The Manager's Commentary - December 2010
While we have trailed the market we are not tempted to chase the speculative fervor currently engulfing higher risk assets, which has been particularly acute in the Canadian market.
As central bankers have openly fretted over challenges to growth (and continue to act on these misgivings with extraordinary policy measures) and western economies wind toward recovery with intermittent conviction, investors have confidently embraced the market’s most economically sensitive and historically volatile sectors. Among favoured groups, resource stocks (particularly those of mining enterprises) have been the strongest gainers. The recent predilection for risk in Canada can be gauged by breaking the S&P/TSX Index into two component parts: the TSX 60 Index (which captures the largest and most mature companies listed on the exchange) and the TSX Completion Index (which comprises everything else). Since the summer, the basket of smaller companies has vastly outperformed the market’s senior set, producing a total return advantage of more than 12% through the closing six months of 2010. Applying the recent winning formula for stocks, however, has not been for the faint of heart: at year end, the TSX Completion Index traded at 45% valuation premium to the TSX 60 and, rather ominously, the last time it outperformed the TSX 60 by such a wide margin was in mid-2007.
For a disciplined value manager with a genetic aversion to risk, such a market back drop is less than ideal. Discipline and emotional detachment are integral to success over long periods, but in the shorter term this commitment to approach can sometimes leave one uninvited to the main room of the market party. Interestingly since 2005 the weighted average rate of earnings growth for Canadian mining companies has been just 1.2% or about 2/3 lower than the rest of the companies in the TSX, while the Materials Index has outperformed the SPTSX60 by some 80% over the same period. The Materials sub-index is discounting spectacular growth going forward, however, given the history of commodity prices returning to their marginal costs over time, the capital intensive nature of resource businesses, generally low returns on invested capital and sporadic free cash flow generation, we believe this an increasingly risky bet.
On a positive front, the fascination with Materials has led to an increase in the value of the Canadian dollar allowing us buy US equities, which we view as more attractively valued than Canadian equities.
As stewards of your capital we are willing to let others bet on speculative outcomes and continue to focus on business fundamentals, free cash flow generation and valuation to guide our decisions.
Dixon Mitchell Investment Counsel
December 31, 2010