Commentary

- Vertex Fund -

For the first quarter of 2019, the Vertex Fund (Class A) returned 4.26% and the Vertex Growth Fund (Class F) returned 7.69%.

After the beating our equity funds took in the fourth quarter of 2018, our phones have not been this busy since the financial crisis of 2008. As long-time investors might recall, the Vertex Fund’s 2008 Q4 Report was aptly titled Annus Horribilis. It once again seems appropriate to quote Queen Elizabeth II, as the tail end of 2018 was indeed “Annus Horribilis”. That being said, aspects of 2019 are also beginning to look a lot like 2009.

After raising interest rates in 2018, the U.S. Fed reversed course earlier this year by pivoting to a more accommodating interest rate policy. This drastic change in tone now has the futures market predicting a 70% chance of an interest rate cut this year. In Canada, we saw the 5-year rate drop from 2.4% to 1.5%, with the central bank fully abandoning its bias towards raising interest rates in favor of increasingly dovish policies.

In early 2009, we significantly reduced the portfolio’s M&A exposure in favor of high-yield debt. Similarly, we have seen some interesting opportunities emerge in the high-yield space in the first quarter of 2019, leading us to reduce our M&A exposure. While we began the year with a small window of double-digit M&A returns in our Red Hat position, the disclosure of Berkshire Hathaway’s acquisition of over 4 million shares of the software maker caused the M&A spread to tighten, and ultimately for us to exit the position.

While equity markets have mostly rebounded after the difficult end to 2018, one massive opportunity has remained in the form of high-yielding equities. Unlike in 2009 where we saw opportunity in acquiring the debt of bankrupt banks, we believe that the opportunity today lies in high quality, blue-chip equities. These companies – most of whom offer decades of steady dividend growth – have seen their valuations cut deeply enough with their dividend yields well above 5%. The attractiveness of this space becomes even more apparent when you consider the spread between Canada 5-years and these high-quality assets.

Here’s a sampling of some of the names we currently own:

Issuer

Yield

Artis REIT6.10%
Brookfield Property6.10%
BCE Bell Canada5.30%
Diversified Royalty7.00%
Enbridge5.80%
Enlink Midstream8.70%
Inter Pipeline7.70%
Viper Energy Services5.90%
NorthWest Healthcare REIT7.00%
NuStar Energy Pfds9.70%

Outside of the high-yield space, we continue to hold a bucket of energy names along with two special situations: Intermap and Social Capital Hedosophia.

We have owned the debt and equity of Intermap Technologies – a satellite imaging company that provides end-to-end geospatial data – for several years. The company has continued to struggle, and new management has not yet managed to turn around this high-cost operation. Last year we received an unsolicited bid for the company based solely on its embedded tax losses. Despite our recommendation that Intermap work with the suiter to take the bid, management has decided to proceed with a full process to sell the company. The steps required for this process are, of course, taking much longer than we thought, and we hope that a higher bid emerges.

Our second special situation position, Social Capital Hedosophia, is a blank cheque company (SPAC) that was formed in 2017 by the venture firm, Social Capital. The intent of Social Capital is to acquire a privately held tech company and to take it public through a SPAC, thereby circumventing the traditional IPO process (when a company is acquired by a SPAC, they go public without paying for an IPO). As with all SPACs, the target company was unknown at the time of the SPAC’s IPO; a process which arguably can help stabilize a company when it goes public. With currently over $800 million USD in cash, a deal has still not yet been announced. Despite the process taking slightly longer than we had anticipated, we are confident in the long-term vision of Chamath Palihapitiya (CEO).

The energy sector has seen a rebound this year, both in market sentiment and in oil price. Despite this, we continue to experience a lag in the performance of individual oil and gas companies. Petroshale and Lilis Energy – two of our favourite oil and gas names that caused us heartburn in the fourth quarter of 2018 – also experienced operational issues in Q1 of this year. This has caused a slowdown in production growth and dampened the expectations set by management in late 2018. In line with our investment thesis, our stance on these companies has not changed as both names have the runway to get production back to expectations by the end of this year. For example, Petroshale (our second largest name) is currently at 5,000 barrels of oil equivalent (BOE) a day, and management has given guidance for 10-11,000 barrels at year end. Although this timeline is one year behind schedule, it trades at 1.5 x cash flow at year end and when 2020 numbers get calculated it will trade at .75x cash flow. Shares could easily increase five times in value.

Regarding Lilis Energy, their neighbours a mile down the road in New Mexico recently discovered a 5,000 BBL/day well; a discovery that will fundamentally change the value of this company based on land value alone. Despite the government shutdown which has delayed the permit process, these should arrive in time to get the company back on track to finish 2019 at 10,000 bbl a day.

Today, as in 2009, we continue to maintain a nimble and long-term investment perspective as we strive to build a resilient and unique portfolio. As always, we appreciate your support and invite you to contact our team with any questions about your investments.

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