This article is authored by MOI Global instructor Reno Giancola, Portfolio Manager of Alignvest Capital Management, based in Toronto, Canada.
There has been a significant underperformance for the Canadian equity market relative to the U.S. equity market since January 2011. For context, at the end of Q3 the TSX was up a scant 4.6%, versus 12.9% for the S&P 500 Index.
So why do we choose to focus most of our effort on Canada? What gets us so excited to come to work every day is the belief that the characteristics of the Canadian equity market make it perfectly suited to active management, and there is tremendous opportunity to add value through research and security selection. Why?
The Canadian business environment is generally less competitive for a variety of reasons. Sometimes it’s because of regulatory protections; in other cases, it’s market conditions (large geography, small population, significant regional differences). Whatever the reason, it’s hard for large foreign businesses to enter the country and succeed in building a national business from scratch (just ask Target!!).
These barriers allow for more durable competitive advantages and persistently higher returns on capital than would be the case in more competitive markets. When it comes to the capital markets, investable assets in this country are highly concentrated among large financial institutions whose size prohibits them from investing in anything other than large-cap companies. Even the huge flow of funds transitioning to passively-managed strategies is largely devoted to large-caps where liquidity is paramount.
The result of these conditions is that we are able to find some outstanding mid-cap companies at quite reasonable valuations. In many cases, these businesses are run by owners who have the vast majority of their wealth tied to the success of the business and take things like capital allocation and financial flexibility seriously.
Many of our most successful investments are companies in this strata that are able to grow either in size (to become “investable” for a larger pool of capital) or strategic relevance (to potential foreign strategic buyers who are looking to “buy” rather than “build” their way into our country), at which point there is a step change in valuation multiples.
The key to finding these remarkable businesses goes beyond simple financial statement analysis and valuation. An investor needs to understand industry dynamics, competitive advantages, track record of capital allocation, governance, management incentives, etc. That requires gaining additional perspective through discussions with management, customers, suppliers, competitors, shareholders, brokers and other industry contacts.
We’ve spent our whole careers looking at mid-cap Canadian equities and we believe our knowledge, experience and network provide us with a significant edge in this regard. It’s not to say we won’t invest outside this sphere, but it’s where we devote most of our time and research effort. By focusing on an inefficient part of the market, and concentrating our capital among our highest conviction ideas, we believe we are in a position to generate attractive long-term returns, well above (and largely independent of) the overall Canadian equity market.
We believe that AutoCanada Inc. (ACQ-T) is a very attractive investment. AutoCanada is the largest publicly traded automotive dealership group in Canada. We first discovered the company in 2009 while at our prior firm, when it (along with the entire auto industry) was facing an existential crisis.
We were impressed by the CEO and founder Pat Priestner but felt like the company could be more effective with its capital structure and growth strategy. We joined forces with a few other large shareholders and were successful in effecting several important changes (dividend policy, capital allocation, board composition).
From 2010-2014, a combination of extraordinary growth (both organic and via acquisition) and multiple expansion took the stock from $4.00 to a high of $92, and it proved to be one of the best investments we’ve ever made. In 2014, after we had exited the position, Pat Priestner sold a significant portion of his equity which didn’t sit well with many investors. That was followed by a collapse in oil prices that weighed heavily on the Alberta economy (at that time, the vast majority of the company’s dealerships were located in Western Canada and a big part of the company’s success was selling highly profitable trucks to labourers during the preceding oil boom).
In 2016, Pat passed the CEO baton to Steve Landry, former head of Chrysler Canada and global head of Dodge. In an effort to diversify away from its Alberta exposure, Mr. Landry continued on an aggressive acquisition strategy, but a combination of higher prices paid for dealerships and poor integration resulted in anemic returns on this capital. Shortly thereafter, a balance sheet crunch forced the company into a 60% dividend cut and the wheels really started to come off.
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