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”
— ValueWalk (@valuewalk) July 26, 2016
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!
From time to time, a few companies that are growing by acquisition blow up in a very public way, leading some pundits to argue that any company that grows through acquisition is somehow less attractive than a company that derives most or all of its growth from organic sources. What these pundits fail to see is that all companies can falter if they make poor capital allocation decisions, which can be broadly stated as 1) they acquire bad businesses and assets, 2) they pay too much or 3) they use too much leverage. The pundits argue that the growth-by- acquisition model is simply a bad model, whereas I argue that any company that allocates its capital poorly and/or uses too much debt will find itself in the dog house, regardless of whether or not it is an organic grower or a growth-by-acquisition company. In fact, I would argue that in some industries, growth-by-acquisition is in fact the superior model.
Consider the fast food business. Let’s say one owns a Tim Hortons location in downtown Toronto and that one has owned it for a decade. There are line-ups every morning for coffee, and the profit margins on coffee are very large. But it’s been that way for a decade, so organic growth is limited. The owner of that Tim Hortons can double or even triple her expenditures on advertising but she is unlikely to get an increase in organic growth that justifies the increase in advertising. The smart thing is NOT to allocate capital to advertising. She owns a cash cow, and the smartest allocation of capital she can undertake is almost certainly to open another location.
But let’s assume that there are no “new” locations available in Toronto. However, there are several other Tim Hortons owners in the area who are ready to retire, and might be willing to sell. She can do the math on their cash flows and make an offer to acquire these locations at a price that she can justify in terms of her cost of funds, hurdle rate, etc. Opening a new location in downtown Toronto is not an option, but acquiring existing stores might be the most intelligent way for her to grow her business. As she moves from one store to two, or ten or a hundred, then the attractiveness of this acquisition strategy might be significantly better than might appear to the casual observer given the possibility of synergistic benefits that come with scale.
The gas station industry has a similar dynamic. Let’s assume you own 30 gas stations in Toronto. All 30 stations are very profitable and traffic flow is strong but not growing appreciably. However, getting a permit to build a new station in Toronto is nearly impossible. Increasing revenues by adding food, coffee, etc. has already been done. Like the Tim Hortons example, increasing revenues through advertising yields poor results. Thus, as the owner of the 30 stations, you have a veritable cash cow, but the only way to grow is either to start “greenfield” stations outside of Toronto or to buy out other station owners in your area of operations. Once again, as the owner of the 30 stations, you can work the numbers and decide at what price it makes sense to acquire versus at what price it makes sense to expand in the hinterlands. As your chain of gas stations expands, synergies probably exist that make the economics of buying existing stations even more attractive than might appear to the owner of a single location.
IT services and software companies appear to have a dynamic that is similar to that of Stantec. Companies like Donville Kent use software and IT services in our day-to-day operations, and the use of these companies’ software and services is now quite entrenched in our firm. Everyone at Donville Kent is used to using the suite of software and IT services that is in place. The hassle of changing either software or IT services companies is significant (or at least perceived to be). Economists sometimes refer to this issue as “barriers to exit.” The incentives to try a different product are low because the costs of changing over are perceived to be high.
Many software and IT services companies are viewed as attractive investments because a significant part of their revenues are recurring or “nearly” recurring. The clients are sticky in large part because the barriers to exit are high or perceived to be high. But the strength of the recurring revenue model cuts both ways. A software company with sticky client relationships competes with other software companies that also have sticky client relationships. One can only spend so much on advertising and promotion to lure away customers, because most of the potential targets will ignore this message. They can’t be bothered with the hassles (real or perceived) with changing software companies. Thus, for many software and IT services companies, the best option for growth is to buy companies that are for sale as a means of acquiring new client relationships.
Companies in the fast food, gas station and software industries will continue to grow extremely effectively through acquisitions. However, this model, like any type of model, must be underpinned by intelligent capital allocation decisions. In Appendix 1, we provide a write-up on CRH Medical, a company that is growing primarily by acquisition. The report was prepared by Callum Scott, a summer intern from the University of Guelph, under the supervision of the DKAM team. Other companies we own that are growing by acquisition and are making consistently good choices with respect to the allocation of capital include TIO Networks, Biosyent, Spin Master, Constellation Software, Boyd, CGI, Open Text, Alimentation Couche-Tard, Enercare, and MTY Food Group.
Focus on superb capital allocators
A lack of demographic growth has led to slower economic growth throughout the world. Thus, finding growth companies is becoming challenging but not impossible. But don’t be discouraged. My feeling is that the big winners in the coming decade are going to come from 1) companies that invent, make, or sell “new things” that nobody owns yet. Such companies typically operate in knowledge-based industries and, 2) companies that are superb capital allocators. My goal is to find the next Stantec, Paladin Labs, or Constellation Software. Some of the companies, like Dollarama and Home Capital, will be companies that grow primarily through organic means. But I sense that the majority of the companies we invest in will be companies in which a significant amount of their growth will come from acquisitions. Regardless of which types of companies we own, all will be superb capital allocators.
After beating the market for eight years in a row, we find ourselves trailing the market at mid-year by a significant margin for the first time since we started in 2008. However, we feel we have repositioned the portfolio intelligently and Q3 is off to a good start. Keep your fingers crossed. I am optimistic for the balance of the year.
Once again, much thanks to my wonderful team – Jordan, Ali, Jesse, Chris, Dominika, James, and Callum – and for the ongoing support of our loyal investors.
Write me if you want to chat – J.P. Donville
See full PDF below.