Nelson Smith

Freelance writer. Contrarian investor. Watcher of baseball. Owner of financialuproar.com. At least my mom thinks I'm funny and/or handsome.

Oct 232014
 

It’s Thursday, which means it’s Eddie. He blogs.here. He promised this week’s edition is “particularly mean”. I’ll let you be the judge of that.

If my count is correct, this is personal finance groupthink assassination number 6.

If I had a nickel for every time I read an article or post from a personal finance blogger, even ones that have a large readership but whose authors are not particularly well read, about the sinister nature of banks, I could not buy anything of value since I stopped reading virtually all PF blogs a long time ago.  However, the propensity for PF bloggers to vilify banks is astounding as it is myopic.

A bank is a business.  More specifically, it is a financial intermediary.  Banks connect net lenders (those who have money via deposits and investable assets etc) with net debtors (those who want loans, mortgages etc) and receive the spread.  They greatly reduce risk on the part of both parties by performing due diligence on each stakeholder to a transaction and facilitating its completion.  Without banks and other enterprises which perform similar functions, deals would have to be negotiated privately between parties.  The difficulty and costs of such an arrangement would be exorbitant.  Imagine going to your rich neighbor and negotiating a $400,000 loan.

The conventional wisdom in the PF world is that a bank is a malevolent spectre that haunts the populace and tries to rob the unsuspecting layman of their hard earned money.  High MERs, ATM charges, and chequing account fees are the tricks in the devil’s bag to deprive the innocent of their wealth.  Luckily, enlightened PF bloggers are on a crusade to deliver us from evil of institutional banking.

Hyperbole and sanctimony aside, banks are terribly misjudged by the masses.  Banks merely try to guide their customers to higher margin products, which is not so extraordinary compared to other businesses.  There are many other enterprises that try to upsell you on their goods or services.  Butchers try to entice you with a higher quality steak, telecom companies recommend more robust communications plans, and tradesman are always looking to expand the scope of their work.  Nothing wrong there.  Banks do not have your best interests at heart, but neither does your hairdresser or banker.  Welcome to the free market.  Some products that banks offer more economic value and higher margins to the bank rather than the customer, but the same could be said for Apple.  Margins on Apple products are enormous but no one complains about that, yet a $6 per month chequing account is anathema (for the record, I despise Apple and everything that company stand for).

One of the most important facts that people need to realize is that, fees aside, the interests of the bank and the customer are aligned.  They may not be perfectly correlated, as you care more about your money than they do. In a general sense, they make and lose money when you do.  For example, a bank can provide financing for a business venture or a mortgage.  If you are successful and repay it, it helps you grow your business or provides a stable place to live.  You make money or receive other benefits, and they receive their cut.  If your business fails or you default on your mortgage, they lose money and incur the administrative burden of getting a portion of their money back.  This is an arduous process for a lender.

I humbly suggest that you view your bank as a partner and not an adversary.  Yes, they will try to direct you to more robust services, but they can more importantly act as a gateway to accessing the capital required to start a business, obtain a mortgage, or upgrade your education.  The latter is infinitely more important than the former.  Banks want to lend you money and have a vested interest in seeing you succeed.  Maximize the value of this relationship by seeing the forest through the trees.  ATM fees and MERs are the cost of doing business.  Acknowledge it, move on, and focus on the more important aspects of the relationship and the potential it contains.

Disclosure: I do not work for a bank nor do I have any as clients.

PS I suspect PF bloggers criticize banks because they do not have the knowledge or sophistication to write about anything else.  Banks are an easy target; when in doubt or at a loss for material, criticize the banking industry.

Oct 212014
 
"When the bamboo runs out, I am so going to eat you."

“When the bamboo runs out, I am so going to eat you.”

Let’s start things off with a hypothetical situation. (I wrote something similar for Motley Fool last week, in the interest of full disclosure)

Say you and I were hanging out. FINALLY, A FRIEND FOR NELSON! TAKE THAT, DAD. I offer you a deal. You put in $20, and I flip a coin. If it comes up on heads, I’ll give you $60. If it comes up on tails, I get to keep your $20. Would you play that game?

I hope the answer is yes. If you could play that game all day long, you’d probably be a millionaire in a week. Once you had enough flips in to even the odds, you’d be effectively be making $20 on each toss. This would be an incredibly profitable game.

But what if I upped the ante? What if the game cost $10,000? Or $100,000? Would you still play? What if I limited the chances you had to just one coin flip? You still had great odds, but it would be a disaster if you guessed wrong.

I think I’d have far fewer people taking me up on the second offer. Risking your life savings on a coin flip is dumb, even if the odds are effectively in your favor. Winning is great, but losing is catastrophic.

How this relates to investing

I used this example for Motley Fool to prove a point about Penn West Petroleum. I’ll let you read the article if you want to learn more about it, but the skinny is this. The company has struggled for years, and now is facing the possibility of low oil prices hampering its ability to sell assets and ultimately pay down debt. If oil stays down for a long period of time, the company’s solvency could be called into question. If you were a debt holder, would you continue to hold if the company couldn’t afford to pay?

Because of this worst case scenario, Penn West is more hammered than a Scot watching a soccer match. Shares have dipped below $5.50 each, which is about a third of the company’s (probably inflated by a good 25% thanks to excessive goodwill) book value. As of this point the company still earns enough to pay the interest, keep its generous dividend afloat, and still have enough for capex, but that’ll get tighter if oil prices continue to decline.

I’m watching it, and will take a closer look once the inevitable dividend cut happens. I’d also like the company to sell a couple more assets to get the debt down a little more, so I’ll be patient. I’m usually too early on these types of investments anyway, I’m trying to stop doing that.

Penn West is pretty much exactly the kind of situation I described above. It could very well head to bankruptcy. If oil falls to $60 a barrel, I’m not sure how it will survive. Asset sales will stop, and it won’t have the cash flow to even service the debt.

But, if oil slowly recovers and it becomes business as usual again, the company won’t just survive, it could thrive. I could see it going up to $15 in a few years once it gets the house in order.

A portfolio of Penn Wests

If you poured all your money into Penn West and then borrowed more, you’d rightfully be laughed at — even if it succeeded. You know it’s a dumb move when I’d laugh at you.

But what if you found 15 different Penn Wests, each with the same odds as the coin flip scenario? If you had enough opportunities to invest at those kind of odds, you’d end up doing well almost by default. It becomes a numbers game, and eventually the numbers even themselves out.

The Winnipeg Jets have a goalie who stat guys say is among the worst in the league, Ondřej Pavelec. In the 2013-14 season, he was dead last in save percentage in the entire league (for goalies with a minimum of 40 games played), and dead last in goals against average.

And yet, he still had a shutout. In fact, he’s had 11 of them over his NHL career. And he’s had plenty of nights where he’s allowed one or two goals and been a really good goaltender. Even though most of the time he’s terrible (at least, compared to a regular NHL goalie to put things in perspective a little), he still has moments where he’ll buck the odds.

The methodology

There’s just one problem with the coin flip analogy. There are three outcomes to investing in a troubled company, not just two. It can either succeed wildly, fail wildly, or not do much at all. If I were to guess, I’d say out of every 10 investments 1-2 fail, 5-6 are dead money, and 2-3 end up succeeding wildly, eventually tripling or more.

The whole point of qualitative analysis is to try to pick the best from the market’s reject bin. Ladies, think of it as going through the 90% off rack at Reitmans, a place I’m assuming you all shop at. Most of the stuff will be worse than a pancake stuffed with mustard, but there will be a few gems hidden among the crap.

The reason I hate debt on the balance sheet on a turnaround project so much is because it hampers the ability to turn things around.

The reason why I look for a company that has traded at a much higher price in the past is because that way investors can psychologically can more easily fall in love with a company again.

And so on. I look for these things not just because I want a margin of safety, but because I’m trying to skew the odds to my favor. Improving the fail ratio from 2 in 10 to 1 in 10 has a huge impact on returns. It’s an inexact science, but I think I’m getting better at it.

It sounds bad, but essentially we all do a form of coin flip investing. But instead of flipping for huge returns, most people are flipping for modest ones. Whatever floats your boat, but if you need me I’ll be doing my best to triple my money on coin flips.

Oct 202014
 

When I first heard about the concept, I thought credit card hacking was kind of cool. I could make hundreds of dollars just by getting credit cards and buying stuff that I would normally buy anyway? That doesn’t sound so bad.

But, like usual, my laziness won out. I have yet to replace my 15 year-old 1% cash back credit card. I just can’t be bothered. Over the years it’s served me well. I haven’t paid a nickel in interest, I’ve gotten approximately $80-$100 in cash back per year, and I’ve got it set up so most of my monthly bills come off it, leaving me just having to pay the credit card off. My credit card is most of the reason why I couldn’t care less about getting a no-fee bank account. I do less than 5 bank transactions a month. I’m not going to fret over 50 cents each time.

Essentially, like I’ve talked about, my life is about simplicity. I will gladly pay a little extra (or forfeit dubious “rewards”) to not have to do something. Plus, it’s not so lucrative for Canadians to do this. Americans get much better sign-up deals.

Still, I can understand why the concept of credit card hacking is attractive. In exchange for signing up for a credit card and spending a few thousand bucks on it (money that probably would have gotten spent anyway), you can get hooked up with hundreds of dollars in free hotel stays, airline tickets, restaurant stuff, free gas, and so on. The PF-o-sphere LURVES this stuff, and you feel like a sucker for being left behind.

Fret not little one. It’s just not that simple.

As the fine folks at Control Your Cash (R.I.P.) used to say, take a look at every transaction from the other party’s perspective. Just what exactly is the Hyatt Corporation or British Airways getting out of teaming up with Citibank or JP Morgan to offer schelps like us $999 in FREE HOTEL STAYS?!?!?!?!

It’s easy, once you think about it.

  • All sorts of free marketing, from the lobby of the hotel to the bank branch to the PF bloggers talking about it
  • Having the business’s logo on a primary use credit card for a minimum of 3 months, and most likely longer
  • Additional customer loyalty because they want to go to that hotel or airline to earn points
  • The chance to upsell customers stuff when they do show up. “Oh what the hell? The room was free!”
  • A cut of the fee the bank gets every time the customer swipes the card
  • Better leverage when it comes time to renew the fees for credit card transactions, which is a huge cost
  • Points encourage people to travel, which creates more opportunities to sell flights and hotel rooms

Using the hotel example, it’s easy to see what a sweet deal it is for Paris Hilton’s (smarter) relatives. Giving somebody a “free” room that would most likely have gone empty anyway hardly has any additional cost. You still need to heat the building, keep the lights on, pay the staff, and so on. There’s just a little extra work for the cleaning staff. In exchange, the hotel gets you in the door and hopes like hell that you get breakfast in the morning or rent some porn. Plus, you know, all that free marketing and a small cut of your purchases.

Even a room at Motel 6 is worth more to you than it is to Motel 6, at least most of the time. Which is why you either can’t use the points on a long weekend, or you’re paying out the wazoo for the privilege of doing so.

Even from the bank’s perspective, it’s a great deal. At a minimum, they’re getting a fee each time somebody swipes the card — why do you think the minimum purchases exist? — as well as a certain percentage of people continuing to use the card, racking up interest charges, annual fees, and even more swipe fees. Just look at these numbers, assuming somebody charges up $10k and doesn’t pay it off for a year.

  • Swipe fees: 1% ($100)
  • Annual fee: $99-$700
  • Interest: 18% ($1800)

And, of course, the points are structured so you’re practically obligated to use they to stay at the underlying hotel or fly the underlying airline. They intentionally make them such a good deal that you can’t pass them up.

So what happens? You get logic like this, from one PF blogger on the comment thread of another, talking about how much they’ve “saved” using credit card hacking.

Screen Shot 2014-10-20 at 1.39.09 AM

Congratulations, you saved $6,000 on this vacation.

Except you didn’t.

Anchoring is the oldest trick in the retail book, and yet we still fall for it. If potato chips go on sale every 3 weeks, did you really save $1 per bag by buying this week? Did you really save $200 on that vacuum cleaner that used to sell for $649 but has been marked down to $449 today only? Hell, if we take the logic to its conclusion, I could argue that because I didn’t charge you $50 to read this article, I saved you $50.

You’re welcome.

Besides, who outside of Taylor Swift spends $6200 to go to London and Paris for a week, and not even during peak travel season? It took me less than two minutes to find a direct flight from Toronto to London (via Air Canada) for less than $750 return (per person). I saved $500 for the blogger above in the amount of time it takes to have a bowel movement. If I was willing to make it an 8-day vacation I could fly non-stop for $637 per person. And that’s out of Canada, which is more expensive to fly than the U.S.

It’s the same thing with the hotels. I found many hotels in London for under $200 Canadian per night, which is closer to $150 for our friends to the south and their richer currency. Yeah, you’re not staying at fancy $600/night hotels, but it’s really easy to get 3 stars or better in a great location for under $200/night. And after an additional 5 minutes of poking around, I found out Paris is even cheaper than London.

It would be easy to stay in decent hotels in both places for under $200 per night, including taxes. So to review:

  • $1500 for flights
  • $1400 for hotels
  • $2900 total

In ten minutes I “saved” $3300 on my imaginary European adventure compared to whatever full price is supposed to be.

Okay, fine, I’ll concede that saving $6000 is better than saving $3300, and even if folks spend 30 hours to do it, that’s still $100 per hour. Good news, I have a better way to save $6000.

Don’t go.

Oh, like you’re one to talk, Korea boy.

I’m the first to admit travel is a frivolous pursuit that’s become the new status symbol, and I hate myself for liking it. But I’m also doing it on the cheap. My living expenses in Korea are a fraction of what they are in Canada. I’m running around Asia and still saving 80% of my after tax income. That doesn’t make travel any less frivolous, but at least I’m doing it cheaply.

But here’s the deal. I imagine that the above blogger and her husband will spend at least $1500 of their own money while touring around Europe. After all, the trip is “free,” so they can live a little. $200 was already spent on taxes for the tickets, so that leaves $1300 in spending money for a week. They gotta eat, get around, pay to sightsee, and go from London to Paris.

It’s not that hard to spend that kind of cash, especially with two people. So what if you did something different?

Instead of credit card hacking for hotel stays and free airplane rides, why don’t you use your points for things that are actually useful? A $300 iPod that gets used for 2 hours a day for 5 years is an infinitely better investment than a trip anywhere. It’s the same thing if you use it on mundane things like gas, groceries, or even gift cards to a local restaurant. Spend the rewards on stuff you’d normally buy anyway.

If you compare an exotic European vacation for $1500 compared to $1000 in free gas, it doesn’t look like a fair fight. The vacation wins every single time. But by buying the mundane, you’ll save $1000 while the European vacationers will spend $1500, plus had to spend the $1000 in gas. You’re up $3500. Sure, you don’t have a European vacation, but that’s a luxury you can easily go without, especially for an extra $3500.

I’m cool with credit card hacking. But the reality is most folks should stick to regular old cash back cards. Even if you only end up with 1% back from buying $5000 per year worth of stuff, you’d still be $1550 ahead of somebody who unnecessarily spent money on a fancy vacation. Don’t fall for the anchoring. Don’t fall for the emotional pleas. And certainly don’t fall for a blogger telling you to eschew consumerism at every turn unless it benefits them.

Bottom line? There’s a certain amount of bullshit that comes attached to all of this. It’s not quite as lucrative as it’s made out to be. Which is why most people reading this shouldn’t bother.

 

Oct 162014
 

It’s Thursday, AKA Nelson’s slack off day. Take it away, Eddie. 

I believe this will be PF groupthink assassination post number 5.

My post this week focuses on a rather technical detail in a recent Moneysense article.  I happen to read Dan Bortolotti’s article How to make it to $1 million that was published in the September/October 2014 issue.

The article postulates that it is very realistic even for a person of modest means to save a million dollars for retirement.  To accomplish this feat, Bortolotti espouses several principles:

  • Start Early – the earlier in life you contribute to a savings plan, the better
  • Make Saving a Priority – use salary increases and employer-matching programs
  • Don’t Buy Too Much Home – avoid large investments in non-productive assets like a home
  • Don’t Buy Too Much Car – completely minimize investments in non-appreciating, non-productive assets like a car
  • Be Frugal, Not Cheap
  • Have an Investment Plan
  • Let Your Plan Evolve Over Time

Bortolotti’s article espouses very basic financial principles and should be read by novices.  They fit with the target market of the magazine and the level of sophistication of the average Canadian.  For the more advanced, the article resides within the realm of Survive Mode.

My issue with the article pertains to a technicality in ‘Let Your Plan Evolve Over Time’.  He presents three scenarios in which people at different stages in life can save a million dollars within their RRSP using different contribution rates.  Bortolotti assumes that the tax refund on the contributions will be re-invested into the RRSP with a 6% rate of return.  In each scenario, the contributor possesses a seven figure portfolio by age 65.

My issue with his analysis is that $1 million held within an RRSP is not akin to having $1 million to freely spend in retirement.  This is because all of the funds is held within the RRSP and is subject to a tax liability upon withdrawal.  While this certainly isn’t news to anybody with a basic understanding of the tax system, accounting for it using reasonable assumptions would increase the amount of contributions a person would have to make to offset the tax liability.  By increasing the contributions, saving $1 million for retirement, rather than $1 million in an RRSP, just got a little more difficult.

To be fair, accounting for this tax liability can be tricky and is obviously dependent upon a person’s particular situation.  Specifically, the overall tax liability is affected by the following factors (non-exhaustive):

  • Residency
  • Marital status
  • Timeline of withdrawal
  • What form the RRSP takes when it is being withdrawn (Annuity, RRIF etc)
  • Marginal tax rates of both partners (which is dependent upon other assets and forms of income)
  • Income splitting measures

Withdrawing from an RRSP has some parallels to withdrawing from a corporation.  Each can provide legal mechanisms to defer tax.  A person may hold real estate, a business, or other assets within a corporate structure.  However, the shareholders are limited as to how they can spend corporate funds.  For example, in virtually all circumstances, the sole shareholder of a corporation cannot use the corporation’s assets to fund a year long trip around the world, as it would be deemed a personal benefit and not in the interests of the corporation.  Similar to an RRSP, it would be foolhardy to assume that cash sitting in a solely owned corporation is equivalent to the same amount of cash held personally.  There are significant tax implications which affects how much can be flowed to the shareholder.

I will delve into these issues in future posts and on my blog at Summaticus.

Oct 152014
 

After talking about popular companies for the last couple days, I’ve had enough. I hate things that are popular. It’s like grade 9 all over again.

Instead, let’s talk about another unloved Canadian small-cap, FP Newspapers Ltd. (TSX:FP), which is the owner of several newspapers in Manitoba, most notably the Winnipeg Free Press and the Brandon Sun. It also owns a half dozen weekly community papers, along with a commercial printing division.

Yeah, it’s a newspaper. If you remember, I talked about Torstar back in the day, the parent company of the Toronto Star. I presented it as a way to profit off the Rob Ford crack scandal, all while getting paid a generous dividend. Plus, it has the highest circulation in the country, even beating out the nationally distributed Globe and Mail.

I didn’t end up investing in it, because I waited too long. I was hoping for the stock to dip below $5, but Prem Watsa showed up and announced a big stake in the company at about $5.20. I would have been up almost 50% if I would have bought then, and even 37% if I would have bought back when I wrote about it.

Oh well.

There are a lot of similarities between Torstar and FP Newspapers. Both are solidly profitable, even though revenues keep slowly declining. Both have dominant positions in their home market, and both pay succulent dividends. Both have traded at a huge discount to book value as well. And I think FP has a couple of potential catalysts that could propel the stock higher.

FP Newspapers has been publicly traded since the early 2000s (I’m too lazy to look up the exact date, but it’s been awhile). 51% of the company is privately owned, while the other 49% is publicly traded. The current market cap is $26.4 million, with 6.9 million shares outstanding. This stock isn’t as illiquid as others I’ve talked about, trading about 6,200 shares per day.

Throughout its history as a publicly traded company, PF has paid out just about all of its earnings to shareholders. It did the same while it was an income trust, and then paid out a little less when forced to convert back to a corporation. The stock currently pays out $0.05/share as a monthly dividend, good enough for a 15.67% yield. No, that’s not a typo. You’re really getting a 15.7% yield.

Well, at least for now.

2014 hasn’t been a kind year so far. Print advertising revenues have fallen by 7.7% compared to last year, while circulation revenue also took a bit of a hit. Folks are still (mostly) buying the paper, but advertisers are continuing to withdraw their ad dollars.

Of course, this problem has been going on for years, and FP is no stranger to it. The company continues to cut costs and lay off workers in interesting ways. The latest offering was giving several senior staffers an incentive to take a cash deal on their pensions. Here’s the money (plus a little extra), now get out so we can not replace you.

Earnings have been slowly declining. Let’s look at the last dozen quarterly profits, on a per share basis. Remember, the stock pays a $0.15 dividend each quarter.

  • 2014 Q2 – $0.17
  • 2014 Q1 – $0.08
  • 2013 Q4 – $0.23
  • 2013 Q3 – $0.12
  • 2013 Q2 – $0.22
  • 2013 Q1 – $0.14
  • 2012 Q4 – $0.29
  • 2012 Q3 – $0.14
  • 2012 Q2 -$0.19
  • 2012 Q1 – $0.12

We’ll stop there. You can see the gradual reduction in earnings, something that’s bound to continue over time. Therefore, investors should expect the dividend to slowly creep down. It could hit $0.04/monthly as soon as next year, but unless the business really takes a dive, it’s reasonable to expect it to continue, albeit maybe at a lower value.

Three reasons to buy

Forget the dividend for a second. Yes, it’s nice to collect, but it’s silly to buy into a company with nothing going for it but a big dividend. There are a few other catalysts that could send shares higher.

1. Paywall

This is the weaker argument, so we’ll explore it first.

In the company’s last quarterly report, management openly mused about instituting a paywall, strongly hinting that something could be happening on that front sometime soon. While a paywall will cut down traffic to the website significantly, it will also bring in steady revenue. This could help stem the tide.

The company has a sort-of paywall now, for folks outside of Canada. I did a little poking around and saw that I needed to hit 50 articles before the paywall kicked in. That seems a little generous.

A paywall would help, but it’s not a game changer by any means.

2. Strong, local brand

The circulation numbers in Winnipeg aren’t even close. Counting all print and digital sales, The Free Press is the winner by a mile, distributing 687k copies weekly. The Winnipeg Sun only manages to do about half of that, or 391k copies weekly. Metro Winnipeg is a distant 3rd, coming in at a weekly circulation of 207k. Metro is a free paper, but is printed by FP.

To put those numbers into perspective, they’re pretty much on par with the leaders in other cites with larger populations. The Calgary Herald has a total distribution of 708k, just a little higher than the Free Press, but with a significant population edge. The Vancouver Province has a circulation of 840k, but it has pretty significant competition with the Vancouver Sun, which leads it by 130k.

It’s the same thing with larger cities like Edmonton (The Edmonton Journal leads with a circulation of 583k), Ottawa (The Ottawa Citizen leads with a circulation of 661k), and even Montreal, which has more than 5x the population but its leading newspaper — Le Journal — only has a circulation 3x that of the Free Press.

Per capita, the Free Press might be the strongest newspaper in Canada. Buying the best is important in a weak industry.

3. Consolidation

Last week, Postmedia made news (heh) when it acquired Quebecor’s English speaking newspapers. These mostly include the Sun papers across the country, as well as a bunch of small community weeklies. The purchase price was $316 million, give or take a few bucks.

The reasoning is simple. Postmedia owns most of the dominant players in Canada’s major markets. It owns the Herald in Calgary, the Journal in Edmonton, the Citizen in Ottawa, both the Province and Sun in Vancouver, and so on. In most markets, the Sun is squarely in second place. The plan is to run both papers separately, while getting synergies by doing stuff like having one sales force and consolidating office space.

Does this mean FP is the next target? It makes sense, depending on how well this works in other markets.

It isn’t just Postmedia that’s consolidating the media space. Torstar owns dailies around the Toronto area, as well as a stake in most of the Metro papers across the country. Power Corporation owns 7 daily newspapers in Quebec. TC Media (a division of Transcontinental) owns 11 daily papers across the country from Nova Scotia to Saskatchewan. Even Glacier Media owns 7 dailies in B.C., including the only daily in Victoria, the Times Columnist.

FP has a market cap of $26 million, which represents half the company. It isn’t a big deal for one of these larger players to acquire it. Torstar is flush with cash once it closes its sale of Harlequin romance novels to News Corp. for $445 million. Transcontinental has a market cap of over $1 billion. Power Corporation has all the money in the world. There are plenty of potential buyers, and it makes sense to consolidate the space.

Wrapping it up

While I like the name, I think you shouldn’t be in any rush to buy it. At least, I’m not.

The stock does tend to move with the TSX, and there’s no end in sight for the slaughterfest that is the index. If I was in charge, I’d probably use this general weakness to cut the dividend to 4 or 4.5 cents, but I can understand management’s thought process in keeping the divvy intact.

When it does cut the dividend, reaction should be pretty muted. There’s still plenty of cash flow to cover a slightly lower dividend, and earnings are still holding up pretty well. Expect to see more of the same going forward — a slow deterioration of the business.

FP Newspapers offers investors the chance to invest in an income stream that should return greater than 10% for the foreseeable future. It returns 15% now, and earnings are only slowly deteriorating. If you add in the potential for a takeover, FP could be a winner. But be patient, I think you’ll be able to buy at a lower price.

 

Oct 142014
 

After identifying it as an interesting investment in yesterday’s post about Pepsi, I decided to crack open Kellogg Company’s annual report and see what was going on. What I found was a company that’s suffering from stagnant revenues, lower margins, and for some reason it had a ridiculously profitable 4th quarter in 2013. Check this out.

kellogg-profit-margins

Once you factor in that gigantically profitable quarter, the investment doesn’t look so sexy anymore. It’s also odd that the company’s 4th quarter was weak, unlike every other food company in North America. It’s also struggling with a shrinking of the cereal market in general, which is still a big part of its business even though it has diversified into different stuff like Nutrigrain bars, Rice Krispie snacks, and Pringles, which it acquired in 2012. And Eggos. Still plenty of terrible toaster waffles.

Undeterred, I kept reading. After all, many of Kellogg’s competitors are suffering from a lot of the same problems, yet they trade at a pretty significant premium in the price-to-earnings department. General Mills trades at 18 times earnings even after falling 10% over the last month, and it grew revenue all of 1% in 2013. Kellogg, meanwhile, has a P/E ratio of 11.75 times. I can endure a lot of uncertainty for an earnings multiple that’s almost 50% less than its nearest competitor. Maybe Pepsi could even throw it a bone and let it buy Quaker. (Note: there is a 0.0% chance of this happening)

Kellogg is doing a few other things right, including embarking on a pretty sizable cost cutting plan, and the other usual things, like paying out a rising dividend and buying back shares. We don’t care about a rising dividend, of course, but if it’s a side benefit to buying a business with significant upside, I’m there.

And then I discovered something that stopped me dead in my tracks. I finished the annual report, but don’t see myself investing in the name unless it gets so cheap I’m practically forced to. That won’t happen, unless consumer stocks somehow start to underperform, and dividend growth investors stop buying them.

This is what I read.

Screen Shot 2014-10-14 at 1.41.02 AM

 

…Okay. What’s the deal? Aren’t share buybacks supposed to be good?

Normally, they are. One of the reasons why I invested in Danier Leather is because the company is so aggressive in buying back shares. The company doesn’t really have a good use for its mountain of cash, so it’s using it to buy back shares that are trading at 63 cents on the dollar (although, admittedly, the company hasn’t brought back any lately).

In theory, even buying back shares of a company that trades at many times book value like Kellogg is supposed to be good. Less shares outstanding will boost earnings for existing shareholders because it increases their share in the company, all without triggering a taxable event.

And yet, when I checked the numbers, I found that the share count during 2013 decreased from 362 million shares outstanding to 358 million. What happened to the other 5 million shares?

The answer is simple. They were issued as bonuses.

The company’s top 6 execs were awarded stock bonuses worth more than $6 million. The CEO, John Bryant, took home the most, getting himself a cool $2.5 mil. The company’s chief growth officer got more than $1 million worth of bonus stock, even though he has a salary of $698k and DIDN’T ACTUALLY GROW THE G.D. COMPANY.

But wait. There’s more. The company’s top 6 managers also got stock options valued at more than $4.1 million. These can’t be exercised for a decade, but still, they exist, and they’re massive.

I dug a little deeper. Let’s talk a little about the company’s growth officer, Paul Norman. The company sent him abroad, presumably to manage the international business. Guess how much they paid him to move. $1.45 million. That’s on top of his stock options, his stock bonuses, and his $700,000 salary. All in all, Stormin’ Paul made $4.4 million to, I dunno, live in China. It’s a pretty good gig.

I’m as capitalist as they come, but I’m getting tired of this stuff. I don’t like the compensation, but I mostly don’t like the number of shares issued to management. At $60 per share, 5 million shares is $300 million in additional compensation, on top of salaries that look to be pretty competitive.

Kellogg make a profit of $1.8 billion in 2013 (which was about double 2012’s total). Is $300 million of it too much to give back to staff? I’m not sure I have the answer to that, but I’m sure most investors would rather have dividends or real share buybacks that are 15% higher than current levels. Too often, share buybacks are just a screen to partially cover stuff like this up. Keep this in mind when investing.

Oct 132014
 

(Happy Thanksgiving Financial Uproarians. I didn’t get to have a turkey dinner, so y’all can go to hell)

Oh hey, it’s Pepsi. Do you guys know I used to sell chips for that particular company? Of course you don’t, since I have literally never mentioned it in my life.

(Does a search for “chips” on FinancialUproar.com, laptop explodes)

I never commented on my thoughts about Pepsi as an investment back when I worked for them, because I knew that my limited experience with the people I dealt with would cloud my overall judgement, and because of my rule of I don’t eat and crap in the same place. You shouldn’t look for a lady where you work, and you shouldn’t load up your portfolio with your employer’s stock either. Even if they give you a discount to buy it.

(Use the discount, buy it, and then lighten your exposure to it periodically. It’s that simple.)

But I’ve been quit for a whole year now, and I haven’t begged for my job back in tears for weeks now, so I suppose it’s safe for me to talk about the company a little. I’ll try to focus on the big picture aspect of the business and less on my exposure to it.

Unlike my unfulfilled hatred of all things Coca-Cola, I’m not terribly bearish on Pepsi. I doubt it’ll outperform the S&P 500 over the next decade or two, but I think you’ll be fine to invest in it over the next few years, mostly because of something that’s bound to happen.

For the sake of this blog post, let’s divide Pepsi up into 4 different divisions. There’s the North American soda division, the North America food division, (including the chips, plus Quaker, Aunt Jemima, Tropicana, and so on), everything in Europe, and everything everywhere else. Europe does a fairly decent chip business, but for the most part the rest of the world part is mostly soda.

An activist investor, Nelson (WHOO!) Peltz, has taken a position in Pepsi that’s worth approximately $1 billion. Like all other activists, he immediately made a big show about how Pepsi was running their business wrong, saying that the food division should be separated from the soda part, which is very slow growing. Let’s take a look at Pepsi’s 2013 annual report for the deets.

Screen Shot 2014-10-12 at 12.58.47 AM

As you can see, it’s a pretty steady business, with one notable exception — Latin American foods. North American soda (which is PAB above) saw volumes decline by 3% and 4% annually over the past 2 years. The company is able to make up for it with price increases (or, depending on the product, making the packaging smaller). Even in Latin America volumes are slowing, revenue is increasing because of currency fluctuations and pushing through price increases. It’s pretty sad when the best part of your business managed a 3% increase in volume, but that’s the reality of investing in giant corporations like Pepsi. You run into the law of large numbers.

Peltz thinks the company should divide into two parts. The North American food part along with the Latin America food part would be one company, which we’ll just call Frito Lay for the rest of this blog post. All the soda would be the other company, along with the chip business outside of North America. We’ll call that Pepsi for the rest of this post.

Pepsi would have revenues of $41.3 billion, with an operating profit of $5.4 billion. Those are operating margins of 13.1%.

Frito Lay would have revenues of $25.1 billion, with an operating profit of $5.7 billion. Those are operating margins of 22.7%.

As a whole, the company has operating margins of 16.7%.

Remember how everyone says soda is the cash cow? Nope. Chips are the business to be in. It helps to not have to compete with the potato chip version of Coca-Cola.

Peltz’s thesis can be summed up in just a couple sentences. The food business has much higher margins than the soda business, which also suffers from the handicap of shrinking volumes. Because soda makes up more than 60% of the total business, the market is valuing the entire company as a no-growth soda company, instead of a no-growth soda company PLUS an exciting food company (which, frankly, only looks good compared to soda).

Peltz isn’t a rookie at this, doing the same thing to Kraft Foods just a couple years ago. Management gave in, and the company spun of Mondelez, which has to be the lamest name for a snack food company ever. (Mondelez’s brands include Chips Ahoy, Oreo, Ritz Crackers, etc., while Kraft kept the boring stuff like peanut butter and Stove Top stuffing.) Both companies trade at a higher valuation than since before the spinout, but that could easily be because of the market’s overall exuberance.

Is Pepsico really undervalued? The company combined trades at a price to operating income ratio of 14.6. We’ll use operating income because it tends to be a more true picture of what the company earns on a normalized basis. All data from here on out comes from Google Finance, so you know who to blame if it’s wrong. (NOT THIS GUY, he’s in charge of shoddy math)

Let’s take a look at Pepsi’s competitors, from a price to OI perspective:

Company Price Market Cap (B$) 2013 OI (B$) Price to OI OI Margins
Coca-Cola $44.47 $195.04 $10.72 18.19 22.9%
Dr. Pepper Snapple $64.43 $12.57 $1.046 12.01 17.4%
Coca-Cola Europe $41.54 $10.20 $0.914 11.16 11.1%
Monster Beverages $94.84 $15.9 $0.573 27.75 25.5%

The jist of the fancy table I made there is pretty straightforward. If a company has better operating margins, it will trade at a higher multiple. Monster is really expensive because of its high margins and, unlike the others, it’s actually growing. Coca-Cola Europe (which is the continent’s largest bottler) is cheaper, but it should be, based on it’s crappy operating margins. Dr. Pepper Snapple  seems to be in the sweet spot (heh), and is probably the spot where I’d put my money.

As a reminder, the soda part of Pepsi has operating margins of 13.1%. This tells us a couple of things:

  • It could probably cut costs, but it has the disadvantage of owning more bottlers than Coke.
  • It isn’t such a great business to be in, even compared to its competitors.

Now the big question. What sort of valuation would a soda only Pepsi command?

I’m going to go with a market cap of 15x operating profits. Admittedly, this is a number that I kind of pulled out of my ass, but with the following caveats:

  • It’s a recognizable name, but not considered quite as bulletproof as Coke. Therefore it would get a premium, but not a huge one.
  • It would have the potential of growth in the developing world, which would help justify the premium.
  • It’s an imperfect measure anyway because it doesn’t consider any debt the company may have, but I ain’t figuring that crap out.

So, based on an operating income of $5.4 billion and a multiple of 15x OI, I gander the soda part of Pepsi is worth $81 billion.

Onto chips

But first, words on synergies

One of the arguments folks bring up against splitting up Pepsi is the synergies the combined company gets. They point to things like a combined sales staff, putting chips and pop on the same truck, building store displays with both brands, and the ability to work together to make the whole operation more efficient.

Whenever somebody makes any of those arguments, I immediately know they haven’t a clue what they’re talking about.

Frito Lay is ran essentially as a separate company as Pepsi beverages. Chips and pop never come in the same truck because they don’t come from the same warehouse. There is not one warehouse in the company that shares space between the two divisions. There is shared office space, but it’s minimal.

Frito Lay sales reps and Pepsi sales reps work together, but not overly so. We would build “power of one” displays, when a store would have soda and chips on sale for the same time. Some of these events were planned out, but as a joint effort between Pepsi, Frito Lay, and store reps. For the most part, the benefits of these promotions was to get a store filled with product one week, and then not need it the next week. There’s value in selling product now compared to a week from now, although it’s pretty minor.

Here’s how a lot of displays work in the grocery business. Unless you’ve got a good spot and a great price, product is going to sit there. Even if you have a good price, folks are acclimated to going to the chip aisle and buying their chips there. I’ve walked into stores countless times to an empty sale item on the shelf and a full display somewhere else in the store. That’s just the way it works.

So I would take the old product from the display, move it over to the shelf, and refill the display. Because, heaven forbid, you don’t want to lose display space, no matter how poorly it’s doing. The only time this works is if the store has a great deal. Great deals come along about 4 times a year for each store (more if you’re Wal-Mart), so most of the time I would build displays for nothing.

Anyway, the point? The combined entity synergies stuff is hot garbage. Frito Lay is ran separately from Pepsi. There are two sets of sales staff. There are two separate warehouse systems, and even two separate support groups. The only time chips and pop are on the same truck is when the chip guy buys a Pepsi.

Now onto chips for reals

As a reminder, Frito Lay (and Quaker thrown in) had operating profits of $5.7 billion on sales of $25.1 billion in 2013. That’s a 22.5% operating margin, which is succulent. Let’s compare it to its competitors. Like with the soda division it’s a bit of an imperfect exercise, but we’ll do what we can.

Company Price Market Cap (B$) 2013 OI (B$) Price to OI OI Margins
General Mills $49.81 $30.07 $2.957 10.17 16.51%
Kellogg’s $60.30 $21.72 $2.837 7.66 19.18%
Mondelez $33.49 $56.46 $3.971 14.22 11.25%
Hershey $93.22 $20.86 $1.339 15.57 18.74%
Campbell’s Soup $42.19 $13.26 $1.198 11.07 14.49%

Again, all of these are imperfect competitors, but mostly because Frito Lay doesn’t have a big competitor. When it comes to chips in North America, they’re the undisputed champions.

Take a look at the competitors’ operating margins. They’re good (especially Kellogg’s, which trades at a significant discount to its peers. If you want a stock in the sector to look at I’d start there.), but they’re nowhere near Frito Lay and its 22.5% margins. I think we could almost be generous and give Frito Lay a 20x operating income valuation, but let’s be a little conservative and say 18x. Investors will be willing to pay a premium for Frito Lay because it’s growing, it has such good margins, and it’s the dominant player in its industry.

Based on 18x 2013’s operating profits of $5.7 billion, Frito Lay can be valued at $102.6 billion.

And based on 15x Pepsi’s operating profits of $5.4 billion, the soda division is valued at $81 billion. 

Currently, the combined company has a market cap of $141.65B. Split apart, I say the companies are worth $183.6 billion. 

Together, the company is undervalued by 29.6%. So if you think Peltz will be successful and split the two companies apart, you’re looking at some decent upside. I wouldn’t buy the stock based on that news, but if I was thinking of buying it anyway, it would probably push me over the edge towards buying it.

Oct 102014
 

Ah, the difference a week can make.

On September 30th, when I did the quarterly update on the Uproar Fund, MRRM was smelling worse than my underpants after a light jog. The stock had sunk to $2.60 per share, significantly below my average purchase price of $3.20. I picked up an additional 900 shares personally (as in, not included in the Fund) on October 2nd, which represented 90% of the trading volume that day. I also upped the price from $2.60 to $2.70 with my limit order.

Finally, I moved the market.

And then, after hours on the 2nd, the company came out with great earnings. Revenue was up 17.7% compared to the same quarter last year, and profit surged, from a loss of $0.02 per share last year to a profit of $0.12. Business was up, rice prices declined, the company paid off about half of its outstanding debt, and it even threw us a bone with comments about continuing the strategic review, apparently even bringing in a second party.

This is all good, and it even did it while the Canadian dollar went down, which impacted margins.

Based on the results, the stock shot up to $3.28, although not on a huge amount of volume (Although, let’s be honest, this stock never does huge volume). It did 1,000 shares that day, but that was it. I’ve been putting in bids at $3.10 over the past few days, but shares haven’t budged.

Book value is $6.99/share, and the company has earned $0.22 per share over the last 12 months. Based on a $3.10 purchase price, you’re getting the company at 14 times earnings, and that drops to just 7.1 times earnings if you exclude the company’s nearly $4 million of stocks, bonds, and other investments it holds on the balance sheet. If you believe management will eventually spin some of those investments off as a special dividend (which it has repeatedly in the past, most recently in 2012), then you’ve got to like the company here.

But please don’t buy. I don’t want the competition.

Time for links

Start things off with Nelson? LET’S GET THE SEXY OUT OF THE WAY. Over at the Fool that is Motley, I took a look at Talisman Energy, a oil company that I think has potential as a long-term turnaround. Plus, Carl Icahn owns some, and that dude is the best.

More Nelson? WHY NOT. I took a look at three struggling companies and asked if they’ll last five years. One was Sears, because it’s more worthless than Bernie Madoff’s Discover card.

Boomer and Echo asks how many stocks you should own. I won’t give away the answer, but it’s more than 1 and less than 4,039,928. I tackled this a few months back too, because everything has to be about me. What? I’m a millennial.

Here’s a guy who thinks real estate prices in Canada are going to fall 50%. That seems a little excessive, but I am intrigued and would like to sign up for his newsletter.

I keep telling you guys, it’s not that hard to get rich. It just takes sacrifices. Pauline from Make Money Your Way tells us how she’s getting roommates to pay her mortgage (and then some) in a place she doesn’t even live anymore.

And that’s all I got. Have a good weekend everyone.

Oct 092014
 

It’s Thursday, so it’s your regular addition of the other guy who writes here. His name is Eddie, and he’s delightfully mean. We’re BFFs. He blogs here

Personal finance fallacy number 4 is about to be challenged.

Here are the first three, if you’d like to read back:

 

This is another in a series questioning the wisdom of PF writers before I begin to write about more advanced concepts that will benefit readers.

Oft written on many PF blogs is urging readers to pay off their mortgage as quickly as possible.  Some more ‘advanced’ writers introduce a bit of tax strategy by using excess cash flow throughout the year to contribute to their RRSPs, then use the tax refund to pay off their mortgage.  It’s a straightforward concept that has some logic, but it is far from optimal.

Other writers justify paying off their mortgage by stating that they are getting a return from paying it off and offering their current mortgage interest rate as their ‘return’.  Paying off your mortgage sooner offers no return whatsoever, it merely lowers your cost of borrowing.  A return is only generated on an asset such as your home through payment of a dividend/income or a capital gain (selling it for more than you paid for it).  Reducing your cost of borrowing by an additional mortgage payment does not fulfill this standard.

The semantics of returns aside, paying off your mortgage more quickly as a savvy financial move ignores opportunity cost.  In other words, there are more important or lucrative things you can invest in other than lowering the cost of borrowing on your house.

A mortgage is likely the lowest cost of borrowing you will ever have because it is secured debt.  Similarly, a home-equity line of credit traditionally has lower rates than unsecured debt (a loan with no collateral) because the balance of the loan the bank makes to you is supported by the equity in your home (pardon the truism).  If you were to ever default, the bank could repossess the home and get its money back (although it’s a pain).

Pretend for an instance that you recognized that there are other options out there than putting money against your mortgage or in a RRSP or TFSA.  Examples include investing in real estate or an existing business such as a franchise.  These alternative investments will likely be funded through a mixture of equity (money that you put up) and debt (money that you borrow).  To obtain the debt financing required to fund the purchase price, the bank and/or business and property that you wish to acquire will insist on equity financing.  Since saving for this equity is likely the largest obstacle to realizing the returns from investment properties or a franchise, the accumulation of capital through personal cash flow is paramount.

The greater the cash flow you can generate, the quicker you can overcome the barriers to entry that real estate investing and franchises exhibit and the much higher returns can be had.  This is certainly not worth lowering your cost of borrowing and ending your mortgage payments in 12 years instead of 13 years.

I can certainly understand the logic to paying off your mortgage sooner.  It is usually the play for very risk averse people or those that lack the outlook or sophistication to invest in other assets or businesses.  If a more conservative approach is right for you, fill your boots; you will get no criticism from me provided it’s an informed decision.  However, do not delude yourself into thinking it’s about returns.  There are much more profitable ventures out there that generate higher returns without much more risk.  Paying off your mortgage can seriously impede the cash flows required to enter these markets and should be factored into any decision.

Oct 082014
 

Investors are divided into two camps.

There’s camp A, we’ll call TEAM STRIKE FORCE. These investors look to buy stocks that are either undervalued or that have good growth prospects (at a reasonable price). They like getting paid a dividend to wait for their investment to recover/grow, but it’s not necessary. Depending on the situation, a dividend could get in the way of the company’s plans, like paying off debt or investing in new infrastructure to help grow sales.

Then there’s camp B, which we’ll call TEAM DISCOVERY CHANNEL. These investors care about getting paid, getting paid, and, oh yeah, getting paid. Any investment without a growing dividend stream is relegated to a pit of dirty diapers, which apparently they have around for some reason. These investors are left choosing between about 90 different stocks, which are mostly dominated by the largest of the large blue chips. When asked, these investors will often say things like it’s only the income stream that matters, and they don’t really much care at all about the principal. It exists just to create income.

I was researching REITs the other day (specifically Dream Office REIT, which I’ve talked about a couple of times before). And I got to thinking about REIT accounting, because I am a boring individual.

You all probably know that REITs are designed to pay very little in taxes. They pay out more than 90% of the money they make to investors in exchange for hardly paying a dime in tax. That income is then taxed in the hands of investors.

When it comes to investors paying tax on the income, it’s not as simple as just a straight dividend. The distribution might be made up of things like other taxable income, capital gains, and reduction on adjusted cost base.

Let’s take a look at Dream’s 2013 tax form from its website as an example.

Screen Shot 2014-10-08 at 1.32.55 AM

Because so much of the company’s distribution is return of capital and capital gains, you’re looking at a pretty attractive tax bill. 53.7% of the distributions aren’t taxable at all, and just about half of the rest are taxed as capital gains.

Don’t sweat knowing too much about this, or worrying about this come tax time. You’ll get a slip from your broker that separates out the actual amounts of cash for you. All you’ll need to do is copy the numbers to your tax form, and actually mail that puppy in.

The other thing you need to know about REIT accounting is why you can’t use net income as a method for valuing REITs.

Most businesses don’t bother revaluing assets on the balance sheet on a regular basis. If a business bought a building for $1 million back in 1952, there’s little incentive for listing that building on the balance sheet for the current value. For that to happen, a business needs to book that as earnings at some point, and the business would have to pay income tax on those earnings. It’s dumb to trigger a taxable event for no reason, so they don’t bother.

(This is one of the reasons why companies will often trade at a huge discount to the value of real estate on their balance sheet, like Hudson’s Bay Co. which has been around a million, billion years. Companies lately have been trying to monetize these assets by packaging them up as REITs and reissuing them back to the market. Aside over.)

Since REITs don’t pay tax, they don’t have this problem. Using Dream as an example again, let’s take a look at its “net income.”

Screen Shot 2014-10-08 at 1.43.00 AM

As you can see, Dream’s net income got pretty close to surpassing its revenue back in 2010 and 2011.

Because it doesn’t have to worry about paying tax on the gains of its property, the company is constantly looking at the value of its portfolio. If it can book a gain, it will. Why? Because it can then distribute that “gain” back to shareholders as a capital gain. Everyone has a low tax bill this way, and presumably everyone is happy enough to not TYPE IN ALL CAPS.

Whoops.

This is also why REIT investors use a value called funds from operations to determine the stability of the payout. Essentially, FFO is just operating income less interest.

Continuing to talk about Dream, let’s take a little closer look at its valuation. Valuing REITs is pretty easy. Since the company continually readjusts the value of its properties, we can assume that the value on the balance sheet is pretty accurate. There’s not a lot of other stuff going on, so it’s essentially an easy equation.

Value of properties+minimal assets-mortgages-minimal liabilities=book value

I’ll save you the work, and tell you that Dream has a book value of $35.72 per share with a loan-to-value ratio of its properties and mortgages in the neighborhood of 50%. Meanwhile, the stock trades at $27.54. That’s a discount to book of nearly 30%.

There are a couple reasons for that. Toronto, which is one of Dream’s biggest markets, is awash in office space right now. Projections are that vacancy rates will jump somewhere into the 8% range by 2018 or so. Dream, meanwhile, is struggling a bit, with vacancy rates approaching 5%. It still makes enough to cover the distribution, but the market is skeptical, hence the company’s overly generous 8.13% dividend yield.

I’m also pretty sure that there are Canadian real estate bubble fears entering the picture here too. Most REITs don’t trade for such a discount to assets. Most don’t trade for a huge premium to assets either, which is pretty much what you’d expect.

Philosophy stuff kinda

Let’s talk about why companies trade at either a discount or premium to book value.

A company might trade at a premium to book value because:

  • Book value is old, and the value has gone up (like with real estate)
  • The assets are able to generate a dependable return of, say, 20%, which make them worth more than cost
  • A company’s competitive advantages make it worth more than just the sum of its parts
  • Investors excited about a company’s ability to generate income or potentially grow bid it up to an elevated level

You see this all the time. A company like McDonald’s or Coca-Cola isn’t worth the sum of its parts. They’re worth far more, because of all sorts of factors. Consequently, these companies have very little in terms of book value. They’re not priced that way, they’re priced on the income they can generate on those assets, which is also known as earnings.

Companies might trade at a discount to book value because:

  • The company is struggling to earn money
  • The market thinks the assets are overstated
  • The company is out of favor with investors, even though it continues to be profitable
  • The company is so small and unfollowed that there’s little demand for the shares, causing it to trade at a huge discount

You see this less often, especially when the market is doing well. Since these companies struggle to earn income, they’re priced on the value of their assets. Especially when there’s debt involved, they’ll sometimes trade at a huge discount to the value of those assets. The company will continue to get punished until income is reliable enough to value it on that, or it goes bankrupt, whichever comes fist.

Back to REITs

This all got me to thinking.

As a real estate investor, I’m interested in two things:

  1. The value of my property
  2. The value of the cash flow coming from that property

REIT investors should be worried about the same things, I’m assuming.

We’ve already established Dream Office REIT’s value above. It trades at a discount to book because the market is nervous about the future of its biggest market. Instead, let’s take a look at a favorite holding of U.S. REIT investors, Realty Income.

Screen Shot 2014-10-06 at 2.05.01 AM

I have to give Realty Income all the props in the world. These guys know who butters their toast, and they cater to that group almost exclusively.

That group, of course, is dividend growth investors. Realty Income does its part by expanding and giving the DGI crowd regular dividend increases from its relentless expansion and any slow rent increases because of inflation. The DGI crowd repays the company by continuing to give it positive press. Everyone is happy.

Because of the benefit dividend growth investors see from the company, shares have been bid up pretty high. The company pays just a 5.34% yield, and it trades at a 56% premium to book value.

Realty Income compares pretty favorably to Canada’s largest REIT, RioCan. Both primarily own retail space. RioCan has a yield of 5.5%, albeit without the stellar dividend growth. Still, RioCan did raise its dividend this year.

The difference? RioCan trades at a premium of just 4.5% of its book value.

It’s not just a Canada/U.S. difference either. American Realty Capital Properties is one of Realty Income’s largest competitors. In fact, it has a little bigger market cap. It trades at a discount of approximately 10% compared to its book value, and offers investors a yield of 8.46%.

There are a million more examples. Finding REITs in the U.S. that pay 7-8% dividends is as easy finding NFL football on a TV on Sunday.

Why does Realty Income command such a premium to book value? Because investors are overvaluing its consistent rising dividend stream.

Over the past 5 years, Realty Income’s dividend has rose 5.6% a year. Most REITs can’t do that, because they’re generally a little more stable. They don’t care about rising dividends.

The big risk with Realty Income is what happens if the dividend increases stop. Based on just about every other REIT in North America, I’d say it would crash down to pretty close to book value.

There lies the risk of paying a premium for ever increasing income. By doing so, investors are turning a company that should be valued at close to the value of its assets (because, let’s face it, there’s no special sauce when it comes to buying retail space), and valuing it because of its rising income stream. Eventually, the growth will stop, and you’ll be left holding the bag of a company that’s valued more than 50% more than the value of its properties.

That’s bad. And that’s why you should never pay a huge premium to book value to own a REIT. Even one with a rising income stream. If you want a rising income stream so badly, use the REIT’s dividend reinvestment plan to keep buying more units. More units = more income, assuming all else stays the same. You’ll get a lot of the same benefits, with not nearly the same amount of risk.