CFP – Divestor

Reviewing the past week

The past week was relatively interesting.

The 10-year bond yield went down about 0.25% from the beginning to the end of the week. Likewise, the long part of the yield curve also dropped (prices rose) and a whole flurry of the usual interest rate sensitive subjects got taken up VERY sharply. I’ll just give a few of them, but you get the idea – these four are from very different industries:

(But also take a look at REI.un.to, CAR.un.to, etc. – also dramatically up over the past few trading days).

REITs, lumber, sugar, and fast food. All of these are yieldly and leveraged. Don’t get me started on other components of the fixed income markets either, but I’ll throw in the 30-year US treasury bond yield:

There is a cliche that in bear markets, bull trap rallies are the sharpest. This is usually the case because short sellers are a bit more skittish than in the opposite direction.

My suspicion is that the bears on the long side of the bond market got a bit too complacent.

The calculation of the risk-free rate is a very strong variable in most valuation formulas. If you can sustain a 5% perpetual risk-free rate, there is no point in owning equities that give a risky 4% return. The price of the equity must drop until its yield rises to a factor above 5% (the number above 5% which incorporates the appropriate level of risk).

So what we see here is the strong variable (risk-free rates) moving down and hence the valuation of yieldy and leveraged equities rising accordingly, coupled with some likely short squeeze pressure on the most leveraged entities.

There are likely powerful undercurrents flowing in the capital markets – the tug-of-war with the ‘higher for longer, inflation is here to stay’ crowd competing with the ‘Economy is going bust, the Fed has to lower rates!’ group.

The last chart, however, I must say was not on my bingo scorecard for 2023 – Bitcoin is up over double from what it was trading at the beginning of the year:

I should have just pulled a Michael Saylor and gone 150% on Bitcoin. Go figure.

What’s a good earnings multiple?

The traditional financial metric has the P/E ratio being some amount over the risk-free rate.

For example, if the long-term government bond yield is 5%, then the equity valuation would be a premium over this, say 8%. The spread is the risk you take for an equity investment compared to a guaranteed payout on government debt.

The above example means you’d pay 1/8% = $12.50 for each dollar of cash flow, or also a price/earnings of 12.5.

This is a gross approximation, and does not take into a myriad of factors, especially future earnings growth/decline over time and the balance sheet condition (leverage distorts the above calculations).

As a most trivial example, Microsoft, which can be reasonably anticipated to be around for the indefinite future, is estimated to earn $10.66 in their fiscal year ended June 2023. If this extrapolates forever, at the current $300 share price, you are getting a 3.6% return, or 28 times earnings.

Considering the 30-year government bond is 2.7% at present, this is not much of a premium to take risk. Obviously there is some anticipation of earnings growth at Microsoft (at a minimum, one can expect them to be able to raise prices for inflation).

Either way, investors are accustomed to buying non-high flying companies at reasonable valuations, say 9 to 30 times earnings, depending on the perceived stability and earnings power of the company.

However, in the cyclical industries, the earnings factor over time is very volatile. Nothing exhibits this better than commodities.

Canfor (TSX: CFP) is a good example of this.

We take a look at their historical earnings, which is extremely choppy:

Just on the basis of historical earnings, if you took the past four quarters, Canfor, at $22.69, is trading at 1.87 times earnings, or a 53.6% earnings yield!

Of course, things are not that easy in commodity-land. There was an obvious windfall opportunity in lumber in the aftermath of Covid-19.

Despite that, analysts are projecting a 2023 earnings of $5.08/share, which is still 22%.

The issue is that this is a stale estimate. If raw lumber prices continue to drop, this estimate will surely drop, along with the share price. Indeed, the share price itself is a reasonable signal that this estimate is likely high.

The other factor is the duration of the earnings. Cyclical companies are, by definition, ones that go through boom-bust cycles as investment kicks in and supply starts to flood the market. The lumber market in this respect is a lot quicker than some other resources that require half a decade to open up infrastructure.

If this level of earnings is projected to last further in time, then the current price will rise. Conversely, if the earnings deflate quicker than expected, the share price will drop.

Either way, it is gut-wrenching to sell a company that seemingly is trading at such a low multiple. Sometimes, selling at a low single digit multiple is a correct decision!

However, unlike the much more stable Microsoft, an investor is rewarded much more for getting the earnings picture correct for a cyclical company – correctly projecting the future in an earnings-volatile environment is much more rewarded.

Does this mean that Canfor, at 2x or 4x or whatever, is a better investment than Microsoft because it is so seemingly ‘cheap’?

This brings me to the original question on the title of this post – what is a good earnings multiple?

The answer is there is none.

Buying is easy, selling is not – Canfor

There’s a great discussion on portfolio diversification between stusclues and Rod in the previous post. I’m appreciative of the time it takes to write these things and for the shared perspective and respect for differences. I was wondering if I was on the internet for a moment.

Going to the title of this post, I have always found the timing of my buying to be a lot better than my selling. The execution of my selling over the past decade or so has been mediocre, to the point where I’ve given it a bit of revision over the years. In general, my problem has been that I have been too eager to sell. I typically buy stocks that are considered to be ‘value’, and when the market realizes it, it tends to over-swing in the opposite direction and I’ve been trying to get a bit better at ‘playing the pendulum’. There have been failures and successes, but for example, in the case of Genworth MI, I probably bailed out a little too early and left some money that I probably shouldn’t have (especially those monstrous special dividends).

Still, one cannot be expected to claim every penny of upside, especially when looking at a stock in retrospect. It is nearly impossible to time the top, as well as being able to time the bottom. A lot of value is captured being directionally correct and not necessarily buying at the low. Also, a lot of value is captured in identifying when the basis for taking the position in the first place was wrong and taking an early small loss instead of a larger one. Finally, if an alternative position poses a better risk/reward, there may be value in diversifying the less attractive alternative – 2020 was rife with sales that today look stupid, but the transaction spreadsheet doesn’t show what was bought in substitution for those sales at that particular time (almost anything sold between March 2020 to May 2020 looked like a bad sale, unless if you take it in consideration with what was purchased at the same time).

Applying these general principles, I have recently decided to bail out my (very small) positions in Canfor (TSX: CFP) and Western Forest (TSX: WEF). These positions were tiny and taken during the Covid onslaught (there was just too much other stuff going on for me to pay more attention), but percentage-wise they were well above a 100% gain. I’ve redeployed the proceeds to companies that are exposed to crude oil prices.

The lumber commodity has been on a huge tear over the past month. The following is a chart of the July lumber futures, and note that the step-up is because on many days the future contract has been locked limit-up:

For contrast, this is the 40 year history of the commodity:

I could only imagine what it was like to be a short seller of the futures over the past month (noting that the 925 price level was already at all-time highs!).

Correspondingly, lumber companies have skyrocketed during Covid. This includes CFP, WEF, WFG, IFP.

I will talk more about Canfor. They are 51% owned by a Jimmy Pattison company (his company also controls Westshore (TSX: WTE)). They were notably in the news in 2019 (pre-Covid) when they tried to take over the 49% minority stake at CAD$16/share. This was a typical Jimmy masterstroke – if it actually passed! The vote failed to meet the passing threshold – barely. Notably, one of the directors, Barbara Hislop, who was a descendant of one of the original founders of Canfor (in addition to working her ranks up the company over a few decades herself), was against the deal. She was the sole director to ‘abstain’ from the board of directors’ vote to recommend selling out at $16/share. That ‘trade’ to not divest saved her many millions of dollars – going into 2021 she had 1.3 million shares of Canfor and has subsequently dumped nearly half of them for around $30 a piece. Talk about vindication.

It’s easy to look at this in retrospect, but even then, Canfor got as low as $6.11 during the pits of the Covid crisis. The trade to not sell out at $16 was looking bad for some time.

In the last quarter, Canfor reported a net income of $3.42/share. Annualized that’s $13.68/share, or about 2.4x earnings at the current trading price of $33. Needless to say, you are correct in questioning my mental sanity when I am selling equity at 2.4x annualized earnings. Didn’t I talk about selling out too early at the beginning of this post?

The reason for this is that lumber is very cyclical. There are boom and bust periods. Right now is the “category 5 hurricane” confluence of events that is triggering a massive demand-supply imbalance and we are in the second phase of that storm where the eye of the hurricane has passed and we are once again facing the winds. Putting a long story short, when Covid started, the assumption that wood executives made was to clear out inventory because the economy would crash and construction would come to a halt. Precisely the opposite happened (everybody decided it was a great time to start building your own deck) and we are seeing the reverberation of those March 2020 decisions today. Now we see 4’x8′ OSB plywood selling at $60/sheet at Home Depot and anything wood-based is insanely expensive.

Certain construction projects must be completed on a timeline – developers generally can’t say “forget it, I’ll wait until lumber gets cheaper to do this project” – there are running timelines that can’t be altered. Discretionary projects, however, will be delayed and this will create its own residual demand which will add to future prices – hence the January 2022 lumber futures are at around $1100. But there will be a point where the demand destruction will kick in, and lumber will hit some regression to the long-time average.

In the meantime, the surviving lumber companies will be repairing their balance sheets and prepare for a day with less profitability than present. Currently, they are pumping out lumber as quickly as they can make it.

In addition to Barbara Hislop selling out, I note that a week ago Brookfield Asset Management dumped a massive stake in West Fraser Timber. While I am not a “follow the leader” type investor, I generally do have respect for Brookfield’s investment decisions.

In terms of the market dynamics, my gut instinct says that now is a good time to cash out. Everything is rosy. It feels terrible to sell out at 2.4x and I am probably leaving 10-20% of upside, but I’m punching out the clock right now. If I had a larger position, I’d get a little more fancy and sell a chunk of it with every few percent of share appreciation (this indeed would capture more of the upside if it were to occur), but I just want this trade out of my mind to preserve my mental bandwidth for other things.

Miscellaneous Market Notes

Quite a few things going on.

1) With the rejection of the Canfor offer, the stock went from $15 to $12, but recovered to $13 as I’m writing this. Many investors are probably engaging in the Canadian version of Buffett-following, which is “if Jim Pattison thinks it’s worth buying at $16, surely buying at $12 or $13 isn’t that bad.”

I do agree with general market sentiment that Canfor was lowballed, but the forest industry is cyclical and most definitely we are in the low part of the cycle. When things will emerge again remains to be seen. The good news with Canadian lumber is that it is one of our few economically competitive exports and doesn’t require a pipeline to transport. In addition, environmental groups have shifted their political focus in the last couple decades from antagonizing forestry to fossil fuels, which gives them some breathing room (for now).

In British Columbia, hardly a month goes by without hearing some news about mill shutdowns and the like. The industry is really suffering right now. The renegotiation of NAFTA and expiration of the previous softwood lumber agreement (October 2015) did not help matters at all.

2) Cineplex (TSX: CGX) getting taken out at CAD$34 is a gift to CGX shareholders. A British firm, Cineworld, apparently has too much money and has spared Cineplex owners from taking future losses. As you can tell by the tone of this paragraph, I did not perceive Cineplex’s future business chances as being particularly rosy. The business did have value but not at the price they were trading at. I’ve written about it a few times in the past and will leave a chart here for historical purposes:

3) Another takeout which I thought would go through was HBC (TSX: HBC), which (at $10.30) was withdrawn by the proponents (Baker Group and others, 57%), and a subsequent $11 offer by another significant minority shareholder group (Catalyst, 17.5%) was rejected by the shareholders offering $10.30. This is a gigantic corporate governance mess, but what was interesting was the posting of all the real estate appraisals on their investor relations site. Get some commercial quality information for free!

4) I’ve actually been active taking small stakes in various companies in late November and December. The range of companies is widely varying. For the first time in quite some time, I’ve deployed some capital south of the border.

Two shareholder votes to watch out for this week – Canfor and Pengrowth

Two shareholder votes happening this week which will be of interest:

Vote #1: Canfor

Canfor (TSX: CFP) will vote on Wednesday, December 18, whether they want their minority shareholders (49%) to be taken out by the majority (51%), which is currently owned by entities controlled by Jim Pattison. The proposed takeout price is CAD$16/share, which was higher than its trading range for most of 2019, but lower than last year when things were looking a lot better in the forestry sector. The majority of minority shareholders is required for the vote to pass.

My guess is that this will pass. The only significant shareholder other than Pattison’s entity is through director Barbara Hislop, who controls about 2.5 million shares (out of 125.2 million shares outstanding). The rest of the shareholder base is likely to be institutional in nature and I do not think they will put up much of an opposition. At Friday’s closing price of $15.45, this seems like an easy 3.5% gain in two days of trading for those that are brave to place a bet.

Most other forest companies have gotten killed – WFT, IFP, WEF and especially CFF – picking look slim right now.

I think Pattison’s sense of market timing is excellent with this one – buy low and collect the cash when the times are better again, and they will be. The fact that this isn’t a no-brainer suggests that he’s getting a good price on the acquisition – indeed, if 99% vote to agree to it, he probably paid too much. But if 60% of the minority agree to the deal? That’s a perfect price.

(Update, December 16, 2019: The deal was rejected with 45% of the minority in favour of the deal, with 50% required. Guessing that Pattison wished that he added another 50 cents on this one to seal the deal!)

Vote #2: Pengrowth Energy

Pengrowth Energy (TSX: PGF) will also be voting December 18. The proposed acquisition price is 5 cents a share, mainly because the company has debt maturities outstanding that will likely be defaulted on if the vote goes negative. The only real question mark at this juncture is why Seymour Schulich, who owns 28% of the common shares, all of which have been purchased at significantly higher prices, is going along with this. He purchased a couple million shares as late as July of this year (for approximately 50 cents a piece) and owns 159.4 million shares out of the 560 million outstanding. Is this going to be the mother of all capital losses? Or did he cut a deal with Cona Resources (the acquirer) that will take place after the transaction concludes?

For somebody with patience, I think Cona is getting an excellent deal. With the debt eliminated, Pengrowth is very highly leveraged to ambient oil prices and if there is any revival in the market, the pain that these companies have gone through in the past half decade will be nowhere close to the rewards that will be gained in the future.