October 2019 – Focused Compounding

Geoff Gannon October 30, 2019

Daily Journal (DJCO): A Stock Portfolio, Some Real Estate, Some Dying Newspapers, and a Growing Tech Company with Minimal Disclosures

This was going to be one of my initial interest posts. Then, I started reading Daily Journal’s SEC filings for myself. At that point, I realized there just isn’t enough information being put out by Daily Journal to possibly value the company. There just isn’t enough information to even gauge my initial interest in the stock. I’ll still try at the end of this post. But, my look at Daily Journal will be a quicker glance than most.

Daily Journal is a Los Angeles based company (it’s incorporated in South Carolina, however) with 4 parts.

Part one is a stock portfolio consisting mainly of – we’re sure of this part – Wells Fargo (WFC) and Bank of America (BAC) shares. The third part of the portfolio is probably (my guess) mostly shares of the South Korean steelmaker POSCO. Yes, Daily Journal does put out a 13F – this is where sites like GuruFocus, Dataroma, etc. are getting the “Charlie Munger” portfolio to show you. However, the way that kind of filing works is that it would entirely omit certain securities. For example, it’d include POSCO shares held as ADRs in the U.S. (which is probably a small number) while not counting any POSCO shares held in Korea (which is probably a bigger number). Daily Journal does have a disclosure about foreign currency that includes discussion of the Korean Won. We can also see by looking at the 13F for periods that are very close to the balance sheet date on some Daily Journal 10-Qs that the actual amount of securities held by Daily Journal is greater than the amount shown in the 13F. There would be other differences too. For example, we know Daily Journal sold some bonds at a gain. Those bonds would not be included in the table filed with the SEC that websites use to tell you what Charlie Munger owns. Everyone can agree on the two big stock positions though. Daily Journal has a lot invested in Wells Fargo and Bank of America shares.

The value of these stakes are offset to some extent by two items.

One, Daily Journal would be liable to pay taxes if it sold shares of these companies. As long as Charlie Munger is Chairman of the company (he’s 95 now, though) I don’t expect Daily Journal to ever sell its shares of these banks. Therefore, I don’t expect a tax to be paid. If a tax was to be paid – you should, perhaps, trim the value of these stakes by over 15%. A very big part of the holdings are simply capital gains. If a stock has increased in value by 4 times while a corporation has held the shares – then, the final amount of taxes paid will seem very large relative to the size of the stake. This is because most of the stake is capital gains that would be taxed on a sale.

The other offset is margin borrowing. Daily Journal borrows using a margin account. …

Geoff Gannon October 29, 2019

Psychemedics (PMD): A High Quality, Low Growth Business with a Dividend Yield Over 7% – And A Third of the Business About to Disappear

Psychemedics (PMD) is a micro-cap stock (market cap around $50 million right now) that trades on the NASDAQ. It is not – by my usual definitions – a particularly overlooked stock. The beta is about 0.53 (low, but many stocks I’ve written about have much lower betas). The share turnover rate – taking recent volume in the stock and multiplying it to see how much of a company’s total shares outstanding would turn over in a given year at this recent rate of trading – is 102%. Again, that’s not an especially high number for the market overall. It might not be high compared to the stocks in most people’s portfolios. But, it’s very high for any sort of truly “overlooked” stock. There are some possible explanations here. Some recent events have caused Psychemedics stock to be especially volatile (this suggests the low-ish beta of 0.53 is more the result of very low correlation with the overall market than of actual low volatility in the stock) and insiders own very few shares of this company. In fact, there’s a ton of float and very few long-term investors in this stock. To give you some idea: insiders all own about 3% or less of the stock individually (and less than 10% taken all together) and Renaissance Technologies (a quant fund) was the largest holder of the stock as of the last proxy statement. This points to a stock that is not closely held by insiders, not generally held by long-term investors, etc. So, it trades a lot. It may not be overlooked. But, it’s still a micro-cap stock. And there’s a decent chance you haven’t seen a longer write-up of this particular stock. So, I do consider it overlooked enough to at least do an “initial interest post”. This is that post.

Psychemedics is in one line of business: hair testing for drugs. Actual testing services make up over 90% of revenue in any given year. The rest of revenue is all very closely related revenue such as charging for the actual collection and shipping of hair samples (in some cases). This is really just a drug testing company that uses hair to do the tests. That’s all you need to know. Historically, almost all revenue and earnings and so on came from the United States. Almost all costs still do come from the U.S. The company is headquartered in Massachusetts and rents about 4,000 square feet there, the actual lab is a rented facility in Culver City, California. Although the lab facility is rented – the equipment is owned. Psychemedics in an asset light business with one exception: it owns a lot of lab equipment. The company depreciates the equipment over 5-7 years. If you do the math on what the equipment was valued at gross, what cap-ex on the equipment is, etc. – this is the one asset heavy part of the business. The company’s assets really consist of technical know-how and a bunch of lab equipment for drug …

Geoff Gannon October 28, 2019

Vertu Motors (VTU): A U.K. Car Dealer, “Davis Double Play”, and Geoff’s Latest Purchase

Accounts I manage own some shares of Vertu Motors (VTU) – bought last week – but, far less than a normal position. Whether we end up owning a full position – that is, having something like 20% of the portfolio in Vertu – or not depends mostly on whether the stock’s price comes down and stays down for a while. As I write this, shares of Vertu trade for about 40 pence. They were as low as 31 pence not too long ago.

I wrote the stock up last year. For my initial thoughts on Vertu, read that post. For a good overview of the entire U.K. auto industry and the various publicly traded companies in it – read Kevin Wilde’s post.

I’m going to spend most of this post talking about whether Vertu is cheap enough to buy now. Before I do that, I should talk a little about Cambria Automobiles (CAMB). I had planned to do a write-up of Cambria before writing up Vertu. I decided not to. My reason for skipping a write-up of Cambria is that I realized I just didn’t have much to say about the stock. Cambria has somewhat better margins and inventory turns than Vertu. So, the actual business provides a bit higher returns on tangible invested capital. On top of this, Cambria has not issued more shares over time while Vertu has. Vertu did two very costly capital raises – both many years ago – that severely diluted existing shareholders at low values versus tangible book. This has had a big influence on the outperformance of Cambria as a stock over Vertu. One possible explanation of this is that top insiders at Cambria own between 40% and 50% of that company. At Vertu, the two biggest insiders combined own something closer to 5% of the stock. Management’s incentives for compounding PER SHARE wealth at Cambria are greater than they are at Vertu. Until recently, Cambria’s management talked a lot more about the kind of metrics shareholders care about than Vertu did. In the last couple years, this seems to have changed – with Vertu’s management using a lot of the usual buzzwords about shareholder value. And then – in the very recent past – Vertu’s actions followed those words. The company bought back over 2% of its shares outstanding in the first 6 months of this year. Those purchases were done at very big discounts to tangible book.

That explains my increased interest in Vertu today versus years ago. It doesn’t explain my reasons for preferring Vertu over Cambria. I should be clear here. I don’t really think of it as preferring Vertu over Cambria. Ultimately, I didn’t decide Cambria wouldn’t outperform Vertu – it may FAR outperform Vertu for all I know – I just decided to pass on Cambria. In a recent podcast, I told Andrew “We almost never bet on change.” I suppose you could argue a bet on Vertu is a bet on a …

Geoff Gannon October 24, 2019

Nekkar: Why We Bought It – And is It Cheap?

Someone emailed me a question about Nekkar:

“I was just curious to understand your thesis on Nekkar. Although they quite correctly have a net cash position of MNOK 0,3bn, they also have close to 0,2 in negative WC (95 in receivables/inventory minus current liabilities of MNOK 274), and I believe most of the cash in Syncrolift (0,2) comes from pre-payments, which over the course of the project will be used for buying raw materials, paying sub-suppliers etc. I am not sure of the percentage but according to the annual filings in 2018 Syncrolift had MNOK 135 in cash and 130 in pre-payments, so I would guess it is a meaningful amount.

EBITDA for Syncrolift was MNOK 30 and 40 in 2017/18. However, if we take out corporate costs of MNOK ~5 which was the average level for the two years, we arrive at a normalized EBITDA of MNOK 35-45. If we slap on a multiple of 6-7x we arrive at a range of MNOK 200-300, so lets use MNOK 250 a midpoint.

With these assumptions I get the following break-up-value of Nekkar ASA:
Net cash Nekkar: MNOK 100
Negative WC Nekkar: -180
Cash (non-restricted) Syncrolift: 25 (?)
EV Syncrolift: 250
= ~200, which is considerably less than today’s market value.”

We don’t value Nekkar on a liquidation basis. Obviously, like an insurer – or anyone with “float” – they would be worth quite a lot less if they ran down their business and closed than if they continued. Syncrolift is quite cyclical. So, this complicates things. If backlog rises over time – the negative working capital position will get more negative (cash will come in the door). If it falls, then cash will end up being used on the project.

So, you’re absolutely right that Nekkar wouldn’t be worth anywhere near what we think it is if it stopped bringing in new orders. The reason for buying the company would be that any new orders would also generate float to the extent that new orders exceed completion on existing orders (backlog rises). They’d always have the same cash on hand (basically) if the backlog stayed essentially flat. Again, this is similar to an insurer. Whenever premiums written today at an insurer drop versus last year, a portion of their balance sheet has to be liquidated and cash flows out the door. They have less customer cash on hand. Nekkar would work the same way. Whenever new orders fall the amount of pre-payments will fall. Whenever new order rise, then pre-payments would rise.

We would never have considered the company unless it was on an ongoing basis. So, the fact that cash isn’t earned isn’t as much of a negative to us looking at this as other people I think. I think other people look at it and say – rightly – that Nekkar can’t (unless they always have this long a backlog) count on having that cash on hand. It’ll flow out of the business in the future.

We look …

miguelneto October 21, 2019

GrafTech: Contracted Cash Flows Covering 60% of the Market Cap

Written by Miguel Neto.

There are some pictures I couldn’t put in this write-up that I included in the write-up I put up on my blog (https://netosnotes.blogspot.com/2019/09/graftech.html)

*****

GrafTech (ticker: EAF) has been in operation since 1886. It went public in 2018 when Brookfield sold 15% of the business, after being taken private in 2015. GrafTech is a backward vertically integrated producer of ultra-high power (“UHP”) graphite electrodes (“GE”), an industrial consumable product used primarily in EAF (“electric arc furnace”) steel production. Around 46% of the world’s steel production is produced through the EAF method, the other 54% being through the BOF (“basic oxygen furnace”). These numbers exclude China, where the BOF accounts for 91% of steel production.

Recent events with increase demand for lithium-ion batteries from EVs, the steel and the graphite electrode industry, have put this company in a position to be able to sell 65% of their 5-year cumulative capacity on take-or-pay contracts, thus almost guaranteeing the company a fixed source of free cash flow 5 years into the future. I believe the supply and demand imbalance will probably we present fro the next 5 years. This report will look into why that may be the case.

The company have a market cap of $3.9bn, $2bn in debt and $200mm in cash. In the past 12 months that company has generated $750mm in cash – of which $525mm has been returned to shareholders. $99mm in dividends, $203mm in special dividends and $225mm in share repurchases. I estimate that by 2023 the company will have earned about three-quarters of its market cap in FCF, which means you’d be paying almost nothing for the company by that year.

GE’s are an industry consumable used to conduct electricity in a furnace, generating an electric arc (a lot of heat) to melt scrap metal to the point where it is a liquid. UHP GE are made of >95% needle coke, whereas ladle electrodes, which are used in BOF’s, are made up of 20-30% needle coke. Ladle electrodes are of lesser quality because they only need to maintain the scrap metal in a liquid, as opposed to UHP GE which actually need to melt the metal. Furthermore, UHP GE takes around 6 months to produce, despite being used up in a single 8-10hr shift. Most EAF’s use 3 electrodes.

Graphite is used because it is the only material that has the chemical properties to handle a current consistently at temperatures needed to produce steel in an EAF – thus there it cannot be replaced by another product. Even at today’s prices GE only accounts for 1-5% of the production cost of steel. This bodes well for GrafTech as customers will be far more concerned with the (1) quality of the product and (2) security of supply, rather than price. Lower quality products lead to higher rates of breakage, more production downtime and thus increases production costs.

Worldwide capacity for GE is about 850,000 MT per year. Demand for steel is

Andrew Kuhn October 2, 2019

LEAPS

Originally posted at www.Gannononinvesting.com on June 01, 2011

by Geoff Gannon

Someone who reads the blog sent me this email:

Dear Geoff,

in your article “Should you Buy Microsoft?” on GuruFocus, you said, that it makes sense for some investors to use LEAPS instead of the stock.

After thinking long about that, I came to the conclusion, that LEAPS can be viewed as a form of leveraged investment with an insurance against a falling stock price included…So LEAPS would make sense, if you want to leverage your portfolio with relatively low risk.

I’m not endorsing LEAPS.

I think they make sense only in situations where there is a level of catastrophic risk in the underlying stock that is not priced into the option. In general, this means low volatility stocks that nonetheless can fail catastrophically if infrequently.

Like banks.

I would use LEAPS to buy a bank because there is always the risk that a bank will go to zero. In that sense, LEAPS leverage your investment and provide protection – basically an involuntary surrender – where you cut down a huge loss while still betting on a favorable outcome.

The problem with LEAPS is that they aren’t long enough dated. 5-year LEAPS would be good. 10-Year LEAPS would be virtually indistinguishable from a stock in terms of a correct analysis resulting in profit. But 2 years is not long enough for a value investor. If Warren Buffett had bought Washington Post 2-year LEAPS instead of Washington Post stock in the 1970s he would have lost his entire investment. By buying the underlying stock, he had a return of 30% a year compounded over the first 10 years.

I’ve had stocks that didn’t work out for 2 years. But, boy, did they work out over 5 years. I would’ve lost money on the LEAPS.

Any bet that depends on the market recognizing something within 3 years is a bet where a value investor can be completely right in terms of analysis and yet lose everything simply because the clock runs out.

Value investing is largely based on being able to hold a position until the market changes its mind. I’d say it’s very unreliable to assume mean reversion in the market mood on a stock within 3 years.

The exception to this is when you’re diversifying both across a group of separate bets and across a period of time. For example, if you buy one stock a month every month and turn over the portfolio every year (by swapping out one stock each month), you may average an acceptable result because you’re actually making a dozen different bets on a dozen different stocks that depend on prices at a dozen different future moments in time.

That’s not what you’re talking about. You’re talking about making one bet on one stock that will succeed or fail based on whether or not the stock reaches a certain price fast enough.

Personally, I’m not interested in LEAPS.

And I really …