With great volatility comes great opportunity.
Maxam Diversified Strategies Fund – Q4 2021 Commentary
The Maxam Diversified Strategies Fund1 gained +18.6% for the 2021 calendar year. We are pleased with the fund’s performance, especially on a risk-adjusted basis. Here is a snapshot of the fund’s absolute and relative returns presented on a risk-adjusted basis since fund inception in 20092.
The fund’s gross exposure to arbitrage3 strategies averaged a little under 20% for the year. Recall that arbitrage is a low-risk and consistent return strategy that exhibits low correlation to equities and other traditional strategies. This strategy’s value will be most apparent when risks are elevated, and equity markets are volatile.
The majority of the Maxam Diversified Strategies Fund’s exposure, the core of the strategy, was in long positions that we broadly categorize as follows:
- Compounders that we believe will generate very attractive returns for several years. These are great businesses, that are growing nicely, trade at attractive valuations and are run by excellent management teams with skin in the game (i.e., they own a meaningful personal stake in the company). We aim to identify and invest in these businesses early and at attractive levels, ideally before they are well-known to the broader investment community.
- Event-driven and special situation opportunities where we believe we have identified an asymmetric reward-to-risk opportunity. These investments can sometimes arise unexpectedly and range from short to medium-term in duration. Targeted situations may include corporate events, financings, strategic reviews, clean-up trades, spin-offs, insider activity and more. The attractive nature of these investments is that they can work in all market environments.
Some notable successes4.
Notable significant successes during the calendar year included two of our top 10 holdings being acquired at material premiums.
In Q2, long-time holding Photon Control Inc. announced that it had agreed to be acquired by MKS Instruments for $3.60 per share – a nice price relative to our initial purchases near $1.00. And in mid-September Spire Global announced it was acquiring exactEarth Ltd. at a material premium – we wrote extensively on this in our Q3 commentary. And towards the end of the year, Fully Managed, one of our few private holdings (and not a top 10 position), announced they were being acquired by Telus.
We love searching beneath the surface and finding great businesses and compelling opportunities to invest in. The objective, of course, is to be rewarded with a higher share price than what we paid, whether that comes from strong fundamental performance being rewarded by the market, or by way of an acquisition at a premium – or sometimes both. We believe we have more than a few holdings in the fund today that will play out in a similar manner.
Our short exposure was low to negligible throughout 2021. We have written about how difficult (unprofitable) short selling has been over the past few years, and certainly since the March 2020 coronavirus crash. While it is never easy, shorting securities in market environments driven by positive momentum, record liquidity, and very strong risk-appetite, is close to futile.
In our Q1 2021 commentary we wrote:
Although our short exposure is not significant today, we believe that we will begin to see more opportunity to profit from short positions as certain segments of this market inevitably turn. Our attention in this regard is focused on pockets of speculation and highly valued mania or momentum stocks – companies that have experienced dramatic stock price appreciation and, in our view, where valuations are well beyond even the most bullish of realistic scenarios.
We won’t try to pick a top, nor try to be heroes on the short side. Instead, we will observe and wait patiently for opportunities where disappointment has begun to ensue, and it is apparent that nothing more than a (formerly) strong narrative was supporting the stock price. Discipline and timing are a key focus for us here.
Many of these high-fliers went further than we imagined, however disappointment has certainly begun to ensue. We perceive that the market landscape is shifting away from ‘story stocks’ and towards companies with more tangible near-term revenues and earnings. With cracks appearing in the narrative supporting some of the companies trading at extremely high multiples, we have initiated some modest short positions.
The fund continues to be well-diversified across individual holdings and sectors. As at the end of Q4, fund net exposure was approximately 17% in arbitrage with the balance predominantly in long positions that we classify as compounders, event-driven and special situations. The fund was invested across all 11 sectors with no sector weight larger than 18% of net exposure. The fund’s top 10 holdings accounted for approximately 28% of assets at the end of the quarter.
Wall of worry.
2020 finished and 2021 began with a great deal of uncertainty. At the end of 2020 there was still much uncertainty with respect to the path of the Covid-19 pandemic, the economic recovery was uneven, record amounts of stimulus and liquidity were being injected into the system, and the Trump administration was set to hand over the reins to the Biden administration.
During 2021 we saw Covid-19 vaccines rolled-out, the rise and fall of meme stonks5, new Covid-19 variants, various pandemic lockdowns came and went (and came back), commodity prices ramped, and inflation went from being transitory to… not transitory?
And into 2022… much uncertainty exists! Recognize a pattern here? The Fed and other central banks are expected to raise interest rates, geopolitical tensions abound (Ukraine, Russia, China), inflation is present, and the economic recovery is uneven.
With hindsight, investors now perceive last year’s risks as comparatively low – “of course they were worth taking!” Conversely, the risks and uncertainty that investors collectively see today is being reflected in the capital markets via price volatility. An old adage is that the market needs a ‘wall or worry’ on which to climb higher.
With great volatility comes great opportunity.
When investors are fearful that security prices will move lower, they tend to sell with little regard for company-specific value and fundamentals. This creates opportunity because price volatility is generally much greater than the volatility of intrinsic value.
Security prices in the short-term can be heavily impacted by sentiment and emotion. Hence the “buy fear / sell greed” advice we typically hear during swift market declines. While it is hard to do in the moment, we agree with the approach – grounded with a focus on value.
As mentioned above, Photon Control and exactEarth were very profitable investments for the fund. Both were initially purchased during periods of uncertainty and volatility, when the risks seemed elevated, they were, of course, well worth taking.
We believe the market environment is in the early stages of transitioning away from one that has favoured the high-multiple, growth-at-any-price, speculative stocks – towards an environment where companies with more tangible revenues and growing bottom lines will be increasingly rewarded. The former group is where we perceive risks, and the latter is where we see value and opportunity.
Our modus operandi is to balance patience and opportunism. We understand the value of what we own in the fund today and we are uncovering new opportunities as a by-product of the market volatility.
This is an attractive environment for our investment style and strategy – one that will increasingly favour our value-oriented and active approach. We are looking forward to some specific events and catalysts for several of our holdings through 2022.
Thank you for your trust and confidence. Please don’t hesitate to reach out with any questions.
Travis Dowle, CFA
President & Fund Manager
Maxam Capital Management Ltd.
1 Maxam Diversified Strategies Fund, Series A, net of fees and expenses. Inception date June 30, 2009. Please contact us regarding other series of fund units or visit our website www.maxamcm.com
2 You want to be in the top left quadrant: higher return, lower risk. Maxam Diversified Strategies Fund Series A annualized return since inception on June 30, 2009. Beta is presented relative to the S&P/TSX Total Return Composite. TSX Small is the S&P/TSX Small Cap Index and Scotia Cdn Hedge is the Scotia Canadian Hedge Fund Index (Equal Weighted). Scotia’s returns are as of November 30, 2021nbecause December 31, 2021 data was unavailable at time of printing.
3 Arbitrage is a low-risk, consistent and absolute return-oriented strategy. We manage the Maxam Arbitrage Fund which focuses exclusively on arbitrage strategies.
4 We refer to these as “2021 successes” but in reality their genesis began years prior at the time the opportunity was identified.
5 Yes, we meant to write “stonks”. From the authorities at Merriam-Webster: “Stonk, a deliberate misspelling of stock (meaning “a share of the value of a company which can be bought, sold, or traded as an investment”), was coined in a 2017 meme. The word is often used humorously on the internet to imply a vague understanding of financial transactions or poor financial decisions.”