4 Growing Small Caps In A Big Pond

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Includes: CGEAF, HMCBF, LRCDF, MHLD
by: Wayne Hylarides

Summary

Cogeco is a communications and media business with stellar dividend growth.

Home Capital Group is significantly discounted as a result of broker fraud.

Laurentian Bank of Canada is slightly undervalued compared to the big four Canadian banks.

Maiden Holdings a small cap reinsurance business that has tripled it's dividend in 10 years.

This article identifies the opportunities that are currently on my radar. I identify opportunities through my evolving screening criteria which includes reading the newspaper and exploring new screening techniques. Through my analysis, lessons learned, and feedback from you, I hope to improve my screening methodology and reduce the time spent performing deep analysis on investment that have bad potential.

Investment Approach

I currently have three main areas of interest:

  1. Deep value investing. This strategy involves identifying severely mispriced securities based on a discounted free cash flow (FCF) analysis or deep discounts to the liquidation value. I'm not always looking for cigar butts. I optimistically look for future upside. I use FCF in my analysis since it is the physical cash the company makes each year, not the accounting number (i.e. EBITDA, EBIT, Net Income, etc).

  2. Leveraged income investing. Although I currently own several rental properties, I am planning to move more capital into stock income plays. I can structure leveraged buys of REITs or other dividend stocks similar to what I could do for an owned rental property. Being a REIT/dividend shareholder comes with different risks and benefits than being a landlord. Currently I'm working on a portfolio and my strategy to manage a leveraged buy. In this article I added a dividend growth requirement to my screening criteria.

  3. Merger Arbitrage. This strategy involves leveraged short term buys of a public acquisition business that is trading under the target acquisition price. This can happen for a number of reasons, primarily due to perceived risk associated with the merger. There are specific skills required to accurately forecast merger success and merger failure (e.g. regulatory blockage). Therefore, I'm still looking to expand my knowledge in this area before investing.

Updated Screening Methodology

In my last article I used the following formula as a quick gauge for estimating value:

Estimate = BV/share + EPS x 9

Through my analysis over the past month, I noticed that EPS is somewhat misleading and very manipulatable (on purpose or not). I actually like that the market focuses on EPS since it can lead to mispriced opportunities. I now focus on free cash flow .

As a result of soul searching, I continue to change the way I look at valuation. You can read my article on how Warren Buffett valuates a business here. In fact, unless looking at cigar butts he strictly focuses on a DCF analysis of FCF from now until "kingdom come". He states that book value is a bad proxy for intrinsic value. My previous formula used book value as a terminal value to capture the residual value after discounting and adding up the first 10 years of FCF. However this isn't really a good approach unless you really see a liquidation event in the close future. You could really leave a ton of money on the table. Now I am moving to a simpler formula, the Gordon Growth Model, where g is the FCF growth rate and k is the 100 year treasury bond (I use 5% - you can adjust if you think differently).

Estimate = FCF * (1+g) / (k-g)

Usually I will assume zero growth indefinitely for my quick calculation, leading to the following even simpler formula:

Estimate = FCF / 0.05 + 1 part of context + 1 part common sense

In my head, I do some initial adjusting to determine if I should use the latest FCF or an average over the past 4 years, depending on the volatility of the FCF history. Of course this tool is only useful as a reference to see how much of a discount something is trading at compared to a risk free treasury bond with zero growth. If you add in some context and common sense to account for FCF risks and growth potential, the discount/comparison to a zero growth treasury bond should give a good reference.

For businesses trading at above the risk free rate, I'll look to try to understand why. Is the firm viewed as very stable? Does it have significant growth opportunities? Is it overpriced? If a company is trading at a significant discount, has a growth history, and has future growth potential, it may be something worth looking into. Remember, at this point it's about applying logic and common sense to filter out the noise and quickly compare opportunities, not come to an exact valuation.

Is it a Deep Value Buyer's Market?

The market continues to rise, which suggests overvaluation. If you have been in the market over the past year, you most likely did well. In a recent interview if CNBC, Buffett indicated that there were plenty of opportunities out there and that stocks were cheap. Although a future crash may happen, my concern is related to not having enough cash on hand to take advantage of the decline. I think that if you look hard enough there are plenty of opportunities still out there. Trying to time the market can often lead to missing some of the largest increases in history.

New interests

My screening criteria included:

  • 250M < Market Cap < 3B

  • Price/FCF < 5

  • 5 year annual dividend growth > 5

Canadian Screen Results

Cogeco Inc (OTC:CGEAF) (TSE: CGO)

Cogeco Inc. is a holding company, which operates in the communications and radio sectors. The communications business sells video, Internet, and phone services through its fiber networks. The other segment consists of radio and advertising. Cogeco operates in Canada (Quebec and Ontario) and in the United States (Pennsylvania, Florida, Maryland/Delaware, South Carolina and Connecticut). The business has had good growth, consistent growing dividends, and great cash flow. Based on the last year's FCF, my formula yields $5.8 billion for a zero growth risk free bond. The current market cap is $926 million or an 84% discount. This is one of the largest discounts I have seen before any adjustments for cash flow risk and growth. Compared this to Bell Canada (NYSE:BCE), which is trading at a 5% discount or Rogers (NYSE:RCI) which is trading at a 7.5% discount. Are the inherent cash flow risks within Cogeco that much higher than the big boys? Are Rogers and Bell growing at absurdly high rates compared to this small cap? Cogeco also looks like it has a lot of potential, but as a small cap communication business playing in a very big pond, you have to tread lightly. I'll look into this one further.

Home Capital Group Inc. (OTC: OTCPK:HMCBF) (TSE: HCG)

Home Capital is a holding company that operates Home Trust Company, offering deposits, residential and non-residential commercial mortgages, and consumer lending. The good - This business is down to $26 CAD from a 52 week high of around $39 CAD. It offers a decent dividend yield and dividend growth, along with solid free cash flow and earnings. The bad - In July 2015, Home Capital Group suspended 45 brokers for creating mortgages with fraudulent income information. The estimated value of mortgages from the suspended brokers on Home Capital's books is $1.5-2 billion. Assuming zero growth, my formula yields a risk free treasury bond would be worth over $10.1 billion. Currently the market cap is around $1.7 billion, or an 83% discount before any adjustments for cash flow risk and growth. To valuate this business, you would have to adjust cash flows for existing business risk and account for the impact to cash flows for the risky mortgage holdings, fines, and the lawsuits as a result of the fraud. Also, consider the business ethics. Is this a one off event or was it a result of corporate culture and management pressures? Cogeco is looking like a better alternative.

Laurentian Bank of Canada (OTC: OTCPK:LRCDF) (NYSE:LB)

Laurentian Bank of Canada is a Canada-based Chartered bank providing banking services to individuals, and enterprises, and independent advisors. It also operates as a full-service brokerage firm. The bank has doubled its dividends in the past 10 years and offers a 4.1% yield. Note this came up on the screener due to a large swing in working capital in 2016, inflating the FCF. A quick peek into Laurentian's historic free cash flow, there have been large swings in working capital. Therefore I used the 4 year average free cash flow to estimate a treasury bond value at $6.2 billion. Currently the market cap is sitting at $2.1 billion or a 66% discount. My initial inclination is that Laurentian might be only slightly cheaper than the big banks when you adjust for growth and risk. But overall, Canadian banks have great insulation from external competition, which makes the moat pretty strong.

American Interests

After sifting through the screening results, the only business that looked promising was Maiden holdings:

Maiden Holdings (NASDAQ: MHLD)

Maiden is a holding company providing reinsurance solutions to regional and specialty insurers in the United States, Europe and select other global markets. Maiden operates through two segments: Diversified Reinsurance and AmTrust Reinsurance. Maiden has tripled its dividend in the last 10 years and has a yield of around 3.75%. It makes a substantial amount of free cash flow. However, as reinsurance is in the business of insuring the insurance industry against large but rare catastrophes, FCF may appear unjustly high until a large scale event happens. Understanding those risks is important to valuing the cash flows of the business. The reinsurance industry is also not what it used to be. I think Maiden is still an interesting business to have a deeper look into.

Summary

I've been meaning to have a good look at how banks and insurance businesses work. I think I'll take the opportunity to evaluate these opportunities against some of the bigger players to see if these are truly good opportunities that can be added to my income generating portfolio.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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