Completion of the Quest for Value

Many stocks trade at large discounts to their book values. Some are destined to trade at such levels (or below) for prolonged periods, while others show strong price appreciation in subsequent periods. How can investors distinguish between the beaten down stocks that are destined to remain beaten down, and those that are potential investment opportunities?

There are three important items to look for. The first thing is to determine how convertible the assets are into cash. Reliable receivables, land, and fast-moving inventories are all quickly convertible into cash compared to highly-specialized fixed equipment for example, where the book value may be nowhere near the realizable value.

Second, it's important to consider the debt level of the company. With debt, any estimation errors of the value of the assets (discussed in point 1) are magnified, as discussed in the third paragraph of this post. Furthermore, if debt obligations are due soon, the company is less likely to be able to sustain itself to get to a point to where it can reward shareholders.

Finally, management's intentions are worthy of consideration. If management is sitting on a boatload of cash, but wishes to spend it on new projects with uncertain outcomes, shareholder risk increases.

Exactly one year ago, we discussed Quest Capital (QCC) on this site as a potential value investment due to its massive discount to its book value. The company was in the business of issuing short-term (approximately 1-year), land-secured loans to finance builders looking to complete projects that were to be sold to various customers.

On all three of the points discussed above, Quest scored well, making for a rather safe investment with strong upside. The loans were due to convert into cash or the land could be seized and then sold by the company (of course, some loans had to be written down as some land values fell below loan values), debt levels were low (allowing for confidence in the net asset values), and management's intentions to take the steps necessary to reduce the discount to book value were very clear.

As a result, the stock generated returns of over 50%, and it did so with little in the way of downside risk. With yesterday's price increase, Quest's price is now within around 10% of its book value, offering investors the opportunity to exit at a price close to fair value and redeploy their funds to the next potential opportunity.

Disclosure: None

A Public Hedge Fund

Hedge fund investing is generally restricted to investors meeting minimum asset levels (i.e. rich people, the thinking being that they'll be all right if they lose a bunch of money) or those making large minimum investments (the thinking being that investors who plunk down $150K on an investment will do their due diligence, unlike the typical retail investor). But for all intents and purposes, it appears that Quest Capital (QCC) is trying to convert itself into a quasi hedge fund!

Long-time readers of this site will already know that Quest Capital has been a stock favourite of ours for a while now. In a move to increase its returns and stock price, Quest appears to be changing business lines, and is taking on a lot of characteristics that one normally associates with hedge funds.

Hedge funds are known for their high, but incentive-laden compensation structures and high management ownership levels, with the idea of aligning shareholder interests with those of managers. Quest is emulating this strategy with its proposed move.

Rather than pay salaries and offer bonus/option plans to managers, Quest will pay a management company 2% of its asset value (annually), and 20% of the excess returns it generates. Furthermore, this company will make a $25 million investment in the firm, thus better aligning its interests with those of shareholders. Unfortunately for existing shareholders, this investment will happen at a price that is below the company's current book value, thus diluting the shares of existing investors.

Quest shares rose around 15% yesterday on the news, further reducing the difference between this company's market value and its book value. But while the market cheered the news, value investors should be cautious going forward. The company is now entering a new line of business, and will have exposure to commodity prices. Commodity prices are inherently volatile, and their prices are very difficult to predict. If prices drop sometime in the future while Quest has a full book of loans receivable, there could be a slew of defaults and a significant loss in value.

For shareholders who are not interested in being a part of this new line of business, Quest is offering to buy back a number of investor shares tendered in a Dutch auction. Unfortunately, the maximum price for this auction is still a good 10% below book value, putting shareholders who want out, but who feel the price isn't quite right, in a bit of a quandary.

Disclosure: Author has a long position in shares of QCC

Info You Can't Get Anywhere Else

Investors who restrict their research of companies to text-based sources are missing out. While company conference calls can contain a lot of redundant and irrelevant data, there are often gems of useful info found on these calls that cannot be found anywhere else.

Yes, they can be quite boring. Many managers will start the call by reading out their entire press release, as if to somehow suggest that shareholders cannot read. And some managers speak at such a "leisurely" pace that they make William Shatner sound like an auctioneer. But it's not all management. For value investors, many of the analyst questions are simply not relevant. Whether an event (e.g. plant closure, new product launch etc.) will have its accounting impact in the 3rd quarter or the 4th quarter of 2016 is of no importance to us!

But on some calls, the questions that are asked or the insights management gives can result in the shareholder getting a great feel for certain aspects of the company. For example, on Quest Capital's most recent conference call, items that were not in any release were discussed, as a result of very specific questions that were asked. Quest is in the process of monetizing its loan portfolio. Listeners heard the following comments from the company Chairman:

"The cash on our balance sheet is ballooning, quite candidly. The issue is what to do with those ballooning cash reserves. We are cognizant of [having a] book value of $1.85/sh, and a stock price of $1.35/sh, and this discount is unacceptable. Our objective is to look at any and all alternatives to narrow the gap between net book value and market value."

When a caller asked if the company had any plans to buy back more shares, now that Quest's previously announced share repurchases have been completed, management replied that it was only allowed to do one Normal Course Issuer Bid per calendar year. If not for that, management claimed it would be buying back shares right now.

Management went on the say that the board is exploring what's called a Substantial Issuer Bid so that it can purchase more shares without waiting for the end of the year. Dividends were also discussed as a means for distributing cash. (Considering these options, however, I would venture a guess that dividends would not be management's favourite option right now.)

The conference call made it clear that cash is currently flowing in, and that management is exploring some very specific ways of distributing that cash that can result in a significant upward effect on the company's share price. None of this information is available in any press release!

Incidentally, cost-conscious investors can use Skype to listen to conference calls through their computers. Skype even provides touch-tone capabilities using the keyboard number pad, so users can fast-forward and re-wind at will as if they were using a normal phone. Ordinarily, listening to the Quest conference call referred to above would have cost me 15 cents/minute, but through Skype the whole call cost me only 50 cents.

Disclosures:

Author has a long position in shares of QCC

Author has no position in Skype or EBAY

Communication

Two companies may have the exact same financial statements, and yet one may be a value investment while the other is not. This is because management's intentions play a big role in determining what kind of investor would find a stock attractive. (For example, consider two companies with large cash balances. If one intends to to use the cash to buy back shares while the other intends to invest the cash to find a new blockbuster drug, the investor profile of each company should look very different.)

As such, it is important that management communicate its intentions with shareholders. Recently, we saw an example of the kind of backlash that can happen when shareholders don't know what to expect. On the other hand, when shareholders do know what to expect, it can lead to a win-win for all.

Few companies are as good at communicating their intentions as Quest Capital (QCC). When the economy turned south, Quest made it very clear that it would stop its lending operations and instead focus on collections. This may have caused shareholders who are primarily interested in earnings to sell their shares, but it also piqued the interest of those looking to buy loan portfolios at a discount. In this way, Quest altered its shareholder profile to one that is in harmony with management's objectives.

When cash inflows far outpaced cash outflows (since the company was no longer lending), Quest made it clear that it would use proceeds to pay down debt and buy out preferred shareholders. This would turn off those looking for leveraged real-estate real-estate returns, but would result in shareholders of a more conservative, value orientation.

Now that debts and preferred shares have been paid down, the company recently announced that it would seek to close the gap between its share price and its book value. The company then went on to buy up almost 10% of its shares in the last five months, doing exactly what it said it would do.

So what's next? Quest's chairman issued the following statement two weeks ago:

"We expect further [loan] monetization to occur and while we have recommenced lending on a cautious basis, we do not anticipate utilizing all of our cash over the near term. In the interim, we continue to look to enhance shareholder value and close the discrepancy between our book value of $1.82 per share and our trading price."

When it comes to some companies, management's intentions are difficult to figure out. For other companies, however, the publication of management's intent can bring along the right kind of shareholder - one who is there because they would do the same if they were in charge, which results in a natural alignment of management and shareholder interests. This can result in fewer surprises, and a much more content shareholder group!

Disclosure: Author has a long position in shares of QCC

Revenge Of The Options

As the stock market crashed in late 2008 and early 2009, many stock options held by managements of both large and small caps were made worthless. Even today, after most stocks have rallied strongly from their lows, many stocks still remain far below their pre-recession levels, effectively reducing (after-the-fact) salaries of managements during the boom years. But it appears that many managements will not take these salary hits lying down, choosing instead to make up for them by increasing option payouts now that prices are recovering.

Consider Quest Capital (QCC), which offers financing to commercial and residential builders. On a single day in January 2010, the company issued over 4 million options to management, more than it has in the previous five years! Has management done such a great job that it deserved more options this year than it has ever before deserved?

What is happening here appears to be a sidestep of the extremely unpopular practice of re-pricing options. As Quest Capital's share price has dropped significantly, the underwater options are expiring worthless. More than ten million options were cancelled or have expired in the last two years, but a big chunk of them have now been replaced at a much lower price! More may be on the way, as the company has a plan that allows it to issue options for up to 10% of the company's outstanding shares.

The value of options outstanding for many companies has dropped significantly since the stock market crashed over a year ago. Shareholders must be on the lookout, however, for companies that are recycling those options at much lower prices. Not only does this lower the value of a company's shares, but it sends a message that management wants all the upside that options have to offer, without taking any risk that the upside may not materialize.

Disclosure: Author has a long position in shares of QCC

Buybacks Are Back

It's not always a good thing when firms buy back their own shares. For example, under the pretense of creating value for shareholders, managements could use owner funds to increase the value of their stock options. But on the opposite end of the spectrum, there are also cases where buybacks have the potential to create enormous value for long-term shareholders.

Consider a company that breaks even that trades for $50 million and has cash of $100 million. It could pay out all its cash, resulting in an approximate 100% gain for existing shareholders. Or, it could nibble away at its shares. Consider an extreme case where the company spends $25 million buying back shares and the share price doesn't budge: the company would then trade for $25 million, but still have $75 million in cash; a cash distribution would now result in a 200% gain for the shareholders who stuck around! Value has been augmented for shareholders who hung on by transferring the value potential of those who sold early to those who stayed.

Now consider Quest Capital (QCC), a company we have previously discussed as a potential value investment. While it is not in the exact same enviable position as the hypothetical company described above, it does share some common traits that make it attractive as a "buyback target".

For one thing, it trades at a deep discount to its net asset value. While those assets are unfortunately not cash, the company is in the process of monetizing them. Since the end of the last reporting date, the company has issued updates announcing that another $20 million of preferred stock has been bought back. This appears to be a signal that monetization of assets is going well, since the company did not have that kind of cash as of its latest report.

Most recently, the company has now announced it plans to buy back common shares, as soon as this week. In its history, this company has not been one to buy back stock. But this time around, the reasons to do so are clear, and the motivations appear to coincide with what we discussed:

The Corporation’s directors believe that normal course issuer bid purchases of shares for cancellation may, by reducing the number of outstanding shares, reduce the discount that may exist between the market price of its shares and the Corporation’s net asset value per share.

Stock buybacks are not just catalysts for prices to align with intrinsic values. They can also boost value for shareholders, by transferring the potential price appreciation of the shares of exiting shareholders to the shareholders that hold on.

Disclosure: Author has a long position in QCC

Interim Updates

Investors commonly rely only on quarterly and/or annual reports to evaluate a company. But occasionally, companies will issue press releases or interim reports that can be valuable. Important and material information is often contained in these reports, and investors can often use this info to determine whether things are going as expected. Consider Quest Capital (QCC), a mortgage lender with very little leverage.

We discussed Quest as a potential value investment three months ago. For this stock to realize its price potential, one of the key success factors is that loan losses (i.e. mortgage debts that customers can't pay) do not come in well below management's estimates. The company has stopped issuing new loans for the most part, so if things are going as planned, cash should be coming in at a decent clip, adding to the company's safety and liquidity.

Last week, the company issued a release with some details describing its intentions towards its preferred shares. First of all, the company declared that it has paid its quarterly preferred dividend in cash. While this may seem non-newsworthy, the company actually has the option of paying this pref dividend in common shares, and it did so just two quarters ago. The fact that it has paid cash for the 2nd straight quarter suggests the cash flow situation is under control.

More significantly, however, the company also described some details with respect to restructuring the terms of its preferred shares. The company paid an upfront cash fee (again, suggesting its cash flow situation has improved) to lower the dividend it now has to pay on its preferred shares and for the right (but not the obligation) to redeem its preferred shares early. The pref dividend was 13.5% (now 12.75%, to be lowered to 12% in three months), as these shares were issued at a time when the company was in dire need of cash. But the fact that the company appears to be focusing on reducing and redeeming these preferred shares for cash suggests that the cash flow situation appears under control.

With the info provided by press releases and interim reports, investors can fine-tune their assessments of a stock's value that was likely primarily derived from the company's annual and quarterly reports. Subtle or not-so-subtle hints in such reports can help confirm or deny an investor's thesis.

Disclosure: Author has a long position in shares of QCC

Diamonds In The Mortgage Rough

Companies offering mortgages or related products are currently out of favour in the stock market, and often with good reason. Many companies spent the last few years borrowing money, and then lending it out carelessly, expecting to make profits on the spread resulting in high returns on minimal equity. When customers couldn't afford to pay back thanks to the downturn, the borrowed money remained due, resulting in strong chances of default for the lender. But not all mortgage companies find themselves in such high risk positions, but you wouldn't know it from their stock prices. Consider Quest Capital (QCC), a real-estate mortgage financier.

The company is owed $386 million from borrowers, all of which is secured by real-estate or corporate/personal guarantees. Based on the value of the underlying real-estate and the quality of these guarantees, the company estimates that it will recover $370 million of these outstanding loans. Even if you believe that mangement is not conservative enough with respect to estimating these losses, the losses would have to be 900% higher than management's estimates to justify the stock price of this company, as the stock trades as if the loans due are worth just $240 million.

The reason the value of QCC's loan portfolio can drop so much and still hold value for the equity holders is that extensive use of leverage is not in use. The company is financed with just $46 million of debt and $40 million of pref shares along with common equity of $290 million. But this equity trades on the market for just $120 million.

To reduce the risk of a cash crunch, the company has stopped originating new loans, and it issued the pref shares just six months ago to ensure adequate liquidity. So now the company will focus on collecting its loans receivable and paying down its debts and prefs, which should further reduce risk. For added flexibility, the company was allowed to pay pref shareholder dividends in the form of common stock, and did so for the last two quarters. Perhaps foreboding that the company's cash flow situation is now relatively safe, the company issued the following statement last week:

The Company currently plans to pay cash for any future dividends declared on the Preferred Shares.

Disclosure: Author has a long position in shares of QCC