TriDelta Investment Counsel – Q2 2015 investment review

Overall, the second quarter of 2015 was one of the weaker quarters in a long time.
 
Of interest, there wasn’t really anywhere to turn to find good numbers on the quarter.
 
Among indices, the results were the following:

Growth oriented TriDelta clients meaningfully outperformed the TSX, but were still mostly down around 1% on the quarter.
 
Conservative oriented TriDelta clients were down in the 1.5% to 2% range on the quarter, still outperforming the TSX.
 
A big impact on client performance was their weighting in Preferred shares. For the most part, clients with a higher percentage of their assets in taxable, non-registered accounts would hold a higher weighting of Preferred shares. Those with very low or no non-registered assets, would have very little in Preferred shares.
 
We do believe that Preferred shares will see some sunshine over the next year, but they have certainly been an underperforming asset class over the past year.

Sifting through the headlines to try to find the economic meat, sometimes we find a lot more noise than news.
 
This is not to say that Greece’s latest brush with bankruptcy, China’s wildly gyrating market, and an imminent deal of some kind with Iran that will remove much of the economic sanctions on the country, are not important.
 
Each is important in a different way, but how do we use this to our advantage?
 
Let’s look at each situation:
 
Greece – a possible default on its debt and departure from the EU
 
Risks:

• A Greece debt default will cause financial stress for holders of Greek debt
• Life for the Greek people will become harder and some revolt is possible.
• A Greek default could cause other weak EU members to do the same.

 
Things we watch for:

• 10 Year Bond Yields in Portugal and Spain – are just 2.8% and 2.1% respectively. This gives us some comfort that the bond market doesn’t see meaningful risks from these two countries.
• Stress tests in European Banks over the past three years which would have looked specifically at how they would be impacted by a Greek default. The results showed that unlike in 2012, a Greek default would primarily impact Greece, the German government and the European Central Bank, but would not have a ripple effect throughout global financial markets.

Investment Opportunities:

• Do not overreact and bail out. Greece is just 1.8% of the EU economy and about 0.4% of the global economy. Given all of the time to prepare, it looks like any result could be contained in the medium term.
• Possibly invest a little cash on bad news days for Greece.

 

China – plummeting stock market of late
 
There is a great summary of the Chinese stock market moves in the New York Times. The link is below.
http://www.nytimes.com/2015/07/07/upshot/how-to-make-sense-of-chinas-plummeting-stock-market.html?abt=0002&abg=0
 
Risks:

• As one of the major drivers of the resource economy, could a stock market collapse in China lead to another hit to the various resource sectors?
• Could stock market volatility lead to social instability in China?
• Could the government interference in the stock market (changing the buying and selling rules as they go), turn foreign investors away?
• Could the decrease in China’s stock market impact global liquidity in other areas?

Things we watch for:

• Does the Chinese stock market strongly correlate to its economy? Over the last decade, huge stock market volatility has not been particularly connected to economic or earnings growth. While this makes investing in China a real gamble, it does suggest that we shouldn’t look to Chinese stock market performance as a driver of demand for Canadian resources, or equity markets overall.
• While the Chinese stock market had dropped 32% over four weeks at one point, it has still outperformed North American markets year to date. Is there really any Chinese stock market crisis to consider? Probably not.
• Is Chinese government interference in the stock market a destabilizing factor? While it doesn’t give most North American investors comfort in the investment space, it doesn’t appear to have any long term impact on the market. Ultimately, the Chinese stock market returns are highly volatile. The companies require greater regulation and transparency, and its stock market performance is not a large factor in our overall investment analysis.

Investment Opportunities:

• Similar to Greece, it doesn’t make sense to overreact to the Chinese stock market. While the returns do impact our Emerging Market investments, we can absorb the extra volatility as we think it will add some growth to the overall portfolios.
• The critical items in China relate to GDP declines, and their impact on global demand for various key resources and consumer goods. While GDP growth is slowly declining, it remains in the 7% growth range and a source of meaningful global growth at a time when Western markets are growing in the 0% to 3% range.

 
Iran – a possible lifting of global economic sanctions as part of a Nuclear deal
 
Risks:

• The biggest risk obviously relates to whether Iran could possibly create and use a Nuclear weapon.
• Iran holds the fourth-largest oil reserves in the world, and it is sitting on another 20 to 40 million barrels in storage on-shore and in more than a dozen tankers floating off its coast. A deal could increase production and exports of oil at a time when supply is already outstripping global demand.
• Domestic response to an agreement could be volatile in Iran as well as in Israel, the US, and several other countries.
• A good overview is provided in this article from US News and World Report: 
  http://www.usnews.com/news/articles/2015/07/13/crude-estimate-how-ending-iran-sanctions-may-impact-oil-markets

Things we watch for:

• Iran’s oil minister pledged to increase the country’s exports by roughly 1 million barrels per day within a year. Experts estimate that the process will take a bit longer, but the numbers are about right in the long run. Worldwide, countries produce about 100 million barrels of crude per day. If that increase does happen, it will certainly put a lower ceiling on the price of oil for the foreseeable future.

Investment Opportunities:

• With small exceptions, we have kept out of the oil patch over the past number of months. We expect that news of a ratified deal will definitely hit the oil patch, possibly more so than on the real impact to the market. In the short term, it could provide an opportunity for an investment, but we will likely stay very underweight on this sector over the short term.

 

In the past year, TriDelta has sold several companies prior to significant declines. Some sells protected client gains while some were not our best stock picks, but our sells limited losses. Here are 6 examples that were held in clients’ accounts (all clients would have held a few of these names):

Exhibit A: Micron (no dividend)
Purchased for US$33.09 in August 2014
Sold for US$31.55 in January 2015
With currency appreciation, this was actually a 3.8% gain in CAD dollar terms over 5 months.
Today, it trades for $17.56 or 44% lower than our January sell price.

Exhibit B: Suncor (2%+ dividend)
Purchase for $28.42 in May 2012
Sold for $44.65 in July 2014
Today it trades at $34.33 or 23% lower than our June 2014 sell price.

Exhibit C: Corus (4%+ dividend)
Original Purchase for $21.80 in March 2012
Sold for $21.96 in March 2015.
Today it trades for $16.90 or 23% lower than our March sell price.

Exhibit D: Michael Kors
Original Purchase for US$88.85 in June 2014
Sold for US$63.46 in April 2015.
Today it trades for $43.79 or 31% lower than our April sell price.

Exhibit E: Alliance Resource Partners
Original Purchase for US$39.23 in January 2015
Sold for US$38.70 in February 2015
With currency appreciation, it was actually a 4.3% gain in one month.
Today it trades at US$24.76 or 36% lower than our February sell price.

Exhibit F: Aimia (3.7%+ dividend)
Original Purchase for $19.22 in May 2014
Sold for $18.80 in August 2014
Today it trades at $14.24 or 24% lower than our August 2014 sell price

While we had no crystal ball, TriDelta used the same discipline that we always use. This approach gave us the warning signs that there are better stocks to own than the ones we held.

Many investment managers say, “it is easy to buy, but hard to sell”.

We have a theory on why we do much better than most managers in the area of selling. With our industry experience, we note that many investment managers tend to have a strong ego. This is actually an important trait for a business that often requires managers to buy when everyone thinks they should sell, and to sell when everyone thinks they should buy.

The downside of this ego is that they don’t ever like to admit mistakes. In particular, in cases where a stock hasn’t done well, it can be hard for an investment manager to admit the mistake and sell the security. This often manifests itself in holding stocks all the way down so that they sit in your portfolio with 50%+ declines.

Whether a stock is a gain or loss for our clients does not impact our sell decision (other than near year end when we look at Capital Loss selling candidates). Our sell decision is simply based on whether the stocks are no longer acting the way that we expected or certain financials are not what we expected, and we decide to cut the cord and move on. These sell decisions are not emotional ones, but rather based on financial changes. Through this financial discipline, we can eliminate the downside of the ego that causes many managers to hold on to securities for too long.

After all, while we are here to grow your money, we are also here to protect it.

 

by Edward Jong

• Our fixed income portfolios have been managed with a shorter duration bias. This means that we will be leaning towards bonds that mature in the next few years as opposed to having most of our bonds maturing in 10+ years. We believe that, even with the cut in overnight rates in Canada, interest rates could retest the recent highs in yields. Volatility will remain a staple in the market place as higher domestic (i.e. North America) interest rates will be pulled lower with anemic growth in Europe and Asia.
• Greece default or exit from the European Union will not have a disastrous effect on the rest of Europe as financial institutions outside of Greece will have little impact. This leaves the markets to focus on what’s happening in their own backyard.
• The European Central Bank will defend the EU at all costs – ideally with hopes that Greece remains part of the union. If markets are able to look beyond their nose, it’s reasonable that we could start to see some strengthening in the Euro and higher global interest rates could be the theme for the rest of 2015.

 

by Cam Winser
 
Canada:
TSX Returns by Month were:

Top Performing Sectors were:

Bottom Performing Sectors were:

• There were a string of negative economic reports in Canada showing a weaker economy especially out west as declines in crude weighed on investment and jobs in the energy sector.
• Manufacturing activity continued to lag despite the weaker Canadian Dollar which should have been supportive.
• Valeant Pharmaceuticals was the major reason for the move in Health Care after a strong earnings announcement and more M&A activity.
• Utilities underperformed as the market had concerns rates were going to rise and adversely affect the sector by increasing debt payments. Utilities have stabilized and started to outperform. We believe rates may actually be going lower in Canada, potentially helping the sector and are looking to add to some existing holdings after this decline.
• Energy was weakened by global activity and domestic election results as the NDP won in Alberta, causing concerns of decreased profits due to an increase in taxes. Oversupply and over storage still seem to be an issue but the numbers are getting a bit better during this higher demand season which usually sees a draw from reserves.

 
United States:
S&P 500 Returns by Month were:

Top Performing Sectors:

Bottom Performing Sectors:

• Data in the US was for the most part mixed. Weaker GDP, which was subsequently revised down further, was shrugged off due to poor weather and west coast labour action.
• Jobs were added at a healthy rate as unemployment fell to 5.3% in June, home sales rose to highest levels post crisis and consumer confidence was up.
• Stronger US dollar is thought to be a burden on U.S. exports and repatriation of foreign earnings. The strong US dollar has negatively impacted what would have been much stronger earnings from US companies with large foreign operations and sales.
• Fed officials are still quoted as expecting a rate rise this year. We generally think the U.S. is stable and global growth is showing signs of improvement.
• Utility companies in the U.S. suffered a similar fate to those in Canada by declining on the expectation of a potentially rising rate environment.
• Healthcare was strong on M&A activity.
• IPO activity more than doubled from Q1 to Q2.

Dividend changes continue to be positive, with no declines in payout in our holdings. We saw dividend increases of between 1% and 18% across 9 names during the quarter, with IBM’s 18% dividend increase topping the list. Given our focus in some portfolios on dividend increases, we like to track and report on this quarterly.
 

While we certainly don’t want to see more Q2’s ahead of us, we do remain a little more cautious than normal. It is worth noting that a few years ago, nobody would be too upset with a quarter where returns were down 1%. In 2015, it feels like we are expecting markets to only go up, and a flat to down quarter is cause for alarm.
 
Historically, stock markets are negative about 30% of all quarters.
 
While there are definitely sectors of the market that we like, there does appear to be a little less positive momentum in the markets overall, and a little more punishment for stocks that don’t meet earnings targets.
 
In the short term this means that we will be more selective, and more patient with buying new names. We may have higher than normal cash positions, and we may look a little more favourably towards some Alternative Investments that are less correlated to the stock and bond markets.
 
We don’t foresee any major declines as long as earnings remain strong and overnight interest rates remain low, but sometimes a little extra precaution is in order.
  

 

Cameron Winser VP, Equities	Edward Jong VP, Fixed Income	Ted Rechtshaffen President and CEO
Anton Tucker Exec VP and Portfolio Manager	David Oliver Chief Operating Officer	Lorne Zeiler VP, Portfolio Manager and Wealth Advisor