After 28 years in the industry, former Third Avenue manager Chip Rewey has struck out to launch his own firm, Rewey Asset Management, based on the strategies he has seen work the best over his career.
Although the time of his start, at the height of a historic bull market, may give some managers pause, Rewey feels comfortable because he does not own the market, he said. The value manager’s concentrated portfolios contain only 15 to 25 compelling small to mid-cap stocks he believes will appreciate over three to five years, allowing him to be market agnostic.
Market forces may even prove auspicious for his focus on neglected companies. As investors have rushed to put money into exchange-traded funds, analysts have overlooked companies that are not represented in major indexes. Meanwhile, increasingly popular quantitative funds either do not have data to mine from companies few analysts follow or model based on past data, which is less valuable than understanding what will happen in the future, Rewey said.
“Given what has gone on in the market, I think there’s been huge neglect of the value space,” he said. “I would say the value space is kind of a neglected value in itself right now.”
Rewey’s philosophy for choosing stocks focuses on three pillars: financial strength, the ability to grow and produce strong profits and a discount of at least 30% to his assessed fair value. He defines financial strength as a strong balance sheet with little or no leverage, low or no contingent liabilities such as pension or environmental and the ability to generate strong free cash flow or earnings. Each is connected, meaning, for instance, a company with no leverage that is losing free cash flow with no solution in the next year or two will eventually become indebted.
A strong balance sheet will also allow management to “stay on the offense instead of defense,” he said. Instead of management spending time on finding ways to repair a poor balance sheet, such as by selling assets, they can take profitable actions such as investing in capital expenditures or opportunistically make acquisitions.
“It lets us risk time instead of capital,” Rewey said, “meaning over time I think I’ll be fine versus risking downside on the stock because I have a strong balance sheet to be the fundamental pillar.”
When Rewey considers the ability to produce strong profits, he does not disqualify companies that have no earnings to post currently. Sometimes, an event may depress margins or profitability for a quarter or year. What is important to him is that the core fundamentals of the company that allowed it to be profitable, including operating margins and return on invested capital, can return.
Many deep-value investors using solely the price-book ratio make a mistake by not putting the ratio in this type of context, Rewey said. He gave the example of investing a thousand dollars in brand new stage coaches the day a railroad opened in your town. The stage coaches may have a high book value, but will not see a good margins or return on invested capital when beat by the better and quicker railroad.
A more modern-day example, he said, is the stream of value investors buying into companies operating offshore supply boats for offshore drilling, many of which have gone bankrupt. Many of the companies had good balance sheets with low debt and attractive book values, but the bigger, forward-looking picture proved more dire. Shale drilling is accelerating in the U.S. and will continue to grow for the next three to five years, with high returns, Rewey said. Shale oil also abounds in many other, lower-cost areas such as Russia, China and Latin America, leaving many of the expensive offshore drilling boats to rust.
“My job as an analyst is to look at the book value, as represented by its capex and its property plant and equipment, and its intellectual property, and think to myself, ‘What can this company earn over the next three to five years, and can it post the returns that it has or greater, and therefore does the book value discount make sense in the fact that I can continue to earn on that looking forward?’” he said. “And again a lot of people hate that I want to look forward, but I think it’s the main job of an analyst.”
For valuation, Rewey looks for a 30% discount to his assessed fair value, or price of where he believes the company should be trading in light of market conditions and peers. As a patient buyer, he commits capital only at the discounted price.
Other items he looks for if the three pillars are in place are takeovers, potential activisms and spinoffs, which can help with valuation.
“If I look back over three decades, if I look for commonality among where I’ve made the most money, it’s these things,” he said. “Said differently, where I’ve made mistakes, it’s where one of these three things have not been true.”
Rewey’s value-minded philosophy scored some champions when he spoke at the GuruFocus value conference in Omaha in 2016. Each of his three selections advanced after two years. Comerica Inc. (CMA, Financial) rose from $44.93 to $93.12 with a peak of $102.66, Visteon Corp. (VC, Financial) rose from $79.55 to $103.01 with a peak of $140.64 and Kirby Corp. (KEX, Financial) rose from $64.03 to $80.50 with a peak of $94.05.
Now he likes regional banks, which have strong balance sheets due to regulators requiring them to have excess capital. In addition, historically low interest rates have prevented them from earning greater returns than they would have on higher capital, and in a strong economy, loan demand has been weak.
Of these, Rewey bought shares of First Horizon National Corp. (FHN, Financial), a Tennessee-based financial institution he called “very well positioned” and “one of the cheapest banks,” with branches in Tennessee, North Carolina, South Carolina and Florida. He estimates the stock, trading at $17.68, is worth $24, and will reach $27 in two years, with a 2.7% dividend yield.
Primarily, he likes the bank’s strong capital ratios, superior credit quality and record of investing in its own business. It recently completed a merger to expand its reach in the Carolinas and Florida, some of the fastest-growing areas of the country. Its strong balance sheet features $27 billion in loans and $31 billion in deposits, 30% of which do not pay any interest rates. Deposit betas at First Horizon have run at about 50% for the last year, meaning that, for the Federal Reserve’s 25 basis-point increase in interest rates, First Horizon will have to pass along 12-13 basis points and keep 12-13 basis points for itself.
“It’s a weird time in history that rising rates are a positive for banks, but they are,” Rewey said.
Regarding the bank’s ability to grow, Rewey pointed to its strong returns on common equity of 18% with a goal of 17-19%, its return on assets of 1.2% and goal of 1.25-1.45%, and its efficiency ratio of 65% with a goal of 60%.
And the market has neglected some important points. Namely, the bank closed a merger in May that resulted in many one-time, merger-related charges in its quarterly results that quantitative firms screening on reported numbers will misread. It then raised synergy targets by 100%, from 8% to 17%, which Rewey thinks may run even higher.
Next, he likes home builder Lennar (LEN, Financial), a stock trading at $48 that he values at $78. Rewey believes the company is cheap on a sum-of-the-parts basis. It may deleverage its balance sheet by selling several assets, such as its investment vehicle unit Rialto Capital Management, a multi-family unit and a subsidiary called Five Point Holdings that held an initial public offering last year. Margins may also expand to 21-22% from their current 17% due to the company raising synergy targets after merging with CalAtlantic. A one-time accounting phenomenon in its quarterly results brought on by the merger led to market neglect, but Rewey sees the issue resolving by the fourth quarter.
It has a compelling valuation, specifically the B-shares that trade at $39 but have 10-1 voting rights versus the Lennar shares. They trade at a discount because the retired CEO (now executive chairman), Stuart Miller, holds 57% of the class, or 30% of the company. Rewey believes that at some point he will monetize the shares due to regulatory pressure or a push from an activist investor, such as Mario Gabelli (Trades, Portfolio) of GAMCO Investors, who is involved. Miller also stands to benefit from converting his shares, which increases the chances it will happen.
“I think there’s kind of the arbitrage of the share class plus the compelling valuation case for the stock at large,” Rewey said.
Last, he favors Ultra Clean Technologies (UCTT, Financial), a semiconductor supplier. The stock dropped along with a retreat in the semiconductor industry, trading at $12.60 after peaking at $34.50 this year. Rewey’s price target is $19.50. The company boasts a strong balance sheet with net cash, and it will enjoy the inevitable long-term growth in 5G, self-driving cars and semiconductors.
But with only four analysts covering the company, Rewey said the market has largely missed an interesting aspect of its business: its August acquisition of Quantum Global, a company Ultra Clean used to clean its tools. With the acquisition, Ultra Clean will not only increase Ebitda 50%, but even out its highly volatile revenue with a more stable stream from Quantum Global. The additional cash flow it generates will help pay off the debt incurred to make the acquisition and return to net cash. Rewey sees 25% accretion from the deal but said analysts have not modeled that because they have only looked back at numbers from the previous quarters. He believes the company will improve over the next five years, with accelerating margins.
Fortifying his case is Ultra Clean’s implementation of a new IT system based on software from Germany’s SAP SE (ETR:SAP, Financial). Companies Rewey has seen use the system have increased their Ebit margins 100 to 200 basis points as it provides better visibility to their cost and inventories on their revenue cycles.
Rewey does not like to give opinions on the macro picture, but going forward he believes the U.S. economy will provide a decent backdrop for investing. He cited solid GDP, low unemployment and historically mild interest rates. His primary concern is tariffs, but said he and most of the investing community view them as a negotiating tool President Trump can adjust to take a less-than-100-percent victory. While tariffs spiraling out of control is the biggest risk he can name, he does not discount the risk he does not see.
“They don’t call it the unexpected because you see it coming,” he said. “And that is why you have to have a strong balance sheet for what you own.”
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