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Gal^Stad
Investments Inc.

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Year in Review

2005 in Perspective,
from the January 2006 issue

The streak held for an amazing 115 years. From 1885 (when Mark Twain penned Huckleberry Finn, Louis Pasteur developed the rabies vaccine and the last spike was hammered into the Canadian Pacific Railway) until 2000, not once had the venerable Dow Jones Industrial Average failed to produce a positive return in a year ending in "5."

Then 2005 had to come along and mess things up: the Dow limped to a 0.6 percent loss.

The other major U.S. indexes did a little better, with the S&P 500 up 3 percent, while the Nasdaq squeaked out a 1.4 percent advance. While America struggled to absorb the impact of a vicious series of hurricanes, as well as oil prices that finished the year 40 percent higher than in 2004, the Canadian stock market rode a petroleum and commodities boom to a superb 21.9 percent performance.

Though the mammoth gains were concentrated in the energy stocks, a vast swath of the blue-chip parade also notched solid improvements.

The Contra portfolio kept up nicely, with a gain of 24.3 percent. If anything slowed us down, it was our fleshy weighting towards U.S. stocks and the 3.2 percent drop in the American currency. Our ten-year performance nudged upwards to 26.2 percent, but it was the five-year number that really blossomed: the round 40 percent result in this column makes us proud as the owner of a prize pumpkin.

What a difference it makes to drop the horrible -17.4 percent clanger from 2000 from the mix -- and even that pitiful showing would've made many a mutual fund manager envious.

Speaking of streaks, how about them takeovers! The year 2005 was the lucky 13th in a row that someone has scooped up a Contra stock, and this annum's morsels were particularly juicy. Worldwide Restaurant Concepts was taken out by Australia's Pacific Equity Partners at $6.92, a truly fabulous vault from our investment of $1.11 in 2001.

Harris Corp.'s purchase of Leitch Technologies was also a huge boost, paying out $14 on our purchase of $4.82 just 20 months earlier. There were however, disappointments -- a bidding war didn't emerge for Hudson's Bay Co. , and Analysts International was jilted at the altar.

Like a pair of broadcasting commissioners, we've been muttering about the lack of Canadian content for a while now, and have been attempting to amend that side of the portfolio. The fruits of our efforts: the repurchases of Cygnal Technology and Saskatchewan Wheat Pool. That's it -- not a sausage more.

A number of factors seem to have conspired to confound us. The investment-trust craze has severely narrowed the field for Canadian equities, as hundreds of corporations either converted outright or were swallowed up by asset-hungry trusts.

Ah, we hear you ask, but what about the trust blow-ups? Shouldn't a contrarian be able to scrape some of that roadkill off the highway, as we once did with Luscar? It's a tempting idea, but difficult to execute. For starters, our ten-year rule is a major hindrance; many of these entities have not been around that long (which hasn't prevented them from imploding in far less time).

Some have cut their distributions too slowly and chosen a long, painful death spiral rather than a quick fix. In many cases, the business model is broken, high management fees get raked off the top, punishing interest payments eat up cash flow -- all while competitive pressures expose the disease of capital underinvestment, the soft underbelly of the business-trust model.

We do think there will be some choice pickings in this sector, but only after transformations from heroes to zeroes are complete.

The more general issue behind the dearth of Canadian stocks worth buying is that the economy has been humming along for a number of years, so most companies are in at least decent shape. There are pockets, such as forestry products, that are flat on the mat, but high debt levels and uncertainty over whether things will get worse before they get better has stayed our hand.

Finally, there is that thing called luck, and that fickle lady has us sleeping on the couch these days. A couple of candidates that would have made excellent additions to the portfolio simply didn't "behave," choosing to hit their bottoms in mid-year before making strong recoveries in the fall.

Others were depressed during our buying period, but not as low as our radar sensed they would go. Could this have something to do with our radar's uncanny resemblance to a hot-dog rotisserie?

Looking ahead on the macroeconomic front, it shouldn't come as news that we think the U.S. economy is going to dip at some point in 2006. Some bears point to a "yield curve inversion" (a point where the yield on ten-year U.S. treasury notes falls below that of the two-year treasuries) as a key signal. Curve inversions have predicted recessions very reliably -- they have called the past five -- but at this point the degree of inversion is very slight.

The U.S. election cycle is also one of the more dependable indicators, and the mid-terms of presidencies are usually weak. Bush is politically wounded, but his Democrat rivals have lacked organization and a clear focus, so the elections appear to be up for grabs. That type of uncertainly is rarely good for the stock market.

The Canadian political scene is also muddy. If the Conservatives end up teaming with the Bloc Quebecois, or the Bloc wins an overwhelming mandate in Quebec, that pushes a referendum call closer to reality, and one can only imagine the ramifications. The potential effect on our currency seems relatively clear.

The loonie has made a remarkable recovery over the past few years. In 2005 it faltered for a while against the USD, then came storming back for a 3.2 percent gain. Increases against the other two main international currencies were much more impressive: 18 percent versus the euro, and 18.5 percent against the yen.

Back when we were saying our buck was vastly undervalued and could go to 80 cents U.S., we were way out of line with the consensus. It's a different story now: some Canadian CEOs are openly stating that they are readying their corporations for a currency trading at par or beyond.

The loonie's good showing rests on two pillars: resource prices and a strong central government with excellent finances. A slowing economy would weaken the former, while a Quebec move toward separation would undermine the latter. Such a combination would send the loonie into a tailspin and scotch any talk of trading at par. And when the rose falls off the housing boom which should happen any time now ... oh, don't get us going!

What is our best guess for the Contra portfolio this year? About three-quarters of our stocks are up in value from their purchase price, which doesn't augur well. In general, the more that have been beaten up, the better our chances of a good year. But the "shape" of the portfolio feels right, and we're hopeful that a Franklin Covey or NQL Energy Services is just waiting to shoot.

Of course, stocks like Fonar do creep into the mix more than we like to contemplate.

Anyhow, only 335 shopping days left till Christmas.


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