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Mid-Year Checkup

Canadian Equity Strategy

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July 28, 2008

Defence may be the best offence

The facts are clear. The global economy along with the economies of the United States, Canada and some of Europe’s largest economic players has slowed over the past 12 months. Whether or not certain countries are technically in recession is irrelevant at this stage as portfolios should still recognize the trends we’ve seen, especially in the United States which makes up 25% of the world’s GDP and is a leading indicator for Canada due to our strong and material trading relationship. And those trends have been anything but positive as of late including a large decline in the U.S. housing market, a deteriorating labour market, falling consumer confidence, a falling U.S. dollar with resulting inflation concerns, and perhaps an indication that U.S. consumer spending has actually slowed for the first time in ages thanks to increasing energy prices, food prices and layoffs. So far, Canada has not felt the same magnitude of economic weakness likely due to our stronger housing market, currency, and government surpluses. But let there be no doubt that it is
almost impossible for the Canadian economy to materially outgrow the United States due to our strong trade relationship. Pain felt in the United States is not immediately felt in Canada, but may lag three to six months, or longer. In other words, just because we may not have seen a weaker labour market and reduced consumer spending in Canada does not mean that we won’t see it in the future, especially as it would appear the U.S. economy is far from making a material, economic comeback. All of these observations speak to why we wanted investors to maintain defensive positions in their portfolios at the beginning of the year and why we continue to emphasize this recommendation. The idea of staying defensive is not meant to reward investors with material share price returns, but to preserve capital and possibly earn a dividend at the same time. We believe the economic struggles of the United States will continue in the third quarter and possibly for the rest of the year and for that reason we continue to recommend investors focus on defensive positions such as Consumer Staples, Telecommunications, Utilities, and gold.

Balanced portfolios should continue to hold gold

We have seen the usual seasonal patterns for the gold price in 2008 with a positive start followed by selling after February. If such seasonal patterns hold true for the remainder of the year then we should see gold price move higher in the third and fourth quarters. Initial strength this year was boosted by a weaker U.S. dollar thanks to 200 basis points of interest rate cuts by the Federal Reserve, but now the focus of the market has turned squarely to inflation as food and energy prices move higher not only amongst industrialized nations but also amongst the emerging markets. It’s unlikely that such concerns will subside in the near term particularly as central banks struggle with the “raise rates – fight inflation vs. lower rates – promote growth” dilemma. Gold has traditionally been purchased as a hedge against inflation, so if inflation concerns do not dissipate, it’s likely gold will continue to move higher thanks to hedgers and speculators. Even with the arguments for buying gold being supported by rate cuts earlier this year followed by increasing
inflation concerns, supply/demand fundamentals remain the crux of our bullish stance and why we will likely be bullish on gold beyond 2008. The facts are simple, we’re taking less gold out of the ground these days and demand is strong. Considering cost inflation, geopolitical risk, and environmental concerns, it’s becoming more and more difficult for gold companies to find new and economical supplies of gold, which we believe will make current gold supplies more valuable.

Opportunities still exist amongst select telecommunications and technology stocks

Six months ago we highlighted two stocks: Rogers Communications and Research in Motion. After a struggle at the beginning of the year, the stock price for Research in Motion rebounded remarkably only to fall back recently after slightly missing EPS guidance expectations and due to the slowdown of the global economy. Although EPS guidance for Research in Motion for the current quarter may have missed by a couple of pennies, the company actually beat analyst expectations on four other material metrics including
revenue growth, device average selling prices, device volumes, and subscriber growth. We believe these guidance parameters are more important and speak to the potential for a strong second half of calender 2008 which will see new device launches including the Bold, the Javelin, the Kickstart and the Thunder/Storm (touchscreen). Recent weakness may also be a result of Apple’s updated iPhone. Although we recognize the material impact that such a smartphone could have in the overall mobile device market, we are also firm
believers that there is more than enough room for multiple participants in a market which addresses over 2 billion handset users worldwide. We still believe Research in Motion is a stock to own going forward.

The story for Rogers Communications has been a complicated one thus far in 2008, but we remain convinced that Rogers will outperform its competitors in 2008. The stock, along with the sector in general has fallen hard in the first half of 2008 as continued rumour and speculation surrounded the company as the Federal Government auctioned off wireless spectrum to a number of bidders in May-July of this year. Such a move had investors speculating that a new entrant would emerge and that Roger’s monopoly with its GSM technology network would come to an end. While it’s obvious that new entrants have emerged from the auction, we can not emphasize enough how difficult it will be for a new entrant to take material market share away from any of the current three incumbents, let alone Rogers, within the next two to five years.

Rogers will continue to have a monopoly on GSM technology for at least another two years which gives it a monopoly on GSM enabled handheld devices and a first mover advantage on the newest handsets as most mobile device makers are electing to launch GSM versions before releasing CDMA (Telus and BCE) equivalents. Although news and speculation have brought Rogers stock price down, we believe Rogers’ strong competitive position and upcoming quarterly results will show why this company should outperform
its competition for the remainder of the decade.

- Gareth Watson, CFA, Associate Director, Portfolio Advisory Group

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