SA Interview: Value Investing With The Investment Doctor
Summary
- The Investment Doctor is an individual investor focused on mispricings in European equities with an emphasis on FCF analysis.
- Why the focus on free cash flow, the importance of using a watch list of stocks and opportunities for companies where the dividend could be reinstated are topics discussed.
- The Investment Doctor shares a long thesis on Rana Gruber.
Feature interview
The Investment Doctor is an individual investor focused on mispricings in European equities with an emphasis on FCF analysis. I'm a long-term investor, with a specific focus on fundamentally undervalued ideas with the potential to yield double digit returns in my Seeking Alpha Marketplace service. Predominantly focusing on Europe, but sector-agnostic and with some side-steps to a few non-European smallcaps. We discussed the upside (and downside) to investing in family-controlled companies, under the radar ideas to benefit from well-known trends and while most mispricings have disappeared as a result of the pandemic, there are a few that remain in the small cap space.
Seeking Alpha: Walk us through your investment decision making process. What area of the market do you focus on and what strategies do you employ?
The Investment Doctor: My investment focus is mainly centered about a free cash flow profile of a company. While most investors seem to be focusing on the net income and thus earnings per share, I’m more interested in the real cash flowing in and out of a company as hard dollars are the lifeline of any enterprise.
I’m relatively sector-agnostic: I mainly try to look at what makes sense from an economical and financial point of view but I obviously stay away (or at least don’t give too much weight) to sectors I don’t have a good understanding of, like pure biotech companies with a binary outcome.
I try to keep my investment strategy quite simple as well. I either buy the stock (or bonds) outright, or I deploy an option writing strategy. In some cases it makes sense to write a put option which could be either in the money or out of the money depending on the desired entry price and how keen I am to actually enter into a position. While working with options may scare some investors, I do consider them to be a very useful tool and by writing put options rather than buying calls, I let the time work in my favor as the time value decays over time. While I realize sometimes those strategies are outside of someone’s comfort zone, the risks are limited. If I would for instance write a put option on AB Inbev (BUD) with a strike price of $60 and an expiry date in December for an option premium of $2.80, the very worst thing that could happen is ending up having to buy 100 shares of BUD for $6000 minus the $280 option premium for an average price of $57.20. So when writing put options, you always know exactly the commitment and risk you’re entering into.
Of course in some cases the worst case scenario could be that someone who writes a put option which expires out of the money ends up with no position (and only the option premium as gain), and that’s why I usually apply a three-pronged approach in my investment portfolio. If I’d want to buy 300 shares of BUD, I’d likely buy 100 shares outright, write 1 out of the money and 1 in the money put option. In that case I end up with for sure 100 shares and 2 option premiums which further reduce my average exposure.
SA: How do you create and maintain a watch list of stocks? Can you give an example of a stock you put on a watch list and later invested in?
The Investment Doctor: As I think it’s very common for an investor to first do his or her homework before investing, it happens more frequently than not I’m adding a stock to a watch list rather than buying a position right away.
While the outcome of an initial due diligence process may look good at first sight, there’s always more information to be harvested and knowledge to be absorbed. Keeping a stock on a watch list while reviewing the performance on a quarterly basis will help to boost the confidence level in an investment, and will help to actually understand a company or a business.
In fact, there are very few stocks I buy outright and most of them are initially added to my watch list. But to give a recent example of a stock that had been on my watch list for a while before getting in; Ferronordic (FNM, Stockholm Stock Exchange) is a stock I initially discussed at ESCI in February 2019 but I never pulled the buy trigger until February of this year when it became clear the company had gotten through the COVID pandemic with very little damage. Ferronordic is actually a good example of an ‘out of the box’ ESCI idea; this small cap currently has a market cap of less than $400M (even after its recent run-up) and has some moat as it is the exclusive dealer for heavy equipment, trucks and parts for Volvo and Renault. It doesn’t have anything to do with the car sales business of those brands, but solely focuses on B2B sales and maintenance for trucks and equipment. Volvo seems to be very happy with Ferronordic’s performance as it has been transferring additional zones of exclusivity to Ferronordic which now has a strong position in growth markets like Russia and Kazakhstan.
SA: Can you discuss the opportunity for a company where you expect the dividend to be reinstated, from how you find these ideas to what to look for? For readers’ reference, you made an excellent call on Boston Pizza Royalties in an exclusive PRO article - you said it would reinstate the dividend and it did less than a week later.
The Investment Doctor: Sure. Investors tend to flee when a company suspends or cancels its dividend while in some cases it really is the most prudent thing to do to ensure long-term survival. So while a stock may be dumped and lose a double digit percentage after cutting a dividend, I would actually potentially be a buyer when I think the situation leading up to a dividend cancellation is a temporary issue and there’s a good chance a dividend could be reinstated.
The Boston Pizza call was indeed a very timely one as I had been studying the company’s financial results and thought that because it was a royalty company whereby franchise operators need to pay a percentage of their revenue to Boston Pizza Royalties with very low overhead costs there was a good chance the distribution would be reinstated upon successfully completing discussions with banks. As you also saw in that article, I was still rather conservative as I was aiming for the dividend to be reinstated at an initially lower level, but the higher than anticipated dividend was obviously very welcome.
Actually, most potential dividend reinstatements are hiding in plain sight. Just to give you another example of a future massive dividend hike (so not a reinstatement, but something that I think will have a similar effect) that was signalled to the market but got lost in the noise was Repsol (OTCQX:REPYY) (OTCQX:REPYF). The company is currently paying a dividend of 0.60 EUR but when it presented its strategic plan for 2021-2025 in November 2020, it was very clearly signalling it will hike its dividends in the next few years (see the image below). I’m not sure why the market didn’t pick up on this and I think it may have gotten ‘lost’ in the positive vaccine news that was hitting the newswires during that month.
Source: Company presentation
But in any case, Repsol is currently trading at just over 9 EUR/share, at an EV/EBITDA ratio of less than 4, a P/E of less than 7 and a free cash flow yield of about 15-17% for this year excluding growth investments and about 7% including growth investments as Repsol is transitioning from a pure oil and gas company to a more integrated energy group including solar farms and wind mills. There’s very little doubt Repsol will indeed hike its dividends as expected which means investors can now pick up the stock at a forward yield of around 8% while Repsol has committed to buying back stock up to 2B EUR which should further boost the value of the remaining shares. The official EBITDA guidance calls for 8.2B EUR by 2025 which is based on $50 oil. That will reduce the EV/EBITDA to less than 3, and I expect a bunch of the excess cash flow to flow back to the shareholders.
Repsol is an execution story now, and thanks to the high oil and gas prices, Repsol is ahead of its scheduled 2021-2025 transformation plan.
SA: Can you discuss the importance of looking at operating and/or free cash flow and not just net income, and how this helps uncover opportunities other investors may have missed? Can you give an example?
The Investment Doctor: Sure. I’m indeed a big fan of using free cash flows to determine how valuable a company is. After all, a good CFO can make an income statement say what he or she wants (both to the upside and downside). It’s entirely possible to reduce the net income by for instance accelerating the depreciation of an asset, or take an impairment charge. But those are non-cash expenses and have literally no impact on how much cash a business is generating.
While I think looking at cash flows to make an investment decision makes much more sense, I’d also like to warn readers that you can’t just use free cash flows at face value either: some companies include interest in the operating cash flow, others see it as a financing cash flow. There’s always some seasonality as in some cases businesses spend less on capex during certain months than others. And of course one has to be knowledgeable to identify businesses with a high upfront capex and very low sustaining capex (like, for instance, shipping companies).
A good example would be Hunter Douglas (OTC:HDUGF) where the reported net income in FY2020 came in at $116M (due to some ‘non-recurring expenses’), but the adjusted free cash flow in that year was approximately $263M, more than twice as high. The company appeared quite unappealing while the main shareholder was trying to take the company private at 64 EUR/share. It subsequently had to raise the offer to 82 EUR/share after heavy pushback from shareholders, and the stock is now trading at in excess of 90 EUR since the buyout failed and some minority shareholders are still resisting. So just looking at a net income or an EPS may not give you a full overview of how a company is really performing.
This is perhaps the best example of why investors should for sure at least compare an income statement with a cash flow statement and understand how potential discrepancies could be explained. So I think it’s important to ‘understand’ how a quarterly result came into being.
SA: Is there a benefit to investing in companies controlled by a family or other large investor? If so, how and can you give an example? Is it possible to screen for these types of companies? Are there any negatives to this structure?
The Investment Doctor: I tend to like companies that have a controlling family shareholder as they tend to have a more focused look on the business. Usually the company represents a large chunk of the family capital and most family members tend to look forward to the dividends as an additional income supply. And exactly because it’s an important portion of the family capital and the income stream, I have the impression most family-led companies have a more cautious approach and are better stewards of (their own) money.
A good example would for instance be Resilux (RES, Euronext Brussels, no US ticker symbol) which produces and recycles PET bottles. The Decuyper family calls the shots and is taking the right decisions to grow the company in a responsible way (i.e. gradually and using its own cash flows while running a clean balance sheet with a very low debt ratio). I also respect the family as they actually accepted a going private offer from a private equity group a few years ago. That deal fell apart for antitrust reasons, but it shows the family also isn’t overly protective of the business and acknowledges accepting a fair buyout offer is in everyone’s best interest.
And while having a strong family as anchor shareholder tends to be positive, you’re also at their mercy if they call the shots. Family-owned enterprises will less likely be entertaining buyout offers from third parties as it is ‘their baby’ – and this is exactly why I appreciate how Resilux dealt with the going private offer it received a while ago. Additionally, some may just try to squeeze out the minority shareholders at a low price like we saw at Hunter Douglas where the company first cancelled the dividend, threw in some non-recurring expenses and subsequently launched a go-private offer.
In other cases, there sometimes is a paralyzing fear. In France, I’m following a small family-owned smallcap Gevelot (ALGEV, Euronext Paris). After selling a division a few years ago, the company is flush with cash. And you can take that quite literally as the current market cap is around 130M EUR, but the balance sheet contains in excess of 150M EUR in net cash which means Gevelot actually has a negative enterprise value. A very safe company, for sure, but the cash has just been sitting on the balance sheet since 2017 and I don’t think this would have been the case if there was no dominant family shareholder.
SA: Are there any under the radar ideas to benefit from well-known trends or themes in the market? How do you find these ideas in the idea gen process?
The Investment Doctor: I’m still a big fan of natural gas as it’s quite evident LNG is becoming more and more appealing as a source of energy around the world. It enables low-cost producers in a low-price environment to convert their natural gas into LNG and ship it to a country where the gas price is much higher. Of course this trade works best when the arbitrage opportunities are good (a very low gas price in the producing country and a high gas price in the receiving country), but LNG is here to stay.
This also means I have been looking at some natural gas companies as those should benefit from the continuously high demand for natural gas. While Canada missed the initial LNG train as the USA and even Australia are now the main LNG exporting countries, I do see opportunities in two Canadian small-cap gas producers. I first discussed Spartan Delta (OTCPK:DALXF) here on Seeking Alpha in June of last year, calling it a ‘once in a decade opportunity’ as an experienced management acquired an asset out of a bankruptcy procedure. The share price was trading at approximately C$3.20 at that point, and is now up over 50% after coming back from a C$6+ share price in Q2. The high gas price has been a tremendous help, and this small-cap has been acquiring other producing assets and end the year with an attributable production of 70,000 boe/day.
A second Canada-listed gas smallcap is Canacol Energy (OTCQX:CNNEF) which solely operates in Colombia. While the operational and jurisdictional risk is higher, the Colombian gas price has remained very steady around $4.5-5 and this provides Canacol with very healthy margins under its take or pay contracts. The past few years the company was focusing on production growth but just as the time to harvest approached, COVID-19 erupted. While Canacol is still doing more than okay, its gas sales level is about 80-85% of the originally anticipated sales results which weighs on the cash flows. However, this also is an excellent time for Canacol to continue its exploration activities in Colombia to extend its Reserve Life Index.
While these two names aren’t European names, I think they continue to offer an interesting risk/reward profile on the natural gas space. In Europe, I’m a big fan of Brussels-listed Fluxys (FLUX, Euronext Brussels) which manages Belgium’s high-pressure gas pipeline network in a monopoly position. Additionally, it owns and is expanding an LNG terminal in Belgium where LNG from for instance Qatar and Russia is being pumped into the European system, or loaded onto other vessels. While the capital gains at Fluxys are relatively limited, I do think the company offers excellent dividend income potential with a current dividend yield of around 4.2% with an acceptable payout ratio based on the sustaining free cash flow.
Another good example would be Enagas (OTCPK:ENGGF) (OTCPK:ENGGY), Spain’s gas transmission company. While the regulator will gradually reduce the fees Enagas can charge for its domestic transmission activities, the company has been using its strong cash flows to expand abroad. It is part of a consortium with Blackstone (BX) which took Tallgrass Energy (TGE) private. Tallgrass is now paying its distributions to its private shareholders and the income from this investment will help to offset the gradually decreasing Spanish gas transmission fees. In fact, I hope this will serve as a blueprint for Enagas to further expand its footprint abroad as it has the financial capacity to scoop up more pipeline assets in the USA, either by themselves or in a consortium with other bidders looking for midstream assets.
In these four cases I used a top-down approach. A few years ago it was getting obvious natural gas would play a more important role in the energy mix going forward, and I think this may have been accelerated by the COVID pandemic and the political decision whereby gas-fired power plants in Europe could actually obtain a ‘green finance label’, classifying them as a sustainable source of energy. Natural gas is here to stay, and both Fluxys and Enagas are able to make the transition to hydrogen down the line so an investor isn’t really betting on ‘just’ natural gas.
SA: A recurring question in this interview series is about the mispricings created by the coronavirus and its short and long-term impact – can you weigh in on this?
The Investment Doctor: Sure. While most mispricings have now disappeared as the panic selling in March created some massive opportunities with for instance Elementis more than tripling since I published an article on them, there indeed are still some interesting opportunities in the market.
While economies have been reopened, I noticed there are still some big differences with how the market looks at commercial real estate and commercial REITs. While even the larger firms haven’t fully bounced back yet, there are several REITs in the small-cap segment that are still trading at very attractive multiples and I think that’s where I still see the main COVID-related opportunity as those companies should re-rate as they continue to report good rent collection levels and FFOs.
I think the main risk related to COVID is that it may take a while for some sectors to earn back the trust and credibility they had in the pre-COVID era. Think about some REITs which were getting uncomfortably close to their maximum LTV level while their book values were optimized by using very low capitalization rates to further expand their borrowing base. So on the company side, some companies will have to regain the trust from the market after what clearly was a crazy 2020.
But I also think there is a major takeaway for investors too. We saw how the markets completely crumbled in just a few weeks' time in March and stocks sank deeper than during the global financial crisis, and did so faster. This strengthens my belief one should always maintain a healthy cash position or an ‘emergency investment fund’ one could use in case these special situations occur again. While that cash may be unemployed for a long time, even years, it will come in very useful when it looks like the world is coming to an end.
And with more market participants and a greater usage of margin in investment accounts, I think we will see more situations where investors will be fleeing to the exits at the same time. I enjoy looking at the FINRA margin statistics for the US markets where the debit balance in margin accounts has now increased to $882B, which is more than 50% higher than the total amount of margin in January last year, right before the COVID crisis erupted. So we are seeing more (new) investors entering the market and we see more margin-based purchases. One day that will result in another liquidity event, and investors should be ready to take advantage of that situation.
Cash should never burn a hole in your pocket.
SA: What’s one of your highest conviction ideas right now?
The Investment Doctor: One of the more interesting companies I’m following now is Rana Gruber (RANA, Oslo Stock Exchange), a debt-free iron ore producer in Norway. Rana is currently producing about 1.6 million tonnes of iron ore per year at an all-in sustaining cost of around $65/t. So at the current iron ore price of around $180/t (coming from $200+/t just last week), Rana is printing cash. The ‘problem’ is that it’s widely expected for the iron ore price to drop and as such, Rana isn’t seeing its share price move at all. But even at an iron ore price of just $100/t (just over half the current spot price), the current enterprise value of less than $300M still offers upside potential and I think the stock should be trading at twice the current share price, even when using a lower iron ore price of $125/t for 2022 and $100/t from 2023 on.
Additionally, the company does have an attractive dividend policy in place with a payout ratio of 70% of the net income so while the great times on the iron ore market last, shareholders will be participating through outsized dividends. Rana paid a dividend of 2.90 NOK based on the Q1 result (which represents 4% of the current share price) and I expect the company’s EPS and thus dividend to increase in the next few quarters.
So while Rana may very well be a value trap trading at just about 4 times its net earnings, investors will still be able to benefit from outsized dividends which will be directly correlated with the strength of the iron ore market. I expect the full-year dividend to exceed 20%, and as long as the iron ore price doesn’t suddenly collapse in 2022 (and has a gradual decline), I expect shareholders of Rana to earn back about 40-50% of their investments from dividends within the next 24 months.
The reason for this undervaluation should likely be sought in Rana completing its IPO without making too much noise as most shares were placed within Norway. Additionally, it’s a small-cap company trading at a lesser known segment of the Oslo Stock Exchange (so not on the main board). I think both factors contributed to the blatant undervaluation we are seeing now as there just are very few eyeballs on this stock.
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Thanks to The Investment Doctor for the interview.
The Investment Doctor has a long position in AB InBev, Ferronordic, Repsol, Resilux, Spartan Delta, Canacol Energy, Enagas, Rana Gruber.
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Comments (5)
While I dare to dabble into growth stories myself, I think a distinction has to be made between whatever 'risk money' I invest in those higher growth names versus the types of companies I feel comfortably enough to talk about and to discuss in greater depth. So while I sometimes feel comfortable enough to invest some of my own money in those names, I'm not always sure it's a good idea to bring it up as 'an idea' to readers if I lack sufficient knowledge about a certain subject.