High-conviction investing

Richard Fortin’s got guts.The Franklin Bissett portfolio manager owns two stocks, Canam Group and Major Drilling, and “we got into both knowing there was likely further business downside risk and the near-term outlook was fairly poor.”

How poor? “On February 3, 2012, Major Drilling was $18. It’s $7.49 today,” says Fortin, who co-manages the Franklin Bissett Small Cap and Microcap Funds.

There’s method to his madness. “Management recently added to the asset base, so Major Drilling’s earning power coming out of the downturn is greater today than it was in the previous cycle.”

Fortin bought MDI for the small cap fund in November 2013 at $9, and has been adding to the position as the share price has fallen. He adds, “We tend to play in underappreciated segments. Our top ten names are close to 50% of the portfolio. Our top ideas are high-conviction, and we’ll live and die by how they perform.”

The companies he looks for have $300 million to $1.7 billion in market capitalization. He currently owns 41 names, and invests in seven sectors. Portfolio turnover is between 15% and 30% per year. As of June 30, 2013, his small cap fund returned 14.5%, compared to 5.8% for the category average.

Originally from Sherbrooke, QC, Fortin’s lived in Ottawa, Montreal, Florida, North Carolina, Edmonton, Connecticut and now Calgary. He has two children, Zach and Sophie, and has been married to Suzanne for 16 years. He’s been with Bissett since January 2009, and has worked at the Telus Pension Fund and a U.S. money manager.

What are your criteria for good companies?

The most important long-term determinant of stock performance would be ability to grow earnings and cash flow.

We like businesses that internally finance their growth, as opposed to having to come back to the market. Great businesses create value at the bottom of cycles by deploying capital. When everybody else is struggling, they grow their businesses. Other criteria include above-average profitability, stable operating history, strong balance sheets, consistent cash-flow generation, free cash flow and shareholder-friendly, experienced management. We prefer high levels of inside ownership.

We narrow the small-cap universe to 150 names we’d consider owning. A lot of materials names just don’t make the screen, since they’d be more speculative. As you go down the cap spectrum, the risk profile tends to go up.

We have businesses that earn return on invested capital in the 20% range, and we’d say those are outsized returns. But most businesses we own earn or exceed their cost of capital, which puts them in the double-digit ROIC range.

What’s one perennial holding?

Furniture distributor Richelieu Hardware. Year after year, it’s grown earnings and increased market share both in Canada and the U.S. Its earnings per share were $2.15 in 2012, versus $1.46 five years ago. Its dividend’s gone from 28 cents in 2007 to an expected 50 cents this year.

It’s a prototypical GARP (growth at a reasonable price) stock, and the business outlook is equally as favourable today as it was five and ten years ago. In the depths of the downturn, management acquired businesses in the U.S. in anticipation of the eventual upside we’re now seeing in U.S. housing.

Why would you exit a position?

For risk management purposes, when Richelieu hit 8%, we trimmed. Our typical weight is 2% to 5%.

We’d exit if we found better investment opportunities elsewhere. Or if valuation became egregious, and there were successive stumbles in terms of operating results and successive poor quarters. Our valuation approach provides for a margin of safety.

Owning Sears Canada is a good example of using that buffer. The retail business has not performed well over the past five years, but they’ve monetized some below-market leases at a significant gain. If you apply that across their real estate portfolio, you get a value above the current share price [around $12 as of August 2013].

Have you ever gotten involved as a shareholder?

Consumer discretionary is our biggest exposure, and Rona is a name where we became a bit more vocal. It continues to be one of our top ten holdings.

Over the past five years, Rona’s strategy was to grow square footage to capture market share at the expense of what mattered: profitability, the balance sheet, and so on.

Lowe’s came in July 31, 2012, and made a nonbinding $14.50-per-share offer for the company. The then-board of directors said, “$14.50 is not good enough—we’re not going to sell the company.” This was when the stock was trading around $11, so it was a big premium.

Not only did they say no, but they also didn’t engage the interested party. The notion that anybody but the shareholders could control the sale of a company didn’t sit well with us. So we came out quite strongly against the board and management and termed them an absentee board.

Now we have a new board and CEO who are acting in the best interests of the shareholders. They’re restoring profitability by potentially shrinking the business, and that’s still a work in progress. They bought back just more than 8% of the business at a discount to what we think the value is.

Going back four or five years, Rona’s been an opportunity cost. We still think there’s value. Ultimately we’re holding a fairly sizeable position at current prices, so we think the business is worth more than where the stock is trading [under $11 as of August 2013].

Do you want Rona taken over?

We’re indifferent. There are different paths to value creation, so long as management is able to execute its current business plan successfully. But that’s a big “if” because it’s never been done over the past five years.

What’s another energy company you like?

Savanna Energy Services Corp. has been a perennial holding, though the results have ebbed and flowed over the past five years. The operating results have been acceptable, but not great.

Going back five years, its asset base was more geared towards conventional shallow natural gas development, while the industry has gone to an approach where you need deeper rigs with more horsepower that are able to drill horizontally. So management had to deploy a significant amount of capital to retrofit the asset base.

We held Savanna through the retrofit period, and we actually provided the business with capital; we were part of the financing. So we’re committed shareholders. We prefer internally financed business plans, but we also don’t like share dilution. If we like the business plan, we will provide capital through buying shares. The main difference to an open-market purchase is that the company issues new shares in exchange for cash.

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.