Jerome Hass, Portfolio Manager at Lightwater Partners

Focus: Canadian mid-caps and long-short strategies
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Market Outlook
Tuesday, November 8th will be one of the most emotionally charged U.S. elections in history. The entire world has a substantial stake in the outcome and capital markets are going to be influenced regardless of who wins. New global powers such as China are flexing their muscles, particularly in the South China Sea. With the announced formal notice of the UK’s intention to exit the European Union in Q1 2017, many say that the full impact of Brexit has yet to trickle down. On top of all this, the effectiveness of central banks is coming under stress. Negative rates are uncharted territory. Central Banks are literally making this up as they go without any precedence to guide their actions. In short, there is a lot of potential market volatility ahead in the coming quarters.

Since our inception nine years ago, we have been agnostic to market conditions. We are a hedge fund that actually hedges and always has portfolio insurance in place in the form of our short hedge positions. This mitigates volatility and reduces correlation with markets. It also allows us to concentrate on company-specific risks without being concerned about market fluctuations and global macro events. As markets and the political environment become more volatile, investors should seriously look to manage their risk exposures.

Top Picks

Currency Exchange International (CXI.TO)
After a four-year wait, a Canadian Schedule 1 bank license was finally awarded on September 19th and its wholly-owned subsidiary, Currency Exchange Bank of Canada, began operations. The licence has a two-fold benefit: (i) margins will improve, as CXI will be able to source foreign exchange directly from central banks, thereby eliminating the middle man and (ii) CXI will once again be able to deal bank-to-bank with major North American banks. When a prior version of CXI was owned by Bank of Ireland, its largest customers were the Canadian Big Five banks. In addition, CXI signed a top-five U.S. bank as a customer last quarter; the benefits should begin to flow in the current quarter. We expect the business to continue expanding organically through new contract wins and added service offerings.
[We last added to our CXI position on September 30 at $29.55]

GMP Capital Inc., Preferred B (GMP_pb.TO)
Richardson GMP is the wealth management arm of GMP. It is owned by its investment advisors, GMP Capital and the Richardson family. November 15, 2016 is a date for GMP investors to bear in mind. There is a liquidity mechanism among the owners of Richardson GMP that allow any of the three parties to initiate a sale process after that date. It appears that all three parties wish to do so. High-end wealth management businesses are rare in Canada, so Richardson GMP should sell for an attractive multiple (say 2 per cent of its $27.2 billion assets). TD, Raymond James, and Wells Fargo are among the list of potential bidders. We do not know what form a potential transaction could take but in the event of a “change of control,” we prefer the Pref. B shares over the common shares as they would be taken out at their par value of $25; in the interim, the 7 per cent yield is attractive.
[We last added to our position on September 30 at $12.86]

Pair Trade: Guardian Capital (GCGa.TO) / SHORT: Bank of Montreal (BMO.TO)
Guardian holds about 4.2 million shares of the Bank of Montreal and other investment securities which are worth a total of $17.96 per Guardian share (as of 30 June) versus a $22.50 current share price. If you strip out the value of its investment portfolio, the underlying business — which has been robust over the last few years — is trading at very low multiples. Guardian is an attractive take-out target; there are few independent asset managers of its size. One morning we will wake up to read about such a bid; in the interim we hedge our position by shorting BMO common shares against it.
[We last added to GCG.A on October 3 at $22.12; we last added to our BMO short on January 29 at $75.20]
 

Past Picks: November 24, 2015

Pair Trade: Callidus Capital (CBL.TO) / SHORT: Canadian Western Bank (CWB.TO)

• Callidus Capital (CBL.TO)
  We invest based on risk versus return, not sentiment. Callidus remains one of our largest positions. Our down-side is protected by (i) a Substantial Issuer Bid at $16.50, (ii) a share buy-back once the SIB expires, (iii) a 7 per cent dividend yield, (iv) a fair valuation range of $18 to $22 as determined by independent assessor, National Bank Financial and (v) a potential of privatization before year end if the share price does not improve to reflect the company’s operational performance.
  • Then: $9.84
  • Now: $16.77
  • Return: +70.43%
  • TR: +81.95%
     
• SHORT: Canadian Western Bank (CWB.TO)
  From the 2008 recession, it took CWB 17 quarters for loan impairments to return to pre-recession levels. Arguably, the 2015-16 downturn has hit western Canada harder and for longer than in 2008. Our view is that the market is not fully recognizing the long impairment and provision cycle that lies ahead for CWB. We remain short on CWB.
  • Then: $25.81
  • Now: $25.17
  • Return: +2.48%
  • TR: -1.28%
     
• Pair Trade Total Return: +80.67%

Pair Trade: Allegiant Travel (ALGT.O) / SHORT: WestJet (WJA.TO)
The motivation for this pair trade was WestJet as a short. We continue to have concerns about capacity growth in Canada and trans-Atlantic routes. We view Air Canada’s discount airline Rouge as a major competitive threat to WJA, shrinking WJA margins on their overlapping routes. About one-third of WestJet passengers are based in Alberta, so it will be disproportionately affected by the lingering weakness in the oil patch.

To hedge industry-specific risks, we were long on Allegiant Travel. ALGT has the oldest, least efficient fleet of planes (primarily McDonnell Douglas MD80s) in North America. Their aging fleet made Allegiant the biggest beneficiary of cheaper jet fuel prices. Unfortunately this spring, management announced plans to purchase more fuel-efficient Airbus planes. This contradicted our investment thesis, so we exited the position in June at $145.46. 

• Allegiant Travel (ALGT.O)
  • Then: $189.83
  • Now: $140.66
  • Return: -25.90%
  • TR: -24.30%
     
• SHORT: Westjet (WJA.TO)
  • Then: $21.54
  • Now: $22.50
  • Return: -4.46%
  • TR: -7.28%
     
• Pair Trade Total Return: -31.58%

Descartes Systems (DSG.TO)
Every portfolio should have a few low-maintenance stocks and Descartes is a good example. Investors like Descartes’ predictability and consistency, combined with its steady growth. It always trades at a pricey valuation, but it is a steady long-term holding. We continue to hold DSG.

• Then: $25.55
• Now: $28.33
• Return: +10.88%
• TR: +10.50%

Total Return Average: +19.86%
 

Past Picks Update

• We covered our short position in Valeant Pharmaceutical in March 15, 2016 at $50.51. It was a top pick on BNN as a short on February 8, 2016 at $124.
• We covered our short position in Shawcor on May 16, 2016 at $29.01. It was a top pick on BNN as a short on February 8, 2016 at $28.78.
• We sold Mylan on August 25, 2016 at $44.32. It was a top pick on February 8, 2016.

Fund Profile: Lightwater Long Short Fund

Performance as of September 30, 2016:

• 1 month: Fund 3.25%, Index* 0.88%
• 2 year: Fund 6.85%, Index* -0.79%
• 3 year: Fund 13.15%, Index* 4.82%

* Index: S&P / TSX Composite Index.

Awards

• The Nimble Fund won first place in the 2015 Canadian Hedge fund Awards (equity focused, best one-year return). 
• The Nimble Fund was named top-performing North American-based hedge fund in 2015 by Preqin in 2015. The Fund returned 46.7 per cent in calendar 2015 (return calculated to include all fees and expenses).

Twitter: @LightwaterPart

Website: www.lightwaterpartners.com