The Fund continues to be ranked in the top 3 performing Canadian Equity Funds tracked by Morningstar over the past 12 months with a return of +4.1%. This represents significant outperformance versus the TSX Composite Total Return Index at -8.7% and the Canadian Equity Fund category average of -7.1%. 

Heading into August the Aventine Canadian Equity Fund (“ACE”) was conservatively positioned, holding a 15% cash weight and solid downside coverage in our option hedging program.  From recent letters investors know that our view for the last several months had been that the market was vulnerable to a moderate bull market correction and we believed that this positioning was appropriate within that context.  However what occurred in August was anything but moderate as risk appetite dramatically collapsed during a period of extremely thin market liquidity.  The resulting wave of selling saw all stocks fall in unison, with the most pronounced declines striking less liquid stocks and small to mid cap companies – areas of the market that have a meaningful impact on us.  Overall it was a difficult month and despite our cautious positioning the Fund lost 5.3% in August.  Notwithstanding, our Trailing 12 Month and Year-to-Date returns at +4.1% and +4.2% respectively, rank us in the top 2 percent of Canadian Equity funds across each of those time periods (as per Morningstar).

It is well known by now that we practice a concentrated approach to portfolio management.  This means that we do extensive research and then take a relatively small number of high conviction positions in our very best ideas – assets that we view as undervalued, under-followed, and catalyst-rich (among other factors).  The concentrated nature of our portfolio means that we aren’t typically reliant on the broad market rising in order to generate investment gains – gains that can be very strong when our research proves correct.  But concentration also means that performance can suffer if important positions go against us.  This was unfortunately our experience in August as our biggest losses came from the largest weights in the Fund.  That said, we strongly feel that the core of our portfolio remains extremely solid.  We remind investors that when we own shares in a company we own a piece of their balance sheet and future cash flows, and that the value of these particular assets are not terribly sensitive to short term swings in either pessimistic or optimism.

Being Canadian investors we are naturally biased towards discussing Canadian markets, but the price movements we experienced here were almost tame compared to what was seen around the world last month.  These declines were truly significant and deserve to be highlighted here, since global equity markets haven’t looked this shaky since 2011.   Gavekal, an institutional research firm, looked at the individual stocks comprising the Morgan Stanley Capital international (“MSCI”) World index and found that only 10% of developed world stocks and 9% of emerging market stocks were trading above their 50 day moving averages as of early September.  Further, 75% of developed world stocks and 89% of emerging market stocks are down more than 10% from their 3-month highs.  Put in context, the recent bout of selling was brutal, indiscriminate and global.

We also took a deep look at the large cap S&P 500 index, which did something in August that has only happened 8 other times in history when it dropped 10% in four trading days.  As the table below details, every other instance of this event has occurred during an extended period of upheaval in global financial markets, so we have to view it as significant.  This means that each prior occurrence was followed by several months of heightened market volatility.  On the surface, volatility can be uncomfortable but it often opens doors to opportunity for patient investors.  In recent weeks we have undertaken a tremendous amount of research on the portfolio, hedges and our potential “buy list”, and are in the process of taking measured steps to position ourselves for outperformance through the coming months.

Past S&P 500 Index Drawdown of 10% in 4 days or Less

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.

Capital Preservation

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.

Market Outlook

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.