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 Speicher.com, 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:



Observations: 
  • 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 magicformulainvesting.com 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)
Interdigital
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).

ROB on CI

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.



Friday, 5 August 2016

CI Financial (Paradox) Part 1

I'm going to write a lengthier piece on CI Financial over the weekend, for now, I've added an updated evaluation model in googledocs to the top right hand side of the blog showing my work on CI.

The company reported earnings this week and is making new 52 week lows (seemingly by the minute). I find this ironic in that the overall market (as measured by the S&P500) is making all time highs while asset managers are not really following suit (with the exception of Blackrock).  I wrote about this same observation in analyzing Gluskin Sheff a while back (which I bought and still hold).

My guess is that this non-participation by companies like CI echoes investor concern that asset managers with higher AUM fee structures inherent in their business models are at the mercy of do it yourself investors and the accompanying mobility of capital seeking near zero fees.

I've also read that CI is potentially highly exposed to new Canadian mutual fund disclosure rules (see globe and mail article here), CRM2, effective July 2016.

These types of situations intrigue me because it's my belief that investors often unfairly punish companies in the expectation of an adverse event (or series of events) unfolding, and when events do not unfold as horribly as previously thought, investors flock back.

For now, my initial observations are as follows:


  • The company pays close to a 5.4% yield (11.5 cents monthly).  The company pays out about 60% of its free cash flow in dividends.  The dividend alone is worth about $16 per share perpetually at zero growth, using an 8% discount rate. 
  • While the company certainly appears exposed to the impact of CRM2 and resulting fee pressure, I wonder if the company wouldn't adjust trailer fees paid down to somehow mitigate top line fee pressure?  For example, in 2015, the company earned management fees of $1.78B, and paid $554M in trailer fees.  The ratio of trailer fees to management fees is just over 30%.  Hypothetically, why couldn't the company reduce trailer fees paid and pass part of the impact down to third party advisors selling their funds?  If CRM2 affects the entire industry, I'd hazard a guess that the entire industry is facing the same concern, so third party advisors aren't as dis-incentivized to stop selling CI funds if AGF just cut their trailer fees proportionately.
  • What about consolidation in the industry in order to unlock synergies?  CI by EV is second only to IGM Financial, and $113B in AUM is significant.  Top line fee pressure may well end up forcing consolidation at some point. 

I'll post further thoughts over the weekend.

Monday, 1 August 2016

TWC Enterprises Ltd. Quasi-REIT or real estate development company?

Entering into the world of small caps (again), and scouring the landscape for illiquid and under followed ideas, I've stumbled across TWC Enterprises Ltd.

The history is interesting.  Prior to buying a controlling stake in the previous public incarnation of Club-Link (LNK), Raj Sahi (Morguard) via Tri-White, accumulated just under a 30% stake and engaged in a tug of war with the previous management team for control.  In 2007, Tri-White upped it's stake in LNK to 70%, and finally, took control of LNK in 2009.

In it's current incarnation, the company operates in two distinct businesses: 1) golf club and resort operation and 2) Alaskan shipping port and railway tours, but any possible catalyst in terms of uncovering possible hidden value stems from a third somewhat related business namely, 3) real estate development. The key here is trying to value the third business on a stand alone basis.

Golf club and resort operations and Alaskan shipping port and railway tours are fairly straight forward to attempt to value.  The company reports annual and quarterly results using net operating income as a key performance indicator by segment, so when I see net operating income I automatically think of REIT's.

My very simplistic method of attempting to value a REIT is as follows:
  1. Take NOI divided by a range of possible cap rates. I usually use between 8% & 12% in order to give myself a sufficient margin of safety in terms of discount rates.  I treat NOI as a perpetuity with no growth.  Arguably, I should use a lower cap rate given the current interest rate environment, but I want to err on the side of conservatism.
  2. Compare the results of 1. above to the reported net asset value of the REIT, and to the current enterprise value of the REIT.  In order to determine net asset value, I take reported income generating assets only (I exclude cash, a/r, other receivables, goodwill or intangibles) and deduct total serviceable debt (current debt + mortgages + other long term debt).  I also compare net asset value of the REIT to current market cap.
  3. If 1. > 2, I believe there is a margin of safety implicit in buying the REIT.  I found that during Jan/Feb 2016, H&R REIT, Artis REIT and Boardwalk Equities REIT were all being valued in the market at less than the net asset value of each REIT.  Hindsight being 20/20, Jan/Feb was a great time to buy these particular REITs.
The Issues as I See Them:
  • Golf club and resort operation is a highly competitive business with limited pricing power.  The company currently runs just under 60 golf clubs located primarily in Ontario, Quebec, and Florida. The company recently entered the Florida market in 2010 and has grown its presence in the South Florida market since then, however, Florida operations still only represent a small percentage of total revenues and net operating income (16% of golf operating revenue and 5% of golf net operating income). Putting pressure on membership, golf rounds and overall growth is oversupply of available golf courses clustered around the company's core locations. Any catalyst here relates to business 3) discussed above, namely, real estate development, and to a lesser extent, exploring additional Florida golf club purchases at the right price.  
  • The Ontario and Quebec golf clubs under operation have exhibited diminishing growth since 2008, partly due to reduced membership, and partly due to competition from other properties.  Canadian golf NOI has shown a 1.57% cumulative decline since 2008 ($37M in 2008 vs. $32M currently).  Factors contributing to this decline include reduced membership and/or sale, closure or conversion of non-performing clubs into development properties.  My understanding is that management actively attempts to identify poorly performing clubs on an ongoing basis. Here are the summary results over the last 8 years:



  • Here's an excerpt showing current geographical distribution in Ontario and Quebec (You can get an idea as to how clustered the majority of the company's golf club operations are by reading the latest annual report, link here).



  • The Alaskan shipping port and railway tour operation arguably has definitive moat characteristics: the company owns and/or leases ports at Skagway Alaska, and runs railway tours catering to cruise ship passengers along the White Pass & Yukon Route. The issue here? Limited growth.  Cruise ship passenger traffic while steady over time isn't likely going to result in run away growth.  Since 2008, cruise ship operating revenue has grown at 3.82% CAGR, and NOI has grown at 4.36% CAGR.  Respectable low, single digit growth.  Port and rail operating revenue accounted for close to 24% of total operating revenue and 46% of total NOI in 2015.  Arguably, the economics of the port and railway operations outweigh the economics of the golf club operations (rail and port generated $27M NOI on revenue of $50M, vs. $34M golf NOI on revenue of $160M).  The catalyst here could be scaleability if the company can somehow acquire additional cruise ship ports, but this is a stretch given that these types of assets will likely command premium valuations currently, and it's my understanding that Mr. Sahi is not particularly disposed to paying premiums for assets.

Real Estate Development

One of the benefits of owning prime development land clustered around Southern Ontario is the potential for converting existing golf club locations into residential and commercial use property. As I've articulated above, I don't believe there's much growth potential behind the company pursuing existing Canadian golf club operations, so any premium built into the shares must reflect investor sentiment towards any real estate value inherent in the company's existing properties.

Here's my analysis of current valuation:






Comparing avg market cap to net asset value of properties only, I estimate that TWC currently trades at a slight premium of 8.5%, up from a discount of 36% back in 2008, and my thoughts are that this premium must be reflective of the value of the real estate development potential inherent in the stock.

Looking at valuation using capitalized NOI vs. EV, I estimate that at an 8% cap rate, capitalized NOI of say, $59M, works out to around $739M vs. current EV of $636M, or a 14% discount to EV. The higher the cap rate goes, the the lower my capitalized NOI becomes, but as I mentioned previously, arguably, I should use a lower cap rate given the current interest rate environment, and a cap rate of 12% is likely too conservative given that the cash flows from golf, port, and rail operations are not likely risky cash flows.  

Even so, I can't see a compelling reason to simply buy the diminishing returns demonstrated by virtue of golf club operation.

This leads me to attempt to value the real estate conversion potential of the golf club operations (which is no easy task) the clearest example of which has been the company's recent announcement that it has filed to redevelop its Glen Abbey golf club into a residential community.  Here's a recent piece on the development filing, courtesy of the globe and mail.

From my understanding, Glenn Abbey is around 230-acres, and the company intends to unlock the real estate value by virtue of developing 3,000 homes.  The company has not yet obtained approval for this proposed development, but if it does, there has to be some way to estimate a range of values attributable to this development potential.

The way I approached this is was by reference to a number of economic development reports, including the 2015 Oakville Economic Development Annual Report and the following Fall 2015 Colliers GTA Land Report, link here.

The Oakville report provides an average estimated value per acre for employment lands of $679K, while the Colliers report provides details on a specific transaction reported during 2015 whereby York Downs golf club was sold for about $1M per acre (City of Markham).

Now, employment lands are different use lands than residential development lands, so my simplistic (and hopefully conservative) method of ascribing a possible value to Glen Abbey is to take the mid-point between the two reported amounts, so $840K.

At 230 acres x $840K per acre, I get around $193M attributable to Glen Abbey as a stand alone development, or around 30% of current EV.  If use $679K, I get 230 acres x $679K per acre, or $156M, or around 25% of current EV.

On a per share basis, at $840K per acre, this works out to around $7 per share, and at $679K per acre, this works out to around $5.8 per share.

Update, August 2, 2016

After I wrote this initial analysis, I started thinking that my per share estimates were too aggressive. I should really have taken per acre value based on % of EV.  The way I initially calculated per share development value was too simplistic. In this case, I get $3 per share at $840K per acre, and $2.46 per share at $679K per acre.  To me, these estimates seem much more conservative than my initial estimates. The idea still remains compelling despite my reduced development estimates, and I feel slightly more comfortable with a lower range of development potential (especially if the Glen Abbey development does not get approved).

Concluding Thoughts

Full disclosure, I bought shares in one of the accounts I manage as I believe the real estate development potential has merit and is not fully reflected in the current share price.  Strong caveat, there are significant risks to my thesis and conclusions drawn, including the company's failure to secure development approval, and/or a significant real estate correction in the GTA which would result in per acre estimates used being too high.