Partners' Fund Quarterly Report
December 31, 2017
The Partners’ Fund invests in high-torque, early-stage companies that have the potential to generate superior returns.
Repap & Outlook
The Partner’s Fund delivered a net return of 36.6% in 2017. This compares to the TSX Venture Exchange which rose 11.6%. Our annualized 5-year return is 22.0% compared to the TSX Venture Exchange which lost 7.0% per year on average over the same period. The table below provides a performance summary:
We are pleased with the Fund’s performance for the year, but caution that the last two years of performance results are unsustainable and not likely to be repeated. Over the last 2 years, we benefited from an exuberant small cap market and speculative frenzy where valuations for many companies have been pushed too high. This exuberance can certainly continue for some time, but eventually the laws of gravity and supply/demand will kick in.
In our 2015 Annual Report, we wrote that it is when times are tough that the best deals present themselves. Times certainly were tough then; two years ago we had leverage in negotiating deals, less competition and lower valuations. This led to quality investments and strong returns. Fast-forward to today and times are far from tough; the small cap bull market has led to confidence, greed and high valuations. For most companies (but not all!), valuations are too high to generate attractive returns for the indiscriminate investor. This moderates our return outlook.
One of the risks to an extended bull market and high valuations is a lack of investment opportunities. In our portfolio management process, a lack of opportunities will lead to a large cash balance (as we are unable to find ‘great’ ideas to invest in). Fortunately, we are still able to fully invest the portfolio and haven’t encountered this phenomenon for a prolonged period of time yet.
The ability to fill the portfolio with compelling opportunities comes from our process. One of our admired investors, Peter Lynch, once commented:
“The person that turns over the most rocks wins the game”
We follow the same philosophy and individually meet hundreds of management teams each year to find new investments. By turning over more rocks and investigating more companies, we create competition for inclusion in the portfolio. This leads to a higher quality portfolio.
We protect our unitholders’ capital and reduce our risk of permanent losses by selling companies as they approach or exceed our estimate of fair value and rotating into new ideas at a deeper discount to fair value.
We remain bullish on the portfolio and our outlook for 2018 remains positive, but with moderated return expectations compared to previous years.
What We Noticed
Some winners work out very fast; others require a healthy dose of patience. This year we had a balanced mix between the two.
Three investments that worked out quickly during the year were Neurotrope Inc (NASDAQ:NTRP), Radient Technologies Inc (TSXv:RTI) and Assure Holdings (TSXv:IOM). All three buys were initiated this year and the stocks contributed 4.0%, 3.4%, and 3.2% to gross performance, respectively.
Investments that generated gains in 2017 after long holding periods were Posera Inc (TSX:PAY), AnalytixInsight Inc (TSXv:ALY), and Imaflex Inc (TSXv:IFX). For all three companies, we are glad that the stock price languished for years after our purchase. It allowed us to gain a deeper understanding of these companies and continually buy more, eventually resulting in a larger portfolio weight and profit contribution. These stocks contributed 5.1%, 4.3%, and 4.2% to gross portfolio returns, respectively.
We first purchased Imaflex in January 2015 at a price of $0.45. For the next two years we continued to add to our position, more than doubling our ownership from the original purchase as the company steadily grew revenues and increased earnings. Entering 2017, exactly two years after our initial purchase, the stock price was flat from our original entry point. During 2017 Imaflex increased by 122%. Similarly, Posera and AnalytixInsight were purchased in 2014 and 2016, respectively. This year, their stock prices appreciated by 107% and 176%.
While we generated strong returns from the above investments, we had our fair share of mistakes and stinkers.
Burcon Nutrascience Inc (TSX:BUR) declined by 76% during the year and 68% from our original purchase price in 2017. We compounded this error by continuing to add to our position as the stock declined, only to see the stock price fall by another 50+%. We underestimated the difficulty that Burcon’s license and production partner Archer Daniels Midland would have in selling their soy protein product once their plant was commissioned. We also misread the impact of shifting consumer preferences away from soy products in the Western world.
Datawind Inc (TSX:DW) declined by 77% during the year and we made the same mistake as with Burcon in adding to our position and compounding our losses once the stock went even lower. Enamored by the potential upside in the low-probability event that everything went to plan, we ignored too many red flags. Most importantly, we underestimated the impact of the Indian banknote demonetization where the government replaced their main banknotes which created prolonged cash shortages (Datawind’s product is sold mainly through home deliveries and paid by cash!).
Changes Going Forward
As we wrote in a recent update, we believe the Partners’ Fund has reached an optimal size. We will be closing the Partners’ Fund to new purchases on February 28, 2018. Our plan is to operate the fund at a size of between $50 and $80 million in assets, depending on market conditions. Once the fund reaches the high end of our operating range, we plan to return excess profits to unitholders.
We wish to preserve the ability to generate superior returns for all unitholders. Our number one priority is to generate the best returns for clients and ourselves. If forced to choose between maximizing performance and generating fees, we will choose to maximize performance. This is part of our Equally Invested™ culture where everyone at Pathfinder invests their own capital alongside clients and pays the same fee. We believe that too many investment firms focus on growing size and generating fees at the expense of returns.
There is a risk that an increase in size could adversely affect performance. We have seen this story play out in other funds who grow too big to execute on their mandate. We would like to avoid the possibility of this outcome. Allow us to elaborate why increased size is a potential detractor from returns. As a fund’s assets grow, it must either a) Own an increased number of investments or b) Own larger amounts of each holding.
The Partners’ Fund is managed as a concentrated portfolio with most of the fund invested in our top 20 holdings. We think it is valuable to invest in our best ideas and don’t want to be owning our ‘100th best idea’. Regular readers of our quarterly may remember that we often write about being selective in our investments and attempt to only invest in ‘great’, not just ‘good’ ideas. We can clearly see that if there are more companies in the portfolio, we will be forced to dilute the quality by investing in merely ‘good’ ideas – not an attractive option.
Since we are unwilling to own an increased number of investments, we now examine the potential of investing larger amounts in each investments. For context and background, regulatory constraints make it cumbersome and disadvantageous to own over 20 percent of a public company. In practice, it is often impractical and difficult to obtain ownership of greater than 10 percent of a company.
We have historically found some of our best investment ideas come from companies whose market caps are very small, often $20 million dollars or less. If the fund grew too big, we would be unable to invest in such ideas. For example, if the fund were $200 million in size, we would need to own half of the company to establish a full-weight core position! Clearly, this is not feasible. By keeping the fund nimble, we can continue to invest in these small companies. If these investments perform well, their returns will be meaningful on a percentage basis. We strive to have our positive investments make a difference to each unitholder’s bottom line.
We don’t know the exact amount at which increased size will have an adverse effect on performance and don’t intend to find out. For this year, we are confident that we can operate the fund efficiently with a beginning capital balance of $50 million. The optimal size of the fund will vary depending on market conditions and we will aim to be conservative in our assessments so that returns are not at risk of declining due to increased size. There is potential to re-open the fund at some point if our view changes or after a return of capital in the future.
We look forward to hearing your feedback on this change. If there are any questions on the above explanation we are happy to speak further. Thank you to all investors for the continued trust and support.
National Instrument 31-103 requires registered firms to disclose information that a reasonable investor would expect to know, including any material conflicts with the firm or its representatives. Doug Johnson and/or Pathfinder Asset Management Limited are an insider of companies periodically mentioned in this report. Please visit www.paml.ca for full disclosures.
*All returns are time weighted and net of investment management fees. Returns from the Pathfinder Partners’ Fund and Partners’ Real Return Plus Fund are presented based on the masters series of each fund. The Pathfinder Core: Equity Portfolio and The Pathfinder Core: High Income Portfolio are live accounts. These are actual accounts owned by the Pathfinder Chairman (Equity) and client (High Income) which contain no legacy positions, cash flows or other Pathfinder investment mandates or products. Monthly inception dates for each fund and portfolio are as follows: Pathfinder Core: Equity Portfolio (January 2011), Pathfinder Core: High Income Portfolio (October 2012) Partners’ Fund (April 2011), Partners’ Real Return Plus Fund (April, 2013), and Partners’ Core Plus Fund (November 2014).
Pathfinder Asset Management Limited (PAML) and its affiliates may collectively beneficially own in excess of 10% of one or more classes of the issued and outstanding equity securities mentioned in this newsletter. This publication is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author has taken all usual and reasonable precautions to determine that the information contained in this publication has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze such information are based on approved practices and principles in the investment industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, neither the author nor PAML can make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your portfolio manager, who can assess all relevant particulars of any proposed investment or transaction. PAML and the author accept no liability of any kind whatsoever or any damages or losses incurred by you as a result of reliance upon or use of this publication.