TFSA Titans: 5 TSX Stocks to Supercharge Your TFSA
A very warm welcome, new Fools!
If you’re familiar with The Motley Fool at all, you may already know that our mission is to help make the world smarter, happier, and richer.
Today, we aim to help you accomplish all three of those goals by calling your attention to what we believe are five outstanding stocks you can buy and hold in your TFSA for years to come. We’ve selected these companies with four guiding principles in mind…
Foundation: Companies that build the bedrock of your portfolio with a heavier allocation. In this category, we’ve selected Brookfield Asset Management and Canadian National Railway.
Value: Companies that appear deeply undervalued and that we’re waiting for the market to “catch-up” on. Here, we’ve selected Tricon Capital.
Huge growth potential: Companies with the potential to become the next MercadoLibre… Shopify… even Amazon. For growth, we’ve selected Lightspeed POS.
Dividends: Companies that pay consistent, recurring dividends that can be counted on for steady returns. Here, we’ve selected Brookfield Properties.
In this special “TFSA Titans” report, we hope you’ll be able to begin (or continue) fully taking advantage of your TFSA with these five stocks we’re especially keen on.
Without further ado, please enjoy the following five recommendations pulled from an assortment of our Canadian stock-picking services in full.
To your wealth,
Your Motley Fool Canada Team
Brookfield Asset Management
From Motley Fool Canada Pro Team
What We’re Thinking
Special companies—companies that make that life rather enjoyable and lucrative—come along every so often in one’s investing life. These companies tend to share a collection of traits and, in hindsight, appear obvious. In the here and now, however, with all the distractions that exist out there, not so much.
Beyond identifying them, the key to investing in these special companies is to make them an outsized position in one’s portfolio.
Fellow Fools, in our opinion, Brookfield Asset Management (TSX:BAM.A) is one of these “special” companies—one that we feel uber-confident in making an outsized position in the Pro Canada portfolio. In fact, I’m not sure there’s a company in the portfolio that Jim or I (Iain here) are more comfortable with at this moment.
That said, comfortable should not be confused with complacent. Indeed, just as with any company/stock, we’re not saying an investment in BAM will provide a straight ride up. There will be bumps along the way—especially when dealing with an entity as vast as this. And it may seem like a grind at times. But those bumps are more likely to be treated as opportunity more than anything—opportunity to continue building this position. Because a decade from now, those bumps will almost assuredly be nothing but, and we foresee this company is going to be worth a whole bunch more than it is today.
For now, we want our “comfortable” views well reflected in the Pro Canada portfolio, and therefore we’re upping our exposure to this somewhat unheralded Canadian champion.
In the meantime, if you want an example of what makes Brookfield so special in our books, we don’t think you can go wrong reviewing the quarterly letters from CEO Bruce Flatt. This snippet from the most recent letter encapsulates what we, and apparently they themselves, love about their performance (note: currency in the table below is in U.S. dollars):
That’s a nearly 20-year track record where essentially any measure you’d care about compounds at between 15% and 19%—consistent, profitable results, and yet the company has been miserly with the share count, respecting its own (and our) equity. Don’t get used to that share count, however, One of Brookfield’s goals, with record, and growing, free cash flow, is to reduce the share count to below where it was in 1999. Management has indicated this as a “medium-term goal” and will undertake such exercise only when it believes it’s buying the shares below intrinsic value. If you read that letter, you’d come away with the impression that Flatt believes the current share price meets that criteria. We listened and are adding today so as to benefit.
How it Fits Into Your Portfolio
We’ve previously highlighted Brookfield as a fine example of a “compounding machine”—companies with wide “moats” or, even better, widening moats, and the ability to earn high returns and then reinvest at those high rates for many years to come. We like to see a history of organic profitable growth and durable competitive advantage. We have no reason to re-classify the company today.
Canadian National Railway
From Motley Fool Stock Advisor Canada Team
An industrial sector stalwart, this railroad is as blue as blue chips come in the Canadian market. It is an ideal holding for all long-term-focused investors.
- Best-in-class rail network that connects three coasts in North America with more than 20,000 route miles of track.
- The owner of an irreplaceable asset in an industry with insurmountable barriers to entry.
- Loads of opportunities ahead, which should ensure that double-digit returns on capital continue for years to come.
|Total Inside Ownership||0.26%|
|TTM = Trailing 12 Months|
|Dollar amounts in millions except recent price.|
|Data as of our initial buy recommendation on March 6, 2014|
Aside from maybe Hockey Night in Canada, I can think of few more prominent Canadian institutions than the railroad. The railroad is part of what has made Canada what it is today. And though it has evolved over the years, and certainly plays a far different role than it did prior to the advent of the automobile, the railroad continues to be a tie that helps to hold our country together—indeed, it truly serves as a backbone to our economy.
There are, of course, two national railways in this fair country, but just one is ideally suited for your portfolio. Canadian National Railway (TSX:CNR)(NYSE:CNI) has played a significant role in the evolution of the Canadian economy, and it has produced outstanding returns for longterm shareholders in the process. We don’t see a reason for either dynamic to change in the decades to come.
Building a portfolio is a bit like building a house. Like a house, every portfolio needs a solid foundation—that is, every portfolio needs to contain a collection of companies that are virtually assured of being worth more in 10 or 20 years than they are today. These kinds of companies aren’t going to win over any friends at a cocktail party, or make you look like a “guru” by surging ahead in a single day of trading. What they are likely to do, however, is protect your capital and earn you a very steady, and over the long term, spectacular risk-adjusted return. Canadian National Railway (CN Rail) is one such company.
The primary reason I’m so confident in this longterm prognosis is the company’s underlying asset. CN’s 20,000 route miles of track blanket North America and touch three coasts: the Atlantic, the Pacific, and the Gulf of Mexico. This expansive network makes CN one of the go-to transporters of goods that are either set to leave North America or need to be distributed throughout North America.
Goods that travel across this vast network include such things as petroleum, chemicals, metals/minerals, forest products, coal, grains and fertilizers, intermodal (i.e., manufactured goods that arrive in big containers from Asia), and automobile-related materials (parts and cars).
Its ability to efficiently transport these goods across the continent makes CN’s rail network one of the greatest assets imaginable. Cross-continent bulk transportation networks are rare, and if you own one, and manage it properly, they serve as a fantastic way to build wealth. Just ask Warren Buffett, whose Berkshire Hathaway wholly owns U.S.- based railroad Burlington Northern Santa Fe, or his buddy Bill Gates, who owns 10% of CN Rail through his investment company, Cascade Investment.
It Gets Better
Because of the unique nature of CN’s asset, the company has incredibly deep ties with its customer base, which only helps to deepen the moat around its business. CN plays an integral role in how its customers do business. It is essentially irreplaceable for many of them.
Not only that, CN is also the best railroad operator in North America, as evidenced by its peer-leading operating ratio of 63.4%. (Operating ratio = Operating expenses/revenues.) This is a critical component of the story because customers tend to like dealing with the best. Also in CN’s favour: Reliable service not only helps retain existing customers but also attract new ones. And the deeper these customer relationships are, the stickier they tend to be.
Full Steam Ahead
That combination—a great asset, deep customer ties, and best-in-class operations—means CN’s future is bright. Opportunities abound to reinvest in this equation and continue to earn a meaningful return. Over the past five years, CN has spent $8.3 billion on capital expenditures (far exceeding the depreciation of its assets, which amounted to $4.4 billion) and has earned an average return on capital over this period of 11.4%. The company expects to spend another $2.1 billion on capital expenditures in 2014, and as long as it can continue generating 12% or so returns on this invested capital, investors should do very nicely.
The bulk of its spending has been plowed back into improving its network and track infrastructure. Also receiving a good chunk of the capital spend: new locomotives and new facilities to help grow the business, such as transloading terminals, distribution centres, and a new Calgary Logistics Park.
Perhaps the most recognized (though not necessarily most significant) growth lever for CN in recent years has been the controversial move toward transporting increasing amounts of crude oil by rail. CN’s crude carloads have surged to approximately 70,000 in 2013 from approximately 5,000 in 2011. While the company expects this energy-related business to continue to grow in the coming years as pipeline systems remain constrained, if it were to be abolished due to safety concerns, those 70,000 carloads are relatively insignificant compared to the approximately 5 million carloads that CN carries annually.
While there’s little reason to believe that the tailwind from energy-related transport will blow through anytime soon, even if it does, CN’s other business lines have more than enough potential to pick up the slack. For instance, significant upside for the company’s intermodal division was cited at a recently held Investor Day.
The three components of CN’s overall growth strategy include expanding the company’s geographic reach, offering new products (which oil falls under), and taking an innovative approach to service. Not one of these components requires CN to reach very far outside of its comfort zone, and the combination is expected to drive above-trend top-line growth going forward.
What About That Other Railroad?
The other national railroad here in Canada is Canadian Pacific Railway (TSX:CP)(NYSE:CP). For a period, CN was clearly the superior operator, even though the collection of freight transported is similar, as is both of their geographical footprints, at least in Canada (CP doesn’t go any further south than Kansas City, which means it misses out on the critical Gulf Coast region). The operating gap, however, has narrowed considerably. CP’s operating ratio currently sits at about 70%, which is down from the high- 70% range that it inhabited just three years ago.
Many of the business-related characteristics we’ve used to describe CN thus far can almost be repeated verbatim for CP. The big difference is that although CP’s operations have improved dramatically, thanks in large part to former CN CEO Hunter Harrison, the market has rewarded this performance with a collection of multiples that eclipse CN’s.
Aside from the aforementioned operating ratio, CN continues to lead CP on a number of performance-related metrics.
|Return on Equity||Return on Capital||EBIT Margin||Total Debt/ Equity|
Source: Capital IQ
And as you can see below, CP’s multiples don’t correspond to the fact that it’s the inferior operator of the two; the market is giving CP credit for improvements that have not yet occurred. We prefer to take the bird in hand, so to speak, and not trust that CP will “get there,” as the market assumes—especially if “getting there” appears more or less priced in.
|TTM P/E||Forward PE||Price/Book|
Source: Capital IQ
We love finding a hidden gem as much as any investor, and we think we’ve come up with a few thus far in Stock Advisor Canada. But our mandate here is to help you find market-beating stocks. In the case of this month’s recommendation, we think we’ve found that in the form of a rock-solid blue chip.
There will be short-term hiccups along the way, caused by such things as a bad grain harvest or weather issues, but over the long term, from a risk-adjusted standpoint, we can think of few other companies more worthy of a place in your portfolio than CN Rail.
From Motley Fool Discovery Canada Team
What Tricon Capital does
Though its roots will remain entrenched in the world of real estate, and primarily, residential real estate across the U.S. Sun Belt, the business mix is about to change. Thanks to its recent acquisition of Silver Bay Realty Trust (NYSE:SBY), Tricon is very much a company in the midst of a transition – for the better.
With the addition of Silver Bay’s portfolio of 9,044 single-family rental homes, Tricon will become the fourth-largest publicly owned company in this vertical, with a total portfolio of almost 17,000 homes. These residences are scattered across the U.S. south, from Georgia to California, and are targeted at a midmarket clientele with annual income of $50k-$95k per year.
Tricon and Silver Bay each began accumulating their respective rental home portfolios in 2012, still firmly in the wake of the financial crisis, as this corner of the market remained mired in a slump. For most of this period, Tricon has been reliant on third-party providers to manage its growing portfolio of homes. But in the past year or so, Tricon severed ties to these outside providers. Now, Tricon American Homes (TAH) is a full-service entity that buys, renovates, and leases homes to steady-income families. And when the Silver Bay acquisition closes, this will be Tricon’s largest division.
The other significant division within the company is Tricon Housing Partners (THP). This is somewhat of a legacy business for the company, which sees it invest third-party capital, as well as capital from its own balance sheet, alongside residential real-estate developers, again, across the southern U.S. Asset management fees are gleaned from the third-party capital Tricon manages, and the division has benefitted from a solid track record of capital appreciation through its investments in the earlier stages of the real estate life cycle.
Two other divisions under the Tricon umbrella, Tricon Luxury Residences and Tricon Lifestyle Communities, are set to be either pared back or sold off entirely, as the company streamlines to focus on Tricon American Homes and Tricon Housing Partners in the years ahead.
What makes it unique?
To have accumulated a portfolio of more than 17,000 single-family rental homes over the past several years or so is no small feat. And given that this portfolio was assembled in the wake of one of the worst housing markets that anyone can recall, the economics underlying it are virtually impossible to replicate.
Of similar importance, and as we look to the future, it’s likely that the platform the company has built to manage and grow this portfolio will prove equally unique. This platform will give Tricon the edge as it reinvests the cash thrown off by its existing portfolio into more and more homes. Just as there aren’t many 17,000-rental-home portfolios kicking around, there also aren’t a lot of operations capable of managing this kind of portfolio.
Why we like the stock today
In our mind, the pairing of these two approaches, rentals and development, makes for intriguing total return possibilities.
As it stands, Tricon sports a dividend yield of 2.4%, and it won’t come as a surprise if dividend increases become a part of this story in the years ahead, given the cash-generating characteristics that coincide with a sizeable rental-home portfolio. That said, reinvesting in this portfolio, as well as alongside Johnson, will be front and centre for Tricon for the foreseeable future.
Describing Tricon American Homes’ opportunity as “vast” is somewhat of an understatement. Residential real estate in North America has always been rather mom-and-pop. Portfolios as big as Tricon’s haven’t existed in the past, and as noted, they’re still very rare. Tricon expects to add to its portfolio through distressed sales, traditional retail channels, and bulk acquisitions, if it can find them. Distressed sales alone, however, which have averaged about 800,000 per year in the U.S. since 2005 (about 500,000 per year outside of the crisis years), should provide enough supply to make a difference to Tricon, and its shareholders, for years to come.
On the TPH front, Tricon is focused on eight Sun Belt states, with six of these markets expected to have the highest absolute population growth of all the U.S. states from 2016 to 2021. In addition, six of these markets ranked within the top 10 states for employment growth in 2015. With the three most important variables to succeeding in real estate being 1) location, 2) location, and 3) location, demographic and economic trends favour the markets that Tricon knows best.
Broadly speaking, an overarching consideration anytime you’re dealing with a financial company is the balance sheet. To remain as enthusiastic about Tricon as we are, and for the company to achieve its potential, it must hold financial risk in check. It took on debt a couple of years ago to complete the Silver Bay transaction — more of its own, and Silver Bay’s — but at this stage, the burden appears entirely manageable. We’ve no concern on this front, but it’s something to pay constant attention to.
Why this could be the next Home Run Stock
In the big picture, a continued accumulation of rental homes across the current footprint, as well as continued success developing new properties, will carry the day for Tricon.
Though I wouldn’t call the company necessarily cheap, I also wouldn’t call it expensive, at about 1.03 times book value. Peer Howard Hughes, a company that has business along the lines of Johnson Development and the THP business, trades at 1.5 times book value. In fact, compared to the past few years, this is among the cheapest Tricon has traded compared to its book value.
Provided management is able to execute through the merger, and realizes the growth alluded to, we not only foresee a bigger company in five years’ time, but also one that trades at a more substantial multiple – and pays a dividend along the way.
How Tricon Capital fits into your portfolio
When it comes to small-cap opportunities, Tricon is certainly at the sturdier end of the spectrum. Its business is well-established, and there’s a clear strategy laid out for the road ahead. The financial part of the equation is also in good shape, which certainly isn’t always the case when it comes to small-caps.
Given that we’re working from such a stable base, in our mind Tricon warrants an allocation that’s significantly larger than a company where speculation is a bigger part of the equation. Based on our collection of 20 companies, we plan to allocate 8% of the capital we’ve available to Tricon.
From Motley Fool Canada Partnership Portfolio Team
About This Partner
- Company Name: Lightspeed POS Inc.
- Country of Origin: Canada
- Partner: Dax Dasilva, Chief Executive Officer and Director
- Age: 42
- Ownership Percentage: Owns 17.31% of shares (worth $377.4 million)
At a very young age, Dax Dasilva knew he was going to start a software company. Dax’s father was a graphic designer and would bring his original Mac home with him from work. In a 2004 interview with Forbes, Dax described his father’s Mac as “magical,” because “it brought simplicity to complexity through a graphical interface.” He began programming shortly after receiving his first Mac from his father at age 12 and his love for the Apple brand led to him getting a job at an Apple dealer in his 20s. And that’s where the seed for his future career was truly planted.
The Apple dealer that Dax worked for owned a chain of four stores, and while they sold some of the world’s most advanced technology-enabled devices, the software that ran their stores was mediocre at best. The problem was that there was very little business software available for the Mac at that time. And that’s when the lightbulb in Dax’s mind lit up – he could create the full suite of software needed for retailers to conduct their business entirely on Macs – and that’s exactly what he did.
However, before his vision for revamping the dealer’s software was realized, the chain closed up shop in 2004. That was just one more hurdle for Dax, which did not faze him. He simply adapted the software and founded Lightspeed the following year. Within months, Dax sold his newly developed software to an association of Apple dealers in the United States and that was the beginning of Lightspeed’s incredible growth story.
Lightspeed has since moved its suite of products to the cloud to cater to any retailer, regardless of platform, and this has helped it deliver on its goal to bring the “Apple store experience” to any business that wants it. Today, its solutions are powering the software for over 51,000 retailer and restaurant locations in approximately 100 countries around the world.
Our Partner: Dax Dasilva
Like many great founders, Dax Dasilva built a successful business by seeing a gap in a market and filling it with a unique solution at a reasonable price. That part is clear. But what makes Lightspeed so unique is the vision Dasilva has brought to building the business. He did not create the company with the goal of getting rich (that just happened to come with it), but to empower entrepreneurs to be the best that they can be while encouraging his employees to put forth their best effort every single day. On both its website and in corporate filings you will find this:
“We believe that commerce belongs to everyone.
From day 1 it’s been about much more than transactions; we set out to help entrepreneurs work smarter, make data-driven decisions, and create the best possible experience for their customers. That philosophy still runs through everything that we do.
We are a company infused with culture, just as much as code. Our values are what unite us, but our differences are what inspire us. We get to do the best work of our lives and we celebrate our successes every chance we get.”
As of December 31, 2018, Lightspeed’s Glassdoor rating was 4.4 out of 5 with 98% of current and former employees approving of Dasilva as CEO, so there is clear alignment within the company. While this is great to see from a financial perspective, since employee turnover is costly, it’s even better to see when considering a company for the Partnership Portfolio, because we want to invest in great leaders that are doing good for everyone – and that’s what we see in Dasilva.
Lastly, Dasilva has significant skin in the game. As of August 22, 2019, he owns approximately 17.3% of Lightspeed’s outstanding shares and because of a dual class share structure, he controls over 45% of the voting power. He is undeniably in control of his baby and we are 100% okay with that.
The Business: Lightspeed POS Inc.
Lightspeed offers an all-in-one, cloud-based, omni-channel, commerce-enabling, software-as-a-service platform for small- and medium-sized retailers and restaurants. That’s quite a mouthful, but what it all boils down to is that LightSpeed offers a platform with all the software, solutions, and support systems, as well as the hardware, that retailers and restaurants need to run their businesses.
In the past, businesses would typically piece together their technology needs, purchasing a POS system and partnering with a payment processor to handle the front-of-the-house needs, and there’d be another computer in the back office with the accounting and inventory management software (among many other programs), and likely other separate tech and accounts for their website, loyalty program, and so on. Lightspeed saw this broken process for what it was and sought to solve the problem by creating its all-in-one solution.
Businesses can use Lightspeed’s platform and select the solutions they need, and they can add more products when they’re ready and can easily scale their technology if they open more locations. The best part, however, might be that businesses can do all of this without breaking the bank as Lightspeed’s average revenue per location is only about US$200 per month.
As you might expect, once Lightspeed brings on a new customer, the chance of them switching to a DIY solution is highly likely. Not only would migrating all of their data be expensive, but retraining employees would be a headache and the risk of messing something up and missing out on sales is far too great.
As more customers adopt Lightspeed’s platform, the potential leverage that comes with scale becomes even more great. That’s because while new customers can be landed and set up at a reasonable cost, the most profitable growth comes when existing customers add solutions or open new locations, since little to no marketing spend is required.
How Lightspeed Will Win
As mentioned before, Lightspeed will win by continuing to grow its customer location count with both new and existing customers, as well as upselling those customers. One of the key upsells to look for will be Lightspeed Payments, which the company launched on January 31, 2019 to U.S. retail customers and has already surpassed $15 billion in gross transaction volume. Bringing payment processing in-house has helped Lightspeed create a “stickier” ecosystem, and that’s exactly what we like to see with SaaS platforms.
In total, Lightspeed estimates its addressable market to be worth approximately US$113 billion today, which is based on its estimation that there are 47 million retailers and restaurants that could utilize its technology and its average revenue per location of about US$200. This means that with a total of 51,000 customer locations as of its most recent earnings release, Lightspeed serves less than 1% of its total addressable market, giving it the runway for growth it needs to achieve our goal of 6x returns in 10 years.
It’s also worth mentioning that Lightspeed notes that its total addressable market could expand to US$542 billion and 226 million customer locations if it broadens its offerings to other industries, which we think is very likely to happen over time. The company has a long history of being acquisitive, including its acquisitions of iKentoo and Chronogolf in the last six months, and we don’t think this will change anytime soon.
Lightspeed was not the first to launch a POS platform, but we have seen this same story play out time and time again: the market for certain product or service appears saturated, but a new player comes along and dominates the category because they are the best. That’s what we have seen with the iPhone, Facebook, Gmail, and Zoom, and we think Lightspeed will be that solution in the POS category.
1. Market size and opportunity
Expansionist mindset and passionate vision: Dasilva believes that commerce belongs to everyone and his focus is on empower entrepreneurs.
Innovative disruption and creative destruction: Lightspeed’s all-in-one solution simplifies operations for retailers and restaurants.
Consumer facing: Lightspeed deals with SMBs, not consumers.
2. Inside ownership, control, and compensation
Ownership and control: Dasilva owns over 17% of Lightspeed’s outstanding shares and over 45% of the voting power.
Institutional shareholders’ long-term support: Caisse de depot et placement du Quebec, one of Canada’s leading institutional fund managers, has been a shareholder of Lightspeed since 2015. It currently owns over 30% of Lightspeed’s outstanding shares and about 20% of the voting power.
Leadership wins when we win: Dasilva’s salary was $292,641 in fiscal 2019, and while that’s a good amount, the vast majority of his wealth has and will continue to be tied to Lightspeed’s stock (where his stake is worth more than $500 million).
3. Financial performance
Sales growth over 15%: Accelerating revenue growth is no easy feat these days, but Lightspeed is showing it, with year-over-year growth of 34% in fiscal 2018, 35.7% in fiscal 2019, and outlook calling for 45-48% growth in fiscal 2020.
Large market opportunity and reinvestment economics: Lightspeed currently estimates its total addressable market to be worth approximately US$113 billion based on its estimation that there are 47 million retailers and restaurants that could utilize its technology and its average revenue per location of about US$200.
Access to capital to fund growth: As of June 30, 2019, Lightspeed has $191.4 million in cash and cash equivalents and no debt, has considerable resources to deploy against its growth plans.
4. Culture and people
High ratings and reviews: On Glassdoor, Lightspeed receives a score of 4 out of 5. Dasilva receives a 90% approval rating from his employees, while 74% would recommend the company to a friend and 75% have a positive outlook on the business.
Passionate workforce with low turnover: There are no obvious signs of employee discontent or high turnover.
High-quality board and network: Lightspeed’s board includes two Lightspeed executives, Dax Dasilva (CEO) and Jean-Paul Chauvet (President). The other four seats are staffed with industry experts with backgrounds that include Amazon, Google, Google Canada, and Open Text.
5. Company Size
Market cap under $25 billion: Lightspeed’s market cap currently sits just below $3 billion.
Winning with 6x returns in 10 years: Lightspeed growth rates, international opportunities, and optionality in many different markets make it an ideal candidate to achieve a sixfold increase in 10 years.
From Motley Fool Stock Advisor Canada Team
Brookfield Property is one of the world’s premier commercial real estate companies.
- It owns a collection of highly unique real estate across the globe at unmatched size and scale that offers loads of optionality.
- It has a growing dividend with potential for company growth at a valuation that appears too good to pass on.
- It has respected operating abilities and capital-allocation skills that set it up well for the long term.
|Industry||Commercial Real Estate|
|Total Inside Ownership||19.69%|
|TTM = Trailing 12 Months|
|Dollar amounts in millions except recent price.|
|Data as of November 13, 2018|
We surfaced Brookfield Property Partners (TSX:BPY.UN)(NASDAQ:BPY) back in our August edition of “Stocks on our Radar,” indicating that real estate in general had potentially been mistreated by the market and that BPY (will run with that abbreviation from herein) had risen above the rest, in our opinion. Perhaps though, before we dive into BPY specifically, a quick word on the entire Brookfield empire, because, indeed, it is a Canadian empire that’s emerged, really over the past five years or so.
I’ve been a professional investor largely focused on the Canadian market for about 15 years now. And Brookfield has always been a part of the landscape. The thing is, for the majority of those years, it always seemed to me, and perhaps this was partially due to inexperience, to be a rather jumbled mess—just a big ball of assets that was hard to figure which end was up.
In a transformation that began about a decade ago, under the leadership of Bruce Flatt, who heads up the mothership Brookfield Asset Management (TSX:BAM.A), this jumbled mess has become a collection of some of the most impressive companies in the Canadian market.
BPY is a subsidiary to the mothership BAM and has just finalized its emergence from the jumbled mess that once existed—an emergence that has resulted in the consolidation of all of Brookfield’s real estate investments into one coherent platform, with the cherry on top being the recent closing of the acquisition of GGP Properties, one of the biggest owners of top-tier mall properties in the U.S.
Featuring Brookfield’s well-regarded capital-allocation capabilities, it’s our opinion, and basis for this recommendation, that the assembled collection of assets within BPY that will continue to evolve over time is well situated to generate the company’s targeted return on equity of 12-15% and feature annual distribution growth of 5-8%—targets that exist across the Brookfield empire and, if achieved, should translate into, quite handily, I might add, the market-beating returns we so crave.
With that background laid down, let’s raise the curtain and get a better idea for how this “unjumbled” entity is going to achieve these targets.
BPY’s portfolio runs the gamut when it comes to commercial real estate. Five years ago, though, this was an entity dedicated to Brookfield Office Properties with (just) $30 billion in assets. Today, thanks to four game-changing moves, that figure has grown to approximately $90 billion in assets. The noted transactions included the acquisition of Canary Wharf in 2015 ($12 billion), Rouse Properties in 2016 ($3 billion), Brookfield Canada Office Properties in 2017 ($6 billion), and the $40 billion acquisition of GGP in 2018.
This mix has created an entity with 42% of its capital invested in office properties, 41% in retail, and 17% in investments through Brookfield-sponsored real estate funds that provide exposure to the likes of multifamily, logistics, hospitality, student housing, and the list goes on.
Though its portfolio is global and includes some of the world’s most iconic real estate in the categories mentioned, about two-thirds of its assets are U.S. based—something that we suspect will diminish over time as opportunities arise and Brookfield’s international web is leveraged. Indeed, in other pieces of the empire, we’ve noted capital being recycled from developed to developing markets. We suspect this same strategy lies in BPY’s future.
With a portfolio so vast, the embedded levers and optionality to spur growth in the years ahead are rather significant.
They can be herded into the four categories outlined below:
Provided occupancy rates remain firm (or improve), generally speaking, the trajectory for rents is up. This means, not only are there annual increases, but as leases expire, they get renewed at a higher rate. In the most recently completed corner, BPY’s rents signed were at rates 11% higher than the ones that expired.
Increased occupancy in existing assets as well as new development/redevelopment are a big part of the mix. Again, referring to the most recently completed quarter, BPY launched its newest ground-up development, the Bay Adelaide North project in Toronto. Once complete, this will add significant new cash flows to the mix.
In terms of redevelopment, as an illustration, the company has already begun to reposition valuable space once occupied by now defunct department stores in its GGP portfolio. This transformation is expected to continue over the next decade, as these stores and entire malls are transformed into places that people want to work, live, and play. If all goes accordingly, in 10 years, many of the GGP assets will look nothing like they do today.
This is a biggie across the Brookfield empire, as alluded to above, and potentially the most material of all four categories we’ll discuss here. You see, at its core, Brookfield—all of Brookfield—runs with a value investing, contrarian bend. This means, once it views an asset as fully valued, it looks to sell, using the resulting capital to buy an asset that it views as undervalued. Essentially, it takes capital that could potentially earn sub-par returns in the years ahead and puts it into an assets that offer, well, better returns. The entire empire is really good at playing this game.
As indicated earlier, 17% of the company’s capital is also allocated to real estate funds associated with other Brookfield entities. This represents an opportunity to deploy BPY’s capital beyond its core office and retail properties, providing diversity and growth opportunities in any number of corners of the real estate world.
Pulling it All Together
Okay. I said this was no longer a jumbled mess, but I understand, it may still feel that way at this point.
The base line here is that BPY has invested in a collection of office, retail, and let’s call it miscellaneous real estate. On top of this collection, BPY’s management is charged with extracting maximum value for us shareholders by pulling on the four levers mentioned above.
To help tie it together, let’s consider a quick case study.
Through the acquisition of three industrial companies in North America and Europe, BPY, and other Brookfield affiliates, assembled a 42-million-square-foot global logistics business. Across this platform, it was able to increase rent by 16% and improved operating occupancy from 88% to 95% between 2013 and 2017. This property is on the block and is expected to generate a 30% projected gross IRR and provide a three times gross multiple of capital contributed. Rinse and repeat. This is the Brookfield formula in play.
All of this is well and good, but here’s where things get really interesting.
It has unique assets, loads of optionality, seemingly endless access to capital—as with all things Brookfield—and well-proven capital-allocation skills. Yet, right now, the market kind of hates this company.
For one, we’re getting a company that plans to grow the distribution by 5-8% per annum. It currently yields a well-covered (by CFFO) 6.5%. Should this dividend growth occur, it potentially beats the market on this alone over the long term.
However, this is an entity with a lot of capital-growth potential embedded within. Separate and distinct from BPY’s ability to arbitrage values and capital flows globally, there are at least three key “internal” drivers of value growth, some of which we’ve touched on:
1) Lease rate mark-to-market via contractual steps and spread capture on rolls.
2) Office occupancy normalization (+100-200bps, to 94-95%).
3) A core office and mixed-use residential rental development pipeline, where its share totals to six million square feet, provides years of opportunity for accretion.
It has a fat, growing dividend, and it’s a company with plenty of internal growth potential. That makes for a pretty nice combination.
Now for the kicker … BPY trades at a historically wide discount to its net asset value (NAV). This discount has ranged from 10% to 30% in the past. Right now, it’s at 30%. We suspect this discount has but one way to go. Provided the NAV doesn’t retreat, which we don’t expect, we think this discount will normalize over the long term, which brings a third factor into our potential return equation.
A fat, growing dividend … a growing company … a shrinking discount to NAV … that’s somewhat of a magical equation.
Risks and Considerations
There are four to highlight:
- Operating risk. BPY—and all Brookfield entities—swings big, entering situations that others can’t or won’t. We’re good with this, as you can’t have market-beating returns without risk, but it does mean that things can go bump in the night. The business is of a size and so well diversified that it would take a severe bump to have any kind of lasting impact, but the potential exists.
- Interest rate risk. This is what we suspect is behind the market’s current hate for this and all things real estate. Short-term rates have gone up, and, generally speaking, rising rates are not the friend of real estate entities. It implies increased funding costs (lower IRR) and impacts fund flows, as investing dollars are routed to more attractively priced bonds from equities. Fair enough. In our opinion, though, we don’t think rates are going to, or even can, shoot higher. A debt-laden world just can’t afford it. We acknowledge that this variable may continue to weigh in the short term, but we think this is a risk worth accepting.
- Economic risk. Several of BPY’s levers are reliant on a buoyant economy. There’s no getting around it. And while we’re confident things like occupancy and mark-to-market gains on lease renewals aren’t going to plummet, growth on these fronts could slow, or even evaporate in a less-buoyant situation. However, this is where a long-term lens becomes so important. BPY is likely to take advantage of an economic slowdown and come out the other side in even better shape to provide the returns we crave, even though going through it is likely to result in some volatility for the stock.
- Financial risk. Similar to most Brookfield entities, BPY is a capital-hungry beast, which means it’s rather reliant on the availability of outside capital to grow. It’s not foreseeable that its access to capital will change, and therefore, this is by no means a deal breaker. It is, however, a factor to always have in mind.
Foolish Bottom Line
There was a time that BAM was the only way to get exposure to the empire. This has changed, and investors should be thankful, because it means we get opportunities to gain specific exposure, like BPY, when the market has almost entirely disregarded it. So, following a strategy that the folks at Brookfield themselves might follow, we’re taking a contrarian stance that we expect will pay off over the long term. Join us, and let’s watch together to see how the market reacts when it figures out it’s got this chunk of the empire all wrong!
Disclosure: Iain Butler owns shares of Brookfield Asset Management. Jim Gillies owns shares of Brookfield Asset Management. David Gardner owns shares of Canadian National Railway. The Motley Fool owns shares of Berkshire Hathaway.