How do you determine that the fundamentals of an investment have changed and it is time to move on regardless of whether or not you have lost money on the investment to date? That is a question we faced recently with one of our investments – ADDvantage Technology (AEY). We were given reason to believe that one of our criteria for investing was no longer present, causing us to re-assess the investment.
AEY distributes and services a comprehensive line of electronics and hardware for the cable television industry. We originally invested because AEY represented that rare circumstance of a micro-cap selling for less than net current asset value while still profitable and cash flow positive (at least 10 years running) with a solid balance sheet and shareholder-friendly management. The stock was down because the company’s relationship with Cisco (one of the suppliers it sells for) had recently changed for the worse and the overall industry was at a low point. We felt the former was more than priced into the stock and the latter would not last forever. Using conservative assumptions, we determined that the company was significantly undervalued. We felt confident that our valuation of more than double the then stock price would ultimately be realized even if took a number of years, which would result in a desirable annualized return.
I mentioned that the company is a micro-cap, which we define as a company with a market cap under $100M. More so than for larger companies, the management of micro-caps requires special attention and analysis because management has the influence and ability to significantly hurt shareholders by acting in their own interests. In a larger company, the efforts of management are more muted by the sheer size of the company. Further, large institutional investors are invested in larger companies and can help prevent management from seriously damaging shareholders. Conversely, micro-caps are almost the Wild West for investors because there really is no one outside of the company to look out for the interests of investors, so they must essentially rely on the goodwill and incentives of management.
We carefully analyzed AEY’s management and came away very impressed. Two brothers have owned 50% of the company for at least the last 13 years. They ran the business when we invested and their previous actions and words, as well as our personal discussion with management, indicated a very shareholder-friendly focus. Management had demonstrated a long-term focus, patience for the right prices, an unwillingness to overpay for anything, and an intelligent allocation of capital. We clearly did not need to worry about unnecessary acquisitions, over-leveraging, and dilutive issuance of new equity. Further, their compensation was reasonable, and there were no related party transactions that were disadvantageous to the company. As a result of management’s 50% ownership and long-term focus on maximizing shareholder returns, our interests were aligned, and we felt comfortable investing.
Sometime after our initial investment, the company announced some changes at the top. The brother who acted as CEO would step down (semi-retire) and would be replaced by a new CEO, an outsider with no previous affiliation with the company. The brothers we respected so much would still be heavily involved with the company, one of them remaining the company’s Chairman of the Board. We figured the brothers enjoyed their run and were ready to pass the day-to-day management duties to someone else. We felt comfortable that the brothers would still look out for shareholder interests. For that reason, despite not being big fans of hiring a CEO from outside the company, we believed our original thesis still held.
After about eight months on the job, the new CEO led the earnings call to discuss results for the quarter ending September of 2012. His comments in that call were very discouraging and are what caused us to re-assess our thesis. The call revealed that the company suddenly has a strong focus on finding another company to acquire to boost growth rather than return cash to shareholders via buybacks when the stock is so incredibly inexpensive. Shareholder-friendly management allocates capital with a focus on maximizing shareholder return, so when stock prices are this inexpensive compared to intrinsic value, there is a very low probability that an acquisition represents a better use of shareholder capital than buying back stock. When pressed on the matter during the call, management did not appear interested in entertaining the notion of buying back its own stock. They stated that, at the current stock price, an acquisition is a better use of shareholder funds. That statement alone is a major red flag because the stock is selling well below net current asset value, let alone net book value. If the stock at such a low price does not represent a great bargain in management’s view, then that makes me seriously question the validity of the balance sheet.
I think the bigger issue is the agency problem. Somehow the new CEO has influenced the brothers we trusted into thinking an acquisition is the best route to success. But what are the new CEO’s incentives? He previously worked for Koch Industries, a tech start-up, and a couple of venture capital funds. That experience seems to jar with the type of company AEY represents – a positive cash generator with a solid balance sheet but limited growth prospects. I cannot help but feel that he realized that AEY is a slow but reliable Volvo when he really wants a Lamborghini. It is common for a CEO to want to grow the company’s revenues via acquisitions regardless of whether or not it is accretive to profits just to boost his own image since the image of a CEO is often tied to the size of his or her company. This sort of behavior is referred to as the “institutional imperative” and something we try to avoid at all costs. Making matters worse is the fact that the new CEO hardly owns any stock in AEY, so it does not hurt him as much personally if revenues grow but profits do not.
Given the positive history demonstrated by the brothers who previously ran the company and are still ostensibly over-seeing its operations in their role as board members, we are surprised they are supporting this new direction set by the new CEO. Unfortunately, we no longer feel comfortable that management has shareholder interests foremost in their mind. As noted above, when dealing with micro-caps, you either must trust management to share your interests or must stay far away from the company. For that reason, we sold our position and are happy to move on to greener pastures.