Leith Wheeler Investment Funds 4th Quarter Review

Canada's Leith Wheeler reviews economy and investments

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Jan 29, 2016
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With the notable exception of Canada, equity markets staged a broad recovery during the fourth quarter of 2015. Over the year, however, equities have generated lacklustre to negative returns, when measured in local currencies. In Canada, low commodity prices have continued to depress the market. This, along with the relative strength in the U.S. economy, created significant weakness in the Canadian dollar. Our Balanced Fund has had a higher exposure than its benchmarks to foreign equity investments and benefitted from the significant decline in the Canadian dollar. Fixed Income funds also generated positive returns as yields continued to decline over the year. This emphasizes the importance of having a diversified portfolio.

After showing signs of recovery from a technical recession during the third quarter, Canadian economic growth faltered again in the fourth quarter with year-on-year growth turning negative and hitting its lowest level since the Global Financial Crisis in 2008. The weakness in Canada has been broad-based, as even currency-sensitive sectors like manufacturing softened during the quarter. We are particularly concerned that the rebound in non-energy exports that materialized during the third quarter has since faltered despite sustained weakness in the Canadian dollar. Additionally, questions remain about the debt levels of Canadians and the risks of a housing correction, and this uncertainty has weighed on the Financial sector. We believe these risks are well priced in, and continue to have an overweight in Canadian financials.

Outside of Canada, economic conditions are mixed. In the U.S., the labour market continues to improve and home construction is trending higher, but manufacturing continues to underperform the broader economy. In Europe, the resilience of economic sentiment has been remarkable in the face of a string of potential drags (including terrorist attacks, the Syrian refugee crisis, Greece and VW’s emissions scandal). Net European imports of oil at lower prices are providing a boost to European GDP; however, this has been offset by currency appreciation following the European Central Bank’s policy action during the fourth quarter. Economic news from emerging markets, in particular China, has remained mixed.

Against this uncertain global economic backdrop, the long-awaited rate hike from the U.S. Federal Reserve finally materialized in December 2015. Although inflation remains persistently below target, the U.S. labour market has continued to tighten, prompting the Federal Reserve to start moving away from its ultra-easy monetary policy. Considering that this was the first interest rate hike in the U.S. in almost a decade, capital markets responded well and market volatility was contained. Further tightening in 2016 is expected to be significantly more modest than in prior tightening cycles. Our projection for U.S. interest rates is below the Federal Reserve’s own forecast, which has consistently proved optimistic, but above the market’s current expectations.

We remain cautiously optimistic on the global economic outlook, albeit with heightened concern for the Canadian economy given sub US$40 oil prices. Global monetary policy measures will continue to support growth, including in the U.S. where policy rates remain ultra-easy. We believe global economic growth will remain positive but below its longer-term trend. Despite this, we believe that the potential returns from the equities in our funds will be significantly higher than fixed income alternatives over our investment horizon of three to five years.

Canadian Equity Fund

After a very difficult third quarter, the Canadian equity market remained under pressure in the fourth quarter, ending a volatile year for the Canadian market. Dragged down by weakness in commodities, the TSX Composite return of -8.3% was among the worst-performing developed markets in 2015.

The Canadian Equity Fund outperformed the TSX in the fourth quarter, declining 1.0% after fees and expenses versus -1.4% return for the index. The Fund’s performance was helped by its holdings in the

Consumer Staples and Utilities sectors which performed well. Saputo, our only Consumer Staples holding, increased 13.4% as the company announced its fiscal second quarter earnings and market concerns over the impact of the Trans-Pacific Partnership (TPP) dissipated. Our holdings in the Utilities sector, including Brookfield Infrastructure (7.9%) and Hydro One (8.7%), also helped relative performance, beating the TSX sector return of -1.3%. The other notable positive over the quarter was having no exposure to Health Care, which declined 36.9%. Valeant Pharmaceuticals (VRX, Financial) continued to decline over the fourth quarter, as questions surrounding its relationships with mail-order pharmacies arose and amid news that its CEO will be taking a medical leave of absence.

Despite the relative outperformance over the quarter, the Fund’s performance lagged the TSX over the year. The dramatic descent we have experienced in commodity prices has led to double-digit declines in the Energy and Materials sectors. This has had a spill-over effect on Financials, as investors have been worried about Canadian banks’ exposure to the oil and gas sector, in addition to concerns of an overheated housing market. In this environment, many investors have crowded into areas considered to be less cyclical and have been willing to pay a premium to do so. As a result, valuations in sectors such as Consumer Staples, Telecom and Utilities look stretched in our view. In contrast, we are finding opportunities to add to solid businesses in other sectors at very attractive valuations.

In the Materials sector, we have added to First Quantum. Management has been very focused on their balance sheet and creating liquidity in this challenging environment. In addition to a streaming agreement with Franco-Nevada that will create $1 billion in liquidity, the company is exploring opportunities for further asset sales. First Quantum is among the lowest cost copper producers in the world, and we continue to like the management team and growth prospects of the company. Over the quarter, we also added to some of our Energy holdings, including Tourmaline (TSX:TOU, Financial) and Western Energy Services (TSX:WRG, Financial), which are both very well-run companies with strong balance sheets. In the Real Estate sub-sector, we initiated a position in Brookfield Asset Management, a global alternative asset manager that has a one hundred year history of owning and operating assets including property, renewable energy, infrastructure and private equity.

Although 2015 was a difficult year for the Canadian market, it also created opportunities for long-term, value investors. We will continue to look for opportunities to purchase well-run companies that are currently out of favour with investors and are priced attractively.

Canadian Dividend Fund

The Canadian Dividend Fund outperformed the TSX in the fourth quarter, advancing by 1.4% after fees and expenses. The Fund was slightly behind the overall market in 2015, declining 8.6% after fees and expenses compared to -8.3% for the S&P/TSX Composite Index. As with the Canadian Equity Fund, we have been using the weakness in the Canadian market as an opportunity to add to high quality companies at attractive valuation levels.

U.S. Equity Fund

After a very impressive run in recent years, the S&P 500’s momentum stalled in 2015. Overall, the index increased a moderate 1.4% for the year, measured in U.S. dollars. However, when measured in Canadian dollars, the S&P 500 increased 21.0% as the rapid accent we have witnessed in the U.S. dollar resulted in large currency gains during the year. Our U.S. Equity Fund experienced a strong fourth quarter advancing 11.0% after fees and expenses, but trailed the index return in 2015. The underperformance can largely be attributed to stock selection in the Energy (Tidewater, Denbury) and Utilities (MDU Resources) sectors.

As mentioned in our last quarterly review, we recently conducted an extensive review of our foreign equity partner Sprucegrove Investment Management with the assistance of Callan Associates, a U.S.-based investment consulting firm. The review covered issues such as performance, investment philosophy, style analyses, succession and personnel planning. A wide selection of managers was reviewed based on the following criteria:

  • Adheres to a bottom up, value-based investment philosophy
  • Material level of employee ownership
  • Ability to effectively transition our asset base
  • Demonstrated long-term track record of added value
  • Stability of their investment teams

The goal was to compare the merits of Sprucegrove against other leading managers and make certain that our clients have access to the best strategies in each individual asset class. Although Sprucegrove ranked well on many of the above criteria, they have not demonstrated a consistent long-term track record of adding value for their clients in their U.S. equity portfolios.

We conducted site visits to a number of firms, including Barrow, Hanley, Mewhinney & Strauss LLC (“Barrow Hanley”), the company we have selected to manage our U.S. portfolios going forward. Barrow Hanley manages over US$88 billion in equity assets and has a 36-year history of bottom up, value investing in U.S. equities with a long-term investment horizon. They have an exceptionally stable investment team, a high level of employee ownership and have consistently produced added value with downside protection over the years.

The transition of assets to Barrow Hanley will take place in late January 2016, with Leith Wheeler covering all the associated transactions costs. We look forward to partnering with Barrow Hanley going forward and are confident they will provide the same high standards of investment research, service and care our clients have come to expect.

International Equity Plus Fund

Similar to North American equity markets, International equity markets were also extremely volatile in the last quarter of 2015. The quarter began with lower quality stocks and Emerging Markets stocks performing strongly, but this was reversed by the end of the quarter. Overall, international equity markets had a strong quarter in Canadian dollar terms. The International Equity Plus Fund advanced by 6.0% after fees and expenses, lagging the MSCI EAFE Index which returned 8.2% during the quarter. Consumer discretionary stocks Ctrip.com, Delphi Automotive and Renault SA helped performance during the quarter. Detractors included Materials stocks Freeport-McMoran and Industrial stock Kansas City Southern.

The country weightings of the International Equity Plus Fund at December 31, 2015 were:

Balanced Fund

The Balanced Fund advanced by 2.7% in the fourth quarter of 2015 after fees and expenses. The asset mix for the Fund at December 31, 2015 was:

Unrestricted Diversified Fund

The Unrestricted Diversified Fund advanced by 2.6% in the fourth quarter of 2015 after fees and expenses. The asset mix for the Fund at December 31, 2015 was:

Income Advantage Fund

The Income Advantage Fund finished the year strongly, up 1.3% after fees and expenses during the quarter, but declined in the year primarily due to the Fund’s holdings in preferred shares and Canadian dividend paying equities. During the final quarter of 2015, the Fund’s performance was helped by these same factors as these assets rallied in October and November. The Fund’s fixed income holdings contributed positively to return as well during the quarter.

The asset mix for the Income Advantage Fund at December 31, 2015 was:

Fixed Income Fund

Fixed income investments performed well during the quarter, benefitting from a continued rally in federal government bonds and good performance in provincial bonds. This was partially offset by an increase in the yield differential between government and corporate bonds (known as credit spreads).

After initially rising in tandem with U.S. yields ahead of the well telegraphed December rate hike from the U.S. Federal Reserve, Canadian government bond yields ended the quarter marginally lower. The downward pressure on Canadian yields and policy rate expectations was due to additional weakness in energy prices and disappointing economic data. After showing some tentative signs of recovery in the third quarter, Canadian economic growth faltered over the fourth quarter as year-over-year growth turned negative. In this environment, credit spreads were only marginally wider.

The Fixed Income Fund portfolio slightly lagged the FTSE TMX Canada Universe Bond Index during the quarter, returning 0.9% after fees and expenses compared to 1.0% for the index. The Fund’s larger exposure than the market to corporate bonds helped performance, as did the holding of high quality, shorter-dated issues.

Our medium-term view continues to be that global bond yields will rise very modestly as the U.S. Federal Reserve continues to normalize monetary policy cautiously through 2016. We acknowledge the ongoing uncertainty around this view, and as a result, we continue to position the Fund cautiously in terms of overall interest rate risk.

As mentioned last quarter, given our economic outlook, we had positioned the Fund in mid-2015 with the lowest corporate credit risk in almost five years. The Fund’s weight in Canadian corporate bonds was essentially unchanged during the quarter. However, we made several changes to the composition of the Fund.

Our outlook for Canadian capital markets remains cautious. Our expectation for additional rate cuts from the Bank of Canada were realized during the quarter, and we now think the probability of further monetary policy easing is balanced and highly dependent on oil prices.

Our view continues to be that the impact of lower oil prices has yet to fully reverberate through the Canadian economy. To date, the labour market and the consumer are showing remarkable resilience. However, the broader outlook for growth continues to be of concern with economic data towards the end of 2015 ending on a softer trajectory.

Although the global economic outlook has stabilized since mid-2015, the normalization of U.S. interest rate policy is likely to have significant implications for global capital markets including Canada. One obvious consequence, a significant depreciation in the Canadian dollar, has provided some support to the Canadian economy; however, the rebound seen in non-energy exports during the third quarter has faltered in recent months and will be a focal point for Canadian policy makers in 2016.

In this environment, we continue to search for the best risk-adjusted fixed income securities. Our view is that there are better opportunities in credit markets rather than in interest rate markets, given the uncertain and divergent global interest rate outlook. We will continue to look for opportunities to add to corporate bonds as they become more attractively valued, but our economic outlook suggests we should be cautious about the speed with which we increase this exposure, as we can envision a scenario where credit spreads could widen even further. In this way, we continue to believe that the Fund is well-positioned to weather this challenging and increasingly volatile market environment.

Corporate Fixed Income Fund

The Corporate Fixed Income Fund performed well in the fourth quarter, advancing 1.2% after fees and expenses. For the year, the Fund was up 1.6% after fees and expenses.

Questions about your portfolio?

If you have questions about your Leith Wheeler portfolio, funds or services, please contact your Portfolio Manager or Karey Irwin at 604-683-3391 or 1-888-292-1122.

FORWARD-LOOKING STATEMENTS

This report may contain forward-looking statements about the Leith Wheeler Funds. Forward-looking statements include statements that predict future events, conditions or results - including strategy, expected performance or prospects, opportunities, risks and possible future actions. Forward-looking statements are based on current expectations and projections about future events and are inherently subject to risks, uncertainties and assumptions about the Funds and economic factors.

Forward-looking statements are not guarantees of future performance, and actual events and results could differ materially from those expressed or implied in the forward-looking statements. These statements require us to make assumptions and are subject to inherent risks and uncertainties. Our predictions and other forward-looking statements may not prove to be accurate, or a number of factors could cause actual events, results, performance, etc. to differ materially from the targets, expectations, estimates or intentions. These factors could include, among others, market and general economic conditions, interest rates, regulation, competition and the risks set out in the Funds’ Simplified Prospectus. Do not place undue reliance on our forward-looking statements. Please note the Funds have no intention of updating any forward-looking statements, whether as a result of new information, future events or otherwise.

Leith Wheeler Investment Counsel Ltd. is the manager and primary investment advisor for the Leith Wheeler Mutual Funds. Leith Wheeler Investment Funds Ltd. is the principal distributor of the Leith Wheeler Mutual Funds. Leith Wheeler Mutual Funds are also distributed through authorized dealers. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed or covered by the Canada Deposit Insurance Corporation, Leith Wheeler, or any other deposit insurer. Fund values change frequently and past performances may not be repeated. The unit value of money market funds may not remain constant.

Additional information about the Leith Wheeler Funds is available in the Funds’ Annual Information Form, Fund Facts, Management Report of Fund Performance and financial statements. You can get a copy of the Simplified Prospectus, and the other documents, at no cost by calling 1-866-292-1122, on our website at http://www.leithwheeler.com or by contacting your dealer. These documents and other information about the Funds, such as information circulars and material contracts, are available at www.sedar.com.

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