No more cash for trash

"No more cash for trash," says Tom Trimble, CIBC Wood Gundy. This catchy theme tracking through private equity investing is explored below by CIBC Wood Gundy's investment expert, Tom Trimble:

It is hard to believe that it has been just over a year since the collapse of Lehman’s and the ensuing market maelstrom. At one point it appeared that the whole financial system was at risk, but the concerted effort of governments around the globe staved off disaster. While conditions have improved markedly, the sheer volume of conflicting information and opinion on what the future holds is staggering.

What we do know is that both the credit markets and the equity markets have roared back from a near death experience. Over the past month we have been conducting a number of annual reviews with clients that have their birthdays in the fall. Part of the meeting has been a discussion of the performance of the portfolios from a year-to-date, one year, and two year perspective. This coincides with the beginning of the meltdown in the U.S. and includes the worst days of 2008 and 2009. It has been encouraging that over this time period the “total” return has been only modestly negative, much better than most expected.

So what now? We would like to discuss several themes that are shaping our current thinking.

Bullish On Equity

As most of you are aware, at the height of the crisis we chose to move into corporate and high yield bonds as they offered the best risk-adjusted return at the time. If the number of bond issues that have come to the market since then is any indication, then credit markets have experienced a rapid thaw from the frozen conditions of March. The difference between Government of Canada bond yields and low grade bond yields has narrowed to almost pre-Lehman levels. At the same time the yield on cash assets have shrunk to almost zero.

While nobody wanted bonds in March, we now find that there is tremendous demand for any type of income product regardless of quality and yield. We are no longer buying much fixed income due to low interest rates and are thus more interested in equity that offers attractive yields and potential for capital appreciation. We feel that equity offers us the best risk adjusted return opportunity, especially the high quality companies that have lagged the market over the past six months. That being said we are very careful about what equity we wish to own. See “cash for trash” below.

In our last commentary we mentioned that we had created four CPMS branch portfolios. We have been meeting every Tuesday as a group to review the portfolio and to make any changes we deem necessary. Since we started on April 1^st we are happy to report that the CPMS portfolios have been excellent performers. Over the next few months we will be integrating the companies highlighted in these portfolios into our accounts. Stay tuned.

No More “Cash For Trash”

We have talked about this issue before, but it is worth repeating. In fact, CPMS has analyzed the characteristics of the best performing stocks over the past six months and it was clear the only positive attributes for these companies have been a low price to book ratio and high earnings expectations in the future. Once the governments stepped in and guaranteed the financial system, these companies were tossed a lifeline and their stocks moved up. This “hope trade” helped move these stocks through several technical barriers and many speculators/investors piled in for the ride. This ride has continued, especially with the commodity based stocks.

We feel that with the third quarter results being posted now, there will be a shift away from these higher risk stocks to the less risky, more consistent companies with steady growth in profits, and good balance sheets. It is our opinion that, in times like this, these are the companies that deserve a premium valuation. There may be a few extra innings on the “cash for trash” trade, but we are beginning to position our portfolios into the companies that offer steady profits, solid balance sheets and may not have moved with the market.

Currency, Commodities And Gold, Joined At The Hip

We are bullish on materials, energy, and agriculture over the long-term based on the age old supply/demand principle. Unfortunately, the U.S. governments’ ballooning deficit adds another dimension to this investment thesis. Since commodities are priced in $US, the movement in the dollar affects the price of commodities, but this does not necessarily improve energy, material, or agricultural companies bottom lines.

For example, if the $US declines by 10% and oil prices go up 8%, the net affect to a Canadian oil producer’s net income is actually negative as they have to convert their income into $CDN and most of their costs are in $CDN. Unfortunately most investors focus only on the price of oil and bid up oil shares as the price of oil goes higher without factoring in the effect of the currency. We don’t like investing in commodities that are inflated by short-term movement of the $US and would prefer to buy them when it is clear that demand is increasing faster than supply.

While we have seen some “green shoots” in the economy, we need to see sustainable demand in the developing world for the rally in commodities to continue based on supply and demand. At the moment, 40% of the China’s GDP is government stimulus spending. This kind of stimulus is not sustainable forever so we would like to see more growth coming from the consumer. If we see a correction in the $US and thus commodities we would add to our positions.

The World, It Be A Changing

Two years ago, all the talk was about the decoupling of the developed economies from developing economies. During the financial crisis this theory was put to the test and failed as all markets declined together. Now that we are in the recovery phase it is becoming abundantly clear that 2008 and 2009 were bumps in the road for these economies of China, India, Brazil, and Latin America.

Their balance sheets and banking systems are in solid shape. They have tremendous potential for consumer growth, they are great savers, and they did not see the asset bubbles from too much leverage that the OECD nations experienced.

If we look at the U.S. we see exploding public sector debt, a huge inventory of homes in foreclosure or about to be foreclosed, decreased consumption and increases savings by consumers, which would indicate a slow rate of recovery.

It is our opinion that we will gradually see a shift from the U.S. being a consuming nation to one that grows through exports. Meanwhile China, India, Brazil, Latin America, and Asia will generate less of their GDP growth through exports and more through domestic consumption. Growth in these economies will place demands on the supply of materials, energy, technology, agriculture, infrastructure and specialized services/industries.

Canada is well positioned to benefit from this economic shift through our commodities, however, our manufacturing sector will suffer with the continued decline of the $US. Our banks have done well recently, but will likely trade sideways for a while until there is visible proof that Canada’s economy is recovering with some strength.

CIBC Wood Gundy

Lisa Applegath Tom Trimble

Investment Advisor Investment Advisor

Contact: Fossati, Susy mailto:Susy.Fossati@cibc.com