Learn to distinguish short-term setbacks from long-term turmoil

Portfolio manager Dennis Mitchell has changed firms, but he hasn’t changed investment styles.

“The way you manage money stays with you no matter where you go,” says Mitchell, who joined Sprott Asset Management in September 2015 as senior vice-president and senior portfolio manager.

“They want me for what I’ve done, which is […] generating returns using [my] process,” he says. He spent 10 years at Sentry Investments before leaving in July 2015. There, he managed $800 million in global equities.

At Sprott, he’s responsible for four funds that are invested in either global or U.S. equities. He’s selecting investments using a bottom-up style he calls focused business investing. There are more than 2,400 companies in the MSCI ACWI, but he invests in 35 to 45 at a time. He’d also rather invest more money into his best-performing positions than across all of them. He says it’s most effective to concentrate on researching and monitoring fewer positions.

Mitchell spoke to AER about one of his career’s most successful deals, and another deal that didn’t go as expected.

Good deal

Macquarie Infrastructure Corporation (MIC)

Macquarie Infrastructure is a conglomerate with four lines of business: bulk liquid storage facilities, airport services, solar and wind power generation, and gas processing and distribution. The American company went public in 2004, and has facilities in the U.S. and Canada.

It’s a tried-and-true stock he invested in while at Sentry that he’s also investing in at Sprott. In fact, it’s his number one position across his four funds.

Putting it through his process

Mitchell first heard of Macquarie Infrastructure when a colleague suggested it to him in 2011. Usually, he finds companies by systematically screening them for four qualities. They are:

• dividend growth;
• return on invested capital;
• leverage levels; and
• EBITDA or EBITA margins.

When analyzing Macquarie Infrastructure, Mitchell focused on the two parts of the company that made up 85% of its cash flow: the bulk liquid storage, known as International-Matex Tank Terminals (IMTT), and Atlantic Aviation. His team visited storage facilities in New York and flew through the aviation division’s facilities, including one in Las Vegas. They also met with management.

“The best metric for evaluating a business or management team,” he says, is return on invested capital. The average S&P 500 company generates a 15% return on invested capital, so Mitchell focuses on ones that clear that number. Macquarie Infrastructure’s free cash flow was so good that it outweighed the fact that its return on capital employed (a similar measurement to ROIC) was sometimes below 15%.

Macquarie Infrastructure

Ticker: NYSE:MIC

HQ: United States

What: U.S. infrastructure and aviation company

Buy price: About US$27, February 2012

Current price: US$62.87 (February 5, 2016)

VINCI Concessions

Ticker: EPA:DG

HQ: France

What: Concessions operator; construction firm

Buy price: About €56, June 2014

Sell price: Mid- to high-€40s, September 2014

His benchmarks for cash flow and leverage change depending on the business itself. Businesses that own infrastructure often have long-term contractual cash flows, so there’s stability in their current and future earnings. Any earnings volatility is usually positive, he adds, as contracts can be tied to inflation or expanded as customers’ demands increase. So, these businesses can sustain higher levels of leverage.

Atlantic Aviation initially appeared to be a cyclical investment, says Mitchell, but when his team looked deeper into the airport business’s cash flow, they saw the flow was consistent through the business cycle.

In modelling Macquarie Infrastructure’s finances, he and his team found the market wasn’t embedding the company’s full cash-generating potential into the share price. That’s because it couldn’t pass earnings on to shareholders due to a dispute between the company and IMTT’s co-owner. That co-owner, Coleman Trust, didn’t want to distribute cash from the subsidiary to Macquarie Infrastructure’s shareholders, so profits were stuck in IMTT.

The other problem Mitchell spotted was that Macquarie Infrastructure’s debt structure forced the company to suspend its dividend in 2009 to pay back loans faster.

Turning point

Despite these two issues, Mitchell still thought Macquarie Infrastructure was an attractive investment because its problems weren’t related to operations. A member of Mitchell’s team with expertise in distressed companies reviewed the court documents in the shareholders’ dispute, and was confident that it would be resolved in Macquarie Infrastructure’s favour.

In March 2012, Macquarie Infrastructure won a settlement from Coleman Trust. It also restructured its debt.

In July 2014, the company bought out Coleman, becoming IMTT’s sole owner.

Post-purchase performance

When the team began researching Macquarie Infrastructure in 2011, its stock was around US$24. By the time they finished vetting and bought later that year, it was about US$27. As of February 2016, it was trading in the low US$60s. Not bad for a stock that was worth US$2.32 just three years before he bought it, notes Mitchell.

Its dividend, which was restored in 2011, has been increasing steadily. It went from 20 cents a share every quarter to US$1.13 in the third quarter of 2015. Mitchell says company management expects future dividend growth of 14% to 15%. He adds that other investors still haven’t realized the company’s full potential. “This is a name with robust cash flows and the ability to grow that cash flow.”

Other analysts agree: as of February 5, MarketWatch lists the stock’s average target price at US$95.67.

Bad deal

VINCI (DG)

VINCI is a French construction and concessions company that specializes in public-private partnerships. It works with governments to design, build and operate airports, highways, dams and other public assets. It operates those facilities under long-term government contracts, known as concessions, that dictate how long VINCI will operate the facility and how much it can earn from it.

It has 185,000 employees in more than 100 countries, but 61.8% of its revenues in 2014 came from France.

Putting it through his process

When Mitchell evaluated the business using his four factors in spring 2014, he found investors were discounting VINCI’s construction business. That’s because Europe’s economy was growing slowly (in 2014, the EU’s GDP grew 1.3% and France’s grew by 0.2%), so demand for construction was low.

VINCI’s stock price—about €56 when he bought it in 2014—was based solely on the value of the concessions side of the business. So, investors were essentially getting a stake in the construction business for free, he says. He’d met with VINCI’s management and seen some of their facilities. When he bought, he knew economic conditions would dampen the company’s construction prospects for the short term, but Mitchell believed the strength of the concession business would carry the company.

Turning point

In 2014, France’s Competition Authority was studying the road concessions business, and said it would release a report in late summer. In the weeks leading up to the report, VINCI’s stock was losing value. Why? Because investors feared the report would challenge the concessions business as past reports had.

“There was great uncertainty,” Mitchell says. “We didn’t know: would the government actually roll [rates] back?”

Post-purchase performance

Mitchell decided to sell at a loss in August 2014. “We bought it in the mid-€50s, and sold in the mid- to high-€40s,” he says. “We took about a 10% hit on that position.” It’s rare for him to sell and realize such a large loss, he adds.

When the report finally came out in mid-September, it was critical of the country’s 19 private highway operators, including VINCI, just as investors had feared. The report stated that operating profits of 20% to 24% weren’t justified by the cost of operating the highways, and recommended that the government change the formula to calculate them. It also suggested that the government force operators to reinvest more of their profits into the roads, or to share more profit with the government.

In the wake of the report, the French government wanted to delay a scheduled toll increase. It also considered changing how long VINCI and other companies would be allowed to operate French-owned facilities.

In October 2014, the stock bottomed out at €41.40. It’s since recovered, trading around €60 in December 2015. Mitchell says the stock’s high volatility means that its annualized return of 5% doesn’t adequately compensate investors for risk.

Lesson learned

Mitchell says there wasn’t any way of knowing beforehand that the government intended to change concessions terms. “It really was a case of doing all of your homework with all of the available information, and falling prey to the information that wasn’t available.”

But in 2013, France’s General Accounting Offices released a report stating that concessions operators had a stronger bargaining position when it came to toll increases than the government did, because the operators could promise road improvements in exchange for toll increases. The report added that tolls were a drag on the French economy, as companies had to pay them to transport their goods.

Mitchell doesn’t recall reading that report, but says its conclusions are self-evident. “Do the concession owners have strong bargaining power? Yes, but keep in mind that usually, when the concession comes to an end, they lose their asset,” he says.

So, it’s in concession operators’ best interests to bargain for higher tolls and extensions to their concessions contracts. Mitchell notes that, ultimately, concession operators must appease governments, because the government could choose another operator to run its infrastructure.

Mitchell says the VINCI investment solidified the lesson that when you’re wrong about an investment, don’t hesitate to exit. “We were wrong here,” he says, “and we corrected the mistake immediately.”

Jessica Bruno is a Toronto-based financial writer.