About Me

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This is written with serious investors in mind, though sometimes they're just drafts in progress. I'm a former reporter, private investigator and institutional equity analyst who digs deep to find niche undervalued and undiscovered securities. I manage money for individuals, institutions and family offices via my business Long Cast Advisers. This blog is part decision-diary, part investment observations and part general musings about Philadelphia sports. It should not be viewed as a solicitation for business or a recommendation to buy or sell securities.

Friday, December 30, 2016

A New Book and a New Idea ($IVTY, $MDT)

I recently received a gift in the mail, a copy of this out of print book by former CIA intelligence analyst, Richards Heuer. The book is influenced by Kahneman and Tversky but framed primarily around the decision making part of analysis and not just the analysis of decision making.

It is a dense read with fewer "cognitive party tricks" than the pages of so many other popular books on the subject, but it's fascinating, even as I'm only halfway through it.

Since I've recently sold some positions and also have some new clients, I have the "high class problem" of having capital to put to work. So the book arrived just as I'm searching for new ideas and as a result, the aspect of the book that's come into sharpest focus is the relative nature of observations and its relationship to decision making.

We all know that colors have a relative nature, changing depending on the background. And we all know there is a relative nature to sound, to speed, to taste, to time, etc.

Concurrently, the book also introduced to me the concept of "bounded rationality", which describes our tendency to frame things in a specific way, then solve for the problem within that arbitrary frame. For example, my wife often poses questions at me along the lines of  "would you rather do this or that?" as if those are the only two options available, and without articulating the problem she's trying to solve. (I'll acknowledge the difficulty of being married to an over-analytical spouse when all she wants to do is go out for dinner).

Reflecting on these aspects of decision making is critical for the obvious reason that ours is a decision making business and few people do it well consistently. Though the first year of my firm provides a good start, consistency is measured in years not months, and I still have a lot to prove.

Furthermore, the returns we put up isn't some theoretical experience; I have a fiduciary obligation and professional responsibility to grow my client's capital and avoid losses on their hard earned money. It's important to get it right and I better not screw it up!

So with these new insights into the relative nature of observations, it comes to mind that the search I've been conducting for new ideas may be rife with biases I'd never before considered. Here I am reading Q's and K's, learning about businesses, screening, modelling, reading, reviewing ... and saying "no" over and over ... and up percolates an emotional experience, let's call it "frustration", about not finding good ideas.

Frustration can lead to impatience ... and then perhaps the relative nature of observations takes over ... and I'm suddenly comparing the next idea to the last idea instead of to an objective benchmark. Each idea is independent of the other - and I should be more eager to preserve cash for the right idea than rush into the wrong one - but what if I'm suddenly framing them relative to each other and thus distorting the analysis?

The problem with all this is twofold: First, the potential lack of awareness that fatigue and relativity can drive decisions. Second, because most of the stocks I tend to buy are lonely trades where validation can be incredibly delayed, I might not know whether I'm "right or wrong" about a stock for months, if not years. I'd rather hold cash than be wrong ... but I'd like to not miss opportunities to be right.

All of a sudden the obvious and well discussed theories behind deep value investing are crystalized: If you buy companies for less than its asset value, you don't have to worry so much about the future. It's an easy philosophy on paper but less so in practice, because some "deep value" businesses absolutely suck and the good ones don't trade for below their asset values for long. Value, as we all know, is infrequently obvious.

This all calls to mind something Howard Marks wrote about "the future":

"It would be convenient to say that adherence to value investing permits investors to avoid conjecture about the future and that growth investing consists only of conjecture about the future, but that would be a considerable exaggeration. After all, establishing the current value of a business requires an opinion regarding its future, and that in turn must take into account the likely macro-economic environment, competitive developments and technological advances. Even a promising net- net investment can be doomed if the company’s assets are squandered on money- losing operations or unwise acquisitions.

There’s no bright-line distinction between value and growth; both require us to deal with the future. Value investors think about the company’s potential for growth, and the “growth at a reasonable price” school pays explicit homage to value. It’s all a matter of degree. However, I think it can fairly be said that growth investing is about the future, whereas value investing emphasizes current day considerations but can’t escape dealing with the future."

The future, the fact that nobody knows it, and the risks associated with its possible outcomes are important considerations in all investments. One I've been considering - Invuity - which makes lighted surgical equipment for the operating room, recently sold off b/c of weaker than expected guidance for 2017 (the near future), but I think it may represent a compelling long term opportunity.

At $6.00, Invuity (ticker: IVTY) has a $100M market cap and is trading at ~2.5x 2017 sales guidance of $40M-$42M, a future that implies 35% topline growth. This is - I believe - a “capitulation price” for a company innovating in an overlooked and undervalued area of the surgical equipment market and in an industry where stocks tend to trade in the range of 2x-10x sales.

The company’s core product is an engineered piece of plastic that delivers cool bright light with a wide field and few shadows directly into the cavity of a surgical "field". This piece of plastic – for simplicity sake let’s just call it a widget for now – either clips onto a reusable retractor that the company sells or is built into the company’s version of ubiquitous operating room tools like "yankauers" and "bovies".

The company has two types of sales; a "capital" sale - an expensive piece of reusable equipment - and a "disposable" sale (ie recurring) via the handheld equipment and clip on widget. These products together improve visualization - a surgeon’s ability to see - in non-laproscopic / non-robotic procedures.

The company currently markets these products into four narrow verticals: Breast oncology, orthopedic surgeries, thoracic and spine procedures. Some procedures like "nipple sparing masectomies" and "anterior hip arthroplasties" are particularly well suited for the device as they are fairly technical and involve smaller incisions for open surgery, making "visualization" difficult.

These procedures benefit the patients via less scarring and/or faster recovery times so the concurrence of the new procedure's acceptance and the improved equipment may help grow their use and thus demand for the equipment, etc. (Note that despite the negative bias towards the anterior approach in this link, it acknowledges speedier recovery for the anterior approach as well as the greater difficulty with visualization).

B/c of the NSM procedure the company has had the greatest traction with breast oncology - about 40% of sales - but has under-penetrated the more lucrative spine and orthopedic procedures.

This is still a small company - not just in market cap but in actual size - selling just a few products into a few narrow verticals. At 3Q16, the most recent quarter, the company had 65 salespeople, many of them with the company for less than a year, selling into 700 accounts. Small, yes, but on a relative basis, compared with last year, this reflects 25% growth in salespeople, 50% growth in accounts, and a 63% increase in procedures per quarter, to 26,000 from 16,000 in 3Q15.

In 1H17, the company will launch one new product - the “PhotonBlade” - a lighted version of Medtronic’s PEAK PlasmaBlade, which will have the "light widget" built in and a tip that causes less scarring. The company believes this product will allow the company to further penetrate breast oncology and spine market.

It is worth noting here that IVTY’s head of R&D, Paul Davison, was the head of R&D at PEAK Surgical, before it was acquired by Medtronic in 2011. At the time of the 2011 acquisition, PEAK had $20M in sales and was acquired for a 6x sales multiple.

So what don't we know?

I have talked to a number of doctor's about the product for qualitative background. One, whom I respect and admire greatly, insists on caution with the investment. "They're not the first to try to do this," he says. "There've been people trying to come up with better lights on surgical tools for more than 30-years."

My response: "That's proof it's a problem searching for a solution."

Several other doctors I talked with expressed enthusiasm for the product; "Tt would be awesome if it did what they say it does" but they all universally blanched at the price.

And price is an issue. The company charges a huge 10x premium for their lighted product. Their disposable yankauers and bovies as well as the clip on widgets (called “waveguides”) cost $250 to $300 compared to non-lighted versions of the same products, which cost under $25.

In a market with thin margins for hospitals and risk that ACA will disappear, it seems ridiculous to think hospitals will pay this much for disposable plastic. The product pricing is the first of many obvious reasons why this company fails.

Yet, despite the premium and all the other obvious reasons, the company is on track to sell $24M of these disposable plastic products in '16 (and $8M in reusable products that the widgets clip into), all at +70% gross profit margins. And these are pure cost to the hospital; there is no CPT code that allows the hospital to get reimbursed for its use.

The reasons for the company's potential success are less obvious. Again, this investment depends on a future. But experience indicates that it takes time – and costs money - to introduce a new premium product to the market and for the market to adopt it. It takes time for a salesperson to “mature” and an account to “mature”. It takes time for doctors to see the light and press a hospital Value Analysis Committee to buy for them a premium priced piece of equipment.

And yes, the costs of selling currently exceed the revenues, but perhaps there is overlooked promise in the early operating evidence, particularly with the recurring revenue disposable widgets and most particularly at 3Q16, where the ratio of incremental sales to incremental marketing spend reached an inflection point and increased to 48%.

Management expects to keep sales staff flat into 2017 and focus on going “deeper” into existing accounts and were this to happen, we would see continued revenue scaling and then perhaps we are just now seeing the inflection and impact of more salespeople and more accounts on revenues.

Yet, the market is most skeptical as signs of success are improving. That skepticism, which underlies the low multiple, is driven by a variety of issues I'll lay out below:

1. The proximate issue with the recent decline in the stock price was a guidance shortfall. On the 3Q16 earnings call, mgmt guided to 35% topline growth in 2017 down from expectations of 50% growth, and this led to the stock’s capitulation. The stock was trading towards $13 heading into the quarter and hit $4.50 on the earnings release.

The 3Q16 sell-off reflected the market’s focus on the weak guidance. Through the lens of a DCF model, such a response makes total sense: If T+1 income is lower, the whole valuation declines. But from a qualitative perspective, there should be no point in investing in this company at any price – regardless of what the DCF says - nor under any circumstance without the belief that IVTY’s usefulness to its customers will grow over time, along with its sales and eventually profits.

What drives long term growth of a company – qualitatively - is a problem identified and solved at a price the customer can afford. We see evidence in the operations that the company’s illumination products are indeed solving a problem and they are generating traction on the valuable recurring revenue side of the business. But ...

2. Price seems to be a major issue.

A former employee I talked with said cost is the single biggest obstacle with "going deeper". This person said as they "get deeper" into accounts and sell more into each hospital, eventually the invoices roll up to the CFO who pushes back.

In addition, every doctor I talked with - bar none - expressed shock at the cost.

The company says the better lighting enables doctors to perform surgeries faster and therefore do 1-2 more per day. A response I got from another doctor was polite laughter: "If I were to make a list of items that slows down my [thoracic] surgeries, lighting would be like item 1,700."

The company also said interestingly, "when we show up on the CFO's desk, it means we're doing something right." Reminds me of the old saying: "Salesmanship begins when the customer says no."

3. In addition to being high priced, there's no CPT code for the product, so hospitals don't get reimbursed for their use. And hospitals aren't rolling in cash to spend on expensive equipment.

4. And recently there seems to be a lot of salesperson turnover.

5. And surgical procedures are supposedly moving away from open towards laproscopic and robotic

My response on these four items is that these issues are not "new". 

A brief look at a scuttlebutt message board for pharma sales reps shows people talking about the high product pricing, employee turnover, competition, etc. since at least 2014. In the interim, sales have grown from $14M to $32M. 

Meanwhile, the cost / benefit analysis of robotic surgeries doesn't appear to be compelling (though as long as insurance covers it, hospitals will do it). 

More broadly, product price is a solvable problem. They can continue down the path of a $250-$300 ASP, scratching for sales within the four narrow verticals and with the new product expected to come out in 1H17, they can offer bundled pricing. 

Or, they can lower prices. These products are cheap to make and if the product is desired, the potential for ubiquitous access across all hospital channels at a lower price is an attractive investment option, though even more attractive at the higher price. 

6. Ultimately though, the skepticism is bound - like life itself - by the limits of time. The company is unprofitable, running at losses of $40M in 2016 on sales of $32M and gross profit margins +70%. It also has $14.5M of outstanding debt at 12.5% interest, held by Healthcare Royalty Partners, a medspace investment firm that also owns 5% of the stock. And although the company has $34M in net cash on the balance sheet, it is still cash flow negative so at some point, there will be a future dilution event.

This is no walk in the park, but startups with losses and debt are not unusual, and this isn't the first rodeo for the management team - lead by CEO Phil Sawyer and CFO Jim Mackaness - who have prior experience running growth distribution businesses.

Nobody knows the future, but at ~2x 2017 sales, the stock market appears skeptical about the prospects due to losses, debt, the recent guidance shortfall, and issues that are not new.

That skepticism overlooks what appears to be some traction in the recurring revenue business and the traction is new, the evidence of success is new, the favorable relationship between the sales and cost curves are new and trending in the right direction.

Sure, my biases and frustrations, hubris about my successes, shame about my losses, all may have contributed to this idea floating up to a level of thinking that ... maybe it's totally irrational. A yankauer for $250? A plastic widget with some special light? Hospitals spending money on stuff they don't get reimbursed for?

Maybe I've talked myself into a bad idea ... but when the market is already valuing this as a bad idea ... and the evidence suggests that its not failing ... it seems to offer a favorable possibility for those armed with information and an uncommon perspective.

 - END –


Thursday, December 22, 2016

Two recent activist situations that are more compelling than ARIS: CDI and SEV

I wrote earlier this week about the absurd activist situation at ARIS, a company whose share price is up 20% last 52 weeks (about 2x the S&P); up from a market value of $20M in 2012 to nearly $100M today (about 30% CAGR) and has concurrently grown bvps over the same per by ~10% CAGR. In short, it is not the most obvious target for change.

Consider in contrast two companies where activist are more appropriately getting involved and that might be worth keeping an eye on: CDI and SEV.


On its best day this company - part temp placement, part perm placement, part "body shop" project work in the construction / oil & gas / aerospace / IT industries - dreams of being a combination of Jacobs Engineering and Booz Allen.

But it wakes up everyday with a stale brand in need of a refresh, due primarily to the neglect of an absent board that has generated fees for itself and its agents while destroying value for shareholders.

Compounding the neglect is an unusual ownership structure; 25% of the company is owned by the  "Garrison Trust", which itself is managed and owned by the board. It is the governance equivalent of chaining the kids (is shareholders) to the radiator so the parents can go out and play.

Family services is finally coming, under the name Radoff and Schechter, who have most recently sent this spot on letter to the board. If it doesn't wake them up, I'm sure there are a few more letters coming. Radoff and Schechter - the activists - have been on an absolute tear ripping new holes into a most neglectful bunch.

To be frank, I wrote negatively about CDI at the end of Sept when it was trading below the value of its working capital + PP&E - l/t liabilities. It was then a wonderful opportunity for deep value investors as it is now trading at 1.6x that asset value.

Beauty, they say, is in the eye of the beholder. I do not see beauty b/c I do not see a pathway to success. The brand is stale. The work is undifferentiated. The company may benefit under the l/t turnaround plan by the "interim" CEO who has experience managing growth at stale brands, but how "interim" is he and what value does the company add that others cant such that there is a wide and probable pathway to success?

The "deep value" investor doesn't truck with possible future pathways, they only need look at the value vs the balance sheet and have done well buying the stock at a discount to that value.


Speaking of possible futures and pathetic boards, here's one that may have both.

Sevcon makes motor controllers for electric vehicles. In the most simplest terms, their product sits between an electric power source and a motor, and allows them to talk to each other. (Consider a switch that sits between a power source and a motor, but is simply either on or off. A motor controller in contrast is a complicated switch that can manage a variety of parameters around the power, the heat, the torque, etc. and constantly manages the power going back and forth, under a variety of conditions).

Some companies like Tesla make their own motor controllers specific to their motors. SEV makes one that is programmable across different electric power sources and motors. An EE told me they are like DOS or LINUX of motor controllers, compared to other companies that make motor controllers equivalent to MACs, easier to program but with fewer parameters.

The value of SEV is they can modify / customize their software to solve for specific problems around drive trains and / or accessories. Their simpler, older generation products, were used in simple EV's like golf carts, electric motorcycles*, and in industrial equipment - scissor lifts, fork lifts, heavy machinery - a business now in steep decline.

* Just a note that Brammo - the electric motorcycle company - was acquired by Polaris in 2015, specifically for its drive train, which included a Sevcon controller. The "holy grail" for Polaris isn't an electric motorcycle - though it is trying to rejuvenate the Victory brand with that purpose in mind - but rather a drive train for an electric ATV, the better to quietly transport hunters through the great outdoors.

Meanwhile, the holy grail for Sevcon - and potentially investors - is moving up the value scale from smaller vehicles to larger 4-wheel vehicles, a business they stumbled onto a few years ago.

They are currently developing controllers for a handful of OEM's that could deliver a stream of future royalty payments if the products under development go into production and are successful with the consumer market.

From the last conf call ...

"We have more projects in the pipeline than never before and we expect the customer enthusiasm for Sevcon solutions will continue. We currently has five major projects in the development phase of the pipeline having added an extension to one of the four projects we mentioned last quarter. We expect two to go into production in 2017, one in 2019 and then two in 2020."

"With the addition of the new content for the high performance sports car manufacturer we expect total production revenue from these projects to be approximately $206 million over the five to seven year production life. This is up from a 166 million that we projected on last quarter’s call. We’ll then be adding on revenues for spares in the 5 to 10 years following completion of production."

... as I once learned: "buy in the order cycle, sell into the delivery cycle." This company appears deep in the order cycle and again, the possibility of a pathway to success. Nobody knows the future.

But back to the present, and back to the board of directors, it's a laughing stock, especially for a high tech company with potential growth ahead.

Someone is finally trying to change that.

One thing that makes this board so ridiculous is that the current chairman of the board actually lists in his bio (ie his achievements) funds that failed under or around his watch,  companies that went bankrupt around his watch, and a firm that was invested in a ponzi scheme around his watch.

He might not be the provocateur that causes problems but he sure carries them around like the stink on cheese. A more proactive board can instill top down changes, drive accountability, set targets, increase the RPM of the growth engine of a company. The slate of potential candidates proposed to replace the board could enlarge the possibilities of future success.

Nobody knows the future but in both these cases, someone is trying to improve the odds for success and that could bode well for investors.

-- END --


Wednesday, December 21, 2016

ARIS: F1Q17 Results and the Most Absurd Proxy Battle Ever ($ARIS, $EBAY)

I've been a fan and stockholder of ARIS since it traded in the mid $3 range and I continue to like the company. I think the mgmt team is unusually strong in a sub $100M market cap company, I think the company still has room to grow in its variety of verticals and finally I think the business sells for a more than reasonable multiple such that a long term investment could benefit from the two attributes of growth and multiple expansion.

Despite these attributes, some impatient investor is challenging the company to sell itself. It is one of the most absurd proxy battles I've ever seen for a company so small. Absurd for so many reasons, but primarily in the waste of money and energy; there have been 15 DEF filings since the antagonist went after them in late October.

The information also directs investors in many cases to the wrong information - notably in this page of his presentation filing - which focuses on Net Income and not FCF. Because ARIS capitalizes its software development, Net Income includes significant depreciation. Back that out and there's quite material divergence b/t Income and Cash Flow. What do you think is more important?

(these are TTM figures)

I don't think the antagonist has a chance of winning the proxy battle - I certainly hope he doesn't, I want this to continue to compound indefinitely - so I think this is simply a drain on the company and shareholders like me who appreciate the value of compounding growth over the long term, and are not focused on the day to day changes in the stock price.

Its the compounding of growth and the benefit to returns that I aim to write briefly about here.

A week or two back, the company reported F1Q17 results. The company reported $12M in sales and $2M in EBITDA, reflecting a 17.6% EBITDA margin. By my account, these results reflect 29% ROE and 18% ROA.

(these are quarterly figures)

On a trailing 12-mos basis, the company has reported $48M in sales and $8.6M in EBITDA. With 18M shares out and $3M in net debt, this reflects a 12x multiple on trailing results. Everyone should decide for themselves what's cheap and what's not, but it seems an attractive valuation to me for a company consistently growing profits and FCF and reinvesting FCF at high returns such that topline and returns are growing consistently.

However, results do not reflect the Auction123 acquisition that closed a day after quarter end. According to the press release that accompanied the purchase, that acquisition adds ~$4M / year revenues.

And then these tidbits from the conference call:

On the $10.5M acquisition ... "From a multiple perspective, we paid 7.2 times the trailing 12-month EBITDA for Auction123 at closing. If the first two-year earn out is paid [$1.5M] and considered part of the transaction then we paid 8.2 times the trailing 12-month EBITDA." >> This implies ~$1.4M in trailing EBITDA, or about 35% EBITDA margins. Is it reasonable to think those margins are sustainable? It's in the same ball park as EBAY's margins so ... why not? 

On the balance sheet post the acquisition close: "... our transaction closed on November 1, 2016, we had about $16.8 million of total debt which is just under two times our trailing 12 months EBITDA, and cash and cash equivalents of approximately $3.3 million or a net debt of $13.5 million." >> On this basis, adding the acquired EBITDA and adjusting the net debt, this is now trading for 11x trailing EV / EBITDA. 

And finally thinking about year end, "... as we look ahead and consider our expected cash flow and debt payment schedule, we anticipate by our fiscal year end on July 31, 2017, our cash balance will be back above $5 million and our net debt will be below $10 million." >> this implies, assuming zero growth, that the company is trading at 10x FY17 EBITDA. 

On a comparable basis, the peer group multiple is about 15x. When it comes down to it, that discounted multiple is really what this whole proxy battle is about from the get go.

It feels a bit lonely talking about this company. I've not seen any evidence or read any information anywhere that this is a bad business. I'm not deterred by the debt as the mgmt team has been a terrific steward of it and is now operating in an environment where the pent up energy of millions of entrepreneurs is about to be unleashed (so much tongue in cheek, I just threw up a little).

I think the evidence suggests this is a good business trading for 10x next year's EBITDA, as good businesses sometimes do, and its generating cash and reinvesting it at high rates. The question is, do you sell now and lose the benefit of a quality mgmt team allocating capital wisely or allow the company to continue to generate cash and grow, and generate cash and grow, and generate cash and grow, etc.

To me, the opportunity for the patient investor is to buy more, and wait patiently.

-- END --


Tuesday, November 15, 2016

Brief Advice on Interviewing Management

I worked earlier in my career as a writer and reporter so I have some experience interviewing people, a skill that comes in handy when assessing management.

These are three short rules to interviewing management that I learned in my early 20's. It's very basic but essential so as to not waste anyone's time:

1. Ask open ended questions. The inverted way of saying this is: Do not EVER ask "yes" or "no" questions. We all do it. Get in the habit of not doing it, by whatever means necessary. The corollary to that is ...

2. Do not ask leading questions. It traps yourself in your own presumptuousness.

3. Silence is your friend. Don't fall prey to the knee jerk reaction of filling empty space and as much as you can, do NOT finish their answers. Invite them to continue to expound on whatever they are talking about.

I recently read somewhere a suggestion to not interview mgmt b/c it creates biases. I find that a mgmt interview puts qualitative skin around the financial bones so I try to be aware of flattery ("Oh, great question" etc) and all the other bullshit people put forward when they talk to me.

One of the ways I try to avoid those biases is by asking myself ...

"how often do you think they repeat this narrative? do they actually believe it or are they just used to saying it? how can I get them off this narrative and get them to talk about things on the 2nd level"

... insincerity is the enemy of revelation.

Management is such a critical component in the long term success / failure of small companies that not understanding their motivations, their perspective and their imaginations leaves too much to the whipsaw of quarterly results, about which, sometimes even they have no control. But they are responsible for the long term operational maneuverings of a company, and that is the essential key to a company's long term growth and profitability and an investors ability to compound wealth repeatedly.

We all have our own truths, in life and in business, and investing is simply a way to handicap them, to quantify them, to wager on them. I don't profess to know more than anyone nor to have answers about everything. But I have a bit of experience interviewing people and I just wanted to share one tool that I think is essential to learning more about an investment.

-- END --


Sunday, November 13, 2016

EMH and the "CON" in Consensus

Anyone who spends time in business meetings, or on boards, or in any engagement with other people (including even sitting around a table and deciding what to have for dinner), probably recognizes that the efficiency of a meeting - ie the achievement through consensus of an optimal outcome - often declines as more people are involved.

And yet, one of the basic tenets of the efficient market hypothesis is that when it comes to market prices, a larger cohort achieves the most efficiency since the price aggregates information "dispersed amongst individuals within a society." (Recall that "efficient" in EMH isn't fitter / happier / more productive but is more a form of "consensus").

But why should a wider and larger base of participants yield more "efficient" results in the stock market, when so much evidence in other avenues of life exists to the contrary?

Perhaps we should think more productively about how often - and where - its likely to be wrong. I think that's a muscle investors regularly exercise.


The trouble with "consensus" - in a meeting and in the stock market - is that people are often anchored on the last comment, or the last stock price, or "what everyone else is doing" - and they mistake these data points as "sources of information" when actually they're forms of biases.

I recall reading once how the last thing Buffett looks at when analyzing a business is its price and chart, preferring to read all other filings first in order to make his own unbiased assessment divorced from the anchoring phenomenon.

It's a useful parable on how to not use consensus. Another is William Goldman's famous saying: "Nobody knows nothing." I say that to myself all the time.


The trend towards passive indexing - a massive trend - is supported by three things:

1. Efficient market hypothesis. If you can't beat the market, why bother trying?
2. Active management returns, which "on average" underperforms the market
3. The difficulty of identifying skilled asset managers who consistently outperform the market over long periods.

So the consequence of taking the EMH as fact has trillions of dollars in consequences.

As well, the "poor returns of active investors". But just as a reminder for a moment; investing is a zero sum game. There are two parties to every trade, a buyer and a seller. Reason therefore dictates that in aggregate, the average of all active investors, after fees, should underperform the market, roughly by the delta of fees.

Now, investors who want to follow a benchmark with the most undifferentiated and readily available solution can and should pursue the lowest cost index funds available to them. Anything else - anyone steered to a higher cost model - is a con job.

But investors who want a differentiated solution - who want an experience apart from and are willing to accept results that are different from the market - should either spend time learning how to invest or find someone with experience and skills who can do it for them.

The difficulty of finding that person, the difficulty of separating luck from skill, salespeople from super investors, wheat from chaff, etc. is the third and perhaps largest foundation of the trend towards passive investing.

It's so difficult even for institutions to identify high quality investment managers, and doubly so for individuals.

All in, you have this easy solution (passive investing) that solves / avoids the problem of having to find good managers yet still supports Wall Street's desire to separate you from your money. It plugs perfectly into the rubric of the industry as it already exists.


But here's where I think EMH and the passive trend have it all wrong and where the opportunity for good investors grows everyday: Finding high quality capital allocators is the only job within the entire investment ecosystem. I take an almost ideological view on this and I think its where investing shares at least as much with the practices of other art (and ethics) as it does with finance and accounting.

As a steward of capital seeking to invest in publicly traded companies I look for executives who allocate capital wisely. These CEO's and CFO's in turn look for managers who can manage capital (staff, equipment, etc) effectively. They in turn prize employees that convert their labor productively, and on and on.

It's the capital equivalent of turtles all the way down.

But since passive investing disabuses the notion that anyone can outperform the market, and EMH says that prices are all accurate, the conclusion is to ignore the search for better capital allocators and simply spread your bets and diversify.

Which is why the price for capital allocators is going down.

But the value of finding good capital allocators - from the CEO down to the line worker, from the endowment to the startup investment manager, from the QB to the special teams coach - is not going away. And for those who desire exceptional outcomes, it never will.

Over time, we who search for good capital allocators will get better at it while the competitive field diminishes.


I was going to write more about a specific idea I've been working on, but I'm still drawing information on it so I'll close with a brief comment on investing with incomplete information.

The other day I wrote about an inference drawn from one company to learn something incremental about another company. It helped to lock in gains and avoid losses for my clients and since a penny saved is a penny earned, I feel it justified my 1% fee.

The opposite of those inferences is acknowledging and valuing incomplete information when making investment decisions, and compensating for that with price and portfolio positioning.

I think good stockpickers, even when they dig down for that 3rd, 4th or nth piece of information, acknowledge the limits of what they know.

For this reason, I am cautious of detailed checklists, b/c it risks creating a false impression that on completing it, we'll have certainty. There never is certainly. I prefer a broad functionary checklist at the top of which I write in big letters: "What don't I know?"

Even as we dig a bit deeper and contextualize financial data with qualitative information, there are always going to be unknowns and surprises.

There's a value to what we don't know. I believe for "good investments" - and by that I mean investments in companies managed by "quality capital allocators" - time and patience is the best way to manage and offsets the risks of the unknowns. It seems an important concept that EMH totally ignores.

-- END --


Wednesday, November 9, 2016

FTLF and An Investment Manager's Responsibility to Their Clients

On November 1, I sent an email to a friend ...

"I have concerns about FTLF 3Q and shorter term traders should likely lock in gains"

... and I sold shares for clients. The genesis of the caution was my review of GNC's 3Q16 10Q, which stated ...

"[GNC's] Domestic franchise revenue decreased $2.4 million to $85.8 million in the current quarter compared with $88.2 million in the prior year quarter primarily due to lower wholesale sales associated with lower retail same store sales of our franchisees as well as the earlier timing of our annual franchise convention, which resulted in $6.3 million of lower sales in the current quarter as compared with the prior year quarter."

... if GNC domestic franchise sales were impacted by the timing of the convention at the end of June, it made me wonder how much of FTLF's astounding $8.7M in 2Q16 sales were pulled forward as a result of the convention.

So I looked at the timing of the convention in prior years and it didn't take long to see a trend ...

... hard to know precisely how much the "convention bump" impacts sales, but I know that 1Q tends to be the seasonally strongest (b/c of new year's resolutions) and it tapers from there. So I just combined 2Q & 3Q together to get a sense of the typical two-quarter figure relative to seasonally peak 1Q sales.

I saw that in a "normal" year (whatever that means) 2Q + 3Q sales ~ 1.6x to 1.8x of 1Q sales. I used those multiples to back into a presumed 3Q16 sales figure in FTLF and at the high end, it inferred $5M in 3Q16 sales.

My stomach dropped at that moment, about as much as the stock dropped when FTLF preannounced 3Q16 sales of $5.3M.

This being the first time such a "surprise" has happened while managing outside money, it got me wondering about how much information of this information I should share. I decided to do nothing, but it seemed like there was no right answer.

Ideas are the lifeblood of an investment manager. It is their passion, their purse and their intellectual capital. That I have been sharing some of them freely has been a function of my own interest in having an open diary into my thoughts, growth and maturation as an investment adviser managing outside capital.

But as I've grown my AUM and client base - and having just struggled with this uncomfortable situation - maybe it is time to rethink that model and morph towards something different, either a paid subscription / advisory or simply quarterly and annual letters for clients, as others investment mgrs do.

I'm not sure how this will change aspects of what I write about in the future, but over time, all things evolve and I imagine this blog will as well so as to avoid this situation in the future.

Either way, my sole commitment - my fiduciary responsibility - will always be first and foremost to my clients.

-- END --

All rights reserved. This blog is not a solicitation for business nor a recommendation to buy or sell securities. This blog is for entertainment purposes only. I am under no obligation to provide any updates on any position I write about here.

Tuesday, October 25, 2016

On the short term activist shaking the ARIS tree

It is an interesting observation that when one types the word "SEVEN" into google search function, it autofills "Seven Deadly Sins" a reflection I suppose on the frequency with which the people check for behavioral affirmations.

In a way, the stock market has a similar effect. Every tick in the market can be a behavioral affirmation of one kind or another that can heighten the tension between greed and charity, or diligence and sloth.

I write here however, of the tension between "wrath" (less formally known as "impatience") and its more virtuous partner "patience". I find the latter to be a stellar principle for sound investing but it can be so difficult in practice that even those who speak of "long-term value-oriented investments" find it hard to back up with actions.

This all comes to mind because of the impatience recently expressed by the investor filing a DFAN14A with the SEC on ARI Network Services (ARIS), indicating a desire to solicit the sale of the company, an action that strikes me less as the endeavor of an activist than an expression of impatience and idiocy.

What we know about ARIS need not be rehashed because I've written about it elsewhere, but I'll summarize in three bullets:
  • It is an $85M market cap company whose CEO Roy Oliver, since taking the reins in 2008, has grown shareholder equity 33% CAGR. 
  • In stewardship with his capable CFO Bill Nurthen, who joined the company in 2013, Oliver now runs a cash flow generating business that has reinvested in high return acquisitions, an attribute of a "compounding" company
  • By increasing the availability of and access to debt, the company should be able to continue to fund what has hitherto been a successful acquisition strategy into the future.
In my ~15 years in institutional finance, I've rarely seen such strong capabilities in companies above $10B market cap and here I am a shareholder of one that is still below $100M, and with a potentially long runway of growth ahead.

Taken all in, I believe the C-suite team is unusually strong and capable for a company so small (though they are not perfect). 

Yet, were the company to sell, we would lose our ownership rights to the company just as the going-got-good and we would lose the benefits of investing in a C-suite team that has performed so admirably. To break up the band, so to speak, seems premature; to nip such success in the bud seems stupid. 

Obviously, once a company has gone public it is in principle already sold; shareholders are the owners and the executives are the managers.

This missive is therefore addressed to my fellow owners who like me can see the long road ahead under present management, who don't want to pay taxes on their growth in capital to date and who know how hard it is to find well run companies that can compound growth over time, for what are well run companies but good mgmt teams allocating capital - labor, time and financial - wisely?

When we find them good companies well managed, we should hold onto them for long periods b/c they are few and far between.

I imagine all shareholders know as much as I do and see the same attributes as I see in ARIS,  but what do we know about the owner advocating for the sale? I aim here to briefly fill in that gap based on available information so we can judge for ourselves whether his suggestions reflect temperance or gluttony.

This appears to be the third activist endeavor for the owner ...

1. AdCare Health (ADK). Period of activism: 2013 until Present (he is now on the board).

Initial statement from April 2013 says he owns 750k shares at $4.01.

In July 2013 he's advocating they sell the real estate to generate $4 / share cash that they pay as a dividend to shareholders and that the remaining business would be worth $9 / share. In August 2013 he says they should split into a REIT and an operating company. July 2014, the company announces it will end operations and convert into a holding company that would make it attractive to be acquired by a REIT. In November 2015, the Vice Chair has fraud charges filed against him. (I can't keep up!).

ADK now sells for under $2 and is the subject of an activist campaign by Echo Lake Capital / Ephraim Fields. Value investors appear to like the opportunity from the NOL's and the property.

2. Resonant Inc (RESN).

Initial statement of ownership of 300,000 shares in Feb 2015 at $15.47.

Continued to buy through the spring of 2015 such that ownership stake reflects 700,000 shares and the stock is trading at $4.75. In February 2016 he's given a board seat with the stock at $1.80. As of 4/27/16 he owns 1.035M shares.

3. ARI Network Services (ARIS)

1M shares bought b/t October and December 2014 @ $3.67 / share. In December 2015 files letter that company should seek potential sale. In Oct 2016, files proxy that company should consider a sale and that he is nominating himself and some investment banker to the board.

... I dare not speak ill of other investors for it is undoubtedly a function of hubris to think that one is smarter than another.

We all see in companies values - the more divergent the value the greater the opportunity - and I hope the value this investor sees in the shares he owns can be realized. I know nothing about two of them. However, I have experienced two things in life that I can say with certainty:

1. People tend to repeat their patterns of behaviors. Conclusion: Someone who has a prior history of buying small cap companies, getting on the board and overseeing value destruction is likely to do that again. We should aim to keep those with a frequency of such behaviors from coming to near to managing the capital that investors, company employees and managers have worked so hard to produce.

2. When my children ask for things they've done nothing to deserve, I say "no". Conclusion: When your unsolicited proxy arrives, shareholders should do the same here.

-- END --


Monday, October 17, 2016

The Half Truths Told About Passive Accounts, And the Whole Truth on Concentrated Patient Investing

Peter Thiel apparently likes to ask an interview question: "Tell me something that's true, that almost nobody agrees with you on."

I prefer the question "Tell me something that's false that everyone believes" and as I've grown older I've gained more confidence in those things that come to mind.

At the top of that list right now is the idea of diversification, (followed closely by Vikings not actually wearing horns on their helmets).

Diversification makes sense b/c it follows the common principle, "don't put all your eggs in one basket".

Ironically however, that principle conflicts with every single one of life's most important decisions; who you marry, what you do as a career, who you work with, etc.

In all the major commitments in life, we by nature put all your eggs in one basket.

I think everyone would do well practicing at least once in awhile putting all their eggs into one basket so they better understand the inputs to and tolerate the consequences of those actions.

Anything else is laziness.


This relates to the half truth that we should invest our savings in the market through a diversified basket of low cost index funds as an alternative to buying and selecting individual businesses for investment.

The whole truth is that when asset returns are correlated the presumed benefits of diversification disappear, so why is it better than individual stock selection?


I reckon most people don't think about the markets as individual companies. I reckon they think about it more like a flock of starlings in murmuration but those of us who analyze individual companies are like ornithologists who can pick out individual birds.

When you dig deeper into "the market" and look at its components it becomes apparent that sometimes "the market" is really just a few stocks overweighted in an index, impacting the whole.


There are a lot of ways to invest in the stock market beyond undifferentiated passive investing. I buy and hold small companies for long periods and limit my portfolio to a handful of what I think are terrific businesses trading at reasonable prices (or better still, unreasonably low prices).

There are plenty of other people who do what I do up and down the market cap spectrum (ie large and small companies) and then there are others who buy bankruptcies, debt, risk / arb, options. There's no lack of variety of investors. Some are more consistent and successfull than others.

Regardless of who those people are, I think I speak for all of them -

every single investor that buys individual securities 

- that the underlying trend towards blanket diversification reflects two forms of laziness - intellectual and professional - that has become nearly universally accepted but is just plain wrong.

By intellectual laziness I mean the inherent incongruency that we should prefer market exposure with market risk over business exposure with business risk.

A well researched, thoroughly analyzed, cash flow generating, under-levered and growing business acquired inexpensively should - at any point in time - be a safer investment than a basket of companies arbitrarily selected by their size or industry or valuation, especially when that basket overlaps so many others. And if properly selected it can generate a more meaningful return than that basket.

But finding those companies takes time and effort and its stressful and difficult and it gets in the way of making money that comes from accumulating assets, which is how all money managers get paid regardless of performance.

By professional laziness I mean the things that happen when people ...

1) accept intellectual laziness and call it a service.

2) do what everyone else does and call it "unique" or "proprietary"

3) take vast sums of money from endowments, pension funds, retirement funds, government entities, etc and put it into instruments that behave like index funds simply b/c it's too hard to allocate them otherwise, and with no consideration of or responsibility for those whose retirement depends on the wise allocation of said capital.

... the alternative in all cases involves work that is difficult and differentiated but could be more meaningful to clients; identifying a handful of undervalued securities and owning them.


I've been investing personally since the late-1990's, starting with 10 to 100 share lots when it was easy and you could read Buffett at night and still buy www.something.com during the day and be up 10x the next and none of it made sense, but it was fun.

The investing structure of Graham and Buffett resonated with me nonetheless and I fell in love with it, slowly transitioning from my prior work as a writer / reporter to institutional research (with stints as a PI and in PE in between) then working for nearly 15 years on the sell side (with an MBA squeezed in) covering mostly industrials and services related companies up until I was laid off in 2012.

Here's a small collection of books I used to teach myself about investing ...

... I have a whole other shelf of text books from my MBA plus it's incredible what's available online now (and at the library).


Ironically, b/c I worked on the sell side, I had little time to spend thinking about my own investments and b/c of Eliot Spitzer I couldn't own the stocks I covered, so my personal accounts (I managed three) were fairly haphazard.

I had three primary accounts: One mostly held companies where friends of ours worked (a quasi Lynchian approach), one was concentrated in micro caps I'd read about in trade journals or found on screens, and one was diversified with large companies.

I tracked returns extensively on Quicken on an early generation Macbook but i gave that up when i started working in the industry. It was okay for me that some stocks went up more than others went down.

When I was let go, and looking for work on the buying side, I figured I should start reflecting on my personal returns. I could only go back as far as the end of 2007 since E*Trade only kept returns for a certain period and here's what I did over that time period.

Nothing earth shattering ... but it dawned on me that owning a handful of random micro-caps in concentrated positions for long periods led to 2x outperformance of the major indices, and with a pretty a low correlation.

What if I just focused on that area of the market, not buying "random micro caps that sounded interesting" but fully understanding the businesses, the managers and executives, the customers, analyzing these tiny companies as I'd analyzed mid- and large-cap companies in my coverage sector, and making big bets in the best ones I could find, while saying "no" a whole lot more?

I decided that's my business, not just b/c of the outperformance over an arbitrary time period, but b/c I liked finding gems overlooked by others and most importantly b/c it would be easier to compound a small sum of money in smaller companies than it would be in larger companies.

Since that time, noting the end dates for the other two accounts which have been moved, that small cap concentrated account is up 18% CAGR. It seems to validate the thesis.

The downside of focus on small caps, which I've talked about with a few institutional PM's who run small cap funds, is that the strategy maxes out at a certain AUM, which caps compensation.

That's fine. That's why so few people do it. It is good enough for now to experience the ego gratification of investing in deliciously inexpensive well run company employing great people doing interesting work satisfying the needs of hungry customers, and doing it with integrity for myself, my clients and the companies I own.


This the most differentiated approach to investing requires patience. It is sometimes quick and exciting, sometimes slow and frustrating, but its always enervating and enlightening way engage the world around me.

The opposite end of the investing is the most undifferentiated mass marketed passive movement. They will charge you the least fees but you get the mass strategy. Someday this institutional passive investing will resemble the equivalent of cheap protein, including i fear, even the slaughterhouse.

-- END --


Friday, September 30, 2016

A Brief Description of the Kinds of Stocks I'm Wary Of

Here's one type at least: The "heroic / satanic savior"

That's where "BNI's" (ie "brand name investors") with terrific financial backgrounds but no industry experience swoop-in heroically with the imprimatur of "financial stewardship" ... and destroy value.

I speak specifically in this case on $CDI, now trading near net / net valuation, but there are so many examples I've seen where this happens. 

In this case, some ex-Eddie Lampert / Sears / Lehman folks joined the company in Oct 2014, and since that time, shareholder equity is down 25% and total debt is up 10-fold.

I imagine their compensation reflects the skills required to achieve such a distinction. In fact the word "compensation" shows up a quite astounding 385 times in the most recent proxy statement, though you'd have to scroll to page 24 to see the actual discussion on executive compensation (by that point, they've already mentioned the term 107 times).

From there on, you'd see there a quite intense amount of description of a comp plan that focuses on "shareholder value," which is mentioned only eight times in the report. (Perhaps a new investment analysis is the ratio of "compensation" to "shareholder value" in the proxy statement).

As for what drives "shareholder value": The company believes "... that if CDI consistently attains or exceeds its target levels of operating profit and RONA, shareholder value will increase over the long term. Our targets are intended to be challenging, yet realistic and achievable at the time they are established."

Since RONA excludes goodwill, that comp plan essentially incentivizes management to lever up and make acquisitions in order to grow operating profit. You can imagine that's the plan. Scorpions gonna do what scorpions do.

But this is a business where the assets walk out the door every night and I can cite many more levered acquisitions in the people business that have not worked than those that have. (My experiences are in the investment banking world where it never works).

Still, the horse is out of the barn. They've already made their first purchase paying $35M cash for "EdgeRock Technologies" a company that supplies project managers for ERP rollouts. Plus, they have a new $100M credit facility to borrow for future transactions and given that they're under levered relative to other staffing firms, they have plenty of borrowing capacity available.

But if they can't maintain or grow the operations, it potentially leaves long term investors holding the proverbial bag.

Staffing is not a complicated business: manage your bill / pay spread, keep overhead as low as possible, and hire high energy, terrific salespeople. But it is also a brutal business characterized by:

- Cyclicality. Staffed employees are first in and first out.
- Low barriers to entry. All you need is an internet connection.
- Incredible competitiveness
- Disintermediated by technology

This is the second staffing company I've looked at recently trading at or near net / net valuation ($HSON is the other one) where some BNI's have come in to "turn it around" ... and they haven't.

The good news is, these are just two of the tens of thousands of companies that  trade everyday in the public market, with a bid on all of them.

If I wanted to own a services rollup, I'd be more keen on companies run by managers with a rabid dog mentality towards selling and collecting vs financial mgmt. I'm just not the type of deep value investor that can step in front of a business unless success is paved with operating excellence.

-- END -- 


Thursday, September 29, 2016

A Comparison b/t C&I loan growth and the ratio of multi family to single family housing permits

Been looking at a lighting company that gets half its revenues from multi-family residential new construction.

Though a different company than TAYD, both are exposed in some way to institutional or commercial construction.

This chart shows changes in C&I loan growth (commercial and industrial loans) - the blue area graph - via FRB layered on top of housing permit data, specifically, the ratio of multifamily permits (five or more units) to single family permits.

I think the takeaway is that multi family construction permits really ramp relative to single family later in a cycle, and that there was a period of under building of multi-family units during the housing bubble.

My sense is that business is passed the peak, at least for the current cycle (yes Virginia, there is a business cycle, no matter how skewed it may be by interest rate policy).

Or maybe slowing C&I loan growth is from uncertainty about future policy and rates, due to the election.

I'm not a macro-investor I just love comparing things.

-- END --


Thursday, September 22, 2016

Happy Birthday Vanguard (I got you a Spotify account as a gift!)

This morning, the Marketplace Morning Report  had a story on Vanguard's 40th birthday and a piece on revenue growth in music streaming. 

It dawned on me that Spotify and Vanguard shared similar dynamics - they are both disruptive innovations - and if that's the case, then it follows that stock pickers are the equivalent of hifi-enthusiasts in an ETF-dominated world; a shrinking community of music perfectionists that think they do it "better" than everyone else. 

Through the lens of convenience, "better" isn't about sound quality and imaging but about pervasiveness and availability. 

There are countless places we've accepted - for the sake of convenience - "lower quality experiences" in our lives. That's a key aspect of disruptive innovation that Vanguard brought to the investment world (the program starts at 3:40)

Vanguard's innovation? At a time when people were trying to beat the market with exceptional results, Vanguard offered a way to be ... unexceptional ... and now its S&P 500 mutual fund and Total Stock Markets Fund are the two largest funds in the country. 

What an incredible experience for the average person who doesn't follow the markets, who doesn't know how to tell a good investment from a bad investment - or even a good investment manager from a bad one - and who has no financial education to not have to make a decision and concurrently be freed from the bonds of snake oil salesmen with the ease and convenience of buying something that's simply good enough. 

What - if anything - are those people missing? And what can I learn from this as a startup RIA focused on small cap investing? 

I don't think people know what they're missing. Many treat their investment and retirement savings with little thought - and much hope - probably b/c they don't know how to think about it, or they've never entertained the notion of "I can invest." So they outsource it.

On the latter - what can I learn? - how do I reach people who don't know what they're missing? I guess I could start a fund and focus on the small market of other hifi enthusiasts who don't want to listen to a compressed version of Eine Alpensinfonie or won't watch "Lawrence of Arabia" on a cellphone. 

I'm passionate about trying to reach a wider audience to help them understand the choices they face, provide some education and service, and, potentially, deliver returns on capital that exceed the market, with less risk, less tumult, and also while avoiding companies whose missions are opposed by my clients. (When you own the S&P, you own companies that build guns, burns coal, promote addictions, etc. Why should someone opposed to those endeavors accept them in their investment portfolios?)

To anyone who thinks investing is hard, I tell them that picking stocks is just a concentrated form of the same decisions people make all the time: what shoes to wear, what fruit to buy, what to eat for dinner. Once you lay out the parameters, it's easier to make a decision. Not easy, but easier.

As an avid investor, I balance the difficulty of decision making with the alternative, and I can't fathom why someone would want to risk capital on an undifferentiated mass of companies whose value - on whole - tracks GDP growth +/- people's attitudes (ie multiples). Why would I want to outsource mine and my clients' capital to other people's attitudes when knowledge and experience can do better? Instead, I prefer to make decisions, and as few as possible. 

Finally, I firmly believe that we lose things when we accept unexceptional, in the investment world and in the real world. 

What we lose in the process of making undifferentiated investments, is, I think a key point in that Sanford Bernstein piece from awhile back, that if we're no longer allocating capital to its best and highest use but simply spreading it around, we disrupt price signals and outsource returns simply to a function of interest rates and money supply. 

And in the personal world, there maybe even worse consequences. Music, art, movies, conversations with people, travel, real adventures - not 3D replicas - these experiences create emotions. Video games create emotions too, that's why they're so much fun. But when we dial down the experiences to a virtual one, I think we limit our emotional selves. We can't possibly experience the same catharsis at a 160 kbps bit rate as we do in real life. 

In both the investment world and the world around us, when the effort at reproduction isn't towards replicating the best experience but only about convenience and accessibility - yeah, it's good enough - something is lost. We shrink the world to a bunch of correlated experiences, rather than expand it to a variety of global ones. 

-- END -- 


Wednesday, September 14, 2016

$EVI Acquisition: Brief Readthrough on WSD Deal + 8x ProForma Valuation

I first wrote about EVI here when I believed it to be the kind of well run company that I wanted to own forever; niche business that generates cash, functions in a kind of protected duopoly and doesn't dilute shareholders. I had behind me decades of financial statements as evidence that the business was a lock box for cash. It was a $16M mkt cap company.

Then, Henry Nahmad acquired a controlling interest in the company and he was pretty upfront that nothing / everything would change.

He'd keep the core business roughly the same but roll up the industry the way his uncle / father rolled up the HVAC industry ~40 years ago to create $WSO. Not a bad pedigree; WSO has returned +12,000% over the last 30 years.

And then nothing happened ...

... until the first week of Labor Day 2016 when the company announced its first deal to acquire Western State Design, a primarily West Coast distributor of industrial and coin/op laundry equipment, for $28M. WSD was privately held and owned by Dennis Mack and Tom Marks. With this first deal done, Nahmad can now be judged on his actions not his pedigree. 

This is a short summary of my reading on the deal.

Price / Structure / Value 

The deal has a headline $28M purchase price split between $18M in cash and $10M in stock. But there's more to the story than the headline ...

The $18M in cash comes from 1.29M shares sold to Nahmad's investment vehicle Symmetric LLC in a PIPE @ $4.65 / share (the close price before the deal closed) + $12M from a newly announced credit facility. The total size of the credit facility is $20M.

Of this cash, $15.2M is paid at the close and $2.8M will be escrowed until 18-mos after deal; this appears to be related to and contingent on collection of AR's at the time of the deal

The purchase price includes 2.04M shares of stock worth $10M based on the average closing price of the stock for the 10-days prior to the Asset Purchase Agreement. Mssrs Mack and Marks - the sellers - will own just south of 20% of the combined company after the deal.

+/- what appears to be standard working capital adjustments from the baseline $4.8M working capital at time of the deal.

Western State Design did $60M in sales last year vs $30M for the core EVI. The company, it should be noted, is tripling in size. Operationally, WSD appears to be more heavily weighted towards coin op than the commercial laundry equipment / boilers that EVI distributes. Also, there appears to be no overlap in regions as WSD is mostly out West and EVI in Florida / Caribbean / Central America.

WSD has more gov't contract / federal work than EVI and apparently has security clearances related to that work that will be transferred in the deal; (what kind of security clearance is required to do laundry?). Very little information is available though it at they are at least savvy enough to protest an award (FWIW).

Based on WSD's $60M sales figure and assuming roughly the same EBITDA margins as the core business, EVI is acquiring a company twice its size at 5x-6x EBITDA.

Before the deal EVI was trading at ~$4 / share or ~10x trailing EBITDA. Proforma it appears to be trading for ~8x proforma EBITDA.

The $12M in borrowings to fund the deal is part of a larger $20M credit facility with Wells Fargo, so they have access to an additional $8M in borrowings. Perhaps other deals are pending as well ... 

A bit about Western Design and its owners / sellers, Dennis Mack and Tom Marks

Mack and Marks are co-owners of the firm. Not much information available about them, strangely enough in this day and age of social media. Would like to learn more and probably will have a chance to meet them at the shareholder meeting in Nov, as they will both become execs of the company and at least one will serve on the board.

In the standard non-compete provision, there is a carve out for a business run by Dennis Mack: "The foregoing prohibition shall not apply to the involvement in any manner by Dennis Mack with respect to Associated Laundry Management, a commercial laundry  in Reno, Nevada." Maybe he has a lab underneath it.

Another irrelevent tidbit: EVI is not acquiring the facility of WSD's headquarters on Tripaldi Way in Hayward, CA, but rather signing a new lease with the existing landlord. That existing landlord is TylerTown LLC, an entity created in 2012 by the controller of WSD, Marianne Lenci, so like EVI itself, WSD pays rents to its CEO.

It's not an unusual situation - lots of companies do this - and its critical for investors who tend to dismiss such things as "inside dealing" to reflect and consider what's actually important information in making an investment decisions. I don't think this is.

Why am I scraping the Department of State filings to get information on this company? B/c I can't really find anything else material.

But as a sense of what kind of managers are Mssrs Marks and Mack, I found this interesting. In 2010 they had plans to develop on spec a "state-of-the-art commercial laundry for sale or lease to an operator, the company says. The building site encompasses 3.87 acres and includes a 14,000-square-foot enclosed service yard. It is strategically located for effective distribution throughout Northern California."

The risks for building on spec were somewhat offset by their ability to get funding from a state issued bond on the deal.

The point is, we know our new fellow shareholders and managers have a nose for opportunity. And they were willing to take 35% of their comp in stock. This reinforces that assumption and provides some affirmative bias that as with already existing shareholders, they see long term opportunity in the business.

-- END --


Tuesday, August 16, 2016

The Bias of Other Shareholders

When the esteemed fashion / style photographer Bill Cunningham died, the WSJ's Ralph Gardner Jr (a colleague from my first job out of college) wrote a piece with a hed / subhed ...

"Bill Cunningham Leaves a Social Void
The late photographer’s presence at an event told you it was worth attending"

... which struck me as a great analog to an activity popular among many investors, which is to look at what other are doing as a way to confirm that the event they're attending stock they're buying is worth owning.

If you're like me, you probably like to know who the fellow owners are and what other good investors are doing. But even while I peek at owners, I remind myself that a company's ownership composition has absolutely no bearing - zero - on its future cash flows, which is the ultimate arbiter of value.

Yet every quarter there's a flurry of time and effort analyzing 13F filings. It is the 3rd biggest waste of time for a practice "generally accepted" among investors. (The 2nd biggest is reading most sell side notes and the 1st is watching business channels).

At least this tweet, which compiles recent 13F filings has the self awareness that yes, it is probably useless. And yet, like a car accident, it's hard not to peak.

Investing is a most personal enterprise, and in some cases a most lonely one. Stop caring what everyone else is doing! Its fine to find comfort in fellow owners and to know what others are doing, but chasing stocks that other's own is a perversion of what makes investing so interesting.

A far better use of time for investors is finding people who disagree with you, a structural advantage for investors who are married.

Remember that the strike zone isn't the same for all hitters. Figure out an investment style that makes most sense to you, find businesses that fit that style, and be okay not giving a hoot what others are doing. You should be good to go.

-- END --


Thursday, July 7, 2016

How to not chase a stock ($TAYD)

While doing work on my last post, I came across Taylor Devices $TAYD on a screen for companies that - similar to $ARIS - have been generating cash and reinvesting it at high rates.

$TAYD is a $61M mkt cap / $55M EV company that makes products that solves problems caused by recoil, sway and / or vibration. These are generally called "dampers" or "shock absorbers" or "snubbers" and they make all kinds of them for two general types of applications: Construction and Aerospace / Defense.

In the construction side of the business, which is now about 60% of revenues, their dampers - including fluid viscous dampers - offset the sway of buildings, bridges and other structures where wind and / or earthquakes effect such things. One of the most recent / high profile applications is in the 432 Park Ave residential tower that blights rises over the NYC skyline like an oligarch's middle finger a tall reed of grass in the center of Manhattan.

On the aerospace / defense side the company sells components of military equipment to stabilize or isolate weapons and radars, personnel or equipment, like on the seats of naval craft or in the hold of the space shuttle.

An interesting tidbit around the history of the company is that it has deep roots providing fluid viscous dampers for the military (ie in the housing of MX missile silos so they would survive a nuclear blast) and then transitioned into the construction side after the end of the cold war, as per this short quote from an article in the January 2008 issue of the Journal of Structural Engineering:

"A major reason for the relatively rapid pace of implementation of viscous fluid dampers is their long history of successful application in the military. Shortly after the Cold War ended in 1990, the technology behind the type of fluid damper that is most commonly used today (i.e., dampers with fluidic control orifices) was declassified and made available for civilian use ( Lee and Taylor 2001). Applying the well-developed fluid damping technology to civil structures was relatively straightforward to the extent that, within a short time after the first research projects were completed on the application of fluid dampers to a steelframed building (Constantinou and Symans 1993a) and an isolated bridge structure ( Tsopelas et al. 1994), such dampers were specified for a civilian project; the base-isolated Arrowhead Regional Medical Center in Colton, Calif. Asher et al. 1996."

In short, this is a business with a long history making a high value product in an unusual niche; just the kind I like to invest in.

Through FY2015 ending May 31, 2015, the company sold $31M worth of these products generating profit of $2.2M, reflecting a net profit margin of 7.1%, impressive.

Even more impressive is that through the first 9-mos of fiscal 2016, the company generated $27M in sales - nearly matching the prior year with a quarter to spare - with net income margins above 10% for 1Q and 2Q and ~14% for 3Q. (The FY16 year end has closed but company won't report until August).

And most impressive of all is that 10-years ago, this company was levered 3x EBITDA, had $86K in the bank and did 1/2 the revenues as they do today, with 92 employees ($130k / emp). Today, they have $7M in net cash, twice the revenues and a stock trading at 3x backlog, with only 112 employees ($275k sales / emp).

How the company turned around its business was a function - like all success stories - of many things happening at once but a few things stand out:
1. wider acceptance and regulatory approval of fluid viscous dampers in earthquake prone areas
2. expanded production facilities with better equipment that improved turn times
3. larger production facilities to accommodate larger products
4. better tax management, (ie lower tax rate), which means IMHO that mgmt is actively working hard to generate higher returns.

Some of the improvement is structural but some benefits from a cyclical real estate / infrastructure tailwind. Such is the nature of all industrial businesses.

And it is the nature of the stock market - especially in smaller niches of the market - to occasionally be imperfect on valuing stocks. To mine eyes, after digging into the company's business and financials, the valuation appears to reflect a mistake by the market, erring towards a rather common mistake of a stock responding to earnings growth rather than the order book.

In short, the stock appears to be violating the old adage regarding investing in industrial long-cycle businesses to "buy in the order cycle / sell into the delivery cycle".

It does not take long for an investor to observe that backlog is declining, avg project sizes are declining, and that book to bill ratio is 0.5x, meaning the company is burning backlog at twice the rate they are bringing in new business.

For those more inclined to visual displays of data, here is a graph of TAYD's backlog activity layered on top of sales activity. It is quite easy to see how the two generally move in the same direction sales lagged one period.

Here is a graph of TAYD's sales and net income. Again, quite easy to infer a relationship between the two, except in the most recent period.

Why would it be that Net Income would suddenly diverge from declining sales? I'd hazard a guess that on large fixed price projects the company can harvest awards on completion, as is the case with many construction related businesses.  And with backlog coming down, one can infer that several large projects have recently completed.

Here is a graph of TAYD's Net Income layered over "price to backlog" a valuation methodology typically used for companies that generate income off of backlog. You can see how investors reward the company with a higher multiple during periods of strong earnings

And finally, here's a chart of the median quarterly price of the stock layered on backlog.

It is certainly possible that the market knows about some orders on the horizon that will boost backlog or potentially future opportunities for sustained margin expansion.

It is possible that the company has been "re-rated higher" b/c of its prior capacity expansion, with another capacity expansion currently under way, that will enable the company to build even larger product and capture more share of the market.

But it is not possible for the company to generate strong results without strong orders, and the orders of late have been lagging.

At $60M market cap, this remains, to the wider market, an "undiscovered gem" and perhaps even a good idea for a long term investment. I don't yet understand enough the competitive landscape to make that decision. But I do know that if the pull of orders tugs earnings down, and momentum buyers flee, there will likely be another bite at this apple at lower prices for patient investors.

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