Donville Kent Capital Ideas Fund letter for the month ended April 30, 2016. No Mention of Valeant at all in any form – interesting….
Donville Kent – Animal spirits
Markets around the world, including in Canada, continue to wrestle with a variety of issues ranging from the direction of interest rates to the outcome of US elections. Meanwhile, away from the stock market, companies continue to sell products and services and to invest and prosper. The Canadian market has been in correction mode since the third quarter of 2014 and pessimists continue to argue in favour of the risks instead of the opportunities. What is an investor to do?
In the short term, markets and companies rarely move in step with their earnings. During corrections, share prices often fall, even when earnings are rising. Eventually share prices catch up and then go through a phase of out-performing earnings. This process is often referred to as multiple expansion and contraction.
The focus of investors should be to own stakes in companies that can earn a strong return on their equity base in good economic times and bad. Companies like this are sometimes referred to as compounders. That is, they are able to achieve high levels of compound earnings growth over many years, and this compounding effect is almost always rewarded with share price performance in line with the compound growth rate of earnings.
In the first quarter of 2016, the Donville Kent Capital Ideas Fund was down 9.3% compared to the S&P/TSX Total Return Index, which was up 4.3%. This is obviously not a good set of numbers but with the key growth sectors, namely health care and technology, now having corrected sharply, I expect better returns as the year unfolds.
Given the correction we have seen in growth stocks over the past nine to ten months, we might ask “Why bother?” Our fundamental investment thesis is that stocks that can consistently earn a high return on equity (ROE) over multiple periods of time are the ones investors should hold for the long run. Looking on both sides of the border, we estimate the long-run ROE for the US market to be approximately 13%, whereas the Canadian market’s ROE, given its emphasis on natural resources, is probably closer to 9%.
Moving beyond the broad market, it is important to note that growth is not ubiquitous. The health care industry remains the highest growth sector in terms of ROE in North America. If we use the US health care ETF (IYH) as a proxy for the health care sector, we estimate its ROE to be close to 26%. The technology sector, weighted on the basis of its market cap, is also a high growth sector, with an estimated ROE of close to 20%. Thus, for long-term investors in search of compounders, the healthcare and technology sectors are important places to look for high ROE companies that can, over time, significantly outperform the market.
To illustrate this point, Figure 1 shows the performance of the US health care ETF relative to the S&P/TSX composite over the last 5 years. There are a couple of key points to note in this figure. First, while the health care ETF has undergone a major correction over the last 10 months, it is still up 103% over the last 5 years. On the other hand, the S&P/TSX is down over the same time frame.
A similar point can be made with respect to the technology sector. In Figure 2 we compare the S&P/TSX composite with the Canadian Software and Services Index, a reasonable proxy for the Canadian technology sector. Once again, we estimate that the largest software companies in Canada have an ROE that is more than double that of the broader market. Thus, as we see in Figure 2, a dollar invested in the Canadian technology sector 5 years ago is now worth $2.85, whereas a dollar invested in the TSX composite is now worth slightly less than a dollar.
So why are the health care and technology sectors doing so much better than the broader economy? The strong performance of these two sectors is driven by two factors. First, with little demographic growth in the world, economic growth increasingly must come from “New Things”. This means new drugs, new gadgets, and new technologies: stuff that we don’t already own or use. Leon’s Furniture, which is an exceptionally well-managed furniture company, will not sell significantly more sofas or dinette sets next year because the Canadian population is not growing quickly. But a new drug or gadget that didn’t exist a year ago has the potential to achieve a high level of sales growth as consumers sample and then adopt this new product or service.
The other growth advantage that health care and technology companies enjoy are patents, which ultimately provide profit margin protection. In a world of slow growth, price competition is intense, and the only companies that can enjoy high margins and therefore high ROE’s are those that have built some kind of moat around them. The health care and technology sectors are underpinned by companies that sell products and services that are protected. This allows such companies to earn high ROE’s not just today, but into the foreseeable future.
In search of compounders
When we talk about compounders, we are typically talking about companies that can earn a ROE that is consistently higher than its cost of equity. This is the underlying premise of Economic Valued Added (EVA) analysis. Companies that achieve returns on equity greater than their cost of equity are adding value for the investor, and this is reflected in steadily rising share prices.
Of course, why some companies achieve high ROE’s is important to understanding their value. Using DuPont analysis, we note that companies can achieve high ROE’s through 1) leverage 2) asset turnover and 3) margins. Typically, we want to invest in companies that earn their high ROE’s from items 2 and 3. We also want to invest in companies that are not one-hit wonders, i.e., a high ROE one year and a low or negative ROE in the following year.
As we scan through the Canadian universe, we see a small number of elite companies (Figure 3) that have a very good (but not perfect) track record of delivering consistently high ROE’s. This list is not exhaustive, but we think it represents a list of companies that earn consistently high ROE’s through the entirety of the economic cycle. It should be noted, however, that most of these companies are fairly well known to Canadian investors, and as such their valuations are in some cases rich. That said, there are also always a few compounders that for one reason or another are out of favour, and these should be the focus of the astute long-term investor. Our goal when looking for compounders is to look for those companies that don’t already have their “greatness” reflected in their value.
Besides compounders, there exists another group of companies that are worth investing in. These are “emerging compounders.” These are companies that do not yet have the track record that the companies in Figure 3 possess but that are showing signs that they could become Canada’s next great company. Most are relatively new companies or newly-listed companies, but in other cases they are more mature companies that have adjusted their capital structure in order to become more capitally efficient. The key reason one should focus on emerging compounders is valuation. If we compare Figure 3 with Figure 4, we see that the key difference is that the “emerging compounders” trade at a significant valuation discount compared to the “compounders.”
Figure 3 and Figure 4 identify 28 Canadian stocks that investors can use to build a well-diversified portfolio. We are not so naïve as to suggest that the cheapest stocks in Figures 3 and 4 are not without their issues. Some are carrying too much debt (Concordia), some are perceived as ex-growth (Supremex) and others are presumed to face certain macro risks (the housing market and Home Capital). That said the prescient investor must be prepared to roll up her sleeves to determine if the risks with the more cheaply priced stocks are fully priced in. If not, keep moving up the list to find those compounders that are reasonably priced but don’t have major risk issues. We think companies like CGI Group, MTY Food Group, Open Text, CRH Medical, and Cara Operations represent very good risk/reward trade-offs.
How we think at a company specific level
The preceding analysis gives a good overview of how we think and the kinds of companies we invest in. For investors who are interested in seeing more granularity to our process, in Appendix 1 we present our analysis of MTY Food Group, a company we own in the portfolio and one which we think offers an excellent risk/reward trade-off. The MTY analysis was prepared by Jesse Gamble.
Growth stocks have had a major correction over the past year, but their ROE’s have not fallen. With so much value being created at the company level, it’s only a matter of time before this fact is reflected in share prices. Our first quarter results were disappointing, but April is going well. I expect the remainder of the year will show better returns.
Once again, many thanks to my hardworking and honest team. Working with people this fine is one of the great joys of my life.
Write me if you want to chat – J.P. Donville