The ACE Fund returned -0.1% in September, capping off a strong Q3 and last twelve months with returns of 5.0% and 17.9%, respectively. 

Global energy markets saw a potentially critical macro event which will be discussed further in this commentary and we are seeing improving economic data which we believe will be rewarding in the upcoming months.

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The Aventine Canadian Equity Fund (“ACE Fund”) finished the month of September essentially flat with a return of -0.1%.  Some months more than others the Fund’s net return figure fails to underscore how broad fundamental developments have improved, supported or de-risked specific thematic narratives within our portfolio. This past month in particular saw a potentially critical macro event for global energy markets that is worth reviewing, along with the continuation of our previously noted investor shift into more cyclical sectors of the stock market.  In our opinion the ultimate influence of each of these on our Fund’s unit price is yet to be felt.

It seems presently that wherever investors turn they are faced with heightened uncertainty – the surge in US populism and its impact on the election, a potential Fed rate hike and its impact on bonds and dividend stocks, fragile politics and a teetering financial system in Europe, high equity valuation multiples, and so on.  The need to separate signals from noise is relentless and can be especially challenging work that requires discipline, patience and resolve. Over time we are confident that our research efforts will prevail over the market’s random walk, as we believe that fundamentals do matter. Further, we understand that strong long term performance is also a product of organizational culture and we are continually working to ensure that Aventine’s philosophy, attitude, process and team are all in alignment with this goal.
 

It was just under 2 years ago when, on November 27^th 2014, the Oil Ministers of OPEC nations responsible for 43% of global oil production blocked calls for a coordinated production cut.  Saudi Arabia, the cartel’s de facto leader, argued that the global oil market should be left to “re-balance” at lower levels, allowing OPEC to strategically rebuild its long term market share as higher cost producers (eg. US shale companies) with high debt levels and low profitability would be forced to shutter. The decision was a surprise to the market which had come to see OPEC as a mostly rational actor over the past 30 years and directly led to the price of oil plummeting 45% over the following 6 weeks and 70% over the following 12 months.

Fast forward to today and OPEC’s strategy is observed as having mostly failed to achieve its desired results.  Certainly energy production in specific areas has scaled back, but these declines have been small relative to the non-OPEC production surge over the past 6 years.  In the meantime oil exporters like the Saudis have seen their fiscal deficits balloon to record levels as oil revenues have fallen to a fraction of their pre-2014 levels. In acknowledgement that unconventional producers have outperformed OPEC’s expectations with respect to maintaining solvency at low oil prices it seems that the cartel’s attitude has finally begun to shift.

This became clear at the meeting in Algiers on September 29^th where, for the first time in 8 years, a soft agreement to reduce overall oil output was announced by OPEC’s major members.  While common sense dictates that we remain cautious of whether or not this actually gets implemented (currently we have only “an agreement to agree” to a production curtailment), it is undeniable that this represents a significant change in tone from recent years.  The oil price reaction to this news has been impressive as we have now crossed over the psychological $50 level and, helped along by softer storage inventories, recently made a new 52 week high.  It is looking more probable that we see a further retracement towards the high $50s or even low $60s, which would be positive for several of our holdings.  While our investment style is not tied to macro forecasts on things such as where the price of oil is going, we have become more confident that a period of enduring relative stability in energy markets is upon us and as a result have spent a lot of time researching some really interesting and undervalued energy service companies.  Two of these now occupy full positions in ACE, and both have benefited disproportionately from the perceived improvements in oil market dynamics over the past few weeks. 

Oil stole the spotlight in late September, but prior to this, much of our inbox was filled with positive news regarding the distinct firming of primary global economic data.  This was illustrated in rising global bond yields, US Fed Funds Rate expectations and improving economic surprise indices.  At the time of writing the probability of a December rate hike by the Federal Reserve is 64% and the prospect of a tightening Fed is having a negative impact on the valuation multiples of stocks considered to possess “high yield” and/or “low volatility” attributes, such as utilities, telecoms, REITs and staples.  We have been positioning the portfolio for accelerating nominal growth and by extension higher bond yields, and have seen a nice lift in many of the investments we hold across the more cyclical economic sectors.  Notwithstanding a significant external shock (President Trump!) we expect this trend to continue through Q4 and into 2017.  The charts below help explain the trend change we are discussing by comparing TSX listed Utilities to the cyclical Auto Components sector.   

Cyclical Sectors Have Rebounded But Valuations Are Still Compelling

Incidentally it should be noted that our overweight exposure to cyclicals in the portfolio is less a macro call on rates and more about how relative valuations in these opposing market sectors have been pushed to extreme levels.  Cyclicals, along with other types of value stocks, have just become too cheap relative to the market and relative to their own historical levels for us to ignore.  Complementing this cyclical positioning is a core set of high quality “anchor stocks” whose low leverage and track record of superior capital allocation lend stability to the portfolio.  Our Anchor Stocks are businesses that you can hold for decades, no matter what market storms come and go, they will continue to produce strong internal returns and generate free cash flow for shareholders.  A few of these names traded softly in September, seeing valuations compress as a result of “hot sector” flows into energy, for instance.  The lesson learnt from past periods of weakness in our Anchor Stock holdings is pretty clear, however – add on weakness and trust the long term fundamentals and management team.
 

New Position

Last month we mentioned we were building a new position in a “classic Canadian success story” and at this point we thought some elaboration was warranted.  Cargojet (CJT-T) is Canada’s largest overnight freight carrier and holds a commanding 90% market share for domestic overnight cargo.  The company history is a phenomenal entrepreneurial story, and stars co-founders Ajay Virmani, Dan Mills and Jamie Porteus in prominent roles (Chariman and CEO Virmani still owns approximately 15% of the company). Through a shrewd consolidation of the freight forwarding industry in Canada, Cargojet has seen its equity market capitalization rise by 650% over the past four years while increasing the share count by only 25%.  The most significant valuation catalyst realized in recent years was Cargojet’s February 2014 awarding of a long term contract with the Canada Post Group of Companies (“CPGOC”), which includes Purolator.

A key part of management’s value creation strategy for Cargojet has been a coordinated effort to leverage their plane network (currently consisting of 21 planes) and increase the effective utilization of these assets.  The strategy has been executed in two dimensions, the first has focused on securing interline agreements with international carriers needing to move cargo within Canada so that Cargojet gets more product onto their regularly scheduled flights.  The second has involved leasing out their planes under ACMI (Aircraft, Crew, Maintenance and Insurance) contracts during times that these planes would otherwise be idle. As a result of these endeavors, we believe that Cargojet is now demonstrating the sort of cash flow generation that gives management the flexibility to pursue corporate value creation across several verticals from deleveraging, to organic growth initiatives, and shareholder friendly corporate actions.   Having already invested both in the capital assets and training costs required to service the CPGOC contract, Cargojet is on a very interesting path. We believe that the market has started to re-rate this well-run, “wide-moat” company based on a new consensus outlook for normalized cash flows over the next several years.
 

Outlook

As we look out over the next couple months to finish out the year we continue to see good reason for optimism for both our portfolio companies and for the global economy.  However as noted earlier there are also any number of political, economic and financial events which could derail the rally we have experienced since mid-summer.  But when isn’t that the case?  Rather than predicting material downside risk from here, we instead believe it more likely that the current broad uncertainty will simply offset the record global stimulus in Q3/Q4 and serve to contain upside multiple expansion in equities.  Sideways activity actually bodes well for our portfolio which is both downright cheap versus the broad market and growing earnings / cash flows at a faster rate.

Balancing the conviction we hold in our very best ideas with the good judgement to nevertheless manage and diversify our risk exposure, we have been recently raising cash and adding to index put options.  If we learned anything from the Brexit fiasco it was to expect the unexpected and so prudence tells us to both be cognizant of the potential for volatility and be prepared to take advantage of any opportunities it may provide.  Owning some market hedges and ensuring that we have some dry powder on hand is helpful in this regard.

Against the current backdrop, we see improving economic data, flickering signs of inflation and the best corporate earnings guidance since Q4 2011.  We have been positioning the portfolio for this dynamic and believe these fundamentals will reward us in the months to come.  We own a great mixture of high quality anchor stocks, balanced with companies that have significant torque to the changing dynamics of the Canadian Equity landscape.  We believe we are in the early innings of this rotation and look forward to this trend unfolding further in the months to come. 
 
As always, we appreciate your support of the ACE Fund and hope you find our monthly letters both valuable and interesting to read. If you have any comments or suggestions, please do not hesitate to reach out. Best wishes for the beginning of the Fall season.