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Mawer Investment Newsletter - Third Quarter

December 13, 2013 | About:
Holly LaFon

Holly LaFon

Market Overview: Investors entered this third quarter faced with the looming threat of tapering. Federal Reserve Chairman Ben Bernanke had sent clear signals to market participants that further signs of strength within the U.S. economy would prompt the central bank to reduce, or taper, its monetary stimulus. As a result, bond yields that had risen last quarter continued to climb higher, while equity investors began to recalibrate expectations to account for higher interest rates.

But then Bernanke surprised everyone by announcing in September that the economy wasn't quite healthy enough for tapering after all. With that revelation, both bond and equity investors scurried to recalculate their valuation models. Businesses, homeowners, and other borrowers would continue to enjoy exceptionally low interest rates, at least for now.

This unexpected policy announcement had a significant influence on capital markets.

Canadian bond markets, which had just suffered a 2.4% decline last quarter, appeared destined for further losses as the 10-year Government of Canada yield climbed from 2.44% at the start of the quarter to 2.82% by early September. But Bernanke's announcement sparked an immediate rally in bonds, and yields in Canada retreated to close the quarter at 2.54%. What appeared to be a second consecutive quarterly loss for the DEX Universe Bond Index turned into a gain, albeit a modest one, of 0.1%.

Meanwhile, global equity markets were on the verge of another healthy quarter before Bernanke's surprise announcement propelled markets even higher. By the end of September global equity markets, as measured by the MSCI World Index (C$), had gained 5.8%. The gains thus far in 2013 now stand at a remarkable 21.3%. The chart below illustrates the quarterly performance, expressed in Canadian dollars, of some of the notable equity indices around the world.

Chart A Quarterly Index Performance (in C$) The absence of any negative returns in the chart above illustrates the breadth of strength across global equity markets. Unlike last quarter when exceptional returns in the U.S. and Japanese markets offset losses in Canada and Pacific ex-Japan, every major equity market exhibited growth this quarter.

In Canada, nearly 75% of the S&P/TSX Composite Index is comprised of companies in the Financials, Energy, and Materials sectors. The fortunes of these three sectors tend to dictate the performance of the overall market. This quarter, Financials gained 7.4% led by a stellar 9.9% gain in the banking sub-sector. Rising crude oil prices, particularly as tensions in Syria escalated, helped drive Canada's Energy sector to a 6.6% gain. Finally, the Materials sector gained 4.5%, which was a welcome reversal from the 22.8% decline last quarter. Beleaguered gold miners relished the recovery in the price of bullion.

In the U.S., the S&P 500 Index (C$) gained another 3.0% to lift the year-to-date gains to 23.8%. Strong performance in the Materials and Industrials sectors offset weakness in more defensive sectors such as Utilities, Telecommunications, and Consumer Staples. Europe proved to be the best performing region in the last three months. Economic data confirmed that the Eurozone has technically emerged from its recession, and the 11.2% return seems to indicate that investors are showing renewed interest in the region. Interestingly, equity markets in Greece, Spain, and Italy significantly outperformed the likes of Germany, Switzerland, Netherlands, and the U.K.

Performance in Japan and the rest of Southeast Asia was positive, although developed markets generally outperformed emerging markets. Australia and New Zealand were two of the strongest equity markets in the region, benefitting from the rise in commodity prices that buoyed Canadian markets.

How DID we Do?

From an asset allocation perspective, we positioned our portfolios leading up to this quarter to be modestly overweight equities and significantly underweight bonds. This positioning has been beneficial in recent years and was advantageous yet again this quarter. Within equities, we have been reducing our exposure to Canada for some time and building a greater allocation to global equities, particularly the U.S. While this has helped our performance of late, Canada's relative outperformance in the last three months detracted from returns. Finally, our relatively large allocation to small caps, both domestically and globally, was especially valuable as both asset classes delivered exceptional returns in the last three months.

Within bonds, we reported last quarter that we held approximately 15% of the bond portfolio in Floating Rate Notes (FRNs) as a tool to build more resilience to rising yields. During 2013, the 10-year Government of Canada yield has moved from a low of 1.67% to a recent high of 2.82% before settling back to 2.54% as of September 30th. As yields approached 2.82%, we began to reduce some of our FRN positions to take advantage of more attractive opportunities that had emerged within fixed coupon bonds, particularly within the short-term bond universe. Our allocation to FRNs stood at approximately 11% by the end of the quarter. While the risk of rising yields remains, it is less concerning than earlier in the year. Thus, we must weigh the additional protection that FRNs offer in a rising rate environment with the improving return prospects of fixed coupon bonds. Looking forward, we may further reduce our 11% allocation to FRNs and add to fixed coupon bonds, although this is conditional on such considerations as the outlook for monetary policy, the slope and shape of both yield and credit curves, and the analysis of return potential in a variety of scenarios. Another rise in yields within the short-term bond universe that is largely unrelated to an improving economy would certainly be one catalyst to expedite that migration.

The Mawer Canadian Equity Fund gained 6.3% (net of fees) this quarter, on par with the 6.2% return of the S&P/TSX Composite Index. One of the biggest disappointments was Potash Corp. The fertilizer producer lost approximately 19% after the break-up of an industry cartel triggered lower fertilizer prices. Fortunately, we had been reducing our exposure to Potash Corp. which lessened the net impact on the portfolio. Defensive companies such as grocers Loblaw and Metro also suffered losses this quarter and hampered performance. These disappointments were offset by exceptional gains in three of our companies in the Health Care and Technology sectors; Valeant Pharmaceuticals, Paladin Labs, and Constellation Software which gained approximately 18%, 16%, and 26%, respectively. We previously reported that we were reducing our exposure to the Energy sector given the potential for increased supply arising from new extraction innovations. We took advantage of the relatively strong performance among Energy companies this quarter by continuing to trim our positions. The proceeds of these sales were reinvested primarily within the Financials and Telecommunications sectors. Canadian small caps were particularly strong this quarter with the BMO Small Cap Index gaining 7.7%. Our New Canada Fund performed significantly better with a net return of 12.4%. Strong security selection across numerous sectors contributed to this outperformance. One of the more interesting stories surrounds Home Capital Group. Home Capital lends to consumers and prospective home buyers who often get turned away by the big banks. As such, it carries the reputation as having a riskier loan portfolio than other Canadian lenders. This summer, a prominent U.S. hedge fund manager singled out Home Capital as particularly vulnerable should Canadian real estate prices weaken. Amidst this negative media coverage, investors began to aggressively sell Home Capital shares and drive the share price lower. As long-time owners of Home Capital, we didn't share the same concerns about loan quality that was being reported in the media. We believed that management was not recklessly lending, but had prudent practices in place. We understood that Home Capital's customers were not all high-risk borrowers but often individuals, such as recent immigrants to Canada, that had the wherewithal to service a loan but lacked the credit history to qualify for loans from the larger banks. So while other investors were selling Home Capital, we took advantage of the share price weakness to build an even greater position in the company. Our conviction was rewarded as Home Capital gained over 30% this quarter.

Mawer's U.S. Equity Fund had a net gain of 3.8% compared to the 3.0% return of the S&P 500 Index (C$). Strong security selection within the Financials and Technology sectors contributed positively to performance. Synnex, one of our recent additions to the portfolio, gained over 40% this quarter after making a transformational acquisition of a business unit from IBM. We made numerous changes to the portfolio in the last three months. Five companies were eliminated; Actuant, Air Products, Emerson Electric, Aflac, and Microsoft. We used the proceeds of these sales to add to several of the companies already in the portfolio, including Blackrock, Oracle, and Pepsi. We also introduced three new companies to the portfolio: Praxair, Intuit, and Autozone. The MSCI EAFE Index (C$) gained 9.2% which exceeded the 6.1% net return of our International Equity Fund. One of the contributing factors to our underperformance was the pronounced weakness in many emerging markets. The anticipation of higher interest rates in the U.S. seemed to be the catalyst for an immense flow of capital out of emerging countries towards the safe haven of the U.S. dollar and other developed nations. Currency weakness in markets such as India, Indonesia, Turkey, and Brazil was considerable and in some cases prompted central banks to intervene and stem the outflows. Last quarter we reported that we had been reducing our direct exposure to emerging markets, but the investments we did retain in countries like Chile, Hong Kong, Thailand, and Israel performed quite poorly in the last three months. But with significant losses comes potential opportunity. Members of our Research team have recently completed visits to, or are currently visiting, South Africa, Thailand, Cambodia, Burma, and Malaysia in order to explore additional opportunities within these markets.

Finally, the net return of our Global Small Cap Fund was 12.8%, significantly outpacing the 7.7% return of the Russell Global Small Cap Index (C$). Our relatively large allocation to Europe proved to be favourable, as was exceptional security selection among North AAmerican companies which comprise approximately 27% of the portfolio.

Company Spotlight

Constellation Software (TSX:CSU) is a Toronto-based firm that delivers software solutions to customers in 30 countries around the world. Their software systems are used by a diverse customer base that includes government entities, hospitals, schools, public utilities, and private businesses. It's quite possible that in a typical day you encounter a Constellation Software system numerous times as you visit a doctor, pay a utility bill, renew a driver's license, or visit a fitness facility. Since it can be costly and onerous for an organization to switch software vendors, Constellation tends to have a high degree of client retention.

Though Constellation Software was founded in 1995, it remained privately owned until its initial public offering in 2006. This was when Mawer established our initial investment in the company. During our research process we gained confidence in the ability to generate shareholder wealth with this business model, and we specifically came away impressed with the quality of the Constellation management team. They appeared highly skilled in the way that they evaluated opportunities, allocated capital, and executed their business plan. Their ability to identify accretive acquisitions and successfully integrate them into the business model was especially noteworthy. In time, they would become our own internal benchmark for managerial excellence, not just in Canada, but on a global stage.

From the chart below, we can see that Constellation shares have performed remarkably since their debut at $17, closing this quarter at a value of $181.

Chart B

Constellation Software Share Price, 2006-2013

Source: S&P Capital IQ

It's critical to note that the company looks very different today than it did in 2006. During this time, management has orchestrated countless acquisitions with each new addition offering yet another platform to compound wealth for shareholders. Investors who estimated the value of Constellation's business on a stand-alone basis, without accounting for the ability of management to continue to create value through accretive acquisitions, may have concluded many times during the last seven years that the company was overvalued.

Our approach, however, was to try to incorporate future acquisitions into the cash- flow forecasts for this company. Had we valued the company on a stand-alone basis, without incorporating future acquisitions, we might also have concluded that the business was overvalued. But through our many conversations with management we gained confidence in their ability to execute on their growth strategy and continue to orchestrate value-creating acquisitions. This allowed us to revise our assumptions and recognize the vast return potential of this business. Though we have trimmed our position on several occasions over the years, we have maintained a core position since 2006 that has delivered substantial returns for our clients.

Looking Ahead

The recovery in the global economy appears to be moving forward, albeit at a tepid pace. Recent growth rates in the U.S. have exceeded expectations with the much- maligned housing sector showing signs of normalization. Economic contraction in Europe has reversed, with the region most recently posting positive economic growth. Despite signs of stress within the Chinese banking system, growth rates in China continue to be healthy. With much of the developed world facing muted growth rates, we have come to rely on emerging markets to uphold global economic proliferation. Up to this point they have delivered, but the outlook from many emerging economies has recently weakened, as evidenced by significant capital outflows and currency depreciation. Whether the developed world can continue to rely on emerging market strength will be a significant theme in the years to come.

Finding bargains in equity markets is more difficult today than one year ago. Current valuations generally appear closer to our estimate of true intrinsic value. This does not necessarily inhibit the ability to generate positive returns, but it does require discipline to re- deploy capital from companies that trade at the higher end of their valuation range to opportunities that are more attractive. We have been active this quarter in re- deploying capital and expect this exercise to continue in the near future.

Within fixed income we acknowledge that the near-term outlook remains challenged, but has improved from earlier this year. We continue to look for opportunities to add value through trading opportunities while maintaining an overweight position to credit securities. Our current allocation to FRNs does provide greater resilience to rising yields and, as noted earlier, should yields rise we would consider re-deploying some of the capital currently held in FRNs to more rate-sensitive securities.

Our asset allocation stance has not significantly changed from last quarter. We believe maintaining a relatively low allocation to fixed income is prudent and we will continue to position our equity portfolios with an emphasis on high quality companies with healthy balance sheets and sustainable dividends.

Much of our outlook is contingent on U.S. politicians resolving their differences prior to a critical vote to raise the debt ceiling. A prolonged political impasse could have dire consequences, while a successful resolution would alleviate much of the fear currently overhanging the markets. Given the unpredictability in politics we are not actively positioning the portfolio to reflect one outcome over another. We believe investors would be wise to maintain a long-term perspective and focus on fundamental security analysis rather than trying to predict political outcomes. Those who ignored the fiscal cliff saga last year and focused on fundamentals have been well-rewarded.

[/i][i]**5% DEX 91 Day T-Bills, 35% DEX Universe Bond, 15% S&P/TSX Composite, 15% S&P 500, 15% MSCI EAFE ND, 7.5% BMO SCI (Blended, Weighted) and 7.5% Russell Global Small Cap

All foreign equity indices are net of withholding taxes.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical simple returns for the 3 month, YTD and 1 year periods, and annualized returns for the 3, 5, and 10 year periods. They include changes in unit value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

Rating: 4.0/5 (1 vote)


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