and … “we screwed up”. And then, in an attempt to deflect some of the blame, he goes on to criticize the Democrats, saying that they are guilty of holding their ground “… instead of trying to help us find a way out of a bad spot”. We consider that last statement absolutely incredible considering that the Republicans have done everything in their power since Obama was first elected to relentlessly attack him and the Democrats, even at the peril of the country as a whole.

We have already discussed how the American political infighting is quickly eroding the public’s confidence in its government and how important confidence in our political-system is to investors. So we will simply conclude with some recent quotes that reflect our position and thoughts on the matter:

“… Democrats won the last election. Like it or not, that is the reality and it is time for the Right to understand that fact.” Dennis Gartman – Right-Wing political and investment pundit.

“The threat to not raise the nation’s debt limit after we have already spent the money is a political weapon of mass destruction comparable to poison gas and should never be used by either party.” Warren Buffet

“We will not negotiate with a gun to our head.” Barak Obama

“The problem with US politics is that there are only two parties, and one of them has all the brains and no balls and the other has all the balls and no brains.” Bill Maher

CANADA: Non-Resource Sectors Continue to Perform Well

The weak global economy continues to impact resource companies. As at September 30, the TSX Composite Materials sector is down nearly 30% year-to-date. The main culprit has been the dramatic retreat of gold, but many commodity prices are well below their recent peaks of 2011. This is the reason that the TSX is lagging the S&P 500 this year, although in Canadian dollar terms, the TSX outperformed the S&P500 in this latest quarter. Sectors such as Consumer Discretionary (+30%), Technology (+24%), Consumer Staples (+17%) and Industrials (+16%) continue to perform extremely well, proof that there is plenty of money to be made in the Canadian stock market. The demise of over indebted Canadian consumers and collapse of our real estate market have not materialized, despite dire warnings by economists over the past few years. This resilience is a testament to Canada’s prudent oversight of the mortgage and consumer loans markets and healthy employment. Even the Energy sector has picked-up from gradually normalizing oil prices as distribution bottlenecks in the US are resolved, and as tensions in the Middle East flare up.

REST OF THE WORLD: All’s Quiet on the Eastern Front (for now)

No news from Europe has meant good news for capital markets over the summer. While Angela Merkel won the German elections in convincing fashion, many problems still fester throughout EURO-land. Italy’s government is on the verge of collapse while its economy is imploding, Spain’s joblessness continues to grow (higher than Greece now), Ireland is back in recession, and Greece may require another bail-out before year end. European banks remain highly leveraged and vulnerable, having procrastinated in repairing their fragile balance sheets, wasting valuable time over the past 5 years.

Last week, the 17 members of the EURO finally agreed for the European Central Bank (ECB) to oversee 130 banks (known as “banking union”), however there is much disagreement about how a failing bank would be rescued. Health checks (stress tests) next year are expected to uncover massive problems (the IMF estimates that Spanish and Italian banks face US$323 billion in credit losses!). This will be European banks’ last chance to come clean, but who will be on the hook? Will shareholders, bondholders and wealthy depositors take losses (as in Cyprus), or will the public have to pay (i.e. citizens of Germany, Finland, etc…) via the European Stability Mechanism? Meanwhile, the ECB’s (Super) Mario Draghi remains armed and ready to “do whatever it takes” to douse any flames, helping to keep sovereign bond yields of morally and technically bankrupt countries and banks well below where they deserve to trade at.

In the Far East, China’s slowdown and attempted reforms have started affecting many Asian countries as well as Emerging Markets. Japan’s all-out war on deflation and attempts to stimulate growth by way of massive money printing (which is devaluing the YEN) is eerily reminiscent of the time leading up the Asian currency crisis in 1997 (a devaluing YEN put severe strain on other Asian countries’ balance of payments forcing widespread currency devaluations including in China). Could this be the calm before the storm?

IN SUMMARY: Playing it Safe in Increasingly Expensive Markets

Because interest rates are still being kept artificially low by central banks, most stock markets have kept rising since investors are willing to pay more today for the discounted net present value of a company’s future cash flows (i.e. those corporate cash flows, generally in the form of dividends, are much more valuable to an investor in a low interest rate environment). Also, artificially low interest rates imply that bond prices are artificially high. This has not only resulted in ultra-low bond yields and paltry fixed income returns, but this artifice dramatically increases the risk of losing money on fixed income securities (bonds and preferred shares) when stimulus is eventually removed. Thus, there has been a large net migration by investors out of cash and bonds into stocks where there is at least the possibility of growth and upside, unlike bonds where there is a fixed amount due at maturity. And with money being so cheap, there is a tendency for investors and speculators to use more leverage. Stock markets have been rising because of cheap money, and not because of strong growth prospects. How this party ends is a topic of much debate.

In fixed income, we continue to buy on dips, picking away at high yield corporate bonds which we feel are mispriced or incorrectly rated (by rating agencies), mainly with 5 to 10 year maturities yielding in the 4% to 8% range. In equities, as markets rise and stocks become more expensive, we are becoming more and more selective, and the search for bargains is becoming increasingly difficult. Our view that the recent drop in high yielding dividend stocks (due to rising bond yields) presented a good buying opportunity is proving to be correct. We also accurately stated several times on BNN that neither Verizon nor any other large foreign carrier was interested in competing in Canada, topping-up our telecom holdings at the time. Such decisions, based on sound reasoning and conviction, are what we are paid to make. We won’t always be right, but if we always agree with consensus and follow the herd, we would not be able to add much value for clients. Going forward, we plan to play it safe. Our resource exposure remains low and we are gradually increasing cash balances. Roughly 35% of our equity portfolio remains buttressed by high dividend yielding stocks in stable sectors like Telecom, Power, Energy Infrastructure and Renewable Energy, with the balance in a diverse mix of small, mid and large cap companies that are either undervalued or have strong growth prospects. We expect that attractive returns will be harder to come by, yet we will still continue to strive hard to achieve them.

Ken Lester, Stephen Takacsy, Peter Dlouhy