Thursday, April 21, 2011

Caisse's 2010 Annual Report

Bernard Morency, Executive Vice-President, Depositors and Strategic Initiatives at the Caisse de dépôt et placement du Québec let me know that the Caisse just published their 2010 Annual Report, Building the Future on Solid Foundations (click here to download English PDF).

I've already covered the Caisse's 2010 results back in February but the annual report was not available at the time. The French version was available last week and on Thursday, the Caisse posted the English version.

Let me begin by going over some priorities mentioned by Robert Tessier, Chairman of the Board (pages 8-9):
During the past year, the quality of the relationship between the Caisse and its depositors remained one of the Board’s top priorities. From this perspective, it should be noted that we implemented a new collaborative model to ensure this relationship takes place in a climate of transparency and trust. In the process, the Board approved the fundamental reorganization of the Caisse’s portfolios to better suit the performance objectives, risk tolerance and asset allocation of the depositors.

The Board strongly supported the continued improvement of the Caisse’s risk management and is also very satisfied with the progress in this area. With the support of the Board’s Risk Management Committee and the close collaboration of the senior management team, the Caisse strengthened its risk management tools and processes with the adoption of best practices.

In addition, the Board is pleased that rating agencies Standard & Poor’s, Moody’s and DBRS confirmed the Caisse’s credit ratings, citing among others its enhanced risk management and financial strength.
Mr. Tessier adds:
The Caisse’s achievements in 2010 were also due to employees who brilliantly met their goals in an atmosphere of renewed confidence. We would like to thank them for their loyalty and commitment.

Overall, the Board believes that the Caisse made progress on all fronts. The financial results testify to this fact. The Board encourages the entire team to pursue the work under way with energy and to build a strong organization striving to improve its management in order to deliver, over time, the results expected by its depositors.
Next, we move on to the President and CEO, Michael Sabia, who wrote the following in his message (pages 10-12):
2010 was a year marked by economic and financial uncertainty. At the Caisse, we stuck to our basic principle of “common sense” that we have followed for the last couple of years: performance, client focus, rigour and simplicity.

This disciplined approach, I believe, enabled us to make a great deal of progress on our five strategic priorities aimed at strengthening the Caisse’s foundations for the long term. Our efforts were aimed at a number of key issues:
  • Collaborating with our clients
  • Restructuring our portfolios
  • Enhancing risk management
  • Strengthening our presence in Québec
  • Redesigning our internal operations
  • Improving our balance sheet
With rigour and discipline, our teams have refocused the Caisse on its core areas of expertise and, by emphasizing the importance of high-quality assets, they managed to navigate a difficult-to-predict landscape.

Thanks to their efforts, the Caisse is healthy again.

What strikes me most about our performance in 2010 is that the Caisse team clearly demonstrated its ability to execute an ambitious strategic plan while generating solid returns. In the coming years, facing an uncertain, volatile environment much like today’s, this execution capability will be fundamental to our success.

Many significant economic changes are under way worldwide – changes that offer as many opportunities to earn returns as to make costly mistakes. This will be an environment that demands vigilance and a capacity to understand underlying trends both in the near term and over the long run. The Caisse, like all investors, will have to remain very attentive to these shifts over the next 12 to 18 months – and especially over the longer term – to grasp their scope and better understand their significance.

In the Short-Term Two Opposing Forces

2010 was the second year of recovery after the 2008 crisis. Up until now, renewed growth required support from public authorities, at least in developed countries. Such support has exceeded US$2 trillion and largely contributed to the stock market rebound in the latter part of the year.

In 2011, however, we expect a deceleration in growth due to the removal of economic stimulus, debt reduction by consumers and governments in developed countries, tighter monetary policies in developing countries as a response to higher commodity prices, and austerity measures in overly indebted eurozone countries.

Two major trends will then struggle for dominance.

On the one hand, the marked improvement in several key economic indicators suggests that the renewed growth will continue for some time. In Québec, the infrastructure program launched before the economic crisis has supported growth, which helped eliminate the gap between unemployment rates in Québec and the rest of Canada for the first time in recent history. In North America, a significant improvement in corporate profits largely explains the increase in business confidence. In this environment, non-residential private investment is increasing rapidly and the employment situation continues to improve. All in all, this trend suggests that the recovery – albeit uneven – will persist despite volatility and lingering uncertainty.

On the other hand, this benign scenario is challenged by the persistence of worrisome downside risks. For example, will geopolitical changes in North Africa and the Middle East significantly disrupt oil production? Is political cohesion in Europe robust enough to ensure that austerity efforts are equitably shared? Will measures by the People’s Bank of China to ease inflationary pressures be successful? Will U.S. residential real estate finally show signs of stabilization?

The struggle between these two opposing forces will continue over the next 12 to 18 months. In our view today, it is very difficult to predict which of these tendencies will prevail. For that reason, remaining vigilant and agile will continue to be our top short-term priority.

If the moderate growth trend weathers the storm over the next 18 months, markets will nervertheless be buffeted by the consequences of the predictable exit strategies of public authorities, including both tightening monetary supply and government budget cuts. Of course, these impacts and their timing are likely to vary by region. Europe is already moving in that direction. In the United States, a fiscal adjustment will likely be initiated only after the next election. The Bank of Canada may resume its tightening cycle, while avoiding major policy differences with the U.S. Federal Reserve.

Market developments over the next 18 months will occur against a backdrop of profound structural changes in the global economic and financial environment. Every investor and every major economic bloc will be confronted with this reality.
Indeed, following 2008, it was easy to ride the beta wave higher, in the next few years, it will be challenging to deliver value added and risk management will be critical for large asset managers like the Caisse who invest in public and private markets all around the world.

Mr. Sabia goes on to write:
How can the Caisse successfully fulfill its mission in a changing and complex world both in the short term and in the years to come? At a minimum, I think we will need three things.

A Better Understanding of Fundamentals

It will be essential to stay disciplined and continue to invest where we have comparative advantages, for instance, in Québec. We must also develop a deeper understanding of the broader world that can be factored into day-to-day portfolio investment decisions. In that sense, greatly advancing our fundamental research capabilities has become an essential priority. Mathematical techniques alone are not sufficient to evaluate issues that are often qualitative in nature and demand judgment. An enhanced research capacity will be a vital tool for identifying sectors and markets with high growth potential, implementing appropriate strategies and making the right choices to generate long-term returns.

At the same time, an enhanced research capability will enable us to strengthen our risk management. Not only will we continue to closely monitor “conventional” risks, but we will also conduct more in-depth assessments of risks related to the economic, financial and political environment. To that end, in addition to the rigour and accuracy of our existing calculation methods and analytic tools, we will need to rely on informed, good judgment, based on a broader, more global view.

A Partnership Strategy

As well, we will consolidate and further develop our alliances with partners worldwide in order to make profitable investments for our depositors. Our strategy will place an emphasis on partnering with local stakeholders in promising markets where we plan to invest, so that the Caisse can benefit from their finer understanding of the market in question. We believe that the development of our global networks and multiple partnerships will also enable us to better support the international expansion plans of promising Québec companies.

The Expertise of Our Team, The Cornerstone of Our Future

The Caisse’s success ultimately depends on the expertise, talent and commitment of our people. Those qualities are very much evident at the Caisse, as reflected by our solid 2010 results. Our people will continue to make the difference in the future. Given the intense competition for professional expertise in today’s global financial markets, talent retention and recruitment will remain one of our top priorities.

With their rigorous and disciplined approach, our people possess the capabilities required to identify and seize real investment opportunities – not investment fads – that will create value for the next 10 or 15 years and provide the source of depositor returns.

In this way, we will realize the Caisse’s full potential to continue meeting the long-term needs of depositors and supporting the growth of Québec companies.

Ultimately, what matters to us is the long run. Because we are in a marathon, not a sprint. The Caisse is here for the long haul.
It truly is a marathon for pension funds. Go back to read my post discussing views from OTPP's CIO, Neil Petroff. Mr. Petroff said that pension fund's have a much longer time horizon than mutual funds, allowing them to capitalize on opportunities that take longer to reach their fully realized potential. When you're thinking over 10 years, not just next year, then you don't manage assets the same way and you're not afraid to take a concentrate position which may take longer to materialize.

Next, I bring to your attention Table 7 on page 28 which shows the evolution of the benchmark indexes over the last five years (wish every single major pension fund in Canada produced such a table!).

On page 30, there is a detailed analysis of the overall results. Some key points below:
  • For 2010, foreign currency depreciated against the Canadian dollar: 5.2% for the U.S. dollar and 2.6% for the EAFE basket of currencies. Hedging most of the currency exposure risk reduced the negative impact of the stronger Canadian dollar by approximately two thirds.
  • The Short Term Investments portfolio produced a return of 0.7%, 12 b.p. (0.12%) above its benchmark index. This performance is due to an environment of very low short-term rates.
  • The Bonds portfolio returned 8.4%, 160 b.p. (1.60%) above its benchmark index.Lower medium- and long-term rates during the year positively contributed to portfolio returns. About three quarters of the added value is due to insightful corporate bond selection. The other quarter comes primarily from provincial and sovereign bond selection.
  • The Real Return Bonds portfolio posted a return of 11.1%, practically identical to its benchmark index. This performance is essentially due to the decline in real long-term interest rates.
  • In the first half of 2010, infrastructure investments were grouped in the Investments and Infrastructures portfolio. In the second half, these investments were integrated into the new Infrastructure portfolio. For the year, the combined return of these portfolios stood at 25.4%, 1,413 b.p. (14.13%) above the benchmark index. This return is due to the good operational performance of the assets in the portfolio, particularly the airport service investments, including BAA, and energy assets, such as Enbridge Energy Partners, Interconnector UK and Noverco (Gaz Métro). The performance also stems from a general reduction in discount rates.
  • In 2010, the Real Estate portfolio’s return was 13.4%, 184 b.p. (1.84%) above its benchmark index. The portfolio benefited from a gradual improvement of the global climate for quality assets. Price increases in the retail and office building sectors in Canada and the United States, combined with a stabilization of fundamentals in the office building benchmark markets in the United States (New York, Washington and Boston), explain most of the portfolio’s performance.
  • The Canadian Equity portfolio generated a return of 15.7%,190 b.p. (1.90%) below its benchmark index. The portfolio’s absolute return is mainly due to high exposure to the energy and materials sectors. Relative to its benchmark index, the Canadian Equity portfolio maintains a greater exposure to large-capitalization companies with compelling fundamentals. In an environment where small companies outperformed their large counterparts, this stock selection primarily explains the underperformance of this portfolio relative to its benchmark index. However, the absolute return strategies contributed positively to portfolio performance.
  • The Private Equity portfolio posted a 26.7% return, outperforming its benchmark index by 2,474 b.p. (24.74%). The portfolio showed resilience to the financial crisis and its aftershocks in 2008 and 2009, due to the quality of its assets. In 2010, the portfolio’s high return was due to the combined effect of the good operational performance of the companies in the portfolio, increase in their EBITDA (earnings before interest, taxes, depreciation and amortization) and the notable reduction of their leverage, given this performance. The portfolio also benefited from the positive effect of rising stock markets on corporate valuations.
  • Leveraged buyout financing activities contributed nearly 50% to the portfolio’s performance. At the same time, development capital activities account for nearly 25% of the return, largely due to the stake in Quebecor Media, given its portfolio weight and excellent performance.
  • The Hedge Funds portfolio produced a 6.3% return, 11 b.p. (0.11%) above its benchmark index (see table 24). Directional strategies (i.e. Managed Futures) and strategies for distressed loans and emerging markets were the largest contributors to portfolio performance. In 2010, the Caisse tightened its hedge fund selection criteria in favour of transparency.
  • In a year that saw a sharp rise in public debt, corporations overall pursued their deleveraging efforts, contributing to narrower spreads. This improvement was particularly noteworthy in the United States. In this environment, management of the new ABTN portfolio, created on January 1, 2010, translated into a $509 million contribution to net investment results (see Table 24). This outcome is largely due to a $781 million increase in the value of the portfolio’s assets, buoyed by improving credit markets, reduced by the $284 million cost of hedge transactions.
  • As at December 31, 2010, the Asset Allocation portfolio posted a negative return of $77 million, particularly reflecting the cost of defensive measures taken to protect the Caisse’s portfolio (see table 24). Overweighting and underweighting of specialized portfolios had a $171 million negative impact on overall performance.
As I stated previously, strong outperformance in private equity, infrastructure, real estate, and bonds helped the Caisse beat its policy (benchmark) portfolio. The underperformance in public equities isn't drastic but I would be curious to know if they're using their full risk budget. (Go back to my comment on OTPP's Neil Petroff and read the concentrated bet they took on Transocean. There were many other large cap stocks that significantly outperformed their indexes in all global regions).

The table below shows an analysis of depositors' net assets for the period 2006-2010 (page 46; click on image to enlarge):

I bring this table up because it clearly shows how the Caisse recovered from the disaster of 2008. It also shows that operating expenses have been steadily declining. From the 2010 Annual Report:
In 2010, depositors’ net assets increased by $20.1 billion, with $17.7 billion in net investment results and $2.4 billion in depositors’ net deposits.

Over the last five years, depositors’ net assets climbed by $29.5 billion, increasing from $122.2 billion as at December 31, 2005 to $151.7 billion as at December 31, 2010. This increase stems from, on the one hand, $15.3 billion in net investment results and, on the other hand, $14.2 billion in depositors’ net contributions (see Table 25 above).

As at December 31, 2010, depositors’ total assets were $183.2 billion, compared to $170.7 billion as at December 31, 2009, an increase of $12.5 billion (see Table 26). This rise stems mainly from the $10.8 billion increase in investments. The Caisse also continued to strengthen its financial position, with a reduction of $7.6 billion in liabilities, which fell from $39.1 billion in 2009 to $31.5 billion in 2010. Liabilities, primarily used to finance investment purchases, largely consist of short sales, securities sold under repurchase agreements, derivatives and financing programs issued by the Caisse’s subsidiary, CDP Financial. The 2010 decrease in liabilities is largely due to the reduced use of securities sold under repurchase agreements.
This brings me to the use of leverage. You'll notice the Caisse is reducing its use of leverage whereas Ontario Teachers' is increasing it. This point was brought up in my comment on OTPP's Neil Petroff and in a recent article in La Presse by André Dubuc, Une avenue plus risquée pour Teachers' (only available in French). Mr. Dubuc cited yours truly and Michel Nadeau, the former second in command at the Caisse who said the "proportion of debt at Teachers' has increased constantly in the last four years and is approaching the dangerous peak reached by the Caisse five years ago". Mr. Nadeau added: "Just how far will Teachers' go on borrowing to keep increasing their returns?". The article also cites a finance professor who says that this type of leverage requires strong risk management, which Teachers' has implemented, focusing on liquidity risk.

The use of leverage is a contentious issue among pension funds in Canada. Some have that option, others don't. That's another reason to be careful when looking at headline performance figures. Teachers' 14.3% return in 2010 is higher than the Caisse's 13.6% but on an unlevered or equally levered basis, Teachers' underperformed the Caisse in 2010. Moreover, the Caisse's benchmarks for their specialized portfolios are tougher to beat.

And that brings me to my final comment on compensation. The Caisse's annual report had a detailed discussion on compensation. Not just boring details, but how individual performance is assessed. Table 68 below shows details on executive compensation. Once again, Michael Sabia has the distinction of being the lowest paid President and CEO of every major pension fund in Canada and the leaders of his executive committee are well paid, but still compensated less than their counterparts at Teachers' and CPPIB (to be fair, Mr. Petroff has been at OTPP longer than Mr. Lescure has been at the Caisse and he oversees both public and private markets, something which I think Mr. Lescure should be doing as well in his CIO functions).

I highly recommend everyone reads the Caisse's 2010 Annual Report. It's excellent and offers many insights for all institutional investors.

Finally, in the spirit of transparency, I will disclose that I recently finished a contract at the Caisse and had the privilege of working with a group of exceptional professionals, some which I knew and others that I just met. I saw firsthand the changes at the Caisse and have no doubt whatsoever that they're on the right track (if I didn't believe it, I wouldn't write it). There is still more work that needs to get done, but they have the right people to implement changes and confront the challenges that lie ahead.

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