Commentary

The fourth quarter of 2011 finally gave equity investors a break from the double-digit losses of the third quarter. The Fund rose approximately 1.5% during the quarter, compared to a 3.1% return of the S&P/TSX Composite Index (TSX), while the loss for 2011 came to -3.2%, compared to -8.7% for the TSX.

The bifurcated equity market in Canada manifested itself in fund flows to lower beta, higher yielding names. For example, of the top-twenty performing members of the TSX in 2011, five were pipelines/midstream processors. Other top performers included a telecommunication company, utilities, two health care/ pharmaceutical companies and a REIT. Investor risk-aversion has pushed valuations of several names among this group to some of the highest ever, in both relative and absolute terms. While I’ve been pointing out for a while that valuations for certain defensive, yielding equities have been stretched, by late 2011 the envelope had been pushed. While prices can continue to frustrate prudent value-conscious investors, one has to seriously question the valuation applied to some regulated, capital–intensive, or low-growth businesses.

The Canadian fixed-income market— also the recipient of fund flows for those seeking safety amidst economic uncertainty and Europe’s debt crisis — fared much better, rising 9.7%. Long-dated provincial and municipal bonds were the best performers, with shorter maturities and corporates underperforming. Like equities, bonds too can become overvalued. If one looks at the rate of inflation investors are expecting in the future, yields on Canadian government debt (and that of the U.S., Germany, etc.) at the end of 2011 are below break-even. In other words, barring a lower rate of inflation, these bond investors will lose money in real terms. The only scenario that works for them is a global depression.

Over the last quarter, the Fund deployed cash as global investors finally had to face up to the fact that some governments won’t be able to pay their obligations. Equity prices briefly began to price in fear, although as pointed out above, certain sectors were less impacted than others. The Fund began to pick away at the shares of industrial and cyclical companies that were being priced for recession, or where earnings expectations had been drastically beaten-down. Despite all the bad news from Europe, The U.S. had seen a number of economic reports that, since June, had been beating expectations: but why let a little good news get in the way of a scary story. The Fund also added to convertible bond positions that had declined in price in October /November.
The end of 2011 is certainly welcome. It was a year when treasuries in the U.S. rose, despite a cut to their credit rating, and prolonged, needless, budget bickering and posturing. Investors across several asset classes have flip-flopped violently in terms of risk exposure. The euphoria that accompanied the expansion of the U.S. Federal Reserve’s balance sheet in Q1 gave way to despair in Q3, as politicians the world over bickered and postured about how to deal with effectively bankrupt countries. The cost of large deficits and bailouts will be slow growth and possible political and social unrest, which will continue to create uncertainty (volatility), which will provide for opportunities.

The silver lining is that economics suffers from “physics envy”: that despite its many models and algorithms, in the end, it’s human emotions that over or under pay for risk. The same forces also lengthen or shorten the duration of investment horizons, depending on how greedy or fearful the market feels. Those willing to be patient and not invest in the rear- view mirror are more likely to be rewarded by the capital markets.
Eric Dzuba