On Markets & Investing

Monthly Stock Idea Lab: May 2023

28 May 2023
This is the second edition of the Monthly Idea Lab. Every week, I come across a dozen stocks that look initially interesting. I find them through sector research, reading the financial press, other investor blogs and letters, annual reports, listening to podcasts, speaking to fellow investors, doing periodical screens, and other sources.

I filter them to keep just one or two with the best risk/reward profiles. By the end of the month, I have between 5 to 10 stocks that I add to my watchlist. I wait for a better price or a stronger conviction depending on a particular case, before deciding to invest in a company. In most cases, a stronger conviction usually comes from a deep dive that I do later or if I address the critical issue behind the share price drop.

Before I share the top five names I selected in May, I wanted to provide a quick update on the previous seven ideas I introduced last month.

Kistos Plc

I have not bought any new shares. Kistos looks the most interesting. Its stock is down almost 20% since I last wrote about it. So far, it has been following European gas prices. Gas storage in Europe is currently 66% full, which is well above historical norms for this time of the year. Warmer and windy winter earlier this year, as well as weaker Chinese growth, are the key factors. I recently read that some traders do not exclude European gas prices turning negative later this summer. While this is all temporary and unsustainable, it can still drag the stock further down.

As a result, the market has completely ignored a new acquisition of Mime Petroleum which was made on quite attractive terms, in my view ($111mn consideration for 24mn boe of 2P reserves plus 30mn boe of 2C resources). Kistos will not pay cash to shareholders. It will repay $75mn of debt and assume the remaining $225mn of the remaining debt. The company expects to receive tax refunds in December 2023 ($80mn), which, together with $109mn of cash on Mime’s balance sheet, would reduce the total deal consideration to $111mn. Kistos has also issued 2.4mn warrants to Mime shareholders subject to operational success and exercisable into Kistos shares at 385p.

Charles Schwab

I did some further work on Charles Schwab and concluded that the risk/reward was not attractive. If things go well, the stock goes back to $80 (+54% upside), but there is a high risk of material impairment of the earnings power as the broker has to replace cheap depositing funding with more expensive funds. What made $NFLX and $META such great trades last year was that both companies had strong funding and were highly profitable. They were also down 70% from ATH. $SCHW is down 46% so far despite facing arguably bigger risks.

Barrick Gold

Barrick continues to look attractive, especially since many leading investors with entirely different backgrounds, such as macro and value, keep highlighting the need to hedge against sovereign risks and inflation. I have not bought it yet because I want to minimise stock-picking risks. Other alternatives are buying Gold as a commodity or a gold stocks ETF. I also think that an investor with a small portfolio should be able to find bargains in small-cap space that would deliver spectacular returns offsetting inflation.

If any of my previous ideas pass further tests, you will find them in the Portfolio section of the website.

New ideas (May-April 2023)

Biglari Holdings

Ticker: BH.A US / BH US
Price: $1,006 / $207
Mkt Cap: $636mn
EV: $146mn

This is the most interesting company I have come across in at least one year. It was founded in 2008 by a young businessman, Sardar Biglari (45), who currently owns 70.4% of voting rights (66.2% economic interest). The way Biglari describes the company’s strategy is very similar to the philosophy of Warren Buffett:

“We endeavour to build upon this collection with companies possessing excellent economics, operated by exceptional management.”

Biglari Holdings owns seven businesses, a cash position ($37.5mn), marketable securities ($69.5mn) and an investment in a Lion Fund, managed by Mr Biglari ($383mn). Total investments amount to $490m (81% of the market cap).

The residual value ($146mn) could be attributed to the operating business which consist of two restaurant chains (Steak n Shake and Western Sizzlin), two insurance businesses, two oil companies and Maxim magazine.

These businesses collectively earned $27.6m of net operating profit in 2022.
The way Sardar Biglari arranged his compensation is also quite interesting. His base salary is $900k, but his main compensation comes from growing the company’s book value. He receives the bonus only if the book value in a given year exceeds the previous high-water mark level by 6%. The bonus would amount to 25% of the incremental book value created above the high-water mark plus 6%.

Given that he is the largest shareholder of the company, such a compensation structure looks too generous, in my view. This would be one reason for the stock to trade at a discount. Needless to say, the richest investor Warren Buffett continues to receive just $100k annual salary with no bonus whatsoever, as 99% of his net worth is locked in Berkshire Hathaway shares.

My next steps are to understand the evolution of the company’s per-share NAV since 2008, more specific reasons for the past acquisitions and the subsequent performance of the acquired businesses. I also want to read more background information on the founder, his incentive arrangement, the Lion Fund and its investment strategy, as well as the evolution of the share count.

Boston Omaha Company

Ticker: BOC US
Price: $19.4
Mkt Cap: $608mn
EV: $506mn

This is quite a controversial company. It is either a small Berkshire Hathaway or a potential disappointment. The company was founded by two young investors, one of whom (Alex Rozek) is a relative of Warren Buffett (he is the grandson of Buffett’s sister). The company publishes very thoughtful letters referring to the same principles that Buffett speaks about. The difference is that management also has stakes in various underlying assets. The company has had several equity raises since 2015, and it is generally harder to analyse the company due to its corporate structure.

The two co-CEOs collectively own 25% of BOC’s shares (and 44% of voting rights).

Management states that:

“Boston Omaha’s focused objective is growing intrinsic value per share at an attractive rate while seeking to maintain an uncompromising financial position.”

The company operates three businesses: a Billboard company, Insurance, and Broadband. In addition, it runs several investment funds with a combined AuM of $157mn. It also has about $52.5mn of cash and no debt at the parent level (just $29mn non-recourse debt at a subsidiary level).

My concerns:

  • co-CEOs seem to have interests in other businesses, and unlike Buffett, they don’t keep 90% of their net worth in one company (BOC)

  • The company pays high professional fees ($7mn in 2021 vs revenue of $57mn and total assets of $807mn; in 2022: $5mn vs revenue of $81mn)

  • Operating loss of $5.2mn, $23.8mn and $4.99mn in 2022, 2021 and 2020, respectively

  • Management has been regularly raising new shares and diluting its interest, although other directors have been buying shares in the market.

Smith-Midland Corporation

Ticker: SMID US
Price: $15.9
Mkt Cap: $83.6mn
EV: $85.6mn

A family-run business founded in the 1960s. Key products include Highway barriers, SlenderWall Cladding, Noise absorbing walls and other construction products.

The business has partially pivoted to rentals which improved economics (relative to the sale of manufactured products).

There are natural barriers to entry as concrete parts are heavy and are not economical to transport long-distance; local manufacturers are mini-monopolies. SMID is a leader in a few South-East locations in the US.

The business seems to be quite cyclical with fairly high fixed costs, as was evidenced in 2022 when a slight decline in revenue led to a negative net income. Operations also require high working capital, which negatively affects the FCF.

Lithia Motors

Ticker: LAD US
Price: $242
Mkt Cap: $6.7bn
EV: $11.5bn

I came across this idea at the end of December 2022 on a podcast with Bill Nygren and Alex Fitch from the Oakmark funds. I have not done any special research on the name, other than checking the key financials. So the facts and thoughts on Lithia Motors are mostly from the Oakmark team.

Lithia Motors is the largest auto dealer group in the United States. It is a franchised auto dealer selling new and used cars as well as services and parts under a variety of different brand names.

For the past decade, that company has been led by its CEO, Brian Deboer, who has consistently focused on acquiring dealers, improving their operations, and then redeploying the free cash flow into further acquisitions. Deboer has spent 31 years with the company, including the past 11 years as the CEO.

The strategy has resulted in exceptional results: Lithia’s 10-year EPS CAGR is 32%. Its stock has increased 10x in 10 years.

Despite such growth, Lithia’s market share is only 1%. The $2tn US auto market remains highly fragmented, with the Top 10 dealers holding about 8% market share. The majority of auto dealers have only 1-2 or 3 shops maximum, compared to Lithia, which runs 300 stores. The industry has natural barriers to entry in the form of OEM relationships. A private equity cannot easily consolidate dealers because it is hard to secure OEM agreements.

The company is trading at 5.2x PE (‘22 eps - $45) and under 7x PE assuming a pre-COVID gross margin of $2k per car. Its trough PE multiple was around 6x back in 2009 and 2020. According to Oakmark, Lithia’s mid-term EPS potential is $50-60. 10x PE leads to a $500-600 share price (2-3x upside).

Risks:

  • Direct-to-consumer sales (e.g. Tesla distribution model)

  • Electric cars have fewer parts, and require less maintenance (30% of profits come from services&parts)

  • Growth may be limited if prices for independent dealers rise or Lithia hits a 5-7% market share which is a cap in some framework agreements with OEMs.

Stella International

Ticker: 1836 HK
Price: HK$ 7.64
Mkt Cap: HK$6.1bn
EV: HK$ 4.5bn

This is the least research idea that I came across at the London Value Investor Conference in London this month. Stella is a manufacturer of high-quality footwear for global brands such as Nike and Under Armour as well as Luxury and Fashion brands (Balenciaga, Chloe, Michael Kors, Lacoste etc).

Stella has its own design products, but they represent a small part of the business. Its main production facilities (46% of volumes) are located in Vietnam, followed by China (28%). Most revenue comes from North America (51%) and Europe (24%).

The company has generated an operating margin in the 4-11% range since 2009 (in 2020, it fell to zero). Management targets a 10% margin in the mid-term by focusing more on luxury and expanding manufacturing facilities in low-cost regions like Indonesia and Bangladesh.

The company saw a generational change in management in 2019 with the appointment of the new CEO, Chi Lo-Jen, and the chairman, Lawrence Chen Li-Ming.

The company has boosted dividend distributions to 70-90% of net earnings. It currently offers 11% dividend yield and trades at about 7x PE.

I plan to learn more about the key competitors and the value Stella generates for its customers (the big brands). During my short conversation with the company’s CFO at the Conference, I got the impression that the global fashion companies care the most about the quality of the production and are not so sensitive to the actual prices they pay to Stella. For example, certain shoes they make are sold for $1,000 to end customers, while the fashion company pays Stella just $100. I need to understand whether this is true based on historical pricing trend and various financial metrics.

DISCLAIMER: This publication is not investment advice. The primary purpose of this publication is to keep track of my thought process to assess future information better and improve my decision-making process. Readers should do their own research before making decisions and always consult with professional advisors. Information provided here may have become outdated by the time you read it. All content in this document is subject to the copyright of Hidden Value Gems. Please read the full version of the Disclaimer here.