Saturday, 20 April 2013

The Triple Crown

As a first priority, adhere to The Magic Formula

I'm sure you have all heard about Joel Greenblatt's Magic Formula.  If you haven't, I can sum up what it achieves in a single sentence: In a given population of stocks, it brings attention to the companies with the best combination of cheapness (as measured by EV/EBIT multiple) and quality (as measured by Return on Invested Capital).   Sounds easy enough, doesn't it?  It is also based on common sense. If you are a long term investor, why wouldn't you want the best quality company for the cheapest price possible? The truth is that most professional investors would fare better if they just stuck with Joel's formula and did nothing else. Mr. Greenblatt is one of the greatest investors ever. I have never attended his classes at Columbia University, but am a big fan of his writing.  Did you know that at one point, he achieved a 40% compounded annual return over 20 years?  That is absolutely ridiculous in terms of an investment track record.  Joel was able to achieve this through (1) extreme concentration - having his capital deployed in his best 5-6 ideas at any given time, (2) using the Magic Formula, and (3) investing in special situations such as spinoffs and merger securities to take advantage of forced selling.  I believe he really is another Warren Buffet. Where Buffett stood apart from all the other great investors was his creative way of securing permanent capital.  Not only did he do this through taking control of a public textiles company called Berkshire Hathaway, he also vended insurance companies into it and benefitted from being able to invest the float at a negative cost of capital.

The Triple Crown

However, there is third prong I would add to the Magic Formula: alignment.  I have already discussed at length in previous posts about the importance of having your investments run by managers who think as owners rather than as employees, so I will not repeat those points here.  The obvious way to add this criterion to the Magic Formula would be add a column for percentage of shares owned by insiders. However, the problem I've encountered with the information providers I have experience with (Bloomberg, Thomson Reuters) is that this field often is not accurate, at least not for my purposes. So while I cannot claim that the Magic Formula should be altered from a computer screening perspective, satisfying the requirement of strong alignment serves as icing on the cake.  In fact, I find alignment to be so important that when I see the right indications, I am willing to think outside the box a little on the traditional yardsticks of valuation and quality.

So what are some indicators of alignment that close attention should be given to?

In my opinion, there are various ways that alignment can be signalled:
  • >10% ownership of stock by founder, a family, and/or notable investor
  • a strategic investor or management backstopping a rights offering in a spinout (e.g. Brookfield Residential, Sears Hometown and Outlet)
  • insider buying (in the open market, private placement, or executive subscribed warrants)
I almost added share buy-backs as a way management can show alignment, but thought the better of it since good capital allocation is a by-product of alignment rather than a signal of it.

Example #1: Brookfield Asset Management

This investment would probably never top the Magic Formula list, but is nonetheless worth mentioning as an "anti-fragile" phenomenon that grows stronger from each global crisis. Brookfield trades less than the sum of its parts but would not show well on an EV/EBIT basis (it owns a lot of land and other investments that do not subscribe neatly to the screen).  The same applies to ROIC; Brookfield's assets are by their very nature capital intensive, though only from an initial capex perspective.  Whether it is office buildings, infrastructure, or hydro-power stations, all these assets in the portfolio benefit from scarcity (usually due to trophy locations), low maintenance capex, and smart financing in the form of non-recourse debt.  So while Brookfield owns assets that cost a fortune to build or replace, they are financed in such a way that in the worst case of a default, the sinking of a single property does not threaten the whole company as a going concern. Furthermore, inflation escalators are typically built into the contracts. For example, in its Class A office buildings, the leases have clauses which allow for pricing in tandem with inflation, thus protecting the value of its cash flows. 

I believe Brookfield will double in price within six years.  Management owns 17% of the company; this number is likely to increase as it was announced last week that stock buy-back is in play to repurchase up to 10% of outstanding shares in the open market.

Example #2: Brookfield Residential Properties

When I purchased shares in the summer of 2011 at an average of $7.50, this had the makings of a Triple Crown investment. From a valuation standpoint, it provided multiple margins of safety: (1) it traded at a 25% discount to book value, which had already been significantly written down during the recession, (2) I estimated $1 per share of earnings power from just the Canadian portion of operations, so in other words I bought the Canadian half of the business at 7.5x normalized earnings and received the U.S. half for free!  With U.S. housing at the very bottom at the time, profitability from a consolidated perspective was somewhat hidden because the Canadian half was being offset by the loss generating U.S. part.  Homebuilding isn't a bad business; it is however inescapably cyclical.  I was willing to forgo the requirement of a virtuous, in-the-box good company in this case.  After all, how many homebuilders were still cash flow positive and financially strong at the very bottom of the U.S. housing market?  Brookfield Residential stood out in this respect because its Canadian portion (mostly in Alberta) was strongly benefitting from a thriving regional economy, which allowed for deficits from its mostly Californian operations (California by the way was one of the hardest hit regions in the U.S. housing crash) in the U.S. to be carried until the housing market naturally recovered.

Last, and most important, were the signals of alignment during the spin-off process.  The parent company, Brookfield Asset Management (written about in Example #1 above) designed the spin-off thusly: (1) a partial spinoff, (2) via a rights offering, with (3) a backstop provision which allowed the parent company to exercise the remaining rights not acted on by other shareholders.

As per Greenblatt, your interest should always be strongly piqued when this sort of spinoff happens. I will add the personal note that this is because management will set a strike price on the rights which undervalues the company, thereby giving themselves an absolute bargain should shareholders overlook the opportunity.  In fact, in the prospectus, assumptions used in the fairness opinion were disclosed, which included a 20% discount rate used in the DCF!  Talk about conservative!  In this case, the exercise price was $10 per share, which was still a steal.  I didn't buy the rights on the market during the 30 days they traded because the underlying share price was around $10 (meaning I could have just bought the shares on the open market).  I was lucky that the Greek crisis a few months later caused the price to dip as low as $6.50, where I filled half my position. 

Even though the parent company owned ~72% of Brookfield Residential post the spinoff, it proceeded to buy more shares in the open market during the summer of 2011 between $6.50 and $8.00 (if my memory serves me correctly - you can verify via the 13D filings on the SEC website) and thus brought its ownership up another ~1% to about 73%.  What a mouth-watering, incredible opportunity this was: a U.S. housing related investment that was still generating profits at the very depths of the U.S. housing market, trading at an obvious bargain price, and bought by insiders (in this case the parent company) in multiple ways!  If it weren't for the Howard Hughes opportunity, I would've taken a much bigger swing on this one!

I recently sold 1/3 of my position at $24 to recover my initial cost.  I know that I'll end up regretting it because significant upside still exists.  However, I believe the U.S. housing recovery is in its 2nd inning, while U.S. homebuilder stock prices have raced ahead to the 5th inning.  Where I stand to be very incorrect is in the ultimate span of the recovery: as we have just witnessed the biggest bust in U.S. housing history, it may turn out to be the case that the recovery lasts for longer than anyone expects given the pent-up demand that has been built up in the system (in the form of 35 year olds living with their parents).

Disclosure: the author owns HHC, BRP, but not BAM