Value Investing in Canadian Equities for the Long Term
TWST: Would you begin with a brief introduction to Baskin Financial Services, including a few highlights from the firm’s history, a bit about your role there, your total assets under management and an overview of your client base?
Mr. Schwartz: Baskin Financial was started 20 years ago by my partner David Baskin. We’re catering to Canadian investors, and we’re registered in six provinces, and we manage customized and tailored portfolios for families, not-for-profit foundations and charities. And our goal is to grow our clients’ portfolios and try to do it by adding alpha and limiting beta. The firm is now managing about $450 million for 350 families in six provinces in Canada. It is an exclusively segregated and discrete portfolio management, so each and every family gets a tailored portfolio to meet their needs for income, their risk tolerance and their requirements for a happy and successful long investing career.
My role is as VP and Portfolio Manager, and this is now my 13th year at the firm. My role is multifaceted. We’re a small company. I manage clients’ portfolios, I help with research and come up with stock ideas, and multitude of administrative and business tasks. We’re a firm of about 11 people, with four people in the portfolio management side and then a number of people on client support and back office.
TWST: Generally speaking, you consider yourself a value investor. Please tell us a bit more about your strategy, and what do you think makes it unique compared to other managers who also use a value approach?
Mr. Schwartz: We are followers of the value approach, and we’re disciples of Benjamin Graham and Warren Buffett. They’ve written a bible, and we pretty much kneel down at their instructions. But there are many different types of value investors. There is the classic value investor, where they’re looking to find hidden gems that the market hasn’t thought of, and trying to come up with finding a cheap business idea. I guess the classic Benjamin-Warren Buffett’s cigar butt where you try and find an investment idea that has more value than the market is ascribing to it. And then there are value investors that are kind of looking to come up with ideas that maybe the market knows about, but come up with interesting ways to value that company and see what other people don’t see. So we’re looking to buy companies that have sustainable business plans, that when we buy them we want to hold them for a very long period of time.
It’s very hard to come up with a good idea. So once you come up with a good idea, you want to be in business with that company for a long period of time. But we want to buy companies where, if we fell asleep for 10 years, its business would still be around and still be growing. And that is very hard to do. But that’s what we’re looking to do. I don’t want to invest in a business that may have an attractive valuation or maybe it’s generating a strong amount of free cash flow, but where its business is clearly declining, and clearly it’s not going to be around for many years.
We also shy away from companies that may have substantial problems or accounting issues or businesses where we just can’t understand, even if it’s trading at a deep discount to book value. So yes, we still are sticking to the value investment strategy. In this environment sometimes fundamentals don’t matter, but we believe, at the end of the day, they do. Even in an era where you have extremely smart people using computers to come up with arbitrage ideas, you’re going against high-frequency traders, we still believe that there is the room for the regular guy with a pad of paper and a spreadsheet and a calculator to come up figuring out what a company is worth and trying to buy that company at a discount to what it’s trading at.
TWST: In a recent blog post, you wrote that “buy and hold” is dead. Instead, you said, you need to buy what you need and wait for the “fat pitch.” Would you elaborate, and tell us how you incorporate that thinking into your investment strategy?
Mr. Schwartz: Sure. It may have been a case in the past where you could buy good quality company like a Wal-Mart (WMT) or a Coca-Cola (KO) and just hold them to the end of time, but I no longer feel that that is appropriate. You need to be a little bit more active when it comes to managing your portfolio and coming up with great ideas. We love it when a company has a slip-and-fall accident. When a company for whatever reason has a bad quarter or has an issue that the market overreacts to and that’s what we call the “fat pitch.” Or when for no reason a stock just starts to drift down in price — if we’re able to buy a company at a 25% discount or more to what we feel it’s valued at, then that to us is a fat pitch. And even better, if that company pays a dividend and has a history of raising that dividend over time, then we’re able to collect the nice income when we wait for the market, which temporarily disagrees with us, to come back and agree with us. So we think that’s part one of the strategy.
And the other part is, if you’re going to be a long-term investor, you have to buy companies that sell products and services that people need and use everyday. And that’s where we think long-term value is created. We all need to eat, we all need shelter, we all need electricity. With all these things that are a requirement for daily life is the types of investments that we want to own. We don’t need to own investments in the companies where the product itself maybe a fad. It’s very hard to figure out what a fad is and when a fad actually becomes part of people’s daily lives. But we’re not about to try and figure that out. So we want to come up with ideas and own ideas where we think people need to use these products everyday, regardless of market environment.
TWST: What you believe are the most compelling reasons to invest in Canada at the moment?
Mr. Schwartz: OK. So for Canadians, of course, the concern is that Canada is only a small part of the world and how can you limit yourself to just Canadian investments? And I would argue that number one, Canadians should, first of all, match your assets to your liabilities. If you live in Canada, if you get paid in Canada, if you have to pay your mortgage in Canadian dollars, if you don’t have residences outside of the country that you live in, then really you should be matching your investments to your liabilities. And so, there is a risk when investing outside Canada, and that’s currency risk. So I think people forget that you are taking a huge amount of risk, because currency movements are unknown. So I think there is an advantage to investing in your own country.
Second of all, for Canadians, if you’re buying dividend paying stocks outside registered accounts or in taxable accounts, the benefit of the dividend tax credit for owning Canadian stocks is very beneficial — essentially, you get to keep more of that after tax income. And the final thing is, Canada really has all the commodities and resources that drive the global economy. If you’re bullish on China, then you have to be bullish on Canada. We provide iron ore, coal, copper, gold, oil, natural gas, lumber, these are all the things that the world needs and uses each and every day, and going to need to use it each and every day to continue to grow. And if you believe that while we may be in a period of slow and choppy growth, 1.5%, 2% a year, then the world is going to need 2% more oil, and 2% more lumber, and 2% more copper, and Canada really is rich in those resources or has companies listed that have those resources in other countries. So we’re very positive on Canada. We think Canada’s economy is very strong. The GDP is showing better growth in the U.S. The unemployment rate here is quite low. Our governments don’t have the same deficit issues as our U.S. counterpart. So there is a good reason to continue to be bullish on Canada, but this is a very, very narrow market. You have to do more research. You cannot just buy the index, and I think that’s where our acumen, our skill comes in as we try to — for our clients, is not to mimic any index. It’s really to research and find value, and we don’t care if we are zero weighted gold, which we are. We’re looking to find value, not being comfortable around the index. Our clients are paying us for our best ideas as an active manager and if our best idea is on 5% of our portfolio in Cineplex Galaxy (CGX.TO) then so be it, and that’s actually the case.
TWST: Do you think global investors have a good understanding of the investment opportunities in Canada? What are some common misconceptions or little-known facts about investing in Canadian equities?
Mr. Schwartz: Well, I think our banks have gotten a lot of more attention over the past two years. Our banks really had no troubles from the subprime crisis, none of our banks cut dividends. Our banks did drop in terms of valuation and sympathy, but the earnings snapped right back; many of our banks are now raising dividends hand over fist; valuations are just as low as the U.S. banks. The difference is our banks are trading at higher price of book values, but I think when it comes to book values of the U.S. banks, it’s impossible to figure out if there really is any tangible book value to them. So I think the Canadian banks are really underappreciated in terms of their ability to generate very strong and consistent profits. And really, their less aggressive, more cautious approach has done wonders for them. Everybody is concerned about the Basel III rules and having enough capital to meet those requirements by 2019, and really the Canadian banks are in a great shape and are probably almost already there. So that’s one thing. Canada is seen as a petro economy, it’s seen as commodity related economy, but I think nothing could be further from the truth. You have some really world-class companies that are starting to make headwinds into the U.S. and globally. And over the next two years, I think investors will be surprised by some of the giant behemoths that we’re creating – a name like Tim Hortons (THI) that is slowly but surely adding restaurants in the U.S. and successful there, or a company like Saputo (SAP.TO) that continues to acquire cheese producers and dairy producers all across the globe, and it’s now become a very well renowned company. But the problem with Canadian companies is that they don’t like to list on the U.S. exchanges, because they don’t get the coverage, and they found that there is no cost advantage through it.
Over the past 19 months, the U.S. stock markets have outperformed the Canadian markets by a large percentage. And I think some of those stocks that have done really well in the U.S. stock markets really offer no growth and no upside. We saw yesterday Johnson & Johnson (JNJ), for example, reported that it will have no growth in 2012. Well, if you believe that the economy is going to continue to show a little bit of nice recovery, there is a lot of cyclical commodity-related companies in Canada that will have potential for significant earnings growth, whether it be fertilizers or some of our auto suppliers like Magna (MGA) that could show strong earnings growth, magnitudes of 10% or 20% or 25%, whereas some of these U.S. stocks are priced to perfection. So I think investors who have over weighted the U.S. stocks should start to look at some in Canada. Another point, I guess is, some of these U.S. stocks are — U.S. companies are complaining that currency will have an impact on the earnings going forward and as the euro continues to drop, as the U.S. dollar continues to get stronger, there is an opportunity there for the U.S. investors to maybe look at some Canadian ideas. Why not use your strong dollar to buy some foreign stocks?
TWST: Would you walk us through your stock-selection process? How do you determine your investable universe and what metrics do you evaluate to select stocks for clients’ portfolios?
Mr. Schwartz: Sure. So let me tell you what my strategy is for buying stocks. I am agnostic when it comes to ideas whether it’s small cap, large cap, microcap. I’m really looking for value. I’m looking for a strong management ownership in the company. One, I like my management to have a healthy stake in the company, I like them to care about the stock price, I want them to get the dividends. If they own a significant stake in the company, then the dividends matter to them just as much they matter to you; and the rising stock price matters to them, just as much it matters to you. And some of these companies where management owns next to no stock and as soon as they get their stock option to cash out, that to me is, I think there is a disconnect. So what I like to see in companies is, first of all, a track record of paying dividends and raising those dividends over time. I think that dividends are the best signal of confidence from the management really telling investors that the management feels that the upcoming year is going to be better than the next. So track record of rising dividends, I like strong balance sheets and strong generation of free cash flow, and that free cash flow should be used to either buyback shares when appropriate, increase dividends or expand the business. So those are really what I’m really looking for, and at the end of the day they have to have low valuations.
I want a margin of safety. I want to buy companies that are trading at deep discount or at least a discount to the market multiple. If I buy a stock trading at 20 times earnings and the market is trading at 15 times earnings, if they have a slip-up, they’re going to the market multiple. If I have a stock that’s trading at 10 times earnings, I think the only way it can go is to the market multiple. So here are a number of ideas I think that fits that category. We really like and started buying probably early last year was High Liner Foods (HLF.TO), and it’s not a very widely followed company. It has a small market cap of only about $350 million, but they made an interesting acquisition in early 2012. High Liner Foods is Canada’s biggest provider of frozen seafood, and to retail as well as to restaurants and other food service businesses. And they made a big acquisition of a company out of Iceland, and now they’re one of the largest providers of seafood in the U.S. primarily to restaurants. So they have a number of great brands, recognized brands in Canada with the Captain High Liner image, and they have a very good coverage in grocery stores. And it necessarily fits to the theme of owning what people need and use everyday. Frozen fish is a staple of our diets, and kids love fish sticks. They continue to source fish from all different sources, so supply is not an issue for them. They continue to be able to increase prices. And it’s trading, in our minds, at a very, very low valuation of earnings. We think it’s trading at less than eight times this year’s upcoming earnings. It has a nice track record of raising its dividend over time. With the acquisition of Icelandic, they now have to focus on repaying debts on that acquisition. But over time, we think they will be able to get the balance sheet back in order very quickly, because of how much strong cash flow they’re generating, and they’ll get back to the business of raising their dividends again, and continue to make inroads into the U.S. and Mexico. They come up with some unique products, whether it’s grilled fish or products with fish for restaurants and people — more and more people are recognizing the benefits of fish, the Omega-3, the fatty acids in them that are positive for our health.
Management owns a healthy stake. There is a significant family ownership, the Jodrey family out of Nova Scotia, that maintains a significant holding in a company, and they’re not selling. It trades, in our mind, half the multiple of some of the other branded food companies like Kraft Foods (KFT) or even a Saputo here in Canada. They trade 16 times earnings, whereas you’re getting High Liner Foods for half that multiple. So that’s number one.
The second name I’ll give you is a company called Morguard (MRC.TO). Morguard is a real estate company that owns about 2 billion square feet of real estate in Canada and the U.S. It owns shopping malls, commercial real estate, office buildings, industrial buildings and apartments. So Canada’s real estate market demand is very strong. We have a number of U.S. retailers continuing to infiltrate. Our economy target has opened up a number of stores. We’ve continued to hear rumors that there are more coming, whether it be The Cheesecake Factory (CAKE), or P. F. Chang’s (PFCB), or a Kohl’s (KSS), or a Marshall’s (TJX). There are also a number of the dollar store companies are coming. So there is a big demand for real estate. They have a number of terrific strip malls and shopping malls and can facilitate this demand. But what we really, really like about it is the valuation. Morguard is not a real estate investment trust, but compared to a real estate investment trust — which trade at a metric of 18 times adjusted fund from operations, which is really the metric of a company’s price, typically cash flow, whereas Morguard trades at 10 times price to adjusted funds from operation. So in our mind, trading at about an 80% discount to some of the real estate investment trusts, so that’s a great discount. We think it’s trading at also about a 50% discount to its net asset value.
The company is buying back shares. The company has a strong management ownership. It’s run by a gentleman named Rai Sahi, who owns more than 50% of the company, and there’s hidden value there. The company owns significant stakes in two other Canadian publicly traded companies, Morguard North American Residential Properties and Morguard Real Estate Investment Trust. So an amazing value there. It has never raised money itself. It has very little analyst coverage. While it does have a miniscule dividend, it has been steadily raising that dividend, and it has been buying back shares.
I’ll give you one more. My final name is Algoma Central (ALC.TO), which like all three of these names suffers from low liquidity. So all three have to be bought with caution, and you can’t throw caution to the wind when buying these stocks. They have low liquidity. You need to limit orders, you need to buy them on days when there is liquidity. But Algoma Central is really a monopoly shipping business on the Great Lakes Seaway. If you’re worried about concerns about Europe or China, it’s one where you don’t have to worry about because it’s essentially 100% focused on North America. And it ships goods from Canada to U.S. and vice versa. It ships iron ore, coal, fertilizer, grains, salts and other types of products for both economies, and we believe that the Canadian and U.S. economies will continue to show growth, which will be very beneficial for Algoma Central. We think its book value is about $125 a share. It’s trading at $117, so it’s trading at the discount to book value. We think it’s going to earn about $16 a share this year in earnings, so it’s trading at seven or eight times earnings. It has a track record of raising its dividend each and every year for the past eight years or so. So you get a nice little dividend, and they are reinvesting and buying new ships that are more efficient, more fuel-efficient, have better loading capacity and to meet demand – another hidden gem, zero analyst coverage. But if you believe the North American economy will continue to grow over time, this is an investment you want to own. And you want to own monopoly businesses, and it’s a monopoly, so very interesting idea.
TWST: How would you describe the client who is going to be an ideal match for Baskin?
Mr. Schwartz: Well, it’s been a very tough market environment. Clients are jittery. In terms of how recent we are from 2008 and how punishing and troubling that was, 2008 impacted us in many ways. And every time we have a bad month, everybody is concerned that, “Oh, no, here we go again.” We’re going to be back to 2008. We’re looking to reassure our clients that these things happen all the time. There is never good time to invest. There is always uncertainty in the world. No one can tell you when Europe is going to get better, China is going to start growing again, it’s impossible to figure that out. So clients need to have patience. I think we’re kind of in a world where you need instant gratification. And when it comes to investing, instant gratification is far and few in between. Investing is a marathon, and investors need to realize that if over time, over a 10-year period, you can grow your portfolio 6%, 7% a year compounded, then you’re going to do very, very well. But portfolios don’t go up in a straight line, and they don’t go down in a straight line. It’s a long-term process, but if you stick with good quality companies that sell and produce products that people need and use every day, and you buy them at discounts to what they’re worth and you’re going to do very, very well over time.
So our clientele, we have some of the best clients, I think, in the world. They ask great questions. They are active and want to know our ideas, and I would simply say that, since 2008, people are more interested in their portfolio and more interested in taking control of their finances, and I think that’s terrific. I think you can’t be a silent partner with your portfolio manager; you have to be an active partner. You have to tell your portfolio manager directly how you’re feeling and your emotions. And if you need reassurance, the manager needs to be there to listen to you. At the end of the day a great partnership between your portfolio manager and yourself is a function of communication. It’s listening to client and making sure that you structure the portfolio to meet their needs, and making sure the client understands what they own and making sure that there is intellectual honesty from your portfolio manager. Are they doing what they say they’re going to do? If we say we’re value investors, if all of a sudden we start buying junior gold mining stocks for our clients, then there is a disconnect there and a lack of communication. So I think people need to be more active, more vigilant in their portfolios. They need to pay attention, more active communication with the portfolio manager, and the portfolio manager has to provide transparency and rationale behind their decisions for each and every client, and I believe we’re doing that and I believe that our clients are also doing that.
TWST: Thank you. (MES)
VP & Portfolio Manager
Baskin Financial Services Inc.
95 St. Clair Avenue West
Toronto, ON M4V 1N6
(877) 227-5468 — TOLL FREE
(416) 929-7208 — FAX