One of the hallmarks of my investing style is that I usually invest in closely held companies. A closely held company is one where a shareholder, often a founder, or founding family owns a controlling stake. The idea is that with a closely held companies minority shareholder interests are aligned with the controlling holder's interests. There is a lot of research to back up this assertion and shows that family owned and closely controlled companies have outperformed the market over the long term. But long term outperformance doesn't mean there won't be a few duds along the way. While it's always nice to talk about and tout investment successes I think it's also important to look at our failures as well.
I wrote about First Aviation (FAVS) in last March. When I found them they were selling an unprofitable division for more than their current market cap. I've found that investments like that often end successfully. This is mostly because the profitable division's hidden value is exposed to investors. The company also has proceeds from the sale that can be used to fortify their balance sheet. When an investor can purchase a company for less than the proceeds from the sale and get a profitable business for "free" it makes sense to invest.
What took place at First Aviation didn't quite follow usual the divest your way to profits playbook. The company is an aviation parts supplier and outsourced maintenance vendor. They specialize in commercial propellor planes, the ones that are used on short haul commercial flights. The company's majority shareholder is an aviation focused private equity group located in Connecticut. I mention the location on purpose, the aviation company's facilities are in North Carolina, Wichita, and Texas. Yet the company leases their office space from the private equity group's headquarters. This was an item that gave me a bit of caution, but wasn't enough of a red flag to pass on the investment. It's hard for executives to manage a company remotely.
In the last year the company has done exactly what it said it would do, they used the proceeds from their division sale to pay down debt and their profitable division's profits have grown nicely. The company reported earnings last week where they reported they earned $.32 in the first quarter. Extrapolated out for the year the company could earn $1.20 a share or more, significant considering their shares trade at $8.40. They aren't only cheap on an earnings basis, they also trade for 68% of a growing book value.
The problem is shareholders aren't going to be the beneficiaries of this growth story. Management decided they'd prefer to take the company private by engaging in a 10,000 for 1 reverse stock split. Any shareholder who owns less than $84,000 worth of stock will be forced out of their shares and paid $8.40 per share in cash. The 10,000 share limit is significant in that it's a much higher amount than normal for a reverse merger. Most likely the company is squeezing out all but a few large shareholders by setting such a high threshold. The company is already a non-SEC reporting entity meaning they have less than 300 shareholders of record. This corporate action isn't an effort to stop filing and reduce costs, it's a way to eliminate all but larger shareholders.
When I purchased the stock shares were priced at $9, so this take-under won't be a huge loss, but it's still a loss. What hurts most about this transaction is that my initial thesis was, and still is correct. I would classify First Aviation as an investment failure, but not an investment mistake.
Unfortunately in the case of First Aviation having a significant controlling shareholder didn't help minority shareholders, it hurt them. I suspect this is because the majority holder is a private equity group who is only watching out for themselves and their (the PE investors) shareholders, not everyone. Private equity doesn't have a great reputation for being shareholder friendly. At times investors can profit investing alongside private equity firms, but it's not a relationship of equals. It's more like the minority shareholder is the bird riding on the rhinoceros' back. You can get a free ride, but if you're in the wrong spot you're likely to be crushed without regard.
I think it makes sense in response to this investment failure to consider whether I'd do anything differently? I'm not sure I would. If this company weren't going private I'd be happy to be a buyer at this price today, especially with how their results have improved. The lesson I've taken away from this investment is that even when everything works out according to a plan it's still possible to experience an investment loss. The problem is as a minority shareholder I am tagging along on all of my investments. I can't control what a company's management does to outside shareholders. If management decides to take action which is detrimental to shareholders I can experience a loss even if my investment thesis is correct.
My experience with First Aviation has made me wary of the recent news out on Schuff Steel, a company I wrote about in 2012. The Schuff family sold their controlling stake to a private equity group. Schuff has the potential to play out in a manner that's similar to First Aviation. The company's results have been recovering dramatically but it's possible outside minority shareholders won't get to enjoy the reward associated with the results.
Disclosure: Long FAVS, SHFK
Looking for value in the overlooked margins of the market.
Pages
▼
Scalable businesses and growth
Value investors have a reputation for not caring about growth. They want to buy a dollar for fifty cents regardless of any growth prospects. While value investors might not care about growth, businesses do. Businesses have an innate desire to grow, a longing to become larger and more prominent. I've spent a lot of time recently thinking about growth and scalable businesses, what follows are some of my thoughts on the subject by way of an analogy.
I want you to think of the market as a forest. A healthy forest is filled with a variety of trees and plants. There are tall trees, short trees, pine trees, oaks, maples, beeches, bushes, grasses, weeds, as well as numerous other plants. A forest doesn't grow all at once, it starts with a few grasses and slowly evolves into something mature. Markets are similar, they don't develop at once, they grow into maturity.
In a forest not all saplings grow into towering trees. Many saplings thrive for a while only to be deprived of enough sunlight or good soil before perishing. Sometimes a sapling falls victim to a grazing deer, or other destructive animal. Likewise there are more smaller companies in the market and not all of them will grow large. Some are small trees won't ever grow tall. Some fall victim to a predator, or are crowded out of the market place.
Given the right conditions, the right soil, and the right seeds a tree can grow large. A tree doesn't grow all at once, it takes decades. As a tree journeys from a sapling to a stalwart many things can happen destroying its progress. A tree might drop hundreds or thousands of seeds of which only a few become full fledged trees. Even less seeds become giant trees. A giant tree needs perfect conditions to crest above the other trees. Once it obtains a certain size it's own size becomes a strength. A larger tree can steal sunshine and nutrients from the rest of the forest. Size becomes a strength for a while.
Trees don't grow to the sky, eventually all trees, even the giant sequoias face an untimely end. Large trees are more susceptible to violent wind storms, they aren't as flexible as smaller trees. If the soil or environment changes large trees they have trouble recovering. Large trees are also targets for lumberjacks whose wood is more valuable.
The location in a forest helps determine the size of a tree. Have you ever noticed that the trees in a valley grow larger than the trees at the top of a hill? The trees at the top of a hill have less competition for light. The trees at the bottom of a valley need to grow above other trees in the valley plus the trees on the sides of the hill if they want light.
Companies trying to grow large face the same challenges as trees. For every large company there are hundreds of small companies attempting to grow quickly. Sometimes a small company successfully makes the journey from small to large, but often small companies remain small. People wonder why small companies stall out in their growth, why can't Second Cup become as large as Starbucks? What I find interesting is that we don't ask the same questions of the forest. Why don't we ask "why aren't all trees large?" There is a place for large and small trees in a forest, a forest with all large trees isn't healthy, there is no new growth. A healthy forest contains trees in all stages of growth. A healthy forest even contains weeds, which in the market might be promotional pink sheet companies with no hopes of profit.
There's an idea in the market that certain companies have moats, sustainable advantages that help them grow large. I believe the concept of a moat exists, but both small and large companies can have moats. Some large companies simply have size. They grew out of a set of circumstances that allowed them to capture marketshare faster than competitors. Once they achieved a certain size they were able to grow even faster due to their size. They are large, but they are also susceptible to storms or shifts in the market.
For a company to grow large it needs to exist in a perfect environment. It needs to have a product that serves a customer need, it needs a business model that's scalable, and it needs competitors who are slightly smaller and less equipped.
Most businesses are not scalable. Think about almost any local dining establishment. What makes it special is probably the cook and the ambiance. Those things can't be re-created, the cook can't be in two locations at the same time. A scalable business has a product that serve a need that can be created through a replicable process. There are many successful and profitable companies that are not scalable. I was thinking about the Jim Cramer franchise this afternoon. He's created a lot of wealth around his personality with books and TV shows. Yet when he decides to retire there will no one to take his place. There is not another Jim Cramer, his business will end. There are many companies like this where the personality of the founder is deeply ingrained in the business. Sometimes as investors this is hard to see. A founder retires and suddenly sales lag unexplainably. What we don't know is that the retired founder is the one who greased the wheels of the operation.
I would posit that almost all businesses are non-scalable. If one looks hard enough there is always a choke point or bottleneck that inhibits growth. Only a few companies are able to overcome this and grow into mega-cap companies. Look at Wal-Mart, or McDonalds. They have perfected the scalable business model. The problem is that as companies scale their complexity increases. Just like trees, as companies grow they become susceptible due to their size alone. If a storm comes and consumers decide they no longer want greasy hamburgers, fries and sugar laden soda McDonalds will have a hard time reacting quickly.
Large companies cannot grow infinitely, eventually their growth slows to the rate of GDP growth plus whatever financial engineering the CFO employs. As a company grows they need larger and large projects to move the needle. A small energy company might drill small wells that can provide a bonanza, yet a large company would ignore the same wells because it isn't worth their time. If a company is able to grow large enough their own size becomes an impediment. I remember reading an article a few years back about the chefs at McDonalds. They wanted to introduce a shrimp salad to their menu. They couldn't because the volume of shrimp they'd need to serve customers would quickly deplete the world's shrimp supply. As a result the company never introduced their shrimp salad (article). They are limited by their size.
There is a lot of money to be made by investors who can identify small saplings that will grow into towering oaks. If you find yourself owning a tree that's growing into a towering oak I'd recommend holding on tight and enjoying the ride. But keep in mind the ride could last decades or longer.
At the same time it's important to recognize that not all companies will grow large. Companies don't necessarily need to become towering trees to be successful. One of my favorite sights in the woods is a stand of young beech or aspen trees clumped together. What's vital though is to understand what you own. Do you own something that can scale into a tall tree, or merely a shrub. Some of the worst mistakes investors make are thinking shrubs or fast growing weeds will become sequoias.
When a tree finally dies it doesn't suddenly become useless. A fallen tree in a forest is a habitat for small woodland creatures. As a tree rots moss grows on it, insects inhabit it and it provides nourishment for the soil. Sometimes a dead tree becomes furniture, or boards for a home. Companies often face the same fate. It's unusual for a failed company to lock their doors and cease to exist. There are remnants of value, patents, intellectual property, and knowledge stored by former employees carried to their next ventures. In this way a dead company nourishes the forest long after it ceases to exist.
I want you to think of the market as a forest. A healthy forest is filled with a variety of trees and plants. There are tall trees, short trees, pine trees, oaks, maples, beeches, bushes, grasses, weeds, as well as numerous other plants. A forest doesn't grow all at once, it starts with a few grasses and slowly evolves into something mature. Markets are similar, they don't develop at once, they grow into maturity.
In a forest not all saplings grow into towering trees. Many saplings thrive for a while only to be deprived of enough sunlight or good soil before perishing. Sometimes a sapling falls victim to a grazing deer, or other destructive animal. Likewise there are more smaller companies in the market and not all of them will grow large. Some are small trees won't ever grow tall. Some fall victim to a predator, or are crowded out of the market place.
Given the right conditions, the right soil, and the right seeds a tree can grow large. A tree doesn't grow all at once, it takes decades. As a tree journeys from a sapling to a stalwart many things can happen destroying its progress. A tree might drop hundreds or thousands of seeds of which only a few become full fledged trees. Even less seeds become giant trees. A giant tree needs perfect conditions to crest above the other trees. Once it obtains a certain size it's own size becomes a strength. A larger tree can steal sunshine and nutrients from the rest of the forest. Size becomes a strength for a while.
Trees don't grow to the sky, eventually all trees, even the giant sequoias face an untimely end. Large trees are more susceptible to violent wind storms, they aren't as flexible as smaller trees. If the soil or environment changes large trees they have trouble recovering. Large trees are also targets for lumberjacks whose wood is more valuable.
The location in a forest helps determine the size of a tree. Have you ever noticed that the trees in a valley grow larger than the trees at the top of a hill? The trees at the top of a hill have less competition for light. The trees at the bottom of a valley need to grow above other trees in the valley plus the trees on the sides of the hill if they want light.
Companies trying to grow large face the same challenges as trees. For every large company there are hundreds of small companies attempting to grow quickly. Sometimes a small company successfully makes the journey from small to large, but often small companies remain small. People wonder why small companies stall out in their growth, why can't Second Cup become as large as Starbucks? What I find interesting is that we don't ask the same questions of the forest. Why don't we ask "why aren't all trees large?" There is a place for large and small trees in a forest, a forest with all large trees isn't healthy, there is no new growth. A healthy forest contains trees in all stages of growth. A healthy forest even contains weeds, which in the market might be promotional pink sheet companies with no hopes of profit.
There's an idea in the market that certain companies have moats, sustainable advantages that help them grow large. I believe the concept of a moat exists, but both small and large companies can have moats. Some large companies simply have size. They grew out of a set of circumstances that allowed them to capture marketshare faster than competitors. Once they achieved a certain size they were able to grow even faster due to their size. They are large, but they are also susceptible to storms or shifts in the market.
For a company to grow large it needs to exist in a perfect environment. It needs to have a product that serves a customer need, it needs a business model that's scalable, and it needs competitors who are slightly smaller and less equipped.
Most businesses are not scalable. Think about almost any local dining establishment. What makes it special is probably the cook and the ambiance. Those things can't be re-created, the cook can't be in two locations at the same time. A scalable business has a product that serve a need that can be created through a replicable process. There are many successful and profitable companies that are not scalable. I was thinking about the Jim Cramer franchise this afternoon. He's created a lot of wealth around his personality with books and TV shows. Yet when he decides to retire there will no one to take his place. There is not another Jim Cramer, his business will end. There are many companies like this where the personality of the founder is deeply ingrained in the business. Sometimes as investors this is hard to see. A founder retires and suddenly sales lag unexplainably. What we don't know is that the retired founder is the one who greased the wheels of the operation.
I would posit that almost all businesses are non-scalable. If one looks hard enough there is always a choke point or bottleneck that inhibits growth. Only a few companies are able to overcome this and grow into mega-cap companies. Look at Wal-Mart, or McDonalds. They have perfected the scalable business model. The problem is that as companies scale their complexity increases. Just like trees, as companies grow they become susceptible due to their size alone. If a storm comes and consumers decide they no longer want greasy hamburgers, fries and sugar laden soda McDonalds will have a hard time reacting quickly.
Large companies cannot grow infinitely, eventually their growth slows to the rate of GDP growth plus whatever financial engineering the CFO employs. As a company grows they need larger and large projects to move the needle. A small energy company might drill small wells that can provide a bonanza, yet a large company would ignore the same wells because it isn't worth their time. If a company is able to grow large enough their own size becomes an impediment. I remember reading an article a few years back about the chefs at McDonalds. They wanted to introduce a shrimp salad to their menu. They couldn't because the volume of shrimp they'd need to serve customers would quickly deplete the world's shrimp supply. As a result the company never introduced their shrimp salad (article). They are limited by their size.
There is a lot of money to be made by investors who can identify small saplings that will grow into towering oaks. If you find yourself owning a tree that's growing into a towering oak I'd recommend holding on tight and enjoying the ride. But keep in mind the ride could last decades or longer.
At the same time it's important to recognize that not all companies will grow large. Companies don't necessarily need to become towering trees to be successful. One of my favorite sights in the woods is a stand of young beech or aspen trees clumped together. What's vital though is to understand what you own. Do you own something that can scale into a tall tree, or merely a shrub. Some of the worst mistakes investors make are thinking shrubs or fast growing weeds will become sequoias.
When a tree finally dies it doesn't suddenly become useless. A fallen tree in a forest is a habitat for small woodland creatures. As a tree rots moss grows on it, insects inhabit it and it provides nourishment for the soil. Sometimes a dead tree becomes furniture, or boards for a home. Companies often face the same fate. It's unusual for a failed company to lock their doors and cease to exist. There are remnants of value, patents, intellectual property, and knowledge stored by former employees carried to their next ventures. In this way a dead company nourishes the forest long after it ceases to exist.
What's wrong in bank boardrooms?
This is annual report season for many companies, especially banks. Since I own 25+ banks in my portfolio I've been inundated with bank annual reports. I rarely read the entire report because in most cases I've already seen the bank's financials on CompleteBankData.com by the time I receive the report in the mail. Even though I've seen the financials I like to receive the reports for a few reasons. The first is I like to read the President's letter if there is one. Secondly I like to evaluate the quality of the report, by this I mean the material it was printed on. Some annual reports appear like they were Xeroxed off in the back room, stapled by the tellers and mailed third-class. Others are heavy card stock and fully of colorful glossy pictures and inspirational quotes. But what I really enjoy looking at are the profiles for the directors of the banks.
After thumbing through some of the proxies send with the reports this week I have to ask:
Who are the empty suits filling bank board rooms?
The board of directors at a company are supposed to represent shareholders' interest in the company. Shareholders elect them to hire and fire the management team and run the company for the benefit of the shareholders. That's the theory at least.
The reality is often very different. A bank's board of directors are usually friends and acquaintances of the CEO or Chairman. They are often somehow involved in the community which in the community banking world somehow qualifies them for directorship. A friend of mine jokes that being a funeral director is a qualification to being a community bank director.
If the board is tasked with managing the managers it would make sense for them to know about banking. Good managers should have an idea of what their subordinates are doing. Bad managers are clueless and often have their head in the sand. The problem is most bank directors have zero banking experience meaning they are ineffective at managing a bank's executives. At these banks the board is reduced to agreeing with management because they don't know better. If the CEO says the lending environment is difficult they agree nodding their heads in unison.
When I page through proxies for some of the banks I own I see directors that run HVAC companies, a golf course, an organic vegetable farm, a seafood company, and a lot of real estate and construction related businesses. In most cases the bank states that the individual's experience in running some small company in their community qualifies them because of their experience with the local market.
A former bank regulator told me a story about a bank he worked with in the 1990s. He said that as he was evaluating the board he discovered that all of the directors had ties to the local auto industry with most being car dealers. When the regulator began to examine the bank's loan book he found that most of the bank's loans were auto loans. Guess what dealerships were doing significant business with that bank? The regulators forced the bank to reduce their auto lending and change the composition of their board. Unfortunately management abuse isn't always that obvious.
I sometimes wish for radical and honest transparency. It would be refreshing to see the truth in a proxy. What if a director nominee's blurb stated something like this: "The CEO and the nominee's sons play on the same soccer team. The nominee and other directors have been in the same fantasy football league for 13 years." or "This nominee's business does significant business with the bank. The bank CEO informally agreed to put the nominee on the board in exchange for continued business."
Another axe I have to grind are with directors who make a career out of being directors. You know the type, their bio talks about a job they held in "business development" in the early 1980s. Since then their only experience seems to be serving on boards. Some directors serve on a number of different boards, enough that they can string together quite a salary.
There are always exceptions to the rule, but not many. One bank I own seems to have the type of board I'd like to see everywhere. FS Bancorp's board consists of individuals who have prior banking experience, or worked in finance and investing. Another exception is in the bio of one director at Sound Financial. This director works in the food industry but states that he has taken extensive training courses and seminars on banking during his term as a director. Even though his professional experience isn't in banking he's made a significant effort to learn the industry something that should be applauded.
There are two solutions to this problem, a regulatory solution and a market solution. The regulatory solution would be a set of rules that force director independence. These rules already exist and they don't seem to be working. The market solution is for investors in these sleepy and mismanaged institutions to fire the directors and to nominate new ones with satisfactory backgrounds. Some of this is accomplished through activist investors, but the majority of the work needs to come from non-activist bank shareholders. I vote against almost all director nominees at banks I own. If someone owns a Vitamin Shoppe that doesn't qualify them to be a director, I let the bank know that with a no vote.
Disclosure: Long Sound Financial, Long FS Bancorp
After thumbing through some of the proxies send with the reports this week I have to ask:
Who are the empty suits filling bank board rooms?
The board of directors at a company are supposed to represent shareholders' interest in the company. Shareholders elect them to hire and fire the management team and run the company for the benefit of the shareholders. That's the theory at least.
The reality is often very different. A bank's board of directors are usually friends and acquaintances of the CEO or Chairman. They are often somehow involved in the community which in the community banking world somehow qualifies them for directorship. A friend of mine jokes that being a funeral director is a qualification to being a community bank director.
If the board is tasked with managing the managers it would make sense for them to know about banking. Good managers should have an idea of what their subordinates are doing. Bad managers are clueless and often have their head in the sand. The problem is most bank directors have zero banking experience meaning they are ineffective at managing a bank's executives. At these banks the board is reduced to agreeing with management because they don't know better. If the CEO says the lending environment is difficult they agree nodding their heads in unison.
When I page through proxies for some of the banks I own I see directors that run HVAC companies, a golf course, an organic vegetable farm, a seafood company, and a lot of real estate and construction related businesses. In most cases the bank states that the individual's experience in running some small company in their community qualifies them because of their experience with the local market.
A former bank regulator told me a story about a bank he worked with in the 1990s. He said that as he was evaluating the board he discovered that all of the directors had ties to the local auto industry with most being car dealers. When the regulator began to examine the bank's loan book he found that most of the bank's loans were auto loans. Guess what dealerships were doing significant business with that bank? The regulators forced the bank to reduce their auto lending and change the composition of their board. Unfortunately management abuse isn't always that obvious.
I sometimes wish for radical and honest transparency. It would be refreshing to see the truth in a proxy. What if a director nominee's blurb stated something like this: "The CEO and the nominee's sons play on the same soccer team. The nominee and other directors have been in the same fantasy football league for 13 years." or "This nominee's business does significant business with the bank. The bank CEO informally agreed to put the nominee on the board in exchange for continued business."
Another axe I have to grind are with directors who make a career out of being directors. You know the type, their bio talks about a job they held in "business development" in the early 1980s. Since then their only experience seems to be serving on boards. Some directors serve on a number of different boards, enough that they can string together quite a salary.
There are always exceptions to the rule, but not many. One bank I own seems to have the type of board I'd like to see everywhere. FS Bancorp's board consists of individuals who have prior banking experience, or worked in finance and investing. Another exception is in the bio of one director at Sound Financial. This director works in the food industry but states that he has taken extensive training courses and seminars on banking during his term as a director. Even though his professional experience isn't in banking he's made a significant effort to learn the industry something that should be applauded.
There are two solutions to this problem, a regulatory solution and a market solution. The regulatory solution would be a set of rules that force director independence. These rules already exist and they don't seem to be working. The market solution is for investors in these sleepy and mismanaged institutions to fire the directors and to nominate new ones with satisfactory backgrounds. Some of this is accomplished through activist investors, but the majority of the work needs to come from non-activist bank shareholders. I vote against almost all director nominees at banks I own. If someone owns a Vitamin Shoppe that doesn't qualify them to be a director, I let the bank know that with a no vote.
Disclosure: Long Sound Financial, Long FS Bancorp
Australian Vintage Ltd, inexpensive, but cheap?
On a recent post a reader recommended that I take a look at an Australian wine industry stock, Australian Vintage Ltd. I've historically done very well investing in wineries and wine related stocks so it only made sense to investigate Australian Vintage Ltd (AVG.Australia).
I think it helps to invest in companies and businesses where the investor has no opinion of the product. I am not much of a wine drinker, I will have a glass with relatives at a holidays, but that's about it. I've had a variety of wine from the $2 bottles at Trader Joes to $150 bottles received as a gift. As a consumer I have the ability to appreciate fine wine, but I don't have any strong tastes or preferences.
Our own preferences can be blinding with an investment. If I only liked Pinot Noir I might hesitate to research Australian Vintage because they're renowned for their white wine. If I were familiar with wine I might recognize the placement of their product at the liquor store, or have a thought on their product. If I had a strong view of a company's products I might have trouble seeing what the numbers say about an investment.
Australian Vintage is a wine grower and producer in Southern Australia. They have three main wineries and their products are shipped worldwide. They crush 150,000 tons of grapes, and sell 85m liters of wine annually. They grow their grapes on 11 vineyards, which are both owned and leased. Their best known brand is sold in Australia and the UK under the name McGuigan. In the US they market their own brands as well as sell bulk grapes to wineries such as Gallo, which produces affordable table wine.
The main attraction for this investment is their valuation. They have a market cap of $82m and tangible equity of $172m. Their book value is higher than tangible equity at $281m, but also includes goodwill, deferred tax assets and water rights. The company is profitable, they earned $3.3m in the first half of 2014, and $7.1m in 2013. Lastly management is very focused on paying a dividend, which was 2.6 cents fully franked (franked means the company paid the tax for shareholders, a non-franked dividend would be higher) per share last year.
The company's results started on a steady decline in 2006. When I see a company with a low valuation and very marginal results I ask myself: "Is this a company problem, or an industry problem?" Company problems are issues specific to the company that corrected would reverse their negative direction. Industry problems are issues that all companies in a given industry are facing. It's very easy to identify which sort of problem a company is facing, look at their competitors. Australian Vintage is facing an industry problem along with other Australian wine producers.
The company's future and results are closely tied to their industry, the Australian wine industry. Over the last five to seven years Australian wineries have struggled against a strong currency and over capacity. These headwinds have harmed the industry as a whole eliminating profits and shrinking margins. Conditions have somewhat stabilized as companies adjusted to the operating environment. The companies still in operation have found a way to survive and are managing to produce small profits.
I've discussed investment pivot points in the past and I came up with two pivot points for this investment:
The answer to the first question is that I don't believe the Australian wine industry will remain in a slump forever. While it might never return to the level of profits it achieved in the early 2000s it will recover. That's because the industry has shaken out weak players and companies have reduced expenses. Even a slight recovery will result in significant profits for everyone involved due to improved cost structures. Unfortunately no one knows when a recovery might happen, and investors are notoriously impatient. If something isn't a quarter or two away investors are often inclined to sell a stock and walk away.
Answering my second pivot question is tougher. The company is earning just enough to stay in business under the current conditions. They've reported very slight increases in profits and sales and expect that to continue. The company has done a lot of right things to get their expenses under control. They have reduced operational expenses and worked to increase their gross margin. They're also working to upscale their brands. The problem is all Australian wineries see upscaling as a solution. Particularly troubling is that the company was heavily indebted and had a number of onerous contracts up until recently. They raised capital through an equity offering to pay down their debt and re-negotiated their onerous contracts, both good things.
The company's debt ratio has been reduced to 39% of equity, and their interest expense is covered 5x. It also looks like their results don't fully reflect the value of their renegotiated contracts. What's been troubling me as I've researched Australian Vintage is their use of debt. They don't have enough cash on hand to finance inventory, so they use debt to finance it. In 2012 they had a very large vintage harvest which required a debt increase. The concern is that they could have a large vintage that coincides with a reduction in demand, or negative currency movements. In that case they would have financed a lot of inventory that they're unable to sell. Beyond being able to sell the inventory they'd also have financing costs to worry about.
It's easy to get hung up on what the worst case scenario might be for a company. I kept reminding myself that the company is already operating in a worst case scenario environment. If someone would have asked their CEO to describe his nightmare operating conditions in 2003 he might have described what exists now. An extended period of time with a strong currency coupled with a large amount of excess capacity and lagging demand for Australian wine. In this worst case situation the company has managed to cut costs and turn a profit. Things could easily get worse, but the company is already priced for bankruptcy.
If the company were to declare bankruptcy, the worst case for stock investors, they could pay off their debt with their fixed assets. Their fixed assets were recently assessed at $120m against the company's borrowings of $107m. That would leave investors with the company's working capital which is $157m, still double the current market cap.
I don't love this company, but I love their valuation. At 28% of book value almost nothing needs to go right for investors to realize a return. If the company can continue to survive they will eventually gain the benefit from a tail wind. The company doesn't even need to be worth book value for investors to benefit. If the market suddenly believes they're worth 60% of book value an investor here doubles their money. The icing on the cake is that while investors wait for a recovery they can collect a 6.2% dividend.
As I looked at this I re-assessed Treasury Wine Estates (TWE.Australia), the larger and more well known Australian wine producer. Treasury Wine Estates is trading for 80% of book value and is facing the same industry headwinds. They've been making changes to their business in an effort to thrive in the current environment as well. If Australian Vintage were to trade at 80% of book value like Treasury Wine Estates they'd be worth $224m. If Australian Vintage were rewarded the same P/E as Treasury Wine Estates they'd trade for book value.
Disclosure: Long Australian Vintage
I think it helps to invest in companies and businesses where the investor has no opinion of the product. I am not much of a wine drinker, I will have a glass with relatives at a holidays, but that's about it. I've had a variety of wine from the $2 bottles at Trader Joes to $150 bottles received as a gift. As a consumer I have the ability to appreciate fine wine, but I don't have any strong tastes or preferences.
Our own preferences can be blinding with an investment. If I only liked Pinot Noir I might hesitate to research Australian Vintage because they're renowned for their white wine. If I were familiar with wine I might recognize the placement of their product at the liquor store, or have a thought on their product. If I had a strong view of a company's products I might have trouble seeing what the numbers say about an investment.
Australian Vintage is a wine grower and producer in Southern Australia. They have three main wineries and their products are shipped worldwide. They crush 150,000 tons of grapes, and sell 85m liters of wine annually. They grow their grapes on 11 vineyards, which are both owned and leased. Their best known brand is sold in Australia and the UK under the name McGuigan. In the US they market their own brands as well as sell bulk grapes to wineries such as Gallo, which produces affordable table wine.
The main attraction for this investment is their valuation. They have a market cap of $82m and tangible equity of $172m. Their book value is higher than tangible equity at $281m, but also includes goodwill, deferred tax assets and water rights. The company is profitable, they earned $3.3m in the first half of 2014, and $7.1m in 2013. Lastly management is very focused on paying a dividend, which was 2.6 cents fully franked (franked means the company paid the tax for shareholders, a non-franked dividend would be higher) per share last year.
The company's results started on a steady decline in 2006. When I see a company with a low valuation and very marginal results I ask myself: "Is this a company problem, or an industry problem?" Company problems are issues specific to the company that corrected would reverse their negative direction. Industry problems are issues that all companies in a given industry are facing. It's very easy to identify which sort of problem a company is facing, look at their competitors. Australian Vintage is facing an industry problem along with other Australian wine producers.
The company's future and results are closely tied to their industry, the Australian wine industry. Over the last five to seven years Australian wineries have struggled against a strong currency and over capacity. These headwinds have harmed the industry as a whole eliminating profits and shrinking margins. Conditions have somewhat stabilized as companies adjusted to the operating environment. The companies still in operation have found a way to survive and are managing to produce small profits.
I've discussed investment pivot points in the past and I came up with two pivot points for this investment:
- Will the Australian wine industry remain depressed forever?
- If it recovers will Australian Vintage be able to last long enough to enjoy a recovery?
The answer to the first question is that I don't believe the Australian wine industry will remain in a slump forever. While it might never return to the level of profits it achieved in the early 2000s it will recover. That's because the industry has shaken out weak players and companies have reduced expenses. Even a slight recovery will result in significant profits for everyone involved due to improved cost structures. Unfortunately no one knows when a recovery might happen, and investors are notoriously impatient. If something isn't a quarter or two away investors are often inclined to sell a stock and walk away.
Answering my second pivot question is tougher. The company is earning just enough to stay in business under the current conditions. They've reported very slight increases in profits and sales and expect that to continue. The company has done a lot of right things to get their expenses under control. They have reduced operational expenses and worked to increase their gross margin. They're also working to upscale their brands. The problem is all Australian wineries see upscaling as a solution. Particularly troubling is that the company was heavily indebted and had a number of onerous contracts up until recently. They raised capital through an equity offering to pay down their debt and re-negotiated their onerous contracts, both good things.
The company's debt ratio has been reduced to 39% of equity, and their interest expense is covered 5x. It also looks like their results don't fully reflect the value of their renegotiated contracts. What's been troubling me as I've researched Australian Vintage is their use of debt. They don't have enough cash on hand to finance inventory, so they use debt to finance it. In 2012 they had a very large vintage harvest which required a debt increase. The concern is that they could have a large vintage that coincides with a reduction in demand, or negative currency movements. In that case they would have financed a lot of inventory that they're unable to sell. Beyond being able to sell the inventory they'd also have financing costs to worry about.
It's easy to get hung up on what the worst case scenario might be for a company. I kept reminding myself that the company is already operating in a worst case scenario environment. If someone would have asked their CEO to describe his nightmare operating conditions in 2003 he might have described what exists now. An extended period of time with a strong currency coupled with a large amount of excess capacity and lagging demand for Australian wine. In this worst case situation the company has managed to cut costs and turn a profit. Things could easily get worse, but the company is already priced for bankruptcy.
If the company were to declare bankruptcy, the worst case for stock investors, they could pay off their debt with their fixed assets. Their fixed assets were recently assessed at $120m against the company's borrowings of $107m. That would leave investors with the company's working capital which is $157m, still double the current market cap.
I don't love this company, but I love their valuation. At 28% of book value almost nothing needs to go right for investors to realize a return. If the company can continue to survive they will eventually gain the benefit from a tail wind. The company doesn't even need to be worth book value for investors to benefit. If the market suddenly believes they're worth 60% of book value an investor here doubles their money. The icing on the cake is that while investors wait for a recovery they can collect a 6.2% dividend.
As I looked at this I re-assessed Treasury Wine Estates (TWE.Australia), the larger and more well known Australian wine producer. Treasury Wine Estates is trading for 80% of book value and is facing the same industry headwinds. They've been making changes to their business in an effort to thrive in the current environment as well. If Australian Vintage were to trade at 80% of book value like Treasury Wine Estates they'd be worth $224m. If Australian Vintage were rewarded the same P/E as Treasury Wine Estates they'd trade for book value.
Disclosure: Long Australian Vintage
Announcing the Oddball Stocks Newsletter
A while back I wrote a post where I tossed around the idea of starting an investment newsletter. Based on the responses I received from that post I decided to go ahead and publish a newsletter. I'm pleased to announce that the first issue is finished and published.
The Oddball Stocks Newsletter can be best thought of as a premium version of this blog. I post a lot of things on here, but my best ideas are going straight to the newsletter. That's not to say I won't ever post about great investments here, I will continue to do that. But the best ideas are reserved for subscribers.
I don't want to give much away about the first issue, but I will say this. All four ideas in the first issue are selling for 50% of intrinsic value. A discount almost unheard of in this market.
For subscription information please visit: http://www.oddballstocksnewsletter.com
A subscription to the newsletter includes:
The Oddball Stocks Newsletter can be best thought of as a premium version of this blog. I post a lot of things on here, but my best ideas are going straight to the newsletter. That's not to say I won't ever post about great investments here, I will continue to do that. But the best ideas are reserved for subscribers.
I don't want to give much away about the first issue, but I will say this. All four ideas in the first issue are selling for 50% of intrinsic value. A discount almost unheard of in this market.
For subscription information please visit: http://www.oddballstocksnewsletter.com
A subscription to the newsletter includes:
- An introduction letter containing general thoughts, thoughts on the current market, investment strategies, and other musings.
- At least four new investment idea write-ups.
- An update section with information on oddball stocks. This is where you will find information on stocks that have been profiled in the past, or other stocks worth mentioning.
- A guest investment idea. The newsletter doesn’t just find undiscovered stocks, it finds undiscovered managers too. A guest investment idea by an undiscovered manager is included in each issue. These are managers who have innovative investment ideas that aren’t well known by the market.
- A profile on an attractive bank stock.
- All issues are distributed digitally in a PDF format.
- An annual subscription consists of six issues approximately spaced two months apart.
- The cost is $295 a year.
Learn more or subscribe: http://www.oddballstocksnewsletter.com
The language of investing
I have a friend who has described investing to me as similar to learning a language. At first you start by translating a word or two at a time, then you attempt to piece together simple meanings. Eventually with enough practice you can read and speak complete sentences and convey thoughts in the new language. Investing is similar in many regards.
There have been a number of studies that have "proved" that investing in low anything (EV/EBITDA, P/E, BV) and recycling the portfolio result in superior returns. Mechanical approaches like this and other approaches such as investing in mutual funds, or ETFs are what I would consider the beginner level of learning a language. The investor buying their first ETF is akin to someone learning that "hola" means "hello". There is nothing wrong with only being able to say a few words in a language, and many people never progress beyond learning some simple salutations and other basic words. For many investors just knowing the beginning words are enough, returns will be satisfactory. Many never have an interest in learning a second language, or becoming a full fledged investor.
I think many investors are stuck between knowing the basics of a language of being fluent. Fluency is a moving target, and it doesn't mean knowing the entirely of a language. This past winter while skiing in Utah I stayed with my cousin. One night we went out with some of his friends, one who is a Spanish teacher in Salt Lake City. I asked him about being a language teacher and how he taught Spanish; his answer surprised me. He said he doesn't just teach words or phrases, but teaches abstract thinking and reasoning. He said language learning isn't about knowing words and their meanings, it's about knowing context and knowing what words to use when. The same word placed in two sentences can mean different things, a fluent speaker knows and understands this. But someone learning a language struggles and in place of reasoning tries to learn rules. Language rules are complex and almost infinite. Nothing is consistent. My four year old son struggles with putting some words in the past tense. He will say he "digged" a hole. The "ed" isn't the appropriate past tense for dig, yet for the word "type" adding an "ed" is the appropriate way to place it in the past tense. Language evolves as people use it, which means the rules evolve with usage.
Investing rules are no simpler or easier than language rules. Excess cash on a balance sheet might be a good thing for one company, but a negative at another. A low P/E ratio doesn't always indicate that a company is selling at a low multiple of their earnings, it might be a cyclical at the top. Even something simple like revenue can mean multiple things. The right type of revenue that's high margin and serviceable is good. But low margin or negative margin revenue is bad.
As an investor starting out learning how to invest navigating financial statements can be daunting. Subtleties caught by an experienced investor can be missed by a novice. Likewise sometimes experts get caught up with the grammar of investing. I love listening to quarterly conference calls where analysts spend most of their time asking investing grammar questions. You'll hear questions such as "Just to clarify, was the quarterly spend on dixie cups for the office kitchen up 1.2% or 1.17%?" It's easy to get lost in the weeds. I remember reading a conference transcript about a year ago, the company was losing money and clearly needed a turnaround. Analysts were asking minutia questions and debating investing grammar with the executives. Then a retail investor was allowed to talk and asked the obvious, why was the company failing, and when would it be fixed? Sometimes we need clarity like that.
Moving from rules based investing to something more fluent means moving towards a system with a lot of gray, and not much black and white. To do this an investor needs to learn the context of the company and then within that context make decisions about their valuation from their financial statements. Getting to this level is to become fluent in the language of investing. What will start to happen is the clunky translation rules that were relied on originally will start to be forgotten.
When an investor becomes fluent in the language of investing they also develop a style. This is similar to a writer in a natural language. Different writers have different styles. Even when one writer tries to emulate another their own style shines through. I think this is why it's so hard to classify investors. As we learn and become fluent we develop our own styles. There are certain types of companies I like to own, but it's hard to define exactly what those are. Yet when I see one that fits my style I know right away that I want to own it.
The goal for investors should be to become fluent in the language of investing. From that you will develop your own investing style. It's alright if it's not the exact same as a famous investors, no one is a copy of anyone else. The only way to become fluent and develop a style is to start investing and practice.
There have been a number of studies that have "proved" that investing in low anything (EV/EBITDA, P/E, BV) and recycling the portfolio result in superior returns. Mechanical approaches like this and other approaches such as investing in mutual funds, or ETFs are what I would consider the beginner level of learning a language. The investor buying their first ETF is akin to someone learning that "hola" means "hello". There is nothing wrong with only being able to say a few words in a language, and many people never progress beyond learning some simple salutations and other basic words. For many investors just knowing the beginning words are enough, returns will be satisfactory. Many never have an interest in learning a second language, or becoming a full fledged investor.
I think many investors are stuck between knowing the basics of a language of being fluent. Fluency is a moving target, and it doesn't mean knowing the entirely of a language. This past winter while skiing in Utah I stayed with my cousin. One night we went out with some of his friends, one who is a Spanish teacher in Salt Lake City. I asked him about being a language teacher and how he taught Spanish; his answer surprised me. He said he doesn't just teach words or phrases, but teaches abstract thinking and reasoning. He said language learning isn't about knowing words and their meanings, it's about knowing context and knowing what words to use when. The same word placed in two sentences can mean different things, a fluent speaker knows and understands this. But someone learning a language struggles and in place of reasoning tries to learn rules. Language rules are complex and almost infinite. Nothing is consistent. My four year old son struggles with putting some words in the past tense. He will say he "digged" a hole. The "ed" isn't the appropriate past tense for dig, yet for the word "type" adding an "ed" is the appropriate way to place it in the past tense. Language evolves as people use it, which means the rules evolve with usage.
Investing rules are no simpler or easier than language rules. Excess cash on a balance sheet might be a good thing for one company, but a negative at another. A low P/E ratio doesn't always indicate that a company is selling at a low multiple of their earnings, it might be a cyclical at the top. Even something simple like revenue can mean multiple things. The right type of revenue that's high margin and serviceable is good. But low margin or negative margin revenue is bad.
As an investor starting out learning how to invest navigating financial statements can be daunting. Subtleties caught by an experienced investor can be missed by a novice. Likewise sometimes experts get caught up with the grammar of investing. I love listening to quarterly conference calls where analysts spend most of their time asking investing grammar questions. You'll hear questions such as "Just to clarify, was the quarterly spend on dixie cups for the office kitchen up 1.2% or 1.17%?" It's easy to get lost in the weeds. I remember reading a conference transcript about a year ago, the company was losing money and clearly needed a turnaround. Analysts were asking minutia questions and debating investing grammar with the executives. Then a retail investor was allowed to talk and asked the obvious, why was the company failing, and when would it be fixed? Sometimes we need clarity like that.
Moving from rules based investing to something more fluent means moving towards a system with a lot of gray, and not much black and white. To do this an investor needs to learn the context of the company and then within that context make decisions about their valuation from their financial statements. Getting to this level is to become fluent in the language of investing. What will start to happen is the clunky translation rules that were relied on originally will start to be forgotten.
When an investor becomes fluent in the language of investing they also develop a style. This is similar to a writer in a natural language. Different writers have different styles. Even when one writer tries to emulate another their own style shines through. I think this is why it's so hard to classify investors. As we learn and become fluent we develop our own styles. There are certain types of companies I like to own, but it's hard to define exactly what those are. Yet when I see one that fits my style I know right away that I want to own it.
The goal for investors should be to become fluent in the language of investing. From that you will develop your own investing style. It's alright if it's not the exact same as a famous investors, no one is a copy of anyone else. The only way to become fluent and develop a style is to start investing and practice.