An ugly bear market…

Quarterly Letter

As you can see, this is an ugly bear market. The US market has actually delivered negative performance during 7 out of the last 9 quarters (since March of 2000).

The following table summarizes the price performance of the main indices for the second quarter of this year.

Indices In local Currency In Canadian Dollars
  2nd Quarter 2nd Quarter
S&P/TSX (Cdn) -8.99% -8.99%
S&P 500 (U.S.) -13.73% -17.93%
Nasdaq (U.S.) -20.71% -24.56%
Europe (Euro) -16.28% -9.42%
Nikkei (Japan) -3.66% +1.83%

The underlying economy does not seem to be affected by all the bad news in the stock market. During the month of July, we notice that Corporate America seems to be showing a turnaround in profitability. Interest rates are stable. There is currently no incentive for the Fed to raise rates as there is no sign of inflation.

The Canadian Dollar has had one of the best rallies in recent history, having risen from US$ 0.6270 to US$ 0.6584 in 3 months. The Euro has done even better, moving from US$ 0.8717 to parity. Could this mean the end of the US dollar supremacy? Not likely! However, a little rebalancing will help the US exports and mitigate the protectionism exhibited by Corporate US recently. Tariffs on imported steel and Canadian lumber are all bad signs for “Free Trade”. In case nobody noticed, the US dollar peaked the day the Bush administration imposed tariffs on imported steel.

Oil prices were pretty much unchanged. There are rumours the US would like to have Russia replace one of the Middle East countries as a supplier of oil to the US. We are not surprised as OPEC’s share of total US crude imports is steadily decreasing.


Judging by the market performance since July 1st, 2002, it certainly looks plausible that we will have a third year of negative index performance in a row. Such an event is extremely rare. It has only happened twice since 1925. This seems like it will be a third time (although it is too early to call).

Prolonged bear markets only happened following some extraordinary events. In 1929, it was after a long period of speculation (1926-1929) on all stocks. In 1939, it was the World War II. In 1974, it was after another period of high speculation on blue chip stocks (Avon was trading at 100 x earnings). This time, it was again after the prolonged period of high tech speculation (dubbed « technology bubble »).

The stock market needs time to consolidate, weed out the excess and will most certainly embark onto another bull market in the years to come.

In the meantime, stock selection is king as the economy continues its course of growth. As mentioned in our last quarterly letter, the correlation between the stock market and the economy is at best questionable. However, the correlation between quality cash flow growth, profit growth and stock price is very high.

Unfortunately, it is not in the well known big-capitalization stocks that we will find these companies. Put it in another way, it will take more work and patience to achieve a reasonable return. During the 1990’s if investors bought the Dow and held it, they would have beaten 95% of the investment managers. The main contributor of this out performance was the decline of interest rates (from 16% in 1982 to 4% in 2000). Well, the party has been over for 2 years.

Recently, clients have been asking us about the next « bubble » in the income trust market. These vehicles have certainly gained popularity and some income trusts of questionable merit have been created. However, it always boils down to the analysis of any specific investment idea. Our view is the following:

  • The existence of bad income trusts does not preclude the existence of decent values in the market place.
  • Income trusts pay a higher distribution than the average stock. As long as our analysis shows that the distribution is reasonable and does not impede the company’s long-term assets and productivity, it is a good value to us. Besides, studies have shown that managers of public companies squander excess profit on empire-building projects that fail to earn a decent return. Investors would be better if those managers distributed corporate earning as dividends, which investors could put into new enterprises that grow faster.
  • As we all know in finance, capital, when it becomes abundant, becomes stupid. That’s why Warren Buffett insists that each division of his empire returns all profits to head office. Then each division managers will have to justify to Mr. Buffett its capital requirement for the future and its potential return. (Basically, there is a cost for every dollar invested).
  • The income trust structure limits the manager’s ability to spend freely as we have seen over the last several years. One major example would be BCE Enterprises: over the last 2 decades BCE wasted more than CDN$10 billion in acquisitions and expenditures (empire building) with no return to shareholders.
  • Last but not least, each income trust is an economic entity just like a publicly traded company. The same fundamental analysis applies and the same selection criteria are used to pick the ones we purchase.

In conclusion, we do not believe there is a « bubble » in the income trusts market. Although fluctuations are inevitable, we are confident that this market will become more important over time as investors are paying more attention to dividends and return of capital.

The Claret Team