Sunday, December 17, 2017

Beyond Convertible Debentures: Guardian Capital Group (GCG.A)
A bird's eye view of the Financial District.  San Francisco, California. Copyright © 2016 Felix Choo / dingobear photography.  Picture is available for licensing from Alamy Images.  Photo may not be reproduced without permission. 

I get that the Canadian convertible debenture market is what we're all here for, but of course there's a lot more out there in the investable universe.  And, if we're all building truly diversified portfolios (as we should be!), we ought to be looking at opportunities in other asset classes as well.

So, with that in mind, we thought that a new, semi-regular (or maybe occasional?) column for this blog might be fun, where we explore different and maybe somewhat less widely covered ideas that exist outside of our little world of convertible debentures.  As such, we present to you Beyond Convertible Debentures, a new semi-regular column here at The Canadian Convertible Debentures Project.

Important disclaimer: Like everything else on this website, content here is provided as information and opinions only and not intended to be a provision of investment advice or a recommendation of any investment action in any form. As with all information concerning investments, it is highly recommended that an individual consult with a qualified investment professional before making any investment decisions.

Beyond Convertible Debentures: Guardian Capital Group (GCG.A)

Ok, let's get started.  For our first Beyond Convertible Debentures column, we thought we would talk about Guardian Capital Group.  Here are some quick facts about the company:
  • Founded in 1962, Guardian is one of the last, independent, publicly traded investment asset managers on the TSX.  Although Guardian invests assets in a number of different asset classes, it is perhaps best well-known for its growth-at-a-reasonable-price (GARP) approach in its equities mandates, and also as one of the country's leading fixed income managers. 
  • The shares of Guardian have been listed on the TSX since 1969.  Today, there are two classes of shares that trade: the common voting shares (ticker: GCG) and the class 'A', non-voting common shares (ticker: GCG.A).  Neither of the two classes is particularly liquid, especially the voting shares.  As such, I consider the non-voting, class 'A' common shares (GCG.A) to be more investable for the average investor.
  • Guardian Capital pays a quarterly dividend of $0.10 per share.  This dividend has increased annually for the last eight consecutive years.
  • The company manages assets for institutional investors such as pension funds, endowment funds, third-party mutual funds, and ETFs, as well as high net worth individuals and charitable foundations.  As at September 30, 2017, Guardian had $26.3 billion in assets under management.
  • In addition to the assets Guardian manages for third-parties, Guardian also manages its own proprietary investment portfolio.  This investment portfolio is an important part of Guardian's valuation as a whole, and we'll get to more details on this in short order. 
But first, a little bit of history.  Back in 2001, Guardian sold its retail mutual fund business (with assets under management of approximately $2 billion) to the Bank of Montreal (BMO) for consideration of approximately $180 million.  But instead of taking cash in return, Guardian opted to take 4.96 million shares of BMO as payment.  This was a good move - BMO shares have more or less tripled since 2001, plus Guardian has collected millions in dividends from its BMO holdings in the intervening period.

In the past few years, Guardian has been slowly selling down its initial BMO position and diversifying the proceeds into its other investment mandates, especially within the global equities asset class.  As at September 30, 2017, Guardian still holds 3.80 million shares of BMO, and the rest of its proprietary investment portfolio as at the same date had a market value of $239.0 million, according to its Q3 financial report.

As you can see, there is considerable value in Guardian's BMO shares and investment portfolio.  When I attempt to value the company, I therefore like to use a sum-of-the-parts type of approach, and there are three main parts to value here: (1) Guardian's asset management business, (2) the BMO shares, and (3) the rest of Guardian's proprietary investment portfolio.  Ok, let's crunch some numbers and take a closer look at the numbers behind these interesting parts (click the table below to view larger): 

Guardian Capital's class 'A' non-voting shares (GCG.A) closed Friday at $26.14 per share and its common voting shares (GCG) closed at $25.50 per share.  If we take a weighted average of the two classes of shares based on their market capitalization, we get a "combined" per share value of $26.07 per share.  Based on the numbers we've calculated, $12.83 of this $26.07 total value is comprised of Guardian's 3.80 million BMO shares, $8.02 of the $26.07 is made up of the rest of Guardian's proprietary investment portfolio, leaving $5.22 of per share value in what's left of the $26.07, which we would, by process of elimination, attribute to Guardian's main asset management business.

The crux of our investment thesis is that the $5.22 per value attributed to the asset management business is, quite frankly, cheap.  As at September 30, 2017, Guardian generated $47.5 million of operating earnings in the trailing 12 months; operating earnings includes the regular income from its fee-generating investment management activities, as well as dividends and interest from its BMO shares and the rest of its proprietary investment portfolio, while excluding any net capital gains (or losses) generated from trading of its BMO shares and/or proprietary investment portfolio.

Based on our figures, the market is currently valuing Guardian Capital's asset management business at a price-to-operating-earnings ratio of 3.28x.  Is this undervalued?  We tend to think so.  But I suppose it's an open question as to what multiple this business should be trading at, as we believe the market isn't fully appreciating the value of Guardian's three component parts.

Just for fun, we tinkered with the numbers to see what the shares of Guardian Capital would trade at if the market assigned, say, an 8.00x price-to-operating-earnings ratio on its shares:

As you can see, with an 8.00x multiple, we would get to a value of $33.59 per share, which is 28.8% higher than GCG.A's close price on Friday of $26.07.   Looks pretty good to us.
To recap, here are what we see as positives associated with Guardian Capital:
  • Not widely followed by Bay Street, we believe that the market appears to be undervaluing Guardian Capital.  When we dive into the numbers and carve out the considerable value of its holding of BMO shares plus the rest of its proprietary investment portfolio, the "stub" asset management business is only currently trading at 3.28x price-to-operating-earnings ratio. 
  • The company's asset management business has a long history of being consistently profitable.
  • Guardian Capital has grown its dividend in each of the last eight years, and the current dividend yield of the stock is 1.53%. 
  • Given that there are few publicly traded independent investment asset managers left trading on the TSX, there is definitely some scarcity value in Guardian.  It would almost certainly be a good acquisition target for any of the big Canadian banks (BMO, I'm looking a you), but this is, of course, just pure speculation on our part. 
There are also, of course, risks to investing in Guardian Capital.  Here are some of the more prominent risks, in our view:
  • The value of Guardian Capital's shares are highly correlated to equity markets, and in the event of a broad market correction, they would almost certainly struggle.  In the depths of the 2008 financial crisis, GCG.A traded as low as $3.00 per share. 
  • Since the company's position in BMO shares is such a large part of its overall valuation, Guardian's fortunes are therefore also tied to that of BMO's.  I tend to think that BMO is a pretty solid bank, but to the extent that BMO runs into any issues, then shares of Guardian would be negatively affected as well. 
  • The shares of Guardian Capital are illiquid.  Even the more liquid class 'A' shares only trade on average about 7,000 shares a day, so bid-ask spreads can be quite wide at any given time.  Our view: know your price and set limit orders, not market orders.
  • With the huge, widespread of acceptance of ETFs and other lower-fee investment options, pricing power for traditional investment asset managers can be argued to be eroding.  This may negatively affect Guardian's ability to generate the same level of fee income per dollar of assets under management going forward.
The bottom-line: in an expensive market, we're always on the lookout for potentially undervalued investments such as Guardian Capital.  This is an old, venerable investment firm that the market appears to be overlooking.  As such, we've initiated a position in GCG.A at an average price of $25.74 per share.

Any thoughts, questions, or comments?  As per usual, please feel free to drop us a line through the comments form below or by sending us an email.  

No comments:

Post a Comment