Contrarians face two major dilemmas. One, there could be a lack of opportunity for a very long period of time. Second, the investment may take a long time to realise gains. The Canadian investment firm Brookfield Asset Management, known for its unique contrarian philosophy, seems to have perfected the art.
In India, it simply waited for almost a decade to find meaningful deals. It has only very recently become active with deals such as Reliance Pipeline, Hotel Leela, Embassy Office REIT, Essar Group’s real estate and IL&FS road projects.
What is common among these assets is most of them have been stressed assets. For instance, Hotel Leela, currently trading at Rs 11.15 a share, has eroded almost 90 percent of investors’ wealth as a result of excessive debt. The company has been struggling to attract investors. For Brookfield, which recently entered into an agreement to purchase four of its hotel properties for a consideration of Rs 3,950 crore, this is an ideal situation to hunt for bargains.
Here are some of the strategies that Brookfield uses:
Betting against the crowd
Brookfield’s investment philosophy has a value investing angle similar to what Benjamin Graham taught and Warren Buffett follows even today. It always tries to walk away from the crowd.
Bruce Flatt, CEO of Brookfield says, “One should always look for opportunity away from the crowd. And do not go with the crowd. Superior returns often require contrarian thinking.”
Around 2016, the world’s largest graphite company, GrafTech, was struggling for survival, hit by the downcycle in the steel industry. No one was interested in buying steel or companies operating in that value chain. They were called boring businesses. Brookfield bought GrafTech at $1.3 billion and later in 2018 got it listed at a valuation of about $4.5 billion. That was a great money-spinner for Brookfield in a very short span of time.
Since it consciously stays away from the herd, the firm doesn’t participate in many ‘hot’ sectors or assets.
Waiting for the opportunity
Brookfield would simply wait on the sidelines for buying a great asset which has a great business and cash flows but is being ignored by the market as a result of short term issues. The private equity firm, which is ready to own assets for 15-20 years or even forever, is ready to sacrifice short-term profits for long-term gains. It has not only demonstrated immense patience in buying assets but has also shown similar patience while selling.
During a period of stress around 1996, Brookfield bought a multi-storey office building in New York City, paying close to $432 million. It saw many downcycles including the 9/11 terrorist attack as well as the financial crisis of 2008. The firm did not make any money in the first 10 years. But it recently sold the property for $2.2 billion, or five times its original purchase.
When does value emerge?
The greatest mistake is supposed to be the greatest opportunity. Many companies make poor choices on financing their businesses, which are otherwise sound and would have never got into trouble. Most of Brookfield’s investments ideas have come from such stressed assets or companies going under bankruptcy proceedings. In 2017, Brookfield acquired the global solar and wind energy assets, including assets in India, of SunEdison, who filed for bankruptcy as the solar market crashed.
Brookfield is constantly looking for desperate sellers who need money to survive. They also look for periods when capital is scarce in the market, like in the case of India, where sellers are finding it difficult to divest assets.
The firm will field its managers and resources in places where the crowd is not interested, capital is scarce, the asset is illiquid, the size of the asset is huge and often perceived to be risky.
The craft of hunting
The most important thing about Brookfield is that it only acts in areas where they have an edge.
Like the way Warren Buffett operates in his circle of competence, Brookfield has identified areas of competitive edge, which is very important for a contrarian because in the end the acquirer of the asset is betting against the market or betting against the consensus.
One has to be sure of what they are doing and that only comes with core knowledge of the business. Brookfield has developed its know-how around real estate, infrastructure projects, gas pipelines, alternative investing, solar energy and a few other assets classes, primarily hard and tangible assets.
Buying assets below their replacement value
The maximum value emerges during times of crisis. In 2009, immediately after the financial crisis, Brookfield bought a coal handling facility, shipping around 85 million tonne of meteorological coal, based out in Australia. It carved out a great deal at 0.75 times the replacement value of these assets. Two years before it acquired them, these assets were bought by someone at 1.5 times the replacement value.
While price and valuation are a very important part of Brookfield’s acquisition strategy, it has also paid a premium for some of its investments, in case they are really great assets to own.
Generally, it will wait for the perfect storm, which is when even the most promising assets are available below their replacement value. Buying assets below replacement value is one of the biggest sources of its overall gains.
However, it would back assets very carefully looking for some really hard and tangible assets such as real estate, coal handling facilities, solar energy assets, which have produced good cash flows but are going through a difficult period. Sometimes it is not the asset which is under stress, it may be the owners of the assets who are under stress and that could be a good opportunity. Buying assets below their replacement value and selling them later at their earnings-based multiple when the crisis is over leads to multi-fold returns.
Never become too positive or too negative
Last but not least, Bruce Flatt suggests that one should not be too positive and too negative. Often assets are acquired by people when they are too positive and sold when they are too negative. Sometimes, the environment in which investment decisions are made becomes too noisy, led by excessive pessimism or excessive optimism fuelled by news headlines. One needs to distill the news and environment around it to differentiate what is real and what is noise, in order to think ahead of the crowd.
Note: This article was originally published on 5th April 2019 for our premium subscribers. After this, the stock prices have changed and thus the valuation data mentioned in the article are only for the information purpose and needs to be adjusted in the current context