Exploiting Cyclical Companies For Outsized Returns — Part [2/2]

Part 2 of my personal experience with cyclical stocks + 5 European net-nets from the steel industry.

In first part of this article, I mentioned one European net-net from the steel industry that’s just crossed my strike price - you can read it here:

Exploiting Cyclical Companies For Outsized Returns — Part [1/2]

Originally, I planned to cover just that one stock, but thanks to the magic of volatility, I discovered yet another net-net with an even more compelling valuation. It’s arguably one of the cheapest companies I've seen in the past few years in terms of fundamentals.

Currently, it trades at approx. 20% of book value, less than two-thirds of its NCAV, has low debt, and boasts a substantial cash reserve - all at a market cap of a few billion EUR. Just a few days ago, I added it to my net-net basket, allocating 6% of the portfolio to this position.

Since my last article, the industry as a whole has experienced further price declines, which impacted many of these companies. As a result, by the end of this article, I won’t just share one investment idea but 5 European net-nets worth considering - some from my portfolio, and some from my watchlist.

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How It All Evolved For USAP

I bought shares in Universal Stainless & Alloy Products (USAP) when they were trading cheaply, with an average cost of between $6 and $7 per share, and sold all of them in parts 1.5 years later between $13 and $15 per share.

Little did I know, the big money came later.

Selling then turned out to be quite a mistake, as when I am writing these words (Oct. 2024), the share price sits at around $41 per share. I could’ve held on for longer because the industry was still rapidly improving, but I sold out, fearing that a potential recession might reverse those good trends and quickly bring in unpleasant headwinds to the industry.

After all, the value of my shares more than doubled since the initial purchase, and the price was getting close to my liquidation value estimates. As it turned out in the end, however, I was overly conservative with the calculations, which caused me to sell out prematurely.

That certainly was a mistake, but also a very much needed lesson. A lesson in courage – to let your winners run when everything points to a long road ahead.

At $41, USAP is a classic case of déjà vu from 2021, but in reverse - overvalued once again. I wouldn’t necessarily bet on shorting it, but I wouldn’t be surprised to see the future repeat itself somewhere down the road.

10/17/2024 Update

Well, scratch that. We won’t see a downturn soon because Universal just announced it’s being bought out at $45 per share. This news dropped today and, at that price, I’m unsure if Aperam is getting a good deal, but maybe they see something I don’t. Perhaps they can leverage their size and expertise to boost efficiency and improve the company in ways that the previous management couldn’t. Or maybe it’s just people being people again. I might be wrong, of course, but I doubt the company has changed as much as some think. Who knows?

Funnily enough, this stock has a history with some big names, as it was featured in Mohnish Pabrai’s book called The Dhandho Investor:

In aggregate, I considered it a bet very much worth making. Pabrai Funds first invested in Universal Stainless stock in April 2002. We bought our initial stake in the $14 to $15 per share range—putting 10 percent of assets under management into USAP.

The similarities between his journey and mine are oddly intriguing. Like when USAP’s management decided to install a new furnace, indicating that the company was prepping for better times. Even though the market practically forgot about this company, you could interpret that as somewhat of a sign of better times coming. That’s very similar to the kind of an expenditure they made while I was invested, almost 2 decades later.

In May 2005, the company decided to spend $2.5 million in capital expenditures to install a sixth vacuum arc re-melt furnace. I have a vague idea (at best) of what such a furnace is. What I did understand from Mac on a conference call is that it would raise EPS by about $0.50 per share annually (wow!)

As I am pening this paragraph on June 19, 2006, USAP’s stock trades at $25.65 per share. The market is concerned about weakening fundamentals for steel companies. USAP is not a typical steel company. While big industry trends do affect it, it is in an insulated niche. Its aerospace and energy industry customers are having their best years ever. USAP’s business prospects have never looked better. Their backlog has never been stronger.

Source: Mohnish Pabrai, The Dhandho Investor: The Low-Risk Value Method to High Returns, p.157-165

This mirrors my own experience remarkably well - just like USAP's trajectory back in the day. And it highlights a broader point: inefficiencies in cyclical stocks have a tendency to repeat themselves.

Of course, for this strategy to work, you need a portfolio of companies like that. An appropriate level of diversification is a fundamental part of deep value investing, as it may happen that some of your picks just don’t get back to the assumed sell price for a long time. By diversifying, you effectively play along with the law of large numbers - the larger the sample of companies with similar prospects, the closer your return is to your desired results, additionally decreasing, or even in some cases completely minimizing, the adverse effects of many company-specific risks.

And I specifically wrote “companies with similar prospects” for a reason - if you increase your sample size by buying worse opportunities, you may be taking away some risk, but you are also, in effect, killing your overall returns.

Achieving “proper” diversification

Some people say 8 companies in a portfolio is enough, others say that 20-30 is the bare minimum for achieving “proper” diversification. I say - it all depends.

You can bet heavily when the odds are stacked in your favor, but the size of your investment should come from your conviction which should be, in turn, based on:

1) how undervalued the company is,

2) how sure you are about its future,

3) how good of an analyst you really are.

Different risks exist, and many we are not even aware of until they actually hit us in the face. Buying cheap does not guarantee any profit. But if you have, say, 20 or 30 such deeply undervalued stocks in your portfolio, the law of large numbers is on your side.

Of course, you won’t be able to eliminate risk entirely. As some people say, shit happens (forgive my language). There are net-nets structured so that they allow for a larger allocation, and there are those which suggest that wider diversification is a better idea.

And it’s not only about downside protection either. If you hold just one company in your portfolio and it takes it 5 years to double (your sell price), that’s 14.87% annual portfolio return. But if you have two companies in your portfolio, one of them doubles after 5 years and the other one in 3 years, not only is your overall annual return even higher than that, as the second company gave you your assumed return well before the 5-year mark, but you are then also able to invest the proceeds in some other opportunity much sooner than you would if you were holding just one stock. Unless you’re absolutely certain about just a few selectively chosen cases, a slightly higher sample size than just a few stocks is probably beneficial.

That is why I personally try not to close myself in brackets of self-imposed diversification rules. If there are enough companies that make me comfortable enough with putting 20% of my portfolio in each, I’ll hold only five companies. If there are no cases that provide me with so much conviction, I’d be happy to buy many at, say, 3% allocation. It all depends on the how the market looks like and also on the number of available opportunities. And in the case of USAP, it once reached 30% of my portfolio with no other company in my portfolio of similar size back then - the rest of my picks were likely closer to 5% each, on average. And if it weren’t for that size, you wouldn’t be reading this article now.

Correct sizing matters more than you think.

Some companies may go down further, widening the gap between price and value, and offering a chance to increase your investment size. Others might deteriorate, eating through your margin of safety and your potential returns. But if you avoid high levels of debt, shady managements, permanently unprofitable enterprises and other such ventures of higher risk, you don’t have to worry that much. If you do your homework and buy things when they’re really cheap, history, as well as mean-reversion are on your side.

Caveat Emptor (Buyer Beware)

Of course, the process of stock analysis is much more complicated in real life than what I describe here – it’s not like you should buy stocks purely based on a 5-minute analysis purely because something has a low price-to-book ratio (although I know people who specialize in this exact thing, and with surprisingly good results too!).

The way I structured my words is, partially, to tell a good story, but mainly to stress how lucrative investing in companies with a large discount to tangible asset value can be, and that such opportunities come up over and over again. It’s not the only metric I look at, obviously, but it is the most important one.

It's essential to weed out any possibilities of falling into value traps. So, as simple as my words may sound, it’s never just all about the numbers.

With USAP, I can’t express how many hours I’ve spent making sure my thinking is sound. Achieving such conviction is my requirement for making any stock a substantial portion of my portfolio. If I can’t get a high conviction, I limit my investment to just a few percent. That is my self-imposed iron rule.

Downside protection is far more important than any potential gains, no matter how sweet the upside might seem. Deep value, this strange and unintuitive method works because if you win, you enjoy a nice return on the capital invested, but more importantly when you lose, you typically don’t lose much – but only if you have correctly assessed the margin of safety. That is the source of alpha in this investing method - downside protection.

And on top of that, you also have the magic of deep value cyclicals. You can either chase the dream of perpetual growth, bidding prices up regardless of fundamentals alongside the rest of the speculators, or you can wait patiently and pounce when others are running for the exits. Most of my returns come from playing the investing game the second way. These types of inefficiencies are simply too lucrative to ignore.

Today’s company feels a lot like USAP once did. It may not be at the bottom yet (I hope so!), but it’s close enough to start a position at two-thirds of NCAV. If it goes lower, I’ll do more work and probably allocate more capital, depending on how things develop. For now, let’s wait and see.

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You have probably heard about this company, as I described it briefly in one of my previous articles. Now, let’s dive deeper into…