Manager’s Quarterly Commentary – Felix Narhi – Q1 2014

The Fund became available to investors on July 5, 2013 and ended Q1 2014 with 19 holdings and a cash weighting of 4.7%. Class A units that were initially purchased at C$10.00 were valued at C$12.53 at March 28, 2014¹.

Most of this quarter’s performance was driven by the appreciation of the US dollar. The greenback appreciated 4% against the Canadian dollar. We do not hedge the portfolio from foreign exchange fluctuations, nor do we have plans to change our stance for the time being. Over short periods, foreign exchange movements can have a meaningful impact on the portfolio performance but over the long term we anticipate that foreign exchange will be a modest factor on annualized performance. Real wealth tends to grow gradually over time as businesses create shareholder value which is eventually reflected in stock returns. A patient, long-term outlook is key to our approach.

In the portfolio, we added initial positions in Iconix Brand Group and Strayer Education. We also sold off our remaining position in Weight Watchers as we lost confidence in management and the outlook continued to deteriorate with little visibility on a turnaround.

Investment Strategy – “Growth” vs. “Value” Investing
Investment approaches have traditionally been categorized into two basic philosophies: “Value” and “Growth” investing. Investors are typically expected to embrace one of these camps and many consider it almost intellectual heresy to consider opportunities that fall into the other side of this philosophical divide. We consider ourselves value investors, but don’t believe these long-held distinctions are necessarily helpful to the investment process. While these divisions have the advantage of being familiar concepts to investors, we believe they can be misleading and lead to muddled thinking.

As value investors, we search for discrepancies between our estimate of the intrinsic value of a business and the price of that business in the market. Intrinsic value can be defined simply as the discounted value of the cash that can be taken out of a business during its remaining life. When estimating a company’s future cash flows, growth, or the lack of growth, is one of the most important inputs that needs to be considered when assessing value. The key to our investment approach is to appreciate that while “Growth” is an important input to estimating intrinsic value, “Value” is not. Value is simply the output.

Although intrinsic value is easy to define, estimating the intrinsic value of a business is no simple task and will never be a precise figure. It requires assessing an unknowable future which has a wide range of possible outcomes. As a result, it is appropriate to think about intrinsic value in dynamic range-based estimates, which will vary over time, rather than a static “target price”. It also requires evaluating a management team’s ability to intelligently deploy the cash that is generated by a business. Successful investing over time is driven by the assessment of two key factors:
1) The economic fundamentals and prospects of the business which change over time; and
2) Handicapping the odds and investor expectations that are embedded in any given stock price.

We are willing to own businesses facing significant headwinds (e.g. Apollo Education Group – highlighted last quarter), modestly growing businesses (e.g. National Oilwell Varco) or fast growing businesses (e.g. SolarWinds – more details below) as long as we believe we are obtaining more value than we are paying for and our return hurdle rate is met.

Investment Highlight – SolarWinds
The portfolio holds SolarWinds, a fast growing software provider with a vision to Manage the Performance of ALL Things “IT”. The company offers powerful and easy-to-use products at very affordable prices to busy IT professionals seeking solutions to mission critical computing issues. We believe the company has a multi-year runway ahead thanks to its unique value proposition and current small size relative to its large addressable markets.

SolarWinds’ stock significantly underperformed the market in 2013 because investors feared a slowdown in growth from the torrid pace of a year earlier. On the other hand, we agreed with management’s assessment that the causes of the slowdown last year were fixable with refocused sales execution. The market’s focus on short-term trends rather than on long-term value opened up an opportunity to accumulate the stock near the trough of its historical valuation range. Indeed, early signs of renewed traction and accelerating growth at the end of 2013 have been encouraging.

When computing cycles hit new inflection points, history teaches us that many tech incumbents find it difficult to adapt to the new reality and hard to abandon their old successful business models. As a result, nimble companies with new business models like SolarWinds tend to emerge and become the commoditizers and disrupters of existing well-defined markets. SolarWinds typically provides 80-90% of the functionality of rival offerings from companies like IBM, HP, CA and Cisco, but markets its products at 10-15% of the cost. The business is fairly “sticky” with high levels of customer retention and recurring revenues.

Despite its robust growth profile, SolarWinds enjoys high returns on capital, best-in-class profitability, and generates free cash flow well in excess of net income. Today, the stock is trading at less than 20x price-to-free cash flow, which is roughly in-line with the S&P500’s valuation, yet the company offers a medium-term growth profile (+20%) and underlying economics that are vastly superior to the average stock, in our opinion. Thus, we believe, what appears to be “statistically expensive” on an earnings basis looks undervalued on a free cash flow basis if growth continues as we envision.

Please do not hesitate to contact myself, should you have suggestions, questions, or comments you wish to share with us.

Felix Narhi, CFA
April 15, 2014
¹ Performance information for the Pender US All Cap Equity Fund is not available because the Fund has been in operation for less than one year. Performance information will become available on the first anniversary of the Fund’s inception (June 28, 2013).