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  Slimming down the portfolio

BENJ GALLANDER and BEN STADELMANN

Friday, June 2, 2006

The essence of investing is understanding the nature of risk and reward — or, to put it in Warren Buffett terms, "Risk grows from not knowing what you are doing."

Peril also increases during good times like these, when upside potential is diminished and the downside is amplified. Optimism shines on the landscape and failure is a distant, forgotten demon. That can lead to carelessness, further negatively skewing the risk/reward ratio.

At Contra the Heard, our Spidey sense is tingling these days, which is why the portfolio has been pared down significantly. Since the New Year, our index finger has rested firmly on the Eject button.

Gone are Claude Resources, Hudson's Bay, Stride Rite, Xanser and parts of our positions in Franklin Covey and NQL Energy. Only one company, Abitibi-Consolidated, has been purchased.

Our thinking is predicated on the belief that in the next year, a recession will result from the confluence of a number of negative economic factors: the double threat of US deficits and a diminished currency stifle the purchase of foreign goods, thereby tripping up the global economy; high personal debt levels allow for less discretionary spending; real estate is losing its lustre, given the huge price increase and a diminished trickle-down effect largely satiated by previous buying. Bloated energy prices are zapping industry and consumers, while interest rate hikes impinge on buying power. Having fun yet?

Countering this, proponents of the "We've only just begun" theory look to China, Brazil and India and cite the pent-up demand from those and other countries which want to "move" into the 21st century.

While this will happen in the long run, every expansion pauses and meanders on its path. Picture the roaring '20s, when the desire to modernize via cars, telephones and household appliances was strong, but that longing was insufficient to stave off the Great Depression.

A key to expansion is that people have purchasing power, and that takes proper economic policies. In North America, fewer people are acquiring a larger percentage of the economy, as tax policies grossly favour the rich while throwing crumbs to the poor.

Perhaps it is time for another capital gains tax cut and increase in the RSP level? Or maybe a further drop in the GST to favour those who can afford to buy the most?

Our preparation for the problems we perceive is never a wholesale dash from the market. It is easy for us to be wrong — it has happened enough in the past! However, by selectively culling and heightening our selectivity, we still play the stock game, albeit at a diminished level, dampening the potential upside while limiting the downside.

This was the same approach we adopted in 1999, and though we lost 17.4 percent in 2000, it was on less money than our norm of the time.

A couple of our sales have been particularly noteworthy. NQL was purchased in December 2004 at $1.11. When the initial sell target of $5.50 was reached late last year, 40 percent of our position was shown the door. In May, another 30 percent was abandoned at $9.49.

Our perception is that there is yet further upside for this entity, as its sound management appears to be continuing to push the right buttons. As mentioned when this one was featured in an April 2005 column, it would not surprise us to see a suitor come calling. CEO Kevin Nugent did pull that off in his previous employment.

In April, one-third of our Franklin Covey also departed in an unusually defensive move. Acquired in December 2003 at $1.55 (U.S.), the sale at $8.84 was shy of our target price of $11.24. Dumping early is a rarity for us. This healthy gain, combined with other sales, meant that FC was approaching 25 percent of the portfolio, a proportion that was further aggravated by the fact that the American side of our portfolio had swollen to the 70 percent range. Risk reduction dictated a partial sale even though the upside still looked sweet.

There are two sides to the financial equation: making money and not losing money. During good times like this, people choose to focus on the former, while forgetting the latter. The Indian writer Pilpay had good reason when he said, "There is no gathering the rose without being pricked by the thorns." To us, the roses appear less lustrous today, the thorns sharper.


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