2006 Q1 Newsletter January 31, 2006
Spring has rolled in and with it has been an excellent performance for the major Canadian indexes. The first quarter of 2006 saw a gain on the TSX Composite Index of 7.4%. The Dow Jones Industrial Average rose in the first quarter of 2006 by 3.7% showing the US economy is shrugging off interest rate fears and chugging forward. The broader S & P 500 Index rose by 3.7% as well on the quarter. The continued out-performance of the Canadian market is consistent with our investment thesis surrounding natural resources.
The continued rise of interest rates in Q1 again buoyed fears of a broader economic slowdown in the U.S. In Canada, our equity markets were supported by continued strength in base metals and energy prices.
Lawrence Decter Investment Counsel experienced a gain of 7.1% in Q1-06. This slightly lagged the performance of the TSX for the quarter. We do not hold gold stocks as we favour businesses less subject to commodity price speculation. In Q1, gold equities had a strong (but volatile) performance propelling the TSX to a strong quarter.
On average, our top 10 positions experienced a gain of 11.3% in Q1.
Of our top ten holdings, 6 increased in value and 4 decreased (although 2 of those 4 were less than one percent). The outstanding performer was once again Hudbay Minerals with its 66% return in the quarter, due to the continued run-up in zinc, copper and gold prices. The largest decliner of the group, TransCanada Corp, has been impacted by the pressure of rising interest rates. The entire utility group also saw selling in Q1-06.
Of note as well is that Acclaim Energy Trust is off of the Top Ten list. Acclaim Energy Trust merged with Starpoint Energy Trust and formed a new trust called Canetic which you will note in the Top Ten list. We are still quite bullish on the prospects for Canetic. As the two companies integrate, we believe there is potential for cost-savings and economies of scale. Both companies also bring great land packages and ample drilling opportunities to the table.
In Q1-06, we added a handful of new small cap stocks to some of the portfolios. These selections can provide an excellent long term (and sometimes an excellent short term) return. We focus on finding companies with strong balance sheets and growth prospects with proven management teams. Companies such as Coastal Contacts, Divestco, Pulse Data, Amerigo Resources and Systems Xcellence would fit into this category, to name a few.
We like companies that are not well known to the investment community that will be able to take advantage of the momentum created by positive news. For instance, almost no brokerage house or major bank had heard of a little mining company called Hudbay Minerals a year ago at this time. You’ll note from our top holdings that Hudbay has grown significantly in the last year because of great operating results and strong commodity prices (specifically copper and zinc). Hudbay grew from a market cap of less than $300mm to over $830mm at the end of Q1-06. Although not all small caps can be expected to have a performance of that magnitude, we feel that shareholder value is often better generated by select, small, entrepreneurial companies.
Zinc and copper prices reached record highs again in Q1. Driven by expanding demand from China and India, these two key industrial metals experienced extremely low inventories globally. It will be several years before new copper and zinc productions lead to a softening of their prices in world commodity markets. We continue to be bullish yet cautious with this group. The cyclicality of commodities is real and has held up historically time and time again. We look for companies in this sector that are creating value by exploring, acquiring and operating well, as well as being exposed to the rising prices of the commodities they produce.
Major Portfolio Changes
Harvest (HTE.UN) to Pennwest (PWT.UN) – Harvest Energy Trust merged with Viking Energy Trust in Q1 2006. The Viking assets are not great, and the Harvest management team largely exited the company on the merger, leaving the Viking team in control. We contend that bigger is not better in every case, and we felt that better value and better management exist in other energy trusts. We preferred another large energy trust, Pennwest, to Harvest. Pennwest has a very diverse asset base and is deserving of a premium valuation compared to other energy trusts. With oilsands exposure and improving capital efficiencies, we see it as a solid long-term hold.
Western Oilsands (WTO) to Opti Canada (OPC) - Concerns over prolonged operational delays and other issues at Western Oilsands made us decide to switch to another oilsands player with some high potential, Opti Canada. Opti is well on its way to completing the Long Lake project with its partners, which will greatly increase production. Opti has an estimated 2.6 billion barrels of recoverable oil.
Encana (ECA) – A long term holding of LDIC, we exited Encana in Q1-06 because we were concerned about operational difficulties affecting their earnings. As a natural gas-weighted producer, Encana was negatively affected by the decline in natural gas prices in Q1-06. Of the major oil & gas producers in the Canadian marketplace, we prefer Talisman to Encana. Talisman is cheaper on a cashflow basis. On a “sum of the parts” valuation of Talisman, the break-up value could be potentially much higher than where it trades now ($60-$66). Talisman is also better diversified in terms of its oil/gas production mix providing stability of earnings.
Hardwoods Distribution Income Fund (HWD.UN) - The performance of hardwoods was negatively impacted by the foreign exchange rate between Canada and the United States. Hardwoods was forced to slightly reduce their distribution in Q1. At the corporate level they suspended interest payments on their subordinated notes. Hardwoods was subject to increasing costs in the past year and no sign of a reversal on the cost front is foreseen. The slowing housing market and fears of a major housing correction also negatively affected the Hardwoods units. We still find a lot of value in the business income trust sector, and thus opted to sell Hardwoods and buy such trusts as Yellow Pages Income Fund and Eveready Income Fund, among others.
Extendicare (EXE.SV) – In Q1-06, Extendicare announced, along with disappointed results for Q4-05, that they were considering converting some or all of their assets into an income trust. This created a selling opportunity when the stock went up almost $5 overnight. We prudently exited at that time, as this was the catalyst we were waiting for to sell.
New Positions and Additions
Three positions to which we added through purchases in Q1 are Wendy’s International, Amerigo Resources, and Countryside Power Income Fund. Our rationale for these investments is below:
Wendy’s International (WEN on NYSE) – As most everyone is aware, Tim Horton’s went public in Q1-06 amid great investor interest. Wendy’s is still the major owner of Tim Horton’s after Tim’s IPO owning over 80%. In buying Wendy’s, our investment thesis is threefold: 1) Tim Horton’s value is not fully reflected in Wendy’s shares. 2) Wendy’s Restaurants (the core business) has great potential for a turnaround as McDonald’s achieved in the past 5 years. 3) Wendy’s also owns Baja Fresh, which has value potentially not reflected in the share price of Wendy’s. We believe in time this value will be realized in Wendy’s share price.
Amerigo Resources (ARG) – Amerigo is a copper producer that looks to double its production in the next 12-18 months. Their main facilities are in Chile and their copper comes from processing tailings from the world’s largest underground copper mine, El Teniente, which is operated by the Chilean copper giant Codelco. Copper prices have recently hit all-time highs. We believe the earnings potential for Amerigo is excellent and its exposure to copper and production growth should fuel share price appreciation. Amerigo also boasts blue chip management and pays a dividend.
Countryside Power Income Fund (COU.UN) – Power generation is a boring, essential business. Countryside has a sustainable payout ratio due to very stable and growing energy demand in North America. The fund includes a renewable power source compenent with 51 megawatts of capacity through 22 separate indirect investments. Through internal growth and external investment we hope to see steady and increasing cashflow from Counstryside.
Prospects for 2006
Although April was referred to by T.S. Elliot as “the cruelest month”, it has begun very positively for our portfolios. Energy, energy services and base metals have all contributed their strength into the 2nd quarter of 2006. Despite moderate increases in interest rates in both the United States and Canada the economy and employment are showing signs of strength.
There are some risks worth contemplating. Some observers who hold the “gravity theory” of markets believe that everything that goes up must come down. These observers believe a major correction is inevitable and that we should flee to gold or cash until it passes.
My own view is quite different. Certainly there are events that drive some equities to prices above their value. However the prospect of further gains are positive for the balance of 2006.
Why do I hold this more positive view?
- The economic progress of China and India show no signs of slowing. Demand for base metals (copper/zinc/nickel) and energy (oil) are likely to grow albeit that higher prices may eventually slow demands.
- The major world economies are coping with $60 + oil and gradually increasing interest rates.
- Terms of trade in the world have turned heavily in favour of resources. This greatly benefits our Canadian economy and our investments.
We remain vigilant to any sign of increased risk to our overall view. We believe that continuing to earn excellent returns will require analytical insight and nimbleness in trading for greater value.
President and CEO