Student of the Game The first half of 2014 has been kind to our investors. The Capital Ideas Fund was up 13.3% 1 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. Wow…I 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 1990’s, 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 couldn’t due to scheduling issues was Professor David Shaw’s 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

2 ROE REPORTER | DKAM was not able to enrol in Shaw’s course, I did r ead 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. Constellation’s 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 Constellation’s superior capital allocation strategy has made a sign ificant difference in terms of its long-term share price performance. Figure 1 - Constellation Software Inc. Price Chart 2007-Present

3 ROE REPORTER | DKAM 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

4 ROE REPORTER | DKAM 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 CSFB’s US based analysts that helped flesh out the way I look at individual companies. The authors were Michael Mauboussin and Paul Jo hnson 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 company’s exces s 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/Johnson’s 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.

5 ROE REPORTER | DKAM 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 O’Shaughnessy 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 don’t 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 didn’t 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 stock’s beta before we buy it, b ut 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

6 ROE REPORTER | DKAM 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 1 Time weighted rates of return for Class A Series 1, net of all fees and expenses

7 ROE REPORTER | DKAM 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.