April 21, 2016

First Quarter Letter 2016


During the first quarter of 2016, the Lester Canadian Equity Fund increased +7.0% versus the TSX Composite total return which was up +4.5%.  While the TSX’s rise was led by soaring gold stocks sometimes seen as a safe haven in turbulent times, our gains and outperformance were due to strong contributions from small and mid-cap holdings, many of which announced good financial results during the quarter.  Despite most global equity markets starting off the year in the red with severe volatility, our portfolio returned the best first quarter performance since 2007.  As mentioned on previous occasions, value investing requires patience as companies can often stay cheap for a long time, being neglected or misunderstood. Our portfolio contains significant unrealized value which is now starting to be recognized by the market.  Since inception in July 2006, our equity strategy has produced a cumulative net return of +143.3%, more than double the +54.1% for the TSX.  This represents a compound return over nearly 10 years of +9.5% annually net of all fees and expenses (approximately +11% gross annually), versus +4.5% per year for the TSX.

Notable winners and losers during the first quarter of 2016 include:

  • D-Box (+56.2%):  Developer of motion systems for cinemas and simulation is posting record results.
  • Neulion (+45.3%):  Leading live sports video streaming enabler.  Stock is rebounding on good results.
  • Andrew Peller (+43.7%):  Leading Canadian-owned wine producer continues to achieve record results.
  • Capstone Infrastructure (+33.9%):  Renewable power producer announced it will be acquired.
  • Innergex (+24.5%):  Renewable power producer started expanding internationally in Mexico and France.
  • Espial (-17.7%):  Lack of announcements with new cable and telco customers is hampering valuation.
  • ExactEarth (-18.5%):  Satellite data provider’s stock sold-off following its spin-off from Com Dev.
  • Sandvine (-21.5%):  Internet traffic control software provider’s stock sold-off despite record sales.
  • Ten Peaks (-26.5%):  Chemical-free decaf coffee processor.  Stock pulled-back from run-up in 2015.
  • Newalta (-44.4%):  Wastewater processor is being hurt by the slowdown in the energy sector

Among winners, we highlight a long time holding, Andrew Peller, Canada’s leading domestically-owned wine producer and marketer.  This well managed family controlled company continues to deliver solid results by successfully launching new products and tightly controlling costs.  Earnings per share have doubled over the past  5 years since we started buying shares, and the market is finally rewarding the company by expanding its valuation multiple.  Consequently, its share price has risen 3.5 fold, yet is still fundamentally cheap when compared to others in its peer group. Andrew Peller is now our largest position, and we intend to continue holding it for the long term.

Among losers, we highlight Sandvine, a 2015 addition to our portfolio.  This Waterloo-based world leader in the development of complex software to help analyse data and control traffic over the internet, sells to a growing global market and generates high margins and strong free cash flow.  The company announced record revenues and has started paying a regular dividend. Sandvine is flush with cash representing over 40% of its market capitalization and is aggressively buying back shares.  However, being a technology stock, it is volatile.  Given its profitability, industry leadership, growth prospects and cheap valuation, we would consider adding to our holdings on significant weakness.

As we have often repeated, the global economy remains fragile and interest rates continue to be suppressed by central banks worldwide.  This monetary stimulus is not generating the desired growth rates and most countries remain heavily indebted.  In Canada, the depreciated Loonie has helped boost exports by non-resource-based manufacturers and employment remains healthy, other than in oil producing parts of the country.  Nevertheless, we are increasing our cash weighting as valuations remain expensive in relation to growth prospects.  We continue to hold shares in dividend paying companies in stable sectors such as Telecom, Utilities, Renewable Energy and Infrastructure, as well as in companies that are able to safely grow despite a weak global backdrop.


Q1 was a tumultuous period for the US markets with the S&P500 at one point down -10% before ending up +1.3%.  Small caps fared worse with the Russell 2000 down -15% before rallying to only being -1.5% on the quarter.  Our US portfolio held in delivering a positive return of +2.0% as some of our names rallied and we were cushioned by our cash positions. We viewed the market drop as creating interesting new opportunities and we made some changes to the portfolio accordingly.  We also identified some attractive new names but unfortunately they rallied before we could get a position.  This leaves us ready to pounce should the market revisit the lows; something we think is distinctly possible.

One of the aforementioned opportunities was to switch out of Regal Entertainment and into Cinemark.  Both are well run movie theater chains focused on the US market, which we like as they are low volatility, recession proof businesses.  However, Cinemark has 20% of its theaters in South America (Brazil, Colombia, Argentina) where the market has been growing quite quickly. Historically, this afforded the company a premium multiple vs Regal who is entirely in the US. With the on-going recession in Brazil and their political drama, this exposure went from being a positive to a negative and Cinemark sold off hard, to the point where both companies were trading at similar multiples.  We took the opportunity to switch into Cinemark, believing that long term, their exposure to South America will be a plus.

Another new position is Gazit Globe.  This is a Real Estate firm based in Israel but with the majority of their assets held in the US, Canada and Europe.  They own these assets through large equity stakes in their public subsidiaries such as First Capital and Equity One.  Both are extremely well run public retail real estate companies that trade at premium multiples attributed to their superior assets and management teams.  Due to the market dislocations we had the opportunity to buy Gazit, which historically trades at the underlying asset values, for a 25% discount.  Thus we get to invest in great assets below market price, and be investing right alongside this strong management team.  They have created tremendous value over the past 15 years and think they will continue to for the next 15 years.  We view Gazit as a great long term hold.


Our dollar weighted average return on fixed income was +3.1% in the quarter.  Individual account performance varied from this depending on cash balances and portfolio weightings.  In the quarter, we outperformed the returns of the benchmarks (Canadian Bond Universe +1.4% and FTSE TMX Canada HYBrid Bond Index +1.6%) due to our exposure to higher yield corporate bonds, which recovered much of last year’s underperformance.  After falling in the first half of the quarter, corporate bonds rallied back to December year-end prices.  Our performance was due to several company specific events and the higher coupon rates that our bonds pay.  We continue to believe that the next significant move in interest rates is up, so we are content to forego the short term stability of government bonds, with the goal of protecting capital when interest rates inevitably rise.  The portfolios are invested exclusively in corporate bonds, both investment grade and high yield, with average yields close to 6% and average maturities of 4.4 years.  To achieve fixed income returns today, we continue to prefer to do our research and take credit risks on corporate bonds, rather than extend term with the commensurate interest rate risk of government bonds.


The fact that we just had the best month ever since we formed our current partnership in 2006 gave us pause to do some reflecting.  We had excellent performance numbers for the first seven years through 2013 and then underperformed the TSX by a couple of percentage points in 2014 and 2015.  As well, our under-performance during the last two years was even more pronounced when compared to the S&P 500 and other USD denominated benchmarks translated into Canadian dollars.  Several clients over this period questioned why we did not switch to US securities as the CDN markets and the CDN $ started to tumble when oil started its decline.  In our 31 March 2015 letter we responded to some of those concerns by saying that we are a long-only Canadian focused securities wealth manager:  That we feel we can deliver long term Alpha (out-performance) in the less efficient Canadian markets and that we will stick to our knitting until we see reasons that could alter our opinion.  Indeed, had we known how low oil would go and for how long, we certainly would have made some changes.  However, we recognize how powerful the hindsight bias is and hold the opinion that it was certainly not obvious then.

Over these last couple of years, even our value oriented investment style was called into question by some clients.  We would then ask: “Do you think we should change our style that has served us so well for seven years because of short term underperformance”?  Which brings us to the point we would like to make here.  We feel that the best thing we can do as portfolio managers is to resist the urge to change every time the markets go against us, knowing full well that out-performance is never a straight line and that long periods of out-performance MUST be intermingled with periods of underperformance (hopefully short).  If one does try to change style based on short term perceptions, our fear is that one will not only generally be late to the party, but more importantly, one will never be fully competent in any style.  As well, a manager who frequently changes styles and thus trades more often will inadvertently suffer more transaction costs; most notably spreads between bids and asks.  We are reminded of a story told by a well-known Canadian portfolio manager about when he was taught to drive by his father.  After starting to feel nauseated again as he did every other time they went out for a driving lesson, the father finally figured out the problem.  He told his son that he was likely focusing too much on the road right in front of the car and that if he were to adjust his vision and look farther down the road, it would help him to minimize the constant movements that were making the drive so unpleasant.  Of course … it worked.

Ken Lester, Stephen Takacsy, Peter Dlouhy