OTCM - OTC Markets Group

[wknecht]

This company is definitely not a typical deep value stock.  And although I recently passed on this idea, I think the stock is quite interesting and potentially a good investment for someone that understands the business environment better than myself, so I wanted to get folks thoughts. This is an illiquid stock so the idea is only potentially useful for those without a lot of money to deploy. A synopsis of the situation follows.

 

OTCM operates an interdealer quotation system (OTC Link) that allows broker-dealers to publish their quotation prices and directly interact with one another. OTCM is not an exchange in that it does not control execution or act as an intermediary - they are a subscription based technology company. They earn revenue in three ways:

[*]Trading Services – monthly license, subscription and connectivity fees paid by broker-dealers for access to the OTC Link interdealer quotation, messaging, and trading platform.

[*]Market Data Licensing – provides subscribers with access to OTC market data and security information collected through the Trading and Issuer Services products.

[*]Issuer Services – various services provided to OTC issuers, such as their “premier” OTCQX marketplace, Blue Sky monitoring, news display, disclosure display.  Participation on the OTCQX marketplace is the fastest growing revenue source.

Some financial stats:

Price: 7.09

Diluted Shares: 10.56mm

Mkt Cap: 76.33mm

Cash: 11.73mm

Debt: 0

Long Term Liabilities: 1.42mm

Equity: 13.78mm

EPS (TTM): 0.49

EPS (5y FY avg): 0.29

P/Diluted EPS (TTM): 14.47

 

Further to the above, over the last several years: (a) returns on equity have been very high (averaging north of 40%), and (b) growth has been substantial, with revenues and diluted EPS growing respectively at 13% and 19% compounded annually over the last 5 years. In addition to this impressive historical record, on a forward looking basis, OTCM also appears to be benefitting from significant tailwinds:

• The universe of securities that OTCQX could appeal to (e.g., international companies that do not wish to be burdened by SEC registration requirements like SOX) is very large
  
• The JOBS act, signed into law in April 2012, promotes alternative means for raising capital for smaller companies by easing securities regulations. This is likely to broaden the universe of OTC traded securities, and increasing Trading and Issuer Services revenue.
  

Risks:

• Regulation: This business is generally quite sensitive to the whims of regulators. A more specific threat: in late 2009 FINRA filed a proposed rule change with the SEC (the Quotation Consolidation Facility or QCF) under which FINRA would provide a national best bid or offer for OTC securities traded on interdealer quotation systems for inclusion in the NASDAQ UTP Level One feed (at $4 per quote). This would essentially annex much of OTCM’s Market Data Licensing business.
  
• Competition: The main thing preventing me from committing to OTCM is an insufficient understanding of the business and competitive environment. Why, for example, couldn’t someone else start a new quotation platform for lower fees and ruin OTCM’s business or at least erode its economics? I don’t quite grasp this yet, as it doesn’t seem particularly difficult to me. In addition to the QCF, OTCM's financial reports give some detail about two specific threats (OTCBB sold industry participant, BX Venture Market).
  
• Technology change: OTCM is largely a technology company and its OTC Link platform is sensitive to changes in technology and/or obsolescence. I don't have any particular insight to evaluate this risk.
  
• Credit risk: OTCM will be accepting greater credit risk going forward through its factoring program, whereby it purchases access fee receivables from the broker-dealers participating on its platform. Currently I think this is a minor risk, but it something that should be monitored going forward using various receivables metrics.
  
• In the event regulation, competition, or other factors erode OTCM’s business, there are few hard assets to fall back on to support the stock price
  

Overall:

OTCM seems like a potentially exciting opportunity given the current price level relative to its current earnings and historical growth. At the moment however, I am not comfortable enough with the long-term outlook of the competitive environment to purchase the stock. Given that future earnings growth is critical to the long thesis, this is currently the deal breaker for me.

[ItsAValueTrap]

1- Generally speaking, I hate trading stocks listed on OTCBB and Pink sheets because I believe I get terrible execution on these trades from my broker (Interactive Brokers... they route some orders through Knight or something like that).

 

This article touches upon some of the issues with the financial world:

http://www.stocktrading.com/wsjsellorderflow.shtml

 

Basically, market makers and other players skim money from investors.  Regulators allow it.  Over time, the abuses that are allowed become less and less.  Those who are well connected (e.g. Bernie Madoff... mentioned in the article) sometimes have an advantage.  All this is legal.

 

2- There are a lot of problems with the stocks traded on OTC markets.

 

a- There are a lot of outright pump and dump penny stocks.  Go on secfilings.com (I like this site) and look at the ads.  Go to timothysykes.com if you want to find some more names (sometimes he drills down into their filings to show how XYZ stock is a blatant fraud).

b- Some stocks out there have a small real business attached.  So they are not entirely pump and dump scams... they're just mostly pump and dump scams. 

c- Some of the stocks out there are real businesses.

 

The product, in my opinion, is somewhat dubious as it facilitates blatant fraud.  So in my jaded opinion, this is not a quality business.

 

It might do well in a bull market for stocks.  If people get really interested in stocks and really greedy, then I would figure that more trading will happen and this will increase OTC Markets' revenues.  However, I don't believe that we are about to enter a bull market for stocks.

 

3- You might compare OTC Markets to CME group.  CME group is a much higher quality business.

a- There isn't a lot of fleecing of investors going on.  On the futures exchanges, you don't have the sub-penny front running BS.  You didn't have trades being cancelled after the flash crash (BS).  The worse that has happened is that the timing of margin increases have arguably contributed to the crash in the price of silver.  The shenanigans that go on are less than on the stock exchanges.

b- CME will do well in a commodities bull market.

c- No chinese reverse mergers or other frauds listed.

d- Potential upside if Joe Public realizes that he has access to really dangerous amounts of leverage in futures speculation.  (Though most people are going towards ETFs without silly amounts of leverage.)

If you look back historically, there used to be CTAs (they were popular) and interest in commodities was much higher than it is now.  There used to be board games where you would trade cotton and other commodities.

 

*Disclosure: Not long CME group.  I don't know why.

[wknecht]

Thanks for the comments. Sounds like you’ve pretty well put this one in the “no” pile, but in case you or any one’s interested, the CEO gave an interview recently that can be listened to here: http://microcapclub.com/2012/09/microcapclub-interview-with-cromwell-coulson-ceo-of-otc-markets-group-otcm/.  He discusses his vision for the business and some of the points you raise, e.g., the tier system they’ve implemented based on information, which I guess in some ways warns potential investors of shell companies etc…all to be taken with a healthy grain of salt of course.

 

I’m trying to learn more of the details of market mechanics generally, so I was wondering if you could slightly elaborate on what you mean by “terrible execution”? Are you placing single limit orders that are quite large and require "skilled trading" to execute without signaling the markets (and IB is bad at this, or IB requires you to do the trading by placing several orders similar to other discount brokers)? Or are they missing better prices that arise as you put your limit order in? Or are market orders executing at worse than expected prices?

 

Thanks!

[ItsAValueTrap]

1- Never use market orders!!!  If you really must do it, use a limit order instead and specific a limit price that should guarantee that your order will get filled.

 

There are just a lot of abuses with market orders.  Even Jim Cramer tells you not to do it.

 

2- I am not 100% sure that execution quality is bad on OTC market.  But here's what I see:

a- Anything routed through Knight is probably a bad idea.  Knight is a market maker and they have conflicts of interests with their clients.  They trade at the expense of the retail order flow that gets routed through them. 

http://www.stocktrading.com/wsjknight1.shtml

The article above is really great and even Bernie Madoff is mentioned in there.  (He used to have a legitimate market making business.  In my opinion, market making is an unethical business.  But it is legal.)

b- I had one limit order with IB for an OTC stock (to cover my position on NXTH) and it filled and the fill was subsequently cancelled.

c- It seems that orders only fill when the market moves against you... though I am not 100% sure on this.

 

More stuff:

http://quantinvestor.wordpress.com/2010/01/09/sub-penny-pricing-is-it-price-improvement-or-front-running/

http://www.futuresmag.com/2010/10/12/thomas-peterffy-world-federation-of-exchanges-keyn      <-- Thomas Peterffy made a lot of his personal wealth as a market maker.  And he is saying that exchanges may not need market makers to function (I agree).

 

Sounds like you’ve pretty well put this one in the “no” pile

Part of this is because I find certain practices in the financial industry to be morally offensive.

 

IB has good order execution in my opinion for everything except for OTCBB and pink sheets.  eTrade is the worst.  TD waterhouse has better execution on really small Canadian penny stocks than IB... it's probably because TD and its affiliates (like Knight) do not make markets for these small obscure stocks.

 

I am extremely impressed by the way IB (symbol IBKR) is run.  And Thomas Peterffy impresses me.  They send minimal amounts of snail mail unlike their retail competitors.  When something funky happens with a stock, a human being at TD Waterhouse calls me.  Whereas with IB it is all electronic.  IB has the low-cost advantage and offer the lowest costs to their customers (but you need to trade a lot).  This is a great business with a great low-cost moat.

 

But I do not own IB.  Their brokerage business is growing, its market making business is declining (part of this may be due to the big players like Goldman being all over the subpenny front running and flash trading game; Goldman accounted for something like 40%+ of all NYSE volume at one point).  If people get really interested in stocks, brokerage volumes will expand and market makers will make a lot more money.  I am bearish on stocks and bullish on commodities.

[Hielko]

How the hell is what kind of orders you should use relevant with regard to investing in OTCM? I don't have an opinion on the business, but what you are saying is not only mostly completely irrelevant but also filled with flawed assumptions and conclusions. Happy to discuss those if you want if you create a new thread, I'll leave this one for people who actually want to discuss OTCM...

[ItsAValueTrap]

Hi Hielko,

 

I was responding to the original poster's request for more information on market structure.

 

Now as far as OTCM goes, market structure is relevant.  The history of the industry has been towards more exchanges, more competitions, and more regulations (to clamp down on perceived/actual abuses).  Margins have been going down as regulators clamp down on the various abuses.  This is offset somewhat by higher volumes.  What the business actually does is quite relevant to its future profits.

 

OTCM may be a little different than other exchanges because OTCM is not actually an exchange.  So maybe somebody who knew more about the company would be able to figure out that some regulations could potentially help OTCM (??????).

[Hielko]

* Using market orders is always a bad idea, also when you trade on an exchange. When liquidity is lower - often the case with stocks on otcbb or pink because the companies are smaller - using a market order is an even worse idea. You (almost) ALWAYS get a terrible execution if you use a market order on a stock with a low liquidity and high bid/ask spread.

 

* the sub penny thing is not specific to trading otc or pink sheets: it also happens on exchanges. And yes, I agree that it probably shouldn't be allowed, but it's also not a big problem.

 

* It is not weird to see the market move against you if you place a limit order and get filled. If you wanted to buy something at X, it now means that someone else is willing to sell it at X, and possible willing to sell more at a lower price.

 

* Most chinese reverse merger frauds were listed on the nasdaq or even the nyse. They moved to the pink sheets after the fraud was discovered.

 

* If you want to find out how the otc markets functions you can simply check out http://www.otcmarkets.com/otc-101/market-structure or http://www.otcmarkets.com/otc-101/regulation

 

Some quotes:

 

FINRA requires member firms to find the market with the best price to execute their customer order

FINRA members may not trade for their own account at prices that would satisfy Limit Orders currently within their order book.

FINRA members publishing quotations in an inter-dealer quotation system must publish the price and full size of a customer order if that order improves or is equal to the member’s price.

Etc... there are a lot of things you can worry about wrt to OTCM, but market integrity shouldn't be high on that list.

[ItsAValueTrap]

Actually I'm not sure if the subpenny stuff goes on for OTC/pink.  I know more about the larger exchanges than OTC/pink.

 

* It is not weird to see the market move against you if you place a limit order and get filled. If you wanted to buy something at X, it now means that someone else is willing to sell it at X, and possible willing to sell more at a lower price.

If stuff like the subpenny front running stuff is happening, then you usually only get filled when the market moves against you.  Rarely are you able to collect the bid/ask spread.

This is my own annecdotal evidence and it is why I dislike OTC/pink sheets.  I don't trust the execution quality on those stocks with IB.

 

Etc... there are a lot of things you can worry about wrt to OTCM, but market integrity shouldn't be high on that list.

My NXTH order being cancelled causes me to question the integrity of this market.  Also, the existence of pump and dump penny stocks scams such as NXTH also causes me to question the integrity of the market.

 

3- You might compare OTC Markets to CME group.  CME group is a much higher quality business.

a- There isn't a lot of fleecing of investors going on.  On the futures exchanges, you don't have the sub-penny front running BS.  You didn't have trades being cancelled after the flash crash (BS).  The worse that has happened is that the timing of margin increases have arguably contributed to the crash in the price of silver.  The shenanigans that go on are less than on the stock exchanges.

b- CME will do well in a commodities bull market.

c- No chinese reverse mergers or other frauds listed.

d- Potential upside if Joe Public realizes that he has access to really dangerous amounts of leverage in futures speculation.  (Though most people are going towards ETFs without silly amounts of leverage.)

If you look back historically, there used to be CTAs (they were popular) and interest in commodities was much higher than it is now.  There used to be board games where you would trade cotton and other commodities.

To clarify... this is to compare the major stock exchanges to the commodity futures exchanges.  This may not be relevant to OTCM.

[wknecht]

Thanks for the additional information. Yes the intent of my question was a curiosity and off topic (although investor experience is relevant). Using a discount broker, I've always felt responsible for execution (from a price perspective). I only use limit orders, and figure things will execute at that price and no better, regardless of listed or OTC - this is why I was curious about your experience with terrible execution.

 

Regarding the market integrity points and the OTCM thesis, I'm personally not overly concerned by this from the long standpoint. But a couple concerns come to mind. One is the extent that it brings lawsuits. I think the tiers they've created probably increases this risk because they might be blamed for instilling undue confidence in investors when frauds, bankruptcies, and other unpleasantries inevitably occur. My approach to investing has always been "buyer beware" whether the security is listed on NYSE or traded OTC. But OTCM has securities labeled "Buyer Beware"; someone might (unreasonably) assume "I do not need to be aware for all the other securities." The other concern on this topic is the regulatory impact. The predecessor NQB has been operating since 1913, and it seems clear that their goal is to make things more transparent (as the CEO put it, they've changed it from a Craigslist type situation, to more of an EBAY). So I don't think regulators would just step on OTCM's business (with the possible exception of the QCF proposal), but they'll probably just have to deal with a little more scrutiny like the other folks in the industry.

 

Still watching from the sidelines.

 

[ItsAValueTrap]

I think you could look more into the history of financial markets?  I don't think that exchanges usually get sued.  In the flash crash cancellation fiasco, nobody was sued AFAIK.  I don't think it's worth the legal fees for large institutional investors.  And it is the regulator's job to sue and to step in.

 

If anything, the risk is that the SEC kills off the pump and dump penny stock market.  This will mean less revenue for OTC markets??  I'm not sure how much they make from those scams though... it may not be material.

 

The universe of securities that OTCQX could appeal to (e.g., international companies that do not wish to be burdened by SEC registration requirements like SOX) is very large

Perhaps I have an extreme opinion, but I think that way too much fraud goes on in the microcap space.  It's ridiculously high.  There should be more regulation in that space, not less.

 

Microcaps may be a massive destroyer of capital.  If you merged all these stocks together, the resulting company may lose a massive amount of money every year.

 

On the other hand, some crazy stocks emerge out of the microcap space.  Altius, SHOO (Steve Madden), and Contango Oil & Gas / MCF were all microcap stocks I believe.  There are VIC writeups on these companies. 

[writser]

The sub-penny stuff has nothing to do with exchanges. Exchanges do not even support it. It is a conflict of interest between you and your broker/market maker.

 

Some more explanation: link

[ItsAValueTrap]

Yes I have read the defend trading article.  The exchanges support it by allowing the market makers to do it.  The market makers pay the exchanges for special advantages and use these advantages against the exchange's customers.  This is not a new practice... you might look at the history of NYSE specialists being able to look at the order book when everybody else wasn't allowed to.

[writser]

The sub-penny trading happens before the trades hit any exchange. It is done in-house by your broker. He can "pick" favourable trades and execute them for their own book instead of on-exchange. Complain to your broker if you don't want that: exchanges have nothing to do with that and can do nothing to prevent it.

 

I am no expert on flash trading but I believe the hype surrounding it is greatly exaggerated. It is a voluntary order type that provides extra liquidity to market takers, at the expense of market makers. Both the Nasdaq and BATS already voluntarily gave up on flash trades due to all the commotion surrounding them. I believe the added value of this order type was minimal to start with. At this point in time the SEC is investigating it but I think it is already a non-issue by the time they come to a conclusion. It's bad PR that the name coincides nicely with "flash crash" and brings a sense of panic to the layman.

[ItsAValueTrap]

Yes the sub-penny stuff can happen if your trade is not routed to an exchange.  (Usually retail orders do not end up on an exchange.)  It can also happen if your trade is routed to an exchange.

 

I used to have access with a direct to market platform with Title Trading... this stuff happens if your orders are routed to an exchange.  If you take liquidity on Citigroup, you may receive rebates (instead of paying them) or you may receive price improvement by a sub-penny price.

[jschembs]

OTCM came up on a recent screen for me, and is still generating absurd (likely unsustainable) ROIC, but not growing all that rapidly (which is fine for me). However, Glenn's comments from a couple of years ago have given me pause to do much more work on it, so I'm curious if anyone has spent any time on a name in the last year or two.

[60North Investments]

OTCM came up on a recent screen for me, and is still generating absurd (likely unsustainable) ROIC, but not growing all that rapidly (which is fine for me). However, Glenn's comments from a couple of years ago have given me pause to do much more work on it, so I'm curious if anyone has spent any time on a name in the last year or two.

 

Did some work on OTCM and wrote it up. Most of the valuation methods are there due to requirements, I wouldn't focus on them. In summary, I think it's a great business with some major threats that are difficult to pin down whether they're likely to materialize or not. Trades at a price that doesn't seem attractive to me.

 

EDIT: Slightly updated the valuation part, hat tip to KJP and frommi for feedback.

Investment_case_-_OTCM.pdf

[frommi]

Did some work on OTCM and wrote it up. Most of the valuation methods are there due to requirements, I wouldn't focus on them. In summary, I think it's a great business with some major threats that are difficult to pin down whether they're likely to materialize or not. Trades at a price that doesn't seem attractive to me.

 

Thanks for your writeup, but i think your IRR calculation is wrong. How can a growing FCF stream with a yield of >7% without debt result in an IRR of 5%?

[60North Investments]

Did some work on OTCM and wrote it up. Most of the valuation methods are there due to requirements, I wouldn't focus on them. In summary, I think it's a great business with some major threats that are difficult to pin down whether they're likely to materialize or not. Trades at a price that doesn't seem attractive to me.

 

Thanks for your writeup, but i think your IRR calculation is wrong. How can a growing FCF stream with a yield of >7% without debt result in an IRR of 5%?

 

Thanks for the comments. Don't know what would be wrong with the IRR calculations as they're quite simply sum of past years NPVs of FCF, added with NPV of NOPAT x terminal multiple. Think the difference comes from my NPVs being discounted @ 8.8%, whereas you may be thinking about it in future value terms, no? If you discount that FCF stream then I imagine we'd have the same result. Hoping to be corrected here.

[frommi]

Thanks for the comments. Don't know what would be wrong with the IRR calculations as they're quite simply sum of past years NPVs of FCF, added with NPV of NOPAT x terminal multiple. Think the difference comes from my NPVs being discounted @ 8.8%, whereas you may be thinking about it in future value terms, no? If you discount that FCF stream then I imagine we'd have the same result. Hoping to be corrected here.

 

I don`t know where the problem in your DCF is, i am probably not smart enough to understand it. But when i have a bond with an interest payment of 7% than my return will be 7%. If the interest payments grow with inflation of maybe 3%, my nominal return will be 10%. If i now have a stock where entry and exit multiple are the same with these characteristics my return will be the same. OTCM trades since several years now around the current multiple, so the base case is at least a return of 10%. In the past it has grown much faster than 3% and its probably not far fetched to assume it will grow faster than that for the next years and i honestly don`t see how a stock with an FCF yield of 7% that has grown by >20% without reinvesting profits the past several years is overvalued at the current price. You won`t find a similar investment at an EV/EBITDA of 8-9 where DA is very low and I is 0, that has a moat and is owner operated. If you do, please show me.

But again, maybe i am just too dumb. :)

[KJP]

OTCM came up on a recent screen for me, and is still generating absurd (likely unsustainable) ROIC, but not growing all that rapidly (which is fine for me). However, Glenn's comments from a couple of years ago have given me pause to do much more work on it, so I'm curious if anyone has spent any time on a name in the last year or two.

 

Did some work on OTCM and wrote it up. Most of the valuation methods are there due to requirements, I wouldn't focus on them. In summary, I think it's a great business with some major threats that are difficult to pin down whether they're likely to materialize or not. Trades at a price that doesn't seem attractive to me.

 

On page 15 of your pdf, did you add, rather than subtract, stock-based comp and CapEx from your projected OCF to get FCF?

 

Why is FCF going to be permanently and substantially higher than your projected NOPAT/net income?

 

Also, what does your IRR calculation represent?  If you projected a specific price at a future date, then I understand how you could compute a projected IRR.  Is that what you're trying to do?

[60North Investments]

Thanks for the comments frommi and KJP. I can now see the silly mistake I made with the spreadsheet in the FCF as KJP mentioned. The IRR is meant as an illustration of what your returns might look like given the DCF value in different years and the current share price. Not meant to say that the NPVs in 10yrs time are accurate at all, just wanted to have it there to see what I might expect to get by buying today given some future assumptions. Let me know if you think that doesn't make any sense!

 

Whether or not FCF will permanently be higher than NOPAT/net income is a valid question. It has been higher mostly due to depreciation > capex, and working capital decreases. Though now that KJP spotted my error in the spreadsheet, my FCF and NOPAT numbers track each other very closely with NOPAT being slightly higher. I think it's a reasonable assumption that FCF won't be much above net income going forward, at least more reasonable than assuming it will continue being significantly higher.

 

frommi, I hope I'm not mistaken but in your example if you discounted those interests to present value then it would resemble more what I did. And in OTCM's case, I'm assuming multiple compression from the current below 20x where its trading to 15x. I agree that it is a great business and has done wonderfully well. I'm just not smart enough to see how they couldn't be significantly damaged by someone stepping onto their playing field and/or the probability of that happening.

 

I appreciate the comments, I need to take a much closer look on the DCF side...

[KJP]

The IRR is meant as an illustration of what your returns might look like given the DCF value in different years and the current share price. Not meant to say that the NPVs in 10yrs time are accurate at all, just wanted to have it there to see what I might expect to get by buying today given some future assumptions. Let me know if you think that doesn't make any sense!

 

 

Your narrative is that growth will slow over time.  If you're right, then the multiple should contract significantly because you're dealing with a very high ROIC business in which growth is very valuable.  Multiple contraction appears to be exactly what you project, as evidenced by the following figures taken from page 15 of your pdf:

 

Year/NOPAT/Market Cap/Implied Multiple

2016/11.4/201/17.6

2021/17.1/242/14.2

2026/24/292/12.2

 

So, I think your IRR calculation is what the return would be if (i) NOPAT is what you project and (ii) the multiple does in fact contract to your projected multiple as of the measurement date.  That is consistent with the negative or very low IRRs you project for a holding period ending in 2016 or 2017, because in that scenario the multiple contraction would occur over a short period of time, swamping the increase in NOPAT during that period.  Am I interpreting your IRR calculation  correctly?

 

Multiple contraction is also the answer to Frommi's question about how compound annual returns can be less than the projected growth in earnings.  To continue with Frommi's bond hypothetical, it's like purchasing a bond above par and then holding it to maturity.  If you do that, your returns will be lower than the interest rate on the bond due to the "multiple contraction" of buying above par and then being paid off at par.

[60North Investments]

The IRR is meant as an illustration of what your returns might look like given the DCF value in different years and the current share price. Not meant to say that the NPVs in 10yrs time are accurate at all, just wanted to have it there to see what I might expect to get by buying today given some future assumptions. Let me know if you think that doesn't make any sense!

 

 

Your narrative is that growth will slow over time.  If you're right, then the multiple should contract significantly because you're dealing with a very high ROIC business in which growth is very valuable.  Multiple contraction appears to be exactly what you project, as evidenced by the following figures taken from page 15 of your pdf:

 

Year/NOPAT/Market Cap/Implied Multiple

2016/11.4/201/17.6

2021/17.1/242/14.2

2026/24/292/12.2

 

So, I think your IRR calculation is what the return would be if (i) NOPAT is what you project and (ii) the multiple does in fact contract to your projected multiple as of the measurement date.  That is consistent with the negative or very low IRRs you project for a holding period ending in 2016 or 2017, because in that scenario the multiple contraction would occur over a short period of time, swamping the increase in NOPAT during that period.  Am I interpreting your IRR calculation  correctly?

 

Multiple contraction is also the answer to Frommi's question about how compound annual returns can be less than the projected growth in earnings.  To continue with Frommi's bond hypothetical, it's like purchasing a bond above par and then holding it to maturity.  If you do that, your returns will be lower than the interest rate on the bond due to the "multiple contraction" of buying above par and then being paid off at par.

 

You're correct, although I must say that the page 15 market cap figures you're referring to are not linked to the IRRs. Shows that I need to re-think how I'll present the DCF to make it understandable for anyone other than myself.

 

But yes, you're absolutely right that the low IRRs are coming from the fact that a) my discount rate is 8.8% (or 11.3x as a multiple), b) my "terminal multiple" is 14.7x, both of which are lower multiples than the current. Combine those with the fact that I don't feel comfortable projecting 20% growth going forward (I used on average 8.5% for sales next 4 yrs and 6% then until 2030).

[frommi]

You're correct, although I must say that the page 15 market cap figures you're referring to are not linked to the IRRs. Shows that I need to re-think how I'll present the DCF to make it understandable for anyone other than myself.

 

But yes, you're absolutely right that the low IRRs are coming from the fact that a) my discount rate is 8.8% (or 11.3x as a multiple), b) my "terminal multiple" is 14.7x, both of which are lower multiples than the current. Combine those with the fact that I don't feel comfortable projecting 20% growth going forward (I used on average 8.5% for sales next 4 yrs and 6% then until 2030).

 

Can you show me one or two investments where your methods project an IRR >10% currently?

[60North Investments]

You're correct, although I must say that the page 15 market cap figures you're referring to are not linked to the IRRs. Shows that I need to re-think how I'll present the DCF to make it understandable for anyone other than myself.

 

But yes, you're absolutely right that the low IRRs are coming from the fact that a) my discount rate is 8.8% (or 11.3x as a multiple), b) my "terminal multiple" is 14.7x, both of which are lower multiples than the current. Combine those with the fact that I don't feel comfortable projecting 20% growth going forward (I used on average 8.5% for sales next 4 yrs and 6% then until 2030).

 

Can you show me one or two investments where your methods project an IRR >10% currently?

 

I began using DCFs like this just very recently, and have done it for only a few companies so far. Wilh.Wilhelmsen, Singapore Shipping, Texhong Textile, Future Bright and perhaps Arcos Dorados and Key Tronic are a few names where I believe +10% IRRs are quite probable (and just to be clear, IRR in the spreadsheet and here is simply what I'd expect to get if I bought today and held until X).

 

My intention is not to say that the DCF is the holygrail of valuation, or that my assumptions are the correct ones. As OTCM shows, I rarely feel comfortable paying 20x multiples and therefore names that are trading in that range are more often than not going to be passed by me. But that's just me, and if I understood OTCM and the industry/regulatory environment more deeply, perhaps I'd have the confidence to buy even at today's prices.