Value Investing

Trapeze Asset Management 1Q17 Letter – Equilibrium

Trapeze Asset Management letter fors the first quarter ended March 31, 2017 titled, “Equilibrium.”

The study of economics tells us that supply and demand dictate pricing. When there are no excesses or deficits, such that a market is in balance, it is said to be in a state of equilibrium.
As investment managers, it’s our job to find areas of disequilibrium. Imbalances or disconnects that have created opportunities to buy or short until normalization occurs. Typically, as they teach us in business school, prices adjust until supply and demand are altered enough to reassert a supply/demand balance—equilibrium.

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Trapeze Asset Management

Almost all assets can be viewed through this simple lens. For example, take a recent hot topic, housing prices in the city of Toronto. Having risen by over 30% in the last 12 months, some are referring to it as a bubble. While this rate of ascent is clearly not sustainable, house prices over time tending to track the growth of personal income, prices have adjusted upwards to get the market closer to equilibrium. Toronto’s supply of housing has been too low, inventory at historically low levels from limited listings and too few new builds—attributable to a number of factors, including available land and zoning issues. And demand has been ever-growing, from general prosperity, low interest rates, and substantial immigration. Demographics also play a role—supply is lower because fewer are at an age that they’re looking to move while there’s a bulge of new buyers.

This phenomenon is not limited to Toronto. In Vancouver, they’ve had a robust market too, with foreign buyers as a driving source of demand. All around North America housing prices continue to recover nicely from the depths of the last recession. Low supply—inventories are at a multi-year low contrasted with the record highs set in '07—and continued economic growth, which propels demand, should continue to keep house prices high. Of course, that’s until the next recession when demand will shrink, and supplies ought to inevitably catch up, such that house prices will at best flatline and, in areas of accelerated growth like Toronto, we could see substantial declines. Interestingly, listings in Toronto just surged by a record 36%—here comes the supply.

Trapeze Asset Management - Buoyant Economies

When excesses occur in the economy—demand running well ahead of supply, central banks step in to rein in growth by raising interest rates and lowering the monetary aggregates. At economic troughs, when supply overhangs abound, governments act to stimulate demand. Without intervention, the economy would adjust on its own, though perhaps after greater extremes in magnitude and duration.

The current economic cycle has been elongated. With few excesses, the anemic growth and muted inflation have caused intervention to be that of continuous stimulation. Only in the last several months has the Fed begun to tighten, and more to ensure they don’t over-stimulate. And with zero interest rate policies, some foreign countries continue to be highly stimulative. The near-term prospect of a global recession remains highly unlikely. Our Economic Composite (TEC™), designed to alert us to recessions in various regions around the world, is suggesting the same. Though there have been a few signs of a slowdown—loan growth at U.S. regional banks slipped into negative territory in Q1, GDP growth was a mere 0.7% and, consumer spending has been relatively weak.

Interest rates around the world remain low. 10-year rates in the U.K., Germany and Japan are 1.1%, 0.4% and 0.04% respectively, so rates in the U.S. aren’t likely to jump materially. In fact, there’s an argument to be made that they can’t, given the extreme debt levels and the additional burden higher rates would cause.

U.S. economic growth continues, albeit at a relatively low rate, with unemployment, now at 4.4%, near full employment, without causing wage pressures. Canadian unemployment is down to 6.5%, below its 10-year pre-recession level. Lower corporate income tax rates, if Trump is capable of getting that through, should fuel U.S. growth too and boost profits—much of which is not discounted in stock prices, in our view, because Trump has been ineffective thus far or because of the longer-term negative impact of lower tax receipts (when they’ve already flatlined) on the deficits.

China’s growth had an uptick recently, though it has been obfuscated by the government’s steps to address the overzealousness in the shadow banking system. And Europe’s expected growth has picked up too, moving up to 1.7% for this year, and slightly higher for '18, with the European Union seeing risks as being more balanced.

Market Balance

The supply/demand equation for common shares remains favourable. Partially from demand for the scarce alternatives, with interest rates still so low. Perhaps if the speculators in the condo market get scared off there’ll be additional buyers entering the stock market. Corporations have been buying back their own shares at a record pace—a boost in demand and an equivalent drop in supply of shares outstanding. With the ongoing M&A activity, the buyouts have shrunk the number of actual issuers trading to a point where the number of hedge funds and ETFs greatly outstrips the amount of actual traded stocks. Even governments have gotten into the game, the Swiss and Japanese buying billions worth of the largest companies in America. The acceleration in passive investing has pushed up demand too, especially in the mega caps.

With share prices having risen, we expect buybacks to slacken and new issues to increase. Interest rates will ultimately rise enough to bring back some demand for fixed income investments too. That, and because the markets are trading above fair value (already in equilibrium) with weaker than normal earnings growth, we’d expect longer-term returns from the indexes to be below-average.

Though U.S. equities remain near all-time highs and somewhat above fair value in our work, absent a recession, we don’t anticipate a bear market. One would also expect to see euphoric sentiment—demand running wild—which isn’t really evident, prior to the next major top. Stock markets peak when there’s over-exuberance at a time when economic growth is about to be quelled. And, our TRIM™ stock market indicators are on buy in most regions providing confidence of an extended bull market. Earnings growth, the fuel for rising markets, continues too. With almost all S&P 500 companies having now reported Q1 results, nearly 80% beat profit expectations.

That said, since the market is somewhat ahead of itself, we wouldn’t be surprised to see a normal market correction—averaging about 6% in a bull market. Stocks do tend to inflect down from TRAC™ ceilings/FMVs (fair market values) once achieved, when they run out of short-term potential, as they appear to have now. A handful of some ultra-large cap bellwethers have been driving the market, such as Apple, Johnson & Johnson, Google, Procter & Gamble and Microsoft, all of which are fully valued, at best, and now at TRAC™ ceilings. We’d welcome a healthy correction in order to find more opportunities for us to get more fully invested. Our search for stocks trading for 85 cents-on-the-dollar or less is ongoing but providing few new potential investment opportunities.

One possibility, though unlikely, is that demand for shares begins to far outstrip supply, potentially leading to meaningful overvaluation. With the prospect of minimal returns from ultra-low interest rates and now rising rates bringing capital losses, there’s been a further migration away from fixed income. The Swiss National Bank grew its global equities by over 40% in 2016 to own over $500 billion worth of equities—one of the top investors globally, for a country with a population of around 8 million. And, artificially low interest rates can create bubbles—an overshooting in prices from exuberant demand—not only in the fixed income markets, but in other areas too, like today for the art market, antique cars, comic books and baseball cards.

Instant Supply

On the other hand, what could cause shares to suddenly flood the market creating at least a short-term imbalance? Geopolitical issues—in North Korea, the Middle East, Russia, the South China Sea, and/or Europe could all wreak temporary havoc. We wouldn’t be surprised by problems closer to home, say, from a meaningful scandal for the Trump administration. Another issue could stem from debt levels. While the government debts remain out of whack, they likely will only be an issue in the next recession or thereafter, as the debt burden magnifies the normal cyclical patterns. However, today’s levels of sub-prime auto loans, student loans and credit card delinquencies have all shown up as potential problems recently with unnerving escalations in the loan data.

We are attempting to avoid positions that would be unduly impacted by those issues. While we gravitate to unpopular stocks, those that are ignored or misunderstood and therefore mispriced, we try to steer away from those which are vulnerable to sudden erosion in value.

Abundance vs. Scarcity

Gluts beget scarcities and vice versa as cycles follow patterns. Oversupply brings low prices—undersupply, high prices. Think abundance versus scarcity. This is no more apparent than in the commodity markets, especially those where supply adjustments are fast and furious. In the uranium market, where producers lock in long-term contracts with utilities, adjustments to bring balance take quite some time because low spot (current) prices, that would normally act to curtail production, allowing prices to rise, are ineffectual with producers’ profits somewhat maintained from locked-in contracts. So the spot price remains below the cost of production. In other commodity markets, like iron ore, adjustments tend to occur more briskly; hence the wild swing in prices, especially given the cyclical nature of the end users.too. With almost all S&P 500 companies having now reported Q1 results, nearly 80% beat profit expectations.

That said, since the market is somewhat ahead of itself, we wouldn’t be surprised to see a normal market correction—averaging about 6% in a bull market. Stocks do tend to inflect down from TRAC™ ceilings/FMVs (fair market values) once achieved, when they run out of short-term potential, as they appear to have now. A handful of some ultra-large cap bellwethers have been driving the market, such as Apple, Johnson & Johnson, Google, Procter & Gamble and Microsoft, all of which are fully valued, at best, and now at TRAC™ ceilings. We’d welcome a healthy correction in order to find more opportunities for us to get more fully invested. Our search for stocks trading for 85 cents-on-the-dollar or less is ongoing but providing few new potential investment opportunities.

One possibility, though unlikely, is that demand for shares begins to far outstrip supply, potentially leading to meaningful overvaluation. With the prospect of minimal returns from ultra-low interest rates and now rising rates bringing capital losses, there’s been a further migration away from fixed income. The Swiss National Bank grew its global equities by over 40% in 2016 to own over $500 billion worth of equities—one of the top investors globally, for a country with a population of around 8 million. And, artificially low interest rates can create bubbles—an overshooting in prices from exuberant demand—not only in the fixed income markets, but in other areas too, like today for the art market, antique cars, comic books and baseball cards.

Instant Supply

On the other hand, what could cause shares to suddenly flood the market creating at least a short-term imbalance? Geopolitical issues—in North Korea, the Middle East, Russia, the South China Sea, and/or Europe could all wreak temporary havoc. We wouldn’t be surprised by problems closer to home, say, from a meaningful scandal for the Trump administration. Another issue could stem from debt levels. While the government debts remain out of whack, they likely will only be an issue in the next recession or thereafter, as the debt burden magnifies the normal cyclical patterns. However, today’s levels of sub-prime auto loans, student loans and credit card delinquencies have all shown up as potential problems recently with unnerving escalations in the loan data.

We are attempting to avoid positions that would be unduly impacted by those issues. While we gravitate to unpopular stocks, those that are ignored or misunderstood and therefore mispriced, we try to steer away from those which are vulnerable to sudden erosion in value.

Abundance vs. Scarcity

Gluts beget scarcities and vice versa as cycles follow patterns. Oversupply brings low prices—undersupply, high prices. Think abundance versus scarcity. This is no more apparent than in the commodity markets, especially those where supply adjustments are fast and furious. In the uranium market, where producers lock in long-term contracts with utilities, adjustments to bring balance take quite some time because low spot (current) prices, that would normally act to curtail production, allowing prices to rise, are ineffectual with producers’ profits somewhat maintained from locked-in contracts. So the spot price remains below the cost of production. In other commodity markets, like iron ore, adjustments tend to occur more briskly; hence the wild swing in prices, especially given the cyclical nature of the end users.

Two commodity sectors we favour today are precious metals and oil & gas. In both cases, the spot price is just above the cost of production for the average producer. With oil, since the U.S. shale boom led to historically high U.S. inventories, that supply overhang has had to be worked off before prices could rise back to normal—where prices trade at roughly 30-40% premiums to the industry’s average all-in production costs. Since last August, U.S. inventories have drawn down in every month but January, including some months where there’s almost always a seasonal build, diminishing the inventory oversupply and by the end of this year a deficit in the supply/demand situation should be clearly evident.

Gold is in a similar situation. With a poor supply outlook and healthy jewelry demand as well as demand from Central Banks and speculators likely to remain high, gold prices should rise too. The typical premium to gold’s all-in costs should return soon too. With negative real rates that also bodes well for gold and commodities in general.

After falling back to floors in our TRACTM work, the price of gold and oil have inflected back up, giving us buy signals. Both commodities appear to be in bull markets again.

Our Strategy

With the market essentially in balance, bargains, particularly in the large cap arena, have become scarcer.

We have purchased a few holdings recently where we have found them at a wide enough discount from our estimate of their FMV, with favourable earnings outlooks, once they have passed our due diligence process. Our objective is to continue to add more large cap positions to our All Cap portfolios as we find compelling ideas and as our current smaller cap positions are sold when they rise close to our FMVs.

Our preference is to be fully invested in order to reap the potential rewards from our holdings. However, if we cannot find appropriate investments then we do not hesitate to hold cash until opportunities present themselves. Volatility, especially in individual stocks, will not disappear so we should rarely have to wait too long before companies we are interested in investing in meet our criteria.

The Canadian dollar has been weak. Low commodity prices and an unfavourable 2-year interest rate differential, where U.S. bonds remain preferable to Canadas, could continue to push the CAD exchange rate lower. Our holdings in stocks from outside of Canada have increased which should benefit from a lower CAD. In our taxable margin accounts for Canadian dollar reporting clients, we have carried debits—a small debit in USD in case the CAD rebounds. If the CAD were to fall below $0.70, we would likely become more fully hedged so a CAD rebound back to its fair value (purchasing power parity) of around $0.82 would cause less impact on our non-Canadian holdings. For taxable margin accounts of U.S. reporting clients, we have been mostly hedged with a CAD debit against Canadian dollar denominated holdings. If the CAD were to fall below $0.70, we would likely eliminate the hedge to benefit from any CAD rebound back to its purchasing power parity.

Our Portfolios

The following descriptions of the significant holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described.

Our All Cap Portfolios – Key Holdings

Our All Cap portfolios combine selections from our large cap strategy (Global Insight) with our best small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. Importantly, they tend to recover back to their fair values much faster than smaller stocks, so they can be traded more frequently for enhanced returns. However, our small cap positions are cheaper, trading far below our fair value estimates; therefore, our All Cap portfolios currently hold a meaningful position in small caps.

Most of our small cap company holdings trade well below our estimate of their respective FMVs. Although these smaller, less liquid holdings are potentially more volatile, the risk of permanent impairment appears minimal while upside potential remains high. We elaborate on these key holdings below.

Orca Exploration’s share price is still completely disconnected from its underlying value. After another year of reasonable production volumes, the company was still able to maintain its significant reserves. Orca’s estimated reserves are valued at over $11 per share, and with the combined value of its receivables and cash balances, net of payables and debt, the overall value is about 4 times the share price.

While Tanzania’s outlook has improved, and the company is positioned to resume growing, Orca needs new contract signings and a production lift to generate interest in its shares. Orca’s production capability exceeds 185 mmcf/d. The country’s demand for natural gas is high and Orca provides nearly all of the natural gas to the country. New power plants are expected to come online, powered by natural gas, which will require long-term contracts with Orca. However, the government, even with prodding from the World Bank, has been slow to foster progress. Though we see little downside because the company trades in line with its net cash and receivables, until there’s visible growth, or at least the perception that the resumption of growth is ahead, the share price is likely to languish. Although, we continue to believe its dominant position in the country could allow the company to monetize assets especially since government issues appear to have stabilized. Given the substantial disconnect from our FMV, we continue to believe that our patience will be rewarded.

Specialty Foods Group, a shareholding in a private company held in our taxable accounts, finally distributed US$55 million (of its more than $60 million) of cash as the company began to implement its wind-down plan. We expect the company to place its remaining business up for sale shortly. Once sold, hopefully by later this year, another return of capital should follow, though the timing and amounts of these payouts still remain uncertain. We still anticipate further potential upside from our carrying value, mostly dependent on the sale value of the remaining business which continues to grow its profitability.

ProShares Short S&P 500 is about a 6% weighting in most 100% Growth mandate accounts. This is a long position in an ETF which mirrors the inverse performance of the S&P 500 (i.e., if the market declines the value of this position increases) on a daily basis. With the market at record highs, in line with its FMV and at a ceiling in our TRAC™ work, it remains a simple way of hedging a correction in the U.S. market. Though, in our view, we remain in a bull market; therefore, we would look to eliminate this position in the next correction. We prefer to only short when our macro tools suggest overall market risks are elevated.

Kirkland Lake Gold has recently raised production and profit guidance. Grades at its principal mines in Canada and Australia have been excellent and costs lower too. The company now expects to produce 530,000-570,000 ounces this year and remains a standout because of its operations in favourable jurisdictions (Canada and Australia), strong balance sheet with over $200 million net cash, low all-in costs below US$900/oz., enormous land packages, high grades and a below peer-group valuation. Kirkland should deliver free cash flow of over $180 million this year. The share price has been somewhat volatile as the industry suffered a sell-off when bullion corrected and rumours about the GDX Junior index rebalance, precipitated by too much demand. It might mean a few million shares may need to be sold into the market by mid June. Meanwhile, drilling results have been superb, and a higher gold price, which we expect, along with continued solid quarterly reports, should help elevate the share price back to, or above, our $12 per share FMV estimate.

Manitok, much like Orca, remains at an unusually high discount versus our estimated FMV. We believe the share price has been restrained by lingering concerns about the company’s debt since its lending bank requested partial repayment to reduce the bank’s overall energy exposure in 2015. The lack of any material news and production growth has not helped either. Meanwhile, drilling results have been much higher than the type curve and costs have been lowered too which should allow the already high IRRs on new wells to shine through.

The company’s 2P reserves recently showed a jump of 60% versus the prior year. Its long reserve life and over 300 drilling locations should be enviable. Manitok’s proved reserve value is $110 million (net of all debt) or $0.42 per fully diluted share, over 3x the share price. The proved and probable reserves are estimated at over $200 million or $0.75 per share, over 6x the share price.

Our top holdings in our All Cap portfolios also include large caps CBRE Group, Hanesbrands, Naspers, Goldcorp and Berkshire Hathaway which are discussed below in our Global Insight portfolio review.

Our All Cap Portfolios – Portfolio Changes

In the last few months, we bought a few new large cap positions including CBRE, Baidu, and Dick’s Sporting Goods—all summarized in our Global Insight portfolio review below. We sold Dollar Tree, Husky Energy, Magna International and American Eagle Outfitters as each triggered sell signals falling below their respective TRAC™ floors and Pulte Homes, Eastman Chemical, Apple, Disney and Facebook as each ran up to a TRAC™ ceiling, close to our FMV estimate. We bought but are reevaluating New York REIT after it fell in response to issuing a disappointing NAV estimate which was below our expectations. The following are mid-cap companies we have recently purchased:

IAMGOLD is a mid-tier gold company with 800,000 ounces of production from mines in Burkina Faso, Suriname and Mali. We found the company appealing because of its organic growth initiatives and potential for significant margin expansion from lowering costs. Its own projects and its net cash position should both contribute to future growth initiatives. We purchased the shares at a reasonable discount to our $6.50 estimate of its FMV, which excludes the prospect of a higher gold price.

KBR Engineering is a defense company which continues to make progress on its transformation into a leading provider of critical support services to governmental agencies worldwide. Its Q1 revenue rose 11% despite an 8% headwind from foreign exchange and delayed profit due to a change in estimate on a large LNG project. Net debt is negligible which gives KBR the flexibility to pursue bolt-on acquisitions to accelerate its transformation. At the end of April, shares declined nearly 10% after the U.K. Serious Fraud Office confirmed that it opened an investigation into KBR’s U.K. subsidiaries as part of its ongoing investigation into Unaoil. This far reaching investigation has touched nearly every major global energy construction services provider. We feel the share price decline to be an overreaction considering KBR’s strong internal protocols and do not feel it will jeopardize its other businesses in any way. Meanwhile, shares trade at roughly a 10% free-cash-flow yield and at a substantial discount to our $20 FMV.

Global Insight (Large Cap) Portfolios – Key Holdings

Global Insight represents our large cap (typically with market caps over $5 billion at the time of purchase but may include those in the $2-5 billion range) model where portfolios are managed Long/Short or Long only. A complete description of the Global Insight Model is available on our website. Our target for our large cap positions is more than a 20% return per year over a 2-year period, though many may rise toward our FMV estimates sooner should the market react to more quickly narrow their undervaluations. Or some may be eliminated if they decline and breach TRAC™ floors.

At about 80 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear to be cheaper, in aggregate, than the overall market. Because of the run-up in stocks, and the fact the overall markets are fairly valued, we are finding fewer investment opportunities and therefore are holding much more cash than usual. ProShares Short S&P 500, given our negative near-term outlook, is about a 7% weighting in most 100% Global Insight accounts. This is a long position in an ETF which mirrors the inverse performance of the S&P 500 (i.e., if the market declines the value of this position increases) on a daily basis. With the market at record highs, in line with its FMV and at a ceiling in our TRAC™ work, it remains a simple way of hedging a correction in the U.S. market. Though, in our view, we remain in a bull market; therefore, we would look to eliminate this position in the next correction. We prefer to only short when our macro tools suggest overall market risks are elevated.

CBRE Group is the world’s largest and leading one-stop shop commercial real estate services firm with competitive advantages derived from scale, switching costs, reputation, and a great culture. The company operates in a highly-fragmented industry and has been accreting market share for decades which has led to increasingly larger cash flow streams that are redeployed into widening their moat. A potential commercial real estate slowdown has unnerved investors even though the firm has transitioned to a largely counter-cyclical and recurring revenue model over the last few years, presenting an attractive opportunity since our FMV estimate is $50.

Hanesbrands, an apparel manufacturer and marketer of brands such as Hanes, Champion, Maidenform and Playtex, has gone into a holding pattern as the market awaits clarity regarding the Trump administration’s tax reform plans that could include import duties and/or tariffs on goods manufactured outside of the U.S. We do not believe taxes on imported textiles will materialize as it would raise the cost of clothing considerably for the average American consumer. We were encouraged that Hanesbrands reiterated its full year guidance on its Q1 call given the headwinds facing its key customers. Through a new cost-cutting initiative, dubbed Project Booster, the company aims to achieve $150 million of annual cost savings, accelerating its plan to hit $1 billion in annual free cash flow. Our FMV estimate is $28.

Naspers, listed in Johannesburg, is the largest company in Africa. It derives most of its value from its holdings in Tencent—one of China’s leading internet companies. Tencent is a broadly based social networking platform with over 800 million users and a 50% market share in China’s online games market. WeChat, its primary brand, is ubiquitous in China and used not just for corresponding but for mobile payments too. Growth has been rapid with Tencent’s revenue up by 55% in its latest quarter. When we purchased the position, Tencent was trading at a reasonable discount to our FMV estimate. Naspers, which owns just over one-third of Tencent, traded at a more substantial 30% discount to our Naspers’ FMV estimate when we include its cable and internet based investments and accounted for full capital gains taxes on its Tencent holdings. Given Tencent’s recent rise and Naspers comparable run up, both are trading closer to our estimate of their FMVs, though Naspers could still rise more if it narrows the gap to our FMV estimate.

Berkshire Hathaway has set back recently, perhaps as a result of the impact on its earnings from Australian weather related losses on its insurance business. Though, the company keeps growing its overall value. Berkshire’s substantial cash hoard will likely get put to work in the next several quarters. Otherwise, Buffett may even consider initiating a dividend, something that’s always been dismissed because there have always been potential lucrative uses for the capital. The company is still sufficiently undervalued, with our FMV estimate at around $195 per B share, while downside appears limited by the diversified nature of its business and the fact that it trades at only 1.36x book value, just above the 1.2x at which Buffett said he’d buy back significant shares—perhaps that level should be raised to around 1.3x, which has a more likely chance of occurring, allowing Berkshire to add even more value shortly on a per share basis.

Kinross Gold is a senior gold producer with over 2.6 million ounces of annual production and over 33 million ounces of proven reserves and a nearly equivalent amount of resources which should drive future growth. The company produces from several mines, most of which are in the Americas with the balance from Russia and West Africa. At time of purchase, Kinross was trading at the lowest price to net asset value of all of the majors even though it has substantial internal growth opportunities and has exceeded guidance for each of the last 4 years. Our FMV estimate is just shy of $6 per share, excluding a higher gold price.

Goldcorp, also a senior gold producer, has all-in costs of production below $750 per ounce, likely the lowest amongst the majors. It also trades below our $24 estimate of its FMV and should benefit from internal growth over the next few years. The company was penalized because it suffered near-term production declines which we expect to reverse over the next few years. Meanwhile, the company is focused on growing its asset value per share from mine site and corporate efficiencies along with reserve additions.

CGI Group, Canada’s largest IT services provider, reported solid results in its most recent quarter. Constant currency top line growth of 6% was the highest in 5 years. Strong U.S. growth was driven by commercial and Federal segments. Shares remain below our FMV estimate of $77. Given the company’s strong growth our FMV was recently revised higher.

Liberty Media (Sirius XM) is a tracking stock (LSXMK) for Sirius XM. Sirius shares trade close to our estimate of its FMV. However, LSXMK trades at a 15% discount to the market price-based value of its holdings of Sirius. Based on our FMV estimate of Sirius, it implies an estimated FMV of about $47 per LSXMK share. We believe that Liberty’s management will move to eliminate the discount. Sirius’ operating results continue to be impressive with rising sales, profitability and substantial free cash flow. Liberty’s only asset is its ownership of Sirius which has now risen to about 68%, and the ownership should grow with Sirius buying back its own shares.

Baidu is one of China’s largest Internet companies with a dominant search engine and video-on-demand platform, a meaningful stake in the largest Chinese online travel agency, and several other prime digital assets that form a critical ecosystem on China’s Internet landscape. The company stands out relative to competitors because of its scale, network effects, and mindshare. Future growth should be driven by increasing mobile ad spending, AI optimization, profitability in their non-search businesses, and several huge secular waves: ad spend shifting online, increasing Internet penetration, and a booming Chinese middle class. Our sum-of-the-parts valuation is $235.

Global Insight (Large Cap) Portfolios – Portfolio Changes

In the last few months, we bought several new positions (a few noted above in our top ten holdings) including Kinross Gold, CGI Group, Crescent Point Energy, Baidu and Dick’s Sporting Goods. We sold Dollar Tree, Husky Energy, Daimler AG and Magna International as each triggered sell signals falling below their respective TRAC™ floors and Pulte Homes, Eastman Chemical, Apple, Disney and Facebook as each ran up to a TRAC™ ceiling, close to our FMV estimate.

Crescent Point Energy is an oil & gas producer with assets in Western Canada where it produces over 170,000 bpd, nearly all high quality light oil from Saskatchewan. The company has long-life reserves and low finding costs of around $11/boe. Continued development drilling and water flooding should expand production and increase reserves. And the company is expected to bolster its balance sheet with non-core asset sales. Our estimate of its FMV is $23. Trading at such a discount to its FMV, the company is a standout especially given its long-life reserves and lower costs.

Dick’s Sporting Goods is a sports apparel and equipment retailer. Despite our concerns with retailers, including mall traffic and fierce online competition, we bought shares because we believe Dick’s possesses several key competitive advantages that will allow it to thrive even as online competition intensifies. As the most powerful player, and one of the few remaining players in the sports apparel and equipment space, the company enjoys bargaining leverage over key vendors and suppliers. As a result, it can command deep discounts and exclusive merchandise, allowing it to compete with Amazon on price and even out-compete on selection. The overall retail environment remains challenging, as evidenced by the company’s recently lowered same-store-sales guidance of 1-3% for the year. However, with a nearly 10% earnings yield and net cash on its balance sheet, we believe the market is overly pessimistic about its future prospects. Our FMV is over $55.

Income Holdings

The 10-year U.S. government bond yield is 2.3%. The Canadian equivalent is 1.6%. As noted above, we do expect rates to rise from relatively low levels; however, there could be a correction from the recent steep rise especially if there’s an economic lull. Though they jumped to a 10% yield early last year, high-yield corporate bond yields have been relatively steady recently and now sit at 5.7%. This is one of the narrowest spreads to U.S. Treasuries historically. Because we have been finding fewer attractive opportunities than usual for our income accounts, we have been holding a larger than usual portion of the accounts in cash while we await more favourable investment opportunities.

We did however buy 3 new positions recently. We bought the Series D Preferred shares in Seaspan, one of the world’s largest shipping container leasing companies. The preferred shares have a current yield of about 9% as they pay us a dividend of 7.95% based on an issue price of $25. The company has the right to call the shares from us in January '18, but in the meantime we earn dividends that benefit from return-of-capital tax treatment. We paid less than the $25 issue price (our target for the security) and have already received our first dividend.

Zargon Oil & Gas 8% 12/31/19 Convertible Debentures are obligations of a small Alberta-based oil and gas producer with a yield-to-maturity of about 11%. The company recently underwent a restructuring where it sold off many assets to reduce debt and used excess cash to repurchase bonds. The converts represent the only debt of the company. This security also entitles us to convert into the common shares at a price of $1.25, which we believe is below its FMV.

InfraCap MLP ETF is an Exchange Traded Fund which actively manages a portfolio of primarily U.S. based mid-stream companies—typically enterprises positioned between energy producers and refiners could be pipeline companies, storage providers or other infrastructure servicers. The MLP (master limited partnership) structure flows through the cash flows to investors by passing through any corporate tax thus providing higher dividends being paid out to the holders. The manager of this ETF uses a combination of some leverage and options in order to further increase the dividends to holders. The run-rate yield has been approximately 19%, boosted from premium earned on options. We expect this ETF to provide a reasonably high yield moving forward too.

We also bought but are reevaluating New York REIT after it fell in response to issuing a disappointing NAV estimate which was below our expectations.

We continue to hold a number of undervalued income positions and collect outsized interest income on these positions due to the depressed prices. Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of over 8%.

Of note, regarding our top holdings in our income accounts: Specialty Foods, now an equity holding of a private company, whose wind-down plan has begun (see the reference under All Cap holdings above); Northwest International Healthcare Properties REIT’s units and bonds are underpinned by a stable income stream; MagnaChip bonds which stand to benefit from the company’s core technology; JAKKS Pacific’s convertible bonds may benefit from the possibility of a buyout; Advantex Marketing debentures maturity was revised to June but it remains secured by the company’s asset base; Manitok collateralized notes are well covered by its reserve base; Ruby Tuesday’s bonds are well covered by underlying real estate; Care Capital Properties REIT’s which was just acquired in an all-share exchange with Sabra Health Care REIT and both companies income streams are non-cyclical and growing; Morguard North American Residential REIT earns a stable stream of income from its diversified multi-family apartment buildings; and, Seaspan whose preferred shares are likely to be called at the first opportunity.

Disequilibrium

The markets have been complacent for quite some time. The VIX—the volatility index—is now at a 23-year low. With government stimulation abating and economic growth continuing at a tepid pace, perhaps that’s the recipe for an extended period in equilibrium.

Because the markets are fully valued, and growth rates are low, the U.S. market is exhibiting the lowest prospect of long-term returns in years—the Value Line appreciation potential index, which has been remarkably accurate over the years, forecasting a 5-year return of only about 6% per year—in the bottom decile since the late '60s.

Therefore, we diligently watch for the end to the bull market—closely monitoring our TRACTM, TECTM and TRIMTM signals for a negative infection from the U.S. market’s current ceiling, for the next recession, and for the market panic that typically follows thereafter. If those tools alert us, we won’t be shy about attempting to diminish and, where we are authorized, hedge off risks.

Until then, we wish to continue to own a portfolio of individual undervalued stocks that have the potential to rise up to our FMV estimates. And if disequilibrium ensues, even for a short period, from too many sellers and too few buyers, we are prepared, with our buy lists in hand and price points set, to buy additional positions.

Herbert Abramson and Randall Abramson May 18, 2017

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