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Second-level thinking in periods of market extremes

Written by Andrew Pastor and Sydney Van Vierzen
April 20, 2020

At periods of market extreme, we’ve put out pieces that explain some of the things that help us sleep at night. This is the seventh iteration and we thought we would use the recent volatility as an opportunity to put a spotlight on the Canadian Portfolio.

In today’s environment, there’s a lot of uncertainty about the near-term future. Generally, this causes investors to behave predictably. People’s time horizons shrink and they start trying to guess what the next three or six months are going to look like. As a result, many investors resort to first-level thinking — they decide to buy companies that appear to be safe like grocery stores or telecommunication companies. We refer to these companies as “obvious survivors”. The thinking is you’ll still need to buy groceries and have to pay your phone bill during the pandemic and when it’s over.

While investing in companies that are obvious to survive feels comfortable, we think investors are sacrificing long-term returns for the short-term feeling of perceived safety. You’ve likely heard us say this in the past:

“If all you know about a business is what everyone else already knows, then you don’t know anything at all.”

The only way to beat the market over the long term is to have a view about a business that’s not widely shared by others. Consensus thinking has caused valuations of these “safety” companies to increase to the point where we believe their future expected returns will be sub-optimal. We’ve made a conscious decision to not invest in these businesses.

Second-level thinking is finding companies equally as likely to survive as a grocery store, but priced like they have no future. We refer to these businesses as “non-obvious” survivors. Many long-time partners will be familiar with the term as we used it to describe how we invested your money during the 2008/2009 financial crisis.

Who are today’s “non-obvious” survivors? These are typically market leaders with long runways for growth but whose revenues will slow down temporarily. Many of these companies can take advantage of the downturn and come out stronger on the other side. This means doing things like gaining market share, acquiring competitors or repurchasing shares at attractive valuations. When fear is so large that investors price a stock like there’s no future, then you get that future for free.

Investing in these businesses has caused us to look and perform differently from the index and our peers. Looking different is uncomfortable, but it’s the right thing to do in order to get to your point B in the long term.

Let’s walk through three examples of companies you own in EdgePoint Canadian Portfolio. They are all Top 10 holdings and represent 15% of the Portfolio.

Onex Corp.

Onex is the largest private equity manager in Canada with over $20 billion in assets under management. The company was founded in 1984 and has successfully navigated many challenging environments. Insiders have a lot of skin in the game with the CEO owning approximately $700 million of stock.

Private equity is the kind of business investors want to avoid in this environment. By its nature, private equity companies operate with higher leverage. More leverage means less flexibility to withstand a shock to the business. To make matters worse, Onex invested in a handful of businesses that are directly impacted by the virus. For example, in December 2019 Onex acquired WestJet Airlines Ltd., Canada’s second largest  airline.

Why is Onex a survivor? We think investors are confusing the debt held by Onex’s portfolio companies with the financial risk of Onex. The parent company (which you own) has no debt and went into the downturn with over $2 billion in cash. Onex owns a diversified collection of businesses across a wide range of industries. While the individual investments have leverage, each one is independent of the others. This means that if any of their 35 companies is impaired, it has no impact on the rest of the portfolio. To put this in context, even if WestJet has no equity value, it represents less than 4% of Onex’s holdings.

At its trough in March, Onex was down over 50% year-to-date. It was trading for less than its available cash and the value of its public equity portfolio. Investors were getting the entire private equity portfolio, credit portfolio and asset management business for free.

It’s difficult to lose money buying a company with no debt and $2 billion of cash on the sidelines. Not surprisingly, Onex has been actively repurchasing shares at these levels.

Element Fleet Management Corp.

Element is the largest fleet manager in North America. Fleet managers like Element provide a mission critical service which isn’t going away.

What does the company do? Many companies choose to outsource the management of their vehicles. This means Element takes care of the financing of the vehicles, repairs/maintenance and fuel management to name just a few  services.

The majority of Element’s customers are blue-chip clients who rely on their fleets to operate their businesses on a daily basis. Customers are extremely sticky with annual retention levels of approximately 98%. While fleet usage might decline during this downturn, this will only be temporary. Fleets of delivery vans, utility service trucks and vehicles transporting samples for lab testing are as important as ever. Just think of all the products you’re getting delivered to your home during this pandemic. There’s a good chance that Element manages some of those vehicles.

We believe that Element is more resilient than many other financials including banks. The company operates with less leverage, their assets and liabilities are matched and their credit risk is low. During the 2008/2009 financial crisis, credit losses were less than 0.1%.

We think that Element can use the downturn to come out stronger. A large percentage of the industry still manages their fleet in house. As a result of the pandemic, many businesses might decide to outsource their fleets to free up capital. If this happens, Element could significantly increase its market share during the downturn.

We believe we’re buying the business at less than 10x free cash flow, an attractive valuation for an industry leader with a long runway for growth. The CEO of Element seems to agree as he recently bought shares in the open market.

Restaurant Brands International Inc.

Restaurant Brands is the franchisor behind Burger King, Tim Hortons and Popeyes. Three iconic brands that we expect to continue thriving for years to come.

While our routines and the ease of buying coffee, pastries, hamburgers and chicken have temporarily changed, our love for those things most certainly hasn’t.

At its trough in March, Restaurant Brands was down 65% from its 2019 highs and over 55% year-to-date. Investors are primarily concerned with how store operations have been impacted and the significant amount of debt on the balance sheet.

While these are both relevant concerns, we think the more specific questions are “how is the debt structured?” and “how are long-term operations likely to be impacted?” It’s important to step back in times like these and remember that the value of a business is based on the lifetime cashflows it produces and that 90 or even 180 days of operations will generally represent only a very small fraction of its intrinsic value.

While the company has a considerable amount of debt, the nearest maturity isn’t for another four years. Between now and then, the business will only be required to pay interest on that debt. At the end of 2019, the company had enough cash on hand to cover roughly three years of interest payments.

We’ll say it again — the value of any business is predicated on its lifetime profitability. Imagine you were going to open a Tim Hortons today and ask yourself — do you think consumers will drink materially less coffee next year because of COVID-19? Will the convenience of picking up a bagel for breakfast become any less appealing? What about in five or even 10 years from today? As simple as the questions may seem, these are critical determinants in the long-term value of this business.

Our view is that people will continue to want these small conveniences for many years to come, which is part of the reason why we think this business has an incredibly enduring value proposition. In addition, we think the opportunity to expand the three brands globally hasn’t gone away.

Based on the current share price, we’re paying less than 14x normalized free cash flow for what we believe to be one of the best businesses in Canada. A defensive, capital-light business model with incredible brands and a very long runway for growth.

The businesses discussed above are examples of businesses where the Investment team has proprietary insights and are discussed for illustrative purposes only. They reflect our views and don’t constitute a personal recommendation or take into account the particular investment objectives, financial situations or needs of individuals. EdgePoint Investment Group Inc. may be buying or selling shares in the above securities.

For the most recent standard performance, please visit the Investment results page.