Category: Columns

$NXEOW Warrant Recap (& Maybe Post-mortem) $UNVR

Reading Time: 3 minutes

It’s been awhile since I’ve discussed the Nexeo warrants, which are now tied to Univar’s stock performance following the acquisition. At one point, I’m pretty confident this blog was the go-to place for information on the merger and its impact on the warrants.

Unfortunately, none of that matters now. We have 145 days to expiry and the strike price is $27.8034 vs. UNVR currently trading at $20.64. History would tell me that this isn’t unsurmountable, but it may not be likely that UNVR is in the money.

But  I try to be an optimist (especially because I still own a lot of NXEOW), so I do have a couple points on why I think the warrants could possibly make it. To be clear, I’m grasping for straws here because Univar really needs to make it to $30 to get the warrants sufficiently in the money.

UNVR has materially underperformed its peers  

This chart compares returns for a broad set of chemical stocks. UNVR has materially underperformed, but that makes no sense. UNVR distributes these company’s chemicals! If the suppliers are doing well, odds are UNVR should be doing well.

If UNVR had performed in line with the average of these names, it would be at $28.70 right now, not closer to $20.

Macro Data is Suggests Chemicals Should be in Strong Demand

Ok, the last chart was pretty hand wavy. But it makes sense why the chemical stocks have ripped. The underlying data is suggesting a really strong economy.

PMI is “an index of the prevailing direction of economic trends in the manufacturing and service sectors. It consists of a diffusion index that summarizes whether market conditions, as viewed by purchasing managers, are expanding, staying the same, or contracting”

So PMI is a measure of expansionary or declining conditions, with 50 being neutral. Clearly we are expanding in these markets.

This isn’t a perfect comparison, but look at PMI vs. the basic materials index. You can see the correlation in their performance. The only thing to remember is that XLB is a basket of stocks that should build value over time whereas PMI can only bounce between 0-100.

In my view, there’s no reason why UNVR shouldn’t be performing better. Commodity prices have improved, industries such as autos and housing (which consume a lot of chemicals) are doing much better. And all of UNVR’s suppliers are doing much better. I guess we’ll find out if they can close the gap.

Post Mortem

Since this may not pan out, I’ll go ahead and write my brief post mortem. I DON’T have regrets investing in these warrants. I say that despite the fact that I stand to lose a decent chunk of change on them.

I had strong conviction Nexeo was being underappreciated by the market and the warrants were a levered bet on that view. Nexeo was indeed taken out, despite tons of pushback from people saying Univar wouldn’t ever do it. I saw the opportunity to possibly 6x my money with downside being the ticket to play the game.

Once people digested what the acquisition meant, the warrants basically doubled in a day. But there are some real lessons here.

  • First, try to avoid warrants in companies that play in commodities. Commodities can swing to the upside putting you quickly in the money, but it can obviously go the other way too.
  • Second, pigs get slaughtered. When you’re up a lot on a warrant or call option, just get out. I should have sold all my warrants and just bought UNVR’s stock if I thought it was still good (even though in hindsight I know it has underperformed now).
  • Third, don’t be duped by a long time to expiry. “I have so much time until these warrants expire… a lot can happen”. Yes, a lot CAN happen. Including a global pandemic.  I should have instead said, “you know what, I think Nexeo / Univar will build a lot of value over 3 years and I should just ride the equity”

What World Changing Things Will Come From This Episode of Irrational Exuberance?

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I think pockets of this market are clearly showing signs of irrational exuberance. The valuations of companies with no revenue, or even products yet, is alarming. I don’t know much about Nikola, but despite a credible short report and the CEO stepping down, they have no product but a $7.6BN equity valuation. I talk about View windows later in this post because even though they have a product, they have $30MM in revenue and a $2.2BN valuation. It is laughable.

Buffett had a good point in one of his shareholder meetings in the 2000’s. He noted that some of these companies wouldn’t even be able to raise debt, but their stock valuations are huge. I see that today – that’s View, in my view.

The point of the post isn’t to argue about these names, it’s not even an argument about “market timing” because I don’t believe you can do that effectively. There are also still some cheap names out there. But I do want to lay some groundwork that there is excess.

But the main point I am wondering what infrastructure is being laid down today that we will benefit from in the future? For example, the tech bubble destroyed returns for any investor in any of the most exciting names. However, the exuberance also led to a lot of fiber cable being laid that we now benefit from today.

You could say there was a huge transfer of wealth. Investors got completely hosed, likely lost most of their money, but the infrastructure led to consumer surplus way down the road.  If you don’t want to hear me discuss the exuberance first, then skip to the end of this post.

We have a SPAC mania. SPAC’s are literally called “blank check companies.” I am giving you a check to just go out and do something — and demand has never been higher. That seems somewhat lost on people. I guess people also don’t realize this is a red hot contra-indicator. When SPACs are booming, that’s a clear sign there’s too much money chasing too few things and probably not a great time to be investing (i.e. “I don’t know what to do with this money… but YOU do… take my money!”).

The last SPAC boom was 2006-2007… was that a great time to be investing in hindsight?

We now dwarf that period. Sure, IPO’ing isn’t easy. But that doesn’t explain all of this.

I would call it desperation to “catch the next thing.” Even though SPACs have totally misaligned incentives, are paying extreme prices for “businesses” they still pop on the announcement, effectively making the deal even more expensive. With the market this wide open, do you really think the seller got the worse end of the deal in the SPAC transaction that it requires trading up?

I recently tweeted the following explanation:

We’ve all seen the huge bid ups in electric vehicle or battery SPACs.

As an aside, one of my favorite SPACs (and by favorite, I mean laughable), is View – which is being brought public by a Cantor Fitzgerald SPAC (ticker CFII). View makes “smart windows” for commercial buildings. By “smart” they mean that you can change the window tint and that helps save energy, allows people to work near windows without heat discomfort, and reduces glare. Despite being around since 2007, View only has $30MM in revenue… The valuation? Right now around $2.2BN… Given the commercial property market right now, its hard for me to imagine upgrading to these windows or choosing them outright…

I immediately thought, “so… they compete with blinds?” and yes they address that upfront. I mean, c’mon, this is kind of hilarious story. Glass is “magical material.”

Let’s look back at other speculative areas and the benefits that actually came from them:

  • The 1840s: Railway Mania. Railroads had emerged and were completely changing the transportation of goods and people. You could now bring freight across the country at a fraction of the cost. It was a clear pattern bubble in the stock market though, but all this capital flooding into the sector helped build more and more railroads.
  • The 1920s: Right before the Great Depression, there was a major stock market mania. I believe it took ~20 years (as we exited WWII and had an economic boom) for investors to break even. Why was there so much speculation? The world had seen the dawn of the automobile, aircraft, radio, and the electric power grid. It was an exciting time. It’s likely that some of this speculation lined the pockets of these manufacturers to create newer and better products.
  • Tech Bubble / Fiber Cable: “the demand seemed so obvious that scores of new telecom carriers sprung up and by 2001 had hung, buried and bored $90 billion worth of fiber-optic cable across the U.S. Optimists predicted Internet traffic would grow 10-fold every year.” That didn’t really pan out and there was a huge fiber glut. But demand for internet traffic caught up and if it wasn’t for all that cheap bubble money, who knows if our gains from the internet would have been as rapid.

So what will lead to consumer surplus in the future?

  • Is it the electric vehicle? With all the capital flowing into the sector, it seems like a self fulfilling prophecy (not that investors will make money in the next 10 years, just that the cars will proliferate at a fast pace).
  • Is it software that increases our productivity? SAAS valuations are pretty high. And I’ve seen many of them issuing equity. This too may be self-fulfilling in that we get better and better software in our lives.
  • Is it further E-Commerce? We’ve seen Amazon take over the US and with COVID 19, every company is investing in e-commerce. Will this get better and better for the consumer?
  • Is it democratization of finance? Big banks have huge barriers to entry… their competitive advantage is cost of capital. But capital is cheap right now, soooo

Moving to the Suburbs has been a Phenomenon… for Decades

Reading Time: 3 minutes

I’ve finally had enough of the headlines, anecdotes, “anec-data.” Everyone thinks COVID is driving people crazy and ditching their city for the outskirts. I hear over and over that this is a new trend we need to watch.

New York City is dead“… “I heard my buddy is moving to the suburbs… maybe even a different state”… “Miami will become the new Silicon Valley / NYC.” Guess what? Moving from the cities to the suburbs has been happening for decades.

Look, I’m not defending New York City. It is losing share of population. I’m pointing out a terrible narrative bias problem. Narrative bias refers to people’s tendency to interpret information as being part of a larger story or pattern, regardless of whether the facts actually support the full narrative. In this case, COVID killed New York, or San Fran, or the office building, etc.

I’ve got 4 points on this. 

Zelman is the leader in real-estate research. They recently had a great blog post on this “new trend.” As they detail, Wyoming and Montana realized a gain in population growth. Is Wyoming the new New York City thanks to COVID???

No. As they say, the 2010-2020 timeframe will mark the fifth consecutive decade in which population growth for the most dense states at that time ranked as the weakest quintile.

Where were these Miami headlines before when CT, NJ and NY were losing population share?

There are three other points I’ll make:

Talk to me when all of the allure of the major cities is able to turn back on, not when when it is closed.Similar to seeing E-commerce sales boost in Q2, we have to remember the alternative (brick and mortar) was largely shut down. Similarly, nearly all the benefits of a city have been taken away – colloboration in person at work, grabbing beers at 5pm on a Friday with everyone, going to the bars and great restaurants in general. Its no wonder to me that NYC is being cast out (with its current, stricter rules) in favor of Miami (which anecdotally seems like its operating back-to-normal).

Second, millennials. Millennials are finally aging into marriage and children age (the eldest millennials are nearing 40, while the youngest are mid-twenties). Households will be getting larger soon. No more living in the basement with mom and dad that was all the rage post financial crisis. Millennials now have enough savings to buy a home vs. the condo (especially with the drop in interest rates).

Therefore, it surprises me not at all that there is a boost in suburban sales.

Lastly, people have been congregating for thousands of years. In my sociology class in college, I learned the theory that if something has persisted for thousands of years in society, it probably has a purpose. I think humans will continue to congregate in cities, maybe just not the Northeastern or Western ones that have high taxes.

“But DD – we now have video conferencing! No need to go into the office!” We’ve had video conferencing for at least a decade. Everything thinks it works much better now. Maybe it does. But I think it works the best now because everyone is using it. Once half the team goes back into the office (including the Boss), people will start to not like it again. “Bill – you are on mute” isn’t as forgivable when everyone is in person except for you.


Hidden Gem at Central Securities $CET

Reading Time: 5 minutes

I typically spend my time analyzing small cap, underfollowed stocks. But I’ve been drawn to closed-end funds for a long time, so I wanted to write a quick post on Central Securities Corp, where we are getting a blue-chip stock portfolio PLUS a top notch insurance company for free.

Most investors have crossed passed with closed-end funds: They’re alluring because they can trade at discounts to NAV, meaning if they liquidated tomorrow, many would result in 10%+ returns just from the discount narrowing (i.e. I can buy a dollar for 90 cents). Unfortunately, discounts often persist without a clear catalyst.

However, there’s one closed-end fund that I’m not buying for a discount to narrow over the next year or even 10 years. I’m owning the Central Securities for (i) the manager who has a great track record, (ii) who owns great companies with low turnover (personally, I get Akre / Phil Fisher / Buffett vibes), and (iii) a hidden insurance asset on the books that makes the discount even more steep.

I think I’m literally “being paid to wait” through an outstanding manager while its largest asset compounds at what I expect will be better than market.

The really interesting thing about CET’s performance is that they own a concentrated fund and the turnover is very, very low. Check out these holdings from the report.

I have to admit – It would be extremely difficult for me to hold Motorola for this long. Or Analog Devices. But at the end of the day, these are largely blue chip stocks.  Other top holdings include Charles Schwab, Berkshire Hathaway, Intel, Capital One, Liberty Latin America, Kennedy Wilson, and so on.

Who is this manager? Central is one of those closed-end funds that started back in the 1920’s. However, the track record is owed to Wilmot H. Kidd III and he’s been at Central for almost 50 years. His son, Kidd the IV, also works at Central. Eventually the baton will be passed on (Kidd the III is 77) and that may be a catalyst for Central in one way or another.

But I want to focus on that top holding, a private company called The Plymouth Rock Company.

Plymouth Rock is a P&C insurer, providing home & auto insurance. However, the manager of the insurer makes me just as excited as Kidd the III. Despite being a private company, they have a financial information section of their website.

Here you’ll find the annual letters from Jim Stone, the chairman and founder of Plymouth. Now this is some Buffett-esque letters. Plymouth, like Geico, invests its float in equities. And their track record is also amazing.

Below are some of the comments in the 2019 letter. I personally can’t wait for the 2020 letter.

Here’s the track record of Plymouth book value over time — it’s a 13% CAGR over 23 years!

One thing you’ll notice about this table is that the value is discounted for “lack of marketability”. The value is appraised by a third party, Shields & Company, as “the price at which the relevant shares would change hands between a willing buyer and a willing seller, both in the possession of reasonable knowledge of all relevant facts, with neither party being under any compulsion to act or not act.” That is the value presented in the table above which is then discounted.

This is where it gets interesting: Central DOUBLE Discounts. 

I pulled the Plymouth Rock values from Central Securities and then compared it to the appraisals from Plymouth. Central is valuing Plymouth Rock at an extreme discount.

Central provides reasoning. They use market comps as well as a massive discount to the appraised value. I’m not sure a 30-40% discount makes sense…

It seems pretty clear to me that CET is just using 1.2-1.3x Book Value for valuing Plymouth. (Note, we don’t have the valuation yet for 2020)

Honestly, paying 1.3x book value for a company that has compounded capital so greatly seems cheap, but currently this is roughly where P&C insurers are trading (Allstate, Travelers, though Progressive is 3x for its growth).

CET trades at 18.7% discount to NAV. Given Plymouth  Rock is ~22% position (based on CET’s valuation), we are almost getting all of Plymouth Rock for free.

As of 9/30/2020, the value of Plymouth on CET’s books was $206MM. This foots to a price of ~$7,250/share for Plymouth Rock (down about 5% from 2019 value of $7,600). This also means that Plymouth is worth about $8/share to CET’s NAV, again 22%. But CET trades at a significant discount to NAV. So if we invert and say  Plymouth is worth the reported value, then at the market price Plymouth is worth 25% of NAV.

Appraised value is obviously more compelling: If we assume the discount is about what the average has been since 2015 (36%), that means Plymouth would be appraised at $11,316/share, or $322MM vs. what CET reported at $206MM. This means Plymouth actually makes up 31% of NAV or nearly 40% of market price.

So invert what I just said before: you believe in the value of Plymouth then you are getting a lot of blue chip stocks for free!

How will Plymouth Rock asset be monetized? I frankly don’t care – I’m fine owning it for 10+ more years if it can compound BV at its current rate and am currently getting it for free. (In the meantime, I also own other blue chip stocks under Will Kidd’s management.)

However, I think insurance will continue to consolidate over time, so it’s possible they do sell it eventually. A strategic would likely pay in excess of 1.5x due to synergies. I don’t think an IPO is likely given its been private for 30+ years.

CET has sold shares in Plymouth in the past. However, with hindsight, those have been mistakes in my view given Plymouth has continued to compound book value at such a high rate.

Secret SAAS Businesses

Reading Time: 4 minutes

SAAS stocks are all the rage. While the S&P500 is up ~12.5% at the time of writing, the Tech-Software ETF is up 41%. Over the past 4 years, the gap is +215% for Software and +88% for the S&P.

It makes some sense. These are companies that have long runways of growth, are FCF generative (if you count stock-based comp as an addback, but point is they tend to be people-heavy, but asset lite), and a good portion of them are really sticky businesses through the subscription model.

A sticky business is important. Imagine you’re a business owner trying to prepare shifts for your employees. You don’t know if a customer will come into your store or if you’ll be bombarded that day. If you are bombarded, you might lose sales because you don’t have enough staff. Recurring revenue companies can plan much more effectively and align costs with revenues appropriately.

I’ve outlined this before, but the subscription models also tend to spend a lot of money on just acquiring the customer. So the first year, the business isn’t that profitable, but on renewal it is highly profitable.

Also think about this dynamic in COVID-19 impacted world. Economies were literally locking down. I was running scenarios on companies that I’ve never had to do before – “how would these businesses look with ZERO revenue for the next 3 months.” If you’re in a business where you are mission critical to the customer and get paid a small monthly fee for that service, then you weren’t sweating it as much.

Therefore, I think there was a changing of the guard this year. Well, maybe it actually happened in the 2015/2016 recession scare. (The latter would make more sense because that’s when we saw the atmospheric launch of FANG and SAAS.)

Investors had long been valuing recession proof businesses at much higher multiples than more cyclical peers. Think Utilities, Consumer Staples, large Healthcare companies. I think following the great financial crisis (the GFC), it had a big psychological impact on investors – “try not to own things that can get crushed like that again.” And therefore, the discount rate on these cash flows went lower (due to perceived lower risk).

SAAS combines those attractive characteristics with ultra growth. But the subscription really made it easy to count on what was going to be in the bank account. So low discount rate + hypergrowth = highly valued.

Secret Subscription Models

Something I’ve been thinking about the past few years is “secret SAAS” or really, “secret subscription” businesses. These have very similar characteristics to SAAS, but aren’t in software.

Some of these companies have highly recurring revenue, but may not have a monthly subscription. Some of these names are also dominant and will own their category, but it might be niche and many people just don’t know about them.

The only thing missing from my list is the hypergrowth. But you also aren’t paying 10-100x sales for any of them…

Perhaps I’ll do a post on each of these, but please feel free to reach out, comment below and comment on Twitter (@DollarDiligent) names you think should be added to the list.

Secret Subscription Business Models (no particular order):

  • Flavor and Fragrance Names such as Sensient Technologies and International Flavor & Fragrances
    • I really like names that are critical to an end product’s use, but are a very low cost input. This typically translates into limited switching and little pushback from some price increases
    • Flavors & Fragrance names provide the products that impart taste, texture, or smell to consumer end products.
    • These are mission critical. They also are sold into pretty recurring end market – food and fragrance.
  • WR GraceAre you a refiner that wants to upgrade that barrel of oil into higher value products like gasoline or jet fuel? Well – you need a catalyst. The catalyst creates a chemical reaction to start the process. This is also true in creating plastics.
    • Unfortunately for you, refiner, you can only get this catalyst from 3-4 companies. But they are very high touch, high R&D businesses and the cost of the catalyst is very little compared to the cost of a refinery.
  • Beacon Roofing and Carlisle Roofing segmentThere is a large installed base of roofs. And many were put in place 15+ years ago. As they age, the roof needs to be replaced.
    • No matter what the economy looks like, if the roof is leaking, it needs to be replaced ASAP.
    • This leads to very high recurring revenue (albeit storms can make some years lumpy)
  • Moody’s / S&P Global / MSCINeed to refi your bond? S&P and Moody’s are the gatekeepers. Need to access the ratings? If you want to access detailed reports, investors need to pay a fee. In a large market, this adds up to highly recurring revenue (in addition to other platform services the companies offer, such as Platts and Cap IQ)
    • For MSCI and S&P – Having managers benchmark to your indices provides a highly recurring fee each year. Changing your benchmark tends to be a “no no” and the more recognized the benchmark company, the more circuitous it is
  • Apollo and Blackstone and other asset managers.
    • Earn management fees on a large, mostly locked up capital. Sure, there are incentive fees that may not be highly recurring, but the bulk is actually just management fees
  • Franchisors – many come to mind like Domino’s, Planet Fitness, McDonald’s etc. These names take little capital to run themselves and earn recurring royalty fees from the franchisees