The document provides a market outlook and forecast for 2013 by Timothy E. Burt, CFA.
The summary is:
1) Most global stock markets performed well in 2012, led by Germany and Japan, while the UK and Canada lagged.
2) The author believes the global economy will gradually improve in 2013, with stronger growth in the second half as issues in Europe and China are addressed.
3) The forecast is for US GDP growth of 3.0-3.5% and Canadian growth of 1.5-2.0% in 2013. US and Canadian stock markets are expected to rise 12-15% with the S&P 500 surpassing its 2007 high.
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Quarterly newsletter january 2013
1. Volume 18 Issue 1 january 2013
cardinal
quarterly
Market Outlook
by Timothy E. Burt, cfa
L ast year (2012) was a good year for stock investors with all of the
world’s major stock markets up for the year. The two best performing
stock markets were Germany (up 29.1%) and Japan (up 22.9%). The next
best performing markets were France (up 15.2%), Australia (up 14.6%)
and the U.S. (up 13.4%). The two major laggards were the U.K. (up 5.8%)
and Canada (up 4.0%). Even the price of gold lagged most stock markets
being up only 5.7%. Both the U.S. and Canada suffered normal
corrections in May and November with declines of 9.9% and 7.7% for
the S&P 500, and declines of 11.5% and 5.5% for the S&P/TSX. Since the Inside This Issue
November 15, 2012 lows, both stock markets have moved steadily higher.
Cardinal Rules.................. 3
For most of the year, investors were worried about another recession,
slowing growth in China, a breakup of the European Union, a collapse of Canadian Equity Pool........ 4
European banks, war between Israel and Iran, and an uncertain political
outcome before the U.S. Presidential election. These fears continued Canada Plus Portfolios...... 4
to cause investors to withdraw from equity funds and to invest in bond
Fixed Income Around
funds or money market funds. The media continued to feed the fears
the World......................... 5
and uncertainties of investing in stocks. Not even record low bond yields
deterred investors from preferring bonds over stocks. We strongly believe Focus on Pipelines............. 6
that such an investment strategy will prove to be a big mistake in the next
few years. The Cardinal Foundation..... 6
We believe that the global economy will gradually improve in 2013.
Investment Q&A............... 7
While most of Europe is still in a recession, things should get better in the
second half of the year. After a central government leadership change in Cardinal Research............. 8
China, we think that the new leaders will refocus on stimulating growth
in the Chinese economy by lowering interest rates and increasing fiscal Cardinal News.................. 8
spending. The U.S. economy continues to get stronger and create new
jobs primarily from a recovery in housing and growth in auto sales. Now
that the U.S. election is over and there is finally clarity on income taxes,
decisions on consumption and investing should be easier to make. The
continued on page 2...
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2. last minute avoidance of going over the so-called fiscal cliff has pressure on food prices. Renewed strength in the U.S. housing
been a short term boost to the stock market. We believe there markets has led to increases in lumber costs and other building
will be a resolution of the debt ceiling issues, fiscal spending cuts, materials. Health care and educational costs are also rising. Many
and the federal budget by the end of the March quarter. This local governments are raising property taxes and sales taxes. Even
should set the stage for better stock market performance for the energy costs are starting to rise again. Inflation rates in Canada
rest of the year. We expect U.S. GDP growth rates in the range and the U.S. have likely bottomed and should gradually rise
of 3.0 – 3.5% for 2013. throughout the year back to levels in the range of 2.5% – 3.0%. If
While we don’t think that Canada’s economy will fall back to this happens, then currently low bond yields will not look attractive.
a recession this year, we do believe its economic growth will lag We expect the U.S. stock market (S&P 500) to surpass its
the U.S. with growth rates in the range of 1.5 – 2.0%. Canada’s record high (set on October 9, 2007 at 1565.15) sometime in the
housing market is weakening and its consumers are heavily in first quarter of this year. It only has to rise another 6.3% from
debt. Fortunately, the job picture remains good and interest its January 10, 2013 level of 1472.12. At year-end, we forecast a
rates are very low. New auto sales in Canada have been very closing level of close to 1650 for the S&P 500 for a full-year gain
strong. Unfortunately, we think that the federal government will of 15%. We expect the Canadian stock market (S&P/TSX) to
introduce an austerity budget this spring as it attempts to move also rise this year, but likely not to return to its previous record
toward a balanced budget by 2015 when the next federal election high (set on June 18, 2008 at 15073.13) until sometime next year
must be held. This step will likely cause provincial budgets to also (2014). It would have to rise another 19.6% from its January 10,
be cut as transfer payments are reduced. Several provinces will be 2013 level of 12600. It could still happen this year, but it would
faced with major spending cuts and/or tax increases. Regardless, require much higher energy prices to achieve it, something we
it will mean that fiscal stimulus is over, and reduced government don’t currently forecast. Our best projection for the S&P/TSX
and consumer spending will slow economic growth in Canada. is to close the year near 14000 for a gain of about 12%. These
Fortunately, corporate profitability remains high and expected returns are above those in 2012, but clearly achievable
corporate balance sheets are strong with large cash balances. given our improving economic forecast and a more stable
We should see continued revenue and profit growth this year as investment climate.
companies keep a tight rein on expenses. This should also allow Government of Canada 10-year bond yields haven’t been
for more dividend increases and stock buy backs. In the current at 5.0% since June 2004 and at 4.0% since December 2007. After
low interest rate environment, P/E ratios are low and should go reaching a low of 1.55% in July 2012, they have since recovered
higher as investor confidence improves. Most quality stocks have to 1.95% as of January 10, 2013. We think these rates will gradually
dividend yields over 2.5% and are very attractive compared to rise to 3.0% by the end of the year.
10-year government bond yields below 2.0%. Our Canadian For the past 3 years, the Canadian dollar has been trading at
equity portfolios have an overall dividend yield of about 3.5%. close to parity with the U.S. dollar. It currently trades at $1.015
Compared to bonds, stocks clearly offer higher yields and better U.S. On November 6, 2007, the Canadian dollar reached a high
capital appreciation potential. of $1.0865 U.S. Since December 2009 it has traded in a range of
Stronger global economic growth should put upward $0.95 U.S. to $1.05 U.S. We think that it will continue to trade in
pressure on agricultural and industrial commodity prices. So far, this narrow band for the next year. The major factors that influence
inflation rates have come down in both Canada (from 2.5% in the trading range of the Canadian dollar are energy prices and
January 2012 to 0.8% in November 2012) and the U.S. (from the interest rate spreads on Canadian Treasury Bills versus
2.9% in January 2012 to 1.8% in November 2012). However, U.S. Treasury Bills.
higher grain prices and transportation costs are putting upward
2 cardinal quarterly
3. Cardinal Rules world in the “mark to market” debate. You have probably heard an
investment professional argue that “you don’t have a loss if you
don’t sell” and yet others would say, “Of course you do. You could
Build Wealth have sold at $840,000 before. Now you can only sell for $750,000.”
By Henry Hudek, cfa The point that opponents of “mark to market” make is that
T he past year was a fascinating one for investors. The ‘roller-
coaster’ seemed to be a little more wild than usual as the
‘domino game’ of serial crises in Europe overshadowed a gradual
real value doesn’t change as much as the market indicates because
the market gets ‘over-emotional’ and exaggerates swings in value.
They believe that market values should somehow be “smoothed’
but tentative recovery in the U.S. economy, and slowing Chinese to reflect true value, without including the day-to-day excesses of
growth whipsawed energy and other commodity prices. In the market’s roller-coaster. This view recognizes that the market
the end, Cardinal’s Canadian equity composite returns slightly is approximately correct over long periods, but can be very wrong
exceeded 10% (gross of fees), a not unreasonable figure, and the over short time frames.
fourth year out of five where we exceeded the S&P/TSX return. As the Certs commercial used to say, “You’re both right!” ,
Unfortunately, as respectable as that sounds, the TSX returns and in that lies two very important truths. A key role in financial
over the last five years have been miserly at less than 1% per year, planning is ensuring that one never has to sell off any of their
and some clients who invested in equities in late 2010 and early wealth when one doesn’t want to, that is, at a loss. Therefore, if
2011 may still be down from their entry level. The Cardinal rule you truly intend to own these shares for an extended period, you
to BUILD WEALTH over the last 5 years may ring hollow when should ignore the current market quote, but if you have to sell,
looking at the current market value on statements today. then you should be concerned about the current market quote.
This begs the question: What is Wealth, and how do we On a day-to-day basis, the market does rule. If you have to sell
find out whether it’s going up or down? When we modern folk something (or want to buy something), the price on the market
think of wealth, we generally think of an amount of money. But that day is what you will have to live with.
consider this quote from the Book of Job, describing Job’s wealth Off course, both being right doesn’t help investors who ride
before his well-documented afflictions commenced: that emotional roller-coaster when they watch market prices
“His substance also was seven thousand sheep, and three plummet. Too often I have heard, “I can’t take it anymore. I
thousand camels, and five hundred yoke of oxen, and five hundred need to get out.” If you feel that you are in this situation you can
she asses, and a very great household; so that this man was the respond in one of two ways. The first, easiest and most obvious is
greatest of all the men of the east. (Job 1: 3-4)
“ to reduce your equity exposure.
Perhaps we should recall that real wealth is measured in The second is far less obvious and far more difficult. Turn off
what we own, and that money is simply the way to measure the TV. If you do not want to ride the emotional roller-coaster,
wealth when it comes in so many different forms. So if we receive then just get off it. It is a sign of our modern times that we can
a statement showing that the current market value of what we determine the market value of any one of our stocks to the second.
own has declined, has our wealth diminished? We can hear an “expert’ opinion daily, if not hourly. We usually feel
If we dividend investors were living in Job’s era, people might that as investors, it is our responsibility to be watching and taking
speak of us as owning 500 shares of Canadian National Rail and care of our investments. Now that information is so readily available,
700 of Royal Bank and 400 of Tim Horton’s: Truly great wealth! shouldn’t we be monitoring it? Isn’t that how we build wealth?
Instead we say, “my portfolio is down from $840,000 to $750,000.” Well, if it were only information that we were accessing,
We still own exactly the very shares we used to own, our camels perhaps the answer would be yes. But it is not usually information
are giving us more milk and our oxen are pulling heavier carts. that we are accessing. Instead, we get reams of opinion. Remember
In fact, many dividend investors like Cardinal clients own more that the media is in the business of demanding attention, not
shares than ever because their dividend income stream is constantly informing. While we feel it is our duty as investors to stay informed,
being reinvested. Most companies in our portfolios continue to the media is not the optimal route to achieving that.
increase their dividends, so if one measures wealth by the income It is absolutely an investor’s job to know what they own, but that
received, our shares have materially grown our wealth. One share job cannot be done through the media. It is done through a rigorous
of Canadian National Rail equals more wealth than it used to and ongoing review of all aspects of a company’s business and
because it generates more dividend income. So if we own as financial situation, and that is the role our clients delegate to us.
much or more than we owned before, has our wealth diminished
Real values of stable, solid, profitable companies don’t fluctuate
or increased? Should we “mark to market” values, or look through
nearly as much as the market value does. Why would you listen
that to the real value?
to mass media when real values come from earnings power and
That issue is one that has plagued the investment industry dividend payouts? Own productive camels and sheep, know their
since inception and still troubles regulators and the pension real worth, and then you can know whether you are building wealth.
Volume 18 • Issue 1 • January 2013 3
4. Introducing the Pool into clients’ overall portfolio management fee. This gives
our clients, as well as us, more flexibility for accounts that are
the Cardinal below our usual account minimums.
Canadian The Pool will be managed with the same investment
approach as our Canadian Equity composite and is only available
Equity Pool to clients who have separately managed accounts with Cardinal.
The minimum account size to invest in the Pool is $25,000 except
By Emily Burt, mba Ontario where, due to securities regulation, it is $150,000 if
T his January, Cardinal launched our very first internally
managed pooled fund. The Cardinal Canadian Equity Pool
will be a new way for our clients to invest with us. This Pool
you are not an “accredited investor” The Pool has a small
.
internal operating expense that will be capped at .25%. For more
information, or if you have any questions about the Pool, please
will not only help to diversify smaller accounts in an efficient get in touch with us.
manner, but it will also allow us to roll any accounts invested in
The Case for Canada great players. We believe there are increasing benefits to going
into some of the stable companies across the border like General
Plus Portfolios Mills, (John) Deere, Microsoft, H.J. Heinz and Wells Fargo.
There are myriad U.S. companies with a long history of paying
BY Henry Hudek, cfa regular dividends, not to mention regularly raising the dividend.
T hroughout the recent financial crisis and subsequent Corporate balance sheets are flush with cash and many have
recession the Canadian economy has held up better than some exposure to the faster growing Asian and Latin American
most of the more developed countries on the planet. This has markets. Share prices are still depressed by the touchy memory
generally been beneficial for investors in Canadian stocks, but of the crisis and by angst over Europe and U.S. political gridlock.
Canada’s equity markets don’t have everything. We have very There are some real opportunities in the U.S., and with the
few consumer goods, industrial manufacturing or technology relatively stable Canadian dollar near parity, it is a great time for
firms of the size and caliber in which Cardinal prefers to invest. Canadian investors.
As the U.S. accelerates out of its recession and Europe seems to Our Canada Plus portfolio currently holds stock in about 34
be bouncing along the bottom, we believe we have an opportunity quality companies, and is diversified across 7 sectors. Dividend
to expand out of the Canadian universe for our clients and add yields in the U.S. are generally a bit lower, but we are seeing faster
quality companies in sectors not available in Canada. For clients growth in dividends there than in Canada. A rising Canadian
able to afford the risks and volatility of the international scene dollar vis-a-vis the U.S. dollar would negatively impact the value
we offer a U.S. mandate as well as a mixed mandate we call of U.S. holdings for Canadian clients. Soaring energy prices, or
Canada Plus. The minimum account size on Canada Plus has the decline of the U.S. greenback as the ‘reserve’ currency of
been recently lowered to $350,000 and is positioned at about choice, are the major factors that would cause the loonie to sig-
60% Canadian and 40% U.S. nificantly outpace the greenback. Although we are very optimistic
Over the next few years we believe it will be highly about energy, it is unlikely that prices can skyrocket. We believe it is
appropriate for clients to give consideration to broadening their relatively safe for Canadian investors to rely on U.S. denominated
investment universe outside of Canada. There is more to the assets. We suggest you discuss with your advisor to consider if
world than Financials and Energy, of which Canada offers many there are tax consequences to moving a portion of your assets to
Canada Plus.
4 cardinal quarterly
5. Fixed Income Around because short-term bonds are less price sensitive than long-term
bonds. In other words, when rates increase, the price of a
the World short-term bond will fall less than the price of the long-term
bond would. Cardinal has also been increasing the holdings of
By Brett Purdy, cfa corporate bonds in existing bond portfolios in order to take
advantage of some higher yields. Corporate bonds from companies
M any events over the past year kept investors looking to
fixed income in safe haven countries such as the U.S. and
Canada. European debt troubles continued into their third year
such as the Canadian banks are high quality and have a credit
rating of AA in many cases.
as the focus moved to larger countries such as Spain and Italy While there are currently better opportunities in equities
where recessions and high deficits caused bond yields to rise. to obtain higher yields than can be found in bonds, there is
The markets worried about weaker global growth as China still a place for fixed income in portfolios for clients whose risk
experienced a slowdown in economic growth. China is the tolerance is low and wish to reduce volatility. In a balanced
second largest economy in the world, and slower GDP growth portfolio bonds can lower the risk of an overall portfolio,
would have negative consequences for its trading partners, providing safety and preservation of capital.
such as the U.S., Europe and Australia, which would then spill Given that negative real yields (or even very low positive
over into other countries. And of course, there was the U.S. ones) are unsustainable in the long run, interest rates will have
presidential election in November and the “fiscal cliff” worries to rise. The timing of this is uncertain and is taking longer than
heading into year-end that gave more uncertainty to the markets. anticipated as a result of the Euro crisis and sluggish economic
However, there are reasons for optimism. Europe seems to growth in most developed countries. We are wary of straying
be slowly working out its issues, China is showing signs of from short term bonds into longer term bonds because when
improvement, and the U.S. government averted the “fiscal cliff” . bond yields do increase as inflation rebounds and economic
Interest rates have stayed at ultra-low levels as the Federal growth improves, bond prices will decline. Long term bonds
Reserve and the Bank of Canada left their key rates unchanged are more sensitive to increases in yields and will fall more than
at 0.25% and 1.0% respectively in 2012. Combined with low short term bonds. We continue to emphasize shorter term bonds
and stable inflation expectations, bond yields remained low for (under seven years) in our portfolios to minimize interest rate risk.
another year. The Government of Canada 10-year bond yield We have been looking for opportunities to increase the yield
declined another 14 basis points to end the year at 1.80% while in our bond portfolios. Provincial bonds that mature in five years
the 30-year bond fell 13 basis points to 2.36%. Three-month or less currently yield below 2%. High quality corporate bonds
Treasury bills finished the year 10 basis points higher at 0.92%. rated A or better can provide around 50 to 55 basis points of extra
This resulted in a flatter yield curve as short-term rates rose and yield. We believe that this adequately compensates an investor for
long-term rates fell. We are at the peak of a bull market in bonds taking on the extra credit risk inherent in corporate bonds. By
that has lasted since 1981. Real bond yields are near zero today focusing on high quality issuers such as the Canadian banks, we
or even negative in many cases, making this an unsustainable can increase the yield in our portfolios without assuming dangerous
environment for bond yields. The timing of the official end of levels of credit risk found in bonds with lower ratings.
this bull market remains uncertain, but at some point rates must
By investing conservatively in short term, high quality
increase to properly reflect the risk inherent in bonds.
corporate bonds and maintaining a position in provincial bonds,
In anticipation of higher rates, Cardinal is maintaining we are improving the overall yield of a portfolio, while ensuring
shorter-term bond portfolios that contain bonds with maturities preservation of your capital for the long term.
of five years or less. This will help mitigate interest rate risk
Volume 18 • Issue 1 • January 2013 5
6. Focus on Pipelines Dislocation with the world prices has happened before in
Canada and the market responded accordingly by building one
By Jeffrey Rance, b. comm. (honours) of the largest pipeline systems in the world. Today is no different,
as pipeline companies are developing tens of billions of dollars’
E nergy stocks underperformed the broader index in 2012.
We believe the main proponent of this is that the market has
concerns regarding pipeline capacity and the price oil producers
worth of new pipeline projects.
Over the near term, projects such as the Seaway pipeline
receive. Production growth in U.S. oil fields has exceeded the reversal, the expansion of the BP Whiting refinery, the Gulf Coast
pace at which the pipeline system can handle the increased portion of Keystone XL, and the continuation of the unprecedented
volumes causing the price Canadian companies receive for their growth of oil on the railroads will help to reduce price differentials.
oil to become dislocated from world prices. Longer term, between Keystone XL, the conversion of the
TransCanada Mainline to oil, and possibly a West Coast option,
Over the near term this is an issue as some companies
we believe that concerns over pipeline capacity are overblown
receive a lower price for their oil and it also makes great headlines
for long term investors in Canadian energy.
when there are temporary declines in local crude prices. It does
not, however, affect all the companies in the portfolio. Companies Ultimately, we believe that the near term volatility creates
that have North American refining operations like Suncor, a buying opportunity as this will not be a long term issue. The
Cenovus, and Imperial Oil have benefited from the reduced cyclicality of the pipeline business has historically lent itself to
crude oil costs while keeping gasoline and diesel priced in short term price dislocations, but has subsequently resulted in
reference to international levels. This has resulted in refining an overbuilding of assets, which is a positive for energy producers.
cash flows that are more than double historical averages. Despite the pipeline capacity issues, the average price Canadian
Underperformance of these companies does not reflect the companies received for their crude in 2012 was the third highest
fundamentals. on record. This has resulted in depressed valuations for Canadian
energy stocks to a point we view as attractive given that cash
flows and dividends continue to grow.
2012 Year in Review • The purchase of new sports equipment for B’nai Brith Camp’s
summer camp programs
By Emily Burt, mba
• Funding to furnish two resident rooms for the Betel Home
A t Cardinal, giving back to our community is a part of
our culture. The Cardinal Foundation allows us to assist
charitable organizations that may not otherwise be able to
Foundation to help keep their seniors living in a comfortable,
safe environment
• A final pledge to the University of Manitoba – Charles
continue providing goods and services to those who need it
Bigelow Study Room, giving University of Manitoba science
most. This philosophy allows us to make a truly positive
students a place to learn, read and collaborate on group projects
impact on our community.
The Cardinal Foundation recently completed its 3rd Annual
By focusing on smaller, tangible donations instead
Sock Drive in support of Siloam Mission. With the help of Cardinal’s
of large capital campaign projects the Board and Grants
staff and an overwhelming outpouring of support from our
committee have made The Foundation’s fourth year of giving
community, clients and business partners, the “Knock Your
more successful than ever. Among the donations were:
Socks Off” drive collected nearly 7000 pairs of socks to help keep
• The purchase of new metal bed frames and mattresses Winnipeg’s homeless warmer this winter. Thank-you to everyone
for Osborne House to ensure that bed bugs could no for their outstanding generosity this year.
longer create dangerous sleeping spaces for those in need
of emergency shelter
6 cardinal quarterly
7. Investment Q&A I like Cardinal’s investment approach because of the dividend
income, but how safe are my dividends?
How many companies have raised dividends this year? Cardinal demands that the companies we own pay a dividend,
In the past year, we had over 15 Canadian companies raise their because we believe that owners should share in the profits that
dividends. Of those companies, 4 companies – Royal Bank, companies make. Of course, individual companies in the portfolio
TD Bank, Bank of Nova Scotia and National Bank – raised their can face challenges from time to time. Last year, Sun Life’s
dividend twice throughout the year. There was also impressive dividend yield crept up over 7% because its share price had fallen
dividend growth in companies across all of our industries. so low. There were reports that Sun Life would have to cut its
Companies such as Canadian National Railway, Tim Hortons, dividend. A dividend cut can be a crucial red flag because it is
Canadian Natural Resources and Suncor Energy all had notable so often a sign of a broken business model when it occurs. In
double-digit dividend increases. the case of Sun Life (as with all our companies) we continually
Dividends and dividend growth are important criteria for assessed its balance sheet and capital reserves and felt confident
companies that we invest in. It provides us with a comfort that that the dividend was sustainable. We also maintained the
we are getting paid for holding shares in that company, and we utmost confidence that Sunlife retained a strong and viable long-
continually receive more income as they increase their dividends. term business. This analysis gave us the conviction to continue
The payment and growth of the dividend also gives us confidence holding Sunlife through a period of turbulence in its share price.
that management believes that their business outlook is optimistic. More recently the share price of Penn West Petroleum has
Not only did our Canadian companies deliver on dividend fallen so much that its dividend yield is now in the realm of 10%.
growth, but we also saw most of our U.S. companies raise their We continue to monitor cash flows and the balance sheet at
dividends last year. The number of companies and the breadth Penn West and visit the company regularly to determine whether
across sectors were similar to our Canadian companies. This management continues to have the desire to maintain the
is evidence that our companies, both in Canada and the U.S., dividend. While continued weakness in natural gas prices could
operate in attractive industries which allow them to grow revenues, eventually pressure the dividend at Penn West, we do not believe
earnings and their dividends. there is an imminent threat of a cut. More important, we retain
absolute confidence that Penn West will be a viable and healthy
Similar to last year, an overwhelming amount of reported
long-term business, despite short-term turbulence. Last year,
news can affect stock market prices and cause uncertainty in
Sunlife was the best performing company in the portfolio with
the short term. Despite this, our Canadian and U.S. companies
a 48% calendar year return including the dividend. Most of this
showed strength in their business and conviction in their ability
return was the simple result of a bounce back from an extremely
to increase their dividends. It is the growth in the dividend that
low valuation. Penn West could appreciate 48% in 2013 and still
will help drive share prices higher in the long term. This will
be trading below its historical average price to cash flow valuation.
provide confidence to investors to own these companies.
Thus, we can easily envision the company as a top performer in
Terry Wong, cma, cfa the portfolio this year and believe our clients will be well served
by our decision to continue holding.
Henry Hudek, cfa
Volume 18 • Issue 1 • January 2013 7
