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Following a strong Q1, 2017 Q2 proved to be a volatile quarter for equity markets in North America. In Canada, we saw the TSX give up the majority of its Q1 gains and in the US we witnessed a violent sector rotation in early June. That said, we are pleased with how the Total Return Fund performed in the quarter. The Fund was up 3% outpacing the 1.6% loss for the TSX and staying on pace with the S&P 500. On a year to date basis it’s a similar story of outperformance for the Fund when compared to its Canadian benchmark but unable to keep up with the red hot gains of the US markets where major indices are at all time highs. Outperformance for the Fund was primarily driven by Technology and Consumer based stocks which we will discuss in more detail further.

Below is an analysis of the Fund and some comparative indices in Q2:

Q2 2017 YTD 2017 Since Inception
Jemekk Total Return Fund 2.99% 7.95% 90.80%
S&P/TSX Composite -1.64% 0.74% 49.70%
S&P 500 (USD return) 3.09% 9.34% 124.01%

*Benchmarks quoted in Total Returns

Canadian and US markets began to diverge in the second quarter. The TSX was positive every month in Q1 but that changed in May as the strength in smaller weighting sectors could not offset the deep losses in energy stocks and the non-performance from financials leaving the TSX up only 74 basis points on the year. There is a lot to be worried about in Canadian markets. We are without a doubt seeing how much Financials and Energy (accounting for over 50% of the TSX) weigh on the index. Without these two sectors performing its tough to paint a rosy picture for the TSX. And we are of the view energy trades at best flat to up small for the balance of the year. Compounding this is the tepid IPO market in Canada. Over the last year we have seen a handful of consumer based names come to the market with limited success (Canada Goose being the outlier) and in Q2 we saw more of the same story. Real Matters, a developer of property valuation software, is trading below issue and Bento, a quick service sushi restaurant, pulled their IPO due to lack of interest. That said, Jamieson Wellness, a maker of vitamins, is trading above issue price. Overall, this does not read well for Canadian equity markets and our view is simply we have saturated the market with consumer based stocks and we would like to see more technology oriented IPOs in an effort to attract capital to Canadian names.

 

South of the border the US markets continue to march higher with all three major indices pushing all time highs despite major geopolitical concerns such as increased terrorist activity in Europe and missile testing from North Korea. The question asked every day is how much farther can US markets increase while volatility is at all time lows, the Fed is increasing interest rates, valuations appear stretched, and earnings growth is lackluster? Although there is good reason to be concerned with valuations generally high, we remain constructive on equity markets and in particular, our holdings. The earnings backdrop for sectors we are overweight appear healthy and should continue to deliver as we head into earnings season.  Another positive is multiples, although high, appear to be holding these levels given the continued interest rate environment.  In other words, some stocks are now growing into their price multiples. The US markets have had impressive performance year to date and we do not expect the same performance for the second half of the year from the same stocks. Consensus is for more value oriented names to do well along with cyclicals while interest rate sensitive names like Utilities and Telecom to underperform. We are of the same view however we are not abandoning Technology stocks as we are against consensus on valuation and believe the stocks we own are worth the multiples they have given their growth expectations. Turning to the political front, we are aware there is a lot of pressure for the Trump administration to deliver on its stated goals which have been a positive catalyst for the markets. We are monitoring these events carefully, namely tax reform, and positioning the portfolio accordingly. To date the market is giving Trump a pass on his promises but we remain concerned about his ability to execute and deliver.

 

The Fund entered the quarter 80% net long and finished 60% net long. We have been actively taking down exposure as we are being much more selective on ideas and sector calls. We are particularly pleased how the Fund has performed given its lack of exposure. However, June’s performance (-1.89%) clearly illustrates the large tech weighting and US exposure in the Fund. On the bright side, our portfolio diversification help softened the weakness during the sector rotation. For Q2, the Fund performance can be attributed to our Technology (Shopify) and Consumer based names (Constellation Brands and Air Canada especially had an impressive quarter). Below we highlight a new name for the Fund:

 

Activision Blizzard Inc.(ATVI) – Widely known for its very popular video game franchises, Activision Blizzard is also making a big bet on the growing popularity of eSports. ATVI has three core business segments: (1) Activision – global player in console gaming; (2) Blizzard – leader in PC gaming; (3) King – revered mobile gaming asset. But what has really attracted us to the story were some of the behind the scene segments which we believe are not accurately being priced by the market. These segments include: gaming distribution, studio and consumer products and most interesting, investments in eSports which is in its early stages of what we think could be an area of massive global adoption. Popular ATVI game franchises include: Call of Duty, World of Warcraft, Candy Crush, and entry into eSports with the game Overwatch.

 

Activision has high barriers to entry. It would be very costly and risky for new competitors to emerge given the runway ATVI has had and scale of monetization. We were impressed to find out how financially sound the company is given the amount of costs that go into game development. The company enjoys a strong margin profile, kicks out approximately $2b in FCF a year with a very healthy balance sheet ($3b in cash + up to $5b in additional debt capacity). Through very smart acquisitions ATVI has built a remarkable company with exposure to every gaming arena and with its Blizzard business able to capture the secular shift from physical cartridges to digital games. By and large the above characteristics are known to the investing public and as such will result in limited upside for the stock. However, why we are long the company is for the push ATVI is making into eSports. What is eSports?

 

eSports – is an organized competition between ‘gamers’ (amateur but more so professional) viewed live (arenas such as Staples Centre), online (Twitch, YouTube, Facebook), or on tv (ESPN). eSports is becoming a global phenomenon that is expected to grow revenues over 30% every year for the next 5 years. eSports is in the very early innings of growth but has already garnered a lot of attention and we believe will one day overtake viewership of the big four pro sport franchises and Activision is set to benefit from this movement. Specifically, (1) the formation of a division dedicated to competing in eSports; (2) ownership of Major League Gaming (MLG), a curator of professional gaming events; (3) creation of Overwatch League which is modeled after professional sports, is designed to build out teams on a city by city basis including recruiting and training sought after talent complete with guaranteed contracts and benefits. Simply, Overwatch League is a way to organize and streamline the process for these athletes to better compete on a global scale. There is a lot to be excited about with a company like Activision but what interests us the most is how well ATVI is positioned in the nascent stages of eSports. For example, ATVI already has 4 of the top 10 titles in eSports and the company is laser focused on being a dominant player in the space and has recently sold franchise rights to seven cities for competition which include serious players like Bob Kraft (owner of the New England Patriots) and Jeff Wilpon (owner of the New York Mets). We believe eSports will be yet another lucrative business segment for ATVI primarily from multi-million dollar media rights contracts, sponsorship opportunities, licensing agreements, and merchandise and ticket sales.

 

We begin Q3 much more cautious than we did when we entered Q1. We remain constructive on equity markets as whole and believe underlying trends still provide reasons to be optimistic. Canada is going to continue to struggle unless there is a rebound in energy and the financials begin participating. Q3 also began with the Bank of Canada hiking interest rates for the first time in seven years which came as a surprise to most market participants and has led to unexpected strength in the Canadian dollar. This should be viewed as a positive signal suggesting Canada is regaining its footing and we have hit an inflection point in our economy. On the US front we are only half way through the year and the S&P 500 is already at or close to market strategist predictions. Which tells us if earnings prove to be more powerful than expected there could be a need to revise targets upward which would create a buying catalyst for the markets.