Q: What is your investment philosophy?

A: We are long-short equity managers, we look for investments predominantly in mid cap companies trading in Canada. Our goal is to get absolute return on capital and we believe we can achieve this best through a long-short approach to investing. Ours is a value-based philosophy and we look to invest “long” in healthy companies trading at a significant discount to their intrinsic values and go “short” companies having weak fundamentals, inefficient and overly promotional management teams as well as aggressive accounting tactics.

Q: Why do you look for investments predominantly in Canadian mid cap companies?

A: While many Canadian companies are large and some are global corporations, the Canadian stock market has many of the inefficiencies of developing markets. Few companies are thoroughly followed and fewer companies are shorted. Canada has a healthy economy and stable political and economic climate but lacks a critical mass of sophisticated investor base. Therefore, we find that we’re able to identify lots of attractive inefficiencies to exploit in the Canadian market, which today can be compared to the situation in the U.S. market 10 or 15 years ago.

We focus on mid-caps that generally lie between the 300th and the 1,000th largest company, because this group has a significant number of inefficiencies making it an attractive market in which to identify opportunities. Our presence in Toronto with a strong local contact network is an added advantage in identifying opportunities.

We do sometimes look at U.S. opportunities but mainly when we possess a particular industry expertise, or where a company has a division in Canada where we have a particular edge over other investors who may not be able to recognize its real value.

Q: How do you identify candidates for your long and shorts?

A: To invest long, companies that attract us are those having high barriers to entry, strong market position, pricing power, management teams who are aligned with shareholders, businesses and industries that we understand and can reasonably predict future cash flows. Typical examples are industries in service businesses, consumer products, and consumer non-cyclicals. Our valuation is based mainly on a discounted cash flow analysis and we try to identify and buy a business at 30% to 50% discount to its intrinsic value, and will hold that stock until its market price grows to reach a price closer to its intrinsic value.

We are also hands-on investors and focus on understanding both a company and its industry. Our approach is free cash flow centric and we always carry out a discounted cash flow analysis of companies in our universe.

Our short investing approach is different. We first identify a business that has fundamental weaknesses, maybe due to a secular decline in its industry, very low barriers to entry, steep competition, pricing pressure, rising input costs, etc. Typical examples are companies in the highly competitive manufacturing industries. If we find that even though these companies appear to trade close to their perceived intrinsic value, our analysis identifies declining fundamentals and reveals that the company’s value is going to decline sharply in the next 3 to 5 years, we will short the stock.

Some criteria that guide us to shorts are: weak cash flow relative to earnings; an over-levered balance sheet; aggressive growth through acquisitions with significant one-time goodwill; overly promotional management teams not aligned with shareholders. A significant red flag is a recent first time earnings miss of a company that may be the result of a fundamental problem that could take longer than one quarter to fix.

Q: How do you generally weigh the longs and shorts in your assets and how much leverage do you use?

A: We measure ‘gross exposure’, which is the overall weighting of our longs plus the absolute value of our shorts. We cap that at 150%. Our typical profile might be something like 70% long, 40% short for a gross exposure of 110% and a net exposure of plus 30%. Hence we’re leveraged only 10 cents on the dollar, a fairly modest amount. The average gross exposure since inception has been between 110% and 120%. There are times when our gross exposure is, as it is currently, below 100% and we have more than 10% of the overall portfolio in cash.

Q: Can you give examples of how you picked a couple of your long and short positions?

A: We have owned Arbor Memorial for the past six years. It is the largest domestic funeral and cemetery company in Canada. Seven years ago we began evaluating the overall dynamics of this industry that had gone through a very significant acquisition binge in U.S. markets in the 1990s. But during 1998 and 1999 all that started to deteriorate. There was a multitude of problems and the unavailability of capital led to a significant re-valuation so that the combined market capitalization of that industry, slumped from over $25 billion to less than $2 billion in two years.

We were attracted to this industry because, fundamentally, a funeral home and cemetery are very good underlying businesses. They have very high barriers to entry with a lot of permits and real estate requirements that need to be secured to enter this business. There’s also a significant heritage linked to funeral homes that have been in a particular location in a city like Toronto for 80 years and generations of the same family have used that funeral home, and particular cemetery.

Significant future benefits such as changing demographics, pricing power and consistent volume growth of people that funeral homes and cemeteries are going to serve - all attracted us and I think with the problems in the industry we saw this as a restructuring type of opportunity. Hence about six years ago we bought Arbor Memorial. Fortunately Arbor was not significantly involved in the acquisition binge that had punished many of the U.S. players. We found they were still generating a significant amount of free cash flow. The business had also been repriced to a very significant discount to its intrinsic value and we bought it at a very attractive price, of C$8 a share.

Today, the stock price is C$30. Still owned by the Scanlan family who established it in Canada, 50 years ago, it is now a national business and continues to trade at a very modest 13 times earnings. They have compounded earnings growth of approximately 13% over the last 5 years, generate significant amount of free cash flow, and have a healthy balance sheet and a strong management team. This is a company that we expect will be a long term holding for us on the long side of our portfolio.

A good short side example is a US company called Georgia Gulf. About a year and half ago, Atlanta-based Georgia Gulf, a chemical PVC company, acquired Royal Group Technology, a Canadian plastic extrusions company, one that we had been watching and thought had many fundamental problems. Royal Group made products for the housing industry that were supplied for both the new home and renovation markets. Now, Wall Street thought that there were going to be significant synergies with this business and liked the fact that Georgia Gulf was vertically integrating their business. Georgia Gulf’s stock price surged significantly based on that acquisition.

At that point we started to do some due diligence on Georgia Gulf and discovered it as a good short opportunity for a number of reasons. One, they were acquiring a business that was very dependent on the housing market at a time that market was extremely vulnerable. Two, the acquisition was financed entirely with debt. They had also leveraged up their balance sheet significantly as Royal Group was a very large acquisition and almost doubled the size of Georgia Gulf’s business. Third, that Royal Group was a unique Canadian company started by a very entrepreneurial guy named Vic De Zen. He had a very loyal employee base, played a key role in his company’s R&D and also had a strong relationship with the suppliers and customers. However the deal was, after the acquisition, he would leave his post at the company. We were therefore gravely concerned that it would be a daunting task to integrate the two businesses without the presence of Vic De Zen.