There are a handful of Trimark funds that started this year with fairly high cash weightings – the Trimark small-cap funds among them – and we’ve received a few questions from advisors about cash deployment, specifically during the most recent bout of market volatility. Fortunately, this is a forum that allows us to respond to your questions as they come in.
Cash levels in our three small-cap funds have remained substantial despite recent market volatility. Here’s why.
Cash in the portfolio
We started 2014 with a 23.03% cash weighting in Trimark Canadian Small Companies Fund, 26.66% in Trimark Global Small Companies Class and 22.23% in Trimark U.S. Small Companies Class. By the time kids were settled back at school and the leaves had started to change, those weightings had increased. The chart below shows changes in cash holdings for the three Funds.
Source: Invesco Canada
The cash in the portfolios is mainly the result of businesses held in the Funds being acquired in takeovers, fewer buying opportunities that meet our valuation criteria and trimming of holdings due to price. While the recent ramp up in volatility can certainly create more prospects, I’m still concerned with valuations, so we’re not rushing to buy.
Current market valuations
We believe that current valuations are still stretched and investors are taking on more risk than they may realize. Over the last few months, there were numerous signs that the market was becoming more speculative, including:
- The VIX Index* (the “fear index”) hitting near-record lows in July 2014
- Spreads between investment-grade and high-yield bonds at their lowest levels in decades
- Valuations, price-to-earnings (P/E) ratio† in the broad market (as measured by the MSCI World Index), are up nearly 50% over the past three years
- The MSCI World Small Cap Index is trading at a price-to-earnings ratio of approximately 17 times (as at Sept. 30 2014)††
At times like these, it is important to put market activity in context. Despite the volatility this quarter, valuations in the broad market have not changed dramatically from spring level. In terms of performance, from its high in June 2014 the MSCI World Small Cap Index fell approximately 13% (USD), which is insignificant considering the index is up approximately 180% from its March 2009 lows.
Overall, while valuations were high early in the year and we saw a pullback in Q3/Q4, it has not been an earth-shattering adjustment.
When to put cash to work
Holding cash is a by-product of our bottom-up stock selection process. Put another way, it is a result of not finding companies that fit our strict buying criteria.
The energy sector is one area where we are seeing potential opportunities. If you are an investor in any of our small-cap funds, you’ve probably noticed that energy weightings have increased over the last few years. Many large producers are shifting focus from capital spending on new projects to generating cash from existing sites, leaving related companies, such as service providers, with reduced short-term earnings. We believe the industry is nearing a trough and opportunities will arise to take advantage of the inevitable turnaround.
For example, ION Geophysical is an energy business we own in all three small-cap funds. ION Geophysical is a leader in small niches in offshore seismic activity for the oil and gas industry. The company is building its own library of data in areas that are typically very difficult to explore (e.g., the Arctic), yet may represent some of the largest areas of undiscovered oil and gas on the planet. We believe the company can withstand the current headwinds because of its strong balance sheet and asset-light business model. At the same time, the company is trading at a cheap valuation, and thus providing a margin of safety.
Having cash at our disposal provides us with the ability to invest significantly in attractive opportunities when they arise, in any market environment.
Despite current market volatility, we continue to focus on investing only in quality businesses at prices that provide a margin of safety. When we identify the right opportunities, cash will be deployed, but not before – that’s the discipline.
*VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-dy volatility.
†The P/E (price-to-earnings) ratio is sometimes referred to as the “multiple” because it shows how much investors are willing to pay per dollar of earnings.
Trimark Canadian Small Companies Fund, Series A provided the following performance returns as at October 31, 2014: 1 year, 14.24%; 3 years, 16.28%; 5 years, 14.77%; 10 years, 8.92%.
Trimark Global Small Companies Class, Series A provided the following performance returns as at October 31, 2014: 1 year, 14.66%; 3 years, 21.31%; 5 years, 17.32%; Since inception, 6.12%.
Trimark U.S. Small Companies Class, Series A provided the following performance returns as at October 31, 2014: 1 year, 18.58%; 3 years, 18.67%; 5 years, 18.39%; 10-years, 8.35%.