Description

Mental Models discussed in this podcast:

• Durability
• Post-Mortem
• Resulting
• Capital Allocation

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Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode118

Timeline

• NACCO spun off Hamilton Beach Brands in September 2017
• I first bought shares in March 2018 at a price of $40 per share
• I averaged down in May and June 2018 with shares at a price of $34 per share.
• Averaged down in September 2018 at $32 per share and October 2018 at $29 per share
• Within a year, the stock doubled to over $65 per share in October 2019. This is the recent peak. Instead of selling, I held because I valued the company at $75 per share at the time. It wasn't yet at fair value.
• May and June 2020, I averaged down again at $26 per share and then $22-24 per share.
• In March 2021, I recognized that holding $NC was a large opportunity cost on my portfolio and I shifted some money to other stocks while the stock was around $24-25 per share.
• In May 2021, I exited my stake in $NC completely at a loss around $25-26 per share.
• Some lots were sold at a gain and some at a loss. Overall, the position was a net loss and a much bigger loss on an opportunity cost basis.

Thoughts and Key Questions

• I should have sold or trimmed after the stock doubled in less than a year. $65 per share was within my error margin for my $75 fair value estimate. Even simply reducing my stake by half would have been a good decision.
  • The main reason I didn't do this was that it would have had to sit in cash. I didn't have many other good ideas at the time.
  • My biggest mistakes are often made when I'm in cash or when I would be creating a cash position. (Always do research for new ideas!!!)
• Was buying $NC in the first place a mistake?
  • No, I don't think so. My theory was sound. I expected positive news from NACCO and it was cheap at $40 per share. It was the best idea I had at the time, I was also running a diversified 10-15 stock portfolio when I bought NACCO. 
  • My thesis was correct, but I had thesis creep as news flow came out. My original valuation placed the stock as worth between $50-65 dollars. I only upped my estimate after high natural gas income. I should have recognized that was temporary and sold. 
  • I thought NACCO was a 3-5 year hold business, but it probably should have been sized as a last puff cigar butt. When that puff came within a year, I should have sold. 
• Did I accurately assess NACCO's business model quality?
  • Yes. NACCO's service model of earning money from unconsolidated subsidiaries allows it to earn high returns on capital as the customer puts up all of the capital.
• Did I accurately assess the durability of NACCO's business?
  • No. I misestimated the likelihood of a coal mine closure.
  • I did assess that coal mine closures were likely and I accurately predicted the degree to which they would harm the business. However, I underestimated the degree to which NACCO's stock would decline. I thought the decline was overdone. 
• Did I accurately assess management/capital allocation?
  • Partial yes, Partial No.
  • I accurately predicted that management would NOT dedicate new capital to new coal mines.
  • I accurately predicted that free cash flow would be dedicated to growing the North American Mining business.
  • However, I underestimated the maintenance CapEx needed for the MLMC consolidated coal mine. This sucked up a large amount of cash flow for the 3 years I owned the stock. Future maintenance CapEx is going to be lower, but the timing was bad on my part. 
  • I also underestimated the ROIC from the money put into the North American Mining business. I expected higher returns for the cash outlay.

Thoughts and Lessons Learned

• Don't buy companies that lack durability and really dive into this question of durability. 
  • A mistake on durability could mean that a very low P/E is justified. 
• Personal preference: I highly prefer buying steady growth companies.
  • I did not enjoy the constant negative and bad news reports from the company while I owned it. The primary problem with owning NACCO for the last 3 years was the opportunity cost of how that money could have grown with other better companies.
  • My actual losses weren't that high. Some of my purchases made a profit.
  • However, the process of turning one profit center (COAL) into a new profit center (NAM) is slow and costly. That's basically a turnaround situation.
• I don't want to own turnaround situations until after they've been turned around.
  • It's basically dead money
  • Creates large opportunity cost situations
• Management is critical
  • I want a management team that I believe is fully aligned with me on skin-in-the-game.
  • NACCO has a good management team, but they don't run the company how I would run the company. They receive regular ongoing stock options and issuance which dilutes me as a shareholder. There isn't a lot of insider buying and there weren't a lot of share buybacks which I would have preferred.
  • If I were assessing NACCO today, while I still believe it is cheap, I don't think it would pass my current management/capital allocation filter. Perhaps that will change in the next 5-10 years. 
• Be wary of thesis creep.
  • NACCO would have been one of my best success stories if I simply sold it after it hit $60 per share. A quick double and it would have been a lot of money for my portfolio as a 20% position. 
  • Instead, I allowed my thesis to creep which resulted in $NC being a drag on my performance for years 2 and 3 of my holding period. 

Summary:

I want to buy and hold high-quality, durable businesses that are growing AND are selling at a cheap price. NACCO had a cheap price and was high-quality, but it was of low durability and had no growth.

Going forward, I am going to be more diligent at filtering out ideas that don't meet ALL of my highly stringent criteria.