Manager’s Quarterly Commentary – David Barr – Q3 2016

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The winners keep on winning and the losers….

We had a strong quarter in our small and mid-cap universe as stock prices continued to rebound from the lows of Q1. As bottom-up stock pickers we find today’s environment incredibly opportunistic. Fundamentals are decoupling from stock prices. It is particularly interesting to have this at a time when major stock indexes are at all-time highs.

As active managers we are confronted with tremendous amount of media coverage that focuses on active managers underperforming index funds. This buzz drives more and more investors into Exchange Traded Funds (ETF) and other passive strategies. Coincidentally, several high profile investors with successful long term track records have underperformed.

In attempting to explain the disconnect in stocks I would like to provide a simplified example of the distortions that ETF’s are having on the market today.

Let’s imagine a market that only has 100 stocks. Then an ETF is established that tracks the 60 largest stocks. Firstly, a lot of investors gravitate to larger stocks for perceived safety. Secondly, the ETF must own the 60 stocks by its very reason for being. Now, enterprising stock pickers who are looking to do better than the index, can either weight their portfolio differently than the index, or invest in stocks outside the index. At times like this, an active portfolio manager will own a selection of the stocks, some within the index, some not in the index. When investors then choose a passive strategy over an active strategy, capital flows out of the 40 stocks not in the index and into the 60 stocks that are in the index. All else being constant, the 40 stocks go down and the 60 stocks go up.

And now the virtuous/vicious (depending on which side you are on) cycle really kicks in. Based on these fund flows, the outperformance by the index relative to the active manager will increase, perpetuating the argument that investors should be invested in passive strategies and therefore flows continue into ETFs.

How could this go wrong? It is the classic “it will work until it doesn’t”. ETF’s, computers, index funds and other automated strategies, by their very design, are indifferent to the very premise of investing. As an investor, you are buying a security that has a certain cash flow stream. Analysis of the security determines the price you are willing to pay, based on the risk to those potential cash flows.

Ultimately, fundamentals will carry the day. We need look no further than the S&P500 that has increased 5.4% over the past 20 years. The key driver of this growth has been the fundamentals. The earnings power of the S&P500 over the same period of time increased 5.1%. This is not a coincidence.

The best offense… a good defense

Given all this, I think it is important to highlight what our investment team is doing to take advantage of opportunities with these fund flows. We are actively looking to trade against investment vehicles which do not look at fundamentals (we have written about this previously with respect to our investments in WiLan and Energy XXI).

We continue to see very attractive opportunities in the “non-index” part of the market. With overall fund flows as described, we see new opportunities every day and some of our existing holdings get more attractive. Over the long term, we believe that companies with strong business fundamentals that find themselves out of favour because they don’t belong to an index are going to outperform. Interestingly, large cap companies that are in indexes will continue to look for growth through acquisitions. The discrepancy in relative valuation between a company that is in an index and one that is outside an index will create a compelling case for acquisition. We may not have to rely on Mr. Market to drive our returns as great businesses with low valuations will increasingly become targets for acquisition.

We are also aware that we don’t live in the simple world of 100 stocks. As we witnessed during the financial crisis, when big trends got corrected, everything is correlated. At the portfolio level we have started to build up our cash positions across our funds. With 20% cash, we have less market exposure to a downturn and more dry powder to buy stocks at resulting low prices. At the same time, with an invested portfolio of 80% in companies that our analysis indicates will outperform index constituents, we believe we will capture the upside in the market over the long term.

David Barr
October 17, 2016

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