Lowell Capital Value Partners commentary for the month ended May 31, 2024.
Dear Partners,
Lowell Capital Value Partners, L.P. (the “Partnership”) was +4.5% in May 2024 vs. +5.0% for the S&P 500 with dividends reinvested (all returns shown are net to investors). For 2024 year-to-date, the Partnership was +7.4% vs. +11.3% for the S&P 500 with dividends reinvested. As of May 31, 2024, the Partnership had 25 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 maintained 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 conservatively and prudently by taking what we think are intelligent risks. We seek to carefully allocate our capital to 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 and misunderstood companies that generate strong cash flow and 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, Terry Smith, and Why ROIC Is So Important
Over the past few years, 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 twelve months or more 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 that 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 the long-term preservation of capital and the 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.
The U.S. economy still seems solid but may be weakening a bit. The Partnership’s investment companies are still performing well, which makes us optimistic. There is always a risk of a recession, but it 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. There are 8,000 publicly traded companies in North America; we only need a few that work for us.
Terry Smith is the CEO & CIO of Fundsmith. Since launching his fund, Smith has amassed over $30 billion in assets under management and has been referred to as “Britain’s Warren Buffett”. Smith has gathered his thoughts and lessons in a book called Investing for Growth. He has a three step core simple investment strategy which has led to significant compounding of capital => 1) invest in good companies, 2) don’t overpay, and 3) do nothing.
Like our Partnership, Smith is highly focused on businesses with high returns on invested capital which can compound value for long periods. Smith believes that it is more important to invest in a good company rather than a cheap company. We agree. One key attribute of a “good company” for Smith is a high return on invested capital or ROIC. Smith cites both Buffett and Munger in supporting this approach.
Almost all the investment positions in the Partnership earn high returns on invested capital, allowing us to compound capital for many years. Our approach is closely aligned with the above quotes from Smith, Buffett, and Munger. We believe we are invested in high-quality businesses that can compound capital over several years. As a result of their high ROIC, our investments generate large and sustainable amounts of free cash flow as they are not capital-intensive. These business models give the Partnership the best opportunity to grow its capital in a disciplined manner over long periods of time.
Our approach for the Partnership is well-aligned with Smith. We do not try to time the market. We stay focused on what we can control, which is our deep research-intensive process of business analysis and our due diligence process. This includes making sure we know the company’s fundamentals, the “competitive moat” of the company, its growth path, its balance sheet, and detailed conversations with the management team. We’re just looking for a handful of those that have a good growth path. Our objective is to buy growth companies at value prices.
We are depending on that growth to drive the value of our investment as their earnings and cash flows increase. Like Berkshire Hathaway’s strategy but with smaller, less-followed companies. We’re trying to pay modest prices and buy at large discounts to our estimate of fair value. 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.
As we look to invest in growth companies at value prices, these businesses must have strong “economic moats” around their business models, 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, profits, and cash flows, and enables the company to grow to a large size despite operating in a hyper-competitive capitalist world.
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 carefully evaluate these businesses and their management teams and what 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 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 embedded 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 May 31, 2024, were as follows:
- Celestica (NYSE:CLS)
- Sprouts Farmers Market (NASDAQ:SFM)
- LSI Industries (NASDAQ:LYTS)
- Property Franchise Group plc (LON:TPFG)
- Mattr (TSE:MATR)
- Sterling Infrastructure (NASDAQ:STRL)
- Brady Corporation (NYSE:BRC)
- AstroNova (NASDAQ:ALOT)
- Hollywood Bowl Group plc (LON:BOWL)
- Academy Sports and Outdoors (NASDAQ:ASO)
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:
Hollywood Bowl, plc (BOWL.L)
Hollywood Bowl Group plc (BOWL.L) operates ten-pin bowling and mini-golf centers in the United Kingdom and Canada. The Company also supplies and installs bowling equipment. As of December 2023, it operated 75 centers under the Hollywood Bowl (65 centers), Putt-stars (5 centers), and Splitsville (Canada) (11 centers) brands. The Company was incorporated in 2016 and is based in Hemet Hempstead, the United Kingdom.
BOWL.L is benefiting from macro trends of (1) increased demand for social experiences by customers and (2) expanded interest in leisure offerings by landlords to drive traffic to their locations. BOWL.L’s strategies are to drive like-for-like revenue growth, actively refurbish its assets, develop new centers and niche acquisitions, and leverage its indoor leisure experiences. The market has priced BOWL.L for a post-COVID letdown (which has so far failed to materialize) but we believe BOWL.L’s post-COVID results will prove more sustainable than the current valuation implies.
BOWL.L has several characteristics we like including (1) a highly resilient business model with deep customer relationships, (2) a highly cash generative business with modest 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 less than 7x adjusted EBITDA, (5) a record of strong sales growth – both organic and inorganic, (6) a disciplined management team focused on accretive acquisitions, (7) a “Ft. Knox” balance sheet with net cash of 42m GBP at 3/31/24, (8) a long-term strategy to grow sales and EBITDA, and (9) a high-ROIC business model with limited capital requirements.
BOWL.L has an attractive valuation given its recent growth profile. Growth in recent years has been driven by a post-COVID increase in demand for affordable entertainment. A family of four in the U.K. can enjoy a bowling outing for a modest amount (approximately GBP 25). This affordable entertainment experience compares favorably to other alternatives like movies and amusement parks. Further, BOWL.L and other players have upgraded their facilities and food to attract a younger demographic. BOWL.L has lapped the post-COVID rebound in demand in FY23 and grew results nicely compared to FY22. Bowlero (BOWL) is the largest bowling player in the U.S. and trades at a much higher valuation (10x adjusted EBITDA) with close to $1.3b in net debt and (we believe) less attractive growth prospects than BOWL.L. Furthermore, BOWL.L has approximately 33% EBITDA margins, about the same as Bowlero (BOWL).
Bowling sales post-COVID have increased significantly due to shifts in consumer behavior (more hybrid working enables off-peak participation); good value (while other entertainment options have increased prices with inflation, bowling prices have been kept fairly constant, making them relatively more attractive to customers); and upgraded centers, with new and upgraded activities, better digital communications with customers, and “pins-on-strings” when enables less downtime on bowling equipment.
We believe that BOWL.L’s post-COVID trends are sustainable and that BOWL.L can grow from this base. At investment, BOWL.L had about 172m shares outstanding trading at about 2.85 GBP per share for a market cap of about GBP 490m. BOWL.L had a net cash position at 9/30/23 of about GBP 52m. BOWL.L had an enterprise value of about GBP 440m which compares to FY23 (ended 9/30) pre-IFRS adjusted EBITDA of about GBP 65m, or less than 7x LTM adjusted EBITDA.
We believe BOWL.L’s current valuation is attractive given its strong growth in revenue, adjusted EBITDA, and adjusted EPS post-COVID. We believe the market has not recognized BOWL.L’s dominant market share in the U.K. and the more resilient and predictable business model that it has developed in the last couple of years. As BOWL.L continues to execute and grow both organically and inorganically, we believe the market will eventually recognize BOWL.L with more appropriate earnings multiples.
BOWL.L is the largest player in the U.K. (with approximately 30% market share) and Canada, its two major markets. This gives BOWL.L a powerful advantage versus smaller mom-and-pop competitors which cannot match its cost structure and brand recognition and well-defined and focused strategy to enhance traffic into its bowling centers. BOWL.L has significant brand recognition as an enjoyable and affordable activity in its key markets. We believe this gives BOWL.L a strong competitive advantage and “moat” that competitors find difficult to match and which is likely sustainable over the long term.
BOWL.L is a highly cash-generative business with modest capital expenditure needs. The Company has an attractive unleveraged FCF yield in the high single-digit range. BOWL.L has generated almost GBP 250m of cumulative cash from operations over the past several years, or half of the current market cap. BOWL.L’s strong cash flows have enabled it to make high-return organic capital expenditures on refurbishments (30% ROI) and new centers (20% ROI) as well as successful strategic acquisitions, such as strategic expansion into Canada with the Splitsville brand, where it is now the largest player in the Canadian market.
BOWL.L has an “Ft. Knox” balance sheet with GBP 41m million in net cash as of 3/31/24. BOWL.L is well-positioned to make further accretive acquisitions like Strikers Limited in Canada and drive additional shareholder value. Its “Ft. Knox” balance sheet reduces risk and enables BOWL.L to take advantage of strategic opportunities.
There has been strong private equity interest in the bowling industry due to its highly cashgenerative business models. Most recently, Trive Capital agreed to acquire Ten Entertainment (TEN.L), the number two player in the U.K. bowling industry behind BOWL.L, in December 2023. In the U.S., the largest bowling industry player by far is Bowlero (BOWL). Atairos Management, a private equity group, is the major shareholder, with close to 70% of fully diluted shares outstanding owned. We believe BOWL.L could represent an attractive investment for a private equity group over the next few years.
BOWL.L recently released their H1 FY2024 results which demonstrated strong performance driven by continued investment in their customer experience and further growth in Canada.
We believe BOWL.L can continue its growth trend over the last few years in terms of revenue and adjusted EBITDA. On an EBITDA basis, we believe BOWL.L could grow pre-IFRS adjusted EBITDA from GBP 65m in FY23 to GBP 80m or more by FY26 and trade for 9x adjusted EBITDA with net cash of GBP 80m or more. Based on 172m shares outstanding, this would result in a share price of GBP 4.65 per share versus GBP 2.85 at investment. Further, we believe BOWL.L’s dominant market position in the U.K. entertainment market, and growing position in the Canadian market, could be attractive to 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 May 31, 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 and Western European economies and believe carefully selected equities remain one of the best ways to participate in their 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