January 25, 2016
YEAR END LETTER 2015
During the fourth quarter of 2015, the Lester Canadian Equity Fund increased by +2.1% versus the TSX which declined -1.4%. Our outperformance during the quarter was due to positive news on several of our small and mid-cap holdings and lower weightings in the materials, energy and financial sectors. For 2015, the Fund declined -11.3% versus -8.3% for the TSX Composite total return including dividends. Our underperformance occurred mainly during the August and September global market rout when there was indiscriminate selling of less liquid small and mid-cap stocks which form a meaningful part of our portfolio. For reference purposes, the Canadian Small/Mid-Cap Index was down -13.3% for the year, so our return was in-line with the average of this index and the TSX. While we are not pleased with the results for the year, we expect there will be short lived periods of underperformance, particularly during extreme market volatility. We remain confident that our portfolio holds significant unrealized value and upside, and are continuously searching for attractive opportunities.
Since inception in July 2006, our equity strategy has produced a cumulative net return of +127.3%, more than double the +47.4% for the TSX. This represents an annual compound return of +9% over the past nine and a half years, net of all fees and expenses, versus only +4.2% for the TSX.
Notable winners and losers during 2015 included:
D-Box Technologies (+92.1%): Developer of motion systems for movie theaters and industrial simulation has been achieving record results. Recent deal with Cinemark bodes well for the future.
CCL Industries (+59.3%): Global packaging company has been announcing record profits as a result of a series of acquisitions. We sold our position after a rise of 450% over the past 3.5 years.
Com Dev (+52.4%): Satellite parts manufacturer announced that it will be acquired by Honeywell and will spin off its data subsidiary exactEarth. Our return was 60% in just over 2.5 years.
Andrew Peller (+36%): Leading Canadian-owned wine producer and marketer has been achieving record results. Valuation still remains inexpensive.
Ten Peaks Coffee (+35.2%): World leading decaffeinator’s sales have been expanding in the US and overseas due to the trend towards organic chemical-free decaffeinated coffee.
FP Newspapers (-80.8%): Profitable newspaper business eliminated its dividend to repay debt faster and make accretive acquisitions. Trading at 3 X EBITDA.
Newalta (-80.2%): Wastewater processor’s results have been negatively impacted by the slowdown in the oil & gas sector. We added to our position expecting results to bottom out in 2016.
Questor (-74.6%): Waste gas emission control equipment manufacturer’s sales declined due to the slowdown in the oil & gas sector. The company is now trading at close to tangible book value.
Conifex (-64.3%): Announced weak results due to lower lumber prices and the delayed start-up of its bioenergy power plant.
Corus Entertainment (-52.9%): Canadian TV and radio broadcaster has seen declines in ad revenues. We added to our position as its shares had become oversold and were trading at an attractive valuation.
Among winners, we highlight one of our newest holdings, Ten Peaks Coffee located in B.C., which is the orld’s only processor of 100% chemical-free organic decaffeinated coffee using the branded “Swiss Water” trademark. Recent growth has been driven by specialty roasters servicing “3rd wave” premium coffee shops and major chains such as Tim Horton’s and McDonalds. Ten Peaks will be building a new plant in the Vancouver area to meet growing international demand as the world transitions away from chemical-based decaffeination processes. The company generates strong free cash flow, pays a dividend, and is still inexpensively valued.
Among losers, we highlight long time holding Corus Entertainment, now Canada’s largest pure-play TV and radio broadcaster, and content producer. Corus has been suffering from a drop in ad revenues and uncertainty over new CRTC rules, yet continues to generate strong margins and free cash flow. Its valuation had dropped to a trailing P/E of 6.2X and TEV/EBITDA of 5.6X. Corus recently announced better than expected results and that it will be acquiring Shaw Media for $2.65 billion, a long overdue and logical combination that will generate significant cost and revenue synergies. Shaw Communications will own 39% of Corus post-transaction and will receive its ongoing dividends in the form of Corus shares, thus further increasing its stake. Also, Corus is selling its pay TV service to BCE for $220 million and will focus more on content creation at its Nelvana studios. Corus’s dividend yield is around 10% and its payout ratio remains low, so investors are well-paid to wait for renewed growth and merger synergies to kick-in.
As we had anticipated, global economic growth remains weak and interest rates are staying lower for longer in order to keep providing needed stimulus worldwide. What we had not foreseen was the hellbent resolve of Saudi Arabia in launching a price war on competing oil producers, nor the depths that the price of oil would reach. While our exposure to resource companies has always been low due to their risky nature and our lingering concerns about China’s slow down, the carnage in the energy sector has spread to other industries. With low government bond yields in Canada and a depreciated Loonie, we remain focused on non-resource dividend paying companies in stable sectors such as Telecom, Utilities, Renewable Energy, and Infrastructure, as well as companies that benefit from a strong US$, being either Canadian manufacturers/exporters or having a growing portion of their earnings or assets in the US.
2015 was a challenging year for a value investor in the US markets. We felt like Michael Burry in The Big Short which we saw over the Christmas break; every day he sees the housing market collapsing but his bet against housing keeps losing money. That is until it doesn’t. 2015 felt the same way as our companies executed well within their respective industries but they either got caught up in macro headwinds that caused investor anxiety (CF, Hornbeck) or just didn’t get any respect (Regal Cinemas). As with Michael Burry, these disconnects don’t last forever and eventually good operating results are reflected in appreciating stock prices. This was our first losing year and the first for many US indices in a long time. For the year, the Lester US strategy was down 8.8% vs a gain of 1.4% for the S&P500, a decline of 4.4% for the Russell2000 and a decline of 7.5% for the Russell2000 Value Index (in USD). The Russell is a small cap index where most of the constituents have market caps between $1 and $3 billion, right in our wheelhouse. Our portfolio is a combination of small cap value names like Dillard’s, Regal and Providence Service Corp. with some large cap names like Microsoft, GE and Verizon to add stability in times when small caps are out of favor.
Our biggest winners this year were consumer oriented companies like Post Holdings (+62%) and T-Mobile (+45%). Post recovered from a temporary scare revolving around the avian flu affecting egg supplies and rallied to new highs as management beat forecasts and did well integrating their acquisitions. T-Mobile continued to add record subscribers as their aggressive pricing, improving network and edgy advertising campaign continues to connect with consumers. We used the rally in Post as an exit opportunity and continue to hold T-Mobile as we believe the best is yet to come.
Our biggest losers were companies facing macro headwinds in their respective market, as Hornbeck (-60%), Dillards (-47%) and CF (-25%) each had their unique challenges. Hornbeck is an offshore oil service company that was caught in the same downdraft as the rest of the energy complex. Our only solace is that we were right about the qualitative attributes that made Hornbeck a more resilient company than its competitors. Due to its superior fleet and geographic location, Hornbeck is the only one of its competitors that is still profitable, and saw half the decline in EBITDA that its competitors saw. It is a best of breed company in an industry going through a generational challenge.
Dillards saw a warm fall and start of winter lead to inventory build ups and high levels of markdowns. This industry problem equally hurt Macy’s and Nordstroms. With one of the cleanest balance sheets and very undervalued real estate, Dillards is well positioned for a rebound as the industry works through the excess inventory. CF, the largest nitrogen fertilizer manufacturer, is the low cost producer in the industry. Industry prices are dictated by the Chinese, the high cost producers who act as the clearing price takers. Due to the devaluation of the Yuan, which kicked off this summer, investors have feared a decline in fertilizer prices. We think this fear is overdone at this point and CF is very close to trading at a floor.
Entering 2016, the markets have had a rough start but we see reason for optimism.
1) It seems value investing is coming back in vogue after taking a few years off (long term value will always provide the best returns).
2) Markets are approaching a level that is closer to the long run average of about 15 times earnings.
3) We are seeing more and more attractive opportunities and we have enough of the portfolio in cash to take advantage of the mispricings as they materialize. The markets tend to be efficient in the long run, but in the short term there are opportunities. Similar to Dillards’ customers, you can catch the market at the right time when merchandise goes on sale.
Our dollar weighted average return on fixed income was -0.9% in the quarter and +0.6% for 2015. Individual account performance varied from this, depending on cash balances and portfolio weightings. In the quarter and for the year, we underperformed the returns of the benchmarks (Canadian Bond Universe: +1% and +3.5%, and FTSE TMX Canada HYBrid Bond Index: -0.2% and +1%) due to our exposure to corporate bonds with higher yields, which underperformed the benchmarks.
Although some of our bonds at year end were marked down and showing losses, we continue to believe that many of them have been overly penalized by the market. Other than events of default or voluntary restructuring, corporations have an obligation to pay interest and principal at maturity; this is important to consider when looking at valuations. Additionally, there can be positive surprises to bondholders. A case in point is our holding of Corus Entertainment Senior Notes, which represented our largest bond position. At December 31st they were priced at 93.00, showing a valuation loss to our clients. Last week Corus announced a significant acquisition that will likely force Corus to redeem our bonds at a significant premium. Rather than waiting for the last few points with inherent deal risk, we sold our entire position at 106.45, a 14% gain in less than two weeks.
In December, a small convertible bond position (IBI Group), that we had purchased the majority of at 100 and was valued at 58 in September, was redeemed as per its original terms at 100. This serves as a reminder that regardless of a bond’s interim pricing, investors should focus on the issuer’s ability to meet its obligations, rather than the price at a specific point in time. To be clear, we abhor this type of olatilitybut unfortunately it is an innate aspect of investing in higher yielding corporate bonds, a sector we have generally excelled in.
Fixed income portfolios remain invested exclusively in corporate bonds, both investment grade and high yield, with average yields close to 6% and relatively short durations. To achieve reasonable fixed income returns today, we continue to prefer to do our research and take the credit risk of our bonds, rather than extend term with the commensurate interest rate risk of government bonds.
THE CHINESE ECONOMY
The unprecedented growth rate in China over the last twenty years has transformed and severely disrupted many industries world-wide, especially those involved with energy and materials. Today’s concerns about how a slowdown in China will impact these same industries are what are causing massive movements, mostly to the downside lately. History teaches us that rapid expansion must include periods of contractions or pull-backs. Indeed, like volcanoes and earthquakes, small and frequent eruptions are preferable to isolated big ones. China has not had a contraction for a long period now and the longer we go without one, the more intense it promises to be. China announced recently that its GDP is likely to “only” go up about 6% in 2016. Any developed country would love to have an annual GDP growth rate of 6%, but in China 6% is a drop from the 8-9% growth that the world has gotten used to. Of course, what really concerns forward seeking markets is what happens to China in the years following 2016. In terms of the effect of a slowdown in China on the rest of the world; there are direct and indirect concerns.
Certainly countries like Canada that are huge net exporters of commodities are being hurt by China slowing down its use of them. At one point recently, China was buying half the world’s copper output, however the current price of copper tells us that this is hardly the case anymore. Indirectly, the rest of the world must be concerned with social instability that is feared to be associated with a slowdown in China.
Until recently, the BOC artificially linked the Yuan to the USD. This made sense because the US consumer was the primary buyer of goods manufactured in China, and China was financing the US consumer by being the biggest buyer, by far, of US Treasuries. As the USD has recently gained significantly against just about all other currencies, the linked Yuan gained alongside and thus made Chinese goods less competitive against goods manufactured in other low wage countries. China had no choice but to devalue. The concern here is that this action could certainly lead to currency wars with other low wage countries devaluing their currencies to match the Chinese. Note that essentially all currencies are in a “race to the bottom” as central banks try to maintain international trade balances with each other.
The Chinese Stock Market
There is a huge learning curve going on in China as its government is trying to encourage its people to invest and participate in the stock market. We actually do not categorize recent downwards movement in CSI 300 (Shanghai Shenzhen Exchange) as a crash, but rather as extra volatility associated with unsophisticated participants. The Chinese have a strong affinity to gambling and games of luck or chance. There is an expression in China that says…”If you do not gamble, how do you know how lucky you are”. As China opened up investing to the average citizen (previously it was restricted to certain professionals), volatility increased. Essentially, new unsophisticated players who are gambling rather than investing will amplify the variance of a market thus creating more bubbles in both directions.
In terms of government intervention, one can clearly see that China is constantly modifying and tweaking the rules and regulations as time goes on. This is part of the learning curve where it is trying to come up with the right balance of rules and regulations that lead to an orderly and smooth operation. Recently the addition and then removal of circuit breakers on the CSI is a clear example of that. As well, the BOC has demonstrated that they are not opposed to massive buying and selling of stocks when they deem the actions as supportive. This has the effect of giving comfort to shareholders that there is a floor. China, of course, is not the only one who does this. For years Canada attempted to keep our dollar fairly close to the USD by openly buying and selling the USD as they saw fit, although apparently that has not been the case for a while now. All this to say that, bottom line, we feel that North American markets have overreacted to perceived problems in China and how those problems may affect the rest of the world.