This article is excerpted from a letter by MOI Global instructors Jim and Abigail Zimmerman of Lowell Capital Management, based in El Segundo, California.
Our focus is on increasing the capital accounts in the Partnership in a conservative and prudent manner by taking what we think are intelligent risks. We seek to carefully allocate our capital into investment opportunities where we believe we have an advantage and where we think the risk-reward ratio is asymmetrically in favor of the Partnership.
Our investment results have been achieved with an average net cash position of over 30%. The Partnership has avoided the use of leverage and, on the contrary, maintained a significant net cash position, and we believe this has reduced the risk to its capital.
Our area of focus, small cap value, has been out of favor in recent years but could see increased interest as higher interest rates shift investors’ focus from high growth technology companies towards value companies with profits and free cash flows. We have an approach of investing in under-followed or misunderstood companies which generate strong cash flows, and we think are under-valued. We believe our holdings remain significantly undervalued and will eventually be recognized. We plan to continue our approach to investing which has worked well over many years and with which we are comfortable.
Stock Market, Economy, Defensive Posture, and Circle of Competence
Our approach continues to be conservative, in line with the thoughts in our recent letters. We took a conservative position with the Partnership after the coronavirus pandemic struck in mid-March of 2020 initially and gradually redeployed capital throughout 2020 and 2021 into businesses which were under-valued and which we believed would have strong resiliency to or even benefit from the coronavirus impact. This strategy worked well in both 2020 and 2021 as global economies gradually exited the pandemic. However, both economies and stock markets globally have been hit extremely hard in 2022 to date as high inflation and supply chain issues and the war in Ukraine have all combined to create a more difficult environment for businesses and investors. Interest rates in the U.S. have moved up and it is likely they have further to go. Current inflation trends show some signs of slowing but there is likely much more work to be done to bring inflation down to levels targeted by the Federal Reserve. While not certain, there is a decent risk of a recession in the U.S. and global economies. As a result of all these factors, we have reduced the Partnership’s risk profile and built up our net cash position. We continue to hold our highest conviction ideas which are best positioned to deal with the current environment but have gradually reduced exposure to business models which could encounter greater challenges in this environment.
We believe the market is likely to eventually shift its focus towards companies with solid earnings and cash flows on a current basis which is our area of focus. However, we believe there continue to be many technology companies which remain over-valued and the exit and volatility from these types of stocks will continue for some time.
We have taken a more defensive posture with our investment portfolio at this time to help manage through the current volatility. We have maintained a current net cash position in the Partnership of about 40% to 45% of capital by retaining but reducing our largest long positions. We will adopt this more conservative approach until we believe the market has stabilized and questions about future inflation rates and recession risks are more clearly visible.
Our primary focus is on long-term preservation of capital and conservative growth of capital. We have managed through other difficult market periods by taking this approach of building cash as we evaluate the investment opportunity set. In our experience, periods of volatility like this can heavily depress prices of some great businesses and create very attractive investment opportunities. We believe our current investments remain significantly undervalued based on their cash generation and long-term growth prospects and will opportunistically increase our exposure going forward.
Our focus is on simple, cash-flowing businesses, with “Ft. Knox” balance sheets and understandable business models, which trade at low multiples of earnings and cash flows, and often pay significant dividends. We believe these types of businesses will ultimately do well as the interest rate environment normalizes and as the economy completely exits the pandemic and interest rates reach a more sustainable level.
We believe that by understanding our circle of competence we are able to avoid problems and better identify opportunities. The concept of the circle of competence has been used over the years by Warren Buffett as well as his partner Charlie Munger as a way to focus investors on only operating in areas they know best. In his 1996 Shareholder Letter, Buffett wrote:
“What an investor needs is the ability to correctly evaluate selected businesses. You don’t have to be an expert on every company, or even many, you only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
Charlie Munger has said
“It is not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one. And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time they don’t. It is just that simple.”
There are 8,000 publicly traded companies in North America. We are not trying to understand all of these companies, but we are looking for a handful that work for us. We are highly focused on a handful of companies that meet our criteria and we are solely investing in businesses that we can understand. This provides us with a level of confidence as we are only investing in our circle of competence and we believe this allows us to mitigate the risk of losses. We want to enter into every investment decision backed up by knowledge and experience in that particular field, which allows us to make informed decisions.
Mistakes are most often made when straying from the discipline of staying within your circle of competence. The simple takeaway here is clear. If you want to improve odds of success, then define the perimeter of your circle of competence, and operate inside. Over time, work to expand that circle but never fool yourself about where it stands today, and never be afraid to say “I don’t know.” We stay within our circle of competence so we can avoid mistakes and not try to understand something we don’t. We are trying to know something that other people don’t know and invest where we have that extra knowledge. We believe this provides us with opportunities that others don’t have.
Our primary objective is to find and invest in securities which are mispriced, generally based on free cash flow generation. Our strategy has not changed – we continue to focus on highly cash generative business models with strong balance sheets and large free cash flow yields that are sustainable. We believe the long-term outlook for American businesses is still strong and interest rates remain relatively low. We continue to use our investment strategy that has worked over many years to purchase companies that we believe are undervalued based on their earnings, cash flow, and balance sheet characteristics.
Good Businesses with Low Expectations
We are focused on investing in good businesses with low expectations (i.e., low valuations). For us, a “good” business is one that earns high returns on invested capital or where you don’t spend a lot of money to make a lot of money. We look at businesses where the total investment in tangible assets to run the business (i.e., net working capital plus the book value of property, plant, and equipment) are modest relative to the sustainable operating earnings or free cash flows. These businesses are not capital intensive. Businesses with high returns on invested capital tend to be strong generators of free cash flow. These are businesses that we like very much.
In terms of low expectations, our investments generally have valuations which are low, and this helps reduce risk. The market does not expect much from the business in the future or is worried about current earnings or free cash flow sharply declining. These may also be situations where a business is simply misunderstood or undiscovered. Our general experience is that if the business can exceed these low expectations or generate results that are less bad than expected, the stock price is likely to increase. Also, if expectations are low, when results are disappointing, the stock is likely to decline less than otherwise. We spend a lot of time studying these types of companies to try to get comfortable that their prospects are better than the market believes. Often specific businesses or industries get painted with a broad brush and their valuations are driven down to what we find to be attractive levels. We think our focus on these out-of- favor companies and industries create an opportunity to earn better risk-adjusted returns than the general market.
Focus on Smaller Companies
We focus on smaller companies, searching for “low-risk, high-return” opportunities. We believe a few good ideas can drive the Partnership’s results. We believe the Partnership can generally achieve better risk-adjusted returns by uncovering a few small “gems” than by focusing on larger companies or macro issues which are much more widely covered. Our focus on smaller, less-followed companies represents a potential sustainable competitive advantage for the Partnership relative to larger investment funds that must focus on much larger companies. Our empirical investment experience validates this belief, as our most successful investment positions have consistently been smaller companies.
We are specifically looking for small companies that may appear risky on the surface but are less risky due to characteristics such as: (a) cash-rich, “Ft. Knox” type balance sheets, (b) consistent free cash flows; (c) unique niches or business models; (d) very low valuations with minimal expectations imbedded in the stock price; and (e) honest and intelligent management teams that are highly focused on driving shareholder value. Most small companies do not possess any of these characteristics. We focus most of our attention on a handful of companies that we believe possess almost all these characteristics.
Top Long and Short Positions
Our top long positions, as of November 30, 2022, were as follows:
Bel Fuse (BELFB)
LSI Industries (LYTS)
Eastern Company (EML)
New Zealand Media & Entertainment (NZME)
Insight Enterprises (NSIT)
Hammond Power Solutions Class A (HPS-A.TO)
Redishred Capital (KUT.V)
We believe our long positions have strong competitive niches, large and sustainable free cash flow yields, low-risk balance sheets, recession earnings capability, shareholder- oriented management teams, and attractive risk-reward characteristics as investments. You will find that most of these companies are not household names and that is exactly as we have intended it. We are seeking to maximize our competitive advantage by investing in underfollowed companies where we may have a greater opportunity to understand the company and the investment better than other investors.
The Partnership’s investments are diversified across a wide range of businesses. Our goal is generally to have core position sizes in the 3% to 6% of total capital range and limit our exposure to any one specific investment to approximately 10% of capital or less. We think this helps limit our downside exposure to any one investment position while retaining substantial upside for those investment positions that work out as expected. Our investment positions are also diversified across several different industries.
We continue to seek out what we believe are attractive values for good businesses in Canada, our neighbor to the north. Canada has a population of about 35m or about 10% of the U.S. and we believe its economy remains in reasonable shape. Canada’s debt to GDP is currently well below U.S. levels. Canadian banks avoided much of the real estate problems of 2008-9 in the U.S. by maintaining more disciplined underwriting standards in making real estate loans. Canada is a natural resource-oriented economy with substantial oil and gas reserves. We will continue to carefully monitor the impact of oil price changes upon the Canadian economy.
Our optimism regarding the future of the Partnership relates directly to our specific investment positions, which we believe are significantly mispriced relative to their intrinsic values. Certain of these are detailed below:
Sylvamo Corporation (SLVM)
Sylvamo Corporation (SLVM) produces and supplies printing paper in Latin America, Europe, and North America. The Company offers uncoated freesheet paper products, such as cutsize and offset paper, and markets pulp, aseptic, ad liquid packaging board, as well as coated unbleached kraft papers. It also produced hardwood pulp, including bleached hardwood kraft and bleached eucalyptus kraft; bleached softwood kraft; and bleached chemi-thermomechanical pulp.
International Paper (IP) spun out its uncoated freesheet paper (“UFP”) business as SLVM on October 1, 2021. SLVM was only about 5% of the combined company and, consequently, there is little research coverage of the stock.
SLVM has a dominant market position in uncoated freesheet paper (UFS) in its three key markets including North America, Latin America, and Europe. SLVM has three mills in North America – Memphis, TN; Ticonderoga, NY; and Eastover, SC; 1 mill in Europe in Saillat, France; and 3 mills in Latin America including Tres Lagoas, Brazil; Luis Antonio, Sao Paulo; and Mogi Guacu, Sao Paulo. These mills have significant cost advantages with Saillat, France generating 85% of energy needs internally and the Ticonderoga, NY mill as the lowest cost mill in North America. SLVM mills in Latin America and Europe are low-cost duopolies. SLVM’s Latin America mills are vertically integrated into owned eucalyptus plantations, making them possibly the lowest cost global paper mills.
SLVM trades at a very depressed multiple of 3.5x enterprise value to adjusted EBITDA. Market expectations are very low and we believe SLVM will deliver results that will warrant a much higher multiple over the next 12 to 18 months.
SLVM has a highly cash-generative business model and management consistently refers to the company as a “cash flow story”. The Company is focused on using that cash to increase shareholder value through maintaining a strong financial position, returning cash to shareholders, and reinvesting in the business. SLVM estimates about $210m of free cash flow for 2022 but this is after expensing about $128m of one-time costs related to the spin-off from IP. On a pro forma basis, adding back these one-time costs, we estimate SLVM free cash flow for 2022 is about $338m or about $7.50 per share. This compares to our purchase price of about $40 per share. At our purchase price, we were investing in SLVM at a free cash flow yield of about 10% to 12% on an unleveraged basis, versus a 10-year treasury rate of 3.5%.
While it is well-known that UFS demand is declining, with developed regions showing worse trends than emerging economies, due to SLVM’s highly advantaged cost structure and strong market position, we believe its volume will not decline with overall paper demand trends. SLVM has iconic paper brands which are well-known and long established in their three key geographic markets. Its Chamex brand is a dominant UFS paper brand in Latin America.
Q3 adjusted EBITDA was $212m consolidated, with $118m in North America (55% of total EBITDA), $74m in Latin America (35%), and $24m in Europe (11%). SLVM has the largest market share in each of its three markets. North America is about 30% market share. Latin America is about 40% market shares in a duopoly structure. Europe is about a 30% market share. SLVM has the lowest cost paper mills for UFS paper in each of its markets.
Since 2019, due to the pandemic, capacity in UFS paper has been reduced by an estimated 21% in North America, 10% in Latin America, and 20% in Western Europe as competitors closed paper mills or converted them to containerboard. No new capacity in UFS paper has been added. SLVM has the lowest cost plants in each market by a significant margin. As schools and offices have reopened, UFS paper has been in short supply, leading to several price increases in 2021 and 2022. SLVM has consistently increased prices and volumes greater than its costs have increased in the last several quarters and we expect this to continue into 2023.
SLVM has dramatically reduced its net debt position from close to $1.5b when spun off from IP in October 2021 to about $750m currently, pro forma for the sale of its Russian operations. SLVM is in a very strong position to drive shareholder value via large dividends and share repurchases, given its strong balance sheet position.
SLVM has been consistently increasing revenues and adjusted EBITDA year over year during 2021 and 2022. UFS industry fundamentals are favorable moving into 2023. There is strong demand for uncoated free sheet paper in all SLVM’s three key markets. Industry data shows that back-to-work and back-to-school have driven increases in UFS demand from the COVID lows, with increased demand colliding with structurally lower production capacity due to mills shut or converted to containerboard. Furthermore, as offices and schools have reopened in SLVM’s key markets, demand for uncoated freesheet paper has been strong and outstripped reduced supplies. This has resulted in several significant price increases for UFS paper over 2021 and 2022. Moreover, offices and schools in SLVM’s three key markets have not yet fully opened indicating additional upside in demand for uncoated freesheet paper.
SLVM announced in October 2022 the completion of their sale of their Russian operations to Pulp Invest Limited Liability Company for $420 million. After foreign currency exchange rates and transaction fees, SLVM received approximately $400 million in cash proceeds. We believe SLVM’s ability to execute this sale at a strong price in a very difficult economic and political environment highlights the strength of its dominant UFS paper mill operations. Post the sale of its Russia operation, SLVM has a “Ft. Knox” balance sheet, with net debt at about $750m.
SLVM also recently announced the acquisition of Nymolla Mill in Sweden for about $150m which is expected to close in Q1 of 2023. This asset has an extremely strong market position, like SLVM’s other mills, and was acquired for less than 2x adjusted EBITDA including synergies. Nymolla is expected to be immediately accretive to adjusted EPS and free cash flow. SLVM currently trades at $49 per share with about 44m shares outstanding for a market cap of about $2.2b. SLVM has a “Ft. Knox” balance sheet with net debt at about $750m. SLVM trades at a very depressed valuation of EV to adj. EBITDA of about 3.5x based on our estimate of approximately $750m of EBITDA in 2022. We believe these results might be more sustainable than the market believes given the large capacity reductions in SLVM’s markets and SLVM’s dominant market positions. We believe SLVM over time will strongly return free cash flow to shareholders through dividends and buybacks.
We believe SLVM will generate pro forma free cash flow of about $325m in 2022 or about $7.50 per share. We believe SLVM will generate adjusted earnings per share of about $7.50 in 2022. We believe as investors recognize SLVM’s exceptional and unique business model and market position in its three key markets of North America, Latin America, and Europe, SLVM could trade for 10x its adjusted EPS and FCF per share or more or up to $75 per share or higher. On an adjusted EBITDA basis, we believe SLVM could trade for 5x adjusted EBITDA of about $800m in 2023 less net debt of about $500m at year-end 2023 for a market cap of about $3.5b or about $75 per share.
We believe SLVM management is focused on returning cash to shareholders and we believe SLVM could eventually pay out a large share of annual FCF in dividends, possibly as much as $5 per share. Further, we believe SLVM could be an attractive acquisition for a strategic or financial buyer, given its unique market share and cost positions. In fact, one successful strategic investor, Atlas Holdings, has recently taken a 14% stake in SLVM, which we believe could lead to an eventual sale.
Bel Fuse Inc. (BELFB)
BELFB is an underfollowed electronics component manufacturer with long-established customer relationships and value-added products and strong engineering capabilities. Electronic components offer good growth potential over the next several years due to the increasing “electrification” of the world and the internet of things (IOT) as well as other trends.
BELFB designs, manufactures, markets, and sells products that are used in the networking, telecommunication, high-speed data transmission, commercial aerospace, military, broadcasting, transportation, and consumer electronic industries in the United States, the United Kingdom, Germany, Switzerland, and internationally. It offers magnetic products, such as integrated connector modules, power transformers, SMD power inductors and SMPS transformers, and telecom discrete components. The Company also provides power solutions and protection products comprising front-end power supplies, board-mount power, industrial power, external power, module, and circuit protection products. In addition, it offers connectivity solutions.
We invested in BELFB at about $28 per share with about 12m shares outstanding for a market cap of about $320m at investment. BELFB had a “Ft. Knox” balance sheet with a modest net debt position of about $40m for an enterprise value (EV) of about $360m at investment. We believe BELFB will generate about $80m of adjusted EBITDA in 2022, so we were investing at less than 5x adjusted EBITDA. Furthermore, we believe BELFB business has very significant tailwinds due to the margin improvement opportunities as discussed below.
We believe BELFB has significant upside over the next 3-5 years due to 1) their gross margins and adjusted EBITDA margins increasing sharply from current levels while still having further room to improve to peer levels, and 2) their EBITDA multiple increasing significantly due to item 1.
The Company spent over 10 years not focusing on profitability and organic growth, and only focused on acquisitions. BELFB welcomed a new CFO in early 2021, Farouq Tuweiq, who has successfully refocused the company on profitability rather than revenues. He has made positive changes in improving margins and delivering organic growth. There is still a lot of opportunity for this positive change to continue.
Many investors have not looked at BELFB because of its disappointing history and poor performance. Most issues in the Company over the last several years have primarily been due to their sales process and compensation structures and severely underpricing their value-added products and services. The Company has strong revenue momentum, great products, and strong technical expertise. Peer companies such as Amphenol (APH) and TE Connectivity (TEL) have margins that typically operate around 30% to 35% gross margins and 20%+ EBITDA margins. We believe BELFB can move towards these industry benchmark margin targets over the next few years, continuing the positive margin trends over the past several quarters under the new strategic plan.
In recent quarters, BELFB has reported strong results as the Company reprices its products and services and exits unprofitable business. BELFB is using its new ERP system to evaluate every SKU in order to make sure it receives an adequate margin on the work it does for customers, something it did not do well before the arrival of CFO Tuweiq, We expect this trend of improved gross margins and EBITDA margins to continue over the next 12 to 24 months as BELFB moves its pricing towards industry standards. Indeed, we believe there is already significant margin improvement embedded in BELFB’s current backlog of about $560m.
BELFB has a multi-pronged strategy for sustained growth with a focus on the quality and expansion of revenue, and optimization and simplification. BELFB is focused on high-growth and emerging markets, focusing on quality relationships with the right customers, and favorable positioning on product designs, and sharpening pricing strategies and practices. Their strategy strategically positions them to create value through margin improvement and a focus on key markets and customers.
The electrification of the world provides long-term secular growth opportunities for electronic components such as fuses, capacitors, and connectors. There are various tailwinds from key sector fundamentals that provide BELFB with a lot of opportunity for growth including electrification, increased data generation, 5G/connectivity, miniaturization, exponential technology advancement, and EV and infrastructure. These positive end market trends position BELFB for long-term success. Additionally, BELFB serves diverse end markets including Network & Cloud (36%), Military & Aerospace (11%), and Industrial/EV (20%).
BELFB currently trades at $34 per share with about 12m shares outstanding for a market cap of about $413m plus net debt of about $32m, which equals an enterprise value of about $450m. BELFB trades at a depressed 6.2x EV to EBITDA with LTM EBITDA of $72m.
We believe our position in BELFB could have considerable upside if the Company continues to execute on its strategic growth plan. Over the next few years, we believe BELFB could achieve total sales of $750m with an adjusted EBITDA of $100m and trade for a modest 8x adjusted EBITDA. Based on zero net debt, this multiple would result in a market cap of about $800m or about $65 per share versus the current $34 per share market price. Further, we believe BELFB could be attractive to a strategic or financial purchaser given its strong long-term market outlook, well-established products and engineering capabilities, and strong customer relationships, and its highly cash-generative business model.
We have sought to protect the Partnership’s capital with short positions of 1% or less on several companies with extremely high valuations and unsustainable business models. As of November 30, 2022, the Partnership had 8 short positions. We continue to research several short position candidates.
We think we own an excellent group of businesses with asymmetrical risk-reward characteristics biased in the Partnership’s favor. We have long-term confidence in the North American economy and believe carefully selected equities remain one of the best ways to participate in their economic growth and protect purchasing power from inflation. We have tried to position the portfolio to achieve these objectives.
We focus on detailed research on individual investment opportunities with asymmetrical risk-reward characteristics in the Partnership’s favor. We are keeping the Partnership’s capital well-diversified in companies with “Ft. Knox” balance sheets. We are doing our best to balance well-publicized macro risks against our micro work on specific companies. A “Ft. Knox” balance sheet, both at the Partnership level and at our individual investments, helps us sleep better at night. Our first goal is always capital preservation, followed closely by prudent, intelligent growth of capital.
We believe that small cap stocks offer us excellent opportunities for attractive risk adjusted returns. Most investors on Wall Street simply cannot focus on these smaller companies due to their small size. This should give the Partnership an advantage over time. There are greater opportunities to find a specific business or security which is meaningfully mispriced before it becomes clear to other investors. We do a large amount of research on these individual positions to achieve a high conviction level which allows us to establish and remain committed to a larger position. We often have detailed discussions with the senior management of our investments to better understand these companies and their industries and thereby strive to increase our competitive advantage. We are one of the largest investors in the Partnership and continue to have a significant investment. We will always maintain a large amount of capital in the Partnership and make sure our interests are closely aligned with our limited partners.
Our goal is to significantly outperform the major indices over a three- to five-year period while taking a conservative approach to risk and we continue to believe we can achieve this goal.
We remain cautiously optimistic on our investments due to our continued ability to find what we believe to be good businesses that are under-valued. We are doing our best to position the Partnership to earn attractive risk-adjusted returns in this environment. We appreciate your patience.
Please do not hesitate to call (310-426-2045) or email ([email protected]) us with any questions. We appreciate your confidence in the Partnership and we will do our best to protect and conservatively grow the Partnership’s capital over time.
About The Author: Jim Zimmerman
Jim Zimmerman is founder and portfolio manager of Lowell Capital Value Partners, LP, successor fund to Lowell Capital Fund, L.P. Mr. Zimmerman managed Lowell Capital Fund L.P. from 2003 to 2015 employing a proprietary strategy laser-focused on smaller and/or misunderstood companies with large, sustainable free cash flow yields and “Ft. Knox” balance sheets. He generated a compound annual return significantly exceeding the HFRI Equity Hedge Index and the S&P 500 Total Return Index over this period, despite holding a significant net cash position (~30%) for most of this period. He has over 25 years of investment banking and investment management experience in a variety of industries and has been involved with several billion dollars of investments. He has been a member of the invitation-only Value Investors Club for over 10 years, contributing detailed investment write-ups on 35 companies to date which have produced an average return exceeding 50% per investment. He has built an extensive network of relationships with value-oriented investment groups and activists. Mr. Zimmerman graduated with a BA with high honors in economics from Princeton University in 1980 and an MBA from Stanford Business School in 1984. He worked at Drexel Burnham Lambert, Inc., 1984 to 1990, serving in the Corporate Finance Department and multiple other investment banks from 1990 to 2003. He is a close follower of Warren Buffett and his investment approach.
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