Why Seemingly Undervalued Investment Cases Don't Pan Out: Reality vs. Theory
Illustrated with Delta Plus - FX, working capital, ROIC vs. ROIIC, and capital allocation
Dear reader,
As shared in our latest Q1 Letter:
This year, we’re planning to publish more in-depth reports into businesses we consider great case studies for quality growth investors. Additionally, we’ll also elaborate on examples of companies whose value creation turned south or didn’t materialize as expected, and why that was the case. There’s a lot to learn from failures during uncertain times, thereby improving our pattern recognition as to how we find stellar compounders. In the end, the question we should ask ourselves: what could break the thesis?
Delta Plus
In this article, we’ll shed light on a company that used to be in our investable universe following the COVID-19 pandemic and appeared to be undervalued: Delta Plus. It’s a French family-controlled small cap business, engaged in developing, manufacturing, and distributing personal protective equipment. It provides head protection products, including eyewear, skull, hearing, and respiratory protection products; and hand protection.
Over the past 10+ years, it’s compounded at a decent mid-teens percent CAGR, but recent performance has been notably volatile and with lower absolute returns, despite a seemingly attractive valuation, manageable debt level to pursue acquisitions, and a necessity-based business model (there’s a fairly high degree repeat purchases for protective equipment, underpinned by employment legislation).
Right now, the stock’s trading at about 9x projected FY25 NOPAT (market cap based). Assuming a bit of growth, the expected IRRs must be quite compelling, no?
Let’s now reflect on a couple of aspects that made the investment case and projected returns fall short of theoretically calculated return expectations.
To make this crystal clear, this article isn’t meant to generalize these concepts or say: “Don’t ever invest in companies whose working capital is strongly positive relative to sales.” Nor does the opposite guarantee success (e.g. extremely high ROIC companies carry little risk and you blindly buy them at any price). Typically, higher working capital business tend to enjoy stronger profitability, and thus have a natural cushion against extreme cash flow volatility.
The primary goal of this article is to make us wary of what could adversely impact our original thesis and modeling. Enhancing this pattern recognition should help us narrow down our investable universe, and it’s worthwhile doing this after quite a few years of volatility. Hence, we have 8 active positions in our portfolio today, while the total portfolio including 0% allocations (i.e. companies we cover, but don’t have a position in right now due to valuation concerns) is comprised of 11 names.
The items that merit a more detailed discussion, as it related to Delta Plus (and other companies:):
FX
Working capital
ROIC vs. ROIIC
Capital allocation and free cash flow
What do these factors have in common? They’re tied to growth, the uncertainty around modeling a company’s intrinsic value, and the framework of opportunity cost.
While investors should embrace some level of uncertainty (it’s part of the game and gives rise to the equity risk premium), the uncontrollable inability to model a company’s cash flow, ROIIC and capital allocation could permanently impair a stock’s valuation. The key thing to consider: everything has a bit of cyclicality, but we don’t like stuff that’s heavily cyclical.
Aside from analyzing these items for Delta Plus, we’ll also break them down for our portfolio.