Background

Founded in 1982, Chesswood has operated in almost every interest rate environment possible. Most prime to subprime equipment financiers were out of business by January 2009, but Chesswood was able to survive due to its strong market position and disciplined approach in the years prior to the crisis.

The financial services company specializes in small- to medium-ticket equipment financing. When a specialty business with large capital expenditures needs to buy new equipment, Chesswood can provide the financing required to do it. The company operates two wholly owned subsidiaries — two equipment financiers for small- to medium-sized businesses in the U.S. and Canada.

The U.S. Equipment Financing segment (“Pawnee”) has approximately 600 independent operators across 48 U.S. states, while the Canada (“Blue Chip”) segment has about 50 independent operators. These independent operators are diversified from various different industries, thus providing even more diversification, even on industry types!

Cash dividends

Chesswood is a very popular stock for its dividend, which is currently at 8.33% as of this writing. Most companies pay cash dividends from its earnings of the year. Chesswood, in particular, pays out about 74% of its earnings to shareholders. Investors can then reinvest these dividends into the stock and continue a virtuous cycle.

A payout ratio of 70-75% is a standard figure for most companies and especially sustainable for Chesswood. This is because it is a financing company, with no expected major capital expenditures in the near future.

Dividend cuts and swings may provide interesting opportunities for strategic investors, but they may not be of interest to the average income-oriented investors. Chesswood has a track record of stability. For the past decade, its cash dividends have been growing at 11% per annum. Earnings, however, are growing at 3.6% per annum. This means that dividend growth is limited, until it can find a way to increase the growth rate of its earnings.

Valuation: Is Chesswood a cheap stock?

Relatively speaking, Chesswood is a cheap stock. With a forward P/E of about 8.4, it is trading at the lowest price that it has been in five years. Element Fleet Management and goeasy have been trading at forward P/Es of 11.4 and 9.1, respectively. These two companies also have extremely low dividend yields, both at about 2%.

Using a very conservative dividend discounted model, which assumes 4% dividend growth until the year 2029 and 2% growth afterwards, the stock is undervalued at about $11.95. This is good news for value investors, as the stock currently trades at $10.09 as of this writing. It is a modest margin of safety, but one nonetheless. It also provides passive income for your portfolio. Chesswood is not a spectacular stock that will make you rich, but it should be a conservative pick for income-savvy investors.

The post 1 Undervalued Stock Yielding 8% to Add Passive Income to Your Portfolio appeared first on The Motley Fool Canada.

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First, a background on valuation and, in particular, valuation of financial firms.

Valuing financial services firms is notoriously difficult.

First, the treatment of debt does not apply as neatly as it does at “traditional” businesses like Coca-Cola or even Amazon. Debt (or liabilities as a line item) is treated as a raw material rather than a source of financing. As banks borrow money (or take deposits) and lend it out at higher rates, it is obvious why analysts treat debt at a financial firm as an operating item.

Second, I must treat capital expenditures (capex) differently. In most cases, the capex at a financial firm is intangible. Traditionally, banks do not spend major amounts of money to expand physical plants or R&D. Most of their capex  are actually hidden in operating expenditures, namely in training staff and building the brand through marketing channels and sales programs.

Third, if I use traditional working capital metrics, valuation will be distorted, as banks record current assets and liabilities to their respective market values. Working capital will be volatile and useless in this case.

With those out of the way, I cannot use traditional free cash flow approaches. A popular way to compensate for these weaknesses in traditional metrics, while still using a Warren Buffett approved method of valuing financial firms through a discounted cash flow approach; I will use the excess returns method.

The excess returns method values equity as such: the current value of equity plus the present value of expected excess equity returns. The former is simply found on the firm’s balance sheet, while the latter is the following: (return on equity – cost of equity) * (current equity base).

Many inputs in the model are overly “scholarized” and, in many successful investors’ opinions, do not work well in practice; it may be fruitful to estimate these numbers based on historical figures. With this in mind, we will begin our valuation on Toronto-Dominion Bank (TSX:TD)(NYSE:TD ) and Royal Bank of Canada  (TSX:RY)(NYSE:RY). For the purposes of this article, I will focus mainly on relative valuation.

TD and RBC are both exceptionally well-run banks; I will study these firms through three lenses: their current valuation ratios, loan portfolios, and management teams. Currently, both banks are trading at a P/(TTM E)  of about 12.3 compared to the industry average of 11.4. P/B is 1.8 and two for TD and RY, respectively. Both banks are valued around the same, according to market consensus.

TD had recently issued higher provisions for loan losses, which may mean overall macroeconomic stalling in Canada. Perhaps RBC has not issued such provisions yet, as it is  more globally diversified than TD is. In any case, both banks will have to deal with macroeconomic challenges, as they brace themselves for volatile markets and uncertain environments.

In evaluating management teams, it is crucial to begin with the compensation structure of key personnel. Are they being compensated fairly and in line with business performance?

According to a recent CBC article, the Big Five banks’ CEOs received a pay hike, with Bharat Masrani’s being the largest. He received $15.3 million for the fiscal 2018. On an absolute basis, it is a huge amount, but on a relative basis, TD performed exceptionally well for the year, both from an earnings perspective and an asset base perspective. Both grew about 4-5% in 2018. RBC’s CEO experienced a similar pay increase, albeit a less drastic jump.

There is lots to like about the two financial institutions and many ways to value them. Both banks have similar valuations, management compensation structures, and competitive asset bases. Moreover, both banks have excellent credit quality and will be good holdings for the long run.

The post Better Banking Stock: Toronto-Dominion (TSX:TD) vs. Royal Bank (TSX:RY) appeared first on The Motley Fool Canada.

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In this overvalued market, it is tough to find undervalued securities that have potential for growth. In searching for equities still trading at cheap multiples, I found Transat A.T. (TSX:TRZ). This is not just a cheap security, though. Some catalysts make this story worthwhile.

First, a brief background on my thinking.

Warren Buffett ran multiple partnerships for investors that were collectively known as the Buffett Partnerships. In their heyday, the partnerships focused on three strategies in investing: value companies, “work-outs,” and controlling stakes (or activist investing). A “work-out” was when Buffett would purchase a security in anticipation of a bullish catalyst likely to occur. In this case, we categorize the Transat story as a “work-out.”

On May 9, Quebecor CEO Pierre Karl Peladeau says he commissioned an investment firm to conduct a financial analysis of Transat and concluded that it would be an “interesting opportunity.” Shortly after that, a developer of Groupe Mach told the Canadian Press that he had already submitted an offer to purchase the company.

A bidding war for Transat is in the cards. Multiple Quebecois entrepreneurs and rumoured Canadian airlines such as WestJet want to have claims to the business or Transat’s attractive assets (like its fleet of 40 planes). As multiple bidders continue to bid up their respective offers, the price tag for shareholders will grow.

Transat’s business has been struggling. With notoriously low margins for the airline business, the company has focused more on the hotel business, which is a higher-margin business. Before the news of the potential purchase, shares were flat YTD to reflect investor pessimism. Furthermore, according to Quebecor’s CEO, Quebeckers like flying with Transat, giving it a strong moat through its “Quebecois” brand name.

The Quebecois government is likely to approve the deal, as they want to see Transat’s headquarters continue to operate in the province. Transat’s management team is also likely to sell, as they require funds for further expansion into the hotel business. They would also need guidance and resources, both of which capable buyers are willing to provide for them. As we observe, there are many moving parts to the deal and a chance for investors to participate.

In Warren Buffett’s book of arbitraging strategies, he participates when a deal is likely to go through. There are multiple factors that go into the likelihood of a successful deal.  When the seller is willing to sell, that eliminates the need for the buyers to engage activist investing, because cooperation is likely. We see this in the case of the Transat bid.

Unless the management team does not want to work with a specific company, they would welcome resources and guidance. Buffett is also more likely to participate in a deal if companies are not too large, as this could result in antitrust issues from the government approving the deal. In this heady market, with cheap money and enthusiastic shareholders, a deal, or a bidding war, will most likely be successful.

If the deal does not go through, Transat’s business is still a stellar one and currently fairly valued, even after its rise in late April.

The post Why This Value Stock Is a Low-Risk, Warren Buffett-esque Play appeared first on The Motley Fool Canada.

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