Tag Archives: stock

True Value Investing Still Works

Value investing is on the ropes. At least, that’s what you’d think reading articles like this one that highlight how “value” has underperformed “growth” in recent years. I put those words in quotes, partly because the distinction between value and growth is somewhat arbitrary , and also because the critics of value investing tend to attack metrics that have no real connection to shareholder value creation. Patrick O’Shaughnessy did a great job of attacking this myth on his blog, The Investor’s Field Guide . He points out that, over the last ten years, investors that have bought the cheapest stocks based on price to accounting book value have significantly underperformed. As we recently pointed out , book value relies upon flawed accounting metrics, diminishing its usefulness for investors. Unfortunately, most of the “value” indexes that people reference, such as the Russell 3000 Value Index, are based primarily off of price to book. As O’Shaughnessy points out, the performance of value strategies varies greatly depending on which metric you use. If you picked the cheapest stocks based on earnings, you did poorly in 2015 but slightly overperformed over the last decade. Stocks with the cheapest price to sale ratios have done very well recently. Despite their superior recent performance, these metrics have their own problems. We’ve pointed out many times how price to earnings ratios are inherently flawed and have almost no relationship with actual value. The sales number is at least less easy for executives to manipulate, but it also ignores structural margin differences and the impact of the balance sheet. What’s The Solution? Investors looking for value need to take a holistic approach that measures a company’s ability to deliver economic earnings to investors and quantifies the expectations for future cash flows embedded in its current stock price. This is what New Constructs aims to do, and while that process is not easy, it can be rewarding, as shown by the long-term outperformance of our strategies . As you can see from Figure 1, over the past decade our Most Attractive Large and Small Cap stocks have outperformed a combination of the S&P 500 and Russell 2000 by 80%. Figure 1: Most Attractive Stocks Outperform Click to enlarge Sources: New Constructs, LLC and company filings. The diligence we do helps us to uncover hidden gems that might not show up in simplistic, traditional value screens, such as computer chip manufacturer NVIDIA (NASDAQ: NVDA ). When we highlighted NVDA as a long idea in September, it had a P/E of 24 and a P/B of 3. Hardly numbers that are going to make your “average” value investor salivate. However, a closer look showed that these numbers were misleading. For one, NVDA’s reported income was artificially depressed by a $60 million write-down hidden in the footnotes . Plus, the company earns a fantastic return on invested capital ( ROIC ) of 34%, demonstrating its competitive advantage and its ability to efficiently allocate capital. After making adjustments to determine the true earnings quality and quantifying the market’s expectations for future cash flows, we saw that NVDA had a price to economic book value ( PEBV ) of just 1.1, implying that the market believed the company would only grow after tax operating profit ( NOPAT ) by 10% for the remainder of its corporate life. For a company that had just doubled its NOPAT the year before, those expectations seemed awfully low. Sure enough, the market has adjusted its expectations for NVDA in the past few months, driving the stock up 25% even as the S&P 500 has fallen by 2%. When the markets get volatile, it’s the real value stocks, the ones with economic profits and low market expectations, that thrive. Meanwhile, the imposters get exposed. Avoiding Value Traps and Imposters Succeeding in a struggling market is as much about avoiding the bad stocks as it is about picking the good ones. Our research helps clients avoid “value traps” that seem like they might be cheap on the surface but are actually significantly overvalued when you look a little closer. One such value trap we warned investors about was Olin Corporation (NYSE: OLN ) back in June of 2014. The stock had a P/E of 13 and a P/B of 2 at the time, but those numbers were highly misleading. Hidden non-operating items boosted its reported earnings by $25 million. Plus, the company was facing obvious headwinds in the form of falling commodity prices for its chemicals division and an unsustainably high level of demand for its Winchester ammunition segment. Despite this fact, the market was expecting that OLN grow NOPAT by 5.5% for 35 years, an unrealistically long timeframe for such a weak and highly commoditized business. OLN was able to coast by on its inflated accounting earnings when the market was strong, but that all changed after the S&P 500 hit its peak in the spring of 2015. Since then, the stock’s been in free fall, and it’s now down 42% from when we made our Danger Zone call. Investors that pick stocks like OLN and ignore ones like NVDA due to simplistic metrics are not truly value investors. In a buyer-beware system like our market, you need to understand how to separate real value-investing research from the imposters. True value investing means performing your due diligence to understand the real economics of the underlying business and the profits it will have to achieve in the future to justify its stock price. Only by doing this hard work can investors uncover value and protect their portfolio. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Exited Gencor For 57.33% Return

On December 2, 2015, we exited our position in Gencor ( GENC ) for a total return of 57.33%. This position was first established on October 5, 2011. We held this stock for 4 years to wait for the catalyst of increased funding for Federal highway projects (transportation bill), which finally seems to be taking shape. Our average cost was $7.1/share and selling price was $11.25/share. Today, the company sports a $116 million market capitalization, carries no debt and has $96 million in cash. If you buy the stock today, you are looking at $20 million to buy the whole business (net of cash), with a great prospect of increased revenues and profits, as the Federal dollars start flowing in the infrastructure projects (which are sorely needed in the U.S.). Whether this is worthwhile investment now or not is your decision; for us, we felt that the capital can be reused elsewhere in this environment. A value trap is a value trap, until it isn’t. It took us close to 4 years to get a 57% return. Was it worth it? Maybe not. I remember when we first invested in Gencor, the large amount of cash on the balance sheet was very attractive to me, and so it was for many other value investors. Over time though, many of these investors have quit the investment. It has been a frustrating experience, for sure, to watch the management do almost nothing with the cash – neither invest in new projects, nor return it back to the shareholders. I suspect a calculation of significant increase in working capital requirements, when the highway funding finally comes through, played a big role in the management’s decision to hold on to cash. Looking at the opportunity cost of this wait, it was probably not worth it. However, one cannot fault the management of being more optimistic of the U.S. Congress’ ability to pass genuinely needed infrastructure funding. If I were running the company, I would have done the same, and then roundly vilified in the investment community. This is where the interests of the investors and the managers diverge a little, which is unfortunate, as we investors need to consider the long-term strategy for the business as the primary driver of the management actions. Why would the management not return the cash to the shareholders and then when needed raise the funds in the debt markets, is a question I cannot answer. Coming back to the Value Trap question – For the first 3 years of the holding, it indeed looked like one. This year the stock has risen 35%, so for a value investor who decided to get in towards the end of last year would definitely not consider this stock as a value trap. It is all in your perspective.

Terraform Power: No More Blood On The Streets, Time To Take Profit

Summary I suggested a long position in Terraform Power on November 20th as panic made the valuation very compelling. Recent newsflow has been positive and generated a 50% rally in the stock since my article was published. It is time to reassess the investment thesis and decide whether to keep or sell the position. Less than a month ago I wrote an article on Terraform Power (NASDAQ: TERP ) titled ” Terraform Power : buying when there is blood on the streets?” At the time the stock was trading at $8.4 and it has been on a rollercoaster since then with a lot of news coming in. At the moment of writing this article the stock is at $12.40 and, including the 35c dividend, generated a 52% performance in less than a month. That was quicker than I expected. But such a big move deserves some additional analysis in order to understand if the time has come to close the position. Recent newsflow A few days after my article, the company announced some management changes . This was not good news as the clear message sent to investors was that objective number one was to save the overall Sunedison / Terraform Power / Terraform Global Group. They called it “organizational alignment”; the way I read it was: TERP is in much better shape than Sunedison (NYSE: SUNE ) and needs to provide some help. As expected the stock reacted negatively once the decision was digested and understood: some of the risk is switching back to Terraform from Sunedison as the Group is trying to go back to the initial yieldco drop down strategy, thus putting at risk TERP’s balance sheet. My own reaction was frustration as the investment thesis was certainly weakened by the news. Luckily a few days later (December 1st) reputable hedge fund investor David Tepper of Appaloosa disclosed a very large position in the company and sent a letter to management highlighting his concerns on corporate governance: “Thus, it is obvious that the deterioration in TERP’s security prices and credit profile this month results from (among other things): (1) the transmission of financial stress related to its “Sponsor’s” ambitious growth objectives and over-extended financial commitments; and (2) TERP’s incomplete and selective disclosures”. Market reaction was massive and Tepper’s involvement acted as a confidence booster. What particularly pleased the markets was that such a high profile hedge fund manager built a significant stake (9.5%) and took an activist role (something he rarely does) to push for a change and more protection for TERP shareholders. It really looked like the older brother trying to protect the younger one from bullies. The market appreciated and I recovered all my confidence in the stock and the investment thesis. The third important announcement was the revision of the Vivint acquisition . I am not sure how much weight Tepper’s letter had in the revision but that was clearly another positive. The change in the terms was not massive (the price was reduced 13% or $123 mln) while the reduction in the commitment on future purchases was more significant, with positive elements such as the downward price adjustment to achieve minimum returns. Overall I would say this was a positive but not “massively” positive. Stock reaction The following chart shows the stock performance since my previous article: TERP data by YCharts As you can see there has been a lot of volatility and a dramatic recovery during the month of December. This recovery was exclusively newsflow driven as many stocks in the energy yieldco space suffered significant losses during the same period of time (KMI comes to mind). Change to the investment thesis At the time of my previous post Terraform Power was extremely unloved and panic was pushing investors out. It was trading around book value pre minorities and had a yield of 16.8%. At the moment the stock is trading significantly above book value and on a yield of 11.3%. I believe there is still some value in the stock but it is not such a compelling story anymore. I believe upside from here in the short term is limited, especially if we consider that, while the stock went up 55%, credit markets deteriorated further in December, putting a lot of pressure and scrutiny on highly leveraged balance sheets. As a result I believe it is time to cash out and wait for better opportunities to arise.