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

James Telfser on BNN-Bloomberg’s Market Call – Feb 27,2019

James Telfser on BNN-Bloomberg’s Market Call – Feb 27,2019

MARKET OUTLOOK

We believe the current investing environment is more balanced from a risk and return standpoint versus a couple months ago.  While financial conditions, breadth and credit metrics have all improved, many recent geopolitical risks have receded and we are more cautious about valuations at current market levels.  We continue to hold a modest amount of cash in our accounts to take advantage of any dislocations to the seemingly “perfect” narrative we keep hearing.  We will get more constructive on equities if we can get more comfort that global growth and earnings have bottomed, as currently it looks like Q1/19 estimates are expected to be negative year-over-year while Q2/19 is deteriorating as well.

Our private client accounts took advantage of the sell off over the last four months by adding to equity positions from our core Canadian and U.S. capital allocator model.  We have also been taking advantage of the weakness in the Canadian preferred shares market as we believe a number of issues are now deeply oversold from the back up in interest rate expectations.   We continue to stress patience as we add a number of great businesses to our watchlist and are waiting for volatility to pick up again to get more aggressive as valuations reach our entry levels. 

TOP PICKS

Market Call Top Picks

EVERTZ TECHNOLOGIES (ET.TO)

Evertz is a global leader in the broadcast technology industry and they are positioned to disproportionately benefit from the upgrade cycle to cloud-based media delivery. The company has demonstrated exceptional internal returns and smart capital allocation practices over a long period of time and is trading at an undemanding valuation while yielding 4.5 per cent. We have a high probability 12-month expected total return for Evertz in excess of 25 per cent with the potential for additional upside from transaction-related catalysts.  One interesting aspect of the company is the incredible alignment of interests as insiders own roughly 65 per cent of the firm.

ATS AUTOMATION TOOLING SYSTEMS (ATA.TO)

ATS is a custom engineer and producer of automated manufacturing systems. The current trends towards robotics and automation across all industries makes this a stock with significant tailwinds.  We have been impressed with ATS from an operational and management team perspective as their new CEO, Andrew Hider (from Danaher), has refocused the organization on driving shareholder value.  Their backlog has been very strong and we believe that recurring revenue is going to increase over the next few years through support services which will further stabilize their operations and increase margins.  This along with their appetite for acquisitions should improve the valuation multiple which is current at a significant discount to peers at nine times expected enterprise value to earnings before interest tax depreciation and amortization (EV/EBITDA).

CCL INDUSTRIES (CCLb.TO)

CCL has been a great holding for us over the years and after watching the valuation for this label manufacturer fall from a peak at 27 times price-to-earnings (P/E) in 2016 to the current high-teens level, we believe it is time to start revisiting the name.  They have struggled over the last few quarters, along with most packaging companies, as increasing resin prices and the general economic slowdown has impacted their growth trajectory as well as margins.  Despite the short-term hiccups it is important to recognize that CCL is a best in class company with a strong management team and excellent prospects for both organic growth and acquisitions.  CCL has done an exceptional job buying competitors and businesses operating in similar industries and helping them bring more of the “Best manufacturing practices” to their businesses while still encouraging and regarding local decision making.  At the current valuation at 19 times this year’s earnings, coupled with a strong balance sheet (One times net debt to earnings before interest tax depreciation and amortization) we believe investors will be rewarded as the company executes going forward.

James Telsfer, Aventine Management Group

Stanley Druckenmiller on Investing

Stanley Druckenmiller on Investing

 "My idea of risk control is a little non-conventional. I like putting all my eggs in one basket and then watching the basket very carefully. 

At most business schools they teach, I think, a lot of nonsense called risked-adjusted return and diversification. As a money manager, if you look at a normal portfolio most people will make 70-80% of their money that year on 2-3 ideas even though they will have 30-40 things in their portfolio. My concept was to put into those 2-3 ideas I have the most conviction in.

 I was also lucky to travel across asset classes so I traded commodities, currencies, bonds and equities. And it gave me the discipline if I didn’t have a good idea in equities, I was happy to have no equities or the same thing with bonds. So when you have a quiver with a bunch of arrows you can usually find something to put a lot of money into. 

The only other thing I’d say is that too many investors look at the present. The present is already in the price. You have to think out of the box and sort of visualize 18-24 months from now and what the world is going to be and what securities might trade at...What a company has been earning does not mean anything. What you have to look at is what people think it is going to earn and if you can see something (in) two years that is going to be entirely different than the conventional wisdom. That’s how you make money. My first boss used to say, “the obvious is obviously wrong.” If you invest in conventional wisdom you are going to lose your butt."

Five Qualities:

1) Self-Directed

2) Contrarian

3) Strategic and Focused

4) Disciplined

5) Identifies Opportunities through Forward-Thinking

The Advantages of Control Investing

The Advantages of Control Investing

I can’t help but feel that over the years Bruce Flatt’s investing philosophy has been largely influenced by his dealings with Third Avenue Management’s Marty Whitman. One of the cornerstones of Whitman’s approach to the markets is the importance of ‘control investing’. That is a major tenant of the thinking process that goes on behind Brookfield Asset Management’s investment philosophy.

Investing for control of a company gives the acquiring company an edge over their investing competitors by way of being able to finance transactions and processes on a highly attractive basis (the ability to use other people’s money for their own purposes). It also confers the ability to create advantageous tax situations (tax shelter).

In exploring investment opportunities in which control situations exist, security buyers frequently have the ability, the resources, and the time to conduct in depth due-diligence investigations, which can be far more comprehensive than would be possible relying solely on public records (a good example of wager value…exploiting little known information).

Control investing allows investors to obtain influence, control, or both over corporate processes, operations, and investments. One of the things this gives the control investor is opportunities to create value by changing the way assets are used or owned by recapitalizing businesses they hold an interest in.

Control investing allows investors to obtain control over the timing of investment tactics on a long-term basis so that they can decide when to take advantage of favourable market conditions. They could for example decide to consummate an IPO, or maybe take a company private, a massive refinancing of debt or a merger in which common stock is issued as all or part of the merger process.

Control investing allows investors to protect themselves by financing projects using the corporate treasury. It also allows them to exert their influence over other financial professionals (investment bankers, attorneys, accountants), by rewarding them or withholding those same rewards to gain advantageous treatment from the people dealing with the corporation.

Resources

Value Investing,

Marty Whitman

Marty Whitman on Investing

Marty Whitman on Investing

"We were young in our careers and watched very difficult markets in the late 1980s and early 1990s," he says. "That was quite impressionable on us to how we run the business today--never put yourself in a situation where you have to sell something in an environment where you should be buying."

Bruce Flatt, CEO of Brookfield Asset Management, taken from Forbes

The precepts of “safe and cheap” investing, of which Marty is no doubt the master therorist-practioner, sound deceptively simple. Insist on financial strength and honest management (Marty, no utopian, actually gives you some slack on this count: he stipulates “reasonably” honest management). Look for high-quality assets and non-burdensome liabilities. Seek out free cash flows from operations. Look for safety in the price you pay. Put not your trust in forecasts. Invest in what’s in front of you. Don’t shrink from investing in complex securities. Think twice or three times before selling. Strive to understand the financial data under which an investor is fairly buried these days – that is, what the numbers mean, not just what they say...

In looking at a transaction, the single most important question seems to be: What have I got to lose? Only when it seems that risks can be controlled or minimized does the second question come up: How much can I make?

Mr Market Miscalculates,

James Grant

Stock Idea…WPT Industrial Real Estate Investment Trust…WIR.U on the TSX

Stock Idea…WPT Industrial Real Estate Investment Trust…WIR.U on the TSX

Price: 13.31

Market Cap: 624.7 Million
Yield: 5.71
Investment Type: Small Cap Income

Company Profile

WPT Industrial Real Estate Investment Trust (the REIT) is an open-ended real estate investment trust. The REIT is engaged in the business of acquiring and owning industrial investment properties located in the United States. Its objective is to provide Unitholders with an opportunity to invest in a portfolio of institutional-quality industrial properties in the United States markets, with a particular focus on distribution industrial real estate. The United States industrial real estate sector consists primarily of single-story properties located in or near major cities. The REIT's portfolio is concentrated in the Midwestern and Southeastern regions of the United States. It owns a portfolio of investment properties consisting of approximately 15.1 million square feet of gross leasable area (GLA), consisting of over 50 industrial investment properties and approximately two office properties, located in over 10 states in the United States.

The Investment Case

WPT is an industrial REIT that is a great play on the growth of online shopping. A few of its largest tenants are Zulily, Amazon and General Mills. The stock presently yields 5.8 per cent and trades at a discount to both the Canadian and U.S. peers on a multiple of funds from operations. The occupancy rate is at 98 per cent and the same property growth posted in Q3 was 2.9 per cent. The company also recently renewed and expanded their agreement with Amazon, which bodes well for future visibility.

Peter Imhof

WPT owns and operates an institutional quality portfolio of industrial properties located in the U.S. We see good visibility on increasing rents, lease terms and occupancy providing earnings and dividend growth for WPT investors. Demand for advanced warehousing, logistics to meet e-commerce secular growth is still in early days. The REIT trades on the TSX in U.S. dollars and yields over 5 per cent yearly.

Robert Lauzon

Morningstar Profile

http://quote.morningstar.ca/quicktakes/Stock/s_ca.aspx?t=WIR.U&region=CAN&culture=en-CA

Company’s Website

http://investors.wptreit.com/CustomPage/Index?KeyGenPage=390997

Stock Idea…Plaza Retail REIT…PLZ.UN on the TSX

Stock Idea…Plaza Retail REIT…PLZ.UN on the TSX

Price: 4:05

Market Cap: 416.4 Million
Yield: 6.91
Investment Type: Small Cap Income

Company Profile

Plaza Retail REIT (Plaza) is a Canada-based open-ended real estate investment trust. The Company's objective is to deliver a growing yield to unitholders from a diversified portfolio of retail properties. The Company develops, owns and manages retail real estate primarily in Atlantic Canada, Quebec and Ontario. The Company offers a business strategy that differs from various peers in the real estate industry. The Company's portfolio includes interests in approximately 310 properties totaling over 7.1 million square feet, which are predominantly occupied by national tenants and additional lands held for development. These include properties indirectly held by Plaza through its subsidiaries and through joint arrangements. The Company's properties are located in Alberta, Newfoundland and Labrador, New Brunswick, Nova Scotia, Manitoba, Ontario, Prince Edward Island and Quebec. The Company's subsidiaries include Plaza Master Limited Partnership and Scott's Real Estate Limited Partnership.

The Investment Case

Plaza Corp is a strong internalized developer of retail properties with holdings in Quebec, Ontario and the Maritimes. It has tenants resistant to e-commerce, like Shoppers Drug Mart (25 per cent of gross leasable area), KFC, Dollarama, Sobeys and Canadian Tire.
It has a strong pipeline of 25 projects, including acquiring old Sears sites for redevelopment. Plaza Corp is the only REIT to consistently increase AFFO/share and increase dividend every year for 15 years. Retail real estate is out of favor, so it’s a good time to buy this undervalued stock. Insiders own 21 per cent and are buying shares (Michael Zakuta). We recently bought more at $3.30. Nice safe dividend yield of 6.5 per cent.

Stephen Takacsy

Morningstar Profile

http://quote.morningstar.ca/quicktakes/Stock/s_ca.aspx?t=PLZ.UN&region=CAN&culture=en-CA

Company’s Website

http://plaza.ca/