STAYING THE COURSE: Leading up to writing this quarterly letter, we couldn’t help but reflect back on the excitement and enthusiasm that surrounded the arrival of the new century a little over three years ago. Celebrations were held in cities around the globe and the outlook seemed so promising. Today we look back in stark contrast to a world where the news flow has been unrelentingly negative.

First came the bursting of the tech bubble, the weakening global economy and corporate fraud. Next, of course, the events of September 11, 2001. Then onto Afghanistan, the war with Iraq and the increasingly threatening tone from North Korea. All reflected in a stock market that has declined for three years running. A virtual cacophony of bad news.

As if this weren’t enough, we now have a global health scare related to the outbreak of a virulent and contagious form of pneumonia. While the general public is likely over reacting to this event, this is one of those situations where perception becomes reality. Travel and retail sales in several parts of the globe are under pressure and some GNP forecasts are being lowered. The steady string of negative events begs the question; if this is just a run of bad luck, are we just about through it? Or has the world shifted into a higher risk and more volatile environment for the time being? Judging by the damage investors worldwide have suffered over the past three years, no doubt there are large numbers of individuals hoping for the former. Perhaps the speedy resolution of the war in Iraq is a harbinger of better news to come. As growth investors, we certainly hope so.

However, when we stand back and assess the macro environment, we see a world plagued by excess capacity in most industries, coupled with deteriorating public finances in many countries (especially our neighbour to the south). Weak demand, the cost of war and a Fed left with limited firepower may delay
the much anticipated recovery. But rather than sitting back, waiting and hoping that an eventual recovery will arrive, we have concluded that we need to be more pro-active in our portfolio composition. We have spent considerable time and effort to identify the select few industries where demand appears to be in better balance with supply and seek individual companies that offer the best prospects for growth in the months ahead. We determined that energy (specifically natural gas), and basic materials (driven by robust demand growth from Asian markets) offer the best opportunities for demand growth and pricing leverage looking forward. At the same time, we have added to our holdings in select Business income trusts so as to augment current income in our portfolios. We will address each theme individually.

Energy

The current conventional wisdom held by most market observers is that the price of oil and natural gas will fall significantly with a victory in Iraq. While there is no doubt that the high prices only recently experienced are unsustainable, we have concluded that energy markets in general (and North American natural gas markets in particular) are very tightly balanced between demand and supply.

Oil prices have declined with a victory in Iraq but we believe that they will not stay in the low $20 range that so many pundits anticipate. Oil inventories worldwide remain at low levels. Production shortfalls in Venezuela and now Nigeria have contributed to tighten markets further. Despite a weak global economy, overall demand remains robust aided by safety issues plaguing the Japanese nuclear industry (oil import substitution) and growing oil consumption in China. Only a few years ago, China was a net exporter of oil to world markets. Today, China is a net importer of approximately 2 million bpd and we have seen research suggesting an average annual import increase of 380,000 bpd in order to keep up with domestic demand. Net imports could increase 3-4x by 2010.

Furthermore, while we recognize that Iraq possesses vast untapped oil reserves, we suspect it will take much longer than currently assumed to develop these reserves and bring them to market. Post-war Iraq will likely be fraught with a host of political issues that will take time to resolve. This will delay meaningful amounts of capital investment by the major oil companies in Iraq’s decrepit energy infrastructure.

If world economies were to somehow surprise on the upside in a post-war environment, then energy consumption would see a similar increase. Given the tightly balanced market, prices would likely stay much higher than current consensus. From our perspective, oil looks encouraging either way. And certainly energy company shares have not kept pace with the oil price.

Natural Gas

Based on our analysis, prospects for North American natural gas markets appear even more encouraging than for oil. Simply put, North America is running out of cheap, accessible natural gas reserves. The unusually cold weather of this past winter only served to advance the timetable. Unlike oil, natural gas is not easily transported so imports are not a near-term solution. Natural gas exploration in the United States is failing to replace even the natural production decline experienced in mature fields. Also, failure to reach agreement in the U.S. Senate to open up vast new areas to exploration in environmentally sensitive Alaska will further delay any domestic sources of new production.

As natural gas prices remain higher than expected, drilling activity will increase. But the experience of the last few years (including the high levels of drilling activity in 2001) suggests that the U.S. industry will not get the supply response that it is seeking.

Canada, by comparison, appears relatively prospective for new discoveries of natural gas reserves. And happily from an investor’s standpoint, a host of new, natural gas oriented companies led by experienced management teams have commenced operation in the past 2-3 years. These companies offer significant growth opportunities and are trading at very reasonable multiples of both earnings and cash flow to their underlying growth rates. Balance sheets and debt to cash flow ratios are very strong.

We are very excited about the prospects for our selected companies over the next 1-2 years. The industry will have to work hard to replace inventories in time for next winter’s heating season. A warm summer (cooling demand) and limited snow pack in Western North America (run-off for hydro generation) will only intensify an already tight market.

Basic Materials

While we have owned companies in this sector in the past, many years of excess supply and under-investment have produced few growth opportunities. However, we suspect that this is all about to change in a meaningful way. The challenge will be to get the timing right.

For years, investors have all heard the China demand story, to the point of perhaps concluding it is full of promise but no delivery. Yet after lengthy study, we have concluded that a major shift is currently underway with respect to the Chinese economy. From 1990-1995, when China was all the investment rage, the story was one of joint ventures and the exporting of goods back to developed economies. Investment capital flowed readily into China only to be disappointed and culminated in the Asian flu in 1997. A strong U.S. stock market and ongoing problems in Asian economies resulted in most of the direct equity capital flowing back home in the ensuing years. The conclusion widely held is that Westerners are unable to successfully invest in China.

Yet despite this conventional wisdom, China continued to be the recipient of Foreign Direct Investment due in large part to its low labour rates and the desire to gain access to it’s huge and growing domestic market. Over the past few years, China has emerged as the “factory to the world” in virtually every labour intensive manufacturing industry.

Admittance to the World Trade Organization (WTO) has only served to speed up this massive evolution. The result is plain for any observer to see. The standard of living is rising in a meaningful way and China now possesses a burgeoning urban middle class with pent-up demand. No doubt, Chinese politics and society still possess many problems. Yet, after we studied Chinese demographics and the comparison to the emergence and impact of the Japanese economy in the 1950-1975 period or even to the rise of the U.S. economy in 1870-1880, we concluded that China will have a significant and meaningful impact over many years on selected basic material industries. China has emerged and cannot now turn back. China’s size and speed of development will see to that.

For all its competitive advantages, China lacks or has limited domestic supplies of several key basic materials. Certain foodstuffs, iron ore, nickel, copper, wood fiber, gold and crude oil are all in short supply in terms of domestic production. China is becoming a major net buyer in these specific commodity markets.

We have no doubt demand levels will ebb and flow over time based on the strength of the domestic economy. For example, in the first quarter, China’s industrial production rose a staggering 17%. This pace cannot be sustained and growth will slow in the very near term. SARS will likely see to that. Nonetheless, in the longer term, China’s emerging economy is a freight train that appears hard to stop. If, for whatever reason it does, then all bets on the global economy are off as well. Furthermore, China must continue to experience 7-8% annual growth in GNP to sustain employment growth otherwise, social unrest will rear its ugly head. This point is clearly not lost on the Chinese leadership. And finally, if growth does not come from Asian economies, where will it originate? Certainly not from Europe with its moribund, socialist governments. South America? Africa?? The only wild card is perhaps a recovery earlier than expected in the United States. However, if the U.S. economy were to surprise on the upside, then Asian growth will be firmly on track, driven by export demand which leads us back to our basic materials consumption story.

While we are not advocating wholesale investment in Chinese stocks (accounting and governance issues, etc.), we do believe that is possible to gain leverage to the Chinese economic emergence by investing in selected basic material stocks right here at home. Although one could argue it is more attractive to invest in nearby economies such as Australia or Malaysia, there are a number of junior Canadian companies that are poised to benefit. We suspect that this will be a very long-term story and we are just at the beginning.

Income Trusts

Over the past several years, the income and royalty trust markets in Canada have seen tremendous growth. The issued market now exceeds $40 billion as a result of both new issuance and corporate conversions. To date, income trusts have largely appealed to the retail market with relatively minor pension fund involvement perhaps, due, in part, to the issue of potential unlimited liability.

After extensive analysis, we have concluded that the income trust market represents a very mixed lot. Most trusts simply represent a return of ones’ own capital after paying a management fee. We advise avoiding these trusts as we fail to see any meaningful investment merit. These include conventional oil and gas trusts as well as many of the infrastructure trusts. A second group of trusts include those lacking attractive underlying assets and should never have gone public in the first place.

And finally, we have determined that there is a limited number of trusts that represent on-going, growing companies that have used the trust vehicle for financing when other forms of equity have been unavailable.

We refer to these select trusts as business income trusts. Typically these trusts distribute approximately 75% of their cash flow while retaining the remainder for maintenance capital expenditures, expansion and industry consolidation. Business trusts possess modest, high single digit internal growth AND very attractive payout yields. When the growth rate is combined with the expected yield, the total return is quite attractive in today’s lack luster environment.

We would also point out that the monthly payout requirement imposes a strict discipline on management to not squander resources which is very important given the current concerns regarding corporate governance.

As to the unlimited liability issue, we acknowledge that a remote liability does exist given current trust law. However, we would observe that all business trusts carry operating company insurance. As well, all of our business trusts are companies that have been operating for some time and have meaningful positive track records. Additionally, with one exception, our selected trusts have been established using a limited liability corporation to actually hold the underlying assets thereby making it more difficult to reach through to unit holders. And finally, we understand that efforts are being made to have provincial laws changed such that trusts which are reporting issuers will be subject to limited liability. In it’s recent budget, the government of Ontario has recognized the need to change the law regarding this concern. Resolution of this issue is expected by the spring of 2004. If this were to occur, we suspect that income trusts would then be added to the TSX Index and a new group of buyers would emerge, namely index funds and pension funds.

As with traditional equities, analysis of each individual trust is essential in order to minimize risk and maximize return. Seasonal and/or cyclical factors as well as client concentration are all issues that could affect payout levels.

Over the short term we expect total returns to be muted due to rising interest rates with returns of 9-10% likely. Longer term we expect total returns of 10-12% annually.

In summary, we have avoided the majority of the income trust market because few meet our criteria. However, we have concluded that a limited number of attractive income trusts do exist that provide reasonable growth coupled with attractive current yield. Selectivity, as always, is key.

Conclusion

In sum, we have re-oriented our portfolios based on our best analysis of the few sectors where product demand is well balanced or exceeds supply. The risk is that we are early in making these judgments. We have positioned our portfolios to benefit from powerful trends that we see emerging in the medium to longer term. As stated previously, our only risk is that we are early.

Disclaimer:
This report is intended for clients of Galileo Global Equity Advisors Inc. Galileo Global Equity Advisors Inc. invests on behalf of its clients in the issuers mentioned in this report. Employees of Galileo Global Equity Advisors Inc. may own shares. This document is not intended to sell or promote securities.

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