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.
Saturday, October 16, 2010
Tuesday, October 5, 2010
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.
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.
Monday, October 4, 2010
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.
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.
Sunday, October 3, 2010
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:
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.
I have posted the report in its original form on Slideshare, for anyone who wishes to read it:
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.
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