Starting To See Value

The Aspiring Analyst Vol. 1 Iss. 9 theaspiringanalyst@gmail.com

The macro picture still looks horrible we continue to see risk flare-ups left right and centre. As leaders and central bankers run around with their fire extinguishers (bailouts) trying to put out small fires, we fear they are leaving too much dry rot lying around, and ultimately a catastrophic fire may engulf the whole forest. This months newsletter is relatively short as we have been busy evaluating investment ideas. The Shiller Cyclically Adjusted PE ratio is now down to 20.0x, which is a considerable improvement from the 24.0x earlier in the year, and we are starting to see good value in some sectors and particular securities. Our advice for investors is to look at as many good companies as you can, determine what their intrinsic values are, and wait for Mr. Market to give you buying opportunities in the coming months.

Jason Chen The Aspiring Analyst

Starting To See Value Twisted Thinking

The Aspiring Analyst Vol. 1 Iss. 9 theaspiringanalyst@gmail.com

The following is an excerpt from a 2004 Federal Reserve paper titled Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment1 which addresses Operation Twist, as it was performed in 1961: The two main actions underlying Operation Twist were the use of Federal Reserve openmarket operations and Treasury debt management operations to shorten the average maturity of government debt held by the public; and some easing of the rate restrictions on deposits imposed by Regulation Q. Operation Twist is widely viewed today as having been a failure, largely due to the classic work by Modigliani and Sutch (1966, 1967). Empirical estimates of the habitat model of interest-rate determination by these authors led them to conclude that Operation Twist narrowed the long-short spread by amounts that are most unlikely to exceed some ten to twenty base pointsa reduction that can be considered moderate at best (1966, p. 196). However, Modigliani and Sutch also noted that Operation Twist was a relatively small operation, and, indeed, that over a slightly longer period the maturity of outstanding government debt rose significantly, rather than falling (supporting Tobins gloomy assessment noted in the footnote). Thus, Operation Twist does not seem to provide strong evidence in either direction as to the possible effects of changes in the composition of the central banks balance sheet. If researchers at the Federal Reserve deemed Operation Twist ineffective in 2004, then why did the FOMC announce on September 21, 2011 that they are going to implement a $400 BB version of Operation Twist?2 Perhaps the above paper was purely an academic exercise and did not reflect the views of committee members? But the paper was authored by none other than Mr. Ben Bernanke himself. So we are left wondering if perhaps the Federal Reserve has run out of options in trying to revive the U.S. economy and has resorted to re-trying failed policies to give the impression that the Fed is doing something. Be Afraid For an excellent summary of what ails the world, we suggest the short article Be Afraid3 in this weeks Leaders section of the Economist. The world economy appears to be grinding to a halt as European leaders continue to bicker over how to bail-out Greece and Ireland and Portugal and Spain and Italy and

Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment, Division of Research & Statistics and Monetary Affairs, Federal Reserve Board, 2004, Ben S. Bernanke, Vincent R Reinhart, and Brian P. Sack 2 Federal Reserve, retrieved October 2, 2011: http://www.federalreserve.gov/newsevents/press/monetary/20110921a.htm 3 Be Afraid, The Economist, October 1, 2011

Starting To See Value

The Aspiring Analyst Vol. 1 Iss. 9 theaspiringanalyst@gmail.com

France while American politicians continue to play with fire as the U.S. Congress narrowly avoided another government shutdown4. Meanwhile in China, we have one official saying China would be willing to help Europe5 while another tells Europe to not expect bailouts6. We are positively terrified. Falling Like A BRIC As we alluded to in our last letter, we will continue to find evidence to conclusively disprove the emerging market de-coupling myth. For those that still believe in the myth, please explain the following charts of BRIC PMI (purchasing manager index, a leading economic indicator):

Figure 1: HSBC BRIC PMI, source: Pragmatic Capitalist, retrieved October 3, 2011: http://pragcap.com/falling-like-a-bric

Bloomberg, retrieved October 3, 2011: http://www.bloomberg.com/news/2011-09-26/senate-will-move-budgetalternative-as-standoff-continues.html 5 Bloomberg, retrieved October 3, 2011: http://www.bloomberg.com/news/2011-09-14/china-willing-to-buybonds-from-sovereign-debt-crisis-nations-zhang-says.html 6 Bloomberg, retrieved October 3, 2011: http://www.bloomberg.com/news/2011-09-14/china-s-wen-says-worldmust-cut-debt-and-deficits-increase-jobs.html

Starting To See Value Starting To See Value

The Aspiring Analyst Vol. 1 Iss. 9 theaspiringanalyst@gmail.com

While equity markets remain overvalued, as measured by the Shiller Cyclically adjusted PE ratio (our preferred measure of valuation) at 20.0x, they have come down from the 24.0x earlier in the year (see our March newsletter, Now Is Not The Time To Buy The Indices):
50.0x
Cyclical PE

45.0x

40.0x

35.0x

30.0x

25.0x

20.0x

15.0x

10.0x

5.0x

0.0x 1881.01 1886.01 1891.01 1896.01 1901.01 1906.01 1911.01 1916.01 1921.01 1926.01 1931.01 1936.01 1941.01 1946.01 1951.01 1956.01 1961.01 1966.01 1971.01 1976.01 1981.01 1986.01 1991.01 1996.01 2001.01 2006.01 2011.01

Figure 2: Shiller Cyclically Adjusted PE. Source: http://www.econ.yale.edu/~shiller/data.htm

Moreover, individual securities have started to look interesting and we have put some capital to work, the first time in many months: Boralex Inc. (BLX-TSX) The simple rationale for our investment in Boralex Inc. is that it is trading at roughly 60% the valuation of its power producer/developer peers at 6.5x 2011E cash flows. We think a combination of factors have led to the discount, including the lack of cash dividend versus peers, the messy takeover of Boralex Power Income Fund in 2010 and BLXs exposure to merchant power pricing (selling power at competitive wholesale market prices). However, we believe these issues will be resolved over the next several years as Boralex shifts from being a mostly un-contracted merchant power producer (60% of cash flows in 2010 came from un-contracted production) to a mostly contracted power producer (70% of estimated 2012 cash flows will be from contracted sources). As cash flows stabilize and become more

Starting To See Value

The Aspiring Analyst Vol. 1 Iss. 9 theaspiringanalyst@gmail.com

predictable, BLX should be in a position to institute a dividend and thus close the valuation gap with its peers. At 10.0x cash flows, Boralex could be a $12.00 stock. Brasil Telecom ADR (BTM-NYSE) Each Brasil Telecom ADR represents three shares of BRTO4 (BRTO4-BOVESPA), one of the many public listings of Brasil Telecom S.A. (Oi S.A.). Oi is the second largest telecom group in Brasil with approximately 25% market share by revenue, according to the companys corporate presentation7. The knock on Oi (and part of the reason why we like it) has been its convoluted corporate structure, with Telemar Participacoes S.A. (TMAR-BOVESPA) controlling Tele Norte Leste Participacoes (TNE-NYSE, TNL-BOVESPA) which controls Brasil Telecom S.A. This corporate structure has obscured a deeply undervalued consolidated entity trading at just 3.5x consolidated EV/EBITDA vs. global peers between 4.0x 7.0x EV/EBITDA (for example, Canadian darlings BCE-TSX and RCI.b-TSX trade at 6.5x). What is important to us is that management recognizes the problem of this bloated corporate structure, and in May, began a process to simplify the organizational structure of Oi Group, with BRTO4 being the intended sole public vehicle going forward. In addition, the company has brought in a new CEO, Francisco Tosta Valim Filho (formerly CEO of Seresa Experian, Brasils leading credit bureau) and has partnered with Portugal Telecom in a bid to bring best of class technology and management to Brazil. Already, the independent board of directors of BRTO4, TNL and TMAR have voted in favour of the proposed corporate consolidation8. The outstanding tasks before a corporate restructuring are shareholder votes (estimated by year-end) and approval by the SEC. We estimate each EBITDA multiple is worth approximately R$6.00 per share of BRTO4 (R$10 BB in 2010 EBITDA divided by 1.7 BB pro-forma BRTO4 shares) or $9.50 per BTM share, at current exchange rates. If simplification and the partnership with Portugal Telecom can increase the transparency at Brasil Telecom and narrow its valuation gap with international peers, it would not be far-fetched for BRTO4 increase its valuation to 5.0x EV/EBITDA over time, or R$19.00, bringing each ADR value to almost $31.00 (it is currently trading at just under $18.00). Moreover, if shareholders approve the corporate consolidation, each BRTO4 shareholder will receive a R$2.54 cash bonus (to equalize the share exchange ratios), which is worth almost $4.00 / share of BTM. Combined with some conservative cost and revenue synergies, BTM (BRTO4) could be a double.

Oi Corporate Presentation, August 2011, http://www.mzweb.com.br/oi/web/arquivos/Oi_APR_Corporativa_Agosto_20110823_eng.pdf 8 Wall Street Journal, retrieved October 3, 2011: http://online.wsj.com/article/BT-CO-20110829-706770.html

Starting To See Value

The Aspiring Analyst Vol. 1 Iss. 9 theaspiringanalyst@gmail.com

Disclaimer: Our goal through this blog is to provide analysis and ideas that you, the reader, might find useful in forming your own investment decisions and hopefully improve our analytical skills in the process. We are not soliciting for the management of your investments nor seeking to provide financial advice. The Aspiring Analyst blog and letters will not take responsibility for any investment losses incurred by readers through the trading of securities and strategies mentioned in this blog or its accompanying letters. The views expressed in this blog and its accompanying letters reflect the author(s) personal views about the subject company(ies) and its (their) securities. The author(s) certify that they have not been, and will not be receiving direct or indirect compensation in exchange for expressing the specific recommendation(s). Readers are cautioned to seek financial advice from qualified persons such as a Certified Financial Planner prior to taking any action in regards to the securities and strategies mentioned in this blog or its accompanying letters.