Q2 2018 Performance

quarterlyperformance

My streak of underperformance continues. I have no idea when it will end. All I know is: you can’t time this stuff. You just have to stick to it. Over time, markets reward disciplined rules-based value-oriented approaches. I think Cliff Assness put it best when he said in a recent interview that you should “find something you believe in and stick to it like grim death”. I believe in this stuff. It’s logical, time-tested, battle-tested. I’m not going to abandon it because of underperformance.

Value tends to do best coming out of a recession. If I had to guess, I won’t really see any outperformance until we see another recession and the recovery from it. That’s going to take anywhere from 5 to 10 years. Of course, that’s not how things worked out in 2000. The outperformance of value actually started before the recession. There simply isn’t any way to know or time it. I just have to stick to it.

This is my key advantage as a small investor. A professional enduring my underperformance would be in serious trouble with their investors. In an effort to keep their job, they would start to buy more popular positions. They would start to hug the indexes. They wouldn’t be able to ride something like this out and be cool with it. This is why most professionals underperform.

What’s my edge? I don’t have an informational edge. The only edge that I have is behavioral, which is something most professional investors can’t afford to have. I can handle the stench and dive into the dumpster. I can ride out the underperformance. If I can’t, then I might as well put this IRA into an index fund.

In short, I have to stick to it like grim death.

Sells

After staying put for the first quarter, I did much more trading this quarter. You can read a list of all of the trades here. I’m trying to stick to some concrete, easily identified sell rules. Those rules are:

  1. I can sell on an operational slip. For me, that is an operational loss. When I’m buying a stock on the basis of EV/EBIT, what is the position worth if EBIT begins to fall apart?
  2. I can sell if I held the stock for at least a year.
  3. I can sell as part of an annual rebalancing or a price increase of more than 50%.

For the operational slip rule, this was a result of the lessons I learned from my positions in IDT, Manning & Napier, and Cato Corp in 2017. All gave me early warning signs of a problem in the form of a decline in operating income and I ignored it.

Selling is one of the hardest elements of deep value investing. You can go with a very simplistic system such as Greenblatt’s magic formula, in which he recommended holding a stock for a year and then selling it unless it was still undervalued. Graham recommended selling after a 50% gain or after holding for two years.

My method is a combination of the two along with an element of downside protection by getting out of positions in businesses that post operating losses.

A deep value portfolio is going to be a high turnover portfolio. I am not buying stocks of companies with deep moats and high returns on invested capital. These are companies with problems that are causing an undervaluation. My goal is to buy when sentiment is poor and sell when sentiment has improved. I also sell when the fundamentals deteriorate. This is a major reason that the account I decided to track on this blog was the IRA, so I wouldn’t have to worry about tax considerations.

My sell rules aren’t perfect. My sale of Francesca’s, for instance, is looking like a mistake. Even though it will result in mistakes, I think sticking to it will help to cut off the bleeding in the worst positions. I will probably add to the rules over time as my experience grows.

Many investors hate rules. I love them. Rules keep me honest. Rules keep me out of trouble. There are thousands of investment ideas. It’s important to have strict guidelines or it will be easier to do dumb stuff. Guidelines and rules keep me honest. They keep me from straying from a tried and true path.

Buys

After selling for various reasons (price pops, operational slips, etc.), I bought a number of positions in the past quarter. They are all listed below. I also included links to my brief write-ups on each position, explaining why I found the idea attractive.

They check all of my boxes: (1) statistically cheap, (2) clean balance sheet, (3) poor sentiment, (4) potential for improvement.

  1. Ultra Clean Holdings
  2. Big Lots
  3. Jet Blue
  4. Aaron’s 
  5. Unum Group
  6. Argan

Macro

I’m fully invested, which makes me nervous when U.S. stocks are as expensive as they are. I’m trying as hard as possible to ignore macro stuff and stick to buying undervalued stocks.

Now I’ll proceed to look at it anyway.

allocation

For US stocks, the average investor allocation to equities stood at 42.82% at the end of Q1 based on the latest data. That’s a slight improvement from 43.63% at the end of Q4 2017. This suggests a 3.2% rate of return from US stocks over the next 10 years. This is the same as than the 10-year treasury yield (3.2%) but much less than the current yield on AAA corporate bonds (4%).

Bottom line, the market is expensive. That should be news to no one. That doesn’t mean it’s going to crash. That doesn’t mean we’re going into another Depression. It means they’re expensive and returns are going to be fairly low over the next ten years. The road to those returns is unknowable.

Expensive markets don’t crash just because they’re expensive. Usually, there is an event that triggers the sell-off. Usually, the event is a recession. I think about rich valuations in the sense of “the bigger they are, the harder they fall”. To fall, you still need something to push you.

The most common cause of a recession is the Fed tightening too much, which is why the yield curve is a useful indicator. The 2 year vs 10-year yield curve still hasn’t inverted, implying that a recession is not imminent. We’re likely entering a very juicy stage of the business cycle (think 1969, 1989, 1999, 2006).

yield

There also hasn’t been an uptick in unemployment, another indicator that a recession is about to begin. Unemployment continues to drop. With a tight labor market, some employers are experiencing inflationary pressures (Eric Cinnamond mentioned others on “the investor’s podcast”). This suggests to me that the Fed won’t stop tightening and at some point, they’re going to push the yield curve into an inversion and trigger a recession.

unemployment

Nonetheless, the fact that I don’t expect a recession in the next year makes me comfortable with the fact that I’m fully invested and have positions in some deeply cyclical industries. The market could easily crash 20%, but I don’t think we’re going to see a really nasty recession that would trigger a 50% drawdown in the next year.

Random

1. I saw “Solo” and didn’t understand the criticism of it. It was fun and it checked off on all the fan boxes: we saw how Han met Chewie, how Han obtained the Millennium Falcon, etc. We even saw the Kessel Run! It was certainly better than “The Last Jedi”. My suggestion is to not listen to the haters and see it.

2. I hope Gamestop gets bought out. This has been one of my long-suffering positions and there are signs on the horizon that the situation is improving.

3. Argan is the position I am most excited about. It certainly seems like a “no-brainer” at this valuation and considering the quality of the company. Still, I’m trying to keep an equally weighted 20 stock portfolio and I am not taking a position that is too concentrated. We’ll see if I come to regret that.

5. My day job has been pretty hectic this quarter but it seems to all be working out. I work in operations for a bank. I was promoted last December to a section manager role and faced an internal audit and headcount exodus right after getting the job. I was able to hire new people who are working out well and I received news this week that I passed our internal audit, which was a relief. I hope the rest of the year is a smoother ride now that those hurdles are gone.

6. My personal highlight of the last quarter was taking a week off of work, going to the beach, and spending my time reading “Margin of Safety” by Seth Klarman. Good times.

7. I also caught a couple of really good under-the-radar movies. Thoroughbreds was a really twisted tale that you should check out. It was unlike anything I’ve ever seen before (American Psycho for rich entitled high schoolers?) Just don’t expect to feel good about human nature when it’s all over. I also really dug Lady Bird, a funny movie about a high school senior in 2002 plotting to get out of Sacramento and go to college. That was actually a feel-good movie. I recommend it!

8. Deutsche Bank really worries me. The bank looks like it is in a slow-motion collapse. It’s one of the biggest banks in the world and I don’t know how the global economy would handle it if the bank fell apart.

9. I’ve really been enjoying the Focused Compounding podcast with Geoff Gannon and Andrew Kuhn. They avoid a lot of the trendy topics that are geared towards big investors that seem to dominate the podcast landscape these days (sorry guys, I don’t care about venture capital or angel investing because I’ll never be able to do it and I think most of them are lucky gamblers anyway). They focus on individual stocks and situations that small investors can take advantage of. This one and “The Investor’s Podcast” are my go-to’s. I look forward to listening to them whenever they pop up in my feed.

10. Politics is nauseating and it is getting worse. When I was in my 20s, I loved politics. I was a news and political junkie. That hasn’t been the case for most of the last decade. It’s becoming increasingly impossible for people to empathize with the opinions of others. This is very apparent on Twitter and I follow people on both sides of the aisle. Everyone thinks the other side isn’t just wrong, they’re evil and need to be destroyed. All of this anger and vitriol isn’t good for people’s state of mind. Both sides have a mob mentality. I don’t know how we’re going to snap out of it. To paraphrase Charlie Munger, ideology is turning our brains into mush.

11. Last, but not least, Captain Kirk’s finest hour.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Ultra Clean Holdings Inc. (UCTT)

chip

Key Statistics

Enterprise Value = $556.88 million

Operating Income = $97.56 million

EV/Operating Income = 5.71x

Price/Revenue = .62x

Earnings Yield = 14%

Debt/Equity = 13%

The Company

Ultra Clean Holdings, Inc. is a small but global player in the semiconductor industry. They sell equipment used to manufacture semiconductors. This includes things like precision robotics, gas delivery systems, wafer cleaning, chemical delivery, and a variety of other tech that I have a limited understanding of. What I do understand is that the semiconductor industry is booming, Ultra Clean is at a dirt cheap valuation, and they’re a key player in creating the technology used in the manufacture of semiconductors.

Sentiment

The stock is down 9.2% over the last year. While the decline was only 9.2% over the last year, this ignores the wild ride. From June 2017 through the October 2017 peak, the stock rallied from $18.75 to a peak of $33.60, at which point the stock declined 49% to its present levels.

Why did the stock endure such a decline? Mainly, a series of earnings reports created doubts that Ultra could maintain its high level of recent growth. A 2 cent earnings miss in October 2017 triggered a 27% selloff. A 1 cent earnings miss in January caused another 34% drop. While earnings missed slightly, revenues increased by 42% year over year in the January earnings report.

My Take

I typically avoid stocks in rapidly growing industries. Growth tends to fall apart as a rule of nature. Contrary to popular sentiment, capitalism and the price system actually work. Growth is also usually rewarded by rich valuations because investors extrapolate the present into the future. For that reason, growth is rarely worth paying a premium for unless you have unique insight into why the growth will persist.

With that said, the EV/OpIncome 5.7x valuation of Ultra is simply too cheap to ignore. I’m not paying anything for the growth rate. Ultra is priced like one of my failing retail stocks that are getting crushed by competition with Amazon. In contrast, this is a company that grew revenues by 64% in FY 2017 compared to FY 2016. The growth is continuing, with the recent year over year quarters showing a 42% gain in revenue. The minor earnings slips look to me like they are simply a result of expenses that are necessary to keep up with the torrid pace of business growth. Cap-Ex increased from $7 MM in 2016 to $16 MM in 2017. Research & development increased from $9 MM to $11.6 MM. COGS went from $475 MM to $756 MM. While the growth in expenses is high and is leading to some minor earnings volatility, they seem to be growing organically with the growth of the business. Managing expenses in a business that is growing by 40% is a hard task. Of course, Wall Street is demanding and unforgiving boss.

This is a situation where minor earnings volatility is leading to roller-coaster stock price volatility and an opportunity for value investors.

The risk here is that the demand for semiconductors falls apart. I have zero insight into whether the demand will continue to grow at its torrid pace, but I do notice that semiconductor demand is tied closely to global economic growth, which doesn’t show any signs of letting up at the moment. With that said, at a debt to equity ratio of 13%, $162 MM in cash compared to $55 MM of debt, Ultra doesn’t look like a company that will fall apart once the demand cycle for semiconductors inevitably falls.

If semiconductor demand continues to be strong, slightly better expense management should cause an EPS beat, which could send the stock back to a reasonable valuation and its 52-week high. The 52-week high was $33, which would be a 100% increase from present levels. The 5-year average P/E is a very high 37x. Currently, the stock trades at 7x. Even if the stock increased to a multiple of only 20x, this would be an increase of 185%.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Big Lots (BIG)

biglotselkton

Big Lots in Elkton, MD

Key Statistics

Enterprise Value = $1.859 billion

Operating Income = $274.5 million

EV/Operating Income = 6.77x

Price/Revenue = .32x

Earnings Yield = 10%

Debt/Equity = 25%

The Company

Big Lots is a large discount retailer. They operate 1,400 stores throughout the continental United States along with a smaller operation (89 stores) in Canada. Big Lots sells everything from candy to furniture, all at a steep discount. Traditionally, Big Lots acquired their inventory by taking advantage of closeout situations. A closeout is a situation where a major vendor wants to bulk dump the last of their inventory on a firm like Big Lots. Big Lots buys the inventory in bulk (it can be completely random – like Keurig machines or inflatable pools) at a steep discount, and they sell the items to their customer at a low price.

This isn’t the only way that Big Lots acquires inventory, but closeouts have traditionally been the core of their business. Their big sales on closeout items are typically what attract customers to the store, who also make impulse purchases on goods that aren’t as attractively priced. Quickly perusing deals on their website, you’ll see that they frequently sell goods at a discount to both Wal Mart and Amazon.

Inventory management and ability to secure merchandise deals are a major part of their business. They have a long track record of successfully navigating this difficult industry, with the business dating back to 1967.

Sentiment

The stock is down 12.8% in the last year and is 35.9% off its 52-week high which was reached in January of this year. The stock is afflicted by the “retailpocalypse” sentiment. At the first sign of trouble, retail stocks are absolutely crushed in this environment.

The past two earnings reports were greeted with horror by Wall Street, hence the steep discount from the 52-week high and ultra cheap valuation. In the most recent earnings report, earnings were down 39% from the same quarter a year ago. Revenue was also slightly off.

My Take

Big Lots is priced like a business that is in severe distress even though it isn’t. Wall Street overreacted to the recent earnings reports just because they are on high alert about any minor hiccup in the retail sector. It’s a good company in a hated industry.

At the current P/E of 10.41, if the stock returned to its average valuation over the last 5 years (16.41), it would be a 57% increase from current levels. For what it’s worth, management expects to earn $4.50 per share this year, which is pretty close to what it made last year. They are not warning of significant deterioration. If the business situation improved just a little bit, I don’t see why the stock couldn’t return to its average valuation multiple.

One of the major risks facing Big Lots is a trade war. They are heavily dependent on cheap goods from overseas markets to support their pricing model. If a trade war truly did happen, Big Lots would be harmed. At the moment, the threats going back and forth between the United States and China seem small and are likely posturing.

Interestingly, Big Lots actually delivers higher returns on capital than its biggest competitor, Wal Mart. Big Lots earned a 10% return on assets, compared to Wal Mart’s 4.43%. Wal Mart’s operating margin is presently 4.3% compared to Big Lot’s margin of 5.24%. Indeed, Big Lots is hanging in there and doing well even though it is competing with brutal competitors: Wal Mart, Amazon, and dollar stores.

There are also no signs of financial distress: they have a 25% debt-to-equity ratio, an F-Score of 5 and Altman Z-Score of 6.88. The decline in the stock seems driven solely by a minor drift down in performance, nothing major.

Like Aaron’s, I think Big Lots is a company that should benefit at this point in the economic expansion. Discount retailing is an industry that should thrive as the lower and middle class begin to feel more confident about their jobs and spend more money on discretionary items.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Jet Blue (JBLU)

air

Key Statistics

Enterprise value = $6.361 billion

Operating Income = $981 million

EV/Operating Income = 6.48x

Price/Revenue = .84x

Earnings Yield = 19%

Debt/Equity = 24%

The Company

JetBlue is a low cost airline with a focus on North America. They fly throughout North America, but their major focus is New York, Florida and Boston. They are headquartered in Long Island City just outside of New York. JetBlue made the somewhat crazy decision of entering the airline business in 1998. I don’t know how anyone in 1998 could look at this history of the business and say “this is an awesome industry, I’d like to get involved!” With the terrible industry economics taken into consideration, JetBlue has succeeded in a brutally tough market. They did this due to their focus on low costs and providing a high level of customer service.

Sentiment

Airlines are a terrible business and most investors are reluctant to invest in them. It is an industry marked by brutal competition, bankruptcy, and recurring public relations nightmares. Fuel prices are a major problem for the industry and cause most of the earnings volatility. Crude oil is up 59% in the last year. As a result, JetBlue’s stock is down 15% despite the meteoric rise in the S&P.

My Take

I own three airlines right now: Hawaiian Airlines, Alaska Airlines, and JetBlue is my latest position. I’m following Warren Buffett’s lead here. Berkshire’s take is that the airline business has changed. It is no longer as brutally competitive as it used to be and is settling into an oligopoly with steadier profits that will grow with nominal GDP.

Buffett is concentrating on larger cap fare and I am focusing on smaller airlines that are statistically cheap and have little debt. They also have less debt than they used to, which was a frequent cause of the industry shake ups. Not only are the smaller airline names cheaper, they also lack the pension obligations and labor battles that plague the more established names.

JetBlue is unique in my portfolio as it is one of the few names that is actually growing. They have been growing their business steadily and impressively for years. JetBlue’s revenues are up over 200% in the last 10 years and earnings have advanced impressively as well, though they have been choppy in the last few years. Despite the rise in crude, earnings have not only been positive for the last year, but have been growing. The market seems to have overreacted to the move in oil while fundamentals haven’t deteriorated. With an F-Score of 7 and Z-Score of 2, a low debt/equity ratio, there are no signs of financial distress.

In short, Jet Blue is performing well while the price reflects the kind of anxiety that makes sense with my retail stocks, but doesn’t make any sense here. The risk is that oil continues its ascent, but fortunately I have positions that will benefit from a rise in oil should that continue (ERUS, ENOR, GBX).

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Aaron’s (AAN)

couch

Key Statistics

Enterprise Value = $3.25 billion

Operating Income = $405 million

EV/Operating Income = 8.02x

Price/Revenue = .94x

Earnings Yield = 9%

Debt/Equity = 20.42%

The Company

Aaron’s is in the furniture and equipment leasing business. They lease items like furniture, tablets, computers, mattresses, dryers, refrigerators. They service a mostly low-income clientele who cannot afford to buy items upfront and typically have limited access to credit. The typical customer has a job but isn’t making much money, doesn’t have savings, and wants to furnish or buy appliances for their apartment or home.

Sentiment

The business that Aaron’s is engaged in generates a fair degree of “ick” reactions from investors. They’re engaged in subprime credit and working with customers who can’t afford to buy furniture which is unappetizing for many investors. Nonetheless, it is a solid business that generates a nice stream of free cash flow and they maintain a safe level of debt.

My take

It looks like we’re in the late stages of this economic cycle. It’s not until the last few years of a boom that lower income groups begin to feel the effects of an economic recovery. Looking at the yield curve, this stage of the cycle looks a lot like 1998 or 2006. Things are good, the recovery is entering its manic stage, and the Fed is tightening and setting the stage for a recession at some point in the next few years. For now, the 2 to 10-year spread is still positive and a recession does not appear to be imminent.

With unemployment at historic lows and wage pressures growing, lower income groups are finally feeling the recovery. As a result, they’re becoming more optimistic. They’re feeling better about their jobs and their wages are increasing but they are lacking in savings. They want a new washer or dryer, a more comfortable mattress, a new couch, etc. They lack the credit to simply put it on a credit card and they lack the savings to buy it outright. Enter Aaron’s as a temporary solution.

Aaron’s should perform well in this environment. This is a cyclical pick. Revenues, earnings, and cash flow have gradually picked up steam with each passing year of the economic recovery. On a simple P/E basis, Aaron’s currently trades at 11 times earnings. The 5-year average is 18, meaning multiple expansion alone could send the stock up by 63%. I think the stock’s valuation remains depressed solely due to the ugliness of the business that it is engaged in.

It’s also worth noting that the company recently announced a $500 million share buyback. This is solidly in the “high conviction” buyback zone, as it is 15% of the existing market capitalization.

The risk is that the economy enters a recession and Aaron’s customers have difficulty making their payments. On the other hand, a recession would likely increase the appetite for Aaron’s business. In the grips of a recession, customers would likely turn to Aaron’s as a way to buy essential household items. Aaron’s actually increased 54% during 2008. This move was bolstered by a sale of their office furniture business to Berkshire Hathaway at the time. Even with that taken into consideration, their model looks like it offers some protection even if the cycle turned ugly. I doubt it would repeat its stellar 2008 performance during the next recession, but it at least calms my nerves that the downside risk is limited even if I’m wrong about where we are in the economic cycle.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Unum Group (UNM)

business stock photo

Key Statistics

Enterprise Value = $9.192 billion

Operating Income = $1.576 billion

EV/Operating Income = 5.83x

Price/Revenue = .77x

Earnings Yield = 12%

Debt/Equity = 34%

The Company

Unum Group is a large international insurance company with a focus on life insurance and long-term disability. It operates throughout the world, but the main focus is their US & UK operation. It is an S&P 500 component.

Sentiment

Unum trades at a 50% discount from its 52-week high. Back in May, Unum missed earnings estimates by 1 penny and the stock dropped 17%. The earnings miss was due to issues in long-term care insurance, which triggered the reaction. The loss ratio in long-term care rose to 96.6% from 88.6%. Despite the rise in the loss ratio and problems in the long-term care segment of the business, operating income actually increased to $275 MM from $236 MM in the same quarter a year ago.

My take

For an S&P 500 component, Unum trades at a significant discount to the market and its peers in the industry. On a raw price/sales basis, the average for an insurance company is 1.35x. Unum, trading at .77x, trades at 57% of this valuation. Insurance is a fairly commoditized product with little differentiation. In this sense, my view is that insurance valuations are mostly a product of premium volume and underwriting standards, which are mostly homogenous in the large-cap universe.

Unum’s valuation is particularly unusual because Unum is actually a higher quality company than most of its peers. The average return on assets, for instance, for an insurance company is 1.31%. Unum delivers 1.65%. The market seems to think that the long-term care problems will overshadow the rest of the business, which doesn’t look to be the case.

My view on risk in the insurance business is simple: where there is smoke, there is fire. It’s not possible to know all of the risks in an insurance firm, but there are indicators. Insurance is a boring business. The main risk is that management with a short-term focus and an appetite for risk enters the picture.  The only way they can juice the returns and make the boring business exciting is by taking on unnecessary risk. This usually shows itself through rapid growth in earnings and revenues combined with higher debt levels and signs of financial distress.

For insurance companies, my focus is on purchasing good relative value and trying to reduce the odds that I’m buying into a nightmare scenario. A good example of a nightmare scenario would be AIG, who decided in the early 2000s that they didn’t want to be a boring old insurance company and instead wanted to be cool and become a high flying Wall Street gunslinger. We know how that worked out. Another example of a nightmare scenario would be GEICO in the 1970s, who loosened standards to fuel growth. This lead to a disaster that almost killed the company. This created a situation where Warren Buffett was able to move in, buy 1/3 of the company for $45 million, and use his influence to save the company. The rest is history.

With a low debt/equity ratio and a Piotroski F-Score of 7, there are no signs of financial distress in UNM. Top line revenues are only up 8.8% since 2013 and growing at a steady, organic pace. This implies that they aren’t playing it fast and loose with their underwriting standards and sacrificing risk management for business growth. Overall, this doesn’t strike me as the risky insurance firm that is going to blow up in the future.

The over-reaction to the penny miss looks extreme to me for an insurance company that is otherwise performing well. Being in the insurance business and investing heavily in short-term fixed income products, I also expect Unum and the insurance industry as a whole to benefit from rising interest rates. The economy is performing well, and unemployment is extremely low (for now), implying that premiums will be sustained.

Overall, Unum isn’t the most exciting deep value opportunity in my portfolio, but I think it presents a decent value proposition. It is a high-quality insurance company trading at a 57% discount to its peers and 50% off its 52-week high.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Argan (AGX)

power-station-643539_960_720 - Copy

Key Statistics

Enterprise Value = $184.8 million

Operating Income = $82.77 million

EV/Operating Income = 2.23x

Earnings Yield = 10%

Price/Revenue = .68x

Debt/Equity = 0%

The Company

Argan is a holding company that operates in the construction & engineering space. The focus of their business is the construction and operational support of power plants. The company has expanded over the decades and acquired other businesses in the same space.

The power plant business is the core of the company and also a source of uncertainty. Out of $675 million in revenues in 2017, the power plant business supplied $586 million of it. Other areas that Argan operates in include industrial fabrication and a telecommunications infrastructure business.

They have been in business since 1961.

A textbook example of Argan’s power plant business is their Panda Liberty Project in Pennsylvania. The project was completed in 2016. It was probably first negotiated in 2011-2012. Permits were then obtained, and it took 3 years to build. It is a small power plant running on natural gas and supplies electricity to 1 million people in Pennsylvania. It shows the nature of Argan’s business: (1) smallish power plants, (2) long time horizons for projects to come together, (3) a specialty in natural gas power production.

Argan acquired a nice book of natural gas power plant business with the decline (and abundance) of natural gas that came about as a result of fracking in the United States.

Sentiment

Argan has been punished in the last year, with the stock down 43% for its levels a year ago. The valuation statistics (2.23x EV), as you can see above, are down to absurd levels. It’s one of the cheapest stocks in the market by several metrics.

If it’s so cheap, what’s the problem? Simply put, the market is concerned that Argan doesn’t have a deep project backlog and won’t be able to continue generating its current level of earnings power. The business is already drying up, with year over year earnings declining by 65%.

Adding to the uncertainty is declining electricity usage in the United States. Electricity usage in the US is actually down since 2010 through a combination of technological efficiency and recession. While electricity use typically declines during recessions, it hasn’t recovered in a typical manner. Previously in the United States, economic growth and energy usage were tied at the hip. This relationship appears to have broken down as technology increases efficiency. As our TVs no longer require a crew of guys to move and refrigerators no longer guzzle electricity, the US economy has been able to grow without increasing electricity usage.

While the more efficient use of energy is likely good for society as a whole, it is terrible news for Argan, as the thirst for electricity (and power plants) isn’t what it used to be.

My Take

While Argan’s future is uncertain, the balance sheet’s quality is crystal clear. Argan’s balance sheet is a fortress. Management clearly expects business to be choppy (power plants don’t sell like candy bars) and prepares accordingly. They have zero long-term debt and a massive cash stockpile, currently at $434 million, or $27.88 per share. This is nearly equal to the market capitalization of the entire company.

While the future streams of business are uncertain, I am encouraged that Argan has been in this business since 1961. They have survived numerous recessions and downtrends in the industry. It seems foolish to think that they won’t overcome their current problems. My expectation with this stock is that they will find new sources of business as they always have, which should send the stock soaring once it comes together.

Electricity consumption might be declining, but this certainly does not mean that Argan’s business is dead. Plenty of power plants are in need of replacement. It might surprise and shock people to know, for instance, that there are still 1,300 coal power plants operating in the United States. Most of the nuclear power plants are also aging because they are mostly over 40 years old and some of them will need to be replaced as well. (We stopped building nuke plants after everyone was freaked out by the three-mile island incident. The China Syndrome didn’t help either. So, we stopped building nuclear power plants to our own detriment as a society.)

Alas, this blog isn’t about saving the world, it’s about making money. There is a large number of dirty, old power plants that will need to be replaced in the United States and that should generate business from Argan. The key to Argan’s future prospects is the generation of new business, which is bound to come.

Natural gas prices also remain cheap (for now), which likely means that Argan’s specialty in this area will be in demand.

Most importantly, even if they don’t find new sources of business, the balance sheet offers protection on the downside. It also makes me conclude that the position won’t blow up in any kind of spectacular fashion. The company is nearly trading for the cash in the bank, which is absurd.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.