The Fund’s current portfolio, on a weighted basis, is trading at only 12.5x forward earnings. This is roughly a 25% discount to the broad Canadian marketplace which is trading at nearly 16x next year’s earnings. With this type of valuation buffer we view the risk of a correction in our portfolio as subdued when compared to the market as a whole. Additionally, while many of our current positions are trading at valuation metrics that represent steep discounts relative to the average Canadian company, we also view these current holdings as rich in catalysts and having excellent prospects for shareholder returns in the near term. That being said, we feel that recent market activity encourages us to be prepared for a sudden geopolitical disruption or moderate market correction and thus we have decided to remain less than fully invested in June. Our average cash position has been consistent at 15% for the past few weeks and it remains near this level at the time of writing. Should the opportunity present itself to acquire additional shares of our portfolio holdings at attractive prices, having a bit of extra cash on hand enables us to do so without having to unwind other positions or use leverage.
The Fund acquired its first “insurance policy” earlier this month in the form of a call option position in the long term US Treasury market. Our thesis with this position is relatively simple. When seeking to purchase asymmetrical insurance-like positions for loss protection in investment portfolios we want to achieve the biggest bang for our buck. Empirical evidence shows that during times of equity market stress over the past 10 years the torque, or price reaction, of long term bonds has been roughly 2:1 versus equities. Put another way, during a 10% or greater equity market correction, the prices of long term US Treasuries have been observed to rise by roughly twice as much as equity prices fall, in percentage terms. Thinking of bang-for-buck, one of the things that made this cross-asset hedge even more interesting is that we were able to acquire it at about 1/4th of the cost of a comparable option that hedged the equity index directly.
The reason for the cheapness of this option is that the bond market is so overwhelmingly bearish (i.e. nearly 100% of market participants believe that interest rates are going higher) that risk has become completely mis-priced. We have been studying retail mutual fund and ETF money flows, positioning data reported in the futures markets, economist surveys, and institutional investment intentions, and it is clear that being bearish on interest rates is the most overwhelmingly crowded trade out there. Moreover, as benchmark US interest rates have fallen 20% or more from the beginning of the year, this has been a punishingly painful trade to the bears who are scratching their heads and asking “who the heck is buying bonds?” (recall bond prices and interest rates move inversely to each other).
The simple answer is that there are no real investors of size left to turn bearish on bonds and sell to drive rates higher. Pair this with the sharp fall in the US deficit and the Fed’s massive ownership in the long end of the yield curve dramatically constricting supply, portfolio rebalancing of pension funds and insurance companies, and short covering by hedge fund managers facing career risk, and you have a market that is a like a tightly coiled spring. The optimal payday from this hedge occurs if we see a geopolitical shock or sharp market sell-off that initiates significant flight to safety capital flows into the bond market and triggers a trillion dollar short covering rally. Under this type of scenario we could realize a 2000% return on the hedge. Identifying price dislocations and taking advantage of a risk-reward profile highly skewed in your favour is the ultimate goal of investing. And while this optimal scenario is low probability, the beauty of hedging with options is that we can continue to participate in any positive market trends should they persist.
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While we may be voicing a cautious outlook in our month’s writings thus far, as students of the market are we are lest to forget one of the key investing rules of thumb that actually works – “the trend is your friend.” Yes, we are holding an overweight in cash and we have purchased a cross-asset hedge with the intention of protecting the portfolio from downside, but our primary expectation is that the market grinds higher, irrespective of the stretched valuations that we discern. Often times rational investors who make an all-in call for markets to decline based on suspect valuations go on to miss continued gains. Just ask Robert Schiller, the well-known Nobel Laureate and Professor at Yale University who called markets “overheated” in 1995 and missed a spectacular run in equities over the subsequent five years. Our primary role as managers of the ACE Fund is to be stock pickers, utilizing the sum total of our skills to manage a portfolio of concentrated, high-conviction investments in companies which we believe will deliver superior earnings performance in the near term as well as be “re-rated” from a valuation multiple perspective. We are having no problem finding these names, but should we begin to gather evidence that the risks to holding our positions outweigh their potential rewards, we will begin to head for the exits in earnest. Our job is not to try and time the absolute peaks and troughs in asset prices, but we will take appropriate action in the Fund’s portfolio when we sense that we are nearing cyclical extremes.
One additional piece of news that we’d like to share at this time is the inception of the Fund’s first short position. The company is a very large cap Canadian icon which we believe has become materially overvalued on an intermediate-term basis. We view the short position as both a profit opportunity as the company’s extended valuation normalizes lower and also as a very good hedge against the broad Canadian market. This position represents about 2% of the Fund’s assets and while it’s unlikely that we will increase this size of our short in this one particular position, we do have several other short candidates on our radar. This is simply a tactical call on our part, but again highlights the sort of tactics and investment flexibility that we can, and do, bring to our investors in the ACE Fund.
It has been a rather calm few months for the Fund’s portfolio after a heavy reporting season in April, but we have had a couple of our investments playing out according to thesis. Gildan Activewear, a manufacturer of t-shirts, socks and other undergarments, recently announced the acquisition of Doris Inc. to gain access to its lines of female hosiery and shapewear products. We saw this as a consolidation that made sense for Gildan and gave them expanded distribution in drugstores as well as enhanced access to women’s apparel. We expect it will add to the bottom line in a big way as the business is integrated and continue to view GIldan as a “best in class” consumer stock with a lot of growth ahead of it. They’ve got a pristine balance sheet and are smart acquirers of growth. We expect them to continue making accretive acquisitions of companies like Doris as well as pursue licensing agreements with premium brands (like its deals with Under Armour and New Balance) which they can use to get more shelf space.
