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Avram Fisher, Founder & Portfolio Manager of Long Cast Advisers, is a former equity analyst at CSFB and BMO covering industrials and business services. He has prior experience in private equity; as a corporate governance analyst; as a writer; reporter and private investigator; and as a lifeguard and busboy (I still clear plates when my kids don't). This blog is an open book of ideas about patient investing and about starting up a small-cap focused RIA. It is part decision-diary, part investment observations and part general musings. Nothing on this blog is a solicitation for business nor a recommendation to buy or sell securities. It is simply a way to organize and share thoughts with an expanding audience of independent, patient and talented small cap investors. www.longcastadvisers.com

Friday, August 17, 2018

LCA 2Q18 Letter + thoughts on the problems we investors are trying to solve

LCA posted negative consolidated returns in 2Q18 and YTD. I wrote some reflections in the quarterly letter, here. I started that letter probably two months ago, and it grew (and grew, and grew) before I cut it back to the final 2,000 words.

Here's something I cut out of it, but wanted to share somewhere. It touches on the chasm between the way a sell side analyst thinks about analysis vs how a share owner thinks about value ...

"The things important to the sell side (typically revenue growth and margin expansion) are vastly different than what's important as a stock buyer. My first inkling of that difference came from a client at Pyramis. He always asked good challenging questions in this friendly laconic way, and occasionally shared his thinking on stocks.

This must've been '10 and we were talking Emcor (EME), a wonderfully managed specialty construction company, then trading in the high teens / low twenties. I'd analyzed that company for years, knew it in and out. I'd even identified correlations b/t labor statistics for mechanical and electrical subcontractors and growth rates and used it to set quarterly earnings forecasts. Such things are important on the sell-side.

So I was pretty dialed-in on those specifics and on the stock in general, but I didn't see any reason to buy it. There was no pending growth acceleration. No weather that seasonally drove up the business. No major infrastructure bills.

I asked what drove his interest and he told me, quite simply, that it was a great well managed company that seemed cheap with a terrific CEO [Tony Guzzi]. He got no disagreement from me, I just questioned the timing.

Sometime after, I reflected on that conversation, I realized something critically important; He wasn't interested - as 90% of my other clients were - with next quarter's "beat and raise". The problem he and other long term oriented PM's are trying to solve is finding good companies to own, that could be owned for years, that weren't going to keep him up at night and had a high probability that it would grow in value over time.

I definitely wasn't aware of the term "compounder" at the time, b/c I had my head so far up the ass of "rev growth and margin expansion", but that's essentially what he was going for. Over time, I realized I wanted to be more like him someday.

Once I left the sell side, the first stock I bought that I hadn't previously covered (ARIS) was attractive to me b/c I'd seen evidence of management's ability to create long term value in the form of BVPS excluding-goodwill.

Ask a sell sider to analyze growth in BVPS and they'll probably ask why that matters but on this side of the desk, it is dear. The consistent creation of value evident over time on a balance sheet is one of the most important elements to consider for long term investors."

... waking up to that difference was a growth moment for this investor.

And now we come to this quarter and this YTD, where performance is offering more lessons. Specifically, questions like, what happens if the companies we own aren't generating long term growth and value as expected? What if management and the board start making choices and decisions that conflict with our principles of long term value creation? Even worse, what if they've been making poor choices all along, and we just didn't recognize it? 

Due diligence is an ongoing process. Mine is not directed towards "next quarter's earnings" but what's actually happening at the company - with operations, customer satisfaction, culture - to assess whether management remains focused on the l/t drivers of value vs short term success. I hope I'm getting it right over the long term. I know I'm spending a lot more time than ever thinking about the differences between the research process, the portfolio management process, the valuation process and the ongoing appraisal process.

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One thing I can say for certain with "long term growth in value" is that you have to be content sitting for years owning shares in companies whose operations consistently improve and whose stocks do nothing, or even decline.

Here's the BVPS of two companies we've recently been investing in (still buying them so going to remain vague on tickers) ...



... the top chart is for a company that's been investing pretty consistently since '05 a cumulative $35M in a software style platform that is finally bearing fruit. The big jumps in the early '00's and in '14 represent sales of earlier businesses.

The stock has gone in hockey stick mode ... but when you read 10-years of financials and five years of conference calls ... I see evidence that they are rational investors who've been focused for quite some time on building a pretty interesting and hard to replicate platform.

For the company to generate a positive IRR on their +$35M cumulative investments, I estimate it needs to generate profits well north of $20M. So while the stock is expensive against this year's annualized income, against that long term "bogey", it remains quite cheap. And based on talking with experts in the industry, its offering is in quite high demand.

The bottom chart shows BVPS for a company whose current CEO joined in '12, did a major writedown / restructuring and identified one strategy that's bore fruit in '17 and another strategy that they think could bear fruit in '19 (but who knows?).

It's been a terrible stock on account of impossible y/y comps that will continue through 2018. Plus, it's a capital equipment provider in the chip space, so you've got that cyclicality. Their equipment does a fairly commodity task of programming chips. Lots of companies do this. But ... there's more data going into chips + there's an idea that security needs to be programmed into the "root" of a chip = separation between competitors based on speed, reliability and access to security IP.

They've locked up some pretty good IP; in a convo with a frenemy, their technology is solid. Their partner who supplies the IP in the security offering was recently acquired for +$30M valuation (on less than $1M sales). If the buyer wants to get a return on that investment they need our company to produce more equipment.

And all they do, all the time is think about putting value into / squeezing value out of this niche business of providing their capital equipment used to program chips. They solve problems for electronics distributors (Arrow, Avnet, etc) and automotive suppliers (Bosch, Johnson, etc), who need fairly small scale (< 10M) units programmed.

It might remain a terrible stock through 2H18. It might be a terrible stock until their security offering starts to work. That security offering might not work until regulations change.

It might be a terrible stock even when it does start to work, b/c they won't be booking large equipment sales but rather high margin pennies per chip sales. But it seems inexpensive relative to it's future opportunity and it's growing installed base.

Like anything else, both of these companies are investments in unknown and unknowable futures. That they are both managed by teams that have long been focused - and demonstrated an ability to generate - value creation offers the outside investor at least something to hang their hat on, and solve that problem I recognized we investors all face, long ago.

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