Monthly Commentaries

Randomness in markets – January, 2006

This year started off with all equity markets increasing in value. The oil rich TSX leads the pack with a 6% gain followed by Europe and then the US. Despite investors’ continued concerns about the health of the US consumer, dollar and budget deficit, the equity markets moved higher. These macroeconomic factors have taken a back seat to individual corporate news (that continues to be good). This month we will address the issue of randomness in financial markets. Diligent research affords a view of what a company should be worth but not what its price will be. There is a degree of randomness that can have a significant impact on the relationship between a security’s value and its price (and therefore its investment performance). There will always be weather events, technological changes, government changes and a whole host of other risks that will emerge unexpectedly. Investors must make a generous allowance for forces that can't be anticipated or measured. Consider a company like Cemex (global cement and ready mix company based in Mexico). Since the end of August 2005 the stock has appreciated by 45%. When we first purchased the stock we liked the company for a number of fundamental reasons, not the least of which was its ability to generate cash. In September 2005 hurricanes devastated the southern US - an event few, if any, investors would have factored into their research. The result for Cemex was three fold. First, the demand for cement went up, as did the price. Second, the shortage of cement resulted in a reduction of tariffs on Mexican cement. Finally, Cemex received a rebate on the tariffs that it had already paid. The result has been a much higher stock price.

Randomness can also work against an investment. No matter how strong the fundamental story, a large allowance must be made for random events. This is precisely the reason that Toron does not have huge concentrations in any investment theme and focuses on companies that have a measure of safety. One single unforeseen event can devastate a concentrated portfolio. As we talk to people we are amazed at the extent to which individuals believe that only higher oil prices lie ahead (and the resulting concentration of oil stocks in their portfolios). The risk is an unforeseen event that extinguishes most of the gains. We believe the more prudent approach is to acknowledge that randomness exists and minimize its consequences by diversifying our investments.

Arthur Heinmaa, CFA Managing Partner