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  Success with Zarlink not random chance

BENJ GALLANDER and BEN STADELMANN

Friday, November 11, 2011

Here's the score: a total gain on capital of 76.1 percent after a holding period of just under five years, generating a tidy annualized return of 12.2 percent. Though it does not sound amazing on its own, the record accrues lustre when compared to the TSX index, which was negative for the same period.

These are the statistics for our investment in Zarlink Semiconductor, but this overall success masks a long and rocky road of tribulation and self-recrimination.

Why the angst over this holding? We purchased Zarlink on November 16, 2006, at $2.26 a share. Until our payment of $3.98 a share arrived on October 18, there were 1,234 trading days, and on 973 of those the stock closed below our purchase price. We spent enough time underwater on this position to grow a set of gills.

The low point came in March 2009, when some pundits were musing about bankruptcy as the stock traded at 21 cents, signifying a paper loss of 90.7 percent. No stop-loss orders for these stubborn Contra Guys!

But yes, there were times when even a couple of patient knuckleheads realized they should have dumped. Zarlink's 2007 takeover of Legerity Holdings for $134.5 million (U.S.) made sense for its expertise in VOIP chips, but it soon became apparent that the integration of the unit would result in heavy writedowns. A sale of ZL, followed by a repurchase a year or so later when the acquisition had been digested, would have been a more optimal strategy.

Zarlink began to regain its mojo in 2010 with a string of improved results featuring strong cash generation and a nifty move into ultra–low power chips for medical devices. This garnered attention from Microsemi, an aggressive Californian chip shop that, in the previous five years, had acquired 14 companies at a cost of $1.1 billion. An offer of $3.35 was spurned, but after much gnashing of teeth and posturing by both sides, a boost to $3.98 salted the deal.

Some might be inclined to attribute this win to dumb luck. No doubt, it seems an unlikely story, better suited to Hollywood's fascination with plucky upstarts who find redemption rather than the staid boardroom.

Nicholas Taleb, the superstar professor and renowned author, discusses in his book Fooled by Randomness, the concept of "alternative histories." He cautions investors that the quality of a particular trade cannot be solely judged by its successful outcome, but must also consider the other possibilities of what might have happened if events had played out in a different way.

Each of these scenarios are "random sample paths," all with the same starting point, but twisting and turning to very different destinations. In one, Legerity might have turned down the acquisition offer, and Zarlink moved in a completely different direction. In another, Microsemi might have started its courting a few months earlier, when conditions were more conducive to igniting a bidding war that might have yielded a higher price.

Taleb points out that, though there are an infinite number of possibilities, the paths are not equiprobable; outcomes have varying degrees of uncertainty. We'll bet a dollar to a doughnut (and yes, we've aware that the odds of that adage have changed over time) that our investment in Zarlink in 2006 was sound because a majority of those paths headed towards success.

Of course, reality cannot be put through one of Taleb's Monte Carlo simulators; there can be no firm conclusions of such thought experiments. But our 30-plus years of experience in contrarian investing suggests some characteristics of this pick that tilted the odds in our favour.

For starters, Zarlink had lots of cash and no debt. The price we paid was relatively low, a fraction of where it had previously traded. That indicated that in the game of expectations, Zarlink had a low hurdle to jump over to surprise to the upside.

The company was part of Kanata's "Silicon Valley North" elite; we knew with certainty that any technical and financial progress would not escape the attention of analysts and the industry. We also knew that semiconductors are not some passing fancy, but the beating heart of industrial society, just as steel was in the days of yore.

None of these traits in themselves guaranteed a return on investment, but the accumulation of small advantages did make it more probable. It should be noted that our rule to never, ever, buy on margin meant that we never had to worry about a margin call forcing us to liquidate at a loss. That allowed us to stay in the game and hang around waiting for a kiss from Lady Luck.


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