Friedman Industries (FRD)

deer

Key Statistics

Market Capitalization = $37.02 million

Current Assets = $69.29 million

Cash & Equivalents = $22.33 million

Total Liabilities = 12.68 million

Net Current Asset Value = $56.61 million

Operating Cash Flow = $3.47 million

Price/Tangible Book = 53%

Altman Z-Score = 4.66

Summary

Friedman is a steel company that has been around since 1965.

Their business is split up into two segments: coil products and tubular steel. Coil products account for 67% of revenue and tubular steel accounts for 33% of revenue.

Coiled steel is basically a form of sheet metal used in a wide variety of different industries. It can be used in the manufacture of automobiles, refrigerators, or roof gutters.

Tubular steel is used for a wide variety of applications. It can be used in the medical industry for stethoscopes or wheelchairs. Engines require tubular steel, which can be used in aircraft or automobiles. Steel tubing is also used in the manufacturing industry, to transport liquids throughout the process. It is also used heavily in the construction industry, for things like structural support or railings.

Friedman is a smaller player in an industry dominated by giants, but it has managed over the decades to continue to survive in a tough industry. Its plants are located throughout the Southern United States. The plants operate in Texas, Arkansas, and Alabama.

My Take

Friedman’s stock has been beaten up. It started to decline last year as a recession and reduced steel demand became more apparent. It hit a low of $3.72 during the depths of the COVID decline. I bought it yesterday at $4.9899. It has gone up significantly since the lows, but I still think it is relatively cheap. A return to the 52-week high would take the stock up to $7.01.

The stock trades below net current asset value, so I don’t expect it to be an outstanding business that is growing fast with high returns on invested capital.

With that said, in the universe of net-net’s (a world of reverse mergers and biotech science experiments), Friedman strikes me as a high quality net-net. In the last year, it has posted positive operating cash flow, so it is a viable business. The Altman Z-Score of 4.66 also shows a high degree of financial quality and limited bankruptcy risk. I’m confident based on the operating history and high level of financial quality that Friedman isn’t going to annihilate its current asset value, which can’t be said for many net-net’s.

The situation currently appears bleak for the steel industry. The customers for steel products are hitting hard times as a result of the recession. Construction and manufacturing activity are likely to slow down.

I think the hard times are already reflected in the stock price. At 53% of tangible book, this is near the lowest level that it has traded in the last 20 years. In the last five years, the stock usually trades in a range of 80%-100% of tangible book. When the steel industry was hot in the mid-2000s, Friedman traded at double tangible book value. I think it’s a reasonable assumption that this can return to 80%-100% range of tangible book, at which point I will sell.

If the economy returns to some semblance of normal, then construction and manufacturing activity will get back to normal. Coiled and tubular steel are essential for a number of uses that aren’t going away.

Meanwhile, steel plants are being shut down and steel production is down for the industry. This means that if demand returns back to normal, Friedman will be well positioned to take advantage of it.

If that doesn’t happen, then Friedman has the balance sheet and discipline to survive. It already trades at a price which indicates that there won’t be a recovery in the steel industry.

For those reasons, I think the risk/reward makes sense, so I purchased a position.

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.

Trades

I sold 125 shares of Smith & Wesson (SWBI) @ $16.8803. I still own 145 shares. I was up 122% on the position and it had grown to 10% of my account. I took it back down to 5%. I still don’t think that the run for this stock is over, as gun sales are likely to be strong.

I bought 350 shares of Friedman Industries (FRD) @ $4.9899, which is below net current asset value and 50% of tangible book.

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.

Portfolio Position in Troubling Times

fork

Goodbye, shorts

I dumped my short position yesterday. It looks like I screwed up with this bet. Fortunately, it wasn’t a fatal bet.

I lost 15% on the position and I’m up slightly over the last few months overall, thanks to the performance of the stocks that I still own. I owned it mainly to stay market neutral and didn’t make a big bet on it, so it’s an outcome that isn’t the end of the world.

I’m still happy that I have been cautious this year. I’m down only 22% YTD, which is a lot better than the deep value universe that I operate in. The universe of stocks with an EV/EBIT multiple under 5 is down 40% YTD. It was previously down nearly 50% and I avoided nearly the entirety of this drawdown. I also outperformed this universe last year, when I was up 32%.

I still badly lag the S&P 500 since I started this blog in December 2016 – which is very disheartening – but I’ll take the good news where I can.

My passive approach (small value, long term treasuries, gold, international small caps, and real estate) has handled the crisis excellently, down only 5% YTD after being down only 20% in the worst of the crisis. I’m often tempted to put this brokerage account into that passive approach, but I still enjoy the hunt of picking stocks and trying to figure out the macro picture.

Positioning

I bought only a couple stocks during the depths of the crisis – VLGEA (super markets) and AOBC (guns – now SWBI). VLGEA is flat, but AOBC has been an outstanding performer. I am up 80% on the position. It looks like my thesis – that COVID would drive higher gun sales – is proving to be correct. I couldn’t have anticipated nationwide riots, but that appears to be helping out the position, as well.

While I am no longer short, I still hold a lot of cash. 78% of my portfolio is still cash. Needless to say, I am still quite bearish on the market, even though I don’t want to be short it.

The Market

If I’m bearish, why aren’t I holding onto the short position?

I know that a trend following element is absolutely essential to shorting.

I walked into the short with an eye on the market’s 200-day moving average. Recently, the S&P 500 crept above the 200 day moving average.

200dma

As a value investor, I have always talked a lot of smack about trend following, but I have been changing my mind after examining the evidence.

A great resource on trend following is Meb Faber’s paper – A Quantitative Approach to Tactical Asset Allocation. The approach advocates owning asset classes only when they are above their 200 day moving average. The approach reduces drawdowns while still delivering the market’s rate of return.

A trend following strategy like that gets out of the market when it falls below the moving average and stays invested when it is above.

Looking at the S&P 500 over the last decade, an investor would have only been out of the market a few times. They mostly turned out to be false alarms that didn’t see the market make a massive move lower. This includes the 2011 debt ceiling showdown, the oil market chaos in 2015-16, and the December 2018 meltdown.

Where a trend following strategy helps is during the big, nasty draw-downs. An investor following a trend system would have sold in February, avoiding all of the mayhem that occured in March. It would have also kept an investor out of the market during most of the 2000-03 50% drawdown. It would have also kept an investor out of the market from 2007-09 during that 50% debacle. Trend following buys in late in the game – but who cares? They avoid the cops showing up to the party, and then arrive a little late to the next one.

When a market is solidly above the 200 day moving average, it usually continues rallying higher, even when the fundamentals don’t support it.

Paul Tudor Jones is probably the most vocal advocate of using the 200 day moving average as a trend indicator. He had this to say about the approach:

My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out.

Historically, it is a very bad idea to be short the market when it is above this level.

While it is often maddening to value investors like me, the fact of the matter is that there is nothing to prevent something absurd from getting a lot more absurd. This is a lesson that value investors who have been short stocks like Tesla have learned the hard way.

It’s something that people who were short the Nasdaq in the ’90s also learned the hard way. An investor could have looked at the market in early 1999 and concluded that it was absurdly overvalued. They would have been correct. Even though they would have been correct, it wouldn’t have stopped the market from wiping them out by doubling before melting down from 2000-03.

Unrelated: “The Hard Way” was a pretty funny early ’90s flick.

 

There is nothing to keep an absurd market from getting more absurd.

As a value investor, I have a visceral hatred of following the herd, but I think it’s important to keep tabs on the movements of the herd to prevent me from getting trampled by it.

Absurdity

Make no mistake: I think what’s going on is completely absurd, but I’m not going to fight it.

The real economy has been eviscerated. We have Depression level unemployment – approaching 20%. America’s corporations are surviving by leveraging up, making them even more fragile than they were before the crisis. Even the tech giants that have enjoyed the biggest gains of the rebound have seen their earnings dissipate.

The Fed is providing liquidity, but that’s all that the Fed can do. Jerome Powell isn’t a sorcerer who can create a 1999 economy out of 1930s unemployment. The Fed is preventing the system from collapsing, but that’s not the same thing as fixing the damage that has been done to the actual economy. The Federal government is providing fiscal stimulus, but that isn’t enough to replace a job or re-create the actual productive economic activity that has been eliminated.

Wall Street doesn’t care. It has doubled down on its commitment to the Fed put – the idea that the Fed will have the power to prevent any further meltdown in the market. The actual earnings capacity of the market has been decimated, but the markets are completely ignoring this.

The bear thesis of the last decade – that the markets are fraudulent and being manipulated by the Fed – has now turned into the bull thesis. Buy stocks because the Fed will make it go higher. Earnings and the economy don’t matter. This is dangerous and absurd thinking.

One take is that the market believes we will swiftly return back to normal with the economy re-opening. Maybe, but I think this is a dubious bet. I’m sure activity will resume and life will go back to normal, but it’s not going to be 100% of where we were before. There will be a number of businesses (like bars & restaurants) that will not re-open, because they couldn’t survive a 100% drop in revenues. Meanwhile, furloughed employees won’t be immediately re-hired, as businesses take a wait-and-see approach to bringing them back on board.

Nor will everyone in the economy immediately leap back to normal. Everyone isn’t going to re-book their vacations, even if 70% of them do. Businesses aren’t going to resume all of their business trips and conferences. Older people will likely wait until it’s clear that the virus has either been overblown or that we have a vaccine. They also command most of the disposable income, so that’s a major hit to the economy.

There also isn’t a guarantee that there won’t be a resurgence of the virus once the lockdowns end. We flattened the curve, but who is to say this won’t start spreading all over again? This virus started with a handful of people in China and spread all over the world. Once we resume normal activities, won’t it start spreading all over again?

Most of the damage from the Spanish Flu occurred during the second wave of the virus. Will we have a second wave of this virus? Will that trigger another round of economically destructive lockdowns? I don’t know, but the probability of that happening is not zero.

Call me a pessimist, but I don’t see a lot to be optimistic about these days. The market is partying like it is 1999 while the economy is in 1932.

I’m still holding a lot of cash even though I am no longer short, simply because I think that the risks are massive and the market is behaving like they don’t exist.

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.

SH

With the market now above the 200 day moving average combined with the fact that it is seemingly immune to bad economic news and nationwide riots, it’s apparent to me that fighting the Fed and buying this ETF was a mistake.

I still think the market is overvalued and hold a lot of cash, but I’m not going to be short this market anymore.

Sold 290 shares @ $23.025.

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.