Saturday, April 7, 2018

**CORRECTION NOTICE** Beyond Convertible Debentures: Guardian Capital Group (GCG.A), April 6, 2018, Update

*** CORRECTION NOTICE.  April 9, 2018. *** Thanks to a comment made by one of our astute readers, it was noted that we were possibly "double-counting" the value of Guardian Capital's BMO shares and corporate investment portfolio since I was including the dividend income that was generated from these two sources in the multiple calculations I had previously done on the company's operating income.   The reader quite correctly indicated that this dividend income should be carved out, and we've done that now - all figures below have been updated.  The corollary of this correction is that the overall thesis I have on Guardian Capital is still the same, but the amount of perceived undervaluation is not as much as I had previously indicated when this blog post was first published over the past weekend.  Please see below for details - corrections in the text of the article are in blue text.  As I always say on this blog, everything you read 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.
A brilliant azure blue male Mountain bluebird (Sialia currucoides) on barbed wire near Beaverhill Lake, Alberta.  Copyright © 2013 Felix Choo / dingobear photography.  Picture is available for sale as prints and wall art at Fine Art America.  Picture is available for licensing at Alamy Images. Photo may not be reproduced without permission. 

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, April 7, 2018, Update

Since our last Beyond Convertible Debentures update on Guardian Capital in late February, the company has officially filed its 2017 annual financial statements and annual information form on SEDAR, which allows us to update a few of numbers before the company files its 2018 Q1 financials.  We won't repeat the background on the company we went into in our last update on Guardian; for a recap, click here

Instead, let's just get to the updated numbers. 

When attempting to value Guardian Capital, I like to use a sum-of-the-parts type of approach.  The way I see it, there are three main parts to company's valuation: (1) Guardian's asset management business, (2) Guardian's large position in BMO shares, and (3) the rest of Guardian's proprietary investment portfolio, which mainly comprised of a diversified global equities portfolio.  The investment premise here has always been that the BMO shares and the investment portfolio constitute a large portion of Guardian's share price, allowing investors to essentially buy the company's main asset business for either very cheap or, at times, free.  Let's see what the numbers tell us: 

Guardian Capital's class 'A' non-voting shares (GCG.A) closed Friday (April 6) at $24.10 per share and its common voting shares (GCG) closed at $24.00 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 $24.09 per share.

Based on the numbers we've calculated from publicly available sources, $12.07 of this $24.09 total per share value is comprised of Guardian's holdings of 3.70 million BMO shares and $9.54 of the $24.09 is made up of the rest of Guardian's proprietary investment portfolio.  This leaves $2.48 of per share value in what's left of the $24.09, which we would, by process of elimination, then attribute to Guardian's core asset management business.  Stated differently, as at the close of trading on Friday, the market is pricing Guardian's asset management business at only $2.48 per share ... because the rest of the share price value is comprised of Guardian's own holdings in a big chunk of BMO shares and a proprietary diversified investment portfolio that is mostly made up of global equities.  

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

The crux of our investment thesis is that the $2.48 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 $48.2 million of operating earnings and carve out the dividends generated from the BMO shares and the rest of the company's corporate investment portfolio (these dividends add to $21.4 million), we get a total adjusted operating earnings for Guardian of $26.8 million.  This is a reflection of the true earnings power of the core asset management business since it excludes any income generated from the company's BMO shares and corporate investment portfolio.

If we take the market-implied market capitalization attributable to Guardian's asset management business (i.e., $2.48 value per share x 29.5 million shares outstanding = $73.1 million market implied market cap) and divide it by the $26.8 million of adjusted operating earnings generated, we arrive at a price-to-adjusted operating earnings ratio of 2.73x for this business.  This compares to a ratio of 3.28x when we first started writing about Guardian Capital in this column back in December 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 very undervalued, it's open for debate as to what kind of price-to-adjusted operating earnings ratio multiple that this business should be trading at. 

Like in our previous columns on Guardian, we've 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 adjusted operating earnings ratio on its shares.  In our view, an 8.00x multiple is quite a reasonable ratio.  Click below to view the numbers larger:

As you can see, with an 8.00x multiple, we would get to a value of $28.87 per share, which is 19.8% higher than GCG.A's close price on Friday of $24.10.  So, based on this quick-and-dirty analysis, there's quite a bit of potential upside here.  As such, perhaps this suggests an opportunity?

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 it's even cheaper now than it had been the last two times we mentioned the company on this blog. When we dive into the numbers and carve out the significant value of its holding of BMO shares plus the rest of the company's proprietary investment portfolio, the "stub" asset management business is currently trading only at a 2.73x price-to-adjusted operating earnings ratio. (I repeat: only 2.73 times!)
  • 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 $711.2 million.  This implies a total business trailing price-to-earnings ratio of 7.47x.  This is also cheap, and considerably cheaper than the TSX as a whole.
  • 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 2.07%. 
  • 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 beginning of 2018, volatility in markets have picked up and we are now firmly entrenched in a rate tightening cycle, not to mention all of the disruptive geopolitical risks out there. 
  • 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 increased  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 $25.57 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.  


  1. Should you not remove the income from the investments to determine what the management company is worth? Are you not double counting the BMO value if you include their dividends when calculating the value of the management company?

    1. Hi, that’s a very good point and definitely an oversight on my part. I will endeavour to re-run the numbers and post a correction when I get a chance later tonight. Thank you for bringing this to my attention.