July 29, 2019
Second Quarter Letter 2019
For the second quarter of 2019, the Lester Canadian Equity Fund’s return was flat at -0.1% net of fees and expenses, versus +2.4% for the TSX Composite total return including dividends. Year-to-date, we are up +14.5% versus +16.2% for the TSX. Our underperformance in the second quarter was mainly due to our zero exposure to the gold sector which rose 12.8%, a low weighting in financials, and cash drag. Also, a few of our largestpositions declined in value on profit taking despite continued strong growth. Since inception in July 2006, our Canadian Equity strategy has produced a cumulative net return of +220%, more than double the +106% for the TSX. This represents an annual compound return of +9.4% net of all fees and expenses, versus +5.7% for the TSX. Measured in terms of “value added” active returns (“alpha”), we have generated +3.7% per year net of fees in excess of the market’s return for 13 years including the financial crisis and several corrections.
Notable contributors and detractors in the second quarter of 2019 were:
- Dollarama (+29%): Retailer announced strong same store sales growth and an expansion into Latin America.
- Altus Group (+23%): Real estate services provider continues to grow its Argus Analytics software platform.
- CCL (+19%): Global leader in labels and packaging announced strong financial results.
- Badger Daylighting (+18%): Hydrovac excavation provider continues to aggressively grow in the US.
- Centric Health (-39%): Delayed sale of drug distributor’s surgery clinics hurt its shares despite better results.
- Blackberry (-28%): Leading provider of security software is transitioning to a SaaS model and bought Cylance.
- Goodfood (-26%): Shares of Canada’s leading meal kit provider pulled back despite continued strong growth.
- Baylin Technologies (-11%): Leader in wireless antenna has seen a pull-back in its shares after a strong run.
As mentioned in our last letter, we expected to lag the market if it continued to rise given our disciplined trimming and conservative stance in an expensive stock market. Our exceptionally strong first quarter was followed by a flat second quarter as we took profits on several holdings and held roughly 10% in cash. Names we added during the late 2018 correction continued to perform well, namely CCL Industries, Dollarama, Stella Jones, NFI group and ATS Automation. During the quarter we added Enbridge as it has simplified its structure, sold assets and reduced debt while paying a healthy 6.3% dividend. Given the opposition and difficulty in getting new pipelines approved, companies like Enbridge with existing infrastructure will only become more valuable.
We also increased our Blackberry position given how much it pulled back from a strong first quarter performance. Our thesis is that Blackberry is grossly misunderstood by the market. Investors still believe that it is a dying company. While its handset business is going to zero, its other segments are growing. Blackberry is entirely a software company today and is a global leader in enterprise security and encryption, imbedded operating systems in 150 million cars, licensing (owns 37,000 patents) and cybersecurity using predictive technology such as AI and machine learning with its recent purchase of Cylance. With the proliferation of connected devices and endpoints for hackers to attack, Blackberry’s goal is to become the dominant provider of software solutions to protect these vulnerable endpoints. The market’s current obsession with faster growing yet unprofitable companies has created attractive opportunities among the unloved like Blackberry. As its high margin recurring revenues grow and flow to the bottom line, Blackberry’s valuation multiple should expand and drive its share price significantly higher over the next 2 to 3 years, becoming a target for the likes of Microsoft.
Notwithstanding a small hiccup in May after Trump enacted tariffs on an additional $200 billion of Chinese goods, US markets continued to rally in the second quarter closing near all time highs. Our US holdings performed well, up approximately +4.3%. This was ahead of our benchmark, a combination of the S&P500 and Russell 2000 which increased +4.3% and +2.1% respectively. Year-to-date, we are still playing catch up, having lagged early in the year. We are up +14.4% versus +18.5% for the S&P500 and +17% for the Russell 2000. While we are finding most stocks expensive, we still see opportunities with limited downside and attractive upside.
One such opportunity resulted in us adding KKR to the portfolios while selling Virtus. Both companies are money managers, though in different parts of the market. KKR is the large private equity group that also has a growing presence in hedge funds, while Virtus is a mutual fund manager we have owned for the past few years. There were a few reasons why we felt the switch made sense in a market we view as expensive. The first is the large amount of cash and investments KKR holds on its balance sheet. Due to KKR seeding their own funds and their asset growth, they retain earnings to reinvest in new fund launches. At the time of purchase, their cash and investments were worth 2/3rds of the current share price, making the downside limited. Another attractive feature is the large amount of committed but undrawn capital available to them. In a bear market, most asset manager stocks perform poorly as the assets drop along with the market, resulting in lower earnings. However, KKR has the luxury of having its clients irrevocably commit ahead of time to invest additional sums when KKR deems the timing right. Therefore, in a market drop, when assets that KKR would buy become cheap, KKR can call on these clients to invest more, keeping the firm’s total invested assets flat and avoiding the earnings decline of a traditional asset manager. As investors, we love this feature and view it as a defensive addition.
T-Mobile continued to perform well in the quarter as their deal to buy Sprint moved closer to the finish line. We think the deal poses an interesting problem for regulators. On the one hand, going from 4 wireless players to 3 will certainly lessen competition (and is the reason investors in Verizon and AT&T are hoping the deal gets approved). On the other hand, Sprint may not make it as a stand-alone entity as it lacks the funds necessary to invest in a 5G network over the next few years. Regulators are left with the dilemma of allowing the deal despite the bad optics and win concessions from T-Mobile or block the deal and risk a messy bankruptcy of Sprint. We think ultimately regulators will approve the deal and squeeze enough out of the combined entity that they can argue a viable 4th player has been created through the forced divestitures. Right now, it looks like Dish may be that potential 4th player who picks up enough assets to have a plausible chance of success. We would be very happy with that outcome as the cost savings from combining T-Mobile and Sprint (mostly by moving to one network) is the biggest benefit of the deal to investors.
After a strong performance in 2018, this has proven to be more of a challenge. Interest rates continued their decline in the second quarter, fully reversing the increase from the second half of 2018 and falling right back to multi-year lows. The yield curve has also inverted, which means short term rates are above long-term rates, a rare phenomenon. This generally means the market is expecting the Bank of Canada to cut rates soon, something we disagree with. This fall in bond yields hurt our relative performance during the quarter as our bonds tend to have much shorter maturities (duration) than those in the Canada Bond Universe. For the quarter our bond portfolios returned +0.2% versus +2.5% for the Canada Bond Universe and +2.6% for the Hybrid index. Year-to-date we are up +3.8% versus +6.5% for the Canada Bond Universe and +7.2% for the Hybrid index. We are not pleased with our underperformance and will discuss why we think it will reverse.
The main driver is the short-term nature of most of our holdings which on average mature in 4 to 5 years. The index tends to be much longer in duration than that. When rates fall, one wants to be holding longer term bonds as they get the greatest lift. In fact, one of the best performing bonds this year is the Canadian Government 30-year bond which closed the quarter yielding 1.68%. We think our shorter-term positioning will pay off as it did in 2018 when we outperformed. The market is currently pricing in rate cuts in Canada which we do not believe will materialize for the following reasons: Inflation is well within the BOC’s target levels, unemployment is at an all time low, wage growth is accelerating, the housing slowdown in Toronto is dissipating, and the impact of trade wars with the US have been minimal. Given the above, we feel the BOC will stay on the sidelines for the rest of the year, and market expectations for a rate cut will abate.
Another headwind was our preferred share holdings. The preferred share index was down 2% this quarter, but despite the underperformance we still think the asset class offers some of the best returns for low levels of risk. While preferred shares are structurally subordinate to bonds, the issuers tend to be of very high quality. Take for example Power Corp preferred shares that now yield approximately 5.5%. Power Corp is one of the highest rated companies in Canada. By contrast a 10-year BCE bond only yields 3% to maturity. We are very comfortable with the credit risk of highly rated preferred shares and are getting much higher compensation for owning them. And that is before the beneficial tax treatment of receiving dividend income versus interest income on bonds. While our positioning cost us in the second quarter relative to the index, we feel the main drivers will reverse in the back half of 2019 when we should again benefit from the higher yields and shorter term of our holdings.
Macro Divergence: The US and Canada
There has been a growing divergence between the US and Canada. In the former, economic and inflation pressures are in the process of softening. This is also generally true in most of the rest of the world, particulary China, which has so far been resistant to policy stimulus. The risk of rising trade tensions is causing concern among US policy makers. Since December, the Federal Reserve has pivoted toward easing and signalled that interest rates will likely be lowered. This has caused the US dollar to weaken and help lift the price of gold. Canada, on the other hand, is one of the few countries exhibiting signs of a stronger economy and firming price pressures, although the most recent data has softened a bit. In the labour market, full time jobs are being created at an increased pace, wage inflation is up, most measures of price inflation are stronger but not at alarming levels. Investment and trade are making positive contributions to growth and the housing market is better than expected. Prices excluding Vancouver, Calgary and Edmonton are significantly higher than a year ago. Retail sales and industrial production had been sliding since 2017 but are now showing signs of stabilizing. Against this backdrop, central bank policy in the two countries is likely to diverge in the months ahead, with the US easing and the Bank of Canada standing pat, or possibly having to tighten slightly if inflation moves up. This has caused the Canadian dollar to rally versus the US currency, and while higher rates in Canada would not be stock market-friendly, other positive off-setting factors need be considered by investors:
- The Canadian market is considerably cheaper than the US market based on forward earnings. Canada has lagged the US market by 60% in relative terms since 2011. A catch up is overdue. The Canadian stock market is ahead of the US market this year, the US dollar having declined 4% versus the Loonie.
- The prospective divergence in monetary policy between the two countries means the Canadian dollar—which is also very cheap by global standards—should continue to strengthen against the US dollar. This would encourage increased capital inflows looking for better value and a rising currency. Higher oil prices would also support the currency and provide a boost for the industry and Alberta in particular.
- The US stock market appears to have broken out to a new high along with very strong market breadth. A good US market is always a positive backdrop for Canada.
- In the global fixed income market, interest rates are at, or close to, record lows and in many places, negative (i.e. below zero.) Globally, there is currently around $13 trillion of bonds yielding less than zero and this appears to be a growing trend, providing a powerful anchor for the fixed income market in Canada. Very low to negative global interest rates are bullish for Canada’s fixed income market and a plus for Canada’s stock market. It should also be kept in mind that with Canada’s 10-year Government bond now yielding about 1.5% and inflation around 2%, the real (inflation adjusted) 10-year interest rate is minus 50 basis points. Also, dividend paying equities in particular, still look relatively attractive.
A big question mark on the minds of many investors is where the global economy is heading. It is currently in a soft patch and bearish business sentiment is prevalent. However, it is clear that more policy stimulus is coming, particularly in China. It is also likely that the Trump Administration will try to do a trade deal with China in the months ahead as election pressures heat up. If so, that would improve sentiment significantly. There are also a number of uncertainties that have created some investor angst, and these should not be ignored. However, markets look ahead, and prospects are good that the current deceleration in the global economy (excluding Canada) will abate as we move into 2020. Interest rates, particularly after adjusting for price inflation, will likely remain low. A better global economy, higher oil prices and low interest rates will continue to provide a good backdrop for the Canadian stock market.
Stephen Takacsy, Jordan Steiner, Tony Boeckh