VOLUME XXIII JULY 2013

INVESTMENT ISSUES STRATEGIES INSIGHTS FROM DONVILLE KENT

Steady as she goes

So far, 2013 has been a good year for investors in common equities that are not linked to the commodity based industries (gold, base metals, and fertiliser). US markets have performed well and the non-resource sectors in Canada have also fared well. For investors in the Capital Ideas Fund, the first half of 2013 has been quite strong with the Fund up 13.7% as of the 1st of July with the TSX Composite down 2.5% over the same time period. My best guess is that the second half of 2013 will also be good for investors in our fund. Weak aggregate demand probably means good stock markets Global stock markets have been in recovery since April of 2009 and indeed one could argue that most stock markets have improved much quicker than the underlying economies they represent. But now the economy has caught up with the market and everything appears to be nicely in sync. US and Canadian economic growth is steady, employment is gradually improving and issues of systemic risk are now rarely discussed. Japan appears to be getting around to solving its problems, in Europe things seem to be getting slightly better and Emerging Markets have slowed but still remain buoyant. Overall, the global economy looks pretty solid. So where do we go to from here? The current market up-cycle is roughly 51 months old and a typical up-cycle lasts 60 months. However, no one market cycle is the same and there is strong evidence to suggest that the current up-cycle will probably be prolonged and here is the underlying logic. In most economic up-cycles since the end of WWII, the party comes to an end when aggregate demand begins to exceed a certain base level of growth (2.5% - 3%) and therefore inflation worries begin to emerge. When growth and/or inflation begin to exceed certain targeted levels, the response from Central banks is to tighten credit through a variety of measures until such time as these inflationary worries abate. Credit tightening typically brings the stock markets up-cycle to an end. Thus, inflation and/or surging levels of GDP growth are the sign that the current cycle is about to end. However, while the global economy appears to be growing at a nice pace, the likelihood of surging aggregate demand appears

to be fairly remote. As the Bank Credit Analyst has recently noted, the world economy is burdened with excess savings and inadequate demand. As such, the likelihood that interest rates will rise significantly in the near term remains remote and therefore the idea that a strong stock market will persist is high. But what about longer-term? Looking into 2014 and 2015 the possibility of a surge in aggregate demand remains equally low and there are two primary reasons behind this prognosis. First, governments and individuals throughout the western world are still carrying too much debt and when that happens, consumption (which drives aggregate demand) tends to be weak. Second, the biggest demographic cohort in the western world, namely the baby boomers have entered their low consumption years. People approaching or in their retirement years tend to spend heavily on a few things like travel and health care, but cut back sharply on most other things. The bottom line is that I expect the next decade will see quite modest levels of aggregate demand growth, but this could very well make for an excellent decade for growth stocks. The markets new sweet spot I recently read an article about the phenomena of market bubbles. This article focused on the creation of and the bursting of the commodity and gold bubbles which is happening as we speak. At the same time, the article speculates on what would be next sector to bubble up and burst. The author suggested that both the bond market and the dividend aristocrats market could be next. The authors perspective was to try and assist investors in avoiding the pitfalls of being in the wrong place at the wrong time. Of course, the other area of bubble analysis is to attempt to identify the next big idea before it happens. Bubbles are nasty when they burst but as those who bought gold stocks in 1999 know, its a great ride during the 7-10 years it typically takes to form a bubble. Trying to find the next big idea is part and parcel of being in our profession. So where do I see the next big idea? In my view, knowledge based companies are the place to be. What is a knowledge based company? They are companies that use technology, science and/or sophisticated and complex operations to create a value proposition that has two qualities. First, the companys good or service can be sold at a significant premium to what it costs in terms of inputs and this is reflected in high profit margins. Second, the uniqueness of the product protects the company from the assault of potential competitors. A knowledge based company that possess these two attributes is typically a company that can generate a high ROE (20% +) on a sustained basis. I also believe that such companies are among the few that can generate high ROEs in a low aggregate demand environment. So what are our favorite knowledge based businesses in Canada? While the Canadian market is not anywhere near as big as the US, we are lucky to have enough great companies here to create reasonably well diversified portfolios.
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The following ten companies which represent 58% of our Assets Under Management (AUM) and are listed in order of their weightings in our fund are companies that leverage knowledge and have the potential to grow at more than 20% per annum for the next 5-10 years. Constellation Software (CSU) - is a leading provider of software and services to a select group of public and private sector markets. They are based out of Toronto but service over 30,000 customers in over 30 countries. CSU has a 5 year average ROE of 74%.

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CGI Group (GIB.A) - together with its subsidiaries, provides information technology (IT) and business process services in the Americas, Europe, and the Asia Pacific. It primarily serves government, financial services, manufacturing, retail and distribution, telecommunication and utilities, and health markets. CGI has a 5 year average ROE of 22%.

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Enghouse Systems (ESL) - develops enterprise software solutions worldwide. It operates in three divisions: Enghouse Interactive, Enghouse Networks, and Enghouse Transportation. ESL has a 5 year average ROE of 21%.

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Paladin Labs (PLB)- a pharmaceutical company, engaged in researching, developing, acquiring, in-licensing, marketing, and distributing pharmaceutical products to pharmaceutical wholesalers, chain pharmacies, and licensees in Canada and internationally. It focuses on various therapeutic fields, such as urology, pain/central nervous system, womens health, allergy, endocrinology, and dermatology. PLB has a 5 year average ROE of 29%.

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MacDonald Dettwiler (MDA) - a communications and information company, provides operational solutions to commercial and government organizations worldwide. It offers commercial communications satellites; and supplies antenna solutions for communications satellites, as well as satellite payloads, antenna, and electronic subsystems. MDA has a 5 year average ROE of 37%.

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Open Text (OTC) - provides a suite of information management software products and solutions. It has a strategic alliance with SAP, Microsoft Corporation, and Oracle Corporation. OTC has a 5 year average ROE of 23%.

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Cipher Pharmaceuticals (DND) - operates as a specialty pharmaceutical company that commercializes novel formulations of marketed molecules. The company focuses on in-licensing clearly differentiated products, advancing them through the clinical development and regulatory approval stages, and either out-licensing to marketing partners or, in the case of the Canadian market, the company may market the product on its own. DND has a 2 year average ROE of 43%.

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Solium Capital (SUM) - provides software-as-a-service solutions for equity administration, financial reporting, and compliance to private and public companies worldwide. The companys proprietary grant-based incentive and savings plan administration products enable companies to automate and manage their grant-based plans and share purchase plans. SUM has a 5 year average ROE of 23%.

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Valeant Pharmaceuticals (VRX) - a specialty pharmaceutical company, develops, manufactures, and markets pharmaceutical products and medical devices in the areas of neurology, dermatology, and branded generics. It offers dermatology, dentistry, ophthalmology and neurology products as well as a range of treatments, including antibiotics. VRX has a 3 year average ROE of 24%.

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Pulse Seismic (PSD) - engages in the acquisition, marketing, and licensing of two-dimensional (2D) and three-dimensional (3D) seismic data for the energy sector in Western Canada. The company owns a licensable seismic data library that consists of approximately 27,630 net square kilometers of 3D seismic data and 340,000 net kilometers of 2D seismic data covering the areas in Alberta, British Columbia, Saskatchewan, Northwest Territories, and Manitoba. PSD has a 5 year average ROE of 32%.

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Final Thoughts The first half of 2013 has been among our best starts since inception. We expect the second half of 2013 to be strong as well. Call me or write me if you want to chat J.P. Donville Jason@donvillekent.com - 416-364-8886

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