The ACE Fund was +4.8% in July, offsetting the losses from June and pushing the Fund back into positive territory for the year at +2.2%.  We are currently positioned to take advantage of a rotation out of low volatility sectors into cyclical value companies which has been very beneficial in July and into August.  We have be very encouraged by the great Q2 earnings season for our portfolio companies and look forward to providing additional updates in our next letter.
 

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Financial Statements
 

July was a solid month for the ACE Fund and our unit price rose by 4.8%, regaining all of the ground we lost during June’s Brexit fiasco. The Fund is back to positive territory on the year, up 2.2%, and has returned 9.1% to investors on annualized basis since inception, after all fees. This continues to compare very favourably against the annualized return of 3.8% for the S&P/TSX Composite Total Return Index over the same period.

Based on the $122.44 NAV for F-class Master Series units the Fund is back within a hair of its all-time high, meaning that every investor in ACE is either making money or flat (our most recent peak was in May at $122.77). Despite great year-to-date performance by the TSX Index, “the market” still hasn’t made a new high since August 2014, meaning long term passive investors have been in the red now for 23 consecutive months.  We also note that the TSX Index was similarly underwater for a period of 31 months between April 2011 and October 2013.  For all the great conceptual things that are written and said about passive investing and ETFs over the long term, we find it curious that nobody talks about how little investment return has been made by passive investors in Canadian equities over the past five years.  We’ll be the first to admit that the ACE Fund’s monthly returns this year have been more volatile than we’d like, but we believe a manager’s ability to compound capital at a superior rate should be more relevant to long term investors than the month-to-month return path. As with other highly concentrated investment funds, the ACE Fund’s unit price can be somewhat volatile over shorter time periods, but this strategy has also demonstrated great resiliency in its ability to quickly recover from unit price declines.

 

Moving to the portfolio, we maintain high expectations for the remainder of 2016.  Earnings season is always an important time for us as increased news flow and operating performance tend to be strong performance catalysts for our portfolio companies.  Perhaps unsurprisingly, the Fund’s biggest gains in July came from companies that reported their Q2 results during the period.

For example, CGI Group Inc. jumped 15% after reporting solid earnings growth and the first organic increase in quarterly revenue since 2014 (on a constant currency basis). We are of the opinion that CGI’s cash flow, balance sheet and track record of consolidation position the company for another accretive acquisition in the near term, and it remains a core position for the Fund.  Four other portfolio companies saw their share prices rise by more than 15% in July.  Exceptional earnings announcements by Lundin Mining (LUN-TO) and Sandvine (SVC-TO) rewarded us with +20% gains in July. Sandvine has been a long term holding of ours and management continues to competitively win new customers and gain market share.  An interesting new element to our thesis is Sandvine’s apparent traction in new international markets which is helping to propel their new customer count to new highs. This is noteworthy because SVC has demonstrated outstanding client retention and per customer revenue growth over time in its current markets, so success opening up new geographies is a very encouraging long-term development.

Another company that performed very well in July was Horizon North Logistics (HNL-TO), a relatively new position for us.  HNL provides remote accommodation and related services to the workers and executives of energy companies in western Canada, including the oil sands.  This is an industry that has been on our watch list for some time and we really started sharpening our pencils after the oil price started to rebound in February.  After meeting with management in April and being really impressed by the CEO, we added a starter position in the Fund at $1.25 per share.  We liked HNL’s vertical integration – they not only build and run the camps, but provide cleaning and catering services as well – along with their relatively clean balance sheet.

We recognized that as drilling activity remained low in the oil patch, competitive pricing pressures would rise, squeezing margins and likely leading to consolidation in HNL’s highly fragmented “camps and logistics” industry.  If the financially stronger and better managed companies would emerge as the ultimate winners then HNL, who smartly raised $50 million of new equity capital in June 2015 at a price of $3.75, was very well positioned to be in that vanguard.  HNL’s war chest was further strengthened by the insurance proceeds ($30 million) from an executive lodging facility that was lost in the wildfire north of Fort McMurray.  In a depressed industry where assets can be bought for far less than replacement (or insurance) value, this windfall gave HNL the capital to acquire Empire Camps Ltd., a major competitor. Shrewd use of the balance sheet has boosted interest in the company and the stock now trades north of $2.00, despite a weaker oil price environment.  With sharp guys like the current CEO, Rod Graham, at the helm we think HNL will continue to make smart capital allocation decisions – decisions that will benefit shareholders tremendously when pricing power and resource utilization return to the industry.

Outlook

Frequent followers of our commentaries will have noticed that the Fund’s exposure to cyclical value companies has risen in recent months. These are undervalued companies in cyclical industries that we believe will directly benefit from upside surprises to growth and inflation, as well as indirectly from factors such as a gentle rebound in bond yields or an appreciating US dollar. Particular industries where we are concentrated include Industrials, Consumer, Non-bank Financials and Materials. While we are not expecting a nominal economic growth to return to the 6% range of the early 2000s we do see acceleration in this respect, along with along a number of other encouraging developments. 

Being value investors, our starting point for any major investment theme (eg. “Cyclical Value”) is valuation.  We knew that these stocks were cheap, but as our research came together we were blown away to discover just how historically extreme valuation spreads were in the current market.  JP Morgan did a great job of capturing these dislocations in the two charts below, which look at equity valuations back to 1980.  The first chart (at left) shows that relative to the “Market”, “Value” stocks are presently the cheapest they have been since the tech bubble on both a price-to-earnings and price-to-book basis.

The second chart compares Value to a segment of the equity market referred to as “Low Vol” (or “quality”) stocks.  The Low Vol stock grouping consists of companies with stable, predictable earnings in lower volatility sectors such as consumer staples, telecoms, utilities, REITs and pharma.  While these stocks were already popular with investors looking for a yield pick-up over low paying bonds, recent performance has attracted big “hot money” inflows and “multiple premium” vis-à-vis the broad market has doubled over the past 12 months as a result. Low Vol stocks are now, by a wide margin, the most expensive they have ever been versus Value stocks (with Value therefore the cheapest ever versus Low Vol), trading at premiums of 10x on earnings and 3.5x on book value.  We believe that the current discount to cyclical value companies is unjustified based on fundamentals and expect to see it begin normalizing in the coming months.  We continue to find great investment opportunities in this unloved and extremely cheap area of the stock market. 

 

The primary catalyst to trigger a mean reversion in these valuation spreads, in our view, is the re-acceleration of economic growth and inflation across the G10. We are presently seeing the strongest economic surprise performance in the developed world since 2014 and with global monetary and financial authorities keeping conditions extremely accommodative macro risks continue to fall.  After declining for several years we expect to see leading economic indicators such as the PMI/ISM surveys begin to turn upwards thanks to the persistence of low global interest rates, with actual economic output to follow.  Increasing activity should restore investor confidence in cyclical market sectors and bring out the bargain hunters.  Also, should interest rates begin to price in stronger growth, we expect profit taking in the Low Vol sectors to further support the rotation into our long Cyclical Value positioning. 
 

While it has been a volatile year for the ACE Fund, we believe we are finally starting to see some alignment between our positioning and broader investment flows.  Our risk models continue to read positively and upgraded outlooks at both the macro level and the individual stock holding level suggest our investments in these businesses will prove quite rewarding for our investors.

As we mentioned last month, the objective metrics for the ACE Fund portfolio are looking among the best they have ever looked. The Fund’s current “PEG ratio” (the forward P/E of a company divided by its Return on Equity) at 0.88x is among the lowest value we’ve ever seen and significantly lower than at any time in 2015. While there is no single forward looking metric that can predict future investment returns we particularly like the PEG ratio as an easy way to combine two metrics which should be important to investors.

As always, we would like to thanks you for your support of the ACE Fund and we hope that you find our monthly letters of both interest and value.  We always appreciate hearing from investors and encourage you to reach out if you’d like to discuss any specific aspects of our investment style or current positions, or if you have any comments or suggestions regarding the commentaries we publish. Best wishes for the rest of the summer, we’ll be in touch again in early September.