Greco roman versus Freestyle For the past six months a wrestling match has been staged between poor macroeconomic news and excellent microeconomic results with neither side as yet claiming victory. At some point in the near future a winner will be declared and I expect that when the “sentiment-jam” breaks the market will move higher. In the meantime, our focus on individual companies with high ROE’s and strong competitive positions has continued to work as both the Capital Ideas Fund and the Financial Services Venture Fund outperformed the market in the first half of the year. We expect more of the same in the second half of 2011. Does a bad economy automatically result in a bad stock market? Europe is burning, Japan is (still) stuck in the mud and the Obama Presidency lacks any kind of economic coherency. Things haven’t been this bad since the 1970’s! There is no way of sugar coating it – the macroeconomic picture is ugly. So what’s an investor to do? Bad macroeconomic environments do not necessarily make for bad investing environments and there are really two reasons for this. First, a so called macroeconomic crisis (such as the European debt crisis today or the US mortgage crisis in 2008) often represents the denouement of an economic problem that has been building for a considerable period of time. As such, a crisis often coincides with a market bottom as the bad news implied by such crises is already priced into the value of risky assets. Valuation (the price you pay for an investment) is one of the key pillars of investment success and a crisis typically provides outstanding entry points for the confident, long-term investor. While a specific crisis can create an interesting short-term opportunity for investors’ some crisis like the 1970’s oil and inflation shocks persist for much longer periods of time but nonetheless create positive opportunities for the truly long-term investor. This point can be illustrated by looking at the concept of the markets “equity risk premium”. We define the equity risk premium as the difference between the equity markets earnings yield (the inverse of the VOLUME XVI JULY 2011 INVESTMENT ISSUES • STRATEGIES • INSIGHTS FROM DONVILLE KENT

2 ROE REPORTER | DKAM P/E ratio) and the risk free rate (US T-bill rate) 1 . The equity risk premium measures the extent to which equity investors are being compensated relative to the risk they are taking in owning stocks relative to US T-bills. As we see in figure 1, the equity risk premium in the US over the past 50 years has averaged around 1.7%. What this means is that in an average year investors have demanded an earnings yield that is 1.70% higher than the T-bill yield. As we see below, this figure became quite elevated throughout the 1970’s, a tough decade for investors but one that I would argue set up the tremendous bull markets of the 1980’s and 1990’s. Fast forward to the current era and we once again see a large and persistent equity risk premium which suggests two likely conclusions. First, a huge amount of risk is clearly priced into today’s market. Second, given where the risk premium has sat over the past decade the potential now exists for a multi-year bull market on a go-forward basis. I should caution that figure 1 should not be seen as a short-term timing device but I strongly believe that the current state of the equity risk premium supports the view that the markets next move is up and that the next decade will be an above average one for equity investors. The second reason why bad macroeconomic environments can provide a good backdrop for stock market investors is that the two key levers of economic policy, namely monetary and fiscal policy, are usually tilted strongly in favor of the investor when the economy is weak. Of course, with most western countries nearly fully tapped-out on the fiscal side of the house most of the heavy lifting will have to come from monetary policy. That of course is exactly what is happening and can be illustrated by the slope of the yield curve which measures the ratio between short-term rates and long-term rates. In figure 2 below we see that the Canadian yield curve remains very stimulative to corporate earnings growth. Based on historical precedent, a yield curve at or above 0.50 should be considered to be positive for Canadian equity markets and anything above 1.0 should be regarded as bullish! 1 In this example we use S&P 500 data as no similar times series exists for the Canadian equity market that is accessible in a timely manner.

3 ROE REPORTER | DKAM Of course, low interest rates are good for a weak economy but they represent an incredible boon for large parts of the economy that were already performing well without the monetary stimulus. Most of corporate Canada and the US will report robust earnings growth in 2011 and this year’s earnings will easily represent a new high watermark for corporate earnings in both countries – and corporate earnings are another of the key levers that drive the markets higher. Thus, notwithstanding all of the bleak headlines, corporate earnings growth this year and probably next will be very strong. Thinking outside the box In the previous pages we have articulated a bullish case for equities in both Canada and the US in both the short-term and long-term. To further illustrate this point, we refer you to figure 4 which was prepared by Mark Deriet of Cormark Securities. This figure shows US equities following a general pattern of over and underperformance over the past 50 years. Note that this figure ties in very closely with figure 1 which suggests that periods of maximum pessimism as reflected by the equity risk premium often coincide with great entry points for equity investors. It should once again be noted that these

4 ROE REPORTER | DKAM cycles are not precise and thus short-term investment decisions should not be made on the basis of what we see below. Nonetheless, the implications are that US equity markets (and by extension Canadian equity markets) are due for a period of significant and sustained outperformance sometime in the coming decade. Figure 4 – US Equities – 10 year rolling average returns – source Cormark Securities US Equities: 10-year rolling average returns 0% 5% 10% 15% 20% 25% 1850 1856 1862 1868 1874 1880 1886 1892 1898 1904 1910 1916 1922 1928 1934 1940 1946 1952 1958 1964 1970 1976 1982 1988 1994 2000 2006 1861 3.8% 1938 4.3% 1924 21.5% 1914 5.8% 1905 15.2% 1896 2.3% 1887 11.5% 1878 4.9% 1871 18.4% 1998 19.5% 1974 2.8% 1958 20.8% 2009 0.6% 1928 21.2% The other figure worth looking at also comes from Deriet at Cormark and it shows the relationship between stocks and commodities. Once again, I would caution investors not to use these figures to make any short-term investment decisions but at the same time they suggest that the relative outperformance of commodities relative to stocks is quite extended and based on historical patterns due for a reversal in the coming years. We don’t see any imminent collapse in the commodity markets but we agree with Deriet’s view that a lot of the easy money in commodities has already been made and that equities are poised for a period of above average performance. Figure 5 – Stocks vs. Commodities – 10 year rolling average returns – source Cormark Securities Stocks vs. Commodities: 10-year rolling average returns -15% -10% -5% 0% 5% 10% 15% 20% 25% 1913 1917 1921 1925 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 1948 20 years 1974 16 years 16-20 years = 2014-18? 1928 14 years 1958 10 years 1998 24 years 1914

5 ROE REPORTER | DKAM Concluding remarks The markets seem to have followed a familiar pattern this year with the TSX up in the first quarter, down in the second and as we start the third apparently on their way back up again. 2011 has been a good year for our funds thus far with the Capital Ideas fund up 8% in the first half of the year and the Financial Services Venture Fund up 3% versus an overall market that was down 1.1%. We are continuing to focus on owning those stocks with consistently high ROE’s and low P/E ratios that also boast competitive positions that will allow them to enjoy the magic of compounding. Call me if you want to chat about the markets or anything discussed in this report. JP Donville – 416 – 364 – 8886 .