Wednesday, February 29, 2012

Why I do not like small cap stocks much at the moment

I run a small hedge fund.

Most people that do that want to use their (lack of) size to find (and exploit) value-priced small cap stocks.

The problem is that almost any company with a market cap of $200 million to $5 billion has teams of private equity (PE) buyers looking at it.

The competition is fierce.

The PE guys have two advantages I do not. They have access to cheap loan funds in quantity. And when they do a transaction they can get inside the company, look at the books and do proper due diligence.

Those are winning advantages - advantages that I would not want to compete against.

One arguable offset to those advantages is that many PE executives are surprisingly inept. They look good in their suits - but I have met a few along the way who really are empty suits. You know the type - straight out of their big-name business schools but without the depth of experience and the humility to know that business can be difficult. For the purposes of investing they are stupid.

Their stupidity however is masked because mistakes are not marked-to-market. A bad transaction can be buried a long time and a few good ones (with lots of leverage) can offset a lot of ills.

I don't understand why so-called "value investors" are drawn to small caps. Trying to find cheap stocks against stupid people backed by seemingly limitless cheap funds and no market discipline does not seem like a good way to construct a value portfolio.




John

60 comments:

Robert in Chicago said...

Really?? What percentage of $200-5000m public companies do you think have a PE shop actively looking at them at any one time? I would guess something less than 10%.

To take the other side: In the last 18 months, two of what were my five core small-cap holdings rose substantially on PE buyout offers. God bless suits with cheap money, as long as you get there first.

Anonymous said...

Not sure why as an investor you think you are in competition with PE for small cap stocks as opposed to other investors who acquire shares in large cap stocks at lower prices?

You are effectively saying that PE would acquire any good small cap company before you got the chance to get set, so all remaining small cap stocks must by rights be over valued? Yet at the same time you say alot of PE people dont understand businesses.

John I love your posts, but I think you have dropped the ball on this one. BTW I'm not a PE guy.

Anonymous said...

Does the idea that PE is all over the small cap universe show up in the numbers? Has this category underperformed?

John Hempton said...

come on Robert.

What do the PE guys do all day?

They don't look at financials - they can't buy them with leverage.

But if the management of a small cap want to sell there is a deep liquid bid. And there are plenty of people aiming for the takeout.

John said...

John,

I'm not understanding your reasoning. You are saying when a market is filled with unintelligent participants it is more efficient?!

Anonymous said...

Eh there is a pretty good valuation argument for not buying US small caps at the moment. No idea about Australia, and in Europe everything looks cheap. I'm just not so sure you need to figure out why things are expensive - whether its people piling into small caps, or PE guys buying anything with earnings growth it doesn't really matter - does it? Expensive is expensive.

I think the PE thing is a sideshow.

Anonymous said...

And yes there are lots of "value investors" who wouldn't understand what a cheap stock actually looked like if it hit them with a bat. Most over used term in the investment management world.

Mark said...

The secret to buying small-caps is to catch beaten-down ones that have reinvented themselves, just as their businesses are starting to improve and before they show up on the PE guys' radar screen. This takes lots of reading, some basic analytical skills and an enjoyment of "the hunt."

adib motiwala said...

John

I'm confused by the title which says at the moment. Does that mean you like small cap at other times ?

2nd why do you disdain fully say so called value investors? Maybe it's their mandate to invest in small cap like Royce. Their record stands the test of time.

3rd. You can go lower than 200$ million.

PE guys won't touch less liquid stocks generally speaking Atleast hedgies don't

Yes large cap in general is cheap. But does not mean you can't find pockets of cheapness in small caps.

Rich Rockwood said...

Smart investors in my opinion are market cap agnostic.

Anonymous said...

John,

You still can beat the PE guys too the punch if you find gyms in the 10-100M segment. You might want to take a look at Axion Power. There good DD out there for those willing to look. Anyhow this one has multi-bagger written all over it in the next 3-5 years.

james said...

Hi, I think you run a great blog here and have been following for some time.

I am ex PE now in HF. I disagree on some things

i) I personally want to look at stocks that potentially have PE take out value. Now, doesn't mean to say that it would be easy to restructure the company, but as long as there exists someone who think they can - its all fair game (like the Keynes beauty parade). Plus you get a catalyst to crystalise value.

ii) Not true that PE doesn't look at financials - look at JC Flowers

iii) Re what % of $200m to $5bn range that PE looks at - well, depends what you mean by look. A large proportion of them have been pitched probably in some form or another in the last 5 years (esp 2007 in Austalia) but whether it progressed anywhere further than that is debatable

On what I agree: probably right to some extent on the empty suits - but you could generalise that for the whole finance industry. And agree on the mark to market point though then again, MTM also represents a lot of noise)

Anonymous said...

"Value investors" look at small caps because you can't find companies growing earnings 30% trading for 5x EPS anywhere else.

Anonymous said...

And what about small caps under 200m. Too small for the big PE players but not too small for a small hedge fund.

Paul said...

I don't think we're in competition with PE at all when investing in undervalued small cap. In my view, PE offers an additional exit. When PE comes in, they offer us an exit at a price which hopefully represents a significantly smaller discount to fair value than the discount to fair value we paid for the stock.

Analyst said...

For what it's worth John, I've been in PE for three years now in two different outfits (small-cap and large-cap) and whilst I am too junior to still even qualify for the term 'inept', I think you paint too harsh a picture as there are (admittedly a minority) of senior private equity investors who truly seem to sweat every investment - genuinely worrying about the quality of the management team vs. the very real execution risk, worrying about what is a sustainable level of leverage, and generally spending a huge chunk of their time wondering if they've made a mistake and doing everything they can to de-risk that.

These are the sort of guys I've been trying to learn under...

Anonymous said...

John,

as many people wrote, the reasoning does indeed sounds strange.

Wherever there are not-too-deep guys with lots of money, fortunes can be made. If you get there before them, you're pretty much always in the money.

Besides, I'd say you overestimate the advantage of "inside due diligence". Sure it's big when you are, khm, average and on the outside, and the other guy is smart and can "go in".
Even then 90% of times there won't be "secrets of the British Crown" and things end up just as they looked on the first glance.

But if you're good, and, well, I've been reading your texts for a while and looks like you are :P, then those "90%" become "99%", because 90% of "surprises" are no surprises at all for someone who puts a little thought into it.

More precisely, there is only one thing that could go wrong with lowcaps: you may miss something that makes stock overvalued or not liquid at all. Now what real *competition* PE guys can make here? You're only competing with your own smarts and, at times, fraudster's smarts - and hey, best of them lot fool brand name audit firms (but not you, at times), so what's there to fear?

Regards,
Dmitry.

Anonymous said...

John, I'm not sure what point you are exactly making here? What's the alternative? Looking at large caps that are covered by dozens of analysts and the whole investing world knows? Is it a case againts value investing, and should everybody just put his money in an tracker?

John Hempton said...

You bet that is what I am suggesting. The valuation is in boring - gone-nowhere-for-a-decade large caps.

Small caps are for shorting if you insist on adding value.

John

Anonymous said...

Holy bad posts Batman. Great blog but that was a stinker.

David said...

On the whole small caps are expensive, but I think there are still opportunities. I found this Buffett quote inspiring:

"I could name half a dozen people that I think can compound $1 million at 50% per year — at least they’d have that return expectation "..."There are little tiny areas, as I said, in that Adam Smith interview a few years ago, where if you start with A and you go through and look at everything — and look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market"

http://www.valueinvestinghq.com/360/buffett-partnership-letters/

David

John Hempton said...

I fully expected this post to be controversial.

I buy the odd small cap - in deeply unfashionable areas within my field of expertise.

But I kind of like the view expressed by GMO lately that the US equity market is overpriced (but the quality end is not).

John

PS. It is an axiom that you can't add value in large caps because they are too complex. But in this case you can add value in large caps - by NOT BEING IN SMALL CAPS.

Boyplunger said...

Sure a small investor cannot compete with guys who can access books, management and operations.

But it is possible to offset the lack of deep DD by watching the time and sales sheet all day long for long periods of time and see where money starts to flow. Specially in small caps and micro caps. Coattailing can be a valid, buffet-like strategy at times. Nobody to pat your back if you find a gem to tell you how smart you are as is more art than science.

Numbers speak. Although never in a straightforward fashion.

Anonymous said...

John,

I love the blog. 99 out of 100 posts are pure genius, so I feel a little bad commenting on the one bad one.

You said you don't like small caps. Why do you care about the size of company? It seems kind of silly to like or dislike a company based on its size. I run a small fund and I just look for the best prospective returns. Doesn't matter if its small or big. Historically it has been easier to find attractive investments in unsexy small caps - that is why I look there first.

Overall your blog is great. Thanks for sharing your thoughts.

Cheers,
Tom

Amit Chokshi said...

I was a leveraged finance guy working solely with LBO shops before I started my own fund. I would say that this post seems a bit inconsistent.

PE funds have access to cheap funds but hedge funds don't? Figure a number of big hedge funds are leveraged anywhere from 2-4 to 1...if you run a $1B+ hedge fund which is still a pipsqueak, you are basically not going to be investing in small caps because of daily liquidity. A $1B fund might have a book of 50 names, that's $20MM on average a pop if they are fully invested, they don't want to be >5% and in most cases probably want to be ~2% or less. That right there makes these $1B minimum companies based on market cap. They also want to be able to get in/out relatively smoothly, <3 days so the stock needs about $7MM avg daily volume. I don't have the figures but that again shrinks the universe and moves the likely area of play higher up the cap spectrum.

Just look at how AAPL stampedes up and how it's held by every hedgie. There are far more crowded trades in the bigger stocks whether its IBM, AAPL, YHOO, etc. than small caps. Those guys are levering their capital and pouring into the big names.

Not to mention, don't you think the larger names get picked apart by every hedgie, every LBO shop, etc. You don't think YHOO for example has not been looked at 1000 ways between LBO shops, Third Point and then the typical half wit followers of 13Fs (like T2).

Secondly, I'd argue that the mid to large caps have far more efficient information due to the large LBO shops and hedgies given what I just said about YHOO. I can tell you a number of "middle market" LBO shops have funds well in excess of $1B. I don't mean, $1B in firm AUM, I mean for their latest raised fund, you're talking $2+B in soem cases while the Blackstones have $15+B funds.

The guys that control the majority of AUM in the LBO space are the big cap funds and those guys are looking at $5+B companies.

Also, small caps may get looked over a bit by a number of small market LBO shops but the reality is most LBO firms are buying deals off actual auctions. It's very hard to solicit a firm and say, hey let's go private. In addition, small cap companies are more difficult for LBO shops to finance because if you are sub $50MM EBITDA, you can't get access to the high yield market generally so you are reliant on bank debt and mezz.

So in an example, maybe you have a $40MM EBITDA co trading for 5x. An LBO shop buys it for 8x EBITDA. The problem is banks don't let 4x. So you might get two turns of bank debt, and then have to find the rest of the financing. Secondly, most LBO shops on an 8x EBITDA deal would want to put in just 3x EBITDA max. So they'd really be levering the co at 5x EBITDA. Meaning once again, 2x bank debt, u have a 3x nut you need to fill with mezz or possibly more equity. The more equity you put in, the worse the IRR = math doesn't work, deal doesn't work.

That means if you are looking at small caps, for LBO shops to be an issue, you actually are inherently investing in stocks with value at least on an LTM cash flow basis. Like I said, if an LBO shop is paying 8x EBITDA for a small cap, it's not going to work. That means they will want to pay say 5-6x. So if you are investing in a decent co that is at say 3-4x EV/EBITDA and has manageable capex, good balance sheet and prospects, you are in an ok spot.

In either case, if the argument is because PE shops have access to credit, the small cap segment offers no value, then the large cap sector cannot possibly over value in that same context when factoring in far easier credit by hedge funds and the fact that both hedge funds and mega cap LBO shops would all be looking at these companies in tandem.

Zimmer said...

Based on my current portfolio, I have agree with you.

I am long a couple of small caps, but the rest of my long portfolio is large caps. It wasn't intentional, just going where I find value.

The short side of my portfolio is almost all small caps. There are an unbelievable number of $100 to $500 million market cap companies with low ROEs and modest growth prospects but 30X+ P/Es.

Hester said...

But PE firms don't buy shares like HF's do, they usually acquire. So wouldn't this mean that the small caps are more likely to be taken over, which is almost always beneficial for shareholders? Just look at the stupid PE deals done in the Chinese fraud space that have bailed out shareholders.

Also, couldn't this line of reasoning be extended beyond PE firms to just larger companies? There are always large caps looking to acquire smaller caps.

So small caps should always underperform. Yet the opposite is true.

But like I said, when most small caps are acquired, by whomever, it is at a premium and shareholders benefit. On the other hand most corporate acquisitions turn out poorly. As Peter Lynch has said, corporate acquisitions are a transfer of wealth from shareholders of large corporations to shareholders of small corporations.

Anonymous said...

Agree with John. Blue-chip LC stocks are [mainly] underfollowed by real analysts and undervalued and unloved since, 'everyone knows you can't add value.'

Small caps have every MF, HF, and PE mgr in that space eye-balling them, along with industry comps who are also willing to bid them out with cheap money. And for many of these the illiquidity premia is huge.

I run a large multi-strat portfolio, mainly equities, and I can liquidate my holdings in about 4 hours, maybe 6 if the market is panicking. Try that in small-caps - their returns have been higher historically for a reason, after all.

smallcap analyst said...

The possibility of a PE take-out is a negative & you would rather compete in the most over-analysed stocks where hundreds of men in suits are running the ruler every day. Could this imply that sell-side analysts &traditional long-only instos are weak competitors?

Ludlow said...

I don't understand your complaint. You do the research, buy a smallcap company cheap, and then some rich stupid PE fund comes along and buys it from you for a massive premium. Are you telling me that ISN'T a way to make big bucks as a value investor?!?!?

Anonymous said...

I do not find this post to be controversial at all, or anything like that. It's just very unclear -- especially when compared to previous posts. It's...awkward, like it wasn't well thought of... It's a sort of "the king is naked" sort of thing. My guess is John is suffering from temporary confusion from reading too many Chinese ARs...

But What do I Know? said...

Unlike most of the commenters, I'm going to agree with JH. Every time I look at a small cap I come away thinking it's expensive (or at least not cheap). Now, that doesn't mean that a PE firm that has to do a deal won't come along and buy it, only that as an investor buying with my own money, I find it unattractive.

Just because the guys using OPM are buying doesn't mean they're cheap. And God knows the money counts just the same if you make it owning buyouts--only be aware that you are not investing, you are trading.

Will C said...

ok everyone, John did say "at the moment". There's enough cheap money floating around that PE and or HF are looking for the best return on the cheap credit they have at their disposal. Buffett/ Grantham/ Insert Major Finance Guy Here etc. have all stated large company's commons are pretty blatantly cheap considering the risk. John has a point- if you can get a high yielding large cap with expanding cash flows while the multiples shrink, what's the point in chasing yields in the small cap arena when one doesn't need to?

o. nate said...

Is the small-cap bid coming mostly from PE shops or from M&A? Here is an interesting post about how M&A is outpacing LBO in the current environment:
http://soberlook.com/2011/12/m-based-issuance-beat-out-lbos-in-2011.html

najdorf said...

"So if you are investing in a decent co that is at say 3-4x EV/EBITDA and has manageable capex, good balance sheet and prospects, you are in an ok spot."

I think we could all probably agree with this point. Have you seen a small cap other than probable Chinese frauds that looks like this since 2009? I have not. Current prices are more like 10x EV/EBITDA for any decent quality small cap, and you see total garbage at 5-6x.

Anonymous said...

I have seen such a company. Lorex Technology out of Canada. LOX.V. No research company, trades at 3x current year ebitda and almost no capex. small but leading market share in a growing niche in North America. they do exist if you put in the time. High ROE, ROC company, low capex and excellent mgmt, growing double digits.

Amit Chokshi said...

"I think we could all probably agree with this point. Have you seen a small cap other than probable Chinese frauds that looks like this since 2009? I have not. Current prices are more like 10x EV/EBITDA for any decent quality small cap, and you see total garbage at 5-6x."

Well I spoke generically, just throwing out the usual metrics that get vanilla value guys excited. A 5-6x ebitda co can be way better than a 3-4x one. As far as seeing companies that are trading for 3-4x ev/ebitda that look good, yeah that's embarassingly easy.

Check out MASC. I owned it but dont at the moment. About 3.6x ev/ebitda, $8 stock with $2.50 of net cash per share. Top line growing cause of the auto sector but they also have a solid building material segment that's improving. They have improved the middle part of the income statement over the past few years by refocusing their businesses as oppposed to just cutting costs w/o any regard for lt strategy. 14% insider owned. Solid capital return metrics.

That right there is one name.

Another name I owned was SURW...at the time sub <4x ebitda regional telecom. they were starting to improve/hike their divy and improve overall ops. People that really just look at comps and have no idea about companies would say gee VZ and T pay a fatter div, or SURW has debt, etc. but take no consideration for the geography SURW occupies nor its actual deployment of telecom protocol (fiber).

Another probable slam dunk is SVU. even with the latest figures, $1.7B EBITDA, $600MM int exp, $500MM capex, assume if u are hardcore conservative $120MM in cash taxes (which wont happen), u are at $480MM in legit FCF. Put a 4 handle on that and you're at about $9. This co is a levered pig which is my specialty and it also, since the div cut last year, only needs $74MM to cover its divy. So if u are a shareholder in this now, u are paying like 4x ev/ebitda for a pretty overall stable co that has time to fix things, that is highly levered financially but also levered to small changes in gross margins which they can improve upon, pays a sustainable divy and then kicks out about $400mm in cash flow after the div that it can use to delever...it's easy...except people will say but but but WMT is killing them. Problem is "high quality" is very ephemeral, you're better off with dirt cheap and some easy hurdles to get by to make your returns...

Anonymous said...

SVU is a terrible company. They have shown miserable comps for 3+ years and no signs of turning that around. The real question is, what is the true ebitda if they had to bring prices down and in-line with their competitors? Also, what is the capex deficit in this company? losing volume in droves means they would have to invest a lot more capital to bring people back...should never use EV/EBITDA for capex hog grocery store evaluation.

Amit Chokshi said...

"SVU is a terrible company. They have shown miserable comps for 3+ years and no signs of turning that around. The real question is, what is the true ebitda if they had to bring prices down and in-line with their competitors? Also, what is the capex deficit in this company? losing volume in droves means they would have to invest a lot more capital to bring people back...should never use EV/EBITDA for capex hog grocery store evaluation."

Uh right, that's why I said $1.7B annualized EBITDA less $600MM int exp, $500MM capex, assume if u are hardcore conservative $120MM in cash taxes (which wont happen), u are at $480MM in legit FCF.

SVU is a terrible company but the stock is a good bargain. People need to be able to reconcile fundamentals with valuation. Great valuation in most cases trumps fundies. Like howard marks said, at a certain price anything can be a AAA.

In the past 3 years SVU stock had gone from high teens now down to about $6.50...this is the area where I think you can do well. As I said, a 4 handle on legitimate free cash flow gets you to a $9 share price.

SVU generates value for an investor through attractive valuation but a healthy and sustainable divy and then major deleveraging. these can generate $500MM in free cash flow, they pay down that debt over a year, the net debt goes from 6,400 to 5,900. Figure these guys trade at the same multiple of 4.6x my $1.7B annualized EBITDA estimate by the same time next year ...the share price would be $9...paying down that $500MM gets you over $2 in equity value...

Anonymous said...

Maintenance capex for a grocery biz is 2% of sales. Check kroger or safeway. If SVU is only spending $500mm, then they are building a massive capex defecit. they should spend $700-$750/yr on maint. capex.
they probably should spend more since their store base is poor vs. the others. that makes the legit FCF much less intriguing.

Anonymous said...

what an unintelligent poor written post....

Anonymous said...

Must be an SVU "value" long who gets crushed over and over again and never learns. Maybe throw in some Radioshack for further punishment.

Anonymous said...

John,

Initially I thought along the lines of what most of the posters on this forum were thinking.

Then I read about Seth Klarman and his plan to go mining

http://finance.fortune.cnn.com/2012/02/15/seth-klarman-baupost-quarry/

In a way he seems to be agreeing with your sentiment. I was about to congratulate you on outgrowing the pond that you were swimming in... its a pattern that I have seen repeated with many investors. Buffett is an example... he gets to a point where his thesis stops and he generally stops investing. To me that's a contrarian indicator of an overheated market.

But you spend a lot of your time shorting... are you trying to say that there are no good shorts? or that everything is overvalued.

Controversial... but good post.

Part of me hope's you are right, part of me hope's you are wrong.

Asoka

najdorf said...

I'm glad you brought up SVU, because that is a great example of how far you have to dig into low quality in the small-mid area to find something with interesting valuation. You have a massively levered company in a business plagued with overcapacity. They are literally the worst competitor in every market where they participate, usually behind 3-4 strong regional competitors and national brands like Walmart. They have been selling off some of their best assets, slashing capex, and cutting the dividend to service debt. There is even more leverage than shows on the balance sheet because the pension is a black hole and they use a large amount of operating lease accounting. As another commenter noted, they have strongly negative comps going back years. In spite of these problems, even without adjusting your EV towards a more accurate number, you are still paying over 4x shrinking EBITDA for it in the market today. This will not be shown to be a cheap price unless management pulls off a startling turnaround that appears unlikely given their track record. This is one of your flagship examples in support of the claim that one can find cheap small companies with manageable capex, good balance sheets, and prospects. 'Nuff said. I agree with John - there is not a lot of easy value out there in small-cap land.

John Hempton said...

Whatever - SVU looks difficult.

There are much easier swings in big-cap land.

I still spend most my time looking at small caps. And mostly find shorts.

J

Amit Chokshi said...

" najdorf said...
I'm glad you brought up SVU, because that is a great example of how far you have to dig into low quality in the small-mid area to find something with interesting valuation. You have a massively levered company in a business plagued with overcapacity. They are literally the worst competitor in every market where they participate, usually behind 3-4 strong regional competitors and national brands like Walmart. They have been selling off some of their best assets, slashing capex, and cutting the dividend to service debt. There is even more leverage than shows on the balance sheet because the pension is a black hole and they use a large amount of operating lease accounting. As another commenter noted, they have strongly negative comps going back years. In spite of these problems, even without adjusting your EV towards a more accurate number, you are still paying over 4x shrinking EBITDA for it in the market today. This will not be shown to be a cheap price unless management pulls off a startling turnaround that appears unlikely given their track record. This is one of your flagship examples in support of the claim that one can find cheap small companies with manageable capex, good balance sheets, and prospects. 'Nuff said. I agree with John - there is not a lot of easy value out there in small-cap land."

I also brought up MASC and SURW...but yeah SVU getting hammered today and everythign you said is what has been acknowledged by me. My EBITDA number is based on their last Q, back of the envelope but feel free to ding it another 10-20%...You buy at $6.50 inside of 18 months u prob have a 50-100% gain. The divy is serviceable at this level and the co can create value through deleveraging...so as a shareholder u get something with a 5%+ sustainable divy, big time deleveraging, and a good value because those like yourself are basically telling me things I've known since this was an $15+ stock. I am touching it in the $6.50s-7 range and feel fine about it.

It's kind of funny cause I had the same argument with Herb Greenberg on HBI in 2008, it was $10 when i liekd it, got to $5, and did fine despite being a levered pig with increasing cotton costs.

BTW is there ever a period where those businesses are plentiful, like <4x FCF, 0 debt balance sheets, and 15% sustainable ROICs...

Amit Chokshi said...

FYI, going waaay back in SVU's history, their capex was always sub 2%...they won't be changing now.

Anonymous said...

SVU is an interesting case. 70mm shares short (north of 30%). I guess a hint of good news would get this a major bounce. On the deleveraging point - the debt has declined from $9.3Bn to $6.7Bn and none has transferred to equity holders as of yet. Maybe now is the time, i don't know. What really gets this stock working? I think if they can show any sign of comp stabilization, it revalues in a major way. Without this, I think people will continue to believe that a chapter 11 is necessary to restructure the leases and debt.

Amit Chokshi said...

"SVU is an interesting case. 70mm shares short (north of 30%). I guess a hint of good news would get this a major bounce. On the deleveraging point - the debt has declined from $9.3Bn to $6.7Bn and none has transferred to equity holders as of yet. Maybe now is the time, i don't know. What really gets this stock working? I think if they can show any sign of comp stabilization, it revalues in a major way. Without this, I think people will continue to believe that a chapter 11 is necessary to restructure the leases and debt."

Exactly..."interesting" is the word. It's a bad company but valuation may be overstretched. They have been able to do the right things in terms of deleveraging, they have a sustainable div and then when u look at the middle part of the inc statement it looks like they are getting the SG&A under control which can eventually be leveraged and gross margins look to be stabilizing (need to account for LIFO). main thing is to get the sales to start going the right way or the second derivative in terms of sales declines to slow down. when that happens, this type of business can do well from a stock valuation perspective. its not a huge hurdle for these guys to jump over and if they can do a few things right, u get the massive upward valuation.

John Hempton said...

This SVU chat is somewhat confirmatory to me. SVU if the bulls are right doubles relatively quickly - or adds 150 percent.

If the bears are right goes to zero quickly enough.

Without any specific knowledge I will put odds on it at 70-30.

I swear that risk-adjusted Google looks a better bet. It is not going to zero - and there is a small chance it doubles. But risk adjusted I think I prefer it.

I hope the guy who is long SVU is leasing the stock out for a rebate. Not doing so is idiotic.

Amit Chokshi said...

"This SVU chat is somewhat confirmatory to me. SVU if the bulls are right doubles relatively quickly - or adds 150 percent.

If the bears are right goes to zero quickly enough.

Without any specific knowledge I will put odds on it at 70-30.

I swear that risk-adjusted Google looks a better bet. It is not going to zero - and there is a small chance it doubles. But risk adjusted I think I prefer it.

I hope the guy who is long SVU is leasing the stock out for a rebate. Not doing so is idiotic."

I have to disagree about the timing on SVU. If bulls are right, yes this is a 50%-100+% return easily for a number of things. Companies that do things correctly in a turnaround benefit from fundamental improvements (so higher EBITDA, EPS, cash flow as the underlying metric before applying a multiple), deleveraging, and potentially multiple expansion. The current valuation is hard to get much worse for SVU so bulls that are wrong take it on the chin if the fundamentals just keep grinding lower. But this is not a zero by any stretch.

This co has $600 int exp, easily serviceable by SVU's current cash flow. SVU fixed income is trading above par. The idea of SVU being a zero as quickly as it can be a 50-100% return is just not correct.

But let's work with some numbers. Maybe there's a 10% chance that this goes to $14...maybe a 30% chance its range bound (say $6.50) and then a 60% chance it goes to $3. The exp val of that would be about $5...or just 20% below where the price is now or so. And that is with some pretty heavy negative expectations assuming a 60% likelihood that SVU is more than 50% below its value right now...

With GOOG, I'd argue you are facing declining ROIC over time unless they hit the lottery with something...they basically plow any gross margin improvements into higher SG&A. plus just the law of large numbers and the fact that GOOG is making everything free. I also would like an example of where you can find companies at that size that benefit from any sort of multiple expansion. GOOG is already fairly valued for a solid business, mid teens EPS, 12x ev/ebitda, lot of cash but the market doesnt give a crap about cash heavy tech cos cause that's just a reflection of the industry (any decent tech co has a solid balance sheet). GOOG is growing EPS at 15% or so, nice but not outrageous. So if I am long GOOG at 11x ev/ebitda, mid teens EPS, it's like ok, i am banking on them cranking that EPS at that level. if EPS slows a bit, these guys get hit with multiple compression and a major adjustment of the share price.

GOOG doubling or adding $200B in market cap to make it worth what AAPL is would require a truly revolutionary product. GOOG is fairly valued, maybe even slightly overvalued. The co has to still perform well for shareholders to benefit.

SVU on the other hand can get you the first 5% off the div, and then prob another 25-50% just if the speed of the deterioration slows. This is also not a co with any massive near term maturities or any operational problems that could blow the co up. SVU has already said they expect -3% comp stores for 2012 and -5% or so decline in the indie biz...so it's a sales play. They have SG&A at a manageable level, gross margins are getting better, they get sales to not decline by that high a level, and they could be in the clear as far as the stock goes.

najdorf said...

John, sorry for hijacking your blog with this point, but I think the specific illustration strongly supports your general point that there is no value to be found in smallcaps and those who falsely believe themselves to be value investors are loading up on risk in order to feel like they are getting a good deal.

Amit: I'm not saying you will necessarily lose money on SVU - there is a positive scenario out there and raw performance doesn't even need to be that good to make it happen. But when you pretend that SVU is not a deeply troubled company and massage the numbers to favor your thesis, you are doing yourself a disservice. Let's check a few things:

1. You flagged "manageable capex" as a key issue, and claimed that 500m was manageable for SVU. When someone pointed out that grocery stores typically spend 2% of sales, you said SVU historically didn't do so. Now, if you go way back, they were a whole different company and the numbers simply aren't comps (more logistics/distribution, vastly fewer owned stores). If you really want to go way back, you have to look at what Albertson's used to spend. I assure you it was more but I don't care to find the number. An easy number is that SVU itself spent 1.14b/44b=2.7% in the year ended 2-2008. 2009 was similar. It was only in 2010-2011 that they created the current level of FCF by slashing capex to make up for declining sales. We will see whether this FCF is sustainable, but I think it is unlikely.

2. You mention that the debt trades at par. Setting aside the proximity of par-trading and bankruptcy for past luminaries like Enron and Lehman, the debt carries yields around 8%, which is a pretty fat spread to risk-free yields, suggesting investors demand compensation for risk to hold the SVU debt. If spreads widened out to 10%, there is no way SVU could carry that interest load/issue new debt and it would just be a matter of time before they restructured. The bank debt maturities in 2015 would probably force the matter. There's a good chance that SVU has drawn heavily on the revolver by then and the banks use the threat of refusing to refinance to force SVU to cut other debt/raise more equity.

3. Relatedly, you are overstating the possibility that this company stays alive with a tiny equity cushion. There comes a point where they start to hit covenants, where managers would rather trade 1-2 years of bankruptcy pain for easier operations going forward, and where lenders start to agitate for a true restructuring (reject leases, reject labor contracts, reduce debt faster) rather than continued uncertainty and possible value destruction by equity-focused management. At this point, no one with any influence in the company cares about saving a theoretical small equity value - you pay lawyers a bunch of money to maybe get you 5% of the new equity and smooth the restructuring. Recoveries are bad enough in this scenario to treat them as effectively zero.

4. You originally told us we could get "good balance sheet and prospects." When reminded that your chosen company had one of the worst balance sheets in the universe of publicly traded stocks and persistently declining comps due to over-capacity in the supermarket industry and superior competition, you responded that sales might perhaps decline more slowly in the future and consequently the debt picture might slowly improve. I think you have significantly watered down your original claim and should acknowledge that this is a levered double-or-nothing play where you are basically guessing at the odds of various scenarios based on hope rather than an honest look at the company.

Amit Chokshi said...

Um no I mentioned THREE companies, leading of f with MASC...a sub 4 cf biz with no debt and improving top and middle part of is. Funny that people skip over that. My posts are long enough so I apologize for not putting up several pages on svu but I am aware of albertsons, I was on a team that was looking at it in 05. I don't dispute any of the main problemsw with svu but the ques is at a certain price it is a buy. Maybe that is 3 for you, I think current prices are good enough.

John Hempton said...

MASC looks like more fun to me. .64 times sales with 9 percent profit margins is a more obvious long.

J

najdorf said...

Amit: At least we provoked an interesting post from John. I didn't go after you on MASC because it actually is an interesting value play (although tiny and difficult to analyze given the massive restructuring they have done in recent years). On SURW, I entirely avoid regional telecom and haven't regretted it yet, but as a result I can't do detailed analysis. SVU is the one I am always tempted to buy, but there is so much leverage built into those headline earnings numbers and so much business deterioration going on in the background that I don't think it wise to invest on the assumption that the equity has significant and stable value. If the price continues to drop without the business getting much worse, it might get cheap enough to treat as an option, but it's not there yet.

Chump1 said...

Great discussion on SVU. I am not sure that I consider SVU (using EV above 5B threshold) to be small cap but I do own it. Yes the equity could fail but I think that mgmt is slowly turning around the company. The focus first is on gross margins (which are better vs year ago) and then the turnaround on sales. Why focus on sales first when existing sales could be more profitable? As a manger that is what I would do (although try to work on both if possible)

I think there is more opportunity in large caps vs small caps at the moment but there are plenty of small caps that I own.

I also own MASC (Amir first recommended) a growing business trading at a conservitive 5.5x FCF. Mgmt bought back 18% of the stock.

I own Vonage (VG). Mgmt has stabilized subs at 2.4M. Refinanced debt twice last year and has net debt of just 30M (including capital leases). Income from operations at 116M or FCF at 130M and see the EV at 500M.

Plenty of other names but this post would be 5 pages long, LXK, OVTI, QLGC, SSW, and SUN. 2 under 200M CNRD.PK, GILT.

What about GARP names? BWLD and PNRA but both have run a lot recently. One now I'm buying on weakness is DECK as the issue is not sales but costs in the short term.

adib said...

With small caps, i look for strong balance sheets. I also own CNRD.PK (that Chump1 mentioned). Another nano cap with a great balance sheet is UFPT. Its not dirt-dirt cheap but I like the business and CEO owns over 10%.

While SVU may well work out, that kind of balance sheet leverage coupled with operating leverage is too spicy for my taste. I am a bit more conservative.

I also own large caps like MSFT, VOD, BDX.

Adib said...

For a levered entity that pays a massive dividend and with pension liabilities, here is an idea

RRD.

I cannot get over their balance sheet even though they have paid this dividend for years.

Amit Chokshi said...

najdorf and John: I hear you, I owned MASC in the $5 range and got out in the $8 area. I don't find it interetsing here because it's a cyclical co. One issue with me is that I can never find the next small cap that rips for years. I don't have the mental programming for that so I like cyclical names becuase you are sort of locked into their business cycles so u have to eventually hit the eject button...these guys cant override their cost inputs and pricing dynamics unlike some of the truly great companies out there that have those moats.

With MASC, they have other stuff outside of auto and to their credit they have improved ops whereby the margin expansion seems legit. the problem is, if u think auto sales may be peaking in terms of YoY growth, i dont see the stock doing that well. The market may be saying <4x for these guys cause auto is as good as it is going to get soon. They do have a blding prod segment which could pick up the slack but when a co is cranking at high ROIC, ROE, low valuation...yes sort of what magic formula is about, i get worried that it is peaking out. I think direction of ROE, ROIC, etc. is more important than just continued growth. Meaning if ROIC drops a percent or two from 15% to 12-13%, the market could punish u a bit. Secondly, i like to normalize tax rates, MASC has an attractive tax rate but i like to knock things down a bit to see what the real EPS could be. Obviously the tax rate could be warranted/legit but it helps me assess what the market could be thinking. MASC's tax rate is very low but if u normalize it, sort of back of the enveleope, say they do $15-16MM pre tax income, u are at $0.90 in EPS for 2011. but the reported EPS could very well be $1.30 or so. I think 10x $0.90 is reasonable so that gets me to $9...even at $10-11, to me the upside here is not huge.

I also dont think the market pays you much for a good balance sheet. So I think u are better off paying for an improving balance sheet and you get paid more for that the crappier the starting balance sheet is. I see value creation driven by fundamental growth - current eps is $1, next year $1.15, market pays u the same multiple and u get that nice 15% growth in your stock. but u also get paid for multiple expansion which can happen based on balance sheet improvements. A company that puts chunks of cash away year after year i dont think gets that cash valued at all. However, a company that can delever, maybe it trades at 4.0x ev/ebitda but if it gets the fundies going the right way a bit and can slowly delever, maybe the market gives it a half turn more in valuation...that is a big difference.

as a former leveraged finance guy i tend ot prefer destroyed balance sheets rather than pristine. in fact my worst investments have been with cos with good balance sheets - WILC (run by morons) and IMN (same story) - yet both have impressive balance sheets. IMN luckily I punched out of relatively quickly rather than some vlaue guys that have ridden itdown forever. I only had one stock that was a solid winner for me that had a great balance sheet which was CSFS (formerly Rentcash) which went from <2.5x ev/ebitda ($4 stock w/ $1 net cash on bs) to about 5x with improving fundies and improved regulatory outlook in Canada (key part of my thesis too based on what various studies were showing about payday lending in Canada).

Anonymous said...

"... It's...awkward, like it wasn't well thought of... It's a sort of "the king is naked" sort of thing. My guess is John is suffering from temporary confusion from reading too many Chinese ARs..."

I couldnt agree with the above from one anonymous post. I do occasionally read a few post here, and some I must say are interesting. But the bad ones are just BAD...

John - take a break - you are embarassing yourself and your own company. Your blog on Hollysys this time last year (alleging it was too 'amazing' a company to be real) was equally amateurish, and stank of poor analysis masked by bold statements.

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