Tag: ELF

When narrative and reality collide – ESG, politics and markets

One rewarding aspect of finance is that participants that correctly perceive reality are eventually rewarded with additional capital, provided you stay solvent longer than the market remains irrational.

As markets are an amalgamation of sentiment, there is an element to psychological timing with regards to asset prices. The prices that are currently seen represent the baked in assumptions of marginal buyers and sellers, each trading with their own motivations – some extremely short-term, some extremely long-term. Another vector is the advent of environmental, social and governance (ESG) driven investing. Formerly labelled as “socially responsible” or “ethical” investing, ESG has generalized this to refer to politically correct practices.

As the politicization of financial markets continue, it is obvious that a focus on ESG and politically sensitive institutional investors (e.g. public pension plans and the like) will take a factor in investment decision making. This has long-since been baked into certain asset prices. Political favourites, such as renewable energy initiatives, have resulted in such assets receiving premium valuations and hence low returns for current investors. Such assets are typically aided by government subsidies (in the form of attractive power purchase agreements, or in the case of Tesla, outright tax breaks and subsidies).

This sort of gaming goes on all the time in most industries, as participants jockey for position. Large entities try to assert control through rent-seeking techniques. Nothing is a better example than how various entities are reacting to COVID-19 – companies such as Amazon are cheering for continued lockdowns as they continue to eat away at conventional retail. The medical industry, both private and public, are cheering their nearly unassailable position as nobody can question the quantum of spending in relation to the overall benefit – “anything to save a life” is the current expectation. By the time it comes to pay the bills, the blame will be attributed to other factors.

On the flip side, we have the ‘enemies’ of ESG, which generally constitute a list of firms in politically incorrect industries. One of these industries that are deeply politically incorrect at present (especially in North America and Europe) is oil and gas exploration.

When looking at core valuation of the major Canadian oil and gas firms, there is a major valuation gap between what the ambient market is offering versus what cash is being generated by the companies in question.

For instance, Canadian Natural Resources (TSX: CNQ) gave out guidance on May 6, 2021 that assuming a US$60/barrel of West Texas Intermediate (right now it is US$63.50 on the spot contract), they will be able to generate around $5.7 to $6.2 billion in cash flow, and this is after their capital expenditure and dividend payout (which is another $5.4 billion). Backing out their $2.2 billion annualized dividend to zero, that’s around $8.2 billion in free cash flow (FCF).

Recall that CNQ’s enterprise value is currently around $67 billion, so a rough valuation would be an EV/FCF of 8 times. This means if things continue at current prices, CNQ could pay down all their debt and buy back all their shares outstanding (at current prices) in 8 years. This isn’t an isolated case. The other Canadian large players, Suncor, Cenovus, Tourmaline, are roughly the same (plus or minus one or two points). There are no other ‘substantially Canadian’ plays that have a market cap of above $5 billion at present (Imperial Oil is 70% owned by Exxon, and Ovintiv, the former EnCana, is now primarily a US producer).

You cannot find valuations like this anywhere else on the large-cap market. A typical utility such as Emera (TSX: EMA) trades at roughly 18 times EV/operating cash, never mind capital expenditures! Royal Bank (TSX: RY) trades at 15 times earnings. Perhaps the only outlier I can find in this respect is E-L Financial (TSX: ELF), which posted a 2020 net income of $129/share (on a current share price of $948).

Needless to say, Canadian Oil and Gas looks cheap, and one reason for this (other than the horrible regulatory climate) is the investment ineligibility due to ESG. The irony is that this creates opportunity for returns for those that want higher returns, such as international investors that do not take North American ESG into their investment consideration.

I can think of one analogy in the past which reminds me of today – the plight of tobacco companies in the late 90’s. Tobacco companies (most specifically, Philip Morris) were vilified in the 90’s for having the gall to produce a product that caused lung cancer and collectively denying it until they had lost all public support. The watershed moment was a US$200 billion settlement with the states in 1998, but in reality, this agreement secured incumbency rights for the existing players. The Philip Morris example (now known as Altria) has them earning $3.20/share in 1999, while the stock closed at $23/share for the year. They bought stock like mad during the dot-com boom and shareholders got very rich. Incidentally, Philip Morris was right up there with Microsoft in terms of generating shareholder value over decades (not really the case today anymore, although tobacco continues to remain very profitable).

I’m going to make a much looser analogy with Warren Buffett buying Apple stock in 2017 and 2018 (at his cost basis of $34/share to the tune of some 907 million shares he currently holds today) is giving him a current earnings yield of about 15%. There are of course key differences – with Apple, you have to assume they can continue selling iPhones, iPads, Macbooks and ‘iApps’ at their monstrously high margins indefinitely. With oil and gas you have to make an implicit assumption that the underlying commodity prices will stay steady. This is another argument for another post, but please humour me by granting this assumption.

Buffett, by virtue of his size and relative fame, is constrained by political considerations. The cited justification for selling off his shares in airline companies at the onset of the COVID-19 crisis was politically motivated – the chances of airlines getting public money bailout with (deep pocketed) Berkshire being a 10%+ shareholder was much less, so they had to sell (I am not sure if this is retrospective analysis that actually went on during the sale, or whether it was a simpler case of the original investment thesis being broken). This is not the only example.

In the most recent 13-HF, we had Berkshire disclose that it had sold half of its Chevron stake and all of its Suncor. Chevron is obviously going to be completely divested by next quarter. There is nothing in Berkshire’s public holdings that relate to oil and gas production going forward. This is very intentional, and I believe it is for political reasons.

Buffett is the son of a former US Congressman and should know a lot about the political dynamics that is going on with ESG currently. There were two shareholder resolutions that came up during Berkshire’s last annual meeting. One was from Calpers and the Quebec Pension Plan, two very credible institutional investors:

In order to promote the long-term success of Berkshire Hathaway Inc. (the “Company”) and so investors can understand and manage risk more effectively, shareowners request that the board of the Company publish an annual assessment addressing how the Company manages physical and transitional climate-related risks and opportunities, commencing prior to its 2022 annual shareholders’ meeting.

The other (from a generally unknown proponent) was:

Shareholders request that Berkshire Hathaway Inc.’s (“Berkshire Hathaway”) holding companies annually publish reports assessing their diversity and inclusion efforts, at reasonable expense and excluding proprietary information.

Normally such shareholder resolutions get voted down, heavily. The Board of Directors almost universally recommend a vote against such resolutions.

However, the actual results of the votes got somewhat close:

There were approx. 548,000 votes cast in the meeting (some votes are not cast due to them being held by brokers that do not vote). The directors control 272,900 of the votes (the vast majority of this is from Buffett himself). So the vote result was a foregone conclusion.

However, excluding the directors’ votes, both resolutions passed with a slim majority.

This has to be interpreted to be a warning shot across the bow to Berkshire and almost any other corporation out there with a large public presence. They are not immune from activist politics and the politics driven behind institutional shareholders.

You can imagine how Buffett might be frustrated in not being able to deploy capital into a field that is liquid enough to make an impact on Berkshire. However, with the world examining his holdings every quarter, he must take politics into his investment considerations.

ESG, just like most political interventions, cause market distortions between perception and reality that can last for years if not decades. Hundreds of billions of dollars of capital are being invested not with a return in mind, but rather with a heavier consideration to other factors, including those that are acceptable today (which may or may not be acceptable tomorrow). Pharmaceutical companies were completely vilified before COVID-19, and now they are being showered with immunity from Covid vaccinations and have a gigantic regulatory shield to work with (until they are no longer in favour again for making outlandish profits). Today’s enemies are those relating to climate change, but this may change in the future as demand for fossil fuel energy outstrips available supply.

I am not making a moral judgement on ESG and its intentions. I am claiming, however, that ESG-driven considerations are causing significant distortions in the returns of investments that would have not otherwise existed.

Ultimately for equity investors, cash flows will dictate returns. It might take some time for political fashions to turn, but just like Philip Morris investors in the late 90’s, they were very well rewarded. Eventually the paydown of debt and payments of dividends and buyback of shares trading at single digit multiples will result in higher equity pricing, no matter which trends are politically correct.

Making investment comparisons

This post is a little more abstract, but the thinking should be fairly easy to understand. The revolves around the concept of hurdle rates, and making comparisons to baseline investments.

I’ve been reviewing a bunch of companies that have balance sheets that have tangible (or nearly tangible) financial assets that when netted against their liabilities are trading below liquidation value. An example of this would be Input Capital (TSXV: INP) which Tyler has tweeted about, in addition to SM keeping me informed by email.

In the case of Input, taking their December 31, 2019 balance sheet as-is without mental adjustments, gives them a $1.24 book value. At a current market rate of 71 cents, that’s trading at a 43% below book discount. Assuming the asset side of the balance sheet doesn’t have more write-down surprises, the company on the income side still makes a modest amount of cash on their canola/mortgage streaming business, albeit at a rather high cost on administration (as a percentage of assets). If they decide to wind down, shareholders should be able to get out with a mild positive. Their mortgage portfolio will amortize and the board of directors can command management to fire themselves and call it a day.

So lets assume I have a chunk of cash, and I’m evaluating this option for the portfolio. To be clear, I’m not interested, and INP has very poor liquidity – typical trading volumes in a day is less than CAD$10,000. Piling onto our list of assumptions, let’s say liquidity is no concern.

The question is: What do I compare this to?

If I compare this to the simple risk-free cash amount (e.g. the brain-dead option is (TSX: PSA) which yields a net 2%), then yes, Input Capital looks fairly good by comparison. If INP materially winds up in 3 years and captures 90% of its present book value (conservatively assuming they lose a bit in the process of wind-down), that’s a 16% CAGR gainer. You’re effectively getting 14% net on the risk-free option – the risk of this not happening is what you’re getting this 14% spread for (such as the critical assumption on whether they choose to liquidate or not!).

However, things are not so easy in our multiverse of investment options.

For instance, you have other choices. Coming up with baseline options is vital for making comparisons. Other than the risk-free option (government bonds or for smaller scale amounts of money, PSA), there are surprisingly a lot of companies out there trading under book value that appear to be making money.

Perhaps the least glamorous, most boring, but relatively safe option is E-L Financial (TSX: ELF) which owns nearly all (99%+) of Empire Life, 37% of Algoma (TSX: ALC), and 24% of Economic Investment Trust (TSX: EVT). At the end of Q3, its book value (stripping the $300 million of preferred shares outstanding) was $1,421/share while its market value today on the TSX is $814, which is a 43% discount below book value, identical to INP’s discount today. ELF also from 2009 to 2018 compounded its book value by 9.7% annually, and clearly is a profitable entity.

So we compare two opposing options: INP and ELF – why in the world would you choose INP? The only reason would appear to be a chance of a quick and clean liquidation over the next few years, and that is measured against ELF earning 10% of book value over those three same years, and staying at a 43% below-book valuation. The only thing you don’t get with ELF is an interesting conversation at a cocktail party.

The baseline comparison of ELF compounding book value at 10% a year creates quite a hurdle for other below book value investments – the underlying mis-valuations must be very severe in order to warrant an investment in other vehicles. When scanning my portfolio, all of the common share investments have clear rationales for expected returns higher than this hurdle rate.

When you compare to real bottom of the trash barrel options like Aberdeen International (TSX: AAB) which are trading 85% below book value, why would you want to put investment capital into a sub-$100 million market capitalization entity when there is a perfectly viable option that is clearly a legitimate firm, and has a very good track record of building its balance sheet? (For those financial historians out there, many years ago Aberdeen was subject to a bruising proxy fight where an activist tried to take over the board for the purpose of realizing book value, but the management was successful at fighting it and then proceeded to fritter away the company into what it is today – a 3.5 cent per share stock – shareholders got what they deserved!).

As a final note, the presence of fixed income options that appear to give off very high low-risk returns tends to make such comparative decisions really difficult. For example, Gran Colombia Gold’s notes (TSX: GCM.NT.U) are linked to the price of gold and give out more yield when above US$1,250/Oz. Given the seniority of the notes (they were secured by the company’s primary mining operation), even at the baseline gold price, the notes represented a very low-risk 8.25% coupon. At current gold prices, the coupon effectively rises to around 15%. It is difficult to compete against such investments, except in this specific instance they must be capped as a reasonable fraction of the portfolio (if the mine had an implosion, explosion, earthquake, etc., then there would be trouble). The opportunity is now gone since the notes are now in a redemption process and the remaining principal value will be whittled away with quarterly redemptions at par values below market trading prices, and the rest of it will likely get called off after April 30, 2021 (at 104.13 of par).

I won’t even get into comparisons with the preferred share market, where there are plenty of viable options with little risk that will yield eligible dividend yields roughly in the 6% range that would require an economic catastrophe of huge magnitude before they stopped paying out. The ebbs and gyrations of the underlying business itself is almost irrelevant to most of these preferred share issuers (e.g. Brookfield preferreds will likely pay dividends in your lifetime and mine). People, however, do get confused on the “stopped paying out” part of preferred shares vs. them losing market value – the preferred share trading today at 6% might look good to leverage up money at 2.2%, but if those preferred shares start trading at 7% or 8%, you might be the unwilling recipient of a margin call or the margin calls of others.

To conclude, just because an investment looks good on an absolute basis doesn’t mean the research stops there before hitting the buy button – making comparative measurements is just as important. Nothing precludes one from buying into both options; after all, if there is no correlation between the two investments and your success rate is 70%, you’ll hit your target on at least one investment half of the time.