Manager’s Quarterly Commentary – David Barr – Q4 2016

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That was an interesting quarter to say the least. Our small cap positions were strong beneficiaries of the post US election rally. We would like to take credit for positioning the portfolio for this event but the reality is we stuck to our knitting and bought companies we liked at a good price. Macro events for the most part don’t impact what we do on a day to day basis. Interestingly we think the outcome of the US election highlights the challenges in positioning portfolios for macro events. In order to properly position the portfolio you had to get two things right, first who was going to win the election and second what the impact would then be. Prior to the election most experts a) expected Hillary to win, and b) predicted that if Trump won, it would be very bad for markets. We’ll stick to picking stocks.

Returning US Tailwinds

Over the past couple of years we have found some great opportunities in the US but have been rewarded with basically a flat market in US small cap. However, it looks like we’ve turned a corner. Our universe has done very well since the US election and in the early part of 2017 we are seeing strong fund flows into US small and mid-cap. This is music to our ears. Increasing fund flows can generate momentum for the sector which allows us to capture returns as stock prices increase to our estimate of intrinsic value.

We also see an improving business landscape for US small caps. Lower taxes are good for business and less regulation is good for business. High regulation can serve as a crutch for large established companies as it creates a barrier to entry for other competitors. Decreased regulation will allow smaller companies to compete more effectively against incumbents, differentiating, disrupting and using their more flexible organizations to build value.

Improving M&A Environment

The core of our small cap “value” strategy is to determine approximately what another company would pay for the business we are interested in investing in. We call this “private market value”, our estimate of intrinsic value. This part of the process helps us find companies with a higher probability of being acquired. While we don’t set out to buy acquisition targets, the output of our process, buying companies that are of interest to acquirers and are priced attractively to acquirers, will lead to companies in our portfolio being acquired.

So far this year, three portfolio companies have been the subject of takeover announcements. We think this is a precursor of things to come with a strengthening M&A market. In order to have a strong M&A environment you need two things.

1. Willing and able buyers; and

2. Willing sellers.

1. The Buy Side

The two categories of buyers are private equity and strategic buyers. Private equity firms are setup to deploy capital within a certain amount of time. If the capital is not deployed they have to give it back. If they give it back, their management fees are usually reduced and potential performance fees will be smaller. As a result, most private equity firms will push to deploy all their capital, creating a very willing buyer.

Strategic acquirers are usually larger companies buying smaller companies, so we will generalize a bit here and talk about large caps vs small caps. As companies start to get larger, organic growth usually slows down and large caps move towards inorganic growth. Why? The management teams of large companies are more likely to be professional managers, in which case, their cash compensation tends to dwarf their share ownership position. It’s only natural for management to want to maximize their compensation. And that’s where compensation consultants play an important role for professional managers. Compensation consultants tend to benchmark CEO compensation based on the size of the company. (I imagine a compensation consultant who based their report on increases in shareholder value – not to be confused with share price – would be highly sought after by shareholders, unfortunately shareholders generally have no say in this process). Large cap CEO’s get paid more if their company is bigger. Given the choice between making an acquisition and increasing their compensation or not making an acquisition and their compensation remaining the same…you get the picture. As an aside, this is one of the many reasons we prefer to invest in founder-led companies or companies where the board and management have large share ownerships; precisely to better align our interests as shareholders.

We have established that they are willing, but are private equity and strategic able to make acquisitions? Yes. Both have cash on hand through fund raising or internally generated cash and both have access to debt markets at attractive rates if need be.

2. The Sell Side

Turning to the sellers, there are lots of reasons that sellers are willing but a lot of the times it will come down to psychology and anchoring. When a stock price sits at a certain level for an extended period of time, people who confuse stock price with business value get anchored on that stock price being the appropriate price for the company. If a buyer comes along at a 30% premium to that price, the people who were anchored to the stock price may think it’s attractive. However, if the stock price moves up 30% and then an offer comes to the table at a 30% premium to the new price, this becomes highly attractive to the sellers, who will view the “value” of the offer at a greater than 60% premium to their biased view of value. This is the situation we are seeing today.

Will the M&A market materialize? We don’t know for sure, we just try to stack the odds in our favour and we like the current environment.

3. Everyone’s favourite buyer

There is a third buyer that we alluded to above and we would be remise if we didn’t mention, good old Mr. Market. As mentioned, we are seeing increased fund flows into small and mid-cap ETF’s, year-to-date. ETF’s are our favourite buyers because they buy for completely non-fundamental reasons. The patsy has arrived. When you have a buyer in the market who is buying because they are forced to by a formula or index weighting that says they must, without any regard for the economics of the underlying business or the price they are paying, Mr. Market can start paying irrational prices for businesses. We won’t be shy selling to Mr. Market when the opportunity presents itself.

David Barr
February 22, 2017

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