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Investing Strategies for a Global Capital Market

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George Lewis
Chairman & CEO
RBC Global Investment Management Inc.

Thursday, September 26, 2002

Good morning. Thank you very much Gay, for your introduction and kind words, and thank you all for coming this morning. This is not an easy time to be making financial decisions, either for your business, or for your own personal investments. The events of the past year have brought on what many investors are viewing as unprecedented market uncertainty.

The fact is, the uncertainty in today's capital markets is anything but unprecedented. Imagine for a moment, you were told that in a 30 year span the United States would experience two of the worst bear markets in history, witness a president forced out of office, lose a war, and undergo a period of interest rates as high as 18 per cent? Where would you turn as an investor? This not a hypothetical plot for the next 30 years, it is the actual case of the last 30 years in the US, during which the equity market returned 11% per annum (1972-2002). Without mitigating the current turmoil brought on in today's markets by international terrorism and our continuing response to it, as well as the business and corporate governance failures of Enron, WorldCom and others, we must remember that this too shall pass.

We are all searching for that one "truth" that will serve as a guidepost for our businesses and investment portfolios. Unfortunately, our experience is likely to be similar to the quest of the philosophy student for the perfect political and economic system. Instead, he finds himself confronted by the Bovinian Theory of Economics and Political Philosophies explained in simple "Two Cow" terms:

Socialism : You have two cows. The government takes one and gives it to your neighbour.

Communism: You have two cows. The government takes them both and provides you with milk.

Fascism: You have two cows. The government takes them both and sells you the milk.

Bureaucracy: You have two cows. The government takes them both, shoots one, milks the other, pays you for the milk, and then pours it down the drain.

Corporatism: You have two cows. You sell one and force the other to produce the milk of four cows and then act surprised when it drops dead.

Capitalism: You have two cows. You sell one and buy a bull.

Clearly the preferred alternative.

I would like to share three things with you today:

First, to provide RBC Investments' perspective on the capital markets and long term investing in these challenging times.

Second, to review how RBC Global Investment Management, (part of the RBC Investments wealth management group) as a Canadian-based investor, is approaching the management of equities in a global context.

Finally, as a manager of over $40 billion of client assets under management, I will provide some of the views of RBC Global Investment Management on the public debate around corporate governance and financial reporting.

Let me begin by providing you with the current capital market outlook of the RBC Investments Strategy Committee. First, what is RBC Investments and second, what is its Strategy Committee? RBC Investments is the division of the RBC Financial Group focused on meeting the investment needs of individual clients - through our financial planning teams in RBC Banking branches, our self-directed and full-service brokerage businesses, and our discretionary investment counselling, private banking and trust services for high net worth individuals.

The mandate of the RBC Investments Strategy Committee is to provide a quarterly strategic review of the capital markets and recommended asset mix for use by all RBC Investments businesses in serving their clients. It is comprised of investment management professionals from around the globe - North America, Europe and Asia. It is supported by RBC Global Investment Management's in-house research team that is focused exclusively on our needs as investment managers to RBC Funds and other areas of RBC Investments.

Beginning with our view of the global economy, the economic recovery has, to this point, disappointed as a burst bubble in equities, weak consumer balance sheets and a lack of pent-up demand in the US has weighed heavily on growth. However, unprecedented cuts in North American interest rates and aggressive expansion of the money supply are an effective offset. This is similar to the situation in the early 1990s when the recovery was buffeted by headwinds from plunging real estate prices, a reeling banking system and over-stretched consumers. Then, as now, monetary conditions were fixed, and left, at a very stimulative setting until the economy found its own legs.

We look for growth of 2.5% in the US for 2002, rising to 3.0% the year following. In Europe, where inflation, and not GDP growth remains the target for monetary policy, we expect growth of only 1.1% in 2002 and 2.5% next year. Japanese GDP should remain stagnant this year and advance only 1.0% in 2003.

Around the world, inflationary pressures remain benign, and outside of Japan, the threat of deflation in our view is remote. With the exception of the Bank of Japan, monetary authorities have provided the right amounts of ease at the right time, and a healthy banking system is putting all of that liquidity to work. The systemic failures that come in advance of a protracted period of deflation are simply not in evidence for most of the industrialized world. We believe monetary policy is now positioned at an appropriate level given the significant headwinds encountered through this recovery. There remains, however the potential for further modest rate cuts, particularly in Europe, if the recovery does not gain traction. In any event, the next round of monetary tightening now appears unlikely prior to mid-2003.

With respect to bonds, the summer rally in fixed income markets has moved yields to levels inconsistent with the economy's current and forecast performance. Bond prices have been bid well beyond their intrinsic value as a result of their status as a safe-haven and the perception that they are the only marketable investment alternative to equities. The move has been exacerbated in our view, particularly in US Treasuries, by leveraged hedge funds purchasing long bonds and capturing the carry available from a steep yield curve. With the Fed on hold, further bullish yield curve flattening is possible, but it is an increasingly risky proposition. Any signs that equities are bottoming or that a Fed tightening is looming could result in a dramatic sell-off, easily pushing 10-year Treasury yields up 50-75 bps. in a very short time span.

With respect to equities, the three-year bear market in stocks has reduced valuations in most countries to attractive levels. Moreover, profits are stirring in North America as the economic recovery and cost cutting show through in firming margins and earnings. The road ahead is not without obstacles. Low inflation and excess capacity limit the potential for revenue growth and profit margins even as the economy shifts into a higher gear. Increased transparency in accounting, particularly with respect to pension plan expenses, while raising the quality of earnings and the level of trust in corporate America, will further expose the difficult profit environment.

Nevertheless, in the wake of the tech wreck, evidence of corporate malfeasance and excess and, more recently, concern over aggressive accounting, expanding risk premiums have pushed stocks to levels inconsistent with interest rates, inflation and a reasonable view of profitability through the cycle ahead. With increased transparency will come trust and, eventually, the gradual lowering of risk premiums, opening the way for a sustained recovery in stock prices.

To sum up, this is an environment where we would recommend a modest overweight for equities vs. fixed-income securities. However, the larger message is that we don't believe that all sectors of the equity markets will perform equally well over the next twelve months, or even the next decade. Rather than a broad market advance across all sectors - financial services, consumer stocks, technology, communications and media, natural resources, health sciences, and infrastructure-related stocks - we expect significant returns will depend on careful sector and, in particular, stock selection.

With this backdrop, there is no substitute for a financial plan that includes a balanced asset mix and diversification within these asset classes. While asset mix should depend on your investment objectives and risk profile, the RBC Investments Strategy Committee currently recommends an equity weighting of 60% for long term balanced and growth oriented investors, along with a 30% weighting in bonds and 10% in cash. A diversified portfolio, with stock exposure at this modestly over-weight position will give your portfolio greater staying power.

With respect to diversification within the equity component of your portfolio, in a market with reduced visibility of earnings and elevated risks, one of the best strategies to manage those risks is by looking at the sector make-up of your holdings.

Traditionally, investors have diversified their portfolios along geographic lines, complementing their Canadian holdings with some US equities and perhaps European, Asian or Latin American holdings. While it is extremely important to use your allowed foreign content of 30% within your RRSP, at RBC Investments and RBC Global Investment Management, we focus on a sector approach, and recommend apportioning your portfolio into industry groups, thereby achieving geographic diversification indirectly.

Why have we adopted this approach? Well, in terms of conducting basic research and portfolio management this approach reflects the increasingly "borderless" markets when it comes to major businesses. Swings in various industries occur globally rather than within the confines of a specific region. As long as one has a defined investment process, which we do at RBC Global Investment Management, conducting global equity management by sector, rather than geography, allows us to concentrate most of our research and investment management resources in a few locations. As such, while RBC Global Investment Management has personnel in six international centres, the vast majority of our 200 investment research, portfolio management and other investment management employees are concentrated in Canada.

The most important reason for adopting the global sector approach is simply this; the benefits of geographic diversification for investors have gone down over the last five years, while the benefits of sector diversification have gone up.

Numerous academic studies of the performance of equity markets around the globe, certainly in developed markets, have shown that the correlation among geographic markets has risen - U.S., Canadian, European, Asian markets have moved more in tandem in recent years. This means there is less diversification benefit from having exposure to each of these geographic markets.

On the other hand, these same studies have shown that there is less correlation of stock market performance across different industry sectors - financial services companies perform differently from health sciences companies, which perform differently from technology companies within one market and across geographic markets. This means that there are more diversification benefits from having exposure to each sector in a global investment portfolio.

While academic studies support this, we don't have to strain to recall a real-world example of this in terms of the performance of equity markets for most of the last three years. Investors who believed they enjoyed diversification by holding Canadian equity funds, U.S. equity funds, European equity funds and, yes, even Asian equity funds had a rude awakening when all declined significantly. The underlying reason in most cases was an exposure to technology stocks of 30-40% in each fund at the beginning of the bear market.

In terms of allocating investments among various sectors under current market conditions, the RBC Investments Strategy Committee has recommended a consistent under weighting of Technology and Telecom for the last year, which remains intact.

The sectors where we are recommending an overweight position are Consumer Staples (vs. Discretionary), Health Care and a modest overweight Financial Services. Several companies within these sectors have demonstrated resilience in their profit margins and have the ability to maintain pricing power in a low inflationary environment. Further, these sectors tend to perform well during periods of modest (versus robust) economic growth, which is the environment we are expecting.

Finally, with respect to Financial Services, this sector has come under considerable pressure globally as a result of credit, regulatory and other concerns. However, we believe this has resulted in low valuation levels that do not take into account the underlying earnings power and stability of some of these companies' retail and asset management franchises. As always, stock selection will be critical.

To sum up, the basic message of the RBC Investments Strategy Committee to you as individual investors -
#1 maintain an asset mix that fits with your investment objectives and has a sufficiently large equity exposure (60%) to enable you to meet your long term goals; and,
#2 ensure that the equity portion of your portfolio is diversified across industry sectors on a global basis.

In reflecting on the messages I've shared with you today concerning setting investment strategy in this uncertain environment, I hope you'll agree on their basic logic. But logic rests on basic assumptions and premises about our world and our economy. Many of these assumptions are now being tested.

At RBC Global Investment Management, we consider many factors when analyzing companies for our potential investment, including the quality of financial reporting and corporate governance. When it comes to increasing the rigour with which companies report their financial performance and exercise good governance, we remain committed to two basic principles: (1) trust in the natural forces of the market; and, (2) an approach to regulation which seeks not only vigorous enforcement, but also to reduce barriers to the natural forces of the market which can act to improve corporate governance.

As recently stated in The Economist, "If the market comes to admire honesty, transparency and good corporate governance, executives will rush to acquire those characteristics. Even in morality, the market rules in the end."

On the basis of these principles, we are supportive of measures that many companies are taking to strengthen their financial reporting and governance practices. Many companies across North America have announced their commitment to reform and transparency. The decision to expense premiums related to employee stock options is an example. On the heels of many of these announcements, we have witnessed a rise in the value of the company's shares.

With respect to regulatory initiatives in the US and Canada, we have been impressed with the degree of ongoing thought and debate on both sides of the border. Again, we are more encouraged by the regulatory initiatives which seek to remove barriers to good corporate governance rather than attempt to artificially guarantee it.

In an attempt to illustrate my point, I sought the advice of my daughter, which is always a good thing, and we came across this little anecdote on the internet:

"When NASA first started sending up astronauts, they quickly discovered that ball-point pens would not work in zero gravity. To combat this problem, NASA scientists spent a decade and $12 billion developing a pen that writes in zero gravity, upside down, underwater, on almost any surface including glass and at temperatures ranging from below freezing to over 300 degrees Celsius. The Russians used a pencil."

Now, one has to acknowledge that, overall, the US space program was much more successful than the Russian space program, and that any serious global player in the aerospace business needs access to the US space and defense industry to be successful.

However, that does not mean each and every aspect of the NASA space program or US regulations should be emulated. There are plenty of pencils available to regulators and public policy makers to reach the objective of enhanced financial reporting and better governance.

Sharpening of these pencils, is required however. Reinforcement and clarification of the roles of fiduciaries and professionals would go a long way toward achieving these objectives. Examples include measures to enhance auditor independence from managements and ensure that their clients are, in fact, the people addressed at the beginning of auditors' reports: "To the shareholders of XYZ Company…".

At the same time, a "clean" audit opinion should be valued, and highly valued, for its traditional conclusion - that the financial statements of XYZ company present fairly its financial position at a single point in time and its financial performance during a given historical period - Not as a guarantor of the success of the company's business model or its future financial performance.

There are other positive initiatives underway in the regulatory arena consistent with the principle of reinforcing fiduciary and professional duty rather than prescriptive rule-making. But improving corporate governance is not only (nor even primarily) the responsibility of issuers and regulators.

The natural forces of the market do not operate unless the owners step up to the plate - those who exercise voting control of the companies that make up the market.

RBC Global Investment Management has always had clear voting policies in place with respect to governance issues such as stock option plans, separation of board and management roles, shareholder rights plans, etc. We have exercised our proxy voting rights to maximize value for our unitholders and clients.

Given the urgency of improving corporate governance, we have come to the view there is strength to be had in numbers. We have decided to join the Canadian Coalition for Good Governance, a group of institutional investors that came together in June of this year, led by the Ontario Teachers Pension Plan Fund and Jarislowsky Fraser. This group has discretionary power and a fiduciary duty to exercise proxy voting rights with respect to more than $400 billion of assets under management. Our goal, simply stated, is to improve corporate governance in Canada. Our preferred method is to work with managements and boards to achieve this goal with particular focus on the following key issues:

  • Board selection and independence
  • Functioning of board committees, especially the Audit committee
  • Promotion of conservative accounting
  • Compensation and its accounting
  • Shareholding value issues in takeover and other extraordinary situations

Not all members of the coalition will agree or need to agree on each issue under consideration. However, our hope is that this group becomes a strong, permanent voice on behalf of shareholders with the Boards of Directors they have hired to supervise the management of the companies they own.

Finally, from the perspective of individuals making investment decisions, we should recognize that valuation bubbles which burst, accounting scandals, and corporate governance irregularities have been the hallmarks of bear markets for centuries. It is somewhat comforting that we are in the third and final phase of this "trifecta" and that companies, regulators and shareholders are addressing these issues with vigour.

We remain of the view that capital markets in general, and equity markets in particular, will maintain or regain their status as primary wealth creation vehicles for patient individual and institutional shareholders.

To borrow from both Adam Smith and Sir Winston Churchill, the invisible hand of the market economy is the worst system for the creation and distribution of wealth - except for the all the rest.

That there is a need to state this view explicitly is a testament to the depth and length of the current bear market in global equities - one that we are cautiously optimistic - or optimistically cautious - is drawing to a close.

Once again, thank you for your time this morning, I would be pleased to take a few of your questions.


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