Trend Management Inc. Second Quarter Report 2015
For the first time in four years, our managed accounts are under-performing the S&P 500 at 2015’s halfway point. Several previous expectations of a tough market were met.
2014’s year-end report mentioned the distinct possibility the S&P 500’s operating margins might have peaked. So far this year, they have declined over 10%. This usually decreases earnings for stocks, too. And has, by over 5%. Because cash- on-hand makes sense in a market with declining earnings, we raised cash in January in anticipation of a messy 2015.
With two exceptions, the operations of our companies have been good this year. Our valuation assessment of Level 3 continues to rise more than its stock does, (up 6%). This stock is a big position for our clients. If we’re right about its business model’s momentum, Level 3 is poised to get bigger, and carry our accounts upward for the next few years.
One bad apple in our account is Maxwell Technologies. A sure-fire sign a stock isn’t doing well is Mark boarding an airplane and flying out to meet with its corporate executives. In Trend Management’s twenty-three-year history, Mark has visited Rentrak, Level 3, and now, Maxwell Technologies.
We doubled our money in Rentrak, and sold it. We are now profitable in Level 3, and the future is bright. We have lost over a quarter of our investment in Maxwell Technologies, and are frustrated its inability to predict its sales cycle. On top of that, this quarter, Maxwell sold stock to improve its balance sheet. This was not something that thrilled us.
Maxwell Technologies produces ultracaps with the ability to rapidly store and transmit power. Maxwell’s primary revenue source is the Chinese electric bus market. Applying the brakes on one of these busses generates electricity captured by the ultracap, then transmitted to help power the bus, saving wear- and-tear on its batteries.
In 2014, Maxwell’s then-CEO and CFO boldly claimed the Chinese bus business would ramp up. We believed them. They were wrong, and are no longer with the company. Mark met with Maxwell’s new CEO and CFO in San Diego, in June. (We have summarized their discussion below, but if you’d like more details, please give Mark a call.) During his visit, it was apparent that ultracap sales in this area can’t be predicted, and why.
The difficulty centers on no one knowing what subsidies the Chinese government will allot to these types of busses. The larger the subsidy, the more ultracaps Maxwell will sell; the lower the subsidy, the lower Maxwell’s sales will be. We don’t like this guessing game, but prefer it over telling you prospects are great, when in the short-term, this uncertainty must be viewed as a negative.
In the third-quarter 2014 report, we wrote: “We continue to think Maxwell’s growth prospects are real and exciting. The company will get it right operationally and grow, or it won’t. If it’s the latter, we predict Maxwell will be bought out by private equity at a much higher price.’’
What we said then, remains true today. Because Maxwell has not performed well operationally, an event we predicted last October occurred in June, after Mark’s visit with management.
A corporate activist has filed with the government, declaring his purchase of over 6% of Maxwell’s stock. The filing conveyed displeasure with the company, and the direction it was taking. This is the first indication private equity may decide to buy out Maxwell, or to force its sale. (Our candidate for the likeliest buyer is Corning, who did a joint venture with Maxwell last year. )
The clock is ticking. The fight will start with the activist trying to get seats on the board for voting purposes. Two investors own 23% of the company, and we’re sure their phones have been ringing. Next, Maxwell will restructure, or sell out. If Maxwell’s stock rises, the activist may take his profit and disappear. If the stock doesn’t go up, and Maxwell doesn’t restructure, the activist will agitate for a sale of the company.
We think the future of ultracaps is good. However, if this activist wins other shareholders’ support, Maxwell may not last as a public company and benefit from that future. If it is bought out, the upside is quite high. We will stay with our position, based on our hope and belief Maxwell’s operational performance will improve.
The other poor performer’s name is familiar: American Public, an online university. Mark hasn’t purchased an airplane ticket, because we think we understand the issues it faces.
American Public’s educational niche, comprising about fifty-percent of its sales, is active and retired military personnel. Five years ago, they represented 66% of AP’s sales. Now it’s about 36%.
Our government continues to make it difficult for active (not retired) military personnel to receive their promised, college benefits. While American Public is struggling to project sales to its primary consumer group, most U.S. colleges are experiencing declining enrollments.
One factor is the cost to earn a degree is high, compared to the post-graduation salary necessary to pay off student loans. We think American Public is less affected by this, compared to its competitors. Its degree specialties, law enforcement and the military, have stable to rising starting pay-scales.
American Public’s cost per course-credit is 15% to 20% below the national average. Being one of the low-cost providers for online education should help it compete effectively in the market. AP’s move toward diversifying beyond the military has also met with some success.
We bought American Public stock because it’s very cheap, and AP has a good business model. The company has no debt, and $112 million in cash is sitting on its balance sheet—equal to over $6 per share. For this stock to be considered of the same value as a normal stock in the S&P 500, its earnings would need to shrink by 70%. We don’t anticipate that happening, but the market doesn’t agree.
AP stock is currently trading at $26. If its earnings stabilized at 2014 levels, a fair buy-price for its stock would be almost $50. Last quarter, AP bought back over 1% of the company. We hope it’s even more aggressive at buying back stock at the market’s pessimistic price. In fact, if we were in charge, we’d initiate a Dutch tender offer (similar to an auction) for another 10% of AP’s stock. It would only cost AP $50 million, leaving $62 million still on its balance sheet.
Unlike Maxwell Technologies, poor management is not among American Public’s problems. We don’t envision it as a take-over candidate, either. The stock is certainly cheap enough, but we can’t pinpoint who the natural buyer(s) might be. Despite an expected decline in earnings for the next twelve months, we will continue to hold AP stock and wait for enrollments to stabilize.
Our macroeconomic monitoring continues to indicate a global, economic recession. It’s improving, but by historic comparison, remains very poor. As a result, commodities lag, as well. (Because we’re contrarian investors, our interest in commodities continues to grow.)
Aside from the U.S., central banks continue to flood their respective economies with money. Stocks and bonds worldwide have benefited, but not the Joe Six- packs in the U.S., Mexico, Brazil, or Europe. At some point, we believe the monetary flow will find its way into the real economy.
A data point revealing subpar economic growth is bank loans in Europe contracting at over 1% a year. Typically they grow over 5% a year, but the demand for money just isn’t there yet, or in Asia, and Latin America.
The world has experienced bouts of fiscal austerity, despite recession, which is historically unusual. The traditional remedy was to print money and initiate government spending. Instead, today’s conventional wisdom theorized central banks could print money, and as a result, economies would grow. That approach ceased to work, circa 2012.
Europe, not the U.S., was ground-zero for that trend, but we think it will begin to reverse (this quarter?). Money printing will slow, with fiscal stimulus taking over to circulate those funds. World economies need more demand for products from somewhere. The public isn’t generating it, so governments must. What they will spend it on, we’re not sure. Possibilities include their militaries, infrastructure, airports, schools, and/or entitlement transfers.
In previous letters, we have mentioned Greece should leave the Euro. Many investors take the opposite view: Greece exiting the Euro would trigger a so- called Lehman moment, causing world stock markets to crash. We disagree.
It’s true, Greece’s departure would make things bumpy for a while, but not like 2008. A Lehman moment would require all the world’s banks to own Greek debt, as they did Lehman’s debt and derivatives. Fortunately, that isn’t the case. We doubt whether any U.S. bank owns a single Greek bond. Most are held by European central banks and hedge funds.
As this letter is written, Greece has closed its banks and instituted capital controls—first steps to leaving the Euro. A nationwide referendum is scheduled during our 4th of July weekend. The country’s unemployment rate is 25%, with youth unemployment reaching 50%. (As a frame of reference, in 2009, U.S. unemployment never topped 10%.) How much more austerity is needed?
In any event, the markets will be more volatile this year, as this Greek tragedy’s final act plays out. Crazy swings in Chinese stocks this month (down 20% in June) are not helping. However, we raised enough cash in January to take advantage of what we’d predicted would be a difficult year in the market. The odds favoring more volatility means better chances for us to find things to buy.
Meanwhile, we will stay with what we own through this correction, and look to be profitable in the next six months. It’s unfortunate the first half of 2015 was a down one for us, but we like what we own, regardless of whether the market does.
Feel free to call us with any questions about your investments. Sincerely,
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR