CBF Commentary – March & April 2016

Caldwell North American Equity Strategy – Monthly Update March/April 2016

Market Commentary

O’Commodities

Canada has been one of the best performing markets in the world year to date, significantly out-performing most major markets. This is due to the Canadian market’s relatively high exposure to commodities (energy, gold, metals, chemicals, and forest products). Comparing Canada to the U.S., for example, 32% of Canada’s TSX Composite Index is exposed to the Energy and Materials sectors versus only 10% for the U.S. S&P 500. This means that, when commodities make sharp moves, especially over short periods of time, Canadian investors tend to notice. The Materials and Energy sectors in Canada are up 43% and 16%, respectively, through April 30th and account for 97% of the Canadian market’s return this year. Gold is the primary driver behind gains in Materials. While the price of gold is up 20%, gold producers have seen their share prices rise much more rapidly. It is interesting to observe that, while investors typically look to gold stocks when market sentiment turns fearful, the best performing gold stocks have been those with the highest amount of corporate risk (via balance sheet / liquidity risk, or concerns over the inability to meet short term obligations and debt payments due to lack of cash). Base metal stocks have also done well and energy prices firmed up after a slow start to the year. In both of these cases, we see the same dynamic where companies in the most serious trouble were rewarded as commodity prices strengthened. One of the features of commodities is that they are susceptible to sharp and unpredictable price movements. While typically a function of supply and demand, recent price increases seem to be tied more to movement in the U.S. Dollar (“USD”), which has seen a dramatic decline on the back of changing expectations for how and when the U.S. Federal Reserve (“The Fed”) will proceed (or not) with raising interest rates. [As a reference, the USD declined 9.3% versus the CAD in 2016 through April, which is a very sharp move for a currency over such a short period of time. This dynamic has acted as a meaningful headwind to our clients’ portfolios given 70% of our equity exposure is in the U.S.]. The Fed’s intervention in markets has added another layer of complexity to the Canadian market, given that most commodities are priced in USD. As frustrating as it can feel to miss out on a ‘hot’ part of the market, when investors ask us to take care of their hardearned savings, we think the better strategy is to focus on finding high quality companies that have greater control of their ultimate value versus participating in the speculation of a commodity rally. This is particularly true of this recent rally, which we expect will have a limited shelf life given the world has recently come off a massive investment in increasing the supply of resources, mainly to drive China’s growth. We think it will be some years before the world faces a sustained supply deficit needed to support a more sustainable increase in commodity prices. While some have argued that markets are always right and rational, our experience does not support that view. Here is a recent example: Earlier this year, we initiated our due diligence process on a company that screened as a buy candidate in another strategy we manage. The company’s share price had appreciated 170% over a 2.5 month period and our job was to understand what was driving that gain. Our first question to the CFO was whether anything had changed at the company or whether the stock was simply participating in the broad based commodity rally. We were told that nothing had changed and learned there were significant issues facing the company with respect to its contracts. The company recently reported Q1 results which included a dividend cut that should not have been a surprise to investors given the contract uncertainty. Nevertheless, the stock dropped 30% in a single day following the reported news. While it is tempting to think that the market is driven by thoughtful decisions made by rational investors, the example above shows that is not always the case. It illustrates the importance of looking beyond a performance number to understand what is driving performance and how much speculation is involved, something that is true for both individual stocks and broader-based market moves such as the commodity rally we discussed above. Providing that understanding is the ultimate goal of these letters. It is our attempt at arming our investors with the power of knowledge and understanding so that they can make well-informed investment decisions when markets introduce emotion, which they always do.

Looking Forward

Corporate earnings are what ultimately underpin stock prices. Corporations have struggled to grow revenue but the trends have showed some stabilization this past quarter. Looking at earnings results of our portfolio companies, energy, retail, spread earners (banks) and credit plays (private equity) have struggled while those companies supporting other corporations have performed well. The growth environment continues to be challenging and we continue to stress the importance of a focused portfolio in a low growth, higher valuation market. This will not be ‘a rising tide lifts all boats’ environment and as such, we believe our focused strategy of 25 stocks across Canada and the U.S. will serve our investors well. We appreciate your continued support.

Best Regards,
Portfolio Management Team