Hidden Value Stocks issue for the fourth quarter ended December 31, 2021, featuring an interview with Lowell Capital Value Partners’ Jim Zimmerman and Abigail Zimmerman.
Interview One: Jim Zimmerman & Abigail Zimmerman
Lowell Capital Value Partners, LP
Jim Zimmerman has over 20 years of experience in the securities industry. He has been directly involved in the due diligence, analysis and structuring of several billion dollars of senior, high yield, mezzanine debt, and private equity in a variety of industries. Prior to forming LCF in early 2003, Mr. Zimmerman was a Managing Director at two boutique investment banks as well as a First Vice President in Corporate Finance at Paine Webber. From 1984 to1990, Mr. Zimmerman served in the corporate finance department of Drexel Burnham Lambert, Inc. Mr. Zimmerman holds a B.A. from Princeton University with high honors and an M.B.A. from Stanford Business School.
His daughter, Abigail Zimmerman, works alongside him at Lowell Capital. She earned her B.A. in Business Administration at Loyola Marymount University in Los Angeles and has worked with Jim for the last several years. She assists in the generation of new ideas, administrative duties, research of small and medium cap companies, and detailed due diligence on potential investments.
To start, could you tell us about Lowell Capital’s background?
I had a background in investment banking for many years and noted the better companies were the ones that generated cash and didn’t really need financing. I was a long-time fan of Warren Buffett and Berkshire Hathaway, and, over time, we have tried to emulate some of their investing approach to smaller and underfollowed companies. We have invested our own capital and capital from high-net-worth individuals and family office type investors. Our primary focus is steady and conservative growth and compounding of capital over time with a heavy emphasis on companies with strong free cash flow characteristics and “Ft. Knox” type balance sheets. Simple and resilient and sustainable business models that we can ideally hold for many years.
We are long-time members of several investment sites where we have posted over 50 investment writeups with very strong and stable performance results. We take a highly transparent approach to investing.
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Lowell has defined its approach as “investing in good businesses with low expectations.” What do you mean when you say you’re looking for companies with “low expectations?”
When we talk about good businesses, we are typically talking about businesses with high returns on invested capital. When we talk about low expectations, we are talking about low P/E multiples, low enterprise value to EBITDA multiples, low free cash flow multiples. We don’t want to pay high multiples generally.
With a focus on small-cap value, why do you believe there are more opportunities in this section of the market?
Small caps are a less closely followed area of the stock market and this creates more opportunities. There is less research coverage and investment banking focus on these smaller companies. We believe this creates opportunities. We are trying to focus on less crowded and less efficient areas of the public equity markets. Many of the companies we invest in have literally no research coverage or maybe one or two research analysts at most. Further, the quality of the research is often less thorough than for larger companies. You have a better chance of finding a mis-priced security which is what we are looking for.
Do you think the growing size of the passive investing sector is having a notable impact on the number of undervalued small caps?
Yes. There is less research coverage of small and micro-cap companies these days. We believe there are close to 8,000+ public companies in North America alone and a large majority have very little, if any, research coverage. This gives us a great opportunity to find under-valued small and micro-cap companies with strong free cash flow and “Ft. Knox” balance sheets and shareholderoriented management teams. We look at thousands of companies to find a handful that fit our investing approach of strong free cash flows and “Ft. Knox” balance sheets.
Sometimes companies are cheap because they deserve to be. How do you screen for value traps in your ideas?
We believe our strong focus on free cash flow helps prevent us from value traps. If a company can sustainably generate and grow free cash flow over time, we find this almost always eventually drives shareholder value.
Do you tend to concentrate on a select few ideas or manage a well-diversified portfolio?
We tend to focus our investments on 5% to 7% of capital at cost and hold a diverse portfolio of 15 to 25 investments on the long side. These investments all reflect our focus on free cash flow and “Ft. Knox” balance sheets. This gives us strong upside when an individual investment works and good downside if we make a mistake.
Small-cap stocks can struggle to attract the attention of investors. Are you looking for any catalysts when you invest which may help drive a re-rating of the equity?
Yes. We often advise small-cap companies on how they can increase their profile or attract more investment attention. Large share repurchase programs, special dividends, Dutch tenders, rapid debt paydown or net cash build up can all help as catalysts. An effective presentation posted on the website and presented at selected industry conferences can drive attention. Several of our companies have been acquired by strategic or financial investors who are attracted to their strong and sustainable cash flows.
Lowell has historically held 30% of assets in cash. What is the principle behind this -- is it part of a risk management strategy?
Yes. We like to hold significant cash positions to create flexibility and reduce volatility when market downdrafts occur, such as the Covid-19 pandemic and the financial crisis in 2008-9. We will adjust our cash position to reflect the opportunity set we find for specific investments and the general outlook for the economy. We have found it enables us to be opportunistic when market disruptions occur. We have most recently been managing the fund with closer to 20% in cash based on the opportunities we are finding.
The fund is looking for “honest and intelligent management teams that are highly focused on driving shareholder value.” What are the main qualities the firm is looking for when evaluating managers?
We like managers that are conservative and under-promise and over-deliver. We focus on managers that understand return on invested capital and are driving growth via high return investments or acquisitions or repurchases of stock at highly accretive prices. We focus on honest management teams that are straight-forward and non-promotional. We focus on management teams that thoroughly understand their business niche in detail and how to create competitive advantage and “moats” for their business.
You’re also looking for “unique niches or business models ” Can you give an example of a previous or current investment, its unique business model, and the qualities that initially attracted you to the stock?
We are always asking: “what is the unique good or service the company provides? What gives it a sustainable moat over many years?” If we get this question right, we will almost always make money. If we get it wrong, we can lose money. The ability to evaluate the strength and sustainability of the business model is one of the most important questions in investing. Recently, in 2020, we invested in a Canadian company, PFB Corp. (PFB. TO), which supplies insulation for buildings and homes and is highly vertically integrated, unlike its competitors. It also has a strong network of locations, since shipping costs of insulation supplies is quite expensive and effectively limits competition within a local market range. We liked the strong cash flows and the conservative balance sheet and the conservative management team. PFB was recently acquired by a private equity firm at a large premium to our investment price.
Moving on to valuation, can you talk briefly about how Lowell approaches valuation Are you willing to pay more for a company with a better management/more substantial competitive advantage?
Yes, we will pay more for a business with a strong competitive advantage where we believe we can hold the investment for many years. Our focus is heavily on free cash flow and sustainable free cash flow generation. We are typically looking for a double-digittype free cash flow yield on an unleveraged basis. We compare this to the current 10-year treasury yield of under 2% and we find that highly attractive assuming our free cash flow yield is sustainable and can grow. We see a significant margin of safety in this approach and significant upside if our analysis of the future free cash flows proves correct.
It would also be interesting to know if there’s has been an investment that initially ticked all the boxes but did not ultimately work out: We invested in Barnes & Noble (NYSE:BKS) which had great cash flows even through the financial crisis in 2008-9. We thought it was trading at an attractive multiple of enterprise value to EBITDA and cash flows.
What initially attracted you to the business?
We liked BKS cash flow and its resiliency through 2008-9. It was valued at a very modest multiple of cash flows, like 3- or 4-times cash flow.
BKS turned out to be kind of a melting ice cube with gradually declining revenues. We thought they had survived alongside Amazon long enough, but they remained under relentless pressure from online book sales. There was just not enough demand for their retail stores and services. We exited with most of our capital back, but it was not a fun experience. It helped further focus on investment strategy to “Skate to Where the Puck is Going to Be, Not Where it is Today” which is the famous Wayne Gretzky quote. We try to be careful to invest in businesses which are growing, and which have sustainable and stable demand from customers for their goods and services. Strong cash flows alone are just not sufficient. Most of our biggest investment gains come from long-term multi-year growth in the underlying business models. This allows us to hold these investments for long periods of time.
Finally, Lowell uses shorts selectively to hedge the portfolio. Can you offer some insight into the qualities you’re looking for in short positions?
Yes. Our short positions are much smaller than our longs and provide some downside protection to market corrections. They tend to have extreme valuations that we think are unsustainable and weak balance sheets and large negative cash flows and dishonest or promotional management teams. All these are the inverse of our long positions, and they can provide some catalysts on price corrections. That said, we do keep our short positions small, as anything can happen to stock prices in the short term and our small sizes helps manage through that.