Friday, July 29, 2022

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.