Dialling up the contrarianism: BC Iron in focus

Chief Investment Officer and founder of Aitken Investment Management
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Yesterday a client sent me an interview I did in The Age newspaper back in March 2009. It was the peak of the GFC and the ASX200 was 3600 points. Back then, no private client wanted to buy an Australian bank, let alone Domino’s Pizza Enterprises…

To this day it was the best summary of what I attempt to do here each week with these notes. You can read the full article here.

Today, I’m even more convinced that a few key points I made in this interview are the way to generate capital gains and relative outperformance in domestic equities.

So what sort of investor is Aitken? “I do try to be contrarian. I think the most money you can ever make for readers is in contrarian ideas. But they can be dangerous, too.
“I would say I’m a valuation-based investor. I believe that the biggest mistake you can make is to pencil yourself into any style of investing. I think you have to be open to any concept that can potentially make you money, be it growth-based, value-based, technical analysis or valuation-based analysis, be it price-to-book ratios or whatever. A fruit salad approach.”
I think you’ve got to have conviction. You can’t kiss all the girls, as we say. You don’t need a thousand ideas, you just need a few good ideas and back them with conviction and good argument.”

Contrarian, style impartial, conviction, which leads to concentrated bets. You need the ability to participate in any potential capital gain and you need the ability to move quickly. That is why I always recommend having some cash holding because of the optionality cash gives you in terms of rapid, opportunist, deployment.

Since that interview in 2009, there have been further developments that support a contrarian, high-conviction style. Technological advances in real-time information to all investors, the rapid growth of high frequency trading, the decline of investment bank principal trading and the growth of index funds/ETF’s, all lead to greater opportunities for high-conviction contrarian investors. As I keep writing: there is time arbitrage in equity markets. The present (spot) is highly efficiently priced: the future is highly inefficiently priced.

This is why I am really dialling up the contrarianism and conviction in our Australian equity strategy. I need to try to forecast what the headlines and spot are of 6 to 12 months away, and position our strategy, both long and short, to maximise leverage to those forecasts. In my opinion, there is absolutely no value in analysing the present and why you will see little reference to the current FY14 reporting season in these notes. I am focused on what gets reported in FY15 and beyond, searching for the greatest potential total returns, across all market capitalisations.

Below is a 2-year chart of a small cap iron ore stock, BC Iron (BCI).

BCI shares have dropped from $5.40 to around $3.00 with the fall in the spot iron ore price. Up until Monday, they were starting to recover with the Australian iron ore sector. What happened on Monday is they announced a predominately scrip-based takeover offer for Iron Ore Holdings (IOH), which was near-term EPS and potentially DPS dilutive. That saw the stock smacked back to $3.00 and slightly below on what I would describe as a ‘capitulation event’.

While only a small cap, BCI is now a classic high-conviction contrarian buy. It’s almost textbook.

Think about this scenario. The product they sell has fallen sharply in price. Investors who bought the stock for “yield” have been creamed. There are consensus EPS and DPS downgrades. Most analysts and commentators are sceptical of the IOH move. Yet, the sector is recovering, Chinese GDP growth is reaccelerating, Chinese rebar prices have bottomed and the AUD price for spot iron ore has bottomed as have grade discounts. China Inc. even made a play for AQA.

While BCI’s move on IOH is without doubt EPS and DPS dilutive in the short-term (9-13%), I am of the view the best M&A deals always are. In this case, the short-term EPS and DPS does see negative revision, but because the IOH deal adds dramatically to overall mine life, it is an NPV (Net Present Value) positive deal. To me that is the key: THIS IS AN NPV POSITIVE DEAL.

Let’s look at the strategic rationale.

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Let’s see what the Board’s think…

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And what does the combined entity look like??

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My view is a combined enterprise value of around $500m will very prove cheap for BCI/IOH. It’s also worth noting that if you buy BCI today, you will be entitled to a guided (but not yet Board approved) 15c fully franked final dividend later this month.

That 15c fully franked final dividend alone is attractive, but to me it’s a nice little bonus for new investors who buy BCI today. You’re effectively getting a dividend when you took no capital risk in the year it was generated.

To my way of thinking BCI at $3.00 is a win/win. If the deal goes ahead you will own a bigger, better company. If it doesn’t go ahead you have strong standalone valuation support 7.8x earnings, EV/EBITDA 2.7x, yield 5.8%FF) and it’s most likely the stock price would recover to pre-deal levels of $3.50.

If the deal goes ahead, and I assume it will, then merged register construction is another supportive development. Due to the 52.7% ownership of IOH by Kerry Stokes, and his intention to accept the deal, in the merged entity institutional investors will be left underweight. It’s worth noting Stokes is accepting BCI scrip and becoming the major shareholding in the merged entity.

Source: Company Data, IRRESS and Bell Potter Securities estimates

I believe BCI is an example of where FY15 potential better total returns lie in Australian equities. At $3.00, the stock will yield 10.6% fully franked (15c final FY14 +17c full year 5) for the next 13 months. On top of that we forecast +27% capital growth. To investors who can value franking credits that is a potential total 13 month return of +42% from the $3.00 level. If that proves accurate, that will smash what the broader market returns.

BCI is a high-conviction contrarian buy after underperforming the market by -35% over the last three months

Go Australia.

100% of Charlie Aitken’s fees for writing for the Switzer Super Report are donated to The Sydney Children’s Hospital Foundation.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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