Stock Market Volatility is Increasingly Creating Opportunity

Stock Market Volatility is Increasingly Creating Opportunity

Increased program trading and passive indexing is creating greater volatility in the stock markets – and in many cases, increasing discrepancies between a stock’s trading price and its true value. For example, a stock that is in a ‘hot’ industry, or fits neatly into an index, may trade at greater than intrinsic value because of these non-company related influences. On the opposite end of the spectrum, smaller companies or those that do not neatly fit into indices may trade at a significant discount to fair market value.

This has been compounded by the reduction of investment research caused by changes to global securities regulation, which in turn has impacted brokerage firms’ ability to provide research in exchange for commissions. As a result, substantial coverage for smaller companies has been reduced or dropped altogether.

Despite this, the underlying businesses are often doing well; this has led in some cases to excellent value purchases in the stock market, compared with what might be considered fair market value. The problem for regular stock market investors is that conditions may not change in the future, and therefore it may be a very long time, if ever, before true value is recognized in the stock market. For businesses that distribute cash flows to shareholders, this may not be as relevant as a large portion of returns can be in the form of cash returned to investors. But for many companies that require cash for reinvestment, the trading value can often be at a large discrepancy to fair value, with no visible event to change the trading valuation (commonly referred to as a Value Trap).

Historically, we have largely used one of three strategies to acquire assets: (i) we carve out assets from sellers who wish to realize cash from a non-core business; (ii) we buy assets in stressed situations, including by acquiring debt in the market and converting it to equity, and (iii) we take companies private in friendly transactions. The first two of these strategies continue to contribute to our sourcing of transactions. Increasingly, however, for investors such as ourselves that are capable of buying entire businesses out of the stock market, the third strategy is becoming the largest source of transactions as market volatility creates greater opportunity.

To put this into context, in the past two years we have taken seven public companies private. We attribute some of this to the above conditions as it enables us to begin discussions with a company at a reasonable starting point for value. In addition, in many cases, investors are frustrated and fatigued, and therefore choose to move on at a reasonable premium to the share price. In real estate, we took Forest City private in the U.S. In renewables, we took TerraForm Global private and acquired Saeta Yield in Spain. In private equity, we have an offer outstanding for Healthscope in Australia. In infrastructure, we privatized Enercare in Canada. All told, these take-private transactions led to the acquisition of over $55 billion of assets. More importantly, we believe we acquired great businesses at reasonable value.

One never knows what the future holds, but for now we see this trend of share price volatility increasing and consequently, there may be more opportunities to buy great businesses for value in friendly transactions with management teams that wish to join us, while at the same time providing existing investors with liquidity and an opportunity to exit at a favorable price.

Bruce Flatt,

Excerpt from Brookfield Asset Management’s Quarterly Letter,

May 9, 2019

Market Environment

Market Environment

The global economic environment is very favorable for investors. Economies are generally strong, but not too strong. Employment levels are among the strongest for many decades. Interest rates are paused at very low levels, and the risk of significant increases in the medium term seems low. Financing for transactions is freely available to good borrowers, but not in major excess. Covenants are lighter than they were five years ago, but the extreme excesses seen in the past do not seem prevalent yet today.

Despite this apparent ‘goldilocks’ market environment, we continue to worry about a world where politics are polarized almost everywhere, interest rates are low globally, and equity valuations are at their peak. With respect to equities, technology-related stocks seem to have particularly high valuations, although to date this has proven to be justified for some, as they have become among the greatest companies ever created. Passive investing is the latest trend to dramatically affect both equities and some classes of debt securities, and the full effects are yet to be seen. In this environment, we continue to cautiously invest capital but ensure that we remain liquid, with substantial cash and dry powder.

The North American economies are strong and South American countries are still recovering from their tough recessions. Europe is slower, but the U.K. is amazingly resilient. Australia is okay, China is slowing but is still robust when compared to global alternatives, and India is struggling with over-leverage. Overall, we think the global markets remain very constructive for our businesses.

Bruce Flatt,

Excerpt from Brookfield Asset Management’s Quarterly Letter,

May 9, 2019