Being a value manager does not preclude you from investing in oil stocks with oil trading near $100, as some might think. Few managers are as fervently committed to both the value style and the peak oil theory as James Cole of AIC Ltd. In fact, Cole picked up and moved his family to Calgary last year from AIC’s headquarters in Burlington, Ontario in no small part due to his desire to be closer to the oil industry where he is heavily invested.
Calgary offers “unparalleled access to information on the Canadian energy industry,” says Cole who has been running AIC Canadian Focused Fund since its inception in February 2000. He joined AIC after a three-year stint managing money at Gluskin Sheff and prior to that at Beutel Goodman. Cole learns new things every day about companies and industries, but in terms of his approach to value, he has always been attracted to AIC’s investment style modelled after world renowned investor Warren Buffet. He tries to “adhere” to that style every day.
He aims to buy companies “for significantly less than they are worth.” A company is worth “all the cash it will throw off over the life of its business discounted at some appropriate rate.” So the real challenge is to accurately forecast a company’s cash flows.
Perhaps it is unsurprising that Cole wants every company he invests in “to be financially strong” to garner an “investment grade” rating. That ensures greater predictability of cash flows. Said another way: “It is one of those things that gives those companies the ability to persevere through adversity which every company will inevitably have.”
A company’s financial position in considered in an “all encompassing way.” Its not just balance sheet measures such as leverage ratios but answers to questions of financial strength such as: “are they generating free cash? What’s the schedule of their debt maturities? What’s the state of their fixed assets?” And income statement measures too: “Are they covering interest expense? How many times out of operating income? That sort of thing.”
“You are looking for companies that have some durable competitive advantage,” says Cole “and that is hard to find in some industries, textiles for example.” Textiles are “pretty much a commodity product.” It is also, not coincidentally, the original business of Berkshire Hathaway, the multi-billion dollar holding company controlled by Warren Buffet. In his 1978 letter to shareholders, Buffett had this to say about the textile industry:
“The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.”
That description applies equally well to the commodity industry, and it explains why many value investors have not invested in energy and materials companies over the past few years when commodity prices were making new highs. Many figure that the commodity industry, which has been a cyclical industry, will turn down with prices and earnings reverting to the mean.
Cole sees things differently having studied the fundamentals of the oil industry in great detail in recent years. He sees a fundamental or secular shortage of oil supply going forward that will prevent oil prices from reverting to the long-term average. The additional demand for oil coming from emerging markets, especially China, makes the problem more acute. It is a situation of “tight supply” that Buffet makes exception for in his description of the textile industry, and it explains why Cole, a value manager at heart, is heavily invested in oil companies.
Cole isn’t attracted to just any oil companies though, but those companies that have an “enduring competitive advantage”, the ones that are producing oil in the Canadian oil sands where oil is literally extracted from a tar that is dug out of the ground. Canadian oil sands producers have “50 years of reserves” compared to conventional oil producers that “may have 10 to 12.” They also have “no finding costs and no exploration risks.” Conventional companies are “always spinning their wheels and suffering production declines.” In contrast, oil sands producers have no production declines either says Cole.
Companies such as Suncor have been part of AIC Canadian Focused Fund since inception in 2000, and Cole remains firmly committed to this company and other tar sands producers. Even after more than doubling in price in recent years, Cole still sees value in these companies. He believes higher oil prices are a permanent feature of the economic landscape and that oil sands producers have been offering the best value opportunities in this space.
Wednesday, December 19, 2007
Tuesday, December 4, 2007
Value Pick: 4kids Entertainment (KDE: NYSE)
It’s hardly a household name, but 4kids Entertainment is cheap. Not cheap using the typical market yardstick of price relative to earnings (P/E). To the contrary, the company, responsible for the Pokemon and Yu-Gi-Oh! TV hits on the Fox Network, has seen its revenues and earnings fade recently. What the market is missing and what Pat Naccarato, portfolio manager at AIC Ltd., has picked up on, is that the stock is trading close to liquidation value, a large part of which is comprised of cash.
In its salad days, 4kids Entertainment was a cash machine thanks to its licenses on former hit animation programming for the youth market which include Pokemon, Teenage Mutant Ninja Turtles and Yu-Gi-Oh! Hit television programs translated to million of dollars in revenues from merchandise sales including toys, trading cards etc.
Hits fade, however, and 4kids Entertainment has yet to follow up with another blockbuster show. The company has also started to produce its own titles rather than license foreign titles which were imports from Japan where some of the best and most popular animation has emerged from in recent years.
Its first, in-house production, Viva Piñata, was an “early success” says Naccarato. It was also released as a video game for the Xbox 360 console in a joint venture with Microsoft. Still despite the success with Viva Piñata, the company posted a loss in the most recent quarter and suffered a 31 percent decline in net revenues.
4kids is facing negative free cash flow because revenues are down to be sure. But things appear worse than they really are because it is plowing money into production where costs are rising. The change in its business model to producing its own original titles rather than license and adapt foreign titles, is resulting in increased capitalized film and television costs.
So where is the opportunity you may ask? Firstly, all the negatives appear baked into the share price, and then some. What investors seems to be missing is the pile of cash on the balance sheet, says Naccarato who regularly screens for companies that trade cheaply relative to assets. 4kids popped up on his radar last year after its share price was decimated by investors who reacted to the weak operating results.
“When the share price was high, the cash relative to the stock price at $80 was relatively small” says Naccarato, “It’s not like they won a windfall one day and the cash just showed up, but now it’s worth two thirds of the company.” The share price recently hit a low of US$11.24. Cash and investments on the balance sheet in the most recent quarter were a cool US$93m representing
More than half of the company’s total market capitalization of US$148m.
Its net asset value at roughly $150m suggests that investors are getting the business for free. The Yu-Gi-Oh! and Ninja Turtles Licenses aren’t worth what they used to be, but they still brought in more than US$26m in 2006.
When you factor in the value of the company’s current licenses, Naccarato figures he is getting 4kids near liquidation value. “The company has no big hits and the market cannot see a big hit in the future,” says Naccarato. “As a long term investors you can buy the opportunity to own another hit.”
That hit may be right around the corner. 4kids recently launched Chaotic, a new television production and trading game with its partially owned trading card company and website. “4kids has historically been involved in 2 of the 3 most successful trading card games ever sold,” says Naccarato. “Chaotic brings their management experience in bringing this new technology driven trading card game to market shortly, and investors are basically getting this potential blockbuster hit for free.”
“As a long term investors you can buy the opportunity to own another hit,” says Naccarato. The market’s view is that 4kids Entertainment is weak and losing money. His view focuses on a company that is trading near liquidation value and the opportunity to get a free ride with a management team that has a track record of success.
In its salad days, 4kids Entertainment was a cash machine thanks to its licenses on former hit animation programming for the youth market which include Pokemon, Teenage Mutant Ninja Turtles and Yu-Gi-Oh! Hit television programs translated to million of dollars in revenues from merchandise sales including toys, trading cards etc.
Hits fade, however, and 4kids Entertainment has yet to follow up with another blockbuster show. The company has also started to produce its own titles rather than license foreign titles which were imports from Japan where some of the best and most popular animation has emerged from in recent years.
Its first, in-house production, Viva Piñata, was an “early success” says Naccarato. It was also released as a video game for the Xbox 360 console in a joint venture with Microsoft. Still despite the success with Viva Piñata, the company posted a loss in the most recent quarter and suffered a 31 percent decline in net revenues.
4kids is facing negative free cash flow because revenues are down to be sure. But things appear worse than they really are because it is plowing money into production where costs are rising. The change in its business model to producing its own original titles rather than license and adapt foreign titles, is resulting in increased capitalized film and television costs.
So where is the opportunity you may ask? Firstly, all the negatives appear baked into the share price, and then some. What investors seems to be missing is the pile of cash on the balance sheet, says Naccarato who regularly screens for companies that trade cheaply relative to assets. 4kids popped up on his radar last year after its share price was decimated by investors who reacted to the weak operating results.
“When the share price was high, the cash relative to the stock price at $80 was relatively small” says Naccarato, “It’s not like they won a windfall one day and the cash just showed up, but now it’s worth two thirds of the company.” The share price recently hit a low of US$11.24. Cash and investments on the balance sheet in the most recent quarter were a cool US$93m representing
More than half of the company’s total market capitalization of US$148m.
Its net asset value at roughly $150m suggests that investors are getting the business for free. The Yu-Gi-Oh! and Ninja Turtles Licenses aren’t worth what they used to be, but they still brought in more than US$26m in 2006.
When you factor in the value of the company’s current licenses, Naccarato figures he is getting 4kids near liquidation value. “The company has no big hits and the market cannot see a big hit in the future,” says Naccarato. “As a long term investors you can buy the opportunity to own another hit.”
That hit may be right around the corner. 4kids recently launched Chaotic, a new television production and trading game with its partially owned trading card company and website. “4kids has historically been involved in 2 of the 3 most successful trading card games ever sold,” says Naccarato. “Chaotic brings their management experience in bringing this new technology driven trading card game to market shortly, and investors are basically getting this potential blockbuster hit for free.”
“As a long term investors you can buy the opportunity to own another hit,” says Naccarato. The market’s view is that 4kids Entertainment is weak and losing money. His view focuses on a company that is trading near liquidation value and the opportunity to get a free ride with a management team that has a track record of success.
Wednesday, November 14, 2007
Value in Action: Pat Naccarato
Pat Naccarato of AIC Ltd is a textbook deep value US equity manager in the tradition of Benjamin Graham, but he is also an acolyte of renowned investor Warren Buffett who counsels buying “great companies at a fair price.” The distinction is real and hinges on the types of companies Naccarato is buying because great companies are easily recognized and rarely available at a great price.
The most basic tenet of value investing is to buy a company with a margin of safety, at a price that offers a sizeable discount to its net worth. This is a risk management strategy to account for the fact that the investment manager never has a complete picture of the investment environment and the company in questions, and that things can go wrong. The implementation of this strategy varies for Naccarato, however, based on the type of company that he is considering.
Great companies consistently earn high returns on capital and consistently increase their earnings. Since they rarely falter, less margin of safety is acceptable, which is perhaps a good thing because great companies are easily recognized; therefore, they are rarely available at a great price. “The very good companies tend to be priced in,” says Naccarato. “I look for these great companies when there is a bump in the road, and I try to buy them at a fair price.”
Here the company is valued as a going concern, based on its discounted free cash flow, the present value of the free cash that a company is expected to produce over the long run. This is an appropriate valuation metric because consistency in earnings means those earnings can be forecasted with a high degree of certainty; therefore, the value of the company is readily ascertainable.
The technology boom of the last 90s was a rare moment in history when great companies were really cheap. They [investors] were “throwing away” companies that had these brands that had been established for decades. “Everyone was saying: ‘why I would want to own Procter and Gamble when it is only growing at 8 percent per year when I could buy ABC technology stock that is growing 8 percent a week?’”
Most days, however, Naccarato has to settle for finding merely good companies trading at a great price. With good companies, margin of safety takes on a new meaning in the sense that earnings are not consistent and free cash flow is not easy to predict. Therefore, calculations of value centre on liquidation value rather than discounted free cash flow.
Here the focus shifts from the income statement to the balance sheet. The former provides a snapshot of a company’s earnings whereas the balance sheet provides a picture of its assets and liabilities, the difference of which determines its net asset value.
This is a traditional deep value approach in the discipline of Benjamin Graham & David Dodd’s as articulated in the seminal book on the subject, Security Analysis. Valuation is determined by a company’s liquidation value, essentially the sum of its parts. If a company can be purchased at or near liquidation value, the only risk to an investor is the opportunity cost of his or her money, what it could earn somewhere else.
Naccarrato runs “screens on assets” to find companies that may be trading at or near liquidation value. For example, he looks for companies that are sitting on lots of cash. A company could be punished by the market for having “a poor product cycle yet” it may have been managed prudently with a clean balance sheet and substantial cash. After discounting inventories, adding them to cash and receivables, and subtracting liabilities such as payables and debt, to calculate liquidation value, if this derived value of the company per share exceeds its price, then it is potentially cheap.
A company trading below liquidation value represents a free call option on its common shares. If management can turn things around for the next product cycle and increase earnings, then the share price will undoubtedly rise. If management fails and the company goes bankrupt, Naccarato figures he will recoup his initial investment.
Bausch and Lomb (NYSE: BOL) hit Naccarato’s screens in the Spring of 2007 after the company’s share price was “cut in half” because users of its contact lens solution were developing inner eye fungus. Naccarato recognized that BOL had two other businesses, contact lens manufacturing and pharmaceutical products, which were separate from and unaffected by the solutions business.
Naccarato had “no idea what the problem was; no idea if it would ever get resolved; and no idea what the reliability was.” So he assumed the worst, that the business was “worthless, going to zero,” and that it had one billion dollars in potential liability. Even with those assumptions he realized he was paying for less than the other two businesses and getting the contact lens solution business for free.”
As the problems at BOL were worked out, private equity firm Warburg Pincus recognized the value, stepped in, and took the company private at a substantial premium (over 50 percent) to its share price. In this case, Naccarato was able to recognize a substantial return on his investment in a few short months.
While this type of quick turnaround is rare, it is commonly the case that well-researched value opportunities are eventually recognized by the market and don’t stay cheap forever.
The most basic tenet of value investing is to buy a company with a margin of safety, at a price that offers a sizeable discount to its net worth. This is a risk management strategy to account for the fact that the investment manager never has a complete picture of the investment environment and the company in questions, and that things can go wrong. The implementation of this strategy varies for Naccarato, however, based on the type of company that he is considering.
Great companies consistently earn high returns on capital and consistently increase their earnings. Since they rarely falter, less margin of safety is acceptable, which is perhaps a good thing because great companies are easily recognized; therefore, they are rarely available at a great price. “The very good companies tend to be priced in,” says Naccarato. “I look for these great companies when there is a bump in the road, and I try to buy them at a fair price.”
Here the company is valued as a going concern, based on its discounted free cash flow, the present value of the free cash that a company is expected to produce over the long run. This is an appropriate valuation metric because consistency in earnings means those earnings can be forecasted with a high degree of certainty; therefore, the value of the company is readily ascertainable.
The technology boom of the last 90s was a rare moment in history when great companies were really cheap. They [investors] were “throwing away” companies that had these brands that had been established for decades. “Everyone was saying: ‘why I would want to own Procter and Gamble when it is only growing at 8 percent per year when I could buy ABC technology stock that is growing 8 percent a week?’”
Most days, however, Naccarato has to settle for finding merely good companies trading at a great price. With good companies, margin of safety takes on a new meaning in the sense that earnings are not consistent and free cash flow is not easy to predict. Therefore, calculations of value centre on liquidation value rather than discounted free cash flow.
Here the focus shifts from the income statement to the balance sheet. The former provides a snapshot of a company’s earnings whereas the balance sheet provides a picture of its assets and liabilities, the difference of which determines its net asset value.
This is a traditional deep value approach in the discipline of Benjamin Graham & David Dodd’s as articulated in the seminal book on the subject, Security Analysis. Valuation is determined by a company’s liquidation value, essentially the sum of its parts. If a company can be purchased at or near liquidation value, the only risk to an investor is the opportunity cost of his or her money, what it could earn somewhere else.
Naccarrato runs “screens on assets” to find companies that may be trading at or near liquidation value. For example, he looks for companies that are sitting on lots of cash. A company could be punished by the market for having “a poor product cycle yet” it may have been managed prudently with a clean balance sheet and substantial cash. After discounting inventories, adding them to cash and receivables, and subtracting liabilities such as payables and debt, to calculate liquidation value, if this derived value of the company per share exceeds its price, then it is potentially cheap.
A company trading below liquidation value represents a free call option on its common shares. If management can turn things around for the next product cycle and increase earnings, then the share price will undoubtedly rise. If management fails and the company goes bankrupt, Naccarato figures he will recoup his initial investment.
Bausch and Lomb (NYSE: BOL) hit Naccarato’s screens in the Spring of 2007 after the company’s share price was “cut in half” because users of its contact lens solution were developing inner eye fungus. Naccarato recognized that BOL had two other businesses, contact lens manufacturing and pharmaceutical products, which were separate from and unaffected by the solutions business.
Naccarato had “no idea what the problem was; no idea if it would ever get resolved; and no idea what the reliability was.” So he assumed the worst, that the business was “worthless, going to zero,” and that it had one billion dollars in potential liability. Even with those assumptions he realized he was paying for less than the other two businesses and getting the contact lens solution business for free.”
As the problems at BOL were worked out, private equity firm Warburg Pincus recognized the value, stepped in, and took the company private at a substantial premium (over 50 percent) to its share price. In this case, Naccarato was able to recognize a substantial return on his investment in a few short months.
While this type of quick turnaround is rare, it is commonly the case that well-researched value opportunities are eventually recognized by the market and don’t stay cheap forever.
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