The Risks of Being a Minority Investor & the Importance of Margin of Safety

[HIPS]

I wanted to use the example of Beaumont Select Corporation (BMN/A or BMNTF) which was a security I had researched and was going to buy as an example of the risks as a minority investor and also generate some discussion about when being in a minority is a risk worth taking. Beaumont is also a good lesson as to why a healthy margin of safety is required in all investments (and an example of what goes around comes around!)

 

 

Background to Beaumont Select Corporation

 

As with most of the companies I get interested in Beaumont was unusual. It consisted of two principal business lines:

 

1.  Naleway Foods - Canada's leading manufacturer of Perogies. Perogies originate from Central & Eastern Europe and are dumplings of unlevened dough which are either served boiled with toppings or stuffed and fried.

2.  Investment Division - consisted of a portfolio of equity securities financed through a combination of cash and margin loans

 

Naleway Foods was cash flow negative and had been a drag on the performance of the company whilst the investment division had been a runaway success (see details later on). It is unclear how and when these two businesses were married but they have been in existence since publically available records (at least easily accessible ones) began 1997 and when the investment portfolio was only CAD$ c. 600k and the food business had revenues of CAD$ c. 27m

 

The final piece of background is a word about the controlling shareholder Winston Ho Fat. What I knew at the time of my analysis was that:

 

•  He was the controlling shareholder in Beaumont and has been since available records when he held in excess of 60% of the stock in 1997

•  He has at various times been CFO, CEO and Chairman of Beaumont

•  Under his stewardship the company had been actively buying back shares to reflect that the trading price undervalued the company in the view of management (I found these comments all the way back to 2000)

•  Through his company Somerset properties he had also been acquiring shares in the company and had c. 94% of the equity ownership when I started my work

 

I started looking at Beaumont in the middle of 2014 when they announced that they had sold Naleway Foods to its management which I saw as significantly de-risking an investment in Beaumont's common equity.

 

 

My Views on Beaumont's Fair Value

 

On the asset side Beaumont had the following assets

 

a. Equity Portfolio

 

•  Ten core securities representing 90% of the value of the portfolio with the remaining 10% spread across 48 other securities

•  42% of the portfolio was made up of one security AutoCanada, Canada's largest franchised auto dealership

•  I analysed the portfolio back to December 2011 to look at returns by security and holding periods which showed that the holding period was always in excess of a year and that Beaumont would often continuously build positions over a long period of time

•  Across nine securities the return were decent with a win/loss ratio of c. 66% and most money multiples in the 1.5x range

•  What was most striking was that the clear knockout winner was their AutoCanada investment which at the time of our analysis was an 8.4x MoM for a total profit less investment costs of c. CAD$ 26m (to do the proper deep dive I should have dug into AutoCanada but there are only so many hours in the non working day)

•  It is worth noting that disclosure on the portfolio was limited and this was the best I could piece together but it is by no means a robust analysis of Beaumont's skill as an equity asset allocator

 

b. Naleway Foods & associated real estate

 

•  As part of the sale the business gave management a vendor loan of CAD$ 1.3m which I valued at par

•  Beaumont also retained the warehouse which Naleway continued to rent and I valued at CAD$ 1.65m based on a estimated rent per square metre (using Colliers Canada data and precedents in the same industrial park) and a 10% cap rate reflecting the poor performance of the tenant

 

From the above I concluded that the underlying asset value of Beaumont was CAD$ c. 65.8m from which I needed to add/(deduct) the following liabilities:

 

a.  Corporate debt - CAD$ (1.9)m

b.  Margin loans - CAD$ (26.3)m

c.  Cash - CAD$ 3.5m

 

This got me to a net equity value of CAD$ 41.1m but in order to arrive at the correct value to Beaumont's shareholders I needed to reflect one final asset

 

c. Somerset Properties

 

•  Somerset is a private entity owned by Mr Fat whose business dealings were intertwined with Beaumont both from an ownership and lending perspective

•  At the time of my analysis Somerset had CAD$ 350k left to pay on a loan from Beaumont which I valued at par

•  More interestingly was the fact that Somerset owned c. 63.7% of Beaumont equity (Mr Fat directly owned c. 28.2%) but at the same time Beaumont owned 19.3% of Somerset's equity. This circular ownership represents additional value for Beaumont's common equity

•  Unfortunately in answer to my question about getting accounts for Somerset so that I could assess the value of Beaumont's stake in the business I was told by management that these were not available (again another plea to anyone who knows if there is any mandatory public filing of accounts in Canada similar to UK companies house)

•  Despite knowing that Somerset had its own separate portfolio of securities from comments in Beaumont's regulatory releases I felt it was prudent to simply value Somerset on the basis of its stake in Beaumont which was 12.3% net (63.7% * 19.3%)

•  This provided a total value for Somerset of CAD$ 5.0m (acknowledging that it could have been much higher or 0)

 

Making this adjustment gave me a total equity value of $46.1m and a value per share of CAD$ 2.85 vs a trading price at the time of CAD$ 1.70

 

 

Beaumont Take Private

 

On 17th October 2014 Beaumont amounted a take private transaction at CAD$ 2.05 per share a 20% premium to the previous trading price but an c. 28% discount to a conservative fair value.

 

Normally under Canadian takeover rules when a takeover is proposed by a majority shareholder there are a number of protections for minority holders principally (a) the deal needs to be voted through by a majority of the minority shareholders, (b) an independent valuation needs to be produced for the shareholders, and; © a court needs to opine on the fairness of the offer to a minority shareholders

 

However, in addition to a plan of arrangement and a take-over bid Canadian corporate law also allows for an Amalgamation Squeeze Out. The amalgamation works as follows:

 

1.  The Bidder (and along with its joint actors), usually a controlling shareholder in a GPT, sets up a new wholly-owned subsidiary in the same jurisdiction of the acquiree (the "BidCo"), to which the Bidder transferred all of its shares of the acquiree;

 

2.  An amalgamation of BidCo and acquiree is proposed and negotiated between the Bidder and the acquiree;

 

3.  A shareholders meeting of the BidCo and acquiree is called, respectively, and both BidCo and acquiree shall approve the amalgamation by a special resolution (i.e., 2/3 of votes cast of the shareholders who vote on the resolution);

 

4.  Upon amalgamation, the Bidder (and along with its joint actors) receives all of the voting shares of the amalgamated company in exchange for its shares in BidCo and all the shareholders of the acquiree receive either cash or, more commonly, redeemable shares in the amalgamated company; and

 

5.  When the transaction is completed, the redeemable shares of the amalgamated company are immediately redeemed for cash. At the end of the day, the Bidder (along with its joint actors) becomes the sole shareholder of the amalgamated company.

 

 

Crucially, in the case of Beaumont, is the fact that an amalgamation squeeze-out for a TSX Venture issuer, does not require a formal valuation (by applying the same exemption as discussed in the plan of arrangement) nor a majority of minority shareholder approval. In other words, a transaction devoid of minority protections is totally fine

 

It was via this method that Mr. Fat legally acquired a set of assets he could have easily liquidated for at least a c. 28% profit day 1 (almost all the positions in the security portfolio represented less than 10 days trading assuming they were liquidated at 20% of the 15day average daily traded volume of the given security). I have to take my hat off to Mr Fat, it is very rare to find a management team / owner that will mandate a company to doggedly purchase their stock over 14 years to the point that they are the defacto controlling shareholder. Furthermore this was absolutely the right capital allocation decision for Beaumont as despite their stellar performance in stock picking I doubt they would have been evaluating many securities that traded at a 60% or greater discount to fair value. Finally why should Mr. Fat not be allowed to chisel the minority shareholders for the value he had generated for them and also in recognition of a neat and not often used part of Canadian corporate law.

 

 

The importance of a margin of safety

 

Where you might ask in this story is the lesson of the importance of buying assets at a substantial discount to fair value. Well in writing up this piece (months after the event) I went back to my Beaumont model and could not understand why it no longer showed the large discount to fair value but that Beaumont was trading at around its NAV. The answer was that my excel was picking up the current prices for Beaumont's stock holdings and not those that existed at the time I was buying the stock

 

Since the take private, assuming that Beaumont's holdings remained static and Somerset was worth what I think it was worth (which is a stab in the dark), the value of Beaumont's securities portfolio has declined by 30% which led to a decline in the equity value of 45% due to leverage through margin loans (the one thing I didn’t like about Beaumont)

 

At the time I was pretty cheesed off at getting taken out at an undervalue but perhaps Winston did me a favour.

[matjone]

Yeah hopefully they all go to zero after pulling nonsense like that.  Is there some reason why they allow those squeeze outs?

[HIPS]

I am absolutely no expert in Canadian takeover law / processes but from reading around the subject to understand how Beaumont achieved the transaction it seems that Canadian securities law offers reasonably robust defences against majority abuse of minority investors (e.g. I am invested in Genterra [GIC:Venture] which did an amalgamation in 2010 with Consolidated Mercantile and there were valuations, votes and the rest, albeit the controlling shareholders did not have over 90% and it was two listed companies amalgamating together).

 

I cannot think a suitable rationale why the regulator would seemly provide minority protections for every transaction except an amalgamation targeted at a TSX Venture listed company. Logic would suggest you would want stronger protections at the smaller end of the market as you lack large sophisticated investors with the time and resources to keep companies, management and controlling shareholders in check

 

When I have a spare moment I may chew through the section of Canadian securities law covering the issue (link below, Section XX) and see if it sheds any light on the subject (might be a couple of weeks before I get round to it)

 

http://www.e-laws.gov.on.ca/html/statutes/english/elaws_statutes_90s05_e.htm