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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

 
 

TriDelta 3rd Q 2012 Market Outlook

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What Happened in the Quarter

The third quarter can be summarized by two major government announcements:

  1. The European Central Bank announced the Outright Monetary Transactions programme aimed at providing significant monetary support to ensure that the “Euro Will Not Fail”. The new bond-buying plan is aimed at easing the eurozone’s debt crisis. The ECB aims to cut the borrowing costs of debt-burdened eurozone members by buying their bonds.
  2. Later in September, the US Federal Reserve Bank headed by Ben Bernanke announced Quantitative Easing 3. This included a commitment to buy $40 billion in mortgage backed securities each month from Fannie Mae and Freddie Mac (the US version of the Canadian Mortgage and Housing Corporation – CMHC). This is in addition to the $2 trillion in Treasury bonds that it bought in QE1 an QE2.

Both of these actions and the expectations of these actions drove markets higher during the quarter. Among the biggest beneficiaries were precious metals, energy, and other commodities – sectors of the market that lagged for much of the year.

The Toronto market was up 6% on the quarter after having fallen over 6% in the previous quarter.

The bond universe market was up 1.2% on the quarter.

How did you do?

At TriDelta Investment Counsel we have two main types of clients. The first group seeks conservative growth and income and are invested in our ‘Pension’ model. The second group is looking for growth, which is delivered via our ‘Core’ model.

Pension Clients:

This group is typically in retirement or close to it and looking for less volatility, higher income and steadier 5% to 10% gain, especially while interest rates and GIC rates are so low.

Most pension clients grew by 1.5% this quarter (after fees).

Our Pension model (based on 60% stocks and 40% bonds) returned 5.5% year to date (after fees). So far on the year we are very pleased to see that our Pension portfolios are delivering the type of returns that they were designed to deliver.

While the performance this quarter was not as strong as the super charged stock markets, it is important to remember why. Our approach is based on finding a mix of bonds, preferred shares and dividend paying stocks that will provide a steady level of income. The capital gains growth from the portfolio will usually come from companies that are rarely flashy in the short term (like the precious metals index) but act more like the tortoise than the hare. Companies like Trans Canada Pipelines, Philip Morris, and Colgate Palmolive.

These are the type of companies that will not jump meaningfully upon hearing about the latest round of quantitative easing.

Dividend Changes in Q3 – Pension

One area of Pension focus for us is to hold companies with stable and growing dividends. In terms of dividend changes this quarter we saw 7 dividend increases and no decreases:

  • Microsoft boost its quarterly dividend by 15%
  • Phillip Morris boost its quarterly dividend by 10.4%
  • Norfolk Southern boost its quarterly dividend by 6.4%
  • BCE boost its quarterly dividend by 4.6%
  • CIBC boost its quarterly dividend by 4.4%
  • Emera boost its quarterly dividend by 3.7%
  • Verizon boost its quarterly dividend by 3.0%

 

Core Performance Clients:

This group of clients is looking for greater growth, less concerned about income, and want to beat the market over time. Ideally for peace of mind, these portfolios will still have less volatility than the market overall. We call this group Core Performance portfolios.

Most Core Performance clients grew by 2% this quarter (after fees).

Our Core Performance model (based on 60% stocks and 40% bonds) returned 9.7% year to date (after fees), with a healthy part of the gains coming in the first quarter.

The numbers are quite positive although we saw a little portfolio drag of higher cash balances in the Q3 performance in our Core Performance portfolios. We look forward to adding some more momentum to the portfolio over the next few months as opportunities present themselves.

Some of the trades we made this quarter and why?

In Pension Portfolios:

  • We sold a Manulife bond that had a coupon of 4.08% and came due in 2015.
  • We bought a Manulife bond that has a coupon of 5.06% and comes due in 2041.

Rationale – The short term Manulife bond had a yield to maturity of 2.57%, and we replaced it with a bond from the same company that has a yield to maturity of 6.02%. The 2041 bond also has a current yield (the coupon payment of 5.06 divided by the purchase price of $86.50) of 5.85%.

We will not likely hold this bond to maturity, but feel that the significant increase in yield (while holding the same company), will benefit investors in the short to medium term, while we remain confident that long term interest rates will remain low (or lower) over that time.

  • We sold Barrick Gold

Rationale – This was a difficult decision. The stock was purchased for most clients around $40, dropped to $31, and came back to $37 when we sold it for Pension clients. The volatility is what made us sell the stock. It remains in our Core portfolios as it passes the financial hurdles of the Core model and the speculative nature and volatility of the stock is more appropriate for that mandate.

In Core Portfolios:

  • We did the same Manulife bond trade as noted above in the Pension portfolios.
  • We bought Tesoro Corporation. It is up 16% since our purchase.

Rationale – Tesoro is an independent petroleum refiner and marketer in the United States with two operating segments: refining crude oil and selling refined products in bulk and wholesale markets and selling motor fuels in the retail market. They had a great earnings report this quarter and continue to prove themselves as one of the best operators in the refining space. Growth wise they have two expansions that should contribute positively to earnings shortly and help accelerate growth. The stock ranks very well and is breaking out of a 11/2 year range that should provide substantial support.

  • We sold Discover Financial Services.

Rationale – The stock had a really good run and was up 45% YTD when we sold it. There was some concern about high valuations and their entry into new market segments such as student loans. So far the stock has continued to do well in August and September.

Our Investment Outlook and how it will impact your portfolio

We believe that some of the market gains in Q3 have been driven by ‘hot air’. By this we mean that it is relatively easy for governments to print and throw money at a major economic problem. What is difficult is seeing fundamental economic improvements on the ground and in the economy.

On the positive side there continues to be signs that the US housing market is stabilizing, with price gains in many markets. Housing market changes tend to move slowly, and a turn from one direction to another can be a significant signal. We are hopeful that this slow shift in US housing will provide one of the foundations for an improving economy.

The other big positive is that historically when the government provides economic stimulus and provides lower than average borrowing costs for consumers and companies, the markets tend to benefit. We have certainly seen some of this benefit in the U.S. market, and think that in the medium term that will continue.

On the negative side, there are a few items:

  1. The China Purchasing Managers Index is at 47.8. This is very low and suggests weak growth in China.
  2. Eurozone Purchasing Managers Index is at 46.0, historically a very low level, and one that indicates a continuing high unemployment and low (if any) growth in the region.
  3. Spain, Greece and Italy have been out of the news for a while, and markets have seen solid increases. At some point, they will make negative economic headlines again and the market will see a pullback.
  4. The U.S. “Fiscal cliff” is the popular shorthand term used to describe the conundrum that the U.S. government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect.

Among the laws set to change at midnight on December 31, 2012, are the end of last year’s temporary payroll tax cuts (resulting in a 2% tax increase for workers), the end of certain tax breaks for businesses, shifts in the alternative minimum tax that would take a larger bite, the end of the tax cuts from 2001-2003, and the beginning of taxes related to President Obama’s health care law. At the same time, the spending cuts agreed upon as part of the debt ceiling deal of 2011 will begin to go into effect.

TriDelta’s defensive stance (with higher than average cash balances) will remain until we see a meaningful 5%+ pullback in markets, so that we can find some better entry points. An example might be outside of Canada. We currently have a meaningful position in the U.S. markets. We will likely be expanding our non-Canadian positions for two reasons. The first is that the Canadian dollar is currently very strong, and we believe it is at the high end of the range making it a good time to invest outside of Canada. Also, we continue to look for greater diversification from the core energy and materials that Canada has in abundance.

When we look at the movements of the markets in the last quarter, through the list of positive and negative items that we are facing, we believe that one of the list of four negative items will be the focus of markets’ attention at some point this quarter, and will lead to a pullback that we can take advantage of.

In the meantime, our portfolios (while a little conservative) are well positioned to continue to see some growth in most market situations.

TriDelta Investment Counsel Investment Committee – October 2012
Cam Winser, CFA, VP Equities
Edward Jong, VP Fixed Income
Ted Rechtshaffen, MBA, CFP, President and CEO
Anton Tucker, CFP, FMA, FCSI, VP, TriDelta Financial Partners

 

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