I have been binge reading Howard Marks's memos over the past few days. During the same few days, I have read several pieces on Trinity Industries (NYSE:TRN) to catch myself up on the events that have taken place in the railcar industry as well as the pending ET-Plus guardrail lawsuit. Between the railcar industry slowing down since its 2014 peak and the ET-Plus lawsuit with a judgment of $663M (they are currently trying to take it to the Fifth Circuit), many investors are probably throwing Trinity Industries out of the window as a potential investment. However, for anyone who has spent some time reading into Trinity Industries, it might be a valuable lesson about how we approach uncertainty and how we relate uncertainty to risk.
Since the October 2014 ruling on Trinity Industries, which happens to coincide with roughly the time when oil prices started racing to the bottom, Trinity Industries' stock also started tumbling:
How does the lawsuit affect Trinity?
Without trying to predict what the outcome of the ET-Plus lawsuit, we can confidently say that it is a possibility that the $663M settlement can be upheld. Fortunately, Trinity's Construction Products Group (the segment that the ET-Plus guardrails in question are sold under) have historically been a small, but stable source of operating profits - or in other words, Trinity does a lot of other stuff too. According to the 10-Q from Q2 2016, Trinity holds $614M in cash and cash equivalents. The likelihood of a $663M settlement crippling Trinity is low. It is safe to say that Trinity's current operating businesses are more than likely to continue operating, regardless of the outcome of the ET-Plus guardrail lawsuit.
At the current price, Trinity holds a price to tangible book value of 1.16:
Take out the $663M settlement from Trinity's tangible book value and we have a price to tangible book value of 1.48. Additionally, Trinity currently trades at 6x P/E. As a reference point, S&P 500 ended September 2016 with a 24.15 P/E and a 2.76 P/B (P/B for Trinity is 0.93 currently).
In his memo titled "Risk Revisited Again", Howard Marks wrote:
"... I discussed the fact that economic decisions are usually best made on the basis of "expected value": you multiply each potential outcome by its probability, sum the results, and select the path with the highest total. But while expected value represents the probability-weighted average of all possible outcomes, we can be certain it will not be the outcome (unless by coincidence it's one of the possibilities). Clearly just one of the many things that can happen will happen - not the average of all of them. And if some of the paths under consideration include individual outcomes that are absolutely unacceptable, we might not be able to choose on the basis of the highest expected value. We may have to shun the quantitatively optimal path in order to avoid the possibility of an extreme negative outcome. I always say I have no interest in being a skydiver who's successful 95% of the time."
Source: Oaktree Capital
At this point, we can start broadly listing possibilities and assigning probabilities. However, I want to focus on what the extreme negative outcome in Trinity's case would be. Frankly, my approach tends to float around observing what a series of negative events looks like and then figuring out just how ugly things could get.
In the six months ended 2016, Trinity posted net income of $191M compared to $409M in the same period for 2015. Let's say that all of Trinity's segments took a turn for the worse and Trinity ends up only making $50M of net income per quarter. In the meantime, the ET-Plus guardrail lawsuit's $663M settlement is upheld. Assuming today's prices remain, we still have a company trading at a 17.5 P/E with a price to tangible book value multiple of 1.48. I have no interest in being a skydiver who's successful 95% of the time either and Trinity sounds like a decent bet.
Trinity has operated with losses in the past, but never for a prolonged period of time. What matters here is what sort of probability we would assign to a $663M or larger settlement combined with a worse environment than 2009/2010 and whether the outcome of that is absolutely unacceptable. A quick glimpse at Trinity's financials hints to me that it is operating in enough different segments that all of them taking a turn for the worse is unlikely. While there is always a chance that a meteor will strike the headquarters, Trinity looks like being a skydiver who's successful 99.9% of the time and not jumping out of the plane may equate to missing out on an exhilarating experience. For those who have actually spent a bit of time reading about Trinity, it was probably a refreshing exercise on how to think through uncertainty.
It seems like the combination of the ET-Plus lawsuit and headwinds in railcar demand have convinced some investors to walk away from Trinity. However, looking at a couple metrics suggests that even with today's environment continuing forward and the $663M bill coming in, there is quite a bit of life left in Trinity. At the very least, I think it is worth taking a closer look at Trinity.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.