Sunday, August 18, 2013

MT thesis

Acting on my thesis on PM from the previous post, I am now looking for a new investment that I want to fund with the money I raise by selling PM. as you can see, I am selling PM with a very heavy heart since it has truly been the shining star in my portfolio. But given all the signs I am seeing, I would rather be wrong on the "opportunity loss" side of things than the "loss of capital" side of things. So what exactly am I looking for in my new investment to replace the star performer. Let me list the characteristics:

1. Low Market cap to book value - Indicates market is not valuing its assets for whatever reason
2. Strong dividend - This is to get paid as I wait for my thesis to play out
3. High free cash flow - So that they are strong enough to fund the business without borrowing too much
4. Low P/E - So that the market is not already paying a premium for the earnings
5. Strong market presence - Should be a good diversified leader in its market

As you can see PM was a start in all these factors 2 years back. It is the (1) that bothers me the most about it now. So I went looking for another stock that I could buy and would have good prospects in the next 10 years or so.

Enter MT. (ArcelorMittal) is the leading steel producer around the world. Steel? Really - you say?

Well here is my general thesis and then I will go about comparing it with the factors I had listed above. The steel industry has been consistently beaten down since the "great recession" and will probably continue to get beaten down further with bad news coming from across the emerging markets. The most telling, to me, regarding emerging markets is what John Chambers said about Cisco's quarter. With negative growth in emerging markets, Cisco is truly the indicator that emerging markets is slowing. though the traders have stopped seeing Chambers as the bell weather, I think the man has predicted approaching slow downs with great accuracy. Assuming the slow down continues for 2-3 years, MT should start turning around in 3 years or so when countries start rebuilding infrastructure in response to expanding GDP. Steel producers are in the forefront of this turnaround and MT is the most diversified producer of steel and other basic materials with a huge mining division that feeds the raw material for their production.

Trading at half book value, MT blows out the (1) criteria listed above. The market thinks very little off their assets (mines, factories, human capital etc) probably because of the capacity and glut that it is currently experiencing. Given the rate at which emerging markets has declined, it might be a fair valuation at this point due to the level of under performing assets. But it is at nearly 50% and I assume at this point that it is an overreaction to the current state of affairs.

What is not to love about the a 5% dividend. If I can get enough position built up at 5% yield, I would be happy to wait for the thesis to play out. The pay out ratio is also fairly under control at below 50% of cash flow from operating activities even in these challenging times. The yield is at this level mostly due to the suffering stock price, but I would take it any day.

Free cash flow is one area were MT is concerning. This mostly due to the macro economic challenges that MT is experiencing at this time with Europe and Asia suffering a slow down. However this could significantly improve if the cost of revenue starts to decline with more assets performing at average levels in the long term.

P/E is a bad indicator for MT at this point due to very spotty earnings and write downs on assets in the past couple of years. Referring to the book value and the market cap, I am ignoring the P/E for now.

MT is one of the most diversified and entrenched player in its space around the world. One of the statistics I read is that MT steel feeds only 10% of the steel market when it was still the largest company out there by leaps and bounds. So there is significant potential to gain market share in this space.

Overall, I am basing my decision on a thesis that should play out in the next 5-10 years. I think I probably have about 2-3 years to accumulate MT before the market turns. I was encouraged by a sudden pop in MT with large volumes last week when news of a healthier Europe was emerging. This is encouraging even if it is misguided for the short term. It shows an underlying interest in the equity if the thesis were to play out. 

Tuesday, August 13, 2013

Turning on PM

Once upon a time I had taken a long position in PM based on the DCF calculations that I had presented. I have to admit that I never expected to be this right on the call. But here is now a case to sell my position. This has been bothering me for the last couple of quarters and now it is really making me nervous.

Let me start with a negative book value. Over the last couple of years PM has been borrowing money (albeit at a very low interest rate) to fuel their buyback program which has been on a tear. The borrowing has been at such a ferocious pace that they have increased long term debt by over 35% in the last two years. This in itself would not have been so bad except for the rather flat income growth over the past year. Flat income paired with accelerating debt is a bad sign except you cannot see that in their EPS because they are shrinking the float at such a fast pace. The borrowing is supporting the dividend payout which is now at staggering 61% of net income.

All the above can be overlooked if they had tremendous growth potential or favorable market forces working for them, neither of which is not the case. Growth is flat to minimally positive while there are tremendous forces acting against them in various countries to curtail the use of tobacco products.

So all in all I don’t see anything good to hold on to this stock at these levels. The only thing that is keeping me from selling at this point is that my cost basis is so low that the true yield I have on that stock is enviable at over 6%. But I know that is no reason to hold to until I start seeing capital depreciation.

I guess I should stop talking and start selling.

PS: I graciously eat humble pie on Facebook (my previous post). Good thing I did not act on it on the short side. But I still believe FB will struggle to show consistent growth which should promptly bring them back.