Interview with Mr. Prakash Hariharan, Portfolio Manager, Front Street Capital
Management
Q: Could you please tell us a little bit about Front Street Capital - the firm and the funds you manage in particular?
A: Front Street Capital is an investment firm that formed when Frank Mersch and Norm Lamarche, from Altamira, brought the investment expertise together. It’s almost 10 years now. We manage about 2.4 billion in assets and most of them are hedge funds and mutual funds. Myself in particular, I’m the co-manager in the Diversified Income Fund and I also am on the investment committee for Ceres Global Ag Corp. We floated that company about three years back, raised about 150 million in IPO and that does a lot of mandates on the agricultural side on a global basis. So that’s my profile. I’m also running some resource funds for offshore money, so that’s what I do.
Q: What is your investment philosophy and how would you describe your investment methodology for selecting potential investment picks?
A: That’s a bit difficult to answer because I think at the end of the day you are looking at the global macroeconomic picture to figure out what part of the credit cycle you are in. My background has always been in credit so I look at credit cycles a little bit more closely. So for me the question is, you know, what level you get into companies when you are in the middle of a credit cycle and when do you exit, when you feel that you are at the top of the credit cycle. So that’s the first thing I look at. And then intrinsically you look for value within companies, whether it has a strong balance sheet, whether the company has the management team that can grow its enterprise value, whether the company has unique competitive advantage in its business. And, you know, how do the metrics line up in terms of valuation through a free cash flow or from an earnings perspective. And also return on equity. For every dollar that you spend on the company, whether the free cash flow the company generates is commensurate to the risk the company has. These are common things I look for.
Q: Do you restrict your investment to only Canadian companies or do you look at opportunities in other markets as well?
A: Predominantly Canadian. I look at North American companies. I look also at emerging markets. But even if you look at Canadian investments they are pretty much global because most of the companies have assets globally. We’ve very few Canadian companies with assets in Canada, so inevitably you are looking at global markets.
Q: What are your views on the global economy for the rest of ‘10 and ‘11? Are there any major risks or areas of concern you are watching for in the global macro environment?
A: I think you are having a mishmash of events in the global economy vis-à-vis the slowdown in the U.S. economy which has a ripple effect across, from a currency perspective and from a commodities perspective. Every time the U.S. dollar weakens then commodities become more interesting to invest in. So that cycle plays out time and time again. But eventually you’ll see an unlocking of that. I’m a firm believer that even in a slower economy you find good companies, so that doesn’t change my perspective. Well, if you look at purely from a numbers or statistics point of view you could see a period of slow growth. But that’s not going to deter good companies to make money and good enterprise value. People talk about things in Japan and, you know, during a period when the Japanese markets dropped for 10 years. Names like Toyota, Mitsubishi, Casio, and Sony grew its enterprise value five-fold during the same period. So these were Japanese companies with a big export market. So eventually you are going to see some economies do well, some economies slow down. But companies will do well that have the ability to withstand these things.
Q: We had a good run in the markets towards the end of summer despite the real economy, particularly that U.S. employment and housing is still bleak. Will this continue, do you think?
A: Yes, I think you are going to see that because a lot of the equities in the S&P 500 are not related to the U.S. economy. A lot of the equities have exposure to economies outside the U.S. A lot of them in the emerging nations like China, India, and Brazil. I’m also including countries like Australia and Germany as an emerging economy because Germany has got a 9 percent growth rate. So obviously, you know, if you look at the S&P 500 I think 40 or 50 percent of the companies on the S&P 500 are leveraged to global economies, not just the U.S. economy. So even if the U.S. economy is slowing down or weakening, maybe a section of the index like the retailers or the food service companies might underperform. But on the other hand, names that have exposure outside the U.S., who grow their earnings outside the U.S., have earnings leveraged to economies that are growing at a faster clip than the U.S., will do well. So if you are looking at corporate earnings the real average earnings of the S&P 500 were something like $90 or $95. So you apply whatever multiple you want to get a mark-up on the S&P 500. What happened in ‘08 was the S&P 500 was discounting at deflation. Like, the high-yield market was discounting at default rate of about 12 or 14 percent and that’s not been the case. Even if you look at the stress test of the banks, it indicated default rates on credit cards to be 11 or 12 percent. And J.P. Morgan just reported a normalized number of 4 percent yesterday. So there’s been some big change in what the expectation was set going into this year and what’s been the reality.
Q: The U.S. Federal Reserve right now is indicating the launch of QE 2.0 and Bank of Canada is pausing its interest rate hikes. Do you foresee a double dip in U.S. and would it impact Canada? And what do you see it doing to markets in the U.S. and Canada? Is that something which you are concerned about?
A: The double-dip recession is something which is very hard to define. Maybe low growth rate is a statistical definition of a double dip recession. Like, when you talk about the QE 2.0, you know, the fed’s coming out with the helicopter theory; they are basically trying to do what the Japanese did not do after they showed a slight recovery after the dip in the early ‘90s. So they failed to stimulate the economy just to keep it and sustain it from a macroeconomic standpoint. So I think what Ben Bernanke’s doing with this theory is that he wants to stimulate it as much as he can just to make sure that even if he does stimulate it to, like, a notional amount of 3 or 4 percent of the GDP in total, you are not going to get into the territory of slower or flat GDP growth for a long period of time. So I think that’s the motivation beyond which you can’t see anything else. Implication for the markets- these are always trading implications. I mean, the first signs of, you know, a QE perspective, potentially QE took copper up to, like, 390. So obviously all, you know, zinc is up and silver’s up and all the commodities have been up. But sustainability of that is going to come in only in terms of a demand pull that will manifest itself. So maybe if you look at commodities, if you are not going to see a supplied response which is very quick, the demand pull can just take it up further. On the other hand commodities which are a stronger supply response may not see that demand pull. So it’s a mishmash of everything. But I don’t believe that you are in a double-dip recession. You could see a soft recovery process but just given the strength of the stimulation that the U.S. fed has been imposing on the economy doesn’t really imply that you are going to see a double-dip recession.
Q: Anything about the Canadian economy in that context because U.S. is the biggest trading partner?
A: I’m more worried about the Canadian economy. I think the Canadian economy is predicated on a housing market that is always very strong. And I feel that the housing market has been extremely strong on account of, you know, low, negligible, short-term interest rates. In fact, if you look at the short-term interest rates globally, it has a negative basis attached to it. So you are creating a little bit of an asset bubble there. So an economy like Canada which is smaller than the U.S., obviously is susceptible more to swings on the other side. So I’m a little bit more worried about,what could be, an impact and slowdown on housing to the Canadian economy. If you look at the implied cap rates of some of the rates, they are trading at about all-time historic highs. So it’s very hard to see a cap rate compression of a significant order from these levels. So I’m more worried about these things rather than the potential double dip in the U.S. economy, because just on account of the leverage to the housing market that the Canadian economy has in general.
Q: In this kind of a market environment what is your opinion on small caps and the prospect of small-cap investing in the next 12 months?
A: Small caps are always a great space to be in. If you are able to identify the right company that can grow its enterprise value, that has access to funding, and that has a unique competitive advantage and a strong business plan, the companies end up doing really well. And time and time again, we’ve seen that in Canada. We’ve seen that globally. So I always have time -- I think it’s a great market for small caps to access the capital markets because you are going to see smart money get into this space. Back to my Japanese example, the small-cap universe in Japan, if you look at the charts, I had a chart that I used to look at time and time again. As the broader, large cap Japanese Nikkei Index has dropped, the small-cap universe has gone up in the same period. So the companies that were leveraged to the export-- on account of a weaker yen- did really well. And you are going to see that, especially on the technology or renewables and clean tech which has got so much government stimulus money behind it. If any of these companies, you know, execute on their business plan, some of them look really good.
Q: We understand that you have a strong focus on the agri business sector which you mentioned initially. Could we get your views on this sector, its growth prospects? And since this is a big vertical, are there any sub sectors you like within the agri sector?
A: I think the agricultural-- what we looked at two years back were the pinch points on a macroeconomic level. What we saw was, you know, people in the emerging nations changing their dietary preferences. There was a big demand pull into areas, you know, hitherto unheard of. I’ve been covering fertilizer companies for many years. I used to work in one before I became a money manager. I was a chemical engineer at BASF in the agrochemicals plant, which is the agrochemicals division of BASF. And I noticed -- I used to notice that year after year the plant would run at full capacity- gets sold out within the first three months. So then I always used to wonder where this demand is coming from. And a lot of it was all local demand. That was in India at that time. And I kept following the story; I kept following the fertilizer companies on a global basis. And I noticed that they were always sold out on capacity within six months. And it wasn’t unsurprising to see the nutrient prices climb up steadily to the point where in 2007, spot prices of potash touched $1,000. So maybe you may not see that, but what I’m seeing now is more a macro -- a big demand pull coming in corn which is so much in use because of it being a feedstock for animal feed. Plus, you know, it’s a demand pull coming from ethanol producers. So if you see the carry-out ratios at the end of the year drop to 6 or 7 percent, the demand pull from corn itself will take anything associated with agriculture to another level. We’ve seen the first leg of the increase in the evaluations of these companies but you could just see the second leg coming in as the demand pulls tightens on, specifically on the grain side. So you are not just looking at fertilizer companies. You are looking at equipment makers. You are also looking at accessory guys around the equipment makers. You are looking at seed companies. You are also looking at food processing companies that use these as a feedstock. And then the retailers who basically retail these products out. So it’s a full chain comprising of imports, processing guys and the retail guys.
Q: Beyond agri sector, I want to know that-- are there any small-cap names in tech and clean tech you like which are in the public markets, small cap? And what do you like about them?
A: Actually, on the clean tech space I do like a few names. A company that I’ve always been involved in is Electrovaya. I was in them very early, but I feel that company has a potential to grow. But, again, it’s a concept name without any revenue. They have a pact with Chrysler for supplying the combine batteries and they have a technology that is non--NPV solvent, which is non-toxic in nature. And obviously it has the kind of plug-and-play chemistry attached to it which can be used in a myriad of applications like energy storage, data storage, so on and so forth. But, again, it’s a concept name. It doesn’t have any revenues so it can swing any way. So a lot depends on the management team to deliver and execute. But it’s a name that stands out on the clean-tech side in Canada. Alternrg Corp (TSX: NRG) is another name that I like. It’s about a $2 or sub-$2 stock.
Q: What’s the symbol of that?
A: NRG listed in TSX
Q: NRG.
A: It’s an engineering consulting firm that has a patented plasma gasifier-- gasification process. So their revenue stream base is based on a licensing revenue stream. So across Canada, for instance, if you are seeing a step change in the renewable side in biodiesel, you know, and biofuel side, to use plasma gasifier to burn woodchips -- this is a company that would benefit. And, of course, there are these geothermal guys who were being beaten down so much. Names like U.S. Geothermal (TSX: GTH) (AMEX: HTM), Magma (TSX VENTURE: MXY), you know, a name like Ram Power (TSX: RPG), those are also interesting names to look at. I’m not sure if you would know a name like Neo Materials Technology Inc. (TSX: NEM), it was a small-cap company at one time, but it’s grown. There are also these neo materials plays which also fall in line with the clean-tech -- just on account of the demand pull coming from wind turbines and as base feed stock for some of these issues like magnets in appliances that are energy efficient and so on and so forth.
Disclosure: Funds managed by Front Street Capital Management has positions in all
companies mentioned in this interview