How we apply our “Average” Quality Rating to MDC Partners Inc.

Our investment planning committee regularly examines MDC Partners Inc. (TSX–MDZ.A) (NASDAQ—MDCA). Since we last looked at it at the start of the summer, the shares have risen by 5.1 per cent. This largely reflects the company’s return to profitability. So we’ve raised its quality rating by a notch, to “Average”. We’ve also upgraded the stock to a “hold” from a “sell”. But only for investors who can accept that MDC has negative shareholders’ equity and that it owes a substantial amount of debt.

MDC describes itself as “one of the world’s largest Business Transformation Organizations that utilizes technology, marketing communications, data analytics, insights and strategic consulting solutions to drive meaningful returns on marketing and communication investments for multinational clients in the United States, Canada and worldwide”.

Our rating system

Our investment planning committee has developed a quality rating system. This system uses a two-stage process to assess investment quality and risk—from a long-term viewpoint.

We base our stage one, or initial, quality rating on asset size. After all, a big company can survive a longer, deeper slump than a small one and is more likely to get government help.

Canadian stocks with assets of more than $1.5 billion start out with our highest rating, “Very Conservative”; with assets of $750 million to $1.5 billion, “Conservative”; with assets of $150 million to $750 million, “Average”; with assets of $75 million to $150 million, “Higher Risk”; and with assets of under $75 million, “Speculative”.

For American stocks, our rating system is similar, except that the asset levels are higher by a factor of 10 times. That’s largely because the U.S. markets expose companies to much greater competition.

Rating MDC Partners

On September 30, MDC’s assets totalled about C$1.924 billion. So it qualifies for a stage-one rating of “Very Conservative”. However, we exclude goodwill in calculating a company’s asset level. MDC’s goodwill came to about $1.046 billion. Subtract this, and its adjusted assets fall to about C$878 million. As a result, MDC qualifies for an adjusted stage-one quality rating of “Conservative”.

In the second stage, we analyze a company’s economic sector, capital structure, long-term prospects and so on. We look at its profit history and pay particular attention to how it did in past economic setbacks. In this second stage, we may raise or lower our initial rating by a notch (in rare cases, two or even more). When a company loses money for two years in a row, we take an especially close look and consider a deeper cut in the rating—all the way down to “Speculative”, if that seems justified.

We often stick with our initial rating of companies in the consumer sector. We may raise the first-stage rating of a financial company or utility. We’ll often lower the initial rating of a company in the resource or manufacturing sectors. They’re vulnerable to unpredictable shifts in demand.

MDC has lost more money than it ever made. That, and generous dividends explain why it has negative shareholders’ equity. It also owes over US$777 million. So we formerly reduced MDC’s stage-one rating by two notches. Then again, it’s expected to earn 68 Canadian cents a share this year and 96 Canadian cents a share next year. As a result, we are now lowering the stage-one quality rating by just one notch, to “Average”. We’ve also upgraded it from a “sell” to a “hold”.

We’ve always acknowledged that ours is not a perfect system, and that well-hidden risks will occasionally escape our notice, if only temporarily. Or, to put it more bluntly, nobody gets it right every time. But our system provides you with a framework for sound investing—for building a portfolio that exposes you to only those risks you choose to accept.

 

The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846