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Love Affairs and Horse Racing

Updated: Jan 22, 2021

“There is no such thing a liking a horse to win a race, only an attractive discrepancy between its odds and its price”

This phrase probably best summarises my investment philosophy. Investors shouldn’t “like" stocks. The first and most obvious reason being it impossible to have a love affair with a stock because a stock will never love you back.

The second is that companies can have incredible prospects for growth, and be “liked”, but make poor investments because their price already reflects those prospects – if it delivers on its incredible prospects, it’ll be worth its current price (i.e. a 0% gain). The incredible prospects are priced in. In fact the company must deliver on those prospects in order to justify its current price. If it falters, it’s likely to fall in value.

Similarly, companies can have anaemic growth ahead, but make great investments, because their price doesn’t imply anaemic growth, it implies substantial reductions in future cash flows.

Fair warning, this will get pretty technical from here on in – and as with every post of mine, it does not constitute investment advice. Do you own work before taking a position.

Using share prices to determine what’s priced in is called “expectations investing”. It essentially asks “what does this company need to do in order to justify its current price?”. You can then compare those demands to their prospects.

Let’s use an example to illustrate. One of my best investments in 2020 was a Dutch engineering company called Arcadis (ARCAD NA). It delivered a 126% return. Arcadis provides engineering and design consultancy services to public and private customers. They design things like metro networks and storm protection walls (e.g. the storm walls around lower Manhattan after Hurricane Sandy).

In late March 2020, the company traded at ~€13 / share. If we examine consensus expectations at the time, we see a company that grows revenues at 3% p.a. over the three year forecast horizon, sees margins return to their historical average, little change to net working capital, and being a services company, almost no capex.

If we calculate the equity cash flows derived from the expectations and estimate the perpetual growth rate required to justify a price of ~€13/share we see -45% growth p.a. beyond the three-year forecast horizon. Pessimistic to say the least.

For the graphically minded, -45% CAGR in cash flows would look something like:

Bye Felicia, indeed.

What’s causing this pessimism? Clearly the stock isn’t trading on fundamentals. In fact, if you believe it still exists in any meaningful form in three years, then it’s worth more than €13.

Arcadis had a short thesis hanging over it for a couple of years – at one point 26% of the stock was sold short, and it was the most shorted stock in Europe. In public equities, that’s about as close to vehement hatred as you get. Essentially, some investors thought the company would breach a debt covenant and need to do an equity raise at seriously depressed prices (bankers estimated ~€10 / share, or -25%).

The second problem was the company had developed a bad habit of missing its own guidance with margins languishing below historical levels and revenue growth failing to materialise while receivables had aged substantially due to overdue invoices in the Middle East. Investors believed this recent history was likely to continue.

However, if you thought margins would improve and the company wouldn’t breach a covenant, the company should be worth something in the range of €29 – 32 / share, a gain of 112 – 134%. I think what we’re looking at is a probability weighted scenario. X% probability of a covenant breach and 1-X% probability of things being okay. We need to answer two questions to understand this investment. The first is, will margins improve? The second, is will Arcadis breach their debt covenants?

The answer to the margin question is, it’s reasonably probable (I estimate a 75 – 80% chance). After speaking to current and former employees, it’s clear a revolving door to senior levels of leadership led to increased staff turnover which is costly in terms of lost business and the expense of hiring and training new staff. Leadership has stabilised, turnover has fallen, so margins should return to their historic levels.

The answer to the second is: it’s unlikely. There’s a risk it’ll happen (I estimate a 5% chance) but at €13 / share, you’re being handsomely rewarded for taking that risk. After interviewing a few of the more prominent short sellers, I figured out the short thesis revolved around a net debt / EBITDA covenant breach and concern around receivables collection. The potential covenant breach concerned their Brazilian operation. Arcadis had guaranteed a plant they designed there would meet certain performance metrics. The plant was facing issues meeting these performance targets which meant there was a risk Arcadis would have a guarantee called, meaning they would need to pay €48m to the guaranteed party, net debt would increase and the ratio would get pretty close to, or above, the 2.5x covenant. Depending on how you calculated it, you might also need to see a decline in EBITDA to breach the covenant (it wasn’t a simple calculation, it concerned an average over multiple periods with some opacity around what you could add back to EBITDA).

What surprised me is that Arcadis had the opportunity to sell one of its divisions for ~€100m at about the same time this guarantee issue came to light. They decided not to sell the division after receiving a couple of offers, none of which they thought fairly valued the division. This is an odd thing to do if you’re at risk of breaching a covenant. So either Arcadis management are not being as wise as they might, or they don’t think it’s going to be an issue (because it won’t happen, or they can see a way out that doesn’t involve an equity raise).

As for the receivables, Arcadis had a large receivable balance outstanding with a middle eastern customer. The customer was paying it, albeit slowly and it had aged considerably (parts of it were more than a year overdue). Some short sellers took this as a sign of manipulation and poor accounting practices. In reality, this is not uncommon in the middle east, provisions had been made for portions of the receivable and importantly, it was being paid. It seemed like an isolated incident, not systemic manipulation.

So, let’s take a look at what probabilities you need to believe in to justify a ~€13 share price. Let’s say the current price reflects a probability-weighted price of two scenarios: The upside, in which Arcadis is worth €30 / share, and the downside (an equity raise) in which Arcadis is worth ~€10 / share.

So the price implied that Arcadis would almost certainly breach a covenant. For context, an 82% chance is roughly the probability of rolling anything other than a 6 on a die. It’s reasonably rare – but no one is surprised when it happens.

I disagreed with the price-implied odds, and thought the probabilities were more like 95% chance of upside and 5% chance of downside. I bought a position on 28 March 2020 and sold it last week at a 126% gain. Put simply, there was an attractive discrepancy between Arcadis’ price and its odds and I took the bet.

Importantly, I didn’t “like” Arcadis. I haven’t liked or disliked a company for many years, largely confining my affections to humans. There are only attractive discrepancies between prices and prospects.

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