Partners in WMK’s Strategic Opportunities portfolio currently own 19 high quality businesses. A few facts about the portfolio: One third of the portfolio is in companies headquartered in Canada or Mexico, nearly all of our businesses have leadership (founders, management, board members or shareholders) who have deep “skin in the game,” and relative to the S&P 500 we are infinitely underweight Tesla!
Over time, we expect our portfolio to grow more concentrated. One of the key benefits of this commitment to concentration is that businesses must always compete for a share of our highly valuable capital. This mechanism raises the bar for investments and makes our conviction much greater in each individual business that we own.
Our portfolio does not reflect any major indices. We are focused on absolute returns, not benchmarking. However, our portfolio has performed adequately on an absolute and relative basis so far. Quarterly returns mean very little (especially in our first full quarter of performance!) and you should judge our performance on at least a 3-year time horizon.
What are we pondering?
March of 2021 marked the anniversary of global financial markets delving into mayhem as they grasped the gravity of the COVID-19 pandemic. A key lesson ingrained in my head over the last year is the fallacy of people being able to accurately predict the future. Despite a year that should remind us of life’s inherent uncertainty, we entered 2021 with bold projections about future stock market returns, interest rate levels, economic reopenings (or closings!), and virus containment.
Rather than make predictions, I am focused on accepting the reality that the future is unknowable. Our job as investors is to make educated decisions while weighing the upside and downside of possible outcomes.
What does this mean to my Partners? I am looking to build a resilient portfolio of businesses that can adapt to a wide range of economic outcomes. First, I want to own businesses that can make money in many environments. Second, I want a margin of safety so that if my expectation of the future is wrong, the downside is limited. Finally, I want stakeholders involved in the business who have deep “skin in the game” and are committed to seeing their business be successful. Things go wrong, but talented people with strong character find a way around inevitable issues.
Portfolio Activity
While we do not make investments with the intention of being short-term, there are times when unique events transpire or material discounts to our view of the intrinsic value of the business close more quickly than expected. There have been two exits worth highlighting in 2021: Lumen Technologies (LUMN) and Canadian Natural Resources (CNQ). Each position was purchased at a discount to our estimate of intrinsic value and sold when that discount materially closed.
Lumen was sold after the price increased dramatically over two days of trading. The stock price did not move so dramatically due to a change in the business, but rather it occurred during the first GameStop short squeeze where retail investors caused a raucous throughout the financial markets. We took that rapid price improvement and locked in a gain for our investors in anticipation of finding better opportunities down the road.
Canadian Natural Resources – founded by Chairman Murray Edwards – is a best-in-class oil and gas company based in Canada. The competitive advantage is both sustainable and long lasting, with oil reserves that have a useful life of 30+ years vs. US shale producers with much shorter oil well lifespans. This unique asset base enables a self-funding business, which is rare in the energy world and incredibly powerful for equity investors.
After initially purchasing the business, we doubled the price at sale. In the meantime, we enjoyed a healthy dividend. The rationale for selling was that oil is no longer “back up the truck” cheap. I do not profess to be the best oil market analyst outside of Texas, but I was astute enough to know that oil will need to settle above the breakeven production rates for much of the world! Our risk reward became skewed in the position from very attractive at time of purchase to quite muted at time of sale.
These sales are indicative of a key point that you should understand about our capital allocation process: Because we are not willing to indefinitely add businesses to our portfolio, we are systematically forced to look at the highest and best use of our collective capital. When businesses have limited ability to reinvest their capital at high returns on investment (both CNQ and LUMN fall into this category), we must closely monitor the discount to intrinsic value. If a business has a very long runway to reinvest capital at high returns, we can be far less precise with the calculation of intrinsic value.
Clearly, owning businesses that can reinvest capital for a long period of time (high quality compounders) is both easier and more lucrative. While we will still purchase businesses that are simply “too cheap,” our efforts are focused on owning high quality compounders.
Converge Technology Solutions
I thought it would be useful to highlight a Canadian business, Converge Technology Solutions (CTS.TO), which was introduced to our portfolio as a significant position earlier this year. Converge is an IT service provider that supports clients in acquiring and implementing top-tier hardware, software, and managed services. Shaun Maine, the Founder and CEO, had the insight to recognize that mid-sized businesses were often overlooked in the IT space. Under his leadership, Converge experienced rapid growth in both revenue and profitability over a short period. The company was recently listed on the Toronto Stock Exchange and, despite its impressive progress, remains relatively small and under the radar within the investment community.
From experience, I can say that running a small-to-mid-sized business can be difficult from an IT perspective. Most leaders know that cybersecurity, cloud infrastructures, and firewalls are important…but we have no idea what to do about these issues! Converge helps fill the IT knowledge void, solving a serious pain point.
Converge is growing both organically and via acquisitions. Since 2017, Converge has successfully acquired and integrated 18 businesses and is on the hunt for more. However, growth only adds value if done in an economically judicious manner. Converge is intelligently utilizing their increasing scale to improve the unit economics of the businesses they acquire and operate.
Let us take an example: A typical standalone business in this industry tends to operate with modest profit margins. Converge, however, benefits from strong vendor relationships, allowing it to immediately improve margins through favorable pricing and volume-based discounts. Further efficiencies are gained by eliminating overlapping costs through shared services integration. As a result, what may initially appear to be a standard acquisition becomes significantly more attractive once these advantages are factored in. But the benefits don’t stop there. Converge also enhances cash flow by optimizing working capital terms, often unlocking meaningful short-term liquidity. This means that the return on investment for an acquisition can be achieved in a relatively short timeframe, even before considering the additional upside from cross-selling services across its growing platform, which remains a key driver of long-term organic growth.
Converge sits in a structurally growing market (we need more technology, not less), works with an underserved piece of this market (their customers want their help), and has capital efficient opportunities to grow. However, there are several more ingredients that increase my confidence in the business.
Converge is founder-led, with meaningful ownership retained by management. They’ve also adopted a thoughtful compensation structure inspired by another successful Canadian company. Instead of relying on dilutive stock options, management is required to buy and hold actual shares on the open market for the long term. This creates strong alignment with common shareholders and helps limit potential dilution over time. Additionally, one of the most respected institutional investors in this space recently took a significant position in Converge. The right stakeholders are in place.
A quick checklist: a structurally growing industry, strong product-market fit, capital-efficient expansion, founder-led leadership, aligned management incentives, committed long-term stakeholders, and a business model I have direct experience with. The foundation is in place for strong business performance, and we were able to invest at a compelling valuation relative to its future cash flow potential. While there is meaningful execution risk and the stock is likely to experience significant volatility, the core ingredients of a high-quality business are present, and we plan to be long-term owners of Converge.
Conclusion
As your Partner in all investments, I will remind you that patience is key to winning this endeavor we call investing. I suspect that the road to material outperformance of any reasonable benchmark will be filled with ups and downs. The path to abnormal results requires investors to stomach challenges along the way. We intend to be long-term investors and thinkers, focused on the business quality and performance first. Over time, our collective net worth improvement will follow.
We are open to new Partners if they share a long-term mindset and are hungry for sustainable (sometimes slow!) wealth creation rather than focus on short term results. Feel free to share our thoughts with those you believe could fit the bill. In the meantime, we will look for wonderful businesses to buy at a reasonable price.
Appendix: Required Reserves Performance
Several of my Partners as well as myself own what is called a Controlled Foreign Corporation, which functions much like a captive reinsurance business. These entities have a significant portion of their capital in a highly restrictive Investment Policy Statement as mandated by the powers in charge.
Given the requirement to hold the vast majority of the portfolio in liquid, U.S.-based investment grade fixed income, it’s not surprising that the recent rise in interest rates has had a negative effect on returns.
Despite this challenge, we put our maximum exposure into preferred and common equity indices as allowed by the IPS, which helped offset some of this pressure. I am not excited to own any source of fixed income today and results are likely to be impaired by the one-sided nature of the fixed income market: rates cannot get much lower but can get much higher. The risk is skewed to the downside.
I still expect that over time we will earn reasonable returns. As more capital builds, more of the funds can be utilized on more lucrative options such as the previously discussed Strategic Opportunities portfolio.
Note that small variations from the benchmark should be expected due to timing of receiving investment funds, which is variable throughout the course of the month and outside of our control. Over time, these should not be material to your investment results.
Disclosures:
The views expressed above are those of WMK Investment Partners. These views are subject to change at any time based on market and other conditions, and WMK disclaims any responsibility to update such views.
Past performance is not indicative of future performance. Principal value and investment return will fluctuate. There are no implied guarantees or assurances that the target returns will be achieved, or objectives will be met. Future returns may differ significantly from past returns due to many different factors. Investments involve risk and the possibility of loss of principal. The values and performance numbers represented in this report do not reflect management fees.
WMK may discuss and display, charts, graphs, formulas which are not intended to be used by themselves to determine which securities to buy or sell, or when to buy or sell them. Such charts and graphs offer limited information and should not be used on their own to make investment decisions. To the extent that certain of the information contained herein has been obtained from third-party sources, such sources will be cited, and are believed to be reliable, but WMK has not independently verified the accuracy of such information.