Portfolio Performance

My very unaudited portfolio performance in the fourth quarter of 2010 is approximately +9%. For the year ended December 31, 2010, the performance is approximately +28%.

You can read the Q3-2010 report here. The 2009 year-end review with 2010 commentary is here. I also keep the links in the upper-right hand sidebar.

Portfolio Percentages

At December 31, 2010:

12% Equities [3 issues]
37% Income Equity [3 issues]
21% Short Term Corporate Debt (Average term: 1.5 years) [6 issues, 5 companies]
8% Long Term Corporate Debt (Average term: 18 years) [2 issues, 1 company]
22% Cash
(Note: “Income Equity” is the term I used to describe equity in companies that give out over 75% of their cash flows as dividends).

Blended together, the current yield on the portfolio is 5.5%. Excluding cash, it is 5.9%. Yield numbers are lower than prior figures due to income trust conversions (along with their lower dividend payouts).

Portfolio Commentary
The portfolio performed much better than my expectations. For the year I was expecting a high single digit return, but principal increases in my core holdings continued to buoy the portfolio. I have been taking advantage of price increases by trimming positions and reinvesting proceeds into other prospects that have a better price/risk ratio.

During the second half of the year, a substantial amount of the portfolio was in cash (between 20-25%). This dampened gains (or potential losses!), but also gave me the ability to fish for opportunities as they come. There were some candidates that came along the way, but many fish saw the hook and decided to swim away (i.e. they never hit my buy prices).

Price increases in the income equity category assisted with portfolio increases, and timely trimming of long term corporate debt positions early in the quarter also assisted with gains. Earlier in the quarter I also trimmed my largest income equity position.

The portfolio has accumulated equity in low-or-no yield companies. I made an addition in the oil and gas sector – this acquisition (a 3% stake which would have been larger had the units fell further than they did) was after an announced dividend cut after their corporate conversion, combined with large capital expenditure announcements. I was aiming for 5%, but 3% will suffice.

I also made a significant (7%) investment in a particular company that has exposure to defense and another technology that is directly transferable to the civilian sector. Due to some rather lucky market timing on my entry algorithm, this is now at 8% of the portfolio.

Incidentially, 2010 was a year of very low transaction volume – the commissions paid for the year was considerably less than 0.1% of portfolio value. While one never knows the volume they will be trading at the beginning of the year, 2010 had the lowest volume of trading relative to portfolio value. In contrast, 2008 was the highest, when volatility was like a yo-yo.

In terms of taxation, the CRA will be quite happy in 2010. A healthy amount of gains accrued from 2008 and 2009 were liquidated, substantively all of it in corporate debt. When you see the Canadian Ministry of Finance release lower than expected deficit numbers, you will know where some of it came from.

Economic Ramblings for 2011
There are many economic undercurrents in play in 2011. An investor has to successfully put on their macroeconomic hat in addition to knowing the industry and companies they invest in. It is very difficult to get everything correct, but investors that do get all of their variables correct will be handsomely rewarded with future gains. Here are some brief thoughts on the various issues and the risks that are entailed:

Canada - Domestically, we have a government that is due for an election. One political issue of contention will be the reduction of the large corporation tax from 16.5% starting on January 1, 2011 to 15.0% starting on January 1, 2012. Although polling would suggesting the existing Conservative government would be able to win the largest number of seats in the House of Commons, it is not at all certain that they can maintain government. If this happens, there will be significant instability and I would treat this as a buying opportunity… a couple months after the media goes nuts.

The Bank of Canada raised short term rates to 1% in 2010. The futures market also predicts that this number will be rising by 0.5-0.75% by year’s end. This obviously depends on whether economic growth can continue, and the state of the Canadian dollar. I do not believe the Bank of Canada will raise rates until the 10-year bond trades above 3.6%. Right now it is at about 3.2%.

The high Canadian dollar will also dampen economic activity on the exports side – especially with the USA, whom forms about 80% of our export market.

The rising commodity markets has assisted with Canada’s rise in currency value, much to the detriment of its manufacturing base. This is a classic East (manufacturing) vs. West (commodities) battle that will be forming the basis of domestic politics. Canada is a great place to invest because of the stability of its legal regime, but try not to pay a premium for it.

Vancouver Real Estate - From a valuation perspective, Vancouver Real Estate has long since traded above levels that could be rationalized by income generation. Indeed, when maintenance and other financial carrying costs are priced in, putting money into Ally at 2% is a more profitable decision. The market is dominated by price insensitive demand (especially Chinese capital flooding into condominiums in suburbs like Richmond) coupled with an implicit assumption of capital appreciation that financially transcends rationality. With relatively cheap (5-year 3.7% fixed) and government subsidized (CMHC) mortgage debt, a relatively small amount of equity transforms into the hopes and dreams of easy money – until the party runs out. When might the lights turn off? My guess is when the Chinese economy goes into recession.

China - Keep your eye on the following chart of the Shanghai Index:

As the stock market should be a leading indicator of economic activity, you wouldn’t expect Chinese growth to be reported at 9% levels judging from how their stock market is trading. As the Chinese economy has been growing like the USA during the 19th century industrial revolution, their economy should also exhibit the same booms and busts. Time will tell.

Already you hear of stories “on the ground” of significant inflation, which suggests that they will need to raise their interest rates in order to rein in surplus capital. The only downside to them doing this is that it will provide huge pressure for a positive revaluation of their currency, and this will kill their export market – and result in their market crashing.

The real question is how does a North American investor react to a Chinese stock market crash? The ripples would hit Canada and the USA in the form of decreased commodity pricing. Along this line of thinking, buying longer-dated puts in China-related ETFs may be a profitable venture – both price and volatility.

USA - After the 2010 midterm elections, Congress is hamstrung, which would suggest that the US economy should perform better than expected, barring disruption in China. As to how much better is difficult to say, but I would generally be more bullish on the US than most are at present. I am focusing a lot of my research in the USA and am looking for options to deploying my US currency. The markets have already picked up on this, with increasing government bond yields and the S&P 500 at year highs.

Although the USA has huge fiscal issues, I do not expect them to show up federally – the canary in the coal mines will be municipalities and states. Whether the federal government will choose to carry the states’ debt burdens or not is another matter. But they will be passing the buck until the bond market tells them “no more”.

Despite what a basket case the USA seems to be, especially in the government and fiscal management of government jurisdictions, it is astonishing to think that they may perform better than expected – at least in the first half of the year.

Oil - Crude oil continues to be everybody’s energy of choice. It has a strange dynamic with all the other economic variables as higher prices act as a friction on nearly everything. As oil goes higher, everything else will dampen. That said, the supply-demand dynamic of oil continues to suggest that it will head higher. People have gotten well-adjusted to US$80/barrel oil, and until the media starts to pump daily headlines about the price of oil, they will continue to pay. I do not expect oil to skyrocket to US$150/barrel like it did during the 2008 speculative binge, but it could get close.

Barring an economic crash in China, crude oil investors should continue to smile in 2011. Although there is some supply hitting the market in various areas (Canada and Russia), fresh supply will be overshadowed by increasing demand. There may be a “head fake” or two in the oil futures, but the reality is starkly obvious – finding easy oil is gone.

Natural Gas - Major producers such as Encana have stated that current prices (around $4/mmBtu) are unsustainable. Commodity pricing is determined by supply and demand, rather than cost and consumption. Inevitably natural gas has to rise, but I expect that 2011 will not see a “turnaround” for the commodity as “use it or lose it” drilling leases encourage supply flooding the marketplace. It should be pointed that the raw energy differential between Crude Oil and Natural Gas continue to remain at all-time highs and this will attract some investment on conversions. However, one year is not a long time to shift energy demand from one fossil fuel to another. 2012 should be a different story for natural gas.

Gold - I would prefer to invest in oil than gold, but if enough people believe in the erosion of the monetary system, gold seems to be the default standby. I do not know much about this metal other than when you hold a physical gold bar, it feels powerful because it is a high density metal. The same can be said for Uranium.

Rare Earths - Take a look at Uranium in 2005-2006 and extrapolate what part of the curve most Rare Earth companies are trading at. An elementary analysis of a company like Molycorp (NYSE: MCP) will highly suggest that valuations are very frothy, especially for companies with no operations. Cyclical markets will correct themselves as new reserves are established. Unlike oil, finding rare earths is much easier at present. You might be able to trade in and out and get a quick double on your investment, or you might have caught the top – speculative froth like this is very difficult to game without deep pockets, and stocks like these attract plenty of gamblers.

Geopolitical - There remains unresolved geopolitical issues that one must keep an eye on – Iran vs. Israel, South Korea vs. North Korea, Russia’s influence in Eastern Europe and Central Asia, and finally the sovereign debt issues in the Euroland. All of these could appear on the radar for a lot of investors, or they may not.

Outlook for 2011

The general theme of 2011 is to prepare for shocks, but in the meantime your portfolio should climb the “wall of worry”. While the nominal course of action would suggest that the economy will plod along without surprises, there should be a few curveballs thrown around. It is impossible to predict what the curveballs may be or when they are thrown, but it is important to get a good swing at them when they arrive. You can only swing at the curveballs when you have cash in the portfolio, hence this is why the portfolio allocation of low-yield cash is currently quite high.

A 2010 example of a curveball was dealing with the Deepwater Horizon Oil Spill. Investors that were patient and waited for their opportunities when the geopolitical risk was maximized was rewarded with speculative returns.

Another example was the investment climate concerning the European Union’s debt crisis in Greece.

The baseline state of the marketplace, however, suggests that equity assets, especially high yielding securities, have all been bidded to the roof – as interest rates are low, investors have been trying to chase yield. The ultimate consequence of this are inflated asset prices on stable dividend-yielding securities. Utility companies, for example, are completely off my radar due to valuation. Most income trusts that have converted to corporations are trading at their upper price ranges. Preferred shares are also giving skimpy yields. Most of the money to be made in the markets are likely to be made if the securities don’t give out a yield.

If I were to guess the geography that was to cause a volatility shock in the marketplace, I would be most concerned with China. However, predicting when their economy has lit too much gasoline is impossible. It could happen in 2011, or it could not. Without having the research arm of Goldman Sachs on my side, it is very difficult to determine what goes on the other side of the Pacific Ocean – figuring out what’s going on in Canada is difficult enough.

It is entirely possible that cash will be the best performing asset class in 2011, but I would want to “lock” in this statement sometime in the first half of 2011 – right now, fighting the flow of very easy monetary policy will be damaging to my portfolio.

I am sure this expression is intruding upon a Yogi Berra quotation, but I will say it anyway: volatility will be muted, except for when it isn’t. I do not know if we will see shocks, but until we do see some volatility, I do not think we will see much in the way of opportunity.

Predictions for 2011

Take these predictions with a grain of salt:

* The US Federal Reserve raises the short term rate by the end of the year. Thus, it follows that:
– The US Dollar will rise relative to the Canadian Dollar in 2011 (close of 2010: 0.9945 USD = 1 CAD).
– Spot Gold ends lower at the end of 2011 than the beginning of 2011 (close of 2010: US$1421/Oz).

* An equal-weighted basket of the five big Canadian banks (BMO, BNS, CM, RY, TD), purchased at the December 31, 2010 closing price, will underperform a 1-year CAD treasury bill yielding 1.4% on December 31, 2010. (NOTE: dividends and interest are not reinvested in this prediction).

* My unconventional prediction for 2011 is that US cash will outperform the S&P/TSX Composite Index (link) starting February 28, 2011.