Balanced Fund Report – December 2014

Caldwell North American Equity Strategy – Monthly Update

Portfolio Additions

We did not add any new positions to the portfolio this month.

Portfolio Deletions

We did not eliminate any positions from the portfolio this month.

2014 In Review: Another Year of Strong Performance

We are pleased to report that 2014 was another strong year of performance for our investors. The Caldwell Balanced Fund (“CBF”) gained 11.2% and was again a top quartile performer in its Morningstar Global Equity Balanced peer group, which returned 8.6%. The CBF also outperformed the Canadian Equity Balanced category (+8.0%), the Canadian Equity category (+9.4%) and the Canadian Dividend and Income Equity category (+5.1%). Before discussing the details of the risks we took, those we avoided and the implications of those decisions on performance, we will quickly recap our investment strategy and what we believe are its competitive advantages as this will provide a framework for the decisions we made throughout the year.

Our Investment Strategy & Competitive Advantages: A Quick Recap

Our strategy consists of protecting our investors’ capital from common risks in the market, specifically, valuation risk, balance sheet risk, management risk and operating risk. History is full of examples where each of these caused significant damage to client portfolios and our goal with every stock we own is to minimize these risks relative to the return opportunity. Our competitive advantages lie in:

1) our actively managed portfolio consisting of approximately 25 stocks and minimal overlap with the index (93% active share);

2) our manageable fund size of $50 million;

3) our ability to diversify risk through U.S. market exposure (some competing mandates limit how much can be invested outside of Canada, which has been problematic with the recent collapse in oil); and

4) our monthly communication, which keeps investors informed about how the portfolio is positioned.

Performance Drivers in 2014

Focusing on the CBF’s stocks, we again outperformed our benchmark (50% TSX/50% S&P 500 in CAD) through active sector allocation and stock selection. Here are the details:

The U.S. Outperforms Canada for the 4th Consecutive Year

The U.S. market (S&P 500, +11.4% in 2014) outperformed the Canadian market (S&P/TSX, +7.4%) for the fourth consecutive year. The drivers behind the stronger U.S. market were twofold: much lower exposure to the worst performing sectors of Energy (-9%) and Materials (+0.1%), and higher exposure to the best performing sectors of Technology (+26%) and Health Care (+26%). The CBF has a higher exposure to U.S. stocks at approximately 60% of the equity portfolio. This is a shift we made years ago and long before it became the ‘strategy du-jour.’ Currency appreciation was an added benefit as the CBF fully participated in the 9% appreciation of the USD versus the CAD.

Avoiding the Bad – Energy & Materials

As mentioned, one of the advantages of our strategy is that we are not restricted to owning Canadian stocks. With energy making up over 20% of the Canadian market, we wrote in our August Commentary about the risks Canadian investors have to falling energy prices. This risk hit home very strongly in the second half of the year as the price of oil dropped 50% from its summer highs. This caused the Canadian energy sector to fall 7.8% for the year and underperform the broader Canadian market by 15.2%.

The reality is that many Canadian investors likely fared worse. While the Canadian Energy sector fell 7.8%, the average return of all companies within the sector was -16.7%. The wide variation is due to the different types of companies within the energy sector, as well as how the sector returns are calculated. Specifically, energy infrastructure stocks were the strongest performing group within the Energy sector. These companies are involved in transportation, processing and storage and have relatively low commodity price exposure. This allows them to pay high dividends, which have been in strong demand given the low interest rate environment. Since infrastructure companies are relatively larger than energy producers and servicers, their returns more heavily influence the overall capitalization-weighted sector return.

Understanding these subtleties illustrates just how well we navigated this challenging energy environment. Four of the CBF’s five energy holdings (Suncor, ShawCor, Parkland Fuel and Chevron) produced an average return of +1.6% in 2014, well above the sector average. Including the CBF’s worst performer, CanElson Drilling, produces an average return of -6.6%, which still beats the sector return of -7.8% and is well above the average return of -16.7%. These returns were achieved without participating in the strongest area of the energy market (we discuss why under the Yield Trade section below).

Turning to Materials, after a 30% decline in 2013, Canada’s Materials sector had another weak year with a -4% return. Absence from this sector has shielded our investors from considerable pain over the last two years. The CBF has had no exposure to materials given our concerns around over-investment in capacity coupled with China’s shift in policy from infrastructure to consumer-led growth.

Participating in the Good – Technology & Health Care

Technology and Health Care were two of the best performing sectors in 2014. The CBF benefited from having sizable exposure to technology with the strongest performances coming from Cisco (+24%) and Celestica (+24%). We felt that many large U.S. technology companies offered attractive risk/return profiles and bought into fears that new technology would displace incumbent providers. Those fears eased throughout the year and drove strong performance.

While the CBF is currently light on Health Care, we realized strong gains on Cigna and Zimmer Holdings when these companies hit our valuation targets. We continue to own Varian Medical, which is one of two major competitors in the world that manufactures radiation therapy equipment used in cancer treatment. We see strong demand for their products as the U.S. goes through a replacement cycle and emerging markets build out treatment facilities.

Financials, Consumer & Industrials

We had strong picks in the financial, consumer and industrial sectors, driven by CCL Industries, Tyson Foods, CSX Rail and Home Capital Group. We sold Home Capital Group in late October as we saw increasing risks to their Canadian housing exposure from lower oil prices. We also sold Tyson Foods on their acquisition of Hillshire Brands. We continue to own CCL Industries, which has considerable runway to consolidate a global label industry, and CSX Rail, which continues to benefit from a tight rail and trucking market.

The Yield Trade: Utilities, Real Estate & Energy Infrastructure

Our focus on capital protection means we will run into situations where we miss out on some upside when elevated risks persist. This occurred in 2014 with our absence from real estate investment trusts, utilities and energy infrastructure, which performed strongly as the 10 year bond yield again fell below 2%. Investor demand for yield has been very strong in this low interest rate environment. This has pushed up the prices of yield-sensitive stocks and has caused their shares to trade at valuations far above historical levels. This introduces valuation risk and is the reason we have avoided this part of the market. Given that capital protection is at the heart of our investment process, we are prepared to forego gains where we feel our investor’s capital is not adequately protected. The April-October period in 2013 when the U.S. Federal Reserve first spoke of raising rates is a good example of the risks facing investors. During this period, the Canadian and U.S. Real Estate sectors fell -14% and -8%, respectively, and the Utilities sectors fell -8% and -6% versus gains of 8% and 10%, respectively, for the broader markets.

Sector Rotation in Canada – Has the entire market become an energy play?

One of the limitations of the Canadian market is its small size. We use an illustration where we take $1 billion, assume a 25 stock portfolio ($40 million per stock) and say that we can only buy a stock if we can buy the entire $40 million position in one day’s trading. The result is that only 8% of the Canadian index, which is around 25 stocks, would qualify. Conversely, for the U.S., 460 of the 500 stocks in the S&P 500 would qualify.

There are several implications here. First, it is very hard to do well in Canada as a large, multi-billion dollar fund. We view this as one of our advantages given our more manageable size. The other implication is that stock returns are less a function of the merit of an individual business and more a function of money flow. The last six months in energy have illustrated this. Whereas the energy sector declined 22% in the second half of 2014, the Consumer Staples, Consumer Discretionary, Health Care and Technology sectors were up 34%, 17%, 24% and 19%, respectively. We believe these strong returns were more a function of Canadian investors rotating out of energy and into these sectors, versus actual positive fundamentals at these companies. This has effectively turned the entire Canadian market into an energy play, which is another reason we continue to have greater exposure to the U.S. market.

Going Forward

We have performed very well over the last several years for our investors and owe much of this to our investment process, which has helped us avoid painful losses entirely (as we did in materials), limit losses in energy and participate in the outperformance of the U.S. market. Valuations, which can be viewed as the prices investors must pay to own businesses, have moved higher with the upward trend in the markets and this has implications for returns investors should expect going forward. While higher valuations may act to lower future returns, we believe our strategy of stock selection positions us well for this type of environment. We will continue to focus on executing our investment process with the goal of making smart decisions with our investors’ capital.

Feel free to reach out to us at any time.

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