New Ideas From Telecom, Healthcare and Salmon Farming

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Seemed like May flew by (along with the rest of 2020!) didn’t it?

The markets continue to confuse professional managers. Robinhood investors are minting money. Riots in the streets, S&P futures up pre-market. Nothing really makes sense.

If there’s one shred of consistency in your life, it’s a fresh new copy of Value Hive in your inbox every Wednesday.

Our Latest Podcast Episodes:

Here’s what we cover this week:

    • Massif Capital Long Thesis on Bakkafrost (BAKKA)
    • Bonhoeffer Capital Q1 Letter
    • Interview with RA Capital on Healthcare Companies
    • Bill Ackman Sells Berkshire

Let’s dive in!

June 3rd, 2020

Meme Of The Week: 

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Investor Spotlight: Bonhoeffer Capital & Maran Capital

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This week’s Investor Spotlight features Bonhoeffer Capital Q1 Letter and Massif Capital’s latest long idea: Bakkafrost (BAKKA).

Bonhoeffer Capital (-33.7% in Q1)

Keith Smith of Bonhoeffer Capital returned -33.7% in Q1. It was a rough quarter for value investors. I love reading Keith’s letters because his fund is so different. As of the letter, his top countries (by allocation) are:

    • South Korea
    • Italy
    • South Africa
    • Hong Kong
    • United Kingdom
    • Philippines

Don’t see the US on that list do ya? That’s because Keith fishes where the fish are!

Keith spends most of the letter discussing Strategic Framework Investing.

What is Strategic Framework Investing?

Here’s Keith’s take: “Valuation models have evolved over time from valuation multiples—which work well with mature companies (Graham)—to discounted cash flow models—which work better for growth companies (Buffett)—to distress-weighted models for declining businesses (Damodaran), and finally to strategy/business models—which focus on market size, growth (including network effects), customer lock-in, economies of scale, and probability of survival for young growth companies (venture capitalists).”

Valuation changes over time. So, the framework through which we view our valuations should change with it.

It doesn’t make sense to value a money-losing start-up company based on P/E ratios. An investor that only uses one valuation method is the same as a man wielding only a hammer. To him, every company looks like a nail.

Why does it matter that we adjust and adapt to the constantly changing business environment? Let’s tap-in Keith for this one:

“With the introduction of disruptive internet capital-light models by young growth companies, current profitability (under the assumption of the presence of either large unreproducible investment or network effects) has been less important than future profitability supported by a business model that can generate strong customer growth, recurring revenue with small amounts of customer attrition due to customer lock-in and/or creating network effects.”

Issues With New Business Models

Keith reeles off a few issues with these new network-effect businesses:

    • LTV, CAC and Churn are hard to estimate
    • Some of the business models are dependent upon outside financing when they are in the growth phase of development

The letter shifts focus to discuss the multiple (P/E, EV/EBITDA) valuation method and mean-regression. I encourage you to read the whole thing — it’s great.

But we’ll end with two ideas from the letter: Telecom Italia (TIT.IT) and KT Corporation (KT.US).

Telecom Italia (TIT.IT)

Business Description: Telecom Italia S.p.A., together with its subsidiaries, provides fixed and mobile telecommunications services in Italy and internationally. The company operates through Domestic, Brazil, and Other Operations segments. – TIKR.com

What’s To Like:

    • 54% Gross Margins
    • Long history of profitability
    • ~$2B 3YR FCF average
    • Trades <6x EBITDA
    • Owns most extensive telecom network in Italy

What’s Not To Like:

    • Low normalized net income margin
    • Net Debt/EBITDA is 3.69x
    • France’s Illiad may cause price war

What’s It Worth:

Let’s assume the company grows to $17.2B euros by 2024. Using historical EBITDA margins (40%) we get almost $7B euros in EBITDA, 2.5B euros in FCF and $37B in Enterprise Value.

Subtract net-debt and you’re left with around $12.7B in market cap (0.60 euros/share). That’s assuming a 9% discount rate and 3% perpetuity growth. If you take a multiple approach (EBITDA or FCF) you’d realize a higher per-share value.

Chart Analysis:

TIT’s showing sideways consolidation below the 50MA. Our price-action base case is a breakdown below support and further price decline. But we’re looking for a reversal given the fundamental background.

KT Corporation (KT)

Business Description: KT Corporation provides telecommunications services in Korea and internationally. The company offers local, domestic long-distance, and international long-distance fixed-line and voice over Internet protocol fixed-line telephone services, as well as interconnection services; broadband Internet access service and other Internet-related services; and data communication services, such as leased line and broadband Internet connection services. – TIKR.com

What’s To Like:

    • Strong FCF generation
    • 40%+ Gross Margins
    • Declining SG&A % of Revenue
    • Improving Current Ratio
    • Net Debt/EBITDA: 1.18x
    • Largest amount of 5G Infrastructure in South Korea

What’s Not To Like:

    • Legacy business still dominates revenues
    • Tensions with North Korea
    • Declining real estate values in KT’s portfolio
    • Failure to spin-off non-core (non-teleco) businesses

What’s It Worth:

KT is a sum-of-the-parts (SOTP) story. They have a hodgepodge of businesses, each with varying degrees of value.

Keith summarized his view on KT’s value in a 2018 post with MOI Global (emphasis mine):

“The shares recently traded at a “look-through” FCF multiple of 5.8x, and look-through EV/EBITDA of 1.5x …  If the shares traded at 6x EBITDA with a holding company discount, the stock would be more than a triple, not including dividends, buybacks or cash flow gains from a growing telecom business.”

Someone call Dave Waters, he loves this stuff.

Chart Analysis:

There’s nothing we can glean from this chart right now. Look for the 50MA to act as resistance over the next few weeks.

Massif Capital: Bakkafrost (BAKKA) Long Thesis

Massif Capital’s back with their latest long thesis: Bakkafrost (BAKKA). You can read their entire report here.

Let’s dive in.

Business Description: P/F Bakkafrost, together with its subsidiaries, produces and sells salmon products under the Bakkafrost and Havsbrún brands in the United States, Europe, China, and internationally. The company operates through four segments: Fish Farming FO; Fish Farming SCT; Value Added Products; and Fishmeal, Fish Oil, and Fish Feed. – TIKR.com

What Massif Likes:

    • Family owned and operated with 19% ownership
    • Consistent 70% Gross Margins
    • Ideal location for growing salmon
    • Commands 15% pricing premium against global competitors
    • 20%+ Operating Margins

Risks:

    • Long-term erosion of salmon prices
    • New diseases / pandemics affecting salmon health
    • Consumer taste changes

What Massif Thinks It’s Worth: BAKKA’s balance sheet has a long-term interest-bearing debt of 𝑘r2.3 billion vs. a cash balance of ~𝑘r1.3 billion. Gross margins are remarkably steady at around 70%. A discounted cash flow analysis, assuming a 10% discount rate, results in a valuation of ~𝑘r741 NOK per share, producing an expected return of 32% at current prices.

Chart Analysis:

BAKKA broke out of its ascending right triangle last week. A brief pullback has us up against the new-found support line. Price remains above the 50MA and 200MA, a bullish sign. __________________________________________________________________________

Movers & Shakers: Bill Ackman Sells Berkshire!

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Bill Ackman isn’t afraid of the spotlight. We’ve heard his name referenced numerous times during this COVID crisis. Who could forget his live-action sob story on CNBC?

This time, he’s in the news for selling Berkshire Hathaway (among other investments).

My reaction: Who cares? There’s tons of ideas out there that are better than the BRK thesis.

Ackman brought up some good points during the interview (emphasis mine):

The one advantage we have versus Berkshire is relative scale. Berkshire has the problem, if you will, of deploying $130 billion worth of capital … Pershing Square, on the other hand, has about $10 billion of capital to invest and therefore can be more nimble … We should take advantage of that nimbleness, preserve some extra liquidity, in the event that prices get more attractive again.”

And that’s my biggest issue with the BRK bull thesis. Buffett is so capital constrained it makes it damn near impossible to find deals. Meanwhile, there’s plenty of opportunities for less capital constrained investors/funds. Look at Poland, Egypt or Italy (to name a few).

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Interview of The Week: Healthcare Investing with RA Capital’s Peter Kolchinsky

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Evercore describes RA Capital as, “ one of the leading dedicated healthcare investment funds and has been built over nearly two decades with a unique approach to analyzing therapeutic categories.”

My circle of competence in the healthcare space is pitifully small. This interview helped expand it a bit.

Let’s dive into the meat of the interview (emphasis mine on the responses).

Q: How have your private company investments changed your view of the field?

RA Capital: “The public markets don’t get to see how the sausage 4 is made, which is just as well because it can be harrowing. But we have come to appreciate the way driven, talented people can work through most any challenge to keep programs going. That makes us more patient public investors.”

I loved this quote. We’ve heard similar things from Scott Miller in some of his past interviews. Working in the belly of a company makes you a better investor. Period.

Q: How do you choose which companies or fields to drill into?

RA Capital: “We’re always mindful of the risk that we might overlook a great investment and are constantly refining our methodology to minimize that risk. For example, because we have someone tracking everything that’s going on in lupus, we know which companies in that landscape are working on something potentially compelling. Either we’ll reach out to those companies about financing them, even if they aren’t talking to investors yet, or, when they reach out, we’ll know to assemble a team of people, including senior members of our investment team, to get a deep update and make a rapid decision.”

Q: What do you see as the biggest risks/opportunities for the sector?

RA Capital: “I think that the risks of drug development are shifting from probability of technical or clinical success, which quantify the risks of – for example – a clinical trial failing, to those of strategic complexity. Historically, the chessboards have been so empty that making any drug that works has been considered a win. However, with more and more drugs coming to market, it’s no longer enough to make a drug that simply works.

If this interview made me realize anything, it’s that I will always be the patsy at the poker table in that space.

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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Creative Thinking: An Investor’s Last Remaining Edge

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Walt Disney epitomizes the ultimate Dreamer and Creator. From cartoons to movies to theme parks and more… His list of achievements is longer than Elon’s baby names.

How can one man develop the capacity to turn his dreams into the reality that billions enjoy today?

Superior models for operating mixed with a near-infinite supply of drive.

The creator of Mickey Mouse used a specific method of thinking to unleash his creative genius. Disney himself didn’t formally articulate this model of thinking. Robert Dilts, an NLP expert, put Disney’s ideas down on paper in 1994.

Here’s the best part. We can apply Disney’s strategy to our investment process.

Why Should Investors Think Creatively?

Before we dive into the method, we should ask ourselves, “why should we use creative thinking in our investment process?” After all, investing is pure math, right? Discount some cash flows, find an appropriate rate of return. Don’t pay too much for a good business … You get the point.

Did Ben Graham rely on creative thinking to profit from the markets? Nope. He used math. Did Walter Schloss dream about varying scenarios and future outcomes? Not quite. He bought a basket of undervalued stocks and held them for a year.

That was before computers commandeered the math.

Ben Graham and Walter Schloss lived in an age where information edges percolated every corner of the market. Find a 10-Q before someone else? You had an informational edge. Now, computers synthesize billions of data points in nanoseconds. Unless you invest in the darkest, most illiquid corners of the market, the days of informational edges are all but gone.

That’s why we need creative thinking.

As investors, our job isn’t to analyze the past. It’s to think about the future. To dream up scenarios nobody else is thinking about. To probabilistically weigh those potential outcomes to reality as we see it now.

That’s our job.

There’s no value in analyzing what’s in the past. All the value comes from what the future will look like in three, five, or ten years.

Take Chris Mayer’s 100 Baggers book as an example. You needed to have a dream of what the company would be in its early stages to hold on for dear life. An early investor in Monster ($MNST) wasn’t concerned with past operating losses. They were focused on the future of the market, the competitive advantages, and a world where Monster energy drinks sat in every grocery store.

But don’t just take my word for it. Take legendary trader Bruce Kovner’s words:

“First, I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine that soybean prices can double or that the dollar can fall to 100 yen.”

We need to think creatively to generate outsized returns. Let’s learn how.

The Disney Method of Creative Thinking

The Disney Method of Creative Thinking is an active process. As investors (many of us one-man teams), we should use this method aloud. Actually speak your thoughts into existence.

The Disney Method has three “rooms” of thought:

    • The Dreamer
    • The Realist
    • The Critic

Step one, separate each room in your home or office. If you don’t have the option to create three different rooms, use your mind. Sherlock Holmes’ mind palace is a good place to start.

Disney’s process relies on flow from one room to the next. The process always follows a set path: Dreamer –> Realist –> Critic.

Now that you’ve got your three rooms, it’s time to start thinking.

The Dreamer

The dreamer is responsible for thinking outside the box. Your wildest dreams not bound by reality, logic, or common sense. You have to use your imagination. I know, it doesn’t feel normal to use your imagination when investing. But try it.

Don’t be afraid to write/say extravagant ideas or future scenarios. That’s what you’re supposed to do in the dream room.

Remember, we’re framing this through the mind of an investor.

Here’s some questions to jog your dreamer process:

    • If Company XYZ expands their product/grows margins/takes over an industry, what would that look like?
    • What will be the main driver of this company’s growth ten years from now?
    • What would sales and earnings look like if Company XYZ was able to achieve a dominant market share?
    • If my dream about the company were to come true, how much of a discount is the current market price?

The important part is that none of the above questions/answers have to make sense. They don’t have to be logical or completely reasonable. You don’t know if it’s possible — and that’s the point.

Check out the Dreamer visualization on the right from VisualParadigm.

When you dedicate a space for dreaming, you create a Rolodex of ideas, thoughts, and scenarios that either stick or don’t. In investing, dreams are often neutered by the scalpel of reality. Don’t let that happen.

One final note about the Dreamer stage — you must dream big. You can’t dream of a company with 20% EBIT margins growing to 22%. That’s not dreaming.

Really dream. Take a money-losing company and dream of a world where they gush cash and return capital to shareholders. That’s dreaming.


The Realist

Did you have fun dreaming of wild and crazy scenarios and futures? Good. It’s time to come back to reality. The next room of thought is the Realist. The goal of the Realist room is to think hard about the dreamer’s ideas. The realist asks questions like:

    • What needs to happen in order for that dream to work?
    • What are the chances that this alternate future comes true?
    • What steps can we take right now to help our dream become reality?

It’s important to note that the Realist is under the assumption that the above dreams will work In the future. In turn, their job is to discern how to actually get it done.

As minority investors, it’s hard for us to take action on a company’s future. But we can still use the Realist room as a way to channel-check our expectations of the company against the company’s plans.

For example, if we dream that a company’s revenues can grow 40% for the next five years, how will that happen?

We can assume our company penetrates new markets, makes strategic acquisitions or raises profit margins through operational leverage.

The realist takes the dreams and formulates ways to make them a reality. Sounds simple in theory.

Another key factor in the Realist process is identifying markers of achievement towards the dream becoming reality. If your dream is a company growing from $10M in sales to $100M in sales, a key marker would be top-line revenue growth. Or your dream is a net cash company with positive earnings. Your markers would be debt/equity, operating margins, etc.

Think of this step as Disney pitching his storyboard. A storyboard is the guts of a film. It’s the raw, unedited format used to build cinematic masterpieces. Every great film started as a storyboard.

Our job as investors is to create a storyboard for each company. These storyboards are investment write-ups.

Write-ups paint a picture of a dream — a variant perception of the future — with steps on how to get there. Like a storyboard reveals character and plot development, investment write-ups highlight business improvement and value creation.

The image on the left sets the stage for our Realist room.

Remember, the job of the Realist is to determine how to turn those dreams into reality.

Putting down our Realist hat, we move to the last room in our process: The Critic.


The Critic

Our Critic room has one job: punch holes and find where we’re wrong. This is the space to red-team your idea. In our Critic room, we ask questions like:

    • Does this plan make sense?
    • What barriers are we overlooking?
    • What competition is out there that could stop our plan?
    • Is the dream worth the work to get there?
    • What are we missing?
    • What are the weaknesses?
    • Where are our blindspots?

The critic focuses on the why:

    • Why won’t this work?
    • Why won’t we grow?
    • Why will it take longer than we thought?
    • Why are we wrong?

This is a critical step for investors. We’re putting our hard-earned capital at risk with each investment. We must know how/why/where we could be wrong in our Realist process. Ruthless criticism might hurt the ego, but it could save thousands of dollars in potential losses.

Talk to any successful investor and they’ll say the same thing: “I want to know how much I could lose if I’m wrong.”

My favorite quote from Joel Greenblatt echoes this sentiment (emphasis mine): “I want my biggest position to be in a stock that I think I have the least likely chance of losing money.”

Focus on the downside and let the optionality of your upside dream take care of itself.

Bringing It Together: An Investor’s Approach

I know, there’s a lot to take in. Let’s boil it down to the three main concepts:

    • The Dreamer: Focus on creating wildly different futures for a company that isn’t reflected in the current stock price and past financial data.
    • The Realist: Create a storyboard (write-up) that outlines how the company will turn your dream into a reality. Be specific, but don’t paralyze yourself with minutia.
    • The Critic: Understand and determine where you could be wrong in your plan for the company’s dream. Don’t be afraid to scrap an idea if the Critic strikes a damning blow to your alternate reality.

I wrote this essay for me. It was a reminder to myself that value isn’t created in screening for low price/earnings stocks. Computers can do that in nanoseconds. I wrote it to remind myself that true value creation comes from thinking non-linearly about dynamic businesses.

Non-linear thought in a linear, computerized world is our last remaining edge.

Computers know if a company is currently unprofitable. What they don’t know is if that same company is on the cusp of profitability. Computers can’t quantify a company culture or the skill of a CEO. Computers react. We dream.

Don’t be afraid to dream. Don’t be afraid to get creative in how you see a company growing over the next five or ten years. Disney’s creative thinking process allows you to think big while remaining anchored to reality. Invite your imagination into your investment process. You never know what you might find.

Monday Dirty Dozen [CHART PACK]

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The beginner plunges ahead on a favorite that loses, then bets lightly on a fair-priced horse that wins. He keeps switching amounts and positions, so that he never has a worthwhile bet on a winner at a worthwhile price. He is always one race behind the form of a horse and several races behind the rhythm of the results sequences.  ~  Robert L. Bacon

In this week’s Dirty Dozen [CHART PACK] we look at the STRONG BREADTH we’re seeing in markets around the world, then dive into the potential source of that breadth, before covering some dirt-cheap international markets with exceptional long-term chart setups, and finally end with some precious metals, demographics, and short-term signs of complacency…

Let’s dive in.

***click charts to enlarge***

  1. Something happened last week that hasn’t happened in 29 years. 96 percent of S&P 500 stocks were above their 50-day moving average… That’s after hitting near-record lows in March. The last time breadth hit similar levels was in early 91’ following the 90’-91’ bear market and recession, which then preceded the great 90s bull market.

 

  1. The following chart from NDR shows past instances (marked by arrows) where this short-term breadth indicator crossed above 90 after falling to at least 75% in between. Out of the 19 cases, the market was up a year later each time with a median return of 16.28% (chart via @edclissold).

 

  1. And here’s the return following each thrust 2-months later (chart via @edclissold).

 

  1. The strong breadth isn’t unique to just the US either. Here’s the same NDR chart but for the MSCI Europe Index where 92% of stocks crossed above their 50-day moving average last week, for the first time in over three years (chart @WillieDelwiche).

 

  1. The Dark Index (DIX), a measure of off-exchange transactions (you can find more information here) hit 52.3% on Friday. That’s the highest number on record. @SqueezeMetrics, the creator of the DIX, points out that “off-exchange transactions have been ‘overwhelmingly’ bullish since late March”.

 

  1. The strong demand for risk assets that we’re seeing is making many financial twitter warriors and newsletter writers head’s spin, as they see a total disconnect between the market and the economy. What they don’t get is that the market operates off its own fundamentals and it recently saw a huge boost to the demand side of that equation. Ben Carlson shared in a recent blog post (link here) how “the major brokerages — Robinhood, Charles Schwab, TD Ameritrade and Etrade — saw new accounts grow as much as 170% during the first quarter” and that one of the biggest beneficiaries of the stimulus checks was securities trading.

 

  1. People email me all the time asking me if I’m bullish or bearish right now. I don’t have a single answer for that question (it depends on the timeframe) and even then, my opinions are very weakly held, especially now. I’m just trying to play the tape in front of me and let the market tell me what’s what.

With that said, there’s some great looking charts in emerging markets and Europe that need to be on your radar. Malaysia (EWM) is one of these. It’s selling on the cheap… there are also a number of long-term fundamental reasons to be bullish on the country — not to mention the monthly price action is 👌.

 

  1. Poland (EPOL) is another. Na Zdrowie!

 

  1. EURUSD has tried to break down only to reverse four months in a row now. This last month saw a strong close. The market is rejecting lower levels which raises the odds of higher ones. It’s still in a sideways regime and we need to wait for a breakout but pay attention. A weaker dollar (stronger euro) would fit with a lot of the other price action I’m seeing across markets right now.

 

  1. Precious metals continue to run strong (I last updated the bull case here). Silver especially has been putting in some work on closing the gold/silver performance gap I pointed out a few weeks back. It saw a strong close for the month. Look for higher prices and a break above its long-term base soon.

 

  1. Ensemble Captial published a piece recently on where they think the “Next Normal” will be, following the impact of the virus, that’s worth a read (link here).

“Obvious: Coronavirus is going to increase the global death rate.

“Less Obvious: Coronavirus is going to increase the global birth rate.

“Historically, baby booms occur for a combination of cultural and biologically programmed reasons. In the aftermath of a tragic experience such as this pandemic, it’s natural for people to reconsider their goals, priorities, and changing circumstances. One of the important things that come out of an event like this, where people are stuck at home or dealing with potentially grave illness, is the realization of the importance of family, companionship, or simply boredom avoidance. Combined with the ability to move further away from urban areas and increasing affordability in the suburbs, it may well be that we see baby booms around the world. In the US, that may stabilize or reverse the trends of lower than replacement procreation (2019 SAW ONLY A 1.7 FERTILITY RATE, below the 2.1 needed to sustain a population ex immigration).”

 

  1. While the strong breadth is certainly a bullish development the stretched put/call ratios are an indication of complacency and a source of short-term fragility as @MacroCharts pointed out last week.

Stay safe out there and keep your head on a swivel.

Two Free Breakout Alerts For The Week Ahead

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Once a month we’ll feature a breakout (or two) from our premium Breakout Alerts service. This service is for members only and highlights half-a-dozen potential breakouts each week! We’ve had decent success this year with the service and returned nearly 20% in Q1.

This article features two new breakout alerts that will go out to our premium members over the weekend.

Let’s dive in!


Breakout #1: Wedge Industries (000534)

Business Description: Wedge Industrial Co., Ltd. invests in, develops, sells, and operates real estate properties in China. It also engages in power generation and steam heat supply activities.

The company was formerly known as Guangdong Wanze Industrial Co., Ltd. and changed its name to Wedge Industrial Co., Ltd. in May 2013. The company was founded in 1992 and is based in Shantou, China. – TIKR.com

Financials:

    • Market Cap: $622M
    • Enterprise Value: $675M
    • EV/EBIT: 36x
    • ROC: 2.90%
    • 3YR Avg. FCF: -$30M

What We Like:

    • Reduction in share count
    • Pays a dividend
    • EBIT covers interest expense 1.50x

What We Don’t Like:

    • Burning cash
    • Lots of debt
    • No room for error in lower earnings on debt payments (could slip into failing covenants)

Chart Analysis:

Short Trade Parameters:

    • 3% Entry: $8.32
    • 1.50% Entry: $8.45
    • Stop-Loss: $8.92
    • Profit Target: $6.95
    • Reward/Risk: 3.20x


Breakout #2: Xilinx, Inc. (XLNX)

Business Description: Xilinx, Inc. designs and develops programmable devices and associated technologies worldwide. The company offers integrated circuits (ICs) in the form of programmable logic devices (PLDs), such as programmable system on chips, and three dimensional ICs; adaptive compute acceleration platform; software design tools to program the PLDs; software development environments and embedded platforms; targeted reference designs; printed circuit boards; and intellectual property (IP) core licenses covering Ethernet, memory controllers, Interlaken, and peripheral component interconnect express interfaces, as well as domain-specific IP in the areas of embedded, digital signal processing and connectivity, and market-specific IP cores. – TIKR.com

Financials:

    • Market Cap: $22.13B
    • Enterprise Value: $21.17B
    • P/Normalized E: 33.19x
    • EV/EBIT: 30x
    • FCF Margin: 28.6%

What We Like:

    • FCF positive 10 straight years
    • 60%+ Gross Margins
    • 25% Operating Income Margins
    • Decreasing Share Count
    • Net Cash

What We Don’t Like:

    • Cyclical industry
    • Loads of competition
    • Increase cash conversion
    • Increase Days Inventory

Chart Analysis:

Long Trade Parameters:

    • 3% Entry: $95.05
    • 1.50% Entry: $93.66
    • Stop-Loss: $85.37
    • Profit Target: $117.78
    • Reward/Risk: 2.91x

That does it for this week’s featured breakouts. If you’re interested in learning more about our premium service, drop us an email or comment down below. We’d love to chat with you!

Four New Ideas, Gavin Baker & Howard Marks

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We hope you enjoyed your extended weekend! As the weather warms up it remains harder to stay indoors. In light of that, you know how easy it is to practice social distancing in a boat? Pretty easy. Just boat six feet away from everyone else!

Before diving in, I want to take time to thank all our servicemen/women for their valiant efforts. It’s what they do overseas (and at home) that enable the rest of us to live free, full lives. We sleep easy at night knowing America’s finest are on the clock 24/7 keeping us safe. We will never be able to thank you enough.

In honor of Memorial Day, my brother and I are attempting “Murph”. For those that don’t know, it’s a workout from hell. Here’s the layout:

    • 1 mile run
    • 100 pull-ups
    • 200 push-ups
    • 300 air squats
    • 1 mile run

Try it out this week! If you do it, email us your time! Fastest times will get a shout-out in next week’s email.

Our Latest Podcast Episodes:

Here’s what we cover this week:

    • Greenhaven Road Partners Q1 Letter
    • Gavin Baker’s Latest Talk at Columbia
    • Howards Marks on Knowing What You Don’t Know

Let’s get it!

May 27th, 2020

Tweet of The Week: 

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Investor Spotlight: Greenhaven Road Partners

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This week’s Investor Spotlight features Greenhaven Road Partners Fund. We hope you find one (or a few) that reach your short-list.

Greenhaven Road Partners Fund: -23.5% Q1

Greenhaven Road Partners (GRP) returned -23.5% in Q1. GRP is a unique fund-of-funds. It invests in small, one-man-shop firms that meet specific characteristics. These firms have concentrated portfolios, invest in off-the-beaten-path ideas and allocate a large portion of their personal net worth into their funds.

The letter highlights some of the funds investments (you’ve heard quite a few of these names):

    • Laughing Water Capital
    • ADW Capital
    • Desert Lion
    • Maran Capital
    • Tollymore
    • Long Cast Advisers
    • Arquitos Capital
    • Far View Capital

We’ve already highlighted the letters of most of these funds,so we’ll cover the ideas we haven’t heard yet.

API Group (API), ADW Capital

Business Description: APi Group Corporation provides commercial life safety solutions and industrial specialty services. The company offers specialty contracting services and solutions to the energy industry focused on transmission and distribution in the United States and Canada; and industrial services, including the retrofit and upgrading of existing pipeline facilities. – TIKR.com

You can read their S-4 filing here.

What’s To Like:

    • Stable end-markets
    • Trades at 5x free cash flow
    • Essential service
    • Boring business
    • Forced buyers from NASDAQ listing

What’s Not To Like:

    • 44% Unionized workforce
    • Serve energy exploration end-clients (cyclical)
    • $1.2B in total debt

What It’s Worth (from the letter):

    • “Given that we believe API’s business is superior to most of its public comparables, has a proven capital allocator/owner at the helm, and has an established framework to expand EBITDA margins over the next few years, we believe the APG stock should trade at a premium to its larger peers. At only 16x 2019 EPS, APG shares would trade at almost $20/share or about a +110% return from today’s prices.”

Chart Analysis

The stock remains above the 50MA but I wouldn’t put too much emphasis on this chart. There’s not much history here.

Gym Group PLC (GYM.L): Tollymore

Business Description: The Gym Group plc operates health and fitness facilities in the United Kingdom. It operates 175 gyms. The company was founded in 2007 and is based in Croydon, the United Kingdom. – TIKR.com

What’s To Like:

    • 20%+ 5YR Revenue CAGR
    • 99% Gross Margins
    • Expanding Operating Margins (18%)
    • Low-cost gym offering

What’s Not To Like:

    • Large cash inflow from “other operations” last two years
    • $430M in net debt ($211M from capital leases)
    • Gyms in serious question post-COVID

What It’s Worth:

Let’s assume $216M in revenue and $108M in EBITDA by 2024. Let’s also assume cap-ex hovers around 25% of revenues (historical average) over the next five years.

That leaves us with $46M in FCF by 2024, $63M in PV of cash flows and $390M in terminal value. That’s roughly $453M in Enterprise Value. Add cash ($3M) and subtract debt ($327) and you’re left with $128M in shareholders equity ($0.77/share).

This assumes GYM doesn’t reduce its debt over the next five years, when in fact the opposite is plausible.

Chart Analysis

GYM remains below its 50MA (bearish) in a solid downtrend. I’d like to see a strong move above the 50MA and a breakout above the 165 level.

Cross Country Healthcare (CCRN): Long Cast Advisers

Business Description: Cross Country Healthcare, Inc. provides healthcare staffing, recruiting, and workforce solutions in the United States. The company operates in three segments: Nurse and Allied Staffing, Physician Staffing, and Other Human Capital Management Services. – TIKR.com

What’s To Like:

    • 25% Gross Margins
    • Reduced Total Debt/Equity
    • Trades for 0.38x Revenues
    • Co-founder returning to company

What’s Not To Like:

    • Consistent laggard
    • Currently money-losing
    • Cash flow from ops is positive due to “other operating activities” not core biz
    • SG&A margin increased while EBITDA margin decreased

Avi’s Take:

    • “The business has some temporary COVID-related tailwinds, but also headwinds due to declines in non-COVID related emergency room visits, operations, other deferred elective procedures, and school closures. Looking through this, I observe an inexpensive yet durable, cash-flow generating founder/operator company doing the right things to weigh the odds more favorably towards profitable growth.” – com

Chart Analysis

This is a turnaround story led by a returning co-founder hoping to revitalize a lagging, money-losing business. If he’s successful, we should see a reversal in share price and a breakout above the resistance line.

Wouldn’t surprise me to see an inverse H&S form on this chart, further bolstering the bullish case and the completion of the turnaround project.

Naked Wines PLC (WINE.L): Far View Capital

Business Description: Naked Wines plc, together with its subsidiaries, engages in the retailing of wines, beers, and spirits in the United Kingdom, the United States, Australia, and France. It operates through four segments: Retail, Commercial, Lay & Wheeler, and Naked Wines. – TIKR.com

What’s To Like:

    • High 20’s Gross Margin
    • Total Debt/Equity of 0.31x
    • 15x EBITDA
    • Shift to DTC wine sales

What’s Not To Like:

    • Money-losing in 2019
    • EBIT/Interest Payments less than 2x
    • Significant share price increase YTD
    • Increase in cash conversion cycle from 35 to 75

Far View’s Take: “As we have seen in other industries, once consumers experience the benefits of an online model, they are unlikely to return to their prior purchasing patterns. As the leader in U.S. direct-to-consumer wine, Naked has the potential for a significant inflection in its business trajectory on a more permanent basis.”

Chart Analysis

WINE broke out of its descending wedge with a strong weekly close above the chart pattern and 50MA. The stock’s up nearly 45% since that weekly breakout. The next real resistance lies around $480 as WINE tests previous highs.

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Movers & Shakers: Gavin Baker & Howard Marks

GIFs by tenor

Man do we have two great resources for you this week! Howard Marks discusses Knowing What You Don’t Know. Gavin Baker chats video games, venture capital, doing what’s obvious and technology.

Howard Marks: Knowing What You Don’t Know

Marks is a distressed investing OG and viral book seller. His most recent discussion on investment philosophy, contrarianism and framing is worth the read.

Marks notes six insights that guided his investment philosophy to what it is today:

1. View Market Movements Constructively

Marks’ Take: “I tend to think of them, more productively, as excesses and corrections.”

2. Know What You Don’t Know

Marks’ Take: ““It’s so silly for an investor to build his investment conclusions around his view of what the disease holds when he knows nothing about it … You shouldn’t make it up on your own, you should look to the experts.”

3. Insist on a Margin of Safety

Marks’ Take: ““The expert calibrates the expression of his opinion based on how firm the evidence is … The investor should calibrate his confidence in his investment based on how much margin of safety there is.”

4. Know When To Get Aggressive

Marks’ Take: ““I think that toggling between aggressive and defensive is the greatest single thing that an investor can do, if they can do it appropriately.”

5. Be Different, But Be Correct

Marks’ Take: ““If you think and behave different from other people — and you’re more right than they are, that’s a necessary ingredient — then you can have superior performance”

6. Get Comfortable with Discomfort

Marks’ Take: ““Every great investment begins in discomfort. If everyone else didn’t hate the investments, they wouldn’t be cheap.”

Gavin Baker: Venture Capital, Tech, Video Games & Doing What’s Obvious

Gavin Baker sat down with the Columbia Student Investment Management Association for a 90 minute knowledge bomb session.

Here’s my time-stamp for the video. It’s 90 minutes long. Pro-tip: watch at 1.75x speed. It sounds normal and reduces the listening time from 90 minutes to 52 minutes.

Check out the video here. If that link doesn’t work, check out Gavin’s YT channel. The video is the latest one on his page.

    • 12:00 – Roadmaps and Loosely-held opinions
    • 23:00 – Technology
    • 28:25 – Video games
    • 38:00 – Winners of the video game industry
    • 49:00 – TikTok
    • 58:00 – Making Difficult Decisions
    • 63:00 – Competition Demystified
    • 68:00 – Freemium Model
    • 76:00 – Venture Capital Models

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Article of The Week: When Safety Proves Dangerous

Farnam’s latest piece, When Safety Proves Dangerous, stabs at the heart of the COVID-19 issue. It’s a five minute read and worth every second.

There’s two ideas that resonate throughout the article:

1. Risk Compensation

Farnam’s Take: “Risk compensation means that efforts to protect ourselves can end up having a smaller effect than expected, no effect at all, or even a negative effect. Sometimes the danger is transferred to a different group of people, or a behavior modification creates new risks.”

2. Risk Homeostasis

Farnam’s Take: “enforcing measures to make people safer will inevitably lead to changes in behavior that maintain the amount of risk we’d like to experience, like driving faster while wearing a seatbelt. A feedback loop communicating our perceived risk helps us keep things as dangerous as we wish them to be. We calibrate our actions to how safe we’d like to be, making adjustments if it swings too far in one direction or the other.”

What does this mean for investors? Let’s use the two frameworks in an example.

You’re up big on the year. You’ll more than likely take bigger swings (i.e., risks) knowing you have the cushion of strong profits. That’s Risk Compensation. Don’t get me wrong. I don’t think this necessarily a bad thing. The Druck uses a similar strategy. If he’s up big he bets big.

Risk Homeostasis is a bit trickier. Let’s say we have a newly defined trading rule (i.e., seatbelt in car) of 1% risk per trade. There’s no denying the 1% risk rule is good for a trader. But what are the second-order consequences of this risk mitigation strategy? Over-trading.

Since you’re only risking 1% of your capital per trade, it could cause you to place too made trades. Even trades of the same correlation.

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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A Private Equity Mindset To Public Markets

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Private equity outperforms public markets. Unfortunately, most PE opportunities are for accredited investors (or high-net worth individuals). This means a majority of retail investors are unable to take part in these outsized returns.

Yet what if there was a way to bring private equity investing to the masses?

What if retail investors, small funds, etc. could access private equity opportunities at scale? What if you could replicate the strategy that helps private equity outperform public markets?

You can, and here’s the solution: apply a private equity investment strategy to public markets.

Thinking like a private equity investor is an edge in today’s short-term, next quarter mindset. Applying private equity principles to public market investing combines the best of both worlds. This gives every investor a chance at recreating that powerful strategy once reserved for high net-worth investors.

The Three Pillars of Private Equity

While thinking about the idea of private equity in public markets, we found recurring themes. We’ll call these our ‘Three Pillars’ of Private Equity in Public Markets. They are:

    1. Smaller is better
    2. Illiquidity Premium
    3. Long-term Thinking

Over the course of this section we’ll dive into these themes that a private equity mindset creates in public markets. Then, we’ll discuss ways to implement this mindset into your investment strategy.

I will warn you. This method isn’t for everyone. It requires a long-term outlook, a disregard for random stock price movements and a stomach for dramatic volatility.

Brief History of Private Equity

Let’s review the two types of PE firms we want to emulate. There’s Leveraged Buyouts (LBOs) and Venture Capital.

Leveraged Buyout Firm

As the name suggests, Leveraged Buyout Firms (or LBOs) use debt to purchase an existing business (either public or private). The leverage juices returns if things go well, but destroys capital in the event of a downturn.

LBOs sometimes use as much as 90% leverage to finance an acquisition. The goal for LBOs is an eventual sale (a.k.a., ‘exit’) three-to-five years down the road. These firms then try to improve the business through the income statement or balance sheet. Improving the business has two benefits:

    1. Increases cash-flow to the PE firm while they own the business.
    2. Presents the opportunity for a multiple re-rating when it comes time to sell.

Two high-profile examples of LBO Firms include Bain Capital and Apollo Global Management.

Venture Capital

Venture Capital Funds are another well-known PE vehicle. These funds invest in early-stage companies. These companies aren’t usually profitable. Some companies haven’t even generated revenue yet.

Venture funds invest (more-or-less) either the founder/CEO, or the vision of the company. Since there’s no profits, venture funds must learn to judge the quality of the CEO and the viability of an idea. These funds invest in either Seed or Series A rounds. Both rounds are the earliest times a company can invest.

Three examples of high-profile venture funds are Sequoia Capital, Insight Venture Partners and Adventur.es.

Here’s what we know: Private equity outperforms public markets.

We’ve already mentioned the three reasons why private equity generates higher returns:

    • Smaller sized companies
    • Illiquidity Premium
    • Long-term Thinking

Let’s dive further into the investment strategy behind many private equity companies.

How Private Equity Firms Think

Private equity investors focus on four main areas when looking at potential investments:

    • Downside Protection
    • Three-To-Five Year Time Horizons
    • Changing Management
    • Buy To Sell

These four areas of focus fit nicely with our larger three criteria for higher returns. Applying these frameworks to public markets can juice our returns. Let’s break them down.

Downside is All That Matters

I know, this sounds confusing at first glance. Aren’t private equity firms known for massive leverage to juice returns? Yes, but as Munger likes to say, “invert, always invert.”

Private equity investors look for the strongest balance sheets. It is because they use leverage that they must look for the strongest balance sheets.

Leveraging an already levered company is like playing Russian Roulette. Sure you might hit it big with one or two names. But it only takes one name to topple the house of cards.

Three-to-Five Year Time Horizons

The standard PE model is to buy a company, instantiate change, and then exit for a multiple re-rating in three-five year’s time. This time-frame, three to five years, is important. The average public market participant can barely hold onto a stock for a year.

In fact, check out the data for average holding period by decade. The erosion in time horizon is stunning:

    • 1960, eight years, four months;
    • 1970, five years, three months;
    • 1980, two years, nine months;
    • 1990, two years, two months; and
    • 2000, one year, two months

The average investor now holds onto a stock for less than one year. Here’s how insane that time frame is. Less than 1% of the business’ future value comes during that time. How then, is an investor supposed to realize the long-term benefits of a business’ cash flows? They can’t with that short of a time frame.

This is why time horizon matters. Three to five years is a minimum if an investor wants to reap the benefits of a cash-flowing business. Barring hard catalysts, these time frames should garner your entire investment decision.

Changes in Management or Operations

One of the greatest advantages private equity has over public markets is their ability to initiate change in management. This is a big reason why private equity returns generally outperform broader public markets.

Even if an investor has great ideas to turn a company around, he won’t be able to build a big enough position to do anything. That is, if she’s investing in larger companies. As we’ll see later, the size of the company can make activism a possibility even for smaller investors.

They Buy To Sell

Harvard Business Review’s article on private equity hints at the “secret” sauce behind PE’s outsized returns. Are you ready? PE firms buy with the intention of selling at a higher price. I know, radical thinking, right? Here’s a snippet from the article (emphasis mine):

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“But the fundamental reason behind private equity’s growth and high rates of return is something that has received little attention, perhaps because it’s so obvious: the firms’ standard practice of buying businesses and then, after steering them through a transition of rapid performance improvement, selling them. That strategy, which embodies a combination of business and investment-portfolio management, is at the core of private equity’s success.”

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Buying to sell flies in the face of conventional value investing principles. Value investors should invest in compounders, right? Well, not entirely. Remember, our goal is to not lose money. It’s not to only invest in compounders. Three to five year time horizons should be our bread and butter. If we can hold onto a business after that, its icing on the cake.

The Solution: Private Equity Investing in Public Markets

So, how do we combine the best of both public and private markets? Before diving into the strategy, we’ll investigate three men already practicing this very idea. Dan Rasmussen, Adrian Warner and David Barr.

Verdad Capital: Small-cap, leveraged Value Stocks

Dan Rasmussen runs Verdad Capital, an investment fund dedicated to private equity-style investing in public markets. Dan’s strategy is simple. He invests in small-cap, leveraged firms. Diving deeper, Dan looks for the following characteristics:

    • Companies trading <6x EBITDA
    • 3-4x Debt/EBITDA leverage ratios
    • Value tilt

According to Verdad’s research, this type of strategy produced an annualized return of 25.1% from 1965 – 2013. That’s not bad!

Verdad prefers public markets over private markets for a few reasons. First, they’re able to invest in cheaper companies while using appropriate leverage. Second, public markets offer greater transparency and trust than private markets. This makes sense as public markets have GAAP accounting, short sellers (to keep you honest), SEC requirements, etc. Private markets have none of that.

Finally, investing in public markets is cheaper than equivalent private market transactions. These savings are passed down to LPs (limited partners) in the way of lower fees (AUM or performance).

For more information on Dan’s strategy, check out his podcast interview with Patrick O’Shaughnessy

Avenir Capital: Private Equity Investing in Australian Stock Market

Adrian Warner is another public equity investor implementing private equity strategies. Before starting Avenir Capital, Warner spent 20 years in Australian and US private equity.

Now, he’s using that experience in public markets. Warner laid out his fund’s strategy in an interview with MOI Global.

During the interview, Warner presented three areas he thinks are vital for private equity investing in public markets. All emphases are mine.

1. Focus on the downside

“There’s a great deal of emphasis on worrying about what can go wrong in any investment, which I consider quite a healthy starting point, and fixating on avoiding permanent loss of capital. That’s probably the first element of private equity we work really hard on bringing over to the public markets.”

2. Strong emphasis on fundamentals and bottoms-up research

“[You should] remove yourself from trying to second-guess stock prices and focus on what you see as the underlying or intrinsic value of an asset and look to invest only in those situations where you can buy at a very material discount it. This bottom-up approach, which is highly consistent in private equity, is essential to what we do.”

3. Absolute, long-term returns is what matters

“There are no benchmarks in the short term, no liquidity or daily pricing of assets. The focus is very much on what you can buy an asset for now and what you think you’ll be able to sell it for three, four, or five years’ time. You don’t worry too much about what’s going to happen to the price in the short term. This absolute long-term return focus is very powerful, but a lot of the public market industry is trapped in the relative benchmarking mindset, which can be very damaging to focusing on the long-term return, in my view.”

I highly recommend listening to the interview or reading the transcript. Avenir’s investment strategy can be summed up in one sentence: Investing with a long-term time horizon, running a concentrated portfolio and evaluating investments as if we are buying the whole company.

PenderFund Capital Management: Private Equity Approach in Canada

David Barr is President and Portfolio Manager of PenderFund Capital Management, Ltd. In 2018, Barr released a slide deck outlining the fund’s public market strategy. Here’s a few snapshots of my favorite slides:

“The Pender Way”

PenderFund focuses on three drivers for long-term value creation:

    1. “Scuttlebutt” research and due diligence
    2. Work with investee companies
    3. Drive a liquidity event or exit

Barr does all these things inside public markets. But he’s not engaging with mega, blue-chip companies. He’s going to the smallest corners of the markets. The small and micro-caps.

According to Barr’s deck, he prefers small caps because of large target markets and long runways for growth:

We know the strategy works, and we’ve seen examples of other investors doing it. Now let’s flesh out the key pillars to the underlying strategy.

Fleshing Out The Advantages (The Three Pillars)

Now it’s time to dive into the Three Pillars of our private equity strategy. We’ll expand on each pillar so that you understand why it matters and how we apply it to public markets.

Size Matters: Smaller Value Companies Win

The data is clear. Smaller companies outperform larger companies in public markets. And no one analyzes the smaller-company edge better than Roger Ibottson.

According to the famous slide deck, Liquidity as an Investment Style, micro-cap stocks outperformed every other size between 1972-2013:

As the data shows, this isn’t the most optimal strategy. Using size as the lone factor increases the standard deviation of returns and reduces the return to risk ratio. We can do better (and we will).

Further research by DGHM & Co., backs up Ibottson’s claim. Between 1928 – 2018, microcap stocks compounded $1,000 into $24M. Large caps during that same time frame? $4M.

It’s evident that the smaller we go, the greater the chance for outperformance. But we’re not done. There’s one more layer we can add to this criteria to really boost potential returns.

Illiquid Stocks Perform Better

We know smaller is better. But we can do better than that. According to Ibottson (and private equity theory), it’s illiquidity that drives outperformance.

There are three things that stand out on this chart. First, low liquidity outperforms high liquidity by nearly 10% per year.

Second, the return to risk ratio is 0.75 for the least liquid investments and 0.29 for the most liquid.

Finally, the standard deviation for illiquid stocks is 20% compared to 28% for high liquidity stocks.

In other words, illiquid stocks generate higher returns with less risk. That doesn’t sound too bad! But, when we combine the above features — small size and illiquidity — we get 1 + 1 = 3. This is our optimal strategy (see photo below):

Illiquid micro-cap stocks generated 16.3% annualized returns from 1972-2013. This far surpasses any other investment category.

Long-Term Thinking as an Edge

As we discussed earlier, many PE firms have three-to-five year time horizons. This is important because value creation doesn’t happen overnight. A large part of most PE strategies involves shaking up management. Sometimes changing the entire course of the business. To assume those long-term efforts will pay off in less than a year is foolish.

But there’s another reason why PE investors need long-term time horizons. Illiquidity. Unlike public markets, if an investment goes south, PE investors can’t quickly sell. They’re stuck with their business, for better or worse.

Thus, illiquidity encourages a greater emphasis on the balance sheet and durability of a business. We can recreate all three of these advantages in public markets.

Creating an Investment Strategy Around our Three Pillars

We’re now ready to create an investment strategy aimed at capturing private equity premiums in public markets. The strategy is simple in its construction, but brutally difficult in execution. Let’s dive in.

Before you do anything, shrink your universe of stocks to microcaps and the most illiquid stocks you can find. I focus on stocks trading at market caps at or below $50M. Of those stocks I look for ones with the least amount of average trading volume.

After you’ve done that, focus on boring business. These are businesses that aren’t susceptible to technological change. Businesses that are small cogs in a larger machine. Think of electrical component manufacturers, valve producers, cyclical companies, etc. The more boring the better. Remember these companies are small. If they’re in a fiercely competitive technology sector, how much confidence is there that they can outspend on R&D?

Narrowing down our stocks to boring businesses we then focus on the balance sheet. Verify that the balance sheet is clean and bullet-proof. Favor current assets over long-term assets (unless its an asset play where management’s liquidating PP&E).

We want to buy companies with little-to-no debt. Remember, we’re thinking like PE investors. It’s hard to leverage a company with an already leveraged balance sheet. This doesn’t mean we’re going to use leverage — but we must think within that same framework.

Finally, from this subset of small companies with great balance sheets, focus only on the most illiquid names. I measure illiquidity by average annual share turnover. The calculation looks like this:

    • 10 day average volume x 252 (number of trading days) / total shares outstanding

The smaller the percentage the better.

Once you get to this point, you’ll have a small list of potential investments. You can do one of two things. You can invest in a basket of microcap and illiquid stocks. Or you can take a more concentrated approach. It all depends on your risk tolerance and portfolio goals.

If you’re using this as a diversification tool within a larger, factor-based portfolio, a basket approach makes more sense. If you’re looking to change course or develop a true, private equity-type strategy — concentrated picks might be the move.

Let’s chat about risk management for a minute. Stop-losses aren’t as reliable in microcap investing given the wide bid/ask spreads. Keep this in mind as you’re deciding on which iteration of this strategy is right for you: basket or concentrated.

Risks of a Private Equity Strategy

Yes, this strategy works. And yes, you can generate significant outperformance. But it doesn’t come without its share of risks. Illiquid, micro-cap investing shares the same risks as the general market. Yet there’s three risks that are unique to an illiquid, micro-cap strategy:

1. Liquidity Risk

A PE strategy applied to public markets brings about liquidity risk. In other words, you might not be able to get out of a stock when you want / need to. In illiquid, micro-caps, there’s not always a complimentary buyer/seller on the other end of the trade. This also works the other way. It may take weeks or even months to establish a full position in an illiquid name.

Are you willing to sit in a position knowing full well you might not be able to get out of it in quick time?

2. Capital Constraints

The second major risk, if you want to look at it like that, is capital constrainment. An illiquid, micro-cap strategy works for small account sizes. The larger you climb the AUM ladder, the fewer companies you’ll be able to invest in. It breaks down to simple math. A $200M fund cannot invest in companies with $5M or less market caps.

3. Increased Volatility

I want to preface this by saying, no, volatility is not investment risk. Yet it is personality risk. Let me explain. An investment strategy is only as good as the person implementing it. So, if you can’t stomach random gyrations in share price, this strategy may not be for you. But, if you understand that share price isn’t indicative of intrinsic business value, you’ll welcome the volatility.

Illiquid micro-caps experience bouts of extreme volatility for several reasons. First, one investor can move the market. It may not be for fundamental reasons. Maybe his daughter needs a new car. Or the investor needs to pay for her vacation. In this space, we’re dealing (for the most part) with retail investors.

Concluding Thoughts

Thinking like a private equity investor in public markets is powerful. Through this lens, we can create a strategy that provides the best of both private and public markets. We leverage the alpha from illiquidity and smaller-sized companies, while retaining higher liquidity than conventional private equity offerings.

This strategy is backed by decades of research confirming its absolute outperformance over broader indices. Here’s the beauty of the strategy. You don’t have to implement it across your entire book. You can create a subsection of your portfolio dedicated to this illiquid, micro-cap space. In doing so, you increase portfolio diversification and expected long-term returns.

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Monday Dirty Dozen [CHART PACK]

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I have resigned from the professional undertaking of coin-flipping. I am not here to tell you where gold’s gonna be. I have no idea. That’s my existentialism. I am a student of uncertainty. I have no idea where the stock market is going to be. So when I am creating trades in my portfolio for my clients, I am agnostic. I just want to enhance the probability that I make money come what may.  ~  Hugh Hendry

In this week’s Dirty Dozen [CHART PACK] we look at the latest Global Fund Manager Survey data, walk through the growth versus value debate, look at falling capex in the oil and gas space, before discussing the dollar, the fall of empires, and recent COVID-19 growth numbers, plus more…

Let’s dive in.

***click charts to enlarge***

  1. BofA’s latest Global Fund Manager Survey (FMS) came out last week. Here are the highlights from the report. Summary: lots of bearishness and the pain trade is up in credit and equities.

 

  1. I like this chart. It shows that the lowest net % of respondents since 08’ think value with outperform growth. Now, I’m never one to fight a trend or step in front of a momentum train. But… we gotta be nearing the point where this theme becomes so disconnected from any possible future outcome that the mean reversion of reality will begin to kick in. I mean, there’s a lot priced in here.

 

  1. In a similar vein, SentimenTrader shows how extended this trend has become. “Russell Growth/Value ratio’s 14 month RSI right now is among the *HIGHEST* readings ever.

This only happened:

Feb 1980: stocks crashed next month in March 1980
Dec 1999: near end of dot-com bubble
July 2015: stocks crashed next month in Aug 2015”

 

  1. The trend is certainly being helped along by COVID-19, stimulus checks, and a new generation of speculators coming into the market for the first time. Goldman Sachs recently pointed out that “Trades consisting of just one contract now account for 13% of total volume.” And Bloomberg noted last week in a report that “In some popular stocks, like CMG and GOOGL, small options trades account for nearly ⅓ of total volume.”

 

  1. UBS thinks this period of historic underperformance from value may be coming to an end.

  1. Though this aggregated BAC credit and debit card spending by state data does show that the virus has caused a rift, essentially creating two separate economies. What macro hedge fund manager, Jim Leitner, calls the “dual economy of bits and things” in this recent Macro Hive podcast (link here).

 

  1. The FT published an article over the weekend titled “Boom to bust in the US shale heartlands” that’s worth a quick read (link here). With current prices well below the lowest average breakeven rates of some of the best US basins, companies are having to dramatically reduce capex spend, which was already on the low side. They say the cure for low prices is lower prices. This is the capital cycle at work. Lots of future opportunities will be born out of this.

 

  1. While the SPX is set to run into some selling pressure in the 3,000-3,100 range, the short-term path of least resistance remains up. When every sell setup fails and every dip gets forcefully bought, it’s a sign that the market is in a bull quiet regime. I think it’ll likely turn in the next 1-2 weeks but we need to wait for the market to change its tone. Until then, higher we go…

 

  1. I think the second half of this year is going to be fireworks in the DM FX market. There’s a lot of tight coiling going on — many springboards being geared up for launch. While I have my biases, I’m trying to stay agnostic on direction and will let the market dictate my trading. This chart from Bloomberg shows that positioning has not followed the move higher in DXY.

 

  1. My friend Kean Chan (@keanferdy) shared this great slide on the twitters recently showing how COVID-19 and souring US-China relations are accelerating the trend of deglobalization and reshoring. Mexico and Malaysia are two countries I’m a long-term bull on and this is one of the reasons why.

 

  1. Ray Dalio published his latest post in his “The Changing World Order” series (link here). It’s a good read and I appreciate how he attempts to quantify the various inputs that drive the rise and fall of empires. There’s some interesting stats in the post. But one area where I completely disagree with Dalio on — and I plan to write a post on this soon — is his blind bullishness on China. I’m of the very strong opinion that China will be a shell of its current self in 20-30 years’ time. Debt, history, and inherent regime fragility nearly ensure it.

 

  1. This heatmap from Exante Data shows the trend of daily growth in confirmed COVID cases across countries. Chile, Brazil, and India have the highest 3-day growth trends of the bunch.

Stay safe out there and keep your head on a swivel.

Quick-Take: Altisource Portfolio Solutions (ASPS)

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Business Description: Altisource Portfolio Solutions S.A. operates as an integrated service provider and marketplace for the real estate and mortgage industries in the United States and internationally. It operates in two segments, Mortgage Market and Real Estate Market. – TIKR.com

The Thesis: ASPS is an “ick” stock that doesn’t screen well, is currently losing money and sports negative earnings per share. But, the future is going to look very different than the past. This counter-cyclical company is expanding their Field Services business and diversifying away from their dependence on Ocwen, NRZ and RESI. We believe ASPS can return to profitable growth and ~13% EBITDA margins over the next five years as they expand their global footprint and reduce per-unit operating costs. For comparison, ASPS did $143M in operating income at 14% EBIT margins. If we’re right, we could see  $20/share and 200% upside.

Management seems to agree with our thesis as they’ve bought back stock hand-over-fist. CEO William Charles owns close to 40% of the company. Interests are aligned.

ASPS Business Segments

    • Field Services: Provides inspection, preservation and maintenance services for pre-foreclosure and post-foreclosure properties. It also provides invoice and oversight workflow solutions.
    • Marketplace: Provides residential asset management, brokerage, online marketing, and disposition services for foreclosures and short sales.
    • Mortgage & Real Estate Solutions: Provides solutions, services, and technologies for originating, buying, selling, and servicing residential mortgages.

Why The Share Price Collapse?

ASPS is unwinding its dependence on three main revenue sources: Ocwen, NRZ, and RESI. This has resulted in five straight quarters of revenue declines. The stock also sold-off hard during the COVID-19 panic amidst myriad government stimulus programs.

Why Should It Turn Around?

ASPS benefits from recessions. The more foreclosures hit the market, the more ASPS’ services are needed. The company should benefit from an incoming recession as people default on their mortgages due to lost jobs, reduced salaries, or continued COVID shut-down.

The company’s growing its customer base away from “The Big Three” mentioned earlier. This should further cement ASPS’ moat and bolster EBITDA margins over the next five years as they spread out costs over more customers.

Risks/Pre-Mortem

    • Not many people have defaulted on their homes in the last five years
    • Interest rates are low so people assume they won’t default
    • Most of their business comes from Ocwen, which itself is a bad business and their agreement ends in 2025

H/T to @hkuppy for putting this one on our radar.

Crisis Investing, Value vs. Growth, and Chapter 11 Bankruptcies

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As always, hope you had a great week. I got to spend the weekend at Hilton Head Island, SC. Beaches weren’t crowded so social distancing was a breeze. In true deep value fashion, we snagged our Airbnb at a 75% discount rate to its historical rental price. I told you we eat, sleep and breathe this stuff!

Anyways, enough about my travels. More stocks.

Our Latest Podcast Episodes:

Here’s what we cover this week:

    • Investing in Chapter 11 Stocks
    • An Aswath Damodaran Update
    • Bill Nygren on Investing in Crisis
    • Mittleman Global Value Equity Q1 Update

Let’s get it!

May 20th, 2020

Tweet of The Week:

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Investor Spotlight: Mittleman Global Equity Value

GIFs by tenor

Mittleman Global Value Equity: -33.4% in Q1 2020

Mittleman Global Value equity lost over 30% in Q1. The investment company takes a global approach to investing in small/micro-cap companies.

Here’s their portfolio stats as of April 1:

The portfolio’s cheap … real cheap. 33% of their holdings are in the US, 18% in Canada and 21% in Hong Kong.

Let’s take a look at their top three holdings:

    • Clear Media (100.HK)
    • Aimia, Inc. (AIM.CA)
    • Revlon (REV)

Clear Media (100.HK)

Business Description: Operates as an outdoor advertising company in the People’s Republic of China. It provides bus shelter advertising solutions. The company serves e-commerce, IT digital product, entertainment, beverage, food, realty, business/consumer service, realty, telecommunication, and education industries. As of December 31, 2018, it operated a bus shelter advertising network of approximately 54,000 panels covering 24 cities in Mainland China. – TIKR.com

What’s To Like:

    • Durable business with NIMBYism qualities
    • Strong insider ownership
    • 30% Gross Profit margins
    • 15% FCF Yield

What’s Not To Like:

    • Going through low-ball takeover offer
    • Chinese company
    • Low-ball offer, if accepted, represents significant value destruction

Mittleman’s Take: “The overleveraged status of CCO, into the maelstrom of the COVID-19 crisis, apparently led them to accept a very low valuation, which puts minority shareholders at risk should enough take up the offer. MIM is optimistic that enough shareholders will reject the low-ball offer. MIM has taken advantage of the price appreciation however and sold a significant portion of the position to buy a couple of new positions and add to select existing holdings”

Chart Analysis

The sudden jump in stock price reflects the low-ball take-out bid. Should shareholders reject the offer we could see it trade back down on the news.

Aimia, Inc. (AIM.CA)

Business Description: Aimia Inc., together with its subsidiaries, engages in loyalty solution business in Canada, the United Kingdom, the United Arab Emirates, the United States, Australia, and others.It invests in Club Premier, a Mexican coalition loyalty program; and BIG Loyalty, AirAsia’s loyalty program. The company offers loyalty strategy, program design, implementation, campaign, analytics, and rewards fulfillment; and the Middle East loyalty solutions business, which includes the Air Miles Middle East coalition program, as well as Intelligent Shopper Solutions (ISS), Aimia’s international data analytics and insights services. – TIKR.com

What’s To Like:

    • Crazy cheap based on NAV and net cash
    • Decent business providing a needed service to airlines and customers
    • Positive changes on the board

What’s Not To Like:

    • Cash burn creates melting ice cube
    • Long-standing distrust in management’s ability to unlock value

Mittleman’s Take: “Aimia also has C$700M in tax assets that MIM does not include in its NAV estimate of C$8.00 / US$5.75 per share, which is 3.8x the quarter-end price. Alas, the perverse illogic of market pricing at times, and yet what wondrous opportunities are produced by such sentimental extremes.”

AIM jumped almost 13% on April 29. The stock now sits at $2.77. This is still well beneath MIM’s estimate of fair value.

Chart Analysis

I missed this move when it broke out of its symmetrical triangle. Now I’m hoping for some sideways consolidation for another optimal reward/risk set-up.

Revlon, Inc. (REV)

Business Description: Revlon, Inc., through its subsidiaries, develops, manufactures, markets, distributes, and sells beauty and personal care products worldwide. The company’s Relvon segment offers color cosmetics and beauty tools under the Revlon brand; and hair color under the Revlon ColorSilk and Revlon Professional brands. Its Elizabeth Arden segment markets, distributes and sells skin care products under the Elizabeth Arden Ceramide, Prevage, Eight Hour, SUPERSTART, Visible Difference, and Skin Illuminating brands; and fragrances under the Elizabeth Arden White Tea, Elizabeth Arden Red Door, Elizabeth Arden 5th Avenue, and Elizabeth Arden Green Tea brands. – TIKR.com

What’s To Like:

    • 50% Gross Profit Margins
    • 87% Insider Ownership
    • Large Insider w/ Cash To Help Sustain Burn from COVID
    • Improved terms on short-term debt

What’s Not To Like:

    • Overleveraged at 16x Net Debt/EBITDA
    • Growing Long-term net debt
    • 20% Sales Hit due to COVID

Mittleman’s Take: “Revlon’s mass market positioning (except for the 20% of sales from prestige brand Elizabeth Arden) should play to the trade-down effect that tends to support mass market brands much better than prestige brands during recessions. Revlon will likely sell its hair colour business (#1 market share in mass market), its fragrance business or Elizabeth Arden for valuations high enough to facilitate substantial deleveraging of its balance sheet.”

Chart Analysis

REV’s range-bound between $16 and $9.50.

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Movers & Shakers: Bill Nygren & Aswath Damodaran

Bill Nygren and Aswath Damodaran are two heavy-hitters in the value investing world. This week we look at two of their latest publications. Let’s start with Bill.

Investing in Crisis with Bill Nygren

Value Investor Insight released their interview with Nygren on April 30. There’s a ton of knowledge bombs, so I encourage you to read the entire transcript.

Here’s some of my favorite snippets from the interview …

“Our early focus was to sort through all the companies whose share prices had fallen significantly to identify those that fell less on an enterprise-value basis and that were more in the eye of the storm.”

This is an interesting concept, and Nygren explains why they focus on enterprise value in the following paragraph:

“When share prices are indiscriminately cut in half, the company with net cash really has been much more heavily hit.”

Bill uses an example to illustrate this concept …

“A simple example: Say two stocks fall 50%, from $20 to $10. Let’s say one has $3 per share in net cash, so its EV has fallen from $17 per share to $7, meaning the market is valuing the business at 60% less than it did when the stock was at $20. The cash presumably was worth $3 before and still is, so the business is worth incrementally less than the fall in the stock price.”

The discussion then pivots towards their latest investment in Pinterest (PINS). I know, not the type of stock you’d expect in a traditional “value” portfolio.

But that’s why I love the guy.

Here’s his basic thesis on PINS:

“The company isn’t yet making money because it has incremental costs in preparing to be a much larger-scale enterprise than it currently is, and also because it is still in the early days of monetizing its platform. The priority to grow users – which now number more than 300 million on average each month, growing 15% a year – is higher than the priority to maximize advertising per user.”

This isn’t the first time we’ve seen PINS dropped in a value portfolio. Scott Miller’s Greenhaven Road initiated a position this past quarter.

Nygren finished the interview with a comment on lasting lessons from the COVID-19 equity collapse:

“We’re pretty good at looking past current events and what companies could be worth on a long-term basis. That doesn’t mean we’re better than anyone else at guessing how the virus evolves or when the economy returns to normal. We need to make sure our portfolios don’t depend on us being experts in areas where we are not.”

Aswath Damodaran: Re-examining The Value vs. Growth Debate

Damodaran’s latest Musings on Markets is loaded with discussions on global equities, valuations, gold, copper, etc. You name it, he’s covered it.

What we care about is his section on Value vs. Growth. I know, you can’t get enough of that debate.

Here’s my favorite bits …

    • “Value investors believe that it is assets in place that markets get wrong, and that their best opportunities for finding “under valued” stocks is in mature companies with mispriced assets in place. Growth investors, on the other hand, assert that they are more likely to find mispricing in high growth companies, where the market is either missing or misestimating key elements of growth.”
    • “It is quite clear that 2010-2019 looks very different from prior decades, as high PE and high PBV stocks outperformed low PE and low PBV stocks by substantial margins. The under performance of value has played out not only in the mutual fund business, with value funds lagging growth funds, but has also brought many legendary value investors down to earth.”

One major realization from this article was that low P/E stocks don’t always offer protection in downturns.

Check this out:

    • “Note that it is the lowest PE stocks that have lost the most market capitalization (almost 25%) between February 14 and May 1, whereas the highest PE stocks have lost only 8.62%, and to add insult to injury, even money losing companies have done better than the lowest PE stocks.”

That’s nuts! Damodaran caps this argument perfectly, saying (emphasis mine), “If I had followed old-time value investing rules and had bought stocks with low PE ratios and high dividends in pre-COVID times, I would have lost far more than if I bought high PE stocks or stocks that trade at high multiples of book value, paying little or no dividends. The only fundamental that has worked in favor of value investors is avoiding companies with high leverage.”

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Whitepaper of The Week: Investing in Chapter 11 Situations

In honor of JC Penny (pour one out!) I found an interesting whitepaper on Chapter 11 investment situations. You can read the entire paper here. The authors (Yuanzhi Li and Zhaodong Zhong) review the trading, value and performance of Chapter 11 investments.

Let’s dive in.

Setting The Stage

The authors looked at 602 total cases of Chapter 11 bankruptcy. Here’s the distribution of cases:

Here’s what the characteristics (metrics) of those 602 companies look like:

The average company in this study had $150M in net assets, lost around $9.5M in net income and generated -2% ROA.

What surprised me was the leverage ratio (total liabilities/total assets). It’s below 1.

Trading Post-Chapter 11

Chapter 11 stocks resume trading activity after a brief decrease post-filing. The paper shows this in the graph below:

This begs the question — who’s doing the trading in these post-Chapter 11 situations? The answer: not institutions

Here’s the graph:

The Performance of Chapter 11 Stocks

Let’s get to what really matters … return statistics. The paper defines performance by Holding Period Return (HPR). The holding period = number of days from the first trading day after filing to the resolution date, or the first trading day after the resolution date if there is no trading on the resolution date.

MHPR = monthly holding period return.

Here’s the breakdown:

MHPR = -16%

Ouch!

Concluding Thoughts

What should you take away from this study? Investing in post-Chapter 11 stocks are hard and (on average) lead to negative returns.

But I view post-Chapter 11 through the SPAC lens. Sure things are garbage on a median basis — but that shouldn’t stop you from digging through the dumpster. You never know what you might find! __________________________________________________________________________

That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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Stocks That Don’t Screen Well: Why It Happens & How To Find Them

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I like fishing. It takes my mind off markets and gets me out in nature. There are many parallels between fishing and value investing. When fishing, you want to fish where the fish are and the people aren’t. As value investors, this is music to our ears.

In most cases, these great fishing spots hide in the shadows. They’re off the beaten path. You have to crawl under branches. Weed through thorn bushes. Spots you wouldn’t otherwise find should you continue on the foot-trafficked path. But once you cut through the thicket, a honey-hole awaits.

It’s at this point you catch as many fish as you can. Do you tell everyone about the new fishing hole? Yes, of course. But only after you’ve caught all the fish you can take. Once word gets out, the spot dries up. No more fish.

Stock screeners are investing’s fishing holes.

Instead of fishing for bass, we’re fishing for shares of undervalued companies. But the principles still apply!

When you run a traditional “value” stock screener, you’re doing two things:

    1. You’re “fishing” where every other investor is fishing.
    2. Reducing your odds of finding something off-the-beaten path.

Using stock screeners prevents you from finding great, unknown companies.

Let’s dissect two types of businesses that won’t appear on any traditional value stock screener:

    1. Good Co. / Bad Co. Dynamic
    2. SaaS model Businesses

The Good Co. / Bad Co. Dynamic

The Good Co. / Bad Co. Dynamic is one of my favorite special situation-type investments. Through the following example you’ll learn the power behind this dynamic, and how to profit when you see it.

The Toothpaste and Toothbrush Example

Imagine you find a company, BRUSH Inc. (XYZ) trading for $10/share. BRUSH Inc. makes two products: toothpaste and toothbrushes. The toothbrush business is a great business. It boasts high margins, attractive variable cost structure and tremendous brand power. This segment generates $1.50 per share in operating earnings for the company.

At its current stock price, you could buy XYZ for 6.6x earnings. Not bad.

But remember XYZ’s other business, toothpaste manufacturing. Unfortunately for XYZ, the toothpaste business isn’t a good business. They can’t mix the right product. Sales are shrinking.  Management’s R&D investments turn into burnt cash. Margins are slim and they’re losing market share. Due to the above factors, XYZ loses $1.00 per share in operating earnings from its toothpaste division.

This is where things get interesting.

What GAAP (Generally Accepted Accounting Principles) Sees

According to GAAP, BRUSH Inc. generated $0.50 in operating earnings. How did they arrive at $0.50? GAAP subtracted the negative earnings from the positive earnings.

So instead of a 6.6x earnings multiple, investors are paying 20x earnings for the same business. A higher multiple and a lower earnings yield. Double whammy.

Why Screens Don’t Pick Up These Companies

In general, this type of company will have a high P/E ratio. This makes intuitive sense. The business generates lower total earnings based on its two operating segments.

We also know that many traditional value screens have a filter for P/E ratios. Most of which are below 20 – 25x.

In other words, most people aren’t looking at these companies. And it’s not because they don’t have the capacity. Rather they don’t even know they exist. They stayed on the beaten path.

This becomes an opportunity for investors like us. Investors that are willing to look under the hood and get our hands dirty.

Why it Pays To Find These Companies

Finding Good Co. / Bad Co. companies can be an extremely profitable venture. These businesses have potential catalysts at their fingertips. Once triggered, these catalysts can reward investors regardless of broader market trends.

The biggest catalyst for a Good Co. / Bad Co. business is the removal of the unprofitable operating segment. This requires management to check their ego at the door, admit something isn’t working and move on. Easier said than done. But what rewards would shareholders reap?

Let’s go back to our toothbrush/toothpaste example to see the benefits.

Shutting down the toothpaste division flips BRUSH Inc. from earning $0.50/share to $1.50. The stock goes from 20x earnings to 6.6x. The earnings yield catapults from 5% to 15%.

With one simple change, BRUSH Inc. now looks like a classic value stock trading at a massive discount to future earnings. Screens will pick up on this change after a while. Soon enough millions of investors will come to find the stock you knew existed all along.

This is why the good co. / bad co. dynamic is so powerful. If you find these types of businesses you can, in essence, fish where nobody else is fishing.

Which Ones Should You Buy?

Now this isn’t to say that all stocks with Good Co. / Bad Co. dynamics are good investments. Like most off-the-beaten-path areas of the market, discretion is advised.

One way to add a margin of safety is to invest in companies that are growing their profitable operating segment. You don’t want a business with a shrinking profitable segment. Soon you’ll end up with two negative operating segments and one bad investment.

Insider purchasing is another helpful indicator. If management’s about to make a change that will affect the stock price, this is where they’ll tip their hat. Remember, people sell for a variety of (legitimate) reasons. But they only buy for one: appreciation.

Knowing How Much To Pay

I like to calculate how much I can buy the good operating segment for, and in turn, get the bad business for free. If you’ve read previous Value Ventures letters, you know this is one of my favorite strategies.

I want to find companies where I don’t have to pay for a lackluster part of their business. Plus, if we think the business would be better off without the negative earning segment, why should we pay for it?

Software-as-a-Service (SaaS) Models

To understand why SaaS companies don’t screen well, we need to know a few key items. First, we need to know how they get customers. Second, we need to know how they receive revenue from those customers. Finally, we need to know the difference between the cost associated with acquiring the customer and the revenue generated from that customer.

The last part is often referred to as the Lifetime Value of the Customer (or LTV for short). Let’s use an example from a fictitious company, XYZ Software Solutions (SOFT).

Understanding Lifetime Value of the Customer

XYZ Software (SOFT) sells customer relationship management software on a subscription basis. They charge their customers $100/month with average contracts lasting 3 years. Let’s also assume they have high profit margins, around 75%.

This means that each customer generates around $3,600 in revenue and $2,700 in profit. This is our LTV.

Yet we know customers aren’t free. Given its sales & marketing spend, XYZ estimates its customer acquisition cost around $400.

On the surface, things look great. XYZ spends $400 to receive $2,700 in profit value per customer. Who wouldn’t want to invest in a model like that?

There’s just one problem. GAAP Accounting doesn’t see it that way.

What GAAP Sees

Under GAAP, XYZ must recognize the costs (expenses) to acquire the customer up-front. XYZ then recognizes revenue once XYZ provides the service. Instead of booking $3,600 as revenue from the customer, you have to recognize it over time, say per-month.

Doing that clouds the financial performance of the company. Now you have $400 of expenses up-front and only $300 of revenue coming in the door. That’s -$100 in losses for each new customer. That looks nothing like our above assessment of the company’s LTV.

GAAP accounting creates a natural distortion between the costs associated with acquiring the customer, and the profit from that customer. As you can see, this translates to optically negative financial statements. Which in turn, leads many SaaS businesses off value stock screens.

We’re Investors, Not Accountants

When it comes to analyzing SaaS businesses, GAAP won’t help us all that much. Instead, we should focus on four metrics:

    1. Bookings (or sales)
    2. Monthly Recurring Revenue
    3. Churn Rate
    4. Recognized & Deferred Revenues

Let’s dive into each category.

Bookings (Sales)

Think of this as the dollar value of the contract each customer signs. For example, if XYZ signs a $200K contract for their software, that’s $200K in bookings.

Remember, we can’t count all $200K as recognized revenue. This is the amount of revenue the business expects to receive over the lifetime of the contract. Tracking this figure provides a more realistic picture of top-line revenue growth.

Monthly Recurring Revenue

Many SaaS companies use Monthly Recurring Revenue (MRR) as their Key Performance Indicator (KPI). MRR serves as a baseline for all revenue the company generates on a monthly basis.

For example, if XYZ has five customers with $200K/year contracts, they’re Monthly Recurring Revenue (per customer) is $16,666. This becomes recognized revenue at this point. I’ll explain why.

Recognized & Deferred Revenue

As the name suggests, recognized revenue is revenue that is booked by the company after they provide the service requested in the contract.

Deferred revenue is simply the opposite. These are revenues that are “booked” (see bookings above), but the company hasn’t yet provided the actual service.

Under GAAP, Deferred Revenues are liabilities on the balance sheet.

This makes intuitive sense. When XYZ signed the $200K contract, they hadn’t provided a years worth of service to that customer. In other words, deferred revenues would be $200K on day of contract.  Check out the photo on the right for an example:

Deferred revenue decreases while recognized revenue increases as the company provides their service.

Churn Rate (Customer vs. Revenue)

Customer Churn Rate is the percentage of customers that stop their subscription during a given period of time. For example, say XYZ had 100 paying subscribers in Q1. But by the start of Q2 that number fell to 75.

The Customer Churn Rate would be 25% since a quarter of their customers churned through their subscription during the quarter.

Revenue Churn is the same principle as above, but uses revenue as the input instead of number of customers. Revenue Churn is a much more important metric for SaaS businesses that offer various pricing packages/deals. Why? Let’s break down the difference between the two.

Losing five customers sounds worse than losing one customer. And in some cases that’s true. If everyone pays the exact same amount, losing five is worse than losing one. Yet many SaaS business models offer varying pricing packages.

Things look different if a business loses one large “Enterprise” customer paying $150/month versus losing five “Starter” customers paying $10/month.

Example: SharpSpring, Inc. (Scott Miller of Greenhaven Road)

SharpSpring is a great example of the power of looking beyond GAAP accounting and quantitative screens.

I found the idea from one of Scott Miller’s quarterly letters. His thesis for the company played out well. There is one key aspect about SharpSpring that makes it a great case study. It hasn’t generated an operating profit.

So what did Miller see in SHSP?

    • High recurring revenue business model with tremendous unit economics.
    • The LTV per customer was significantly higher than their customer acquisition cost.

So, SHSP did what any reasonable company should do in that situation. They plowed all their profits into acquiring as many customers as they could. This makes sense.

Yet by investing all their cash back into the business, they had nothing left to show for “earnings”.

What did Miller have to say about SHSP’s capital allocation strategy?

“The right way to run this business [high LTV/CAC ratio], in my opinion, is to spend every available dollar on sales and marketing to build the customer base, not worrying about short-term profitability.

How To Find Stocks That Don’t Screen Well (How To Beat Machines)

This isn’t going to be a popular answer. It’s not one you’d see on a Motley Fool ad, either. The best way to find these types of companies — the ones that don’t screen well — is through brute force work.

I know. We live in an age where automatic processing is eating the world. Computing power reaches new levels each day. Yada yada.

Yet the only way to beat the machines is to find things that machines can’t pick up.

Quant-centered funds run exclusively on (you guessed it), quantitative data. Moreover, these funds, strategies and screens focus on historical data. They’re backwards looking.

Here lies the opportunity.

We have the benefit of being able to look forward into the future. Three to five years beyond the immediate horizon. We can make reasonable guesses as to where a business might end up in the next five years. Quants don’t care about that. They only care about what the company did in the past.

This isn’t a fault of quants themselves, but the strategies they use. Algorithms use old data to make buy/sell predictions about the current price. What these algorithms don’t (and can’t) understand are special situations when things change. Sometimes dramatically, sometimes due to GAAP accounting.

Method 1: Download Excel File of Ticker Symbols

You read that correctly. The first method to find stocks that don’t screen well is to download an Excel file and go through each stock symbol.

There’s three main benefits to doing this grunt work:

    1. You learn about a lot of different businesses, economic models and management teams.
    2. It improves your ability to quickly say “No” and quickly put companies in the “too hard” bucket.
    3. You’ll find hidden gems — if you look hard enough.

This is obviously the most time consuming method of finding companies that don’t screen well. But if you’re serious about investing, this is the best method. No time is wasted as you learn about businesses, say no to companies quicker and find your preferable industry.

Method 2: Change How You Screen

The tendency when screening is to focus on one objective: refine, refine, refine. If you’re going to use screens, cast a wider net.

The best way to widen your screen is to focus on higher-level variables. Variables like:

    • Market Cap
    • Enterprise Value
    • Insider Ownership
    • Debt/Equity

These types of variables aren’t as dependent on financial or balance sheet metrics. They provide a more qualitative feel to your screen.

My Favorite Screens

If I’m not going through companies one-by-one, I like to use a screen filtered by insider ownership. The screen still spits out 300+ names. I’ll then go through each of those one-by-one.

Concluding Remarks

Ronnie Coleman is one of the greatest bodybuilders of all time. When asked what it took to reach his level, he had this to say:

“Everybody wants to be a bodybuilder, but nobody wants to lift no heavy ass weights.”

Change a couple words and the quote applies to value investing.

“Everybody wants to be a value investor, but nobody wants to research no long ass list of stocks A-Z”

Value investing isn’t about hitting home runs and watching your gains fly. Yes, that can be an end result. Value investing is about the desire to understand businesses at deeper levels. It’s a longing to learn as much as you can. A lifetime of discovery.