A look at the holding company Quebecor, which could be trading at a discount of over 30%, the reasons for it – and why we expect it will go away. Warren Buffett’s take on Berkshire Hathaway’s public company investments:
When a company is buying back its own stock (as QBR is), shareholders should want to see a lower share price, not a higher one. So let us begin:
Why the discount?
Let’s consider the reasons we have heard for the QBR holding company discount: 1. Management are not seen as being shareholder-friendly in that they do not provide guidance, provide easy access to management, conduct a largescale IR program or promote the stock aggressively. Dividends are modest. 2. The stock is illiquid and carries above-average leverage 3. The company has diversified operations 4. The company has made bold investments in the past, and investors perceive reinvestment risk 5. The Caisse holds a substantial (25.7%) minority in QBR’s operating business, and will likely sell it back to QBR at a negotiated price in the future.
A higher share price: Good or bad?
The answer is obvious for value investors, but let us look at it through a wider spectrum. Consider what Warren Buffett wrote in the Berkshire Hathaway 2011 annual report on its stake in IBM:
The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply. Charlie and I don’t expect to win many of you over to our way of thinking – we’ve observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus. And here a confession is in order: In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of Ben Graham’s The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life.
In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity. And if repurchases ever reduce the IBM shares outstanding to 63.9 million, I will abandon my famed frugality and give Berkshire employees a paid holiday
– Berkshire Hathaway, 2011 annual report.
Quebecor is less forthcoming about its long-term intentions, but its actions speak loudly. On October 3, the company agreed to buy back part of the Caisse’s substantial stake in the business at a price equivalent to about $51 per share.
Most investors would probably agree that this price was about equal to the public market value of the assets at that time, although well above the QBR share price. Despite the significant increase in leverage, QBR has since continued to buy back its own stock, with 4Q12 repurchases of 330K shares. Total repurchases have exceeded 900K shares (about 1.5% of total shares outstanding) in each of 2011 and 2012.
To paraphrase Warren Buffett: Quebecor’s long-term interests are better served if the shares continue to trade at a large NAV discount , for as long as it continues to increase its stake in that business. Long-term investors in QBR should want the same. Increase the dividend? On this logic, QBR would be better served by a dividend cut – but we do believe that management is trying to be fair to existing shareholders.
On liquidity and leverage
Last August, a widely-cited academic study (“Buffett’s Alpha” by Frazzini, Kabiller and Pedersen) did an attribution analysis of Berkshire Hathaway’s spectacular long term performance. According to the authors, stock selection was a factor but the bigger drivers were investing style (selecting high quality/low-beta investments) and, perhaps more surprisingly, leverage (much of it coming from insurance float):
Looking at all U.S. stocks from 1926 to 2011 that have been traded for more than 30 years, we find that Berkshire Hathaway has the highest Sharpe ratio among all. Similarly, Berkshire has a higher Sharpe ratio than all U.S. mutual funds that have been around for more than 30 years.
We find that the Sharpe ratio of Berkshire Hathaway is 0.76 over the period 1976-2011. While nearly double the Sharpe ratio of the overall stock market, this is lower than many investors imagine. If his Sharpe ratio is very good but not unachievably good, then how did Buffett become one of the most successful investors in the world?
The answer is that Buffett has boosted his returns with leverage, and that he has stuck to a good strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or a career shift. We estimate that Buffett applies a leverage of about 1.6-to-1, boosting both his risk and excess return in that proportion. Thus, his many accomplishments include having the conviction, wherewithal, and skill to operate with leverage and its risk over multiple decades
. – Buffett’s Alpha; Andrea Frazzini, David Kabiller, and Lasse H. Pedersen, Yale Department of Economics, 29 Aug 2012
So what’s the connection with Quebecor?
Iwould argue that the cable business – particularly Quebecor’s – is exactly the type of defensive, high margin business that Berkshire Hathaway targets. In fact, Berkshire was a major holder of Comcast until mid-2010 (missing most of the subsequent run). QBR itself is a leveraged investor in cable, with net debt at ~3.5X EBITDA. And while liquidity is a concern for many investors, it should be less so for those with Buffett-like time horizons.
Diversification
Diversification is an oft-cited reason for NAV discounts, particularly when management plans further diversification. (Here, Berkshire Hathaway is a rare exception.) But on our math, this point no longer applies: Quebecor’s core inregion telecom/cable operation accounts for 89% of our enterprise value. On this definition, only one stock in our coverage universe (Bell Aliant) is less diversified.
Reinvestment risk Berkshire Hathaway is not a dividend payer, and Mr. Buffet tdefends this policy as appropriate when there are “moat-widening” or otherwise attractive reinvestment opportunities. With QBR, investors are concerned that potential reinvestments won’t meet this test. The facts suggest to us that these concerns are unwarranted.
Under a new CEO, presumably keen to build net worth, we would expect the company focus very sharply on shareholder value creation
The Caisse, which presumably has similar objectives and no wish to increase its exposure to a large, illiquid investment, retains a veto on major M&A
Leverage – and the prospect of a future Caisse- sell-down — is likely to keep a lid on M&A activity
There have been no big acquisitions since Osprey Media in 2007.
No likely deal is alarming, in our view: 1) a new Quebec hockey team is far from certain, and would in any case fit the Berkshire Hathaway “moatwidening” criterion; 2) in wireless, it is unlikely in our view that QBR will be a consolidator or an acquirer of spectrum outside its home market. But if it is, any such purchases are likely to be at fire-sale prices. 3) In newspapers, there is little to buy, and we sense a decline in QBR’s interest in this segment. Again, QBR has scale in this business — and knowledge, acquired the hard way. (We note that even Berkshire Hathaway, according to the 2012 annual report, acquired 28 daily newspapers for $344 million in the past 15 months.)
The Caisse overhang
In last year’s QMI sell-down by the Caisse, the price was arrived at by negotiation (presumably backstopped by the possibility of an IPO) but the more important point is that the actual price was very consistent with public market values. If one assumes that QBR will always command a holding company discount, then buying in minorities at public market value will be dilutive to valuation. But if we assume that the holdco discount will eventually go away, then such a buy-in is non-dilutive (and any share buybacks in the mean time are of course accretive).
Disclosure: Long BRK no position in QBR
