Excerpt from Fourth Quarter Letter 2018 of Lester Asset Management

Excerpt from Fourth Quarter Letter 2018 of Lester Asset Management

A year ago, we wrote that the capital markets party would soon end given that high valuations for most financial assets were vulnerable in the context of rising interest rates, modest growth and U.S. trade wars. Throughout 2018, the US equity market marched upward and onward, driven by President Trump’s tax cuts, while global markets stalled. This “disconnect” between the US and the rest of the world was bound to end and did so abruptly and with brutality in October as talk of inflation and synchronized global growth turned to that of an impending recession. This U-turn unleashed an avalanche of selling across global equity markets during the last quarter of 2018, with never-before-seen speed and depth as investor sentiment turned on a dime from euphoria to fear.

The pull-back in equity prices was amplified by computer-driven algorithmic program selling, high frequency trading, momentum strategies, quantitative models, the liquidation of several large hedge funds, and the indiscriminate selling of baskets of stocks held in ETFs triggered by panicky and leveraged retail investors, as well as tax loss selling. It is estimated that 85% of trading volume had nothing to do with actual company fundamentals, a fact born out by the equally rapid rebound in stock prices being experienced by global equity markets thus far in 2019. It appears that “the herd effect” has only gotten bigger with the growth in automated trading and ETFs, leading to more pronounced periods of over and undervaluation. This suggests that markets are becoming less efficient, creating opportunities for active portfolio managers going forward.

CANADIAN EQUITY

During the fourth quarter of 2018, our Canadian Equity Fund decreased -12.4% versus -10.1% for the TSX. Our underperformance was mainly due to indiscriminate selling across all sectors which dragged down small and mid-cap stocks more than their larger cap brethren in the index, compounded by tax loss selling. While we outperformed the TSX during previous market declines in the 1st and 3rd quarters of 2018, there was no place to hide in the 4th quarter. For the year, the Fund declined by -13.6% net of fees and expenses (-12.1% on a gross basis) versus -8.9% for the TSX Composite total return including dividends. The good news is that as of the writing of this letter, equity markets are rebounding and the Fund is up around +6% year-to-date.

Since inception in July 2006, our Canadian Equity strategy has produced a cumulative net return of +179.4%, more than double the +77.4% for the TSX. A $100,000 investment on July 1, 2006 (two years before the financial crisis) would be worth $279,400 today, representing an annual compound net return of +8.6% over the past twelve and a half years, versus +4.7% for the TSX. Measured in terms of “value added” active net returns, we have generated +3.9% per year more than the market’s +4.7% annual return during this period.

A few bright spots during 2018 were:

Neulion (+108%): Digital technology provider of live video streaming services was acquired by Endeavor.

CGI Group (+22%): World leading IT consulting firm posted a record backlog and increasing profits.

Badger Daylighting (+19%): Hydrovac excavation company continues its rapid expansion in the U.S.

Baylin Technologies (+11%): Global leader in wireless antennae made several transformative acquisitions.

Goodfood Market (+8%): Canada’s leading meal kit provider is quickly growing its subscriber revenues.

During the year we gradually redeployed cash by adding new positions such as CCL, Stella Jones, Dollarama, New Flyer, Blackberry, Pollard Banknote and ATS Automation, at valuations we consider reasonable, however with the relentless selling pressure towards year-end, it was difficult to predict when prices would bottom. Given the ongoing economic and geo-political uncertainties, equity markets are likely to remain volatile, so we continue to be very selective. We consider our portfolio defensive in nature with low exposure to cyclical or economically sensitive sectors relative to the market. While we should have done better in 2018, we believe that many stocks in our portfolio are oversold and that, in due course, value will surface as it did during 2016 and 2017. Wealth creation requires taking a patient long term view to investing and keeping emotions at bay.

Stephen Takacsy,

Lester Asset Management