Opportunity and its Knocks Most of us have heard those famous investment sayings. Baron Rothschild, an 18th century aristocrat, investor and scion of the Rothschild banking family is credited with saying that “the time to buy is when there is blood in the streets”. Similarly, War ren Buffett has been quoted as saying that “the time to be fearful is when others are greedy and the time to be greedy is when others are fearful.” These are of course investment truisms or clichés that surround the concept of contrarian investing which is based on the idea of buying assets or investments that are out of favour. However, few of us rarely act on such words of wisdom because what the Rothschild and Buffett quotes fail to mention is that contrarian investing is very hard on the nerves. Why is this? Contrarian investing requires an investor to be good at two things. First, a contrarian investor must be good at identifying investments that will “bounce back” and while good contrarian investments are often easy to identify in hindsight they rarely are so when, as Rothschild says “there is blood in the streets”. Second, a good contrarian investor must also be good at going against the crowd which is easier said than done. Human beings are not wired to be contrarians and members of the human race feel most comfortable within the supportive embrace of the crowd. This is true whether it be in the context of investing or in most other areas of human endeavour. A Contrarian’s Perspective on Asset Classes As we sit at the mid-point of 2012, there exists a great deal of uncertainty surrounding virtually all types and classes of investments. The spectra of a failing Europe weighs most heavily on the markets but other issues ranging from a real estate meltdown in China to high unemployment in the US are also in the mix. These various “issues” have been weighing on the market in one form or another since 2008 and have created a great deal of uncertainty within the investment world. VOLUME XIX JULY 2012 INVESTMENT ISSUES • STRATEGIES • INSIGHTS FROM DONVILLE KENT

2 ROE REPORTER | DKAM However, much of this uncertainty stems from what I call faulty analysis and the tendency to extrapolate recent events into perpetuity. This approach flies in the face of one of the central tenets of investing which is mean reversion. Thus, in reality things don’t stay good or bad fo rever, but instead revert back to the middle. Asset classes that have outperformed over the past decade are unlikely to do so in the next decade and vice versa. At the root of contrarian investing is the idea that the best place to look for investments are in those areas where pessimism and negativity reigns, as this negativity is reflected in attractive valuations. Thus, astute long term investors like Buffett know that assets that are “loved” by the masses are almost certainly expensive while those that are “hated” are almost invariably cheap. Our quest as investors is to look for cheap assets. Most readers of this newsletter will have access to 4 or 5 broad asset classes and it is therefore my goal in this newsletter to look at each of these in a general context. The investment returns of an asset class and its valuation has a tenuous link in the short-term but long-term returns are closely linked to valuation. Thus, while it is difficult to say how bonds, or real estate or equities will perform in the short-term (say next 90 days), it is relatively easy to say which asset classes are cheap or expensive in a long-term context and therefore gain insights into which will perform best in the coming decade. Let’s take a quick look at the following asset classes namely bonds, commodities, real estate, precious metals and equities. Bonds Bonds are obviously a broad asset category and here we are referring primarily to government treasuries and the high-quality end of the corporate bond market. Real government treasury yields are near record lows [Figure 1] (they are probably in fact negative) and thus represent a poor investment for investors other than those who believe that a severe deflationary environment is just around the corner. As such, we believe that high quality fixed income portfolio investments will perform poorly in the coming decade. The only exception to this thesis would be the junk bond market which is heavily influenced by equity markets and is therefore still reasonably attractive in a long-term context.

3 ROE REPORTER | DKAM Figure 1- U.S. 30 Year Treasury Yields Source: U.S. Department of Treasury Commodities Commodities tend to perform along multi-decade cycles that consist of 10 to 12 years of boom like conditions followed by 10-20 years of either bust or stagnating pricing. Between 2000 and 2012, commodities rose by close to 400%, which is consistent with past historical up-cycles. However, over the past year commodity prices have begun to trade sideways as supply has begun to respond to the large up-tick in prices over the past decade [Figure 2]. In a historical context, oil, metals, gold and even farmland are expensive. Thus, while commodities are not as stretchered as bonds, rich valuations suggest that commodities in general will perform poorly in the coming decade. Figure 2- 10-Year Commodity Compound Annual Growth Rate Source: Cormark Securities Inc.

4 ROE REPORTER | DKAM Real Estate Real estate tends to be heavily affected by the supply vs. demand factors that exists in local markets and thus we need to be careful with broad generalizations. For many investors, real estate investments tend to exist in the form of their principal residence or Real Estate Investment Trusts (REITs). In the context of the Canadian market, both investments have performed very well [Figure 3]. Today, yields on Canadian REITs are near all-time lows (which means they are expensive) while cap rates in a number of real estate sectors in Canada are near multi-decade lows (once again suggesting that this asset class is over-valued). Figure 3- Average Canadian Home Price Source: CREA Precious Metals Like commodities in general, gold, silver and platinum are expensive in an historical context. In real terms, gold peaked in the early 1980’s and has returned to similar valuation levels in the past year [Figure.4]. This does not mean that gold or any of the other precious metals cannot go higher but the easy money in gold has probably been made. The same can probably be said for Silver and Platinum.

5 ROE REPORTER | DKAM Figure 4- Inflation Adjusted Gold Price Equities Equities are the asset class that everyone seems to be avoiding and part of this has been its poor performance over the past decade. Equity valuations peaked in 2000 in both Canada and the US at the height of the tech-bubble and equities have been moving sideways ever since. However, what many investors fail to realize is that earnings have been steadily growing ever since and valuations are now attractive in absolute terms [Figure 5]. If we further adjust equities to take into account the cost of the risk free rate (the ten year government treasury) which is sometimes called the equity risk premium, we see that equities are about as cheap as they have ever been. Equity valuations suggest that equities will soon embark on a multi-year period of outperformance. Figure 5- 10-Year U.S. Equity Compound Annual Growth Rate Source: Cormark Securities Inc.

6 ROE REPORTER | DKAM The Coming Rally in Stocks The preceding discussion has attempted to make the investment case for equities over all other major asset classes. Equities are clearly cheap but in order for equities to perform, some type of improvement in the risk profile of the market is necessary because the next big move in the market will come not from a surge in earnings, but in an expansion in the market multiple. So what is the market multiple and what will lead to its expansion? The market multiple is simply the multiple of earnings that the market trades on. Thus, when market participants feel positive the multiple tends to be high (say 20x) and when participants feel negative the number can be low (say 10x). We can further adjust the market multiple to take into account what is referred to as the risk free rate (the government 10 year yield). When the risk free rate is low, the market multiple should be high and vice versa. Thus, equity market multiples are currently low but with the risk free rate being near zero, this would imply that the markets multiple should in fact be very high (perhaps as high as the mid 20’s). Thus, the market should be trading on a significantly higher multiple than it is today and a potential rally of 30%+ would still see the market trading at a discount to what is implied by the level of earnings and interest rates. So what will lead to this multiple expansion? The biggest issue by far is Europe. The Euro-crisis has been brewing for some time with the Greek debacle highlighting the extent to which the current EU monetary structure is unable to deal with the current economic problems. However, there is a growing sense that European policy makers are finally getting closer to putting in place the appropriate monetary and political schemes that will allow it to move forward on many different levels. Let there be no misunderstanding. Europe’s problems will take years to solve but the policy solutions that are currently being constructed will allow the market to find its bottom and also allow for a cycle of renewal to begin. It is my sense that in the coming year, such a policy response will emerge and that a significant rally in global equities will ensue. Concluding Remarks The Capital Ideas Fund has outperformed the market so far this year and we expect better returns in the second half of 2012. Call me if you want to chat (J.P. Donville – 416 – 364 – 8886)