October 22, 2015

Third Quarter 2015 Letter

Canadian Equities

During the third quarter of 2015, the Lester Canadian Equity Fund declined by -12.4% versus -7.9% for the TSX Composite total return including dividends. Year to date, the Fund’s return is -13.1% versus -7.0% for the TSX. Our underperformance during the quarter was mainly due to larger than market declines of less liquid small and mid-cap stocks, which form a meaningful part of our portfolio, caused by indiscriminate selling during the equity markets correction in August and September, as well as some company specific events. While we are not pleased with these results, we are cognizant that there will be periods of extreme market volatility and underperformance. Nevertheless, we are off to a good start in October and are focused on improving returns. We remain confident that our portfolio holds significant unrealized value and upside.</p>

Since inception in July 2006, our equity strategy has produced a cumulative net return of +122.6%, over double the +49.5% for the TSX. This represents an annual compound return of +9% (net of all fees and expenses) over nine years versus +4.4% for the TSX.

Notable winners and losers during the 3rd quarter included:

  • CCL Industries (+22.2%): Global packaging company announced strong 2nd quarter results.
  • Emera (+12.5%): Defensive utility holding. Announced 19% dividend increase and a large US acquisition.
  • Plaza (+4.5%): Real estate developer of retail properties announced strong 2nd quarter financial results.
  • Linamar (+4.1%): Auto parts company purchased after market correction and negative Volkswagen news.
  • BCE (+2.9%): Defensive telecom holding. Announced strong 2nd quarter financial results.
  • FP Newspapers (-79.5%): Eliminated dividend to repay debt faster and evaluate acquisition opportunities.
  • Neulion (-61.7%): Announced the loss of NHL contract representing 12% of revenues. Insiders have been buying shares. We expect new contracts to replace the lost business soon.
  • Conifex (-47.1%): Announced weak 2nd quarter results due to lower lumber prices and the delayed startup of its bioenergy power plant.
  • Questor (-47%): Waste gas emission control manufacturer sales declined due to the slowdown in the oil & gas sector. The company is now trading under book value.
  • Veresen (-39.6%): Dropped more than other energy infrastructure stocks on news that its LNG project will be further delayed. Stock has rebounded 20% since.

Among winners we highlight a new holding, Linamar, which we purchased after a large correction in its stock price. This well-managed and fast growing global auto parts supplier is benefiting from outsourcing of the manufacturing of precision engineered aluminum parts which are helping cars become lighter and more fuel efficient. It also just recently announced a large acquisition which will help diversify its customer base, vertically integrate its operations and expand its international presence. Linamar trades at a low valuation in relation to its future earnings growth.

Among losers, we highlight two long time holdings which operate profitable print media businesses. These two stocks have been severely hit after eliminating their dividends so that they can focus on debt reduction and growth opportunities. While in secular decline, both Glacier Media and FP Newspapers generate strong free cash flow with minimal capital expenditures. They now trade at very low valuations of 3.5X and 2.5 X EBITDA (earnings before interest, taxes, depreciation, and amortization) respectively. Glacier owns community newspapers in Western Canada and several high margin business information services, and our sum-of-the-parts analysis indicates that the shares are worth significantly more than what they currently trade at. Glacier plans to divest of its community media assets and reinvest in its high growth data businesses, and insiders have been aggressively buying shares. FP, on the other hand, is looking to further consolidate print operations in Manitoba and Saskatchewan. Despite now having a market cap of less than $10 million, FP has paid out substantial dividends to shareholders over the years totaling $178 million since going public in 2002. We expect cost cutting and accretive acquisitions to boost its share price.

We continue to believe interest rates will stay lower for longer due to weak economic growth in Canada and globally, and dividend yield continues to be an important part of equity returns. We thus continue to hold dividend paying stocks in stable sectors such as Telecom, Utilities, Renewable Energy, and Infrastructure. The economic slowdown in China and global price war in oil are keeping us away from resource related stocks, and we are focusing on companies that benefit from a strong US$, being either manufacturers/exporters or having a growing portion of their earnings or assets in the US.


The third quarter was a trying period for the US stock market with nowhere to hide. The good news is we are already seeing a strong recovery to start Q4 and our companies continue to post solid fundamental results. For the quarter our US strategy was down -10.7% and -5.5% year-to-date compared to the S&P500 of -6.4% and -5.3% YTD. The Russell 2000 is down -11.9% and -7.8% for the quarter and year respectively. Similarly to Canada, small caps were hit hardest as they are more illiquid and investors look to the perceived safety of large caps in times of market stress. In actuality, small caps tend to have operating results more closely linked to the strength of their home country and with the US still looking like the best performing economy in the world, we do not think this small cap underperformance will last long.

We were active in the quarter adjusting the portfolios and revisiting old ideas. We repurchased Dillard’s as the stock has come back down to a level where it is reasonably priced on the department store business and you get 50% upside from their valuable real estate holdings, should the Dillard family choose to monetize these assets. We also repurchased Kulicke and Soffa, a company we have made money on in the past. Kulicke is trading for about 3 times earnings net of the substantial cash holdings on their balance sheet. This large cash position gives us downside protection on the investment with upside, should management continue to buyback stock aggressively. We sold our Post Holdings, and although we love the company and its management team, there was little upside to the stock at such a high trading price. We would look to get back in should the valuation become more reasonable.

Two underperformers in the quarter were CF Industries and Hornbeck Offshore. Hornbeck fell along with the entire energy services space as oil hit a fresh low. This is in spite of the company again beating expectations and reporting industry leading operating results. Our thesis that Hornbeck’s superior fleet and management will enable them to charge higher day rates and enjoy higher levels of utilization than the competition during the downturn is playing out, and eventually Wall Street will take notice too.

CF industries sold off with the overall selloff in commodities. CF is the largest nitrogen fertilizer manufacturer in North America with an enduring cost advantage over worldwide producers. This is due to their low feedstock costs of natural gas, the primary input into fertilizer. The cost advantage they possess is a long term stable advantage, yet the company is still trading for only 9x next year’s earnings. We find this very low for a growth company that is shareholder friendly in an industry as essential as fertilizer and think it should trade closer to 15x 2016 forward earnings. We expect these two companies to be amongst our biggest winners in the next 12 months.


Our dollar weighted average return on fixed income was -2.4% in the quarter and is +1.5% YTD. Individual account performance varied from this, depending on cash balances and portfolio weightings. In the quarter, we underperformed the returns of the benchmarks (Canadian Bond Universe +.15% and FTSE TMX Canada HYBrid Bond Index -1.65%) due to our exposure to corporate bonds, which sold off in the quarter along with equities. Several of our energy and materials bonds closed significantly lower, however at this time they have partially recovered. 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 relatively short durations. To achieve fixed income returns today, we continue to prefer to do our research and take the credit risks of our bonds, rather than extend term with the commensurate interest rate risk of government bonds.

Volkswagen: A Lesson in Short Term Thinking

Certainly one of the most important and interesting business stories of the year, on many levels, is what happened at Volkswagen. In hindsight, it seems almost impossible that those particular decisions, to install software that tricked emission monitoring equipment, could have been made. How could a company do something like this when they HAD to know that it would eventually be discovered? Indeed, it is becoming evident that this was not only a secret amongst a small cabal of devious engineers, but rather a widely known strategy. In fact, Volkswagen’s senior management was warned by at least one of its software vendors that it was embarking on a dangerous path by deploying this illegal, deceptive device on its cars.

So what were they thinking? To us, this is a prime example of a major problem today in business and investing: The propensity to focus on the short term at the peril of long term utility or benefits. One can imagine that the particular decision makers at Volkswagen were under pressure to deliver short term goals. Perhaps their pay was structured in such a way as to handsomely reward performance in the short term. Or even more compelling, they held stock options. This deception which began around 8 years ago was a big reason why Volkswagen had recently become the biggest car seller in the world. Rivals spent hundreds of millions of dollars trying to compete with Volk’s “achievement” – of maintaining high performance while complying with ever stricter emission standards – but failed. This “success” was intoxicating and Volk’s upper management was likely busy celebrating and patting each other on the back rather than paying attention to the details of how they got there. As the Madoff scandal, and many other assorted Ponzi schemes that constantly fill the news, have taught us; it is human nature to look the other way and not question things as long as we are benefiting from them. Even when what is happening is obviously not sustainable or logically impossible, we have a way of tricking ourselves into believing it. “This time it is different…” is often the cry of justification. Somehow the powers to be at Volkswagen deluded themselves into thinking that this strategy of deception was the right thing to do and would not be caught, at least in their working lives.

Incidentally, let us not forget that this is not a problem limited to Volkswagen. Two hedge fund-backed, debt-fueled consolidators disguised as pharmaceutical companies, Valeant and Concordia Health, are being hammered in the market and in the news for pursuing completely unsustainable business plans of growing revenues purely by continually hiking up drug prices after acquiring them from other companies. Both companies, as well as others like them, have been able to hide their modus operandi from everyone including shareholders by using the usual excuse; “revealing the actual breakdown in numbers will hurt our competitive advantage”. The real problem is that our system is set up to overly reward short term performance and as long as these often grotesque incentives are in place, humans will invariably succumb to the temptations.

Another takeaway from the Volkswagen episode is the fact that it happened to an industry leading “Blue Chip” company, not to a small desperate startup. There is a widespread perception amongst investors, reflected in share value premiums, that there is a measure of enhanced safety when buying shares in larger corporations. They have systems in place to protect against mistakes. Too many eyeballs to fool. Too much at stake to take chances. Well, perhaps in this day and age with such disproportionate focus on short term gains, the opposite is true. It could be that smaller companies that have fewer moving parts and are subsequently easier to monitor, are actually safer investments in this regard. We think so.

Ken Lester, Stephen Takacsy, Peter Dlouhy