The financial performance reported by our portfolio companies during the recent earnings season was quite good overall and most companies either met or exceeded our expectations. Unfortunately we also had a few companies report underwhelming performance in August, never a good thing when the market is aggressively selling off. Two names that fell into this bucket were Linamar (LNR-T, -22%) and Mitel Networks (MNW-T, -22%), which together cut a total of 1.8% off our return in August. To illustrate just how violent the moves in these names were, Linamar – a $4.5 billion company – missed its quarterly earnings per share figure by a penny ($1.83 vs expectation of $1.84) and was sold down by 10% that day! Mitel suffered a similar fate when it reported an “in-line” quarter but gave slightly softer forward guidance, to wit, 10% was instantly carved off the value of this business.
As Portfolio Managers with a concentrated basket of shareholdings you can be sure that we understand the fundamental businesses of each and every company we own. This knowledge is essential when faced with situations like the earnings reports from Linamar and Mitel where a small negative earnings surprise is met with a large negative market reaction. Evaluating whether this type of response is the result of a permanent business impairment or just short-term noise is a key to our ongoing success. For the record we continue to own both Linamar and Mitel, and have been accumulating Mitel at current levels. We believe that the broad market has acted irrationally in punishing these names so severely.
In addition to the buffer provided by holding a 15% cash weighting, our hedging program added roughly 1% to the Fund’s net asset value in August. We hedge the Fund’s capital base by committing a portion of our assets to owning securities which rise in value when the price of an equity index (for example) falls, such as put options or shorts. In August we made money from price declines in each of the Emerging Markets Index (EEM.us), the S&P/TSX 60 Index (XIU.to) and the S&P 500 Index (SPY.us). While it would be nice to be 100% hedged during times of stress, in reality this would be a prohibitively expensive endeavour. Instead, our process is to set levels of protection a few percentage points below then current market levels, which exposes us to the first leg down in a correction but protects us from deeper losses. With 25% of our capital covered by hedges and a 4% TSX decline in August, the hedging gain of 1% was on target with our expectation for this component of the portfolio. Further, the hedges continue to add value through early September. This process is an important part of the Fund’s overall strategy and has added several percentage points of alpha to the Fund’s “Since Inception” return figure. But capital preservation is about more than just hedging. It’s about having a culture of engagement and accountability, one where our entire investment committee participates in regular discussion on a broad range of risk management topics such as liquidity, position sizing, loss limits and cash management.
Volatility has returned to financial markets and this letter finds us playing a bit more defense than offense for the time being. That means an above average cash reserve and an active hedging program. The recent correction has given us the opportunity to verify the thesis behind certain of our investments and ask ourselves if we remain highly convicted in the ownership of those assets (we do). It has also allowed us to begin deep research on several companies which we have wanted to own for a long time but that until recently have been too expensive (stay tuned).
Superior investment returns are by definition difficult to achieve. We can be disciplined, well researched and thoughtful value managers with an excellent long term track record but still be far from perfect in the short run. We believe that our fundamental approach works over time and going forward we see absolutely no reason to deviate from it. The names in our portfolio will change but the underlying characteristics and traits which have consistently generated outperformance for us in the past will persist: We will own undervalued, high quality and catalyst-rich companies led by great management teams.
We appreciate your time and support and hope that you will continue to follow our progress. Should you consider joining us as investors in Aventine Canadian Equity Fund, your capital will receive great care and attention, as it is invested right alongside our own.