Investment Commentary

Report to Investors 1st Quarter 2020

Firm Update

We usually save the firm update for last in our quarterly commentaries but given the severity of what we are all experiencing as a result of the coronavirus, we wanted to provide this quarter’s addition upfront.

We take the health and well-being of our clients and employees seriously and moved to a work from home environment in early March, ahead of many governments mandates to do so. We are happy to report that all our employees remain in good health and we hope the same can be said for all our clients and their families.

Thanks to a robust and regularly tested business continuity plan, our operations proved resilient and transitioned without any major issues. Despite the physical distancing, the entire team is in regular contact and our focus on protecting and growing our clients’ wealth has not waivered. It has been a tremendous companywide effort and we thank all our employees for it.

We also want to thank our clients, who despite the near term challenges the current market environment is posing, continue to support us with their trust. During the first quarter, we saw net inflows in our assets under management and administration of approximately $250 million, highlighting their confidence in our investment process.


Investment Commentary

The challenges brought about by the coronavirus pandemic have been significant and unique in so many respects. The virus has spread to approximately 180 countries, sickening 1.9 million people and killing approximately 114,000 as of April 11. The effects have been pervasive, with entire countries essentially ordering shutdowns to contain the spread of the disease as it quickly moved from a local issue in Wuhan in January to the World Health Organization declaring it a global pandemic in mid-March.

After initially ignoring the virus as it spread across China, markets eventually responded in kind, leaving few places to hide. Intra quarter, the S&P 500 fell approximately 34% from the peak on February 17 to the low on March 23. The speed of the decline was the fastest on record and led to the worst first quarter result since the 1930s. Fixed income markets did not fare much better with the cost of corporate default protection soaring for both investment and junk rated issues.

Governments and central banks around the world rightfully saw the pandemic as not just a public health crisis, but also a potential economic disaster with lockdowns leading to drastic and significant declines in economic activity. With slumping cash flows and tighter financing conditions, corporations began undertaking cost savings measures causing large increases in unemployment, further exacerbating the economic challenges they faced. The damage to small business has been even worse.

Policymakers responded, rapidly flooding the financial system with unprecedented monetary and fiscal stimulus to contain the collateral damage of a potential credit cycle. The globally coordinated effort had the affect it intended with the VIX Index, commonly regarded as the market’s measure of fear, falling substantially by month end (although still at elevated levels). The S&P 500 rose 16% from the March 23 low to quarter end and is continuing its run into April.

Many uncertainties remain and while we do not know the ultimate extent and duration of the coronavirus induced damages, we do know there will be a recovery. According to the Harvard Business Review, history does provide some context regarding prior epidemics, with all experiencing V-shaped rebounds in GDP.

Exhibit 1. Economic Impact of Prior Epidemics

Source: Harvard Business Review

At Bristol Gate, we have never put much stock in making macro-economic predictions, knowing the difficultly in trying to accurately predict the next cycle. We instead have focused our efforts on our evidence-based approach of combining data science with fundamentals to identify a collection of the best expected dividend growth companies of the highest quality. We believe owning such companies is the best way to preserve and to grow wealth over time and through all market and economic cycles.

Our investment process attempts to remove some of the emotional baggage that can significantly impair decision making during times of stress by using a systematic, model driven process to identify high potential ideas. As most market participants wax and wane between panic and fear of missing out with every central bank action or new virus datapoint, our dividend prediction model consistently processes fundamental, market, analyst and macro data in an unbiased fashion to guide us to where the best income growth opportunities exist.

While no model is perfect, and this crisis is somewhat unprecedented, our machine learning model is performing as well as can be expected given the volatility. In running the US Model through the periods of February and March, the Top 65 average dividend prediction fell by roughly 350 basis points, appropriately capturing the general expected slowdown in cash flows across the market.

Compared to quantitative only strategies, which typically have a difficult time responding and adapting to the new environment in a timely manner, we believe our human and machine approach is much better suited to deal with unique situations such as the one we are currently in. This period has been particularly challenging as things have unfolded at a much faster rate than comparable events of the past. Our fundamental work corroborates the model’s predictions under changing conditions in real time, working to quickly capture and assess new information as it arises. It also helps assess dividend growth sustainability beyond the model’s one-year time prediction horizon.

Although there is always room for improvement, we believe our process is sound and has consistently resulted in portfolios that have produced attractive returns over time. This does not mean it produces the best returns every time.

We are often asked about the type of environments during which our strategy can be expected to underperform, and our typical response highlights periods such as the one we are currently in. Periods where some macro risk causes a rush to “safety” in government bonds generally pose challenges for high quality, dividend growth-oriented investors. During these events investors often reward high dividend yield, not dividend growth.

Even though our investment process is sector agnostic, we have historically been over-weight the consumer discretionary and industrial sectors because that is where we have uncovered some of the highest quality income growth. It was no different entering the current quarter. Unfortunately, these two sectors have been particularly impacted in the new world of physical distancing and self-isolation as they generally do not produce the goods or services that are essential in the type of health crisis we are currently experiencing. Things like groceries, certain healthcare/biotech products and services, utilities, and technology services delivered through the cloud are all segments currently in high demand. Many of these companies are not part of our investing universe as they generally have limited dividend growth or no dividends at all.

In short, the Bristol Gate portfolios were not positioned to outperform the market in a global pandemic, especially considering the speed and magnitude of the economic downturn, but that does not mean our longer-term opportunity is impaired.

In their book, “Strategy Beyond the Hockey Stick”, McKinsey researched more than 2,000 companies over two decades and found a small number capture the lion’s share of global economic profit, while the vast majority return just slightly above their cost of capital. The top performing firms had dynamic resource allocation, disciplined M&A and dramatic improvements in productivity. These are all items considered in our fundamental process as part of our Productive Capital Analysis because they are some of the necessary components to sustain high dividend growth over several years.

Exhibit 2. The Resilients

Source: McKinsey, (h/t H. Schaeffer @ RBC)

In a follow-on article McKinsey studied 1,100 publicly traded companies and found that during the last downturn, about 10% of them fared materially better than the rest from a total shareholder return perspective. They called these companies the “resilients” and we believe our process focused on sustainable high dividend growth leads us to many of them.

According to Empirical Research Partners, the market has recently been discounting an approximate 25% decline in dividends. On April 6, the FT reported the futures market implied S&P 500 dividends will take nine years to recover from the cuts caused by the coronavirus.

Exhibit 3. S&P 500 Dividends per Share and Futures Market Implied Dividends

Source: Financial Times

In contrast to the broader market, we expect our holdings to continue posting attractive average dividend growth in 2020. Our companies have strong balance sheets and the financial flexibility to deal with disruptions such as this. We do not own any companies that are beholden to the capital markets to fund their business models, which is not something we can say for each of the constituents of the S&P 500 or S&P TSX Composite, our two relevant benchmarks.

Assuming our portfolio companies continue paying the dividends they did last quarter or maintain increases they recently declared, we expect our US portfolio to deliver a minimum 12% dividend growth on average this year and our Canadian holdings to deliver 9%. While these rates are lower than the 20% and 12% the portfolios have historically delivered, respectively, they are significantly better than the forecasts for the overall markets. It is important to note that these forecasts are not our base case. We expect our companies as a group do better than the minimums above. For example, our model currently predicts 14% dividend growth on average for our US holdings and approximately 10% for the Canadian strategy. In our mind, those dividend growth rates highlight the quality of our companies and are a better representation of the relative earnings power of our businesses compared to those implied by current stock prices.

From our perspective, the long-term prospect of our portfolios remains largely intact and as such represent attractive value at current levels. In the meantime, our systematic quarterly rebalancing process will take advantage of material short term mispricings in the market via its inherent contrarian approach and we continue to look for opportunities to improve the quality of our portfolios across our four pillars (dividend growth, business quality,  valuation and fit) as we work our way through the effects of the global pandemic.

Bristol Gate US Equity Strategy (all returns USD)

The US Equity Strategy fell 23.2% in the first quarter compared to the 19.6% decline for S&P500 Total Return Index®. Tyson, Boeing and Broadridge were the three largest relative detractors but weakness was broad based and security selection accounted for the bulk of the under performance. Our overweight in Industrials was by far our biggest detractor from a sector allocation perspective.

First quarter earnings season will begin shortly, and some caution seems warranted given the current environment. We believe there are two elements of our process that provide some protection against a permanent impairment of capital: our focus on cash flows via our Productive Capital Analysis fundamental process and our requirement for strong balance sheets.

Undoubtedly, the near- term earnings across our entire portfolio will slow. If we were using next quarter’s earnings to value our companies, many would appear to be significantly overvalued in the face of substantial declines. However, when evaluating our companies’ expected cash flows over the longer term, there is limited impact on our assessment of value from a near term, albeit significant decline. To put this in perspective using an example, assuming Starbucks’ revenue declined 30% over the next 12 months and free cash flow by almost 60%, our assessment of intrinsic value falls by less than 5% assuming the company’s operations return to normal and the rest of our forecast period is a reasonable approximation (we are generally conservative in our out year forecasts).

We are confident that our portfolio companies have the resilience, provided by their strong balance sheets and relatively lower payout ratios to sustain attractive dividend growth in the coming years.

Exhibit 4. US Equity Strategy Returns and Risk

Net Returns

Boeing and Southwest Airlines were sold during the quarter. It became clear the companies would not be able to maintain their dividends with the ongoing 737 MAX grounding and global travel grinding to a halt. The combination of the two factors was too much to overcome in our opinion. It was also reported both were considering government assistance to sustain operations through the significant disruptions brought about by the pandemic. Accepting government assistance negatively impacted shareholder distributions of the banks during the financial crisis and is generally not a positive development for dividend growth-oriented investors.

All securities positions were re-balanced to equal weights on March 23, leaving two units of cash at quarter end which we have been allocating to two new high quality candidates subsequent to the quarter, consistent with our goal of using this volatile period to high grade the portfolio.

Bristol Gate Canadian Equity Strategy (all returns CAD)

The Bristol Gate Canadian Equity strategy was down 19.7% in the first quarter, slightly better than the negative 20.7% return for the S&P/TSX Composite Total Index®. Relative outperformance was a combination of sector allocation and security selection. No exposure to the high yielding Utilities sector hurt as the sector held up better than most. Our security selection and underweight allocation in the Energy sector helped relative performance. Our two holdings in the sector, both pipelines, fared better than companies with more direct exposure to the underline commodity, which saw drastic declines following disagreement amongst OPEC members regarding supply and a significant fall in demand.

NFI Group, Canadian Natural Resources and CAE Inc. were the largest detractors of absolute and relative performance, while Quebecor, Visa and Canadian National Railway were the best performers for the quarter. The portfolio’s exposure to the US dollar via Visa and UnitedHealth had a positive effect.

Exhibit 5. Canadian Equity Strategy Returns and Risk

Net Returns

NFI Group and ONEX Corporation were sold during the quarter. NFI’s recent acquisition of a UK bus company resulted in increased leverage that under the current environment was a contributing factor in management’s decision to cut its dividend. The company may benefit from fiscal stimulus, especially on its transit segment, but its coach segment will continue to face a challenged environment of increased aftermarket supply. In hindsight, ONEX’s acquisition of WestJet Airlines was untimely and while it is still a fraction of the company’s assets, deteriorating growth prospects and leverage in many of its other businesses led us lower our assessment of the company’s net asset value.

All securities positions were re-balanced to equal weights on March 23, leaving two units of cash at quarter end which we will be allocating to two new ideas in the subsequent quarter.

Thank you for your continued support.

Yours sincerely,

The Bristol Gate Team

Important disclosures
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.
The Bristol Gate US Equity Strategy Composite was formerly known as the Bristol Gate US Dividend Growth Composite until April 1, 2015. The Composite inception date was May 15, 2009. The Composite consists of equities of publicly traded, dividend paying US companies and is valued in US Dollars.
The Bristol Gate Canadian Equity Strategy Composite was formerly known as the Bristol Gate Canadian Dividend Growth Composite until April 1, 2015. The Composite inception date was July 1, 2013. The Composite consists of equities of publicly traded, dividend paying Canadian and US companies and is valued in Canadian Dollars.
The S&P 500® Total Return Index measures the performance of the broad US equity market, including dividend re-investment, in US dollars. The S&P/TSX Composite Index measures the performance of the broad Canadian equity market, including dividend re-investment, in Canadian dollars. This index has been provided for information only and comparisons to the index has limitations.
There is the opportunity to use leverage up to 30% of the net asset value. Leverage is not used as an investment tool to enhance returns, but for cash management needs of certain composite portfolios.
This Report is for information purposes and should not be construed under any circumstances as a public offering of securities in any jurisdiction in which an offer or solicitation is not authorized. Prospective investors in Bristol Gate’s pooled funds or ETF funds should rely solely on the fund’s offering documents, which outline the risk factors associated with a decision to invest. No representations or warranties of any kind are intended or should be inferred with respect to the economic return or the tax implications of any investment in a Bristol Gate fund.
Bristol Gate claims compliance with the Global Investment Performance Standards [GIPS®]. To receive a list of composite descriptions and/or a presentation that complies with the GIPS® standards, please contact us at Bristol Gate Capital Partners Inc. has been independently verified for the periods commencing May 2009 until December 2015 by Ashland Partners International PLLC and for the period January 1, 2016 to December 31, 2017 by ACA Compliance Services, LLC.
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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