Balanced Fund Report January 2014

Caldwell North American Equity Strategy ‐ Monthly Update January, 2014

Portfolio Addittons & Deletions

We did not make any changes to the portfolio last month.

Commentary

This past year was a great year for our investors and we thank you for your support. While we typically focus on the road ahead (What did we buy/sell and why? How are our portfolio companies progressing on their initiatives? Where are we seeing risks and opportunities and how are we positioned?), we will spend some time reviewing how we did this past year.

The Caldwell Balanced Fund was up 23% in 2013 on the back of very strong equity performance (clients in our separately managed account program with a greater weighting to equities would have done even better). While everyone is proud of a good return, what excites us more is how we achieved that return.

Looking at the performance of the U.S. and Canadian markets, and their major business sector components, we can see that 2013 was a year of both risk and opportunity. We are pleased to say that we managed to avoid many of the painful areas of the market, while fully participating in many of the bright spots.

Avoiding the Bad

Anyone that has read a business paper over the last year is likely familiar with two popular investment themes that turned out to be quite harmful to investors.

The China/Money Printing investment theme argued that ‘hard assets’ like gold and commodities were the best thing to own given strong growth and infrastructure development in emerging markets, and money printing by the US Fed. We can see from the Materials and Gold returns in the performance table that investors lost a lot of money following this strategy.

Investing in safety/yield was another popular investment theme. Given low interest rates, higher demand for yield from baby-boomers, and fear of a weak economy, investors were attracted to the safety that stable cash-flowing companies, like REITS, utilities and pipelines, historically provided. While investors likely broke even on the year in this strategy, the opportunity cost of not participating in other parts of the market was very high.

Participating in the Good

At the same time, two unpopular investment themes turned out to be winners in the market: moving money to the U.S. and owning companies whose earnings are more tied to economic growth. Both were unpopular because they were considered too risky/uncomfortable, as the uncertainty around economic growth, especially in the U.S., was much higher than it is today.

Structured to Outperform

In both cases, we made decisions that were not common place at the time, but that allowed us to outperform for our clients. Our ability to make these decisions was driven by our portfolio structure and investment process, which is the reason we are excited. When you speak to structure and process, you speak to repeatability, which is a key factor in assessing the quality of an investment manager.

While the features of our structure and process, which we discuss below, seem common-sense, many of our peers cannot speak to them, which is why we believe we have an advantage going forward.

1. Simply Buying the Best Opportunities: Many portfolio managers use the index as a starting point and over or underweight stocks according to their views. We use a different approach – we simply look at the largest 1500 stocks in Canada and the U.S. and select the best opportunities, regardless of which business sector they are in, or how big or small the companies are relative to the index. Essentially, we are not tied to owning anything, which allows us to simply buy the best opportunities. This approach helped us avoid the harmful areas of the market this past year.
2. Owning Concentrated Portfolios: Many portfolio managers hold many stocks (we have seen instances of 50+ different stocks in portfolios). Our strategy is to hold a more concentrated portfolio of around 25 stocks. While we still get ample diversification across business sectors, we are able to be more selective in the stocks we purchase. We believe this is the best approach in a low growth environment, which we see as persisting for the next several years.
3. Active Management of the Canada/US allocation: 1000 of the 1500 companies in our investment universe are U.S. based. Performance of Canadian and U.S. markets this year highlights the importance of having access to U.S. stocks. Currently, we have a 45/55 Canada/US split – this will change over time based on the relative attractiveness of opportunities in each market.
4. Disciplined Buying Process: Capital protection serves as the foundation of our stock selection process. We minimize risk across each step of our process, which includes a) not overpaying for stocks (valuation); b) investing in companies with strong balance sheets (good credit ratings); c) investing in management teams that make good decisions with our investor’s capital; d) avoiding companies operating in challenged, longer term environments.
   Valuation, or how much we have to pay for an investment, was a key factor in avoiding the China/Money Printing and Yield/Safety investment strategies that produced below-average returns. While the stories behind both investment strategies sounded good, it didn’t make sense that investors were willing to pay any price to participate. The lesson is that risk is not defined by a strategy or security or asset class, but by the price one has to pay for it.
5. Disciplined Selling Process: Our sell discipline involves selling a stock when news comes out that contradicts our original investment thesis. We are very diligent about this and avoid “hoping” for a better exit point, as cutting losses and redeploying capital is critical to achieving superior returns over time.

Back to Looking Forward

Here are some observations as we look to the year ahead.

– Many in our industry spend vast amounts of time and money trying to predict the future, often with limited success. The reality is that it is very difficult to predict, with consistency, which events will cause confidence to leave markets, and when. The best protection is to own well-managed companies with strong balance sheets, as these are the companies that can sustain losses of confidence and are likely to emerge even stronger once confidence returns.

– Valuations are a big driver of investment returns and set the stage for how markets respond to stressful events. While market valuations still seem reasonable and unlikely to cause significant and permanent capital loss, the strong performance in markets has made it harder to find good opportunities. This speaks to the importance of having an investment process that allows us to focus on areas of the market where opportunities still exist.

– Valuations/opportunities continue to look more compelling in more economically tied companies, especially versus yield plays.

– We will continue to manage our client portfolios in a balanced fashion, where we have exposure to our fear, growth and stability buckets. Fear stocks are companies we are able to buy at depressed prices because some type of uncertainty is keeping other investors on the sidelines. These stocks make up the biggest part of our portfolios. Growth stocks are companies that are able to grow faster than the economy while stability stocks are companies that are less cyclical in nature. These serve to smooth the volatility of fear stocks, as we can never be sure of the timing around when the uncertainty that’s providing the opportunity will pass. Having said that, we are conscious to not overpay for growth or stability, and so there is always a value skew to each of these buckets.