Investment Portfolio Quarterly · Scotia Strategy 2013 Outlook & Model Portfolios Update 4 Economic Outlook United States to Emerge Stronger Following Fiscal Cliff 10 Canadian Strategy

Investment Portfolio Quarterly

Insightful PerspectivesWinter 2013

Portfolio Advisory Group

Winter 2013 1

Contents Page

Executive Summary

IPQ Winter Review and Outlook 2013 2

Portfolio Strategy

Scotia Strategy 2013 Outlook & Model Portfolios Update 4

Economic Outlook

United States to Emerge Stronger Following Fiscal Cliff 10

Canadian Strategy

Top 10 Canadian Stock Picks for 2013 16

U.S. Strategy

Top 10 U.S. Stock Picks for 2013 29

Fixed Income Strategy

Outlook for 2013 – Rates Will Get There But You Better Pack a Lunch…Sizeable Headwinds Remain 44

Equity Hybrid Strategy

Investing in Convertible Bonds 49

Mutual Fund Strategy

Low Volatility Investing 53

Exchange Traded Funds

The Differences Between Physical and Synthetic ETFs 55

Guided Portfolios

Canadian Core 57

Canadian Income Plus 60

U.S. Core 62

North American Core 65

Quant Portfolio 67

Core-Plus Fixed Income 69


2

Executive Summary IPQ Winter Review and Outlook 2013 Shane Jones — Chief Investment Officer & Co-Head, Portfolio Advisory Group

The fourth quarter proved to be as turbulent as the third with uncertainty surrounding the U.S. Presidential election and fiscal cliff talks being offset by positive U.S. and Chinese economic data. Markets in Canada would trade in a very tight range to start the quarter with the focal point being the outcome of the U.S. Presidential election amid lackluster Q3 corporate earnings. Shortly after Barrack Obama’s victory, attention quickly shifted to fiscal cliff talks, a term used to describe the expiration of Bush-era income-tax cuts, the end of certain payroll-tax reductions, and automatic decreases in government spending mandated as a result of last year’s failed debt-ceiling talks. The fiscal cliff totaled US$607 billion which left untouched would trigger on January 1, 2013; with the threat of leading the U.S. economy back into a recession. Fiscal cliff talks would drag on for the majority of the quarter largely due to the makeup of Congress, with the Republicans keeping the majority in the House and the Democrats retaining control of the Senate. Equities also faced selling pressure post-election on concerns over the potential for increased taxes on capital gains and dividends starting next year in the U.S., prompting investors to lock in gains on some of their winning stocks. Markets took a nose dive following the election results only to rebound mid-quarter as sentiment improved, encouraged by the constructive comments made by both House Speaker, Republican John Boehner, and President Barack Obama, regarding a resolution to the fiscal cliff. Nothing would be accomplished by the end of November with both GOP and the POTUS gridlocked with their respective budget proposals. Markets would continue a rally towards the end of the quarter as markets priced in a resolution to the fiscal cliff.

Offsetting negative sentiment surrounding the U.S. budget talks was improvement in economic data from the world’s two largest economies, the U.S. and China. Signs that the U.S housing-market recovery would extend into 2013 were underscored by data points released during the quarter. U.S. Housing Starts would rise to an 899,000 annual rate for the month of November, the most since July 2008. Housing prices would also indicate housing demand, as the S&P/Case-Shiller index rose by 4.3% from the previous year, the biggest 12-month advance since May 2010. U.S. employment continued to strengthen during the quarter led by Initial Jobless Claims which fell to a four-year low at the beginning of the quarter, the lowest since February 2008. The unemployment rate also held in strong at 7.8%, an improvement from the start of Q3 where unemployment was at 8.2%. Consumer confidence among Americans rose to 72.2 in October, the highest level since February of 2008. In China, a bottoming of growth became apparent as infrastructure initiatives implemented by Chinese policy makers started to influence the economy. Early in the quarter, China Cosco Holdings Co., China’s largest publicly listed shipping company, indicated they are “beginning to see signs of recovery.” This was consequently supported by economic data mid quarter as China released data indicating the first improvement in factory output in 13 months after a seven-quarter slowdown. A preliminary reading by HSBC of Chinese PMI (Purchasing Managers’ Index) came in at 50.4 for November compared with 49.5 for October; a reading above 50 indicates expansion. Industrial production also rallied during October, up 9.6% YoY, beating consensus expectations of 9.4%, and rising again in November, up 10.1% YoY. Equity markets in China would react positively to the rebound in growth, with the Shanghai Composite index posting an 8.8% return during Q4.

European debt fears were virtually non-existent as indicated by tightening of bond yields among indebted nations. Early in the quarter, finance ministers from the 17 euro countries officially declared the European Stability Mechanism (ESM) operational. Luxembourg Prime Minister Jean-Claude Juncker said creation of the ESM “makes the strategy of member states credible and equips the euro area with much better tools to appropriately respond to future crises.” The ESM can lend directly to governments, intervene in bond markets, offer credit lines, and provide loans that can be used to recapitalize banks. The ESM replaces the temporary European Financial Stability Facility (EFSF), which has spent 192 billion euros of its 440 billion euros on loans to prop up Ireland, Portugal and Greece. Greek 10 year bond yield s dropped 759 bps to 11.90%, Italian 10 year bond yields fell 60 bps to 4.497%, and Spanish 10 year yields fell 67 bps to 5.265% during the quarter.


Winter 2013 3

Canadian equity markets would receive a boost towards the end of the quarter as Industry Canada, with input from Prime Minister Stephen Harper, approved two State Owned Enterprise (SOE) acquisitions: China-owned CNOOC Ltd.’s $15.1 billion bid for Nexen Inc. (NXY) and Malaysian owned Petronas’ $5.2 billion bid for Progress Energy Resources Corp. (PRQ). With the deal came a handful of revisions to guidelines in the Investment Canada Act, effectively closing the door on future SOE takeover bids in Alberta’s strategically important oil-sands assets. This however, does not preclude other M&A activity in the oil sands from non-SOE companies.

Equity markets in North America would finish the year on a high note with the S&P/TSX Composite index rising 0.9% in Q4 to end 2012 up 4.0%. The U.S. benchmark fared better on the year, rising 13.4% despite falling 1.0% during Q4. Canadian equities underperformed the broader global market due to a heavy weighting in gold equities which underperformed as production costs rose and as gold bullion prices declined 5% in the quarter. The Energy sector also underperformed on the year due to weakness in WTI crude oil which lagged other commodities during 2012, falling 7% as improved drilling methods boosted global output thereby weighing on prices. Conversely, natural gas rallied 12% in 2012 after falling 66% in 2011. Gold and silver rallied 7% and 9%, respectively in 2012, while copper advanced 4%.

As we look forward to 2013 our bias is to the upside in equities due to continued strength in both the U.S. and Chinese economies. This should translate into higher corporate earnings in the second half of 2013 along with increased demand in commodities thereby allowing for further multiple expansions. There are risks to speak of; although the worst is likely over in Europe, socio-political unrest in the region could spark market uncertainty; the debt ceiling talks in the U.S. have not been resolved and could pose early headwinds in 2013; tensions in the Middle East could escalate at any moment posing threats to the global economy and commodity prices. That said, we expect a strong performance in 2013 from equities and a weaker performance from fixed income markets.

Here are some of the highlights of what our Winter 2013 Investment Portfolio Quarterly (IPQ) offers:

The Scotiabank GBM Portfolio Strategy Team provides a review of 2012 and talk about their outlook for markets in 2013.

Scotiabank Economist Derek Holt discusses the outlook for North American economies in 2013 with an emphasis on the US economy regaining momentum while he has a cautious stance on the Canadian economy.

Our Equity Team provide you with their top 10 stock picks in both Canada and the US for 2013.

Jean-Anthony Mentor writes a piece entitled ‘Why Invest in Convertible Bonds.’

Andy Mystic, Fixed Income Advisor, discuses expectations for the 2013 rate environment and the headwinds that could impede rate normalization.

Carolyn Tsai for our Fund Research Team discusses the growing trend towards low volatility funds.

Joel Beriault, our ETF Specialist has written a piece on the difference between Physical ETFs and Synthetic ETFs.

In conclusion Steve Uzielli provides his quarterly review and commentary on the performance of the Equity Guided Portfolios.

We hope you all enjoy the Winter 2013 version of the IPQ and recommend you contact your ScotiaMcLeod advisor with regard to any ideas presented here which interest you, or to review you investment portfolio.


4

Exhibit 1: Market Returns (in USD, total return) – 2012 YTD and 2H/12 (As at December 27, 2012)

32%

27%

18%

17%

15%

15%

9%

8%

5%

4%

3%

2%

-1%

-3%

-3%

-5%

0% 5% 10%

15%

20%

25%

30%

35%

-5% 0% 5% 10

%15%

20%

25%

30%

35%

Germany (DAX)

Mexico (Bolsa)

MSCI Emerging Markets

MSCI AC World

U.S. (S&P 500)

U.K. (FTSE 100)

Canada (TSX)

Japan (Topix)

Canada Govt Bond Index

China (Shanghai)

US$ per C$

U.S. Govt Bond Index

DXY Index

Brazil (Bovespa)

CRB Index

H2/2012

2012 YTD

Source: Scotiabank GBM, Bloomberg

Portfolio Strategy Scotia Strategy 2013 Outlook & Model Portfolios Update Vincent Delisle, CFA — Portfolio Strategist, Scotia Capital

Hugo Ste-Marie, CFA – Portfolio Strategist, Scotia Capital

Bottom Line Trumping Headline

Financial markets were greatly influenced by policy risk throughout 2012, extending a dominant theme that has been in place since the global recession of 2008. From the U.S. elections and “fiscal cliff” fears to the leadership change in Beijing and the countless important votes in the Eurozone, political uncertainty was the main driver of investor sentiment and a prime source of volatility in 2012. Although headline news has remained challenging and predominantly pessimistic in recent months, actual market returns have fared better than perceptions, especially in Europe and the United States. Bottom line has trumped headline in recent months, and this trend could continue in 2013. For the most part, companies have weathered the financial crisis with relative success, especially in the Unites States, where profit margins are hovering near record levels. Although government and monetary policy have been a constant focus, corporate profits have been the main driver of equity returns and global leadership in the last year.

Cyclical assets enjoyed mixed returns in 2012 as equity gains (MSCI AC World +17%) were somewhat overshadowed by declines in commodities (CRB Index -3.2%) and lacklustre returns in higher-beta benchmarks in China (+3.8%) and Brazil (-3.1%); see Exhibit 1. U.S. equities (S&P 500 +15%) managed to outperform bonds (+2.2%) in 2012, while Canada’s TSX Index (+9.0%; +6.6% in CAD) trailed the MSCI World due to negative performance in resource sectors. Within LatAm, Mexico (+27%; +19% in MXN) edged Brazil (-3.1%; +6.5% in BRL). It is worth noting that the TSX, Brazil, and commodities enjoyed a much better second half. Performance numbers are in U.S. dollars and are total return.


Winter 2013 5

As shown in Exhibit 1, global equity leadership was concentrated in developed markets throughout 2012 but some key emerging market benchmarks suffered. Slower-than-expected GDP growth in developing countries, along with diverging earnings trends are at the root of 2012 global equity leadership.

According to the IMF, world GDP growth slowed to 3.3% in 2012 (versus 3.8% in 2011), with the loss of speed coming mainly from China (7.7% versus 9.3% in 2011), Europe (-0.4% versus 1.4%), India (4.9% versus 6.8%), and Brazil (1.5% versus 2.7%). North America fared better, with U.S. GDP momentum improving to 2.2% in 2012 (1.8% in 2011), Mexico pacing at 3.8% (3.9% in 2011), and Canada slipping below 2% (2.4% in 2011). Tepid momentum in emerging markets dealt a blow to earnings estimates of commodity-sensitive benchmarks, and forward (next 12-months) earnings estimates have been cut by 1%-9% in Canada, Brazil, and China. In contrast, forward earnings estimates have increased in Mexico (+0.1%), Germany (+4.0%), and the United States (+5.1%) in the last 12 months, the performance leaders for 2012.

With the exception of the United States and Germany, forward earnings estimates trended lower in 2012 in most regions. Hence, P/E multiple expansion played a big role in delivering positive returns in the last year. The MSCI World AC forward P/E expanded by 1.6x (+16%) in the last 12 months and P/E gains tallied 0.9x for the S&P 500 in 2012, 1.0x for Mexico, 1.3x for the TSX, and 1.2x for Brazil. The trend in forward earnings estimates has recovered since Q3/12 along with an improving World PMI Index.

Exhibit 2: Real GDP Growth YoY - Developed vs. Emerging

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

World U.S. Canada Eurozone Japan Brazil China India Mexico

2013 IMF Forecast

2012 IMF Forecast

2011

2004-2010 Average

Source: Scotiabank GBM, IMF.


6

Big Picture Outlook

Notwithstanding the fiscal headwinds expected to weigh on output next year, the U.S. economy is carrying positive momentum heading into 2013. GDP hit 2.7% in Q3/12, the unemployment rate has declined to 7.7%, consumer spending has remained resilient since mid-2012, inventories are down, and new orders strength bodes well for 1H/13. Relative to other G7 countries, we believe the United States will remain top of the class in 2013 as the housing recovery continues and fiscal clarity paves the way to increased business spending. Our scenario for the United States continues to be one of positive mean reversion in the economy’s key segments, which should sustain 2%+ GDP growth.

Our U.S. Leading Economic Indicator (Scotia Strategy LEI) has recovered from its August lows and momentum has picked up since Q3/12. On a six-month annualized basis, our U.S. LEI currently stands at +0.7% and we expect momentum to carry the LEI toward +5% by Q2/13. If this scenario holds, earnings revisions could trend higher in the first half of 2013, thus supporting the S&P 500.

Chinese GDP growth last peaked at 12% in Q1/10 (PMI hit 57), but restrictive monetary policy has dented momentum in 2011 and 2012. Fortunately, the trend appears to be reversing and China’s 30-month economic downturn bottomed in Q3/12. We believe recent data supports stronger momentum next year and we expect China’s 2013 GDP growth to recover towards 8%. Still, the magnitude of recovery in China could disappoint and may not propel commodities prices higher. For one thing, China’s easing cycle is more muted than in 2008/2009 (56 basis point [bp] lending rate cut in 2012 versus 189 bp in 2008/2009) and the supply/demand situation in many commodities is not as supportive as it was five years ago. Moreover, GDP growth of less than 9% is unlikely to trigger broad and significant bounce in the CRB Index.

The good news for China-sensitive equity benchmarks (Canada, Brazil) is that post-easing periods tend to be the most supportive. However, projected gains will be predominantly driven by valuation expansion as commodity upside appears limited.

U.S. Housing Tailwind Continues

The U.S. housing recovery has been one of the brightest spots in recent months and U.S. housing tailwinds could offset some of the fiscal drag heading into 2013. All housing numbers released in Q4/12 beat consensus forecasts and highlight sustained improvements. Existing home sales hit 5.04 million units in November 2012, with median prices rising (10.1% year over year [YOY]) and inventories falling. Homes for sale dropped to 2.03 million last month, their lowest level since 2002. At the current pace of sales, the current inventory of homes would be gone in 4.8 months, the lowest ratio since 2005. Stronger demand for existing and new homes also lifted homebuilders’ confidence, which hit the highest level in more than six years in November 2012, according to the NAHB Index. Housing starts also reached a multi-year high in November 2012, with builders breaking ground at an annual rate of 861,000 units. In our opinion, attractive affordability (own-to-rent ratio the best since 1996), low inventories, and pent-up

Exhibit 3: U.S. Housing Starts and Unemployment Rate (1990-2012)

3

4

5

6

7

8

9

10400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

Jan-90

Jan-92

Jan-94

Jan-96

Jan-98

Jan-00

Jan-02

Jan-04

Jan-06

Jan-08

Jan-10

Jan-12

Jan-14

U.S. Housing Starts ('000s) - LHS

U.S. Unemployment Rate (inverted) - RHS

Source: Scotiabank GBM, Bloomberg.


Winter 2013 7

construction jobs point to positive GDP contribution from housing in 2013. As shown in Exhibits 4 and 5, the housing recovery is likely to trigger an increase in household spending and a firmer pace of hiring in the construction sector, which in turn should support economic growth.

Although the Federal Reserve’s exceptional easing stance precludes a material upward shift in bond yields, the current disconnects warrant caution. Based on the trends in employment and housing, the pickup in yields should have already occurred.

Canada Housing Headwind

In contrast to the United States, Canada’s domestic economy will be challenged by negative housing headwinds in 2013. The pace of sales has precipitously declined in the second half of 2012 following tighter restriction for mortgages, and price erosion is expected to follow. The impact of employment growth will have to be monitored very closely and we could see the U.S./Canada unemployment rate spread narrow further in coming months, which could put pressure on the Canadian dollar. With inflation slowing down toward the Bank of Canada’s target, monetary policy should remain neutral in 2013.

Our Canada Leading Economic Indicator (Scotia Strategy LEI) has had a bumpy ride in 2012 and is currently recovering from its July 2012 low, albeit at an uneven pace. On a six-month annualized basis, our Canada LEI currently stands at -0.2%, up from -0.9% in September 2012.

Pent-up Capex

Steady employment gains and rising home values have solidified U.S. household confidence as net worth recovers. On the other hand, corporate America’s mood appears more muted. Business spending has been slow to recover from the recession compared with earnings and cash balances. Since the end of 2008, business spending has rebounded 14%, while earnings have more than doubled. During that period, cash and other liquid assets have increased 25%. According to the Federal Reserve, corporate America is sitting on cash balances of US$1.7 trillion and cash on the sidelines currently represents 11.1% of GDP versus a historical average of 8.5%. If the consumer spending outlook remains well anchored and Congress avoids fiscal suicide, some of the excess cash could be used to boost latent corporate spending in 2013. If cash balances revert back to 8.5% of GDP, corporate America could free up US$400 billion in cash. Assuming half of that money is spent on capital expenditures, capex could go up by about 17%, which would help sustain economic growth in 2013.

Exhibit 5: U.S. Housing Starts & Construction Workers

5,000

5,500

6,000

6,500

7,000

7,500

8,000

250

500

750

1,000

1,250

1,500

1,750

2,000

2,250

2,500

Dec-99

Dec-00

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12

Housing Starts (000s) - LHS

Construction workers (12-M lag; 000s) - RHS


Exhibit 4: U.S. Housing Starts & Household Appliances

1.4

1.5

1.6

1.7

1.8

1.9

2.0

2.1

2.2

250

500

750

1,000

1,250

1,500

1,750

2,000

2,250

2,500

Dec-99

Dec-00

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12

Housing Starts (000s) - LHS

New Orders of Household Appliances (US$B) - RHS



8

P/E Expansion and U.S. Unemployment

Since 1960, S&P 500 P/E expansion/contraction cycles have occurred alongside improving housing and employment conditions (see Exhibit 6). Monthly payroll gains have averaged 157,000 in 2012 and the unemployment rate has declined to 7.7% (as at November 2012) from 8.7% (in November 2011). If payroll momentum continues and weekly claims decline closer to 300,000 in coming months, valuation multiples could expand further in 2013. The MSCI AC World forward P/E stands at 11.8x, 25% below its long-term average (TSX at -9% discount versus -17% for S&P 500). A 1x-2x point increase would give around 8%-12% upside based on current forward EPS levels.

Global Strategy Outlook-2013

Macro View, Targets, and Game Plan

Our 2013 “big picture” scenario is that World GDP growth exceeds 2012 (+3.3%). However, the pace is unlikely to be strong enough to significantly lift commodities prices. The global economy is entering 2013 with positive momentum, mainly in the United States and China, but Europe continues to weigh on global activity. Japan has been a drag on global growth for years, but a policy shift could take the yen lower and revive exports.

A sustained U.S. housing and employment recovery could lift U.S. 10-year bond yields above 2% (now at 1.90%). The pickup in yields could be more modest in Canada, as challenging housing conditions take their toll. We expect equities to outperform bonds in 2013 as long-term yields rise above 2%, corporate profits grow 5%-7%, and P/E multiples modestly expand.

Purchasing manager surveys (PMI and ISM) bottomed early in Q3/12 and we expect the recovery to continue in 1H/13. U.S. data in Q4/12 has been influenced by Superstorm Sandy’s effects and we expect improvements to continue early in the New Year. As PMI/ISM indices improve toward the 53-55 level (48.4 in Q3/12; 49.5 in Q4/12), forward earnings estimates should also benefit and support risk appetite early in 2013.

Valuations could provide support again in 2013 as systemic risk slowly moderates. The MSCI World is currently trading at 12.2x forward earnings and P/Es range from 10.8x in Brazil, 12.7x for the S&P 500, and 12.9 x for the TSX to 15.7x in Mexico. Our index targets are set at 12,800 for the TSX, 1,550 for the S&P 500, 46,000 for the Bolsa, and 68,000 for the Bovespa.

Exhibit 6: S&P 500 P/E Ratio and Unemployment Rate (1960-2012)

2

3

4

5

6

7

8

9

10

115

7

9

11

13

15

17

19

21

23

25

Jan-60

Jan-63

Jan-66

Jan-69

Jan-72

Jan-75

Jan-78

Jan-81

Jan-84

Jan-87

Jan-90

Jan-93

Jan-96

Jan-99

Jan-02

Jan-05

Jan-08

Jan-11

Jan-14

S&P 500 Fwd P/E* - LHS

U.S. Unemployment Rate (inverted) - RHS

*Trailing P/E from 1960 to 1984, Forward P/E 1985 onward.

Source: Scotiabank GBM, Bloomberg, Thomson Financial, Shiller.


Winter 2013 9

Our game plan for 2013 is to be positioned for pro-growth conditions (equities over bonds; cyclicals over defensives; EM over DM) in the first half of the year. In our opinion, EM stands its best chance to outperform Western Europe and the United States since 2009. We plan to stay constructive on equities as long as housing and employment improvements continue, but will also look to adjust cyclical exposure based on our risk-on/risk-off indicator, our U.S. Economic Surprise Index, and the ISM new orders to inventory spreads.

The TSX could modestly edge the S&P 500 initially in 2013 as China momentum picks up, but a supportive housing trend and tepid commodity gains could keep the U.S. benchmark ahead of the TSX again in 2013. The S&P 500’s upper range could move closer to its historical high of 1,565. Within LatAm, premium valuations threaten Bolsa’s leadership and recovering risk appetite should rejuvenate the Bovespa.

Exhibit 7: Scotiabank GBM Financial Forecasts Forecasts 2010 2011 2012 2013E 2014E

S&P/TSX 13,443 11,955 12,434

EPS 673 833 818 875 950

S&P 500 1,258 1,258 1,426

EPS 84 96 99 105 112Mexico Bolsa 38,551 37,078 43,706

Brazil Bovespa 69,305 56,754 60,952

Chile IPSA 4,928 4,178 4,301

46,000

68,000

4,650

Equity

12,800

1,550

Source: Scotiabank GBM & Scotia Economics estimates, Bloomberg, CPMS, S&P.

Exhibit 8: Scotiabank GBM Asset Mix - Focus 2013 Update

Change FromBenchmark Recommended Last

Equities 60% 64% +2% Canada (TSX) 5% 6% -1% U.S. (S&P 500) 22% 20% -2% Europe (U.K./Germany) 12% 12% -1% Japan 6% 7% +3% Far East ex-Japan 10% 12% +2% LatAm 5% 7% +1%

Bonds 40% 34% -2% Government 30% 20% -2% Corporate 10% 14%

Cash (91-D Tbills) 0% 2%

Asset Mix

Source: Scotiabank GBM estimatesP.


10

Economic and Market Outlook: United States to Emerge Stronger Following Fiscal Cliff Derek Holt, MA, MBA, CFA – Vice-President, Scotia Economics

Dov Zigler, MA, Scotia Economics

Canadian equities vastly underperformed U.S. equities in 2012 as the TSX climbed by about 3% while the S&P 500 was up by about 11%. Canada underperformed most other major equity markets in 2012 (see Exhibit 1); Canada also underperformed in 2011. Canadian equities clearly did not benefit from the buy-Canada bias that was evident in sovereign bond markets where Canadian and U.S. 10-year yields rode in near lockstep fashion and both defied concerns about a bond bubble for another year, while foreign appetite for Canada Mortgage Bonds and provincial bond issuance was strong. Over this two-year horizon, the Canadian dollar was a flat and average performer among the major crosses versus the U.S. dollar and, while volatile, the USD/CAD exchange rate has been directionless. Thus, whether you consider returns in local currency terms or common currency terms, one did not make up portfolio returns through the currency on a trend basis over this period, during which the world was supposedly in love with Canada.

Will Canada’s underperformance continue? As our contribution to the debate, we focus on the fundamentals that could come to drive the earnings tone, currency movements, and equity valuations. Notwithstanding downside risks to the U.S. and Canadian economies over 1H/13, we think the longer-term picture is likely to be more favourable to U.S. fundamentals than Canadian fundamentals. The heavily resource-oriented Canadian market is unlikely to get much of a lift from European risks as the Eurozone faces the risk of a Spanish bailout and French underperformance on fiscal targets; further ratings actions could also mean further ratings actions on the European Stability Mechanism, and Germany’s election will likely limit its appetite for further meaningful reforms. Simultaneous to this is our view that China will remain within the priced-in status quo range of 7.5%-8% annual growth, with minimal upside to commodity prices. From the standpoint of global investors, the big 2013-2014 macro play is, therefore, likely oriented toward viewing Canada as being at a mature point in the cycle after having withstood the worst consequences of the global crisis, while the United States lies in the nascent stages of an upturn that awaits on the other side of peak fiscal policy uncertainty, which is likely to weigh on markets in the early part of 2013.

Exhibit 1: Global Equities: 2012 Returns

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

DAX* HangSeng

CAC 40 FTSE100

S&P 500 Nikkei225

TSX Shanghai Bovespa*

USD

Local Currency

total return, Dec 31, 2011 to Dec 27, 2012

* Simple price appreciation, dividend reinvestment not available from Bloomberg.

Source: Bloomberg, Scotiabank Economics.


Winter 2013 11

United States to Regain Momentum Over 2H/13 – 2014

Growth upside to the U.S. economy and earnings is likely to take until the second half of 2013 and 2014 to emerge as the impact of fiscal retrenchment weighs on the economy over the first half of the year. The broad risk trade is likely to anticipate this turning point in advance by perhaps as much as six to nine months. We are not optimistic regarding U.S. growth in the early phase of the new year as a higher tax bill and reduced government spending, accompanied by persistent longer-run fiscal policy uncertainty, will likely weigh on consumer confidence, spending, and capital goods orders. It is naïve to view this as just a drag on the public sector, with no stock market implications, as the outcome is likely to translate into less take-home pay for consumers, higher taxes on investment returns, and trickle-down effects of reduced government spending on business activity.

After the greatest degree of fiscal policy uncertainty subsides and both households and businesses have adjusted to a different set of rules, the path should be cleared for growth upside. A weak starting point in 1H/13 should pose base effect upside to growth afterward. Also, it is not unreasonable to anticipate that housing will increase from minimal contributions to GDP growth at present to more than 1% contributions to GDP growth in 2014, once all multiplier influences are considered. That could well put upside to our growth forecast and hold out the possibility of +3% growth in 2014. Housing resale inventories, including shadow inventories of foreclosed unlisted homes, remain high but are significantly declining; months’ supply of just the listed inventory sits at the lowest level since 2005, while unsold new home inventories are at the lowest level on record in absolute terms (see Exhibit 2). Coupled with excellent housing affordability, the release of pent-up demand should carry housing starts back up to above 1 million into late 2013 and 2014, or double the crisis depths. Credit conditions are likely to ease in lagged fashion to the cycle, as they usually do, and therefore become self-reinforcing in a virtuous cycle that builds on housing strengths.

Against the misperception that Americans have fully lost the past cycle’s interest in housing is the National Association of Home Builder’s measure of model home foot traffic, which is on a significant upward trend and waiting for a sustained lift in confidence on the other side of the fiscal cliff to translate window shoppers into a building housing recovery. In contrast to the view that a housing recovery cannot occur until after job growth accelerates, we believe that job growth will accelerate alongside and following a building housing recovery as the vast majority of Americans who have jobs push toward unleashing pent-up demand. The key here is that there will always be a segment of U.S. homebuyers that will buy new, and the exceptionally lean new home inventories, coupled with pent-up demand, will require a much greater rate of new supply to be brought into markets. This matters far more to GDP than the resale picture, since new home construction activity contains more value-added from a GDP standpoint than resale transactions, which are largely paper swaps.

Against this backdrop, we expect the Federal Reserve to continue with its stimulus. We think the eventual target for additional total purchases of mortgage-backed securities and Treasuries will equal more than US$1 trillion over the next 12-18 months. This should support the risk trades while simultaneously keeping the Treasury curve reasonably well behaved in a low-inflation environment. As growth traction emerges later in our forecast horizon, we anticipate the Fed will move toward a more neutral set of unconventional monetary policies by reinvesting coupon to flat line the balance sheet, before balance sheet contraction is then pursued as the first preliminary signal that the Fed is shifting toward slightly

Exhibit 2: Exceptionally Lean U.S. Housing Inventories

0

2

4

6

8

10

12

14

16

0

100

200

300

400

500

600

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

000s months

Existing Homes Months' Supply

(RHS)

New HomeSales Inventory

(LHS)

Source: NAR, Scotiabank Economics.


12

tighter monetary policy by ceasing coupon reinvestment. In our opinion, this migration – from being supportive to the risk trade until the economy has enough traction and then tighter monetary policy – should insulate the U.S. dollar against concerns of long-run debasement and support longer-run currency influences on U.S. equity returns over time.

Shine Off Canada?

The Canadian economy is expected to marginally underperform the U.S. economy on GDP growth over 2013-2014 and, in our opinion, the risks are likely skewed to the downside of our Canadian forecasts on net. The country serves as an attractive destination for capital flows in a world marked by rolling sovereign debt and banking shocks given its relatively sound fiscal policies and well-capitalized banking system, which is at the forefront of embracing Basel III capital adequacy and liquidity rules. Low external debt and relatively high foreign exchange reserves are added positives insofar as the country’s external finances are concerned. Lagged mandate shifts across global central banks and portfolio managers continue to be marked by a quest for diversifying currency reserves relatively away from the U.S. dollar and euro in favour of a dwindling number of AAA-rated sovereigns like Canada. This backdrop is expected to remain Canadian-dollar supportive in our base case print forecast. We expect the Bank of Canada to remain on hold throughout 2013 and, thus, keep most of the high-beta currency’s influences skewed toward broad global risk appetite, particularly insofar as it impacts the commodities landscape, which is principally a China story. The country’s stretched fundamentals, however, are the principal downside risk to the currency and broad global appetite for Canada, which leads us to be much more cautious toward the Canadian market than when we recommended an overweight position in the past.

Indeed, this embarrassment of riches through appetite for the currency carries a price via the full general equilibrium impact that risks boomeranging back on the currency itself, principally through lost trade competitiveness. The country has been afflicted with record trade deficits over recent years. As the U.S. economy faces downside risks in 1H/13 through direct and indirect fiscal policy effects, it isn’t clear that this trade picture is on the verge of improvement, particularly as weak (though debated) labour productivity growth has also cost Canada’s competitiveness. A key issue is whether energy is able to rebound from an odd medley of technical disruptions to production, including refinery fires and production bottlenecks, which have contributed to large deviations in the key Western Select oil price benchmark versus WTI and Brent. With exports equal to about one-third of Canadian GDP and energy accounting for about one-quarter of exports, a rebound in energy exports from shaking off production disruptions is a key to the nation’s fundamentals. In this regard, while we and the Bank of Canada are cautiously assuming that trade may be a lift to Canadian GDP growth over the forecast horizon, the new wildcard is the heightened focus on U.S. energy independence and whether this will incrementally crowd out U.S. energy imports from Canada and/or elsewhere, and to what extent this will play out in terms of prices received by Canadian plays in addition to volumes sold into the United States. As Exhibit 3 demonstrates, the sharp turn at the margin toward domestic U.S. production is cannibalizing U.S. energy import demand; this is true across crude oil and natural gas as the United States develops shale reserves and springs the spigot on liquefied natural gas exports. This renewed focus on energy independence in the United States may slow pipeline progress and hamper the highest-cost Canadian energy plays.

Exhibit 3: Average Monthly Domestic Crude Production & Imports

8

9

10

11

12

13

14

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

1995 1998 2001 2004 2007 2010

Crude Oil Production (LHS)

Imports (RHS)

Barrels per Day,Millions

Barrels per Day,Millions

Source: Scotiabank Economics, EIA.


Winter 2013 13

The second broad macro theme affecting Canada concerns the extent to which the shine comes off housing and consumption. Given that the rise in new home construction over recent years has been in multiples and mostly through condos in a handful of cities, the speed with which new condo sales are correcting is likely to come at the sharp, lagged expense of housing starts. This is why we anticipate housing being a drag on GDP growth. Toronto’s new condo sales, for example, are down 50% in year-over-year terms. Not-for-occupancy investors have dominated demand for new condos over recent years, and yet the speed of price increases led the carrying costs to sharply outpace the rental income stream and turned the math against investors at the same time as a glut of new supply has emerged. Rapid price gains in the single detached segment of the housing market also pose affordability constraints. This is occurring against the backdrop of all-time highs across the home ownership rate, renovation spending, consumer spending, house prices, and household leverage. Indeed, Canada’s rise in the home ownership rate is virtually unsurpassed (see Exhibit 4).

Despite overwhelming evidence of structural peaks in the household sector, credit conditions have tightened to a greater degree than in the depths of the global crisis as pro-cyclical housing finance policies turn from overly easy in 2006-2007 to overly tight today. This is occurring on multiple fronts, including tighter mortgage rules, direct Canadian Mortgage and Housing Corporation oversight powers granted to the Office of the Superintendent of Financial Institutions (OSFI), stricter lending guidelines issued by OSFI to lenders as well as greater oversight over lenders and mortgage insurers, and Basel III. Over-tightening at the peak of the cycle compounds downside risks to the Canadian household sector, while the fixation on how the country arrived at a record-high debt-to-income ratio ignores the weakest credit growth since the moribund 1990s with additional downsides likely still ahead. Excellent corporate balance sheet strength, resource investment to feed global demand, widespread infrastructure projects and capital spending, and less fiscal austerity than elsewhere should be important offsets to uncertainties governing housing, consumption, and trade. That said, what makes future conditions distinct from the short-lived housing correction of 2008-2009 is that we are unlikely to repeat the structural push toward lower borrowing costs, which were, at the time, accompanied by a rapid recovery in jobs lost during the downturn. Indeed, the push through lower borrowing costs and regained employment only lifted housing to even more unsustainable heights. What should help avert some of the more disconcerting scenarios that draw parallels to the United States and Europe and keep the focus on a more moderate correction scenario, is the vastly different and much sounder micro fundamentals that govern Canada’s mortgage market. We, therefore, think more of the emphasis should be placed upon risks to volumes of activity in housing and consumer markets as opposed to sharp credit-quality concerns.

The bottom line is that Canadian investors were wise to follow a simple rule of thumb in the post-Global Financial Crisis investing environment: be overweight Canada and tread carefully in approaching U.S. assets. The rationale was that housing deleveraging would continue in the United States for quite some time while Canada would benefit from a consumer-led boom coupled with massive investment in the natural resource sector. Most of those stories have now matured. Canada’s natural resource sector has seen large capital inflows, which have positioned it to succeed for decades – but how much more investment will it need, and what will be the returns from here? Canada’s housing sector has seen

Exhibit 4: Canada Is At A Cycle Top In Housing

60

62

64

66

68

70

72

1991 1996 2001 2006 2010e

U.S. Canada

U.K. Australia

%

Scotiabank estimate for 2010. Source: Statistics Canada, Census of Population, U.S. Census Bureau, Housing Vacancy Survey, U.K. Office for National Statistics, Census ofPopulation, Australian Bureau of Statistics, Census of Population and Housing.


14

significant investment, resulting in the transformation of many Canadian cities – but does Canada need five more years of such urban development? Meanwhile, it has been five years since the correction in U.S. real estate began in earnest, and it finally looks like that sector is set for sustained gains over time. The United States has undergone an oil and gas revolution, with positive spin-offs for manufacturing, trade, and hopefully lower energy prices. In a nutshell, the U.S. economic configuration is stronger than Canada’s at the moment once the worst of the fiscal cliff worries are in the rear-view mirror. That’s why we’re expecting the U.S. economy to grow faster than Canada’s over our forecast horizon. The jury is out, however, on whether this medium-term story will hold over the long term. The world needs Canada’s commodities – particularly given longer-run prospects across emerging markets – and this stands in contrast to the United States, which faces years of fiscal drag effects that will cap longer-run growth compared to prior cycles.


Winter 2013 15

Economic and Market Outlook 2011-2013 2012f 2013f 2014f

Canada

Economic Performance (annual average)

Real GDP (% change) 2.0 1.7 2.3

Consumer Prices (% change) 1.6 1.9 2.1

Core CPI (% change) 1.7 1.7 1.9

Unemployment Rate (%) 7.3 7.2 7.0

Yield Curve (%, end of period)*

Bank of Canada Overnight Target Rate 1.00 1.00 2.00

2-Year Canada Bond 1.14 1.95 2.75

10-Year Canada Bond 1.79 2.40 3.20

United States

Economic Performance (annual average)

Real GDP (% change) 2.2 2.0 2.5

Consumer Prices (% change) 2.1 2.2 2.2

Core CPI (% change) 2.1 1.9 2.0

Unemployment Rate (%) 8.1 7.6 7.1

Yield Curve (%, end of period)*

Fed Funds Target Rate 0.25 0.25 0.25

2-Year Treasury 0.26 0.40 1.30

10-Year Treasury 1.73 2.50 3.25

International

Real GDP (annual % change)

World (based on purchasing power parity) 3.1 3.2 3.8

United Kingdom 0.0 1.3 1.5

Euro zone -0.5 -0.1 1.0

Germany 0.9 0.7 1.3

France 0.1 0.1 1.0

Italy -2.2 -0.8 0.8

Japan 2.1 0.8 1.2

Australia 3.5 2.6 3.1

China 7.7 8.0 8.3

India 5.5 6.0 6.5

Brazil 1.0 3.5 4.0

Currencies (end of period)*

Canadian Dollar (USDCAD) 1.00 0.96 0.94Canadian Dollar (CADUSD) 1.00 1.04 1.06Euro (EURUSD) 1.32 1.27 1.25Euro (EURGBP) 0.82 0.77 0.75Sterling (GBPUSD) 1.61 1.64 1.66Yen (USDJPY) 86 90 92Australian Dollar (AUDUSD) 1.04 1.08 1.10Chinese Yuan (USDCNY) 6.24 6.10 6.04Mexican Peso (USDMXN) 12.98 13.17 13.05Brazilian Real (USDBRL) 2.04 2.15 2.20

WTI Oil (US$/bbl) (ann. avg.) 94 94 96

Gold, London PM Fix (US$/oz) (ann. avg.) 1,670 1,750 1,700

f: Forecast (Scotiabank Economics Global Forecast Update report (December 20, 2012)

* 2012 market data quoted at December 27, 2012

Source: Scotiabank Economics, Statistics Canada, U.S. Dept. of Commerce, U.S. Bureau of Labor Statistics, Bloomberg.


16

Canadian Equity Strategy

Top 10 Canadian Stock Picks for 2013 Himalaya Jain, CFA – Director, Portfolio Advisory Group

Ross MacLachlan – Associate, Portfolio Advisory Group

Steven Salz – Associate, Portfolio Advisory Group

Goodbye 2012! You started out with great promise, fell victim to global issues mid-year, and then regained your composure

As we close the books on 2012, it’s worth taking stock of the past year’s performance. The year started on an optimistic tone, with some economic indicators beginning to point upwards and expectations that Europe would move to stabilize its sovereign debt crisis. Most commodities, such as oil, copper, and gold, stampeded out of the gate, helping the TSX Composite Index keep pace with the S&P500 during the initial weeks of 2012. The early year equity market rally peaked in March and then derailed in early-May as Greece once again teetered on the brink of bankruptcy. By the end of a volatile summer, European authorities finally obtained the tools to begin repairing their damaged union, the Federal Reserve announced QE3, and China announced a new wave of infrastructure spending. Autumn ushered in a slew of positive U.S. economic signals showing a long-awaited improvement in housing and employment. Markets became jittery immediately after a close U.S. election due to “fiscal cliff” uncertainties. Canadian and U.S. equity markets strengthened into the home stretch as optimism increased that a “cliff” deal would be reached, and because of improving global economic conditions.

Despite a volatile year, our top picks list for 2012 on average managed to outperform the TSX Composite Index by 228 basis points on a price-only basis (see Exhibit 1). As in any portfolio, we had our share of homeruns, strikeouts, and everything in between. Magna, up 46%, was the best performer on our list. We chose it because of attractive valuation and early signs of a U.S. consumer recovery. Magna appears on our 2013 list again due to improving U.S. momentum. All of our financial/consumer picks (RY, TD, BPO, SJR.b) delivered respectable returns, with each name outperforming the benchmark. With the exception of Suncor, Cameco, and First Quantum, our energy and material picks turned in a disappointing performance. Indeed, it was less a factor of our stock picks and more an issue with lower commodity prices that resulted in generally poor performance in these sectors. Our worst performer was Trican Well Services, on which we were clearly too early. One sector where we outperformed was a sector that we avoided: Gold. The TSX Composite Gold Index declined 15% in 2012, dragging down overall TSX Composite performance by 150-200 basis points. Despite what appears to be attractive valuation, we have chosen to avoid gold equities again in our top 10 list for 2013.

Exhibit 1: Performance of 2012 Top Canadian Picks 2012

Price Current Price Return

Company Ticker 12/30/2011 12/31/2012 Yield Price Only

Brookfield Office Properties BPO $15.97 $16.96 3.3% 6.2%

Cameco CCO $18.41 $19.59 1.9% 6.4%

First Quantum Minerals FM $20.05 $21.91 0.9% 9.3%

Magna International MG $34.00 $49.68 2.1% 46.1%

Potash Corp. POT $42.11 $40.48 1.3% (3.9%)

Royal Bank RY $51.98 $59.88 3.7% 15.2%

Shaw Communications SJR/B $20.25 $22.84 4.2% 12.8%

Suncor SU $29.38 $32.71 1.4% 11.3%

Talisman TLM $12.98 $11.25 2.8% (13.3%)

TD Bank TD $76.29 $83.75 3.5% 9.8%

Teck Resources TCK/B $35.91 $36.15 2.2% 0.7%

Trican Well Services TCW $17.55 $13.12 1.2% (25.2%)

Average 6.3%

S&P / TSX Composite Index 11955.1 12433.5 4.0%

Outperformance 2.3%

Source: Bloomberg


Winter 2013 17

Hello 2013! We’re optimistic that equities will perform well; but the U.S. may outperform Canada, again

As global risks dissipate, and recoveries take hold in the U.S. and China, we expect risk appetite to consistently increase. The 31-year bull market in U.S. Treasuries, which began in 1981, has likely come to an end. With the multi-decade tailwind not blowing anymore (indeed, it could become a headwind) we believe some fixed income investors may begin to migrate into equities in 2013 to seek better returns. Just as the U.S. housing picture gets brighter, the Canadian housing market is beginning to cool.

Although we are forecasting a soft landing for Canadian housing, we expect lacklustre economic growth in Canada in 2013 as compared with the U.S. With Canadian bank earnings growth expected to slow, and some commodity sectors possibly remaining out of favour, we expect the TSX Composite to underperform the S&P500 in 2013. While we continue to encourage investors to increase U.S. equity weightings, we have selected a list of Canadian equities which we believe should outperform in 2013. This top picks list (see Exhibit 2) has less direct commodity exposure (BTE, FM) than our 2012 list and more indirect plays (TRP, GEI, FTT). The 2013 list also has a lower average beta (1.14 vs. 1.38 last year). While appearing more conservative, this year’s top picks still maintain adequate exposure to an improving U.S. economy (TD, BPO, MG).

We have a bullish outlook on equities, but we acknowledge that some risks still linger

Although our bias is to the upside, there are still near-term obstacles which could dampen returns. Risks associated with the euro-debt crisis have likely bottomed; that being said they have not evaporated, as socio-political strife continues to plague indebted nations. Although a compromise resolution to the fiscal cliff was achieved on New Year’s Day, policy makers still have to make arrangements for the U.S. debt ceiling which could provide an overhang to markets. Finally, unease in the Middle East is expected to simmer, with Iran’s nuclear ambitions continuing to be a risk in 2013.

Exhibit 2: 2013 Top Canadian Picks

Current Price

Company Sector Ticker 12/31/2012 Beta Dividend Yield

Baytex Energy Energy BTE $42.87 1.26 $2.64 6.2%

Brookfield Office Properties Real estate BPO $16.96 0.95 $0.56 3.3%

Finning International Industrials FTT $24.57 1.43 $0.56 2.3%

First Quantum Minerals Materials FM $21.91 2.25 $0.12 0.6%

Gibson Energy Energy infrastructure GEI $24.05 n/a $1.04 4.3%

Magna International Consumer Disc. MG $49.68 1.12 $1.09 2.2%

Manulife Financial MFC $13.51 1.27 $0.52 3.8%

TD Bank Financial TD $83.75 0.89 $3.08 3.7%

Tim Hortons Consumer Disc. THI $48.83 0.47 $0.84 1.7%

TransCanada Energy infrastructure TRP $47.02 0.58 $1.76 3.7%

Average 1.14 3.2%

S&P / TSX Composite Index 3.0%

Source: Bloomberg


18

Cognizant of the aforementioned risks, there are also a number of supportive factors for equities in 2013 which are worth highlighting:

The economic picture is improving in the U.S. and China making a sustainable rally in 2013 more likely. In the U.S., a strong rebound in housing and employment data is also starting to look sustainable:

o U.S. Housing Starts recently reached a three year high, rising to 894,000 on an annual basis, rising steadily from a 40-year low of 478,000 starts in 2009;

o New home sales have increased from the low experienced in February 2011 of 273,000 to a recent level of 368,000. Existing home sales have accelerated at a faster pace over the past 2 years, rising from a low of 3.39 million in July 2010 to the most recent print of 5.04 million;

o Home prices have started to increase while U.S. homebuyer affordability remains attractive;

o U.S. job growth is gaining momentum, with unemployment down to 7.7% from a high of 10% in late 2009.

In China, policy makers have successfully avoided a hard landing with recent PMI Manufacturing reports showing expansion after 13 months of contraction. A rebound in growth in China should bolster commodity demand.

Stronger economic data is likely to result in upward revisions in corporate earnings in the second half of 2013. A diversion of funds from fixed income into equities could also result in multiple expansion.


Winter 2013 19

Baytex Energy Corp (BTE – $42.87, 1-SO, Target $56.00)

Profile:

Baytex Energy Corporation was formed in September 2003 through a re-organization from a corporation into a trust structure (and subsequently reconverted to a corporation). Baytex has a portfolio of production and reserves primarily focused in Alberta, Saskatchewan, and North Dakota. Approximately 88% of Baytex's production is weighted toward crude oil, with a particular emphasis on heavy oil.

Reasons to Buy:

Strong operational track record. Baytex reported another production record in Q3/12. Volumes came in at 54,381 boe/d, above consensus of 53,824 boe/d. BTE reported Q3 FFO of $1.14 per share, well ahead of consensus of $1.05. The company’s long-range plan calls for a projected organic production growth rate of 8% per annum. Baytex has maintained a relatively conservative balance sheet compared with many of its peers, partly due to its ability to replace reserves at industry leading finding, development, and acquisition costs.

Solid dividend. BTE has a current monthly dividend of $0.22/share, representing a simple payout ratio of 58% and an effective payout ratio (including both maintenance and growth capex) of 130%. In announcing its 2013 production guidance, Baytex announced no change to its dividend after three consecutive years of increases. BTE will be holding its dividend at current levels ($0.22/share per month) for 2013, which is prudent as it tries to preserve its balance sheet strength ahead of material thermal project spending in its Peace River and Cold Lake properties.

Bouncing back from a wide current Canadian heavy oil – WTI differential. The company’s share price has recently come under pressure due to a widening of heavy oil differentials. We believe that differentials should decline back to normal levels during the second half of 2013 as new heavy oil refining capacity comes online. Furthermore, BTE’s crude-by-rail (30% of total production) and active hedging program should mitigate the impact of current wide heavy oil differentials.

Valuation attractive, upside remains. BTE shares currently trade at 9.9x 2013 EV/DACF versus 9.7x for the peer group. We believe this modest premium is justified by the company’s superior asset base, reserve life, and ability to regularly beat production estimates. BTE is able to consistently deliver value through acquisitions and its current asset base with industry-leading capital efficiency. Baytex has done this while maintaining a clean balance sheet and growing its dividend. Since the end of 2009, BTE has increased production by 27%, while increasing its shares outstanding by only 11%. Indeed, the company has issued new equity (other than DRIP) only once in the past four years.

Exhibit 3: Baytex Energy Corp

Recommendation: 1-Sector Outperform Risk: Medium

Price (December 30/2011): $15.64 Fiscal Year-End: December12-Month Target: $19.00 Dividend: $0.56Total Return: 25% Yield: 3.6%52-Week High: $20.07 52-Week Low: $12.80Trailing ROE 9.6% Market Value ($mil) $7,864

Annual 2009A 2010A 2011E 2012E

AFFO: $1.05 $1.16 $0.85 $0.87

P/AFFO Multiple: 14.9x 13.5x 18.4x 18.0x

(BPO-TSX, BPO-NYSE)

Summary Data (U$)

AFFO Per Share (U$)

Source: Scotia Capital, Bloomberg


20

Brookfield Office Properties (BPO – US$17.02, 1-SO, Target US$19.00)

Profile:

Brookfield Office Properties (BPO) is the 10th-largest publicly traded real estate company in the United States (largest in Canada) and is focused on owning and managing premier office buildings located in high-barrier-to-entry commercial business districts (CBDs) primarily in the U.S. and Canada. Brookfield’s current portfolio comprises an interest in 114 buildings (totalling almost 80 million sq. ft.) and 21 million sq.ft. of potential office development. BPO is the publicly traded U.S./international office property arm of Brookfield Asset Management (BAM.a). BAM.a owns a 49% equity interest in BPO.

Reasons to Buy:

Large 2013 lease expiry is weighing on the stock: Shares of BPO have materially underperformed U.S. and Canadian peers due to a scheduled lease expiry at its World Financial Center property in Lower Manhattan. Bank of America Merrill Lynch is set to vacate approximately 3.1 million square feet of space in October 2013 and BPO has not yet re-leased this space. This space is material to BPO’s overall portfolio, and potential loss of rental income has resulted in declining earnings estimates and reduced investor interest. An improving U.S. labour market has improved tenant interest in this space to the highest in more than four years. We expect BPO to begin announcing leasing deals starting in 2013. Of the estimated $19.00/share net asset value, it is estimated that the WFC space is worth approximately $3.00/share. At the current price, investors are essentially paying $0.50/share for space that is ultimately worth substantially more.

Getting paid while waiting for lease-up: With a current dividend of 3.3%, and a depressed valuation, patient investors should get paid while the BofA lease overhang clears. The current dividend yield represents an AFFO payout ratio of 71.3%, suggesting that sustainability is not an issue.

Valuation is attractive; trading at 14.6% discount to NAV: BPO’s stock price has been under pressure since the Summer of 2012, declining 10.2% from its recent highs. The underperformance becomes more pronounced when compared with the Canadian and U.S. REIT sectors, which have rallied ~10% and ~11% YTD, respectively, compared to BPO which is up a marginal 3.5% YTD. BPO is currently trading at 20.0x 2013E AFFO while its closest peers are trading at 19x-24x. BPO’s portfolio is trading at an implied cap rate of 6.4%, far above the average 5%-5.5% of its closest peers. Using a conservative 6.0% cap rate results in a net asset value of $19.00/share, suggesting that BPO trades at a discount to NAV while the Canadian REIT sector is trading at an average premium to NAV of approximately 6%. The eventual lease-up of the BofA space could result in a 15%-20% valuation lift to the shares.

Exhibit 4: Brookfield Office Properties

Recommendation: 1 ‐ Sector Outperform Risk: Medium

Price (December 31/2012): $17.02 Fiscal Year‐End: December

12‐Month Target: $19.00 Dividend: $0.56

Total Return: 15% Yield: 3.3%

52‐Week High: $18.60 52‐Week Low: $15.25

Market Value ($mil) $8,455.76

Annual 2011A 2012A 2013E 2014E

AFFO: $0.87 $0.79 $0.83 $0.68

P/AFFO Multiple: 18.0x 21.5x 20.5x 25.0x

AFFO Per Share (U$)

(BPO‐TSX, BPO‐NYSE)

Summary Data (U$)

Source: Scotiabank GBM; Bloomberg


Winter 2013 21

Finning International Inc. (FTT – $24.57, 1-SO, Target $28.50)

Profile:

Finning International Inc. is the largest Caterpillar dealer in the world. The company sells, rents, and services Caterpillar machines and engines in Western Canada, the U.K., and South America (Chile, Argentina, Uruguay, and Bolivia). Finning serves a diverse range of industrial markets, including mining, forestry, construction, pipeline/oil field construction, agriculture, government sector, marine, transportation, fisheries, and the commercial transport industry. The company was founded in 1933 and is headquartered in Vancouver, Canada.

Reasons to Buy:

Strong outlook for growth in China. Finning shares trade closely with the commodities that its customer base mines, particularly as it relates to copper prices. Recent economic data showing a rebound in Chinese manufacturing data can be attributed to the US$160 billion of infrastructure spending that the country announced back in September. That paired with a rebound in the U.S. economy should bolster demand driving copper prices higher. Weakness in FTT shares earlier this year was a result of reductions in CAPEX programs by the global mining industry. As the global economy improves, we should see an improvement in CAPEX by mining companies.

Conservative market exposure. Finning has a relatively conservative business model with the majority of its revenue coming from Western Canada, where oil sands, mining and construction activity are expected to remain stable for 2013. South America represents its second largest geographic segment, with demand for heavy equipment rising. Infrastructure spending in Chile is expected to get a boost due to the Presidential election in 2013. The U.K. and Ireland operations represent the smallest portion of the company’s revenue with an expected drop next year due to a persistently weak European economy. At its recent investor day, management indicated likelihood for margin improvement in 2013. Approximately 50% of Finning’s revenue is derived from equipment sales, 40% from service, and 10% from rental operations.

Attractive valuation. We believe FTT is trading near trough multiples at 6.7x EV/NTM EBITDA versus an average of 8.0x since 2007 and below its peers at 7.9x. The shares are also trading attractively on a P/E basis at 10.5x P/NTM EPS which compares to the 17.5x ten year average and its peers at 11.6x. FTT offers some income with a 2.3% dividend yield at current levels. We believe current share prices offer an attractive entry point despite a recent rally.

Exhibit 5: Finning International Inc






Market Value ($mil) $4,561

Annual 2011A 2012E 2013E 2014E

EPS: $1.48 $1.84 $2.28 $2.67

P/E Multiple: 15.0x 13.4x 10.8x 9.2x

Summary Data (C$)

Earnings Per Share (C$)

(FTT‐TSX)



22

First Quantum Minerals Ltd. (FM – $21.91, Consensus Target $24.70) Profile:

First Quantum Minerals Ltd. is a mid-size mining company engaged in mineral exploration, development and mining. First Quantum's current operations are the Kansanshi copper-gold mine in Zambia and the Guelb Moghrein copper-gold mine in Mauritania. The company's project development pipeline includes the Ravensthorpe nickel project in Australia, the Kevitsa nickel-copper-PGE project in Finland, the Sentinel deposit in Zambia, and the Haquira copper deposit in Peru. Ninety percent of the company’s revenue is derived from copper.

Reasons to Buy:

Strong production growth profile. First Quantum has developed and acquired a robust pipeline of projects. In a recent update of its Kansanshi copper-gold mine from the company, measured and indicated resources increased by 121% in tonnage and 74% in contained copper metal. With this significant increase in reserve and resource, First Quantum notes that the planned increased to 50 Mtpa from the current 25Mtpa is fully justified, with an estimated 16 years mine life at the higher throughput rate. First Quantum’s equity share of copper production is expected to increase to 799.7 tonnes copper by 2014E from 650.1 tonnes of copper in 2012E, a 23% increase. In addition, Kevitsa achieved production in August this year, adding 1,874 tonnes of copper and 1,041 tonnes of nickel. Its Sentinel project is expected to be completed by 2014.

Strategic position on the Copperbelt. First Quantum has secured a dominant position on the Copperbelt, which would make it the most likely acquisition candidate if a major mining company decides to make Zambia a focus. The significant infrastructure associated with Kansanshi, and soon Sentinel and the smelter project, makes First Quantum the “go to” name in sub-Saharan Africa.

Attractive valuation. First Quantum shares are inexpensive relative to the peer group. On 2013E EV/EBITDA, the shares trade at 6.5x, in line with it’s the peers at 6.8x. The shares trade at a discount on a net asset value basis, a larger discount than its peers; we believe this discount to the peer group relates to market uncertainty over the company’s ability to deliver their projects on time and on budget.

Strong balance sheet. With US$374.9 million in cash on the balance sheet as at Q3/12, FM is well positioned to fund its projects or make accretive acquisitions as seen by their recent $5.1 billion takeover offer for Inmet Mining. Due to the company’s strong balance sheet and asset base, First Quantum itself could be a takeout target by other large international mining companies.

Exhibit 6: First Quantum Minerals Ltd

Recommendation: Not Available Risk: Not Available






Annual 2010A 2011A 2012E 2013E

EPS: $1.00 $1.26 $1.21 $1.61

P/E Multiple: 21.6x 15.7x 18.1x 13.6x

Summary Data (C$)


(FM‐TSX)



Winter 2013 23

Gibson Energy Inc. (GEI – $24.05, 1-SO, Target $24.00)

Profile:

Gibson Energy is a midstream energy infrastructure company. Its core assets include oil terminals located at Alberta's major hubs, Edmonton and Hardisty. These terminals have 3.3M bbl of storage capacity and move about 385k bbl/d of crude oil and associated products. Gibson integrates truck transportation with terminals and owns over 2,000 trailers. Other businesses include retail propane distribution (68M gallons annually), wellsite fluids (16k b/d of refinery capacity in Sask.), and marketing. GEI has been private since 1953 but went public when Riverstone sold a 38% stake in a 2011 IPO.

Reasons to Buy:

Solid organic growth and accretive acquisitions. GEI recently reported Q3/12 adjusted EBITDA of $72M ($65M in Q2/11), above consensus estimates of $71M. Results were solid again at GEI, as organic growth especially in the Terminals business continued at an impressive pace, with expansion at both Hardisty and Edmonton. The increase in volume flow at terminals tends to lift Marketing profit as well due to increased blending opportunities. Terminal oil volumes were up 45% YOY so far and in that context marketing profit doubled.

Accretive U.S. acquisition. The company recently completed a $445 million acquisition of U.S.-based Omni Energy Services (OMNI). According to the company’s disclosure, this acquisition is expected to be 18% accretive to cash flow per share. The acquisition of OMNI shifts GEI’s business composition away from an infrastructure investment to a more cyclical and growth driven business. OMNI’s core business is driven by environmental services and fluid handling relating to hydraulic fracturing as well as production services related to well pumping. OMNI is expanding into the most robust drilling area in the U.S., the Bakken, where the company will start construction this quarter on a permitted commercial waste facility including a salt water disposal well, where producing oil well numbers are still rising.

Organic growth pipeline larger than expected. GEI released a 2013 growth capital budget of $235 million, which was well above consensus of $110 million and 2012 levels of $165 million. Initial 2014 growth capital is expected to exceed $200 million, with 60-65% directed at terminals/pipelines. The company has adequate liquidity to fund these accretive growth projects and should be able to maintain a net debt/EBITDA ratio below 2x.

Valuation and dividend growth: Gibson is currently trading at 9.0x EV/EBITDA and is yielding 4.3% with a payout ratio at 53% of 2013E CFPS; the indicated 2-year dividend growth rate is 4.1%. With the added cash flow from the OMNI acquisition, the company is well positioned for another dividend increase in 2013.

Exhibit 7: Gibson Energy Inc.







Annual 2011A 2012E 2013E 2014E

EPS: $0.60 $0.91 $1.19 $1.20

P/E Multiple: 31.6x 26.4x 20.2x 20.0x


(GEI‐TSX)

Summary Data (C$)



24

Magna International (MG-TSX, MGA-NYSE – US$50.02, 1-SO, Target US$58.00)

Profile:

Magna is the world’s fifth-largest auto parts supplier, and the largest North American-based supplier. It is also the world’s most diversified parts supplier in terms of product capabilities. In addition to components manufacturing, MG is also the world’s largest contract manufacturer of complete vehicles through its Austrian-based subsidiary. Magna has 256 manufacturing operations and 82 product development, engineering, and sales centres spanning 26 countries and five continents. The company’s sales are split roughly evenly between North America and Europe, with the rest of the world accounting for approximately 5% of sales. Magna is also well-diversified in terms of its customer base, with Detroit 3 OEMs accounting for just under 50% of sales, and the other half composed of a broad mix of primarily European-based OEMs.

Reasons to Buy:

Cyclicals to outperform broader market: The pace of the economic recovery has significantly accelerated as indicated by the steady rebound in U.S. housing and jobs data. Chinese manufacturing has also improved in recent months indicating a bottoming of the economic slowdown. U.S. auto sales have benefited from an improving economic environment, rising to 15.46 million vehicles on an annualized basis, matching early 2008 levels. The Euro-debt crisis has reduced economic activity in Europe, with car sales in Western Europe expected to decline to 12.15 million units, a 6% drop from 2011. Luxury auto makers however continue to experience healthy growth as China’s explosive demand for premium cars has been a key growth driver for companies like BMW and Audi. Both BMW and Audi are major Magna customers in its European division.

Strong balance sheet; compelling valuation; attractive dividend yield: Magna has a strong balance sheet with a net-cash-to-capitalization of 13%, and a net debt-to-EBITDA ratio of -0.5x. Magna currently trades at 4.1x EV/NTM EBITDA and 9.1x price/NTM EPS. This compares to the 12 year P/E average of 10.9x. Magna currently pays a quarterly dividend of US$0.275/share, equating to a yield of 2.2% and a payout ratio of 21% on 2012 consensus EPS. We believe there is room for margin expansion and dividend growth.

Substantially improved corporate governance: Last year, Magna founder Frank Stronach stepped down from the board of directors to pursue a political career in Austria. Stronach’s presence had been an overhang on the company due to his track record of non-strategic acquisitions. As part of his exit, the company also eliminated its dual class share structure, which previously handed Stronach voting control which was disproportionate to his economic interest in Magna.

Exhibit 8: Magna International Inc

Recommendation: 1 ‐ Sector Outperform Risk: High






Annual 2011A 2012E 2013E 2014E

EPS: $4.53 $5.15 $4.62 $6.01

P/E Multiple: 7.3x 9.7x 10.8x 8.3x

(MG‐TSX, MGA‐US)

Summary Data (U$)

Earnings Per Share (U$)



Winter 2013 25

Manulife Financial Corp. (MFC – $13.51, 1-SO, Target $14.00)

Profile:

Manulife Financial Corporation (MFC) is a leading global financial services company providing financial protection, wealth and asset management products and services to individuals and groups in 22 countries worldwide. Products and services include individual and group life and health insurance, long-term-care protection, pension and annuity products and services, reinsurance, mutual funds, and institutional asset management. The company is one of the largest life insurers in the world.

Reasons to Buy:

Interest rate headwinds should become tailwinds. All else held equal, life insurance profitability (and hence share price) generally moves directionally in line with long-term government bond yields and equity markets. This is due to the nature of a lifeco’s assets and liabilities, with lower bond yields translating into a higher present value of liabilities and a slower rate of appreciation of assets. High levels of equity market volatility and record low bond yields in recent years have resulted in depressed earnings for most North American lifecos. Based on improving global economic trends, particularly in the U.S. and China, we expect U.S. and Canadian equity markets and long-term government bond yields to continue moving higher in 2013. The trend in lifeco earnings should be positive under this scenario. The 25% appreciation for MFC shares in 2012 reflects these capital market trends and improvement in investor sentiment. We believe there is further room for multiple expansion as the macro environment improves.

Despite complex lifeco earnings, underlying operating trends appear to be improving. MFC reported Q3/12 EPS of -$0.14, ahead of consensus of -$0.30. The net loss of $227M ($0.14 per share), included charges tied to the annual actuarial assumption review, a goodwill impairment charge, and a charge to recalibrate assumed equity market returns, totalling $1.2B, or $0.66 per share. In Asia, insurance sales were flat, while wealth sales jumped 22%, mostly due to higher sales of fixed annuities in Japan and bond fund sales in China. In Canada, sales fell 7% due to a decline in group benefit sales which tend to be lumpy from quarter to quarter, but individual insurance, mutual funds, and group retirement sales were strong. In the U.S. insurance sales rose 11% and wealth sales increased 5%, while JH Funds and retirement plan sales were solid. Book value per share at the end of Q3/12 was $12.11, which was down 3% from 2011. MFC's capital position remains strong but the MCCSR ratio declined from 213% in Q2/12 to 204% in Q3/12, largely due to the reported loss in the quarter.

Attractive valuation on P/BV; in line on P/E basis. Manulife currently trades at 1.1x price-to-book value, which is below its Canadian peer group average of 1.3x (SLF 1.2x, IAG 1.2x, GWO 1.7x) and a 10-year historical average of 1.9x. On a forward P/E basis, MFC trades at 10x, in line with its peer group (SLF 10x, IAG 10x, GWO 11x). We consider MFC’s dividend yield of 3.8% to be sustainable.

Exhibit 9: Manulife Financial







Annual 2010A 2011A 2012E 2013E

EPS: ‐$0.40 $1.17 $1.35 $1.48

P/E Multiple: n.m. 9.3x 10.0x 9.1x

(MFC‐TSX, MFC‐NYSE)

Summary Data (C$)




26

Tim Hortons Inc. (THI – $48.83, 1-SO, Target $57.00)

Profile:

Tim Hortons is one of the largest publicly-traded quick service restaurant chains in North America based on market capitalization, and the largest in Canada. As of September 30th, 2012, Tim Hortons had 4,138 system-wide restaurants, including 3,365 in Canada, 755 in the United States and 18 in the Gulf Cooperation Council. Tim Hortons' business model is vertically integrated as it owns both the bakery (50% JV) and distribution elements of its business. The company has established a track record of menu innovation which has resulted in consistent same-store sales growth.

Reasons to Buy:

Long-term thesis remains intact despite slow Q3/12. THI reported Q3/12 adjusted EPS $0.72 and EBITDA $195.3M which was in line with the Street. What surprised investors was concern over SSS (same store sales) which came in at +1.9% in Canada, and +2.3% in the U.S., well below estimates on both fronts. THI shares were off ~5% post release, reflecting concerns around sales. With no shortage of economic concerns on both sides of the border, consumption trends are weak generally and competitive activity up; through this, THI has held market share and outperformed. The company continues to see growth opportunities in Canada through intensification efforts in major urban centres. The company’s U.S. segment is achieving higher SSS growth metrics than its Canadian segment, and offers an attractive long-term growth opportunity.

Still returning cash to shareholders. THI repurchased 0.72M shares in Q3/12 (a 3.1% YoY reduction in shares outstanding) at an average price of $51.75, and continues to pay a steady quarterly dividend of $0.21/share. THI has a current dividend yield of 1.7% and 5yr dividend CAGR of 24.6%. We expect the company to continue growing its dividend and buying back shares in 2013.

Long-term outlook on course and valuation remains attractive. We continue to believe the business model is intact and expect to see further growth as THI captures greater market share through ongoing menu innovation, speed of service initiatives, and the continued appeal of its price-value proposition. The company has high visibility on growth and remains committed to returning cash to shareholders. THI trades at a slight discount to its peers, with a P/E of 16.1x on 2013 consensus earnings. THI has traded at an average forward P/E of 17.5x since 2005. THI currently trades at a PEG ratio of 1.3x, in line with its historical average.

Exhibit 10: Tim Hortons Inc.







Annual 2010A 2011A 2012E 2013E

EPS: $2.11 $2.37 $2.69 $3.01

P/E Multiple: 19.5x 20.8x 18.2x 16.2x


(THI‐TSX, THI‐NYSE)

Summary Data (C$)



Winter 2013 27

Toronto-Dominion Bank (TD – $83.75, 2-SP, Target $95.00)

Profile:

The Toronto-Dominion Bank, together with its subsidiaries, provides financial and banking services in North America and internationally. The company’s Canadian Personal and Commercial Banking segment offers various financial products and services to personal and small business customers. It also provides banking solutions through telephone and Internet banking, as well as serves approximately 13 million customers through a network of 1,168 branches and 2,800 automated banking machines in Canada. Its Wealth and Insurance segment offers direct investing, advice, and asset management services to institutional and retail clients; and a range of insurance products, including home, auto, credit protection, travel, life, and health insurance, as well as reinsurance through phone and online. The company’s U.S. Personal and Commercial Banking segment provides retail and commercial banking operations in the United States. This segment offers its financial products and services through a network of approximately 1,315 branches located along the east coast from Maine to Florida. Its Wholesale Banking segment provides a range of capital markets and investment banking products and services comprising underwriting and distribution of new debt and equity issues, providing advice on strategic acquisitions and divestitures, and meeting the daily trading, funding, and investment needs.

Reasons to Buy:

Best exposure to U.S. retail banking among Canadian peers. Based on Q4/2012 results, 30% of TD’s P&C earnings were derived from its U.S. operations, with much of it coming from its extensive retail franchise. With expectations that the U.S. housing market will continue to accelerate, we think TD’s current 2013E and 2014E earnings estimates are conservative.

Above average forecast earnings growth rate. Based on consensus forecast, TD is expected to grow EPS at a 6.1% CAGR over the next two years, better than the sector average 5.3% expected CAGR.

Attractive valuation. The average forward P/E for the Canadian bank group is presently 10.1x, compared with a pre-credit crisis range of 11x-13x. An expectation for slower Canadian economic growth, driven largely by a cooling housing market, has resulted in lower earnings growth forecast for Canadian banks. In the current 5%-6% earnings growth environment, compared with 12% in the pre-credit crisis period, we do not expect P/Es to increase materially in the near-term. Despite a better than average earnings growth forecast, TD is trading at 10x 2013E EPS, which is just below the sector average. As the U.S. economy gains momentum, we believe the market will begin to reward TD with a better valuation multiple.

Exhibit 11: Toronto-Dominion Bank

Recommendation: 2‐Sector Perform Risk: Low

Price (December 31/2012): $83.75 Fiscal Year‐End: October





Annual 2011A 2012A 2013E 2014E

EPS: $6.86 $7.41 $7.80 $8.50

P/E Multiple: 11.0x 11.0x 10.7x 9.9x

(TD‐TSX, TD‐NYSE)

Summary Data (C$)




28

TransCanada Corp. (TRP – $47.02, 1-SO, Target $52.00)

Profile:

TransCanada (TRP) is the largest gas pipeline company in North America. Its assets include the main Alberta gas-gathering system, which is now plugged into Horn River and Montney, and the Canadian Mainline, which runs from Alberta to Ontario, the U.S. Midwest, and points east. It also has a large power business consisting of almost 11,000 MW in Canada and the U.S. A growing oil pipeline business is the Keystone pipeline system, which now moves oil from Hardisty, AB, to Wood River, IL, and Cushing, OK. When approved and completed, the Keystone XL pipeline will add 510,000 barrels per day, increasing the total capacity up to 1.1 million barrels per day.

Reasons to Buy:

Both short- and medium-term positive catalysts, with an asset base favourably positioned for a number of investment themes. Increasing volumes from the Alberta oil sands, northern natural gas, and the expected approval of TRP’s Keystone XL pipeline in early 2013 provides near-term upside opportunity for investors. We believe earnings upside from a positive decision on the Keystone XL pipeline is only partly being accounted for in TRP’s current share price, leaving room for additional share price appreciation. Other positive developments include the restart of Bruce 1-2, the awarding of two natural gas pipelines in Mexico for $1.4 billion, and an agreement to co-develop a $3 billion pipeline in Northern Alberta.

Attractive valuation. TRP continues to trade at a discount to its peers including Enbridge, Inter Pipeline, and Pembina Pipeline. TRP is currently trading at a forward EV/EBITDA 2013E of 11.8x, 8.6% FCF yield 2013E, and a Debt/EBITDA ratio of 4.47x 2013E, which is below the average of its peer group. TRP has a current dividend yield of 3.7%, a payout ratio of 44% of free cash flow, and 5-year dividend CAGR of 5.4%.

Positioned for growth. We view TRP as having a strong growth profile moving forward with a robust project pipeline and diversified EBITDA mix. TRP has the most geographically expansive pipeline network in North America, in which it currently has a market leading position. Further, management expects $13b of projects to be coming into service by 2015, generating an estimated $1b of cash flow. With a relatively low payout ratio, we expect much of TRP’s growth capex could be self-funded.

Exhibit 12: TransCanada Corp

Recommendation: 1 ‐ Sector Outperform Risk: Low






Annual 2011A 2012E 2013E 2014E

EPS: $2.23 $2.00 $2.40 $2.60

P/E Multiple: 20.5x 23.5x 19.6x 18.1x

(TRP‐TSX, TRP‐NYSE)

Summary Data (C$)




Winter 2013 29

U.S. Equity Strategy Marco Martin – International Equity Consultant

Top 10 U.S. Picks for 2013 Major equity benchmarks around the globe ended the year on a positive note, with gains varying widely from country to country and region to region. On a relative basis, the U.S. market was one of the better performers in 2012. In fact, the S&P 500 managed to post a strong 10.3% gain in Canadian dollar terms compared with a modest 4% for the TSX Composite Index, a gain of 12.7% in the Euro Stoxx and a loss of 2.5% for Hang Seng. Within the S&P 500, nine of ten sectors provided a positive total return. A mix of cyclical and defensive sectors like Financials, Consumer Discretionary, Technology, and Healthcare outperformed; however, we expect that cyclical sectors will lead the market in 2013.

The S&P 500’s substantial performance was supported by stronger U.S. economic data which indicated the economy is turning around and gaining momentum in key sectors like housing. The conclusion to the U.S. election, passage of the ESM in Europe, and encouraging economic data out of China have taken some pressure off the impact of other global macro news and the market has renewed its focus on corporate earnings and fundamentals.

Last year, macro-economic news drove the market, making it volatile and unpredictable; on average our top picks list for 2012 under-performed the S&P 500 Index by 800 basis points on a price only basis and underperformed by 510 basis points including dividends. Performance was impacted by companies shifting strategic direction, emerging market sales hampered by the Chinese economic slowdown, and fiscal uncertainty affecting corporate spending. Our best performer was Wells Fargo, up 24% and helped by the recovery in the U.S. housing market, General Electric moved higher by 17% as GE Capital finally contributed to the bottom line and the U.S. economy gained momentum. John Deere and AT&T managed to have decent returns in the low double digits, while our Materials and Energy picks where hurt by softness in the commodity markets. Peabody was down almost 20% on falling coal prices and competition from natural gas, while Freeport McMoRan decided to shift strategic focus and get into the energy business, forcing us to take it off of the recommended list with an 8% loss. We also removed Hasbro from the list back in October with a 20% gain as the company’s revenue growth started to underperform.

While there are challenges ahead, we believe that improving U.S. and Chinese economic data, and a relatively stable situation in Europe will support underlying business fundamentals and equity market performance. Recent data points show the Chinese economy is bottoming, and the new government could be more willing to use aggressive monetary policies to incentivize growth. Weakness in some European economies will be offset by comparatively stronger growth in emerging markets and the U.S., arguing for the continued need for global diversification.

Exhibit 1: Performance of 2012 Top U.S. Picks 2012

Price Current Price ReturnCompany Ticker 12/30/2011 12/31/2012 Yield (Price Only)

Alcoa Inc AA $8.65 $8.68 1.7% 0.3%

AT&T Inc T $30.24 $33.71 5.2% 11.5%

Deere & Co DE $77.35 $86.42 2.0% 11.7%

Freeport‐McMoRan Inc FCX $36.79 $34.20 3.4% (7.0%)

General Electric Co GE $17.91 $20.99 3.2% 17.2%

Halliburton Co HAL $34.51 $34.69 1.0% 0.5%

Hasbro Inc HAS $31.89 $35.90 3.8% 12.6%

Microsoft Corp MSFT $25.96 $26.71 3.1% 2.9%

Peabody Energy Corp BTU $33.11 $26.61 1.4% (19.6%)

Wells Fargo & Co WFC $27.56 $34.18 2.5% 24.0%

Average 5.4%

S&P/500 Composite Index 1257.6 1426.2 13.4%

Outperformance (8.0%)

Source: Bloomberg


30

In the U.S., corporate balance sheets are in good shape with record cash and cash flows allowing companies to return profits to investors via increased dividends and share buybacks. Profit margins and corporate earnings are at record levels reflecting extensive cost cutting and improved utilization of assets.

Our stock picks for 2013 have a cyclical orientation, which is aligned with our view that global economic growth will likely accelerate this year. Most of the companies in our list are trading at discounts to their peers and the S&P 500, and offer compelling upside potential. This list was constructed with the belief the U.S. economy will continue to recover in the year ahead and China will finally bounce, hence we see value in the shares of the companies we have chosen.

With the exception of Kroger, the list emphasizes U.S. multinationals. Our recommendation to buy Valero Energy is driven largely by the stock’s attractive valuation and the belief the shares will be re-valued as high crack spreads will provide the company with expanding margins over time. We are more optimistic on U.S. Financials generally, and JPMorgan is benefitting from improving asset quality, bond trading and a resurgence in mortgage lending. We have also chosen to include mega-Techs Microsoft and Apple Inc., whose core businesses are in solid shape and valuation does not reflect each company’s persistent earnings growth and balance sheet flexibility. From a thematic perspective, data storage provides EMC, with 23% global market share; it is a play on the growth of “the cloud” and mass data storage services.

Exhibit 2: Top 10 U.S. Picks for 2013 – Consensus Data*

Dec. 31,

Consensus

Potential

Total

Market

Cap.

Company Ticker 2012 Dividend Yield Target Returm 2012 2013 2012 2013 (millions)

APPLE INC AAPL $532.17 $10.60 2.0% $730.96 39% $48.86 $57.43 10.9 9.3 $470,580

CATERPILLAR INC CAT $89.61 $2.08 2.3% $103.21 18% $9.10 $8.58 9.9 10.4 $61,842

DIRECTV DTV $50.16 $0.00 0.0% $57.75 15% $4.21 $5.16 11.9 9.7 $32,188

EMC CORP/MA EMC $25.30 $0.00 0.0% $30.61 21% $1.69 $1.90 15.0 13.3 $51,002

FLUOR CORP FLR $58.74 $0.64 1.1% $70.89 22% $3.69 $4.16 15.9 14.1 $10,317

JPMORGAN CHASE & CO JPM $43.97 $1.20 2.7% $49.67 16% $4.96 $5.28 8.9 8.3 $174,484

KROGER CO KR $26.02 $0.60 2.3% $28.60 12% $2.47 $2.66 10.6 9.8 $13,402

MCKESSON CORP MCK $96.96 $0.80 0.8% $107.65 12% $7.31 $8.08 13.3 12.0 $23,933

MICROSOFT CORP MSFT $26.71 $0.92 3.4% $33.38 28% $2.87 $3.20 9.3 8.4 $225,856

VALERO ENERGY CORP VLO $34.12 $0.70 2.1% $41.50 24% $4.80 $5.17 7.1 6.6 $19,540

Consensus EPS Consensus P/E

*U.S. dollar

Source: Bloomberg.


Winter 2013 31

Apple Inc. (AAPL)

Company Description

Apple Inc. is one of the world’s largest computer and electronic device makers and one of the great success stories in the history of American business. In 1976, Steve Jobs and Steve Wozniak founded Apple Computer Inc. Sales grew quickly enough for them to take the company public four years later. Steve Jobs departed Apple to found NeXT. Jobs returned to Apple twelve years later, resuming his role as CEO after Apple acquired NeXT. Apple’s true renaissance began in 2001 when Steve Jobs introduced the iPod digital music player, which ultimately changed the way people bought and listened to music. In 2007 it introduced the highly successful iPhone, and in May 2010, the iPad, its latest take on the tablet computer. Today, Apple’s suite of products and services includes personal computers, mobile communications, table computers, and music players . Apple operates an online store as well as over 250 stores in the U. S. and 140 stores internationally.

Reasons to Buy

The iPhone remains the core engine of growth at Apple with estimated annual sales of between 150–170 million units, according to Business Insider. Since being launched in 2007, the device has reached almost cult like status supported by a developed ecosystem, which has created some 700,000 product specific applications. Currently the iPhone accounts for 51% of Apple’s 2012 sales. The iPad, representing Apple’s second most important product line, has expanded its reach by targeting multiple markets, providing several hardware options and price points with the introduction of their iPad 3 and iPad Mini. Following on the heels of the successful iPad 2, the iPad 3 now features a faster processor to speed performance and improve graphics quality, while the iPad Mini’s affordable $329 starting price make it appealing to Apple fans in many emerging markets.

The emerging market opportunity: Apple is expected to launch more stores in emerging markets ( 7 of which are in China and 2 in Hong Kong). Apple now also offers the iPhone thru various carriers in several emerging markets, including China Mobile, the largest mobile operator in the world with 700 million subscribers. China Telecom Corp., the third largest mobile phone operator, began offering the iPhone 5 in mid December, the first entry of Apple Inc.’s latest smartphone into China.

The “Jobs” Factor: We believe the company has demonstrated strong management depth in recent years that made the passing of Steve Jobs only a very modest concern for the company’s future. CEO Tim Cook’s recently announced management changes, are intended to promote better collaboration across hardware, software and services teams. These actions show that Tim Cook is prepared to make changes to try to help the company better position itself and execute.

Apple Inc. shares have a very, very attractive valuation, currently trading at 2012E earnings multiple of 10.8 times, ex- cash at 8.2 times earnings, which compares with the 12.8 times industry average, and 13.7 times for the S&P 500 Index. Over the last five years, Apple shares have traded in a rage between 11 times to 50 times. Apple’s PEG ratio is impressive at 0.50 times, and the consensus of analysts’ estimates suggests earnings per share growth of 18% for 2013. Apple has a clean balance sheet with no debt and currently sits on approximately U$121 billion in cash, or more than U$128 per share of cash, representing ~25% of the share price.

Exhibit 3: Apple Inc. APPLE INC Ticker: AAPL

S&P Capital IQ Rating: Strong Buy (5-STARS) Date: 31‐Dec‐12Risk: High

Summary Data (U$)

Current Price $532.17 Fiscal Year‐End: 09/2012




ROE 43% Market Value $626,550 ($ mil)


Annual 2010A 2011A 2012E 2013E

EPS: $15.15 $27.68 $44.15 $47.00

P/E Multiple: 21.3 14.6 12.1 11.3

Source: Bloomberg & S&P Capital IQ


32

Risk Factors

Apple is exposed to disruptions in its supply chain and component availability. The Company is also dependent on worldwide economic conditions, the successful management of frequent product introductions, inventory management, and the support of third-party software developers.

Caterpillar Inc. (CAT)

Company Description

Caterpillar Inc. (CAT) is the world’s leading manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives worldwide. While Caterpillar equipment can be found in virtually every country in the world, 36% of sales come from North America. The company segments there business into five parts: Construction Industries (33% of revenues, 21% of operating profit in 2011), Resource Industries (26%; 34%), Power Systems (33%; 31%), Financial Products (5%; 6%), and Other (3%; 8%). The Construction Industries segment supports customers in infrastructure and building construction applications, Resource Industries serves mining, forestry, and quarry applications, Power Systems targets electric power, industrial, oil and gas, and rail-related end markets, while Financial provides equipment financing to CAT dealers and customers. Caterpillar represents a solid industrial play which provides good leverage to mining activity, the positive trend in U.S. construction activity and the replacement of aging construction equipment in developed markets, as well as growth in emerging markets.

Reasons to Buy

For the 10 years through 2011, CAT recorded compound annual growth rates (CAGRs) of 11.4% for revenues and 21.0% for earnings per share. The company also generated an 18.3% return on invested capital (ROIC) in 2011, helped by demand for construction equipment which has risen sharply over the past two years, after a major downturn. Although analysts have been revising earnings estimates lower recently to reflect economic uncertainty, consensus estimates are still forecasting 17% EPS growth in 2012. The 2011 acquisition of Bucyrus International, a manufacturer of specialized mining equipment, contributed $1.2 billion to sales, increasing Resource Industries profit by $285 million.

Based on the current macroeconomic environment, CAT shares appear to to have a significant upside potential. Strong economies in emerging markets and the need to replace machinery and power systems in developed markets, especifically in the U.S., had boosted CAT's operating results over the past couple of years. Today’s challenging global economic conditions threaten CAT's near term growth as mining projects are postponed, but demand should turn around with improvement in the Chinese and U.S. economies. In early December, the release of the Chinese November official PMI (Purchasing Manager’s Index), a measure of manufacturing activity, rose to 50.6, its highest reading in seven months, indicating economic expansion, and thus is expected to support commodity (mining) prices. Since the beginning of the political leadership change recently in China there have already been announcements of increased manufacturing capacity in the country and new infrastructure spending initiatives expected to directly benefit Caterpillar.

Exhibit 4: Caterpillar Inc. CATERPILLAR INC Ticker: CAT

S&P Capital IQ Rating: Buy (4-STARS) Date: 31‐Dec‐12Risk: Medium

Summary Data (U$)







Annual 2010A 2011A 2012E 2013E

EPS: $4.15 $7.40 $9.40 $10.20

P/E Multiple: 22.6 12.3 9.5 8.8



Winter 2013 33

Caterpillar offers investors an attractive dividend yield of 2.4% based on its current annual dividend rate of U$2.08 per share. The company’s dividend payout ratio is low at only 24% of consensus forecast 2013 earnings. The company has been growing its dividend at an average annual rate of ~9% for the last five years.

Caterpillar’s valuation is attractive with shares trading at 10.3 times 2013 EPS near trough multiples relative to historical valuations, and compares to the ten year average of 13.0x.

Risk Factors

The primary risk for CAT is weakness in copper prices, factory capacity utilization, state spending on road construction, rising office vacancy rates and a renewed slowdown in U.S. housing could cause earnings to fall below current consensus expectations.

DIRECTV Group (DTV)

Company Description

The DIRECTV Group (DTV) provides digital television entertainment primarily in the United States and Latin America. The company engages in acquiring and distributing digital entertainment programming, primarily via satellite, to residential and commercial subscribers. It offers direct-to-home digital television services as well as multi-channel video programming distribution services under the DIRECTV and SKY brands. In addition, the company owns and operates three regional sports television networks based in Seattle, Denver, and Pittsburgh under the ROOT SPORTS brand name.

Reasons to Buy

DIRECTV has approximately 20 million subscribers in the United States and 13 million in Latin America: approximately 4.3 million subscribers primarily in Argentina, Chile, Colombia, Ecuador, Venezuela, and the Caribbean; approximately 4.2 million in Brazil; and 4.3 million in Mexico. In the U.S. DIRECTV is the second largest pay TV provider after Comcast and the larger of the two satellite TV providers followed by DISH Network; between the two satellite companies they have a combined total pay TV market of 30%. DIRECTV’s large subscriber base allows the company to obtain programming on favorable terms and secure unique and exclusive programming or events.

Latin America has been a success story for DIRECTV as the company has witnessed strong growth in the region; Latin America’s GDP is growing at 4.2% per year and has an emerging middle-class. DIRECTV is the largest pay TV service in Latin America and increased its subscriber base by 34% in 2011 with gross additions of 1.3 million customers. The Latin American satellite competitive landscape is less formidable than in the U.S. giving DTV the advantage of covering the entire region at a low cost per user and the ability to upgrade its entire customer base all at once, nimbleness cable providers cannot match.

Exhibit 5: DIRECTV Group DIRECTV Ticker: DTV

S&P Capital IQ Rating: Hold (3-STARS) Date: 31‐Dec‐12Risk: Medium

Summary Data (U$)





ROE #VALUE! Market Value $29,560 ($ mil)


Annual 2010A 2011A 2012E 2013E

EPS: $2.30 $3.47 $4.18 $5.16

P/E Multiple: 15.3 12.2 12.0 9.7



34

The company was able to enhance its competitive positioning by providing bundled services to its subscribers. DIRECTV competes against bundled offerings from cable operators and other telecommunication companies. DIRECTV has co-branding agreements with Verizon, AT&T, Windstream and Quest to provide bundled offerings of voice, mobile, data, and video, enhancing the reach of the company’s services. Bundling of services has been a key competitive advantage enjoyed by telecommunication and cable companies. By bundling services, DIRECTV has enhanced their competitiveness and better positioned the company to drive revenue growth.

There are new technology opportunities. DIRECTV has taken several initiatives to increase their video on-demand offering, providing more access to TV programs, spots and movies to their subscribers. Also, the company has tapped online video viewing by providing their customers with the best anywhere / anytime, multiple screen experience. DIRECTV’s TV Everywhere service can be accessed on a variety of devices from the PC, tablets, to Smartphones, providing access to an array of pay-per-view content.

DIRECTV has an attractive valuation currently trading at 2012E earnings multiple of 11.9 times, compared with the 15.2 times industry average, and 13.7 times for the S&P 500 Index. Over the last five years, DIRECTV shares have traded in a 12 times to 30 times range. DIRECTV’s PEG ratio is impressive at 0.72 times.

Risk Factors

Deere’s business is highly cyclical and could be affected by an economic downturn and an extended drop in crop prices. The company’s leading position in many of the markets it serves, and its large cash balance could help offset some of this risk. The agricultural equipment business is becoming more competitive, particularly in emerging markets. The merger of certain large competitors and their global expansion is leading to greater competition for Deere in markets like India, China, Brazil and Russia.

EMC Corp. (EMC)

Company Description

EMC Corp. is the world’s leading mass data storage device maker with about 23% market share, followed by Hewlett-Packard and IBM with 19% and 16%, respectively. Financial institutions, government agencies, manufacturers, Internet service providers, and retailers all use massive amounts of information in their daily operations. EMC’s RAID (redundant array of independent disks) devices allow the storage and quick retrieval of massive quantities of data. Major product lines include: Symmetrix VMAX, CLARiiON, and Centura. EMC also makes file servers, and software designed to manage, share, and protect data. Information storage represented 74% of corporate revenues in 2011 with revenues growing 16% during the period. EMC is the majority owner (80%) of VMware (VMW), which provides software designed to reduce costs in data center operations, and its RSA division provides security software. VMWare grew revenues 32% in 2011 and is estimated to have approximately 90% market share of the server virtualization market. Products are sold directly, through distributors, system integrators, resellers, and OEMs.

Exhibit 6: EMC Corp. EMC CORP/MA Ticker: EMC


Summary Data (U$)







Annual 2010A 2011A 2012E 2013E

EPS: $0.88 $1.10 $1.68 $1.87

P/E Multiple: 21.3 19.5 15.1 13.5



Winter 2013 35

Reasons to Buy

The upside potential for EMC Corp. is being driven by increasing demand for data storage globally and the continued migration toward cloud computing. Both individuals and corporations are converting records, books, photos, music, and other data into electronic files; some of this conversion is mandated by the trend toward increased regulation which demands access to historical records. Cloud computing allows enterprise level IT groups to enhance their data storage capacity outside the limits of their physical premises, to the Internet, where both data and software can be stored in a virtual “cloud”. Although this phenomenon conjures images of information being stored out in the ether, the reality is that ultimately that data has to be physically stored somewhere, promoting a massive upgrade cycle to data storage infrastructure – EMC’s sweet spot.

EMC is a compelling investment as the company enjoys significant levels of recurring revenue from the software and services part of their business, and is expected to continue its recent growth trend through further market share gains. In addition, storage-related companies are expected to experience higher growth rates than most other segments within the Information Technology sector.

In 2003, EMC purchased a stake in VMware, Inc. VMW's software is designed to enable customers to achieve much higher utilization of the server, storage and network resources deployed within their operations, while dramatically simplifying how the workloads running on those systems are operated and managed. Revenues from the VMware Virtual Infrastructure business unit grew 32% in 2011. In the fourth quarter of 2010, EMC acquired Isilon Systems. This acquisition strengthened EMC's presence in “scale-out” or as-required NAS (network attached storage), which is believed to be a fast-growing market segment.

EMC Corp. has a very solid balance sheet, ending the September quarter with U$5.5 billion in cash and investments, or approximately $2.61 per share. EMC shares trade at 13.2 times consensus EPS estimates for 2013 versus their five year average P/E of 15.3 times; an attractive valuation given the company’s EPS growth rate, and suggesting a PEG ratio at a discount to IBM.

Risk Factors

Key risks to EMC thesis include: IT spending weakness due to economic concerns; difficulty sustaining growth and margins as server vendors push a converged infrastructure approach; NAS gains share from SAN (storage area network ); and NetApp attempts to move into the data center, disruptive technologies emerge such as flash; potential management turnover when CEO Tucci retires and a new chief is picked; and earnings issues at VMware (25% of EMC profits).


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Fluor Corp. (FLR)

Company Description

Fluor Corp. is one of the world's largest engineering, procurement, construction and maintenance companies. It has five principal operating segments. The Oil and Gas segment (34% of 2011 revenue) provides services to oil, gas, refining, chemical, polymer and petrochemical customers. Industrial and Infrastructure (41% of 2011 revenue) provides EPC (Engineering, Procurement and Construction) services to businesses, including industrial, commercial, telecommunications, mining and technology. Global Services (7% of 2011 revenue) provides operations and maintenance support, equipment rentals and sales, and outsourcing through TRS Staffing Solutions. The Government segment (15% of 2011 revenue) provides support services to the federal government and other government entities. In the Power segment (3% of 2011 revenue), Fluor provides a full range of services to the gas fueled, solid fueled, renewables, nuclear and plant betterment markets

Reasons to Buy

Fluor Corp. has momentum, particularly in oil & gas. The company is working on various early stage projects totalling $30b of investment in the Gulf Coast; it is expected that these US projects move forward in mid-2013. Management also believes oil & gas margins should improve in the second half of 2013. Broadly, FLR expects every segment to have a growth story in the second half of 2013 into 2014.

Buybacks picking up. Fluor reiterated on their third quarter earnings conference call that buybacks would pick up in the fourth quarter. The company repurchased approximately 3.2 million shares through October 31st, and paid ~$80 million in dividends. FLR’s strong and steady cash flows enable the company to support organic growth, diversifying acquisitions, and their ongoing dividend program.

In August 2012, the company raised the low end earnings forecast of its 2012 guidance by $0.10 to $3.50 to $3.80. This forecast includes costs of $0.20 to fund the company's majority investment last year in NuScale Power, which makes small modular reactors, a market FLR believes could be huge in future years. It is expected the company will seek strategic acquisitions primarily in the infrastructure design market for rail, highway and bridge projects, as well as in offshore oil and gas, newbuild nuclear power generation and wind farm businesses, helped by President Obama's budget which includes loan guarantees for the Department of Energy and subsidies for renewables. FLR is confident that sticking to bidding discipline in the Mid-East over the last several years was the right decision, and that it did not prevent FLR from growing.

Valuation: Ending the October quarter with U$2.8 billion in cash and investments, or approximately $16.80 per share, FLR shares trade at 14.1 times consensus EPS estimates for 2013 versus their five year average P/E of 15.2 times; an attractive valuation given the company’s 1.02 PEG ratio.

Exhibit 7: Fluor Corp. EMC CORP/MA Ticker: EMC


Summary Data (U$)







Annual 2010A 2011A 2012E 2013E

EPS: $0.88 $1.10 $1.68 $1.87

P/E Multiple: 21.3 19.5 15.1 13.5



Winter 2013 37

Risk Factors

Key risks to Fluor Corp include: a slowdown in mining; delays to oil and gas project awards; project cost inflation; lack of financing for oil and gas projects; competition across the segments (particularly on infrastructure and power bids); a decline in federal military spending; and falling oil prices.

JPMorgan Chase (JPM)

Company Description

JPMorgan Chase is one of the largest banking institutions in the US, with $2.3 trillion in assets and operations in more than 60 countries. JPMorgan operates more than 5,500 bank branches and 17,200 ATMs across a 23-state footprint. JPMorgan also offers a full range of investment banking products and services in all major capital markets. Card Services is one of the nation's largest credit card issuers, with over $132 billion in loans and over 65 million open accounts. Asset Management, with assets under supervision of $1.9 trillion, is a global leader in investment and wealth management. JPMorgan operates under six different business segments: Investment Banking (~27% of sales), Commercial Banking (~8% of sales), Treasury (~8% of sales), Asset Management (~10% of sales), Retail Financial Services (~27% of sales), and Card Services and Auto (~20% of sales). JPMorgan Chase & Co. was founded in 1823 and is headquartered in New York, New York.

Reasons to Buy

Industry outlook is improving: For the major U.S. banks, success in 2013 will depend on the precarious situation in Europe, international and U.S. economic growth, housing prices, the low interest rate environment, and regulatory costs. For these banks, analysts expect a rebound in net revenues, on increased noninterest income, and an increase in net interest income and loans. The major banks are well capitalized, with an average Basel I Tier 1 capital to risk-weighted assets ratio of 13.20% at September 30. The banks are also well-positioned for Basel III.

A preferred play on banking: JPMorgan’s scale, fee income and mortgage growth opportunities, domestic and international investment banking exposure, lower cost funding, and attractive valuation make this bank a preferred play among large U.S. banks.

Q3 results suggest a stronger start to 2013: Third-quarter earnings was highlighted by mortgage banking and market-related revenue, partially offset by a slowdown in commercial loan growth and a higher-than expected loan loss provision. It is expected that declining provisions for credit losses will drive 7.8% earnings growth in 2012 and 3.5% growth in 2013. Capital ratios increased, in Q3, with the Basel I Tier 1 common ratio at 10.4% and the estimated Basel III Tier 1 common ratio a solid 8.4%.

Improving capital levels support return of cash to shareholders: In early 2011, JPMorgan was one of only a handful of major U.S. financial institutions to receive approval from the U.S. Federal Reserve to increase its quarterly dividend to common shareholders. It responded by raising its quarterly payout to U$0.30 per share from U$.25 per share. The stock currently yields 2.9%.

Exhibit 8: JPMorgan Chase JPMORGAN CHASE & CO Ticker: JPM

S&P Capital IQ Rating: Buy (4-STARS) Date: 31‐Dec‐12Risk: Low

Summary Data (U$)







Annual 2010A 2011A 2012E 2013E

EPS: $3.96 $4.48 $5.10 $5.20

P/E Multiple: 9.7 6.9 8.6 8.5



38

JPM received Federal Reserve approval to reinstate its $15B share repurchase program which was suspended May 11 after large trading losses in the London office. Also, JPM settled with U.S. SEC, subject to court approval, related to complaints over mortgage securitizations made by Bear Stearns at the height of U.S. the housing bubble. Both items are positives for JPM, particularly the share repurchase program, which could be as high as $12B in 2012 and $3B in 2013.

Valuation: Based on the consensus of earnings expectations, JPMorgan trades at 8.8 times forecast 2012 EPS of U$5.02 and 8.3 times forecast 2013 EPS of U$5.28, a discount to its industry peers. JPMorgan trades at 0.9 times Q3/2012 book value, a slight premium to Citigroup and Bank of America, but at discount to Wells Fargo. Current valuations are at a substantial discount to historical multiples.

Risk Factors

Possible risks faced by JPMorgan are their association with on the Libor manipulation scandal, a worsening of the European fiscal crisis, and a U.S. economic slowdown

The Kroger Company (KR)

Company Description

The Kroger Company was founded in 1883 in Cincinnati Ohio and is one of the largest grocery retailers in the U.S. operating 2,425 supermarkets and multi-department stores in 31 states under different banners : Kroger, City Market, Dillions, Jay C, Food 4 Less, Fred Meyer, Fry’s , King Soopers, QFC, Ralphs and Smith’s. Also, Kroger directly or through its subsidiaries runs 788 convenience stores, 342 fine jewellery stores, 1,124 supermarket fuel centers, and 37 food-processing plants.

Reasons to Buy

Kroger’s supermarkets and multi-department stores operate in several formats. Their Combo stores feature a combination of food and drug stores; these stores include natural food and organic sections, pharmacies, general merchandise, and pet centers. The Multi-department stores offer a collection of general merchandise products like apparel, home furnishings and accessories, electronics, automotive products, toys, and fine jewellery. The Marketplace stores are a combination stores, multi-department – marketplace stores; they feature fuel centers, full-service grocery and pharmacy, electronics, home goods, and toys. The Price impact warehouse offer grocery, health, and beauty care items.

Kroger has a dominant position among the largest retailers; their strong corporate and national brands have helped them gain customers’ loyalty. In 2004 Kroger undertook its Customer 1st strategy, a multi-dimensional plan that not only focuses on low prices for their customers, but an enhanced shopping experience. This strategy is a customer-centric model that focuses company efforts on improving employee communications and training: using customer research and loyalty data analysis to personalize stores on market-by-market and store-by-store basis; boosting customer loyalty by improving customers’ shopping experience (like lowering store-front wait times to 30 seconds); and pricing within an acceptable range of discounters’ prices whereby price becomes a neutral factor in customers’ shopping decisions.

Exhibit 9: The Kroger Company KROGER CO Ticker: KR

S&P Capital IQ Rating: Buy (4-STARS) Date: 31‐Dec‐12Risk: Low

Summary Data (U$)







Annual 2010A 2011A 2012E 2013E

EPS: $0.11 $1.74 $1.01 $2.47

P/E Multiple: NM 13.6 25.8 10.5



Winter 2013 39

Kroger offers about 1,100 private label items as part of their merchandising strategy. Kroger products are sold in three tiers; Private Selection is a premium quality brand, designed to meet or beat gourmet or upscale national or regional brands. The banner brands (Kroger, Ralphs, King Scoopers, etc.) are designed to equal or better the national brands. The Kroger value brand is designed to deliver good quality at an affordable price. About 40% of Kroger’s corporate brand volume is manufactured in the company’s 37 food-processing plants.

Kroger enhances growth target and dividends. On October 18th the company held an analyst conference in which they upped their long term earnings per share growth target to 8%-11% from their earlier target of 6%-8%. The company will largely focus on incremental return on invested capital and will bring operating efficiencies through cost containment to enhance profitability; the company is in its 8th consecutive year of cost reductions. KR announced that they will boost capital spending by an incremental $200 million annually to concentrate on store expansions and support their growth strategy. Moreover, to provide room to its earnings, Kroger announced a new $500 million share repurchase program, resetting its existing plan which had about $340 million remaining. The company also enhanced their dividend on September 13th to $0.60 per share from the earlier level of $0.46 yielding 2.5%; this is the sixth consecutive increase in the quarterly dividend since it reinstated dividend payments in 2006.

Kroger has an attractive valuation currently trading at a 2012 earnings multiple of 10.6 times, compared with the 16.3 times industry average, and 13.7 times for the S&P 500 Index. Over the last five years, Kroger shares have traded in a 18 times to 10.4 times range. The consensus of Bloomberg analysts’ estimates suggests earnings per share growth of 7.6% for 2013

Risk Factors

Possible Risks faced buy Kroger are the sluggish economic recovery that may affect consumer shopping patterns, and KR’s higher debt-to-capitalization ratio.

McKesson Corp (MCK)

Company Description

McKesson Corp. is the largest pharmaceuticals distributor in the U.S., providing drugs, medical products and supplies, as well as health care information technology products and services. McKesson Distribution Solutions (97% of FY 12 (Mar.) revenues) distributes ethical and proprietary drugs and health and beauty care. The medical-surgical distribution unit provides medical-surgical supplies, equipment, logistics and related services to alternate-site health care providers. Products are sold through 28 distribution centers in the U.S. and 16 in Canada. MCK also has a 49% interest in Nadro, a Mexican drug distributor. McKesson Technology Solutions delivers enterprise-wide patient care, clinical, financial, supply chain and strategic management software solutions, pharmacy automation for hospitals, as well as connectivity, outsourcing and other services, to health care organizations throughout North America, the United Kingdom and other European countries. This segment also includes MCK's Payer businesses, which provide medical management tools, claims payment solutions and care management programs. Customers include hospitals, physicians, home care providers, retail pharmacies and payors.

Exhibit 10: McKesson Corp MCKESSON CORP Ticker: MCK

S&P Capital IQ Rating: Strong Buy (5-STARS) Date: 31‐Dec‐12Risk: Medium

Summary Data (U$)







Annual 2010A 2011A 2012E 2013E

EPS: $4.62 $4.29 $5.70 $7.30

P/E Multiple: 15.2 18.1 17.0 13.3



40

Reasons to Buy

MCK's large footprint in drugs, medical supplies and information technology provide important cross-selling opportunities. McKesson has as lead position in drug and medical products distribution and their pharmacy systems reinforce its cost-competitiveness. It is believed that MCK has garnered some of its largest account wins mainly by offering one-stop shopping and competitive prices. In addition, MCK and its two large national competitors are consolidators in this highly fragmented market.

McKesson renews a new pharma prime vendor contract with the U.S. Dept. of Veterans Affairs (VA). The contract is worth up to ~$31.6B over next eight years (~$4B annually).

Obamacare and Generics will drive growth: It is expected that up to 32 million additional Americans will eventually be covered by health insurance under the Affordable Care Act (recently upheld by the Supreme Court) and therefore, better able to afford pharmaceuticals. U.S. prescription drug sales are expected to rise in 2013 and 2014; the gain should reflect drug price increases and volume gains in specialty and generic drugs. Distributors should especially benefit from new generics resulting from patent expirations on many large selling branded drugs. Generics are important for drug distributors because they carry wider margins than branded products.

McKesson’s balance sheet is in good position allowing for acquisitions. McKesson ended the second quarter 2013 with a cash balance of $2.8 billion or $11 per share. With growing cash balances and healthy FCF dynamics, McKesson announced the acquisition of PSS World Medical (a laboratory and private physician distribution company) for $2.1 billion in cash. The transaction when completed should be $0.15-0.25 accretive in the first 12 months post-closing and will complement MCK’s medical-surgical business.

Risk Factors

The primary risks to McKesson include: the possible loss of major accounts, slowing trends in pharmaceuticals growth, unfavorable regulatory changes, buy-side pricing environment changes, and the impact of the Medicare drug benefit plan on price structure.

Microsoft Corp. (MSFT)

Company Description

Microsoft is the world’s largest software company, with a near-monopoly position in desktop operating systems and office productivity software. The barriers to entry are high given Microsoft’s huge installed base and brand awareness. Despite competition from Linux and Apple, Microsoft Windows operating system still runs more than 90% of all PCs. Microsoft Office remains the leading productivity application suite in use today. Microsoft also sells the xBox video game system. There are five operating business divisions: Windows and Windows Live (25% of sales), Servers and Tools (25% of sales), Online Services Business (4% of sales), Microsoft Business (32% of sales), and Entertainment Devices (11% of sales). The Company’s business strategy has been moving away from a PC-centric computing environment toward “cloud computing” where multiple devices, including mobile, gain access to information over the Internet.

Exhibit 11: Microsoft Corp. MICROSOFT CORP Ticker: MSFT

S&P Capital IQ Rating: Strong Buy (5-STARS) Date: 31‐Dec‐12Risk: Medium

Summary Data (U$)







Annual 2010A 2011A 2012E 2013E

EPS: $2.10 $2.69 $2.00 $3.02

P/E Multiple: 11.6 9.8 13.4 8.8



Winter 2013 41

Reasons to Buy

Microsoft’s core business is in solid shape and will be driven by the new Windows 8 and Office 2013 products, generating 75% of its revenue. While global consumer PC sales have been disappointing, a function of sluggish economic and job growth, the Enterprise segment will benefit as companies upgrade their PCs, and through expected growth in the cloud and data center infrastructure. By some estimates, the corporate refresh cycle (transition to Windows 7 operating system) will be aided by the discontinued support of Windows XP in April, estimated to impact 200 million machines. The recent launch of Windows 8 should help the Company penetrate the mobile device market with their cross platform Windows 8 and the introduction of the Surface tablet. Entertainment and Devices is currently Microsoft’s fastest growing business segment. Sales momentum for the xBox remains solid as the product transitions from a gaming console to a full entertainment suite.

Earnings Growth: S&P Capital IQ earnings expectations for fiscal 2013-15 imply an average annual earnings growth of 8.6%. Windows 8 and Office 2013 should provide the bulk of the growth over the next 24 months.

Balance Sheet: Microsoft had U$66.7 billion or U$7.92 per share in net cash on its balance sheet as of the end of its last reported quarter. Net cash represents almost 29% of the current share price. The huge cash hoard and strong free cash flow will continue to support share buybacks and dividend growth.

Dividends: Microsoft has grown its dividend at a compound annual rate of 17% over the last three years. Microsoft shares offer investors an attractive yield of 3.4%. We believe Microsoft can sustain this growth as its dividend payout ratio is only 27% of the company’s cash flow after capital expenditures.

Microsoft has a very attractive valuation, currently trading at 9.3 times 2012 Consensus EPS and only 8.3 times forecast 2013 EPS. This is a substantial discount to its peer group that includes Oracle Corp. (ORCL), Adobe Systems (ADBE), Citrix Systems (CTXS), and Symantec Corp (SYMC). We do not believe Microsoft’s valuation reflects its market dominance, large installed base, projected earnings growth, and solid balance sheet.

Risk Factors

There is a cyclical element to software sales underscored by weakness in the consumer PC segment in recent quarters. There are signs the European debt crisis and the fiscal cliff are beginning to affect enterprise IT spending, which could impact financial results in 2013. There are also risks inherent in launching new products. Microsoft’s penetration of the mobile market is dependent on the adoption of Windows 8 operating system.


42

Valero Energy (VLO)

Company Description

Valero Energy is one of the largest independent refiners in the U.S. VLO owns and operates 16 refineries located in the U.S., Canada, the United Kingdom, and Aruba. Its refineries produce conventional gasolines, distillates, jet fuel, asphalt, petrochemicals, lubricants, and other refined products. VLO also markets refined products through a network of about 6,800 retail and branded wholesale stores in the U.S., Canada, the U.K., Aruba, and Ireland. In addition, VLO owns 10 ethanol plants. The company operates in three business segments: Refining (86% of 2012 operating income), Ethanol (4%), and Retail (9%). Valero possesses above average refining complexity which allows it to process a large amount of lower-cost heavy and sour crudes. The company has the strategic geographical advantage of having most of its refineries in the Gulf Coast, giving Valero the unique opportunity of accessing lower cost heavy crude oil in combination with easy access to export markets for its distillate products in Latin America and Europe.Key

Reasons to Buy

Crude oil production from U.S. shale plays and the Canadian oil sands is turning into a game-changer for refiners. The Energy Information Administration expects oil production from U.S. shale to grow at a compound annual growth rate (CAGR) of 5%, while the Canadian National Energy Board sees that country's oil exports increasing at a (CAGR) of 5.5%. Most of this oil is heading toward Cushing, Oklahoma, the major U.S. oil and gas trading hub, and then toward the Gulf Coast, facilitated by existing and planned pipeline expansion and reversal pipeline projects. The growth in North American crude oil (WTI) production is depressing the price of locally sourced crude oil and creating a pricing disparity between it and imported crude (Brent). As a result, locally sourced crude has become a cheaper feedstock in comparison to imported crude oil.

The increasing North American crude oil production is positive for Valero which has refineries in the Mid-Continent and Gulf Coast. We believe the location of these refineries provides the company with access to the growing crude oil supply, enabling them to take advantage of lower cost feedstocks. There are suggestions that by 2014 there could be a surplus of imported light sweet crude (Brent) in the Gulf and Mid Continental regions as refiners fill their cokers with the less expensive heavy crude (WTI) first. It is expected that the surplus could lead to lower light sweet (Brent) prices in this region providing Valero with expanding margins overtime.

Export of distillate and gasoline products from the Gulf Coast has been on the rise since 2004 from under 200,000 barrels a day to over 1,100,000 in 2011, benefiting Valero over the years. The sharp rise has lead to concerns that higher competition in the export markets will lead to a compression in margins of Gulf Coast products. Some evidence of this has been reflected as Gulf Coast gasoline prices have already fallen to a discount to European products. It is believed that much of the price weakness is already reflected in product prices and if Gulf Coast crude oils become cheaper than global equivalents, then Valero’s overall refining margins will expand. Also, Valero has shifted a portion of their output to take

Exhibit 12: Valero Energy VALERO ENERGY CORP Ticker: VLO

S&P Capital IQ Rating: Strong Buy (5-STARS) Date: 31‐Dec‐12Risk: Low

Summary Data (U$)







Annual 2010A 2011A 2012E 2013E

EPS: ‐$0.65 $1.62 $4.07 $5.04

P/E Multiple: 14.3 5.8 8.4 6.8



Winter 2013 43

advantage of the price discount to European gasoline and diesel products thus improving their margins. We believe that even if European economies remain weak, they will still consume 14 MBD of product annually and Europeans will prefer lower priced products coming form the Gulf Coast and Eastern Canada. On 2012E earnings, Valero trades at 7.2 times, substantial discount to its peer average which currently trade at 14.74 times.

Risk Factors

Valero include excess industry refining capacity, decreasing North American crude oil production, a narrowing of the light-heavy crude differential as feedstock, a decline in refined product prices, and lower global demand for petroleum products.


44

Fixed Income Strategy

Outlook for 2013 – Rates Will Get There But You Better Pack a Lunch…Sizeable Headwinds Remain Andrew Mystic, MBA –Director, Portfolio Advisory Group, Fixed Income

Relative to 2011, 2012 bond markets offered up a much more tepid performance. Risk markets are beginning to show more buoyancy, but risks continue to abound – suggesting diminishing bond returns in 2013. Despite a notable slew of headwinds out of Europe; the uncertainty of a US election; and a virtually untenable level of political brinkmanship over the US fiscal cliff – 2012 saw bond markets become increasingly convinced that the global outlook had cautiously turned a corner for the better. In 2011, bond yields fell between 0.25-1.20% in Canada and 0.11-1.44% in the US – largely in response to heightening global risk sentiment. In 2012, Canadian yields reversed course rising between 0.04-0.22% in the 2-7 year range and falling modestly in longer dated bonds (yields fell 0.13-0.17% in 10-year and long bonds). In the US, yields fell only 0.01-0.17% across the curve. Looking at the broader indices, the DEX Overall Total Return Index returned 3.6% in 2012, versus the strong performance of 9.67% in 2011.1 In fact, with very few exceptions, Canadian investment grade indices notably underperformed the returns seen in 2011. In the quest for yield, the Canadian High Yield space was one exception bringing in a total return of 14.75%.2

Investors who extended term and over weighted credit were rewarded for doing so in 2012. Despite the performance, we believe our shorter duration overweight credit recommendations better shielded investors from the potential shocks that have begun to materialize in the early part of 2013. Those investors who were willing to extend term were rewarded for doing so in 2012 with the DEX Overall Total Return Mid and Long indices returning 4.65% and 5.21% respectively – versus the Short Overall index which returned only 2.01%. Global credit risks, particularly pertaining to Europe, did keep mid-term and longer dated bond yields better bid than expected. The recent sell off in bonds at the beginning of 2013 however, has us feeling that our shorter duration call was the right one – given the rapidity of bond losses seen at the beginning of 2013. As of January 10, 2013, US Treasuries have nearly wiped out their 2012 gains losing 2.3% versus the 2.5% gained in all of 2012. 3 Given the relative levels of rates, investors remain vulnerable to sudden sell-offs – particularly as the Bank of Canada continues to signal the potential for rate hikes in the face “household imbalances” and the US economy incrementally continues to gain traction.

Investors who followed our recommendations in overweighting credit, benefitted from the notable spread compression seen across the Canadian curve. Each of the DEX Corporate Short, Mid and Long Total Return indices, outperformed their Overall equivalents by 1.92% (3.93% vs. 2.01%); 3.47% (8.12% vs. 4.65%) and 4.27% (9.48% vs. 5.21%) respectively.4

1 PC Bond Analytics 2 PC Bond Analytics 3 Treasury Bonds Erode 2012 Gains Before Year’s First Auction, Bloomberg 4 PC Bond Analytics


Winter 2013 45

Rising Rates Should Gain Traction Going Into H2/13 There will be a number of potential headwinds that should keep rates well behaved during the first half of 2013 but rates having seemingly begun their longer-term unwind. We expect this to incrementally accelerate going into the second half of 2013 and to continue into 2014. Scotiabank Economics Global Forecast, published on December 20, 2012 – is forecasting a more subdued growth picture in 2013, although real growth is expected to accelerate going into the second half of the year. Scotia expects that US real GDP growth will decline to 2.0%, down from 2.2% in 2012, while Canadian GDP is expected to fall to 1.7%, down from 2.0% in 2012. In both instances, growth is expected to pick up in the second half of 2013. A number of risks are expected to keep both rates and growth prospects slightly more contained in the beginning of the year including:

Spending and debt ceiling negotiation in the US. Although legislation (American Taxpayer Relief Act of 2012) was passed very late in 2012/early 2013 to avert some of the potential fallout from the US fiscal cliff – the deal delayed negotiations on potential spending cuts. The fact that these negotiations will now coincide with debt ceiling discussions, adds an element of risk and uncertainty that will likely impede near term growth and leave overall rate levels well contained in the first half of 2013.

Although the European debt crisis does seem to be incrementally groping its way to a sustainable solution, the continued risks and potential for global headline risk should not be underestimated. With the European Economic and Affairs Council having arrived at an agreed position on bank supervision – namely to establish the ECB as a central bank regulator for European banks – the council took an important first step in establishing a Single Supervisory Mechanism (SSM). A mechanism which could potentially transfer the burden of European bank recapitalization away from European governments. While the theory appears pleasing to the eye, there remain a number of practical implementation hurdles which have the potential to lead headline risk in 2013 – keeping risk markets at bay. Keeping in mind that the European Union remains young and the potential for political and social unrest remains high – Europe will continue to be an important area of concern in 2013.

Despite the European debt crisis and political wrangling in the US having the potential to contain rising rates, technical trading indicators support the view that rate normalization is gradually beginning. Over the past few months markets have increasingly looked past European headline risk while being encouraged by the improving economic picture in the US. This was demonstrated by the recent move upward in US yields after the passing of December’s fiscal cliff deal where US 10-year yields finally broke through their 200-day moving average – a break out not convincingly seen since March of 2012. With the US economic data gathering positive momentum; a seemingly firm commitment to deal with the European debt crisis; and questions rising within the Fed as to whether extraordinary monetary policy stimulus should continue beyond 2013 – a supportive backdrop for rate normalization now seems to be more firmly in place than at any time in the recent past.

US Treasury 10-Year Yields (Exhibit 1): US Treasury yields recently broke above their 200-day moving average of 1.75% on December 17, 2012 and have continued to trade in the 1.75% to 1.91% level. This breakout represents a feat not accomplished since Mar 14, 2012 (303 days) and not sustainably accomplished since December 7, 2010. The move reflects risk market relief over the fiscal cliff agreement and recent steps taken in Europe.


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Although we would still expect any movement upwards to be carefully tempered by the Fed’s desire to sustain the growth trajectory of the US housing market, rates do appear to be poised to move higher in the back half of 2013. This would leave returns in the Canadian bond market largely negative over the next 12-15 months. Should this base case materialize, we would expect Canadian rates to be generally pulled along with those of the US, although the bias for higher rates in the front end, and in the belly of the Canadian curve, would likely be more upwardly pronounced. Tempered Canadian inflation concerns would likely see the long end of the Canadian curve hold in a bit better than that of the US.

Based on where current rate levels are trading, and Scotia forecasts, our expectation for total returns over the next 12-15 months is largely negative. Scotia Economics’ December 20, 2012 forecast is calling for Canadian 5 and 10 year rates to end Q1/14 at 2.40% and 2.70% respectively. Long dated bonds are expected to rise to 3.35%. The implications on our Horizon model is that Canadian government long bonds will be the poorest performing bond class returning -13.95%. The best performing bonds promise to be in the 2-year area of the curve, providing an anemic 1.61% for in single A bank paper.5

Canadian Curve (Exhibit 2): Scotia Economics year-end forecast suggests that the Bank of Canada will remain on hold at 1.00% until Q1/14. 5-year and 10-year yields are now expected to rise to 2.40% and 2.70% respectively, by the end of Q1/14. Long bonds are expected to widen to 3.35% over the same period. Consensus forecasts are currently calling for a flatter Canadian curve.

5 Scotiabank Global Forecast Update, December 20, 2012

Exhibit 1: US Treasury 10-Year Yields

Source: Bloomberg

Exhibit 2: Canadian Curve

2 YearCanada

2 YearProv

2 YearA Bank

2 YearA Corp

5 YearCanada

5 YearProv

5 YearA Bank

5 YearA Corp

10 YearCanada

10 YearProv

10 YearA Bank

10 YearA Corp

30 YearCanada

30 YearProv

30 YearA Bank

30 YearA Corp

Scotia 0.66% 0.88% 1.61% 1.38% -1.86% -1.21% -0.27% -0.79% -3.58% -2.26% -0.79% -2.16% -13.94% -10.77% -5.25% -2.16%Consensus 0.80% 1.01% 1.74% 1.52% -0.86% -0.22% 0.71% 0.19% -2.37% -1.10% 0.31% -1.00% -7.22% -4.86% -0.62% -1.00%

-16.00%

-14.00%

-12.00%

-10.00%

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

One Year Forecast Returns

Source: Scotiabank Global Forecast Update; Scotia McLeod


Winter 2013 47

Corporate Credit in 2013 – The Quest for Yield Will Continue to Be Supportive of Higher Beta, Higher Yielding Bonds and…..GICs??? The quest for yield and insulation against higher underlying government rates will likely leave corporate credit well bid in 2013 – higher beta names will likely outperform. Although bank paper will continue to provide decent liquidity over the coming year, spreads in this category have rallied notably in 2012. With bank paper seemingly having little room left to compress, we see little upside in this space. Investors willing to bear medium to high risk exposures will continue to be drawn to higher yielding bonds in 2013 – leading to a more meaningful upside in higher beta names. This view is driven by: (1) the belief that in the quest for yield investors will continue to move up the risk scale and down the capital structure scale in 2013; (2) the relatively healthy balance sheets held by most Canadian companies will mitigate the perception of risk for many investors; (3) expectations for relatively strong credit fundamentals over the coming year will be supportive of a higher beta strategy, within appropriate risk tolerances (4) The expectation that global risks will persist, but will begin to retreat in the second half of 2013, leaving the potential for some upside in credit. Investors should keep in mind that relative outperformance might not necessarily translate into positive nominal returns in the event that rising government rates outstrip the pace of spread compression.

For those investors looking to sustain exposure to higher quality credit protection, GICs will likely continue to offer attractive relative value. Over the past year, GICs have typically offered some excess return over comparable senior deposit note credit as banks and other financials have sought to capture some short-term funding at the front end of the Canadian curve. We believe that this trend will continue in 2013. For those investors looking to take on shorter term credit risk in high quality names (or lower quality names with CDIC protections) GICs will likely remain a relatively attractive place to investment money.

GIC Pick-Up over Deposit Note (Exhibit 3): The following chart compares before commission GIC yields of AA rated GIC issuers and deposit note yields of various Canadian issuers. Although GICs will typically be less liquid, for clients assuming a buy and hold approach, they will typically realize a 10-40bps pick up over comparable term deposit notes. Assuming investors remain within CDIC protection limit these yield pick-ups can be marginally higher for non-rated entities.

Exhibit 3: GIC Pick-Up over Deposit Notes

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

0 1 2 3 4 5

Yield

Maturity (in Years)

Bank Deposit Notes vs. GICs Yields

GICs

Deposit Notes

Source: PC Bond Analytics


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So What Should Fixed Income Investors be Doing in 2013? Most importantly look at your asset allocations and begin to rebalance. Bonds appear poised to conclude a 30-year secular run. 2012 was another decent year for bonds but total returns are increasingly running out of steam. With the unwind in rates looking likely to accelerate in the back half of 2013, investors should be looking at their asset allocations and ensuring that they are appropriately positioned for such an eventuality – based on their risk/return objectives and constraints.

Lower grade bonds will likely outperform in the coming year. Investors with corporate credit exposures will likely benefit from having some portion of their portfolio in higher beta names (e.g. single A and BBB ratings). With the high degree of spread compression seen in higher quality names (e.g. deposit notes) we do see there being potential for spread expansion in that space – potentially compounding the impact of rising government rates. Investors could benefit from exposures to higher beta names and sectors including Communications, Real Estate and Life Insurance. Investors may also be able to benefit from some expose to High Yield bonds, although familiarity and diversification do become a concern in this space. Again, investors should always consider their risk tolerances when moving up the risk scale.

For those investors with relatively low liquidity needs and a desire to remain high on the quality scale, GICs will continue to be a good alternative. Over the past year GICs have provided a decent yield pick up over comparable quality (more liquid) paper. For investors who have the capacity to assume a buy and hold approach, GICs will be an important area of focus. Although secondary markets are typically available for GICs, investors will typically do better to hold to maturity.

The balance of our recommendations remain largely the same: For fixed income exposures remain shorter duration, overweight credit and Canadian dollar exposed. The seeming end of the secular bull markets for bonds continues to favor shorter duration positioning as does an overweighting of credit. As well, we believe the Canadian dollar will continue to exhibit strength over the coming year, relative to most major currencies, leaving little reason to look outside of our own borders for fixed income needs.


Winter 2013 49

Equity Hybrid Strategy Investing in Convertible Bonds Jean-Anthony Mentor– Associate, Portfolio Advisory Group – Equity Hybrids

Why? Convertible bonds are hybrid securities that share features of both bonds and equities. They have the ability to offer investors a risk profile that is similar to that of corporate bonds while providing returns comparable to the performance of common shares. At issuance, convertible debentures are structured like corporate bonds as they typically distribute semi-annual coupon payments and the company has an obligation to pay the principal at a set maturity date in order to avoid defaulting on the debt.

However, convertible debentures have a call option on the issuer’s common stock and instead of trading over-the-counter, most of them trade on public exchanges (with a few exceptions). This allows for greater transparency over regular bonds since investors can see bid and ask prices as well as posted volumes.

Unlike regular corporate bonds, convertible debentures are often structured to allow the issuer to redeem the principal amount of the security at approximately 60% of the term after inception under certain conditions. Moreover, they can do so unilaterally one to two years prior to the final maturity date. When used in a strategic and/or opportunistic asset allocation strategy, the advantage is that the converts may help lower the duration of a bond portfolio. Lower sensitivity to changes in interest rates tends to lower a component of the volatility associated with converts. The majority of the new convertible bonds in 2012 were issued with an average term to maturity of five to six years.

Convertible bonds typically share many characteristics that are akin to high yield bonds. They are subordinated debentures and they rank below the claims of senior creditors of the issuer. Those can come in the form of bank loans (i.e.: revolving bank credit facilities) followed by senior straight bonds that are non-convertible. Yet in terms of corporate liabilities, converts rank ahead of the preferred shares and the common stock of the issuer. These products are often issued as an alternative source of financing and allow the company access to another source of capital. The investor is compensated with greater yields than government bonds as well as other investment grade non-convertible corporate bonds.

Not all stocks appreciate or depreciate at the same time and by the same magnitude. Also bonds tend to outperform equities in poor economic times. Purchasing a convertible debenture facilitates the participation in two asset classes and it enhances a portfolio’s diversification due to the lack of pure correlation with either bond or equity markets. Convertible bonds allow for the participation in the upside of a growing firm while offering the stability and the downside protection of a regular fixed income security.

Risks There are many potential risks that should be considered before purchasing a convertible debenture and they should not be underestimated. The market of convertible debentures simply represents an alternative source of financing for a non-investment grade company and it would typically be subject to much less restrictive covenants on its publicly issued debt. Generally, this type of hybrid security is not rated by a credit rating agency the majority of times or is non-investment grade when rated. Assessing the firm’s ability to meet fixed debt charges remains crucial. Although they are considered debt on a company’s balance sheet for accounting purposes, convertible bonds are subordinated debentures that rank below the senior debt on the firm’s capital structure.


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Investors should be aware of the changes and the volatility associated with benchmark interest rates. The price of the underlying stock as well as its volatility can also be a source of concern. The price of a convert may fall below its straight value and by a greater proportion than its stock when a company is in distress. Many of the firms that issue convertible debentures are small to medium sized firms in terms of market capitalization. Overall, they are much less liquid than bonds, preferred shares or stocks.

Also, exercising your conversion right further dilutes the stocks of the company. Stock splits or stock dividends dilute the value of the conversion privilege unless the conversion ratio gets adjusted. As previously mentioned, many convertible issues have call features that allow a company to redeem its debentures at par value before the maturity date. When ignored, that can lead to purchasing an investment with a negative yield. On the other hand, converts can sometimes get extended beyond the original maturity date if the company succeeds in getting the sufficient number of vote approvals from debentureholders. Finally, most issuers retain the right to meet their interest and principal payment obligations by delivering newly issued common shares.

Taking all of these into consideration, convertible debentures are viewed as suitable for investors with a moderate to aggressive risk tolerance and a balanced risk/reward profile at the very least.

Valuation Challenges The valuation of convertible bonds remains very complicated. One cannot simply add a credit spread over a benchmark government yield to explain the valuation of an issue. Companies active in the convertible debenture market typically have a small equity market capitalization. As such, converts tend to have stronger correlation to the small cap sub section of equity markets. In addition to its straight bond value, the pricing of this hybrid security is also affected by multiple embedded options. The underlying common share price, the stock volatility, the dividend yield, stock borrowing rates, the level of interest rates, time to maturity, coupon levels, issuer and investor redemption options, liquidity, credit quality as well as put options all need to be evaluated. The challenge is in assessing the value of each option. Convertible debentures need to be valued as these multiple factors interact with each other.

Convertible Bond Strategies Seeing as convertible bonds are “hybrid securities”, purchasing that asset class allows for the adoption of a number of different investment strategies and concepts. Understanding the various mechanisms of the product and knowing which approach to use relative one’s risk/reward profile is the key to ultimate success in this risky asset class, regardless of the current [or expected] market environment. You cannot trade or control the market; you can only trade your “beliefs” about the market. As a result, it is important for an investor to determine exactly what those beliefs are in advance, set objectives given their risk tolerance and establish a plan that will be appropriate to help reach those objectives. In order to maximize the potential of investing in the convertible bond market, it is important to consistently apply your investment strategy and exercise discipline. For example, you could establish predefined targets for gains and losses at let’s say +/-10%. It might be a time to re-evaluate the position once its goes beyond +10%. However, you would decide to exit out of the position once it declines -10% and move into another security that is in line with your investment strategy.


Winter 2013 51

Convertible debentures should be used as a sub component of a portfolio’s fixed income asset allocation that allows for non-rated and/or non-investment grade securities. It is not a exact science, but the convertible bond portion within the fixed income allocation of a portfolio for an investor with a moderate to aggressive risk tolerance should range between approximately 10% and 25%. Whether converts are used for their “high yield” features, bond-like attributes or equity-related prospects, they can strategically be incorporated within the income producing section of an investment portfolio to tactically enhance overall yields and rate of returns. Unlike regular bonds, the “buy and hold” strategy might not always fully exploit the potential of that asset class but rather an “actively managed” approach might be more valuable.

1) High Yield Bond Strategy (Aggressive Strategy) This strategy involves the search for converts that trade at a deep discount or a higher yield relative to their peers. Investors can specifically look to purchase convertible bonds from issuers that have a weaker credit profile relative to the broad market. These issues are often more illiquid than average but debenture holders will tend to be compensated with higher coupon payments and/or a higher yield-to-maturity. Such debentures will trade at a very high conversion premium and the basic concept of downside protection while being able to participate in the rise of stock prices no longer really holds. It is a very speculative investment strategy that tries to exploit opportunities from companies operating in a difficult economic and business environment. This strategy is only suitable for sophisticated and knowledgeable investors that have an aggressive risk profile. Success is dependent on the correct assessment of the issuer’s probabilities of survival.

Exhibit 1: Convertible Price Behavior

BondPrice

Underlying Stock Price

Credit/Interest Sensitive Hybrid Equity Sensitive

Bond value

Stock price

Convert price

Downside

Upside

Source: PIMCO, Author, Frank J. Fabozzi with Steven V. Mann (2005). The Handbook of Fixed Income Securities. (Seventh Edition). New York NY: McGraw-Hill


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2) Hybrid Security (Most Common Strategy) With this strategy, the investor is purchasing a convertible bond that is trading near or slightly above its par value. At that level, conversion premiums are in the mid section of the spectrum. The investor will still benefit from a level of capital preservation but at the same time, the hybrid convertible bond will provide indirect equity exposure and allow participation in a portion of the rise in the price of the stock. Although losses can never be fully avoided with convertible debentures under any circumstances, capital preservation must be supported by a sound credit analysis of the corporate issuer in the hopes that the company will remain solvent in spite of falling equity prices and that the bonds will be repaid at maturity. On the other hand, as equity prices rise, the investor needs to be aware of the increasing sensitivity to the common shares, greater downside risk, and adopt a strategy to lock in the gains achieved up to that point. Obviously… buy low, sell high!

3) Equity Alternative (Bullish on Underlying) One of the great advantages of purchasing convertible bonds is being able to participate in the significant upside potential in response to a rise in the underlying common equity if it performs well. The debentures in this strategy will tend to trade at a price premium above par value but the investor will be compensated by a higher capital appreciation potential. The convertible bond will display a very low conversion premium but it will also experience the same volatility as the stock. Once the underlying common shares of the issue begins trading at and above the debenture’s conversion price, the security will have an upside potential practically identical to the equity. It is typical for this strategy to yield a higher total return as compared to directly holding the equity. When the equity pays very little or no dividend, the investor is only compensated with capital appreciation. When holding the convertible debenture, the investor is actually getting paid interest in addition to generating a capital gain due to a rise in the underlying common shares. While the downside risk will be comparable to that of a stock, the convertible debenture will outperform the equity when prices fall.

Controlling Risk & Knowing when to Exit The main aspect of succeeding in investing in convertible bonds is about controlling risk. It is very difficult and nearly impossible to predict the market and prices accurately into the future. What is important is that the size of profitable trades far exceeds the size of losing trades. There needs to be a careful balance between profits and losses. That can be achieved by knowing how much to invest in a position and knowing when to exit out of a losing position. Predefining the initial risk you are willing to take sets the maximum loss you are willing to take (worst case scenario). It is a very simple measure designed to preserve your capital and that should be established before taking on any convertible bond position. It is also a way of quantifying your risk and reward ratio. Cut your losses and let your profits run!


Winter 2013 53

Mutual Fund Strategy Low Volatility Investing Carolyn Tsai – Mutual Fund Advisor, ScotiaMcLeod PAG Fund Research

Many investors continue to be hesitant in investing in equities after suffering significant losses during the credit crisis. As negative news such as the sovereign debt crisis, the fiscal cliff and subdued growth dominate the headlines, uncertainty still weighs heavily on investors’ minds. As volatility is expected to continue, investors need to rationally explore the options available to them. One option is to sit on the sidelines in money market or high interest savings accounts. While this option may protect investors from possible short-term loss of capital, it may at the same time expose them to other risks such as the erosion of capital and potentially missing meaningful opportunities to achieve their longer-term financial goals.

Another option is to move into bonds; however, there exist significant risks in this asset class given the low rate environment and the potential impact on value when rates rise.

The third option is to get back into equities. As evidenced in Exhibit 1, it appears that investors are still shying away from this option. Record equity fund sales in 2007 were followed by equity fund redemptions as the market fell in 2008 and into the early parts of 2009 with investors crystallizing what were once just paper losses. As the TSX rebounded significantly, investors remained fearful and continued to redeem out of equity funds thereby missing the significant rebound in 2009 and 2010. The outflow continues today.

While short-term volatility can cloud an investor’s judgment, the focus must be on long-term investing which we believe should include equities. For nervous investors, funds focused on managing volatility may be an appealing option. The prospect of limiting volatility risk while maintaining equity returns has gained momentum amongst institutional investors and we are beginning to see similar offerings in the retail world. Known as the low volatility anomaly, academic research has shown that buying the least

Exhibit 1: Equity Fund Flows Versus S&P/TSX Composite TR

Value of $100 invested in the S&P/TSX Composite TR on December 1, 2002

Equity Fund Flows (billions $): $6.3 -$9.1 -$5.9 -$7.0 -$10.8 -$12.9Up to the end of Nov 2012

2012201120102009200820072006200520042003

Value of $100 invested in the S&P/TSX Composite TR on December 1, 2002

Equity Fund Flows (billions $): $6.3 -$9.1 -$5.9 -$7.0 -$10.8 -$12.9Up to the end of Nov 2012

2012201120102009200820072006200520042003

Source: IFIC, Morningstar Direct


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volatile stocks and holding them for the long term has matched and at times exceeded the overall market returns. As per Exhibit 2, on an annualized basis over the ten years ended March 31, 2012, the two low volatility indices experienced higher returns than the market cap-weighted benchmark S&P 500. Researchers have found that this is not isolated to the US as similar results were found in markets around the world.

There are a number of theories as to why the low volatility strategy works in spite of the traditional investment hypothesis of higher risk equals higher returns. Low volatility stocks are typically associated with profitable businesses with little leverage which produces stable returns over time. These are boring stories as opposed to the “glamour” stocks which typically attract investors’ attention. Preference for lottery-like payoffs leads large number of investors to bid up riskier names that are in the news which they believe will result in large gains in a short timeframe. On the flip side, these stocks will tend to drop more dramatically should there be negative news regarding the company or the market in general. Low volatility stocks therefore will tend to outperform during short-term sell offs. The smaller losses to recoup combined with the compounding effect over time may explain the outperformance of low volatility stocks over those with higher volatility over the long term.

The downside of the low volatility strategy is that it can underperform when the overall market is rising because investor tend to crowd into riskier stocks during big rallies. This strategy is therefore more suitable for investors focused on the longer term.

As mentioned, we are beginning to see launches of a number of investment funds in the retail space with each based on a different methodology. The available mutual funds include the family of RBC Qube Low Volatility funds, currently with Canadian and US mandates. Manager Bill Tilford is the head of Quantitative Investments at RBC GAM and has over 20 years of experience in quantitative management. As opposed to focusing on backward-looking risk measures of volatility, these funds are actively managed with custom risk models assessing forward looking factors such as growth and quality as predictors of future volatility. In addition to being experts in quantitative modeling, Mr. Tilford and his team provide a level of fundamental analysis to provide context to the numbers. We like these differentiating factors in the low volatility product space.

As volatility continues to dominate markets worldwide, it is important for investors to look beyond shorter-term market movements. We feel the inclusion of equities in a well-balanced portfolio is important in helping investors meet their financial goals. Low volatility strategies have become the focus of attention in the institutional world and we feel retail investors can benefit. For details on low volatility products and how to incorporate them into your portfolio, please contact your ScotiaMcLeod advisor.

Exhibit 2: Return and Risk Comparison

March 2003 to March 2012 Returns Standard DeviationS&P 500 Low Volatility Index 6.95% 10.75MSCI USA Minimum Volatility Index 5.10% 12.32S&P 500 4.12% 15.99

Source: Soe, Aye M. (2012) “The Low Volatility Effect: A Comprehensive Look” S&P Dow Jones Indices


Winter 2013 55

Exchange Traded Funds The Differences Between Physical and Synthetic ETFs

Joël Bériault – Advisor, ScotiaMcLeod PAG Fund Research Team

There are two main types of Exchange Traded Funds (ETFs) trading on stock exchanges around the world: the traditional or “physical” ETFs, and the newer, “synthetic” ETFs. The majority of ETFs trading in North America are physical ETFs whereas synthetic ETFs are much more common in Europe comprising approximately 37% of assets, having declined from about 50% only two years ago.

Physical ETFs are open-ended structures that trade on a stock exchange and hold a basket of physical securities. They will typically try to replicate a specific index by investing directly in the securities that constitute that index. The open-ended structure means that new ETF units can be created and existing units redeemed resulting in a process that ensures the value of the ETF is aligned close to the value of the underlying basket. The process by which new units are created for physical ETFs is also known as “in-kind” creation because virtually no cash is exchanged between the Authorized Participant (typically a large financial institution) and the ETF itself. This unit creation process also shows that the liquidity of an ETF is primarily determined by the availability of the underlying basket of securities and the efficiency of the exchange between the Authorized Participants and the Capital Markets.

Physical-based ETFs are transparent because their underlying holdings are normally reported daily, and in general are easily understood. However, the fees and tracking error can be higher due to the nature of indexing; there can be, and regularly is, turnover caused by index requirements (changes in market capitalization) and the cost-driven difficulty of precisely managing the securities in the portfolio.

Synthetic ETFs are very similar except that instead of holding physical securities, these ETFs will replicate the performance of an index through the use of derivative instruments such as swaps. These derivative contracts are usually done with a Canadian chartered Bank as the counterparty. This process involves an ETF posting collateral and having a counterparty pledge the return of the chosen index in exchange for the return generated by the collateral. The swap counterparty is contractually obligated to deliver the precise index return, and bears all responsibilities, risks and costs of managing the index exposure.

Synthetic ETFs will deliver the exact performance of an index, so they have much lower tracking error than a physically replicated ETF. In the case of an ETF that uses a total return swap, the ETF receives the total return of the index, which means no distributions are made making the ETF more tax efficient as well (Exhibit 1).

While both physical and synthetic-based ETFs share the common goal and attempt to replicate the performance of a specific index, their costs, performance and risk characteristics differ. January

Costs

Physical ETFs will typically have higher transaction costs and thus fees because the ETF manager has to regularly rebalance the ETF weightings in order to ensure that all of the index constituents are represented in the same proportion as that of the referenced index. With synthetic ETFs, the actual shares are not physically held and therefore can have lower transaction costs and fees because the ETF manager does not have to physically rebalance the portfolio as the index weightings change.

Exhibit 1: Examples of Physical and Synthetic ETFs Physical ETFs Ticker Synthetic ETFs Ticker Index

iShares S&P/TSX 60 Index Fund XIU Horizons S&P/TSX 60 Index ETF HXT S&P/TSX 60 TRiShares S&P 500 Index Fund (C$ Hedged) XSP Horizons S&P 500 Index (C$ Hedged) ETF HXS S&P 500 (C$ Hedged)

Source: Morningstar Direct


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Performance

In the case of synthetic-based ETFs, the counterparty delivers the precise return of the index to the ETF provider, and the investor receives that return minus the fees. Because of this structure, the return of the ETF will always closely match the return of the underlying index, or in other words will have a lower tracking error. On the other hand, because physically-based ETFs must constantly physically rebalance the fund in question, its tracking error will typically be higher.

Risk characteristics

For physical-based ETFs, the risks are threefold: 1) market related, 2) the potential failure of delivery of units by the authorized participant, and 3) the risk of securities lending.

Most physical ETFs lend out a portion of the securities that they hold to generate additional revenue. The ETF temporarily transfers the securities to another investor in exchange for collateral, such as cash or other securities. If the ETF needs to sell stock, it needs to get it back from the borrower. If the borrower is unable to deliver the shares, the ETF uses the collateral. The risk with securities lending is that the securities may not be returned (if the borrower goes bust, for example), and need to be replaced at a higher value than the posted collateral.

In the case of synthetic-based ETFs, the Fund delivers the performance of an index without actually directly owning the securities. In this case, the counterparty promises to deliver the returns as if the securities are physically held. This structure involves posting collateral and having a counterparty pledge the index return which adds an element of risk not present with the physical-based ETF structure. The counterparty risk can occur if the counterparty terminates the swap agreement early (due to bankruptcy as an example) and as a result the ETF provider has difficulty finding a new counterparty.

In Canada, counterparty risk and collateral risk are very minimal as it is the big Canadian Chartered Banks that are providing this service. In addition, they have the infrastructure in place, benefit from economies of scale and are well funded.

In general the physical-based ETFs employ a more straightforward structure and process while synthetic-based ETFs may require more scrutiny due to their more complex structure; ultimately however, the key thing is to understand the benefits and the costs of each. When it comes to selecting the right ETF, investors should not focus on which type is safer but rather how risky is this particular ETF and how will it fit within their portfolio. Investors should therefore make an effort to educate themselves on the ETF structure, the cost, tracking error and tax efficiency of the structure, the quality of the counterparty or securities lending program, the quality of any collateral, the transparency of the ETF and the overall objective and potential risks of the ETF itself.


Winter 2013 57

Equity Guided Portfolios Stephen Uzielli — Portfolio Manager, Portfolio Advisory Group

The Equity Guided Portfolios are models designed to provide investors with a convenient way of investing directly in individual holdings and building diversified portfolios composed of equity securities. The portfolios are actively managed by a dedicated Portfolio Manager with oversight from the Investment Committee of the ScotiaMcLeod Portfolio Advisory Group. Each portfolio has a specific mandate but they all have the common objective of providing investors with a consistent long-term rate of return through holding a portfolio of stocks comprised of industry leaders with unique franchises and strong management teams, combined with an attractive trend in profitability.

ScotiaMcLeod Canadian Core Guided Portfolio Performance Update

Canadian equities generated solid returns in the fourth quarter, concluding a year in which stocks advanced in every quarter with the exception of Q2. The most recent quarter commenced with a rather volatile October where Canadian stocks were influenced by U.S. corporate earnings releases and investors traded cautiously ahead of a tight U.S. Presidential election. October also brought early signs of improvement in the world’s second largest economy as China reported third quarter GDP grew 7.4%, its best quarterly performance since Q3, 2011. Market action in November suffered large swings as U.S. fiscal cliff talks weighed on market sentiment following Barack Obama’s victory in the U.S. Presidential Election. Equities also faced selling pressure on concerns over the potential for increased taxes on capital gains and dividends depending on how fiscal cliff negotiations were resolved. Canadian stocks underperformed U.S. stocks during the month, posting a negative return due to the impact of gold stocks as the S&P/TSX Gold Index declined 10.7% during the period. Stocks posted better returns in December however, as bond yields moved higher during the period and investors anticipated a positive resolution to the fiscal cliff negotiations in the U.S. Congress. Bolstering Canadian equity markets was news that the Canadian government approved two acquisitions in the oil patch by State Owned Enterprises (SOE): China-owned CNOOC Ltd.’s $15.1 billion bid for Nexen Inc. and Malaysian owned Petronas’ $5.2 billion bid for Progress Energy Resources Corp.

The Canadian Core Guided Portfolio increased in valued during the quarter, generating a total return of 2.2% while modestly underperforming the benchmark S&PTSX60 Index which posted a 2.3% return on the same basis. Although stock selection in the portfolio was generally favourable with strong relative gains in Financials, Telecom, and Materials, the biggest negative contribution can be attributed to poor returns among a couple of oil and gas holdings. WTI crude oil futures traded slightly lower during the quarter, ending the period down 1.7%, closing at US$91.82 per barrel. Natural gas futures moved modestly higher early in the quarter but fell off in December as the winter heating season started with above average temperatures; gas ended the quarter 0.9% higher, closing at US$3.35/mcf. Outside of the energy complex, other commodities delivered mixed returns; copper futures declined 1.7%, closing at US$3.69/lb. Gold bullion futures declined 5.1%, ending the quarter at US$1684/oz. Materials sector holdings outperformed the underlying sub-index despite very poor performance by gold stocks. The S&PTSX Gold Index underperformed the commodity during the quarter, declining 13.4% while portfolio holding Barrick Gold dropped 14% before we switched into a new position in Goldcorp Inc., which subsequently sold off 19% after the company indicated an increase in operating costs. Goldcorp has best-in-class assets and the highest production growth profile among senior gold producers. Meanwhile, the Claymore Gold Bullion ETF, which tends to track movements in the gold price more closely than do gold equities, declined 5.5%.


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One holding in particular caused a drag on performance as shares of Talisman Energy declined 19% before we sold the position in November following the announcement of a new corporate strategy which accompanied their Q3 financial results: a shift in focus away from the historic goal of 5%-10% production growth toward a new goal of merely sustaining current production, while maintaining a capital program equal to current year cash flow generation. Further details on this sale can be found in the Changes section below. Crescent Point Energy was another disappointing holding during Q4 as it dropped almost 14% during the period. The stock came under pressure after the company raised $750 million in new equity to fund the acquisition of Ute Energy Upstream Holdings LLC for $784 million, its first purchase in Utah’s Uinta Basin. The transaction marked the seventh acquisition and third equity financing in 2012 and investors responded with a degree of “deal fatigue” and an absence of buying.

The back-up in bond yields observed during the quarter fuelled a rise in Financial stocks, with insurance stocks performing particularly well as evidenced by the 15.6% lift in the shares of Sun Life Financial. Intact Financial shares rallied 8.3% during the period, partially propelled by very solid Q3 financial results released in early November. Shares of both Rogers Communications and Shaw Communications also responded well to better than expected financials; both stocks rose almost 14% in Q4. But the best performance among portfolio holdings was seen in the shares of Teck Resources which rallied +24.6% despite softness in copper, as the outlook for coal improved, coal volumes increased, and a 12% dividend increase was announced. Teck shares also benefitted from a migration by Freeport McMoRan shareholders looking for a copper investment alternative. (See Freeport notes in U.S. Core commentary).

The New Year’s Day legislation to resolve the fiscal cliff impasse dealt almost exclusively with the tax (revenue) side of the ledger; now Washington must focus on cuts to government programs (expenses) which will most assuredly be required by Republicans, forcing the White House to emphasize deficit reduction in order to get approval for the debt ceiling increase required by the end of February or early March. While we are constructive on equities for 2013, we anticipate the market may trade in a more narrow range until the debt ceiling negotiations are concluded successfully; discussions are expected to intensify after the President’s inauguration on January 21, 2013. Imminent spending cuts may restrain U.S. economic growth to some extent; however, we remain optimistic that the U.S. housing market will continue to improve and jobs growth will ultimately follow, perhaps more in the second half of the year, helping to support equity valuations in 2013.

Changes

On November 1st, we removed Barrick Gold from the portfolio after recently installed management announced poor Q3 results and further cost creep and delays at their Pascua-Lama project in Peru. This new information only served to further compound investor concerns around management credibility at Barrick Gold, which is expected to keep the stock in the “penalty box” for some time. As a result, we elected to switch into a new position in Goldcorp Inc. (G) as we believe Goldcorp is the best way to maintain exposure to large cap gold producers. The company is a low cost producer and is the world’s second largest gold miner by market capitalization. While 85% of the company’s current production occurs in North America, G expects to grow their gold production by 70% over the next five years. Goldcorp was one of the first companies in the mining industry to return capital to shareholders through the paying of regular dividends. At the current annual dividend rate of $0.60 (paid monthly), G shares offer a 1.2% dividend yield.

On November 7th we removed Brookfield Renewable Energy Partners (BEP.UN) from the portfolio. We acquired the position in BEP.UN almost a year ago as we sought a defensive investment which offered both growth and an attractive dividend yield. In the intervening period the stock exceeded expectations; however, we had been advocating more cyclical exposure in portfolios and elected to take profits. The shift in portfolio emphasis is based on our investment thesis which anticipates the bottoming of economic growth in China and a better U.S. economy supported by continued improvement in housing and labour markets, and by extension consumer confidence. With this in mind, we added an Industrial


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name in Finning International Inc. (FTT). Finning is the world’s largest Caterpillar dealership, with operations in Canada (50% of revenue), South America (Chile, Argentina, Uruguay, and Bolivia; 36%), and the United Kingdom (14%). Each region consists of a network of Caterpillar dealerships that provide new and used equipment and related parts and services, a power systems business, and rental operations. We believed that the concern about potential slowdown in the global mining industry, cited most recently by Caterpillar management, was already reflected in the FTT valuation which was at historically low levels.

On November 7th we also removed Talisman Energy (TLM) from the portfolio; TLM had been a long-term holding in this portfolio, and outside of a few brief periods of outperformance, was a perennial underperformer. Similar to Barrick Gold, a long-term holding we exited the previous week, Talisman’s stock offered much promise in terms of production growth potential, and typically traded at a discount valuation to its peer group, making the shares often appear particularly attractive. The discount valuation invariably was proven justified however as the company repeatedly disappointed investors with project delays, operational issues, cost overruns, and earnings misses. Given the company’s new strategic direction which would limit growth, we switched into Baytex Energy Corp (BTE). BTE is engaged in the acquisition, development and production of crude oil and natural gas in the Western Canadian Sedimentary Basin and in the Williston Basin in the United States. Approximately 89% of Baytex's production is weighted toward crude oil, with a particular emphasis on heavy oil. The company’s corporate strategy is founded upon maintaining its production and asset base through internal property development and delivering consistent returns to its shareholders. Baytex pays a monthly dividend on its common shares, currently providing an annual dividend yield of 6.0%, with a reasonable payout ratio relative to the peer group. Although BTE shares trade at a premium valuation relative to its peer group, we believe the stock is attractive and the premium is justified by the company’s superior asset base and reserve life.

Exhibit 1: ScotiaMcLeod Canadian Core Guided Portfolio Risk Price Target Dividend Potential

Company Symbol Rating Ranking 31-Dec-12 Price Dividend Yield ROR

Interest Sensitive:

Bank of Nova Scotia BNS SP Low $57.46 $65.00 $2.28 4.0% 17%Brookfield Office Properties BPO FS Medium $16.96 $19.00 $0.56 3.3% 15%Intact Financial IFC SO Medium $64.77 $75.00 $1.60 2.5% 18%Rogers Communications RCI.B SO Medium $45.16 $50.00 $1.58 3.5% 14%Royal Bank of Canada RY SO Low $59.88 $72.00 $2.40 4.0% 24%Sun Life Financial SLF SP Medium $26.37 $27.00 $1.44 5.5% 8%Toronto Dominion Bank TD SP Low $83.75 $95.00 $3.08 3.7% 17%

Consumer Products:

Shaw Communications Inc. SJR.B SO Medium $22.84 $25.00 $1.02 4.5% 14%

Industrial Products:

Canadian National Railway CNR SO Medium $90.33 $100.00 $1.50 1.7% 12%Finning International FTT SO Medium $24.57 $28.50 $0.56 2.3% 18%

Resource:

Agrium Inc. AGU SO High $99.14 $120.00 $1.99 2.0% 23%ARC Resources Ltd. ARX SO High $24.44 $27.50 $1.20 4.9% 17%Baytex Energy Corp BTE SO High $42.87 $56.00 $2.64 6.2% 37%Canadian Natural Resources CNQ SO High $28.87 $38.00 $0.42 1.5% 33%Claymore Gold Bullion ETF CGL $14.98 $0.00 0.0%Crescent Point Energy Corp. CPG SO High $37.62 $52.00 $2.76 7.3% 46%Goldcorp GG SO Medium $36.57 $51.00 $0.59 1.6% 41%Suncor Energy SU FS Medium $32.71 $42.00 $0.52 1.6% 30%Teck Resources Ltd. TCK.B DC High $36.15 $46.00 $0.90 2.5% 30%TransCanada Corp. TRP SO Low $47.02 $55.00 $1.76 3.7% 21%



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ScotiaMcLeod Canadian Income Plus Guided Portfolio Stephen Uzielli – Portfolio Manager, Portfolio Advisory Group

Performance Update

The Income Plus Portfolio proved to be the top performing Guided Portfolio during 2012 as investors sought higher yielding equities to help offset market turbulence. The Canadian Income Plus Portfolio generated a total return of 7.0% during the fourth quarter and 16.4% for 2012 as compared to the benchmark Dow Jones Select Canadian Dividend Index which returned 4.9% and 9.4% over the same time periods. Outperformance of the portfolio was supported by a heavy weighting in Energy positions which outperformed the sector while Financials holdings also largely outperformed the broader market.

The top performer in the portfolio was Sun Life Financial, up 15.6%, which reflected the rise in interest rates as sentiment improved toward the global economy. Portfolio performance was also augmented by contributions from Canadian banks which reported strong Q4 earnings. On average, bank holdings in the portfolio advanced 4.9% in the fourth quarter and 12.7% over the course of the year. Rogers Communications and Shaw Communications were also top performers on the back of strong Q3 earnings making these companies the preferred choice for investors over other names in the Telco sector. The best performers from the energy infrastructure space included pipeline companies Enbridge Inc. and Inter Pipeline Fund (IPL.UN). IPL.UN moved higher after reporting strong Q3 results while also announcing a 5.7% dividend increase. Only three portfolio holdings declined during Q4. The big laggard was Crescent Point Energy, while shares of Baytex Energy declined since adding it to the portfolio due to the widening in heavy oil differentials. Shares of Brookfield Renewable Energy were down a marginal 1.1% during Q4.

Changes

In December we elected to switch out of Vermilion Energy (VET) and into Baytex Energy (BTE). Vermilion Energy was added to the portfolio in August, 2011, and in the intervening period, the stock had generated a total return of approximately 21% which exceeded both the broader market as well as the Energy sub-index during the same period. In the shorter term, since the beginning of October 2012, shares of VET had rallied approximately 9.3% while the S&P/TSX Energy Index was down 3.2% over that same period. On a more macro scale, one of the main factors explaining the outperformance is the company’s relatively higher exposure to Brent-based crude oil as opposed to West Texas Intermediate crude oil. From a more micro perspective, also supporting the relative outperformance in VET shares was their 5% dividend increase. With the shares of VET trading near all-time highs, and despite the high-quality of the company’s operations and balance sheet, we elected to take profits in Vermilion, and re-invest the proceeds into another Energy company with a better risk/reward profile and a higher dividend yield, thus offering better total return potential: Baytex Energy Corp. (BTE)

Similar to VET, Baytex (described in the commentary for the Canadian Core Guided Portfolio) offers a solid balance sheet alongside conservative cash flow payout ratios. The annual dividend yield for Baytex is 6.0%, versus 4.8% for VET. With the shift into Baytex, the portfolio assumes less exposure to natural gas, which we believe will continue to face volatility in 2013. Baytex’s estimated gas production in 2013 is expected to be approximately 11% compared to that of Vermilion’s production of approximately 31% natural gas. Baytex currently has a reserve life index of approximately 13.0 years and this compares to Vermilion’s reserve life of 10.9 years.


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Exhibit 2: ScotiaMcLeod Income Plus Guided Portfolio Risk Price Target Dividend Potential


Interest Sensitive:

Bank of Nova Scotia BNS SP Low $57.46 $65.00 $2.28 4.0% 17%Brookfield Renewable Energy Partners LP BEP.UN SO Low $29.38 $32.50 $1.37 4.7% 15%Power Corp. of Canada POW SP Low $25.38 $26.50 $1.16 4.6% 9%Rogers Communications Inc. RCI.B SO Medium $45.16 $50.00 $1.58 3.5% 14%Royal Bank of Canada RY SO Low $59.88 $72.00 $2.40 4.0% 24%Sun Life Financial SLF SP Medium $26.37 $27.00 $1.44 5.5% 8%TELUS Corp. T SP Medium $65.10 $68.00 $2.56 3.9% 8%Toronto Dominion Bank TD SP Low $83.75 $95.00 $3.08 3.7% 17%

Consumer Products:

Shaw Communications SJR.B SO Medium $22.84 $25.00 $1.02 4.5% 14%

Industrial Products:Baytex Energy Corp BTE SO High $42.87 $56.00 $2.64 6.2% 37%Crescent Point Energy Corp. CPG SO High $37.62 $52.00 $2.76 7.3% 46%Enbridge Inc. ENB SO Low $43.32 $48.00 $1.26 2.9% 14%Gibson Energy Inc. GEI SP Medium $24.05 $24.00 $1.04 4.3% 4%Inter Pipeline Fund IPL.UN SO Medium $23.50 $24.00 $1.11 4.7% 7%TransCanada Corp. TRP SO Low $47.32 $55.00 $1.76 3.7% 20%



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ScotiaMcLeod U.S. Core Guided Portfolio Stephen Uzielli – Portfolio Manager, Portfolio Advisory Group

Performance Update

Despite positive performance in November and December, U.S. equities delivered negative returns in the fourth quarter, unable to offset a poor October. The benchmark S&P500 Index declined in October on the back of lower-than-expected earnings from market stalwarts like Google Inc., Apple Inc., and McDonald’s which weighed on market sentiment; weakness in earnings was partially balanced by improving U.S. economic data. While Euro debt fears continued to subside during October, the focal point for investors centered on U.S. corporate earnings releases. While the market sold off in the immediate aftermath of the U.S. election and rising anxiety surrounding the pending fiscal cliff, stocks rebounded in the back half of November and then through December as optimism grew and investors began to anticipate an improving economic outlook for 2013.

Toward the end of the quarter there was another sign of improvement in U.S. housing, as applications for U.S. home mortgages increased, rising 6.2% in the week ended December 7. Heading into 2013, housing is expected to make a greater contribution to economic growth, its more traditional role during economic recovery. Employment data is also getting better as U.S. jobless claims are near their lowest level since early 2008. Following the most recent FOMC meeting in mid-December, the Fed stated they are now targeting a specific unemployment rate of 6.5% before they see the Fed Funds interest rate rising from current low levels. The latest unemployment reading for December was 7.8%, the lowest since January, 2009. The Fed also committed to increase monetary stimulus through further Quantitative Easing measures, with plans to buy $45 billion of U.S. Treasuries per month starting in January. Curiously, minutes of that same FOMC meeting indicate an increasing tendency by many Fed governors toward reducing monetary stimulus earlier than anticipated. Regardless, the Fed’s comments are an acknowledgement that the U.S. economy is improving and may require a different monetary policy response at some point.

The U.S. Core Guided Portfolio underperformed relative to its benchmark in the fourth quarter, generating a negative total return of -1.8% while the S&P500 Index returned -0.4% on the same basis. There was a “risk on” or cyclical bias in the market as the top performing sectors were Financials, Industrials, and Materials, while ultimately the market was dragged lower by negative returns among Telecommunications, Technology, and Utilities. The largest negative contributors to portfolio performance during the period included shares of AT& T Inc. (-10.6%) which fell victim to sector rotation by investors despite reporting better than expected Q3 results in October. Technology shares sold off during the period with holdings in the sector on average falling more than 11%. Shares of Apple Inc. (-20.2%) declined on concerns regarding supply issues, profit margin compression due to the launch of several new products at once, management changes, and tax-related selling by investors electing to lock in long-term gains in advance of a potential capital gains tax increase in 2013.

Despite a successful launch of their new Windows 8 platform, Microsoft Inc. (-10.2%) shares dropped on investor concerns regarding slowing demand for personal computers due to cannibalization by tablet devices. The other big decliner in Q4 was Freeport McMoran Copper & Gold which declined 18% during the quarter prior to our exiting the position following the announcement of a company-changing new corporate strategy. Further details on this sale can be found in the Changes section.

There were several holdings which delivered double digit returns and for the second quarter in a row, the top performer was Marathon Petroleum (+15.4%) which closed the year at an all-time high; Marathon continues to profit from low cost oil in the mid-continent and the stock received an additional boost from the announcement of increased share buy-back activity. State Street Corp. (+12%) was also among the top gainers in the portfolio after beating expectations in their Q3 earnings report, while shares of drug and medical supply distributor McKesson Corp. (+12.7%) moved up after reporting Q2 earnings which beat


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estimates, and then announcing the purchase PSS World Medical Inc. for about $2.1 billion. Shares of Nike Inc. which had suffered earlier in the year on China-slowdown concerns rallied 8.7% in the quarter as the company agreed to sell its Cole Haan fashion brand to private-equity firm Apax for $570 million, then announced a 2-for-1 stock split and increased its dividend by 17%.

Our preference remains for equities over bonds in 2013 and cyclicals over defensive stocks. Given our constructive view toward the U.S. economy, we recommend increased exposure to U.S. equities. However, we anticipate a sideways market early in the year until the debt ceiling negotiations conclude, similar to the 1000+ point range observed in the Dow Jones Industrial Average during 2012. Meanwhile, bond yields are expected to continue rising which would be supportive for equities and Financials in particular. Scotia Economics is forecasting a 2.5% yield on U.S. 10-year Treasuries by the end of 2013. We believe some fixed income investors may begin to migrate into equities in 2013 to seek better returns.

Exhibit 3: ScotiaMcLeod U.S. Core Guided Portfolio Risk Price Target Dividend Potential

Sector Symbol Rating Ranking 31-Dec-12 Price Dividend Yield RORInterest Sensitive:

AT&T Inc. T 3-Hold Medium $33.71 $36.00 $1.80 5.3% 12%MetLife, Inc. MET 4-Buy Medium $32.94 $40.00 $0.74 2.2% 24%State Street Corp STT 4-Buy Medium $47.01 $50.00 $0.96 2.0% 8%Wells Fargo & Co. WFC 3-Hold Medium $34.18 $36.00 $0.88 2.6% 8%

Consumer Products:

Coca-Cola Co. KO 5-Strong Buy Low $36.25 $44.00 $1.02 2.8% 24%McDonald's Corp MCD 4-Buy Medium $88.21 $101.00 $3.08 3.5% 18%McKesson Corporation MCK 5-Strong Buy Medium $96.96 $107.00 $0.80 0.8% 11%Nike Inc. NKE 3-Hold Medium $51.60 $56.50 $0.84 1.6% 11%Pfizer Inc. PFE 4-Buy Medium $25.08 $29.00 $0.96 3.8% 19%

Industrial Products:

Apple Inc. AAPL 5-Strong Buy High $532.17 $665.00 $10.60 2.0% 27%Caterpillar Inc. CAT 4-Buy Medium $89.61 $117.00 $2.08 2.3% 33%EMC Corp EMC 4-Buy Medium $25.30 $30.00 $0.00 0.0% 19%Fluor Corp. FLR 4-Buy Medium $58.74 $70.00 $0.64 1.1% 20%General Electric Co. GE 3-Hold Medium $20.99 $24.00 $0.76 3.6% 18%Intel Corp. INTC 3-Hold Medium $20.62 $23.00 $0.90 4.4% 16%Microsoft Corp MSFT 5-Strong Buy Medium $26.71 $37.00 $0.92 3.4% 42%

Resource:

ExxonMobil Corp. XOM 5-Strong Buy Low $86.55 $103.00 $2.28 2.6% 22%Marathon Petroleum Corp. MPC 4-Buy Medium $63.00 $70.00 $0.40 0.6% 12%Occidental Petroleum OXY 4-Buy Medium $76.61 $100.00 $2.16 2.8% 33%SPDR Materials Select Sector ETF XLB $37.54 $1.32 3.5%

Source: Scotiabank, S&P , Bloomberg


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Changes

On December 4, 2012, we recommended reducing positions in Freeport McMoRan Copper & Gold (FCX) in response to the company-altering surprise announcement regarding plans to acquire two companies in oil and gas exploration and production. FCX plans to pay $6.9 billion in cash and stock to acquire Plains Exploration & Production and another $2.1 billion in cash to acquire the balance of McMoRan Exploration that they do not already own. The proposed acquisitions represent a dramatic shift in strategy, (pro forma 74% mining / 26% oil & gas, versus the current 100% mining), and management did not clearly defend their perspective on the long-term benefits of the shift other than diversification both geographically and by commodity. The significant share price decline in response to the announcement reflected investors’ negative view regarding FCX’s announcement as they apparently preferred FCX as a pure play mining company, as do we.

Although we believed the share price decline was probably an over-reaction from a long-term investment perspective, we also felt the stock would remain in the “penalty box” in the short term and did not envision any near-term positive catalysts, short of a rebound from oversold conditions and/or a general market move higher. We advised selling half of FCX positions to protect against further near term downside, anticipating selling the balance on any bounce in the share price. The following week we decided to exit the balance of the position following a relief rally, and switched into an ETF representing broad Materials sector exposure: SPDR Materials Sector ETF (XLB).

SPDR Materials Select Sector ETF (XLB) seeks to track the price performance of the underlying holdings in the S&P 500 Materials Select Sector Index. Our oft-stated investment outlook sees continued U.S. economic momentum supported by ongoing recovery in the U.S. housing market and gains in employment. We wanted to remain virtually fully invested in equity portfolios in anticipation of a positive resolution to the fiscal cliff debate and our belief that investors should be positioned in advance of that event. Specifically we favour cyclicals over more defensive sectors and so wanted to maintain exposure in the Materials sector. We continue to analyse appropriate switch candidates in the U.S. Materials group but until identifying our next investment, will hold a position in the SPDR Materials Select Sector ETF.


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ScotiaMcLeod North American Core Guided Portfolio Stephen Uzielli – Portfolio Manager, Portfolio Advisory Group

Performance Update

The North American Core Guided Portfolio generated a negative total return of -0.8% during the quarter, lagging the hybrid benchmark North American index which generated a positive 1.6% return on the same basis. The U.S. dollar advanced against global currencies early in the quarter, only to retreat post-election in the wake of fiscal cliff concerns, ending the quarter essentially unchanged. While trading in a similar pattern versus the Canadian dollar, the U.S. dollar advanced 1.1% against the loonie in Q4 which had the effect of partially mitigating the declines among U.S. portfolio holdings during the period after allowing for currency translation.

Top performing holdings in the fourth quarter included Sun Life Financial, Nike Inc., and Teck Resources. Several U.S. holdings were particularly hard hit during the period with the biggest declines seen in shares of AT&T Inc., Apple Inc., and Microsoft Corp., along with Canadian holdings Crescent Point Energy and Goldcorp Inc.

Changes

Late in the quarter we made changes in this portfolio as well, selling Barrick Gold and switching into Goldcorp Inc. for the same rationale described in the commentary for the Canadian Core Portfolio.


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Exhibit 4: ScotiaMcLeod North American Core Guided Portfolio Risk Price Target Dividend Potential


Financials:Interest Sensitive:Bank of Nova Scotia BNS SP Low $57.46 $65.00 $2.28 4.0%Brookfield Office Properties BPO FS Medium $16.96 $19.00 $0.56 3.3% 15%Royal Bank of Canada RY SO Low $59.88 $70.00 $2.40 4.0% 21%Sun Life Financial SLF SP Medium $26.37 $27.00 $1.44 5.5% 8%Toronto Dominion Bank TD SP Low $83.75 $95.00 $3.08 3.7% 17%Wells Fargo & Co. WFC 3-Hold Medium $34.18 $36.00 $0.88 2.6% 8%

Telecommunication Services

AT&T Inc. T 3-Hold Medium $33.71 $36.00 $1.80 5.3% 12%

Consumer Discretionary

McDonald's Corp MCD 4-Buy Medium $88.21 $101.00 $3.08 3.5% 18%Nike Inc. NKE 3-Hold Medium $51.60 $56.50 $0.84 1.6% 11%

Consumer Staples

Coca-Cola Co. KO 5-Strong Buy Low $36.25 $44.00 $1.02 2.8% 24%

Health Care

Pfizer Inc. PFE 4-Buy Medium $25.08 $29.00 $0.96 3.8% 19%

Industrials

Canadian National Railway CNR SO Medium $90.33 $100.00 $1.50 1.7% 12%Fluor Corp. FLR 4-Buy Medium $58.74 $70.00 $0.64 1.1% 20%General Electric Co. GE 3-Hold Medium $20.99 $24.00 $0.76 3.6% 18%

Information Technology

Apple Inc. AAPL 5-Strong Buy High $532.17 $665.00 $10.60 2.0% 27%EMC Corp. EMC 4-Buy Medium $25.30 $30.00 $0.00Intel Corp. INTC 3-Hold Medium $20.62 $23.00 $0.90 4.4% 16%Microsoft Corp. MSFT 5-Strong Buy Medium $26.71 $37.00 $0.92 3.4% 42%

Energy

Canadian Natural Resources CNQ SO High $28.64 $38.00 $0.42 1.5% 34%Crescent Point Energy Corp. CPG SO High $37.62 $52.00 $2.76 7.3% 46%Occidental Petroleum OXY 4-Buy Medium $76.61 $100.00 $2.16 2.8% 33%Suncor Energy SU FS Medium $32.71 $42.00 $0.52 1.6% 30%TransCanada Corporation TRP SO Low $47.02 $55.00 $1.76 3.7% 21%

Materials

Goldcorp Inc GG SO Medium $36.57 $57.00 $0.59 1.6% 57%Teck Resources Ltd. TCK.B DC High $36.15 $46.00 $0.90 2.5% 30%

Source: Scotiabank, S&P, Bloomberg


Winter 2013 67

ScotiaMcLeod Canadian Quant Guided Portfolio Stephen Uzielli – Portfolio Manager, Portfolio Advisory Group

Many investors find themselves looking for an investment methodology which removes the sometimes harmful element of emotion and human instinct from the decision making process. Quantitative (Quant) investing addresses this issue head-on as all investment decisions are driven exclusively by the output from a computer model which eliminates subjective factors while assessing investment opportunities. By following the results of historically successful, pre-determined statistical investment criteria, investors are relieved of the burden of decision making and can instead invest confidently by following a consistent, disciplined, and repeatable investment process.

The ScotiaMcLeod Canadian Quant Guided Portfolio is based on the results of a quantitative screening process utilizing a proprietary investment strategy developed by the ScotiaMcLeod Portfolio Advisory Group and driven by screening software and data provided by the Morningstar CPMS Equity Market Service (“EMS”). Morningstar is one of North America's leading independent equity research firms and enjoys a reputation for delivering only the highest quality data. Morningstar maintains EMS proprietary databases for the Canadian and US Markets, including historical data, adjusted for unusual, non-recurring items and/or discontinued operations. The EMS ranking software allows for simultaneous screening of fundamental characteristics, expectational, and technical data. (Morningstar is not acting as an investment advisor to ScotiaMcLeod or any ScotiaMcLeod client, and ScotiaMcLeod will not hold Morningstar out to any third party as acting in that capacity).

Holdings in the ScotiaMcLeod Canadian Quant Guided Portfolio will be selected from constituents of the S&PTSX60 Index. As this portfolio has a quantitatively driven investment mandate, there will be no requirement to have fundamental research coverage, favourable or otherwise, by Scotia Capital Equity Research or any other fundamental research provider, as this would be irrelevant to the process. Inclusion is determined by the top 15 ranked stocks based on a proprietary investment strategy which considers a combination of growth, dividend, and value criteria, creating a portfolio positioned in equal weights in each investment selected; there will be no attempt to derive specific sector allocation. Changes to the Canadian Quant Guided Portfolio, if any, are made on the first trading day of each month, based on results using previous month-end data; any holdings that no longer rank in the top half of the investment universe will be eliminated and replaced, in rank order, by new holdings that have moved up in ranking to the top 15.

Due to the concentrated nature of this portfolio, it will be subject to greater volatility as a result of the lack of diversification, and thus is inherently higher risk. As such it is appropriate only for investors with a medium to high risk tolerance.

The ScotiaMcLeod Canadian Quant Guided Portfolio provides investors with a focused investment solution which follows a consistent, disciplined, and repeatable investment process in pursuit of higher risk-adjusted returns.

Performance Update

The Canadian Quant Portfolio underperformed its benchmark during the quarter as it generated a total return of only 0.5% while the S&PTSX60 Index advanced 2.3% on the same basis; for all of 2012 the portfolio generated superior returns, increasing 13.6% versus the benchmark which posted a total return of 8.1% in the same time frame. Gold stock declines hurt performance in Q4 as shares of IAMGOLD Corp. (-26.9%), Yamana Gold (-8.9%), and Barrick Gold (-15.2%) all suffered losses. Top performers included Sun Life Financial (+15.5%), Rogers Communications (+13.5%), and Shaw Communications (+13.5%).


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Changes

There were no changes indicated for the ScotiaMcLeod Canadian Quant Guided Portfolio during the quarter. As per the quantitative screen conducted using data from month end on December 31, 2012, we present the holdings for the ScotiaMcLeod Canadian Quant Guided Portfolio:

The Guided Portfolios returns are not calculated according to CFA Institute "Performance Presentation Standards". Returns are calculated on a total return basis (including dividend income). The returns are used to gauge our performance by comparing the returns of the Portfolios to benchmark total return indices such as the S&P/TSX 60 and the S&P 500. Historical performance of the Guided Portfolios is not necessarily indicative of future performance. Each client's return will vary depending on the number of shares purchased, as well as the timing of purchases or sales. The Guided Portfolios themselves should not be used as benchmarks with which to compare our clients' portfolios.

Exhibit 5: ScotiaMcLeod Canadian Quant Guided Portfolio

Quant Price Dividend Risk Company Symbol Rank 31-Dec-12 Dividend Yield Ranking

Agrium Inc. AGU 1 $99.14 $1.99 2.0% HighSun Life Financial SLF 2 $26.37 $1.44 5.5% MediumIAMGOLD Corp. IMG 4 $11.39 $0.25 2.2% HighYamana Gold inc. YRI 5 $17.11 $0.26 1.5% MediumRogers Communications Inc. RCI.B 6 $45.16 $1.58 3.5% MediumPotash Corp. of Saskatchewan POT 7 $40.48 $0.83 2.0% HighBCE Inc. BCE 8 $42.63 $2.27 5.3% MediumSuncor Energy Inc. SU 9 $32.71 $0.52 1.6% MediumBarrick Gold ABX 10 $34.82 $0.79 2.3% MediumCanadian Imperial Bank of Commerce CM 11 $79.97 $3.76 4.7% LowNational Bank of Canada NA 12 $77.24 $3.32 4.3% LowBank of Montreal BMO 15 $60.86 $2.88 4.7% LowShaw Communications SJR.B 17 $22.84 $1.02 4.5% MediumPower Corp. POW 21 $25.38 $1.16 4.6% LowTELUS Corp. T 25 $65.10 $2.56 3.9% Medium

*As this portfolio has a quantitatively driven investment mandate, there are no recommendations or target prices listed.

Source: Scotiabank, ScotiaMcLeod, Bloomberg


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ScotiaMcLeod Core-Plus Fixed Income Guided Portfolio Tim Vlahopoulos —Director, Portfolio Advisory Group

Investment Objective

The ScotiaMcLeod Core-Plus Fixed Income Guided Portfolio (“Portfolio”) is designed for investors with a moderate to higher investment risk profile and who want to take a more active approach to managing their fixed income assets within a diversified portfolio. The objectives of the portfolio are to provide both a high level of current income, and a reasonable level of return to protect against future inflation. The overall goal of the portfolio is to exceed the performance of the DEX Universe Bond Index (“Index”). Typically, superior returns are not achieved every year; however, the goal is to achieve these rates of return over the long-term. Approximately 75% of the portfolio is invested in a 10-year bond ladder and 5% is invested in inflation-protected securities. These comprise the core holdings of the portfolio. The remaining 20% is allocated between two active value-added trade strategies that attempt to outperform the benchmark.

Market Update

Bond markets were generally softer in the fourth quarter of 2012 as market participants looked past the results of the US election, the "fiscal cliff" debate, and the European debt crisis, resulting in fourth quarter yields ending higher from an overall perspective as compared to the third quarter. The US 10 year Treasury traded in a range between 1.58% and 1.84%, only to end the quarter at 1.76%. The Canada 10-year experienced a similar path with the bond starting the quarter at 1.73% and ending at 1.80%. The trading range for this security was 1.69% to 1.91%.

US economic data showed an improving trend as employment and housing data demonstrated some buoyancy before the end of the year. However, brinkmanship politics over the "fiscal cliff" debate and lingering concerns out of Europe helped contain some of the weakness provided by the improving economic data. In the end, this containment was lifted once the American Taxpayer Relief Act of 2012 was passed. The passing of this legislation helped avert some of the impact of the much anticipated "fiscal cliff". Bonds sold off notably on the back of this news as it seemed that the market priced in a failure on the part of Congress to come to an agreement. The potential for continued bond selling into early 2013 remained somewhat contained though as Congress failed to come to a deal on a spending cut program as part of the package. The spending cut negotiations have now been pushed forward into early 2013 to coincide with the upcoming debt ceiling debate. This could provide an early opportunity for politics to once again emerge as a central theme and provide the potential to keep interest rates low on US Treasuries in the short term.

Performance Update

The ScotiaMcLeod Core-Plus Fixed Income Guided Portfolio returned 0.48% for the fourth quarter which ended on December 31st, 2012 while the DEX Universe Index returned 0.30%.

The Core-Plus Portfolio outperformed the Index because of the structure and composition of the portfolio as compared to the Index. The Core-Plus Portfolio was underweight the long end of the yield curve as compared to the index. The index has approximately 25% allocated in the long end of the yield curve while the portfolio only held about 12%. The Core-Plus Portfolio was also overweight short term, corporate bonds. The DEX Universe Index only had 28% allocated to corporate issues while the portfolio had a 32% allocation. Part of that allocation was in higher yielding securities which were up 3.07% for the quarter as measured by the iShares US High Yield Bond Index Exchange Traded Fund or XHY on the TSX. These two decisions impacted overall performance because firstly, the benchmark Government of Canada yield curve drifted higher at the end of the quarter as macroeconomic factors weighed on interest


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rates. Secondly, corporate debt, and high yield debt in particular, outperformed the indices. The corporate sector of the portfolio returned 1.33% for the quarter while the DEX Corporate Index returned 0.80%.

Current Active Strategies

The two active positions in the Portfolio were maintained this quarter as there were few trading opportunities that presented themselves. The iShares US High Yield Bond Index Exchange Traded Fund hedged against the Canadian dollar (XHY on the TSX) continued to be a holding in the portfolio. The ETF returned 2.90% for the quarter outperforming the 0.30% returned by the index. This position has generated a total return of 10.5% for the year while the index has returned 3.60%. The high yield sector of the market has been in favour as investors continued to search for yield in this low interest rate environment. The ETF attempts to replicate, as closely as possible, the performance of the Markit iBoxx USD Liquid High Yield Index but currency exposure is hedged back to the Canadian dollar.

The second active position was also maintained during the quarter. The second 10% allocation was equally invested in two cashable Guaranteed Investment Certificates while we wait for trading opportunities.

Forward Outlook

Going forward, global risks will continue to be a concern although those concerns related particularly to the US debt ceiling and spending negotiations should retreat going into the second quarter of 2013.

Our baseline expectation is that both Canadian and US economic growth will remain tepid in the first half of 2013 but will accelerate during the second half of the year and into 2014. The implications for bond total returns remains much the same, namely that both Canadian and US total returns will be negative across the greater part of both curves. This expectation continues to favour positions with a shorter duration and an overweight in credit in either market. However, based on Scotia forecasts, the Canadian dollar is still expected to outperform most other major currencies in 2013, leaving Canadian dollar fixed income securities as the preferred choice.

Exhibit 1: ScotiaMcLeod Core-Plus Fixed Income Guided Portfolio

Issuer Name CouponMaturity or Call Date

Current Weighting

Total Return for Q4 2012

Total Return Year To Date

Core PositionsCanada 5.000% Jun 1, 2014 7.3% 0.05% 0.61%CMHC 4.350% Feb 1, 2017 7.4% 0.18% 1.66%Canada 3.250% Jun 1, 2021 7.4% -0.17% 3.62%Canada RRB 3.000% Dec 1, 2036 4.9% 0.14% 3.46%Royal Bank Fixed Floater 5.450% Nov 4, 2013 7.5% 0.49% 2.30%Canadian Tire Corp 4.950% Jun 1, 2015 7.5% 0.51% 3.67%Telus Corporation 5.050% Jul 23, 2020 7.6% 0.51% 8.96%Metro Toronto 5.600% Dec 18, 2018 7.3% 0.41% 3.21%Saskatchewan 4.500% Aug 23, 2016 7.5% 0.16% 1.68%Quebec 4.500% Dec 1, 2019 7.5% 0.39% 3.67%

Ontario (1) 2.850% Jun 2, 2023 7.4% 1.49% 1.49%Active PositionsEquitable Trust Cashable GIC 1.550% May 23, 2013 4.9% 0.39% 0.94%Home Trust Cashable GIC 1.800% May 23, 2013 4.9% 0.45% 1.09%iShares US High Yield Bond Index ETF 10.1% 2.90% 10.49%

Returns for the ScotiaMcLeod Core-Plus Fixed Income Guided Portfolio

0.48% 3.59%

Returns for the DEX Universe Bond Index 0.30% 3.60%(1) position was added on November 28, 2012

Source: ScotiaMcLeod Portfolio Advisory Group, Bloomberg, and PC-Bond


Winter 2013 71

We continue to expect that Europe will remain a concern going forward into 2013. We anticipate that news out of the region will sporadically lead to risk off sentiment and thus temporarily impede the path of rising yields. However, recent reactions to much of the European headline news has softened. Therefore, we expect that the European situation will gradually continue to improve and become less of an issue as we move into the end of 2013.

During the early part of 2013, the other key event that will impact short-term interest rates will be the negotiations involving the US debt ceiling. If the US government fails to reach a workable solution to spending and/or an increase in the debt ceiling then we could see bond yields rally inside of our baseline expectations.

Overall, if the impact of the European debt crisis and the US debt ceiling negotiations are muted, then the recent strength of US economic data could lead rates notably higher. This is precisely why investors at this point should be examining their fixed income exposures. The secular bull- run in fixed income is seemingly coming to an end and that within the next 3-6 months, US and European head winds may provide investors with a final opportunity to take advantage of what increasingly appears to be a rate normalization trajectory.


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Notes


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Important Disclosures – As of 01/17/2013

This report has been prepared by members of the ScotiaMcLeod Portfolio Advisory Group. ScotiaMcLeod is the full service retail division of Scotia Capital Inc.

The author(s) of the report own(s) securities of the following companies. Suncor Energy Inc., Talisman Energy Inc., Toronto-Dominion Bank, Teck Resources Limited, Manulife Financial Corporation, Tim Hortons Inc, Bank of Nova Scotia, Rogers Communications Inc., Sun Life Financial Inc., Canadian National Railway Company, Power Corporation of Canada, TELUS Corporation, Enbridge Inc., BCE Inc., Bank of Montreal, General Electric Co, Royal Bank of Canada, Brookfield Office Properties, First Quantum Minerals Ltd., MG, Trican Well Service Ltd., Baytex Energy Corporation, Finning International Inc., Gibson Energy Inc., TransCanada Corporation, Brookfield Renewable Energy Partners L.P., Halliburton Co, Microsoft Corp, Peabody Energy Corp, Apple Computer Inc, Caterpillar Inc, EMC Corp/Massachusetts, Intel Corp, The supervisors of the Portfolio Advisory Group own securities of the following companies. Bank of Nova Scotia, Scotiabank, Global Banking and Markets is what is referred to as an “integrated” investment firm since we provide a broad range of corporate finance, investment banking, institutional trading and retail client services and products. As a result we recognize that we there are inherent conflicts of interest in our business since we often represent both sides to a transaction, namely the buyer and the seller. While we have policies and procedures in place to manage these conflicts, we also disclose certain conflicts to you so that you are aware of them. The following list provides conflict disclosure of certain relationships that we have, or have had within a specified period of time, with the companies that are discussed in this report.

Thomas C. O’Neill is a director of BCE Inc and is a director of the Bank of Nova Scotia. BCE Inc. Ronald Brenneman is a director of BCE Inc and is a director of the Bank of Nova Scotia. BCE Inc. Tanya Jakusconek is a Director of Equity Research for Scotiabank, Global Banking and Markets and is a member of the board of directors for Tahoe Resources Inc. Goldcorp Inc. is a significant shareholder of Tahoe Resources Inc. Goldcorp Inc. Rick Waugh, Chief Executive Officer for The Bank of Nova Scotia, is a member of the the Board of Directors of TransCanada Corporation. TransCanada Corporation Scotia Capital (USA) Inc. or its affiliates has managed or co-managed a public offering in the past 12 months. Agrium Inc., ARC Resources Ltd., Bank of Montreal, Bank of Nova Scotia, Barrick Gold Corporation, Baytex Energy Corporation, BCE Inc., Brookfield Office Properties, Brookfield Renewable Energy Partners L.P., Cameco Corporation, Canadian National Railway Company, Canadian Natural Resources Limited, Enbridge Inc., Finning International Inc., Gibson Energy Inc., Intact Financial Corporation, INTER PIPELINE FD, Inter Pipeline Fund, Manulife Financial Corporation, National Bank, Power Corporation of Canada, Rogers Communications Inc., Royal Bank of Canada, SIMON PPTY GROUP INC NEW, Sun Life Financial Inc., Teck Resources Limited, TELUS Corporation, Toronto-Dominion Bank Scotia Capital (USA) Inc. or its affiliates has received compensation for investment banking services in the past 12 months. Agrium Inc., ARC Resources Ltd., Bank of Montreal, Bank of Nova Scotia, Barrick Gold Corporation, Baytex Energy Corporation, BCE Inc., Brookfield Office Properties, Brookfield Renewable Energy Partners L.P., Cameco Corporation, Canadian Imperial Bank of Commerce, Canadian National Railway Company, Canadian Natural Resources Limited, Enbridge Inc., Finning International Inc., Gibson Energy Inc., Intact Financial Corporation, Inter Pipeline Fund, Manulife Financial Corporation, National Bank, Potash Corporation of Saskatchewan, Inc., Power Corporation of Canada, Rogers Communications Inc., Royal Bank of Canada, Shaw Communications Inc., SIMON PPTY GROUP INC NEW, Sun Life Financial Inc., Suncor Energy Inc., Talisman Energy Inc., Teck Resources Limited, TELUS Corporation, Tim Hortons Inc., Toronto-Dominion Bank, TransCanada Corporation, Trican Well Service Ltd. Scotia Capital (USA) Inc. or its affiliates expects to receive or intends to seek compensation for investment banking services in the next 3 months. Manulife Financial Corporation, TELUS Corporation, Trican Well Service Ltd. Scotia Capital (USA) Inc. had an investment banking services client relationship during the past 12 months. Agrium Inc., Bank of Montreal, Bank of Nova Scotia, Barrick Gold Corporation, Canadian National Railway Company, Canadian Natural Resources Limited, SIMON PPTY GROUP INC NEW, Teck Resources Limited, Toronto-Dominion Bank The issuer paid a portion of the travel-related expenses incurred by the Fundamental Research Analyst/Associate to visit material operations of the following issuer(s): Agrium Inc., Barrick Gold Corporation, Canadian Natural Resources Limited, Gibson Energy Inc., Goldcorp Inc., Talisman Energy Inc.


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Scotia Capital Inc. and its affiliates collectively beneficially own in excess of 1% of one or more classes of the issued and outstanding equity securities of the following issuer(s): Bank of Montreal, BCE Inc., Brookfield Office Properties, Canadian Imperial Bank of Commerce, Canadian National Railway Company, Enbridge Inc., Inter Pipeline Fund, Manulife Financial Corporation, National Bank, Power Corporation of Canada, Rogers Communications Inc., Royal Bank of Canada, Shaw Communications Inc., Sun Life Financial Inc., Toronto-Dominion Bank, TransCanada Corporation The Bank of Nova Scotia is the parent company and a related issuer of Scotia Capital Inc. and ultimate parent company and related issuer of Scotia Capital (USA) Inc. Bank of Nova Scotia The Fundamental Research Analyst/Associate has visited material operations of the following issuer(s): Agrium Inc., ARC Resources Ltd., Barrick Gold Corporation, BCE Inc., Brookfield Office Properties, Canadian National Railway Company, Canadian Natural Resources Limited, Enbridge Inc., Finning International Inc., Gibson Energy Inc., Goldcorp Inc., Inter Pipeline Fund, Manulife Financial Corporation, Potash Corporation of Saskatchewan, Inc., Rogers Communications Inc., Shaw Communications Inc., Sun Life Financial Inc., Talisman Energy Inc., TELUS Corporation, Tim Hortons Inc., Trican Well Service Ltd. Within the last 12 months, Scotia Capital Inc. and/or its affiliates have undertaken an underwriting liability with respect to equity or debt securities of, or have provided advice for a fee with respect to, the following issuer(s): Agrium Inc., ARC Resources Ltd., Bank of Montreal, Bank of Nova Scotia, Barrick Gold Corporation, Baytex Energy Corporation, BCE Inc., Brookfield Office Properties, Brookfield Renewable Energy Partners L.P., Cameco Corporation, Canadian National Railway Company, Canadian Natural Resources Limited, Enbridge Inc., Finning International Inc., Gibson Energy Inc., Intact Financial Corporation, INTER PIPELINE FD, Inter Pipeline Fund, Manulife Financial Corporation, National Bank, Power Corporation of Canada, Rogers Communications Inc., Royal Bank of Canada, SIMON PPTY GROUP INC NEW, Sun Life Financial Inc., Teck Resources Limited, TELUS Corporation, Toronto-Dominion Bank Scotia Capital Inc was retained by Telus Corporation to provide a fairness opinion with respect to a proposed share conversion. TELUS Corporation This issuer owns 5% or more of the total issued share capital of The Bank of Nova Scotia. Bank of Montreal, Canadian Imperial Bank of Commerce, Royal Bank of Canada, Toronto-Dominion Bank Scotia Capital Inc. participated in a bought deal with Intact Financial Corporation. The proceeds from the bought deal were related to a proposed acquisition by Intact Financial Corporation of JEVCO Insurance Company, which is related to The Westaim Corporation. Intact Financial Corporation

Definition of Scotiabank GBM Equity Research Ratings & Risk Rankings

We have a three-tiered system, with ratings of 1-Sector Outperform, 2-Sector Perform, and 3-Sector Underperform. Each analyst assigns a rating that is relative to his or her coverage universe or an index identified by the analyst that includes, but is not limited to, stocks covered by the analyst.

Our risk ranking system provides transparency as to the underlying financial and operational risk of each stock covered. Historical financial results, share price volatility, liquidity of the shares, credit ratings, and analyst forecasts are evaluated in this process. The final ranking also incorporates judgmental, as well as statistical, criteria. Consistency and predictability of earnings, EPS growth, dividends, cash flow from operations, and strength of balance sheet are key factors considered. Scotiabank GBM has a committee responsible for assigning risk rankings for each stock covered.


Winter 2013 75

The rating assigned to each security covered in this report is based on the Scotiabank GBM research analyst’s 12-month view on the security. Analysts may sometimes express to traders, salespeople and certain clients their shorter-term views on these securities that differ from their 12-month view due to several factors, including but not limited to the inherent volatility of the marketplace.

Ratings

Focus Stock (FS) The stock represents an analyst’s best idea(s); stocks in this category are expected to significantly outperform the average 12-month total return of the analyst’s coverage universe or an index identified by the analyst that includes, but is not limited to, stocks covered by the analyst. Sector Outperform (SO) The stock is expected to outperform the average 12-month total return of the analyst’s coverage universe or an index identified by the analyst that includes, but is not limited to, stocks covered by the analyst.

Sector Perform (SP) The stock is expected to perform approximately in line with the average 12-month total return of the analyst’s coverage universe or an index identified by the analyst that includes, but is not limited to, stocks covered by the analyst.

Sector Underperform (SU) The stock is expected to underperform the average 12-month total return of the analyst’s coverage universe or an index identified by the analyst that includes, but is not limited to, stocks covered by the analyst.

Other Ratings Tender – Investors are guided to tender to the terms of the takeover offer. Under Review – The rating has been temporarily placed under review, until sufficient information has been received and assessed by the analyst.

Risk Rankings

Low Low financial and operational risk, high predictability of financial results, low stock volatility.

Medium Moderate financial and operational risk, moderate predictability of financial results, moderate stock volatility.

High High financial and/or operational risk, low predictability of financial results, high stock volatility.

Speculative Exceptionally high financial and/or operational risk, exceptionally low predictability of financial results, exceptionally high stock volatility. For risk-tolerant investors only.

General Disclosures

The ScotiaMcLeod Portfolio Advisory Group prepares this report by aggregating information obtained from various sources as a resource for ScotiaMcLeod Wealth Advisors and their clients. Information may be obtained from the Equity Research and Fixed Income Research departments of the Global Banking and Markets division of Scotiabank. Information may be also obtained from the Foreign Exchange Research and Scotia Economics departments within Scotiabank. In addition to information obtained from members of the Scotiabank group, information may be obtained from the following third party sources: Standard & Poor’s, Valueline, Morningstar CPMS, Bank Credit Analyst and Bloomberg. The information and opinions contained in this report have been compiled or arrived at from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness.

While the information provided is believed to be accurate and reliable, neither Scotia Capital Inc., which includes the ScotiaMcLeod Portfolio Advisory Group, nor any of its affiliates makes any representations or warranties, express or implied, as to the accuracy or completeness of such information. Neither Scotia Capital Inc. nor its affiliates accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents.

This report is provided to you for informational purposes only. This report is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation or particular needs of any specific person. Investors should seek advice regarding the appropriateness of investing in financial instruments and implementing investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized.

Nothing contained in this report is or should be relied upon as a promise or representation as to the future. The pro forma and estimated financial information contained in this report, if any, is based on certain assumptions and management’s analysis of information available at the time that this information was prepared, which assumptions and analysis may or may not be correct. There is no representation, warranty or other assurance that any projections contained in this report will be realized.


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Opinions, estimates and projections contained in this report are our own as of the date hereof and are subject to change without notice.

Copyright [2012] Scotia Capital Inc. All rights reserved.

Additional Disclosures

The content may have been based at least in part, on material provided by Standard & Poor's (S&P), our correspondent research service. S&P has given ScotiaMcLeod general permission to use its research reports as source materials, but has not reviewed or approved this report, nor has it been informed of its publication. S&P’s Stock Appreciation Ranking System is used by S&P analysts to rate stocks within their coverage universe assigning one to five STARS – five STARS – five STARS indicating a “buy” and one STAR a “sell”. S&P’s analysts also provide earnings estimates for these covered issues.

S&P’s Stock Appreciation Ranking System is a rank of the potential for future performance over a six to 12-month period. The STARS selection process relies on a disciplined investment approach that combines fundamental and technical analysis, sector weightings, reasonable turnover, performance-based bonus system, and a “top-down” overlay with influence from the S&P's Investment Policy Committee. The overarching investment methodology is “growth at a reasonable price”. Unlike equity valuations from other financial firms, STARS is a forecast of a company's future capital appreciation potential versus the expected performance of the S&P 500 before dividends. ScotiaMcLeod is committed to offering its valued clients a disciplined approach to investing. A hallmark of this approach is access to comprehensive research reports, including fundamental, technical, and quantitative analysis that investors can use to assist them in bringing informed judgment to their own financial situation and investment decisions. In addition to the reports prepared by ScotiaMcLeod through its Portfolio Advisory Group, we also offer our clients access on request to insights in the form of research from other leading firms such as Standard and Poor’s, which offers independent research of relevance to our investment process. Further to your request, please find attached a research report of Standard and Poor’s (or one of its research affiliates), a member of the National Association of Securities Dealers (or similar securities regulatory authority). As Standard & Poor’s is not subject to Canadian regulation, this research report does not conform to Canadian disclosure requirements. ScotiaMcLeod is a division of Scotia Capital Inc. Scotia Capital Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. Neither Scotia Capital Inc. nor its affiliates accepts any liability whatsoever for any loss arising from any use of this document or its contents, including for any errors or omissions in the data or information included in the document or the context from which it is drawn. ® Registered trademark used under authorization and control of The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member CIPF.


Winter 2013 77

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Documents

Investment Portfolio Quarterly · Scotia Strategy 2013 Outlook & Model Portfolios Update 4 Economic Outlook United States to Emerge Stronger Following Fiscal Cliff 10 Canadian Strategy