April 24, 2017

First Quarter Letter 2017


During the first quarter of 2017, the Fund rose +3% versus +2.4% for the TSX Composite Total Return. Our outperformance was due to several strong earnings announcements among our core holdings, and a low weighting in energy stocks. We are particularly pleased with this result considering the historically high cash balances we held throughout the quarter which averaged well over 10%. Since inception in July 2006, our Canadian Equities strategy has produced a cumulative net return of +192%, more than double the +82.8% for the TSX. This represents an annual compound return of +10.5% over the past ten and three quarter years, net of all fees and expenses, versus +5.8% for the TSX. Measured in terms of “value added” performance, we have generated +4.7% per year over and above the market’s return over this period.

Notable contributors to our positive returns during the quarter were:

  • Halogen (+49.8%): Human resources software developer announced that it would be acquired.
  • Savaria (+28.8%): Home accessibility equipment supplier posted record profits and raised 2017 guidance.
  • Diamond Estates (+22.2%): Canadian wine producer and sales agency continues to achieve record sales.
  • Winpak (+16.9%): North American manufacturer of specialized packaging materials reported record profits.
  • Equitable (+14.3%): Residential mortgage lender reported record financial results and increased its dividend.
  • NAPEC (+12.9%): Electrical systems and natural gas networks contractor is growing by acquisition in the US.
  • Veresen (+12.1%): High yielding natural gas pipeline and mid-stream operator is growing free cash flow.
  • Boralex (+12.1%): Renewable wind and hydro power producer was added to the TSX Composite Index.

The above list illustrates well the merits of our disciplined investment strategy. Besides many of our holdings generating strong financial results and their share prices rising in response, we highlight three recent additions to our portfolio. First, Halogen was an out of favor human resources software developer that was mismanaged but had good products. At the time of its initial public offering in 2013, we passed on it as we did not like management’s free spending ways or the company’s valuation. Halogen’s stock price declined significantly since the IPO, from $15 to under $8. When a new CEO was brought in last year to focus on profitability, we travelled to Ottawa to revisit the company, and decided to add it to our portfolio at around $9 per share. We were rewarded only a few months later when a strategic buyer emerged, seeing value as we had, resulting in a offer to acquire the company for $12.50 per share. Second, Winpak, a well-run packaging company that we have liked since 2013, was always too expensive. Yet the stock price more than doubled in 2014, and then stalled as the company’s earnings caught up to its valuation. In late 2016, we finally purchased shares as we felt the valuation was now justified. It was better to pay a higher price that we considered was fair, than pay a lower price that we felt was too expensive. Finally, we invested in NAPEC, a contractor with new management focused on growing in the US utility sector and increasing its margins. This neglected company is trading at a low total enterprise value of around $200 million, yet has a backlog of over $600 million. We expect results to improve and the market to revalue NAPEC’s share price higher.

While stock markets have continued to rise on the back of historic low interest rates and renewed optimism of stronger global economic growth, valuations appear stretched. We have had to work hard to generate the above returns, by digging deeper into industries and companies in search of good value. We also have to show added discipline in redeploying cash balances, not an easy task when markets seem to be rising effortlessly. Nevertheless, we have identified plenty of opportunities to invest in once they become more affordable.


The U.S. markets continued to be driven by the positive Trump momentum, with which they entered the year.For the first quarter, our U.S. strategy returned +2.5% compared to +6.1% for the S&P500 and +2.5% for the Russell 2000. We did not keep pace with the rising market due to our approximate 15% cash position and relatively conservative investment portfolio.

When markets are at all-time highs, one of the most important behavioural traps is being drawn in due to the feeling of missing out. It seems like everything is rising and an investor can do no wrong. Then the tide goes out and some of these high flying stocks can experience some of the sharpest declines. Smart investment managers who should have known better are caught with nothing to cushion the fall. It’s our job as your investment managers to control those emotions and act as professionals. This can actually be as important as doing the fundamental bottom-up stock research that takes up the majority of our day.

So how do we do it? A key factor is to maintain the same standards for new investments that we would have applied even if the market was substantially lower. Just because the market is setting new highs does not mean businesses are fundamentally stronger or generating more cash over the full business cycle than they were 3 years ago. So why should we pay 50% more? Of course, it is harder to find as many investments that meet our standards today, and the result is cash as a percentage of the portfolio will trend higher. It is also for these same reasons that after markets suffer substantial drops we tend to have very small cash balances; at those moments there are so many attractive investments to be made.

That said, we have been hard at work looking for potential winners with limited downside. One such investment we recently made was buying shares in Nuvectra, a small medical device manufacturer. The company is in the early stages of a roll out and thus not yet profitable. However, we purchased shares for just over $5 when the company had $7 in cash per share on its balance sheet. Effectively, we were being paid to take the entire product line and patents. When the company rallied to $7.50 we took some profits as the risk/reward was less compelling. Should their business plan work there is strong upside, but the cash cushion is no longer as large. This example highlights how we are trying to find opportunities to generate decent returns and not get caught when the tide goes out as it invariably does during every market cycle.


Our average gross return on fixed income was +2.8% for the quarter, with individual account performance varying from this depending on cash balances and portfolio weightings. In the quarter, we surpassed the returns of the benchmarks (Canada Universe Bond Index +1.2% and Canada HYBrid Bond Index +2.3%) due to our exposure to higher yield corporate bonds, which outperformed government bonds.

Our strong performance emanated from all sectors. Higher quality corporate bonds rallied along with government bonds, and yield spreads between corporate and government bonds narrowed once again. The higher coupon rates that our bonds pay contributed as usual. During the quarter, over 10% of our bond portfolio came to maturity or was redeemed at an early call premium. We were able to successfully re-invest most of the proceeds, however at lower yields to maturity than we have enjoyed in recent years. A benefit of this is that we dramatically reduced our exposure to energy companies and have better diversified our portfolios. At this juncture, we are finding it increasingly challenging to deploy capital into fixed income with reasonable returns for the commensurate risk. Therefore, we are holding higher cash balances in the interim, until we find more attractive investment opportunities. Given current market conditions and valuations, we again ask that you moderate your expectations for 2017.

We will continue to invest in short duration investment grade and high yield corporate bonds, with the goal of protecting capital when interest rates inevitably rise. Our average maturities are just over four years with yields of approximately 5%, however we anticipate several early calls in 2017. To achieve decent fixed income returns today, we continue to prefer to do our research and take credit risk on corporate bonds, notwithstanding the inherent volatility.

Our preferred share investments performed very well in the quarter, and this sub sector of the fixed income market continues its recovery while presenting reasonable value relative to the bond market. In general, these issuers tend to be of better quality than those of many high yield bonds, however, we are being selective due to the subordinate ranking of preferred shares and their predominantly perpetual nature.


What Uber has done to the taxi industry and what Airbnb has done to the hotel industry has other sectors concerned about what kind of disruptive new technology or know how is about to be unleashed that will change everything. Of course, major changes are generally negative for existing conventional entities. This phenomenon is nothing new. Note that as the Industrial Revolution took hold in Germany in the 19th century and started to move westward, success favored the countries that had most recently built their factories. By using the most up-to-date technology, England was able to outperform Germany, followed a few decades later with the United States outperforming England.

Our industry, finance and wealth management, is certainly not immune to these concerns. In fact, financial technology (aka “Fintech”) is thought by many to be the very next big disruptive force in business overall. Banks worldwide, including all the Canadian chartered banks, are investing major funds into Fintech research, feeling they risk getting left behind.

While Uber and Airbnb use computers, the web and special apps to wrestle clients away from traditional modes of transportation and hospitality, it is still humans doing the work and indeed both companies argue that they actually spread revenues amongst more people (albeit less money overall, thus the overall savings to consumers). Fintech, on the other hand, like driverless trucks, threatens to put whole groups out of work without the shift of employment to others. In wealth management, artificial intelligence (algorithms) designed to analyze securities, charts and trading patterns coupled with high frequency trading technology stands to make for formidable competition and those who dismiss this are being naive. On the other hand, we believe that regardless of the extent of technology’s penetration, there will still be a need for human involvement. Indeed, there are many elements to wealth management, other than quantitative analysis and technical trading, where human interaction is necessary such as personalized service and applying sound judgement.

In terms of the adoption of Fintech, perhaps there is another parable in the past to guide us here. When computer programs first started playing chess, many claimed that there was a limit to their abilities and that any decent player would always beat a computer. Too much creativity and far too many variables as the game progresses for computers to manage, cried the naysayers. In 1950, Alan Touring wrote the first computer chess program that could do little more than “know” how the board was set up and how pieces moved. There was little advancement until 1962 when MIT wrote a program that could beat some beginners. Although earlier in 1957, the Nobel Prize winner Herbert Simon predicted that a computer would be the world champion within 10 years. It took a little longer, but in 1997 IBM’s Deep Blue beat Gary Kasparov, the world champion at the time and arguably the best player ever, in a six game match. Since then, it is no contest. Chess programs are indisputably the best players in the world and find challenging matches only against each other. Today we are somewhere on that spectrum and perhaps at the point where futurists, like Herbert Simon, are indicating that it is now a question of when rather than if.

Ken Lester, Stephen Takacsy, Peter Dlouhy