Logos Capital Q2 2018 letter to investors the long case for Industrial Alliance
Logos LP Second Quarter As of July 20th, 2018
“Do you have the patience to wait till your mud settles and the water is clear? Can you remain unmoving till the right action arises by itself?”
– Lao-Tzu, Tao-te-Ching
The following table represents Logos LP’s YTD return compared a basket of relevant indexes.
Although the first half of the year has been challenging for the fund, we are starting to see an uptick in certain stocks that were purchased earlier in the year. As of the date of this letter, the fund is up 3.43% for the year and for the month of June, the fund was up 4.79% versus 1.97% for the S&P 500 in CAD, 0.62% for the S&P in USD and 1.69% for the S&P/TSX in CAD. Currently, the market contains several very expensive large-cap stocks (in fact roughly 10 stocks account for all the S&P 500’s first-half gains) but also has many stocks are trading at very reasonable valuations or which are in bear market territory. Entire sectors such as banking, utilities and consumer staples are seeing widespread weakness being sold-off, and we consider this an opportunity to forage for future outperformance.
At present, there are 18 names in the portfolio with our top 10 comprising 77.50% of the fund’s net asset value. We believe some of these businesses have been in bear market territory for some time, despite having very strong 2 tailwinds, rising margins and growing returns on invested capital which present us with unique investment opportunities for outperformance over the next 3-5 years.
Within the first half of the year, we exited certain positions such as Savaria (TSX: SIS):, Criteo (Nasdaq: CRTO), BofI (Nasdaq: BOFI) and Richelieu Hardware (TSX: RCH) and trimmed Booking Holdings (Nasdaq: BKNG). Moreover, we are starting to get more interested in names that we currently own such as Huntington (NYSE: HII), McKesson (NYSE: MCK) and Bank of the Ozarks (Nasdaq: OZRK) as we believe these businesses are trading at compelling discounts to intrinsic value. We also have our eye on specific utility-like or energy service businesses such as Inter Pipeline (TSX: IPL) as many of them are trading at historically low multiples despite strong cash flow growth. New businesses that we purchased in the fund include Industrial Alliance and Financial Services (TSX: IAG), Alimentation Couche-Tard (TSX: ATD), Cerner (Nasdaq: CERN) and Johnson and Johnson (NYSE: JNJ). We also upped our position in Lassonde Industries (TSX: LAS), as we believe there are tremendous growth opportunities for this company in the coming decade. I will provide a very quick summary on the investment thesis for Industrial Alliance and Financial Services.
Industrial Alliance (TSX: IAG) is a financial services company in Canada focused on the following businesses: property and casualty insurance, health and life insurance, warranty dealer services, wealth management and financial advisory services, mortgages and other various insurance products. The company operates in the oligopolistic market that is the Canadian insurance industry and is one of the smallest insurers in Canada compared to SunLife, Power Financial, Manulife, Intact, Fairfax and even compared to the insurance departments of the large Canadian banks. Despite a declining stock price and moderate return on assets, we believe Industrial Alliance is the cheapest financial services company in Canada presenting a tremendous opportunity for outperformance in the coming years. The company is trading at 1x book value yet boasts consistently double-digit ROE (currently near 11%) and ROA is on an upward trend (from 0.44 in 2011 to 0.89 TTM). Industrial Alliance has almost tripled revenue over the past 10 years and net income has grown by 8x over that same timespan. However, we believe there are unique tailwinds that position Industrial Alliance for at minimum 10% per annum earnings growth for the next decade.
First, the company is making a very large push to become one of the largest non-bank wealth management firms in Canada via their acquisition of HollisWealth. Their AUM and AUA have almost doubled over the last 2 years and they still have very little penetration versus the other major Canadian banks. They continue to innovate by launching new funds, investing in client digital experiences and will leverage the very large HollisWealth distribution network to push more financial products to Canadian households. Second, they are an active acquirer and 3 continue to focus those acquisitions in the US. Their recent acquisition of a dealer service business was purchased at a very attractive multiple and has above average ROE (over 13%) versus the rest of the business. They also will continue to pursue wealth management and distribution related businesses in the US, which typically have higher margins, growth and return profiles versus Canadian counterparts. Finally, they are notorious for their operational efficiencies and cost containment – it is expected that 1% of their 10% EPS growth will come from greater investment in technologies and cost reductions, which would certainly improve ROE and ROA. By purchasing a stake in Industrial Alliance, we believe we have acquired a very high quality financial services company in Canada trading at a very attractive valuation with a 3% yield.
At present, we have a much larger than usual cash position as holding cash when prices are not in our favor helps prevent capital loss, while providing “dry powder” for future opportunities. We are evaluating several promising opportunities including MTY Food Group (TSX: MTY), Ituran Location and Control Ltd. (Nasdaq: ITRN), Coherent Inc. (Nasdaq: COHR) and Air Canada (TSX: AC). Although we remain for the most part fully invested to maximize the effects of compounding, we always monitor our entire portfolio, particularly our smaller peripheral positions. Our plan is to continue to search for companies, particularly in Canada or outside the US, that have little debt, strong (and growing) ROIC trading at historically low multiples that we deem reasonable given expected operating income growth. As we have mentioned before, we are tempering expectations for below-average expected returns in 2018, yet we believe we have positioned the portfolio for above average long-term returns.
We are grateful for your continued support and will continue to dedicate our time and effort on your behalf. In the meantime, if there are any questions please feel free to reach out to us and we would be more than happy to answer.
Peter Mantas General Partner, Logos LP firstname.lastname@example.org
Matthew Castel, General Partner, Logos LP email@example.com