The Risk of Regret: NACCO (NC)
Someone emailed me this question about NACCO (NC):
“If you don’t mind me asking, why do you so strongly recommend other people not buy the stock given your obvious high conviction? It seems like a classic value situation where a company in a hated industry (coal) with a long-term bleak outlook has an individual player (NC) where the cash flow characteristics are more than enough to justify the current stock price. If you prefer not to answer because your answer is embedded in your member-only site, I totally understand, but I am quite intrigued. For what it’s worth, I am not at a point where I am seriously considering NC for potential investment – I am more interested in Frost (CFR), although I would prefer it to come down more. I am just trying to understand the business and what a fair price for it is. It seems to me that if we had 100% certainty that all the contracts would remain viable for a couple of decades, then NC is easily worth say double where it trades now, but the name of the game is in handicapping the risks of the mines closing, and I would be interested in your thoughts about doing that. It’s obvious that you view this risk as worth the price paid, but I am curious why you do not think others should take the same risk.”
I’ll quote from the write-up I did on the Focused Compounding member site. I had sub-titled sections in this write-up. So, let’s just bullet point the headlines that appeared in the article.
They were:
* All value comes from the unconsolidated mines
* There are risks
* NACCO’s business model
* Each share of NACCO is backed by 5 tons of annual coal production
* NACCO makes anywhere from 57 cents to $1.75 per ton of coal it supplies
* Side not: amortization of coal supply contracts
* NACCO vs. NACoal
* Quality of earnings
* Risk of catastrophic loss
* How I “frame” NACCO
* Why I don’t recommend NACCO shares
You asked about “why I don’t recommend NACCO shares” and that’s one of the section headers. So, let’s look at that part:
“I put 50% of my portfolio into NACCO. But, I think people reading this should put 0% of their portfolio into NACCO. As long as electricity demand in the U.S. is declining and natural gas production is rising, coal power plants will shut down. As a shareholder of NACCO, you could wake up any morning to the news that the company has lost 35% of its earnings overnight. I don’t think this is a risk most investors can handle.
Therefore, I don’t recommend anyone invests in NACCO even though it’s now my biggest position.
Let me be clear: I’m not just saying this is a ‘perceived’ risk you may want to avoid.
It’s a real risk.
NACCO is a risky stock.
I absolutely can’t prove that all of the power plants NACCO supplies won’t shut down real soon. This means I can’t prove NACCO won’t lose literally all of its business in the very near future.”
I wasn’t joking when I wrote any of that. I talk a lot to investors. And I feel certain they shouldn’t put any money into NACCO. That kind of business specific risk – that a stock you picked could lose 35% of its earnings overnight – has the potential to make them feel so stupid, that they shouldn’t invest.
It’s not just that I think differently about stock picking than other people. It’s that I feel differently about stock picking. If I lose a lot of money in NACCO, I’ll lose a lot of money – same as anyone else. But, losing a lot of money in NACCO won’t crush my psyche. That kind of loss will do a number on most other investors’ heads.
To have success in investing, you have to stay in it long-term. That – more than anything else – is the key. You can have the optimal system picked out, but if you quit after just 8 years of investing instead of sticking it out for 50 – you lose. The real risk to investors is not the risk shown in something like the Kelly Criterion where you will end up with a zero dollar bankroll at some point. The real risk is that you’ll stop picking stocks. And the reason you’ll do that is because your mind gets broken – not your bankroll.
Losing a lot of money in an obscure stock like NC that I picked out for myself vs. losing a lot of money in the S&P 500 doesn’t feel any different to me. It feels different to the average person out there. So, when I say: you might lose 35% overnight in NC because of a single event that hasn’t happened – that’s disturbing to most investors. But, the way I look at it – you might lose 35% in NC because of an event that hasn’t happened yet. But, you will lose 35% in the S&P 500 because of an event that has already happened (it’s more than 50% overpriced right now).
That sounds wrong to most people.
But, it’s right.
The fact that all investors are aware of the S&P 500 and almost all of them don’t believe it’s overvalued by at least 50% doesn’t change the fact that it is overvalued by at least 50%. Likewise, the fact that almost no investors are aware of NACCO doesn’t change the fact that there is some price level below which it should not sell.
I looked at the stock before the spin-off. And I came to the conclusion that the stock shouldn’t sell for less than about $45 a share. I didn’t value it at $45 a share. I just said: “it’d be really weird for this stock to ever trade below $45 a share” and then the stock was trading at around $32.50 a share when I first checked the price on October 2nd (the day of the spin-off). So, I bought it.
I wrote the article at Focused Compounding in which I discussed NC after the spin-off had happened. So, I used $32.50 as the price I discussed in that article.
Basically, what I said was something like this:
Over the last 5 years prior to NC’s expansion into (and now exit from) the very different business of owning and operating an underground bituminous coal mine (Centennial), NACoal reported an after-tax profit of over 90 cents per ton of coal mined if we assume all “corporate” losses stay with NC and none go to HBB. NACCO is now producing more than 5 tons of coal per share of NC stock. So, 90 cents times 5 tons = $4.50 per share in earnings. Furthermore, NACCO is taking a non-cash charge in the form of amortization of its coal supply contracts with every ton of coal it mines. This causes NACCO’s reported profit per ton of coal mined to come in well below its cash received per ton of coal mined.
Then, I knew that HBB was supposed to pay NACCO a $35 million cash dividend just prior to the spin-off. And, knowing that, I could see that this would leave NACCO with a balance sheet that was basically free of meaningful net debt or net cash. NACCO has long-term liabilities. But, these don’t require much in the way of immediate funding (they aren’t things like bank loans). And the company has cash on hand right now. So, I assumed the net result – in my quest to simplify the situation – was that the asset and liability situation came close enough to being a wash that I could just value the stock as if it was nothing but an annual stream of free cash flow.
So, for the sake of simplicity, you have a stream of free cash flow that’s about $4.50 a year and costs you about $32.50 (with no meaningful cash or debt attached).
Normally, free cash flow is capitalized in the stock market at a rate no higher than 6% (that is, 16-17 times free cash flow). So, a stock priced at $32.50 a share with neither meaningful debt nor cash attached to it is priced like it is expected to deliver an annual stream of free cash flow of $1.95. In other words, NACCO looked like it would normally have about $4.50 a share in free cash flow and yet it was priced like it would normally have about $2 a share in free cash flow.
This meant that NC’s free cash flow could end up being (more than) 50% lower than what I calculated without the stock price needing to decline to reach fair value.
The way NACCO’s unconsolidated mines are set up – where the customer takes all the capital risk – made me feel that NACCO was better situated to lose a big chunk of revenue without necessarily losing a much bigger chunk of free cash flow. At many businesses, a decline of say 35% of revenue could cause a 100% decline in earnings. Here, I didn’t think that – after the initial year or so following the contract loss – a loss of 35% of revenue would cause much more than a loss of 50% of free cash flow.
So, I looked at the stock and said that NACCO at $32.50 a share is already priced like it has lost its biggest customer. That’s your margin of safety. It’s priced like it’s lost its biggest customer. And yet it hasn’t yet lost its biggest customer yet. And – while you own the stock and wait for it to lose that biggest customer – cash will pile up on the balance sheet at a rate of about 10% to 15% of your original purchase price, or you’ll get a dividend (right now, it’s about 2% of my cost in the stock), or the company will buy back stock, or the company will – as it did in the past – acquire businesses unrelated to coal mining.
This looked like a good deal to me. So, I bought the stock. However, I don’t recommend anyone else buys the stock, because they will have such tremendous regret if they buy NACCO and then coal power plant after coal power plant after coal power plant closes and the company’s stock drops nearly to zero.
The regret they feel losing money in NACCO will be much greater than the regret they’d feel losing the same amount of money in something like an S&P 500 index fund, because in the case of NACCO their loss will be their fault. In the case of the S&P 500, they can take solace in the knowledge that everyone they know also lost money the same way.
Unlike most people, I don’t really feel regret. And so: one loss feels just like another loss to me.
For example, I lost a lot of money in Weight Watchers (WTW).
That doesn’t really bother me. I know some other people who followed me into that stock, lost less money than me (or pretty much broke even) and yet are still bothered by the experience.
This is why I warn everyone away from NACCO even while owning the stock myself. You may really regret owning NACCO in a way I won’t.
For me, if I look back on a stock purchase I made and can say “knowing what I knew then it seemed like a good bet at the time” – I won’t regret that purchase no matter how much I lose.
Also, if I do something like keep money in cash that could go into the S&P 500 and then the S&P 500 goes up 20% or so (like it did this year) despite already being expensive – I won’t regret not being in the market. Because, yes, it went up 20%. But, looking back a year ago – it certainly didn’t look like a good bet at the time. So, I don’t think anyone who has made 20% in stocks this year should give themselves credit for being lucky a little longer than it probably was safe to be.
This may or may not be how most investors think. But, I know it’s not how most investors feel. So, there are just certain stocks the average investor should avoid for purely psychological reasons. And I think NACCO is one of those stocks.