As we pass the half-way post on the year, the Aventine Canadian Equity Fund finds itself in unfamiliar territory, down 2.5%.  However we expect there to be more profitable times ahead for the Fund as growth and earnings improve over the coming months and market leadership rotates back in favour of our positioning.  

For those interested in listening to our mid-year update (as opposed to reading it), our Partner Andrew Shortreid was on Bloomberg TV last week discussing many of the themes from this month’s letter.

Fact Sheet
Manager Profile
Firm Profile
Financial Statements
 

The ACE Fund returned -4.8% in June giving back all of May’s 3.6% gain and putting us in the red at the midway point of the year. Since inception (March 31, 2014) the ACE Fund has returned +7.2% on an annualized basis, versus +2.2% annualized for the S&P/TSX Composite Total Return Index.  We should also note that at the time of writing, July has been very strong for us with an estimated unit price gain of approximately 5% through mid-month. 

As our readers are likely aware, global financial markets were sent into a tailspin towards the end of June by a surprise “Leave” vote in the UK referendum on European Union membership. The spike in political and economic uncertainty related to this result translated into several days of extreme volatility before the market rebounded into month end. While many positions in the portfolio recovered quickly alongside the market, several others did not which was an unfortunate drag on performance through quarter end. Our exposure to the UK wasn’t the issue so much as the general preference towards owning defensive, low volatility stocks which saw investors put new cash to work in these “safe” areas over the types of value stocks we hold.

Events such as Brexit, the Chinese economic growth scare of last summer, and an ongoing battle for share in global oil markets have driven investors into defensive “low vol” stocks at a record pace this year, bidding up their valuations to historic extremes.  With economic growth finally showing signs of strengthening, we believe that investors will begin to recognize that limited upside exists in holding expensive stocks in defensive sectors such as utilities, REITs, telecom and staples.  Our expectation for the second half of the year is to see a growth-inspired rotation away from the constellation of defensive assets (low volatility equities, bonds, gold, etc.) which have been driving markets so far this year in favour of a more balanced market where deeply undervalued cyclicals such as industrials, diversified financials and consumer discretionary take the lead. We’ll expand on this theme in more detail a bit later, but first we’d like to share some fundamental updates on a few of our core holdings.
 

• Winpak (WPK.TO) was added to the S&P/TSX Composite index in June, creating additional demand for shares from indexers and sending the stock to 52 week highs. We continue to believe this is an underfollowed name and that it is ripe with potential catalysts given their clean balance sheet, free cash flow and ownership structure.  We wrote about this name in our April commentary here. 
• New Flyer (NFI.TO) reported a very strong Q1 where management expressed confidence in their ability to grow margins from the ongoing streamlining of operations at Motor Coach Industries, acquired last year.  We continue to see significant upside with New Flyer although we have trimmed our position a bit.
• Clearwater Seafood (CLR.TO) reported strong results in a seasonally weak Q1, but the stock was weak post earnings on market chatter that an equity issue was forthcoming to pay down debt.   While we thought that capital structure was fine, management caved to the market and came to market with a $50M bought deal on May 31.  This was an incredibly successful raise, oversubscribed by 4-5 times with management participating to the tune of 30%. We believe this clears the way to all-time highs as more institutional investors get involved in this high quality, large moat business. 
• Cott (BCB.TO) had a volatile June as the company first announced a large European acquisition, then subsequently raised $230 million through a bought deal, and finally was sold down sharply on the UK “Leave” vote (13% of their EBITDA comes from the UK).  We believe the impact of Brexit on Cott will be minimal, however, given how naturally hedged the company is due to its operations in the UK.
• Concordia Healthcare (CXR.TO) continued to whipsaw, seeing a high of $45 and a low of $25 in June.  Entering the month, expectations were high that CXR would be acquired by a large US private equity player, however when it was reported by the Wall Street Journal that two of the three potential bidders had declined to proceed, the stock fell swiftly.  While it is difficult to speculate on what is actually happening behind closed doors, we continue to believe that CXR is deeply undervalued based on its cash flows and would not be surprised to see management act to support the stock price given an extremely large short position (roughly 85% of the float). 
• Newalta (NAL.TO) has been our strongest performer the past few months (+33% in June) benefitting from the price stability of oil above $45.  Working closely with oil & gas producers on waste recovery and recycling at well sites, NAL has incredible torque to an uptick in production activity, not just in utilization but also in their ability to sell recovered product. While financial leverage is a concern with this stock, we believe that the company has controlled costs well through the downturn and expect the balance sheet risk to diminish over the coming quarters.

2016 Leadership by Gold & Defensive Sectors

As value investors with little exposure to the resource sector, we saw the broad Canadian index outperform us pretty handily through the first half of the year.  The clear winner of 2016 so far has been the gold mining sector, which had nearly doubled through June 30th on a resurgent interest by global investors in gold’s safe haven qualities.  Despite being only an 11% weight in the overall index today, gold and base metals stocks have accounted for two-thirds of the TSX Composite’s 9.8% gain year-to-date.  Outside of the miners, leadership has been skewed towards higher yielding, low volatility defensive equities such as REITs, utilities and telecoms which have accounted for the other one-third of index performance this year.  The other 80% of the Canadian market, which includes the financial, energy, industrial and consumer sectors, has been negative before counting dividends.  The chart below illustrates various sources of return (price only) for the TSX Composite so far this year.

Defensive Low Volatility Stocks Are Overvalued

The collapse in global bond yields engineered by central banks over the past several years has led to steady flows of capital from income-oriented investors into low volatility equities and other bond substitutes. This “defensive yield” strategy has been particularly effective in Canada, outperforming the TSX index by better than 5% annualized since 2011. Over the past 18 months, the valuation spread between defensives and the rest of the market has jumped materially wider as interest rates continued falling and investors became increasingly nervous about commodities and the business cycle. We believe that large new flows from momentum-oriented investors have been responsible for sending relative valuations in this space to extreme highs recently, in terms of both forward earnings and book value multiples. The two charts below from JP Morgan (labelled Figure 7 and Figure 8) provide a historical context for viewing this valuation spread back to 1980. While JPM is looking at the US markets, we see similar distortions here in Canada and believe that a tipping point for mean reversion is not far off.

Gold Is Overbought

As noted earlier, gold has been a big beneficiary of the push into negative interest rates by central banks in Japan and Europe. At the time of writing, roughly US$12 trillion in global sovereign debt – nearly half of all developed market bonds outstanding – is trading with negative yields. One of the biggest knocks against gold as an investment asset has always been that it pays no income, but in a world where negative interest rates are common, zero represents both a high yield and a suitable safe haven destination. Our broad view on gold is that it can be a reasonable hedge against uncertainty and we have had some exposure in the Fund this year for that reason, but its attractiveness has limits. Similar to how momentum investors have pushed defensive equities into extreme valuation territory, investor flows into gold ETFs have been massive this year and the gold sector has very quickly become crowded. For instance, the SPDR Gold Trust “GLD”, a popular way for investors to acquire gold exposure has received over $12 billion in new capital year to date.  To put that number in context, the GLD fund has attracted more new investment dollars this year than any other ETF on the planet. Further, speculative positioning in the US futures market which is tracked weekly by the Commodity Futures Trading Commission (“CFTC”), shows that traders have now built up the largest net long position in Gold ever, some $15 billion dollars worth (we no longer have any gold exposure).

The Catalyst: Stronger Growth

There is no question that economic uncertainty has carried a heavy weight in the allocation decisions that investors have been making. Investors have placed a premium on predictability and market leadership has been reflective of a late cycle behavioural bias with bonds, defensives and gold all outperforming value stocks. With positive economic surprises at a 2 year high across the G10 nations and having improved materially versus earlier this year, we see an upgraded outlook for corporate profits in undervalued cyclical sectors like industrials, consumer discretionary and diversified financials. As growth, profits, employment and inflation all continue to firm we believe that the market’s expectation for another US rate hike in 2016 is currently underpriced. Stronger economic data will be the catalyst which sees this expectation revise upward, trigger profit taking by fast money in the defensive equity and gold sectors, and prompt the leadership rotation back into cyclicals and value stocks.

We have been vocal on BNN, on Bloomberg and in our recent commentaries about the benefits of shifting into undervalued cyclical stocks over the past few months. Being early to this rotation means that we have been able to build full positions in several great Canadian businesses trading at plus or minus 6x EBITDA. By comparison, most of the defensives we track are trading above 18x EBITDA – a valuation premium of 300%. Despite the prevailing sentiment that low interest rates justifies these types of equity multiples, we see the entire complex of defensive assets as being unsustainably rich and therefore vulnerable to correction. Some of the things that we are looking for in the macro space to indicate that this view is playing out include continued strength in ISM/PMI surveys, retail sales, and labour market health. We are also expecting a better than average corporate earnings quarter accompanied by upbeat management guidance.
 

The Fund is positioned to take advantage of valuations in Canada that we view as unjustifiably low on a fundamental basis, specifically in the areas of Industrials, Consumer Discretionary and Diversified Financials.  At the aggregate level our portfolio trades at 10.5x expected P/E, representing one of our “cheapest” valuations to date.  Long term investors in the ACE Fund know that we do not simply buy a stock based on its cheapness; there also must be a “quality” aspect as well as a high degree of confidence on our part that we are buying a business cheaply relative to its value.  Given the volatility in the portfolio over the past month, we had many opportunities to add to these positions at large discounts to what we believe they are worth. For investors who may be heavily overweight in the defensive sectors of the market, we urge caution as we believe their premium valuations leave no margin of safety and expect that a reasonable price response to our “Stronger Growth” thesis playing out would likely analog what income investors experienced during the summer of 2013.

It has become a mainstay of our investor letters to state that we have substantially all of our own investment capital invested in the ACE Fund. This remains the case, along with our belief that the prospects for superior long term returns in our strategy are excellent.  We are thankful to those friends and investors who have supported us in the early years of our endeavour. 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.