2006 Q2 Newsletter September 30, 2006
The second quarter of 2006 reduced much of the gains from the first quarter of this year. The TSX composite dropped by 4.1%. The Dow Jones Industrial Average rose in the second quarter of 2006 by 0.4% showing the US economy is struggling with interest rate fears and deficits. The broader S & P Index fell by 1.9% as well for the quarter.
This quarter was also the first full quarter with the new US Federal Reserve Chairman Ben Bernanke in office. Bernanke has clearly stated he intends to fight inflation with higher interest rates. As a result, we have seen the Fed funds rate edge up to 5.25%. The market is anticipating at least one more rate hike in August of 2006. These higher interest rates are amplifying the rhetoric of fears of a slowdown in the US economy. In the face of this, the Canadian economy is still quite strong. Canada’s unemployment rate was at a 32-year low of 6.1%.
Lawrence Decter Investment Counsel experienced a loss of 1.9% in Q2-2006. This was less than half the drop of the TSX Index. Our substantial exposure to income trusts and a strong performance by some key holdings, not all of which made the top ten, helped mitigate much of the poor performance of the TSX for the quarter.
On average, our top 10 positions experienced a loss of -0.1% in Q2.
Of our top ten holdings, two increased in value and eight decreased. The outstanding performer was once again Hudbay Minerals with its 45.3% return in the quarter, due to the continued run-up in zinc and copper prices. The largest decliner of the group, Norbord, has been weak on seasonally low prices for OSB (oriented strand board). We expect Norbord to recover in Q3 and Q4 of 2006. Norbord’s value is also $1 lower because they paid out a $1 special dividend during Q2 which has not yet been received. Net of the dividend the loss decreases from 21.9% to 13.6%.
May and June saw a large correction in global equity markets as a result of, among other things, fear of inflation. We do believe this was a “market correction” and not an economic correction. Such sell-offs are characteristic of commodity bull-markets.
We would note as well at the time this report was printed many of the stocks have continued their recovery from their June lows.
Natural gas prices have been very weak in 2006. The abnormally warm winter reduced demand to the point where there are fears of over-supply going into this fall. We have not, however, significantly reduced our long-term natural gas weighted holdings. The reason for LDIC maintaining a long-term bullish stance on natural gas is because drilling for natural gas in North America has boomed in the last ten years, yet production is essentially flat. In order to simply maintain current production levels new wells must be drilled every year to replace declining wells. We believe natural gas prices will rebound significantly if major producers reduce the amount of new wells drilled.
Zinc and copper prices reached record highs again in Q2-2006. Driven by expanding demand from China and India, these two key industrial metals experienced extremely low inventories and higher spot prices globally. Prices skyrocketed this year. Copper, for instance, closed on the NYMEX in 2005 at US $2.04. During Q2-2006, the price of copper traded above $4.00. The May 11, 2006 price of $4.04 marked a stunning 98% price increase year-to-date. We expect metal prices to moderate somewhat but believe high prices will continue for two to three years due to restricted new supply.
Major Portfolio Changes
Fairborne (FEL.UN) to Vermilion (VET.UN) – Vermilion is one of the best-driversified energy trusts with assets in France and Belgium as well as a large Canadian asset base. Vermilion has one of the strongest balance sheets in the energy trust sector. With a better cost structure, more diverse assets, better liquidity and visibility of growth we preferred Vermilion to Fairborne and made the switch at the end of June.
Shoppers Drug Mart (SC) to Jean Coutu (PJC.A) – Although we still like Shopper’s Drug Mart, we decided to exit because we believed the share price had reached its full value. Jean Coutu is a “turnaround story” and we believe they are capable of executing this turnaround. After their acquisition of Eckerd drug stores in the US, PJC’s share price plummeted. We believe the worst is over and Jean Coutu has great value at these levels as earnings improve post the acquisition of Eckerd.
Falconbridge (FAL) – Falconbridge was the subject of several takeover bids from both Xstrata and Inco during Q2. We decided, given its significant share price appreciation, to take money off the table and search for other opportunities.
Fairquest (FQE) – Fairquest, a junior natural gas exploration company, was quite negatively affected by poor drilling results and low natural gas prices. As a result they have had to reduce their capital budget for 2006 therefore, possible reducing the likelihood of meeting year-end production numbers and their outlook worsened. The poor drilling and low commodity prices increased Fairquest’s debt load and as a result we decided to exit in lieu of other exploration companies with stronger balance sheets.
New Positions and Additions
Three positions were added through purchases in Q2-2006 which were Teranet Income Fund, Aeroplan Income Fund and AG Growth Income Fund. Our rationale for these investments is below:
Teranet Income Fund (TF.UN) – Teranet runs the land registry business in Ontario in an effective monopoly. Teranet went public on June 9, 2006. Although its price fell several percentage points at the beginning of the offer it has recently returned to almost its issue price of $10. We believe Teranet will be a solid core holding going forward. It is a large trust with a good yield of 7.5% at issue and very stable distributions. With its growth opportunities through acquisition backed by a solid management team we will continue to add to our Teranet position.
Aeroplan Income Fund (AER.UN) – If you have flown with Air Canada, you will be familiar with Aeroplan points. Over the past few years, Aeroplan has evolved from a frequent flyer program into a loyalty marketing program with over 5 million active members today. Recent new partners like ING Canada Insurance, XM Radio and Sunlife Financial add breadth to Aeroplan’s network of more than 60 partners in the financial, retail and travel sectors. Although Aeroplan is up more than 30% since its IPO in 2005, we believe there is further growth for this company. It continues to negotiate more partnerships especially in the broad retail sector and increase operating margins by offering more non-air rewards incentives as well as by implementing its “Dynamic Pricing” program, its members redeeming miles for any available seats at market rates.
AG Growth Income Fund (AG.UN) – AG Growth is in the boring but profitable business of manufacturing portable grain handling equipment like augers and belt conveyors. These are all essential low price point ($1,000 -15,000) equipment with regular 3-7 year replacement cycles. We like AG Growth because it is a dominant market leader with 40% market share and a strong distribution network of more than 1,400 dealers throughout the US and Canada. It offers an attractive yield of $1.69/year or 10.3% with a possible special dividend at a conservative payout ratio. As a dominant player in a highly fragmented industry, there is also potential for growth by acquisition. Although AG Growth has exposure to raw material prices, especially steel prices, management has historically been successful at managing its costs and has also demonstrated its pricing power to offset rising production costs.
The global economy continues to struggle with higher commodity prices, especially energy. Central banks in Canada and the US are expected to stop raising rates during Q3-2006. We expect inflation to remain somewhat higher than recent history. Continued strength of the Canadian dollar will put pressure on Canadian manufacturers and exporters.
We will continue to endeavor to secure exceptional returns for our clients through prudent investment.
Michael Decter President and CEO