Chadwick Wasilenkoff with the purchase of the paper mill in Thurso, is not the only British Columbia businessman to make contrarian investments in Québec. On March 29, 2010 (just 11 days after the Thurso transaction), it was the turn of fellow B.C. entrepreneur Rick Doman to buy assets in Québec that nobody seemed to want …

His company, Eacom Timber (TSX Venture – ETR) has completed the acquisition of 7 Domtar sawmills (3 in Quebec and 4 in Ontario). When we look at the present state of the lumber industry, it’s clearly a very bold and contrarian investment. The price of lumber is currently too low for these mills to be profitable. Two of them (Sainte-Marie and Ear Falls) are even inactive.

Rick Doman is obviously betting on a turnaround. He said the supply of lumber is expected to decline in coming years because of the devastation caused by an insect (the pine beetle) in Western Canada and Northwestern U.S. forests. Meanwhile, economic recovery will increase demand. The decrease in supply coupled with increased demand should raise lumber prices and transform Eacom’s sawmills into highly profitable operations.

Eacom paid 129 million to Domtar for the mills (102 million cash and 27 million in shares of Eacom). The company conducted a share issue of 145 million to finance the acquisition. Following this transaction, Eacom has no debt and still has 43 million in cash.

Rick Doman has worked all his life in the lumber industry. His father, Herb Doman, is the founder of Doman Industries (now Western Forest Products). He knows the domain very well and applies the old contrarian investor recipe of buying when the market is bottoming out and then waiting for a rebound. The transaction is perhaps bold only in appearance …

In conclusion, the lack of daring entrepreneurs in Québec seems more and more evident when compared to the likes of Wasilenkoff and Doman!

Bertrand Marotte Globe and Mail article

Fabrice Taylor Globe and Mail article

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1. Riding Coattails
2. Understanding Fortress Paper
3. Fortress Paper

Hemisphere GPS is a small firm that has been rumored for years to be an acquisition target. Despite great R&D, Hemisphere struggle to achieve meaningfull profitability. By being part of a bigger ag player, Hemisphere could benefits from stronger sales channels and lower G&A expenses and achieve greater profitability.

So, should Hemisphere GPS hire some merchant bank like CIBC World Market and put themselves up for sale ? I think this could be an interesting option for the company and its shareholders.

Who could be the potential suitor ? First, there are Hemisphere direct competitors like Trimble Navigation, Novatel, Novariant, Raven and Topcon. A second type of potential acquisitor could be big OEM manufacturers like CLAAS, STARA or John Deere. Hemisphere products could be a nice fit in their current offerings.

In conclusion, I have no clue if Hemisphere GPS is going to be acquired in 2011 but I think it remains a logical possibility.

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1. Hemisphere GPS

Hemisphere GPS (HEM.TO) is a Calgary based company that develops GPS navigation systems primarily for the agricultural sector. Formerly known as CSI Wireless, the company took a major turn in 2006 by disposing of its wireless operations to focus on the development and marketing of GPS systems.

In an industry dominated by giants such as Garmin and Trimble Navigation, Hemisphere GPS has carved itself a niche in the agricultural sector that generates 85% of its revenues. The use of GPS guidance systems helps farmers optimize the spraying of pesticides, fertilizer and seeds. Auto-steering systems even allow tractors to evolve by themselves in the fields following pre-programmed route. The sub-inch accuracy of those advanced GPS systems enable farmers to reduce input costs and increase crop yields.

Hemisphere GPS is one of the world’s leading company in this niche market. Thanks to its R&D effort and the acquisition of smaller competitors like Outback and Beeline, the company has a variety of products and over 70 patents. Growth prospects looks bright when considering the still early penetration of GPS guidance systems in agriculture. In North America, less than 40% of farms over 500 acres use GPS guidance and only 20% use auto-steering systems. The adoption of these technologies is even lower in the rest of the world.

In 2010, Hemisphere GPS released its new Outback eDriveX auto-steering system. So far, the product seems to be well received by customers. The company recently signed a distribution agreement with CLAAS Agrosystems in Europe and a OEM partnership with China’s FOTON LOVOL.

First, let’s have a look at the company’s financial data:

The balance sheet is clean with no debt, $8 million in cash and  $25 million in working capital. Book value per share was estimated at $1.53 by management on September 30, 2010.

The picture is less rosy when we look at the recent earnings history of Hemisphere GPS. The company earned $6 million ($0.11 per share) in 2008 on $73 million revenues but lost the same amount ($6 million) in 2009 on much lower sales ($54 million). Projected 2010 sales are $59 million which could result in a loss of approximately $5 million.

Without a doubt, the recession dampened the financial results of Hemisphere GPS over the past two years. However, I think their business is starting to turn around. Recent high grain prices have led to big profits for farmers. They are now flush with money and ready to spend again on field equipment. With its diversified range of products, Hemisphere GPS is well positioned to thrive in such agricultural bull market.

Next, let’s have a look at possible financial outcomes:

(In millions)

Since a large part of their expenses are relatively fixed, I think the company has a lot of operating leverage. Any meaningful increase in sales could have a big impact on net income and share price. This is the type of opportunity that growth-oriented investors are looking for.

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1. Hemisphere GPS : an acquisition target ?
2. Is Aeroplan an Economic Bellwether ?

The trend is your friend is a famous adage on Wall Street. Numerous are the speculators using technical analysis and other “momentum traders” who try to enrich themselves by surfing on an uptrend. And contrary to what one might expect, investors having a long-term horizon and basing their decisions on fundamental analysis also have a strong propensity to follow the trend …

Take the example of a company with above average earnings growth over the last three years. It is likely that the fundamentalist investor identifies such a company as being of high quality and invest in it. Thus, betting that the company will maintain its above average growth in years to come. In short, he relies on a continuation of the trend.

People investing in the stock market through mutual funds also have a beautiful friendship with the trend. They often buy funds with the best performance over the past two or three years and hope they continue to perform very well.

More often than not, these investments are disappointing. By an obscure phenomenon, the strong performance of the stock or the fund seems to fade in the years following our purchase decision. Without really knowing it, the investor faces a very powerful principle in the financial world and in life in general: the regression toward the mean principle.

It is very difficult for a company to maintain a high level of growth for several years. Professor Josef Lakonishok has studied the statistics of U.S. public companies from 1951 to 1998. He concluded that the past growth rate of profits is not a valid indicator to predict the future growth of these! For example, among the companies that experienced above average growth in profits between 1989 and 1992, only 9.5% (1 out of 10!) were able to maintain this outperformance from 1992 to 1995. A percentage entirely consistent with the laws of chance …

An investor who expects a continued high growth is thus betting on a low probability scenario (one chance in ten). He is in direct confrontation with the principle of regression toward the mean. Meanwhile, companies that experienced a below average performance over a period of three years tend to improve their results in the following three years.

Regression toward the mean is not a purely statistical phenomenon. There is also an economic rationale behind the principle. A company with great success will attract competition and face heavy competitive pressures that can reverse its rate of growth towards the average of its peers. Similarly, a firm with poor results will take steps to improve its profitability. It may dispose of unprofitable activities or outright replace its management team. It is easier for a company to move from being “mediocre” to “average” than to stay on top of the pack.

Contrarian and value investors have realized that the trend is not a friend you can count on. They much prefer to team up with the principle of regression toward the mean. According to Prof. Lakonishok, this explains the historical superiority of value investing over growth. Clearly, the trend is not your friend!

The study by Professor Lakonishok on the persistence of growth rates

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1. Life and Death of a Growth Stock

Last June, the CEO of Fortress Paper, Chad Wasilenkoff, appeared before a Canadian Senate committee to explain its various business projects. This group of senators seeking solutions to the  problems of the forest industry were very impressed with his presentation. In my opinion, this is the best explanation I have read about the activities of Fortress Paper. I want to thank Eddie Chandonnet, a reader of this blog (and experienced investor) for his discovery of this document.

You can access the complete document here.

Here are some interesting excerpts on …

… Wasilenkoff’s past investments

My background is as a contrarian investor, first and foremost, and an entrepreneur. I typically look for investment opportunities in areas that are heavily out of favour, where other investors typically would not like to tread. When gold was $275 an ounce, I was able to secure two gold mines. When oil was $15 a barrel, I built up two oil and gas companies. When copper was 80 cents and seemed to be going lower, I bought a copper mine. When uranium was $8 to $9 and no one was looking at that space, it having been in a 25-year decline, I was able to secure assets from Cameco.

… the Thurso project

These assets we were able to acquire and secure for $1.2 million. A lot of people thought we were crazy and probably spent too much. However, their replaceable insurance cost is $851 million. These assets are more than 95 per cent ideally suited for our new product, dissolving pulp. As we turn this project around and convert to dissolving pulp, we are able to take these $1.2 million assets that were heavily underutilized by the previous owner, and, once we are fully converted to dissolving pulp, even at the initial stages, given the current or spot price of dissolving pulp, the mill will generate just over $200 million in profit.

… looking at things differrently

If we look at the Thurso project and what we will produce there, this concept is a bio-refinery producing multiple chemical products and co-products from biomass feedstock. This concept is gaining acceptance worldwide. It offers possibilities for creating new value chains and diversifying the forestry sector. The concept is analogous to today’s petrochemical refineries, where multiple products are produced from a single raw material.

… India and China

A large chunk of the population in India and China are moving into middle-income status. The first thing they buy is a cell phone, and then they improve their wardrobe. In these hot regions like India and Indonesia, they want fabrics that breathe better and are more absorbent. The industry is growing at about 10 per cent per year. We will no longer be relying on the structural decline taking place in the paper industry.

… the Dresden mill

As an example, I bought a mill in Dresden, Germany. It was manufacturing wallpaper. They had good inroads and a strong, deep understanding of the wallpaper industry, the sales cycle and the customers, but they were making a standardized simplex paper, which is not that dissimilar to photocopy paper. It was for a different use, but any paper machine in the world could make it. Through research and development, we developed a non-woven type of product (a dry strippable wallpaper).

With that, if we look at the wallpaper industry globally, it is still in a 1 per cent or 2 per cent decline. Most people say it is not a great area for investment. Within that industry, though, this non-woven product is taking off and displacing the old product. We are growing at between 15 per cent and 20 per cent per year. Since acquiring the mill, I have made three upgrades. We have more than doubled the capacity. We now represent 55 per cent of the global production of this non-woven wallpaper, and we command 20 per cent profit margins. With the old product, we would lose about 1 per cent, no matter how efficient we made it. It was the wrong product mix.

… a Senate proposal

One of your proposals that caught my attention was to try to grow and promote the biomass and biofuels industry for heating and electricity. Look at the innovation and growth that has occurred in the computer industry in the last 20 years. Exciting things happen in leaps and bounds annually, which attracts young people. In contrast, in the forestry sector, when creating heat and electricity from biofuels, we are basically only burning wood in one form or another. After 300 years of Canadian forestry and billions of dollars spent through profits and government subsidies, our great light-bulb idea is to burn the wood? The caveman came up with that.

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1. Fortress Paper
2. Contrarian investing in Québec
3. Riding Coattails

The Group Aeroplan issued Q2 2010 financial results above expectations. The operating profit (adjusted EBITDA) rose by 10% and all business units contributed to this growth. These good results contrast with the current discourse of the financial media who seem terrified by the “jobless recovery” and the return of the recession.

Aeroplan is a loyalty program manager with a strong geographic diversification (Canada, United Kingdom, United States, Italy and Middle East). The company has many partners very sensitive to the state of the economy such as CIBC and American Express in Canada or HomeSense in United Kingdom. Business travelers are also major users of the program in Canada. I think Group Aeroplan can be seen as an interesting indicator of the mood of consumers and businesses. Last quarter profit growth  and optimism expressed by the company management contradict the theory of a relapse of the economy.

In my opinion, Aeroplan is one of the most underrated stock among Canadian mid-cap. The company generates significant free cash flow and its business model requires little capital expenditure. It is becoming established as the world’s leading loyalty program. In addition, the company pays a safe dividend of 4% and buy back its shares massively.

The misunderstanding of its business model and fears for its reliance on Air Canada are probably two reasons for skepticism about Aeroplan.

As for its business model, Aeroplan sells milles to its various partners. They then distribute them to their customers. Eventually, these customers go back to Aeroplan to redeem their miles (to get an airfare, iPod, etc..). Aeroplan thus receives income before having to provide an actual product. It is a model similar to insurance companies who collect insurance premiums first and pay compensation (if needed) in a more or less near future. However, the Aeroplan model is much less risky because of the fixed value of Aeroplan miles (contrary to the compensation paid by insurance companies whose extent is unpredictable).

Air Canada is an airline that has had its share of financial troubles in the last decade. These problems gave umbrage to Aeroplan. However, you should know that the percentage of Aeroplan income coming from Air Canada has declined significantly due to the expansion of the loyalty program. In 2007, Air Canada accounted for 25% of the group 950 million income. In 2010, it is only 12% of the two billion projected income that will come from Air Canada.

In short, Aeroplan is a a bit of a unloved and neglected stock that could rebound in a big way during an economic recovery.

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1. A Castle Under Siege

Shares of Research In Motion (RIMM – NASDAQ) have undergone a sharp correction in recent days. The market was not impress by RIM Q1 results despite a 23% increase in profits and revenues. After this correction, the gap between current valuation and it’s valuation from two years ago is nothing less than phenomenal! On July 3, 2008, the stock of the BlackBerry maker was trading at $ 115 U.S. or 51 times their $ 2.26 profit from fiscal 2008 (ended March 1, 2008). On July 2, 2010, becoming a RIM shareholder costs a whopping $ 48 equivalent to 11 times the EPS of $ 4.32 from fiscal 2010.

According to Mr. Market, a company that almost doubled its profits and increased its revenues from 6 to 15 billion in two years deserve a price/earnings ratio similar to Pfizer ! In my opinion, such a low valuation is probably the result of the market general pessimism combined with the obsession of the media for a company named Apple. The reasoning seems to go as follows: RIM is not anymore the dominant player in the smartphone market because of competition from Apple and Google, so the company is basically worthless! QED !

It is obvious that a company trading at 50 times its profits must absolutely stay the dominant player in its sector for its shareholders to have any hope of enrichment. The interest in RIM current stock price is that global and interplanetary domination is no longer a need to provide an attractive return. The smartphone market is still in its infancy. The term “smartphone” will itself be obsolete in a few years when all mobile phones will be smart. As sexy are Apple and Google products, they probably won’t have 100% of this market. RIM may loose its number 1 position, but remains well positioned to be a major player.

The skepticism vis-à-vis the Waterloo firm does not date from yesterday. Currently, many analysts fear that the next generation of products to be unveiled within weeks may not be up to par. It could be, but we must not forget that RIM has always delivered the goods in terms of product quality and innovation. Since 1997, the company confounds skeptics on a regular basis. Its CEO and founder Mike Lazaridis is a genius who belongs to the same league as Steve Jobs.

In short, RIM sells to less than 10 times expected profits for this fiscal year. The company is well positioned in a market poised for strong growth in the coming years. Expectations are low despite its history of success. From an investor perspective, the risk/reward equation is very attractive. Buy quality when no one wants has always been the winning recipe of stock market riches.

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1. Is Potash Stock Too Expensive ?

Valuing cyclical stocks is a very different discipline from valuing non-cyclical ones. We have read recently in the financial media that Potash stock ( POT – TSX) was clearly too expensive. This Canadian company is the largest potash producer in the world (potash is a basic component of fertilizer). The stock of Potash is said to be too expensive because of its price / earnings ratio of 20, a ratio supposedly too high for a cyclical stock. I am not an expert in the field, but I doubt that the “high PE ratio = expensive stock” equation is really the right way to evaluate a producer of raw materials such as Potash.

Let’s go back in time. At the end of 2004, Potash stock is trading at 30 times profit, the stock was indeed very expensive according to the theory cited above. However, the share was then worth $ 27 and was at the dawn of a surge that was going to lead to a high of $ 230 in June 2008. At that time, the PE ratio  of the stock had fallen to 20. On this basis, the stock was therefore less expensive than in 2004, and despite the multiplication by 9 of its market cap! Most people will find completely illogical that a stock can be considered “less expensive” after a ninefold increase and they are right! In fact, the PE ratio is a poor tool to evaluate a cyclical stock like Potash.

Producers of commodities are cyclical stocks because their profits follow the cycle of commodity prices. Generally, the PE ratios will tend to be high at the bottom of the cycle, because the market is anticipating a price hike of raw material and an increase of the producer’s profit. Conversely, the ratios are low at the top of the cycle, because investors do not pay a high multiple for profits that may decline in coming years. To make money, you have to buy at the botton of the cycle (regardless of PE ratios) and sell at the top (at a generally low PE).

The challenge posed by this type of investment is obviously to determine the point in the cycle we find ourselves now. For this, we must understand the mechanisms governing the supply (easiness to increase production, add new mines, etc..) and demand (who are the consumers?, what is their financial situation?, etc.. ) for a specific resource. We must also gain some  knowledge of the resource historic prices. In the case of potash, the price was long depressed by the collapse of consumption in the former Soviet Union (following the breakup of the country). This created an excess supply which took more than a decade before being absorbed by the market.

In short, it is futile to attempt to evaluate a cyclical stock if we have no idea where the current price of the resource fit in the cycle. Understanding this famous cycle requires specialized expertise that is beyond the reach of a lot of people. In the case of Potash, the stock is not that expensive if potash price is at the bottom of the cycle, but that’s another story if it is in the middle … There is also a theory that fashion that we are currently in a bullish ”supercycle” for everything related to agriculture. This may be true as this may be the ag version of the “Peak Oil“ theory ! Time will tell …

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1. The Subtleties of the P/E Ratio
2. A Castle Under Siege
3. Contrarian investing in Québec

Since its founding in 1986, Home Capital Group has concentrated in subrpime mortgages (or Alt-A in the mortgage jargon). These loans are granted to individuals not meeting banks criteria to obtain a mortgage. HCG has been able to succeed at the game through his niche expertise to assess the risk of this type of clientele, its traditional financing by issuing certificates of deposits and its conservative capital structure (high tier-1 capital ratio). In summary, HCG has long feasted from the crumbs that fell from the table of major Canadian banks.

The summer of 2008 arrived and with it came an unprecedented financial crisis which led to a significant lessening of competition in the canadian mortgage market. HCG saw a golden opportunity to enter the “traditional” mortgage market . What was their Trojan Horse? Independent mortgage brokers! The latter, seeing less alternatives for their clients were very happy to welcome HCG in this market segment. From now on, the small Toronto company would sit at the big table!

In Q3 2009, 68% of mortgages issued by HCG were triple-A mortgages insured by CMHC. 29% of the mortgage portfolio of HCG is now CMHC-insured compared to 15% at December 31, 2008. Mortgage brokers seem very satisfied with the personalized service that offers HCG. A service that contrasts greatly with what they get from the big banks. Big banks have their own sales force and have always had an ambiguous relationship of collaboration / competition with mortgage brokers.

In conclusion, Home Capital Group has used the crisis to reduce the risk level of its business while increasing profits. The firm run by Gerald Soloway is another example that the theory stating that we should take more risks to make more profits is in fact … just a theory!

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1. Buy RIM when Nobody Wants It
2. Is Potash Stock Too Expensive ?

Investing in stocks is often a solitary sport where independent thinking is a valuable quality. This does not mean that our success depends to 100% of our ideas. Fortunately for us, there are brilliant investor, with an incredible talent for wealth creation and who are little known to the public (this is not an article on Warren Buffett). The beauty of stock markets is that they allow us to partner with such a specimen when we finds one. What’s easier than buying some shares and then leave it to our “new partner” with the task of working heart and soul to our enrichment!

I believe Chad Wasilenkoff, founder and CEO of Fortress Paper is one of these buffettesque individuals obsessed from an early age with money accumulation. His personal story is not mundane (he his only 37 years old) and contains some similarities with that of Nebraska most famous investor. At 10 years old, Wasilenkoff hired his friends to recover golf balls lying at the bottom of ponds. He then sold them with a tidy profit to golf club clients (a kid in Omaha was doing the same in the 30s). As a teenager, he developed a business around reselling Atari’s computer games (the teenager of Omaha rented pinball machines in an other era …). Our ambitious teen then expanded its business from the sale of video games to that of bicycles to that of used car!

Then came adulthood and serious matters. His first big coup was the takeover in 2003 of Dynasty Metals for $ 1 million. The subsequent rise of gold price from $ 300 to $ 700 did inflate the market capitalization of the company to $ 150 million! Wasilenkoff repeated the same trick in 2004 with the acquisition for a pittance of Titan Uranium, while the uranium price was at a bottom. The rest is history… the uranium price exploded from $ 10 to nearly $ 100 a pound and Wasilenkoff had the flair to sell its stake at the top!

The creation of Fortress Paper in 2006 by the acquisition of two paper mills of Mercer International follow the same logic. Again, Wasilenkoff buy cheap assets in a sector in disfavor (pulp and paper). Although cheap, those mills are quality assets that he believes will worth much more  in the coming years (see my analysis). As the owner of 20% of the company’s stock, his interest are clearly aligned with the rest of the shareholders.

In conclusion, I am convinced that riding coattails of an investor with such a flair can pay. Of course, nobody is infallible, but why not put all the chances on our side by “partnering” with someone who seems born to make money? If you had the choice between a self-made man like Wasilenkoff or a technocrat CEO who used his political skills to succeed (and his stock options to get rich), which one would you choose? As for me, the choice is already made!

For more info:

An article about the expansion of Fortress Paper

An article about Chad Wasilenkoff

An article of the Globe & Mail

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1. Contrarian investing in Québec
2. Fortress Paper
3. Understanding Fortress Paper