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Gordon Pape
Gordon Pape

Piotroski-Inspired Portfolio: A Winning Strategy

September 29, 2012
We welcome back contributing editor Ryan Irvine, one of Canada's top experts in small-cap stocks. Ryan, who is based in the Vancouver area, is the CEO of KeyStone Financial (www.keystocks.com). Here is his report.

Ryan Irvine writes:

I read an article in The Globe and Mail this past week which highlighted an investment approach that sounded very familiar. The strategy was based on a paper entitled "Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers" and was authored by Chicago accounting professor Joseph Piotroski. The paper focused on stocks with high book/market ratios (the inverse of the price/book ratio). Mr. Piotroski realized that some high book/market stocks might be inexpensive for good reason - financial distress. These we would like to avoid.

To compensate for this risk, Mr. Piotroski ran high book/market stocks (those in the market's top 20%) through a variety of accounting-type tests to make sure they were on solid financial footing. Mr. Piotroski showed that from 1976 through 1996, a portfolio that was long high book/market stocks that passed his tests, and short those that did not, would have produced a 23% annualized return - more than double the S&P 500's average annual return over that period.

One fund manager who is now employing a 10-stock Piotroski-inspired portfolio stated in the article that it has been the best performer among his Canadian portfolios this year. Strangely enough, two of the four stocks mentioned from the portfolio are current Buy recommendations from KeyStone.

Of course this is why the strategy seems so familiar. It has been used for half a century as part of the tool box for some of this world's most successful investors including one Mr. Warren Edward Buffett. It is part of the strategy we have employed for the past 14 years.

While not revolutionary, we thank The Globe and the professor for highlighting the dramatic success this type of company-specific investing can produce long-term in a focused growth stock portfolio. True, it is not as sexy or easy as following a pair of squiggly trend lines on a graph that will purportedly lead you to some euphoric truth about a stock. But it works!

In fact, a modified version of this strategy helped us identify the value and growth opportunities in the two stocks we are updating this month.

Athabasca Minerals Inc. (TSX-V: ABM)

Our first update comes from a recent IWB recommendation (January 2012) in the micro-cap arena, which is not for the faint of heart. The company, Athabasca Minerals Inc., is a management and exploration firm. It develops and explores industrial minerals in Alberta, providing aggregate management for the construction, oil sands, and infrastructure industries of the province. Athabasca runs of one of the largest aggregate operations in Canada and holds a significant land position in the Athabasca region of Alberta. The stock was originally recommended at $0.485 as a Buy in the $0.48-$0.55 range. Reiterated the Buy call in our June update when the stock was trading at $0.64.

We are happy to report that based on a very good first half and a strong outlook for the mid-term, Athabasca has seen its share price jump over 190% to its current price of $1.41. Today, we review the company's second quarter financial results and our current rating on the stock.

Athabasca derives the majority of its revenue from the management and production of various types of aggregates in Northern Alberta. The ability to remove gravel from pits is hampered by cold and wet weather conditions. As a result, winter and spring are traditionally the slowest time for the company. However, during this year's first quarter, Athabasca reported record high sales volume with unusually increased demand for aggregates. During the second quarter, aggregate demand from the public pits surpassed last year's same period by 68.9%.

Year-to-date, the company's public pit tonnage demand exceeded the prior year by 81%. Total aggregate tonnage sales including private pit sales through six months ended to May 31 totaled 4.5 million tonnes, an increase of 91.8% over the comparative period. As various oil sands companies have announced plans to increase their production, management anticipates strong continuing demand for aggregate.

Second-quarter revenues jumped 89.2% to $3.21 million from $1.7 million last year. Total revenue was comprised of $2.77 million in aggregate management fees and private pit gravel revenue of $443,705. The management contract with the Government of Alberta allows for an annual increase in the management fee based on the Alberta Consumer Price Index increase of the preceding year, contributing to the growth in aggregate management fee revenue. Also, additional fees are charged when the scales are operated beyond normal business hours. During the second quarter, there was an increase in requests for overtime scale operations, which resulted in increased revenue.

Net income for the quarter jumped 102.3% to $721,252 ($0.026 per share) from $356,537 ($0.013 per share) in the same period of 2011. Changes in the composition of net income primarily include an increase of $1.07 million in aggregate management fees during the quarter and operations of the House River pit, which generated $443,705 in revenue. This resulted in a $1.51 million increase in revenue during the quarter. This was partially offset by $878,632 in increased aggregate operating expenses during the period, including $570,351 increased stripping and clearing expenses. Pre-tax profitability increased 51% to $1.14 million from $753,819 in the same period of 2011.

On May 1, Athabasca announced it is receiving price quotations from contractors for gravel crushing at its wholly-owned Kearl pit. The Kearl pit is located approximately 60 km east of the Susan Lake gravel pit (which Athabasca manages on behalf of the Alberta government). Athabasca completed construction of an all-weather road linking the aggregate site to a number of major oil sands operations surrounding the project area. Kearl pit is available for year-round aggregate extraction and sales. Stripping activity within the Kearl pit was performed during the second quarter. Subcontracted services were utilized for gravel crushing within the Kearl pit during the third quarter of this fiscal year.

Management anticipates the availability of processed and stockpiled aggregates at this strategic location will result in aggregates sales from the Kearl pit. The rationale supporting this expectation is the pit's close proximity to local potential customers who are currently sourcing aggregate from more remote locations. Since hauling costs can be a significant portion of the total landed cost of obtaining aggregate supply, customers may potentially be able to source aggregate from the Kearl pit at more favourable prices due to reduced hauling expense. Athabasca is currently engaged in marketing discussions with prospective customers.

Sales of aggregates produced at the Kearl pit are anticipated to commence during the fourth quarter of this year. We remind investors that until contracts are signed and in hand, these potential deals remain just that - "potential" deals. The company has seen indications of interest in the past only to have projects pulled back and delayed (2008-2009 for example). Having said this, the environment is more stable and advanced today and with additional projects having been given the green light, the potential for significant contracts has increased.

In what is a seasonally slow period for Athabasca, once again the company's second-quarter financial results handsomely exceeded expectations. Despite the fact that the stock is up in the range of 190% since our original IWB recommendation, it continues to appear relatively cheap on a long-term basis. On a trailing basis (over the past 12 months), the company has now posted earnings-per-share of $0.143 giving it a p/e ratio of around 9.9.

We conservatively expect the company to earn $0.16 per share in 2012 with upside from here depending on the signing of private pit sales. Based on this, the stock is trading at 8.8 times current year earnings. With an improving balance sheet, better liquidity, strong cash flow, the potential for further wholly-owned pit sales in the fourth quarter, and strong near- to long-term demand forecasted for its managed operations, the stock remains attractive.

Action now: We maintain our Buy rating on the stock in both the near and long term. Due to liquidity, use limit orders and be patient - expect volatility. The shares closed on Friday at $1.41.

Boyd Group Income Fund (TSX: BYD.UN, OTC: BFGIF)

Our second update is in reference to long-time favourite Boyd Group Income Fund which we highlighted as a Buy in late August 2010 in the IWB at C$5.50, US$5.20. The stock was updated in April of this year and with it trading at C$9.20 we shifted our near-term rating to Hold (six months or less). At the time, we stressed that our long-term rating (one year or more) remained at a Buy and was decidedly positive given the strong execution of the company's strategy. We viewed near-term weakness, if any, as a potential entry point for those who had not yet taken a long-term position in Boyd.

That near-term weakness did not occur. In fact, Boyd has powered to all-time highs since that time, closing this week at C$15.75, US$15.83.

Boyd, through its operating company The Boyd Group Inc. and its subsidiaries, is the largest multi-site operator of automotive collision repair service centres in North America. It currently has 181 locations in the four Western Canadian provinces and thirteen U.S. states. Boyd carries on business in Canada under the trade name "Boyd Autobody & Glass" (39 centres). In the U.S., Boyd operates under the names "Gerber Collision & Glass" (96 centres), "True2Form" (38 centres), and "Master Collision Repair" (eight centres).

Recently, the company reported that fiscal 2012 third-quarter revenues increased 32.7% to $102.9 million from $77.6 million in the same period last year. The $25.4 million increase was driven largely by U.S. sales from Cars Collision, Master Collision, and 14 other new collision repair locations opened since April 1, 2011. Sales in Canada decreased 7.9% to $17.2 million from $18.7 million in the same period in 2011. The decline was primarily due to a same-store decrease of 10.9% due to mild winter weather conditions that reduced work-in-process and pent-up market demand coming into the quarter. That was followed by a dry spring, further reducing claims from normal levels.

Second-quarter adjusted earnings before interest, income taxes, depreciation, and amortization (adjusted EBITDA) rose 39.4% to $6.8 million, or 6.6% of sales. That compared with adjusted EBITDA of $4.9 million, or 6.3% of sales, for the same period a year ago. The increase was the result of EBITDA contribution from Cars Collision, Master, and from other new locations, as well as improved gross margin and favourable currency translation of same-store sales.

The fund recorded income tax expense in the amount of $0.4 million compared with $0.2 million for the same period in 2011. Net earnings were $1.1 million, or 1.1% of sales, compared with a loss of $2.4 million, or 3.1% of sales, last year. Adjusted net earnings increased to $3.2 million ($0.26 per share), or 3.1% of sales. That compared with adjusted earnings of $2.7 million ($0.22 per share), or 3.4% of sales, for the same period in 2011.

During the quarter, the fund generated adjusted distributable cash of $3.2 million and declared distributions and dividends of $1.5 million, resulting in a payout ratio based on adjusted distributable cash of 46.1%. This compares with adjusted distributable cash of $2.9 million and a payout ratio of 42.5% a year ago. The increase in adjusted distributable cash was largely due to higher cash flows from operations. However, the payout ratio also increased as a result of higher distributions versus the same period last year. The payout ratio remains relatively conservative.

As expected, Boyd's second-quarter numbers were not without challenges, particularly in its Canadian operations. Having said this, smart accretive acquisitions in the U.S. produced strong revenue and decent bottom line growth in the end. We were also pleased to see that gross margins increased to $46.4 million, or 45.1% of sales, for the second quarter from $34.7 million, or 44.7% of sales, for the same period in 2011. Gross margin percentage increased due to improved paint and material margins as well as a more favourable mix of higher margin labour sales versus parts sales.

Finally, we were pleased that cash flow generated from operations, before considering working capital changes, was $4.6 million for the latest quarter compared to $2.7 million reported last year.

The extremely warm winter weather conditions seen in late 2011 and the beginning of 2012 had some impact on the company's results. Notwithstanding these conditions, the strength in Boyd's business model and its core operations was encouraging. Boyd continues to increase market share and expand throughout the U.S. with key strategic acquisitions and unit growth. The focus for the balance of 2012 is to continue to grow revenues, both organically and through new locations and acquisitions, while working to enhance margins by increasing efficiency throughout the operations.

Despite its meteoric rise, Boyd continues to have relatively attractive valuation metrics which include a trailing price to adjusted earnings multiple of around 12.52 and price-to-sales of 0.46. The company continues to have a relatively decent balance sheet and while we would like to see it pay down some debt, cash flow services it well and the company's pay-out ratio remains conservative and has still allowed for growth.

The company's units have performed tremendously well since our original recommendation. To be frank, returns will not come close to this over the coming 12 months, but the company's strategic growth-by-acquisition and market share strategy is a model that has the potential to outperform long term in a low to zero growth environment (which we expect for the broader economy),.

Challenges in the broader economic environment persist, however. Affected by consistently high unemployment rates and high gas prices, the number of miles driven continues to trend down.

The units pay monthly distributions of $0.0375 each ($0.45 per year) to yield 2.9% at the current price.

Action now: We see Boyd as fairly valued in the near term in its current range and we expect its performance over the next 6-12 months to mirror the market average return. In the long term (one year or above), due to its above-average growth rate, we expect it to outperform the market. So we would Buy if your outlook is beyond a year. Hold if you already have a position and your investment horizon is short-term.

- end Ryan Irvine

About the author:

Gordon Pape
Gordon Pape is the best-selling author/co-author of many acclaimed investment books, including the recently-published Sleep-Easy Investing (Viking Canada ). He is also publisher and editor of five investment newsletters, including the Internet Wealth Builder, Mutual Funds Update, The Income Investor, and The Canada Report, which was created specifically for U.S. residents interested in investing in Canada . He is a columnist for several magazines and websites and a frequently quoted media source. He has been a featured speaker at numerous events including the World Money Show in Orlando . His websites can be found at www.BuildingWealth.ca and www.TheCanadaReport.com.

Rating: 4.0/5 (5 votes)


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