Respect reality

I think the hallmark of a good life is accepting reality.

The practice is simple to understand but challenging to implement.

We tend not to see things as they are. We instead see things as we are. Every individual has a unique background that creates a different experience of an objective reality.

You can't bargain with reality. So you either align with it and be at peace, or deny it and go through a version of the five stages of grief.

In investing, the ultimate reality is price. A lot of intellectual firepower is spent on determining the right price, but nothing and no one can argue with the actual price.

It is emotionally heavy and intellectually humbling to abandon a declining stock you own and have spent much effort researching. 

Disasters happen when you reject the reality of price and insist on your effort paying off.

I read about exceptional investors buying into dips and reaping the rewards. But exceptional people are exactly that. They are the exceptions, not the rule. 

Who knows whether the exceptional would repeat their feats. Most are playing with matches while surrounded by oil barrels. They may not be burned, but it's still a stupid thing to do.

I opt for survival over exceptionalism. 

I wrote about UNIR a month ago. The stock has tumbled 50% since UNIR deregistered and went dark. 

How much risk should I reduce? I went with half and stayed with UNIR, only because there was no fundamental reason for the stock to fall (Deregistering is a technical factor, in my opinion).

I don't know how low the stock can go. A stock at all-time lows can always go lower. Reducing risk protects my downside and adds optionality. The capital can be allocated to better positions or added back to UNIR.

But the fundamental story didn't change. Why reduce risk?

Because the stock price has declined significantly since my purchase. This shows my timing was wrong. 

UNIR also didn't explain why it went dark. Reducing expenses should be the key reason, but I'm never sure. 

Proper respect for reality means protecting against detrimental unknowns. It is not essential to know what would happen. I only have to be financially invulnerable no matter what happens. 

Yet static rules should not apply to a dynamic game. I may buy into a dip. My hurdle is just very high. 

More important than the will to win is the will to survive. Runners can't beat a race with broken legs. Investors can't profit without capital.

The best bet in Energy

Active investing is tough. 

Many more mutual funds (proxy for active investors) have shut than started since 2016:

Passive investing, which typically mimics entire markets using ETFs, appear to be the future.

This is because most active investors (think 90%) fail to beat returns from passive ETFs in a long enough timeframe.

It also argues against the existence of this blog and my fund.

To exist is to not only be different, but also right.

What I do different is that I own the most discarded, cheapest, and smallest companies. These companies are too small to move the performance needle for large asset bases.

Consider a $1B fund. If it sets an ownership limit to 10% of a company, it would need to invest in a thousand $10m companies (typical size in my world), which requires more resources than analyzing twenty billion-dollar companies.

I am also never too confident in my positions. I can never predict anything for sure, even for my largest positions.

This means that I can never over-concentrate by having just 5 positions.

But I can also avoid over-diversifying, common in passive investing, by screening out companies with obvious bad fundamentals. 

This philosophy led me to 30 positions for now, and I hope to find more without lowering my hurdles.

I know that I'm different enough. Time will tell whether I am right.

One of my larger positions is Energy And Environmental Services Inc (OTC: EESE). EESE manufactures chemicals mostly for oilfield drilling, completion, and production.

EESE has the best fundamentals among the small companies I've seen. The latest quarter saw 50% revenue growth with 66% gross margins, 20% net margins, just 1x run-rate leverage, and a clean capital structure without warrants or preferreds.

Look at the properties it owns. All these valued at $6m on the balance sheet seem cheap.

"Our research and development lab and organic fertilizer plant is a 7,000 square foot building located at 6300 Boucher Drive, Edmond, Oklahoma. Our oilfield chemical plant is housed in a 27,500-square foot building located at 6701 Boucher Drive, Edmond, Oklahoma. Our Enduro-Bond® coating operations are mostly done in a 30,000-square foot facility located at 1728 Frisco Avenue in Chickasha, Oklahoma. We own these buildings as well as an 80,000-square foot chemical warehouse in Snyder, Texas, and a 2-acre lot on Boucher Drive, Edmond, Oklahoma. We also own land and building in Abilene, Texas, which is used for our production chemicals and services."

EESE uses little debt to own all that and generate monster earnings. Debt was $3.6m against run-rate EBITDA of a similar amount. 

You can own all that at only 4x run-rate PE!

Why is a well-run company available at a cheap price? The low valuation may imply that high earnings are temporary. If real earnings are lower, the PE would be higher and more in-line with the market.

Is EESE over-earning? It all comes down to oilfield drilling activity and oil prices. The stock is saying that those would eventually slow down or decline.

I am bullish on oil prices and drilling activity. Chronic under-investment in global oil exploration is the key ingredient in the recipe for higher energy prices. 

Shale oil producers in the US have also limited oil supply by refusing to drill more, despite higher oil prices. The scars of the previous shale bust are still fresh.

The demand picture also seems supportive of higher energy prices, despite recessionary concerns.

While rising inflation supports higher oil prices, that can be offset by higher costs that reduces profits. This appears not to be a problem for EESE for now. The company reported passing higher prices to customers in the latest quarter.

If inflation and oil prices remain where they are, EESE can easily be a 10x PE story. If both go higher, the stock may be a home-run.

Energy is a cyclical industry. Over-investment can quickly follow periods of under-investment. Before the capital spigots are turned on again, I remain bullish on EESE.

The Cyren call

Turnarounds seldom turn.

That means you should look and even bet on stocks in turnarounds.

If turnarounds usually do not work, expectations are low. This means the vast majority of investors have sold the stock. Your downside in the stock is limited.

When expectations are low, the stock only needs a little shift in expectations to move higher. Your upside is potentially large.

Heads you win. Tails you don't lose much.

Why wouldn't you like those odds?

You won't need the turnaround to work. All that is needed is a slight shift in expectations that it would work. 

Some stocks in turnarounds have a better chance to move than others. Economic tailwinds, recurring revenue, and active equity owners can shift the odds in your favor.

Cyren Limited (NASDAQ: CYRN) is a stock in turnaround worth betting on.

Cyren provides SaaS-based cybersecurity products that detect malware, phishing, and other threats.

I am no expert on cybersecurity. All I know is that the industry progresses rapidly. Cyren appears to have lagged behind its peers for years, but it has survived because of how its products are distributed. Cyren's products are built into software sold as a bundle to enterprises, allowing the company to ride on coattails.

This strategy worked until the rise of hacking and large ransoms motivated CIOs to scrutinize and demand better cybersecurity.

Revenue stagnated and declined starting in 2014. Warburg Pincus, a large venerable private equity firm, bought a 50% stake in 2017, perhaps attracted by recurring revenues from enterprise contracts, low valuation (~2.2x ttm sales vs 5.3x peak), and the potential for large profits from a turnaround.

Investors were very optimistic about Warburg's involvement, sending the stock 33% higher a month after. For the next two years, they were right. Warburg pushed for more software bundling and larger contracts, restarting revenue growth.

But the core issue of lagging technology was never solved. Revenue peaked in 2019 and declined after, even during Covid. Covid started the work-from-home movement and boosted the demand for enterprise cybersecurity (that extended into homes). But Cyren was one of few SaaS companies that failed to capture the tailwind.

Warburg appeared to have stumbled in Cyren. Why should anyone bet on it succeeding now?

Because expectations have never been lower. 

Very low expectations mean the stock only needs a bit of optimism to move higher.

Cyren trades at .95x net cash and .63x book, on a fully diluted basis (excluding 'busted' warrants with >$10/sh strike prices that won't be redeemed for a long time, if ever) and after the sale of a segment for 10m euros. This is a stock that has traded mostly >2x book (more than 3x higher from current) since 2010.

At the start of Warburg's involvement, Cyren traded at 4x sales and 6x GP. Now it's only .5x sales and 1x GP. 

No one expects Cyren to turn around, which is exactly the right time to bet on it.

Amidst the gloom, the company came up with a new anti-phishing product that has doubled revenues in the past year. The new product was so promising that a legacy business was sold to raise capital for it.

The new product may result in the optimism that the stock needs to move higher.

Warburg bought most of its stake at $40-50/sh (split-adjusted) in 2017. The stock has declined 95% to <$2/sh now. But Warburg still owns about 30% of Cyren. I think the firm would stick around to support the stock and minimize losses. Otherwise it would have exited long ago. 

In Greek mythology, Sirens are half-bird, half-beautiful maidens that sang to lure passing sailors to their doom. But for this Cyren, I am heeding its alluring call.  

A little Tectonic effort required

Buffett once said his favorite holding period was forever. 

Hold on to the great business, do nothing, and allow it to compound earnings for decades.

That sounds wonderful, except that the great business is hard to find.

Even when the rare great business is spotted, the market may already price it as such, reducing your potential return.

For many followers of Buffett, their outcomes are worse than a missed opportunity. 

They invest in businesses that look great but aren't. Look at those companies that showed exceptional growth only during Covid.

Or they buy expensive stocks because great businesses deserve high valuations, only to see them melt away in time.

The worst outcomes belong to those who hold onto not-so-great businesses through corrections, just to sell near the bottom.

It is not easy to do what Buffett does.

Your favorite holding period is unlikely to be forever.

I sold ETCC (see here for writeup) yesterday at my target price, a 4-year high. The price was about .75x ttm sales, which is the middle of the .5-1.0x range that ETCC was in during most of its history.

The price action was captured by the single large green candle (at the extreme right) in the 10y chart below:

What I want to highlight is how short-lived the opportunity to sell at my target price (about $0.90) was. See the price action again, now shown in a 2d chart:

ETCC surged more than 50% late on Aug 5 Friday and closed at my target price. I should have sold but failed to place orders.

I then placed limit orders to sell on Monday, which allowed a smooth exit when ETCC opened.

I didn't know that the stock would plunge, so do not applaud my timing.

What is worth noting is the sudden surge. nulla-spe (meaning hopeless) stocks responds quickly even to slight changes in sentiment.

When surges are accompanied by news or filings, it is wise to re-underwrite the investment case and adjust target prices.

When they are not, like in ETCC, I stick to target prices and sell, even when the rationale behind the surge is unclear.

It is tempting to hold a surging stock beyond its target price. What if buyers bidding up the stock know something that you don't? 

That may be true. It may also not be. When it is unclear why prices move, I avoid guessing and rely on what I know.

To not guess is a conscious decision because it defies instincts. The intuitive act is to guess because of the innate human instinct to explain something that lacks clarity. 

After selling ETCC, I continue to monitor it. Its price may justify me owning it again.

 

Mark Twain said that what kills you is what you know for sure that isn't true. I strive to invest like Buffett does. But before I know for sure, this approach works for me.

No Creativity needed

I met an analyst who knew every detail about Clorox (the company and its ubiquitous disinfectant have the same name). 

He knew what every product line was, where they are manufactured, what chemicals are required, which suppliers are used, and more, down to the trucking companies that serviced each manufacturing plant.

But he was almost always wrong on the direction of the stock price.

He was wrong so often that I quietly labeled him as having a "reverse golden touch". Whatever he said the stock would do, bet on the opposite.

The analyst understood the business but failed to understand the stock.

Knowing the business is not the same as knowing the stock. 

They overlap, but they are not the same.

To know a stock is to know what moves it. 

Investors, especially of the institutional breed, would say earnings, and quote Buffett and academic research along the way.

But if everyone thinks only earnings matter, it won't. 

To have an edge would mean transcending earnings to elements that predict earnings. After everyone knows those elements, the edge would have to transcend again.

And the cycle repeats.

This is why the markets are so competitive, and attract participants of a similar nature.

If you think that standard fundamentals matter most in a stock, you don't know the stock. 

Let's get back to the topic. How do you know what moves the stock? They aren't the same for every stock. And you can't know for every stock.

I think it's perhaps easier for stocks that exhibit some form of extreme qualities. It is those extreme qualities that move the stock.

Take Apple. What is its signature product that accounts for its extreme success? That moves the stock.

I may know what moves the stock, but it does not mean those elements are knowable.

That sounds cryptic, so hear me out. Knowing what does not mean knowing exactly what.

Take Apple again. iPhones matter a lot for Apple stock. But there is no way for me to predict iPhone sales correctly.

It's about the important and the knowable.

To know a stock is to know not only what is important, but also the chances of you being accurate on those.

A stock that I think I know is Alliance Creative Group Inc (OTC: ACGX).

ACGX designs packaging, provides printing services and packaging materials, and fulfills orders for consumer goods. It operates out of 7 warehouse locations.

Think of ACGX as the first stop for emerging consumer brands. ACGX works with young brands to design and print packaging for their products. When products are sold online or elsewhere, ACGX also fulfills orders by sending the products to buyers.

ACGX is extremely small and cheap. It trades with a $400,000 market cap and .73x tangible book

Between 2011-21, gross profit was unchanged because of competition and mismanagement.  What has changed is expectations. In 2011, it traded at 50x book. Today it is about 1.5% of that.

Among the company's questionable decisions is an expansion into trucking. The capital-heavy economics of trucking made it difficult to manage. Management finally sold the segment in 2019.

Another bad decision was in acquisitions. ACGX bought and invested in PeopleVine (a CRM platform) for about 400-500k (at or exceeding its market cap today), which does not seem to generate revenues and should be sold or written down.

ACGX isn't thriving, but has survived the business cycle and is even sprouting young shoots of growth. Tangible book per share has almost doubled since Covid-lows in 2020. Revenue grew 19% in 2021 and another 11% in q122. Gross and operating margins have stabilized. It is even cash flow-positive.

Its industry is very competitive but has tailwinds. The digitization of commerce and dynamics of the creator economy make creating, marketing, and distributing a product fairly easy with decent unit economics. This should allow emerging brands to proliferate (as seen on YouTube/Facebook/TikTok), and support ACGX and peers.

It may even stand out from peers with its roster of high-profile consumer brands including Uber, Kroger, Aldi, and Paul Mitchell.

CEO/Chairman Louis is the key insider, who seems ready to see through the turnaround by maintaining a significant stake (100% of preferred stock and 67% overall) since becoming CEO in 2011.

Metrics at the extreme underscore the opportunity:

• Extremely low valuations: ACGX trades at only .1x LTM sales, .5x GP, and .73x TB. In its heyday, .5-1.0x sales were common. Just reaching half of the lowest in the range is enough for a 150% return.
• Extremely small: Very few investors look at sub-$1m companies. The smaller the company, the fewer investors involved, the easier to find under-valuations.
• Extremely discarded: The stock has traded in a narrow range since 2020 (except for a brief period in 2021) near all-time lows. The more discarded the stock is, the lower expectations are, the lower the hurdle required for the stock to move.

ACGX banks on being creative to be competitive. But investors do not need to be creative to make good bank on its stock.   

UN-loved, Imperfect, Ready to bounce

What is a good stock?

If you’re buying, a good stock is one that goes up.

That sounds simple enough, but it should be refined a little.

You want to buy the stock before it goes up. Buying a stock after a huge run is probably a bad idea.

So a good stock is actually one that is conditioned to go up but has not gone up yet.

The first condition I look for is seller exhaustion. After sellers are done selling, the stock has little room to go down, and future buying would encounter little resistance to bid prices higher.

The problem is how the stock looks. Remember that you're buying a discarded stock that many have sold. The picture is never pretty. Look at the chart of ETCC (written in a previous article, click to zoom in) below:

Buying ETCC now means buying at multi-decade lows, even below the lowest prices during the epic financial crisis in 2008/09.

And the stock may go lower from here. A multi-decade low does not imply that sellers are extinct. It means fewer sellers relative to when the stock price is higher. 

It is never comfortable to buy after every living soul has sold and no one you know is buying. You have to be independent and resilient to buy a good stock. Making money is never comfortable.

The second condition I look for is potential. What does (or would) the stock have that would attract buyers?

This may come in the form of new products, new customers, existing customers spending more, industry tailwinds, and quality incentivized management among others.

The good news is you won't need much. Just a little optimism is sufficient to move the stock. Without sellers, buyers would bid prices up without resistance.

Uniroyal Global Engineered Products (OTC: UNIR) is a stock that meets both conditions. Look at its ugly chart (click to zoom in):

UNIR manufactures vinyl-coated fabrics used in car seats, car door panels, furniture upholstery, stadium seating, and other applications. It sells mostly direct to customers, in particular auto OEMs (~60% revenue).

UNIR is not well-managed. Pre-Covid from 2013-19, sales were stagnant, gross margins declined, and debt ballooned by 60%. 

Covid nearly killed the business, which was rescued by PPP and a zero-interest debt package backed by "automotive lenders". This is interesting. Who are these lenders? How are they able to extend financing at 0%? Why would they do so?

I suspect that the auto OEMs are the lenders. They are large enough to extend cheap financing to small companies. That they would do so to UNIR perhaps implies that it is important enough to their supply chains. 

Fabric is a commodity. I'm sure auto OEMs can source it elsewhere given their size and reach. But global supply chain issues may make the economic case to source from local companies such as UNIR.

Geopolitical tensions may play a part as well. Sourcing cheap fabrics from China may no longer be an option.

UNIR may also benefit from rising ESG concerns about using animal leather. The company is most known for manufacturing Naugahyde, a type of resistant faux leather (and invented in Naugatuck, Connecticut, no less), marketed as cruelty-free fabric.

The shift towards more customized products appear to be working as well. About 24% of FY22 revenues are made in customized fabrics, up from 15.5% in FY19. The shift would eventually benefit margins, which are still depressed by inflation.

There are other reasons to be optimistic. FY22 revenues increased 19%, indicating a potential turn in the auto OEM cycle (and a much-anticipated drop in used car prices). Margins are slowly marching back from a combination of product strategy and cost controls.

This is a simple story if you believe that UNIR is important enough to auto OEMs such that when the OEM cycle turns, UNIR would be brought along for the ride. The turn should expand its multiple from a currently depressed .07x sales and .6x book to about .2x sales, where it traded during the cyclical rise.

The key insider is also a strong pillar for the stock. CEO and Chairman Curd owns 48% of Class A stock and 100% of Class B stock, and has been involved since 1992. He is also 83 years old, and may sell the entire company for estate planning. 

Curd doesn't appear to be the best executive, but I give him credit for maintaining his stake for three decades and for not diluting shareholders when UNIR needed capital during Covid.

I don't know when the auto OEM cycle would turn. At this moment, recessionary fears abound, consumer spending looks likely to weaken, and inflation is at multi-decade highs. 

All I know is that the cycle would eventually turn, and UNIR appears ready to ride the rebound.

Tectonic effort not required

Many of my smart friends have the same problem.

They choose the most difficult games.

It is difficult to get excellent and sustainable results with difficult games. Difficult games attract competitive players, who are not only smart to begin with, but also improve over time.

If your goal is to be constantly challenged, you should choose a difficult game. But if you want consistently excellent results, it may pay to look at less difficult and lesser-known games.

Many of my peers from business school work in very competitive industries. I wonder about an alternate reality - what if they utilize their talents in less competitive fields, like rolling up small wholesale suppliers to barbers (this is an actual business)? Chances are they would be paid more with a less demanding schedule as owners.

There is nothing wrong with challenging yourself intellectually while playing difficult and competitive games. But if you want results, look for a simpler and less competitive game that you can win in and get good returns.

This is why I prefer to look for stocks in the nano-cap and micro-cap space. It is a more simple and less competitive space compared to investing in larger, more well-known companies.  

The media barely covers the space. Business information may be scarce. Institutions have too many assets for the space. The Wolf of Wall Street gave the space a bad name (specifically OTC stocks). 

And there is a lack of liquidity. You can't build a full position quickly, and can't exit immediately.

If you're willing to do your own work instead of relying on brokers/media/databases, if you're willing to have conviction and forgo the opportunity to trade quickly, the space offers compelling opportunities.

One such opportunity is Environmental Tectonics Corp (OTC:ETCC).

ETCC is a nano-cap ($3m market cap) industrial that manufactures aerospace simulation equipment, commercial sterilizers, and commercial environmental testing and simulation systems.

A stock, priced to be dead, just needs to prove it won't be dead to move. It's trading at .25x LTM rev, near all-time lows of .15x during Covid, and below the .5x average post-2009. 

Yet ETCC generates enough cash to trade at 1.4x FY22 FCF, and has been mostly CFO-positive since 2010. The only debt it has is a credit facility underwritten by PNC, a reputable regional bank. ETCC appears to have excellent credit. It pays a low 3.25% rate on the credit line, and has passed PNC's conservative underwriting for the past decade.  

The low valuation may be explained by its aerospace simulation business (~60% FY rev, think training equipment for pilots). Covid devastated the industry in 2021, during which the segment halved its revenues yoy. Supply chain issues prevented it from taking advantage of the higher demand for flight personnel in 2022. 

However, without Covid, its aerospace simulation business has generally been stable, interrupted occasionally by the flow of large orders. And its business is more indexed to stable human capital dynamics than the volatile aerospace OEM capex cycle. I expect the aerospace segment to recover, albeit slowly because of supply chain issues.

The stock may not even require aerospace to recover to move. In Q123, growth in commercial (~40% rev), its other segment, was so strong that it almost made up for the decline in aerospace (~60% rev), making overall rev growth look stagnant. 

In the commercial segment, demand for sterilizers in a post-Covid environment was obviously strong. Environmental testing systems (think air quality testing equipment or noise testing labs in manufacturing) resumed growth in q123, driven by strong demand in automotive and HVAC. The focus on ESG and the shift to EV manufacturing may drive new demand for environmental systems.

There is no need for ETCC to actually make a full return to normalcy for its stock to move. Just the perception of a likely return to near-normal conditions is sufficient to move the multiple for a 100% return (.25x sales to .5x sales). If sales actually does grow, the return would add to multiple expansion and be even higher. 

Insiders appear committed to seeing through the turnaround. Lenfast, the former chairman and largest shareholder with a 54% stake, was involved for 20 years before he passed in 2018. His estate has held on to the stake after his passing and through Covid. The stake would have been reduced long before today if not for steadfast commitment.

Prospects would be better if Lenfast were alive as an executive of ETCC. But I rather much prefer a committed insider stake than flighty public capital.

The stock now trades at 6 cents above all-time lows. Seller momentum has been exhausted. ETCC does not need a tectonic shift to move higher. Buy and wait. 

Maybe not a Nova

Nulla Spe means no hope in Latin. 

I like to invest in stocks lacking expectations. If enough investors dislike and sold the stock, it would have little room to decline further. My downside risk is limited.

The upside is potentially significant. It doesn't take much to move a hopeless stock. A government contract, one significant customer, or a slightly less negative guidance would suffice. Its underlying business just has to become functional from being outright dreadful.

Heads I win, tails I don't lose much. 

I like those odds. 

This effective yet simple philosophy once didn't resonate with me. It started my investing journey, and had excellent results, but was seemingly too simple for outsized returns. 

What I have learned, after reflecting on a painful stint in growth investing, is that I was the simpleton who was unable to uncover its full potential

Let's move on to the first stock I found upon returning to the nulla-spe philosophy: Nova Lifestyle (NASDAQ: NVFY), a debt-free nano-cap ($5m market cap) wholesale supplier of furniture.

True to its name, NVFY behaved like a nova, shining brilliantly during its initial public years before fading. At .24x tangible book now, it is priced to perish, but would it? Look at the list of disasters it survived:

2018: A short attack by Andri Capital, which rated NVFY a Strong Buy in November 2018 before reversing into a Strong Sell a month later

2019: Higher trade tariffs imposed by the Trump administration devastated NVFY's margins made on importing Chinese furniture, forcing it to stop imports and reducing sales by 73%

2020: Covid lockdowns in China reduced the Company's imports further. Sales fell 48%.

NVFY is showing encouraging signs of a turnaround. In 2021, sales increased yoy for the first time in 4 years. The shift towards higher-margin products has worked. Higher ASP, lower volumes, and revenue growth were observed in 2021 and q122. 

q122 also didn't have any write-downs of slow-moving inventory, the first since 2019. NVFY may finally have the right inventory now.

Its working capital cycle appears to be normalizing as well. Inventory turnover is getting faster, and receivables are turning over much faster than in previous years (perhaps due to factoring, which wasn't mentioned in the 2021 10k). Given its recent history of inventory write-downs, I'm glad that someone is willing to buy its receivables

NVFY still has a long way to go to return to its former glory. It used to trade at 1-4x tangible book pre-tariff. If it could adapt to a post-tariff environment with higher-margin products, it may return to a 1x TB multiple (a 4x return!).

Warrants would trigger a 17% dilution at $3.50/sh, which is distant for investors targeting a 4-5x return from current levels.  

I don't know whether NVFY would maintain sales and margin momentum for the rest of 2022. Management is certainly incentivized to right the ship. Liu, a vice-president, has owned 30% since 2018, and CEO Lam about 1%. The ownership structure makes me think that Liu is the real leader.  

Perhaps the sales growth so far was more a result of a Covid-led stay-home boom than improving product-market fit? Who knows. 

All I know is the stock looks like an asymmetric bet at all-time lows.