In this article, I write about some of the lessons learned and observations made over the last 5 years.
My investment process prefers businesses that are cash generative (i.e high cash conversion rate coming with adequate returns on invested capital). As an investor I want to understand the following: What is the company’s ability to generate cash that can be returned to equity holders or reinvested in the company? And for the latter type of criteria, at what rate of return can the cash be reinvested in the company?
In the future, I will focus more attention on the company’s ability to reinvest cash at attractive rates (i.e return on investment higher than weighted average cost of capital). Many successful companies cover their true cash flow potential by immediately reinvesting their incoming cash flow. In recent years, the proportion of companies whose growth investment accrued in the income statement in contrast to showing up in investing cash flow has grown rapidly. From the outside, valuations for most of these companies were looking stretched. Nevertheless, historically and particular over the last 5 years many compounders (companies that can reinvest their capital at high rates of return) delivered exceptional operating results and often validated their market price. Due to their high realized return on investment, the companies were able to compound capital faster than most other available investment opportunities.
1. Reminder: Put more focus on the compounding effect when investing in companies. What level of return and profitability needs to be reached at what point in time to validate the current market price?
This thought brings me to another aspect. I invested in a number of special situations. Here, the discount to NAV was massive. German and Italian real estate funds in liquidation, Retail Holdings, Eredene Capital, BHF Kleinwort Benson Group and UMS AG provided the portfolio with attractive risk adjusted returns and made up a large part of the portfolio allocation throughout the five years. However, these investments have a limited holding period until the event materializes (i.e. takeover, liquidation). Therefore, special situations need to be sourced on a regular basis to replace them when the company returns cash to investors. On the other hand, companies that reinvest cash on a regular basis at adequate returns can stay in the portfolio for a longer time than special situation investments. More compounders in the portfolio will reduce portfolio turnover and increase available resources to be allocated to each investment.
2. Reminder: The need to regularly reinvest cash from special situation investments can interfere with efficient portfolio construction. Also think about the tax effect this transition might have on long term portfolio returns.
A large pile of hard assets accompanied by a relatively small amount of debt/other liabilities should provide for a solid company? If the company trades at a large discount to net assets, it should provide for an attractive investment? It is not that easy. In at least two investment cases, I did not scrutinize the cash generation potential of the underlying assets. In both cases cash from operations was negative throughout the investment period. Asset fair values started to decline and the company’s cash balance got stretched. In both cases, Dundee Corp and AG Bad Neuenahr, equity holders have (almost) been wiped out.
3. Reminder: Do not let the asset base dominate the cash flow potential in your analysis. Reported asset values might be inflated.
The increase in money supply by central banks has boosted the weight of expected cash earnings that are distant to the present (based on the discounted cash flow model). Obviously, prices of growth companies profited more from this environment than mature companies. The dovish central bank policy around the globe supported permanent multiple expansion for companies with expected earnings growth in the future. Currently, markets might have reached a tipping point were the momentum has started to slow, because the crowd is leaving.
4. Reminder: Despite being a stock picker, include important macro themes in your investment decision and neglect the noise. “Don’t fight the Fed”: The decisions of central banks affect each and everyone in the financial markets.
Most of my investments have been in mature companies with relatively low growth prospects.
Generally, from time to time mature companies are facing operational issues. As a consequence, equity markets tend to overreact to the downside (provided that the company’s business model is still viable. An assumption that needs more and more scrutiny nowadays). Market price overreaction can provide attractive entry points.
Still, the overreaction can persist for lengthy periods and can therefore put continuous pressure on the stock price. Consequently, when investing in a company that is facing a problem, timing makes the difference between a good and a bad investment. In general, most investors shun the idea of being able to time the market. On a company level however, investing at the right time of the cycle is an important factor to maximize the internal rate of return of each investment. This does not contradict a patient investment approach. It is the name of the game to uncover potential earnings surprise before the majority of market participants do. However, it might pay off in the future to follow a more balanced approach by waiting until the fundamentals show first improvements and the market is taking notice. With this approach, I might not be the first to participate in the following positive market price reaction. Most of the time however, there should be sufficient upside potential left.
Houston Wire & Cable fits an investment where I actually had a good timing from an operational point of view. I started to accumulate shares in Q4 2015. The business touched the bottom of the cycle in Q2 2016. Over the last two years, revenues have recovered by 50% and the company regained profitability. Still, the share price is hovering around historic lows. In this case uncertainty about the future outlook prevails despite improving results. The market seems to question the length of the recovery.
5. Reminder: Stay one step ahead. Navigating through economic / industry cycles takes time. Be patient when investing in cyclical / mature companies and look for sustainable signs of improvement.
From my point of view there is not much difference left between a 1 bn market cap company and a 100 m company in terms of potential mispricing due to market inefficiencies. Inter alia, this may result from more investor focus on index investing, a decreasing amount of equity analysts available and an increasing number of trading strategies that require relatively high trading volumes. Consequently, there is no need to stick to the micro cap segment any longer.
A good example for this is Logicamms, an Australian mining/oil service company. Logicamms was my first Australian investment which I discovered by reading through the well written literature of Australian Fund Manager Forager. In hindsight, it was a mistake to invest in one of the smallest players in the industry. The opportunity set included larger and stronger competitors that offered similar return profiles at lower risk levels. Many of them have performed very well since I have invested in Logicamms.
6. Reminder: The opportunity set is expanding. Nowadays, the same level of inefficiency can be found in the small/mid cap segment like it used to be the case in the micro cap segment only.
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!