Investment Commentary

Annual Letter to Investors – 2019

2019 marked a number of milestones for Bristol Gate. Our US Equity Strategy celebrated its 10-year anniversary in May, our firm AUM surpassed the US$1 billion mark and both our US and Canadian Equity Strategies received Morningstar’s 5 Star rating. It was also a year of change.

In September, we announced Peter Simmie’s retirement from his role of Chief Investment Officer at year end. Peter was instrumental in designing a process and creating a culture that espoused continuous improvement without ever wavering from the firm’s core principle of increasing clients’ income every year by a significant amount through high dividend growth.

Over the last decade, that process has humbly produced outstanding results without ever owning some of the largest contributors to the S&P 500 Index returns over the same period.

Exhibit 1. Top Contributors to the S&P 500 Over the Last Decade.

Source: Bloomberg.

Peter will remain a shareholder and Director of the firm and assume the role of Vice Chair. We thought you might be interested in having him provide some parting words of wisdom as outgoing CIO. Here’s what he had to say:

Returns can be earned a variety of ways in the market, but we don’t see many private or institutional investors that can effectively and consistently execute some of the strategies below – too much hope, too much belief that they just deserve a return, too little commitment to maintain an investment discipline! What you should be careful of:

  • Timing the market. The success stories with this strategy are minimal – even with complicated hedge funds trading by the minute. Be warned, charts seldom provide consistently helpful forward decisions.

  • Buying on tips. It is not hard to find what someone else thinks is a good investment. Even professional portfolio managers can succumb to using another’s analysis and recommendations. Do your own work.

  • Buying companies with limited operating histories or high levels of debt. The most recent example is the cannabis industry, but there have been many before. Why do companies have high levels of debt? Mostly because they can’t generate sufficient cash from operations.

  • Following the herd. It’s not necessary. Bristol Gate has generated a “top of the industry return” over 10+ years, without owning Facebook, Amazon, Google or Apple.

  • The “hockey stick” approach. Needing a significant upward adjustment in operating cash introduces unnecessary and potentially unrewarded uncertainty. We are convinced that there is much less risk and higher returns by buying companies that continue to perform as they have in the past.

There are no free lunches in investments. Everything has a cost.

  • Incurring losses seriously disrupts your ability to increase your financial assets. Losses require an increase in expected return on the remaining assets. Unfortunately, many investors will modify their investment strategy at precisely the wrong time or hang on far too long with an underperforming investment.

  • Warren Buffet claims you only need 3 stocks to diversify a portfolio. Beyond a certain point, more stocks or bonds in a portfolio does not necessarily reduce risk, but it more likely obscures the underlying reasons for poor performance. Sectors provide virtually no useful information to execute risk management.

  • It is easier to buy – you sign a cheque, but you need to be able to sell an asset to realize a profit. Don’t underestimate the importance of being able to get out when you want to, not when you have to. Selling discipline is rare.

  • Passive index funds. Buying an index fund will likely keep your costs low but exposes you to the risk of the entire market. To reduce risk, you need to introduce other asset classes that are not correlated with the index or strip higher risk stocks out of the index. Because historical correlations may not hold in the future, introducing other asset classes may not work as planned. Removing stocks with junk level debt, new issues with no track record, dividend cutters, no growth companies, etc. can generate index like returns with less than index risk.

  • Risk and returns. It appears that annual returns are similar in all asset classes: small companies, private companies, public markets. Higher returns do not come from taking more risk, as suggested by finance theory, but by taking less risk.

Understanding returns when obscured by industry jargon can be difficult. Don’t use performance measurements that you don’t understand. Rather take your accounts and compute actual monthly returns in $ and %. Maybe a better approach is to assess performance as we do – in terms of how much income it generates and how much that income is growing, rather than its principal value, i.e. “I have $156,000 annually in income and my income is up 20% over last year”, rather than “I have a $2 million portfolio”.

Lastly, investors tend to focus on dividend yield rather than dividend growth as a measure of a company’s investment appeal, but dividend growth produces significantly better returns. With yield you are seeking to earn more than fixed income, with dividend growth you attempt to outperform the equity markets and bond markets. The top deciles of dividend growers in the US market consistently generate higher total returns and have for many years.

It is clear from Peter’s comments what you don’t do often matters as much as what you do. Although we never owned many of the top performing stocks over the last decade, not doing some of the things mentioned above helped us avoid 146 of the 148 negative contributors to the Index’s return over the last decade (one of the two we did own was inherited via a spinoff and only owned for a very short period). And we all know, the best way to compound capital is to not lose it in the first place.

Bristol Gate US Equity Strategy (all returns USD)

The US Equity Strategy gained 5.7% in the fourth quarter, trailing the S&P500 Total Return Index® by 339 basis points, but finished the year up 35.5%, 405 bps ahead of the broader market.

During 2019 the market experienced significant multiple expansion raising valuation concerns generally. Traditional valuation multiples of our portfolio and the market have been relatively similar over time, but we believe we have consistently owned a higher quality portfolio, and pay considerably less for our companies on our version of a PEG ratio for dividend growth (Price/Dividend to Dividend Growth or PDG). We are regularly able to buy dividend growth at much lower multiples of dividends than the market pays.

Exhibit 2. Price/Dividend to Dividend Growth

Source: Bristol Gate Capital Partners, Bloomberg.

Our portfolio is very inexpensive in this regard, especially given stronger fundamentals, with median EPS growth YOY of 13% on revenue growth of 6% last quarter, versus a market with flat EPS growth and 4% revenue growth. Based on our current predictions, the portfolio is expected to produce 17% dividend growth on average in 2020 compared to the 7% consensus is forecasting for the market.

Exhibit 3. US Equity Strategy Returns and Risk

Net Returns

Inception: May 15, 2009

The top three contributors to quarterly results were UnitedHealth, Bank of America and NetApp. Boeing, Cisco and Home Depot were the top detractors due to ongoing regulatory delays with the 737 MAX return to service, an IT spending slowdown and conservative guidance relative to expectations, respectively.

All securities positions were re-balanced to equal weights on November 20, 2019. Three position changes were made during this period, bringing the total changes for 2019 to eight [three in February; two in June and three in November].

NetApp, Cisco and Ingersoll-Rand were all sold because expected dividend growth was below our hurdle. In the case of Cisco and NetApp, ongoing global trade tensions led to a slowdown in corporate IT spending. Ingersoll said they expected to maintain their dividend at current levels through 2020 despite revenue growth in the mid single digits.

Intuit, Allegion and Tyson were added in their place, increasing the projected dividend growth of the fund by approximately 200 basis points.

Intuit is a leading provider of personal and small business tax and accounting solutions, through its Turbo Tax and QuickBooks software packages. The company has grown its dividend over 16% a year over the last five years and we expect similar levels to be sustained going forward given numerous growth opportunities (conversion from competitive products, reduced churn, new products, new geographies), high FCF conversion (~30% of sales) and incremental profitability (>25%).

Allegion is a leading global provider of security products that include locks, locksets, key systems, door closers, controls and exit devices, doors and door systems and other access control solutions. The company’s dominant share in the North American commercial and residential markets through its Schlage brand affords it industry leading profitability. The security market is fragmented with the top four suppliers controlling about 30% of the market, offering a long consolidation opportunity. Coupled with Allegion’s pricing power, general move to higher value electro-mechanical locks, and an ongoing recovery in residential and institutional construction/investment, we believe the company is poised to sustain above GDP growth rates. This, plus a relatively low payout ratio should allow the company to continue growing its dividend at rates similar to the past (five year CAGR >27%).

Tyson is one of the largest diversified protein companies in the world. The company has grown its dividend over 33% a year for the last five years and we believe can continue growing at high rates in the near term in part because of the effect African Swine Fever (ASF) is having on global protein markets. China accounts for 50% of global swine production and approximately half their herd has been wiped out. This has led to higher pork prices and a switch to alternative proteins, which are also seeing prices rise as exports to China increase to fill the void. In addition, China has lifted a nearly five year ban on poultry meat imports from the US. We expect Tyson to be a direct beneficiary of this given their fully integrated chicken business and general beneficiary of higher protein prices overall.

Bristol Gate Canadian Equity Strategy (all returns CAD)

The Canadian Equity Strategy gained 5.62% in the fourth quarter and was up 24.41% on the year, outperforming the S&P TSX Composite Total Return Index® by 245 basis points for the quarter and 154 basis points for the year. The source of the outperformance was primarily security selection, with sector allocation positively contributing to a lesser extent. Currency had a negative effect, as the Canadian dollar appreciated vs. the US dollar, hurting the CAD return of the portfolio’s two unhedged US positions.

The aggregate characteristics of the portfolio remain consistent with the mandate of investing in high dividend growth companies, with a median dividend growth rate of 15.4% versus 5.5% for the S&P TSX Composite Index. We continue to believe the portfolio is well positioned given the expected dividend growth, quality characteristics (with higher average return metrics (ROE, ROIC) than the benchmark) and aggregate valuation metrics (P/E, EV/EBIT in-line or lower than the benchmark).

Risk metrics continue to illustrate that performance has not been generated through taking increased risk.

Exhibit 4. Canadian Equity Strategy Returns and Risk

Net Returns

Inception: July 1, 2013

The top three contributors were UnitedHealth, Enghouse Systems and Canadian Natural Resources. The top three detractors for the quarter were Dollarama in the Consumer Discretionary sector, TD Bank in the Financials sector and NFI Group in Industrials. Industry and company specific issues caused these companies to post results or provide outlooks below expectations.

All securities positions were re-balanced to equal weights on November 20th, 2019. One position change was made at the same time, bringing the total changes for 2019 to four [three in February and one in November].

Canadian Tire was sold because expected dividend growth declined significantly within the past year. An increasingly competitive environment, worsening fundamentals and a less attractive valuation were contributing factors in exiting the position. Open Text was added in its place, considerably increasing the projected dividend growth of the fund.

Open Text has a history of value creation and dividend growth at double digit rates. A leader in Enterprise Information Management software with high switching costs and high levels of recurring revenue, the company’s consistency and healthy cash generation have allowed it to execute an effective M&A strategy to grow intrinsic value. We are excited about the prospects of the business going forward.

Firm Update

At December 31, Assets Under Administration and Management were approximately CAD $1.4 billion.

Since our inception, we have continually invested for the long-term, both in our Strategies and in our business. Our pipeline of active opportunities is perhaps the largest it has ever been. We are evaluating investments in systems, people and processes to future proof our business and help considerably more investors in the years ahead.

We thank our current investors for their continued trust in us and we welcome the opportunity to compete for our prospective investors’ hard-earned savings.

Yours sincerely,

Richard Hamm
Chief Executive Officer

Achilleas Taxildaris
Portfolio Manager

Important disclosures
Disclaimer: This is presented for illustrative and discussion purposes only. It should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities and it does not consider unique objectives, constraints, or financial needs of the individual. Under no circumstances does this piece suggest that you should time the market in any way or make investment decisions based on the content. Investors are advised that their investments are not guaranteed, their values change frequently, and past performance may not be repeated. References to specific securities are presented to illustrate the application of our investment philosophy only, do not represent all of the securities purchased, sold or recommended for the portfolio, and it should not be assumed that investments in the securities identified were or will be profitable and should not be considered recommendations by Bristol Gate Capital Partners Inc. The information contained in this piece is the opinion of Bristol Gate Capital Partners Inc. and/or its employees as of the date of the piece and is subject to change without notice. Every effort has been made to ensure accuracy in this piece at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and Bristol Gate Capital Partners Inc. accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. We strongly recommend you consult with a financial advisor prior to making any investment decisions. Please refer to the Legal section of Bristol Gate’s website for additional information at
Gross returns in this report refer to the Bristol Gate US Equity Strategy Composite and Canadian Equity Strategy Composite. No allowance has been made for custodial costs, taxes, operating costs, management and performance fees, which will reduce performance. Allowance for withholding tax in the US strategy composite is partially reflected in the composite returns for periods commencing January 2017 and after. The Net returns for the Bristol Gate US Equity Strategy Composite and Canadian Equity Strategy Composite are reflective of the maximum management fee charged by Bristol Gate of 1% and 0.70%, respectively. Past performance is not indicative of future results.
A Note About Forward-Looking Statements
This report may contain forward-looking statements including, but not limited to, statements about the Bristol Gate strategies, risks, expected performance and condition. Forward-looking statements include statements that are predictive in nature, that depend upon or refer to future events and conditions or include words such as “may”, “could”, “would”, “should”, “expect”, “anticipate”, “intend”, “plan”, “believe”, “estimate” and similar forward-looking expressions or negative versions thereof.
These forward-looking statements are subject to various risks, uncertainties and assumptions about the investment strategies, capital markets and economic factors, which could cause actual financial performance and expectations to differ materially from the anticipated performance or other expectations expressed. Economic factors include, but are not limited to, general economic, political and market factors in North America and internationally, interest and foreign exchange rates, global equity and capital markets, business competition, technological change, changes in government regulations, unexpected judicial or regulatory proceedings, and catastrophic events.
Readers are cautioned not to place undue reliance on forward-looking statements and consider the above-mentioned factors and other factors carefully before making any investment decisions. All opinions contained in forward-looking statements are subject to change without notice and are provided in good faith. Forward-looking statements are not guarantees of future performance, and actual results could differ materially from those expressed or implied in any forward-looking statements. Bristol Gate Capital Partners Inc. has no specific intention of updating any forward-looking statements whether as a result of new information, future events or otherwise, except as required by securities legislation.

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