For lower risk mandates such as the Cambridge dividend suite and Cambridge Asset Allocation, protecting capital from permanent impairment is the primary objective. While this does not mean being immune to market volatility (they are not), it does mean extra emphasis must be placed on focusing on the downside. The obvious question that arises is, “How do we aim to do this?” This blog will offer two examples – both are Canadian commodity exposed businesses that are perceived to be higher quality.
Company A had a strong reputation among its peers due to their track record of growth and their highly regarded CEO. The stock also offered an attractive dividend, backed by what appeared to be a sufficient level of cash flow and at one point we owned it.
As part of our ongoing investment due diligence process, our energy analyst Authi Seevaratnam took a fresh look and performed a deep dive on the business. After considerable work he concluded that there was more risk than what we and the market had appreciated at the time.
The risk centered on incremental returns in the business under commodity prices we viewed as justified given fundamental shifts in supply and demand dynamics. His view was that half and full-cycle returns would no longer be acceptable, eventually leading to either an impaired balance sheet, an unsustainable dividend or both. This new reality was being masked by above-market hedges that would ultimately roll off and expose the true economics of the business. If commodity prices improved, they (and others) would be bailed out; however if they did not, shareholders could see their equity permanently impaired. One needs to keep in mind that commodity prices needed to improve before they ran into financial difficulties; otherwise you could be right on a commodity rebound but not be around to enjoy it!
This business was perceived to be higher quality but also higher risk because parts of their business were very cyclical. Despite the cyclicality in parts of their business and overall negative sentiment towards the name at the time, our view was that the risk of us permanently impairing client capital was actually very low.
The first reason was that the business generated very strong cash flow even during bad times. In fact, this business had a counter-cyclical cash-flow cycle, meaning that in bad times they actually generated more cash due to the fact that they required less investment in inventories and receivables. If the market deteriorated further, they were positioned to continue servicing their financial obligations.
The second reason was that while parts of their business were highly cyclical, other parts were far more resilient and protected from competition. This meant that if the market did not recover, there would still be a steady stream of higher margin revenue and cash to make sure they would be just fine.
Finally, we had considerable faith in management. In addition to being well aligned with shareholders, management was focused on the right metrics and had a strategy that made sense for the business. They also had demonstrated their ability to execute and make hard but necessary choices. While our upside scenario of this business was far more optimistic, our work led us to believe that even if the environment remained challenged, we were unlikely to lose money over a reasonable length of time.
These are two examples of how we use bottoms-up analysis to help protect against permanently impairing capital. It is worth repeating again that short-term volatility and permanent capital impairment are two different things. The former can create opportunities; the latter is difficult, if not impossible to overcome. We highlight this at a time when we see signs of speculation across a number of markets. While speculation can be lucrative at times, it comes with considerable risks that investors need to fully appreciate before making an investment. Assets backed by little to no current or prospective cash flow, earnings or even revenues can perform spectacularly well when in vogue, but have little fundamental underpinning if sentiment turns.
We hope you had a relaxing break and wish you all the best in 2018.
P.S. A question we often get is, “Where are you seeing opportunities or investing your own money these days?” The answer is that I will be personally investing some more capital into Cambridge Global Dividend Fund. We continue to find unique bottoms-up opportunities out there and I find the ability to invest abroad (with strong Canadian dollars) to be an attractive option over the long term.
This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. This commentary may contain forward-looking statements about the fund, its future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Cambridge Global Asset Management is a division of CI Investments Inc. Certain funds associated with Cambridge Global Asset Management are sub-advised by CI Global Investments Inc., a firm registered with the U.S. Securities and Exchange Commission and an affiliate of CI Investments Inc. Certain portfolio managers of CI Global Investments Inc. are associated with Cambridge Global Asset Management.