Conduril: balancing concentration and diversification

One of the toughest things as an investor is the balancing act between managing risk by building a diversified portfolio and maximizing returns by putting money at work in your best ideas. Warren Buffett is known for his dislike of diversification, and this quote from the 1993 letter to Berkshire Hathaway shareholders nicely illustrates his thinking:

If you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk.

Key in this statement is of course that he’s talking about companies with a long-term competitive advantage. This is worlds apart from a Graham net-net approach where you almost always buy below average companies, but you simply buy them at a very cheap price. Some will fail, some will just limp along and others might turn around spectacularly. Buying a portfolio with 10 net-nets is, in my opinion, foolish from a risk management perspective, and buying 20 is still borderline irresponsible. Buy a basket of 30-50 stocks and you should be doing alright. How concentrated you should be not only depends on the returns you expect, but also the range and amount of possible negative outcomes. And this is easier said than done: translating the theory in a portfolio percentage isn’t trivial.

While Berkshire Hathaway is reasonable diversified these days Buffett made very concentrated bets in the past. In his early investing career he had for example invested more than 65% of his net worth in GEICO. Interesting enough that investment resulted in what was probably his biggest investing mistake since he sold after a year for a 50% gain while it would have delivered a 100x return the next two decades. From Buffett’s 1995 letter:

You may think this odd, but I have kept copies of every tax return I filed, starting with the return for 1944. Checking back, I find that I purchased GEICO shares on four occasions during 1951, the last purchase being made on September 26. This pattern of persistence suggests to me that my tendency toward self-intoxication was developed early. I probably came back on that September day from unsuccessfully trying to sell some prospect and decided despite my already having more than 50% of my net worth in GEICO to load up further. In any event, I accumulated 350 shares of GEICO during the year, at a cost of $10,282. At yearend, this holding was worth $13,125, more than 65% of my net worth.

You can see why GEICO was my first business love. Furthermore, just to complete this stroll down memory lane, I should add that I earned most of the funds I used to buy GEICO shares by delivering The Washington Post, the chief product of a company that much later made it possible for Berkshire to turn $10 million into $500 million.

Alas, I sold my entire GEICO position in 1952 for $15,259, primarily to switch into Western Insurance Securities. This act of infidelity can partially be excused by the fact that Western was selling for slightly more than one times its current earnings, a p/e ratio that for some reason caught my eye. But in the next 20 years, the GEICO stock I sold grew in value to about $1.3 million, which taught me a lesson about the inadvisability of selling a stake in an identifiably-wonderful company.

This excerpt also shows something that was recently mentioned by Nate at Oddball Stocks: Buffett seems to have made a lot of money by buying extraordinarily cheap companies. Reading his old letters you get the feeling that back in Buffett’s early days everybody with a few working brain cells could have made money simply by buying companies at a 1x or 2x PE-ratio. Today there are probably less companies that are that cheap, but Conduril is one of them. The following three ratios should say it all:

  • P/E: 2.3x
  • P/B: 0.33x
  • EV/EBITDA: 0.61x

And that’s for a company that compounded book value at a 33% annualized rate the past six years straight through a recession, while paying dividends and without posting negative results in a single year. Just for fun I tried running a screen with the above three ratios as screening criteria. The only thing it returned from the US market were a handful of Chinese frauds, but most frauds even failed to meet the above criteria: Conduril is that cheap!

While I think that Conduril is really cheap it’s also not without risks, although it’s getting increasingly less risky. Their asset/equity ratio has been decreasing every year since 2006 and is now standing at 2.36x versus 2.93x last year (and 4.21x in 2006). They also turned around a net debt position of €6.4 million in 2011 to a €15.3 million net cash position at the end of 2012.

With the kind of valuation ratios that Conduril has it shouldn’t come as a surprise that it also looks very cheap compared with other public construction firms in Portugal. Two of the firms listed below are on the brink of bankruptcy with an insane amount of leverage. The best comparable is probably Mota-Engil that, just like Conduril, does a lot of business in Africa.

Conduril comparables

I don’t think the mean and median values are very useful in establishing an implied value for Conduril since there are a lot of outliers / distressed companies in the list above. But it says something when even the most crappy competitors are trading at higher valuations. Based on the comparables I’d say that Conduril should trade at least at book value and potentially higher. That doesn’t seem like a stretch given their historical profitability and their current backlog. To get an idea of how Conduril compares to Mota-Engil a quick overview of some financial stats and ratios:

Conduril versus Mota-Engil

I’m not quite ready to follow Buffett’s footsteps and put the majority of my net worth in a single stock, nor do I think it’s a great idea in this specific case since an emerging market construction company is not a sure thing. But Conduril is remarkable cheap, especially considering the profitability of the business and the low amount of leverage compared to its peers. Not allocating a significant portion of my portfolio to an idea this attractive seems like a major mistake. So even though the stock is up ~36% since I initiated my position last year I added ~70% more shares. This increased my allocation to the stock from ~7% at the beginning of the year to 12.5% now, making Conduril my biggest position.

The million dollar question is of course: is this the appropriate balance between risk and reward? Personally I think I might have erred on the side of caution, but since overbetting on a position is a bigger mistake than underbetting I’m comfortable with that. What do you think? How would you size this?

P.S. If someone thinks he owns something that’s cheaper than Conduril I’m all ears!

P.P.S. If you have a good argument on why this will end in tears I’m even more interested!

Disclosure

Long Conduril

14 thoughts on “Conduril: balancing concentration and diversification

  1. Floris

    Awesome piece, as a fellow shareholder I really think the downside is protected, but the most risk is obviously in the receivables, as you are well aware. There is discretion in accounting for project business and under percentage of completion. If I am not mistaken their provision for bad debtors is quite aggressive, especially given the countries where they operate. I don’t think its a risk compared to the prices paid currently for the shares, but it could potentially be a negative hit later on.

    reg,

    Floris

    Reply
    1. Alpha Vulture Post author

      Yes indeed. What I really liked seeing in the latest annual report is that the amount of receivables was down from 260M to 210M, and the amount of cash was up. Already reduces the credit risk risk they have significantly.

      Reply
  2. brian

    hi-

    very nice blog! this seems like a pretty good idea, particularly given cheapness on ev/ebitda + insider buying, but i’ve yet to find the best broker to buy international stocks. wondering if you have any recommendations? i am in the united states. i currently use td ameritrade and they don’t seem to be able to buy most international non-adr stocks it seems. thx in advance!

    cheers,
    brian

    Reply
    1. Alpha Vulture Post author

      I’ve heard you can buy it through Fidelity, but have no account nor have I checked this. Part of the cheapness is probably because it’s so hard to buy for most people.

      Reply
    1. Alpha Vulture Post author

      I did not actively reduce one of my position because I wanted to buy Conduril. I reinvested some dividends, and had some cash from positions I sold earlier this year for unrelated reasons. I would have sold something though if I didn’t have the cash.

      Reply
  3. Benedita

    Interesting stock, but it rarely seems to trade? The 10% bid-ask spread scares me a little, if 20% upside is needed just to cover trading costs. Or do you find that you can avoid crossing the spread?

    Reply
    1. Alpha Vulture Post author

      Thinking in therms of a bid-ask spread doesn’t make a lot of sense with illiquid stocks: if someone is willing to sell at 30 and there is no bid in the order book, what are my trading costs? If someone is willing to sell at 30, and someone else has a buy order at 29.50. Do I suddenly pay less when I decide to buy at 30?

      The thing with these kind of stocks is that sometimes there is liquidity to buy, and sometimes there is liquidity to sell. You only pay high trading costs when you are desperately trying to buy or sell when there is no liquidity. So you need patience when buying and you need to be willing to hold this for the long-term, and worst case you get your liquidity from the company in the form of dividends.

      Also a remark on the current bid/ask spread: the stock was trading at 36 before someone sold a big block of 5K shares at 30. So when you are buying at 30 who’s exactly incurring the high trading costs? Is it you, or the seller?

      Reply
  4. Kr

    can you really trust the Portuguese stock market?
    Can be no difference then Chinese or russian market
    better to stay away

    Reply
  5. clint

    Could anyone point me to a public website shows current bid-ask spreads and volume? My Broker let’s me buy, but doesn’t give me relevant information.

    thanks-clint
    no position

    Reply

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