Value Investing

Trapeze Asset Management: Unpopularity Contest

Randall Abramson’s Trapeze Asset Management newsletter titled, “Unpopularity Contest,” for the second quarter ended June 30, 2015.

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It is often not easy to be value investors. Even before the U.S. stock market recently corrected violently from near all-time highs, many stocks were languishing. Clearly those in the commodity sector from the extensive commodity rout in energy, base metals, precious metals and food products. The Commodity Research Bureau’s commodities index is back at the recession level of '09. The U.S. industrial sector is also down this year and looking attractive. Indeed, the resource heavy Canadian stock market is one of the worst performing in the developed world this year. Disinflation is in the air and central bankers, concerned about the potential for deflation, are in stimulative mode.

And yet, simple supply and demand economics would suggest that low commodity prices should increase demand and diminish supply. Many commodities are below their all-in cost of production which will discourage additional supply. And, we believe those forces will ultimately, hopefully sooner than later, cause commodity prices to start to rise again, helping the depressed shares of their producers. Oil prices are up over 20% from their recent lows. Value investors are often driven to what is temporarily unpopular and cheap, with less potential downside risk relative to upside potential. Trading off risk for patience. Looking not just at the stock market but at the market for stocks. Value investing 101.

Trapeze Asset Management - Fighting Deflation

Central bankers everywhere are focused on the deflation signs and wish to have their currencies lower to stimulate exports and inflation. And this in a world of ultra-low interest rates in most of the developed countries. In the U.S., the rate on the 10-year bond is now at 2.16% compared to the dividend yield of 2.23% of the S&P 500. We believe the bull market in bonds is likely ending, especially if inflation picks up.

Global economic growth for 2015 is estimated by the IMF to be only 3.3%, with weak global demand. But the combination of low interest rates, currencies and commodity prices could ultimately be stimulative of growth, spurring inflation generally.

The Eurozone’s growth was somewhat weaker in Q2 with slower growth in Germany and poor output in France, so the E.C.B. will continue its stimulative quantitative easing. And unemployment in the Eurozone dropped slightly to 10.9% in July. Japan is improving from its increased quantitative easing and the low Yen, contracting in Q2 less than expected. China, the second largest economy, which has seen its growth slowing from weaker exports and factory output, and where stock market volatility has been scary, just devalued its currency, lowered interest rates and its reserve requirement, and is likely to see further government policy easing to assist its economy and stimulate inflation.

While Canadian GDP growth was slower in the first half, clearly affected by low oil prices, the lower loonie should help with improved trade numbers. July exports were up 6.3%, the biggest monthly gain in many years, shrinking the trade deficit and improving the growth outlook. Annual inflation also rose in July to its highest level since December, also helped by the lower currency.

On the other hand, the strong U.S. dollar, up about 20% since mid-2014, is impeding U.S. companies with foreign exposure, and the potential for a Fed rate increase in September, or later this year, will not be helpful. Q2 annualized U.S. GDP growth of 3.7% was better than anticipated but helped by higher inventories which could be a drag on future growth. Housing, consumer spending, durable goods orders and employment are improving, though wage growth remains at multi-year lows. Household net worth is at a record high. Existing home sales were up 2% in July. July retail sales were higher, and automakers reported stronger than expected sales. Manufacturing weakened but the U.S. trade deficit fell in July as exports rose, notwithstanding the global growth slowdown.

Trapeze Asset Management - Market Correction

The U.S. stock market was overdue for an outsized correction, but it likely won’t result in a bear market. Positively, S&P 500 companies have strong balance sheets with $3.6 trillion in cash and marketable securities, to finance share buybacks, dividends, and to invest more when the opportunities are there. Earnings and dividends should continue to grow and, following the recent correction, the bull market should continue, particularly with attractive share prices, competitively low interest returns from bonds, high cash levels and bearish investor sentiment. And, insider buying has picked up, another positive indicator.

Our macros pillars—TEC™ and TRIM™—our economic composite and market momentum indicators—helped us remain bullish in the face of the recent market correction, as neither triggered alerts. Our economic composite, as tested for the last 50 years, typically signals well in advance of recessions. And, while the S&P 500 fell right to the bottom of its TRIM™ line, it then inflected back up. Only in bear markets should one typically be overly pessimistic because the median corrective decline in bull markets has been about 6%, though, about every 2 years, a 10% or so decline takes place. The last decline in excess of 10% was nearly 4 years ago. With the markets fully valued and overdue for a setback, commodity prices having accelerated their decline recently, more signs from China of slowing growth and steep corrective days for the Chinese and other overseas markets, the U.S. and Canadian markets suffered a quick 13% pullback from their peak.

We continue to believe money will be treated the best in the stock market. At just below our assessment of its fair market value (FMV), the U.S. stock market has an earnings yield of about 6% versus 10-year bonds yielding about 2.16%. And, we are able to construct a portfolio of large-cap global equities with earnings yields well above the market’s 6%. Apple, Ford and Celanese, three of our latest purchases have earnings yields of 8%, 11% and 10% respectively.

Unlike the large cap North American stock markets, the small cap resource stocks (and now the large ones too) have once again been stuck in a bear market. One that stemmed from the high commodity prices post the Great Recession and the ensuing oversupply of various commodities rather than economic weakness, making the declines from 2011 difficult to predict. Now though, in the same fashion that commodity prices overshot to the upside, we are seeing an even more pronounced overshoot to the downside. Unless we are in the midst of a global deflationary slowdown, which results in an even higher U.S. dollar, and a major global economic dislocation, then we see a major inflection underway. Lower commodity prices will cut supply, while demand continues to grow, somewhat from the lowered prices themselves, which should boost commodity prices in the months ahead, especially since some have fallen unusually below the costs of production. This ought to help support the stock market in general. Earnings for the S&P 500 have been flat to down slightly. But, without the energy sector whose weakness is masking overall strength, they’re up about 9%.

Trapeze Asset Management - Our All Cap Portfolios - Key Holdings

Our All Cap portfolios combine selections from our large cap strategy (Global Insight) with our best small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. Importantly, they tend to recover back to their fair values much faster than smaller stocks, so they can be traded more frequently for enhanced returns. We continue to increase our large cap weighting. However, our small cap positions are cheaper, trading far below our fair value estimates, and therefore our All Cap portfolios still hold a significant position in small caps.

Our small cap holdings have remained extremely undervalued, mostly attributable to the extended commodity bear market. Now that gold and oil prices are trading at or below the all-in cost of production, a rebound should not be far off. Most of the oil producers and gold producers globally have all-in sustaining costs above today’s low oil and gold prices. Normally, these commodities trade at a 30-40% premium to the industries’ average all-in costs. Although we’ve witnessed prices below industry costs in the past, it’s usually during periods of great economic dislocation and, even still, those periods are short-lived—typically lasting only several months.

Meanwhile, each of our small company holdings has recently had, or is about to have, a major positive transformational event which should assist in lifting their respective FMVs. Although these smaller, less liquid holdings, are potentially more volatile, the risk of permanent impairment appears minimal while upside potential remains high. We elaborate on these key holdings below.

Specialty Foods Group, a shareholding in a private company held in our taxable accounts, has been preparing to liquidate its assets through a wind-down. The company has placed $40 million (of its more than $50 million cash) in trust, earmarked to be distributed to shareholders, pending required Board approvals. Its remaining business line is performing very well and we expect it to be put up for sale later this year. The approval of the wind-down plan, including the distribution of cash held in trust, requires Board approval and the complicated corporate organization structure needs to be unwound before the remaining proceeds can be distributed. We expect a partial return of capital in the next few months with the balance by the middle of 2016. As at June 30th our carrying value rose again based on the third party valuation and, in our view, there still remains 10-30% upside to our carrying value, mostly dependent on the sale value of the remaining assets.

Orca Exploration is undergoing a number of changes which we see as transformational events. Since the IFC (an arm of the World Bank) is investing $60 million toward Orca’s $120 million expansion plans (terms are now being finalized), Orca is embarking on reworking 3 key wells and may drill offshoots or new wells if need be. This development work is being completed to significantly boost Orca’s production and assist in filling the new pipeline that, after years of waiting, is just now being completed by the Tanzanian government. Orca provides over 90% of the natural gas to the country which generates over 50% of its power, yet brownouts are the norm in the country as the pipeline has been needed to deliver sufficient gas to power plants.

Meanwhile, the government has been in a better position to pay its obligations to Orca, thanks to the World Bank which has been providing aid to the government. TANESCO, the national power utility and Orca’s primary customer, is meeting its current obligations to Orca and is reducing the arrears too. Orca’s cash (it has no debt) and funds still owed by TANESCO, net of payables, amount to about 75% of the entire share price. With an estimated reserve value of over $11 per share, the combined value is about 4 times the share price. Because the value is so high relative to the share price and the World Bank is now involved, downside appears minimal. The company’s long-life natural gas reserves, low operating costs and high netbacks should make the company of interest to potential suitors. Orca announced last fall that it had received unsolicited expressions of interest in all or parts of Orca’s assets. As the uncertainties in the country dissipate, perhaps some of these discussions may advance.

St Andrew Goldfields has been assisted by the falling Canadian dollar which has boosted profit margins. Gold, in CAD, is about $1500/oz. The Taylor mine was given the go-ahead by the company to move toward production and only awaits government approval prior to starting production in a month or so. Taylor’s initial results from its bulk sample were excellent showing 9 g/t. The company’s overall reserves and resources jumped by 25% last year and recent drilling results are indicative of an even further extension of mine life. The existing mines continue to perform well allowing the company to suggest production will come in at the high end of original guidance for the year. And guidance for next year is 125-135k ounces, a material lift from 2015. At today’s gold price, St Andrew should deliver free cash flow of over $25 million in 2016. With net cash in excess of $27 million and only about $90 million of EV (enterprise value—market cap plus debt less cash), the market continues to undervalue St Andrew at less than 4x free cash flow—on many metrics making the company the cheapest in its sector. The net asset value of the company, based on reserves only, at today’s gold price, is more than $0.60 per share, twice the current share price. If gold prices rise back to normal—at a reasonable premium to the industry average cost of production, in line with the marginal cost of production—upside should be even higher.

Manitok Energy has now completed its major acquisition of land, including 1,800 boepd of production, in the Wayne area, near its Entice properties, and acquired the other half, that it did not already own, of the checkerboard sections at Entice—all from PrairieSky Royalty. The company had some production glitches—tie-in issues—over the last year which caused production to stagnate. These glitches are nearly fixed. Total production should be a corporate record high in excess of 6,000 boepd by year end. More importantly, the Entice discoveries gave rise to several new oil pools but the new wells have not been on line long enough to offset the impact from declining energy prices. Manitok also renegotiated its arrangement on the freehold land it leases from PrairieSky whereby the royalty rate was lowered to a flat 17.5%. The required drilling timelines were extended too, helping concerns that previous terms may have proved onerous for Manitok’s balance sheet if energy prices were to remain low.

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