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Reflections from 20 Years of Investing (2001-2008) Pt 2

July 05, 2013 | About:



“Creativity is just connecting things. When you ask creative people how they did something, they feel a little guilty because they didn’t really do it, they just saw something. It seemed obvious to them after a while” – Steve Jobs





I was brimming with confidence entering 2004; I had just recorded my best year ever in terms of gains versus the S&P. All the market indices had recorded a resounding rally since the early fall of 2002; the rally was fueled by the Federal Reserve’s monetary easing policy and a new found optimism about future of corporate profits. It seemed that the tragedy of September 11 was now a distant memory and its effects on the psyche of the US consumer had all but disappeared.



Following precipitous market rallies, value investors must devote increasing research time to uncover bargains. Such was the case in 2004, many of the obvious values had disappeared and simple asset plays, as well as beaten down cyclical stocks were quickly vanishing from the screens of value investors.



During such times, investors either have to become more imaginative in regard to uncovering value propositions, or reduce the number of companies that they hold in their portfolios. At that point in my investing career, I still lacked the confidence to hold just a few large positions; thus I decided to become more creative in my investments. I starting searching for theme investments which I thought would prosper during the cyclical recovery.



The Investing Climate in 2003-2007



Oil, natural gas and other commodities were entering a bull market, driving up the value of the companies who owned or leased the land which held the resources. Oil service and equipment stocks as well as the mining equipment companies would benefit mightily as the demand for their products and services rose dramatically.



Likewise with the housing market, not only were home builders and banks benefiting from the housing boom, so too were the building material suppliers and virtually any business which was related to the worldwide surge in housing market.



I started to focus upon finding companies that would benefit from the aforementioned investment themes, but only investing in companies which still held reasonable valuation metrics. The idea was to locate companies that remained undiscovered by Wall Street which were likely to increase their forward earnings. Furthermore, such companies would frequently become buyout candidates, as larger companies looked to increase their earnings by acquiring businesses that were not already “sky high” in price.



When I would check the ownership of many of the companies that I found to be worthy of research, I frequently ran across the name of Jeffrey Gendell who titled his hedge fund Tontine Asset Management.



The Rise and Fall of Tontine Asset Management and ENGlobal (ENG)



Gendell rarely conducted interviews, almost never publicizing his stock selections or his theories in regard to investing. The average investor had never heard of him or his hedge fund; however anyone who tracked money managers closely, was well aware the outstanding returns which were flowing into the pockets of the clients at Tontine. In 2003 and 2004, Gendell recorded near miraculous gains, approximately doubling the value of his portfolios, in back to back years.



Gendell first caught the eye of Wall Street when he became extremely bullish on US steel companies in the early 2000s. Similar to today, US steel companies were on the outs with investors and Tontine boldly stepped in, heavily overweighting the sector. Shortly after Gendell entered the sector, steel companies began a protracted bull market; it seems that Wall Street had a brand new emerging superstar that was capable of spotting cyclical bottoms as well as possessing sufficient courageous to act upon his convictions.



The prodigious gains of Gendell caught my eye as well, and I began to track the companies in which he held significant ownership. One of the companies that I ran across was tiny ENGlobal (ENG), a Houston-based provider of engineering services to the energy sector. The stock fit my investing theme perfectly and it did not hurt my confidence to know that Gendell felt the same way. Further, the stock appeared to be reasonably valued in terms of the business the company was writing and I believed that its earnings were about ready to spike upward. As you can see, I was not exactly demanding a large margin of safety in my theme investments at that point in time.



I purchased ENG in the spring of 2005 for $2.20 a share; by the mid to late summer of the same year, the stock had climbed to around 9.00 a share. I now had to make a decision on whether to sell the stock and take my gains or continue to hold the stock. As it turns out my decision was made considerably easier when I turned on Mad Money that night and much to my amazement, Jim Cramer was touting this tiny microcap stock. My decision was now etched in stone; I sold ENG at the open of the market the following day, for exactly 9.00 per share.



It had been my experience that Cramer’s late entry into a momentum stocks generally resulted in a market top for the equity. Such was the case with ENG, after the price ascended slightly higher, the stock quickly dropped below 7 dollars a share. In fairness to Cramer, the stock did go much higher several years later but that was a merely temporary spike, the case of a low quality company hitting a temporary sweet spot. A few years later the stock steadily dropped and never recovered; today it trades under a dollar a share.



Now back to the saga of Jeffrey Gendell and Tontine Asset Management. It seemed that Mr. Gendell was not adhering to Ben Graham’s prime directive which suggested that investors should minimize their risk by demanding a sufficient margin of safety on their investment selections. Not only was the hedge fund highly leveraged but almost his entire portfolio was concentrated in debt-laden cyclical companies which were currently benefiting from rising real estate and commodity prices. Apparently, Gendell simply did not believe that the bull market which was triggered by the real estate bubble and the boom cycle in commodities was going to end any time soon.



To make a long story short, in early 2009 Tontine was forced into liquidating its positions and shutting down the fund. I noticed one of the stocks that Gendell was forced to sell was ENG—I wonder if Cramer was still holding the stock? The experience served as a lesson for all investors (me included) who might decide to coat-tail a respected investor without regard to performing their own due diligence on the guru’s stock purchases. The Gendell saga also exposed the extreme danger of employing excessive margin in the hopes of “juicing” one’s investment returns.



The Essential Points Successful Theme Investing



I will close out today’s discussion by integrating value theory into successful theme investing. Theme investing can help investors identify cyclical companies which may benefit from a temporary period of enhanced earnings, as a result of favorable macro or micro economic conditions. Further, a well constructed economic thesis might identify a stock with a powerful catalyst in the form of an acceleration of future earnings. That said, merely identifying companies that are likely to temporarily prosper in terms of earnings is not enough; the stocks must also contain favorable valuation metrics or the investor is merely engaging in speculation. In other words, the stock must also be cheap or it should be avoided without regard to a impending earnings explosion.



One of the common banes that plague the average investor is his/her affinity for selecting stocks which are trading at or near their multiyear highs. If one wishes to become a successful value investor, that tendency needs to be eliminated promptly. Nothing is more damaging to long term capital appreciation than being chronically late to the party. There is no shame in recognizing a catalyst after the stock has already moved; that is merely a fact of life in investing. The shame lies in committing one’s hard earned capital into a stock which has already moved precipitously and is now becoming over priced.



John Maynard Keyes once opined: “Successful Investing is anticipating the anticipation of others.” That notion applies in spades when it comes to theme investing. Typically, a stock moves upwards long before its improvement in earnings comes to fruition. Warren Buffett colorfully observed: “If you wait for the robins, spring will be over.” Should an investor wait for an earnings confirmation to validate his/her theory, then the time to invest will have already passed. I will end today’s discussion by profiling two successful investments I made in high quality cyclical companies during the period of the mid-2000s. The companies are: Maverick Tube (formerly MVK) and Astec (ASTE).



Maverick Tube: A Strong Demand in OCTG Leads to a Buyout



Entering 2005 I was scouring the oil service and equipment sector for undervalued companies. Being somewhat late to the party, it was difficult to uncover many stocks in the sector that offered much value. Most of the companies had experienced earnings explosions in 2004 and were now trading at multiyear highs, in addition to sporting exorbitant trailing PE multiples.



The 2004 hurricane had done extensive damage to offshore rigs in the Gulf of Mexico. The following year, the US would experience one of its worst hurricane seasons on record which would result in record natural gas prices in late 2005 and early 2006.



At that point in time, land drillers did not possess the technology to extract the massive reserves of natural gas which existed deep in shale deposits throughout the United States. Natural gas typically traded between six to ten times the price of crude oil. Generally speaking, high oil prices begat high natural gas prices. Additionally, the US natural gas market was isolated from world markets since barriers to its worldwide transportation existed. Therefore, severe disruptions in off shore reserves significantly disrupted the supply of natural gas in the US, which in turn increased demand for US land drillers.



The aforementioned demand and subsequent increase in natural gas prices, lead to an unprecedented increase in the need for Oil Country Tubular Goods (OCTG). The record demand for steel pipes which were used in the drilling of natural gas wells was resulting in record profits at Maverick Tube (formerly MVK). Maverick Tube was one largest suppliers of tubular steel products for the energy sector, in the United States and Canada.



In 2004, Maverick Tube had recorded profits in excess of $4.50 per share. Although, the stock had risen significantly in the last several years, its price still appeared to be reasonable at around 40 dollars a share, in the mid to latter months of 2005. Furthermore, Maverick was not a “one-trick-pony”. They were also doing well in their industrial segment which supplied steel conduit to the commercial building market. Additionally, company had an excellent history of profitability.



In mid 2005, the Baker-Hughes rig count which echoed the demand for the company’s energy products was continuing to increase. As natural gas prices continued to ascend in 2005, it appeared that Maverick’s earnings would continue to increase well into 2006.



Maverick appeared to be one of the few bargains still available in the oils service and equipment sector in 2005. Shareholders were rewarded a year later when the company was acquired by Tenaris (TS) at a price of 65 dollars a share in June of 2006.



Following the acquisition of Maverick, I quickly rolled my profits into Long Star Technologies (formerly LSS) which at the time was Maverick’s chief rival. Lone Star was subsequently acquired by US Steel (X) approximately one year later. In retrospect, I believe I was extremely fortunate to have the company taken out at that time, since I doubt if I would have sold out of my position in Lone Star any time soon.



Natural gas prices would experience a final large spike in early 2008 but they would soon drop precipitously. In a few months, the credit crisis of 2008 would dramatically suppress the demand for OCTG and other energy related products. I believe that Long Star’s price per share would have quickly eroded to a level well below my original purchase price.



One of the major lessons I have learned in the course of my investing career is that cyclical stocks must be sold when they still appear to be cheap in terms of price to earnings. Alternatively, the best time to purchase them is when they are historically cheap in terms of their price to book ratio. At that point the companies are generally losing money or recording little in the way of net income. The counter-intuitive nature of such equities will likely continue to confound investors for the foreseeable future.



Astec Industries (ASTE): A Play on the Highway Bill of 2005



Deep Throat allegedly implored Bernstein and Woodward to “follow the money” in order to solve the mystery of the break in which occurred at the Watergate hotel; the success of the young reporters eventually led to the resignation of Richard Nixon. In mid 2005, I was employing exactly the same strategy in my attempt to uncover undervalued theme stocks which would benefit from the flood of money that would soon be released by the federal government in an attempt to rebuild our infrastructure.



Initially I became excited in August of 2005 when following a series of delays, the Safe, Accountable, Flexible, Efficient Transportation Equity Act: A Legacy for Users, (commonly referred to as the Highway Bill) was put into law. I would spend an inordinate amount of time attempting to identify companies which would temporarily benefit financially as a result of its passage. Following an extensive period of internet research, I was unable to uncover any undervalued stocks related to US infrastructure that I felt would benefit from the impending release of federal funds in accordance with the act. In essence, I had stuck out; I decided to give up and spend my time in a more productive manner.



In the summer of 2006, I was combing through the 52-week lows when a very interesting stock presented itself. The company was Astec Industries (ASTE), and they made the majority of their profits from various types of asphalt equipment which was principally used in US road construction. I immediately delved full throttle into the company’s filings and started listening to their conference calls.



Astec was one of the first companies that convinced me that about the expediency of listening to conference calls. The former CEO of ASTE was J. Don Brock, and he was a veritable fountain of information relating to the road construction business. Listening to his conference calls was tantamount to enrolling in a road construction school. He would inform the listeners about the difference in prices between concrete and asphalt, the amount of regrind that was permitted in a particular state, the cost to repave a road, as well as many of the microeconomics that supported the various machines that the company manufactured and sold.



It took me very little time to decide that I should not “look this gift horse in the mouth”; rather I decided to start buying ASTE hand over fist. I reread the annuals and quarterly reports and researched the effect of the prior Highway bill (which was passed in 1998) on the company’s earnings and stock price; rarely have I ever become so excited in regard to the prospects of a stock.



As a matter of fact, I was so confident that I implored all of my friends to get involved in the stock. I even recommended it to our son and his wife, something which I had never done before. I wrote the stock up on message boards, complete with charts and an extensive rational for purchasing the stock which included an assessment of when one would need to sell their holdings.



I planned to sell the stock in just over a year (to avoid short term gains) at what I believed would be about the midpoint of their earnings explosion. I believed that the company would continue to prosper for about another year following my sale but I was extremely concerned about savvy investors selling their positions long before the company’s earnings began to turn downward. I had learned a considerable amount about buying and selling cyclical stocks and in the case of ASTE, I had noticed that the stock had began to drop long before their earnings began to recede during the preceding Highway Bill boom and bust cycle.



As it turned out my analysis was spot on; I had never previously—and probably never will again— handicap a stock so perfectly. I bought the stock around its 52-week low at an average cost of under 25 dollars a share and sold it slightly over a year later in the Summer of 2007, in the mid to high fifty dollar range, virtually at its all-time high.



We were visiting our kids in Virginia at the time of the second quarter conference call in August of 2007. Astec’s earnings were phenomenal and the prospects appeared good for the rest of the year, but I had already made my decision in advance. I borrowed my son’s computer and sold every share of ASTE that very morning.



After selling my shares I made it a point to advise my son and his wife to sell immediately, reiterating every detail which I had made when I advised them to buy the stock. I specifically recall admonishing them that “cyclical stocks must be sold when their earnings still improving” and ASTE had just announced record earnings.



Following a precipitous decline in Astec stock a few months later, I called my son and daughter-in-law to reiterate how wise they were to sell the stock and take their profits. Much to my dismay, I found out that they had not divested a single share of Astec stock; I might as well have been lecturing to a wall. Such is the power of a high momentum stock on a novice investor’s psyche; apparently my reasoning and prescribed plan of attack, was not sufficient to overcome the lure of continuing to hold a rapidly rising stock.



Reflections from Twenty Years of Investing will return with the final edition for the years from 2001-2008 (it seems that describing this period is taking longer than I had anticipated). The edition will cover Imperial Sugar, a number of Chinese stocks and a profound investing error that severely damaged my long term rate of return.








































Rating: 3.7/5 (25 votes)

Comments

xtddd
Xtddd - 1 year ago
excellent article. john. you say you buy stocks traded below tangible book but ASTE was never not.
vgm
Vgm - 1 year ago
Thanks for the stimulating article.

With all due humility, I think Steve Jobs is understating what's involved in creativity. The hard work of accumulating knowledge in the field(s) must be done in the first place in order for the mind to be ready and able to connect the right things. "Chance favors the prepared mind" as Pasteur put it.
John Emerson
John Emerson - 1 year ago


Hi XTD,

You are very familar with my preferred method of investing which has evolved through time. In the mid 2000s are was doing some things that did not demand the high margin of safety that I try to adhere to today. At times I was successful, other times I was not but the overall process was quite educational. You will see how I arrived at my current philosophy as the articles progress. That said I think it is important that one never becomes so type cast in a certain philosophy that one becomes uncreative and close-minded.

VGM,

I concur with your point that the accumulation of knowledge greatly facilitates creativity and the ability to connect the dots. One must alway keep in mind that ideas are rarely original; rather they are the result of ones ability to build upon the thoughts of others and combine seemingly unrelated concepts.

Thank you for the comments.

carefull
Carefull premium member - 1 year ago
John,

I throughly enjoyed both of your articles and look forward to the sequel. I think we should have a section titled "investing mistakes I have made."

I put over half my net worth into a small company with legal claims against IBM. The claims are valid--great! The attorneys are top-notch (Boies Shiller & Flexner), and have skin in the game.

After more than doubling my cost on the run-up to the trials, the stock went to zero after a series of stunning legal losses. The claims are still alive, so there is hope. However, later I learned that the attorneys themselves diversify with about 20-30 of these multi-million dollar cases at a time.

Mark
Koheleth
Koheleth - 1 year ago
Love your articles, but for me this part needs a qualification: ..."One of the common banes that plague the average investor is his/her affinity for selecting stocks which are trading at or near their multiyear highs. If one wishes to become a successful value investor, that tendency needs to be eliminated promptly. Nothing is more damaging to long term capital appreciation than being chronically late to the party. There is no shame in recognizing a catalyst after the stock has already moved; that is merely a fact of life in investing. The shame lies in committing one’s hard earned capital into a stock which has already moved precipitously and is now becoming over priced."

Generally agree BUT it depends on whether it is overpriced or a full price. I recall Buffett saying if the company is going to make more and more money over time, than the price paid becomes less important. In the book "The Outsiders" the classic example is See's Candies. Buffett and Munger almost didn't buy it because it wasn't cheap enough. Because of pricing power they compounded returns over 30% annually I believe.

But even if they paid DOUBLE what they did, they still would have compounded over 20%. As Lynch said about Walmart, it went up 10x the first ten years, it went up another 10x the second decade, so "you have plenty of time". You would have been mislead if you worried about the 52-week high.

Just depends on the company itself. So price paid helps but it is not the only thing.

Thanks for sharing,

Koheleth
Koheleth - 1 year ago
... and totally agree with you about PE's for cyclical oil companies, or any commodity for that matter. A low PE can be VERY misleading. You must have a feel for where commodity prices are compared to historical averages. If they are at all time highs like the period you are referring to, then you will be getting fat earnings which will make the PE look cheap.

Also on the qualitative side, I think you have to have a feel whether the oil company is any good at exploration. This is one industry where the ceo's experience is vitally important, whether he/she really does have a background in drilling and exploration or is just an accountant.

I think Lynch makes the point about low cyclical PE's as well in his book "One Up on Wall Street"
John Emerson
John Emerson - 1 year ago
Hi Koheleth,

In regard to See's Candy, I believe that Buffett paid about 12x earnings, not all that expensive for a company that required very little in the way of capital to run the business. As I recall what bothered Buffett was the fact that he paid such a high premium to the tangible book value of the company. At that point he was not attempting to buy companies with significant economic goodwill. He credited Munger for his epiphany.

Occasionally an investor can get away with buying a stock at a 52-week high but it must be one with a great growth prospects and a durable competitive advantage. The typical investor misdiagnosises those two attributes and generally buys such stocks on the basis of momentum.

Good points about energy stocks which is an area that I have never felt particularly comfortable.

Thanks for the intelligent comments.
xtddd
Xtddd - 1 year ago
hi ,john. i have talked about the investing by emails with you and i am familiar with your method. yes,you are right.sometimes, i look at the depressed stocks traded with a small premium above book value.look forward for your articles.

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