Active Management: Taking Advantage of Passive Instruments. Again.
At Pender we practice active management and are fundamental value investors who base our investment process on taking advantage of market inefficiencies, such as when a company becomes significantly mispriced in comparison to what the business is worth either to a third party acquirer, its liquidation value or the risk adjusted present value of its future cash flows. Basing investment decisions on fundamentals makes intuitive sense to us, but we also realize there are many kinds of market participants that have their own investment rational (or irrational, as the case may be).
If you want returns on an investment to double, it comes down to simple math. You must purchase a security at 50% of its selling price. The purchase is simple, however, which security and “when” are not so simple.
Market participants such as Exchange Traded Funds (ETFs) are passive instruments that base investment decisions on criteria that are in stark contrast to fundamental analysis, often disregarding what a company may actually be worth. This makes these funds the perfect trading partner – an entity that will sell to us when a stock is cheap and will buy from us when it is expensive. And recently, with the proliferation of these passive funds, we have found a growing number of opportunities which we are able to exploit to the benefit of our unit holders.
For example, a company cuts its dividend from 21 cents to 5 cents and sets in motion a chain of events that gave Pender the opportunity to double its return on a holding.
Wi-LAN is an intellectual property licensing company that helps patent owners monetize their existing patents. Patent owners seek out Wi-Lan to unlock dormant value in their patents, which in turn creates an ability to better fund future growth initiatives. Wi-Lan currently has a patent portfolio of over 15,000 patents, built through acquisition and partnerships, and possesses an impressive long-term track record of monetizing patents compared to sector peers. Pender has been following the company for 10 years, buying and selling based on our fundamental analysis. In May 2015, after several quarters of negative growth and changes in the US patent environment putting pressure on the company, we took the view that the risk outweighed the potential reward and sold our position in full. However, knowing the company as well as we do, we kept an eye on the fundamentals.
The central tenet of the iShares S&P/TSX Dividend Aristocrats Exchange Traded Fund (CDZ-T) is to passively track the Canadian Dividend Aristocrats index. For a company to be included in the index, and therefore the CDZ-T, it must have increasing cash dividends for five years straight. The criteria of the index is purely mathematical and historical in nature. A portfolio manager does not fundamentally analyze how these dividends may change in the future by trying to determine the strength of the company’s competitive positon in relation to its peers, whether the cash flows generated by the company can afford the current dividend or management’s aptitude. The way it generates returns for shareholders is by hoping that past dividend increases will project into the future.
Over time Wi-LAN became a key holding in the CDZ-T and due to the combination of the company’s relatively small market capitalization size and the fund’s increasing size, the CDZ-T ended up owning more than 10% of Wi-Lan’s outstanding shares. Owning such a large portion of the company meant that when the CDZ-T bought or sold Wi-Lan, it had a major effect on the value of the company.
Given the changing industry conditions, the company reorganized its operations for the long term benefit of shareholders and made the decision to cut its dividend by around 80% from 21 cents to 5 cents. Regardless of the practicality of the decision, the CDZ-T had no choice but to passively track the index, so when the index dropped Wi-LAN for no longer meeting its dividend criteria, the fund sold its entire block of Wi-LAN stock. With unfavourable industry dynamics and dividend investors fleeing the stock, Wi-LAN declined 45% in under a month and became significantly undervalued, in our opinion.
Knowing the quality of the company and the potential benefits from the reorganization, the fire-sale on this volume of Wi-LAN stock made it too good to ignore. We started buying in December of 2015 between $1.40 and $1.60 and patiently waited for the company to emerge from the downturn.
In March 2016, as the stock returned to a more reasonable valuation of $2.50, we began to trim our position and have slowly been reducing our exposure as the stock hovers between $3.50 and $3.70 (May 2016). We currently retain a small weighting and have duly benefitted from the decisions of our passive fund counter party.
This investment episode is not about the return, favourable though that was. There are two key takeaways from our recent experience with Wi-LAN: a) it pays to be fundamentally active, b) passive market participants can create wanted volatility.
- Most ETF’s are designed around inflexible investment criteria, and by having an opportunistic approach we have the ability to exploit a passive fund’s actions to our benefit. When a security no longer meets the investment criteria of a passive fund, the instrument is obliged to make a switch. These decisions happen without regard for the quality of the security that no longer qualifies. Blocks of stock being floated onto the open market, that similarly fail to qualify for other passive instruments, represent an opportunity for an active manager, for whom the fundamentals are the basis of investing.
- Capital flows into passive instruments have been substantial which inherently increases their effect on the securities which they hold. The valuation of a company can reach stratospheric levels, simply through inclusion in an index and the opposite is also true – a dip in value caused when a company is excluded from an index. An investor must remain diligent in understanding the motivations of such passive instruments and take advantage of the non-fundamental investment decisions made. The alternative is to invest in unfollowed, less in-demand parts of the market where passive funds are unlikely to be present and the fundamentals drive a company’s value.
Combining these lessons, you can rest assured we will be on the lookout for more opportunities, all the while remained focused on mitigating long term impairment of capital.
Read more on Active Management: