Beyond Convertible Debentures: Guardian Capital Group (GCG.A), December 6, 2018, Update

The bear (market) is coming for us all. What to make of Guardian Capital, then? Anana, the polar bear, at Lincoln Park Zoo in Chicago, Illinois. Copyright © 2014 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, 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.

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Beyond Convertible Debentures: Guardian Capital Group, December 6, 2018, Update

Since our last Beyond Convertible Debentures update on Guardian Capital in August, the company has reported on its fiscal third quarter, 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, 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 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.  Note that the ownership of (2) and (3) here belong solely to Guardian Capital; these positions are separate and apart from the assets it invest on behalf of its clients.

The investment premise with Guardian Capital 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 today (December 6) at $21.75 per share and its common voting shares (GCG) closed at $21.85 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 $21.76 per share. Like many other stocks in the last couple of months, it's taken quite a swipe from the bear. 

Based on the numbers we've calculated from publicly available sources, $11.98 of this $21.76 total per share value is comprised of Guardian's holdings of 3.70 million BMO shares and $9.48 of the $21.76 is made up of the rest of Guardian's proprietary investment portfolio.  This leaves only $0.31 of per share value in what's left of the $21.76, which we would, by process of elimination, then attribute to Guardian's core asset management business.  Stated differently, as at the close of trading today, the market is pricing Guardian's asset management business at $0.31 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 cheap. 

Does cheap equal good value here?  Well, it depends on perspective.  Since we started following this name, we have always thought so.  Let's do some mental gymnastics to state our case as to why.   

The crux of our investment thesis is that the $0.31 per value attributed to Guardian's core asset management business is, quite frankly, low for the things what the company brings to the table.  As at September 30, 2018, Guardian generated $24.0 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 core asset management business (i.e., $0.31 value per share x 29.0 million shares outstanding = $9.0 million market implied market cap) and divide it by the $24.0 million of adjusted operating earnings generated, we arrive at a price-to-adjusted operating earnings ratio of 0.37x for this business.  On pure numbers, it doesn't get much cheaper than that.    

This said, even though I think Guardian Capital continues to be underrated by the market, it remains very much 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 played around 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 - different opinions is what makes a market.  In any event, using an 8.00x multiple, here's what the numbers look like:

As you can see, with an 8.00x multiple, we would get to a value of $27.59 per share, which is 26.9% higher than GCG.A's close price today of $21.75.  So, based on this quick-and-dirty analysis, we think there's some relative upside here - but only if the market starts assigning more value to the Guardian's core asset management business.

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. 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 0.37x 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 very, very cheap.
• The company's asset management business has a long history of being consistently profitable.  In the last 12 months, the company booked $97.5 million in after-tax net earnings.  Based on today's close prices, the company has a market capitalization of $631.1 million.  This implies a total business trailing price-to-earnings ratio of 6.48x.  This is also cheap, and is favourable when compared to the TSX as a whole.
• Guardian Capital has grown its dividend in each of the last eight years, and based on the current quarterly dividend of $0.125 per share, the current dividend yield of the stock is approximately 2.30%. 
• 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 company has never been eager to sell, and has remained independent for more than half a century since its founding.

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.  And guess what? As you investors know all too well, the volatility of the last couple of months makes one wonder if a true bear market is around the corner, which would not be surprising after a decade-long bull market. 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 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.  Note that BMO shares have not done particularly well the last couple of months, which has helped drag Guardian's intrinsic value down.  In addition, the rest of Guardian's proprietary investment portfolio is largely comprised of global equities, which has similarly traded off this fall, further lowering intrinsic value.
• 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. 
• The illiquidity mentioned above is due, in part, to the company having a majority owner.  One can (successfully) argue that Guardian deserves to be trading at a discount to its intrinsic value due to the presence of a majority owner, which will have final say in important company matters such as, for instance, any potential sale of the company.
• 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.
• Outside of the Guardian's acquisition of US-based Alta early in 2018, Guardian's assets under management have actually declined in the last year or so.  This could be due in part to the point above, and also due to general declines in the market.  Either way, this is something to keep an eye on; if net redemptions persist or accelerate, this is not good for Guardian's core business.
• 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 valuable (albeit market-sensitive) components.  We continue to hold a position in GCG.A with an average cost base of approximately $25.19 per share, with dividends automatically reinvested.   



An Alternative View

In investing and life, it's always good to be open to alternative views.  Over at the Canadian Value Stocks blog, the principal there continues to follow Guardian Capital, which he most recently mentions in a post 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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