The Risks Inherent With Investing In Warrants

I thought I would write a quick post on the risks with investing in warrants, because the practical risks are not always discussed in finance courses or textbooks. In fairness, the thought to write a post on this topic was borne out of an article posted on The Financial Post a few days ago with respect to the Franco-Nevada Mining / Gold Wheaton acquisition that was recently announced. It provides an instructive example and lesson as to why warrants are inherently risky - especially for those deciding to go long outright.

On December 13th, it was announced that Franco-Nevada Mining would acquire Gold Wheaton by way of Plan of Arrangement for 0.0934 Franco-Nevada shares per Gold Wheaton share and $2.08 in cash consideration. In sum, the consideration would total $5.20 per GLW share, equivalent to a one day 19% premium, and a 60% / 40% split in favour of FNV shares and cash.

As an initial shareholder of GLW (which came into existence in its current form in June 2008), I would not be happy at all in the sense that the original over-subscribed equity raise was for $260mm (with green shoe) at $5.00 for subscription receipts (after a 10 for 1 share consolidation in February 2010) that included one GLW share and a 1/2 warrant struck at $10.00 for 5 years. In my estimation, the value of the 1/2 warrant was anywhere from $0.65 to $1.00 in additional consideration. This deal was well oversubscribed, and you can see the demand for this issue as the stock price tripled in value in the span of a few months (see graph below). The most startling thing is that they were able to issue the 1/2 warrants at 100% ups, which I guess is offset by the fact that each warrant had five years of time to expiration. Typically, in Canada, the strike price is about 20-40% higher than where the underlying is currently trading, and the warrants have an expiry of 18 to 24 months after the deal closes. In hindsight, I do understand why this deal was over-subscribed, and ultimately upsized, with all the brokers and management buying in as well. Any way you slice it, it was a very attractive deal for anybody that bought, which is partly why the stock rifled higher afterwards in the secondary market.





Immediately after the acquisition by FNV was announced, GLW started trading at $5.10 and GLW.WT started trading at $0.28 (see graph above). As a buyer of the sub-receipts on July 8th, 2008 for $5.00, the consideration I am getting out of this deal once it is all wrapped up is approximately $5.20 - a laughable 4% return over the span of approximately 2 years and 8 months. Note that the consideration calculation assumes the FNV portion remains constant (in reality FNV's shares will fluctuate slightly) and the public warrant holders get nothing because they are far out of the money. Moreover, as you can see from the chart below, GLW was being valued quite low by the market. The two charts below were taken from a GLW corporate presentation that was done on November 9th. Given the trading price of the stock, GLW's NAV is approximately $5.65, which means that FNV is only paying 92% of NAV - still a massive discount to where the comps are trading at. So, to clarify, GLW is being valued too low on an absolute and relative basis. Now, the original deal was well supported with players such as GMP, Paradigm, FNX, Sprott, Frank Guistra, and various other insiders buying in, so I am baffled as to how this deal got done because unless they sold when the stock was $10 or $15 (which was only a period of 5 months, under which they were mostly under lock-up), it seems to me that nobody has made any money!





From the perspective of a GLW warrant holder, I would not be happy. First, as an instructional, warrant values are driven off of three main inputs - the underlying share price, the volatility priced into the shares / market by traders, and the inherent time to maturity negotiated into the warrant indenture. Typically it is the former two that drive the pricing of the warrants on a day-to-day basis, as the latter is whittled down slowly as time passes. Let's look at what happened in the case of GLW warrants in the context of this deal.

• Stock Price - In an acquisition, the stock price rifles upwards on announcement of the deal. This is obviously positive for a warrant as part of its value is derived from the stock price. It does depend on where the stock price is in relation to the warrant's strike price. If the value of the consideration offered is less than the strike price, the warrant is basically worthless because it has no intrinsic value and limited time value. In the case of GLW, the publicly traded warrants had a strike price of $10.00, and therefore they will ultimately have zero value once the deal is completed.

• Time To Maturity - The longer the time to maturity, the greater the value of the warrant because it has more time to become "in the money". In the context of the GLW deal, the time maturity shrinks massively, thereby destroying the value of the warrant. Prior to the deal being announced, the warrant had 939 days left until expiry. After the deal was announced, the warrant had 108 days to expiry under a worst case scenario (assuming the deal is wrapped up by the end of March). In one fell swoop, 88.5% of the time that the warrant had left to expiry was eliminated because of the acquisition. This is what we call "event risk" and that is the first explanation for why the warrants dropped in price from $0.57 to $0.28 the day after the announcement, and settled in at $0.17 thereafter.

• Volatility - Prior to an acquisition, a stock price trades freely based on fundamentals and sentiment. After an acquisition, a stock trades in relation to the acquisition price and usually moves very little. If it does move, it is based on the assessment of the deal getting done. In essence, the volatility in the stock evaporates because the stock has no reason to gyrate in response to macro-economic reasons, industry changes, or even company specific developments, etc. It only moves based on news flow related to the deal and supply and demand from the arbs, which means that the stock will typically move very little. Although it would have been more prevalent in a case where the warrants were in the money, in the case of GLW warrants, volatility dropped significantly (see the post-acquisition announcement trading price graph below) and the price of the warrants in the open market cratered. In the case of an acquisition, because both time to maturity and volatility are drastically reduced, it is a little difficult to estimate what portion of the value reduction was attributable to which lever, especially because volatility is imputed from the price of the stock. However, once again, from the graph below you can visually see that volatility of the underlying GLW shares has disappeared.



Now, if you run the black-scholes model, you'll find that the theoretical price of GLW warrants is actually around 2-3 cents, yet the market has priced them anywhere from $0.15 to $0.29 post-deal announcement, and has traded them in decent volume. I'm not quite sure why anybody would pay so much over their theoretical value, but my guess is that it is simply speculators that are trading for a few pennies of profit here and there.

The other grating aspect of being long warrants of a company that is being acquired is that even if you are hedged (by shorting the stock), because volatility - the primary driver of a "warrant volatility" strategy - drops like a rock, your warrant goes down more in percentage terms than the stock you shorted.

Although this post has largely been about the negative aspects of warrants, it is important to understand the fundamentals as to how these types of securities work, and oftentimes that is best learned through losing money (such as GLW warrant holders did). On the flip side, warrants provide a significant amount of leverage and are fantastic ways to make money very rapidly, if you can navigate the minefield and buy and sell at the right time. This is especially true with warrants because time is constantly working against you when you employ such a strategy.

In Canada, there are approximately 162 public warrant issues outstanding currently, and there are probably hundreds of warrant issues that trade hands privately. In short, there are a lot of long-dated derivative ways to make money in the Canadian markets. One of my goals in the new year is to rebuild my database of warrants with updated terms. I think with the VIX currently toeing 15-16, there is a good chance to put on some attractive warrant volatility trades in the near term. It is just a matter of sorting through the rubble to find the gems. Time to add that to my New Years resolutions list.

Novartis Versus Alcon - A Win For Alcon's Minority Shareholders And Minority Shareholder Rights

As I had previously discussed the Novartis / Alcon deal in a post entitled '"Majority of the Minority": A Simple Remedy for Minority Squeeze-Outs', I thought I would give a quick update on the outcome of the deal.

On December 15th, Novartis announced that it had come to terms with the Board of Directors of Alcon, and proposed a deal to acquire the remaining 23% stake in Alcon it did not already own from minority shareholders (http://invest.alconinc.com/phoenix.zhtml?c=130946&p=irol-pressReleasesArticle&ID=1507867&highlight=). The reason why this is important is because the history of the deal extends for several years, and Novartis initially attempted to squeeze out minority shareholders for significantly less consideration than it paid for the controlling stake it acquired in Alcon from Nestle. This was a significant win for minority shareholders, as Novartis had no such obligation to give them as much consideration as Nestle under Swiss securities law. Here is a brief outline of what occurred:

• April 7th, 2008 - Novartis acquired a 25% stake in Alcon from Nestle for $143.18 in cash consideration. The deal had some interesting provisions worked in, whereby Novartis had the option to acquire Nestle's remaining 52% stake by a certain date at a certain price.

• January 4th, 2010 - Novartis exercised its call option to acquire Nestle's remaining 52% stake for $180 in cash consideration. Simultaneously, Novartis made an offer to minority shareholders for $153 in the form of an all-share offer of 2.8 Novartis shares. The first issue was that the offer was lower in monetary terms. The second issue was that it was in shares, which although technically fungible with cash, are worth less than an all-cash offer because they created uncertainty of what a minority shareholder would receive in the end. Moreover, the deal was further complicated because Novartis shares are priced in Swiss Francs, which introduced exchange rate risk for a minority shareholder. In short, the offer was inadequate any way you looked at it. Luckily, the three independent directors of Alcon formed a committee to review the transaction.

• January 20th, 2010 - Alcon's independent committee determined that the deal was "grossly" inadequate.

• February 17th, 2010 - RiskMetrics publicly stated that the Novartis deal was prejudicial to Alcon minority shareholders.

• July 8th, 2010 - Alcon's independent committee created a $50mm "litigation trust" that allowed them to continue to legally protect minority shareholder rights upon the acquisition of Nestle's 52% stake by Novartis.

• December 15th, 2010 - After a little over 11 months, Novartis folded their hand and agreed to acquire the remaining 23% in Alcon for a price of $168 per share. This is payable with 2.8 Novartis shares, and if the value of the share consideration falls short at closing, then it will be topped up to $168 with cash. The $168 consideration is basically the blended price that Nestle received for its two blocks of shares.

As always, there is some commentary that I would like to make. First and foremost, I find this deal to be bittersweet for minority shareholders. It is a positive outcome to this deal in the sense that the deal is finally getting done. It is negative in the sense that it has been a long time between the initial offer in January and the closing of the deal will be over a year, and closer to a year and a half once the legalities are wrapped up. Alcon shareholders have been in limbo, and will continue to be this way for the next few months.

Secondly, the bump in consideration from $153 to $168 is also positive. However, the consideration is in shares, which any appraiser can tell you are less valuable than cash. It is true that it will be a "tax free" rollover for shareholders, so they have the option of holding onto their stake without tax consequences. However, cash is a certainty and should always be valued higher than shares. Share values are transient. They are typically supported by fundamentals in the long-term, but can deviate significantly in the short-term. The other aspect of this transaction is that if the value of the offer comes in at more than $168 at closing, the share ratio will be reduced to ensure consideration remains at $168. Although I am skeptical of Novartis' share price rallying much higher prior to deal closing (due to hedging), the attractiveness of the consideration received will only be certain on the closing date. At current prices, Novartis is trading at 14x earnings, which is at the higher range of comparables, although not outrageous on an absolute basis. What I would be worried about as a potential Novartis shareholder is multiple compression, and more importantly, fund managers selling their newly acquired Novartis shares on the open market after the closing date, thereby depressing the price. In short, the consideration received is uncertain, and there is some probability of it being less than $168.

Third, the $168 is a blended price that Nestle received in total. It is a combination of an initial $143.18 on the 25% stake sold in 2008 and $180 on the 52% stake sold in 2010. I maintain that the $143.18 price was a trade done in the context of a different market and at a different time. As such, it is irrelevant to the pricing of any stake being sold in 2010. Moreover, the value of the Alcon business was different in 2008 than in 2010. I believe that the minority shareholders should have argued for $180, as they should receive the same consideration that Nestle received in 2010. At the very least they should have argued for an interest adjustment on the $143.18 portion, as Nestle effectively had access to that cash two years prior. My solution would have been to apply some sort of risk-free interest rate (t-bill or short-dated treasuries) to the $143.18 portion of the consideration calculation to bring the value of the cash to present value. Using one month US t-bills as the proxy, the additional consideration would amount to about $0.31 or 20 basis points more than what Novartis offered, primarily because rates cratered over the 2 year time frame. Although the methodology is more fair and correct (in my view), this option was probably not considered due to the minor amounts involved and the relative negotiating positions of Novartis and Alcon. On the flip side, I do understand that there is a control premium ascribed to Nestle's 52% block of shares, which minority shareholders cannot take part in. This is the main "bitter" aspect of the deal. The shares are probably worth $180, but minority shareholders have no legal way to force a bump. Nor can they argue that they deserve the price ascribed to a control block. Given that the independent committee has recommended that shareholders approve the deal, I believe it will go through as planned.

Fourth, I must applaud the independent board of directors for taking the steps necessary to fight for minority shareholder rights. The $15 increase in consideration for the 69mm shares held by minority shareholders translates into a little over $1bn in additional value that is rightfully theirs. That is the product of three individuals fighting for minority shareholders, but a slew of other parties as well. Both proxy advisory firms, Glass Lewis and RiskMetrics were instrumental in guiding the market to refuse Novartis' "grossly inadequate" initial offer.

Fifth, as indicated by market folly's recent post, this deal will get done because of the fact that the arbs are now deep into this trade and will vote in favour. I wanted to point out visually how the market responded to this deal throughout time.


The graph shown above displays the spread value on a relative basis. What I mean by this is the spread value of the deal originally announced (the value of 2.8 NVS shares minus the value of 1 ACL share). As you can see, the market immediately priced a negative spread on the deal, as it believed that minority shareholders should get closer to $180 for their shares. Three things are playing out here. First, the ACL shares are initially being hedged with NVS shares as arbs have to short 2.8 NVS for each 1 ACL they own. That put tremendous pressure on the price of NVS in the market, thus lowering the value of the share consideration immediately. This is in addition to the share dilution concern by NVS shareholders who would have sold NVS for that reason alone. Second, as markets began to tumble in the summer, NVS shares had more pressure on them which pushed the value of the share consideration down even further and the expectation of a bump in the share exchange ratio up. Hedgies would look at the value of the share consideration at $135 and say that it is too low relative to the already low absolute valuation of $153 that was set by NVS only 6 months prior (keeping in mind there is relatively little change in the fundamental value of the business). They would also assume that they are getting a free option on a bump in the share exchange ratio, and would thus put on the spread at +$5 all the way up to $20. Third, as market participants talk and determine what the real value of the minority stake is and the likelihood of a bump, their expectations for a bump increase simultaneously (along with the risk trade being put back on in August) and they begin to push the value of ACL shares from the $150's into the $160's. The interesting aspect of this is two-fold. First, given what market folly indicated in his post, the hedgies could have been colluding to go long at the same time and thus affect the status of the deal (a form of quasi-activism). The second interesting aspect is that as soon as the stock continues to hang at the $160 level for an extended amount of time, it is clear to any market participant that NVS will be forced to offer more consideration if it wants to close the deal - in essence, the bump is a self-fulfilling prophecy. You can see this in the chart below. From August onwards, the deal traded at a negative spread (assuming a $153 payout), with ACL rallying all the way to $170, presumably under the assumption by some poor-sap that a deal would get done at $180. It promptly sold off to a more reasonable level in the low 160's when NVS decided to bump to $168 to get the deal done.


Sixth, strategic deals like this always get done in the end. Novartis is primarily concerned with acquiring and running the business for fundamental / strategic reasons. They could not continue to fight to oppress minority shareholders because they have the business to run as control investors. I understand that they tried to take advantage of minority shareholders, however, I am just baffled at how long it took for them to work out the deal. You can clearly see them integrating the business as time goes on (appointment of Novartis CFO to oversee Alcon, appointment of Novartis CEO to chair Alcon, etc), so you can see their thought process playing out in the press releases, and it was apparent to me that they were going to do the deal at some point in time. Why did it take eleven months? I guess we'll never know.

Seven, it took NVS approximately 8 months to acquire Nestle's 52% stake, and my assumption is that it will take a shorter time frame to acquire the minority stake held by the public. The company has guided to "the first half of 2011" in terms of closing, which makes it a 6 month long wait until consideration is paid out, assuming a worst case scenario. I think there is a chance it could get done sooner. From a risk-arb perspective, that is a long time to have your capital at risk, which will not be attractive to all arbs. The share price of ACL should stay within hailing distance of $168. At the current price of $161.70, the annualized return is roughly 8%, which is about right for this type of trade. I think ACL has to trade down to $157 or $158 to make it attractive currently. With that said, I think there will be an opportunity at some point in time to go long ACL at an attractive annualized return (+15%). Given the volatility in the markets and the skittishness of arbs, there is a good chance of ACL being sold off in the coming months due to the risk trade being taken off by funds. As it stands right now, I'm a buyer at $158.

Long Trade Idea - Pollard Banknote Limited

I love researching small and micro-caps because I always seem to find treasure amongst what is perceived as the trash. These businesses are never covered in the media or by analysts, and they are often dirt cheap for a reason. Analytically I find it more stimulating to be able to research these companies than to take for granted what 20 analysts have said about a large-cap bank or oil stock. Risk-reward wise, these small firms also tend to have a lot more upside than larger companies, as evidenced by the small-cap performance advantage discussed in many academic studies.

One of the micro-cap companies that I researched in the summer was Pollard Banknote Limited. I researched it primarily for my own investing purposes, but I also gave a presentation to the Ivey Finance club on why it should be bought. Below, please find the Media Fire link to the PowerPoint presentation, which has audio embedded. In addition, for anybody that does not have the time to watch the presentation, I have done a quick write-up on the investment thesis below that. Enjoy!

http://www.mediafire.com/?gb529c90u9iu52a

Founded in 1907 by the Pollard family (73.3% majority owner), Pollard Banknote (TSX: PBL, $2.50 share price, $16mm float) is in the lottery business. Specifically, Pollard is in three business lines:

1. Instant scratch tickets (88% of revenues) – Pollard produces 10.3bn / annum.
2. Charitable gaming (11% of revenues) – These are essentially pull-tab tickets.
3. Vending machines (1% of revenues) – Vending machines that dispense scratch tickets.

Pollard sells to 45 lotteries world-wide, and generates 56% of its revenues from the US, 24% from Canada, and 20% internationally. They have about 20% market share globally, but 83% in Canada and 20% in the US.

• PBL IPO’d in 2005 as a trust at $10 and has traded down to a low of $2.24. I believe the shares have stabilized at the current level of $2.50. In essence there is limited downside, and I believe this is so because of the cheap valuation and stable business results that it can generate.

• PBL underperformed for five years due to volatile top-line growth, competitive industry pressures, a decline in very volatile earnings, two distribution cuts, a 50% increase in long-term debt since the IPO, and the fact that no research analysts cover it. In short, it is an un-loved, under-followed value stock.

• Since converting into a corporation in May 2010, the dividend is now stable at $0.12 / annum, translating into a 4.8% yield. You are paid to wait for this company to reach a higher, more appropriate valuation.

• Gross margins have always been stable at ~20%. Net margins have fluctuated, but have averaged around 6%. They have trended downwards to about 4% recently. EBITDA margins have stabilized at 12% on a normalized basis. The key take-away? The business is stable, and this is especially so because PBL is part of what is essentially a duopoly in North America.

• PBL trades at 35% of book value and 7x 2010E P/E. It can get cheaper, but I believe it has bottomed based on fundamentals.

• Management rationalized a new $8.5mm press-line installed in 2008 / 2009. It took two years to attain proper efficiencies, so the costs associated with that will no longer be present going-forward. In addition, with the closure of the Kamloops facility, a $4.7mm restructuring charge was assumed in recent quarters, but this will save $4mm in costs per annum in the future. This cost reduction will go directly to the bottom-line and into shareholder’s pockets.

• As capacity utilization is cut (Kamloops), and costs eliminated from the business, growth cap-ex will be cut which will free up the $10-$15mm of free cash flow that the business generates on a normalized basis for debt pay-down. By paying down the $75mm (out of $105mm) credit facility already drawn, the financial / bankruptcy risk of this business will dissipate rather quickly, and I think the market will begin to value PBL slightly higher.

• Taking into account the above mentioned cost-reduction measures, normalized earnings should be around $0.50 / annum. Applying current EV/EBITDA and P/E multiples to the more appropriate forward earnings produces share price targets of $3.40 to $4.00, implying 40% to 60% upside. This does not include contract wins, which are all upside.

• Ultimately, I believe management will privatize the 26.7% of the business it doesn’t own at $3.50 to $4.00, as those are private market values at 7-8x earnings, and represent a 12.5% to 15% earnings yield on the business. Very attractive from an insider's perspective. The final point is that management owns 73.3% of this company. It has been in the family for 103 years. Furthermore, the livelihood and reputation of four Pollard brothers depends on this firm. They will not risk the company by levering it up anymore. Rather, I believe they will take it private and start paying down debt to achieve a higher private-market valuation for the company.

Money Never Sleeps

Money may never sleep, but I was damn close during this movie. Ever since I first heard about Oliver Stone doing a sequel, I was excited about the chance to see Bud Fox and Gordon Gekko back in action. Alas, just like many other sequels, it did not live up to the precedent set by its predecessor, nor the high expectations set by every fan of the original Wall Street. It was also about 30 minutes too long.

First, Shia LaBeouf? Really? They could not get any better actor than the guy from Transformers? I’ll give it to him that he was mildly believable, but I still can’t get the picture of him running around with giant robots out of my head. *tsk tsk*, Oliver Stone. Poor casting job.

Secondly, the overt references to Lehman, Goldman, Bernanke, et al. By trying to make it so similar to the players and events that actually occurred during the financial crisis, it honestly felt contrived - especially so soon after the events occurred. Given that I didn’t really live through the LBO boom and corporate raider phenomenon, I wonder if the original Wall Street seemed as contrived to people that truly experienced the 1980’s Wall Street? Moreover, the forced inclusion of Bud Fox was a travesty. Bud Fox should have either been a main character or not included at all. Regardless, the cameo was forced and there was not an ounce of chemistry or connection between Fox and Gekko like there rightfully should have been.

Third, and worst of all, Oliver Stone made Gekko cry. Let me repeat. He made Gekko cry. This is supposed to be a character with a heart of stone that would kill for a dollar. Although he was supposed to be the villain in the original Wall Street, he really was the hero to every guy in finance. Part of what made Gekko so great was that he was so twisted. He was everything a normal human being isn’t. He was the guy who didn’t care about humanity, who made gobs of money, who traded size, and got whatever he wanted. In short, he always won. Winners don't cry.

Despite the movie’s shortcomings, I will say that it did have a few highlights. For example, when Gekko is sitting in his new offices in London with his newly formed team and you see that he turned the expropriated $100mm into $1bn. That one minute scene was enough to change the course of the entire movie and put a smile on anyone’s face. Although we never knew how the original Wall Street ended up, we all knew that Gekko was doomed at the end of it. We then waited 23 years for our hero to dig himself out of his hole and rebound to the top again. In that moment when Gekko’s net worth hits 10 figs, the antagonist of both movies rose to become the protagonist for the second time, and it gave all Bay / Wall Street guys that rare feeling that compels our minds and drives our bodies on a daily basis. Not just the feeling of winning. The feeling of winning BIG. Yes, ladies and gentlemen. Greed is still good.

The second best part of the movie was the wardrobe. The tailored suits were impeccable. See below for proof.

China: Communism to Capitalism

In May, I had the pleasure of travelling throughout China and Hong Kong with 32 of my classmates from Ivey. The purpose of Ivey’s China Study Trip is to complement the extensive in-class knowledge gained from our GLOBE module. This module focuses on the increasingly global nature of business and includes topics such as economics, international trade, technology, government and public policy, entrepreneurship, and corporate governance. China has been splashed all across the headlines over the past few years as a model of growth and a case-in-point when it comes to the success of globalization. Reading about it is one thing, however, experiencing it is another thing altogether. Although China and globalization is generally outside the purview of this blog, I thought it appropriate to write about my experiences.

One aspect of the trip I really enjoyed was having the opportunity to read the newspapers in China - South China Morning Post and The China Daily. I was amazed at the depth and breadth of activity that is going on in these economies. In North America, we hear only about the high level activity, such as China growing its GDP at +8% for decades or the undervaluation of the Yuan relative to the USD. These tidbits of information are great for a macro perspective on China, but they do little to help one understand the context and the nitty-gritty details of why and how this is all occurring. For that, you have to see for yourself by visiting the country, talking to business-people, and by reading the newspaper.

Here is a small list of the things that I witnessed in the newspaper and in person during my two weeks in China and Hong Kong:

• In one issue of the newspaper, I saw four separate capital raises totaling billions of (converted) Canadian dollars alone. In comparison, the new equity issue market is practically dead in Canada, and I was astounded that one of the Chinese equity issues was 38x over-subscribed! This demonstrates how much appetite for investment opportunities there is in China.






• Pepsi decided to spend $2.5bn over three years to build new plants and expand R&D efforts in China. This piece of information is further proof of international firms making strategic investments and building out their capabilities in China.

• China celebrated the one month anniversary of index futures trading on the newly formed CSI 300 Index, an index of 300 large-cap stocks that trade on the Shenzhen and Shanghai stock exchanges. The establishment of Chinese stock futures demonstrates the financial liberalization that is occurring daily.

• Beijing announced a goal of eliminating smoking inside all public establishments. This data point really highlighted to me how progressive the Chinese government is. It realizes that for it to reach G7 status and become a true super-power, it must make dramatic and sweeping changes to its society.

• Probably most telling of China's economic rise to power, is the symbolism contained in the picture below. While I was there, an exact replica of Wall Street’s Charging Bull statue was unveiled on the Bund in Shanghai.



These data points are small pieces of information by themselves. However, when you see these occurrences on a daily basis, you start realize that economically and culturally speaking, something really special is going on in China. Although I doubt much of my investment research and activity will focus on Asia going forward, I definitely have a new found appreciation for Asia and the impact these countries will have on the world in the future.

Danier Leather: Reminiscences Of My First Research Report

As I was going through my old records the other day, I stumbled upon my first equity research report on Danier Leather (TSX: DL). By fluke, as I was flipping through the report reminiscing of the fun I had researching and writing about the stock, I realized that it was literally six years to the day that I had written the report. As that moment smacked of serendipity, I thought it would be worthwhile to look at what has happened with the company at the corporate level since then, to see if my thesis worked out as I had predicted, and to write about some of the lessons I have learned from that experience.

I have posted the report in its original form on Slideshare, for anyone who wishes to read it:

Danier Leather Research Report (September 26th, 2004)

View more documents from kyledsilva.

Upon re-reading the piece, the first thing I noticed is how novice I was back then. In hindsight, this is actually understandable because at that point I had only seen a handful of research reports prior to writing it, and I was in the process of completing my “Advanced Corporate Finance” class in undergrad, which essentially taught me some of the tools needed to do such a stock analysis. With that said, I think it was amazing that I was able to complete the analysis and write the report given my total lack of real investment knowledge or mentoring at that point in time.

In six years after having written the report, I completed my CFA designation, worked in mutual fund sales, worked at a quantitative equity research firm, and worked as an analyst on a sales & trading desk. In addition, I have completed my MBA at Ivey. In essence, after both the educational and hands-on work experience in the capital markets, I believe I have a more holistic tool-box necessary for researching a company, analyzing a stock, and making an investment presentation. With that said, I would like to make a few observations:

• The Difficulty of Forecasting - Being fresh out of university, having never seen a sell / buy side research report before, and having absolutely no knowledge about fashion or the market for luxury leather goods; I somehow made fundamental forecasts 10 years out for Danier Leather. Now, anyone that has spent time reading academic research knows that the theoretical value of a common stock is the residual equity cash flows to infinity discounted back to present value at the appropriate cost of equity capital. I applaud anyone that has the ability to make the hundreds of assumptions that go into a traditional DCF analysis, as this requires intelligent thought, hard core research, access to management, and a sizable serving of luck in making estimates. However, I frown upon my previous analysis. As evidenced on page 7 of the report, what I essentially did was one DCF analysis and did ten different scenario analyses. This produced theoretical stock values of $6.56 to $11.72 (I’ll spare you the detailed assumptions). I am definitely supportive of performing scenario analysis; however, it must be performed with realistic assumptions. I believe what I did, and what many other professional analysts do, is create assumptions and massage the numbers so as to produce a DCF value that is in-line with what the current stock price is. A much more appropriate way to do this is to take the current stock price, and test for assumptions that make the current price true. This “reverse DCF” allows for you to see very easily whether or not the market is being rationale in its pricing. Regardless, I glanced at what my estimates were in 2004 and what actually transpired since, and my estimates were not even close. Looking at the Exhibit 1 below, you can see both earnings and EBITDA jump around wildly. The lesson here is that nobody should be making long-range forecasts for firms where you can barely forecast the next six months.

Exhibit 1:


• Uncertainty Of The Future – Although I briefly mentioned catalysts on page 9 of the report, it was impossible for me to know both how and when those catalysts would appear. Given the intonation in the report, at that time I understood Danier’s management to be worried about an unwanted Takeover Bid. Fast-forward 5 ½ years and the real catalysts that appeared were an NCIB and a Dutch Tender Auction this past January. The Dutch Tender Auction alone reduced the total share count by 23.88% to 3.5mm total shares (SVS and MVS) outstanding. While the stock took a few weeks to respond, it has gained 113% this year, as shown below in Exhibit 2. I think the lesson learned here is that the catalysts that you believe will occur may never actually happen, or may take longer than anticipated. Anybody could have seen that Danier Leather’s management was buying back stock very accretively, however, the stock just never responded in a timely fashion. The second takeaway is that you can try and forecast what catalysts will occur, however, you can never really know what will transpire unless you are actively trying to make a desired outcome occur. The best way to make money is to buy cheap assets and let the invisible hand do its job.

Exhibit 2:


• Value Creation - Although there is certainly a market and economic effect on the stock price of Danier Leather, it is apparent that there has been no going-concern, shareholder value creation over the past 6 years. The question is why? One the one hand, I understand that multiples and equity valuations have come down significantly over the past 6 years, for both fundamental and non-fundamental reasons. However, Danier Leather was reasonably priced to begin with (relative to normalized earnings and book value). The first rational explanation would be that Danier Leather is not truly earning its economic cost of capital, hence the stock not continuously marching up. The other explanation is that Danier Leather was truly undervalued for approximately six years and the stock market did not care about it. This is plausible as the CEO, Jeffrey Wortsman, continuously bought back stock over that time frame. In fact, Danier Leather had 6.9mm subordinate and multiple voting shares outstanding in 2004, and through both an NCIB and Dutch Tender Auction, reduced the number to 3.5mm by 2010 (see exhibit 1). Wortsman owns 1.2mm multiple voting shares, so I doubt he would have repurchased shares if either forms of buy-back would have caused permanent loss of capital for his own shares. The lesson here is that value creation can take a lot longer than you expect, and it does not always come from operating the business itself.

• Intrinsic Value - One thing that must be kept in mind is that intrinsic value is a moving target. Although this is technically incorrect because it does not take into account return on capital and cost of capital, let’s take book value as a proxy for intrinsic value. At the time of the report, the stock was trading at $11.20 with a book value $8.83, indicating that price was 1.25x intrinsic value. Over the course of the six years, book value increased to $12.00, and the stock price is now $11.93, indicating that it is almost fully valued. So, in essence, intrinsic value of the firm increased (through both profitable operations and accretive share buy-backs) over time, and the market has responded to reflect it, although one can argue that the market still has not fully rewarded Danier Leather yet. If I were considering purchasing the stock at this point in time, it would be wise to do a full-blown analysis to determine value, and then relate that to the current price of the stock. This should be done when one is considering both purchase and sale of a stock.

• Relative Valuation – This methodology was mis-used in the research report that I wrote, as the share values ranged from $7.83 to $25.60. I should have had the presence of mind to understand that some of the metrics and peers I was using did not contribute to realistic share value estimates, and I should have cut them entirely.

• Owner-Operator Model – It is absolutely imperative to have alignment between management and shareholders, and the best way to do this is to ensure the leaders of the firm own alot of stock. An even better scenario is when management is not only monetarily committed, but emotionally committed. Jeffrey Wortsman currently owns 1.25mm MVS, which gives him 78.6% of voting rights of the company and a ~35% economic interest. Although I hate the MVS structure, his massive ownership stake virtually guarantees that he will do right by shareholders. He has also been with the firm since 1986, indicative of an emotional commitment to the firm, as he has essentially built it from the ground up. While the combination of these two factors does not ensure that mistakes will not be made (the Power Center expansion strategy for Danier Leather), it will ensure that they will be rectified very quickly and that shareholder value creation will be at the forefront of management's minds.

• Growing Per Share Value By Downsizing - Unless a firm enjoys an inherent competitive advantage, it is the Board of Directors and management that drive the direction of the company, which should ultimately build value. Most people view growth in stores, units, and revenues as the de-facto form of value creation. This is simply not true. In 2004, Danier Leather had 98 stores, $178mm in sales and 377,527 sqf of retail space. From the chart below, you can easily see that sales have dipped and essentially flat-lined since then. Retail square footage has plummeted by 16%, and the number of stores has been reduced to 90. The most notable aspect here is that all of the shrinkage has come from a reduction in the number of Power Centres, and a retracement of the growth strategy. However, Danier Leather is now more lean, efficient, and actually profitable, which is the key to a higher equity valuation. The lesson? Higher per share profitability is the key to a higher stock price. Moreover, as evidenced by the increasing cash balance over the course of the six years, profits in the form of free cash flow is what is important.

• Value Is The Answer – So, let’s assume that my assessment of the per share value of Danier in 2004 was correct. You would have watched the stock plummet to $2.30, and rebound to $11.93, where it is trading at today. In essence you would have made no money on the trade, and in fact, lost six years of compounding potential. This is precisely why it is important to buy stocks that have a significant margin of safety embedded in the purchase price. You never know if the stock will go up or down, but you want to stack the odds in your favour. Moreover, you really want to purchase stocks where the intrinsic value goes up over time, because then you achieve the holy grail of investing - intrinsic value growth plus the closing of the price to value gap. Let’s assume for a moment that you had bought DL when it first hit $7.00 (my recommended entry price) on August 16th, 2006 (let’s also assume my re-assessment of value was the same in 2006 as in 2004) and held until now, you would have generated a pre-tax return of 70%. Annualized, this translates into a compound return of 13.76%, which is not bad, considering the TSX is flat over that time frame. Lesson? Sticking to the basics by buying companies with growing fundamentals at cheap prices is what will give you decent returns over time. The hard part is having the patience to stomach the volatility, as you would have lost 67% of your capital from entry in DL at $7.00 before it turned the corner.

Okay, eight lessons is enough for one night. I’ll be back shortly to post on my experiences in China and Hong Kong this past May.

Long / Short Trade Idea - Urbana Corporation

Recently I have been working diligently on a few new investment ideas, and I will be posting them on here for everyone to see. My ideas are eclectic and run the gamut from long, to short, to merger-arb, to spin-offs, etc. The basic theme amongst them is that I perceive there to be a high probability of a large, low-risk profit. In addition, I typically perceive there to be a catalyst that will crystallize profit in the near future.

The first investment thesis is on Urbana Corporation, and it is a long / short trade idea. I have fleshed out the thesis into a PowerPoint presentation with audio dubbed over it. If you are interested in seeing it, you can download the presentation here:

http://www.mediafire.com/?wmdl2maizpvb22z

The basic investment thesis is shown below. Please note that this was written during the first week of August, so the numbers may be slightly different at the time of this post, however, the basic thesis remains intact.

• Urbana invests in the exchange sector and holds both public and private exchanges.

• It is trading at a 35% discount to its NAV, which is calculated every week. The NAV is about $1.94 (will fluctuate with market prices and FX rates) and the stock is at $1.24.

• You can hedge 70% of the NAV by shorting the NYSE, the CBOE, and the TMX Group in terms of their percentage make-up of the NAV.

• Running basic stats on the NAV and the stock price shows that the NAV has a standard deviation of 45% whereas the stock has a standard deviation of 100%, indicating that the stock is alot more volatile and therefore is more likely to reach NAV. In fact, in the past two years, it has traded between a 40% discount and a 0% discount essentially twice. As such, at a 35% discount, I view this as being a 7:1 upside / downside ratio in terms of there being 35% upside and 5% downside.

• There are several catalysts: 1) Management has been active on its buyback, taking in 2% of the stock in June and July alone. 2) The Bombay Stock Exchange, which represents 15% of NAV, is set to go public in 2011. It should unlock value and will allow an investor to hedge a full 85% of NAV. 3) Portfolio company revaluations. George Soros just took a 4% stake in the BSE for $40mm. Applying that price to Urbana's stake in the BSE increases the value from $23mm to $26mm, and adds a few pennies per share in NAV value. 4) Tom Caldwell, the CEO, is adamant that the CBOE will not be a public entity in the near future, either via a Takeover Bid or a merger. The CBOE makes up 30% of NAV, and a transaction would obviously create a lot of value for Urbana shareholders.

• Comps, such as closed-end funds don't trade at such a high discount typically, and right at this moment.

If there are questions or comments, please feel free to post. Constructive criticism is always welcome.

Ivey Finance Club Sales & Trading Presentation

On June 29th I gave a presentation to the Ivey Finance Club on Sales & Trading. Many current Ivey students are interested in getting into the capital markets in terms of I-Banking, Sales, Trading, and Research. My presentation was designed to give students a good understanding of what the Sales & Trading function is, how it fits into the capital markets, and what the lifestyle is like. Below, please find my presentation.

Sales and Trading Overview V2

View more presentations from kyledsilva.

“Majority of the Minority”: A Simple Remedy for Minority Squeeze-Outs

During the last ten years of my life I have had the good fortune of experiencing the booms and busts of the markets, and have seen many incredible things occur over this time frame. In particular, working on the Sales & Trading Desk at a boutique dealer generating ideas for hedge funds gave me some really great experiences in terms of being on the forefront of what is happening in the world, especially in the M&A and risk-arbitrage space.

Over my time in the markets, one thing I have noticed is the massive difference between Canadian and foreign M&A rules and regulations. Specifically, I notice much more inequity in foreign M&A, especially when it comes to calling special shareholder meetings, the rampant use of poison pills (in the US in particular), and in the recent case of Novartis and Alcon, the treatment of minority shareholders (http://online.wsj.com/article_email/SB10001424052748704140104575057841177401382-lMyQjAxMTAwMDEwMTExNDEyWj.html).

In this case, Novartis, a 25% holder of Alcon, made an all-share offer to the remaining Alcon shareholders. Two issues arise here. First of all, all-share offers expose shareholders to market risk, which is evident as the 2.8 Novartis share offer, originally valued at ~$180, has traded down to ~$160. The deal is quite clearly much less attractive to any shareholder that did not hedge their stake in Alcon, which quite frankly, would be the vast majority of minority shareholders. As you can imagine, any shareholder who was expecting $180 per share and is getting $160 in actuality would be upset with the outcome. Secondly, Nestle is the majority owner of Alcon with a 52% stake, so they basically control any and all actions of Alcon. This is especially true in M&A situations, because it is clear that both companies (which own a cumulative 77% stake) want the deal done. Under Swiss securities laws, the 23% of minority shareholders have very limited say.

In comparison, such a situation in Canada would be settled rather easily and amicably. For example, in Canada we have a simple provision called a “majority of the minority”, which directly addresses minority shareholder concerns in M&A and / or other major shareholder vote situations. This rule was instated by regulators to give minority shareholders a voice, because traditionally, minority shareholders would be steam-rolled by corporations and / or large shareholders that may not have the best interests of ALL shareholders in mind. If the Novartis / Alcon deal were to occur in Canada (under OSC rules and regulations), there would be two votes required in order to get the deal done. First, there would be an overall shareholder vote that would include Alcon, Nestle, and the remaining minority shareholders. In the worst case scenario, this vote would still go through as the 77% held by Novartis and Nestle would supersede the 66.66% of votes required by Ontario securities laws. The second vote would occur for just the minority shareholders, with Nestle and Alcon abstaining. If greater than 50% of the 23% minority shareholders voted in favour of the transaction, it would proceed. You can see how this is a much more fair method in terms of giving a voice to the minority shareholder.

Like many exciting market / legal events such as Novartis / Alcon, the precedents set in the past were exciting landmark events as well. In Canada’s case, the importance and strength of the “majority of the minority” provision was really exemplified in the 2005-2006 case brought against Sears Holding Corporation (SHLC) (http://www.ogilvyrenault.com/en/resourceCentre_1622.htm) by a group of hedge funds (Hawkeye, Knott Partners, and Pershing Square). In this case, SHLC was a majority shareholder (56%) of Sears Canada (SCC), and attempted to wrest control of the company by offering a premium to the shares of ONLY one other major shareholder (Vornado Realty Trust) relative to the minority shareholders ($18.00 compared to $16.86). There were many twists and turns to this case with several other issues at hand, however, the OSC ended up ruling in favour of the hedge funds because SHLC effectively tried to give additional consideration to one particular shareholder at the expense of all others. This is simply not allowed under Canadian Securities laws, as the consideration paid for one security must be pari passu with another security that possesses identical features. In the end, SHLC withdrew its bid and decided to acquire a greater stake in SCC by purchasing stock piecemeal on the open-market. However, if SHLC had proceeded, it would have been forced to give a “majority of the minority” vote for SCC shareholders, which they would have ultimately lost as the hedge funds effectively controlled that majority.

Circling back to the Novartis / Alcon deal, I must say that even though Alcon cannot invoke a “majority of the minority” vote, I find it fascinating that the Board of Directors of Alcon had enough foresight and heart to establish a Special Committee to review Takeover Bids in order to prevent the oppression of minority shareholder rights. Furthermore, it is good to know that corporate governance is alive and well somewhere in this world, as the Alcon Special Committee is actually in the process of establishing legal actions to prevent this deal from occurring, or at least ensure that minority shareholders get what they deserve.

A Social Perspective On Shareholder Activism

With the explosion of corporate social responsibility in recent years, many corporations have been asked to be more accountable for their actions by social groups, governmental bodies, special interest organizations, and paradoxically, their own shareholders. While the first three have always been present in some form, the latter is a new development that is growing in power and influence.

A prime example is what occurred over the last few days, with a small group of BP’s shareholders staging a public campaign to prevent BP from moving forward with its investment in and development of their oil sands assets. Specifically, an organization called FairPensions (www.fairpensions.org), backed by well-funded charities such as OxFam, WWF, and GreenPeace, engaged BP on behalf of various institutional and individual investors (http://www.fairpensions.org.uk/news/tarsands/080210). On behalf of these investors, FairPensions tabled a Shareholder Resolution for BP’s annual meeting on April 15th requesting more accountability on their oil sands activities. On the surface, this appears to be a daunting task in terms of taking on such a large corporation head-on; however, FairPensions recently had success in influencing Royal Dutch Shell to disclose more information on its oil sands operations. To me, this clearly shows that this nouveau method of social activism is the beginning of a long-term trend that is taking hold in the markets, and is having real and measureable effects.

In addition, this campaign really highlights how activism, whether it is social or shareholder, has progressed over time. Initially, activists had to “scream and shout” at shareholder meetings or make high-impact demonstrations repeatedly in order to get what they want. Although this still occurs to an extent, new paradigms and processes have emerged for activists to voice their concerns and have an impact on what matters to them.

Finally, this example also highlights a structural shift in activism towards large, institutional investors taking the time to research CSR issues, and to voice their perspectives to management teams and boards, whether this is through themselves or through other organizations. This has typically not been the case in the past, as institutional investors own hundreds of securities, which makes it difficult to keep up with anything more than quarterly and annual reports as well as proxy materials. Pension funds such as CALPERS, CALSTERS, and OTPP have been on the cutting edge of these industry changes, and I would expect that it becomes a larger shift within the markets as a whole over time. The simple fact is that CSR is a priority of upcoming generations, and therefore, is not going away anytime soon. As such, financial institutions will be forced to incorporate it into their decision-making process going forward.

While I cannot always agree with social activist’s viewpoints, I have the utmost respect for their methodologies. Activism is activism, whether it is on behalf of shareholders or the environment, and I respect the bias for action and support the push for change.

2009 vs 2010: Developments In The M&A Market

While we have a brand new year ahead of us with the start of 2010, I believe it is important to examine the recent past in order to help us determine the near future. With that said, I thought I would highlight the M&A market in 2009 to give us a sense of what I personally expect in 2010. The graphics below are from www.wsj.com, which sourced them from www.dealogic.com.

From a regional perspective, we can see that there was effectively a massive dip in M&A activity throughout Q2 and Q3, which is not much of a surprise to anyone that paid attention to the front page of the newspaper over the course of the year. The majority of the differences between the regional markets is effectively because of the mega-deals that occurred. Specifically, I would say that the US market seems to be off kilter relative to the rest of the world because of the involvement of the government in so many industries and financial institutions. It has taken a lot of time for the system to start working again, and I believe much of the M&A activity has been pushed back further and further as companies have tried to delay the inevitable. One other thing to note is that despite the low absolute levels of activity in the smaller markets such as Latin America, Africa, and the Middle East, there appears to be only a moderate drop-off in activity over the course of the past year. I believe this is partially due to the size of the overall M&A markets and the focus of the regions themselves (operational compared to deal focused).



Following on the previous chart, the one below really highlights to me how much the US makes up in terms of the global M&A market. In some months, the US makes up all if not the vast majority of activity, which is an amazing sight to see. Although a regression cannot be run on those statistics, I would be really curious to see a correlation analysis between US M&A activity and the rest of the world, both as a whole and split country by country. While there would obviously be major differences on a country by country basis due to different regulatory regimes and business cycles, my instinct tells me that the correlation on a US versus global basis would be quite significant. However, I should say that the majority of the activity would be driven by the availability of credit, which is certainly different across markets. Perhaps that is the main reason for the difference in size of the M&A market in the developed and emerging markets.



It should be no surprise to anyone that M&A deal volume was off significantly relative to 2008, as evidenced by the chart below. Effectively no, dealer posted better numbers than 2008, except for Morgan Stanley and Barclays. Goldman moved from 2nd to 1st in the global league tables, taking JP Morgan’s spot. With the markets in turmoil and the BoA / Merrill merger underway, clients clearly did not trust BoA with their M&A activities, which pushed BoA from 3rd last year to 5th. On the face of it, there might not be a lot to take away from this particular graph, however, I would want to see some analysis of how much, historically speaking, deal volume has fallen from its peak, and how long it has taken to reach that peak again, or at least stabilize. If we had access to that information, I think it would give us at least a basis for predicting where the M&A market will head in the future. As we have seen stabilization across the board from the Q2 / Q3 2009 lows, I think we are going to see a slow recovery process as the taps are opened once again, and credit begins to flow more freely. In terms of the particular dealers, although there will definitely be more political and social oversight of these companies, I do not foresee them going anywhere. The only major points to make are that 1) the relative ranking will remain relatively static with the Goldman Sachs and Morgan Stanley’s of the world staying at the top, and 2) The financial institutions that have gone through restructuring, mergers, or are still tied to the government via TARP (or its foreign equivalent), will continue to suffer. The M&A business is built on reputation of the people involved in the process. If turmoil occurs at these firms, the best people tend to leave, and the business tends to go with them.



The chart below should, once again, come as no surprise to anyone. The volume and value of transactions are down across the board. However, the glaring difference year over year is in the finance sector where M&A dried up. As firms could barely understand their own books in a risk-focused environment, they were certainly unwilling to merge and acquire other firms, as many of them were wary of acquiring future potentially unknown liabilities. As such, M&A volume, although large, fell off a cliff. Most of the focus shifted to restructuring, with a large contingent of banks going belly-up, as well Bear Stearns and Lehman having an effect. I think what we can take away from this graph is the simple fact that M&A trends in 2008 continued into 2009 in terms of sectors. Oil and Gas, Healthcare, and Telecom were major contributors to the overall activity. Will this trend continue in 2010? I believe that it will, although I must say that with Berkshire buying Burlington Northern and the frenzy of activity surrounding Cadbury which culminated in its purchase by Kraft, there is definitely interest in strategic acquisitions in the Transportation and Food & Beverage sectors. However, I believe there are simply fewer opportunities for major deals in these sectors primarily due to firm size and market share, which drive anti-trust concerns.



Although, overall deal volume fell off significantly across the board, there was still a dearth of mega-deals. Looking at the largest ones, there was no overall theme in terms of sector. However, energy, materials, and pharmaceuticals were at the top of the heat. Once again, we see the dominance of the US throughout the global ranking of deals. This dominance will not dissipate in the near term, as the US market is simply configured to do deals by virtue of its political, social, regulatory, legal, and credit regimes. With credit finally coming back, expect more mega-deals coming to fruition in 2010. Also, expect an increasing number of large-cap and mid-market deals as we progress throughout the year.



As markets inevitably go through boom and bust cycles, the graph below really highlights the shift in focus of the markets from M&A to restructuring. If we lined up the IPO market activity with the two graphs below, I am positive we would see the life cycle of the market, from birth through growth up until to death. Going forward, I would expect M&A volume to recover slowly, as evidenced by the stabilization in Q1-Q4 of 2009. This will obviously be driven by the US and Euro-land primarily. I would also like see a longer time period which would give us more information about the previous boom and bust cycles, and I would want to regress these datasets against each other in order to see if there are any correlations amongst the markets. With this type of information, we might be able to better to predict what will occur in terms of activity in the M&A in 2010.