Manager’s Quarterly Commentary – Felix Narhi – Q3 2015

Class A units were down 3.7% during the quarter and were valued at $12.01 at September 30, 2015.

Panera Bread, Strayer Education and Markel led the gainers for the quarter, while Platform Specialty Products and Colfax were the biggest detractors. Platform and Colfax were new additions in the quarter (discussed below) and we anticipate being long-term holders of both stocks. To raise funds for the new additions, we exited three holdings: Strayer Education, Apollo Education and NOW Inc. We modestly trimmed Markel following its strong run, but consider it a core long-term holding. The Fund ended the quarter with 19 holdings and a cash weighting of 3.1%.

“The key organ for investing is the stomach, not the brain.” – Peter Lynch

While the S&P500 is near its all-time highs and trading at relatively full valuations, it is masking significant turmoil in many corners of the market. Periods of volatility may be difficult to stomach, but it demonstrates the market’s pricing inefficiency and illustrates the importance of knowing a company’s intrinsic or private market value which, unlike its share price, usually swings very little over a short-term period.

We believe there are two types of companies in the market:

• Companies that currently have problems, where stocks are cheaper and where we tend to redouble our research efforts to uncover opportunities
• Companies that are going to have problems, which will eventually become cheaper after they too hit a road bump, so one can always get to those ideas later.

The key is to differentiate between those companies that are facing solvable or cyclical issues which are only temporary from firms that have more permanent or structural problems which will continue to drain business value.

We are content to patiently hold reasonably priced, high quality companies as they grow over the business cycle; but aim to make our initial purchases when we believe those companies are either misunderstood, ignored or become cheap due to unduly gloomy market sentiment. While we don’t like pessimism, we like the low prices that it produces.

Many companies that were put on a pedestal and revered by the market only a short while ago are now suddenly scorned for the same qualities that had been praiseworthy earlier. Currently stocks of companies with high exposure to commodities or emerging markets and/or utilize high leverage and acquisitive strategies have come under enormous pressure. The market delights in throwing out the baby with the bathwater during periods of stress.  Strong and weak companies alike have been lumped together and sold off indiscriminately in the stampede for the exits.

A number of stocks we have long admired that looked pricey just a few quarters ago suddenly went into the bargain bin.  We took advantage of the volatility during the quarter and added two of them as core holdings to the portfolio: Platform Specialty Products (PAH) and Colfax (CFX).

Back to the Future (or the Next Best Thing)

We are fans of studying the successful strategies of wealth creating outliers like Marten Franklin of Jarden (JAH) and the Rales brothers of Danaher (DHR).

We have followed Franklin over the years as he grew Jarden by rolling up a collection of seemingly mundane consumer product businesses with brands like Breville, Coleman and Bicycle playing cards. Yet, the returns for the stock have been anything but boring. A dollar invested in Jarden when Franklin first became CEO in September 2001 has turned into almost $40 today, compared to less than $3 in the S&P500. A stellar record.

The Rales brothers’ track record with Danaher is even more impressive over more than three decades. Over that period, Danaher acquired more than 400 companies, eliminated inefficiencies and built upon the strength of its growing collection of great businesses. A dollar invested in Danaher when the brothers took over operations at the end of 1984 has turned into more than $440 today, compared to about $26 in the S&P500.

In short, both founders used methodical and repeatable strategies to create vast fortunes for themselves and rewarded patient investors.

Unfortunately, the DeLorean time machine remains as fictional in 2015 as it was when the Back to the Future movie first debuted in 1985. One can’t go back in time to invest in Jarden in 2001 or Danaher in 1984. However, one can do the next best thing and invest alongside these same owners, using comparable plans at an earlier stage of their next big respective ventures, Platform Specialty Products (PAH) and Colfax (CFX). It is rare to find market leading companies led by proven operators selling at bargain prices.  However, that is the case today as both companies trade at compelling valuations because investors are focused on today’s cyclical challenges rather than the likely path ahead. We believe this will prove short-sighted.

The value of exceptional management is hard to quantify, but is often one of the most important drivers of performance as demonstrated by the strong long-term returns of Jarden and Danaher. Although there have been numerous ups and downs along their journey, the total returns after Franklin and the Rales brothers took control of their respective companies would place them amongst the top 1% of the S&P500’s outperformers. Some of the most lucrative times to put capital to work in Jarden or Danaher would have been when their stocks were cheaper during one of the challenging periods in their wealth creating journey. We believe the same will be true for PAH and CFX.

The Next Best Thing – Adding Two New Compounders

Platform Specialty Products (PAH) is a rollup of “asset-light, high-touch” specialty chemical businesses founded by Martin Franklin. As Chairman and one of the largest shareholders in PAH, Franklin is looking to replicate his Jarden strategy in the highly fragmented specialty chemicals industry by acquiring high free cash flow businesses, cutting costs to improve the operations and building upon the new base. The excess cash flow from the growing mix of existing businesses is then recycled to help fund more acquisitions.

Following its initial listing in 2013, PAH leaped out of the gate and completed four acquisitions with two additional deals pending. Today PAH is a collection of mature businesses with meaningful barriers to entry, a diversified portfolio of products across key industries with strong cash flow generation characteristics. The stock initially surged higher as investors applauded PAH’s strategy, peaking at more than $28 in June 2015. Since then the stock has lost more than half its market value as investors suddenly became wary as many of the same factors that contributed to investor enthusiasm just a few short months ago have suddenly become reasons to fear and send the stock spiraling downward.

We believe today’s depressed share price is an attractive entry point. Today, we estimate the stock trades below 10x “normalized” free cash flow, a very compelling valuation considering the company’s strong competitive position, favourable underlying economics and long-term growth profile. In our view, the core strategy remains just as sound as it was at its IPO. Acquisitions will always be episodic and opportunistic depending on market conditions and the window is shut for now. In the meantime, there is a lot of opportunity to grow value through execution of cost synergies of the acquired companies and organic growth.

We also initiated a core position in Colfax (CFX), a leading multi-platform industrial company. Colfax represents the Rales brothers’ effort to replicate their success at Danaher, which is arguably the best-run large conglomerate in North America and a text book example of a successful rollup. While we do not expect CFX’s returns to be as spectacular as DHR’s past, we believe Colfax can be more successful than the average industrial company over time thanks to its corporate lineage and management pedigree.

Colfax has been publicly listed since 2008, but made a transformational acquisition of Charter in early 2012 which established two large “platforms” in order to consolidate the gas handling and welding industries. The stock rose steadily and peaked at $75 in mid-2014 but has been in decline since, losing almost two-thirds of its market value as foreign currency, emerging market and commodity-related tailwinds turned into headwinds.  The time to be cautious is when cyclical companies are firing on all cylinders. The time to be contrarian and become more bullish is when investors see nothing but more downside ahead. Colfax’s end markets have always been cyclical. We believe the company is far nearer to the bottom of the cycle than the peak and patient investors will be rewarded for contrarian thinking as the cycle resets and headwinds once again become tailwinds.

In addition, Danaher’s DNA runs deep at Colfax – its leadership ranks are filled with accomplished managers that were trained at Danaher to use similar value creation strategies. Looking a few years out, Colfax has plans to create new “platforms”. Similar platforms added tremendous value to Danaher over time, but this future “optionality” is not priced into Colfax’s stock. 

We believe both PAH and CFX enjoy favourable underlying economics, leading positions in attractive and defensible markets with decent organic growth potential. Of note, both companies are consolidating their respective industries and are led by founders with demonstrable track records of value enhancing acquisitions, a relatively rare attribute and highly valuable in today’s slow growth world. When the respective founders of both companies recently started to buy their own stock in meaningful amounts for their personal accounts, we followed their lead and initiated core positions.

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

Standard Performance Information (September 30, 2015)