January 28, 2010
GLOBAL CATALYST FUND
The final net asset value for the fund was $5.99 or up 48.9% for 2009. If we add in any value for the non-market priced warrants it pushes the percentage return to the low 50’s. This compares quite favorably to the indexes in countries where we invest – S&P TSX + 34.36%, S&P 500 + 8.65% or the Dow Jones Euro Stoxx 50 + 12.00% (all figures in Canadian dollars).
THE REARVIEW MIRROR
Looking backwards it is easy to see the collapse of the world as we know it did not happen. The Lehman Brothers default in September of 2008 set off a series of events that froze the global economy. By March of 2009 global stock markets had reached bottom. This process was epitomized by panic selling even when faced with the knowledge that global fiscal and monetary stimulus was about to begin in a coordinated manner that the world had never seen. The combination of low interest rates and government sponsored liquidity programs re-invigorated investors to buy risk assets – in a big way.
Speculation led the initial leg of the rally (March through September). These stocks had similar low quality characteristics: low prices, high betas, high P/E ratios and small market capitalization. These were the same stocks that were hurt the most in the carnage of 2007 and the early part of 2008. More to the point the U.S. Financial Sector which had been decimated was the top performer during this period. The Financial Sector rose 142% from the markets March 9th low to September 30th. This was almost three times the S&P’s 58% return.
In September the market changed. For the first time, since the crisis began in summer 2007, merger and acquisition activity picked up. We saw big deals in energy, health care and technology. Deals in September included Xerox buying Affiliated Computer Services, Covidien PLC buying Aspect Medical Systems, Adobe Systems buying Omniture, Dell buying Perot Systems, Dai Nippon Pharma buying Sepracor and Baker Hughes buying BJ Services. We at Camlin feel this is one of the best indicators that the world has stabilized. Equilibrium has been found and strategic buyers were putting toes in the water in again.
During the fourth quarter our returns accelerated versus the market. The rotation out of low quality stocks to high quality stocks that had begun in earnest in September continued. The fund benefited as investors looked for higher quality growth stocks that had not participated in past two quarters, stock market volatility continued to subside and the US dollar remained weak (stock markets have been inversely correlated to the USD all year).
LESSONS LEARNED ….
The lessons learned from 2008 – 2009 warrant comment. Four bear mentioning here as they directly impact our view of the portfolio.
1) Expanding liquidity drives financial markets. This is works even better as the perception of risk is lowered – both stocks and bonds move higher. Low quality assets that have been left for dead move first while quality assets lag.
2) The reflation, of physical assets, started in 2008 has worked and averted a deeper recession or depression.
3) One should not believe that the above mentioned reflation will serve as the sole panacea for healing either the global economy or the global financial system. Debt has simply been shifted from private to public hands – it has not been eliminated. It is no wonder that the ratings agencies are downgrading sovereign debt (Greece and Portugal are just the beginning). These governments will “eventually” need a solution. This will surely come in the form of higher taxes and a reduction in services. The world has not finished deflating.
4) Zero interest rate policies (ZIRP) are both good and bad. First the good, they help improve balance sheets – public, private and corporate – by increasing asset prices. The bad news about ZIRP is that these policies are not sustainable long term (the Japanese model is clear in this regard) and raise concerns about rising interest rates. To us it is not if but when interest rates move higher. This will add uncertainty to capital markets as we move through 2010.
THE PORTFOLIO AT DECEMBER 31, 2009
At December 31st the Catalyst Fund was fully invested (100% long) with no hedging in place. As governments continue to drive liquidity into the markets we remain invested. It is unclear when liquidity will be removed from the system. We are hard pressed to believe much will happen in early 2010 as the unemployment picture remains bleak and mid-term elections in the U.S. are pending. However, once liquidity is withdrawn from the system we will look to lower our market exposure as upward pressure will be placed on interest rates. This will dampen growth expectations, put pressure on balance sheets and increase the number of entities (corporate and sovereign nations) at risk of a credit downgrade.
As such the Catalyst Fund has been positioned accordingly. We have increased the average market capitalization of our holdings to $3.9 billion, focused on dividend paying stocks, increased our exposure to defensive sectors and shifted our energy exposure from oil to natural gas – which is less inversely correlated with the U.S. dollar.
10 THEMES FOR 2010
In this section we discuss ten themes that we are currently watching at Camlin. Some are inter-linked while others stand on there own – but all have implications for the Global Catalyst Fund. We will provide an update on how these themes are progressing with the June 30 quarterly report.
1) The merger and acquisition market will continue to improve in 2010 in response to improved liquidity, the desire to secure a long-term supply of increasingly scarce resources and the need to augment slower internal growth rates through acquisition. Corporations and government backed entities are willing to buy strategic assets. Energy, materials, health care and technology will continue to be the sectors where consolidation is focused.
2) The world appears wrapped in deflation … for the time being. We are not ruling out a comeback in inflation but it will most likely appear gradually and take longer to show up than consensus estimates. Globally we are awash in capacity, unemployment is high and debt has not been lowered to levels that will ultimately support asset price increases.
3) While central banks talk about exit strategies to the easy monetary policy, it will be much harder to implement than most think. In order to tighten the system, governments must be sure the underlying economy is actually on stable footing or improving. While the economy is off life support it has been driven by government programs and is as such artificial and temporary. The real question is when does the private sector take hold and start driving the economy again?
4) Household savings rates will continue to increase. This will lead to a decrease in consumer spending. Historically the rule of thumb is that consumer spending accounts for roughly two-thirds of GDP. This ballooned to above 70% in 2007 – 2008 and is now in the process of retracing back to historic norms.
5) We are in a golden period for equities. Corporate earnings look good on a year over year basis (remember the world was ending a year ago) and cost cutting has achieved its desired result. Valuations and sentiment are not at extreme levels. The question is how long will this last?
6) Foreign governments have no choice but to continue buying U.S Treasuries. While the U.S. dollar will rally at times its ultimate path is lower. It benefits everyone to make this as orderly as possible.
7) Active portfolio management will return in 2010 as decreased volatility will see greater differentiation in asset prices and strategies. (Remember 2008, as volatility increased differentiation diminished – this is the opposite.)
8) Stable income streams will gain importance in individual and pension portfolios as yields remain low. In a world of 0% short rates, 3.5% 10 year bond yields and modest expectations for equity returns, income will be a key focus for total returns.
9) The European Union will come under extreme pressure from the PIGS (Portugal, Italy, Ireland, Greece, Spain) due to adverse economic conditions within each country. There is no mechanism for the PIGS to devalue the euro to make themselves more competitive or political will to reduce wages (these are two avenues to competitiveness). We will hear banter about disbanding the European Union in 2010.
10) Natural gas will become a greater and greater focus of U.S. energy policy. With technological advances in horizontal drilling more and more natural gas is available in the U.S. for recovery. We look at recent drilling results from the Eagle Ford Shale and the Marcellus Shale as two examples of this. It will not be long before we are hearing about natural gas powered vehicles in the U.S.
CONCLUSION
2009 was a rebound year for the Catalyst Fund and we are cautiously optimistic about 2010 – especially the first half. Ample liquidity currently remains in the system, interest rates are low and valuations are not stretched. Reflation, to this point, has worked. The question of how and when exit strategies are implemented will continue to worry the market going forward. We don’t see a major shift in policy coming anytime soon. Interest rates will remain low … at least in the near term.
We get constructive on the outlook for the Catalyst Fund in this environment. First active management has returned as volatility has subsided. Second, we believe a new Merger and Acquisition cycle has begun. Our focus on consolidating sectors, growth companies and strategic valuations are perfectly suited for this type of market.
We thank all our loyal investors for their continued support and look forward to the challenges that lie ahead in 2010.
N. John Campbell, Portfolio Manager
Guy Wildeman, Associate Portfolio Manager
