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Second Quarter Letter 2016

July 28, 2016

CANADIAN EQUITIES: Celebrating 10 Years of Outperformance

During the second quarter of 2016, the Lester Canadian Equity Fund increased +6.4% net of all fees and expenses, versus the TSX Composite total return which was up +5.1%. While the TSX’s returns continue to be led by rising gold stocks complemented by a recovery in energy companies and high yielding sectors being lifted by low interest rates, our outperformance was mainly due to strong contributions from a diverse group of small and mid-cap holdings. Year-to-date, we are up +13.8% versus +9.8% for the TSX. This quarter marks the 10th anniversary of the new partnership and Canadian equity strategy, and we are proud that from inception in July 2006 to June 2016, we have produced a cumulative net return of +158.7%, versus +61.9% for the TSX Composite. This represents a compound net return of +10% per year for 10 years (approximately +11.2% gross), double the +4.9% generated by the TSX, placing us in the top percentile of Canadian Equity managers over the period. In this world of ETF and passive indexing hype, our active strategy proves that diligent research-driven stock-picking and patient long term value investing can add significant value to our clients’ investment portfolios.

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

  • Savaria (+34.1%): Provider of medical equipment announced record results and equity financing.
  • Prism (+29%): Provider of medical equipment is being acquired by Handicare of Sweden.
  • D-Box (+28.1%): Developer of motion systems for cinemas and simulation is posting record results.
  • QHR (+27.6%): Electronic medical records software provider continues to grow user base.
  • Input (+26.1%): Lender to farmers to help increase crop yields, rebounded after a sharp sell-off.
  • Neulion (-16.5%): Shares of leading sports video streaming company pulled back after a steep run-up.
  • Linamar (-26.4%): Despite record results, stock has sold-off with other auto part manufacturers.
  • Asian Television (-27%): Advertising revenues are strong, but loss of subscribers to piracy is a concern.
  • ExactEarth (-50.1%): Satellite data provider’s profits were reduced on Canadian government contract.
  • FP Newspapers (-53.1%): Declines in print advertising continue to reduce free cash flow.

Among winners, we highlight two core holdings in the same sector: Savaria and Prism Medical. Both companies manufacture, distribute and sell healthcare equipment to facilitate accessibility and mobility. In Savaria’s case, the company makes and sells stair lifts and home elevators for the residential market, as well as retrofits cars with ramps for wheelchairs. Prism on the other hand, makes and sells ceiling and floor lifts for the institutional market (hospitals, and long term care and acute care facilities). Both are Canadian companies expanding rapidly in the US and benefitting from aging demographics. Over the past two years, we accumulated just under 10% of Prism on the expectation it would one day be sold. While we would have liked to see Savaria acquire Prism for cash and stock so that we could remain invested in the business, we are still pleased with the cash offer made by Swedish company Handicare.

Among losers, we highlight Neulion, a US-based technology company that helps broadcasters and rightsholders stream live sporting events and other content over multiple digital platforms. Revenues and profits continue to grow internationally and the company generates strong recurring free cash flow. Just recently, Walt Disney Co. announced that it is buying a stake in a rival sports video streamer, MLB Advanced Media, valuing that company at US$3.5 billion. The stock market currently values Neulion at around CAD$200M, which we feel is very low for this industry leader. While not typically our style, we have taken advantage of the recent volatility in Neulion’s share price to trade the stock to lock-in some gains, while still keeping a core position for the ultimate pay-day when the company might be acquired.

Central banks worldwide continue to supress interest rates in order to stimulate economies mired in slow growth and deflationary headwinds. This globally-coordinated monetary stimulus has been ongoing since the financial crisis eight years ago, yet it is still not having the desired impact on economic growth. While many large countries remain heavily indebted, Canada’s finances are sound. As well, non-resource sectors and employment remain healthy. Nevertheless, we are adopting a cautious stance towards equity markets by taking some profits and hoarding cash awaiting better opportunities, particularly in light of some of the current external geo-political risks. In our opinion, stock valuations are elevated in relation to growth prospects and continue to be propped up by the “lower for longer” interest rate environment and lack of attractive investment alternatives.

US EQUITIES

Despite the quarter end turmoil from Brexit, US markets continued to march closer to their all time highs. The S&P500 ended the quarter up 2.5% (3.8% YTD) while the Russell2000 ended up 3.7% (2.1% YTD). Our portfolio performed well thanks to some new names, up 3.6% for the quarter (5.8% YTD). One of these new names is Crestwood Equity Partners, a midstream company in the oil and gas space. Having dropped 85% from its high due to the oil crash and being positioned in what is normally a stable space, we had to take a closer look. We found a company with some great assets and some bad assets that was paying too high a dividend. We knew the dividend would be cut, but the question was to what new sustainable level? Even if they were to cut the dividend by 70%, we thought the stock was cheap. Thus we looked at each individual asset that was troubled and took a conservative view on cash generation going forward. Our work showed us a 60% cut was likely and we purchased shares. In the end management sold some assets at a very good price and cut the dividend to a new sustainable level, 55% less than the original rate. On these positivedevelopments the stock rallied providing an 82% total return in the quarter. We sold some stock but are keeping  the rest as we think there is more upside. 

An underperformer in the quarter is Dillard’s department store, down 29%. Dillard’s was not alone as all department stores got hit including Macy’s (-25%) and Nordstrom’s (-33%). Investors saw retailers report a weak first quarter and assumed Amazon would crush old world retailers. We are not convinced and believe we have enough protection in Dillard’s to maintain an investment. Recall Dillard’s owns much of their real estate, which we believe could one day be monetized for almost the entire market cap of the company. Further, the Dillard family owns over 50% of the stock and aggressively buys back shares. The cheaper the stock gets the more shares they can afford to buy back and the closer the day gets when they buy out minority shareholders (for a premium). We also understand retail is prone to sentiment and periodic weakness and this too shall pass.

Overall, we still view the US market as expensive and are a bit surprised with the ease at which it has climbed higher since March. We have been trimming some names as they begin to close in on our target prices, cognizant to maintain cash balances at high levels to take advantage of the next dip. We ended the quarter with most US portfolios at around 10% cash. While this will hurt us in a rising market, it will reward us in a selloff. One of the worst feelings is to be fully invested, only to see great companies selling off and being unable to buy without selling an existing equally great name that is also falling.

FIXED INCOME

Our average return on fixed income was 5.1% in the quarter and 8.4% in the year to date (YTD). 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 2.6%, 4.1% YTD and FTSE TMX Canada HYBrid Bond Index 3.4%, 4.8% YTD) due to our exposure to higher yield corporate bonds, which outperformed government bonds that also did well. Much of our strong performance emanated from the energy sector that continued to rally with the price of oil, as companies’ prospects improved. The higher coupon rates that our bonds pay contributed as usual. To some extent, this quarter’s exceptional returns represent a catch up of last year and should not skew an investor’s expectation of future returns.

Although we believe that interest rates are lower for longer, we continue to believe that the next significant move in rates is up. Therefore we continue to invest in both investment grade and high yield corporate bonds with relatively short durations, with the goal of protecting capital when interest rates inevitably rise. Average yields to maturity are close to 5% and maturities are just over four years. To achieve fixed income returns today, we continue to prefer to do our research and take credit risk on corporate bonds, notwithstanding the inherent volatility, rather than extend term with the commensurate interest rate risk.

The Brexit and Its Effect on the US Election and What That Means To Our Canadian Securities. Since the surprising Brexit vote on June 23th, much has been written on what this means for the U.K., the rest of Europe, and to a lesser but still significant degree, the rest of the world. One of our partners was asked to appear live on CTV to discuss the effect of the Brexit on Canada, with the concluding message being that although the direct effects were/are minimal, it is the indirect effects that Canadians need to be concerned with. In regards to the rest of the world, we find the possible influence it might have on the upcoming election in the US the most interesting. For this letter we confined ourselves to financial and particularly investment issues, although the social ramifications are potentially far reaching as well. As a Canadian wealth management firm, we conclude by addressing how this event has and will affect Canadians and their portfolios.

The result of the Brexit vote caught many by surprise. Polls and London bookies had the "Remain" side winning a clear majority all the way leading up to the vote. That explains the rapid and significant sell-off in markets worldwide. [Note that at the time of this writing, markets worldwide have recovered and the only lingering effect seems to be to the British Pound itself, which is now trading about 15% below the USD and Euro pre-Brexit]. Investors hate surprises, especially those with potentially harmful consequences and the Brexit vote delivered that in spades. Not only was England the first country to indicate unequivocally that it wanted to leave the European Union (EU) - which in itself is unsettling- but the Brexit result also immediately lent credence to many other “Exit the EU” movements. How the EU ends up (if at all) when the dust settles is a huge unknown at this point. How long it will take for the dust to settle is another huge unknown with all sorts of waffling on the actual meaning of the vote and on Party leadership upheavals emanating from England as we speak.

If that is not enough to create the insecure uncertainty that capital markets loathe, we also have a US election in November, which represents an altogether new unknown - read Trump - with possibly more serious economic and financial ramifications, especially to Canadians. We bring this up here in the context of the Brexit because we believe that just like the Brexit may have become a vehicle for all sorts of scared and unhappy Brits, especially those with strong racist beliefs who are apparently more prevalent than was assumed, the election of Trump may evince a similar type of xenophobic fear.

In addition, just as the Brexit may unleash similar movements in the EU, we fear that the Brexit may not only be a canary-in-the-coal-mine for the US Presidential Election, it may actually encourage many Americans to vote for Trump - even with all of his horrible qualities. This concept was predictably not lost on Trump and his handlers who transported him within hours to Scotland after the vote, where he pontificated on how similar the Brexit was to what he was trying to achieve in America.

A Trump victory in November, which was considered impossible and indeed laughable only several months ago, could bring dire results to markets. Ironically, markets almost always like Republicans with their general pro corporate, pro rich and anti-government assistance for the underprivileged. This time, however, it feels like it will be the opposite. If Clinton wins, markets know, within certain parameters, what to expect and will thus adjust for it. Alternatively, markets have no way of knowing what future awaits a Trump win and if history is any indication, they will err on the side of caution and sell-off as quickly as possible. Until recently, we along with most, laughed at the thought of Trump in the Oval Office. Today we continue to believe that Clinton will prevail in November, however that laughter formerly directed at her opponent has been staunchly replaced by a kind of knot in our collective stomachs. We will be watching very carefully going forward and we will not hesitate to raise cash levels in our portfolios if we see the possibility of a Trump victory increase.

We have heard arguments recently that Canada may actually benefit from a Trump victory. The logic here is that disgruntled capital and brain power would migrate north. While we agree that with Trump in the White House (hard to write that!), there would certainly be some benefits to Canada, on the whole it is not something we should wish for. On the other hand, at least we can feel a little better about being Canadians these days.

 

Ken Lester,  Stephen Takacsy,  Peter Dlouhy
 

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