The Next Move

Talent alone isn’t enough to guarantee success, according to Majedie’s US Team. In reality it takes time, hard work and a little bit of patience.

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On entering the grand auditorium, we were immediately struck by the intense concentration of the thousands of spectators. They were waiting for the world champion to make his next move. Journalists in the next room debated the positions, their views broadcasted worldwide. I had taken my son, not to a typical high-octane sports event, but rather to the London Chess Classic, where world champion Magnus Carlsen was playing one of a series of games to defend his title.

Popularly known as the ‘Mozart of Chess’, Carlsen became a grandmaster at the age of 13, and won the World Chess Championships for the first time in 2013, at the age of just 22. Since then he has defeated all challengers and achieved the highest chess rating of all time, an accolade held by Gary Kasparov for 22 years before Carlsen’s ascendancy.

Carlsen’s incredible talent and media appeal has, according to the aficionados, elevated the game’s profile to a height not seen since the 1972 Cold War showdown between the United States grandmaster Bobby Fischer and his Soviet rival Boris Spassky. Outside of the official tournaments Carlsen often displays his skill with popular events such as when defeating ten of Harvard’s top players — not only did he play them simultaneously, but he was also blindfolded — and hence had to keep track of the 320 chess pieces in his mind.

My son, a strong player for his age-group, often asks how grandmasters achieve this level of excellence. Upon investigation the answer is both inspiring and daunting. According to the broad academic research on this topic, the consensus is that alongside talent, to achieve grandmaster status, more than 10,000 hours of focused study is required, typically over a minimum of ten years. That is alongside playing tournament games themselves, which often last more than five hours. All this hard work goes toward building a mental encyclopaedia of historic grandmaster games, that the experts hope to draw upon at some stage in the future should the same position arise.

This level of devotion clearly requires patience and a faith that hard work will be rewarded. With humility, I often draw a parallel with our industry with respect to the time delay often experienced between effort and reward. We dig deep to analyse companies and their industries, attempting to build an edge in understanding the fundamental outlook. We will often spend a month or two researching a company, only to conclude that the time is not yet right — either the risk-reward needs to become more attractive, or that patience is required for the fundamentals to fall into place.

Two examples of this are our holdings in BWX Technologies and Equifax. Both are companies that we admired for a long time from afar, but which were too expensive. After waiting several months or years both subsequently had an ‘issue’ which resulted in steep falls in share prices and hence, as explained by Hong and James, presented us with attractive entry points.

BWX Technologies – Hong Yi Chen

Virginia-based BWX Technologies is a great example of how we use temporary setbacks in otherwise high-quality companies as favourable buying opportunities. In the course of our research we discovered that the company was the sole supplier of nuclear reactors to the US Navy, and that this would benefit from an accelerating shipbuilding schedule as the US Navy attempts to reverse decades of under- investment to grow to a 355-ship navy from 287 today.

The company was undeniably high quality. About 75% of its revenues came from the navy reactors segment. This was a very steady business, less cyclical than other defence contractors thanks to its long build cycles. It takes around eight years to build an aircraft carrier, for example. Indeed, in 2013, when the US defence budget shrank 10% under sequestration, the segment still grew over 6%. Going forwards the main driver for this business would come from the Columbia Class submarine, which replaces the Ohio Class as the platform for the Trident nuclear missile. The remaining business serviced nuclear power reactors and managed nuclear research facilities for the US government. The power business will benefit from a Canadian reactor refurbishment cycle over the next several years. This segment also recently bought a very exciting medical isotopes business that distributed technetium-99 (Tc-99) generators, a radioactive isotope used in 80% of nuclear imaging procedures worldwide. Currently there is no production of molybdenum-99 (Mo-99), the source that decays into Tc-99 in the generators, in North America after the manufacturing test reactor closed in 2018. All Mo-99 is currently imported from Europe. BWX has developed a superior method of making Mo-99 that does not use uranium-235. This avoids many expensive problems surrounding disposal of radioactive waste and the associated proliferation risk. They intend to gain FDA approval for their product in 2021 and distribute it through their medical isotopes business. They will likely gain significant share of the North American market and there may be export opportunities as well. This business will generate c.40% margins, far above the groupwide 17%.

Although BWX had many exciting growth opportunities, it was also rather expensive with a price to earnings multiple (P/E) in the high 20s, which cooled our interest. However, not long after our initial analysis the company suffered several setbacks, including taking write-downs on a missile tube manufacturing contract that rocked investor confidence in the company with an otherwise consistent record of execution. The timing was unfortunate as management also gave 2019 guidance significantly below investor expectations. This was down to the timing of the Columbia Class ramp up and the Canadian reactor field service cycle. They did stress that longer term targets for double digit EPS growth remained intact, although understandably there was a heavy dose of investor scepticism. The share price fell almost 40% over the next two months as their P/E fell to 15x.

We saw this as an opportunity to buy a high-quality company at a heavily discounted multiple. It was key for us to establish that this setback was indeed temporary and did not compromise their longer-term growth trajectory. After building a model and several calls with the company, we were satisfied that the underwhelming guidance was down to timing. The low multiple provided a significant margin of safety for us to begin buying shares. As of writing this article, the share price has appreciated over 60% from our point of entry, after printing a strong set of Q2 results.

Equifax – James Dudgeon

When your business is to sell crucial data to financial institutions who then use that data to make mortgages and loans, a security breach covering 147 million people’s personal information is a pretty bad day at the office. From 7 September 2017, Equifax’s market cap tumbled by 35% over just a couple of days as news broke that hackers had accessed millions of Americans’ Social Security numbers, birth dates and addresses. We did not own the stock at the time, but events like this cause us to sit up and take notice. Equifax operates in an industry with attractive dynamics, has a very sticky revenue base, a history of good organic growth but hadn’t been on our radar due to a high valuation. Unquantifiable events like this can lead to great opportunities as it creates uncertainty which the stock market tends to shun. How much will they be fined? How much do they have to spend on security? What will be the impact on organic growth?

We spend a lot of time looking at the risk/reward potential of stocks. In scenarios such as the Equifax breach, we thought it was highly valuable to attempt to quantify what the downside could be. There are precedents for data breaches. Companies have done IT upgrades before. Organic growth can be analysed over cycles. The market tends to take a shoot first, ask questions later approach. The exciting thing for us is that in the upside scenario, as all these risks start to diminish, they become catalysts. Once the market knows that the IT spend will be $1.25bn, other than ephemeral teething problems with implementation, where is the incremental risk? Once the fine is agreed in a global settlement of $700m the balance sheet risk is reduced. On the organic growth side, what is most amazing is that the organic growth rate in the core US business only fell to -3% in the worst quarter post the largest ever data breach. This highlights how incredibly sticky this business is. As a peer company described to us, “replacing your primary credit bureau is like re-doing all your plumbing while living in the house”.

Given the uncertainty, we purchased Equifax for a mid-teens prospective P/E multiple. Looking at the upside scenario, the two main peers (in a three-player industry), were trading on much higher valuations. Since purchase we have continued to meet management, and peers, and have built further conviction in the quality of the industry, the incredible data sets Equifax possesses and the potential for growth in the coming years. On top of this, the great thing about a company going through an investment phase, is that the market tends to be slow to recognise what the business will look like on the other side. Our upside scenario looks out beyond the significant IT investment, to a period when margins should be structurally higher; the business will have continued to shift to the highest growth areas and management will have a balance sheet free from the risk of fines. In such an upside scenario we would in turn expect the share price to move some way above current levels on a three-year view.