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.
- 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.
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.
Thanks for linking to my write up. I really wanted to like Guardian, and do, just at a lower price. It's telling though that I tried to be harsh to Guardian with every assumption and still came to the conclusion it's probably worth $27.08.
ReplyDeleteI'd love to see more of these Beyond Convertible Debentures articles, whether on Guardian or otherwise. I have a particular soft spot for your positions in DIV and ALC, being a former DIV shareholder and a wannabe ALC buyer.
While I admit I'm too conservative for my own good, I would like your take on a few things about Guardian:
1) There is a fairly substantial future capital gains tax liability on the portfolio, particularly BMO, isn't there? Any idea how to account for that? Tough to do since there's a big tax bill, but most will be deferred for years (if BMO is sold off slowly). It certainly sways the intrinsic value quite a bit if you discount the investments at all.
2) AUM was ticking lower before the Alta deal, not a lot but not what you'd like to see. While Guardian has a pretty good reputation and does well in its niche as you said, how would you rate the quality of the business?
3) It looked clear to me that the best thing for shareholders is to liquidate. Asset managers are getting 2% of AUM in acquisitions (which would be $20/Guardian share), and there's a lot of consolidation going on. Yet Guardian is going the other way and trying to grow (looking at the Alta deal). Do you see any chance of Guardian being acquired when they've shown they want to be acquirers?
Hi Tyler, I am sorry, I did not see your comment until now. (For some reason, I hadn't been getting notifications on comments awaiting moderation on this blog). Thanks for your comment and your kind words.
DeleteDIV and ALC are both interesting companies. Would love to publish more detailed posts on both at some point but time always seems to be at a premium. Will definitely consider it though.
On your questions on Guardian:
1) Fair point on the tax liability. To be honest, I don't have a great idea on how to measure this, and I acknowledge that you did take a stab at it in your blog, which I thought was well-considered. Let me mull this one over.
2) Also a fair point which I, too, have noticed. Shrinking AUM is definitely not what you want to see. That said, I do think Guardian has been very disciplined and have stuck to a Canadian focused, GARP strategy in its investing - and as you know, Canadian equities and dividend investing have been relatively out-of-favour in light of the recent dominance of big tech. Pivoting to US and global equities has been slow for this company, and in the interim, I believe institutional investors such as pension funds have reduced Canadian equity allocations in favour of foreign equities as a matter of policy, and unfortunately, this has negatively affected Guardian. I would still rate the quality of their business as high, but I think acquisitions which further diversify the company's investment style will benefit them in the long-term.
3) As you know from reading my posts on Guardian, I also think the sum of the parts are currently worth more than the whole. Of course, Guardian does have a control block and any takeover will require the majority shareholders' support. Thus far, they haven't been interesting in selling presumably, but everyone has their price, right? If the discount of the core business becomes too great and an interested suitor offers enough, I think this company could put itself on the block. Given the large number of BMO shares that Guardian owns (which is about 0.58% of outstanding BMO shares), it would make sense for BMO to be a purchaser of the company as they have added incentive to take those shares' Guardian owns back into treasury.