Stephen Takacsy on BNN-Bloomberg’s Market Call – Mar 27, 2019

Stephen Takacsy on BNN-Bloomberg’s Market Call – Mar 27, 2019

MARKET OUTLOOK

At the end of last year we saw a massive sell-off in stock markets, which was in part a healthy and long overdue correction. However, this correction was magnified by mindless algorithmic trading, momentum and quant funds and retail panic selling. We mentioned last time that this indiscriminate liquidation had created huge opportunities, particularly in the small- and mid-cap sectors, where many good companies were trading at historic low valuations despite record results and strong prospects.

Markets have rebounded strongly this year as fears of an impending recession have faded, central banks have stopped raising interest rates, and U.S.-China trade wars keep getting pushed out. Canadian stocks are also recovering after years of suffering from institutional outflows due mainly to our energy sector challenges. We’re taking some profits as stock rise and raising cash as global growth is indeed slowing down, but continue to see many good long-term opportunities, particularly in the neglected small- and mid-cap sector.

UPDATE

Sold 50 per cent position of Grande West Transportation around $0.80 after buying in at $1.66. New orders have been slower than anticipated.

TOP PICKS

SWISS WATER DECAFFEINATED COFFEE (SWP.TO)

Owned since mid-2015.

Formerly called Ten Peaks, Swiss Water is the world’s only third-party processor of 100-per-cent chemical-free, organic decaffeinated coffee. Based in Burnaby, B.C. it also provides green coffee storage and handling logistics services. The company does the processing for and sells to large chains like Tim Hortons and McDonald’s, specialty roasters and global importers.

To meet growing demand, the company is building a new plant in the Vancouver area to double capacity, which should be completed this fall. It’s seeing strong demand in the U.S. and internationally, where the decaf market is still mostly chemicals-based. Growth in volumes has been good while margins are expanding. The stock is cheap at 10.8 times trailing price-to-earnings (P/E) and 8.5 times earnings before interest, tax depreciation and amortization (EBITDA) for a free-cash-flow-generating business with high barriers to entry and global growth. We own around 8 per cent of the company. It also pays an attractive 4.6 per cent dividend.

GOODFOOD MARKET (FOOD.TO)
Owned since 2017.

Goodfood is the largest meal kit provider in Canada, with an estimated 45 per cent share of this fast-growing market. Meal kits are pre-portioned fresh food with gourmet recipes delivered directly to the home.

Business has quintupled since we first mentioned Goodfood on BNN Bloomberg 18 months ago. It now has 159,000 active subscribers and a gross sales run rate of over $200 million per year. It has a national platform, with distribution centers in Montreal and Calgary. It’s also adding breakfast items and ready-to-eat meals.

Goodfood is a disruptor with a more efficient business model than traditional groceries since there’s no inventory, no wastage, minimal handling (from the supplier to the distribution centre to the home), and higher gross margins. Market cap is around $200 million, the current gross sales run rate, while grocery chains in the U.S. like Kroger and Albertsons have been acquiring meal kit companies for 1.5 to 2 times their run rate. We think Goodfood can grow sales to $500 million within a few years and will eventually be an attractive acquisition target. Stock should be worth over $6 within 18 months based on forward gross sales.

STELLA JONES (SJ.TO)
New position.

Stella Jones is the leading North American producer of railway ties and utility poles with sales of over $2 billion, most of which is recurring revenue tied to the replacement market. The company’s valuation was expensive because it made lots of accretive acquisitions, but has been range-bound for four years as growth slowed and profit margins came down due to higher input costs (lumber) and oversupply. Organic growth has resumed, margins are improving, and there are acquisitions to be made. Stella Jones trades at a reasonable 16-times 2019 earnings per share and we expect the stock to return mid-$50s.

Stephen Takacsy, Lester Asset Management

Book Review of Modern Security Analysis (circa June 26, 2013)

Book Review of Modern Security Analysis (circa June 26, 2013)

Legendary investors Martin J. Whitman and Fernando Diz have billed their new book, Modern Security Analysis: Understanding Wall Street Fundamentals (Wiley, 2013), as the 21st century's answer to Graham and Dodd's original value investing bible Security Analysis. That puts me at a disadvantage, or so I thought, since I've never read the 1934 classic. However, the newer book has effectively challenged my views on finance and investing; it offers readers a comprehensive understanding of how much and what types of risk are acceptable (which is to say, very little). 

To be sure, at a few sheets shy of 500 pages, Modern Security Analysis does not make for beach reading. It's a monster of a text, and I had to reread a few chapters after I had the opportunity to sit down with the authors. Both writers are heavyweights in the field: Whitman is the founder and portfolio manager of the Third Avenue Value Fund, and Diz is a Professor of Finance at the Martin Whitman Business School and a Director at the Ballentine Investment Institute.

In terms of investing strategies, their book's main takeaway is that value investors in particular should seek out creditworthy companies that the market is pricing below their readily ascertainable book value (the authors refer to it as net asset value, or NAV). This way, when unforeseen economic or monetary events occur, the company will retain access to capital markets and be able to proceed advantageously once the shock subsides. It's a strategy that seems particularly wise in the modern world and in today's market, as global credit has exploded and the ups and downs of economic cycles are becoming more volatile.

I noticed a telling difference between the authors' investing principles and those of Graham and Dodd: Diz and Whitman do not put a premium on investing in stocks that carry higher dividend yields, such as REITs and utilities, which investors have been flocking to as of late. Specifically, Diz and Whitman feel that unless a dividend yield accompanies solid growth and a discount to NAV, the company does not offer any better value than one with a much lower dividend. I asked Whitman whether he believed that the recent phenomenon of issuing debt to fund stock buybacks or dividends was an effective use of a company's capital resources. He said he didn't see a problem with the practice in some cases, such as with Intel Corporation (NASDAQ:INTC), where the company was able to significantly lower its cost of capital without jeopardizing its access to capital markets.

During our discussion, Whitman also remarked, with a sly grin, that he would never purchase a stock that did not have a price at 70% or 80% of its NAV. By comparison, the S&P 500 (INDEXSP:.INX) today has a price to book of almost three times (300% of NAV), or about 2.25x according to forward annual estimates. Looking forward, the authors believe that either company growth will catch up to stock prices, or stock prices will revert to actual growth. When the time comes -- and it will -- to purchase a stock with a discount to its book value, investors should focus on quality companies. In the long run, however, 90% to 95% of companies' book values will expand each year.

Hot-Button Topics: "Too Important to Be Reorganized" Institutions and US Debt

A number of hot-button issues were discussed in the book, which came as a welcome change of pace for me since much of the book was about the nitty-gritty of finance. One prodigious subject that has drawn much discussion in recent years, and which Diz and Whitman tackle, is the concept of Too Big To Fail (TBTF), or the more progressive term, Systemically Important Financial Institution (SIFI).

These terms, of course, are applied to businesses that have become so extensive and so ingrained in the economy that their failure would supposedly have a disastrous ripple effect on the economy. The belief is that the government must step in to provide assistance, when necessary, to prevent such businesses from failing.

But the authors have coined a slightly different term, calling these institutions "Too Important to Be Reorganized," since major institutions like American International Group Inc (NYSE:AIG) and Citigroup Inc (NYSE:C) did, in fact, fail. Given the outsized liabilities of these institutions, the authors view the process of Chapter 11 default as too expensive and too harmful.

The size of US debt had a chapter all its own in the book, and I believe investors can gain important knowledge from it. The authors acknowledged that many leading economists and policymakers incorrectly obsess over the total debt in the US and other developed nations versus the total GDP as a detractor from future growth. Conventional theory says that once the debt/GDP level passes a certain point (90% to 100%, depending upon the opinion), it begins to hamper economic growth.

The authors had a much different take from the mainstream thinking on this, however. Instead, in conjunction with their investment ideas about individual companies, they feel it is more important to look at a country's ability to borrow and access capital markets rather than the size of its debt. In the history of the industrial world, debt has always grown in the aggregate and is rarely repaid. It is either defaulted on or effectively rolled over ad infinum. If a sovereign nation or company continues to have access to capital markets, it stands little chance of being forced into a default scenario.

Two Main Risks 

Although market players have to contend with a large number of financial dangers, the authors view market risk and investment risk as the most prevalent hazards in the modern world. Whitman and Diz believe that market risk, which is largely out of investors' control, should be avoided at all costs by taking a longer-term approach to the market. When it comes to investment risk, in the long-term, investors can be wrong in their analysis; sometimes events -- such as a change of control in a company -- are unpredictable. But market risk is also affected by speculation-driven movement in the short-term.

On a related subject, the authors stress the importance of only parking one's money with companies where investors have the ability to understand the company's financials. In other words, look for easily parsed audit reports and financial disclosures that allow investors to make clear choices. Whitman offered with a chuckle that, if you can't understand or value a company's books, then you obviously shouldn't be investing in it. This quick and easy guideline is an effective way to avoid the Enrons of the world.

The authors believe investors' views toward valuing and purchasing companies have detrimentally changed. Specifically, they feel investors have become too focused on short termism, or the primacy of income (i.e. cash flow and earnings). They also think investors place too much emphasis on top-down rather than bottom-up analysis, and have too strong a belief in equilibrium pricing. Additionally, the authors feel that it's easier to manage a portfolio by focusing on a smaller subset of companies instead of on "timing" the market. They acknowledge, though, that timing is extremely difficult in the short term, and that longer-term timing makes investing much easier.

Management Is Key

Throughout the book, the authors focus on management's role in a company and the importance of being able to separate management's performance from that of the stock and other linked securities -- something I found very eye-opening. The authors say that good management plays three roles: operator, investor, and financier. In that sense, good management knows how to pull every last cent from a company. In the book, the authors use the example of the $2 billion acquisition of Hertz Global Holdings, Inc. (NYSE:HTZ) in 2006 by The Carlyle Group, Clayton Dubilier & Rice, and Merrill Lynch Private Equity. Between 2006 and 2012, HTZ's new management was able to extract $5 billion from the company despite declining earnings. Other recent examples include Apollo Global Management LLC (NASDAQ:APO) issuing a equity secondary that allowed internal executives to sell large chunks of stock, and Sam Zell historically selling his real estate holdings into the market top in 2006.

Shift Your Outlook

I did not agree with everything I read in Whitman and Diz's book, and you likely won't either, as there is no Holy Grail for investing. The authors even acknowledge potential shortcomings in their investing principles as there are always two sides to every trade or investment. Overall, however, the book was highly beneficial to me as an investor because it explored and offered counterpoints to the generic playbook that many are taught.

The authors offer differing views from Graham and Dodd's original analysis, but they were quick to point out to me that Graham and Dodd's ideas were originally conceived as far back as 80 years ago, and that the market has made quantum leaps since then in areas like disclosure and the speed of information flow. At the very least, I believe the book will encourage readers to look at the market and companies in a different light as we all have become conditioned to pay attention to each tick rather than the longer term picture.

Review by Michael Sedacca

Market Environment

Market Environment

Economic fundamentals generally remain strong globally. We continue to see good availability of liquidity in debt markets, and inflows into our fund strategies have been robust. This is all playing out against a backdrop of political upheaval and the reality that we are in the late stages of the business cycle, and therefore will likely see a recession at some point in the next few years.

The U.S. economy, while slowing from the pace in late 2017 and early 2018, continues to be strong. Interest rates are still historically low and we expect that to continue. The stock market took a welcome pause at the end of 2018 which brought rationality back to the equity markets. In the context of this backdrop and amidst these conditions in 2018, we found a number of great businesses to acquire.

Economic momentum in Europe has been slow for some time due to uncertainty over Brexit, Italy’s budget deadlock with the EU, and long-term structural issues. We expect activity to be better once the outlook on Brexit becomes clearer, but in the meantime, we believe there will be select opportunities to deploy capital.

Canada and Australia are exceptional long-term markets for investment and while they are small on a global basis, both are very important to us, given our major presence in each. We believe they will continue to be excellent markets for us, given their stability and resilience. In 2018, we were successful on a number of fronts in both countries.

The South American markets in which we invest have been recovering nicely, with Brazil the slowest, but are set to recover now that a new government is in place. We invested significant capital in South America over the past three years and will both continue to tuck-in assets around these businesses and monetize investments as the currencies and economies recover.

Asia continues to increase its importance in the global economy. While trade issues have been disruptive in the short term, and growth is slowing due to the law of large numbers, these countries are very important global investment markets. We continue to judiciously increase our investments in India, China, Japan and South Korea.

Bruce Flatt,

Excerpt from Brookfield Asset Management’s Quarterly Letter,

February 14, 2019

How Chief Financial Officers (CFOs) Earn Their Keep

How Chief Financial Officers (CFOs) Earn Their Keep

An informative piece written by the team at Liberty International Investment Management Inc.

My Liberty colleagues, Brett Girard CPA, CA and Thomas Zagrobelny, have written this article on how Chief Financial Officers (CFOs) earn their keep.

Essentially, if a company can earn more from its capital investments compared to how much it costs to earn that return, the firm should be profitable today, tomorrow and in the future. And if the returns are above average, then the odds for shareholders’ investment success improves.

And, now, to Brett’s and Thomas’ research:

Part of investing in a company for the long term is being able to determine if management is adept at consistently increasing shareholder value.

Our research has shown that free cash flow growth is a good proxy for increasing shareholder value. While measuring free cash flow growth is important, what if there was a tool to predict if cash flow will grow before it does? It turns out there is: Compare Return on Invested Capital (ROIC) to the Weighted Average Cost of Capital (WACC).

While the financial media has probably familiarized you with ratios like Price-to-Earnings, it’s unlikely you’ve heard of the comparison of ROIC to WACC. It’s a powerful tool used to evaluate the profitability of a given capital allocation or investment.

For example, imagine you have the opportunity to purchase a residential multiplex. The purchase price, or invested capital, is $1,000,000, annual rents are $100,000 and annual expenses are $30,000.

Based on this math, you would earn a net profit, or return, of $70,000 annually. A return of $70,000 on invested capital of $1,000,000 translates into a Return on Invested Capital, or ROIC, of 7% ($70,000/$1,000,000).

Now, 7% sounds good but we need more context – what if the interest rate at which the bank will lend us money is 10%? In that case, borrowing at 10% to invest at 7% does not sound attractive.

The borrowing rate is one component of the WACC. The other component of the WACC is the opportunity cost of the funds being invested. Opportunity cost can be thought of as the implied amount of return we are foregoing by making an investment.

Using the example above, you could buy the multiplex and earn 7% or you could invest in your neighbour’s bakery and earn 5% - by investing in the multiplex you forego the ability to invest in the bakery.

Returning to the original example of $1,000,000 invested to purchase the multiplex, if we are going to write a cheque for $200,000 and borrow the balance ($800,000) from the bank, our weighting of equity (our investment) to debt (bank borrowing) is 20% and 80%, respectively.

Let us then assume that the borrowing rate (cost of debt) is 3% and the opportunity cost (cost of equity is 5%). If we insert these figures into the formula below we can arrive at our Weighted Average Cost of Capital, or WACC.

In this example, the WACC of 3.4% allows us to make a binary decision as to whether we should invest in a project or not. If the expected return, or ROIC, is greater than 3.4%, we cover our cost of capital and will generate a return if we proceed with the investment, whereas if our ROIC is less than 3.4%, we will lose money on the investment and should not proceed.

This type of decision is made by CFOs and management teams every day. If a proposed investment, be it a new product line, purchasing a competitor, or buying a new piece of machinery shows an ROIC to WACC ratio of greater than 1, management can proceed, trusting that the returns generated will be accretive to shareholders.

Switching from the theory to a “real world” application, we have completed the analysis to the right on Rollins Inc., one of the largest pest control companies in the world and a stock that some of our clients own.

Looking at Rollins’s ROIC to WACC relative to their competitors demonstrates that the company is able to generate superior returns on invested capital. The chart below shows that for each $1 invested, Rollins is able to generate roughly $3 while its competitors make only $2. If this relationship holds over a decade, Rollins will be able to turn $1 into almost $20,000 while the competitors will turn that same $1 into about $500.

From the chart below, displaying Market Capitalization (the market value of the company), we can see how powerful a superior ROIC to WACC is to shareholder value.

Over the 10-year period from 2007 to 2017, Rollins earned a compound annual return of 20%, while its three competitors earned returns between 7% (Rentokil) and 11% (Ecolabs).

Things to consider about Return on Invested Capital (ROIC)

 → Asset intensity is a factor

The denominator of the ROIC calculation varies across industries. If you compare a brick and mortar business that has an asset-rich balance sheet, like TransCanada, to an asset-light service-based business with large amounts of goodwill and intangibles such as Rollins, the denominator in the equation will be substantially less for the latter, making ROIC look artificially high.

→ Overall industry growth is a factor

Young or fast-growing industries, on balance, will have higher ROIC expectations since there is new market share to acquire. This differs from mature and more stable industries where gains in market share are zero-sum and must be taken from a competitor.

For the companies in the young or fast-growing industries, this can be a double-edged sword, as high expectations lead to high stock valuations - any ‘slip-ups’ along the way can severely punish the firm’s stock price.

Things to consider about Weighted Average Cost of Capital (WACC)

→ Weighted Average Cost of Capital is based on risk.

The higher the risk of an investment, the higher the cost of capital that investors need to be compensated for taking more risk. All things equal, some of the drivers of WACC are as follows:

Generally, the larger a company, the more stable are its operations (think of Domino’s Pizza relative to the local pizza shop down the street). If you were lending money or making an investment, you would require a lower return from Domino’s, given the lower risk profile of the investment.

If the market perceives a company to have a sustainable competitive advantage, or economic moat in the parlance of Warren Buffett, then the expected risk of an investment will be lower relative to the competition. This reduces the required return investors expect, thereby lowering the cost of capital.

→ Consider the company’s capital structure, or how the assets are funded.

If a company is debt-free and then decides to issue debt, the likelihood of the debt being serviced is high. Compare this to a company that has a debt-to-equity ratio of 4-to-1, where for each dollar of equity invested they have borrowed $4.

The ability of the more in-debted, or highly-levered company to repay the debt is worse than the debt-free company as it already has a lot of debt on the books.

 → Industry cyclicality is a factor.

Certain industries involved in technology or industrials tend to be more cyclical than defensive industries like healthcare or financials. This riskiness factors into capital costs - companies in the latter, less risky categories can generally access funds from the capital markets at a lower rate.

→ The influence of interest rates

WACC is also influenced by interest rates. If you think back to the example of using bank financing to purchase an investment property, the mortgage rate will be dependant in part on what the underlying interest rate is. In practical terms, a spread is placed above the central bank reference rate leading to a percent for percent adjustment of WACC as interest rates fluctuate upwards and downwards.

When using research methods of both free-cash flow generation and combining it with an analysis of ROIC vs. WACC, investors can get a sense of what makes a quality company.

Companies that can illustrate these two qualities have the financial flexibility to compete effectively and make shareholders happy by consistently raising their dividends. This should, therefore, help improve their chances of investment success. That’s why it’s such an important metric in Liberty’s research efforts.

Resources,

https://www.libertyiim.com/wp-content/uploads/2018/10/Liberty-eNewsletterSep2018-FINAL.pdf

Excerpt from Fourth Quarter Letter 2018 of Lester Asset Management

Excerpt from Fourth Quarter Letter 2018 of Lester Asset Management

A year ago, we wrote that the capital markets party would soon end given that high valuations for most financial assets were vulnerable in the context of rising interest rates, modest growth and U.S. trade wars. Throughout 2018, the US equity market marched upward and onward, driven by President Trump’s tax cuts, while global markets stalled. This “disconnect” between the US and the rest of the world was bound to end and did so abruptly and with brutality in October as talk of inflation and synchronized global growth turned to that of an impending recession. This U-turn unleashed an avalanche of selling across global equity markets during the last quarter of 2018, with never-before-seen speed and depth as investor sentiment turned on a dime from euphoria to fear.

The pull-back in equity prices was amplified by computer-driven algorithmic program selling, high frequency trading, momentum strategies, quantitative models, the liquidation of several large hedge funds, and the indiscriminate selling of baskets of stocks held in ETFs triggered by panicky and leveraged retail investors, as well as tax loss selling. It is estimated that 85% of trading volume had nothing to do with actual company fundamentals, a fact born out by the equally rapid rebound in stock prices being experienced by global equity markets thus far in 2019. It appears that “the herd effect” has only gotten bigger with the growth in automated trading and ETFs, leading to more pronounced periods of over and undervaluation. This suggests that markets are becoming less efficient, creating opportunities for active portfolio managers going forward.

CANADIAN EQUITY

During the fourth quarter of 2018, our Canadian Equity Fund decreased -12.4% versus -10.1% for the TSX. Our underperformance was mainly due to indiscriminate selling across all sectors which dragged down small and mid-cap stocks more than their larger cap brethren in the index, compounded by tax loss selling. While we outperformed the TSX during previous market declines in the 1st and 3rd quarters of 2018, there was no place to hide in the 4th quarter. For the year, the Fund declined by -13.6% net of fees and expenses (-12.1% on a gross basis) versus -8.9% for the TSX Composite total return including dividends. The good news is that as of the writing of this letter, equity markets are rebounding and the Fund is up around +6% year-to-date.

Since inception in July 2006, our Canadian Equity strategy has produced a cumulative net return of +179.4%, more than double the +77.4% for the TSX. A $100,000 investment on July 1, 2006 (two years before the financial crisis) would be worth $279,400 today, representing an annual compound net return of +8.6% over the past twelve and a half years, versus +4.7% for the TSX. Measured in terms of “value added” active net returns, we have generated +3.9% per year more than the market’s +4.7% annual return during this period.

A few bright spots during 2018 were:

Neulion (+108%): Digital technology provider of live video streaming services was acquired by Endeavor.

CGI Group (+22%): World leading IT consulting firm posted a record backlog and increasing profits.

Badger Daylighting (+19%): Hydrovac excavation company continues its rapid expansion in the U.S.

Baylin Technologies (+11%): Global leader in wireless antennae made several transformative acquisitions.

Goodfood Market (+8%): Canada’s leading meal kit provider is quickly growing its subscriber revenues.

During the year we gradually redeployed cash by adding new positions such as CCL, Stella Jones, Dollarama, New Flyer, Blackberry, Pollard Banknote and ATS Automation, at valuations we consider reasonable, however with the relentless selling pressure towards year-end, it was difficult to predict when prices would bottom. Given the ongoing economic and geo-political uncertainties, equity markets are likely to remain volatile, so we continue to be very selective. We consider our portfolio defensive in nature with low exposure to cyclical or economically sensitive sectors relative to the market. While we should have done better in 2018, we believe that many stocks in our portfolio are oversold and that, in due course, value will surface as it did during 2016 and 2017. Wealth creation requires taking a patient long term view to investing and keeping emotions at bay.

Stephen Takacsy,

Lester Asset Management