Clinica Baviera

And the power of illiquidity

It’s often claimed that small-cap and micro-cap stocks offer investors improved chances of identifying mis-pricings versus mid-cap and large-cap securities. I’m not fully convinced. Markets are, by and large, very efficient even with respect to smaller companies. What I will argue until I’m out of breath is that illiquidity is the factor that investors should seek out if they really wish to tilt the odds in their favor. Like all markets where the most sophisticated and deep-pocketed buyers cannot transact, illiquid securities will experience inefficient price discovery and informational asymmetry with disproportional frequency.

That’s why I spend most of my time looking at securities where liquidity, measured either by average daily trading volume or by the dollar value of free-floating shares as a percentage of total market capitalization, is as dry as the Mojave.

The drawbacks to investing in illiquid securities are many. Most are easier to buy than to sell (the “Hotel California” effect.) Many have severe governance issues that outsiders are powerless to address. I doubt this is news to anyone reading this. But for the enterprising investor with a skeptical eye and a reasonable tolerance for volatility, I submit there is no better opportunity set.

Introduction complete. Let’s take a look at a high quality, illiquid, and cheap European healthcare provider. Clinica Baviera (“CB”) is the operator of over 90 ophthalmology centers offering surgical treatments for common eye problems and diseases like cataracts, myopia, presbyopia, etc. Clinica Baviera, ticker “CBAV,” operates mainly in Spain and Germany, but has a growing number of centers in Italy and one in Austria as well. CB has a market capitalization of €293 million, but it trades less than €100k worth of shares daily and only €15 million worth of shares are tradable in the public float.

Spain is a tantalizing market. Despite the size of the Spanish economy, the Madrid market has a reputation as a sleepy, dusty marketplace dominated by a few large enterprises. But there are over 250 issues traded in Madrid, three-fourths of them valued at less than €1 billion. Few attract any attention from investors outside Spain.

Back to CB. The company was founded in 1992 by Dr. Julio Baviera and grew steadily to the point that it caught the attention of giant Chinese eye health company Aier Eye Hospital Group Co Ltd. Aier launched a takeover attempt in 2017 and ultimately purchased just under 80% of Clinica Baviera shares. A couple of investment funds own a further 15%, leaving just 5% of CB’s shares in public hands.

Clinica Baviera performs elective and/or non-emergency eye procedures, so it exists outside the national healthcare systems of the countries where it operates. The company has agreements in places with dozens of private insurers and mutuals. The eye surgery market is a good place to be for the long run. As Europe’s population ages, the need for procedures like cataract correction will only increase. There’s also evidence that rates of eye problems like myopia are on the rise. As a long-established company with hundreds of thousands of patients and procedures performed, CB is well situated to capture a large percentage of the market’s growth.

From 2011 through 2021, Clinica Baviera grew its revenues at a 6.4% annual rate. The company benefited greatly from increased scale over time, allowing it to grow its operating margins from 8.6% in 2011 to 22.0% over the twelve trailing months. For the twelve months ended September 30, 2022, CB reported operating income of €42.4 million and free cash flow of €39.3 million, including investments in new centers. The company maintains a strong balance sheet with minimal debt and cash in excess of the company’s total capital lease obligations.

There is good reason to believe Clinica Baviera’s results will continue to improve as its newer centers reach maturity and contribute fully to operating results. The company’s German and Spanish operations each report EBITDA margins in the low 30s, while the newer Italian operations are still scaling up. I expect that the Italian market is less structurally profitable than the Spanish and German markets, but I still expect the Italian segment’s EBITDA margin to reach the lower 20s as Clinica Baviera increases its unit count there.

And Clinica Baviera should increase the number of eye surgery centers it operates, because the economics are phenomenal. For the trailing five full years, CB recorded an average return on equity exceeding 50%, all without significant debt financing. I don’t expect these excess returns to be competed away any time soon. Eye surgery requires highly trained and specialized surgeons, doctors, nurses, and other medical staff. The medical field is highly regulated. It’s just not that easy to open an eye surgery center. The difficulty in attracting qualified staff is probably why Clinica Baviera hasn’t expanded more aggressively. The company adds only 2-3 new units annually. On the plus side of things, this measured pace allows the company to focus on ensuring each new unit is properly staffed, trained, and supported, rather than racing on to the next opportunity. Because only a portion of its free cash flow is reinvested in expansion, CB has lots of capacity to return capital to shareholders. Buybacks are not realistic due to the tiny number of shares in the free float, so the company is generous with its dividends.

Despite steady growth, a healthy outlook, excellent returns on capital, and a sensible capital allocation policy, Clinica Baviera trades at just 9.7x trailing earnings. Just over 8x excluding the company’s balance sheet cash. The enterprise value/EBIT multiple is just 7x.

Why? A company with identical economics, but US-listed and with liquid shares would trade at 25-30x earnings easily. But of course, Clinica Baviera is not US-listed and its shares are not liquid. They’re difficult to acquire and there’s always the risk that the 80% Chinese owner could either attempt to buy the rest of Clinica Baviera at unfair price, or could seek to sell all or some of its position and create a temporary share overhang, depressing the share price. I think each of these concerns is overwrought, but nonetheless, they will keep investors from considering Clinica Baviera.

This brings me back to my original point about illiquidity and returns. I think illiquidity is a great friend to investors buying into a high quality company like Clinica Baviera. In this case, the illiquidity allows investors to buy in at a valuation well below what Clinica Baviera would fetch in a liquid market. Investors can allow the company to work for them, building value year after year and perhaps someday achieving full value in a sale or with a more liquid listing. I have observed that a good company’s shares tend to become more liquid with time as the company’s results attract increased attention from investors and as productive investments increase the value of the company itself. On the other hand, I have seen the illiquid shares of many marginal companies become even more illiquid with time as investors give up hope and the company’s terminal value diminishes.

The lesson here? Investors with a truly long-term investment horizon and a tolerance for volatility should not fear illiquidity as long as their illiquid investments are in high quality securities. Venturing beyond into speculative illiquid opportunities is a great way to learn a difficult lesson that I have had to learn the hard way more than once.