Broken Plates and Negative Associations
Market participants tend to undervalue companies that carry a temporary imperfection, even if the issue is isolated to one particular part of the business. In other words, the negative association is cast across the whole company rather than objectively contained to the relevant segment when pricing the company. This has created compelling opportunities in the past, such as Brookfield Residential Properties in 2011. Current opportunities in this genre abound in a variety of industries.
Our tendency to misappraise situations that require the separate evaluation of more than one component is highlighted in the following example. A study done out of the University of Chicago by Christopher Hsee asked a group of students to price two sets of dinnerware. The first set contained identical pieces as the second and an additional sixteen pieces, seven of which were intact and nine broken. Logically, one should be willing to pay more for Set A given it clearly has more economic value.
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Set A
Set B
However, Hsee’s study showed the opposite. Separate groups, each evaluating only one set, priced Set A at $23.25 and Set B at $32.69. Ultimately, the subjects were influenced by the presence of defective pieces, such that they priced the intact dishes much lower than had fewer intact pieces been offered in the first place (Set B).
The tendency to misprice “sum of the parts” situations, as illustrated above, applies directly to stock investing. Three out of sixteen positions in Starvine’s strategy have this dynamic, all in unrelated industries (packaging, real estate, and media). One may wonder, though, whether it is a good idea to own stock in companies that are painted all over erroneously with the same brush. After all, is it not possible that the company stays undervalued for an extended period of time? If human tendencies undervalue such situations, could we not be waiting for a decade for the valuation gap to close? The answer is yes to both, and that is why it is key to study management’s track record in both their present and past companies, if applicable. Have they successfully spun off overlooked divisions in the past to highlight value? Have they capitalized on undervaluation by repurchasing shares at low prices? These are a few corporate action tools that management can use to surface value.
Brookfield Residential’s Broken Plate
Going back to Brookfield Residential Properties (BRP), this was very much a case of buying an intact plate along with a broken one. BRP was the result of a simultaneous spin-off of Brookfield Office Property’s Canadian homebuilding and land sales business, and a merger with Brookfield Homes (BHS) which carried out similar activities but in the U.S. Brookfield Asset Management, the parent company, seemingly engineered this transaction to ensure that BHS (the U.S. division) was financially supported while it recovered from the U.S. housing recession. At the time, in mid-2011, BHS was generating slight losses given its concentration of property in suburban California, one of the worst hit regions in the U.S. housing crash. The merger was not expected to bring much in the way of cost synergies, so it was feasible to evaluate each half independently.
I estimated at the time that the Canadian side generated about C$1 per share in earnings power. The stock started trading at C$10, but the price was driven down during the Greek Crisis to a low point of C$6.50, which implied a 6.5x P/E ratio on the Canadian business alone. Despite the near-dormant status of the U.S. side of the business, it didn’t take a genius to realize that the ~50,000 residential lots had a lot of latent value. Even at C$10, you were arguably paying only for the Canadian business and getting essentially half of the company as a free option on the U.S. housing recovery.
BRP was destined to be neglected by most professional investors. With the parent company owning more than 70% of the shares from inception, less than C$300 million of float was freely trading, meaning it would have been suitable only for small cap funds. It came as no surprise that sell-side analysts did not begin covering the company until a few years after BRP began trading, given the grim prospects of generating trading commissions from such an illiquid stock. Add to that the strong stigma still attached to anything related to U.S. housing at the time, and furthermore the nasty headlines from the Greek crisis in 2011, and you were handed a perfect cocktail of pessimism that drove the valuation from cheap to dirt cheap.
Similar to the dinnerware example above, I believe the presence of a broken plate (U.S. housing business) resulted in a lower initial valuation for the Canadian business than if it had been listed as a pure-play Canadian housing business. If Mr. Market’s view of U.S. housing lightened up just a bit, I knew this situation stood to generate significant profits. The key insight was the realization that the broken plate would repair itself eventually. In less than four years of trading, BRP was taken private by the parent company. Based on the last trade at C$31.25, initial investors who bought in at $10 realized a ~30% IRR (triple over four years), while those who opportunistically entered near the bottom realized a ~57% IRR (almost five-bagger over 3.5 years). Almost as a rule, freshly minted spin-offs like BRP do not screen well in commercial databases. While not overly arduous, assembling a thesis required going through the prospectus in detail to put some basic numbers together. The financial histories of each half were also obtainable on the respective company websites.
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