CBF Commentary – December 2015, Full Year

CBF Commentary – Full Year

CBF Portfolio Additions Broadridge Financial Solutions (BR-us)

About the Company:

Our addition to CBF Broadridge (BR) provides investor communications, securities processing and data analytics solutions to financial institutions. The company’s services are mission-critical and deeply ingrained in the financial services world. For example, Broadridge touches1100+ broker-dealers, 6700+ institutional investors, 140,000,000 individual accounts globally, 80,000+ financial advisors, 45,000+ global corporate issuers, 800+ mutual fund families and 250+ retirement service providers.

Investment Thesis:

We view BR shares as a good asset to own given:

1) This is a high quality, sticky business with 90% recurring revenue and 98% client retention. Return on equity runs above 20% and the company showed strong resiliency in earnings throughthe 08/09 recession;

2) Attractive growth opportunity. Revenue grew 7% last quarter and is expected to continue increasing on the back of i) market share gains: BR’s annual revenue is $2.7 billion versus an estimated $24 billion addressablemarket; and ii) secular growth drivers in the areas of mutualization (business process outsourcing), digitization (continued shift from paper) and data analytics (given BRs many touch points, they possess valuable data that they have started converting to revenue);

3) The business generates a mid single digit free cash flow yield, which we believe is attractive in the current investment environment;

4) catalysts in greater analyst coverage. The company, this past year, hired a new head of investor relations who will beresponsible for increasing the company’s profile across the investment community. We see positive catalysts here as the company currently has minimal analyst coverage.

CBF Portfolio Deletions:


A Review of 2015

The Caldwell Balanced Fund gained 3.7% in 2015. As a reminder, our investment strategy and process aims to protect investors from common risks in the market; specifically: valuation risk, balance sheet risk management risk and operating risk.History is full ofexamples of each of these causing significant damage to investor portfolios and our goal with every stock we own is to take acceptable risks relative to the return opportunity.Two major themes dominated the market in 2015. In Canada, investors only did well by avoiding everything Canadian. In the U.S., value was a tough place to be.

The Canadian Minefield -Home Country Bias Hurts Again

We first highlighted the dangers of home country bias for Canadian investors in August 2014 as energy prices were beginning their collapse.Those over-exposed to Canada were hurt again in 2015 as this was the 5th consecutive year that Canada (TSX -11.1%) underperformed the U.S (S&P 500 -0.7%).Energy continued to lead the painwith a 25.7% decline (the average energy stock was actually down 33% as the sector return was inflated by stronger performance by its largest companies). Materials was the second worst performing sector, down 22.8%,with the gold sub industry down 16.2%. Health Care lost 15.8% on the back ofValeant Pharmaceutical. This is a company that became the 3rd highest valued in the Canadian market (behind RBC and TD), after which investors saw their shares plummet an excruciating 70%.Industrials and Utilities, which carry indirect exposure to weak energy and commodity markets, lost 12.5% and 7.8%, respectively

Needless to say, the Canadian market provided many opportunities to harm investor portfolios and we are pleased with the way we shielded our clients from much of this damage.Specifically: 1) we completely avoided several weak areas in the Canadian market, such as Materials, Gold, Industrials, and Utilities. 2) While we participated in the energy sector, our stocks performed much better than their peers, mainly because of their superior balance sheet positions. 3) We did not participate in Valeant’s roller coaster ride. We spotted several red flags in their story, which is a testament to our disciplined due diligence process.

What did work in Canada?Looking at 9 of the top 10 performers in the Canadian market (see note below1), a few things stick out: 1) 9/9 had no direct exposure to energy or commodities; 2) 9/9 had noindirect exposure to energy or commodities; 3) 9/9 generated less than 25% of their revenue from Canada (5/9 generated less than 10% of their revenue from Canada). What worked is owning Canadian companies that have little to do with Canada.This is a great example of how focused one had to be to do well in the Canadian market. In this regard, our holdings in Onex, Celestica and CCL Industries, which have very little Canada in them, performed well.1NovaGold was excluded from the analysis of the top 10 performers on the TSX. The company currently generates no revenue as it works towards receiving allpermitting to commence production of its Alaskan gold property.

No Love for Value Investors in the U.S.

While the U.S. market was essentially flat for the year, it was particularly harsh on value-oriented investors such as ourselves.The top 2 performing stocks in the S&P 500 last year were Netflix and Amazon. To own these stocks, investors must now pay 565x and 325x earnings, respectively. These are big numbers and mean that much of the value being assignedto these companies isdependent on a lot of good happening in the future. This creates heightened valuation risk as the future contains no guarantees. While these stocks may ultimately live up to their lofty valuations, there are many instances in history where investors lost significant amounts of money because the future was not as rosy as originallythought.

While we believe it is wise to remaindisciplined in our approach to valuation risk, the market does not always reward those trying to be responsible. Amazon, Netflix and Facebook (another high valuation stock at 44x earnings) had a combined contribution of +1.2% to the S&P500. This means that managers who did not participate inthe fun of new tech saw themselves behind their benchmark index by this amount.

Another way the market was harsh on value investors was that the cheapest stocks, where value investors tend to look to find value, ended up being the worst performers. Specifically, when we divided each sector into 5valuation groups according to each stock’s valuation at the beginning of the year, the cheapest group of stocks ended up with the worst performance in half of the sectors: Consumer Discretionary, Consumer Staples, Health Care, Materials and Technology.The primary driver of this seems to be related to the shifting of business models from old to new: Amazon versus Macy’s, Netflix versus Viacom, cloud versus on-premise technology providers, etc. While a recent study highlighted in the Harvard Business Reviewconfirms that the lifespan of businesses is declining, we believe the market may have over-punished legacy businesses while over-hyping new models.

CBF Performance Summarized

While we have touched on a number of things that drove performance, here is a more comprehensive review:

Top Contributors:

1) an overweight position inthe U.S., along with exposure to the appreciating U.S. dollar (we hedged 1/3 of our USD exposure at 1.37)

2) an overweight position in Technology (32% of the equityportfolio at year end);

3) the complete avoidance of the Materials sector4) security selection in Energy (Suncor, Parkland Fuel and Chevron)

Bottom Contributors:

1) security selection in Technology (not owning Amazon, for example)

2)securityselection in Industrials (W.W. Grainger and CSX)

3) an underweight position in Consumer Staples

Key Benefits of This Strategy

Throughout this piece, we touched on anumber of benefits investors get with this strategy.

1) Our ability and willingness to diversify outside of Canada.While investors in this strategy have been benefiting from greater exposure to the U.S. for several years now, many Canadian investors are still feeling the pain of home country bias. We looked at mutual funds available to Canadian investors, focusing on 3 Morningstar categories: Canadian Equity, Canadian Balanced and Canadian Dividend & Income Equity. Funds in these categories are restricted in how much they can allocate outside of Canada and therefore have a higher home country bias. Collectively, these funds have $184 billion of Canadian investors’ money. That is 184 billion dollars ourclients are glad they are not part of.

2) Our ability and willingness to run a high active share portfolio CBF (i.e. be different from the benchmark index). We call this managing with focus and believe it is critical to successfully navigating today’s low growth, high valuation market. Going forward, it is hard to see a scenario where a rising tide will lift all stocks. Our team believes investors must have a manager that can completely avoid harmful parts ofthe market while focusing investments on niche plays that are succeeding in today’s economy. We are part of a rare breed of managers in Canada that are managing with high active share -a screen of 1400 mutual funds in Canada showed only 65 (less than 5%) that possess this characteristic.

Appreciating your continued support,

CBF Caldwell Investment Management Team


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