An excerpt from the Hidden Value Stocks September 2018 Issue.
Introduction
Welcome to the fall issue of Hidden Value Stocks.
In this issue, we have our usual fund interviews as well as their four value stock ideas. On top of our regular content, we also have an investment idea from Papyrus Capital: A deeply undervalued Hawaii/Maui real estate play with a potential upside of 250%.
Over the past two years, Hidden Value Stocks has grown rapidly and earlier this year we made the decision to incorporate the business as a standalone entity. This move should allow us to provide better service to readers, and more content. Unfortunately, it also means that, due to the higher costs of operating as an independent business, Hidden Value Stocks is increasing in price from $399 to $449 at the end of September.
Q2 hedge fund letters, conference, scoops etc
If you’re an existing subscriber, you have nothing to worry about. We pledge to all our members to grandfather you in at the current rate for perpetuity if you renew. And for a limited time we’re offering a special deal for existing subscriber referrals. You can refer a friend and for each member (who completes the 5-day trial) you both get 10% off your membership price (new members will still receive the $399 price). We offer further reductions for multiple subscriptions.
You can refer a friend and for each member (who completes the 5-day trial) you both get 10% off your membership price (new members will still receive the $399 price). We offer further reductions for multiple subscriptions. So, if you enjoy Hidden Value Stocks please spread the word and help us grow the community.
We hope you enjoy the fall issue of Hidden Value Stocks and as always, if you have any questions or comments please do get in touch.
Sincerely,
Rupert Hargreaves
Jacob Wolinsky
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Fund Updates
Update from Choice Equities on Reed’s Inc (profiled in the June issue of Hidden Value Stocks):
From Choice’s Q2 letter to investors:
Reed’s Inc. is a company that has had its ups and downs. You may know it as a market leading manufacturer of ginger beer and a pioneer in the small but rapidly growing craft consumer beverage segment. As the only leading player making ginger beer that actually has ginger in it, the company is well positioned to expand on its lead in the space and capture much of the growth in this category. But it was not always this way.
Chris Reed, the company’s founder, essentially brought the category mainstream and grew this company from scratch to an organization with multiple brands together doing near $50 million of sales per year. He should be commended for building such a well-regarded brand, an effort he initiated largely on his own. But the company had its share of missteps. The most costly one was an ill-fated and strategically questionable foray into expanding its manufacturing operations with a major investment in a new plant in 2015. This move diverted capital away from marketing spending and brand building initiatives and brought operational execution risk into the picture. Later that year the company began having problems fulfilling its commitments to customers, and the company was hurt by increased distribution costs and lost sales. Further troubles soon followed which ultimately led to the installation of a new board and management team last summer.
The new Chairman of the Board is John Bello, founder of Sobe and former Chairman of Izze. A year ago he tapped a new CEO, Val Stalowir, who I had the pleasure of meeting for lunch in Greenwich, CT a few months ago at a restaurant named, quite appropriately, The Ginger Man. He likewise has impressive experience within the industry with prior leadership and operational experience. The new team is appropriately transitioning the company to an asset-light strategy. The intended sale of its L.A. based plant will finalize the move away from the capital-intensive manufacturing operations and the company will devote the lion’s share of its resources towards marketing and brand building going forward. The focus will be on only their most visible and best-positioned brands, Virgil’s and Reed’s, as these two brands hold leadership positions in categories that are growing at mid-single digits and mid-teens levels annually, respectively. The new team looks intent on developing the brands and potentially positioning them for a sale to a larger player, a common play in the consumer beverage playbook.
This position resides as a smallish for one us as shares are up ~40% from our initial purchase levels earlier this summer. Unfortunately, while we were doing our due diligence, the price moved quickly. Choosing discipline over chasing the stock, we have held steady at a low to mid-single-digit size position. Still, if they are able to execute successfully on this plan, it seems shares could double or better from recent levels over some two to three-year horizon.
Update from Livermore Partners on Jadestone Energy (profiled in the June issue of Hidden Value Stocks):
From Livermore’s Q2 letter to investors:
With Jadestone (JSE), our thesis continues to manifest along with very strong returns for this exciting and growing oil producer. Jadestone successfully IPO’d in London in August. Jadestone executed a $200 million transformational Australian asset acquisition from Thailand giant, PTTEP. We hold a seat on the Board of Directors of Jadestone, added to the equity position on the raise, and continue to focus hard on its growth trajectory.
Jadestone has a chance to be a true small cap champion and the potential to be a $1 billion company in the face of Brent’s uplift near $75 a barrel. Adding to this are the strong free cash flows from the new Montara acquisition, which on a proforma basis, will allow $100 million of annual FCF for a company today trading at a large discount (1.5X EV/EBITDA for 2019) to any peers. We continue to feel Jadestone is in a great position to prosper in the years ahead thru both acquisition and organic growth and reflects the strength of an excellent management team. My hats off to CEO Paul Blakeley and his team!
Returns
Quim Abril - Global Quality Edge Fund
Mr. Quim Abril, served as Head of Equity Funds within BMN Asset Management from July 2004 to January 2015, where he developed the Earnings Quality framework analysis and Forensic Accounting. His flagship fund´s 5-year performance ranked Top 5 in the Spanish Equity Funds category, while also pushing Mr. Abril to the #429 (2° in Spain) among the top 1000 equity PMs in the world, according to Citywire. In addition, Mr. Abril has had active participation within the Spanish economic press, also appearing as a guest speaker in leading asset management conferences.
Can you tell our readers a bit about your background and the Global Quality Edge Fund?
Sure, in the last 15 years I’ve been working at different asset management firms in Spain; primarily investment arms within banking. Looking back, it was a great experience but I reached a point where the l realized I needed to set up my own investment vehicle and break away from the limitations that come with working in a bank. It has now been two years since I made that difficult decision of giving up the comfortable lifestyle I had in banking to create my own hedge fund.
Before all this happened, my background had mostly been in finance, particularly in accounting and auditing while also (more importantly) analyzing businesses from a qualitative and strategic perspective. Above all, though, what has really helped me out the most has been the experience I acquired from one-to-one conference calls with senior managers at companies in which we analyze and invest at the fund. My daily contact with other people within the same sector, their vast experience in strategic analysis has also been incredibly helpful. While I will not mention names, they know who they are!
Global Quality Edge Fund was officially launched in June 2017 with €1.5 million of AUM from a single investor. Today, we have grown the fund to €6 million from 15 investors and we hope to achieve the €10 million milestones by the end of this year.
The fund invests mostly in extraordinary companies with solid and sustainable long term competitive advantages, who are leaders in their niche markets, face low or null competition, have low broker analyst coverage, sound capital management, high ROIC across the business cycle, low correlation to equity market indices and visible interest alignment between shareholders and company management.
We generally invest in small and midcap size businesses. Our preference0 for this size range can be explained in 10 points:
- 80% of the investable universe is made up of listed companies with less than €2.5 billion euros in market cap.
- Their underlying businesses are easier to understand and study.
- They focus on niche segments within their respective markets.
- Their senior management is more accessible to contact and exchange insight.
- They offer higher earnings growth potential and longer-term return, not always having to compromise on the increased volatility.
- Low analyst coverage.
- Lower correlation to market indices.
- A higher percentage of insider ownership.
- Higher chances of receiving take-over offers.
- If in the U.S., favorably benefiting from the recent tax reform.
Whenever we feel the likelihood of a recession increasing, we apply tail-risk hedging strategies and protect our fund from significant losses, like those seen in 2000 and 2008.
You’re looking only for "extraordinary companies." How would you define extraordinary? What qualities are you looking for in a business?
I think an extraordinary company is one that has very low or no competition thanks to one or more competitive advantages (structural characteristics attributable to their business), which translate into higher return on capital and margin.
For example, Victrex (VCT), a British Specialty Chemicals company and a global leader in engineering thermoplastics. Their signature polymer solution, PEEK, component for a number of industries. It has a 65% market share with only two direct competitors. Acerinox (ACX), on the other hand, a Spanish listed steel company, competes in price against a multitude of players globally where the only possible moat is to be the lowest cost structure.
Although both companies’ products are key materials for other businesses, Victrex has a 4x higher return when compared to Acerinox. Is it reasonable to think that both companies will have qualified top senior management teams leading them; however, the main difference is the competitive advantage of Victrex, and the balance that exists between supply and demand, which is why Global Quality Edge Fund will and is always seeking markets where supply cannot always keep up with demand.
Another critical feature an extraordinary company must have is that they must cater to a niche market, where size matters in relative, not in absolute terms. If we take Holland Colours (HC), their total revenues were €84 million in 2017 within a potential global market of €11 billion in the coloring system business. However, if we study Holland Colours in greater detail, they actually have a 30% market share in a sub-segment of the colouring system business of €300 million. Is Holland Colours, then, a small or large company?
We try to understand the company from the perspective of the customers, as generally speaking the quality of their customers can also determine the quality of a company.
Happy customers also allow for better forecasting in future earnings. We could then ask ourselves, how dependent is the customer or client to the products or services offered by our case study company? What is their client retention rate? Is it easy to convince them to buy the products and services? Does the company in question have customer concentration? Tessi SA (TES), for example, is a market leader in document processing and payment services for the financial sector in France. In the last few years, they’ve achieved a 90% client retention rate. Similarly, Espey (ESP), a British manufacturing company that serves the military market and is largely protected by competition from its patents; has more than 50% of its sales come from its top 10 clients. If we look at Victrex again, it manufactures a polymer that is a critical supply material within the industrial sector, and its customers would not tolerate any error or settle for anything of lesser quality. To some extent, they’re captive clients and switching costs to another competitor are incredibly high.
Lastly, we must ask ourselves the following: Is growth in earnings and profitability consistent or erratic? In the commodities space, for example, companies have no control on the pricing of the products they’re selling, as the raw material it involves is directly linked to the cycle of the economy, there is exposure to price deflation and most of the companies destroy value for their shareholders. If we now think of software companies like Microsoft, where the user pays an average price and upfront fee of $100 for Office 365, generating a positive impact in working capital, visible and recurring earnings from their licensing, room for potential price increases and knowing switching costs are very high.
And another key part of your strategy is finding companies with a "low probability that an accounting problem could reduce the profit or cash flow.” Can you tell us some more about this goal?
In the last 25 years, there have been many accounting fraud cases where senior management misled investors. Enron, Health South and Valeant in the U.S. and Gowex and Pescanova in Spain, to quote a few examples.
Most of the time, these situations are remote and hard to spot but what think are far easier to detect are the possible accounting practices that may put future earnings and cash flow generation at risk: accounting ‘red flags’.
While it is always imperative to understand the business model of a company, their competitive position and their capital management, it is equally relevant to look for these ‘red flags’; something we dedicate a lot of time in doing for our Global Quality Edge Fund.
To avoid falling victim to these mistakes we read annual filings in detail. These documents are not always easy to read and will change over time to reflect new accounting rules and guidelines; which is why a strong knowledge in accounting is necessary to understand them fully.
If we put these ‘red flags’ in context, I can maybe start off by saying - without running too big a risk - that the US economy is almost reaching its final economic stage and companies will begin to feel the strain to maintain or continue growing their earnings. In answer to that challenge, some senior management teams may start applying aggressive accounting practices to keep earnings growth, stable cash flow generation and a clean balance sheet. In the last 10 years, we have spent our time listing and classifying red flags according to their type which then help us identify possible accounting risks and understand how senior
management think and act around them.
At Global Quality Edge Fund we prioritize time speaking to senior management. It is precisely on these calls where we get better insight to clarify and find answers to these possible accounting risks.
In one of his famous letters to shareholders, Warren Buffett once said "...trouble awaits managements that paper over operating problems with accounting manoeuvres. [They achieve] the same result as the seriously-ill patient who tells his doctor: "I can’t afford the operation, but would you accept a small payment to touch up the x-rays?"
Another renowned American investor, Thornton O’Glove, would explain it through the following
example: "If we assume that company reports earnings per share of $2, would there be a reason
for the CEO to undervalue this number? Surely not but he could have inflated it from $1.5 to $2 to give the appearance that it is greater than is really is." These two stories serve as a reminder to investors that companies massage their accounts, preferring in some cases illusion over reality.
Do you have an example of a business that initially looked interesting, but turned out to have accounting issues?
Yes, halfway through 2017 I came upon Mitie Group (MTO), a leading British outsourcing service company, which provides facilities management, office cleaning services, waste management, security and document management.
A typical and very boring business made interesting because of the specialist services they offered. Mitie managed almost always to renew all their service contracts, enjoyed high retention rate due to high switching costs, economies of scale and attractive returns on capital. Once I began to review their annual statements, I found what I had initially presumed would be a ‘red flag’ when they purchased Enara, a leading home care service provider in 2012. When analyzing the deal, I realized Mitie was assuming very high forecasts for their care service unit that could force a negative goodwill adjustment and subsequent losses on their P&L. Goodwill represented 45% of Mitie’s market cap of which Enara contributed more than 20% to the total value. Under note 31 from the 2012 annual report, you could see how the amount paid to complete the acquisition was £115.7 million of which £94 million was allocated to Goodwill; in other words, more than 80%!
In addition to this, note 13 from the 2016 annual report showed how Mitie was aggressively
forecasting total revenue growth rates of 20% when the underlying business was running on a loss. The years that followed, the pharmaceutical line of business began to deteriorate, and yet senior management chose not to write-off the goodwill although they did explain they would be open to it if the business did not improve. Eventually what I anticipated became a reality. Mitie announced their exit from the pharmaceutical business and recorded an impairment charge of goodwill, generation losses due to discontinued operations worth £132.4 million.
On 19th September 2016, after hosting an earnings call with analysts, the share price quickly dropped by 28.8%. Today, the stock is 50% below its yearend 2015 price.
In conclusion, whenever a company acquires and merges with another business, and the total value of the deal is significant, it is essential to analyze all of their accounting reports in greater detail.
You also like to talk to management as part of your invest process. What qualities are you looking for in the management teams you invest alongside?
I can think of many but we generally begin by asking ourselves what type of manager leads the organization and what is his or her degree of independence when it comes to decision making.
(1) Bank of the Ozarks, now known as Bank OZK, is lead by Georg Gleason, CEO and founder of the company in 1979. The passion that George transmits when running the day to day business is undeniable and far-reaching throughout the entire company. All his decisions are long-term and never influenced by what the competitors may be doing, proved recently by giving up growth in his CR&E division to avoid compromising the quality of OZK’s loan portfolio at a time when there is certain pricing pressure. In our teleconference calls with Tim Hicks (CFO), he told us that OZK only approves between 5-7% of applicants out of all the offers they study and will only do so when there is an imbalance between supply and demand.
Another important indicator to look out for is managers with low salaries, low stock-option compensation schemes and high stock ownership.
(2) Christian Canty is president and CEO of Installux, and his base salary is not even 0.5%
of total sales, does not offer option linked compensation, and he’s the owner of more than 50% of the company.
An interesting characteristic that’s often not reflected in the market is how senior management values its employees.
(3) Employees of Holland Colours own 25% of the company, which impacts the profitability of the business both directly and indirectly.
In another conference call with Neurones (NRO) the colouring company’s CEO, Luc de Chammard, explained how their decentralized business model helps improve profit growth and retain talent. The company’s level of talent retention is amongst the highest in the industry
It is also relevant to know if the CEO and CFO are making good decisions when allocating capital.
(4) Inchcape plc (INCH) is a good example. Their investments, working capital, M&A, dividend payments and timely share repurchasing programs have all added value for shareholders.
Share repurchase agreements are worth understanding and seeing if their timing is opportunistic or not.
(5) O’Reilly Automotive (ORLY) has a long history repurchasing shares. In May 2017 when the stock was trading at 15x earnings, O’Reilly announced it was boosting it by back facility by $1 billion raising the total to $9 billion, which represented 50% of its market cap.
(6) Straco Corporation (S85) announced a share repurchase program last April of at least 10% of shares outstanding, at which point the stock price was close to SGD 0.75 with a cash P/E of 10.5x and an average daily volume of 100,000 shares.
Lastly, insider trading is a key indicator to buy stock whenever the CEO drastically increases his or her stake in the company.
(7) In June this year, Walgreens (WBA) CEO, Stefano Pessina, bought 1.7 million shares valued at $109 million, increasing his stake to 15%.
You also employ a tail risk strategy. Can you give us some insight into this strategy and why you’ve decided to implement it?
The idea behind hedging through options is to protect the tail-risk of the market, a practice that is also known as tail-hedging and was mainly developed by value investor Mark Spitznagel.
Throughout history, most drops in equity indices above 20% have been recorded when the economy enters into a recession. Our most recent evidence of this is the dot-com bubble in 2000 and the financial crisis in 2008. To avoid or diminish the drop, we buy out-of-the-money put options on market indices to protect our fund from market downturns greater than 20-25% whenever there is a significantly high chance of this occurring by closely monitoring Conference Board indicators (Leading, Coincident and Lagging indicators) for US and Europe.
We classify the business cycle in four phases based on the rate of change of the US Conference Leading Indicator, on a year-on-year basis and year-on-year three month moving average. We believe the business cycle in the US is now in the expansion phase where (along with the recovery phase) is where we see higher returns for equities. We expect that towards the end of 2018, the business cycle in the US could move into the deceleration phase where stock returns will still be positive but not as high as the previous cycles.
Global Quality Edge: Stock Idea One
ITURAN LOCATION
Your first stock pick is Israeli company Ituran Location (ITRN). How did you first discover this business?
I discovered Ituran in a forum on American listings which I never miss; they are always a great place to learn about lesser known companies. Ituran was one of them and despite going public in Tel Aviv in 1998, it wasn’t until 2005 that this Israelibased company began trading on the Nasdaq.
Even though it has several years of history behind it, it is largely unknown to American investors. Less than five analysts cover the stock; they’re all local and the company itself never attends investor conferences.
What does the company do and what is its market size or potential for growth?
Ituran is a leading provider of location-based services, consisting primarily of stolen vehicle recovery (SVR-most important), fleet management services and tracking services. Ituran principally operates in Israel, Brazil and Argentina, has more than 1 million subscriptions.
The SVR business consists of locating, tracking and recovering stolen vehicles through a subscription fee service.
Ituran installs the AVL tracking unit in the car and has a network of transmission and reception stations for monitoring and a 24-hour control and customer service centre on standby. In the majority of countries in which it operates, the Ituran security staff is in direct communication and coordination with local police. Most of the company’s customers are individuals, insurance companies and agents, OEMs (original equipment manufacturers) and industrial fleet management companies. Another line of business within Ituran is their Wireless Communication which encompasses all the AVL technology products, making up 25% of total sales.
Demand for SVR products is strongly linked to crime and motor vehicle theft rates within a country. Brazil ranks at the very top in both categories. According to recent figures from Interpol, 557,000 vehicles were stolen in Brazil in 2017, of these case, 70% involved violence. The number of stolen vehicles secured by insurance companies is growing at a double-digit rate. Regardless of how you calculate it, this South American country is perhaps one of the worst places to own a car and the best for Ituran to do business. If the income per capita continues to increase among middle classes, demand for vehicles will rise, theft rates will also grow and demand for Ituran’s services is almost guaranteed. We forecast a market share in Brazil of about 25% (precise figures are hard to come by) and believe it will continue growing in what we see as a fragmented market with tiny players and potential for future inorganic growth for Ituran.
What makes Ituran an "extraordinary" business in your view?
There are two reasons. Firstly, a competitive advantage in the form of a ‘network effect’ and the second one being its size or scale. In a rapidly growing market, like Brazil, its high market share allows it to have a higher degree of control on market trends.
A network effect exists when the value of a service is increased by the number of users who; in turn, attract more users, creating a virtuous cycle that displaces smaller networks giving way to more dominant ones. Over time, the increase in the user-base makes the marginal cost of adding one subscriber decrease and contributes to the overall sustainability of the network business model. In Ituran’s case, their recurring sales (>80%) from their SVR line of business is one of their most exciting features. Their consistency in successfully increasing the number of subscribers year-on-year since going public 1998 is exemplary, leading them to surpass the one million subscriber milestone by the close of 2017. Most of the users are located in Israel and Brazil and pay an average $200 subscription fee.
One of the reasons why Ituran is unknown in the US market is because their total revenue figure is impacted by foreign exchange rates when converting sales from their local markets in Brazil and Israel to US Dollars. During 2015 and 2012, the Israeli Sequel and the Brazilian Real depreciated considerably against the US Dollar, giving the appearance of a drop in sales of 3 and 6%, despite the double-digit growth in the user base.
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