Forced conversion of Canadian income trusts creates attractive opportunity

The other day I had a pretty good idea. It is similar to the thesis for investing in spin-offs and re-organization securities.

The government of Canada recently implemented a tax law that removes the preferential tax treatment of income trusts, which were previously untaxed at the corporate level. Without the preferential tax treatment, financially, these "businesses" are better off under the corporate structure. And as of 2011 they must all be converted to the corporate structure.

These trusts were typically held because of their high annual cash distributions yields. When these trusts convert to the corporate structure they will either cut the dividend drastically in order to keep cash in the business or change to growth oriented model in which the dividend is cut completely. What happens here is that all the pension funds, insurance companies and dividend mutual funds that had owned units in these trusts are forced to dump the units because they must hold income paying securities. The forced selling causes downwards price pressure and the price becomes disconnected from the underlying value of the company. This is an attractive purchasing opportunity; eventually the market will weigh the proper value of the company and will be reflected in the per unit price.

SG

Being right for the wrong reasons -- XTENT Inc. (XTNT)

On May 15 XTENT Inc filed a preliminary proxy form stating the company's intention to liquidate and distribute all remaining assets to shareholders. The estimated liquidating distribution was 0.11 to 0.40, quite a wide margin. I bought this stock on May 17 for 0.30.



A look at the table stating how these numbers were estimated showed that the only major divergence was in a category called "Total estimated liabilites and reserves". A footnote stated that this category "Includes (i) approximately $0.7 million and $0.9 million in the high and low estimates, respectively, in accounts payable and accrued liabilities, (ii) approximately $0.5 million and $5.3 million in the high and low estimates, respectively, reserved in connection with resolution of pending and potential litigation, claims, assessments and related obligations and liabilities." Reading this I proceeded to attempt to find what the 5.3M liabilities consisted of in order to weigh the probability of these 2 estimates. The balance sheet showed only 1.76M total liability, plus a reference to commitments and contingencies.

A look at commitments and contingencies showed that most of the liabilities were based on payments that XTENT would have to make IF CERTAIN MILESTONES WERE MET. Since the company was liquidating these milestones were not likely to be met. There were also license agreements for minimum royalty payments, none of which added up to 5.3M. I could not find a scenario under which the company would be required to pay out that much in liabilities. Therefore, I thought the distributions were likely to come in at the higher end of the range, and I purchased the stock.

The estimated distributions did not include sale of any intellectual property rights, which I thought was also a highly likely scenario because they had recently received CE Mark approval for a system in March 2009. I figured that I was paying absolutely nothing for this option, since the normal distributions were likely to come in higher then 0.30.

On June 4th the company announced that it had received FDA approval for its stent system and the stock jumped up to 1.60 and then to 2.10. I averaged somewhere in between for a total return of 490%

In this instance I was right but for the wrong reasons. I'll gladly take the earnings.... but it is unlikely to be repeated.

SG

Read This Letter to Buffett!!

One of the major questions I always had while learning about Warren Buffett and reading his annual reports, was why he suddenly switched from investing in Graham type companies to the "great" companies he now speaks of. Some say it is Munger's influence, and I think it partly is. But I think another reason is because he simply had too much money to put to work in Graham type plays. I was always nervous investing in small, problematic companies even after I'd read Graham because it really doesn't make much logical sense. But the fact is, these companies are just simply more undervalued then the "great" companies that you can sometimes buy at a small discount to value.

This was the proof I needed:

Dardashti Letter to Buffett!!


SG

Seth Klarman - Shareholder Letters

Came accross a link to Seth Klarman's letters to shareholders from 1995-2001. Particularly interesting, is the breakdown of his portfolio allocation and returns. Also, he talks in great detail about the frothy market environment of the late 1990's. It's always interesting to see what strategies these experienced veterans are employing and how they turn out in different types of markets. Sadly there is no letter in this compilation from a year where there was a bear market. Anyways, here is the link:

Klarman Shareholder's letters 1995-2001

Thanks to distressed debt investing for this compilation.

SG

Neose Technologies (NASDAQ:NTEC) Liquidation

I took a position earlier this year in Neose Technologies after they had announced their intention liquidate. They were a development stage biotech company that had not been profitable since inception. I took the position after they announced that they had been able to find buyers for their 2 patents. I essentially thought this situation was a low-risk scenario, ie. heads I win a lot, tails I don't lose much. In their filing for the asset sale they described their intention to distribute proceeds of the sales to shareholders of record. Their was a table showing management's estimates of what the payoff would be. Essentially, the payoffs ranged from $0.36 a share to $0.52 a share. The stock was trading at $0.35.

An analysis of the estimated distribution table showed that the only thing the amount of the final payoff depended on was the company's ability to either renegotiate their office lease, or sublet the lease. I thought either of these situations were highly likely, and therefore the expected payoff could be closer to $0.52 rather then $0.36.

On March 24th NTEC announced their initial distribution of $0.33 a share. Shareholder's on the last date of record will have received this amount plus the remainder when all liability claims are settled. Management's estimate is still between $0.36 and $0.52 a share. Even if the payout comes in at the lower end of the range my position will still be profitable.

UPDATE

I sold my shares after the stock transfer books closed on the OTC market for .12 a share. I received in total .33 + .12 = .45 on a .35 investment. My return was 29%.

These opportunities are great because they have no correlation to market activity and can help lift a portfolio in a bear market.

SG

Forgent Networks (ASUR) - Arbitrage Opportunity

Forgent networks (NASDQ: ASUR) will be undergoing a going-private transaction. All holders of less then 750 shares will be cashed out at $0.34 per share, approx. 126% premium to today's price of $0.14. The transaction is still in it's preliminary stages and a definitive vote date has not yet been set. Probability of success is quite high as the stock will be forced to de-list, due to NASDAQ requirements, if the company is not voluntarily taken private. If the company is forced to de-list it will still have to incur expenses associated with regulatory reporting, whereas if the transaction is approved it will no longer have to file the required regulatory materials. Since the going private transaction is the more favourable of the alternatives, it can be expected to be approved.


SG
Disclosure: I own ASUR

Dr. Pepper Snapple (DPS)

“DPS was spun off from U.K.-based Cadbury PLC in May 2008. The Partnerships established their position at an average price of $23.84, which represents 12x estimated 2008 earnings. DPS exhibited many of the characteristics we have seen in successful spin-off investments, including favorable management incentives (which were struck while market participants were still wondering how bad the company’s initial outlook might be in the difficult industry environment), systematic selling by U.K. shareholders more interested in the global confectionary business and less so in the U.S. beverage business, and a conservative management posture. DPS is the third largest liquid refreshment beverage company in the Americas, with a portfolio of 50 brands including Dr. Pepper, Canada Dry, 7-Up and Snapple. The company is a combination of a high-margin concentrate business (like Coke and Pepsi, which trade at 17x earnings) and a lower-margin and more capital-intensive bottling and distribution operations (like Coca Cola Enterprises and Pepsi Bottling Group, which trade at 12x earnings). While the market seems to apply a discount for its bottling ownership, we believe that an integrated model affords DPS the opportunity to expand distribution of its underrepresented and newly-launched brands. Over time, DPS has the potential to generate meaningful earnings growth through new product extensions, increased use of its distribution capacity, further cost reduction, and increased exposure to single serve channels, where it is currently underrepresented. DPS shares ended the quarter at $26.48.”

David Einhorn (Greenlight Capital)

Seth Klarman - Margin of Safety

One of the all time best books on value investing! It is no longer in print. A quick search on amazon.com shows remaining copies are selling at close to $1000 USD. Not the typical price someone looking for value might pay! There are only a few remaining copies in existence. The New York City library has a copy in the rare books section (I believe in a protective casing).

I stumbled across a PDF copy of the book online, while looking up information on Klarman.

Margin of Safety by Seth Klarman

SG

Greenlight Capital - 2008 Annual Letter to Shareholders

David Einhorn, manager of Greenlight Capital, has been earning 26% average annual returns for his hedge fund over the past 10 years. He uses a long and short strategy, based on extensive research. I find it interesting to read some of the better managers' letters to shareholders. Here is a link to Greenlight Capital Annual 2008 letter to shareholders.

Greenlight Capital - 2008 Annual Report

SG

Cheung Kong Holdings LTD - Value Opportunity

Market environments like the current environment often create opportunities that are so obvious that in-depth analysis proves pointless. Take for instance Cheung Kong Holdings LTD, a company that trades on the Hong Kong stock exchange and on the American OTC market as depository receipts (OTC: CHEUY).

Cheung Kong is a real-estate conglomerate, mostly focusing on property development and property management. However, they also retain a controlling interest in CK Life Sciences which is a pharmaceutical company. They currently have operations in 56 countries around the world, with a large focus in Asia.

This investment hypothesis is based on several quite basic, and quite obvious concepts:

1. The company has seen growth averaging around 25% for the past 15 years.
2. The company has about 20 projects currently in development set to be finished in the next year, so the growth rate is sustainable in the short-term.
3. China’s GDP has grown about 7-9% over the past 10 years and this growth will translate into a long-term prosperity for Cheung Kong.
4. Real estate is a stable industry. While it is interest rate sensitive, the future economics of the industry will look similar to how they have in the past under normal circumstances.
5. The current low-interest rate environment should allow for improved financing position. Strong financial position should ensure Cheung Kong’s ability to secure financing.
6. This investment can double as a play on currently depressed real estate prices.
7. Li Ka-Shing and Li Tzar Kuoi (chairman and managing director) own in aggregate about 77% of outstanding shares in the company. This will act as an incentive to shareholders’ interests.
8. Trading at only 7 times last years earnings. Even if the company was not growing at 25% per annum this would be a bargain. With 25% growth the market is effectively putting a negative value on growth.
9. If the company is able to earn $13 HKD a share in the coming years, an extremely conservative estimate, the company is trading for only about 4.5 times earnings.
10. The company is trading at $62.8 HKD which is about 66% of book value per share $98.9 HKD, using fair value accounting for investment properties. Once again, the market is applying a negative value to the operating business and future growth effectively offering them for free.

At the current price of $62.8 HKD per share (about $8 USD) this company investment is a bargain. Typically investors will have to pay out the nose for growth. The recent financial turmoil has created situations such as this one, where the investor is effectively paying nothing for 20+ % growth.

SG

Disclosure: I do not own shares of Cheung Kong.