Student of the Game

The first half of 2014 has been kind to our investors. The Capital Ideas Fund
was up 13.3%
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as of the end of June, and we feel optimistic about the markets
for the balance of the year.

The month of July has been a busy one for me personally, as I was in Denver
for close to ten days watching the World Lacrosse Championships. As a
supporter of Team Canada, I had the joy of watching my oldest son living out
one of his dreams and the thrill of watching underdog Canada score a stunning
8-5 victory over Team USA in the championship game. WowI am still
tingling!

On high ROE stocks

Since my last newsletter I have had more than a few discussions with analysts
and clients about why I focus on high ROE stocks. While I have written on this
topic before, I thought I would share with you a few insights that will give you
a better understanding of the methodological journey that I have been on since
the early 1990s, when I attended the University of Western Ontario Business
School (now called the Richard Ivey School of Business).

I arrived at the University of Western Ontario in the summer of 1990, just a
few months removed from the First Canadian Submarine Squadron. At that
time, all I knew about myself was that I was ready for a career change and that
I wanted to acquire the basic accounting, marketing, finance and operations
knowledge that would allow me to be employable and successful in a business
career.

At Western, I had the benefit of taking a number of wonderful courses that
opened my eyes onto worlds I had never thought much about before. The one
course I wanted to take but couldnt due to scheduling issues was Professor
David Shaws course on capital allocation, which leaned heavily on the work
of the consulting firm Stern Stewart and valued based management. While I
VOLUME XXVIII July 2014

INVESTMENT ISSUES STRATEGIES INSIGHTS FROM DONVILLE KENT
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was not able to enrol in Shaws course, I did read the textbook and the key
concepts that I took from the book formed the basis for how I looked at
companies and investments. For me, the key concept from Stern Stewart was
that capital has a cost, and the most valuable companies to own are those that
can consistently earn a return on capital that is well in excess of their cost of
capital. A second concept, which was almost as important, was the impact that
management can have on the enterprise by getting the asset allocation function
right. Companies make things, sell things, etc. but the role of allocating capital
intelligently is in itself a sophisticated skill set, and many companies that are
good at making and selling things can also be poor allocators of capital.

While I admit that the previous paragraph is a bit dry, when we look at specific
companies, the importance of capital allocation that I learned from the likes of
Stern Stewart hopefully become a bit more interesting. Readers of this
newsletter know that I am a fan of technology companies, and two companies
that we have looked at frequently over the years are Constellation Software
(Figure 1) and Descartes Systems (Figure 2). Both companies are very
successful software companies and thus they each get high marks in terms of
making and selling things. But we have chosen to own Constellation Software
over Descartes because we think the former is a much better allocator of
capital. Constellations Return on Equity (as we measure it) is typically three
times higher than that of Descartes, in part because Constellation runs with an
appropriately lean capital structure while Descartes is perennially over-
capitalised. Both companies have delivered strong returns to investors, but
Constellations superior capital allocation strategy has made a significant
difference in terms of its long-term share price performance.

Figure 1 - Constellation Software Inc. Price Chart 2007-Present




















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Figure 2 - The Descartes Systems Group Inc. Price Chart 2007-Present

















On to Asia

Upon graduation from Western, I bought a one way ticket to Asia and joined
Credit Lyonnais Securities Asia (CLSA), a firm that was in the process of
inventing its own methodological approach to growth investing. In 1992,
CLSA was a bit late to the party in Asia in terms of investment banking (if you
can believe that) and CLSA thus decided to focus its franchise around research
excellence rather than investment banking or some other area of finance. As
such, our research agenda at the time I joined CLSA was to help overseas
investors in particular to identify and own the best long-term investments in
Asia. During that time, a great internal debate, led by the likes of Brad West,
Edmund Bradley, Nels Friets and Donald Skinner, was underway to identify
the factors that drive great long-term investment. This group of savvy
researchers looked at a variety of methodologies and approaches, and
eventually all roads led to one place: Omaha, Nebraska.

Warren Buffett never sat down and wrote a book like his mentor Benjamin
Graham did, but throughout the pages of the Berkshire Hathaway annual
report, he dropped a lot of hints about the secrets of great investing. Many of
these hints and theories were being tested at CLSA. What we discovered was
that Return on Equity was the best factor in identifying long-term winners.
This dove-tailed nicely with the work of Stern Stewart, which admittedly
employed a more sophisticated tool for measuring the extent to which a firm
was in fact achieving a high ROE.

A few years later I left CLSA and joined Credit Suisse First Boston (CSFB) in
Jakarta. By this stage in my investing life, I had been using the ROE-centric
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model that I had learned at CLSA for several years with some success. At
CSFB, my responsibilities tended to be bigger-picture in nature (and therefore
less company-specific), but I somehow managed to stumble across the work of
a couple of CSFBs US based analysts that helped flesh out the way I look at
individual companies. The authors were Michael Mauboussin and Paul
Johnson and the report they wrote was titled Competitive Advantage Period
(CAP) The Neglected Value Driver. This report (which is posted online on
the Columbia University website and is free for anyone to read) made the
linkage between a companys excess returns to capital and its competitive
advantage.

The Mauboussin/Johnson report was a critical piece in my intellectual
development. Any database miner can dig through a database to discover a
list of high ROE stocks, but the theory of mean reversion rightly suggests that
many of these companies will revert to the mean quickly. Simply buying high
ROE stocks then, was not enough. Buffett had developed a knack for finding
high ROE stocks that did not revert to the mean or did so very slowly, and the
Mauboussin/Johnson report elegantly explained why this was so important. As
Mauboussin/Johnson wrote:

The essence of growth investing, it appears, is to purchase stocks of
companies with high returns, and stable and expanding competitive
advantage periods (CAPS). We would note that CAP is unlikely to
expand if the rate of return on incremental capital is declining
sharply or is below the cost of capital.

To extend Mauboussin/Johnsons ideas to the way I look at investing, imagine
two companies that are growing their sales at 30% per annum and then assume
they are trading at the same P/sales ratio. One of these two companies,
however, has an ROE of 30% and the other is only slightly profitable, with a
return on equity that is below its cost of equity. For many analysts, given the
identical sales growth rate and P/sales multiple, these two companies might be
viewed as similarly attractive. For me, however, the two companies are worlds
apart. The reason is that sales that are being priced at a level that is below the
(economic) cost of producing them is not particularly valuable to me from a
valuation or CAP perspective. The company that can sell its products at a
significant premium relative to the cost of making or delivering the product
(and assuming no accounting jiggery pokery such as high leverage) is one with
a strong implied competitive advantage. Of course, it would now be my job as
an analyst to make some kind of prediction on the sustainability of the
competitive advantage, but an important part of the analytical process, i.e. the
identification of the probable existence of competitive advantage, has already
been done.

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Beyond those of Stern Stewart, Buffett, and Mauboussin/Johnson, there were
still a few more lessons to be learned. Over the years I have read more than a
few tomes on high ROE stocks, and the writings of Joel Greenblatt and James
OShaughnessy have greatly influenced my thinking. Both have written
extensively on valuation combined with ROE as factors in the investment
process and both point out that many high ROE stocks are already well
recognised by the market and therefore priced at valuations that reflect the
existence of a significant competitive advantage period. Greenblatt in
particular emphasises the importance of combining ROE with a strict valuation
discipline, because many of the high ROE stocks in highly efficient markets
such as the US trade at extremely expensive valuations. Indeed, Greenblatt has
hinted that when combining the two factors (ROE and a low valuation multiple
like P/E), valuation might even be the stronger of the two factors. We dont
necessarily disagree but have found that combining the two factors leads us to
the kinds of companies that we feel most comfortable investing in.

I would like to share one other reflection, one that relates to risk. For most of
my investing career, I have not been overly concerned about risk. But a few
years ago, consultants were looking at our returns and happened to notice that
our fund had a very low risk profile, with our portfolio operating at
significantly lower than market risk levels each year since inception. We were
asked then, and continue to be asked, what kind of black-box tools we use to
mitigate risk. To be truthful, we didnt have a lot of magic to share. Upon
reviewing our past and current portfolios, we began to realise that our low risk
profile flowed directly from the individual companies we invested in. That is,
most of the companies that we tend to invest in from a growth and return on
equity perspective have, as an added benefit, low betas. I have to admit that I
never look at a stocks beta before we buy it, but for some reason, our
investment approach seems to put us into a lot of low beta investments.

A few more thoughts on risk

2008 seems like a distant memory now. Stock markets in Canada and the US
have performed well for more than five years and the market has not had a
significant correction in a while. But sometimes things change quickly, and in
order to protect our investments if things suddenly change, we hold a certain
number of short positions in the portfolio. In June we also bought a large, out
of the money put option that will protect a good part of the portfolio against a
large correction (more than 7.5%). With market volatility being quite low, the
cost of that put option was remarkably low.

Final thoughts

I continue to be grateful for the support I have received over the years from a
wonderful network of investors, friends and employees. All are important to
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me, but none more so than Paul Marsiglio and Mike Scott who each played a
critical role in the formation of DKAM and have been close friends for more
than a decade. Both recently lost their fathers, who each in his own way were
everything that a wonderful father should be: hardworking, doting, caring,
loving, a natural teacher, a terrific grandfather, and ferociously proud of their
wonderful sons. Paul and Mike, you each have big shoes to fill but you were
both trained by the very best! Godspeed.

Call me or write me if you want to chat J.P.Donville
Jason@donvillekent.com 416-364-8886










































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Time weighted rates of return for Class A Series 1, net of all fees and expenses
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DISCLAIMER

Readers are advised that the material herein should be used solely for informational purposes. Donville Kent
Asset Management Inc. (DKAM) does not purport to tell or suggest which investment securities members or
readers should buy or sell for themselves. Readers should always conduct their own research and due diligence
and obtain professional advice before making any investment decision. DKAM will not be liable for any loss or
damage caused by a reader's reliance on information obtained in any of our newsletters, presentations, special
reports, email correspondence, or on our website. Our readers are solely responsible for their own investment
decisions.

The information contained herein does not constitute a representation by the publisher or a solicitation for the
purchase or sale of securities. Our opinions and analyses are based on sources believed to be reliable and are
written in good faith, but no representation or warranty, expressed or implied, is made as to their accuracy or
completeness. All information contained in our newsletters, presentations or on our website should be
independently verified with the companies mentioned. The editor and publisher are not responsible for errors or
omissions. Past performance does not guarantee future results. Unit value and investment returns will fluctuate
and there is no assurance that a fund can maintain a specific net asset value. The fund is available to investors
eligible to invest under a prospectus exemption, such as accredited investors. Prospective investors should rely
solely on the Fund's offering documentation, which outlines the risk factors in making a decision to invest.

The S&P/TSX Composite Total Return Index ("the index") is similar to the DKAM Capital Ideas Fund LP ("the
fund") in that both include publicly traded Canadian equities of various market capitalizations across several
industries, and reflect both movements in the stock prices as well as reinvestment of dividend income. However,
there are several differences between the fund and the index, as the fund can invest both long and short, can
utilize leverage, can take concentrated positions in single equities, and may invest in companies that have
smaller market capitalizations then those that are included in the index. In addition, the index does not include
any fees or expenses whereas the fund data presented is net of all fees and expenses. The source of the index
data is S&P/Capital IQ.

DKAM receives no compensation of any kind from any companies that are mentioned in our newsletters or on
our website. Any opinions expressed are subject to change without notice. The DKAM Capital Ideas Fund,
employees, writers, and other related parties may hold positions in the securities that are discussed in our
newsletters, presentations or on our website.