Concentrated Equity: A Deep Dive into the Portfolio
Sometimes, we get asked why we invest in particular stocks or avoid others. In this article, I'll highlight the stocks in our model and summarize why they are included. I've tried to bucket these into different categories to organize the conversation. We occasionally evaluate other types of stocks and may own them for clients in other portfolios.
Some vital context is required before getting into the nitty-gritty. Diversification has many merits, but opinions vary as to how much is necessary. Most investors want and should require more diversification than our concentrated portfolio delivers. Holding a small number of stocks means that we will not have exposure to many types of businesses, and our returns often deviate significantly from the broader market. Some clients may have tax and/or portfolio reasons that may hold additional stocks or not be invested in the whole list. This is just a summary. Please do not buy or sell any security based on this article. Talk with your advisor before making any decisions, and always do your due diligence.
Additionally, we do make changes from time to time. When investing, the goal is to own the security for several years. Studies show that too many trades result in poor investment results. Quality investments usually take time to pay off, and so patience is required.
As a reminder, our investment philosophy requires a margin of safety because we have reason to believe the stock trades at a significant discount to its fair value. Further, understanding competitive advantages and management incentives helps us better understand the company and its appropriate valuation.
Now, let's talk about some investments:
The Unloved Cash Cow
Successful companies will eventually generate more cash than they can effectively use to grow the business. In those instances, the managers should look for ways to return that excess to shareholders via debt reduction, dividends, or buybacks.
Diamond Hill (DHIL)
Diamond Hill is an investment firm based in Columbus, Ohio. The stock market currently values the company's equity at around $ 400M. We estimate that the company generates about $50M in cash flow each year that it can use to either seed new investment products or distribute to investors. Currently, we get a dividend yield north of 4% and the company has repurchased over 4% of its shares on average over the past 5 years—the operations of the business fund that. In addition, the company has about $25M in cash and $158M in investments (primarily to help new investment products gain traction).
The operations are generally stable, and because the company generates so much cash and has a fortress balance sheet (no debt), it can return that to shareholders. From 2020 through 2024 (5 years), the company paid over $175M in dividends and repurchased over $119M in stock. A company priced at $400M could return almost $300M to shareholders over 5 years and still has $183M in cash and investments with no debt.
That sounds like a good deal to me.
Overlooked Growth Potential
All else equal, we always prefer to own shares in a company that can grow quickly. However, the market currently places a significant premium on growth, so we find few opportunities to purchase these at fair prices. We have seen two in our portfolio that meet our criteria.
Mobileye (MBLY)
Mobileye is an Israeli technology company founded by Amnon Shashua in 1999. It was founded around using computer vision and software algorithms in automobiles. It has long been a leader in the area and was acquired by Intel in 2017 for that reason. As Intel's fortunes waned, the company (still majority owned by Intel) was spun off as a separate company in 2022.
The company pioneered ADAS (advanced driver assistance systems), works with 50 automakers globally, and maintains a commanding market share. Their system-on-chip technology has been deployed on over 200 million vehicles. This business provides a springboard towards working with automakers on more advanced autonomy solutions.
This is a space moving quickly. Waymo has successfully launched robotaxis in geofenced areas, and Tesla has been aggressively rolling out FSD to consumers. Tesla was once a Mobileye customer, but Mobileye severed the relationship because they were uncomfortable with how Tesla marketed its system's capabilities. In the background, Mobileye continues to win new deals to advance its business in the area. Most recently, they announced an agreement with Volkswagen and Uber to launch a robotaxi venture in Los Angeles, but they also have a partnership with Lyft, which is slated for Dallas.
Mobileye is different in its approach. Their ADAS customers collect data through front-facing cameras to build high-definition maps (much more data than Tesla). The perception model is standard regardless of solution (though higher levels of autonomy require lidar and proprietary radar) to allow for the benefits of scale. Still, the automaker gets to create a system for how the vehicle responds. This allows an OEM (original equipment manufacturer) to differentiate the driving experience and maintain their brand identity. Custom hardware, software, and maps make Mobileye a cost leader. Mobileye also supports a more gradual transition with a product they call "Surround ADAS". With each phase of enhanced technology, Mobileye's revenue per vehicle goes up several times.
Mobileye doesn't necessarily need more customers to be successful. They need to support those customers through this transition. And not all customers will want to change at the same rate, so it's essential to have a technology partner to accommodate the wide range of consumer acceptance. This is why companies like Volkswagen and Porsche are working with Mobileye on advanced solutions, many of which will launch in the US over the next several years. And the best part is that the company's market capitalization is only around $13B. The company only makes about $1.6B to $2B in revenue per year (mostly traditional ADAS), but as the next generation of products gains wider adoption, they should see significant growth. ADAS only gets about $50 per car, but even surround ADAS could triple that, and robotaxis will likely run in the thousands.
Lovesac (LOVE)
The pandemic induced a frenzy of home-related purchases. In Lovesac's fiscal year ending January 2020, they did $233M in revenue, which by the year ending January 2023 had ballooned to $ 651 M. However, over the last few years, the industry has dealt with worse declines in furniture sales than we saw in the financial crisis. Lovesac is still taking a lot of market share, which translates to flat growth when the industry faces this sort of trouble. So why stick it out?
Couches wear out and need to be replaced. People eventually start to move again and will be looking for new furniture. Lovesac has built a better mousetrap and will likely continue to win more and more of those customers. These tough times can benefit the recovery as weaker competition is weeded out. Lovesac is leaning into this, announcing an ambitious product launch schedule over the next several years. Also, the stock is still valued at similar levels to when they were doing $233M in revenue. The business is several times larger now. Like many growth companies, their profitability is masked by significant investments in new products that we are only now beginning to see come to market.
Let me finish this with some of my favorite anecdotes about this special business. Except for Apple and Tiffany, their showrooms generate more revenue than other retail concepts per square foot. That's special, conferring an abundance of competitive advantages that will allow them to become very profitable as the business matures. The market capitalization of only about $320M is minuscule for a company that can boast such results. Their couches are also durable, modular, and backward-compatible. Combined with a direct-to-consumer model, this provides a data advantage to market upgrades and add-ons to existing customers. This is unique for a furniture company. I expect them to expand the product line into more rooms of the house over time with the same ethos. Even with the recent slowdown in the industry, their revenue has expanded at a compounded rate of over 23% in the past 5 years. The market seems to believe their days of growth are over, but why do they continue to win market share? I think we'll be rewarded for our patience when the dust settles.
Discounted Assets
These types of investments are among the easiest to underwrite. Suppose you can reasonably ascertain the value of a company's assets and buy the stock for significantly less (after netting out any debt). In that case, you don't need much ability to forecast the future. You only need a management team to commit to actions that unlock that value.
Air Lease (AL)
Air Lease is a relatively simple story. Boeing and Airbus can't make commercial jets as fast as their customers need them, creating a shortage that should last many years as long as the demand for air travel remains strong. During the pandemic, many airlines retired jets early to save themselves. At the same time, Air Lease stepped into the void by placing large orders with Boeing and Airbus at significant discounts. Now there is a 10-year wait for new aircraft, and as Air Lease takes delivery of jets, they can demand high prices on leases. The interesting thing is that the stock of Air Lease trades at about 20% less than the value of those assets on their books. The discount grows from there as you adjust to account for the shortages and their impact on the market value of aircraft. I expect this to result in significant profit growth as planes are delivered and old leases are renewed at higher rates. Having recently achieved their goals on debt reduction, they are currently evaluating options for excess cash flow. Air Lease is positioned to benefit from this scarcity, and for some reason, the stock price doesn't yet reflect that.
Farmland Partners (FPI)
Farmland Partners owns farmland across the United States and rents it to farmers. Farmland is not a sexy investment, but unlike real estate like office buildings, the owner rarely goes without a tenant. Stock market investors seem to ignore the long-term capital appreciation (with little maintenance costs) associated with farmland. As a result, the stock trades at a significant discount relative to the market value of the farmland. Management has been working to correct this by selling off land while reducing debt, paying special dividends, and buying back stock. They have also been cutting corporate expenses to increase cash flow to appease Wall Street. The management team (who also own much of the stock) is motivated to take advantage of the undervaluation. I expect they'll continue selling off farmland to unlock that value unless the stock market begins valuing the assets more appropriately.
Undervalued Consumer Staples
Companies with strong brands used daily have strong customer loyalty and pricing power. They tend to be relatively predictable and long-lived. Once they acquire a customer, it's often for life. As a result, I believe it is wise to invest in these sorts of companies when they are attractively priced.
Diageo (DEO)
Diageo is a large alcohol conglomerate formed in a 1997 merger, but the history of its brands illustrates the staying power. It's leading beer brand, Guinness, was started in 1759. Its largest scotch label, Johnnie Walker, goes back to 1820. They sell beer and spirits throughout the globe. In addition, Scotch has tremendous barriers to entry, limited by geography, that help protect it from new competition. The stock rarely trades this cheaply as investors fret over the lower propensity of Gen Z to consume alcohol. They drink less but tend to buy better, spending similar levels to previous generations at the same age. That plays into Diageo's hand as a purveyor of high-end spirits. They also have a strong foothold in the emerging demographics of India and Africa, providing ample growth opportunities for the future.
Philip Morris International (PM)
Philip Morris was born from a split with Altria as the US cracked down on big tobacco. They essentially own the rights to those historic brands like Marlboro everywhere but the US. That business has been around since 1847. However, Philip Morris is undergoing a transformation led by a new product generation that significantly reduces health risks to their customers. Led by brands like Zyn, iQo, and Veev, 42% of their revenue is now smoke-free and growing quickly. Those brands were launched after the split with Altria, giving them a new foothold in the US market. The latest products are much safer than cigarettes and more profitable. The goal is to separate nicotine from carcinogens, which could transform public perception into something more like caffeine. While the stock isn't nearly as cheap as it was a year ago, the business looks like it has a bright future.
Commodities Producers
Commodities producers play an important role from a portfolio perspective. Their performance tends to be uneven. However, rising commodity prices tend to be negative for most stocks, so these companies provide a valuable hedge. I believe it is a lovely time to invest in the industry. The global economy underwent a commodity boom in the 2000s but has systematically underinvested in finding natural resources since the mid-2010s. The long period of underinvestment makes our economy vulnerable to shortages. This is a cycle that repeats itself over decades. It is impossible to predict the timing precisely, but the ingredients are there for it, and the stocks trade at attractive prices.
Coterra Energy (CTRA)
Coterra Energy operates oil and gas fields in the United States. They are a low-cost natural gas producer in the Marcellus Basin, having shown the ability to earn profits even at historically low prices. Demand for natural gas is growing due to rising exports and power generation from AI data centers. As demand grows, companies like Coterra will require higher prices to justify the investment to increase production. Coterra also operates a large shale business in the Permian, producing oil and natural gas. The market values this company's stock at around $20B and is expected to generate around $2B in cash flow this year, even with relatively low oil and natural gas prices. They tend to pay an attractive dividend to shareholders, which could become more lucrative as global oil & gas fields show their age.
Exxon Mobil (XOM)
Exxon Mobil tracks its history back to John D Rockefeller, and while they do produce natural gas, it's more of an oil company than Coterra. Exxon also owns extensive chemicals and refining businesses that often perform well when oil prices are low. The investments Exxon has made over the past decade or so are underappreciated, including the oil project in Guyana, one of the largest finds in recent history. They also build significant carbon capture, hydrogen, recycling, storage, and lithium businesses, which help insulate them from changes to energy sources. Exxon has tremendous advantages in terms of size and resources. Oil demand continues to grow, despite the adoption of electric vehicles. Oil companies have been starved of capital and encouraged to limit drilling and exploration. Shale fields can produce oil & gas in months, masking global underinvestment. But other fields can take at least 5 years, and as the shale fields eventually decline, oil prices will need to rise further to justify the investment required to meet demand. Even with EVs, we still need oil for jet fuel, plastics, asphalt, etc. And so far, even the rapid adoption of EVs hasn't led to a decline in oil consumption.
Sibanye Stillwater (SBSW)
Sibanye Stillwater is a global mining company based in South Africa. Their most profitable segment is the South African gold mines because of a surge in the price of the shiny metal. Their most significant concentration of assets is in PGM mines, which produce mainly platinum, palladium, and rhodium. PGM prices have been low recently as automotive companies deal with a slowdown in production. PGMs are primarily used for catalytic converters in internal combustion and hybrid engines. Demand is expected to slowly decline over the years, which has depressed the stock price. However, platinum is also used heavily in the hydrogen economy, and much of the world will be slow to switch to EVs due to a less reliable power grid. And the Bushveld Complex spanning South Africa and Zimbabwe, where they have PGM mines, is the only known place where PGM mines can predominantly produce platinum, rather than other metals. By my calculations, Sibanye produces roughly 21% of the world's platinum. In context, the US is the world's largest oil producer, delivering 20%. Sibanye has a larger share of global platinum production than any COUNTRY does in oil.
There has been a general destocking of PGM metals in the supply chain that has weighed on prices. According to mining.com, ground inventory levels are at 40-year lows for rhodium and 50 years for palladium. Higher PGM prices should come with an eventual destocking, allowing Sibanye's PGM mine profits to recover.
Significantly, Sibanye has been transforming its business to thrive in a post-internal combustion world.
While the stock trades at around $3.3B, the company produced more than that in cash flow over two years ending in December 2021. The company paid substantial dividends during that period. Still, they also started a lithium project in Finland, purchased a Zinc miner in Australia, a metals recycling company in North America, and a nickel refinery in France. Importantly, they are now receiving exceptional assistance from the EU to accelerate those projects as a strategically important supplier on the continent. Sibanye is also now receiving similar support from the US to maintain its PGM mine in Montana. The company has invested over $1.5B in growth capital in the past 3 years. Sibanye also recently contracted with a firm to monetize the uranium in their tailings (all the extra material that piles up in the mining process). They are currently a drag on financial results, but things could look very different as those projects come online.
The stock is highly volatile, but they have positioned itself as a low-cost producer of metals that the world needs. I think the stock is highly undervalued.
Defense Contractors
Defense contractors have been our particular focus for the past several years, based on the belief that the US/China relationship would become more confrontational over Taiwan. In addition, as the US becomes more focused on countering China, Europe would need to increase its military spending. Russia invaded Ukraine in 2022, accelerating the timeline for Europe. Since the end of the Cold War, military spending as a % of GDP has collapsed for Europe and declined dramatically in the US. Those trends are now reversing and should provide a tailwind for defense contractors.
Northrop Grumman (NOC)
Northrop Grumman is a large defense contractor that we find appealing because of its position in key priorities for the US government. The first is the nuclear triad (air, sea, land), considered the cornerstone for deterrence as it assures second-strike capability. Northrop has the contract to update the land-based arsenal. They also made the new B-21 Raider, a stealth bomber that the US government recently asked Northrop to accelerate production. As far as the sea, Northrop has a small contribution to the new class of nuclear submarines. In addition, Northrop has a thriving space business, making everything from solid rocket motors to satellites to the James Webb Space Telescope.
Huntington Ingalls (HII)
Huntington Ingalls is one of just two shipbuilders for the US Navy. The market values the stock under $10B, but their leading position can be seen in their $48B backlog. They expect to receive another $50B in orders by the end of 2026 as the US and its allies look to beef up their navies. Much of their growth will come from submarines, where they share the work with General Dynamics. The US government has begun incentivizing them to increase production to meet future needs. This includes autonomous submarines that can launch from a manned one. The US naval fleet has been shrinking for some time, and the government wants to reverse that trend. Aircraft carriers are another interesting area, but there is some debate on their future role. Drones have proven themselves in combat, but they need a way to reach the battlefield and still benefit from having human-piloted aircraft nearby for many missions. One solution is to use aircraft carriers as floating factories. Huntington Ingalls is the only manufacturer of aircraft carriers for the US Navy. Once built, they last for 50 years. Huntington Ingalls is paid to refuel (nuclear-powered), modernize them along the way, and eventually decommission them, providing long-term revenue visibility.
Financially, the company has seen its profitability decline slightly from rising labor and material costs, but new contracts offer more inflation protection. As those old contracts are completed, the company should be able to combine rising revenue with the better margins it historically enjoyed.
In Conclusion
Suppose you've made it this far, thanks for reading! I hope this provides a window into our thinking and portfolio construction. Please reach out if you have any questions or knowledge about these businesses that may further my understanding. Investing is a constant state of re-evaluation, even if concrete changes happen infrequently.
Invest Curiously,
Austin
Austin Crites, CFA
Chief Investment Officer
Aurora Asset Management/Aurora Financial Strategies
Austin Crites is the Chief Investment Officer of Aurora Asset Management, an Indianapolis-based subsidiary of Aurora Financial Strategies located in Kokomo, IN. He can be reached via email at austin@auroramgt.com. Investment Advisory Services are offered through BCGM Wealth Management, LLC, a SEC-registered investment adviser. Registration with the United States Securities and Exchange Commission does not imply that BCGM or any of its principals or employees possesses a particular level of skill or training in the investment advisory business or any other business. This blog does not constitute advice. This is not an offer to buy or sell securities. The advisor is not licensed in all states. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. BCGM Wealth Management, LLC, manages its clients' accounts using various investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Clients may own positions in the securities discussed.
