Surfing the Tsunami
(Guest Commentary by Rick Konrad – September 18, 2008)
Dear Subscribers and Readers,
For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary. Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick will be talking briefly about the current financial crisis/panic, what successful investing entails, as well as offer his thoughts on an unconventional stock pick, John Bean Technologies – a food processor and a provider of goods and services in the air transportation industry. As usual, Rick does not disappoint! Without further ado, following is a biography of Rick:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Lulled into Complacency” for his last guest commentary). Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog. You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
The major financial events of the last couple of weeks are remarkable in the rapid succession that the dominos that have fallen. But financial crises and panics are really as old as capitalism. Speculative mania leads to leverage which leads to panic which leads to de-leverage. In 1928, Charles Merrill advised his clients to “take advantage of present high prices and put your financial house in order.” “Good Time Charlie” as he was known, mostly for his philandering behavior outside the boardroom, had anticipated the 1929 Crash and had pleaded with President Coolidge at the time to speak out against speculation. Coolidge didn't listen. Merrill divested many of his holdings before the Crash. Merrill Lynch survived two world wars, the Depression, numerous presidencies, worse yet, numerous Congresses, yet the Main Street broker managed to survive and thrive. Pity that the firm could not maintain that sort of discipline as it essentially was forced into a shotgun marriage with B of A. Yes, I know it's a takeover or merger but it sure feels like a failure.
What's particularly interesting to me is that Merrill's investment research, its strategists, its economics team all seemed to be among the most bearish on the street. Check out this link:
As Richard Bernstein, chief investment strategist at Merrill Lynch, said in a note that didn't mention his own firm that it's too early to call a bottom. "Whereas many may argue that this weekend's events are the events signaling a bottom to the global financial crisis, we continue to believe that the global financial sector will go through massive consolidation for quite some time. Simply put, there is too much capacity in the financial sector, and that capacity must shrink," he said.
Current management, and the despised former management continued to roll the bones. The presence of financial services exotica such as CDOs, CDS, and umpteen kinds of derivatives have led to the undoing of the Wall Street model.
Similarly, Dick Fuld of Lehman was touted by Barron's as one of the 30 best CEOs in the world. Fortune magazine in 2006 lauded him as one who transformed Lehman from a Wall Street also-ran to a super hot machine! Assets per share had risen from $475 to $1300 in the period from 2000-2008. Leverage to equity was smoking!
Regrettably, too many assets accumulated quickly with too much confidence and too little regard for risk. Too much debt funded with inappropriate horizons. Wall Street excels as a mover of goods, not a holder of goods. It is set up for the short term as a trader, when inventory hangs out, look out!
As we all know, it has been major league ugly for so many financials. The scorecard is dreadful. From the market peak of August of last year, the drop in market cap is absolutely astounding:
||Peak Market Cap
||Current Market Cap
After a scorecard like that, it is difficult to not have a very jaded opinion about ever owning a financial again. Often our perceptions and hypotheses become our realities, regardless of the facts. This is a tough time to preach patience and to strengthen our resolve, yet that is exactly what we need to do at challenging times like this. Our emotions tend to run amok and we fail to challenge our conclusions on stocks that we own in our portfolios and continue to like, or on stocks that have hurt us and we despise not only the experience, but their industry. Negative events seem to have twice the emotional impact as positive events.
Be pragmatic. Ground your optimism (if in fact anybody out there has any optimism left) in a rational assessment of what a business is worth. Also ground your negativity in rational reasoning as well. In this way, you will at least have enough confidence to look for opportunities rather than let them slide by.
Chuck Brandes, a major league highly successful value investor has an analogy of investors being on a bus. As we travel toward our investment goals, fellow passengers yell out directions or urge us to turn around. A rational value investor will stay in the driver's seat. He is aware of the behavioral tendencies to do the wrong thing. He hears the yelling, the screaming and the cajoling, but need not act on them.
Years ago, John Maynard Keynes described that, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” Many years later, the great investor of Yale's Endowment Fund, David Swensen described in his book, Pioneering Portfolio Management, “Active management strategies demand un-institutional behavior from institutions, creating a paradox that few can unravel. Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.”
Diversification is more than just spreading yourself around. Proper diversification demands exposure to areas where your sense of discomfort and uncertainty is unsettling and scary. These are often the sectors that produce the most returns! Rather than chasing rainbows, seek returns in unusual but solid securities.
Here is an example of such a company: John Bean Technologies.
John Bean serves customers in the food processing and air transportation industries in the United States and internationally. It offers various industrial food processing systems, equipment, and services for the preparation of ready-to-eat meals, shelf stable sterilized packaged foods, meat, seafood and poultry products, juice and dairy products, fruit and vegetables, and bakery products. Its air transportation industry products and services comprise ground support equipment, airport gate equipment, and facility maintenance services. The company markets its products and services through a direct sales force, independent distributors, and sales representatives. John Bean is based in Chicago and was spun out of FMC Technologies, Inc. in July 2008.
JBT has several of the characteristics we look for in long investments. The company has:
- Technology and market leadership with a good customer base
- A large installed base and a growing base of recurring revenue
- A track record of profitable growth
- A global footprint
- Highly capable owner/managers with significant industry experience
JBT derives 61% of revenues and 63% of EBIT from its FoodTech division. The company sterilizes more than 50% of the world's shelf stable canned foods, freezes more than 50% of the world's frozen foods, and squeezes more than 75% of the world's citrus juices. In addition to market leading positions, we believe developing markets could provide a significant opportunity for processed food technologies. As incomes increase, dietary components in such markets are highly likely to continue shifting toward prepared/packaged foods. 39% of revenues and 37% EBIT are derived from the AeroTech division, where the company's products are used to load 70% of the world's overnight express packages and board 75% of all US passengers. JBT has the #1 or #2 market position in each of its core product offerings of ground support, gate equipment, military equipment, and airport services. A large installed base on both sides of its business has allowed the company to increase aftermarket revenue, which is recurring in nature, to 21% of total revenue and approximately 50% of total revenue comes from outside the US.
Like many spinoffs, JBT is an orphan security. With no Wall Street research coverage and a significantly smaller market capitalization than its former parent, there is very little institutional interest in the company. Moreover, many people are skeptical about the company's near-term outlook given pressures in the food processing and airline industries. However, it is important to note the relatively large long-term runway for the company's products, particularly on the food processing side.
Working capital management at JBT is nothing short of extraordinary, running at just 10% of revenues compared to mid-teens for most other industrial companies. Likewise, capital requirements of the business are modest at just 2% sales. Combined, this means that free cash flow typically exceeds net income and is well in excess operational needs. On a pro forma basis, the business is selling at 5.5x EBITDA and 10x earnings. Return on equity should run in the high teens to low twenties through a cycle with return on invested capital settling in the low teens. The pro forma debt load is about 40% of the capital structure, but is quite manageable at just 1.6x EBITDA and 9.4x EBITDA interest coverage. The pro forma free cash flow yield is above 10%, more than 700 basis points higher than the 10-year US Treasury.
We believe a business with the qualities of JBT should trade for at least 8x EBITDA on an enterprise value basis. In our valuation, we assume no top line growth and stable margins. We estimate the equity value of JBT at approximately $610m, or $22 per share. This compares favorably to the $370m, or $13.50 per share, total equity value of the company currently. We note that high quality industrial companies have typically sold for closer to 8-10x EBITDA and industry-leaders with unique product niches like JBT have sold for as much as 12x.
Panics are frightening experiences, not unlike surfing a tsunami. Jitters and emotions evolve that cause thinking to be less than rational at times. But the discipline of understanding how value evolves, how securities work together to reduce risk in a portfolio, and keeping an open mind to evolving risks and opportunities should serve you well.
A former partner of mine used to say, “When you don't know where you are going, any road will do.” Muddling through can work through many aspects of life, but finding clear-cut disciplines works best in investment management. When we make glaring mistakes, and there are many in my portfolios, fess up, and clean them out. Risks are out there. With them come some pretty darn attractive prices and opportunities. I continue to believe that investors will be rewarded as the market's confidence is restored over time. It may be tough, but hang in there!
Disclaimer: I, my family, or clients have a current position in John Bean Technologies.