October 20, 2016
Third Quarter Letter 2016
CANADIAN EQUITIES: 10 Years of Outperformance Continues…
During the third quarter of 2016, the Lester Canadian Equity Fund rose +7.9% net of all fees and expenses, versus the TSX Composite total return which was up +5.5%. While the TSX’s returns were driven by energy stocks and financials, our outperformance was again due to strong contributions from a diverse group of small and mid-cap holdings. Year-to-date, we are up +22.8% versus +15.8% for the TSX. The previous quarter marked the 10th anniversary of our Canadian equity strategy which from inception in July 2006 to September 2016 has produced a cumulative net return of +179.2% versus +70.7% for the TSX Composite. This represents a compound net return of +10.5% per year for over 10 years (approximately +11.7% gross), roughly double the +5.4% for the TSX, making us one of the top Canadian Equity managers over the period.
Since many companies contributed to our strong results during the third quarter of 2016, we thought we would list more of them than usual including:
- QHR (+59.8%): Electronic medical records software provider announced that Loblaw would acquire it.
- Diamond Estates (+45.8%): Wine producer and sales agency announced much improved financial results.
- Savaria (+36.7%): Medical equipment supplier posted record results and was added to TSX Small Cap Index.
- Badger Daylighting (+26%): North American hydrovac fleet operator posted improved results and outlook.
- Neulion (+24.2%): Shares of leading sports video streaming company rebounded after a sharp pull-back.
- Park Lawn (+22.6%): Cemetery and funeral home operator posted strong results following US acquisition.
- Veresen (+22.4%): Energy infrastructure firm announced sale of renewable power assets and good results.
- Andrew Peller (+21.8%): Leading Canadian wine producer announced strong results and a 3:1 stock split.
- Element Financial (+19.9%): Fleet manager and equipment lessor plans to split the company into two.
- Linamar (+19%): Auto parts manufacturer posted strong results despite negative sentiment affecting sector.
- Newalta (+13.5%): Industrial waste processor stock moved higher on recovery of oil prices.
- Prism Medical (+12.7%): Provider of medical equipment received a higher offer from Handicare of Sweden.
- Maxim Power (+12.5%): Electricity producer sold its operations in France and negotiated a favorable settlement with FERC which should pave the way for a sale of its US assets.
Rather than highlight a particular winner or loser during the quarter, we thought we would stress that the key to successful investing and stock selection is in following a rigorous and disciplined process. This requires establishing a strict set of investment criteria and performing in-depth research to identify attractive opportunities. It also involves setting appropriate risk parameters, constructing portfolios to dampen volatility, monitoring investments diligently, while being opportunistic and exercising plenty of patience.
At this juncture, we believe that there is no shortage of macro risks that could threaten capital markets. Artificially low interest rates have inflated the value of financial assets such as stocks, bonds and real estate, yet globally-coordinated monetary stimulus which has been in full force since the financial crisis, has still not managed to stem deflationary trends or spur world economic growth to desired levels. Investors consider that “there is no alternative” (TINA) and appear complacent while markets climb a wall of worry. Antiglobalization sentiment reflected in Brexit and US election rhetoric, and concerns surrounding the health of systemically important financial institutions such as Deutsche Bank have us more cautious than usual.
We continue to feel that stock valuations are elevated in relation to growth prospects and have taken some profits on several of our larger holdings. We are also being patient in redeploying cash received from numerous takeovers that have benefitted us this year. Consequently, equity portfolios currently have larger cash weightings than usual while we patiently wait for better investment opportunities.
US markets continued their seemingly inexorable climb in Q3 to hit new highs. While we are defensively positioned with larger cash balances than normal, we were more than able to keep pace. During the quarter our US strategy returned 5.3% bringing year to date gains to 11.3%. The S&P500 gained 3.9% in the quarter and sits at 7.8% for the year, while the Russell 2000 gained 9.1% in the quarter with a gain of 11.5% so far this year. Our portfolio is a combination of large and small cap stocks thus we expect returns to come in the middle of these two indices and are pleased when they outperform the average of the two.
Similar to our Canadian companies, we had three take-outs in the quarter. Outerwall was bought out by a private equity firm for $52 per share. While we view the take-out price as low in relation to our fundamental view of the company, it represented a decent premium to the trading price of the shares, which had been underperforming. We think the private equity firm got a steal. Media Company Starz announced they were combining with film studio Lionsgate in a combination of cash and shares. Again we view the price paid as leaving money on the table but since we receive stock in the combined company, we can still participate in the future upside. Starz’ originals continue to attract growing audiences and the added scale of the combined company will help Starz negotiate better deals with the cable companies. The final take-out was Enbridge announcing it will be acquiring our Spectra Energy in an all stock deal to create a pipeline powerhouse. We will sell our Enbridge shares when the deal closes. All three deals helped contribute to our 5.3% performance in the quarter.
We added a new name this quarter when we purchased Calfrac debt. While the US strategy generally consists of buying stocks, we also buy distressed bonds from time to time when the potential return is equity like and the risk/reward is favorable. In this case, the Calfrac bonds at 64 cents on the dollar offered an attractive 21% yield to maturity and the potential for an even quicker gain should the company post better results. The company owns and operates fracking equipment used in oil and gas development. Calfrac is one of the larger companies in their space in North America, with operations on both sides of the border. While their results are currently weak, we think the assets on the balance sheet give our bonds good protection. The pricing on the sale of equipment in two fracking bankruptcies this past January and February (arguably the bottom for oil) implies our bonds would be paid off in whole.
One of the advantages at Lester is that we are not constrained by a single asset class. When a bond becomes distressed and offers an equity-like return we have the ability to analyse the risks and buy it for our equity accounts. Larger Portfolio Managers are boxed in by their strict mandates to either buy only bonds or only stocks, missing some attractive opportunities that we can take advantage of for our clients.
Our average gross return on fixed income was 4% in the quarter and 12.7% 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 (Canada Universe Bond Index 1.2%, 5.3% YTD and Canada HYBrid Bond Index 2.6%, 7.9% YTD) due to our exposure to higher yield corporate bonds, which outperformed government bonds. Once again our strong performance emanated from the energy sector that continues to rally, with significant contributions from other sectors. The higher coupon rates that our bonds pay contributed as usual. We reiterate that the year to date’s exceptional returns represent, to some extent, a catch up of last year and should not skew an investor’s expectation of prospective returns on fixed income.
We believe that investing in most government bonds represents risk without return and therefore we continue to invest in short duration investment grade and high yield corporate bonds, with the goal of protecting capital when interest rates inevitably rise. Average maturities are close to four years and yields are approximately 5%. 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 of government bonds.
We have increased our investments in preferred shares for taxable accounts, as this sub sector of fixed income is recovering from a very difficult period and presents good value. In general, the issuers tend to be of a better quality than many high yield bonds, however, we are being selective due to the subordinate ranking of preferred shares and their perpetual nature.
Trump and the US Election
After two rounds of Presidential debates and one amongst the VP candidates, it seems quite likely, barring any major Democratic misstep that Hillary Clinton will win in November. Speaking of missteps, it seems that Trump has finally crossed the line of decency with the powers to be in the GOP and voters, when the 11 year old tape emerged with Trump boasting about his popularity with women. At least, that is what he thought he was doing. To most women, what he said was highly insulting and abusive to say the least. Indeed, we wonder how any woman can possibly support him now, let alone before.
Therefore, we are working on the assumption that Clinton wins. We also think that the market is now pricing in a Clinton victory. In other words, if the election was today and Hillary won, then the markets would remain flat. The next concern is what happens in the House of Representatives and the senate. We believe that if the market “knew” that the Democrats were going to sweep all three pillars of the American politics, there would be a significant move to the upside from here. This is contrary to how markets usually behave when it comes to Democrats in power… but this time it is different. Some point to Obama’s victories which seemed to be cheered on by markets as another exception, but note that markets were happy that Obama could not control congress. However, after 8 years of government stalemate, markets seem ready to embrace a President who also controls the House and Senate… even if they are all Democrats.
There is an argument that it does not really matter who is the President. That the President cannot, and does not, change much. This argument states that during different periods in time, politicians with specific characteristics rise up the ranks. Put another way, it is not the President who changes the times in which he/she lives in. Rather, it is the times in which we live in that determines who is President. That, perhaps, explains Trump. Well known Right Wing commentator, Glenn Beck recently likened Trump to a Molotov cocktail. The crazier and more volatile, the better. Supporters want him to win so that they can toss him into Washington and figuratively blow the whole place up. In the past, it was inconceivable that there would be enough support for the destruction of Washington to actually elect someone like Trump. Sadly, it seems like there are a vast number of voters who are angry or deluded enough to do just that. Perhaps some people, like the Brexit supporters in Britain, should be more careful in what they ask for. Bill Maher said it best when during the primaries, before the outcomes were clear, he suggested that “Bernie is what the US needs… Trump is what the US deserves.”
We mentioned in our last letter that we would start raising cash if we felt that Trump was gaining in popularity, but current polling is telling us his odds of winning are low. Additionally, we are always looking at valuations and these days it does seem harder to find “fat pitches”. As of this writing we are at about 15% cash in our accounts on average and in this environment we are comfortable at this level.