2009 Q1 Newsletter March 31, 2009
In the context of volatile and negative world equity markets, Canadian markets generally held their ground in the first quarter. Canadian equity markets outperformed those in the United States, losing only 3.0% versus 11.0 to 13.0% losses. Economic news was extremely negative in the first quarter with significant job losses in Canada and in the United States. Markets began in 2009 with a short rally before retesting the lows experienced in the fourth quarter of 2008. After making new lows, equity markets rallied on a combination of bargain hunting and increasing confidence in US recovery measures. The most recent efforts by the Federal Reserve and the Obama Administration are convincing investors the risk of a deep recession becoming a Depression has receded.
Our strategy in the first quarter was to preserve capital while keeping open the potential for recovery in values. Our defensive stance allowed us to reposition holdings to increase safety and income for our client portfolios.
Overall, LDIC performance was down -0.3% in Q1. The S&P TSX dropped 3.0%, outperforming both US indices. The S&P 500 was down 11.7% and the broader Dow Jones Industrial Average declined 13.3% in the first quarter. For the year LDIC has outperformed all three indices.
On average, our top 15 positions experienced a 1.1% loss during the first quarter. Seven securities were down with 20.6% loss for Rogers Communication Inc, 17.2% loss for AltaGas Income Trust, 10.1% loss for TransCanada Corp, and 8.3% loss for Pembina Pipeline Income Fund. Eight securities were up lead by Energy Savings Income Fund with a 21.3% gain and Goldcorp Inc with a gain of 10.6%.
Major Portfolio Changes - Exits
Daylight Energy Trust (DAY.UN)
We exited our position in Daylight Energy during the quarter. With a declining natural gas pricing environment we felt the distribution cuts were likely to occur for most of the natural gas oriented income trusts. We switched the proceeds into companies with a higher production mix of oil versus gas such as Crescent Point Energy Trust and TriStar Oil and Gas Ltd.
Franco Nevada Corp (FNV)
We exited our position in Franco Nevada during the quarter and took profits off the table as the stock was up over 50.0% since its Initial Public Offering (IPO) launched in late 2007. We believed the valuation was a little rich in a lower energy price environment and took the opportunity to rotate into a more conservative holding, Energy Savings Income Fund.
Ithaca Energy Inc (IAE)
We exited our position in Ithaca Energy during the quarter. We felt the unit price appreciation was sufficient for the current commodity price environment. The company’s financing needs for growth are at risk and assuming financing needs are met, we believe the valuation is no longer compelling. Ithaca is expected to start up production at its Jacky field in the second half of the year. Nearly 7,500 barrels per day of production will bring cash flow needed for working capital into the end of the year. Ithaca needs capital for growth and presently the company does not have any more available credit from its partner as its facility is fully drawn and the United Kingdom banks do not appear to be lending money yet to the North Sea developing projects. We feel there are less leveraged companies which present better investment opportunities than Ithaca Energy at this time.
Potash Corp of Saskatchewan Inc (POT)
During the quarter we exited our position in Potash Corp. Our reasoning was two fold. First, given the economic downturn and credit contraction occurred during fourth quarter of 2008 and into first quarter of 2009, many farmers chose to defer fertilizer purchases and reduce application rates. As a result the volumes shipped for the quarter will likely be significantly lower, negatively impacting the bottom line. Potash Corp is guiding towards earnings per share of $0.70 to $1.00 for the first quarter which is estimated 40.0% lower than 2008. Potash Corp has curtailed production growth plans for 2009 and thus is
guiding to flat production and earnings growth year over year. Second, the key to Potash Corp earnings will be contract price settlement with China, the largest potash importer globally. If the contract price settles lower than last year this could materially affect earnings for Potash Corp in 2009. With the 25.0% price appreciation in Potash Corp unit price during the quarter, we felt that the risk of holding these units given the possibility of a declining earnings profile outweighed the benefit of an upside surprise. The share price trading at a 10.0 times price to earnings multiple on flat year over year potash prices and we felt the units were fully value.
Major Portfolio Changes - Additions
Bird Construction Income Fund (BDT.UN)
We continued to accumulate more shares in Bird Construction Income Fund during the quarter as operating performance continues to be strong and valuation remains compelling. Bird Construction provides general contracting, construction management and design build services to the institutional, retail, and industrial sectors across Canada. We like Bird Construction because it pays out a strong yield on an attractively low payout ratio. It has no long term debt and has $120 million in cash on the balance sheet. The valuation is outstanding, trading on a 4.4 times trailing twelve months earnings per share multiple while growing earnings 80.0% year over year.
Brookfield Asset Management Inc (BAM.A)
Brookfield Asset Management is a global asset manager focused on power, property, and other infrastructure assets. The company has approximately $80 billion assets under management in the Americas, Europe, and Australia which produce stable and sustainable cash flows. We initiated a position in the equity during the quarter as we felt the unit price had been sufficiently battered, down some 40.0% over the last six months. Brookfield generates significant free cash flow and has only $2.3 billion in debt at the parent level only $200 million of which is due before 2012. The company is expected to earn $1.00 share and cash flow $2.40 share in 2009. The shares also yield about 3.3%.
Energy Savings Income Fund (SIF.UN)
We added a position in Energy Savings Income Fund during the quarter. This company is an energy marketer engaged in the sale of fixed price long term gas and electricity contracts in various North American markets. We started accumulating a position as we felt the units were unfairly oversold given the fundamental strength of the company’s business model and operating history. The company has had double digit growth in earnings every year of its existence, has no debt, and has cash on its balance sheet. Furthermore, the yield is very attractive at about 11.6% given the predictability and sustainability of the company’s cash flows. The company also has growth prospects as management is actively looking at US markets for accretive acquisitions.
Hudbay Minerals Inc (HBM)
We started rebuilding a position in Hudbay Minerals during the quarter. Hudbay is an integrated mining company that owns and operates three mines in northern Manitoba, two concentrators, a copper smelter, a copper refinery, a zinc plant, and a zinc oxide facility. In the third quarter of 2008, it completed the acquisition of Skye Resources, which is developing the Fenix ferro nickel facility in Guatemala. The company also owns 19.9% of Lundin Mining which was acquired through a private placement in February of this year. This acquisition has a market value of approximately $188 million. In addition, Hudbay retains a significant cash position on its balance sheet of over $700 million. This cash position is valuable because it can insulate the company from severed downturn in metal prices, provide significant capital to fund organic exploration plans, and increase the ability of the company to return funds to shareholders or acquire a value enhancing project or company.
Migao Corp (MGO)
During the quarter we added a position in Migao Corp, a Chinese specialty fertilizer company. We like this company for its balance sheet, significant earnings growth and attractive valuation. The company has no long term debt and has sufficient cash on hand to fund its growth plans. This company will see earnings growth of over 100.0% from 2008 to 2010 mainly on productive capacity expansion. China has been reluctant to remove export taxes on potash. This confirming our view domestic demand for fertilizer remains strong and thus Migao’s gross margins should remain intact. On a valuation basis, we feel Migao is a significantly undervalued quality growth stock, trading at just four times 2009 earnings per share.
As the positive impacts of large scale stimulus take hold in North America we expect early signs of economic recovery in leading sectors such as construction. While there may be several more months of economic decline, we believe equity markets will rally based on early indications that stimulus measures are working. Economic news is likely to remain mixed in the second quarter. For example, job loss, a lagging indicator will likely continue at a slower pace. By contrast, housing starts increased in March reflecting recovery. The stream of mixed economic news will continue a level of market volatility.
The China stimulus efforts are clearly working with growth expected to rebound from 6.0% to appropriately 7.0 to 8.0% this year. China demand has driven copper prices from a low of $1.20 per pound to over $2.00 per pound. We expect to see second quarter impacts from stimulus efforts in North America, Japan, and Europe moving slower than China’s efforts. Our investments are focused overwhelmingly in Canada. We believe Canada was the last in the G-8 to enter recession and will be the first emerge from recession. We expect growth in the Canadian economy in 2009. We expect equity markets to recover strongly six to nine months before the economy.
President and CEO