CBF Commentary – September & October 2016

Caldwell Balanced Fund Update September—October 2016

Contents:

Portfolio Additions: Bird Construction (tsx:BDT), Quintiles (Q)

Portfolio Deletions: Mentor Graphics (MENT)

Market Commentary:

    Market Timing: Who’s Glad the U.S. Election is Over?!?

    A Review of Earnings

Portfolio Additions

Bird Construction (tsx:BDT)

About the Company: Bird is the 3rd largest publicly listed construction company in Canada behind SNC Lavalin and Aecon. The company and its predecessors have been in operation for 95 years. While the construction industry is cyclical, Bird has shown attractive value creation over the cycles.

Investment Thesis: Expectations have become very negative on Bird as the company faces a timing gap between when energy-related revenue runs off and infrastructure-related revenue picks up. In this regard, 2017 will be a transition year that will see noticeably lower revenue overall. Analysts have priced in margin levels that are significantly below the company’s long term average and at a level that suggests a cycle low (margins below this level are typically associated with bad contracts, which are not a factor in this case). Looking beyond 2017, even those most negative on the stock admit that better days lie ahead. Monetary policies have shown little effectiveness in boosting growth and we have seen central banks increasingly call for fiscal spending as a way to growth. The Canadian government, and now the U.S. government, both have infrastructure spending on the agenda and while projects may not be coming as quickly as some had hoped, the plan is for higher spend. Bird, through its PPP business, is well-positioned on a number of these initiatives. The company is seeing increasing bidding activity, which should lead to an acceleration in revenue growth beyond 2017. Picking the exact bottom in these cases is never clear cut, which is why we initiated the position with a half weight. This turned out to be a good strategy as Bird’s latest quarterly results and outlook were incrementally negative and the Board chose to reduce the dividend. The market never likes a dividend cut, especially when it is unexpected (Bird is in a net cash position versus peers that have considerably more debt) and so the shares fell on the news. When we peel back the reason behind the cut, however, it was to preserve cash that is required for an increasing amount of bidding activity, which should support growth going forward. While the investment did not start out as strong as we would have liked, we believe investors will be happy with this purchase over the next 1-2 years.

Quintiles IMS (Q)

About the Company: Quintiles is the world’s largest contract research organization (CRO), in which it advises, designs and executes clinical trials for biopharma companies, with a focus on Phase II-IV clinical trials. They also provide a variety of post-approval services that assist with the sales process (sales representatives, marketing strategy, late-phase research). The company operates in 100 countries and has approximately 36,000 employees. A merger was recently completed with IMS Health where 2015 pro forma revenue was $7.2B. Pro forma geographic split is 46% Americas, 36% EMEA and 18% Asia Pacific.

Portfolio Deletions

Mentor Graphics (MENT)

Reason We Sold: The stock has had a very strong run, being up 57% in 2016 at the time of sale. This was after a harsh sell off following a significant reduction in guidance at the end of last year. The company books revenue up front versus many software companies that pro-rate revenue over the life of a contract. As such, MENT’s revenue declined sharply on consolidation across their semi-conductor clients and a competing product coming to market which slowed contract renewals. MENT moved higher on much better results and outlook the last 2 quarters. Our decision to take money off the table was driven by: i) the stock’s valuation multiple expanding by 25% since our initial purchase; ii) our observation that order-driven businesses have experienced more lumpiness in their growth trajectories; iii) other investment opportunities. We feel quite unlucky with this sale as the company was bought out at a 20% premium a couple of weeks after we sold it. While it certainly would have been nice to capture that additional upside, we focus on the fact that our investment process led us to an opportunity that turned out to be very positive for our investors (MENT +16% versus +0.2% and -3.6% for the S&P500 and TSX Index, respectively, since our initial purchase in April 2015).

Market Commentary

Market Timing: Who’s Glad the U.S. Election is Over?!?

Given the drama and media attention, we were often asked how we were positioning portfolios for the election. Because, unfortunately, politicians rarely come through with their election promises, we thought it was better to spend our time focusing on finding companies that can grow their value regardless of who is in power. Yes, the election of the U.S. president is an important decision, but think of all the time and money that was spent on that decision, and all the analysis on the expected outcome that turned out to be quite wrong. We are glad we did not spend too much time on such analysis. Like Brexit, the biggest lesson for investors, again, is how difficult it is to time the market. The expectation of a surprise Trump victory was that markets would collapse, but here we are at record highs after a sell off that only lasted during after-hours trading the night of the election result.

A Review of Earnings

Most of our portfolio has now reported Q3 earnings and results were generally fine. Our average company grew revenue by about 4% while earnings per share exceeded expectations by about 5%. One trend we did notice is some softness in discretionary spending categories, and there is debate as to how much of this was driven by ‘election uncertainty’. We suspect this pattern will be more the norm in today’s low growth world and will be conscious of this in our decision making. Overall, our companies are executing well and generally have good prospects ahead of them. We will continue to search our investable universe for the best opportunities the market has to offer and will once again state our belief that focused portfolios are the best strategy in today’s low growth world.

We appreciate your continued support.

Best Regards,
Portfolio Management Team