ALJJ: From Gray to Black and White

Last year, I took a 3% position in ALJ Regional holdings at about $3.20 (and wrote about it here and here). Today the stock trades below $2, and I have lost nearly 40% of my invested capital.

The central question is: should I hold on, or cut my losses?

The investment case for ALJJ has morphed over 2018 from something that could take years to play out to something that might take only a few quarters. In less than a year, it is conceivable that ALJJ goes bankrupt, or doubles from here!

The bear case is straightforward:

  • Q1 2018 results were a disaster! Two of the three operating segments are becoming an increasing drag!
  • the company is highly levered, and is uncomfortably close to breaching its debt covenants. Bankruptcy is on the table.
  • the CEO is accused of sexual harassment by a former colleague, and may be distracted

On the other hand, the bull case is:

  • The company is dirt cheap on a cash flow basis! On the Q4 2017 earnings call (Jan 8) about a month before the Q1 2018 results came out, the company projected about $18M in FCF for 2018 (FCF = EBITDA ($36-39M) – CapEx ($7-9M) – interest ($8-10M) – tax ($1-1.5M)). For a $72M market cap company, this translates to $18/$72 = 25% FCF yield!
  • The CEO increased his already large ownership in the stock by 3.7% after the debacle in the stock price (he paid ~$2.25/share). He comes from a distressed debt background, and probably has a more sophisticated understanding of how to navigate the covenants.
  • Dave Waters of Alluvial Capital summarized the bull case pretty effectively.

Because of the binary nature of the payoff, I haven’t added to my holdings. My plan is to hold on to my shares for a quarter or two more, and see which way the wind blows stronger.

Subjectively, I think the risk of bankruptcy is elevated but not overwhelming (if I had to pull a number from my ass, I would guess something like 1/3).

Currently, the expected 2018 FCF/share $18M divided by 37.6M shares is over $0.45/share. If the debt fears go away (perhaps as incremental FCF is directed towards debt reduction), the company might deserve a 10x FCF multiple or be worth $4.50/share. The expected value is then $3 (2/3 * $4.50), which is 50% above the current price.

Thus, while the position has a lot of hair, a lot of the bad news is more than baked in, and I plan on holding until 2Q or 3Q 2018.


Thoughts on BRK and GOOG

Berkshire Hathaway

  • Semper Augustus 2017 Client letter (link) continues a annual tradition by taking a deep dive. They figure BRKB is worth somewhere around $250/share.
  • Whitney Tilson (presentation) updates his valuation to $230/share, probably rising to $250 by the end of the year.

Either way, BRK looks about 20% undervalued at current prices near $200.


This is not a stock I own, but one I have looked at many times over the past 5 years hoping for a pull back. Here are two different takes:

  • Whitney Tilson (presentation) argues that we aren’t paying much of a premium over the market to own a high-class business (PE ~ 21x 2018). If we consider the optionality of YouTube and “Other Bets” then one can argue that its valuation is very reasonable.
  • Geoff Gannon, on the other hand (link), does a back of the envelope calculation on the limits to the advertizing spend. Google and Facebook capture a large (and rapidly increasing fraction) of a slowly growing pie, and will have to contend with slower growth in the future. This will result in lower multiples, and hence unspectacular returns.


Brookfield Asset Management

Brookfield Asset Management (BAM) is well known among value investing circles. It is a leading global manager of real assets.

It is easy to get lost in BAM’s complicated structure. It is both: an asset manager, and an asset owner. It owns significant portions of publicly traded names (listed issuers like BPY, BIP, BEP, BBU), and private flagship funds that it manages like a traditional asset manager.

BAM eats its own cooking, and it is a good cook.

The funds and companies have provided superb returns in the past. As a part owner, some of these earnings and distributions flow to BAM. As an asset manager, it charges other investors and partners sharing the ride (fee bearing capital), and earns a performance-based carried interest (like a 2 and 20 hedge fund).

There is a lot of great commentary and information on BAM. Here is a small subset:

  • The Brooklyn Investor looked at BAM in June 2015 and did not seem particularly impressed by the value proposition
  • “Value by George” revisited it around that time, and had a more favorable take
  • There is a decent (and recent) stab at valuing BAM on SeekingAlpha by Eric Sprague
  • The 2017 Investor Day presentation provides a fine overview of the key drivers

Here are some important takeaways:

  • It is hard to argue that they have great management. BAM is a well run machine. The annual and quarterly (!) letters are a treat to read. The business is global and complicated, but the management seems quite transparent. They have strong culture, and a deep bench.
  • The business model is unique. As asset managers, they can leverage their investment gains on the assets they own by levering it with outside capital. They also earn a base fee on the outside AUM.
  • There are structural tailwinds, as allocations to real assets are increasing.
  • BAM is also a growth story. The AUM has grown 10%/year (2012 – $158B to 2017 – $258B)


The 2017 investor presentation provides a glimpse at what the company might look like in 2022. They value the asset owner and asset manager parts separately, and add the two portions together.

I am unsure if one can come up with an estimate of intrinsic value without finding the intrinsic value of its holdings separately.

It is preferable to be simple and approximately right, than to chase down every moving part in this intricate operation.

In the presentation, they subtract the debt/corporate capitalization ($10B) from the total invested capital ($65B) for a $55B asset owner value.

For the asset management business, they slap a 20x multiple on fee related earnings ($1,689M * 20 = $33.8B) and a 10x multiple on carried interest (10 * $1, 054M = $10.5B). Adding them and dividing by the total number of units gives a value per share of $100.

I prefer to tone this number down.

For example, assuming ~3% dilution in the number of shares brings this number down to $80/share. Nevertheless, at today’s prices of ~$42, even the lower number implies a nearly 14% return.

What about just looking at the 2017 numbers? Using a similar methodology, the asset owner stake is worth $38.5B – $9B = $29.5B. The asset manager stake is worth $14.6B (FRE) and $6B (carried interest) for nearly $50B in intrinsic value. Dividing by the number of shares (1,065M), we get a per share value of approximately $47. Thus, even by this reckoning, shares are about 20% undervalued.

I took this opportunity to start a 1.5% position. I hope to add to the position, as I get more comfortable with it.


Correction Time

The S&P and Dow are both down 10%+ from their recent highs.

Despite my large cash balance, I am also down about 5%; in part this is due to my over-exposure to the energy sector.

Volatility has been resuscitated from its death bed. While there is nothing to be super-excited about yet, let’s just say, things have started getting interesting.

Here are some resources to put things into context”

  • A Field Guide to Stock Market Corrections: The base rate of a 20%+ bear market given a 10% correction is 50%. Thus, the odds of a continued decline in the market, or a recovery are about even.
  • What Past Market Declines Can Teach Us: 10% corrections are quite common; they occur about once a year. When they don’t deteriorate further, they take about 4 months to heal. 20% declines are also surprisingly common; they occur about once a leap year. On average, they take an year to climb out of.
  • Putting Pullbacks in Perspective: There have been three declines of 40% or more since 1945. They have taken about 5 years to recover from. Longer bull markets (time since last 10% correction) lead to deeper stock market losses. Based on the length of the current run (about 1.5 years), the regression line (in the linked article) suggests that we should expect a pullback of about 15%.
  • The stock market over the last 200 years: This article from Basehit Investing always provides a valuable lens with which to see any current market turmoil. Volatility is a natural part of the stock market. Patience is key.
  • Testing Times: Aswath Damodaran takes a deep breath, and takes a clinical look at the underpinnings of the current market conditions.

For some reason looking at numbers, and zooming out to see the bigger picture in times like these is helpful. It prevents my reptilian brain from retreating in panic or doubling down in hubris.


Switch to Interactive Brokers

One year ago I did a major housekeeping change.

I finally opened an Interactive Brokers account  (I still have accounts with TDAmeritrade and OptionsHouse – now ETrade).

I don’t particularly like IB’s web interface or the desktop GUI. But one year in, it bothers me far less than it used to. I love the speed and the quality of execution. My other brokerage accounts, while offering better UIs, force me to bid in increments of 5c, and often take forever to fill comparable orders.

The big factor, of course, is cost. Instead of shelling $5+, most of my options cost me $1 or less. IB often gets me a price better than my limit price. I understand that it could pocket the difference, and I would never know. Actions like these build trust (Costco/Amazon playbook). In 2017, almost 90% of my trades were executed on IB.

It also pays me meaningful interest on my cash balance (0.92% currently for cash balances above $10k). This is higher than the interest at my bank.

As my portfolio moved from 16% cash at the start of 2017 to nearly 35% currently, the interest I earn underwrites all my commissions and then some.


Interesting Thread on Edge

Recently, I read two superb takes on whether retail investors have any meaningful edge.

Nate Tobik did a “Drake equation” to estimate that there are about 1000 pairs of eyes following listed stocks in the US. So really, our edge is nonexistent or smaller than we think.

Geoff Gannon generalized the discussion with a broader notion of “edge”.

He argues that unlike a casino, the stock market inherently has a positive edge. If you spend infinite time in a casino, you will go bankrupt. If you spend infinite time in the stock market, you will end up extremely wealthy.

So at the base level everyone in the market has an edge over those on the outside. This is a generic edge.

Then, there is the special edge.

Since buying certain kinds of stocks (high quality businesses, cheap stocks, and stocks rising in price) works better than buying other kinds of stocks (low quality businesses, expensive stocks, and stocks falling in price) an investor who systematically bets in order to maximize certain factors (like high quality, good value, and positive momentum) has an edge over both operators who systematically bet in order to maximize other factors (low quality, poor value, and negative momentum) and operators who don’t bet systematically.

And finally there is the stock-pickers edge, which Nate talks about.


GME Update

GME recently released 2017 holiday season.

There is good news and bad news; but in aggregate the news is negative. The stock responded by falling more than 10%.

The good news is that holiday sales were better than last year. The bad news is that both preowned games (key profit driver) and technology brands (expected future growth driver) declined.

My narrative on GME has been the following: “Competent management trying to manage a cash-generative core business in secular decline, by pivoting and expanding more profitable growth businesses.

Such transitions are never smooth.

The latest report seems to suggest that the core business may be declining more slowly than expected, but some of the new businesses are not ramping up as fast as one would like. Here is a decent take on the latest news release on SeekingAlpha.

My prior bear, base, and bull cases price targets were $14, $27, and $35, resepectively. I haven’t redone a complete valuation yet (will wait for earnings release), but my feel is that all these numbers should probably be revised downwards by a couple of dollars.

I have a tiny position (~1%) in GME at an average price of approximately $17.50. I will probably wait another quarter to see if my base case thesis has broken fundamentally. For the moment I continue to hold because:

  • tax bill will help lower tax rate (~35% in the past, and assumed for the future in my valuation); this will increase IV about 10-20%.
  • short interest is high; more than 35% of the float has been shorted. Based on the average trading volume, the days to cover are 15. The chance that it takes off to $25 on a good break is quite high (for example if the latest report had TechBrands neutral to positive, instead of down double digits)
  • the impairment charge is better to assume in 2017, when the tax rate is high, compared to next year, when it would be “worth” less. The most charitable interpretation of the writeoff might point to management’s willingness to acknowledge mistakes early, and monetize them opportunistically.
  • GME remains volatile and “interesting”. Option premiums are fat.
  • The stock pays a generous dividend, which makes it easy to hold on. There are no foreseeable liquidity issues. The debt is well-covered by cashflows.

I continue to believe GME is a modestly undervalued, but risky turnaround story.