Friday 23 February 2018

Favouring the specific over the general; Tinkoff and Washington Prime Group

In markets, there is a frequent biasing of the general over the specific, and it is a recurring source of opportunity for investors that are prepared to set aside preconceived notions; dig a little deeper; and favour the specific over the general in their investment process.

The psychology of the biasing of the general over the specific is the same psychology that gives rise to stereotypes and unjustified discrimination in the non-financial world. We oppose discrimination and the use of stereotypes not because they are necessarily wrong in a general sense (although that might also be the case), but because they are unfair to the individual who may not manifest such generalities. However, this sort of progressivity is still notably absent in financial markets, where unjustified stereotyping still runs rampant (I also discussed this issue in my Ferrexpo post in February 2017 here).

Generalising simplifies a complex world, and this is one reason why it is so intuitively appealing to investors. Investors face a wall of information, and need to process it into usable and actionable insights, and generalised arguments are simple and seductive, and are therefore easy for the financial industry to 'sell' to clients. However, often important nuance is lost in this process, and when it is, pricing inefficiencies can result that can create wonderful investment opportunities. I will provide two examples - the shares of TCS Ltd (TCS LI), and Washington Prime Group (WPG US).

Two very common generalisations that exists today are the beliefs that corporate governance in Russia is extremely poor, and that the country is little more than a corrupt petrostate that is incapable of anything in the way of innovation (despite the fact that Russia used to be a global superpower that almost won the space race, and which continues to enjoy a disproportionate share of the global engineering talent pool).

As generalisations, these beliefs are not wholly inaccurate, although I would argue that the perceived shortfalls in governance and innovation are for the most part no worse than in many favoured emerging markets such as Indonesia, which are accorded much higher valuations on account of a more bullish generalised narrative about an 'emerging middle class' (Indonesia trades at 25x earnings, but try to name three non-commodity globally competitive brands/companies deriving from the country - I doubt you can). However, the level of corporate governance and innovation in Russia varies widely between companies. This is, after all, a nation of some 140m people, and they are not all the same.

An example of the disconnect between the generally-held narrative and the bottom-up specifics, are the shares of TCS Group (TCS LI), which I have owned since US$7 (and which currently trade at about US$22). TCS is a fintech/online bank, which is highly innovative; transparent; and minority-investor friendly. The company got its start offering credit cards, and over the past decade, has succeeded in snaring 11-12% market share - placing it second only to industry behemoth Sberbank (which I also own). However, more recently, the company has diversified its service offering, moving into SME current accounts and consumer debit cards, and has also recently launched an online 'financial marketplace' offering insurance, mortgages, and securities trading products.

The company has grown rapidly by offering high levels of customer service and process automation that has made the bank easy for customers to deal with viz-a-viz inefficient state-owned competitors. It has also benefited from the pariah status of Russia amongst the global investment and business communities, which has resulted in a veritable complete absence of competition (how many global players are rushing to set up business in Russia?). In an interview a couple of years ago, the company's founder noted that it has basically no competition, except from Sberbank, which it said was surprisingly innovative and efficient for a state-run bank - something that caused me to promptly increase my Sberbank position materially (I have owned Sberbank since US$5-6 and continue to own it).

Unlike many 'fintech' companies, TCS is extremely profitable. Not only is it growing at 30% pa, but it is making a 50% ROE, and on account of its high profitability, is relatively 'capital light' and is therefore paying out approximately two-thirds of its earnings as dividends. It has an extremely long growth run-way, with Russia's banking sector having consolidated down significantly in recent years following its 2014-15 recession, with many banks still hobbled by bad loans and insufficient capital. The company's disclosure it also extremely transparent.

The company has a history of guiding earnings conservatively, and consistently 'beating and raising'. It expects to make a R 18bn profit in 2017 (to be reported in March), and has already guided for R 24bn+ in 2018 (and already earned R 5bn in 3Q17). The company's market capitalisation is currently US$4.1bn, or about R 230bn, and despite having already rallied 20% YTD, is still trading at less than 10x forward earnings and on a high-single-digit forward dividend yield. The Russian Rouble remains undervalued as well, in my opinion - particularly with oil prices having begun to recover.

A company with comparable growth, profitability, dividend payout, and shareholder friendliness, in virtually any other country, would likely trade at 20-30x earnings - particularly because the company has in recent years been investing heavily in the roll-out of new service offerings, which are only now just surpassing break-even. Their latest investor presentation materials can be found here. As can be seen, despite what many might assume (and continue to assume) from the fact that it is a Russian company, TCS's disclosure and governance is in fact world class.

The stock is not without risk. Credit costs have moderated to 5-6%, but were temporarily as high as 15-20% during the height of Russia's recent recession (although the company still roughly broke even at the nadir). The stock fell to as low as $1. Another macro-instability-driven rise in credit costs will no doubt impact the shares. However, the company is well capitalised and highly profitable (before credit costs); has already been tested in an extremely challenging economy; and the outlook for the Russian economy is brightening. If the Russian economy continues to modestly recover (at say 1-2% pa), the company stands a good chance of maintaining high rates of earnings growth of >20% for many years, and will likely also experience multiple expansion. I currently have a 6% position in TCS.

A second example are the shares of Washington Prime Group (WPG US). WPG is a leveraged (debt-to-EBITDA of 6x) owner of regional shopping malls in second-tier cities in the US. Bearish generalisations abound; everyone knows that (1) the US has too many malls; and (2) that Amazon is killing traditional retail. Coupled with the company's high leverage, it could be readily assumed (and has been) that the company is fast on its way to bankruptcy.

As a result of these generalisations, WPG has been sold down 75%, and was recently trading for as little as 3.5x adjusted FFO (funds from operations), and a dividend yield of 18% (on a payout of about 2/3rds of FFO). I recently accumulated a 65bp position at an average of US$5.70, although was perhaps not aggressive enough, with the stock having already popped to north of US$6.30.

What was lost amongst these generalisations were the following very important specifics:

*Firstly, although WPG's aggregate leverage appears high, the way the debt is structured is extremely important and was overlooked. The company has US$4.5bn in mall assets at depreciated book value (based on historical cost), and about US$3.0bn in debt, but about half of that debt is non-recourse mortgages held against specific mall assets, and only about half is corporate-level unsecured debt. For secured mortgage debt, the company has the right to simply hand the keys back to the lender and walk away if the specific mall property is deemed to be worth less than the outstanding mortgage.

Over the past several years, the company has been skillfully unencumbering its best assets, and has keep the mortgages against its weaker assets. As a result, the company has been reporting large profits on gains from the extinguishment of mortgages by walking away from such assets (or negotiating with lenders for significant haircuts). With a market capitalisation of about US$1.1bn (US$1.3bn including preferred stock), the unencumbered assets are being valued at about US$2.8bn (including all unsecured debt), and the encumbered assets at zero, but it is highly unlikely the unencumbered assets are worth less than this. The level of risk involved is therefore in actuality far less than it might first appear, even before taking into account the significant value-creation optionality the company continues to enjoy (including the ability to negotiate loan haircuts with secured mortgage lenders).

One of the proximate triggers for WPG's recent sell-down from US$7.00 to as low as US$5.40 was a downgrade in FFO guidance and dividend cut by 'peer' CBL & Associates. The experience of CBL was generalised to WPG. However, CBL's debt is structured much less favourably than WPG, with significantly less unencumbered high-quality properties, and its assets are also weaker. The generalisation that WPG would inevitably follow a similar path caused WPG to be sold off, without the specifics of WPG's existing assets and debt structure being taken into account. After WPG affirmed its dividend and posted decent 4Q17 numbers and 2018 guidance earlier this week, the stock has started to rebound.

*Secondly, a vast over-simplification as arisen in the analysis of the US mall REIT space which categorises mall assets as being either 'Tier 1' assets (incumbent malls in prosperous Tier 1 cities, that are generally seen as completely immune from the for Amazon threat and have cap rates of c5%); and Tier 2-4 malls, which are all considered doomed. In fact, as WPG points out, Tier 1 cities are in many cases more over-malled than Tier 2 cities, and premium malls in Tier 2 cities are often as well, if not better positioned, than many malls in Tier 1 cities, with less competition and larger monopoly catchment areas; high levels of consumer disposable income (due to lower costs of living); and less same-day e-commerce fulfilment coverage (which favours the big cities first). Troubled department store exposure is also no higher in regional malls than in Tier 1 cities, and it is also possible consumer lifestyles may also be less fast paced and mall footfall could therefore also prove more resilient.

More than 80% of WPG's income now derives from open-air and what it regards as Tier 1 enclosed malls in these regional centers, and these malls continue to (modestly) grow their income, while its remaining Tier 2 assets (the other 20%) saw a 10% decline in income in 2017. In 2018, an even larger 90% of its income is expected to come from its Tier 1 and open-air mall assets, as it has been selling down its Tier 2 assets and/or handing the keys back to lenders. The stock is priced as though the majority of its portfolio is Tier 2 assets likely to see a continuing rapid collapse in income, and yet the majority of its mall portfolio is in fact still delivering positive rental income growth.

*Thirdly, of the company's circa US$1.50/share of FFO, it is paying out US$1.00 as dividends, but reinvesting the rest back into redevelopments of its existing open air and Tier 1 malls - particularly to redevelop departing enfeebled department store tenants. There is sometimes a legitimate objection to valuing REITs on FFO multiples, as FFOs exclude necessary maintenance capex requirements (albeit that these are significantly less than accounting depreciation), and it is believed that WPG is merely throwing good money after bad with these redevelopments, and that they are unlikely to yield acceptable returns. The non-dividend part of WPG's FFO is therefore being valued at zero, and it is also believed that WPG's dividend payout will also likely prove unsustainable.

However, what is being missed is not only the company's claim that the expected ROIs on this capital spending will be about 10%, but also that this is based on contracts already in place with incoming tenants, prior to such redevelopments commencing. These redevelopments are therefore not speculative in nature, and are being confined to assets with a bankable ROI proposition, and these redevelopments are therefore likely to actually generate increased FFO medium term.

*Fourthly, while it is true that B&M retail is shrinking (particularly department stores), there are some countervailing forces that are being ignored, including the trend towards more dining out, which is seeing more mall space dedicated to F&B. 47% of WPG's re-leased space in 2017 was to leisure and F&B tenants, including restaurants, gyms, and other entertainment venues. A case can be made that people will always like to go out, and that for well-located destination assets in regional (as well as major metropolitan) centers, that there will be opportunities for adjusted tenant mixes to compensate for structural shrinkage in certain B&M sectors.

In short, WPG potentially represents a compelling investment opportunity, and the opportunity exists because generalisations are being given primacy over individual company specifics (ETF flows are likely accentuating this trend - if investors want to sell shopping mall ETFs because they fear the impact of Amazon, all stocks will be sold irrespective of their own idiosyncratic merits).

In my view, both TCS and WPG represent compelling value opportunities, and exist at a time when global markets - and in particular, US markets - are widely believed to be universally overpriced and devoid of opportunities for value-oriented buyers. I beg to differ.


*The above analysis is furnished for informational/entertainment purposes only, and is not to be construed as investment advice. The author provides no warranty whatsoever as to the accuracy of the contents of the post, and reserves all rights to trade in any securities mentioned in any article at any time.