You Got Your Chocolate in My Peanut Butter

I’ve followed many of the stocks on my 300-name possible buy list a long time. Although the list changes slightly over time, in the near-term my possible buy list is relatively stable. Having a stable opportunity set has many advantages. One advantage is I can act decisively once opportunities arise since I’m already very familiar with the businesses and I don’t need to start my analysis and valuation work from scratch.

Being familiar with a business is a simple and effective way to avoid making large investment mistakes. Rarely will I buy a new stock idea without it first being on my possible buy list for a reasonable period of time. If a stock isn’t on my buy list and I’m not familiar with the business, I won’t buy it, even if it appears to be selling at a discount to value. Just like with people, companies can emanate first impressions that eventually turn out to be false. By placing a company on my possible buy list and getting to know it in real time, I’m better able to fully understand and ultimately trust the business.

Since many of the stocks have been on my possible buy list for years and even decades, it’s not unusual to recycle holdings. In other words, many of the stocks I’ll own, I’ve owned in the past. Once a stock is sold it typically goes from the portfolio back onto the possible buy list. Opportunities within the possible buy list tend to fluctuate along with market and profit cycles.

While the market cycle impacts the number and degree of opportunities on a broader level, company specific profit cycles also have an influence. Individual stocks are often correlated to the underlying business’s profit cycle. All else being equal, the stock of a company generating peak profits usually performs better than a stock of a business generating trough profits. As the peaks and valleys of a company’s profit cycle come and go, the discount or premium of its stock often follows. In effect, I attempt to use the natural cyclicality of a company’s profit cycle and the resulting stock volatility to my advantage.

A company I’ve watched go through several profit cycles is Tidewater (TDW). I’ve owned and profited from its stock many times. Founded in 1956, Tidewater is a leading provider of supply vessels for the offshore energy industry. It’s a company I’ve been following for 20 years. Tidewater is a highly cyclical business with extreme booms and busts – its business and stock can be very volatile. While many investors are turned off by this volatility, I’m attracted to it as it has historically caused large and frequent disconnects between the company’s stock price and the underlying value of its assets.

Currently, Tidewater is suffering from another industry bust. During the most recent crash in energy stocks, Tidewater’s stock also declined meaningfully. After the initial decline, its stock was trading significantly below tangible book value, replacement cost, and my normalized free cash flow valuation. I thought its stock was selling at a large discount, but I refused to buy it. In an investment world with limited opportunity, why didn’t I buy?

Before I answer that question, let’s go back to another time Tidewater declined meaningfully and I purchased its stock. During the last energy crash in 2008-2009, I bought Tidewater along with several other energy related companies. Discounts were so attractive, I thought it made sense to get aggressive. By March 2009, I had approximately 20% of the portfolio in energy stocks. While I was finding similar value when energy stocks crashed earlier this year, my positioning was not nearly as aggressive. My reasoning behind the smaller position size this cycle versus last cycle is balance sheet related.

The energy industry invested heavily this cycle. A large portion of this investment was funded with debt. Using Tidewater as an example, on March 31, 2009 the company had $300 million in debt and $251 million in cash, or $49 million in net debt. Tidewater’s net debt was tiny compared to the $523 million in cash flow from operations it generated that year. Considering Tidewater’s strong balance sheet in 2009, I was confident that they would survive the cycle’s trough. And that is in fact what happened as energy prices eventually rebounded and Tidewater had no problem navigating through another choppy profit cycle.

Since the last cycle’s trough in 2009, Tidewater, along with most companies in the energy industry, invested aggressively in property and equipment. Tidewater built new supply vessels and turned an aging fleet into one of the newest in the industry. As a result, the company’s balance sheet ballooned. Total assets increased from $3.1 billion in 2009 to $5 billion in 2016. Net debt also increased from $49 million in 2009 to $1.4 billion in 2016. As energy prices and drilling activity remained depressed, EBITDA declined from $417 million in 2015 to $212 million in 2016. From this cycle’s high of $63 in 2011, Tidewater’s stock now trades at $2.43. Although I’m relieved I didn’t repurchase Tidewater’s stock this cycle, it upsets me when I see a company that I’ve known for so long and has treated me so well stumble. It’s similar to seeing a good friend go through tough times.

While I believe Tidewater’s net assets continue to sell at a large discount to replacement value, I’m unwilling to buy its stock due to my buy discipline and guidelines on financial risk. Specifically, I will not buy a cyclical business if the company’s financial risk exceeds my threshold of debt to cash flow of 3x. This rule of thumb has saved me from many investment disasters. Remember, as absolute return investors it is extremely important that we avoid large losses. Combining excessive financial risk with above average operating risk is the opposite of those old Reese’s cup commercials when peanut butter and chocolate suddenly collide. It’s not surprisingly good. In fact, it’s predictably bad. In my opinion, combining too much financial leverage and operating leverage is one of the easiest ways to lose it all.

By refusing to combine operating and financial risk, I believe I’m also in a better position to avoid being at the mercy of fickle credit markets or fair-weather bankers. Tidewater is a good example of this as well. Currently the company is negotiating with lenders for an amendment on its credit facility. Tidewater was recently non-compliant on its EBITDA to interest coverage ratio. While the company was able to get an extension until October 21, as management noted, there’s no guarantee they’ll be able to renegotiate the loan. Last week during a presentation management said, “The most important priority we have right now in the short term and with the deadline of October 21 is to get our deal done with the lenders. People want to hear that we’re going to guarantee it, we can’t do that. We believe we have made significant progress with our lender group. And I think rational minds come to bear.”

Tidewater isn’t alone. There are many energy companies that took on too much debt this cycle. While I believe several energy related stocks traded at large discounts to my assessed values earlier this year, the industry’s balance sheets have eliminated many stocks from my opportunity set. Furthermore, the few energy companies with strong balance sheets didn’t decline nearly as much as their more leveraged counterparts, limiting opportunities in companies that pass my financial risk threshold. In conclusion, I’d like to own energy companies again, including Tidewater, but balance sheets will need to improve.

Investing in energy stocks today is much different than 2008-2009. For many energy companies, there’s much more financial risk this cycle than last cycle. Depending on the near-term direction of energy prices, investing in energy stocks with considerable financial leverage may work wonderfully or be a complete disaster. I’m not confident in either outcome as I don’t have a strong opinion on the short-term path of energy prices. However, as an absolute return investor, I do have a strong opinion about unnecessarily losing large sums of money. Combining excessive financial and operating risk is on the top of my list of preventable investment mistakes.