KeyStone’s Stock Talk Show Episode 270.
Great to chat with you again – I will start this week with a look at Moats and how they apply to investing and if they are a good data point to use when investing in small-cap stocks. In our YSOT segment, Aaron revisits a viewer question on Exro Technologies Inc. (EXRO:TSX), clean technology company that has developed new-generation power control electronics. When he last reviewed the small-cap, Aaron recommended avoiding the company and we presented another profitable electrical-related stock, Hammond Power (HPS.A:TSX) as a better alternative. We will let you know how both performed over that period. Brennan reviews a small segment from our recent Live Webinars on How to Find the Next 10x Stock – answering the question “when one should take profits on a stock. Finally, Brett takes a viewer question on Ballard Power Systems (BLDP:TSX), a developer and manufacturer of Proton Exchange Membrane or PEM fuel cells, a type of hydrogen fuel cell. For decades, Ballard has held promising technology, but the lack of profitability has produced dismal long-term returns for shareholders – Brett let’s you know the company’s current financial picture.
Let’s get to the show – my cohost, Mr. Aaron Dunn – and the killer B’s, Brett & Brennan.
Poll Question.
One of the core areas of our research is profitable, growing small-cap stocks. We just completed a Webinar on how and where to find 10x stocks – or essentially great long-term growth stocks. The data tells you that profitable micro-caps stocks are a fertile ground for identifyng potential 10x stocks. In the Webinar we included 10 traits we look for in a potential 10x stock. One questions we get, seemingly more and more often these days surrounds the ideal of a MOAT – which is one thing we look for, but cannot always define with confidence, particularly in the small-cap arena. So today, I thought I would give you a brief definition of what Moats are in terms of investing and if they apply well to identifying great long-term small-cap growth stocks.
What is a “Moat” or “Key Advantage”
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- In finance, we love using both or sports and military relative terms to describe what we think are “like” economic terms so the analogy relates to the moats that would surround medieval castles and act as a barrier of protection. Put differently..
- An “economic moat” describes an advantage that is difficult to copy or emulate giving a business the ability to maintain a competitive edge over its competitors.
- The term was made popular by Warren Buffett, who described how seeking such businesses is a fundamental tenet of his investing strategy.
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
– Warren Buffett.
Of course, not everyone believes economic moats are the bees knees for a company or in the investing world.
Elon Musk for example, so eloquently stated, and I quote…
“I think moats are lame…If your only defense against invading armies is a moat, you will not last long. What matters is the pace of innovation–that is the fundamental determinant of competitiveness.”
Both have points and I also think that both are not mutual exclusive.
I would not think for one minute that Buffett believes that once a company achieves some sort of economic Moat (hard or soft) – they can just rest on said Moat and forever milk the profits. He believes in innovation – in investing, nothing is a straight line – arguments are not black and white and the goalposts are always changing. I believe Buffet understands that to sustain a Moat, innovation is critical. Therefore, you can both want to find businesses to invest in with Moats and also require them to innovate to sustain that Moat.
But, for Musk, a nuanced agreement, while likely more correct, does not make for a good quip or tweet – such as that Moats are lame.
Five basic Economic Moats.
- Network effect.
A network effect is present when the value of a product or service grows as its user base expands. Each additional customer increases the product’s or service’s value exponentially.
. For example, the more consumers who use Visa V credit cards, the more attractive that payment network becomes for merchants, which in turn makes it more attractive for consumers, and so on.
- Intangible assets.
Though not always easy to quantify, intangible assets may include brand recognition, patents, and regulatory licenses. They may prevent competitors from duplicating products or allow a company to charge premium pricing.
Walt Disney is a good example of a company that has built a moat based on the intangible asset of brand. In fact, strong brands support robust and sustainable economic profits at both of Walt Disney’s key businesses. Starbux is another.
In terms of Patents – drug companies with long-term protected exclusivity are a good example.
3. Cost advantage.
Companies that are able to produce products or services at lower costs than competitors are often able to sell at the same price as competition and gather excess profit, or have the option to undercut competition.
If you can make it for less, you can sell it for less – the can apply to manufacturing or other industries. Buffett, when thinking of low-cost production moats, uses GEICO (a Berkshire Hathaway acquisition) as an example. GEICO is considered a low cost insurance provider – it has been essential to their competitive advantage.
- Switching costs.
Switching costs give a company pricing power by locking customers into its unique ecosystem. Beyond the expense of moving, they can also be measured by the effort, time, and psychological toll of switching to a competitor.
Consider Intuit Inc. (INTU), which offers its customers various bookkeeping software solutions. Because learning to use Intuit’s applications takes significant time, effort, and training costs, few users are willing to switch away from Intuit. Similar, if not even better examples are Adobe and Autodesk Inc.’s AutoCAD – Computer-Aided Design software application for 2D and 3D design and drafting – very hard to change once your entire staff has been on the program for years.
- Efficient scale.
This moat applies – In a market limited in size, potential new competitors have little incentive to enter because doing so would lower the industry’s returns below the cost of capital.
Moats built on efficient scale apply to a small number of businesses, like a large freight rail operators. They also apply to companies that enjoy monopolies on public utilities, like electricity.
There are also “Soft Moats”
Some of the reasons a company might have an economic moat are more difficult to identify. For example, soft moats may be created by exceptional management or a unique corporate culture. While difficult to describe, a unique leadership and corporate environment may partially contribute to a corporation’s prolonged economic success.
In terms of small-caps – we find a true economic moat, at the micro-cap level is more difficult to define with certainty as the businesses are by definition, starting small – other than holding an Intangible assets such as a patent – it can be far more difficult to define a true Moat at the small-cap level.
- A Moat initially, at this level is often based on opinion rather than data and Moats are therefore as a singular thesis for investing in a small-cap are often fraught with perril –. Yes, Microsoft has a definable moat, but it is the largest company in the world. Today, Boyd, due to its size, can be said to have somewhat of an economic moat that allows it to have greater purchasing power and reduce costs with with over 950 plus locations, but one could not say that when we originally recommended it with around 37 locations – it could only be a prediction or guess at that stage with a high degree of risk. What I am saying is, Boyd did not have a easily definable MOAT if any, I argue, when we originally recommended it.
A moat is great to have, but harder to define with any degree of certainty in most cases with smaller companies. .
$46-$47 in June 2023 – today $131.
WHEN TO TAKE PROFIT
So when should one take profit?…. And this is a question that we get all the time from clients, and as you can see, just a couple of weeks ago I received this email from a client asking when he should take profit as he was up over 100% on one of the stocks we have under coverage. And unfortunately, I said to this client, the answer isn’t as straight forward as most would like and needs to be taken on a case-by-case basis for each stock which you own and ultimately depends on the underlying financials of the business. And we went through some examples together over the phone so he could understand what I was meaning. So, in this section I will touch on the issue of how to hold a great stock long term and will run through a case study example from our past coverage so you can understand when you should either take some profit on a stock, hold, cut your losses, or potentially buy more.
So before we jump into the case study I have, I am just going to show the framework which we will be assessing each example on. Like I already mentioned, we need to look at the decision from the perspective of why the stock went up or down, and how the business fundamentally looks today. This includes “Why did the stock go up or down?” and is the move justified? 🡪 was it driven by good financial results, some kind of news, Macroeconomic factors, or simply sentiment driven? We need to look at “What type of business we are dealing with” 🡪 is it a stable growth stock, contract driven, commodity based, Cyclical, or Defensive…. IF the stock is a contract driven, cyclical, or commodity-based business trading with elevated valuation multiples, we would typically be more prone to taking profit if the stock is up given these businesses have more volatility in their financial results. And last here, “what are the valuations looking like relative to its growth outlook” 🡪 is it fair-value, undervalued, or overvalued.
Now the case study is on Photon Control (PHO:TSX), a manufacturer of optical sensors and systems to measure temperature and position for semiconductor manufacturers – which tends to be quite a cyclical industry. We originally recommended the stock in 2014 at $0.46 per share, because the business had strong backlog over the previous year (so we anticipated growth) and it traded at just 8x earnings.
Then in 2018, while the stock traded at $2.40, up 420% since our initial recommendation, we reassessed the business and decided it was diligent to take profit given the volatility of the cyclical semiconductor sector along with a heightened valuation at 24x earnings.
And we basically repeated this process from 2020 to 2021, re-recommending the stock at $0.88 as the business’ backlog grew substantially, indicating there was a growth path ahead of it. And based on our earnings estimate it was trading with a forward P/E multiple of 8x. And finally advising clients to take some profit in the $2.70 range while growth was slowing, and the valuation again became elevated. And just a few weeks later, the stock was bought out at a large premium at $3.60 per share by MKS Instruments.
So again, to go over our framework, the reason for the share price move was due to a surge in backlog and EPS growth – so it was certainly justified – but again earnings are quite volatile with this cyclical contract driven business which made us more prone to take profit when it traded with elevated valuation multiples.
Now if a stock goes down, you can do the same process which I followed here. Look at the business from a fundamental perspective, understand what kind of business it is, why the stock has gone down, and determine whether you should cut your loss and move onto a better opportunity or if the investment thesis remains in-tact.
Now in the webinar that we recently did that can still be purchased on our website, we go over another example from a stock that is currently under coverage and despite the stock running over 100%, we would actually continue to buy more rather than take profit given the increase in its earnings, it’s a relatively stable business, and now reasonable valuation in relation to its growth path…
YSOT Ballard Power Systems
1)
Ballard Power Systems symbol BLDP on the TSX and NASDAQ is a developer and manufacturer of Proton Exchange Membrane or PEM fuel cells, a type of hydrogen fuel cell. The company is targeting the medium and heavy-duty mobile market from buses to trains as well as stationary power applications.
2)
The stock trades at US$1.70, down 53% year to date, at a market cap of $510 million.
3)
Zooming out further, the stock is down 68% over the past year, but even worse if you bought at the 2021 peak you are down over 95%. Not great, so what has driven this decline and does the financials and operations give any hope of recovery?
4)
-Looking at a 10-year high-level view of the income statement.
We can see a stagnation in revenue after 2017, in that $100 million range. But further, we’ve seen a decline into a gross loss. This means every unit sold produces additional losses at the current cost and price combination.
Further, the company has never been operationally profitable on an annual basis and is not profitable in any sense for net income.
5)
This means over time when you do see consistent losses the operation needs to be funded by existing cash and then raising capital through debt or equity issuance. Ballard has gone down the equity issuance route, having outstanding shares increased by 126% over the past decade. This is even with the company taking advantage of the euphoric share price in late 2020, or early 2021. In the graph I have up you can see that besides when shares are issued the cash balance consistently falls as the company has been fueling itself not with hydrogen sales but share issuance. The cash balance currently sits at $678 million, higher than the company’s current market cap.
6)
Leading us to Q2 2024 results, the last quarter,
The company had a $16 million market cap, a negative gross margin of 32%, and a net loss of $31.5 million or $0.11 per share. The company’s 12-month backlog fell quarter over quarter to $169.5 million, also I will note that the actual revenue for the last 12 months was lower than the backlog implied this time last year, at a revenue conversion rate of roughly 71%.
The company does provide expense guidance which it updated to total operating expenses of $145 million to $165 million and a lower CapEx of $25 to $40 million.
7)
Last week, September 12th, the company announced a restructuring of the business.
- The CFO and COO are being replaced by the end of 2024.
- A plan to reduce total operating expenses by 30% in 2025 with the reason being to align with delayed market adoption.
- As a part of this plan, the company is conducting a strategic review of its Chinese Joint venture WeiChai Ballard which it has a 49% stake in.
Effectively the goal of the strategic shift is to extend out the company’s cash, hoping for hydrogen infrastructure and fuel fuel cell demand to increase.
8)
So put together the company’s operations have not been and in the current state of hydrogen infrastructure and fuel cell market is not financially viable. The company does have the ability to lean on its cash balance for 4 to 5 years at the current rate of burn, likely longer if they are able to temper losses in the coming years post-restructuring. But that brings me back to why they have the cash in the first place it wasn’t due to previous profitability or successful ventures it was share issuance at absurd valuations and unrealistic expectations.
Sure there is a chance at a turnaround given the cash balance but I wouldn’t count on it given the at this time over a decade-long streak of financial weakness, with a backdrop of weakening hydrogen demand.
So as far as investing in the company I would stay away as it is not an operationally successful company and does not have a strong path to becoming one at this time.
