2005 RETROSPECTIVE AND 2006 PROSPECTIVE

What a year!

At the beginning of 2005 very few pundits, if any, were forecasting a TSX Total Return of just over 24% following 2004’s 15% return. Income Trusts, now integrating with the TSX Index, also defied gravity posting a second year total return over 28% (CIBC W M Total Return) despite some interference in the last quarter.

The bond market posted better than expected returns as well. The S&P TSX Canadian Bond Index finished the year with an all-in return of close to 7% down from just over7% in 2004. Cash returns increased modestly to 2.3% from 2.1% based on the 1-month bill rate.

International investors in Canada were not so fortunate last year. The US S&P 500 increased 3% which was entirely offset by the strength in the Canadian dollar which appreciated by the same amount. The MSCI EAFE (European, Asian and Far East) Index advance 14% in US dollars, 11% in Canadian dollars. Generally, Canadian investors were better off in Canadian investments.

Just what drove these stellar domestic returns?

It should come as no surprise that energy was the story of the year. The TSX Energy Index reported a total return for the year of 63.4% following a 30% return in 2004! Geopolitical factors conspired with market speculators to drive the price of crude oil through $60 US a barrel. The energy sector finished the year comprising over 27% of the TSX Composite and contributed over one-half of the annual performance.

Utilities posted a surprising 38% return for 2005, up from a modest 9% the year previous. Concerns over power availability and the prospects of lucrative infrastructure projects drove demand for utilities. A favourable proposal to enhance the value of dividend paying stocks in the fourth quarter also provided impetus to prices at year-end.

Financials also benefited from this tax proposal and reported a total return for the year of 24% following a 20% return in 2004. All was not smooth sailing with the banking sector as some credit concerns were evident domestically and abroad. Most notably, the CIBC took a massive write-down in its third quarter with respect to Enron. The insurance sector, particularly the life companies had a better year, while the property and casualty companies reported better underwriting profits from auto but suffered where exposure to the hurricane Katrina was evident.

In all, only three of the ten major categories of the TSX posted negative returns for the year; Info-tech (-16%), Heath Care (-3%) and Consumer Staples (-1%). In general, consumer related ares performed poorly relative to the more capital intensive sectors.

2006 PROSPECTIVE

We approach 2006 with cautious optimism.

Cautious because the stock market does not look cheap by any means with respect to historical valuation measures. As we enter 2006, the opportunities presenting themselves through our research are few and far between. This is not to say that we are not finding any opportunities, but we are having to kiss a lot of frogs to find a few princesses.

Optimistic because we believe that the secular forces which have driven the market thus far remain intact. Global growth is driving the demand for basic materials where little capital has been allocated to capacity for some time. Antiquated infrastructure is fueling the need for more projects while exacerbating pricing due to shortages and capacity constraints in North America. A more benign interest rate environment should be the response to slower economic growth which will alleviate some pressure on very stretched consumer.

2006 has commenced with an inverted US yield curve (i.e. short term interest rates are modestly higher than longer term rates). This condition is often the harbinger of a recession, but not always. It is hoped that this situation will cool the largely over-heated housing market in North America by restricting credit if lower long rates in fact support current house prices to a large extent.

The danger, in our view, stems from the potential for inflationary conditions brought on by high commodity and energy prices to force rates higher in a precipitous fashion. Some of this inflationary pressure will be mitigated by more modest growth abroad, partly in reaction to this high price environment. As often occurs, the global economy sits on the precipice of muddling through a period of slower growth or sliding into recession; a condition not seen in North America for some tome.

Overall, our outlook remains quite positive for the Canadian market which will benefit from the higher material and energy environment. The demand for capital should support the financial sector. Energy, Materials and Financials account for around 75% of our market. The Canadian dollar is likely to continue to appreciate relative to the US dollar. Hence, we will continue to be very selective in our quest to add US exposure. Gold should also continue to benefit from uncertainty over the future of Euro and concerns for the US dollar. Physical demand should also serve to maintain high gold prices.

We will continue to apply our bottom-up methodology to building portfolios. Securities will be added opportunistically as they are identified to have valuation characteristics representing greater upside potential over the long term relative to the downside. At Sprung & Co., we seek the highest quality companies with solid financial underpinnings and good management selling at prices we believe to be compelling as a business owner.

We wish everyone a Happy and Prosperous New Year!

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