DK EQUITY GROWTH FUND. Quarterly Report September 30, Rates of Return

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1 DK EQUITY GROWTH FUND Quarterly Report September 30, 2001 Rates of Return 3 Mths YTD 1 Yr 2 Yrs 3 Yrs 4 Yrs 5 Yrs 6Yrs 7 Yrs 8 Yrs DK Equity Growth Fund -16.8% 5.3% 1.9% 0.4% 9.4% -8.7% -2.7% 5.4% 8.6% 9.7% Nesbitt Burns Small Cap -21.9% -13.8% -27.0% -7.8% 0.6% -9.9% -3.9% 0.1% 0.8% 1.1% Index (Unweighted) TSE % -22.6% -33.1% 0.5% 8.3% 0.8% 6.9% 8.9% 8.5% 8.9% The North American stock market indices established new lows following the terrorist attacks in the U.S. on September 11. The table below shows the correction from last year s highs to the most recent lows (all on September 21) for the four major North American indices. TSE300 S&P500 DJIA NASDAQ Peak (date) 11,389 (01-Sep-00) 1,527 (24-Mar-00) 11,723 (14-Jan-00) 5,049 (10-Mar-00) Low (date) 6,513 (21-Sep-01) 956 (21-Sep-01) 8,236 (21-Sep-01) 1,423 (21-Sep-01) Decline (%) -43% -37% -30% -72% Close Sep 30 6,839 1,041 8,848 1,499 Bear Market Duration to date (months) After almost a decade of irrational exuberance, an inevitable correction in the stock market indices began last year. The Dow Jones Industrial Average peaked in January 2000; the S&P 500 and the NASDAQ in March 2000; and the TSE 300 in September Non-North American markets followed in a similar trend. The Morgan Stanley EAFE (Europe Asia and the Far East) peaked in January 2000 and has declined 44% between then and September 21, The heavier the weighting in technology and telecom stocks, the greater has been the decline witness the NASDAQ (-72%) and the TSE 300 (-43%). This correction is beginning to look much like the 1973/74 correction. We have written before about the similarities between the late 1990 s stock bubble and the bubble of the early 1970 s. At that time, the Nifty 50 stocks (Avon, Polaroid, etc.) were the internet stocks of their day and

2 2 traded at ridiculous multiples of times earnings. When that bubble burst, the carnage looked like this: Bear Market Start Duration Months % Decline Dow Jones Industrial 01-Nov % S&P Nov % NASDAQ Composite 01-Nov % The U.S. economy is most likely in the midst of a recession. Economists define a recession as two consecutive quarters of negative economic growth. The last U.S. recession was in the latter part of 1990 and early Since the last recession, the U.S. has experienced an unprecedented period of uninterrupted economic growth and productivity increases. This fueled unrealistic expectations for growth in corporate profits and unrealistic prices were paid for many types of businesses. Nowhere was this more exaggerated than in the technology dominated NASDAQ market. It is worth updating a graph we have used before to remind us of the magnitude of the speculative bubble that took place. The annualized return from January 1995 to September 2001 was a realistic10.76%. The shaded area above the line is the speculative bubble. This was one of the greatest bubbles and economic fantasies in the history of mankind. The U.S. economy was probably already in a recession in the third quarter prior to the terrorist attacks. In our view, the subsequent decline in consumer and business spending has made the recession a fait accompli. Make no mistake, recessions do not cause market corrections - overvaluations do. This correction began 1½ years ahead of this recession. The overvaluations were unprecedented at the peak and the subsequent correction, particularly the NASDAQ, has been equally unprecedented. We are not going to try to predict the immediate course of stock market indices or the economy. It is a mugs game and not relevant to what we are trying to do. We are trying to buy businesses at fair enough prices that give us a chance to earn a decent return over the long haul.

3 3 Let us just make a few simple observations regarding the U.S. economy. Yes, we are probably in a recession. How long and how deep will it be? We don t know and neither does anybody else. However, let s look at some of the facts. The U.S. Federal Reserve has cut interest rates nine times this year, twice since September 11 alone. Tax rebates have been distributed and lower tax rates have begun to apply. Since September 11, substantial additional spending measures have been approved for the airlines and for New York, and more spending is on the way for defense and reconstruction. The incremental spending already in the pipeline is estimated to be in excess of $60 billion. Moreover, the previously expected U.S. budget surplus for 2002 has disappeared. The point is, although the very near term outlook is uncertain, a very significant amount of monetary and fiscal stimulus is on the way in the U.S. as the Fed and the Treasury attempt to reflate the economy. Furthermore, do not underestimate the potential economic boost from the decline in oil and natural gas prices. Natural gas is down 60% from its high and oil is down 22%. The news is not all bad. Although we do not know where the broad stock market indices are headed, we do think that many big cap stocks are still very optimistically priced. For example, let s look at Coca-Cola, one of the 30 stocks in the Dow Jones Industrial Average. Since its peak in mid 1998 of $88 per share, the price has come down to $46. By any historical measure, it is still overvalued. Even at today s price it trades at roughly 30 times earnings, but has a potential growth rate of only % per annum. By our estimation this company could easily trade at 15 times earnings, or $23. Gillette is another example. At roughly $30 per share it also trades at 30 times earnings with a long-term growth rate of about 10%. This stock would be more fairly priced at $15. The point is, many of the stocks that set the value for the indices could go lower and take the indices down further. The Bank Credit Analyst put out a very interesting piece at the end of September which came to a similar conclusion regarding the S&P 500 index. They point out that the average P/E ratio for the S&P 500 over the past century is 14 times. The S&P 500 currently trades at a P/E of just over 30 times. Earnings are currently 35% below their Q peak. Even if earnings return to this peak, the S&P 500 would still be at a P/E of 20, well above the long-term average. Their conclusion: the lack of good value remains a headwind, especially given the uncertain earnings outlook. At the peak of the stock mania two years ago, we clipped this cartoon out of the newspaper. The vast majority of stock investors in the 1990 s, both private and so-called professional, had only experienced a bull market. The result was the gaudiest bull mania in history and a massive misallocation of capital, which will take some time yet to sort out.

4 4 Our area of concentration, smaller cap stocks, did not participate to the same extent in the valuation craziness of the late 1990 s. As a result, they were more fairly valued going into the correction and have not been devalued to the same extent as the larger company stocks over the past year. A graph that we have used before shows the relative returns of small caps versus large caps since The picture shows that between 1996 and late 2000, the mania for big technology growth stocks produced the longest and widest period of differential returns in favour of big stocks in the history of the data. The U.S. data shows a similar picture. It is the declining valuations in the big caps in 2000 and 2001, not a revaluation in small caps that has resulted in better relative small cap returns since late last year. NBSC Index vs. TSE 300 Relative Performance (%) on an annual basis Significant Small Cap Outperformance (10.00) (20.00) (30.00) Significant Large Cap Outperformance (40.00) (50.00) In our opinion, most of the attractive opportunities are still in the small cap area. In addition to small cap stocks, we believe there are also attractive investments in the energy area. Energy is a

5 5 greatly misunderstood sector that we believe will provide attractive returns over the next few years. As we pointed out earlier, both oil and natural gas prices are well below their highs of last winter. In our opinion this is a result of a temporary slowdown in demand growth. The longterm supply problems have not been addressed and we expect a sustained period of higher oil and gas prices. The fundamentals for world oil and North American natural gas are similar. Firstly, it is important to point out that oil is a global commodity because it can be efficiently transported on the high seas. Natural gas is a more regional commodity because it is more costly to transport, other than by pipeline. In our opinion, the picture for world oil prices is similar to the early years of the 1970 s. From 1959 to 1973 the price of West Texas Intermediate Oil (WTI) had been consistently within a band of $ $3.00 per barrel. Because of persistent low prices, demand for oil exploded and by 1973 the worldwide oil industry was producing at 100% capacity. In 1970 the U.S. was the largest consumer and producer of oil in the world at 10mm barrels per day. U.S. oil production peaked in 1970 and has continuously fallen ever since. From 1970 on, the U.S. became increasingly dependent on foreign supplies. Because the worldwide system was operating at capacity in 1973, and because the U.S. had ceased to be self-sufficient in oil production, the Nixon administration was aware of the danger and unveiled a detailed U.S. Energy Strategy to the American public in The events of September 11, 2001 have caused many to forget that the Bush administration unveiled a strikingly similar strategy earlier this year. In 1973 the pricing power for oil shifted to OPEC. The onset of hostilities in the Middle East in October 1973 (the Yom Kippur War) led to the Arab embargoes on oil shipments to the U.S. There was virtually no excess production capacity and oil went from $3 per barrel in mid 1973 to roughly $12 per barrel by December of that year. Your author remembers being in gasoline lines for hours in New England, only to be allocated a few gallons. After the embargo ended in early 1974, the lack of any significant additional capacity in the system, combined with more turmoil in the Middle East in 1979/80, the spot price rose to over $40 a barrel by the mid 1980 s ($60 a barrel in today s dollars). In a period of seven years the price of a barrel of oil increased 13 fold. The only area of the stock market in the 1970 s where money was made was in energy stocks. In fact, by 1980 energy grew to 25% of the S&P 500 and the TSE 300 almost like the tech stocks of the late 1990 s. The extraordinary rise in oil prices in the 1970 s had two effects on the oil market consumption growth was curtailed, and increased drilling resulted in an increase in production capacity. The shortages that existed in 1973 were replaced with excess capacity by the mid 1980 s. Subsequent to the price peak in mid 1980, and save for a spike in 1991 when Iraq invaded Kuwait, the price of oil declined until its low point of $10 in late This was the lowest inflation-adjusted price since the Great Depression. The declining oil price over the past two decades reignited a significant growth in demand for oil, particularly from developing nations such as China. At the same time, lower prices have curtailed drilling at a time when the maturing producing basins of the world have begun to experience

6 6 steepening decline rates. As we entered this new decade we are once again in a period not unlike the early 1970 s. There is very little excess capacity in the world oil system, and what little does exist, is eroding quickly. And once again we are facing hostilities in the Middle East. The world currently consumes 76mm barrels of oil per day. Non-OPEC supplies 63% of world oil demand. Non-OPEC production has been flat for 3 years. We consume roughly 1 billion barrels of non-opec oil every 23 days. So just to stay even, we must find a new 1 billion barrel pool every 23 days. Good Luck! It is not likely going to happen, and will never happen at today s price deck. Remember this - $30 oil today equates to a price of roughly $7 a barrel in 1973 dollars. Coincidentally, this is the same price that Henry Kissinger in 1974 tried to get the world to adopt as a floor price for oil so alternative sources of energy could be developed. Sound familiar? We need a sustained period of higher prices to provide the cash flow needed to drill the wells necessary to meet demand. In our view, this bodes well for Canada s exploration and production companies, and oil service companies. As a group they have fallen from roughly 25% of our stock market 20 years ago to less than 10% today. This will change going forward. The North American natural gas fundamentals are similar to world oil. The U.S. ceased to be self-sufficient in natural gas production in the mid 1980 s and has become increasingly reliant on Canada. Canada currently supplies roughly 15% of America s gas needs. Recent statistics show the average gas well in the U.S. is currently facing declines of 30% per annum. New wells drilled in Texas and the Gulf of Mexico are experiencing first year decline rates of greater than 40%. In simple terms, if no new wells were drilled in the U.S. next year, production would decline by 30%. Big problem! At today s gas prices, not enough wells are being drilled in North America to offset the declines. When demand growth resumes we will be looking at supply shortages and higher prices. World oil prices are now being determined in the pits of the New York Mercantile Exchange by speculators with limited fundamental knowledge and very short-term investment horizons. Furthermore, the ownership of Canada s oil and gas industry is in the hands of Bay Street portfolio managers who were in diapers when oil and gas represented 25% of the stock market. At less than 10% of the market they can afford to ignore it. In our opinion we are grossly mispricing these assets because of lack of understanding and a short-term focus on quarterly returns. This year, American energy companies have already taken over eight public Canadian exploration and production companies for a total of roughly $19 billion of equity value, or $25 billion of enterprise value. These American companies know what their decline rates look like and are taking a long-term view. The four most recent takeovers have been done at takeover premiums compared to the price 30 days earlier, of between 37% - 52%. That is how far off we are pricing our strategic assets. We believe two years from now we will discover we sold these assets too cheaply.