Does anybody remember the crash of ‘87?

Quarterly Letter

We don’t have to tell you that the past quarter (3rd quarter of 2001) has yielded an abysmal return. Actually, it is the worst quarterly performance since Q3 of 1987 when the market dropped a whopping 22.54% (does anybody remember the crash of ‘87?).

The following table summarizes the performance of the main indices from July 1st to September 30, 2001:

Index In Local Currency In Canadian Dollars
TSE 300 -11.60% -11.60%
S&P 500 (U.S.) -14.99% -11.34%
Nasdaq (U.S.) -30.65% -27.68%
Bloomberg Europe (Euro) -19.48% -9.86%
Nikkei (Japan) -24.63% -18.86%

A weak economy combined with the September 11th attack on the World Trade Center convinced the Federal Reserve Board to ease its monetary policy once again. The US Treasuries short and long term rates both plunged to levels unseen since the 1960’s. We believe long-term rates could reach 4% in the coming year. Unfortunately, corporate bonds might not experience the same downtrend because of the increasing default risk due to the recession.

As for the Canadian Dollar, it declined from US$ 0.6568 to end the quarter at US$ 0.6332. It has since decreased to an all-time low of US$ 0.6200. As previously mentioned, the Canadian Dollar, albeit undervalued, can only strengthen if we have policies that attract and retain foreign investment. Instead, we have managed to decrease the value of our assets to such a level that American multinationals go on buying sprees to acquire our oil and technology companies. The Euro, on the contrary, has put on quite a show, having moved from US$ 0.849 to US$ 0.918. Nothing has changed in the Euro landscape from our perspective. We are eagerly waiting for January 1st, 2002 to arrive as this is when all European currencies must be converted to Euro or else they become obsolete.

Oil producing countries, especially the ones in the Middle East, were handed a nasty surprise when terrorists blew up the WTC. Oil prices have since plunged by 30% and continue to weaken. As the recession deepens over the next several months, hope for a quick recovery is slim at best. Moreover, the developed countries have come to realize that their dependence on oil from the Middle East has made them very vulnerable to an energy crisis in the future. We would expect more emphasis on alternate sources of energy in the long term in order to reduce this dependency on oil from the Arab nations. Unfortunately, this change could accentuate the current tension with these nations and it could lead to more violence and terrorism.

Please refer to the portfolio valuation in the next section of the report for a complete list of securities you own. You will find a transaction report that includes descriptions of selected securities that have been purchased.


The Stock Market is at crossroads following the September 11th attack on the World Trade Center. You must have read and heard enough horror stories on the event and their possible repercussions on the world economy. As is usually the case, there are two sides to the story:

On one side, The Bullish Camp cite several reasons for justifying its stand:

On the other side, The Bearish Camp also has its reasons:

  • Statistically, war is good for the Market since whatever has been destroyed must be rebuilt, hence driving the economic activity;
  • The Federal Reserve Board has lowered interest rates on several occasions, increasing liquidity in the financial system. As recently as last week, it has lowered the discount rate by additional 50 basis points to 2%. This is tremendously bullish for stocks and bonds;
  • As pessimism increases, the Wall Street saying, “The market always climbs a wall of worries, ” will hopefully work its magic again.
  • Investors lived through a “Technology collapse” that destroyed a lot of wealth. Although debatable, it took 18 years for this bull market to bring itself to the spectacular “Bubble” we witnessed in 1999-2000. As in any bubble (imagine a balloon), after it is punctured, it is impossible to re-inflate. After two decades of excesses, the following hangover has to last longer than 18 months (the excesses on the Nifty Fifty in the late 60’s took 10 years to unwind).
  • If we use the traditional measuring yardsticks, i.e. P/E, Price to book, Dividend yield, the S&P 500 still trades at lofty multiples even after a 39% decline in prices. As we enter a recession, corporate profits will fall further making the market look even pricier.

We can go on with more reasons from both camps to justify their stand; neither is totally wrong. Amid the apparently confusing and contradictory indicators, our bottom up approach and analysis gives us a very sensible explanation of what is actually going on that has significant consequences to the average investor:

There are actually two stock markets. One is represented by the Big Capitalization (like GE, Wal Mart, etc.) and the Technology companies. This is where most of the money was lost since March 2000. They are very visible to the “Average Investor” and passive investor because of the way the Indices are constructed: the Dow Jones, the S&P 500 and the Nasdag all emphasize these “big cap” and “growth” companies. The other market is represented by a large group of mid to smaller sized companies with very reasonable valuations and a good growth history. This group has undergone a bear market that lasted from 1998 to March 2000. They are since recovering and are still very “cheap” historically. They have been almost invisible to the Average Investor as their weightings in the indices are not significant enough to be highlighted in everyday newspapers. Besides, who wants to know about a paint company when it is so cool to talk about B-to-B, broadband, Internet, Optical networking, etc?

We believe that the so called stock market represented by the main indices like Dow Jones and Nasdaq might end up spending the next years (if not decade) within a large trading range, a lot like the 70’s where the Dow spent its time fluctuating between 500 to 1000 points. However, beneath this bearishness for the big caps, there will be a stealth bull market led by the so called old economy companies which have adapted and embraced new technology and don’t look so old anymore. After all, houses still have to be built, painted and renovated once in a while; we still have to eat, drive, buy clothes etc.

There are 2 main consequences derived from our analysis: Great news for active money managers and bad news for big cap buyers (average investors) and index buyers.

  • For the first time since 1982, selectivity and stock picking will be extremely important which give active money managers a good chance to beat the index performance in the next several years.
  • The Average Investor did not have to do much to outperform 90% of the mutual funds and money managers in the last 2 decades. They just had to buy and hold the top 30 names of the index like the Dow Jones or the S&P 500. Unfortunately, few had applied this strategy then and as it became more and more popular over the last several years, it contributed enormously to the build up of the “Bubble” and ultimately its demise. We believe that indexing strategies will yield low returns over the next 3 to 5 years as the markets continue to shred off the excesses and come back to a more normal valuation range, especially regarding the Big Cap and the Tech stocks.

Regardless of the outcome in our forecasts, our model will not change. We will continue to work hard in our search for stocks of growth companies that we believe have been inefficiently priced by the market due to some short term hiccups in the industry.

In closing, we are pleased to inform you that we have recently changed our database system to enhance the services offered to you. The quarterly statement you are receiving today was generated from our new state of the art system. We believe the new report format is easier to read. Please feel free to give us your comments.

The Claret Team