Things my dad taught me – 1st quarter, 2015
When I sat down to write my previous commentary in March 2014, my dad, Peter Chisholm, had just been diagnosed with pneumonia. Unfortunately, it turned out to be much more serious and within a few weeks he had passed away from an aggressive form of B-cell lymphoma. Since then, not a day goes by that I don’t think about the positive impact he had on my life, my family’s and others, many of whom I only came to know because of his passing.
Why is my dad’s impact on me important to you? I think it’s because we’re all products of both nature and nurture. Though I won’t attempt to qualify or quantify the natural value of the DNA he gave me, I’d like to tell you about how I was raised because I believe the values and beliefs my parents instilled in me have significant bearing on how I invest your savings. In my previous three commentaries, I attempted to describe how we think rather than what we think. I can’t imagine being able to provide better insight into this than telling you more about my background. In thinking about writing this commentary I also reflected on the fact that you’ve entrusted me with a part of your life’s savings and, in most cases, have no idea who I am except that I’m a member of EdgePoint’s Investment team. I hope, in a small way, to reciprocate your trust by shedding some light on the values I was raised with that shape the decisions I make on your behalf.
To start it might be helpful to give you a snapshot of my dad’s life. Later I will attempt to weave in how I believe he influenced my way of thinking. A large part of his life was spent in Lucan and London, Ontario, and in Placerville, California where my grandfather owned a gold mine. His mom (my grandmother) died when he was nine and he, his brother and two sisters subsequently spent over a year in an orphanage while my grandfather figured out how he would take care of four children. My dad started working at the age of 12 to help support his family and continued to do so well into his thirties. He was recruited by the Toronto Maple Leafs but instead chose to get a post-secondary education mainly because hockey players of that era didn’t make a very good living. To finish high school, he had to hitchhike 21 miles daily from Lucan to London because the high school in Lucan offered neither grade 13 nor a bus service. After high school my dad went to the Royal Military College (RMC), where he was a squadron leader and earned the nickname Pogo after the comic strip character (more on that later).
Post-graduation, he served in the Canadian special forces in Korea for a year and, because military service was compulsory for a free education at the RMC, he spent another three years as a Royal Engineer in Canada once the war ended. After leaving the military he got his Master of Engineering from the University of Toronto and attended Stanford for his PhD. He worked for many years as a consulting engineer. When he tired of the travel in 1969 he became a fulltime professor of engineering at the University of Guelph. Born at the start of the Great Depression, my dad didn’t believe the trying circumstances he had to overcome were any harder than the next person, which is probably why I heard the stories of his early years from my mom and not him.
My dad taught me countless lessons, but I thought it would be most useful to focus on the things that affect my day-to-day the most at EdgePoint and thus your investment with us.
Do well for the sake of doing well
“Truth, Duty, Valour” is the RMC’s motto. My dad chose to express these values to me in a very simple phrase: do well for the sake of doing well. He taught that if you set out to do your best and to do so selflessly that good things will follow even if the incentive to do well isn’t completely clear from the outset. At EdgePoint, I’m fortunate to be surrounded by people who share this core belief, as stated in our company creed, that we’ll put you first in all business decisions. As your fiduciary, we have a duty to act in your favour rather than in our own. We see this as much more than a legal responsibility. Being a fiduciary to you and your savings is the foundation for everything we do; it’s truly a guiding principle. You may expect this is a shared value across our industry, but I can assure you it’s not. For me, this is best illustrated by the growth of closet indexing, with 12 of 20 of the largest fund companies passing themselves off as active managers when in reality they’re closet indexers (Source: Cremers, M., Ferreira, M., Matos, P. and Starks, L., “The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance,” Social Science Research Network, 2013). Closet indexers do little more than collect fees to deliver investment results slightly worse than their benchmark after said fees are accounted for. I think you’d agree that truth and duty are sorely lacking in their endeavours.
Valour may not be the first attribute that comes to mind with portfolio management yet some amount of courage is always required. It takes courage to buy a stock when it’s down 40% in a single day – something Tye, Geoff and I have all done. Nothing we do is life-threatening and I don’t want to overemphasize the role of courage; however, our ability to live within a narrow emotional band under times of stress is a significant long-term contributor to your investment success with EdgePoint.
I mentioned earlier that my dad’s nickname at the RMC was Pogo after the comic strip character. This wasn’t just because of his amiable and philosophical nature; it was also because of the famous line from that comic: “We have seen the enemy and he is us.” My dad’s curiosity was pretty boundless. His friend spoke to this personality trait when he recounted a story about when they were stationed together in the Yukon after Korea. He remembered being on a hike in the mountains with my dad when they came across a cave or, maybe more appropriately, a den. My dad wanted to explore it and see what was in it. His friend replied that he’d wait for my dad a little ways away to give him a good head start when the grizzly bear that was surely inside started to chase them.
We’ve all heard someone described as having a “natural curiosity.” I actually don’t believe curiosity is natural. I’m not sure it can be taught either. It’s instead something absorbed through the observation of, and dialogue with, people around you during your formative years. My dad had extremely broad interests ranging from the natural world and all areas of science to sport and even philosophy, and his curiosity most certainly rubbed off on me. I’m sure his mom’s untimely death gave his curiosity further leeway, more than most moms would be comfortable with (including my own) especially when it came to carnivorous bears!
At EdgePoint, all five members of our Investment team are generalists, meaning we invest in businesses from around the globe and across a broad range of sectors. Most of our work is basic fundamental research on companies we’re interested in. Essentially we read all day and relish the joy of discovery that comes with it. Curiosity in knowing which caves to explore deeply and which to just peek into and move on from is essential to our investment success. You can thank my mom for helping me understand the caves to avoid.
Pay attention to details
If you assumed my dad was detail oriented because he was an engineer, you’re right. When helping me with my homework he’d always remind me to pay attention to the details. I heeded his advice. Moreover, he taught me that some details are crucial, others important and many more are completely insignificant. In investment research as in science, the best results are achieved by focusing on the first two categories of detail and ignoring the remainder. To achieve investment success you must be able to separate the signal (the crucial and important details) from the noise (the meaningless although often interesting stuff). We build spreadsheet models to understand the financial specifics of the companies we invest in. I believe the greater value to building these models is their ability to sharpen our questions about companies rather than their ability to predict investment returns. Key to our success is being prepared to ask the right questions in an inherently uncertain world. Knowing the right questions allows us to filter out the noise and find the salient details necessary to form, support or dismiss an investment thesis.
Being prepared with the right questions is important as is tempering the answers you get with a healthy dose of scepticism. You may think that someone who attended the RMC and was a special forces officer wouldn’t question authority. That wasn’t the case with my dad. This wasn’t born out of disrespect or cynicism. Rather, he learned from his experiences that even leaders make big, seemingly irrational mistakes and are often dogmatic in their denial of responsibility. When I talk to executives, I assume they’re telling me what they think I want to hear. Part of our process is to “trust, but verify,” meaning we don’t necessarily take management teams at their word and always confirm for ourselves the details they provide.
Mies van der Rohe probably said it best: “God is in the details.”
My fondest memories of my dad were when we went fly fishing on the Crowsnest River in Southwest Alberta. It’s a beautiful, peaceful place that I look forward to returning to.
My dad was an avid fisherman. In teaching me to fish there were many times when our patience was tested from hours spent in the rain without a bite or spinning reels that turned into bird's nests. My dad used to say that like most people, I preferred catching to fishing. As I grow older I’ve come to appreciate the subtleties of fishing, which include an often lengthy pursuit to achieve a result. I think the most important thing fishing has taught me is patience and I believe that without this a willingness to persevere is often difficult.
When EdgePoint launched its portfolios in 2008, finding good investments was like fishing a river full of many very hungry fish. As time has passed and the economy has improved, our ability to find good investments has become more like a typical fishing trip where both patience and perseverance are needed because the prize fish are less plentiful and not as hungry. It’s when investment opportunities are less fruitful that our collective 70 years of experience reminds us that hurrying the process through unnecessary activity is likely to do more harm than good. Our willingness to pursue opportunity is what's important; regularly making significant changes or rushing the process isn’t.
Patience is required both in pursuing new opportunities and with companies we already own. When we invest, we’re making an investment in the future of a company and things don’t always go as planned. Patience and calm are required to live through the short-term ups and downs of an investment’s results. Seizing opportunity and openly admitting our mistakes are two of the biggest determinants of our long-term success.
Process is important
At the University of Guelph my dad was known as the father of design. Whether it was planning a sewage treatment plant or Canada’s first solid waste recycling program, my dad used process to achieve his intended results. Along with telling me that I should do well for the sake of doing well, he also thought that a job should be done well or not at all. One of my chores growing up was cleaning the family swimming pool. The trick to this process was slowly and methodically vacuuming the silt from the bottom to ensure it didn’t stir up and make the water cloudy. Until I learned to master this process, I spent a great deal more time vacuuming.
At EdgePoint we use an investment process inherited from Bob Krembil, a process he developed and evolved over decades. While it’s not the only investment approach out there, we believe it’s superior. In my past three commentaries (Foxes and hedgehogs, Process versus outcome and We won’t deal in drama), I’ve highlighted why I believe it produces better results and have supported this with empirical evidence. Simply put, we invest in a concentrated portfolio of quality businesses. When we commit your dollars to a company, we take a long-term view. This process affords us the time to discover the best investment opportunities the world over, lucidly examine the details and patiently let the investment story unfold. It allows us to do our job well.
Global investment idea
EPAM Systems is a Pennsylvania-based global provider of outsourced software development and testing. I first came across EPAM while researching another EdgePoint holding (Atos SA) that also does outsourced software development. Unique to EPAM is that the majority of its software developers are in Ukraine and Belarus, with a few in Hungary and Russia. Though its developers are in Eastern Europe, its customers are global software companies like Microsoft and Google as well as large corporations with internally developed software like Canadian Tire. In researching EPAM, I learned it was the crème de la crème of outsourced software developers, more highly skilled than most India-based competitors and at least as skilled as large Western outsourcing companies like Accenture and Atos. What else set it apart from its Western counterparts? It was much cheaper on a rate basis and could do the job much faster.
When I first researched EPAM I saw a very attractive business with large growth opportunities. It had a very small share of the global outsourced software development market even though it was better and cheaper than its rivals. As its reputation grew for quality work at value prices, its revenue and earnings followed at a greater than 30% rate. Because of this, the stock was expensive so I just kept it on my watch list.
EPAM’s valuation became much more attractive in late February 2014 when the revolution in Ukraine began. It became even more attractive in March 2014 when elements of a civil war surfaced in Eastern Ukraine. When we started buying EPAM in March 2014 the stock had dropped almost 40% and was very attractively valued. Despite having a large percentage of its development staff based in Kiev, it experienced only minor disruptions during the political uprising. Most importantly, over 90% of its revenue came from customers in the U.S. and Europe. We learned from these customers that while they were concerned and continually monitoring the situation in Ukraine, this wasn’t new to them. They had experience working with other outsourcing partners that were operating in conflict zones like India, Russia, Morocco and Tunisia. It was something they’d learned to live with.
We managed to get a small position in EPAM into the Global Portfolios in March and April of last year. As EPAM continued to report great financial results and other investors came to understand that the conflict was isolated to Eastern Ukraine (far from EPAM’s developers) the stock recovered all of its losses and then some. We sold our position when the valuation became less attractive relative to the opportunity.
Canadian investment idea
At an investment conference in August 2011, I saw a presentation by a Canadian company called Altus and subsequently researched it. Though interested, I was uncomfortable with the amount of debt it had and decided to pass. But, in doing my research, I discovered that it had an equity stake in another company called Real Matters. Despite it being privately held, I managed to do some digging, including talking to a friend who chaired the Appraisal Institute of Canada, the industry Real Matters was involved in.
We then talked to a banker and suggested we’d be interested in buying Altus’s equity interest in Real Matters if it was interested in selling it to reduce its debt. Tye, Geoff and I met with the recently appointed CEO who, in our meeting, gave us an “if you’re interested in buying, I probably shouldn’t be interested in selling” look. He declined our offer.
Real Matters subsequently needed to raise capital so after meeting with its CEO and CFO, we decided to invest. The company essentially automates the real estate appraisal process making it much more efficient, effective and less costly. It also provides a better valuation framework to ensure real estate is appropriately valued. Part of this opportunity stems from the new regulatory process in the U.S. that ensures the banks that are doing the lending aren’t also doing the appraising. This safeguard prevents banks from inflating real estate values and lending opportunities. CEO Jason Smith, founder and significant shareholder of Real Matters, and his team have delivered more than we imagined possible. They’ve taken the company from a standing start to gaining a 9% market share. Real Matters recently signed some significant customers and we expect it to continue to substantially grow its share.
I feel very fortunate to have been raised by my parents in a way that they felt would allow me to positively impact the world. I also feel fortunate to work with people at EdgePoint who share the same values and beliefs. We’ll continue to apply them to our common goal of achieving investment performance at or near the top of the categories we compete in over a ten-year period.
By Frank Mullen, portfolio manager
“Anybody who is intelligent and not confused doesn’t understand the situation very well.”- Charlie Munger, Daily Journal AGM, March 2015
While I’m certainly not professing to be as intelligent as Munger, I found the above quote comforting considering the level of confusion that I’m experiencing when analyzing the current global interest rate and credit environment.
Low rates simply keep going lower
This time last year we would have characterized the environment in which we were operating as a low-rate environment and yet rates have continued to drop significantly around the world. While we used to think that Canadian government bonds yielding 2.5% were low, today those same bonds yield 1.35%, falling 115 basis points (bps) in only 12 months. This isn’t isolated to Canada with U.S. and German rates falling 85 and 140 bps respectively. In fact, most developed nations have experienced similar decreases.
Typically investors buy bonds to earn a yield, but over the last 12 months they were rewarded with unusually high bond returns as a result of falling interest rates and the subsequent price appreciation. For example, if you had bought a 10-year U.S. government bond at the beginning of 2014 and held it for one year, you would have earned over 10.5%, a great return for a bond whose starting yield was only 3%. We’re in a much different place today as your starting point is a yield of just 1.9% and bond prices are higher. Rates would have to fall approximately 100 bps to experience another 10% year, which would leave 10-year interest rates under 1%. Though many investors are focused on equity markets with high valuations, the majority fail to see that similar risks currently exist in bond markets. Strong recent performance has reduced the potential for future returns.
Discussing returns is only one side of the coin. You can only judge the attractiveness of a potential return by comparing it to the risks that must be taken to achieve it. We’ve long believed that rates will rise at some point. We certainly try to understand what happens to an investment if rates do in fact reverse course but we don’t believe we have any ability to predict the timing. The significant returns investors of long-dated bonds earned recently will reverse if rates begin to rise. In my opinion, current low yields don’t compensate for this risk.
There are some fixed-income traders who purchase low-yielding bonds with the expectation that rates will continue to fall. They do so expecting to sell their bonds before the eventual increase. We don’t think we’re smart enough to make those calls and continue to keep our bond duration very short.
The Costanza approach
Traditionally one would think that 0% is the lowest yield possible for a fixed-income investment but rates are now negative in several parts of the bond market. What does this mean? We’re now in an environment where instead of earning a yield for loaning money, investors are paying the borrower for the right to do so.
Danish, Swiss and German government debt up to five years in maturity now trade at negative yields. This trend was buoyed by recent comments by the European Central Bank when it indicated its willingness to buy bonds with negative yields through its quantitative easing program. Don’t think this is unique to government debt, we’re seeing similar trends in the European corporate bond market too.
I have written in the past about the deterioration of credit quality in the North American high-yield market. Investors’ thirst for yield has not only driven credit spreads tighter and bond yields lower but it has also put the negotiating power in the hands of the borrower. It was unconventional when we started to see borrowers issuing debt without restrictive covenants traditionally in place to protect investors. It’s gotten even more perverse with investors actually buying bonds from companies unwilling to disclose its financials. How can you judge the creditworthiness of an investment without looking at their financials? Buying bonds based solely on their yield with no concern for the underlying fundamentals of the borrower seems to be a recipe for disaster. We pride ourselves on our ability to perform in-depth credit analysis. It’s the foundation of our investment approach. Rest assured we will never purchase debt or equity of a company without looking at its financials.
How we’re managing risk
When considering the points above, I see many potential risks lurking for fixed-income investors. There’s no way of knowing if any of these risks will cause investors harm, but I believe it’s prudent to invest like they could. An investor must be compensated for taking on risk and in this low-rate environment it’s difficult to understand how one is. With that in mind, we continue to be very comfortable maintaining our fixed-income allocation in the Growth & Income Portfolios toward the low-end of its spectrum at 30% and keeping our duration short, staying clear of long-dated bonds.
Our investment approach focuses on credit analysis and the development of proprietary insights. This has historically helped steer us away from many of the risks that I’ve discussed and we continue to have confidence that we will find attractive opportunities.
Risks beget opportunities
The recent volatility in the oil market has had material implications for the high-yield market and we’ve made investments to take advantage of the potential opportunity. Those familiar with our investment approach know that we view volatility as opportunity and not as risk. If you believe you know the value of a business and its debt, you hope the price will drop suddenly because it gives you the opportunity to invest at a lower price. The drastic drop in the price of oil has affected the fundamentals of all businesses in the energy industry, including their debt. Although short-term fundamentals have changed, so too have the prices of these securities. Many oil and gas producers and energy service companies have seen their equity and bond prices drop materially. Our focus has been on finding companies whose fundamentals are strong enough to withstand a prolonged period of low energy prices and hopefully come out of the downturn stronger than when they went in. We’ve been selective in adding to the sector but have increased our weights in several issuers and continue to look for opportunities in the space.
I think it’s fitting to end with another quote from Charlie Munger that encapsulates how we’re trying to operate in this environment. We strive to add value to our clients not only by finding attractive investment opportunities but also by not participating in situations that we do not fully understand. Today, risk avoidance is just as important to returns, if not more so, than yield generation.
“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”- Charlie Munger