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Year in Review

2006 in Perspective,
from the January 2007 issue

"Hope for the best, prepare for the worst." So the adage goes. One has to wonder whether some of the purveyors of doom and gloom really wish they'll be wrong. Take ol' Joe Granville, for instance, who once moved markets with his prognostications. He predicted the Dow would end 2006 at 7400 -- just another blown call, but at 81 years of age, how much longer does Joe have to get his mojo back?

Or take Elliot Wave guru Bob Prechter, who came out with his book Conquer the Crash, in which he predicted a Dow meltdown that would wipe out 90 percent of its value, just in time for the October lows of 2002. Four years on, a Dow at a new record high can't be good for book sales.

The fact that 2006 was more benign than we anticipated leaves us genuinely pleased. The decision by the U.S. Federal Reserve to halt its campaign of raising interest rates was welcome, given that consumers had to shell out more due to jumping gasoline prices. And despite the grave warnings of another round of killer hurricanes, few of these powerful storms actually appeared. Indeed, markets around the world shrugged off the global structural issues we fretted about and put in a rock-solid performance.

Despite a slackening of the oil boom, the TSX carved out a 14.5 percent gain, riding a wave of megabuck takeovers in the mining sector and steady results for banks and insurance companies. The mighty mites on the venture exchange stormed ahead for a 33.5 percent lift, indicating that the skies are azure above the resource patch.

South of the border, the gauges were all gaudy green. The Russell 2000 index of smaller firms led the way, up 17 percent. Of the big guns, the blue-chip Dow did best, busting through the 12,000 level for the first time and finishing 16.3 percent higher. The S&P 500 and Nasdaq are still well below the high-water marks set in 2000, but also had respectable increases of 13.6 and 9.5 percent respectively.

Overseas, 2006 also sparkled. Despite doubts about the sustainability of the Chinese miracle in the face of dramatically higher costs of raw materials, the Hang Seng index was up 34 percent and the Shanghai Composite climbed an astonishing 130 percent. From Australia and New Zealand to Singapore, stocks brashly closed at all-time highs. Smaller emerging markets, so hot a few years ago, also reignited: Russian stocks skyrocketed 71 percent and Mexico was up a spicy 49 percent.

The Contra portfolio's showing was far less impressive. Although a 9.1 percent gain isn't cause to break out the crying towels, this achievement, which is satisfactory on an absolute basis, sits between two Jekyll-and-Hyde extremes.

Several of our older holdings would do the good doctor proud, and ample profits were cashed on the Hudson's Bay takeover (making 2006 the 14th straight year in which a Contra holding was gobbled up) and sales of Air France-KLM, Stride Rite and Xanser. Relative newcomers Franklin Covey and NQL Energy Services (another takeover target) were also multi-bagger standouts. But the spirit of Robert Louis Stevenson's despicable villain lurked in the woeful performances of many of the newer members of the team.

Although we averaged down aggressively on Analysts International and Cygnal Technologies, these two miscreants spurned our faith and went lower. Our bridgehead in the healthcare sector blew up, resulting in a substantial loss with Theragenics and an outright disaster with Fonar, where we lost three-quarters of our investment. Penn Treaty, our long-term care insurer, whose turnaround seemed to be rolling along in 2005, fell off the wagon with a thud for a 23 percent loss.

For the first time since 2001, the Canadian dollar ended the year lower than where it began, though by only a fifth of a cent. That slightly increased the converted value of our American holdings at year-end, yet our overall results still managed to get dinged by currency translation to the tune of a little over half a percentage point. That's because of the loonie's surge during the year, over the 91-cent mark in June (a 28-year high), the result of which was that we actually received less from our big U.S. stock sales during the year. We also put fewer of those greenbacks to work, purchasing only one American stock, Solectron.

Our buck did far worse against the euro, losing about 12 percent. That helped goose our profits in Air France. Without a doubt, it was a year when having more foreign content was worthwhile.

One prediction that we did get right was that investment trusts would be a big story in 2006. We reckoned that their addition to the S&P/TSX index was a sign that their best days were behind them, and in November the government finally acted to introduce new taxes on these vehicles.

Oh, what a wailing and gnashing of teeth sounded across the land! People, people, take a chill pill. Not that we like the manner in which it was done -- duplicitous politicians who say one thing on the election hustings and then do the opposite from their comfy corner offices deserve all the reprobation sent their way. But something had to be done to halt the disembowelling of corporate Canada, and Finance Minister Jim Flaherty's action was neither drastic nor onerous.

For starters, real-estate investment trusts are, for some reason unknown to us, exempt from the legislation, so those cash cows can still be milked. Distributions on business trusts won't be taxed like ordinary income, but at the dividend tax rate -- oh yeah, the one that was cut just last year. That softens the blow.

Finally, the new tax is only immediately relevant to newly minted trusts; existing trusts have nothing to worry about until 2011. In political terms, such a length of time is a distant horizon, especially for a minority government. It's a lock that there will be an election before then, so the tax may get watered down, or perhaps a delay of a few more years will be tacked on, so that it will conveniently fall to the poor slobs in the new "new government" to actually do the dirty deed.

The long and the short of it is that the proposed changes merely put distributions from business trusts on the same level as dividends from corporations. Seems pretty logical to us.

Another of our prior predictions came true in the second half of 2006 -- well, sort of. We were early in calling a top in the real-estate market; in most of Canada, housing prices remain buoyant. But in the U.S., it is taking a record amount of time to sell homes, and inventories are piling up faster than old VCRs (or new Chryslers). And prices are sliding, housing starts have fallen sharply, and the stock prices of many homebuilders are in the dumper. But consumers are proving to be a hardy lot, particularly those who are more affluent, so the fallout on the general economy has so far been subtle.

Economic health has also been aided by the rate of inflation, which has been downright tame. This is attributable to two main factors. First, the "China Syndrome" is alive and well, as the range of products that can be inexpensively imported from that country and other low-wage locales continues to expand, thus pressuring competitors to hold the line on prices. Second, wage increases have been modest, so aggregate purchasing power is growing slowly.

Lots of experts are worried that higher inflation will haunt us again soon, though -- probably many of the same ones who worried about deflation. The porridge never seems to be "just right."

So, how do things look for 2007? Both the U.S. Federal Reserve's chairman, Ben Bernanke, and our own David Dodge are cautiously trying to engineer a so-called "soft landing."

The idea is to stand pat on interest rates, allowing the previous increases to work through the system and dampen inflation, while cooling the economy to a slower, but healthy and sustainable pace.

Economic soft landings are one of those notions that tend to keenly separate optimists from pessimists. Confident folks believe either that the landing will be executed as planned, or, even if a little rough, central banks will be quick to cut interest rates and get the economy chugging again. That spells enhanced corporate profits and a cheery stock market. The example held aloft is the successful 1994-95 soft landing that avoided recession and set up five more years of a thriving bull market.

Worrywarts point out that the batting average on soft landings leaves a lot to be desired. The 1990-91 recession started out soft, and wasn't nearly as deep as that of a decade earlier, but it hung around for a long time -- especially in Canada, where unemployment hit its peak of 11.3 percent in 1992. The landing in 2001 was fairly soft -- in terms of the general economy, the recession was so brief and mild that economists are still arguing if it even was a recession. Regardless, everyone remembers that the stock market still got trashed.

As for the portfolio, the Canadian content has improved to 50.5 percent, which is a far better balance than we've had in the past few years. Of the 18 stocks that finished 2006 in the portfolio, 14 had gone up in value since they were purchased, three were down and one was dead even.

Typically, the portfolio does best when a lot more stocks are down than up, so that bodes negatively. However, our gaggle of stocks is fairly young overall, and we believe that our 2006 purchases have come later in the cycle after their turnarounds have begun, so there ought to be less time to wait until target prices reach fruition.

Despite an adjustment to the weighting system to increase the amount spent on each stock, the total amount of money invested in the portfolio is down, but that isn't surprising given that we had 23 positions last year at this time. The reduction is also a reflection of our reticence about the economy and a dearth of candidates that we both feel comfortable with. The ocean is wide, but there are precious few of those sweet droplets that the Contra Guys prefer to drink.


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