ABC Funds Value Favourites

THAKRAL HOLDINGS

Thakral Holdings (ASX:THG) is an Australian-based property group operating in three main areas: hotels, retail/commercial, and property development. On the hotel side, Thakral’s portfolio consists of over 2,500 rooms, making it one of Australia’s largest hotel owners. The portfolio includes several landmark hotels located in Sydney, Melbourne, and Brisbane. Thakral’s commercial and residential assets, which receive over 30 million visitors annually, provide a steady stream of cash flow. At the end of 2006, the hotel group had a fair value of AU$622 million and the commercial properties were valued at AU$256 million.

Like many parts of the world, low interest rates and a strong economy have fueled Australia’s real estate sector. The S&P ASX 300 Property Index is up 70% since 2004. Despite this broad-based strength, Thakral Holdings continues to trade well below its net asset value. Using a sum-of-the-parts valuation, we derive a net asset value of $1.15. This NAV includes the value of the Company’s real estate assets plus the present value of its various development projects.

While many of the Company’s development projects and real estate assets are well known in Australia, Thakral itself maintains a relatively low profile. In addition, 40% of its float is held by Thakral Investments, the Thakral family’s investment vehicle. In 2001, the Thakral family considered selling its interest because it felt its large ownership position and lack of public liquidity unfairly punished the Company’s market valuation. The situation is mostly the same today, and it is interesting to note that in March 2006, Standard & Poor’s removed Thakral from the S&P/ASX 300 property index.

Another reason behind the current discount to net asset value is the impact that the adoption of AIFRS (Australian equivalent to International Financial Reporting Standards) will have on the financial reporting of its property development division. Before AIFRS, profits from project development were recorded on a “profit emerging basis.” Going forward after 2005, a project’s profit will only be recognized upon completion. The value of large projects such as Alchemy, Trilogy, and Ultra will not be recognized for several years.

Considering that most of Thakral’s peers trade at an average premium of 30% over net tangible assets, the Company may elect to commence a strategic review process to unlock the value of its portfolio. Even without such an initiative, we believe that it is only a matter of time before the market recognizes Thakral’s undervaluation.

POLARIS MINERALS CORPORATION

Polaris Minerals Corporation (TSX:PLS) came to our attention late in the 2005 calendar year. Management, led by Marco Romero, was raising equity to build an aggregates quarry in B.C. The term “aggregates” refers to the crushed stone, sand and gravel found in naturally occurring deposits and used in construction. We were immediately drawn to the extraordinary economics of the business and the tremendous forecasted free cash flow. We purchased just less than 10% of the IPO, making us one of the largest institutional shareholders.

Polaris owns 88% of the Orca Sand and Gravel Quarry, located on Vancouver Island. The quarry includes a ship loading facility capable of handling 70,000 tonne vessels and is permitted to produce 6 million tonnes per year. The Company also owns 70% of the fully-permitted Eagle Rock Quarry, located near Port Alberni. Production will be shipped to coastal urban markets, particularly northern California. To guarantee access to the target market, Polaris owns a 70% stake in an aggregates storage and distribution terminal in the Port of Richmond, San Francisco.

The huge California market is currently facing a supply deficit, caused by steady growth of housing and infrastructure and environmental opposition to new quarries. The California Department of Conservation has estimated that approximately 13.5 billion tons of aggregates will be needed over the next 50 years but just 4.3 billion tons of supply has been permitted. Amazingly, the cost to ship from Orca to San Francisco Bay, a distance of about 1,200 miles, approximates $5 per ton and is comparable to trucking the material 25 miles. According to the Company’s prospectus, operating cash flow is expected to stabilize at $46.6 million by 2013, based on flat pricing for the balance of the 25 year mine life. However, sand and gravel prices have increased steadily over the past 15 years. In consequence, we believe that cash flow growth should actually outpace inflation over the life of the quarry.

Although the initial public offering wasn’t a “hot issue”, shares of Polaris have almost doubled since October of last year. The Orca Quarry was completed on time and under budget and the first shipment was loaded onto a Panamax-class bulk freighter on March 31, 2007. Upside to the Polaris story comes from stone, sand and gravel price increases, production from the Eagle Rock Quarry, further quarry acquisitions and the potential for a takeout due to the strategic importance of the Company’s assets.

Irwin A. Michael, CFA

 

 

Hunting For Bargains

When I talk to a company
that tells me the last analyst
showed up three years ago,
I can hardly contain my enthusiasm.

Peter Lynch

My fishing friends always tell me that the best place to go fishing is where the fish are and “not where they are not.” This statement has always made infinite sense to me…just as one should go apple picking where apple trees grow or go golfing where people play golf, namely, a golf course. Once again, this is all quite logical and shouldn’t be open to debate. However, with regard to successful investing quite the opposite is true. Let me explain.

In hunting for investment bargains we attempt to uncover dirt-cheap stocks which many investors overlook. We search for companies that have low price-earnings and cash flow multiples, trade at a discount to book or net asset value and are generally not in investors’ sights. Many of these common shares are small capitalization companies that attract little analytical and stock broker attention. These stocks lacking investment recognition tend to trade at significant discounts to their intrinsic valuations and may languish for years. In consequence, once discovered by an enterprising analyst the shares can often be accumulated at bargain basement prices. Hopefully this happens before the stock rockets upward upon general market recognition. Strange as it may seem, unlike the fishing or golf analogy, astute investment analysts will often hunt for stocks where no other investors have tread. Upon discovery these analysts will salivate when they unearth an orphaned public security that hasn’t had its tires kicked for many years…and therein lies the opportunity.

Buying stocks that other investors have not noticed, however, is not a foolproof formula to investment success. Firstly, it involves a lot of tedious primary research which may not be readily available. Secondly, moving against a herd of investors involves considerable investment conviction, patience but, more importantly, a strong stomach. Being an early investor does have its negatives, too, since these investment decisions are frequently undertaken without full investment analysis or with imperfect information. Furthermore, these undervalued security selections may continue to languish for months before they are commonly recognized by the marketplace.

In summation, the aggressive analyst must undertake considerable initial research to fully understand an obscure, “fallen between the cracks little gem.” Overall, it should be noted that the risk/rewards of such selections often provide for remarkable investment returns for the patient investor who happens to go fishing where others have not ventured.

Irwin A. Michael, CFA

 

 

 

Success

The toughest thing about success is that you’ve got to keep on being a success.

Irving Berlin

Maintaining top performance is a difficult task in any demanding endeavor. A history of top performance creates a magnified expectation of not only future performance but also of, perhaps unrealistically, consistent top performance. Whether one is a top-tier athlete (e.g. Lance Armstrong) or portfolio manager, the drive to maintain high achievement levels is intense and grows in crescendo.

The fact is that no one person, company or organization can consistently keep up a winning performance without a break. Nonetheless, hope springs eternal and we all try. For instance, it is interesting to note that, Bill Miller, one of the finest investment managers of our generation, just broke his 15-year streak of beating the Standard & Poor’s 500 index in 2006. As reported by the National Post on January 5, 2007:

“Mr. Miller’s US $21-billion Legg Mason Value Trust rose 5.9% last year, trailing all 107 competing “multicap value” mutual funds tracked by Bloomberg that buy stocks managers perceive as being cheap. The Legg Mason fund had beaten the S&P 500 every year since 1991, rising at an average rate of 15.7%, topping the 11.8% advance of the US stock benchmark. … Mr. Miller wasn’t the only well-known value investor to trail the S&P 500 in 2006. Ronald MuhlenKamp’s US$2.9 billion MuhlenKamp Fund returned 4.1%. Manu Daftary, who had the second-longest streak of beating the S&P 500 at eight years, also struggled. His US$967-million Quaker Strategic Growth Fund increased 5.1%”

Winning streaks or success are tougher and tougher to maintain as time marches on and the risk of shattering a successful streak becomes greater and greater. However, breaking a streak does not imply that an investment manager, pro football team or high-scoring, talented hockey player has suddenly become stupid or lacking in talent. The fact is that streaks or great runs of success, in real life, are meant to be broken or interrupted.

The challenge to professional athletes, as well as investment managers, is to disregard short-term disappointment and return to performance excellence. While this is not always easy to accomplish, it remains the distinctive standard between the mediocre and extraordinary individual or organization. This point was best highlighted by General George S. Patton when he declared “success is how high you bounce when you hit bottom”. This statement, I believe, is well-worth remembering.

Irwin A. Michael, CFA

Expect the Unexpected

History never repeats itself…
but sometimes it rhymes.

Mark Twain

It is my view that each stock market and economic cycle is different from the ones which preceded it. No matter the sense of déjà vu which might occur to the observer there are always distinct differences which set apart one cycle from the next. In fact, if each cycle repeated itself exactly as in the past we wouldn’t need investment analysts or economists…just historians.

The stock market, in my view, is a complex institution. It is a madhouse of conflicting economic and investment opinions all revolving around the objective of making money. In short, it is a cornucopia of divergent investment views culminating in a spirited tug of war between the forces of fear and greed. Each investment situation is different and one must expect that nothing goes according to plan. One cannot program investing like setting an alarm clock or brushing one’s teeth. The intense psychological emotions in the heat of a lively and volatile trading environment necessitate a rock-solid philosophy and nerves of steel. The volatility of the market place with its innumerable peaks and valleys infatuates and, at the same time, enervates many investors’ resolve. For instance, over the years I have observed perfectly rational, well-educated and emotionally stable individuals make ill-advised, illogical and foolhardy investment decisions. These decisions were largely driven by the omnipresent twin factors of fear and greed.

In summation, investment success is a function of many inter-related factors. The key to success, I continue to believe, includes serious fundamental analysis, discipline, focus, stamina, patience and courage of one’s convictions. Admittedly, these attributes are easy to list, and yet, difficult to follow. Nonetheless, they are all-important ingredients to investment success. However, in closing, I would add another significant factor: expect the unexpected. It is my view that investor flexibility, thinking outside the box and willingness to accept change are factors which are just as important to the ultimate goal of investment success.

Irwin A. Michael, CFA

 

 

Investment Discipline

The importance of investment discipline cannot be over-emphasized.

The dictionary suggests that investment discipline can be acquired through instruction. We believe it is best learned through the "battle-hardened," real world experiences of stock market volatility. Ultimately, this brings a semblance of order or control to portfolio managers. Consequently they are able to function effectively during panic-like conditions.

Investment discipline was all-important during the pandemonium last summer. Throughout August, the stock market lost all perception of value. Common share prices were marked down at will. Investor fears brought on a buyer’s boycott and share prices plummeted. Experience, patience and a strong dose of investment discipline enabled managers to ride through this abnormal period with a minimum of emotional selling.

Last year was a volatile, contradictory and stressful period for many investors. If one owned the big Canadian banks, BCE, and utility stocks while avoiding resource and small capitalization stocks, one did well. It was the same story in the U.S. market where big stocks outperformed smaller ones.

Were these big cap stocks fundamentally cheap? No. The large capitalization, non-resource/non-cyclical stocks were expensive and became even more so. Nevertheless, these stocks appreciated, while many small caps and resource shares wilted. Investors fled to the safety of liquid holdings that were perceived to be immune from the Asian problems. Lower interest rates also positively affected stocks as price earnings multiples increased regardless of the murky profit outlook. Again, prime beneficiaries were the largest companies. Middle and small capitalization shares lagged the TSE and Dow Jones index benchmarks by 15-20%. In fact, for 1998, the Wood Gundy small cap index underperformed the TSE 300 by about 19%, having declined 20.6% versus the TSE 300 loss of 1.6%.

As one Wall Street analyst concluded, "the perfect 1998 stock investment was a large capitalization, non-dividend paying, perceived high-growth company". Fundamental "value" stock market performance substantially lagged the "growth", "momentum" and "concept" stocks in 1998.

This partially explains the underperformance of the three ABC Funds. We were hurt by our exposure to natural resources, including oil and gas, forestry, mining, and small capitalization companies. While we had a few successful takeovers including Oshawa Group, Schneiders and Toastmaster, these were not enough to override our underperforming stocks.

Will this trend change in 1999? We think so. We believe that fundamental value wins out in the end. We remain disciplined and will stick to our value style. At times, this can be frustrating, but we remain patient. We expect that many of the value losers of 1998 could be the value gainers in 1999. If many of the fundamentally cheap value stocks do not appreciate, we expect them to be the object of mergers, takeovers, stock buybacks and privatization bids.

We expect stock prices to continue to be very volatile during 1999. This will not be all bad. Wild mood swings in stock prices provide excellent opportunities for the disciplined value investor as stock prices under - and over-shoot their intrinsic values. Moreover, the value spread between large and small companies is extraordinarily wide in both Canada and the United States. We look for these undervalued, out of favour, companies which offer tremendous value to be the big, pleasant surprise for 1999.

Irwin A. Michael

 

 

Stock Picking: How We Pick Stocks at ABC
Surrey Metro Savings Credit Union

We are often asked how we find undervalued, out-of-favour common shares. Actually, there is no deep secret or black box formula. We try to employ rational common sense. We observe the latest of economic, financial, political and corporate events and then seek out stock market anomalies. We are opportunistic and aggressive when a potential profitable situation unfolds. A recent example is our latest purchase of Surrey Metro Savings Credit Union of Surrey, British Columbia.

Surrey Metro, founded in 1947, is the second largest and only publicly-traded credit union in Canada. It serves the rapidly growing Fraser Valley and suburban Vancouver region of British Columbia. Its 17 retail branches and centralized call centre offer a wide range of financial services including, residential first mortgages, wealth management, insurance and financial planning. Total assets of over $2 billion are 85% funded by retail deposits. Surrey has a relatively clean balance sheet with a $14.33 December 31, 1998 book value. Earnings per share for 1998 were $1.81 and the company pays a $0.40 dividend. Surrey has only 5.49 million non-voting public shares outstanding with barely a $70 million market capitalization.

The Board of Directors and management led by President Lloyd Craig have been very capable. In short, Surrey Metro is very well run, profitable and is located in a significant growth area of British Columbia. To remain competitive for the future, management decided to link up with a comparable national institution. In its desire to thrive and grow, a merger between Canada Trust and Surrey Metro was proposed at a $24 takeout price. This was an eminently fair price to the shareholders since Surrey had been trading at $14-15 before the proposed takeover. This 60% takeout premium was also a $9.67 premium to the year end book value of $14.33.

To make a very long story short, the proposed merger did not succeed. While the public 5.49 million non-voting shares voted 86% in favour of the transaction, 76% of the credit union members voted against it. Due to the fact that the amalgamation vote had to pass by a two-thirds majority of both groups, the merger could not proceed. Naturally the stock price plummeted from about $24 to around $13. Suddenly we became interested.

We had looked at Surrey Metro several years ago but because we could not purchase a meaningful position we stopped following the company. With the aborted merger, a significant amount of stock became available at $13 and lower from disappointed arbitrageurs and retail shareholders. We quietly accumulated a meaningful position for both ABC Fully-Managed and ABC Fundamental-Value Funds.

We believe Surrey Metro is undervalued and out of favour. While everyone is disappointed about the failed $24 merger, the fact is, Surrey is well-run, profitable and in a growth area of B.C. While we do not discount another merger attempt in the future, Surrey could take another tact due to its public status and become a consolidator of other B.C. credit unions. In the meantime, we intend to hold onto this undervalued holding until its full potential is realized.

Irwin A. Michael, CFA

 

 

Patience: The Hard Part of Value Investing

Over the past twelve months we have written innumerable pieces about patience and value investing. We have stated that fundamentals and value always win out in the end. Not surprisingly, we continue to hold to these strong views.

We hunt for undervalued common stocks and whenever possible we attempt to sell overvalued shares when they reach our target prices. Our operating policies, style and discipline do not change. But there is a very hard part to successful value investing. Let me explain.

Firstly, let me admit that the easy part of value investing is finding cheap stocks. We start off by diligently researching a company's balance sheet, prospects, hidden assets, potential liabilities, and etcetera. As a second line of defense, we will also review a company's technicals or stock price chart patterns to give us a trading perspective. Ultimately, if a stock cuts it, we attempt to buy our position. This process, in all candour, is the easy part of value investing. Now the hard part of value investing begins… and that is the patience of waiting it out until the general market (i.e. other investors) catches on to our new investment purchase. The realization of our ultimate price target, unfortunately, may take weeks, months or even years to play itself out.

For instance, three recent ABC successes, including Oshawa Group, Cogeco Cable and Astral Communication each took up to two years from the time we originally bought the shares to when we recently sold them. While we eventually earned 100 to 200% returns over a two year holding period, there were times when each of these three investments were quite frustrating. In all three cases, their market prices declined below our initial purchase price. At times it appeared that no one even cared about these fundamentally cheap stocks in spite of the fact that all three offered dividend yields of 1.5 to 2.5%. Moreover it was of little consolation to investors that these shares were trading at over 50% below their net asset or intrinsic value. We were questioned many times why these stocks traded so poorly and when (heaven forbid) might we throw in the towel and sell out. Clearly, patience and discipline became the hard part of value investing.

To say in retrospect that it was all very easy would be untruthful. But whatever the catalyst, Oshawa Group (Sobey takeover) or Astral and Cogeco Cable (internet/communications frenzy) suddenly appreciated to our price targets. Fortunately, our patience and resolve, which had been severely tested, prevailed.

But even the sale of these securities was not easy. Take Cogeco Cable for example. We sold this holding in both the ABC Fully-Managed and the ABC Fundamental-Value Funds in late January at $26 (our cost $8.50 to $9.00). This was the height of the internet/cable euphoria. The stock price had simply overshot our price target and no longer represented fundamental value. Fortunately, several brokerage analysts had suddenly affixed "outperform status" on the stock, which enabled us to sell our huge position in a relatively illiquid stock. While it is possible that Cogeco Cable may eventually reach $30 to $35, we stuck to our value investment discipline and our selling philosophy. The sale proceeds added a significant 6% cash position to each ABC fund, which we are using for other out-of-favour, undervalued stock purchases.

In conclusion, we offer the following observations:

1.                              At the early stages of value purchases there is considerable frustration and investment agony until a particular stock's value is recognized and its share price climbs.

2.                              Once recognized, the value stock rapidly runs up in price. This sudden appreciation and transformation from value to momentum share play will equally test a value investor's resolve regarding the "when to sell" decision.

When all is said and done, I honestly believe that fundamental value investing, notwithstanding the time element, always wins out in the end.

Irwin A. Michael, CFA

 

 

Goodwill

The excess of the purchase cost over the book value of all identifiable assets purchased

The Principles of Managerial Accounting
- Kryzanowski, Gandhi, & Gitman

I do not like goodwill. Furthermore I must admit that I do not like to see goodwill on a company balance sheet. Simply described, goodwill can be an obscure, intangible asset. It is very fluffy.

As explained by Carl Moore and Robert Jaedicke in Managerial Accounting:

" The intangible assets consist of valuable rights, privileges or advantages. Although the intangibles lack physical substance, they have value. Sometimes the rights, privileges and advantages of a business are worth more than all of the other assets combined… A Company is said to possess goodwill if it can earn a higher-than-normal rate of return upon invested resources. The higher rate of return may be caused by various factors such as managerial skill, popular acceptance of the products, or some other favorable circumstance."

Now the fact that goodwill lacks physical substance and may not even exist bothers me. In reality, goodwill only exists if a company is earning extraordinary returns. But economic and investment circumstances do change. New processes, inventions, and patents are discovered and older advantages no longer have value. In effect, goodwill becomes a depleting or a wasting asset. Often the reality of this occurrence is recognized far too late.  Several examples come to mind.

In May Nortel Networks Corp. announced it would close down Promatory Communications Inc. of Fremont, California which it purchased only 12 months earlier for over $1 billion dollars. Nortel also announced that it has written off two other acquisitions, which it bought several years ago for greater than $800 million. The magnitude of these writedowns and timing so soon after purchase concerns me as an investment analyst.

Moreover as described in the National Post on May 17, 2001:

"But goodwill writedowns still loom, especially since JDS Uniphase Corp. of Ottawa announced in April a massive US$40 billion writedown of its goodwill assets.

Goodwill accounts for 45% of the total value of Nortel assets according to a study , a level that makes it highly vulnerable to a write down. Nortel said it is reviewing the carrying value of its goodwill and "long-lived assets" ."

Overall we take a hard-line view towards goodwill. When confronted with goodwill on a corporate balance sheet, with few exceptions, we discount its value to virtually "nil'. This might be considered an unduly harsh treatment. But we believe that with the multitudinous corporate acquisitions of the late 1990's and the accompanying enormous goodwill, many corporations are vulnerable to significant goodwill writedowns. Consequently we will continue to take a serious and discriminatory approach toward corporate goodwill.

Irwin A. Michael, CFA

 

 

 

 

Fear, Greed and Fundamental Value

October 19, 2003

Dear Mr. Michael,

We look forward to once again being accepted into ABC Funds.

The past few years have been a revealing journey through the morass of greed with countless occasions to ponder and appreciate both the clarity of the words "fundamental value" and the inherent wisdom in your approach to managing money.

There is no substitute for patience and value is the best friend an investor can have.

Sincerely,

K.H.

Occasionally a client will leave the ABC Funds and decide to return several years later. While some of our redeeming clients may go on to bigger and better things, most do not and subsequently lose a good portion of their hard-earned capital. This, I believe, was the case during the 1998-2000 period.

The mid 1998 to mid 2000 interval represented a most difficult time for value managers and the ABC Funds. The high technology sector was the rage as stocks like Nortel, JDS, 724 and 360 Networks soared in value. Initial public offerings with little more than a "tech" suffix literally doubled on the first day of trading. Investors became greedy. Many felt little need for professional money managers and rationalized that they could do far better on their own.

At the beginning, some did quite well as the tech mania gathered momentum. But alas, as with most "feeding frenzies" good things eventually come to an end. In retrospect, the technology craze was no different from the 17th century Dutch tulip bulb mania, previous boom and bust real estate cycles and the 1979-1980 run up of gold to $800. Unfortunately for many, history had repeated as trillions of dollars were erased from portfolios.

When I received the above letter I was truly moved on several counts. I would like to share my thoughts:

1) I was particularly touched by the sincerity and erudite commentary of this individual. Many people would be too embarrassed and full of ego to return to ABC Funds, let alone to submit a straight from the heart letter of this sort.

2) The writer's description of this period as "a revealing journey through the morass of greed" quite eloquently described the investment scenario of the time. Moreover, "with countless occasions to ponder and appreciate both the clarity of the words fundamental value and the inherent wisdom in your approach to managing money" the writer offered a real world reflection on the subsequent decline of high technology and the huge financial losses that befell many investors.

and lastly

3) "There is no substitute for patience and value is the best friend an investor can have" perfectly sums up our ABC Funds investment philosophy.

Irwin A. Michael, CFA

 

 

 

Common Sense, Irrationality and Greed

"To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight or inside information. What’s needed is a sound intellectual framework for decisions and the ability to keep emotions from eroding that framework."

Warren Buffett

I have always thought that the key to successful investing entailed discipline, focus, contrary opinion, persistence, the courage of one’s convictions and profound patience. While all this may be true, serious security analysis and profitable investing is often confronted by one of man’s greatest failings ---- greed.

It is amazing how intelligent and normally rational people involved in important and responsible employment can become so smitten by excessive stock market euphoria. At these times they lose all sense of rationality, perspective and discipline as unbridled greed leads to featherbrained investment decisions. Unfortunately, once undertaken, these poor investment decisions cannot be taken back since there is no money-back return policy in the investment world.

It is our view that successful investing is a 24-7 analytical process. Furthermore, once fundamentally analyzed, an investment decision must be fully-thought-out as to the appropriateness of the security to a particular portfolio and a future exit strategy. Difficult bottom-line decisions must be made devoid of giddy and greedy emotions. In the heat of the battle this is often easier said than done as powerful human greed overtakes all rationality and common sense.

The best commentary on this human failing, I believe, was an April 2004 Investor’s Business Daily article written by Craig Shaw entitled, “Don’t let intelligence breed dumb investing mistakes”. In this piece Shaw writes:

“Sir Isaac Newton lost money in the South Sea bubble of the 18th century. Mark Twain squandered his fortune speculating on inventions and real estate. Plenty of Ph.D.’s and M.D.’s saw their nest eggs shattered in the 2000-02 bear market. The lesson? A high IQ often means little when it comes to investing.

After his experience, Newton said, “I can calculate the motions of heavenly bodies but not the madness of people.” Albert Einstein once said, “Only two things are infinite, the universe and human stupidity, and I’m not sure about the former.”

In summation, it is not enough to thoroughly analyze a potential investment. More importantly, as investors, we must seriously bullet-proof ourselves from ourselves. Difficult as it may be, we must adhere to our strict and time-proven investment decision-making processes and refrain from poor, momentary, lemming-like, greed-driven judgments.

Irwin A. Michael, CFA

 

 

 

A New Closed-End Fund

For years I have wanted to start up a closed-end investment fund. For those not familiar, a closed-end investment fund raises investment capital from an initial group of investors and (unlike open-end funds) does not continuously offer units to new investors. Once formed, a closed-end fund does not accept new money on a continuous basis nor does it allow for regular redemptions at net asset value. Instead, liquidity is provided by an active secondary market between buyers and sellers, usually on a stock exchange.

The attraction of a closed-end fund from a portfolio manager’s perspective is that it is easy to manage and can provide greater stability to unitholders, since this new fund is not faced with major fund redemptions or huge cash inflows that could distort the portfolio and force security rebalancing. Conceptually, a closed-end fund is a portfolio manager’s dream in that he can focus solely on discipline, investment style and long term valuations.

ABC North American Deep-Value Fund will concentrate on deep-value investing by purchasing the best value stocks held in our three ABC Funds. But more importantly, we will also designate as much as 25% of the portfolio to micro capitalization stocks (but this fund will only invest in securities of public companies). These shares have market capitalizations of $50-100 million and are smaller than our usual small capitalization company purchases. In many cases, they attract little or no investment attention; this fact, I believe, represents an enormous opportunity. Up to this point, when we have come across attractively priced micro caps, we have generally passed over them due to liquidity concerns for our three open-ended funds.

It is noteworthy that there is little incremental analytical work involved since, in most instances, our investigative methodology has already selected these stocks as undervalued. We regard this new fund as quite exciting and adding a new dimension to our present work. Common to our three existing funds, Royal Trust will act as trustee/custodian and PriceWaterhouseCoopers will perform the fund’s annual audit.

While somewhat limited, liquidity will be provided through a “virtual exchange” whereby I.A. Michael Investment Counsel Ltd. will set up a book of interested buyers and sellers. At the end of each month, on a best efforts basis, we will match up these buyers and sellers at net asset value. In addition, this new fund will offer unitholders further liquidity through limited annual redemption of units at net asset value.

In all honesty, the new ABC North American Deep-Value Fund is not for everyone. Compared to our existing ABC Funds, this new fund will have a $250,000 minimum rather than $150,000 and will be less liquid. This new fund will have a longer term investment horizon. The management fee, while lower at 1%, will also include a performance fee of 20% on any returns above 10%.

On the positive side, this new fund will have maximum flexibility to invest in a diversified mix of deep-value Canadian and American common shares, convertible debentures and fallen-angel unit trusts. The country and asset mix as well as the currency exposure will have no set limits. As investment manager, we will have maximum flexibility and opportunity.

As a measure of my deep personal and professional commitment, I will be the first investor. I will commit $1 million to the start-up of the ABC North American Deep-Value Fund.

Irwin A. Michael, CFA

 

 

Milking The Market

"My father asserted that there was no better place to bring up a family than in a rural environment… there’s something about getting up at 5 A.M., feeding the stock and chickens and milking a couple of cows before breakfast that gives you a lifelong respect for the price of butter and eggs."

Bill Vaughan

There is an old saying in the investment business: “if you buy a security well, it is half sold.” The point of this statement is: if a stock is well-researched and analyzed combined with an astute investor focus, discipline and sense of timing, it is highly likely that the investment will be very rewarding.

It is no secret that we spend a great deal of time researching our stocks. This process can be tedious and time consuming. We are guided by our disciplined investment principles which we have labeled our Ten Commandments of Value Investing. Analytically, we are free-thinking, contrarian, very picky, deep-value hunters. We may review ten stocks and through a rigorous process of investigation we may only select two or three.

Like Bill Vaughan’s quotation, we do wake up before sunrise to complete our early morning investment chores. Through our fundamental analyses, we hunt for deeply-undervalued, oversold securities. Often, they trade at low price earnings and cash flow multiples and are out of favour. In many cases, these companies are priced well below book and net asset value. Also, they may have a number of valuable hidden assets such as surplus real estate, tax-loss carryforwards or other understated balance sheet assets. More often than not, these diamond in the rough securities are not followed by any investment analysts and therein lies the opportunity. Recent ABC Funds examples of these stocks include Riverside Forest Products, Prime Hospitality, Edelbrock Corp., Lufkin Industries and Russel Metals. All were liquidated this past quarter with significant realized profits.

In a nutshell, to successfully “milk the market” one must have market respect, humility and sensitivity. One should remain focused, diligent, patient and persevere regardless of short-term, faddish diversionary trends. In the end, I believe, that if one adheres to a prudent and self-disciplined strategy, the long-term rewards are remarkable.

Looking ahead, we are quite enthusiastic about our new closed-end ABC North American Deep-Value Fund. We intend to apply the same investment principles which we have successfully employed with our three existing ABC Funds. While this new closed-end fund will present our investment team with an exciting challenge we believe that we are sufficiently motivated and can continue to provide for superior long-term investment performance.

Irwin A. Michael, CFA

 

 

Hatching The Egg

The key to everything is patience
You get the chicken
By hatching the egg
- not by smashing it

Arnold Glasgow

We have always taken a patient longer term approach to investing. Our prime objective has been “consistent investment performance” and, as such, we preferred to be the plodding, disciplined tortoise rather than the frenetic hare. Just as Rome was not built in a day, we have always considered the road to investment success to be one of painstaking fundamental analysis combined with the patience of Job.

Invariably, this investment plan of action is easier said than done. This is due to the fact that we are constantly bombarded by economic, financial and political storms which may temporarily set us off course. The challenge is to be alert, flexible and persevering to recalibrate our positions toward our goal of investment excellence. Notwithstanding this track we cannot simply operate in a market vacuum; we must also be sensitive to client concerns. Unfortunately, there may be times when our investment approach may be zigging versus a hyped market which may be zagging. This occurred in 1999-2000 when high technology and Nortel were the flavour of the day. At that time we remained true to our deep-value philosophy regardless of what might have been “in style.” This, unfortunately, was not an easy task as we came under incessant criticism for a period of over 18 difficult months.

Going forward, we must be patient and cling to our investment principles despite the fact that we might temporarily be out of sync with the market benchmark. The fact is that we do not follow the crowd nor any standard index. We believe that this course is consistent with our stated objective of uncovering dirt-cheap value stocks and out of favour securities. As a result, we are often early with the security purchase and must patiently await a price catalyst. Recent successful examples of this strategy include EuroZinc Mining Corp, Hudbay Minerals, Saxon Energy Services, Goody’s Family Clothing, Cobra Electronics Corp. and Foodarama Supermarkets. In all of these cases we thoroughly analyzed the companies, affixed a 12-18 month price target and patiently purchased these out of favour securities at deeply discounted valuations. Although we recognized that price appreciation might be slow in coming we were comfortable with our analysis and were prepared to sit with these investments until our price objectives were attained.

As we look ahead at the markets over the next 12 months we are quite optimistic. We believe it will be a stock picker’s market with plenty of mergers, acquisitions, takeovers and privatizations. We have targeted our four ABC Funds’ portfolios to a fully invested position. We intend to remain true to our investment style and disciplines; this will not change. We are confident that over the long term our time-proven deep-value style will continue to provide superior investment performance. In effect, we are quite content to hatch the egg rather than smashing it.

Irwin A. Michael, CFA