Equity Fund
October 2008
It was a wet summer in Toronto, particularly on Bay Street where the rain poured hard. The S&P/TSX Composite Index dropped 18.2% in the third quarter. The situation was also ugly south of the border, where the S&P 500 fell 4.4% (down 8.4% in U.S. dollar terms). The two indexes are now down 14.4% (TSX) and 16.5% (S&P 500) over the past year.
The Equity Fund dropped 15.0% in the quarter and is down 11.7% over the past 12 months.
Much of the turmoil stemmed from the troubled U.S. financial system. Overlevered financial institutions met their demise as the lending markets dried up and banks and investment houses were unable to access the short-term capital needed to drive daily operations. Despite the troubles on Wall Street, the fund’s two bank holdings, TD (+1%) and HSBC (+7%), weathered the storm quite well all things considered. This is in part a reflection of their capital strength and prudent management. As for the fund’s other holdings in the financial sector, Manulife also gained ground (+8%), but TMX Group (-30%) and Home Capital Group (-20%) didn’t avoid the pervasive sell-off.
The contagion spread to most other sectors of the market as well, as investors threw fundamentals out the window and traded on emotion – i.e., fear. Energy and materials stocks took it on the chin, as the price of oil and many other commodities retreated. Crude oil finished the quarter down more than 25%, despite recording the largest one-day price gain in history ($16/barrel) late in the quarter. The fund’s package of energy stocks (Canadian Oil Sands, Suncor, Birchcliff Energy and Pason Systems) all pulled back in step.
The agricultural-focused holdings, PotashCorp (-42%) and Compass Minerals (-35%), gave back much of their gains from earlier in the year. Both stocks now represent great value, trading at roughly 6-7 times next year’s projected earnings, especially considering nothing has changed with their core business and they produce a product that continues to be in high demand.
The manager, CGOV, took advantage of the irrational behavior to add to a number of existing holdings in the quarter. They bought additional shares in PotashCorp and Compass as well as TMX Group, Rogers Communciations, Home Capital Group and Nokia on price weakness. Holdings in HSBC and Shoppers Drug Mart were also topped up. All of these companies are market leaders and are in great shape from a cash flow standpoint. CGOV feels very comfortable that these stocks will serve investors well over the long run.
Aside from the above-mentioned purchases, CGOV didn’t add or remove any names from the fund in the quarter. As we often stress, they are long-term shareholders. They like the businesses they own and their conviction in them only became stronger with the drop in valuations. With an average price-to-earnings ratio (P/E) of roughly 12, the valuation of the portfolio is compelling.
When the dust settles, a number of companies will see their competitive position become much stronger with the failure of weaker businesses. In other words, the strong will get stronger. With CGOV’s focus on financial strength and cash flow, the 25 companies they own are in a good position to come out on top.
While the manager put some incoming cash to work in the quarter, the fund still holds a reasonable cash reserve of 7%, and it has maintained roughly 40% of its equity exposure outside Canada.
We’re in the midst of a financial crisis and the situation is painted more discouraging in the media every day. Seasoned investors know this is the time to make money. When irrational behavior takes hold of the markets, there’s no better time to accumulate positions in leading businesses. While stocks could fall further, valuations look very attractive and suggest that there’s far more upside potential than downside.