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

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

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