Category: Portfolio Management

Patterson Companies

Published on:
June 15, 2019
Last Update:

In investing one group cheers while the other fears. When Patterson Companies (PDCO on Nasdaq) was delisted from the S&P 500 index, in the course of 90 days, Patterson’s common stock price dropped by 42%, to $22 from $38. Shareholders were disappointed.  

The S&P 500 composers replaced Patterson with three companies. The first company was SVB Financial Group (SIVB on Nasdaq), a bank holding company. Take-Two Interactive (TTWO on Nasdaq), whose business is video games, was the second company. And Nektar Therapeutics (NKTR on Nasdaq), a pharmaceutical, was the third. Shareholders were pleased.    

It is unconventional to buy the stock of a delisted company - not only has the stock lost momentum, pundits argue, but also the delisting follows some deterioration in the business fundamentals. "The results we report today clearly do not meet our expectations," said Patterson's boss, Mark Walchirk, a year ago. "They fall short of what we know the business is capable of achieving."

The original investment thesis

I wrote about Patterson Companies in May 4, 2018. My original thesis was that while the company's operating performance was poor over the second quarter of 2018, if investors had saw the company's operations over the prior decade, a different view would emerge – that the company had materially improved both its market share and operating performance.

PDCO earnings over past decade
A 10-year outlook on PDCO's earnings

One of the reasons I bought Patterson was that employees are shareholders of the company. In the 2018 proxy statement, on page 23, management reported that employees of the company owned 11.7 million shares, about 12% of the outstanding stock.  

Another reason for buying Patterson were tailwinds of the two industries in which Patterson operates in - veterinary and dental products. Its website  summarized the bull case for the dental and animal industries: "95% of adults say they value keeping their mouth healthy. 68% of U.S. households own a pet. And 200 million tons of protein will need to be produced by 2050."

I estimated that management would restore the operating margins. The average pre-tax income to revenue ratio was over 10% between April 2004 and April 2012. It steadily declined over the following 7 years. The most recent ratio reported was a minuscule 4%. In addition, the pre-tax income on tangible assets over the past decade was greater than 10%, a reasonable ratio for a company in the distribution business.  

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Last year

With no corporate restructures, major refinancing efforts or corporate shakeups, it is little surprise that Patterson's stock price has not moved since May 2018. Patterson is trading at the same price it traded hands a year ago, at about $22 per share. Over the past year, the stock climbed to $26 in November 2018 and dropped to $19 in December 2018.

PDCO Stock price over past year
PDCO's stock price over past year (Screenshot from Google)

Mark Walchirk has been the President and Chief Executive Officer since November 2017. Don Zurbay has been the Chief Financial Officer since June of last year, effectively when I began to buy the stock, and Kevin Pohlman has been running the animal health division since July 2017. The only new addition to the executive team is Eric Shirley who began to head the dental division 5 months ago.

In regard to financials: as of the third quarter of this year, Patterson reported on $1,472 million or $15.77 per share in equity compared to $1,461 million or $15.65 per share in 2018. Revenue is $4,137 million or $44.31 per share for the last 9 months ending in January 26, 2019 compared to $4,065 million or $43.56 the prior year. The main shortfall is that pre-tax income is down by $79 million because of an increase both in cost of sales and in expenses.  

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In a year or two

Unless Patterson's stock trades hands at over $30 per share a year or two from today, I will sell the position. The reason for the $30 price tag is that over the past decade, investors paid between 15 to 20 times for one dollar of pre-tax income per share. At the time of this writing, given the lackluster operating performance, investors are paying less than 10 times one dollar of pre-tax income.  

Should Patterson's financial performance improve, so will its stock price. But when - and if - the increase will happen is unknown to me. Since my return objective is 15% to 25% each year, unless the stock appreciates to $30 in two or three years the position will be sold for "time is money" reasons.

***
In business, random, short-term driven decisions have a long-term impact. A friend of mine recently described his work environment as akin to a tank, in that senior management was reacting to obstacles along the way without any strategic thought. This was eroding the company's culture.

What appear to be random decisions also affect prices. The S&P 500 composers believed replacing Patterson with three companies would be a boon for the index over the long term.

Yet, collectively, the stock price of the three companies tumbled by 25% over the past year. SIVB traded for $320 a year ago and now trades for $213. NKTR traded for $53 a year ago and now trades for $37. TTWO fell from $120 to $109 over this period.

Judged by the rules of the stock market, that prices are paramount, replacing Patterson with a trifecta of a pharma company, a video game company and bank was a mistake. And owners of the S&P 500 index would be better off  had Patterson never was delisted. But then I would not cheer for the stock.

Burying my head in the sand

Published on:
June 1, 2019
Last Update:

In Where the Financial Statements Reveal Little Economist Reality , I bragged that buying Frontier Communication was effortless. All one had to do, I proclaimed, was to compare the prior years price, which was in the triple digits, to the 2018 stock price of $5.

A year passed and the stock price more than halved - which issues a few lessons. In this essay I describe these lessons and explain why I am still holding the stock nonetheless.

The four lessons

The first lesson is that not all equity is created equal. What I failed to see last year was that the reported 2017 equity of $2,274 million consisted of $5,035 million in additional paid-in capital which was offset by $2,263 million in accumulated deficit (The remaining $497 million was related to treasury stock and OCI). What this means is that the equity balance consisted of proceeds from past stock issuances - not from profits.

The reported equity should have embarrassed management. But instead management had no problem diluting common shareholders by issuing additional shares. There were 66 million outstanding common shares five years ago. There were 78 million outstanding shares a year ago. There are now over 90 million outstanding shares. This 6% annual growth in common shares, likely to continue, is worrisome.   

The value of reported goodwill and intangibles assets is always questionable. But in FTR's case, these two accounts were no assets at all. In 2016 goodwill and intangibles were $12,336 million. Management had written down these assets to $7,877 million by 2018, a whopping $4,459 million loss that was fully recognized in the income statement.

FTR's goodwill and intangibles are over a third of the value of the reported assets. And if we are to remove these accounts, as any bidder for the company surely would, we would be left with exactly nil - zero, nadir, nothing, zilch - in common equity. FTR's tangible assets, which exclude the goodwill and intangibles accounts are $15,782 million or $17 per share. FTR's liabilities are $22,059 million or $24 per share. Since the liabilities are worth more than the assets, the common equity is worthless. The omission of thought related to the intangibles is lesson number two.

The third lesson was the lack of margin of safety. Even at $5 per share, which was historically low, FTR had too many concerns. To name a few: (a) the fixed coverage ratio was deteriorating. The ratio was over three times in prior years and is now less than two times; (b) leverage, defined as total liabilities divided by total assets, was historically at 75% but is now at 93%; (c) pension liability increased from $1,055 million in 2012 to $1,750 in 2018. And there is no sign of this liability but to grow; (d) the percentage of employees under labor agreement increased from 23% to 64% and (e) the wireline telecommunication industry is doing bad.

Practically all telecommunication companies’ stock prices dropped. Anixter (AXE on Nyse) now trades at $57 compared to $99 five years ago. Centurylink (CTL on Nyse) now trades at $10 compared to $37 five years ago. See the table below for more examples.  

How telecommunications companies are trading nowadays

That I bought too much stock is the fourth lesson. I started to buy FTR in March of last year, when the stock traded at $7.76 per share. Then I bought twice as much stock, at $4 per share in November. I finished 2018 with 8,000 shares at a weighted average cost of $5 per share. The FTR position represents 8% of my portfolio while no stock represents more than 2% in comparison.

Why I still hold FTR

Admittedly, I bought too much stock and was careless, too. Reviewing FTR's latest public filing, I was ready to sell the entire position and to recognize the loss. But I found enough reasons (or excuses) to keep it.

There is - and I project will be continued - a reasonable pre-tax cash flow. FTR gathered $3,752 million in after-tax cash flow, after capital expenditures that is, since 2011. In two years the company showed a cash flow deficit: in 2016 the deficit was $227 million, and in 2015 the deficit was $31. But in 2018 the pre-tax cash flow was $687, and the 7-year pre-tax cash flow was $525 million.

The pre-tax cash flow matters. It allows management to change the capital structure by reducing the total liabilities (indeed, management reduced total liabilities by $551 million over the year and is planning to sell asset according to Barron's.) The pre-tax cash flow will allow the company to  compete better as well.

Plus the operating data improved over the past decade. FTR now has more customers in both the consumer and the business segments. For example it had no broadband or video subscribers ten years ago and now reports on 4.7 million broadband and video subscribers. In addition, the churn rate, the annual percentage rate at which customers stop subscribing to a service, is at normal levels.

FTR's Growth in customer base over the past decade


So FTR still meets the cheap, distressed criteria of a stock that trades at less than 50% of the net asset value and of less than 10 times the adjusted earnings per share. The reported book value per share today is $18 and the adjusted pre-tax cash flow is $7.  

***
My brother asked if I had a stop loss in place. Stop loss means that if a stock drops below a certain price, say a drop by 40%, then it is automatically sold to prevent the investor from future losses.

No, I said. Investors, especially investors who target distressed companies, expect - and should be ready - to see much volatility in market prices of their  holdings. May the case of FTR serve as a case in point a year from today.

Bury your head in the sand

Published on:
May 4, 2019
Last Update:

"We face danger whenever information growth outpaces our understanding of how to process it," wrote Nate Silver in The Signal and the Noise. "The last forty years of human history demonstrate that it can still take a long time to translate information into useful knowledge and that if we are not careful, we may take a step back in the meantime."

Indeed, I had taken a step back this week and wanted to bury my head in the sand. This was the result of the movements in my stock portfolio.

I was overwhelmed with information. Companies reported annual earnings this week - which set an immediate price reaction by Mr. Market. Frontier Communication, my largest position, and one that represents almost 10% of my stock portfolio, reported higher-than-expected revenue which translated to a $4,000 increase in unrecognized market gain. Mr. Market also welcomed news from management of Stericyle, a position I began in January, which described began its business transformation. The reported goods news resulted in an increase of $1,500 in recognized market gain.

But the stock of Oprah Winfrey's Weight Watchers (which I bought in January) tumbled by 27%. The 2018 earnings per share of over $3 per share were abnormally high noted management. Management also lowered the 2019 earnings per share forecast to be about a dollar per share. Management reported on a gloomy outlook (some would say realistic) given "competitive pressures." and the market was infuriated. The dreary news resulted in $4,000 unrecognized market loss.

Management of Victoria’s Secret, a position I started last year, reported to shareholders that it will close 53 Victoria's Secret stores this year. L Brands stock fell by 10% shortly after, to $25 from $28, a $2,000 unrecognized market loss for me.

The unrealized market gains were offset by unrealized market losses. But I was not dispassionate about the whole thing. On days my portfolio value was elevated by 30% gains, I felt great. I happily talked to everyone and even showed a somewhat, jovial stride.

Yet on days my portfolio was is down 30%, I shut the my offie's door. And instead of walking outside, admiring the beauty of San Diego weather, I made repeated trips to the break room to fill with coffee my empty cup. The emotional toll from market fluctuations was real and unpleasant.

The vagaries of Mr. Market

The emotional toll has a real emotional toll but hardly anyone in finance or in business talks about it. In The Psychological Price of Entrepreneurship, Jessica Bruder writes of "entrepreneurs who have begun speaking out about their internal struggles in an attempt to combat the stigma of depression and anxiety that makes it hard for sufferers to seek help."  

Yet Wall Street has not caught up with Silicon Valley. On Wall Street, you don't talk about emotions. "And if you do," said a Wall Street veteran who asked to remain anonymous, "It's a sign of weakness."

Over the weekend, after markets had closed, I realized how idiotic my behavior was. To track daily or even weekly the market value of my stock portfolio was sill. I had no plans to sell stocks so what investors were willing to buy the stocks for was meaningless. I manage my own money and no investors I need to report to on the portfolio value. And I never buy stocks on margin so there was no risk of a margin call.

Calling Charles Schwab

A few years ago I read in a book by Nassim Taleb that if I was to daily check the price movement of the stock portfolio, by the nature of statistics, the amount of losses would be greater than the gains.

In Fooled by Randomness, he wrote:

"A minute by minute examination of a portfolio means that each day you will have 21 pleasurable minutes against 239 unpleasurable minutes, amounting to 60,688 and 60,271, respectively, per year." 

Yet knowing that something is harmful and doing something about it is not the same. Hence, my solution going forward is to call Charles Schwab for market orders.

The problem with trading over the Internet is that it forces you to log into your brokerage account. That in turn forces you to see the price movement of your stock portfolio. And if that's not enough, all brokerage platforms add a visual cue. Just in case you don't remember what was your cost basis, they color the gains in shiny green and losses in bright red.

***  
In Jewish philosophy it is said that where penitents stand, even the wholly righteous do not stand. I bring this sentence of wisdom as a means of an excuse. I knew that watching price movements was wrong. Great investors, from Warren Buffett and Guy Spier to Nassim Taleb, commented on this issue in the past. But I had to feel for myself the emotional distress in the present to finally do something about it. Sometimes, lessons are learned only by experience.

When on a shopping spree

Published on:
April 28, 2019
Last Update:

Where to look for stock ideas? In this week's essay, I describe the four places I visit most often.

13-F filings  

Investors who manage over $100 million in the U.S. report to the U.S. Securities and Exchange Commission (SEC) on their trading activity every quarter. The 13-F form includes the name of the companies bought and sold and the number of shares the fund owned as of the the filing date.

While this information - the trading activities of investors - is not a call to blindly follow their steps, it serves as an idea generation tool. A starting point to look at the kind of stocks knowledgeable investors are buying and the industries in which they are looking at. It is also an intellectual activity to think what drove them to buy a specific stock in the first place.

Most of the time I can't figure it out. The price may seem too high or the company debt position may be too aggressive. But occasionally there are investable ideas. Seritage Growth Properties, a stock I bought in April of last year is one recent example. I had never heard of Seritage prior to reading that Fairholme Funds, a concentrated, value-oriented fund headed by Bruce Berkowitz, had bought the stock. Later on, I learned that Warren Buffett was an investor, too.  

Annual reports to shareholders


Voltaire once said that the secret to being a bore is to tell everything. But today, with social media websites such as Instagram, with best selling books titled Radical Transparency, the appeal of secrecy faded away. Yours truly, who you will not find tweeting or scrolling, has no other option but to embrace this culture. The detailed annual reports to shareholders of funds managers are a good outcome of the transparency trend.    

A few of these fund managers share enough information so that the reader can under their decision-making process. If 13-F filings allow us the see numbers (how many shares were bought), the annual reports to shareholders explain the rationale. I find the latter both very educational and very important.

Two examples. First, I recently bought the stock of Superior Industries International (SUP)  because I noticed that six months prior, Mario Gabelli, the legendary value, paid a price that was twice as high.

I also bought the stock of Stericycle link in January of this year because of Laura O'Dell’s (of Diamond Hill) description of the strong franchise and business model link.

Screeners  

With about 109,000 publicly traded companies worldwide and about 3,700 in the U.S. alone, stock screeners narrow the list of investable stocks. I filter out companies with market capitalization less than $100 million and greater than $2 billion. I filter out any company trading at above 10 times the earnings per share and any stock that shows a big increase in outstanding shares, which I define as over 10% compounded annually over a five-year period.

I look at three screeners each week. The first screen is for companies trading at the 52-week low. Famous Dave is a stock I found as a result of this list. Its market price was $4 when I bought it and for no apparent reason jumped to $7 in less than six months.

The second screen looks at stocks trading at discount to reported book value of at least 20%. Like the first screen, this list often returns companies in too much distress or industries which I cannot understand (read: any industry that ends with a "techs": biotech, fintech and hitech), but once in a while a jewel appears. A fond memory was Regal Entertainment. I bought the stock at 45% discount to book value and sold the position at par nine months after.  

The third screen is the experimental one. One week I may look for companies trading at high pre-tax earnings to reported assets. In a different week, I may focus on companies with management that is buying back the common stock. And in another week, I may look for companies with a negative equity balance which sometimes arises due to accounting rules and not losses per se. Read the excellent The Manual of Ideas If you are looking for further stock screen ideas.

Miscellaneous

I also like to keep a certain sense of wonder. I am not fixated on a specific way of finding stocks. Instead I leave room for ideas to come to subconscious or unplanned sources. As Blaise Pascal once said, "The heart has its reasons, which reason knows nothing of."

My purchase of Tupperware serves as illustration. In 24 hours, three things happened: first, my best friend's mom, a Tupperware fanatic, called me out of the blue and asked how I was doing. Second, I was reading Guy Spier's The Education of Value Investor  where he uses Tupperware as an example. Third, I lost two of my Rubbermaid lunch boxes and was in the market for a Tupperware myself.

Not as mystical but certainly unusual, I like to research the stock of companies that fall off a widely known index. In the third quarter of 2018, when it was announced that GE was no longer part of the Dow Jones, I read its annual report for the first time (but decided against buying shares - the business is too complicated for me.) But I felt I can reasonably understand the business of Patterson Companies, a $2.0 billion in market capitalization company that fell from the S&P 500 in the first quarter of 2018. I bought Patterson's stock two months after.

So there you have it - four places I visit every week to find bargain stocks. Unfortunately, not unlike your everything-for-99-cents retail store, the stocks offered are often no bargain at all.

No Pain No Gain?

Published on:
February 23, 2019
Last Update:

Frontier Communications

I bought the stock of Frontier in March of last year. In that article, I smugly wrote that, "sometimes, all we really need is one good investment idea."

But a year passed and I am not as confident. When I bought the stock, Frontier's valuation was low, I thought, compared to prior years. But I did not study the telecommunication industry enough to understand what an appropriate valuation would be.

I own 8,000 shares in Frontier and my cost basis is about $5 per share. The stock now trades at $2.55, which results in a 50% loss in market value or $20,000.

Orchid Paper Company

When I bought the stock of Orchid I overlooked important information. One example is that Orchid had only four customers. More so, Benjamin Graham would find it disgraceful that I utterly ignored the right side of Orchid’s balance sheet.

I did learn about securities lending by investing in Orchid. A few months after I had purchased the stock, a Charles Schwab representative called and inquired whether I would lend my Orchid shares to short sellers at a rate of over 52%. Sure, I replied, and you can read about it in “The Time Charles Schwab Asked for a Loan From Me”.

I own 10,000 shares in Orchid; my cost basis is about $3 and the stock trades at $1, an $18,000 paper loss and almost a 40% loss in market value.  

Lifeway Food

Lifeway's management is highly invested in the company, the company carries little debt obligations, generates ample after-tax cash flow and I consume their product on a weekly basis.

In August of last year I described the normalized earnings for the business - my opinion of the company did not change.

I own 10,000 shares in Lifeway, which I bought for $3 a share; the stock trades for $2.36, a $6,300 or 21% paper loss.

Tupperware Brands  

I learned about Tupperware from Guy Spier who described his purchase of the company in The Education of a Value Investor. But what Spier hated about Tupperware when the stock traded at $45, I did not mind as much as when it was trading at $36.

So, I bought 600 shares in August of last year and comically wrote to Tupperware's management about its ill use of leverage.

My cost basis is $36 and the stock trades at $31, a 14% paper loss or $3,024.  

Diversified Restaurant

I bought 17,000 shares of Diversified at a cost of $1.25. I estimated the value of the stock to be roughly $2 per share. In A Senseless Market Capitalization I explained my investment thesis; mainly, that the cost of buying shares in SAUC was much less than developing similar restaurants. And that I was confident that Paul Brown, who had revamped Arby's, is an excellent manager. The stock price is $0.93 which results in a paper loss of $4,446 and the stock is down 25% from my cost basis.  

L Brands

Not the lure of attractive women walking down an aisle while wearing laundry convinced me of buying shares in the L Brands - it was the accounting profession. In September of last year,  I wrote about the deficit in the equity account that was related to the company buying its own shares.

I had bought 1,000 shares, at $30 per share, and the stock trades for $27, a paper loss of $2,921 or 10% per share.  

The remaining companies

I have a paper gain on the remaining 6 stocks. I will write more on each stock when I sell them. Purchased in May of last year, Patterson Companies, which I wrote about in One Advantage of Short Term Thinking? A Cheap Stock Price is worth slightly more than when I bought it.

Stericycle, which I bought last month, is trading at roughly the same price and so is the common stock of Voxx International, which I wrote about in January of this year

I purchased in that month, too, the stock of Carriage Services which is up 19% and so is the stock of Seritage Growth Properties, which is up 10% and ARC Documents Solutions, which is up 15%.

It is not by accident that I write about my paper loss and hardly mention the stocks with a paper gain. The reason for the disproportionate attention is that there is nothing to be learned when a stock is purchased less than year ago and is now randomly trading at a higher price. To hold such positions does not take any mental energy.

But that it is different when positions are trading at 50% - and even 60% - below the cost basis. Such paper loss forces me to reflect on why I had bought the stock in the first place; to observe why the stock market is bearish on the future of the company, and to assess whether I was wrong in buying the shares in the first place. 

Most of all: a paper loss requires the attributes of patience and conviction. The last two are not easily attained.