The value of simplicity

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Analysing value stocks requires a deep understanding of the underlying assets. In their responses, Nathan Bell from Peters MacGregor, Alex Shevelev from Forager Funds, and Matthew Booker from Spheria Asset Management explain the importance of simplicity and a deep understanding, and share a value stock that ticks the boxes.

Understanding the value-drivers

Alex Shevelev, Forager Funds

Getting the drivers right can mean the difference between a very profitable investment and a complete write-off. The first step when assessing any potential idea is to understand the business. Deeply. How does the company generate revenue? How does it interact with competitors, suppliers and staff? Is the industry fragmented or concentrated? Is the firm able to set prices, or is it a price taker?

If you can understand those factors the key drivers will become clear.

A good example is Matrix Composites & Engineering (MCE). The company is a supplier to the oil services industry so an obvious driver might be the oil price. But the oil price could rise 50% tomorrow and it won’t have much impact on Matrix, yet.

That is because most of its sales are to customers building new rigs and vessels for the offshore oil and gas industry, and their equipment is almost the last thing to be attached to a new rig. It is rig newbuilds that are the real driver for Matrix’s business, and we won’t be seeing many of those for quite a while yet.

Downside protection with a whole lot of upside

Optionality is useful. It gives you the potential for a great outcome. Value and optionality often go hand in hand: looking at value stocks for optionality will mean getting it on the cheap.

Matrix Composites and Engineering (MCE) is firmly in value territory and has plenty of optionality.

On traditional value metrics such as price to book, it stacks up reasonably well. Tangible net assets, mostly made up of buildings and equipment, represents $1.06 per share. They might deserve a discount, but we have some margin of safety here: the net cash equates to $0.15 per share. Matrix is currently trading at $0.50.

But when will we actually get some earnings off these assets? It might not be for a while. One source of optionality is higher oil prices increasing demand for their buoyancy products. Another is the set of new products using existing equipment. At current prices, Matrix offers some downside protection and a whole lot of potential upside.

The crayon principal

Nathan Bell, Peters MacGregor

Peter Lynch once wrote that you should ‘never invest in any idea you can't illustrate with a crayon.’ The genius behind this statement is that you should never invest in a business that you don’t understand, but also that before you can explain something as complicated as an investment idea you need to understand it very well. That said, in my experience, it’s always the simplest ideas that turn out best.

There’s no substitute for the basics when it comes to understanding how a business adds value. Analyse the company’s website, which usually tells you loud and clear how the company thinks it adds value for customers. Annual reports and presentations are also important, as much for what they don’t tell you as what they do tell you.

Understanding how customers perceive the value of the company’s services and products is essential, as you need to figure out whether a company can raise prices over time or not. If it can’t, the risks are that much higher, and you’re more reliant on rosy outcomes to make money. Studying the competition is also therefore very important.

A high-growth company at low-growth prices

A common metric used to compare the value of a telecommunications company or broadband provider is the Enterprise Value to EBIT (earnings before interest and tax) multiple.

Typically, a slow-growing telecommunications company might trade around a multiple of five or six, depending on how fast it’s growing, its market share and its technology.

In contrast, a high growth broadband provider might trade on a multiple of 10 or more, sometimes much more. Again, it depends on how fast earnings are growing, and the strength and size of the company’s network and subscriber base.

Broadband provider Liberty Latin America’s (NASDAQ: LiLA.K) multiple is currently around seven, as it’s a spin-off that’s produced lousy operating performance recently. However, it holds number one or two market positions in fast-growing nations where broadband usage is often half what it is in developed countries, has numerous acquisition opportunities and is run by one of the most successful businessmen ever in John Malone. In short, this business shares little in common with a low growth telecommunications company despite being priced like one.

Market perceptions can change dramatically

Matt Booker, Spheria Asset Management 

The most important driver of value for a business is its expected free cash flow and the price you pay for those cash flows. We try to keep it simple whilst many market participants make it much harder than it should be. Anyone who has their own business knows free cash flow after all capital expenditures is all that matters. EBITDA or any other acronym relating to profit is meaningless unless you are selling your business.

Given our two-fold focus on free cash flow generation and buying at a price below the present value of those future free cash flow, we are often buying companies that are substantially out of favour but where risks are asymmetrically skewed to the upside.

Recently we have taken a position in Prime Media (PRT) which is Channel 7’s regional affiliate. It is trading on less than 4x free cash flow and has very little debt. Essentially, we are talking about a 4-year payback. Yes, it is facing structural pressures but what industry isn’t? We can’t think of many, but complacency reigns when share prices are going up.

Those buying Domino’s Pizzas at 40x earnings seem to be blithely ignoring the increasing number of competitor delivery motorcycles (e.g. UberEats, Foodora, Deliveroo) that are buzzing around. We are not saying that Domino’s is a bad business (in fact it’s a good business) but at 40x there is little room for error. When we are buying PRT at less than 4x we think the mathematics alone protects our capital investment. Fairfax, a few years ago at sub-40c was suffering a similar “futile” plight and now its trading at nearly $1, thus illustrating how dramatically market perceptions can change.

Shifting perceptions in action

We believe Vita Group (VTG) is still a compelling investment case despite it rallying over 100% from its recent share price low of 79c. When the company was trading at $5 we believe the market was extrapolating >10% EBIT margins when history suggested 4% was a more sustainable level. Having a monopoly supplier in Telstra always warranted caution in our view but now the market is underestimating how important VTG is to Telstra.

VTG is the largest third-party distributor of Telstra mobile phones and operates over 100 stores for them. Telstra is an infrastructure company, it is not good at selling phones, nor can it run these stores as effectively as VTG. This provides a counterbalance to the relationship and the recent improvement and clarity around contractual terms between the parties reinforces this.

Trading at only 5x free cash flow, we believe the valuation discount will unwind particularly as issues with Telstra are now clearly behind it.

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