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TriDelta Investment Counsel – Q4 2013 investment review

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Equities maintained strong upward momentum during the fourth quarter of 2013 completing an excellent year. The sustained & better than expected US economic reports, fueled a global market surge that surpassed our expectations.Virtually every major global equity market was up double digits for the year with a few notable exceptions including China and Brazil. Indications suggest that the global recovery following the major market shocks in 2007 & 2008 has taken hold. The recovery is being led by the US economy and is believed to be sustainable although will likely deliver its fair share of surprises as it unfolds further.Emerging market equity returns were slightly positive in the fourth quarter, but as a group recorded slightly negative returns for the year.

Precious metals remained under pressure throughout the quarter and were well down on the year. Gold investors recorded a negative 28.3% return.

Fixed income on the other hand showed signs of stress in light of the broad based US economic strength, exasperated by talks of the US Federal Reserve tapering. Most global bond indices were flat or slightly negative. The DEX Universe of Canadian bonds recorded its first negative return of -1.19% in well over a decade. Losses were driven by government issued debt and bonds with longer maturity dates while corporate bonds in aggregate returned 0.84% for the year.

 

The Bank of Canada remains concerned that inflation remains well below target, but is also troubled by record high consumer debt levels spurred by low interest rates. This dilemma suggests that they will likely remain neutral (in other words, not increase rates) for some time.

Despite the difficulty of double guessing the Bank of Canada, our opinion is that longer dated bond yields may rise albeit not for some time. Once Canadian rates move higher increases will likely remain within a tight range between 2.5% and 3%.

16413399_sWe reiterate that bonds have a key role to play as part of very necessary diversification as we build wealth. We also focus on capital preservation while delivering clients with a steady stream of predictable income. We forecast that our bond portfolios will deliver an approx. 3.5% return in 2014.

In 2013 our Core bond portfolio returned 3.68% and our Pension bond portfolio 1.66%, despite our benchmark DEX losing 1.19%.

US Fed policy remained the big discussion amongst market strategists who debated timing and the extent of QE tapering. December delivered the first decision to begin the easing process with a $10 billion monthly reduction of bond purchases from $85 to $75 billion starting in January 2014. The fear of tapering hindered 2013 bond performance, but we believe it is no longer a big issue and that bond markets have now priced in the effect of eliminating it entirely in 2014.

Despite the positive economic news including the IMF and World Bank forecasts of better global growth in 2014, caution is warranted, particularly after the steep market gains. Our ‘TriDelta 2014 Financial Forecast’ published in late December details our outlook for the year ahead.

How did we do?

2013 was another positive year for TriDelta clients. The Toronto Stock Exchange equity index (TSX) returned 7.3% in the fourth quarter and 13% for the year whilst the Canadian Corporate bond component of the DEX Universe Index was up 0.87% for the year while the overall DEX Universe was down 1.19%.

Most TriDelta clients had a net return for their portfolio between 6% and 16% depending on their risk tolerance/asset mix. Pure equity returns before fees were 22.45% for our Core portfolio and 18.41% for our Pension portfolio.

TriDelta Equity Model Returns in Canadian Dollars (to December 31, 2013):

TriDelta model 1 month 3 month 6 month 1 year (2013)
Core Equity 1.60% 6.64% 9.97% 22.45%
Pension Equity -0.15% 7.44% 11.64% 18.41%

 

What worked well in Q4?

Sectors: Info Tech +15.7%, Industrials +16.8% & Health Care +13.8%

Core Model Stocks: Core – Constellation Software +24.5%, 3M +22%, Priceline +18.8%

Pension Model Stocks: Norfolk Southern + 24.8%, Abbvie +23%, Apple +22.3%

What did not work well in Q4?

One of our beliefs at TriDelta is to be very open about our business, its successes and its weaknesses. Openness is not a hallmark of the financial industry, but something that we believe is important in order to build trust, strong performance and partnership with our clients.

Sectors: Materials +0.8%, Utilities +4.7%

A few of our holdings had negative returns, some of which are listed below:

Core Model Stocks: Manitoba Tel -11.1%, S&P 500 Short -9.4%, Tourmaline -4.5%

Pension Model Stocks: Iamgold -13%, S&P 500 Short -9.4%, Cdn Oil Sands -.9%

The Best and Worst performers of 2013

Pension portfolio:

Company Name Change
Abbvie +68%
Norfolk Southern +64%
Home Capital +39%
Wajax -12.7%
Iamgold -12.9%
Potash -15.2%

 

Core portfolio:

Company Name Change
Priceline +99.9%
Magna +78.6%
3M +64.8%
Marathon Petroleum -15.2%
Barrick Gold -17.0%
Coastal Energy -17.7%

Dividend changes:

We strongly believe in the power of dividend growth and those companies who have a history of increasing their dividends over time. These companies have generally outperformed the market with lower volatility. This quarter was no exception and we were proud to own the following companies that increased their dividends:

Company Name % Dividend Increase
Abbott Labs 57%
3M 34%
Atco Ltd 15%
Canadian Utilities 10%
National Bank 6%
McDonalds 5%
Merck 2%
TD Bank 1%

One company we owned removed their dividend entirely, which was a disappointment. It was Iamgold Corp

Summary

We’re proud to have protected and grown our client wealth in 2013.

We have also successfully delivered on our core beliefs of comprehensive financial planning, tax efficiency and an investment plan that generally lowers volatility, typically increases income and ensures we own many of the best companies as identified by our exclusive quantitative led selection process.

2013 is another example of our achieving above average risk adjusted returns in an extremely low interest rate environment. We remain committed to our proven investment approach and philosophy.

Thanks for your continued support.

 

TriDelta Investment Management Committee

Cameron Winser

VP, Equities

Edward Jong

VP, Fixed Income

Ted Rechtshaffen

President and CEO

Anton Tucker

Executive VP

Lorne Zeiler

VP, Wealth Advisor

TriDelta Investment Counsel Q3 Review – US Government Battles – What Now?

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As we write this, the US government is locked in a battle around whether to increase its debt limit. Some government workers are taking a forced vacation, and if agreement is not reached by the October 17th deadline, the US could default on its debt in the week or two after that date.

Our general approach has been to be a little cautious heading into Q4, with higher cash weightings (approximately 10%) and even a purchase of an inverse ETF (we bought an ETF that will go up in value if the US S&P500 goes down in value).

We anticipate that the fear factor will build over the month as CNN and Fox News focus on an ‘impending’ US default that we believe to be highly unlikely.

We also anticipate that the height of this fear will likely create short-term market pullbacks that will be a great time for us to buy some cheap stocks.

Traditionally, November, December and January have been some of the best months of the year for the market, and we see a decent rally coming off of the almost inevitable decision for the US to raise their debt ceiling, and stave off a default… at least until the next debt ceiling deadline sometime in 2014.

Review of Q3

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As we review the third quarter of 2013, the numbers showed stable to solid stock performance and flat to negative bond and preferred share performance.

TriDelta clients had net gains in the range of 1% to 2.5% over the quarter (annualized at 4% to 10%).  Clients with a greater growth focus (higher stock weighting) were closer to 2.5% and those with more conservative goals (higher bond weighting) were closer to 1%.

In the North American stock markets, we saw Canadian stocks outperform the US by over 3% in the quarter.  This was the first quarter in quite a while where Canada outperformed.  There is certainly some belief that metals, mining and energy stocks are undervalued at the moment, and have an opportunity to outperform other parts of the market – although the timing of this remains to be seen.

Weakness continued on the Utilities and Telcos front vs. other sectors.

Our best performing holdings in the quarter were:

  • Home Capital up 30%
  • Priceline up 19%
  • Suncor up 19%
  • Two strong purchases this quarter were Goodyear Tires and Transcontinental – both up 17% so far.

Our worst performing holdings in the quarter were:

  • Potash down 17% (we decided to sell the stock after the market closed but before the announcement that the Russian potash cartel was dissolving – unfortunately by the time the market opened the stock had already fallen)
  • Trilogy Energy down 17%

Dividend Changes

Given our focus on dividend growth, we report on all dividend changes in the quarter.  Once again there were no declines in dividends in any of our holdings, while a few companies did have a dividend increase.

 

Company Name % Dividend Increase
Home Capital +7.7%
Royal Bank +6.4%
McDonalds +5.2%
TD Bank +4.9%
Norfolk Southern +4.0%
Bank of Nova Scotia +3.3%
Verizon +2.9%

 

Goodyear Tires initiated a $0.05 dividend that pays on Oct 30, 2013 after not paying a dividend for many years.  This puts its yield at a little under 1%.

On the bond front, we continued to outperform the bond and preferred share indices, but net returns were very flat over the quarter, with weak returns in July and August, and some recovery in September.

With preferred shares, we saw a tale of 3 stories in the quarter.  Somewhat surprisingly, rate reset preferred shares index lost 1.5% in the quarter, floating rate preferreds lost 1.8%, while fixed rate preferreds were actually up 0.2%.    We have taken a little heat for being overweight fixed rate preferreds, but given the view of short term rates holding for at least another 1 to 2 years, floating rate preferreds make little sense at the moment.  We also believe that 10 year interest rates will be trading in a range for a while, which will likely put fixed rate preferreds at a slight advantage.

It should also be noted that 10 year Government of Canada interest rates actually declined a full 25 basis points (0.25%) in late September.  We feel that this is a real sign that long term interest rates are unlikely to rise in the near time and there will likely be several opportunities for gains in bonds as rates wax and wane.

What we see in Q4

  • We remain cautious in the very near term as the US government politicians play ping pong
  • We will look to add stocks on pull backs
  • For now, we will keep the short S&P ETF
  • Valuations are fair overall, but are a little stretched on some of the less cyclical names (utilities, telcos, etc.) leaving greater opportunity in the cyclicals (financials, metals, consumer discretionary) as long as the economy doesn’t stall out.

Our worst case scenario for the US government is actually quite positive for bonds.  While we believe it is very unlikely that there will be a lengthy government shutdown and extremely unlikely to see a default, given the fragility of the current economic rebound, it would not be a stretch to even consider the possibility of a quick dip back into the recessionary zone.  The last government shutdown occurred in 1995/96 during an episode of better economic circumstances, and had essentially negligible economic impact, but long-bonds rallied.

In the short term we believe that US economic fears will lead to delays in US bond buying tapering and push off any risks of interest rate increases.

Summary

The markets move on fear and greed.

Fortunately, in the world of 2013, we can count on the media to intensify both of those emotions when the time is right – although the media does ‘fear’ much better.  We believe that by keeping our emotions in check, there will be opportunities to take advantage of this media enhanced fear.

We believe that October may be one of the best examples of this.

 

TriDelta Investment Management Committee

Cameron Winser

VP, Equities

Edward Jong

VP, Fixed Income

Ted Rechtshaffen

President and CEO

Anton Tucker

Executive VP

Lorne Zeiler

VP, Wealth Advisor

 
 

The end of income investing — for now

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As interest rates declined and people found they could only renew their GICs at 2.5% or less, the search for high-income stock alternatives reached its peak, although the search for yield has been an investing battle cry for several years now.

You want 5% or 6% yields?  Here is what you get in Canada this year:

REITs: 6% yield; -11% total return YTD

Utilities: 6% yield; -8% total return YTD

Telecommunications: 5% yield; -1% total return YTD

REITs, telecoms and utilities since 2009 have been money in the bank. What happened?

Following 2008, when REITs were down 38%, they have annually returned 53% in 2009, followed by 22%, 21%, and 16% in 2012.

Utilities in 2009 returned 19%, followed by 18%, 6% and 4% last year. Strong returns for what are considered safe investments.

Another traditionally lower-volatility, higher-income sector has been telecommunications. In 2009, it was one of the worst performers (in a strong year) but still returned 8%. This was followed by 19%, 23% and 12% in 2012.

All three sectors are down this year. Is this just a temporary blip?

I believe there is a real change happening, and that the market shifts are not going to be positive for income investments for three main reasons.

The 3 strikes against income investing today

Strike 1: Some income investments are just too expensive today, while other sectors have been beaten down. Comparing Enbridge Inc. to Barrick Gold Corp. highlights this movement.

Enbridge is a fantastic business that made it through the 2008 crash better than any other TSX 60 stock.  The problem is that the stock is arguably overvalued for that safety.

Enbridge in 2009 had a price-earnings ratio (the price paid by an investor for every dollar of profit) of eight, which is historically quite cheap for the company.  Since then, Enbridge’s stock price has simply gone up — until recently.  It now owns a P/E ratio topping 50. This is beyond expensive for a pipeline company, even one with significant growth expected.

As a result, this “very safe” company has a real risk of price declines unless its profitability rises meaningfully.

On the flip side, Barrick Gold (which I now own) was trading at 50 times earnings in 2009 and is now trading at forward earnings of eight.  Forward earnings are based on the price of a company for every dollar of expected earnings in the next year.

This does not suggest that everyone should sell Enbridge and buy Barrick Gold, but it does show that the old adage of “buy low and sell high” is hard to do, although always in style.

Of course, things that are low can go lower, and things that are high can go higher, but when it comes to valuations, they often eventually come back to their normal ranges.

Today, many, but not all, income investments are expensive from a historical perspective.

Strike 2: When interest rates go up, income investments such as utilities, REITs, bonds and preferred shares usually go down in value.

After a three-decade period of interest rate declines, it certainly looks like we hit bottom in the first few months of 2013. With 10-year Government of Canada bond yields comfortably under 2%, there was little room to go down further. Having said that, the super-low interest-rate environment not only lasted longer than anyone expected, but we are still living it today since 10-year rates are under 3%.

The key is that the trend has changed. While rates may move in fits and starts (not always going up), the long-term trend is definitely higher, and that is not good news for interest-sensitive investments, because it starts to make risk-free GICs look more compelling.  It also makes the cost of leverage much higher for these companies.

Strike 3: The investment cycle suggests it is time to move out of interest-sensitive sectors.

Fidelity Investments in the U.S. recently put together a report on how different sectors of the market perform depending on where we are on the business cycle.

The key takeaway is that in a recession phase of the market, the clear winners are consumer staples, utilities, telecom and health care. We are past that phase in North America.

The report then goes on to outline what sectors in the U.S. do well in the early-growth, mid-cycle and late-cycle stages.

Some might think we are past the early phase of the business-cycle recovery, but the fact that central banks haven’t yet raised interest rates suggests we are still likely in the latter stages of the early phase.

In this stage, consumer discretionary, materials, industrials, technology and financials usually outperform, while energy, utilities and telecom lag. We are seeing that right now.

As we head towards the mid-cycle, when interest rates begin rising, technology, energy, industrials and health care tend to outperform. It is not until the late stages of a business cycle that utilities and consumer staples start to reemerge as places to be overweight. We are likely at least a year away and possibly a few years from that stage.

These are but a few of the many key pieces of information that might go into your portfolio choices, but they certainly help to explain the performance changes in income stocks.

Some things, of course, have not changed.

Income remains important. Low volatility is still highly valued by many investors, but the focus needs to be about corporate cash flow and profitability, not yield. This is something that some investors have forgotten in the search for ever-higher yields. When a company can’t maintain its high income payout, the punishment is severe. Just look at names such as Atlantic Power, Yellow Media, Chorus Aviation and Just Energy.

Dividend growth is also still tremendously important as a measure of a company’s long-term health. Many historical studies show that companies with strong dividend growth over many years provide greater long-term returns than most other companies.

Sometimes that may mean investing in stock that has a yield of only 1.5% or 2%, but if it is sustainable and growing regularly, then the dividend growth will become a key driver of overall returns. Dividend growth typically means higher future profits, which often results in stock price appreciation as well.

So what does this all mean?

In my view, a traditionally focused income portfolio needs to be changed unless you want to see a long period of underperformance versus the overall market.

Change doesn’t mean the income yield has to drop too much; it may just need to come from a different sector. An example might be that you want more exposure to technology, with large companies such as Cisco or Apple paying 2% to 3% in dividends — and an expectation that they will increase over time. These are companies that my firm currently holds for clients.

It is also important to remember that a lower yield on your portfolio does not necessarily mean lower returns or digging into your capital.

If the total portfolio is growing at a rate faster than $2,000 a month, and you draw down $2,000 a month, you are essentially not touching your capital. It doesn’t matter if the portfolio has an income yield of 0% or 5% driving that growth.

Investing isn’t easy, and one of the main reasons is that things are always changing. It is looking clear that focusing only on Canadian income stocks and REITs is now one of those things that should change.

Ted can be reached at tedr@tridelta.ca or by phone at 416-733-3292 x221 or 1-888-816-8927 x221

Bond market review – March 2013

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The hunt for yield will remain the consistent theme for 2013. In this 30 year low interest rate environment as governments across the globe are looking to reflate the economy.

At TriDelta Investment Counsel, we are constantly seeking opportunities to enhance portfolio yield and returns by actively managing the portfolio and applying tactical shifts along the yield curve and with credit quality.

Persistently low inflation readings will keep central banks at bay suggesting that we are sometime away from rising interest rates. Although ironically, the Bank of Canada may actually be forced to consider a cut to its overnight lending rates because of recent sluggish growth and anemic inflation readings.

Political and economic turmoil persist in Europe, although economic growth in the US is tilted higher. The Federal Open Market Committee (FOMC) will likely stay the course with Quantitative Easing (QE), as benefits outweigh the costs. However, tapered QE purchases in the months to come will be mitigated by smaller deficits and a projected decline of $260 billion in bond issuance in the US. Growth, inflation, and job targets, none of which are binding constraints for the US Federal Reserve, will not force the Fed off its agenda to maintain low interest rates for awhile.

We believe interest rates will stay low for a prolonged and indefinite period.  The bond market is far from being complacent given the disaster experienced during the financial crisis of 2006 to 2008.  Fixed income investors are still seeking yield; however, less from duration and more from credit.  At TriDelta we continue to monitor and favour:

  • Gradually, and if appropriate, increasing our bond portfolio’s overall term to maturity (duration) to take advantage of higher interest rates on longer term bonds.
  • Take advantage of the premium interest rates paid on corporate bonds versus the low rates on government bonds.

At TriDelta we have structured our portfolios to provide ‘risk adjusted returns’ by ongoing monitoring of market internals and seizing what we see as opportunities to outperform. We have opted to:

  • Remain a little shorter on term to maturity than the overall DEX Universe Bond Index for most clients.
  • We have over weighted the belly of the yield curve (and underweighted the wings) by not taking a significant duration risk.

bonds‘Yield curve’, ‘sector’ and ‘duration’ allocation is important in bond portfolios; as such, we take these into consideration as we design and manage our portfolios.

We believe that investors are fearful of higher overnight lending rates, but central banks have little control over the rest of the yield curve (aside from central bank operations; such as, quantitative easing) and as such have made portfolio tactical shifts to put the odds in our favour.

Lastly, higher quality non-government bonds (known as investment grade bonds) continue to remain cheap, whereas slightly lower quality (known as high yield bonds) are particularly cheap when compared to US equivalents.  We believe that there is a good likelihood that these Canadian bonds outperform their US counterparts.  In a worst case scenario, we believe corporate bonds will perform better than government bonds.  Our portfolios are overweight in corporate bonds for this reason.

The yield-to-maturity for the Core and Pension Models is at 4.64% and 3.59% which will help cushion any decline, or add to the capital gains.

At TriDelta we feverishly monitor trends and look to capitalize on the tactical opportunities available to boost bond portfolio yield and returns without sacrificing our capital preservation and seeking a consistent stream of income mandate.

Article written by Edward Jong, VP Fixed Income at TriDelta Financial

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