Market Commentary

September 2011

Friday, September 30, 2011

Global equity markets tumbled in the third quarter as investors waited for a European sovereign debt solution which has proven more difficult than first thought. Policy indecision and political wrangling on both sides of the Atlantic added to the uncertainty and investors staged a broad retreat from equity markets as the summer progressed.

Canada’s benchmark index succumbed to the uncertainty with the S&P/TSX Composite Index falling 12.0% for the third quarter of 2011. The Fund outperformed the index by 1.3% during this period slipping 10.7%. 

Stock selection as opposed to sector allocation drove the outperformance, with seven out of ten S&P/TSX sub-sectors positively contributing to the excess return. The Fund’s three largest sectors at quarter-end were financials at 30%, materials next at 25% and energy ranked third at 21%.

Overall, the portfolio management team became more defensive in the latter stages of the quarter. Within energy, we reduced our exposure from 26% to 21% selling Vermilion Energy, Enerplus Corp., and ARC Resources, to name a few, as risks accumulated in the global economy. For the quarter, the S&P/TSX Energy sector was the second worst performing (behind Information Technology), falling 18.7%. The Fund was hurt by the downward pressure of this sector with TransCanada Corporation, Suncor Energy, and Canadian Natural Resources Ltd. detracting from overall portfolio performance.

The materials allocation remained near static in the quarter, contrasting with the second quarter when our weight in this sector rose sharply. The second quarter increase in allocation was largely due to an increase in gold producer holdings. The team was quite satisfied with this weighting as we entered the third quarter and our patience was rewarded as gold reached its all-time high of almost US$1,900 per ounce on the back of euro zone debt concerns. This benefited the Fund in the quarter, as five out of the portfolio’s top ten producing stocks came from the gold sector. Among them, Yamana Gold was up 28.1%, IAMGOLD up 14.8%, Newmont Mining up 14.3% and Barrick Gold up 12.4%.

The financial services allocation turned out to be a bit of a mixed bag with familiar names in the portfolio slipping such as Bank of Montreal (down 3.6%), Bank of Nova Scotia (down 8.4%) and Canadian Imperial Bank of Commerce (off 2.4%). Less-known names did, however, aid portfolio performance with American Capital Agency (up 5.7%), First Capital Realty (up 4.4%) and CYS Investments (up 6.3%) all posting positive returns in a down market.

Also benefitting performance were non-cyclical names such as Merck, which rose 1.3% and Eli Lilly up 6.4%. Allocations to telecom, healthcare and utilities sectors rose over the quarter, incrementally adding to excess returns.

The net result of our activity over the quarter is a portfolio that’s more concentrated, holds fewer benchmark holdings and has a higher average market cap. And with the Fund’s yield north of 9%, it is also significantly higher than that of the S&P/TSX which stands at 3.1%. The top three holdings at quarter-end were Barrick Gold Corp., Suncor Energy Inc. and Goldcorp Inc.

Overall, although current economic conditions are currently unlike those that precipitated the 2008 financial crisis, late-summer market behaviour is strongly reminiscent of those times. When macroeconomic fears such as these occur, they temporarily overwhelm company fundamentals as we witness many stock prices trading in irrational fashion. These conditions make for a very difficult environment to pick stocks in the short-run, but also afford numerous long-term opportunities to swap into or add to new names. We are starting to see significant value in a number of cyclical names and have purchased a few due to compelling valuations.

On the whole, however, we’re patiently waiting for some sign of a globally-coordinated policy response to remedy the Greek situation before we become more aggressive. What we’d like to see is a combination of currency management, banking co-operation and collaborative monetary easing. Whether it comes to pass is anybody’s guess but we remain optimistic that financial turmoil does not run beyond the control and influence of key global policy makers. If it does, we may still see a return to the printing presses which would further spur a run to hard, productive assets.