Looking Forward and Building Long-Term Value
Financial markets in both Canada and the US bounced back nicely in the first four months of 2019 recovering all the losses sustained in the last 3 months of 2018.
Over the last 18 months, there has been a heightened sense of uncertainty in financial markets. The second half of 2018 began with the stock market at record highs, which moved steadily downward throughout the year, as fears of recession intensified. While it is the nature of financial markets to be volatile, both stock and bond markets suffered negative returns in 2018 for only the second time in three decades. Then they recovered almost completely this quarter, reminiscent of the first quarter of 2016.
On top of that turmoil, political events have been unsettling. Brexit is in disarray, causing uncertainty and unnecessary costs for nearly every global business. Rising populism, the source of protests in France, and new governments in Mexico, Italy and Brazil, are disquieting the political landscape. US sparked trade disputes ebbed and flowed throughout the year, increasing still further uncertainty about the global economy.
All of this creates a frustration and confusion in financial markets. Most people respond by shortening their time horizon and try to anticipate these largely unpredictable events. They emphasize speed and whim over substance. For them, everything centres on the present – what to do now, only to do something else tomorrow.
A glance at the chart below shows stock prices are nearing the peak level last seen in October 2018. Should the rebound in economic data prove less soothing than hoped, it may be challenging for equity prices to continue their upward trajectory.
The S&P500 index has led the way and is now above last year’s peaks. At the beginning of April, Wall Street was already looking beyond the first negative year-over-year quarterly earnings season since 2016. The consensus estimate for first quarter 2019 earnings is a decline of 3.9% — that should mark a trough. However, earnings so far are stronger than estimated and with 46% of the S&P 500 reporting earnings have only declined 2.3% year-over-year.
The recovery in share prices so far this year reflects the more accommodative Fed policy, and the financial markets expect even more easing. In November of last year, the US 30-year bond reached 3.5%; it now yields 2.7%. Shorter interest rates fell commensurately — the US 5 year note went from 3.1% to 2.3%. The same thing happened in Canada. The 10-year Canada bond peaked in October at 2.6%; it is now 1.7%. And the 2-year yield has dropped from 2.3% to 1.6%.
Futures markets are predicting that this trend will continue throughout the year with yields on short dated instruments dropping another 0.4%. That supports improving markets. We shall see if it comes to pass. The jury is still out.
Given the Fed’s nascent signs of tolerating greater inflation pressure after undershooting for much of the decade, any late cycle shift to higher rates is a 2020 story at the earliest.
Kingwest’s long-term success depends on our ability to help people build better financial futures. Our focus is resolutely on the long-term. Our clear sense of purpose and our culture drives the passion and the innovation that has differentiated us since 1982, and ultimately delivers our results. We all live and breathe it every day.
Kingwest is built to protect and grow the value of our clients’ assets. Over the last 25 years, we have delivered annual returns well in excess of the market. This performance has come from one thing above all else: our unwavering commitment to our purpose.
Tim was going over some old letters a while back, and he came across the following that we wrote 12 years ago. It was relevant then; and is equally relevant now. We thought we would repeat it today as an affirmation of how we see things, and as a confirmation of the consistency of our investing model.
“We operate like a business owner, not a stock market speculator. We focus on the fundamental economics of a business and its ability to improve its cash flow over time. The more cash the business can generate for its owners, the more it is worth.
We look to what a business is capable of in a “normal” environment, focusing on the critical drivers to their success, and arbitraging the market’s myopic approach versus our longer view. While this fundamental, long-term approach can cause returns to vary relative to the index in the short term, it has proved to be a source of outperformance over the longer term. We maintain our disciplined approach in stressful times as others capitulate. That is a major source of competitive advantage for us.
Above average gains in good times are not proof of a manager’s skill, it takes superior performance over an entire cycle to prove that those returns were earned through acumen, rather than by taking additional risk.
Understanding market inefficiency is critical. Performance in the stock market is driven not only by actual performance, but also by the market’s expectations of that performance. While in the long run securities prices gravitate towards their fair value, in the shorter term, people often overreact to dramatic and unexpected news thereby causing price and value to diverge, sometimes dramatically.
Successful investing is about recognizing these distortions and having the confidence to take a position contra to conventional wisdom. Our job is to understand the market’s view, how our view differs, and to develop the evidence to give us sufficient comfort that our view is correct.
The route to achieving consistently excellent performance is through superior knowledge of companies and their competitive position. Our investment process is entirely bottom-up. It is based on our own company specific research. Our due diligence starts with what we know, the assets, moves through new developments in the company’s affairs, and the likely consequences of those developments.
Investing is all about the future. You lay out money today to get a return in the future. Past occurrences are relevant only as much as they reveal something about future behaviour.
You do not drive a car by looking in the rear view mirror; you do not invest that way either. Traditional value investors have a backward looking approach. They search for opportunities statistically, looking at past items, such as low multiples to earnings, sales, cash flow or book value. Then, they review the business to see which possess pre-determined attributes necessary to qualify as a “good business.” If it passes the test, they buy.
Our approach looks forward: Kingwest investment principles derive from the late Benjamin Graham, the father of financial analysis. We look for mispriced securities. We emphasize companies that build long-term value, even in economic or market downturns. This does not mean that the share price will not be volatile but that the underlying business value will be continually improving.”
These are the investing principals that have served our clients and ourselves well over the last 37 years and will no doubt serve us well into the future.
The moves we have made in your portfolio recently highlight this strategy.
Brookfield Property Partners LP (BPY.UN)
We bought BPY in late January this year at $24.19. We believe that the company is worth $45 per share and expect it to trade at that price in 2 years.
Brookfield Property Partners is the flagship real estate vehicle for Brookfield Asset Management, one of the largest alternative asset managers in the world, who own 53% of the company directly. In its financial statements, BPY has stated that the net asset value of its real estate assets is US$28 per share, or about $40 Canadian. In addition, it has developments under construction that when completed and fully leased over the next 2 years will add another $5 to that asset value.
Why is BPY mispriced? Brookfield Property was originally established in 2014 to hold shares in other public real estate companies. Securities holding companies normally sell at large discounts to their value, and BPY was no exception.
As we said above, we often take a contrary view. Over the last few years, the business has transformed into owning real estate directly. It now owns some of the best office properties in major cities around the world — Toronto, New York, London, for example. BPY is the second largest shopping centre owner in the US, owning only valuable A centres. We believe the market is in the process of transforming its view of the company from a holding company valued at a discount to an operating company valued at asset value or higher. Beyond the current value, the company continues to develop exciting new office buildings and it is also taking some of the shopping centre properties to higher and better use. Value continues to increase.
Not only do we expect substantial price appreciation, but we are earning a generous return while we wait for the share price to react. Brookfield Property currently yields 6.4% and it expects those dividends to increase at a 5% to 8% annual rate, as cash flows rise 7% to 9% per year for the next five years.
All in all, this is a high quality asset increasing in value, selling at a cheap price. Investments with these attributes are our sweet spot.
And Brookfield is not the only recent acquisition with these characteristics.
AMC Entertainment (AMC)
Douglas recommended the purchase of AMC Entertainment, the largest cinema chain in the world (we mentioned AMC in our last letter).
Subsequent to our purchase around $17, the share price declined in the tumult of the fourth quarter last year. We purchased the company because an enviable record of success had been interrupted by the worst year in movie box office in years. We were, and are, confident that Hollywood will recover, box office take will improve, and AMC stock will go back over $35.
The price decline gave us the opportunity to buy more at cheaper prices, lowering our average cost to around $15. We are now in a profit position as the shares have recovered to around our original price.
This highlights another important advantage of our approach. Bruce Greenwald, a professor at Columbia Business School, has shown that good value investors who have deep knowledge of their companies are comfortable taking advantage of market disruptions, like this one at AMC, to buy more when prices go on sale. You do it at Walmart, why won’t you do it with your investments?
Value investing has outperformed by about 1.5% per year. Good value investors increase their returns by a further 1% by buying when the market sells off. This is consistent with our experience and explains the 3% per year outperformance that we have achieved over time.
In conclusion, although in the short-term we do hit short rough patches where we don’t outperform, our history is one of superior performance. By sticking to our knitting, focusing on investing in high quality companies that are adding value, and emphasizing the longer term, we are confident that we will continue to deliver you outstanding long-term results in the future as we have in the past.
Today, the “Value Gap” of our portfolio as a whole — the difference between the value of the companies we are invested in and their market price — is at 45%. Our portfolio not only has substantial potential in the next few years, but it also has a wide margin of safety. We look forward to realizing these gains over the next couple of years.