Lowell Capital Value Partners’ commentary for the month of March 2024.
Dear Partners,
Lowell Capital Value Partners, L.P. (the “Partnership”) was +3.0% in February 2024 vs. +5.3% for the S&P 500 with dividends reinvested (all returns shown are net to investors). For 2024 year-to-date, the Partnership was +3.1% vs. +7.1% for the S&P 500 with dividends reinvested. As of February 29, 2024, the Partnership had 20 long positions (representing about 73% of total capital) and 9 short positions (representing 3% of total capital). The Partnership had no leverage and a 30% cash position giving our portfolio a net long position of about 70%.
We have slightly increased our long position in recent months as inflation has moderated but remains elevated. We continue to expect the Fed to maintain higher interest rates to ensure inflation is brought under control. While recent inflation reports have been improved, Fed comments indicate current conditions will likely be maintained until inflation is further reduced from recent levels.
Our focus is on increasing the capital accounts in the Partnership in a conservative and prudent manner by taking what we think are intelligent risks. We seek to carefully allocate our capital into investment opportunities where we believe we have an advantage and where we think the risk-reward ratio is asymmetrically in favor of the Partnership.
Our investment results have been achieved with an average net cash position of close to 30%. The Partnership has avoided the use of leverage and, on the contrary, maintained a significant net cash position, and we believe this has reduced the risk to its capital.
Our area of focus, small-cap value, has been out of favor in recent years but could see increased interest as higher interest rates shift investors’ focus to value companies with profits and free cash flows. We have an approach of investing in underfollowed or misunderstood companies that generate strong cash flows, and we think are undervalued. We believe our holdings remain significantly undervalued and will eventually be recognized. We plan to continue our approach which has worked well over many years and with which we are comfortable.
Stock Market, Economy, and Peter Lynch
Over the past few years, both economies and stock markets globally have dealt with high inflation, supply chain issues, the war in Ukraine, and a volatile political environment. These and other factors combined to create a more difficult environment for businesses and investors. Interest rates in the U.S. have moved up to significantly higher levels. The economic impact of these higher interest rates may not be fully felt until six to twelve months after they occur. Our approach has been to continue to hold our highest conviction investment ideas which are best positioned to deal with the current environment while reducing exposure to business models which could encounter challenges in this difficult environment. So far, our investments and their business models have held up relatively well in the current economy.
We believe the market continues to shift towards companies with solid earnings and cash flows on a current basis as interest rates have moved up and money is no longer “free”. These types of companies are our area of focus. Our primary focus is on long-term preservation of capital and conservative growth of capital. We believe our current investments remain significantly undervalued based on their cash generation and long-term growth prospects and will opportunistically adjust our exposure going forward.
A major positive has been that the U.S. economy still seems strong, and our investment companies are still performing pretty well which makes us optimistic. There is always a risk of a recession but does not look like there will be one this year. While the stock market has moved up, we remain cautiously optimistic due to our focus on specific investment opportunities we have uncovered, as well as the performance to date of our portfolio companies. We reiterate once again — there are 8,000 publicly traded companies in North America, and we are just trying to find a handful that work for us. We believe the market is still shifting towards value companies with “real” earnings and cash flows – this should work in the Partnership’s favor.
Peter Lynch is the legendary former manager of the Magellan Fund at Fidelity. Lynch invested in growth companies at value multiples, and he would hold investment positions often for very long periods of time. Lynch grew Fidelity Magellan from $20 million to $14 billion over 13 years. Under his 13-year management, Magellan earned annualized returns of 29.2%, consistently more than doubling the S&P 500’s performance. Many fund managers look to trim or sell their winning stocks while adding to their losing positions. Lynch famously said that: “selling your winners and holding your losers is like cutting the flowers and watering the weeds.” Lynch’s investment strategy included investing in stocks of companies that he was familiar with and then evaluating their business models, competitive landscapes, growth potential, and more before investing. He also stressed that undervalued stocks with great growth potential could yield large returns. For Lynch, the most important rule when investing is knowing and understanding the company that you own. Lynch famously said, “know what you own, and why you own it.” In 1997, Lynch said in a speech, “if you can’t explain to an 11-year-old in two minutes why you own a stock, then you shouldn’t own it.” Lynch emphasized the importance of understanding the business behind the share price, as it is the performance of the business that drives the share price performance over the long term.
Like Lynch, we stay focused on companies we understand by utilizing our due diligence process which includes making sure we know the company’s fundamentals, the “competitive moat” of the company, its growth path, its balance sheet, and we often have detailed conversations with the management team. We’re just looking for a handful of those that have a good growth path. Ultimately, we are looking to buy growth companies at value prices. We want companies that we can hold for several years that can grow for long periods of time. We believe that we only need a few of these companies to drive our results.
Most investors in the stock market have little idea what they own. Even someone who owns the S&P index doesn’t really know what is in the S&P 500. A lot of the S&P 500 includes the “Magnificent Seven” which are the large tech companies that currently trade at high valuations. Our strategy is to put our money into companies we’ve done a lot of research on, specifically undiscovered companies that people aren’t paying attention to. We then do a lot of work to figure out what that company is worth. We are not looking at the daily news feed on politics or the day-to-day noise or macro numbers, rather we’re looking underneath at the underlying growth path of our companies over the next several years. We are depending on that growth to drive the value of those companies up if their earnings and cash flows increase. That is like Berkshire Hathaway’s approach. We’re trying to pay modest prices and buy at large discounts to our estimate of fair value. We select and regularly monitor all these investments very carefully. Our objective is to create a “mini-Berkshire Hathaway” by taking a Buffett approach to small cap stocks. We’ve done a lot of work, and we think long term these are good businesses, each of which has a “competitive moat” that allows them to grow in a competitive, capitalist economy over multiple years.
Regarding our specific investments, key fundamental facts are often known and understood by only a handful of investors and analysts, not by the general market. This is because these companies are not followed closely by analysts and Wall Street in general. The stock market often will not react to this information until it is clearly reflected in improved earnings and cash flows at the underlying companies. There is an opportunity to identify important and impactful facts and, thereby, anticipate stronger future results for these businesses. We follow Lynch’s advice and seek to always “know what we own and why we own it” with a heavy focus on fundamental investing.
We have increasingly focused on investments in “growth companies at value prices”, with strong “economic moats” around their business models. These investments have performed much better for us than businesses which are undervalued but do not have strong long-term growth paths. Essential to these growth companies is a strong “economic moat”, or some good or service that competitors cannot easily replicate or provide. A strong “economic moat” can enable a company to grow and compound capital for many years into the future. It is the economic moat that protects the company’s revenues, and profits, and cash flows, and enables the company to grow to a large size despite operating in a hyper-competitive capitalist world.
There are almost 8,000 publicly traded companies in North America. We are looking for just a few that work for us and meet our strict criteria. If we can find a few growth companies at value prices with strong economic moats each year, we believe the Partnership can do quite well. Our goal is to hold these growth businesses as long as reasonably possible since these characteristics can lead to growth paths far higher than might be apparent at first investment. Therefore, we believe that “it is a market of stocks, and not a stock market” and that is a key component of our differentiated investing strategy. We just need a few mispriced equities each year to drive strong investment results.
We are focused on companies that generate large amounts of sustainable free cash flow and, in addition, have strong long-term growth characteristics. These companies have some niche or business moat that enables them to sustainably grow their revenues, profits, and cash flows over many years. We try to carefully evaluate these businesses and their management teams and what exactly their economic moat might be. We believe we can carefully allocate capital into a handful of these growth investments each year and hold them for many years to compound the Partnership’s capital.
Good Businesses with Low Expectations
We are focused on investing in good businesses with low expectations (i.e., low valuations). For us, a “good” business is one that earns high returns on invested capital or where you don’t spend a lot of money to make a lot of money. We look at businesses where the total investment in tangible assets to run the business (i.e., net working capital plus the book value of property, plant, and equipment) are modest relative to the sustainable operating earnings or free cash flows. These businesses are not capital- intensive. Businesses with high returns on invested capital tend to be strong generators of free cash flow. These are businesses that we like very much.
In terms of low expectations, our investments generally have low valuations, and this helps reduce risk. The market does not expect much from the business in the future or is worried about current earnings or free cash flow sharply declining. These may also be situations where a business is simply misunderstood or undiscovered. Our general experience is that if the business can exceed these low expectations or generate results that are less bad than expected, the stock price is likely to increase. Also, if expectations are low, when results are disappointing, the stock is likely to decline less than otherwise. We spend a lot of time studying these types of companies to try to get comfortable that their prospects are better than the market believes. Often specific businesses or industries get painted with a broad brush and their valuations are driven down to what we find to be attractive levels. We think our focus on these out-of-favor companies and industries create an opportunity to earn better risk-adjusted returns than the general market.
Focus on Smaller Companies
We focus on smaller companies, searching for “low-risk, high-return” opportunities. We believe a few good ideas can drive the Partnership’s results. We believe the Partnership can generally achieve better risk-adjusted returns by uncovering a few small “gems” versus focusing on larger companies or macro issues which are much more widely covered. Our focus on smaller, less-followed companies represents a sustainable competitive advantage for the Partnership relative to larger investment funds that must focus on much larger companies. Our empirical investment experience validates this belief, as our most successful investment positions have consistently been smaller companies.
We are specifically looking for small companies that may appear risky on the surface but are less risky due to characteristics such as: (a) cash-rich, “Ft. Knox” type balance sheets, (b) consistent free cash flows; (c) unique niches or business models; (d) very low valuations with minimal expectations imbedded in the stock price; (e) excellent long-term growth prospects; and (f) honest and intelligent management teams that are highly focused on driving shareholder value. Most small companies do not possess any of these characteristics. We focus most of our attention on a handful of companies that we believe possess almost all these characteristics.
Top Long and Short Positions
Our top long positions, as of February 29, 2024, were as follows:
- Celestica (NYSE:CLS)
- Sprouts Farmers Market (NASDAQ:SFM)
- Academy Sports & Outdoors (NASDAQ:ASO)
- Duratec (ASX:DUR)
- AstroNova (NASDAQ:ALOT)
- Belvoir Group plc (LON:BLVN)
- Sterling Infrastructure (NASDAQ:STRL)
- Hollywood Bowl Group plc (LON:BOWL)
- LSI Industries (NASDAQ:LYTS)
- Brady Corporation (NYSE:BRC)
We believe our long positions have strong competitive niches, large and sustainable free cash flow yields, low-risk balance sheets, recession earnings capability, shareholder-oriented management teams, and attractive risk-reward characteristics as investments. You will find that most of these companies are not household names and that is exactly as we intended. We are seeking to maximize our competitive advantage by investing in under-followed companies where we may have a greater opportunity to understand the company and the investment better than other investors.
Position Sizes
The Partnership’s investments are diversified across a wide range of businesses. Our goal is generally to have core position sizes in the 3% to 6% of total capital range and limit our exposure to any one specific investment to approximately 10% of capital or less. We think this helps limit our downside exposure to any one investment position while retaining substantial upside for those investment positions that work out as expected. Our investment positions are also diversified across several different industries.
Northern Exposure
We continue to seek out what we believe are attractive values for good businesses in Canada, our neighbor to the north. Canada has a population of about 35m or about 10% of the U.S. and we believe its economy remains in reasonable shape. Canada’s debt to GDP is currently well below U.S. levels. Canadian banks avoided much of the real estate problems of 2008-9 in the U.S. by maintaining more disciplined underwriting standards in making real estate loans. Canada is a natural resource-oriented economy with substantial oil and gas reserves. We will continue to carefully monitor the impact of oil price changes upon the Canadian economy.
Recent Investments
Our optimism regarding the future of the Partnership relates directly to our specific investment positions, which we believe are significantly mispriced relative to their intrinsic values. Certain of these are detailed below:
LSI Industries, Inc. (LYTS)
LYTS Industries (LYTS) provides corporate visual image solutions in the Unites States, Canada, Australia, and Latin America. It operates via two segments – Lighting and Graphic. The Lighting segment manufactures and markets outdoor and indoor lighting and lighting controls for the commercial, industrial, and multi-site retail markets, including the petroleum/convenience store, quick-service, and automotive markets. It primarily offers exterior area, interior, canopy, and landscape lighting, as well as light poles and photometric layouts; lighting system services; and solid-state LED solutions. This segment also designs, engineers, and manufactures electronic circuit boards, assemblies, and sub-assemblies for the manufacturing of LED light fixtures. The Graphics segment manufactures and sells exterior and interior visual image elements used in graphics displays and visual image programs in various markets that include petroleum/convenience store market, quick-service restaurants, grocery, and multi-site retail operations. Its products comprise signage and canopy graphics, pup dispenser graphics, building fascia graphics, video boards, menu boards, and digital signage and media content management products. This segment also provides installation management services for the installation of interior or exterior products. LSI Industries, Inc. was founded in 1976 and is headquartered in Cincinnati, Ohio.
LYTS has several characteristics that we like including (1) highly resilient business model with deep customer relationships, (2) a highly cash-generative business with low capital expenditure needs, (3) a strong focus on higher value-added services with longer-term and “stickier” customer relationships, (4) an attractive valuation trading at 8x adjusted EBITDA and a high single-digit free cash flow yield, (5) a focus on end-markets that are sustainably growing over the long term, (6) a record of strong sales growth – both organic and inorganic, over several years, (7) a disciplined management team focused on driving organic growth via new products and solutions that are highly engineered as well as accretive acquisitions, (8) a “Ft. Knox” balance sheet with net debt at under 1x adjusted EBITDA, (9) a long-term strategy to grow sales and EBITDA, and (10) a high-ROIC business model with limited capital requirements.
Over the past 5 years, under CEO Jim Clark, who joined LYTS in November 2018, the Company has shifted its business model away from commodity, “off-the-shelf” products and solutions to higher value-added products and relationships with customers with higher margins and longer contract periods. LYTS has focused on highly engineered and designed solutions to deeply integrate into its customers. LYTS also focused on specific market verticals and industrials with strong long-term growth potential. LYTS eliminated lower-margin work and removed revenue contracts with lower-margin profiles.
Two primary drivers of LYTS’ improved growth and financial results have been more highly engineered products and solutions and a vertical market focus, as summarized below. LYTS solutions for its vertical markets represent higher value-added and stickier and longer-term relationships with customers. LYTS has carefully selected vertical markets that are growing and resilient and where its products and solutions can add significant and differentiated value for its customers. These include Refueling & C-Store, QSR, Retail & Grocery, Automotive, Warehouse, Parking, and other vertical markets. LYTS will often develop a highly customized solution for one customer in a specific vertical and then leverage it across the entire industry with other customers.
LYTS has an attractive valuation, especially given its recent growth profile, driven by its vertical market and value-added solutions strategy. From FY20 to FY23, LYTS grew revenues at an 18% CAGR and adjusted EBITDA at a 48% CAGR and adjusted EPS at an 88% CAGR. LYTS has 30m shares outstanding trading at about $14 per share for a market cap of about $420m. LYTS has a net debt of $21m at 9/30/23 which will soon be zero. LYTS will have an enterprise value in FY24 of about $420m (zero net debt assumed) versus LTM adjusted EBITDA of about $53m or about 8x LTM adjusted EBITDA. Further, LYTS earned adjusted EPS of about $1 per share in FY23 which compares to its current price of about $14 per share or about 14x.
We believe these multiples are modest and remain extremely attractive given LYTS’ strong growth in revenue, adjusted EBITDA, and adjusted EPS over the past 5 years under CEO Jim Clark and his team. We believe the market has not recognized LYTS’ resilient and cash-generative business model and “stickier” customer relationships. As LYTS continues to execute and grow organically and inorganically, we believe the market will eventually reward LYTS with higher earnings multiples.
We believe LYTS can continue its strong growth trend over the last few years in revenues, adjusted EBITDA, and adjusted EPS. LYTS originally projected to achieve revenues of $500m and adjusted EBITDA of $50m by FY25 and achieved these results two years early in FY23. CEO Jim Clark and his team, rather than resting on their laurels, quickly produced an updated 5-year plan that targets revenues of $800m and adjusted EBITDA of $100m, for a 12% adjusted EBITDA margin, by FY28. CEO Clark and his team expect to achieve approximately half of this growth organically and half from strategic, tuck-in acquisitions. We believe LYTS can achieve these FY28 targets with its highly resilient, customized product business model, and increasingly strategic relationships with major customers. LYTS is laser-focused on highly engineered and proprietary products which differentiate them from commodity lighting suppliers and allow them to develop long-term strategic relationships from a very impressive customer list.
We note that LYTS has indicated results for FY24 may be impacted by deferred capital programs by major grocery chains (the two largest chains are involved in merger discussion) and, consequently, we believe growth for Q2 and Q3 of FY24 could be fairly modest, and investors should position themselves accordingly. However, we have strong confidence in the multi-year outlook given the quality of the business model and the management team’s execution over the last 5 years under CEO Jim Clark.
We believe LYTS can achieve adjusted EBITDA of $100m or more in FY28 and its highly cash-generative business model can trade for 10x adjusted EBITDA with zero net debt for a market cap of about $1b. Based on 30m diluted shares outstanding, this would result in a price of about $33 per share versus the current price of about $14 per share. Finally, we believe LYTS’ strategic and diversified manufacturing platform and long-term customer relationships could be attractive to either a strategic or financial purchaser.
Short Positions
We have sought to protect the Partnership’s capital with short positions of 1% or less on several companies with extremely high valuations and unsustainable business models. As of February 29, 2024, the Partnership had 9 short positions. We continue to research several short position candidates.
Concluding Thoughts
We think we own an excellent group of businesses with asymmetrical risk-reward characteristics biased in the Partnership’s favor. We have long-term confidence in the North American economy and believe carefully selected equities remain one of the best ways to participate in its economic growth and protect purchasing power from inflation. We have tried to position the portfolio to achieve these objectives.
We focus on detailed research on individual investment opportunities with asymmetrical risk-reward characteristics in the Partnership’s favor. We are keeping the Partnership’s capital well-diversified in companies with “Ft. Knox” balance sheets. We are doing our best to balance well-publicized macro risks against our micro work on specific companies. A “Ft. Knox” balance sheet, both at the Partnership level and at our individual investments, helps us sleep better at night. Our first goal is always capital preservation, followed closely by prudent, intelligent growth of capital.
We believe that small-cap stocks offer us excellent opportunities for attractive risk-adjusted returns. Most investors on Wall Street simply cannot focus on these smaller companies due to their small size.
This should give the Partnership an advantage over time. There are greater opportunities to find a specific business or security which is meaningfully mispriced before it becomes clear to other investors. We do a large amount of research on these individual positions to achieve a high conviction level which allows us to establish and remain committed to a larger position. We often have detailed discussions with the senior management of our investments to better understand these companies and their industries and thereby strive to increase our competitive advantage.
We are one of the largest investors in the Partnership and continue to have a significant investment. We will always maintain a large amount of capital in the Partnership and make sure our interests are closely aligned with our limited partners.
Our goal is to significantly outperform the major indices over a three- to five-year period while taking a conservative approach to risk and we continue to believe we can achieve this goal.
We remain cautiously optimistic about our investments due to our continued ability to find what we believe to be good businesses that are undervalued. We are doing our best to position the Partnership to earn attractive risk-adjusted returns in this environment. We appreciate your patience.
Please do not hesitate to call (310-426-2045) or email (jez@lowellcap.com) us with any questions. We appreciate your confidence in the Partnership, and we will do our best to protect and conservatively grow the Partnership’s capital over time.
Sincerely,
Jim Zimmerman,
Portfolio Manager
Abby Zimmerman,
Research Analyst
Lowell Capital Value Partners
