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.

 

Midyear June 2012 Update!

Midyear 2012 has drawn to a close as one of the more difficult years for natural resource investing in recent

memory.  The main drivers of this commodity sell-off were slowing growth in both China and the U.S.

and, even more critically, an accelerating deterioration in Europe.

 As of June 30, 2012 the S&P/TSX  index is  down 1.5% with the Energy sector down over 8% continuing the underperformance of resource equities.  As poorly as gold and oil have performed lately, the underlying equities have fared even worse!

For the Period Ending June 30, 2012 the portfolio I managed has outperformed and has shown positive returns mainly due to my underweight in the energy sector which is approximately 6 % of my overall portfolio compare to a weight of 26% for the S&P/TSX  index.

To put this into perspective the top two largest  holdings of my portfolio are Coca-Cola (4.3 % weighting) and Merck  (3.4 % weighting) is greater than  my total energy weighting and both have outperformed .  Coca-Cola is  up 73.09 % and Merck is up 23.22  % since I added both to the portfolio.  Last week  the shares of Merck jumped 4% in early trading Thursday, the day after it said it was ending a key Phase III clinical trial for its osteoporosis drug candidate odanacatib ahead of schedule because the drug had been shown to be highly effective.

The Focus Stock  for the month is Coca-Cola, which carries S&P Capital IQ’s highest investment  recommendation of 5-STARS, or strong buy.  Coca-Cola, based in Atlanta, GA, is the world’s largest producer of soft drink concentrates and syrups, as well as the world’s biggest producer of juice and juice-related products. The company also owns or has majority stakes in 97 beverage bottling or canning plants located around the world, which are consolidated into the Bottling Investments operating segment. Coca Cola operates in more than 200 different countries, I see that providing a steady runway for future growth as well as strong opportunities to increase per capita consumption.

 According to data from the company, 2011 global per capita consumption averaged 92 servings per year, with the United States coming in at over 400. This compares to the developed world average of 267, the developing average of 251 (including Brazil at 230 and Turkey at 173) and an emerging market average of just 31 (including Russia at 73, China at 38 and India at 12). Moreover, I think the company’s global infrastructure positions it well to grow its both carbonated and non-carbonated beverage brands. Today, the company licenses and markets more than 500 different brands. In 1997, it had only five brands exceeding $1 billion in retail sales. By 2011, that number had grown to 15, and I expect more brands, particularly in the non-carbonated arena, to join that group as the company expands distribution of its newer brands into more countries.

Moreover, I  still find the valuation of the shares compelling, trading in the lower half of KO’s historical average with a dividend yield approaching 3%

WEALTH PRESERVATION IS A PRIORITY !

May was one of the more difficult months for natural resource investing in recent memory ! Crude oil (WTI) finished the month down 18% to a seven-month low – one has to go back to October 2008 to see a drop of similar magnitude. The main drivers of this commodity sell-off were slowing growth in both China and the U.S. and, even more critically, an accelerating deterioration in Europe.

In an environment where we would have expected the world to increasingly gravitate towards gold as a safe haven, investors have instead continued to rush into U.S. Treasuries and Japanese Government Bonds, where 10-year maturities are now offering record low yields of 1.559% and 0.819% respectively, despite considerable new issuance.

What to do?

My fund remains heavily weighted towards cash and dividend-paying companies. I believe that North American interest rates are likely to remain low for a surprisingly long time. As such, good quality high-yielding equities should remain an attractive investment – providing investors with regular income.

The Opportunity

Central banks are facing rising political pressure to step up money printing efforts in Europe, China, Japan, and the U.S. The accelerating European bank run in particular is increasing the odds of a massive ECB response at any moment. Given the scope of the threat, we would not rule out an announcement of a globally coordinated initiative.

The obvious direct beneficiary from increased money printing is gold, which effectively acts as a fixed supply “currency” (store of value) relative to depreciating paper currencies.

At a time when massive money printing by the world’s central banks is not only inevitable, but potentially imminent, we believe that gold should be viewed in its traditional role as a store of value rather than just one more “risk-on” trade.

In order to mitigate downside risk and generate income (above 10% currently), I have exposure to a covered call option strategy on 33% of the securities of my Gold Portfolio. The level of covered call option writing and income vary based on market volatility and other factors.

Sell Encana Corporation

I attended the Encana AGM a few weeks ago. I have attended the Encana AGMs the last couple of years and my first impression is that they have made it very difficult to attend their AGMs with security screening exceeding any other company AGMs I have attended.

They also schedule the AGM at the exact same time and date as Cenovus which made it difficult as a shareholder to attend - most shareholders owns shares of both Encana and Cenovus since the split and the Encana AGM was not well attended by shareholders.

On September 10, 2009, Encana reignited plans to proceed with the split of the corporation into two independent energy companies. An integrated oil company Cenovus Energy was created, which split off EnCana's oil sands and downstream assets. Post its corporate split, Encana's estimated upstream production is roughly 100% natural gas focused - a very bad move with gas prices below $2!

 

In my view with the lack of any concrete plan, Encana’s success with material liquids growth is not optional given its dry gas weighting, time is not a luxury the company can necessarily afford for gas prices to recover. Encana may need to consider an oil or liquids weighted acquisition that would augment its organic prospects with a more immediate and concentrated development fairway which plays to its execution strength. My rating is a Sell!

 

The Future of Investing: Alternative Hedging Investing!

Driving the change and demand for accessible alternative investments was the 2008 market crash and the three years of ensuing volatility. It became obvious that relying solely on the wait-for-growth approach, also known as a long-only approach, was a mistake. Even with a well-rounded stock portfolio, analysts realized long-only investing placed investors’ wealth at too much risk.

Today, while the market volatility is not near the levels of 2008/2009, returns remain depressed and alternative investments provide a new vehicle for higher returns not tied to traditional equity markets.

Do You Need A Covered Call ETF?

Investors are taking a renewed interest in a strategy abandoned during the recent recovery; the covered call. A covered call consists of going long on an underlying security while selling call options on the same underlying security. This has the effect of generating additional income (the premiums received from selling options), which helps to offset some losses when markets are falling. When markets are rising, however, the call options sold can come “in-the-money,” offsetting gains generated by the long position in the underlying security. ETFs employing the covered call strategy have lagged behind traditional beta funds as markets headed higher, but have sharply outperformed the broad market during the recent period volatility and declining equity prices. 

Covered call strategies can also pair a long position with a short call option on the same security. The combination of the two positions can often result in higher returns and lower volatility than the underlying index itself.

Bearish about market prospects for 2012

Welcome to my last post of 2011.  Unhealthy global government balance sheets and structural economic problems as a result of years of excess and financial engineering have created a dangerous negative feedback loop in 2011 which I expect to cause recessions around the globe in 2012. This December post outlines this negative feedback loop and explains why I expect a difficult market environment in 2012.

In summary global governments are carrying more debt than ever and raising question as to whether or not a second — and perhaps even more dangerous credit crisis — is inevitable. The clock is ticking and every second, the world takes on more debt. In 2001, global government debt totaled $18.2 trillion. Fast-forward a decade, and the figure now totals nearly $44 trillion, an increase of 140 percent (more than 9.0% a year).
According to The Economist, global sovereign debt is forecasted to grow an additional 7% in 2012 reaching a historical high of $47 trillion

One of the problems with economic crises is that mainstream economists and financial experts
don’t see them coming. That’s exactly what happened in the fall of 2008, when the financial crisis kicked off in the United States. Since that time, governments have continued to spend, all while production has slowed and unemployment has skyrocketed. As we enter the fourth year of the post-crisis environment, there is no sign of growth that is impressive enough to get us out of the negative feedback loop in which governments have continued to operate. A negative feedback loop takes hold when massive government debt loads, a weakening financial system and a slowing economy feed off each other, interrupted by Federal Reserve and other central bank reflationary attempts. The result of this rising debt means more government interference, a further slowdown in the already debilitated economic environment and the possibility of further citizen uprisings in some countries.

As noted, I am very bearish about market prospects for 2012 and I will be adding more non correlated alternative investments to my portfolio.  See my next post The Future of Investing: Alternative Hedging Investing!