Small cap funds review: Second half of 2016

Greg Dean's picture

Dear fellow Fund Holders,

2016 was a milestone year for Cambridge—but not for the reasons you might think. I promise to get to the fund specifics, but first, I wanted to share some team developments, which in my opinion will be far more important to the long-term success of our current clients than an arbitrary time period evaluation.

In 2016 we added five new people to the team and had two individuals move on. What made 2016 so important is that we feel like we (finally) ended the year with the right people focused on the right areas and feel as prepared as ever to deliver on a global basis for clients. Not to say that we aren’t always on the lookout for top talent (after all, our people are the core of our franchise), but the bulk of the build-out is now complete.  Again, we have been on this quest since Bob, Brandon, Steve and I decided to join Alan at Cambridge in 2011 and have interviewed close to 250 people.  We are very excited to have reached this milestone in terms of our investment team, client communication efforts as well as our institutional business. The average age of the team is 34, meaning we have now established the core of the Cambridge team, and our clients can rest assured that their hard-earned savings will be in capable hands for the long term.

There were also some very notable happenings in the investment landscape in 2016. What began with talk of recession has ended (thank you, President Trump) with very strong returns for our clients and, in our opinion, a very elevated risk appetite among other market participants. I wrote a few months back that the re-emergence of the very scary (to us) term “animal spirits” had us worried, so our portfolios were conservatively positioned. As we come into 2017, the portfolios I oversee are the most defensively positioned they have been since I began my career, with cash levels around 15–20%.  They are tilted away from cyclicals (industrials, energy) and towards more defensive companies and sectors (consumer staples—I even bought a gold company!).

2016 saw our team travel extensively, as Steve has shared. For me personally, the major areas I went to uncover opportunities were the UK, Japan and earlier in the year Calgary, which at the time the market had written off as if all they did was produce oil or gas. In Japan, I came away confident our process/philosophy will scale there; it is ripe with a lot of underfollowed/uncovered smaller companies with a lot of cash on the balance sheet and high returns on invested capital that are poised to create a lot of value for shareholders. This was a very positive surprise from the rhetoric we read about in the financial press about Japan. We found a lot of very entrepreneurial companies and management teams focused on shareholders, who think and act like an owner.

We had a very well-timed trip to the UK just weeks prior to the Brexit vote that  gave us the opportunity to add to B&M European Value (UK dollar store chain) below 240p (stock now over 300p) and Auto Trader (UK) under 340p (now 400p). The UK now accounts for roughly 25% of the Cambridge Growth Companies Corporate Class Fund.

Canada is where our portfolios have seen the greatest rotation back to less cyclical growth after material de-ratings in the stock (earnings up and stock down, which is our favourite). Positions in companies like Metro, Weston Foods and CCL Industries have been initiated or added to the portfolio.

In terms of puts and takes on the year, let’s look at the mistakes first. It is important at the outset to define a mistake: the permanent loss of capital. So the discussion that follows will only include companies no longer held in the portfolio or where the weights have been reduced dramatically. If we still own it, then it could be that we simply don’t agree with the markets’ perception of the business value, which can happen. In fact, if it didn’t, we wouldn’t be able to outperform the market over the long term.

Avis Budget – I held this in the Cambridge Canadian Growth Companies Fund and Cambridge Growth Companies Corporate Class Fund, with a view that the recently consolidated market structure would allow for better real pricing to stick (price increases above cost inflation). That did not and has not come to be evidenced, thus I eliminated it from both portfolios, incurring a roughly 20% loss on the position. They generate significant free cash flow, but I don’t believe the business is worth more than 10x EPS until they prove the market becomes less competitive, which has proven tough with one of the three big remaining players owned by a very conservative family.

McKesson Corp – One of North America’s largest health care distributors, I owned this because it had corrected 20% from its highs and was finally available at what I thought was an attractive price—15x. I felt they had the potential to continue taking share in the generic drug distribution market, and that their scale would not only be sufficient insulation from intense price competition, but would also allow them to bid for more volume, creating somewhat of a network effect over time. As it turns out, the business began to falter in mid-2016, as it became clear they were over-earning on their US generics business by not passing on price reductions from drug manufactures to their customers and keeping the difference. We identified that this was a big portion of their profits and was at risk. I exited the position at a 20% loss.

Here are some of the meaningful contributors to the strong returns of 2016 that are no longer in the portfolio or substantially reduced.

CSC – I have held this company for several years, but in 2016 they pulled off an absolutely stunning acquisition where they merged the company with the enterprise services business of HP and came out with 50% of the combined company (contributed 25% of the revenue!). It has now grown from a smaller company to a US$20B global IT powerhouse with a new name as wellDXC Technology. Fortunately for us, the CEO and management team remain the same.

Melrose Industries PLC – This company is a UK-listed private equity firm that uses their operational smarts instead of excess leverage to drive an improvement in the businesses they acquire and subsequently sell once fixed. They have an outstanding track record and after returning about 2.4B GBP to investors following the sale of their largest business to Honeywell, they went on to make their largest acquisition ever of a US-listed HVAC manufacturer that was in financial distress. After adjusting for the return of capital, we made almost three times our money on the holding in 2016 and have since reduced the position to reflect the optimism around the fair price you are now paying for the base business. Their acquisition track record remains undervalued, and thus I still own some across my non-Canadian funds.

Texas Capital Bank – I have written about this one in a previous post which can be read here. This holding is no longer held in my portfolios.

While we were fortunate that none of the mistakes were large holdings and several of the positive contributors were very large holdings, it doesn’t always work out that way. 2015, for example, was a year where some of the mistakes were larger holdings, and it is my hope we keep those few and far between because of the impact they can have on our ability to compound value over the long term.

Please stay tuned and expect us to address capacity within the Cambridge Pure Canadian Equity Fund with you all sometime in 2017. As a unit holder myself, I want to make sure we do not harm existing clients by taking too many new clients on in our pursuit of superior risk-adjusted returns. We have always indicated that we would cap that strategy as it approaches $500m, and with it sitting above $400m today, I expect we will close it to new investors in 2017. Rest assured, it will be communicated in advance and in consultation with our partner clients.

Best wishes to all of you in 2017 and thank you for your continued support!



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