Mathematicians give names to numbers that cannot be expressed as common fractions. Consider the constant Pi  or the square root of two as examples. In this week's essay, I make the case that stock investors should copy how mathematicians dealt with uncertainty .
A few weeks ago I bought shares in Gulfport Energy. At about $4 a share, GPOR traded at four times the trailing 10-year average earnings per share of $1.84 and at less than a third of its reported tangible book value.
Peer companies traded at much higher valuation. Southwestern Energy (SWN on Nyse) traded at four times the 2018 earnings per share but the 10-year average earnings per share we negative. Southwestern traded at roughly the reported tangible book value.
Another peer company, SM Energy (SM on Nyse), with reported book value per share of $2 and 10-year average earnings per share of $0.26, was trading at 60 times the earnings per share and at about two-thirds of book value.
Yet I felt discomfort after buying Gulfport. I attribute the unease to my inability to understand where Gulfport operations will be in five years. There are three factors that drive Gulfport's business. And all three factors are practically impossible to predict over a five-year time frame.
First are the macroeconomic issues. These macro factors are heterogeneous and myriad in scope: from consumer spending and confidence levels to employment statistics such as Mass Layoff Statistics (MLS). From prices, productivity and wages variables as indicated by the Consumer Price Index (CPI) to international economic indications such as the German Industrial Production.
Macro factors also include supply and demand variables. For U.S- based natural gas investors, that means a visit to the U.S. Energy Information Administration website, and a review of the domestic production .
Then gas investors are expected to determine the trends in each of the demand drivers - those being industrial use, electric power, consumption and exports - a Sisyphean task. Read Forbes' article about Oklahoma gas and oil industry as example.
The second factor relates to natural gas reserves. The natural gas company will determine how long the company's revenue can continue without incurring additional debt or equity issuance. Uri Geller, a psychic known for his trademark television performances of spoon bending, was once employed to predict how much natural gas reserves could be found. This antidote serves as example that it is, at the end of it all, somewhat of a guessing game.
In a May 2019 presentation to investors, Gulfport Energy's management reported on 92,000 in net reservoir acres in SCOOP (read about SCOOP on Enversus blog) and 210,000 net acres in Utica Shale. Management also reported that as of fiscal year end 2018, it had reserves of 1.3 net Tcfe in SCOOP and 3.4 net Tcfe in Utica Shale. But who can tell how much is still buried in the ground?
The third issue is the regulatory and political environment which greatly affects the price of natural gas. A recent example from the state of Israel demonstrates how. The exploration for the Tamar gas field began in 1999, then a decade after, in January 2009, "Tamar was the largest find of gas or oil in the Levan bain of the Eastern Mediterranean Sea and the largest discovery," reported the Jerusalem Post. Noble Energy joined the drilling activity in 2006 and was the primary benefactor of the discovery.
Nobel's energy investors were thrilled but the Israelis threw a fit. The Israelis blamed their government of dire misuse of natural resources, which belonged to citizens and not in the hands of foreign, private interest groups, and that forfeiting such a national treasure was, in effect, a security threat. This political debacle began five years ago and continues to this day. In short, political and regulatory concerns are real.
Merriam-Webster dictionary explains gambling as "to bet on an uncertain outcome." And if we were to use their narrow definition of the word then indeed buying Gulfport was a gamble. But I will propose a wider definition. Let us expand on Webster's definition with "without any margin of safety."
The wide margin of safety was the result of the low price to earnings ratio and low price to book value ratio. It was the result of today's investors receiving $24 billion of proved developed and undeveloped per share, while five years ago investors received $8.7 billion, and ten years ago they received $740 million. The margin of safety also results from management's buy back strategy and reduced planned capital expenditures for 2019.
"You've got to have models in your head," said the famed value investor, Charlie Munger. "And you've got to array your experience - both vicarious and direct - onto this latticework of mental models." My main point in this essay was to advocate that investors should observe how mathematicians had dealt with irrational numbers: they defined the phenomena and moved on with the analysis.
While researching Gulfport, I understood how uncertain the future price of natural gas would be. So I looked for a wide margin of safety. I then moved on to read about the company.
Corporate America cannot stand still. Executive management reports to shareholders on growth expectations and on future strategy. Middle management reports to executive management on upcoming changes to processes and to efficiency measures. And each employee, as anyone who has worked in an office knows, is permanently busy.
This phenomenon, the need to act, can be seen in balance sheets. Consider the balance sheet of Signet Jewelers (SIG on Nyse), a company whose common stock I bought this week, is a prime example.
First, between 2015 and 2014, the goodwill and intangible accounts increased to $966.3 million from $26.8 million. On the right side of the balance sheet, Signet’s long-term debt increased to $1.3 billion from practically nil. These changes occurred because Signet had bought Zales, an online jewelry store. Forbes magazine described the acquisition in February 2014.
Second, 2016 and 2017, Signet reported on a preferred stock of $611.9 million. It also reported that it would be selling the receivables portfolio (read: the loans Signet provides, partly through third parties, when customers purchase jewelry). And indeed a year after the receivables dropped to $779 million from $1.9 billion. The cash flow from the receivable sale was used to pay down the long term - it dropped to $688 million from $1.3 billion.
Third, between 2018 and the first quarter of 2019, Signet continued to sell the receivables portfolio. As of its recent public filing it reported on $96.2 million in receivables, down from $779.7 million the year prior. Another major balance sheet change was that that goodwill and intangible accounts, dropped to $561 million from $1.3 billion. The drop in the goodwill account was due to an impairment loss related to the Ret2Net purchase. Read about the acquisition here.
How should we understand this pace of activity? One group of investors cheers for Signet's Animal Spirits while the other prefers if the company would operate in a conservative fashion. What is worrisome to both groups is probably the company’s long-term trend.
Five years ago when Signet traded as low as $75 and as high as $151 (at an average earnings multiple greater than 15 times the trailing earnings per share), investors argued that Signet's market share of the bridal segment was increasing alongside the consumer’s demand for jewelry. The conventional wisdom was that, in the long-term, shareholders would be awarded.
But in the long term we are all dead*. Signet is not the same company it was five years ago. In numbers: the pre-tax return on tangible assets ratio was 15% in 2014. It has steadily declined to a minuscule ratio of 3% in 2019. The pre-tax profit margin, defined as pre-tax net income divided by revenue, was 10% five years ago. It is now less than 2% (even after removing the non-cash impairment charge related to Ret2Net acquisition).
The balance sheet tells a similar tale: in 2014 for every dollar of common equity, Signet reported 57 cents of liabilities. Today the ratio increased by fivefold: for every dollar of common equity, Signet now reports $2.60 of liabilities. Another way to look the company's leverage is that Signet had zero long-term debt five years ago. It now has $650 million. For the long-term investor, in short, Signet in 2019 is not what Signet was in 2014.
Three lessons present themselves. First, investors with an investment outlook of three- to five-years must allocate time, perhaps quarterly, to review management decisions. They should review and question management's capital expenditures decisions, find out what the business strategy is and closely monitor how management reports on operations in the each of the quarterly earnings calls.
Second, Investors should look for industry trends and for regulatory changes. For those who invest in jewelry companies, or more broadly, in consumer discretionary segments, the regulatory environment greatly matters (Signet's sales are largely driven by the consumer's ability to take personal loans).
The third lesson is that whether to buy a stock should be based on present circumstances, using historical financial statements so that future estimates and pro forma projections should not sway the attention. And why I bought the common stock of SIG, based on the present conditions, will be the topic of s future essay.
In our business environment, which reveres Andy Grove, former Intel CEO, chronicler of paranoia in the Only the Paranoid Survive, executive management will make poor decisions due to hasty decisions driven by a need to act.
In the case of Signet, by merely looking at the balance sheet, we see an executive management that has been wearing too many hats. They wore the financier hat when they replaced long-term debt with preferred equity. They wore the visionary hat when they acquired Zales in 2014. Too bad that they recently had to wear the accountant's hat, the least attractive of the three, when they took an impairment loss of $740 million this year.
In this article, my main argument was to highlight that investing for the long-term is no excuse to let stock investments idly sit in the the portfolio. Corporate America’s behavior is such that every few years a large transaction will occur**. That transaction will dramatically change the business fundamentals and the company’s outlook, be it a restructure, an acquisition or a change in capital structure. More so, it is the nature of capitalism, in which yours truly is ardent believer, that in a free market system, profitable enterprises will lose competitive advantage***. Often too quickly. And brutally often.
Beasley is in advertisement. That is to say, advertisers pay the company to broadcast their ads. So the simple math to generate revenue is the number of advertisements times the price Beasley charges the ad companies. The trends are positive
In 2018 the company reported on $257.5 million in revenue compared to $58.7 million in 2014. Pre-tax income increased to $29.3 million from $3.8 million during this five-year period. Over the past decade, the company did not report any losses. The lowest earnings per share was in 2009 at 15 cents per share. The highest earnings per share were in 2017 at $3.14 per share but over $2 of that was related to a one-time charge related to the U.S. tax code.
Beasley burns about 80% of its revenue before it pays lenders. Of the reported revenue of $257.5 million in 2018, $45.3 million was left to service the debt obligations of about $16 million.
The ratio between gross operating income and interest expense was 2.8 times in 2018 and 2.20 times in 2017. It is a thin margin.
The annual capital expenditures expense was $4.2 million over the past two years and about half of that over prior three years. After capital expenditures expense, Beasley reported positive net cash flow in each of the past five years.
Broadcasting rights are 80% of the tangible assets. These contracts are typically negotiated every eight years. They are renewed if Beasley operates within acceptable practices as deemed by the FCC.
Net tangible assets, defined as total assets less intangible assets less total liabilities, were $246.8 million or $8.96 per share in 2018. So at $3 per share, the stock trades at about two-thirds discount to net tangible assets.
To finance the acquisition of radio stations, Beasley borrows money. And as the company’s appetite for acquisition increases, so does its leverage ratio, which increased from about 25% to 35% over the past few years.
The current $252 million in term loan will mature on November 1, 2023. The company is paying interest based on Libor index plus an interest rate spread, which amounts to 6.5%.
And as any borrower soon realizes, borrowing someone else’s money comes with conditions. It is no different here. Beasley’s lender, U.S. Bank, limits the amount of leverage the company can take and monitors its dividends policy. Not necessarily a bad thing.
Over the past 10 years, the stock traded hands as low as $1 in 2009 and as high as $18 in 2017. The 10-year average range in earnings multiple was between 7 and 20 times the earnings per share.
While management grew the pre-tax income by over 50% compounded annually, it did not dilute shareholders to do so. Beasley had 22.9 million outstanding common shares in 2014 and $27.5 million in 2018, a compounded dilution of less than 5%.
This behavior, of increasing pre-tax earnings while the number of outstanding shares is invariably the same, is because management is heavily invested in the company. The Beasley family owns 59.4% of the outstanding shares.
I sifted through the operating performance of five competitors: Saga Communications (SGA on Nasdaq), Ascent Capital (ASCMA on OTC), Emmis Communications (EMMS on Nasdaq), Salem Media Group (SALM on Nasdaq) and Townsquare Media (TSQ on Nyse.)
Key findings: ASCMA and EMMS ratio of total liabilities to net tangible assets was 1.28 times and 2.03 times respectively. Beasley’s ratio was 0.65.
Both ASCMA and EMMS reported losses last year.
The pre-tax income to net tangible assets ratio was 10% and 13% for SALM and SGA compared to Beasley that averaged between 18% and 15% over the past 5 years.
Most comparable company to Beasley is SGA. It has a lower leverage ratio of 41% and reported on 13% ratio of pre-tax income to net tangible assets. Its profit margin is higher than Beasley at 14% compared to 10%. Yet it is an expensive stock. Its pre-tax income per share - $2.8 - was valued at 12 times (the stock trades at $34). Beasley pre-tax income was $1.06 and it trades hands at about $3.
Investors in Beasley (yours truly owns shares) should be wary of five risks. First, between the period June 2019 and April 2022, as the company will renegotiate its broadcasting licenses, the stock price is likely to be volatile.
Second, advertising is considered a discretionary expense. Read: at times of downturn, revenue will decline. Third, the company has a balloon payment due in November 2023.
Fourth, Boston, MA, Philadelphia, PA and Tampa, FL serve 60% of the company’s revenue, making Beasley highly dependent on the wellbeing of these markets. Fifth, to partner with the Beasley stock is to have a leap of faith in the Beasley family.
Readers of this blog know that I only buy stocks that I expect to double in price. If I am right, then within five years, the expected return is 15%. If I am right within three years, the expected return is 25%. This range is my ultimate desired rate of return in Beasley. (If within 2 or 3 years my thesis is wrong, I typically sell the stock.)
I am uncertain why Mr. Market is bearish on Beasley. I also could not understand why the stock price halved over the past year. I will leave that discussion to others.
My investment thesis is that Beasley is a well-managed company, with shareholder-friendly management that sells a service that I can reasonably estimate its future cash flow.
In 2009 I began to write a weekly journal so that I could have a better appreciation of the present and a greater sense of direction for the future.
But until this week, I never took the time to look back at my actions in the stock market. So this week's essay is a summary of these activities. Not unlike a horse race, below is my scorecard.
I now own the common stock of 21 publicly-traded companies that operate in various industries; from airlines (Hawaiian Holdings) to specialty retail (Signet Jewelers); from media companies such as Beasley Broadcast Group to Carriage Services, a death care company.
Some are large companies - L Brand market capitalization is $7 billion for example - and some companies are small (Lifeway Food, the maker of Kefir milk, has market capitalization less than $50 million.)
Practically all my positions are less than a year old; Patterson Companies is the only company I've held for 14 months. Over the past year, on average, I bought two positions every month and reduced my position in three companies: Diversified Restaurant Holdings, Lifeway Food and ARC Documents Solutions.
Not unlike the Russell 2000 index, my portfolio market price dropped in May of this year and in December of last year. In May, the portfolio lost 6% in (unrealized) market price compared to 8% in market loss for the Russell 2000. In December, the portfolio market price fell by 11% while the Russell 2000 lost 12%. On an annual comparison, my portfolio is down 7.6% while the Russell 2000 is down 6.4%.
The reason for the drop in market value is due to two positions The first is Orchid Paper, a position with which I started with 4,000 shares in July 2018 and then bought 6,000 more shares in October 2018. Orchid filed for bankruptcy in May of this year. While I did not sell my Orchid position, I "wrote down" to zero the value of this position. This was an unforced error on my part. Click here to read why.
Frontier Communications was the second reason for the market loss. I bought 2,500 shares in July of last year and then bought 5,500 more shares in November. My cost basis is $4 and the market price of the stock is now 70% lower. I am holding 8,000 shares, but I am uncertain where Frontier will be in two or three years. I am certain, however, that today I would never have bought Frontier in the first place.
I learned more about stock investments over the last 12 months than I did over the past decade. As with many other things in life, there is no substitute for actual, real world experience (can you imagine learning to ride your bike by reading about it?)
Last year, I generated stock ideas mainly by observing price movements; today, I research what other value investors are buying. Last year, I was watching the list of 52-week low; today I watch daily the market price of over 50 stocks and built stock screens.
I also think on the portfolio-level. While a year ago I had 8 positions that represented 55% of the portfolio, today the entire 21 positions represent 52% of the portfolio (the rest is in cash). A year ago, I was running a very concentrated portfolio. Today, no stock represents more than 5% of the portfolio.
So I evolved. Because I used to follow the adage that "investing is not looking at the market price of the stocks;” - I never tracked the portfolio's value. But as preparation for this essay, I reviewed the portfolio and found the process valuable.
It now takes less than 20 seconds to answer questions, such as how did the portfolio return compare to the benchmark return in December, and which stocks performed best or worse during that month?
I invested over 750 hours over the last year in screening, researching, reading, analyzing, reviewing, comparing and thinking about stocks. If we assume that my hourly rate is $60, then I could have earned $45,000 pre-tax had I bought an ETF that tracks the value of the Russell 2000 instead of hand picking stocks myself.
But I expect at least 5 stocks to double in price over the next three years. Should that be the case, it will make up for the $45,000 in "opportunity cost,".
Some of these names include Hyster-Male, a lift truck company, Superior Industries, an aluminum wheel manufacturer, Gulfport Energy, a natural gas company and Flexsteel Industries, a furniture company.
That is just the economic side of the things. There is no price, or perhaps it was priceless, to find a craft which I am passionate about.
In a recent meeting I attended, my greatest strength was assessed as a passion for study - stock investing is one of the most enjoyable avenues to exercise this skill.
Similar to physical exercise, over the last year I overcame hurdles and now feel mentally stronger. For example my stock portion of the portfolio dropped by 40% in December of last year (but because I had reserved cash, the total effect on the portfolio was less than 10%). Not only did that not scare me, I bought Seritage Growth Companies and Voxx International during that month.
In short, tracking the portfolio allows to live with the past, not in the past.
This week I sold 10,000 shares of Diversified Restaurant Holdings (SAUC on Nasdaq) at $0.73 per share. As I type these words, two days after my first stock sell in 2019, SAUC climbed to $1.03. So not only did I lose money since as my cost basis was $1.40 per share, but also I lost $2,500 by trading on Tuesday instead of Thursday.
I have zero regrets. I sold the shares because I was wrong in buying shares in SAUC in the first place. In this week's essay I explain why.
Between 2013 and 2018, SAUC traded as low as $2 and as high as $4. So when I bought the stock at $1.40, I assumed that price was low enough to serve as a margin of safety. I was wrong. A closer look at the publicly available financial statements would reveal that SAUC in 2018 was not the same company it was in 2016. This was because 26 of Dave and Buster's restaurants were no longer part of the company.
Score: Noam: 0. Mr. Market: 1.
I did not factor in SAUC's minuscule market capitalization of $25 million. Mistake number two. Companies with less than $100 million in market capitalization are riskier than larger capitalized companies. This is because it is tougher for pygmy companies to obtain debt or equity financing without diluting shareholders. Another risk is that small cap stock is usually off the radar screen of larger capitalized stock. So, unless the market readjusts the small cap stock valuation, the investor has no exit strategy.
As a rule, if a billion in market capitalization is selling at 10 times the earnings per share, then 25 million in market capitalization stock, given the risks detailed above, should sell at no more than 4 times the earnings the per share. But I had not discounted for size.
Score: Noam: 0. Mr. Market: 2.
SAUC owns 64 franchises of Buffalo Wild Wings. I estimated that the value of each franchise was $2.5 million. This value was based on how much it would cost to build and open a Buffalo Wild Wings franchise and based on the price franchises were selling in the market place.
So, the replacement cost was $160 million. With total liabilities of $118 million I estimated equity to be $40 million or $1.38 per share. I paid about par of the net asset value which dear valuation. Purchasing the equity at 50% - 80% would be sensible according to Marty Whitman, founder of Third Avenue Management. But not only did I disappoint one of the masters of value investing, I overlooked the right of the balance sheet.
Score: Noam: 0. Mr. Market: 3.
"The company cannot conclude that it is probable that it will secure a credit facility," warned management on page 29 of its latest 10-k filing. "This raises substantial doubt that the company's ability to continue as a going concern."
SAUC may not be a company a year from today. Management had agreed to debt covenants that raise two problems. The first problem is that SAUC's debt is variable. It is based on LIBOR plus a margin that depends on the company's leverage ratios. This condition is a two-edged sword because as operations deteriorate, the cost of capital will increase. The combination of two will tarnish earnings.
The hidden liabilities are the second problem. When SAUC spanned off Bagger Dave's it continued to guarantee the leases. In the event Bagger Dave's decided to give the keys back to lenders, SAUC will be liable for the rent. This is like selling your home and then guaranteeing tax authorities that if the buyer is not able to pay the appropriate taxes, they can come after you.
Score: Noam: 0. Mr. Market: 4.
SAUC’s senior management is invested in the company but lacks disclosure to shareholders. Michael Ansley owns 2.2 million shares, Jason Curtis 1.1 million shares and David Bruke owns 580 thousand shares. Together, the shares represent about 20% of the available stock. Yet they are not reporting enough about the company operations.
To understand the performance of the restaurant business, you need to understand more than revenue and profit trends. All shareholders of a company should know what the guest satisfaction is, what the hourly compensation costs are and how the cost of food affects margins. But management provides none of this information.
Other industries, such as the airline industry, share information on a granular level (read my recent purchase of Hawaiian Airlines as example). It was a mistake to buy shares in a company that does not value transparency.
Score: Noam: 0. Mr. Market: 5.
In A Senseless Market Capitalization for Diversified Restaurant Holdings link, I wrote that:
"Animal Spirits may explain why an investor would prefer to franchise a Buffalo Wild Wings restaurant as opposed to simply purchasing Diversified Restaurants Holdings stocks."
I was positive that Mr. Market was wrong and that I was right. That I was wrong is obvious and not worthwhile to further mention. What is important, though, using the game of tennis as an analogy, is to highlight that all the mistakes were unforced errors.
The 5 mistakes highlighted above were not due to unforeseen changes in industry or by remarkable performance of competition. Investing in SAUC was a mistake that could have easily been avoided.
As a resolution I began this month to spend an extra 10 hours reviewing an “unforced error” checklist. During this review, I answer questions such as: Does the company have variable or fixed rate debt? Is management sharing with shareholders how they evaluate business performance? For every dollar of retained earnings over the past year, has management increased the value of the company? Hopefully, going forward, this will improve my scorecard against Mr. Market.