SW8 Asset Management Inc. Q SW8 Top Ideas Conference Call Wednesday, April 9th, :15 PM ET C O R P O R A T E P A R T I C I P A N T S - PDF

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C O R P O R A T E P A R T I C I P A N T S Danielle Skipp Chief Operating Officer Matt Skipp President and Chief Investment Officer returns to our investors. SW8 is committed to being transparent and a
C O R P O R A T E P A R T I C I P A N T S Danielle Skipp Chief Operating Officer Matt Skipp President and Chief Investment Officer returns to our investors. SW8 is committed to being transparent and a partner with the investment professionals that support and follow us. It is one of the advantages of being local. We are accessible and we encourage you to reach out to us and ask us questions on these calls or find us back at our desks. With this, I will hand the call over to Matt. C O N F E R E N C E C A L L P A R T I C I P A N T S Akshay D Souza RBC Scott Cathcart Mackie Research P R E S E N T A T I O N Good afternoon, ladies and gentlemen. Welcome to the Q SW8 Top Ideas Conference Call for investment professionals. I would now like to turn the meeting over to Ms. Danielle Skipp. Please go ahead, Ms. Skipp. Danielle Skipp, Chief Operating Officer Hello, everyone. Welcome to our Q2 conference call for investment professionals. My name is Danielle Skipp and I am the Chief Operating Officer for SW8. Thank you for joining us this afternoon and in one minute I will hand the call over to Matt. With the arrival of spring and the start of Q2, I anticipate that most of you are commencing or in the midst of quarterly reviews for your clients. With equity indices coming out of last year at all time highs, the case for hedge funds is certainly not straight forward. The reality, however, is that now, more than ever, we advocate that this is exactly the time investors need uncorrelated opportunities to balance out their portfolios. Q1 saw increased volatility in the market and this played well into our strength to seek opportunity, both long and short, for our investors. Our goal with our monthly commentaries and these quarterly calls is to share with you some of our ideas and strategies we use to deliver uncorrelated Thanks, Danielle. Before jumping into the picks, a few opening remarks. The written package we sent out and my remarks today start with our macro themes. This is by design because so many of our ideas are based on macro views. We do generate ideas from any number of avenues, but it is generally part of our strategy to consider how these opportunities fit into a larger macro view we hold. As I said last time we did this conference call a quarter ago, highlighting long and short ideas on their own and not within our overall portfolio construction does require a bit of a caveat because we definitely focus more on portfolio construction than individual names. Okay. So, with that I will start with some of our macro themes and number one on our list is US dollar strength. The US has the strongest economy and we continue to think that as it tapers as the Fed tapers, the dollar will strengthen. Europe is facing disinflationary pressures and Draghi and the ECB have now strongly hinted that a QE policy for Europe is in the cards. With both Japan and Europe possibly using QE policies at the same time, we think the US dollar is going to charge higher. A long position US dollar is one of our larger positions. Second major theme, volatility will continue to increase. As the Fed reduces again its open market purchase of treasury and mortgage backed securities I put this stat in monthly commentaries before since the March 09 stock market lows, QE policy has a correlation of 0.94 with rises in the stock market. Tapering is a reduction, so it is still QE policy but, simply put, when the Fed buys bond and mortgage backed securities, the stock market rises and it stands to reason that volatility will continue to increase as they do less and perhaps stop later this year. Third big theme is deflation. Deflation risks are growing. Europe, again as I just mentioned, worried about Japanese style deflation. We think ironically if both Europe and January start on QE policy sorry, Europe and Japan, we think QE policies keep interest rates low, deflate currencies, and put downward pressure on prices Page 1 for goods and services in a global economy. Simply put, any policy that leads to a weaker currency allows the country in question to compete on price, not productivity, for its goods and services. It may see counterintuitive, but we think deflation risks are going to rise substantially if both Japan and Europe embark on QE programs. Actual deflationary fears are currently very muted, but if this changes, I would expect equity PE multiples to contract substantially. We re not seeing that at all, but it s something I think to definitely be wary of. Fourth big theme: growth versus value. The recent sell off in high flying growth games is only partially due to excessive valuation and the parabolic loop higher. We think the melt down in biotech, Internet, and uber growth names is also being cause again by Fed tapering and fears of higher interest rates. High octane growth stocks generally have insignificant earnings and cash flow, so they have a heavy reliance on cheap capital to fund growth. When this is threatened, you can see a dramatic change in valuation and that is what I think you ve been witnessing in the biotech, Internet, and solar squares recently. Value names have seen inflows from capital departing these trades and we do have a pick that plays on this theme. It s a you ll see that later. Obviously today, with the Fed minutes out, there was some interest rate relief from there you know, very easy money talk, which did help the growth trade bounce. Fifth big theme: energy and base metals. Chinese demand for base metals is slowing, but global supply is growing. We think slowing demand for base metals out of China has still not been fully discounted by investors in the resource space. We re watching the recent swoon in copper prices to see if it has any carry-on effect on the oil markets, and one of today s picks does play on this theme to some extent. Market direction: 2014 looks to be a challenging year for equity market in North America and mid-term election years are generally very tough on Q2 investment returns. Going back to 1970s, the average return in the second quarter in mid-term election years is minus 2.5 percent. The markets have had a great reflexive bounce from the January sell-off, but it s important to remember that since 1950, there has been 24 January declines and odds of a positive year fall below 50 percent when this has happened. In fact, the median return in those 24 years was negative 4.8 percent. We re not saying that 2014 is going to be a negative year, but we do believe, at the very least, it will remain volatile. The last market s data we ll throw your way is supposedly one of Warren Buffet s favourites and is total market capitalization as a percentage of nominal GDP. In the last five years, it has gone from 70 percent to over 140 percent. The last time it was 140 percent was in 2007, and we all know what happened next. Okay, off the macro and onto our picks. Last quarterly call we had four picks. Today we have three. This is a long idea. Current we own it, Indigo Books & Music. Indigo operates book stores throughout Canada under the name Indigo Books & Music. We think Indigo is materially undervalued based on asset value and growth potential. The Company has prime real estate locations across Canada, with 96 large format and 131 small format stores. Though it does not own the underlying real estate, we believe their extensive portfolio of lease holdings could be monetized for a significant sum in a liquidation scenario, whether it be a partial sale of leases or entirety. The Company also has no debt and should end the 2014 fiscal year Indigo has a March year-end, so that s this year, it should end with $185 million in cash. That works out to $7.23 in cash per share. Cash on hand, potential real estate value, and a growing retail franchise make Indigo worth considerably more than its current share price of $9.50, I think, as of yesterday s close. Indigo is a neglected name in retail because of fears over declining book sales. However, in the most recent quarter, physical book revenues increased by 1 percent and they have been relatively stable for a number of quarters now. In 2009, book revenues were responsible for over 90 percent of revenues, and as of Indigo s most recent quarter, they were still responsible for approximately 80 percent of revenues. Gross profit margins on book sales are still over 40 percent. The Company has recently invested heavily to expand into other non-book retail items, such as home goods, and this segment is growing nicely at 15 percent per year and carries a gross profit margin of close to 50 percent. The growing lifestyles retail segment will further enhance revenue growth and provide the catalyst for a high stock price going forward. For example, under new retail lines, as a father of three girls I can tell you that Indigo s upcoming launch of the American Girl doll collection is significant and should be a boon to both store traffic and revenues. The Company will debut the brand this coming May at two of its larger stores, Robson Street in Vancouver and Yorkdale in Toronto. We think this rollout will give a big boost to revenues and profitability. Lastly, in terms of valuation, we believe Indigo is cheap. Typically, a five times enterprise value to EBITDA multiple can be ascribed to steady, lower growth businesses. In fact, its US equivalent, Barnes & Noble, Page 2 trades at 4.9 times currently. At a share price of $9.60, Indigo is trading at two times enterprise value to EBITDA. We believe revenues will grow by 2.5 percent next year, such that 2015 revenues should come in around $890 million. Conservatively, assuming that Indigo can capture an EBITDA margin of 3.1 percent, the Company will have $27.4 million, or thereabouts, of EBITDA in Based off its current market cap, $245 million, and expected year-end cash balance, Indigo has an enterprise value of $61 million. This boils down to a current easy to EBITDA multiple of 2.2 times. Applying a five times multiple to that number again, we think that is quite conservative, will get us a share price well over $12. So, in summary, we think there s a lot of upside in the name. The decline in book sales has troughed. The newer retail segment is growing by 15 percent plus annually and is trading at a significant discount to asset value and discount to its peers. Second pick another long pick, Valero in the United States, symbol Victor Larry Oscar. Valero is the world s largest independent integrated oil and refining company. The Company currently has 16 refineries and is expanding access to domestic oil and growing its export capabilities through significant strategic initiatives. We see Valero as a company with solid fundamentals, a strong balance sheet, and dependable cash flow for an extended period of time. We think and this, again, does fit into our macro theories that we mentioned earlier, because we think oil prices in North America and we use WTI for that, could pull back because of increased production, over supply, lack of infrastructure, green bottlenecks, and inability to export from the US. We believe the international market price and we use Brent Crude for this, is always has geopolitical concerns, a lack of stair capacity from OPEC, and the potential to be much stronger than West Texas for that reason. Valero fits our macro outlook because it benefits from perhaps a weakening in West Texas, but more importantly, widening crack spreads between WTI and Brent. The crack spread is the price difference in this example, between Brent prices, which are used as a benchmark for pricing in oil and gasoline, and cheap West Texas, which is used as an input. This allows for an increase in margins to take for US refineries going forward. Valero has a diversity of product as it has gas, medium and heavy sour crude, diesel, and ethanol. Pressures on operating margins in one area are offset by improved margins in other areas. So again, we like Valero because it s a well diversified oil refiner, it gives you exposure to the energy space, and at the same time, you re not exposed to a potential sell-off in energy, and again, we think there s a good chance it makes lots of money at current price levels and we think there s a really good chance that the differential widens. The risk, again, for all integrated oil and refining companies remains economic growth, which influences demand for gas and prices for crude oil, natural gas, and refined products. Another risk would be that the higher margins have come from ethanol over the last two years. Valero shares and corn futures do have a negative correlation, again, but we do like Valero for the play on crack spreads. Our third and final pick today is a short in an ETF. It s the US Utilities Select SPDR Fund, the XLU. This is based on a sector rotation call. In the past month or so, we ve seen growth stocks get pummelled with money rotating out of these high flying stocks and into dividend paying securities. We believe the rotation into value stocks is growing long in the tooth and valuations are getting stretched, but this tick, by the way, can be interchanged with any number of yield securities. But, we ve gone with the short thesis on the XLU, which is our ETF proxy to the US utilities space. The XLU tracks the Utilities Select Index, which is a cap weighted index consisting of components of the S&P 500 that fall within the utilities sector. This includes communication services, electric power providers, and natural gas distributors. Since the start of the year, the NASDAQ Internet Index, the QNET, which holds high growth names such as Amazon, Facebook, ebay, and Groupon is down over 6 percent. That was before today, by the way. The S&P is barely above water on the year; again, as of last night s close, up around 20 bps. Meanwhile, the XLU is up 10 percent on the year as of the end of March. In fact, the utilities sector is the best performing sector in the S&P by at least a margin of 4 percent. In terms of valuation, the 10-year average for a P ratio for the utilities sector is 14 times and the five-year is also around 14.1 times. The XLU currently trades at 16.6 times as of yesterday s close. The highest P in the last five years, and that occurred on April the third. Additionally, the index currently trades with a 3.67 percent dividend yield, which is a premium to its five-year historical average dividend yield of 3.99 percent. We think the rotation into safety, into ETFs like this is running out of steam. The index historically has a negative Page 3 correlation to interest rates, with the stronger correlation being that to short-term rates, e.g. the 10-year versus the 30-year. This is a short-term trade for us and just a way for us to be opportunistic, and again, the horizon on this trade, if it works, would be anywhere from literally a week to a month more than likely. In closing, just before we open up the call for any questions, I ll end just with a short summary on how our portfolio is positioned. Our largest position remains a long US dollar position, expressed through UUP. This mimics the movements of the US dollar against a global basket of currencies defined by the DXY Index. We think this position will make us money if the US economy improves and/or if the Fed continues to taper. We also think this position acts as a systemic hedge against most global events. This leads to a de-risking or a flight to safety. In Canada, our long positions are in precious metals, merger arbitrage, consumer discretionary, biotech, and technology. In the US, our long picks are in oil refineries, hospitality, biotech, solar, coal, and insurance. Our shorts in Canada are focused on oil names at the moment. We think the recent sell-off in copper and iron ore foreshadows a sell-off in oil prices. In the US, our short positions are focused on big multi-national financial and utilities that have been bid up on money flowing out of growth stocks. Again, this is we re very flexible here and very opportunistic. It s a fluid portfolio. Similar to last quarter, we think the significant pullback in the Canadian dollar is more of a danger sign for flow of funds leaving the country than it is a buying signal for companies that might benefit from a lower Canadian dollar. In summary, we think the second quarter of 2014 is going to be good for our style of investing. We think the absence of volatility in most of 2012 and 2013 was abnormal. As an active manager, our strategy can take advantage of volatility to generate significant absolute returns. We strongly believe that investors should be increasing their allocations to hedge funds that are active and focused on uncorrelated returns. Thanks very much for listening, and, we can now open the call up to questions. Certainly,sir. Ladies and gentlemen, we ll now take questions from the telephone lines. If you have a question and you are using a speaker phone, please lift your handset before dialing your selection. If you have a question, you can register by dialing star, one, on your telephone keypad and you can cancel your question if you wish by dialing the pound sign. Please press star, one, at this time if you have a question and there will be a brief pause while participants register. Once again, please press star, one, on your telephone keypad if you have a question at this time. And, the first question is from Akshay D Souza at RBC. Please go ahead, your line is now open. Akshay D Souza, RBC Hi. Thanks for taking my call. You mentioned that it s important to keep in mind that you focus on portfolio construction more so than names. Could you please elaborate a bit more about what you mean by this? Thank you. Yes. Thanks for the question. We are very focused on the overall portfolio for a number of reasons. One, we re an active management styled fund. We want to be liquid and take advantage of sector moves. This allows us to take advantage of our strength, which is my former trading background. So again, 70 percent plus of our portfolio is focused on trying to get the right direction in sectors. We don t want to load the portfolio up with individual names, just to the randomness of events that can happen with individual names. That said, like Indigo s example today, we will find the odd stock that we think is materially undervalued but, again, we don t want to load up the whole portfolio with names like that and have liquidity concerns. So, again, focus on trading, focus on active management, and sector calls. Hopefully that answers your question. Akshay D Souza, RBC Great, thank you very much. Q U E S T I O N A N D A N S W E R S E S S I O N Thank you. The next question is from Scott Cathcart at Mackie Research. Please go ahead. Your line is now open. Page 4 Scott Cathcart, Mackie Research Matt, congratulations on a solid quarter. You were mentioning you were sort of negative on the base metal names. Do you have a couple that you re kind of on the knife edge of shorting? Yes, I do and generally if I m negative on a sector or even positive on a sector, but more importantly negative, which involves short selling, I m always trying to avoid a short squeeze, a liquidity problem, or and it happens, you think you have it right and a takeout occurs. So, what I do to avoid this risk is to focus on leaders in a sector, so sometimes it s an ETF. The copper example, it s been First Quantum, which we highlighted as a short in the last quarterly investment ideas call and Freeport in the US with its Indonesian operations and political issues there. So, those two have been the go-to names and, again, I m very active, so I will be short, decreasing the weighting, and moving in and out on a continuous basis. same. Thanks very much for joining and we will speak to you next quarter. Thanks, everybody. Thank you. Ladies and gentlemen, your conference has now ended. All callers are asked to hang up their lines at this time and thank you for joining today s call. Scott Cathcart, Mac
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