KeyStone’s Stock Talk Show Episode 262.
Great to chat with you again – in a week that kicked off with more Canadian M&A activity with both Sleep Country and A&W announcing transactions. I will start by reviewing the idea of Behavioral Finance and specifically how biases, both cognitive and emotional can produce poor judgements from investors. Aaron will review the A&W Revenue Royalties Income Fund (AW.UN:TSX) transactions and whether or not that makes the stock a buy/sell/ or hold today. In our YSOT segment, Brennan answers a viewer question on Atlas Engineered Products (AEP:TSX-V), a profitable small-cap that designs manufactures and sells engineered roof trusses, floor trusses, and wall panels. The stock continues to perform well despite macro headwinds – Brennan let’s you know his take on the current and future fundamentals. Finally, Brett chimes in with his take on Covered call ETFs which have become increasingly popular with many financial institutions creating more flavours each year.
Let’s get to the show –my cohost, Mr. Aaron Dunn – and the killer B’s, Brett, and Brennan.
Canadian Market Mid- Small Cap M&A Ripe for M&A?
HRX:TSX & STLC:TSX Acquired in last 5-days.
Now ZZZ and AW.UN (to a degree).
Behavioural finance
Behavioural finance is commonly defined as the application of psychology to understand human behaviour in finance or investing.
The efficient market theory which states all equities are priced fairly based on all available public information is often criticized / debunked for not incorporating irrational emotional behavior.
A subfield of behavioral economics, proposes that psychological influences and biases affect the financial behaviors of investors and financial practitioners.
One of the key aspects of behavioral finance studies is the influence of psychological biases.
There are many – I am going to touch on a few that we see investors and clients struggle through
trying to invest effectively in stocks.
In the investment realm, we will define behavioural biases as systematic errors in financial judgment or imperfections in the perception of economic reality.
There are both cognitive and emotional bias – both produce irrational judgments.
Cognitive biases can be technically defined as basic statistical, information processing, or memory errors that are common to all human beings.
Emotional biases originate from the subjective feeling, intuition or impulses.
Let’s touch on a couple of the later or Emotional biases to start and we can discuss.
Loss Aversion:
Loss aversion bias was developed as a concept by Daniel Kahneman and Amos Tversky in response to the observation that people generally feel a stronger impulse to avoid losses than to acquire gains.
The possibility of a loss is, on average, twice as powerful a motivator as the possibility of making a gain of equal magnitude.
For instance, the pain of losing $100 is often far greater than the joy gained in finding the same amount.
Endowment bias.
People who are subject to endowment bias place more value on an asset they hold property rights to than on one they do not hold rights to.
This behaviour is inconsistent with standard economic theory, which says that a person’s willingness to pay for a good or object should be equal to the person’s willingness to sell the good or object.
Psychologists have found that the minimum selling prices that people state tend to exceed the maximum purchase prices they are willing to pay for the same good.
Investors continue to hold securities they own rather than disposing of them in favour of better investing opportunities.
This is something we see play out in real time with individual investors and it hurts returns long-term.
Now I will look at a couple of cognitive bias.
Overconfidence
Overconfidence is defined generally as unwarranted faith in one’s intuitive reasoning, judgments, and cognitive abilities.
Investors tend to overestimate both their predictive abilities as well as the precision of the information they have been given.
They believe they are smarter and have better information that they actually do.
Example: An investor may get a tip from an investment advisor, from a TV program or read something on the Internet about a stock, and buy based on his or her perceived knowledge advantage.
WE SEE THIS ALL THE TIME – BEIT INVESTORS ACTING OFF OF A TIP ON BNN.CNBC OR AN INTERNET CHAT FORM….
This final bias is a little more nuanced, but I will give an example at the end.
Representativeness.
Because human beings like to stay organized, they develop, over time, an internal system for classifying objects and thoughts. When confronted with new circumstances that may be inconsistent with existing classifications, they often rely on a “best fit” process to determine which category should house and form the basis for understanding these new circumstances.
This perceptual framework provides a practical tool for processing new information by simultaneously incorporating insights gained from past experiences. Sometimes, however, new stimuli are representative of elements that have already been classified, while in reality, there are differences. In such an instance, the classification reflex is wrong, and it produces an incorrect understanding of the new element that often persists and biases future interactions with that element.
Investing example: an investor may be presented with an investment opportunity that contains some elements that are representative of a good investment. The investor’s desire to mentally classify the investment opportunity may cause him or her to classify what is really a poor investment opportunity as a good one, based on the few elements that are representative of a good investment opportunity. Initial public offerings (IPOs) are a good example of this concept.
YSOT Atlas Engineered Products (AEP:TSX-V)
Question from Steven on Atlas Engineered Products (AEP) – “Atlas Engineered Products (AEP), Interested in your “Take” on the company’s balance sheet and how they are executing on their strategy of consolidating companies operating in their same business segment of engineered wood products.”
Price: $1.41
Market Cap: $97.3M
Description:
Atlas Engineered Products designs manufactures and sells engineered roof trusses, floor trusses, and wall panels. The company also distributes a range of various engineered wood products for use by builders of residential and commercial wood-framed buildings. These include single family homes, townhouses, multi-story wood-framed residential buildings, commercial buildings, and agricultural structures.
The company’s strategy is focused on profitability and organic revenue growth within its current markets, and the pursuit of a roll-up acquisition strategy to consolidate similar companies operating in the truss and engineered wood products industry across Canada.
Slide 2
I covered Atlas back in February 2023 and at that time my overhanging fear with the investment case was the comments from the CEO during our analyst call when he said “money being very cheap and interest rates going above 4% could potentially disrupt the business’ growth”. But the stock continued to climb approximately 50%….
Slide 3
Looking at some Operational Updates:
The company has made 8 acquisitions since going public in 2017. With the most recent acquisition in August 2023, when it acquired Léon Chouinard et Fils Co. Ltd. located in New Brunswick. The company is a manufacturer of roof trusses, floor systems, and wall panels and a supplier of engineered wood products. The focus of the acquisition is to grow the company’s national footprint, and the company paid $29M with a price to Earnings multiple of ~4.6x earnings.
Slide 4
On June 26th, the company announced it closed a private placement for gross proceeds of $14.5M, issuing 10.7M shares at a price of $1.35 per share. The company intends to use the net proceeds of the Offering for the purchase and installation of robotic automation equipment at facilities located in British Columbia, Ontario & New Brunswick, along with additional equipment and upgrades required to incorporate the robotics at these locations. And following the private placement, I believe the company has approximately 69 million basic shares outstanding.
And this is a nice segway into the next operational update as on June 6th, the company announced that it accepted proposals for the installation of robotic automation equipment at three of its locations and that it has made initial deposits to secure the installation of equipment. The robotics installation is expected to have a total cost of just over US$7 million for all three locations. And the robotic automation is anticipated to double the board foot output of roof truss manufacturing while providing “potentially significant” cost savings.
And I saw an estimate from Cormark which placed the estimated robotics initiative to cost CAD$25-$26M over the next two years with a new greenfield facility accounting for $15-$17M and the investments expected to invesase truss manufacturing capacity at about 400% at Hi-Tec, 100% at LCF (which is the last acquisition they made) and 50% from Clinton, with expected lower operating expenses and approximately 50% reduction in labor costs… And the robotics upgrades are expected to be completed over the next 2 years.
Slide 5
Recent Financials (Q1 2024):
|
CAD$ Millions |
Q1 24 |
Q4 23 | Q3 23 | Q2 23 |
Q1 23 |
Q4 22 |
Q3 22 |
Q2 22 |
Q1 22 |
Q4 21 |
Q3 21 | Q2 21 | Q1 21 |
| Revenue | $9.1 | $14.2 | $14.4 | $11.2 | $9.6 | $15.0 | $17.6 | $14.4 | $12.4 | $13.9 | $17.6 | $14.4 | $9.1 |
| Net Profit | $(1.0) | $0.5 | $1.3 | $0.8 | $0.5 | $2.1 | $3.1 | $1.6 | $1.6 | $2.5 | $2.8 | $1.6 | $0.05 |
| EPS | $(0.02) | $0.02 | $0.02 | $0.01 | $0.01 | $0.04 | $0.05 | $0.03 | $0.03 | $0.04 | $0.05 | $0.03 | $0.00 |
- Revenue decreased 5% to $9.1 million, due to material price stabilization at a normal level which was less than the prior two years, and a more competitive construction market created by interest rate hikes by the Bank of Canada. The company does not anticipate that increased interest rates will affect sales long-term. However, sales may continue to be affected in the short-term as the market stabilizes and everyone waits to see if interest rates will be lowered by the Bank of Canada.
- Adj. EBITDA was down to $247K, compared to $1.7M for the same period last year.
- Net loss was $(993K) or $(0.02) per share, compared to a gain of $543K or $0.01 per share for Q1 2023.
- The decrease in adjusted EBITDA and net income was primarily due to lower revenues in a market with reduced housing demand and reduced gross margins due to the increased market competition and seasonality of the LCF acquisition.
- Balance sheet had $7.2M, with $30.9 million in debt and leases, providing a net debt position of $23.7 million. And remember this does not include any cash from the recent equity raise, but I will say that the net debt to EBITDA multiple has climbed, as it was under 1x as at February 2023, but is now up to 3x.
- Right now, I really think that the business is trading above fair value at over 40x earnings, 15 times EBITDA and 28x CFO…. As last time I reviewed the stock it was trading at about 6 times earnings which I noted as attractive… But as a reminder, this is on trailing earnings despite the company looking at significant capacity enhancements.
Slide 6
And just looking at the outlook, management indicates that markets have been very competitive in 2023 and is expected to be competitive in 2024 given rising interest rates which have affected the housing market. But the company notes that it recognizes the need to be ready for a potential significant increase in demand if interest rates decrease during 2024 given the number of homes still needed to be built to support Canada’s population growth.
Slide 7
Conclusion:
So I guess the first question is why has the stock continued to climb despite its weaker financial results??? Well, I would say #1 is due to the increased sentiment from capacity expansion utilizing robotics and the ability to reduce costs. And I would say #2 is the shortage of Canadian homes… as there needs to be a significant increase to meet the population growth in Canada.
Fundamentally the business remains pricey on trailing numbers, but if over the next couple of years it can fulfill its capacity enhancements and lower costs, the forward numbers will appear much better.
Overall, I think that Atlas is a good business, debt may be getting a little elevated, but even if it is unable to grow in its current markets it will have the additional capacity to expand geographically.
And whether I think it’s a buy sell or hold, I think it really comes down to whether an investor believes Atlas will be able to fulfill their new upcoming capacity and capitalize on the potential cost savings which could grow eps over the next few years. But just like Hadi had said to us previously, elevated interest rates could disrupt the company’s near term growth, which it appears to be transpiring.
I think it will be worth it to jump on a call with management to get some more insight on the potential cost savings, strategy and ability to fulfill capacity, and for us to get more color on the current market environment given elevated interest rates.
COVERED CALL ETFs
1)
Covered call ETFs have become increasingly popular with various entities creating more ETFs. They come in various forms but we can look at the commonalities and the general structure of them. It is like a normal ETF but sells call options against the underlying allowing for the fund to collect additional premiums by selling the calls normally allowing for continuous distributions.
The way covered call ETFs work is the same way covered calls on individual stocks work except against a basket of assets. Effectively, you give up a degree of the upside price increase for a period of time in exchange for a premium, a cash payment to you at the time of sale.
The ETFs might use the terminology covered call or things like enhanced yield, high yield and so on.
2)
Covered call ETFs do have some limitations,
The requirement for covered call ETFs requires an active options market, which does limit the potential underlying. For example, you’ll have covered call ETFs on common Indices like the S&P500 or the TSX 60, as these indexes have active options markets, but if you wanted specifically, a covered call ETF on small-cap Canadian stocks you’re out of luck. However, there do exist covered call ETFs on more liquid stocks with liquid options such as the Canadian Big Six banks, and we will go into one in a minute.
3)
Also, these ETFs are sometimes actively managed or passively managed.
The passively managed ETFs will use a systematic approach meaning it follows a rule-based system, selling options at a certain out-of-the-money percentage for x length.
The actively managed ETFs are more discretionary and are less strict when it comes to the manager’s choices.
Choices may include the strike price of the relative options or how out of the money the options they sell are, the length of the options, the amount of the fund covered by options, or the leverage of the fund which some funds employ.
The general trade-off between actively managed and passively managed is that actively managed funds have the goal of beating the index either through lower volatility and/or higher returns but may have higher fees.
4)
The easiest way to see the pros and cons and think about the dynamics of covered ETFs is by comparing a covered call ETF to a standard ETF with the same underlying but no derivatives used. So compare an S&P500 covered call ETF to SPY.
The benefits of covered call ETFs are:
- Being an income strategy the funds commonly distribute the premiums and potential dividends from the underlying.
- Reduced volatility, as you are selling call options you reduce your sensitivity to the underlying stock or index.
- Downside protection compared to non-covered call ETFs, as you collect a premium by selling the potential upside, meaning in the scenario where the underlying is either flat or down you will still either receive a positive return or a lower negative return compared to a standard ETF.
- In Canada, covered call ETFs are generally tax efficient as they are taxed as capital gains
5)
Switching to the cons of covered call ETFs
- Reduced capital upside, in a strong bull market a covered call ETF will underperform the non-covered call version of the ETF
- Only limited downside protection, unlike a protective put you only receive a premium, which will mitigate downside risk but if the underlying collapses in price at a fast rate like the COVID drawdown in 2020, the premium’s protection will only be a drop in the bucket. The faster the price decreases the less useful the covered call is as a hedging tool, as it gives less time for the premiums to decay.
- Covered call ETFs have higher fees, the degree of increased fee largely depends on the exact management style.
6)
Looking at the Mulvihill Bank ETF, CBNK on the TSX as one of our viewers asked about it.
The fund targets a 7% annual yield with additional capital growth opportunities.
The underlying is the big six Canadian Banks, ranging from 14.2% to 18.3% weightings, so nearly equal weight.
They deploy 1.25 leverage, meaning they are using margin loans to amplify the returns and losses, with the benefit of being able to write calls against the additional stock.
The ETF has a current yield of 9.63%, with distributions of $1.69 since its inception in March of
2022.
The ETF has a MER of 0.65% against the NAV, net asset value.
However, since the inception of the ETF in March of 2022, the fund has declined in total value which includes distributions of 6.31%, and we can compare it against an equal-weight bank ETF HEWB, the same underlying until active management comes into play.
The total return of CBNK is negative or a loss of 6.3% whereas HEWB has had a positive return of 1.9%.
So, overall the covered call ETF, CBNK has underperformed a comparable underlying ETF, I haven’t run the statistics behind it but it also appears to have higher volatility as well so risk-adjusted returns will likely be worse as well due to the leverage aspect.
7)
I’ll just close it out with some general thoughts,
The most important part of covered call ETFs is the underlying, it’s still going to drive the risk and returns, options are ultimately a strategy which alters the risk-return but does not overhaul it.
If you do believe in the efficient market hypothesis strongly, where the market and therefore derivatives are priced optimally, the covered call ETFs will always underperform due to the higher fees. This effectively means if you are a purely passive investor you have no expectation to beat the market, just stick with a normal ETF.
That being said there are specific cases due to temporary market conditions or beliefs of market conditions where covered calls can be effective but if those cases do arise you can probably sell covered calls on your own accord.
8)
Lastly just to drive the point home, here are a couple of other examples of covered calls underperforming.
Here XYLD, an SP500 covered call index underperforms the index significantly after taxes and distributions only averaging 7.2% return vs the S&P averaging 13.4% and even the index which is before fees for covered calls averages 11%. Overall even without the impact of trading expenses covered calls were still worse performers.
As well comparing two indices for the TSX 60, the covered calls produced annualized returns of 6.50% vs 7.8% over 10 years with brief periods of outperform.
So generally, if you are looking for long-term holding just get the standard ETF.
