Profile - Tim McElvaine

In the 11-year period from 1997 to 2007, Victoria, B.C.-based investor Tim McElvaine returned 21% per year before fees (16% net to investors), compared to 11% for the S&P/TSX index.  Moreover, he didn't suffer a single down year, while the index fell three times.  This impressive result was achieved despite holding large amounts of cash: in fact, on average he was only 82% invested over the period.  In theory, had he been fully invested, McElvaine's gross returns would have exceeded 25% per annum.

But - and with a cutoff year of 2007 you knew there was a "But" coming - in 2008 his fund fell by almost half.  McElvaine was hardly alone in this, of course; unlike many investors, however, he has yet to rebound sharply since the end of the Great Recession.  Indeed, even after a net return in 2012 of 18.3%, McElvaine remains about 30% off his former peak.  In absolute dollars, his fund has shrunk even more dramatically, forcing him to lay off most of his already small group of staff.  Will Tim McElvaine return to his past stellar performance, or was he permanently diminished by the recent turmoil?

An 11-year run of substantial outperformance is likely long enough to rule out pure fluke.  However, in order to determine with confidence if his pre-2008 success was a streak of long-lasting good luck, or the product of skill and experience, it's necessary to look beyond just the numbers and assess the "How" and "Why" of his performance.  

McElvaine's philosophical influences include John Templeton, Ben Graham and Warren Buffett.  Peter Cundill, though, was not only an intellectual influence, he hired the young and persistent McElvaine, and mentored him first-hand.  One of the qualities that Cundill instilled in McElvaine was patience.  This helps explain why McElvaine has steadfastly - and correctly, in this writer's opinion - held on to Glacier Media.  For many years Glacier has been his largest position, but the stock has underperformed lately, and is partly responsible for his restrained post-2008 performance (in fairness, he originally paid around $0.70 for GVC, so the fact that it hasn't done anything for him lately doesn't mean it hasn't done anything for him at all).  In addition, Cundill's interest in Japan wore off on McElvaine.  Most notable North American investors must think the fallen country's nickname is Land of the Setting Sun, if they think of it at all, but McElvaine had 17% of his portfolio committed to Japan at the end of 2011.

In the manner of Graham and Buffett, McElvaine has a disciplined, multi-faceted approach to estimating a company's value, and is sure to only buy at a discount, leaving him a "margin of safety."  His own personal twist is that he likes to buy when sellers are so determined to unload their position that they "don't care about price" (p.36).  Arguably, buyers of Glacier Media have been purchasing from sellers that blindly lump the company together with the newspaper industry in general, without regard for its genuine differences.  Other cases where sellers want out regardless of price may include a stock that has been delisted from an index or distressed securities that funds are not permitted to hold.

In addition to the margin of safety, McElvaine's investing approach is similar to Buffett's in several ways: like the Oracle of Omaha, McElvaine runs a concentrated portfolio, where single positions can constitute 10% or more of his portfolio; when a stock falls, he tends to add to his position, on the reasoning that the upside is higher and the margin of safety larger; when he assesses management and directors, he ensures that they behave in the shareholders' interest, not their own, and occasionally takes a seat on the board to make sure executives don't confuse the two; and he focuses on return on capital and cash flow.

Some of McElvaine's habits and values resemble Buffett's, as well.  In describing a typical day at the office, he cites a poster that reads, "Sometimes I sit and think, and sometimes I just sit," which would delight Buffett, who firmly believes that activity is the enemy of investors.  McElvaine, like the Berkshire Hathaway CEO, has the bulk of his family's money invested in his fund, as they both like to "eat their own cooking."  And McElvaine's letters to partners, while not appointment reading for most of the investing world, are unfailingly candid and humorous.

One important area where McElvaine strays from Buffett, however, is in his willingness to own "duds" (p.45).  As he explains, "What I ideally like is a mediocre business, so to speak, that each year will be worth a little bit more primarily because of cash flow" (p.47).  Buffett, on the other hand, refuses to invest in companies without a sustainable competitive advantage.

There's a good chance that McElvaine will return to form in the future.  His success in the past was not an accident, and he has wisely remained loyal to the key ideas that have served him, and many other excellent investors, so well.  To be sure, he has tweaked a few things, such as investing less money in small caps to provide more liquidity, and diversifying into a somewhat larger number of holdings.  To his credit, however, he hasn't abandoned a formula that is likely to work over time.  And a greater commitment to buying only companies with a wide and formidable "moat" would further increase the odds that Tim McElvaine returns to his past glory.

Sources: Thompson, Bob.  Stock Market Superstars: Secrets of Canada'sTop Stock Pickers. Toronto: Insomniac Press, 2008.

Publications that can be found on Tim McElvaine's website. 

Other Profiles include investor Tom Stanley, and New Yorker writer James Surowieki.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Investing in Le Chateau - Earnings Power or Book Value

A few years ago, I invested in Le Chateau, a well-known Canadian apparel retailer, for about $9.75/share.  Seven or eight months later, after pocketing three dividend payments totaling about $0.50, I sold the shares for better than $14.00, and gave himself a hearty, self-satisfied pat on the back.  After all, 50% or so gain in eight months is an annualized gain of about 75%.  Not bad.  Not bad at all. 

But the investment was a mistake, since it was made on the assumption that the business would grow slowly, but steadily, for at least several years in the future.  At worst, I believed, the company would be able to maintain the level of profitability that it had established, then north of $1.00 EPS.  Return on equity was over 20% and a large portion of earnings were consistently being paid out as a dividend, so the downside seemed limited.

Founded in 1959, Le Chateau has grown carefully and at a manageable pace.  While the barriers to entry in apparel retailing are low, the company operates over 200 stores and has a reliable presence in all of Canada's significant cities, usually in malls.  With sales in excess of $300 million, Le Chateau enjoys the scale to advertize in a major way, keeping the company's brand in customers' minds.  Unlike most of its clothes-peddling competitors, the company designs, develops and manufactures (some of) its merchandise, giving it flexibility and shorter lead times, a valuable asset in the fast-changing world of fashion. 

Profits peaked, however, in fiscal 2009.  EPS was $1.55, which slipped to $1.22 in 2010 and $0.79 in 2011.  Unfortunately, in 2012, the company lost $0.10 per share.  Most companies stumble at some point, though, and one bad year should not be fatal.  However, the balance sheet is more concerning than the income statement: indeed, liquidity has become a major threat to the company.  A year ago, the company had $48 million in cash and investments, compared to $36 million in debt.  At present, cash and investments have fallen to just over $7 million, while debt has grown to $46 million.  The kamikaze-like stock has plummeted, recently trading at 1.53.  In market parlance, the stock is "discounting" bankruptcy. 

In fiscal 2011, the company increased access to liquidity in moderate amounts.  Fortunately, the company was recently thrown a lifeline.  In late April, it signed a credit agreement with GE Capital Canada on a 3-year, $70 million revolving credit facility.  This gives Le Chateau time and capital to attempt a turnaround.  As the stock flirts with penny territory, is it time to buy? 

Warren Buffett would likely say no.  In the past, he's remained faithful to companies and their managers through periods of sub-par performance, but he would likely conclude that Le Chateau doesn't enjoy the unbridgeable "moat" that he requires.  With few barriers to entry, apparel retailing is intensely competitive.  While clothiers have the ability to create a unique product and brand to differentiate their threads from all the rest, it's difficult to do so.  One indicator of future performance is past performance.  The company has grown steadily over decades, but the trend over the past few years has been downward.  For an investor that prefers the unchanging businesses of Coke, railroads and wallboard, the dynamic world of fashion is too unpredictable.

Ben Graham, on the other hand, might have been intrigued.  Graham looked for companies trading at a discount to tangible book value, and was particularly fond of the "net-net," or a company trading for less than working capital minus debt.  Le Chateau doesn't quite meet the second, more elevated, criteria, but it trades for a mere fraction of book value.  Indeed, tangible shareholders equity currently stands at $138 million, or $5.59/share, nearly four times the share price.  The $234 million of assets are almost entirely inventory ($119 million) and property and equipment ($96 million). 

Some balance-sheet oriented investors consider book value as more of a theoretical yardstick for measuring a company's worth, while others take it more literally.  This latter group of fundamentalists appraise what a company is worth "dead, not alive," knowing that it may indeed be liquidated at some point.  For investors worried about the company's future as a going concern, what's a reasonable estimate of the present breakup value?

The liabilities, alas, are rock-solid.  What of the assets?  While inventory is accounted for at the lower of cost or net realizable value, the second benchmark is only an estimate: the company was forced to write down the value of inventory in each of the past two years, and may yet have to write down more to sell it.  Only time will tell what it's actually worth.

The property and equipment consists mostly of leasehold improvements, furniture and fixtures.  It's impossible to tell what they would fetch in a fire sale, but it would be wise to assume a number far smaller than what they're being carried for.  This is not to suggest in any way that assets are being accounted for aggressively, but it's difficult to tear fixtures out of a store built specifically for a particular company and receive full value for them.

Some investors are attracted to a discount-to-book-value style of investing because they view it as easy.  After all, one only has to compare book value to market value, which allows for hassle-free, computer-based screening.  Certainly, there are cases where a company is sitting on valuable real estate that's not needed for its operations, or has set up shop in a ritzy building that could be monetized in a sale-leaseback.

But this method of investing is not always so straightforward in practice.  With few exceptions - Peter Cundill and the late Walter Schloss, to name two - today's value investors use Buffett's more expansive, earnings-based definition of "intrinsic value," rather than Graham's asset-based conception of value.  The "margin of safety," buying at a discount from value, is timeless, but in most cases "value" lies in the earnings power of a business, not the assets.

Conclusion

The future of Le Chateau is unclear.  If it returns to even half its former level of profitability, the stock will appreciate handsomely.  Indeed, at EPS of 0.60-0.75, the company currently trades at a mere 2x future earnings.  If it fully reclaimed its former glory, just the dividend would pay out that amount every year. 

2012 will be about reducing inventory, cutting costs and correcting fashion mistakes.  Year end inventory was 39% of sales in 2012, compared to 29% in 2011 and 18% in 2010.  The company intends to bring this proportion down to more normal historical levels, which will require margin-squeezing markdowns.  On the plus side, the rise in inventory explains most of the company's rising debt, but as inventory falls, debt is expected to decrease, too.  Le Chateau's capital expenditures will fall to $6.5-8.0 in 2012, far less than the $20-25 million of recent years, and depreciation and amortization will likely be around $20 million in 2012.  If the company posts modest losses on a net income basis in 2012, it should at least be cash flow positive.

Le Chateau's long-term performance has been impressive, the short-term has not.  It's unsettling how quickly the company's recent short stumble left them desperate for liquidity.  Would-be investors in Le Chateau must invest in the company with the expectation that it can turn things around, and cannot depend on liquidation value as a backup.  First, it's not easy to arrive at.  Second, whatever it's worth today, it would surely diminish if the company continues to struggle.  The best approach for investors is to find businesses with durable competitive advantages whose future earnings can be roughly predicted.

Disclosure: The author did not have any position in Le Chateau at the time the article was published.

Sources: The company's most recent MD&A, Financial Statements and Annual Information Form, which can be found at sedar.com

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Book Review - There's Always Something to Do: The Peter Cundill Investment Approach, by Christopher Risso-Gill

In 2011, Christopher Risso-Gill published There's Always Something to Do: The Peter Cundill Investment Approach, the first and only book about one of finest Canadian investors in history.  Risso-Gill observed Cundill from a front-row seat, serving for a decade as a director of the Cundill Value Fund, which returned a hair above 15% annually for 33 years.  The author's personal and professional proximity to his subject allows for a detailed look at an excellent career.  Risso-Gill draws on the vast paper trail that Cundill left behind, giving readers a first-hand look at Cundill's thinking. 

In crystal-clear, economic prose, Risso-Gill brings Cundill to life, with the help of many long, direct quotes from Cundill's journal, excerpts from letters and speeches, and scraps from notes and memos.  Risso-Gill outlines the trajectory of his career, from his early days managing a tiny fund, to his time as renowned all-star; discusses the people Cundill forged business, political and social connections with; and includes interesting anecdotes along the way.  Cundill had a razor-sharp mind and a wide-ranging curiosity.  Indeed, he gleaned wisdom from a range of sources including Inuit folk sayings, Korean potters, and the hard-to-fathom facts of astrophysics.  An avid runner and athlete, he also augmented mental fitness with physical health.

Most importantly, the author illuminates Cundill's investing tenets and philosophy, and gives examples to show the interaction between theory and practice.  His revelation came when he learned of Ben Graham, Warren Buffett and the concept of the "margin of safety."  The margin of safety is a simple idea: buy a business for less than its true value.  It reduces risk, Graham noted, by allowing for miscalculation or bad luck.  After all, the cheaper a stock is the less room it has to fall.  Cundill liked businesses that had "escape hatches": inventory that could be monetized, spare real estate, rainy-day investments etc.  Buying cheap not only reduces downside, it increases upside: eventually a stock will reach its true value, and the steeper the climb, the higher the profit. 

The book features many examples of Cundill's investments: Grahamian net-nets, including an operating copper mine, debt-free and trading at a discount to working capital; stocks selling at a discount to the sum-of-the-parts; shares oversold on short-term negative news, such as luxury-seller Tiffany's in the depressed 1970s; companies with hidden or misunderstood assets; multi-layered holding companies, with assets hidden within assets; distressed debt, especially during the Savings and Loan crisis; companies reorganizing through the bankruptcy process; sovereign debt, including that of several struggling Latin American countries in the early 1990s, and so on. 

Most of these investments had one thing in common: a healthy balance sheet.  However, Cundill was not a passive investor familiar only with the ink-on-paper details of the balance sheet: he also became intimately familiar with factories, real estate and other hard assets represented by the official filings.  In addition, he considered a company's profitability, its price-to-earnings ratio, and whether it paid a dividend.  To a lesser extent, he studied management and tried to get a feel for a business's culture.  But he never lost sight of assets and financial position of a company.

Investors learn from failure just as they do from success.  Fortunately, Risso-Gill discusses Cundill's mistakes, such as when he underestimated the time and trouble it would take to move LTV Corporation, a large steelmaker, through bankruptcy.  As all investors do, Cundill suffered through a soft patch in the early 1990s, which affected his mood, confidence, even his decision making.  In a testament to just how rattled he'd become, Cundill meditated upon one of Nietzsche’s darkest warnings, "Gaze not too long into the abyss, lest the abyss gaze back at you."  He wisely remained faithful to his proven approach, and in 1993 his fund jumped 43%.

Investors must decide not only what a company's worth today, but what it'll be worth tomorrow.  Cundill watched for companies that "burned" cash, since money wasted reduces intrinsic value.  Liquidation value is an appraisal of what a company's worth dead, not alive, but companies in mortal danger will rage against the dying of the light, rather than quickly and quietly going under.  Straightforward analysis, then, must be complemented by meta-analysis: how safe is the margin of safety?  Cundill's biggest failure involved a cable company that looked sound upon investment, but later destroyed value by making foolish acquisitions.  The mistake was largely responsible for the fund's 11% loss in 2002.  In response, Cundill encouraged more dissenting voices when debating the merits of an investment.

Understanding that value investing applies across geographies, Cundill became a globe-trotting international investor.  In addition to investing in North America and the UK, he was particularly active in Japan, where he first invested in 1985, later shorted the Nikkei when it became wildly overvalued, and finally reversed himself again and went long after it crashed; in Sweden, he toured Volvo's factory and test-drove one of its cars before buying the company's shares; he invested in Latin America in the early 1990s; he put capital in riot-stricken France in the mid-1990s; he even put some money into the oilfields of sub-Saharan Africa.  In short, Cundill found value in far-off lands, where most investors fear to tread.

Warren Buffett, Ben Graham's only A-plus student, far surpassed his teacher, partly by expanding the definition of "intrinsic value" from a narrow focus on the balance sheet, to the earnings power of business.  But two of Warren Buffett's investment requirements - a return on equity of 15% or more, and the presence of a durable competitive advantage - are scarcely even mentioned by Cundill.  That a modern investor could ignore them and succeed affirms the timeless power of the margin of safety, the idea that made Cundill's career.

Book reviewers are supposed to find something, anything, to quibble about.  But this book is a triumph.  Risso-Gill breathes life into Cundill the man, covers his entire career, places it in its social, political and business context, and outlines his philosophy.  The book is more than a biography of ideas, though: it's also of practical value to investors.  Risso-Gill manages a delicate balance: he discusses Cundill's investments in enough detail to be useful to investors, but avoids offering a dry, lifeless series of case studies.  As well, following the main body of the text are a grab-bag of terms, a glossary, and appendices that include a net-net work sheet to assist investors.  Most impressive is that Risso-Gill is a first time author.  Often, first books are as much about the author's potential as the work itself.  However, this fine book is not about promise, but fulfillment.

Source: Risso-Gill, Christopher.  There's Always Something to Do: The Peter Cundill Investment Approach.  McGill-Queens University Press, 2011.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.