Back to the Future We’re entering the last quarter of 2018 with the Capital Ideas Fund up 5.73% 1 for the year, while the market is up 1.36% 2 . Our annualized return since inception sits at 18.75% 1 while the Canadian market has returned 6.30% 2 . This newsletter is all about time . There are two related – but very different – questions when it comes to timing and how it relates to investing in the stock market. At first the two questions below appear to be related but from our point of view they are anything but. 1) How do you know when to get in or out of the stock market? 2) How do you know when to get in or out of a stock? This edition of the ROE Reporter aims to answer both questions and concludes with a DKAM specific example of a stock we’ve recently exited. Along the way we will revisit our stance on growth versus value. This distinction is pivotal in informing both our buy and sell decisions within the portfolio. Being able to predict the future value of a company is the Holy Grail of investing and is much more valuable than predicting market moves in general. We believe we run a “machine” capable of consistently beating the market by picking stocks that outperform the market. The inverse of this would be the ability to consistently predict the upward and downward moves of the actual stock market. In order to do that successfully, one would need a time travelling DeLorean parked in their garage. To our knowledge, no one actually possesses such a device, which makes sense because no one has exhibited the ability to consistently trade stock market fluctuations. It’s appropriate to reiterate the old adage, that the measure of making money is “time in the market” and not “timing the market.” Not many people have been able to consistently time the market, but there remain a few studied experts who have been able to outperform it…enter Warren Buffett. VOLUME XLV October 2018 INVESTMENT ISSUES • STRATEGIES • INSIGHTS FROM DONVILLE KENT

2 2 2 ROE REPORTER | DKAM Flux Capacitor In 1955, Doc Brown fell off the toilet and hit his head on the sink in order to realize that the Flux Capacitor was the key to time travel. Fortunately, we didn’t need to do anything of the sort to understand the key to stock picking because Warren Buffett already did it for us. Only two years after Doc’s “discovery,” Warren Buffett, along with friends and family, invested a total of $105,000 in his limited partnership. This would ultimately propel him to great success as Warren had created his own DeLorean. Warren’s DeLorean is powered, not by a flux capacitor and plutonium, but by the compounding effect of retained earnings and ROE. Physicist Albert Bartlett put it this way: “The greatest shortcoming of the human race is our inability to understand the exponential function.” The counter intuitiveness of compounding is responsible for the majority of disappointing trades, bad strategies, and successful investing attempts. Good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off hits that kill your confidence when they end. It’s about earning pretty good returns that you can stick with for a long period of time. That’s when compounding runs wild. In order to time travel, the DeLorean relies on the Flux Capacitor, which itself relies on plutonium for energy. In our world, superior stock picking relies on compound growth, which itself relies on Return on Equity. Return on Equity, our proxy for growth, is the best metric to evaluate stocks versus any of the value-based calculations like Price to Sales, Price to Earnings, Price to Book, Enterprise Value to EBITDA etc. We think Warren Buffett would agree with us, even though most people think he’s a value investor. We think he’s instead a growth investor who buys excellent businesses at prices that make business sense, instead of simply seeking bargains. For example, Buffett invests in Coca- Cola at 24x Price to Earnings, Moody’s at 17x EV/EBITDA and Costco at 29x Free Cash-Flow*. Multiples like these would make a value investor blush. Good thing Buffett’s not a value investor and neither are we. ROE is also a superior metric to picking stocks based on sales growth or earnings growth. Sales growth isn’t a good proxy for value creation and earnings growth isn’t a good proxy for sustainability of growth or measuring operating efficiency. ROE is a culmination of all the ratios and metrics we really care about: sales growth, margins, taxes, earnings growth, interest payments, and so on. _______________________________ * Each of these companies has an ROE of 25%-30%.

3 3 2 ROE REPORTER | DKAM What we need to do is pick the most efficient capital allocators and let them compound the values of their businesses. The market will eventually reward the most efficient companies. Compound growth can only be ignored for so long. We’re able to sleep well at night knowing each year, quarter, and even day, our businesses are growing the underlying values of their companies. 88 MPH Marty McFly had to reach a speed of 88 mph in order to travel through time. For us, the critical threshold for a company to outperform the market, is to have an ROE over 20%. The market average ROE sits around 10%, so in order to outperform the market, you would want to own stocks with ROEs above 10%. But why stop there? The ROE threshold of 20% allows for a concentrated yet diversified portfolio of roughly 10-20 stocks, while still optimizing compound growth and eliminating less valuable companies. As Buffett’s assets have grown in size, he has had to lower his hurdle rate, as his size has forced him into larger capitalization stocks. The average market cap of Berkshire Hathaway’s stock investments is now $109 billion. Staying small and nimble has allowed us to remain disciplined with our targets and continue to invest only in very high ROE companies. When Lightning Strikes If you research investing techniques, you’ll find the most common topics refer to Value versus Growth investing. We are over-simplifying, but there is a certain practical usefulness in thinking of it this way. We’ve established why we and Buffett think growth investing based on Return on Equity is optimal. However, it is still helpful to review the alternative, and to understand the psychology of investing based on searching for bargains. We refer to a lot of value stocks as being Hotel Californias, paying homage to the iconic Eagles song with the verse “You can check out any time you like, But you can never leave.” This is the main issue with value investing: the unknown variable of time or – in other words – the value trap.

4 4 2 ROE REPORTER | DKAM We view value traps in three ways: 1) The cheap stock declines after buying it, but because the reason to buy it in the first place was that it was cheap, price declines only make it cheaper and hence more attractive. High quality companies, that possess defensible moats that lend themselves to compounding, aren’t the type of stocks that can be found in the bargain bin. 2) A value investor may know what he/she believes the company is worth – say it is trading at $10/share and they think it is worth $15/share. What they don’t have however, is an investment horizon or any real idea of the time it will take for the stock to reach fair value. 3) When, or if, the value of the stock is realized, the value investor sells, realizes the gains, pays the tax man and then has to find another investment idea. All of this is why value investing doesn’t lend itself to successfully compounding capital. Most of the issues with value investing relate to time, specifically investment horizons. If someone invested in something purely because it is cheap, then they are at the mercy of the stock market. For the gap to close between the market value and the fair value, there needs to be an event that changes the minds of the market participants. And unless they’re an activist investor, this event is out of their control and now they’re playing the waiting game. Each day that goes by, their annualized return decreases. This type of investment would make it hard to sleep at night because of the uncertainty of how the market will treat the investment and when the thesis will play out. Hope is not a strategy. However, we invest in high ROE companies because they’re continually increasing their intrinsic value…even if we don’t know when lightning will strike the clock tower. OUTATIME Let’s revisit the second of our original time related questions, knowing when to exit a specific stock. When we invest in a company, we don’t do it with an exit in mind. Just like Buffett, we plan on holding and allowing the magic of

5 5 2 ROE REPORTER | DKAM compounding do its thing. However, sometimes the situation changes and just as Buffett exited his position in IBM and AT&T, we have exited our position in MTY Food Group. We first invested in MTY in 2009 at roughly $8.00. The stock now trades at $65.00. When we enter an investment, we plan on holding it forever, as long as the compounding machine (ROE) keeps working or the stock price doesn’t get ahead of the business fundamentals, becoming overly expensive (PE). In cases where one of these scenarios occurs, we will exit the position and put the money to work in an investment with better risk to reward tradeoffs. In the case of MTY, both the ROE and PE have gotten out of zones we are comfortable with. MTY is up 23% this year and we believe most of this is due to multiple expansion (getting more expensive). At the same time, it appears the company has had to lower its hurdle rates for acquisitions. In other words, it is acquiring less and less attractive businesses. Using our methodology for calculating ROE, this Delorean has run out of plutonium. The combination of a higher PE and lower ROE has led us to move on and put money to work in more attractive businesses. Top Picks The natural next question to ask is what stocks we like better than MTY. In essence, this is asking the same question as what are our top picks at the moment. We believe, if you could travel to the future, you would find out that Tucows, Constellation Software, Colliers International and Spin Master are still the companies you would want to own and we remain confident in their continued success. Final Thoughts At the time of writing, the TSX Composite Index sits at the same level as it was in June 2014. Even though the Canadian stock market hasn’t gone anywhere meaningful in over 4 years, we remain disciplined and patient, knowing that our investments continue to compound their intrinsic values. Once again, many thanks to our amazing team here at DKAM. Finally, to our investors, thank you for your support and patience. J.P. Donville & Jesse Gamble info@donvillekent.com

6 6 2 ROE REPORTER | DKAM All estimates, projections and calculations have been generated by DKAM. This does not constitute advice for personal investments but rather a breakdown of how Donville Kent approaches stock analysis. 1 Time weighted rates of return for Class A Series 1, net of all fees and expenses as of September 28 th , 2018. 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 Bloomberg. 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.