2009 Q4 Newsletter December 31, 2009
During the fourth quarter (Q4) of 2009 the strong rebound in equity markets continued. Accelerating growth in China and other Asian nations supported a continued rebound in copper, oil and other commodity prices in Q4. Strong job creation in Canada signaled economic recovery as well. Commodity price gains and more robust job numbers aided Canadian equity markets in their recovery. The rebound in oil prices to the $80 level coupled with a strong rebound in natural gas prices supported increases in energy equities.
Our strategy in Q4 was to continue to reinvest cash into income trusts and equities. We shifted some weighting from very conservative trusts to more growth oriented equities. Our strategy continues to increase our potential for gain in the rebound in equities and position the portfolio for economic growth in 2010.
There are preliminary signs of economic progress in the American economy. Time will tell how robust this recovery will become.
Overall, LDIC performance was up 10.3% in the fourth quarter. The S&P TSX gained 3.1% underperforming both US indices in contrast to last quarter. The S&P 500 was up 5.5% and the lesser Dow Jones Industrial Average gained 7.4% in the second quarter. On a 2009 full year basis LDIC achieved a 44.6% gain well above all of the other indices. The S&P TSX gained 30.7% while the Dow Jones and the S&P 500 underperformed at 18.8% and 23.5%.
All of our top ten holdings were up in fourth quarter. Armtec & Keyera were the leaders, with returns in excess of 25%. The average return of 12.5% also compares favourably with the TSX index, up 3.1% in Q4. Worthy of note is that these returns do not include dividends or distributions. The average annual yield of the top ten holdings is 7.3%.
Major Portfolio Exits
We exited five equity and trusts positions and reduced one other major holding in Q4.
TransCanada Corporation (TRP)
We exited our long-standing holding in TransCanada Corporation in Q4 for various reasons. The primary reason was our desire to reduce our total exposure to utilities and pipelines in favour of more energy equities and income trusts. We are also concerned about falling production of natural gas in Alberta that may reduce gas available for TransCanada’s main line. We were able to increase yield as well as potential for gains by switching.
Ag Growth International (AFN)
We exited our position in Ag Growth International in Q4. We felt it had become fully valued and we were able to find higher yielding stocks elsewhere. We preferred First National Income Fund.
Kinross Gold Corporation (K)
We exited Kinross in the quarter after a series of disappointing quarters. We prefer Goldcorp as a way of benefiting from gold price increases.
Labrador Income Fund (LIF.UN)
We exited our position in the very low-yielding Labrador Income Fund in Q4. We saw potential for greater overall returns in 2010 in either higher yielding securities such as Brookfield Renewable Power Income Fund or Consolidated Thompson Iron Mines, a medium-cap iron ore producer that will begin production in the first quarter of 2010 with room to grow.
Research in Motion (RIM)
We exited Research in Motion in Q4 after holding the stock for about a year. RIM has been subject to more competition from Apple, Nokia and Motorola in the last year with all three coming out with better products, while the recession has led to pricing pressure. The venerable Blackberry maker, which had historically boasted a very solid track record with respect to network uptime and minimal service outages, saw several prolonged outages recently. Although the company remains quite solid, we believe its competitive position is eroding and in the short to medium term the valuation could come under pressure. We preferred to add to holdings with exposure to the energy industry.
CML Healthcare Income Fund (CLC.UN)
We reduced our holding of CML Healthcare Income Fund, preferring investments with more growth and distribution yield in the next year. We believe that CML Healthcare will still provide a stable dividend yield and that company is still on solid footing. However we believe that growth prospects are limited and that the Ontario government may exert downward pressure on fees.
Major Portfolio Additions
We added four new holdings in Q4, as well as increasing our weighting of five existing holdings. Not all of these additions will be in each portfolio as we base selections on the objective selected by each of our clients.
Brookfield Properties (BPO)
Brookfield Properties is one of North America's largest office property companies with interests in 74 million square feet of predominantly premium-quality downtown space and 15 million square feet of development. We added Brookfield Properties to the portfolio because 1) the valuation remains compelling – Brookfield shares are currently trading at a 25% discount to net asset value versus peers trading at a premium 2) the dividend payout ratio is low at 60% (based on 2010 funds flow), the distribution is safe and there is potentially room for an increase and 3) the company has US $1.3 billion of cash which the company is planning to redeploy opportunistically. The company has been growing net operating income year-over-year despite the downturn in commercial real estate and the portfolio occupancy remains high at 95%. We started buying BPO in Q3 and continued in Q4.
First National (FN.UN)
First National is an income trust with an excellent management team and strong record of growing sustainable, recurring revenues. The yield of 7.87% is being fully earned and we believe it will be maintained when First National converts from a trust to a corporation. The company is an originator, underwriter and servicer of residential mortgages in Canada. The company has grown significantly in market share in the last four years. It has a competitive advantage in customer service because of its MERLIN software, which is considerably more efficient than its bank competitors. This advantage has led to a 10-year revenue growth rate of 36% and EBITDA (earnings before interest, taxes, depreciation and amortization) growth rate of 39%.
Penn West Energy Trust (PWT.UN)
Penn West Energy Trust is the largest Canadian conventional oil & gas royalty trust. The trust operates in the Western Canadian Sedimentary Basin and has significant light & medium oil production as well as a large in-situ oilsands project. The trust is very active in the Pembina Cardium region, which has become a very hot area recently. New drilling techniques using horizontal wells have significantly increased oil recovery and initial production on new wells, making previously uneconomic drilling locations become highly valuable. Penn West pays a dividend of 9.6% and has significant potential for capital appreciation over the next year as it executes on its Cardium drilling plan, growing production and cashflow.
Churchill Corp (CUQ)
Churchill Corporation provides building construction, industrial construction and maintenance services throughout western Canada. Over 80% of the company’s revenue comes from the institutional sector such as public infrastructure and the balance comes from the commercial sector. We like Churchill Corp because 1) the company has not only been growing earnings over the past few years but they have been doubling EBITDA margins year-over-year, 2) there has been an underinvestment in Canadian infrastructure over the past few decades (60% of Canadian infrastructure is 40 to 100 years old) and we believe that Churchill is well positioned given its public infrastructure focus to take advantage of the opportunities to come – the federal government announced a $12 billion infrastructure package and Churchill’s backlog is up 32% year-over-year, and 3) the company’s cash balance continues to grow (now at $150 million or $8.57 per share) giving the company ample financial flexibility. We added to Churchill in Q4.
We added Aecon to the construction and infrastructure holdings in our portfolios. We have positions in Bird Construction, Armtec and Churchill. We believe all of these companies will benefit from federal and provincial government stimulus spending. Aecon has a strong order backlog and prospect for growth across Canada. Aecon’s acquisition of Lockerbie & Hole will also provide earnings growth when oilsands construction spending increases in 2010 and beyond.
Suncor Energy (SU)
Suncor recently merged with PetroCanada to form Canada’s largest integrated oil company. Suncor Energy will benefit more than many of Canada’s other major oil producers from the rebound in oil prices to the $80 a barrel level due to their oilsands assets. The company’s production is 82% oil and 18% natural gas. The merged company is expected to generate $300 million in annual operating savings and up to $1 billion in capital efficiencies. With expected higher free cashflows, the company has the potential to raise dividends and initiate share buybacks.
Enbridge is our favourite utility equity. In addition to solid revenue from its pipeline and distribution businesses Enbridge has very strong growth over the three years. Enbridge distributes natural gas to 1.9 million customers in Canada, adding 30,000-50,000 customers each year. Enbridge is also the dominant supplier of US crude to the United States market via a number of pipelines and transports 11% of US oil imports. Compared to other utilities, Enbridge has the most growth coming from oilsands production currently and beyond 2012. Enbridge also has a large Gulf of Mexico operation, transporting oil and gas from the major offshore wells. In addition to its oil & gas transportation businesses, Enbridge also has various projects in wind energy, one solar power project and one hybrid fuel cell power project.
Brookfield Renewable Power (BRC.UN)
As a result of a swap of assets the hydroelectric generating assets previously in Brookfield Asset Management are now largely in Brookfield Renewable Power. These assets include 42 hydroelectric power stations and a wind farm and total 1,600 megawatts. One megawatt can power roughly 1000 homes. The company generates long-term, stable cashflows compared to other “green” stocks and will not have to pay cash taxes until at least 2014. We expect Brookfield Renewable Power to benefit from the long-term trend toward government incentives to invest in renewable energy.
Daylight Energy (DAY.UN)
Daylight Resources Trust is a Calgary-based natural gas (67% weighted to natural gas) and oil medium-sized conventional royalty trust, producing 22,000 to 26,000 barrels of oil equivalent per day in 2009 and growing to 36,000 barrels of oil equivalent per day in 2010. In August of 2009, Daylight acquired Highpine Oil & Gas for approximately $523 million (in cash, equity & debt assumed) to gain exposure to the Pembina-Nisku field which includes 600,000 net undeveloped acres and a drilling inventory of over 600 locations. Successful wells in this play can exhibit initial production rates greater than 1,000 barrels of oil equivalent per day of light (40 API) oil, condensate and associated sour gas. Daylight’s management has experience with this play through its 2006 acquisition of Sequoia Oil & Gas. We like this acquisition because 1) we believe it is accretive on a cashflow basis (2010E increased by 16%), 2) it reduces the trusts leverage and 3) reduced the trust’s payout ratio (payout ratio reduced to 57% from 65%). We added Daylight to the portfolio because the distribution appears safe and we believe this trust offers solid leverage to an eventual rebound in natural gas prices. We continued to add to Daylight in Q4.
Our outlook for 2010 remains positive. We believe economic recovery will continue and gradually accelerate. We continue to favour infrastructure, energy and income producing companies. Dividends and distributions are an important element of over ongoing strategy. They provide income as well as a defensive posture when negative sentiment befalls markets. We have added to growth equities gradually in Q4 and based on our positive outlook we will continue to add.
We continue to favour Canada over the United States as a country in which to invest. Our banks have proven much sounder and better regulated. Our housing market has rebounded strongly while the US housing market is still troubled. We believe Canadian economy will grow more rapidly than the United States economy over the next 18 months.
Our strategy will be to protect the gains achieved in 2009 by adapting a patient and prudent stance. We will await further progress in the economy before shifting further weighting to growth equities. However if economic data continues to show strength this shifting will occur as early as Q1 of 2010.
I would like to thank each and every client for their confidence and trust during the very difficult markets of 2009.
Michael Decter President and CEO