Peter Kennan On His Philosophy To Deep Value Investing With A Corporate Finance Twist

Other than a direct takeover, the events that works best in Hong Kong are those that effect earnings. It’s a very earnings driven market. So if you’ve got a catalyst that’s more around multiple expansion rather an earnings effect, then it’s a riskier proposition for the upside. We had a toll roads company in China where the government announced a review of tolls. Subsequently, the whole toll road sector sold off. It sold off so much that the implied unleveraged IRRs were 18-19%. Having done all of the analysis, we knew the risk was overblown. The Government needed toll revenue to remain at the current level to meet debt service costs. There was just a complete misunderstanding of the situation. So we invested in a Chinese toll road company. The Government ended up shutting down some illegal tolling and didn’t touch the overall tolls. The market just yawned, and the stock prices did not move.

What was one of the best investments you’ve ever made? And give us a backdrop there as well.

PK: The best investment we have made so far is Elders Preference shares. It made us about 35% of our NAV in the one transaction. I scanned for preference shares. In Australia, they’re called hybrid securities. (Ben Graham’s book, Security Analysis, talks about them as far back as the 20s and 30s.) Essentially, they’re perpetual debt securities. The only penalty for the company in not paying the coupon is it can’t pay ordinary dividends. This stipulation makes them a terrible instrument to buy at 100 cents on the dollar. But in distress, they often get mispriced because they’re poorly understood and neither debt nor equity.

We found this security trading at $0.30 on the dollar. The company, Elders, is in rural services in Australia. It’s a bit like Agrium, but, in Australia, the agricultural market is driven by grazing and livestock as opposed to horticulture. Elders is an iconic Australian company with a 185-year-old brand name. The staff are instantly recognizable in their Akubra hats and bushmen’s shirts. All the major rural towns have an Elders branch. It’s a trophy asset, and they’re connected with the land. They lost a billion dollars in forestry during the global financial crisis. This company has been in work out with the banks from 2008 onward.

As a result, the coupon was not being paid on the hybrids. The company decided to sell all its non-core assets, and then to sell the core business as well. At which point they would return capital to shareholders. We did the work and thought: “The hybrids are worth, maybe not $100, but at least $60.” We’re buying at $30, and we also analyzed the corporate finance activism aspect because if we owned a blocking position of the hybrids, then we could skew the distribution of payout to the hybrids rather than to the ordinary shareholders. Sometimes when preferred securities are held broadly, there’s no single voice. The lack of a unified voice can lead to things like a 50-50 share between common and hybrids, rather than a 90-10 split.

That was our strategy — it was a deep value strategy on the $30 versus $60, then activism to create additional value. In 2013, it was an especially difficult year for the rural sector because there was a drought in Australia. It was one of the worst they had seen in many years. The drought caused the company’s earnings to drop to virtually zero. They sold all the non-core businesses, but they couldn’t sell the core business. The drought ended up being a blessing in disguise as Elders was restored to being a pure Ag business.

It was the first time management had headroom to focus on the core business. They didn’t touch the core business before because it was generating all the cash flow to help them to survive.All of a sudden they went from $0 to $25 million of EBIT. With the rains coming back, they are currently now at $45 million of EBIT. There was such a pricing dislocation at the bottom. Even when we invested the ordinary market cap exceeded the market cap of the preferred shares, which makes no sense because it’s preferred. It was classic mispricing. Graham talks about this in Security Analysis.

This type of mispricing can happen in retail hands. Retail investors didn’t know what to make of these hybrid securities. They didn’t know what was going on and didn’t like the coupon not being paid. Post the earnings recovery, the company was doing so well they raised common equity. The company then bought back $30 million worth of the hybrids last August. We are now pushing to have all of the hybrids redeemed or converted by the company. Our average entry price was $22 and the hybrid is now trading at $80.

If you look back at your 20-year-old self, knowing what you know today, what advice would you give yourself?

PK: That’s a good question. I think about this for my kids. What career advice to give them and I think the key thing is to follow what you’re good at and what you enjoy as opposed as to what may earn you the most short-term income or status. I think that’s what I would advise myself.

What would you say are the three things an investor should focus on the most to generate abnormal excess returns over the long term?

#1 — I think the first thing is protection on the downside. If you’re wrong, you only lose a little. It’s super important for everything I do.

#2 — Then you need to buy things at a discount to fundamental value (margin of safety). Your margin of safety also provides a source of upside return.

#3 — You can’t just buy cheaply. I think you need a process or events to realize value over a reasonable timeframe. I think very few companies continue to win over the long run as things always change. You’ve got new competitors, management changes, regulation changes, technology changes, demographic changes, changes in consumer preferences, etc. I agree with Mohnish Pabrai when he talks about how every business is an arbitrage of limited duration. Keeping that in mind is important when making investments; understanding the creation and destruction that capitalism applies to companies and corporate situations.

We can tell you love what you do, so please keep doing what you do.This has been fantastic, thank you for your time and amazing insights!

PK: Thank you very much, Luke. I appreciate the opportunity and appreciate what you do.

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