Manager’s Quarterly Commentary – Felix Narhi – Q2 2014

Written by Felix Narhi

The Fund became available to investors on July 5, 2013 and ended Q2 2014 with 21 holdings and a cash weighting of 8%. Class A units that were initially purchased at C$10.00 were valued at C$11.91 at June 30, 20141.

1 The Fund was incepted on June 28, 2013, but first became available to outside investors on July 5, 2013.

During the second quarter we added positions in Liberty Media Corp (LMCA) and Gaming & Leisure Properties, Inc. (GLPI). We believe both are strong, founder-led businesses trading at attractive valuations with potential catalysts to unlock value ahead. We also gained a position in Now Inc. (DNOW) after National Oilwell Varco (NOV) spun out its distribution arm. We sold off our entire position in Broadcom (BRCM) as our “close the discount” thesis played out as the stock surged on news that the company was exiting its money losing wireless business.

The Fund now has the first year of results under its belt. Performance over the first three quarters following the Fund’s launch went well, posting a gain of 25% which was better than the market’s sizzling pace. Unfortunately, the Fund gave back part of its gain in Q2 2014 while the S&P500 continued to march higher. Still, we are pleased with the Fund’s absolute performance over the past 12 months (up 19%). Broadly speaking, the Fund enjoyed the strongest gains from its investments in semiconductors (Volterra, Broadcom), education (Apollo, Strayer) and the holding companies of outstanding capital allocators (Markel, Onex, Brookfield). The S&P500 posted an even more supercharged year (up 27% measured in C$). Virtually all of the relative difference and dip occurred in April and May 2014 whereas the Fund began to regain some lost ground in June 2014. While we provide commentary quarter to quarter, we don’t normally take short-term stock price fluctuations too seriously (and neither should most investors seeking to grow their wealth over time). Given the Fund’s low relative valuations today and our ability to seek out value unconstrained to benchmark-driven strategies, we are optimistic that the Fund will continue to generate solid returns over our rolling time horizon of 3 to 5 years.

Recent Performance

Fund performance of the A class C$ units declined about 5% last quarter for four main reasons: 1) US currency weakness contributed about two-thirds of the decline, giving back most of what we gained in Q1 2014 – we don’t hedge currency; 2) Our significant exposure to Consumer Discretionary stocks, which has been the weakest of the ten economic sectors so far 2014, contributed to soft performance; 3) We are heavily skewed to US small-to-mid cap stocks which have underperformed US large cap stocks. We currently own 21 holdings, but only 3 are in the large cap S&P500 index; 4) Permanent capital impairment for one holding (Liquidity Services – LQDT). The first three issues are largely transitory in our opinion, part of the ebb and flow of the markets over time and not related to long term business value. We anticipate most of those factors will bounce back over time and become tailwinds again. On the other hand, the permanent capital impairment of LQDT was disappointing, especially considering our overriding focus to minimize such potential “risks” in the first place. We are still holding onto a smaller stake in LQDT because we estimate the business is worth more than the recent quote.

A number of our high quality smaller cap holdings have sold off since the spring for reasons unrelated to the intrinsic value of the underlying business in our view. We have been adding to numerous existing holdings that we believe have strong long-term prospects as their valuations became cheaper (e.g. Syntel, Panera Bread, SolarWinds). Indeed, many of our largest holdings are trading near depressed valuation levels not seen in years. We believe this sets up potential upside over the coming year and beyond, especially since we believe most of them have better prospects and more compelling valuations than the average S&P500 firm.

Market Comment – Finding Value in an Extended Bull Market

In general, stocks in the S&P500 have continued to outperform their underlying businesses which has helped to deliver such strong returns. Investors can see this manifest itself through the rising S&P500 P/E multiple which has approached levels not seen in almost a decade. The recent flurry of initial public offerings, elevated mergers & acquisition activity and the fact that some of the smartest money in private equity have been net sellers can attest to the cheery state of the U.S. stock market. Hardly a “value” investor’s paradise. Yet, pockets of value will almost always be available in unpopular industries and within company-specific situations (we own a number of them!). Importantly, most of the Fund’s holdings are trading near the low ends of their respective historical valuation ranges which contrasts to the S&P500’s elevated levels.

Low starting valuation levels have usually been one of the best predictors of potential returns. As the DJIA and S&P 500 continues to make new highs, there are fewer and fewer stocks trading at below-normal valuations. Finding high-quality names at attractive valuations in the midst a long bull market usually requires acceptance of at least some negative company-specific news. When seeking value, we believe investors must be comfortable with being uncomfortable at times. We believe all of our portfolio holdings are undervalued (why else would we own them?).

We don’t determine our holdings based on their potential popularity or attempt to time market moves, but rather when we believe we are obtaining more value than we are paying for. We are often attracted to company-specific “accidents” in the market, or those businesses we believe are facing either a fixable or a transitory rough patch and become cheap because the market is focused on short-term prospects – Panera Bread (PNRA), SolarWinds (SWI), and our two most recent additions (LMCA and GLPI) are some portfolio examples. The best returns often come from those companies or sectors that were unloved a few years ago. We attempt to take advantage of this recurring pattern in the markets. The key is to buy cheap and stay patient!

Different Than the S&P500

Investor should also keep in mind that the Fund is concentrated and not diversified in the conventional sense. This will lead to lumpier results over any given period, but with the expectation of above average results over time. The Fund’s top 10 holdings account for almost 62% of the portfolio. In addition, the Fund currently has no exposure in the Materials, Telecom, Utilities, and Consumer Staples sectors. If those sectors become popular and move higher for a period to time, our relative performance will suffer. We are currently skewed to holdings in Consumer Discretionary, Info Tech and Diversified Financials simply because that is where we are finding the best opportunities and importantly, contain businesses where we are best equipped to assess value. Finally, we believe small to mid-cap companies offer better hunting grounds to find value relative to larger cap names (only 3 of 21 holdings are in the S&P500). Bottom line: The Fund will always look and behave very differently from the S&P500. As the S&P500 valuations continue to push higher, we think it is increasingly important to be opportunistic and seek value outside of today’s frothy markets.

It is important to keep in mind that the intrinsic value of most large businesses does not change much over a few quarters. The longer you hold onto a stock, the more your returns will typically reflect the economics of the underlying business. As long as business value is building up at a satisfactory pace and valuations remain cheap or reasonable, we don’t normally take short-term moves of the stocks we own too seriously – we remain focused on the long view. As famed money manager Peter Lynch observed, “What makes stocks valuable in the long run isn’t the market. It’s the profitability of the shares in the companies you own. As corporate profits increase, corporations become more valuable and sooner or later, their shares will sell for a higher price.” On the other hand, market “noise” and investor psychology tend to be the main drivers of short term returns, but also provides the price swings to act opportunistically.

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

Felix Narhi, CFA
July 11, 2014