SA Interview: Value Investing With Michigan Value Investor

Feature interview

Michigan Value Investor is a value oriented fund manager who has recently launched a new marketplace service: Concentrated Value with MVI. Michigan Value Investor wrote an article about the marketplace service and readers can try out Concentrated Value with MVI with a two-week free trial. We discussed the opportunity in M&A (beyond merger arb), the many paths to the buyside and why it’s important to have a “completely frictionless mind” when investing.

Seeking Alpha: Walk us through your investment decision making process. What area of the market do you focus on and what strategies do you employ?

Michigan Value Investor: For me, value investing in all cases means carefully considering the intrinsic value of a security that you understand well, and then buying at a discount to that value. Intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life. In this definition, growth is a part of the value equation, since a business that grows will produce more cash over its life than one that doesn’t. The distinction between growth and value is artificial, because growth is a component of value.

From there I have to understand the security well, by which I mean my estimate of intrinsic value is more likely to be right than the market. That’s Circle of Competence. And buying only at a large discount is known as a Margin of Safety, both concepts originally coined by the legendary Ben Graham and likely familiar to many of your readers. And then, since I always have more ideas than I can use, I decide between them using the principle of Opportunity Cost – another value investing staple – to sell something I own in order to buy something else that’s even better. Mr. Buffett once described his experience in 1974 as selling at a P/E of 5 in order to buy something else at a P/E of 3. There is no set buy or sell price. The key is to always be invested in the best ideas you have, which can include cash if you think cash is better than the alternatives.

There’s no particular area of the market that I always focus on. I go where the value is. Ten years ago there was an incredible opportunity in large cap tech companies. Remember when Apple and Microsoft were trading at a 10 PE once you backed out all the net cash on the balance sheet? And now the best opportunity set that I see is mostly in small caps.

SA: You made an excellent call on Franchise Group with an 8.4x return in 21 months – can you bring readers up to speed on this, from how the fundamental thesis has played out, and if there is additional upside?

MVI: My initial observation about Franchise Group (FRG) was that the price had collapsed 75% due to the pandemic. But FRG owns The Vitamin Shoppe [TVS], and people cared more about their health than ever. TVS stores were being kept open during the pandemic because they were deemed essential, and they were absolutely packed. Booming. I visited some and called dozens and it was always the same story. So the stock price was way down because of the pandemic, and business was way up because of the pandemic. It was an important insight and made for some pretty great returns.

But there’s a lot of room left to run in the stock. That first observation was a lucky one for me, because it got me to look carefully at a company I might otherwise have missed. And it turns out that FRG is run by a brilliant CEO, Brian Kahn, who’s absolutely obsessed with the business. He’s a former private equity guy who has bet everything on FRG and owns ~25% of the shares, so maybe that partly explains the obsession. Management has an M&A track record that’s absolutely stellar, tripling EBITDA/share in only a few years. And they’ve been very clear they are in a target rich environment right now. More M&A is coming. Meanwhile the business segments they already own generate lots of FCF, and are growing rapidly. This is no melting ice cube situation. FRG can be bought at a single digit FCF multiple, and there’s a $500 million buyback they just put in place, enough to buy 40% of the outstanding shares at the current $34 price.

FRG has already been a home run, but there’s plenty more to go. My target price for 2024 is in the triple digits. There are no heroic assumptions required to get there, just a recovery to normal conditions – demand in the home furnishings segment is currently at 50% of pre pandemic levels – and some organic growth, and a few acquisitions like shareholders have seen them execute so many times already. A 12 multiple on FCF gets the stock, including dividends, to $130. That’s up 20x from when I first wrote about it. It’s amazing what you can find if you look hard enough.

SA: As a follow up, while FRG seems like the opportunity existed due to a market overreaction, can you discuss how you are able to identify opportunities that the market isn’t even aware of, for one reason or another? Can you give an example?

MVI: To the extent that I’ve been successful, I think the trick has been to look at a lot of pitches, and to know what it is you’re looking for. Emphasis on the latter. My favorite stock ideas meet what I call the “Nexstar Criteria”, after my best ever investment. I bought Nexstar (NXST) in 2012 for ~$6.25 and I own it today, currently over $200. That stock had the following elements:

1. A brilliant, obsessive CEO

2. A business that was misunderstood, so it traded at a low multiple

3. Lots of organic growth

4. Lots of FCF

5. A really rich M&A environment that the right CEO could take advantage of.

FRG is one business like this, and another – which I only recently discovered and wrote about here [link], is Harrow Health (HROW). I lay out the case in the article, but the short version is that it meets all 5 of my Nexstar criteria. I was just minding my own business, when a friend of mine said I should check out Harrow, a dominant company in the very small ophthalmology pharmacy niche.

The legacy business is pharmacy compounding, and the market just hates this business with a passion. It’s nothing in particular about HROW, just the whole space. There’s a lot to complain about, with patients and physicians feeling poorly served by a confusing and inefficient network of middle men feeding on an opaque system. Harrow was built in response to this, by listening to customers, as an efficient, transparent, and vertically integrated company with production, distribution, and marketing all under one roof. Their customers love them. Its CEO, Mark Baum, is a former private equity guy who has gone all in to make this happen. It’s a brilliant idea, and he is obsessed with it in my opinion.

HROW is growing like crazy, from no products or customers in 2014, to the largest U.S. ophthalmic focused pharmacy today. Revenue in the most recent quarter is up 29%. And they are expanding into a new business line of branded pharmaceuticals through M&A, which should be transformative for the company. They can just take their platform – they have a huge customer base – and sell into that base as they acquire products they think will serve their customers well. It’s a very rational reason for M&A, and management’s enthusiasm is palpable.

I think $2 a share of FCF is coming in 2024, and $10 a share is not out of the question within a few years after that. That’s a lot of FCF for an $8 stock, and HROW has a real shot at being a 25 bagger from here.

SA: Can you discuss the opportunity in M&A (beyond merger arb), from how to tell the difference between a good merger and a bad one (and objectively evaluating management’s claims about the merger) to what factors surrounding a merger can cause a mispricing?

MVI: It’s often just not possible to tell from the outside. At least for me. And if I can’t tell, I am very cautious about the outcome.

But there are times when M&A really works out well, and in my experience these typically have the following in common. First, management is candid with shareholders. There’s no fluff or hype, just a straightforward explanation. If all you are hearing is hype, there’s the deadly possibility that that’s all there is to it. But when there’s a real logic to the merger, management can just say what it is. That’s the first bit.

The second is that there has to be some reason why it makes sense. There are a few classic reasons that I look for. The first is that there may be real synergies. As an example, NXST used to make acquisitions that were instantly highly accretive by acquiring smaller broadcast stations. Every large broadcaster gets better terms from networks and cable/satellite companies (the so called “rate book”) than the little guys, and NXST had the contractual right to immediately reset the rates at any acquired companies. So each acquisition was instantly accretive the day it closed.

Or it could be that the company is rolling up an industry. That often works well, as best practices can be shared across acquired companies, scale can provide advantages with vendors, and the competitive landscape gets altered for the better when there are fewer competitors. Another example could be that the acquired company is in distress, and had to sell at a low price, or is poorly managed, while the acquirer has a demonstrated history of improving the companies they buy. FRG is a good example here.

And the final piece of the puzzle is management credibility. Some management has proven themselves already, and if they have, it’s important. Really important. It’s easy to give management with a long history of expert acquisitions the benefit of the doubt.

SA: What advice would you give to readers considering starting their own fund, or who are currently working on the buyside (and want to stand out) or who are looking to move to the buyside?

MVI: I don’t know that I have any special expertise to share here, and my path was pretty unorthodox. How many readers got a Physics PhD and then decided to switch to value investing? So take what I say here with a grain of salt. I am a one trick pony and can only comment on what has worked for me. What I did was to develop an interest first. I thought about stocks and tried to figure them out – and I had a real job at the time! – and just as much, I tried to figure out who I should listen to. I started with Warren Buffett and Charlie Munger, and that’s still a pretty great beginning. And eventually I developed a circle of competence. There were some stocks I could write intelligently about, and some of those were worth buying. And I reached out to a value investing fund and they hired me, based on that. And then those ideas worked out pretty well. I now had a skill set, and a track record, and I could talk intelligently about investing. And that was the path to having my own fund. People saw what I had done, listened to what I had to say, and were willing to invest.

I’m not saying it’s the path anyone else should necessarily take. But starting with being really interested in investing, then getting good at it, and then developing a track record, and being able to communicate intelligently. I think anyone who does that has a pretty good chance.

SA: What’s one of your highest conviction ideas right now?

MVI: I have a lot of conviction about Atkore (ATKR), which I first wrote about here [link]. This is another stock that meets all 5 of my “Nexstar Criteria”, and although it doesn’t have quite as much upside as some other ideas, it’s practically bulletproof due to its deep moat, very strong balance sheet, and huge current cash generation. It’s a totally misunderstood business, all the more so because it’s currently experiencing windfall profits that we need to look past.

Atkore is a very deep moat, growing business that produces metal and PVC conduit for use in non-residential construction. The company has, and continues to, roll up many of its competitors, creating oligopoly markets with only one or two major competitors. Margins have expanded as a result, and the company has grown EBITDA per share for 9 years at an impressive 25% CAGR since 2015, through what I estimate a normal year in 2024 will look like. In 2022 the company is actually generating windfall profits as competitors failed to deliver due to supply chain issues. Atkore’s deep moats have only increased as a result.

What’s more, no competitor has the same breadth of products that ATKR does. This is another moat for them, as they can often arrange delivery of multiple SKUs in a single shipment, which is both more cost effective and simpler for the buyer. And they have recently invested heavily in CAPEX, which will allow them to decrease their industry leading 4 day delivery time to only 1 day. They are very hard to compete with. Margins, while they will inevitably decline from windfall levels, will therefore prove to be durably high, and the company will continue to grow normalized EBITDA/share at an impressive rate into the foreseeable future.

I estimate FCF per share of $11.35 for 2024. ATKR clearly deserves a 20 multiple as a deep moat growth business, but it’s still priced as a commodity industrial company. At a 15 multiple in 2024 the stock would nevertheless be $170, up almost 100% from $92 today. At a 20 multiple it would be $227, up 150%.

SA: You’ve said in the past that it’s important to have a “completely frictionless mind” when investing. What do you mean by that?

MVI: That’s something that has been said about the legendary John Malone, that he has a completely frictionless mind. I think it just means that as the facts change, he changes his mind. I strive to emulate that quality. Emotion has no place in intelligent investing, and every investor should be nimble and flexible when the facts change, and not be wedded to a thesis. Now, I am not naturally emotional about stocks. I take no credit for it, it’s just the way I’m wired. Even so, it makes sense to make deliberate effort in this regard. My process is to wake up every morning and imagine what stocks I would own if I were constructing a brand new portfolio. Then, if my holdings are different from that, I adjust accordingly. I find that many people become emotionally invested in a stock that they already own, in a way that they never would if they were considering it fresh. This process helps remove all of that legacy emotion.

SA: You just launched a new marketplace service, Concentrated Value with MVI. Why now?

MVI: I mentioned earlier that being in cash is always an option. In fact, I almost always have at least some of my portfolio in cash, to serve as a kind of “dry powder” just in case there are some great opportunities that come along. But every once in a while it makes sense to be 100% long. At the lows of the pandemic, and the lows of the Great Financial Crisis, for example, I was 100% long back then. And I am again today, too.

The best opportunity is when the other folks are panicking, but you keep your head. That time is right now, and my level of conviction is as high as it’s ever been. I can’t think of a better time to launch than that.