2007 Q3 Newsletter September 30, 2007
The third quarter (Q3) of 2007 proved to be extremely volatile. Two issues unsettled financial markets. Subprime Mortgage defaults in the United States became the trigger for volatility and negative markets in July and August. In Canada, concerns about Asset Backed Commercial Paper had the same impact. Market drops were severe, sudden and well reported in the press. Our strategy noted in our August letter proved prudent and we recovered most of the lost ground. Recovery in September resulted in a near flat quarter.
Overall, Lawrence Decter Investment Counsel Inc. (LDIC) performance was down 0.38% in the third quarter. This underperformed the 1.38% gain on the S&P TSX by 1.76%. The Dow Jones Industrial Average gained 2.66% and the broader S&P 500 gained 0.48% for Q3.
On average, our top 15 positions experienced a 0.7% gain during the third quarter. Eight securities were up with a 15.7% gain for HudBay Minerals Inc. and a 14% gain for SNC Lavalin. Seven securities were down lead by Verenex Energy Inc. with a 22.5% decline.
Major Portfolio Changes
We exited two major positions in Q3 as well as reducing our exposure to Canadian banks.
Rally Energy Corp. (RAL)
Rally is a Calgary based oil and gas exploration, development and production company. The company’s primary area of operations is in Egypt located on the west shore of the Gulf of Suez, where it has a 100% operating interest in the 20,000 acre Issaran Oilfield. The company also holds a 30% working interest in the 200,000 acre Safed Koh Block in the Province of Punjab in Pakistan where it is participating in the development of large natural gas/condensate discoveries. We were attracted to both the resource potential (Egypt: 127 million barrels (BBL) of recoverable oil, Pakistan: 3 Trillion Cubic Feet (TCF) of recoverable gas) and the highly qualified Canadian exploration and development team exporting its skills internationally. On September 27 2007, Rally Energy announced that it has completed a transaction whereby Citadel Capital Company and National Petroleum Company S.A.E will acquire all of the outstanding common shares of rally for CDN $7.30 per share, a deal valued at $898 million. LDIC tendered all of its shares and is re-investing the proceeds accordingly.
Iberian Minerals Corp. (IZN)
Iberian Minerals is a base metals miner with assets in the Iberian mineral belt in Spain who is working on reopening the Aguas Tenidas copper-zinc mine in the belt. Iberian also recently announced a deal to acquire a producing copper mine in Peru from its partner, Trafigura. Although our view on Iberian is still mildly positive, in the context of an increasingly risk-averse market environment, we decided to exit the position to mitigate exploration risk exposure. We believe that our holdings in other producers like HudBay, Brilliant Mining and Teck Cominco provide our clients with continued exposure to the base metals market.
We added three major positions in Q3.
Potash Corp of Saskatchewan Inc. (POT)
Potash Corp is an integrated producer of fertilizer, industrial and animal feed products. It is the world’s largest fertilizer company by capacity and produces all three primary plant nutrients: potash, nitrogen and phosphate. Tight supply/demand fundamentals for potash positions the nutrient for further strength in the next few years. While potash prices have been trending upward for 17 years, the sharpest increase occurred in the last 5 years when prices increased from ~US$80/tonne (t) in 2003 to US$165/t in 2007. Potash Corp has 22% of the world’s potash capacity and the majority (75%) of the world’s unused capacity which, the Company is bringing online through de-bottlenecking and expansion projects as opposed to developing expensive new mines. One analyst estimates that Potash Corp will realize an average of $208/t in 2008 versus $165/t in 2007. Potash Corp is also the world’s 4th largest nitrogen producer with 2/3 of its ammonia production in Trinidad where it benefits from long-term lower-cost gas contracts and the world’s 3rd largest phosphate producer. We like Potash Corp’s strong operational discipline which, has resulted in very strong (and growing) margins. We also like Potash Corp’s focus on ensuring its cash flow return on investments exceeds its cost of capital (in 2006, Cash Flow Ratio (CFR) was 14.5% or 5.7% higher than its cost of capital). Valuation would appear stretched at compared to historical multiples however, given our expectation of continued growing demand for food (as indicated by creeping food price inflation) and hence the need for better yields through fertilizer/nutrient use, we believe PotashCorp is an industry leader that will continue to benefit from higher potash, phosphorus and nitrogen prices and grow its earnings 20-30% annually.
Sino-Forest Corp. (TRE)
Sino-Forest is the leading commercial wood fibre supplier in China. Strong economic growth in China, increasing focus on stopping illegal logging practices globally and the implementation of export log tariffs in Russia (which began being implemented in July) has resulted in an increasingly tight global fibre market. As a result, timber prices have surged and macro global trends as well as the increase in acquisition activity in this industry indicate that this is likely to continue. Sino-Forest has built up an enviable plantation base in China, the fastest growing user of fibre, through organic planting and acquisition. We like that management continues to shift from plantation operations (i.e. growing trees) to log processing (i.e. harvesting). This strategic shift is evident in Sino-Forest’s plan to replenish harvested acreage with eucalyptus, which has a shorter growing cycle thus increasing the acreage harvestable each year. With the recent acquisition of the 400,000 hectare Hunan and 200,000 hectare Yunnan plantations, the Company appears to be on track to increase its annual harvest from 10 million m3 to 20 million m3 per year by 2009-2010. We believe management has shown a record of operating and strategic success through accretive acquisitions and a focus on return on invested capital. We also believe that because of their long operating history in China, Sino-Forest is well-positioned to benefit from any future plantation sales by the government, who currently still owns ~42% of 175 million hectares of forested land.
Bioteq Environmental Technologies Inc. (BQE)
BioteQ has proprietary patented technologies that treat acid wastewater generated by mining activities. These processes concurrently treat acid contaminated water while recovering saleable metals from the water so the water discharged from the processes contain very low concentrations of toxic heavy metals. The incremental metals recovered contribute to a relatively short payback period for mining companies that use BioteQ’s technology. We like BioteQ because its patented technologies address an urgent environmental issue that we believe will face even more stringent regulatory scrutiny as the level of mining activity increases globally. BioteQ has a proven project-based business model that ensures the each new project is profitable. The Company’s experience and deep relationships with key players in the mining industry (current customers include Phelps Dodge, INCO, Barrick and Codelco) are significant barriers to entry. We expect BioteQ to be able to take on increasingly larger projects because they are well-financed and have a 3-year option to acquire an engineering firm that significantly increases its headcount. We also believe that BioteQ is a potential acquisition target as a rare pure-play water treatment company given its strong market position and patented technology platform (recall GE’s acquisition of Zenon Environmental and Danaher’s acquisition of Trojan Technologies).
We increased two major existing positions in Q3.
Power Corp of Canada (POW)
Power Corp. is a diversified North American holding company that owns interests in Power Financial (including Mackenzie Financial and Putnam), Great-West Lifeco, IGM Financial (wealth management), CITIC Pacific (Hong Kong-listed company with investments in China and HongKong), Gesca (newspaper, specialty magazine and book publisher) and Power Technology Investment Corp. Power Corp also has a sizable interest in Pargesa which, in turn holds significant positions in Total (oil and gas), Suez (energy, water, waste services), Imerys (specialty minerals), Lafarge (cement and building materials) and Pernod Ricard (wine and spirits). It continues to be one of our top core holdings. We have always liked Power Corp for its diversified asset base and the strength of its team. In view of the uncertainty surrounding some of the Canadian banks, we opted to add to our Power Corp position during the quarter as our financial sector exposure. Despite the inevitable holding company discount, we believe that holding Power Corp continues to be the best avenue for diversified exposure to leading companies in various industries including financial services and healthcare, two areas which we expect to have above average revenue growth driven by demographic trends.
GLV Inc. (LVG.A)
We first bought GLV Inc. (previously known as Groupe Laperriere & Verreault) last quarter when it was a more diversified industrials company with ~50% of its revenue generated by providing consulting industrial process services. Shortly after our entry, GLV announced the sale of its Process Group for cash at a significant premium to Danish company, FLSmidth & Co. We received $33 in cash and one share in the new company comprised of the Water Treatment and Pulp & Paper Groups. Our main reason for owning GLV was for the Water Treatment assets as part of our overall thesis that water shortage and water contamination will become an increasingly important issue therefore; we took the opportunity to add to our position with some of the cash proceeds from the divestiture. We believe the management team has a proven history of growth, both organically and via acquisitions. Possibly at some point in the future, management might divest its Pulp & Paper business once it has achieved critical mass, thereby further streamlining its operations to focus on water treatment.
We have a positive outlook for Q4 2007. It is our strong belief that the fundamentals of the world and Canadian economies are very solid. Employment levels are high and job creation is continuing. Asian growth continues to fuel Canadian economic performance. We are confident that despite occasional volatility the prospects for Q4 and 2008 will prove positive.
The rapid rise in the Canadian dollar will slow the manufacturing sector and tourism. However, we believe the strength in the Canadian economy will survive the rise in our currency.
Michael Decter President and CEO