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.