Late Q3 Commentary

This was a letter written at the end of Q3. Just getting back into posting something. I will resume with real posts soon.

I have edited out reference to clients and performance as it is irrelevant but I did a crappy job, so if the flow is bad, deal with it.

Q3 Letter

The key to making money in stocks is not to get scared out of them. -Peter Lynch

The General Market in Q3 2012
During Q3 we have seen increased hopes that the economic situation in Europe might not be as bad as previously thought. This, combined with the widespread belief that the Fed will continue attempts to stimulate the sluggish U.S. economy at all costs, caused a rally in the market. My personal view is that the latest round of quantitative easing is a signal that the Fed feels like the economy is in trouble. The expansion of the money supply that has occurred within the last four years is unprecedented. We will not know the exact effects of this for many years but it seems dangerous to carry on such an experiment.
Interest rates as low as we now see with an almost guaranteed inflationary environment occurring within the next decade creates a terrible environment for lenders. Who wants to lend money at 1% with inflation running higher than that currently and potentially much higher than that in the future? Having said that, government and corporate bonds are being purchased in large numbers (a form of loan to the government or corporation), so obviously somebody wants to. While the payoffs from owning equities may not come for years (like a bond with no definite coupon or maturity date) owning pieces of businesses at the right prices seems to be the safest, and most lucrative, investment over the next 10 years. As always with long-term investing, a prediction like that could make me look pretty stupid for some time; luckily I have some time.

…you don’t win by predicting the future; you win by getting the odds right. You can be right about the future and still not make any money. At the racetrack, for example, the favorite horse may be the one most likely to win, but since everyone wants to bet on the favorite, how likely is it that betting on the favorite will make you money? The horse to bet on is the one more likely to win than most people expect. That’s the one that gives you the best odds. That’s the bet that pays off over time. –Will Bonner
Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. –Charlie Munger
I always enjoy looking where others are not. With investing not only must you be correct about your thesis but it must be one that others aren’t able to see or act on or your view will already be priced into the issue. That is why I prefer companies with little or no analyst coverage. It is very difficult to gain insights that others don’t have about a company that is followed by a team of the world’s greatest analysts. To this extent, I believe in the weak form of the Efficient Market Hypothesis. Well-followed companies are almost always correctly priced and studies show that the best and brightest suffer from the paradox of skill when they wander into this area. Everyone analyzing those companies is so good that they can’t beat each other. While that may not be entirely true, it is almost entirely true.
On that note, I would like to introduce you to the largest position in our portfolio. Despite its recent run up I still think it is worth holding.
Conrad Industries, Inc (CNRD) builds and repairs a variety of marine vessels at four facilities located in Louisiana and Texas near the Gulf Coast. It has been in operation for 64 years. The founder, now 96, still sits on the board. 2/3rds of revenues come from new construction while the rest comes from repairs. The repair business is higher margin and growing.
CNRD has a small competitive advantage that all Jones Act builders participate in. The Merchant Marine Act of 1920 states that any vessel that transports goods between American ports must be U.S. built therefore CNRD gets a lot of steady business.
CNRD currently has an enterprise value of $76m and had operating income of $29m on average capital expenditures of about $4m for free cash flow of $25m. At the current price the owner gets an earnings yield of 33% and an EV/EBITDA multiple of 2.3. 10 year average operating income is $12.6m for an earnings yield of 17%. Their business has changed for the positive since 2005 with the construction of a deepwater facility that can better service their oil customers and focus on higher margin business. Conservative and cyclically adjusted estimated run-rate earnings would be right around $15m. A recent comparable sold for an EV/EBITDA of about four although the comparable company (Todd Shipyards) had lower margins and lower growth numbers than CNRD. I believe that CNRD should at least trade in line with this comparable.
The company has $55m in unadjusted net current assets which is about $9 per share and a total net asset value of $103m which is $16.91 per share. The company last traded hands at $17.99 and our average price paid was right around $16. Seeing net assets at 6% above our purchase price is a comforting thing.
The interesting part of the asset valuation comes when adjusting property, plant, and equipment to their real value. The land that CNRD operates on was purchased in 1948, 1974, 1996, 2000, and 2011 but is carried at cost. CNRD’s return on average equity (which is a good metric given that they are nearly debt free) is roughly 22%. Of course, this is overstated because book value is understated due to the unadjusted carrying value of the land. I can’t know exactly what the land is worth, but it is safe to say that it is worth more than it was in 1948. Also the goodwill of the operations that were purchased with some of the land has since been amortized to zero, this accurately reflects accounting goodwill but not economic goodwill.
We can know that returns on invested capital have been good given that CNRD has compounded book value at nearly 14% for the last ten years and more than 20% for the last five.
Insider ownership is just about 50% but executive compensation is reasonable. Management is not abusing shareholders in the slightest and has been aggressively buying back shares – annually retiring about 3% of shares.
The risks here are the cyclicality of the business and some customer concentration. Neither of these is especially concerning given the price we are paying. CNRD’s capital structure can handle a downturn just fine and while government and oil make up large parts of revenues, it is worth noting that these are both uniquely steady and reliable customers.
With a 33% earnings yield we pay for the investment in three years. Even if we are near peak earnings for this cycle, that is awfully cheap.
I have been following the company since 2010 when I first purchased it for my personal portfolio at around $8 per share after searching through the business casualties of the Deepwater Horizon incident. At the time it was the best risk/reward investment I had ever seen. At nearly $18 I still believe it is a good investment.
So what’s the catch? Why is it so cheap?
It’s illiquid and it’s cyclical.
CNRD is illiquid which means that large, intelligent buyers can’t participate (there aren’t very many advantages to having small amounts of capital but this is one of them.) Even smaller funds would have a hard time taking a position in a company like this. Aside from the fund’s prohibitive size they must always be afraid of investor redemptions which would force them to sell shares into lurking limit orders, placed by bottom feeders (like me), in order to gain the liquidity that the fund needs to exit the position. I am fortunate to have patient investors so taking advantage of a situation like this becomes possible. I have never thought liquidity should be much of a prohibitive issue just as ease of divorce should not be a reason in favor of commitment.
The cyclicality makes the business somewhat unpredictable. Lucky for us, foolish Mr. Market seems to fear uncertainty more than risk and the negative cyclicality is more than priced in. Benjamin Graham once said something to the effect of “most investor losses come from poor companies purchased in good times” which then results in the investor losing money as earnings regress to the mean. Of course any business is a great investment at one price and a terrible investment at another. CNRD may not be a great business but it is better than average. I don’t believe that the business risk in CNRD is substantial at $16 per share given that the company has a good history of operations and could likely be liquidated for not much less than $16.
The situation reminds me a little of KSW because KSW was similarly illiquid and cyclical with substantial insider ownership and a solid balance sheet. I first purchased KSW for about $2.90 in 2010 thinking it was worth about $6. It then rallied to over $4 and I sold it not because it had reached full value but because I found something more attractive. In the summer of 2011 KSW was once again pushed down to about $3 at which point I bought it again. The price eventually climbed to about $4 before it was bought out at $5 by another company. This up and down over more than two years is typical of value investments and just because the person who bought my shares from me at over $4 had to sit on 30% losses for a time, it doesn’t mean that anything had changed with the business or that their investment was a poor one. It just takes time for value to be realized. I never judge how the investment is doing based on the share price, it’s how the business is performing and the value of the underlying assets that matter. Eventually the market will realize that value.

Going Forward
I am increasingly convinced that basic quantitative evaluation outperforms qualitative evaluation. I think most of the outperformance comes from the elimination of investor bias – in other words, eliminating investor emotion. In a game of probabilities, which investing so often is, a purely logical formula is likely to beat those who make decisions that mood could possibly influence. I continue to move further in this quantitative direction as I see more and more evidence that it works.
The bulk of my strategy consists of running a variety of screens that have a long history of outperformance, then further narrowing down the list by qualitative evaluation. In the last year the basic quantitative screen has beaten my performance. Of course, any time frame less than three years is mostly meaningless but I will continue to heavily rely on a purely quantitative formula to generate lists and will focus on the highly ranked companies when I make my decisions. Most of my losses over the years have come when I strayed from the surety of the numbers into biased projections of what a company’s potential was. Benjamin Graham would not have been impressed.
I will remain true to a strategy that has worked ever since equities have existed and has also worked in every market around the world. The strategy is buying cheap companies based on the numbers in obscure and inefficient areas of the market, being patient, and holding enough companies that the odds can work in your favor. As Warren Buffett has said so many times, “investing is simple, but not easy.” Kind of like dieting.
Stocks are not as cheap as they were a year ago, however, they are still the best of the investing alternatives as far as I can see. I think we will be glad that we owned them, and not something else, in 3-5 years.

(The above is not a solicitation or recommendation to buy. Do your own research, do not rely on mine. The author holds a position in CNRD)


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