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INVESTMENT EXECUTIVE
Mid-February 2003
Focus on Products
Limits to the patience of Mackenzie Cundill Recovery Fund
If a holding doesn’t measure up within 18 months, it will be replaced
By Jade Hemeon
As a disciplined value investor, James Morton, London-based manager of Mackenzie Cundill Recovery Fund, is a patient man. He seeks out hidden investment opportunities in unpopular companies, then waits for their potential to be recognized by others who will buy and bid up the price.
But Morton, who was in Toronto recently to speak to the financial services community about his fund, says his patience has limits. While many value investors say valuation defines the level of risk in a security but doesn’t help with timing a purchase or sale, he’s willing to give a new holding 18 months after its purchase to make a contribution to his fund’s return. If a stock or bond doesn’t show signs of life by then, he’ll discard it in favour of something else.
“One of the points of difference between the Recovery Fund and some of the other funds in the Cundill fold is our impatience,” Morton says. “If something doesn’t measure up in terms of our expectations regarding a catalyst for change, we’ll replace it.”
As its name suggests, the globally oriented Mackenzie Cundill Recovery Fund, offered by Mackenzie Financial Corp., invests in companies coming out of crisis, which gives it a unique mandate among mutual funds available in Canada. Distressed securities and troubled companies are typically the domain of aggressive hedge funds or may make up a small portion of a handful of strict value funds. But to Morton, “recovery” is another term for “renaissance,” and it encompasses a range of situations related to positive change.
Many companies in his fund are going through financial reorganization, emergence from bankruptcy or change in ownership. Before he gets in, however, Morton looks for his exit opportunity. That’s why he also likes to identify a realistic short-term catalyst that will unleash value and cause prices to rise. That could mean new management “is
taking a broom to the place,” a plant is being revitalized, there’s a new product line, the company is being refinanced or there are plans for an acquisition, share buyback, takeover or liquidation.
“We are not looking for the walking wounded or those in intensive care,” he says. “We’re looking for companies that are about to be outpatients.”
A look at the list of company shareholders can be revealing, he says, and the name of a corporate predator or a shareholder activist is often a good sign.
“We talk to activists and ride on their coattails,” he says. “If management won’t fix a problem, active shareholders will fix management.”
His performance indicates he is astute at diagnosing his patients. According to Morningstar Research Inc., Cundill Recovery was the third best-performing fund in the global equity category in 2002. Cundill Recovery finished the year up 1.7%, a far superior performance to the MSCI world index loss of 20.2%. Only three of about 450 funds with one-year track records even made money last year, and the other two are not available to small investors. For the three years ended Dec. 31, 2002, the fund had an average annual compound return of 5% — again superior to the index, which had an average annual loss of 13.8% for the three years.
The fund was introduced in October 1998, and Morton took over as lead manager a couple of months later. Peter Cundill, legendary founder of the Cundill funds, is a co-manager.
“It’s fair to say that Peter [Cundill] and I are reasonable soulmates when it comes to value investing, and are both great believers in the Ben Graham approach,” says Morton, a 35-year financial industry veteran and the author of several books on investment and other subjects, including an assessment of the work of Prince Charles published on the prince’s 50th birthday.
But, as a result of changes in the universe of corporations that contribute to the world economy, Morton has strayed a bit from the strict value guidelines originally pioneered by U.S. investment guru Ben Graham.
Although Morton seeks companies that trade at a discount to net asset value and other traditional value criteria, that’s merely a starting point.
Cash-flow analysis is important, and so are economic trends that can influence valuations of cyclical stocks. He also assesses price/sales and price/earnings ratios, dividends and interest payouts, and the cash available to a company to cover these payments. Although he likes to buy at a discount to underlying value, the discount must be measured against other opportunities.
“We like to buy securities at 50¢ on the dollar, but if the whole sector is trading at 50¢, we want to buy at 30¢. A company must be cheap in the context of its peer group.”
The key is to buy a stock after the trouble is over, but before the improvement is recognized in the price, when whatever has caused the price to deteriorate has stopped but the market is not at the point at which it’s interested.
“We have to be early to get things cheap, but we don’t catch falling knives,” says Morton. “That’s the road to the poorhouse. We come along after the ship sinks and we snatch the life rafts. There can always be ‘nasties’ that come out of the cupboard, but a lot of the mistakes have been made by the time we arrive on the scene.”
Morton prefers to run a relatively concentrated portfolio of about 30 to 35 names. Initially, he won’t put more than 6% of assets in any one holding, but as a company’s fortunes improve and its price rises, it could take up more space.
Currently, the $26-million portfolio is small enough that Morton can still invest in a lot of small- and micro-cap companies without running into liquidity difficulties. The top names in his fund may be unfamiliar to ordinary Canadians. They include Darby Group, a British glass manufacturer; Finova Group Inc., a U.S.-based financial services provider; and Asia Aluminum Holdings, a Hong Kong-based aluminum-extraction firm.
In the case of Highbury House, a British magazine publisher, it is the second time Morton has had the company in his portfolio because the price fell back to undervalued levels after he made a profit on the stock.
“We deliver a completely different set of opportunities, and that’s deliberate,” he says. “The fund is designed to have a low correlation to other funds and to indices.”
Most investment ideas are aired at staff meetings with other value-oriented Cundill managers and must stand up to criticism and questioning. It’s an environment of “tough love,” Morton says, but, ultimately, the lead portfolio manager takes responsibility for the decisions.
“It’s extreme value investing,” says Dan Hallett, senior investment analyst at Windsor-based Sterling Mutuals Inc. “It takes a lot of research and a lot of confidence to act on your conclusions when no one else is going there.”
Morton is currently finding opportunities in Southeast Asia, and has 34% of his portfolio in this region. Britain is next, with 24% of assets, followed by France, the U.S. and Switzerland. About 3% of his portfolio is in Canada, spread among four companies: Northstar Aerospace Inc., Capital Alliance Group, Thistle Mining Inc. and Antrim Energy Inc.
“There is less institutional interest in the smaller names, and more opportunity to take advantage of market inefficiencies,” says fund analyst James Gauthier at Dundee Securities Corp.
He believes Morton’s positive performance in the past few years of tough markets indicates the fund’s ability to provide downside risk protection, although it may lag in hot markets. While neither he nor Hallett view the fund as a core holding, they say a slice will add diversification to a portfolio of larger company funds. IE