- A combination of momentum and multiple value factors is one of the best strategies among the 300 strategies described in What Works on Wall Street.
- Every month I quantitatively rank stocks according to this strategy.
- According to this month's list Otelco is a good pick on a statistical basis. I describe the company below.
In What Works on Wall Street James O'Shaughnessy describes about 300 quantitative stock investing strategies. He investigates their long term returns and risks. Last year I discovered it is possible (but not easy) to implement many of these quantitative strategies. So these advanced strategies are not just an edge for hedge funds any more but anyone can implement them at home. It can be done by screening for stocks using very flexible criteria. Then export fundamentals and price data for each stock and then rank them on multiple criteria. Finally compute the combined ranks.
One of the best strategies described in What Works on Wall Street is a mix between value and momentum called Trending Value. He ranks US stocks with positive momentum on various value factors and then proceeds with the 10% with the best rankings. These best 10% he ranks on momentum. The 25-50 stocks with the best momentum enjoy high returns (21%) despite low risks (Sharpe ratio 0.9).
I have done something similar, but with various improvements. One of the biggest differences is that I rank on smooth momentum instead of on raw momentum. Smooth momentum suggests many knowledgeable investors are slowly buying into the stock. Therefore smooth momentum serves as better evidence for "wisdom of the crowds" than bumpy momentum caused by a few events. For more details including links to scientific papers see my freely accessible article on statistical investing.
For international stocks I share the details of the best ranked stocks with my Marketplace subscribers. For the much more expensive US-listed stocks I share results here on the free part of Seeking Alpha.
Otelco (NASDAQ:OTEL) has the third best ranking on this month's list. The ranking ignores recent momentum because this is subject to mean reversion. My ranking considers smoothness of momentum but unfortunately I do not have many price points for this automated judgment. Therefore I improve this automated smoothness analysis by looking at the charts myself. Based on the chart I think this is the best momentum stock this month:
This month's list compares valuations and momentum of 853 selected stocks. These stocks have been selected on momentum criteria and fundamentals (mainly EV/EBIT < 20). Among these selected stocks 90% of the stocks has a less favorable rank on a combination of multiple value factors. In particular Otelco's stock is relatively cheap based on P/E, EV/EBIT and Price/Free cash flow. The company is also very cheap in terms of the sum of 7 years of free cash flow divided by its total assets.
Returns from low P/B investing are mostly explained by low ratios Price/Retained Earnings. I use cumulative retained earnings over the last 8 reporting years instead since retained earnings from the balance sheet can only be looked up manually. Unfortunately they are not available in my screener. Using 8 years of cumulative retained earnings is my workaround. I use 8 years because this is the length of the typical business cycle. So I think 8 years of retained earnings is a good replacement for just retained earnings, in fact it may be even better.
Over the last 8 years the company paid out more than it earned. It did earn money but also paid a dividend every year, until 5 years ago. So retained earnings, that is total earnings over the last 8 years minus payouts, were negative. Therefore the stock is expensive based on Retained Earnings from 8 years/Market cap.
The good momentum is also backed by a moderate to high Piotroski score of 6. This metric is based on year over year improvements in among others earnings, share count and the balance sheet. So independent from momentum it confirms fundamentals are improving.
Otelco owns several local exchange carriers servicing rural parts of the US. As such the company provides telecommunication services and internet to customers in north central Alabama, central Maine, western Massachusetts, central Missouri, western Vermont, and southern West Virginia. The company operates nearly 97,000 access lines. See also the first pages of the annual report over 2016.
In the table below I have summarized the company with some basic numbers from the 12 months ending on September 30, 2017:
Tangible book value
Cash flow from operations
Free cash flow
Revenue has been declining already for 8 years. I think this is caused by a declining number of access lines, already for many years as well. Probably many of these lines are replaced by mobile connections.
Otherwise the company does not have much competition. See page 2 of the annual report over 2016. In three of their rural territories nobody else provides landlines, and in the other eight territories the company has at most one competitor, but only in parts of their territories. Prices are regulated though.
At the moment video services (television, pay-per-view, security, etc) account for only 4.4% of the revenue, although this revenue stream is slowly increasing. Apparently Americans living in rural areas do not watch TV via a home internet connection (as almost everybody does in The Netherlands, even in rural areas).
When looking at the revenue during the last couple of years it seems the decrease in revenue is slowing down. From the quarterly numbers it seems the revenue decline has even bottomed. However part of the revenue is just subsidy from among others the Alternative Connect America Model program, or ACAM. For details see among others here. Unfortunately I could not find the total amount of government support for Otelco but from page 16 of the recent quarterly report I estimate $8 million in 2017. This support will stop after 2026, which may not be a problem. To get the support the company has to invest in infrastructure for broadband internet. When the government support ends this obligation will also end. Then revenue might go down but free cash flow will probably go up.
Using these government grants Otelco invests in broadband internet infrastructure for its rural customers, on the cheap. This affects most of Otelco's customers since it participates with 10 of its 11 rural area's in the ACAM program. According to page 6 of last quarterly report Otelco plans to spend at most $7.5 million on capex during 2018. This may be less than the government support the company receives, see above. I don't think competitors can do the same if they do not have a customer base in Otelco's areas already. Probably they would also need some minimal infrastructure in place to start. I also do not think it makes sense for new entrants to apply for these government grants in Otelco's business areas.
Otelco will gradually monetize the new infrastructure. As discussed above the company has and will have little competition. Furthermore the expected and ongoing population increase in the US helps getting the most out of the network. In particular TV over internet will stimulate customers switching to broadband subscriptions. Also the repeal of net neutrality in the US might generate extra income for Otelco.
As can be seen in the table the enterprise value is much higher than the market cap. That is caused by about $87 million of long term debt. Recently the company refinanced this debt. This was an extremely favorable transaction since management estimates the interest rate to drop from about 10% to about 6%. I estimate this increases net profits and therefore free cash flow with $2.5 million per year. If Trump's tax plan will not become effective the interest rate drop will increase net income still with $2 million per year.
How much is Otelco worth?
I think Otelco can be best valued based on free cash flow. The interest savings should increase the free cash flow to about $12 million, see above. Then it is safe to assume the company's own investments in broadband internet will be earned back. Therefore there is room for an increase in free cash flow of $2 million per year. That makes $14 million per year in total.
Usually people pay firm prices for stable cash flow centers like Otelco. Therefore a Price/Free cash flow multiple of 10 is reasonable. A multiple of 10 already results in a value of $140 million, above the current enterprise value. A multiple of 12 is not unrealistic however. On top of that an acquirer could pay an extra $20 million because an acquire can save several millions per year on overhead. So I could see the value of the company somewhere between $140 and $190 million.
What shareholders say and do
Good momentum stocks mirror the expectations of the knowledgeable crowd. These investors seem to be enthusiastic about the stock.
A large shareholder is Ira Sochet. Just after the refinancing in November 2017 this outsider increased his stake much at $11.95. He might have bought these shares from Solas Capital Management, who sold out their stake of 9.8%. See also here. Also last month Ira Sochet bought more just above $14. He now owns 20.9% of the shares.
Of course the CEO and the CFO have good incentives. Every year they get restricted shares as part of their package. The CEO owns 35,929 shares or about 1 percent. The CFO owns 24,473 shares. They have not sold. On top of that they have similar but larger amounts of restricted shares. These shares have not vested yet.
Dave Waters, manager of Alluvial Capital, got in between $10 and $11. He thinks the stock is still very cheap expecting it to earn $3.25 in 2018. He did not say how the company could achieve this result however. He expects the company to initiate a dividend and mentions the dividend could be more than $2 per share from 2020. He also thinks the number of access lines will continue to decline but expects "the decline will be largely offset by increasing non-regulated revenue and ACAM income."
BTW, another investor estimates $3 per share of EPS for 2018. He gave some explanation on this number. First he estimates EPS of $1.65 over 2017. In 2018 the company will earn another $1.04 per share because of lower interest payments. In addition the company will get some extra EPS from costs savings from a new billing and operation support system.
On Value Investors Club a bullish article already appeared in November 2016. That author estimated a value of $16.66 per share, in an optimistic scenario. Just after the refinancing a year later a commenter estimated the value of again and thought it could be worth $17.34 per share. This estimate is based on EBITDA of $27 million and a multiple of 7. That is slightly less than my upper bound of $190 million in terms of enterprise value.
Knowledgeable commenters on Seeking Alpha think there is room for the EBITDA number to go higher: to $29 million in 2017. That could justify an optimistic valuation.
Certain other commenters on Seeking Alpha think the stock can be worth up to $25 for an acquirer. However during last conference call the company said it had stopped looking for deals. Apparently the offers it received were not good enough. The company assured it expected to get new inquiries from time to time and it would take these requests seriously.
What could spoil the party
In November 2017 debt was refinanced with a variable interest rate. This interest rate comes down to LIBOR plus 4.5%. If LIBOR goes up much the stock price could go to distressed territories again. Longer term the company could also have problems monetizing its investments in broadband internet. Since I do not think captive rural customers have many alternatives I am not worried. Considering current earnings I do not think there is much downside at the current share price, for long-term investors.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
I do not invest in these US-listed stocks since stocks I find with my international screener are much cheaper and therefore have higher average returns. See again my free overview article Use your extraordinary edge with these 2 investment strategies for details.
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