This up-dates and expands our Blog of September 22, 2010

The Great Fake Fright of 2010

Towering forecasts of failure created renewed panic in the summer of 2010 and many investors cashed out their portfolios. This happened not at the climax of a stock market crash, but at the mid-point of recovery. This time, those rushing for the exit weren't rattled retirees but stock market experts - traders, economists, bankers - who read the business section daily as part of their professional routine and who drink each other's bathwater.

Forecasters profess to know the unknowable and it must be remembered that these modern day witch-doctors make a living by being heard. Their audiences were still shaken by the events of 2008/09 and drank the poisonous brews being prepared for them.

Why did the crescendo of doom peak in the summer of 2010? In August, the market deck was stacked in the doomsters' favour. As you see from the chart below, markets invariably decline in September and October, and it was easy to believe dire predictions made this summer would be validated by stock market declines in the fall. The proclaimers of peril had a good chance of appearing to be right.

Instead, this time, prices didn't decline! Markets actually rose in September and the S&P 500 recorded its best month of September since 1939!

Why was the Fright a Fake?

It turns out that commentators were just spooking themselves. One of the abiding fears of the summer of 2010 was the potential impact on the financial system of risky sovereign debt. This raised the spectre of another settlements crisis, the gravest factor in the Crash of 2008.

However, there is a way of tracking the viability of the settlements system. This is through the difference between the interest rate charged by banks lending to each other - exemplified by the 'London Inter-bank rate' or LIBOR - and the risk-free rate of US Treasury Bills. As can be seen by the chart below, provided by John Aitkens of TD Securities, both the short (31 day) and intermediate (2 year) term spreads showed no concerns. The peaks show that the system was validly worried in 2008, but was not at all worried in 2010.

The market was not concerned either. The chart below shows that volatility was normal in the summer of 2010.

The chart below verifies the market's calmness amidst the forecasts - how it rose throughout all the so-called bad news.The problem with dire predictions is that they always have a chance of being right. However, this doesn't mean that the best strategy is to be out of the market. Corporations generally have seldom been in better financial shape and will probably survive even the most severe downturn. With huge increases in money supply looking for a home, even the worst of scenarios are not likely to bring a stock market crash like the '30s. Instead, starting in the first quarter of 2009, the liquidity brought a stock market and commodity boom.

Gloom is a less risky outlook than euphoria. Note that since the S&P/TSX peak in June 2008 (at a time of euphoria), the market decreased by 8 percent to September 2010 (at a time of gloom). The average Heathbridge equity account, on the other hand, was up nearly 18 percent.

A steady hand steers a better course.

'Buy and hold' is a great market strategy, particularly in the recovery period following a stock market crash. Be sure to attend our presentation on November 22nd when we will show you what returns such a strategy can reasonably be expected to provide.

Our clients' experiences in the market crash of 2000 - 2002 were similar. Our average account value in this period broke through previous peak levels after 11 quarters, fully 1 .5 years before the S&P/TSX index regained its losses.

The reasons why our accounts have been more resilient relate to the tenets of Checkmark Investing^TM.

One of these is better diversification. We don't duplicate any investment position, so each of the 20-odd stocks in our typical portfolio is fully differentiated. In other words, even though we run concentrated portfolios, our investments are better diversified than the S&P/TSX benchmark and most of our competitors.

You can see below how our accounts are more diversified than the S&P/TSX index which tends to have disproportionate weightings in hot stocks and sectors. Such indices - and those of our competitors' funds that secretly mimic them - are vulnerable to sharp corrections. In 2000, the TSX and closet index funds were over half invested in technology and telecoms. In 2008, they were three-quarters invested in resources and financials. Our portfolios were much safer.

Another tenet is our focus on companies which have financial strength and an enduring competitive advantage. Financial strength enables our investments to weather the storms without depending on financing from fickle banks and capital markets. We also screen companies for some 'unfair advantage' such as the attributes listed below. Put simply, our investments have been more resilient.

A third tenet is our timing discipline which directs us to purchase our target investments after price declines, as shown in the chart below. This 'governance mechanism' kept our attention focused on the extraordinary opportunities that were being created in the last quarter of 2008 and the first quarter of 2009. It kept us from selling at the wrong time and encouraged us to buy at the right time.

These tenets along with other facets of the Checkmark InvestingTM discipline have served everyone well through two vicious bear markets and two subsequent recoveries.

Review of Investments

'Successful investing doesn't require extraordinary intelligence, but rather extraordinary discipline'.
- Warren Buffet

We typically review all the companies in our equity universe twice a year. Since our turnover tends to be low, this frequency is sufficient to inform without over-burdening. Within each portfolio, we try to assemble a group of sound, well-diversified, well-bought businesses rather than trying to time their stock price movements. The results of this process are best measured by the long-term returns on the whole portfolio rather than by the short-term successes or failures of its components. We always welcome your inquiries on your portfolio and its individual securities.

Our letters for the first and third quarters typically discuss only the main changes to the investments in our equity universe for the three months of the quarter under review. Not all the securities mentioned will be found in every account due to differences in risk tolerances and stock prices at the time the portfolios came into our care.

Summary of Activity in the First Quarter of 2010

Activity in the first quarter of the year was muted. We are in a 'harvest mode' for the moment. New investment candidates for the most part don't seem to be as sound as the ones we already own, yet in general, prices have not risen enough to generate further trims. The table below summarizes our primary transactions in the period.

Bought or Added

Sold or Trimmed

To protect the interests of our existing clients, we have excluded this section in our abridged version of our quarterly letter.

In conclusion

Investing can be a test of endurance at times, but disciplined and patient investors are well rewarded for remaining on track. In spite of grueling peaks and valleys, investors can own the podium by focusing on the long term. We remain comfortable with our current stable of investments and continue to believe that the Olympian companies in your portfolio will with time continue to deliver superior returns.

We appreciate your trust in having us manage your capital and we continue to strive to grow together for the long term. Your comments and questions are always welcome. Please call us at 416-360-3900, or toll-free within North America at 1-800-446-3819.

Heathbridge Capital Management Ltd.

PLEASE READ THE LEGAL STUFF:

This report contains forward-looking statements which are generally identified by words such as 'may', 'believes', 'expects', 'estimates' and similar expressions. Forward-looking statements are subject to a number of known and unknown uncertainties that could cause actual results to differ materially from those expressed in the statements.

Our discussions of corporations and assertions as to their attributes may be presented in definitive-sounding statements which are generally indicated by words such as 'is', 'has' and similar expressions; however, investors should recognize that our understanding of the corporations discussed may be incomplete and our opinions and ratings may be wrong. We use reasonable efforts to obtain information which we believe is reliable but we cannot research authoritatively all facts relating to markets or companies and, to some degree, markets are unpredictable. Therefore, we must make investment decisions based on information that is often incomplete. We use a diversified portfolio investment approach to try to offset instances where the information and opinions we hold on individual investments prove to be erroneous. We do not guarantee results and cannot be held responsible for investments made or losses suffered by investors relying on information contained in this letter.

We thought it would be fun and educational to test you with an end-of-year quiz.

Question 1

Given all the turmoil in the world, wouldn't I be better off just investing more in personal real estate?

Answer:

No. Stocks outperform housing. From September 1982, near the bottom of the housing cycle over a quarter of a century ago, to September 2009, the best performing Canadian housing market was Toronto. Toronto house prices increased by 5.5% per year, growing to more than 4 times the original investment value. However, house-related expenses such as renovations and maintenance would have considerably reduced this return.

In the same time frame, the S&P/TSX returned 10.4% per year, growing to more than 14 times the original investment.

Question 2

Am I not better off just investing in the oil-rich Canadian market and leaving the debt-ridden US alone?

Answer:

No. In the long term, the US investment market is broader and more exposed to
global growth. Even after the bottom-to-top run in commodity stocks from 1982 to 2009 inCanada and ten years of stagnation in stocks in the US, the broad-market S&P 500 annualreturns measured in either Canadian or US dollars beat the S&P/TSX returns.

The full text of the Quarterly Letter addresses four more questions, as well as much more information of value to investors. Please fill in the form on this page to receive the full text.