Beyond Convertible Debentures: Guardian Capital Group (GCG.A), August 10, 2018, Update

 
Whale shark for Shark Week at the Osaka Aquarium Kaiukan.  Osaka, Japan. Copyright © 2018 Felix Choo / dingobear photography.  Photo may not be reproduced without permission. 

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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 reading 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, August 10, 2018, Update

Since our last Beyond Convertible Debentures update on Guardian Capital in April, the company has reported on two full quarters, which allows us to update a few of the numbers we've tossed around in previous analyses. We won't repeat the background on the company that we've gone into in previous updates; click here to for links to our previous posts on Guardian Capital. 

Instead, we'll 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 core asset management business, (2) Guardian's large position in BMO shares, and (3) the rest of Guardian's proprietary investment portfolio, which is mainly comprised of a diversified global equities portfolio.  The investment premise here has always been that the BMO shares and the proprietary 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 current numbers tell us: 

Guardian Capital's class 'A' non-voting shares (GCG.A) closed Friday (August 10) at $23.66 per share and its common voting shares (GCG) closed at $23.47 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 $23.64 per share.

Based on the numbers we've calculated from publicly available sources, $13.21 of this $23.64 total per share value is comprised of Guardian's holdings of 3.70 million BMO shares and $10.25 of the $23.64 is made up of the rest of Guardian's proprietary investment portfolio.  This leaves only $0.19 of per share value in what's left of the $23.64, 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 $0.19 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. In other words, an investor that buys Guardian's shares at current prices is essentially getting the company's core business for free! 

Is the market mispricing Guardian Capital?  We continue to think so. 

The crux of our investment thesis is that the $0.19 per value attributed to Guardian's asset management business is, quite frankly, too low for all of the things what the company brings to the table.  As at June 30, 2018, Guardian generated $22.4 million of adjusted operating earnings in the last 12 months.   Note that "operating earnings" here includes the regular income from Guardian's fee-generating investment management activities, less the dividends generated from the BMO shares and the rest of its proprietary investment portfolio.  This figure also excludes 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., $0.19 value per share x 29.0 million shares outstanding = $5.4 million market implied market cap) and divide it by the $22.4 million of adjusted operating earnings generated, we arrive at a (ridiculously low!) price-to-adjusted operating earnings ratio of 0.24x for this business.  In my mind, this is just silly.  

That said, even though I think Guardian Capital at current prices is clearly undervalued, it remains open for debate as to what kind of price-to-adjusted operating earnings ratio multiple that its core 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, but there's no magic to this number per se.  Others may make more or less aggressive assumptions.  In any event, using an 8.00x multiple, here's what the numbers look like:

Ok, as you can see, with an 8.00x multiple, we would get to a value of $29.11 per share, which is 23.0% higher than GCG.A's close price on Friday of $23.66.  So, based on this quick-and-dirty analysis, we think there's some upside here. 

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 as cheap now as it's been since we've started following the story.  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 0.24x price-to-adjusted operating earnings ratio. In other words, an investor buying it at current prices is essentially buying Guardian's well-established asset management business for free.
• The company's asset management business has a long history of being consistently profitable.  In the last 12 months, the company booked $75.5 million in after-tax net earnings.  Based on Friday's close prices, the company has a market capitalization of $685.8 million.  This implies a total business trailing price-to-earnings ratio of 9.09x.  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 2.11%. 
• 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 continue 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 volatile 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, whose value is backed up by some interesting components.  As such, we continue to slowly build a position in GCG.A with an average cost base of approximately $25.19 per share.   



An Alternative View

In investing and life, it's always good to be open to alternative views.  Over at the Canadian Value Stocks blog, there's a relatively less bullish view on Guardian Capital, which you can access here.  Please note we are not affiliated in any way with the other blog, have no control and take not responsibility over its content, and make no opinions and endorsements of it therein.  We are merely providing this link for information only, which potential readers that are interested in Guardian Capital may find useful. 

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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.  

August 3, 2018, Update: Peanut Convertible Debentures Power Rankings

Hi, again.  I know it's been awhile since our last update - I appreciate you sticking with us.  This is the 33rd update of the Peanut Convertible Debentures Power Rankings, which is current to August 3, 2018.  Thank you for continuing to read and support the Canadian Convertible Debentures Project.
      
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For a summary of the rankings of our entire convertible debenture coverage universe including the quantitative model prices of, and notes on each issue we follow, click on the table below to view it larger.

The Top-5 picks in the Power Rankings are also described with a little more detail in the corresponding section below.

For background information on the Peanut Power Rankings, please see our FAQs by clicking here. 

Important: the Peanut Power Rankings are provided as information and opinions only and are 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.


Public Service Message: the Financial Post Convertible Debentures List

We've received quite a few emails asking about the Financial Post's convertible debentures list, which has apparently vanished from the newspaper's website.  Unfortunately, we don't know of another complete list of Canadian convertible debentures that is available free to the public that has the same depth of information that was contained in the Financial Post list.  The stats and figures we use for the Peanut Power Rankings we collect from various public sources and calculate ourselves (it's a lot of work!); we don't have a complete list of convertible debentures either.

For those of you out there that are clients of a full-service brokerage firm with a research team that covers convertible debentures, you may be able to obtain a complete list if you ask your broker.  Also, as we announced on December 20, thanks to one our valued readers, we were informed that the TSX publishes a basic list on its website approximately monthly.  It's not the same as the old Financial Post list, but hopefully it can still be of use to some of you out there. 

Market Commentary - Quick Points (August 3, 2018)

• There's a word for a system of government where cult of personality prevails while political opponents and news media are declared as enemies of the people. 
• If it wasn't already abundantly clear, what's happening right now is disturbing and dangerous.
• The above points aren't meant to be political statements. 
• Let that sink in for awhile.
• From a financial perspective, you already know that markets hate instability.
• The current US administration is exacerbating trade tensions with China, Canada, Mexico, and a host of other nations and economic regions.
• The current US administration pushes democratic allies away while embracing dictators and adversaries. 
• The current US administration forced through an unnecessary tax cut that blatantly benefits the more wealthy over the less wealthy, which will help raise the US deficit above a trillion(!) dollars a year.
• The current US administration has taken measures to further cripple Obamacare, which, beyond the headlines, amounts to another unnecessary tax cut that benefits the more fortunate over the less fortunate. 
• The current US administration has taken measures to seriously cripple environmental regulations across the board. The myopic may cheer this as "pro-business" and "being competitive", but longer term, beyond the next quarterly earnings or annual earnings, this has serious (and expensive) implications for public health, safety, and wellness.  Resulting long-term costs will be socialized by the tax-paying public while the short-term profits will be privatized.  
• The current US administration has taken further measures to cripple public education.  Draw your own conclusions as to whether this makes an electorate easier to govern and/or rule.
• The current US administration has put badly needed investment in crumbling (productive) infrastructure on the back burner in favour of (pointless) infrastructure such as a wall on the Mexican border. (Sidebar: if you're paying attention as investors, there's going to be an opportunity here to invest in productive infrastructure once (if?) the craziness subsides). 
• The current US administration is starting to show signs of threatening the US Federal Reserve's independence to conduct monetary policy, which may impinge on the Fed's ability to take measures to manage inflation and the economic cycle. 
• Sigh, this is a lot to digest.  2018 makes one nostalgic for 2015 when that nice fella who read books and played basketball was still president and the Chicago Cubs still hadn't won a World Series in 106 years.
• Despite all of this, for now, the S&P 500 is managing to chop higher (albeit at elevated volatility) as summer progresses. 
• Given all of the above, this would seem counter-intuitive but maybe there is a logic to this: as a whole, the stock market represents collective financial wealth.  This financial wealth is distributed unevenly.  To the extent that current policies favour those who control more of this financial wealth than those who don't, then, in the stock market, why worry, right?
• The question of course is whether this is sustainable. This bull market is already old, equity valuations have been stretched for awhile, and after the unnecessary tax cut, exactly what catalysts remain? It feels like we're playing musical chairs inside a log cabin while the forest outside is on fire.  One way or another, at some point the music stops for awhile just like it did in 2008 or 2000 or 1987 or 1929 ...
• Here in Canada, the trade situation for us is either bad or worse. Sometimes, you just get dealt bad hand and you play it as best you can, which is what I think our federal government is trying to do now.
• Here in Canada, I can feel an increase in the hyper-partisan elements that define the political environment south of the border.  This is troubling.  We've already been through elections in British Columbia and Ontario, with Alberta and federal elections on tap for 2019.  
• Here in Canada, those who whinge about weak Canadian competitiveness relative to an American position that has been shaped by short-sighted policies (see points above about US tax cut, repeals of environmental regulations, lack of investment in infrastructure and education, etc.) are being similarly myopic.  An opinion: those who whip up this whinging to incite the impressionable public are doing so for their own (short-term) political and/or financial gain.   
• Here in Canada, we should expect better of ourselves than this.
• Here in Canada, previous tightening by the Bank of Canada is starting to show in economic data.  Most economists think there will be one more rate hike in September, but I'm not even sure this is a slam dunk. 
• Here in Canada, I (still) think it's best to stay broadly diversified and protect your capital.
• Let's get to the Top-5 convertible debentures.  As usual, any and all comments on this blog are my opinions only,       

Peanut Power Rankings Top-5 Convertible Debentures (August 3, 2018)

1. Diversified Royalty Corp, 5.25% 31-December-2022, Convertible Debentures.  (Ticker: DIV.DB), (Last update's ranking: #1).  As per usual, DIV pre-releases sales results of its royalty interests prior to the release of its quarterly financial results.  As a pleasant surprise, AIR MILES® seems to be bouncing back after a six negative quarters in a row, with Q2 miles issued up 2%.  Meanwhile, Mr. Lube and Sutton Realty same-store-sales look in-line with expectations.  So generally, the sentiment is positive. 
   The bottom line: DIV is an interesting royalty company that focuses on well-known trademarks, and currently owns the Sutton Realty, Mr. Lube, and AIR MILES® trademarks in Canada.  Management is highly regarded, and are aligned with shareholders through their own shareholdings.  Finally, the terms of the convertible debenture seem positive and this is a reasonable credit risk, in our view.  DIV.DB is holding steady in the current volatile market environment.  We continue to think that the underlying stock has the potential to pop at the announcement of the next royalty acquisition - but it's unclear when that will be - it's been a year since the company's last royalty acquisition. We're long DIV.DB at an average price of $100.08, and quietly await along with everyone else.  We also have a position in DIV common shares.

2. American Hotel Income Properties REIT LP, 5.00% 30-June-2022, Series 'U' US Dollar Convertible Debentures. (Ticker: HOT.DB.U), (Previous ranking: #3).  The CEO keeps buying units on the open market, but the market keeps not caring.  What the market does care about: the Q2 results, which will be announced on August 10.  This REIT needs to post a good quarter to bolster its flagging unit price.   

The bottom line: HOT.DB.U has traded below par in the months since it hit the market. This is a play for those who have confidence in the REIT's highly regarded management, believe in the strength of the US economy, and have a negative forward view on the Canadian dollar.  Arguably, the trust units of the REIT are trading cheaply, but the company does need to start hitting earnings estimates.  We're long HOT.DB.U at US$98.00.

3. Tricon Capital, 5.75% 31-March-2022, Series 'U' Extendible US Dollar Convertible Debentures. (Ticker: TCN.DB.U), (Previous ranking: #4).  Since the last update, Tricon has entered into a $2 billion joint venture with a couple of institutional investors to acquire more more rental houses in the US.  (Read the press release here).  They are building a nice critical mass in the US residential home rental business.  Q2 results are expected on August 9.

The bottom line: TCN.DB.U is a very good quality convertible debenture issue, and has a nice combination of potential upside, yield, and USD-denominated exposure (for those who believe the Canadian dollar will depreciate somewhat, as we still do).  We've been long TCN.DB.U since it debuted at US$100.00 and will continue to hold it unless there's a change in fundamentals.

4. Surge Energy, 5.75% 31-December-2022, Convertible Debentures. (Ticker: SGY.DB), (Previous ranking: #2).  The 2018 increase in oil companies has kind of taken a breather for now, and so has the price in Surge's underlying stock.  Q2 results are expected shortly. 

The bottom line: If you have a positive outlook on energy prices or even just a neutral one, SGY.DB might be worth a look here.  Please note, however, investing in an junior Canadian resource company - even in its convertible debentures - requires a relatively higher risk appetite.

5. Morneau Shepell, 5.00% 30-June-2021, Series 'A' Convertible Debentures. (Ticker: MSI.DB.A), (Previous ranking: #5).  The share price of Morneau Shepell, the human resources, retirement benefits, and technology company, remains at lofty levels.  Q2 results are expected as soon as this week, and it'll be interesting to see if the company can maintain its earnings momentum. 

The bottom line: This is a quiet but solid company that executes very nicely in its niche, and the convertible debenture is now trading in the money thanks to the continued strength of the MSI common shares.  MSI stock isn't cheap, but should it continue its positive price momentum on the back of earnings growth, the MSI.DB.A convertible debentures will come along for the ride.  We have no position in MSI.DB.A.

Picture of the Day


Sundown, from the other side of the Pacific.  Yokohama, Japan. Copyright © 2018 Felix Choo / dingobear photography.  Photo may not be reproduced without permission. 

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In addition, for media, sponsoring and/or financial institution inquiries, please email us at convertibledebs@gmail.com.  Thank you for your interest!

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