Manager’s Quarterly Commentary – Felix Narhi – Q4 2015

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“The average long-term experience in investing is never surprising, but the short-term experience is always surprising.” – Charles Ellis

Last year was a very challenging year and unfortunately, full of unpleasant surprises for most investors, including us. As investor sentiment swung from “risk on” to “risk off”, global financial markets were hit by contagion from the four “C”’s – China, Commodities, Currencies and Credit. Firms with exposure to any of the four “C”’s faced a particularly challenging time. In an increasingly risk averse environment, investors sought the relative safety of the US dollar. In turn, the strengthened US dollar was bad news for American firms that sold their wares abroad in foreign denominated currencies. Emerging markets decelerated and the US manufacturing sector started contracting. As a result of these factors, large American firms are facing the worst corporate earnings revisions since 2009 and the S&P500’s earnings for 2015 are now expected to dip below 2013 levels.

What worked last year in the US markets was an increasingly narrow group of large cap, momentum stocks. The ten largest stocks in the S&P500 rose 23%, while the bottom 490 fell 3.5% on average. As contrarian and fundamental value investors, we invest primarily in small-to-medium sized companies or out-of-favour blue chips and found ourselves out of step with this market environment. It has been a reminder that the stock market’s “job” seems to be to maximize the number of investors to look like fools in any given period. That said, we have seen this story before and we are optimistic that better days lie ahead.  As sure as night follows day, the pendulum always swings back. Mr. Market has an enduring history of becoming too optimistic after easy gains near business peaks and then overly depressed following a string of losses near the trough. From our experience, it’s best not to take stock prices as indicators of true value too seriously at either end of the emotional market cycle.

Uncertainty and Risk

Assuming there is no global recession, we believe the impact on our holdings from the “C”’s will prove to be largely transitory in nature. Investors frequently confuse uncertainty with risk. The markets repeatedly remind investors that the future is always uncertain, irrespective of whether the current outlook is rosy or pessimistic. However, risk generally decreases when stocks are cheap (because there is less downside potential) and increases when stocks are pricey (because there is more downside potential). In other words, pessimistic outlooks are frequently associated with high perceived risk, but low real risk.

Although today’s challenges remain real, we believe the stock prices of our impacted holdings have declined far more than their underlying business values, based on our assessment of their risk profile, normalized earnings power and long-term growth prospects. Any hint of a recovery, sentiment change back to “risk on” or weakening of the US dollar could fuel a significant rally from very depressed stock prices. Moreover, a number of our investees have business models and balance sheet strength that enable them to thrive and be opportunistic during distressed times, including Brookfield Asset Management, Kennedy-Wilson, Onex and Leucadia.

Of the 17 holdings held in the Pender US All Cap Equity Fund at the end of 2015, we classify 11 as “Compounders” which we believe have the potential to grow their intrinsic value at a double-digit annualized pace over the next five years. Six are “Close-the-Discountii” situations, or statistically cheap stocks with compelling upside potential once business conditions normalize and valuations revert closer to their historical averages. For companies in the first category, we intend to be long-term owners of the businesses, occasionally trimming and accumulating on price swings, but we are generally patient and philosophical about the markets ups and downs, as long as the intrinsic value keeps compounding at a reasonable pace. Truly great, well-run businesses with lots of runway ahead tend to be rare. The big money in such stocks is made in the waiting. However, we will also consider less-than-ideal businesses under the right circumstances. If we identify an asset we estimate is conservatively worth $1, but selling for 50 cents, we will consider buying it even if that dollar of intrinsic value is not growing. Both investment approaches have proven merit and the mix will vary depending on the market’s opportunity set. IT outsourcer Syntel is an example of a holding in the first category, while South Korean Steelmaker Posco would be an example in the second.

Our Strategy and the Long-Term Odds

In the short-term the stock market is a popularity contest, but in the long-run it is a weighing machine. Surprises, both positive and negative, are inevitable and no investment strategy works all the time. However, there are investment principles and strategies which have been tested and proven over time. One of the central components of our investing process is to know the long-term odds and stick with them.

First, we are value-focused and occasionally contrarian in nature. Value investing works over time, but requires patience. Historically, some of the best returns over a medium-term horizon have been made when stocks were bought in pessimistic times, when profitability is below normalized levels and when valuation multiples are low. In other words, depressed business fundamentals (which will eventually improve) and bear market valuations (which rebound after the cycle turns) are good starting points for outsized returns. With the S&P500 trading near decade high valuations and corporate margins at elevated levels, large American stocks seem priced to disappoint. Multiple expansion, rather than underlying earnings growth, has fueled much of the S&P500’s returns in recent years. This is unsustainable. Stocks cannot forever outpace their underlying businesses. Popularity, as opposed to long-term fundamentals, often drive markets near the end of their cycles and that appears to be the case with the S&P500. There will always be pockets of decent value among US large caps, but they become harder to find after a long bull market. The vast majority of our holdings are trading well below their historic norms and have suppressed earnings power which we believe represents pent-up potential.

Second, mathematically we know that stock returns must approximate the returns of the underlying businesses over the long run. Over the last decade, the revenue growth and earnings power of large American businesses listed on the S&P500 have compounded at roughly 3% per annum. Mired by an over dependence on the resource sector, the TSX’s record has been even more muted. A low growth world indeed! Not surprisingly, excluding dividends, the returns of both indices have roughly mirrored their anemic growth profiles. We tend to skew to small-to-mid sized companies because we find their growth prospects are often better than for their large cap counterparts. Ideally, we seek to pay fair prices for well run businesses that will be worth substantially more in five to ten years. We believe it makes sense to concentrate investments in a handful of good ideas and remain patient through the inevitable ups and downs of the market. Investing in such “Compounders”, which tend to be smaller companies, is a core strategy of Pender.

Finally, we recognize that the differences in outcome between companies run by exceptional managers and their less able peers can be huge. The stock market’s long-term returns would be a pale shadow of itself without the performance boost from great companies like Apple, Starbucks and Walmart when they were run by their founders during the early, fast growing days. As such, we are biased to invest in founder-led companies (or companies where insiders have a sizable ownership in their businesses) and have a long record of value creation and treating outside investors fairly. In essence, these owner-operators are managing their own capital, care relatively little about short-term earnings or investor sentiment, and stay focussed on the long-term drivers of their businesses. They are a rare breed, worth singling out because they tend to outperform the market over time. Of course, great businesses and enduring wealth are not built overnight. Bumps along the journey are commonplace. All successful owner-operators have had to persevere through several business cycles and/or internal challenges as they compiled their great track records. Today, the four “C”s are yet another challenge these owner-operators need to overcome. Based on their exceptional records, one would think they have earned the benefit of the doubt. Yet, in times of market distress, investors places little to no value on this extremely important, but-difficult-to-measure intangible factor. Despite Albert Einstein’s thoughtful counsel that, “Not everything that can be counted counts, and not everything that counts can be counted,” investors frequently taken a “shoot first, ask questions later” approach in pessimistic times and indiscriminately sell-off all companies with perceived risk, regardless of management pedigree.

Although we believe our approach is based on sound reasoning, none of these plans or strategies matter over the short term. 2015 provided yet another vivid reminder that anything can happen in the short-term and once again showcased the power of momentum and psychology in the markets. Last year, the price-momentum investment strategy (buying the most popular stocks that have gone up the most recently while ignoring underlying fundamentals) worked fabulously. According to independent investment banking advisory firm Evercore ISI, price-momentum was the best performing strategy out of 14 categories and traditional value investing was the worst. The last time price-momentum performed as well was 2007. Despite slowing growth prospects, large caps also continued to outperform while small caps lagged. Finally, owner-operator companies as a group trailed professional-manager-led companies (we track some 170+ owner-operator companies.) In short, the cheaper stocks of small founder-led companies failed to keep up with their more expensive, larger, professional-managed peers.  

A punch in the mouth

As we attempt to make sense of recent market conditions, we can’t help but to recall a famous quote by former boxer Mike Tyson, “Everybody has a plan until they get punched in the mouth.” Adversity is inevitable from time to time.  It is how one reacts to that adversity that defines you, not the adversity itself. Sometimes the best laid plans of owner-operators and investors alike get punched in the mouth by Mr. Market.  Should investors pivot or stay the course?

Over short periods, fundamental factors can be overwhelmed by market forces and investor psychology. Time and again, investors have seen waves of euphoria and pessimism drive wild swings in stock prices which are often disconnected from long-term fundamentals including the late 1990s tech boom/bust, the mid-2000s US housing bubble/bust and more recently the China-driven commodities super cycle/bust. During such times it can be difficult to remain resilient and stick to the long-term odds. As noted value investor Seth Klarman recently wrote, “You don’t become a value investor for the group hugs. Indeed, one can go long stretches of time with no positive reinforcement whatsoever. Unlike some other fields of endeavor, in investing you can do the same thing as yesterday but achieve completely different reported results. In the long run, the research and analysis you perform should overcome market forces; the fundamentals ultimately matter. But in the short run, markets can trump effort and insight.” 

Last year was no picnic, but we are staying the course. Value investing as a strategy is overdue for a comeback, small caps won’t trail their slower growing large peers indefinitely, and we are optimistic that our owner-operator-led companies will once again prove their exemplary long-term records were no fluke. Our strategy has worked for us in the past and we remain confident it will continue to work in the future.

Please do not hesitate to contact me, should you have questions or comments you wish to share with us.

Felix Narhi, CFA

February 9, 2016

iCompounders –

iiClose the Discount –