How to quickly exclude stocks from further research

Welcome to Value Investing School, article 1 – How to quickly exclude stocks from further research.

With this article I wish to show how investing is mostly a game of exclusion if you are a bottom up value investor and you know what to look for. I’ll analyse L’Occitane en Provence as an example.

Things to learn are:

  • Investing is a game of mostly exclusion.
  • Focusing on the business yield, current or future, makes things easy.
  • Don’t be a relative investor, be an absolute investor.

locicitane

Source: L’Occitane

During the week I look at lots of stocks but what makes it easy for me to separate the interesting investments from the other, is the business return or the future potential business return. I look for current or even better, future double-digit yearly business returns and if a business doesn’t show that potential it is quickly skipped.  This makes me an absolute value investor and not a relative investor, a very costly and risky mistake many investors currently make. As would Buffett say, we invest in businesses and not a stock that goes up and down during a day.

I am currently researching a stock list from an Asian Value investing fund with some very interesting names but also some strange decisions like the L’Occitane en Provence stock. On this stock, I wish to explain:

  • 1) the risks of not focusing on the business yield
  • 2) the risks of relative versus absolute investing and,
  • 3) how easy it is to say no to an investment.

The business yield

If you are an investor in businesses, not stocks, all you care about is the yield of the business, the earnings and how the same earnings are reinvested or distributed at the end of the year. The higher the return on equity, your equity, the better. When buying stocks, your equity is the price you pay for the stock and the yield is derived by comparing the price you pay with the earnings. For example, L’Occitane is a growing company with revenues (1) tripling over the last 10 years (FY (fiscal year) 2019 revenue reached 1.42 billion EUR) and net income (2) almost doubling.

2 revenue

Source: Morningstar

However, when I look at the net income, I see that the average over the last 5 years is around 100 million EUR. I compare it to the current market capitalization (the value of all the stocks outstanding) is 20.6 billion HKD or 2.6 billion EUR. This means that the business yield the company currently provides is at 3.84% given the price earnings ratio of 26 (100/26 = 3.84%).

3 stock

That is far too low for me but then I must look at the growth the company promises. I look at the growth and see that same store growth is actually very low at 2%.

4 growth

Source: L’Occitane

And that all of the growth the management hopes for comes from acquisitions and emerging markets. From reading a bit about the company there is a new management, the company is restructuring and it is something Warren Buffett despises, a turnaround. From the conference call transcript:

5 trust

Source: L’Occitane

When you find words like ‘new management, new strategy, build trust’ it could be truth, but it could be also lots of baloney. Not what a value investor gets in to. So, when I see that I am already at ohhhhh.

Just another one for the record. On top of the new management, the company that made about a billion in profits over the last decade, suddenly decides to make an acquisition of a cosmetics brand and pays $900 million for a company with $40 million in EBITDA.

6 acquisition

Source: Elemis acquisition announcement

All of the above is simply too risky, it might work, I hope it works for them, but it might also backfire as that kind of corporate actions often do. The plan is to scale the brand, a totally new brand, in China.

7 skincare

Source: Elemis acquisition announcement

It could happen it might not, too much risk and the actual business yield is below 4%. Enough for a value investor. So, let me finish this with why are other investors investing in this? Well, they do so because they are relative and not absolute investors.

Relative vs. absolute investors

This is a concept well described in Seth Klarman’s book Margin of Safety and L’Occitane is a great example. A relative investor looks at the company and says:

“I have a great global brand growing at double digit rates that just made a potentially transformational acquisition trading at a PE ratio of just 26. A fair valuation in this market should be 40, thus the stock is undervalued by 30%.”

This might be true and the market might revalue the stock, or re-rate it as the lingo goes,  in case it shows faster growth in the future and improving margins. However, as a value investor you want both future growth and good earnings or value already there, not in some future promise. Also, the fact that the stock was much higher in the past, means absolutely nothing. Actually, it confirms that it was overvalued in the past and the market is slowly but surely re-rating it.

Conclusion

That is it, this is how I mostly spend my time, looking at companies that are not that interesting but from time to time, there is something interesting. To finish with a nice quote that summarizes this:

“Whatever you do, do it with all your might. Work at it, early and late, in season and out of season, not leaving a stone unturned, and never deferring for a single hour that which can be done just as well now.”

That is how bottom up value investing is done. You exclude more than 99% of businesses you look at and with time it becomes a fast process. Buffett says how it takes him 5 minutes to read through a business. Therefore, the more stones you turn, the better are the investments you will find.

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Michael Burry’s Stock – CorePoint Lodging REIT Stock Analysis

Introduction.

CorePoint Lodging – Business analysis

Cash flow calculations

Selling properties to unlock value

Stock catalysts already there

The risks

Investment strategy

Introduction

The CorePoint Lodging REIT (CPLG) is a company that got the eye of the public when dr. Michael Burry, famous for being one of the big shorts in the movie The Big Short disclosed CPLG as his largest position.

1 michael burry

CPLG is a real estate investment trust owning hotels that belong to the La Quinta brand. It is a spin-off from the La Quinta company and the stock hasn’t been doing well since then.

2 cplg stock price

Source: CNN Money CPLG

I have been reading a bit about the company because I find it interesting to dig into the reasons of why a person like Michael Burry would invest in a company like this. Since his exposure got disclosed the stock went up from the low teens to the mid teens but after the last earnings report it tumbled again.

3 cplg 6 months chart

Let’s see whether there is value and a good investing opportunity or at least why would Michael own it.

CorePoint Lodging – Business analysis

The hospitality industry is a complex one where it all goes around room values, revenue per available room (REVpar), occupancy etc. But at the end, for investors, it all boils down to cash flows, like with everything else.

CPLG has 40,115 rooms, a market capitalization of $665 million and debt of $1 billion. When we add everything up and divide by the number of rooms the value per room is $41,505 including the debt and market capitalization. ADR is $90 and REVpar is $59 due to the occupancy of 66%.

4 revpar

Source: CPLG

On the other hand, Chatham Lodging Trust (NYSE: CLDT) has a market cap of $900 million with $585 million in debt. RevPar $134, so double CPLG’s but it has only 6000 rooms.

5 chaltam

So, the value per room is $250k for Chatham.

Apple Hospitality REIT (APLE) has a market cap of $3.65 billion, debt of $1.4 billion and 30,000 rooms. The value of a room is $166k and RevPar is $105.

6 aple

Source: APLE

However, it all boils down to times funds from operations, Apple’s is $400 million, Chatham $130 million with a bit more of debt, so the $900 million market cap.

$165 million for CPLG where the market cap is $665 million. So, it is cheap from this perspective.

The point is that it will not go bust as interest costs are $50 million, it will hardly go lower but the upside is high, plus you are buying a hotel room for $40k.

In private hands, with RevPar of $59, should give $21k in revenue per room per year. $40k for Apple and $50 for Chatham. This means CPLG has room for improvement and higher margins or the margins are much lower.

7 portfolio segmentation

The core part of their business brings 94% of the EBITDA while 24% of the hotels bring in the rest. By disposing or changing the non-core hotels, CPLG can improve its ratios and make itself look better. Plus get some money to do buybacks or to pay down debt.

Cash flow calculations

This is the guidance for 2019:

9 ebitdare 2019

– 8% to 9% of revenue goes for capital expenditures,

– 2.5% + Libor = 5.5% interest rate = $60 million in interest payments.

$180 million in EBITDA minus $77 million in capex for 2019, minus $60 million in interest rates should give me cash flows of $43 million that on a market cap of $700 million is a return of 6.1% which is in line with the dividend yield, or just below it. The buybacks of another $50 million make this look attractive but this is not a business yielding 15% as the company without asset sales will not have an extra $50 million to do buybacks. However, value can be unlocked by selling the properties.

Selling properties to unlock value

The asset value is supposed to be $2.4 billion according to HVS. This is also what is on the books. Given the current market capitalization, there you have already a 50% discount. You are practically buying hotels across America with a 50% discount. Book value of assets $2.4 billion, debt $1 billion, value = $1.4 billion. Market cap is $700 million.

10 asset value

Source: CPLG – prospectus

I went to look at the list of what they could sell and found the following.

11 hotels

Source: CPLG

On top of the discount of 50% there might be more hidden value. For example, their hotel in Sheboygan is valued at $828k and was build in 1975, refurbished in 2004. However, with 73 rooms with a starting price of $75 I find it hard to believe the value of it is only $800k. That would be $11k per room. So, there might be a few tens of millions in hidden assets lying around in these properties, probably just the land will be worth as much.

12 sheboygan

Source: Google

Or, if I go to Salt Lake City, they own 3 hotels where the book value goes from $2.5 million to $8.4 million on a similar room number (100 to 122) and the price of the rooms is also close.

6 la quinta

One of the hotels was built in 1997 while the other two are 20 years older, therefore the higher value. We must also not forget that many hotels were refurbished in the last two years that should also increase the book value.

The point is that if the management manages to unlock value, transform the potentially good properties and get rid of the bad for a good price, one could expect nice things to come from CPLG. If someone pays $2.4 billion for all the portfolio, that is a market cap of $1.4 billion or double the current level.

However, without going into a detailed value analysis of all the hotels, there are some potential catalysts lying in plain sight.

Stock catalysts already there

Since the La Quinta merger with Wyndham, the customer loyalty base will expand fourfold which could increase revenue and occupancy.

13 improvements

So, if CPLG improves revenues or EBITDA by just $20 million, those $20 million would improve cash flows from $43 million to $63 million, allow for a higher dividend or buybacks and therefore for a much higher stock price. Given the book value, there is a margin of safety with high upside situation here. That is in my opinion what dr. Burry has been buying.

15 customer base

Plus, it is a spin-off and if not performing immediately well, most previous owners ditch it. Only one analyst has been at the last conference call, so nobody is following what is going on which might make it go under the radar. If and when cash flows improve, it will get recognized.

The risks

The main risk for CPLG is an economic slowdown. Less travel, less business would lead to lower revenue and lower cash flows. However, higher margins offer some kind of resilience in case of a recession.

14 margins

But, CPLG should get rid of the low margin hotels as those would produce losses in case of a slowdown.

I managed to find LaQuinta’s annual report and in their risk description they tell how revenues declined 17% in 2009 and EBITDA 30%.

16 la quinta

As CPLG is a different business, a decline of 17% in revenue should hit it hard as the EBITDA would be gone practically.

Something that the investing community might have missed is the government shutdown that will certainly impact hotel revenue when those disclose them in Q1 2019.

However, as long as the situation with the economy remains as is, we can expect stability and slow managerial improvements for CPLG. The question is what will come first, recession or value unlocking?

The debt is always a risk but you never know how will the current leveraged situation unfold over the long term. The FED has paused with interest rate hikes, we might see cuts which makes it impossible to predict. It is unlikely the government will let half of America go bust. Too big to fail all over again…

Investment strategy

I am not going to invest in CPLG now as I look for a 15% return and CPLG offers a 7% return from the cash flows. When they improve their business, the cash flow yield might go to 10%, which would probably double the stock price, but stock price moves, especially short-term ones are not what I invest in.

From a dr. Burry perspective, this will probably not go bust, in case of a recession it will survive where the dividend will probably be cut and that is it. The value is there and over the next decade it will be unlocked given the management’s focus and freedom to do whatever after the spinoff. It is a value investment where over the long term you will hardly lose money, you are exposed to the American economy and if the value unlocking happens fast, you might also see higher stock prices in the next 12 months giving you great returns. If not, you still get the 6 or 7% yield.

To conclude, CPLG is a good investment offering value and a margin of safety with potential upside. It is a dull business so a perfect fit for value investors. See how it fits your portfolio, I am going to put it on my watch list to see where it goes and compare to other investments out there. If it goes to $20 during this year, well good for dr. Burry.

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To Buy or to Sell Stocks with Crash Coming? Doesn’t Matter for Value Investors – Buy Value

I received this very interesting comment from a subscriber as I bought my 5th stock for my lump sum portfolio which is now 50% invested. So, I invested 50% of my portfolio over the last 3 months that might surprise people scared of the upcoming crash or recession.

stock market crash

I have 3 points to answer this question:

  • I can’t predict the future, nobody can

Nobody knows what will happen with the market, we have the last two crashes in our mind that were close to 50%, but that doesn’t mean it will happen again. Nobody, and I mean nobody knows.

  • A recession is always around the corner

There are recession predictions for 2019 and 2020, but the same could had been said in 2018, 2017, 2016, 2015, 2014, 2013, 2012, 2011, and especially 2010 and 2009. There are many out there that have been waiting on the side-lines since 2009 or they just got in in the last few years. No need to mention the missed opportunities.

For example, my largest position in January 2018 was Nevsun Resources.

3 nevsun

In January 2018 there were fears about China slowing down leading to a copper crisis etc., fears of a recession and market crash over the next two years with Ray Dalio saying there is a 70% chance for an U.S. recession. I would have been better in cash than investing in a copper miner, right?

Well, all depends on value, if you find it, even if a recession happens, your returns are delayed by a year to 3. The point is that if you buy value, you will survive those bad years and get ahead after the crash. So, I, as a selective investor, simply buy when I see value and when I am happy owning the business. It has rewarded me very well in the past no matter the possible crashes. And yes, I lost money in 2008, but it is not comparable to what I made from 2009 onward and from 2002 to 2008.

Index fund investors

For those who invest in index funds, just invest on a monthly basis, just dollar cost average and forget about stocks, don’t even think about it, you will get your returns whatever they will be, own your home, invest in another property, diversify and you will be well off. Your wealth doesn’t depend on the market, but mostly on you and you not doing stupid things like most did, I.e. selling in 2009 march.

3) Highest possible return long-term

I know if there is a recession my portfolio will get hit, but I also know that the highest possible return I will get is when I buy value when I see it. So, in good years I will have great returns, in a bad year, I don’t know how I will do. There is a nice passage in the book Margin of safety by Seth Klarman discussing how when you buy value, real value, it often offers downside protection as it is already depressed in price and the price can’t go much lower. All my current 5 stocks trade below book value, mostly tangible book value, have high earnings yield and potential. So whatever happens, I am a happy owner, owning assets and that gives me a margin of safety.

To explain in an easy way what margin of safety investing is, I’ll make the next video article apple.

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