VOLUME XXVII April 2014

INVESTMENT ISSUES STRATEGIES INSIGHTS FROM DONVILLE KENT

The Winners Game

For the first quarter of 2014, The Capital Ideas Fund and Capital Ideas Trust were up 3.7%1 and 3.6%1 respectively. As we enter the second quarter, the market appears to be correcting, but as of this writing, we appear to have held on to the gains made earlier this year. As we look into the balance of 2014 we see a couple of themes emerging. Stock market valuations have become rich while monetary stimulus, which has been reflected in low interest rates, remains strong. As such, the portfolio is close to fully invested, although we have taken profits in some of our more expensive winners. In summary, finding companies that can earn a consistently high ROE (20% or better) remains relatively easy, but finding such companies with low valuation multiples is becoming increasingly difficult. In terms of sector themes, we remain heavily weighted in the knowledge based industries, which include a concentrated basket of companies that operate in the software, IT services and pharmaceutical industries. Within the natural resources sector, the only commodity that excites us at the moment is natural gas, and in this area we now have a weighting of close to 13%. We expect to make a good return on all four of our natural gas investments even if natural gas stays at the $4.70MCF level, but we believe that natural gas prices will go higher.

What can sports teach us about investing? I have two wonderful sons and an equally wonderful daughter, none of whom has expressed any interest in following their father into the financial services industry. All three of my children are strong students and accomplished athletes and the closest area of overlap between what I do professionally and what interests them personally is the area of sports. If I attempt to talk to my children directly about things related to my profession such as P/E ratios, competitive advantage, or return on capital, they quickly tune out (and who could blame them?). When I engage them about topics related to the analysis of sporting events, competitions or statistics, however, I quickly regain their interest and typically find myself in the midst of a wonderfully nuanced discussion. During a recent visit to baseball spring training in Florida with my younger son, I had a chance to talk with him about some of the things that I have learned from sports that have made me a better investor. Here are a few of the things we talked about. Charles Ellis and the Losers game In 1975, Charles Ellis, the founder of Greenwich Associates, wrote a famous article for the Financial Analysts Journal titled The Losers Game. The purpose of the article was to identify factors that explained why professional fund managers struggled to beat the market. Ellis article would have been a somewhat dry read for a non-finance professional but what makes it far more interesting to the general reader (and to my son in particular) is Ellis refer ence to the sport of tennis, which allows him to make some very fascinating analogies between tennis and investing. In developing his thesis, Ellis cites the work of Dr. Simon Ramo, author of Extraordinary Tennis for the Ordinary Player. Ramo noted that the most skilled tennis players in the world won primarily by making points, whereas the typical amateur won by making fewer mistakes than his opponent. As Ellis points out after extensive scientific and statistical analysis, Dr. Ramo summed it up this way: Professionals win points, amateurs lose points. Professional tennis players stroke the ball with strong, well-aimed shots, through long and often exciting rallies, until one player is able to drive the ball just beyond the reach of his opponent.. (in amateur tennis)the victor in this game of tennis gets a higher score than the opponent, but he gets that higher score because his opponent is losing even more points. The Losers Game was the starting point of my discussions with my son about sports and investing, and if I recall, our opening discussion began over breakfast in an IHOP in Clearwater, Florida. My son found the tennis analogy quite interesting as he could recall times in his own sporting life where he or a team he played on was playing not to lose rather than playing to win. He went on to cite examples in which teams that he played on were in the lead of an important game, tried to preserve the lead by playing not to lose, and

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eventually lost. He agreed that playing not to lose was a largely unsuccessful tactic in sports, and I suggested that this concept extended well beyond the world of sport. Ted Williams and the perfect pitch Neither my son nor I play tennis and since we were at spring training, our discussions rightly turned to baseball. Soon we were talking about the game we would be watching later that day (the Pittsburgh Pirates vs the Boston Red Sox), and before long we were talking about hitting. I pointed out to my son that Ted Williams, a former Red Sox great, is widely regarded as the greatest hitter of all time and that he has influenced both the baseball and non-baseball world with his writing. Williams, for those who are not baseball fans, was the last major league baseball player to hit over .400 (which means he hit the ball and got on base 40% of the time) in a season, which he did in 1941. Over the course of his career he hit 521 home runs, had a lifetime batting average of .344, and had more walks than any player in the game. Williams numbers would have been even more impressive if he hadnt left baseball to serve in WWII and the Korean War. Williams was a student of the game and he shared his views in a number of articles and books, perhaps the most famous of which is The Science of Hitting. Williams had many strengths, but his greatest was his ability to pick the perfect pitch to swing at. There is a subtly here that needs to be repeated and that subtly is that Williams greatest strength as a hitter was not his hitting per se, but rather his ability to judge in advance of the balls arriving across home plate which pitches should be swung at and which should not. Williams divided the strike zone into sections and through study and analysis, knew which sections of the strike zone would provide him with the best chance to make a hit. He also studied pitchers closely and noted which types of pitchers and which pitches they threw matched up best relative to his strengths as a batter. For example, Williams knew that pitches that were low and outside as well as pitches that were high and inside were bad pitches for him to swing at given his batting style. Williams eye for the perfect pitch helped him in two ways. For the 20 -30% of the pitches he didnt swing at, a certain number would turn into strikes and could eventually lead to outs. However, many would turn out to be balls and eventually walks, which, while not helping his batting average, would allow him to get on base and eventually score. By having a strong sense of what HIS perfect pitch looked like, Williams was able create an environment in which he had a higher probability of getting a hit. This in turn led to his outstanding batting average. Thus, his cost of not swinging was low (some strikeouts but a lot of walks too), while his profit from swinging at higher probability pitches

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was high. His single season and lifetime baseball statistics remain among the best ever in a number of hitting categories. Williams influence on baseball was assured by his various publications, including The Science of Hitting, a book that Warren Buffet read and to which he has referred on numerous occasions in the Berkshire Hathaway annual reports. According to Buffet, The most important thing in investing is what Williams said was the most important thing in hitting waiting for the right pitch. Whats nice about investing is you dont have to swing at pitches. You can watch pitches come in one inch above or one inch below your navel, and you dont have to swing. No umpire is going to call you out. You can wait for the pitch you want. To summarise both Williams and Buffett, the secret to succeeding in both baseball and investing is to know what the perfect pitch looks like, to avoid less than perfect pitches, and to swing only at the perfect ones. And yes, the Red Sox beat the Pirates. Tony Dungy and the Power of Habits As we drive home from the baseball game we see a sign for the NFLs Tampa Bay Buccaneers, and I am reminded of a book I read a few months ago, The Power of Habits by Charles Duhigg. I turn to my son and say, Hey, JD, have you ever wondered how Tony Dungy turned around the Tampa Bay Buccaneers? JD smiles and says with a mischievous smirk on his face, It doesnt matter, Dad, because I know youre going to tell me anyway. We both laugh, and then I share my thoughts on Tony Dungy. The Tampa Bay Buccaneers were an NFL expansion team created in 1976 who promptly lost their first 26 games. Following a brief winning period in the late 1970s they proceeded to lose the majority of their games for 14 years in a row (1983 to 1996). In 1996 the team brought in a new coach, the unheralded Tony Dungy, who up until then had never been a head coach. Dungys first season started poorly, with a 1-8 record for the first nine games, but his way of doing things started to kick in during the second half of the season that saw the team go 5-2 for the balance of the year. The following season the Bucs went 10-6 and for the next decade the Bucs were among the most competitive teams in the NFL. In 2001, however, Dungy was fired for failing to win a Super Bowl. Ironically the team that he built won the Super Bowl the following year. This part of the story still has a happy ending for Dungy, as he was hired by an underperforming Indianapolis Colts team in 2002 and led that team to a Super Bowl in 2006. The question I wish to address is how Dungy managed to turn around a Tampa Bay Buccaneers team for which losing was endemic? Duhigg posed this question to Dungy, who responded as follows: Champions dont do extraordinary things, Dungy would explain. They do ordinary things, but

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they do them without thinking, too fast for the team to react. They follow the habits theyve learned. Dungy echoes some of the ideas raised by Ted Williams. Success in life, sports, and investing comes from the habitual application of best practices. Dungy admitted that he did not teach his players truly new habits. What was missing in Tampa Bay was the systematic application of simple habits that would allow the team to win. Dungy actually simplified the offensive and defensive schemes that the team had been using prior to his arrival. The secret in Dungys Tampa Bay system was to get his athletes to make fewer decisions and instead react quickly to habits. While Dungys approach took a li ttle time to kick in, once the team begun to win, his focus on the repetition of simple habits became self-reinforcing. Jonathan Bales and the importance of consistency The next morning we awoke early in anticipation of seeing the Philadelphia Phillies play the Atlanta Braves, but soon our discussion turned to football and then to a broader discussion about fantasy sports. A fantasy sport is a game in which the participants act as owners of a team (baseball, football, etc.) and compete with other owners based on the performance stats of the players they buy, draft, trade, etc. Typically in fantasy sports there is some restriction on the owner in terms of either budget or draft order. I began this part of our discussion with my son by asking When you p lay fantasy sports, is there ever any incentive to play not to lose? JD says, no, and I think he is right. In most fantasy sports leagues, the rewards of winning typically only go to those who finish first and occasionally second. There are no rewards for being average. There are equally no large costs, however, for taking on risk, and the loss (the admission price for entering the contest) is typically low. Thus, in a fantasy sports league, everyone who is rational plays to win in part because the rewards for winning are large and the costs of losing are small. I then ask my son, What if your fantasy leagues rewards were slightly different? Lets say you could win by being above the average score. How would that influence the team you picked? I suggest to my son that to win at this kind of game, one has to become adept at weighing the positive and negative trade-offs inherent in each selection rather than simply focusing on one side of the equation (the athletes ability to score points). JD stops t o think about this for a minute. I point out to him that I suspect he would balance the value of his winners with the cost of his potential losers. Thus, ones thinking would shift from simply trying to buy the best players to also including the avoidance of low probability long shots. Why? Because now in order to win, its not an all or nothing proposition. One is not simply looking to pick potential high achievers but also to factor in the probability that the player you choose might not perform well this season.

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I suggest to my son that the underlying psychology of sports betting (and investing) is influenced by a factor sometimes referred to as the recency affect. This is the tendency to place heightened importance on a most recent experience. Thus, a football player who has on average rushed for 1200 yards a season throughout his career and suddenly rushes for 1900 yards is likely to now be seen as a 1900 yard rusher when in fact his lifetime stats are probably a better indication of his rushing stats next season. I point out to my son that Jonathan Bales writes about these kinds of issues for The New York Times. Speaking about fantasy football leagues, Bales points out, Each year, the first round consists of players who were statistical outliers from the previous season. These players probably scored more points than they should have, and are thus likely to regress in production. Bales goes on to explain that one of the biggest mistakes that unsuccessful fantasy owners make is to overpay for players coming off a statistically great season. I explain to my son that this happens in the investment world with great frequency. In investments, many investors focus on value or growth, but they often do so with a short-term perspective. Thus, many investors are prone to over-pay for growth or companies where too much weight is placed on the most recent years financial performance. Continuing my discussion on consistency, I ask my son, If you were picking a fantasy team for a competition that would last five years instead of a single season, what would you do differently? JD finds this question intriguing. I guess I would look for players who were early in their career but had already played enough games to clearly demonstrate their ability to play at a major league level. I tell my son that people like Warren Buffet believe that one of the secrets to investing is to assume that any investment should be thought of as one that could not be sold for at least 5 years. This way of thinking forces an investor to look more carefully at issues that a more short-sighted investor might overlook. Thus, for investors like Buffett, sustainability, consistency and competitive advantage become the factors driving the investment process, while near term growth and valuation factors become far less important. Could it be that this is the way to pick a better baseball team as well? Michael Lewis, Billy Beane and inefficient markets Of course, no discussion about sports and sports statistics can avoid the topic of Michael Lewis. I turn to JD and ask him, Do you remember that movie about the offensive guard who now plays for the Baltimore Ravens? JD replies, Sure Dad, thats The Blind Side. It was a great movie. Well, do you realise that the same guy who wrote The Blind Side also wrote Moneyball? JD replies The baseball movie with Brad Pitt in it? Yes, I reply, same guy! Lewis of course has written more than just two books about sports. Liars Poker and The New New Thing were definitive books that captured the essence

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and excesses of the bond trading world of the 1980s and the tech market of the late 1990s. Just as we are leaving Florida, news is out that Lewis has just completed a new book that focuses on high frequency trading. Whether about sports or finance, Lewis is a brilliant storyteller, and while we could talk at length about many of Lewis books, it is Moneyball that I want to talk about before our trip comes to an end. I tell my son that the first thing I found fascinating about the book was its subtitle, which is The Art of Winning an Unfair Game. The subtitle can be interpreted in many ways and I prefer to look at it in David vs. Goliath terms. Moneyball is about the Oakland As and their amazing success on the baseball field despite operating with one of the smallest team budgets. I think Lewis is asking, How could a team from Oakland, with its paltry budget, take on teams in New York, Chicago, Los Angeles and Boston, with their massive budgets and infrastructure.and win? I pose this question to my son and then ask in a similar vein How could a hayseed from Omaha, Nebraska compete against on all those smart people in New York, London, Tokyo, etc.and win? Oakland did it with a General Manager named Billy Beane. In Moneyball we learn that the traditional approach to scouting and drafting players has always been highly subjective and prone to errors based on stereotypes, superficiality, emotions, and in some cases, weak data. Beane could relate to these issues most directly and personally, as he himself was a first round draft pick in the 1980 Major League Baseball Draft. Beane was projected to become a star but things didnt pan out. In six major league seasons he appeared in just 148 games, with a lifetime batting average of .219, 3 home runs and 29 RBIs. When Beanes playing days were over he approached the Oakland As for a job as a scout and Beane then came under the tutelage of Sandy Alderson. Shortly beforehand, the previous owner of the As had passed away and Alderson and Beane were trying to figure out how to build a competitive team with no money. The two began using statistics to search for new ways to understand and identify undervalued players. So what did they learn and what can we learn from them? Moneyball highlighted a number of issues that are relevant to both sports and investing. Perhaps the most important for me is that markets tend to be efficient at the center but that they are often surrounded by pockets of inefficiency. Thus we see in Moneyball that high school baseball statistics are highly inefficient and therefore not particularly useful for predicting future success. At the same time, players who can generate strong statistical performance in the far more efficient NCAA Division I, but are somehow overlooked by conventional scouts, often make for much better draft picks than the so called teenaged phenom. I believe that financial markets are exactly the same; they are very efficient in the middle but surrounded by pockets of inefficiency. This is where the real money is made.

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The second lesson that we can learn from Moneyball is the concept of the crowded trade. When the crowd, in this case major league scouts, are all interested in the same player, chances are that player will be either difficult or expensive to acquire. Better to focus on a player who is 95% as good but is valued at 50% of the value of the so called phenom. Oakland had a knack for drafting or trading for obscure players with outstanding statistics who were overlooked for one reason or another. The third lesson echoed in Moneyball that goes back to Ted Williams and Warren Buffett is the recognition of the perfect pitch. Conventional wisdom on hitters tended to focus on the batting average, but Beane, with the help of an obscure school of baseball statistics aficionados called sabremetricians, figured out that on base percentage was far more relevant than batting average. Even if Beane could become the master practitioner of the old-school of scouting players, he quickly began to realise that the old-school approach, even when expertly applied, was flawed. Beane built a better methodological mousetrap. On fathers and sons/daughters Our trip was approaching the end. We caught an afternoon game with the Blue Jays (who lost) and then sprinted to the Tampa Bay airport. Sitting in the departure lounge, I had the chance to reflect on our trip to spring training and a week spent with my son in near isolation from all the things I would have been busy with back home in Toronto. Here are my concluding thoughts. Sport has sometimes been called life with the volume turned up. Sport offers so many wonderful ways to learn about life, including things we can learn about investing. Many people who will read this newsletter have sons and daughters who are interested in sports pools and fantasy leagues. Let me assure parents that your kids are not wasting their time. The thinking that can go into the way your kids approach these games may be among the most challenging thinking they do. My advice to you is to encourage a rigorous approach to these types of games and to challenge them to explain the underlying logic that drives their decisions. And let me share one other observation. Even if you are not a baseball fan, spending a week on the road with a son or daughter, staying in non-descript motels, eating breakfasts at the IHOP and bad hot dogs in the afternoon is a good thing. In fact, its a really, really good thing.

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Final thoughts Let me once again reiterate my thanks for the support of our investors and my ongoing gratitude that I am surrounded at DKAM by such wonderful partners: Jordan, Ali, Jesse, Chris and Dominika. Call me or write me if you want to chat J.P.Donville Jason@donvillekent.com 416-364-8886

Time weighted rates of return for Class A Series 1, net of all fees and expenses

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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.

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