Earlier this month I wrote an article that reviewed some of my biggest Seeking Alpha mistakes and what I had learned from them. This article will come from the opposite direction and review the article from 2018 of which I'm most proud. The article that holds this distinction is "Owens & Minor Inc. Is Cheap, But This Alternative Is A Better Value" and it was published back on February 5th, 2018. (That link should be un-paywalled, so everyone can read it.) The genesis of the article came after I read a bullish article from another SA author (one whom I admire) about Owens & Minor (OMI). OMI had sold off over -50% from its highs and it looked like a very good investment candidate for my style of investing, which focuses on beaten-down stocks that trade more than -30% off their highs. After taking a closer look and running OMI through my impairment tests, however, I found some warning signs that kept me from buying the stock. I decided to share those warning signs with other investors in that February article.
My general policy when writing bearish articles is to suggest some sort of alternative that is likely to perform better than the stock in question. Usually, that alternative investment takes the form of an ETF, but in the case of Owens and Minor, I thought that Hawkins (HWKN) had a better risk/reward profile. While Hawkins has a smaller market cap than OMI and is in a different sector, it was going through a similar acquisition cycle that OMI was going through at the time and Hawkins offered a respectable, and safe, dividend. Here is how the two investments have performed since the article was published compared to the S&P 500 index:
Owens & Minor has dropped an incredible -51% since the article was published while Hawkins has risen about 24% and the S&P 500 has returned about 5%. In the next section, I'll review what led me to avoid OMI and buy Hawkins so perhaps other investors can apply some of the thinking and methods to potential investments they might make in the future. A person back in February who invested $10,000 in Hawkins instead of OMI would now have $12,200 in their account instead of $4,900, so I think the process is worth reviewing.
Impairment Tests & Debt-to-Equity
Those readers familiar with my general investing approach know that I look to buy stocks that are beaten down, usually when they are over -30% off their highs. When I wrote about Owens & Minor back in February it was already -60% off its highs:
This sort of price movement has a tendency to scare away many investors. I'm not a technical analyst, but I'm going to go out on a limb and say the chart above looks pretty bad. That said, chart-wise, Hawkins didn't look a whole lot better at the time:
And Hawkins kept falling even more after the article was published, before eventually rebounding. Even though OMI had fallen farther, that wasn't what kept me away from the stock. (I had purchased 3D Systems (DDD) a month earlier after it had fallen -90% and it ended up returning almost 100% this year.) What made me avoid OMI and choose Hawkins instead was how they fared on my impairment tests.
I designed my impairment tests for cyclical stocks that had a history of recovering from deep drawdowns in the past. The hard part about cyclicals is that it is difficult to use traditional valuation metrics to identify bottoms in the stocks. For that reason, I tend to rely on history as my guide for when to buy these stocks. The trouble with that is sometimes the businesses are in worse shape during the current cycle than they were during past cycles, and that can prevent or delay them from recovering (think General Motors (GM) during the 2008 downturn). So the job of the impairment tests is to identify trouble spots that might prevent a cyclical stock from recovering like it has in the past and to help me avoid these traps.
One of the interesting things about the impairment tests is that they work quite well for stocks that are less cyclical, too. Stocks like Owens & Minor, for example.
I have noticed that there are six major reasons why a stock that has demonstrated historical cyclicality may not recover in a timely manner. They are:
- A fatal flaw in the company's business model is exposed for the first time.
- The price did not drop enough.
- The stock price experienced a recent super-cyclical high.
- There is a clear and present disruptive threat to the core business.
- The company has high relative debt compared to past down-cycles.
- Management is corrupt or incompetent.
In the case of Owens & Minor, the stock hadn't traditionally been all that cyclical. When this is the case, I tend to focus more on traditional historic P/E valuation, debt, clear disruptive threats to the business, and management. Back in February, OMI had a P/E of around 11, while its long-term average P/E was 17. At its peak, before the price started falling, it traded at a P/E of around 20. Sometimes, with less-cyclical stocks, we get big sell-offs simply because the multiple has slowly crept higher after many years and trades in the 30-40 P/E range or higher, then earnings slow a little bit, and there is a rush for the exits that can send the stock much lower simply due to multiple compression. That didn't seem to be the case with OMI, though. For a less-cyclical stock, 20 wasn't a particularly high peak P/E ratio.
What I noticed about OMI had to do with the convergence of three factors. The first was that they were a low margin business. The second was that they had been growing via acquisitions. And the third was that their previous acquisition had yet to pay off before they made another acquisition. This showed up when I examined their debt-to-equity chart.
A lot of times acquisitions will show up in debt-to-equity charts quite clearly because the acquiring company will take on debt in order to buy a company to help them grow. That causes a spike in the chart. If an acquisition goes well, usually within a few years we'll see the debt-to-equity come down as the acquisition pays for itself and the debt is paid off. In fact, that is what we see for most of OMI's history since the 1990s.
The chart above is what I was looking at back in February. Notice how for twenty years everything was going fine, but then in 2015, the debt-to-equity jumped and simply stayed flat through 2017 instead of coming down. That's a sign of a bad acquisition (or at least that the price paid was too high). That's not horrible in and of itself. It happens from time to time. Typically, it just takes a few more years to eventually recover from over-paying. But, what OMI did, when it became obvious that things weren't going well, was to buy another company, taking on more debt, in 2017. And that's the last spike in debt-to-equity we see at the end of the graph. Here is what I had to say about it in the original article:
While its debt-to-equity is high, it's not unprecedented. One noticeable thing is that the debt it took on for its two acquisitions in 2014 wasn't fully digested and paid down much at all before its most recent acquisition last fall. This is beginning to feel like a story of desperation, or at the very least, an overlapping acquisition cycle. What I mean by that is OMI's 2014 acquisitions were not meeting expectations by April of 2016, the stock began what we would expect to be a slow decline for a couple years while those acquisitions were digested. As I noted earlier, it usually takes a couple of years after this type of decline begins for the acquiring company to bottom. But what happened here is that about midway through that process, OMI made another big acquisition. When this happened, it essentially created overlapping acquisition cycles, which accelerated the downturn we've seen in recent months. Debt-wise, I'd say that OMI had just enough room to take such a chance on a big acquisition, but the timing is very questionable, which brings me to my last potential reason why a stock might not recover in a timely manner: Management.
Then I went on to say how unimpressive management was. Here is what that chart looks like 9 months later:
Much of this is due to the fact that the stock price has fallen so much since February, but I thought I did a good job of forecasting the danger using the data I had at hand back in February. Of course, someone who really dug into the financials of the company could have picked up on all this, but what I like about debt-to-equity is that it is fast. If the debt-to-equity pattern diverges from the past, it can be a quick tell that something isn't the same this time around, and a sign that one should be cautious before making an investment, or dig deeper into the financials.
As a post-script to this section, doing a quick investigation of management was helpful in assessing OMI as well. I've found that for stocks that have fallen a lot off their highs, comments on archived Seeking Alpha articles or news items are great sources to find out what previous investors thought of management. Another good, quick, source, that not too many people seem to use is Wikipedia. They usually have a section about controversies surrounding the company and investigating how management handled previous controversies can be quite telling.
Hawkins & Debt-to-Equity
I chose Hawkins as an alternative investment because it had recently made an acquisition like OMI had and was trading down, too, but I thought that unlike OMI, Hawkins would probably recover in a timely manor.
Traditionally, Hawkins carried very little debt, but in 2015 they made an acquisition and as we can see, debt spiked fairly significantly. It is likely that they may have paid too much for the acquisition, but over time we see the debt-to-equity ratio steadily coming down. When the debt-to-equity comes down, even as the stock price is dropping, like back in February, it can be a good sign to buy, and that's what I did.
Debt-to-equity on its own probably isn't sufficient to make investment decisions on, but used in conjunction with other information, it can help to shed light on certain situations enough to both prevent an investment and to make an investment. Most importantly, debt-to-equity can do so quickly. When I sit down each week and scan the market for good potential buys, I examine dozens of stocks, bad debt-to-equity dynamics helps me sift quickly and eliminate riskier stocks that might not rebound the way they have in the past.
I think the OMI/Hawkins article was the first article in which I used the term "acquisition cycle" because it was during the course of researching OMI and Hawkins that the pattern fully took form in my mind. It is fairly well-known among investors that acquiring companies tend to over-pay for the companies they are buying and that many times the purchasing company would be better off doing nothing at all.
While I haven't done a comprehensive study of this, I have noticed that there are two main ways that big acquisitions tend to play out. Either they are complete disasters that cripple the acquiring company permanently (or at least for many years), or they work out, but take more time than management promised. The ones that are in danger of permanent impairment we want to avoid, but there can be opportunities with those stocks that simply take longer than expected to digest their acquisitions. Here is how I described it in the article:
Essentially, what happens with acquisitions cycles is businesses buy other companies in order to help with growth or reduce competition. Typically, in order to buy the new company, the purchaser pays a premium price, and also quite often, the purchaser promises too much too soon for current shareholders in terms of the future growth and synergies the purchase will achieve.
Quite often, within 2-3 years after the purchase, shareholders grow disenchanted with the raised debt levels of the purchaser, and also get annoyed that management's promised 'synergies' haven't materialized as expected, and the stock proceeds to slide steadily downwards. Eventually, this negative sentiment can get over-done, though, and this can create buying opportunities, especially if the synergies eventually do arrive.
I believe there are opportunities to be had with acquisition cycles, but I'm still in the beginning stages of developing a good strategy for investing in them. The main difficulty is in figuring out just where the bottom might be since there isn't much historical data to guide us. With Hawkins, I did a pretty good job, but with others stocks that I've invested in since then, like Molson Coors (TAP) and British American Tobacco (BTI), the bottom has been more elusive to find. So far, I've been approaching these investments like I would approach any other cyclical investment using two entry points. I may have to adjust that to four in order to more effectively get close to a bottom, and probably do more research about the dynamics of these cycles to find some additional guide I'm not yet using.
But perhaps a more important lesson in the discovery of acquisition cycles are the dangers they present to a long position. Understanding the medium-term dangers of big acquisitions helped me warn potential investors of Thor (THO), that it could face a very deep downcycle, and if I had known of the dangers back in January I might have been able to avoid an investment in McDermott (MDR), which is the biggest loser I'm holding in my portfolio right now, down about -40% after making two purchases.
So, while there is still a lot of work to be done with acquisition cycles, I think the discovery of them will probably lead me to both find more opportunities, and to avoid some mistakes, in the future. The OMI article was the first time I wrote about them, though, and I think it's a fairly original observation and strategy.
My article on OMI/Hawkins has been a winner on every front and in my opinion was the best article I wrote this year, in terms of its accurateness and originality. I have decided to take profits in Hawkins now, though. I still think there is probably some upside left in the stock, but in my original article, I thought the stock could outperform the S&P 500 by 20% during a downturn. We haven't had much of a downturn, but we are right at that 20% outperformance mark now after only 9 months, and I need to free up a little bit of cash in my Roth account in case Apple (AAPL) stock falls a little more before the end of the year. It's interesting. I have lots of cash available in my other accounts. I purchased Apple for my daughter's account in 2013, and for my son's account in 2016, but I never bought any for myself, and most of my cash position is held in those other accounts and in a 401k. So, for portfolio considerations, along with having made a healthy profit from Hawkins these past few months, I'm going to sell here, and free up some cash in my Roth. I'll be looking to get back into Hawkins again, though, if I get an opportunity down the road.
Disclosure: I am/we are long AAPL, MDR, BTI, TAP.
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.