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%. 

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.

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.

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 31^st) 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.

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.”

“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. 

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.

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.