Donville Kent Asset Management newsletter for the month of July, 2016. Presented without comment although we wanted to highlight one specific paragraph which we found “cute”


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Donville Kent Capital Ideas Fund: Valeant Loss

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Donville Kent: Where Is The Growth?


The past twelve months have seen a major correction in growth stocks in Canada and throughout the world. As I write this newsletter, I sense that this correction is coming to an end and that new leadership in the stock market is beginning to emerge. With the unanticipated Brexit now behind us, markets appear to be settling down and record low interest rates make equities the most attractive asset class to own for most investors.

We believe that the global demographic slowdown is behind much of the social and political instability we face in the world. Growing dissatisfaction by voters in Europe, the UK, and the US is in part related to the fact that economic growth and therefore opportunities for better jobs and prospects are becoming scarcer. The outlook for demographic growth, and by this I mean growth of the employable part of the population in most advanced economies, is modest and likely to stay that way for a while. Thus, I suspect we will face a restless and dissatisfied world for some time to come.

Against this backdrop of modest growth, we are still finding high growth companies trading at attractive multiples. We are in a sense reloading the portfolio with companies for which we see the growth opportunities in the next cycle. This process started in Q2 and is continuing in Q3 as we take profits in some companies and establish or add to positions in growth stocks that we think can beat the market in the coming 5-7 years.

The first half of 2016 has seen a major correction in growth stocks and resurgence in materials and precious metals stocks. For example, Gold stocks were up on average by 94%1 in the first half of 2016 while technology stocks were down 6%2. During this time the S&P TSX Composite Total Return Index rose 9.84%3, while the Capital Ideas Fund was down 9.56%4 over the same time period. We expect better returns in the second half of the year.

Donville Kent – One winter’s day in Winnipeg

I started my career as an equity analyst in Singapore in 1992. At that time, SE Asia was in the midst of a major economic boom, and growth companies were easy to find. Most of the growth companies I encountered were focused on a rapidly growing population and/or rapidly growing incomes amongst a nascent middle class. Virtually all of these companies were growing organically and didn’t need to acquire other companies. In the early 1990s, most companies in SE Asia could grow quickly simply by increasing production, adding locations, or expanding in some other way into a rapidly growing market.

When I returned to Canada, I was able to get a job fairly quickly as an analyst, and the first company I initiated coverage on was a small engineering services company based in Edmonton. Stantec was founded by Dr. Don Stanley in 1954 and went public in 1994. At the time that I initiated coverage of Stantec, the company had revenues of roughly $212MM, and was largely unknown in the investment world given its small, $79MM market capitalisation. The company also had a new CEO, Tony Franceschini.

At the time that Franceschini took over, the company had 2000 employees. Franceschini’s vision was to grow the company 5 fold over the next decade. Shortly after I initiated coverage of Stantec, I had a chance to take Franceschini to Winnipeg to meet with institutional investors. It was a cold day in February, and when we finished our meetings and arrived back at the airport, we discovered that our flight was delayed for a few hours. For me this was a positive development as it gave me a chance to ask Franceschini a couple of relatively simple but important questions. Here is my recollection of the salient parts of our discussion:

Q. Stantec is growing by acquisition, acquiring engineering and consulting firms consisting of 50-250 professionals. Why not just hire 50-250 engineers from engineering schools and the marketplace?

A. Engineering firms have sticky client relationships. While recurring revenue is not guaranteed, if the prices a firm charge for its services are fair and the quality of the work is high, a significant amount of repeat business comes to the firm. A group of engineers that we could potentially hire have tremendous skills, but they don’t have the entrenched client relationships that drive the profitability of our industry.

Q. But the companies you acquire are not free. You are paying a premium compared to what it would cost to simply hire more engineers. Is it worth it?

A. That’s a good question. We employ over 2,000 professionals at the moment and we have asked some of the smartest people in the company to analyse this very issue. What we have discovered is that if we can acquire other professional engineering companies at a low multiple of EBITDA, a start-up is unlikely to be anywhere near as attractive from a return on capital perspective both in the short term and long run. In making these calculations, the valuation discipline we employ is critical. We often meet with a firm that is potentially for sale, and they initially balk at our price. But many return to the table and accept our price for reasons ranging from a lack of other options to their desire to sell to a firm that cares about culture and quality.

Q. Are there other benefits from growing by acquisition rather than growing organically?

A. Yes. We now have unique engineering expertise all over the world and our management systems are geared to cross-selling those skills in markets in which we have recently acquired a company. The fact that we sell these services through existing relationships is critical. This is hard to quantify, but I can list many examples in the past year where we won major contracts and the recently acquired firm, which didn’t possess the skill set at the time of acquisition, nonetheless played a critical role in helping Stantec get into the competition and in many cases win the contract.

A few years after I initiated coverage of Stantec, I became a financial services analyst and therefore didn’t maintain coverage of the stock. But Stantec continues to execute its strategy and is now one of the largest engineering services companies in the world. Gross revenues are now approaching $3.0BN and the total number of employees stands at more than 22,000. From a shareholder perspective, the story is equally impressive. At the end of 1999, the stock was trading at $1.39 and today it trades at $33.62. Including dividends, Stantec has delivered a compounded annual growth rate of 23% over the past 16 years. Amazing!

Donville Kent

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