I’ve had some requests from people for stock picks. That’s what we’re going to be discussing today. Spoiler: I’m going to recommend you to buy Tokyo Tekko (5445.T), a Japanese steel manufacturer, and I’m going to explain why.
But first, I want to start off by looking at a comment from some dude who wanted to shit on me about a year ago:
I guess you have started investing in March 2020 and now you think you are Warren Buffet in spe. You are not. Buying fallen angels once and then selling them on rebound is nothing exceptional. It was your once in a lifetime chance, you did it but most likely you will lose to the market in long term and judging by your egotism, you will be broke really fast.
So yeah, I hope you will invest a lot in nanocaps and VC funds.
You can find this gem here.
The VC fund he is referring to is ARIX Bioscience. Here’s what I had to say about ARIX Bioscience back on August 23, 2020:
Stock markets behave irrationally, because there are simply not enough people with money, looking to take advantage of all the irrationalities. I’m going to give you one simple example.
ARIX Bioscience is a venture capital fund, with 135 million shares issued in total. The shares are valued at 80.5 cents each right now, for a total valuation of the company at £107.13m. What does the company own right now? Look for yourself here. For their last reported date, they have no real debt, 55 million worth of cash and stocks valued at 150 million. Those stocks would have to go down by two thirds since their last reported price, for the company to be worth less than its balance sheet. Some of them are publicly traded, you can check for yourself and notice their value has mostly stayed the same.
What’s going on here is that the company is trading at a discount of around 45% to its net asset value, simply because there’s not enough people who know of the opportunity, who are willing to step in. If you’re at the supermarket and one wealthy old guy tells you “I’ll hand you fifty bucks if you carry my groceries to my house RIGHT NOW”, while another wealthy old guy tells you “I’ll hand you a hundred bucks if you carry my groceries to my house RIGHT NOW”, you’ll ignore the guy offering you fifty bucks. What everyone else notices is just you not grabbing the fifty bucks and they’ll be skeptical, they’ll be unable to believe the opportunity is real. That’s how it works with stocks. In periods like we live in right now, the opportunities are so numerous for small investors, that many of them simply go ignored. I’m not claiming I found one of the best opportunities out there right now, I’m merely claiming this is a pretty good one.
And now for shits and giggles, we’ll look at what happened to ARIX Bioscience:
So yes, you could have followed my advice here instead of mocking me and doubled your money in three months. I offered you a chance for returns that exceed the average crypto Ponzi scheme and you mocked me. Somehow, I still managed to book high returns after my “once in a lifetime chance”. I mean, sure, this particular case is exceptional, I sold well before the peak myself. It’s also perfectly possible that you follow my advice and lose twenty percent in half a year. I don’t claim to have positive returns every month, but in the long run I expect to outperform the indexes. However, I’m not cherry-picking here either. This is simply the only stock I mentioned by name in the post.
Things trading at a discount can also start trading at an extreme discount, but an extreme discount generally shouldn’t last very long in places with proper minority shareholder protection policies in place. The direction of minority shareholder protection should generally be upwards: Governments want economies to function better, so frauds will over time become less common.
Value investing doesn’t take a genius either. As Warren Buffett has explained, beyond a 120 IQ more intelligence doesn’t really do much to make you a better investor. In a case like this, you just have to be able to look at a balance sheet and understand what it is you’re looking at.
In contrast to cheap Chinese plastic junk at a department store, stocks can’t sell at a discount to intrinsic value forever. Either management completely destroys the intrinsic value, which tends to be rare, the market recognizes it’s trading at a discount and fixes the inefficiency, or management gets its shit together and starts buying shares off the market to return value to shareholders.
Screw growth investing
Growth investing is all the hype these days, because by most conventional metrics, growth investing strategies have performed better than value investing strategies for the past twenty years or so. You were better off buying companies with rapidly growing revenue than you were buying companies that generate high earnings relatively to their market capitalization. However, that’s actually a good thing for value investors, because of the concept of reversion to the mean.
Imagine you’re watching a dolphin in the sea. As the animal dives into the water, you know that it eventually has to rise to the surface again: Just as it’s the nature of dolphins to require fresh air to survive, it’s the nature of companies that their valuation ultimately has to reflect their potential to deliver earnings to their shareholders. If the dolphin has stayed underwater for a long period and you have a good clear view of the sea around you, then it’s just more likely that the dolphin is about to rise to the surface again.
I’m not saying here that all value investing metrics that were used in the past still work well today. It’s perfectly possible that price to book value doesn’t give us a lot of useful information anymore in an era where companies most valuable assets tend to be brand names. However, the basic principle of value investing should still function: A company’s purpose is to deliver dividends to its shareholders by generating earnings. A company that generates more earnings relative to its market capitalization is thus a better investment than a company that generates less earnings.
In our situation, growth investing performed better than value investing for a number of reasons. Low interest rates create a situation where companies can cheaply borrow money. You borrow money when you plan on rapidly expanding your revenue. This also creates a situation where people can earn very little return on bonds and thus move from investing in bonds to investing in stocks.
When everything seems to be in a bubble, as happened in this low interest rate environment, economic actors start searching for increasingly speculative and dubious sources of future revenue. That’s how you get companies like Theranos and Tesla, as well as the bizarre situation where people spend vast sums of money on cryptocurrency.
A situation like this doesn’t last forever, because governments and central banks can’t allow it to last forever: When you allow everything to grow, you end up growing a bunch of bullshit. The longer you allow it to last, the more bullshit you end up with and the costlier it becomes to get rid of it. You need periods of creative destruction, during which you find out which companies are actually the next Amazon or Google and which companies were the next Microstrategy or Wirecard.
Basically, what most people are doing now is investing in what I would call the Motley Fool method. You look at companies with rapidly growing revenue and you ask yourself: “Which of these is the next 10 bagger?” In other words you’re trying to figure out which company is going to grow rapidly and see its market cap increase by 900%. I think trying to figure this out involves a degree of hubris, but the hubris involved is obscured by the fact that everyone is doing this.
When everyone is buying Bitcoin, you don’t notice the problem that it’s a token that generates no earnings and converts your money into carbon dioxide in rural Xinjiang: You just notice the price going up! Similarly, when everyone is buying these growth stocks, you don’t notice the problem that they have no chance of ever paying you in dividend what you spent on acquiring shares.
On the other hand, value investing doesn’t really depend on having a crystal ball and holding unique insight into how the global economy is going to evolve: It mostly requires you to understand how to read a balance sheet. It also requires you to remember such outdated concepts as the idea that a company’s purpose is to generate earnings for its shareholders as opposed to attracting a steadily growing supply of greater fools willing to buy shares.
Value investing tends to require more patience than growth investing. To some degree, this problem can be addressed, by limiting yourself to those companies trading at an extreme discount to intrinsic value, while making sure to filter out the scams. That’s the difference between stockpicking and buying a fund.
If you buy a Japan value fund, you’ll own a diverse collection of stocks, all of which have in common that they’re relatively cheap compared to the eanrings they generate for shareholders. A fund like that may require patience of you, but it should generally protect you against the kind of situation where your net worth drops by 75% in a year: A company trading at eight times earnings won’t start trading at two times earnings for very long, because people like me would step in to buy it.
On the other hand, investing in rapidly growing tech companies means having to accept the possibility that you may have stepped in at the very worst possible time. Investing in the largest 100 companies on the NASDAQ at the wrong time could have caused you to lose 70% of your net worth over a period of two years back around the turn of the century: That’s what happens when you step into an economic bubble at the wrong time. Remember, this is not picking the wrong company, it’s the strategy people think of as reasonably safe: Just buy an index with a bunch of big names on it.
Screw passive investing too
Just like growth investing, passive investing can be profoundly dangerous to your net worth. To understand what I mean, take a look at this:
You’re Mrs. Watanabe, the year is 1989 and you think to yourself: “I’m going to invest everything in the largest 225 Japanese companies, so that I can retire twenty years from now. What’s the worst that could happen?” Well here’s the worst that can happen. According to this calculator, stepping in during march 1989 and stepping out during march 2010 would mean you would have lost 61.8% of your money, after adjustment for inflation and with your dividends reinvested.
In my case, that would mean I can start delivering mail again in the year 2041. I hope I can offer future me a better perspective. My own expectation is that this is what’s going to happen to a lot of the FIRE people. They throw everything into index funds, not realizing the stage of the cycle we’re in. That’s how you lose it all.
The way to plan a safe retirement is not by simply buying a handful of giant companies through an index. It’s by buying companies in safe industries, trading at safe valuations.
I’ll make one admission: I’m actually perfectly fine with people buying indexes. The nice thing about passive investing is that it makes the market less efficient. That means what I do, value investing, should become more profitable.
You’re visiting the market and the fruit stand has a new intern. He has accidentally swapped all of the prices: A watermelon is now priced like an orange, grapefruit is priced like strawberries, andsoforth. A bunch of people show up, they’re just ordering “one of each”. They don’t pay attention to the prices, they just know this stand as a place where you get a pretty good deal. For you this is fantastic: If people were paying attention they would be buying giant watermelons at the price of one orange each, but you can now grab that opportunity yourself.
Of course I’m also perfectly fine with things becoming efficiently priced after I bought them. I bought a watermelon at the price of an orange, so what do I want? Do I want people to continue to believe “well if the watermelon is priced at fifty cents then that must be a fair price for a watermelon”? I like watermelons, but I can’t eat them all on my own. No, I’m going to point out to everyone: “THIS WATERMELON COST ME FIFTY CENTS, YOU CAN HAVE IT FOR TWO EURO, THE OTHER STALL SELLS WATERMELONS AT FOUR EURO SO I’M OFFERING YOU A GREAT DEAL!”
Tokyo Tekko: A Great Deal
So that’s what I’m doing today. I’m going to tell you about a cheap company I bought. The company is called Tokyo Tekko, its ticker is 5445.T. They’re in the steel business, their main product seems to be long wires used to build earthquake-proof buildings. That’s pretty important, considering that Japan is in an earthquake prone place. I think this is the kind of product people will still be needing ten years from now.
I also think their product is pretty niche: Not a lot of countries are forced to build earthquake proof-highrise office towers, so not a lot of other companies will be selling the same product. This means profit margins should remain pretty high. You generally want to be buying stock of a company that doesn’t have to worry much about competitors, because with too many competitors profit margins will generally move towards zero. All of this also means it’s easier for me to value a company like this than trying to value a company like Twitter.
So why am I telling you about this, because I’m a saint who wants to hand out money to random people? No, two reasons. I kind of like showing off and I don’t have any money left to buy more stock, so I’m eager to see it trade at a price that better reflects its intrinsic value. I’m probably still going to find myself selling it at a discount to its intrinsic value, but I originally bought it at a big discount to its intrinsic value, it dropped 20% since then and now it trades at an extreme discount to intrinsic value. I hope to sell it when it trades at a small discount to intrinsic value, at which point buying it should probably still allow you to beat the market provided you’re patient.
First things first, a company has a number known as its Enterprise Value. The Enterprise Value of a company tells you what a company is worth if you subtract debts, cash on the balance sheet and unfunded pension liabilities. Enterprise Value is often a more useful number than Market Cap when trying to value a company. In Japan, companies often have an Enterprise Value lower than its market cap. This happens because Japanese managers are overall extremely conservative: Most Japanese people take pride in the company they work for and they want the company to be able to survive bad events.
In addition, Japanese investors are very conservative too, because they have been traumatized by the massive bubble of the late 80’s. The stock market to most elderly Japanese people is a place where people gradually see their savings decline. Many Japanese people only buy stock because you get discounts on products from the company whose stock you own.
This is why Japan is such an attractive market: Many small companies in boring industries trade at very big discounts to their intrinsic value. The Japanese government is encouraging companies to become more active in delivering value to shareholders, because they want to get their economy out of a slump.
In Japan you will find situations you won’t really find in Europe or North American, which finally brings us to Tokyo Tekko. Tokyo Tekko trades at a Price/Earnings ratio of 2.91. Immediately that raises alarms. the SP 500 trades at a Price Earnings ratio of 44.26 right now. So what’s the catch? The most obvious explanation would be that their most recent earnings figure was unusually high.
But that’s not the case! Here you can see Tokyo Tekko’s earnings, as you can see, their earnings have been pretty steady:
You don’t just want to rely on earnings alone when judging a company’s potential, particularly in an industry like the Steel industry, where margins are relatively low. Rather, you also want to look at revenue. You can find a comparison to its industry here. It suggests the company trades at a discount of around 33%.
But that’s an unfair comparison however, because as a Japanese company, it’s in an unusual situation: It has a big pile of cash on its balance sheet that it’s not using! Specifically, it has a market cap of 14.4 billion and an enterprise value of just 5.7 billion, because of 11 billion Yen on its balance sheet! You don’t really encounter this in other construction or steel companies, so this company has a huge advantage.
If you want to look at its Enterprise Value/EBITDA ratio, you find that it trades at 0.57. Compare this to other companies in the United States. If you’re only including companies with positive EBITDA, the American steel industry trades at 9.74 and the construction supplies industry trades at 15.23. This is not entirely fair however, because its most recent EBITDA is probably exceptional and won’t recur in the future.
So yes, it’s cheap, ridiculously so. And management has figured this out too, so they recently announced a buyback program. They’re going to help out shareholders like me, by buying up their own stock off the market. In May of this year, they announced they’re going to repurchase up to 300,000 shares, representing 3.21% of its issued capital, for ¥500 million.
It’s currently trading around 1600 yen. I honestly don’t see how it could drop much more than that, I think it’s probably going to be its absolute bottom. If management is not aggressive enough in buying up the company’s stock it may trade around this price for a while, but it can’t drop much more, because then people would start buying it for its juicy dividend.
In fact, the best thing that management could do if it wants to fix the situation without reducing the number of shareholders (Japanese businessowners take great pride in having publicly traded companies) would be to simply boost the dividend. Only 13% of earnings are paid out as dividend. Double the dividend and you’re guaranteed to have small investors who will notice the opportunity.
How should you value a company like this? I’m going to treat the 11.37 billion Yen as 11.37 billion Yen. Then there’s the enterprise itself, which is now valued at 5.72 billion. I’m not going to look at EBITDA, which fluctuates too much, I’m going to look at its EV/Revenue. For Tokyo Tekko, this number is 0.09. In the United States, the construction supplies industry trades at an EV/Rev of 2.27 times. The steel industry in the US trades at 0.93 times Rev.
If you think American steel companies are fairly valued and Tokyo Tekko can be properly compared to them, it would mean Tokyo Tekko is trading at a 90% discount to its fair value. This is a simple exercise in demonstrating what its fair value might be, there are many other ways. If you think the company won’t suddenly decide to spend its cash on cocaine and hookers then it should be pretty clear it’s being undervalued.
How undervalued is it? Well the fact that this situation could ever even emerge in the first place doesn’t reflect very well on management in my opinion, as does the fact that management doesn’t seem to own a lot of shares themselves. Those tend to be the sort of issues you will overlook when you only look at the numbers. The numbers however still matter. Unless you’re dealing with scammers or corporate fraud, a company with bad management is still attractive as an opportunity for small investors like me. It’s perfectly possible that bad managers retire and are replaced by better ones, or large shareholders start demanding action. In our case that’s not necessary, because management has finally embarked on a buyback program.
Personally, I will start considering selling my shares if the share price doubles from this point. It might very well rapidly double again after that first doubling, but that won’t matter to me if I found something else that is also very undervalued.
My goal in investing is pretty simple: I want to see consistent inflation adjusted returns of at least 20% every year, for the next five years or so. That’s what I want to achieve. With 20% in a year, I would have 100,000 euro to spend in a year, which is far more than I actually spend in a year. In a normal year I spend 20,000 euro, but I don’t travel, I live in a cheap house and I don’t own a car.
I know some of you are probably looking for that elusive “ten bagger”, the kind of company that trades at ten times its current price a year from now. That’s not the kind of business I’m engaged in, so I can’t help you with that. I’m a value guy, looking for companies that are trading at a discount to intrinsic value and where I have reason to believe the market inefficiency will be resolved in the next year or so.
It’s theoretically perfectly possible that Tokyo Tekko is one of my unlucky picks: A value trap where you have to wait a couple of years for the company to reach its intrinsic value. That doesn’t really matter much when you’re diversified, because companies like this won’t just drop 66% in the meantime: A Japanese company isn’t going to trade at a dividend yield above 10% for very long. In this case, I’m quite convinced that it’s not a value trap, because of management’s new buyback program.
Anyway, that’s all I have to say. This became much longer than I planned on, because I don’t just want to recommend things to people without explaining my underlying reasoning. Please let me know in the comments if you’re joining me and my friends in becoming a shareholder.