Stephen Takacsy, president, CEO and chief investment officer of Lester Asset Management

Focus: Canadian equities and fixed income
_______________________________________________________________

MARKET OUTLOOK
Valuations of most North American equities are stretched on the hopes of corporate tax cuts and massive stimulus spending in the U.S. The “Trump bump” will stall and risks becoming the “Trump slump” as reality sets in about what the new administration is able to accomplish or not. We don’t believe that U.S. economic growth can be increased on a sustainable basis, particularly as the Fed is on a path of normalizing interest rates to the upside. We continue to live in a slow-growth, highly-indebted, deflationary world with aging developed populations and excess capacity. There is also much uncertainty created by Trump’s protectionist rhetoric, which could have devastating effects on what little global growth there is. Our focus has and continues to be been on Canadian companies, many of them small/mid-cap, that have local businesses including operations in the U.S. and that will benefit from infrastructure and other spending, and/or from a stronger U.S. dollar. We are also holding nearly 15 per cent in cash waiting for better valuations before redeploying excess funds.

TOP PICKS

K-BRO LINEN SYSTEMS (KBL.TO) – New position since March 2017
Canadian leader in laundry and linen services to the growing health care and hospitality industry. High barriers to entry and limited competition. K-Bro has 30 per cent market share in Canada and long-term contracts with high renewal rates. It is the lowest-cost producer with strong EBITDA margins and free cash flow. Major capex program to build new plants in Ontario and B.C. will increase processing capacity and further lower costs, allowing K-Bro to widen its lead over the competition. Recently raised $60 million at $38 per share. Stock has always been expensive but has come down due to lower temporary margins from new plant startup costs, yet is more fairly valued now at around 10-11x 2018 EBITDA. Market cap is $370 million. Pays a three per cent dividend with a payout ratio under 50 per cent. Core holding initiated at around $38.

EQUITABLE GROUP (EQB.TO) – Core holding since early 2015
Canada's second-largest alternative mortgage lender. Was being dragged down by problems at Home Capital Group and false rumors by short sellers that Canada's housing market was collapsing. Announced record profits in May and a $2-billion backstop line of credit from Canada's major banks, which has not needed to be used. Has been gaining market share from Home Capital over the past year, and originations are now at all-time highs due to uncertainty at Home Capital. Will be the major beneficiary of Home Capital's problems (besides Warren Buffet). Very strong management team/board which took pre-emptive measures against possible contagion. Company is generating strong EPS growth ($8.50 per share) and high ROE (17 per cent). Trading at around 7.5x EPS and 1.1x book value ($57 per share). We recently bought more shares near lows at around $37. EQB is now our largest position. We are also a big purchaser of EQB's HISA (EQB200, which is currently yielding 1.75 per cent).

TEN PEAKS COFFEE (TPK.TO) – Core holding since mid-2015
World’s only third-party processor of 100 per cent chemical-free, organic decaffeinated coffee using the branded Swiss Water trademark, based in Burnaby, B.C. Also provides green coffee storage and handling logistics services. Processes for and sells to large chains like Tim Horton and McDonald’s (including some of its U.S. business), specialty roasters (Third Wave specialty coffee shops), and global importers. Current plant is running at near-full capacity, so raised funds in 2015 at $8.80 to build a new plant in the Vancouver area. Strong growth in the U.S. and internationally, where the majority of the decaf market is still chemical-based (chemicals banned in Japan). Just reported strong first quarter results. We are expecting sales volume growth to resume in 2017. Stock is cheap at 12x trailing P/E and market cap of only $54 million, or 0.8x sales, for a high-barriers-to-entry, consumer-product company with strong free cash flow generation and global growth potential. Also pays a 4.2 per cent dividend. We added more shares in low $6s and now own over 7.5 per cent of the company.
 

PAST PICKS: JUNE 29, 2016

D-BOX TECHNOLOGIES (DBO.TO)
World leader in motion systems for the entertainment market (movies, video games and virtual reality) and industrial applications (vehicle training and simulation). We expect seats with D-BOX motion systems to be installed in roughly three per cent of all movie auditoriums worldwide over the next 10 years, following an evolution similar to 3D screens. D-BOX is now present in nearly 600 screens of 150,000 worldwide (0.4 per cent) including in China, where over 80 auditoriums per week are being built, and deployment of D-BOX seats with Cineplex and Cinemark continue to grow. D-Box is generating record revenues. However, its sales backlog stalled during 2016 as movie theaters replaced their seats with recliners. This caused the stock to fall. D-BOX has developed a motion system for reclining seats and thus this delay may become a golden opportunity to finally penetrate major U.S. chains. New applications such as VR will also be huge. Last week, D-BOX announced Q4/17 results which were very strong, and we expect some big announcements this year. Market cap is only $50 million, and the company is grossly undervalued in relation to its global growth potential, lack of direct competitors and growing recurring revenue stream from movie ticket sales on an increasing worldwide installed base. We have been buying recently in the low $0.30s. Core holding.

• Then: $0.67
• Now: $0.32
• Return: -52.23%
• TR: -52.23%

SANDVINE (SVC.TO)
Global leader in broadband network policy control solutions and business intelligence. Helps global telecom and wireless providers with Internet traffic management tools to optimize their networks, and with data analytics. Was a very inexpensive tech stock trading at five times EBITDA, a significant discount to U.S. peers, when we recommended it around $2.55 a year ago. Company recently announced that it has received an offer to be acquired for $3.80 per share from a private equity firm and management. We, and other large shareholders we have spoken to, are very unhappy with this price. Because management is in a conflict of interest as part of the buying group, disinterested minority shareholders will have the final say. We expect a higher offer to emerge from a strategic buyer during the current no-shop period, which expires July 7. The market seems to agree as the stock is trading above the $3.80 offer price. We purchased additional shares at $3.85 after the announcement. Core holding.

• Then: $2.62
• Now: $3.92
• Return: +49.80%
• TR: +53.61%

BADGER DAYLIGHTING (BAD.TO)
North America’s largest operator of hydrovac services (excavation by high water pressure trucks). Growth stalled over the past few years due to a slowdown in the oil-and-gas sector, particularly in Western Canada. However, penetration has been strong in the U.S. and in non-energy sectors such as utilities, where hydrovac services remain less developed and competition is fragmented. The U.S. now represents a majority of its sales, which are growing at double-digit rates. Badger recently announced it was increasing its build rate for new trucks, a sure sign that business is picking up. U.S. short sellers, the same ones who were spreading misinformation about Home Capital, recently began scaring investors about Badger, driving the stock down from the low $30s to the low $20s. Thanks to these misinformed market manipulators, we “loaded up the truck,” adding to our position at around $23. We expect strong results in 2018 as the energy sector picks up again and infrastructure spending grows. Badger generates healthy profit margins and strong free cash flow, and has little debt. Valuation is reasonable at 8x 2017 EBITDA, well below its historic range. Core holding.

• Then: $22.74
• Now: $25.76
• Return: +13.28%
• TR: +14.70%

TOTAL RETURN AVERAGE: +5.36%