Context matters

I was watching one of Joel Greenblatt’s MBA classes at Columbia the other day where they analyzed some investment writeups of Charlie479 on VIC. When Greenblatt asked the class for their thoughts on the write-up, many classmembers pointed out the more obvious points to the investment thesis (buying back shares, cheap on some metric, etc), however one thing that he brought up that his students were missing was the psychology of each investment – what was the difference between market perception and reality?

NVR was misunderstood – everyone thought it was a homebuilder, in a capital-intensive, cyclical business, and therefore deserved the same multiples as the other homebuilders. However, they missed its capital-light model, negative working capital, and its business practice of pre-selling.

NII Holdings was disregarded as a post-bankruptcy stock, and its earnings were difficult to compute, because the filings were so complicated. The fact that it took Charlie479 significant effort to come up with the 2.8 EV/EBITDA figure was something that stood out to Greenblatt that the students brushed over. Greenblatt realized that if it was that difficult to discern its earnings, NII Holdings must be misunderstood. (As an aside, this stock eventually went bankrupt again – a so-called “chapter 22” filing – and has again emerged from bankruptcy. It ought to be worth a look again this time.)

Finally, Sportsman’s Guide was regarded as a catalog business, however, what the market didn’t see was the potential to cut costs dramatically from internet sales. The students did concentrate on this as a salient point, but what differentiates Greenblatt’s approach is a concentration on what the market doesn’t see.

There is a plethora of new value investors on the scene (myself included) who probably spend too much time on simple metrics – EV/EBIT, ROIC, P/E, P/FCF, etc. However, what Greenblatt emphasized continually in his MBA classes is that context matters.

Current Ideas and Framework

Currently I am considering some of the following ideas:

DDD

I followed this for a while back in 2013. At that time I made money on the long side, the short side, then the long side again, by identifying a reflexive trend – using stock sales to fund acquisitions. It was a classic reflexive boom-bust, as outlined in chapter 1 of Alchemy of Finance. I lost money in the 2nd half of 2013 when I called the top of the bubble too early. I was squeezed out with a number of other shorts, and the stock chart turned parabolic until it peaked in Jan 2014. After that, it has fallen for over two years from the mid $90’s to current prices under $10. I learned some lessons –

  1.  to wait until you see the “whites of their eyes” when you are shorting – wait until the chart sets up perfectly to short, or
  2. to size appropriately in order to have staying power.

I am not the best reader of charts, so #1 seems difficult. #2 seems more within my grasp, although it involves a lot of discomfort as you “fight the market”. Whitney Tilson entered the DDD short at about the same time I did, however he had the staying power to make a lot of money on it. This demonstrates that I have a lot to learn still.

I am more interested in the long side now. I think that it’s margins could normalize  because of its cost cutting efforts (it acquired lots of unnecessary workers as part of its acquisition spree), an exit from the consumer space (which has always had lower margins), and a new metal printer (I haven’t confirmed the technical merit of this new metal printer). Such a turnaround would give it an EBIT somewhere in the neighborhood of 70-80 mm. At an 8X EV/EBIT, it would justify the current share price. That is not good enough to warrant an investment however. After a reflexive bust, the stock ought to become a true value, with an adequate margin of safety.

I have been trying to build a financial model that would allow me to test my assumptions, however it is taking me far longer than I expected. In the meantime, the stock has rallied so much that even if it was a bargain, it may not be by the time I finish. This seems to be why George Soros adopts a principle of “invest first, invesigate later”. The only problem with that approach is that you have to remember to do the investigation after you have invested and not complacency set in. This is especially difficult if the trade goes your way – you tend to do minimal work to prove the thesis without assessing the risks adequately because things are working.

AGRO

This is an idea I first read on Value Investor’s Club. I would have been better off if I’d invested then, but I decided to wait out the global turmoil, attempting to be smart and time the markets. So much for that.

The thesis is that

  1. Macri, the new president of Argentina, has eliminated export taxes on many of Adecoagro’s products, which will give it somewhere in the neighborhood of $50 mm of FCF per year.
  2. years of capex in its sugarcane business are winding down, which also ought to contribute $50-60 mm of FCF per year.
  3. a 50% devaluation in the Argentinian peso has occurred, which ought to contribute $60 mm of FCF,
  4. Export subsidies of Argentina’s competitor countries have been eliminated under the Doha round of the WTO. I am not sure what the end impact of this will be, but it will assuredly be positive. India is a big competitor in the sugar markets, however it has massively subsidized sugar cane for years. At current sugar prices, few of its domestic sugar cane operations will be profitable. Also, The E.U. is a competitor in the dairy market (an area where AGRO plans to invest its new cash flows) and it had massive dairy subsidies.
  5. An agriculture inventory that has been building for several quarters. Management of AGRO anticipated Macri’s victory and the elimination of export taxes, and waited to sell certain inventories for several quarters. This depressed cash flow for prior quarters and will increase it in future quarters.

Risks include

  1. The Brazilian real has fallen. This affects the price of ethanol that AGRO sells directly into the Brazilian market. However, the dollar has risen, and the vast majority of its revenues are in dollars. I can’t really tell if the dollar bull market is a positive or not, for reasons of #2 below:
  2. The prices of commodities have been falling. This is largely due to the dollar. So the effect of the rising dollar doesn’t really benefit AGRO as much as you’d think – though it receives revenues in dollars, it is receiving less dollars per unit of product because the price of the commodities is falling.
    So far, I’ve been chalking currency changes to a positive, because many of its costs are in the peso which devalued much faster than the dollar. However, I may be totally wrong on this – there many forced pointing in different directions and its all a little confusing. The other thing is the Fed is likely going to abandon a strategy of multiple interest rate hikes this year, which ought to weaken the dollar.
    Will this increase commodity prices? So far it looks like the answer is yes. The commodity index is up today on news that the Fed is turning dovish. Perhaps the best tack is to just keep doing a bottom up analysis of this and if the value is there, whichever of the conflicting macro forces wins out will not hurt the thesis too much.
  3. El Nino. This is another possible risk, possible benefit. The yield of sugar from sugar cane decreases with increased rainfall, and half of its cash flows come from sugar. However, other crops have increased yields with the increased rainfall. Overall, it might be a slight negative.
  4. Dollar denominated debt. The company has some dollar denominated debt, and its borrowing costs have been increasing because of the rise in the dollar. The amount of debt is $580 mm, which is 4X EBITDA before all the aforementioned increases in profitability, which will come to something like 1.5-2 X EBITDA after those changes. Furthermore, the rise in the dollar could halt or reverse, and I think the company will be able to aggressively pay this down over the next couple of years, so I don’t think this risk is all that bad.

Maybe some of the risks pull the cash flow numbers a little lower for 2016. Either way, you are still going from a situation where cash flows were flat to slightly negative for the first part of 2015, suddenly turning at least $100 mm of positive FCF and possibly as much as $200 mm of FCF in 2016. The stock has rallied by about 40%, but I think this is far too small of a rally. The EV is currently about 2 billion, so the price isn’t that low, but once the debt starts getting paid off and new investments (like the dairy investments mentioned) start working, the stock will probably seem underpriced.

Now that I’ve gone through the value argument, I think the main reason why I’m so interested is that perceptions ought to dramatically change after the company starts reporting massively profitable quarters. So the time horizon on this isn’t as long as a typical value investment – I’m looking for this to work out in the next 6 months or so or I’ve made some wrong assumptions here.

DOC

This is an idea I saw on IBD talking about how investors turn to REIT’s during times of market turmoil. What I saw that got me excited was another possible reflexive boom-bust – the company is issuing a ton of shares and using them to acquire real estate. The company did several hundred million dollars in acquisitions last year, and management states they want to do over a billion this year. They just completed a share issuance for $320 million, and the stock rallied. I haven’t done a lot of work on this, but these seems like a prime “invest first and investigate later” type of investment – the stock has a perfect technical setup, so I dont want to miss it.

The stock has an inverted head and shoulders with a neck line of $16. After breaking through, it dropped, tested $16, and the level held. This indicates that it won’t likely fall through $16 again. As such, I can pretty clearly define the risk on this trade – if it falls through $16, I’m wrong. If it doesn’t, it ought to keep rising. The one thing I don’t expect, is that the price will stay where it is for the next year.

I would have to monitor this position closely, and I really must remember not to get complacent on this – that’s how you lose tons of money on these things.

Japanese stocks

I really don’t know which ones I like yet, but I’m putting this down as a theme I’m watching for now. The BOJ seems determined to make inflation happen, in an environment where one their key metrics of inflation, oil prices, keeps falling. This puts them in the struggle of printing more and more money by buying assets. The trouble is, those assets they are buying are JGB’s, which are now incredibly scarce. So they have turned to buying stocks outright through purchasing ETFs. They want the investment banks to make a custom ETF for them with Japanese companies that investing in Japan. Who the investment banks pick remains to be determined, but Mizuho put out a list of four possible candidates recently. After scouring those companies, I could only find one that I actually liked, Colopl, a mobile phone video game developer, now investing in VR games. It was cheap (7 X EV/EBIT), but not terribly cheap for a Japanese company – there are a ton of net-nets in Japan right now.

So far I have three possible strategies:

  1. Buy up net-nets. These are proven to outperform the market over a longer time period. But if Japan is devaluing the yen, then the value of holding cash decreases, and maybe this isn’t the best environment to do net-net investing.
    On the other hand, maybe Japan isn’t successful in further devaluations. Nearly everyone in Japan thinks the yen will devalue further, so this is a very against-consensus idea, but the yen might appreciate a lot if the risk-off dynamic persists.
    So then the yen might be a buy right? Well why not buy yen at a discount? If you buy up a bunch of net-nets, you can essentially buy cash at a 50-75% discount. Then, if the yen appreciates, the true value of your holdings has appreciated. If the yen continues to depreciate the core businesses and earnings improve, and the stock ought to go up. These might be a win/win
  2. Buy companies with lots of debt. These ought to be more volatile and their borrowing costs are decreasing, so they may go up more than net-nets in this environment
  3. Buy the companies I think will be included in an Abenomics ETF. Maybe this works, maybe it doesn’t. I don’t have a lot of confidence – after analyzing the candidates Mizuho put out there, they don’t look like great values.

GPRO – GoPro

Okay, the TTM EV/EBIT is 3.6X. Okay, sure, I know trailing numbers include this huge fad trend, and Gopro might never regain that kind of popularity again. But 3.6X!

I’ve generally observed that EVERY time that I’ve ever seen a fad stock crash to this kind of crazy level, it rebounds. I’m not saying it’s never happened that a stock falls and doesn’t recover, but I think there is usually at least a “dead-cat bounce”.

I think there’s a lot of potential for upside surprise here. What if the drone product takes off? What if people have a Gopro replacement cycle every 3 years and sales start picking up? What if other countries really start digging the Gopro thing? There’s a lot of ways it could go right.

Of course there are a lot of ways it could go wrong also, but I get a feeling that its all priced in.

I still have work to do, but I just get a hunch that there is value there. The last thing that makes me bullish is this article I saw at Motley Fool. When long term bulls are throwing in the towel, it’s usually a sign of the bottom.

The way I’d play upside surprise would usually be a simple call option, but the calls are so darned expensive. I’m thinking about buying a call spread – long a call at $10 or so, short a $20 call. This ought to lock in a 300% gain to 100% risk ratio, which seems about right for the probabilities here.