Case Study: Michael Burry – Caterpillar Inc.

20) Michael Burry 18052016.jpg

By now, every investor worth his salt knows who’s Michael Burry. Made famous by a best selling book and a movie, he’s the guy who foresaw the GFC and profited very handsomely from it.

In the midst of doing so, he had to stare down investors who wanted to bail out after disagreeing with him, as well as multiple lawsuits. It sure takes guts and an iron-clad conviction to be able to do this.

This is the rarest of all traits, similar to what Ackman displayed in his successful shorting of MBIA before it collapsed. How does one stand firm, despite everyone saying something to the contrary, and stay firm for MANY YEARS at a stretch? Let’s not forget that no matter how you structure your shorts, there’s always a running cost to maintain a short position (Please let me know if there’s some way to short without having a running cost to do so), so time is not really on your side.

In this regard, when you have a short position, it’s not enough to be right. You gotta get the time frame approximately right too. You have to get both the investment thesis, AND the timing of the investment right. As they say, the markets can stay irrational than you can stay solvent.

Anyway, I was studying several of his investing theses. This was many years ago, before he became famous. Fortunately, he was active in investing forums and boards, and contributed many of his ideas then. I thought one such post that he made was very reflective of the thought process and decisions I personally face when evaluating an investing opportunity.

Below is what Burry wrote:

21) Caterpillar Inc Logo 18052016.png

Journal: August 3, 2000
•Buy 200 shares of Caterpillar (CAT) at the open.

“This cool Cat is one hot stock. Today, let’s go with two ideas, on the surface terribly divergent in character. The first is Catepillar (CAT), which is bouncing along lows. Whenever the stock of a company this significant starts to reel, I take notice. Everyone knows that domestic construction is slowing down. I don’t care.

Why? Let me explain. Let’s pose that a hypothetical company will grow 15% for 10 years and 5% for the remaining life of the company. If the cost of capital for the company in the long term is higher than 5%, then the life of the company is finite and a present “intrinsic value” of the company may be approximated.

But let’s say the cost of capital averages 9% a year. Starting with trailing one year earnings of $275, the sum present value of earnings over 10 years will be $3,731. If the cost of capital during the remainder of the company’s life stays at 9%, then the present value of the rest of the company’s earnings from 10 years until its demise is $12,324.

What should strike the intelligent investor is that 76.8% of the true intrinsic value of the company today is in the company’s earnings after 10 years from now. To look at it another way, just 5.7% of the company’s intrinsic value is represented by its earnings over the next three years. This of course implies that the company must continue to operate for a very long time, facing many obstacles as its industry matures.

Caterpillar can do this. Let’s take a cue from the latest conference call. When people in the know think of quality electric power for the internet, they think of Caterpillar. Huh? Yes, Caterpillar makes electricity generators that generate so called quality power. There are lots of uses for power that’s uninterruptible, continuous and free of noise, but some of the largest and fastest growing are in telecommunications and the Internet.

Caterpillar is the No.1 provider of this sort of power, and the market is growing explosively. In fact, Caterpillar’s quality power generator sales had been growing at 20% compounded over the last five years, but are up a whopping 75% in the first six months of 2000 alone. Caterpillar expects revenue from this aspect of its business to triple to $6 billion, or 20% of sales, within 4½ years. “This is our kind of game,” the company says.

General sentiment around Caterpillar is heavily influenced by the status of the domestic construction industry. But while domestic homebuilding is indeed stumbling, we’re talking about less than 10% of Caterpillar’s sales. Caterpillar is quite diverse, and many product lines and geographic areas are not peaking at all. In particular, the outlook for oil, gas, and mining products is bright. In fact, Caterpillar’s business peaked in late 1997/early 1998 and now appears to be on a road to recovery. The market has not digested this yet.

The balance sheet is also stronger than it appears. Caterpillar is another industrial cyclical with an internal finance company. I don’t count the financial services debt, as I explained in my Aug.1 journal entry. Hence, long term debt dives from $11 billion to $3 billion, and the long term debt/equity dives from 200% to just 55%.

The enterprise therefore goes for a rough 11 times free cash flow. Cash return on capital adjusted for the impact of the financial operations reaches above 15% over its past cycles, with return on equity averaging 27% over the last 10 years. Also, management is by nature conservative. Keep that in mind when evaluating its comments on the potential of the power generation business.

The main risk is that, in the short run, investors may take this Cat out back and shoot it if interest rates continue up. I’m buying 200 shares here along the lows.”

So how did this particular investment perform for Mr Burry?

22) Catepillar Inc share price 19052016

The chart says it all.

While I do not know exactly when he exited this position, it’s safe to say that this was a pretty successful investment, whichever way you look at it.

My Thoughts

Mr Burry was using the discounted cashflow (DCF) model to work out the amount of free cashflow he expects the business to generate throughout the life of the business. I worked out the figures based on what he wrote and they all roughly check out.

Ironically, the DCF data should actually discourage him from making the investment. 76.8% of the true intrinsic value of the company would only be generated after 10 years from the point when he did the analysis. Just 5.7% of the intrinsic value would be generated within 3 years at the time of his writing.

Of course, he subsequently substantiated why he made the investment by doing an analysis of the macro situation of the industry, CAT’s ability to thrive in the industry long term, as well as the current balance sheet of the company. The DCF data, although negative from the point of view of an analyst trying to determine whether to invest or not, was actually used by him to determine how long it takes for the company to earn back the present value of his investment, in future. He then concluded that it takes a pretty long time, but CAT is able to “continue to operate for a very long time, facing many obstacles as its industry matures”

This is what I personally face when evaluating potential investments. Another person running through this same data, may interpret the CF from the DCF model as highly unfavorable, and decline to invest. Afterall, if you’d imagine, the climate at that point of time was bearish on building equipment suppliers like CAT. Add the negativity from the DCF data, it is hard to imagine ignoring these facts and making the investment.

The difficulty is not in finding or analysing the data, but interpreting the data accurately and executing to benefit from this particular interpretation

I mentioned this in an earlier post about LTC Corporation (Part I and II). Most investments are not outright clear cut. I suppose if there is one such investment where all data and your analysis is favorable, that’d be a very strong conviction buy/sell.

In most instances though, some data is negative, whereas others is positive. The key question is how do we then decide that this negative data is not that negative, or this positive data is actually more positive than the market deems it to be. That’s the difficulty. When people talk about investing as being both an art and a science….. This aspect is surely the art part.

A true value investor, pays utmost attention to macro factors

Mr Burry is certainly a value investor. His influences are similar to WB’s, and he has cited WB on several occasions. Still, he develops his own style. For eg. he partially disagrees with WB’s buy and hold forever strategy.

In a different post, he said that WB has to do this simply because of the size of the capital he manages. He needs to find big opportunities that involve large capital investments. He needs to think in terms of many years, decades even. In WB’s initial years, his investments were considerably shorter term in nature, and he has even been an activist investor before despite his current criticisms of such hedge funds. By following him blindly, investors dealing with much smaller capital are losing a very important edge they’d otherwise have.

As one can see in his above analysis, Mr Burry does pay attention to the macro factors of the industry, and relates the company’s financials to the industry.

For cyclical companies, look at long term data. Think in decades, not years

Mr Burry analysed long term data. Not 3 yrs, not 5 yrs, but at least 10 yrs. For cyclical companies, looking at short to even mid term data runs the risk of looking at a picture through a pinhole – you just cant get a view of the whole picture.

No catalyst is needed if the company is strongly undervalued

As seen on the chart above, Mr Burry pretty much caught the bottom. Not long after his investment, the share price started rising strong. There wasn’t any particular stimulus to trigger the rise. Or rather, there could have been, but none of the stimulus would’ve been predictable at the point of the investment. In his words “Specific, known catalysts are not necessary. Sheer, outrageous value is enough.”

 

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