Manager’s Quarterly Commentary – Felix Narhi – Q3 2014

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Class A units were up 1.6% during the quarter and were valued at C$12.10 at September 30, 2014. The performance was driven by a stronger US dollar. The Fund ended the quarter with 22 holdings and a cash weighting of 4.2%. With a few exceptions, we believe most of our holdings increased their intrinsic value and/or deepened their “moats”1 over the past year which we believe will show up in share price appreciation over time.

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 low valuations of the Fund’s holdings today, relative to our estimate of their intrinsic value and our ability to seek out value unconstrained to benchmark-driven strategies, we remain focused on the long view and are optimistic that the Fund will continue to generate solid returns over our rolling time horizon of three to five years.

The “Hot Money” Crowd and The Switch

During the third quarter we added a new position in Post Holdings (POST) and sold off our entire position in XPO Logistics (XPO). POST is building a diversified consumer goods enterprise, while XPO is building a large scale third-party transportation and logistics services company. Both companies are utilizing somewhat similar “private equity-like” strategies to build business value, including aggressive merger & acquisition activity and by utilizing financial leverage.

However, their respective stocks have recently been at the opposite ends of the “hot money” trade. We sold XPO on strength after investors became enthusiastic about some of their recent acquisitions and bid the stock up to what we considered a full valuation. Earlier this spring POST was also a big favourite of the hot money crowd. However, it ran into some troubles since then. At the recent lows, the stock had been almost cut in half from its peak – what a difference a few quarters can make! We bought POST on weakness as investors became pessimistic about the outlook after the company ran into some of the challenges that often come with rapid business change. We think these challenges are either temporary, fixable or can be offset by momentum in some of its other businesses. We believe these issues created an attractive entry point for a business that should be worth far more in three to five years.

Ultimately, we anticipate both companies will be successful in building shareholder value, but switched from XPO to POST in part because we believe the latter has better potential upside from recent prices and, perhaps more importantly, offers a greater margin of safety.

The Compounder vs. Mr. Market

A good illustration of our long-term approach and not being phased by Mr. Market’s manic mood swings and short-term price fluctuations is Syntel (SYNT), the Fund’s largest holding and a company the Portfolio Manager has been following for over a decade. Syntel is a leading mid-tier IT outsourcer that is headquartered in the US but has most of its operations in India. Syntel has shown robust growth over the years thanks to its long-term sticky relationships with blue chip clients like American Express, State Street and Federal Express. When it comes to compounding machines like Syntel, the big money is not in the buying and selling, but in the waiting. Including reinvested dividends, a dollar invested in SYNT has turned into 3x more wealth than a dollar invested in S&P500 over the last decade, an impressive performance that would place the stock in the top decile of the index. We expect the stock’s outperformance to continue over time because we believe Syntel’s business prospects remain far superior to the average S&P500 firm. Yet, the stock has historically been volatile over shorter periods as measured by beta. As long time followers of the company, we find the stock’s periodic wide price swings are often disconnected from the actual changes of the underlying business. We expect this to continue and don’t worry too much about it. As long as business value continues to compound at a satisfactory pace and the valuation remains cheap to reasonable, we remain comfortable owning the stock.

The “hot money” crowd has not been enamored by Syntel this year. Why? In part, because management recently lowered its 2014 revenue guidance slightly. The market was anticipating top line growth of 12% at the beginning of the year, but Syntel now expects 11% growth after some clients in its Healthcare segment temporarily reduced spending on certain projects. Management expects this spending to return within a few quarters. On the other hand, 2014E EPS guidance actually increased from the beginning of the year. Per share earnings for 2014 are now expected to be $5.66, or 9% higher than the consensus of expectations at the beginning of the year. The 2014E P/E is now about 14x, near the low end of its historical trading range. In other words, the intrinsic value of the company continues to advance at a decent clip, but the stock price and valuation have gone down for 2014.

Our enthusiasm for Syntel grows when the “margin of safety” between today’s depressed price and our fair value estimate widens because it increases our prospective returns. Over time, a stock will roughly follow the path of the underlying economics of the business. When considering the company’s impressive track record and ongoing prospects, we believe that Syntel has the ability to continue to double its intrinsic value every five years or so. The trick is not to pay too much for the company given its growth prospects. Even a great business will give investors poor returns if its stock is overvalued. Luckily, SYNT is currently cheap in our view. Thus, we anticipate a potential “double dip” return from the stock. First, from the above average growth of the business itself, and second, as the stock’s valuation multiple rises to reflect its fair value.

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

Felix Narhi, CFA
October 21, 2014

1 The competitive advantage that one company has over other companies in the same industry.

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