April 28, 2008

FirstService: Commercial Real Estate Value Idea

Real Estate companies have been under stress due to the burst of the housing bubble and deleveraging occurring in the economic system. All types of real estate firms from REITS, services companies and financiers have declined significantly from mid last year into this year.

I have been wading through the sector to find good buys and have review some in previous postings. Today I made the purchase of FirstService Corp; I bought an entry position in the company that I am hoping to add more in the future as i think it will come down in price somewhat in the short term.

FirstService Corp. is:

.... a leader in the rapidly growing property services sector, providing services in the following four areas: commercial real estate; residential property management; integrated security and property improvement services. Industry-leading service platforms include: Colliers International, the third largest global player in commercial real estate; FirstManagement Partners, the largest manager of residential properties in North America; FirstService Security, the fifth largest integrated security company in North America; and The Franchise Company, the second largest franchisor of residential and commercial property services in North America.

Investment Rationale:
  • Premier real estate company with international exposure.
  • leading market share in residential property management.
  • full service platform for commercial real estate
  • Asset light operating firm
  • variable cost: about 60-70 of its cost is variable, they will do well when real estate boom and costs will come down in bust times.
  • recurring revenue stream from property management
  • Strong management team
  • Strong ownership structure

I beg the value to be in the range of $31 on low end and $50 for the high end. The company is asset light and most of the valuation is based on the brand name they have and future earning prospect. I will have a more detailed writeup soon.

April 22, 2008

Bank of America Dividends

Bank of America’s quarterly numbers were pretty bad and it showed all that is wrong with the economy. There were the customary write-downs on CDOs and leveraged loans. losses in investment banking and trading. More importantly, all the reserves taken against consumer loans and credit cards. those reserves are typical in a slow economy, people will default on their loans when they are out of a job. It remains to be seen if the reserves taken by BofA are conservative, which I believe they are, then they will report better numbers in the future.

In spite of BofA’s downbeat outlook for the rest of 2008, the bank is standing firm on its hefty dividend. At 7.5 per cent, BofA’s Tier 1 capital ratio is below its target of 8 per cent, but above the 6 per cent level regarded as a minimum for being well-capitalized. BofA's CEO has reaffirmed the bank's commitment to its dividend policy and will only consider if the economy went into a deep rescission.

As an investor I do not like the dividends to be cut, but I'd rather than than equity dilution. BofA has many options to boost its capital ratios:
  1. Asset sale: BofA can sell Visa stake, Chinese bank stake, investment banking division, which is underway right now.
  2. Less loan underwriting, which is happening right now.
  3. Issuance of preferred shares, and
  4. lastly a dividend cut.
As a shareholder I would rather have the dividend cut than equity raising. I do not want to see my ownership get diluted by raising more shareholders equity. Dividends can be reinstated in the future but ownership and earnings dilution is hard to compensate for.

A Hedge

Typically my views on the overall market is never overly optimistic or pessimistic. I tend to look at valuation and that what guides my investment decisions. I tend to dismiss most writings that discuss an overly bullish or bearish case on stock market direction, as no one really knows the direction of market prices. Moreover, I do not understand people's obsession of calling bottoms or tops, for me it is always a valuation issue. There are two cases to be made for the current US market: a bullish case and a bearish case. I will review reasons for each case.

10 reasons to buy US equity, courtesy of BlackRock CEO:

  1. Investor and consumer sentiment measures are very pessimistic, which often marks the bottom of equity market falls.
  2. Monetary policy in the United States is being eased earlier and more rapidly than is usual.
  3. U.S. households are about to get fiscal stimulus checks from the government.
  4. The current earnings recession of negative year-over-year comparisons will last four quarters. Q2 2008 will be the fourth.
  5. The cheap U.S. dollar means boom conditions for U.S. exports, a significant offset to the residential real estate recession.
  6. The health of the non-financial corporate sector remains strong, with healthy cash flows.
  7. Credit-related downturns often include the failure of an important financial organization, followed by double-digit growth in the S&P 500 .SPX. The failure of Bear Stearns on March 17 has passed.
  8. Credit markets have improved noticeably since Bear Stearns' failure.
  9. Technical factors have also improved since March 17, including the fact that up-day volume has been heavier than down-day volume.
  10. The earnings yields of equities compared with 10-year Treasuries are at their best level in 30 years.

So why not to be too bullish, my views:

  1. Inflation growth will eat away at corporate earnings and consumer ability to spend.
  2. Credit crises will dampen earnings growth. The ability to borrow by businesses is critical for economic expansion and without it many growth plans are halted and so is earnings growth. As long as we are in a credit tightening cycle I do not see how a sustained growth in earnings going to be achieved in the following year or two.
  3. US economic weakness will eventually make its way to the global economy and will reduce US international earnings. Global economy demand is lagging the US economy and will soon feel the affects of the slowing demand of the US. The US is still a large chunk of the global economy and it sluggishness will have an impact.
  4. Residential real estate is still far from stabilization and recovery.
  5. Rich valuation for the entire market. I wrote about the US market valuation here.
  6. Global banks are in trouble and yet to find stability in their capital needs:
    1. Bank Stock Valuations Are Still Excessive:
      • Current stock valuations of the Top 50 banks relative to historical valuations, remain expensive -- even with the recent poor performance.
      • The Top 50 banks' forward 12-month P/E ratio stands at 13.2x, which is roughly one standard deviation above the mean (25-year avg of 10.9x).
      • During the trough of the last two bank stock bear markets, 1990-91 and 2000-01, P/E ratios for the top 50 banks declined to 5.7x and 10.1x, respectively.
    2. Recessionary Forces Will Lead To Bigger Credit Quality Problems:
      • In prior recessionary periods, credit problems typically followed as a result of the weakening economy.
    3. Loan Loss Reserves Are Too Low:
      • Bank management teams will often claim loan loss reserve adequacy only to boost reserves in subsequent quarters. BofA has boosted its reserves substantially in its latest quarters other banks have not takes such conservative steps and may have to report lower earnings in the future.
    4. More Credit Problems may be in store for Banks :
      • If the economy deteriorates significantly then commercial real estate, construction and leveraged loan portfolios have significant room to weaken in 2008 and cause write-offs.
So where does this leave me? I still look for undervalued companies as I thinks some companies have declined by more than they should given the US slow down. However given my estimate the the US market overall is still overvalued given the backdrop of economic events, I have taken a short position on the S&P 500 by buying puts.

I have bought December 2008 SPY 120 puts at $3.6 per contract. The puts will act as a hedge for my stock positions. The case for the position is as follows:

Pay off $
Prob. Weighted
Trading range


The option has a delta of $.2, so for each point decline in the SPY I earn $.20. I expect a 10%, or 14 points decline, so that translate to $2.8 expected pay off. Theprobabilities outlined in the table works to give me an expected payoff of 3%. I am fine with such a low payoff as I continue to allocated more funds to equities in the meantime, so if the market recover, the returns on those equities willoutweigh my loss.

April 19, 2008

Broofkfield Properties: Value Idea


Brookfield Properties Corporation (BPO) is a commercial real estate company. The Company operates in two principal business segments: the ownership, development and management of commercial office properties in select cities in North America, and the development of residential land. As of December 31, 2007, the Company’s commercial property portfolio consisted of interests in 109 properties totaling 73 million square feet, including 10 million square feet of parking. As of December 31, 2007, its development/redevelopment portfolio comprised interests in 16 sites totaling 18 million square feet. The Company’s primary markets are the financial, energy and government center cities of New York, Boston, Washington, D.C., Houston, Los Angeles, Toronto, Calgary and Ottawa.

Office Real Estate Macro Factors Affecting Supply and Demand:

  • Foreign buyers and sovereign wealth funds are looking to focus on buying trophy office properties in major cities like Boston, new York, Chicago...etc. This will put a floor on potential steep price decline.
  • Although demand for downtown office space is expected to decline slightly over the next one-year horizon, Moody's said that supply has also slowed to barely a trickle-down to 0.6%, its lowest level since 2005. As a result, the relatively small supply-demand imbalance should not undermine market stability too profoundly.
  • Fundamentals are deteriorating as vacancy rates are increasing and due to low absorption rates there is downward pressure on asking rents in the short term.
  • Immigration towards "mega cities", see my post earlier here. The trend of immigration towards mega cities will create demand for office space and real estate in general. The table to the side displays the percentage rent growth year over year in major cities. The demand for limited down town office space will grow as long as the trend is intact.
  • Supply will be limited in the future. The lending issues will slow development down dramatically, and it already has nationally. Nationally it has greatly slowed down the pace of new development. Capital will not be as readily available for new projects unless there are just very compelling reasons to do so — unique locations, tremendous pre-leasing to creditworthy tenants. Good projects will get done. Marginal projects won't be offered capital to develop them.
  • The boom in material and base metal prices will undermine new projects as costs are becoming more prohibitive and decreasing potential returns. This will lead to decrease in new supply in the future increasing the value of current properties.

BPO Micro Factors Affecting Revenue Growth:

  • BPO owns premier class A office buildings in major metropolitan cities like New York, Los Angles, among others highly dense populated cities. Below is a listing of their cities and owned space.
  • Most of these properties are downtown properties. Any downtown property in a major city has a very sustainable competitive advantage: high barrier to entry. with down town properties there exist a high barrier to entry as New building supply in some of these markets is not easy to come by.
  • Rent charged to BPO's tenants is below market asking rent. BPO have a chance to grow its rent by raising new leases with tenants to market asking rent. The growth potential from new leases can contribute to BPO's FFO growth.

Total Area (000,000's Sq. Ft.)% of total
New York Downtown13.218%
New York Midtown6.38.6%
Washington, D.C.6.58.8%
Los Angeles10.714.6%

Risks and Uncertainties:

A broad recovery in property share prices is likely to hinge on how quickly and completely the global economy works through the liquidity and credit crises that escalated in 2007. U.S. real estate securities were trading at an 18% discount to their underlying net asset value as of December 31, 2007, compared with a premium of 13% at the end of 2006, and compared with a historical average premium of 5%. The size of this discount suggests that the market is expecting at least a mild U.S. recession and a meaningful decline in property values. However, the strength in commercial real estate fundamentals and cash flows, I do not think a meaningful decline in property values will occur.

  • Economic Risks: There is a high probability that slower economy would impact the intrinsic value of BPO. As the economy slows down and money centre banks layoffs accelerate due to the credit crunch, office space demand will slow. In general there is a small probability that commercial real estate will decline by 15-20%. However the office market in major city centres will face a smaller decline due to high barriers to entry. I estimate 0-5% chance of such decline for cities like New York, Toronto, Houston and LA. If we have a severe recession in the U.S., it will put stress on the system. Right now I am not seeing a multitude of tenant bankruptcies, but there are profits decline. If you have a rash of tenant bankruptcies, it will slow down demand for office space.
  • Income Risk: With a high probability of slowing demand to one of BPO's biggest markets, New York, due to lay offs in the financial industry, BPO can't realize the rent growth or sustain high level occupancy. BPO will be very hard pressed to raise rates in such an environment. It won't see rent declines but growth in rental revenues will be limited. The Canadian office market may offset some of this risk as the Canadian office vacancy rates at record low levels.
  • Financing Uncertainty: with the credit issues still hangs over the banking sector, financing or refinancing any property is difficult. However, BPO is a premier property company, it will get any financing done through insurance companies, commercial banks or pension fund companies as they are still large player in commercial financing. Having said that I think the financing will be at a higher rate absent the competition from the CMBS market. However, in this uncertain credit market it will present financing risks particular to BPO in several ways:

    1. Higher financing costs. Most fixed financing, which what most real estate operators use, has higher rates due the tightness of lending.
    2. Miss match of funding. With higher fixed rates BPO have opted to use the variable and short term debt packages, which leads to miss match between its asset and liability. Miss match funding is very risky for a real estate owner, which can lead to fire sale if BPO could not refinance in the future. The episode of Macklowe unravelling properties due to short term financing is a perfect example of funding miss match risks. Macklowe had to liquidate the premier and the crown jewel of his properties in a hurry to raise funds as he failed to refinance a one year loan to buyout seven building from Blackstone deal with Sam Zell.
    3. High leverage of BPO. BPO has a higher leverage ratio compared to other US and Canadian reits, management says it is not a problem, but I beg to differ. BPO employs 61% Long term debt to Enterprise value, while other US reits uses just under 50% with the quality names using under 45%. Since values are falling in the short term, the last thing you want is too much debt. With the lack of financing in the market, this means we are left with a select few of longer-term investors—those with significant equity to invest as part of long-term programs. This shift will definitely start to dictate lower pricing if BPO needs to sell something and in general will reduce the intrinsic value of the company.
    4. Refinancing risk. BPO has 11% of its commercial debt due with 12 months. That is a large chunk to be refinanced in this environment. Commercial banks in Q1 of 2008 have reduced their lending activities by 26% year over year ( figure from Reuters Loan Pricing Corp). If the loans are refinanced, it is going to be at a higher rates that will eat into their FFO figures. Moreover they have 8.8% of their long term debt from Commercial Mortgage Backed Securities debt that they have to refinance at various times which poses a significant refinancing risk. The CMBS market has all but shut down for any new securitzation. BPO has to find an alternate funding source from a commercial bank or an insurance company.

Given these risk and the potential for a company like BPO and Commercial real estate in general, there are two possible extreme scenarios in the intermediate future, and many combination in between, as follows:

Expected Return
Worst case:

1. deflating asset prices due to continuation and deepening of the credit issues, which can put a downward pressure on commercial real estate prices in the short term as well as increase financing costs.

2. economic activity takes a steep turn for the worse

3. BPO refinancing risk is realized.

decline of 15-20% of NAV
Best case:

1. a recovery in financial industry and

2. a resolution of the credit crises, which means a substantial reduction in the risk profile explained above.

This scenario will likely play out in the span of 18-24 months.

increase in 5-10% of NAV


The stock is not cheap. I figure it is fairly valued at $20 a share; its Net Asset Value (NAV) ranges between $21-29 per share. I have determined its NAV in two ways:

  1. Using Cap rates for recent quarter and applying it to BPO's recent Net Operating Income (NOI).
  2. computing average recent sales per sqr ft for comparable properties in BPO's markets and applying it to its owned space.

Please note that sales prices in Q1 2008 are scarce as not many transaction have been done due to tight credit and financing. That's will affect most of the valuation points that I gathered whether it is CAP rates or market sale price per sqr ft. Therefore I will apply a discount of 3% to all valuation computed using the decline in the S&P/GRA Commercial Real Estate Index from its peak in 2007 as a measure of decline in BPO properties.

Cap Rate Approach:

The current prevailing national blended cap rate for office real estate is 6.5%, according to CBRE. Using this cap rate the market value of BPO properties is $21 Billion, 33% higher than its book value of $15.8 Billion. I am confident that BPO's specific properties will yield much tighter CAP rate than a blended average. Their properties are all class A buildings in the heart of mega cities where CAP rate can reach 4-5% even in slow economic times as the one we are in. Here is a range of probable real estate values:

CAP RateProperties ValuePremium to BV
7%$ 18 Billion14%
6.5%$ 21 Billion33%
5.5%$ 22.9 Billion45%

Using recent Sale prices, I got the following prices (using LoopNet DB):

NET OWNEDHigh MKTLow MktHigh end ValueLow end Value
MarketINTEREST (000)Price per Sq FTPrice per Sq FTin 000sin 000s
Boston2,150 520 700 1,505,000 1,118,000
Calgary2,899 200 250 724,750 579,800
Denver1,795 300 400 718,000 538,500
Edmonton157 200 250 39,250 31,400
Houston3,744 200 300 1,123,200 748,800
Los Angeles4,721 200 300 1,416,300 944,200
Minneapolis3,008 100 200 601,600 300,800
New York13,210 1,000 1,100 14,531,000 13,210,000
Niagara Falls47 100 100 4,700 4,700
Other73 100 100 7,300 7,300
Ottawa618 382 400 247,200 236,076
Toronto5,770 364 400 2,308,000 2,100,280
Vancouver759 200 250 189,750 151,800
Washington, D.C.4,093 300 500 2,046,500 1,227,900
Total25,462,550 21,199,556
Discounted Value24,698,67320,563,569

BPO's properties seem to range from a low end of $20.5 to a high of $24.5 Billion. Both figures represent a NAV premium to the market price of BPO between 2%-39% (adjusting for some balance sheet accounts).


With several risks that outweigh potential rewards or upside in BPO, I will stay out of this one for the time being. I will start buying at or below $17.5, which the stock have touched in recent weeks, but I was in the midst of my analysis then. I think at that level I have enough of a discount to justify taking on mainly financing risks associated with BPO. I will also be a buyer at $20 per share, if the credit issues are resolved and the lending environment returned to normal, or showed signs of returning to normal as it is showing now.

April 18, 2008

Banks' Earnings

Banks have been reporting earnings this quarter and they have been terrible, yet their stocks are rallying.

Today Citi reported a huge $6 billion loss, give or take few billions who is counting at this point, and the stock is up 6% or so last time I checked. J.P. Morgan earnings slumped and the market rallied, yet JP Morgan is quietly raising money, although it is one of the better capitalized banks, so its situation is not as strong as everyone believe.

The view is that the huge writedowns are coming to an end and the biggest losses are behind them. I am fine with that point view, but investors tend to underestimate the unpredictability of the consumer lending business losses that banks have yet to absorb. Loss provisions could continue rising in the coming months as the effects of the US slowdown are felt. In prior recessionary periods, credit problems typically followed as a result of the weakening economy.

Another risk is where the earning going to come from going forward?

With housing market on the rocks, the employment situation is shaky and real earnings are being eroded by high inflation, how banks are going to lend or earn fees from the strapped consumers. More importantly banks like Citi have a weakened franchise that can not go after market share.

I have bought USB and BofA recently and I still like them as a business. My picks are for the heavy presence of BofA and USB in their states and the strong market share that can be leveraged to gain additional business from all their weak competitors. I think BofA and USB will grow earnings as a result of gaining business from others rather than nominal growth.

I will not add to my positions or look for another opprtunity in banks, as I think better returns can be had elsewhere.

April 17, 2008

GE to Buy Most of Citis Commercial Lending Unit - Mergers, Acquisitions, Venture Capital, Hedge Funds -- DealBook - New York Times

GE to Buy Most of Citis Commercial Lending Unit - Mergers, Acquisitions, Venture Capital, Hedge Funds -- DealBook - New York Times

Citi has been selling its assets left and right. Lets recap some of the sales:
  • Sale of commercial and leasing unit to GE,
  • Sale of leveraged loans to private equity,
  • Sale to Wells Fargo & Co. (WFC) of consumer and business deposit accounts and loans, totaling $500 million in deposits and $60 million in loans,
  • The closing of several branches around the country this year -- eight in Texas, six in Florida, three in New Jersey, one in California and one in Maryland,
  • Halt plans to open two branches in Florida, two in California, and two in Maryland,
  • Sale and lease back of real estate: it has conducted several sale and lease back transaction on some of its buildings,
  • Selling or closing some retail branches and consumer-finance operations in Europe, Asia and Latin America.
Most of Citi moves have one thing in common: protect the international franchise, while shedding all US retail operation to a minimum. Citi is in a tight bind and they rather sacrifice the US operations for the growing international units. I think Citi will emerge from this realignment as an international investment and commercial bank mainly rather than a mega super store financial institution, which is fine as long as they have a solid and clear vision of themselves.

Additional moves made by Citi, from Forbes magazine:
  • - MORTGAGES: Earlier in March, Citi said it would reduce the residential mortgage assets of its U.S. mortgage business by about $45 billion over the next 12 months.
  • -- WEALTH MANAGEMENT: Citi said earlier in March that it would reorganize its wealth management business.
  • -- LAYOFFS: Citigroup, having eliminated 17,000 jobs last spring before the credit crisis even began, announced in January it was reducing its staff of about 320,000 by another 4,200, and that more layoffs were likely to come. The bulk of these job losses are in the company's investment banking group. -- OPERATIONS ABROAD: On Monday, Pandit gave more autonomy to Citi's operations around the world by naming executives to head the Asia Pacific region; the Western Europe, Middle East and Africa region; the Central and Eastern Europe region; and the Mexico and Latin America region. Meanwhile, Citigroup said earlier this year it would be merging its Japanese businesses with the ones it now runs after acquiring Japanese brokerage Nikko Cordial Corp.

April 16, 2008

US vs Canadian Real Estate Securities

Real estate securities, which had factored in a good deal of positive news at the start of the year, ended 2007 with considerable pessimism priced into their shares. Overall, REITs were trading at an 18% discount to their underlying net asset value as of December 31, 2007, compared with a premium of 13% at the end of 2006, and compared with a historical average premium of 5%. The size of this discount suggests that the market is expecting at least a mild recession and perhaps a meaningful decline in property values. That is unlikely scenario as commercial real estate fundamentals are sound and will dampen any impact from economic deterioration. I am factoring some declines into property asset values due to higher cap rates, particularly for class B properties and secondary markets, but I do not expect a dramatic downturn.

The group’s projected earnings growth is higher than projections for the S&P 500 Index, yet REIT earnings are far less volatile than the average S&P 500 company. In addition, at 15 times FFO, PE equivalent metric, REITs have a lower P/FFO ratio than the S&P 500 (16.3x) while their dividend yield is higher (4.2% vs. 2.0%). REIT dividend yields also compared favorably with the 10-year Treasury bond’s 4.0% yield at the end of 2007. In an uncertain environment, investors could find these metrics appealing.

A comparative analysis between US and Canadian REITs, reveal that Canadian Reits are that much more undervalued than their US counterparts. The average Canadian Reit P/FFO is 12.4 times compared with 15 for the average US REIT. In addition, Canadian REITs are sporting 6.2% dividend yield compared to 4.2% for a US REIT.

The average Canadian REIT has a less of a risk profile that their US counterpart as well. Canadian REITs rely on less leverage as their long term debt to Enterprise value stand at 44%, while the US REIT stands at 48%. Also, the Canadian economic environment is much more favorable than that in the US, as the Canadian employment and consumer spending trends are much more positive than the US. Reits as a sector offer value if you pick the right ones. Canadian REITs offer much more value than US ones due to lower risk profile and cheaper valuation.

I have assembled certain metric for comparative between the two groups:

US Reit CDN Reit
Div yield 4.2% 6.2%
P/FFO 12.4 x 15 x
Entp Value/ FFO 29x 22.9x
LTD/ Entp Value 48% 44%
LTD/ Mcap 1.04 x 86%
Payout % 61% 76%
FFO/ Debt 8% 14.5%

I have already bought RioCan and I am looking at two other Canadian real estate securities that promise some value. I have listed all my watch list of potential value idea here.

April 15, 2008

US vs Canadian Markets

Over the last three months the Canadian markets have outperformed the US markets. The Canadian index is up 6.5% while the S&P declined around 4%. The divergence of performance is attributable mainly commodities stock performance. The Canadian index is biased towards commodities, mining and energy related companies. Canadian Energy sector performance and particularly oil sands related companies are on fire.

I just wonder if this relative out performance will continue the future? If commodities continue to run like this, then why not.

Mega Cities

There is a trend of urbanization that have been unfolding over the past decades. Large cities are getting larger and larger. People are immigrating in droves to what is called "mega cities". The trend is not new however there is no sign that it is abating any time soon. As you can see from the chart below the percentage of urban population living in mega cities is on the rise. The trend is not specific to western world but it is happening in China and the far east. Cities like new York, London, Shanghai and Tokyo are getting larger as illustrated in the second chart.

The rapid increase of the world’s urban
population coupled with the slowing growth of the rural population has led to a major redistribution of the population. The world’s urban population will double in 38 years. Virtually all the population growth expected during 2000-2030 will be concentrated in the urban areas of the world . During that period the urban population is expected to increase by 2 billion persons, the same number that will be added to the whole population of the world. The number of cities with 5 million inhabitants or more will pass to 59 in 2015. Among those cities, the number of "mega-cities" (those with 10 million inhabitants or more) will increase to 23 in 2015.

The population increase in these cities means that they will need more of everything. Residents will need more services, more power and utilities, more mall space to shop in and more office space to work in.

There is plenty investable ideas in this trend especially in today's markets.

Real Estate

The migrating population to these cities will need space to work in and space to shop in; office space, community shopping centres and mall space will be in demand to serve the expanding population. Currently with the stress of the credit markets on all aspects of the economy and in particular real estate, it makes for an opportune time to buy strategic properties in large urban cities. Commercial real estate prices are declining due to lack of financing. Owners can't refinance due to lack of credit and will start selling at depressed prices. That makes for an excellent time to buy into some of these properties. Real estate in those locations have a huge barrier to entry; there is not any more land to build on. If you can sustain the short term volatility and begin to accumulate positions in some good companies the pay offs can be large.

Power and Utilities

Again a similar theme continues with power and utilities requirements. It is expected that demand will accelerate with the increased immigration to large cities. Companies that operate and generate power to markets that include mega cities will do well. A host of utilities services like gas storage and distribution, power transmission and generation and water supply and treatment will be in high demand.

TransCanada pipeline recently has bought a Power Plant new new your City for $2 Billion, which wall streeters did not like and send the stock down sharply. I think it was short sided of them. Such power plants are a valuable assets especially near markets like New York City where demand is expected to grow.

Public Infrastructure

The ability to build, maintain, and finance infrastructure is more important today than ever. With cities are getting bigger more services are needed to expand the infrastructure and maintain it. Government are not going to be the gate keeper any more as their budget deficits balloon; government are outsourcing this function to private entities. North America has been slow on using this business model but I expect it to be the normal mode of operation in the future. Private entities will build toll roads and bridges, ports, transportation systems...etc. Companies that service those mega cities will do well.

All these ideas are long term in nature and have horizons that stretch 10-20 years. Due to the long term nature of these ideas they are more suitable for institutional investors rather than individuals investors but there will be some opportunities to take advantage of, particularly in the commercial real estate. I will be exploring some ideas in the weeks to come along the lines of this theme maybe I can find some value ideas.

April 12, 2008

Large Cap and Value Investing

GE announced their earnings on Friday and was the catalyst for a large sell off in North American markets. That got me thinking about the merits of investing in a company like GE and theorized that large cap companies are not a good investment for long term horizons. Do not get me wrong GE is a great company and their management is second to none but at that size most likely it would never offer an above average return.

Lets take the example of GE over the last 10 years; GE's returns were meager compared to the index. GE appreciated a cumulative 11% compared to the Dow Jones 37%. If you factor in the dividends, GE's cumulative total return is 37.74 % compared to the Dow Jones 44.34%.

To invest in large companies like GE, CISCO or Exxon you have to remember three things:

  1. Over the long term, you are not likely to yield any above average returns compared to the whole market. The earnings growth of companies like these will never exceed the nominal growth in economic GDP.

  2. You have no information advantage. Large companies are analysed to death by hoards of analysts and investment professionals and believe me they do far better job than you and I when it comes to investing institutional funds in a company like GE, so it is fair to say that large cap companies are rarely under valued.

  3. Large cap companies are complex to understand. I try to stay away from analysing them as they overwhelm me with the all their moving parts. A true picture of economic drivers is not easy to understand. Moreover, to arrive at an intelligent risk assessment of these companies is extremely difficult. Looking at historical earnings and dividend growth records or ratio analysis of various financial statement metrics is not suffice to understand and arrive to a company intrinsic value. This framework is akin to driving by always looking in the rear view mirror; an extremely dangerous endeavour.

Large cap companies can offer good returns, however those occasions are very rare. For example, Altria came under huge distress with all the the tobacco litigation in the 1990s and was sold off due to the uncertainty surrounded the litigation. Investing in Altria then was a good move. Another example is Merck with its Vioxx suit. Smart investors analysed the situation and deemed that this uncertainty does not impact the underlying value of the franchise and in that instance large cap companies offered exceptional returns.

The conclusion here is a buy and hold strategy of large cap companies will achieve average or sub optimal returns compared to the market index, however investors will bear higher risk due to the specific operations of the company. You can only get good returns from these large cap when they are engulfed in uncertainty about their prospects, while the competitive advantage or the franchise value remains intact.

FT.com / Companies / Financial services - Citi struggles to reduce EMI loan exposure

FT.com / Companies / Financial services - Citi struggles to reduce EMI loan exposure

Citi deal to sell leveraged buyout loans to a group of private equity shows the desperation of Citi for two reasons:

1. Citi financed $9 Billion of that purchase, and
2. It took out all the questionable loans that it could write down in the future like EMI loan in the story. In other words the loans that Citi got rid off are good loans.

Next week will be interesting with JPMorgan Chase, Merrill Lynch, Citigroup and other large banks and financial services companies reporting their first quarter earnings. With their reporting could answer some questions about :

1. Have the financial losses begun to decline?
2. Is guidance going to show that we are starting to see the light at the end of the tunnel?

If the answers to these questions are worse than the negative sentiment or expectations of investors, then financial stocks probably are going to get knocked down again.

April 10, 2008

Private Equity trun at Financials

Private equity is the latest group to try their luck bargain hunting in the financial sector. The first one to test the waters were the sovereign wealth funds and they got burned bad. Second it were the billionaires and they to got burned bad, Bear Stearns anyone. Now Private Equity is getting into the fray and in a big way. Here are some examples:

  • Private equity has bought $12 Billion of Citi debt assets,
  • Private Equity invests $7 billion in Washington Mutual
  • Another PE outfit is looking for banking assets:
    The firm has been looking into loan and property portfolios of certain regional banks, even as the financial sector is rocked by the credit crunch, the report said.
  • Wilbur Ross says he is looking at banks:
We intend to keep adding servicing ... because we think the mortgage business is fundamental to America. The mortgage business isn't going away; it's just going to have to be done in a different way going forward.
  • All the distressed fund popping all over the place to take advantage of bargains in banks and financial assets.
The good news is there is a buyer out there, but will Private Equity get the same treatment as others? Only time will tell.

April 8, 2008

Citigroup near sale of $12 bln loans: sources | Reuters

Citigroup near sale of $12 bln loans: sources Reuters
That is a positive move for the banking sector in general. However the devil is in the details. The discount is a mundane 90 cent on the dollar, that is not enough for the private equity group to make enough return to satisfy their hurdle rates. So the deal has to be leveraged. Maybe it is to the tune of 10 to 1 to generate satisfactory returns for private equity investors.

The $12 billion question is who is going to provide the leverage? May be Citi will provide financing? That will be fine deal making by Citi management. It would be very interesting to see the details of this deal. May be credit problems for Citi are over or it is just the begining!

April 7, 2008

CHC Buyout: an update

CHC has announced the date for their special shareholders meeting to approve the buyout by First Reserve Capital. They also filed their annual information document with SEDAR. The stock has has shot 3% in the span of two days.

The proxy did no disclose any new information, however it gave the breakdown of financing that will be used in the buyout. Initially First Reserve said it will finance the deal with a large portion of its equity but failed to give any details. In the proxy it disclosed that the debt portion will be $850 million out of $2.5 billion deal. I guess seeing the commitment by First Reserve alleviated a lot of concerns around uncertainties of the buyout exposure to the credit market trouble.

The deal is bending the following steps:
  1. shareholders approval, which is almost a none issue,

  2. regulatory approval, German officials gave their blessing others will follow suit, and

  3. court approval will be given once shareholders approve the deal.

The stock price has closed towards the buyout price sans 4.11%. I expect to see the price inch closely towards that mark in the weeks to come.

Review of distressed sectors

If you followed my writing over the past few months, you would have noticed that I have been buying into three sectors: retail, real estate, and Banks. In this post I will review briefly each sector and my investment actions going forward.

The sector came under stress due to credit event mainly. My thesis for investing in Banks like US Bancorp and Bank of America is the decline of prices happened due to a credit event and once the event is resolved prices will be restored. However the credit event is unprecedented in its duration and complexity something I underestimated. Another factor is the market share that will be gained by Banks like BofA USB; they will grow at the expense of failed banks and contracting operations, rather than normal overall sector earnings growth. The earnings growth that powered big returns in financials in recent years now appears to have been driven by borrowing and moving certain assets off their balance sheets. It isn't likely to return soon.

I am not big on investment banks as I do not trust their earnings and liquidity as much as commercial banks. Most of their earnings come from trading earnings that is non recurring and should be valued less than banking fees. I have no desire to own any investment bank at any valuation. Most of these institutions have no real competitive advantage or if they have any it walks out of the door each evening; I am skeptical of the value in businesses like these.

Banks have a lot of challenges going forward: mainly searching for revenue growth and shedding non performing assets so their earning will be pressured for the next two years. More importantly the complexity of financial relationships and estimating the risks are becoming more paramount. One thing the credit event have reminded me is the lack of transparency in general on Wall Street, let alone banks. I will not add to any additional position in this sector and will only concentrate on UBS and BofA.

Real Estate:
I am talking about real estate operators rather than residential home builders. The group has recovered some what during the past quarter, actually the group has outperformed the S&P 500 on YTD basis. REITs have recovered somewhat when investors realized that they oversold the sector in reaction to the meltdown in the residential property market. Commercial property prices will come down a bit but with rising stock prices the discount of market price to REIT's Net Asset Value is closing slowly. I do not think that commercial properties will hold their price despite of the good fundamentals; there are simply too many headwind forces to overcome.

I still think there are opportunities to be had in this sector but you have to be selective. I am looking for unique assets in highly dense urban cities, where barriers to entry are so high that supply can not be easily generated.

Retail has also outperformed the S&P500 on a YTD basis. I still think there is a lot of undervalued businesses in the sector that can be well positioned to recover nicely once the economic environment improves. Some of the retailers are selling at levels that is ridiculously low; their P/E s are in the single digit. I am still evaluating some businesses in this space but I will be happy to add to my existing position in Lowe's and Sears Holdings.

April 6, 2008

Tech as Viable Investment

I worked in the technology sector all my life, however I would limit my investment in it. Currently outside my own business, I do not consider owning any investment in a hi-tech company. The rate of change is simply too vicious to suit my investment style of long-term value investing. Category killers are introduced in high-tech more than any other filed I know. Here are few observation on the sector:

  • Single product companies like Google and Research in Motion are far more riskier than companies with a host of products like Microsoft or Apple. Google killed Yahoo and Yahoo killed Lycos and host of other search engines in a flash. Same thing with the BalckBerry maker, an introduction of a superior product can kill the company prospect in an instant. I would never invest in a Google or RIM, as their demise can come way more faster than any other company.
  • Most hardware companies are a commodity business. Computers, servers and similar devices are pretty much a commodity business that lack any differentiation or any real competitive advantage.
  • Software makers days are at a competitive disadvantage compared to software-as-a-service providers. The software model will be dead soon and software companies like Microsoft, Oracle and SAP will be go through a gut wrenching change to alter their model and their success probability at that will be very small. Software culture is vastly different than the service culture and established software companies will be losing to new smaller companies that are built around that model. Simply you can't just take your existing software and turn it into a service; it was not designed to be a service and companies who follow this strategy will fail.
  • Companies that provide service as core of their product line like software-as-a-service will do better than software developers. In particular look for companies that are transactional rather than subscription based. More importantly companies that provide process oriented services are better positioned to capture more share than generic software.
  • Hi-tech companies product differentiation has gotten far too complex to satisfy customers. When I try to decide on a chip for our environment I get lost in how Intel and AMD are marketing their chips. The good old days of 386, 486, Pentium are gone; now the same chip have endless configuration that I am not quite sure any more if I need all this information to make a decision. I will look for something simpler if I can find it.
  • I like business process focused solutions rather than pure technology focused companies. In reality the end customer do not care about the latest innovation rather the best technology to run his business. I see companies that focus on business processes to be more successful.

Investing in technology companies can be rewarding, as early stage investors in Microsoft and Cisco and even Google found out. But I bet you for every Microsoft there is 10 maybe 30 other companies that did not make the grade and failed. Your odds of picking the next Microsoft are against you, simply there are so many factors that must be aligned for a high tech company to be successful like Microsoft. That's why I work in one where I can control the decision making process but I will seldom be an investor as it will be too hard to study all the factors that can produce a winner.

April 1, 2008

Risk vs. Uncertainty

I tend to evaluate and buy risk but I ignore uncertainties when thinking about equity valuation. The difference between the two is subtle yet very important. The market tend to hate and avoid both, which can create opportunities. The current market situation contains a lot of uncertainty and risks as well. I am willing to take on risk in face of uncertainty while many investors are willing to take neither and that's why you see treasuries are yielding negative real returns.

Uncertainty, in my mind, is when you can't articulate a set of finite scenarios and attach a probability to those scenarios. Risk, on the other hand, is where an intelligent investor can outline a set of outcomes with expected probability of occurrence. With this definition in mind, the uncertainties facing the investment environment in the short run today are :

  • Political uncertainty : who wins the US election, what kind of tax regime will be instated, fiscal budget management ...etc. All these issues are uncertainties as you can't pin point accurate outcomes with realistic attached probabilities.
  • Economic uncertainty: the rise and fall of economic activity and which sector is under pressure, job loss ...etc are another set of uncertainties that companies or investors have no control over nor can they do anything about.
  • Financial bankruptcy uncertainty: you do not know who will it be and what will be the impact. It could be a benign event if some small regional bank went under or even a big investment bank. The impact is not quantifiable so it is uncertainty for me.
  • Regulatory uncertainty: with the introduction of new banking regulation, its impact on financial is uncertain as the details of these regulation are unclear.

So what kind of risks in the short term are facing the markets:

  • Credit risk: There are a lot of credit risks and issues that face certain sectors more than others. The Banking sector faces more credit risk than any other sector due to its nature. There are risk in commercial real estate defaults, although as I wrote before I think it will be benign. There are increasing consumer loan defaults and mortgage ARM resets that can lead to more write downs. You can attach an estimate of $100- 200 Billion in write downs for this risk.
  • Inflation risk: This has become more acute in recent periods. An increase in inflation will reduce your real return so once factored in your analysis it will affect return expectation.
  • Earning risk: the risk of decline of corporate earnings has increased with slowing economy. This risk will lead to lower valuation of equities.
However in face of these risks there is an upside :
  • credit improvement: there are signs of thaw in the credit market. You can see a lot of risk spreads coming down as well as a lot of the credit default swaps on banks have declined significantly. If credit environment improve you can see a lot of upside in bank earnings as a lot of the write downs will become write up.
  • Cash has been accumulating in money markets and low yielding treasuries; the question is how long will investor be satisfied with meager returns before they accept risk? These funds can give a boost to equities and other depressed asset classes like real estate.
Given these risks I think there is room for an opportunity in the most beat up and distressed areas of the market that being banks, retailers, real estate and credit instruments. If you have been following my posts and investment you can see that I have bought the risk into these areas in face of the uncertainties that the market is worried about. Risk vs uncertainty is an important distinction. Knowing which is which can allow the investor to earn good return.