Investment Letters

The following are quarterly investment letters sent to all clients, highlighting our macro outlook, investment strategies, and security holdings.

These investment letters are provided for reference purposes only and are not intended to provide any form of advice. The information contained therein is not a substitute for investment advice from qualified financial or investment advisors and should be verified with your financial and/or investment advisors prior to being relied upon by you.

TRICKY TIMES (February 29, 2016) (Click for summary)

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Stock markets were not expensive yet markets around the world have endured major corrections. While fair market value dictates the ultimate direction of the stock market, the path can be altered by psychology in the shorter term. We have been wrestling with heading for the hills, i.e., selling and holding few stocks, then buying the cheap stocks as they fall to bargain price levels. Every day can feel like either Black Friday or Boxing Day but we restrain ourselves because our tools indicate that even better bargain price levels may lie ahead as the macro concerns overwhelm. Our preference is to remain defensive. That said, we are still interested in buying shares of solid companies at wide discounts from fair value, assuming their earnings outlooks are positive and particularly where we can find ones with immediate potential positive catalysts.

THE THEORY OF RELATIVITY (December 3, 2015) (Click for summary)

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These days with global growth relatively slow, inflation relatively low, central bankers relatively stimulative, government bonds at relatively (historically) low yields, stocks have been a relatively desirable asset class. We don’t believe that rates will continue to remain this low, and we believe that all the stimulation will tend to improve global growth. In the meantime we seek companies in the undervalued category that have strong balance sheets to survive and to grow. Even though high price/earnings ratios and profit margins suggest U.S. markets are richly valued, our work does not suggest any bear market approaching soon or an imminent recession. And we see some extraordinary value opportunities in some unpopular areas. Stocks remain the asset of choice relative to bonds.

UNPOPULARITY CONTEST(September 4, 2015) (Click for summary)

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With central banks focused on growth and generating inflation, and their pedals to the metal, we believe the ultimate outcome will be inflationary growth, or even stagflation. But, inevitably, a boost for depressed commodities and the depressed share prices of their currently unpopular producers. A particular opportunity when the correction phase ends and the bull market resumes. Time to be contrarian. And patient value investors should clearly be rewarded.

HALF FULL OR HALF EMPTY(May 28, 2015) (Click for summary)

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We believe, from our work and others we follow, that a recession in the near term is unlikely, that central banks will continue to be stimulative keeping interest rates relatively low, that deflation risks will diminish, that worldwide economic growth should slowly continue and likely accelerate. And that equities will continue to be the preferred asset class, with bonds presenting a risky alternative. Ultimately the Fed will raise rates but it’s probably being discounted as, likely, is the risk of deflation. Clearly stocks remain a glass half full, but their expected returns are lower than the last 5 years because of their already full valuations. Canadian small caps have been for some time, and still remain, incredibly undervalued—a shot glass half full. Certain sectors—energy, materials and financials—are cheaper, from the headwinds they have faced. Naturally, as value investors, we obviously are driven to cheap stocks currently out of favour.

THE BIG PICTURE(Feb 26, 2015) (Click for summary)

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As consummate value investors we are continuously seeking individual stocks and bonds that are trading at mispriced undervaluations. Looking up and down for value. However, these days we need to look up more intently to the macro picture, which is complex, historically unusual, and volatile, and which has helped some big cap stocks, the so-called safe dependables (for their low volatility and yield), while hurting others, the cyclicals and commodity resource producers, and small caps generally. The big picture, the global economic condition, is characterized by record high debt levels, an unusually slow recovery from the ’08 Great Recession, ultra-low interest rates from stimulative measures taken to combat deflation, competitive currency devaluations, and deflation concerns in most regions. Investors clearly need to proceed with caution and to be discriminating, by asset class and geographically. Even more than usual, today one must very carefully select undervalued positions to ensure future potential returns. Time to keep all eyes on our top down tools as we continue to invest from the bottom up.

RISK AND REWARD (Nov 26, 2014) (Click for summary)

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As value investors we seek to minimize the risk and maximize the reward by buying significantly undervalued securities with solid businesses and the potential for above average upside. Several macro risks, and their perceptions by investors, have created some bifurcations with investors chasing perceived safety. For example, sentiment for commodity producers and, especially, for small cap resource stocks, is dreadful; on the other hand, sentiment levels for stocks generally indicate excessive enthusiasm, warranting caution. These bifurcations, while creating pain for investors, clearly create opportunity for patient value investors such as us who focus on bottom-up value investing in healthy businesses. While buying equities is not without risk—especially commodity related equities exposed to the fluctuations in price of what they produce, and more volatile small caps—it is still desirable for patient investors to opportunistically buy these grossly undervalued businesses with strong balance sheets, good cash flows, good managements and great prospects for future production growth.

THE ONLY GAME IN TOWN (Aug 22, 2014) (Click for summary)

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Our recent quarterly letters cautioned that, as the market was fully valued, a modest correction was likely, and that investors needed to proceed carefully, seeking out undervalued stocks. Yet, the market continued to make record highs. The markets recently began correcting, but have now mostly recovered. We still maintain the market is fully valued, and vulnerable to the potential correction we have been warning about. Stock market corrections should become more frequent but leave the bull market nevertheless intact. Our two top-down macro pillars—TEC™ and TRIM™—do not indicate a forthcoming recession nor a bear market, respectively. We have believed that the artificially low rates have created somewhat of a bond bubble, and that all the money printing will likely result in devaluation of money, i.e., higher inflation, ultimately leading to higher rates and to bond losses. Under current conditions, compared to other asset classes equities are the best, if not the only game in town.

CLIMBING WALLS CAREFULLY (May 26, 2014) (Click for summary)

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It’s been said that bull markets climb a wall of worry. This one clearly has since the crash lows of March ’09, but recently the bull seems to be climbing a wall of optimism. We worry about the optimism. The markets have been making new highs and investor sentiment is high too. Importantly, based on our own Trapeze Economic Composite (TEC™) we do not foresee a recession in the near future. But we do anticipate continued slow growth. And, we do believe that the markets are fully valued, and in need of a correction. We aren’t expecting a bear market, just a healthy overdue correction from a fully valued market. It’s time, we believe, to hold some cash, have some overvalued short positions (in accounts that authorize it) to hedge the decline, and make sure that what we own is adequately undervalued and can potentially withstand a correction.

HIDE AND SEEK (February 27, 2014) (Click for summary)

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Hide and seek. A game investors played as children but should not forget these days. Currently, investors need to hide safely to protect from some unfavourable developments in an environment that could hurt them. First and foremost, the S&P 500 is near a record high and based on our work is fully valued. The U.S. markets did correct recently, but there’s likely more to come. Particularly confronted by recent unfavourable economic news and some turbulence. We believe that market sentiment has been too bullish, which combined with a fully valued market at our TRAC™ ceilings, warrants a correction. We don’t believe this is the onset of a bear market, just a healthy correction. The S&P 500 is fully valued based on a multiple of over 16x 2014 expected earnings, on price to sales ratios, on price to book ratios and even based on its dividend yield, leaving little, if any, upside except from earnings growth. Based on our TEC™ indicator we don’t foresee any looming recession; we just anticipate slower than normal growth.

TURNING OVER ROCKS (November 29, 2013) (Click for summary)

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The S&P 500 is at a record high and we believe the markets generally are fully valued. Corporate revenue growth is anemic, profit margins are stretched, and the prospect of earnings rising meaningfully is not high. And, the outlook for the U.S. and global economy is still uncertain. Market psychology is at a level suggesting the market is overbought. Margin debt is at record levels and the current popularity of stocks by retail investors at market highs is in itself a red flag. The equity markets have benefited from the huge inflows from low-yielding bond funds into U.S. equity funds.

EMBRACE BOTTOM UP (August 21, 2013) (Click for summary)

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The news from the world’s largest economies is mixed and the outcomes are not clearly predictable. With the major indexes at highs—for example, stocks in the S&P 500, at 15x next 12-months earnings, are at their multi-decade historical average—equity investors need to seek out undervalued assets and be patient until these neglected opportunities get recognized. Selected stocks, those with either outsized growth or those trading at discounts to their fair value, can still provide potentially high rewards.

BIFURCATION BLUES (May 24, 2013) (Click for summary)

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Bifurcation means “a division into two parts”, which is what we are witnessing in many investment areas and is exhibiting to value investors those areas to avoid and the most attractive to embrace. Although there has been some migration from bonds to equities, investors have initially taken interest in the biggest and safest stocks—the so-called defensive, safe dependables—which has driven the S&P 500 to a record high, even while the economically sensitive names—the cyclicals, energy, materials, technology, industrials and consumer discretionary—at much lower earnings multiples than the safe dependables, have been lagging. The defensive names have become overvalued and the economically sensitive names are undervalued and therefore the place to focus. As investors continue to return to stocks, we believe the better valued economically sensitive names will outperform. The bifurcation we’ve seen is creating a significant opportunity for patient value investors.

THE GREAT MIGRATION (February 26, 2013) (Click for summary)

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Money ultimately migrates to where it will be treated the best. That destination is not cash, nor bonds with paltry returns, especially in a reflationary environment. Interest rates are likely to rise and we believe the 31-year bull market in bonds is over. We think from an asset allocation standpoint, equities are the place to be. The positive migration to them is here for a while and the dips should be an opportunity to add.

THE LONELY HEARTS CLUB (November 16, 2012) (Click for summary)

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Value investing means buying what’s at bargain prices, usually from the unpopularity of those investments. And selling, and selling short, what’s at overvalued prices usually from over-popularity and/or excessive expectations. We often go against the grain—whether buying or shorting, to the chagrin of many of our clients, to whom “contrarianism” is often misunderstood. Sometimes the consensus is right. But often it is best to be contrary, to find the inefficiencies, especially for the longer term, and especially at valuation extremes.

THROUGH OUR EYES (July 20, 2012) (Click for summary)

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Investor sentiment has recently been at the greatest level of pessimism of the last three years. But the market should start to ignore disappointing news that’s already “in the market”, and start to invest for the recovery for which policymakers strive. This is an extraordinary buying opportunity not seen since the 1970s. Confidence will return and stock prices (and interest rates) will rise. And investor patience will be rewarded.

STAYING BULLISH (May 7, 2012) (Click for summary)

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Even as the stock market has improved this year, from record corporate earnings and modestly improved economic growth in the U.S. and Canada, risk aversion among investors generally remains high. Understandable, with the relentless scary headlines. Nevertheless, we believe we are in a new bull market, and bull markets thrive on climbing that proverbial wall of worry. Bullish sentiment is low and bearish sentiment high. Anxious retail investors, having suffered two ugly bear markets since 2000, continue to shun stocks. The public is hugely underinvested. Cash on the sidelines is enormous. The fuel to ultimately power stocks higher as confidence returns. And investor concerns have made the comparative valuations of stocks “inefficient”, i.e. created an extreme disparity of valuations between groups. Bottom up, stocks in general are reasonably priced but, we believe, especially cheap in the groups and the holdings we own.