Update - Pzena Investment Management Inc. (PZN)

Review

In October of 2020, I provided an overview of my investment in Pzena Investment Management (here), an investment firm founded and run by Richard Pzena and his co-founders.  The thesis of the investment was based on 4 points (downside protection, dividend payout, recovery from pandemic and reversion to the mean for value stocks.)  Interestingly, all of these factors have come into play over the past 20 months since that write-up.

On July 26^th, 2022 when PZN announced their second quarter results, they also announced that the company would be taken private by the current class B shareholders.  As mentioned in the previous write-up, the capital structure of PZN ensured that any such action could not be met with significant resistance.  The valuation of the “merger” was set to provide a buyout of the class A common shareholders at $9.60, a 49% premium over the closing price on the day it was announced. 

It should be noted that the previous write-up mistakenly mentioned that the company is run for the benefit of the class “A” shareholders when it should have said class “B”.  The relationship between the two classes was otherwise accurate.  However, what was also accurate was the caution that the class “A” shareholders were betting that they would not be exploited to the benefit of the “B” shareholders. 

While it would be difficult to say that Pzena exploited the class “A” shareholders, there can be no doubt that the structure of the company was opportunistically used by Pzena to capitalize on the current market situation and the environment that he sees going forward.  While there is little point in expanding on the details of the outcome here, it remains disappointing that a suitable investment will be needed to replace the one in PZN.  Finding such a high-quality investment is never easy.

While I have not precisely calculated the gain from this investment, it exceeds 50% (30% on an annualized basis) due to the sale of 6000 shares at a price of $11.60 on a basis of less than $5 over a (approximate) 9 month holding period.  Shares were then repurchased as the price has fallen over the past few months.  The current holding of over 25K shares will bring a return of 50% over a holding period ranging from 3 to 20 months.  These returns are certainly far greater than any of the major indices and do not include the nearly $10K in dividends received.  However, despite the good return, the longer-term opportunity cannot be captured now that the company will be taken private. 

Recap Key Points

• Investing alongside outstanding investors remains a solid strategy, particularly when a company similar to PZN can be found.
• A favorable entry price was absolutely necessary for a good outcome in this case. 
• In retrospect, a full sale of fully valued shares at the $11.60 price would have resulted in improved returns, however, capturing this result required market timing and knowledge of the coming downturn that ultimately returned PZN to the $6 level.
• The level of research performed was appropriate and also proved accurate.

Update - Overview of Investment of Currency Exchange International (CXI/CURN)

Review

In late December of 2020, I provided a write-up (here) of Currency Exchange International, a foreign currency exchange and payments provider to both retail and wholesale customers in the US, Canada, and throughout the world.   At that time, CURN was losing (hemorrhaging might be a better description) money and in the midst of a restructuring effort to ride out the pandemic and position the company for longer-term growth.  My initial investment in CURN was based on their business plan prior to the pandemic.  As events of the pandemic unfolded and the company responded to these events, I gained confidence that the company would remain solvent and that they potentially might have good or even substantial upside once the impacts of the pandemic began to subside. 

In the initial analysis, I also reviewed the potential forward paths as I saw they might develop.  While the actual path of the events differed somewhat from those presented, the basic elements remained unchanged from my previous analysis.  Overall, the company has made outstanding progress toward revenue and profitability recovery.  As the rebound has unfolded, the revenue gains were broader than expected and much of the opportunity remains uncaptured.  There is no question that the early bounce-back in the business has exceeded what would be expected by economic conditions.  This suggests that the initial assumption about the business and future prospects was accurate if not underestimated. 

 

Current Situation

In their recent Q122 filings, CURN reported their highest ever quarterly revenue at $12.46MUSD.  The most surprising aspect of CURN’s results was that this record revenue came at a time when international travel was (and is) clearly in the very early stages of recovery.  Further, the uptick in revenue comes during a time of year that has traditionally been the lowest seasonal performance for the company.   Most of the growth occurred in the banknotes segment and seems to confirm management’s strategy to restructure that business while opportunistically taking advantage of the competition’s exit from select markets. 

My investment in CURN was initially based on their overall safety, actions to scale their business, improve margins and build out their banking business.  These factors remained as good drivers despite the decline in their business due to the pandemic.  However, the opportunity presented by a beaten-down price and eventual recovery from the pandemic seemed to have a potentially compounding impact.  This prompted me to continue buying CURN in (over 50) bite-sized pieces over the past 14 months.  Prior to reporting of their Q122 results, my position had grown to over 25% of my portfolio! 

I’m continuing to understand how the actions that the company has taken and continues to take in its banking business will impact the revenue and profitability of the banknote business.  It is not clear to me how has the company managed to achieve the results seen in the most recent quarter.  The company has really not offered enough quantifying explanations to sort this out, but from their conference calls and information provided in their filings, it is clear that much of the improvement lies outside of the retail operations.  While my understanding falls short of any predictive ability in future outcomes, what is certain is that the impacts of these actions have been positive and that it is not unreasonable to assume that further rebounds in travel will produce future gains, potentially substantial ones.  At this point, there is simply no way to quantify the size of these gains without a better understanding of CURN’s potential market size and capture of market share. 

Less encouraging was that the recent quarter showed performance in the payment segment of Currency Exchange International’s business was (potentially) subdued from some of their previous progress.  While the number of customers grew in the quarter, the revenue growth coming from this segment in the past two quarters seems to have slowed considerably.  It is too early to understand if growth has stalled or if it simply is a function of other factors.  The company continues to be optimistic toward this segment.  They continue to discuss their search for acquisition targets that are aimed specifically at the payments business.  Given Pinna’s conservative management style, such an acquisition would likely be positive for the future of the company.

 

Outlook

While the company does not provide any sort of guidance, information gleaned from other investors who claim conversations with Pinna have pinned the company’s potential revenue in 2-3 years in the 70M range.   As those conversations took place approximately one year ago, I believe it is reasonable to use this as an FY24 number.  Based on past performance and other recent growth factors, I see the 70M as conservative and near the low end of the potential range (absent another pandemic-type event).   In my simple model for the company, I have estimated a range of $70-95MUSD for FY24.  Given their revised structure, operating margins are difficult to predict.  But, framing them using historical numbers to bookend the margins and multiple, a price between $15 and $60 is likely for that level of revenue.  While a very large range, there is still safety in that range for my cost basis near $10. 

I continue to see a positive business opportunity for the company.  Should the pandemic’s impact on travel continue to abate, it is likely CURN will continue to grow at a pace that exceeds general market performance.  With the four pillars of their strategy taking hold, the chances that one or more of those pillars might provide for substantial growth remains a good reason to remain fully invested in the company.  However, as the recent results have pushed the price up over 40% from my average cost, the percentage of my portfolio invested in the company is far too high for me to consider any additional investment.

Absent a sale or acquisition by a larger firm, CURN will remain a small company, and price volatility will be part of its path forward.  However, today’s price near $14.00 still provides substantial value and safety for new money.  I estimate that the banknote business is likely worth around $20 on its own.  Future analysis (in 1-2 years) will focus on valuing the company by attempting to assign values to the individual pieces of the company.  I expect these pieces to be retail banknotes, wholesale banknotes, and payments.     

Update - Overview of Investment in Argan Inc. (AGX)

Just over a year ago, I wrote (here) about my investment in Argan.  At the time AGX was my largest position and my expectation for the stock in the coming (12) months was that it would move up in lockstep with expected, improved earnings results.  My expectation was also that it could further benefit in multiple expansion from a sustained backlog that was regularly converted to active projects.  Because the price was underpinned by a large cash holding and the prospect of consistent business performance, I had good confidence that the stock would not lose money and would potentially gain 30-80% over a two-year period from my average cost of approximately $35.  These were (and remain) the key drivers for my investment.

What has happened in the past year is that AGX’s price rose to a high of 54 in April of ’21 only to recently fall back into the low 40’s to high 30’s. Much of this rise and fall has followed the sentiment in the market of value stocks which surged and have more recently pulled back in the wake of continued, renewed pandemic-related concerns.

As the overall gain in AGX has been modest, other, better performers have now replaced AGX as my top holding.  Some of these companies now have better, more visible prospects.   That said, I’m continuing to hold AGX despite considerable headwinds facing the construction of new natural gas power plants.  Those concerns have continued to be discussed in the company’s 10Q and 10K’s.  Argan has continued to highlight these headwinds and add to the narrative in the Market Outlook section of their filings. 

The most recent (Oct ’21) 10Q repeats and expands upon an earlier discussion regarding the circumstances and consequences of the current national and world views related to power generation and its impact on climate change as it is balanced with the growing demand for electricity.

In October ’21, Argan’s Atlantic Projects Company’s (APC) subsidiary announced that they had won an engineering and construction project for a 660MW natural gas power project in Northern Ireland.  This is welcome news against the backdrop of uncertainly in of US projects.  The project has already started, however,  APC’s performance on their last major project continues to subdue any excitement that might be generated by such an announcement.  At the same time, AGX remains positive about the prospects for continued business at APC as supported by policy decisions in Ireland. 

In May ‘21, AGX announced the win (by GPS) of a 100MW renewable power plant EPC project.  Gemma received an immediate notice to proceed with the project scheduled for completion in the second half of 2022.  This signals that the leaders at AGX are deeply concerned about the prospects for their core, natural gas-fired EPC business as they continue to convey in their 10Q/K’s.  The fact that AGX has provided incentives to the management of Gemma to pursue contracts for renewable projects in wind and solar is further evidence that AGX is not standing still while external factors threaten their business development prospects.

There can be little doubt that some of the current backlog is at serious risk for further delay or cancellation.  However, the continued need for natural gas plants and the prospect for using hydrogen as a long-term source of utility-scale power production should underpin AGX’s business model.  It is unlikely, however, that multiple expansion beyond today’s 15x TTM exists in the near future of AGX.  That leaves only actual EPS performance as a driver for upward appreciation of the stock price.  Unfortunately, in the wake of the most recent earnings announcement, the analysts that follow AGX have reduced their 2022 revenue and EPS projects and related price targets for AGX.

So, what is a value investor to do given the formidable headwinds now facing AGX?   Should the investment be held waiting for the eventual disposition of some of the backlog projects?  Alternately, should the position be cut or eliminated entirely in the face of policy and public opinion that seems to give ever-smaller chances to convert the backlog to sustained earnings and continued growth for AGX?  With the lagging price performance of the stock, it’s clear that the marginal investors in AGX have decided that waiting is not the best use of capital. 

Evaluating AGX’s actual performance over the 14 month period since my previous write-up reveals a return of approximately 7% in total price appreciation and 10% in dividends including 2 special $1 dividends paid in FY21. While this (approximately) 15% annual return lags the market during this period by nearly all benchmarks, it did provide a reasonable return at a very good level of safety, albeit at the lowest end of my target.   Since this is generally in line with my expectations for the company, I will continue to hold AGX at the current level and re-evaluate as new information about future performance can be assessed.

Generally, that assessment will be aimed at the prospects of converting the backlog and progress on mitigating the impacts of sentient toward natural gas-fired plants.  Another key will be the use of cash for special dividends or buy-backs and any other factors impacting Argan’s expected future returns. 

 

A Brief Review of Investment in Investors Title Company (ITIC)

 

Background

Investors Title Company is a holding company and trades under the symbol ITIC on the NASDAQ exchange.  ITIC is a small-cap residential and commercial title insurance company that operates as one reporting segment through two companies, Investors Title Insurance Company (ITIC) and National Investors Title Insurance Company (NITIC).  NITIC was acquired in 1983 and had formally been known as Northeast Investors Title Insurance Company.    At a recent market cap in the high 300M range, ITIC has a relatively light trading volume at just under 5000 shares daily.

 

Although ITIC is a small player in the (US) national title insurance market, its ability to generate high margins, a growing presence in regional markets, a family-based ownership structure, generous dividend payouts, and growth patterns are all factors that initially attracted me to invest in this company.   Each factor will be explored in greater detail below in the investment thesis.  This write-up is intended to help solidify my case for investment in ITIC.  I expect this company to perform over a longer-term investment period of 5-10 years and provide an annual return ranging from 5-10%.  The company's stock was purchased at a smaller than normal discount (approx. 20%) to my estimate of fair value, which is primarily based on its book value multiple.  While I’m typically looking for companies selling at deeper discounts, ITIC provides enough downside protection to justify the lower expected returns. 

Investment Thesis

Title insurance is a mandatory part of real estate transactions in the US.  Most buyers of title insurance only become aware of its need through the home buying process.  Since title insurance is tied to real estate transactions, home building and refinancing are directly proportional to the number of policies written and revenues of title insurance companies in the US.  While ITIC’s performance has certainly been influenced by the overall level of activity in home buying (and refinancing), it has been profitable since 1984 in all but two years (1992 & 2008).  In each of the two losing years, the losses were relatively minor at just over $1M.  This performance and a very conservative capital structure provides a reasonable assurance that even under distressed housing market conditions, ITIC is not likely to suffer a solvency crisis. 

Notably, ITIC has continued to grow revenue at an accelerating 10-year growth rate for the past 5 years.  At the same time, net margins have continued to climb to an average of 20%.  While certainly this growth has been fueled by the fall in interest rates over the same period, ITIC has also grown their capital reserves to a very high level.  This high level of cash and short-term investments are expected to cushion any fall in premium revenues caused by rising mortgage rates while protecting the investment from a precipitous price decline during short or extended periods of reduced housing financing activity.  

By plotting ITIC's revenue since 2000 alongside the total mortgage activity (new mortgages + refinances) in the US, it is clear that ITIC’s growth is not purely a function of increased overall activity.  While mortgage originations remained flat in the decade following the 2008 crisis, ITIC’s revenues continued to grow.  While North Carolina is ITIC’s largest market, growth in other states has been a driver for the company revenue in the past 10 years.  

There are two key questions that exist with ITIC.  First, can the company sustain its recent growth trend against its larger and entrenched competitors (Fidelity National Financial, First American Financial, and Stuart Information Services) in the US title insurance market, and secondly, what will be the impact on Investor’s market share and overall company performance when the mortgage market cools or potentially craters?  To address these questions, it is important to understand what competitive advantages ITIC brings to this highly regulated, mature business.  It also depends on whether their cash reserves can be effectively deployed in the future to offset the cyclical downturns.

As a small player, ITIC has significant room for growth.  Authors who have written about the company on Seeking Alpha point to that headroom as an opportunity for growth.  However, in an industry that will increasing rely on technology to reduce cost and meet customer preference within the competitive mortgage business, ITIC may not be able to provide the capital investment in technology necessary to stay competitive.   

I purchased Investors Title as a substitute for holding cash at a time when overvaluation in the stock market is apparent.  Finding small, undervalued companies is increasing difficult as recovery from the pandemic is anticipated.  Due to the recent run-up in small-cap stocks and a move toward higher prices in value stocks, I began searching for a company for my portfolio that was similar to my holding in Vitreous Glass (VCI.V) that pays a special dividend and has extremely high insider/family/founder ownership.  ITIC seemingly meets this target as they have paid a special dividend for the past three (3) years.  Last year’s special $15 per share dividend added to their normal 1% dividend would have returned just over 10% for 2020, based on my average price of $160.  While the payment of a special dividend in 2021 and forward years is far from certain, it does seem that management as founding family members who retain over 20% of the stock are incentized to do so.

Investor’s Title was not significantly undervalued at the time of purchase (Jan-Apr ’21).  However, the relatively low downside risk of this stock provides reasonable protection against permanent capital loss.  The likelihood of a small dividend, the possibility of a special dividend of up to 7-9%, and the ongoing potential for continued revenue and margin growth are all sound reasons for the investment.  However, at this point, I am not adding to my position of ITIC as their recent (Q1/2021) results were at a record level, pushing the stock price near my estimate of fair value. 

 

The Edge – Is ITIC is better than a 50/50 bet?

As write-ups on this site progress, some sections will become standard.  One such section will be why the investment is better than 50/50 (or random selection) bet on the market such as an indexing ETF.  As this concept is core to my overall investment strategy, I will discuss this concept in more detail in a future post.

At this point, I fundamentally see my only edge in the ITIC investment as:

a.)    An ability to invest in this small, unfollowed company status

b.)    A lower return expectation as a cash substitute with its protection from downside risk

c.)    An ability to adopt a longer investment horizon vs. the average market participant

As none of these “edges” are specific enough to provide a significantly higher than market return, the investment in ITIC represents a weak upside case against its strong downside.  My position, therefore, is smaller than it might otherwise be.

In the coming months, I will continue to research & analyze the competitive advantage that has allowed ITIC to grow and assess whether this growth is likely to continue, accelerate or stall.   At the same time, should shares become cheaper, I may look to add to my position if the research yields a favorable growth outlook. 

 

Overview of Investment of Currency Exchange International (CXI/CURN)

Background

Currency Exchange International is a foreign currency services provider with both retail and wholesale operations throughout North America, primarily in Canada and the US.  This is a micro-cap company with a current market cap of 69M CDN/54M USD that is listed on the Toronto Stock Exchange under the symbol (CXI) and Over-the-Counter-Market (CURN).  Trading in the stock is generally very thin, but has seen an uptick recently on the Toronto Exchange. 

According to the company website (here) the company was founded in 1998 by Randolph Pinna.  That timing may be a bit misleading as Pinna founded another company that was part of a “friendly acquisition” by the Bank of Ireland.  He remained at the bank until 2007 as the CEO of the North American Foreign Exchange Business.  CXI was incorporated in 2007 in Florida and became a public company on the Toronto Stock Exchange in 2011.    

Pinna owns approximately 21% of the equity in the company and is therefore fully aligned with shareholder interests.  Although I have had no personal exposure to Mr. Pinna, his approach and demeanor on conference calls is straightforward and absent of the jargon sometimes associated with company executives.  A recurring theme in those who knowingly write about Mr. Pinna is his high energy and high regard for personal relationships.  His tenure and experience in the retail foreign exchange and banking foreign exchange are an extremely important asset for the company.  In addition to the shares owned by Pinna, Pembroke Management, an institutional and private client wealth management firm based in Montreal and Toronto owned 11% of CXI before recently selling enough stock to be under the 10% reporting threshold.  The recent uptick in trading may indicate continued selling by Pembroke or other large shareholders who are unwilling to wait on a recovery.     

 

Investment Thesis

I initially invested in CXI in early 2020 as a growing, low risk company with little debt at a reasonable (or potentially value) price.  With virtually no debt and the high level of excess cash, the downside risk and potential for insolvency seemed very low.   CXI has seen excellent revenue growth over the past 10 years, however, profitability has taken a hit since 2017 as the company has been expanding its network and building out their banking business.  This reduction in margin was reflected in the stock price with a distinct downtrend since the fall of 2018 when the stock was selling near it’s high of $24.  My investment was a bet that CXI would be able to improve margins significantly and further scale the business.  While pre-2017 margins were very high, I did not (and still do not) expect margins to return to previous levels.  This is mainly due to the change in business structure associated with their banking business.  The thesis seemed to be on track at the start of 2020 as I began to purchase my position in CXI.  It seemed CXI was nearing an inflection point as they began seeing improved operating margins. 

But, as the impacts of the pandemic began hitting in early 2020, international travel was one of the first and hardest hit industries.  It’s hard to imagine a worse business more directly blunted by the smashing blow of global responses than international travel.  CXI’s direct tie to this segment of the market continued to punish the stock from its already downward path initiated by the margin compression mentioned above.  Revenues for CXI in the 3rd fiscal quarter were slashed by nearly 70% over the prior year and the outlook in the short term and even medium term shows little sign of improvement.  While international travel was one of the first businesses to be impacted, it will likely be one of the last to recovery and the trajectory remains a guess by even the most informed sources.  Even as this impact continues to push the stock price down, I still consider the potential for insolvency very low.  That said, the price could easily see additional downward movement.  My average price of approximately $13.85 in early January of 2020 has taken a major hit as Currency Exchange International’s price as of this writing is in mid-$8 range.   (note that to avoid confusion, all figures in this write-up will be in the CXI reporting currency of USD.)

With the further depressed price and the smaller size of the CXI position relative to other stocks in my portfolio, I am now purchasing additional shares of CXI ahead of any signs of recovery.  With the price now close to the liquation value for the company, I essentially consider my current purchases of CXI an option play on recovery in international travel.  There can be no doubt that further downside risk to the price does exist.  I expect the pace of this risk will, however, roughly approximate the reduction in liquidation value as the company burns through its cash reserves   Below, I present a series of scenarios that I see as the likely course that CXI could take in the coming months.     

While recovery is certainly nowhere in sight, the company has sufficient resources and is developing a three-year plan to ride out what will likely be protracted effects of the global pandemic.  And, while survival for the company is anything but certain, they have stated in their regulatory filing that they are in a good position for at least 1 year.  I will revisit this write-up at the end of 2021 to update the investment thesis with the latest developments.

Other write-ups on CXI used for reference:

Value Investors Club:      February 10, 2014 - 10:16am EST by MSLM28

                                        August 23, 2020 - 2:01pm EST by ChapterTwelveCapital

SeekingAlpha:  Contributor Articles (all) 

 

Forward Scenarios

To explore the potential outcomes for this investment, I considered a series of potential outcomes for the business.  To keep the analysis as simple as possible, I chose to look at 4 possible cases and assign a rough probability to each.  While admittedly these probabilities are somewhat artificial, they represent my view of potential paths.  These outcomes are:

1. Permanent damage to the international travel industry with no long-term profitability for that segment.
2. The slow recovery in international travel, exceeding 3-4 years.
3. Moderate recovery in international travel, in 2-3 years.
4. Full return to pre-pandemic international travel in 2 years and/or positive future business developments. 

None of these cases will be the future outcome as the number of variables for the world economy, pandemic spread and containment, country and airline responses, etc. far exceeds any reasonable means of prediction.  However, these cases provide a basis of how I am thinking about my investment in CXI.  I believe my edge in this investment is the company size and extended time over which the recovery will be expected to materialize.  For position sizing purposes, I have assigned that edge somewhere between 2 and 5%, calling it 3.5%.   My financial models for each of these scenarios will be updated each quarter to account for revenue recovery status and for actual actions taken by the company against the cash burn rate.  Below is a summary text of each of the 4 scenarios…

1.)    Permanent damage to banknote business -  Because of the high insider ownership and strong balance sheet, I give the chances that the company will quickly burn through all of its excess cash and subsequently borrow money to keep the company afloat a 5% probability.  This applies even in the case of a protracted recovery in international travel.  I have previously owned a company that fell into bankruptcy during the grips of a multi-year recovery that never materialized.  This (painful) experience is used as a basis for my assessment of CXI’s prospects for a similar outcome.  Any sign that the company is on such a track and could continue to burn cash, ultimately posing a risk of insolvency, will be cause to exit the stock.  In the case that significant signs of recovery do not emerge, a restructuring should be expected within 12-18 months (mid 2022). 

 

2.)    Slow recovery in international travel, exceeding 3-4 years.  This scenario is potentially the most concerning for the stock’s medium-term performance and future actions as exit signs will not likely to be clear.  For this case, I chose to consider 2021 and 2022 financial performance to be flat against full year fiscal 2020 performance.  While cash burn may be slowed in this case, it would be extremely unlikely that the company could return to profitability in any year before 2023.  I would expect the low end of the price to ride the cash position down.  For this case, I have estimated up to a 25% share price reduction from today’s levels ($8.30 USD) to the low $6 range.  Below $5 would be cause to consider exiting the entire position absent clear signs of recovery.  I have assigned a 20% probability to this scenario.

 

3.)    Moderate recovery in international travel extending 2-3 years is my base case for the stock.  It is not likely the spread of the virus will see a dramatic decrease (globally) before mid-to-late 2021 or possibly 2022.  I would not expect to see much recovery in CXI prior to a sharp downward trajectory in worldwide cases.  However, with this case, I would expect some adjustment in CXI’s spending with the potential for closing a limited number of their retail outlets in an effort to improve their cash burn.  The company has stated it is developing a 3-year plan for this case.  I would expect some details of that plan to emerge over the coming quarter.  I have assigned the probability of this path to be 50%

 

4.)    A fourth, more optimistic scenario, is a moderate recovery in the pace of international travel coupled with a catalyst in CXI’s business.  One such case would be the reduction in competition in the bank note business.  This would result in higher eventual revenues for CXI or/and significant improvement in the commercial business.  This could include acquisition of a major, new customer(s) or the widescale adoption of their foreign exchange currency software.  In comments to the VIC write-up recently, mm202 noted that the CXI software solution is, “top notch” and he/she claims to have done some due diligence on the system.  I cannot comment on this potential catalyst, however.  I have assigned a probability of this total scenario at 25%.    I have lumped the potential for a 5^th outcome in with this scenario.  That is, the buyout of the firm by a large institution or private equity.  As with Pinna’s first venture, the assumption that he will someday be looking to cash out of the company is likely, but has no timeline that can be assigned.  As with most buyout cases, I can claim little more than a guess of a 15-30% premium to the market price at the time of announcement. 

 

Final Comments

A popular counter-argument to an investment in CXI is the death of paper currency, a trend that began over 50 years ago and continues today.  Certainly, betting against the downward slope of the use of banknotes seems almost naïve, if not insane.  However, it is the overestimated rate of decline that an investment in CXI is attempting to capitalize on.  The overestimation of the demise of many legacy businesses has repeatedly made for fertile grounds for value investors and I see CXI as a niche player with a longer than expected runway in this area.  The experience of Randolph Pinna and his team in this area should not be underestimated.   A strong balance sheet, reduced competition, and deep market knowledge are all positioned in CXI’s favor for the near and medium term.   As the banknote portion of the business wanes, room for investments in adjacent business or even a dominant position in a corner of the foreign exchange business could easily be a longer-term story that moves the company forward. 

Overview of Position in Pzena Investments (PZN)

 

Investment Thesis

Pzena Investment Management is a firm founded and run by Richard Pzena along with co-founders John Goetz and William Lipsey.  Pzena is dedicated to value investing and his firm now (Oct ‘20) has approximately $33B assets under management.  In this write-up, I discuss why I took a position in PZN earlier this year and why I believe it was a relatively safe investment, with a limited risk of permanent capital loss.  It is my view that anything short of a complete melt-down in the company’s model and/or global markets will likely sustain operations at a level equal to or above the current level.  I estimate that the company is currently fairly valued given today’s market conditions and recent earnings of PZN.

Should there be a substantial market recovery among investment firms such as PZN and/or a return to favor in value stocks, the stock price could double in the next 3-5 years.  Because the firm primarily serves institutional investors, Pzena has been successful in growing the company despite generally under-performing the S&P 500 index over the last decade.  With the move toward passive/robo/index investing in the past few years, this growth has not been without its challenges.  Active investing firms that have underperformed have struggled to retain customers.  Pzena’s ability to offset this trend coupled with an expected reversion to the mean for value companies in the coming years supports the decision to invest in the low to mid-$5 range. 

In summary, my investment in PZN is based on 4 main points. 

•            Downside protection
•            Dividend payout
•            Recovery from the pandemic
•            Revaluation of value stocks vs expensive stocks (reversion to the mean)

 

Downside protection

Many articles have been written surrounding the alleged death of value investing.  Pzena has recently addressed this point in conference calls and particularly in this video.  It was recorded early in 2020 during their 2019Q4 update call with investors.  The video was recorded before the Covid-19 pandemic and Richard Pzena accurately predicted that “I have no idea what will happen in 2020.”  And, despite openly admitting that his firm has underperformed the S&P500 over the last decade on average, Pzena has continued to grow his client base.  The inflow/outflow numbers for the last three years show that Pzena’s firm can attract investors at a higher rate than those leaving the firm for greener pastures even in difficult environments.

Should the company performance vs. the S&P500 reverse over the coming years (which R. Penza says he believes it will) their investments should prosper along with an improved inflow/outflow ratio.  At a time when the shift away from active management at the retail level is restructuring investment firms, Pzena’s focus on institutional investing on a global scale has held up relatively well.  During conference calls, Pzena has repeatedly mentioned that they serve a different customer than those currently feeling the effects of shift toward passive investing.  While he admits there continues to be pressure on fees, he does not see the current environment any worse than the general, downward, trend on fees that persisted in the past 5-10 years. 

 

Dividend payout 

Pzena (PZN) is a public company.  But investors should not be mistaken that the capital structure of the company is intended to primarily benefit investors who own “A” shares of the common stock.  The capital structure of the company is complicated and difficult to understand, but essentially there are two classes (A and B shares) with the "A" shares having only a small percentage of the voting rights.  With a total share count of slightly below 79M, the “B” shares outnumber the “A” by more than 3.5:1. Further, the "A" shares have voting rights of 1/5 of the “B” Shares.  This results in a final “B” share voting advantage of over 18:1. The "B" (including B-1) shares are owned primarily by Richard Penza, Directors and Employees of the company, making any outside influence nearly impossible.  With the complicated structure, investors in PZN are betting that Penza will not exploit the “A” unit shareholders to the exclusive benefit of the “B” unit shareholders.  

Dividend payments have been both high and growing over the past few years.  At a stock price in the low $5 range, the payout has been roughly 10% for the past 3 years.  This has come in the form of three ($.03) quarterly distributions and one special dividend of $0.42, $0.49, and $0.46 for each of the last three years.  Pzena did not suspend the $.03 dividend when their results were punished by the pandemic and the stock price dropped in mid March of ’20.  Even with the continued recovery of AUM through the final months of the fiscal year, investors should assume that a special dividend will be significantly reduced or non-existent for FY21.  However, the ability of PZN to attract new investors and limit outflows during the pandemic, and return to a more normalized environment should help support future special dividends.  In the meantime, Pzena has stated that he believes supporting the dividend is important.  Even in the current, depressed environment, an expectation of 2.2% payout is reasonable.  Higher payouts will depend on Pzena’s ability to recover from the combined impacts of the pandemic and overall performance levels of their portfolios and funds.

 

Recovery from Pandemic

At the time of this writing, PZN shares are in the mid-$5 range.  This represents a 60% reduction from the mid $8 levels that the stock had hovered at prior to the pandemic.  Recovery from the Covid-19 environment has no visible barriers to a return to their previous performance except the recent dilution of shares that took place at the end of FY19. 

As a value investor, Pzena has taught in the past that investors need to determine whether the reason for a stock to be on sale is whether the issues facing it are temporary or permanent.  Investors who believe, as I do, that most of the impact of the pandemic-related recession issues are temporary in nature, should see price improvement over the coming year.  Given the low level of interest in the stock, this will not necessarily provide a sufficient catalyst for a full recovery even if the AUM fully recovers.  It should, however, provide greater than 20% upside to the current price suggesting a one-year improvement to the mid-$6 range. 

 

Revaluation of value stocks vs expensive stocks (reversion to the mean)

The final price recovery to previous highs of PZN ($9+) will likely require that the growth to value disparity in valuations return to more historical average levels.  As Pzena himself continues to emphasize, this revision to the mean, is reasonable to expect.  Exactly when that will happen, no one can predict.   Rich Pzena openly admits that value investing has not had a good run since the 2008/09 financial crisis and particularly in the past three years.  However, he remains committed to their investment philosophies because of the longer-term outperformance that they have enjoyed as a reversion to the mean has repeatedly brought value companies back into favor and rewarded a disciplined approach.  And while the pandemic impact on US and global stock markets has amplified the discrepancies between value and high growth companies, Pzena is betting on some of the most forgotten names and sectors that he believes will enjoy significant returns in the coming 5-10 years.

 

Risks and Drivers Away from Estimated Value

The list of risks to investment firms that depend on fees is well documented.  But perhaps the biggest risk with Pzena Investments is in the name itself.  Rich Pzena provides the brand for the company and the company has only a little over 100 employees.  Separating Richard Pzena from the company is almost certain to have dramatic unfavorable consequences to the common equity.  Should Rich Pzena become ill, die or otherwise not be able (or wish) to carry forward with his role, the stock price would likely suffer a devastating blow.  I have not done extensive research to understand the probability of this risk, however, there is certainly the possibility of this.   The probability remains unknown, but my assessment is that it eclipses all others listed in the 10K. 

 

Other Downside Risk

A protracted, further period of under-performance in value stocks would certainly weigh the stock price down as AUM, outflows and fees would all suffer.  Pzena has indicated there is room to cut cost should they feel it necessary, but no cuts to headcount are indicated at this time.  However, even if costs (headcount) are reduced, it will not be able to keep pace with the revenue reductions and investors should take any headcount reductions as a very negative sign.

Another source of downside risk to the stock would be another round of dilution of the stock aimed at incenting employees or moving the balance of benefits further toward the “B” shareholders.  There is no evidence that this would happen, but the equity structure presents the risk should times get tougher.  While the recently created B-1 shares were taken as a one-time charge to income, it does signal that Pzena is willing to dilute the share base.  Another round of dilution would be cause for concern and possible exit from the stock.

To the Upside

Higher Than Expected Growth, Multiplying Impact

This opportunity is very real given value’s long stretch of underperformance and the distortion in valuations of tech and growth stocks current present in the market.  Pzena’s long term track record and willingness to weather under-performance is no guarantee of outsized performance in the next 3-5-10 years, but he does seem to expect it.   If value comes roaring back, the number of clients knocking on Pzena’s door will undoubtably go much higher driving AUM, performance fees and the resulting stock price up and to the right.

 

Addendum:

A Review of PZN against Buffett criteria

In his 2017 Talk at Google (here), James O’Shaughnessy presented some of the results of his research in market performance over time and the factors that impact outcomes.  The key factors in Buffett’s methodology for finding and investing in stocks followed a few simple rules as described on the slide.  For PZN (and all investments that I make) I apply this quick check to help me stay focused on what has worked over long periods of time.  Below is the outcome of my review of PZN against this methodology.  

Recognizable brands with a wide market:  As discussed above, it is Rich Penza’s name and brand that has provided him with the opportunity that now exists.  In the most difficult of times (past 3 years), inflows in his firm have exceeded outflows.  The addressable market for his size firm is extremely large.

Simple, easy to understand products & services:  Investment management says it all. 

Consistent, solid earnings over a long time period: PZN has continued to grow net income over the past 10 years.  No losing years over that same period.

Low & manageable debt: 33M Cash & Equivalents, 0 Long Term Debt, 13M Long term lease obligations, Other long-term liabilities 29M.

Good ROE and other solid ratios: 5-year average ROE 45%, minimum in that time = 16%.  ROIC lower due to the capital structure of the company.

In this same talk, O’Shaughnessy also presented his findings on total shareholder yield (dividend + buybacks) as a predictor of positive, long-term performance.  While the recent dilution does seem to violate this premise, PZN’s payout ratio and buyback program should be enough to offset the negative impact of the B-1 share creation.

Overview of Investment in Barrett Business Services, Inc. (BBSI)

Investment Thesis

Barrett Business Services is a provider of payroll and administrative services as well as professional employment services to small and mid-sized businesses.  It is based in Vancouver WA and has the majority of its current business in the West (CA, OR, UT, WA, CO, ID, AZ, NV, and recently NM) and a smaller base in the East (MD, NC, PA, DE, VA.)  A number of important factors are behind why BBSI is a relatively safe and potentially very good investment in the 1-3 year time horizon.  Growth and multiple expansion are both possible for this small-cap with an excellent balance sheet, solid normalized earnings, and a checkered past. 

As it has done in the recent past, BBSI has plunged in price and is certainly still in value-stock territory at the time of this writing, despite a significant rise from recent lows.  It is an understatement to say that BBSI’s share price has been on a roller-coaster ride over the past 6 years.  Three times over that period it has reached into the high $90’s only to fall back under the cloud of issues that sent the share price plummeting.  Workers' compensation reserve issues, accounting irregularities, and most recently the Covid-19 pandemic provided the drivers for these pullbacks.   The recent low of $27 was reached during the point of maximum market uncertainly in March of 2020.   As was the case for many companies, an entry at that point would have provided an investor with an attractive return even against today’s price in the low $50s.

Although many companies have managed to return to pre-pandemic levels, this write-up explains why I believe an investment in BBSI in the $50-55 range provides an excellent margin of safety and could yield a 3-year annualized return of up to 10-30% not including the current annual dividend yield of 2.25%.

BBSI has been written up multiple times on Seeking Alpha and Value Investors Club.  In most cases, the main theme of these articles has been its low P/E multiple and expected strong recovery due to a solid business model and continued growth.  With such a large number of articles available, I will refer readers to the better of these articles and discuss the support of my investment thesis.  I believe the excellent work by tim321 posted on January 19^th, 2018 on VIC (here) provides the clearest and most comprehensive look at BBSI.  Despite the negative return since that publication 2.5 years ago, there is no issue with the premise presented in tim321’s article.  With the exception of potentially rising interest rates, the author’s projections for revenue, EPS, and resulting share price were accurate and actually exceeded by BBSI.

However, the impact of a much-anticipated recession at the end of 2019 followed by the Covid-19 pandemic delivered the stock price a one, two blow that has landed it in value territory once again.  Due to the massive uncertainty surrounding BBSI’s small and mid-sized clients during the global pandemic, BBSI’s share price cratered well ahead of any real drop in revenue or profit forecast.  And although much of the uncertainty of their forecast has been removed, investors cannot be blamed for shying away from a business so closely tied to businesses the size of BBSI’s clients.  This lack of interest in the stock is further explained by the outsized performance of momentum and technology mega-cap companies that have attracted so much money, attention, and produced high returns during the Covid-19 crisis.

Valuation Drivers and Estimates

Augmenting articles posted by others, this posting focuses on the factors that make BBSI a safe, good idea for investors looking for the possibility of excellent returns without sacrifice of the margin of safety.  As with most value plays, however, no immediate rise share price is expected or likely.  A timeframe of 1-3 year will be necessary for BBSI’s value to be realized in the stock price. 

Despite its wild swings in price, BBSI’s current 10-year revenue growth stands at 14%.  Future growth expectations are supported by recent investments in technology and an expansion strategy under the leadership of recently appointed CEO Gary Kramer.  Improvement in the stock price is not solely, or perhaps at all, dependent on this growth.  A full recovery from the pandemic alone should be enough to raise the price to the $80-90 range.   A more detailed review of each of the three catalysts should help to reinforce this idea. 

The three catalysts to drive BBSI’s share price above the current levels include 1.) Leadership changes driving investor confidence, 2.) growth in revenue driven by the expansion of BBSI’s business into new markets, both geographically and client type and 3.) P/E multiple expansion due to restored business at client companies. 

 

o   Leadership Change

The recent retirement of Michael Elich, former BBSI CEO,  is the first major catalyst for change and driver for the expectation of a rising stock price.  While growth under Elich cannot be discounted, other issues surrounding his tenure were destructive to shareholder sentiment.  The most concerning were workers' compensation reserve and inaccurate journal entries by the former CFO that resulted in DOJ and SEC investigations and charges/fines against James Miller, the former CFO, and BBSI as a company.  Miller was said to have benefited substantially by selling stock options that rose in value under the improvements afforded by the fraud that he orchestrated.  While Elich was not charged, the fact that the issues occurred on his watch is cause enough for concern even without a formal accusation or indictment of wrongdoing.  I find it unlikely that such actions occurred completely without his knowledge, if not direct involvement.   

Additionally, claims by employees on review sites such as Indeed and Glassdoor were less than complimentary of Elich.  Such negative claims are often motivated by personal vs. business concerns and require careful review.  However, items focused on the use of company jet, sponsorship of events and the unusually high number of disparaging comments aimed directly at the CEO cannot be ignored; particularly when coupled with the fraud convictions.   Shareholders clearly agreed with this concern as a jump in stock price accompanied the announcement of the retirement and replacement with Gary Kramer. 

Kramer was brought to BBSI from Chubb Limited as CFO to remedy the situation with the reserve and accounting issues in 2016.  And, while it is still early in his tenure as CEO, Kramer has wasted little time in taking steps to make an imprint on the company in a seemingly positive direction.  One such example is a personnel move made shortly after Kramer was appointed.  The elimination of the Chief Strategy Officer position seemed to point to some needed housekeeping (and SG&A reduction) as he took the reins.  Kramer’s approach in his first conference calls and investor the presentation has made a positive impression on me as straightforward and focused on providing stability and growth to BBSI.  Additionally, the recent appointment a legal counsel to the management team should begin to provide a backstop for the concerns that have kept investors at bay in the years following the accounting issues. 

 

o   Growth Plans

Recently, BBSI became eligible to do business in all 50 states.  This action allows BBSI to move away from its West and East bases and into markets that will provide for future, non-organic growth.   

Additionally, BBSI has recently completed an upgrade to their service and data platform called MyBBSI.  This upgrade will reportedly allow expansion of BBSI into PEOs that are more white-collar, professionally based versus the grey or blue-collar clients that they have traditionally served.  Expansion opportunity from this avenue has not been quantified but reduces barriers to entry into other market types.

Kramer has identified growth by acquisition as one of his objectives.  He has explained that a “fit’ with the BBSI’s culture and business model as the key aspects of possible targets.  No specific growth targets have been made public, but sustaining revenue growth consistent with the recent past (absent the Covid-19 pullback) should be achievable.  The growing unrestricted cash reserve provides ample room for a number of smaller acquisitions like the ones discussed by management without the complete sacrifice of their balance sheet strength. 

 

o   Multiple Expansion to Normalized Levels

For a company growing revenue and net income as BBSI has done over the past 9 years, a multiple that is near their all-time low and far below both the market and peers points to recovery once the issues of the pandemic have cleared.  Estimating when that will happen with any level of accuracy is impossible.  In the meantime, BBSI’s stock will likely continue to linger or drift lower with its low TTM and forward P/E multiples.  Investors assuming anything other than a range-bound movement in the price of BBSI stock before significant pandemic clearing has occurred are likely engaging in wishful thinking.  Moreover, ensuring the P/E multiple does not regress after an eventual recovery will depend on BBSI building longer-term confidence with the market that some of their past issues are indeed in the past.  Any hint of accounting or other company/leadership integrity will very likely return BBSI to low multiple status and should be cause to consider exiting any position in the company.    

o   Stock Valuation

To derive a current and future price range for BBSI, we look to it’s current and projected earnings with and without growth.  Below, an expected value for one, two, and three years into the future is then given based on these values.  This approach may appear as imprecise; however, the range is included to illustrate the downside protection that BBSI affords under most market scenarios. 

Revenue growth was assumed at a rather modest 9% for the years of 2022 and 2023 for which no projections are available from analysts.

For EPS values, I use the full range of values used by the 4 analyst that now cover BBSI for the 2020 and 2021 fiscal years.  Further, I assume that some of the existing unrestricted cash on hand is used for acquisitions and a low level of stock buybacks.  In the “Low” side, the acquisitions are assumed to sustain, but not improve revenue.  Only under the worst conditions, below the “Low” estimates would these assumptions not hold.  Net margins are assumed at historical levels under similar revenue levels.

 

 

Risks and Drivers Away from Estimated Value

As with all equity posts, this section should be carefully considered.  These comments are intended to provide a review of the factors which can be expected to cause the share price to diverge to the extremes or beyond the estimates provided. 

In the case of BBSI, the most significant risk to price appreciation is any real or perceived threats to timely and accurate company financial reporting or any other legal issues that might impact the company’s finances.  This is particularly true of any adverse news regarding workers' compensation reserves or risks.  It is no coincidence that the first 4 risk factors listed in the most recent 10K relate to workers' compensation.  Even against growing revenues, profits, and cash reserves,  BBSI’s past issues have hung over the company like a dark cloud.  Institutional and retail investors alike are fully aware of this past and will undoubtedly evaluate any small issue as a sign the company has not reformed. 

Further Downside Risk

Future Failed Acquisition(s) 

In conference calls and investor presentations, BBSI CEO Gary Kramer has pointed to the possibility that an acquisition that would provide entry into a market where BBSI does not currently do business could be one of their growth strategies.  The failure to profitability execute a future transaction of this type could drive the price lower, even if overall company profits are not negatively impacted. 

Competitive Pricing Pressure

BBSI operates in an ever-growing space of outsourced personnel services.  Continuing to maintain a high retention rate among their client base will depend on remaining competitive in that space.  As size and scale become a factor in activities such as payroll processing, it is possible that innovations by larger firms focused on these specific areas may make this segment of BBSI’s business unprofitable or a drag on their model.  It is not possible to quantify just how this would impact BBSI, but currently, reported retention rates may not fully reflect the erosion of this type which might ultimately impact margins.

 

To the Upside

Higher Than Expected Growth

Either organic and/or inorganic growth that exceeds the 9-10% assumptions that are part of the valuation above will almost certainly raise the stock price beyond provided estimates, all other things being equal.  Despite its past troubles, BBSI has seems to handle the scaling of their business model without issue.  This model and recent information platform upgrade should enable continued margin expansion as BBSI increases revenue through increased client counts.  BBSI has expressed interest in entering the more employer-friendly markets of Texas and Florida.  If successful in these markets, growth to the upside could be expected to far outpace projections.

 

Solid and Consistent Financials

BBSI’s recent sale of a portion of their workers compensation liability reinforces the company’s position that their book of claims and reserves are in line with risk profiles of those claims  (see press release here.)  It is my view that the key statement in the release that, “The transfer price of the LPT was approximately equal to the book value of the claims liabilities with no material gain or loss on the transaction.”  This substantiates that BBSI’s claims reserves are indeed appropriate and that WC claims are much less likely to impact the company’s performance going forward.   Should BBSI be able to stabilize their earnings coming out of the pandemic and find drivers that would further reduce the cyclicality of their business model, the market would almost certainly assign a higher multiple to the stock.

 

Final Thoughts About BBSI

Clearly, the operating space of small and mid-sized businesses that BBSI serves is counter to a major and growing US trend toward mega-cap company investing bias.  This trend has prevailed since the financial crisis of 2008 as a dominant investment theme.  The underperformance of value and small-cap stocks over that time has been the subject of countless articles and discussions. If this trend continues, it will undoubtedly provide a headwind for BBSI’s clients.  Whether that trend translates into a headwind for the company has yet to be seen and will certainly not help their case. 

By the same token, should that trend reverse course, BBSI’s current value status and small company association will almost certainly be a tailwind for the company.

At this time, investors should consider these macro drivers as tiebreakers, but not necessarily primary considerations for investment in BBSI.  The potential for stabilizing the company, growing their solid business model, and reaping the benefits of returning investor confidence are the primary reasons for investing in BBSI.  As the impacts of the global pandemic subside, BBSI should be well-positioned regardless of these and other macro trends.