January 6, 2020—Stock Indices Have Banner Year as Valuations Hit All-Time Highs. Is it Time to Diversify?
WESCO Starts Bidding War for Anixter, Topping PE Firm CD&R. How High Can it Go?
Satellite Company MDA Sells to Canadian Investor Group for $1 Billion. Why are They Buying It?
U.S. Military Kills Iran’s Powerful Military Commander Qasem Soleimani by Air Strike in Iraq. What Are the Market Implications?
Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.
Julian Klymochko: Welcome investors, traders, speculators and podcast listeners. To episode 46 of The Absolute Return Podcast. I am your host Julian Klymochko.
Michael Kesslering: And I am Michael Kesslering.
Julian Klymochko: Today is January 3rd, 2020. That is right, a brand new year. We took a bit of a hiatus there, couple of weeks off, but things are really picking back up in the market. A lot of interesting events over the break that we want to discuss.
- One thing that we wanted to chat about is, you know, 2019 was really a banner year for all sorts of asset classes, especially the S&P 500, which had its best years since 2013. But with that, valuations have hit all-time highs. That being said, is it time to diversify?
- Some very interesting M&A news is happening right now. In fact, my favourite merger situation, Wesco started a bidding war for Anixter, topping private equity firm CD&R. How high can Anixter go?
- Another M&A situation satellite company MDA sells to Canadian Investor Group for one billion dollars. Why are they buying it?
- Lastly, some geopolitical macro stuff. We are going to chat about that. The U.S. military killed Iran’s powerful military commander, Qasem Soleimani, by airstrike in Iraq. What are the market implications?
Julian Klymochko: So the S&P 500 finished 2019 with its best performance since 2013, just pretty exceptional result. But nearly all of the annual gain in the index came from multiple expansion. And what is multiple expansion? That refers to just an increase in the earnings multiple driven by an improvement in sentiment. So there’s a number of things that can lead to investment returns. One is the multiple that investors put on earnings. The second is earnings growth, and the third is just dividends as a portion of total returns. But despite zero profit growth in 2019, U.S. equity valuations now sit at all-time highs on a number of measures. These include price to sales, EV to EBITDA, and a third measure, market cap to GDP, which happens to be the favourite broad based valuation measure of none other than Warren Buffett. And if you look at long term of these metrics – price to sales, EV to EBITDA, market cap to GDP, they’re in fact matching or exceeding previous market peaks as the tech bubble in 2000 and also the big run up into 1929 and you know what happened, both those eras. After the 1929 stock market crash, I believe the Dow Jones over the next five years went down something like 80 percent. Then after the tech boom of the late ’90s, quite the hangover there with the S&P 500 declining over 50 percent. Not calling for that, just calling for perhaps some prudence and some caution in the market with all these various valuation measures saying the same thing, which is just kind of flashing yellow as a warning. Another measure is CNN’s Fear and greed index clocked in at ninety-five, which is the highest extreme greed ranking on record, which goes back only three years. Another valuation metric that people looked at is that cyclically adjusted price earnings ratio. Now this hit 31, which happens to be the highest of all time, excluding the tech bubble of 99-2000. So it briefly went above 40 during that era.
However, it is higher than it was in 1929 and it is this cape ratio cyclically adjusted price to earnings. It is actually double the average of 16 where it has been historically. If we look at earnings on a one-year basis, S&P 500 PE ratio sits at twenty-four point three. Based on trailing earnings now this is 54 percent higher than its historical average of nearly 16. So what does this tell you? Well, at best, you are likely to accept or expect a very low or much lower than average future market returns. Have a couple of forecasts here. Goldman Sachs is predicting 2020 returns of five and a half percent. And this is largely based on earnings growth. I know street consensus for S&P earnings growth is about 7 or 8 percent right now. And so if you maintain that same market multiple, what investors paid for those earnings and you get that 7 to 8 percent growth and you should see a good return in the market. However, street estimates are always way too high and pretty much every single year those come down as we progress throughout the year.
Bank of America, they are a bit more bearish. However, they still project a gain. This one is only 2.4 percent. Lastly, BMO Capital Markets with a five and a half percent gain for the index. So no strategist really sticking their neck out here, predicting any significant performance. Certainly not, like 2019 where we saw gains north of the 30 percent. What are your thoughts on current market valuations here?
Michael Kesslering: Yeah. In terms of market valuations, I would just like to preface our conversation. The fact that markets are overvalued right now, specifically the S&P 500 does not mean it can’t become more overvalued in a historical context.
Julian Klymochko: Yes, it has been a really poor timing tool, especially over the past 10 years, they just kept going higher and higher, right?
Michael Kesslering: Absolutely. Really, since about 2014, you know, markets have been above historical averages. So you hit the nail on the head. I mean, it is difficult to time these, but nonetheless, looking at, you know, what is actually driving some of this multiple expansion in the S&P 500. So over the last 10 years, the S&P earnings have grown at about nine point eight percent annualized, which is a very healthy rate of growth on the earnings side.
Julian Klymochko: And that is earnings per share?
Michael Kesslering: Yes.
Julian Klymochko: Which is different than net earnings because you can have earnings per share growth through an increase in earnings or a decrease in shares outstanding, which we’ve seen pretty significantly over the past 10 years. Many, many publicly traded corporations buying back shares, which juices earnings per share growth.
Michael Kesslering: Absolutely, just the same with EPS. There is a numerator and a denominator. Same with the PE ratio and it is interesting to dig down into those elements to see what is actually driving it. But as I had mentioned, so nine point eight percent for EPS and the price part of that ratio has grown at eleven point two percent, now that is excluding dividends. If you include dividends would be thirteen point five percent and then for the TSX 60 as well. So it’s currently sitting at a 12 month trailing PE ratio of sixteen point four times relative to a 10 year average of seventeen point three times. So it’s actually sitting a bit below the 10 year average. But looking into that, you’ve seen that earnings have grown on the TSX 60 at 4.2 percent annualized. So over, you know, less than half of the S&P 500 earnings growth, EPS growth, while the price has grown at just 3.9 percent excluding dividends. If you include dividends would be 7 percent. But one other thing, just looking at this past decade in the markets is to look at the TSX top returners over the decade. Now, the Financial Post had a nice little article pointing out some of these top performers over the last 10 years.
And I think people would be very surprised to see that these aren’t really in highly sought for the most part, aren’t in highly sought after industries like cannabis or they’re really upper echelons of tech where gilt consumer tech. So something like Apple or Blackberry for earlier in the decade. But some really boring companies, for example, the Boyd Group, which is a Winnipeg based auto body shop, is up over four thousand two hundred percent over the last 10 years. Constellation Software up over 4000 percent, which is a favourite among value investors. They have really just have a roll up acquisition strategy in niche enterprise software verticals and led by their now famous CEO, Mark Leonard, to hard-core investors. As well a couple others Dollarama, which just operates simple dollar stores, is up over a eleven hundred percent and CCL industries probably the most boring of the companies just mentioned up over 1000 percent over the last decade. And they are the world’s largest label maker, so you really don’t have to find a lot of these very highly sought after industry. Something that would sound very good at a cocktail party to make money in the markets.
Julian Klymochko: Yeah, and I think one thing that investors have to consider is what now? you look out into the current market dynamic and see that the U.S. equities highly valued. Yes, you have had pretty tremendous earnings per share growth over the past 10 years. However, on top of that, you have had even greater multiple expansion compared to other markets. So what we’re seeing now is on multiple metrics, S&P 500, the highest valuation of all time. And some people say, oh, interest rates are low, they had the tax cut, etcetera, etcetera. But you look at Japan. Their interest rates have never been lower yet versus 1988; their market is down significantly. In the late 80s, Japan went to like north of 70 to 80 times earnings. Now they are, you know, sub 15 times. So I think you can find tremendous values in Japan, emerging markets, which have done quite poorly. Europe. And so what I’m saying here is perhaps if you’re a U.S. focus investor, you can maybe consider diversifying, looking into Japanese stocks, which prevent or present pretty tremendous values on a relative basis these days, not to mention Europe, Canada or emerging markets, which imply a much higher earnings yield.
And really the primary determinant of future investment returns is really starting valuation. I like the Howard Marks quote where he indicated that it is not what you own, but it is what you pay that determines your results in investing. So it’s really important to consider when estimating future returns. What is the starting valuation? So certainly, investors should think about diversifying not just different geographies, but perhaps different asset classes as well. Looking at fixed income, there is a lot of options there. Government bonds, investment grade credit, junk bonds, levered loans. You can look at alternatives, which is just a vast array of various strategies, private equity, hedge funds, etc., and so that is something to really keep in mind. As the S&P 500 specifically reaches the highest valuation of all time. And just to disclose, we do have long positions in both Boyd Group and Constellation Software.
Julian Klymochko: Onto the most interesting M&A situation in the market. Currently, interloper Wesco International has commenced a vicious bidding war with private equity firm Clayton Dubilier & Rice, also known as CD&R for electrical component distributor Anixter International.
So what happened here is a couple of months ago, CD&R struck a friendly deal to acquire Anixter for 81 bucks per share in cash. Now, what this represented was really disappointing result for Anixter shareholders. It was only at a 13 and a half-percent control premium, which represents the bid price compared to the unaffected price prior to the bid. And it represented a valuation of eight times EBITDA now for comparative purposes over the past eight years, I looked at our database and over thousands of M&A transactions. The average control premium was 37 percent, so that thirteen and a half percent premium is quite a bit below the average. Not to mention the S&P 500 is currently trading at about thirteen point three times EBITDA. So CD&R getting to buy Anixter at eight times EBITDA. That is relatively low vs current valuations in the market.
So what happened? Unsurprisingly, an interloper came in. An Anixter competitor, Wesco International. They came in with an unsolicited proposal, announced it with the public. And over the past month, there’s been this back and forth takeover battle where CD&R announces a friendly bid. WCC Wesco – It goes back and forth and where we are at now, the price has gone from a CD&R initial 81 per share bid to now ninety-seven dollars per share, which is Wesco’s current unsolicited or hostile proposal, which represents an increased valuation to nine point five times EBITDA. A control premium of 36 percent, putting it in line with historical transactions, which were at 37 percent. The other key dynamic here is that Wesco is a competitor to Anixter and CD&R as purely a financial buyer. And so Wesco has this unique opportunity to generate cost savings or synergies because they have significant overlap with Anixter and those synergies are worth 200 million dollars. And we’re talking about Anixter EBITDA of less than five hundred million. 200 million represents a substantial amount of synergies, including those synergies brings that, and a half times EBIDTA estimate to below seven times. So those synergies due to the overlap between Wesco and Anixter represent a value creating opportunity that private equity firms such as CD&R really can’t match. So that’s a real key component here why CD&R is really going to have a tough time to compete. On the other hand, we have discussed this in the past. How much money, how much capital is flooded into the private equity industry such that there is now 2.5 trillion of dry powder.
And by dry powder we mean capital that’s been raised by private equity firms that they absolutely need to spend in order to start generating their lucrative 2 and 20 fee. And so you have CD&R private equity firm that is really desperate to put money to work. They thought they had a good deal with Anixter and eight times EBITDA. But Wesco has come in over the top, forced them to pay increasingly higher prices. So it’s a really super interesting dynamic and just a massive win for arbitrageurs here. Looking at the average spread or, you know, the discount between the current price and the consideration of the entire current merger arbitrage universe. That said, about 1.4 percent, which equates to a 5 percent annualized return or yield. You look at what has happened with Anixter and a shareholder bought it the first day after CD&R initial friendly 81 per share bid has been announced. You have had a 16 percent return over two months. Now that is significant higher than the current 1.4 percent spread in the market, and that is 16 percent over two months is about one hundred percent annualized. So it’s an arbitrage that really just as the ability to make your year because you have a much, much, much better return than you expect. And it’s really just a sweet Christmas gift to arbitrageurs. They are kind of the main winner here, aren’t they?
Michael Kesslering: Absolutely. And also coming in at the end of the year. So just the timing of it just phenomenal for them. One thing to mention. I mean, you know what you were kind of alluding to with the dynamic with the private equity firm CD&R and Wesco is really just that CD&R likely has a way lower cost of capital than Wesco, just given their ability to raise dry powder. One thing that we have mentioned on the podcast before is the go shop provisions that LBO firms typically do offer to buyout candidates. And this is actually an example for Anixter shareholders where there was an initial go shop provision. So this is actual example where this has worked out quite well for the go shop. I mean, it is just a very interesting dynamic, a lot of somewhat irrational bidding and will be one to follow into the New Year. It will be very interesting on how this ends up.
Julian Klymochko: Yeah, like you said, a lot of interesting dynamics to mention the successful go shop process and go shop that allows the target company board to go solicit other buyers here, obviously and this one success and finding another bidder through Wesco. The other is auction process dynamics such that Anixter shareholders they benefit from what’s known as the auction winner’s curse, where you have two parties competing, neither them wants to lose. And so you end up with non-fundamental pricing and better than expected result for Anixter shareholders. That has given those competitive dynamics. A third thing that we have yet to mention is that is disclosed in a regulatory filing just today that CD&R also tried to buy Wesco last month at 68 bucks per share represents roughly 25 percent premium for Wesco shareholders. And so what I think Wesco is trying to accomplish here is what’s known as kind of the Pac-Man defence and Pac-Man defence as a takeover defence mechanism where the target company kind of turns around to buy the acquire company. Now, in this case, they can’t buy CD&R, but they can buy CD&R target Anixter with the goal of saving their own jobs. Not just that, but harvesting those synergies for Wesco shareholders instead of CD&R investors. So a lot of interesting dynamics here and really just a great case study on merger arbitrage and auction process, go shop process and a competitive bidding war on really the best-case scenario for an arbitrageur.
Michael Kesslering: Absolutely. With the case study example as well. Looking back to the merger docs, at the time of the original bid, there was discussion of, you know, a bidder A, which was unnamed at that time. And so it is interesting to follow through from the start of that process to now, where that Bidder has now been named with Wesco. So just a very interesting case study that anybody looking to learn about merger arbitrage is a very good case study to follow.
Julian Klymochko: Yeah and as for the result, I mean, it is still inconclusive. Where we are at right now is that CD&R has a friendly deal at 93.50. Wesco over the past day or two came out with a $97 topping offer. We have yet to hear back from C&R, but when we do, we will let you know.
Julian Klymochko: Some more M&A news with space tech company MDA, formerly known as MacDonald Dettwiler and Associates. It is being acquired by a group of Canadian investors. Including John Risley, who is the co-founder of Clearwater Fine Foods, and Jim Balsillie, the co-founder of BlackBerry. Now, both these guys are quite wealthy, perhaps billionaires, or at least centamillionaires. This one billion dollar acquisition of the company from the U.S. pays parent MAXAR Technologies, which has really struggled as of late. This will see MDA headquarters move back to Canada after their ill-advised merger with Digital Globe just a few years ago. Now for investors, these investors Balsillie, Risley, amongst others. It is a bet that MDA will play a critical part in supplying players into this new space race where they are all competing to create low earth orbit constellations to drive global Internet coverage. Basically Internet driven not through Wi-Fi or your cell network. But low Earth orbit satellites up in the sky where you can access Internet basically anywhere in the world. So MDA and MAXAR have really struggled. Number one, lower demands for these geospatial satellites that they were manufacturing.
Basically the main market for those where satellite TV and we all know, consumers are moving from satellite TV to streaming. Satellite TV is super expensive, and, you know, people are cancelling their direct TV subscriptions that go over a hundred bucks a month gone with Netflix, which costs, you know, maybe 10 bucks a month. So they have faced years of declining revenue and profits. MAXAR put MDA on the block that summer to raise money to cut its sizeable 3.1 billion dollar debt load. Now, the sale of this Canadian business, MDA, is an attempt to right the ship at MAXAR., who have seen their shares drop 90 percent in value from late 2017 to just a couple of weeks ago before having a bit of a rally off of this deal. MAXAR stock was up 20 percent on the news, but really, there is no guarantee that internet from space will work. We know of a couple of other companies that have tried it. One is Iridium, another one was Globalstar. You have a lot of big players moving into the space, such as Amazon, Facebook, Apple, Space-X. There is a number of firms going for this dream of global Internet coverage through satellites, so. Well, MDA be the one to benefit from that. I mean, who knows?
Michael Kesslering: Yes, absolutely and just to go into a little bit of the background of the backers of this deal, John Risley and Jim Balsillie. Risley was the founder of Clearwater Fine Foods and he is a Nova Scotia native. He has an estimated net worth, about $1.2 billion. I believe that was as of 2015. So there could be a little bit of volatility around those numbers. Then Jim Balsillie now, he was one of the co-founders of Research in Motion, which is now BlackBerry. So one of Canada’s most famous tech companies in recent history.
Julian Klymochko: Used to be.
Michael Kesslering: Yes, absolutely. I might may say infamous. His estimated net worth now is about $800 million. But he really became a high profile figure as well during his attempts to buy NHL franchises and he ultimately failed three times to do so between 2006 and 2009.
Julian Klymochko: And that really marked the peak valuation for Research in Motion shares as well.
Michael Kesslering: Absolutely. You know, his struggles to buy at NHL franchise was really just his goal of bringing a team, a second team to southern Ontario, which he was ultimately unsuccessful to be able to do. But as well, I mean, when this transaction does close, he will be joining the board. He is really kind of come out of retirement the last few years. And I know The Globe and Mail a few months ago had a big piece on him about being a big proponent of bringing Canadian tech back home. He has talked a lot in depth about the dangers of foreign owned tech companies operating within Canada, as well as foreign owned companies getting control over Canadian tech companies. So this is really him just walking the walk, I guess, with bringing a legacy company back home. Specific to MacDonald Dettwiler and Associates. You know, they do have a bit of history with the investment Canada Act. Do you want to go into that a little bit Julian?
Julian Klymochko: Yeah, a number of years ago, probably about 15 years ago, there was an acquisition proposal of MacDonald Dettwiler by U.S. based company. And back then they did not have the Investment Canada Act, which is the U.S. equivalent to CFIUS, basically governs foreign acquisitions of Canadian companies and at the time, the Harper government was concerned with respect to national security because MacDonald Dettwiler were building satellites for the Canadian government. What the Harper government did is they formed this new government department called Industry Canada, which implemented the new Investment Canada Act. At the time and this deal was the first time it was ever used to block a deal. The initial sale of MacDonald Dettwiler to a U.S. firm roughly 15 years ago…13 or 15 years ago. Was blocked by the new Investment Canada Act, which is still around today. I think it might have been used…Oh, yeah…was used on the blockage of the Aecon sale to Chinese investors, but it is a very rare tool that the government actually utilizes to block deals, but this is one example of a company in which the government has used it to block an acquisition. However, the sale to Canadian investors is effectively a reversal, bringing MDA back home to Canada, where it was initially created and where it really thrived.
Michael Kesslering: Absolutely. Just back to the Investment Canada Act, I mean, even though it is rarely used to truly block deals. It more just seen as a disincentive for any of those deals that could potentially be announced. To be announced in the first place.
Julian Klymochko: Wanted to touch on a bit of macro news, some geopolitical conflicts happening as the U.S. military killed Iran’s powerful military commander, Qasem Soleimani. Now, he was the head of Iran’s elite Quds Force and the mastermind of Iran’s military strategy in the region. Now, Soleimani was widely seen as the second most powerful figure in Iran. President Trump has stated that Suleimani was, quote, “directly and indirectly responsible for the deaths of millions of people.” A statement from the Pentagon indicated that Soleimani had been developing plans to attack American diplomats and service members in Iraq and throughout the region. The strike was aimed at deterring future Iranian attack plans, and as you can see this was really just a pre-emptive strike, defensive strike, not necessarily in reaction to anything he did yet. However, they were fearful that he was going to do something and they had the opportunity. They took him out. Now, this killing really marks an escalation in tensions between Iran and the U.S. and you saw it in the market action today. Equity markets trading down. You had the price of oil, obviously, when there is conflict in the Middle East that tends to have potential supply issues. Oil was up 2 to 3 percent. Gold, a safe haven asset, was up nearly 2 percent on the news. So interesting market dynamic, but ultimately something that is expected. Got a quote here from the Iran foreign minister. He called the attack an act of international terrorism, tweeting that the U.S. bears responsibility for all consequences of its rogue adventurism. So some market participants concerned about potential blowback from Iran on this deal, what are your thoughts on it?
Michael Kesslering: Yeah, I mean, a lot of the price reaction you saw like in the minutes after this was announced. There was quite a bit of volatility, but keep in mind that is after hours trading and so the markets are a little less liquid. The price movements are, by their very nature, just larger by nature. So oil prices, you know, increasing about three point one four percent by market close today. So that did come down a bit throughout the day today. As you know, we are about 18 or 20 hours since this attack actually happened. Really seeing somewhat of a muted reaction by now. So for long term investors, this really isn’t something to worry about at this point. Obviously, how Iran response to this that will determine, you know, what future market ramifications will be but at this point, it’s kind of too early to say one way or another, but also very difficult to say that this is something that’s going to truly affect the long term outlook on stocks.
Julian Klymochko: Yeah, exactly. You look at the long term market implications beyond one day and we look back a number months ago where those that strike on Saudi oil infrastructure. Yeah, oil went up tremendously in one day, up double digits, but within weeks, it was back below where it was pre strike. And so all of this is highly speculative and at this point, there’s really no supply side issues for oil and perhaps and most likely that nothing is going to come of this. As I said, market action today purely speculative. So say if it is bad for investors, is just, you know, stay diversified and if you are, then do nothing. Don’t get spooked by some of these, you know, media headlines like they say if it bleeds, then it leads and the media tends to blow these things up. Then we are seeing really the emergence of the first major meme of the new decade, which is World War 3, and so I am seeing quite a bit of that on Twitter and Instagram. So it’s something to keep an eye on, but nothing to break a sweat over.
All right. That is it for episode 46 of The Absolute Return Podcast. If you liked it, you can always listen to more absolutereturnpodcast.com. You can send us an e-mail if you have any questions or comments to email@example.com. You can find a ton of content on our web site accelerateshares.com. If you want to follow us on Twitter, you can find me. I am The People’s Hedge Fund Manager @JKlymochko
Michael Kesslering: And for myself, it is @M_Kesslering for any show recommendations.
Julian Klymochko: And until next week, good luck trading investing, speculating and we will chat with you soon. Cheers.
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