VOLUME XXV JANUARY 2014

INVESTMENT ISSUES STRATEGIES INSIGHTS FROM DONVILLE KENT

A tale of two ships

2013 was a solid year for Canadian equity investors and a strong year for the Capital Ideas Fund. The TSX Composite rose 9.6% while the Capital Ideas Fund was up 51.6% for the year. In 2013, the key portfolio decision we made was to lighten up, at the start of the year, on natural resource stocks gold, metals, energy and agriculture. This allowed us to benefit from the surge in non-resource stocks that occurred throughout the year while avoiding the pounding that endured for natural resource stocks for most of 2013. For 2014, we expect another positive year for equity investors but doubt that this year will be as strong as 2013. Valuations have expanded significantly since the market bottom in 2009 and bargains are now getting harder to find. As such, we have positioned the portfolio a bit more conservatively than in past years. Regardless of how we think the market will perform in 2014, we will continue to focus our investment strategy on a small basket of companies that we think are capable of delivering superior returns on shareholders equity over extended periods of time. We think that security selection (i.e. stock picking) is more important than market timing. And that is not to say that market timing isnt valuable. It certainly is if one could actually do it, but people like Warren Buffett dont believe it is possible and neither do we. Thus, our strategy remains focused on owning outstanding companies that can deliver high ROEs in all economic environments.

The goal of every investor Imagine that 15 years ago (1998) you came across a fund manager with whom you invested with and subsequently she (he) delivered the following returns
Figure 1 - 15 Year Track Record of one of Canada's Best Fund Managers Year Annual Return These returns are indeed pretty spectacular and the 1998 20.7% manager of this fund in fact exists. However, before I 1999 21.8% reveal the identity of the said fund manager, let me point 2000 23.2% out that his fund consists of the net assets or 2001 23.8% shareholders equity of a public company and the 2002 24.3% manager in question does not manage an investment fund 2003 27.4% per se. The manager in question is Gerry Soloway and he 2004 31.4% is the CEO of Home Capital, a federally regulated trust 2005 31.8% company based in Toronto, Ontario. 2006 27.4% To once again reiterate, the returns laid out in Figure 1 2007 28.9% are not the performance of a fund; they are the return on 2008 27.8% equity (ROE) of Home Capital. However, over time the 2009 28.2% return of a stock and its ROE tend to coincide quite 2010 27.3% nicely. To confirm this point, we note that on the first of 2011 27.1% January, 1998 Home Capitals share price was $1.63 and 2012 25.5%

today it is roughly $80.00. Excluding dividends, the stock is a 49 bagger over the past sixteen years. However, Home Capital has been paying a dividend since 1999 and thus, including dividends; the stock has appreciated at a CAGR of 28% over the same time frame.

ROE REPORTER | DKAM

The Holy Grail of equity investors are companies like Home Capital that have as their key attribute the ability to consistently earn an ROE of 20% or better. Once you have found such a company to invest in, the related goal is to hold this stock or basket of stocks for as long as the Company can achieve said returns. Easier said than done, but nonetheless achievable. At the start of each year, I write about a few stocks that I believe should be the focus of a long-term investors portfolio. The 2014 list appears later in this newsletter while my past pics are listed below. The purpose of Figure 3 is not to gloat about past picks but to point out that many of our past picks, which also happen to have been our largest positions at the time, have been on our favorites list for years. Rest assured that my picks for 2014 look a lot like my picks for 2013.
Figure 3 - Past DKAM Franchise Stocks 2010 2011 Constellation Software MTY Food Group Paladin Labs Logibec Constellation Software MTY Food Group Paladin Labs Home Capital Glentel 2012 Constellation Software CGI Group Paladin Labs Home Capital Glentel 2013 Constellation Software CGI Group Paladin Labs Home Capital High Liner Foods MacDonald Dettwiler 2014 ? ? ? ? ? ?

Quality of management A significant part of the story of the great franchise stocks that we focus on each year is quality of management. CEOs like Mark Leonard (Constellation Software) , Gerry Soloway (Home Capital), Jonathan Goodman (Paladin Labs), Claude Roy (Logibec and now Mediagrif) and Stanley Ma (MTY Food Group) only to name a few, are business leaders of great integrity and skill who have and continue to deliver superior returns to their investors. Of course, most investors believe that quality of management is important but like me they struggle at times to find ways to measure it. This issue is particularly challenging for Do-it-yourself (DIY) investors who rarely if ever meet with management teams. I first encountered the challenge of rating management teams many years ago. Fresh out of business school in 1992, I began work as an equity analyst in Singapore and one of the first lessons I learned as an analyst was not to confuse affability with quality. My first job in Singapore involved writing equity research on ship repair companies such as Sewbawang, Keppel, Hitachi Zosen and Jurong, along with shipping companies such as Neptune Orient Lines and Pacific Carriers. I was assigned coverage of the marine sector in part because of my previous background as a Naval Officer. It was assumed (correctly) that I had a genuine interest in ships and their repair facilities. Further, my ability to tell salty dips, the naval euphemism for a good story, with the CEOs of marine based companies who had also spent time in their youth at sea allowed me to quickly build a rapport with key management

ROE REPORTER | DKAM

teams. On the surface, I really looked like I knew my stuff until it was obvious that I didnt. As a young analyst, I somehow equated the friendliness of certain management teams with the level and quality of their management skills. Thus, in my naivety the management teams running companies such as Sembawang Shipyards and Pacific Carriers were assumed to be the best (which I would soon learn was not true), while the always grumpy K.K. Tan, CEO of Jurong Shipyard, was assumed to be merely OK, when in fact he turned out to be the best of the bunch. Within a few years of becoming an analyst I began to realise that quality of management is critically important to the long-term success of a company and it was at that time that I began to look for ways to objectively measure it. Here are my thoughts on the subject.
1. Assessing the quality of management from the outside is difficult Many investors and pundits will extoll the virtues of a particular management team without really having any objective basis for doing so other than by noting that the Companys stock has gone up. Assessing the quality of management is difficult but it can be done. Those who are REALLY good at assessing managerial capabilities look for objective measures and/or quantifiable measures to go along with more subjective measures. 2. Long-term track record is EXTREMELY important One or two year snap shots in time tell you very little about a company or its management because even mediocre companies and mediocre management teams have a good year once in a while. If you want to assess a management team, look at the last five years of track record and if you can go back longer than do so. Its surprising how obvious certain trends can be to spot in a Company when you lay its past history out in a manner that allows one to move easily from year to year. Once you have the 5 year (or longer) track record in front of you, focus on three or four key factors that are important to YOU! For me, the three key line items I would look at are; 1) ROE, 2) Sales Growth and 3) Share issuance. Any management team can achieve a high ROE for a year or two but doing it for 5 years in a row or more takes a great deal of skill because the profits from the first high ROE year must be intelligently redeployed in the business or the ROE will begin to fall quickly. Any company that can maintain an ROE in excess of 15% per annum while growing sales at a high rate (10% or better per annum) and do so without issuing more shares is probably one that is run by a strong management team. To achieve all three of these items at the same time is actually a rare feat and suggests that a very skilled management team is in place. 3. Working capital management is another key way to look inside the business For investors who have a bit more financial or educational training, performing an analysis of a companys key working capital ratios will give you an idea of whether or not the company is in ship-shape or not. Here we are talking about inventory turnover, accounts payable and receivable management, and cash

ROE REPORTER | DKAM

management. Management teams that are on top of the details tend to be quite efficient at keeping working capital low and/or efficient. Ideal levels of working capital differ from industry to industry but with a little bit of effort it will become obvious which companies are sharp and which are bloated or sloppy. My experience is that such sharpness or sloppiness in terms of working capital management transcends other areas of the business. 4. Attend the AGM, listen to management and make notes Most DIY investors do not have direct access to management but they can listen in on conference calls and attend the Annual General Meeting. For the DIY investors, attending an AGM is both a wonderful social and educational experience and also a chance for you to ask questions directly of management. During the AGM, many questions will be asked and you should be attuned to any discussion regarding the 2-3 key goals or challenges facing the company at this stage in its history. For the longterm investor, you should make notes of what those two or three issues are and then ask yourself if I couldnt speak with management, how would I measure the companys progress on achieving its key goals or solving its issues. If you return for the next AGM, ask management to give an accounting of how they did in relation to the goals or issues they were trying to address the year before. If you follow this process with the companies you own, you will quickly see which management teams are really sharp and which are ordinary.

The four points I have described above should provide investors who do not have frequent and easy access to management teams with some ways of assessing how well their management teams performed. For investors who wish to go beyond these four points, perhaps the best checklist for rating management can be found in Common Stocks and Uncommon Profits by Phillip Fisher. The best part of the book is Fishers Fifteen Points to look for in a Common Stock and the bulk of Fishers points are managerial in nature. Warren Buffett considers Fishers book, which is available in bookstores everywhere, to be among the most important he has ever read. I think the book is still highly relevant to investors who want to buy stocks and think like an owner of business and not simply a holder of share certificates. Looking for great companies in 2014 The Capital Ideas Fund is built around the idea that the best stocks to own are those that can earn a consistently high ROE without resorting to accounting gimmickry or excessive amounts of leverage. The best way to look for such companies is by preparing a list of those companies that are earning a high ROE in their current financial year. Figure 4 below presents the best companies in our database based on projected Return on Average Equity (ROAE) for 2014 using DKAM estimates and adjusted for cash earnings and dividends.

ROE REPORTER | DKAM

Figure 4 - High ROE Stocks in Canada - Based on 2014 DKAM estimates

Rank Company Ticker Industry Mkt Cap ($MM) ROAE*

1 Constellation Software CSU Technology/Software 2 Gluskin Sheff GS Asset Manager 3 Macdonald Dettwiler MDA IT/Space/Technology 4 Valeant Pharma VRX Pharma 5 Avigilon AVO Technology/Software 6 Intertape Polymer ITP Tape 7 Yellow Media Y Advertising 8 First Service FSV Services 9 Tim Hortons THI Donuts and coffee 10 Auto Canada Inc ACQ Auto-Finance 11 CGI Group GIB.A IT services 12 Rogers Communications RCI.B Telecoms 13 Mitel Networks MNW Network 14 Alimentation Couche-Tard ATD.B Convenience Stores 15 MTY Foods MTY Food franchising 16 Element Financial EFN Financial Services 17 Open Text OTC Software 18 Home Capital Group Inc. HCG Specialty Lender 19 Saputo SAP Milk and cheese 20 High Liner Foods HLF Fish 21 Dollarama DOL Retailing 22 Enghouse ESL Software 23 Badger Daylighting BAD Industrial (Daylighting) 24 Norbord NBD Forest Products 25 Canadian Pacific Railway CP Railways * return on average equity, based on cash earnings and adjusted for dividends

4897.7 829.1 2862.0 50879.0 1095.7 755.5 769.1 1382.1 8129.0 940.7 10807.3 24591.3 1099.8 14979.9 610.7 2109.4 5859.4 2777.0 10771.0 717.3 6261.8 880.2 1173.2 1318.0 28235.3

55% 52% 37% 35% 35% 31% 30% 28% 27% 24% 24% 24% 23% 22% 22% 21% 21% 21% 21% 20% 20% 20% 20% 20% 20%

Figure 4 a gives us a good idea of what kinds of companies are performing well in 2014 but it doesnt address valuation. In figure 5 below, we rank the same list of 25 companies from cheapest to most expensive in terms of P/E ratios. As is the case each year when we present this list, there are always a few companies trading at remarkably low P/E ratios and a few that appear to be quite expensive.

ROE REPORTER | DKAM

Figure 5 - High ROE Stocks in Canada - Ranked by 2014 DKAM Estimated P/E
Rank Company Ticker Industry Mkt Cap ($MM) PE

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Yellow Media Norbord Home Capital Group Inc. CGI Group Intertape Polymer Gluskin Sheff Rogers Communications Mitel Networks High Liner Foods First Service Macdonald Dettwiler Open Text Saputo Constellation Software Tim Hortons MTY Foods Alimentation Couche-Tard Enghouse Canadian Pacific Railway Element Financial Auto Canada Inc Valeant Pharma Dollarama Badger Daylighting Avigilon

Y NBD HCG GIB.A ITP GS RCI.B MNW HLF FSV MDA OTC SAP CSU THI MTY ATD.B ESL CP EFN ACQ VRX DOL BAD AVO

Advertising Forest Products Specialty Lender IT services Tape Asset Manager Telecoms Network Fish Services IT/Space/Technology Software Milk and cheese Technology/Software Donuts and coffee Food franchising Convenience Stores Software Railways Financial Services Auto-Finance Pharma Retailing Industrial (Daylighting) Technology/Software

769.1 1318.0 2777.0 10807.3 755.5 829.1 24591.3 1099.8 717.3 1382.1 2862.0 5859.4 10771.0 4897.7 8129.0 610.7 14979.9 880.2 28235.3 2109.4 940.7 50879.0 6261.8 1173.2 1095.7

3.8 8.6 9.3 9.6 10.8 11.1 12.5 12.7 12.9 13.1 13.6 15.9 16.1 16.3 16.3 16.9 18.0 18.7 19.2 19.2 19.2 19.7 21.7 25.3 30.9

Figure 5 shows us which companies are reasonably valued and which ones are expensive but as investors we really want to maximize ROE while minimizing cost. In Figure 6 we combine both ROE and P/E, so that we can see where the best trade-off occurs. Interestingly, some of the best growth names in Canada still trade at a reasonable Growth/PE ratio. We consider any stock with a ratio of 2.0 or better to be highly attractive and any stock at 1.0 or lower to be fully valued. Investors should also note that Figures 4, 5 and 6 only look at a single year of data, and therefore should only be used as a starting point in terms of ones investment due diligence.

ROE REPORTER | DKAM

Figure 6 - High ROE Stocks in Canada - Based on 2014 ROAE/PE estimates

Rank Company Ticker Industry Mkt Cap ($MM) ROAE/PE

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Yellow Media Gluskin Sheff Constellation Software Intertape Polymer Macdonald Dettwiler CGI Group Norbord Home Capital Group Inc. First Service Rogers Communications Mitel Networks Valeant Pharma Tim Hortons High Liner Foods Open Text Saputo MTY Foods Auto Canada Inc Alimentation Couche-Tard Avigilon Element Financial Enghouse Canadian Pacific Railway Dollarama Badger Daylighting

Y GS CSU ITP MDA GIB.A NBD HCG FSV RCI.B MNW VRX THI HLF OTC SAP MTY ACQ ATD.B AVO EFN ESL CP DOL BAD

Advertising Asset Manager Technology/Software Tape IT/Space/Technology IT services Forest Products Specialty Lender Services Telecoms Network Pharma Donuts and coffee Fish Software Milk and cheese Food franchising Auto-Finance Convenience Stores Technology/Software Financial Services Software Railways Retailing Industrial (Daylighting)

769.1 829.1 4897.7 755.5 2862.0 10807.3 1318.0 2777.0 1382.1 24591.3 1099.8 50879.0 8129.0 717.3 5859.4 10771.0 610.7 940.7 14979.9 1095.7 2109.4 880.2 28235.3 6261.8 1173.2

7.9 4.7 3.4 2.8 2.7 2.5 2.3 2.3 2.1 1.9 1.8 1.8 1.6 1.6 1.3 1.3 1.3 1.3 1.2 1.1 1.1 1.1 1.0 0.9 0.8

Great franchise stocks to own for 2014 The preceding discussion has meant to serve as a lead in to our discussion regarding the best franchise stocks to own in 2014. Before we launch into Company specific analysis, it has sometimes been asked why I choose certain companies from our list and not others, particularly if they appear to meet our ROE and P/E requirements. The answer typically is either a poor track record or cyclicality. Some companies tend to have a pattern of earnings which I call good year, bad year. Such companies appear in our screens but their lack of consistent track record over the years prevents us from owning the stock or recommending it to others. The second type of company is the cyclical company, which will often appear attractive at the peak of the companys economic cycle, when in fact we know the stock is actually expensive. Each of the stocks that I discuss subsequently are ones that I think are reasonably priced, have good track records and can perform well in all economic environments. Constellation Software Is a Toronto based software company and is arguably run by the most astute management team in Canada. The company is a leading provider of software and services to public and private sector markets and close to 90% of its revenue is now derived from outside of Canada. The Company is led by Mark Leonard who has skillfully guided the Company
ROE REPORTER | DKAM

since start-up. We expect the Company to grow by close to 35% in 2014. Constellation Software remains our largest position with a 13.6% weighting in the Capital Ideas Fund.
Figure 7 - Constellation Software Inc. FYE Dec 2007A 2008A Rev ($MM) Cash Earnings ($MM) Cash EPS ($) Net margin (%) ROAE* Source: Donville Kent 243.0 33.5 1.59 14% 40% 330.5 57.6 2.73 17% 63% 2009A 437.9 70.8 3.35 16% 68% 2010A 634.0 97.9 4.62 15% 76% 2011A 773.3 158.8 7.49 21% 80% 2012A 891.2 177.8 8.39 20% 69% 2013E 1179.0 243.8 11.50 21% 93% 2014E 1414.8 290.7 13.72 21% 55%

MacDonald Dettwiler Is a Vancouver based technology company with operations that include satellite communications, space exploration, surveillance, and robotics. The Company is one of the few truly high technology companies listed on the TSX and while its annual profits tend to be a bit lumpy, its ROE consistently exceeds the 20% level. We expect the Company to grow by 37% in 2014 and it represents a 3.3% weighting in the Capital Ideas Fund.
Figure 8 - MacDonald Dettwiler & Associates Ltd. FYE Dec 2007A 2008A 2009A Rev ($MM) 1204.2 Cash Earnings ($MM) 104.0 Cash EPS ($) 2.55 Net margin (%) 9% ROAE* 23% Source: Donville Kent 1168.5 73.7 1.82 6% 15% 1000.9 115.4 2.84 12% 22% 2010A 688.0 135.3 3.34 20% 24% 2011A 761.1 163.8 5.15 22% 39% 2012A 879.9 96.3 3.02 11% 38% 2013E 1846.0 142.0 3.94 8% 32% 2014E 2080.0 218.2 6.06 10% 37%

CGI Group CGI Group is a Montreal based multinational information technology consulting, systems integration, outsourcing and solutions company. The Company has achieved an ROE in excess of 20% in nine of the last ten years and is currently one of the most reasonably priced High-ROE stocks in Canada. While CGI has its detractors, we believe the company will continue to deliver strong returns to investors via its ongoing operations, acquisitions, and share buybacks. CGI represents 9.2% of the Capital Ideas Fund.
Figure 9 - CGI Group, Inc. FYE Sep 2007A Rev ($MM) 3633.9 Cash Earnings ($MM) 378.3 Cash EPS ($) 1.17 Net margin (%) 10% ROAE* 21% Source: Donville Kent 2008A 3705.9 413.1 1.34 11% 22% 2009A 3825.2 450.5 1.53 12% 21% 2010A 3732.0 486.0 1.79 13% 22% 2011A 4223.9 571.1 2.19 14% 25% 2012A 4772.5 587.0 1.91 12% 20% 2013A 10084.6 649.8 2.09 6% 17% 2014E 10400.0 1222.4 3.97 12% 24%

ROE REPORTER | DKAM

Home Capital Toronto based Home Capital is the holding Company for Home Trust which is a federally regulated trust company offering deposit, mortgage lending, retail credit and credit card issuing services. Over the past twenty years, Home Trust has never achieved an ROE of less than 20%. Home Capital represents 7.6% of the Capital Ideas Fund.
Figure 10 - Home Capital Group Inc. FYE Dec 2007A 2008A 2009A 2010A 308.8 181.0 5.22 59% 27% 2011A 361.3 190.8 5.50 53% 27% 2012A 422.7 228.7 6.59 54% 26% 2013E 496.0 262.9 7.57 53% 24% 2014E 580.3 305.2 8.78 53% 21%

Rev ($MM) 188.3 224.6 277.6 Cash Earnings ($MM) 90.3 109.4 145.4 Cash EPS ($) 2.62 3.17 4.22 Net margin (%) 48% 49% 52% ROAE* 29% 28% 28% Source: Donville Kent (*2010 transition to IFRS)

Valeant Pharmaceuticals Montreal based Valeant Pharmaceuticals is a multinational specialty pharmaceutical company with a focus on branded pharmaceuticals, branded generics and over-the-counter products. The company was created in 2010 via the merger of Valeant and Biovail and is now one of the fastest growing speciality Pharmaceutical companies in the world. We expect the Company to grow by at least 35% in 2014. Valeant holds a 9.6% weighting in the Capital Ideas Fund.
Figure 11 - Valeant Pharmaceuticals International, Inc. FYE Dec 2007A 2008A 2009A 2010A Rev ($MM) Cash Earnings ($MM) Cash EPS ($) Net margin (%) ROAE* Source: Donville Kent 842.8 243.6 1.51 29% 19% 757.2 251.3 1.57 33% 20% 820.4 281.2 1.78 34% 22% 1181.2 11.4 0.06 1% 0% 2011A 2463.5 717.4 2.35 29% 16% 2012A 3546.6 812.9 2.66 23% 21% 2013E 5750.0 695.0 2.08 12% 15% 2014E 8250.0 2577.0 7.72 31% 35%

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Final Thoughts The global economy appears to be on a good footing but there are as always risks. I think we are in for a long period of modest growth and modest inflation. Stocks and markets will go up and down but when I look at the various asset classes from a high, I still think that equities are the place to be. We did well in 2013 but as I write this note in early January 2014, I want you to know that Im not feeling complacent. Preserving your capital and making it grow remains my top priority. Call me or write me if you want to chat J.P. Donville Jason@donvillekent.com - 416-364-8886

ROE REPORTER | DKAM

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