While the world has balked at volatility in equity markets and oil, value investors have been reaping incredible dividends from even the largest and most liquid stocks. A.J. Noronha of Atlanta’s Desai Capital Management found such opportunity in Dow Chemical, the second largest chemical company in the world. Since Noronha articulated Dow’s under-appreciated value on SumZero, the stock has soared almost 25%, a value creation of over $10B in a few months. We sat down with Mr. Noronha to discuss how he found the fast-appreciating blue chip every investor dreams of.
SumZero: What about Dow initially caught your attention as a value investor?
A.J. Noronha, Desai Capital: DOW combined many value drivers, each of which would be valuable on their own but when combined offered an excellent synergistic effect which mitigated downside risk and provided a great risk/reward opportunity. First, we identified an intrinsic value that offered a 25%+ premium to market price. Risk can never be entirely eliminated for any investment, but we believe that investing in situations with a strong margin of safety helps protect against downside risk, especially when dealing with an established global leader in its industry.
Second, the large negative price move in oil and natural gas pricing provided another strong catalyst, as DOW is heavily reliant on commodity pricing as an input for its specialty petrochemical products and thus was able to realize significant cost savings. While such price moves may also lead to lower end product prices, this was more than offset by increased customer demand, which allowed DOW to actually increase its profit margins.
Finally, activist investors can play a large role in bringing market price in line with intrinsic value, and DOW had two extremely well-known investors in Dan Loeb from Third Point (for whom DOW was his largest position) and Warren Buffett from Berkshire Hathaway. Mr. Loeb has built a strong recent track record as an activist investor and pointed out both reasons why DOW had lagged the market as well as numerous concrete value drivers for DOW which we agreed with, and as value investors, we cannot think of a better validation for an investment thesis as being on the same side of the most successful value investor of all time in Mr. Buffett.
SumZero: Given Dow is such a large company, why was the market missing the big picture?
A.J. Noronha, Desai Capital: As mentioned above, Mr. Loeb pointed out that DOW had consistently lagged both the broader S&P index and the S&P Chemicals index. He also mentioned that DOW was operating inefficiently as they had roughly the same EBITDA as LyondellBasell despite having a far larger production capacity (economies of scale), and that DOW’s accounting methods did not provide transparency to investors. More importantly, he brought up several potential catalysts to drive value creation, namely that DOW should spin off its commodity petrochemicals unit and have it separate from its specialty petrochemicals business.
We agree with Mr. Loeb’s comments, and also believe that DOW ‘s relative inability to clearly articulate its value proposition prior to activists entering the picture led to lower valuation multiples than peer companies such as DD and LYB. Additionally and as discussed above, depressed oil prices may have been another catalyst that the market missed. A large reduction in input prices combined with pricing power in specialty chemicals will increase margins, as has been shown in both quarterly earnings results since our thesis.
SumZero: Is Dow still attractive to buy at today’s prices?
A.J. Noronha, Desai Capital: We continue to hold DOW as a long position in our portfolio, as we believe several catalysts have yet to fully unfold. However, while we believe that DOW has remaining upside potential, investors not currently holding a position should note that DOW has also appreciated almost 25% since our initial recommendation, which provides a lower margin of safety and changes the risk/reward balance from our entry price.
SumZero: What key metrics should investors be paying attention to as your thesis matures?
A.J. Noronha, Desai Capital: In addition to share price appreciation (as we measure price vs. intrinsic value), we believe profitability is the most important metric to pay attention to going forward. As discussed in more detail in the risks section, DOW has realized increased profit margins on lower revenues as the increased customer demand and cost savings from lower input prices have outweighed lower end prices (and subsequent revenue) in both Q2 and Q3 results since our initial recommendation, and we will continue to closely watch this. Oil prices are another related and very important metric to monitor given their effect on input prices, demand, output prices, and margins. Finally, non-metric areas to monitor include potential divestments and spinoffs, as DOW has recently spun off its specialty agriculture and chlorine businesses and may have more profitable disposals.
SumZero: What were the biggest risks associated with the trade in your view?
A.J. Noronha, Desai Capital: As with any value investment, the relative risk/reward must be considered, and we follow a conservative approach to better increase our odds of success. Two risks we identified were the potential for a global economic slowdown and the extreme volatility in oil prices, which ended up having a strong correlation. With the potential for a global economic slowdown as seen by the slowdown in China’s economic activity and the European debt crises, DOW may have faced slowing demand for its products. While this was something that the company could not control and a very important risk factor that could not be completely mitigated, we also believed that DOW’s specialty end products and pricing power as an industry leader did help mitigate this vs. demand for an industry like consumer discretionary.
Similarly, oil price volatility was another factor out of the company’s control but which had the potential to have a large impact on the business as it affects both their input prices and end product prices. As we conducted more research, we found that the negative move in oil prices actually led to increased consumer demand rather than the decreased demand one might expect from a slowing economy, and when combined with lower input and end product prices, the net effect was higher net income and profit margins on slightly lower revenue. While we continue to monitor both of these risk factors as unexpected changes could hurt profitability, we believe that the risks were not as severe as what we initially expected and were outweighed by the significant catalysts discussed above (profit margins have remained strong in both quarters since our analysis), making DOW very attractive.
SumZero: Is this thesis representative of the A.J. Noronha and Desai Capital investing style?
A.J. Noronha, Desai Capital: As a global leader in its industry trading at a discount to intrinsic value, with favorable external factors that boosted profitability, and with highly respected activist investors that could advocate for value creation, DOW checked all of the boxes that we look for. Desai Capital Management takes a long-term, fundamental driven, bottom-up, and long term approach focused on identifying securities trading below their intrinsic value to maximize capital appreciation & minimize downside risk. Our approach draws on influences such as Buffett, Graham, Marks, Klarman; is designed to maximize returns & preserve capital regardless of market direction; and has consistently created alpha since Fund inception.
SumZero: Where else do you see value in the market today?
A.J. Noronha, Desai Capital: The strong bull market of the last 3+ years has made value harder to find than what we would expect from a flat or bearish market, but we also believe there are opportunities in any market, particularly as there are many companies like DOW which are currently trading at a deep discount from intrinsic value.
A few specific stocks to watch are DKS, as well as media companies such as TRCO, SBGI, and MEG. The upcoming year has a lot of catalysts. First of all, local advertising takes a huge jump in an election year. Also, the large pullback in media companies has presented a buying opportunity. Olympic years when the events will be able to be watched live are also strong catalysts for ad sales. Regional airlines will also experience increases in demand from the election year, regional airport travel and lower fuel prices. Southwest's shift towards larger airports will allow regional airlines to increase pricing power. Major airlines, especially LUV, UAL, and AAL will suffer from increased competition.
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