Trapeze Asset Management commentary for the second quarter 2017, titled, Myths and Misconceptions.
History shows, and investment strategists tout, that small cap stocks are the best performing asset class. While small caps outperformed the runner-up, large cap stocks, over the last nearly 100 years, research has shown that the outperformance hasn’t persisted over all multi-year time periods and that the outperformance is concentrated in microcap stocks.
We have always been go-anywhere, all-cap, investors. In the early 2000s, when we were finding little value in large caps and a plethora of value in small caps, we became concentrated in that area. And while our declared preference is to be all-cap investors, availing ourselves of a greater opportunity set—knowing that smaller companies can get absurdly undervalued which rarely occurs with larger companies—our preference is to emphasize large caps. Because we do believe potential returns from large caps can match that of small caps. Larger, more well-known companies trade more efficiently; and therefore, tend to revert more quickly to fair value. Also, in order to use our macro overlays—which are designed to alert us to a recession or bear market—we wish to have the opportunity to exit positions, rather than being liquidity constrained (as one might be in small caps), in order to limit the impact of market drawdowns.
Value vs. Undervalued
We don’t buy value stocks per se. We buy undervalued stocks. There’s a difference. Value stocks are generally understood to be those that trade at low multiples of earnings or book value. And many investors practice their trade by purchasing what they believe to be cheap stocks by finding those that are trading at relatively lower multiples than the market or industry peers. We prefer a stricter approach, analyzing companies and arriving at appraisals of fair value such that we have an absolute (as opposed to relative) view of the company’s price with respect to our fair value estimate. We believe this approach offers a better margin of safety and provides us with the ability to have appropriate targets—fair market values (FMVs) where we look to exit positions. Most stocks trade between undervaluation and fair value. Once fair value is achieved, the best one can hope for is to track a company’s growth rate but the stock becomes more susceptible to a downturn from any overall change in the expected growth rate or other factors impacting its value.
Growth vs. Value
Observers also like to distinguish between growth and value stocks. Generally, growth stocks are those that trade at high multiples and whose earnings are expected to grow at a fast clip, whereas the opposite view is held for value stocks. Again, here, we have a different opinion. Most of the time, a company must be growing, and at a decent pace, to justify it being good value—though a company can have flat or declining earnings and still be undervalued, if its price is too far below the expected future free cash flows of the business. However, normally it’s a value trap—a company that appears undervalued but whose fundamentals are deteriorating, in turn eroding fair market value along with its share price. We seek to own companies whose FMVs are growing up and to the right—companies whose earnings are ever-advancing but for various reasons, usually a recent setback, the share price has declined or remained flat while our view of underlying FMV remains higher.
While this may sound academic (i.e., too technical), it’s an important distinction. It has led us to focus on the type of securities we prefer to own. Research over many years has shown that owning value stocks over growth stocks leads to market-beating results. We have always embraced that research. However, we try to focus on companies that aren’t just undervalued but also have steady earnings growth rates, generally higher quality businesses that are strong operationally and financially, in an effort to also mitigate losses.
Fully Invested vs. Hedge?
It’s generally believed that one should be fully invested at all times. The reasoning is simple. If stocks are the highest returning asset class and if market downturns are difficult to predict—there’s always some prognosticator calling for doom and gloom—then one should ignore the noise and remain “in it to win it.” Here too we differ. In spirit we agree—one should be fully invested most of the time—because over two-thirds of the time we are in a bull market. If, on the other hand, one could forecast the timing of the other third—the bear market—one could avoid the drawdowns. Something business schools teach can’t be done—to have our cake and eat it too.
We don’t like drawdowns and our clients detest them. And, simply put, when FMVs are falling, so are share prices. When are most company values declining? In a recession. So we developed an Economic Composite (TEC™) to alert us to recessions both in the U.S. and abroad. Similarly, we developed a market momentum indicator (TRIM™) to alert us to bear markets—those that decline by more than 20%. And, in periods when our alerts aren’t triggering, like today, we should have even more confidence to be fully invested. Though, one key caveat now, we still need to be able to find enough investment opportunities that meet our criteria—currently not an easy task. In our large cap only portfolios we have held an outsized cash position which has restrained our returns. Not because we have been bearish, but for lack of our ability to find enough attractive opportunities, not for lack of looking.
Undervalued vs. Overvalued
There are countless opinions as to whether the U.S. stock market is currently overvalued or not. In order to arrive at a conclusion that the market is undervalued the assumptions need to include that interest rates will remain permanently at today’s levels or lower, that corporate tax rates are headed lower and that economic growth will uptick. Many argue that stock markets are overvalued because earnings multiples are near all-time highs, that growth is weak, that the bull market has gone on too long and that large government debt will weigh too heavily on the global economies.
However, we are still witnessing few excesses, anemic growth and muted inflation, such that near-term prospects of a global recession remain unlikely. Our TEC™, designed to alert us to recessions in various regions around the world, is suggesting the same. U.S. equities remain near all-time highs and around fair value in our work. But, absent a recession, we don’t anticipate a bear market. Stock markets peak when there’s over-exuberance at a time when economic growth is about to be quelled. And our TRIM™ stock market indicators are on buy in most regions too, providing confidence in a continuing extended bull market.
The market is setting records for duration without even a normal-course 5% correction. However, we still anticipate a normal market correction, which averages about 6% during a bull market. Most of the stocks we analyze are near either side of fair value. So we await a healthy correction to find more attractive opportunities to get more fully invested.
Passive vs. Active
At the bottom of the market, passive investing can make a lot of sense. When bargains abound it can pay to invest broadly—to have exposure to everything and limit the risk of a few holdings preventing outsized returns. However, when valuations are full, or markets are overpriced, then caveat emptor (buyer beware) as broad exposure can be riskier than holding a better mix of undervalued stocks.
Because the markets are fully valued and growth rates are low, the U.S. market is exhibiting the lowest prospect of long-term returns in years. The Value Line appreciation potential index, which has been remarkably accurate over the years, is forecasting a 5-year return of only about 6% per year—in the bottom decile since the late ’60s. And a 60/40 asset mix (60% S&P 500 stocks, 40% U.S. 10-year bonds) which before fees has returned 8% per year since 1880, half of which came from bond yields, looks like wishful thinking today given a 2% government bond yield, a fully-priced stock market and the lowest economic recovery rate of the last several economic cycles.
Risk On vs. Risk Off
Risk is on now. But central banks are becoming more restrictive. Government balance sheets are becoming lopsided—the Fed’s has grown by almost 5-fold since ’08. While there’s little risk of a severe economic downturn, there are signs of slowing. U.S. hiring slowed in August and the unemployment rate ticked up, though to a still low 4.4%. Retail results have been poor as the consumer appears to be in a lull. We watch some economic stats carefully, in case a yield-curve inversion—the primary driver of our TEC™ alert—does not occur due to artificially administered low interest rates. We want to make sure we are prepared when risk goes off again.
Our Strategy
The U.S. markets are at all-time highs and with volatility historically low, bargains, especially large cap ones, are quite scarce.
We sold a number of positions as they ran up in price relative to our FMVs. We have also been able to purchase a few holdings that passed our due diligence process where we have found them at a wide enough discount from our estimate of their FMV, with favourable earnings outlooks. Our objective is to continue to add more large cap positions to our All Cap portfolios as we find compelling ideas and as our current smaller cap positions are sold when they rise close to our FMVs.
We prefer to be fully invested in order to reap the potential rewards from our holdings. However, if appropriate investments can’t be found, then we would rather hold cash until opportunities arise. Volatility in the overall market will again rise and volatility in individual stocks will always be present. We don’t expect to have to wait too long before those companies in which we are interested in investing meet our criteria.
We have recently found bargains in two commodity sectors, precious metals and oil & gas. Until its recent ascent, the gold price was just above the cost of production for the average producer. Oil is still hovering around the cost of production. Global oil inventories have declined sharply, which we expect to continue over the next several months. The typical 30-40% premium to these commodities’ all-in costs should soon return. Gold is nearly there. After falling back to floors in our TRACTM work, the price of gold inflected back up, giving us a buy signal and we expect WTI (Brent crude has already) to do the same. Both commodities appear to be in bull markets again.
After noting in our last letter that the Canadian dollar had been weak, it did a complete about-turn. Commodity prices have recovered, Canada’s GDP growth rate has accelerated to 4.6% and the 2-year interest rate differential suddenly favours Canadian bonds over U.S. Treasuries with each having helped pull the CAD back to its fair value (purchasing power parity) of around $0.82. On the way up, we eliminated most of our hedge for taxable CAD accounts.
Our Portfolios
The following descriptions of the significant holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described. In a new format below, to keep our letters more concise, we discuss each of our new holdings but do not provide updates on all of our key holdings, only where there have been material developments.
All Cap Portfolios and Recent Developments for 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. However, our small cap positions are cheaper, trading far below our fair value estimates; therefore, our All Cap portfolios currently hold a meaningful position in small caps.
Most of our small cap company holdings trade well below our estimate of their respective FMVs. Although these smaller, less liquid holdings are potentially more volatile, the risk of permanent impairment in our small cap holdings appears minimal while upside potential remains high.
Orca Exploration announced government approval to double its Songo Songo gas supply. So the company should begin growing again over the next year. And separately, the company also announced a possible minority investment—from a local Tanzanian group that could be as much as US$139 million, which would assist in demonstrating the company’s considerable value. Orca has also indicated that it expects to collect full payment of the total TANESCO receivable.
Kirkland Lake Gold raised production guidance and delivered a reserve update for Fosterville, its core Australian mine, that more than doubled Fosterville’s reserves. Grades were up significantly to about 18 g/t and drilling results have been way ahead of expectations.
Manitok Energy has announced mergers with 2 smaller groups and 1 larger company. The amalgamation with Questfire Energy should close in the next few weeks, making the company an 11,000 bpd producer and should be accompanied by a refinancing of its debt obligations that should relieve the company of market concerns surrounding its current lender which has rattled the market since mid-’15 when the lender unusually requested that a material amount of its demand loan be repaid.
IAMGOLD’s net asset value jumped substantially after the company announced its Rosebel reserves jumped by nearly 80% to 3.7 million oz. The company then announced its Saramacca property in Suriname added an initial resource of 1.5 million oz.
Corridor Resources entered into a settlement with the Quebec government essentially ending the Anticosti project but the company received $19.5 million plus other costs for its 21.7% interest. This leaves the company with net working capital of about $53 million, around $0.59 per share.
All Cap Portfolio Changes
In the last few months, we bought a few new large cap positions including CIBC, Foot Locker, Dollar Tree and Seven Generations Energy—all summarized in our Global Insight portfolio review below. We sold New York REIT, KBR and Dick’s Sporting Goods as each triggered sell signals falling below their respective TRAC™ floors and Baidu, Liberty Media Sirius XM, and Naspers as each ran up to a TRAC™ ceiling, close to our FMV estimate. We have also reduced our Kirkland Lake Gold weightings as it has run up too. The following are smaller cap companies we have recently purchased:
Wesdome Gold Mines, a small-cap position, was added after this Ontario-based company’s share price fell back to a significant discount to our FMV estimate of $3.70. The company has a 30-year production history but is just now emerging as a more significant producer. Good growth is expected as it moves from 50,000 oz. of production annually to 80,000 oz. over the next 3 years. The company is in a net cash position, has the highest grades in the Western Hemisphere, next to Kirkland’s Macassa mine, and potential from its fully permitted Moss Lake and Kiena regions, where drilling results have been strong. Ongoing drilling on Wesdome’s previously underexplored properties should markedly expand the company’s resources and reserves. The company is headed by St Andrew Goldfield’s former CEO who has brought aboard other strong former coworkers.
Whitecap Resources is a mid-sized oil & gas producer with assets in Alberta and Saskatchewan. The company has long-life reserves, low decline rates and produces predominantly oil (82%) at above-average netbacks. Its leverage ratios are better than peers and it pays a reasonable dividend (currently yields 3.0%) from its stream of free cash flow. We anticipate an organic production growth rate in excess of 10% per year. Its economics are solid with type curves showing less than 1-year paybacks on wells drilled—implying very high IRRs. It too trades at a significant discount to our $13 FMV estimate.
Howard Hughes is a real estate development company operating in 14 states whose primary assets are in Houston, Honolulu, Las Vegas and New York. The company has shown the ability to grow its net asset value at a fast pace, though the market has not fully valued its parts due to a lack of earnings visibility and the long-term nature of its large-scale projects—master planned communities and mixed-use properties. Concerns related to the company’s Houston assets as a result of the energy downturn and hurricane Harvey have also unduly impacted the perception of investors toward the overall company. With several projects nearing completion, our $180 FMV estimate may prove conservative.
Global Insight (Large Cap) Portfolios and Recent Developments for Key Holdings
Global Insight represents our large cap (typically with market caps over $5 billion at the time of purchase but may include those in the $2-5 billion range) model where portfolios are managed Long/Short or Long only. A complete description of the Global Insight Model is available on our website. Our target for our large cap positions is more than a 20% return per year over a 2-year period, though many may rise toward our FMV estimates sooner should the market react to more quickly narrow their undervaluations. Or some may be eliminated if they decline and breach TRAC™ floors.
At about 80 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear to be cheaper, in aggregate, than the overall market. Because of the run-up in stocks, and that the overall markets appear fairly valued, we are finding fewer investment opportunities and therefore are holding much more cash than usual.
There were no material developments for our key Global Insight holdings since our last newsletter.
Global Insight (Large Cap) Portfolio Changes
In the last few months, we bought several new positions including CIBC, Dollar Tree, Foot Locker, RioCan REIT, Total, the Vaneck Vectors Gold Miners ETF, Oracle and Seven Generations Energy. We sold Dick’s Sporting goods as it triggered a sell signal falling below its TRAC™ floor and we sold Baidu, Liberty Media Sirius XM, and Naspers as each ran up to a TRAC™ ceiling, close to our FMV estimate.
CIBC is our favourite Canadian bank. We believe the market is focusing on its relatively higher mortgage exposure and ignoring its strong wealth management results and growing U.S. business. To be sure, Canadian housing values are overheated, especially in Vancouver and Toronto. However, CIBC’s average loan-to-value for mortgages against properties in these two areas are 46% and 52%, respectively. Our FMV estimate is $120.
Dollar Tree reported Q2 EPS of $0.99, exceeding analyst expectations. EPS guidance for this year was raised and stores recorded 2% year-over-year comparable sales growth, the 38th consecutive quarter of positive results. Family Dollar, acquired in 2015, returned to growth with a 1% comp. Many Family Dollar stores remain in substandard condition, representing a huge opportunity for Dollar Tree. As we expected, the Trump administration has abandoned plans to tax goods from China. As a fully domestic retailer, a reduction of the federal corporate tax rate would be a significant boost to earnings. However, with nearly $7 billion in debt, changes to interest rate deductibility may eat into any benefit from a lowered tax rate. Our FMV estimate is $95.
Foot Locker experienced a substantial decline in its share price after reporting disappointing Q2 earnings. In May, Foot Locker’s management provided Q2 guidance of low single-digit comparable sales growth and anticipated a strong second half of the year. It came as quite a shock when, just 3 months after this promising outlook, management reported Q2 comps of -6% and forecasted a 20 to 30% decline in second half earnings. According to management, Jordan sales were down “considerably” and certain Adidas models slowed beyond expectations. Hot products were in short supply so consumers either left the store empty-handed or gravitated to markdown product, hurting margins. With new, innovative products around the corner from key partners such as Nike and Adidas, we believe Foot Locker will post positive comp sales in ’18. Online competition is growing (e.g., Nike’s recent deal with Amazon) but Foot Locker remains a key destination for premium sneakers and will continue to be a key partner for the major shoe and apparel brands. We have lowered our FMV estimate to $45 from $70.
RioCan REIT’s price dipped back to where we believe it’s trading at a discount to our FMV estimate of $29. The market may have been preoccupied with the Target Canada fiasco, though it’s more than halfway unwound, with new tenants paying over a third more than Target was paying. And rising interest rates have impacted real estate in general. RioCan is a dominant shopping centre owner in Canada. Its tenants remain some of the strongest and most stable retailers. The company has been reducing debt substantially and we expect it to be in a position to raise its distribution in early ’18 as the payout ratio has pulled back to 80%. In the meantime we collect a healthy 5.9% yield.
Global oil giant Total is poised to deliver strong production growth and free cash flow—even should oil continue to hover around $50/bbl. High cost assets such as Gina Krog have been sold or fully exited with Fort Hills and Martin Linge likely next. Total’s $7.5 billion purchase of Maersk Oil will improve its upstream breakeven point. With an eye to the future, Total is slowly expanding its low carbon production and expects 20% of profits to come from renewables by 2030. Our FMV estimate is €55.
The Vaneck Vectors Gold Miners ETF provides exposure to a diversified basket of the largest gold miners globally. After receiving buy signals in both our TRACTM and TRIMTM tools, corroborating our fundamental view, we chose to have a heavier weighting in this group, complementing the 2 undervalued positions—Kinross and Goldcorp—already held. Oracle’s cloud revenues should hit $5 billion soon, comprising more than 12% of total revenues. This is a key milestone for the company and will drive total revenue growth going forward. Cloud revenues rose 65% over the last year and, coupled with steady on-premise results, should lead to total revenue growth of 3-5%. As cloud represents a larger share of revenues, margins should expand too. We see free cash flow growing at twice the rate of revenues. Our estimate of Oracle’s FMV is $58.
Seven Generations Energy is an oil & gas producer with assets in Alberta’s high-quality Montney Formation—Canada’s premier region. Seven Gen has experienced extremely strong production growth which we expect to continue, though at a lesser pace. The Montney allows the company to have highly efficient fracking and higher recovery factors and industry leading IRRs. The company’s NAV grew by more than 50% in 2016. It trades at a significant discount to our FMV estimate of $34, despite having a less levered balance sheet, a substantially higher growth rate and higher IRRs than industry peers.
Income Holdings
While the 10-year U.S. government bond yield has dipped back to 2.2%, the Canadian equivalent has risen substantially to 2.1%. We expect rates to rise from these relatively low levels. High-yield corporate bond yields have been relatively steady recently, after leaping to a 10% yield early in ’16, and now sit at 5.6%. The spread to U.S. Treasuries is one of the narrowest historically. Because we have been finding fewer attractive opportunities than usual for our income accounts, we have been holding a larger than usual portion of the accounts in cash while we await more favourable investment opportunities.
We did buy RioCan REIT which is summarized in our Global Insight section above and added to our Cominar REIT position, after it announced a plan to divest certain assets and refocus on its core area.
We sold New York REIT. It fell in response to issuing a disappointing NAV estimate which was below our expectations and then broke below a TRACTM floor. And we sold Care Capital Properties REIT after it rose but then fell somewhat as its merger partner, Sabra Health Care REIT, whose shares Care Capital was to be exchanged into, also fell below a TRACTM floor.
We continue to hold a number of undervalued income positions and collect outsized interest income on these positions due to the depressed prices. Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of over 8%.
Of note, regarding our top holdings in our income accounts: Manitok collateralized notes should benefit from even better asset coverage with its recently announced acquisitions; and, Ruby Tuesday is reviewing strategic alternatives which may lead to the outright sale of its business—since a change of control leads to a forced call at $101, we may sell our position as it’s nearing that level.
Just the Facts Jack
The complacency of the market continues. The VIX—the volatility index—is now at historic lows. Even with issues like debt ceilings, North Korean missiles, Chinese credit excesses, potential Russian incursions, Trump (no elaboration necessary), hurricanes, peak auto cycle, and deteriorating retailers, the market hangs in. We believe it’s because of low inflation, low interest rates and few investment alternatives, along with anemic growth rates and no material economic excesses which prevent the central banks from clamping down.
It’s our task to cut through what might be hype and to try to assess the facts to the best of our abilities. We keenly watch for the end to the bull market—monitoring our TRACTM, TECTM and TRIMTM signals for negative inflections, for the next recession, and for the ultimate market panic that usually follows. When those tools signal, we intend to attempt to diminish and, where we are authorized by clients, hedge off risks. Meanwhile, we continue to hold what we believe to be good absolute values, stocks trading below our estimate of their FMVs. And we’d welcome a correction to find more of the same to become more fully invested.
Herbert Abramson and Randall Abramson
See the full PDF below.
