Sunday, 25 December 2016

Thoughts on the week ending Dec 23, Trump Market Moving Tweets, Globe and Mail 2016 Dogs (and by association Coca Cola Femsa, and Trip Advisor)

A few quick thoughts on the week ended Dec 23, 2016 and on Mainstream Financial Media (take your pick, BNN, CNBC, etc.).

For the most part, BNN, CNBC, etc., usually aren't a source of anything newsworthy. I say usually, because on the odd occasion, these networks will have great guests on with compelling viewpoints, but I'd peg these occasions as infrequent, especially in Canada where we get to enjoy BNN, rife with regurgitated news, entire broadcasts devoted to marijuana grow-ops posing as going concerns, and "unbiased experts" pitching their books in the guise of top picks nightly (in their defense, if they didn't pitch their books to BNN viewers, they'd have nobody to unload positions onto).

My daily BNN/CNBC routine is as follows:

I check in at 7 AM to see if I've missed any headlines from the previous evening and then I switch off and watch the sportscentre highlights which are far more interesting. I also watch market call while working out in the evenings in order to draw inspiration for fighting through my workouts. I find that market call provides great fuel for pushing out extra reps, especially when the discussions are exceptionally stupid.

This week, CNBC was falling over itself on two themes. 1) Dow 20,000, and 2) Trump's Tweets.

First off, Dow 20,000

I'm probably not the first participant to state that Dow 20,000 is irrelevant, and I won't be the last. But to me, the Dow is entirely irrelevant. Why? Well, firstly, the Dow is one of the financial world's most closely watched barometers, and because of this, I find the barometer itself irrelevant. By virtue of everyone focusing on the Dow, I choose not to. Secondly, 20,000 means nothing. It's a price level derivation based on the price weightings of the underlying constituent companies. Here's the calculation courtesy of wikipedia:


So here we have an index construct moving higher (or lower) based entirely on price weightings of the constituent companies. For reference, here are the top price weighted companies in the Dow as of Friday Dec 23rd, courtesy of

Based on the above, it's not difficult to understand why the Dow has rallied 11% since Trump won the election on Nov 9. Goldman Sachs alone has rallied close to 40% in less than a month!

Being the cynical participant that I am, I've started to wonder about the fundamental underpinnings driving this move. What has changed so drastically as to support a 40% move in Goldman Sachs? The answer is something along the lines of: everything and nothing at the same time.

From my readings thus far, the move has been in anticipation of relaxation of financial regulatory and accompanying constraints and the potential repeal of the Frank-Dodd Act as a result of Trump's ascension to office. So, devoting an entire broadcast week (or month, or quarter) fixating on whether GS will rally another 10%-20% in order to move the Dow another 100 points is idiotic to say the least. I'd hazard a guess that GS is more likely to give up some portion of the 40% move in the next year vs. continuing up ad infinitum, and any pressure on GS will translate into pressure on JPM (and other financials) as well. These two constituents represented around an 11% weighting in the Dow as of Friday's close, so if Dow 20,000 indeed happens, it will happen when no one is watching (or cheering for it).

This brings me to my next point on Trumps Tweets

In my opinion, we are faced with an increasingly risky investing environment going into 2017. While the markets have vaulted to all time highs, the vault seems to have been built on anticipation of policy change due to a changing of the guard in the oval office. And the scary thing here is, this has become pervasively accepted investment rhetoric as participants seem to now all agree that Trump = good. When everyone seems to be lined up on the same side of the ledger, well, only good things can happen, right? My guess is that as 2017 unfolds, maybe, just maybe, some discernible level of doubt will rear its ugly hide and work to unwind some (or all) of the initial jump in optimism based on, well nothing (yet). I'm going to draw from Seth Klarman's 2015 annual Baupost letter as Mr. Klarman gives voice to short term exuberance much better than I can:

"Value investors must be strong and resilient, as well as independent-minded and sometimes contrary. You don’t become a value investor for the group hugs. Indeed, one can go long stretches of time with no positive reinforcement whatsoever. Unlike some other fields of endeavor, in investing you can do the same thing as yesterday but achieve completely different reported results. In the long run, the research and analysis you perform should overcome market forces; the fundamentals ultimately matter. But in the short run, markets can trump effort and insight. They move in unpredictable cycles, with investors stampeding this way and that. Businesses quickly come in and out of favor, and the same business can be valued by the market very differently in a matter of days, sometimes on the basis of new facts, but often because of mercurial investor perceptions or simply money flows"

This week, Trump tweeted about Lockheed Martin's F-35 fighter being too expensive which, according to the MSFM, "roiled" LMT. The stock was down close to 3% in the premarket and CNBC had a piece on questioning whether this was a buyable dip.

Well, here's LMT monthly as of Friday's close. Is it time to buy the dip yet?

In my opinion, the fact that the most influential politician on the planet resorts to tweeting is ridiculous, and my prediction for 2017 is that Trump will continue tweeting, and will rattle markets horrendously at some point during 2017 by being a moron on twitter. Maybe a Trump tweet will be stupid enough as to actually cause a real buyable dip (as opposed to a CNBC or BNN broadcasted buyable dip)!

Globe and Mail 2016 Dogs

Well, we got our 2016 dogs courtesy of the Globe and Mail this weekend. Included in the dogs are two very interesting ideas which the Globe (and by extension everyone else) seems to have written off, link here

First up Coca Cola Femsa (by extension from the Globe's write-up on the Mexican peso).

I'll start with a monthly chart and elaborate on the story behind it:

Why KOF? Well, firstly, the Globe profiled the Mexican peso as a casualty of Trump's ascension to office, and as the Mexican peso goes, so too, by logical extension, will the Mexican economy go, maybe. Funnily enough though, balance of trade has swung to a surplus in Mexico recently as a lower peso has resulted in higher exports to the US, go figure. Now, recently is way too short a time period to draw meaningful conclusions, and a repeal of or significant modification to NAFTA could materially impact future trade flows. There is huge uncertainty here, but the largest casualties of the threats thus far have been anything Mexican (from the peso to Mexican Bolsa constituent companies) dependent on continued unmodified free trade with the US. KOF is impacted by virtue of its exposure to purchases in US dollars. As the peso weakens, it gets more costly for KOF to purchase formula from Coca Cola under the terms of its existing bottler agreements. KOF has also taken on a significant amount of US dollar denominated debt in order to build additional bottling capacity over the last three years. I've plotted a correlation study between KOF and EWW over time, and we can see that KOF pretty closely tracks the performance of the Mexican stock market in general.

The story behind the last three years of abysmal performance in KOF is a function of the imposition of a soda tax in 2014, which hammered Coca Cola Femsa's sales. Prior to the imposition of the soda tax, KOF was firing on all cylinders. I have no idea why it rallied at a 51% CAGR clip between 2009 & 2013, but I'm going to guess that highly mobile capital flows looking to deploy capital into levered bets out of the 08/09 crisis chased KOF up to unsustainable levels predicated on higher estimated per capita consumption of soft drinks in Mexico (and the rest of Latin America), extrapolated forever (this type of logic couldn't possibly apply to capital chasing Goldman Sachs +40% now could it?).

The following infographic courtesy of Statista, link here, details growth in per capita consumption of soft drinks by country between 1991 and 2012 (just before the imposition of the soda tax):

Guess what! Mexico, Panama, and Argentina round out 3 of the top 5 countries on the list, they all ranked ahead of the US with the exception of Argentina, and all three of these countries are major stomping grounds for KOF. What looked like permanent strength in trend (price trend, not valuation trend) between 2010 and 2013 has given way to an economic reality adjustment over the ensuing three year period since the soda tax was introduced, and with reference to the company's most recent annual report, the soda tax had a material impact on the company in terms of volumes, especially in the initial years after introduction. And if a soda tax wasn't bad enough, now comes the depreciation in the peso vs. the USD! Talk about the consensus paying $160 per share back in 2013 and getting it entirely wrong!

Are we at the point of maximum pessimism yet? No idea, but I do note the following:
  • The universe of $160 per share cheerleaders through soda consumption rhetoric extrapolaters are all likely gone by now (good riddance)
  • The current investing paradigm surrounding Mexico is now bearish
  • There is huge uncertainty surrounding what changes to NAFTA Trump may make
In support of KOF, I performed my own attempt at analyzing the company and performed my own valuation, and I note the following:
  • Notwithstanding the +60% decline in the price of the stock since 2013, the company has a moat and a potential runway by way of future Latam soft drink consumption. While the imposition of a soda tax hit volumes in the first years after introduction, interestingly, consumption seems to have adjusted from the initial reaction, per WSJ, link here:

  • Despite the drop in sales, KOF seems to have been able to maintain operating margins at 15%. No easy task given the absolute % drop in sales since 2013, per below:

While sales are off -25% since the 2013 peak (just before the introduction of the soda tax), EBIT margins has remained constant at around 15%. Taking a closer look, gross margins have actually improved slightly vs. 2012/2013 (on a tttm basis), and have remained constant at around 53%-54%, so I take this to mean that even in the face of the soda tax, the company has maintained pricing power.

And the valuation metrics haven't been this low for some time (ignoring 2008 & 2012 as outliers):

For comparison's sake, here's Coke itself:

Caveat, this is a bit of an apples to oranges comparison because KOF is a bottler and KO sells the syrup, so very different business models with very different capital requirement constraints. Even so, whether KOF deserves a multiple 33% lower than KO on a ttm PE basis, 44% lower than KO on a ttm EV/EBIT basis, or 48% lower than KO on a ttm EV/EBITDA basis, is up to the individual investor to decide.

A more suitable comparison would be to compare KOF to other regional botllers, such as CCE (Coca Cola European Partners), reproduced below, courtesy of gurufocus:

While I don't know where KOF may bottom (somewhere between $63 and $0 in theory), on a free cash flow basis, I get the following matrix of potential valuations at different growth rates:

Arguably, if KOF got to $45 from here, and assuming 2.5% growth, we'd be looking at a very interesting situation, based on the following:


  • Soda tax doubles from here, further impairing sales
  • Peso continues to drop vs. the USD, impacting future margins
  • KOF can't renew it's license agreements with Coca Cola on favourable terms, impacting future margins
  • Material changes are made to NAFTA which could affect KOF's future purchase supply chain 

Finally Trip Advisor

Courtesy of the Globe and Mail, here's this week's write up on poor old TRIP, categorized as one of 2016's dogs:

Superficial write-up in my opinion, and my questions are as follows:
  • Was valuation really relatively high?
  • Why did marketing costs soar?
  • Why wasn't TRIP able to capture market share to competing alternatives?
  • Does TRIP have a moat?
Was valuation really relatively high?

Yes, and no. In order to answer this, I have to look at closest comparables. When I think of Trip Advisor, I think of online travel, and closest comparables might be Priceline, Expedia, and to a lesser extent, Travelzoo and C-Trip. But there are differences in the models between the comparables. Priceline & Expedia are OTA's (online travel agencies), and are customers of Trip Advisor. TRIP earns revenue from CPC's by virtue of referring (directing) traffic to OTA's and other direct customers (hotels).

Superficially, TRIP entered 2016 at some pretty lofty multiples relative to the above group. 34x EV/EBITDA and 47x EV/EBIT, based on 12/31/15 reported #'s.

This compares to 18x EV/EBITDA and 20x EV/EBIT for Priceline and 12x EV/EBITDA and 18x EV/EBIT for Expedia, based on 12/31/15 reported #'s.

So we know that valuation looked relatively, high, but the next question is why? Why were participants content to own TRIP at 34x EV/EBITDA and 47x EV/EBIT up to the end of 2015, and how have these multiples adjusted during 2016?

My first observation regarding 2015 is that included in operating expenses was a one time donation of TRIP shares to the Trip Advisor Charitable Foundation of $67M. Normalizing 2015 EBIT for this donation, I get EBIT of $300M. This puts 2015 adjusted EV/EBIT at 39x EV/EBIT vs. 47x as originally thought. Per review of the company's 2015 10K, the contribution was made in Q4 2015, so the ttm numbers also reflect the Q4 contribution.

Currently, TRIP can be had for 26x ttm EV/EBITDA and 46x EV/EBIT. While EV has dropped by close to 50% since the end of 2015, EBIT hasn't improved much if at all, so on a superficial basis, TRIP is still expensive despite a 50% drop in pps. EBIT dropped from $232M at the end of 2015 to $131M on a ttm basis, but adding back the $67M Q4 charitable contribution, normalized EBIT on a ttm basis should be closer to $198M, and normalized EV/EBIT should be closer to 31x. A little better than initially thought.

This leads into the next point:

Why did marketing costs soar and why wasn't TRIP able to capture market share to competing alternatives?

Superficially, marketing costs soared as a result (or consequence) of erosion in CPC's in the company's hotel user base. This makes sense on the surface, as average # of hotel users dropped and CPC per hotel user dropped, the company theoretically played defense in order to win back customers by virtue of ramping up marketing spend, logical right?

Well there's more. Prior to 2014, the company identified a couple of problems with its business model, which were 1) failure to monetize (convert) unique site visitors into clicks, and 2) leakage. Leakage was a direct consequence of 1), and as a result, the company began spending heavily on transitioning its old user interface model with mutiple pop ups redirecting visitors to non TRIP / OTA sites, to an Instant Booking ("IB") model which allows visitors to book hotel travel directly within TRIP's interface without leaving the site.

The IB roll out commenced in 2014 and according to management's most recent quarterly 10Q, is now complete, so any analysis of prospective results must look to what IB may bring as opposed to focusing on the transitional time period during between 2014 and now. Management clearly explains the risks surrounding IB integration in its 2015 10K, including IB not resulting in closing the monetization gap, and/or OTA partners not buying into the new IB model.

There is a fantastic article on the potential of IB over at seeking alpha recently, link here, which outlines the case for IB in great detail. The author demonstrates that over the last few years, revenue per hotel shopper and EBITDA margin per hotel shopper have declined from close to $.60 per hotel shopper in 2014 to $.45 and from 42.7% per hotel shopper in 2014 to 32.4% most recently. The author argues that these declines are due in part to lower conversion rates on IB vs. metasearch, and low initial commission rates offered to OTA's as an inducement to adopt IB. The author makes a convincing argument that the pressure on margins is likely temporary, and goes on to explain that over time, IB adoption and conversion could very well eclipse metasearch conversion on a CPC per hotel user basis, resulting in CPC per hotel user getting back to pre 2014 levels. The missing clues were commitments from large OTA's, and interestingly enough, Priceline and Expedia have now signed agreements with TRIP under the new IB model.

Hypothetically speaking, what would TRIP's valuation look like in 2017/2018 if IB adoption results in CPC per hotel user returning to $.56 per visitor? For argument's sake, I modelled using EBIT margins at 30% as opposed to using EBITDA, despite the company being capital light. EBIT margins reflect operating income after stock based comp, R&D / marketing spend (which should drop post IB rollout) and non cash charges which I'm going to assume will approximate actual spend on ongoing capx / intangible.  Here are the results:

Assuming $.56 per hotel user, x 1.6B (ttm) annual hotel visitors (source: Trip Advisor Q2 2016 supplemental financials, link here) works out to $879M in IB hotel revenue. I modelled display based and other hotel revenue using TTM 2016 numbers, and used ttm non-hotel revenue of $338M.  The real key here is whether EBIT margins per hotel user will revert back to pre-IB rollout. Assuming 30% EBIT margins works out to an overall $393M EBIT contribution from hotel (net of negative contribution from non-hotel for now). The key to this assumption is the gearing in converting top line revenue into EBIT. The company seems to be a capital light compounder, so assuming cessation of 2014-2016 spend on IB going forward, any uptick as a result of conversion should flow directly to the bottom line.

Based on the above scenario, I get a current P/E of 25x and EV/EBIT of 15x, a lot different than conventional superficial analysis would have us believe. But that's our job isn't it? Looking beyond superficial summary reporting and asking how/what/why/where! If it wasn't for widespread groupthink like that published in this week's Globe, investors wouldn't have any work to do! This leads to my last question:

Does TRIP have a moat?

I'd say yes, but with a caveat. Borrowing from John Huber's writings on ROIC, TRIP seems to have characteristics of a two sided network. It is an accepted central hub for community ratings globally, but the problem facing the company has been converting these unique community visits into money! Therein lies the $1M question, is TRIP currently in the throes of a gradual move towards obsolescence as evidenced by falling revenue and EBITDA per user, or will it reinvent itself by virtue of rolling out IB? Only time will tell.

My bet is that IB will work.

Friday, 16 December 2016

Market Linked Principal at Risk Notes or Cineplex Convertible Debentures?

I overheard a couple of colleagues at work discussing market linked products on Friday. The conversation was typical of retail logic in my opinion, which somehow escalated market linked GIC's into the realm of shiny happy goodness. I think they are anything but. Retail logic goes something like this: heads, I make the market return, tails I don't lose much. The problem with this line of thinking is that both outcomes depend on a multitude of factors all converging at the same time in order for an investor to achieve the optimal outcome, which in the best case is usually between a 3% or 4% CAGR (for GIC's), and maybe, a 6% to 7% CAGR for linked notes (principal at risk).

The factors are:

1) The type of product (notes or market linked GIC's, principal at risk or principal protected)
2) The payout formula (set by the payor, and adjusted by the payor for each new series, contingent on the payor's expertise )
3) The underlying basket (index, Cdn banks, etc.)
4) Where we are in the overall cycle

Using principal at risk notes for example, from my understanding, an investor can lose principal if the underlying basket declines and stays down through maturity. These are slightly different than straight market linked GIC's, but the concepts are similar, limited upside participation with the added feature of downside protection, but only up to a point.

Here's a concrete example offered by BMO, BMO Autocallable Principal at Risk Notes, Series 27 (I can't believe they've had 26 previous series of these things!), link here

Here are a few excerpts from the prospectus supplement illustrating the payoff matrix (did I mention that these notes are auto-callable, meaning that BMO has the right to call the notes early on each valuation date if the index is > the reference return?)

BMO then explains four payoff scenarios with illustrations. I'm going to reproduce the scenarios illustratively and then provide payoff matrices for all four scenarios based on the prospectus supplement:

And here are the payoff matrices in excel demonstrating CAGR under all four scenarios, plus an added feature demonstrating average return and standard deviation of returns comparing the note scenarios to the index scenarios:

A few observations on this analysis:
  • In scenarios 1 and 2, BMO calls the notes early once the index level exceeds the auto-call level. There is no participation beyond the auto-call date (obviously), but the index investor gets to participate in additional upside and continues to collect a dividend stream beyond the auto-call dates (he/she is not prisoner to BMO's structured products desk). The notes investor has reinvestment risk.
  • In all four scenarios, the index investor collects dividends. The BMO note participant does not, and gives up a 3% yield. This yield softens the blow in scenarios 3 and 4 for the index investor, and enhances the overall return to the investor in scenario 2
  • The CAGR are the returns over the time period invested. Scenario 4 looks tame because it's a CAGR of -9.71% , but the reality is that the index is -40% by the fifth year and the note participant only gets $6K back! Imagine retail Joe going into his branch in the fifth year and being advised that of his $10K (which he thought he was putting into something safe) is now $6K. The response to this comment will be that -40% are highly unlikely, therefore it's worth taking the risk. My response to this response to this comment is, if this is indeed the case, stop being cute and buy the flipping index, not the notes.
  • The average index return is higher and the standard deviation of returns lower for the index vs. the notes under all 4 scenarios.
Update - December 18

I was thinking about the initial observations I made. Statistically, I should be comparing the annual returns on the index to the notes in each year under comparison, not just the CAGR returns at the end of each scenario. In scenarios 1 and 2, the annual returns on the notes are zero when the index is < reference level, but the index shows a negative return. Once the index > reference level, both the notes and the index show positive returns.  Here are the average return and standard deviations for reference under all four scenarios calculated based on annual experience returns during the holding period:

This shows an entirely different picture! The notes by year have a much lower average return and standard deviation (explained by virtue of 0 return in most of the years under study).

An investor must draw their own conclusions from the above.

Onto Cineplex Convertible Debentures

My conversation with my colleagues got me thinking of possible alternatives to the above.

Cineplex has an issue of 4.5% convertible debentures outstanding, maturing December 31, 2018. These are priced to yield around 1.5%, so absolutely nothing to write home about. At today's ask of $105.50, an investor buying these convertibles is locking in 1.5% over two years (not much better than a GIC, but not as bad as a market linked GIC which may pay nothing, or a principal at risk note which could loss of principal);  Here's the math:

I borrowed the calculator from Professor Damodaran, link here

I assumed that Cineplex would be rated close to other BBB issues, yielding 2% in the market for two year maturities. The value of the straight bond with two years to maturity is around $104.85 & the value of the option is $1.46. The conversion ratio is $1,000 / $56 = 17.86 shares for every $1,000 face value.

The optionality here is interesting. The stock has been stuck in a trading range of between $48 & $52 for almost two years, see chart below:

Arguably, the stock is expensive trading at a PE of 24x ttm, but I've seen worse, especially in consideration of the company's virtual monopoly over exhibition across Canada.

Q4 historically has been the strongest quarter, and on an adjusted EBITDA basis, YTD adjusted ebitda is tracking at $167.2M per the company's most recent investor fact sheet.

TTM EBITDA  is around $288M, so at today's closing EV, this would put EV / EBITDA at around 12.6x (on a TTM basis). The company has managed to grow adjusted EBITDA at close to a 10% CAGR since 2006, and has most recently invested in gaming / recreation outside of traditional exhibition, so at today's multiples, I can only assume that investor's expect growth from areas outside of traditional exhibition.

This brings me to complete and utter speculation on my part: What would an acquirer pay for a virtual exhibition monopoly in Canada as the Canadian dollar continues to weaken vs. the USD? Whistler Blackcomb was purchased for close to 16x EV/EBITDA by Vail Resorts, so my guess is, anything's possible. At 15.6x EV/EBITDA, this would put Cineplex at $4.5B, or around $62.50 per share.

I'm speculating on this outcome here only because I find it strange that the stock has basically been pinned to $50 for the last year, and the strike price on the convertibles is less than $6 away. With a cheaper Canadian dollar, a US acquirer could use strong currency to buy a cash flow stream (albeit in Canadian dollars). I also noticed what appeared to be a lot of volume in the convertible debentures themselves today ($3M face value traded, vs. average volume of basically nothing).

At a take out price of $62.50, the convertibles should trade for 62.50 x 17.85 = $111.50 vs. $105.50 currently. The risk is limited to a 1.5% YTM (assuming no default risk), vs. a minimum 7% return if Cineplex gets taken out within two years ($60 profit on the convertibles + interest of $90 over the two years).

Wishful thinking I suppose. Full disclosure, I own the debentures (I do not own principal at risk notes or market linked GIC's)

Update - December 18

Another correction in my initial analysis: The minimum return is not 7% if Cineplex gets taken at $62.50 within two years!  If Cineplex got taken out at $62.50 on Dec 31st, investors would receive $62.50 x 17.85 + accrued interest up to the closing date of the takeout. If the closing date is 6 months, from closing, this works out to 1/2 the annual coupon from date of announcement, so total P/L would be:

$62.50  x 17.85 + (4.5% x 1/2) x $1,000 = $1,116 + 22.50 = $1,138 vs. $1,055 as of Friday's close = $83

($1,138 / $1,055) ^ (2) - 1 = 16%

<I'm going to ignore PV'ing the $1,138 for 6 months)

Another alternative is no takeout but price continues higher between now and December 31, 2018, assume $62.50 again on December 31, 2018:

PV of $62.50 x 17.85 <received on Dec 31st 2018>
PV of $45 received at the end of Dec 31st 2017 <assuming annual payment for simplicity>
PV of $45 received at the end of Dec 31st 2018 <assuming annual payment for simplicity>

I'll use 2% as my discount rate:

($62.50 x 17.85) / (1.02)^(2) + $45 / (1.02) + $45 / (1.02) ^(2)

= $1,073 + $44 + $43.25 = $1,160

vs. $1,055 as of Friday's close:

P/L = $1,160 - $1055 = $105

Over the two years:

($1,160 / $1055) ^(1/2) - 1 = 5%

Tuesday, 13 December 2016

Thoughts on the week ended December 9, Financial Advisory, Portfolio Management and Morningstar, Francis Chou, Jean Coutu, and Non NVCC Insurance Preferreds

Before I get into the good stuff, a quick look at the week ending December 9:

New all time highs across the board because Trump is going to save the world.

On the subject of financial advisory and portfolio management

(Caveat, the content dealing with financial advisory was written around November 22nd, and since then, I have made some changes to the weightings in my portfolios)

I had a meeting with a highly recommended (big bank) advisor in late November, as part of me wants to outsource the management of my retirement assets which are now just over $151K in total. In his office there were two 60 inch screens on his wall, one with a portfolio of Canadian stocks updating in real time, and the other with an interface that reminded me of's website.

I prepared a summary information package illustrating the distribution of assets as follows (circa Friday November 18th):

During our discussion, the advisor made the following comments, in no particular order:
  • He never has more than 5% cash in his managed portfolios. 38% cash could lead an investor to make sub-optimal decisions. At my age (44) it's better to be fully invested and use downturns in the market to dollar cost average into existing holdings because my time horizon is so long. I can achieve this by making additional lump sum RRSP contributions during times when the markets move down.
  • With reference to my current common shareholdings, he didn't recognize many of the names I currently own (Acasta Enterprises common + warrants, Newfoundland Capital, Corby Distilleries, Becker's Milk, etc.).  His general comment was that I have to be careful holding smaller, unknown names due to liquidity.
  • He follows a Morningstar CPMS model tailored to screen for and set up model portfolios All of his current clients are invested in the same model. All of the advisors at his branch basically use a subset of the same model. The model consists of 20 Canadian and 20 US stocks, ranked and selected based on Morningstar's proprietary research (more on this later). I can tell you that the 20 Canadian names included nothing unexpected, most of the Canadian big banks, one of the Canadian railways, one of the major pipelines, one drugstore chain, one astronomically priced software consolidator, one non-bank financial services alt-mortgage lender, etc. These were the stocks I observed on one of the 60 inch screens on the wall when I first walked into his office.
  • If I were to become a client, I would need to relinquish current control and trust his ability to follow and adhere to the model process. I thought this comment was interesting because even though he expressed some concern over at least one of the current Canadian model constituents, he told me that his job is not to question the model, it is to adhere to the model process, which has yielded market beating returns (relative to the TSX total return) over time (even during 2008/2009).
He then proceeded to show me the Morningstar CPMS database and model selection process, which is an outsourced screener / stock selection model. Advisors who subscribe to CPMS get to choose one of Morningstar's themes (such as value, growth, momentum) in order to construct, monitor, and modify portfolios. The value proposition for advisors here is that resources do not have be wasted on constantly researching ideas. Instead, they use the CPMS model output which saves them time. I wouldn't categorize CPMS as 100% robo-advisory, as the underpinnings of the selection process are based on Morningstar's in house research, so I guess it's a hybrid between rob-advisory and human selection.

Maybe it's just me, but alarm bells started ringing in my head. The advisors at his branch all seem to follow Morningstar for research and stock selection, and they all pay a fee per year to subscribe to the Morningstar model. If Morningstar is that pervasive, why don't I own Morningstar? Maybe there's a runway in Morningstar's robo-advisory process I never knew existed? After all, research is expensive to perform in house as it's a product of human capital. If the industry is moving towards robo-advisory and Morningstar offers robust, fully integrated portfolio management solutions, maybe the answer is research Morningstar?

I believe the advisor is onto something in terms of putting cash to work and in terms of adhering to a process. I have been sitting in almost 50% cash for most of 2016 waiting for the perfect idea, and I believe I have been putting pressure on myself as a result of this. I have taken profits too quickly on ideas that showed me a profit this year and have redeployed the proceeds back into cash looking for the next set-up. The problem is, the set-ups never came! We never got a repeat of December/January/February, we just got a slow grind up without much backing and filling.

Perhaps my takeaway here is to work on articulating and defining my process explicitly. Once I have articulated my process, I can adhere to it. My process does not have to revolve around buying into something as exotic as a CPMS model and throwing caution to the wind. It can be as something along the lines of what I'm already doing, such as the following:

"Determine companies with the combinations of highest ROIC and lowest relative valuations drawing from any and all resources at my disposal (once a week/month/quarter) and prepare a short list for further research. Once researched, take initial positions. <Stage #1 - initial research>  Initial position size should be a function of total assets under management. Max position size should be no greater than 5% of AUM <Stage #2 - define initial position size>

Monitor once a month, and do not act on temporary adverse deviations from initial purchase price to exit. Similarly, do not exit after small initial advances. <Stage #3 - monitor subject to allowing holdings to breathe> Eventual exit should be based either on my estimate of valuation targets reached, or on my initial research being proven wrong <Stage #4 - exit rules subject to objectivity & flexibility>"

There should also be a feedback mechanism to evaluate ongoing performance. I manage my parents' retirement assets and each month, I send an email to my parents discussing performance drivers. It may sound silly, but I think I should also send an email to myself at the end of each month discussing performance as if I were a third party client of myself.

I also believe that objective expected hurdle rates have to be explicitly worked into the overall process. For example, I calculated my returns to the end of November, which worked out to around 4.8% annualized. Using my November 18th allocations, I made the following observations:

The main issue here is how to achieve a 10% expected ROR based on the asset mix above. There are three possible solutions, 1) increase expected ROR from common shares, 2) decrease cash and increase my equity allocation, or 3) a combination of 1) and 2).

Here's the problem with 1), expected ROR is already high at 20%, and if I use anything higher, I believe I'm setting myself up for undue pressure and disappointment. I am not a pro, I'm a retail "Joe" with a keen interest in continuing to evolve while not doing anything too stupid. If I expect a 30% ROR on equities, I will most likely be setting the bar too high, and even then, my weighted average return would still only be 5% with current weightings.

2) is more realistic. In theory, I can achieve a 10% weighted average return with a 40% weighting in equities and a reduction of cash to 8%. This would still leave me plenty of dry powder + the ability to continue to make cash contributions to take advantage of weakness to add to holdings. But, this then becomes a question of what to buy to take equities up to 40%. With respect to adding to equities, it can’t be done haphazardly, each purchase has to be based on a foundation of research.  I could go out tomorrow and throw darts at 10 names x $3K each, and I may end up lucky and get to my ROR!  But then again, I may not!

December 9 update

Since I wrote the original piece on advisory, I changed the portfolio weightings as follows, by decreasing my overall cash, fixed income and preferred weightings and increasing exposure to equities, without hopefully adding too much risk. In this case, my expected ROR is around 8%, but I have lots of dry powder to put to work in order to get to my target.  Around $10K of fixed income strip bonds are maturing at the end of December, so fixed income will drop to 37% from 44%, but cash will increase to 28%, so either I find replacement fixed income or I find additional equities, neither of which is as easy as it sounds.

Here's what I added in order to bring re-calibrate the weightings in the portfolio:
  • Added $5,000 of each of  the Chou Associates Fund and the Chou RRSP Fund
  • Added $3,675 of The Jean Coutu Group
  • Added $3,800 of Coty Inc.
  • Added $2,500 of Fairfax Financial
  • Added $3,000 of Gluskin Sheff
  • Added $3,800 of Linamar
So, in total, I increased equities by around $27K.

I'm going to provide a brief synopsis of why I added some of the above holdings.

Chou Associates and RRSP Funds

I have long been an avid reader of Francis Chou's writings. His annual letters can be found here.

He's an under the radar portfolio manager and I believe he's brilliant. I know that the dividend growth universe typically leans towards low cost do-it yourself investing (either by way of fractional share purchase auto-pilot investing or by buying ETF's, or a combination of both), and buying units of an actively managed fund (and paying management fees) is typically frowned upon, but, I believe there is a place in portfolios for intelligent active management. Why? Because if participants have embraced one approach, i.e., passive low-cost ETF indexing, to the detriment of active management, eventually, most, if not all participants will be positioned similarly, by mirroring the index. And when most, if not all participants all buy passive low-cost ETF index funds, in theory, the index should get more expensive, and active management should get cheap. So, what was initially viewed as a cheap way of owning the index becomes risky (over time).

I believe that Francis Chou offers an intelligent alternative to closet indexers believing they will generate sufficient alpha over time owning passive ETF's, and his record speaks for itself:

Here are the Chou Associates Fund returns between 1997 & 2006:

And here are the Chou Associates Fund returns between 2006 & 2015:

I split my analysis into two 10 year time-frames. Between 1997 & 2006, the Chou Associates Fund beat the S&P 500 total return in terms of average return, standard deviation, and risk adjusted excess return as measured by sharpe ratio. Between 2006 & 2015, the Chou Associates Fund underperformed the index, and I believe the majority of the underperformance is mostly attributable to three years, 2011, 2014, & 2015. The problem in 2011 is explained below:

So, Francis Chou was buying TARP warrants beginning in 2010 and well into 2011, which impacted returns. While the index rose on the back of Google, Amazon and Facebook, Chou ran concentrated bets in TARP warrants and other US financials that came to life last month.

Here are the current holdings as at June 30, 2016:

I'm willing to bet that the underperformances relative to the S&P 500 are outliers in 2011, 2014 and 2015, and the contrarian in me is willing to take the opposite side of Morningstar's 2 star rating by adding Mr. Chou's investment savvy to my retirement mix. My guess is that Mr. Chou will trounce the index over a sufficiently long period of time. I want to be buying Mr. Chou when Morningstar rates him 1 star over the last three years (too bad Morningstar didn't bother to analyze the reasons for underperformance), and everyone in the advisory world chases passive index ETF's or 5 star Morningstar rated funds hoping for linear extrapolation into the future.

The risks here are as follows:

  • Concentrated bets in some really nightmarish stuff (i.e., Valeant, Ascent Media, Resolute Forest, Sears Canada, Sears Holdings, Sears Hometown). At first glance, the weighting of the obscure bets was around 30% of total investments. The Valeant weighting was around 9%, and the total Sears weightings were around 11%. The counter argument here is that there is optionality in the event that these bets work out (but then again they may not)
  • Illiquidity: the funds have a minimum purchase amount of $5,000 and a 2% redemption fee charge if redeemed within one year. 
  • The fund has generated negative returns in previous years, -17% in 2011, -29% in 2008, -10% in 2007, -9% in 1999, -2.5% in 1994, & -11% in 1990. By my calculations, the standard deviation of the fund returns is not materially different than that of the overall index, so anyone invested in passive index ETF's already (implicitly) accepts the same volatility risk.

I'm currently researching the Chou Europe Fund as a possible candidate for consideration, and I'm honestly scared just looking at the holdings (almost 22% of the holdings are in Greece, and 14% of the holdings are in two Russian pharmaceutical companies). Maybe the fact that I'm feeling scared should be a reason to purchase units of the fund! The fund has performed horribly over the last few years, most likely due to the Greek bets.

The Jean Coutu Group

I wrote extensively about The Jean Coutu Group last year and I believe I came to a premature conclusion that the shares were worth around $10. This was first level thinking and I was wrong. I re-analyzed Jean Coutu recently, and while there still is concern over Pro Doc and the removal of the Quebec pharmacy cap, I believe that these concerns have been worked into the rhetoric for almost two years now, as the company has deliberately warned that future results will be adversely impacted, and during this period, the market has had plenty of time to digest the warnings and potentially reprice risk. One estimate from TD last year pegged the impact of an increase to 40-50% professional allowances at a negative $25M-30M hit to EBITDA, link here. 2015 EBITDA was $331M, so a $25M-$30M hit would reduce consolidated EBITDA to $301M at the low end.

Per the 2016 AIF, the company owned 184 stores, 146 of which were leased to franchisees, and the company sublet another 268 stores. This gets us pretty close to the 417 network stores in operation. In 2015, the company generated $100M in rental income ($39M from owned properties and $61M from subleases). At a minimum, the $39M rental income stream should be valued separately. Assuming NOI is about 2/3rds of gross rental income, a cap rate of between 6% & 7% suggests $39M x 2/3 / 6.5% = $402M. I'm going to ignore attributing any value to the sub-leases, as they should be a wash.

Enterprise value as of Friday was $3.86B, less say, $402M attributable to the value of owned property real estate, gets us to $3.46B for the operating business. At $3.46B, the company trades at 11.5x EV/EBITDA, as compared to say, Shoppers Drug Mart, purchased in 2012 for $12.4B plus assumption of debt and outstanding operating lease commitments, which at the time, amounted to around $4B (un-discounted). I estimate that Shoppers' 2013 EBITDA amounted to around $1.18B, so this would put the purchase price multiple at around 14.7x EBITDA.

The main investment risk here is that bill 81 levels the generic playing field in Quebec, further hampering (or worst case, eliminating) Pro Doc. With reference to the 2016 annual report, Pro Doc contributed 27% to consolidated EBITDA, and without Pro Doc, the company becomes a pure play franchisor with EBITDA of $240M. Estimated EV/EBITDA in this case jumps to 14.4x, in line with the Shoppers' purchase multiple. The investment thesis thus becomes predicated on how much of an impact bill 81 will have. If an investor believes that Pro Doc will still be relevant (although less of a contributor to overall profit vs. pre bill 81), then there is an investment case to be made.

Finally, Revisiting Non-NVCC Insurance Preferreds (and concentration risk)

I wrote extensively about non NVCC insurance preferreds last year. As at November 18th, I had close to 8% of assets invested in these preferreds (around $13K). While most of these had returned a slight profit + dividends since I purchased them last winter, I came to the conclusion (whether rightly or wrongly) that a basket of $13K worth of non-NVCC insurance preferreds is no different in terms of risk than buying one or two of these names. Obviously there are different characteristics between the fixed and floating names and different reset spreads amongst the group, but the end game is the same, an investor is buying these in the hope that OSFI eventually pushes NVCC rules down to insurance co's, resulting in eventual redemption at par prior to 2025 (James Hymas has discussed extending deemed maturity to 2027, which would further force YTW down).

So, rather than have $13K spread amongst MFC.PR.F, GWO.PR.N, SLF.PR.G, SLF.PR.J, IFC.PR.A, I did what I thought was logical and sold out of 1/2 of the holdings to bring the weighting down to 5% of assets, as I believe I have concentration risk in owning all of these preferreds as it's all the same bet.

Saturday, 19 November 2016

Thoughts on the week ended November 18, Canopy Growth, Newfoundland Capital, Bond Rout, Fairfax, and Acasta Enterprises (again)

Well, it's official. The week ended November 18th was, without a doubt, the week that Canadian speculators in marijuana stocks lost their collective minds.

First off, Canopy Growth:

This reminds me of my days on the trading floor at CIBC WM during 1999, where all someone would need to do is utter the words "internet", and any stock with an internet theme would double (or triple) in a week.

Well this week, Canopy got up to a market cap equivalent of almost $2B intraday on the prospect of being a winner in the political legalization sweepstakes. Funnily enough, the same day Canopy almost reached $2B, it closed red, and reversed almost $700M in market cap in less than 3 trading hours. None of this matters to me as this is not my arena to play in. I can only observe and feel for the poor souls that paid close to $18 on the day, only to watch $18 become $10 before the day was out. No doubt the move up to $18 must have been a short squeeze as liquidity disappeared.

I've been thinking about the numbers underpinning this move. Year to date, sales have totalled $15M, but have grown close to 400% on a year to year basis. Fiscal 2016 sales will probably come in somewhere between $25M to $35M, so on a market cap of $2B, this works out to roughly 67x sales, Bulls will argue that the velocity of price is completely justified given the company's opportunity, but me being somewhat grounded, thinks that this is rubbish.

There have been varying reports over the last few weeks pegging the North American marijuana market at between $5B & $10B, so assuming $5B, at a $2B market cap, Canopy investors were pricing in (crudely) $2B/$5B = 40% of the market, and assuming $10B, $2B/$10B = 20% of the market, on existing annualized sales of $30M?

Out of curiosity, I wanted to find something to compare the growth story to, so I figured why not look at Craft Beer market share over time.

There's an interesting piece from Marketwach on U.S. beer industry market share, link here, which pegged beer industry sales at just over $100B in 2015. Craft beer accounted for about 21% of the dollar value, according to this brewer's association article, link here.  What's interesting about the brewer's association article is the infographic on growth, link here, and reproduced below.

Thinking about the growth here, unit volume has grown at close to 18% per year since 2009, and volume share has increased from 5.7% to 12.2% since 2011, at close to 20% growth per year. Now, none of this growth comes anywhere close to Canopy's 400% year/year growth, but the funny thing about growth that seems to get lost on the bull case is that it diminishes incrementally the larger the comparative base period gets.

In defence to the bulls, the market dynamics are different: Craft Beer filled (and continues to fill) a niche void not enjoyed by the incumbent producers (at least historically), and in this respect, Canopy may well have a prime mover advantage in uncharted territory, but my guess is that the barriers to entry on demonstration of abnormal economic profits will only attract more players (eventually), which will drive economic profits down. From the looks of it, Health Canada continues to actively process applications, see link here.

So, while a prime mover advantage may exist, I wonder how long it will be sustainable for in the absence of enforceable barriers to entry.  For curiosity's sake, Boston Beer, which has grown sales from $30M in 1991 to just under $1B in 2015 (good for 16% CAGR over 24 years) sports an EV of $2B on sales of $2B, and had about a 2% market share of the total $100B US beer market. If under perfect competition, marijuana production and sales "eventually" mirror the economics of the craft beer market, I wonder if it would be fair to estimate that a 2% share of a $10B  market equates to a market cap of $200M at the high end, about 80% below current?

One final observation, I couldn't help but observe the following disclosure in the latest quarterly report regarding per gram pricing: Is it just me, or is this going the wrong way on the way up the supposed exponential growth curve?

I wouldn't be surprised if this all ends badly, but I've been wrong before (more than once).

Next up, Newfoundland Capital

While observing the temporary insanity at work in Canopy, I happened to read a research report published on Cogeco Inc. where an analyst made a case for upgrading the company based on the discount between Cogeco Inc. and Cogeco Communications Inc. being too wide. I thought, novel idea, but what if Cogeco Communications Inc. itself is overvalued? This got me thinking about cable and broadcasting, and I stumbled onto Newfoundland Capital Corp Ltd., a tiny little company no one has likely heard of or cares about, trading at 9x earnings with a market cap of $253M and an EV of $400M. They are an operator of radio stations primarily in Eastern Canada, although they've recently branched out to Ontario and B.C.

I read their 2015 annual report and was interested to discover that in 2014, they purchased the shares of five companies which operated two Toronto radio stations and five Vancouver radio stations for around $111M (net). Out of the $111M, $109M was allocated to broadcast licenses. Prior to the acquisition, existing broadcast licenses for all of the company's other radio stations were carried at $162M, so the total of all old broadcast licenses of $162M + total new broadcast licenses of $11M add up to $272M carrying value, vs. a market cap of $253M. Either the market thinks radio broadcasting is going the way of the do-do, or I've stumbled onto something here. Here are my calculations on historical ROIC

NCC has grown its revenue (100% radio ad spots) at close to a 6% compound clip since 2006, and  its operating income at 16% compound over the same period. I take this to mean that the company is an efficient operator.

The company took on additional debt to purchase the Toronto and Vancouver stations, which has reduced ROIC since 2014, but from my research, the company generates close to $30M in free cash flow per year, and has been using free cash to repay debt and buy back shares. If NOPAT stays constant and acquisition debt continues to get repaid, ROIC should return to 2012/2013 levels. I think this is part of the investment thesis here, that ROIC should improve vs. current.

The closest comparable I can think of is Corus which trades at an 11x EV/EBITDA multiple vs. Newfoundland Capital at 8x EV/EBITDA. I'm assuming that the spread is due to tight control of the float &/or oversight in the market. At 11x EV/EBITDA, NCC would fetch  $49.6M  (ttm) x 11 = $546M, or +36% from current. Maybe this isn't such a stretch, given that the balance sheet is cleaner relative to Corus. Maybe NCC is an acquisition target for a larger media conglomerate looking to buy established radio operations cheaply? This is all speculation on my part.

When Canopy hit close to $2B intraday on Wednesday, I couldn't stop thinking that momentarily, it was worth 5x NCC on a literal fraction of NCC's sales, but obviously, NCC ain't growing at 400% per year. On the other hand, NCC does seem to have barriers to entry in the way of broadcast licenses which aren't issued nearly as generously as marijuana grow up licenses, but then again, what do I know.

In terms of potential growth runway, I offer the following infographic from the 2015 AIF:

While not as sexy or alluring as a company on the medical marijuana exponential growth breakthrough frontier, I offer the suggestion that NCC, acting as the only pure play public radio broadcast company in Canada, seems to have demonstrated strong operational capabilities in an industry where the majority of broadcast licenses are still held outside of the big four, so perhaps NCC's value proposition is to continue acquiring existing licenses at reasonable prices, below current market multiples...

With reference to the July 2014 acquisition report, the gross purchase price of the shares acquired was $111.9M (net purchase price was $109M).  Here's the balance sheet at the time of the purchase:

It appears that NCC paid just around 1x book for the acquired assets.

The annualized EBITDA I calculated based on the period from July 5, 2013 to March 30, 2014 was just under $14M, so this works out to $112M / $14 = 8x EV/EBITDA, and the free cash generated during the same period was $14.7M as stated over the 8 month period, which works out to $22M annualized, or a multiple of $112M / $22M = 5x EV/FCF.

Full disclosure, I bought shares this week at $9.90 and intend to hold for some time.

Bond Rout vs. Fairfax

I had no idea that Fairfax was a fixture in the fixed income universe. Here's TLT vs. FFH over the last six months. Eerily similar:

I'm assuming that this short term correlation means a few things in the minds of investors:

  • Investors who previously thought Fairfax was a "market crash hedge" (one of the most ridiculous notions I have ever heard btw) have woken up and realized it actually isn't
  • Investors don't believe that the deflation hedges will have any chance of working given the change in regime in the US post Trump. The notional value of the deflation hedges was around $109B at last check, but as the deflation bet basically seems to be deflation puts, at risk are the premiums paid of around $600M.  If Mr. Watsa is wrong, he loses the premium. The way the stock has acted over the last month, you would think that investors believe there's more at risk than just the premiums paid.  With reference to this, there's a great article written by the Brooklyn Investor on this bet from a few years ago, link here. Suffice it to say, if we ain't getting deflation, TLT seems to be suggesting we're getting inflation, so the two have moved in lockstep recently by virtue of Fairfax turning itself into a deflation payoff machine 
  • Maybe investors are waking up to the notion that hedging 100% of the equity portfolio over the last seven years and changing your tune in one week hasn't created the "crash hedge" value they originally thought was the case (I know, this sounds ridiculous)
The contrarian in me thinks that as sheep sell based on the above and re-price Fairfax based on no crash hedge and deflation bet in the toilet (for now - there's still +5 years to maturity left), there's still an insurance company buried underneath all of this, and rising yields have lit a fire under other insurers, so at some point, once the old "crash hedge" guard finish exiting and go buy marijuana stocks, there will be opportunity for value investors here.

Finally, Acasta Enterprises (again)

I wrote about Acasta last week and I've had time to digest the +500 page prospectus (while juggling regular work and three kids) and I made some further notes.

First off, the market hasn't really moved in respect of the common shares, which still sit at $10. I believe this is due to an additional share offering to be done at $10 in order to complete the acquisitions. The deal is also subject to vote and approval in early December, but if the founders have voting control, I can't see the deal being opposed (but anything is possible). 

Here's an excerpt from the prospectus on management's estimate of post closing NAV:

So what are they buying exactly?
  1. Two consumer staples companies (one in beauty & personal care, the other in laundry care & dish-washing products), Apollo & Jempak
  2. An aviation finance company, Stellwagen (an Irish domiciled company)
I believe that the narrative behind the consumer staples value proposition is that the industry is fragmented and offers a chance for an efficient operator/consolidator to create value over time, and the value proposition behind the aviation finance company is that there is an opportunity as a result of lenders exiting the space during and after the 2008/2009 crisis, and fleet management/finance is pegged to grow.

So really, this becomes a bet that Mr. Melman will be able to create significant value over time starting with these three acquisitions as an initial platform for growth and deal flow.  

What are they paying in terms of multiples? My rough notes are below, using 2016 annualized data from the prospectus:

These are rough calculations only. I tried to back into the 2016 pro-forma combined EBITDA of $60M per the prospectus, but I think this includes expected operating synergies post combination. In any case, at worst with no synergies, they seem to be paying 10x 2016 EBITDA, and with synergies, 8.5x EBITDA for the consumer staple platform. This compares with almost 15x for XLP the consumer staples sector fund for what it's worth.

The Stellwagen purchase seems to have been done at 8.8x EBITDA.

Proforma EBITDA per the prospectus is as follows:

Annualizing, I get $164M, so at an EV of $1.2B post closing this works out to 7.3x (lower than the estimated 2016 purchase price multiples paid).

Full disclosure, I own both Class A units and warrants.

Saturday, 12 November 2016

Thoughts on the week ended November 11, Fortis , Fairfax and Acasta Enterprises

This week was a tumultuous week for dividend investors, despite the Dow hitting a new all time high. Under the surface, there was a noticeable rotation out of income "proxies" like REIT's, consumer defensive, and utility stocks. I also noticed rotation out of high beta / tech favourites, like Google, Facebook, and Amazon.

Anything that had done exceptionally well this year due to yield or momentum chase got sold this week and anything that could potentially benefit from the Trump electorate (and by extension, anything that would benefit from higher rates, elimination of Obama-care, and continued deficit spending) got bought (banks, insurance, E&C contractors, etc.).

On the subject of this theme, let's look at Fortis. Long an institutional and retail dividend favourite, here's Fortis this week:

Now, a one week move doesn't really do justice to a long term trend, so here's Fortis over the last 10 years:

Putting things in perspective, this last week's performance looks like a blip. The problem I have with charts is that they only capture what has happened historically. To some extent, they offer clues as to what may happen going forward, but clues are not research, they are at best suggestions as to possible courses of price action through which experienced traders assign probabilities in order to make decisions. Whether those decisions ultimately lead to profits is a function of how good the trader is. In the case of the average investor, none of this should really matter, but I've digressed.

In order to really understand Fortis (or by extension, any regulated utility), I think it's important to understand how Fortis operates its business, and how management allocates capital in order to earn returns on invested capital.

Looking simply at Fortis as a "stalwart/dependable" dividend payer only tells a fraction of the story. The company's ability to pay dividends is a function of how well management allocates capital, and historically, management has allocated capital with a lot of help from accommodating capital markets.

First, a comment on return on invested capital. As noted in my previous post on Great Canadian Gaming, I have begun tabulating a database of incremental ROIC by companies I am interested in. I noticed something really interesting as I worked my way through the universe of investable Canadian companies, which I'll demonstrate by example below:

Here's Great Canadian Gaming again:

And here's Fortis:

As I've been comparing ROIC between companies with different capital structures, I noticed that ROIC for non utilities was significantly higher than ROIC for Fortis. Intuitively, this makes sense. Fortis has massive investments in PPE, which is fundamental to the company's ongoing operations. Put another way, one could make a reasonable prediction that investment in PPE on a similar scale will continue indefinitely. The company is committed to continuously maintain and/or upgrade its grids / capacity etc. in order to operate.

My estimated ROIC at 5% x a 150% reinvestment rate tells me that on balance, the company has capx in excess of operating cash flow. The difference between op cf and capx needs is funded by access to capital markets, either by virtue of issuing debt or equity.

For anyone interested, in order to estimate my reinvestment rate, I took average capx over the last 3 years, and divided this by average operating cash flow over the same period. For Fortis, capx / op cf worked out to in excess of 150% reinvestment, and this again, makes intuitive sense to me from the standpoint of understanding what a utility does. It constantly reinvests in capx over and above it's operating cash flows. My theoretical value compounding rate then becomes a function of ROIC x reinvestment rate. I think this result is synonymous with the empirical concept of estimating "g" in traditional DDM models. The dividend growth rate, "g" in conventional introductory finance is reinvestment x ROE, derived by virtue of solving for g in the formula, ROE = g  / (1-payout).

In my backwards (or forwards) way of thinking, I've substituted ROIC for ROE in order to solve for "g", where "g" is an estimate of a value compounding rate.

Obviously, "g" under either model isn't static, as required reinvestment changes over a company's life cycle.

My question here is, is a +150% reinvestment rate observation an outlier? By assuming reinvestment in excess of operating cash flows, I'm making a pretty significant generalization about the nature of utilities. There's an easy way to test this result, and that is to observe the ratio of capx to operating cash flow over time. Here's Fortis, courtesy of Morningstar:

Generally speaking, capx has exceeded operating cash flow every year since 2006, and the ratio of capx : op cash flow has ranged in scale from 2.15 : 1 to 1.1 to 1 over the last 10 years. Again, this is a general observation and intuitively, it makes sense as the company has needed to constantly upgrade PPE in order to upgrade and maintain its productive asset base in order transmit & deliver electricity &/or gas.

Is this result problematic in its own? Probably not, but it makes sense for anyone interested in buying the stock simply because it pays a dividend to understand that in order for the company to continue paying dividends, it must a) be able to grow operating cash flows (subject to rate regulation constraints) and b) continue to have unrestricted access to accommodating capital markets in order to balance a) with indefinite capx constraints.

Here's a quick look at just how accommodating capital markets have been in terms of bridging the gap between operating cash flow and capx:

Roughly, the company has raised over $6B in either debt or equity issuances since 2011 in order to upgrade &/or maintain PPE and to make acquisitions. Not included in the above is the debt raised in order to acquire ITC Holdings this year, roughly $2B US.

So far, I've only discussed ROIC, but what about WACC? I think this is the missing component in understanding Fortis (or by extension, any regulated utility).

As I've calculated above, ROIC has averaged around 5% incrementally since 1996, and it appears that the value compounding proposition is a function of reinvestment driving growth. In reinvesting in excess of 100% of its operating cash flow, Fortis has been able to compound at 7.5% annually. So what about WACC?

From my readings along my investing journey thus far, a company can only create value over time if it earns an ROIC in excess of it's WACC. I find the concept of WACC tough to get my head around, simply because it's loaded with estimation. I am not in any way, shape or form, a finance maven, nor am I able to offer any expertise in terms of attempting to estimate beta, Rf, or the spread between Rm and Rf. The best I can offer is a point in time look at what WACC may (or may not be) today based on currently accepted parameters in the market.

Simply speaking, WACC is an estimation of weighted avg cost of capital, and my best (lazy) attempt to calculate Fortis' WACC is as follows:

% debt = $12.5B / ($12.5B + $10.3B) = 55%
% equity = (1 - 55%) = 45%

AT Cost of debt = (1-.28) x $293M x 2 / $12.5 = 3.4%

Cost of lazy equity:

The laziest estimation I can come up with is to simply use the incremental ROIC as the cost of equity. In this case, I use 5%.

The empirical estimation uses Capm as follows:

Re = Rf + Beta x (Rm - Rf)

For Rf, I'm going to borrow from Professor Aswath Damodaran and use a current point in time estimate of the North American risk free rate of 2%, and similarly, for the equity risk premium for Canada, I'm going to use Canada's equity risk premium of 6.25% (link here). Arguably, risk free rates are close to zero, but I don't feel comfortable modelling zero as this is a function of QE in my opinion and may not be sustainable over time.

For Beta I'm going to borrow from Professor Aswath Damodaran and use the beta for utilities as a group (currently) of .55 (link here)

Re = 2% + .55 x (6.25%) = 5.4%, pretty close to ROIC.

At 0%, Re = 0% + .55 x (8.25%) = 4.5%

My hybrid lazy WACC(2%) is therefore = 55% x 3.4% + 45% x 5% = 4.1%, and WACC(0%) is therefore = 55% x 3.4% + 45% x 4.5% = 3.9%

Now here's where analyzing Fortis gets really interesting. Recall my comment that a company can only create value over time if it earns an ROIC in excess of it's WACC.

Well, here's Fortis' spread based on Rf at 2%:

ROIC - WACC(2%) = 5% - 4.1% = .9% economic spread

And here's Fortis' spread based on Rf at 0%:

ROIC - WACC(0%) = 5% - 3.9% = 1.1% economic spread

One more piece of the puzzle. Given the above results, i.e., accepting that the economic spread is positive but just marginally equal to 1%, why has Fortis commanded a premium valuation over time?

Here's Fortis' multiple over time as compared to the S&P/TSX:

In every year with the exception of 2009, Fortis has traded at a premium multiple to the market. One possible explanation here is that because Fortis is essentially a regulated monopoly, it has been awarded a premium valuation by investors over time.

I personally think it's odd that investors would pay upwards of 20x earnings for a company with an economic spread between ROIC and WACC of 1%, but maybe the thinking here is that this 1% spread is sustainable and impenetrable by virtue of the company's monopoly status over time.

This is pure speculation on my part, but part of me believes that the most logical explanation for this:

Can only be due to this:

As yields have generally plummeted over time, the logical beneficiaries are levered entities such as utilities, because in theory, as yields move down, WACC moves down (assuming some part of the existing capital structure is floating), and the spread between ROIC and WACC increases. Now, a 1% spread ain't much, but a movement in spreads from .5% to 1%, x leverage, well, intuitively, this is a recipe for higher valuations.

Now here's where things get interesting, and to close off on Fortis, I'm going to use an excerpt from Professor Aswath Damodaran's blog from last week (link here):

"That is not to say that I am sanguine about low interest rates. The low growth and low inflation that these numbers signal are having their effect on companies. Real investment has declined, cash flows to investors (in dividends and buybacks) have increased and cash balances have surged. The increase in debt at companies will not only increase default risk but make these companies more sensitive to macro economic shifts, with more distress and default coming in the next downturn. Finally, to the extent that central banks send signals about the future, the desperation that is being signaled by their policies does not evoke much confidence in them."

Could the recent spike in yields (globally) be the start of spread compression impacting utilities? If so, there could be a lot more pain in store for Fortis and the like.

Onto Fairfax

I'm not sure if anyone has had time to digest the news this week reporting that Fairfax has removed 50% of it's equity hedge book. Here's a link to the news release courtesy of the Globe and Mail.

I find this a fascinating about face, especially considered Mr. Watsa's bearish stance since 2010! By my estimation, he's run an almost 100% hedge book on his common stock portfolio for almost 7 years now, and during one of the most ridiculously volatile weeks in recent history (the Dow has rallied close to 2000 points since the Tuesday night post election lows), Watsa reports taking off 50% of the hedge book?  How is this not capitulation on a massive scale?

I did some quick and dirty math using the reported #'s from the 12/31/15 annual report.

Here's an excerpt on the hedge book:

By my read, he added another $1B in notional shorts during the first few weeks of 2016 (talk about painful).

Here's note 24 from the 2015 annual report:

Prior to the news release, he was short 112% of the fair value of the equity holdings, so assuming $6.7B at the end of 2015 + whatever return his equity holdings have generated YTD during 2016 (let’s use SPY and assume 7% YTD), he’d have been short $6.7Bx 1.07 x 112% = $8B notional?

The majority of the weighting was in individual equity and Russell 2000 swaps.  He must have gone into the market this week and covered  a combination of $4B notional total return swaps and individual shorts on a +2,000 point move against?

Utterly fascinating. Now that the last big bear has thrown in the towel, the market can really crash.

Onto Acasta Enterprises

This is a little known Canadian SPAC (blank cheque company) run by Mr. Anthony Melman, previously second in command at Onex. Acasta went public last year and raised close to $250M. I've owned units in the accounts I manage since the IPO, and my educated guess was that Mr. Melman (and the who's who of the executive team) would end up doing something exceptionally interesting in the future. I've pretty much ignored the units as they've done nothing since I bought them. I figured that owning units is akin to owning a call option with limited downside (if no strategic acquisition is done within a certain time frame, the units will get redeemed at close to par, and if a strategic acquisition is done, well, enjoy the ride).

Well, this week Acasta announced two strategic acquisitions and a new direction for the company. Basically, my read is that Acasta is going to be run like a mini Onex.

Here's an interesting excerpt from the news release concerning the acquired businesses and new direction, link here:

The units didn't do much this week, they only ended up around $.10 (some poor schmuck paid $11.80 on the open after the halt trade) but what drew me to the release was the estimated post closing NAV estimate and the stated price hurdle increase of up to $13-$15. There are lock up provisions in the release stipulating that the shares must reach $12 before founder shares can be sold, and the founders are taking on a significant amount of remuneration in the form of shares. Hopefully, this means that management are all aligned with creating value over time.

One last interesting tidbit: there are warrants outstanding with an exercise price of $11.50 and a 5 year life post approved strategic acquisition. These came alive this week, and I bought some, despite the stock only trading marginally above par.

I ran a simulation as follows using 50% expected volatility, a 5 year time to expiry, and a strike price of $11.50. Here are the results with stock price at $10:

Here are the results with stock price at $13:

It will be interesting to see how this all unfolds.