Ag Growth International

I have taken today to complete my position in Ag Growth International (TSX: AFN), a Winnipeg-based company that can be classified as “all things grain-related”. I started picking up shares in the 16s and even 15s but today was a good chance to top it up to a full position. I also have a small portion of the debentures (TSX: AFN.DB.D).

I’ll spare you from the cut-and-paste description of their business from their annual information form, but the business is about providing everything you can imagine it takes running a grain and feed-based farm on an industrial scale. The sales from the business are international, and they are an integrator of various agricultural technologies.

The stock is not widely followed. There is hardly any ‘buzz’ at all from the usual message boards, BNN, etc., which is always a plus (less buzz means less competition for accurate stock pricing).

The thesis for the recovery of this COVID-19 investment (the stock has been taken down about 2/3rds since the COVID-19 pandemic) is pretty simple.

People have to eat. Food has to be grown (whether plant or animal) and the quantities of food that need to be produced require industrialization and equipment. Farming for over a century has shifted toward industrialization which promotes gigantic yields, and this industrialization requires investment in proper capital equipment to obtain these yields.

As long as the population is rising, food consumption will remain a core industry where demand over a medium range period of time will be steady – any demand not met today will simply be reflected in demand experienced later on in time.

Thus, COVID-19 should have a transient effect on the business of AFN.

Financially, 2019 was a poor year due to various cyclicalities of the grain business. In a more “normal” earnings environment, the company should be able to earn at least $3/share of GAAP net income and I would expect to see this in future years. The only financial issue of concern (and likely the reason why the stock has been taken down so much) is that they are quite leveraged, with about half of their debt via a senior secured revolving credit line, and the other half through issued unsecured debentures (AFN.DB.D to H on the TSX), which currently trade at YTMs of 10-12%. The original cost of capital for the unsecured debt was around 5%, and the secured debt at a function of LIBOR plus 1.45 to 2.5%. At the end of 2019 the combined rate was 5.11%, but this surely has gone down due to the rate cuts post-COVID-19.

To this extent, they made the not so surprising news release last night that they are reducing their dividend from $2.40/share to $0.60/share and this will allow them to deleverage. They extended the credit facility to 2025, and obtained a relaxation of the senior debt covenant. The next issue of debt that is due is AFN.DB.D, which is due on June 2022, and is also convertible into stock at 95% of TSX market value if the company so chooses – typically in the past it has rolled over the debt and when things normalize that is the likely route here.

The risk is that COVID-19 is prolonged and there will be some form of permanent demand destruction among the customers (e.g. if the industrial farms were to exhibit financial stress and had to scale back their capital investments), but I am discounting this possibility in the longer term just simply because of what I wrote in the earlier – people have to eat, and capital investment in farm equipment is required to facilitate this need. It is easily conceivable that we can see a $60 stock price again like two years ago, but it will take some time to get there. I can wait.

Quick market commentary

The month of March (up until the 23rd) was like pushing on a spring, where people and funds were getting cashed out on margin.

We’re still on the spring back. How high this will go is anybody’s guess, but my trading instincts suggest it’s probably a good time to take a few chips off the table, at least temporarily. There will be some ‘rebound’ news that will get injected into the the world that things aren’t as optimistic as projected, that the lockdown will have to last for longer, that secondary infections will come back from people previously confirmed without the virus (when it probably turns out that they were false positive diagnosed to begin with and just caught Covid-19 from somewhere else), etc. There is also the element of sheer greed from participants that want to make the quickest buck.

The rebound down will take the market down 3 or 4%, the people that have loaded up will get frightened and dump, a bunch of people will panic over the revenge of the Coronavirus and that’ll likely be the best time to load up, just when it looks like things are getting awful. The speed that this is all happening, however, is quite remarkable. The market action is happening three times as fast as the 2008-2009 economic crisis.

You’re not going to get anywhere close to the bargain pricing you saw in March but there’s still considerable upside coming as long as you avoid the sectors that are sensitive to the “main street” economy (e.g. I wouldn’t want to be owning a sports franchise).

Continue to pay attention to debt covenants, but note that credit is going to become easier to get as the corporate debt market normalizes (this is what happens when the central banks are buying corporate debt – they’ll clear out the investment grade, which means banks can loan to the BBB, BB and Bs of the world). As long as there aren’t significant maturities coming up in the next 12 months or so, you’ll probably be fine if the debt loads are ‘reasonable’. This crisis will also scare a lot of corporations into de-leveraging or lightening up on leverage – the better capitalized companies will likely clean up better in this environment. Entities that should be trading at low yields (e.g. Rogers Sugar, RSI.DB.E/F) are already at a YTM of 600-650bps while just a few weeks ago they were well into the double digits. Of course, the trashy companies are trading in the teens and above still, but even then the ones that generate reliable cash flows will get back to normal (looking at Chemtrade).

The time to buy stocks…

… is not when the S&P 500 is up 6%. There will be down days of 2-3% when further news comes out of some catastrophe occurring, but the markets are now going to be in a “two days down, three days up” mode for the indefinite future as the waterfall of ZIRP money hits the market.

Now is the time to take a look at the individual components of your portfolio. Things that are trading at a P/E of 20 might not look cheap, but in a zero rate environment, it’s better than the alternative! If you have stocks that are up above the average, ask yourself why, and then consider adding when we get one of those down days.

Likewise, if your stock is down on a day when the main indicies are up heavy, ask why and guess whether there will be a ‘regression to the mean’. If your stock is fueled by index purchasing to begin with, then momentum trading is the way to go.

Companies using Covid-19 to cut dividends

Do not rely on the reported “current yield” statistic on nearly any stock out there. There will very likely be changes.

Companies that have regular dividend policies always find it difficult to reduce them or even scrap them entirely since there is an expectation of a return from their shareholder base. However, never letting a good crisis go to waste, you’re starting to see some action on this front.

If you think the banks are immune, HSBC Hong Kong scrapped their planned 4th quarter dividend (amusingly, there is a news article about shareholders planning a lawsuit – good luck suing yourselves!). You’re probably wondering about the Canadian banks, and they are too – calculating what their net exposures are. Securitized residential mortgages they can dump to the Bank of Canada, but on the commercial loan side of things, I’d expect their losses to rise significantly. The question is how much? For psychological reasons I do not think they will cut dividends, but Canadian banks are very opaque entities to analyze and you just never know when they will go on the brink. Entities like Deutsche Bank (DB) have always looked good on paper, but without having good granularity on their loan portfolio, who knows what the heck you’re investing in?

Food Service: On April 1st, A&W (TSX: AW.UN) suspended distributions. Their historical rate used to give out 15.9 cents per month, but clearly the take-out business is not nearly as strong when there is zero foot traffic. I wouldn’t be surprised if the Keg (TSX: KEG.UN) followed (they have yet to announce) but their units have already gotten hammered 50% from their ambient levels pre-Covid-19. MTY Group (TSX: MTY), owner/operator of a couple thousand restaurant franchises, announced they will scrap their next quarterly dividend.

Aviation, not surprisingly, is not doing well. Chrous Aviation (TSX: CHR) is suspending dividends. CAE, maker of very good flight training simulators, suspended dividends.

The list will continue. REITs, in particular, I think are prone to have distributions reduced as they need to build capital on their balance sheets to restore their debt to equity ratios to proper proportions. Since real estate is not the most liquid asset, it will take time for those fair market values to be reflected, but anybody relying on the price-to-book ratio should be cautioned that fair market value adjustments go down as well as up!