Resources based economies outperform the industrial ones

Quarterly Letter

2004 has definitely been the year of the commodities. Energy, base metals and other raw materials prices have all gone up tremendously. Therefore, resources based economies (such as Canada, Sweden, Australia and New Zealand) have seen their stock markets outperform the industrial ones.

The following table summarizes the price performance of the main indices for the 4th quarter and the year of 2004.

  4th Quarter Year 2004
  in local currency in Cdn dollars in local currency in Cdn dollars
S&P/TSX (Cdn) + 6.67 % + 6.67 % + 12.48 % + 12.48 %
S&P 500 (U.S.) + 8.73 % + 3.62 % + 8.99 % + 1.01 %
Nasdaq (U.S.) + 14.69 % + 9.29 % + 8.59 % + 0.63 %
Europe (Euro) + 5.70 % + 9.78 % + 9.35 % + 9.05 %
Nikkei (Japan) + 6.15 % + 8.47 % + 7.61 % + 4.19 %

The US economy has actually been quite strong last year despite a fairly weak job market. History has shown that consumer spending will not be sustainable without growth in new jobs. We mentioned last quarter that we expect a recession in the next 12 to 24 months. Although it is still premature to worry about it, a little caution would not hurt.

The Canadian Dollar had a gangbuster year, ending at US$ 0.832. We have been bullish on the Loonie for many years. However, while we are still optimistic about our parity prediction (with the US Dollar) by the end of this decade, we don’t think it will get there in a straight line. In fact, with all the negative comments and forecasts regarding the US Dollar, trade deficits, debts etc., we would not be surprised to see the reverse happening in the short term, i.e. a surprise strengthening of the US Dollar against the Euro, the Yen and the Loonie. Consensus in financial forecasts, especially in currencies, never pays off.


For those of you who expect some sort of financial forecasts in the following pages, we are sorry to disappoint you. First, we do not have a crystal ball to tell the future; second, there are enough forecasters out in the market so you really do not need another opinion; and last, we were taught that: “in the forecasting business, you‘d better forecast often…” and we believe we have better use for our skills and get greater results for our time spent analyzing companies.

That being said, we do have a few concerns regarding some consensus forecasts that you have been reading in your daily newspapers. We will voice them here and urge caution if need be. After all, we are paid to worry…

  1. The whole world is looking at China in awe, with its high economic growth rate and wonders how they can get on board and get rich fast. Financial magazines, along with investment and mutual fund dealers suggest a panoply of strategies, ranging from direct purchase of Chinese stocks to commodities funds. While we will certainly not disagree that China is an economic power to reckon with in this century -- we actually dedicated the 3rd quarterly letter to the Middle Kingdom --, we ‘d like to remind investors that:

    • Economic growth does not follow a straight line. The US experienced at least 10 “boom and bust” cycles over the last 120 years on its way to become THE economic powerhouse of today. Let us not forget also that these cycles include the 1929 depression (when stock markets lost 90% of its value) and the 1974 recession (when it lost 50% of its value). As of today, Japan is still struggling through the deepest domestic economic contraction ever, having seen its stock market lose 75% of its value since 1990.

    • Contrary to some optimistic forecasters, economic soft landing (slowdown in economic growth without going into a recession) in a country that has been growing at close to double digit rate is unheard of. Recession is the way the economy cleans itself out of the excess that has been built during expansion. The longer the expansion, the greater the excess and therefore the more painful the clean up will be. The best analogy we can give you is the following: One does not have to be a big drinker to know that the ensuing hangover is proportional to the amount of alcohol ingested.

    • Most of the publicly listed Chinese companies are still controlled by the Central government and corporate governance is non-existent. God knows how many “Enron”s there are in China. Considering the weakness of its banking system, the poor state of its banks’ balance sheets caused by massive amounts of bad debts, one must wonder how profitable “Corporate China” really is (would you not pay back your loans if you were making money? And if so, where are those bad debts coming from?) As commodities have all gone up in prices over the last 2 years, one would expect some adjustments in import prices in the US. Yet, excluding energy and food, there is almost no inflation in import prices. Is “Corporate China” not absorbing the cost of rising raw materials prices to the detriment of its bottom line? We really do not have answers to these questions and therefore are quite cautious on the subject. It could well be that the Central Government’s goal is to have full employment instead of profits. It is not that far fetched considering the fear that Chinese ruling party has if unemployment skyrockets. Riots in China never end in peace; remember Tian An Men in 1989?

  1. We have also noticed the rising popularity of income trusts and related mutual funds. Investment dealers are raising billions of dollars through all kind of trusts vehicles with an objective of paying an unusually high income. We certainly like these investment vehicles, as you can judge by the amount of income trusts we own. However, let us not forget that:

    • These securities are equity related. We have done thorough analysis on every one of them before we bought them. Moreover, they are basically small cap stocks with big dividends. Therefore, diversification is of utmost importance.

    • With such high popularity, we are afraid the sector is getting to be a little bit crowded. Looking at the new income trusts Initial Public Offerings schedule, the quality of some new issues is somewhat questionable.

    • Unlike government bonds which are subject to basically one risk – the interest rate risk --, income trusts could deliver a “double whammy” on the downside – besides (1) interest rate risk, (2) distributions could disappear because of bad business conditions, consequently dragging the unit price down by the same token.


From our readings throughout the year, we have gathered some very interesting comments from people and reporters, some we consider very wise and knowledgeable, others we consider a reflection of mass psychology. Here they are. We certainly hope you‘ll enjoy them.

  1. Warren Buffett’s comments on Bill Gates’ $300 million worth of Berskhire Hathaway holdings and his joining the Berkshire’s board of directors: “…Charlie (Munger) and I love such honest-to-good ownership. After all, who ever washes a rental car?”

  2. Winston Churchill on taxes: “I contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle”.

  3. In the Wall Street Journal, from an investment “advisor” from American Express, regarding the public’s feeling on the US Dollar: “…Three years ago, a lot of clients would say, “Whatever you do, don’t put any money overseas”… Now, they think it makes sense…”

  4. Jeremy Grantham, investment manager, on his portfolio: “…we have learned the hard way that if you take too extreme a position, even though it will be the best in the long term, you won’t have enough business left to celebrate the long term…” [That is to say that markets can stay irrational a lot longer that you can stay solvent].

  5. Jim Rogers on China after his recent trip:“…The country is heading for a hard landing in the next 12 months. The pullback will affect not only Chinese companies but world commodity prices as well…and when it happens, I hope I’m brave enough, smart enough, and alert enough to pick up the phone and buy a lot more commodities and a lot more China.”

The Claret team