|Apr 8, 2015|
In the comment left on my last post, a reader suggested I discuss what I'd learned from the performance of the stocks mentioned in my earliest blog posts at the beginning of 2012. I thought that was a good idea. With the benefit of hindsight, it is clear where my analysis of the various stocks contained solid reasoning and great foresight, and where it most assuredly did not. I present five lessons I have taken from my progress as an investment practitioner.
Normalize, Normalize, Normalize
Nearly every value investor has a story of discovering a company trading at low, low multiples of cash flows and earnings and buying in, only to see earnings and cash flows begin a steep decline. What looked like a bargain based on current profits was actually fairly-priced or even over-valued based on forward-looking profit measures. Conversely, nearly every investor can remember passing on a company due to high valuation multiples, not realizing that earnings and cash flows were about to explode as the company's economic outlook improved. These cases illustrate the risks of valuing cyclical companies using peak or trough results. Great danger lies in assuming good times will last indefinitely, and also in assuming bad times will do likewise. Excepting cases where demand for the company's goods or services is likely to remain in decline (newsprint, wireline telecom, most types of coal) or likely to grow at an above-average rate for long periods to come (healthcare, data and data services) investors are well-served to estimate mid-cycle earnings and cash flows and use those as the basis for valuations, not current results. Homebuilders, shipbuilders, construction, and semiconductors are all examples of industries that deep boom and bust cycles, and estimating earnings power based on only a short part of the economic cycle is hazardous to one's wallet.
Knowing this was what lead me to successfully identify Schuff International as an attractive security, though current earnings and cash flows were weak. The financial crisis took an immense toll on construction spending, but I was reasonably sure that Schuff's profits would eventually rebound. In 2011, Schuff earned only pennies of operating income per dollar of assets employed, but I knew it had once earned far more and believed it would again, one day. As the economy recovered and companies and governments once again launched major building efforts, Schuff's profits rocketed and so did its share price.
Don't Sit Across The Table From Management
Not every company I invest in has a stellar management team. Some seem half-asleep, content to let cash pile up on the balance sheet without any clear plan to use it productively. Some have their hands stuffed a little deeper in the cookie jar than I think is fair, and pay themselves excessively. Others are unfocused, choosing to pursue distracting side ventures rather than concentrate on the company's strong core offerings. All of these I can forgive, so long as the company's operations are going well and shareholders are being treated fairly. What I can't accept is when management acts in opposition to shareholders, scheming to deprive them through abusive related-party deals or absurd compensation. I also cannot accept when managerial compensation is totally divorced from performance, allowing management to profit even from outright failure.
I overlooked this possibility when I was analyzing Webco Industries. The company's financial statements disclosed little, making it difficult to see just how richly management was rewarding itself from quarter to quarter. Furthermore, I failed to see that management had chosen to "bet the firm" on a massive and costly expansion when other steel companies were struggling with weak demand and pricing. Since my post, Webco has struggled to produce sustained profits and remains saddled with a great deal of debt. Despite the poor results, management continues to grant themselves thousands of additional shares each quarter, a huge number for a company with under 1 million shares outstanding. Since my write-up, Webco's management has granted itself shares worth between $2.4 and $4.5 million, depending on the share price at the time of the grants. In a time period where the share price has been cut in half, management has seen fit to transfer ownership of 4.5% of the company from shareholders to themselves. I'm not saying Webco would have been a successful investment without this compensation. The challenging economics of the steel industry would likely have prevailed. But knowing how management treated shareholders at the time of my investment might've made me question just who would reap the benefits of any future profits.
Beware Of Customer Concentration
If a company depends on just a few customers for the majority of its revenues and profits, those customers have significant bargaining power over the company. These customers may be able to win price discounts or better payment terms. If the worst case scenario occurs and these customers end their relationships with the company, financial results can fall off a cliff. This risk is elevated with micro-cap companies, many of which depend on a limited customer base in a small geography.
QEP Company was severely affected by the loss of a major customer. I rationalized the loss as manageable, believing the company would be able to replace the lost revenues in short order. I should've run for the door. Several quarters have gone by and the company has spent millions of shareholder wealth on acquisitions, yet results have not recovered. If I'd properly discounted my estimate of QEP's worth for its high customer concentration, I may have avoided a costly mistake.
Perception Lags Reality
The stock market is very efficient. New information is almost immediately incorporated into stock prices. The biggest exception to this general efficiency I've found is the market for micro-cap and thinly-traded stocks. Information seems to move at a trickle in these market niches, leading to opportunities for sharp-eyed investors. At the smallest and least liquid end of the market, stock prices seem oddly tied to out-dated perceptions of company health and value. Once-distressed companies that have cleaned up their acts trade at low valuations long after the turnaround is in full swing. On the other hand, once healthy companies with trouble on the horizon often retain premium valuations well after the stormclouds have arrived.
When I found Alaska Power & Telecom, the company was only a few years removed from a brush with bankruptcy. The company had shutdown its loss-making operation and had secured new financing, and was making progress in reducing its leverage. Despite this progress, the company traded at a dismally low multiple and offered great value. As the market's opinion caught up, shares appreciated to a more realistic valuation. Now, who's to say I wouldn't have made the same mistake as the market if I'd known of the company in 2010 and 2011? Perhaps the company's prior difficulties would have colored my analysis and kept me from investing. As investors, we must strive to keep out estimates of value forward-looking and avoid being anchored by past company failures or successes.
Investing Doesn't Take Place In A Vacuum
As much as some of us would wish it, investing is so much more than a numbers game. Beyond the figures on the financial statements, uncountable factors can influence the success of an investment. Leadership changes, technological and demographic changes, government actions, even weather will influence the companies we buy in profound ways. While many of these impacts cannot be anticipated, investors should attempt to incorporate those that can be into our estimates of company value. Luckily, the SEC requires companies to help us in this task. I am convinced that one of the most valuable sections of any SEC-filer's annual report is the "risk factors" section. Yet, it is perhaps the least-read section. It's easy to understand why, as this section is typically full of legal boilerplate and bland, generic verbiage. Yet companies will often disclose threats their business faces that are discussed nowhere in the remainder of the filing or in quarterly earnings calls.
Another early post of mine discussed a metals supplier, Empire Resources. My investment in Empire Resources worked out well, but it would have worked out much better except for government action. When the government failed to renew the General System of Preferences in mid-2013, it resulted in substantial cost increases on raw materials imported from the company's main suppliers. I gave little thought to the possibility of this negative government action. After all, the company didn't seem to express much concern in quarterly earnings presentations. But there it is in the company's 2012 annual report under risk factors:
"During 2011 and 2010 approximately 54% and 42%, respectively, of our purchases of aluminum products were from countries that were considered developing countries whose exports were eligible for preferential tariff treatment for import into the U.S. under the generalized system of preferences or duty free. There can be no assurance that any of our suppliers will continue to be eligible for such preferential tariff treatment or that the generalized system of preference will be renewed after its expiration on June 30, 2013."
I should've built this risk into my estimates of future earnings for Empire Resources. Perhaps I wouldn't invested anyway, but perhaps some other stock would have looked relatively more attractive, and I could have made more by investing in it instead.
Hopefully this list of concepts and their explanations will be helpful in your quest for the next great stock. Investing is a never-ending learning process, and I owe a great debt to other investors who have taught me lessons along the way.
Again, I'll be in Toronto April 14-16 for the Fairfax shareholders' meeting and would enjoy meeting any blog readers who will be in town.
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