ACE Fund: Manager Letter September 2015

September 30, 2015



30 September 2015
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Aventine Canadian Equity Fund

Monthly Fund Manager Update – September 2015

Executive Summary


The Aventine Canadian Equity Fund finished the month of August down -6.1%.

The Fund continues to be ranked in the top 14% of all Canadian Equity Funds tracked by Morningstar over the past 12 months with a return of +1.0%. This represents significant outperformance versus the TSX Composite Total Return Index at -8.4% and the Canadian Equity Fund category average of -6.3%. 

Fund Documents

Purchase Documents


Media Appearances


Performance Overview

Net Asset Value per Unit

AMG250 (A) AMG350 (F) AMG450 (I)
Aventine Canadian Equity Fund $102.80 $104.04 $107.82

Current Year Performance

1 Month 6 Months Year to Date
Aventine Canadian Equity – Class F -6.1% -9.0% -2.2%


Historical Performance

1 Year 3 Years* Inception*
Aventine Canadian Equity – Class F +1.0% n/a +2.7%
* Performance for periods >1 year are annualized.

Top Holdings

Goeasy (GSY-T) 7.1%
Concordia Healthcare (CXR-T) 6.0%
Clearwater Seafood (CLR-T) 5.6%
New Flyer Industries (NFI-T) 4.6%
Sandvine (SVC-T) 4.5%

Metrics of Average Company

Market Capitalization ($B) $4.8B
Expected EPS Growth 35%
Forward Price-to-Earnings 11.9x
Dividend Yield 1.4%
Return on Equity 11%

Fund Commentary

September for the ACE Fund was a month in which our outlook and positioning were on target, but our returns failed to reflect the team’s positive strategic moves.  Instead, as per the table above, we suffered a second consecutive month of losses, which is frustrating for all us invested in the Fund.  A significant portion of the loss in September is attributable to a single holding that experienced a series of extraordinary negative events – but which we remain very bullish on – and will explain in a bit more detail below.

While the S&P/TSX Composite Total Return Index has fallen 8.4% over the past year, the “average” stock in the index has actually fallen by 20.3%.  Regular readers know that capital preservation is very important to us and during a very difficult 12 months for Canadian investors the ACE Fund has met that mandate, rising by 1.0%.  Despite a forgettable quarter which saw us give back gains made earlier in 2015, the Fund continues to be ranked solidly in the top quartile of our peer universe and we are encouraged to note that ACE is among a small group of Canadian Equity Funds that have not lost money over the past 12 months.

Crash, Rally, Re-Test… What’s Next?

Markets have generally followed the path we wrote about last month.  After crashing dramatically in late August, a “throw-back” rally developed from deeply oversold conditions.  The rally was turned back at the underside of the 2014 lows and now a successful test of the August bottom has completed.  So where do we go from here?

Fundamentals such as valuation and earnings expectations are always important to us, but so are technical readings on the market like investor sentiment and positioning, and structural elements like volatility and credit spreads.  We may not be ready to give an “all clear” signal but the ongoing rebound has resulted in positive developments on several fronts and at this point we feel that we risks are decreasing, as opposed to increasing.

Looking at valuations, most companies we track are trading at very attractive levels and so we have started putting some cash to work.  Recall that most of our portfolio is comprised of companies which are benefiting from low interest rates and fuel costs, have solid pricing power and are growing organically at a strong pace.  We have been adding selectively to current holdings as well as taking new positions in a couple of stable, well run companies trading at discounted prices.  And early October even finds us with a bit of capital allocated back into energy and metals exposure.  The result is that the Fund’s sector allocation is now quite balanced across the cyclical, defensive, resource and financial sectors in Canada.  Looking at our holdings today we don’t think that the overall portfolio has ever traded at more attractive valuation metrics and we expect strong profits as lingering investor fear subsides and capital begins flowing back into stocks.

Concordia Healthcare

The company mentioned in this month’s leader above, the one responsible for nearly half our loss in September, is Concordia Healthcare (CXR-T, -44%).  Concordia is one of the few large health care companies listed on the Toronto exchange and up until recently was a market darling, rising 116% in 2015 (through August 31st) on the strength of the following business plan:

  1. Acquire individual legacy drugs / drug companies with high free cash flow.
  2. Use that cash flow to fund ongoing enhancement of the existing drug portfolio.
  3. Provide organic growth through a development pipeline of speciality drugs.

Since becoming a public company in 2013, Concordia has been extremely active and closed acquisitions worth over $1.7 billion, as detailed in the presentation slide below. The company’s track record of identifying, purchasing and integrating attractive assets has been exceptional and shareholders (ourselves included) have been rewarded with a soaring stock price.  Based on all of the foregoing as well as public statements by management, we were expecting the company to announce another major acquisition in the near term.   This announcement came on September 12th when Concordia announced an agreement to acquire Amdipharm Mercury (“AMco”), a UK-based specialty pharma company with a large portfolio of niche medicines and a global footprint.  On paper this was exactly type of deal that Concordia was looking for – accretive to shareholders, diversifying to the product line, and providing the company with a new level of global scale.

A Botched Deal

Upon announcing the deal, Concordia’s stock price started to decline and we heard concerns from several trading desks that investors were wary about the amount of equity and debt the company would need to raise to fulfill the purchase price.  There was also some skepticism that Concordia’s management had bitten off more than they could chew with an acquisition of this size and scale.  Sentiment towards Concordia appeared to be wavering, but we viewed this a strong fundamental acquisition for Concordia and the financials of the pro-forma company looked impressive.  We also have a lot of faith in management and did not find the size of the deal to be worrisome as it related to management capability.  Then this happened:

A smug young hedge fund manager turned pharmaceutical entrepreneur appeared on CNBC defiantly promoting how his company had just raised the price of 62 year old malaria drug by over 5,000%.  This captivated the media who began publishing stories on pharmaceutical price gouging, inciting fury among the public and several campaigning presidential hopefuls.  The following day an “outraged” Hillary Clinton announced her intention to “take on” the speciality pharmaceutical industry, sending many pharma and biotech stocks down 25% or more almost instantly.

This attention came at a crucial time for Concordia who was in the midst of selling US$500 million in new common stock to fund its acquisition.  Faced with a sharply lower share price and potentially higher regulatory risks, many investors who had previously indicated an interest in buying up the new Concordia share issue simply vanished.  Others who were contractually obligated to buy under purchase agreements found they had been delivered a vast inventory of unwanted extra shares, which then had to be sold into the market at steep losses.  All of this happened very quickly and a company valued at over $4 billion, expected to generate $600 million in cash flow next year, essentially went “no-bid.”

The Parable of Mr. Market

As we write, Concordia’s stock is within a few percent of the price at which we started accumulating our shares last November ($41.40), but it is a much, much different company today.  By carving the stock price in half, the market is saying that the risk profile and economic prospects of this company have shifted tremendously in the past 4 weeks.  But have they?  We find ourselves skeptical in this regard and recall Benjamin Graham’s Parable of Mr. Market:

“An ever helpful fellow, Mr. Market stands ready every business day to buy or sell a vast array of securities in virtually limitless quantities at prices that he sets. He provides this valuable service free of charge. Sometimes Mr. Market sets prices at levels where you would neither want to buy or to sell. Frequently, however, he becomes irrational. Sometime he is optimistic and will pay for more than securities are worth. Other times he is pessimistic, offering to sell securities for considerable less than underlying value. Value investors—who buy at a discount from underlying value—are in a position to take advantage of Mr. Market’s irrationality.”

Valuewalk provides more background on Graham’s Parable, including insights on Mr. Market provided by none other than investing greats Warren Buffet and Seth Klarman. 

An Opportunity Created

We believe that we have accumulated a pretty considerable knowledge base on Concordia’s business and include the following notes to highlight the irrationality of the recent price movements and support of our positive view on the company’s shares.  If any investors or colleagues are interested in additional detail or color on Concordia, let us know and we would be happy to share our research findings with you.

On Valuation:   Our conservative estimate is that Concordia will earn $8 per share over the next 12 months and generate $5 per share in free cash flow.   This means the company is trading today at just over 5 times next year’s earnings, which represents a discount of roughly 60% relative to its industry peer group average.  Based on a normalized valuation of 12 times, we see fair value for Concordia in the $95 to $105 range.

On Stability:   Until now, Concordia’s revenue has been heavily concentrated in a small number of products sold mostly in the US.  The AMco assets broaden Concordia’s drug portfolio to more than 200 products marketed in 100 countries with no single medicine accounting for greater than 10% of sales.  The diversification benefits from a broadened portfolio are very clear with respect to improving revenue stability and reducing regulatory risk.

On Growth:  AMco has grown their revenues at a compound annual rate of 18% since 2012 and Concordia’s CEO Mark Thomas has guided for high single digit organic growth for the combined company. Increased scale and management expertise significantly expands the pipeline of potential acquisition targets once the share price recovers.

On Talent:   The management talent acquired at AMco is every bit as important to Concordia as the product portfolio.  The AMco team has successfully built their platform out to over 1000 SKUs globally through pipeline development and targeted acquisitions.  On conference calls related to the deal both management teams have noted their complementary strengths and expect to collaborate closely in ongoing corporate development initiatives.

On Headline Risks:   We find it pretty absurd that a campaign trail tweet from Hilary Clinton cost the biotech and specialty pharma sectors of the stock market over $160 billion in lost valuations.  This is a clear case of a situation getting blown well out of proportion.  We just don’t see any real economic impact coming from this obvious politicking.

In Summary:  We view the risk/reward proposition currently being offered to buyers of Concordia by Mr. Market as very attractive.  We estimate that the company can generate C$8.00 in earnings per share next year (versus analyst consensus at $9.25), so we can buy those earnings today at about a 5-times multiple.  Despite the financing debacle and regulatory scare, we expect few changes to the company’s fundamental business or economic soundness and see the stock as solid value at current prices. Psychologically, retail investors are likely to be a bit wary of the stock, but we expect institutions and funds to be buyers and believe this interest will move the company’s valuation back towards a 9-10x EPS multiple (+100% from current levels) in the relatively near term.

Market Outlook

Despite a couple of disappointing months for the ACE Fund, we wish to clearly express that there is rock solid conviction behind both our investment process and our positioning.  We hate suffering losses but remind ourselves that we have added substantial value over our benchmark and our Canadian Equity fund peer group since launching ACE in March 2014.

The 15% decline in the S&P/TSX Composite Index since May has created price dislocations in several pockets of the Canadian equity market.  Starting October with a cash position of nearly 25% affords us the opportunity to add weight to existing holdings that we view as fundamentally strong but trading at discounted valuations, as well as acquire several new assets that more emotional investors seem willing to sell to us at “fire-sale” prices.  More broadly, we are becoming comfortable with the prospect that a bottoming process is now underway in overall markets and believe that investors are willing to provide support around current levels.  As the famous investing adage goes, the best time to buy is when there is blood in the streets.

Lastly, it is important to note that while we always attempt to keep our investors up to date on a monthly basis through our commentary, our investment decisions are made for the medium term, not month-to-month.  We take a much longer term view of our investments and will remain confident and convicted for many months and quarters to come.  Many of our best ideas over the years have been misunderstood by the market at one point or another and required diligent research and conviction to stay long.  We have always been surprised that many investors are willing to sell at prices significantly below reasonable valuations given that the expected returns over the medium term are the greatest at those very levels.

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.

Performance Presentation

Fund Inception: March 31, 2014

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  © *|CURRENT_YEAR|* AVENTINE MANAGEMENT GROUP INC., All rights reserved.

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