The Theory Of Relativity by Randall Abramson, Trapeze Asset Management
No, not Einstein’s theory. But the one that investors use to compare asset classes, as they relate to one another, to find those that are the best relative values.
These days with global growth relatively slow, inflation relatively low, central bankers relatively stimulative, government bonds at relatively (historically) low yields, stocks have been a relatively desirable asset class. U.S. stock markets are near all-time highs, rising smartly after a previous 12% correction. Some three-quarters of S&P 500 companies beat earnings expectations for Q3.
We are dyed-in-the-wool value investors, attracted to temporarily unpopular value stocks that tend to relatively underperform when interest rates are so low and riskier growth equities are preferred. We don’t believe that rates will continue to remain this low, and we believe that all the stimulation will tend to improve global growth. And inflation. China, Europe and Japan have all been stimulating. The U.S. Consumer Price Index rose 0.2% in October, the best in several months. In the meantime we seek companies in the undervalued category that have strong balance sheets to survive and to grow.
The strong U.S. dollar has hurt U.S. exports and inflation. U.S. GDP, up a disappointing 2.1% in Q3, is suffering from an inventory correction and an understandable trade deficit from the high dollar. U.S. factory activity grew more slowly in October. We believe these will run their course and with improved U.S. and global growth, and better commodity prices, equities will continue to strengthen, particularly the depressed value stocks including, obviously, the very depressed commodity stocks and neglected smaller cap companies.
We also believe many commodity prices are at or near their lows, that unemployment and wage growth should continue to improve as they recently have, along with improved economic activity (low oil prices alone are stimulative) and that these combined effects should drive corporate earnings and share prices.
Investors, overly concerned about a Fed rate hike, deflation, a seemingly vulnerable stock market and a potential recession, are being cautious and cash on the sidelines is growing along with high short interest. The Fed will likely raise rates nominally in December and the market will likely yawn from its relative insignificance and the fact it’s been discounted in the markets. Probably the biggest concern of the Fed is the high dollar relative to other developed country currencies. Its strength may continue and hinder growth and inflation but should help the economies of its trading partners who certainly need help. The U.S. dollar should ultimately weaken and commodity prices should improve. Commodity sentiment is so negative now we are likely near the bottom. Relativity at work.
Even though high price/earnings ratios and profit margins suggest U.S. markets are richly valued, our work does not suggest any bear market approaching soon or an imminent recession. And we see some extraordinary value opportunities in some unpopular areas. Stocks remain the asset of choice relative to bonds. Though retail sales are barely growing, consumer spending should improve. In China too, where fiscal and monetary stimulation is the order of the day. China’s new two-child policy should stimulate consumer spending—on diapers for sure.
The renowned economist Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.” Well, monetary growth is strong and high debt levels are the order of the day—everywhere. The U.S. government debt is a whopping $18.5 trillion. By way of example, Brazil and Russia, both in recession, are enduring considerably high inflation.
Commodity prices are sitting at floors while the U.S. dollar is at the top of a ceiling. Unless we are entering a global deflationary slowdown, today’s extremes should reverse. Gold, oil, copper and other commodities have fallen to their respective global average all-in costs of production. This has depressed resource heavy Canadian stock markets, particularly the junior ones, with the Venture Exchange Index now at an all-time low. Logic would dictate that the supply/demand influences should normalize commodity prices and that resource stocks have also likely seen their lows.
The U.S. market is fully valued though growing earnings and dividends should continue to provide an upward bias to the markets. And already bearish investor sentiment is also supportive of a market that should only endure normal corrections until the next recession. A recovery in commodity prices would also help support the overall stock market.
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 fair market values (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 stakeholders. It has a remaining business line which is performing very well. The approval of the wind-down plan, including the distribution of cash held in trust and the sale of the remaining business and distribution of its proceeds, requires Board approval and the complicated corporate organization structure needs to be unwound. We expect a partial return of capital from the existing cash in the next few months with further distributions thereafter, though the timing and amounts remain uncertain. Our current carrying value is based on a third party valuation as at June 30 and, in our view, there still remains upside to our carrying value, mostly dependent on the sale value of the remaining business.
Orca Exploration finalized its agreement with the IFC (an arm of the World Bank). The company can now draw on up to $60 million if needed. Though, Orca’s needs may have diminished as it has now reworked 2 key wells successfully and a third is underway and the costs are significantly below original estimates. The development work significantly boosts Orca’s deliverability and a production boost should follow over the next 12 months. The country’s new pipeline is now operational. Orca still provides nearly all of the natural gas to the country and given the droughts and agricultural requirements, hydroelectricity should no longer be a competing source of power. And the addition of new power plants powered by natural gas will materially boost demand in the region.
The World Bank has also been providing aid to the government allowing TANESCO, the national power utility and Orca’s primary customer, to meet its current obligations to Orca. We still expect Orca to receive all its 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. The country reelected the incumbent party, though with a new President committed to stemming corruption and increasing efficiency. We believe the new government officials will now work expeditiously to bring Orca’s dearly needed gas to market.
St Andrew Goldfields recently entered into an agreement to be acquired in a share exchange by Kirkland Lake Gold. The deal was done at a 46% premium to both companies’ 20-day volume-weighted average price, allowing St Andrew to trade closer to its FMV. Since Kirkland is also undervalued, in our view, there remains healthy upside. Kirkland is amongst the highest grade gold miners in the world. Given its proximity to St Andrew, it was a natural fit to combine these two companies in the Timmins/Kirkland Lake camps. The combined company should produce around 300,000 ounces in 2016, making Kirkland an intermediate producer which should trade closer to its net asset value. We expect the company to deliver significant free cash flow enabling it to pull harder at each entity’s respective land packages. Kirkland has had excellent ultra high-grade exploration results recently and St Andrew brings along its 120 km expansive land package with many regional drill targets. The combined company is worth about $0.60 in St Andrew share terms in our estimate, even at today’s gold price, providing good upside potential. Once gold prices rise back to normal—at a reasonable premium to the industry all-in average cost of production, in line with the marginal cost of production—there should be even more upside.
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