Our Anchors of Investing
Focal points
At Pendulum Capital, we focus on fundamental analysis, but the valuation exercise extends far beyond the financials. Financial statements are just the product of a company’s business model, capital structure, and overall strategy. Thus, it is critical to dive deeper to uncover the links between the various aspects of running a business because those tell a more comprehensive view.
We primarily search for turnaround, distressed, and overlooked companies, ones that are not the flavor of the month nor in the spotlight. Once the headlines of Bloomberg, Financial Times, and other mainstream news sources post about their “hot” picks, it is generally too late. These companies have already climbed the cycle, nearing their ceilings. Instead, we look at small to mid-cap stocks where certainty and oversight may be lesser but opportunities higher. We hope to battle through the throughs measuredly, patiently waiting to be swept back up to the peaks.
Outlined below are 4 anchors we adhere to in any investment pitch.
Anchor 1) Promising business, sector, and macroeconomic winds
The nature of a business and its industry supersedes most considerations when analyzing a company. We believe this governs a significant factor in the success of any company because sector-wide movements originate from macroeconomic factors, which are not easily addressable. If a company unfortunately positions itself in a perishing and substitutable sector, no matter the pedigree of the management, the value proposition is heavily restricted. Determining the sector's attractiveness is the most essential step in successfully selecting a valuable company.
In 2021, we invested in clean product tankers at the onset of the Russia-Ukraine war. Through the previous few years, almost every listed company with a comparable business model jumped 3-4x in value. In this situation, there were no losers because the sector-wide shift in the demand for product tankers shot upwards, carrying every participant with it.
In 2020, the COVID-19 shutdowns and heightened security measures led to supply chain turmoil. The mandatory health checks and quarantines restricted port access for ships, but demand for import and export goods remained elevated, leading to supply chain disruptions. For example, the local epidemic controls in the Yangtze River led to weeks of waiting time for container ships to enter the delta. This is one of the root causes of the sharp rise in dry goods transport (container ships) rates in 2021. Consequently, companies that operated Panamax and other container ships experienced sharp rises in profitability, which the markets rewarded.
A company does not have to check the 3 boxes strictly, but it should have at least no negative headwinds against it.
Anchor 2) A distinct driver among comparables
Before diving into the financial and detailed analysis, a company must have a leading position among its peers in some capacity, whether it stems from undervaluation, a better product/service, or a more perceptive direction from management. A lack of differentiating factors severely hinders the value premise, and investing in a company with that condition represents an investment into the sector as a whole rather than the company itself.
The markets have observed Nvidia's formation into a star. However, the chip sector itself, which comprises a variety of companies, has not been able to catch up with it. The unfortunate peer Intel, by contrast, has not gained any value at all. This case exemplifies the cost attributed to a lack of distinction and foresight on the management’s part.
When it comes to financial performance, the business model dictates the anatomy of the financial statements. Each sector’s unique design should be the benchmark against which a target investment should be compared. As a result, it is futile to use a universal standard to analyze companies across different industries. We need to comprehend the character of the business and its implications on the formation of the financials. That understanding allows us to tweak different knobs here and there to more accurately determine a company’s position among peers. This leads to the next point, which is deconstructing the financials and rebuilding them to form a projection.
Anchor 3) Alignment between financials, strategy, and business model
The tedious task of breaking down financials can lead to various interesting findings. Running through the 10-K and 10-Qs is an imperative effort that provides enough data to give a sufficiently observable framework of the company at hand. Through this, we hope to find details that can not be caught from 30,000 feet, such as notes to the audited statement, debt covenants, other specific accounting policies, etc. These findings can make or break an investment case, as they serve as data points that can be linked to form a broader conclusion.
Examining revenue and cost by source is another exercise that generates influential data points. We can address risk factors such as country/currency risk from international sales, cost volatility from raw materials, unaligned compensation policies, etc., which all contribute to creating confidence in the stability of income generation. This dovetails into the first anchor mentioned above on macroeconomic winds.
The cash flow statement and the mid and lower sections of the income statement reflect the overall capital structure and financial policy. As we invest mainly in common equity, the most junior component in the capital structure, it is important to identify each instrument that sits between common shareholders and the company’s cash flow. By decomposing this, we can discern the true value that public investors have the right to and if the company's management works with the shareholders to increase that value.
Cash utilization in the cash flow statement determines the allocation of capital, which in turn indicates the company's direction in the near future. We would like to see companies use these resources prudently, such as paying down expensive debt, investing in sustainable growth, or engaging in creative M&A activity.
Ultimately, the evidence produced from these various analyses should build grounds for a company with the foundation to accrete value.
Anchor 4) Complementing valuation methodology
Valuation is a personalized task. The output derives only from base numbers and assumptions, the latter of which are highly subjective. After adhering to anchors 1 to 3, a sufficiently descriptive basis, along with a suitable valuation methodology, should be formulated together to build a financial model.
For companies such as The GEO Group, for which we wrote a thesis, the suitable method was sum-of-the-parts of liquidation value and DCF on contract agreements. The selection came from the market outlook that the company was deemed to be insolvent soon. We built a case that the value of the property itself (at a discounted value), let alone the asset-free business, was already sufficient to repay the debt in the event the company filed for Chapter 11, which we believed was extremely unlikely.
On the other hand, in a less extreme instance, we used an equally weighted average of market P/E, market EV/EBITDA, and DCF to evaluate JAKKS Pacific's fair value. Here, the value proposition lies in the company’s return to profitability, settlement of all indebtedness, and eventual catchup to median market multiples.
The balanced boat
The four anchors serve as a stabilizing force to accommodate the ever-changing waves in financial markets. Trends are capricious; they never last forever. However, a rooted thesis based on a multifaceted, fundamental analysis provides grounds for a durable investment case that Pendulum Capital believes will not only generate alpha but also offer a hedge to the market norm.
“The underlying principles of sound investment should not alter from decade to decade, but the application of these principles must be adapted to significant changes in the financial mechanisms and climate.”
