The Stock Market: Everything Has A Price

July 10th, 2008 by Potato

The stock market is a very interesting place where shares in the ownership of a great many companies are traded and priced on a daily basis by investors. For almost any corporation you care to name, you can find someone willing to buy its shares for some price. Even people who owned shares in Bear Sterns managed to find buyers as the company was going down in a liquidity crisis and being snapped up by JP Morgan.

Often, as a small-time investor you will want to own a well-diversified collection of truly excellent companies. Ones that will have good returns for many years to come. Quality stocks.

One of the easiest ways of doing this is to buy the index, which often represents some of the largest household names out there. It’s very difficult to beat the index, especially when the market is “efficient”, when nearly everything is going up and when nearly everything is priced rationally according to accurate information about the business environment. There’s a lot of information out there about index and passive investing, including a few previous entries here. In general, I recommend it. Part of my portfolio is indexed via the TD e-series funds, and it’s the only part of my portfolio that’s growing at the moment.

However, I don’t think the market is “efficient” at the moment. It’s in chaos. Things are down, then they’re up, then down again. There’s a lot of fear, a lot of uncertainty about what the future holds, even some uncertainty about what the current balance sheet holds, and more than a few margin calls going on. The quality stocks are being sold off with the junk, and even the mediocre companies look to be oversold. This to me seems like the time to try to “outsmart” the market and look for values. Note that this is, essentially, gambling: I’m taking on more risk to pursue higher rewards.

I’ve already talked a fair bit about some companies that I think are really good companies in general, but possibly under-priced. GE I think “should” be at least $32 by this time next year, and YLO.UN “belongs” in the $11 range, like, now. I won’t talk too much more about those ones, especially since I’ve been wrong so many times before, and they continue to slide down no matter how much I jump up and down. Come back to this entry in a year and odds are good that I’ll be wrong again.

I mentioned earlier that every company’s shares get priced on the market. That goes for poor companies and mediocre companies as well. Generally, you want only want to own quality, but if mediocrity is cheap enough, it might be worth looking into. Virtually everything is a buy at some point, even if its just to buy up the shares and liquidate the assets. That brings me to Priszm Income Fund (QSR.UN). They run a number of KFC, Taco Bell, and a few Pizza Hut restaurants in Canada. This is not exactly a huge growth business: you’re not going to wake up in a few months and find 6 new KFC restaurants opened and bustling in your neighbourhood. In fact, they’re downsizing and selling off some of their restaurants. The future does not look particularly bright for QSR, and sales were down 4% from last year. However, the market can factor all of this into the price of a stock. It can even overcompensate, pricing a mediocre stock too low and turning it into a potential gem. Priszm is an income trust, so essentially it sells delicious-smelling chicken with 11 herbs and spices and redistributes the money to unit holders. QSR is handing out $1.20/year at the moment, and with the stock at $3.50, that’s a 34% yield. It’s crazy, I know, and that’s of course because they can’t possibly keep that kind of distribution up with the way their business is going (the payout ratio is, according to TD, about 140% at present). A distribution cut is obviously priced in right now — but has the market gone too far? A few months ago, TD’s analyst estimated that the distribution would have to be cut to 7 cents/month ($0.84/year), which is still a very attractive 24% yield at this price. Even if the distribution was cut in half to $0.60/year that would be a yield of 17%, which is pretty nice. Of course, since it looks like they might continue to lose sales for the next few years, there might be further distribution cuts after that one. Being an income trust, it’s fairly amenable to being analyzed as an annuity: how much would I pay for a distribution of 84 cents this year, and which goes down by 5 cents/year every year thereafter? What is the present value of that? Well, if my target rate of return is 15%, that kind of payout would be worth about $3.60. Not bad considering I didn’t include any mention of book value, and that there is a chance that the management of QSR will stop the bleeding before the distribution drops to zero. The high target return rate and the book value help give some downside safety to that analysis of value…

But of course things could be worse. At that rate of decline, they’d still be in business (or at least have a positive cash flow) for another 17 years. What if it dropped 15 cents per year, putting them out of business in 5-some years? (Present value: $2)

They could also go tits-up like the Colonel himself. So what are the odds of that happening? Unfortunately, I can’t really say. At this point, the market seems to be anticipating not only that Priszm will cut its distribution, but that the cut will be huge, or possibly that it will cease to have positive cash flow all together. My dad says that they’re never going to stop selling fried chicken, and he might have a point — but that won’t necessarily stop these restaurants from getting to the point where they can’t spin off cash to the investors. While KFC is a bit of an icon, consumer tastes do seem to be slowly shifting away, especially since they were slow to get away from trans fats, and even slower to get broiled/grilled/toasted chicken on the menu (this year!). So I’m a little negative on the long-term prospects of this company. I think it’s not one of the top-quality stocks that everyone always wants to have in their portfolio; it doesn’t have this insurmountable economic moat, or brilliant growth prospects (or really, any growth prospects at all — just a hopefully long, graceful decline with many years of continued profitability yet). However, at this price I can’t help but see some value there. Take that, my precious few readers, with a giant grain of salt: I’ve been seeing value in Priszm for a while, and thought it might make a good buy at $5, too. It’s quite possible I’m missing signs of more serious financial trouble at that company and am being a retard for talking this up as a value. As the saying goes, a cheap price is not necessarily a value; or, sometimes you get what you pay for.

Of course, with the market the way it is, I’m seeing values almost everywhere. My problem now is not lack of values but lack of cash. I couldn’t buy any more Priszm if I wanted to, nor could I snatch up a tasty piece of GE, YLO, TD, or CNR along with some oil, either (oops! the market found CNR today [Jul 8] – up 5.5% already!). The only place I’m having trouble seeing value right now is Potash. Don’t get me wrong, I like the Potash “story”, and think it’s probably still a good investment… but mistake though it may have been at the time, I didn’t see the “downside protection” at $100, and at $200 it seems a little too speculative to me (despite the fact that I don’t feel the same way about oil, oddly enough). Sure, I could easily see it hitting $300 by next year or the year after, and that’s awfully attractive, but I can also see the potential to drop back down to $100, so I don’t really feel the need to buy any outside the little bit that I already own in my index. One has to also consider the possibility that I am letting psychosis interfere with my financial analysis. Do I not see value in Potash because I made a mistake last year in not buying it, missing out on a huge growth story, and so continue to not see value there, justifying my earlier decision to myself? Do I think Priszm is worthwhile because I bought some at a (much) higher price, and am missing something obvious to the other investors, perhaps that management might not have much foresight if they continue paying out a distribution from cash they don’t have? Am I suffering from confirmation bias?

Finally, I’m rethinking my stake in CanWel building materials. CanWel (CWX.UN) is a distributor of housing materials. For some reason completely unknown to me, the stock price started going really wonky a few years ago, getting stuck in the $4.25-$5 doldrums (my cost is $6.70/share). The distributions have been consistent, and it’s currently yielding almost 16% (with my yield-on-cash-invested being about 10%). They sell building materials (lumber and hardware) to stores like Rona and Home Hardware, as well as to some customers in the US, and some housing manufacturers directly. Because of the housing downturn in the states, sales are off by about 8%, and that’s what really has me worried: the housing market is nose-diving in the US, and the Canadian market does not look far behind. Moreover, this stock hasn’t been completely crushed by our current bear market (down 16% compared to HR.UN down 26%, compared to RON down 49%). That makes me wonder if I should get out while the getting out is good. True, I’d realize a loss and miss out on a pretty decent distribution. I am afraid that distribution might be cut, and I’m going to model that in just a bit, but at the same time they just had a bonus distribution a few months ago. That to me doesn’t speak of a management team that expects a distribution cut or is running short on distributable cash. My dad is still keen on CanWel, but had this bit of advice “If you’re not comfortable, just sell. The $29 commission is pretty cheap insurance.” So let’s run some numbers.

Despite falling sales, their distributable cash flow and margin have increased over the last year. This is largely due to better inventory management, so I don’t expect continued margin improvements. The payout ratio is 91%, which is a good place to be in a general sense, but in these uncertain times means that there’s no cash flow cushion to keep up distributions if sales sag. Using my ghetto spreadsheet/annuity analysis, and choosing a target rate of return of 15%, at its current distributions (and assuming they can be maintained past 2011), CanWel is worth about $4.80 — very close to the current share price, which of course is because the yield is about 16%, above my target rate (and then the buy price gets a slight boost from the book value in my reckoning). Now, sales are down 8% already just from the US housing market slowdown, but this is a Canadian company. A slowdown here could knock sales down 25-50%. Heck, maybe more, what do I really know? Running the 25% and 50% reduction scenarios, with a recovery to present levels by 2014 (arbitrarily chosen so I’m not overly negative), and I figure the worth goes to $3.90 and $4.30. At the current price of $4.40 then, some of these coming decreases might already be factored in — or I might be too optimistic in my calculations, or worse yet, completely out of my depth and doing meaningless Excel massaging. Assuming that $3.90 does represent a potential bottoming out for decreased sales/distributions, then that’s only another 11% downside. In that case holding on and collecting the cashflow is probably the best answer.

However, those calculations are cold comfort, and I can’t get over that nagging gut feeling that something nasty might be in store for CanWel, especially as the new CMHC guidelines might put a very sudden damper on the market. It is a very thinly traded stock — even my meagre holdings if liquidated would affect a typical day’s volume. So what I think I might do is put in an ask at my “fair” price of $4.80 and see what happens.

One Response to “The Stock Market: Everything Has A Price”

  1. Potato Says:

    As an update: I’ve been kicking myself pretty hard over Canwell, as it’s well below $3 lately. The latest quarterly results were fine, and the payout isn’t in danger (and the payout is what really matters), but I still would have felt better if I sold it and missed the downturn. Ah, well, c’est la vie. I was right about Potash though, it’s back down to $100.