Saturday, February 24, 2018

Beyond Convertible Debentures: Guardian Capital Group (GCG.A), February 23, 2018, Update
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Beyond Convertible Debentures is a semi-regular column on this blog where we explore different and somewhat less widely covered investment ideas that exist outside of our favourite asset class of convertible debentures.  We hope at least some of you out there find it interesting. As always, thank you for logging into The Canadian Convertible Debentures Project.

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Beyond Convertible Debentures: Guardian Capital Group, February 23, 2018, Update

In our last Beyond Convertible Debentures column, we discussed Guardian Capital Group, an independent asset manager that is public traded on the TSX.  On Thursday, the company released its 2017 operating results.  Consequently, in this column, we've updated some of the numbers from our previous analysis.

Ok, let's recap.  Here are some quick points 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 maybe best well-known for its growth-at-a-reasonable-price (GARP) approach in its equities mandates, and also for being one of Canada'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 on the exchange: 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 would consider the non-voting, class 'A' common shares (GCG.A) to be more investable for the average investor.
  • Guardian Capital currently pays a quarterly dividend of $0.10 per share.  (Correction update: However, beginning with the dividend payment scheduled for April, the quarterly dividend will increase to $0.125 per share, which is effectively a 25% increase.  Sorry, I had previously missed in the press release announcing Guardian's 2017 operating results).  Guardian Capital's dividend has now increased annually for the last eight consecutive years. Good stuff.  We will see if we get another dividend increase this April, which is the month when the company has typically increased its dividend in recent years.
  • The company manages investment 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 December 31, 2017, Guardian had $27.3 billion in assets under management.
  • On January 2, 2018, Guardian closed its acquisition of a majority (70%) interest in Alta Capital Management, a Salt Lake City-based US asset manager.  The acquisition effectively increases assets under management at Guardian by over US$3 billion.  Because this acquisition closed after quarter-end, the financial effects of bringing Alta Capital Management aboard will not be reflected until Guardian's 2018 first quarter results are available in May. 
  • In addition to the assets Guardian manages for third parties, Guardian also manages its own proprietary investment portfolio (i.e., investment assets that Guardian itself owns).  This investment portfolio is an important part of Guardian's valuation as a whole, and we'll get to these details a little further below.  
  • On February 12, 2018, it was announced that Scotiabank was paying $950 million to acquire Jarislowsky Fraser, a privately held, Montreal-based independent investment manager with about $40 billion in assets under management.  This acquisition provides a bit of a baseline on what Guardian might be worth should it, too, be acquired.  However, because Jarislowsky Fraser was privately held, there are no publicly available financial statements for the firm and I am not aware if it has a similar significant proprietary investment portfolio to the one held by Guardian.
Ok, let's now review some history concerning Guardian. In 2001, Guardian sold its retail mutual fund business (with assets under management of approximately $2 billion at the time) 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 done really well 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 held 3.80 million shares of BMO.   Guardian's February 22, 2018, press release which pre-announced the company's 2017 operating results (the actual 2017 annual financial statements aren't expected to be released until mid-March) did not separately disclose the number of BMO shares the company still holds (this information is usually disclosed in its financial statements).  However, it did disclose that Guardian's entire proprietary investment portfolio (which includes the BMO shares) as at December 31, 2017, had a market value of $650 million. 

As you can see, there is considerable value in Guardian's BMO shares and investment portfolio - and that's before the regular earnings and cash flow the company generates from its regular business of being an investment asset manager for third-party assets.

When I attempt to value the company, I therefore like to use a sum-of-the-parts type of approach.  The way I see it, 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 (February 23) at $25.47 per share and its common voting shares (GCG) closed at $25.20 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 $25.44 per share.

Based on the numbers we've calculated from publicly available sources, $12.80 of this $25.44 total per share value is comprised of Guardian's 3.80 million BMO shares and $9.28 of the $25.44 is made up of the rest of Guardian's proprietary investment portfolio.  This leaves $3.36 of per share value in what's left of the $25.44, which we would, by process of elimination, then attribute to Guardian's primary asset management business.  Stated differently, as at the close of trading on Friday, the market is pricing Guardian's asset management business at only $3.36 per share ... because the rest of the share price value is comprised of Guardian's proprietary investment portfolio including its holdings in BMO. 

So, is the market mispricing Guardian Capital?  We think so. 

The crux of our investment thesis is that the $3.36 per value attributed to Guardian's asset management business is, quite frankly, too low for what the company brings to the table.  As at December 31, 2017, Guardian generated $48.2 million of operating earnings in the last 12 months.   Note that "operating earnings" here includes the regular income from Guardian's 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.

If we take the market-implied market capitalization attributable to Guardian's asset management business (i.e., $3.36 value per share x 29.5 million shares outstanding = $99.1 million market implied market cap) and divide it by the $48.2 million of operating earnings generated, we arrive at a price-to-operating-earnings ratio of 2.06x for this business.  This compares to a ratio of 3.28x the last time we ran this column and, at the time, we thought 3.28x was undervalued.  This means the market is possibly underestimating Guardian's asset management business even more now than it was before Christmas.

That said, even though we think it's undervalued, it's open for debate as to what kind of price-to-operating-earnings ratio multiple that this business should be trading at. 

Like last time, 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 (click below to view larger):

As you can see, with an 8.00x multiple, we would get to a value of $35.14 per share, which is 38.0% higher than GCG.A's close price on Friday of $25.47.   All in all, still looks pretty good to us. 
To summarize, here are what we see as positives associated with investing in Guardian Capital shares:
  • Not widely followed by Bay Street, we believe that the market continues to undervalue Guardian Capital - and even moreso than the last time we ran this column.  When we dive into the numbers and carve out the significant value of its holding of BMO shares plus the rest of its proprietary investment portfolio, the "stub" asset management business is currently trading only at a 2.06x price-to-operating-earnings ratio. 
  • The company's asset management business has a long history of being consistently profitable.  In 2017, the company booked $93.7 million in after-tax net earnings.  Based on Friday's close prices, the company has a market capitalization of $751.1 million.  This implies a total business trailing price-to-earnings ratio of 8.02x.  This also seems cheap to us.
  • Guardian Capital has grown its dividend in each of the last eight years, and based on the go-forward quarterly dividend of $0.125 per share, the current dividend yield of the stock is approximately 1.96%. 
  • 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 (given their history of dealing with one another, BMO would seem like a possibility), 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 less than 10,000 shares a day, so bid-ask spreads can be quite wide at any given time.  Our view: know your price and set limit orders and not market orders when buying or selling.
  • A large part of Guardian's business is focused on managing assets for institutional investors such as pension funds.  In recent years, large institutional investors have tended to reduce their allocations to liquid assets such as stocks and bonds, and instead increasing allocations to such asset classes as real estate, private equity, and infrastructure.  If this trend continues, traditional asset managers such as Guardian could be negatively affected.
  • With the huge, widespread of acceptance of ETFs and other lower-fee investment options, pricing power for traditional investment asset managers is arguably 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 today's (expensive!) market, we're always on the lookout for potentially undervalued investments such as Guardian Capital.  In our view, the market continues to undervalue this investment asset management firm.  As such, we continue to build a position in GCG.A; our average cost base is approximately $25.69 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.  

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