March 2015 - The Quarter that Was

The TSX had an OK start to the year, with a 1.8% return over the quarter. Of course, energy was down another 1.9%. Declining crude prices continued to put pressure on energy stocks, but technically stocks are behaving well having put in what may be their low in December with higher highs and higher lows since then. The US S&P 500 was up just 0.4% in the quarter. But currencies added 9.1% for Canadian investors!!

 

As this is my first blog of 2015, I thought it would be useful to share how I think about Investing and my long-term goals for my portfolio. My long-term goal is to compound capital at a high rate of return while minimizing the risk of permanent loss of capital in any individual security or holding. In other words don’t lose money but outperformed the major market indexes. So far so good!!

 

I expect to continue to hold a 60/40 (60 % equity, 40% cash) allocation in about 40 to 50 investments, and estimate that my typical holding period will be long-term, typically ten or more years.

 

Recently I was approarch by a fellow investor and his advice was to sell equities because of technical indicators he seen on another blog which could cause a market crash. Personally I have no time for technical indicators or reacting to other people investment advice when managing my portfolio. I tried to keep in mind of some famous quotes by Warren Buffett on Investing ;

 

 “A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.”

 

 “We have long felt that the only value of stock forecasters is to make fortune-tellers look good.”

 

I couldn’t agree more and as a matter of fact “time arbitrage” can be an investor advantage. For example by taking advantage of the opportunity for long-term profit offered when short term investors sell due to disappointing short-term macro or business progress – this has always been a major source of profitability for my portfolio. In my experience, stock prices are often much more volatile than the underlying value of the business they represent.

 

I believe it is self-evident that the value of a business is the present value of the cash that it will generate for distribution to its owners over its lifetime. For the high quality, simple, predictable, low-leverage businesses in which I prefer to invest, their discounted expected lifetime cash flows generally do not change meaningfully due to events in Greece, greater Europe, or technical indicators in the markets.

 

As always for my quarterly blog I like to profile one of my holdings;

 

Portfolio Update - Agrium

 

I began taking a position in Agrium last year when the stock was in the low 80s.

 

Agrium is a well-diversified crop input company. The company’s Retail division operates North America’s largest agricultural retail network and has significant operations in Australia. Agrium Wholesale has significant operations that produce nitrogen fertilizers, along with sizable operations that produce phosphate and potash fertilizers. Agrium’s nitrogen operations are primarily located in Western Canada with access to low cost natural gas and located near higher netback regions – Western Canada and Western US nitrogen prices are typically priced at a premium.

 

EPS estimates have increase with the start of many positive trends for Agrium's operations in 2015. The increase was primarily attributable to lower nat gas input costs and a more favourable CAD/USD exchange rate. While not immune to agricultural headwinds, I continue to argue the longer term outlook for Agrium retail segment remains underappreciated. I base my argument on (i.) further cost reductions (incl. asset rationalization) and working capital improvements, (ii.) global growth in private label initiatives, (iii.) additional improvements in Australian Retail (an emerging theme), (iv.) Viterra results continuing to surprise to the upside.

 

I expect Agrium to focus capital on the following (i.) maintaining its core asset base , (ii.) growth investments with minimal returns of ~12% (in excess of AGU's 8% WACC), (iii.) sustainable dividend growth, (iv.) opportunistic share repurchases.  

Capital Allocation- Show Me the Divy!

 

Agrium free cash flow inflection in 2016 can support much higher dividends: I  forecast  significant  free  cash  flow  starting  in  2016  based  on sustained Retail cash generation, improved nitrogen earnings due to Borger expansion start-up, and continued ramp-up of the Vanscoy potash mine.  Additionally,  I  expect  capital  expenditures  will  decline  from approximately $2B in 2014, to $1B in 2015, and then $600M in 2016. I believe this oncoming free cash flow inflection will allow management to significantly increase its dividend while remaining confident that the company can support its dividend payout even in a downside scenario. I think a $5/share dividend by 2016 is not unreasonable, and even extreme downside scenario would support dividend payments well in excess of $4/share.

 

 

 

 

 

 

 

Fiscal 2014 Update - OPEC Didn't Blink - Will US & Canadian Producers?

On a average to low risk adjusted basis my 60/40 (60 % equity, 40% cash) portfolio grew 12% in the 2014 calendar year. Positioning the portfolio to be underweight the two poorest-performing sectors (Energy and Materials) and overweight some of the best-performing sectors (Consumer Staples, Utilities) and U.S. Equity all worked to my advantage.

 

Canadian equity markets were mired in negative territory given their relatively large exposure to the besieged  Energy sector. In 2014, the S&P Global Energy Sector decline 11% and recent data by RBC Global Energy suggests continued challenging energy market conditions well into 2015.

 

· The oil market is roughly 800,000 Bopd oversupplied.

· The overwhelming issue is continued hyper US production growth.

· There has been steady growth out of Canada as well and this is likely to be a little sticky as oil sands projects have a longer-term horizon.

· OPEC is currently producing roughly 30.5 MMBopd. There may be modest upside to this over time due to potential growth in Iraq and the potential resumption of offline barrels.

· For the last 16 years, OPEC has defended price as opposed to market share. This changed on November 27.

· If and when oil prices move a fair bit higher, we will start to see a production response from the US, which could re-accelerate global production.

· The last six bear markets for oil have averaged 141 days with oil dropping 39% over that time (139 days, 32% ex. global financial crisis).

· The current bear market has persisted for 172 days with oil dropping 36% since June 13. If recent patterns hold, we could be nearing the bottom for oil.

 

Over the past 16 years (1998-2014), the global oil market has witnessed three major episodes of pricing collapse, each of which coincided with a dramatic macro economic or political event which either caused or was associated with a severe drop in oil demand growth. These include;

• 1997-98 (Asian Currency Crisis),
• 2001-02 (9/11 Terrorist Attacks), and
• 2008-09 (Global Financial Crisis).

On average, the aforementioned episodes displayed depressed or negative global oil demand growth for 2–4 quarters before staging a sustained demand growth recovery, which supported an oil price rebound. The Brent price pullback of late has not been associated with a major financial crisis at this juncture, but Saudi Arabia’s policy uncertainty has exacerbated the situation.

 

Canadian benchmark oil prices have fared relatively well by comparison to US oil prices, in part due to the insulation afforded by a softening Canadian dollar. Indeed, Canadian benchmark oil prices are based not only upon US benchmarks, but also the foreign exchange rate. As such, a softer Canadian dollar is favourable for Canadian oil prices. This stabilizer is often overlooked, but important in our eyes because an investor is buying a cash flow stream. As a simple illustration – holding all other factors constant, a US$0.01 depreciation in the Canadian dollar would largely off-set a US$1/b fall in WTI as it relates to Canadian light and heavy oil prices.

 

But you still need to be careful when looking at Canadian Oil & E&P, my Least Favourite Stock – is Canadian Oil Sands because it is;

• Oil Sands Pure Play - 100% light sweet un-hedged crude oil production (Syncrude)

•  Operating Performance Challenged - Recurring unplanned maintenance = lower volumes + higher operating costs

• Dividend Cutter -  Dividend recently cut by 43%, Further cut possible given low oil prices

Keep in mind that in most countries, the fall in oil prices is generally seen as a positive development as it relates to future GDP growth. Moreover, most central bankers have been quick to emphasize that they will look through the “one-off” effect of lower oil prices and, instead, focus on movement in core consumer prices as they set policy. The IMF looked at a supply-side exercise in last October’s World Economic Outlook— albeit in reverse—using its own macro model. They examined the likely impact of a reduction in Iraqi oil supply that would increase the price of crude by roughly 20%. Their work suggests the net GDP impact from a 20% decline in oil prices could be in the range of +0.4% to +0.7% after two years for countries such as the US, Japan and China as well as the Eurozone.

 

Portfolio Update - Alaris Royalty Corp.

 

Alaris Royalty Corp is a Calgary-based provider of capital to well managed and profitable private companies seeking alternative avenues of financing. Its  strategy is unique in the sense that unlike most private-equity firms, it provides alternative financing to private companies without seeking a controlling stake. Alaris’s long-term goal as a company is to create the optimal dividend stream available for its investors. With that goal in mind, it seeks private companies that generate predictable, low volatility, and low cyclicality cash flows for monthly cash returns.

 

Early in 2014 I began accumulating shares in Alaris Royalty, over the past 12 months, Alaris Royalty shares returned 36% in total returns, and they hit 52-week highs, grossly outpacing the 6% from the TSX. Alaris Royalty generates 40% of revenues from the US. I forecast this should rise well above 50% in the next two years as Alaris capitalizes on its US-focused investment pipeline. Given the rise in the USD, I expect positive tailwinds to revenues and earnings including sizeable unrealized gains on its US holdings. Alaris continues to benefit from having little to no exposure to oil and the Western Canadian economy.

 

 

 

 

2014 Mid Year Update

My June quarterly blog is a little bit later than usual as I am always willing to defer the writing of the quarterly blog in favor of spending the time required for an existing investment in the portfolio or for the analysis of a promising new investment. 

The summer heat is upon us, after the first 6 months of the year, where overall returns have been strong – especially in Canada – recent history suggests that the summer is a quieter time for the markets – although July has seen strong volatility with Argentina defaulting and the Ukraine situation. The recent string of 1%+ return months may just come to an end. The key is not to overreact to the ‘interesting’ items like seasonality or external events, but to remain focused on earnings, interest rates, and your asset allocation. 

Allocating Your Assets: How Much Stock Is Too Much? 

Don't go overboard when deciding how much of your portfolio to put into stocks.. This advice is particularly timely now, as memories fade of the 2007-09 bear market and many investors find themselves with swollen stock allocations—either consciously, or unwittingly through failing to rebalance their holdings. Recently I took some profits in a few positions to rebalance my non registered holdings to 60% in stocks and the other 40% in mostly cash. 

Most people recognize they need to lean heavily on stocks to fund retirement, etc. Yet the extra return you earn for going with an all-equity portfolio is small relative to a traditional balanced portfolio that puts just 60% in stocks and the other 40% in bonds. 

Since Jan. 1, 1926, according to Ibbotson Associates, an index fund benchmarked to the S&P 500 or its predecessor would have produced a 10% average annual return, assuming dividends were reinvested. A portfolio that allocated just 60% to this S&P index fund and the remainder to intermediate-term U.S. Treasurys (which are considered risk-free) would have gained 8.7% annualized, or 1.4 percentage points a year less, on average.

That certainly appears to be a rather modest price to pay for cutting your portfolio's risk nearly in half, as measured by volatility of returns. 

Furthermore, many all-stock investors who at some point bail out do so at the worst possible times—near the bottom of a bear market—and don't get back in until a bull-market recovery is well under way. As a result of this counterproductive behavior, it is extremely rare for an investor's real-world return to be anywhere close to an all-stock index fund's theoretical potential. 

You are much less likely to engage in this destructive behavior with a 60/40 portfolio, and therefore odds are good that you will perform just as well over time—if not better—than if you were to invest 100% in stocks. 

The non registered and registered portfolio performance was particularly strong given that over 17% of the above portfolios is invested outside of Canada and was hurt by the strengthening Canadian dollar. 

It is important to remember that with investing 17%+ of stocks outside of Canada, the US dollar is the biggest investment in your portfolio. As such, I pay close attention to currencies, and look for opportunities to add value to overall returns 

The Dow's top four stocks (Caterpillar Inc., Intel Corp.,  Merck, Johnson & Johnson) by share-price performance so far this year, all have dividend yields, or the ratio of annual payouts to share prices, that are higher than average for the blue-chip index.  Currently the portfolio owns three of the following Caterpillar Inc.,  Merck and Johnson & Johnson.

 

Positioning for the potential for higher interest rates 

Canadian equities (particularly interest-sensitive equities) have benefitted from an extended period of falling interest rates, which begs the question: “What happens as interest rates rise?”.

In Canada, the last inflation rate announcement showed an inflation rate of 2.3%, the first time in 2 years the rate was above 2%. In general, this would lead to a push towards nearer term interest rate hikes. However, volatile energy prices pushed inflation up in the past couple of months, but could just as easily bring inflation down with a late summer decline in oil prices. 

Regardless, we believe it is important to understand the potential shifts in market leadership, which are likely to impact portfolios when interest rates do rise. Sectors at risk – Share prices in some sectors appear to have benefitted significantly from falling interest rates, most notably, Energy Infrastructure and Real Estate/REITs.

 

How about a raise!

I continue to pay close attention to dividend growing stocks because who doesn’t like getting raises each quarter. I believe that this is a strong part of long term, lower volatile investment success.

I am pleased to say that there were no dividend declines in this year, and the list of 2014 dividend growers year to date included 22 of my 45 positions!

I look forward to even more dividend increases in the second half of 2014

Portfolio Update

 

SNC-Lavalin 

In APRIL, 2012 given ongoing investigations and shareholder uncertainty re outcome and potential impact to firm reputation and future contract awards SNC-Lavalin stock drop from the mid 50s to the mid 30s – this is when I initiated a position in - SNC Lavalin. The corruption news has abated, and we believe that the initiatives by the new CEO are more than veneer. 

SNC Lavalin is Canada's largest engineering and construction company with a global office network reaching over 35 countries employing ~24,000 employees. SNC engages in engineering, project and construction management, project financing, construction and operations and maintenance. SNC was founded in 1911 and has been public since 1986 on the TSX. 

The Infrastructure (ICI) portfolio is in the sweet spot. Infrastructure assets are in demand and valuations appear attractive for vendors. .Even at a price in the mid $50s the stock looks attractive. There could be upside to the ICI portfolio that is value at book, that have been growing in value, but at this point I am comfortable valuing the ICI portfolio at $30/SNC share after tax. This implies that the engineering business is trading at 8.5x our 2015 engineering EPS estimate of $1.70. I believe that this valuation is attractive enough to provide investors with enough of a return to be compensated for the volatility that they are likely to encounter in the next few quarters.

 

 

 

 

December 29, 2013

What a year! 2013 was the best performing year for the portfolio since its inception. The last two quarterly blogs were delayed as I am always willing to defer the writing of quarterly blogs in favor of spending the time required for an existing investment in the portfolio or for the analysis of a promising new investment. As a result, these blogs occasionally get delayed, particularly, as one might expect, in a year as interesting as 2013. The Spotlight have change to the Potential Move in Long-Term Interest Rates as opposed to the Eurozone crisis and China’s hard landing.

On risk adjusted basis the portfolio outperformed all its benchmark for 2013, even more satisfying the portfolio has never experienced a down quarter since inception and has adequate hedging in place for any black swan events.

 

Portfolio Update

During July 2013, I established and added to positions in all of the major Canadian Banks. Canadian Banks hit a 52 week low during the beginning of July as increases in longer-term bond yields have led to many questions around the potential impact of higher interest rates on financial services companies. I believe that the profitability of both banks and lifecos would benefit from a higher interest rate environment for reasons that are both direct and indirect, assuming that higher interest rates are experienced across the term structure and reflect an improved economic outlook.

 

Higher interest rates impact on Banks and Lifecos

I added to Canadian Banks as I do not believe that either sector is positioned to benefit materially more than the other from such a scenario. Lifecos used to be much more exposed than banks to movements in macro factors, but have greatly reduced their exposures, to the benefit of their earnings volatility. I do not believe that the larger banks are positioned materially differently from one another, but banks will continue to increase their dividends annually as opposed to Lifecos.

Banks would benefit from a higher interest rate environment for reasons that are both direct and indirect, assuming that higher interest rates are the result of a stronger economic outlook. Direct positive impacts would include improved net interest income margins and reduced defined benefit liabilities. Indirect impacts would include higher wealth management and capital markets revenues, loan growth and credit quality. Banks are most exposed to short-term to medium-term (i.e. 5 years) interest rates, and an increase in the interest rates they are exposed to, if it materialized, would impact net interest income margins over a multi-year period rather than immediately.

While it is difficult to determine how much margin upside there might be to a higher interest rate environment, I believe that the banks that would see the largest increase in net income from higher net interest income margins (i.e.ignoring indirect impacts) are those with more exposure to retail banking and weaker efficiency ratios. The two smaller banks (Canadian Western Bank and Laurentian Bank) would benefit more than the larger banks.

Paychex

 

The top performer for the portfolio this year was Paychex, up over 50% year to date. Paychex provides payroll and integrated human resource and employee benefits solutions predominantly for small and mid-sized businesses almost entirely in the United States. The firm has 12,500 employees and is based in Rochester, N.Y. and was formed through the consolidation of 17 payroll processing companies in 1979. It has been one of the most successful human resources outsourcing firms in the United States. The minimal amount of capital required for operations and the firm's significant competitive advantages have allowed it to produce returns on invested capital that have averaged 70% over the past 10 years. 

Switching from one payroll processing vendor to another is a very difficult task, and customers' unwillingness to do so has allowed Paychex to build a relatively sticky client base. This inelasticity has enabled the firm to raise prices annually and expand profits. Strong scalability has also allowed the firm to be price competitive without feeling significant margin pressure.

Upside scenario

Upside potential assumes acceleration in revenue growth driven by 1) improving US labor markets, 2) a higher interest rate environment, both of which are well underway in the United States.

Outlook 2014:

It seems like we’ve been talking about the low-return world forever, but it keeps getting delayed. Low returns didn’t materialize in 2013, and U.S. equity markets are trading at fairly full valuations. I still think risk will be rewarded and well-structured portfolios can achieve realistic investment goals. 2014 will begin as 2013 did with the added twist that the Fed seems set to begin the process of withdrawing from money printing during the year. We can’t be sure of the consequences, but extra volatility seems a good bet.

The signs of economic healing in Europe and Japan along with the improved growth outlook for the U.S. should keep equity markets moving slightly higher with some fits and starts over significant tax policy changes in Japan and still a less than perfectly unified Europe which will create occasional tension.

First Quarter 2013 Update!

The quarterly blog is a little bit later than usual as I am always willing to defer the writing of the quarterly blog in favor of spending the time required for an existing investment in the portfolio or for the analysis of a promising new investment. As a result, these blogs occasionally get delayed, particularly, as one might expect, in the first quarter of 2013.

On risk adjusted basis the portfolio outperformed the major market indexes  including the S&P/TSX COMPOSITE INDEX,  A Wealth Preservation Index,  and a North American Balanced Index for the first quarter of 2013. The relative outperformance versus the Index can be attributed to asset allocation and security selection. Asset allocation contributed mainly to the  outperformance,  I decided to overweight US stocks since 2012,  current positions include COCA COLA CO, PAYCHEX INC, MCDONALDS , ELI LILLY & CO, PROCTER GAMBLE CO,  Johnson & Johnson and MERCK & CO INC to name a few. From an asset allocation perspective, I am maintaining a significant underweight in bonds.

Eli Lilly and Co

 

Eli Lilly and Co. is a leading maker of prescription drugs, offering a wide range of treatments for neurological disorders, diabetes, cancer and other conditions. Animal health products are also sold. Foreign drug sales accounted for about 46% of total revenues in 2012. Based on positive clinical developments in several important pipeline assets targeting diabetes, cancer and Alzheimer's disease, the stock has outperformed the S&P 500 Index and most of the Big Pharma stocks over the last year. Lilly recently filed ramucirumab for stomach cancer, and empagliflozin for type 2 diabetes, with three more Phase 3 assets to be submitted later this year. Relative to its size, Lilly holds a disproportionately high amount of potential blockbusters in Phase III development.  I continue to like the stock due to a robust catalysts profile relative to peers, pipeline optionality , and reasonable valuation.

 Portfolio Update

During the quarter, I eliminated the portfolio position in Chorus Aviation and added to the portfolio position in Enbridge Income Fund Holdings Inc.

 Chorus Aviation

Chorus Aviation is Air Canada's regional carrier providing domestic and transborder flights to Canadian and U.S. destinations. Chorus Aviation was formed in January 2001 when Air Canada combined its four regional carriers into one. Chorus Aviation operates as a separate business with its own management and union contracts..

 

I eliminated the portfolio position in Chorus Aviation in early January and took some modest profits including reinvested dividends.  Even though Chorus continues to generate healthy cash generation and sufficient free cash flow to more than adequately fund the $0.15 quarterly dividend, I became concern about  the upcoming decision in the arbitration relating to the benchmarking provisions within its Capacity Purchase Agreement  with Air Canada and decided to take a modest profit after a run up in the stock in January 2013.

2012 Yearend Update!

The quarterly blog is a little bit later than usual as I am always willing to defer the writing of the quarterly blog in favor of spending the time required for an existing investment in the portfolio or for the analysis of a promising new investment. As a result, these blogs occasionally get delayed, particularly, as one might expect, in a year as interesting as 2012.

On a risk adjusted basis the portfolio outperformed the major market indexes for 2012, even more satisflying the portfolio has never experienced a down quarter since inception and has adequate hedging in place as uncertainty regarding the fiscal cliff, the Eurozone crisis and China’s growth potential move back into focus.

Portfolio Update

 

During the quarter, I established positions in McDonald’s Corporation and Caterpillar both at or near its 52 week low.

 McDonald’s Corporation

 

McDonald’s Corporation is now 1.83% of the overall portfolio. McDonald’s makes money in principally two ways: first, by collecting an approximate 14%+ share of its franchisees’ revenues for the use of McDonald’s brand, a business coined “Brand McDonald’s” and second, by generating operating profits from a portfolio of company-operated stores. 

McDonald’s brand royalty business is one of the greatest businesses in the world because it generates an annuity-like revenue stream which can grow without the requirement for meaningful investment of capital from the company. Because the company’s revenue share comes from more than 32,000 different stores spread around the globe, it is an inherently stable, currency-hedged, inflation-protected stream of cash flow.  

Another underlying strength is McDonald's cohesive franchisee and affiliate system, which collectively operates 80% of the chain. This structure provides the firm an annuity like stream of rent and royalties even during challenging economic times with minimal corresponding capital needs. As a result, McDonald's generates excellent free cash flow and returns on invested capital in the mid- to high teens. These results are even more impressive when considering that the firm owns 45% of the land for its restaurants (more than $5 billion in land assets), meaning that the returns are generated on a higher invested capital base than most franchised restaurant chains.

 Caterpillar Inc.

Caterpillar Inc. is now 1% of the overall portfolio and is the world's dominant maker of construction and mining equipment, as well as a leading producer of diesel and gas engines, industrial turbines (essentially jet engines that power equipment and generate electricity), and locomotives. No competitor can match the breadth of Caterpillar's product line. Cat’s goal is simple: Ensure that customers make more money using Cat equipment than using competitors' equipment. Though Cat equipment generally costs more than anyone else's, the model requires it to be the least expensive over its lifetime, factoring in purchase price, maintenance costs, operating costs, uptime, life expectancy, and resale value. Dealers are key to these economics. A machine that breaks down can halt an entire job, and getting back under way in two hours rather than 48 hours means big money. Large, successful dealers that carry lots of parts, maintain skilled technicians, and move fast are thus a major selling point, and Cat's dealer network is the undisputed best in the business. Big, strong dealers help Cat sell the most machines; all those machines in the field bring dealers lots of revenue from parts and service, so much that they can survive in years when they don't sell any new machines at all; and that financial stability enables dealers to grow bigger, attracting even more customers, and build a larger base of machines that need to be serviced.

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Equities, while volatile, have marched higher over the past three-year recovery. Bonds, on the other hand, are almost pricing in a recession with 10-year yields at 1.73% in the US and 1.80% in Canada. Fed buying, deleveraging and a lack of investor confidence continue to put downward pressure on yields. While this disconnect between equities and bonds can be resolved in either of two ways, we believe there is greater risk owning bonds at these yields. From an asset allocation perspective, I am maintaining a significant underweight in bonds.

 

I decided to reduce my Canadian equity exposure in 2012 to source the cash. The European recession, slowdown in China and softness in many other emerging markets does not stack up well for commodity-focused markets like ours. Easy monetary policy has kept commodity prices elevated, but this does not substitute for real end-demand growth.

Third Quarter 2012 Update!

Third Quarter 2012 Update!

 The portfolio for the third quarter was up 2.56%, on a risk adjusted basis the equity position was 39.6% and the cash position in the portfolio was a very low risk adjusted level of 49.5%. The portfolio has outperformed all indexes  ( A Wealth Preservation Hedge Fund,  The S&P/TSX COMPOSITE INDEX and a Canadian Monthly Income Fund) it tracks and has never lost money since inception in 2010!

 

I continue to underweight the energy sector which is approximately 4.85% of the overall portfolio compare to a weight of 26% for the S&P/TSX index.  As poorly as energy underlying equities have performed lately, the underlying equities may fared even worse in the next year with the global slowdown!

 

I initiated a position in Great-West Lifeco. Generally I am enthused by the low valuation, paying 0.9x to 1.0x book value for expected ROEs of 11% to 12%, make the lifecos cheap. Positively, Great-West is above Canadian lifeco peers given lower expected earnings volatility and higher expected ROE (16.3% in 2013) and is less exposed to movements in equity markets and interest rates than its lifeco peers.

 

 Lifecos’ shares exhibit greater volatility (up and down) than banks’ as their earnings and capital positions are affected more materially by movements in equity markets and interest rates, particularly for Manulife, Sun Life,

and Industrial Alliance. Those potential impacts dwarf the impact of sales or near-term management actions on earnings and capital, and as such we continue to expect moves in interest rates and equities to be the primary drivers of share prices. The near-term overweight/underweight call comes down to individual investors’ views on equity markets and interest rates.

 

 Lifecos trade at low P/B valuations, which we believe is appropriate rather than making lifecos cheap given ROE expectations of 11% to 12% for three of the lifecos (Sun Life, Industrial Alliance, and Manulife). For us to be more positive on those three lifecos, we would have to look for reasons to believe that core ROE will exceed 11% to 12% or that equities and/or bond yields are about to rally significantly. Investing in those three lifecos as a play on higher interest rates and equities only makes sense, for investors looking for annual equity market returns in excess of 8% and annual interest rate increases in excess of 40 to 75 basis points. I have a Above Average Risk rating on Sun Life, Industrial Alliance, and Manulife due to sensitivity to interest rates and we believe that a prolonged period of low interest rates, or a decline in interest rates, could cause reserve additions as part of future annual reserve reviews.

 

On the other hand Great-West remains less exposed to movements in equity markets and long-term interest rates than its peers. Great-West’s sensitivity to equity market movements is lower and mostly fee-driven. The decline in bond yields since Q3/12 began, is also not as potentially negative for Great-West’s near-term net income outlook as it would be for its peers. We are less concerned about movements in macro factors—particularly interest rates and equity markets—having a major impact on our earnings estimates for Great-West. The lower exposure to interest rate movements is driven by tighter asset/liability duration management, which has kept the company less exposed to longer duration products. The lower exposure to movements in equity markets is a reflection of the company having introduced GMWB variable annuities later than peers and therefore being exposed to a much more conservative segregated fund/variable annuity portfolio.

 

Great-West has a more highly rated investment portfolio than its peers but more exposed to Europe, given the company’s business mix, although the majority of that exposure is in the UK. Isolating the peripheral European countries, exposure to banks and other financial institutions’ bonds (Ireland, Italy, and Spain) is 0.4% of invested assets. Additionally, approximately 0.2% of the company’s invested assets are in bonds issued by the Governments of Portugal, Ireland, Italy, and Spain. The company has no exposure left to the Greek Government or Greek banks, and no exposure to Portuguese banks.