December 24, 2024

The Canadian Equity Fund Turns 30: Interviews with the Team

We will remember 2024 for more than strong markets and the official canonization of Taylor Swift, as it marked the 30-year anniversary of the Leith Wheeler Canadian Equity Fund.

It’s been a remarkable ride, one that has generated significant value for our clients. Figure 1 shows the 30-year performance of the Fund versus the S&P/TSX Composite, from inception through the nearest quarter-end (June 2024). $1 million invested in the Fund would have grown to over $21 million over that timeframe. By comparison, the broad TSX would have generated just over half of that.

Figure 1: Leith Wheeler Canadian Equity Fund, April 27, 1994 – June 30, 2024

⁽¹⁾ Fund performance is gross of fees. Fund and index performance are annualized for periods greater than one year, returns shorter than one year have not been annualized. Fund and index performance are total return expressed in CAD currency. ⁽²⁾ The inception of the LW Canadian Equity Fund (Series B) was on April 27, 1994. LW Canadian Equity Fund (Series B), gross of fee returns to September 2004, then (Series A) gross of fee returns thereafter.

Like that chart, it hasn’t been a straight line. Through conversations with four of the fund’s leaders over the past three decades, I set out to capture the essence of what’s made the Canadian equity team so successful over time.

In the beginning

Steve Jobs once remarked that the core of Apple’s success was not its processes, but its content – an insight IBM missed. In investment management, both are important. The process gives people guardrails to help judge long-term value creation opportunities and risks, but the content – the idea generation and recognition – is at the core of everything.

In the earliest days of our firm, Murray Leith⁽¹⁾ and Bill Wheeler were the Canadian equity team. They’d come from Pacific Management, the counseling arm of brokerage house Pemberton Securities, and pursued lots of ideas. These included many holdings that Wheeler acknowledges wouldn’t likely feature in today’s portfolio because back then they always matched the price requirement but not always the quality one.

“I would say they were higher-beta stocks… definitely not dream stocks,” Wheeler said. “We were looking for, at that time, pretty deep value compared to later on. I think we became less committed in terms of what's the price-to-book and that sort of thing.” The early portfolio therefore contained many junior mining and energy stocks, and other “unloved” stocks that looked cheap compared to the market.

As we wrote in this article, another legacy of Wheeler’s years at the firm was his commitment to advocacy on behalf of clients. The case of Petrokazakhstan captured both the more speculative nature of some of the portfolio holdings back then, as well as Wheeler’s fighting spirit.

What happened with Petrokazakhstan?

Wheeler explained that Petrokazakhstan (called Hurricane Hydrocarbons in the early years) “had an interest in just a beautiful oil field. It was a big, proven producing, high potential margin operation that was run by a Russian oil company. They ended up getting about 50% of this whole pool. We bought stock in Hurricane, and it was the higher risk end of things than we might normally buy. It turned out it was at a higher risk than I thought.”

Wheeler bought stock from $2.50 up to $6.00 per share and then the price of oil fell precipitously, a bad situation made worse by the fact that Hurricane’s main customer was a refinery “owned by a bank, [which was] obviously owned by powers that be in Kazakhstan,” Wheeler said. “They basically put the screws to Hurricane and dropped the price they would pay for a barrel of oil. Hurricane had no alternatives; it had debt and they couldn't make the payments on the bonds. It was very touch and go.”

As one of the biggest shareholders, new Hurricane CEO Bernard Isauthier tapped Wheeler to join him in a negotiation with the bondholders. “It was really one of the most antagonistic meetings I've ever had,” Wheeler said. Bondholders were presented with an offer but refused it. “Essentially, they were doing their best to drive this company under and grab these superb assets.”

Hurricane shares hit $0.27. Things were looking dire. And then fortune smiled on it at last: the price of oil began to rise. And rise. Wheeler and Hurricane dragged out negotiations as long as they could “and lo and behold, the price of oil went up to a level that Hurricane could now pay the bondholders, which they did. They paid a penalty and went out of bankruptcy.”

A subsequent temporary, armed takeover of the refinery notwithstanding, Hurricane (then Petrokazakhstan) shares rose to ~$38, at which point Wheeler sold. While clients netted a massive gain at these levels, there was more to come in this story.

Chinese National Petroleum (CNP) made a $55 offer for the company shortly after Leith Wheeler’s exit, but the Alberta Securities Commission then fined CNP for insider trading ahead of the takeover bid. Recognizing that these illegal buys disadvantaged Leith Wheeler clients, Wheeler launched a class action lawsuit against CNP. It took 5-6 years for a settlement, but he got it: $9.999 million – a hair shy of his $10 million goal. “It wasn't a bad outcome, but that was a lot of work,” Wheeler said. “I negotiated with the Chinese on it, and two law firms worked on our behalf. And so to me, it was a satisfactory outcome from the whole thing, but it was quite a trip.”

The quiet evolution

We recently wrote here about the evolution of our equity investing style, which is akin to Warren Buffett’s move from “cigar butt” investing to his current approach: focus on buying stocks at a discount to intrinsic value, not just ones that look statistically cheap. It helps you avoid “value traps” (stocks that prove to be cheap for a reason, and so never deliver the returns) and biases you to companies with stronger fundamentals, growth opportunities, and management. Price still matters, but in conjunction with value creation.

Bill Dye joined Leith Wheeler in 1985 straight out of UBC. He would serve as Head of Canadian equities from Wheeler’s retirement in 2006 to his own in 2022 so he was right on the front lines as the team’s investing style underwent that evolution in the ‘90s. “I think as a firm, we generally moved to more robust business models,” he said, pointing to several core areas the portfolio came to focus on.

That has included a long-time commitment to the Canadian banks, which Dye described as “snowballs” given their ability to compound returns over the years due to their massive branch network, millions of customers, and multiple business lines.

“There's the rails,” he continued, which have “irreplaceable assets. They're not building them anymore. We've owned CN for years. The Caterpillar dealers, both Finning and Toromont, are essentially regional monopolies. We've historically had a couple of high-quality utilities in BC Gas, Pembina [Pipelines], Hydro One. And the resource companies we did own tended to be, in my opinion, best-in-class, the CNQ [Canadian Natural Resources] for oil, and Tourmaline for natural gas.”

“You could probably continue to go on and look at the food retailers,” he said, pointing to Metro and [George] Weston, which are essentially oligopolies, along with the Brookfield group of companies, “which have quality assets, excellent management teams, and growth potential.”

“I think as you think about Canada, there's not that many really great businesses,” he said. “And so I think we figured out you kind of have to own those, own them for a long period of time, and then fill in those core areas with special situations.”

Teamwork... works

Other important figures on the Canadian team in the first 20 years included Dan Lewin⁽²⁾ and Byng Woo. Woo served as an early mentor to Bill Dye and Dave Jiles, who joined Leith Wheeler in 1994. Jiles also celebrated his 30-year anniversary with the firm this year.

While Jiles took over as department head in 2022, he was quick to point out that the team operates as just that – a team. Decisions have always been made through consensus, and while one person always carries the “Head” title, it is more an acknowledgment of the additional managerial responsibilities required to run the team, rather than a reference to any preferential trigger-pulling power within the portfolio.

“It's always about the team,” he said. “It's about having candid conversations in good times and bad times about stock selection, position sizes, and correcting mistakes and learning.”

The team shares book recommendations and invite each other to outside analyst meetings and management updates, even if it’s not their sector. “We try to really make that a collaborative approach because I think the shared knowledge, the shared wisdom, allows you to make better results, better decisions.”

Jiles analyses industrials, consumer staples, and utilities sectors today but in the late 1990s, he had the unenviable position of covering technology stocks.

Dot-com boom (and echo)

When the dot-com craze gripped markets and Nortel occupied more than a third of the TSE 300 Index at its peak, Jiles and the team steadfastly refused to drink the New Economy Kool Aid. “Murray Leith identified Nortel as a fraud early on,” Wheeler said. “…making it a ‘don’t own.’”

In a market that rewarded exposure to the sector and this company in particular, resistance required steely nerves, especially when clients began to lose patience with performance that lagged the index by over 10%.

Jiles recalled one trip to Winnipeg with Institutional Portfolio Manager Brian Scott in early 2000 for a 90-minute update with a large client, shortly after losing a couple of other large clients due to underperformance. Tech was still on fire and the Old Economy portfolio couldn’t keep up. The pressure was on.

“It was 40 below outside and 90 degrees inside in his office,” Jiles said. “And basically, he shone a spotlight on me. He said, ‘Okay, let's go through the portfolio.’ We went through every name. When I came out of the room, I was just drenched.”

A day later, the phone rang. It was the client – with a cheque for an additional $80 million. “So, basically he just wanted to know if we were going to capitulate.”

The history of that market debacle is well documented, and the team’s discipline paid off for our clients. Figure 3 shows how years later, the impact of those decisions were still clearly being felt (in a good way) in client portfolios: for the three years ended June 30, 2003, this sample client’s Canadian equities had compounded up at nearly 6% per annum – exceeding the TSX by 16.3% per year over those years. If you think back to our “$1 million invested” chart, over this period, $1 million in the Canadian Equity Fund rose $189,000 while the TSX fell $280,000, a difference of $469,000.

Figure 2: Excerpt from a balanced client report for 3-year period ended June 30, 2003

Think different

Jiles reflected on another client meeting which highlighted both the importance to the team of bucking consensus thinking, and the fun that can be had.

At a new business pitch with long-time Institutional Client Head, Gordon Gibbons, a consultant asked Gibbons about the tracking error of the portfolio. (Tracking error measures how differently the portfolio performs over time, relative to the market. Low tracking error means your portfolio acts more like the broad market. High tracking error means you are taking meaningful positions different from the market – and so are actively managing the portfolio.) Without a word, Gibbons stood and began packing up his bag. As Jiles looked on in confusion, the consultant asked why he was leaving. Tongue in cheek, Gibbons replied, “It’s been lovely meeting you and we’ve enjoyed our time here, but if tracking error is important to you, we are not the right manager for you.”

Another way the team has differed in its analytical approach over the years is the weight it gave to “ESG” factors, long before the concept was mainstream or the acronym even existed. The team views issues of worker safety, environmental stewardship, and diversity as key to a company’s long-term success. “They can represent risks, or opportunities, but if you don’t understand them, you won’t know which,” Jiles said.

For companies who also prioritize these issues, there is an alignment between the team and management, which plays an important role in trust and relationship building. One CEO recently told Jiles, “We tell the story, Dave; we don't identify you, but when people ask us who our best investors are, we say, our best investors are the people who are aligned with us in terms of how we run the business. There's a firm in Vancouver that their first question at every meeting is about safety.”

Cloudy with a chance of windfalls

When a company is out of favour with investors, we say it has a cloud over it. If the cloud is more of a fog that’s obscuring continued great potential beneath, we invest. If the cloud is full of golf balls, we pass. Hopefully our record is better than a meteorologist’s.

In 2005, CIBC [Canadian Imperial Bank of Commerce] was still smarting from its outsized exposure to the Enron fraud a few years earlier. CEO John Hunkin was leaving after the bank charged nearly $5 billion to settle a class action lawsuit and pay its lawyers – a quarter of its book value. Most investors were avoiding the stock but Bill Dye, with the support of the Canadian Equity team, sensed an opportunity.

“The Commerce was super controversial at the time. It was so out of favour because they had just had that whole [Enron] debacle,” he said. But the introduction of Jerry McCaughey, CIBC’s conservative new CEO, indicated to Dye that change was in the air. “I remember having some meetings with the new management. I said, ‘You know what? This is quite different. This is a whole different approach. And this could be a re-rating here.’”

The team added to the CIBC position. McCaughey’s cautious approach brought back investor confidence. The clouds cleared and the stock performed well in the subsequent two years.

The value of compounding

By the time Richard Liley joined the team in 2000, the evolution from deep value to discount-to-intrinsic-value was well established. The approach freed the team to consider stocks that don’t look “cheap” but still offer the potential for excellent long-term returns.

Constellation Software was one such stock. It has never traded at traditional “value” Price/Earnings or Price/Book multiples, including when Liley bought shares through the company’s initial public offering (IPO) in 2006.

“Software companies are good, underappreciated assets generally, but what set Constellation apart was their process for replicating their success in buying companies,” Liley said. Core to that process is distributing the knowledge base so there are multiple people at any given time repeating and reinforcing that acquisition secret sauce.

Unlike other tech darlings like Shopify, whose fortunes have risen and fallen several times in recent years, with Constellation “the company is the model, not the product,” he said.

As discussed in this article, Constellation’s record of earning outstanding return on invested capital has translated into stratospheric returns for Leith Wheeler clients. Through 2023, the stock had returned over 19,000%, or about 35% per year since its IPO. As of time of writing in late December, it’s up another 40% in 2024.

30 down, 30 to go

It’s been 42 years since the first Canadian stocks were purchased for Leith Wheeler clients and 30 since the Canadian Equity Fund was launched, and the team is as robust as ever.

In addition to Jiles and Liley, Analyst and Leith Wheeler Board Director Nick Szucs has spent nearly 14 of his 22-year investment career at the firm and brings significant firepower in his coverage of resources, insurance, and health care, including our successful investments over the years in Brookfield companies and funds, both public and private.

Analyst Marco Tang has been a solid contributor on real estate, telecoms, diversified financials, consumer, and industrial stocks and the “new guy,” Research Associate Prabjot Sidhu has now been here over two years.

As we reflect back on 30 years, it’s been a time of change but also of doing some things the same.

“I think what's been consistent is we haven't done a lot of crazy stuff in here,” Bill Wheeler said. “We've not pursued the latest hot ticket, and that's hurt sometimes in the short run, but really worked out for our clients in the long run.”

Photos

⁽¹⁾ We sadly lost Murray to cancer in 2003.

⁽²⁾ Lewin formed Lewin Capital Management in 2008 after a decade at another firm. Woo sadly passed in 2023.