The Under Appreciated Value of Capital Cycle Analysis

The Under Appreciated Value of Capital Cycle Analysis

In our public markets investments at Volta Global, we are fortunate not to be constrained to a specific strategy or segment of the markets. We are only looking for the best opportunities for long-term capital appreciation, in a completely sector and asset class agnostic manner.

Such opportunities often do present themselves as a result of two situations:

Finding truly great businesses with sustainable competitive advantages that are temporarily mispriced due to market “noise” or short-term events (the much espoused “Buffet/Munger approach”).

Significant developments taking place in the supply side of an industry that often go unnoticed by the market.

Situation #1 is widely covered, and any student of the markets will be very familiar with those teachings. Situation #2 is less appreciated but equally powerful, and forms the basis of “capital cycle analysis” — an investment philosophy long championed by Marathon Asset Management (and excellently covered in their book Capital Returns.)

While capital cycle analysis is a very simple fundamental concept — companies are impacted by changes in the supply side of the industry in which they operate much more than changes in the demand side — it is also the one that most investors and analysts often ignore. They instead devote a majority of their time and effort into analyzing the demand side, which is much harder to accurately predict, and in the long run much less impactful to a company’s profitability, and thus their stock price.

I strongly recommend reading Capital Returns in its entirety, but the key aspects of the approach can be quickly summarized as follows:

Stock prices are mostly driven by long-term levels of profitability, and reward companies that can consistently earn returns above their cost of capital.

Changes in the supply side of an industry are more important to profitability than those on the demand side, yet the vast majority of professional analysts and investors are trained to focus their attention on the demand side. The implication then is that changes in the supply side tend to be under appreciated by the market, and slower to show up in company stock prices.

Value vs. Growth is a mostly irrelevant construct for capital cycle analysis — high valuations alone are not enough to kill a positive supply side dynamic, and companies in industries going through a lasting positive change in supply side dynamics can sustain high valuations for longer periods of time than the market expects.

Many investors are not well suited to performing proper capital cycle analysis, which requires both an “outside view” (tough for industry “experts” to have) and a very long-term perspective (very tough for most active managers to have these days).

Jeff Evans, Volta Global

Recycling Capital in my Portfolio

Recycling Capital in my Portfolio

I sold Descartes Systems Group Inc (DSG on the TSX) last week. It was a hard thing to do as it had been a very good stock for me over the years, and I still believed in the management team and the fundamentals of the underlying company. But it had gotten really pricey (price to cash flow ratio of 38.4…The stock has always gotten a premium valuation from the market due largely to its recurring revenue model based on it’s sticky relationship with its customers. It didn’t pay a dividend.

Now that I’m 65 I have to start looking down the road when I turn 71…that’s when I have to withdraw between 5 and 6 percent from my RRSP which will turn into a RRIF at that time. So I’m putting an emphasis on dividend paying stocks, especially ones that pay a rising dividend. My thinking is to try to have my dividend income cover the amount the Government wants me to take out of my RRIF without touching my principle.

I in turn, bought Whitecap Resources Inc (WCP on the TSX). It has a price to cash flow ratio of 2.9 (dirt cheap). It’s an oil company with long life assets and low decline rates. And despite its growth orientation, it pays a nice dividend of 6.36 %. The company’s profile is as follows…

Whitecap Resources Inc focuses on the acquisition, development, optimization, and production of crude oil and natural gas in western Canada. The company acquires assets with discovered petroleum initially in place and low current recovery factors. Light oil is the primary by-product of Whitecap's Canadian assets. To extract petroleum products from its resources, the company uses horizontal drilling, in addition to multistage

fracturing technology. Crude oil is the leading revenue generator out of the basket of energy products sold by Whitecap.

The management team seem to be good allocators of capital making opportunistic acquisitions with a focus on growing the asset base of the company. I often poke around Brookfield Asset Management’s website and noticed one of their closed end funds...Brookfield Select Opportunities Fund (BSO.UN on the TSX) holds this company in their investment portfolio…Brookfield are known for their value orientated approach while insisting on quality at the same time. I should also mention that the management team at Whitecap has been recently buying stock in their own company...I guess they think its cheap too.

It has been a savage bear market in the energy sector but I feel the low is in and now is the time to once again test the energy waters. Remember the Speculator’s Edge…Demand Supply and Supply Demand.

Reaching for Yield is a Sign of the Times…

Reaching for Yield is a Sign of the Times…

Risk arises as investor behavior alters the market.

Howard Marks

Canada’s bond market is churning out issues backed by increasingly riskier assets -- and yield-starved investors are lapping them up.

Recent deals have included debt backed by a variety of assets including mortgages on Hudson’s Bay Co. stores, a junk-rated retailer; consumer loans charging interest rates of as much as 40 per cent; and home equity lines of credit. Non-bank mortgage lenders may also soon issue debt, market watchers say.

The bonds are hitting the market amid a mixed picture for the Canadian economy. Ten-year government bond yields are trading below the Bank of Canada’s overnight rate. Consumer spending has been tepid and inflation weak, but the economy also recorded its best monthly advance in growth in eight months in January and boasts an unemployment rate at a four-decade low of 5.8 per cent.

“The flattening of the curve, in which you see the ten year bonds inside the overnight rate is prompting investors to hunt for yield,” said Randall Malcolm, senior managing director of fixed income at Sun Life Investment Management.

The new issues included $250 million of securities backed by mortgages on Hudson’s Bay department stores in Montreal and Ottawa, arranged by Royal Bank of Canada. The $207.8 million portion of top-rated bonds were priced to yield 3.64 per cent, or close to 200 basis points over government bonds. A $28.13 million tranche of class B bonds were issued at a yield of 4.36 per cent, data compiled by Bloomberg show.

The borrower of the loans is a joint venture between Hudson’s Bay Co., which is rated six grades below investment grade by Moody’s Investors Service, and RioCan Real Estate Investment Trust, which holds S&P Global’s second-lowest investment rating. Hudson’s Bay has reported losses in at least nine out of 10 quarters, data compiled by Bloomberg show.

The issue is Canada’s first-ever commercial mortgage-backed security pooling loans from a single entity. That gives it “an element of concentration which I haven’t seen in a long time,” said Malcolm.

Fairstone Financial Inc., a lender owned by an investor group including J.C. Flowers & Co., also sold C$322.4 million of bonds backed by a pool of consumer loans with interest rates as high as 39.99 per cent, according to DBRS data. Almost 70 per cent of the loans carried Fico credit scores below 649, which is considered subprime by credit reporting bureau Experian.

The issue, in several tranches, was the first non-prime asset-backed securities deal out of Canada since 2007. Its C$225 million portion has an expected maturity of 2.6 years and holds a 3.94 per cent coupon, Bloomberg data show. That compares with a two-year government bond yield of about 1.59 per cent.

Heloc Issues

The strong interest in the deal was partly driven by “Fairstone’s long history and tenured track record of providing transparent and responsible lending options for a segment of the Canadian market that may experience sudden financial needs, but is not eligible for prime credit,” company spokeswoman Fiona Story said in an e-mail. The biggest portion of the deal holds top credit ratings, she said.

Canada also saw its first issue of Heloc bonds since October 2017 as Fortified Trust, a securitization unit of Bank of Montreal, sold $750 million of notes and $14.8 of subordinated debt at yields of 2.558 per cent and 3.308 per cent respectively.

In Canada, borrowing through Helocs has grown faster than residential mortgages since 2017 and stood at $243 billion in October, or about 11 per  cent of total household debt, according to DBRS Ltd.

Consumer Stress

In addition to those three securitization deals, there’s been five issues backed by credit-card debt and two by auto loans and leases.

Tim O’Neil, managing director and head of Canadian structured finance, at rating company DBRS expects to see more auto and credit-card backed deals and potentially some from non-banking mortgage lenders -which tend to cater to borrowers who can’t qualify at a mainstream bank.

“Credit delinquencies are showing low numbers so it’s good timing to issue,” said Montreal-based Yves Paquette, a portfolio manager at AllianceBernstein Holding LP, which manages $550 billion of assets. His firm is reducing exposure to Canadian credits, however, which can be vulnerable to a cyclical slowdown.

While average charge-offs of Canadian credit cards remain close to record lows, consumers reduced their average monthly payments in February to 38 per cent of outstanding balances, the lowest since 2015, according to Royal Bank of Canada, based on data from securitization programs.

“That deterioration in payment rates may be attributed to some stress on the consumer,” Vivek Selot, a credit analyst at RBC, said in a March 27 note to investors. “Considering that fragile household balance sheets could be a precipitating factor for the credit cycle to turn, any signs of consumer credit quality deterioration seem worthy of attention.”

News Item from BNN Bloomberg,

April 04, 2019

https://www.bnnbloomberg.ca/debt-backed-by-consumers-paying-40-lure-yield-hungry-in-canada-1.1239648