2006 Q3 Newsletter September 30, 2006
As noted in our last newsletter signs of a slowing American economy are beginning to be evident. Economic and employment growth have slowed. Of particular importance is the end of the steady increase in the Federal Reserve key interest rate from just 1.0% in June 2004 to 5.25% in September 2006. Interest rate increases appear to have halted in Canada as well. Citigroup is forecasting a 0.25% rate reduction in the first quarter of 2007. Other economists are predicting a 1.0% rate reduction over the next twelve months. Already declines are visible in the yield on longer term bonds.
The slowing American economy and the flattening of interest rates have implications for our investment strategy. Our third quarter (Q3) results have been adversely affected by softening commodity prices, particularly for natural gas and oil. These softer prices have been caused by perceived weakness in future demand due to economic slowing as well as, the absences of hurricanes or extreme hot weather in the summer of 2006.
Declining oil and gas prices have been a negative factor for the TSX and for our holdings. Both the TSX and LDIC are more heavily weighted to energy and resources. However this same decline has boosted the Dow Jones Industrial Average. We remain confident our strategy will yield returns over the medium term. For Q3 our overall return of -0.26% represented a loss of gains earned earlier in the year, although our year-to-date return remains positive at 4.60%. We anticipate seeing overall positive returns to close 2006.
Among our top ten positions in Q3, results were positive. Seven gained and three declined. The major decline was experienced in Canetic Resources Trust, this oil and gas trust is a long time holding. We are confident as we move through the “shoulder” season, when natural gas prices usually fall, into the winter drawdowns that Canetic will recover along with natural gas prices.
The most significant declines came in energy prices during Q3.
Base metal prices held their ground reasonably well in Q3.
During Q3 we exited or began to exit several major positions. Two investments ranked among our top ten, both Norbord and Yellow Pages Income Trust were sold in Q3. As well, we sold Jean Coutu, Movie Distribution, Strongco, Russell Metals and Systems Excellence. Reasons varied for the exits.
In the case of Norbord the softening of U.S. housing starts led to declining oriented strand board (OSB) prices. As this is Norbord’s sole product, their future earnings are likely to decline as well as the share price.
Yellow Pages Income Trust sale resulted from the belief its valuation was becoming too rich compared to some other business trusts, especially given its limited future growth prospects. We also believed the potential for meaningful acquisitions in the Canadian market are becoming limited given the large size of Yellow Pages Income Trust.
We sold our Jean Coutu holdings at a reasonable gain after the company merged its U.S. Eckerd stores into Rite Aid. Our original expectation had been a Jean Coutu turnaround of the Eckerd pharmacies but they chose a different road. Therefore, we were not comfortable becoming an indirect investor in Rite Aid due to its very heavy debt load.
Our experience with Movie Distribution has been very disappointing. Battles between the majority shareholder Alliance Atlantis and Movie Distribution management became very public and very damaging. We exited at a loss rather than endure further uncertainty and greater loss.
We sold Strongco, Russell Metals and Systems Excellence to realize solid gains from our initial cost. We are not of the view further significant gains are likely from the current levels.
Quebec Hydro Zero Coupon Bonds
North American central banks indicated in Q3 that the end of the interest rate raising cycle is upon us. After holding rates steady for a few months, we believe interest rates in the US and Canada will begin to fall and could fall a full percentage point or more. Since our investment thesis is that interest rates will be lower than current levels one year from now. The 30-yr Hydro Quebec “zeros” (Zero Coupon Bonds) are our way of achieving leverage to maximize investment gains. The near-term returns of a zero coupon bond are heavily levered to the interest rate. Also, the longer the maturity of the bond (i.e. the further in the future the maturity date of the bond) the more heavily levered will be the return should interest rates drop. The two main reasons we selected Hydro Quebec for the majority of our position in zero coupon bonds is their availability and their more attractive yield to maturity relative to federal issues. We expect to hold these bonds for 12 to 18 months. This holding also provides a measure of “insurance” against difficult equity markets.
Beyond our bond purchases we continued to add to several positions started in our second quarter particularly Teranet, Tim Hortons, Aeroplan, and Ag Growth. We have been impressed with the performance of each of these companies. Once the full distribution of Tim Horton’s shares by Wendys is complete we expect it to become a core holding for many Canadian investors. Teranet and Tim Horton’s joined our top 10 list of holdings in Q3.
We anticipate strong earnings in the base metals sector but an overall slowing of economic growth in the fourth quarter of 2006. We intend to reduce our energy exposure over the winter heating season. We believe this slowdown will trigger interest rate reduction in 2007. This should benefit our interest sensitive holding such as pipeline income trusts as well as our new bond holdings. From a portfolio stand point we will continue to seek value in this somewhat volatile market. We remain optimistic our approach will yield solid returns over the next several quarters.
Michael Decter President and CEO