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4Q 2015 Portfolio Manager Commentary

Macro and Markets

The year 2015 will be remembered for the end of the six-year bull market in equities and for the dramatic slowing of global economies. It will also be remembered as the year that Central bankers went short global currency markets as the unorthodox race to revive slowing economies picked up pace and bordered on the absurd at the same time. Barring a handful of tech names, the US equity markets entered a bear market. China’s slowdown entered its third year, with severe consequences for its stock market. Emerging market economies witnessed a significant outflow of portfolio investments and a dramatic fall in currency values.

While market conditions changed significantly especially from the second half of 2015 our “discount to intrinsic value” investment approach has not changed. We continue to solicit opportunities using our intrinsic value methodology and continue to exercise caution and patience in executing our strategy, preferring cash to other asset classes

Portfolio Performance

The Vulcan Global Intrinsic Value Portfolio fell by -0.7% during FY 2015 vs a -11.1% decline for the TSX Composite Index and -4.5% fall in the MSCI AC World Index. Since inception three years ago the portfolio has generated gains of 55.7% vs 9.5% for the TSX Composite in that period. The compound annual portfolio return since inception is 15.9% vs 3.1% for the TSX Composite.table 1

The Vulcan portfolios maximum common equity exposure is 70% (US, Canadian and international) and minimum of 20.% allocated to preferred shares and the balance in money market instruments and cash.

Figure 1: Portfolio Performance from Dec 31, 2012 – Dec 31, 2015

Figure 1

Investment Overview and Portfolio Strategy

It is important to note that though for simplicity sake we measure our performance against the TSX Composite index, our performance is significantly impacted by the US markets, since as of December 31, 2015, 42.5% of the portfolio is invested directly in the US and another 5.0% held in US dollar money markets. International names listed in the US accounted for 14.4% of the portfolio, while 32.7% of the portfolio is invested in Canada as of December 31, 2015 and another 5.0% in Canadian dollars and money markets.

US common equity exposure was reduced during the year from 58.0% at the end of 2014 to 42.5% of the portfolio at the end of 2015, while the international component dropped marginally from 15.2% to 14.4%. Canadian common equities investments grew from 9.5% of the portfolio in 2014 to 14.7% at the end of 2015. We introduced a new asset class to our portfolios; floating rate preferred shares, accounting for 18.0% of the portfolio.

We covered floating rate preferred shares very extensively in our 2Q2015 Portfolio Manager commentary but will very briefly recap what floating rate preferred shares are and how they work.

A preferred share is a hybrid financial instrument that has characteristics of common equity shares as well as bonds. These securities are issued at a face value of $25 each and pay a quarterly dividend. The subsequent value of floating rate securities, whether preferred shares or bonds, move in the same direction as interest rates, if interest rates fall the value of these securities decline and if interest rates rise, the value increases. The reason being, dividends paid from these securities are linked to the actual level of interest rates. In the case of Canadian floating rate preferred shares, dividends are tied to the three-month Government of Canada treasury rate. Prices of fixed-rate preferred shares and bonds, on the other hand, move in the opposite direction to interest rates. Fixed rate securities are of little value to us, given that we are somewhere at the tail-end of falling interest rates and where short and medium term rates are already near zero (Please see Fig 2 – Ten-year trend in 3-Month GoC Treasuries). As of December 31, 2015 this rate was 0.47% as against 0.9% on December 31 2014.

Figure 2: Ten-year trend in 3-Month Government of Canada Treasuries

Figure 2

10-yr trend in 3-month GOC treasury rate shows the steep fall and then the rise post 2008-09 financial crises and then the further fall post rate cut in 2015 followed by an even sharper fall in the run-up to a second rate cut.

While impossible to predict the trajectory of interest rates, it makes sense to own a beaten down asset class with a quarterly reset in yields given the extreme reaction of the market to a cut in rates. Prices of floating rate preferred traded in the second half of 2015 as if benchmark 3-month GOC Treasury Bills were at negative yields. The subsequent fall in the price of these preferred shares caused a significant portion of our mark-to-market losses and trade at a very significant discount to fair value.

table 2

Relative valuations as of year-end still appeared a little high in the US, but seemed to be moderating in Canada. It is likely that we will be adding further to our Canadian investments during 2016 if valuations continue to moderate and as opportunities present themselves. We exited all of our emerging market holdings during the year, barring Petrobras, our only common equity holding in Brazil.

Petrobras, having been beaten down severely remains a very cheap stock and trades approximately at a 65.0% discount to its intrinsic value as of December 31, 2015. Our investment was based on the premise that the Brazilian government’s practice started by President Dilma Roussef of using Petrobras cash flows to subsidize retail gasoline and other refined fuels would be discontinued. Other emerging markets have dismantled indirect fuel subsidies and Brazil should eventually be no different. We have also run into a huge corruption scandal involving Brazilian government officials, politicians, Petrobras employees and company contractors that likely will play out fully in 2016. While the fuel subsidy issue has forced the company to load up on debt, lower oil prices, lower refined prices and lower imports means that the fuel subsidy bill has also reduced. Petrobras value proposition is its near complete ownership of almost all energy production and energy infrastructure in Brazil, including pipelines, refineries and retail distribution. It is the pioneer in deep offshore oil production and has significant investments (mostly completed) in deep offshore fields in Brazil, which are among the most prolific and long-lived of any oil and gas asset worldwide. Unlike fracking, which needs multiple oil wells to be drilled at regular intervals, deep offshore wells once drilled stay productive over long periods of time.

We intend retaining our investment in Petrobras despite the controversies surrounding the company, which we think will eventually be resolved, including a realignment of government policies. In time the Petrobras common equity should appreciate closer to its intrinsic value

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