January 2010 Commentary

At Kingwest, we are long-term investors in businesses. We assess how much a reasonable person should be willing to pay to own the entire company. We invest only when the share price is at least 40% less than our assessment of intrinsic value. We prefer businesses where value is increasing.

We sell when the share price approaches intrinsic value, and continue to reinvest in other opportunities where the discount to intrinsic value exceeds 40%.

The last decade was one of the most challenging equity, credit and economic environments since the Great Depression. We ended 2008 and began 2009 at the very trough of this calamity. Nevertheless our experience over the past 27 years indicates that the best investment opportunities come at the bottom of an economic cycle. We look to the future with optimism.

The Lost Decade

The twenty first century started with the tech bubble, endured September 11, the war in Iraq, the rise of China, the credit crunch, and ended emerging from the ‘Great Recession’. The return of the Canadian equity market was 5.6% per year for the decade. On a relative basis that was great. The US, European, and Japanese equity markets all suffered declines - their worst ten year performance since the 1930’s. A few other countries had positive returns but all were well below historical norms. Even in China where the economy soared at a double digit rate, the stock market rose at less than 7% per year (less than 4% in terms of Canadian dollars).

In this ‘Lost Decade”, the stock market endured two major declines of about 50%. In 2009 we learned yet again that the world is cyclical.

Is the market more volatile now than before? The information age was thought by some to bring a steadier, more rational basis to the securities market. The glut of information did the opposite. It exacerbated the wild swings. It is no wonder; our news is increasingly coming from 24 hour business channels and the Internet that are at best 10% news, 90% opinion. The knowledge gleaned from these sources is broad, superficial and frequently unencumbered by fact. It is trite to say that 20 second sound bites and two paragraph summaries lack depth, yet many investors – both individual and professional - seem to base their actions on them.

Value is a function of the future. Decades of research into securities markets confirm that assessing value requires knowledge, insight and judgment that come only from in-depth analysis. If you do not understand a business, you cannot come to a realistic judgment of what it is worth. Price is just a reaction to the present.

Kingwest is different. We are long-term, disciplined investors and we are patient. That means we can hold existing investments until markets are higher and more liquid and can exit at full value, rather than being forced to sell into a rapidly deleveraging market. Our discipline also allows us to be more aggressive in a depressed environment when we can deploy capital to the maximum benefit of our investors.

There is hope for optimism

Today, as we begin 2010, conditions continue to improve. We are in the early stages of economic recovery, in Canada, the U.S and internationally. Continued global government stimulus programs, coupled with inventory restocking, are currently contributing to improving earnings and GDP. Asia and Latin America are experiencing strong economic growth. The extent of the current economic improvements in North America is becoming much clearer.

If we look at how the economy has behaved on previous declines of this magnitude, we should expect growth in the next twelve months to be 6–8%. Consensus forecasts seem to be well below that. Most people who forecast these things (we do not) expect growth will be about 3–3.5% -- roughly half of normal. So instead of regaining all lost ground within about seven months, it looks like it will take about fifteen months – slower than normal growth, but a recovery nonetheless.

This is the expectation we have built into our assessments, as we mentioned in our last commentary. As the economy approaches new peaks so too should the stock market.

The primary cause of the slower recovery in this cycle is that U.S. consumers entered the recession carrying a heavy burden of debt. They are still in the process of unwinding their debt, which is depressing spending.

Household savings however is increasing dramatically. We have seen a huge appetite in both Canada and the U.S. for fixed income securities as saving increases and yields decline. This is a normal pattern; people move first into securities with the highest credit standing then begin to move on to the less creditworthy securities as yields on the safest assets become less attractive. Today very little has found its way into the equity market; the thirst is still for income.

This will change. Consider the pattern of interest rates. The spread between U.S. Treasury bonds and the lowest investment grade (Baa) corporate bonds has narrowed to its lowest level since July 2007. People have been moving from safe assets to more speculative ones as safe assets returns became unattractive. Dividend yields on common stocks remain attractive.

Source: Bespoke Investment Group

Portfolio Update

The Portfolio has never been better positioned. As of December 31, 2009, Toronto Dominion Bank, Royal Bank, American Express and Ingersoll Rand were amongst the largest holdings in the portfolio.

Due to the dramatic movement of the market in the last nine months of last year, portfolio activity was much greater than normal. We used the opportunity provided by the dramatic shifts in relative prices either to add new securities that became uniquely cheap or to substantially improve quality. We also purchased more shares of our companies at reduced (sometimes ridiculously low) prices.

On average the businesses we own produce very high returns on capital while maintaining strong financial positions. Most run global operations with significant revenues outside of North America; thus we participate in emerging market dynamics even in our relatively concentrated portfolio of North American based companies. These companies have the ability to produce above-average revenue and earnings growth in the years ahead. Today the value gap in the portfolio remains in excess of 50%.

In January of 2009, almost no one thought that the incredible equity results of the year were possible. That is the unpredictability of securities markets in the short-term. Over the longer-term returns trend towards their average and saner minds prevail. There is still quite a way to go to reach the previous market peak. We are confident that security prices will go through those levels but not in the way that the general media might expect. The important point is to stay the course and let the dynamism of the North American economy work on your behalf.