Staying in the game Fears that the world was about to implode have now abated. Instead, we are told that we should now worry about the lack of growth in the world. The fact is that there are always new things to worry about. Once we accept that the things we are told to worry about are perennial, we begin to realize that the “coast is never clear” but life goes on. After all, all of the great things that have happened to us in life, from the birth of our children, to graduations from great schools, or that most memorable vacation, have all occurred against a back- drop of risk. Risk (and return) is omnipresent. The game of investing like the game of life, is about finding our comfort zone in the universe, a place where the trade-offs between risk and reward work in our favor. The idea of simply not playing the game is a non-starter. Warships are safest in port, but that is not what they are made for. For investors in the Capital Ideas Fund, the first quarter of 2013 has gone well. The Capital Ideas Fund was up 8.4% in Q1 of 2013 while the TSX was up 2.5% during the same time period. While we expect the market to be quiet over the summer, we are quite cashed up and thus we are on the look-out for more growth stocks. We are off to a good start in Q2 and optimistic about the future. How we look at growth Readers of the ROE Reporter will note that I refer to “Return on Equity (ROE)” as the primary proxy for the companies we seek to invest in from a perspective of both growth and quality. So why do we like ROE so much? Because it is easy to calculate and it neatly captures both growth and quality characteristics in a simple metric. From a growth perspective, ROE captures the growth in the net worth (or book value) of an enterprise and is superior to other alternative measures of growth including revenue growth, profit growth and EPS growth. From a quality perspective, we also like ROE because it provides a strong measure of the extent to which a company enjoys a competitive advantage. Indeed, the spread between a Company’s ROE and its Cost of Equity is in our view the primary measure of the Company’s competitive advantage or “Moat”. VOLUME XXII APRIL 2013 INVESTMENT ISSUES • STRATEGIES • INSIGHTS FROM DONVILLE KENT

2 ROE REPORTER | DKAM That said, the formal definition of ROE is net profit/common shareholders equity. However, this measure of ROE fails to differentiate between two companies wi th identical ROE’s but differing dividend payout ratios. As such, at Donville Kent we use an “adjusted ROE” number which provides us with a more accurate measure of growth and one that can allow us to look at companies with different dividend policies on a n “apples to apples” basis. Without getting too technical, I will illustrate this point with a comparison of two similarly looking companies by showing how “adjusted ROE” is computed and then how we employ that metric. The first example we will call Large Bank Co. Large Bank Co has net profits of $20MM earned on an equity base of $100MM and thus has an ROE of 20/100 = 20%. Large Bank Co also has a generous dividend payout ratio that sees it paying out 80% of its profits as a dividend. If we assume that we buy shares in Large Bank Co at the start of the year and that the company trades at the same P/Book ratio throughout the year, than our total return for the year will be equal to 1) the % growth in the book value per share of Large Bank Co over the course of the year 2) plus the dividend yield. Returning to Large Bank Co, we see that it trades on 10x earnings throughout the year which therefore means that it also trades on 2.0x Book Value Per Share (BVPS). For the year the company makes a profit of $20MM and the dividend is equal to 80% of its profits or $16MM. Thus, over the course of the year the book value grows by $4MM (from $100MM to $104MM or 4%). The dividend for the year was $16MM and in relation to the value of the Company, represents a yield of 8%. Thus, Large Bank Co delivers a total return for the year, assuming a constant P/book ratio, of (4% + 8%) = 12%. In the second example, we look at a company we will call Toronto Trust Co. Toronto Trust Co also has a net profit of $20MM earned on an equity base of $100MM and thus also has an ROE of 20/100 = 20%. However, Toronto Trust Co has no dividend because it is growing quickly and can easily re-employ its capital back into the enterprise at high levels of ROE. Once again using the same math as we did in the first example, we see that after one year we get no dividend, but the book value per share has grown by the full $20MM or 20%. Therefore, one’s total return, assuming a constant P/Book ratio, is 0% for the dividend, plus 20% in capital appreciation (the book value went up by 20% so with a constant P/Book multiple, the shares appreciated by 20%). The two companies used in our examples above trade on identical P/E and P/Book multiples and have identical ROE’s. However, the true growth rate of Large Bank Co is 12% while the true growth rate of Toronto Trust Co is 20%. In the case of Large Bank Co, its ROE is 20% but its real growth rate is 12% while Toronto Trust Co’s true growth rate and ROE are identical at 20%. Thus, we would argue that Large Bank Co’ s dividend policy obscures its true growth rate and thus, the adjusted rate becomes the one we use to make “apples to apples” comparisons.

3 ROE REPORTER | DKAM Before we move on to a broader discussion of adjusted ROE’s it should be noted that if you add up the difference between a 12% return and a 20% return over time, the difference is quite stunning. Over the course of a decade for example, Large Bank Co becomes a “3.1 bagger” (up 310% in a decade) while the Toronto Trust Co becomes a “6.2” bagger (up 620% in a decade). Bot h returns are attractive, but the later return is obviously quite exceptional. The preceding discussion illustrates the need to normalize or standardize ROE’s for companies with differing dividend payout ratios in order to ascertain growth rates more accurately. So why is this so important? Because valuation must ultimately be linked to some assessment of future earnings or cash flow and those future profits are a function of growth. We like adjusted ROE as our best measure of the growth of the enterprise and linking that measure of growth to value allows us to identity valuation anomalies. A look at the Canadian Lenders, which we present in figure 1, illustrates our point. Figure 1 provides a fair bit of data but the key columns to look at are “Simple ROE” in the first column and “Adjusted ROE” in the fifth column. Here we see that many of the lending institutions that we think are growing quite quickly in fact are not growing quite as fast as their simple ROE’s suggest. Growth and value should have some sort of rationale trade-off and as we see in figure 1 in the column on the far right, each of the companies in the table offers us quite a different trade-off between growth and value. Home Capital for example offers 3.1 units of growth per unit of P/E while the Bank of Nova Scotia offers just 1.1 units of growth per unit of P/E. While we recognise that each of the institutions have remarkably different risk profiles, we also believe that this sector is far more “inefficiency priced” than many i nvestors realise. Home Capital is one of our largest positions and the only stock listed in figure 1 that we currently own. Figure 1 - Canadian Lenders Ranked by Adjusted ROE Financial Simple Retained Growth in Dividend Adjusted P/E Units of Institution ROE Profits BVPS Yield ROE Growth/PE A B A + B Home Capital 24.1% 86.2% 20.8% 1.9% 22.7% 7.4 3.1 First National 34.0% 30.2% 10.3% 7.5% 17.8% 9.3 1.9 CIBC 21.1% 55.3% 11.7% 4.8% 16.5% 9.3 1.8 National Bank 19.4% 59.7% 11.6% 4.5% 16.1% 8.9 1.8 Equitable 15.9% 92.2% 14.7% 1.2% 15.9% 6.5 2.4 Royal Bank 18.2% 53.8% 9.8% 4.1% 13.9% 11.2 1.2 CWB 14.8% 73.3% 10.8% 2.5% 13.3% 10.9 1.2 TD Bank 15.4% 58.2% 9.0% 4.0% 13.0% 10.4 1.2 BNS 14.9% 53.4% 8.0% 4.2% 12.2% 11.0 1.1 BMO 13.9% 51.5% 7.2% 4.8% 12.0% 10.2 1.2 Laurentian Bank 11.4% 51.5% 5.9% 4.1% 10.0% 8.3 1.2 Source: DKAM Estimates

4 ROE REPORTER | DKAM Final Thoughts It’s almost May, and of course we all know the expression “Sell in May”. But Buffett doesn’t sell in May to the best of our knowledge. Buffett’s philosophy is to own great companies with high ROE’s and ride them until they stop creating wealth. In Buffett’s view, if the wealth creation is there, the share price will take care of itself. I am highly certain that Home Capital, which we discussed earlier, will grow its book value by roughly 2% next month, and the month after that. As far as its share price goes, I can’t really guess where it will be next month. But if its ROE stays at close to 24% (roughly 2% per month) then over time its share price will go up by roughly the same amount. Focus on the growth in book value and the share price will do just fine. When you look at it that way, it’s a lot easier to stay in the game. Call me or write me if you want to chat – J.P. Donville Jason@donvillekent.com - 416-364-8886