The ACE Fund was down -0.8% in April as losses in the Financial and Materials sectors offset strong performance in Technology and Industrials. Since inception, the Fund has outperformed the S&P/TSX Composite Index including dividends (“TSX”) by 3.5% on an annualized basis, returning 12.3% compared to 8.8%. Annualized volatility of 7.2% compares favourably to the TSX at 8.3%. For April, our top positive contributions came from Sandvine (SVC-T, 4.5% weight) which was up 15% and Badger Daylighting (BAD-T, 4.5% weight) which was up 11%.

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April saw a bit of a buying panic in many resource names as industrial commodity prices began to stabilize and the price of oil traded higher on speculation of rising demand and falling supply later this year.  The resource sectors – Energy and Materials – collectively account for roughly 35% of equity market capitalization in Canada and the share price gains in this corner of the market powered the TSX Total Return Index to a 2.4% rise in April.   We have been underweight resource names for some time now and despite the recent surge in prices we aren’t convinced that much value exists in the sector outside of forestry and a few catalyst-oriented opportunities.

As the below charts show, the commodity prices which ultimately drive earnings for most resource companies remain broken, for lack of a better word, although there are signs that a bottoming process may be under way.  The fundamental view we hold is that commodity prices will broadly settle into new, lower trading ranges, and we’d like to get a better handle on what cash flow and earnings look like in this sector before committing new capital.  Recent price moves may represent significant percentage gains off of the “lows” but we would highlight that investors who held through the crash have actually recovered less than one-quarter of their losses from the highs last year.  Avoiding large losses in the first place gives you a great advantage – you aren’t forced into taking excess risk to get back to even.

The core objective of our investment process is to identify under valued and under followed Canadian companies that are exhibiting sustainable operating improvements and increasing market support.  Many value managers have a process focused on mean reversion; they buy beaten up stocks as they fall, hoping to catch a bottom on the belief that prices (or valuations) will tend to mean-revert to some average level over time.  Our process, while still value-oriented, is more trend-follower than mean-reversionist in nature.  Yes, we love finding cheap and well run companies, but instead of trying to call bottoms by stock or sector we wait for clear fundamental evidence that a previously unloved company has turned the corner operationally.

This requirement may prevent us from capturing the full multiple expansion a company experiences during its recovery, but it also keeps us away from “value traps” or stocks that look undervalued but continue to get cheaper.  While capital has begun to flow back into the above mentioned resource sectors based on early signs of improving fundamentals, we are not ready to call this trend sustainable and view the near term risk-reward as skewed to the downside.  That fact notwithstanding, we think we own some fantastic companies in the Technology, Consumer Discretionary and Industrial sectors, each of which are exceptionally well run and organically growing at a superior pace.  We don’t see the need to sell companies with relatively low business execution and valuation risks just to add some commodity volatility to the portfolio.

The investment team here talks a lot about what we call “wealth maximizing behaviour.”  In essence this concept involves doing more of what adds to the wealth of our investors and less of what takes away from it.  Theoretically this couldn’t be simpler, but investors both professional and amateur often botch it in execution.  Humans have the biological tendency to want to buy what goes down and sell what goes up, when often they should be doing exactly the opposite.  Investors who sell their winners to rebalance capital into losing stocks or sectors as they fall actually reduce their ability to outperform over time because their biggest positions are often their worst performing.   We take the approach of rewarding investments that increase in value with additional capital and expect, over time, our largest positions to generally be our best performing.

Last month we wrote about a number of catalysts that were realized by portfolio companies in Q1 and while these all contributed to our performance during that time period, many of them consolidated in April, hurting our return.  Many of these catalysts were transformational in nature and had a substantive positive impact on our investment theses.  We see an opportunity for superior return on capital in each of these companies and have been buyers of the below names through April, on balance.

We have been analyzing a number of new names for the portfolio in the past month and have found some great businesses, management teams and exciting growth prospects, but are finding it increasingly difficult to swallow the valuations that the market is placing on these businesses.  We are quite alright with having a number of names on the backburner as we are quite excited about the prospects of our current holdings, especially as earnings season here in Canada unfolds.

While valuation levels have risen for a number of companies in our cross hairs (and for the broad market in general) we would draw attention to the 12-month Forward Price-Earnings ratio for the Fund which sits at just over 14x on an equal weighted basis versus the TSX at over 17x.   Lower is better of course, but we are also projecting greater than 20% earnings growth in our portfolio companies over the coming year versus the TSX at roughly flat.  It seems that we have a lot to be excited about after all.

In closing, we don’t believe that energy or metals prices are poised to run significantly higher over the medium term, but expect continued growth in other areas of the economy and markets.   The focus of the ACE Fund remains on owning a portfolio of great companies with superior earnings potential over the next twelve months, yet are still cheap and under followed.  Thanks as always for your continued support and we invite those readers interested in investing some of their capital alongside the Aventine partners in the ACE Fund to get in touch and set up a meeting.