At Kingwest, we are long-term investors in businesses. We assess how much a reasonable person should be willing to pay to own the entire company. We invest only when the share price is at least 40% less than our assessment of intrinsic value. We prefer businesses where value is increasing.
We sell when the share price approaches intrinsic value, and continue to reinvest in other opportunities where the discount to intrinsic value exceeds 40%.
The share price rally that started in March 2009 continued until May 2010. Since then, stock markets around the world have retreated. At the end of July, the TSX was down 4.9% from its high in May, and up 1.3% for the first seven months of the year. The pattern is similar in the US where the market declined 9.7% from the May high and 1.8% since the beginning of this year (all in US$.) The story is similar in Europe and even in the booming emerging economies of China and India.
Right now equities are cheap and corporate balance sheets are also the strongest in history. The companies in our portfolio are generating cash at very strong rates and prospects for the next two to three years look even better. At June 30th, the psychology of the stock market however, couldn’t have been worse; since then the situation has improved slightly. When share prices and company values are disconnected, as they are now, there is great opportunity. This is such a time.
The sell off in the markets in the last half of June was very disconcerting to many. Are you actually surprised that after fourteen months of an almost unprecedented stock market rally there should be a pause? Are you surprised that the pace of recovery from the worst recession of the past sixty years is not a neat straight line? Past recoveries, no matter how strong, have never been without fits and starts. Why are we holding this one to a higher and perhaps impossible standard?
Is this a normal cyclical pattern, a momentary pause in a long expansion, or is it signaling the end of the economic recovery? We strongly believe that expansion is continuing, and your portfolio is structured to take advantage of this. In this letter, we will explain why we continue to be confident in the ongoing expansion and the equity markets in North America.
There are four reasons to be optimistic or, at the very least, less pessimistic:
1. The economy is growing
The media is alarming us by turning to a plethora of pundits all calling for a “double-dip.” Interestingly, it is these same economic forecasters who doubted and dismissed the recovery that began in March of 2009 who are now being quoted in the press. They keep looking to where we have been, rather than where we are in their forecasts.
Yet Nouriel Roubini, (who is known as “Dr. Doom”) dismisses the “double-dip” as not likely either in the US or globally. Roubini, who remains one of the leaders of the pessimist camp, looks for slow growth, not negative growth.
Nominal GDP in the US and Canada each attained their highest levels ever at the end of March 2010 - yes, higher than the peak in 2008 – although real GDP is still 1 – 1.5% below the peak in North America. The forecasts of even the most negative of pundits expect real GDP to exceed the previous peak before the end of this year.
So why the negativism? Since March, the slow pace of job creation in the US (note it is still positive) and flat GDP in Canada for April has led to concern for some. Job creation always comes late in a recovery. The last recession ended in November 2001, but job losses continued for more than a year and half until June of 2003, ditto for the 1990-91 recession. In short, the data is much more positive than the newspapers would have you believe. Although prospects may be improving, businesses will want to ensure the improvement is durable before hiring new people, and then generally they hire temporary workers before they increase full time employment. (Hence our investment in Robert Half Corporation, the world’s largest provider of temporary personnel in the fields of accounting and finance)
2. Corporations are strong
Business activity at the firm level continues to improve as measured by both the magnitude of upward sales and profit revisions as well as the breadth of positive earnings revision sentiment. Going into the second half of 2010 North American companies are very strong both in terms of the stability of their balance sheets and in their ability to generate cash.
The US Federal Reserve reports that US corporations had over $1.8 trillion in cash and other liquid assets at the end of March. Cash comprises 10.4% of the assets of corporations, near the highest in history. This cash sits on company balance sheets, waiting to be deployed when managers grow more confident that the outlook is improving.
Corporate Canada is also awash with cash to a similar degree as our southern neighbours. When this cash is invested it will drive further economic growth.
3. Stock valuations are low
Cash holdings by S&P500 companies are at or near the highest it has been in 25 years, as is the ratio of Free Cash Flow (cash earnings in excess of required capital spending) to stock market capitalization- a measure of cheapness. Companies are continuing to pile up cash, yet share prices do not reflect it. Just look at the charts below.
Shares of North American stocks trade at a 5% yield premium to 10-year government bonds. The S&P now stands at about 11 times next year’s $93 consensus estimate of net income from operations, and it yields 2.2%. What does this mean? It means that investing in a company’s earning stream today will earn you 5% better return per year than investing in a bond. These are the earnings of today; they do not account for any growth in the future. This earnings yield premium is the highest it has been in 20 years.
“Grant’s Interest Rate Observer” of May 28 had a headline article entitled “Buy beer, sell bonds.” The point of this article is that it is riskier to buy a US 10-year Treasury bond yielding 3% than it is to buy shares in Molson Coors Inc., a brewer whose earnings yield exceeds 9%. At a 3% yield, the bond will give you a zero return after accounting for both taxes and inflation. On the other hand, a well-run brewer can make money during tough economic times (beer has been consumed for over 4,000 years) and it will participate in better times as well. Overall at these levels after taxes and inflation the brewer is better – so good in fact that Molson Coors is part of your portfolio. (If you would like a copy of this article please call or e-mail us and we would be happy to send it to you.)
4. Our Portfolio
While we have made the case for the equity markets in general, our portfolio today is even better positioned. The companies in our portfolio have the benefit of strong, stable cash flows and very attractive prices.
H&R Real Estate Investment Trust owns over $5 billion of office, industrial and retail properties across Canada and the U.S. Its tenants include Bell Canada, Canadian Tire, Home Depot, and Royal Bank, to name a few. H&R is currently constructing The Bow, a 2 million square foot office tower in Calgary entirely leased to EnCana for 25 years with annual rental escalations. There are plans for an additional 200,000 square feet of retail and cultural space to be built on adjoining lands. In November 2008, the financing for this project was up in the air due to the financial upheaval. H&R had to borrow $200 million at an exorbitant cost of 11.5% and also accept covenants that limited annual distributions to H&R’s unit holders. This spring, the REIT sold $230 million of bonds with an average yield of 5.5% and repurchased the high cost loan. At present, H&R distributes only half of the cash it earns from operations (most REITS pay out over 90%) and the units yield 5.0%. The company has stated that it will raise the distribution from the current $0.84 per year to $1.05 by April 2012 (the completion date of the Bow). The distribution rate at that time will be less than 60%. If the distribution rate were to rise to its historic level and the shares were to sell at a yield similar to other REITs, the units would trade at a price 50% above the current level plus you would have received distributions in the intervening period averaging 5.5% per year. This investment looks to return better than 30% annually in each of the next two years.
Vodafone Group plc. (VOD) is a new investment in the US equity portfolio. Vodafone is one of the world's leading mobile communications companies operating across the globe providing a wide range of communications services to over 341 million subscribers.
Vodafone’s core consolidated operations in Europe, Asia, the Middle East, and Africa produced $3.7 billion of Free Cash Flow in the March 2010 quarter – that was up 25% from the previous year. They generate in excess of an 8% equity Free Cash Flow yield with a dividend yield of over 7%. This valuation attributes no value to VOD’s most significant asset, a 45% ownership in Verizon Wireless the #1 U.S. cellular operator. Vodafone neither consolidates Verizon Wireless in its earnings nor receives dividends from it. We believe that this has led the market to ignore its value, despite significant growth in revenue, EBITDA, and cash flow.
Verizon Communications, which owns the other 55%, has been using the cash flow from Verizon Wireless to repay debt owed to it. That debt will be fully repaid within the next few months. At that point we expect Verizon Communications will reinstate the dividend to maintain its cash flow from Wireless. We believe that any changes that reveal the value of VOD’s stake in Verizon Wireless will cause the market to re-rate VOD shares. Verizon Communications has always stated that it “would be willing to buy the 45%.” As we wait, we collect a nice dividend. If we ascribe the EBITDA of Verizon Wireless pro rata to VOD and that of it’s other unconsolidated assets as well, VOD trades at less than 3x estimated 2010 EBITDA, versus a comparable multiple in excess of 5x for the peer group average in Europe. We acquired the shares at just over US $20 and expect to double our investment within two years.
There is a big disconnect today between the common sense economics of companies and the psychology of the market. Even employing the economic forecasts of the pessimists, the return potential for equities over the next few years is good. If the economy and corporate profits progress according to most economists, the potential is tremendous. If you are patient and can take a longer view, even just the next couple of years, we are confident that you will be handsomely rewarded from equities.
Rates still remain at historic lows with the 10 year Government of Canada bond yielding 3.1% and the 3 month T-bill 0.7% at the end of the July. The long Canadian Government bond- a 27 year term - yields just 3.7%. With the prospect of rising rates and future inflation, we continue to keep your fixed income portfolio in shorter-term maturities to guard against capital depreciation and to take advantage of reinvesting at higher yields in the future.
We look to the future with confidence. Please feel free to contact us if you have any questions.