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This month Singular Diligence covers Breeze-Eastern Corp (NYSEMKT:BZC) a manufacture of sophisticated engineered mission equipment for specialty aerospace and defense applications. BZC’s products are used to complete rescue operations and military insertion/extraction operations, move and transport cargo, and load weapons onto aircraft and ground-based launching systems. It’s an obscure, cheap stock in a duopoly. The extract below describes the company’s moat:

Breeze-Eastern has over 50% market share in helicopter rescue hoists. Outside of the former Soviet Union, it is part of a true duopoly with UTC Aerospace. Most customers believe they have only two choices for rescue hoists. They can either go with UTC or Breeze. It is important not to overstate the technical difficulties of this business. Breeze is a duopoly. And there are good reasons to believe it will stay a duopoly.

But there are not serious technical obstacles to overcome to enter the rescue hoist business. In fact, it is possible to modify a helicopter designed to work with a Breeze rescue hoist so it can instead be equipped with a UTC rescue hoist.

There are many more helicopter models than rescue hoist models. There is no need to design a completely new rescue hoist model for each helicopter model. A former Breeze-Eastern engineer told us: “In general I would say rescue hoists though somewhat customizable for each airframe in general the overall design was consistent. As with any aerospace product there is some uniqueness per aircraft whether it is electrical or mechanical interface or some unique performance requirement. But Breeze has a great baseline hoist that was easily modified as needed for the application.”

Breeze’s experience in cargo winches is probably similar to what a new entrant in rescue hoists would face. Breeze had a high initial investment. After this initial investment was made, Breeze hoped to invest much less in engineering each subsequent cargo winch project it worked on because it would have a base to work from. Here is a quote from a 2011 earnings call: “… we are using the engineering work that we’ve done for those in our bidding on other programs—so trying to use derivatives off of that with much less engineering—incremental engineering investment or effort than we had to make to do the from scratch development on a couple of those cargo winches.”

Although Breeze is part of a duopoly without a lot of change, it would be wrong to equate the technical challenges Breeze and its competitors face with something like what Babcock does in nuclear power components for the U.S. Navy. Rescue hoists are fairly simple. They only average a cost of about $250,000. There are not huge risks of cost overruns or delays in construction due to technical challenges. A rescue hoist is a niche product. But it is still a product. It is not a custom project. Historically, Breeze or UTC invested in all the upfront spending on designing a hoist to work with a certain helicopter. This is a big reason why the original equipment manufacturers do not mind a duopoly. They can choose from one of two companies who can offer a good solution. And those two companies will spend the necessary time and money on designing the hoist. The rescue hoist manufacturer then benefits from that new helicopter model specifying the hoist it is meant to work with. But, eventually, a popular helicopter model will be capable of working with a hoist from either company. This is because–eventually–the competitor who did not work on the helicopter when it was originally introduced does the necessary engineering work so it has a hoist that can work with that helicopter. The Sikorsky Blackhawk, Bell 412, Eurocopter AS350, AgustaWestland 109, and many other helicopters now work with rescue hoists from either Breeze-Eastern or UTC. So, a customer can buy a fleet of Blackhawks and then have its choice of which hoist to use: Breeze-Eastern’s or UTC’s. It’s not clear how important this choice is to the competitive position of the two companies. That may seem like a strange statement. But there are two facts to consider. One, when a new helicopter model comes out it generally has only one hoist meant for it. So, if you are an agency getting deliveries of some helicopter within the first few years of its introduction–you may not have a real choice. Also, customers—unlike the original equipment manufacturers–are focused on search and rescue. So, a customer might have 10 helicopters and even when buying a new model, they may still have 5 helicopters of a different model. In the Maryland State Police example we gave, they have a fleet of 20 helicopters split between 11 of one model and 9 of the other. A customer would not like to use one supplier for repair and replacement work on half the fleet and another supplier for repair and replacement parts on the other half of the fleet. Remember 90% of replacement parts are proprietary and the two companies’ parts do not work together. This preference may sound excessive. Airlines, militaries, government agencies, etc. frequently operate more than one model of airplane or helicopter in their fleet. Why not use two different kinds of rescue hoists? But there is an extensive distribution structure for even proprietary parts from most airplane and helicopter manufacturers. Remember, there is easily 10 or 20 times more helicopters out there than there are helicopter hoists. And there are far, far fewer helicopters in the world than airplanes. Logistically, it is much easier to service airplanes than helicopters. And it is much easier to service helicopters than to service helicopter rescue hoists. The inventory levels related to rescue hoists are very, very low. We know this because we can see Breeze-Eastern’s inventory levels and we know how long they take to get replacement parts to customers. We also know UTC is no better.

This is an area Breeze is working on. But, it is worth discussing the logistical problem caused by how small the rescue hoist niche really is. One customer told us: “My issue is that we equip all 12 of our helicopters with hoists and the operations are things we train extensively on. If a hoist is taken out of service we get very uncomfortable because one of our prime reasons for having them is to rescue our own firefighters from getting burned over by a forest fire or for getting an injured person in a remote area out for medical attention. I’m not sure either company gets that and it may be that the armed services have enough spares so that it never happens. The hoist is used because in almost all instances where it is used it is not possible to land the helicopter. So we don’t like having a helicopter available but no hoist. They don’t break often but they do break.” Another customer who complained about the lack of customer attention explained this problem is caused by the size of the addressable market: “UTC is the only manufacturer that makes the type of hoist we use and we selected (that hoist) for some very specific reasons. I suspect that things would be different if there were 5 manufacturers who made a hoist like this and they were interchangeable, with little or no work, but the market is too small for that to happen, so here we are.”

Customers know they can modify their fleet to use Breeze or UTC hoists. And several customers told us they have heard of people doing this. The reason for switching was always poor customer service. But the problem is that “there are significant changes in the fixed provisions” Fixed provisions are non – optional (required) parts. This point of fixed parts was stressed to us again and again by customers and engineers. For example, another customer told us: “…the external hoists from both manufacturers do not have any interchangeable parts. Wiring diagrams are also specific to each manufacturer. Each hoist type comes with a helicopter model specific flight manual supplement so these are also different between hoist manufacturers and helicopter models.”

So, it is not technically very difficult for Breeze-Eastern or UTC or anyone else with a good base hoist system to engineer solutions that work with different helicopter models. It is also not impossible for a helicopter operator to switch from one hoist to another. But there is an installed base of search and rescue helicopters out there. And each hoist manufacturer’s replacement parts only work with their own hoists. This discourages switching between hoist suppliers. If an operator believes the two companies offer roughly similar solutions the obvious decision is to stick with the solution they already have in place. This is why delivery times can be slow and gross margins can be high on replacement parts. Historically, it has probably been the case that Breeze and UTC work harder to please an original equipment manufacturer than they do to please the helicopter operators. As we’ve mentioned before, Breeze’s CEO has said they plan to improve customer service and speed up delivery times. But, historically, once an operator is using a certain hoist they generally have to deal with slow delivery times and high prices on the parts they need.

Click here to subscribe or buy this issue.

 

Bruce Murison* contacted me at the start of June with an interesting proposition: He would open a dedicated account to trade the Acquirer’s Multiple All Investable Stocks Screen and post his strategy and results on the site. He thought knowing there was a public eye keeping him on the straight and narrow might assist with his discipline (the same reason I launched Greenbackd in 2008). He wondered if a real time, real money account tracking the acquirer’s multiple’s performance would be interesting to readers of the site. I of course leapt at the opportunity. Bruce hopes that his project might encourage outside the box thinking and maybe lead to others posting their strategies and ideas that could become an interactive community of users. Here begins Bruce’s first post in what I hope will be a long series:

I am dedicating a $25,000 real money account to trade stocks ranked favorably according to The Acquirers Multiple (TAM). Every stock will be chosen and traded according to these rules:

  1. For purposes of this plan, Qualifying Stock (“QS”) is defined as the stock on the All Investable Stock Screen (“Screen”) with the lowest Acquirer’s Multiple, after excluding stocks currently held in the portfolio.
  2. The fully invested portfolio will consist of ten QS and negligible cash.
  3. The initial portfolio will be constructed over the course of the first year by buying the new QS every 36 calendar days until fully invested.
  4. When any 36th day, measured from the date of the previous purchase, falls on a day U.S. markets are closed, the QS will be bought on the next trading day.
  5. Each stock will be reviewed shortly before the one year anniversary of its purchase. If its sale would result in a loss, sell just before the one year anniversary; if a gain, sell just after.
  6. Replace each stock sold with the current QS.
  7. If, however, the stock to be sold, would, if not already held, be the new QS, do not sell but hold for review again one year later.
  8. If a portfolio stock becomes the object of a takeover or merger that closes before the one year anniversary of its purchase, reinvest in the current QS as soon as the cash is received and / or any securities received in exchange are sold.
  9. Strive, at purchase, for equal dollar weightings of each stock, to the extent possible. However, no rebalancing trades will be made during a stock’s holding period.
  10. All trades will be market-on-close.
  11. No margin will be used.
  12. The performance benchmark is the total return of the Russell 3000 Index.

Read more.

The latest issue of Singular Diligence is out with a deep dive into an obscure duopoly stock, Breeze-Eastern Corp (NYSEMKT:BZC). Breeze-Eastern Corp (NYSEMKT:BZC) makes rescue hoists, cargo winches, and cargo hooks for helicopters. They are typically used to lower and raise people from the helicopter, for example, to lower a rescuer down from the helicopter to the ground or sea and then have that rescuer attach an injured person and raise them both back up to the helicopter. A Breeze-Eastern rescue hoist can cost $250,000. The company has one competitor.​

BZC is one of the safest and best long-term buy and hold opportunities we have featured in Singular Diligence. We have picked stocks with more upside. And we have picked stocks that were cheaper. But we have not picked any stocks with a clearer future. BZC is the perfect buy and hold stock.

Read more.

A little over a month ago I travelled to Harvard at the invitation of Michael Bigger of Bigger Capital to speak to Michael Parzen’s business statistics class on Deep Value and the acquirer’s multiple. Here is the recording of that talk.

You can get a free list of the best deep value stocks in the largest 1000 names on The Acquirer’s Multiple.

Buy my new book Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover or Kindle, 240 pages, Wiley Finance) from Wiley Finance, Amazon, or Barnes and Noble.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on Deep Value, or connect with me on Twitter, LinkedIn or Facebook. Check out the best deep value stocks in the largest 1000 names for free on The Acquirer’s Multiple.

I’ve just finished the rough draft of a new book about concentrated value investing and the investors who practice it. One of the side-effects of extreme concentration is idiosyncratic portfolio performance–concentrated portfolios behave differently from the market. This makes sense. To beat the market one must hold stocks in a different composition to the market, which in turn means performance that’s different, both to the upside and the downside. The investors interviewed in the book all have very long track records (more than 25 years) of massive outperformance, but all have endured regular and extended periods of underperformance. Such is the toll of concentrated investing.

The performance of the market–let’s say the S&P 500–is the market capitalization-weighted average performance of the largest 500 stocks in the US. In most years the performance of the aggregate doesn’t tell you a great deal about the performance of the underlying stocks. The extent to which the performance of the best stocks in the market outperform the worst stocks is known as dispersion.

Patrick O’Shaughnessy has a great new site called The Investor’s Field Guide where he shares the results of backtests and other research he conducts. In Is Being Different Better? Dispersion and Active Management he takes a look at dispersion. In the chart below he compares the average excess returns for the best and worst performing 10 percent of stocks in three different market capitalization ranges–large, small and micro–over the last 50 years.

dispersion-of-returns-by-cap-space

These are excess total returns measured against an equal-weighted benchmark, which means, for example, the +58 percent result for the Best Performing 10% (Large) means that those stocks beat the market by 58 percent in any given year. As the chart makes clear, the smaller the stocks in the universe, the greater the magnitude of outperformance (or underperformance). Micro cap stocks offer the best opportunity for skilled stocks pickers (and the greatest opportunity to trip over). That’s dispersion.

O’Shaughnessy notes:

Since our goal is earning the highest returns possible above the market, it stands to reason that we should prefer parts of the market which offer the greatest chance of earning huge returns. … [T]hese results highlight an opportunity in micro- and small-cap investing. This is especially true for smaller, individual investors who don’t have to worry about market impact when trading. Large institutions simply can’t run meaningfully large micro-cap portfolios, and so many small stocks go unnoticed.

Check his new site The Investor’s Field Guide or read more Is Being Different Better? Dispersion and Active Management.

You can get a free list of the best deep value stocks in the largest 1000 names on The Acquirer’s Multiple.

Buy my new book Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover or Kindle, 240 pages, Wiley Finance) from Wiley Finance, Amazon, or Barnes and Noble.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on Deep Value, or connect with me on Twitter, LinkedIn or Facebook. Check out the best deep value stocks in the largest 1000 names for free on The Acquirer’s Multiple.

Josh Payne and the folks at Quantopian ran some tests on the performance of the acquirer’s multiple and Joel Greenblatt’s Magic Formula.

I have argued in Deep Value and Quantitative Value that the acquirer’s multiple (enterprise value / operating earnings) tends to outperform the better known Magic Formula although it is only one-half of the Magic Formula, which also includes return on invested capital. Josh and Quantopian wanted to test that idea in the Quantopian backtester.

They tested a few variations of operating earnings, including EBIT, EBITDA, and EBITDA – Cap Ex. The results were recorded in their notebook, which you can view on the site by clicking here and finding the red “View Notebook” button to the bottom right of the first screen. Here are some of the backtest results:

Quantopian Backtest

After optimizing the results, Josh and Quantopian conclude:

Taking a look at the Cumulative Returns, Sharpe Ratios, Max Drawdown, Calmar Ratios, Annual Returns, and Annual Volatility we see that the Acquirer’s Multiple beats the Magic Formula in almost every category except drawdown and annual volatility. However, given the Sharpe ratio and Calmar ratio, it seems that the volatility and drawdown is for good measure.

..

In short, Magic Formula has slightly better performance with defensive metrics like volatility and drawdawn, but the superior returns that the Acquirer’s Multiple provides proves to be worth it, as encapsulated in metrics like Sharpe Ratio and Calmar Ratio.

Simpler, it seems, really is better in this case.

Quantopian has a really cool feature: You can grab the source code for the acquirer’s multiple backtest and run variations of it using Quantopian’s backtest data, or test your own ideas. Check it out here.

You can also check out the top acquirer’s multiple stocks in the largest 1000 names for free on the acquirer’s multiple site.

Buy Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover or Kindle, 240 pages, Wiley Finance) from Wiley Finance, Amazon, or Barnes and Noble.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on Deep Value, or connect with me on Twitter, LinkedIn or Facebook.

[Sponsored Post]

The London Value Investor conference is the largest gathering of Value Investors in Europe and is Moderated by Richard Oldfield and David Shapiro. It will take place on Wednesday 20th May at the Queen Elizabeth II Conference Centre in Westminster, London. The conference will feature well known investors such as Charles Brandes, Dato’ CHEAH Cheng Hye, Jonathan Ruffer and Neil Woodford.

At the 2015 Conference, the following speakers will provide valuable insights in to their methods and approaches as well as giving specific investment ideas. The full line-up:

  • Neil Woodford, Woodford Investment Management
  • Charles Brandes, Brandes Investment Partners
  • Jonathan Ruffer, Ruffer LLP and Auckland Castle Trust
  • Dato’ CHEAH Cheng Hye, Value Partners Group
  • Hassan Elmasry, Independent Franchise Partners
  • Nathaniel Dalton, Affiliated Managers Group
  • Tim Hartch, Brown Brothers Harriman
  • Johan Du Preez, Eastspring Investments
  • Bernd Ondruch, Astellon Capital Partners
  • David Shapiro, Towers Watson (Moderator)
  • Richard Oldfield, Oldfield Partners (Moderator)

A key feature of the conference is the 10-15 minutes dedicated to audience Q&A which is led by Richard Oldfield of Oldfield Partners and David Shapiro from Towers Watson.

This will also be a unique networking opportunity as this conference is the largest gathering of value investors in Europe, we expect there will be 400 paying delegates present this year.

Click here to learn more.

 

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