Market volatility has seen the stock prices of many companies we like trade at levels significantly below their intrinsic value.  We have been taking advantage of these opportunities by adding to our highest conviction ideas and by “high grading” the portfolio with large cap dividend paying securities.   

Global markets are visibly upset with the Fed, China and OPEC, which has led to large capital outflows, a sharp jump in volatility and significant losses for many investors.  The resource concentration that made Canada “un-investable” to global asset managers in recent years has actually been a tailwind for the TSX during this risk-off period.  Paced by an 8.5% rise in gold stocks and a late month surge in energy companies, the TSX was among the best performing equity markets in January, falling only 1.2%.  By comparison the average global large cap equity index was down 6.7% (in local currency terms), with small caps faring even worse.  See below for a summary of global asset prices performance in January:

Since mid-January the investment actions taken by us have been to meet two specific goals.  The first has been to ensure that the portfolio’s core positions are represented in sufficient weights given our conviction on their business strength, current valuation, and future return prospects.  The second has been a continued high-grading of the portfolio through increased exposure to defensive market sectors, improved portfolio liquidity, and increasing the size of our short book.

When making these allocation decisions, it is important to push aside our emotions and remember that the best way to meet our long term return objective is to add capital to our highest conviction investments during times of market stress, which can be painful initially and in fact lead higher volatility over shorter time periods.  Concentration is the key to great value investing success and sometimes higher short term volatility is the opportunity cost of long term outperformance.

Volatility vs. Permanent Capital Loss

Volatility is a commonly used measure of risk by investors and there has certainly been a rise in it over the past six months.  Within the ACE Fund we use several techniques to try and dampen volatility such as the use of options, shorts and cash management, but volatility is not our preferred gauge of risk.  When we make an investment we are less concerned with its expected volatility and more focused on understanding what factor or factors may lead us to experience a permanent capital loss of material size.  In our experience, volatility is a “shared” event; it hits entire sectors or markets equally, it ignores the intrinsic value of any specific asset or company, and it is temporary.  Permanent capital loss by contrast is often isolated, the result of a significant and enduring impairment in an individual company’s intrinsic value such that its shares reprice sharply lower, never to recover prior highs.

This distinction between these two concepts is of crucial importance to us and requires that we constantly monitor the operating performance and news flow of businesses we own.  If the share price of a company in the ACE Fund (or on our watch list) changes by 30% we need to be able to clearly identify what factors or events have made that particular stock go up or down.  If we can successfully argue that there has been no fundamental, company-specific reason for a material change in the value of that business, then an opportunity exists.

Over the past few months, our core portfolio companies have continued to execute well and strengthen fundamentally, yet in several instances (particularly Concordia Healthcare and Aercap Holdings) we have seen significant multiple contraction.  Nothing in our view suggests that the core businesses of these companies have become impaired and we believe that their true value is much higher than their current share prices.  This is to say that despite rising volatility in the ACE Fund we do not believe that our exposure to risk – in the form to permanent capital loss – has increased.

Below we highlight several companies where we believe the disconnect between price and value as a result of recent market volatility has become exceptionally attractive.   These companies had a large negative impact on the ACE Fund’s return in January despite positive fundamentals and improving earnings estimates.

Concordia Healthcare
2016 EPS Estimate Revisions: +4% (over last 90 days)
January % Price Change: -32%
Price-to-Earnings 2016: 3.7x

Aercap Holdings
2016 EPS Estimate Revisions: +2% (over last 90 days)
January % Price Change: -29%
Price-to-Earnings 2016: 4.3x

Element Financial
2016 EPS Estimate Revision: +1% (over last 90 days)
January % Price Change: -8%
Price-to-Earnings 2016: 7.4x

Our market outlook conversations these days are headlined by oil, China, and the Fed, although banking system concerns, economic growth and corporate earnings are also receiving some attention.  We hear a lot of asset managers comparing the current situation to summer 2011 when the US credit rating was downgraded while Europe was in the midst of a code red debt crisis.  Despite the specific issues being a little different today the comparison is likely fair as the negative feedback loop of bad news and sour sentiment probably hasn’t been as strong since then.  With so many moving parts we find it helpful to distill each major risk down to its root cause, against which we can measure improvement or deterioration.

1. Oil:  We produce too much oil today relative to demand and this has pushed prices down below the threshold at which the negatives from financial dislocation outweigh the benefits from lower prices (around $40/bbl).  Supply needs to adjust.
2. China:  A crisis of confidence in Chinese leadership, particularly with respect to financial stability, is resulting in massive capital outflows.  Erratic policy moves and the disappearance of asset managers and CEOs have not helped matters. Either policy needs to change in a major way or asset prices will continue to fall until they hit a level that begins to adequately compensate investors for these risks.
3. The Federal Reserve / other Central Banks:  With the Fed raising interest rates into a decelerating US economy and central banks in Europe and Asia openly embracing “NIRP” (negative interest rate policy) their credibility has come under fire.  Central banks need to back away from rate hikes and NIRP stimulus in favor of asset purchases (eq. quantitative easing).
4. The Global Banking System:  Investors have sharply sold down shares of global banks as they assess the impact that potential write-downs related to energy companies and high yield debt may have on capital, and the extent to which NIRP and a globally flattening yield curve will reduce profitability. This should not become a systemic issue however, and ongoing communication along with effective disclosure regarding losses will be key to regaining investor confidence.
5. Economic Growth:  Global economic activity in both manufacturing and services has been decelerating since mid-2014 and the idea of recession – unthinkable six months ago – is now a hotly debated subject.  Expectations for growth are still too high, as evidenced by deeply negative economic surprise indexes, and need to be tempered.  Moving the goalposts in this regard will allow some positive momentum to build in terms of “beats.”
6. Corporate Earnings / Valuations:  The aggregate operating earnings of North American companies have now fallen for 3 straight quarters and look poised to decline again in Q1 of 2016.  Corporate guidance suggests minimal earnings growth for 2016, which calls into question both the current bottom-up EPS consensus as well as the market’s 16x forward valuation multiple.

Despite broad negativity and a challenging outlook we are reminded of the maxim that there are no bad assets, only bad prices.  We believe that prices at the low end of the recent range, around 1,800 on the S&P 500 for instance, are reflective of excessive fear and have represented good buying opportunities for us.  Markets under severe pressure can rebound on even slight improvements in economic data or earnings as selling sentiment exhausts, creating a lift to equity valuations.  As per the three holdings noted above, we are certainly not paying a lot for the earnings of our portfolio companies, earnings that we expect will be met currently and grown significantly in the years ahead.

Our playbook is in this environment is similar to the Q3-Q4 period last year.  We will continue to manage the ACE Fund with an above average cash reserve, hold hedges and shorts, and take advantage of dislocations caused by emotion rather than by fundamentals.  As the Oracle of Omaha says, “whether we’re talking about buying socks or stocks, I like to buy quality merchandise when it is marketed down.”

The majority of our portfolio companies report in February/March and we are looking forward to this earnings season as proof that our conviction is well placed.  We are expecting these high quality businesses to deliver strong cash flows and affirm superior earnings guidance.  Great results get noticed in tough markets and we expect our holdings to benefit from an earnings-driven flow of new investors.

Investors who are familiar with us know that we have substantially all of our investment capital invested in the ACE Fund and we believe the prospects for superior long term returns in this strategy are excellent.  We are thankful to those friends and investors who have shown us support in our endeavours and we look to build on the ACE Fund’s early success.  The Fund remains open to new capital and we are always happy to chat about the portfolio and our approach with any investors, old or new.