The Troika Of Ebola Speculation

In the last week we have witnessed a few low-float stocks become Ebola speculation targets as the first confirmed case in the U.S was announced September 30th, 2014. It is fascinating to watch these narratives unfold and low-float momentum plays be ignited as pools of capital cohesively and strategically buy-in. Understanding how the market operates, how media cycles affect expectations and how market participants influence each other asymmetrically are key characteristic of understanding the manic-depressive nature of Mr. Market.

First you may be asking what in the world is a Troika. It is a harness used for three horses to pull a sled in the 19th century.

[Figure 1: Troika Example]

What is speculation exactly?

Speculation is: “the forming of a theory or conjecture without firm evidence.”

VOLUME

That is exactly the dynamic that seems to be unfolding over the last few days in the personal protective gear makers, Lakeland Industries, Versar Inc., and Alpha Pro Tech Ltd. When a company trades its entire float a few times in one day, it is a sure sign speculation is brewing. Since Oct. 7th, (eight trading days ago) all three of these companies have risen over 150%+ while the float was traded an exuberant amount of times.

Company Float Size
LakeLand Industries (LAKE) 4.2M
Versar (VSR) 8.04M
Alpha Pro Tech (APT) 14.77M

In the last eight days Lakeland Industries float has traded 30+ times and the 30-day average daily volume is now 4.86M shares or 120% of the float. The last example of a low-float momentum theme that is quite similar is Digital Ally, a manufacturer of police cameras. Digital Ally had a 2.24M share float and from Aug. 19th to Sept. 2nd (during the Ferguson fiasco) there was cumulative volume of 114 million shares or 51x the float in 11 trading days. The share price during the period went from $3.70 to $33.50 and is currently trading for $10.60 as of this writing.

chart-3
LAKELAND

The narrative at play seems to be Hazmat suits are needed for the Ebola epidemic, there are bagged shorts in these low-float names and there are concentrated hands holding back supply. The media frenzy does not help and the lack of education behind how the disease is spread (direct fluid contact versus airborne) also fuels the fire. LakeLand Industries put out a PR and the president and CEO Christopher J. Ryan explained:

“With the U.S. State Department alone putting out a bid for 160,000 suits, we encourage all protective apparel companies to increase their manufacturing capacity for sealed seam garments so that our industry can do its part in addressing this threat to global health.” 

And PCI Global VP went on to say…

“There’s a very short supply around the world.  We were able to procure these 276 suits through a medical supply company in California, so we bought them up as soon as we could.”  The suits that were procured and shipped were sealed seam garments manufactured by Lakeland Industries.”

So apparently there were only 276 suits available from Lake Land but 160,000 production volume is what is being construed by the market.

The company jumped from 40 million-market cap to 126 million because they sold 276 suits? Unlikely. What is more plausible, is the expectations changed and the market thinks Lake Land will sell 160,000 suits at 6% operating margin (with no CAPEX) using imaginary production capacity. The selling price would need to also be at the maximum of estimates ($10,000 a suit).

In 2014 FY Lake Land Industries had $93 million in sales, a negative operating margin and a loss of just under $4 million. In the last 10 years they have lost a total of about $4 million.

VERSAR 

Does Versar even have Ebola exposure or did speculators mess this one up?

When you word search Versar 10-Ks for “health”, “biological”, “ebola” or “disease”, nothing related is returned. Versar purchased a U.K subsidiary, Professional Protection Systems, ltd that services the nuclear industry. The 2014 sales of the company (bolstered by the Olympics says management) were $2.6 million and included in the Professional Services Segment (PSG). Versar grew $35 million in market cap in 3 days as a result. The argument is that Nuclear suits are a substitute product.

ALPHA PRO TECH

·      The Disposable Protective Apparel segment consists of a complete line of shoe covers, bouffant caps, coveralls, gowns, frocks and lab coats.

·      The Infection Control segment consists of a line of facemasks and eye shields.
These two segments DPA and IC, had combined revenue of $17 million in 2013. The two segments before taxes had earnings of $2.6 million. The company grew $70 million in market cap in the last five days.

chart-4

COMPETITORS 

These three companies also compete with Kimberly Clark, Cardinal Health, Dupont (Tyvek and Tychem) and 3M, among others. Why didn’t these companies jump 5%+ during the same period (they are all negative since Oct.7th) if they are the most likely beneficiaries of protective equipment sales? Because they do not have a low float and are not easily manipulated.

All of these competitors have much higher production capacity and if Hazmat suit supply was a serious issue we would witness production utilization kick up and suit prices adjust upward in the mean time. These competitors have the working capital to finance the growth of the production capacity and they have the ability to buy any of these speculative companies with less than one quarters income.

COMMON THEME
I won’t name any names but it is very likely that the same group that was behind pumping up Digital Ally is also behind the pump in these names. I am not here to condemn people for participating in low-float momentum stocks or for orchestrating the rise. What I am doing is shedding light on the fragility of these underlying narratives. Low-float momentum stocks (on the long-side) have 1 similar characteristic each time they run.

1.     It is about supply and demand, controlling a large portion of the float prior to the share price running. As controlling hands (or market makers) are aware of their influence they watch and test the supply/demand strategically through “nibbling” and level 2. (as shorts accumulate, covers are harder to find, increasing price volatility). Low floats are easier to control with fewer dollars, hence the role of supply and demand. Shorts end up trapped and a short squeeze commences. There is also a narrative underlying why the product will instantaneously be in very high demand, whether Ebola, police brutality or 3D printing overthrowing large batch manufacturing.

Pump-and-dump and low-float momentum stocks are interesting to study and remind me of 19th century Wall Street with Jay Gould, Jim Fisk, Daniel Drew and Cornelius Vanderbilt during the railroad mania days. What can be learned here is that price volatility in the short-run is a function of supply and demand of the float, while long-term value is created through return on invested capital exceeding the weighted average cost of capital. This is what Benjamin Graham meant when he proclaimed “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Ebola won’t disappear overnight and I do want to see the crisis solved as much as everyone else. What will disappear over night is half of the market capitalization of these companies. Which night is up to the market…

Further Reading: A very interesting case study on another pump and dump

Plugging into some Reality: Fair Value of PLUG is 50 cents (Citron)

Citron is out with a new report on Plug Power, a fuel cell company, calling it a cult stock, a dream stock (in dreamland with biotech and 3D printing) and a casino stock. Citron makes a compelling argument of why management is toxic and should not be trusted. Regardless of your conclusion the valuation is hardly justifiable and there can’t be to many seriously long-term oriented shareholders when in one day more than the entire outstanding float changes hands, twice. 

Isolating Incentives: Where Are The Carrots Aligned?

Incentives: There is much to be said about incentives and how they influence our individual and collective actions, for better or for worse. It was incentives that unfortunately helped cause the last recession, extravagantly compensating Moody’s credit analysts by quantity (piecework) of rated ABS, MBS and CDSs. Quality of work deteriorated and everything was quickly rated AAA even though it shouldn’t have. Without the credit rating agencies’ blessing, banks would not be able to sell the securities and pension funds unable to buy, suppressing a large portion of both demand and supply.

Real Estate Commission Example

A great example examining the influences of incentives is real estate agents. (There is provided below a quick three-minute video from “Freakonomics.”) Essentially, the real estate agents are influenced by quantity or “closing time” as opposed to looking out for the house seller or buyer, achieving the highest or lowest closing price regardless of closing time.

We can also all think about the typical example of the stock broker who has an incentive to turn our portfolio for commission, inducing us to trade/gamble our hard-earned savings. Fund managers have an incentive to hug the index to keep their job, continually collecting fees from AUM. Established (wealthy, schloarly or political) people are more risk averse, as they have a position to protect and plenty of options. People in poverty or that are not established have fewer options and thus are induced to be risk seeking. The list is endless.

A great quote by Steven Levitt from “Freakonomics” holds true now more then ever while the global bankers (BOJ, BOC, PBOC, FED, ECB, BOE) are holding the golden carrot, artificially creating demand for the lower end of the yield curve, systematically suppressing interest rates. This pushes investors all over the world to reach further up the risk curve for an equivalent return they may have earned otherwise. Historical risk adjusted returns (theoretically) suffer.

“An incentive is a bullet, a key: an often tiny object with astonishing power to change a situation.” – Steven Levitt

Warren Buffett (TradesPortfolio) and Charlie Munger have been advocates of understanding incentives, the biases they cause and have talked numerous times about incentives over the years. Thinking about the incentives involved in a typical situation is a form of inverting the situation, examining it from the other parties’ point of view. Usually, identifying incentives is a great way to avoid a toxic situation or to partake in an enriching one.

So Why, As an Investor Could This Be Beneficial?

Well think about management’s ownership and how this may benefit you. We have all heard the phrase “aligned incentives” but what does it mean? It means that the parties involved are striving towards a similar incentive or goal with reciprocity as the targeted outcome. These are the situations (as investors and business owners) we want to be involved in.

But take the incentives of a management team facing fraud allegations (think Enron’s Jeff Skilling), willing to fight until the bitter end. Not only is their job at stake, but personnel criminal charges are also a possibility.

Identifying where incentives are aligned can be difficult, but if or when a plausible scenario is identified where incentives are aligned in a positive manner, it is best to ride the wave, so to speak.

One personal example of my own that comes to mind is JPMorgan (JPM).

Jamie Dimon bought roughly $20 million worth of JPMorgan shares in the summer of 2012 after the London Whale loss. This instantly caught my attention because I knew it was a large loss (cut the stock 25%) and Dimon already owned a large portion of stock. With the $20 million purchase he was putting his money where his mouth was when he told the Street it was a one-off situation. From what I can recall from my research, he had a net worth of $200 million at the time, most in JPM common shares. The new purchase represented a 10% net worth bet on a horse that he would be jockeying.

The point is, I purchased 200 shares the next morning at $33 (it went to $30 or $31) doing absolutely no research other than on Jamie Dimon’s compensation and incentives, reading the 2011 annual report, and seeing JPMorgan was valued under B/V after a quick balance sheet examination. I sold the shares shortly after in the fall of 2012 for just shy of $40 or a 20% return in three months. The moral of the story: Ride the bigger fishes’ currents, it is a lot less work.

Stock options that are awarded can also be influential incentives behind the company’s performance (or GAAP-reported performance). Stock option induced incentives can create short-term thinking and a desire to achieve analysts’ estimates, sacrificing long-termshareholder value because the ones with the options have no skin in the game, hence one of the reasons Warren Buffett is not fond of (and does not issue) options but pays bonuses in cash on a pay-for-performance basis.

Executive Compensation 

The following is an excerpt from Buffett (TradesPortfolio) regarding executive compensation and identifying executive incentive structure, i.e. compensation.

Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay. The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.

Take, for instance, ten year, fixed-price options (and who wouldn’t?). If Fred Futile, CEO of Stagnant, Inc., receives a bundle of these – let’s say enough to give him an option on 1% of the company – his self-interest is clear: He should skip dividends entirely and instead use all of the company’s earnings to repurchase stock.

Let’s assume that under Fred’s leadership Stagnant lives up to its name. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $25.80. Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined by 20% during the ten-year period.

Fred can also get a splendid result for himself by paying no dividends and deploying the earnings he withholds from shareholders into a variety of disappointing projects and acquisitions. Even if these initiatives deliver a paltry 5% return, Fred will still make a bundle. Specifically – with Stagnant’s p/e ratio remaining unchanged at ten – Fred’s option will deliver him $63 million. Meanwhile, his shareholders will wonder what happened to the “alignment of interests” that was supposed to occur when Fred was issued options.

A “normal” dividend policy, of course – one-third of earnings paid out, for example – produces less extreme results but still can provide lush rewards for managers who achieve nothing.

CEOs understand this math and know that every dime paid out in dividends reduces the value of all outstanding options. I’ve never, however, seen this manager-owner conflict referenced in proxy materials that request approval of a fixed-priced option plan. Though CEOs invariably preach internally that capital comes at a cost, they somehow forget to tell shareholders that fixed-price options give them capital that is free.

It doesn’t have to be this way: It’s child’s play for a board to design options that give effect to the automatic build-up in value that occurs when earnings are retained. But – surprise, surprise – options of that kind are almost never issued. Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation “experts,” who are nevertheless encyclopedic about every management-friendly plan that exists. (“Whose bread I eat, his song I sing.”)

Getting fired can produce a particularly bountiful payday for a CEO. Indeed, he can “earn” more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets. Forget the old maxim about nothing succeeding like success: Today, in the executive suite, the all- too-prevalent rule is that nothing succeeds like failure.

Huge severance payments, lavish perks and outsized payments for ho-hum performance often occur because comp committees have become slaves to comparative data. The drill is simple: Three or so directors – not chosen by chance – are bombarded for a few hours before a board meeting with pay statistics that perpetually ratchet upwards. Additionally, the committee is told about new perks that other managers are receiving. In this manner, outlandish “goodies” are showered upon CEOs simply because of a corporate version of the argument we all used when children: “But, Mom, all the other kids have one.” When comp committees follow this “logic,” yesterday’s most egregious excess becomes today’s baseline.

Comp committees should adopt the attitude of Hank Greenberg, the Detroit slugger and a boyhood hero of mine. Hank’s son, Steve, at one time was a player’s agent. Representing an outfielder in negotiations with a major league club, Steve sounded out his dad about the size of the signing bonus he should ask for. Hank, a true pay-for-performance guy, got straight to the point, “What did he hit last year?” When Steve answered “.246,” Hank’s comeback was immediate: “Ask for a uniform.”

(Let me pause for a brief confession: In criticizing comp committee behavior, I don’t speak as a true insider. Though I have served as a director of twenty public companies, only one CEO has put me on his comp committee. Hmmmm . . .) 

Avoid Excessive Top-Heavy Compensation Structures 

As we can see, identifying outright ownership is an important variable to isolate as it directly aligns with our position, direct ownership through common shares. Stock options, hidden conflicts of interest (consulting fees, kicked to self owned subs or friends), salaries, bonuses and other “perks” can be examined with a search on the Internet and proxy statements (specifically DEF 14A).

If we find incentives are not aligned and compensation is abused at the expense of shareholders, it is time to flip the next rock and move on. If we find incentives are aligned it is time to dig deeper or buy a stake in the business. For the rest of 2014 and beyond let us all practice identifying incentives and inverting situations we face whether investing related or personal, proverbially standing in the shoes of others.

“I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. Never a year passes that I don’t get some surprise that pushes my limit a little farther.” – Charlie Munger

Transcendent Technology Or A Speculative Frenzy?

In recent reports from MarketsandMarkets and Transparency Market Research, authors claimed that the 3-D printing industry as a whole would be the beneficiary of 23% to 28% CAGR until 2020. That sounds fantastic with no additional information, but my Bayesian instincts kicked in after hearing a few additional pieces of information, the first being that the market in 2012 was an estimated $2.2 billion. Taking the highest estimate of 30% for the next seven years, one would arrive at a cumulative 3-D printing market value of $13.8 billion at the beginning of 2020. Although the market research report estimates a market of roughly $8.41 billion by 2021.Goldman and Credit Suisse took offense and published their reports claiming a total market of $10.8 billion by 2021 and that it is very disruptive technology.

The second piece of information I received was that Hewlett Packard (HPQ) as well as General Electric (GE) were both strategically interested in the technology and thought that it could be a big hit for their future businesses (HP has had 3-D printing in production for at least five years, and the technology was invented in 1984). Last time I checked, the industry behemoths are not the innovators and likely using it as a mass appeal strategy. Both have annual revenues of over $100 billion.

The third point is that Whitney Tilson is short ExOne, 3D Systems and VoxelJet. Whitney Tilsonhad the following to say about the 3D Systems, the largest short of the bunch.

Ya can’t make this stuff up! From a friend who met with the CEO of DDD (not some penny stock, but an $8 BILLION company): Avi told me during a 1×1 that “his company is 50% technology, 20% innovation and 30% awesomeness.”

What is the appropriate discount rate to apply to “awesomeness”?

Remember that line – it’s a classic; like Chuck Prince’s infamous: “As long as the music is playing, you’ve got to get up and dance.” The only surprise is that Elon Musk didn’t say it.

DDD is one of so many unbelievably great shorts out there right now. I haven’t written it up (yet), but Citron wrote an excellent report in February entitled, What do a Comb, an Egg Cup, and a Justin Bieber Vibrator Have in Common? The stock is a much better short today, as it’s up 26% since then but the fundamentals are deteriorating and the company lowered guidance in its last earnings report. But that hasn’t deterred the bulls, as it trades within a few percent of its all-time high, at 17.2x REVENUES, 64x trailing EBITDA, and 63x next year’s earnings estimates.”

3D Systems had 2012 sales of 353 million or roughly 16% of the 2012 market share, while Stratasys had $215 million in sales or roughly 10% market share. Now taking even the highest estimates of market value in 2021, the highest CAGR estimates, an assumption market share will not erode to larger and deeper pocketed competitors, we reach roughly $3.5 billion market share (in revenues for 2020) for the two companies mentioned above.

3D Systems and Stratasys have market capitalizations of $7.8 billion and $5.74 billion respectively, or a combined total of 13.54 billion. This equates to 4x estimated 2020 sales (using the ridiculous assumption above) or about 4.7x the 2013 market in its entirety. Yes, those two companies have 26% market share and are worth the [Credit Suisse] estimated 2021 market. I am not having a hallucination; the sum of the parts is being valued more than the projected market as a whole.

I was not around during the early 1900s but if I was, I am sure I would have a taste of nostalgia right now. The auto industry had over 1,800 manufactures in the U.S during the early 1900s, with only three remaining today, two of which have been nationalized at least once. Whitney Tilsoncompared 3D printing to the SegWay and how it was expected to be a breakthrough on the innovation front but was an embarrassing flop.

ExOne (XONE)’s Julian Mitchell said, “We see three key downside risks to consensus sales growth assumptions: (1) uptake of the core technology is liable to be constrained by lack of CAD penetration in Asia (where XONE has higher exposure than peers); (2) there is a need for significant post processing in metals (unlike competing technologies); (3) revenues are highly cyclical, given full exposure to industrial markets and minimal materials ‘tail’ following a system sale.”

Citron was a little more ruthless in their recent report about VoxelJet, calling it a F***ing joke.

Now to compare price to sales, price to earnings, PEG and EV/EBIT between a few 3D printing companies, you be the judge if valuation is fair (N/A means the company is losing money or lack of earnings). I am not recommending shorting any particular company but avoiding the sector as a whole.

Metrics SSYS VJET XONE DDD
Market Cap 5.74 Billion 588 Million 771 Million 7.8 Billion
P/S 11 45.9 22.9 13.7
P/E(TTM) N/A N/A N/A 109.5
PEG N/A N/A N/A 0.6
EV/EBITDA 161 287.62 343 68.7


Tilson I suspect is short 3D systems for liquidity and volatility reasons instead of VJET or XONE.

I could not recommend any of these companies to anyone and they should be avoided. When the party stops these inflated balloons will be the first to pop. When two companies (that have 26% market share) are valued at the entire estimated 2021 market you have a problem, a problem ofrisk seeking versus avoidance and risk that growth does not materialize. When companies are priced beyond perfection it is not my cup of tea. Margin depression, market share loss, lack of industry growth or financing drying up due to cyclicality could cause anyone of these companies to witness a 50% hair cut and still be richly priced.

3D Systems Corporation 10-Y History of P/S Ratio

Dec03 Dec04 Dec05 Dec06 Dec07 Dec08 Dec09 Dec10 Dec11 Dec12
1.18 2.38 2.03 2.05 2.04 1.27 2.26 4.62 3.17 7.26

3D Systems currently has a P/S ratio of 13.7.

We are seeing indications everywhere of a speculative frenzy within the industry. From the proposals of 3D printing ETFs, to short interest as an investment thesis, the sector is littered with folk who can not remember just five and 13 years ago. Ignorance of the past is a root of future imprudence.

The Great American (Ponzi) Scheme – Capital Intensive Businesses And Diminishing Returns

“A growth rate of that magnitude can only be maintained by a very small percentage of large businesses. Here’s a test: Examine the record of, say, the 200 highest earning companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years.” – Warren Buffett

(I will do this experiment after my finals and post an article to follow.)

Above was a small discussion from Warren Buffett in one of his annual letters to shareholders about the pitfalls of investing in yesterday’s winners. This article is based from the small excerpt from John Train’s“The Money Masters” under the first chapter on Warren Buffett, the final entry being “The Great American Jam Tomorrow Ponzi Scheme.”

Buffet explained in 1980 that a large portion of American enterprises are at risk and investors should stay clear of them, based on the massive investment that they will have to make. The cause of the large investments these companies must make is regulation, competition, rising labor costs, globalization, pursuit of productivity improvements, higher obsolescence rates than depreciation, etc.

Essentially, these companies need endless amounts of (net) new cash, and of course, this (net) new cash offers interest and dividend payments in the mean time to induce investors to continually partake in the illusory party. Dividends are continually increased to push equity prices higher then further secondary offers commence to pay for additional capex and dividend liabilities, diluting shareholders and ending in most cases with an eventual dividend cut. Other wise investors will continually stake money in mandatory rights offerings to continue to own the same percentage of the company. The chances investors ever actually see their (full) capital returned is slim, let alone with a satisfactory return, either due to dilution, bankruptcy, or take-overs below investors average costs.

Buffett described this process in a simple phrase, “Jam yesterday and jam tomorrow, but never jam today.” Companies that continually issue bonds or offer equity, while paying a dividend or are simply net users of cash (after honest depreciation plus competitive capex) and never actually provide net cash over long periods of time, could be classified as a Ponzi scheme. These companies have an obsolescence rate that is faster than their allowable depreciation, thus creating bottomless capex pits.

Buffett uses an example of Ford Motor Company (in 1980): “Ford doesn’t ordinarily pay enough dividends to give its own shareholders after taxes, the equivalent of 100,000 cars a year out of the 6-odd million that it makes. All that money, that huge plant, those many generations, and still the impact of higher costs, taxes and foreign competition mean that the owners can’t even claim 2% of the output.”

These companies need to retain earnings continually to pay for improvements and new plants, machinery, equipment, etc. Like most of us would know and agree, compounding capital or interest can work in the opposite direction, although asymmetrically (meaning a 50% loss must be made up by a 100% gain).

The key here is increasing your purchasing power in real terms, not absolute values. Buffett provided another three examples of capital-intensive businesses in “heavy” industries. The examples were AT&T, American Airlines and General Motors (ironically GM he now owns).

AT&T can be classified in the “ratchet up” dividend-equity offering strategy outlined above, coupled with large bond offering to finance capex, acquisitions and dividends. General Motors is a similar example to the Ford example provided; scroll up for a refresher.

In regard to American Airlines, Buffett mentioned it only turns its capital (including leased equipment and facilities) once a year. He said on that basis it would need to realize close to 20% pre-tax profit margins on sales in order to net 10% if financed by equity capital. This would put American Airlines at the time at the top of the industry for pre-tax profit margins. (It has gone bankrupt in the mean time and is planning to to exit after a recent federal judge approval).

Buffett when talking to an executive of a capital-intensive business (anonymous) asked, “Why don’t you buy back your own stock? If you like to buy new facilities at one hundred cents on the dollar, why not buy the ones you know best and were responsible for creating twenty-five cents on the dollar?” 

The executive responded, “We should.” 
Buffett: “Well?”
Executive: “That’s not what we’re here to do.”

He didn’t buy the stock.