2010 ANNUAL REPORT TO UNITHOLDERS
We are pleased to provide you with The Investment Partners Fund year-end report including our audited financial statements and year-end commentary.
RESULTS IN 2010
We have calculated the performance of the Investment Partners Fund total return relative to the S&P/TSX Composite Total Return Index to December 31, 2010:
* Performance is presented before fees and since inception figure is cumulative, not annualized. ** October 1, 2009.
RELATIVE VERSUS ABSOLUTE PERFORMANCE
While we are pleased with our 2010 annual performance on an absolute basis, you can see that we slightly underperformed the Index on a relative basis. The simplest explanation for this relative outcome is our average cash balance of 47.8% during the year.
With today’s low interest rates, our rate of return on our cash did not add to our performance in a meaningful way. However, since inception (October 1, 2009), we finished the year 2010 ahead of the Index while maintaining an average cash balance of 45.5%. It is important to note that the average annual return from the Index over the last 55 years has been 9.6% so the Index return in 2010 was about 8% higher than the historical average.
This brings us to an important point about relative versus absolute performance. Given our sector weightings disclosed at the end of each month (bearing little resemblance to the Index) and our tendency to carry large cash balances, it is clear that the Index plays no role in influencing our investment decision making. The Investment Partners Fund, and therefore by definition, 100% of the Portfolio Managers net worth, is invested with an absolute return focus and not a relative return focus. We believe this is the best way to manage money.
This may mean that there are periods where our performance is significantly different than the performance of broad indices. We are comfortable with this fact and are confident that the right way to invest is to judge an investment on its own merit, independently and objectively. When we invest in a stock, we believe that we have a high probability of making a profit and that the profit will be adequate compensation for the risk that we may be wrong. We do not buy a stock so that we can have more or less of it as a percentage of our portfolio relative to an index, in the hopes of beating the index in this manner. There are funds out there that do this. We are not one of them. We do not believe the broad indexes are the best possible collection of investment alternatives relative to the risk investors bear by owning them. Indexes, by definition, do not carry a cash balance and are fully invested all the time.
During periods of up trending stock prices, indexes will produce very attractive results. Up trends do not last forever and we know from experience that many investors make unfortunate decisions during periods of downside volatility. The only risk management tool present in an index is individual security and sector diversification. This will likely protect you from losing all of your money by investing in an index (ie. we cannot imagine a scenario where a major equity index value goes to 0).
However, it does not necessarily protect you from mediocrity. Index investing simply ensures that you achieve average performance. We present the performance of the Index to alert investors to an alternative approach that is widely recognized and followed by investors, but you can be assured that we will not be influenced by it.
WHAT MAKES THE INVESTMENT PARTNERS FUND DIFFERENT?
Our assets under management grew from $2.2 million at the end of 2009 to $16.2 million at December 31, 2010 (the Fund is just under $20 million today). We have had added many new investors to the Fund in 2010, most of whom have seen our full presentation describing our investment process and philosophy in detail. We have decided to present all our unitholders with highlights of some of the more important points as a reminder of what makes us unique.
Back in the 1920’s, the first mutual fund was created. By 1929, there were approximately 19 open-ended mutual funds available in the US. Fast forward to 2011. A quick search through GlobeFund’s database of all non-index mutual funds in Canada, yields over 13,000 mutual funds. For comparison purposes, there are slightly more than 2,000 stocks listed on the Toronto Stock Exchange.
Something has been lost in the proliferation of the mutual fund industry. Many of the advantages of its simple structure, professional management, diversification, and economies of scale, have been overshadowed by a failure of investors to achieve the results they expected and paid for. The median compound annual average rate of return of the Global Equity category in the GlobeFund database for the 10 year period ending December 31, 2010 is -1.3%. The median management expense ratio for this same group of funds is 2.88%. Investors have good reason to be frustrated and cynical. Many of the most “successful” funds in Canada, which in industry terms means the largest funds, are characterized by having a large number of holdings that look very similar to broad market indexes. These traditional funds are managed by portfolio managers that also manage other funds and may or may not own units of the fund they are managing. We think successful should mean the “best performing” for a given level of risk and not necessarily “the largest”. The benefits of mutual fund size do not accrue to the investor as much as they do to the mutual fund company.
We created The Investment Partners Fund to address these “structural” problems. There are three key differences that make The Investment Partners Fund unique:
Alignment of interests between the Portfolio Manager and the investor
- The Portfolio Managers only manage one fund, The Investment Partners Fund.
- 100% of the investable net worth of the Portfolio Managers is invested in the Fund alongside unitholders. We filed this promise in writing with the Ontario Securities Commission in our Statement of Investment Policy.
A disciplined investment process that emphasizes three characteristics
- Scott Jarvis, CA, CMC, CFA has over 16 years of experience in the financial services industry and is a co-founder of the Fund with 100% of his investable net worth invested alongside unitholders.
- Brian Durno, CFP, CFA has over 14 years of experience in the financial services industry and is a co-founder of the Fund with 100% of his investable net worth invested alongside unitholders.
- The Fund was founded on a shared belief in our unique investment philosophy and a commitment to the disciplined execution of our investment process.
The basis for our investment process is the creation of a trading range for a particular stock. We create a downside and an upside target range that we believe a stock should trade within. We try to buy stocks when they are trading at the bottom end of our range (ie. on weakness) and sell them as they approach the high end of our range (ie. on strength). This concept is simple but not easy. Before we buy a stock, we always have a plan in place. We know at what price we would like to buy, what price we would like to buy more at and what price we would sell the full position. We perform this analysis for our entire investable universe which is made up of over 700 of the largest companies in the world. Then, we wait and watch, every single trading day (this is one reason why there are two of us). We require the market to move a stock into our buy range. As we are always buying on weakness, our buys tend to occur when there is some recent bad news.
For example, a recent holding, Family Dollar Stores (FDO), released its first quarter earnings on January 5, 2011 and missed analysts estimates by about 5%. FDO declined more than 9% the day of the release. That put FDO on our radar screen. Over the next month, investors continued to punish the stock and drove it down far enough for the upside reward to greatly outweigh the downside risk and we entered the stock at $41.60 (February 2, 2011), more than 15% below the price one day before the earnings miss back in January. It is always part of our plan to “dip our toes in” and not buy a full position all at once. That way, if a stock price falls after our initial purchase (which tends to happen more than most investors like to admit), we are prepared to buy more and lower our average cost. On our initial investment, FDO became about 3% of the Fund’s assets. We were expecting to see continued pressure on the stock and were prepared with surplus cash to average down. However, we were not the only investors watching this story. Before the market open on February 16, 2011, a story broke on the Wall Street Journal (online) that activist investor Nelson Peltz was proposing a purchase of FDO for a valuation of between $55 – $60 per share. As experienced investors in merger arbitrage situations, we carefully analysed the proposal and quickly concluded that this offer was not solicited nor did it have the support of FDO’s board of directors. In deal making terms, there was a very real risk that this deal would not proceed on the proposed terms. More importantly, the offering price was well above our sell target. We entered our sell order at the open and sold the majority of our position in the first 30 seconds of trading that day and completely exited at a realized price of $55.50. We never enter a stock with any expectation of an outcome like this, however, we are pleased to take advantage of opportunities when they present themselves.
INVESTABLE UNIVERSE AND PORTFOLIO MANAGEMENT
Our investable universe consists of about 700 of the largest and most liquid companies in the world. When investing in companies outside of Canada, we will utilize a hedging strategy to mitigate against fluctuations in foreign currency.
To be considered for our watchlist, a company must exhibit the following characteristics:
- Liquidity/high trading volume: Allowing us to buy or sell the stock without having any influence on its trading price.
- A strong balance sheet: We do not want to invest in a company whose balance sheet might become a headline.
- Overall company quality: Determined by standard financial criteria (return on equity, return on invested capital) as well as its competitive advantage.
Our trading ranges are created based a careful analysis of three factors:
- Historical financial information: Information is used for the last 20 years if available.
- Industry comparable information: Companies are compared to other companies within their peer group/industry.
- Current market conditions: Trading ranges are updated dynamically to reflect market conditions.
The portfolio is built from the bottom up, meaning we invest in companies based on their relative attractiveness compared to all other investment opportunities on a risk adjusted basis. We carefully monitor the Fund to ensure appropriate diversification. The Fund will be concentrated on our best 10-20 investment ideas. In the absence of great investment ideas, we will remain comfortably in cash. It will not be uncommon for us to carry larger cash balances than traditional mutual funds, especially during long periods of rising markets.
We would like to thank our investment partners and we look forward to continued partnership in 2011.
Brian Durno and Scott Jarvis