Manager’s Quarterly Commentary – David Barr – 2012 Review

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2012 was a fantastic year for the Fund. It was up 31.29%, compared to the S&P/TSX Capped Composite Total Return Index which was up 7.18% for the year and the S&P Small Cap Index down -2.22% for the year.

The outperformance was driven by two key attributes of the Fund. Firstly, we continue to hold very limited exposure to resource companies (6.69% of the portfolio at year end). Second, identifying companies that were either acquired or had take-outs announced during the year. Santa even showed up a little bit early for us and gave us one last takeout, Peer1 Networks, right before Christmas!

An Acquisitive Year

In 2012, the Fund was invested in 15 companies that were in the process of being acquired and by year end, eight of those transactions had been completed.  Furthermore, of these 15 companies, eight were acquired by other companies while the other seven were involved in private equity-type transactions.  The Fund’s strategy since inception has been to determine the intrinsic value of a company and buy the stock when the market value trades at a significant discount to our estimate of intrinsic value. The second part of the strategy is for the market value of the stock to close the discount to intrinsic value.  The typical catalysts for the closing of this gap tend to be acquisition by a company, acquisition by a private equity group or an increase in the share price through increased investor interest.

While 15 take-outs in the Fund for the year is an incredible number, we believe that 2012 was not a one off. Many factors point to this being a sustainable trend. We are currently in a slow growth environment so for large companies looking to grow, acquiring other companies is pretty much the only way to do it.  With CEOs that are compensated to grow and whose egos are fueled by running larger and larger companies, CEOs are going to continue to buy companies.  As for the private equity crowd, there is about $200 billion of capital that needs to be deployed over the next 24 months.  If the capital is not deployed, it needs to be returned to LPs and the General Partners stop getting paid.  Again, there is clear incentive for this group to buy companies. The third leg to the stool about to make itself felt, is “The Great Rotation” from bonds into equities.  With bond yields at all-time lows, institutional and retail investors alike are being driven from bonds to equities in order to generate the returns they need to meet retirement and cash flow obligations

Finding Value – Portfolio Update

Our favourite part of managing a small cap fund is looking for new investment opportunities.  As a result of the significant takeovers in the Fund this year, we were very active and added 23 new names to the portfolio.  We sold 14 positions in the Fund, eight as a result of take outs and six because our ongoing analysis told us to get out.  We were also active within the portfolio as we increased the weighting of three companies where we determined the margin of safety had increased and decreased the weighting of seven positions as the market value moved closer to our estimate of intrinsic value.

The Fund had a cash position of approximately 28% at year end. Technology continues to be the largest industry sector represented at 48% of the Fund.  

Forward Thinking

As we start the year, the major topics in the business news have been the fiscal cliff, the debt ceiling and “The Great Rotation”.  While the first two may introduce some short term opportunities (oops, I mean volatility), the potential impact of large amounts of investment capital flowing from bonds to equities could have a significant impact on equity performance over the next few years.  We have just seen the second biggest equity in-flow ever (US$22.2bn) for the week ending January 9, 2013. The stock market after all, is just about supply and demand.  We continue to take a conservative approach to allocating capital, but will capitalize on opportunities to start new positions or add to existing positions when stocks are cheap.  The ideal exit from companies in our portfolio is when an acquirer emerges, but we will happily ride the wave of price appreciation if significant investment capital continues to come back to equity markets.

Dave Barr,
December 31, 2012

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This commentary is intended for information purposes only and does not constitute an offer to buy or sell our products or services nor is it intended as investment and/or financial advice on any subject matter and is provided for your information only.  Every effort has been made to ensure the accuracy of its contents.

© Copyright PenderFund Capital Management Ltd. All rights reserved. 31 December, 2012.