Fixed Income and Equity Quarterly Commentary. Stocks to Buy in an Expensive Market. The Johnson, Johnston and Macrae Investment Group

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1 The Johnson, Johnston and Macrae King St. E. Kingston, ON K7K 6Y3 Moe Johnson First Vice-President Investment Advisor (613) Fixed Income and Equity Quarterly Commentary March 2014 Chris Macrae Vice-President Investment Advisor (613) Ryan Johnston Associate Investment Advisor (613) Stocks to Buy in an Expensive Market Linda Wilson Investment Advisor Assistant (613) Glen Johnson Investment Advisor Assistant (416) Michelle Flegal Investment Advisor Assistant (613) Connect with: Gov t of Canada Rates Dec 31/13 Mar 31/14 Change 5-Year 1.97% 1.72% Year 2.80% 2.49% Year 3.26% 3.00% Indices % Change S&P/TSX 13,622 14, % S&P500 1,848 1, % DJIA 16,577 16, %

2 March 9 th marked the five year anniversary since the bottom of the stock market following the financial crisis of Since then, the S&P 500 index has jumped 178%, while the TSX Composite in Toronto increased 89%. Where are we today? Analysts tend to revise (downward) their estimates throughout the year The forward price-earnings ratio (P/E) is a valuation metric commonly used to determine the price of a security at a specified future date. The higher the ratio, the more an investor is willing to pay for a company s future earnings. A caveat to the forward measure of the P/E multiple is that forecasted earnings can vary from actual results, and they usually do. Analysts tend to revise (downward) their estimates throughout the year as their overly optimistic assumptions revert to more realist numbers. By no means is the forward P/E ratio an accurate indicator of value, though it has become the standard metric for company analysis. Keeping up with the current analyst forecasting method of choice, we will highlight the forward P/E ratio here to demonstrate the current valuation of the market. According to data provided to us by S&P Capital IQ, the forward P/E sits around 15.5x next year s earnings, up from 13.0x a year ago, suggesting the market is anticipating higher growth in corporate profits for GMO s Jeremy Grantham recently suggested in Barron s that the stock market is 65% overvalued Ten year Canada bond yields have dropped 32 basis points (0.32 of 1%) this year The current aggregate dividend yield on the S&P 500 is just below 2% last year s average stood at 2.3%, even as companies increased dividends 11.8%, collectively, over the prior year, according to FactSet. Meanwhile, corporate profits increased 5% last year, while the S&P surged ahead 26%. Clearly, investors are willing to pay an increasing premium for (meager) earnings growth and pay up considerably for an increasing source of income from dividends on common shares. GMO s Jeremy Grantham, co-founder and chief investment strategist, oft quoted in this space, recently suggested in Barron s that the stock market is 65% overvalued, and that we have reached a predictable point in the stock market cycle where institutional investors have begun to reach for return by speculating extending beyond the rational behaviour associated with investing. Ahhh, but relief he also suggests that the market might have another 35% to run. Yale professor Robert Shiller s calculation of a decade of inflation adjusted earnings used to derive a P/E ratio suggests that the current reading of 25.5 times P/E is 54% above the average going back to And turning more country specific in economic terms, the Canadian bond market is telling us something about the future growth of our economy versus that of the U.S. Ten year Canada bond yields have dropped 32 basis points (0.32 of 1%) this year even as the Federal Reserve Board in the U.S. has been scaling back its monthly bond purchases. Conversely, if bond market yields were increasing, this would be an indication that inflation, and the economy, were set to roar ahead (if you believed what the bond market was telling you). Our economy is forecast to grow between 2.2% and 2.5% versus 3.0% for the U.S.

3 gross fixed investment has averaged 16-21% of GDP from 1950 to That figure now stands around 13%. Getting back to the analysts. There is one good reason to suggest their estimates are overly optimistic. While operating margins (earnings before unusual items) in the U.S. are near record highs, ending 2013 at 8.9%, analysts profit growth estimates of 13% would catapult margins to 9.5%. The historical average, cyclically-adjusted, operating margin is around 6-7%. Earnings estimates have already been revised down since the first quarter of 2014, indicating a more subdued 8% rise in profits for Expectations of 8% profit growth this year might be in part based on the expectations of US GDP growth of around 3% (from 1.7% in 2013). We can only hope, and in the process see corporations increase their capital spending and reduce their record $1.2 trillion+ cash pile on their balance sheets. According to JP Morgan Chase, gross fixed investment has averaged 16-21% of GDP from 1950 to That figure now stands around 13%. Just getting to the midpoint of the average would lift capital spending by $600 billion and provide a boost to the long-term outlook for the economy and stocks. While screening a universe of stocks we focus on several dynamics: Investors asking where the best place is to invest right now are asking the wrong question. Companies must be able to grow their dividends, and if they aren t paying dividends, then they should be generating enough cash flow to invest in their business and internally finance operations. Revenues should be expected to grow; with margins at historically high levels, in order to circumvent any decrease in margins, sales must take the reigns in order to maintain profit growth. Companies must be well capitalized and enjoy good access to capital, if needed. Interest rates are still at low levels and while it may seem convenient today to borrow excessively, higher interest rates could prove fatal for poorly capitalized companies. Although the stock markets in North America have hit record high after record high, there are still opportunities, albeit not as many as Many of the stocks we like conform to the maxim of the late John Templeton. Investors asking where the best place is to invest right now are asking the wrong question. The right question to ask is where are the stocks that are currently out of favour. We highlight a few here: The Allstate Corporation (ALL-NYSE/$56.58/1.98%) The U.S. based company is the second largest property and casualty insurer and one of the largest life insurers in the country. Catastrophic losses have caused the stock the lag. ALL has a market capitalization of $24.8 billion and serves over 16 million households across America. Recently the company has focused its strategy on four business segments which we feel will better address the needs of its consumers over time: 1) Branded products, which offers customers local personal advice and service 2) Esurance platform, where more price-conscious consumers benefit through online and call-center service 3) Encompass Group, bundles products through independent agents, directed toward more affluent customers who aren t brand sensitive and 4) Answer Financial,

4 Allstate, is currently priced at 10.9x this year s earnings and 1.2x book value. sells products from other carriers to online customers who wish to choose form a variety of insurance needs. The company has closed 1,000 underperforming agencies (agencies are intermediaries between the insurer and the customer) and changed its payment structure to align bonuses with performance. The company s pricing power allowed it to increase homeowners insurance by 40% despite the weak economy. The company has become more conservative in terms of investing its float (premiums customers pay up-front). Allstate, while increasing its dividend 7.7%/yr over the past three years, is currently priced at 10.9x this year s earnings and 1.2x book value. The stock is cheap, historically and relative to its peers. Bristol-Myers Squibb Corporation (BMY- NYSE/$51.95/2.77%) BMY is trading at 31x this year s earnings on market cap of $91 billion. By standard valuation measures, the stock is not cheap. The company has divested lower margin assets, more recently related to a diabetes venture with AstraZeneca (AZN-NYSE), and concentrated on developing its HIV, Hepatitis and immuno-oncology drugs where the market shows greater promise. Similar competitors branded drugs have generated sales in excess of $8 billion annually. Drug approval goes through four phases, with each successive phase ultimately leading to approval and public sale. BMY has some promising drugs in Phase 2, awaiting approval in Phase 3 in the coming The company has increased its dividend 4% annually over the past three years. Trading at 12x this year s earnings and with an increasing backlog over $19 billion, CGI s stock is out of favour and a buy. CGI Group, Inc. (GIB.A-TSX/$34.13/0.00%) CGI is Canada s leading independent IT (information technology) service outsourcing and integration company. With a $10.8 billion market value, GIB.A creates value through strong cash flow generation which in turn helps it fund share buybacks, debt repayment and acquisitions. CGI has exposure to an economic environment where companies are spending on technology integration to better allow them to compete. 60% of its sales are from Europe and 20% in North America. CGI is known as the company that created the US Government Healthcare website, which was plagued with integration problems. US healthcare represents only 2% of total sales. Trading at 12x this year s earnings and with an increasing backlog over $19 billion, CGI s stock is out of favour and a buy. The Coca-Cola Company (KO-NYSE/$38.66/3.16%) Coke has increased its dividend 8.5%/year over the past three years and trades at 18x this year's earnings. Buy. The largest beverage company in the world with a market cap of $168 billion, Coke has one the largest consumer franchises in the world. Of it s 500 brands 16 generate more than $1 billion in sales annually. With the cold weather and recent tax impositions on soft drinks in Mexico, KO has seen its volumes, sales and earnings decline recently and the stock has underperformed for three years. But, 700 million people worldwide will join the middle class by 2020, leading soft-drink sales to double over 10 to 15 years. And the bottling infrastructure to serve them has already been built, worldwide. The company plans on re-franchising its bottling, warehousing and distribution centres in the US with a goal of matching the beer industry in efficiency. Coke has increased its dividend

5 8.5%/year over the past three years and trades at 18x this year's earnings. Buy. Dundee Industrial REIT (DIR.UN-TSX/$9.40/7.45%) A strategic introduction of its services in South-east Asia provides another catalyst to grow and sustain revenues and earnings for a long time to come. Intact has increased its dividend annually at a rate of 9% over the past three years. Trading at 12.2x this year s earnings, the market still has not factored in the potential for growth in European sales. DIR.UN is a warehouse and industrial property real estate investment trust. With a market cap of $665 million, the company operates a portfolio of 16 million square feet of industrial real estate assets strategically located in major Canadian distribution hubs. Dundee has a moderate payout ratio (dividends paid relative to net income earned) of 90% and trades at a price-to-funds from operations ratio at 9.7x. The finance management team is strong, with a good track record of growth headed by DREAM (Dundee Real Estate Asset Management). A lower share price of late has prevented the company to use its stock as currency in takeovers. But over time, the company should benefit from acquisitions, rising rental rates when leases expire over the course of the coming years and debt refinancing at favorable terms. The yield of 7.45% is attractive. Enerflex Ltd. (EFX-TSX/$17.60/1.71%) EFX is a $1.2 billion (market capitalization) leading natural gas compression, processing, refrigeration and power generation company operating in 16 countries including Canada, Australia, and Singapore. It has exclusive rights to market the General Electric s natural gas compression engine in Canada and in many of the states in the US. In North America, EFX could benefit from an increasing export market in LNG (liquefied natural gas). The company has very little debt (debt to equity ratio below 10%) and trades at 13.6x next year s earnings. A strategic introduction of its services in South-east Asia provides another catalyst to grow and sustain revenues and earnings for a long time to come. Intact Financial Corporation (IFC-TSX/$68.80/2.79%) IFC is Canada s largest property and casualty insurer with over 17% market share. With a market value of $8.9 billion, IFC s conservative investment profile, smart underwriting practices and bolt-on acquisitions (growing market share and consolidating a highly fragmented industry) have delivered returns on equity of 15%/year, consistently five points greater than the industry average. Severe weather this winter and auto premium reductions mandated by a meddling Ontario government have impacted earnings, presenting an opportunity to add to the company s shares. Industry consolidation is a long-term positive for IFC s pricing power. The price-to-earnings ratio is 11.5x and price to book value is 2. Intact has increased its dividend annually at a rate of 9% over the past three years. Magna International Inc. (MG-TSX/$106.28/1.58%) MG is North America s largest auto-parts manufacturer, controlling over 11% of a fragmented market. It sells nearly every part required to build a vehicle, and its customers include the foremost auto makers in the world. Trading at 12.2x this year s earnings, the market still has not factored in

6 The company also creates shareholder value by buying underachieving businesses THI consistently generates high returns on equity (over 40%), while trading at lower multiples than its US peers. the potential for growth in European sales. Europe represents 40% of Magna s total sales and European vehicle demand have been growing recently. Profit margins should grow through increased car production. The company has over a $1 billion in net cash (cash minus total debt) and has increased its dividend over the past three years at a rate of 26%/year. ONEX Corp. (OCX-TSX/$61.38/0.24%) Canada s largest private equity company, with a market cap of $6.8 billion, has generated an internal rate of return of 28%/year since inception (1985). OCX has a prudent management team, with a compensation structure aligned with the goals of its investors. The company trades around 1.1x book value (total assets less liabilities). OCX generates fee-based earnings on some of the assets it manages. The company also creates shareholder value by buying under-achieving businesses, improving their prospects and later divesting them under favorable market conditions, such as now. Over the past three years the company has increased its dividend 8% annually. Tim Horton s Inc. (THI-TSX/$61.14/2.09%) Tim Horton s controls 42% of the quick service restaurant and 75% of the caffeinated beverage market share in Canada. The $8.3 billion (market capitalization) company s recently appointed CEO, Marc Caira, who has taken on a new strategic initiative to change its menu items (healthier, down-sizing items, specialty drinks), shore up its US operations (focusing on profitability rather than more stores, minimizing capital expenditures, and partnering with experienced franchise networks), renovating their drive-thru operations and improving THI s distribution network. The stock has underperformed this past year, giving investors an opportunity to buy. THI consistently generates high returns on equity (over 40%), while trading at lower multiples than its U.S. peers. The company has increased its dividend 26% annually over the past three years. CIBC Wood Gundy March 2014 Connect with:

7 This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. CIBC World Markets Inc CIBC Wood Gundy is a division of CIBC World Markets Inc., a subsidiary of CIBC and a Member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organization of Canada. Clients are advised to seek advice regarding their particular circumstances from their personal tax and legal advisors. If you are currently a CIBC Wood Gundy client, please contact your Investment Advisor. Yields/rates are as of March 31, 2014 and are subject to availability and change without notification. Minimum investment amounts may apply. Ryan Johnston is an Associate Investment Advisor working with Moe Johnson, Investment Advisor. CGI Group Inc. is a client for which a CIBC World Markets company has performed investment banking services in the past 12 CIBC World Markets Inc. has managed or co-managed a public offering of securities for CGI Group Inc. in the past 12 CIBC World Markets Inc. has received compensation for investment banking services from CGI Group Inc. in the past 12 for investment banking services from CGI Group Inc. in the next 3 CIBC World Markets Corp., CIBC World Markets Inc., and their affiliates, in the aggregate, beneficially own 1% or more of a class of equity securities issued by CGI Group Inc.. A senior executive member or director of Canadian Imperial Bank of Commerce ("CIBC"), the parent company to CIBC World Markets Inc. and CIBC World Markets Corp., or a member of his/her household is an officer, director or advisory board member of CGI Group Inc. or one of its subsidiaries. The equity securities of CGI Group Inc. are subordinate voting shares. Dundee Industrial REIT is a client for which a CIBC World Markets company has performed investment banking services in the past 12 CIBC World Markets Inc. has received compensation for investment banking services from Dundee Industrial REIT in the past 12 for investment banking services from Dundee Industrial REIT in the next 3 for investment banking services from Enerflex Ltd. in the next 3 for investment banking services from Intact Financial Corp. in the next 3 CIBC World Markets Corp., CIBC World Markets Inc., and their affiliates, in the aggregate, beneficially own 1% or more of a class of equity securities issued by Intact Financial Corp.. for investment banking services from Magna International Inc. in the next 3 Magna International Inc. is a client for which a CIBC World Markets company has performed non-investment banking, securities-related services in the past 12

8 CIBC World Markets Inc. has received compensation for non-investment banking, securities-related services from Magna International Inc. in the past 12 CIBC World Markets Corp., CIBC World Markets Inc., and their affiliates, in the aggregate, beneficially own 1% or more of a class of equity securities issued by Magna International Inc.. for investment banking services from Onex Corporation in the next 3 Onex Corporation is a client for which a CIBC World Markets company has performed non-investment banking, securities-related services in the past 12 CIBC World Markets Inc. has received compensation for non-investment banking, securities-related services from Onex Corporation in the past 12 The equity securities of Onex Corporation are subordinate voting shares. for investment banking services from Tim Hortons, Inc. in the next 3 CIBC World Markets Corp., CIBC World Markets Inc., and their affiliates, in the aggregate, beneficially own 1% or more of a class of equity securities issued by Tim Hortons, Inc..