ACE Fund: Manager Letter June 2014

June 30, 2014



30 JUNE 2014
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The ACE Fund posted its third consecutive positive monthly return capping off a very strong first quarter of operations. The gains in June were led by Technology and Energy Services but held back by Industrials, our largest sector weight.  The largest individual contributor on the month was our position in Micron Technologies (+16%).



ACE Fund  (Class A) 1.3% 5.1% 5.1%
ACE Fund  (Class F) 1.4% 5.3% 5.3%
TSX Total Return Index 4.1% 6.4% 6.4%


AMG 200 (Class A) $105.11
AMG 300 (Class F) $105.27
AMG 400 (Class I) $106.29


The ACE Fund had a successful third month of operations and our master series of F class units (our oldest outstanding units) increased 1.4% after all fees.  June also capped off our first full quarter of operations, during which our unit price increased 5.3% after all fees and expenses.  We want to express our deep gratitude to the families, friends and clients who believe in us and are supporting our ambition to build the best twenty year investment track record in Canada.  These first few months have started us on the long path leading to that goal and we hope you will continue to follow us as we progress towards it.  We also hope that somewhere along the way you will allow us to manage your investment capital for you, if we aren’t already doing so.

The gains we saw in June were tempered by conservative positioning in the Fund.  The broader Canadian market saw a fairly significant move in June, rising 4.1% on resurgent commodity prices for oil and gold (the TSX Gold Index was up 16% in June).  We have been watching many of the largest companies in the TSX Index experience valuation expansion far beyond what we believe to be reasonable, from both a relative and a historical context.  As our investors know, the ACE Fund’s management team possesses a high degree of flexibility with respect to Fund’s investment positioning and we have chosen to exercise that discretion in several ways during our first quarter of operations.  Recall that whereas a typical “long-only” Canadian equity fund will experience added volatility through the high resource exposure needed to generate TSX-comparable performance, the ACE Fund’s performance objectives allow it to detach from benchmark weights in its efforts to deliver solid performance across most market regimes.  At the present time our outlook is one of caution and the investment policy that reflects this view compels us to manage the portfolio to a reduced level of risk exposure, practice selective investment and generally avoid high beta sectors like the gold miners.


Enghouse Systems (ESL) 4.8%
Firstservice Corporation (FSV) 4.7%
Magellan Aerospace (MAL) 4.7%
Sandvine Corporation (SVC) 4.6%
Gildan Activewear (GIL) 4.6%
Easyhome (EH) 4.4%


Market Capitalization ($B) $4.3
Debt-to-Equity Ratio 50%
Forward Price-to-Earnings 12.5x
Price-to-Cash Flow 8.2x
Dividend Yield 0.9%
Return on Equity 12%


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.

Click to enlarge any of the above charts

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.


It has been a truly exciting first quarter of operations for us and the new Fund and we very much appreciate all the support we have been given by all of our unit holders.  We are large unitholders of the ACE Fund ourselves, each holding a majority of our liquid net worth in the fund, and are thrilled have posted a positive return of 5.3% in the first quarter of operations, despite the conservative positioning we have employed.   Our goal is to perform equally well over the coming months and years and hope that you will consider investing alongside us.


Andrew, Jim & James

Our growth oriented North American equity fund, investing in companies with strong momentum in earnings and revenue growth, positive management guidance trends, and superior share price performance. A monthly investment strategy bulletin from our Chief Investment Officer. Focuses on the big picture global economy, asset allocation, and risk management strategies to preserve capital in volatile markets. While we mostly distribute our thoughts on the financial markets, sometimes our activities at the firm level are important enough to share with our clients, friends, colleagues and other stakeholders.

This email communication is intended to provide you with information about the Aventine Canadian Equity Fund managed by Aventine Management Group Inc. This Fund is distributed by prospectus exemption exclusively to qualified investors in the provinces of Alberta, British Columbia and Ontario. Important information about the Fund is contained in its Offering Memorandum which should be read carefully before investing and may be obtained from Aventine Management Group upon request, or by clicking on the link at the top of this email. The Offering Memorandum of the Aventine Canadian Equity (“ACE”) Fund does not constitute an offer or solicitation to anyone in any jurisdiction in which such an offer or solicitation is not authorized, or to any person to whom it is unlawful to make such an offer or solicitation. All investors should fully understand their risk tolerances and the suitability of this Fund prior to making any investment. Rates of return presented for all periods greater than one year are the historical annualized compound total returns for the period indicated. For periods less than one year the rates of returns are a simple period total return. Rates of return do not take into account income taxes payable that would have reduced net returns. The performance presented for Class A and Class F Units of the ACE Fund is the performance of the target series of each class and the NAV Per Unit presented for Class A, Class F and Class I Units is the current NAV Per Unit of the target series of each class. The value of the Fund is not guaranteed and will change frequently. Past performance may not be repeated. All credited third party information contained herein has been obtained from sources believed to be reliable at the time of writing but Aventine Management Group Inc makes no representations as to its accuracy.

Copyright 2014 Aventine Management Group. All Rights Reserved.

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