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The first quarter of 2016 proved to be a volatile one, following on from the volatility experienced in 2015. Although stocks began with one of the worst starts to a year in history, they reversed course and ended the quarter up strongly. As can be seen, small caps led the advance with the WSIB portfolio up over 12%, significantly outperforming the TSX and other global indices.
|
January |
February |
March |
YTD |
|
| JZA Special Equity Fund |
-3.34% |
+6.51% |
+7.22% |
+10.39% |
| S&P TSX |
-1.17% |
+0.47% |
+5.28% |
+4.54% |
| S&P TSX Small Cap |
-4.09% |
+5.35% |
+7.40% |
+8.52% |
What was most notable in the quarter was after the poor performance in the Energy and Material sectors over the last few years, it was those sectors that showed leadership. The CRB index finished the first quarter with a gain of +6.5%, WTI Oil jumped +13% in March and Lumber gained over +22%. The biggest winner was Gold, which benefitted from a fall in the US dollar and rose +16%. The only loser in the commodity sector to date was Natural Gas and Uranium, losing -14% and -15% respectively. Sectors leading the advance were Materials (+20.0%), Telecom (+11.5%) and Utilities (+9.6%). The worst performing sectors include Health Care (-67.3%), Info Tech (+0.3%) and Consumer Discretionary (+3.1%).
With this back drop, the portfolio performed well with its overweight position in both materials and energy.
The sector allocations of the portfolio can be seen below.
| Sector | Portfolio | Benchmark | +/- |
| Materials |
45.00% |
11.00% |
34.00% |
| Info Technology |
13.90% |
3.10% |
10.80% |
| Health Care |
4.00% |
0.90% |
3.10% |
| Cash |
0.00% |
0.00% |
0.00% |
| Consumer Discretionary |
6.30% |
6.80% |
-0.50% |
| Consumer Staples |
3.70% |
4.65% |
-0.95% |
| Utilities |
0.90% |
2.50% |
-1.60% |
| Energy |
16.80% |
19.30% |
-2.50% |
| Industrials |
4.30% |
8.20% |
-3.90% |
| Telecom Services |
0.00% |
5.70% |
-5.70% |
| Financials |
5.10% |
37.85% |
-32.75% |
| Total |
100.00% |
100.00% |
The three positions contributing most to the first quarter’s performance included Nexgen Energy Limited, Claude Resources and Newmarket Gold. These positions added +4.5% to returns.
Nexgen Energy is a uranium company that has made a significant discovery on the south western side of the Athabasca Basin. The company is well funded, having recently completed a $20 million capital raise in the quarter. NexGen continues to actively drill the Arrow deposit and expand the high grade resource adding additional pounds, higher grades and identifying new targets. With continued drilling this summer, I anticipate the company will significantly increase its resource; the portfolio continues to hold a large position.
Claude Resources is a gold company mining high grade ounces underground from its Seabea Mine in Saskatchewan. At the bottom of the cycle, this company’s balance sheet was seriously strained but over the course of the last two years the company has refocused its operations, repaired its balance sheet and started producing positive free cash flow. This quarter Silver Standard made a bid for the company. We have subsequently sold the position into this bid.
Newmarket Gold is a recently formed gold company with three mines located in Australia. The company’s board include veteran Canadian mining executives Randall Oliphant, Raymond Threlkeld and Lucas Lundin. In July of 2015, Newmarket completed a transformational merger with Crocodile Gold. Like many gold companies, the merged company has focused on cost containment, generating free cash flow, and growing its resource base to add to mine life. Relative to its peers, Newmarket stock continues to be significantly undervalued and the portfolio still holds its position.
The three stocks that detracted from the portfolios returns included, Enablence Technologies, Performance Sports and Dealnet Capital. Collectively these three names subtracted -3.2% from performance.
Enablence is a technology company that provides optical products for the telecommunications industry. During the quarter the company raised capital from the EDC and investors to ramp up production for ZTE Corporation (China’s largest-listed telecommunications equipment company). Upon meeting ZTE’s production and specification targets, we anticipate follow on purchase orders from ZTE. In the interim, Enablence will likely require further capital, which likely explains the pressure on the company’s stock price. The portfolio is still holding its position.
Performance Sports is a leading developer and manufacturer of hockey, lacrosse and baseball equipment/apparel. Its brands are considered category leaders in the sports they dominate; Bauer, Combat and Easton. Last year the company purchased the baseball division of Easton. The timing and funding provided difficulties for the company, as their debt is US$ denominated but the majority of their EBITDA is Canadian. Although they are current with their bank payments and not in violation of any bank covenants, their balance sheet is highly leveraged. Adding to the strain, sales in the baseball division were lower than anticipated as two large US customers folded. By the end of the first quarter, Kevin Davis was replaced by Amir Rosenthal as interim CEO. On the news of the disappointing quarter, we added to the position, however we are closely monitoring the company’s performance and debt to ensure that the business does not deteriorate further.
Dealnet Capital, is a consumer finance company. In February, the company closed their acquisition of Eco Home Financial. In making the acquisition the company raised capital at .55/share, which has put pressure on the stock. On the last day of the quarter, Dealnet announced that the integration of Eco Home was progressing well and the originations were ahead of expectations. We continue to hold the position.
Outlook
Stocks started 2016 on pace for the worst beginning of any year in recent history, but then made one of the sharpest reversals on record, bringing the market all the way back to a positive return for the year. Emerging markets were also some of the biggest winners, with the downtrodden Brazilian stock market leading the pack with a gain of over 20%. Clearly investors had just gotten too bearish on the outlook for stocks and commodity prices. Once oil broke down below US$30, the consensus had it going to $20 and even more investors piled into the short trade. The same situation occurred with stocks, as bearish sentiment climbed higher at the same time as there was too much cash on the ‘side-lines’, waiting to buy on weakness. Now stocks have rallied sharply, oil is back above US$40 per barrel, valuations are back to the top end of their recent range and investors are expecting the U.S. Federal Reserve to stay even more ‘dovish’ about interest rates than expected when they started raising rates in December. Volatility of the stock market has dropped sharply, indicating lower levels of concern about the outlook.
A key determinant of the direction of stocks in the first quarter was the direction of the U.S. dollar. The trade-weighted value of the U.S. dollar hit an interim peak in early February and its subsequent decline provided the spark for the rallies in oil, most commodity-related stocks as well as the currencies of resource producers such as Canada and Australia. If the U.S. Federal Reserve holds back on interest rate increases in the first half of 2016, then the U.S. dollar may fall further and commodities could continue to fuel stock market gains.
By the end of the first quarter, I had reduced the overweight in energy. With WTI having moved from a low of $26.00 / barrel to just over $40.00 / barrel, energy stocks had begun pricing in much higher oil prices than current prices. With that said, I fully expect to take the position to an overweight if we see a meaningful pullback in prices or lower US production. I still prefer staying in the highest quality balance sheets as most companies still struggle to generate positive cash flows at the current oil price. Asset quality is critical, as we look to build companies for the future. Energy companies with a good cost of capital will be the ones able to take advantage of property sales from those in financial distress.
As I reduced the portfolio’s oil exposure, I have increased some of my special situation positions due to their underperformance in the first quarter. We have added to our positions in Kinaxis, DIRT, Prometic Life and NYX Gaming. I have once again taken the portfolio’s gold exposure up with a conscious decision to move into smaller exploration and developing companies. As we go through this gold cycle, it is painfully obvious that senior gold producers are facing significant production decreases (beginning in 2017). We have already seen an active merger and acquisition cycle within the gold sector but I anticipate that it will continue to heat up as producer’s backfill the decline in production. The portfolio holds several names (such as Integra, Bello Sun, Dalradian and Sabina) that have caught the eyes of the senior producers and are likely takeout targets.
Despite concerns about global growth, interest rates, currencies and commodity prices, the first quarter ended up remarkably strong. With so many investors pessimistic and under-invested in resource stocks, we are cautiously optimistic that Canadian Small Cap stocks are finally moving off the bottom and in the early stages of new bull market.
Stay tuned ………