The Most Annoying Risk…

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People really like to complicate things. They worry about non-problems. They over-trade. They over-think. They ignore the obvious. I believe this investing game is actually quite simple—buy unusually cheap companies with strong macro-tailwinds and then don’t sell until something changes. It’s really that easy.

Unfortunately, I’m not the only one practicing this craft. While the stock market is populated by manic traders positioning for each data-point, swinging stock prices around wildly, Private Equity thinks differently. Compared to active public market investors, PE doesn’t care about the next CPI print. They don’t care about what Russia may or may not do with Ukraine. They don’t care about next quarter’s earnings. Most PE has a singular objective; buy cheap assets with lots of financial leverage at times when investors are ignoring those assets. Unfortunately, this often coincides with inflections in the value stocks that I target. I have literally lost track of how many times a PE firm has swooped in on one of my stocks, right before I think it takes off. I get a lousy 1-day bump to performance, and they likely get a multi-bagger, levered a few times on top of that.

Back in January of 2021, a PE firm stole Atlantic Power at 2.5x TTM FCF, right before North American power prices inflected. Those buyers made out like absolute bandits. At the time, I was livid, but didn’t know what to do about it.

Then in November, a PE firm tried to buy Lee Enterprises (LEE – USA) at $24. Today it closed at $28.83, but had rallied into the low $40s before the recent market sell-off. I believe this was an opportunistic offer, right as the digital business accelerated. Unlike with Atlantic Power, I decided that after years of being a victim of PE, I would stand up for once and defend my rights. Thus far, it appears to have been the correct move.

I bring this up because, once again, a PE firm has made an unsolicited bid on yet another portfolio position and a top-5 position at that. This time, it’s Cornerstone Building Brands (CNR – USA) where the PE firm is bidding roughly 3.5 times what I peg 2022 adjusted EBITDA to be (yeah, I think they can hit $900 million in adjusted EBITDA). Subtract about $300 million in maintenance cap-ex and interest expense, and why can’t CNR do $600m in pre-tax income? There’s no way on this earth I’d sell a growing business with better than a 30% ROIC for 5 times pre-tax income to equity. That’s ludicrous!! And it’s happening in a raging bull market for housing, with their commercial business now looking like it is inflecting. These PE guys are not dummies. They own 49% of it. They know the assets and they’re being greedy because the market was stupid about valuing CNR.

This article isn’t meant as a fight piece, I’m going to sell into the bid. Instead, I want to talk about one of the most annoying, underappreciated and serious risks of being a minority investor in deeply undervalued securities—PE theft.

You see, I tend to be a bit early. I try to purchase deeply discounted companies that the market is ignoring. As a result, in that moment before inflection, my companies are sitting ducks to PE—often when they are substantial owners with increased access to insiders who know that their businesses are undervalued and about to inflect. Sure, I get a quick uptick to my performance number on the day the deal is announced, but I’ve tied up capital hoping for a multi-bagger, not a quick pop. I believe my capital is too valuable to just sit there and then get abused—especially as I run a concentrated fund. I believe it’s the larger winners that create out-performance, covering up for mistakes. A 50% pop is effectively dilutive to my strategy.

When I think of all the risks to an investment, PE take-overs are the concern that never gets enough attention. Too often, hedge funds are happy with the quick bump to returns, institutions do whatever ISS says and ETFs don’t even realize they own it. Meanwhile, I believe my returns suffer.

I wish there was something more that could be done. I’m not in the mood to go fight every fight, but this tends to happen to me a few times a year. I’m positively sick of selling what I think are rapidly inflecting companies at low-single digit multiples and letting some PE fund pick my pockets.

When I think of the playing field, as my fund gets larger, it is almost inevitable that I become a bit less nimble. I hope to make up for that by having the heft to fight more of these PE funds.

Disclosure: Funds that I control are long shares of CNR & LEE and have various CNR option positions.

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