I initiated a small position for myself in JCPenney yesterday at $20.50. If Bill Ackman is correct, investors stand to make 15-20x their money at the current price (see Pershing Square's May 2012 presentation here).
Just for those hailing from outside North America, JCPenney is a department store chain in the U.S. with ~1,000 locations. It was at one point (in the 1960s) the 2nd largest company in the U.S. by market capitalization, but has since fallen into disrepute because of mismanagement and intense competition. The following points outline why I believe this could be a good investment:
1) Downside protection from real estate value. If we take Ackman's statement that the replacement cost of the real estate is $11 bilion, then after subtracting the $3 billion of debt (not even considering the company's ~$800 million cash balance), we arrive at $8 billion for net asset value. This would work out to a little more than $36.50, or 77.5% above the current price. Using $36.50 as the floor price, of course, assumes that in a worst case scenario of bankruptcy and liquidation, we will be able to realize market value in a bankruptcy sale (which is unlikely). I have come up with something a little more conservative for my own crude calculations. Given JCP's outright ownership of 49% of its stores, this works out to ~55 million square feet of ownership. Using Sears' sale of 11 stores to General Growth in April 2012 as a precedent transaction, the price per square foot was $150 ($270mm paid for 1.8mm sq ft). Applying $150 to 55 million square feet gives us a value of $8.25 billion. Now subtract $3 billion of outstanding debt from the $8.25 billion and you get $5.25 billion ($24/share), which is still a 16.5% premium above the current price.
2) Strong insider ownership. With Pershing Square's 26% ownership stake, we have patient money backing the company's new strategic initiatives, which would have no chance of success if a quarter-by-quarter investor were to be in control. Bill Ackman (founder of Pershing) actually sought out and effectively installed Ron Johnson, who is the current CEO of JCP. Upon taking the helm, Johnson invested $50 million in warrants with 7.5 years to expiry that are not excercisable until year 6. He paid approx. $8 per warrant with a strike price (market price at the time) of $29 - thus his break-even point is $37. Hence an investor entering in today would experience ~80% capital appreciation just to get to the point where Johnson breaks even in year 6 of his investment!! This compensation structure, which no doubt gives the CEO a leveraged outcome (and leaves no room for error on the downside) is unique and present in only one other company I know of called the Howard Hughes Corporation, where Bill Ackman serves as the company's chairman. While this warrant ownership scheme is no guarantee of success and by no means protects you against management misjudgement, one thing is for certain: the CEO is more likely to think for the long term versus appeasing investors quarter-to-quarter.
3) Management's reasoning makes sense. While JCP's earnings are likely to continue hurting for the next few quarters, Johnson's new intiatives make a hell of a lot of sense. I would encourage you to read the presentation (linked to above), as it walks through what management plans to do over the next few years. In a nutshell, JCP was terribly mismanaged by previous leadership through extreme couponing (average of two sales per day at up to 60% off normal price) which led to the perception among suppliers of a lack of price integrity. As a result, most brands refused to sell their wares in JCP and this led to a cycle of decreasing price points. Johnson's strategy is to use JCP's structural advantage, being its low cost ($4 per sq. ft.) leases and direct ownership of stores, to offer incoming (and higher value) brands the opportunity to set up their own mini-stores within each location and thus acheive nationwide distribution. He labels this his "mall within a mall" concept. Secondly, Johnson has targeted $900 million of cost cuts. Considering that $1.8 billion of costs would need to be chopped in order to reach Macy's efficiency level, $900 million hardly sounds unreasonable.
I would argue that the current valuation is already pricing in a grave level of pessimism. However, giventhe fact that this turnaround will take time, I would not be surprised if the share price tanks again on August 10th when the next quarter of earnings is reported. This of course depends on how disappointing sales are. Sales were down 20% in the most recently reported quarter; if an even greater decrease is reported in August for Q2, it could be a sign that the situation is getting out of control and that JCP's previous customer base is running for the exits. In this scenario, Johnson may be pressed to sell some stores to raise cash for working capital to make ends meet until his plans work out. If however the year-over-year sales decrease is less than expected, we could in fact see the share price pop as investors decide to price in a lower level of pessism. The truth is that I don't know whether we have reached the bottom on JCP... if the next quarter is worse than expected, I wouldn't be surprised if the stock crumbles another 50%. However, as I believe the odds of doing well (from the current price) on this bet over the next 5-6 years are good, I have decided to invest ~50% of a full position now vs. speculating over the next earnings release. In other words, I am not letting my long term speculation to be influenced too much by my short term speculations.
Saturday, 21 July 2012
Thursday, 17 May 2012
Negative feedback loops and financing risk
So it appears my first pick on this blog (Tigray Resources) has thus far been an utter stink bomb. Perhaps it goes to show just how important some of Mr. Buffett's concepts are, being Margin of Safety and Circle of Competence. I violated both for three reasons: 1) I have a fascination for spin-outs and thought this was a case wherein management was trying to get in on the best asset of Canaco for themselves, 2) I previously met management at a retail investor's conference and trusted them, and 3) I was lured by the prospect of quick profits.
In hindsight, this was a very expensive way to reinforce things I knew beforehand. By observing many multi-baggers in the small cap Canadian mining market over the past few years (before the bubble burst around the time of the Fukushima incident), I had lost appreciation for what an accomplishment it is for a company to achieve a 15-20% compound annual growth rate in earnings. When metal prices are climbing and the market is in a "risk on" mood, the junior resource companies seem to experience a positive feedback loop where their share prices rise, thereby triggering analyst coverage and subsequent equity issues or IPOs, followed by follow-up sell-side reports loaded with optimism. Before this loop reverses course, investors forget about financing risk (i.e. the fact that these companies are not self sufficient and are thus at the whim of markets when more money is needed).
Tigray has lost more than 80% of its value since I began investing in it. At its current price of $0.28, the stock needs to nearly quadruple in order for me to break even. Even if I had more hard earned savings to average down my cost base at new low, I cannot commit any greater a percentage to speculative stocks than I already have. So where did I go dead wrong? Well, there are two main places. First of all, I did write about how Tigray is effectively tied to the hip of the company it got spun out of (Canaco Resources). Canaco finally reported its initial resource estimate yesterday after delaying it two times, and it was about half of market expectations in terms of number of ounces and grade. Tigray's price was already beaten up before this announcement, but I assume a lot of Canaco investors "pulled the chute" on both holdings upon the news. As you may know, the Canaco management team still runs Tigray as no independent management team has been installed since its spin out in September 2011.
But the primary risk I underestimated here was the possibility of a negative feedback loop triggered by market worries about financing risk. In Tigray's case, I believe that much of the price devaluation has to do with the fact that market participants were aware that the company will need to experience some kind of share dilution in order to continue drilling. The most recently reported cash balance appeared in the slide presentation that was posted on Tigray's website in early April and at the time, there was $2 million remaining in the company's coffers. With a monthly burn rate of ~$1 million, it is possible that the cash balance is near zero. It goes without saying that an equity issue at the current price would effectively restructure the company and wipe out shareholders. For example, if $10 million were to be raised tomorrow at $0.28, this would result in the number of shares increasing by close to 80%! And equally frustrating is the fact that the $10 million raised would not even last one year. But how do I explain the drop from $0.90 just a few months ago to the current level? I think the answer is that as investors realized the company is running out of money and will need to use its stock as a currency, they began to walk out the door. As the price declined and it became more apparent to the market that management has few alternatives besides issuing equity to restore its working capital, more left as the lower price meant that when the share issue happened, it would be more dilutive to current shareholders. On so on and so on...
The only things I see that can snap Tigray out of its funk are the following: 1) A sudden surge in gold/copper prices - maybe QE3? Certainly out of any market participant's control. 2) An unexpected sale of the near-surface gold gossan delineated at the Harvest project (probably contains ~500K ounces) to Sinotech, which would have the financial means to mine this resource. This would provide Tigray with a sum, which I do not care to speculate about here, to use as working capital and continue its drilling program. Otherwise, Tigray will either have to state that it is freezing its second phase of drilling or complete a massively dilutive round of financing. If management were to step in and support another round of financing, this would be positive in a way as it would show their confidence in the project; however, my equity would still get wiped out in the process.
In hindsight, this was a very expensive way to reinforce things I knew beforehand. By observing many multi-baggers in the small cap Canadian mining market over the past few years (before the bubble burst around the time of the Fukushima incident), I had lost appreciation for what an accomplishment it is for a company to achieve a 15-20% compound annual growth rate in earnings. When metal prices are climbing and the market is in a "risk on" mood, the junior resource companies seem to experience a positive feedback loop where their share prices rise, thereby triggering analyst coverage and subsequent equity issues or IPOs, followed by follow-up sell-side reports loaded with optimism. Before this loop reverses course, investors forget about financing risk (i.e. the fact that these companies are not self sufficient and are thus at the whim of markets when more money is needed).
Tigray has lost more than 80% of its value since I began investing in it. At its current price of $0.28, the stock needs to nearly quadruple in order for me to break even. Even if I had more hard earned savings to average down my cost base at new low, I cannot commit any greater a percentage to speculative stocks than I already have. So where did I go dead wrong? Well, there are two main places. First of all, I did write about how Tigray is effectively tied to the hip of the company it got spun out of (Canaco Resources). Canaco finally reported its initial resource estimate yesterday after delaying it two times, and it was about half of market expectations in terms of number of ounces and grade. Tigray's price was already beaten up before this announcement, but I assume a lot of Canaco investors "pulled the chute" on both holdings upon the news. As you may know, the Canaco management team still runs Tigray as no independent management team has been installed since its spin out in September 2011.
But the primary risk I underestimated here was the possibility of a negative feedback loop triggered by market worries about financing risk. In Tigray's case, I believe that much of the price devaluation has to do with the fact that market participants were aware that the company will need to experience some kind of share dilution in order to continue drilling. The most recently reported cash balance appeared in the slide presentation that was posted on Tigray's website in early April and at the time, there was $2 million remaining in the company's coffers. With a monthly burn rate of ~$1 million, it is possible that the cash balance is near zero. It goes without saying that an equity issue at the current price would effectively restructure the company and wipe out shareholders. For example, if $10 million were to be raised tomorrow at $0.28, this would result in the number of shares increasing by close to 80%! And equally frustrating is the fact that the $10 million raised would not even last one year. But how do I explain the drop from $0.90 just a few months ago to the current level? I think the answer is that as investors realized the company is running out of money and will need to use its stock as a currency, they began to walk out the door. As the price declined and it became more apparent to the market that management has few alternatives besides issuing equity to restore its working capital, more left as the lower price meant that when the share issue happened, it would be more dilutive to current shareholders. On so on and so on...
The only things I see that can snap Tigray out of its funk are the following: 1) A sudden surge in gold/copper prices - maybe QE3? Certainly out of any market participant's control. 2) An unexpected sale of the near-surface gold gossan delineated at the Harvest project (probably contains ~500K ounces) to Sinotech, which would have the financial means to mine this resource. This would provide Tigray with a sum, which I do not care to speculate about here, to use as working capital and continue its drilling program. Otherwise, Tigray will either have to state that it is freezing its second phase of drilling or complete a massively dilutive round of financing. If management were to step in and support another round of financing, this would be positive in a way as it would show their confidence in the project; however, my equity would still get wiped out in the process.
Friday, 6 April 2012
U.S. Housing - Excerpt from JPMorgan Annual Letter
The following is a great summary of the current U.S. housing situation from the 2011 JPMorgan shareholders letter. A must read:
There has been a tremendous focus on the fact that housing prices remain depressed and, in fact, are still going down some. The large “shadow inventory” of homes in delinquency or foreclosure that has not yet hit the sale market adds to the fears that this will continue for a long time. New home construction still is very depressed – so, to most, the future looks bleak. However, if one looks at the leading indicators, all signs are flashing green – the turn is coming if it is not here already. We don’t want to be blindly optimistic, but the facts are the facts:
• America has never stopped growing. The United States has added 3 million people a year since the crisis began four years ago. We will add 30 million people in the next
10 years.
• This population growth normally would create a need for 1.2 million additional housing units each year. Household formation has been half of that for the past four years. Our economists believe that there is huge pent-up demand and that household formation will return to 1.2 million a year
as job conditions improve.
• Job conditions have been improving, albeit slowly. In the last 24 months, 3.45 million jobs have been created.
• On average, only 845,000 new U.S. housing units were built annually over the last four years – and the destruction of homes from demolition, disaster and dilapidation has averaged 250,000 a year. The growth of new households, even at a reduced rate, has been able to absorb all of this new supply,
and more.
• The total inventory of single-family homes and condos for sale currently is 2.7 million units, down from a peak of 4.4 million units in May 2007. It now would take only six months to sell all of the houses for sale at existing sales rates, down from 12 months two years ago. (This low of an inventory number normally would be considered a positive sign for future housing prices.)
• While the shadow inventory mentioned above still is significant, it has shown a visible declining trend since peaking at the end of 2009, when the number of loans delinquent 90+ days or in foreclosure was 5.1 million homes. It now totals 3.9 million, and we estimate it could be 3 million in 12 months. The shadow inventory also may move more quickly as mortgage servicers get better at packaged sales and short sales and as real money investors start to buy foreclosed homes and rent them out for a good profit. Home prices still are going down a little bit, and they will stay depressed for a while. Distressed sales (short sales, foreclosure sales, real estate-owned sales) still are 25% of all sales, and these sales typically are priced 30% lower than non-distressed sales. As the percentage of distressed sales comes down over the next 12-24 months, their negative effect on housing prices will start to diminish.
• Housing is at an all-time high level of affordability due to both low home prices and low mortgage rates.
• It now is cheaper to buy than to rent inhalf of the markets in America – this has not been true for more than 15 years. Relatively high rental prices can be a precursor to increasing home prices.
• At the same time, American consumers are finding more solid financial footing relative to their debt. The household debt service ratio, which is the ratio of mortgage plus consumer debt payments to disposable personal income, stands at its lowest level since 1994. This is a result of rapid consumer deleveraging – household mortgage debt now is down $1 trillion from its 2008 peak. (Reported U.S. mortgage data do not remove mortgage debt from an individual’s debt obligations until there is an actual foreclosure. It is estimated that $600 billion of the $9 trillion in currently outstanding mortgage debt is not paying interest today and effectively could be removed now from these numbers.)
• Recent senior loan officer surveys by theFederal Reserve show that, while there are not yet clear signs of credit loosening for new mortgages, at least the rush to tighten
mortgage lending standards has abated.
• Over the last two years, $2 trillion of mortgages have been refinanced, substantially aiding homeowner burdens. We expect another $2 trillion to refinance over the next two years, with approximately 10% coming from recently announced government programs, and, at that point, we estimate that only 15%-20% of Americans will be paying interest rates over 6%.
More jobs, more households, more Americans, good value – it’s just a matter of time.
HHC and BRP: Two U.S. Housing Ideas for the Backburner...
I would like to introduce two new investment ideas that have increased significantly in price since I bought them, but that I would increase my position in if their valuations were to fall back in the short term. Rather than write a full out thesis on each (which I do not have time to do), I will release tidbits across time. I firmly believe both are worth significantly more than their current trading prices. However, due to the recent run up in each stock and the markets in general, I would hold on to cash for the time being and wait for a better entry point - perhaps in the summer months when housing related stocks tend to lag.
The two ideas I am proposing to put on your radar are The Howard Hughes Corporation (NYSE: HHC) and Brookfield Residential (NYSE: BRP). The following investment characteristics make both compelling investments:
As time goes on, I will pick certain aspects of each stock to explore, which perhaps may be expedited in the event that prices sharply fall for whatever reason and thus create an opportunistic entry point. In this post, I will pick one theme that is common between the two: strong alignment in the form of insider ownership.
The Importance of Management Alignment
One thing I usually require in an investment is that management own a meaningful percentage of the company. Though not a guarantee of success, I believe it reduces the likelihood that the CEO makes decisions that are adverse to shareholders but yet can benefit himself. A common example of such a decision would be a CEO's decision to acquire another company with weak strategic fit that also carries a high price tag, thus decreasing per share intrinsic value. How could low ownership by management result in bad decision making? Can't hired managers with little or no ownership in the company still do a stellar job? The answer is absolutely. To make it clear, low ownership by controlling management does not translate into poor performance. However, it so happens that there tends to be a strong correlation between public company size and management compensation, and so often times CEO's are incentivized to grow the company for the sake of growth rather than make decisions based on building long term, sustainable per share value. This is especially so if the CEO was hired from outside the company, given a wack load of free five-year options, and not required to invest in the company from his own pocket. In contrast, a CEO or founder whose net worth is fully vested in the company shares in the downside with you as well as the upside.
A Look at Alignment in The Howard Hughes Corporation
The Howard Hughes Corporation was spun out of General Growth Properties in late 2010 as a development company. Contained in it are 34 assets in the U.S., including three master planned communities, the South Street Seaport shopping area in lower Manhattan, and the Ward Centers in Hawaii.
The alignment technique in HHC is shared by JC Penney, thanks to a strategic hedge fund investor named Bill Ackman (of Pershing Square) who is a cornerstone investor in both companies. In both HHC and JCP, the incoming CEOs committed substantial personal investments in the form of seven year warrants that will expire out of the money if the share price is not above a certain point by the sixth year of their investment. The CEOs of Howard Hughes and JC Penney are thus hyper aligned. That is, unlike you or me whose investment will be tied to whatever the share price is in six years, if HHC's share price is not at least $53 between 2016-2017, CEO David Weinreb stands to lose his entire $15 million investment. On the contrary, his upside will be leveraged if he can in fact redevelop the properties as planned.
Another positive sign in HHC is the record of insider buying. Numerous directors have made significant purchases since the stock began trading in November 2010, which is a vote of confidence especially given the real estate expertise and caliber of the company's directors (their profiles can be read on www.howardhughes.com)
A Look at Alignment in Brookfield Residential Properties
In the case of Brookfield Residential, the parent company (Brookfield Asset Management) opportunistically increased its ownership stake by buying shares in the open market last summer when the price was under $7 (now >$10). Why would the parent company want to increase its stake when it already owned 72.5% of BRP at the time? I think we all know the answer. Brookfield Asset Management's investment track record is legendary, and when it buys shares in anything that trades in the open market - especially its own subsidiaries - it is certainly worth paying attention to.
In the latest annual report, it was disclosed that a "certain executive" purchased two million shares within the last year through an escrowed share purchase program via the parent company. I believe this is why the insider purchase was not reported through the typical channels (e.g. INK Research, SEDAR). I do not know which executive purchased the shares, though I suspect it was Allan Norris, the current chief executive.
It must be remembered that strong alignment is no guarantee of investment success; however your downside is more protected from management stupidity with characteristics such as those mentioned above.
The two ideas I am proposing to put on your radar are The Howard Hughes Corporation (NYSE: HHC) and Brookfield Residential (NYSE: BRP). The following investment characteristics make both compelling investments:
- strong alignment of management interests through insider buying and ownership
- hidden value in the form of either overlooked real estate assets or acreage recorded in book value under valuations recorded up to a few decades ago
- inevitable upside leverage to a housing recovery in the U.S.
As time goes on, I will pick certain aspects of each stock to explore, which perhaps may be expedited in the event that prices sharply fall for whatever reason and thus create an opportunistic entry point. In this post, I will pick one theme that is common between the two: strong alignment in the form of insider ownership.
The Importance of Management Alignment
One thing I usually require in an investment is that management own a meaningful percentage of the company. Though not a guarantee of success, I believe it reduces the likelihood that the CEO makes decisions that are adverse to shareholders but yet can benefit himself. A common example of such a decision would be a CEO's decision to acquire another company with weak strategic fit that also carries a high price tag, thus decreasing per share intrinsic value. How could low ownership by management result in bad decision making? Can't hired managers with little or no ownership in the company still do a stellar job? The answer is absolutely. To make it clear, low ownership by controlling management does not translate into poor performance. However, it so happens that there tends to be a strong correlation between public company size and management compensation, and so often times CEO's are incentivized to grow the company for the sake of growth rather than make decisions based on building long term, sustainable per share value. This is especially so if the CEO was hired from outside the company, given a wack load of free five-year options, and not required to invest in the company from his own pocket. In contrast, a CEO or founder whose net worth is fully vested in the company shares in the downside with you as well as the upside.
A Look at Alignment in The Howard Hughes Corporation
The Howard Hughes Corporation was spun out of General Growth Properties in late 2010 as a development company. Contained in it are 34 assets in the U.S., including three master planned communities, the South Street Seaport shopping area in lower Manhattan, and the Ward Centers in Hawaii.
The alignment technique in HHC is shared by JC Penney, thanks to a strategic hedge fund investor named Bill Ackman (of Pershing Square) who is a cornerstone investor in both companies. In both HHC and JCP, the incoming CEOs committed substantial personal investments in the form of seven year warrants that will expire out of the money if the share price is not above a certain point by the sixth year of their investment. The CEOs of Howard Hughes and JC Penney are thus hyper aligned. That is, unlike you or me whose investment will be tied to whatever the share price is in six years, if HHC's share price is not at least $53 between 2016-2017, CEO David Weinreb stands to lose his entire $15 million investment. On the contrary, his upside will be leveraged if he can in fact redevelop the properties as planned.
Another positive sign in HHC is the record of insider buying. Numerous directors have made significant purchases since the stock began trading in November 2010, which is a vote of confidence especially given the real estate expertise and caliber of the company's directors (their profiles can be read on www.howardhughes.com)
A Look at Alignment in Brookfield Residential Properties
In the case of Brookfield Residential, the parent company (Brookfield Asset Management) opportunistically increased its ownership stake by buying shares in the open market last summer when the price was under $7 (now >$10). Why would the parent company want to increase its stake when it already owned 72.5% of BRP at the time? I think we all know the answer. Brookfield Asset Management's investment track record is legendary, and when it buys shares in anything that trades in the open market - especially its own subsidiaries - it is certainly worth paying attention to.
In the latest annual report, it was disclosed that a "certain executive" purchased two million shares within the last year through an escrowed share purchase program via the parent company. I believe this is why the insider purchase was not reported through the typical channels (e.g. INK Research, SEDAR). I do not know which executive purchased the shares, though I suspect it was Allan Norris, the current chief executive.
It must be remembered that strong alignment is no guarantee of investment success; however your downside is more protected from management stupidity with characteristics such as those mentioned above.
Saturday, 4 February 2012
New Beginnings
Welcome to my blog. This website will serve to identify value investment opportunities and build on the knowledge base of companies under consideration over time. As the name suggests, I have a strong inclination for contrarian themes and spinoff stocks, two facets of value investing which require one to be comfortable with going against the crowd for a prolonged period of time. I wish everyone luck in their investment endeavors and hope that information provided in this site will prove useful for someone, somewhere in the world.
Subscribe to:
Posts (Atom)