Skin in the Game

Skin in the Game

I have a confession…When driving a rental car, I don’t slow down for speed-bumps nearly as much as I do when I’m behind the wheel of my own vehicle. When I’m driving the rental back to the lot, the last thing that crosses my mind is, “Where’s the nearest car wash?” I don’t think I’m alone. Who would ever think about washing their rental car?!

It’s sad, but this way of thinking isn’t far off from the way many management teams run public companies. Far too often, these managers are merely “agents” for shareholders – hired professionals to run the company until they hand the keys over to the new drivers of the business. For these agent/operators, things like car washes and oil changes are usually not a priority because there’s not a sense of ownership.

We prefer to partner with managers who will not just wash their vehicles, but wax them – the owner/operator management teams.
Most public companies are what we call agent-operator companies. And many are still worthy owning. But in a lot of cases, management at these companies are focused on the next quarter or next year. They try to “please the street.” They like to make headlines. They’re compensation-orientated. And, they like to grow their asset base, sometimes by doing questionable acquisitions. After all, there’s no easier way to a larger paycheck than by managing a larger empire. But because management doesn’t have much skin in the game, they avoid the consequences of their decisions.

Owner/operator companies are different. They’re typically run by the founders or sizable shareholders and what sets them apart is they’re run with the mindset of a private business owner. There’s a culture of ownership. They like to make money, not headlines. These companies are managed for the next decade, not the next quarter. The operators focus on managing the business rather than managing Wall Street or Bay Street relationships. They typically have the majority of their wealth at risk in the company they are running, which means these companies tend to be conservatively financed. No one wants a more bulletproof balance sheet than these operators who have so much skin in the game.

One element that sets owner/operators apart is their opportunistic and sometimes contrarian approach to running their businesses and investing capital. This mindset allows these businesses to grow in any environment.

Resources,
Dan Hincks
2015 Odium Brown Annual Address (edited)

Stephen Takacsy on BNN-Bloomberg’s Market Call – Sept 24 2018

Stephen Takacsy on BNN-Bloomberg’s Market Call – Sept 24 2018

MARKET OUTLOOK

World stock markets continue to be complacent in the face of rich valuations and escalating U.S. trade wars which are starting to have an impact on corporate earnings. There are also increasing financial risks as interest rates rise to counter inflation, which is being fueled by wage growth from a tight labor market and now import inflation caused by the higher cost of foreign goods subject to Trump’s trade war tariffs. There are also signs of a market top as investors keep piling into U.S. ETFs led higher by a narrow group of tech stocks and various speculative manias such as cannabis stocks trading at nonsensical levels and cryptocurrencies, which have begun to crash in value. For this reason, we continue holding larger cash balances than usual. Nevertheless, we’re finding attractive opportunities in the less liquid and underfollowed Canadian small and mid-cap segment whose valuations have not been driven up by fund flows because they’re not part of any ETF basket of stocks. In fact, some companies are trading near the low end of their historic valuation range despite prospects never having been better. Also, some yield stocks have pulled back to attractive levels due to rising interest rates.

TOP PICKS

CENTRIC HEALTH (CHH.TO)
New position. Last bought at $0.25.

Centric is one of Canada’s largest providers of medication and healthcare services to senior residences serving 31,000 beds. It also owns a network of surgical clinics. A new CEO from Cardinal Health has just been hired to increase profitability, which was recently impacted by regulatory drug price reforms in Ontario and Alberta, and aggressively grow the pharma business. Centric also just announced an agreement with Canopy Growth to supply it with medical cannabis; it’s one of the only companies in Canada who will be licensed to distribute cannabis to senior communities. It’s also launching a revolutionary automated drug delivery device for seniors living at home.  The stock has dropped to bargain levels and we expect a big turnaround to triple the stock over the next 18 months.

GRANDE WEST TRANSPORTATION (BUS.V)
New position. Last bought at $1.35.

B.C.-based developer of North America’s only single-frame heavy-duty medium-sized transit buses for public and private transit. The “Vicinity” bus was designed from scratch for the B.C. Transit Authority and is cheaper, lighter, more fuel efficient and sturdier than competing buses, which are made by cutting up larger ones. Business model is “capital-light,” with outsourced manufacturing and final assembly in Vancouver and Atlanta. The stock has declined due to delivery delays (not the company’s fault) and lack of recent orders although the RFP pipeline is very strong. Grande West recently reported strong profits and is now “Buy-America” compliant, allowing it to bid on public transit contracts in the U.S. such as in the state of Georgia where the “Vicity” bus was recently approved for purchase.  New bus orders in the U.S. should drive share price higher in next few months. We expect stock to double in the next 12 months.

BADGER DAYLIGHTING (BAD.TO)
Core holding.

By far North America’s largest operator of hydrovac services (excavation by high water pressure trucks) used in the municipal, utilities and oil and gas sectors. Badger has been generating record results this year due to strong growth in the U.S. The company now generates 70 per cent of its business in the U.S., which is expected to double over the next three to five years since hydrovac services are still new in many parts of the U.S. and infrastructure spending is growing. Stock is trading at around 15 times earnings and 7.3 times EBITDA for 2018. It’s never been cheaper, yet the company’s results and prospects have never been better. It should be a $40 stock.

Corporate Restructuring

Corporate Restructuring

Corporate restructuring is another area where extraordinary changes, ones that don’t always occur under the best of circumstances, can create investment opportunities. While the term “corporate restructuring” can mean a lot of things, when we talk about restructuring, we won’t be talking about minor tweaking around the edges, we’ll be talking about big changes. Not just any division, either. We’re talking a big division, at least in relation to the size of the entire company.

Of course, corporate restructurings are going on all the time. It’s painful and sometimes necessary part of the capitalist system. The type of restructuring situations that we’ll focus on and the ones that provide the most clear-cut investment opportunities are the situations where companies sell or close major divisions to stanch losses, pay off debt, or focus on more promising lines of business.

The reason why major corporate restructurings may be a fruitful place to seek out investment opportunities is that oftentimes the division being sold or liquidated has actually served to hide the value inherent in the company’s other business. A simple example might be a conglomerate that earns $2 a share and whose stock trades at thirteen times earnings, or $26. In reality that $2 in earnings may really be made up of the earnings of two business lines and the losses of another. If the two profitable divisions are actually earning $3 per share while the other division contributes a $1 loss, therein lies an opportunity. If the money-losing division could simply be sold or liquidated with no net liability, the conglomerate would immediately increase its earning to $3 per share. At a price of $26, this would lower the stock's earnings multiple from 13 to less than nine. In many cases, the sale or liquidation of a loss-ridden business can result in positive proceeds. Of course, this would make the investment opportunity more compelling.

Similar to the benefits that result from spinoffs, the sale of a major division may create a more focused enterprise which can offer real advantages to both the company and its shareholders. This benefits both management - who can focus on more limited and promising operations - and the value of the company in the marketplace - which may be willing to pay a premium for more specialized and profitable business operations. Though it may seem counter-intuitive (because, in many such cases, there has been a business failure), companies that pursue a major restructuring are most often among the most shareholder oriented. Unless a company is in extreme distress, just making the decision to sell a major division is an extremely difficult thing to do. Most managements that go through with such a plan have their eye on shareholder interests.

There are basically two ways to take advantage of a corporate restructuring. One way is to invest in a situation after a major restructuring has already been announced. There is often ample opportunity to profit after an announcement is made because of the unique nature of the transaction. It may take some time for the marketplace to fully understand the ramifications of such a significant move. Generally, the smaller the market capitalization of a company (and consequently the fewer the anlysts and institutions following the situation), the more time and opportunity you may have to take advantage of a restructuring announcement. 

The other way to profit is from investing in a company that is ripe for restructuring.This is much more difficult to do. I don't usually seek out these situations, although sometimes an opportunity can just fall in your lap. The important thing to learn is to recognize a potential restructuring candidate when you see one. If it's obvious to you, many managements (especially those with large stock positions) are often thinking along the same lines.

Resources
You Can Be A Stock Market Genius
Joel Greenblatt

Trade Wars

Trade Wars

I’ve mentioned before that reading of the quarterly letters of a select few fund managers and CEO’s can make for far more informative and revealing insights into what is going on behind the manipulative and exploitative headlines of the newspapers and the nonsense that passes for news on the internet…The fund managers and CEO's that I follow are actually out there investing in the real world, instead of just talking about it...The following is a good piece featuring one manager's take on the trade war hub bub that's plastered on the headlines everyday.

Experience—recent and longer-term—shows that Trump is rational when looked at from his perspective and what he is trying to accomplish. Ultimately, he wants a deal with China, the European Union and Canada on trade that will be a win for the U.S. and he has a strong hand for two reasons. Firstly, the U.S. is a huge market and it is running an $800 billion global trade deficit on goods. Secondly, China, the European Union and Canada do have some protectionist policies in place that the U.S. has always found to be unfair. However, compared to China, both other economies are relatively open and, even using U.S. data, Canada runs an overall current account deficit with the U.S, not a surplus. The balance with Canada is simply not a big deal in the total U.S. trade picture. However, we should not expect Trump to back down on his pressure tactics.

To understand Trump better, it is important to look closely at how he operates. An excellent analysis was recently written by Daniel Greenfield. It provides clear insights into the posture that Trump has always taken to get the deal he wants. Greenfield asserts that Trump follows five basic rules, and this applies to his negotiations on foreign policy:

Act, Don’t React

Try Everything

Chaos is Power

Never Show Your Hand

Don’t Be Afraid to be the Bad Guy^[1]

Trump always prefers to make the first move, giving others no choice but to respond. He counts on others’ need for a return to stability to create opportunities that he can exploit and is not afraid to fail and try something different. Unlike most leaders, he doesn’t care about looking like the bad guy. Bullying, lying, fake news and made-up data are all fair game. Anything to take the offence and make the other side uncomfortable enough to offer concessions. This is Greenfield’s assessment and we think he’s bang on. When viewed by others, Trump obviously appears thoroughly unlikable and comes across as ignorant of basic economics and the historic fundamentals and logic behind the complex web of global trade agreements and supply chains.

He is likely going to get some kind of win against China, the EU and Canada because they have more to lose than the U.S. However, because of the way Trump operates, it is not possible to say how things will play out with any certainty. He can and does change his mind in an instant, a master of the bait and switch. But the way he operates is very consistent and rational from his perspective. Further, his popularity has been rising in the U.S., indicating that a lot of Americans like what he is trying to do and admire the tough guy posturing. This provides him with positive feedback, so we can expect more of the same.

Canada does have a number of protectionist and non-free market policies. Supply management and marketing boards in the dairy industry, for example, have always been troublesome for the U.S. and not necessarily in the best interest of Canadians, who are forced to pay high prices to benefit a small number of farmers. However, it should be kept in mind that Canada’s dairy industry is only worth about $15 billion. The total dairy trade (imports and exports) is valued at about $1 billion. Canada’s dairy imports are four times its exports. The lumber industry is also a continuing contentious issue but that has to do primarily with the structure of the industry. The big point, however, is that, contrary to fake news generated in the U.S., Canada actually had an overall current account deficit with the U.S, not a surplus. For the 12 months ended March 2018, a U.S. surplus on services of $25.6 billion more than offset a deficit of $13.9 billion on traded goods. That U.S. deficit in goods dropped 10% from the previous 12 months and amounts to under 0.1% of U.S. GDP.

It is also worth pointing out that much of the total U.S. trade deficit in goods of $800 billion with the world (of which Canada’s portion is less than 2%) is caused by the U.S. fiscal deficit, which will be boosted sharply by Trump’s tax cuts. Fiddling with tariffs while the U.S. economy is already at full employment will not likely move the needle much on the U.S. trade deficit. Further, as protectionist pressure escalates, the U.S. dollar rises. Its trade-weighted value is up 8% since the end of January. In Canada’s case, our currency has fallen about the same amount against the U.S. dollar since September 2017. Devaluation of the Canadian dollar will benefit Canada’s trade by making our exports more competitive and making imports less competitive (i.e. more expensive). Thus, currency depreciation will provide an important offset to increased U.S. tariffs.

The bottom line is that even though the data shows that Canada is not the villain behind the U.S. trade deficit as Trump claims, we are still in his crosshairs. Uncertainty and risk have clearly risen but it is premature to get too bearish on the trade front alone. How things will play out is quite complex but there are important potential offsets if the U.S. persists with the imposition of higher tariffs on Canada or a detrimentally revised NAFTA agreement.

Conclusion

The problem for Canada is that we have no idea what a revised NAFTA agreement would look like, how long it could take to get a deal (Trump postponed negotiations until after the mid-term elections), whether we will ever get a deal and what sort of tariff and non-tariff agreements could finally be reached. In the meantime, economies, businesses and markets hate uncertainty, risk and particularly chaos. Given Trump’s modus operandi, which thrives on chaos and unpredictability, investors are having to live with this. The rational response for investors to take in the face of increased risk is to take a more conservative stance.

[1] Daniel Greenfield, “Trump’s 5 Rules for Ruling the World,” Frontpage Mag (June 15, 2018).

Resources

Stephen Takacsy

Lester Asset Management

2^nd Quarter Letter