Monday, 8 August 2016

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.

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