Financial Jungle

Last week on BNN, I caught a sound bite of renowned Canadian value manager, Irwin Michael, who manages a string of sensational mutual funds. Most notably, the ABC Fundamental Value Fund, which returned a stellar 18.8% since inception 16 years ago. What I love about Irwin Michael is his uncanny ability to uncover diamonds in the rough while the shortsighted market is too busy chasing yesterday’s hottest stocks. Visit Irwin’s ABC Fundamental Value and note the propensity to divest from the market return over his 16-year tenure as the fund manager. Remarkable isn’t it?

Irwin Michael shares his wisdoms monthly on his website. I think my all time favourite has to be his contrarian take on exuberant market in December 1999. Here are a few excerpts:

This TSE index performance has been led by anything related to high technology, telecommunications or Internet whereas most other sectors such as financial services and resources, for instance, have languished most of this past year. …

Although we do not dispute the economic importance of high technology, telecommunications or e-commerce, many of the public companies associated with these sectors are outrageously expensive. …

We are particularly attracted to the natural resource and cyclical sectors which have become virtual investment pariahs. Especially cheap are oil and gas, forestry, metals and mines which have significantly under performed the popular stock averages for the past 6 months. Many companies trade at huge discounts to net asset value with low P/E and cash flow multiples. …

We are especially optimistic with regard to the Canadian dollar. …

Don’t you just love contrarians? If I didn’t know any better, I would hail Irwin as the genuine oracle of the stock market.

Okay, enough sucking up to him. What I wanted to discuss is his pick of the segment: KeyNote System. This is more of a quantity analysis, as I’m not terribly familiar with their business, but according to their website:

Keynote is the leading provider of on-demand test and measurement products for mobile communications, VoIP, streaming, and Internet performance. Connected companies will know precisely how their Web sites, content, and applications will perform on actual browsers, networks, and devices long before their customers and business is impacted.

Keynote is recently trading at around $14. They just delivered their Q3 results, and they are awesome to say it professionally. The company is debt-free and has $103.1 million in their vault. Divide that by the number of diluted shares, that’s $5.48 money-in-the-bank per share. We’re not done yet. Besides the cash, the balance sheet records $35 million worth of real estate value. This understates the true value immensely, because the figure already endured 6 years worth of capital depreciation for the purpose of tax savings. You see, Keynote bought their headquarter for $85 million back in 2000. Assuming 6% annualized appreciation, their real estate is worth $120 million today, or $6.38 per diluted share.

So when you buy Keynote for $14 per share, $11.86 is backed by cash and real estate. Not only that, it still has another $1.50 per share worth in computer equipments, software, leasehold and property improvements. All these assets validate Keynote an attractive take-over target notwithstanding the prevailing credit crunch. According to Irwin Michael, any high tech giant can absorb Keynote, use its $103 million to foot the bill, and occupy the 60% vacant space in Keynote’s mortgage-free head office.

Suffice to say, you’re getting the Keynote operations for next to nothing, and the business itself isn’t too shabby either. Revenue growth is 10% over the previous 5 years. According to Irwin Michael, Keynote should reap the rewards of its operating leverage very soon:

Once a platform has been built; incremental revenue is usually highly profitable, and the market is willing to look forward to future earnings growth. We believe Keynote is close to reaching this threshold. Management believes that if revenue can reach $100 million [FJ: it’s current at $65 million], its EBITDA margin would increase to 23% from 5% currently. This would essentially double Keynote’s free cash flow [FJ: $0.72/share over previous 4 quarters], and could result in significant investor interest.

For a non-dividend paying stock, it sure whets my appetite. For disclosure, I don’t own the stock nor have an entry price. We might be witnessing the infancy of an explosive growth, but just to be on the safe side, I want to make sure that the margin expansion materializes over the next few quarters.

The market tormenting me. The extra turbulence over the last few business days had taken everyone prisoner, except that they allowed the Biovail stock to revive 10% from its 52-weeks low. D’oh! I was so close in securing a juicy 10% dividend yield, my Achilles’ heel in investing, but the stock got away from me, at least for now.

Immediatelly after FDA’s thumbs down on Biovail’s studies on its formulation of bupropion, “a key component of a new antidepressant”, the market punished Biovail mercilessly sending the stock 37% lower to $17. In the process, it lifted the yield to a remarkable 8.8%.

This drug was supposed to fill the revenue hole left by Wellburtrin XL, a time-release antidepressant which accounted for 44% of Biovail’s revenues. Wellburtrin XL comes in 2 versions: the 300- and 150-milligram dosage. The 300-milligram version is already off-patent, while the 150-milligram version will face copy-cat competitions from generic producers. According to Biovail’s second-quarter financial report, generic competitions had swallowed half of the Wellburtrin XL revenues. That’s a 20% decline of total revenues.

Is the correction overdone? I think so. At the very least, I believe the stock has absorbed much of the decline and there’s plenty of value left in the post-Wellburtrin era. I know this isn’t a growth story like my superstar generic, TEVA. But, if the stock is indeed sufficiently below its intrinsic value, who will say no to free money?

Where’re the values? For starters, the company has $870 million in the bank in 2007 Q1. It means when you buy Biovail for $18/share, $5.40 is cash in the bank, so you’re really paying less than $13 for the pharmaceutical business. With the market being so volatile these days, patient investors might snap this up for a couple bucks less. Imagine one third of each Biovail share being backed by hard cash! I’d be stunned if the stock falls to anywhere near the vicinity of $5. Even cash flush stocks like Microsoft has only $2.49 on a $28.26 share.

The question that most critics enjoy picking on is can Biovail sustain the $1.50 dividend distribution policy in light of their top seller, Wellbutrin XL, going off-patent. For the sake of argument, let’s assume the misery by eliminating all revenues from Wellbutrin XL. (In real life, Wellbutrin XL should chug along residual revenues as with their other legacy drugs.) This drug is responsible for 44% of the 2006 revenues. Just to be on the conservative side, I’ll half their 2006 operational cash flow from $522 million to $261 million. Subtract $45 million for CapEx and $160 million for dividends, and that leaves $56 million of free cash, which serves as another margin of safety in my valuation.

Based on that, Biovail should sustain their dividend policy, but please help correct any flaws in my rudimentary analysis.

Possible Upsides:

• FDA’s eventual approval of bupropion.
• Successful foray into the multi-billion-dollar, global sexual-dysfunction market.
• According to their 2006 report, they have 10 new drugs in their product pipelines: 5 for central nervous system disorders, 2 for pain management, 2 for cardiovascular disease, and 1 for gastrointestinal disease.

One Objection I Heard:

Biovail relies heavily on outside collaboration/alliances with other companies, research institutes and projects for current R&D. Not having expertise in house can provide limitations over control.

Even with an army of in-house Ph.D.’s, expertise can be surprisingly difficult to find, according to a report by McKinsey Quarterly, Do You Know Where Your Experts Are - Companies need a new approach to finding their ellusive experts.

Early in the project, it needed someone with deep technical knowledge of a particular protein. We spent weeks looking for an expert — calling HR, asking around the office, scanning personnel records. Finally, we concluded the expert didn’t exist. Three days later, I’m in an elevator complaining about this to a colleague, when the woman next to me turns and says, “I wrote my doctoral thesis on that protein. What do you need to know?”

Take Procter & Gamble for example. Despite having a $1.7 billion R&D budget and 1,200 Ph.D.’s in-house, the company enjoyed a 45% success rate by outsourcing its most challenging problems to Innocentive, a market place setup by Eli Lilly to bring together solution seekers and 80,000 scientists from across the globe. I don’t view having a small R&D team as necessary a handicap for Biovail. In fact, it’s good risk management to selectively align with drug-development companies to license, develop, manufacture and market promising drugs to the market.

As always, I’m not your financial advisor. I’d be interested if anyone can point out any pitfalls with Biovail.

Disclosure: I don’t own Biovail shares, although I might start nibbling below $17.

In many ways, I’m living the deja vu of the 2006 summer correction. The skittish stock market, beleaguered by the subprime mortgage woes and the credit crunch, is lunging 1% ahead one day and plummeting 2% the next. As in the last summer, my Hotmail account is flooded with stock alerts which I setup on Globe Investors. Not that I’m pulling the trigger on every alert. It’s more for awareness than anything else, however I did nibble on few fallen stars like as Bank of America, Citigroup, Bank of Nova Scotia, Bank of Montreal, National Bank, CI Financial, Telus and Talisman, and 2 significant positions on Inter Pipeline fund and Boston Pizza Royalty fund.

It’s nerve racking to watch some of my holdings tumble, but I’m thrilled at the same time as I need to deploy new savings to high-quality but inexpensive businesses, and most stock screens always seem to bring me back to the same stocks in my portfolio. If I have it my way, we’d have a correction every second day, and Bank of Montreal would remain at $61 for the rest of my life, because a cheaper stock means more shares, more dividends and more importantly, a shorter road to financial freedom. I bought BMO in 2006 at $60.40. It rocketed to $72 before falling back to my purchase price momentarily on Wednesday. Fantastic! Same price as last year, but with a phenomenal 4.4% yield that will knock your socks off - they increased their dividends by 28%. It’s not just BMO, the other Canadian banks are teasing me with their dividends too.

If I learned anything from the 2006 correction, it’s that the moody market rewards contrarian dividend investors who have the conviction to become net buyers in a tough market. Looking back, I’m laughing myself silly that I peed my pants (not literally) when I bought IGM below $45 at a time when other investors were cringing under the falling sky. No, I wasn’t a genius. I was simply good at following instruction out of any sensible dividend investing book such as “Stop Working” by Derek Foster. Since that time, IGM’s quarterly dividends surged from 37 cents to 46 cents per share — a 24% hike! I need to have a talk with my boss about matching that pay raise.

Alas, I’m still a rookie investor. Some of my purchases have been premature; most notably DR. Horton. This time, I suspect it’ll take longer than a year before l laugh myself silly. Although my batting average is far from perfect, over the long-term, I feel that the aggregate of all the dividend-paying positions will do marvelously. Aspiring dividend investors who hang tough in this ordeal won’t come out empty handed, especially when corporate balance sheets are strong, profits are rich and unemployement rate is at a 33-year low.

In order to elevate fundamentals over the long-run, short-term pains are necessary to prune out dead weights, such as questionable structured commercial papers, loose lending standards and as ThickenMyWallet put it, NINJAs (no income, no job, no asset). Once these excess baggages are out of the way, the path to prosperity is paved for many decades to come.

Jungle Guy’s shopping list: all Canadian banks, REITs, Yellow Pages, Reitmans, pipelines (TRP/ ENB/IPL.un), insurance (MFC/SLF), CML Healthcare and CI Financial.

• It’s been a long time since Vancouver suffered any blows to real estate prices, and many young speculators are cajoled by the same headlines from prior bubbles. Langley Financial Planning revived a precious post from the Vancouver Housing Blog, who had amassed a collection of newspaper headlines just prior to the last 2 housing collapses. Here are my favorites:

  “To those who are waiting for Vancouver house prices to collapse, I can only advise them not to hold their breath . . . Unless there is a major recession or significant depopulation, house prices are unlikely to drop significantly.” - Jerry Jackman, VP Royal Lepage, November 18, 1988 in the Vancouver Sun. (In 1989, prices started to drop - with an eventual 30% or so drop. Real prices did not attain these heights again for 58 quarters, or around 15 years.)

  “The whole world wants Vancouver because everybody is moving here now and everything points up, up, up.” - Realtor David Goodman, December, 1989 in the Sun. (The market did not reach these heights again for 15 years.)

  “Price stability, rather than decline, would be expected for most of the housing stock . . . since underlying home ownership demand remains strong due to continued high immigration.” - Frank Clayton, January 18th 1981 in the Sun. (The market crashed by about 50% over the following year. )

• Before you visit eBay, try some of these shopping tips from Lisa, a guest from Get Rich Slowly. A few tips include sniping the goods to discourage pre-mature bidding wars, favouring gently used items, and keeping a watch on shipping costs.
• Can money buy you happiness? Not exactly, but it can help if you know where to spend it. Linda Stern, from Reuters, offers a few techniques to convert your wealth to happiness. It may surprise you that most of these techniques don’t include buying big toys like sport cars or big screen TVs. I’ve also written a topic on money and happiness.
• Despite recent hissing from investors, stocks remain cheap, according to professor Jeremy Siegel:

  Based on the S&P 500 Index, which constitutes 80% of the total market value of U.S. stocks, these stocks are now selling at 16.5 times a conservative estimate of 2007 earnings. In a world where government rates are below 5% and inflation is below 3%, stocks are not only reasonably priced, but cheap on a historical basis. - July 30, 2007

That’s all, folks!

I’ve failed over and over and over again in my life and that is why I succeed.

Michael Jordan says it well. Shouldn’t we celebrate and honour our failures as if they’re stars on our shoulders? Even the best basketball player in the world couldn’t make a cut for his high school basketball team, so why should we expect perfection in investing? In fact, the stock market is a place that rewards players who expect failures, because they understand the law of taking a step back and springing two steps forward.

I have this odd habit of observing how investors with different experiences interact in the forums. One consistency and irony I find is that seasoned investors tend to reveal their mistakes more openly, while know-it-all amateurs tend to be more egotistic. Perhaps it’s simply human nature to seek social acceptance by putting their best foot forward — even when neither feet is modeling material. On the other hand, mature investors see every failure as an opportunity to turn over a new leaf. By regularly acknowledging mistakes, these investors become receptive to constructive criticisms from themselves and others, and leave the door opened for further touch-ups to their investment philosophies.

“Sometimes it is better to lose and do the right thing than to win and do the wrong thing.”- Tony Blair

Now that they have inspired me, I’ll reveal my wall of shame!

DoubleClick - Bought $91, sold $76 one month later.
Cisco - Bought $104, sold $73 nine months later.
Knight/Trimark - Bought $57, sold $35 four months later.
AboveNet - Bought $55, sold $39 two months later.

The worst blunders?

Conexant Systems - Bought $163. Still holding it at $1.36.
AirIQ - Bought $28. Still holding it at $0.15.

The lessons I learned? Always invest for the long-term, analyze the financial statements and think independently from the others — but it’s okay compare notes with experienced investors whom you respect.

ps. If you don’t have a role model, I recommend you frequent the Financial Webrings investment forum.

ps2. I have more blunders, but can’t find all the receipts at the moment.

I’ve recently picked up a couple of non-financial income trusts: Inter Pipeline and Boston Pizza Royalty Income Fund.

Inter Pipeline Fund

You can read about Inter Pipeline in my How To Pick Pipeline Trusts post, where I highlighted their key assets as well as their strong and growing free cash flow. Interestingly, The Vancouver Sun has an article on Not enough pipeline for surging oil production, regular says.

The National Energy Board said the pipeline industry may face a capacity crunch as oil output this year rises to 2.9 million barrels a day, nine per cent more than in 2006. Almost all new Canadian oil comes from the oilsands region of northern Alberta, where more than $100 billion worth of projects to exploit reserves are planned or underway.

Boston Pizza Royalty Income Fund

Onto Boston Pizza Royalty Income Fund, this is my very first restaurant investment. The fund owns the Boston Pizza trademarks and licenses them to a private corporation, Boston Pizza International (BPI), for a 99-year term. In return, BPI compensates the fund with 4% of franchise revenues from 266 Boston Pizza restaurants across Canada. The beauty of this “top-line” funneling is that the fund enjoys a stable and consistent cash flow with no dependency on the restaurants’ profitability. Their cash flow statements are an eye-opener — no capital expenditures! BPI and their franchisees incur all the maintenance and expansion costs, while the fund gleans 4% off their total sales.

There are few contenders in the restaurant royalty space, which includes A&W Revenues Royalties, Pizza Pizza and The Keg Royalties Income Fund. However, Boston Pizza Royalty stands out of the pack with their higher liquidity (about 4x the others), generous yield (9.5%) and best-in-class same-store-sales-growth (6.5% over 10 years).

Same-store-sales-growth (SSSG) is crucial because that’s the main driver behind the fund’s distribution increases. The fund went public in 2002 with an initial monthly distribution of $0.0833, but has since risen it 12 times to $0.1130 for an annualized 6.36%, which is in line with the 6.5% SSSG.

Between the 9.5% yield and 6.36% growth, my expected internal rate of return is 15+%. The trust is trading at around $14.50 while distributing $0.113 per unit per month. This is a much better value than when it was trading at over $20 before Halloween. Back then, it was distributing only $0.109 per unit per month.

The distribution is about 84% taxable, so it’s more tax-efficient to hold the fund inside RRSP. Short of that, the second best option is to hold it under the spouse with the lower tax-bracket.

Reference:

• Boston Pizza Royalties Income Fund Fact Sheet
• Frequently asked questions