Animal spirits Markets around the world, including in Canada, continue to wrestle with a variety of issues ranging from the direction of interest rates to the outcome of US elections. Meanwhile, away from the stock market, companies continue to sell products and services and to invest and prosper. The Canadian market has been in correction mode since the third quarter of 2014 and pessimists continue to argue in favour of the risks instead of the opportunities. What is an investor to do? In the short term, markets and companies rarely move in step with their earnings. During corrections, share prices often fall, even when earnings are rising. Eventually share prices catch up and then go through a phase of out- performing earnings. This process is often referred to as multiple expansion and contraction. The focus of investors should be to own stakes in companies that can earn a strong return on their equity base in good economic times and bad. Companies like this are sometimes referred to as compounders . That is, they are able to achieve high levels of compound earnings growth over many years, and this compounding effect is almost always rewarded with share price performance in line with the compound growth rate of earnings. In the first quarter of 2016, the Capital Ideas Fund was down 9.3% 1 compared to the S&P/TSX Total Return Index, which was up 4.3% 2 . This is obviously not a good set of numbers but with the key growth sectors, namely health care and technology, now having corrected sharply, I expect better returns as the year unfolds. Why bother? Given the correction we have seen in growth stocks over the past nine to ten months, we might ask “Why bother?” Our fundamental investment thesis is that stocks that can consistently earn a high return on equity (ROE) over VOLUME XXXV APRIL 2016 INVESTMENT ISSUES • STRATEGIES • INSIGHTS FROM DONVILLE KENT

2 ROE REPORTER | DKAM multiple periods of time are the ones investors should hold for the long run. Looking on both sides of the border, we estimate the long-run ROE for the US market to be approximately 13%, whereas the Canadian market’s ROE, given its emphasis on natural resources, is probably closer to 9%. Moving beyond the broad market, it is important to note that growth is not ubiquitous. The health care industry remains the highest growth sector in terms of ROE in North America. If we use the US health care ETF (IYH) as a proxy for the health care sector, we estimate its ROE to be close to 26%. The technology sector, weighted on the basis of its market cap, is also a high growth sector, with an estimated ROE of close to 20%. Thus, for long-term investors in search of compounders, the healthcare and technology sectors are important places to look for high ROE companies that can, over time, significantly outperform the market. To illustrate this point, Figure 1 shows the performance of the US health care ETF relative to the S&P/TSX composite over the last 5 years. There are a couple of key points to note in this figure. First, while the health care ETF has undergone a major correction over the last 10 months, it is still up 103% over the last 5 years. On the other hand, the S&P/TSX is down over the same time frame. Figure 1. Source: Donville Kent A similar point can be made with respect to the technology sector. In Figure 2 we compare the S&P/TSX composite with the Canadian Software and Services Index, a reasonable proxy for the Canadian technology sector. Once again, we estimate that the largest software companies in Canada have an ROE that is more than double that of the broader market. Thus, as we see in Figure 2, a

3 ROE REPORTER | DKAM dollar invested in the Canadian technology sector 5 years ago is now worth $2.85, whereas a dollar invested in the TSX composite is now worth slightly less than a dollar. Figure 2. Source: Donville Kent So why are the health care and technology sectors doing so much better than the broader economy? The strong performance of these two sectors is driven by two factors. First, with little demographic growth in the world, economic growth increasingly must come from “New Things”. This means new drugs, new gadgets, and new technologies: stuff that we don’t already own or use. Leon’s Furniture, which is an exceptionally well-managed furniture company, will not sell significantly more sofas or dinette sets next year because the Canadian population is not growing quickly. But a new drug or gadget that didn’t exist a year ago has the potential to achieve a high level of sales growth as consumers sample and then adopt this new product or service. The other growth advantage that health care and technology companies enjoy are patents, which ultimately provide profit margin protection. In a world of slow growth, price competition is intense, and the only companies that can enjoy high margins and therefore high ROE’s are those that have built some kind of moat around them. The health care and technology sectors are underpinned by companies that sell products and services that are protected. This allows such companies to earn high ROE’s not just today, but into the foreseeable future.

4 ROE REPORTER | DKAM In search of compounders When we talk about compounders, we are typically talking about companies that can earn a ROE that is consistently higher than its cost of equity. This is the underlying premise of Economic Valued Added (EVA) analysis. Companies that achieve returns on equity greater than their cost of equity are adding value for the investor, and this is reflected in steadily rising share prices. Of course, why some companies achieve high ROE’s is important to understanding their value. Using DuPont analysis, we note that companies can achieve high ROE’s through 1) leverage 2) asset turnover and 3) margins. Typically, we want to invest in companies that earn their high ROE’s from items 2 and 3. We also want to invest in companies that are not one-hit wonders, i.e., a high ROE one year and a low or negative ROE in the following year. As we scan through the Canadian universe, we see a small number of elite companies (Figure 3) that have a very good (but not perfect) track record of delivering consistently high ROE’s. This list is not exhaustive, but we think it represents a list of companies that earn consistently high ROE’s through the entirety of the economic cycle. It should be noted, however, that most of these companies are fairly well known to Canadian investors, and as such their valuations are in some cases rich. That said, there are also always a few compounders that for one reason or another are out of favour, and these should be the focus of the astute long-term investor. Our goal when looking for compounders is to look for those companies that don’t already have their “greatness” reflected in their value.

5 ROE REPORTER | DKAM Figure 3 – Canadian Compounders ranked by 2016 P/E* *Cash earnings = GAAP earnings plus amortization of intangibles Source: Donville Kent Besides compounders, there exists another group of companies that are worth investing in. These are “emerging compounders.” These are companies that do not yet have the track record that the companies in Figure 3 possess but that are showing signs that they could become Canada’s next great company. Most are relatively new companies or newly-listed companies, but in other cases they are more mature companies that have adjusted their capital structure in order to become more capitally efficient. The key reason one should focus on emerging compounders is valuation. If we compare Figure 3 with Figure 4, we see that the key difference is that the “emerging compounders” trade at a significant valuation discount compared to the “compounders.” Company Sector 2016 ROE - % 2016 P/E - (x) 1 Pulse Seismic Energy 32 6.6 2 Home Capital Financial 18 7.8 3 Freehold Royalties Energy 15 8.9 4 MacDonald Dettwiler Industrial 17 13.5 5 CGI Group Tech 21 13.7 6 MTY Food Group Consumer 22 13.9 7 Open Text Tech 21 14.2 8 Badger Daylighting Industrial 15 16.2 9 Alimentation Couche-tarde Consumer 27 18.4 10 Boyd Group Industrial 26 20.0 11 Constellation Software Tech 70 20.0 12 Enghouse Tech 21 21.5 13 Dollarama Consumer 59 25.4 14 First Service Industrial 28 32.4 15 Kinaxis Tech 25 54.9 Average 27.8 19.2

6 ROE REPORTER | DKAM Figure 4 – Canadian “Emerging” Compounders ranked by 2016 P/E* *Cash earnings = GAAP earnings plus amortization of intangibles Source: Donville Kent Figure 3 and Figure 4 identify 28 Canadian stocks that investors can use to build a well-diversified portfolio. We are not so naïve as to suggest that the cheapest stocks in Figures 3 and 4 are not without their issues. Some are carrying too much debt (Concordia), some are perceived as ex-growth (Supremex) and others are presumed to face certain macro risks (the housing market and Home Capital). That said the prescient investor must be prepared to roll up her sleeves to determine if the risks with the more cheaply priced stocks are fully priced in. If not, keep moving up the list to find those compounders that are reasonably priced but don’t have major risk issues. We think companies like CGI Group, MTY Food Group, Open Text, CRH Medical, and Cara Operations represent very good risk/reward trade-offs. How we think at a company specific level The preceding analysis gives a good overview of how we think and the kinds of companies we invest in. For investors who are interested in seeing more granularity to our process, in Appendix 1 we present our analysis of MTY Food Group, a company we own in the portfolio and one which we think offers an excellent risk/reward trade-off. The MTY analysis was prepared by Jesse Gamble. Company Sector 2016 ROE - % 2016 P/E - (x) 1 Supremex Industrial 28 6.1 2 Concordia Healthcare Health 21 6.8 3 Enercare Industrial 29 7.9 4 Nobilis Healthcare Health 26 8.3 5 CRH Medical Health 36 13.0 6 Stingray Digital Consumer 22 13.7 7 Pollard Banknote Consumer 23 14.2 8 Biosyent Health 40 16.1 9 Cara Operations Consumer 28 17.8 10 Tucows Tech 43 18.7 11 Canadian Pacific Railway Industrial 24 19.2 12 CCL Industries Industrial 18 22.4 13 Spinmaster Consumer 50 23.9 Average 29.8 14.5

7 ROE REPORTER | DKAM Final thoughts Growth stocks have had a major correction over the past year, but their ROE’s have not fallen. With so much value being created at the company level, it’s only a matter of time before this fact is reflected in share prices. Our first quarter results were disappointing, but April is going well. I expect the remainder of the year will show better returns. Once again, many thanks to my hardworking and honest team. Working with people this fine is one of the great joys of my life. Write me if you want to chat – J.P. Donville Jason@donvillekent.com

8 ROE REPORTER | DKAM Appendix 1. *All estimates, projections and calculations have been generated by DKAM *This does not constitute as advice for personal investments but rather a breakdown of how Donville Kent approaches stock analysis MTY Food Group Inc. (MTY) MTY franchises and operates quick-service restaurants across Canada and more recently into the USA and the Middle East. The company, established in 1979, is based in Saint-Laurent, Quebec and is still run with an “outsider” mentality by the low-profile but impressive Founder & CEO Stanley Ma. The driving forces behind this investment start with MTY’s enduring and defensible economic moat. This is what enables MTY to consistently produce high top-line growth but more impressively deliver growth with some of the best margins in our entire investable universe. Highly profitable growth is what makes MTY a great company, their relative valuation is what reinforces it as a great stock to own. According to “The Street” this is by no means a slam-dunk investment. Their main concerns focus on a lack of Same Store Sales Growth (SSSG) and what they like to call a premium valuation. Both of which we believe to be unfair judgements and analogous to missing the forest for the trees. Competitive Advantage MTY is protected by brand recognition, supported by strong management and aided by a defensible & replicable growth strategy. Brand recognition is simple. We know and trust names such as Vanellis, Extreme Pita, Jugo Juice and Thai Express. This familiarity not only attracts customers but is also much more appealing to potential franchisors as well. Evaluating the strength of management is a much more qualitative task. The fact that MTY has been able to acquire and revitalize fledgling brands such as Country Style in 2009 and Mr.Sub in 2010 confirms their turnaround capabilities. In addition, their temperament, considerable inside ownership and low-turnover allows them to plan and manage for long-term value creation. What’s so good about MTY’s strategy? The company is diversified across 2,700 locations with over 39 banners that span multiple food types. This diversification protects them against shifts in customer preferences and they often have multiple banners in a given location allowing them to capture a higher share of one’s daily food spend.

9 ROE REPORTER | DKAM Top-Line Growth MTY’s revenue has increased at a compound annual growth rate (CAGR) over the past 5 years of 17%. In the majority of cases, companies see diminishing top-line sales as they grow simply because of the law of large numbers. The bigger you are the harder it is to move the needle. That being said, MTY’s revenue grew at 26% in 2015 (Figure 1). Figure 1. MTY Food Group’s Historical Financials Source: Donville Kent MTY’s lack of SSSG (roughly 1%) is a strong point of contention against the stock. We believe SSSG in general is an overly scrutinized metric, especially in the case of MTY. Once a new location is up and running it doesn’t take long for MTY to have it operating efficiently. This single location is now generating strong cash-flows and MTY has the task of deciding how this cash is invested. They could do some additional marketing or develop new menu-items to attract the marginal customer and boost SSSG. McDonalds is a great example of investing for SSSG with their successful launch of All-Day Breakfast but also their failures like the McLobster. These types of investments aren’t cheap and by definition have diminishing returns. This is where MTY’s great capital allocation track record comes into play. They invest those same cash-flows at a much higher rate of return than if they strictly focused on creating SSSG. This is shown by the compounding growth in the underlying value of the company. How we view growth Going back to the tree for the forest metaphor, this is the forest. Figure 2. MTY ROE Trend & DuPont Analysis Source: Donville Kent The long-term trend of a company’s ROE (Figure 2) is very telling and probably the most powerful tool in the DKAM toolbox. If we think we have found a company with a sustainable ROE the next step is DuPont Analysis. The table above breaks MTY’s ROE into its separable parts of Leverage x Asset Turnover x Net Margin. MTY is currently Net Cash and as you can see FYE Nov ($CAD) 2008A 2009A 2010A 2011A 2012A 2013A 2014A 2015A 2016E 2017E Sales 23.9 42.2 66.9 78.5 96.2 101.4 115.2 145.2 167.0 187.0 Cash Earnings 11.6 15.0 18.5 19.3 25.9 29.9 31.4 40.9 46.8 52.7 Dividends No Div No Div 0.9 3.4 4.2 5.4 6.5 7.6 9.2 10.6 Payout ratio No Div No Div 5% 18% 16% 18% 21% 19% 20% 20% Cash EPS 0.61 0.78 0.97 1.01 1.36 1.56 1.64 2.14 2.45 2.76 BVPS 2.58 3.22 3.99 4.65 5.54 6.84 7.56 8.72 10.24 11.96 Shares in issue (basic) 19.1 19.1 19.1 19.1 19.1 19.1 19.1 19.1 19.1 19.1 FYE Nov ($CAD) 2008A 2009A 2010A 2011A 2012A 2013A 2014A 2015A 2016E 2017E ROE 26% 27% 27% 23% 27% 25% 23% 26% 26% 25% Leverage (X) 1.2 1.2 1.3 1.3 1.3 1.3 1.4 1.4 1.3 1.3 Profit Margin 49% 35% 28% 25% 27% 29% 27% 28% 28% 28% Asset Turnover 43% 62% 77% 73% 76% 66% 62% 69% 70% 69%

10 ROE REPORTER | DKAM has never relied on leverage to juice their returns. Their asset turnover is stable and helped by the fact that they operate an “asset light” business and are able to run their business with minimal Property, Plant & Equipment leaving them with less capital invested and more free cash flow. One of the most observed trends when analyzing companies is a declining ROE that, in most cases, is driven by deteriorating margins. This is a quite intuitive outcome. If a company is highly profitable, other companies will look to grab a piece of that business. If the business model isn’t defensible then more and more companies enter and this increased competition drives margins lower. Another recurring trend is what we call a “good year, bad year” ROE. A cyclical company may have a high ROE at the top of the cycle but a much lower, maybe even nonexistent, ROE at the bottom of the cycle (ex. an oil company’s profits at $90 oil versus $30 oil). However, a third trend is possible but harder to find. MTY has reported a +20% ROE each of the last 15 years! Enough said. Valuation All of previous analysis focused on MTY as an operating entity and supported the opinion that it is a great company. However, the price at which you have to pay for such a business will determine if it’s a good investment or not. Today MTY is trading at $33.98/share with 2016 cash earnings projected to be $2.45/share, putting it on a 13.9x multiple. Determining if this is expensive or cheap is a relative game. Unless you have unlimited capital, you need a way to rank your investment universe in order to only invest in your best ideas. This is the crux of being a successful stock picker. For brevity’s sake we ranked MTY exclusive to the Canadian restaurant industry (Figure 3). Not only do we believe MTY is trading on a relatively cheap earnings multiple but it has the highest growth rate in the group, suggesting that it actually deserves a premium valuation. Figure 3. MTY Comp Table Source: Donville Kent *2016 Estimates Company ROE P/E G/PE MTY Food 26% 14x 1.9x Cara Operations 24% 20x 1.2x A&W Royalty 25% 28x 0.9x Pizza Pizza Royalty 10% 15x 0.7x Restaurant Brands 13% 44x 0.3X Industry Comp Table

11 ROE REPORTER | DKAM I would like to leave you with one final calculation. Over the last 10 years the stock has returned 20.5% a year, plus a 1.4% dividend = 21.9% total return per year. Now compare that to their 10 year Sustainable Growth Rate of 22.1%. The fact that these amounts almost match perfectly isn’t a coincidence. Allocate Wisely, Jesse Gamble jesse@donvillekent.com 1 Time weighted rates of return for Class A Series 1, net of all fees and expenses as of December 31, 2015 2 S&P TSX Composite Total Return Index is the Net Total Return version of the S&P/TSX Composite Index 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.