In the approximately 18 months since I wrote my bullish piece on Gentex Corporation (NASDAQ:GNTX), the shares are up about 35.5% against a gain of 24% for the S&P 500. Much has happened since then, so I thought I’d look in on the name again. After all, a stock that’s trading for X is, by definition, less risky than one that’s trading at a price 35% higher than X. I’ll review whether this is a buy or hold or sell at current levels by looking at the financial history here, and by looking at the stock as a thing distinct from the underlying business. Also, because I’m a creature of habit, I’ll be talking about short puts as an alternative to stock ownership.
I know you’re a fairly busy person, dear reader, so I’ll jump right to the point. I think the shares are currently overpriced and I can’t recommend buying at current prices. That said, a number of insiders bought recently at prices that I think guarantee a great return. Thankfully the options market allows us to generate income today while possibly engineering a buy at prices similar to those recently paid by insiders.
Gentex is a growth company, as evidenced by the fact that they’ve grown both the top and bottom lines for years. Specifically, since 2013 revenue and net income have grown at CAGRs of 9% and 13% respectively. In addition, I really like the fact that the capital structure here is one of the cleanest I’ve written about, with virtually no long term obligations.
That said, the first quarter of 2020 was softer than the same period a year ago as a result of the obvious shut down of auto manufacturing in various parts of Europe and Asia. Specifically, revenue and net income were down by 3% and 14% from the prior period. To put this 3% figure in context, it should be remembered that global light vehicle production levels declined 24% as a consequence of the Covid-19 pandemic. None of this stopped the company from basically doubling the money spent on buybacks and increasing the dividend for the 10th straight year.
I think the dividend and its sustainability is of critical importance to investors, so I want to spend some time writing about it in particular.
When I consider whether a particular dividend is “safe” or not, I compare the size and timing of its future outflows with the current and likely future cash available to meet those obligations. I’ve gone through the effort of compiling the size and timing of future obligations in the table below. You’re welcome. Please note that I derived by CAPEX figure by averaging the amount actually spent on capital expenditure over the past three years. I feel fairly comfortable with this CAPEX estimate given that the company itself has guided an investment budget between $85-$95 million. We see from this that 2020 will actually be a fairly heavy year of obligations for the company.
Source: Latest 10-K
Against these obligations, the company currently has about $409 million in cash and short term investments. The company has an additional $75 million available on its line of credit. This leads me to conclude that the company will require an additional $400 million or so to meet this year’s obligations. The fact that the company has generated an average of $519.5 million in cash from operations over the past three years suggests that the company will meet these obligations, but only just. It’s also somewhat troubling to consider that 2020 may not be a typical year, given what we’ve seen so far. In my opinion, the recent buyback was ill timed, given these upcoming obligations at a time when the business seems to be entering a soft patch.
Source: Company filings
I’ve made much of the fact that a great company can be a terrible investment if the investor overpays and a mediocre company can be a great investment at the right price, so I don’t need to belabor the point too much. Suffice to say, the stock is a thing quite distinct from the business, and it’s governed by forces that are often unrelated to what's going on at the company. For example, stocks may be influenced by pension fund managers who must buy a “basket of U.S. mid-cap stocks” or stocks may be driven by the zigging or zagging of central bankers. Because stocks are distinct, I need to spend some time writing about them.
I judge whether shares are reasonably priced or no in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value. The more that an investor is being asked to pay for $1 of future economic benefit, the riskier the investment in my opinion. When I first wrote about Gentex, I was struck by the fact that the shares were trading at about 12.5 times free cash flow. The shares are now about 24% more expensive, per the following:
In addition to looking at the ratio of price to some economic value, I seek to understand what the market is assuming about the future of a given company. In order to do this, I turn to the work of Professor Stephen Penman in his book “Accounting for Value.” In this work, Penman walks investors through how they can isolate the “g” (growth) variable in a standard finance formula to work out what the market must be thinking about a given company’s future. Applying this methodology to Gentex suggests the market is forecasting a perpetual 5.5% growth rate. I consider this to be a fairly optimistic forecast. Since the shares are now about 24% more expensive, and they are priced quite optimistically in my estimation, I can’t recommend buying at current prices.
I’ve written it before, and I’m absolutely certain that I’ll write it again. Not all investors are created equal. Some are better at this enterprise for a number of reasons. For example, some people are quite good at investing because they have teams of analysts at their disposal. Some people are good at this because they have the emotional discipline required. Some people are particularly good at investing in a particular issue because they happen to work at the company in question. As such, they know more about this business than any Wall Street analyst ever will. It’s this last group that I want to focus on. In the month of March alone, there were five purchases made by insiders, totaling about $58,000 of capital invested. I’ve created a table of these transactions below for your enjoyment and edification. This is important because when the people who know the business best put their own capital to work, that is a very good sign in my view.
At the same time, though we should acknowledge that the shares are currently trading about 35% higher than the price at which these people purchased shares. This mutes the power of this signal somewhat, and I conclude that insiders would certainly be willing to buy at $18.50, but may or may not be willing to purchase at today’s valuation.
I think investors are on the horns of a dilemma here. On the one hand, this is an excellent business, and obviously insiders agree as they put their own capital to work in the firm. On the other hand, the valuation is currently nowhere near where these investors purchased. So an investor can either wait for shares to drop to that price again, or they can generate some premia for their accounts immediately by selling short puts on the name. The former strategy is troublesome for two reasons in my opinion. First, there’s no guarantee that the shares will ever return to $18.50-$19. Second, if shares do drop by more than 20% from current levels, the investor will be presented with a series of very sound reasons to not buy. As is most often the case, the opportunity will pass the investor buy as they convince themselves to stay on the sidelines. One of the most significant benefits of a short put, then, is that it forces the investor’s hand. It forces them to buy a great company at a great price, no matter what the media noise machine is telling them. This is not a comfortable strategy, but is a very successful one. Short puts are also superior to waiting in my view because waiting is very tedious.
In particular, my preferred short put here is the December expiry with a strike of $20. These are currently bid-asked at $.70-.$.95. I consider this to be a “win-win” trade because if the shares remain above $20 between now and December, the investor simply pockets the premia. If the shares drop in price, the investor will be obliged to buy, but will be doing so at a net price within shouting distance of the price insiders just purchased at. That translates to a dividend yield of about 2.5%, which I think is very reasonable.
I really hope that you're excited by language like “win-win”, dear reader, because it's time to splash cold water all over the optimistic mood by writing aboot risk. Investing, like most activities, involves making choices among a host of imperfect trade-offs. In public markets, there is no 'risk-free' option. We do our best to navigate the world by exchanging one pair of risk-reward trade-offs for another. For example, holding cash presents the risk of erosion of purchasing power via inflation and the reward of preserving capital at times of extreme volatility. Unless you're an extremely new investor, the risk-reward trade-off of buying shares should be self-evident in 2020.
I think the risks of put options are somewhat similar to those associated with a long stock position. If the shares drop in price, the stockholder loses money and the short put writer may be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices.
Puts are distinct from stocks in that some put writers don't want to actually buy the stock; they simply want to collect premia. They will rarely write a long dated put like the one I recommend above because the risk of exercise is too great. Such investors care more about maximizing their income and will, therefore, be less discriminating about which stock they sell puts on. These people don't want to own the underlying security. Sleep is such a rare luxury for me that I value it too much to sell puts on anything other than companies I'm willing to buy at prices I'm willing to pay. For that reason, being exercised isn't the hardship for me that it might be for many other put writers. Based on that, my advice is that you would be wise to only ever write puts on companies you'd be happy to own at entry points that are associated with subsequent great returns.
In my view, put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This circumstance is objectively better than simply taking the prevailing market price. This is why I consider the risks of selling puts on a given day to be far lower than the risks associated with simply buying the stock on that day. To use Gentex as an example, an investor can simply buy these shares today at a price of about $26.00. Alternatively, they can generate an immediate credit for their accounts by selling put options that oblige them - under the “worst” possible circumstance - to buy the shares at a net price about 26% below today's level. In my view, that is the definition of lower risk.
I think this is a great business, but I worry about the upcoming obligations at a time when the business is slowing. At the same time, the market price for the shares has risen to very optimistic levels in my opinion. Insiders have recently purchased aggressively, but did so nowhere near current prices. All of this suggests to me that now is a good time to sell shares at current prices. That said, I’d be happy to own again at $19, so I’ll be selling the puts described above. I think price and value can remain unmoored for some time, and I think investors would be wise to sit on the sidelines until price falls to match value here. Even more wise than this would be to generate some income today by selling puts with a strike price that is near where the insiders purchased. If I’m wrong (yes, it’s been known to happen) and the shares continue to rally, the investor simply pockets the premia. If I’m right and the shares are “put” to the investor, they’ll be buying at a great price.
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Disclosure: I am/we are long GNTX. 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.
Additional disclosure: Although I'm currently long the stock, I'll be selling this week. In addition, I'll be selling 10 of the puts described in this article.