There is no better time to reflect on portfolio holdings than today . This week's essay is about the three questions you should ask as you spring clean.
The first question is whether the business will survive for the next few years. The second question is whether the company generates free cash flow. And how essential is the business is the third question. To illustrate the concepts, I will use examples from my portfolio.
It is going to be challenging to refinance debt and to raise equity. And any business that relies on capital markets to fund its on-going business operations is going to face a large number of rejections.
A friend of mine, a founder of a start-up company, told me she is now spending the bulk of her time in understanding (1) how long can her business run until cash reserves are depleted, and (2) what can she do today to better prepare for that day.
The same mindset is applicable to portfolio holdings. If you own a company that has a sizeable maturing debt over the next year or two, you should reflect on how likely will it be able to refinance the mortgage, at what terms, and how it will affect operations.
Here is a summary of what I learned about some of the stocks I bought in 2019:
Graftech reports $1,812 million in long term debt. And on page 80 of the 2019 annual report, you can read that the debt facility will mature on February 12, 2025. In other words, Graftech has five years of breathing room.
Teva Pharmaceutical reports on $24,562 million of long term debt. The company will have to pay down $5,263 million, an average of $1,023 million each year until 2025. But I don't foresee that an issue as the company has $1,975 million in cash on hand and $5,676 million in receivables.
Micron reports on long term debt of $4,541 million and holds $7,152 million in cash and $3,195 in receivables. And on page 58 of the 2019 annual report, we read that most of Micron's debt is due after 2025.
Two companies that will face challenging times ahead are Seritage Growth and Gulfport Energy. Seritage Growth Properties reports on $1,598 million in fixed debt with Berkshire Hathaway Life Insurance as the lender. The loan matures July 31, 2023. Gulfport energy reports on $1,978 million in long term debt. Where $329 million in due 2023 and $603 million is due in 2024, and $529 million is due in 2025.
In the case of Gulport, current cash and receivables will not cover the pending debt obligations. So either Gulfport will sell assets (it reports on $10,595 million of oil and natural gas properties), or somehow it will manage to refinance the debt miraculously.
Investors usually accept negative free cash flow when the business promises growth. But future growth always comes with a present cost: either the right side of the balance sheet increases or current shareholders will be diluted.
Consider Ormat Tech (Ora on Nyse) as an example. The Israeli-based, geothermal company reported negative cash flows between 2015 and 2019 . So, the company issued more debt and diluted shareholders. (Long term debt in 2015 was $856 million and increased to $1,035 in 2019. Common shares were 49 million in 2015 and went up to 51 million in 2019.)
Yet positive, free cash flow is one of the most useful antidotes to keep a healthy balance sheet. Positive cash flow allows management to remain independent of capital market woes and fury and to grow the business without niceties to lenders.
There are two ways to find free cash flow. The CFA Institute defines free cash flow  as net income plus non-cash charges plus interest minus capital expenditures minus working capital expenditures
Another approach is to use cash flows from operations. To find the free cash flow, you take the cash flow from operations, add back interest less capital expenditures.
Consider Whirpool as an example. On page 37 of its 2019 annual report to shareholders, management reports on $1,230 in cash provided by operating activities less $532 in capital expenditures. It reports on $912 million in free cash flow
If you can't reasonably estimate today where the business will be in ten years, you shouldn't invest in it. The 10-year outlook is important because of two reasons, a pragmatic one and a psychological one.
The pragmatic reason is that if you can't estimate the business outlook, you can't estimate the earnings. And if you can't estimate the earnings, how could you determine the value of the business?
The second reason is psychological. When capital markets freeze, when investors are selling, and the quoted price of your stocks drops, understanding the future of the business will allow you to better weather the storm. A few examples will explain this statement.
I bought Carriage Services in January 2019 for about $20. The stock went up to $28 by year-end 2019 and now trades at $15, a 46% drop from the peak, and a 25% discount from my cost basis. But instead of selling the position, I remind myself that the business outlook for Carriage, who is a funeral home company, is invariably the same. Just because markets are discounting the business does not mean the business fundamentals deteriorated.
Another example is Teva Pharmaceutical. Two months ago, I explained Teva's tailwinds:
"Other trends in global healthcare include an aging population, chronic diseases, and growing pressures from governments to provide affordable healthcare solutions."
I don't believe the tailwinds changed.
But I have made mistakes by overlooking the 10-year outlook criteria. For example, I bought Weight Watchers in March of last year. I didn't have the slightest idea then, and I don't know how the business will look like in a decade from today. This business falls in the "too complicated" bucket.
Another mistake I made was buying L Brands in late 2018. In hindsight, there is no way to predict our clothing preferences in a decade (let alone next season.) Not only is it difficult to correctly predict what color will be fashionable next season.
Last week I visited the headquarters of a local real estate company that owns, manages, and develops apartment buildings. The company, which shall remain anonymous, operates about 70 apartment buildings in the western part of the United States. It has over 400 employees, and in the past year, it bought over a billion dollars in real estate.
The founder's focus in the early days was to buy distressed properties from banks. And from that humble beginning in the 1990s, with grit and tenacity, he grew the company to be one of the most respected apartment operators in California.
This essay is inspired by my conversation with him. Where I learned how much business has to teach us.
A good business does not make for a good investment necessarily. Last week, I attended a webinar where one of the speakers explained that Coca Cola is a "compounder stock." By that, he meant that whether you bought the stock in the 1980s, the 1990s, or in the current decade, you would get a good return.
Really? As a careful student of finance, I looked at what Coca Cola was trading for between 1997 and 1999. It was easy to see that you would have to wait for about a decade until you saw the price of the stock return to your cost basis. I don't know many investors who have that kind of patience.
Consider Salesforce.com (CRM on Nyse). At $163 per share, this cloud-based software company is trading at over 90 times the earnings. And a quick review of their website tells you why investors willing to pay the hefty multiple. Salesforce focuses on software design, big data analysis, and artificial intelligence. Choose any path for a career, and you likely do well.
The inverse logic works just as well. You should probably avoid low p/e industries. For example, both Noble Energy (NBL on Nasdaq) and Murphy Oil Corporation (MUR on Nyse) are trading at less than five times the trailing earnings. (So, why bother with a profession when you know you will compete on positions with experienced candidates?)
Consider Nvidia Corporation (NVDA on Nasdaq) as an illustration of the nonlinearity concept. Between 1999 and 2016, investors in Nvidia saw a rate of return of about 8% . But investors who bought Nvidia in 2016 saw a rate of return of 52%, a fourfold increase. (Nvidia now trades at $238.)
Similarly, life is not linear. There are times when we feel stuck and lack vision for the future. And at such times, going over the historical record of companies such as Nvidia, which shows an overnight success (that took the company to achieve over a long period) I find to be to alleviate the mood.
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In Brave Companions, the historian David McCullough tells that the time former president Teddy Roosevelt spent in Medora, a little town in the Badlands of North Dakota, had a profound effect on the former president's life. Similarly, I believe that just one or two stocks will have a profound effect on your life.
Take Amazon, for example. If you bought $10,000 worth of shares a decade ago, the value of the position would today be 33 times higher, $330,000. If you had placed the same amount of money 20 years ago, you would earn 100 times your money. The value of your Amazon position would be a million dollars.
By studying the stock market, you read and experience fear, greed, euphoria, , and times of immediate and unexpected duress .
Not only will you learn about the psychology of other investors, but you will also better understand your psyche.
My parents visit Paris each year and marvel at the ingenuity of the Impressionist era. And how can we not marvel at the wonders of business.
Want to study the art of business? Just read about the annual report by MasterCard, Maotai, Markel Insurance, and Moody's.
Many find inspiration in the words of Shakespeare and Henry James. And to me, annual reports can be a form of literature. I love reading annual reports by Carriage Services (which I bought last year), Jamie Dimon at JP Morgan, and Warren Buffett at Berkshire Hathaway.
Stock research is also an opportunity to explore the world. A friend of mine looks for companies outside the United States that share a similar business model to successful, U.S-based companies. So, for example, she will look for Indian-equivalent Moody's. Or the South-Korean equivalent of a stock exchange such as the New York Stock exchange.
Last month I bought a few shares in Micron (I will publish the investment idea in the upcoming weeks (write to me if you would like to be notified when I post the investment idea). And I quickly realized that geopolitical tensions resulted in a 10% loss in revenue.
Where the business will be in ten years is one of the first questions I ask before buying a business. For example, it is reasonable to assume that in ten years, we will keep chewing gum (say, Wrigley's) and that we will drink soup in the winter (say, Campbell's). So it is reasonable to project ten-year cash flow and to compare the net present value to the current price. But who can predict where our payment system will be in ten years?
So when you buy a stock with a long term outlook, you tend to ignore daily market movements. And thinking over the long term requires you to focus on the business fundamentals, whether management is capable and invested in the business. And whether the industry is growing. In short, the stock market also teaches us to focus on what matters.
Carriage Services (CSV on Nyse), Stericycle (SRCL on Nasdaq), WW International (WW on Nasdaq), and Hyster-Yale (HY on Nyse) are the winner stocks this year.
CSV is up 55%; SRCL is up 51%; WW is up 33%; and HY is up 41%; Together, they contributed third quarters of this year's return.
The high returns on Carriage and Stericycle are because of the low prices I paid for both companies in the first quarter of this year, and not because of a material change in business fundamentals.
I can't remember where I got the Carriage idea. But I do remember reading about Stericycle from Laura O'Dell, CFA of Diamond-Hill.
Download O'Dell's report titled Stericycle: Waste Not, Want Not.
Buying Hyster-Yal was a bet that the geopolitical and trade wars will wane away at some point. And that Mr. Market confused risk with uncertainty.
When I bought HY in May, the stock traded at what is now the 52-week low, about $45 per share. I published an essay on Hyster-Yale in September. (If you are interested in getting live updates on my stock activities, write to me.)
Oprah Winfrey's Weight Watchers traded $30 a share when I wrote about it. And in less than 48 hours after I bought the stock, because of a gloomy earnings call, WW dropped by a third in price.
But in August, WW bounced back to $30 a share and now trades at $39. Weight Watchers has a recognized brand with sophisticated, deep-pocket investors. But WW is not a compounder stock or a long-term hold - I hope to sell the position soon.
The three worst-performing stocks, which I define as stocks that experienced a price dropped over a third, were Superior Industries (SUP on Nyse), Gulfport Energy (GPOR on Nasdaq), and Beasley Broadcast Group (BBGI on Nasdaq).
I bought Superior at almost $6 a share in May, and SUP now trades at $3 a share. I first hear about SUP from the legendary investor, Mario Gabelli, of GAM Investments. Even the price halved, I like Superior's business model and believe that SUP offers a dollar of value for 50 cents.
I will write a full-length report on Superior in the upcoming months (Write to me if you would like to know when the article is published.)
Gulfport is another stock that halved in price. After reading the company's recent public filings, which will leave you in state of gloominess, I decided to buy a few GPOR shares only because I thought Firefly Value Investors, an active investor and hedge fund that specializes in a turnaround situation, may revive operations. Read more about Firefly on the SEC's website.
A contrarian position I took was buying BBGI. At $4 a share, I thought it was a Benjamin-Graham-bargain-stock. The Beasley family owns BBGI for the most part. And the family had done a reasonable job in capital allocation decisions over the past years.
But I don't see a heroic future for the stock and will likely sell the position in 2020. I have little interest in following the economy of radio stations - especially as the industry continues to experience headwinds.
I should have followed Charlie Munger's who said that "one of the lessons management has learned - and unfortunately, sometimes relearns - is the importance of being in businesses where tailwinds prevail rather than headwinds."
In short, the three companies, which in total represent 10% of my portfolio, fit in the contrarian, cheap buckets. While I don't expect a particular wondrous future for these positions, the stocks were cheap, and so I bought a few shares. In total, the three companies detracted 35% percent from the annual return.
The first company is GrafTech (EAF on Nyse.), which I bought a month ago. The second company is Mednax (MD on Nyse.), which I purchased in April 2019. I believe that over the next three- to five years, these two companies will have a more meaningful role in the portfolio than all the of all other stocks combined.
Both Mednax and GrafTech had little effect on the portfolio results this year. But they have more value of all portfolio companies.
In April, I published an introductory article on Mednax, and last week I wrote a summary about GrafTech. In my view, Mednax has a CEO that is a great capital allocator, and GrafTech has a unique position in the market place; It is a low-cost producer of needle coke, which I estimate will increase in price - and in demand - over the upcoming years.
I was more active in the stock market this year than I would have liked. On Average, I placed small bets (less than 2% of the portfolio size) each month and traded 16 times. GrafTech was an exception. This position now represents about 15% of my portfolio.
To fund the purchases, I exited from 8 companies, for a slight gain.
In two cases, I bought and sold the position within a few months . The two companies were Signet Jewelry (SIG on Nyse) and Flexsteel Industries (FLXS on Nasdaq). The net realized gain from activity was negligible.
I overpaid in both circumstances. And there were too many abrupt changes in the industries. In jewelry industry: the lure of diamonds is waning down. And who knows how will we shop for furniture in the future.
To further summarize the performance in numbers, in 2019, my total return was 8%, which included 5% in capital appreciation and a 4% in dividend and interest received. My portfolio now has 16 names, with the largest position being GrafTech.
Finally, let the digital record show that my goal in 2020 is to own a much more concentrated portfolio: with no more than ten companies by year-end.
The first part of this essay is a description of GrafTech (EAF on Nyse), a manufacturer of graphite electrodes and petroleum coke. As much as possible, I keep this part objective, stating facts and not my opinions. But the second part is subjective. Here I give reasons why I bought GrafTech's common stock.
You can tell that GrafTech is manufacturing something (more on that 'something' below) just by glancing at the property, plant, and equipment account (PP&E).
PP&E of $689 million represents about a third of the balance sheet. It is $67 million in the value of buildings, $46 million in land, and $532 million in machinery. The PP&E hints at us that GrafTech makes stuff.
Specifically the company makes graphite electrodes which are a small-but-integral part of the steel manufacturing process. In GrafTech's words:
"Graphite electrodes are an industrial consumable product used primarily in EAF steel production, one of the two primary methods of steel production"
Here is how Brookfield (an asset manager that acquired GrafTech in 2015) describes graphite electrodes:
"Graphite electrodes are 10 to 12 inches in diameter and can be up to nine feet long. They can take up to six months to manufacture, in a multistage process that requires significant technical skill and raw material known as petroleum needle coke. GrafTech is the only graphite electrode produce able to produce its needle coke, a significant competitive advantage."
GrafTech's five plants are in Mexico,Pennsylvania , Texas, Brazil, France, and Spain. The company's headquarters are in Brooklyn Heights, Ohio. It also leases five locations, mainly for sales.
While GrafTech does not itemize the depreciation expense in the income statement, it is worthwhile data to go over. In total, depreciation expense was $131 million over the past three years.
Between 2018 and 2015, the total capital expenditures were $131 million, too. So if you belong to the group of investors that follows the magic formula investing , you would be pleased to see in GrafTech a business that requires little capital improvements.
The table above shows that GrafTech had a dramatic revenue increase in 2018, largely the result of the graphite electrodes price hikes. (Also, bottom line benefited from some operational efficiencies.)
The weighted realized price for graphite electrodes was $9,937 in 2018 compared to $2,945 in 2017. The company produced 185 million tons of it in 2018 compared to 172 million in 2017.
Over the past three quarters of 2019, GrafTech showed high operating margins. The average realized price for electrode graphite was $9,976; the average operating margin was 56%, with an average net income margin of 41%.
I estimate the company will report in 2019 an annual revenue of $1,800 million in revenue and earnings of $767 million, roughly $2.5 to $3.0 per share.
"Change is the law of life," former U.S. President John F. Kennedy once said. "And those look only to the past or present are certain to miss the future." Returning to GrafTech, let's focus on future earnings.
On page 45 of GrafTech's annual report which you can download here, GrafTech shows future contracts of 674,000 million ton of graphite electodes at about $10,000 per MT. These contracts represent about 65% of the planned capacity. GrafTech writes:
"We have executed three- to five- year take-or-pay contract, representing approximately 674,000 MT, or approximately 60% to 65% of our cumulative expected production capacity from 2018 through 2022. Approximately 90% of the contracted volumes have terms extending to 2022.
These expected earnings will determine GrafTech's future value. And these expected earnings are dependent on (1) the growth in the graphite electrodes industry, (2) the price of graphite electrodes, (3) the production capacity, (4) competition from BOF manufacturing (more on that below), and (5) the cost to produce the product.
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There are two ways to make steel, the electric arc furance (EAF) method and basic oxygen furnace (BOF) method.
Visually, this is how EAF looks like:
And this is how BOF looks like this:
"In the EAF method, steel scrap is melted and recycled to produce liquid steel, while in the BOF method, virgin iron ore is smelted with metallurgical coke, a carbon product derived from metallurgical coal."
GrafTech is a low-cost producer. In my view, it costs the company about one-fourth to produce the graphite electrodes compared to its peers. To be a low cost producer is good, it is even better in a tight marketplace, where the top five electrode graphite companies  of the world hold over 80% of total production.
GrafTech is the only vertically integrated electrode manufacturer. Vertically integrated means that they control the price of needle coke, the main ingredient behind graphite electrodes. GrafTech writes on page 10 of the 2018 annual report:
"Seadrift [the needle coke manufacturer] provides a substantial portion of our petroleum needle coke supply needs internally and at a competitive cost and allows us to maximize capacity utilization more efficiently than
competitors, who may be more constrained by petroleum needle coke supply."
There are direct and indirect competitors. The direct competition  are four companies that compete with GrafTech . With these companies, GrafTech competes in production capacity, the price of the product, and the cost to produce the product.
The indirect competition to GrafTech is BOF steelmaking. While the difference between the steel manufacturing method is only exciting to students of mechanical engineering, for this essay suffice to note that if BOF manufacturing decreases, then EAF manufacturing increases. And if EAF manufacturing increases, GrafTech benefits.
That, at least, has been the historical case. According to the steel statistical yearbook, produced by the World Steel Association, Between 1984 and 2011, EAF steelmaking was growing at 3.5% per year.
But this trend was reversed between 2011 and 2015 because of an increase in blast furnace (BOF) steel production that for the most part came from China.
(Write to me if you would like a detailed description of the dynamics in the steel industry.)
Value Line ranks the steel industry in 91 of 97 possible ranks. ( Why I read Value Line reports.) According to Value Line, you can't find any worse businesses to invest in over the next few years.
Here is how much you would have lost if you bought five years ago any of the following steel companies:
AK Steel Holdings loss was 69%; Posco loss was 42%; Timmenksteel loss 83%; and U.S. Steel loss was 53%. In short, if you want to spot a liar, ask someone at a party if they made money on steel stocks over the past few years.
"The main question is the long-term outlook for the company," writes Sven Carlin. "As the main product is steel, electrode prices will depend on steel prices and demand for it, especially for EAF steelmaking."
Because of the reported declines in both revenue and earnings by practically all publicly traded steel companies, the outlook for the steel industry is gloomy. Paraphrasing Howard Marks , there is too much steel chasing too few manufacturers.
At a market capitalization of about $3,500 million, GrafTech is trading a multiple of one. As I wrote in the first section of this essay, I estimate GrafTech will report to shareholders of $1,800 in revenue and of $767 million in earnings for 2019.
And since GrafTech sold 674,000 million tons at $9,937 per MT, we can estimate total revenue of $6,700 million and earnings of $2,814 million by 2022. Adding $767 million and $2,814 million, we find $3,851 million in profits by 2022.
A p/e of one for a company whose 2018 operating margin was 49% and net profit margin was 45% seemed nonsensical to me.
Careful readers of GrafTech's annual report will see that between 2008 and 2017, the price for electrodes graphite was $4,500, and during the worse year (2016), the price was $2,500 per MT.
At about $10,000 per million ton, GrafTech's operating margins are high. But the operating margins are reasonable at $5,000 per MT, too.
There are also reasons to believe of growth. The first reason is that China will export less steel in upcoming years. In 2019, for example, it exported between 4 to 6 million tons of steel per month. But in 2015, in comparison, China exported about twice as much, between 6 to 10 million tons of steel per month.
There are two other factors, which I cannot estimate their effect numerically. The first factor is the price of needle coke may jump in the near term as a result of the growth in electric vehicles (EV) sales .
And the growth in the EV industry is clear. Five years ago lithium-ion batteries production was 1,00 million tons. And last time I checked it was 60 times as much, about 60,000 million ton.
A reminder for readers: my goal in writing is to share thoughts. None that was said above should be construed as investment advice.
Also, this essay is incomplete; there are many important topics I left out. Among them: GrafTech's management and compensation structure, why Brookfield purchased GrafTech, a detailed analysis of the risks ahead, a peer-company review, and a valuation analysis.
More on that in future essays.