Cash is offence, stock picking is defense

Brandon Snow's picture

One of the comments that we frequently hear has to do with managers “raising cash” when they get defensive. We find it comical when we are told that someone has shifted from 2% to 8% cash in their portfolio because they are bearish – what really matters is the 92% of the portfolio that remains invested!

At Cambridge, we consider our stock picking and risk-reward discipline to be defensive actions in our portfolios, while the cash positions (which run at about 8% to 10% on average, with a range of 2% to 40% depending on the market and fund) is our offence. Holding cash gives us the ability to put significant amounts of capital to work quickly without having to sell other investments at potentially inopportune times. Of course, patience is the key to this process.

Recently, we were fortunate that a number of opportunities presented themselves in short order and we were able to react quickly to the benefit of fund holders across several of our mandates.

Our first opportunity came with the initial public offering of PrairieSky Royalty Ltd., a Western Canadian oil and gas royalty business that was spun off by Encana Corp. Those of you who have heard from us over the last few years are likely aware of our belief that significant dividends paid by energy companies are not in the long-term best interests of equity holders. Put simply, in the energy sector we are looking for companies that offer significant growth potential driven by high returns on the incremental capital they deploy. If a company can generate an internal rate of return of 50% or higher on an incremental dollar spent on their assets, why would I want them to instead return the capital to me? Many of the companies that pay out high amounts of cash flow do so because their reinvestment potential is not very attractive, in which case we are not interested in the name. This philosophy has been reflected in our management of Cambridge Canadian Dividend Growth Fund, where we reduced the energy weighting by 75% after taking it over late last year.

PrairieSky, however, is a completely different business model in that it lends itself to both significant return of capital and growth potential. As a royalty business, PrairieSky does not have to invest incremental capital in order to grow.  It signs contracts with third parties that have an interest in spending their own capital on PrairieSky’s land. Recognizing the quality of this business model, we performed our due diligence across the organization and found strong intentions to invest in the IPO from the Board of Directors all the way through the employee ranks. Given PrairieSky’s high quality business model, the management and employee alignment with shareholders and the company’s commitment of returning capital over time, we have made the company a core holding across several Cambridge portfolios.

The next opportunity was a secondary offering in one of our existing holdings, Allison Transmission, a designer and manufacturer of automatic transmissions for heavy applications. I won’t rehash the core thesis, but this continues to be, we believe, a misunderstood business with quality beyond what the market is recognizing, end markets that are closer to trough than to peak, and trading at an attractive absolute valuation. In just a 24-hour period, two events offered an attractive entry point for us to add to our holdings. First, Allison’s private equity sponsors announced a secondary offering for nearly the balance of their position in the company, and management showed belief in the value of the business by buying back nearly 3% of the shares outstanding on the deal. The following day we held another meeting with the company’s CFO that increased our conviction in the name and offered some indication of additional upside potential. We quickly increased our holdings in Allison by over 30%.

The final unique opportunity came when Scotiabank announced its decision to sell most of its holdings in CI Financial. The market, of course, reacted in its typically myopic way, driving the price down due to the overhang of a significant amount of stock for sale. After the announcement, we were confident this was a long-term positive development for CI; the sale would open up the potential for a more fruitful strategic partnership, it would increase the float and therefore add to the tradability of the security, and the company’s valuation would potentially improve as a result of becoming a unique and standalone asset in the Canadian marketplace. Our cash position allowed us to act quickly, buying on the deal and in the market the same day. We were able to build a significant position in a long-term core holding.

Our willingness to hold cash, combined with the patience to act on valuable opportunities allowed us to commit a significant amount of fund capital – over $300 million – in a short period of time. We continue to hold significant amounts of cash across our portfolios for reasons outlined in our recent blog posts; however these examples show that we are ready to act when the opportunities arise.

At Cambridge, active management doesn’t just mean a high active share. It also means being opportunistic with our ability to hold cash. This approach remains core to our investment philosophy.

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