2009 Q2 Newsletter June 30, 2009
During the second quarter (Q2) of 2009 there was a strong rebound in North American equity markets. Promising signs of recovery in the economies of Asia led to a rebound in commodity prices such as base metals and oil. This aided Canadian equity markets. Signs of economic recovery are beginning to appear globally.
Our strategy in Q2 was to gradually reallocate cash back to work in the equity market with a focus on income producing equities and income trusts. We remain cautious but optimistic based on the evidence of Q2. While unemployment continued to climb, leading indicators of trade began to improve. We added positions such as Teck Resources, Labrador Iron Ore Royalty Income Fund, and Hudbay Minerals based on recovering metal and steel prices. Another addition was H&R REIT based on their successful financing of the EnCana office complex project in Calgary.
Overall, LDIC performance was up 14.8% in the second quarter. The S&P TSX gained 19%, outperforming both US indices. The S&P 500 was up 15.2% and the lesser Dow Jones Industrial Average gained 11.0% in the second quarter.
Top Ten Holdings
On average, our top 10 positions experienced a 16.4% gain during the second quarter. Only one security was down with 4.7% loss for Goldcorp Inc. Nine securities were up lead by H & R REIT with a 42.6% gain, Crescent Point Energy Trust with 30.2%, and Keyera Facilities Income Fund with a gain of 28.0%.
Major Portfolio Exits
Epcor Power LP (EP.UN)
EPCOR Power has 20 underlying assets which include three hydroelectric, two biomass, 13 gasfired cogen, and two coal-fired facilities located across Canada and the U.S. We exited our position in EPCOR following poor first quarter performance. Over the last few months, there has been a surplus of power available in Alberta which has lead to lower prices. Further, EPCOR’s coal fired production may come under scrutiny and be negatively impacted by new environmental laws such as carbon taxes.
SXC Health Solutions (SXC)
SXC Health Solutions is a provider of healthcare information technology tools and services for the pharmacy benefit management industry. High earnings growth for this company appears to have slowed and the units look fully valued. SXC Health Solutions had been growing earnings by over 50% year over year but analysts now expect growth will slow to 20% in 2010. The units are trading at 24 times forward Price per Earnings (P/E) and over 8 times Enterprise Value per Earnings Before Interest, Taxes, Depreciation and Amortization (EV/EBITDA) and we believe growth prospects are fully priced into the stock.
TMX Group Inc (X)
TMX Group was formed as a result of the merger between the TSX Group and the Montreal Exchange. The combination unites the cash and derivatives markets in Canada, creating an integrated national exchange with the abilities to list, trade, clear, and offer market data to participants. The TMX Group owns and operates Canada's two national stock exchanges: the Toronto Stock Exchange and TSX Venture Exchange. We exited our position in the TMX Group for several reasons. Equity and derivatives trading volumes are expected to drop off between 10 to 15% in 2009; price competitive alternative trading systems are gaining market share and threatening to cannibalize trading revenue, and given the growth prospects the units look fully valued trading at 13.5 times and growing at 13% year over year.
Major Portfolio Additions
Brookfield Asset Management Inc (BAM.A)
Brookfield Asset Management is an international diversified property, power and infrastructure, investment and management company. The company has $80 billion of assets under management and provides investors with a highly visible and stable growth vehicle. The company generates approximately $1.5 billion in free cash flow a year and has only $2.3 billion in debt at the parent level. The company has $3.6 billion in cash and core liquidity. Brookfield Asset Management expects to capitalize in the nearterm on what it perceives to be historic opportunities to invest in high-quality shopping centre and office properties, notably in the U.S. and the U.K. In the past 10 years, Brookfield Asset Management shares have traded at a high of 34% above estimated net asset management and a low of 38% below net asset value (NAV). Currently, the units trade at an attractive 18% discount to NAV.
H&R Real Estate Investment Trust (HR.UN)
H&R REIT is an open-ended Real Estate Investment Trust which holds interests in 35 office properties, 123 single-tenant industrial properties, 121 retail properties and three development projects, principally in the Greater Toronto Area. H&R’s property portfolio is one of the most defensively positioned of Canadian REITs with the highest average remaining lease term in the Canadian REIT universe and just 6.7% of leases maturing in 2009 to 2011 time period. The REIT’s top four tenants account for approximately 29% of revenues. H&R is conservatively financed with long term mortgage debt and at its current distribution of $0.72 per unit on an annualized basis; H&R REIT has among the lowest payout ratios in the REIT universe. The units are currently trading at an estimated 40% discount to NAV and we believe current prices represent a compelling entry point.
Hudbay Minerals Inc (HBM)
Hudbay Minerals is an integrated mining company focused on the exploration, development and production of copper and zinc. Hudbay Minerals flagship asset is the 777 mine located in Flin Flon, Manitoba. The company’s other assets also include in Trout Lake and Fenix, The company will be closing its Flin Flon copper smelter before July 2010 due to low copper treatment charges and tighter greenhouse-gas emission standards. As of the second quarter, Hudbay has a significant cash position of more then $800 million dollars and no debt. This gives the company immense ability to grow both organically and through accretive acquisitions. We believe Hudbay Minerals is undervalued with the shares trading at just 0.3 times NAV; one of the lowest multiples seen in the Canadian base metal universe.
Labrador Iron Ore Royalty Income Fund (LIF.UN)
Labrador Iron Ore Royalty Income Fund is a limited purpose trust established in 1995. It holds a 15.1% equity interest in Iron Ore Company of Canada (IOC) and receives a 7% gross overriding royalty and a 10% tonne commission on all iron ore products produced, sold and shipped by the IOC. Recently Japanese steel mills, the second largest consumers of iron ore after China, have agreed to a 30% price cut. China, a high cost producer of iron ore, is holding out and trying to negotiate for a 40% price cut with major mining firms. A deal has yet to be reached and China continues to import large amounts of low cost iron ore to feed its increasing steel production. The pressure to supply steel mills with large amounts of low cost iron ore will certainly weaken the Chinese’s case for a significant price cut. Absence of a settlement means that Chinese buyers may be forced to make purchases on the volatile spot market. Spot iron ore prices in China have raised by approximately 20% in the last month and now trade above where the Japanese steel mills settled. We believe iron ore prices may have bottomed and China may be forced to accept the same price cut as the Japanese. Labrador Iron Ore’s units trade at just under 3 times EV/EBITDA on what we believe to be conservative volume and price assumptions for 2010.
Teck Resources Limited (TCK.B)
Teck Resources is Canada’s largest diversified mining, mineral processing, and metallurgical company. Headquartered in Vancouver, the company owns and has interests in 15 mines in Canada, the US, Chile and Peru, as well as one metallurgical complex in Canada. Teck Resources is the world’s second largest producer of seaborne hard coking coal and zinc. The company is also a significant large copper producer. We bought a position in Teck Resources during the quarter as the company has gone to significant lengths through asset sales and high yield debt refinancing to bolster its balance sheet. Recently, Teck Resources sold a 17.2% equity stake to China Investment Corporation for C$1.74 billion dollars. Teck Resources has some of the best assets in the world and we believe the units present compelling value at these levels given the significant leverage the company has to commodity prices.
Verenex Energy Inc (VNX)
Verenex Energy is a Canadian based international oil and gas exploration and production company operating in the Ghadames Basin in Libya. As of the middle of January 2009, Verenex had drilled and cased 17 exploration and appraisal wells. In February 2009, CNPC International Ltd (CNPCI) made a $10/share bid for Verenex. Subsequent to this, the Libyan National Oil Company (NOC) announced it intended to use its pre-emptive right to acquire Verenex on the same terms and conditions offered by CNPCI. It has now been four months and the NOC has failed to make an offer or to approve CNPCI’s bid. In late June, Verenex announced it has received two letters from Libya’s NOC accusing the company of being improperly pre-qualified to bid for a property it acquired in 2005. At this time, we continue to hold Verenex and are evaluating information on the sale process as it becomes available.
GST on Discretionary Investment Management Fee
The Federal Court of Appeal recently upheld a decision of the Tax Court of Canada in the Queen verses The Canadian Medical Protective Association ("CMPA") that "discretionary" investment management services are a "financial service" and therefore exempt from GST.
There are two key issues. Whether we should or should not continue to charge their clients GST on discretionary investment management fees. Secondly, in this time of uncertainty of the taxation of investment management services, should we encourage clients to file rebates for GST paid in the last two years?
As a member of the Investment Counsel Association of Canada (ICAC), we made a request of the Department of Finance in early May and this week to advise us whether the government plans to accept the CMPA decision or whether they plan to make a legislative amendment to support discretionary investment management services being a taxable service. We were advised last month and again June 17th that they are in the process of evaluating the implications of the court decision and are not in a position to provide direction on this matter at this time. Until CRA or Department of Finance provides some clarification of this issue, we understand most tax advisors are of the view investment management fees remain fully taxable.
We encourage clients to seek individual advice from their tax/legal advisors on this issue. We are monitoring this case closely through our association with the ICAC, our accounting firm Ernst & Young and our legal advisors McCarthy Tétrault and will broadcast all definite results.
Our outlook is positive for the third and fourth quarters of 2009. We expect to see continuing improvement in the North America and global economies. Stimulus efforts in Canada are beginning to flow dollars but it has been a slow process. The Chinese stimulus package worked far more rapidly. With Chrysler and GM emerging from bankruptcy protection we expect job loss will decrease in the manufacturing sector. We expect a large jump in motor vehicle output in the third quarter to restock depleted inventory levels. We also expect new equity issues from many companies seeking to strengthen
their balance sheets.
We intend to take full advantage of the opportunities presented by a recovering economy and equity market.
President and CEO