Investment Philosophy
The Calrossie Partners Fund is a “core-plus” fund, meaning that it looks to add value over and above the returns of a carefully selected core portfolio.
The core portfolio is comprised of Canadian stocks, primarily those paying a dividend. The objective of the Fund is to outperform the S&P/TSX Composite Total Return Index by several percentage points annually, after covering the 1% management fee. Since inception, the Fund has more than achieved this goal.
The sections that follow lay out the investment philosophy of the Fund in more detail. Please see the Offering Memorandum, as well as the Subscription Form and Limited Partnership Agreement for full details regarding an investment in the Fund (available on request).
Dividend-Paying Stocks are the Core of the Fund
The primary focus of the Fund is on dividend-paying stocks because: (1) they have historically outperformed non-dividend paying stocks; and (2) they automatically deliver cash flow for retirement needs, reducing the need to sell securities.
In his highly-acclaimed book “Stocks for the Long Run”, Wharton Professor Jeremy Siegel shows that over a 50-year period not only did the highest dividend-paying stocks in the S&P 500 outperform the index by an average of 3.09% per year, but they outperformed the lowest dividend-paying stocks by a full 4.53% per year.
Why do dividend-paying stocks outperform non-dividend paying stocks? For two reasons:
First, non-dividend paying stocks are typically growth companies (i.e. companies that are growing more quickly than average). By and large, such companies don’t pay dividends because they are reinvesting all of their cash flow in their business in order to fund growth. The problem from a stock market perspective is that, human nature being what it is, investors often become overly optimistic about the prospects for growth of these companies and consequently bid up the price of the shares to excessive levels.
Put another way, growth stocks underperform as a group because they are usually overpriced. Over the course of time, a pattern becomes clear: While one growth stock is ascending, a previous star is usually falling back to earth, with the net aggregate result for growth stocks being less than that from the steady progress of dividend-payers. There are, of course, exceptions, and some growth stocks go on to greater and greater heights. But the growth sector’s aggregate historical underperformance is well-documented.
The second reason dividend-paying stocks outperform is that the discipline of having to pay the dividend keeps the company from the syndrome of what may be called “chasing the CEO’s latest great idea”. CEOs are often seduced by prospects in new areas rather than focusing on the core competencies of their companies. While some of these prospects do indeed pan out, many do not, and the corporate world is littered with failed acquisitions and promising new ventures that failed to deliver. The need to make dividend payments, therefore, acts as a disciplining function in the allocation of valuable capital.
“Over a 50-year period the highest dividend-paying stocks in the S&P 500 outperformed the lowest dividend-paying stocks by a full 4.53% per year.”
The Core “Buy and Hold” Portfolio
The Fund has a “buy and hold” bias toward its core dividend-paying stocks. We continually review the gamut of Canadian dividend-paying stocks in search of those with the best combination of value and long-term prospects. We look for companies with proven management, sound balance sheets, solid earnings track records, high barriers to entry, and conservative dividend payout ratios. Within these constraints, we also look for companies that add to the diversification of the portfolio, thereby reducing risk.
We view ourselves as long-term owners of pieces of the best publicly-traded Canadian companies, and see little merit in trying to sell those pieces when times are bad (and their prices low), and then trying to buy them back when times are good (and their prices high). Our view is that overreaction to market variations is a detriment to returns.
Not only is a buy-and-hold strategy a good investment style, but it also has the advantage of reducing taxes payable from capital gains. We want to maximize the after-tax return to our unitholders, not the before-tax return. As a result, we have no interest in “locking in a gain” by selling a moderately overvalued core holding if this will result in sizeable capital gains taxes.
From time to time, however, conditions compel us to sell our core names, and when we do it is usually for one of three reasons: there has been a fundamental deterioration in the long term outlook for the business; the stock has become substantially overvalued; or, the balance sheet has become over-levered (i.e. too much debt) because of an acquisition or major project.
Our investment process results in the core portfolio being invested in a wide range of industries. Our largest concentration is in financial services, reflecting the large number of attractive dividend-paying companies in this sector in Canada.
“We continually review the gamut of Canadian dividend-paying stocks in search of those with the best combination of value and long-term prospects.”
We Generally Avoid Gold and Other Resource Stocks in the Core Portfolio
We have not owned significant amounts of gold stocks in the past, and are unlikely to do so in the future, especially in the core portfolio. We find gold stocks to be too volatile and unpredictable for our purposes, and also prefer companies where the product price is set primarily by fundamental demand, as opposed to being susceptible to speculative influences such as with the price of gold.
In addition to avoiding gold, we do not usually hold in the core portfolio stocks exposed to other resources such as base metals, fertilizers, and uranium. While some of these companies do pay dividends, as with gold we find these names to be overly volatile and unpredictable.
The main exception we make on resources is a core position of about 5-10% in oil and natural gas, with an approximate 50% split between the two. We have a core position in this sector for several reasons: the large weighting of this sector in the Canadian economy; the fact that we are all significant users of oil and natural gas; and, the sector’s occasional spikes. We find that having a core position in oil and gas keeps us from chasing this unpredictable sector over the top or selling it through the trough. We view this core position as similar to having some oil and gas wells in the back yard – i.e. it’s one’s personal hedge against the occasional big price increases in these commodities.
The Trading Portfolio
In addition to the targeted long-term returns from the core portfolio, we look to increase total returns by having a shorter-term, more trading-oriented portion of the portfolio that we fund using a moderate amount of leverage. Specifically, for every $100,000 invested in the Fund, we may borrow up to an additional 30% - $30,000 - to increase the total amount of securities purchased and the potential returns.
Typically, we have a large number of such positions, with each position accounting for anywhere from one-tenth of one percent to two percent of the Fund’s net asset value (NAV), for a total of 10-15% leverage from this source. The holding period can range from less than a day to several quarters, or more.
In contrast to the “good long-term companies” approach we take with the core portfolio, our trading portfolio is focused on shorter term mispricing of securities. We find this mispricing often results from companies in turnaround situations, excessive reactions to bad news or slow reactions to good news. Being much smaller than the typical mutual fund, we are able to be more nimble, moving in and out of trading situations with relative ease.
The use of leverage in the trading portfolio increases the potential volatility of the Fund. At least partly offsetting this effect, however, is the lower-than-average volatility of our dividend-paying stocks. This characteristic was demonstrated in the major market downturn of 2008-2009 when the Fund’s NAV declined less than the overall market by 4.9 percentage points (34.2% versus 39.1%), despite the Fund being fully invested (measured from Fund inception in April 2008; see performance graph).
“Being much smaller than the typical mutual fund, we are able to be more nimble, moving in and out of trading situations with relative ease.”
Canadian and U.S. Stocks in the Trading Portfolio
While we focus on Canadian stocks for both the core and the trading portfolios, sometimes we buy U.S. stocks for the trading portfolio. We focus on Canadian stocks for the core portfolio because of the preferential tax treatment given to Canadian dividends, and to avoid currency exposure. We occasionally buy U.S. stocks for the trading portfolio in order to take advantage of the wider range of opportunities. The U.S. purchases are typically funded with U.S. denominated borrowing, which gives us a natural hedge on the currency exposure.
We Are Not Market Timers
Our philosophy is to have the core portfolio fully invested at all times. While it is tempting to sell when the economy is deteriorating, usually the markets have already declined a fair bit by the time the deterioration is apparent, and then, on the way up, markets typically rebound before the recovery is well established. As a result, market timing is extremely difficult to execute profitably. Time tends to heal all market wounds. Even after the unusually sharp recent recession, the Fund had recovered to its pre-recession level one year after the market trough without any dramatic changes in the portfolio.
An additional disadvantage of market timing is that it causes the early payment of capital gains taxes on long-established positions. Deferring taxes for as long as possible works to an investor’s advantage because of the greater amount of capital retained.
Our Mission: An Attractively-Priced, Well-Founded Approach to Wealth Creation and Preservation
As we stated earlier, the objective of the Fund is to outperform the S&P/TSX Composite Total Return Index by several percentage points annually, after covering the 1% management fee. It is important to emphasize, however, that there will no doubt be lengthy periods of time when we will significantly underperform the market. Even companies that we view as less desirable from a longer term standpoint eventually get cheap enough that they outperform the market for a significant period of time. Sometimes this happens with an entire sector, and sometimes that sector is a large component of the index, such as gold, where as mentioned we are typically zero-weight.
Overall we believe our Fund offers an attractively-priced, sound approach to wealth creation and preservation, and we welcome investors who have a long-term focus and who share our investment philosophy. Please contact us if you would like to discuss the Fund in more detail or would like to review the Fund’s legal documents.
Note to Reader: The opinions expressed and information contained above and elsewhere on this website are not intended as the solicitation of any offer to buy or sell any of the securities referred to herein. In addition, the commentary in this website is not intended as specific investment advice for individual investors.