When Goodwood Funds takes an activist stake in a company, its managers don’t wait for the stock market to reward their position. Instead, they remake companies to highlight their worth to potential purchasers.
The firm loves unrecognized assets, says president Curt Cumming. “It could be real estate or a division that we think could be spun off. When the market isn’t paying attention to a redundant asset, that’s an opportunity for us to shine a light on it and increase the company’s value.”
Passive management has also brought the firm success. The Goodwood Milford Fund, helmed by portfolio manager Chris Currie, won second place at the 2014 Canadian Hedge Fund of the Year Awards in the Best Five-Year Return category. Created in 2006, the fund invests in high-interest corporate bonds and takes long and short positions on North American equities.
With a compound annual return of 16.63% since inception, investors who put $100,000 into the fund in 2006 would have $389,210 as of October 31, 2014, while the S&P/TSX Composite would have returned $166,493. Goodwood has more than $100 million in assets under management, Cumming says. We spoke to Cumming, Currie and Peter Puccetti, chairman and CIO.
Q: Why is your approach attractive to institutional clients?
Cumming: Goodwood uses a private equity approach to public markets. We’re similar to private equity because we have concentrated positions and a longer-term approach.
We have a non-correlated approach to value investing, and we seek to avoid the value trap risk: something can be inexpensive, but that doesn’t mean the price is going up. You need a catalyst to unlock that value. It can be something that’s brought about by the market, a macroeconomic event, or a company-specific event, such as a planned divesture of an asset. However, when those events aren’t happening and the company is non-receptive to those opportunities, Goodwood will communicate the shareholders’ desire for corporate change.
Q: What is your hedge-fund investing style?
Puccetti: The firm looks for undervalued companies and work with management to improve the firm. But activist situations come in different shades. It can be everything from back-channel communications, such as having a one-on-one conversation with the board, to running a proxy contest to change the composition of the board. We’ve done 10 proxy fights, which probably makes us the most prolific Canadian activist investor. But we don’t focus on that. Historically, 10% to 15% of our positions have been activist. A more typical situation would be trying to identify something that we think is fundamentally cheap, and where we think there are some catalysts.
Q: What research goes into an activist position?
Puccetti: The fundamentals are almost identical for a passive or active position. But an activist position takes a lot more effort because, after making an investment, it involves phone calls, letter writing, and talking to lawyers and other shareholders.
One position we’re known for happened in 2007. The company was ATS Automation. ATS was a basket case. It had value: wonderful customer relationships and a long track record, but it suffered from mismanagement. So, quarter- by-quarter, you never knew if you were going to have a win or a loss. Divisional managers were calling the shots on all sorts of important decisions when they didn’t have the whole picture. If someone hadn’t have gotten involved, the company would have eventually disintegrated.
We, along with U.S. hedge fund Mason Capital, replaced ATS’s board. My partner Cam MacDonald, two people from Mason and I went on the board. We fundamentally changed the business. We found a new CEO, Anthony Caputo, who has managed to grow business and make smart acquisitions. Anthony was the COO at SPAR Aerospace, and was a proven operator in a troubled situation. He’s totally revamped ATS. The things that used to be done in a haphazard way before were centralized.
It used to be that the 23 different plans each bought their own material. They would sometimes bid against each other, without even knowing it, for an exotic piece of material they needed for a customer contract. Amongst the many things he did, Anthony put an end to that. He put in a centralized buying group and took advantage of ATS’s scale to get concessions on pricing from those materials suppliers.
Probably the single best thing you can do in most cases is to find a good CEO. Then there are other kinds of activist situations, such as small-cap companies, where we’ve done proxy fights and become management.
We did that most recently at Dacha Strategic Metals, where we turned all the assets to cash. Unfortunately, Dacha was a disappointment, because rare earth metal prices went down. Our cost was about 24 cents in 2012, and in August 2014 we liquidated the assets for 18 cents. After costs, we realized about $12 million.
At the time, we looked at roughly 61 ideas about what to do with the public listing and cash, including technology, mining, oil and gas, and healthcare. When you’re in control of a public vehicle with no operating business but a decent amount of cash (which I would define as being $10 million to $50 million), everybody calls you with deals. Doing a reverse takeover, rolling their business into a public shell and being assured of the cash, makes their efforts to get public a lot less risky, and more likely.
We decided on a transaction with a Canadian, publicly traded pharmaceutical company called Merus Labs. We gave Merus our cash for their shares to help them finance an acquisition. We think there’s a lot of upside from here on in, but the Dacha cash proceeds were less than we were hoping for, frankly.
Q: When do you sell a company, or become less involved with it?
Puccetti: Sometimes in six months. Other times, I’ve held positions for seven or eight years. The reason I haven’t sold ATS, for example, is we’re on the cusp of what it could become. Caputo’s made improvements, but M&A is going to drive the stock higher. They’ve made strides in their ability to acquire and integrate businesses.
Q: Could you give me an example of one of your passive investments?
Puccetti: Our second-biggest position is in Great Canadian Gaming Corporation. It’s the largest physical facility gaming company in Canada. Traditionally, gaming has been a high-margin business with tremendous ability to produce free cash flow, which we love. The company is using its free cash flow to buy back stock instead of paying dividends. That’s shrunk the number of shares outstanding, so there are fewer shareholders with whom to divvy up the spoils.
That piqued our original interest, and we happened to know the fellow who became CEO three years ago, Rod Baker. We have a lot of respect for his abilities. He’s focused, cautious, always plans for worst-case scenarios and watches the downside. He has a background in being a successful investor and executive.
And it’s fundamentally a good business to be in. For example, its main market is British Columbia, where the company’s headquartered. The British Columbia Lottery Corporation provides incentives for operators to make capital expenditures on their facilities. For those dollars spent on capital expenditures, the government’s cut of gaming revenue is reduced to allow for faster payback on that investment. It’s also a regulated business, so the barriers to entry are high—it’s difficult for new competitors to enter the market.
Q: How do bonds fit into a hedge fund strategy?
Currie: We primarily short equities. But, we might short government bonds if, for example, we feel interest rates could rise in the near future. A 100% equity or 100% bond fund can be volatile, so we try and reduce volatility with hedging. We don’t see an immediate near-term rise in interest rates, so we’re not shorting yet.
Q: On the bond side, are there indicators you look at in the company?
Currie: A number of those factors are similar to what a stock analyst would use, but instead of looking at the price-to-earnings ratio, we look at the spread over government bonds. For instance, we own Amaya Gaming Group’s bond, which has a 7.5% coupon and matures in 2016. The equivalent Government of Canada bond might be 1%, so this has a spread of 650 basis points.
Then, we would analyze whether the corporate bond is six times as risky as a government bond. We’d talk to the rating agencies about it (though this one happens not to be rated). Then we look at the credit environment: Is the economy getting better? How’s the stock market doing? Can the company generate positive credit events, such as raising the equity capital that makes it more likely to pay off interest and principal?
We’d look at comparable companies and the company’s growth prospects. We look at leverage: Is the company able to pay the bond off at maturity, or will they have to refinance it? Most Canadian companies manage their leverage well, and their long-term debt isn’t more than two years of cash flow. When it gets higher than that, you have to look into it. Is it temporary or permanent? Is cash flow falling? Are they adding debt recklessly? When a company adds more debt, it’s going to add more interest expense unless the cash flow is growing, and it’s going to have more difficulty making interest payments.
Q: When would you short a company?
Cumming: There needs to be a valuation mismatch, and a catalyst that will revert that stock to its proper value. It could be improper accounting or outright fraud, or the stock could be overhyped and the real value is considerably less than where it’s trading.
We have a net-long bias. When you’re long and own a company, there’s an infinite amount of potential capital gains. On the short side, you’re limited to 100%. So if you buy something at $10, it can go up forever, but if you short something at $10, it can only go to zero. There’s also more capital chasing long investment styles. For those reasons, we choose to go net long.
Originally published in Advisor's Edge Report