Category: Investment Philosophy

Why I like to invest in good companies with bad balance sheets $PAH

If you take a look at my investment recommendations over 2018, you might notice a lot of the companies I target have poor balance sheets (as measured by debt / EBITDA or debt / total capitalization). Why do I target these companies?

  1. The Equity market clearly overreacts to highly levered names (which provides opportunity to nab good businesses)
  2. Patience is rewarded
  3. As the company pays down debt, every dollar of debt paid down is a dollar gained to the equity

It may be best to walk through a few examples. And to be clear, in most cases, I am discussing names that don’t have near-term maturity issues as it is hard to bank on the capital markets always being open. That is my one important disclaimer.

The company I will be discussing today is Platform Specialty Products, a specialty chemical company that originated as a SPAC formed by Martin Franklin. Franklin is a serial deal maker, known for a strong track record at Jarden where he conducted dozens (maybe even hundreds) of bolt-on acquisitions. According to Fortune, Jarden’s 10 yr annualized return was 17.9%. Not too shabby.

Anyway, Franklin’s strategy with Platform was to buy “Asset light, high tough” business. That is, those with limited capital intensity, but high margins because of the service the businesses provided to its customers. Essentially, it was targeting really strong businesses. It also would have a target leverage range of 4.5x, which is on the higher end of companies, but if you assumed the companies were worth 12.0x together, it wasn’t that big on a debt to cap basis.

Long story short, after a series of frenzied acquisitions (mostly funded via debt), Platform got over its skis, fundamentals for its Agriculture chemicals business got burned by the Brazil real devaluation, and the company was 7.0x levered. The stock fell from $28 to slightly below $6, valuing the company at ~8.0x EBITDA (when comps were trading at double-digits), plus a high-teens FCF yield to equity, and a portfolio of strong businesses.

pah_chart

The headlines and chatter at the time were ridiculous. The company’s nearest maturity was >5 years out and people were concerned about Platform tripping a covenant (it had no covenants other than on its revolver, which would only spring into play if it was drawn down a significant amount. Even still, revolver lenders roll over on these covenants pretty customarily as they do not want to own the business).

As the company addressed some of its debt problems, the stock moved up to $15/share ~1 year later for ~150% return.

This to me is a clear example of the 2/3 items I noted above (except for number 3, which I’ll show more below). The problem for some investors is that the volatility in share price can pick up because of this, but as Warren Buffet likes to say, if your neighbor shouted a price to buy your home everyday, would you panic and sell if the number he shouted began to go down? Certainly not.

Let’s then look at a home and the math of it being funded more with leverage and assume the mortgage will be covered by rent. As you can see, putting 20% down on a house and assuming no growth in rent or home price appreciation provides a nice little IRR. Notice each dollar of debt paid down accretes to the the equity. The reason being that you are essentially LBO’ing your home in America.

(Note, I assumed a 5% mortgage rate here)

home 80_20

Now that is pretty good, but what if you were looking at an investment of solid property, same assumptions. This will be an investment for you that you plan to dump in 5 years, but you have to pay a 5.5% mortgage rate to compensate for higher risk (i.e. putting less cash down).

home 90_10

As a result, you get a 70% return on your money (vs. 40% in the first example) and put less down which frees up capital to put elsewhere.

Levered bond?

Said another way, if you view a high quality company as a stream of cash flows, then levering those cash flows can help boost returns.

Let’s say you bought a 5% coupon bond trading at 95 with 100% equity. If you held it to five years to maturity and sold it at par (or 100) your IRR or yield to maturity would be ~6.2%.

Bond IRR_Equity.PNG

Now lets say you bought that bond by borrowing half of the purchase price with debt, funded at 3.5% (which Interactive Brokers actually offers, so I’m not being crazy). The IRR then boosts to 8.8%.

Bond IRR_debt.PNG

There’s clearly risk here if the bond does not return par, since leverage cuts both ways. If the bond only paid back 90 cents on the dollar, you’d be down ~10% instead of only 5%.

All in all, this is no different than private equity. They have tremendous returns partially because they don’t have to mark-to-market every day like public equity fund managers do. That’s why I like these scenarios as a long-term investor. In the case that something goes right for these levered assets, that obviously provides even more upside.

As I result, I have invested in past in names that were levered 8x when I thought the business was worth 6x when I thought the fundamentals were moving in the right direction and EBITDA growth would help the leverage scenario. I’ve also bought into companies that were in the middle of negotiating covenant relief with banks, as banks typically will provide relief if it is a result of 1x issues or even a cyclical issue that is expected to pass in the longer term and the company can still make payments.

 

Catching Falling Knives amid Headline Risk $FB $AAPL $MSFT

Here we go again. Facebook’s stock has hit another pocket weakness and was down to $132/share as I write this piece (-5.5% on the day). New articles have been posted in the media about Facebook having a morale problem and there has been in-fighting and finger-pointing during this time of “chaos” in the company…

All of this sounds eerily familiar to an article entitled “Apple’s Employee Morale Problem”, published in 2013, another which pointed to its top execs leaving, published in 2012, or the plethora of articles written about how Apple can no longer innovate (published first in 2013 and again in 2015).

If you recall, these articles were being published at a time when it was not fun to be a shareholder of Apple. It was absolutely a falling knife and the headlines everyday were only negative. Although we have hindsight to help us, we now know what those headlines ended up being worthy of…

You can’t blame the media for publishing on large cap names that have been under selling pressure. If you own the stock, you’re definitely going to search around and see what the hell is going on. Is there something I am missing? “If key employees are leaving, how will the business stay on top?” Selling begets selling and articles get clicks.Apple

What I love about the stock market is that we can come back to real data in our analysis to see what is priced in. As of this writing, Facebook trades at 7.7x 2020e EBITDA… by comparison Microsoft trades at 13x. Apple trades at 9.1x. Visa, no question a good business, trades at 17.6x EBITDA… The S&P in aggregate trades at 12.6x LTM.

Facebook looks way too cheap me today, especially when you look at sales growing at 20%+ CAGR at least over the next 3 years (and they haven’t even truly monetized WhatsApp yet). The business also earns extremely high returns on capital, which supports the multiple. In other words, Facebook is worth more than the average S&P500 company…

I cant help but think this is another case of Apple. Can I say when the slide will stop? No. But I can look at the numbers to help realize the market is pricing in much worse case than I think will be the reality.

Growth vs. Value… Why not both?

I’ll admit it. When someone asks me what type of investor I am, I always say value investor. But is that accurate? What really is the difference between the two?

On one hand, traditional value investors would describe themselves as ones who buy statistically cheap stocks. The companies they buy may be down and out, but there is still a solid business supported by earnings / cash flows that you can nab for cheap. If sentiment improves or results come in better than feared, that’s all gravy.

On the flip side, I think growth investors are often relegated to universe of momentum investors. They are viewed as ones searching quickly growing companies and often ignore what the earnings of the business are.

But is this description correct or warranted? I often think of growth and value investors as one in the same. Value investors are searching for companies that they think can be a low hurdle that investors are ascribing to the business. Growth investors are searching for assets that they think will beat a high hurdle.

In fact, I’ve come to learn over the years that growth can pay for a lot of sins. As Charlie Munger once said,

“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with a fine result.”

Facebook’s recent decline in which it lost more than any other company in a single day is an example of this. At the end of the day, yes. Facebook has had some privacy issues among other things, but it is still a solid platform. They also own Instagram (which I spend way too much time on) and Whatsapp. Indeed, even after the disappointing earnings call that led to the drop, analysts still expect sales to grow 25% over 2018’s level and 21% in 2020. EBITDA is expected to grow at a 20% CAGR as well (slower than sales due to the company’s margin comments).


Let’s examine what can happen when you buy an asset that is growing at this level. Note, this is not Facebook’s results, but an example of how growth can pay for “high-multiple” transgressions. Facebook currently has ~60% EBITDA margins, so allow me to use something more along the lines of Google and Apple at high 30s range (which is still incredible, though capex will also be high).

Let’s say you buy a business similar to this for 20x EBITDA (for context, FB trades for 14.3x est. EBITDA for this year).

Hypothetic buy

Again, these are all made-up numbers, but lets assume strong growth rates for the next few years that starts to level off over time. The business maintains high incremental margins (but offset by capex reinvested in the business). I assume little debt needed as these businesses such as Google, Apple, and Facebook don’t actually consume much cash (which is why their cash balances balloon).

Hypothetic buy 2

As you can see, the end result is still extremely attractive. I cut the multiple to 8x EBITDA which is well below where it started at 20x. The important factor still, as I have written before, is that the business has a competitive moat so that it can reach these targets. If they can, tech companies in particular are attractive since a company like Facebook or Google have tremendous platforms and additional customers or users cost next to nothing for them to serve.

On the flip side, if you’re buying a fashion retailer (something that is subject to fads), or a technology that is good today but could be disrupted tomorrow, then this is less attractive because it could be here and grow well in year 1, but destroyed in year 2 (perhaps a Snapchat IPOing vs. Instagram stories…).

Beware of anecdotal evidence when investing…

There’s one thing I can’t stand when I hear an argument: Anecdotal evidence.

I think humans are inherently story tellers and perhaps a good story provides some comfort. To me, though, it is no different than someone saying, “well my Dad smoked a pack of cigarettes a day and he lived to be 90!” Ok, so is that actually good evidence for me to smoke? Or should I trust the troves of actual, scientific evidence that says I should not smoke? (yes, I know I just wrote an article about “sin” stock out-performance)

Equally, when I hear a stock pitch or reason for investment, I hate to hear anecdotal evidence as a real justification. Here are some examples:

  • Media: I just cut the cord and hear all my friends are too. Cable companies like Comcast are going to face pressure
  • Transportation: I hear millennials are all about traveling compared to buying new products. I am buying airline stocks that will benefit from this.
  • Healthcare: My grandma needs a lot of medical attention. As the baby boomer wave hits retirement, the amount spent on healthcare is undeniable going up.
  • Retail: I only shop at Amazon now. All other retail / distribution is essentially un-investable.
  • New Technology: I read an article on how this [new technology] was able to do [something in a novel way]. There’s going to be a paradigm shift in the way we do things.

I think this type of investing is popular for a few reasons. For one, it is easy. You can just identify something you know and think of a company that will benefit from a trend. Second, Peter Lynch often wrote in his books that his children would talk about something they liked, he bought the stock, and it ended up being a 5-bagger or something.

I do think it is extremely important to be aware of trends, but this sort of investing has led to a lot of trouble. You also have to know “what is priced in”. For example, look at the return of Comcast since cord cutting really starting about 10 years ago — it is up 300%+ compared to the S&P return of ~170%. Sure Netflix is up more, but do you think many people analyzed whether or not growth in other Comcast businesses would offset the traditional cable model? Or that this was a lower margin business so therefore it didn’t impact earnings as much as one would expect? Also think about how much people complain about Comcast… yet it still prints a lot of money. That is a testament to its business model!

On the flip side of that negative outlook, look at something in the technology sector like 3D printing. It used to be all the rage where people would discuss how the industry would change the world after they saw it in action. However, that would have been a disastrous long-term investment decision, as shown below:

3D Printing stocks

These types of situations often allow a contrarian investor to profit. All asset prices reflect people’s expectations of future growth. By analyzing what investor expectations are compared to the price today, we can see whether an investment makes sense and is particularly undervalues. That’s often why in my model I run a “worst case” scenario for industries in which people believe are in secular decline as well as a “what do you need to believe” in the case of booming, hot technology stocks.

As a value investor, I like to invest in stocks where the expectations are really low. I’m critical of using earnings and the P/E ratio for valuing a business (I prefer FCF), but for simplicity, let’s look at this example. If you value a business on 1) current steady state part of the business and 2) the future growth of the business.  For number 1, we should assign a multiple equal to the cost of equity. If that cost is 10%, that is a 10x multiple. If I buy the business for 10x and those earnings are sustainable, then any future earnings are complete upside for me. If I can pay a low multiple then for a company that has a history of value creation, then I can get the business for value + the upside for free.

I think I should also mention one other thing: a secular declining business can last a lot longer than people think, but it has to have the right capital structure. For example, the yellow pages are still around! And the business actually throws off a lot of cash because the managers don’t need to reinvest in the business. However, YP has also been overlevered in the past, which has led to cases of bankruptcy. If someone had acquired the business for cheap, ran it with conservative leverage, then it might have been an attractive equity return.

Three (not largely discussed) things to remember when investing in Emerging Markets

I wanted to take some time to discuss 3 things when investing in Emerging Markets that are not widely discussed. The impetus for this article was driven by my blog post at the beginning of 2018 titled, “How to invest when inflation picks up“, in which I said that because I was bullish on commodity prices, I was going long Brazil. Brazil has a very commodity driven economy (oil, metals & mining, agriculture) and my view was that a rebound in commodity prices would result in Brazil’s economy improving and its stock market should improve as well.

That call has not come to fruition yet, as shown by the Brazil ETF EWZ being down 21% since that call. And here are 3 lessons I think are important when investing in emerging markets, of which the first will relate to why my call on Brazil has been wrong so far.

1. Changes in currency can have a big impact on results

I would say a central reason why my call on Brazil has been wrong is because of currency. The Real (Brazil’s currency) has been very volatile and has depreciated against the dollar since the slowdown in China started to occur in 2015 along with the commodity bust, which put Brazil in a deep recession. Recently, a trucker strike derailed plans to get the economy back on the path to recovery and sent the currency tumbling again.

BRL depreciation

What this has meant for my dollar investment is also depreciation… Let’s use an example to see why: say a stock in Brazil was trading for 100 BRL when the USD/BRL rate was at 3.00. I place an $10,000 order, exchaning my dollars for 30,000 BRL and buy 300 shares. In local currency terms, lets say the stock goes up 10%, such that the quoted price is 110 BRL. I should have made $1,000 bucks on my investment, right?

Nope. If the BRL depreciated like it did in the chart above from 3.00 to 3.85, I’d be sitting on a pretty poor return actually, as shown below.

BRL Investment Example

Alas, this would mean even though I was right on stock selection, the currency movements negatively impacted my returns. This is partially why with all the global currency volatility, currency hedged ETFs are launching all over.

Do I advocate for currency hedges? Sometimes. It depends on the time-horizon. A long term investor may look at the levels of the BRL to the USD and see this as a buying opportunity and therefore, you can be right on stock selection AND the currency may be in your favor which would boost returns.

However, I don’t think anyway can really tell me where a currency will be in 10 years, so I won’t opine on that. What I will say is that our return thresholds should be much higher when investing in Brazil than lets say the US or another developed economy like Germany. I don’t know what the currency will do over the next 2-3 years, but what I do know is that the real will depreciate over time relative to the dollar. No one questions that the inflation rate in Brazil will be higher than the US over the long run and that should mean that over time, the real should depreciate relative to the USD.

In sum, you have to be aware of currency, especially volatile ones. You’re taking a risk, so we should get paid for that.

2. Just because you’re buying a company’s stock overseas, it does not mean you are afforded the same protections as the US.

Alibaba’s stock is up 25% in the past year and has ~doubled since IPO’ing in 2014. But did you know that if you hold BABA which trades on the NYSE, you actually don’t own Alibaba at all? China forbids foreign investors from owning certain types of companies. As such, you aren’t really buying Alibaba. You are buying a holding company that has a claim on Chinese subsidiaries profits, but no economic interest. The risk here is that China comes in and says that is not allowed and guess what? You own nothing. The New York Times reported on how China has not actually weighed in on this. You may also want to check out the risk factors of Alibaba’s 10-k entitled, “If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations”. 

I don’t mean to pick on BABA here (Tencent, Baidu, JD.com each have this problem as well), but the risk here might be higher than you think. Lots of people would say, “look China is relaxing its command economy and moving more to a free market. They wouldn’t do something like that.”

And to that I say, look at Russia. In the 1990’s, following the “end” of the Cold War, Russia issued privatization vouchers that allowed investors to actually own former State Owned Enterprises. This was a huge step for Russia and it seemed like the old communist power would be relaxing its grip on businesses. But I encourage you to study what happened when Russia deemed it needed to re-control “strategic sectors”. Yuko Oil Company is a fascinating case study.

In a very brief summary, Yuko went to the private markets and quickly adopted transparent rules and practices, became one of the world’s largest non-state owned oil companies, and even had 5 Americans on its board. The company was paying dividends and growing internationally as well.

When Putin came to power, things quickly changed. The CEO of Yukos was arrested for tax evasion and fraud and Yukos was slapped with a $27 billion fine which was higher than its total revenues for the past 2 years. Yukos was forced to break up and its shares were frozen (to prevent a foreign company like Exxon from buying them). Eventually, Yukos declared bankruptcy. Many viewed this as a direct attack on the CEO of Yukos who was gaining political power.

In sum, I think its important to remember these risk factors and not get too comfortable in international / emerging markets that are known to have limited privileges to foreign investors.

3. Active management makes sense in Emerging Markets

So much has been written on active vs. passive investing in the US, it is actually making me nauseous. But I think this is a good topic to end on for this post, because it sums up the previous points here. An active manager can weigh the impact of currency on a potential investment. They can weigh the political changes that are happening in the base of a country. And lastly, they are paid to do work on changes in the tastes of the economy.

One area of research I always try to look for is primary work. That is, if I buy the stock of a company, particularly one oriented to consumers, I want to conduct surveys on what its consumer say about the actual product and understand if that helps or hurts the investment decision in any way. It’s also important to remember that sometimes we take for granted the tidal shift occurring in the U.S. such as Amazon, Netflix, or Apple because we interact with those products and see them on TV everyday. But how can you tell what type of products they are using in India or China without being there? Did you know Netflix and Apple are not the primary sources of products in those countries? They have their own.

Tastes change and they change quickly, so in my view, unless you’re traveling to the country often, you are paying an active manager to do that work. Indexes are backward looking (i.e. they weight the companies that have performed the best in the past at the top in a market cap weighted index), so they do not always calculate the risks mentioned herein. Sometimes they don’t include the entire universe, which can limit returns or at least potential for higher returns.

And as a result, we can see in the chart below that it pays to pay the higher management fee for active. This chart (taken from AllianceBernstein) shows that “70% of active managers in emerging equities have beaten the benchmark over the five-year period ended March 31, 2017, while 66% have outperformed over 10 years, net of fees. On a rolling five-year basis, the percent of active managers outperforming the EM index has never fallen below 50%”.

Active managers in EM

Hope this was helpful for you. Please let me know if you have any questions or comments.

-DD