Understanding Brookfield's Malaise
by: David Daly posted on: August 18, 2008
Brookfield Asset management (BAM) is a very fine firm. I hold it as one of the main positions in my UpDown account and in my real accounts. I believe that the market is currently holding down BAM's share price for several reasons. The firm faces formidable competition in the execution of its asset management strategy but, on balance, I'm optimistic that they will emerge as a leader in the field.
The stock is probably worth about U.S. $35 today (about five dollars more than its current price), and should trade significantly higher in the 2009-10 time frame as the housing inventory overhang clears, commercial real estate finds its legs, and as the market wakes up to the many other positive attributes of Brookfield. Details follow.
First, through Brookfield Properties (BPO), BAM is a major owner of commercial real estate in North America, the UK and Australia. The market believes that commercial real estate will follow residential real estate down. That may indeed be the case and BPO does has some new construction in my neck of the woods (Washington, DC) which is sitting vacant.
An important point here, however, is that that BPO's, and by extension BAM's, real estate holdings are exclusively in high-grade, major urban centers. Indeed one might say that their exposure to Canary Wharf in London is about as far afield as their property portfolio gets relative to the various central business districts of the world (and, with Docklands Light Rail, even Canary Wharf isn't so far afield now-a-days). My experience is that buildings of this kind, while expensive and usually offering modest initial cap rates, are the last to fall when prices soften and the first to recover when the market firms. We all intuitively know this to be the case in the residential market, and it's the same really in the commercial property market.
For an example of what a company looks like when they hold a real estate portfolio which is not concentrated in high quality, central business districts, as is the case with BPO's portfolio, take a look at First Potomac Realty (FPO). The father and son team there bought a bunch of low grade properties in middling markets around Washington, DC and now they can barely make their REIT dividend. I think they have now stabilized their financial situation with some property sales, but my point is not to criticize FPO, which is mostly a decent operator, but, rather to illustrate the contrast with an operator like Brookfield Properties. The name of the game is buying quality at a fair price, not building an "empire" of mediocre properties. Brookfield has spent years acquiring good quality at reasonable (not cheap) prices and with conservative financing arrangements. They will eventually fill their vacancies and they will certainly survive --which is not something one can say about all commercial real estate players.
Second, turning away from commercial real estate, Brookfield Asset Management (BAM) also has exposure to the residential market both through BPO's residential operations in the U.S. and Canada and through separately traded Brookfield Homes (BHS), the latter of which has now begun to actually lose money. Morningstar and Barron's, citing various publicly available data sets and a bit of market rumor, have recently talked about the possibility that a housing bottom may be near, or, at least, the free fall is slowing.
By contrast, BHS management says we will not bottom until 2009. Whatever the case, and bearing in mind that they may all be right, housing stocks are again putting in a bottom, and a strong upward movement in BHS's share price could be one possible impetus for a movement in BAM's price.
Third, and related to point number two above, BAM's timber operations, most of which are based on the former Longview Fibre, and some of which are held via Brookfield Infrastructure Partners (BIP), are also being weighed down by the weak housing market. Timber prices react to many factors but U.S. housing starts data are a key variable. Even if the inventories of homes for sale begin to go down, it will be a while before we get enough new housing starts to lift timber prices.
Still, in the very long term, timber has attractive qualities because of climate change, overall population growth, and the fact that timber is a rare example of an item of inventory which quite literally grows in value irrespective of trading conditions. (Even the oil majors cannot say that about their crude oil reserves, which might go up in value because of price rises or new, adjacent discoveries but does not actually reproduce/grow on its own. Timber is unique in some ways for that reason. Although wine makers or scotch makers --like Diageo with their Johnnie Walker brand-- experience a similar phenomena in that their inventory usual goes up in value as it ages.) Thus, timber is a good buiness, but it's a tough time in the market.
Fourth, BAM's partly owned Crystal River Capital (NYSE: CRZ) has also had a tough time of late. That's a tiny part of their business, but it's indicative of the overall level of anxiety in the capital markets, especially in regards to real estate.
I believe these foregoing factors are on the market's mind and masking a number of very promising recent developments at BAM. These include the continued growth of the great hydropower portfolio, a generally good track record at Hyperion Brookfield in the midst of the current mortgage market mess (they won the mandate to take over management of the Regions Bank Morgan Keegan mortgage security funds), the K.G. Redding bolt-on acquisition, and the very sensible Multiplex acquisition. The latter was almost transformational in size and scope and I generally hate it when my companies make big acquisitions but when reflected on 10 years hence, Multiplex will probably be viewed in a positive light.
Lastly, in terms of recent developments, they have continued to build-up a truly unique set of assets in Brazil. As the saying goes, Brookfield was in Brazil (well) before Brazil became fashionable (BAM was previously called Brascan). These assets include hydro-power, retail real estate, and residential real estate through separately traded Brascan Residential. The latter has not done so well post-IPO, but it will likely do well over time as the Brazilian retail mortgage market develops.
Furthermore, at both the corporate level and the operational level, BAM has a number of attributes and promising initiatives in place.
At the corporate level, these include a good dividend history (with the recent spin off of Brookfield Infrastructure Partners being an integral part of this record), and good corporate governance, to include a solid slug of insider ownership.
At the operational level, and looking beyond the aforementioned recent developments, the Brookfield "story", so to speak, is two-fold.
First, many of their assets, including much of their real estate is either under valued on their books or it does not generate cash flow that is readily apparent on the income statement. Thus, I've always thought of BAM as one of those firms/stocks whose accounting makes a mockery of investors who use exclusively quantitative screening tools.
In any event, the second key element to the overall Brookfield story is their effort to use their rich portfolio of assets, be it real estate or hydro power or equity in a restructuring deal, and whether it be in Canada or Chile or where have you, to seed investment funds for institutional investors. Many institutional investors, especially pension funds with long-lived liabilities, would like to have stakes in these kinds of largely illiquid assets, usually classified under the rubric of infrastructure investment.
In as much as infrastructure is increasingly being viewed as an attractive asset class with "steady as she goes" bond-like returns that have inflation adjustment features, this is a good strategy. There is demand for this kind of product in large part because the worldwide market for inflation adjusted bonds is not big enough to fund all of the pension assets out there which need to be invested safely while staying ahead of inflation. It's tough to stay ahead of inflation without investing in stocks but infrastructure, whether it be electricity transmission lines, hydro-power, or commercial property, offers a reasonable alternative to stocks with more consistency in the cash flows.
With respect to this initiative to transform itself from being an operator of assets into an asset manager of infrastructure-focused investment funds, BAM faces tough competition from Babcock & Brown, Goldman Sachs (GS), Merrill Lynch (MER), and Macquarie (MIC) among others. Plus, many pension funds are big enough that they have the scale to directly invest in real estate or timber, etc.
All the same, I think BAM will be able to continue to grow its assets under management [AUM] because the demand for these types of investable assets is growing fast and BAM brings a lot to the table in terms of it's long history of successful on-the-ground operations of things like hydo power and electric transmission lines. Even if she or he were a Wharton graduate, I would not want the average Goldman Sachs employee to be doing maintenance on any hydro-power plants on which I rely for electricity. Brookfield, by contrast, actually has employees on staff who get greasy. Thus, in a sense, they have "street credibility" as an owner/operator of the assets they are seeding into their funds.
I would also venture to say that the recent problems faced by Merrill and Babcock & Brown as well as the overall tightness in the credit markets may lessen the degree of competition faced by BAM in bidding on new assets.
In sum, BAM is being weighed down by the market, and not unreasonably so, but the drum beat of the underlying positive story will grow louder as the U.S. residential and commercial real estate markets stabilize.
At the present time, I would guess that BAM is undervalued by the market by about U.S. $5. Over the longer term, it should do very well so the current price may present an attractive entry point.
One option for the faint-hearted is to split your capital 50-50 between shares of BAM itself and shares of the sister company, Brookfield Infrastructure Partners (BIP). The latter has less long-term upside potential but it currently trades with a very nice yield near 6% as of this writing. By my calculation BIP is also currently trading at less than 80% of its $22.60 book value per share. The price it probably depressed because of BIP's exposure to the soft timber market; the fact that it was only recently spun-off from BAM and so many holders are deeming it a non-core holding and purging it from their portfolios; and because Morgan Stanley seems to have recently accidentally bought too big of a stake so they are now having to quickly liquidate some of their position (there was an SEC filing on this).
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