Spring 2011
“What did we learn?
Not to do this again.”
– Joel and Ethan Coen
Return to Normalcy
Inside this Issue
+ Return to Normalcy
page 1
+ What I’m recommending today
page 4
After almost three challenging years, most investors who own
primarily Canadian stocks are now back to “normal”. The TSX/S&P
Composite, while still nominally about 4% below its high of 15,073
achieved in June 2008, has returned a total return of 5% for past
three years ending March 31, 2011, when reinvested dividends
are included. However, the more volatile TSX Venture Exchange
has yet to fully recover and remains about 27% below its all time
high achieved in April of 2007. Its loss for past three years ending
March 31, 2011 is 3.2%, despite recent strength in the commodity markets.
TSX S&P Composite
TSX Venture
Linear (TSX S&P Composite)
16000
3500
14000
3000
12000
10000
2500
2000
8000
6000
4000
2000
0
12
/3
1
06 /0 1
/3
0/
12 0 2
/3
06 1 /0
/3 2
0
12 /0 3
/3
1/
06 0 3
/3
0
12 /0 4
/3
1
06 /0
/3 4
0
12 /0 5
/3
1
06 /0 5
/3
0/
12 0 6
/3
06 1 /0
/3 6
0
12 /0 7
/3
1/
06 0 7
/3
0
12 /0 8
/3
06 1 /0
/3 8
0
12 /0 9
/3
1
06 /0 9
/3
0
12 /1 0
03 /31
/3 /1
1/ 0
11
Brian Hayes, MBA, CIM, FCSI
Associate Portfolio Manager
604.718.7503
[email protected]
Source: Thomson ONE
1500
1000
500
0
As for valuation, the forecast 2011 earnings for the companies comprising the S&P TSX Composite are expected to increase 27% this year to $961 according to research prepared by UBS
Securities Canada Inc. The growth in forecast earnings is largely a function of very strong mining and energy earnings. This equates to a forward stock price to earnings ratio of about 14.5X,
which was the average price earnings ratio from 2004 to 2008. This “normalcy” suggests
to me that the recovery stage of the market has more or less run its course, and that future
increases in value will be a largely function of continued improvements in the wider Canadian
economy.
As for fixed income, the DEX Canadian Universe Bond Index is the three year winner, with a
total return of 5.1%, which is more or less in the range of the 1 (5.1%), 5 (5.3%), and 10 (6.1%)
year returns.
What did we learn?
We are, in my opinion, back to normal. But what did we learn from the past three years other
than to not do it again? As usual there is no shortage of opinions from money managers,
economists, journalists, academics, politicians and of course, my favourite, the “talking heads”
on the business TV channel.
Some of the opinions voiced are well thought out, but a lot of them are just gibberish.
My personal bias is that significant portions of the financial and investment industry have proven themselves to be challenged by our primary mission, that being the efficient and productive
allocation of capital. I therefore attempted to screen out those opinions that merely reflect their
author’s parochial self interest.
I also excluded the opinions of those in our industry that do not have to sit across the table
from individual investors and explain what has happened to their savings.
I then eliminated the opinions of those managers who, for what ever reason, have not been
able to post positive results for the past three years. This eliminated about 60% of Canada’s
13,458 mutual funds. You are, after all is said and done, what your record says you are.
Lastly, I ignored anyone who quotes Jesse Livermore in their writings. Jesse, a Wall Street
trading legend, was briefly the richest man in the world after shorting the market in 1929.
Unfortunately he was unable repeat his previous success and committed suicide. Jesse has a
huge cult following amongst more speculative managers, so this screen reduced my research
burden considerably.
Lessons Learned (Again)
In addition to the normal “rules of the road’ such as diversification and asset allocation learned
over the past 34 years, both in school and in business, the following lessons were learned in
the aftermath of the “Great Disappointment” of 2008. In no particular order, we learned the
following:
Brian Hayes, MBA, CIM, FCSI
Associate Portfolio Manager
604.718.7503
[email protected]
2 | Spring 2011
1. Be patient. Holding a reserve of cash to employ at the darkest moment when the
market is pricing the common stock of a good business on the assumption that the
company will fail is invaluable. Cash is also useful to pay bills when staring into the
abyss of a collapsing market. Holding cash requires patience in an upward trending
market such as we have recently experienced, but as in pee wee baseball, no balls are
called in this game. Resist the desire to swing at every pitch. We have learned to wait
for the “fat” pitch!
2. Be very careful when combining high leverage with high volatility investments. You
stand a high probability of financial ruin, unless you are in a position to receive your
own private bail out, if you leverage your investments. Many individual margin investors were ruined by margin calls in the fall of 2008, while large hedge funds, banks, insurance companies and even pension and endowment funds that should have known
better, were rewarded for their risky behaviour as they were deemed “too big to fail”.
They were not only exempted from normal margin requirements by the opening of the
discount window to lower quality collateral, but were rescued, first by TARP (Troubled
Asset Recovery Program) and then by QE (Quantitative Easing). Individual investors,
and US homeowners who borrowed big, were left to twist in the wind. They discovered that leverage simply reduced their ability to withstand temporary reductions in
value and turned short term volatility into a permanent loss of capital.
3. Be a contrarian. It feels safe and warm in the middle of the herd, but it is hard to
see the opportunities, or the threats. Many investors are currently crowded around
the punch bowl of low interest rates, debating the duration of the latest commodity
“super-cycle”, but as history has shown us, most parties end when the host closes the
bar and turns off the music, as he inevitably does. As we learned in kindergarten, it is
best to find a chair before the music stops.
4. Simplicity trumps complexity. At the end of the day there are really only four types of
investments; loans (bonds), ownership of fractional interests in business enterprises
(stocks), physical assets such as real estate, gold, timber or even sacks of rice that
you can touch, and intellectual capital. After acquiring an education and a home, most
investors normally concentrate next on acquiring stocks and bonds in order to save for
their retirement. So-called financial engineering has given retail investors a number of
derivatives which allow them to own these basic investments indirectly. Some common derivatives such as GICs, certain types of insurance, and certain core exchange
traded (ETF) or mutual funds are really quite useful and safe, particularly for those
with smaller accounts and those that prefer other activities to watching the markets
closely. Other derivatives, such as Principal Protected Notes (PPN) are more “sophisticated”, relying on complicated, high cost swaps and options. The now disgraced Asset
Backed Commercial Paper (ABCP) and low quality Mortgage Backed Securities (MBS)
merely used thinly disguised leverage, unregulated exchanges, and flawed investment
ratings in their efforts to achieve their promised alchemy. Many derivatives are simply
too dangerous for retail investors. Investors are cautioned too avoid derivatives unless
there is a clear, easily understood reason to include them in their portfolio.
Brian Hayes, MBA, CIM, FCSI
Associate Portfolio Manager
604.718.7503
[email protected]
5. Be skeptical. Most of what passes as innovation in the investment industry is simply
poorly disguised leverage. The rest is primarily the equivalent of continually reinventing the wheel, albeit in a slightly less stable form. Junk bonds sank the US Savings and
Loan industry in the late 1980’s, while dodgy sub prime mortgages torpedoed most of
what remained of the global banking industry in 2008. What’s next? I have amassed
an significant collection of business cards obtained from mutual fund wholesalers
and their investment managers who, after extolling the virtues of their firm’s latest
“structured product” in a presentation, were unable to answer a basic question on
“what happens if…..? Their usual response was “I’ll get back to you”. Most of them
have never been heard from again! Simply put, if a new product seems too good to be
true, it probably is.
Spring 2011 | 3
6. Control and reduce risk. Conventional risk for most retail investors comes in numerous forms, but the major risks are liquidity (you can’t find a buyer when you want to
sell your investment), fundamental (you buy the stock of a poorly managed or uncompetitive business), valuation (you pay too much), and financial (you borrow big and are
unable to pay back big). Risk is not the value at risk (VaR) number calculated daily by an
army of rocket scientists toiling away in the backrooms of the global banks and hedge
funds. Nor is it one of the dozen or so numbers such as beta or standard deviation that
our trusty Bloomberg terminal regurgitates upon request. No, at the end of the day,
risk is the permanent loss of your capital.
7. Pay close attention to costs. The relatively low rate of return, achieved by the S&P/TSX
Composite (6%) and the S&P/TSX Venture Composite (-4.6%) over the past 5 years,
has exposed the impact of high management costs on indidivual achieved returns.
While this a hotly debated topic in our industry, widespread availability of ETFs have
provided investors with a viable alternative to certain actively managed funds. In my
opinion, all investors should seriously consider using ETFs for a portion of their portfolios, particularly for the passive portion of their account, in order to reduce their overall
costs.
In conclusion, the “Great Disappointment” of 2008 was not only useful for what it taught us
about investments, but also for what it revealed about our character, both as investors and as
advisors. Many investors discovered their tolerance for volatility was lower than they had previously thought. I find it ironic that prescribed low interest rates and large fiscal deficits appear
to have been more effective at encouraging a rebound of speculative behaviour, rather than
stimulating productive employment and building a base for economic growth, particularly in
the US. The “punch bowl” of cheap money will inevitably be taken away, but apparently now
is not the time.
What I’m recommending today
During the first quarter of 2011, social upheaval in the Middle East created the opportunity to
participate further in the higher oil price/secure supply theme. We added an additional energy
position when Canadian Natural Resources (CNQ) dipped in price as a result of a fire at its Alberta oil sands up-grader. As is often the case, the market panicked and overreacted to the bad
news, reducing CNQ’s total valuation by about $4 billion, far in excess of the estimated cost to
repair the damage. CNQ, which is one of Canada’s largest and lowest cost oil producers, has
since recovered in price by about 18%.
Brian Hayes, MBA, CIM, FCSI
Associate Portfolio Manager
604.718.7503
[email protected]
4 | Spring 2011
In late March, Innergex Renewable Energy was added to the portfolio. Innergex, one of Canada’s largest producer’s of “green” electrical power, owns 14 run-of river projects in Quebec and
BC as well as 3 wind farms in Gaspe Bai, having a total installed capacity of 326 megawatts,
or about ½ of the output of Point Lepreau nuclear generating station in New Brunswick. Some
clients who prefer “green” investments had owned Innergex Power Income Fund for up to
five years, earning a relatively consistent return. I was concerned Innergex’s ability to generate
cash might prove too variable for more conservative investors as its cash flow was ultimately
dependant upon either rainfall or wind. However, Innergex has not only been able to consistently pay an attractive distribution over the past eight years, it has been able to both grow its
business and build up strong reserves to maintain its dividend should rainfall decline or should
the wind fail to blow. Innergex’s current dividend yield is 6.1%.
As a March 31, 20110, the Core Equity Portfolio is as follows:
BCE Inc.
Canadian National Railway
Canadian Natural Resources
Cenovus Energy
Enbridge
EnCana Corp. Fortis Inc. Imperial Oil Innergex Renewable Energy
Power Financial Corp. Royal Bank of Canada Suncor Energy TD Financial TransCanada Corp. Cash
4.5%
5.1%
5.3%
5.8%
4.7%
6.4%
4.7%
5.9%
5.0%
4.8%
4.8%
5.5%
8.2%
5.0%
0.8%
Canadian Weighting
76.5%
Claymore Broad Emerging Market ETF
Claymore S&P/TSX Global Mining ETF
Claymore US Fundamental Index ETF
Front Street Growth Mutual Fund
Global Weighting
7.9%
9.2%
5.5%
0.9%
23.5%
100%
Year to date non-annualized return for the period December 31, 2010 to March 31, 2011 was
8.16%. The Standard & Poors TSX Composite Index total return for the same period was 5.59%.
Returns prior to December 1, 2010 are not easily calculated as the Core Equity Portfolio was
held in accounts that also contained speculative investments that are not appropriate for all
investors. The portfolio has now been consolidated into separate accounts; a Canadian and a
Global account to facilitate the tracking of returns in a consistant and verifiable manner, using
my firm’s portfolio software. The December return was 4.33%, which compares well to the
S&P/TSX December total return of 4.1%. Current dividend yield has been increased to 3.12%
on the Canadian portfolio with the inclusion of Innergex. Current dividend yield on the Global
portfolio is 2.32%.
For those investors who are not comfortable owning individual stocks, the Claymore Canadian Fundamental Index ETF (CRQ), which is designed for asset based fee accounts, has now
achieved its five year results, achieving a 5 year total return of 7.47 %, a premium of 0.98%
over the return of the S&P/TSX 60 Index of 6.49% for the same period. CRQ owns 68 Canadian
equities chosen on the basis of cash flow, dividends, sales and book value of equity. CRQ has
significant overlap with the Core Equity Portfolio. CRQ.A, the fee inclusive version of this ETF,
is cost efficient to purchase in amounts as small as $10,000, making it attractive alternative to
the Core Equity Portfolio for smaller accounts.
Brian Hayes, MBA, CIM, FCSI
Associate Portfolio Manager
604.718.7503
[email protected]
With respect to fixed income, I have eliminated several bond funds and a corporate bond
ETF’s containing significant amounts of perpetual maturity, interest rate reset bonds, from
client portfolios. Derivatives such as interest reset bonds performed poorly during periods of
rising interest rates in the early 1990’s. Some mangers hold them to improve the current yield;
however I believe they may be susceptible to significant declines in price, if and when interest
rates increase.
Spring 2011 | 5
Should you have any questions whatsoever on your investments, insurance or your financial
plan, or would like further information on either the ETF or the core equity portfolios, please
call me at 604-718-7503 or e-mail me at [email protected]. As always, in the event
any member of your family, or one of your friends, has any concerns about their investments,
insurance or their financial plan, I would be pleased to provide them with a no-obligation second opinion.
Regards,
Brian Hayes, MBA, CIM, FCSI
Associate Portfolio Manager
PI Financial Corp. is licensed as a broker-dealer in all provinces and territories of Canada and is a member of
the IIROC and the Canadian Investor Protection Fund. The contents of this newsletter are not intended, and
should not be construed, as a solicitation of customers or business in any jurisdiction in which we are not
registered as a dealer in securities. This newsletter is intended for investors who reside in British Columbia
or Ontario. Insurance products are provided to BC residents by PI Financial Services Corp. The opinions expressed in this letter are those of Brian Hayes and do not necessarily reflect the views of PI Financial Corp. or
PI Financial Services Corp. The information contained comes from a variety of sources, and while every effort
is made to ensure accuracy, is subject to change and is not guaranteed. Any portfolio changes discussed may
not be suitable for all investors. Please contact me if you have any questions on your portfolio.
Brian Hayes, MBA, CIM, FCSI
Associate Portfolio Manager
604.718.7503
[email protected]
PI Financial Corp.
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