October 25, 2017
Third Quarter Letter 2017
During the third quarter of 2017, the Lester Canadian Equity Fund rose +0.8% versus +3.8% for the TSX Composite Total Return. Year-to-date, we are up +6.1% versus +4.5% for the TSX. Individual managed account returns vary from these results depending on cash and stock weightings. Our underperformance during the quarter was due to low weightings in the energy and financial sectors which were up +10.5% and +3.7% respectively, and high weightings in Consumer Staples and Utilities which were down -2.5% and -3% respectively. High cash & equivalent balances, which averaged around 15% bolstered by the takeovers of Sandvine and Veresen, also dragged performance yet buffered volatility during the quarter. Since inception in July 2006, our Canadian Equity strategy has produced a cumulative net return of +200.7%, over double the +86.4% for the TSX. This represents an annual compound return of +10.3% over the past eleven years, net of all fees and expenses, versus +5.7% for the TSX. Measured in terms of “value added” or “active return”, we have generated +4.6% per year above the market’s return, net of fees, for over 11 years.
Notable contributors during the quarter include:
- Goodfood Market (+74%): Newly listed shares of Canada’s leading meal-kit provider dropped to a level we found cheap enough to buy post IPO, and have since rallied on strong sales growth.
- TVA Group (+45%): Quebec’s leading broadcaster released strong results despite a tough advertising market.
- Cenovus (+31%): Oil sands producer has been selling assets at favorable prices to reduce acquisition debt.
- Nanotech Security (+28%): Optical security technology developer reported a strong increase in sales.
- Altus Group (+13%): Real estate services and technology company reported strong results.
- Logistec (+12%): Marine cargo handler and environmental services provider posted good results and backlog.
- Andrew Peller (+10%): Second largest Canadian wine producer acquired three wineries in B.C.
We continue holding high cash balances given our belief that most stocks are expensive, particularly those of large capitalization companies. We are “defensively positioned”, meaning that we also hold high weightings in utilities and consumer staples. When markets rise, our performance may drag as was the case in the third quarter, however when markets drop, we should normally drop less. To find good value today, most opportunities lie in companies that are ignored or out of favor, as was the case when we added 5N Plus earlier this year (up over 70% since we purchased it). Along these lines, we highlight Rogers Sugar and Centric Health, two recent additions to our portfolio. Rogers Sugar is one of two players in Canada’s duopolistic low growth refined sugar market. It is a cash cow that pays a large 5.75% dividend and was regarded as a “sugar bond”. New management has embarked on a strategy to diversify the company into higher growth ingredients such as maple syrup, and recently acquired the world’s largest maple syrup exporter. Centric Health on the other hand, was overindebted after an ill-fated acquisition binge, but has since sold off assets and paid down debt. It is now strictly focused on specialty pharma distribution (fulfilling prescription drugs to retirement homes and longterm care facilities) and operating surgical and medical centers, one of few ways to invest in the Canadian healthcare sector. Both were reasonably valued relative to their growth prospects.
During the quarter, with little warning, the Bank of Canada (BOC) increased interest rates by a total of 0.5% to undo a similar cut when oil prices collapsed in 2015 and start normalizing rates from historic lows, and this despite an inflation rate well below 2%. The BOC move negatively impacted interest rate sensitive sectors like Utilities, and sent the Canadian dollar soaring, potentially hurting exporters. We see the threat of rising interest rates as short lived. We are more concerned about the NAFTA renegotiations, although we believe that our portfolio is well positioned to suffer limited impact under a worse case scenario.
We repeat what we said last quarter: US markets continue to hit fresh all-time highs, seemingly every day. The bull market continues and volatility seems to have vanished from the world. Our holdings outperformed returning +6.7% in the quarter versus +4.5% for the S&P500 and +5.7% for the Russell 2000. Year-to-date we are up +13.1% versus +14.2% for the S&P and +10.9% for the Russell. Value stocks outperformed towards the end of the quarter as discussions around Trump’s tax cuts picked up steam. If Trump succeeds in lowering corporate tax rates to 20%, value stocks should benefit the most as they have more earnings than growth stocks (many growth stocks lose money). Already beaten up retailers would enjoy the greatest benefits as all their earnings are US based and highly taxed.
We mentioned last time how we exited Office Depot at a profit but that the jury was still out on Dillard’s. During the quarter Dillard’s experienced a runup on what seemed to be a short squeeze and we used the opportunity to sell half of our position at around $74. We then began to buy back at $58 as the stock drifted back down, looking to add more should it reach our buy points. We believe the stock is worth closer to $100 and note that the Dillard family continues their aggressive stock buyback. By our calculation, they will run out of stock to buy in about two years, and then make their move to privatise the company at a nice premium.
We added one new name in the quarter, WPT Industrial REIT. This could be considered a hedge in case retail really is dead. The REIT buys industrial property and then leases it out to large players who need extra room for their distribution and shipping centers. These days that tends to mean Ecommerce players. The REIT counts Amazon and Zulily amongst its larger customers. The dynamics of the industry are quite attractive, with occupancy tight and rents increasing faster than inflation. The REIT offers investors a healthy yield and a good chance of capital appreciation. While we don’t expect to hit it out of the park with this one, we think it’s the right place to be for the next 5 years. Overall, we’re hoping for the best but planning for the worst. We are sticking to quality names that are not too expensive and pay healthy tax rates that will soon hopefully go lower. We think this period of low volatility will end, as it invariably must. We cannot predict when, but will be ready to take advantage of it when it does.
We had a great third quarter in fixed income, as our short-term positioning and exposure to preferred shares helped our returns when interest rates finally rose. Our average gross return on fixed income portfolios for the quarter was +1.7%, and +5.2% year-to-date. Individual account returns vary depending on cash and securities weightings. Our benchmarks, the Canada Universe Bond and the Canada HYBrid Bond indices, returned -1.8% and -0.6% respectively for the quarter, and +0.5% and +2.8% respectively year-to-date.
In June, the Bank of Canada (BOC) swiftly changed the message it was giving to markets regarding the direction of interest rates. While he had previously seemed neutral or even dovish, Governor Poloz now seemed concerned that the rapidly improving Canadian economy may soon lead to an increase in inflation. This caught markets off-guard and with rates sitting near record lows, bonds sold off. This continued throughout the summer as the Canadian economy continued to post strong economic data. The BOC eventually raised rates twice by 0.25%, and is expected to raise rates once more before year end. The 5-year Canada government bond yield rose from 0.95% to 1.80% at quarter end. This explains why the bond indexes did so poorly, as they are mainly composed of bonds of longer duration than ours, and as yields rise bond prices drop.
So how did we sidestep the rate increase and post positive returns? For some time now, we have been concerned that rates would eventually rise. We didn’t know when (and have been wrong before), but we made the decision years ago to keep our bond portfolio relatively short term in nature. We were also protected by the higher yield makeup of our corporate bond portfolio, which also benefitted from spreads narrowing due to the positive Canadian macro-economic environment. Finally, we were helped by some of the rate reset preferred shares that we added over the past 18 months, which trade higher when rates rise.
Today, we find that the same spread tightening that benefitted us this year is making us adjust our bond holdings again. We believe that current corporate spreads are too tight, and that we are not being compensated for taking credit risk. Thus, we have been adding new bond positions that are either more highly rated than we previously bought (with expected lower yields) or, on a very selective basis and after an in-depth analysis, bonds that yield 10% or more. Examples of the latter purchased over the past few months are bonds of Aimia and Sherritt. We think this barbell approach will offer us an acceptable 4% to 5% annual return without taking the risk of spreads widening back to more normal levels
PASSIVE VERSUS ACTIVE INVESTING
“Passive” investment strategies (i.e. mimicking indices) have been around for a long time for institutional investors. In recent years, they have become widely available to individuals through ETFs (Exchange Traded Funds). ETFs provide a way for investors who have realized that mutual fund fees are onerously high while their performance on average has been poor, to invest in a basket of securities representing an index. Very few mutual funds do better than market averages, particularly after fees, mainly because they have become so big (managing billions of dollars) that they are forced to buy only the largest and most liquid securities, thus “becoming the index” themselves. ETFs provide an easy way for individual investors to achieve close to broad market returns at very low fees. The proliferation of sub-indices (e.g. technology, corporate bonds, emerging markets, etc.) have also enabled investors to develop asset allocation strategies, a sort of “do-it- yourself” (DIY) portfolio management. The benefits are tempting for investors who have trouble finding good “active” managers (i.e. stock pickers) that outperform the indices or have limited funds that don’t meet the minimum requirements of professional managers like LAM. ETFs also appeal to those who enjoy the DIY approach at being their own “expert”, which is not as easy as it sounds without proper accounting, finance and economics courses, as well as lots of experience.
As a result, the flood of new money into ETF products has gone exponential (there are almost as many ETFs as stocks). In the investment world, whenever a product develops a manic following, as is the case for ETFs, it is important to understand the risks and the consequences. When new money goes into an ETF, the “manager” of the product needs to buy the individual securities that comprise the index being mimicked, without any analysis as to the merits of investing in those securities (i.e. valuation, outlook, leverage, etc..). The greater the money inflow into an index, the higher the price one is paying for the underlying securities and the lower the margin of safety when the market corrects. When a market gets expensive (e.g. the S&P 500 in the U.S. now trading at a near-record high P/E ratio), investors owning the corresponding ETF are, by definition, owning expensive securities. In a real mania, the danger to investors can become huge. In 1989, for example, passive index investors in Japan owned stocks with an average P/E ratio of 60 before that market crashed and has since never recovered. In 2001, Nortel (which later went bankrupt) was trading at around 120 times earnings and had grown to a 40% weighting in the TSE (now the TSX). “Passive” investors owning the TSE index, therefore, had 40% of their money in a ridiculously overvalued company and suffered the consequences. Bre-X, another Canadian disaster, turned out to be a fraud. It was valued at $6 billion in 1996 and had become part of the TSE. Investors in the TSE index thus had invested part of their money in Bre-X.
There are obvious advantages to having one’s money managed by a smaller “active” manager who is focused on value and has a long-term track record of outperformance like LAM. Investors can take comfort that proper research, analysis and diligent securities selection, combined with the flexibility to choose securities with the best risk/return characteristics, will help avoid the situations above and prevent getting trapped in overvalued baskets of securities when everyone starts selling the same ETFs at the same time.