• Market Guy Mailbag
  • Riocan revisited
  • Legacy Hotels
  • Canadian Hotel Income Properties
• Trading Note: Pengrowth Energy Trust
• A Market Tease

Market Guy Mailbag
Mike from Ottawa-Centre writes:

Thanks for “Market Guy”. I am really enjoying it. I was very interested in learning more about Riocan as two of their properties are close to my heart: Westgate Shopping Centre and Lincoln Fields Shopping Centre (in Ottawa). I lived three blocks from Westgate during my formative years and opened my first bank account there at the age of eight. Lincoln Fields was where I began my illustrious retail career at the late, lamented Woolco, selling polyester ties.

You sold polyester ties at Woolco? Well, I wore leather ties at Zellers. I had a blue one, a pink one, and a black one. Put on a pair of mesh shoes and I was ready to head out on the streets of Miami with my sidekick, Rico Tubbs. I really like how Mike reminds us that many stocks are more than just charts, income statements and balance sheets. Rather, we’re talking about businesses that are woven into the fabric of our daily life. They become part of our routine and our running history. From the opposite direction, many of the businesses in our lives are represented by charts, income statements and balance sheets. And therein lies opportunity.

This reminds me of a story involving the famous money manager, Peter Lynch. His wife came back from grocery shopping after purchasing several containers of a new product, L’eggs pantyhose. Lynch was intrigued. He figured that since she liked the product so much, he’d probably have to buy more. Someone was making money here. So he decided to research the manufacturer, Hanes. The next day he assumed a substantial position in the company and his investment increased by 10-fold in just a few years. This illustrates that investing opportunities are all around us. Think about who is making money off the products you buy, the services you use, etc. Where is all that capital going?

Here’s my example. A couple of years ago, I needed to start going for twice-a-month blood tests. I picked up the yellow pages and located a testing lab that was only 5 minutes from the house. I go down there and notice it’s a busy place. Someone is making money here. That afternoon I started my research and eventually purchased shares in Canadian Medical Laboratories (now called CML Healthcare; CLC on the TSX) at $18.50. Late last year, I sold one-third of the position at $29.75, and the remaining in March at $32. I really enjoyed my discussions with the blood technician. On several occasions she complained about the owners of the place making too much money. Little did she know that I was one of them.

I’m not suggesting that people should run out and buy stock in the companies whose products they use everyday. Rather, looking to your environment is a great starting point for research. And you have to start somewhere.

Let’s head a few miles to the west. That’s where another Mike, this one in Kanata, wrote:

I have been following a couple of REITs especially since you’ve been talking them up so much over the past couple of years. Since I was with hotels I keep an eye on Legacy Hotels (LGY.UN-T) - definitely not a good catch - unless there is some bargain hunting possibilities. They have, as you believe to be unwise, cut their distributions completely because of the flailing airline industry, weak US economy, BSE and SARS. Pretty ugly time to be in Toronto hotels (20% of their fund is in downtown Toronto). I may watch to see if the price dips much more to buy low because it’s not like the bricks and mortar are going to disappear. Toronto WILL be a tourist destination once again.

To borrow from Mr. Burns (of The Simpsons), “I like the cut of your jib!” Investing in the hospitality industry has some intuitive appeal, doesn’t it? People check-in, send up room service, order a movie, and enjoy a $32 bottle of water from the mini-bar. A license to print money, right? As someone formerly in the biz, you know it’s not that simple.

Let’s have a look at Legacy Hotels (LGY.UN on the TSX). This real estate investment trust owns 22 luxury hotels in Canada and one in the US. Think of Château Frontenac, the Royal York, and the Château Laurier. Speaking of the Château Laurier, the Market Gal and I had the opportunity to stay there last year. For most of our vacations, the hotel is largely an afterthought. As long as it’s clean, close to stuff, and has a pool, we’re happy. But when you stay at a high-end joint, the hotel becomes one of the highlights. You just don’t get the same feeling checking into the Best Western. Comments heard during our Château Laurier visit included:

• Wow
• I don’t want to go home.
• Please send up some fresh fruit with the champagne.
• Put the do not disturb sign on the door.

Comments heard during our visit to a Best Western in Virginia included:

• Can damp be a smell?
• You look pale.
• Do you think the car is safe?
• I’ll leave the baseball bat behind the door.

Despite having a superior brand, Legacy Hotels just announced the suspension of their second quarter distribution, and the stock immediately declined by over 10%. Although a reduction in the distribution was widely-anticipated, few expected the outright cancellation. I can’t help but wonder if the company could have done a better job of managing investor expectations. In any event, I think management deserves considerable slack on this one. The problems facing the hotel industry have been well-documented, and it’s hard to imagine how the corporate brass could have positioned the company any differently. On the plus side, event-driven problems sometimes create opportunities. I agree that Toronto will become a tourist destination once again. And the Legacy brand is tops. Like you, I’m concerned about the Canadian tourism sector in general. Add the strong C$ to the list of problems and it could take a while to navigate through this storm. On July 22nd, the company will release second quarter results and update their outlook for the rest of the year. We have to wait until September to find out if there will be a third quarter payout. In the meantime, I like your strategy of hoping for additional weakness in the stock price. This would make Legacy an even more interesting speculative play.

Just a side note: It’s not that I believe distribution cuts are unwise. In fact, a cut is advisable if business conditions are seriously limiting the cash available for distribution. I’d rather have a cut than have the distribution funded from debt or equity. The former strategies would compromise the integrity of the balance sheet, and that’s not positive. Rather, I believe a company that pays a significant distribution will behave differently than those that don’t. Distributions leave management more accountable to shareholders and less likely to initiate risky strategies. And if management is expected to announce a payout, there is less cash on the table to fiddle with. But despite this, I prefer a conservative payout policy (% of available cash distributed to unitholders). I want the company to have enough cash to fund operations, pay down debt, make accretive acquisitions, and the like. If a lower payout stabilizes distributions over time and cushions the company (and me) from a nasty surprise, then I’m all for it. The point is that I prefer owning companies that place some cash in my hands (say it with me: give me the cash…ohm). And if they have to pay me, it means they have less money to buy those magic beans on the side of the road. Of course, this is all in theory. But as we’ve seen with Legacy, sometimes their just isn’t enough cash to go around.

The only hotel name I’ve ever owned was Canadian Hotel Income Properties (a.k.a. CHIP; ticker: HOT.UN on the TSX). This real estate investment trust owns or manages 36 properties, with over 8000 rooms across 10 provinces. The portfolio consists mainly of mid-market and full-service hotels such as the Delta Edmonton South and the Crowne Plaza Ottawa. Fortuitously, only one of the properties is in the Toronto area (Mississauga). The annual payout settled at $0.90 after a post-September 11th cut. A respected, internalized management team (meaning there is no costly external management contract) has maintained a strong balance sheet. Through the first quarter of this year, they seemed to be sidestepping any serious hits to their occupancy rates and revenue per available room (RevPAR). No doubt this owes much to geographical diversification. However, the problems facing the Canadian hotel industry spread beyond Toronto. For example, CBC News recently interviewed a representative from the Calgary Stampede. Apparently the advertising campaign to attract US tourists has been suspended. They don’t believe many Americans will be coming this year. Of note, 10 of CHIP’s hotels are in Alberta. What’s the punchline? Should I reinitiate a position? Well, I like the trust, but I’ll stay on the sidelines for now.

This concludes the second edition of the Market Guy Mailbag.

Trading Note: Pengrowth Energy Trust
Earlier this month, the position in Pengrowth Energy Trust (PGF.UN on the TSX) was eliminated at $17.09. This is one of the largest energy trusts in the business, with a market cap over $1.8 billion. Pengrowth is one of the higher cost producers, does not use an aggressive hedging strategy, and has a very high payout ratio. All of this renders the trust (and the distributions) extremely sensitive to commodity price swings. This is great when prices are increasing. But energy prices are at historically high levels and I think a correction is inevitable. The last straw for me was favourable mention of Pengrowth by a US money manager in Barron’s magazine. Well, the Americans swept in and the unit price shot up immediately. Nobody buys stocks like the Americans. Unfortunately, nobody sells stock like Americans and I’d rather sell when they’re buying. I’ll revisit the units when the energy price correction is well underway.

The only remaining energy name in the portfolio is similarly-sized, ARC Energy Trust (AET.UN on the TSX). I like the holding because ARC, a) is a relatively low-cost producer; b) has been actively hedging production at these high prices; c) has a more conservative payout ratio; d) has a strong balance sheet. Current distributions are $0.15 a month (est. 35% tax-deferred). Distributions should decline along with oil and gas prices, but the more conservative approach to running the business should make the ride less bumpy than with Pengrowth. The production profile is 55% gas and 45% oil. I’m holding.

A Market Tease
Now I’d like to prime you for some upcoming columns. I plan to write about my worst investment experience ever (yup, the Market Guy got his money ass handed to him on a platter…I have no idea what that means), my first experience with an IPO, strategies I’m using to play the low interest rate picture, what behavioural finance has to say about our sell decisions, and maybe, just maybe, how quotes from the 80s television show Miami Viceand the movie Highlander can be used to help us understand the markets.

The Market Guy is an Instructor with the Department of Psychology at Carleton University. He’s not a professional advisor. He’s just a guy who loves investing and talking about the markets. This past weekend he finally took his mitre saw out of the box and installed baseboards in the kitchen. Many cuts at a 45 degree angle. If you have an angle, cut over tomail@marketguy.ca