The Quest for Growth The past quarter has been a good one for investors in the Capital Ideas Fund LP. The fund was up 10.7% in Q3 and 25.8% year to date vs. the TSX which was up less than 3% year to date. Historically the period October through May is the strongest time of the year for the TSX and with the US Debt ceiling debacle now out of the way, we expect a smoother market for the next six months. Looking beyond the next six months, we think low interest rates are here to stay and will underpin a slow but steady economy. Finding individual companies to invest in that are growing and at the same time are trading at a reasonable price is what we do and at this juncture we continue to find well priced investments in Canada. I was recently asked by a client if I paid attention to macroeconomic issues. The answer is of course, yes. I do watch macroeconomic events quite closely because it’s important for me to understand the context within which the companies that I have invested in operate. However, I continue to base our investment philosophy around companies that can consistently earn an ROE in excess of 20% per annum. I believe that stocks that possess this characteristic can perform well in all types of markets and economies. That said here are a few thoughts on some of the macro issues that we are watching as we move into the 4 th quarter of 2013. Looking for growth in a low-growth economy In terms of Canadian stock market cycles, the past 50 years have seen a stock market that on average rises for 60 months and then trades down for a period of 12 to 18 months, before repeating that cycle. In the US, it has been estimated that the typical bull market duration is a slightly longer 67 months with a median duration of 50 months. As such, a 60 month up cycle is relatively average or “normal”. It should also be pointed out that these cycles tend to be quite sporadic in terms of duration with up cycles ranging from 3 to 8 years. VOLUME XXIIII OCTOBER 2013 INVESTMENT ISSUES • STRATEGIES • INSIGHTS FROM DONVILLE KENT

2 ROE REPORTER | DKAM So where are we at in Canada? The current bull market in Canada has now run for about 55 months . That’s the bad news. The good news is that the things that typically bring a bull market to an end have not shown up yet. Towards the end of a typical bull market, the economy expands to a point where excess resources in the economy are used up and concerns about inflation begin to emerge. At that point in time, the central bank begins to raise interest rates in order to stave off inflation and a short time later, the rise in interest rates typically takes the steam out of both the economy and the stock market. Eventually the economy slows too much, interest rates are once again lowered and the next cycle begins. Market timing is difficult to do at the best of times, but the level of interest rates is probably the best leading indicator of when the economic and stock market up cycle is coming to an end. Economists and market timers can look at the interest rate environment from a number of perspectives but perhaps the most widely used is the yield curve. The yield curve as presented below shows the spread between short term (2 year) and long term (10 year) rates. When that spread is wide, the economy and stock market tend to perform well. When the spread is low and occasionally inverted (short term rates are higher than long term rates), the stock market in particular performs poorly. Figure 1 shows the shape of the Canadian yield curve going back over 15 years. Currently we see two positive developments in the yield curve. First, the spread is currently a healthy 1.5% and secondly, the spread is widening. This chart is sometimes referred to as the market’s liquidity profile and in this context the liquidity profile of the Canadian market is quite healthy. When the spread between short and long-term rates falls to 0.50 or less is where I begin to get nervous.

3 ROE REPORTER | DKAM Of course, liquidity is not the whole story. However, those who would argue that the current bull market is about to come to an end need to make the case that interest rates are about to rise. I don’t see it and therefore in the absence of a sharp rise in interest rates, I expect the current “steady as she goes” stock market and economy to continue for some time. I believe the correct “macro thesis” is that the global economy has entered into a long period of slow economic growth. Growth is scarce in a low growth economy, but it is still out there. But before I talk about my quest to find great growth companies, let’s first understand why economic growth is muted in so many places. In so called “normal times”, an economy should exhibit annual economic growth of somewhere between 2% and 3%. However, the long term “normal” growth rate can be affected by three factors that can accelerate or decelerate the “normal” growth rate. These three factors are sometimes referred to as the 3D’s, n amely Debt, Deficits and Demographics. When an entity (an individual, household, company or country) increases its borrowings, it is typically reflected in above trend consumption and thus demand surges above the level that would be in place in “normal” t imes. The same happens in reverse. When such entities stop borrowing and therefore over-consuming, that trend reverses itself and therefore the demand for goods and services falls below trend. Surging demographics works exactly the same way. Young, expanding families buy a lot of things. Retirees, even those that are quite wealthy, do not. Thus, when a nation faces a slowing or aging demographic profile, the result is less demand for goods and services and therefore muted aggregate demand. The trend in Debt, Deficits and Demographics has been pro-growth in Canada and many other countries for several decades but has begun to reverse. The result will almost certainly be below trend economic growth for at least a decade. But all is not “gloom and doom” bec ause there are always pockets of growth somewhere. Charlie Merrill of Merrill Lynch fame became quite wealthy during the 1930s depression by investing in food store chains (A&P, Safeway, etc.). So for the diligent growth investor here are three ways to look for growth. So where does one look for growth? Bottom up – We continuously screen through the market for companies that are growing quickly and when we find what we are looking for, we begin to dissect their business models with the goal of deciding w hether the company’s high current growth rate is sustainable. For us, the most attractive factor is consistently high return on equity (ROE) that is driven largely by a high profit margin. We then look at a company’s industry dynamic in the context of Port er’s framework in order to assess how sustainable the growth rate is. Growth companies can be found in any industry but ones that meet our test typically have some type of competitive advantage as well a product or service that is relatively new or novel (Figure 2).

4 ROE REPORTER | DKAM Source: Thematic – A thematic approach works for some investors if they have a good feel for where growth can manifest itself. However, many of the greatest growth companies come out of left field and thematic investing presumes that one already knows generally where the next great growth opportunity is. While we are primarily bottom up investors, we do find that the bulk of the companies we invest in come from three areas. The first is knowledge based industries which some people might refer to as technology. In this sector, companies can achieve high levels of growth through a combination of intellectual property strength as well as the emergence of a rapidly growing niche industry. The second category where we tend to find many great growth compa nies in Canada is in financial services. Canada’s financial services landscape is full of oligopolies which are highly protected clusters of companies that do not compete on price. Companies in this industry tend to be very profitable and small ones, (which admittedly are rare due to the high barriers of entry) can grow quickly for decades. The third category is the “super consolidators” who are able to channel their superb cash flows into highly accretive acquisitions. These companies tend to be one off, with the strength of their franchises often driven by superior management teams (Figure 3).

5 ROE REPORTER | DKAM Source: Small companies – Small capitalization companies are perceived by many investors to be risky but most academic studies show that small caps generally outperform large caps on a risk adjusted basis. In Canada, the small cap market is littered with junky concept stocks but within that junk pile there are always a couple of fast growing gems. Small cap stocks in our portfolio must meet the same ROE hurdles as any other stock we own and the TSX produces many wonderful new fast-growing companies (Figure 4). Source:

6 ROE REPORTER | DKAM Final Thoughts As of the end of September 2013, the Capital Ideas Fund LP has a five year track record and our 5 year CAGR is 25.7%. This is a good number but don’t assume that I am taking it or our investors for granted. At the same time, I also wanted to acknowledge a few people who have been a bigger part of this number than you might realise. In 1993 I had the good fortune to join CLSA in Singapore and at the time I didn’t realise how lucky I was. Donald Skinner was my first boss and he remains the best boss I have ever had. He was a great teacher and also a guardian angel to me and my family. Gary Coull, Brad West, Nels Friets, Jonathan Compton, Jonathan Slone, Edwin Lucas, Edmund Bradley, Jason Wee, Nam Nguyen, Ali Naqvi, Ernest Fong, Felix Rusli, Randall Gilberd, and Viddyah Rustaman each taught me a great deal about investing in growth stocks and about life. Indeed, I think about and employ the things I learned at CLSA every day. Thank you. I also want to acknowledge my current partners. Jordan Zinberg, Ali Jaffer and Jesse Gamble are each people of marvelous talents and exceptional integrity. Similarly, Paul Marsiglio and David Atlin have been central to the success of DKAM. It’s a pleasure to come to work every day when you are surrounded by people like that. Finally, to our investors. Thank you for your support and at times council. Protecting your money and making it grow is what we do. Thank you Call me or write me if you want to chat – J.P. Donville Jason@donvillekent.com - 416-364-8886