Manager’s Quarterly Commentary – Felix Narhi – Q4 2013

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The Fund became available to investors on July 5, 2013 and ended the year with 18 holdings and a cash weighting of 4.5%1. Class A units that were initially purchased at C$10.00 were valued at C$11.87 at December 31, 2013.

2013 was an exceptionally strong year for the US stock markets in spite of numerous worrisome macro events. The Fund started at the mid-point of the year and benefited from this favourable market tailwind.

Positive contributors during the quarter included Apollo Education Group (NASD:APOL), XPO Logistics (NYSE:XPO), Vitamin Shoppe (NYSE:VSI) and Broadcom (NASD:BRCM). Most of the Fund’s holdings were positive during the quarter with the notable exceptions of Liquidity Services (NASD:LQDT) and Weight Watchers (NYSE:WTW). We remain optimistic about Liquidity Services, but have trimmed our Weight Watchers position after management cited more challenging conditions for its turnaround.

Investment Outlook & Strategy

Despite the customary prognostications from pundits this time of the year, no one has a crystal ball. Successful long-term investing requires the mindset of marathoners, not sprinters who focus on shorter-term speculative gains. To our marathoner way of thinking, a stock’s returns will ultimately reflect the economics of its underlying business and assets over time. Yet, market action is increasingly dominated by sprinter-like behaviour that increases volatility which concerns some investors. Paradoxically, this wild market action produces an excellent hunting ground for disciplined investors because a lot of these “sprinters” are irrational, momentum-driven speculators who care little about valuations. Therefore stock price changes are frequently way out of proportion to changes in underlying company fundamentals which means additional incremental positive returns are possible if individual stocks are carefully purchased below their fair value. Therein lies the opportunity.

Broadly speaking, U.S. market valuations are higher today than a year ago as stocks have outperformed their underlying businesses. The deep undervaluation that existed in the Great Recession of 2008/2009 has largely been corrected. Today, we believe the US stock markets are trading within the bounds of their fair value. As such, we believe it is increasingly important to be more selective as markets head higher and the opportunity set of potentially undervalued equities shrinks. As we run concentrated portfolios, we focus on buying and owning undervalued individual companies rather than making predictions about the overall markets.

Company Highlight

There are two approaches to investing that we follow with the goal being to compound your capital:

1) Intrinsic Value Growth, or buy low and let grow (see Q3 commentary for investment example, Markel (NYSE: MKL), and;

2) Close the Discount to Intrinsic Value, or buy low and sell high.

Apollo Education Group falls into the Close the Discount category. Best known for the University of Phoenix (UoP), Apollo is the bellwether stock of the for-profit education sector. We made our initial purchase in August 2013 when the stock was trading at about 2x trailing pre-tax earnings, net of cash. It was very cheap stock with a very bad story.

In the early-to-mid 2000s, Apollo lost sight of its roots educating “working learners” and let its stock price become the primary driver of its business strategy. Ultimately, this move backfired and Apollo has faced well-documented headwinds and severe scrutiny from all stakeholders. Furthermore, the entire for-profit education sector in the U.S. is facing declining student enrollment numbers and a challenge to traditional models from newer online modes of delivery. Given these issues, it is not surprising that investors worry about more troubles ahead. The ultra-cheap valuation of the stock last summer suggested that Apollo’s mere survival was in question.

Yet, there are plenty of reasons for optimism. Despite its significant challenges, Apollo has remained profitable thanks in part to its asset-light business model. Apollo’s cash rich balance sheet provides both downside protection and flexibility for opportunistic acquisitions and share buybacks. The company is in the late stages of a turnaround and refocused on long-term student success rather than just driving quarterly profits. We believe stabilization of student enrollment is likely to occur within the next few years. Management has realigned much of University of Phoenix over the past 12 to 18 months, become a more efficient organization and gone on the offensive to grow its international business. The industry is fragmented, but the opportunity for private players is large and growing. The global post-secondary market is about a $1.5 trillion market globally and only about $100 billion is provided by the private for-profit sector. As a long-term leader in innovation and use of technology in education, we believe Apollo is well placed to serve the evolving needs of working learners. As pieces of the new strategy gradually fall in place, management’s goal to return to growth from a smaller and more sustainable base is gaining credibility. We believe the stock should trend higher as traction gradually improves and investors continue to warm up to this successful turnaround.

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

Felix Narhi, CFA
January 15, 2014

1 Performance information for the Pender US All Cap Equity Fund is not available because the Fund has been in operation for less than one year. Performance information will become available on the first anniversary of the Fund’s inception (July 1, 2013).

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in net asset value and assume reinvestment of all distributions and are net of all management and administrative fees, but do not take into account sales, redemption or optional charges or income taxes payable by any security holder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This communication 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.  January 15, 2014.