2008 Q1 Newsletter March 31, 2008
We are enduring difficult global economic conditions focused in financial markets that are impacting the investment environment. It has been a negative period for many of the positions we have favoured. We remain confident we will recover the gains that have been eroded by the impact of the sub-prime credit situation.
It is our strongly held view, despite the pessimism in markets, the actions taken by the US Federal Reserve, the Bank of Canada and others will be sufficient to reverse the decline in the economy and restore confidence to markets. We have witnessed dramatic reductions in interest rates in the US. This restoration of confidence is taking longer than originally anticipated because of the depth of the sub-prime mortgage debacle in the United States. Some six million homes are affected. However, we remain strongly convinced that the strength in Asian economies, the strength in the Canadian economy and the global demand for resources and food will reward patience in the positions we hold. We have shifted our portfolios to lower risk securities during these volatile markets so we are well positioned for solid growth upon the return of more stable positive markets.
The Canadian economy created 100,000 new jobs in Q1 although the US economy lost jobs. We expect the Canadian economy will slow but continue to outperform the US economy. Our emphasis remains on Canadian equities.
Overall, Lawrence Decter Investment Counsel Inc. (LDIC) performance was down 5.8% in the first quarter. The S&P TSX outperformed both US indices. The Dow Jones Industrial Average was down 7.6% and the broader S&P 500 declined 9.9% in the first quarter.
On average, our top 15 positions experienced a 10.2% gain during the first quarter. Eight securities were up with a 33.7% gain for Franco-Nevada Corp. Seven securities were down lead by Rogers Communications with a 17.9% decline. Of note in the first week of April, Rogers recovered more 60% of its Q1 loss.
Major Exit Portfolio Changes
Arise Technologies Corp (APV)
Arise Technologies is a Waterloo, Ontario based company dedicated to becoming a leader in high-performance, cost-effective solar technology. The PV Cell Technology Division of this company is developing a high-efficiency photovoltaic cell based on proprietary technology. The division is completing construction of its first manufacturing plant in Germany and expects to begin shipping to PV module makers in April 2008. We had anticipated a wafer supply contract for Arise to be signed during the middle of the first quarter of 2008. Nearing the end of the quarter this had not happened and we lost
confidence in Arises ability to deliver first production for April 2008. We exited our position in this name and switched to Timminco (TIM) a similar solar technology company. We felt Timminco, given it does not rely on an external source for solar wafers, and has a larger market capitalization is a safer investment on a risk-reward basis.
Armtec Infrastructure Income Fund (ARF.UN)
In Q1 of 2008, we exited our position in Armtec Infrastructure fund. This fund is Canada’s leading manufacturer and marketer of drainage products and engineered solutions for infrastructure applications in a diverse cross-section of industries including agricultural drainage in Canada. Approximately 38% of the funds revenue is from Western Canada. During the fourth quarter of 2007 the company reported record sales and earnings, up 24% and 21% over 2006 respectively, and the stock experienced significant appreciation in the quarter. As a result, we felt the stock was near fully-valued and we therefore took profits. We continue to like the company and would consider re-entering the position on a significant lower in price.
Brookfield Asset Management Inc (BAM.A)
Brookfield Asset Management is a global asset manager, managing approximately US$95 billion, focused on property, plant and other infrastructure assets. In the first quarter of 2008, we exited our position in this company. Given our concerns of a US slowdown and Brookfield’s significant exposure to this market, we felt there was more downside risk to the company’s ability to generate top line net income growth and sustain their 12-15% cash flow
Neo Material Technologies Inc (NEM)
Neo Materials is a leading producer, processor and developer of neordymium-ironboron magnetic powders, rare earths and zirconium-based engineered materials and applications. This 14 year old company is headquartered in Toronto and has 1,300 employees in 10 different countries worldwide. Neo Materials operates in an industry with significant barriers to entry and high market share. Although Neo Materials has grown both its revenues and earning over the last year, its EBITDA margins have been compressed due to higher inputs costs and an inability to pass these on to customers. We exited our position in Neo Materials given our belief that cost pressure will continue to impact the company’s margins and a dilutive acquisition may occur in the next 12 to 18 months.
Royal Bank of Canada (RY) & TD Bank (TD)
During Q1 of 2008, LDIC re-entered the Canadian financial sector through investments in Royal Bank of Canada and TD Bank. We began the year optimistic that the worst of the US sub-prime and credit crisis was behind us. Since the beginning of Q1, a number of factors have convinced us that our decision to re-enter the financial sector from a risk-reward perspective may have been premature. Firstly, Q1 earning miss were larger then expected, approximately 50% lower from Q1 of 2006. Secondly, we believe the commercial loan books have further write-downs to come in the next few quarters especially TD Bank through its US ownership in Banknorth. Thirdly, we believe the wholesale investment banking side will be hit hard given the slow-down in deal flow witnessed year to date.
Major New Portfolio Changes
Barrick Gold Corp (ABX)
In Q1 of 2008, LDIC invested in Barrick Gold as a hedge against global inflation, slowing US growth and the depreciation of the US dollar. Barrick Gold is the world’s largest gold company in terms of market capitalization, annual production and reserves. During 2008, Barrick intends to acquire the remainder of Aurizona Star. Upon completion, Barrick Gold will own 51% of the Cerro Casale project in Chile which is considered to be one of the largest undeveloped gold deposits in the world with reserves of 22.9Moz of gold. Barrick Gold is our preferred large-cap gold stock due to its solid management, sustainable production, healthy balance sheet and relative inexpensive value. Barrick Gold is comparably cheaper then its large-cap peers on a price per net asset value basis, 2008 expected cash flow per share and 2008 earnings per share basis.
Daylight Energy Trust (DAY.UN)
Daylight Resources Trust is a high quality balanced natural gas and oil medium-sized conventional royalty trust headquarters in Calgary. The Trust was formed as a result of the merger between Daylight Energy Trust and Sequoia Oil & Gas Trust on September 21, 2006. The company is currently producing an average of 20,583 boed. This represents a 17% increase in production over 2006 levels. We like Daylight because the company has
improved its operating netbacks 11% quarter over quarter and 5% over 2006 levels. The payout ratio has been reduced by 10% to a more sustainable level from 2006. The company continues to improve its balance sheet by reducing its bank debt by 30% from 2006 levels, and the 2008 capital expenditure plan of $85M will be strategically invested in an inventory of repeatable, low risk exploitation projects.
Duvernay Oil Corp (DDV)
Duvernay is an intermediate oil and gas exploration and development company located in Alberta and British Colombia. Duvernay is currently producing 20,966 boed of which 89% of this is natural gas. Duvernay has relatively low finding costs and high operating netbacks. Further, the company has increased cash flow per share 14% and production per share 11% over 2006 levels. Duvernay also has a large position of land in the Montney area in British Colombia. This is an unconventional gas reservoir estimated to have one-three trillion cubic feet (Tcf) of unrecovered gas resources in place. Duvernay has 120 sections in this area which, could add significant upside to the share price over the next few years. Additional horizontal drillings and additional information on production flow rates per well are needed to determine the full potential of Duvernays land positions. We believe Duvernay is well positioned to gain from strong natural gas prices, potential upside from horizontal drilling on its unconventional gas acreages in the Montney and strong net asset value (NAV) growth over the next 12 to 18 months.
The Mosaic Co (MOS)
Mosaic is the world’s largest producer and marketer of concentrated phosphate and potash fertilizer. The company was formed through the merger of Cargill Crop Nutrition and IMC Global in 2004. Mosaic’s production facilities are located in North America and the company has a global distribution footprint of 36 facilities in 11 countries including the US, Brazil, China, India and Southeast Asia. Phosphate prices, which Mosaic has the best leverage to, have soared nearly 350% over the last 12 months. Mosaic has a cost advantage on both the phosphate side given that it has its own phosphate rock supply, paying 84% less then international peers and on the sulphuric acid side, paying 60% less then international peers. On a valuation basis the company’s stock looks undervalued. Mosais is expected to grow its earning by 75% over the next year on the back of stronger pricing, better margins and volume and the stock is trading at a mere 13x forward Price/Earnings (P/E).
Timminco Ltd (TIM)
Timminco is a specialty materials company, focused on the production of magnesium, calcium and strontium alloys and extruded magnesium products. It currently has three production lines with annual capacity of 3,600 metric tonnes. The company is in the midst of ramping this up to 14,400 metric tonnes by mid 2009. Timminco has currently signed 6,000 metric tonnes of its future production to customers and 26 other manufacturers are currently testing Timminco’s material. We like Timminco because the company has proven its ability to manufacturer high-purity solar grade silicon on a large-scale basis. It is now the only source worldwide for high quality metallurgical silicon applicable to solar wafer manufacturing. We strongly believe the next two years will take Timminco from a smallscale concept idea to a full production-based company poised to significantly grow its revenue and earnings.
We believe the interest rate reductions and other measures taken by the central banks will lead to an overall rebound and growth in the North American economy in Q3 and Q4 of 2008. The second quarter may remain volatile as a mixture of negative and positive economic views are received. However, we are optimistic the decline in equity values in Q1 will be recovered through the balance of 2008. Canada continues to benefit from robust commodity prices, surplus budgets in governments and significant new investment in Western Canada.
Patience is a very difficult when one is bombarded by newspapers and television stations broadcasting dire predictions. We do not share this pessimism. We are convinced that patient value-oriented investors will be rewarded as stability returns to financial markets and growth to the economy.
President and CEO