As we do every January, we are devoting this month’s newsletter to a review of our performance over the past year. On the Canadian side, performance was generally poor, with the inclusion of BCE being our one saving grace. While we underperformed the TSE 300 quite significantly (2.3% vs the TSE’s 29.7%), the one factor that must be kept in mind is the fact that the TSE is a weighted index whose value is determined largely by Nortel and TSE. Roughly three quarters of the TSE’s gains in 1999 are attributable to these two stocks, and any diversified equity fund that didn’t have either BCE or Nortel in it probably didn’t keep up with the market this year. BCE is up over 125% this year, while Nortel is up almost 300%. Nortel’s stock has been propelled by the company’s success in its fibre-optics business, which is expected to post top-line growth of 25% in the fourth quarter. Although BCE holds only a 40% stake in Nortel, and Nortel’s earnings make up less than half of BCE’s consolidated earnings, Nortel currently accounts for over 80% of BCE’s market value. BCE is considering a spin-off of its Nortel interest as a means of unlocking the value of its remaining assets, the premise being that if the companies were valued separately, the market would recognize the low valuation currently placed on BCE’s remaining assets.

The merger between BC Tel and Telus was supposed to create a western telecommunications company that would be strong enough to take on Bell Canada, but like many mergers, this one has not gone smoothly. The president and CEO quit in September due to differences of opinion with the board over acquisition strategy. Revenue and earnings growth has remained flat in 1999, suggesting the synergies from the merger are not being achieved. We took a loss on Telus, removing it from out list in August at $33.60, down 19.6% from January.

The strong rebound in energy prices in 1999 sustained CP's share price for the first half of the year. The company's PanCanadian Petroleum subsidiary posted a 128% increase in net income in the first nine months of the year, following a 58% drop in 1998. While PanCanadian and CP Hotels have shown marked improvement this year, the company's main business -- CP Rail -- continues to be affected by weak demand for bulk commodities. Operating expense reductions have not kept pace with revenue reductions, prompting the company to take a half billion dollar (pre-tax) restructuring charge in the second quarter. This restructuring is not expected to be completed until the end of 2000, which explains why the share price has been drifting downward since the summer.

After a strong 1998, Loblaw’s performance this year has been lacklustre. The stock continued to trend up in the first quarter, but began a downtrend in April that lasted the remainder of the year. The poor performance is attributed to the company’s Provigo and Agora acquisitions in 1998, which are having a negative impact on earnings: in the first nine months of 1999, revenues were up 63%, but earnings were up only 39%. Excluding Provigo and Agora, revenue growth this year has been in the high single digits. Another factor depressing the stock is the lengthy review by the Competition Bureau, which in August told Loblaw that it had to divest another twelve stores in addition to the 41 stores previously owned by Provigo that it has already sold.

MDS International, which this year changed its symbol from MHG to the more appropriate MDS, did not generate the returns we were expecting. The company's earnings growth remains strong, but the company's Health Division was affected in the second quarter by delays in implementing IT systems. The company is also facing some bad publicity after the BC Hospital Employees’ Union released a report that indicates that MDS is a financial backer the controversial private hospital in Alberta that will benefit from the privatization of surgical procedures. The union accuses MDS of using tax dollars earned through outsourced lab services. The stock may also have been affected by movements in a couple of large US contract research organizations – such as Covance (N-CVD), Parexel (NQ-PRXL) and Quintiles (NQ-QTRN) – which have performed exceptionally poorly this past year due to cancelled research contracts and a slowdown in spending by drug companies.

Power Corp has been impacted by two things this past year: the demutualization of the insurance industry and weak mutual fund sales. The company's Great-West Lifeco subsidiary has posted ho hum performance this year, and with the demutualizations in the insurance industry last year, investors who wanted to buy into this industry suddenly had a number of better performing stocks from which to choose. The company’s Power Financial subsidiary, which owns 67% of Investors Group, has been affected by weak mutual fund sales in 1999. In the first nine months of the year, Investors Group net mutual fund sales were down 50% from 1998. This is not unique to the company – according to the Investment Funds Institute of Canada, net sales of all mutual funds (excluding money market funds) are down 65% in the year up to November 30.

TransCanada has been a big disappointment to Canadian investors in 1999. In the fall, the stock fell amid rumours that the company was considering a cut to its dividend – rumours which proved to be true in December, when the company unexpectedly announced a 30% reduction in its dividend starting in Q1 of 2000. TransCanada is about to face competition in its pipeline business when two new projects come on-stream in late 2000, and justified the dividend cut by claiming that the company had to build up its capital base in order to better compete. Admittedly, the dividend cut puts TransCanada's payout ratio more closely in line with its competitors, but given its existing asset base and relatively cash position, it can be argued that the 30% dividend reduction was not entirely necessary.

Trilon has been on a downward slide for most of 1999. When we added it in April, we were anticipating a rebound, but this didn't seem to happen. Trilon is a financial services company engaged primarily in institutional investment management and merchant banking. With a 6% yield, Trilon has a higher payout than any of the financial services stocks, yet it trades at a lower earnings multiple. The company's US$50 million exposure to the now bankrupt Royal Oak Mines has not helped the company's profile, but given the size of this investment relative to its $1.7 billion loan portfolio and the industry diversification within that portfolio, Trilon appears to be trading at a significant discount.

While we are not particularly pleased with the performance of our Canadian picks this year, we do take some consolation from the fact that minus BCE and Nortel, the rest of the market posted only modest gains on average. Besides, if we were able to give BCE a 75% weighting in our average return this year, we’d be up over 90% in 1999!

Our US picks fared significantly better than our Canadian picks, averaging 17% in 1999. A small number of notable disappointments – E*Trade, Philip Morris, Safeway and Advanced Micro Devices – pulled down the performance of the whole list, although on the whole we are satisfied with the performance of our remaining picks. As with the Canadian market, the US market was somewhat polarized, with a small number of stocks accounting for most of the gains in the S&P 500 last year. As can be seen from the histogram below, the distribution of returns among S&P 500 index components is skewed quite heavily, with a small number of very large returns pulling up the whole index. The median return on the S&P 500 last year was around –2.5%, and the average return was 16% -- making the return on our list appear not so bad in comparison. We also note that we exceeded the average (i.e. unweighted) return on the S&P 500 without the inclusion of Internet stocks, such as AOL (up 100%) or Yahoo! (up 200%), as we could not justify buying in at the ridiculous valuations the market has put on some of these companies in the last few years.

We added AMR to our list in April, just in time to catch a rally to US$75 before an anti-trust action was launched against the airline in May. AMR was being investigated for predatory pricing -- setting fares below cost in an effort to drive the competition out of business. Rising fuel prices throughout the year have affected profitability throughout the industry, but improving yields and airline traffic pushed the stocks higher in the fourth quarter.

American Water Works spent most of 1999 moving sideways, before a rapid fall in November and December. Whenever AWK has made acquisitions in the past, its share price has fallen due to the dilutive effect on earnings over the short-term. The company has been pursuing an aggressive acquisition strategy, with three acquisitions announced in October alone. These acquistions, valued at US$1.3 billion, are being financed with cash and debt – and quite a bit of debt, given the fact that the company’s cash reserves were only US$46 million as of the end of September.

Internet stocks were still going strong in the first half of 1999, pulling the online brokerage firms up with them. Not only did companies like E*Trade and Charles Schwab benefit from Internet valuations, but they also got a revenue boost from all the online traders placing orders through their systems. We added Schwab in March, and booked a 47% profit in two months. Unfortunately, we added E*Trade just as the Internet and online brokerage stocks retreated, and recorded an 80% loss by the time we gave up on it in October.

The performance of our non-Internet financial services stocks was mixed. In January, we added Wells Fargo to our list at US$39.938 on the basis that it is operating in nine of the ten fastest growing states following its merger with Norwest, and now had the largest residential mortgage underwriting business in the US. The company adopted a slow integration approach to the merger in an effort to minimize execution risk, but with delayed synergies and a prolonged period of duplicate processes. This has affected the stock, which spent most of 1999 see-sawing between US$37 and US$45. We dropped WFC from our list in August at US$39. In its place, we added Citigroup, which was a strong performer in the fourth quarter. Unlike WFC, which is taking a cautious approach to merging operations, Citigroup and Travelers (whose merger was completed in October 1998) have taken a more aggressive approach. The company stated that it would reduce expenses by US$2 billion in 1999, and management expects to achieve that target. Citigroup beat consensus expectations in the third quarter, with cost control and strong revenue growth in consumer banking offsetting weakness in trading revenues.

Networking and communications stocks in our list performed quite well on the whole last year, averaging 41%. We had a total of six stocks from this sector in our list in 1999: Ericsson (NQ-ERICY), Motorola (N-MOT), Newbridge (T-NNC), Tellabs (NQ-TLAB), Sprint PCS (N-PCS) and MCI Worldcom (NQ-WCOM). Sprint PCS, which we added in June, was by far the strongest performer. This is hardly surprising given the fact that it is the fastest growing wireless carrier in the US with 4.7 million subscribers and average growth of over 200,000 subscribers per month. MCI Worldcom, the other carrier we added in July, did not perform quite as well. Wireline carriers such as WCOM, T and FON performed quite poorly over the summer, followed by a fourth quarter rebound. WCOM's merger with PCS announced in October gave both companies a boost -- WCOM because the merger gives it a wireless business and PCS because it provides a source of cash to finance its negative earnings. In November, after WCOM's share price had risen above US$85, there was some doubt as to whether the Sprint merger would be completed, since the initial terms were based on WCOM's share price remaining above US$62.15 and below US$80.85.

Wireless hardware stocks were strong performers in 1999. Motorola, which we added in January at US$61.063 and dropped in June at US$82.813, moved sideways over the summer before posting a strong gain in the fourth quarter. Similarly, Ericsson posted a strong gain in Q4 after a flat summer. In retrospect, we dropped both stocks too soon -- had we held MOT until the end of the year, we would have been up 141% instead of 36%, and 136% instead of 73% in the case of ERICY. Most wireless stocks were up in December, including MOT, ERICY, and NOK, as industry fundamentals point to strong wireless growth in 2000 and beyond.

On the networking side, performance was somewhat weaker. Newbridge, which we dropped from our list at the beginning of May at US$54, came out with a fourth quarter profit warning that brought the stock down 25%. The outlook for the rest of the year was somewhat bleak as well, contributing to the stock's poor performance in 1999. Tellabs, which we added in November, ended the year pretty much where we bought it. After a brief run-up in November, the stock was pulled down late in the month when it announced that Sprint was not proceeding with its JCS 2000 initiative, which was intended to consolidate all voice network traffic on to an ATM backbone using Tellabs networking products.

While oil prices have been rising in 1999, integrated oil stocks have shown mixed performance, particularly in the second through fourth quarters. Rising prices have been good for upstream operations – exploration and production – but integrated companies such as Exxon, Chevron and Texaco still face depressed conditions in downstream operations (refining and marketing). When prices rise rapidly, as they have in 1999, these increases can’t be passed on to customers immediately due to supply contracts, thereby eroding margins in the marketing side of the industry. Similarly, high crude oil prices translate into high input costs for refiners, which also erodes margins. In a nutshell, high oil prices aren’t always good for integrated oil companies – what they need are high but stable oil prices, and it was the volatility in oil prices that affected stock performance in this sector in 1999.

Our computer hardware and software picks generally performed well, with an average return of 38.8% last year. In January, we started with Apple and BMC Software, both of which performed well in 1999. Apple has done an incredible job turning itself around with the return to profitability in Q1 of fiscal 1998 and the introduction of the iMac in August 1998. We dropped Apple in November, after the company prompted a mini correction in October by hinting at supply problems, although in retrospect we could have achieved a much higher return had we held it to the end of the year. Similarly, Oracle is a stock we dropped far too soon. After several months of Y2K concerns holding back enterprise software stocks, Oracle had a strong fourth quarter based on e-commerce momentum. An agreement with Ford to jointly built an online business-to-business system for Ford’s US$300 billion supply chain was the event that triggered the fourth quarter gains in excess of 100%.

BMC Software, which we added at the beginning of the year, was a fairly decent performer on the whole, and while we dropped the stock in October to miss out on a further 20% gain, in doing so we avoided the big drop in January after the company issued a profit warning. We added HP in October, after the stock had fallen significantly since the summer on poor enterprise server numbers. The fourth quarter, following the hiring of a new CEO and the spin-off of its measurement equipment unit, turned out to be much stronger, and the stock gained 26% in the quarter.

Our one disappointment among computer stocks this year was Advanced Micro Devices, which we added in February on a dip only to see it dip even further over the following three months. Competitive conditions were blamed for the February profit warning, with lower prices combined with unit shipments coming in 10% below company targets contributing to a 20% decline in first quarter revenues over fourth quarter revenues, and a loss of US$128 million. Second quarter results weren’t much better. Or third. In November, the company announced that strong demand for Flash memory products in Q4 may lead to a breakeven profit, and the stock has been on an uptrend ever since.

Pharmaceuticals as a group were poor performers in 1999. This reflects fundamental industry factors, including the number of patents that are due to expire within the next three years, the number of blockbuster products in the pipeline to replace those whose patents will expire, and the possibility of rising interest rates that would affect discount rates used to value these companies. Lilly's dependence on Prozac sales, which were declining in 1999, contributed to a more severe decline in this stock relative to others, while Johnson & Johnson's uptrend was replaced by a sideways pattern based on valuation relative to its industry peers.

Food and drug retailers were also poor performers in 1999. Safeway, which we had in our list in 1998 and 1999, lost 42% on the year. This poor performance is generally attributed to the company's weak same-store sales growth, with third quarter same-store sales up only 0.5% over the previous year and down slightly over Q2. Performance among other retail stocks was mixed, as market preferences appear to be shifting from department stores to specialty stores, discount stores and online shopping. While many of the big name department stores performed poorly in the latter half of 1999 – such as Sears, Ames, and Federated Department Stores – the one retailer which has really stood out in 1999 has been Wal-Mart, which is benefiting from the shift towards discount retailers. Comparable-store sales are up 8.1% for the 48-weeks ending December 31, with total sales up 20.5% over the same period. As we mentioned in our January 1999 newsletter, we don't believe Amazon will become the Wal-Mart of the Internet -- we believe Wal-Mart will become the Wal-Mart of the Internet. It seems we weren't too far off on that one, as Wal-Mart and AOL announced a partnership in late 1999 whose basic objective is to get AOL services marketed in Wal-Mart's physical stores and web traffic to Wal-Mart's online stores.

While the neverending litigation in the tobacco industry has already been priced into tobacco stocks, certain developments this year have added further downward pressure to this sector. In early September, an appeals court judge ruled that punitive damages could be determined on a lump-sum basis for a class action suit filed in Florida rather than on an individual basis. The implication is that tobacco companies would be required to put up a bond -- possibly in the tens of billions of dollars -- while the ruling is appealed. While this is bad enough in itself for the industry, Florida is but one state, and there could be another forty nine such class action suits with similar rulings in the future. (As an aside, we note a certain irony in these punitive damages awards, in that the only way tobacco companies can ever hope to pay them off is if they continue to sell more cigarettes). We have believed for a long time that it would be in Philip Morris' best interest to separate its tobacco holdings from its Kraft Foods and Miller Beer divisions, as these businesses are not getting the valuation they deserve on account of their continuing association with the tobacco division's legal troubles. We also believed that the sagging share price would provide sufficient incentive to get management to spin off Kraft and/or Miller. Apparently we overestimated management's commitment to increasing shareholder value.

For 2000, we are wiping the slate clean, and starting with a new list of picks. The Canadian side is admittedly light, as there are few Canadian companies that we would recommend buying at current valuations, even for long-term RRSP holders. We continue to recommend BCE for two reasons: first, investors need to hold it if they want to keep up with the index, and second, the spin-off of Nortel should yield some upside for the remaining BCE assets that are not adequately priced into the stock at present. Imperial Oil is another Canadian pick. Imperial is 70% owned by Exxon-Mobil, which may decide to either buy back the remaining 30% from public shareholders or merge the company with Mobil Canada. Our third Canadian pick is Inco, which currently appears to be rising on a cyclical upswing in base metal prices.

Our US picks are also fairly light for the beginning of the year. In the technology sector, we are including Hewlett-Packard, Dell and Intel. As Y2K concerns become a distant memory (or embarrassment, depending on how one chooses to look at it), spending on both personal and enterprise computers can be expected to pick up. Many IT purchases were postponed in the latter half of 1999, which should contribute to strong spending in the first and second quarters of 2000. We are also adding GM Hughes to our list this year. The satellite communications subsidiary of General Motors owns and operates a fleet of geostationary satellites, which host the company’s DIRECTV direct-to-home broadcasting services, among other things. Recent legislation in the US allows satellite broadcasters to transmit local channels into local markets – a major hurdle which has impeded penetration of direct broadcast satellite services up until now. In addition to being in a compelling industry, GM Hughes has an attractive valuation relative to its primary – yet significantly smaller – competitor, EchoStar.

Four additional stocks we are including on the US side this year are Citigroup, Exxon-Mobil, Bristol Myers Squibb and Best Buy. Citigroup has had a good fourth quarter, fueled by strong investment banking, trading revenues, and credit card volumes. The company is diversified geographically, with continuing investments in the Japanese market, which should provide some cushion should the Federal Reserve opt to raise interest rates in 2000 as expected. The merger of Exxon and Mobil makes our decision of which oil company to include relatively easy this year. Provided crude oil prices stablize in 2000, Exxon-Mobil is well positioned to benefit from high oil prices this year given its market share and the opportunity to create operating efficiencies. Bristol-Myers Squibb is being added this year as our pharmaceutical pick. Not only does BMS have a broad portfolio of brand name products, but it also has established generics and consumer products businesses to provide some stability as patents expire. Finally, we are adding electronics retailer Best Buy to our list this year. In December, the company entered into an agreement with Microsoft to offer discounts to customers that sign up for Microsoft’s MSN Internet service. Not only did this deal come with a US$200 million equity investment from Microsoft, but each ISP sign-up could generate up to US$3 per month in ongoing royalty income.

As we have mentioned in the past, it is not always possible to provide timely investment advice through a newsletter that is published only once a month, as events can move a stock significantly by the time our next newsletter is published. Investors are encouraged to consult with their broker for specific entry and exit dates.