Major Volatility Hits… Everything!
A global selloff on Monday left little untouched across multiple asset classes and currencies. The Japanese Nikkei 225 had its second worst day in history, collapsing over 12% on the back of interest rate hikes and impacts from currency volatility. The yen appreciated 10% against the US dollar in the past three weeks. This is significant as it has been the catalyst driving investors to unwind what is called the “yen carry trade”. The carry trade has been a significant funding source for global investors. The trading strategy involves borrowing money in a low interest rate and weaker currency country, while simultaneously reinvesting the funds in another country for higher returns. While Japan has been the go-to market for this, the sudden change in backdrop has forced traders to unwind this strategy and caused volatility to skyrocket.
In addition to the above-mentioned international dislocations, the following factors are leading to significant cracks in the stock market foundation closer to home:
- Continued weakness in US technology and growth stocks which were previously propping up the market;
- A weaker-than-expected US employment report has investors nervous that the prospects of a recession may be greater than the market’s consensus; and
- Surprise earnings disappointments seem to have investors scratching their overly optimistic heads!
Our CIO, Mathew Hermary, recently provided some excellent insight on the risks we’ve been wary of, which can be read here.
More Takeouts in the Canadian Small Cap Strategy
Switching to some better news. A couple of months back, Steve Kim, our Canadian small cap Portfolio Manager, said he wanted to buy me a coffee after one of our Investment Committee meetings. Steve is a passionate value investor, and I always learn something when chatting with him. He’s constantly bombarding me with articles about companies and industries or taking me through the economics of his holdings. I thought it would be a fun visit as I wanted to catch up and share some tall tales about my recent fly-fishing adventure. Fat chance of that, as he launched deep into the portfolio before I could get my hands up to show him how big the rainbow trout was!
His mood was a bit strained as he shared his frustration with how little interest the market was showing in what he believed were excellent companies. This reminded us of the classic Benjamin Graham quote, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.” In other words, the market can behave much like a popularity contest in the short term, but the true value of a business is what underlies the stock quote and will eventually be discovered. Not to be outdone by Benjamin Graham, Steve added, “Just because the market isn’t recognizing the true value of these businesses doesn’t mean it’s not there!” Within the next two months, nearly 9% of the Canadian small cap strategy had been acquired at significant premiums.
Big Bucks for Burgers and Beds
In addition to the acquisition of strategy holding Canadian Western Bank in mid-June, both Sleep Country Canada (ZZZ) and A&W Revenue Royalties Income Fund (AW/UN) were the targets of buyers within the past couple of weeks.
Sleep Country was acquired by Fairfax Financial for $1.7 billion, or roughly a 30% premium from where the shares traded. Sleep Country developed a strong franchise, maintained a healthy balance sheet and was able to generate considerable free cash flow. While the stock market didn’t seem to care much for these attributes, solid long-term investors at Fairfax did. A&W Royalties and A&W Food Services announced a strategic combination with an implied premium of 30%. The A&W transaction allows for possible continued ownership in a new entity with a heightened growth profile. We are currently assessing the opportunity as we believe the franchise to be strong and well-managed.
The Market is a Weighing Machine
We’ve now had five beneficial take-outs or strategic combinations in the Canadian small cap strategy since the start of the year. Historically speaking, this is very high. While we can’t control the stock market’s mood in the near term, if the market misprices assets long enough, either other businesses or private investors will step in to provide a truer value. The very healthy premiums on these transactions provide validation that we aren’t completely out of touch in our upside assessments. We see continued opportunity available to us in the unloved Canadian small cap space.
We continue to manage all our mandates with an eye to safety as we believe risks are elevated. We’re now currently witnessing this play out. Our portfolios are built on fundamentals which will allow us to manage through whatever the markets throw at us in the near term. In the meantime, if anyone wants to hear about that rainbow trout… I’ll buy the coffee!
