By Scott Ronalds

We often remind our clients that they don’t need to do much once their portfolios are set up, as our managers do most of the heavy lifting. While it may sound like lip service, it’s a phrase that carries weight.

In times of heightened volatility, such as the past two months, it involves capitalizing on opportunity. The manager of our Equity Fund, CGOV, noted recently that opportunity has been plentiful as a result of investors fleeing stocks due to negative economic events, margin calls and sheer panic.

A recent article in Barron’s (Buy Stocks, Not Economic Data) sums up nicely how investors are being increasingly barraged with economic data and how it should be interpreted when making long-term investment decisions:

“The fact is that macroeconomic data and policies to influence the economy are having little impact on what's really important to equity investors, corporate performance. Yet rarely has there been more attention focused on macroeconomic data and policy decisions. Clearly, the solution is to focus with blinders on what really matters to equity investors — earnings and dividends, and the price they pay to participate in those sums.”

While the economic backdrop remains uncertain, CGOV is investing in profitable, growing businesses, not U.S unemployment numbers or Spanish GDP figures. In the manager’s words, “We are confident that Ritchie Bros will still be conducting auctions in all economic environments and that Suncor will keep producing oil.” Recently, they have added to a number of companies that have seen their share prices decline based largely on panic, including TD Bank, Home Capital Group, Suncor, Insperity and Novartis. The profits of these companies will face little impact from a downgrade in the U.S. government’s debt or new austerity measures in Greece. CGOV also recently added Mead Johnson to the fund, a dominant global player in children's nutritional products and infant formula. They’ve admired the company for a while and the market pullback has provided a purchase opportunity.

The manager has been able to boost returns by trading around core positions. In other words, adding to holdings on share price weakness and trimming on strength. Or, put more succinctly, profiting from the emotions of others. The chart below illustrates a few examples of how they have been able to benefit from an active management approach of trading around their core positions throughout the volatility of the past few years – the heavy lifting in action.

Nalco, the world’s leading water treatment company, recently entered into a merger agreement with Ecolab (a provider of cleaning, food safety and infection prevention products and services). CGOV, the manager of our Equity Fund, sold the stock following the announcement. They originally purchased shares in Nalco in the summer of 2009 and by the time they sold the stock late last month, it had gained over 85%.

We initially reported on Nalco in March, 2010. We highlighted the stock because it was an example of an opportunistic investment. The company scored top marks in three areas that CGOV pays close attention to – cash flow, competitive advantage, and management. Nalco also carried a large amount of debt, however, which was a notable strike against the company.

This follow-up posting is a summary of how the investment played out.

A new CEO, Erik Frywald, took the reins as chief executive of Nalco in 2008. His mission was to increase the company’s revenue growth from existing levels of 3-4% per year to a target of 6-8%. He also set new productivity targets and aimed to reduce the company’s debt.

After gaining a level of comfort with the new CEO and watching his words turn into actions through better financial results and an improving balance sheet, CGOV purchased the stock at a price they felt was significantly below its true value.

Nalco was positioned in the right markets (energy, mining & mineral processing, chemicals & fertilizers, etc.) and Frywald and his team were able to increase revenues by raising prices on their products and winning new business. The company’s balance sheet also improved as a result of refinancing high-cost debt at more attractive terms, and cost cutting. The stock appreciated significantly and CGOV’s investment thesis proved correct.

Following news of the proposed merger, the stock gained nearly 30%. CGOV sold it at roughly $36. At a buyout price of $38.90, the stock still had upside potential of 8%, but if the merger falls through, they believe there is downside potential of 30%, so they felt the sale was the wise course of action (the merger is expected to close in the fourth quarter). If the stock continues to fall in a jittery market, the manager would consider buying it again.

Nalco is a story of buying into a business with a wart or two on it at the right price. While the bulk of the holdings in the Equity Fund have stronger balance sheets and more consistent earnings growth than Nalco did at the time of purchase, there are a few other companies in the Equity Fund that represent similar opportunistic plays, meaning they have attractive attributes and operate in a desirable industry, but have a strike against them which can range from debt issues to problems with a segment of their business to overly-negative sentiment (e.g., Kinross Gold, Manulife Financial). The end result won’t always be as profitable, nor come as fast as it did for Nalco, but when it does the water tastes that much sweeter.

By Scott Ronalds

Our Global Equity Fund has had a poor stretch of performance since early 2010. The fund’s manager, Edinburgh Partners Limited (EPL), is the first to admit this. While they don’t manage the fund with a close eye on what the index is doing, any sustained period of under-performance is cause for concern. There are occasions when a dispassionate, comprehensive review is required. This is one of those times.

The manager recently prepared a detailed analysis that examines: (1) the portfolio’s structure and performance; and (2) market valuations. Here are the key takeaways.

Portfolio Structure and Performance

• Investors have been focused on growth prospects in the developing markets. Specifically, companies with exposure to emerging market consumption and commodities have performed well. These companies have not been limited to the emerging markets, as a number of European and U.S.-based luxury goods, automotive and engineering companies have shown strong price performance.
• EPL agrees with the consensus view that the emerging markets are poised to grow at a much faster pace than the developed markets. They believe, however, that the majority of companies were already pricing in this differential.
• While companies with the highest growth rates may have good prospects, their valuations imply that their profit margins will continue to rise and sales growth will continue to accelerate. Yet, margins are already at peak levels and sales growth is likely to slow in a world with a significant debt overhang. Investors are thus paying a premium for growth and/or making unrealistic assumptions about what is achievable over the next five years.
• The portfolio’s investments are concentrated in companies whose long-term forecasts are achievable in a slower growth environment. Included in this group are: (1) companies with attractive emerging market exposure that trade at reasonable valuations (Unilever, Heineken); (2) “mature” technology companies (Cisco, Applied Materials); (3) European companies in unfashionable businesses such as banking and insurance (UBS, Aviva); and (4) select Japanese companies (still viewed as the cheapest major market in the world).

Market Valuations

• The portfolio currently has a pronounced “value” bias. It is concentrated in stocks with low price-to-earnings (P/E) multiples, low price-to-book value ratios, and slightly higher dividend yields.
• The current structure reflects where EPL is finding investment opportunities today and is not how the portfolio will always look. In some periods, it will have more of a focus on companies with strong growth potential, if such growth is not being valued appropriately. EPL feels strongly, however, that investors are currently overpaying for growth. In fact, the portfolio exhibits the most extreme “value bias” in EPL’s history.
• Importantly, although the portfolio has an extreme value orientation, it does not hold a large proportion of cyclical stocks (which include paper and mining-related companies, among others). Such stocks can exhibit volatile price swings.
• Based on current valuations, higher growth stocks are trading at a 40% premium to value stocks. They will need to grow earnings at a higher-than-normal pace over the next five years to achieve fair value in the manager’s view. Value stocks, on the other hand, only require earnings growth of roughly half their historical long-term rate to achieve fair value, which would come with attractive price appreciation.

EPL believes that if their forecasts are broadly correct, strong absolute performance can be expected from the portfolio over the next five years. Valuation differences (between growth and value stocks) look to be particularly stretched and while the timing of the reversal can’t be predicted, history suggests that when the axis tilts, it can happen in a very short space of time.

In Connor, Clark & Lunn’s latest outlook, they assess the recent pullback in commodity prices. After a sharp run-up that began in early 2009, many commodities have been in retreat recently. Silver has grabbed the headlines, falling over 30% since late April, but copper, gold, oil and many others have been sinking as well.

Is this dramatic reversal the end of a bull market or just a correction in an ongoing upward trend? CC&L looks at four factors in their assessment: (1) supply/demand, (2) liquidity, (3) technical conditions, and (4) the U.S. dollar.

From a supply/demand perspective, the enduring debt problems in Europe, supply chain issues in Japan, slow GDP growth in the U.S., and a deliberate slowing of economic growth by the authorities in China all point to a weakening in final demand for commodities.

As for liquidity, there is growing concern that the coming end to the recent phase of quantitative easing (‘QE2’) will take away a major source of buying (demand).

From a technical perspective, a lot of speculators may be taking some chips off the table because of the huge gains that have been realized over a short period of time. As well, sentiment may be changing as investors react to increased margin requirements. Further, CC&L notes that the recently announced Glencore IPO ($65 billion) is seen by many as a cashing-out by the largest group of commodity insiders.

Finally, the recent strengthening in the U.S. dollar (against major global currencies) is one of the key factors in the unwinding of a lot of commodity positions. Ongoing weakness in the U.S. dollar has been an important source of strength for commodities (the greenback is negatively correlated to commodity prices), but a reversal of this trend could be detrimental for prices.

CC&L feels the end result is that commodity prices will probably enter a wider trading range until the economy takes a more definitive turn (either up or down) or there is a major move in the dollar.

These factors suggest that the tailwind behind the commodity bull market could change direction in the near term. This isn’t to say that the long-term trend will be downward. A convincing case can be made that a growing world-wide middle class will be a hearty consumer of natural resources. Indeed, the China and India stories are hard to ignore. Commodities have historically been a volatile asset class, however, and there is seldom a one-way street in price movements. Moreover, history has shown that the downturns can be particularly punishing.

It is for these reasons that our funds are positioned cautiously in the sector. Our managers own very few precious metal stocks and have stayed well away from the more speculative areas of the market where valuations are hard to justify. Their focus instead is on oil & gas producers, which is a sector where they continue to see strong fundamentals and good long-term growth prospects.

The following is a recap of Edinburgh Partners Limited’s (EPL) investment in Carlsberg. It’s an example of a turnaround opportunity, which is a common theme in our Global Equity Fund.

To re-state the obvious, the recession and credit crisis of 2008/09 impacted many businesses around the globe. Corporate earnings and profit margins took a hit, and poor consumer sentiment and investor fear were damaging factors for many stocks.

As is often the case, over-reaction led to opportunity. Businesses that could weather the downturn and restructure by cutting costs and improving efficiencies looked like good bets.

Carlsberg was one such opportunity. The stock dropped nearly 70% in a two month span in late 2008 after the company cut its sales and earnings forecasts and the credit crisis was rearing its ugly head. Yet, Carlsberg presented a reasonable outlook for 2009 (and in fact reported decent earnings for 2008). Their stated focus was on increasing cash flow, controlling costs, “protecting earnings”, reducing capital expenditures, boosting sales in emerging markets and accelerating debt repayment.

The company faced another setback in the second half of 2009 in one of its key markets, Russia, where the government proposed a hefty excise duty tax that would lead to price increases and a feared ‘trading down’ trend to less expensive local beers.

At the time, Edinburgh Partners was eyeing the stock as a good turnaround opportunity. Their thesis was that significant earnings growth could be expected from margin improvement in European markets, sales growth in emerging markets (especially Asia) and from reducing debt. And while Russia presented uncertainty, the manager felt the risks were sufficiently factored into the stock price. Carlsberg was cheap in EPL’s view, and they purchased the stock in the fall of 2009.

Edinburgh Partners uses a 5-year earnings forecast model as part of their analysis and typically have an investment time horizon of 3-5 years or longer. The Danish brewer was an exception; it was sold after one year. By the summer of 2010, Carlsberg was well along the path of recovery. It had achieved double-digit growth in operating profits, strong revenue growth in Asia, and higher margins in all regions. Further, the decline in Russian volumes was smaller than expected. The stock had rebounded sharply on the improved results.

Carlsberg had delivered on its objectives faster than Edinburgh Partners had anticipated. By the fall of 2010, the stock had gained roughly 70% since their first purchase (in October ’09). The outlook for the company was still positive, but the stock was no longer cheap in EPL’s view and they sold the position.

Today, the manager is finding a similar opportunity in Heineken. The stock has been weighed down by weak European growth, but the company has significantly broadened its access to higher growth markets with the purchase of FEMSA’s beer unit (Dos Equis, Tecate, Sol). Further, Heineken is the world’s leading premium beer brand, and it trades at a lower valuation and offers a higher dividend yield than Carlsberg. The manager doesn’t anticipate the turnaround will be as brisk as Carlsberg’s, but the story is nonetheless appealing.

Although Carlsberg and Heineken are European-based companies, both have significant exposure to markets outside the continent. While Europe is out-of-favour due to the sovereign debt issues in the region, many investors are overlooking companies that have an old world address but a global reach. In EPL’s view, this negative sentiment is presenting attractive investment opportunities.

A final word on Heineken: it’s the preferred lager of this author, which should provide a good boost to short-term revenues so long as the Canucks don’t take a premature bow out of the playoffs. Early signs are encouraging.

While it’s still premature to evaluate the impact that the tragedy in Japan will have on businesses and the economy, Edinburgh Partners (the manager of our Global Equity Fund) has conducted a preliminary assessment.

Before addressing specifics, EPL notes that the comparisons some commentators are making with the stock market’s reaction after the 1995 Kobe earthquake are not appropriate. In 1995, the stock market was expensive, trading at a cyclically-adjusted price-earnings multiple (P/E) of over 35x. Currently, the P/E is less than half that level and earnings growth remains strong (although it will be hampered in the near-term by the residual effects of the earthquake and tsunami).

In evaluating the potential impact on corporate earnings over their 5-year forecast horizon, the key question EPL is addressing is the extent to which production facilities have been affected. For many companies, where the plant remains intact, they’re expecting only short-term supply chain disruptions. In the case of construction and power companies, they are looking at comparatively larger and more sustained impacts.

EPL’s analysts expect that for the majority of companies in the Global Equity Fund, long-term earnings forecasts will not vary by more than 10%. In general, they feel the share price declines for these companies have been excessive and expect to see sustained appreciation when the nuclear threat abates and general sentiment improves. Once they’re able to confirm their initial findings, they’ll look to increase holdings where appropriate.

For certain construction-related companies, EPL anticipates a potential positive change of more than 10% in long-term earnings forecasts, as these companies are likely to benefit from a significant increase in public works spending. Kajima is an example of a portfolio holding that falls into this category.

The manager believes that the two principal caveats to a recovery in stock prices relate to nuclear risk and bond market risk (i.e. reconstruction financing needs will place excessive pressure on government finances). The first risk remains unclear. The current expert appraisals suggest minor contamination at a local level but until definitive statements are made by the authorities, concerns will remain.

While the second risk is also real, EPL feels that a different scenario will emerge whereby the magnitude of the disaster will stimulate national unity in the political process and we’ll see a co-ordinated reaction from the Treasury and the Bank of Japan. Early signs of this are encouraging.

At the risk of sounding pat, we encourage investors to stick to their long-term plan and avoid any knee-jerk investment decisions based on the news coming out of Japan. Our manager is on top of the situation and is making the hard decisions on your behalf.

As the Japanese disaster unfolds, we are dealing with many cross-currents in the capital markets. The pictures, dramatic news stories and unknown nuclear dangers are all part of a mix that has the potential to create an overreaction by investors.

In our case, we are watching the situation closely given the global nature of stock markets and the fact that we hold 8 Japanese stocks in the Global Equity Fund (Bridgestone, Fujitsu, Kajima, Panasonic, Mizuho Financial, Mitsubishi, Sony and Yamaha Motor).

We haven’t had a lot to say so far because we’re letting the analysts at Edinburgh Partners (EPL) do their thing. They’re assessing the extent of the damage to the companies’ productive capacity and factoring that into their earnings estimates. Clearly the power cuts, rationing and general disruption have shut down offices and facilities this week, but the impact on longer-term values is less clear. As we’ve noted before in situations like this, asset write-offs and short-term operating losses are real, but unless they have a lasting impact on a company’s market position (which may be the case in some situations), they will have very little impact on a company’s long-term value.

We don’t yet know if EPL will make any changes to the portfolio, Japanese stocks or otherwise, as a result of the earthquake. Further updates to come.

Note: As of yesterday's closing prices (March 15), the Global Fund is down 3.3% over the last three trading days and is now down 2.4% year-to-date.

(The indicated rates of return are the simple returns including changes in unit value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Past performance may not be repeated)

By Scott Ronalds

At our recent client presentations, there was a subtle shuffling of feet and an air of unease when the topic of Japan came up. Japanese stocks have been an area of increasing interest for our global manager (Edinburgh Partners) and we laid out the reasons why:

• Japanese stocks are cheap on several measures.
  
• The proverbial story of an overvalued stock market and stagnant economy is outdated. Despite an ugly aggregate picture, there are key areas of strength and businesses worth owning.
  
• The future for China lies in increased consumption and Japan holds strong market leadership in consumer electronics and manufacturing/automation.

Yet, investors still love to hate Japan. The country’s stock market has trended downward for two decades, its economy has sputtered and its demographics are unfavourable (the population is the oldest in the developed world). The warts are easy to see, which is why most investors prefer to ignore the region.

Lately, however, Japanese equities are raising some eyebrows. As mentioned, Edinburgh Partners likes the prospects of select stocks and feels there is cause for optimism. The firm’s CEO, Sandy Nairn, has scripted a précis on why he believes the market is worthy of investment. You can download the summary here (a warning, though – it’s 19 pages long and quite technical).

Warren Buffett plans to visit the country soon and noted last spring that he’d like his company (Berkshire Hathaway) to make a big acquisition in Japan in coming years. His sidekick, Charlie Munger, noted that Berkshire is “quite favorably disposed to doing more in Japan.”

The New York Times also recently published an article titled Japanese Stock Market is Getting New Respect which suggested that fire-sale stock prices are slowly attracting more investors. The piece quotes a New-York based manager: “Japan is by far one of the cheapest markets in the world … it’s so universally hated, yet it might be one of the world’s best-performing markets over the next five years.” The article cites some interesting facts:

• Nearly two-thirds of the 1,700 companies listed on the Tokyo exchange have price-to-book ratios below 1 (meaning if one of those companies was dismantled and sold off for parts, it would fetch more than its market value).
  
• Despite a recent up-tick, the market is still more than two-thirds off its 1990 peak.
  
• Some companies are starting to raise dividends and have announced share buybacks to counter longstanding investor complaints that companies hoard too much cash.

Further, the author suggests that Japanese export-oriented companies seem like a less risky way to invest indirectly in the Chinese growth story, and if the inflation emerging in other countries spills into Japan, it could help reverse depressed prices, which would be positive for the market.

The Japanese market has been down-and-out for 20 years – enough to discourage many investors. But stocks are cheap and the country is well-positioned to benefit from increased consumption throughout Asia. Our global manager sees Japan as fertile ground for value. It appears that the country is slowly starting to get a little love from other managers too. We recognize that the Japanese story is an uneasy one for some investors, but we strive to be transparent in our communications. Our discussions on unloved investments may lead to more feet shuffling and unease at future client presentations. Thus, we’re thinking of serving wine beforehand – which may tie in nicely with our conversation on France.

The manager of our Equity Fund, CGOV, recently published a short piece that addresses a timely topic – inflation. With commodity prices rising across the board, investors may be curious as to how certain companies are affected by this trend.

CGOV references five portfolio holdings to illustrate how some companies will benefit from rising prices while others will feel the pinch.

The manager’s key takeaway is that the Equity Fund is well positioned to withstand an environment of rising commodity prices, as roughly 25% of the portfolio is invested in commodity producers (e.g. Suncor, Potash Corp and Crescent Point) and several companies have sufficient pricing power that enables them to pass through rising input costs to their customers (e.g. Unilever and Nalco).

Click here to read the full report.

Morningstar’s David O’Leary recently wrote a research report on our Small-Cap Fund. The piece, titled There’s a Lot of Potential in this Obscure Fund, is available on Morningstar’s website for subscribers to their premium service.

Morningstar also published a short video yesterday in which David and a colleague review the fund. Key points of discussion include the portfolio’s tight level of concentration, the manager’s investment style, and how the fund is different from many of its peers. Small, unconstrained and ‘quirky’ are the main themes. If we’ve piqued your interest, you can watch the clip here.

Small cap stocks were hit particularly hard during the credit crisis of 2008/09.  In this update, Tom talks with Wil Wutherich (the manager of the fund) about the current financial shape of the businesses in the portfolio and how they weathered the storm. Wil also shares a few anecdotes on some of the fund's holdings to bring his investment philosophy to life, and discusses why he's optimistic (and comfortable) about select oil stocks in Colombia.

Download, subscribe via iTunes or RSS, or watch now:

"Japan has been bad for so long, it's largely ignored. Just to give you a flavour of that, we had the senior management of Sony in to see us and they told us we were their largest shareholder in Europe. And we're not a large company. It tells you the lack of interest in Japan."
      - Dr. Sandy Nairn, CEO of Edinburgh Partners Limited 

In this update, Tom and Sandy discuss some of the opportunities and dangers in the global markets (Sandy's firm manages our Global Fund). They touch on the outlook for the economy and how it impacts EPL's research efforts, their views on Asia, and the return expectations for the portfolio.

Download, subscribe via iTunes or RSS, or watch now:

In this update, Tom discusses the Equity Fund with Ted Ecclestone, a partner at CGOV (the manager of the fund).

The portfolio has an emphasis on high-quality stocks, which have underperformed the broader market over the past several quarters. Ted reviews where CGOV stands today on this positioning. He also discusses some of the recent changes in the fund and addresses a few stock specific glitches (Manulife and Shoppers Drug Mart) and a key win (Potash Corp).

Download, subscribe via iTunes or RSS, or watch now:

With the camera rolling, Tom recently sat down with Warren Stoddart, a Vice President and Managing Partner at Connor, Clark & Lunn, to provide an update on our Income Fund (which CC&L manages).  Topics of discussion included:

• interest rates
  
• inflation
• return expectations
• corporate bonds
• real estate investment trusts (REITs)

In his latest interview with Independent Investor (a U.K. publication), Sandy Nairn, the CEO of Edinburgh Partners (the manager of our Global Equity Fund), provided his views on the global economy and capital markets. After being cautious in late 2007 and bullish in early 2009, Sandy sits more in neutral territory today. He sums up his outlook for investors as follows:

“I’m not massively depressed about the outlook. But nor am I massively excited either... Returns from equities are likely to be lower and volatility greater than in the past, but the long-term outcome for equities remains a positive one, both absolutely and relative to other asset classes. In other words: get rich slowly!”

As for how Edinburgh Partners is positioning the Global Equity Fund:

• “We expect to retain substantial holdings in the U.S., but as with other developed economies, unless valuations fall meaningfully from here, it is unlikely we will have much exposure to those sectors of the economy which are exposed to falls in Government expenditure and direct consumer purchases.”
  
• “We are still finding European stocks worth buying. Europe is very much a region of contrasts. The largest economies are not in bad shape, even though both Italy and Spain do need fiscal retrenchment. It is in the periphery that the issues reside and it is important to keep in context the relative sizes of each.”
  
• “The one area where we’ve made a significant increase recently is in Japan, where we’ve gone from having 4% of our global portfolio to more than 15%. The percentage could easily go up further.”

The piece expands on Edinburgh Partners’ rationale for Japan, and touches on a number of issues that are top of mind for global equity investors today – namely, the Greece/euro situation, the outlook for China, the recovery in the U.S., opportunities and obstacles in Europe, and banking reform.

If a ‘staycation’ is in the cards this summer, click here to download the full article. Sandy will take you around the world.

Last week I met with Edinburgh Partners Ltd (EPL), the manager of our Global Equity Fund, on their home turf. Here are the highlights.

The Firm

EPL has been in existence for almost 7 years and has been very successful. They manage C$11.4 billion for corporate, government and mutual fund clients. It’s a credit to their team and long-term record that they’ve been able to attract many blue chip clients, including a number of pension plans in Canada. To control their growth and ensure a proper transition for new clients, however, EPL recently closed for new business. They aren’t near maximum capacity, so I would anticipate they’ll reopen later this year or in 2011.

In step with their success, they’ve continued to invest in the business by adding experienced people (I met two of the new hires) and enhancing their risk management and IT systems.

Big Picture

Sandy Nairn, the founder and CEO, said that it’s not useful to have one economic theme right now. The world is out of sync. Developed countries are burdened with debt, have challenging demographics (in some cases) and are focused on stimulating economic growth. Their monetary aggregates have not expanded because the banks haven’t been lending. The less developed / emerging economies on the other hand, are well financed and in a position to continue growing at above-average rates. They are more concerned about inflation and have been trying to dial down the expansion.

As a result of this dichotomy, the EPL team is cognizant of where a company’s revenues come from. For example, Carlsberg, a fairly new holding, is based in Europe, but its growth and profitability is tilted toward the emerging markets.

European crisis

Without coming across as unconcerned or cavalier, my sense is that Sandy and the team feel that the crisis is overblown. Certainly the debt problems are serious, but Sandy does not see Spain being in jeopardy and the issue around Greece is its “competitiveness” more than its debt. For Greece to become more competitive, such that it can support its debt load and a reasonable standard of living, it may need to find a way to devalue its currency – i.e. bring back the drachma. How else can they make a 25% pay cut palatable?

The Fund

So far, the crisis hasn’t triggered any changes to the fund’s holdings. EPL felt at the outset that the global economic recovery would be slow and bumpy, and the portfolio is structured with this in mind. While the team wishes they owned “one less European bank”, they don’t want to sell any at current levels. As for buying, the team has been more focused on Japan and the U.S. than Europe, although that may change with the weakness of the last few days. EPL is always quick to jump on opportunities when they arise. There are no committee meetings or world-wide conference calls to schedule.

Despite all the turmoil, EPL is still projecting attractive returns for the portfolio (which obviously improve with every down day) and are maintaining a balanced approach, which means the fund isn’t tilted towards any one theme or economic factor. This is in contrast to their cautious stance in 2008 (when the portfolio was heavily weighted in health care, telecoms and cash) and more aggressive positioning in 2009 (when they acted on opportunities in the emerging markets and within the technology sector).

I recently attended a luncheon hosted by Connor, Clark & Lunn, the manager of our Savings Fund and Income Fund. The session focused on the economy. Larry Lunn, the firm’s chairman and co-founder, was the keynote speaker. Larry is an experienced industry veteran who has navigated through a number of economic and market cycles and always has a thoughtful and well researched view – and he doesn’t sugar-coat it.

Prior to introducing Larry, the presentation started with a quip by Phil Cotterill (Head of the Client Solutions Team at CC&L) that the session had been moved to a lower floor of the building at the last minute (read: to prevent any ‘jumpers’). After the presentation, I wished I hadn’t turned down the Heineken at lunch.

Larry and the team at CC&L didn’t exactly paint a rosy picture of the secular forces that will shape the next decade. They focused on the debt hangover that the global economy is facing and the unfavourable demographic scenario that is emerging as the boomer generation moves past its peak equity accumulation period and into a ‘dissavings’ phase. In a follow-up report, CC&L summarized their take on the next ten years as follows:

• The structural imbalance between a savings-short, leveraged American consumer and the Chinese mercantile economic model, with an emphasis on too much savings, fixed investment and exports, will be disruptive.
  
• We will face a period of anemic sub-par economic growth because of changing demographics and debt formation, which will lead to shorter and more volatile business cycles.
  
• Bigger government, more regulation and higher taxes are in store.
  
• Higher risk premiums (because of the aforementioned imbalances) will lead to lower P/E (price-to-earnings) multiples on stocks.

Larry concluded the presentation by suggesting that investors should expect low single-digit stock and bond returns over the next decade. As I said, no sugar-coating.

I was hoping to leave the session with some positive insights and messages to report back to our clients, but I was stumped.

After reflecting on CC&L’s message for a few days and reviewing their outlook, however, I’ve changed my stance. There were some useful takeaways worth sharing. First, the economic situation is not entirely discouraging, as they note in their report. Corporate profits have improved (substantially in some cases), growth has picked up, government spending is creating stimulus and interest rates remain very accommodative for growth. While government spending and low interest rates will eventually have to be unwound, the immediate future appears reasonably bright (notwithstanding the debt hiccup in Europe). There are certainly longer-term issues that need to be addressed, but that is not to say they can’t be resolved.

Second, economic forecasts are just that, forecasts. They are meant to paint a rough picture, not a detailed map.

Third, greater short-term volatility can play into the hands of opportunistic investors and agile managers.

Fourth, it’s motherhood stuff, but investors are well advised to make sure they have an asset mix that they’re comfortable with – one that reflects their risk tolerance and time horizon. Those who take on too much risk and/or can’t handle short-term volatility will have the most sleepless nights.

Fifth, Larry and his team are preparing their clients for low single-digit returns over the next decade, not negative returns. Given the economic headwinds they foresee, they still believe the capital markets will provide positive, albeit volatile, returns.

And finally, Europe and the U.S. are on sale for Canadian investors. Our dollar goes a long way these days in buying foreign assets. In fact, if the Vancouver real estate market holds up and southern Europe goes bankrupt, I’m thinking of selling my place and buying Greece as a ‘fixer-upper’.

First it was swine flu. Now it’s fragile economies. Seems like pigs can’t catch a break these days. The southern European nations of Portugal, Italy, Greece and Spain (PIGS) are garnering plenty of attention in the media, as investors fear these countries may default on their debt obligations, with Greece at the forefront.

Reminiscent of the global credit crisis of 2008/09, emergency bailout measures have been proposed to curb another financial fallout. Not surprisingly, we’ve seen an increase in stock market volatility and overall nervousness about the events transpiring across the pond.

As our name suggests, we are encouraging investors to maintain a steady hand on their portfolios. Knee-jerk reactions to negative short-term news and uncertainty are often ill-timed and later regretted. That said, it would be irresponsible to simply turn a blind eye to the state of affairs in Europe.

So, what exactly is happening? Best to turn to the source, Edinburgh Partners (the manager of our Global Equity Fund). Tom is making a trip to Scotland next week, coincidentally, to visit the team in Edinburgh and will report back with an update on the portfolio and EP’s views on the economic situation and investment conditions in Europe. In the meantime, investors interested in details on the recent bailout package may find Bank of America’s latest report useful.

If you have a specific question you’d like answered by the manager, email us and we’ll send it along with Tom (and his golf clubs) to Edinburgh.

It’s always great to visit Montreal, but last Thursday was particularly timely for reasons beyond the sunny, warm weather. It is the home turf for Wil Wutherich, the manager of our Small-Cap Fund, a fund that has just turned three years old (along with the rest of our lineup).

To the end of February, the fund has gained 0.5% per year in an environment where small cap stocks dropped (-2.1% per year) and were considerably more volatile than the overall market. The fund had a great year in 2007, weathered the storm reasonably well in 2008 and had a poor 2009 when it lagged far behind a soaring small-cap market.

My meeting with Wil reinforced why the fund performed so differently compared to the overall market. As background, he looks for small companies that have a profitable history of growth and market share gains. His universe of potential holdings ranges from ‘micro-cap’ companies (small and undiscovered) to ‘mid-caps’. He closely follows a select number of stocks (45-50) and builds a concentrated portfolio from that list. The research list and Steadyhand fund represent a diverse mix of stocks, but in no way reflect the market indices, which are heavily weighted towards resources and financial services.

Three years is a short time in which to assess the performance of any portfolio, but Wil and I talked extensively about the missed opportunity in 2009. While it was clear that this fund would never have kept up with a market driven by beaten-up resource stocks, the shortfall was nonetheless substantial.

The 2009 performance was reflective of two things primarily. The first is the fact that Wil’s universe held up better in 2008, and as a result, gave the fund less recovery potential in 2009. Because he was comfortable with the companies’ fundamental positions and the stock prices were down substantially, he didn’t see the need to make significant changes. In hindsight, there proved to be better opportunities elsewhere. It should be noted, that while most of the fund’s holdings experienced earnings declines, none were forced to raise emergency capital, as has been common in the small-cap arena.

The second and more important factor relating to 2009 was resources. The fund didn’t own enough of them. In the past, Wil has generated excellent returns for his clients in the resource sector, which resulted from buying stocks when commodity prices were at rock bottom levels. He missed most of the move this time, however, because as he says, “$60-70 oil just didn’t look that cheap to me.”

As significant unitholders in the fund, our team felt the performance shortfall in 2009 along with our clients. Of more importance to investors, however, is how the fund performs longer term. So far, we have not achieved our goal of generating attractive ‘absolute’ returns, but we think a more positive investing environment will give Wil the opportunity to do that going forward.

Currently, the portfolio holds 15 stocks. The largest positions (in order of size) are Stantec, Canadian Helicopters Income Fund, Total Energy Services, MacDonald Dettwiler and Vecima Networks. With some good moves in a number of the fund’s holdings, Wil has been making some adjustments. He eliminated Hanfeng Evergreen recently and has increased the MacDonald Dettwiler and Evertz Technologies positions.

The Small-Cap Fund fits well into the Steadyhand lineup. Wil’s concentrated, non-benchmark approach has the potential to generate out-sized returns, as it has for his clients in the past, and the fund’s low correlation to the overall market serves to dampen down the volatility of our clients’ overall portfolios.

David and I met last week with Ian Cormack and Cathy Alsop from Edinburgh Partners (EPL) in Toronto. EPL manages the Steadyhand Global Equity Fund.

The meeting reinforced the depth and experience of the firm (they announced two senior additions to the team the day we met) and the commitment to their central discipline – namely, that time horizon is the key market imperfection. The EPL philosophy and research discipline is based on valuing company earnings five years out. It’s noticeable to me that phrases like ‘underweight’ and ‘overweight’ the benchmark never came up. They are totally focused on looking for undervalued securities.

As we’ve noted previously in the blog and quarterly reports, EPL is not seeing the same wide-spread opportunity in the market that it did 12-16 months ago. Company valuations now more accurately reflect their long-term earnings outlook.

Having said that, EPL’s calculation of the 5-year annualized real return (after inflation) for the fund is still sitting at a healthy 10%. That number, which is an estimate based on their earnings estimates and valuation work, is sure to be wrong, but it is an indication of how compelling the opportunities are. For context, this projection was over 13% a year ago.

After a period of playing ‘defense’ (mid-2007 to the summer of 2008) and then ‘offense’ (fall of 2008 until recently), the fund is now sitting firmly in the middle. There is no specific tilt to cyclical, defensive, growth or value. Recent changes have come out of stock specific opportunities rather than an overall theme.

As for the new holdings, they could only be described as ‘ugly but cheap’. Lately, EPL has been running against the grain on many levels:

• Country – Japan has been the location of many of their new ideas, despite the fact that there is a strong consensus that the Land of the Rising Sun is headed for a third ‘lost decade’. Can you say SLOW GROWTH?
  
• Industries – EPL has bought two construction companies – a home builder in the U.S. (DR Horton) and a building contractor in Japan (Kajima).
  
• Companies – There are warts on the new additions, but perhaps the ugliest is Fujitsu, a money-losing, slow-growing ‘big iron’ computer company that was in the press this week because the former CEO has been linked to organized crime. As Ian pointed out, the warts are well recognized and little or no improvement in operations or valuation have been factored into the stocks.

Overall, the portfolio holds 38 stocks that cover the spectrum of country, industry and beauty. U.S.-based companies account for about 30% of the fund while Japan is now the second on the list at 16%. Technology remains the largest industry weighting at 18%, although that has come down modestly as a result of some sells.

The Steadyhand Equity Fund consists of no more than 25 stocks. This is one of the manager’s (CGOV Asset Management) disciplines that we love. It ensures that we’re only getting their best ideas. Nalco is one of these ideas.

The Nalco story is a little different than most of the fund’s other holdings. As we emphasize in our reporting, CGOV favours companies with strong cash flows, proven management teams, clear competitive advantages and little debt. Nalco scores top marks in all of these, except the last one.

First a little background. Nalco (NYSE: NLC) is an Illinois-based water treatment giant. The company also owns a majority stake in a leading emissions control business (Nalco Mobotec). Nalco’s applications are used by mining, paper and petroleum companies, as well as hospitals, schools, and hotels, among others. Its products and services help prevent contamination, increase efficiency, and reduce pollutants. The company is also active in developing new environmentally-friendly technologies that improve efficiencies while reducing pollutants.

There is a lot to like about the company, as illustrated by CGOV’s investment thesis:

• Water is becoming an increasingly scarce resource and Nalco is twice the size of its nearest competitor in the water treatment and water related services market.
  
• The company operates on a service based model where 80% of revenue is recurring, providing better than average predictability in the business.
  
• There are high switching costs, resulting in a very loyal customer base.
  
• The company generates a lot of cash.
  
• With 70,000 customers and a diverse client base, they can offer new services easier than a new entrant.
• The business model is “green” yet also sustainable, as opposed to many solar and wind companies that depend on subsidies and do not have the same competitive advantage as Nalco enjoys.

Yet, Nalco has had a mixed record of delivering strong and consistent earnings and has been saddled with debt – a notable strike against the stock that kept CGOV on the sidelines until recently. In 2008, a new CEO took the reins (J. Erik Frywald) and implemented an aggressive strategy that focused on reducing costs, increasing productivity and trimming debt. His efforts have paid off. Over the past year, cash flows have improved, costs have been reduced, expensive debt has either been paid off or restructured (the balance sheet has been de-levered) and more energy has been focused on higher-growth areas such as advanced technologies and projects in the emerging markets.

Nalco has long been an attractive business, but its improving balance sheet finally made it an attractive investment idea to CGOV. Given there is still more risk associated with the company relative to some of the manager’s holdings with rock solid balance sheets (e.g., Rogers Communications, Cisco Systems, TD Bank), CGOV accumulated the stock in tranches. They initiated a small position last July and purchased additional shares in November and last month, as they became more comfortable with the new management team’s ability to execute.

Investments like Nalco come with higher return expectations. Yet, they also come with greater risk. To compensate for this, the manager typically maintains a smaller position size (e.g., 3%) and purchases the stock at what they believe to be a much greater discount to its true value.

Given the fund’s low turnover (11% in 2009) and the manager’s high level of conviction in their investments, a new holding often generates some discussion and buzz around the proverbial water cooler here at Steadyhand. In Nalco’s case, this seemed particularly fitting.

The manager of our Global Equity Fund, Edinburgh Partners Ltd. (EPL), has had a personnel change that is of interest to Steadyhand clients. Christine Montgomery has left EPL and joined another firm in Edinburgh, Martin Currie. While the firms are comparable, Christine’s role at the new firm will focus more on client service than research.

Christine was the manager assigned to our fund and was committed to helping Steadyhand grow. While we are going to miss her, we will still be in good hands. Robin Weir, the co-manager, will continue to oversee the fund until the new lead manager, Ian Cormack, can get his Canadian licensing in place. Robin and Ian are senior members of the EPL investment team and have over 20 years of experience in the business. They both joined founder Sandy Nairn when the firm started in 2003.

A little background is important. Each member of the nine-person investment team at EPL manages client portfolios in addition to their research duties. Portfolios with the same mandate (i.e. global equities in our case) are managed similarly, although the designated manager is responsible for executing on the team’s overall strategy. This involves managing cash flows, re-balancing from time to time and buying or selling stocks when there is a change to the model portfolio. The manager’s goal is to blend the client’s needs with the EPL model as seamlessly and smoothly as possible.

We hired EPL in 2007 because they have a deep, veteran team; a disciplined approach; and an excellent track record. While we’re always on alert when personnel changes occur at our managers, we don’t think this change in anyway weakens EPL’s ability to deliver excellent long-term returns.

On my recent trip to Toronto, I spent some time at the CGOV office, meeting with Gord O’Reilly, the manager of the Equity Fund, as well as other partners of the firm.

Out of all the conversations, pizza and beer came very little that was new – even though they’re a fun group, their management approach is boring. Indeed, there are few changes to report, although the strength of the market rally has changed their outlook slightly.

They added one new name to the list (I can’t mention it because they are still buying) and sold Tim Hortons on recent strength. With few exceptions, the market position and competitiveness of the 24 companies in the fund have improved over the year. The hostile operating environment exposed the weaknesses of Manulife (unhedged market exposure) and Birchcliff Energy (balance sheet), both of which were forced to raise capital at low prices, but the other companies will come out of the recession in a better position.

Gord is still making sure the portfolio has some balance to it, including companies that will do well in a slow or bumpy recovery – drug store chains Shoppers Drug Mart and CVS Caremark, Diageo (booze) and Ritchie Bros. (auctioneers). This part of the portfolio has held back performance during the rally, but could prove beneficial when growth is harder to come by.

The fund has had a nice recovery (up 12% for the year to August 31st and 33% from its low), but hasn’t kept up with the rocket ship called the S&P/TSX Composite Index (up 24% so far in 2009). There are a few reasons for this: (1) The quality of the companies gives the fund less recovery potential – this rally has been described as the ‘Dash for Trash’ and there is no trash here; (2) The fund has healthy exposure to resources and banks (this year’s market leaders), but not as much as the TSX does; and (3) The returns from the U.S. and international stocks have been dampened by the strong loonie, even though stock selection has been quite favourable.

As for the outlook, the Tim Horton’s sale is indicative of what Gord and the team are thinking. They sold the stock on strength and haven’t re-invested the proceeds yet. Their bottom-up analysis shows that stock valuations are still attractive, but the market has come a long way and has been carried along by momentum in a number of sectors. They are inclined to keep some powder dry and be ready for any opportunities the fall may bring. The Tim’s sale has increased the cash level from 4% to 7% of the fund.

We posted a blog in late 2007 (Edicts from Edinburgh) that highlighted a few excerpts from an interview that Dr. Sandy Nairn, the CEO and founder of Edinburgh Partners Limited (EPL), did with a U.K. publication, Independent Investor.

At the time, Sandy had a number of concerns about the markets and the prevailing economic climate.  He felt that risk was being dropped from the investment lexicon and he didn’t buy the ‘de-coupling’ theory – which proposed that Asia’s economic prospects no longer rested on the health of the U.S. economy and the emerging markets would be immune from a downturn in the western world.

EPL’s chief executive felt there were still good companies with strong cash flows and relatively secure earnings, telecoms and pharmaceuticals in particular.  He also felt there were small pockets of undervaluation in the financial sector.  It was these areas in which the Global Equity Fund’s assets were concentrated at the time.  Sandy was also happy to hold a relatively high weighting in cash (which rose to 20% by mid 2008).

While EPL’s caution proved to be warranted, the Global Equity Fund didn’t escape the ravages of the market decline.  The large cash reserve and emphasis on defensive companies served the fund well, but was largely offset by significant declines in the financial sector.  And as we’ve reported before, there were virtually no areas of the market left unscathed.

Since the first interview, a number of things have changed and Sandy and the team in Edinburgh are much more positive about the prospects for equities.  In a follow-up interview with Independent Investor, Sandy discusses the global investment environment and explains why his attitude has undergone a radical change. 

You’ve no doubt heard much talk about the current opportunities in the market and may have grown tired of the topic, but we feel that Sandy’s assessment is particularly thoughtful and rests on a well researched foundation.  While a little lengthy, the 8-page interview is worth the read if you’re looking to round out your opinion on the prospects for the markets.

Here are a few key takeaways:

• My view is that on most historic comparisons, and modeling what happened during previous recessionary periods, it is hard to argue that equities are now in general any worse than fair value.
• Instead of 18 months ago finding small pockets of undervaluation in a large ocean of overvaluation, I would now describe it more as finding pockets of overvaluation in an ocean of fair value or better.  In some cases, shares are simply, unequivocally cheap once more.
• There’s no consistently predictive way to know when something peaks or when it troughs. The only predictive capability we have, if you have a long term view, is that when something gets to fair value, you have to start averaging your way in.
• In our portfolio, which had 20% in healthcare and 20% in telecoms, those proportions have drifted upwards because of their relative performance. We have started reducing them and putting the money into companies whose earnings growth rates are way ahead of what the pharmaceutical industry, for example, could deliver.
• At current valuations companies with strong growth opportunities look the best risk/reward for the long-run and we are increasing our technology and emerging markets exposure.
• China is the other major area where we have gone from almost zero exposure to north of 6% in a very short space of time. Having believed the ‘decoupling’ story to a ridiculous extrapolation of the economic importance of China, we have seen a complete turnaround in sentiment to the extent that some share prices are down 70-80%. That is creating an opportunity for us to invest with what we regard as some of the best risk reward propositions.
• Now you can find companies with excellent earnings potential at cheap valuations. This really is exciting. It is hard to be excited when the world is beset by bad news but that is why such valuations exist. It is absolutely imperative that you take advantage of them which requires you to accept that it may be a while before sentiment changes and prices start to move in the right direction.

And to leave you with Sandy’s answer to the question on everyone’s mind, ‘Is now the right time?’ - You don’t miss the bus by being early, although you might get cold and bored. Being late though is definitely the wrong strategy.

As I was reading the year-end report from CGOV, the manager of our Equity Fund, I was blown away by the numbers.  We’ve talked in the past about the quality of companies in the fund, how well positioned they are to benefit from the recession and how reasonably priced their shares are.  But as the report goes through the holdings, it’s like a wave washing over you. 

Here’s what I mean.

Administaff increased its dividend 18% last August.  The company is debt-free and has $4.30 per share in cash.  IDEXX Laboratories...no debt...$1.40 per share in cash.  Lincoln Electric raised its dividend by 8% on December 4th and has net cash (i.e. cash minus debt) of $4.00 per share.  Twenty-two percent of Nintendo’s market capitalization is represented by cash.  Pason Systems has minimal debt.  TMX Group...no debt...cash and securities totaling $4.50 per share.  Cisco Systems has $27.5 billion of cash on its balance sheet and is expected to generate $10 billon of free cash flow in 2008.

The portfolio is well financed (as you can see), is generating a huge amount of free cash flow and has a high return on capital.  And I can keep going with the names - Research in Motion, CVS/Caremark, Compass Minerals, Diageo, PotashCorp, Ritchie Bros. Auctioneers, Rogers Communications, Shopper’s Drug Mart, Tim Hortons.

CGOV and I are not oblivious to the economic outlook.  We’re all in for some serious hurt in 2009 and perhaps beyond.  But even in the face of earnings estimates coming down, or slashed in some instances, we own an excellent group of companies that are inherently profitable and very liquid. 

With regard to the corporate health measure I wrote about recently (Debt is the Pariah in the New Economic Order), the Equity Fund is solidly on the ‘liquid’ side of the dial.

CGOV (Equity Fund)

- Valuations are at ‘generational lows’ for many stocks.
- Tax-loss selling could hold the market down, but CGOV is optimistic from these levels.
- None of the businesses in the portfolio depend heavily on customers’ access to the credit markets – e.g., Tim Hortons, Shoppers, and Compass – and all generate free cash flow.
- Sony was sold and replaced by Nintendo.  Wii is in high demand and is sold out everywhere.  In this type of market, Nintendo is the more attractive company to own.
- Nokia was sold and replaced by Research in Motion.  RIM has been on their radar screen for a while.  The stock is now trading at 10-12X earnings and represents great value.  With a new product ramp-up, strong market position, and low valuation, the stock has attractive upside potential.
- They have been adding to a number of existing positions, and the cash level now stands at approx. 3-4% (down from roughly 7% at the end of September).

Wutherich & Company (Small-Cap Equity Fund)

- Small-cap stocks are as cheap as they’ve been in a number of years.
- Stocks with the least liquidity are suffering the most from panic selling.
- There’s been incredible pressure on some very good companies.  For example, Gennum and Evertz are both in a solid financial position with no debt, lots of cash and ‘in-demand’ products.
- Hanfeng Evergreen was added back to the fund following a steep drop in its share price.  The stock represents excellent value (especially at the sub $5 level), and the Chairman of the Board and CEO have recently been buying shares.
- Sterling Shoes and Flint Energy Services are two troubled stocks that are being re-evaluated.
- The cash position is sitting around 11% and is being deployed opportunistically.

Edinburgh Partners (Global Equity Fund)

- Global markets are still experiencing heavy selling and volatility remains high.
- Financial stocks remain the biggest risk and opportunity.  As a sector, these stocks are very cheap, but it is still difficult to get any short-term clarity on what their assets are worth.  However, even with depressed assumptions, the survivors will make money over the next five years and if valuations return to normalized levels, share price increases will be substantial.
- Telecoms and pharmaceuticals have been performing well.  These stocks continue to be a large part of the fund (roughly 40% combined).
- That said, selective ‘defensive’ telecom and pharma positions have been reduced with some of the proceeds being reinvested in new, more ‘offensive’ holdings (China Mobile, Fanuc, Nokia, UBS, Aviva).
- The emerging markets are starting to look more attractive.
- The cash position has been brought down to approx. 4% (from 8.5% at the end of September).

We’ll report back in early January, as usual, with more detailed commentary in our Quarterly Report.

For the most part, I don't have any argument with this view.  The economy is going to get worse before it gets better, and there are still skeletons in the Wall Street closets.  The fact that the U.S. government is bailing out banks (Bear Stearns, IndyMac) and the SEC is interfering with the capital markets by selectively  preventing (naked) shorting on 17 financial institutions, tells us that we're well into a financial crisis.  

I'm not, however, in the 'high oil forever' camp.  I think the price will ultimately reflect the economic slowdown and the meaningful changes taking place on the demand side.  And I don't necessarily agree with the investing conclusion that comes out of the consensus view. 

In trying to predict the market, we not only have to get the outlook right, but we also have to determine how much of that outlook is already factored into stock prices, or baked into the cake as they say.  Dr. Sandy Nairn, the founder of Edinburgh Partners (EPL), makes that point in a special letter to clients this month.  He wrote, "The key question, as always, refers to the profile of future profit growth relative to what is already discounted by the market."  With regard to the slowdown he goes on to say, "One cannot draw the simple conclusion that those sectors most affected should not be owned."

Sandy is referring to the two necessary elements of the investment process – the fundamentals and the valuation (which includes investor sentiment). 

I want to use our Global Equity Fund, which Sandy's firm manages, to illustrate the two elements at work.  

EPL's outlook for most industry sectors continues to be subdued.  Their profit forecasts reflect a continuation of recessionary conditions (fundamentals).  

There are parts of the market, however, where they think the outlook is more than factored into the stock prices (valuation).  For example, about 15% of the fund is in financials, which is where they think the greatest opportunity lies, although the risk is still high.  Valuations are attractive, even after assuming more writedowns and dilutive capital raising.  In other words, investors are being amply paid to take the risk and when things stabilize, the stocks will bounce back dramatically.

As an aside, it is the financials that have caused the fund the most grief over the last year. While EPL was expecting the economy to weaken, it underestimated the impact that the sub-prime meltdown and subsequent credit crisis would have on the banks and insurers (fundamentals).  While they did adjust quickly to the new reality, they subsequently made another misstep by incorrectly reading how much of the bad news was factored into the prices (valuation).  The stocks dropped further on announcements that EPL was for the most part expecting.

Looking forward again, EPL is balancing off the financials by investing 40% of the fund in the more conservative telecoms and pharmaceuticals.  For most of these companies, the outlook for profits is "dull" (fundamentals), but the dividends are substantial and look to be secure.  In other words, the outlook isn't exciting, but the market isn't expecting much either (valuation).

Technology and energy stocks account for about a quarter of the fund.  The outlook for energy companies, even at lower oil prices, is very good (fundamentals), but the stocks are the most expensive ones on the list (valuation).  EPL's bias is to reduce the energy holdings.

We are all uneasy about what's going on right now.  Our capitalist system, at least the U.S. version, is being put to the test.  The consensus view may prove to be right, or heaven forbid, too optimistic.  But as investors, we have to make sure we consider both elements of the investment process.  The market is a discounting mechanism.  It looks forward.  That is why the best opportunities come out of the gloomiest periods.

I'm not yet mortgaging my house to buy the market.  A gloomy outlook is only one of the necessary ingredients for a good buying opportunity.  But I am cautiously nibbling at the odd stock and adding to the parts of my portfolio that are down and out (global equities specifically).  

Christine covered a lot of ground, but I’m just going to highlight a few items that we haven’t fully covered in our quarterly reports.

• China and emerging markets - The fund currently has very light exposure to emerging markets including China.  EPL is interested in the growth potential of companies in these markets, but in recent quarters have not felt the valuations made sense.  With significant declines in the Asian markets, some stocks on their watch list are getting closer to a buy range.   They recently purchased LDK Solar, a leading Chinese manufacturer of solar wafers.
• EPL expects global economic growth to continue slowing.  In their bottom-up analysis, they still think earnings expectations are too high (outside the financial sector), so they fully expect more profit warnings.  Having said that, Christine was more optimistic about the opportunities they are now seeing than during any time in the last year.
• Defense to offence.  The fund is still positioned quite defensively (13% cash; heavy weighting in telecoms and health care stocks), as the time is not quite right to aggressively gear up the offense (emerging markets, beaten up financials).  The timing of such a shift may not be that far off, however.
• Japan is looking more intriguing.  The macro picture isn’t overly optimistic, but there are many companies that should benefit from importing high-end manufacturing equipment to Chinese companies.  Many of these businesses on the mainland are thirsty to move up the “value chain” and need Japanese technology to do so.
• Fawlty directions. The drive up the I-5 from Seattle (Christine and Cathy’s prior meeting) to Vancouver can be a lot more entertaining when you’ve got a GPS with John Cleese’s voice dictating directions (yes, there is such a thing). 

If you’re interested in hearing more of Christine’s thoughts on the investment climate and the positioning of the Global Equity Fund, we encourage you to listen to our latest podcast.

It shows the extra yield an investor receives from owning a Canadian agency bond (i.e. Farm Credit Corp) compared to a conventional Government of Canada bond.  While these bonds are explicitly guaranteed by the Federal Government, they typically trade at a higher yield – approximately 10 basis points (bps) or a tenth of 1% - because they are not as liquid as Canada bonds.  Big investment managers who are moving a lot of money around prefer to use the more tradable Canada’s.

But as you can see, the nervousness in the markets has led to the spread widening to over 50 bps.  This to me is a huge indication of how nervous investors are.  I may not think it’s rational that TD Bank bonds trade at 150-200 bps above Canada’s (I don’t), but without knowing what’s going to happen in the banking sector, a spread of that size may be warranted.  With agency bonds, however, there is no credit risk.  No credit analysis can justify the current spread.  It’s just plain irrational nervousness.

Our Income Fund is more than 50% invested in corporate bonds at this stage.  CC&L feels very strongly that we’ve been given a once in 10 or 20 year opportunity to buy good quality corporates.  Undoubtedly not all of their selections will work out as they hope, but the agency spread chart tells me they are planting seeds in very fertile ground.

A couple of times in recent months I've used the banks as a framework for talking about investing and the buy side of the street. I'm back at it.

We have just finished quarter-end reviews with our fund managers and as you would expect, the banks were discussed extensively. The two managers that invest in large-capitalization stocks have been taking different approaches - one is holding back on further commitments to the financial sector and the other has started to nibble on banks that have been badly beaten up.

Cranston Gaskin O'Reilly & Vernon Investment Counsel manages our Equity Fund (we picked them despite having the most awkward name in the industry). The fund holds two banks - Toronto-Dominion Bank and HSBC - in addition to Manulife and Home Capital in the financial sector. For a Canadian-focused fund, this is a unique lineup. Most funds of this ilk own four or even five of the Canadian banks. In contrast, CGOV's approach is to make large commitments to the stocks they like the most and run a concentrated portfolio (maximum 25 stocks). Thus two banks.

Like everyone else, Gord O'Reilly, who manages the fund, is watching the goings-on in the sector and trying to figure out what will happen next. His assessment is that there are more skeletons in the closet, but there isn't enough transparency to know how many there are, or how big they'll be. Gord wants to see more bad news come out before he goes value-hunting in a big way.

Having said that, CGOV recently added to TD when it was under $60.

This trade may seem a tad inconsistent given their industry view, but it's really not. There are no guarantees obviously, but TD is not involved in most of the banking industry's war zones. It has its problem areas for sure - some analysts are concerned about the Commerce Bancorp acquisition in the U.S. and/or its commitment to help fund Ontario Teachers purchase of BCE - but compared with CIBC, BMO and many of the global banks, it's very clean.

For CGOV, the TD purchase was not an industry call, but simply an addition to a long-term holding that had gotten too cheap. They know that TD isn't the stock that will benefit the most from an industry turnaround - it hasn't had enough problems - but as Gord's partner Roy Hewson said in our meeting: "We're buying it for the next six years, not the next six months."

Edinburgh Partners, who manage our Global Equity Fund, also runs concentrated portfolios and has a similar take on the industry. They expect further bad news and have factored it into their estimates. On stocks like Bank of America, Citigroup and Royal Bank of Scotland, they are assuming substantial writedowns are still to come. With some of the banks, they are also allowing for further dilution from equity issues at discounted prices.

Christine Montgomery, who pulls the trigger on trading decisions for the fund, said to me this week that "our numbers show that even with further writeoffs and dilution/capital-raising, many bank shares offer a reasonable risk-reward tradeoff."

In her typical understated way, Christine is saying that the odds are stacked in her favour. Despite the unknowns, there is limited downside risk remaining in some of the stocks, and huge upside when the recovery comes. In their view, when it does, the stocks will move fast.

In this column I often talk about taking risk. Risk is the fuel that drives an investment portfolio. The key to being a successful investor, is making sure you are being compensated for the risks you take. At this stage in the cycle, CGOV is not there yet - they're holding the highest quality banks while they watch and wait. They like the exposure they have and are happy to use their risk budget in other areas of the market where there is more transparency.

Despite a similar macro view, Edinburgh Partners has started to take new positions (including Citigroup) and add to existing holdings. In their view, the bank stocks have just gotten too cheap. They have diversified across a number of banks in different countries, but given increased uncertainty surrounding the ones they're interested in, their strategy is a few notches higher on the risk/reward meter.

Two managers. Same objective - to generate attractive risk-adjusted returns. Similar view of the world. Very different strategies. That's what makes the buy side so interesting.

As background, CGOV holds two banks – TD and HSBC – in addition to Manulife and Home Capital.  Like everybody else, they are watching the goings-on in the sector and trying to figure out what’s going to happen.  Their assessment so far?  The sector has more skeletons in the closet and needs more time to heal.  They’re not going value hunting just yet. 

So, what position did they add to recently?  TD Bank. 

Given what I just said, this trade may seem a tad inconsistent, but it’s really not.  There are no guarantees obviously, but TD is not involved in most of the war zones in the banking and credit markets.  It has its problem areas for sure (some analysts are concerned about its commitment to help fund Ontario Teachers’ purchase of BCE), but compared to CIBC, BMO and the global banks, it’s very clean. 

For portfolio managers who feel the worst is over for the banks and who want to take advantage of low valuations, the TD is not going to be the bank they buy.  It hasn’t gone down nearly as much, so it’s not going to give them enough zip as a turnaround/bounce-back candidate.  When the recovery comes, TD will go up a lot, but it will almost assuredly lag behind the lower quality banks. 

The issue for Gord O’Reilly and Roy Hewson, the managers of our fund, is that they don’t know where the bottom is.  If they knew, they might buy one of those other banks.  In the meantime, they’re happy to add to one of their favourite holdings at a sale price of $59.  As Roy said, “we’re buying these shares for the next 6 years, not the next 6 months.”

That’s where the similarities end.  They all have unique skill sets and different views of the world, which provides our clients with useful diversification.  Here are the takeaways from each meeting.

CGOV (Equity Fund)
Our partners in Yorkville feel that we’re in an environment where the “strong will get stronger”.  They continue to focus the fund on what they refer to as ‘Franchise’ stocks – great businesses; great management; good price.  Companies like Cisco and HSBC are prominent examples of this theme.  CGOV hasn’t changed any stocks in the fund, but has made some adjustments.  With the widespread selloff in early January, all stocks got hit.  It gave them a chance to add to some ‘Franchise’ names at attractive prices, including Starbucks, the purveyor of an “addictive, non-regulated substance”.  Conversely, Compass Minerals was trimmed as the stock continues to perform well but may be getting slightly ahead of itself from a valuation perspective.  CGOV feels that the short-term downside risk to the portfolio is now quite modest, while the medium-term upside potential is compelling.

Edinburgh Partners (Global Equity Fund)
Christine Montgomery provided us with a balanced update in her usual charming tone.  EP’s view has not changed and they haven’t made any notable changes to the fund.  The portfolio is roughly 15% in cash.  They don’t think the rest of the world is ‘decoupling’ from the U.S., and therefore businesses with strong cash flows and balance sheets are best positioned in a slowing global economy.  They’ve spent much time revisiting their earnings models to ensure their outlook is as realistic as possible.  They are not assuming that the super-cycle we’ve just had is the norm.  Speaking of super-cycles gone bad, EP is still concerned with the financial sector and is only nibbling at these types of stocks.  Elsewhere, investors have given up on the Japanese market, as it’s down nearly 10% so far this year.  In contrarian fashion, a research trip to that country is happening this week. 

Wutherich & Company (Small-Cap Equity Fund)
Wil Wutherich’s comments from Montreal were short and sweet.  The fund pulled back in January, but has since maneuvered nicely through the turbulence that has seen many small-cap stocks drop sharply.  Total Energy Services has had a good run early in the year, as has Cervus, Gemcom and Sherritt.  Wil is holding about 14% cash in the fund right now.  As we reported at year-end, he continues to look closely at a stock or two, although he is being patient.   The stocks in the portfolio are unchanged since year-end, although Wil has adjusted a couple of the position sizes significantly.

In 2007, the capital markets were defined by acronyms (CDO, ABCP, SIV, CDS), but the big new word doing the rounds now is "decoupling". Decoupling refers to an economic theory that says that even though the United States is in recession, the rest of the world will continue to grow and prosper. The decouplists contend that domestic growth in places like China, India, Brazil and Russia will allow the global economy to continue growing.

For money managers, decoupling is one of those issues that has danger written all over it. If you buy into the theory, you're basically saying that "it will be different this time," which are the most dangerous words in investing. They are dangerous because betting on something that hasn't happened before - in other words, a new paradigm - has almost always been hazardous to a portfolio's health. You may ultimately be right in your view, but if the market takes a while to come around to your way of thinking, it can lead to a big performance shortfall and ultimately client losses.

It's also tricky because a manager may ultimately be right in his/her view that it isn't different this time, but if the market takes a while to figure this out too, then the manager can underperform the market. For example, the manager of our Global Equity Fund, Edinburgh Partners, and others like them, left some returns on the table in 2007 by not going along with the decoupling theory.

Personally, I don't buy this decoupling thing either. It reminds me of the arguments being made at this time last year about the subprime mortgage mess and last year's big word, contagion. It was argued by some that the subprime problems wouldn't migrate into other areas of the capital markets. We were told there would be no contagion.

We all know where that went and I think the weakened U.S. economy will ripple through the system as well.

I'm not suggesting that the countries I mentioned don't have lots going for them. As they grow, the American consumer becomes a smaller part of their sales mix. But the United States is still everyone's largest customer, either directly or indirectly.

In arguing against the decoupling theory, Sandy Nairn, the founder of Edinburgh Partners and the manager of our Global Equity Fund, points out that the size of the U.S. trade deficit is almost equal to one-third of China's gross domestic product.

My interest in the topic, and that of other portfolio managers, relates specifically to the ability of corporations of all nationalities to keep expanding their bottom lines in the next two years. What drives markets is the rate of change of profit growth, which in turn is driven by business activity at the margin.

Ninety per cent of a company's sales base may be rock solid, but it is the customers at the margin, the other 10 per cent, who are key. They define the industry dynamic. Do the sellers still have pricing power? Do the weak competitors go into panic mode and dump inventory or slash prices? Does shiny new production capacity become surplus production capacity?

The world economic situation today reminds me of the telecom boom in the late nineties. Everything was roaring along until someone noticed that (1) the big manufacturers like Nortel were heavily into financing their customers and (2) those customers, new and old, were struggling to make money.

In the current context, the United States is the big customer that is being financed by the rest of the world. And guess what, it isn't doing very well. The virtuous cycle that fed on itself on the way up - cheap money, rising prices, more room to borrow, even higher prices, even more room to borrow - has now reversed. Money is as cheap as ever, but Americans don't have the same capacity or appetite to borrow, and the banks aren't going out of their way to make it happen.

Is the importance of the United States in the world declining? Absolutely. I personally am in the "crumbling empire" camp. But is the U.S. so diminished that the world can charge ahead while it is in recession and its financial system is in crisis? I think not. The decoupling argument doesn't recognize how integrated and leveraged our world is today.

It sounds like a good strategy to buy U.S. companies that have significant international exposure, or European companies that are focused on their domestic economy, but if I'm right, it isn't going to matter. A U.S. recession will affect companies of all stripes.

In the meantime, for Canada's sake, I hope my arguments prove to be decoupled from reality, or at least not contagious.

I can’t say our household has latched on to this idea, although Lori and I could probably get rid of two items for every new one and not run out of clothes for ten years.

Cranston, Gaskin, O’Reilly & Vernon (CGOV), the manager of our Equity Fund, has a similar approach. They have capped the number of stocks they will own at 25. If they are at that number and want to buy a new stock, they have to sell something. It’s not a rule that works for everyone, but I really like it. They are forced to constantly assess what they already own and keep the portfolio fresh. With only 20-25 stocks, they can’t go to sleep on a stock because every one has a significant impact on the fund’s performance.

I wish the wealth management industry had the same discipline as my friend and CGOV. Yesterday I opened my daily email from Investment Executive magazine to find announcements for 10 new funds from 5 fund companies. This was just one day’s worth of news.

• Investors Group (2) – ‘Global Real Estate’ and ‘Monthly Income and Global Growth’
• AGF (3) – quantitative funds managed by their subsidiary, Highstreet Asset Management – ‘Canadian All Cap Equity’, ‘Global High Income’ and ‘Global Balanced High Income’
• ING (1) – an index-based fund, the Streetwise Fund
• Mackenzie (3) – target date funds (2015, 2020 and 2025) called ‘Destination+’
• RBC (1) – ‘ O’Shaughnessy U.S. Growth Fund II’, a follow-along to the previously closed fund

These announcements prompt a few comments.

First, it’s notable that there were no announcements as to which existing funds were being closed, or put out on the front porch for the Salvation Army to pick up.

Second, the trend continues whereby the words Income or Monthly Income or High Income keep showing up in fund names. I can’t help but think these words, which were magical a few years ago, have become hackneyed, and maybe even deceiving.

Finally, the Mackenzie announcement is a testament to the proliferation of ‘life cycle’ or ‘target date’ funds. Mackenzie is just one of a long list of firms that have recently added this type of product to their lineup. These funds are kind of nifty (in the near future I’ll do a post on their merits and demerits), but it’s feeling to me like another fad gone bad. A few years from now we’ll have a bunch of uneconomic funds cluttering up the already cluttered mutual fund shelves. Do you remember ‘Clone funds?’

It’s obvious that I’m a cynic when it comes to our industry’s product proliferation. I think we have gone way beyond the point where investors benefit from variety. My wish for 2008 is for one of the mega firms to do a slew of fund mergers and cut their lineup from 100 funds to 10, and pass on the cost savings to their unitholders. OK, maybe 20 funds.

This is an excerpt from a recent interview that Dr. Sandy Nairn, the CEO and founder of Edinburgh Partners Limited (EPL), did with a U.K. publication, Independent Investor.

The interview is an in-depth piece that runs eight pages. As he did in a previous piece we published in May (For 'New Paradigm' Read 'Decoupling'), Sandy does a great job of putting the big picture into perspective. In that context, he talks about the current cycle and how alternative investing, leverage and China fit into the management of a global equity portfolio.

For those who want more detail on EPL’s strategy for the Global Equity Fund, the last two pages are an excellent review. If you don’t have time to read the full interview, here are a few other quotes from the good doctor:

• When abundant liquidity and low borrowing costs coincide, investors typically react the same way. Risk is dropped from the investment lexicon.
• The other thing that happens during sustained periods of low interest rates is that market practitioners get to work creating new esoteric vehicles ... In all but a few honourable exceptions, returns have been driven by leverage rather than by some new discovered skill set.
• On the prospect of Asia’s economic prospects decoupling from the U.S. economy: Two things worry me about this argument. The first is that the orders of magnitude just don’t work. The U.S. economy is five times the size of China. To expect the latter to be able to bail out the former is simply asking too much. It is mathematical nonsense.
• Confusing exciting stories with investment opportunities can be very dangerous.
• What often happens to global equity managers is that the further into a bull market you go, the more their portfolios start to look like emerging market portfolios. In the chase for growth, risk gets forgotten.
• If I hear one more busted hedge fund manager talking about a once-in-a-thousand year event, I’m going to lose my sanity.

Dr. Nairn isn’t shy of voicing his opinions, which quite evidently aren’t formulated from following the herd. And while his tone in the interview is bearish, his underlying message is that EPL has taken a defensive stance to better weather a coming downturn in the economic cycle. This isn’t done by avoiding stocks. As Sandy puts it, “It is hard to imagine a situation where you could find no companies at all to invest in. Hence it is unlikely you will ever want to go 100% into cash.”

EPL’s CEO feels there are still companies with good cash-flow strength and relatively secure earnings – telecoms and pharmaceuticals for example. As well, there are pockets of value emerging in the banks and homebuilders. It is these areas where the Global Equity Fund’s assets are concentrated.

A few things come to mind after spending time with Christine and Cathy:

• Nice people come from Scotland...especially if they’re originally from Ireland.
• I can never go back. When I get immersed in the Edinburgh Partners way, I just can’t imagine owning 100-200 stocks in my foreign equity portfolio ever again. 30-40 stocks provide ample diversification and they all count in the performance.
• Long term in a short-term world. Lots of managers talk about ‘out time-framing’ other investors, but few have a specific strategy for doing it. EP’s approach is built around an estimate of the 5-year price/earnings ratio of each stock. The EP managers consider other factors, but this 5-year discipline gives their approach a backbone.
• What do you really think? Like Steadyhand, EP isn’t afraid to be transparent. In the course of one day, Christine told us they screwed up on Countrywide Financial. At the evening presentation, she used a chart on Irish Life to demonstrate their investment approach, even though the stock has been weak in recent months. She was always open about what the team was currently agonizing over (banks, banks, housing stocks, banks).
• EP is a tough place to climb the corporate ladder...at least on the investment side. Their team is made up of 10 experienced managers. No juniors in sight. While you can’t tell by looking at Christine, they have all been through the wars. Fortunately, they are a ‘young’ veteran team. While our beloved Canucks don’t have a first line, EP only has first liners.

Global equity markets have been a tough place to invest in over the last couple of months, but my time with Cathy and Christine reinforced my belief that we’ve chosen one of Scotland’s finest exports to manage our Global fund. And when the markets are a little shaky, you can always turn to Scotland’s more well-known export, a well-aged single malt, to help calm the nerves.

Date: Thursday, October 11, 2007
Time: 6:00 - 7:00 PM
Location: The Hyatt Regency Vancouver (Seymour Room) - 655 Burrard Street

Light refreshments will be served. Wil and the Steadyhand team will be on hand following the discussion to answer any questions you may have.

Please RSVP to info@steadyhand.com or 1-888-888-3147.

Countrywide is America’s #1 home loan lender and the country’s third largest federal savings bank. The Steadyhand Global Equity Fund holds shares in Countywide, and given the recent volatility in the company’s stock price, we wanted to provide investors with some visibility on the company. The following is an update from the manager of the fund, Edinburgh Partners.

We took a position in Countrywide Financial last year because it was one of the cheapest stocks in our database. The shares had a price-to-earnings (P/E) ratio in year five of under eight times under a central case scenario where the U.S. housing market suffered a two year downturn before returning to a subdued level of growth [as a central part of their research process, Edinburgh Partners focuses on forecasting the five year earnings of a company]. Our earnings forecasts in years one and two were substantially lower than the market’s expectations. Conscious of buying the shares in the face of a downturn in the U.S. housing cycle, we took only a 2% position in the portfolio, our smallest entry level.

The surprise to our forecasts has been the extent of the contraction in the spread at which Countrywide can sell on mortgage risk to investors other than the government sponsored entities (Freddie Mac and Fannie Mae). At present, Countrywide sells on 68% of its mortgage production to these GSEs, so the risk is to only 32% of its book. The GSEs have a political mandate to stabilise the mortgage market.

As margins contract, Countrywide (and all the other mortgage lenders) will step back from writing new loans, and growth will slow in the short term. However, as many rivals we believe will exit the market, Countrywide will emerge stronger as the market returns to normality.

The bankruptcy speculation in the market stemmed from one particular research note, which we have read. The argument it suggested was that if confidence fell and Countrywide was unable to access credit, it would no longer be able to function. This argument can be applied to every bank, and there are many with weaker positions than Countrywide. Unlike many of its smaller peers, the company has confirmed access to short term and back up lines of liquidity.

On our revised forecasts, the shares are cheap, even if we were to find that we need to revise our expectations further. The shares are currently trading at 80-85% of book value. Over the last 20 years, the shares have traded in a range of 100%-250% of book value. Whilst losses are certainly possible, continual losses are now the central market assumptions.

We know that buying shares on the basis of their long term valuation is the way to achieve good returns, even though this often feels uncomfortable. Therefore, as long as the shares conform to our valuation criteria, we will be holding on to our position. At this stage, the shares comprise less than 2% of the portfolio and we expect to buy further shares when the end of the housing market downturn becomes apparent.

The addition of a new name to the fund provides a good opportunity to walk through CGOV’s stock evaluation process and their definition of a “franchise” company. I’ll make this as plain English as possible, so no need to grab a venti double shot latte to stay awake.

Let’s start with the business. Starbucks has transformed the way people think about and drink coffee (as a non-coffee drinker, they’ve even converted me into a semi-regular customer thanks to their blended cremes and frappuccinos). The company is innovative, highly profitable, a leader in its industry, and has become one of America’s most recognizable brands – like it or not. And although it may seem like there’s a green awning on every corner (in Vancouver, at least), the business still has plenty of opportunity for expansion, especially in the promising Asian markets.

Now for the people. CGOV thinks highly of Starbucks’ management team. They are effective allocators of capital (they know where and how to reinvest profits in their business), have plenty of experience, a clear vision, and a clear alignment of interests with their shareholders (they want to see their stock price rise).

And finally, price. By early July, Starbucks’ stock price had fallen nearly 25% since the beginning of the year, due in part to sluggish U.S. sales and higher dairy prices. The valuation of the stock dropped to roughly 24X next year’s earnings, which CGOV believed marked an attractive entry point (the stock had been on their radar screen for a while), given the company’s potential for 18-20% earnings growth over the next five years.

This last factor, price, is often the most difficult determinant in any investment decision. A good business is pretty easy to find, a management team can be evaluated on their past accomplishments and experience, but what represents a good price? There are certainly other specialty retailers trading at lower valuations than Starbucks. In this case, however, the manager felt that the company’s growth prospects, in combination with its brand power and ability to generate lots of cash, justified a slightly higher price. Not to mention the stock has historically traded at much higher valuations.

Starbucks has always been a great business run by great people, but it hasn’t always traded at a good price. It was this latest drop in valuation that moved the stock into “franchise” status according to CGOV’s criteria.

While this is a rather simplified overview (CGOV’s research process involves much more number crunching, forecasting, and discussion with management), it’s a good example of what CGOV looks for in a “franchise” company.

Recognizing that "franchise" companies are hard to come by, the manager also invests a portion of the fund’s assets in "non-franchise" companies (of the fund’s current 25 holdings, 5 are non-franchise companies). These are good businesses, run by great people, trading at great prices. But this is the subject of another blog and I’m craving a raspberry mocha frappuccino.

I’ll be available in Toronto on the afternoon of Wednesday, May 16, and the morning of Thursday, May 17, to meet with anyone who would like further information on our company, funds, or forms.

Please contact me by email (sronalds@steadyhand.com) or phone (1.888.888.3147) if you would like to arrange a meeting (at CGOV’s office at 21 Bedford Street).

For 'New Paradigm' Read 'Decoupling'

At the risk of being overly simplistic, it is worth setting out a number of key relationships which markets seem repeatedly to forget.

Company operating margins are directly correlated with economic growth. When economies are growing, companies are able to produce greater volumes without having to increase the assets employed proportionately. Profits therefore rise not just because sales are higher, but also because margins are higher. Few companies or industries are exempt from this relationship. The only question is the degree to which they are impacted.

• Emerging markets companies tend to be more affected because they are growing faster;
• Small and mid-sized companies tend to be more affected because they are growing faster;
• Companies producing bulk homogeneous products where pricing power is weak, such as paper, steel, chemicals, oil, metals, tend to be affected more. Indeed this relationship is used to describe them – cyclicals
• Companies dependent upon discretionary expenditure are impacted more because discretionary expenditure is reduced when conditions toughen.

Companies where both the end demand and margins are more stable are clearly less impacted. It is not that there is no impact; it is just that the effect is less.

While this may appear startlingly obvious, it lies at the root of why market anomalies appear. All the evidence points to the fact that market imperfections derive from the inability of investors to work with a sufficiently long time horizon. Often this manifests itself in confusion about what is sustainable and what is not. This confusion is typically exacerbated by an elegant argument over why ‘this time it’s different’ (aka ‘new paradigm’, ‘decoupling’).

Putting this another way, because of stock market myopia, typically what share prices discount is a continuation of whatever has happened recently. Most of the time this extrapolation is not a bad approximation of what happens next, which is why it tends to persist. However, when it is wrong, it is very wrong. The time when it is most wrong is when economies are turning.

The Economic Cycle and Forecasting Errors!

When economic conditions are rough or recessionary, companies margins will be low, sales growth will be slow or negative, and profits will be poor. However optimistic analysts are, their expectations will be deflated and the valuation that the market puts on profits (the P/E ratio) will consequently be low.

When economic conditions have been buoyant for a while, margins will be high, sales growth will be strong and profits will be good. However pessimistic analysts are, their expectations will remain inflated and the valuation that the market puts on profits (the P/E ratio) will be high (see chart). This is not logical – P/Es should logically be lower at market peaks, when shares are dear, and higher at market lows, when shares are cheap - but it is what happens through every market cycle.

I should apologise for spelling this out in such a pedantic manner, but it is important, as it goes to the root of why we can see such violent moves in markets and how money can be made if one has the correct time horizon. Critical to this of course is a recognition that the economic cycle is not, has never been, and never will be, abolished. Equally important is fundamental economic truth that ‘everything is related to everything else’. Much as it may be wished for, economies are inter-related, as are companies, as are industries. They do not ‘decouple’ and hence one cannot and should not treat the potential downturn in a major economy as being an isolated event which will not impact the rest of the world. To do so is simply wishful thinking and a subset of the ‘this time it’s different’ category.