John Arnold, Managing Director, AGF International Advisors Co. Ltd.;
Michael T. McHugh, CFA, Portfolio Manager, Dynamic Mutual Funds;
Jonathan M. Wellum, CFA, President, Georgian Capital Partners Inc.
2002 INVESTMENT OUTLOOK
Chairman: Bill Laidlaw
President, The Empire Club of Canada
Head Table Guests
Margaret M. Samuel, CFA, Portfolio Manager, Hirsch Asset Management Corp. and Director, The Empire Club of Canada; Michael Scott, Executive Vice-President, Equity Capital Markets; The Hon. Tom Hockin, PC, PhD, President and CEO, Investment Funds Institute of Canada and Director, The Empire Club of Canada; Horst Hueniken, Vice-President and Director, TD Newcrest; William F. White, President, 1BK Capital Corp.; Joseph J. Oliver, President and CEO, Investment Dealers Association of Canada; Gerald C. Throop,
Executive Vice-President and Managing Director, Equity Markets Group, Merrill Lynch Canada Inc.; Blake C. Goldring, CFA, President; and CEO, AGF Management Limited and Director, The Empire Club of Canada; David A. Brown, QC, Chair, Ontario Securities Commission; Jim C. Kelly, Director, Fixed Income Sales, RBC Capital Markets; Grant Kerr, Associate Minister, St. Paul's United Church Brampton; and Eric Tripp, Vice-Chairman, BMO Newbitt Burns Inc.
Introduction by Bill Laidlaw
John Arnold is the Managing Director of AGF International Advisors Company Limited in Dublin, Ireland.
His expertise in fund management spans over 30 years, 24 of which were spent in London, England. The AGF European equity class, his prime fund, was voted the best regional equity fund at the recent Canadian mutual fund awards.
In the early 80s he worked for one of the U.K.'s largest life insurers. In 1982 he joined Crown Financial Management and since then he has travelled extensively to evaluate markets prior to planning his annual strategy.
Mr. President, ladies and gentlemen. It is an honour to address this august body, although my message is muted as 2002 will be a modest year for equity markets.
Consensus is that 2002 will be a low inflation year globally driven by low fuel prices. At current valuations, fund managers need more than one year of low inflation certainty. If economic confidence begins to recover in early 2002 then fears will begin to arise over inflation in 2003 and the resulting tightening of interest rates by Central Banks. In the old days in London it was referred to as the "Grand Old Duke of York" - he marched them up to the top of the hill then he marched them down again! Also, markets remain hostage to the War on Terrorism rolling over into an assault on Iraq with the resulting uncertainty for oil prices.
So lets talk about productivity. We have done some work abusing statistics on relative productivity. Japan led with productivity gains in the 1970s and early 1980s and we were all buying books on Japanese management techniques. With the Japanese markets surging the perception was confirmed. The US was designated as a 'Banana Republic' in terminal decline exactly at the time that a relative change had commenced in productivity favouring the US.
At the end of the 1990s the USA was all dominant, Japan had shown no economic growth for a decade and everyone was reading books about Jack Welch and Bill Gates and the US productivity miracle.
Europe was a continent embraced by 'Bureaucratic Sclerosis' and not a contender with its trade union dominance and socialist governments. And yet, in the same way that nobody noticed the changing of the leadership of relative productivity gains at the end of the 1980s from Japan to the US, so the relative productivity baton has been passed to Europe unheralded. The business opportunity of the decade will be to become the guru of European management style with a series of books explaining the new Holy Grail of caring, sharing, consulting socialist management.
Therefore, my major theme for 2002 is buy European equities which are at a 40% valuation discount to the US. The European stockmarkets, traditionally nationalistic and minor, are now effectively one big stockmarket. European quoted companies have generated earnings equivalent to 96% of US earnings, but, the market capitalisation is 40% less (source: Datastream). The last time the P/E gap was as enormous was 1973 and in the following 5 years Europe outperformed the USA by 60%.
The growing Federal European Union becomes more real every day. The Euro currency became money in my pocket within 3 days of the start of 2002 , despite the Irish currency remaining legal tender for another 5 weeks. Europe has an economy equivalent in size to the USA with a larger population. The current high unemployment motivates flexibility for future growth. BMW, with plants and sales globally, has been able to strike its best labour deal for flexible working in Germany.
The US market remain overvalued on profit driven criteria, but, even more frighteningly Americans have forgotten that the purpose of owning equity is to receive dividends. Dividends that should grow each year so that over a long period the income return on equities is superior to bonds.
The yield today on US equities is only 1.4% compared with 2.4% on European equities.
In a bull market capital appreciation appears easy. Therefore, pay no dividends, reinvest the money saved in the company and deliver even more capital growth. Buy up new acquisitions, sell the synergy dream of future profit growth.
Then comes the bear market and corporate management realise that they bought turkeys from that charming and very rich Investment Banker - but hopefully they cashed in and sold the share options early.
I recently met a US company that had made 13 acquisitions in 3 years. They had failed to maximise the benefits and overall group profit margins had declined rather than expanded. What of the future? More acquisitions is the strategy because they have a new integration program which will make new acquisitions more efficient and grow profits. The question of "why, if it has not worked to date" was pushed aside with a very revealing answer - without more acquisitions the growth rate would be only 2% not the 5% corporate objective.
The argument that share buy-backs are an effective alternative use of dividend money does not wash when analysis shows that over the last 5 years only a handful of companies have reduced share capital successfully.
The reality is that 50% of long term appreciation from equities comes from dividends. The biggest challenge for the US equity market is rebuilding sustainable growth in profits from the rubble of the last 5 years of the technology bubble. Then the concept that equity is free will have to be replaced with a positive dividend policy.
Could we see a return to a more balanced relationship between income and capital in the USA? Because corporate profits have collapsed as a % of GNP to the low levels seen in the 1980s the potential for a rebound in profitability is enhanced.
Additionally, many US corporations have been so shocked by the rapidity of the profits collapse that the current philosophy of managing for cash generation and paying down debt may result in clean balance sheets in a couple of years if the discipline remains intact.
Cash generative rather than cash hungry companies may be more willing to pay dividends.
Therefore, despite the wall of money continuing to accumulate each month in pension plans the US equity market even with the benign economic recovery may need 3-5 years to retake previous peaks. Sideways is boring, but, there are plenty of examples of markets after a major bull excess needing a decade to recoup.
On my recent visit to Wall Street the strategists were cautious and sector analysts were uniformly negative on their group of stocks because profits are falling and therefore valuation multiples are rising.
As a contrarian, such uniformity of misery would normally make me an avid buyer - not this year though.
There is no relief to be found in Asia. Avoid Japan as it continues to be a basket case with budget deficits and continuing downgrades by the rating agencies. How can you motivate a population burdened with big mortgages and negative equity resulting from 70% losses on their house purchases after the deflating bubble of 1990?
Beware the future of the banking sector. Dominoes falling over may be the analogy from March when the Government withdraws its protection of deposits from the banks.
Mr Koizumi may not survive the year as prime minister. I spent an evening with a senior Japanese fund manager who, six month previous, had waxed lyrical about the potential for reforming the economy after Koizumi won his mid-year general election. He was so disappointed by Koizumi's subsequent behaviour that I could not persuade him to discuss politics. Instead we had 4 hours of unremitting Karaoke to forget the dream lost. My rendition of "the House of the Rising Sun" by the Animals was beastial!
In Singapore at a cocktail party I was told the US downturn in high tech was decimating Singapore exports. It was despair for all but the Feng Shui advisors. Innocently I asked "why" - "Because they get paid up front" was the answer.
To conclude, economic recovery is to be expected in 2002 but stockmarkets will be challenged by continued overvaluations as a profit recovery needs time to develop. Long live the new Federal Europe, the new relative productivity winner. The only hope for up to 10% reward in 2002.
Michael T. McHugh:
Mr. President, honoured head table guests, ladies and gentlemen, good afternoon. It is a pleasure to speak at such a distinguished forum to present my fixed income outlook. Investors who maintained or increased their weighting of fixed income securities over the last two years have certainly been rewarded. Capital preservation and single digit returns once again became an acceptable investment objective. Following two consecutive good years for fixed income the outlook relative to equities does not appear as promising. Nevertheless, a diversified portfolio of bonds should outperform cash this year.
Before reviewing my outlook for fixed income I want to comment on the role of forecasts. We all know there are few certainties when investing and this definitely applies to investment outlooks. Forecasts typically distinguish themselves by their errors of foresight. They may be based on erroneous conclusions or fail to accurately anticipate market volatility or exogenous events. Consequently, market expectations are subject to constant revision. For a forecast to be of value in formulating an investment strategy it must be a fluid process incorporating new information that impacts investment expectations.
To distill market information to create an investment strategy there are two components to my investment outlook. The first is the construction of what I consider to be the most probable economic and policy scenario based on expectations of fundamental developments. The second is overlaying a view of what capital markets are currently discounting. The combination of the two produced the fixed income outlook that I present to you today.
My base case scenario evolves from three expected developments. First, global growth in the industrialized countries will experience a modest improvement this year. While there will be exceptions, most notably Japan, the US and Canadian economies appear poised for recovery. Recent evidence suggests that the two economies are troughing but the recovery will likely be choppy and evolve over many months. In the US the contraction in the manufacturing sector, which began a year ago, will reverse but businesses will likely be cautious restocking and ramping up investment spending. Consumer spending should remain positive but will be constrained by record debt levels and a rising unemployment rate. While the situation in Canada is slightly different both economies should achieve moderate growth this year of around 2% driven by firmer growth in the second half of the year.
The second development is that disinflationary pressure will persist containing inflation this year. Slow growth, limited pricing power, unutilized capacity and lower energy prices should permit inflation to decelerate in the first half of the year before gradually rising in the second half. This year inflation will likely be around 1.5% in the US and closer to 1% in Canada.
The last point is that central banks in the major industrialized countries are close to concluding easing policies begun early last year and the Fed will likely be on hold by the end of this month. It is probable that the Fed will be the first central bank to raise rates but not before the second half of the year. Based on expectations of slow growth and the absence of inflationary pressures I anticipate the Fed will exercise patience before raising rates, and once initiated, rate increases will be gradual. As it did during the easing cycle I expect the Bank of Canada will lag the Fed when implementing a higher rate policy.
Based on this scenario and taking into account what capital markets are currently discounting, my fixed income outlook is characterized by the following four themes.
First, the yield curve will be flatter but this trend will not unfold until later in the year. Capital markets appear to be pricing in a robust economic recovery this year. This is reflected in the aggressive central bank tightening currently discounted in forward curves over the next twelve months. However, this would appear premature. Following a recession monetary tightening typically awaits evidence of re-accelerating growth and tends to be gradual. This suggests value currently resides in short-term bonds. Similarly, longer-term bonds are likely to experience periodic rallies over the near term in response to evidence contradicting a steady economic recovery. Later in the year forward-looking expectations should support a sustainable flattening of the yield curve. Consequently, as the year progresses risk resides in the front end of the yield curve.
Canadian 2-year yields could rise another 100 basis points to hit 4% by year-end. Pressures in the long end of the yield curve will be relatively limited which takes me to my second point.
Modest growth, the absence of inflationary pressures and the suspension of long Treasury issuance will limit the rise in long term US bond yields and result in a flattening of the 10 to 30 year yield curve. The long end of the Canadian yield curve should experience a similar flattening. Certainly as the year progresses bonds will be vulnerable to further price erosion as economic statistics confirm improving economic growth but the downside should be limited for the reasons just mentioned. While the risk to long bonds this year is for higher yields I expect 2002 to be characterized by consolidating price activity. Long Treasury yields are likely to be concentrated within a 5-6% range during the year.
My third theme addresses Canada's relative performance. Government of Canada bonds should outperform Treasuries this year as 10 year yields converge from the current 30 basis point spread. Four factors support this view. First, over night lending rates are likely to converge as the Bank of Canada catches up with the most recent Fed rate cuts. Second, the Canadian recovery is likely to lag the US. Third, the Canadian government will adopt a less stimulative fiscal policy than the US and fourth, Canadian inflation is likely to remain below the US rate. With the Canadian dollar currently at $1.60 versus the US dollar I believe the odds favour Canadian bonds will do even better on a currency adjusted basis.
Lastly, I expect a diversified portfolio of corporate bonds to outperform government bonds this year. While corporate bond spreads have already contracted from their recent wides of last September a more stable economic environment will contribute toward tighter corporate bond spreads over the course of the year. Near-term, corporate bond spreads are vulnerable to deterioration in equity markets as well as unforeseen supply pressures. However, any widening of spreads will provide investors with attractive buying opportunities. As always, this does not eliminate the need for diligent credit analysis. Pressures on ratings and earnings will likely continue over the next few months suggesting that investors must remain attentive to specific credit concerns. The recent credit downgrades, which has broadened the universe of BBB bonds in Canada, offer many candidates that will likely experience significant spread compression in a more stable economic environment.
From these four themes the most dominant negative impact on fixed income returns will originate from the flattening of the yield curve. I expect the 2 to 30 year yield curve to compress from it current 250 basis points to below 150 basis points by year end. The small capital erosion resulting from this bear flattening will be offset by coupon income and gains in the corporate sector to generate around a 4% return for the Canadian bond market this year.
As with all forecasts there are risks not reflected in the base case scenario. The biggest upside risk is the failure of consumers to sustain positive spending growth under the weight of high debt levels and rising unemployment. This of course would be a positive for the bond market. The biggest downside risk is a rapid global economic recovery and a US dollar reversal that would push the entire yield curve higher.
Finally, we must always be alert to unforeseen events that cause a dramatic re-pricing of capital markets. Rare is the year that does not include surprises for the investor. To these we can only be responsive and flexible to avoid being adversely affected by rigidly adhering to earlier biases. It is by following this discipline that determines an investors success rather than the accuracy of their forecasts.
Thank-you for your attention and may you have a profitable year.
Jonathan M. Wellum:
Market Outlook - Canadian Equities
Thank you for this opportunity to express my views concerning the overall market and some opportunities in the Canadian equity market. I am reminded of several expressions before I start to become too predictive in regards to my thoughts.
(i) Talk is Cheap. Supply exceeds Demand.
(ii) Buffett states that forecasters only exist to make fortune-tellers look good.
(iii) The First Law of Economists: For every economist there exists an equal and opposite economist. The Second Law of Economists: They're both wrong.
B. Our Investment Philosophy - The Power of Focus
It is absolutely essentially that I briefly articulate to you our core investment philosophy in order to properly set the stage for my comments concerning the TSE and a handful of companies of interest to us.
Our philosophy at Georgian Capital is based on five guiding principles:
1. Leverage long-term trends
Capital should be concentrated on companies positioned to benefit from long-term secular trends that provide a basis for generating sustained compound growth.
2. Invest in quality businesses
What are some of the attributes of a quality business?
(i) Proven and competent management
(ii) Reasonable capital demands
(iii) Long product cycles
(iv) Value-added products or services
(v) Barriers of entry
(vi) Pricing stability
(vii) Powerful Brand Equity
(viii) Free cash flow generation
(ix) Strong Balance Sheet
3. Purchase securities at a significant discount
What you pay for a position is a key determinant of total return!! This is a concept that people appreciate more after the last two years.
4. Avoid over-diversification
Wealth is created through concentrated well-researched positions.
5. Hold investments for the long-term
Be patient and defer taxes! Delayed gratification can result in greater gratification!
As our partners at AIC Funds say, BUY, HOLD and PROSPER.
C. General Comments on the TSE 300
Catalysts that supporting a rebounding economy and healthier stock market include:
1. Significant decrease in energy prices - cash savings to consumers estimated at (45-50 billion in the US)
2. Record low real interest rates.
3. Positive sloping yield curve, which is usually a good indicator of a strengthening economy.
4. Significant reduction in inventories over the past year. Should help stimulate capital goods market. Seeing stabilization and some increases in orders.
5. Easing fiscal policy, deficit financing in Canada and in the US an extra $75 billion in cash flow.
6. Consumer confidence is strengthening after recent lows.
D. Current Areas of Focus/Opportunities
1. Financial Services
(i) Capital Markets (Trading Revenues, Corporate Finance).
(ii) Consolidation Opportunities.
(iii) Credit and Balance Sheet Issues.
(iv) Demographics/Savings Products.
Major Stock Ideas:
AGF (Leading provider of savings vehicles, consolidation player)
TD Bank/RBC Financial (Leading retail banks with exposure to rebounding capital markets with strong balance sheets)
Power Financial (Large exposure to both asset management and life insurance products with consolidation opportunities)
(i) Continued growth in new services
a) High Speed Internet
b) Digital Television (both cable and satellite)
c) Potentially IP Telephony
(ii) Advertising Recovery
a) More pronounced in the US, encouraged by a strengthening economy, Olympics and mid-term elections
b) New digital channels provide opportunity for select few in Canada
Major Stock Ideas:
Shaw Communications, CHUM and Thomson Corp.
(i) Demographics/Aging of Population
(ii) Cost Containment/Growth in Generics/Record Patent Expirations
(iii) R&D Spending/Contract Research & Manufacturing
Major Stock Ideas:
Biovail (Specialty Pharma and Generics),
MDS (Laboratory Testing, Pharmaceutical Services, R&D equipment SCIEX 10%),
Patheon (Manufacuring & Pharmaceutical Services).
(i) Private label protects business from competition
a) Strong brands
b) Higher margins
c) Loyalty programs
d) Exclusivity to destination points
(ii) Value proposition remains the key to most consumer and retail businesses
Major Stock Ideas:
Loblaw/Weston (Loblaw is one of the best retailers in the world)
(i) Demand Recovery
a) Inventory corrections
(ii) Cost cutting initiatives
a) Companies looking to maximize margins with lower sales levels
b) Improving asset utilization rates (outsourcing/automation)
Major Stock Ideas:
Dupont Canada (manufacturing high value-added high margin products integral to many key areas of the economy),
Magna/Intier (Outsourcing opportunities still exist in the auto industry)
ATS Automation (Helping companies in numerous industries drive up productivity and lower per unit costs)
Celestica (Assisting technology companies drive up their asset utilization through outsourcing and obtaining scale earlier than they would by keeping manufacturing in-house)
E. Long-Term Challenge for Canadian Equity Markets
There is a very interesting sculpture above the New York Stock Exchange. This sculpture shows a woman representing integrity standing in the center of the sculpture with hands stretched out to both sides, holding the world's business at her sides: mechanical arts, electricity, surveyors, and builders on the left, and mining and agriculture on the right - the products of invention versus the earth. Our fore bearers understood that wealth is only created within a value rich environment characterized by integrity.
What does the word integrity mean? Webster's dictionary defines integrity as "an uncompromising adherence to a code of moral values: utter sincerity, honesty, and candor: avoidance of deception, expediency, artificiality, or shallowness of any kind."
What will have the greatest impact on our country and on our ability to create wealth over the next ten to twenty years has less to do with interest rates and fiscal policy and more to do with our moral values, our civility, our respect for life, our honesty in all affairs of life. The integrity and effectiveness of Canada's future in the world depends ultimately on the integrity and effectiveness of the faith in the hearts and lives of Canadians. Many Canadians after the terrorist attacks of September 11th finally realized that we have too much to live with and too little to live for.
In a nation that has been so richly blessed we would do well to remember the words of the great King Solomon when he states in the book of Proverbs that, "righteousness exalts a nation but sin is a disgrace to any people." You only have to look around the world to see the truthfulness of this statement. Nations in which integrity abounds are nations characterized by peace and prosperity. Businesses can make investments and allocate capital with a confidence in the laws of the land and the civility of the population.
My prayer is that Canada will be a nation characterized by integrity. May we remember the sculpture over the New York Stock Exchange; when integrity governs, wealth creation follows!
The appreciation of the meeting was expressed by Blake C. Goldring, CFA, President and CEO, AGF Management Limited and Director, The Empire Club of Canada.