Saturday, 3 September 2016

Bed Bath and Beyond, Serious Underperformance, Why? Part 2

In my previous post, I drew attention to relative under-performance in Bed Bath and Beyond (BBBY) vs. basically everything (this year), and wondered what the market might be inferring.

I'm going to attempt to answer this question with reference to John Huber's series of articles on ROIC over at Base Hit Investing.  If you haven't read these articles, I highly suggest you do.

There are two particularly powerful articles which I've read, and re-read, and re-read again which provide an amazing conceptual framework for understanding ROIC and identifying companies with moats.

The first article, entitled "Importance of ROIC: "Reinvestment" vs "Legacy" Moats, link here, articulates an approach to distinguishing between both types of moats, and the role ROIC plays in compounding returns over time. I've never really thought along these lines until recently, but I'd hazard a guess that any serious investor has likely has thought along these lines without knowing it.

The second article, entitled "Calculating the Return on Incremental Capital Investments, link here, articulates the math behind evaluating ROIC. Like any other point in time return parameter, ROIC cannot be evaluated just at a point. I believe it is most useful when evaluating returns over time.

The key takeaway from the first article is that a serious investor looking to compound returns abnormally needs to spend his/her time identifying companies with reinvestment moats. Simply put, a reinvestment moat allows a company to reinvest earnings at exceptionally high rates of return over time. This type of company likely has a durable competitive advantage combined with a long runway of growth.  One of my favourite observations from this article is as follows:

On the subject of "Judging the "Runway" to Reinvest:

"Many investors focus purely on growth rates driving up the valuation of a company growing at high rates even if the growth does not carry positive economics. The key to Reinvestment Moats is not the specific growth rate forecasted for next year, but instead having conviction that there is a very long runway and the competitive advantages that produce those high returns will remain or strengthen over time. Instead of focusing on next quarter or next year, the key is to step back and envision if this company can be 5x or 10x today's size in a decade or two? My guess is for 99% of businesses you will find that it is almost impossible to have that kind of conviction. That's fine, be patient and focus your energy on identifying the 1%."

Absolutely brilliant comment and a clue. My interpretation as applicable to me? Don't try to force ideas. Every single day there's a flurry of opinion surrounding everything ticking red/green by the mili-second. Most companies out there likely don't have reinvestment moats. And the ones that do? Well, the market has most likely priced the reinvestment moat in (think Amazon, Facebook, Google, etc.) Focus instead on a) identifying companies with possible moats, and b) distinguishing between legacy vs. reinvestment moats. Once a reinvestment moat is identified, conservatively envision how a company might be able to grow to 5x - 10x today's size in a decade.

The key takeaway from the second article is thinking forward. The act of calculating ROIC over time forces you to evaluate where a company is at in terms of likely future runway to reinvest. The author gives two examples, comparing Walmart (Legacy Moat) to Chipotle (Reinvestment Moat, well up until recently anyway).

I'm going to demonstrate my findings using Bed Bath and Beyond, and doing so, I hope to evaluate whether BBBY has any type of moat, and/or future runway to reinvest (source = company 10k's)

Some overall observations:

I have split the periods evaluated into three distinct phases, as follows
  1. Hypergrowth: Growth from 34 stores to 396 stores between 92 and 2002. Hypergrowth was accompanied by > 100% reinvestment rates (as an aside, reinvestment rate = incremental capital invested / cumulative earnings over period). This was a function of expansion, as the company took on off balance sheet commitments (new store leases). Capitalizing the future commitments, you get a sense of the extent of growth. BBBY needed to commit to new leases as they expanded aggressively, and reinvested more than their cumulative net earnings in terms of future lease commitments. ROIC is around 9%, but value compounding return is 24% as the company grows.
  2. Steady Growth: Growth from 108 stores to 888 stores between 1997 and 2007. The steady growth phase was still accompanied by > 100% reinvestment rates, but the reinvestment was falling relative to the hypergrowth period as rate of new store growth decreased. I've highlighted the rate of decrease commencing in 2001. ROIC is around 14%, but value compounding return has dropped to 17% as company growth slows.
  3. Mature to no Growth: Growth from 888 stores to 1530 stores between 2007 and 2016. Here, the reinvestment rate has fallen to 27.5% vs. > 100% in the previous comparative periods. ROIC has dropped to around 9%, and value compounding return has dropped to 2.5% as the company matures
I think the clues here as to whether or not BBBY has any sort of moat (and accompanying opportunities for reinvestment) is a) the use of capital over the last decade, and b) the consistently low ROIC. In the context of John Huber's framework, management are sending a clear signal that there is a real dearth of reinvestment opportunities because they choosing not to redeploy capital into expansion any more. Instead, they are engaging in massive share buybacks.

Concluding Thoughts

Arguably, there is no legacy moat (and certainly no reinvestment moat) as the returns on capital are slowly eroding and there's nothing to prevent price competition from eroding margins going forward. It's doubtful there's a long runway of growth here. Back in 1992 however, a shrewd investor might have picked up on the growth potential of the big box housewares concept at the time the company only had 30 stores. At +1500 stores, and slowing rates of growth in terms new store openings, the likelihood of +3000 in a decade seems a stretch.

The counter argument is that the runway lies in either global / international expansion outside of the US as BBBY is predominantly US based, but this would be a huge about face from the company's established market.

Now I understand why BBBY is cheap.

Monday, 22 August 2016

Bed Bath and Beyond, Serious Underperformance, Why? Part 1

This will be a short initial post as I'm up north over the weekend and not near a computer.

Bed Bath and Beyond is intriguing for one simple reason, and that reason is, it appears cheap across a variety of conventionally accepted metrics, P/E, EV/EBITDA, P/S, P/FCF, etc. All metrics appear to be pointing in the same direction. Additionally, BBBY, scores highly on my pseudo Greenblatt screener, and has consistently scored highly in Greenblatt's own magicformulainvesting d-base.

So, when all valuation metrics point the same way and a stock seriously underperforms over a long enough time period to confound anyone relying on relative cheapness as an investment thesis, I wonder what's wrong. Maybe, just maybe, there's something more going on beneath the surface to allow the conditions of relative cheapness and relative underperfomance to perpetuate.

I suppose the contrarian view here is that BBBY should (in theory) close any relative valuation gap at some point, considering the furious rallies shares in other companies (deeply cyclical, and more recently, other retailers, etc.) demonstrating nowhere near BBBY's earnings power have enjoyed during 2016, while BBBY has basically done nothing.

I leave this initial post with a comparative performance chart of BBBY from the company's 2015 10k, illustrating the extent of underperformance over the last 5 years. The question I have is, what is the company going to do in order to invoke enough investor confidence to close this relative underperformance gap?

Tuesday, 16 August 2016

Follow up Comments on Canadian Shareowner Ranking Screener, and Gilead at Top Spot

I spent a good chunk of time over the weekend thinking about possible shortcomings in my Shareowner screener (which I'm certain are plentiful). I noted that Gilead was ranked #1 in May and August according to my pseudo Greenblatt ranking system, and I made a general comment, as follows:
  • The entire ranked universe really is a relative point in time snapshot vs. the comparable stocks in the universe, and should be viewed as a starting point for additional research. For example, as at August 11th, 2016, Gilead had the highest ranking relative to every other stock in the Shareowner universe. The ranking tells us a set of facts, but does not tell us why this set of facts exists at this point in time. The job of the investor is to determine why Gilead is relatively cheap comparably. Sometimes, top ranked stocks are cheap for a reason.
With this said, I wanted to look further into the Gilead story as there seems to be no shortage of proponents for buying the stock based on apparent cheapness relative to other large cap companies in the S&P500, and especially based on relative cheapness vs. other large cap biotech or pharmaceutical companies.

While I personally don't like using P/E, it is a widely accepted conventional measure of current market based valuation on the fly. My problem with P/E is that it's a point in time estimate only, and in my humble opinion, investors can end up deluding themselves by solely relying on P/E without going beyond why a P/E is relatively low (or high).

I am by no means an expert on the biotech or pharmaceutical space, but my layperson's opinion on attempting to make relative comparisons within the space/s based only on P/E is to first understand the cyclical nature of the drug life cycle. There's a great article I read over the weekend illustrating the drug life cycle, link here, source, Awesome Capital.

If one were to use the above table of statistical probabilities through phase transitions and concurrent changes in valuation in order to broadly visualize how a sample company's P/E would look during each phase, I would suggest the following (I've added my own "later phase" italicized bullet points at the end):

  • Pre-clinical to Phase 1, little to no earnings, high R&D, extremely high to undefined P/E
  • Phase 1 to Phase 2, little to no earnings, high R&D, extremely high to undefined P/E
  • Phase 2 to Phase 3, little to no earnings, high R&D, extremely high to undefined P/E
  • Phase 3 to NDA/BLA, little to no earnings, lower R&D, extremely high to undefined P/E
  • NDA/BLA to Market Approval, initial earnings, lower R&D, high P/E
  • Introduction of product to market, generating incremental cash flows, substantial earnings, low R&D, falling P/E
  • Maturation through patent expiry, product continues to generate incremental cash flows, declining earnings, rising R&D, stabilizing P/E
  • Patent expiry, generic competition, falling cash flows, declining earnings, rising R&D, rising to high P/E
The article also outlines the connection between big pharma and biotech, as follows, which I found fascinating, a strategy which Gilead, interestingly enough, pursued to a tee (see excerpt below)

So here was Gilead back in 2011, purchasing a late phase HepC pipeline by way of an $11B deal, which, at the time, represented almost 1/3 of Gilead's market cap.

Returning to the apparent mystery of Gilead's relatively low P/E, my thoughts are as follows:
  • The market doesn't just arbitrarily assign a low P/E without reason, especially only two years removed from two blockbuster drugs being introduced to market. The fact that the P/E appears relatively low should be a signal that the market is telling us something about the expectations investors have pertaining to the company going forward
  • The patent protection on both Sovaldi and Harvoni, which accounted for close to 60% of F' 2015 revenue runs through 2029 and 2030 respectively, so there's a 15/16 year runway for incremental cash flows before patent expiry. A low P/E could be symptomatic of market concern over peak cash flows shortly after drug introduction due to pent up demand for initial treatment (or other possible reasons I'll outline below)
  • Peer group large cap biotech/pharmaceutical P/E's measured using Amgen, 17x, Biogen 18x, Abbvie 19x, Roche, 24x, and Novo Nordisk, 22x, average 20x. Applying a similar peer group multiple to Gilead, valuation would either have to rise to $327B from current (i.e., $16B net x 20x), or earnings would have to fall to $5.25B ($5B x 20x = $105B current mkt cap). 
  • The key point here is understanding the case for why earnings may more likely fall vs. a threefold rise in valuation as the overall justification for Gilead's below peer group P/E
Why doesn't the market believe the story?

I found the following articles, courtesy of the Chicago Tribune and Bloomberg, outlining the rationale supporting doubts over future growth.

First up, the Chicago Tribune, link here, summarizing background, current political backlash, and competitive threats to the Sovaldi and Harvoni story.

A few excerpts from the article follow:

In a nutshell (funny I just wrote that because I'm actually eating roasted peanuts as I'm writing this), there has been the equivalent of a political upheaval in response to Gilead's pricing strategy surrounding the introduction of both Sovaldi and later Harvoni. One only need peruse the 2015 10K in order to develop an understanding of how far reaching the consequences might be:

Next up, Bloomberg on competition from Merck, link here, and a few excerpts from this article, which I found fascinating, copyright Bloomberg:

The key takeaway I got from this Bloomberg article is that the case for Sovaldi and Harvoni peak sales seems plausible, even with Zepatier and Viekira each remaining at under $2B in sales through 2020, while Gilead's recently reported year to year variances in Q2 2016 Sovaldi and Harvoni sales seems to suggest the same.

Michael Price on Valuing Pharmaceuticals

How can I attempt to write a piece on attempting to intelligently address the mystery of Gilead's relatively low P/E without referencing Michael Price, who had the following to say about valuing pharmaceutical companies, courtesy of Greg, link here:

So here's my attempt at a Michael Price type valuation on Gilead. Assumptions as follows:

  • 5% decline in Harvoni and Sovaldi revenue between 2016 and patent expiry, no price cuts
  • All drugs facing patent expiry drop to 20% of previous year's revenues in the year after expiry
  • Assume 50% net margins
  • Perpetual cash flows subsequent to 2030 are discounted at 8% 
  • Discount cash flows by year at 12%, compare to current market cap
Results as follows:

  • Cash flows don't take future pipeline &/or drugs under development into account, they only consider current pipeline
  • Cash flows model Harvoni and Sovaldi out to 2030 at linearly declining rates (5% per year). Reality may prove much different, if Gilead bows to pressure and reduces prices with no accompanying increases in patient uptakes. 
  • The market is finite. According to the WHO there are approximately 3-5M US patients with Hepc. At close to 200K treatments sold per year (Harvoni + Sovaldi combined), and no competition from other drugs, courtesy of Merck &/or Abbvie, the US patient population would be close to treated by 3030 (or at least the %ge of the population who can afford the treatment).
  • Is a 50% net margin over time realistic? In years where R&D spend climbs, margins will be lower
  • On the subject of why I used a 12% discount rate, the answer is two-fold, 1) there is uncertainty over what form future sales growth will take impacted by price sustainability, future patient uptake, or competition, & 2) I believe that during R&D heavy years, net margins will be lower, therefore I upped the discount rate
Based on the above, current capitalization at $105M exceeds the sum of my estimated DCF's by around $13B, or just over 14%, and based on Michael Price's comments above, he seemed to only be interested in buying when his DCF's up to patent expiry exceeded current valuation (i.e., he had a margin of safety): in this case, he was buying at a discount and getting the pipeline for free. 

I don't believe this is the case with Gilead currently, and certainly, this is an interesting and counter-intuitive result, because it suggests that Gilead is currently overvalued with a P/E of less than 7x ttm earnings.

Update, Aug 16th, figured I'd add a monthly chart for perspective. The chartist in me asks whether this setup is symptomatic of a base being formed (the answer is no):

Monday, 15 August 2016

Disney Monthly Chart

I keep an ongoing watchlist of monthly charts as I find that monthlies "sometimes" offer a forest from the trees look in terms of evaluating long-term trends.

Here's my current annotated Disney monthly chart.

This set up is interesting to me for a number of reasons:

  • Triangles (or pennants), often mark a period of consolidation. I believe Disney is currently at the tail end of a 2+ year triangle or pennant. The ensuing resolution should move at least the distance within the triangle (or pennant), so in Disney's case, +20/-20
  • Conventional charting wisdom suggests that any resolution of a triangle (or pennant) should move in the direction of the primary trend (i.e., up). I'm not sure I believe this is the case. Conventional wisdom is often anything but. I believe price will resolve whichever way it damn-well wants to. The job of the speculator is to be flexible enough to recognize this.
  • A clean resolution down may not actually produce a -20 point move down as there seems to be a secondary pattern in the form of a falling wedge. A clean resolution up by way of a monthly close < $100 seems less inhibited, and an obvious target would be a move to $120 to retest the old all time highs. I have no idea which type of resolution is more or less likely. 
Here's how I played this:

I bought to open:

1 Jan 17, $105/$110 call spread, net debit, $.90

1 Jan 17, $87.50/$82.50 put spread, net debit, $.67

My thoughts are as follows:
  • If Disney resolves up, the target is $120. My spread (at expiry) should be worth $5 against a debit of $1.57
  • If Disney resolves down, the target is $80. My spread (at expiry) should be worth $5 against a debit of $1.57
  • My risk is no resolution, or a sharp resolution down or up and then subsequent flattening by expiry below $105 and above $87.50 (i.e., Disney goes nowhere by expiry). In this case, I lose $157.

Friday, 12 August 2016

Canadian Shareowner Investments Stock Universe (Pseudo Greenblatt Ranking)

I'm going to imbed the work on the Shareowner "pseudo" Greenblatt rankings I've been doing as a googlesheets link on the blog. I hope that by sharing my research, people can get an idea as to the highest and lowest ranked stocks. I say "pseudo" Greenblatt because I've sort of tailored my ongoing research based on what I feel are important categories to me, which are 1) margin of safety at an 8% cap rate, calculated as FCFF / 8%, 2) pretax cap rate = EBIT/EV, 3) ROIC (not Greeblatt's ROC). I've split the worksheet into two tabs, financial and non-financial. I'm most interested in the non-financial tab, and I've only linked to this tab on the blog.

Strong caveats:

  • These are preliminary rankings based on rolling raw ttm data. 
  • I will only update the rankings once a quarter. I could drive myself crazy and update the rankings more often, but I don't see how this could help my decision making process
  • I will update the data (EBIT, FCFF, ROIC) once a year. I was thinking of even revisiting the models at the end of this year and using average data (EBIT, FCFF, ROIC) over the last 5 years instead of ttm, this way I'm more conservative. I haven't made my mind up yet on this
  • The entire ranked universe really is a relative point in time snapshot vs. the comparable stocks in the universe, and should be viewed as a starting point for additional research. For example, as at August 11th, 2016, Gilead had the highest ranking relative to every other stock in the Shareowner universe. The ranking tells us a set of facts, but does not tell us why this set of facts exists at this point in time. The job of the investor is to determine why Gilead is relatively cheap comparably. Sometimes, top ranked stocks are cheap for a reason.
  • The data is historically geared and does not forecast future growth or future cash flows at all. For example, if a company makes a significant acquisition which is going to result in immediately accretive cash flows, my historical methodology of determining FCFF does not reflect this
  • If a stock has a high ranking in my database, it does not automatically mean that the stock is cheap. It means that it is cheaper relative to other more expensive stocks in the the Shareowner universe, which is predominantly comprised of large, blue-chip, dividend paying stocks. If the overall universe of large, blue-chip, dividend paying stocks as measured by the S&P500 is not cheap, I may be looking at a non-representative sample in conducting my analysis, when I should really compare rankings across the entire universe of stocks, not just the S&P500.
Here are the top 20 ranked stocks as at August 11, 2016 based on my methodology:

And here are the top 20 ranked stocks as at May 4, 2016:

It's interesting to compare the changes in the rankings between periods. Gilead held top spot at the end of both periods, and based on backward looking data, is cheaper now relative to all other stocks in the Shareowner universe. It also doesn't surprise me that there is a proliferation of retail names in the top 10, Buckle, Gap, Bed Bath & Beyond, specifically. Apple always seems to round out the top 10, as does Cisco. Certainly a good starting point for further research.

Monday, 8 August 2016

Revisiting my Greenblatt Experiment One Year Later, and a New Experiment with Real Money

Ok, I'm about a month early, but I thought I'd chime in how the overall magic formula dart throwing exercise unfolded.

Last year on September 25, I selected 20 hypothetical darts using the magic formula system straight off of the site.

The ideas are straight out of Greenblatt's book, The Little Book that Still Beats the Market.

Here are the results through August 8, 2016:

So how did the darts do?

With just over a month left, the portfolio has returned 9.3% before dividends, and 11% including dividends. Annualizing, I get 12%.  Over the same period the S&P 500 as measured by SPY has returned 14.86% in USD's (Sep 25 through current) before dividends, with nominal year/year change in USD/CAD (surprisingly enough).  Including dividends, SPY has returned closer to 17%.

So, just by buying and holding SPY, an investor would have improved on the magic formula darts by about 500 bps. There's still a month to go, but I don't see the above darts improving on SPY comparatively in this short a time period.

So what went wrong?

Firstly, the magic formula darts had too much concentration in retail/apparel. Buckle, Cherokee, and Gamestop, represented 15% of the total dart portfolio. Were I to construct an actual portfolio, I'd probably limit retail/apparel exposure to a much lower weighting (likely zero).

Secondly, the magic formula darts had too much concentration in biotech.  Enanta, Gilead, and Lannett, represented another 15% of the total dart portfolio.  Again, were I to construct an actual portfolio, I'd probably limit biotech exposure to one position instead of three.

Winners included:

Higher One - Acquired by  Blackboard
Argan and Flour Corp (both engineering and construction companies)
CA Inc.
HPE (spinning off enterprise unit and merging it with Computer Sciences)
Liberator Medical  - Acquired by CR Bard
Liquidity Services

Overall, I believe that the construction of a magic formula investing geared portfolio has to consist of more than just arbitrary dart throwing.  I believe that consideration has to be given to overlapping exposure to companies in the same or similar lines of business or sectors, as it's not enough for a company to just be good and cheap.

The New Experiment

This time around, I've started a new experiment with actual money, but I've chopped the overall value of the portfolio in half.  I'm using $10K.  My rules are as follows:

  • The portfolio is to be equally weighted in 20 separate positions using a combination of Greenblatt's magic formula methodology and supplemented by the occasional special situation (blue chip on sale based on my research, merger/arbitrage candidate, spin-off, etc.)
  • Each position cannot initially exceed $500 in total capital at risk
  • Each position must be held for 1 year.  After 1 year, the entire portfolio will be reevaluated in terms of good and cheap. If a position has become cheaper vs. the prior year, and there has been no deterioration in the fundamentals or the outlook/prospects, the position will be maintained, otherwise it will be sold.  Similarly, if a position has done really well and it appears expensive based on fundamentals or the outlook/prospects, the position will be sold, otherwise it will be maintained.
  • The worst positions with deteriorating fundamentals and the best performing positions with deteriorating fundamentals will have to be turned over in order to free up capital for new additions to the portfolio.

The current portfolio is as follows (I'm also adding a new tab to the top of the blog with these holdings).

A brief synopsis of each position below:

Commerce Hub - Spun off recently, I believe the company has a potential reinvestment moat in terms of facilitating drop ship fulfillment for ecommerce

AMC Networks - One of the top good and cheap stocks on the magic formula ranking, and for good reason.  The market is worried about how AMC can generate future cash flows once The Walking Dead fizzles out

Franklin Resources - Asset management, Fidelity, pressure on fees, almost 1/3 of the capitalization is cash, tightly controlled float

H&R Block - I believe it's undervalued and another of the top good and cheap stocks on the magic formula ranking

MSG Networks - Another recent spin off, has performed poorly since the spin off. I believe the company's networks are valuable (MSG sports etc.), and another of the top good and cheap stocks on the magic formula ranking

Neustar - Lost a contract to maintain its position as the main number portability incumbent provider. Has since sued the FCC. Another of the top good and cheap stocks on the magic formula ranking

Oaktree Capital - Howard Marks, need I say more?

Boston Beer - I believe the company could get bought out.

Teradata - Has fallen by the wayside in the data analytics and storage space and is trying to reinvent itself. Another of the top good and cheap stocks on the magic formula ranking.

United Therapeutics - Another of the top good and cheap stocks on the magic formula ranking, and at $4.4B, a possible acquisition target in the biotech space

Depomed - In receipt of recent letters from Starboard Value looking to shake up the board. 

Cogeco - Ontario / Quebec cable provider, I believe they could be bought.

CI Financial - Small position, I'm probably early and would prefer buying closer to $20.

Bristol Myers - Is down close to 20% on news of a late stage trial failure for the company's lung cancer drug, Opdivo. 

I'm up to 14 positions, so I'm looking to add another six positions between now and the end of the year in order to round out the portfolio.

CI Financial (Paradox) Part 2

Continuing from my initial observations on CI Financial...

Rather than present a detailed hypothetical analysis of why I think the shares may (or may not) be cheap presently, I thought I'd discuss CI in the context of a) a very interesting series of articles I read over at Base Hit Investing recently concerning ROIC (Return on Invested Capital), Legacy Moats and Reinvestment Moats, and b) an equally interesting article from the globe and mail (originally published in ROB magazine) outlining the challenges facing CI coming into 2015 (and beyond).

The original BHI article is here, and the original globe and mail / ROB article is here. Both are fantastic reads for anyone interested.

BHI, ROIC, Legacy, and Reinvestment Moats

Basically, the concepts articulated are as follows:
  • A business which exhibits a durable competitive advantage enables that business to earn high returns on invested capital.  This in turn leads to creation of value over time. 
  • According to the author, a very small group of companies have sustainable durable competitive advantages.
  • There are two types of moats: Legacy and Reinvestment. Well established companies exhibiting legacy moats typically result from past investment. Quoting the author directly, "because there are no reinvestment opportunities offering those same high returns, whatever cash the business generates needs to be deployed elsewhere or shipped back to the owners"
  • Reinvestment moats are rare, and result from a superior business' ability to reinvest incremental cash flows at high reinvestment rates, protected by a long runway of growth in terms of time
I think the key takeaway here relates to the investor's ability to first identify companies which exhibit characteristics reflective of durable (and hopefully sustainable) competitive advantage. Once identified, an investor should consider whether the candidate companies exhibit characteristics encompassing a Legacy vs. a Reinvestment Moat.  

The problem I personally have with this conceptual framework above is that typically, most participants (professional or otherwise) are looking for the same thing! Most investors are looking to buy those companies which exemplify durable sustainable competitive advantage combined with either a legacy or reinvestment moat, and they are looking to buy these types of companies before anyone else does.

Guess what happens when a ton of participants sharing the same or similar information, analysis, and beliefs about a company all converge on the same idea? Valuations rise, and often (if not always), valuations rise to a point where it no longer makes sense to buy the shares as the probability for incremental returns (theoretically) diminishes the more stretched a company's valuation gets.

While valuations can remain stretched for a long time, in my opinion, chasing stretched valuations predicated on market group-think surrounding companies perceived to have durable/sustainable competitive advantages and legacy or reinvestment moats is a recipe for invitation of risk (whether such risk is systematic or unsystematic is another argument altogether). The counter argument here is that an investor can overpay for a business capable of earning high returns on invested capital and still be ok over a long enough time period as the effects of compounding offset the initial overpayment.

A logical subset of the first takeaway is a second key takeaway (especially relating to the small do it your-self investor), which is to recognize the existence and impact of the first takeaway on the financial universe.

I'll attempt to articulate the second key takeaway as follows: As a small investor, understanding the impact that highly mobile and transitory capital has on the valuation of companies exhibiting strong return characteristics is an essential step in developing an investment thesis supporting consideration of a subject company's shares for purchase. In my opinion, an investor should not simply ignore valuation just because a company is collectively perceived to a have durable/sustainable competitive advantage and a legacy or reinvestment moat. In a nutshell, a small investor should a) understand the dynamics of the arena in which he/she has chosen to participate (or more aptly, play) and b) be able to pick his/her spots when eventually participating.

I believe that the super investors I've been reading about limit their participation to identifying situations where companies previously perceived as having durable, sustainable competitive advantage have fallen from grace in order to take advantage of the ensuing valuation compression/erosion in response to this change in perception.

In the same way that market group-think pushes valuations up during periods where companies are believed to exhibit characteristics of impenetrable moats coupled with sustainable competitive advantage, the same forces work to compress valuations when the opposite perception perpetuates.

These super investors are able to pick their spots when eventually participating, and support this participation with an ability to find holes in current perception surrounding fallen company fortunes. I believe that this approach is one subset of value investing (Mike Burry best articulated this approach as buying road-kill, and selling when the story gets polished up a bit).


How does any of the above relate to CI?

I'm going to reproduce a few extracts from the original globe and mail piece, copyright globe and mail (circa August 2014).  Before I do, a bit of background and a monthly chart to show some perspective.

Now the third largest remaining independent asset manager in Canada as measured by AUM, CI has a storied past, growing AUM at a 20% CAGR since it's IPO (from close to $4B in 1994 to close to $110B currently).

In 2002, CI and Sun Life made a deal whereby CI sold Sun Life a 37% stake in the company in exchange for Sun Life's Spectrum Investments and its Clarica Diversico asset management arm. During the 2008/2009 financial crisis, Sun Life sold it's stake to Scotiabank for $2.3B. The relationship ended in June 2014 when Scotiabank monetized most of it's stake in CI for close to $2.6B. It's my understanding that Scotiabank still holds about an 8% stake.  The ROB article describes the evolution of the relationship between CI and Scotiabank between 2009 and 2014, which at times, was tenuous.

Here's the monthly chart including reference points to the buy/sell blocks at different times.  I've also drawn in a couple of possible long term trendlines which make sense to me as possible areas of support.  Notice how significant $20 is at different times historically over the last 20 years.

On the subject of moat, quoting the former CEO directly from the ROB article:

"Institutional investors always ask us, 'What's the moat around your company to protect it from other forces?'" says MacPhail, 57. "And here's what I show them". He produces an investor presentation he's been giving recently and points to one slide that he's particularly proud of. It shows that in 2013, CI held two major conferences, 1,167 training sessions and roadshows, and 15,581 one-on-ones, branch meetings and conference calls-all of them with advisers. "If you figure there's 300 working days in a year-well, you do the math," MacPhail says. "So if you want to know the one competitive advantage about CI, it's our ability to do that."

The ROB article continues to develop the background supporting what sounds like a discernible competitive advantage by virtue of the following characteristics:
  • Strong (and hopefully enduring) relationships with CI's network of advisers
  • Cost control 
  • CI's ability to attract and retain top tier asset managers
The above characteristics may well work to preserve any in-place competitive advantage over time, however, no analysis is complete without examining potential risks surrounding erosion of the aforementioned competitive advantage.

Widely known risks facing CI appear to be as follows:
  • Migration of CI's AUM base towards lower cost alternatives, like ETF's. I believe CI attempted to address this risk by purchasing First Asset Capital in 2015, but First Asset's AUM pale in comparison to CI's overall AUM ($3B vs. $110B).
  • Continued competition from vertically integrated established bank networks, whereby banks can distribute in house funds to existing banking clients
  • Pressure on MER's resulting from any future investor pushback in response to CRM2
In the context of the BHI investing articles on ROIC, I offer a suggestion that while CI appears to have high ROIC likely due to an in place Legacy Moat, the company may now be facing potential erosion (or perception of erosion) of this Legacy Moat due to the confluence of risk factors listed above.  I would further offer a technical suggestion contributing to current share price weakness, and that is a work off of an almost $3B block of shares sold in 2014 almost 20% higher than current. $3B : $7 market cap works out to close to 40% of the traded float.  When close to 40% of the float is absorbed at 20% higher than current, 40% of the participants on the other end of the bought deal in 2014 are now underwater.

I suggest a Legacy Moat as opposed to a Reinvestment Moat based on my understanding of the economics and characteristics of the asset management industry in Canada, which in 2015, was estimated at close to $2.78T in terms of investable assets under management (courtesy of TD Asset Management 2015 Top 40 Money Managers Report, link here), and CI's foothold in the industry.

Out of this total, mutual fund assets under management were estimated at $811B, so CI has about an 18% share of total mutual fund assets. My guess is that most of CI's growth in AUM occurred based on CI being a prime mover in the past, as evidenced by CAGR in AUM's at close to 20% since CI went public in 1994. Arguably, the larger CI has become, the harder it is to grow AUM's at anywhere close to 20% per annum. My analysis shows that AUM's have grown at a 6% CAGR since 2006 (see below), so the days of 20% growth are long gone (but, this is not to say that CI can't make strategic acquisitions to supplement growth in AUM going forward).

Concomitant to an evaluation of existence of moat is consideration of pricing power, and in order to address this, one only need examine the trend in CI's ability to maintain top line management fees as a % of AUM (and to a lesser extent, advisory fees as a % of AUA). The results are as follows:

My analysis demonstrates that while AUM's and AUA have grown to about $149B as at June 30, 2016 (about a 5% CAGR over the last 10 years), this growth has not been accompanied by a corresponding expansion in average management or advisory fees. On the contrary, management fees are lower by almost 30 BPS since 2006, and advisory fees by 15 BPS.  At the same time, while SG&A as a % of total revenues has decreased (19.54% for the ttm period ended 06/30/16 vs. 21.79% in the year ended 12/31/06) the average proportion of trailer fees to management fees appears to have increased (30.74% for the ttm period ended 06/30/16 vs. 27.20% in the year ended 12/31/06).

As a side note, my initial observation under (Paradox) Part 1 regarding CI being able to reduce trailer fees commensurate with pressure on top line management fees appears incorrect.  If part of CI's moat is a function of adviser relationships, I'm not sure how much room CI will have in terms of potentially reducing trailer fees without compromising relationships.  This really only leaves scale of AUM and cost control as the two remaining characteristics of CI's Legacy Moat. On the subject of AUM, in order to increase scale, CI would likely need to acquire AUM in order to make significant progress beyond current.

These figures are supported by management's slides in their Q2 2016 presentation, as follows:

And finally, my analysis of ROE and ROIC as per below:

So, here we have situation where CI is clearly exhibiting signs of slower growth in AUM's and AUA's, combined with management and advisory fee pressure, and yet ROE and ROIC remain persistently high. To me, this is further indication of the existence of a Legacy Moat in the framework of the BHI article, i.e., the company demonstrates high returns on invested capital as a result of past investment. One need only examine the latest MD&A in order to confirm the reinvestment rate on incremental cash flows, it's zero as almost all free cash is returned to shareholders in the form of either dividends or buybacks, per below:

This lack of reinvestment and return of 100% of free cash flow to shareholders fits right into the BHI author's framework in suggesting that, "because there are no reinvestment opportunities offering those same high returns, whatever cash the business generates needs to be deployed elsewhere or shipped back to the owners".

Concluding Thoughts

Most of the above is observational on my part. I am interested in buying the shares, but I'd like to be able to buy the shares closer to $20, as supported by my free cash flow valuation work below:

The BHI author uses an interesting example describing the power of compounding on future returns in comparing a reinvestment moat company to an undervalued, non-reinvestment moat company with limited potential for future growth.  See below:

The illustration shows that reinvestment moat co., which is able to reinvest and compound 100% of its earnings at 25% should have a theoretical value 7x that of the initial investment in year 0, while non-reinvestment moat co, with limited potential for growth and returning 50% of it's free cash to shareholders, should have a theoretical value 3x  that of the initial investment in year 0, and less than 1/2 that of reinvestment moat co.

I believe that CI is more characteristic of undervalued co., but at the right price, it's an interesting candidate for addition to my accounts.