Pioneering Technologies: Part 4

PTE logo

  • Parts 1 through 3 reviewed recent activity, solvency and risk, and future potential.
  • In Part 3, we determined that regulation changes in 2019 could drive large sales.
  • In Part 4, we show how increased sales will impact the company and share price.

We closed Part 3 of our review with the belief that regulation changes to coil top stoves in 2019 would create safety awareness, and in turn, could drive increased sales of the Smart Burner product. Given the very large size of the US market (43.8 MM rental households), we decided that only a small fraction, 274,000, or about 6/10 of 1%, might install a Smart Burner once the regulation change takes effect.

What’s the impact of sales of 274,000 units: Now that we have determined what we believe sales could look like in 2019 (post “regulation change”), we can relatively easily determine what the economic impact (on the company) will look like.
From publicly available information, we can see that the Smart Burner sells for anywhere between $190.77 US and $221.99 US, as per information from both the Staples Supply and Interline Wilmar websites (below):

 

Staples smartburner.png

Source: https://www.staples.com/Smart Burner/directory_Smart Burner

Wilmar smart burnerr.png

Source: https://www.wilmar.com/Search?keywords=Smart Burner&filterByCustomizedProductOffering=False&previouslyOrdered=False

These prices are not reflective of what Pioneering might be receiving, as both Staples, Wilmar, and HD supply act as distributors. Therefore, this leaves us with an unknown: we know how much the distributor receives when the consumer buys a Smart Burner, but we do not know how much Pioneering is receiving from the distributors. However, we do know that the distributors apply their own mark up. If we can make a reasonable estimate as to how much distributors typically mark up an item, then we can effectively determine how much they are paying when they purchase it from Pioneering.

While I am no “supply chain” expert, some web research provides us with the following information:
“The average wholesale or distributor markup is 20%, although some go as high as 40%.”

Source: https://www.pros.com/blog/distributor-pricing-profit-margins-pricing-markups/

This is validated via another source, as shown below:

Reasonable markup to distributors.png

Source: http://www.tom-gray.com/2012/04/26/reasonable-markup-to-distributors/

Both of these data sources suggest that the distributor markup could be anywhere in the range of 20% to 40%. With this data in hand, we can then calculate what the revenue stream to Pioneering would be, using these ranges as bookends. With this information, we can extrapolate what the sale of 274,000 units could look like, under the following assumptions:

• We are only calculating sales of Smart Burners in the US market. Sales in the Canadian market would be incremental to this analysis.
• We are not attributing any value to any other Pioneering products, nor are we attributing any value to the partnership Pioneering has with Innohome.
• We use the lowest price we could find, $190.77 US.
• We assume that COGS (& gross margin) will come in at 50%.
• Because Pioneering is domiciled in Canada, we convert gross margin from US$ to CAD$.
• We use a conservative FX rate of $0.90 US$ = $1.00 CAD$. This is the weakest US$/CAD$ FX rate over the last 5 years, and the average FX rate (2014 to June 2018) has been approximately 0.80. A stronger US$ would improve these results.
• We apply the FX rate directly to the US$ gross margin, rather than attempting to model how the accounting for FX gains or losses would appear on the income statement. We realize that actual accounting gains/losses would be realized via currency hedging, etc.
• After converting gross margin to CAD$, we continue to use CAD$ for the rest of the analysis, as Pioneering G&A costs are denominated in CAD$.
• We assume G&A increases significantly, coming in at an annual amount of $12 MM CAD, double the current G&A costs which are forecast at ~ $6.0 MM CAD for fiscal 2018.
• We ignore non-cash charges such as DD&A, as they are not material (~ $30,000 CAD$ for fiscal 2017).
• We assume a corporate tax rate of 25%.
• We use the total diluted shares outstanding.

The outcomes of a sales volume of 274,000 Smart Burners under various distributor mark up percentages is shown below:

PTE 274000 units.png

When we began this analysis, our thesis statement was that this was “a sales story”, and the key was whether or not Pioneering could increase sales. We believe that with pending regulation coming into effect in 2019, sales are likely to increase, and in doing so, will drive the profitability (and share price) of Pioneering. This being the case, we believe that todays share price weakness is a significant opportunity for those investors that are risk tolerant and have a longer time horizon.
Disclosure: The author of this analysis holds a long position in PTE. The author has received no compensation from Pioneering Technologies for the writing of this analysis.

 

Pioneering Technologies: Part 3

PTE logo

  • Part 1 reviewed recent share price activity from 2016 to today.
  • Part 2 compared Pioneering financials today vs the those prior to latest financing.
  • Company is not at risk of going bankrupt, & balance sheet is solid.
  • However, the question of future sales volumes is still unanswered.

When we ended our discussion of Pioneering in Part 2, the key question we were trying to answer was one of sales: can Pioneering increase sales of the Smart Burner, and when. However, to understand the sales story, we should also understand the product, why it appeals to a particular market segment, and how large this market segment is.

The product is unique.   The Smart Burner is unique in that it prevents a fire from occurring, rather than setting off an alarm after the fact, or putting out the fire via an attached automated fire extinguisher or sprinkler. There are a number of safety devices on the market that do one (or perhaps even both), but one of the key points raised by end users is that prevention of combustion is far superior to an alarm or a product that extinguishes a fire after the fact. End users have highlighted that once an alarm is set off, the building may still need to be evacuated, and the local fire department may be on the way, regardless of whether or not the fire has been extinguished. When viewed in the context of an apartment building, this causes inconvenience for the residents, and may imply some cost to the building operator for each visit by the fire department. Additionally, residents & property are clearly less at risk from a situation where there is no combustion vs one where combustion occurs and is extinguished.

In addition to this, the Smart Burner is unique in that it meets the pending change to UL858 (Underwriter Laboratories) regulation, which will take effect in early 2019. The UL858 change will necessitate that all coil top stoves sold in the North American market must pass an ignition test. The test requires that an electric coil top stove, at it’s maximum setting, must be allowed to operate for 30 minutes with a pan of cooking oil on the element.  The stove must operate for 30 minutes or until such time that the cooking oil ignites. If ignition occurs, then the product cannot be sold North America.

The product is meeting a distinct need.   Statistics indicate that the vast majority of fires start in the kitchen, so the product has a clear application. The pie chart (below) shows quite clearly that over ½ of all residential fires start as a function of cooking. While this particular pie chart represents fires in Great Britain, data from the US National Fire Protection Association (NFPA)  is consistent with British statistics (NFPA data also shown below).

British kitchen fire stats.png

Source: https://www.ifsecglobal.com/innovation-at-ifsec-fire-safety-products-for-the-kitchen-by-innohome/

NFPA kitchen fire stats.png

Source: https://www.nfpa.org/Public-Education/By-topic/Top-causes-of-fire/Cooking

This data suggests that there is a very clear niche market that is currently not being addressed. However, while it is clear that a market exists, we have to ask how large this market is.

 

The size of the potential market is large.  Data sourced from the National Multi Family Housing Council provides the following snapshot of the US housing population:

US households by type.png

Source: https://www.nmhc.org/research-insight/quick-facts-figures/quick-facts-resident-demographics/

From this data, we can quickly see that there are 118 Million households in the US that could potentially install a Smart Burner. Of this total amount, we will ignore the Owner-Occupied segment. Home owners are far more likely to purchase a stove that is esthetically pleasing (glass top, gas, induction) vs one that is utilitarian. By comparison, the 43.8 MM rental units are owned by landlords, who are typically driven by cost and functionality. If we put ourselves in the shoes of a landlord, we can see that traditional coil top stoves are an easy choice for rental units based on the following criteria:

Landlords and stove type

While a landlord may ultimately put in whatever they want, for the various reasons shown above, coil top stoves are an easy choice. Coil top stoves are cheap, simple, pose no extra risk from a natural gas source, have no cooking surface (glass top) that can shatter, and do not require special pots or pans to be used. So from this data, we can say that out of the 118 Million households, the 43.8 Million rental households are the likely candidates for the installation of a Smart Burner.

With this data in hand, we then have to ask ourselves how many of these landlords will install a Smart Burner ? Again, the exact answer is difficult to pinpoint, but to answer this we will look at the implementation of another safety device – the home smoke alarm.

The first battery operated smoke alarm was available as far back as 1969. However, smoke alarms were not widely used, given that there was no law or regulation that required their use. In 1972, about 200,000 smoke alarms were sold in the United States. This changed significantly in 1976, when the NFPA (National Fire Protection Association) passed NFPA101, which was referred to as the “Life Safety Code”. This was the first document that stated “smoke alarms are required to be in every home”. By 1976, 8 Million units were sold, and in 1977, 12 Million units.

Source: http://www.mysmokealarmla.org/history-of-smoke-alarms/

This information highlights two important consumer trends. First, if consumers are left to their own devices, the majority tend not to implement safety improvements. This is not entirely surprising. Readers who live in jurisdictions where it snows have experienced this. While snow tires significantly improve stopping in winter conditions, many consumers prefer to use all season tires in order to save money.

Secondly, when regulation finally takes effect, the purchase of the device can experience a sharp increase. While the parallel between smoke alarms and the Smart Burner is not exactly the same, we are also not suggesting that the increase in Smart Burner purchases would be this significant. What we are saying is that the change in the UL858 standard will create awareness, and consumers (such as landlords) may be more likely to purchase a Smart Burner for their rental units.

This brings us back to our question, specifically, how many of these landlords will install a Smart Burner ?  Based on our smoke alarm example, we know that the introduction of regulation increased sales by a factor of 40 – but this was in 1976. To better understand what total sales of 8,000,000 smoke alarms in 1976 really means, we have to understand what the population of the US was in 1976, which (lucky for us) is relatively easy to do:

US population 1976

Source: https://www.google.ca/search?source=hp&ei=57YNW_WPOJr7jwTnkIqIAQ&q=Population+of+the+USA+in+1976&oq=Population+of+the+USA+in+1976&gs_l=psy-ab.12..0i22i10i30k1.370.6433.0.9649.30.21.0.0.0.0.283.3030.0j13j4.17.0….0…1c.1.64.psy-ab..13.17.3024.0..0j35i39k1j0i67k1j0i22i30k1.0.rgfatTHyJiY

Lastly, because we are comparing “households”, we have to adjust for the number of people per household, which has changed since 1976. Again, this is also easy to find:

US households size in 1976.png

Source: https://www.google.ca/search?ei=8rYNW8H7FqfojwT4_YBA&q=Average+household+size+in+USA+1976&oq=Average+household+size+in+USA+1976&gs_l=psy-ab.3…56520.64131.0.65177.34.23.0.10.10.0.257.2780.0j15j2.17.0….0…1c.1.64.psy-ab..8.25.2622…0j35i39k1j0i131i67k1j0i131k1j0i67k1j0i20i263k1j0i22i30k1j0i22i10i30k1.0.PVxKOQjp-hM

From all of this data, we can infer that in 1976 there were 75,432,526 total households (218,000,000 total population  / 2.89 persons per household), of which 8,000,000 purchased smoke detectors after the introduction of NFPA 101, or a total of 10.6% of all US households.

This answers our question as to what percentage of landlords might purchase a Smart Burner. However, we would suggest this 10.6% to be a “pie in the sky” type of figure. The UL858 change will require that any new coil top stove sold in North America is compliant – not that any homeowner or landlord (who already owns a stove) must be compliant with a stove they already own. We would suggest that once the UL858 change takes effect, and compliant products begin to show up at retailers, consumer awareness will increase, which in turn will spur sales of the Smart Burner. Landlords, seeing that  “safer” stoves are available, may want to achieve a similar level of safety with their existing coil top stoves. By reducing false alarms and potential fires, a Smart Burner may be able to save them money via reduced insurance rates, or simply decreases the risk profile of their housing units. So, some landlords may decide to purchase a Smart Burner to better equip & de-risk their housing portfolio. Like any new (or disruptive) technology, adoption does not occur “en masse”, and different people (and organizations) will take more or less time to decide to adopt a new product or methodology. This is consistent with what is known as “The Technology Adoption Curve”, which is shown below:

Tech adoption curve

Source: http://www.web-strategist.com/blog/2010/01/03/social-technology-adoption-curve-benefits-and-risks/

One can see that “Innovators”, who are early adopters of new technology, make up 2.5% of the potential marketplace. To be very clear, we are not suggesting that a safety device such as the Smart Burner is as sexy (or interesting) as an Iphone, we are simply highlighting what percentage of “innovative” landlords might be tempted to purchase a Smart Burner. In addition to this, it is unlikely that the entire 2.5% of the landlords that are “Innovators” will suddenly rush to order the product come 2019. Because of this, we would suggest that only a portion of this group will be interested in purchasing a Smart Burner in 2019. We would err on the side of conservatism, and in doing so, suggest that perhaps 25% of potential “Innovators” might purchase a Smart Burner in 2019, or 274,000 in total (43.8 MM x 2.5% x 25%).

In summary, our lengthy discussion of the potential market size (and the associated opportunity) highlights a few key points:

  • For various reasons, landlords likely favor coil top stoves for their units.
  • Because of this, landlords will be a very likely market for the Smart Burner.
  • Landlords control approximately 43.8 Million housing units in the US.
  • The UL858 standard change will create more awareness, and potentially more sales.
  • Increased sales of the Smart Burner would most likely happen in 2019 or later.
  • People (or companies) that are early innovators tend to make up 2.5% of the potential population, or approximately 1.1 MM of the potential 43.8 MM rental units.
  • Lastly, because people (and organizations) tend to move slowly, we would suggest that only 25% of the 2.5% of “Innovators” (approximately 274,000) would be initiating orders for the product once regulation changes in 2019.

This information provides a more definitive answer to the question we were left with at the end of Part 2. When we concluded Part 2 of our review, we had determined that the “million dollar question” was if Pioneering could actually sell increased volumes of the Smart Burner, and if so, when might we see these increased sales.  Having answered this question, Part 4 of our review will focus on how such increased sales might impact earnings & share price.

Pioneering Technologies: Part 2

PTE logo

  • Part 1 of this series reviewed recent share price activity.
  • PTE went from ~ $0.20 to $1.50 – and back again as of May 2018.
  • Recent revenue misses have caused massive selling pressure.
  • However, balance sheet is rock solid, with no insolvency risk.
  • Investment thesis boils down to one issue: can PTE increase sales.

In Part 1 of our review, we took a look at the activity of Pioneering common shares from 2016 through to May of 2018, and how they came to run from under $.20 to a high of $1.50 – and back.  In this segment, we take a look at how good (or bad) the company is today, after having given up virtually all of its gains over the last few years. Essentially , is the company worse today than it was yesterday ?

To answer this question, we look first at the most recent financial statements of Pioneering (6 months up to March 31 2018) versus the financials immediately before the February 2017 financing (Audited 2016), beginning with the balance sheet:

 

PTE 2016 2018 compare bal sheet

 

Using the basic share count, what becomes clear from this comparison is that the company today is debt free and has ~ $0.12/ share in cash and short term investments.  Before the financing, Pioneering had $1.3 MM in long term debt and had only $0.07/share in cash. Additionally, the 23.6 current ratio today is significantly improved over the current ratio of 1.47 of December 2016. In terms of potential bankruptcy risk and capital structure, the company is in a much better position today.

This being said, any rational investor would question how long cash reserves can last. Based on the most recent 6 month period (October 01 2017 – March 31 2018) & 3 month period (Jan 01 2018 – March 31 2018) we can see that Pioneering burned $0.954 MM & $1.284 MM respectively, including all changes in working capital. While we don’t know which one of these is indicative of the future, we can assume that the future cash burn could be anywhere between $428,000 / month (using the 3 month value), or as low as $159,000 / month (using the 6 month value), or an average of $293,500 per month.

 

PTE Mar 2018 cash flow.png

 

Now that we have an understanding of what the cash burn looks like, if we then assume that Pioneering continues to sell at these depressed levels, then the company could continue to operate, without requiring incremental financing, for somewhere between 16 months ($6.8 MM / $428,000) and 43 months ($6.8 MM / $159,000).  In essence, both the balance sheet and the cash flow statement confirm that insolvency risk is not an issue, and that dilution via further share issuance is unlikely in the near future.

While a clean balance sheet and cash in the bank are always nice to have, we should also take a look at the income statement to understand how revenues and expenses have changed over this period of time (below).

PTE 2016 2018 Inc St.png

 

At first glance, a few things are immediately apparent. Gross margins have deteriorated, from an average of 66% in 2015 and 2016 versus a significantly lower 52%-53% in 2018. While this is clearly “not good”, gross margins of over 50% are still very robust. It is possible that a significant portion of this deterioration is attributable to the move to large distributors (Wilmar, HD Supply, & Staples), as larger distributors may agree to purchase larger volumes, but at a somewhat reduced price. With this in mind, we will assume the lower gross margins are here to stay. Additionally, one can see that G&A costs have increased significantly, from full year 2016 costs of $3.39 MM to forecast 2018 costs of between $5.9 MM to $6.5 MM.

The increase in costs are not entirely unexpected. We should recall that the companies push into the (very large) US market is a fairly new development, and significantly increases their exposure – and potential sales. As the saying goes, “there is no free lunch”, and it is reasonable to expect some increase in G&A to go along with the anticipated increase in future sales. Additionally, some of the G&A costs noted for both 2016 and YTD 2018 include non-cash charges. We are not referring to DD&A, as these costs are less than $30,000 annually. Rather, we are referring to non-cash compensation expenses that are buried in other G&A line items. Extracts from the notes to the financial statements (below) show the total non-cash charges for each period:

2016 and 2018 stock based comp.PNG

Adjusting for these values, this means that actual cash costs for fiscal 2016 and YTD 2018 come in at $2.80 MM and $2.34 MM respectively. If we then assume that the $614,472 of non-cash costs for the first 6 months of 2018 were evenly distributed throughout the 6 month period, we can then annualize both 6 month and 3 month G&A costs, which gives us a full year estimate for 2018 of somewhere between $4.69 MM and $5.30 MM.

So, after review of all available financial information, we can make the following assertions:

  • Balance sheet has been de-risked, with significant cash on hand and no long term debt.
  • Company has no insolvency risk, and should not require a capital raise for some time.
  • Company can operate at current “depressed” sales level for 16 to 43 months.
  • Gross margin has deteriorated from ~ 66% to ~ 52%.
  • Some of this deterioration may be explained by the move to larger distributors.
  • G&A is significantly higher, even after adjusting for all non-cash charges.
  • However, this too may be a function of the company adjusting cost structure for larger future sales volumes.

While it is clear that PTE shares won’t be hitting $0.00 soon, our original question is only 1/2 answered. While insolvency is a non-issue, & the balance sheet is significantly improved, the income statement appears to be “less improved” at the very least, if not worse. We are still left wondering, is this glass half full, or half empty ?

To answer this question, we first have to determine  if  Pioneering will be able to actually sell increased Smart Burner volumes, and if so, when. This is perhaps the key to the PTE story, and this is exactly what we will discuss in Part 3.

 

 

 

 

 

 

 

 

 

Pioneering Technologies: Part 1

PTE logo

  • Recent revenue misses have caused massive selling pressure.
  • However, balance sheet is rock solid, with no insolvency risk.
  • Investment thesis boils down to one issue: can PTE increase sales.

Who are they and what do they do ?  Pioneering Technologies is based out of Mississauga, Ontario, and produces fire safety products that prevent kitchen fires. Having been listed on the TSX Venture exchange for over 10 years, their flagship product, the “Smart Burner”, allows users of traditional coil top stoves to replace the existing coils with the Smart Burner, which allows for the cooking of food, but prevents temperatures that reach combustion. Pioneering also provides other similar safety products that are cooking related, such as the SafeTSensor for microwave ovens and the Range Minder, which works with gas, ceramic, or coil top stoves. However, we will be focussing on their flag ship product, the Smart Burner, as this makes up the bulk of their sales. Our discussion is broken into four parts as follows:  company activity & share price activity from 2016 to today (Part 1), whether the company is in better or worse shape today (Part 2), why the investment opportunity has upside (Part 3), and what future results and associated share price might look like (Part 4).  The reader should note that all financial values are quoted in Canadian dollars unless otherwise indicated.

Part 1: Why is this chart so ugly ?

PTE no info chart.png

There are two things that the above chart makes very clear. First, any investor who went long on PTE in early 2016 (or earlier) could have done very well, as shares peaked at $1.50 in February of 2017. The second thing that becomes clear is that any investor who went long in early 2017 (or later) experienced a significant loss. So, the question is: what caused the significant run up in share price, and what caused the significant decline?

If we look at the same chart, with a bit more information, we have a better picture of what happened:

PTE info chart.png

 

The chart above shows price movement along with the timing of non-financial press releases, earnings releases, financings, and analyst research. We categorize a “non-financial press release” as any press release that imparts information outside that of typical earnings news or any significant financial change, such as a financing. For example, a press release announcing a new large customer would be categorized as “non-financial”. While the information may be interesting (it is typically bullish), it imparts information that is entirely at the discretion of the company, and is not required (or mandated) by regulation or law.

One can see that during 2016 there was a total of 11 non-financial press releases, most of which were concentrated in the period between June & October of 2016. These press releases introduced new participants to the Pioneering story, and by creating more awareness, also created more potential buyers of the shares. With this new awareness, the shares rode a wave of popularity, peaking at $1.50 in February of 2017. In March of 2017, the company undertook a private placement at $1.10, which in turn resulted in analyst coverage by the same institution. Bullish coverage followed for approximately 8 months, until Pioneering issued full year 2017 numbers which fell well short of inflated investor expectations. Similar underperforming quarters followed in March and May of 2018, causing further sell pressure, and resulting in a 52 week low (as of May 31 2018) of $0.21.

Seasoned investors will note that this is not the first time this story has played out, as analyst coverage often is overly bullish and creates expectations which are hard to meet within a short time frame. This story is no different. Investors who purchased after Q1 of 2016 saw a relatively consistent stream of positive news, which culminated in bullish institutional coverage. Once results were clearly short of expectations, selling pressure took over, and the share price has yet to recover.

For those readers that are interested, links are included to all the noted non-financial press releases (below).

This concludes Part 1 of this review of Pioneering Technologies. For those that are interested, I will be publishing Part 2 shortly. If you have any questions or comments, you can reach me at greyswan2@gmail.com.

https://www.accesswire.com/438618/Pioneering-Technology-to-Present-at-the-2016-Microcap-Conference-in-Toronto-on-April-12th

https://www.newsfilecorp.com/release/20565/Pioneering-Technology-Appoints-Contact-Financial-as-its-Investor-Relations-Firm

https://www.newsfilecorp.com/release/21160/Pioneering-Technology-Teams-with-Siemens-to-Deliver-Energy-Efficiency-Fire-Safety-for-Houston-Housing-Authority

https://www.accesswire.com/441990/Pioneering-Technologys-Smart BurnerTM-Poised-for-Growth-viaNew-US-Distribution-Agreement-with-Market-Leader

https://www.newsfilecorp.com/release/22043/Florida-Universities-Installing-Pioneering-Technologys-Smart Burner-as-New-School-Year-Approaches

https://www.accesswire.com/443905/Multifamily-Residential-Insurance-Carrier-Recognizes–Pioneering-Technologys-Smart BurnerTM-for-Insurance-Discount

https://www.yahoo.com/news/pioneering-receives-largest-single-purchase-120000342.html

https://www.accesswire.com/445303/Massachusetts-Fire-Department-Receives-US-Federal-Grantto-Equip-Local-Housing-Authority-with-Pioneerings-Smart Burners

https://www.newsfilecorp.com/release/22903/U.S.-Property-Management-Firm-Begins-Rollout-Pioneerings-Smart Burner-Across-Apartment-Portfolio

https://www.newsfilecorp.com/release/23018/Pioneering-Technology-Enters-into-Partnership-Agreement-with-European-Cooking-Fire-Prevention-Leader-Innohome-OY

https://www.accesswire.com/447253/Pioneering-Technology-Corporation-to-Present-at-The-MicroCap-Conference-on-October-24-25-in-Philadelphia

https://www.newswire.com/news/pioneering-technology-corp-to-present-at-the-microcap-conference-on-june-27th

https://globenewswire.com/news-release/2017/09/11/1198406/0/en/Pioneering-Technology-Completes-First-Installation-of-New-Product-at-U-S-Ivey-League-University.html

https://www.pioneeringtech.com/pioneering-technology-recognized-again-as-one-of-canadas-fastest-growing-companies/

http://www.marketwired.com/press-release/pioneering-technology-reports-largest-purchase-to-date-2236044.htm

https://globenewswire.com/news-release/2017/11/02/1198411/0/en/Home-Hardware-Expands-Pioneering-s-Smart Burner-Offering-to-Meet-Growing-Consumer-Demand-in-Canada.html

https://www.newswire.ca/news-releases/leading-us-buying-group-partners-with-pioneering-technology-679251733.html

 

 

 

 

 

Need vs Want: Or why your neighbours are drowning in debt

A recent article caught my eye today with some glaring headlines: “Canada’s middle class is on the brink of ruin”. Pretty dismal stuff, but unfortunately, probably true.

When I was a kid, I have a very distinct memory as it relates to debt. Debt was something that was considered with great deliberation. Typically, one used it to purchase very significant things – homes, and in the case of my father, machinery that helped him do his job. Other than those situations, it was to be avoided at all costs. The concept of debt was inherently negative – one was exposing oneself to risk, so a great deal of thought went into the process before the paperwork was signed.

However, I do recall one time that my parents broke this rule, and it was a result of my insistence. We were shopping for clothes before going back to school, and my mother and I were waging a cold war. She had a pair of jeans in hand that fit, but weren’t “cool”. I had in my hand a pair of jeans that would cement my place within the grade school pecking order, and they fit. The choice was clear, to me at least. I insisted that the un-cool jeans simply didn’t fit, but my mother saw right through me. Nonetheless, she eventually relented, and with a great sigh, pulled out the credit card. I remember her reluctance to do so, and the memory stayed with me for a long time: she was going out on a limb for a non-essential item, and it was a big deal.

In 2017, this little anecdote is quaint – but unfortunately, that’s all it is to many people. Credit today is two things – easy to get, and easy to use. Because of this, we confuse the concepts of “want” and “need”, something which gives me instantaneous migraines. When I hear someone close to me say “We need to buy a new…” , I know the statement is almost always incorrect. In some cases, we do need something. For instance, when the neighbour’s kids accidentally nails our window with the soccer ball, we do indeed need a new window. But in almost all other instances, what is really being said is “we want a new car”, or “we want a new toy”. With the easy availability of credit, the concepts of “want” and “need” have become so muddled, that many people are unable to really differentiate between them.

The linked article goes into much greater detail than I can provide (or want to) here, but it’s the confluence of easy credit and “keeping up” that keeps people chained to jobs or careers they despise. The net effect is a large segment of society that might not be living that healthy of a lifestyle. How happy can you be when you get up to go somewhere that you don’t want to really go? You try and make yourself feel better via some retail therapy, thereby guaranteeing that you will go back to your job or career tomorrow. In the meantime, you are likely unhappy, and your family is suffering the fallout. Perhaps Mom & Dad are both doing this. Wow – what an awesome environment for the kids.

Don’t get me wrong – I’m not against working. I believe it’s important to find something that engages the mind and the spirit. We can’t all sit around gazing at our navels. But when we begin to dislike (or despise) our work, and are working only because we are desperate to keep up with payments, something is going to bust. Many people begin their careers with noble intentions, but get derailed by buying things they can’t afford, which turns the tables on them. The individual that once showed up at the office because they wanted to pursue a particular career is now showing up because they are being pursued by an unsustainable debt load and lifestyle. The job or career that was once a choice is now a necessity, and if it goes, the house of cards collapses.

So, you might ask, what is the point of this rant? I think it can be boiled down to some fairly old-school wisdom, which I’m sure everyone has heard before:

  • If you really need something because it’s a necessity, buy it. You have to eat.
  • If you want something, ask why? What happens if you don’t have it?
  • When you go to work, remember: you are trading your life for money. You can’t get more life.
  • Since you are trading your finite life for money, try & do something you actually like.
  • Lastly, spend money wisely. You traded your life to get it, so you are really “spending your life”.

Polaris infrastructure: Tuning out today to focus on tomorrow

Having worked at more than my share of “big companies”, I was often subjected to the short term nature of decision making. Quite often, decisions were driven for “optical” reasons that produced sub-par results over the long term, but made one particular group happy over the shorter tem. The company, having boxed itself in by one bad decision, would continue to lurch from quarter to quarter – healthy enough to stave off impending insolvency, but still trying to staunch the bleeding from some poorly executed acquisition.

Companies are not unlike people – they have different motivations, and do things for different reasons. Like people, some have a very short term view of things, while others might be able to see the proverbial “forest for the trees”.

The same is true for investing. Early in my investing career, I was also guilty of focussing on the shorter term picture. While the balance sheet and the income statement of today (and yesterday) provide a clear picture, that picture is only that – the picture of “today”. I was focussed on what had happened, but largely unable to think about what could happen. I eventually realized that my focus on the present (and the past) caused me to eliminate many potentially sound investments because, in their present form, they looked too ugly.

If you are an investor who takes an interest in particular companies, the ability to see beyond the ugliness of today is crucial. For that matter, even if you are an index investor, the ability to see beyond present market conditions when the headlines are screaming panic, is also crucial. The problem with humans is that our brains are still wired for the newsflash about the stampeding herd of wildebeest – better to stay in the cave a little longer, than risk getting trampled like your cousin Larry. In the meantime, the herd is long gone.

Those of you that are familiar with my investment philosophy know that I subscribe to a somewhat unorthodox style. A part of my portfolio is always reserved for the ugly and the misunderstood, as these companies can sometimes provide investment returns bordering on the unheard of. With this in mind, I try my best to look beyond the sometimes dismal financial statements of today, to see if there are any bright spots of future improvement.

Often times, these are small things that don’t scream “improvement”, but require a bit of research. Things like adoption of a particular companies product (or a similar one) by a new market segment, new government legislation that favours the adoption of a particular companies product, or changes in macro economic events can often turn a small companies fortunes on a dime. By the same token, keeping an eye out for similar things that might imply negative impacts for a particular company is also key. Either way, sometimes the most useful investment information about a company is not found in its own present day statements, but in an unrelated press release about another company, the general economy, or shifts in social issues.

An excellent example of this is a company which I had been following for some time, Polaris Infrastructure. Polaris was formed when RAM Power, the predecessor company, was recapitalized, resulting in a significant reduction in debt and the associated de-levering of the balance sheet. The newly formed Polaris Infrastructure was concentrated both with respect to geography and business lines, as they operate geothermal electrical generation in Nicaragua. Add to this fact that the company reported in US dollars, but traded on the Canadian TSX exchange, and you can understand why it may have flown under the radar.

Many investors were distracted (and still are) by the fact that this small company was operating in a foreign jurisdiction, traded on a non-US exchange, and had a chart that looked like the last half of a roller coaster. However, missed in this was the fact that the company is effectively an electrical utility, providing “clean” power via fixed contracts denominated in US dollars. My curiosity in the company was piqued significantly in 2016, as crude oil (and the Canadian dollar) both proceeded to fall precipitously. Polaris, with its contracts denominated in US dollars, also initiated a dividend in US dollars.

 

For investors in the frozen north such as myself, we could buy Polaris in Canadian dollars, but receive a dividend denominated in US dollars, which would then benefit from the falling Canadian dollar vs the US dollar exchange rate. As one can see, many of the most interesting things about this story were not to be found on the pages of the most recent financial statements, and required a bit of “looking beyond” the current information. I purchased Polaris in early 2016, and have been holding it ever since. Eventually, the CAD-USD exchange rate will move again, but by this time, it’s likely that Polaris will have added more generation capacity, which should increase cash flow & the associated dividend.

 

In this particular example, the current focus on clean energy and the changing exchange rate landscape were perhaps the two key things that were not to be found on the income statement or balance sheet. These two things pointed to how this companies fortunes might pan out vs what was happening “right now”. If nothing else, it highlights the fact that it never hurts to keep an eye out for “where the puck is going” as opposed to “where it is right now”, as you’re far more likely to make a good play at the end of the day.

 

Please note – this post is not meant as an endorsement of Polaris Infrastructure, or as a suggestion that the reader should invest at this time (or at any time)  in this company.  The company is mentioned and discussed only in the context of demonstrating a particular investment philosophy or style.

Why pick stocks ?

There are a great many finance blogs out there, and many of them are clear when it comes to “active management”. Various studies have shown that active managers rarely beat the market indexes, so the question is clear: if the professionals are lousy stock pickers, why try to do it for yourself ?

For many of us, that’s the only information we need in order become index investors. Nonetheless, as the saying goes, “variety is the spice of life”, and my approach has always included an element of active investing. To be clear, I am not against indexing. Rather, I’m simply explaining why I still actively seek out and pick individual stocks. To be even more clear, I’m not suggesting everyone run out and do the same (I doubt you will). Think of this as a glimpse into my view of the markets. If it’s entertaining, then I’ve done my job. If you learn something, as unlikely as that might be, then even better.

I follow a two pronged approach in my investment philosophy. I have two “buckets” of money: shorter term liquid investments which I can use for anything, and longer term and less liquid investments which are distinctly earmarked for retirement. Note that short term money can migrate to the long term bucket, but long term money never migrates the other way. Once it is “locked in”, it stays there. I should also clarify that “retirement” means “golden years” kind of retirement. In the meantime, I may not be working a standard 9 to 5 job, but I am not retired either.

The long term bucket is, for the most part, invested in companies that show steady growth and pay steady dividends – think consumer staples (Kraft), pipelines (Enbridge), and REITs. In this bucket, I am far less active, but I keep an eye out for bargains nonetheless. For instance, when oil started to go into a tailspin in 2015, I didn’t look at oil & gas producers, but rather at the pipelines that transported the commodities. The market, acting as it sometimes does, decided that pipeline companies should also be re-priced, despite the fact that pipeline tolls are designed to largely eliminate commodity risk. In any case, this bucket is not unlike an index fund, as it typically holds very large and very stable companies that change very little over time.

It’s in the short term bucket that I am most active. In this bucket, I favor the very small, the misunderstood, and the ugly. When all the stars align, it can be all three. Some of you reading this may be nodding, and you are probably saying that this is a classic deep value approach. This is partially true, as I will explain.

Early in my investing career, I tried various approaches, with various degrees of success. To make a long story short, I discovered that picking large cap value stocks at steep discounts was more difficult than it appeared to be. While there are sometimes bargains to be had, the market tends to be efficient with big names. I also tried momentum investing, with little success, as my charting skills were poor to say the least. Finally, over time I realized what should have been obvious – that the smaller end of the market, and the very small end of the market, was where true inefficiency came to hang out.

At this point, I’m sure many of you are no longer nodding in agreement, but rather shaking your heads in disapproval. Dreaded penny stocks, the veritable scourge of the investment world, are vilified by many, and for good reason. Many of them are over promoted shell companies that are intended only to enrich insiders. However, some of them are real companies with real intentions on making a better mousetrap. The trick is to separate the wheat from the chaff, and then, to separate further.

When I look at these very small companies, I tend to look for specific things such as:

  • A high level of management ownership that has stayed relatively steady or increased over time.
  • Management that has deep pockets. Think of Tesla and the way Elon Musk has backed it.
  • A company that is not just a resource or commodity company.
  • A history of operations. I’m looking for a company that has been at it for a while.
  • Low debt levels.
  • A minimal amount of outstanding options or warrants that will create excessive dilution.
  • A product that is relatively simple to adopt or implement, or clearly solves a problem.
  • A strategic advantage with respect to relationships or location.
  • Hopefully, a reasonable price to book value ratio.
  • No analyst or investment banking coverage. The idea is to be the first person at the party!
  • Lastly, a nice flat lined chart that indicates current investor sentiment is indifferent.

I may have missed some things, but this list encompasses the bulk of the factors I look for. Once I’ve found a potential company, I call them to see how approachable they are and to see if I can glean any more information. I call customers who use the product to ask about their experience with the company, and I call distributors who sell the product. I try and talk to anyone who deals with the company or uses the product to get a better understanding of how good or bad the product (and the company) is.

This process probably sounds time consuming, but I’ve come to consider myself a full time investor. This being said, I can assure you I don’t spend eight hours a day on the phone. Because the company in question is usually not a hot prospect at the time, the share price is usually fairly flat, so there is little risk that something material is going to happen right away. I will have these conversations over long periods of time, and will make notes accordingly. If the research turns up good information, I slowly add to my position. Rarely do I put in a large volume order, as with small companies, one can move the price quickly. Once I have a significant position, I monitor things – and wait, sometimes for a long time.

As you can imagine, this process is not for the faint of heart or for the impatient, so it tends to weed out those shareholders. But the payoffs, when they do occur, are well in excess of normal returns. While there is always the risk that a company can go bankrupt, thereby handing you a 100% loss, when these companies turn the corner, they pay off far beyond ones expectations. It only takes one to move an entire portfolio, as I discovered a few years after starting to pursue this “tiny ugly company” strategy. Over the period of 24 months, I watched the share price of one of my holdings move from under $0.20 to over $6.00. That single holding moved my entire portfolio significantly, and made up for everything else that was just plodding along.

So, at the end of the day, I’m an active investor almost entirely in the darkest, smallest recesses of the markets, as this is where one can truly find companies that may provide abnormal returns. By purchasing a basket of companies like this, risk is diversified. It’s not necessary for all of them to do well, or for that matter, for the bulk of them to do well. While I can never say that “XYZ Corp is going to go from $.25 to $100”, I do know that there is a reasonable probability that some of these will muddle along, some will go bankrupt, and one or two will perform beyond my wildest expectations. My job is to stay curious and keep looking for the small, the ugly, and the misunderstood, as these are the companies that will provide those abnormal returns over the longer term.