We at LTIM are attracted by businesses that have large barriers to entry, and therefore, are involved in markets where there are few competitors. When companies have certain positive attributes that create such a market structure, we find few companies that are unable to make exceptional profits.
We are even more excited when we see the pricing of the financial securities of such companies are trading at prices that do not include the potential value generated from having the ability to generate exceptional profits.
The aggregates business is a simple one whereby companies own or lease land where quarries are mined, and the extracted rock is sold. Customers primarily use the material for the development of roads or property (in the majority of cases).
Aggregates are a relatively cheap material (approx. 10 $/ton), but very difficult to transport. As a result, a local quarry will often have a monopoly of the local supply of aggregates.
VULCAN MATERIALS has one of the largest aggregates reserves in the USA. They are very large in the South East, states that have the largest population growth in the country. In these areas they consistently have greater than 40% of the crushed rock quarries under their ownership. This gives them a large market share in the areas they conduct business.
The common stock has suffered a large decline since 2007. In that period it was trading close to 120 $/share. Now it is trading at approx. 43 $/share.
At this price we believe the stock is an interesting asset play. Indeed, over the last few months we have presented various asset play ideas that derieve from a currently weak US housing sector. Though we do not believe the housing sector in the US will bounce back to 2007 levels next year, we think current pricing has been to aggressive in discounting the value of real hard assets. In this case of aggregates, in past examples like St Joe, physical land.
Many investors are currently focused on the short term earnings of Vulcan materials and how much they can increase volumes or pricing in the next quarter or two.
I am more concerned on how much their aggregate reserves are worth. Here is my simple calculation:-
Reserves = 14 billion tons of proven and probable aggregate reserves at its production facilities in the US and Mexico
Aggregates sell for approx. 10 $/ton
This implies a valuation of 140 bln
However, margin for extracting aggregates is often around 10% (normalised over the business cycle)
Hence we have a valuation of 14 bln
If we remove total liabilities of 4.5 bln
We have a value of 9.5 bln (lets say 9 bln)
The current market cap of the company is 5.5 bln
The company also extracts other materials and has a cement plant in Florida. We assume those assets are worth zero for simplicity and to be conservative. There seems to be a suitable margin of safety if you agree with the above mentioned reasoning.
Risks to consider? Considering current production rates it would take over a 100 years to exhaust their resources. One could express concern that during such a large period the pricing of aggregates may decline significantly. We take shelter in the fact that this material has been used since biblical times in construction, that permits to open new quarries are becoming more difficult to achieve (no one wants a quarry in their back yard!) and that the concentration of the market should allow princing power to be maintained to a satisfactory level. The problem is volume variation as demand is cyclical and costs are primarily fixed (hence a large margin reduction will be felt during a recession. This can be clearly seen from the financial statements as well as the stock price, which is very sensitive to the income statement).
Another cause for concern that must be followed closely is how the cost structure of the company evolves. For example, such capital intensive companies often have relatively large energy costs. It would not surprise me if next quarter earnings will be below expectations due to the strong performance of the oil price. Many mines use diesel power as a source of energy. If these costs can be passed over by higher pricing than the current normalised margin can be used to estimate the future value of their resources (we ignore their earning power. Our only assumption is that over the business cycle they will not burn cash).
Tuesday, 8 March 2011
Uncertainty always exists...
When young European entrepreneurs are expanding profit making businesses, they pay litte attention to whether a war in Libya will affect the value of their company.
And quite rightly so, in our opinion.
Their principal concern is having access to capital, using that capital to generate a return greater than the cost of the capital, and using the surplus cash flow to meet liabilities and re invest in the company to generate further profits whilst the return on capital is greater than its cost.
It is a shame the financial securities of publically traded companies are not priced in the same way.
Actually, we try and make a business out of this fact: as long as this occurs, the longer we can work. Long live the short term orientated "macro market timer" who wishes to make "easy profits" from trading the market on contemporary news or the current quarters business developments.
We take the approach of viewing a companies financial securities as if we were the owner of the business: How can I grow my business (investment, in our case) so that over the entire business cycle the company can develop in an optimal manner. If we can find good companies with good management who ask this question everyday, and the market structure is positive, we would shy away from obscene portfolio diversification for diversifications sake and simply hold a few companies in our portfolio.
The reality is these companies are hard to find, and indeed, very few exist. This will not stop us, of course, from looking....
This rather long introduction we feel is necessary to cement home our approach to investing (indeed, life in general). It is in times that the world seems more uncertain that you must most remember the above mentioned concepts. Do you really think life was less uncertain yesterday? We don´t think so. You just had the illusion it was. This may be due to media influence or a lack of experience, which allows one to temporarily believe that event is predictable. Just as when you flip three coins in a row and you correctly guess all three outcomes you start to feel you may have a special ability to judge how a coin will drop; on the fourth attempt you are reminded that it was an illusion, you had no special gift.
In life, as in investing, one must continuously remain humble. We feel it helps us make profits: indeed, we feel this is a strong competitive advantage for us. Investing is as much about the stomach as the head, and when one continuously judges risk as being there, as uncertainty existing, one is better able to spot what is cheap or expensive, and hence act decisively when one must.
And quite rightly so, in our opinion.
Their principal concern is having access to capital, using that capital to generate a return greater than the cost of the capital, and using the surplus cash flow to meet liabilities and re invest in the company to generate further profits whilst the return on capital is greater than its cost.
It is a shame the financial securities of publically traded companies are not priced in the same way.
Actually, we try and make a business out of this fact: as long as this occurs, the longer we can work. Long live the short term orientated "macro market timer" who wishes to make "easy profits" from trading the market on contemporary news or the current quarters business developments.
We take the approach of viewing a companies financial securities as if we were the owner of the business: How can I grow my business (investment, in our case) so that over the entire business cycle the company can develop in an optimal manner. If we can find good companies with good management who ask this question everyday, and the market structure is positive, we would shy away from obscene portfolio diversification for diversifications sake and simply hold a few companies in our portfolio.
The reality is these companies are hard to find, and indeed, very few exist. This will not stop us, of course, from looking....
This rather long introduction we feel is necessary to cement home our approach to investing (indeed, life in general). It is in times that the world seems more uncertain that you must most remember the above mentioned concepts. Do you really think life was less uncertain yesterday? We don´t think so. You just had the illusion it was. This may be due to media influence or a lack of experience, which allows one to temporarily believe that event is predictable. Just as when you flip three coins in a row and you correctly guess all three outcomes you start to feel you may have a special ability to judge how a coin will drop; on the fourth attempt you are reminded that it was an illusion, you had no special gift.
In life, as in investing, one must continuously remain humble. We feel it helps us make profits: indeed, we feel this is a strong competitive advantage for us. Investing is as much about the stomach as the head, and when one continuously judges risk as being there, as uncertainty existing, one is better able to spot what is cheap or expensive, and hence act decisively when one must.
Tuesday, 1 March 2011
Understanding a company
To determine if their is a difference between the price and value of a company we believe five moving parts need to be very well understood:-
1 The costs of the company and how they compare to competitors
2 The product and the pricing power on that product
3 Regulation and government influence
4 Macroeconomic influence
5 How different companies interact with each other and suppliers/customers
6 How the market structure has evolved and is influenced by factors 1-5
1 The costs of the company and how they compare to competitors
2 The product and the pricing power on that product
3 Regulation and government influence
4 Macroeconomic influence
5 How different companies interact with each other and suppliers/customers
6 How the market structure has evolved and is influenced by factors 1-5
Wednesday, 23 February 2011
Risk reduction on the menu
We have moved to being aggressive sellers of cyclical companies this quarter.
Many of the cyclical positions we have reduced or sold entirely were bought as asset plays. As they have approached our estimates of their net physical assets we have sold, rather than wait for the earnings component of the investment to kick in.
The truth is we remain deeply concerned about:-
1. The valuation of equity markets in most of the world (developed and emerging)
2. The weakness of consumers and governments due to their large debt burdens
Though the S&P 500 has reached a valuation we theoritically would be happy to short, we are nervous to do so. I cannot rationalise this statement other than to make explicit my lack of conviction on how external factors beyond basic economics (i.e. government intervention) can affect the valuation of risk assets. As a result we are starting to accumulate a rather large bucket of cash in different currencies.
We are extremely pleased on how our asset plays have performed, and are also upset to sell a number of them. Inflationary pressures are receiving greater media attention and simple inflation srategies continue to perform well. However, I cannot fight the discipline within me - we sell when our original story gets achieved unless we have a strong investment case(rather than a momentum play) the company is worth more. A few asset plays for this reason have been held, many have been sold.
With regards to our second point above mentioned, some clients dont even listen to me any more. "The debt crisis is over Alex, you will have to get over it at one point". I hope they are right, but I can assure you I am not managing portfolios assuming that is the case. This is quite likely to lead to an underperform of our portfolios relative to market indices in the short term, and quite possibly, the medium term. My mind however believes this will not be the case in the long term. when faced with such dilemmas over different time periods, we always chose the option where we have long term confidence.
Yours sincerely,
Long Term Investment Management
Many of the cyclical positions we have reduced or sold entirely were bought as asset plays. As they have approached our estimates of their net physical assets we have sold, rather than wait for the earnings component of the investment to kick in.
The truth is we remain deeply concerned about:-
1. The valuation of equity markets in most of the world (developed and emerging)
2. The weakness of consumers and governments due to their large debt burdens
Though the S&P 500 has reached a valuation we theoritically would be happy to short, we are nervous to do so. I cannot rationalise this statement other than to make explicit my lack of conviction on how external factors beyond basic economics (i.e. government intervention) can affect the valuation of risk assets. As a result we are starting to accumulate a rather large bucket of cash in different currencies.
We are extremely pleased on how our asset plays have performed, and are also upset to sell a number of them. Inflationary pressures are receiving greater media attention and simple inflation srategies continue to perform well. However, I cannot fight the discipline within me - we sell when our original story gets achieved unless we have a strong investment case(rather than a momentum play) the company is worth more. A few asset plays for this reason have been held, many have been sold.
With regards to our second point above mentioned, some clients dont even listen to me any more. "The debt crisis is over Alex, you will have to get over it at one point". I hope they are right, but I can assure you I am not managing portfolios assuming that is the case. This is quite likely to lead to an underperform of our portfolios relative to market indices in the short term, and quite possibly, the medium term. My mind however believes this will not be the case in the long term. when faced with such dilemmas over different time periods, we always chose the option where we have long term confidence.
Yours sincerely,
Long Term Investment Management
Thursday, 27 January 2011
Three main ways to invest
We see three main investment strategies available to investors:-
1. Macro: Best used to identify the investment environment over the next business cycle. It can indicate how the credit cycle will evolve, hence the market cycle. It does not resolve the timing issue of when to invest, nor what security to buy. Can help identify asset allocation and where bubbles/busts may occur
2. Value: This approach can best identify which sectors/industries/companies are available with a smaller probabilty of making a permenant capital loss, especially if you consider the market structure of the sector. It can help identify bubbles, though not when they will break nor when they will occur
3. Momentum/technical: Can help identify when a bubble will burst or start
1. Macro: Best used to identify the investment environment over the next business cycle. It can indicate how the credit cycle will evolve, hence the market cycle. It does not resolve the timing issue of when to invest, nor what security to buy. Can help identify asset allocation and where bubbles/busts may occur
2. Value: This approach can best identify which sectors/industries/companies are available with a smaller probabilty of making a permenant capital loss, especially if you consider the market structure of the sector. It can help identify bubbles, though not when they will break nor when they will occur
3. Momentum/technical: Can help identify when a bubble will burst or start
The Leveraged buy out (LBO) model of valuation
Prior to the "great" recession of 2008, LBOs were all the rage. Every investor from the most conservative to the most aggressive wanted a piece of the action.
In this article we highlight how their valuation model is necessary to be understood to appreciate the difference between the "fair value" of a traded company on the stock exchange for a non leveraged investor and the "fair value" for an LBO buyer.
The free cash flow (FCF) yield is the same for all investors at a particular price if the deal financing is the same. You take the FCF generated and divid by the current market cap. However, if you are a leveraged investor, you divid the free cash flow generated by the equity you put in. Hence, if 80% of the deal is financed by debt, you can afford to pay a considerably higher price than a non leveraged investor, yet still can achieve a higher return on your equity! This implies that large investors with a good reputation and work closely within a well financed business circle can afford to pay more for assets whilst still achieving higher returns.
As a result, the fair value for a LBO buyer and a small time non leveraged buyer is different! Fair is defined by the financing method applied to the deal, as well as a number of other variables.
Prior to 2008, financing could be achieved with almost 100% debt financing. This made valuations expensive. This is why in a credit expanding phase of the credit cycle valuations of risk assets become richer (the multiple becomes larger). What is also important is the cost of the borrowing. Indeed, for the LBO to be worthwhile the FCF yield must be greater than the cost of borrowing. This is the theoritical maximum a LBO buyer would pay for a business.
As a result, it is intuitive to appreciate that LBOs reduce in number as the cost of borrowing increases, unless equity markets also drop!
In this article we highlight how their valuation model is necessary to be understood to appreciate the difference between the "fair value" of a traded company on the stock exchange for a non leveraged investor and the "fair value" for an LBO buyer.
The free cash flow (FCF) yield is the same for all investors at a particular price if the deal financing is the same. You take the FCF generated and divid by the current market cap. However, if you are a leveraged investor, you divid the free cash flow generated by the equity you put in. Hence, if 80% of the deal is financed by debt, you can afford to pay a considerably higher price than a non leveraged investor, yet still can achieve a higher return on your equity! This implies that large investors with a good reputation and work closely within a well financed business circle can afford to pay more for assets whilst still achieving higher returns.
As a result, the fair value for a LBO buyer and a small time non leveraged buyer is different! Fair is defined by the financing method applied to the deal, as well as a number of other variables.
Prior to 2008, financing could be achieved with almost 100% debt financing. This made valuations expensive. This is why in a credit expanding phase of the credit cycle valuations of risk assets become richer (the multiple becomes larger). What is also important is the cost of the borrowing. Indeed, for the LBO to be worthwhile the FCF yield must be greater than the cost of borrowing. This is the theoritical maximum a LBO buyer would pay for a business.
As a result, it is intuitive to appreciate that LBOs reduce in number as the cost of borrowing increases, unless equity markets also drop!
Monday, 27 December 2010
The Asset Play as an Investment Strategy
In our view markets are currently being priced assuming an optimistic growth scenario for the economy in general. As a result, LTIM are now reducing positions in cyclical companies/sectors/industries. We should add we are finding it harder to purchase companies at good prices considering their stable earning power.
A good price is a rather subjective concept, confirmed by speaking to several investment advisors whom will give several different responses. For LTIM it has a rather precise concept. It means we pay a reasonable multiple for stable free cash flow generation, whereby the yield we expect to receive at the price paid is higher than the return we expect to achieve from our portfolios (which is cash rates + 3% over a three year average). As a result, any growth will effectively come for “free”. At current market prices, few companies are offering growth for free. Hence our difficulty in purchasing companies on a stable earning power basis.
However, we are not building up a cash position larger than 15-20% of the portfolio in an environment where inflation risks seems to be increasing. Whilst we are reducing cyclicals, we will not simply wait for the next market crash to occur. Whilst growth assumptions have to become more aggressive to purchase a stream of future earnings, companies trading at market prices below their net physical assets are still available in certain industries. This is the domain of the asset play strategy. In this domain, net physical assets are at least as important as future free cash flow.
Asset play strategies usually involve the purchase of companies that are currently unloved. Investor demand for visible earning growth ensures that earnings, rather than assets, is the variable markets are most sensitive to when placing a price on a company that is publically traded on a stock exchange. We see this from the way stock prices shift aggressively if reported earnings are greater or less than estimated, by the format of analyst reports that emphasis the earnings evolution of a company in the next 12 months, as well as the way companies are crudely valued by many market participants applying a multiple on estimated short term earnings.
This focus on short term earnings can be physically measured by viewing how investors are allocating capital in the equity markets. For example, in the US the average holding period of a common stock in 1940 was around 7 years. In 2007, the average holding period was 7 months. It seems no one wants to forecast a companies earnings beyond 2 quarters. That seems to fit in well with what my hedge fund buddies say, and do.
The aim of the asset play is to try and take advantage of this “time arbitrage” that seems to exist in publically traded securities. It is common knowledge that certain asset heavy companies that suffer cyclical stress or poor news can be bought on the secondary market at a price considerably cheaper than their net real assets. However, assets plays can remain asset plays for a considerable period of time, which can dilute the potential return of the investment strategy.
In LTIM asset plays we therefore look for a specific catalyst that can reveal the hidden value within a companies balance sheet. In this environment, for a short period of time, the assets can lead the stock price, as opposed to the earnings. Marty Whitman would refer to such a catalyst as resource conversion, an important source of return for the value investor. The catalyst usually comes in the form of a new owner holding the asset. Hence relevant market transactions would be a new aggressive passive or majority shareholder, a merger or acquisition, or the selling of assets. Such a market based transaction can make visible the discrepancy between the price of the asset on the balance sheet and its true value in the market. As a result, the price to book ratio expands.
Asset plays are an interesting diversifiaction in a portfolio when growth assumptions become too aggressive, as is the case now for many companies we would like to own, but are not happy with the prices they are currently available. Furthermore, for those investors who fear inflation, such asset plays are an interesting way to gain access to physical assets at a relatively good price, which does not seem to be available via purchasing commodities via spot or futures markets at the moment.
In practice, we often combine an asset backing with a stable earning power assumption. As a result we feel comfortable the potential for a permanent loss of capital is minimal due to the net assets behind the company if a liquidation was to occur, whilst any growth in future earnings will come for free. As a result returns are likely to come from earnings, but a resource conversion event is a possible bonus. We like the risk -return characteristics of such investments when the price is right. Many opportunities are being provided in such unloved sectors as real estate - a sector much loved by everyone only a few short years ago...
A good price is a rather subjective concept, confirmed by speaking to several investment advisors whom will give several different responses. For LTIM it has a rather precise concept. It means we pay a reasonable multiple for stable free cash flow generation, whereby the yield we expect to receive at the price paid is higher than the return we expect to achieve from our portfolios (which is cash rates + 3% over a three year average). As a result, any growth will effectively come for “free”. At current market prices, few companies are offering growth for free. Hence our difficulty in purchasing companies on a stable earning power basis.
However, we are not building up a cash position larger than 15-20% of the portfolio in an environment where inflation risks seems to be increasing. Whilst we are reducing cyclicals, we will not simply wait for the next market crash to occur. Whilst growth assumptions have to become more aggressive to purchase a stream of future earnings, companies trading at market prices below their net physical assets are still available in certain industries. This is the domain of the asset play strategy. In this domain, net physical assets are at least as important as future free cash flow.
Asset play strategies usually involve the purchase of companies that are currently unloved. Investor demand for visible earning growth ensures that earnings, rather than assets, is the variable markets are most sensitive to when placing a price on a company that is publically traded on a stock exchange. We see this from the way stock prices shift aggressively if reported earnings are greater or less than estimated, by the format of analyst reports that emphasis the earnings evolution of a company in the next 12 months, as well as the way companies are crudely valued by many market participants applying a multiple on estimated short term earnings.
This focus on short term earnings can be physically measured by viewing how investors are allocating capital in the equity markets. For example, in the US the average holding period of a common stock in 1940 was around 7 years. In 2007, the average holding period was 7 months. It seems no one wants to forecast a companies earnings beyond 2 quarters. That seems to fit in well with what my hedge fund buddies say, and do.
The aim of the asset play is to try and take advantage of this “time arbitrage” that seems to exist in publically traded securities. It is common knowledge that certain asset heavy companies that suffer cyclical stress or poor news can be bought on the secondary market at a price considerably cheaper than their net real assets. However, assets plays can remain asset plays for a considerable period of time, which can dilute the potential return of the investment strategy.
In LTIM asset plays we therefore look for a specific catalyst that can reveal the hidden value within a companies balance sheet. In this environment, for a short period of time, the assets can lead the stock price, as opposed to the earnings. Marty Whitman would refer to such a catalyst as resource conversion, an important source of return for the value investor. The catalyst usually comes in the form of a new owner holding the asset. Hence relevant market transactions would be a new aggressive passive or majority shareholder, a merger or acquisition, or the selling of assets. Such a market based transaction can make visible the discrepancy between the price of the asset on the balance sheet and its true value in the market. As a result, the price to book ratio expands.
Asset plays are an interesting diversifiaction in a portfolio when growth assumptions become too aggressive, as is the case now for many companies we would like to own, but are not happy with the prices they are currently available. Furthermore, for those investors who fear inflation, such asset plays are an interesting way to gain access to physical assets at a relatively good price, which does not seem to be available via purchasing commodities via spot or futures markets at the moment.
In practice, we often combine an asset backing with a stable earning power assumption. As a result we feel comfortable the potential for a permanent loss of capital is minimal due to the net assets behind the company if a liquidation was to occur, whilst any growth in future earnings will come for free. As a result returns are likely to come from earnings, but a resource conversion event is a possible bonus. We like the risk -return characteristics of such investments when the price is right. Many opportunities are being provided in such unloved sectors as real estate - a sector much loved by everyone only a few short years ago...
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