Christopher D. Towle (Towle & Co.) on a Deep-Value, Private Equity Approach to Investing, Using Checklists, and Why He ...

Exclusive Interview with Christopher Towle (Towle & Co) brought to you by Vantage Research. This interview is just a portion of the in-depth interviews and idea generation they conduct for InvestorVantage subscribers. 

In 1994, Chris Towle joined Towle & Co., a St. Louis-based deep value investment manager that seeks to capitalize on market inefficiencies in the public equity market. The firm specializes in a long-term, deep value investment discipline, but with a modern day private equity twist.

Chris has been instrumental to Towle’s growth and development over the years. He’s involved in nearly every aspect of the investment management process including research, trading, and portfolio management. Prior to his arrival at Towle & Co., he served as a General Manager of H. H. Brown Shoe Company (a subsidiary of Berkshire Hathaway).

Today, Chris and the investment team are finding value in the manufacturing, metals, and publishing sectors, most notably in such companies as Navistar (NAV), Ryerson (RYI), and Tribune Publishing (TPUB). The three businesses featured offer an exceptional margin of safety based on Towle & Co.’s conservative estimate of earnings power, while trading at a fraction of their sales.

How did value investing start for you, and has your view of investing evolved over time?

Chris Towle: In 1981, it all started with my father, J. Ellwood “Woody” Towle, who remains fully engaged in the portfolio management process. After I joined in 1994, it seemed only natural to begin building the firm, the team, and the processes around what my father started in 1981. That’s really been the focus of my 20+ year career in the asset management business. Without a doubt it has been a big team effort and, thankfully, I believe we’ve accomplished this goal. Today, managing investment portfolios at Towle & Co. is no longer about a single individual but rather it’s the mission of a dynamic team of dedicated individuals seeking to uncover hidden value from different perspectives. This team approach fosters more objective analysis and promotes better decision-making while strengthening the firm longer term.

As a teenager in the 1950s, Woody started investing for his personal account. He subsequently became very intrigued and interested in the value greats – Benjamin Graham, Sir John Templeton, and Warren Buffett of the 1960s. The investment philosophies of these men formed the genesis of Woody’s thinking and, ultimately, the building blocks behind Towle & Co.’s deep value strategy. After receiving his MBA from the University of Missouri (Columbia), he started working at Brown Shoe Company, now Caleres, Inc. (NYSE: CAL). At Brown Shoe, he finished his career as Manager of Corporate Development where he played an integral role in the firm’s merger and acquisition activity. After about 10 years at Brown Shoe, he left to eventually start Towle & Co.

Everything we do is a blend of traditional contrarian, bottom-up fundamental analysis combined with a private equity (private market) view of the world. Of course you have to get the price right – price is king. However, over time we’ve learned a couple of things as we’ve evolved. First, make sure the CEO, CEO’s team, and the board are all really capable. You want them to be the kind of people you want to work side-by-side with over the long-term with capital on the line. We think that assessing management is highly critical. Secondly, we spend much more time on trying to understand industry dynamics. We do this because you can buy cyclical companies that might be the low cost producer or they might have the best management team, balance sheet, brand or distribution, but knowing the industry fundamentals and understanding the cycles can provide tremendous insight. Headwinds and industry cycles can overwhelm even the best businesses in a certain group.   So balancing the industry dynamics and cycles (and getting them right), along with trying to find those businesses that are ideally more “self-help” stories is part of our everyday process.

We want these companies to have numerous “levers” to pull that are not subjected to industry headwinds (or even tailwinds) that are out of their control. And that’s the balancing act because in the deep value space you’re always going to have more of the cyclical or commodity type businesses. So you need to get the industry cycle right. That’s how it’s evolved over time – spending more time on the higher level, qualitative assessment of these businesses rather than just valuing them.

With that said, as a firm I do think we are quite good at valuing businesses and understanding what they’re worth to a strategic or financial buyer. Our record of M&A transactions occurring within the portfolio over the last 33 years validates my view. The other qualitative factors are much more difficult to assess, but it’s still critical to our investment management process.

Do you have any daily rituals that help you keep your investing edge?

CT: Waking up early and having quiet time to really think about your day is critical to getting in the right mindset. If you just come into the office every day and get absorbed by the headlines and daily price movement, you can lose perspective and motivation. It’s important to guard your thinking, to stay focused on the things that matter most to your success as an investor. I encourage everyone in our office to live a balanced life. I believe personal time with your own thoughts, an emphasis on family, and appropriate exercise are absolutely critical for daily productivity and long-term satisfaction.

I will say there is no typical day because we are very opportunistic in terms of what’s happening in the market and the news flow. At the portfolio manager level you can see more of the forest through the trees. So I’m not really getting too concerned with reconciling an item on the balance sheet. Peter Lewis, James Shields, and Wesley Tibbets are CFAs and they comprise the intensive research team. Their days are much more absorbed and detail oriented. I’m certainly looking more at the current environment and the broader picture.

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What do your weekends look like? Are you able to “shut-down” your investing brain or separate it from your normal life?

CT: It’s hard to extract or remove myself from investing. A lot of it has to deal with the amount of capital we personally have on the line. Also, as a family unit, as a team, it’s who we are and what we do. For example, if you ask my kids and my wife what we talk about at dinner during the weekday and the weekends – most of it has to deal with lessons learned this week in the market or how the Greek debt woes could potentially impact the ability for higher-yield, lower quality credits in the energy space in the U.S. So my kids have lived through this stuff and it’s how I grew up too. I grew up talking about value investing, compounding capital, and being a contrarian at the dinner table. It really is a multi-generational affair, so I don’t know if we can completely remove ourselves from it.

I am an avid cyclist and I do race. We do travel sometimes overseas to gain some perspective on how extraordinary the U.S. is – it really is an amazing place. I’m not a golfer, so when I get on my bike I get into my own mental state, my own haven. It really gives me space.

What’s a little known secret about Towle & Co. that no one knows?

CT: I wouldn’t say it’s a secret per say, but we believe that the investing world, or investors in general, don’t fully comprehend what we’re doing. When you get into our world and we start talking about buying businesses with price/sales ratios of .10 – people will look at us and say, “so what?”

So I would say that our little deep value world feels like one big secret sometimes. We’ve been trying to tell people about it for years, but it still feels like an untold story.

Who are the people that inspire (or inspired) you the most? And why?

CT: My father, Woody, has certainly inspired me the most. He’s a man that loves humanity unconditionally. And he understands the inherent gift, whether it’s divinely ordained or not, of the human spirit when it comes to creativity, innovation, and ingenuity. That’s the basis for the infinite universal law of good. If you’re a value investor you have to fundamentally believe that good prevails over time. Access to instant information and news feeds gives us the sense that the world is “blowing up” all the time. And this isn’t the real picture.

If you take a step back for a moment and look at the facts – we’re as wealthy as we’ve ever been, we’re as healthy as we’ve ever been, and we’re as equal as we’ve ever been. When you look at women’s rights, education, and the world being as peaceful as it’s ever been. Global lifestyles are as high as they’ve ever been. Human longevity continues to grow every year.

When you look at those things, it’s a wonderful time to be an investor and be living in this era (especially if you’re an American). My father helped me develop this way of thinking about the world and that’s why he inspires me more than anyone else. He’s been my business partner for 20 years and I think he’s one of the greatest living investors today.

I am also hugely inspired by all the greats – Sir John Templeton to Warren Buffett. As well as all the great business builders – Steve Jobs to Phil Knight to Bill Gates. Even small entrepreneurs inspire me. The guy that owns the small concrete business in Little Rock, Arkansas to someone that owns a chain of footwear stores and is knocking it out of the park.

So it’s not so much the individuals that inspire me, but the qualities that go beyond the individuals and are expressed by the broader American entrepreneur. It’s very inspiring and reminds you to focus on the positives, the progress that’s been made, and the progress that’s still to come.

What are the top 3 books people don’t talk about, but that you would recommend to an investor?

CT: He’s getting more and more press, but I love how Howard Marks writes and how he thinks. The Most Important Thing was a phenomenal book. I think every investor should read this book.

Think and Grow Rich by Napoleon Hill is also outstanding. A lot of people talk about it, but it seems to be popular in some circles and not others. It can help you to arrange your own thought process systematically and it also helps in how you want to think about the world. And it also helps you think about a business that might be on its knees, but having the ability to recognize that it might be in a transformative stage on the cusp of greatness.

One book that might be newer is The Breakthrough Company by Keith McFarland. For me, this book provides an outstanding framework on a number of things, such as analyzing companies in our portfolio, continuing the improvement process within our own firm, how to properly construct a family, how to properly construct a non-profit organization, and how to systematically construct a career path for a young person. I found it to be a great way of thinking. It’s one of my favorite books.

How do you search for investment opportunities and what are your criteria for investment?

CT: Fundamentally, we believe that the market, especially in our space, is at times indiscriminately mispriced. I think that’s a very important assumption to embrace. We know the market is unduly influenced by short-sightedness, human behavior, the emotional pendulum swinging between fear and greed, as well as institutional constraints and restrictions. These conditions create short-term dislocation and asset mispricings that translate into investment opportunities for the contrarian, deep value investor.

In our daily search for new ideas, we use several data bases and quantitative screens to identify investment candidates for the portfolio. We look for companies with very low price-to-sales ratios trading at single digit multiples to their intrinsic earnings power. These businesses are typically way out-of-favor with the investment community and significantly under-priced relative to their private market value or the amount a potential buyer would pay for the whole business. The defining factor for us is the innate earnings power of a company and what those earnings are worth.

If someone asks us what we do? We tell them that we strive to buy unrecognized, unappreciated operating leverage or earnings power on the cheap. In a nutshell, that’s what we do. This obviously requires us to be independent in our analysis and contrarian in our thought. We are constantly running against the herd, going into those areas currently despised by the investment community.”

How are you looking at the energy sector right now?

CT: We are heavy in the energy sector right now. We have a couple of energy stocks that were dinged up – one was an asset play and the other an earnings play. Although we have not added capital to those names yet, we do view it as an opportunity. I would say one is distressed now and the other border-line distressed. But with the decline in oil, where else can you find companies that are trading at significant discounts to any normalization – especially if you believe that oil is going back to $75-80 in the next 3 years.

If you believe that scenario, then prices look pretty cheap. In the January – March period, when oil traded down into the $40s, we initiated a number of new energy-related positions knowing that no one knows where oil is going. Thankfully we’re up on 2-3 of our new energy stocks. Of course, we looked brilliant with the “shot-in-the-arm” rally when oil rallied from the mid $40s to $65, but here we are back under $50 – back in the soup, so to speak. But we do think this is where you need to have capital. I don’t know where else you can find a big, liquid pocket of value in the equity markets today. If you’re a true value guy we feel you need to be in the space.

Is there a portion of your investment process or philosophy that you would consider unique?

CT:  I believe there are two defining metrics, or characteristics, that we use. A big one for us is the price/sales ratio (p/s). There are many analysts that say if you can buy a company for under 1x p/s it’s a cheap stock. We traffic down in the .2-.3x p/s area. I think on a p/s basis we have the cheapest portfolio in the world probably. That gives us a unique philosophy as it relates to investing. We like it because you are buying a lot of revenue and economic activity on the cheap. Obviously there are inherent risks associated with it because you’re probably dealing with more levered balance sheets, which is generally the case. So there’s a little more volatility and risk in the portfolio as a result. We believe this gives us a certain edge, especially when you look at our returns over a 5, 7, and 10-year time horizon – rather than daily. If you look at them daily, you’ll get spooked easily when you’re in those kind of names. That’s a big differentiating factor for us.

Another unique characteristic is our whole return on market value concept. I haven’t really been able to find others who look at the world this way. It’s basically return on investment (ROI). For example, let’s say you’re buying company with a $10 stock price. We need to see a return on market value of least 15% on an investment over the next three years. This means that if we’re buying a $10 stock, need to have conviction that over the next three years the company will earn at least $1.50 in earnings over a 12-month period. So the $1.50 in earnings over the $10 stock gets you 15% return on your investment (after tax). That drives what we do – it’s where the rubber hits the road, so to speak. So the whole process of how we screen companies, run through our investment checklists, creating earnings projections, and then sell targets. Everything is driven by the inherent earnings power of the business and then it has to meet that 15% on market value hurdle.

This process and philosophy really helps to focus the mind. It focuses the team on the conditions that need to be in place prior to investment.

You mentioned your investment checklist during your investment process. Can you list some of the major components of your checklist?

CT: Our investment checklist continues to evolve and get refined over time. It’s not a static document. We didn’t have a rigorous checklist up until the last five years. It’s so labor intensive that you really need a small army to get through it now. Prior to that, it was just myself, Woody, and Peter. It was more iterative and open – it wasn’t as systematic. The checklist process begins when we find a business that we all collectively want to conduct a “deep-dive” on – a company that’s been sponsored internally. New investment ideas can come from anyone on our team. If we all concur, then we conduct the deep dive on the company. That’s when we go into our investment checklists and when we formally look at the business in its historical context. Here are some of the major components 

a. Historical Fundamental Assessment Versus Peers: Looks at the gamut of fundamental ratios over long periods of time to capture the full impact of cycles through the lens of valuation, profitability, balance sheets, working capital, and cash flow.

b. Technical Analysis: Price stabilization, moving averages.

c. Ownership : Looks at insider ownership, institutional holders.

d. Competitive Landscape: Consider market share, market segmentation versus competition, assess end market trends, competitive advantages, verify management’s claims.

e. Industry / Business Cycle: Considers headwinds, tailwinds that may be temporarily supporting or inhibiting the business.

f. Management Assessment: Check sources to verify competency and experience, confirm management’s vision, plan, transparency, urgency, capital allocation skills, etc.

g. Identifiable Catalysts: What will change the fundamental trajectory of the business?

Risk analysis is looked at throughout all the sections. We also look at the management team, the ownership structure, and we spend a little time on technical analysis as well to help us avoid the falling knife.

So that’s a rough explanation of our investment checklist – the big sections.

Not many value investors mention technical analysis as part of their process. Can you explain the role technical analysis plays in your process?

CT: Like yourself, it's probably 1% of our process. There are so many studies and indicators in technical analysis, and many of them can throw you off when you’re trafficking in our kind of businesses. You really need to take technical analysis with a grain of salt. For example, if there’s a big liquidity event and it’s a fairly illiquid stock, you’d probably look at it on a chart and there would be no way a trader would buy it using traditional technical analysis indicators. With that said, we realize that news like that will be digested over time and the stock will float back up. So that type of event could be a tremendous opportunity even though the technicals were completely blown-out. You always need to take it with a grain of salt.

We’re looking at situations where a stock is starting to base and whether there is volume at attractive price points. We look at various moving averages to help us figure out whether the stock is trying to base or not.

Are you more of a generalist in search of value and market inefficiencies?

CT: Yes, I would say we’re generalists across a sub-set of industries but, we don’t invest in sin stocks (alcohol, tobacco, gambling, etc.). These are areas we don’t want to support with our capital. We also don’t invest in healthcare or high-tech industries.” If we do anything in tech, it’s normally low-tech. Low-tech companies include companies in distribution and manufacturing side such as, EMS companies or companies like Ingram Micro (IM). Normally low multiple, low margin distribution and logistics companies in the tech space.

We do believe we have a fairly good handle on consumer retail – we’ve spent a lot of time there and done very well. Industrials and transportation have done well for us. Depository institutions is also an area we’ve done well historically, but we have zero exposure there right now. We did well coming out of the financial crisis between 1989-1991. It was a huge driver of our success during that time. Essentially we try to focus our efforts on consumer retail, industrials, transportation, and basic manufacturing. We have cumulative experience in these areas that we benefit from as a group.

Describe your value discipline once you have arrived at an understanding of the Intrinsic Value? How does it relate to portfolio management?

CT: We typically have 33-40 companies in the portfolio. And it’s all driven out of opportunity and conviction on our part. When we start a new position, it’s usually 1-1.5% of the entire portfolio. It can grow from that percentage to as high as 3-3.5% (in terms of cost), but we generally don’t go higher than that regarding position sizing. So it’s a fairly concentrated set of holdings.

When we go into a name, it’s all about maintaining upside potential in the portfolio. We look out three years in our process. Every company we analyze—whether it’s a prospective company or a company we are monitoring—we’re always looking out three years. And we’re always looking at eight basic assumptions at the portfolio:

1) Revenue Growth

2) Profit Margins (gross profit margins)

3) SG&A (OpEx)

4) Capital Structure

5) Cost of Capital (weighted average interest rate they are paying)

6) Tax Rate of the Business

7) Shares Outstanding (fully diluted if there are issues)

8) Appropriate Earnings Multiple to assign in that Business

We support this analysis with P/S valuations – which we love because it’s very tough to cheat on a revenue line (unlike cash flows and earnings). Then we’ll look at EV/EBITDA multiples because it’s a great way of calibrating a business relative to the private market worth of that business with private market transactions. It helps to compare against a broad range of industries and cap structures.

The assumptions I just mentioned help to build out our definition of earnings power for a particular company. We are constantly tweaking this from daily information flows, quarterly reports or discussions with management teams. We constantly think about how those eight assumptions are impacted by the information flows. All with a three year time horizon – I can’t mention that enough.

When a new company enters the portfolio, typically it means that another company has reached its sell target. And we also believe that when the eight assumptions driving the earnings power of the business in conjunction with the appropriate earnings multiple is reached or exceeded, we are ultimately left to leave that company and redeploy the proceeds into a company that we feel is further down on that continuum. That’s the ongoing, constant process.

We do a great deal of position sizing on the edge. So we’ll do a lot of .5-1% moves out of companies that have appreciated and then deploy those proceeds into companies we feel are more attractively priced. We will make buy and sell decisions weekly.

What is your take on book value, tangible book value, or price to tangible book value?

CT: Historically it was meaningful, but I don’t think it’s as meaningful as it once was. I believe a lot of that has to do with the M&A binge that corporate America has been on for 20 years and the Great Recession with all the asset write downs. Book value is such a nebulous number now. As a result, we’re much more focused on earnings power. We are very comfortable now buying businesses with zero tangible book value because we’re strong believers that earnings and cash flow drive stock prices. We’re much more sensitive to the P&L than a company’s book value.

What was the worst investment you've ever made?

CT: When you’ve been doing this as long as we have you’ll have an awfully long list. One of really bad ones was dry-bulk shipper, Genco Shipping (GNK). This is certainly under the category of lesson learned. Unlike many of the dry-bulk shippers that were based mainly out of Greece, Genco was U.S. based and headquartered in New York. We felt they had the controls in place, the management team, and better business practices to make it through. The big mistake we made on our part – and maybe this is a big mistake for deep value investors in general – is not understanding the cyclical forces that can be very long in the tooth and last many, many years. Essentially devastating well-structured companies. We call it creative destruction in the deep value space, but it’s not from creativity – it’s from cyclical destruction. In the deep value land, we keep learning this lesson over and over again. I think this is a hugely important lesson – these low interest rates we’ve experienced for the last 15-20 years have driven corporate decision making, which has fostered and enabled investors and corporations to do really dumb things. Obviously, we saw this with housing. We’re now seeing it in coal companies, shale companies, and ship building. Capital is so free, and so freely available, that the incentive has been to grow, grow, grow and put on all this capacity and supply. And when growth expectations are not met, it’s unmitigated disaster for all players. Which is exactly what we’re seeing today in certain sectors.

It creates over-investment because the cost of capital is so low. Getting in front of that kind of cyclical destruction (supply overhang) is very difficult. It’s best to try and avoid it at all costs. That may be the #1 lesson over the last decade for us.

What was the best investment you’ve ever made? What happened?

CT: A more recent investment that was a lot of fun was Arkansas Best. They are a less than truckload (LTL) company. We bought it in the fall of 2012. We actually owned the stock previously and had done very well with it. We liked the core culture and their footprint in the industry. However, they were challenged by the aftermath of the Great Recession which enabled many of the other LTL carriers to get relief with their union contracts as it related to their costs and legacy liabilities. Arkansas Best did not receive some of those concessions and they were beat up as a result. However, they had a solid balance sheet and made some really smart acquisitions to move into some more asset light logistics businesses to get away from that asset intensive LTL and hub and spoke network that they built. They had to really figure out how to right size their costs to remain competitive in the LTL segment. Especially since they now had to compete with not only the non-union carriers (like Old Dominion), but they now have to compete against the other union carriers that had some of these concessions that had come through to really maintain the unions and keep employment up.

So it became a one factor stock for us. We were buying it around $7-8 at such a discount to the revenues relative to its earnings power. Any intelligent long-term assumptions about growth or operating margins gave us $2-3 in earnings power. At the time the company was in contract negotiations with the unions. We were under the assumption that it was in the unions benefit and the corporation’s benefit to come through with an agreement that made sense for Arkansas Best’s longevity.

The market was really concerned about this uncertainty. Our view is that great returns occur when your portfolio collides with future events. And that’s exactly what happened. The concession came through a few months later into late 2012 and early 2013, and the stock launched during that time as the company’s revamped cost structure enabled them to be competitive again.

It was great because we owned it before and knew it well. We’d also done very well with trucking companies historically. We felt very good about the potential outcome when the market was skeptical.

What is your investment thesis in Navistar (NAV)?

CT: Navistar is a diversified industry leader in the U.S. and Canadian truck markets with a solid market position in medium and heavy duty trucks (class 6 through 8). Navistar is a name we’ve been involved with for quite some time now. And it’s one that has been faced with a significant amount of challenge. Former CEO, Dan Ustian, bet the ranch on an emissions technology called EGR. And EGR was an eternal emissions control system that only Navistar really pursued. Ustian spent hundreds of millions of dollars (risking a tremendous amount of shareholder and firm capital) on this technology that did not pan out. It’s our understanding that he moved ahead in a very bull-headed manner and against the advice of people both inside and outside the firm. This put the company in risk and created a great deal of ill-will in the marketplace.

We actually owned the company prior to this situation. Thankfully, we bought the business at the right time with and fairly high margin of safety, if you look at the valuation of Navistar relative to its closest competitor (PACCAR PCAR). So we haven’t been hurt in the name, but it’s been a long time coming. There have been multiple iterations of management in trying to right size the company and the product.

As a result, Navistar’s market share and brand reputation have suffered due to the emissions technology debacle that occurred 3-4 years ago. Large warranty costs have run through the P&L because of this as well.

With that said, the company has a great allegiance in the marketplace. International trucks are still highly regarded. Other than the engine, people love the truck’s design, the chassis, how they ride, and the technology they put in the trucks. When you fast forward to the new CEO, Troy Clarke, he is making great strides to bringing Navistar back to where it needs to be with the products, engines, and cap structure. We think there is significant upside, particularly from current levels around $18 per share.

Describe how you arrived at the valuation of the business?

CT: If you look at the valuation of the business, with just top-line growth at 3% we’re modeling with a 15% gross profit margin. And if you look at what they did last quarter, they did about 13.3% gross profit margin. If you look at PACCAR and some other competitors, they are in the 17-18% range. So we’re taking a conservative view of the valuation from a gross profit basis. We also run through what the management team says they can do, which is an 8-10% EBITDA margin. And management says their right on track for their plan. We talked with management last week and those numbers translate to 5.9%, or $716M when you take out the D&A assumptions or $316M per year. When you flow that down through the rest of the business, you get to a $3.50 earnings power with 81M shares outstanding. So we have a company with $3.50 earnings power on a stock that's trading around $18. This gives us a return on market value of 18% — remember our hurdle is 15%. You don’t want to say it’s a no-brainer because they have a lot of heavy lifting to do and we’re looking out three years. And they still need to prove that they’re executing in terms of the profit and delivering to the bottom line over the next 2-5 quarter. 

Regardless, this gets us to a very fairly attractive target because with we think it can trade at an 11x multiple. That gets us to $38 with shares trading around $18. This is a recently revised earnings projection. Previously, we had a sell target at $46 and had to adjust downward because we had a much higher expectation in their ability to regain market share. Through recent channel checks, research, and discussions we don’t believe that the market share gains are coming back as quickly as we imagined. The damage from the EGR fiasco is still lingering longer than we thought. So we ratcheted down our growth rate from 7% to 3%. We’ve been in a nice recovery when you just look at the Class 8 units being sold in the U.S. So it’s more of a slower growth and self-help story today than we had originally thought. But we still like it at this price. We just averaged down in the $19s a couple of weeks ago.. You can call it a turnaround or a transformation change within the business because they’ve taken out capacity and headcount. And we believe they’re closer to the 4th or 5th inning, which can be right near an inflection point of an earnings rebound if your looking out 12-18 months.

What is your investment thesis in Ryerson Holding Corp (RYI)?

CT: Ryerson is another name we’ve owned before and it looks really interesting at current levels. It’s an odd one in that it was taken from us when it was bought out by Platinum Equity. They acquired it back in 2007 and then of course all of their end markets went down into the toilet -- transportation, construction, appliances, aerospace. This company has been in triage. They did one of the big stock dividends, as private equity firms do, by leveraging the balance sheet. I think they tried to shop it and they didn’t find any real takers.

So they did a partial IPO to monetize some of their investment. This gave us an opportunity because the stock is remarkably illiquid. But at the same time, Platinum Equity comprises the majority of the management team and the board. And they also own 66% ownership of the company. It’s essentially a quasi public/private holding. There just aren’t that many asset management firms that can take the better part of 2 months to build a position in such an illiquid position.

We like how Ryerson is positioned in the marketplace. When you look at the industry (metals distribution), which is a $200B industry. Many of the larger players that they compete against, like Alliance Steel, only have a single digit market share. And it’s the same with Ryerson. It’s an industry that’s highly fragmented, which makes it critical for where you are positioned in that industry and what niches you can capitalize on and what equipment you have and capabilities you have for their end customers.

They are basically a middle man. They buy raw steel and then bend it and shape it to different tolerances for application in the manufacturing process -- small appliances, autos, aerospace, energy, construction, etc. They’ve spent a lot of money prior to the business becoming public expanding into businesses that are higher margin. They also spent a lot of time transforming their corporate overhead and cost position and margins.

The reason that the business has really taken a hit is because of the decline in metals pricing. It’s created a delay in their customer base in terms of purchasing. The customers obviously look at the same metrics that Ryerson is faced with regarding cost of goods sold. And so you have customer delaying purchases and contracts. So margins have historically been fairly stable. However, if you go through various points in time, there are times when the costs of goods decline and then it delays their purchases on the top line. This causes a reduction in margins as they have to work through higher cost inventory that they purchased when the input prices were much higher.

That’s where we are today. As late cycle demand picks up, and as they work through their higher cost inventory, margins should begin to normalize to the upside. Right now Ryerson has a very limited float. We’re providing liquidity in the marketplace and I believe we are capitalizing on the small cap liquidity premium. In addition, Ryerson is an under followed business in the investment community.

Describe how you arrived at the valuation of Ryerson ?

CT: If the base business grows at 3%, which is on par with growth plus inflation, and you look at historical SG&A and the EBIT margin, we get 4%. That’s what the business has done historically. If you look back at when we owned it previously in 1999-2006, the stock was trading up in the $40s. Now the stock is trading around $7 per share and it’s fundamentally the same business. With basic assumptions, they can generate a return on sales of 1.1% (which they’ve done historically, and it’s all we’re asking them to do). That gives us $1.30-1.40 in earnings on a $7 stock. And they’ve earned much better than that in the past. As they de-leverage, the business should be able to generate a 2% return on sales. At 2% return on sales, the earnings power begins to approach $2-3 per share on a $7 stock.

We think from an operating leverage perspective that this is a very hidden and cheap stock that’s stuck in the nooks and crannies of the market. The operating leverage is powerful. For us, we feel that with Platinum Equity involved, the risk of bankruptcy is very modest given the kind of cash they can generate and how diversified their customer base is. The markets that they’re in -- autos, residential, construction, infrastructure -- are late cycle and they’re in recovery mode right now. So they have this cyclical tailwind and a private equity sponsor that’s interested in de-leveraging its balance. We think that the de-leveraging is a big catalyst.

What is your investment thesis in Tribune Publishing (TPUB)?

CT: It’s similar to Ryerson in that it’s a spin-off that’s kind of orphaned right now. It has a limited operating history in it’s current form. It’s not the media side of the old Tribune Corporation. It’s the newspaper side of the business with assets such as, LA Times, Chicago Tribune, and the Baltimore Sun. The spin-off occurred and we focused on properly evaluating the media business versus the publishing side. Obviously many of the other media businesses are doing this, which Gannett (GCI) did last month.

We like Tribune for a couple of reasons. We think that they’re digital strategy has been neglected. When you look at the amount of subscribers collectively, they have more subscribers than the NY Times. Only USA Today (Gannett) has a greater subscriber base to their traditional publishing assets. When you look at the number of digital subscribers they have today, it’s minuscule (especially when compared to NY Times and The Wall Street Journal). We believe this is the opportunity for them to ramp up their digital presence and platform to help off-set the declining revenues in the traditional print media and print advertising. We all know this is in structural decline.

The NY Times, Barron’s, and The Wall Street Journal have done it. The blueprint is there. So the formula is there. It’s not like they have to go out and create a new widget. The CEO who runs the company has gone out and made two really important hires. One is Michael Rooney, Chief Revenue Officer. He comes from the digital side of the Wall Street Journal and Barron’s. Why would a guy who’s in his prime join Tribune Publishing? We think he sees the potential and hopefully he’ll be able to use his bag of tricks to make it happen. The other big hire was Denise Warren. She was at the NY Times for 28 years and was very involved with the digital build-out of the NY Times.

So you have these two big hires and you also have the realignment of their sales team. This will allow them to package to their various markets the solutions in print and digital to really be a go-to source from an advertising and promotional perspective. They also have great content. If you talk to anyone from Chicago or LA, they will tell you they read those papers. They are the go-to for local content.

The other strategy which is fascinating is continuing to utilize their printing capacity and consolidating other newspapers. They are quietly making acquisitions to utilize their print capacity to really leverage their operating costs. They are able to buy these legacy papers at really deep discounts around 4x EV/EBITDA.

Describe how you arrived at the valuation of the business?

CT: We think they’re great at allocating capital. Their market position is great. The management they’ve assembled is great. They also have the best balance sheet in the publishing business which gives them a lot of flexibility. We also love that they are trading at .23x P/S. When you look at Gannet or the NY Times, they are trading at 1.25x P/S. So even if you think they move to just .75x P/S (which is probably where it should be now), you have a big move in the stock.

We also think there are numerous catalysts that can drive the move. The investment community will probably wake up with the margin improvement occurring and the top-line revenue stabilization. We’re about to be at the one year anniversary of the IPO and we expect more coverage to come on board. And we think it’s starting to base in this $15 area.

What are The 3 Things an investor should focus on the most to produce out-sized investment returns over the long-term?

#1 Frame of Mind – Being contrarian in your views, Being independent in your thought analysis, and taking the long-term view. Must have all three.

#2 Recognize that there is a permanent return advantage in small cap investing. It’s driven by valuation and liquidity premiums. If you can understand that, you’ll be able to compound rates higher than the S&P for a long period of time and become wealthy in the process.

#3 Arrange your life, and your portfolio, in such a way that it increases the probability of benefiting from what you expect will happen in the future.

For more information on Chris and Towle & Co, please visit http://hvst.co/1NDslHd 

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