On Tracking Tigers + LCA 3Q22 Letter

I recently attended a small retreat for fund managers where one of the guest speakers, via video presentation from a game reserve in S. Africa, was a lion tracker. He shared some point about tracking lions that had significant overlap with investing. I thought I'd share a few notes I jotted down ... 

Intuition drives the first step 

"Trackers sit in the tension of the unknown" 

"Trackers are energized buy the state of the unknown" 

Walking over the same areas multiple times offers opportunities to see new things more clearly 

Trackers develop narratives based on information but they need to be open to new information and open to re-calibrating those narratives. 

"We take in the macro (sounds, wind direction, weather) and integrate it into the micro."

When trackers lose a trail, they stop. Then reassess.  

... there were many more nuggets of information, and the guy was pretty inspiring, but I wondered how much more effective a tracker is vs simply hanging out at a watering hole and waiting. I suppose that would be the index investing analog to tracking a lion: Less fun, less interesting and though unlikely to have as high a success rate, zero effort utilized. Of course, if hanging out at the watering hole is just as good as the tracker, then maybe the tracker isn't so good? 

Our portfolio is having a pretty good YTD - here is a link to my 3Q22 letter - but whatever success I'm having rests heavily on lessons learned from 2020, which was a very hard year for me and our portfolio. It took me a long time to internalize the experience of significant losses and learn from it. I wrote about some of these lessons in my 3Q20 letter and these lessons very much inform my work as a portfolio manager today. I can summarize those lessons in three words: "IRR is everything."  

I started my business with significant experience as an analyst and zero experience as PM. I knew there was a lot to learn and seven years in, I've learned a few things beyond just the importance of IRR. It includes the importance of changing ones mind, limiting large losses, starting with smaller sized investments and growing them over time, buying on the way up or down, all in the effort to upgrade the lowest expected IRR company in the portfolio with companies with higher IRR's. Though I aspire to own stocks forever, the realities of managing a portfolio of SMA's is very different and occasionally prohibitive of that endeavor. 

I realize what I do is idiosyncratic and not for everyone. I'm still not earning what I would make if I were an employee, but it's all moving in the right direction, slowly and steadily. I love engaging my curiosity about the world through the lens investing and I believe I'm building something thoughtfully and step-by-step that I can do for decades longer. If I keep my head down and show consistency in finding companies that grow in value, the business will grow in value too, and create something of substance for me and my clients.  

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ALL RIGHTS RESERVED. PAST HISTORY IS NO GUARANTEE OF PRIOR RETURNS. THIS IS NOT A SOLICITATION FOR BUSINESS NOR A RECOMMENDATION TO BUY OR SELL SECURITIES. THIS IS NOT FINANCIAL ADVICE. I HAVE NO ASSURANCES THAT INFORMATION IS CORRECT NOR DO I HAVE ANY OBLIGATION TO UPDATE READERS ON ANY CHANGES TO AN INVESTMENT THESIS IN THE COMPANIES MENTIONED HERE, WHICH I MAY OWN.

Richardson is Having an Interesting Product Cycle

This is a product-based thesis. The company, Richardson Electronics (RELL), long a “dog” stock with a lousy corporate governance structure, is having its day. It has a few new products that are finding eager audiences. These products include ultracapacitors to replace lead acid batteries in backup power systems (wind farms, telecom base stations, et al); lithium phosphate batteries to replace lead acid batteries in diesel engines; and magnitrons used to convert methane into diamonds (seriously).

“Why this? / Why now?” comes down partly to Maxwell’s demise under Tesla; partly due to ESG rethink of the use and pervasiveness of lead batteries; partly due to keen segment management by industry veteran Greg Peloquin, who returned to the company from Arrow in 2016; and partly due to the CEO’s willingness to fund odd and interesting projects.

The stock may be cheap for a number of reasons. Investors may assume growth is cyclical semi CAPEX related. The company’s long history of under-performance and poor corporate governance may lead to doubt and disbelief among otherwise knowledgeable investors. It is likely to fly under many investors radars and requires a bit of effort to understand. But the company seems to have locked up substantial supply of raw materials at reasonable prices and has a head start on competitors in what could be a large and durable niche in the uninterruptible power supply ecosystem and possibly beyond.

Introduction: Richardson Electronics (ticker: RELL), an electronics parts manufacturer and distributor, is a publicly traded family business. At the current price of $14 and with 14M diluted shares outstanding (Class A + Class B), RELL has a market valuation of ~$200M. Less ~$40M cash (no debt) yields an enterprise value of $160M. Given TTM EBITDA of ~$18M this yields an EV / EBITDA multiple of ~9x. It trades roughly in line with, if not at a slight premium, to its industry group but TTM sales growth of 30% is the highest among them and EBITDA has grown faster.

The electronics distribution business is operating in the midst of global inventory imbalances and a semiconductor CAPEX cycle. Knowledgeable but uninformed investors would wisely apply a low multiple to cyclically inflated sales for companies so exposed. However, the underlying thesis on RELL is only partially driven by current cyclical industry conditions.

This thesis is primarily driven by specific products the company offers. Broadly speaking, these products are supported by “a new age of electrification”. I realize it’s a weird thing to say 90 years after the death of Thomas Edison, but there is a shift happening on the margins resulting in changes in energy storage away from non-hydrocarbon sources and changes in generation from non-combustion sources. Wind and solar generation, hydrogen, lithium or various kinetic systems for storage, nuclear, etc.

How much of the total energy pie these alternative eventually provide isn’t known or even relevant; it is such a big pie that small changes are meaningful, especially to the component supply dynamics in the electronics industry, leading to changing demands for power management and power storage across the production chain. This is RELL’s wheelhouse.

Specifically, there are three product tailwinds of note:

1.   Ultracapacitors replacing lead acid batteries for remote backup power, et al. A lead industry website indicates that 86% of global lead production is for lead-acid batteries used in transportation, and also for zero emission and hybrid vehicles, back-up power (for example for computers and telephone systems), and energy storage in remote power applications. Global production of lead is about 12M tonnes and it is said that 90% of lead is recycled but this math doesn't seem to foot.  

How big is the lead market? I’ve seen (free) internet data that global lead sales is ~$20B and that global lead acid battery sales are ~$40B. How much of that is uninterruptible power supply? I am trying to find out, but don't think 10% is a conservative guess. A UPS system typically includes a lead acid battery as a starter. Given how we’ve "rethunk" lead in paint and gasoline it’s not a stretch that engineers would rethink its use in batteries, especially in an ESG dominated world. Ultracapacitors, which hold a charge longer than regular capacitors, offers an improved solution for UPS systems. 

These improvements are especially functional in wind turbines, which take a lot of effort to maintain. Each blade of a wind turbine has its own pitch control system so the blade no longer catches wind. Each pitch control modulator has its own backup power system. Vestas wind turbines control blade pitch hydraulically (in a fault, gravity does the work) but hydraulics are messy and prone to failure. Other manufacturers – including most GE wind turbines - use electronic systems with a lead acid battery as the backup power source.

The problem is that lead acid batteries require replacement every 3-5 years and degrade in extreme temperatures. There are opportunities to do better. Wind turbine owners are electing to swap out lead acid batteries for ultracapacitors, which last more than 10 years and operate consistently in wider temperature bands. An ultracapacitor need only store enough power to pitch a blade, which takes less than 30-seconds. Here's a short video from 2018 with a former regional sales manager at Maxwell (he's now at Licap). 

In May I attended the American Clean Power conference and talked to competitors, customers, OEM’s and installers all of whom affirmed this evolution. In the US based aftermarket wind turbine business alone, this is estimated to be a $300M opportunity (30,000 installed GE wind turbines x $10,000 / turbine). 

The opportunity to sell U/C’s into the wind farm world fell into RELL’s lap when Tesla acquired Maxwell for its dry capacitor business and shut down everything else. RELL (and many others) formerly sourced U/C’s from Maxwell. Forced to go elsewhere, it now has an exclusive supply agreement with Korean-based LS-Mtron for distributing U/C’s into the US “green energy” space. RELL is supposedly buying every U/C LS Mtron makes and at a significantly lower price than from its prior supplier. 

RELL US assembles the U/Cs into a form factor identical to the lead acid battery system and has a patent on this design. Former Maxwell folks have split into two separate companies (LICAP and UCAP, which acquired the old Maxwell business). They, along with Skeleton in Europe, are pursuing this market, all from behind RELL.

I think this market alone is enough to support continued growth and earnings from a low base. But taking a step back from wind turbines, when one considers how often a lead acid battery is integrated into a backup power system (at telecom base stations, to start a generator, etc) and that ultracapacitors last longer and need less maintenance than a lead acid battery, and that lead acid batteries are considered “dirty” in an ESG world, it isn’t a hard stretch to believe the ultracapacitor opportunity could be quite a bit larger than simply backup pitch control systems for GE wind turbines.

2.       Diesel electric engines replaced with lithium phosphorous engines. RELL has a supply distribution agreement with Chinese based Amolgreen to supply lithium phosphate batteries to Progress Rail – a division of Caterpillar – for integrating into rail cars. The sales value per car is in the six figures. RELL is one of the few US manufacturers with the capability to assemble these cells in the US, meeting “Made in America” purchasing requirements. The company believes that in-roads with CAT could bear fruit on additional machinery and implements.  

3.       RELL builds specially designed magnetrons that used to create synthetic diamonds from methane and for tire recycling. The specialty magnetron is an engineered solution where RELL has called out significant growth as per the 3Q22 earnings call (4/7/22): “For instance, on the magnetrons, in the normal year on the YJ1600, we build 800 a year. And we went from building 800 last year, we have orders for over 5,000 right now.”

In addition to these secular tailwinds, and as previously mentioned, there is concurrently a semiconductor CAPEX cycle, which is driven by both supply / demand dynamics (ie resolving “chipageddon”) and the effort to produce chips and components domestically. Chip making is a highly cyclical and high capital intensity business and development CAPEX will ebb and flow. The key is that I think most investors believe whatever is happening at the company today is mostly tied to the semi CAPEX cycle and missing the greater product related “secular” event.

History. RELL was founded by the father of current CEO Ed Richardson, who has worked there (according to his self-reported business biography) since 1961. Mr. Richardson owns 2.1M Class B shares, which convert 1:1 to common shares but has 10x voting rights. This situation gives him ~60% of the vote, a corporate governance red flag and therefore should be noted right off the bat.

Started in the 1940’s as an electronics overstock seller and distributor, the company moved into manufacturing through the 1981 purchase of National Electronics in La Fox IL – still the national headquarters - and it went public in 1983. Skip ahead to 2010: Over-levered, losing money and suffering from the transition from analog to digital TV, the company sold its core RFPD electronics distribution business – it’s largest segment - to Arrow Electronics for $210M, leaving behind a smaller company with two business lines: The “Electron Device Group”, focused on capacitors, vacuum tubes, and high voltage power supplies and an integrated display business (ie “Canvys”) focused on the healthcare space. (Expecting parents possibly saw the first glimpse of their issue on a Canvys display integrated into an ultrasound machine.)

In 2014, three years after the sale of Richardson RFPD to Arrow, the company rehired that segment’s leader, Greg Peloquin, who had been part of the sale, and put him back in charge of the EDG division, an effort akin to “getting the band back together.” The primary driver of this investment thesis is substantial growth and opportunity in this segment, now renamed “Power and Microwave Technologies” (PMT), and notably in ultracapacitors and magnitrons.

A homegrown third business line called “Healthcare” launched in 2016, manufacturing replacement tubes (“Alta 750”) for CT-scanners and MRI machines. This business has struggled due to OEM’s willingness to match replacement prices in order to protect long term service customers. This segment has been a drag on earnings and possibly as an acknowledgement of its poor market position, incentive compensation for the Canvys and PMT business leaders excludes performance at the Healthcare segment (ie 50% segment results, 50% corporate OpInc excluding Healthcare).

Status quo in Healthcare is not sustainable. Either of the two alternatives - success in pending product launches for Siemens machines or outright closure of the segment – would both be beneficial to earnings. I don’t anticipate any success here; any would be meaningful upside to what is already attractive.

Financials. The company’s fiscal year ends in May and it already preannounced FY22 sales of $225M, up 27% y/y, accelerating from 13% sales growth in FY21. Margins have expanded since 2H21 from the lower single digits to higher single digits. Backlog at year end was $200M, up 87% y/y, but this should be taken with a grain of salt, since the company has only recently started quantifying backlog. (Management says it was previously immaterial).

Management has indicated that backlog is driven primarily by volume, not price and not supply chain backup. The concurrent growth in sales AND backlog speaks to this trend. If these opportunities for ultracapacitors and magnitrons are as real as they seem to be and they are delivering on them as they seem to be, this will be worth substantially more.

FCF. It’s understandable for a company in the distribution space to use its working capital to fund growth by re-investing profits into inventory and receivables - that’s what distributors do – but RELL’s FCF conversion is lumpier than larger, well known and arguably better managed distributors. This probably speaks to the opportunity for better w/c management. Given the corporate governance structure, the CEO would need to find their own motivation to change. In the meantime, he’s buying as much inventory as he can b/c he thinks the market could be big

Valuation. The company is likely to do $20M in EBITDA this year, so the stock is trading at less than 8x FY22 results. Growth is largely driven by discrete products in the company’s portfolio and primarily tied to a secular “age of electrification”. If these trends continue and the company can indeed deliver, there’s an argument for this re-rate higher against higher forecasts. Given the importance of a few products on this thesis, and given the company’s long history of under-performance, I expect this asset will require a more than the usual monitoring.

Risks. There’s a tendency for investors to try to encapsulate risks as if they aren’t infinite. On the flip side, it’s not hard to worry unendingly about everything. Here are a few rational concerns at the top of my risk list:

As a family business, it is possibly not run to optimize for efficient manufacturing. A database search for “six sigma” or “lean manufacturing” within RELL documents showed zero hits.

Ultracapacitors don’t work / manufacturing is shoddy. This is kind of a new market and variuances out to be expected. Maybe turbines are the test bed, particularly b/c the maintenance is so onerous. But what if they don’t hold up? Also, RELL says its sole sourcing from a S Korean manufacturer that is new to the market and therefore reliant on a single supplier for a large market.

Limited history of value realization. For the many years the company has been around, results have been mixed. Over the last 20 years, you’d have seen growth in Tangible BVPS (see graph) only for the first 10, culminating in the RFPD sale. And the company has come across my radar over the over the years generally viewed as a “value trap” ie cheap without a catalyst. I think the poor corporate governance, the long history of under-performance, and the belief that growth here is all driven by a cyclical semiconductor CAPEX cycle phenomenon leads to the mispricing. However, underlying secular trends notably effecting the PMT group offer potential for a sustainable shift in earnings power that is not yet reflected in the price.

 

Corporate governance risk. For better or worse, the CEO does not make decisions 100% optimized for capital allocation and shareholder returns. The reality is, most CEO’s - and most people too - operate for the sake of ego gratification first and foremost and it’s the rare leader that puts the customer or shareholder first. My impression is that the RELL CEO cares deeply about customer and employee satisfaction but that has not translated into durable shareholder returns.

Changing tides on ESG. I don’t see anyone “standing up for lead” the way they do with coal or gas, especially given we’ve removed it from other products over the years due to its extreme toxicity, but anything is possible.

These risks can be ameliorated through portfolio management ie keeping the position size reasonable until pending deeper due diligence over time.

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ALL RIGHTS RESERVED. PAST HISTORY IS NO GUARANTEE OF PRIOR RETURNS. THIS IS NOT A SOLICITATION FOR BUSINESS NOR A RECOMMENDATION TO BUY OR SELL SECURITIES. THIS IS NOT FINANCIAL ADVICE. I HAVE NO ASSURANCES THAT INFORMATION IS CORRECT NOR DO I HAVE ANY OBLIGATION TO UPDATE READERS ON ANY CHANGES TO AN INVESTMENT THESIS IN THE COMPANIES MENTIONED HERE, WHICH I MAY OWN.

capital losses is tuition in the school of portfolio management

So CTEK is selling itself for $1.25 / share. The company is in a “go shop” period until the end of June and still publishing contract announcements, so maybe there’s a higher price on the horizon but it's unlikely to exceed our cost basis. It will result in a permanent loss of capital. 

Owning this company (for this long) has been a terrible mistake. I say "has been" and not "was" b/c large portfolio losses have long tails, often why managers restart under new names after events like this. Not me. The only clients I've heard from are adding money, which is not a bad idea at the moment. War. Inflation. These are terrible times to invest, so valuations are attractive. 

Energy is an interesting environment. What seems different this time is that producers have financial flexibility to increase capacity based on higher, not lower prices, the scourge of past cycles. It is not an area we invest in, a view whose justification has been upheld by an argument lost many years ago to someone who isn't even a client, so possibly up for revisiting (as my son says: "money is money"). I'm in no rush to change but there was easy money in oil when it turned negative during COVID. 

Back to CTEK, I’ve written a letter to the Board reviewing mistakes - theirs and mine - and a public version of it is linked to here. (The private version was quite a bit harsher I'm afraid to say). 

A characteristic of SMA's run as if it's pooled capital is that purchases are allocated towards available cash, regardless of account. I make an effort to rebalance but - and i'm stating the obvious here - it is hard to know the "best and highest use of capital", ie choosing between A and B, at any time. That is of course portfolio management in a nutshell. It isn't easy. I generally think about upgrading the "worst" position in the portfolio: Which one has the highest risk of costing me money? Get rid of it. 

I've improved my portfolio management skills over the years, the tuition partially paid for by those CTEK losses. Given two paths for solving the complexity - either owning a little of everything or as few things as possible - I choose the "fewer" route and continue to endeavor to consolidate around best ideas, not b/c i understand them best but b/c I think their opportunity relative to their risk is highest. For accounts with constraints on cash, the CTEK sale frees up capital at less unattractive prices, to reallocate to higher return ideas. 

One new idea I am buying is in the electronics space; design, assembly and distribution. Component manufacturing is not historically a great business and it is possible that what I find attractive here is simply a semiconductor CAPEX cycle masquerading as a secular trend. But the hypothesis I am testing is whether the electronics space is experiencing "a new period of electrification" 91 years after  Thomas Edison died. 

I observe shifts happening in the way electricity is generated and stored. It might only be on the margin and the overall slice of the energy pie will likely remain overwhelmingly hydrocarbon and combustion based for the forseeable future. But energy is a big pie and small changes can be meaningful, especially when it bumps up against an industry that is historically static and commodity driven. I think we are still in early iterations of companies figuring out what works best. Wind turbines are improving. Solar farms are improving. The T&D grid has to improve. OEM's are building products that implement new ways of managing and storing energy. 

I think it's possible something big is happening with profound changes in valuation on the horizon for companies so disposed. I think the company we are presently allocating towards is benefitting from one such shift. Getting a read on an industry has to include looking at its biggest players so while I most enjoy burying my head in smaller more obscure companies, ARW's and AVT's are in the hopper. Will write more about this later. 

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ALL RIGHTS RESERVED. PAST HISTORY IS NO GUARANTEE OF PRIOR RETURNS. THIS IS NOT A SOLICITATION FOR BUSINESS NOR A RECOMMENDATION TO BUY OR SELL SECURITIES. THIS IS NOT FINANCIAL ADVICE. I HAVE NO ASSURANCES THAT INFORMATION IS CORRECT NOR DO I HAVE ANY OBLIGATION TO UPDATE READERS ON ANY CHANGES TO AN INVESTMENT THESIS IN THE COMPANIES MENTIONED HERE, WHICH I MAY OWN.

An Observation on High ROE Companies and their Market Caps

Been awhile since I've written here. I've cooled on the blog to focus on my investment business, Long Cast Advisers, which continues to grow, slowly and thoughtfully. But the not-writing has left me with a hole of sorts. I like researching companies and sharing what I know with others who might be interested. Having been stuck at home with the fam basically the last two years, I can say confidently that folks around here are not interested. So I gotta put it "out there" instead. 

Figured I'd start with a quick review of hits and misses over the years, what's aged well and what hasn't, etc. I went back and briefly scrolled through old posts.  

What's working >> OTCM, CCRD (nee INS), QRHC and CCRN 

What's worked >> (all takeouts) IVTY, ARIS, SEV and CDI

What didn't >> FHCO, PSSR, ESWW and STLY 

What stings the most >> post on not buying OLED. (I generally regret most the things I don't do). 

FTLF gets a special call it. I sold it long ago but kudos to Dayton Judd, who recapitalized it and transitioned into a capital light and pure play brand now generating growth in profits and book value ahead of where it was before he took over. He understood the value of the brand and put the right investments behind it to make this all happen. 

Thinking about "the value of the brand and the right investments", I have stumbled on a chance to share a recent observation, which is a wide disparity in valuation multiples for small companies versus large companies that both have high ROE's. 

But let me take a brief step back ... With regards to finance, every few years there's some new / old idea and even occasionally new / new idea that takes the world by storm (CDO's and MBS, REITS and MLPS, SPACs, etc.) and promise juicy returns for investors. Often they do for some period of time, and certainly enrich the facilitators of these idea, but these rarely endure. 

But there's something foundational about active value investing where the less "new" the better. This is why timeless classics of investing are still relevant even if you've already heard them 1,000 times. I think adhering to the principles of value investing is what makes it so simple and pure, though one get lost at times looking at shiny new things. 

That's how I found myself flipping through Chris Mayer's "100-Baggers". There are always going to be stocks that go up 100x to great fanfare ... and then crash when no one is looking. This book is largely about the durable businesses that continue to operate to plan. It's not a ground breaking book, more of a tasting menu of other great books, and that's not a critique, it's just that the attributes of durable businesses that comprise 100-baggers haven't changed that much, so drawing on the "the Outsiders" and Joel Greenblatt and Michael Mauboussin, etc. is totally appropriate. 

For me it served as a simple reminder of the foundational principles of investing and one of those principles is looking for companies that have high ROEs. 

It's been awhile since I've done a simple "high ROE screen" but I got it in mind and fired up Sentieo's screening to look up companies with ROE between 25% and 45% and found something kind of crazy. Based on the data kicked out by Sentieo (which is sometimes quite wonky) on average, small companies with high ROE's trade at less than half the valuation multiples of large companies with high ROE's (and I included the median to account for outliers). 

This is just an observation. I don't think there's really enough data to draw firm conclusions as to why this might be the case and I don't want to fall into an anova excel-hole at the moment, though I'd be keen to explore how revenue growth might be a factor here. (Happy to share the data with anyone or collaborate on some deeper analysis). 

But my hypothesis is that larger companies whose brands are by nature better known enjoy the premium b/c investors believe the "moat" is wider and deeper, so easier to protect the R of ROE. One thing to note from this observation; investing in small companies with high ROE's might (might!) be a value trap unless there's a pathway to larger growth. 

Another thought is that from a high level, all business is "... a brand with the right investments behind it." That brand can be perceived or actual "better product quality, service, results, etc." Smaller companies are still developing those brands so there's more uncertainty to the brand value vs larger companies where the brand value is already established. 

And one final thought is the value available when a small company with an established brand that has endured years of poor investments gets taken over by someone who can put the right investments behind it. Like FTLF, or maybe that yellow pages company THRYV (which I don't know enough about). It was certainly part of the thesis behind the investment in CCRN and a few others over the years. 

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ALL RIGHTS RESERVED. PAST HISTORY IS NO GUARANTEE OF PRIOR RETURNS. THIS IS NOT A SOLICITATION FOR BUSINESS NOR A RECOMMENDATION TO BUY OR SELL SECURITIES. I HAVE NO ASSURANCES THAT INFORMATION IS CORRECT NOR DO I HAVE ANY OBLIGATION TO UPDATE READERS ON ANY CHANGES TO AN INVESTMENT THESIS IN THE COMPANIES MENTIONED HERE, WHICH I MAY OWN.