Rationality Quest

tisdag 29 mars 2016

Hexpol - A 50 bagger

I am currently trying to go through all stocks in the Nordics from A-Z. The approach I have taken is to take a list of all reporting companies from January 1st to March 31st and just pile through it.

Today I stumbled upon Hexpol, which is quite interesting to study. The reason is that the stock is a ~50 bagger since early 2009 (after 2008 results released). What caused this?

3,5x revenue increase
Almost 2x on margins

Expansion from 9,7 in 2008 to 17,5 in 2015

7x multiple expansion

P/E rising from around 3 in early 2009 to 22 in 2015

It is a hell of a result and shows the underlying drivers of exceptional stock performance. In order to reach extreme results you need help from all levers, great future business results combined with a fantastic entry valuation. And then you have the hardest part which is to be patient and just stick with it to let compounding do it's magic.

Let's look into Hexpol's business

HEXPOL is a world-leading polymers group with the main business area called Hexpol compounding (93% of sales). They also have a BA called Hexpol Engineered Products making up 7% of sales

HEXPOL Compounding focuses primarily on three key segments of the polymer market:

Rubber compounds
Thermoplastic elastomer compounds (TPE)
Thermoplastic compounds (TP)

HEXPOL Compounding have 30 manufacturing units (mostly acquired) in Europe, Asia and NAFTA

Market - mainly automotive

Automotive industry constitute some 40% of sales and demand is highly linked to car sales. Hexpol provides e.g. these plastic sealing strips for doors and windows.

They also see growing customer applications in the medical technology, general industrial and oil and gas industry.

Industry in consolidation

The industry has three main groups:

Small number of global players
Many smaller local/regional players
Customers with proprietary rubber compounding operations

We have two distinct industry trends driving growth:

Consolidation of the industry

Hexpol grows quite a lot by acquiring and integrating smaller players in their operations. They can then generate value by implementing best practices and move production between units production performance.

Outsourcing by vertically integrated customers

Customers with rubber compounding operations have difficulty to keep their internal units competitive with more focused external players. Therefore we have a outsourcing trend increasing the addressable market for Hexagon.

Operational set-up and strategy

Decentralized structure but trying to leverage some scale advantages (in global unit)

R&D - global coordination between units in development of new materials and products.
Purchasing

Price negotiations and strategic supplier choices. However, main input is commodities (e.g. oil based materials) which limits the leverage a large buyer can have.

Engineering (design of equipment)

Separate units

Responsible for sales, product development and production
Benchmark and implementation of best practices in between

Product development to avoid commoditization

E.g. 80% of products in Europe are based on "unique proprietary formulas"
Around 5% of employees engaged in product development. Very low percentage of sales though.

Objective of being most cost effective company in the industry
Global scale is an advantage

Hexagon can deliver the same products with same quality to e.g. a global automotive company which is a competitive advantage relative to prue regional players.

Investment opportunity?

Before I would invest in Hexpol I would like to understand the following:

Runway for growth

How large share of the industry sales is either smaller regional players or customers with in-house production

More detailed knowledge of scale advantage

Hexpol grows by acquiring smaller players, integrating them and rolling out best practices.

On average what is the margin difference between a Hexpol operated unit relative to a independent one?

What is the main drivers of this?

Hexagon has 30 production facilities.

Why can not a competitor get better economics by putting up a huge production facility? Need to understand the production economics.

How can they keep 17,5% operating margin in the automotive industry?

Main driver here is having a large part of sales in differentiated products. Why will this area not become more standardized resulting in margin pressure?

In summary:

Hexpol is an interesting company and I suspect that they have what Bill Ackman calls platform value. They are in a fragmented industry and could have unique capabilities (expertise and scale) which enable them to improve performance of acquired companies in a way that few others could, resulting in excess returns on M&A.

With 500 MSEK in net cash we also have a potential to leverage up the balance sheet. Hexpol makes it to the watch list and with their exposure to the highly cyclical automotive industry we can hope for some bad times and an entry point.

måndag 28 mars 2016

ABB - Easy toss in the too hard pile

One post a day did fail last week. I will lower the quality ambition further and just post some general notes on the companies I review. Starting off with:

ABB (ASEA Brown Boveri)

ABB is active in the power and automation market. It is very difficult to get a grip on what they do. Just look at the products and services offered in the main segments - they do a lot of stuff:

Discreate Automation and Motion
Low Voltage Products
Process Automation
Power Products
Power Systems

Financial development:

Source: Borsdata.se

We have seen a margin compression which ABB is pushing hard to turn. My takeaways from trying to understand the underlying reasons for this:

ABB has the last years taken out some 3-5% efficiency on cost of sales annually the last 5 years.
However, the competitive pressure has more than made up for these efficiency gains putting a pressure on margins (i.e. due to pricing).
Oil and gas decline is also putting pressure on margin both from a mix (O&G is high margin) and from a volume perspective

ABB has a clear intention to turn this going forward, objective until 2020:

10-15% annual operational EBIT improvement
3,5-6% annual revenue growth

ABB is today selling for a P/E of 21,1, if we assume

12,5% EPS growth until end 2020
Ending P/E of 15
We get an annual return of 10,8%

Growth return of 6,8% + dividend yield of 4%

Some of the measures ABB are taking to achieve this:

Share buy-backs
Working capital push to raise 2B dollar (presumably used for share buy-backs)
Relentless execution on efficiency
- Efficiency program of 1 BSEK gross savings on top on ordinary year on year improvements (at least 50% will hit net operating EBITDA). Staff and support function cost reduction of 30%
Technology differentiation - out-innovate competition
Project selectivity

Manage risks in projects - some e.g. turn key projects can have large downside in unexpected costs
Focus on projects where differentiated solutions yields high profitability

New organzation and incentive system

In summary - This is an easy toss into the too hard pile:

In order to reach their objectives they need to out-execute competition in efficiency and delivery to improve margins. High competitive pressure on pricing has historically resulted in a Red Queen effect.

On easiness to implement it cannot be the easiest hurdle to clear e.g. a 30% cost reduction in support functions

ABB have grown a lot with acquisitions and hopefully they did not go out and promise these gains just from a best practice benchmark.
With their previously decentralized structure you probably have a lot of different processes and systems patched together with manual activities. In order to drive efficiency you then have a lot of system and process harmonization needed. Tends to get quite complex and time consuming when you get into the details

With a P/E 21 large share of targeted improvements is priced in
Clearly outside circle of competence. Do not like (or understand) the unfocused, wide and complex the product portfolio.
- Why will they become the best in the world in all these ares? What is stopping more focused competitors from running circles around them?
Long term they state that their space will become a lot more software heavy (Intelligent solutions, AI and Learning Machines). Given performance within e.g. PLC they have a lot to prove in the software space.

/ RQ

onsdag 23 mars 2016

The best learning resource on value investing

Sanjay Bakshi is a fund manager (with fantastic performance) as well as a professor of value investing in India. I think that he has put out the best learning resources on value investing out there:

http://www.sanjaybakshi.net/

There you can find all his course material on value investing as well as a lot of talks and publications.

His blog is world class and he has even put out the books he has read (for any hardcore cloners - 10 years worth of heavy reading)

As an example, here is a good talk on the prejudices of Mr. Market

Any other suggestions on learning resources would be highly appreciated.

BR / RQ

måndag 21 mars 2016

On reaching world class

Today I went first looking into some take-aways on the topic of reaching world class in a field of mental performance. Objective was to then try to apply this on investing, but gut stuck and instead ended up aiming to understand and define what is world class in investing

1. Study Techniques, Principles and Theory until they are integrated into the unconscious

"The deep structure of the human mind requires that the way to full scope competency of virtually any kind is to learn it all to fluency—like it or not." Charlie Munger

The book Focus - The hidden driver of excellence talks about two brain functions, automatic and deliberate. If you have trained enough for a mental task to be automatic you need no cognitive effort for a mental task.

In order to reach world class level in for instance chess you need many thousands hours of training to free up capacity and attention for the extra level only seen at the top. The same applies in any field of expert mental performance.

2. Deliberate practice and breaking down the area of practice in narrow fields

"To get the results very few people have, be strong enough to do what very few people are willing to do"

Deliberate practice and the 10000 hour rule became hot stuff after the book Outsiders. The numbers of hours required is still debated. However, in most literature on performance it is clear that in order to reach mastery in any field you need to break down the field into it´s component parts and focus specifically on some sub-area of performance until you reach mastery and then move on to the next area.

Time alone will not take you anywhere as anyone can see in work-life where people having 30 years of experience often are less competent than people having 2 years. In Golf it is clearly not the one who plays the most 18-hole rounds that becomes the best golf-player (I played 18 hole a day for three years and still ended up with skills as golf player that is anything but exciting).

To really improve you need to break down your area of mastery into really focused sub-areas. In chess you might study very specifics of end game (e.g. King and 3 pawns) or in Golf it could be 2 meter puts in different slopes for 3 weeks straight. Such activities are designed to improve performance, with high quality feedback and repetition, and is not that fun. Most people never come close to satisfying the conditions of deliberate practice.

3. How about reaching world class level in investing?

I really struggle to nail down what world class investing is and sat over an hour to get down to the following two bullets (not claiming bulls-eye):

As the investor choose when to play or not play the game. A world class investor is one who are making best predictions/analysis in the games he choose to play.
But much more importantly it is about identifying attractive games to play, i.e.

Having a process that serves you with world class investment opportunities.
Being able to identify those opportunities.

Number one is about circle of competence, quoting buffet:

What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

I completely agree with Buffet that a world class investor needs to know the boundaries of his circle of competence. In having a world class decision making quality, avoiding mistakes is crucial and to do that you must only make decisions in areas where you know what you are doing.

On the topic of world class investor, I however disagree with Buffet notion that the size of the circle of competence is unimportant. Here is how I reason:

In the investment Universe we have tens of thousands of stocks. Let's assume an almighty analyst had plotted a normal distribution on the expected value of all these stocks based on current available information. Let's assume:

Of all these tens of thousands of stocks

1/100 have a EV return of 20% p.a. over a 10 year period
1/1000 have an EV return of 30% p.a. over a 10 year period

The world class investor is the one who can find and correctly evaluate and buy as high percentage as possible of his portfolio in stocks as far right as possible in this normal distribution. An world class investor is therefore one who:

Has a process which identifies many very high expected value opportunities
Can correctly evaluate those opportunities

Since very high expected value opportunities will be quite few, it is unlikely to overlap with your circle of competence if you have a narrow one.

How to set up the process and how to practice to reach world class level in investing, I must think about and try to come back in some other post.

BR / RQ

söndag 20 mars 2016

Poem of Wisdom

Not much done today to get in bed a bit wiser. But saving the day in the final hour as you can do a lot worse than reading below poem carefully.

Written in 1895 and nails down some great wisdom on investing and life. Rinse and repeat!

IF..

By Rudyard Kipling

If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
But make allowance for their doubting too;
If you can wait and not be tired by waiting,
Or being lied about, don’t deal in lies,
Or being hated, don’t give way to hating,
And yet don’t look too good, nor talk too wise:

If you can dream—and not make dreams your master;
If you can think—and not make thoughts your aim;
If you can meet with Triumph and Disaster
And treat those two impostors just the same;
If you can bear to hear the truth you’ve spoken
Twisted by knaves to make a trap for fools,
Or watch the things you gave your life to, broken,
And stoop and build ’em up with worn-out tools:

If you can make one heap of all your winnings
And risk it on one turn of pitch-and-toss,
And lose, and start again at your beginnings
And never breathe a word about your loss;

If you can force your heart and nerve and sinew
To serve your turn long after they are gone,
And so hold on when there is nothing in you
Except the Will which says to them: ‘Hold on!’

If you can talk with crowds and keep your virtue,
Or walk with Kings—nor lose the common touch,
If neither foes nor loving friends can hurt you,
If all men count with you, but none too much;
If you can fill the unforgiving minute
With sixty seconds’ worth of distance run,
Yours is the Earth and everything that’s in it,
And—which is more—you’ll be a Man, my son!

Share this text ...?

lördag 19 mars 2016

Book review - Double your profits in 6 months or less

It is getting quite tiresome to do one post a day, 4 posts done and 86 to go. Better done than perfect will be the motto.

Double your profits in 6 months or less

The founders of 3G Capital sure has an interesting story.

Starting with a small brewery in Brazil they managed through a series of mergers to take control of the largest brewery in the world, Anheuser-Busch InBev. With backing from Berkshire they went on to take control of giants such as Burger King and the now merged Heinz-Kraft.

How did they do it?

They have taken cost cutting to a whole new level, and as Munger puts it "are probably the best in the world at making companies functioning better at a lower cost"

The book "Double your profits in 6 months or less" is a required readings for all managers at firms controlled by 3G capital and therefore a must read to understand how you undertake effective cost cutting.

Here are my key learnings from the methods evangelized in the book:

1. Strategic and non strategic costs

The book has very simple categorization of costs as follows:

Strategic Costs

Things that clearly bring in business and improve the bottom line such as sales people, advertising and commerciable R&D

Non-strategic cost

Necessary to run the business but do not clearly bring in more business

Rules:

We will outspend our competitors on strategic costs in good times as in bad
We will ruthlessly cut all non strategic costs to the bone

2. A very strong bias to saying "No"

In order to succeed in cutting the non strategic cost to the bone the author prescript an unwavering suspicion of every non strategic cost. It is very important to start with the belief that all non strategic costs are unnecessary, the burden of proof should be in justifying the cost. There are no sacred cows and you as a manager needs to assume that all costs can be eliminated unless proven otherwise.

The first mistake that managers make is being too cautious in cutting costs. Cut first ask second - the comforting thing about cutting cost is that if you make a mistake, someone will always tell you.

I believe a strong bias for "No" is a quite sound policy as we have the following natural tendencies in an organization:

Man with the hammer syndrome - For a man with a hammer, every problem looks like a nail.

For instance if you are a e.g. an HR manager you are naturally biased on the importance of HR. You of course see huge value in e.g. improved HR-systems to enable better workforce tracking and planning.

Deprival superreaction syndrome - A clear natural tendency towards cost cutting

The Mungers once owned a tame and good-natured dog that displayed the canine version of Deprival Super Reaction Syndrome tendency. There was only one way to get bitten by the dog. And that was to try and take some food away from him after he already had it in his mouth.

3. Extreme Organizational Focus

A management that adapts this philosophy will have an unmatched organizational attention on increasing profits, cutting costs and eliminate wasted time.

Every ounce, every fiber, every dollar, every minute of our organization we focus on realizing or potential and making a profit
Every other dollar and minute will be ruthlessly stamped out
When you eliminate costs or bring in a new customer you are helping to make a great company, when you sit in a meeting or fiddle with technology that no one will buy you are helping to sink the company

4. Create scarcity

Always keep resources very scarce because that is the only way for people to soul search on what is value creating or not. Always set deadlines in the very near term, by this people eliminate the non value adding tasks from the activity.

5. Meritocratic system, incentivize heavily on profits

Rewards & promotions will be based on performance, not seniority, likability or anything else. There will be a very wide spread of rewards, as wide as the difference in performance.

You need to pay well so people will feel that they share in the benefits of creating a highly profitable business. Need to be tied to performance or the whole system will come tumbling down.

6. Cost cutting tactics

He lays out several cost cutting tactics in the book, such as:

Employee

New hires - Say no until they are screaming, this drive inefficiency out of the system
Reductions - About one third of white collar employees can be made redundant in an average company. Be most ruthless with your own internal staff and support functions

Categories for "low hanging fruit" purchasing costs

Computers, software, capacity utilization of computer systems
R&D - Scrutinize each spending category
Every day expenses (Travel, Furniture, Office supplies, Maintenance contracts, Subscriptions, Phones etc.)

Set arbitrary non-negotiable stretch budgets (e.g. office supplies etc.)
Make them come ask the boss

Anyone who wants to spend money in this area needs to contact you first and ask permission.

Focus on small costs

Sends a strong message. CEO should let go of his own office to send a strong message.
You be surprised of how big savings you can make

Streamline your meetings and reporting

Eliminate as much as possible of internal reporting
Make decisions with as few people as possible
Make your meetings very short - 5 min can be sufficient for a decision. 30 min almost always is
Never call a meeting to discuss, only call meetings to decide
Stop off sites meetings

Overall it is a good book and well worth a read. However, the author goes too far in some instances, for instance proposing to not pay your suppliers (many will not notice) or underpay what you have agreed since they might have no choice than continuing working for you. That is in my view border line stealing and such lack of integrity and honesty is certainly not something to model.

Does the system work and does context matter?

I think the success of 3G capital makes it quite clear - it works.

However, I got the sense that the author was seeing this as a universal approach. I am very suspicious to a one size fits all in most business matters. Also here I believe context matters:

Looking at 3G capital they have focused on quite simple consumer goods businesses (such as Heinz Ketchup), which I believe is optimal for implementing this kind of methodology. Although many points here are valuable for all businesses I think the feasibility and ease of implementation differs a lot.

Some quick and high level thinking on the key parameters for this?

Complexity off the business

The more complexity you have the more risk for errors and difficulty discerning the essentials from the waste.

Easiness / risk of screwing up - if it is very difficult to screw up in the business you can move forward milk the approach very boldly

How would you screw up the ketchup-making by cutting white collar staff at Heinz?

The bargaining power of the employees

It must not be fun for an organization to undergo this medicine. If the competition for talent is high in the industry and many employees are difficult to replace they can vote with their feet or stop the initiatives by threatening to leave
Of course much easier to do in US than in France or Japan, where the Union could basically put a stop for any headcount reductions.

You need the right persons in charge

Not to empathetic people pleasers

BR / RQ

fredag 18 mars 2016

Deadly blows to the Castellum case

Today I will look into on a favorite among Swedish dividend investors and promoted as a strong buy among bloggers - Castellum. A compilation shows that 26 popular blogs own Castellum (link). Data in this post will be in Swedish, sorry for that.

The Castellum Investment Case

In summary, the investment case looks something as follows:

Castellum is the largest public commercial real estate company in Sweden and is a very stable foundation in a long term portfolio.
Castellum have increased dividend every year since listed on the stock exchange 1997. The company have an objective of increasing income from property management (förvaltningsresultat) with 10% every year. Although this is a stretch it is very likely that Castellum will continue as before - Increasing profits and dividends every year.
With a current dividend yield of 3,76% it is a fair price for a wonderful company

The history sure looks promising::

Today I will deliver three, in my opinion, deadly blows to the investment case

Historically unsustainable investment pace and inflated property valuations
Inflated income from property management driven by low interest rates
The stock is trading at historically high levels on this inflated valuation

1. Unsustainable investment pace and inflated property valuations

The table above shows the annual net investments for Castellum. Subtracting "income from property management" we get a proxy of annual "over investments". This is because:

Castellum is using 52% of income from property management for dividends
Castellum has a target 50% debt to assets

Example:

Castellum had a profit from property management of some 1,5 B SEK in 2015. A bit more than half of this result is used for dividend and the other half 0,75B SEK is used for investments in new properties. Their target of a debt to asset of 50%, provide an opportunity to borrow 0,75 BSEK, leaving the sustainable investment level at 1,5 BSEK.

This sustainable investment level is for a balance sheet in equilibrium, with no spare debt capacity or need to repay debt. Goeff Gannon has a great post on debt capacity and impact on returns which is a must read.

Totally they have overinvested 5 billion SEK the last 10 years. The debt to asset ratio has increased from 45-49%, which is close to the target level of 50%. The reason the debt level have not increased more can be seen in the following table:

10 Years Overview

Dividing the "operating profit per square meter" with the "valuation per square meter" we get the return requirements implied in the real estate valuations. Compared to 2006 we have had a non-fundamental positive valuation effect of assets of 4,72 BSEK, driven by lower return requirements.

It should be noted that the return requirements 2006 was not particularly high with 7,146%, we had higher return requirements 2012 of 7,231% and if we go back to 2003 the return requirements on properties was 7,99%.

Conclusion:

Castellum has been growing at a rapid rate the last 10 years. This growth have however been inflated with one-offs namely

Increased debt level
Record high valuation on properties, due to decreasing return requirements from the market

All things the same as today, the future growth will be slower than the past 10 years. However, the big risk is of course that the pendulum swings in the other direction

Example:

What happens if the return requirements on properties (valuation) normalizes on the 2012 level?

In order to keep the target 50% debt to asset ratio, Castellum need to amortize more than two times the 2015 income from property management. If they where to keep the current dividend level we would have 4 years with no investments in assets and growth.

Market turmoil generally move the property valuation in the wrong direction, and higher interest rates would over time certainly normalize property valuations. That takes us to the second blow to the Castellum case, the 2015 years inflated income from property management driven by low interest rates

2. Inflated income from property management due to low interest rates

In the annual report from 2015 we can read the following:

"Den genomsnittliga räntebindningstiden uppgick per 31 december 2015 till 2,5 år (2,8).................Kassaflödesmässig resultateffekt nästkommande 12 månader vid en ränteförändring om +/– 1% uppgår till – 78 respektive – 30 Mkr. På grund av räntegolv i kreditavtal har Castellum inte möjlighet att dra full nytta av negativa räntor, därav uppstår ett negativt utfall även vid en sänkning av räntan med 1%-enhet."

We can conclude that any interest rate changes have negative effect on the income from property management. By looking at the interest maturity structure below we can make this calculation ourself:

Calculation:

1 % higher interest rate next 12 months gives:

Interest hike of 1% on 9,46 BSEK of debt with a average binding period of 0,2 months equals some 77 MSEK income effect

What would happen to results if interest rate normalize to historical average?

Normalized income from property management would be ~20% lower relative to the 2015 result

Does rental price adjustments acts as a buffer?

Some bloggers have argued that an interest hike have relatively small effect for Castellum, since price adjustments in rent levels are linked to interest rates. Here is what Castellum says on rent price adjustments in the 2015 annual report:

"Hyresavtalen innehåller normalt en bashyra, d v s överenskommen hyra vid avtalets tecknande, samt en indexklausul som innebär en årlig för- ändring av hyran motsvarande en viss andel av inflationen under föregående år, alternativt en procentuell minimiuppräkning"

I find no evidence that they have a direct link between interest rates and rental pricing. Both the statement above and the calculation of interest rate sensitivity indicate that higher interest rates directly hit the results.

Conclusion:

Current income from property management is inflated. Normalized levels are significantly lower due to the record low interest rates. Actually, changes in interest rates can only have a negative effect for Castellum.

Furthermore, I do not see any cyclical factors affecting the result not being on the high end of historical averages. For instance, vacancy rate 2015 is at record low of 9,7% 2015 relative to a historical average of 11,1%.

As we conclude that the 2015 income from property management is inflated, we move on to the final and mortal blow to the Castellum case. A historical high valuation on this inflated income.

3. Historical high valuation

Summing up

Castellum is a good commercial real estate company. They have stated an ability to buy properties with high vacancy rates at lower prices and with their size and related customer relationships/channels quickly fill these properties. A rare competitive advantage in the real estate sector.

However, at current price levels I do not view the expected value of the stock as attractive over a 5-7 year period. We have correlating factors, providing quite substantial downside risk in mean reversion, namely:

Reversion of current record high property valuations would imply a need for Castellum to use income from property management to amortize debt
Income from property management normalizing at a lower level, driven by higher interest rates
A stock valuation reverting to historical levels

Usually the pendulum swings both ways and the real estate industry have feedback loops built into it which are quite interesting. See illustrative example below:

Confirmation Bias

I´ll encourage you to comment on any mistakes you see in above reasoning for mutual learning. Castellum is a favorite among the Swedish investing community and I expect few shareholders reading this to take any action. I leave you with some nice pictures of confirmation bias, something we all must fight as investors:

BR / RQ

Full disclosure: I do not have any long or short position in Castellum