Passive Investments such as Index Funds and ETFs are Only the Second-best Solution

Passive investing with index funds and ETFs is experiencing a real boom. There are good reasons for this, but passive investing still remains the second best solution. We describe the best solution in this article – it will surprise no-one…

On August 31, 1976 the American John Bogle launched the first index fund, the Vanguard 500 Index Fund. Passive investment was born. Probably no-one suspected at the time how successful this approach was to become.

The idea is very simple. Instead of actively choosing the stocks one holds, one replicates an index by holding all of the securities that it contains in proportion to their weight in the index. Thus Bogle simply bought the stocks in the Standard & Poor‘s 500 Index, this being one of the most widely used by American investors. It contains 500 of the most important stocks and covers 75-80% of the American stock market capitalization.

Passive investors avoid the costs of a research department. Large index funds thus have annual management fees of 0.1-0.4% per annum, which is significantly less than the 1.0-2.0% for actively managed funds. Transaction costs are low, too, as stocks need only be bought or sold in accordance with money in- and outflows and when the composition of the index being tracked changes. Another advantage of index funds is that one may be relatively sure that a fund will achieve pretty much the same return as the index year in and year out. A few years ago the Exchange Traded Fund, in short ETF, was introduced. When ETFs invest like index funds, which most of them do, they also counts as a passive investments. However, they have the advantage that they can be bought or sold anytime on the market.

Passive investments are becoming increasingly popular. Thus the share of stock ETFs traded on the Swiss market climbed from 9.6% of the volume of all mutual funds available for sale in Switzerland, resp. CHF 21.7 billion, in 2009 to 14.1% or CHF 47.5 billion in 2014. It is estimated that already one-third of all institutional assets in the US (pension funds and insurance companies) are invested passively.

In the last years the trend has accelerated, as the graph below shows. Thus in the US actively managed funds had to accept net money outflows of a few hundred million dollars (green), while index funds (orange) and ETFs (blue) gained correspondingly.

Cumulative flows to and net share issuance of domestic equity mutual funds and ETFs, billions of dollars; monthly, 2007–2013
Source: The Investment Company Institute

The reasons for this behavior are evident. As countless studies about the performance of actively managed funds have shown, most funds return 1.0-2.0% points less than their index. Due to career risk and cognitive biases (see our article from 20.12.2013), most active managers end up closely following the index, thus more or less matching its performance before expenses. Their funds’ relative underperformance can be explained by their total expense ratios, TER, which measure administration costs in relation to net assets. (TER does not, however, include the upfront loads which serve to finance an often expensive distribution system, thereby further reducing investor returns.) In our blog entry of 25.9.2013, “A fund’s long-term track record is an indicator of future outperformance”, we showed that the 359 global equity funds available for sale in Switzerland with a ten-year track record, out of a total of around 1’600, the great majority underperformed the MSCI World Index and the average annual return lay 1.4% below the MSCI’s.

As the costs of index funds are significantly lower, their performance over longer periods of time is almost automatically better than the average actively managed fund’s. Assume that 30 years ago you had invested CHF 1’000 in a global equity index fund with an expense ratio of 0.2%. Your portfolio would be worth CHF 6’190 today (annual average return of 6.27%). If you had put your money into an actively managed fund with a TER of 1.4% that just managed to match the index, before fees, that figure would be CHF 4’420 (5.08% interest rate). Thanks to the cost savings of 1.2% annually, your portfolio would be 40% higher if it held the index fund. By the way, it would have amounted to CHF 6’550 if you had not had any expenses at all.

So does that mean that one should only invest in index products? The answer is yes and no. It is certainly better to invest in an index fund than a typical active one with high expenses that ends up following the index anyway. But if one is reasonably certain of having found a fund that beats the index over time, then that is the best solution.

The trouble is that it is not easy to find such funds, because there are very few of them, as recent research covering the period from 1984 – 2006 by Eugene Fama and Kenneth French confirms. That makes index funds a very attractive option for someone who does not know a good manager and lacks the time or interest to find one.

If one simply chooses a fund that has done well in the recent past one is likely to be disappointed. The reason for this can be found in the laws of statistics: because the fund universe is very big, there will always be a few random winners, even over longer periods of time. But these lucky fund managers often do especially poorly in subsequent periods.

However, there are some funds that have truly beaten the odds, indicating that their managers are indeed adding value. Interestingly and of comfort to us is the fact that there are a great deal of value funds among them and that vice-versa many value investors have achieved above average returns. In his highly interesting book, “Stocks for the Long Run”, Jeremy Siegel notes that of the 86 American mutual funds which survived the period from 1972-2012, the Sequoia Fund has the number one rank with a yearly average return of 14.2% (by comparison the S&P 500 index returned 10.1%). This fund is managed by Bill Ruane, a student of Benjamin Graham’s, who is the father of value investing. Of the other nine, four followed the value style and were ranked two, four, six and seven. That is especially interesting because there are more growth than value funds in the US.

We have some indications that the situation is similar in Switzerland. Among the 65 global equity funds that have been in existence at least as long as the Classic Global Equity Fund, there are only a handful of value funds, of which only four are of significant size: the Classic Global Equity Fund, the Acatis Aktien Global, the Tweedy Browne International Value Fund (CHF) and the GAM Global Diversified. However, these four hold the ranks of two (Classic Global), four, six and seven in terms of performance from 16.12.97 to 24.2.15!

Obviously some non-value funds have also done very well over time. That raises the interesting question of what these managers have in common with successful value managers, if not the investment style. Unfortunately, we can only answer the question based on our very limited knowledge and by no means definitively. The top performers from Siegel’s list all worked for independent and smaller companies or, in the case of Peter Lynch at Fidelity, within their large organizations enjoyed an enormous amount of autonomy to pursue their investment strategy. Also, they were very clear about what this strategy was. We think an investor should look for those characteristics in any active fund.

The advantage that value investors have is that the style takes advantage of a systematic mispricing in the market, the circumstance that the market and some of its sub-segments tend to make exaggerated moves on both the up- and the downsides (on this topic see our article from 30.11.2013, “What does the 2013 Nobel Prize for Economics have to do with Value Investing?“). If one invests in the index, then one automatically and fully participates in these bubbles and crashes. If, however, one systematically invests in undervalued securities, then one avoids the overvalued shares and profits from the fact that the cheap ones tend towards their intrinsic values over time. This results in long-term outperformance against the market as a whole: the so-called value premium.

A great number of academic studies have re-confirmed the existence of the value premium, as the table below shows. In these studies the performance of shares that are especially cheap on a fundamental basis (value stocks) is compared to that of fundamentally highly valued stocks (growth – as a rule taking comparing the 20% of shares that are cheapest with the 20% that are most expensive). The value-premium versus the market as whole – that is, the index – is thus half as high as the premium of value versus growth.


In sum, well managed value funds are tried and proven instrument that ought to appeal to rational investors.

The above post was originally published on the blog of Braun, von Wyss & Müller.

Annual Investment Review

It has been quite a while since my last (/first) year-end letter! That missive was penned following a successful year of investing for my personal account in 2010, and led directly to a terrific opportunity that kept me out of the market and under a cone of silence for the next several years. With the cone now removed, I am free to write to you once more. I have also taken to tweeting @tobyshute, which has proven an unexpectedly rich source for new connections and ideas.


I’m not able to present a tidy high-level performance review for 2014 as I did in 2010, because I wasn’t in the market for the entire year, and I was managing different family accounts for different periods of time. Things didn’t really kick off in earnest until my wife handed me the keys to her 401k rollover, which I parked at Interactive Brokers (Nasdaq: IBKR) – IB for short, and more on those guys later. That account got funded on July 8, and from that point through the end of the year my managed accounts collectively returned 7.8%. It was an unspectacular but entirely satisfactory result.

Most important, within the IB account I succeeded in following my wife’s investment policy statement. It’s a rather dark spin on Buffett’s Rule No. 1: “Don’t lose this money, or I’ll kill you.” So far so good, honey!

I incurred my fair share of realized and unrealized losses in 2014, but most were of the paper cut variety and on balance things worked out alright. I’ll adopt the approach of my friend Eric Burnside and start off with the things that didn’t work. Interestingly, none of the top three detractors from performance was a stock pick gone awry.

Dollar Domination

My costliest activity in 2014 – at least in terms of impact on the P&L between 7/8 and 12/31 – was diversifying internationally. While the underlying performance of the foreign-denominated securities I purchased was positive, the FX translation on those securities plus cash held in other currencies robbed a full 2% of performance from the IB account. (My family’s other accounts don’t have such globe-trotting capabilities, and were thus inadvertently insulated.) The dollar rose against every major currency for the first time since 2000, and both emerging markets and developed international markets collectively fell for the year, albeit gently compared to their double-digit declines in 2011.

The lesson here? There’s none that I can discern. Currencies will fluctuate, and I’m not about to stop scouring foreign exchanges for miss-priced securities. As long as I don’t do something remarkably stupid like taking a leveraged short position against the Swiss franc prior to it getting unpegged against the euro, I should be fine.

Hedging: A Waste of Time, Most of the Time

A second rather expensive choice was my attempt to hedge out some market exposure by owning RWM, an ETF that returns the daily inverse of the Russell 2000 small cap index. While flawed, this seemed like the best instrument for the job, given my inability to short stocks or purchase put options in our retirement accounts. As it turns out, this wasn’t a job worth doing, and the hedging activity detracted 1.4% from performance across all accounts.

I bought put options on IWM, the Russell 2000 ETF, back in ‘07-‘08 and that was a pleasantly profitable experience. It made me feel smart and prescient. Since then, all my index-based hedging activity has been a drag, and has more or less negated all of the profits generated by those earlier put purchases. I would expect this to be the general pattern over time: regular losses as the market marches onward and upward, roughly offset by the occasional burst of profitability following a panic or crash. This is probably not a great use of my time or money.

The Seductive Allure of the Cheap Stock Trade

The third-biggest drag on my 2014 performance was over trading. This has not been an issue for me in the past, and I can chalk it up to at least three causes. One is that I had not been actively investing for the FA for several years, and one could say I was a bit trade-deprived. Pulling the trigger felt good, and I got a little trigger-happy. Second, most of the money I am managing now sits in retirement accounts and is either not taxable or tax-deferred, so I am more likely to take short-term profits. Third, commissions on the IB platform generally run $1 (unless you buy large blocks of low-priced stock or shares on foreign exchanges, both of which I did). The remarkable cheapness of and ease of execution on this platform can have a real influence on your trading activity if you allow it to.

Some of this more active trading was helpful, as I was able to cost-effectively scale in and out of positions rather than try to get the low or high tick in a single trade. I also established some small “getting to know you”-sized positions – a number of which I exited upon further research – with minimal frictional costs attached. On balance, though, I placed far more trades than necessary, and total commissions detracted 1.3% from performance across all accounts. That’s unacceptably high, and cost me more than any single stock selection, excluding the inverse ETF discussed above.

Two Stocks Not Well Bought

Rounding out the Flub Five were two stock picks that went south and are unlikely to recover any time soon. I’m choosing to omit a warrant position that is marked at a significant loss, but which is inherently more volatile and in which I have a great deal more confidence going forward.

First was Evolution Petroleum (NYSE MKT: EPM), a small cap E&P that I recommended to Motley Fool Special Ops members back in 2010 at ~$5/share. The thesis played out well over the ensuing years, with EPM pushing up into the low teens as the enhanced oil recovery project in which the company holds an interest progressed. Not everything has gone according to plan, but the plunge in crude prices was by far the biggest reason for EPM’s tumble to $7.34/share at the close of 2014.

Given this exogenous event, I wouldn’t necessarily characterize this investment as a mistake. Taking a concentrated position would have been, given Evolution’s dependence on unpredictable commodity prices, but position sizing helped limit the damage to a 1.1% loss across accounts.

Second was Altisource Portfolio Solutions (Nasdaq: ASPS), a technology company that provides mortgage- and real estate-related services to related party Ocwen as well as other real estate market participants. This purchase was an unambiguous error of commission.

At the time of purchase, Altisource struck me as an appealing platform business with high margins, low capital requirements, and recurring revenue that was locked in over a long contractual period. At ~7x expected cash earnings, the valuation on ASPS seemed to more than adequately discount for the cloud of regulatory uncertainty hanging over the company’s head.

The Ocwen complex had come under great regulatory scrutiny, in part owing to an issue with backdated notices of default being sent to homeowners. With ASPS down from $170 to $50, and with the company having repurchased boatloads of stock at the $100 level during Q3’14, I thought it was probably safe to walk into this burning building. It was not long before flaming timbers proceeded to pummel me from above.

Founder Bill Erbey stepped down from all of his publicly traded entities a few days before Christmas, suggesting at least the possibility of some serious impropriety, and ASPS ended the year at $33.79. I’ve lost count of how many shoes have dropped here, but after a number of additional events in recent weeks, the stock is now trading below $20. ASPS detracted 0.8% from performance in 2014, which understates the (unrealized) damage done through to the present date. While the range of possible outcomes here is wide, Altisource is likely to make a repeat appearance in the lowlights section of my 2015 letter.

Bullets, I’ve Dodged a Few

In the close calls category, I will place Jason Industries warrants (Nasdaq: JASNW), Quarter Merger Corp rights, Pangaea Logistics Solutions (Nasdaq: PANL), and Rayonier Advanced Materials (NYSE: RYAM). These are all investments I made and then quickly sold, avoiding 30%+ subsequent drawdowns. RYAM produced a small loss partly offset by an even smaller gain on JASNW, while the combination of Quartet and Pangaea (the former was a special purpose acquisition company that became the latter following the consummation of a deal) produced a material gain. I was profoundly lucky to escape from that debacle with profits on two separate occasions – and I got to meet the talented Jacob Ma-Weaver in the process.

In the case of Rayonier Advanced Materials – one of many spin offs that went sour in 2014 – the stock is off ~47% since I sold it for a small loss after reevaluating their end markets, competitive position, and integrity of management. Rayonier AM looked attractive as a spin off with high orphan potential, as it was likely to be cast off by yield-seeking investors in parent Rayonier (NYSE: RYN). The former parent CEO moved to the spinoff, which was a promising signal.

RYAM makes cellulose specialty fibers, a significant use of which is cigarette filters. This is the first product listed in the company’s information statement on Form 10, which discloses that over half of sales for the prior three years were tied to this end use. Searching for the word “cigarette” on the company’s website turns up zero results, however, and the image of a cigarette is certainly not included among the ten products pictured on the site’s “Our Fibers In Your Life” page. I’ve seen plenty of misdirection and misrepresentation by companies over the years, but this is a pretty flagrant case. The unveiling of this whitewashed website was a big contributor to my decision to jettison the stock, along with other minor issues like industry over capacity and the fact that cigarettes are horrible. That sale helped me avoid a 0.5% hit to overall performance through year end.

Chicken Dinner

Reflecting a relatively diversified portfolio (see my wife’s investment policy statement and you will understand the gravity of running a highly concentrated portfolio on her behalf), 2014 saw 13 different investments contribute at least 0.5% to performance, or 14 if I count the Quartet/Pangaea combo. I will just touch on a few here.

My biggest winner in 2014 was also one of my most bitter disappointments. I had very high conviction in the quality and growth runway of the core energy brokerage platform business at World Energy Solutions (Nasdaq: XWES). This business quality was obscured by both a crummy secondary division and an accounting restatement that obscured the earnings picture for over a year. I was pretty lukewarm on management, but some activist shareholders came in and started agitating for change, such as focusing on the core business. I agreed 100% with their concerns, and hoped to see a sale of the inferior energy efficiency business. Instead, management shopped the entire company, and they accepted an all-cash bid from EnerNOC (Nasdaq: ENOC) that I felt significantly undervalued the company and stole material upside away from XWES shareholders. No other bidders emerged during the go-shop period, however, so I had no choice but to sell in late December.

A secondary frustration here was that my position sizing was too small for a Best Idea at less than 7%. I realized this by late October, but as I sought to increase the position I encountered an evaporation of liquidity. I was able to purchase all of seven shares on 11/3 and 31 shares on 11/4, the day that XWES was halted after hours pending the announcement of the cash bid. The position contributed a gain of 3.1% across my managed accounts. I’m getting annoyed all over again, so let’s move on.

The second biggest gain for the year came from a position that I continue to hold, and which has risen many times over in value here in the first month of 2015, such that it is now up nearly 750% from my cost basis. It’s a bit surreal. Then again, I bought this stock with the expectation that it could rise at least 20 fold, so the performance is not exactly unexpected, and I’m not selling any. I’m sure I will have a lot to say about this one next year (unless there is a clamor for quarterly letters!), but for now I’ll just thank Thomas Braziel for putting me onto the scent here.

Rounding out the top five P&L contributors are an odd lot tender offer, an NOL shell, and the aforementioned Interactive Brokers. I am mildly embarrassed to admit (to you and to myself) that two of the most lucrative investments I made all year required practically zero analysis. Then again, there are no extra points awarded for difficulty. On June 11, CBS (NYSE: CBS) announced the split off of billboard company CBS Outdoor Americas (NYSE: CBSO), enabling the parent to offload the remaining 81% of the company it still owned following an IPO in April. This was achieved via an exchange offer that allowed CBS shareholders to tender their shares and receive CBSO shares at a 7% discount on a tax-free basis.

This is free money, and it’s called an odd lot tender offer because of the following key provision:

Proration: If the exchange offer is oversubscribed and CBS cannot fulfill all tenders of CBS Class B common stock at the exchange ratio, then all shares of CBS … that are validly tendered will generally be accepted for exchange on a pro data basis in proportion to the number of shares tendered. We refer to this as “proration.” Stockholders … who beneficially own “odd-lots”(that is, less than 100 shares of CBS Class B common stock in the aggregate) and who validly tender all their shares will not be subject to proration.

As long as you tender no more than 99 shares into such an offer, you are guaranteed to have them all accepted. That is what I did, and I made a ~11% return on the position in about a week. That was good for a 1.8% contribution to overall performance, which tells you what a short stack I’m playing with. This kind of opportunity doesn’t scale well, but so long as I’m not managing multi-millions I will continue to keep an eye out for similar situations.

The NOL shell that will remain nameless was one of several that I purchased in 2014. These are companies with no remaining business operations, but with some cash on hand and substantial net operating losses available to offset future taxable income. I continue to hold several of these stocks, which in some cases offer a more or less free option on a deal being consummated. ALJ Regional Holdings (OTCMKTS: ALJJ) is the Platonic ideal of such situations.

I criminally undersized my position in ALJJ, and this position sizing error kept the stock just outside of the winner’s circle of top five contributors. Instead, fifth place goes to Interactive Brokers. Unlike the more esoteric, “early Buffett”-style situations I tend to invest in, IBKR is more of a “late Buffett” value investment: great business, highly skilled and well-aligned management team, attractive price. The firm’s brokerage business — which generates most of the profit at this point despite the firm’s origins as a market maker — is growing like mad, especially in Asia. Based on its low cost and superior execution, I expect the firm’s market share gains to continue at a strong clip for a long time, both among individual traders and in the RIA/hedge fund space.

One of the biggest reasons IBKR is mispriced is the fact that it is majority owned by insiders, which results in a low “free float” of shares available to other investors. This situation keeps it under followed by sell-side analysts and under-weighted in popular stock indices. I recommend reading Murray Stahl’s writing for more insight on such situations.

A Public Pitch

Another of my favorite compounder-type ideas for the years ahead is Westaim (TSXV: WED), which I had the privilege of presenting to an esteemed audience of discerning value investors in January of this year. My write-up was published in the January issue of The Manual of Ideas, and my audio presentation was made available to attendees of ValueConferences’ Best Ideas 2015 online conference. I owe many thanks to the Brothers Mihaljevic for the opportunity; they are true gentlemen. I have attached the excerpt from the publication along with this letter.


While 2014 presented more than its fair share of personal and professional challenges, it was a year in which I formed a lot of new relationships that I value highly. After cobbling together my addressee list, I see that I also lost touch with many of you over the past few years. I hope this note prompts us to reconnect.

I had some interesting new experiences last year, such as presenting an investment idea at the High Church of Compounding Machines (the stock remains stubbornly above the level where I believe it should be bought), calling up a large number of hedge funds to see if anyone wanted $200 million to manage, traveling around Italy with a toddler, and running on a dissident slate of nominees for election to the Board of Directors of a public company. I look forward to more opportunities to learn, grow, and challenge myself in 2015.

On a personal note, my family is actively seeking to relocate to Denver this year, and I would appreciate any and all personal introductions, job leads, daycare leads, Mexican food recommendations, etc.

This post has been excerpted from Toby Shute’s 2014 Year End Letter .

The content of this website is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, principals and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated on this website. This summary is meant in no way to limit or otherwise circumscribe the full scope and effect of the complete Terms of Use.

In Depth Analysis: Westaim (Toronto: WED)

A few years after graduating from Rice University with a degree in cultural relativism, Toby initially parlayed his budding passion for investing into a contractor role with The Motley Fool. He penned over 1,000 articles for over the course of several years. He also contributed investment ideas for a period of time to Motley Fool Special Ops, a special situations-focused newsletter helmed by Tom Jacobs, the Mentor of Marfa. Toby left the Fool in early 2011 to consult for Zeke Ashton at Centaur Capital Partners, the investment advisor to a long/short hedge fund as well as a total return-oriented mutual fund. He wrapped up his stint with Centaur in mid-2014, and has since performed contract research for a variety of funds and newsletters while seeking a new analyst/PM opportunity. He and his family currently reside in Washington, DC.

Price: C$3.05. Shares out: 70.3M. Potentially dilutive securities: 5K deeply OTM options and 2.375M recently granted RSUs payable when vested in cash or shares. Market Cap (basic): C$214.4M. Net Cash: C$94.9M. Non-capital losses (expiring 2026-2034): C$45.6M. IFRS Book Value: C$185.9M. Adj. BV (HIIG marked at 1.0x BV at 9/30/14 FX rate): C$191.6M. P/Adj. BV: 1.12x (All per-share figures are presented on a split-adjusted basis to reflect the 50:1 share consolidation effected 10/1/13, and all dollar figures are in USD unless denoted otherwise.)

Summary Thesis

Westaim is a Canadian investment company that partners with management teams by providing capital and strategic expertise to businesses, primarily within the financial services industry. Its goal is to maximize intrinsic value per share over the long term.

Book value is split ~50/50 between cash and a 37.7% interest in Houston International Insurance Group (HIIG), a private U.S. specialty insurer run by Stephen L. Way, the founder and former CEO of HCC Insurance (NYSE: HCC). Way skillfully ran HCC for over three decades before leaving in the wake of an options backdating probe. HIIG is his second act. Westaim already hit one homerun with Canadian specialty insurer Jevco, achieving a ~29% unlevered IRR on the investment. Given its discounted purchase price (~87% of book value) and Stephen Way’s track record, I believe Westaim’s HIIG investment will also compound at a very high rate. The firm is cashed up and on the hunt for opportunistic investments.

Following Jevco and HIIG, I am excited to see management’s third act. Cameron MacDonald led value-oriented investment firm Goodwood as CEO for a dozen years before dedicating his full energies to Westaim. He and other insiders own 15.9% of the company, making for strong alignment with outside shareholders. Importantly, Cam purchased the vast majority of his stake, as did Chairman Ian Delaney. I believe the opportunity to partner with this management team (and, indirectly, HIIG’s) at a modest premium to adjusted book value is a very attractive one.

Inauspicious Origins

Originally an advanced industrial materials R&D shop, Westaim was capitalized with ~C$180 million of cash and spun out of Viridian (f/k/a Sherritt Inc.) in 1996. Ten years later, the company had largely narrowed its focus to two majority-owned businesses, iFire Technology and Nucryst Pharmaceuticals. Though their divestiture would yield nearly C$40M in cash in the 2008-2009 period, these ventures were essentially failures, and investor aversion was understandably high. Still, Westaim had a strong balance sheet and tax assets, leaving it deeply undervalued during the crisis.

Enter Goodwood

In December 2008, Toronto value shop Goodwood filed a 13D (Westaim was then dual-listed on the NASDAQ) indicating a 19.8% ownership stake, acquired for a whopping $4.4 million. Two Goodwood officers, Chairman Peter Puccetti and then-CEO Cameron MacDonald, were promptly invited to join Westaim’s Board, which they did.

In its 2008 annual report, Goodwood outlined Westaim’s straightforward appeal: at an average cost below C$12/share, Goodwood was paying less than net cash. The fund managers laid out their go-forward plan as well:

We are looking forward to working with the Board of Westaim (of which we are members) in finding opportunistic situations in which to invest Westaim’s capital and grow shareholders’ equity at a meaningful pace. There are high-return transactions that can be pursued in a concentrated manner through Westaim given its capital base is permanent. Ultimately, the shareholders of Westaim and the unitholders of the Goodwood Funds will best be served by maximizing Westaim’s non-cash holdings (in particular, its tax loss carry forwards and 75% interest in Nucryst Pharmaceuticals) and finding new avenues of long-term, profitable growth.

There is a lot to salivate over in that one paragraph! Cameron MacDonald became CEO of Westaim in April 2009, and he has been pursuing the strategy laid out above ever since. Cam ended his 12-year engagement as President and CEO of Goodwood Inc. in December 2012, leaving Westaim as his principal focus. To be clear, he was not a portfolio manager at Goodwood, so that firm’s track record largely belongs to founder Peter Puccetti, and is not especially relevant to the thesis here. Here’s a snapshot of the inception-to-date performance anyway:

1(That’s a 10.14% net compound return vs. 7.88% for the benchmark, for a solid 226 bps annualized outperformance since inception.)

Prior to Goodwood, Cam had a long career in wealth management, first at CIBC Wood Gundy and then at Connor Clark Private Trust. For evidence of Cam’s investing and dealmaking chops – and those of Westaim’s COO Robert Kittel, himself a former Goodwood Partner and Portfolio Manager – we turn to Jevco.

Revving Up Jevco

The first major deal under new management was announced in January 2010. Westaim agreed to acquire Jevco Insurance Company from its then teetering parent Kingsway Financial Services (TSX: KFS and NYSE: KFS) for 94.5% of 12/31/09 book value, or C$261.4M. Jevco is a Canadian specialty insurer primarily offering non-standard auto, motorcycle, and other recreational vehicle insurance (together, Personal Lines) as well as a variety of Commercial Lines (Surety, Commercial Auto, and Property and Liability). Jevco needed capital to grow, whereas Kingsway needed to deleverage, so the two were no longer a good fit. Jevco’s credit rating had also been hurt by downgrades on Kingsway-affiliated entities in late 2009.

When the deal was announced, the Globe and Mail headline read “Kingsway Sells Crown Jewel.” Management knew this was a high quality business, and it moved fast after receiving an inbound phone call from a former Kingsway director on November 23, 2009 – the day after Kingsway announced that Jevco was for sale.

The acquisition, which closed in March 2010, saw Westaim raise C$265.1M via subscription receipts priced at C$25/share and was backstopped by Alberta’s AIMCo, a C$75B+ pension fund manager. Her Majesty the Queen ended up owning ~40% of Westaim common, plus a slug of warrants and non-voting shares, following the capital raise. Directors and officers of Westaim, funds managed by Goodwood, senior management of Jevco and “certain other designated investors” collectively put C$17.5M into the deal. Cam MacDonald personally invested C$0.6M and longtime Westaim Chairman Ian Delaney plunked down C$3M. Thanks to Kingsway’s distress, Westaim got quite a deal here.

Comprehensive income from the 3/29/10 deal closing through 12/31/11 totaled C$71.6M, or over 27% of the purchase price. That income excludes the C$25.1M bargain purchase gain that Westaim recorded. In the same period, unpaid claims and adjustment expenses (the company’s major liability line item) fell by roughly C$90 million, aided by favorable development of prior years’ claims within both Personal Lines and especially Commercial Lines in both 2010 and 2011.

Personal Lines lost money in 2010 (112.5% combined ratio) due to an acceleration in accident benefit claims, but this was more than offset by very strong results in Commercial Lines (53.2% combined ratio). In 2011, Personal Lines improved to a nearly break even underwriting result, aided by a hardening standard auto market (increasing non-standard retention), favorable provincial legislative changes, and two significant rate increases granted in Ontario, where Jevco is the largest player in non-standard auto. Jevco’s underwriting income nearly tripled from C$5.6M in 2010 to C$14.6M in 2011. There were plenty of favorable tailwinds here, but Westaim management also took many important steps to enhance Jevco’s operations, as detailed in their Jevco Case Study presentation:

  • Assumed capital allocation responsibilities and provided operational support
  • Secured adequate credit rating from A.M. Best to allow Jevco to resume growth
  • Worked with Jevco management to establish its long-term growth and strategic business plan
  • Management incentives were altered to emphasize ROIC as opposed to growth in premiums
  • Internal reporting was overhauled and streamlined to better measure performance Stricter governance and insurance specific oversight was implemented at Jevco

By March 31, 2012, Jevco’s book value, boosted by ~C$20 million of net capital contributions by Westaim (~C$50M injected minus a C$30M dividend received later on), had increased to C$398.5M. While Jevco was not acquired for a quick flip, a C$530M unsolicited bid from Canada’s leading P&C insurer, Intact Financial (TSX:IFC), led to a sale in May 2012. The sale price represented a 33% premium to book value. The deal closed in September 2012, and Westaim distributed C$521.4M to shareholders via a return of capital that same month. The distribution totaled C$37.50 per share, which was a 50% premium to the 2010 capital raise and over 3x what Goodwood had paid to accumulate its initial stake in Westaim during the dark days of 2008.

The Jevco sale and return of capital left Westaim with a book value of ~C$2.50/share (virtually all cash) and no operations, leading to a voluntary decamping to the TSX Venture Exchange. Absurdly, the stock wallowed around the C$1.25 to C$1.75 level for the next 10 months, and insiders bought out AIMCo’s entire 6.17M share stake at C$1.50/share in mid- August 2013. Cam MacDonald bought 2.4M shares for C$3.6M and Ian Delaney bought 3.26M shares for C$4.9M. The company’s cash per share stood at C$2.63 as of 6/30/13, so Cam and crew were once again buying Westaim stock at a big discount to cash. I don’t know if AIMCo was a forced seller, or simply got tired of waiting for management to execute its next deal. Either way, bad call, Her Majesty.

Houston, We Have a Deal

In March 2014, Westaim announced its plan to make a significant investment in Houston International Insurance Group (HIIG) via Westaim HIIG Limited Partnership. The purchase of shares was a combination of a
$53.7M bargain purchase from a liquidity-seeking PE group led by Lightyear Capital and an $85M purchase of additional treasury shares at ~100% of 12/31/13 adjusted book value. The purchase from the motivated sellers was executed at a ~29% discount to that adjusted book value, with the major adjustment being an add-back of the $31.5M valuation allowance taken against HIIG’s NOLs as a result of the ownership change. At the 7/31/14 closing, the partnership took a 70.8% stake in HIIG for a purchase price of $138.7M at an effective valuation of ~87% of adjusted book.

Westaim HIIG LP was capitalized with $141.1M from the following:
(i) approximately $75.7 million by Westaim, (ii) approximately $24.3 million and $22.9 million by affiliates of Everest Re (NYSE: RE) and Catlin Group (LSE: CGL), respectively, (iii) $10 million by Stephen L. Way, Chairman and Chief Executive Officer of HIIG, and/or certain investors affiliated with Mr. Way, and (iv) approximately $8.2 million by certain other existing shareholders of HIIG and other investors.

As a result of the above, Westaim holds 53.3% of the LP units, giving it a 37.7% indirect interest in HIIG. It also owns the general partner, which entitles it to an annual fee for advisory services under a management services agreement ($1M for years 1-3, $0.5M in years 4-5). Stephen Way has a ~11.9% interest in HIIG, split between his ~8.3% direct ownership and his ~5.1% stake in Westaim HIIG LP. The partnership has four representatives serving on HIIG’s six-member Board of Directors, allowing for strong oversight and accountability.

In order to raise enough money to both fund its share of the partnership and fatten its coffers for additional investments, Westaim issued 56.4M shares at C$2.65. Cam MacDonald invested C$1M in this private placement, and Ian Delaney invested C$6.5M. PE firm Trilantic Capital Partners, a 13.2% HIIG owner prior to the deal, directed all of its sale proceeds of C$14.3M to the Westaim equity financing, making it a 7.7% owner of Westaim.
So exactly whom and what did Westaim invest in this time around?

Show Me the Way

Stephen L. Way founded HCC in 1974 and served as its CEO until 2006 and its Chairman until 2007. Under his leadership, the specialty insurer grew both organically and via 30+ acquisitions (mostly underwriting agencies) into a multi-billion dollar firm. Way took HCC public in late October 1992 at a market cap of $60M. From that date through 2006, HCC grew gross written premiums and assets at a high-20’s CAGR and generated an average return on equity of 15.9%. The company averaged around a 90% combined ratio and never reported a single year of adverse development from continuing operations. Shares rose ~1,200% during this period, generally trading north of 2x book. HCC’s market cap now exceeds $5B, and it trades at a ~35% premium to book as it flirts with all-time highs. That is Way’s legacy… except for one black mark at the end of his tenure.

In August 2006, HCC’s Board began investigating the company’s stock options granting practices for the prior decade. It was found that Way had backdated options for various employees and Board members, on dozens of occasions from 1997 through 2005. The backdating made in-the-money option grants appear to be at-the-money options, allowing HCC to both make employees’ options more valuable by lowering the strike and to keep a cumulative $26.6M of stock comp expenses off its income statement.

According to the SEC complaint, Way himself reaped ~$5.5M in ill-gotten gains, which he later returned to the company. In his July 2008 settlement with the SEC, he agreed to a $200K fine and was barred from serving as a public company officer for five years.

I don’t want to downplay any of the foregoing, as it represents a genuine ethical lapse, but it is worth noting that, as of March 2005, Way owned an estimated $95 million stake in HCC. Self-enrichment was unlikely the primary motivating factor behind the backdating activity. The Special Committee determined that Way’s motivation was to attract and retain employees by getting them better option prices, which is believable enough. I don’t like that this happened, but I can understand the intense pressure to compete for talent in an industry where your most important assets walk out the door every day and can easily get poached by competitors. Stephen Way could have slipped into a quiet and extremely comfortable retirement in 2007. Instead, he chose to start all over again.

Digging into HIIG

Nine months after leaving HCC’s Board, Way incorporated Southwest Insurance (SWIP) with the backing of several insurers and high net worth investors at a capitalization of $100M. In December 2007, SWIP made its first acquisitions: managing general agency Bunker Hill Underwriters and its A-rated sister company Great Midwest Insurance, plus P&C wholesale broker Southwest Risk. Next, SWIP bought life and health insurer National Health Insurance Company in 2008. SWIP sold Southwest Risk and NHIC – neither for a great outcome – in 2010 and 2012, respectively.

SWIP was principally a wholesale underwriter at this stage, representing non-affiliated insurance companies and Lloyd’s underwriters through Bunker Hill. That all changed following the merger with NYC-based Lightyear Delos Acquisition Corp. (LYDAC) at the end of 2010.

Despite strong A.M. Best ratings, LYDAC’s underwriting was a mess, and its 2006-vintage PE sponsors hoped Way could mend it. He proceeded to fire everyone in senior management and put 24 out of LYDAC’s 26 programs into run-off, eliminating ~75% of its premium. Way is not really a distressed insurance investor (“That’s sort of like running an orphanage. It’s a good thing, but I’d just as soon let somebody else do it”), but he was attracted to the platform offered: an admitted insurer with 50 licenses (f/k/a Delos, now Imperium), and a surplus-lines company with 48 licenses (f/k/a Naxos, now Houston Specialty). Those licenses would allow Way to build a substantial specialty insurer once he finished plugging the holes in the leaky LYDAC boat. This would take longer than expected.

HIIG’s 2012 financials show 12/31/10 equity of $231.7M, declining to $203.2M in 2011 and $185.4M by the end of 2012. HIIG would later make indemnity claims against the former LYDAC shareholders, leading to the return and cancellation of 3M shares (8.8% of o/s shares as of 12/31/12). It seems LYDAC’s underwriting was in even worse shape than had been represented at the time of the merger. The strong post-merger balance sheet, with moderate leverage of 26.7% debt/cap according to A.M. Best, would come in handy in the years ahead.

Despite taking a reserve charge on the LYDAC run-off business at closing, HIIG still experienced prior period adverse development on non-continuing lines of $17.3M in 2011 and $15M in 2012, principally driven by workers’ comp and commercial auto. These two categories accounted for over 75% of total net reserves at the end of 2012, with over 80% of the $229M in net reserves attributable to the run-off book. The runoff business contributed pre-tax losses of $22M in 2011 and $27M in 2012. Meanwhile, the big reduction in written premium spiked the combined ratio from continuing ops to over 140% in 2011 and to 118% in 2012, adding further operating losses. An indemnity claim made by the purchaser of Southwest Risk, whose founding CEO left in 2012 with two of its brokers and allegedly started soliciting its clients, led to a large provision that also stung. HIIG incurred comprehensive losses of $32.4M in 2011 and $24.8M in 2012.

In early 2013, Stephen Way restructured HIIG’s claims operation, replacing some claims directors, instituting an extensive file review to analyze case reserves, and accelerating the pace of case file closures. The latter has helped to whittle down non-continuing claim counts from an estimated 16.3M at year-end 2010 to 2.5M exiting 2013. The detailed file review led HIIG to again increase its reserves, resulting in prior period adverse development on the run-off book of an even steeper $29.3M. That left non- continuing net reserves of $121.7M at 12/31/13, 46.1% of which was workers comp and 23.9% of which was auto.

In the March 2014 merger slides, Westaim said it believed the risk of further adverse development on the run-off book had been “significantly reduced.” There was further adverse development of $14.1M in 1H’14, however, including $10.2M on the runoff book. HIIG is still not entirely out of the woods, but there are signs that the light of day is visible through the cedar elms. One is that claim counts are dropping quickly, reducing the number of future potential surprises. Another is that the business is both very well capitalized and profitable (we’ll get to the latter in a moment).

Finally, I draw a fair amount of comfort from the list of parties participating in the Westaim HIIG LP investment. Not only did sophisticated new parties, including two multi-billion dollar insurers pony up (incidentally, HIIG’s CFO was previously CFO of Catlin US), but insiders and existing HIIG investors participated as well. I can understand why Way would dig in his heels, but if original LYDAC sponsor Trilantic saw much more pain ahead, I can’t imagine why it would stick around.

Turning from the run-off issues to the continuing business, HIIG’s operations are really kicking into gear. Underwriting income from continuing ops turned positive in 2013, principally driven by HIIG’s rebuilding of its net written premiums, which rose ~5x on a continuing ops basis from 2011. This brought expense ratios down to ~35%, which should continue to fall as HIIG achieves scale (HCC’s expense ratios averaged ~26% during Way’s tenure). Pre-tax income from continuing ops was an estimated $16.7M for 2013.

HIIG has continued the positive momentum in 2014. Year-to-date net income through 9/30/14 stands at $15.6M, and that includes discontinued operations. For the same period, net premiums written are up 11% YoY at
$224.8M, and the net loss & LAE ratio (including runoff lines) is down from 69% to 65%. The investment portfolio stands at $643.4M, and book value is $239.4M. By my math, that puts HIIG’s BV/share at $4.80, over 20% above Westaim HIIG LP’s cost basis.

This is an extremely seasoned underwriting team, with an average of 25 years of experience writing business. Here are HIIG’s segments, their net premiums written, and their loss ratios for YTD through 9/30/14:

Segment Net Premiums Written Net Loss & LAE Ratio
Construction $34.4M 62%
Energy $41.6M 55%
Specialty $104.6M 69%
Professional $23M 60%
Property $17.9M 35%

With $85M of fresh capital injected and the run-off book dwindling, HIIG is in full-on growth mode. This past August, the company hired away AIG’s global offshore energy head of 14 years — a coup aided by her past employment at HCC during the Way era. She will lead a new Global Energy division that was set to begin underwriting on 1/1/15. I would expect more organic efforts such as this one, as well as plenty of tuck-in M&A. Insurance Insider reported in November that HIIG was close to entering the medical stop loss market, an ~$800M line of business at HCC in the Way era, through an acquisition.

For Stephen Way’s M&A playbook, I strongly recommend reading the Property Casualty 360 article “Picky HIIG Seeks Unadvertised Specials.” In a sentence, Way seeks independent agencies with niche, high quality books of business that are looking for a home where they can remain entrepreneurial — and he avoids competitive auctions. That works for me.

Management Compensation and Incentives

Goodwood initially ran Westaim via a management services agreement, pursuant to which Goodwood provided services (CEO, CFO, directors) in exchange for a 2/20-type comp package (2% of book value, 20% of pretax income). Following the Jevco acquisition, the incentive fee was eliminated and the services fee was fixed at a flat amount. Goodwood was paid C$1.7M in 2009, C$1.9M in 2010, C$3.3M in 2011 (including an C$800k bonus) and C$3.4 million in 2012. The sale of Jevco in 2012 constituted a change of control, triggering a C$5.5M termination payment that ended the MSA. Westaim subsequently employed its team directly. In addition to the foregoing comp, Goodwood Management (which was controlled ~50/50 between Puccetti and MacDonald) was granted 900+K RSUs from 2010- 2012. Between 2010 and 2011, roughly 709K RSUs were granted, equating to 6.1% of outstanding shares. GMI exercised a portion of these RSUs for C$4.5 million in 2011 and took the rest (~730.3K) in shares when it was wound up following the Jevco sale. Ultimately, Cam MacDonald’s ~50% cut of those RSU grants comprise a small portion of his total ownership of Westaim, reported at 3,122,258 shares following the HIIG-related capital raise. Between the 2010 capital raise, the purchase of AIMCo’s shares in 2013, and the 2014 capital raise, MacDonald purchased 2.8M shares for C$5.2M (and got back C$0.9M through the 2012 return of capital).

For 2011-2013, Cam MacDonald’s salary was ~C$250K and his total comp ran from C$250K in 2013 (no business operations, no bonus) to ~C$669K in 2012. Now that Westaim has made its HIIG investment, MacDonald is eligible to receive a bonus again. His change of control comp is C$250K. On November 14, 2014, Westaim approved the grant of an aggregate of 2,375,000 RSUs to certain officers, employees and consultants. The RSUs vest over three years and are payable when vested with either cash or shares.

The grant amounts to 3.4% of outstanding shares. I believe the size of the grant reflects the significance of the HIIG transaction, as was the case with 2010’s relatively large RSU grant following the Jevco deal, and I don’t expect share dilution to recur at this elevated level.

Immodest Expected Returns

As it shifts from repair mode to growth mode, I think it’s reasonable to expect HIIG to generate low to mid-teens ROEs and compound book value at a similar rate. As a base case, call it a 12.5% CAGR from an approximate BVPS at the 7/31/14 closing of $4.71 (I’m just interpolating between $4.66 at 6/30 and $4.80 at 9/30). Over the course of five years at 12.5%, that grows to $8.49/share. Let’s assume that Westaim then divests its HIIG stake for a 33% premium to book value, which is in line with the Jevco sale and modest for a quality specialty insurer. That would net $11.31 per share, for a 19.2% annualized return on book value and, more tantalizingly, a 23.6% IRR on Westaim HIIG LP’s discounted purchase price. A good case of 15% BVPS compounding at HIIG followed by a sale at 1.5x book would produce a 29.3% IRR on Westaim’s investment over the same five-year time frame.

Of course, Westaim’s cash holdings will be a drag on the compounding of its own book value. If it just lets the cash lie fallow for five years, the effect on the base case laid out above would be to drop Westaim’s own book value CAGR south of 15%, before considering share dilution. That’s not going to happen, though, and I wouldn’t be here if I didn’t expect the team to find smart ways to put this capital to work in the years ahead.

Westaim, under IFRS fair value accounting, still carries its HIIG investment somewhat below book value after marking it up by C$13M in Q3’14 (a combination of fair value adjustment and USD appreciation). My adjustment to 9/30/14 book value simply marks Westaim’s 37.7% indirect HIIG interest at 1.0x book at the 9/30 USDCAD spot rate, producing an adjusted BVPS of C$2.73. I have made Westaim a meaningful position in my personal account with a cost basis slightly north of that figure.

I have a hard time seeing how an investment in Westaim at a modest premium to adj. book value will not produce satisfactory returns over a five- year (or preferably much longer) holding period. That said, I’m sharing this idea in part so that you can tell me why I’m wrong. I welcome your comments at (a list of helpful links is also available).

This post has been excerpted from Toby Shute’s guest write-up for The Manual of Ideas.

The content of this website is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, principals and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated on this website. This summary is meant in no way to limit or otherwise circumscribe the full scope and effect of the complete Terms of Use.

Unconstrained Value Investing

Despite our caution about the high valuation of the U.S. stock market, we are still finding some attractive investment opportunities that we feel have a good chance of delivering a double return over the next five to 10 years. A way to describe our investment philosophy is what we call “Unconstrained Value Investing”. This involves owning the best investment opportunities regardless of the size or location of the company. We will own companies located in Asia, Europe, South America and the U.S. and companies that range in market value from $100 million to hundreds of billions of dollars. We generally do not manage our equity portfolios to an index. Instead, we build our portfolios one investment at a time with the goal of achieving the highest return possible with the lowest level of risk. Over the long-term this thinking has the best chance of delivering attractive returns that will beat comparable indices.

We believe the biggest risk factor associated with owning a company is valuation risk. You can buy the best company in the world, but if you pay too high of a price it will probably turn out to be a poor investment. Over the long-term stock prices tend to track their underlying intrinsic values. It may take years for a company’s stock price and underlying intrinsic value to meet, but more times than not, it usually happens.

On November 5th, in our Intrinsic Value and Dividend Growth & Income portfolios, we sold Procter & Gamble at $88.99—a holding I have owned personally since February 2009. It is also one of our original holdings when our first clients joined Granite Value Capital in May 2009. Started in 1837 by candle maker, William Procter, and soap maker, James Gamble, the products of P&G have become ubiquitous around the world. The company has 23 brands with sales over $1 billion. These well-known brands include Pampers, Tide, Bounty, Charmin, Nyquil, Oral-B and Head & Shoulders. The portfolio of brands comprises a global powerhouse in P&G which has annual sales exceeding $80 billion. P&G is one of the greatest companies in U.S. history.

chart_2Great companies do not always make great investments. The chart to the right illustrates this point. Over the almost six years of owning P&G, it generated an attractive total annualized return of 12.1 percent per year. This return can be broken down into three factors—the dividends that were received, the growth of the company’s intrinsic value and the narrowing of the gap between price and intrinsic value. Over the time period of owning the stock, dividends account for about 3.0 percent of the return, growth in intrinsic value 1.0 percent and the narrowing of the gap between price and intrinsic value 8.1 percent.

Contrast this recent performance to the period between December 1999 and March 2009 when the company was not a good investment and an owner of P&G’s stock received a total return of 0.5%. During this time period P&G’s business did extraordinarily well as its intrinsic value grew at a rate of 12.2 percent per year. Dividends contributed 1.8 percent per year. However, the company’s stock went from being very overvalued (trading 43 times earnings), and trading well above our estimated intrinsic value, to being very undervalued (trading at 15 times earnings), and trading well below our estimated intrinsic value. This dramatic drop in valuation was a drag on performance to the rate of –13.5 percent per year. (The dashed line tracks this time period.)

The performance of P&G through the years illustrates the importance of only owning stocks that sell at a discount to their underlying intrinsic value and the potential long-term attractive returns a value based investment process can generate. We are firm believers that over the long-run the stock prices of most companies track their underlying intrinsic values. However, it can take years for the market to correct itself. You will not see us owning stocks whose share price trades above our estimated intrinsic value. It is at this point that owning a company becomes more of a speculation than an investment.

table_001As we look out at the investment landscape, many of our most attractive investment opportunities are in non-U.S. stocks. About 22 percent of our holdings are in non-U.S. companies and we have been slowly increasing this weighting in the past year. (Due to currency risks, we will limit our exposure to no more than 30 percent of our portfolio to non-U.S. stocks.) In the fourth quarter we established a new position in China based Hopewell Holdings in our Intrinsic Value strategy.

chart10Hopewell Holdings is a Chinese conglomerate that has been around since 1970. They own interests in real estate, hotels, a toll road and a power plant. We believe the concern over a real estate bubble is weighing on the shares of Hopewell Holdings. Despite this concern, we feel Hopewell Holdings is an outstanding investment opportunity that offers substantial upside potential with very little downside risk. The company rates very favorably under our “Three Pillars” approach to investing that looks at each investment from a business risk, balance sheet risk and valuation risk perspective.

The table on the top of the chart summarizes segment revenue for Hopewell Holdings. From a business perspective, only 12.9 percent of its business (property development) is directly exposed to a potential bursting of the Chinese real estate bubble. About 24 percent of their business is involved in less speculative real estate of owning commercial real estate and hotel properties. 63 percent of their business is involved with the relatively predictable revenue streams associated with owing a toll road and power plant. We believe the overall business risk of the company is quite low.

The company is very conservatively financed. This is evident by the fact that their net debt to equity is only three percent. When real estate bubbles burst, it is the highly leveraged companies that get killed. The balance sheet risk of Hopewell Holdings is extremely low and if the Chinese real estate bubble bursts, Hopewell Holdings should weather the storm very well.

As is the case with all of the companies we buy, the valuation risk of Hopewell Holdings is quite low. We purchased the shares during November and December at an average price of $3.58—a very low 52 percent of our estimated intrinsic value. The chart above tracks the price of Hopewell Holdings against our underlying estimated intrinsic value—as measured by the company’s tangible book value per share. Hopewell Holdings has grown their intrinsic value at 12 percent per year over the past decade. If they can grow at half this rate, and we collect the three percent dividend, and it takes seven years for their stock price and estimated intrinsic value to converge, it is possible to get an annualized total return in the 19 percent range. If the business does not grow as fast or in fact the intrinsic value declines, there is still a good chance we could get a return of around 10 percent.

Successful long-term investing is all about putting your money into situations where the probability of making a high return greatly outweighs the probability of losing money. Much of this probability is putting money into situations where a company’s stock price is selling well below its estimated intrinsic value. We feel we have found such an investment with Hopewell Holdings and think with patience and a long-term time horizon, there is a high probability we will be rewarded.

Another outstanding example of our “Unconstrained Value Investing” philosophy is the purchase of Barrett Business Services during the fourth quarter in our Intrinsic Value Equity Strategy. The company is an underfollowed, small ($200 million market cap) and obscure company that we thought offered great upside potential with relatively little downside risk. The company provides consulting and business management services to small and medium sized businesses. The company was founded in 1965 and went public in 1993. We feel the company qualifies very well on our “Three Pillars Approach” to investing and offers very little business, balance sheet and valuation risk.

chart_11Barrett Business Services’ stock had a wild ride during 2014. After peaking at $102.20 in January, the stock fell to as low as $18.25 in October on concerns associated with an increase in the company’s workers compensation reserve. We purchased shares on November 11th at an average price of $22.91. Clients may wonder, “Why do you want to own a stock that has declined by 78 percent from its 52 week high?” As discriminating value investors, even after adjusting for the increase in the company’s workers compensation reserve, we thought the stock was significantly undervalued and offered a great investment opportunity.

The chart to the right illustrates this point by comparing our underlying estimated intrinsic value of Barrett Business Services and its stock price since 1994. Notice how the stock price has tracked its underlying intrinsic value over the past 20 years. Over the long-term we believe most of the time a company’s stock price will track its underlying intrinsic value. For an investor with a long-term time horizon, that can look beyond the performance of a company’s business over the next few quarters or couple of years, they can try to take advantage of this belief. After taking into effect the increase in the company’s worker’s compensation reserve, we think the company is worth about $56. Our purchase price was about 40 percent of this level—a very large margin of safety. This large margin of safety should protect us even if there is another increase in the company’s worker’s compensation reserve.

We also take great comfort in the fact that six different insiders, including the Vice President of Finance and the CEO, bought shares in early November at an average price of $23.40—just above our purchase price. The purchase amounts ranged from $40,000 to $194,000. These are sizable purchases and indirectly lead us to believe we made an intelligent investment in purchasing the shares alongside management.

From a business and balance sheet perspective, the company is attractive and we think offers relatively low risk. The company is conservatively financed due to the fact that is has net cash and investments of $66 million—equal to about one-third of its market capitalization. The company’s business requires very little capital expenditures, generates high returns on capital (averaging 240 percent over the past decade) and has had only one year of negative cash earnings as a public company. chart_12The low level of balance sheet risk, business risk and our attractive purchase price, or low level of valuation risk, makes Barrett Business Services a very attractive investment opportunity.

The last new position we established during the fourth quarter was Baxter International—purchased in our Intrinsic Value and Dividend Growth & Income portfolios. We established this position on October 22nd at $68.54.

Baxter is a well managed medical products company with a diversified product base and a solid pipeline of potential new products. Cash return on invested capital over the past decade has consistently hovered around 30 percent. (As a rule of thumb, a return on invested capital over 15 percent is considered very good.) Over the past decade the business has performed well with its intrinsic value growing at nine percent per year. We expect the company has a good chance of growing at a level near this rate over the next decade. The company is conservatively financed and our purchase price was 72 percent of our underlying estimated intrinsic value of $94.71. As illustrated in the graph above, we expect the company’s stock price to track its underlying intrinsic value over time.

Unlike the broader U.S. stock market, we think Baxter International’s shares are undervalued and have a good chance of generating a double digit return over the next five to 10 years.

The above post has been excerpted from a recent newsletter of Granite Value Capital.

This newsletter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Any information prepared by any unaffiliated third party, whether linked to this newsletter or incorporated herein, is included for informational purposes only, and no representation is made as to the accuracy, timeliness, suitability, completeness, or relevance of that information.

Granite Value Capital, LLC is an SEC registered investment adviser with its principal place of business in Hanover, NH. Granite Value Capital and its representatives are in compliance with the current notice filing requirements imposed upon registered investment advisers by those states in which Granite Value Capital maintains clients. Granite Value Capital may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. This newsletter is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Granite Value Capital with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Granite Value Capital, please contact Granite Value Capital or refer to the Investment Adviser Public Disclosure web site (

For additional information about Granite Value, including fees and services, send for our disclosure statement as set forth on Form ADV using the contact information herein. Please read the disclosure statement carefully before you invest or send money.