Cryptocurrencies and precious metal are bonds with zero real interest rate

This is not a write-up on individual stocks, but with all the buzz going on, I'd like to share my personal view on cryptocurrencies and precious metal for those who are interested. Disclaimer: I own both in my portfolio.

Many like to criticize crypto and precious metals because they are not income producing assets. Here is my question: why do people buy bonds? Because bond holders earn interest income by lending money to others. However, many don't know that the earned interest is denoted in fiat currencies, not the real purchasing power. The increased account balance in your bank may well be delusional to make you feel you have more money to buy more goods and services.

For example, you love eating apples and one apple costs you $1 today. You have $100 cash which can be converted into 100 apples. Now you decide to invest instead and use all your cash to purchase a bond of $100 with an interest rate of 10%. The next year you are paid the interest $10, and you thought you have $110 cash to buy apples. However, what if I tell you one apple has become more expensive and will cost you $2 now? Congratulations, you earned interest, but your money can buy you only 55 apples. This is so-called inflation.

The example above is extreme because we don’t have 100% inflation rate in any developed nations, but if you understand the logic, you will see this is exactly what is happening in most developed nations due to all the loose monetary policy and money printing, including the US, EU and Japan - the real interest rate is negative. Real interest rate = nominal interest rate - inflation rate. When the inflation is higher than the nominal interest rate, holding bond with negative real interest rate over time will actually decrease your purchasing power. I'm not making this up. This is today's real interest rate published by U.S. Department of the Treasury - the real interest rate is sitting negative for US government bonds with all maturities. Inflation is the fiat currency depreciating against all other goods and services.

In the old barter economy where people directly exchange goods and services for other goods and services, how much you can exchange for apples with other goods depends on the demand and supply of both products. For example, you have 1 gram of gold that is worth $100. Assume both apples and gold have constant demand and supply over time. 1 gram of gold can exchange for 100 apples ($1 per apple) today; next year when the price of apple increases to $2, the 1 gram of gold you have will also increase to $200 (think the fiat currency is just a unit of account), and can still exchange for 100 apples. Regardless of the fiat currency movement, the purchasing power remains the same.

You can consider precious metal and cryptocurrency as a special bond with zero real interest rate that retains your purchasing power. They can perfectly hedge the inflation risk, but that has one condition - the demand and supply for them is relatively stable compared to other goods and services. If a new technology is invented to increase the production of apples at lower cost, given all the other conditions the same, 1 gram of gold can actually buy you more than 100 apples now because the supply of apples has increased.

Let’s examine the supply and demand of precious metal and cryptocurrencies. Supply is easy. Gold discovery and mining is relatively stable (gold production may have peaked steady). Unless people invent a technology to extract gold from sea water in a cheap way, I don't expect much surge in gold supply. Cryptocurrencies are more straightforward. One of the things that supporters like to tout about crypto is the capped supply of Bitcoin. Bitcoin's supply is strictly limited to 21 million coins. After halving of Bitcoin this year, the new supply will become half of the prior amount.

Switching to the demand side which is trickier. The demand for something is not necessarily based on the usability of a certain product. Besides decoration and jewelries, gold doesn't have much industry application, but people like its rarity and stability so the value of gold has been persisting over thousands of years throughout our human history. It is the consensus among the crowd that creates demand and assigns a price to a product. The value of gold will not change much if just a few people think gold is absolutely useless and decide never to own any gold. It really doesn't matter what YOU think about gold. When the majority of the population start to like, want and desire gold, the demand will be developed. Once the demand hits a critical mass, even the early doubters will be forced into adopters because they have no other choice but to own some gold when overwhelmingly majority has accepted it. It's just crowd psychology.

Similarly, many crypto bears often argue that cryptos are useless, inconvenient, waste of energy, etc. Keep in mind that the demand of a product is not determined by its usability. It is people's perception that creates the demand and value. Just like precious metals, cryptocurrencies are also stable and have limited supplies. Think about it - over the past few years, do more or less people hear about cryptocurrencies? Do more or less people accept it as an asset or payment? Just look at the adoption of crypto by institutions and the growing inflows into GBTC; the answers are clear to me. Thanks to the bears, they also played a very important role to increase the awareness among the crowd. Ask people around and see how many actually own cryptocurrencies - I believe we are still in a very early stage of adoption but it's important to know where the trend is going. However, not all the cryptocurrencies are created the same - I would stick with the ones on the top of the list which are most recognized and accepted. Again, it is how other people think that matters the most to determine the demand. Just follow the trend.

Not many people realize the safe government bonds they hold are producing negative real interest rate for them. These investors may see an increase in their bank balance with the earned interest, but by the time when they need to convert their bonds into real goods and services, they will realize their purchasing power has become less by holding the bond. Now, if I present you with i) a bond with a negative real interest rate and ii) an asset that has zero real interest rate, what would you pick?

This is why I believe the potential demand for precious metal and cryptocurrencies is far from fully realized. When the majority starts to understand the logic above, animal spirit will drive the crowd into precious metal and cryptocurrencies, increasing the demand and price of the asset. The increased price will attract even more buyers to follow, pushing up the demand even higher. At that time, precious metals and/or cryptocurrencies may well become another bubble. That's when I will sell, but right now it's far from there. 

The Bitcoin price chart is a bonus for those curious technical chartists. I'm not saying right now it's a low risk point to buy BTC, but look at the big volume bars when the price was at the bottom since 2019. It is obvious to me that some big players are accumulating. In contrast, the volume during the distribution phase was really nothing comparable when the price hit the top in 2017. The on-going upward trend has been confirmed by an increasing volume along with it. If the 2017 "bubble" is mostly created by retail investors, the run-up this time will be driven by institutions. It will go much higher from here. I will hold until the smart money distributes. 

Footnote: in my opinion, cryptocurrency is never going to be a replacement to our current currency system exactly due to its limited supply. When the economy grows and GDP increases over time, ideally, we need the equivalent increase in money supply (maybe slightly more) to denote the additional productivity. Money is important to facilitate transactions in an economy. When there is not enough money in circulation, deflation will happen where goods and services become cheaper compared to the currency. When deflation happens, people would rather hold cash and not spend it because they expect the goods and services to become cheaper in the future. When people are reluctant to spend and make transactions, the economy will shrink and collapse.

Before industrial revolution, our global economies are pretty stagnant without much growth up until 20th century. Gold/silver standard had worked well because the supply of gold and silver are relatively stable too. However, the supply of gold or silver becomes insufficient to support the exponential growth of economies after 20th century, and that's why we see all countries have abandoned gold or silver standard. This is the same reason why Bitcoin can never replace our current currency system.

Buy BXRX when there is blood in the streets

Happy holidays and Happy New Year! Full disclosure: I'm already fully invested in Baudax Bio Inc (BXRX) with an average cost basis around $1/share. Before this year ends, I want to take some time to write down this thesis for my own reference, and hopefully this can provide some insights to someone who is also interested in this beaten-down biotech company.

What I like about BXRX:

• Low risk entry: a very strong accumulation base on chart with a sexy gap to fill
• Two private placements in total $20M have offering prices of $1.165 and $1.185 per share, at a premium to the market (this is very important)
• Commercial launch of FDA-approved drug Anjeso, a non-opioid long-acting IV treatment, with significant commercial opportunities
• Founder CEO Gerri Henwood has over 2.5M shares to vest (I like when management has their skin in the game)
• A spin-off from Recro Pharma Inc (REPH) on 11/22/2019. (I like it more when a stock is under selling pressure that has nothing to do with its fundamentals)
• They should be good without raising more capital for another 12 months
• Non-opioid drug theme

What I don't like about BXRX:

• Mismanaged capital raise earlier this year. The # of shares increased quickly from 17M shares in March to 42M now (78M fully diluted)
• Revenue ramps up slower than expected due to hospital shutdown caused by COVID

Overview
BXRX owns Anjeso, a non-opioid, long-acting IV drug for moderate to severe acute pain. Anjeso was originally acquired by Recro Pharma Inc (REPH) as an asset deal from Alkermes (ALKS), along with a contract development and manufacturing organization (CDMO) business, together for $50M in 2015. At that time, Anjeso was just ready for starting Phase 3. After a few years of trial and a couple of back and forth with FDA, Anjeso finally received FDA approval in Feb 2020. 

Near the end of 2019, with the anticipation of the receipt of FDA approval, REPH decided to spin off BXRX from its CDMO business and prepare for the commercial launch of the new drug. BXRX is targeting at rapidly growing non-opioid market which addresses the need to reduce the reliance on opioid for acute pain management. According to BCC Research, "the global market for non-opioid pain treatments should grow from $13.8 billion in 2019 to $31.8 billion by 2024 at a compound annual growth rate (CAGR) of 18.3% for the period of 2019-2024."

Low risk accumulation phase
Chart is always my first key to understand a company. Look at the beautiful flat line since November 2020, together with the huge volume spikes over the same period. The stock is absolutely unloved by most and gets dumped harshly by the market. Apparently, this has shown a great support at this price level - someone is accumulating all the shares sold by panicking crowd. That's why the stock didn't keep plummeting under continuous heavy selling pressure because someone is constantly buying to support the current price level. Then I ask myself - who are the buyers? It has to be smart money. BXRX is not a business that sits there doing nothing for fun; it has a drug approved by FDA earlier this year and it's making progress quickly to ramp up sales. This is not just my speculation: this hypothesis has been reaffirmed by the institutional investors (the smart money) by paying a premium to get over 20M shares and warrants. Although it may not be the same institutions who bought shares on the open market, it clearly shows that the smart money wants the shares.

The share count have been increasing rapidly so far this year. I compiled the following table to look at the change of market cap throughout the year. COVID has negatively affected the commercial activities, but the valuable asset the company holds (the drug Anjeso) remains the same since its approval. Between the first public offering in March to December 2020, many progresses have been made to prepare for commercialization, including filing patent on Orange Book, getting permanent J code for medical billing, and on-boarding the first batch of 50+ accounts. Assuming the market opportunity for Anjeso hasn't changed, I find it hard to justify why the valuation becomes 30% less now when the company is getting more ready for commercialization. If analysts and investors think the stock is undervalued back earlier this year (PT average $9.0), the current valuation is a steal to me.

Date	2/21/2020	3/23/2020	12/29/2020
Event	FDA approval	First public offering	Today
Price	$9.16	$3.25	$1.02
# of Shares	9.3M	20.9M	42.6M
# of Shares (Fully Diluted)	12.8M	36.3M	78.3M
Market Cap	$85M	$68M	$43M
Market Cap (Fully Diluted)	$117M	$118M	$80M

In addition to the strong base setup, on 10/20/2020 when the company announced its plan to convert outstanding warrants, the stock price plunged 40% from $2.6 to $1.5, leaving a price gap on the chart. Keep in mind that 90% of the gaps end up getting filled. I recently learnt the rationale behind this and found it quite fascinating. Market makers are the participants that buy and sell the same security to narrow the spread between bid-ask spread and provide liquidity to the market. They make profits by selling the security at a higher price than what they buy. When a bad news hits, market makers see lots of market sell order before the opening of the market. Their best interest is to set the price as low as possible so when the market opens they can absorb most of shares from the sellers who sell on market orders. This sudden price drop forms the gap on the chart. However, remember market makers are there to make money by providing liquidity. The question becomes how are they going to make money after they've amassed so many cheap shares? Again, it is now their best interest to sell those shares in their inventory at a higher price - they push the price up to back where they were, and the gap will get filled. Yes, I'm aware that not all gaps are created equal and 10% of those never got filled, but 90% odd is still in my favor. It's just a game of statistics.


Non-opioid drug competitive landscape
I'm not a medical expert in any sense, but I'm still trying to put together a competitive landscape in the table below so that I can understand the potential market opportunity for Anjeso. 

Drug	Anjeso	Exparel	Zynrelef	Ofirmev	Caldolor	Dyloject	Toradol
Company	Baudax Bio Inc (BXRX)	Pacira Biosciences Inc (PCRX)	Heron Therapeutics Inc (HRTX)	Cadence Pharmaceuticals (CADX)	Cumberland Pharmaceuticals, Inc. (CPIX)	Hospira, Inc. (HSP)	Generic
Duration	24 hours	72 hours	72 hours	6 hours	6 hours	6 hours	6 hours
Drug Price	$94.00 / dose	$334.18 / dose	FDA approval pending	$47.37 / dose $173.84 / 4 doses	$78.60 / 4 doses		$9.84 / day
Market Valuation	$80M (fully diluted)	$2.56B	$2B	Acquired by Mallinckrodt plc for $1.4B	$46.01M
Peak sales	$250M (Est.)	$470M	$545M (Est.) Current revenue $84.90M comes from other drugs	$340M	$5.2M ($42M sales comes from other products)	No meaningful sales

The two failed drugs Caldolor and Dyloject have very similar profile with the generic drug, Toradol, with effective duration for only 6 hours. In contrast, Anjeso has a special position among all, being the only drug that provides 24 hour pain relief duration and competitive pricing compared to other brands. Many bears are concerned that the cheap generic Toradol will limit the growth of Anjeso. However, according to BXRX, their ambition is really to gain more market share from the traditional opioid treatment and to target at those physicians who are open-minded to experiment with different kinds of new non-opioid solutions. With the public sentiment shifting away from opioid use (e.g. U.S. Sues Walmart, Alleging Role in Fueling Opioid Crisis), I believe there is still a significant opportunity for non-opioid drugs to take over. If I discount analysts' estimate for peak sales and assume BXRX can only achieve 20% of the target, given average P/S ratio 4 across the industry, Anjeso should have a fair market cap of $200M which is more than double of what it has right now even based on a fully diluted basis. If BXRX can really hit that estimate, the upside is 10X. The risk and reward looks very attractive to me.

Here is the comment from John Harlow, chief commercial officer at BXRX about their competitive landscape:
"A certain number of accounts are not spending any branded dollars, including for Ofirmev and Exparel, for non-opioids. They prefer opioids and ketorolac and we’re not going to win the clinical discussion. However, a significant opportunity exists in about 2,000 accounts beyond what Ofirmev has sewn up"
"From a physician standpoint, we have done the same type of segmentation work among orthopedic, colorectal and general surgeons. We have those who want to reduce opioids, we have physicians who love ketorolac and think it’s an oldie but goodie and don’t want to change, and we have a handful we somewhat label as ‘spreaders’ because they like to use all products."

Cash runway and cost reduction
I have to admit, the public offering in March 2020 was absolutely mismanaged. The management failed to contemplate a situation where they need to raise more capital so soon and the stock price is lower than the warrants' exercise price. In order to attract additional capital, they were forced to exchange the existing warrants with newly-issued shares for free in October. That's the main reason for the significant increase in the share count.

With that said, the company was still able to raise capitals via two private placements that have successfully added $20M to its balance sheet in December. Based on the most recent 10Q before the capital raise, BXRX has $24M cash on its balance sheet and burnt $11M cash in the same quarter. In the quarterly press release, the company has announced to reduce the workforce to save an annualized cost of $10.6M and there will be significant cost reductions made for 2021 manufacturing and launch related activities (unspecified amount). Let's spread the $10.6M across 4 quarters equally and assume $1-2M cost saving per quarter from manufacturing. It gives us $6-7M cash burn per quarter moving forward. Adding the $20M capital that was recently raised, that $44M cash position should be giving BXRX at least 4 more quarters to run until the end of 2021 before it needs any additional financing. In addition, after the recent two private placements, although another 20M warrants are now overhanging, if exercised, that will raise another $20M, or 2 more quarters, for the company to operate.

How much longer will the pandemic last? Nobody knows, but with all the recent vaccine news, I believe it will take less than 1 year for the economy to gradually recover and for hospital to resume more elective surgeries. The company has taken all the necessary measures that will help them operate more sustainably while the pandemic is still going on.


Conclusion
BXRX has been a bloodbath this year for many investors who got in too early. Many investors have experienced 50-80% drop in value and many are even concerned the company is not able to generate any revenue after they cut the sales force. This is exactly my favorite time to buy shares when the sentiment is at its lowest. When the market feels so hopeless and hateful about a stock, any positive news can reverse its trend easily. Due to the favorable setup and risk reward profile, BXRX has become one of my largest positions in my portfolio. The stock price may consolidate around this lowest level for a little bit longer, but once the tax-loss harvesting season is over, I believe the company is well positioned for a strong rebound and beyond.

MDCA is almost guaranteed to produce nearly 100% return

MDC Partners (MDCA) got added to my 3-month high alert in the past week. Its chart has caught my eyes as it shows a textbook example of accumulation phase - it's currently traded on flat tight price bars with low volume and there was a record weekly volume spike just a few months ago. Digging deeper into how much the insiders have paid for their shares, it has strengthened my conviction to buy into this stock - I'm always happy to pay less than the insiders because no smart money wants to lose their investment. Interestingly, a catalyst is already in place: the Chairman and CEO, Mark Penn's private equity, Stagwell Group, is the largest shareholder of MDCA and has proposed to combine with the company by acquiring all the shares at $4.25/share. That's what has caused the record volume back in June. 

Value investors may not like this thesis as much. This is a special situation type of investing strategy. I couldn't care less about the company's business outlook and fundamentals.

Numbers about MDCA:

• Current share price: $2.35
• CEO's private equity, Stagwell, has paid $3.5/share and also holds 50,000 preferred shares with a conversion price of $5
• CEO, Mark Penn, also holds 1.5M option awards with exercise price of $2.19 due in 2024
• Goldman Sachs, holds 95,000 preferred shares with conversion price of $7.42
• A going concern: positive free cash flow and no major debt due until 2024

Textbook accumulation phase

MDCA has been an embattled advertising company for years with a declining net income and share price. I like how flat the price has been since 2019 with tight price bars and low volume. This stock apparently has gone out of favor with the market until this June when a record volume has piled in. High volume bars are where millions of shares have transferred hands. Smaller retail investors typically are not big enough to create such a surge in volume; big volumes often reveal the footprints of those big players in the market. 

One simple thing to remember is that insiders are in the market to make profits. They have more information than the public and have the resources to maneuver the public sentiment towards a stock by manipulating accounting practices and timing news releases. Insiders always buy low and sell high.

When the price is low, insiders buy; when the price is high, insiders sell. Just as simple as that. Combined with volume bars which can tell you where the insiders are, you have the tool to easily tell when insiders are accumulating or distributing based on the price level.

Coming back to the case of MDCA, the current price is near historical low and now you see a huge volume spike. Do you think that's insiders buying or selling? To me, shares are clearly transferred from weaker hands to stronger hands.

Riding the wave together with the smart money is one of the safest investing strategies out there, because you can firmly believe that the smart money won't allow themselves to lose money. The good news is that an upward trend has yet been developed following the volume spike. That gives us plenty of time to enter and build positions as the stock continues to trade within a narrow range.

The price insiders have paid

We now know that the insiders have been accumulating shares. Let's look into how much skin they actually have in the game.

Mark Penn, a Microsoft vetaran and founder of Stagwell Group, a private equity fund focused on the marketing services industry, has paid $100M in 2019 to invest in this troubled ad agency. Stagwell has become the single largest shareholder of MDCA and Mark has been assigned as CEO and chairman since then. 

The following is what I've found in Schedule 13D filed on 3/14/2019.

"On March 14, 2019, SAH and the Issuer entered into a Securities Purchase Agreement (the “Purchase Agreement”), pursuant to which the Issuer agreed to sell: (a) 14,285,714 Class A Shares for an aggregate purchase price in cash of $50 million and (ii) 50,000 newly authorized and issued Series 6 convertible preference shares (the “Preference Shares”) for an aggregate purchase price in cash of $50 million, subject to the terms and conditions set forth in the Purchase Agreement (the “Transaction”). The sale closed on March 14, 2019."

And this is the detail about Series 6 convertible preference shares in 2019 10-K.

"The holders of the Series 6 Preference Shares have the right to convert their Series 6 Preference Shares in whole at any time and from time to time, and in part at any time and from time to time, into a number of Class A Shares equal to the then-applicable liquidation preference divided by the applicable conversion price at such time (the “Conversion Price”). The initial liquidation preference per share of each Series 6 Preference Share is $1,000. The initial Conversion Price is $5.00 per Series 6 Preference Share, subject to customary adjustments for share splits and combinations, dividends, recapitalizations and other matters, including weighted average anti-dilution protection for certain issuances of equity or equity-linked securities.

The Series 6 Preference Shares’ liquidation preference accretes at 8.0% per annum, compounded quarterly until the five-year anniversary of the Series 6 Issue Date..."

The math is simple for common shares: the CEO, Mark Penn, has paid $50,000,000/14,285,714 shares = $3.5/share last year. 

The calculation for preference shares is a little bit more complicated. Each preference share is initially $1,000. Each preference share can be converted into $1000 ÷ $5/share = 200 common shares at the end of 5 years. With 8% annum dividend yield compounded quarterly for 5 years, the total dividend per share aggregates to $1000 × (1 + 8% ÷ 4)4×5 - $1000 = $485.9. Deducting the dividend, each preference share is equivalent to being acquired at the price of $1000 - $485.9 = $514.1. Now you get 200 common shares with each preference share - the average cost is $514.1 ÷ 200 = $2.57/share.

Whether it is common shares or preferred shares, the acquisition cost for the CEO is higher than the current stock price.

In addition, in the 2019 proxy document, I found that Mark Penn is holding 1.5 million options with an exercise price of $2.19 due in 2024. The options were awarded to him as part of his 2019 compensation package. If the stock price is lower than $2.19 by 3/18/2024, all his 1.5 million options will expire completely worthless. What would you do to the stock price if you were the CEO? If I were him, $2.19 is absolutely the lowest price I would aim for by 2024.

The catalyst

In June 2020, Mark Penn's Stagwell Group, has made an announcement that proposes to combine with MDCA and value MDCA's shares at $4.25 per share. This is the exact reason why the volume spiked in June. The stock has jumped almost 80% on the day of announcement, but it is still currently trading ~45% discount to the proposed acquisition price.

Stagwell Group, the largest single shareholder of MDCA, is holding 29.4% of outstanding shares. It's hard to imagine why the proposal will not be approved by the shareholders. The below is the reaffirming message from Mark Penn during the most recent Q3 earnings call.

"In terms of the special committee, I have to let the special committee speak for itself. Obviously, like Stagwell, we announced an agreement in principle. And so the next steps obviously are to go into the next level of agreement. And beyond the fact that I think I remain hopeful that - optimistic that we'll be able to bring the companies together. And their specific requests should go to the special committee.

In the modern world, complex combinations simply just have a lot of evaluative and legal steps. So I won't comment directly. But there is nothing unusual in the process that I've seen so far. It's just, in some sense, an education in just how one has to dot every I and T in a very significant transaction such as this."

The one risk I'm concerned about is that Stagwell Group is going to lower the proposed price at the cost of the rest of the minority shareholders. However, as we've seen earlier, $2.19 is absolutely the lowest it can go so that the CEO's personal options will not expire worthless.

Some improving fundamentals

Stagwell Group invested in MDCA in the first place with the hope of turning it around under the help of its strong partnership and networks. There are some business fundamentals improving here and there. They may be good additions to the overall turnaround story but it's not something I really pay much attention to in this specific case. For example, in the recent quarter, the EBITDA margin continues to expand as Stagwell has been working with MDCA to centralize back office operations and real estate in order to reduce the cost.

With that said, one thing I did check is the solvency of the business before the catalyst is realized. MDCA is heavily indebted but the majority of its long-term debt will not be due until 2024. Its operating cash flow has been consistently positive and the interest expense is well covered.

Conclusion

Joel Greenblatt once defined margin of safety as "limit downside risk; the upside will take care of itself".

I will confidently add to my position when the price drops below $2.19 to eliminate my downside risk. A catalyst is around the corner and good things will eventually happen. I'm not sure exactly when but I know the business can survive long enough to see that day to come. 

MWK is likely to be a superstock

I was excited when I discovered Mohawk (MWK) because it checks off most boxes of a potential super stock. It has a huge breakout with large volume back in April 2020, forward P/S ratio less than 1, rapid revenue growth, enormous operating leverage to expand profit margin, founder-operated business with a strong incentive to increase the stock price and a super theme in AI and eCommerce.

The reason why I like MWK:

• Low market cap $125M with relative low float 15.4M shares 
• Low forward P/S ratio = 0.64 with rapid revenue growth and profit margin expansion
• It's at the inflection point - recent quarter is the first quarter that reports positive adjusted EBITDA.
• Enormous operating leverage with economies of scale: small increase in fixed cost as revenue grows
• CEO/CFO/CRO have large # of options exercisable at the price of $9.72
• Recent insider buying on open market
• eCommerce/AI theme

Company Overview

I cannot do a better job to describe what MWK does than the company itself. This is how it puts it in the most recent investor presentation - Mohawk Group Holdings is a rapidly growing technology-enabled consumer products company. Its proprietary AIMEE (AI Mohawk eCommerce Engine) platform leverages data and AI to automate the design, development, and launch of best-selling consumer products:

• Identifies new market opportunities
  
• Launches new products
• Automates marketing variables
• Analyzes and optimizes owned and operated consumer product brands

The company has identified the secular trend of declining value of brand recognition in the context of eCommerce - customers do not begin their product search by searching specific brand names; instead, customers rely on reviews and compare prices to make their purchase decisions. This has given Mohawk ample opportunity to compete with well-established big brands. The graph below contrasts the difference between Mohawk's business model vs the traditional approach. AIMEE platform has significantly improved the life cycle of product launch and shortened the time from idea generation to product fulfillment.

Technical Chart

I like technical charts as a great starting point to screen stocks because charts are the real-time visualization of market psychology. Unlike 10-Q and 10-K forms that look at a company from the rear mirror, charts are always forward looking and tell a lot more about the future.

MWK had a big breakout with its record weekly volume in April 2020 - the market starts to show lots of interest in this stock and the stock has begun its upward trend since the breakout. The price trend follows 11-week moving average pretty closely, which serves as a support level. Every stock has its own main trend line to follow (the implicit line exists because it is also the indicator that big money players look at to decide their buying point). Any price action that deviates too far away from the main trend will eventually be pulled back closer to it. The current position provides a favorable risk/reward profile and a low-risk entry point. The price is right around the main trend line with a tight weekly price range and a light volume. 

Bonus section about chartists

I didn't appreciate charts as much until many trading books I recently read helped me understand how much chart can actually reveal. However, many books have covered a lot about HOW to use charts correctly, but very few of them have explained the theories behind WHY charts are useful. The following section is not related to MWK specifically but more of my own thoughts I want to write down to reconcile what I've learnt lately. Feel free to skip this part if you are here for MWK.

Charts have two main components: volume and price. Trading volume essentially measures the amount of disagreement on the price of a stock. People sell because they think a stock is overpriced while people buy because they think a stock is underpriced. When there is disagreement on the price, there is transaction. When there is a lot of disagreement, there will be a lot of transaction and hence a large trading volume. In contrast, when the market has lots of consensus on what the price should be (think bond market), fewer people transact and the market reaches equilibrium, which is always accompanied with a lower trading volume.

On the other hand, stock prices are always determined by the most optimistic buyers who are willing to pay the highest on the market - a stock, therefore, is more likely to be overpriced when the trading volume is high and when the crowd is enthusiastic. When I say overpriced here, it's only short-term price action - it means buying at a high volume is likely to experience higher volatility and correction/consolidation after the market calms down.

Theoretically, if the stock has strong fundamentals, given long enough holding period, buying at high volume is not a problem because any price correction will eventually come back up in long run to catch up with its fundamentals. However, practically, this price correction always goes against human nature and is proven to be a problem for many people who failed to make the biggest profits from stock market. Many people lose money in stock market not because they didn't find the right stocks to buy; most of the time, they failed because they didn't hold the stock long enough until they make money.

Although the correction for stocks with strong fundamentals is believed to be temporary, nobody can really predict how much the correction will be - it can be as little as 5% or as much as 30%, easily. The most common reason to sell too early is the emotional pain one has to endure with extended period of paper loss. Psychologically, it's always painful to watch the price of a stock to drop right after your purchase. To reduce the chance of paper loss, starting a position when the volume is low and bar is tight, will greatly strengthen your conviction to hold a stock for long enough until you make profits from it.

Fundamentals

Charts can only tell so much about whether a long-term price trend has been developed and when is a low-risk entry point. The price advancement will only sustain if the company itself continues to grow its revenue and earnings. 

First, MWK has very rapid revenue growth - in the recent quarterly announcement, the revenue growth has accelerated from 43.6% in Q1 to 97% in Q2 from continued eCommerce tailwind. The company expected its net revenue in full year 2020 to be between $170 million to $180 million. That's an easy 49% increase compared to reported revenue $114 million in the prior year 2019. The analysts' estimate for MWK's revenue in 2021 is $214 million, which represents only 22.2% growth rate. This number seems underestimated given how early stage MWK is at in terms of the company's life cycle. It's not necessarily a bad thing to have an easier forecast target to beat, because it is always the surprise of beating/missing the expectation that moves the stock price. MWK still has so many levers to pull to further grow its business, such as launching more products in its main US market, expanding to international markets and monetizing its AI platform. The following presentation slide lists 5 different opportunities they have identified to drive their future growth; many of them are just starting, far from maturity.

Second, I'm very encouraged by its textbook example of economies of scale. MWK is not a profitable company yet, but in the recent quarter it has reported its first quarter with positive EBITDA. I took a closer look at its recent income statement - the fixed cost has barely grown from $27 million to $29 million when the revenue has almost doubled from $30 million to $59.8 million. 

This operating leverage will create a moat for MWK's business. As the revenue continues to grow, the percentage of operating expense in the total sales will become smaller and smaller, which will lead to eventual profitability. A company's stock price is ultimately determined by how much profit it earns. Profits are simply a function of two factors, sales and profit margin. So many companies dream to grow their earnings by growing their revenues or expanding their profit margins, but MWK seems to have both of them.

Insider holdings

Last but not least, I like to check the ownership of the management team to see whether their interest is aligned with all the other shareholders. It's reassuring to see the management team also has some skin in the game - when their personal net worth is directly tied to the stock performance of a company, they are more motivated to manage the company well and create values for the shareholders.

The table below shows the compensation the C-suite received in 2018 and 2019. Majority of the total compensation package came from option and stock awards. This is the compensation structure I generally prefer to see because the management team are not simply employees who are paid with a fixed salary. They own a share of the company they manage.

The details of the option awards also enhance my conviction in MWK. Most unvested option awards the management team holds have an expiration date in 2028 with an exercise price of $9.72. That's higher than the current price MWK is being traded at on the market. To prevent their option awards from expiring worthless, the management team has absolute incentives to increase the stock price to at least $9.72. This has provided enough margin of safety if the stocks are bought at current price level.

Conclusion

MWK has shown some very positive signs to be a multi-bagger super stock. I believe the company is still at a very early stage of its growth and it's currently at an inflection point to turn into a profitable business. With the presence of a relatively low risk entry point, I'm going to hold a sizable position until the investment pays off. 

USEG is speculative but ready to pop

Disclaimer: this is not the typical profitable company that attracts value investors. If you are looking for long-term quality businesses to hold forever, this is not for you. If you are into low float stocks with a turnaround potential, please continue to read.

U.S. Energy Corp. (USEG) is an independent energy company focused on the acquisition and development of oil and natural gas properties. A speculative play that has very low float with only 1.35M shares. 41.4% of the outstanding shares is held by the largest insider who paid $8.7/share in 2017. The stock was closed last Friday at $5.89. In addition, CEO holds 5%, and another trader, Guy Gentile, accumulated 9.79% in May 2020. 

The math is simple - the number of shares is already low to start with, and almost 60% is held by insiders who are not going to sell when they make a profit. Any small change in the sentiment or positive catalysts will pull the trigger.

Stats

• share price: $5.89
• average cost of the largest insider: $8.7
• 1.35M shares outstanding after 1:10 reverse split in Jan 2020
• only 540K shares (around 40%) are available to trade on the market
• zero debt

Average cost of the largest insider

The largest insider, APEG II LP, didn't acquired its holdings through the open market; it takes a little effort digging into the historical filings. This is what I've found in the 13D form filed on 3/27/2019:

"The Shares beneficially owned by APEG II LP were the result of an exchange of loans held by APEG II LP and made to the Issuer, and these loans were financed with working capital through a creditor relationship whereby APEG II LP held $6,000,000 in principal amount of loans under the Credit Agreement dated as of July 30, 2010, as amended (the “Credit Facility”), as set forth in Item 6, comprising the entire principal balance outstanding under the Credit Facility (the “Balance”). APEG II LP then exchanged $5,063,380 of the Balance for 5,819,270 Shares on the terms and conditions set forth in the Exchange Agreement entered into on September 28, 2017, by and among the Issuer, Energy One LLC, and APEG II LP, as set forth in Item 6."

USEG had 1:10 reverse split in January 2020. The actual number of shares held by the APEG is now 581,727, which was exchanged from its debt balance $5,063,380 in 2017. It gives you $8.7/share.

Charts

1-year chart

5-year chart

10-year chart

The stock has formed a long quiet base since 2016 - it is unfavored and depressed. The price volatility has increased noticeably in the past week; I interpret this as an indicator that the liquidity is drying up. Think shares as a standardized commodity that can be traded on the market freely in real time. For anyone who knows economics 101, the price of the shares is determined by the basic law of demand and supply. When the supply is low (low float + insiders' shares not for sale), a small change in demand can push up the price easily. All it needs is a shift in the sentiment or a positive catalyst. More often than not, price can move higher without any significant news, especially when there are no more sellers left on the market. As small investors chase after price changes, an upward price movement can even become a catalyst itself.

The volume spike in the past week reveals an increasing interest in this stock. Many hands are exchanged to move the price up and down in big ways. All it needs is to wait for all the small sellers to sell out their positions - that's when the supply is close to 0 and a small demand will push up the price.

Fundamentals

As I said in the beginning, this is not a profitable business with an exciting story to tell. The net income has been negative for the past few years while still maintaining somewhat inconsistent free cash flow.

The good thing is that the business is at low risk of going out of business while waiting for the turnaround to take place given that it carries zero debt. At the same time, the largest shareholder, Patrick E. Duke, has been placed as a director on the board with an intention to change the business. This quote is from 13D file his company, APEG, filed:

"APEG II LP (together with its affiliates, “APEG”) continues to believe that the Issuer has the potential to be a strong company, but that substantial changes are needed, given the prolonged underperformance of the Issuer. Despite the past litigation between APEG and the Issuer, which is described further below in this Item 4, APEG hopes to dialogue constructively with the Issuer’s management team and board of directors (the “Board”) regarding opportunities to unlock value at the Issuer, including changes to the Board‘s composition. APEG believes that while it had no intention of making its concerns about the Issuer public, the Issuer‘s management and the Board’s actions have left it with no other alternative. In light of what APEG believes to be clear and continues shareholder value destruction, APEG has determined that it must act for the benefit of all shareholders to protect its investment in the Issuer."

I'll not bet a big position on this one, but I've put down a reasonably small position to wait and see. I like this classic Dhandho situation described by Mohnish Pabrai: Heads I win; Tails I don’t lose much. 

A free hydrogen fuel cell business within HY

Hyster-Yale Materials Handling (HY) is not a typical micro cap per se but is under-followed and unfavored by the market; yet it is one of my biggest positions so far. I noticed HY in 2018 when the insiders had some intense buying on the open market. The company has been going through a series of transformations since 2017, and the insiders have been increasing their positions in the past few years. This has aroused my interest to further investigate the reasons behind their move. I've been building up my position gradually with the insiders since last year. 

A few quick highlights about HY:

• Market cap $635M with 16.7M shares
• Insiders have increased their position from 18% to 24% in class A shares between 2017 and 2020
• • Insiders paid around $50 on the open market
• $0 market valuation for Nuvera, the undiscovered hydrogen fuel cell division within HY (yes, it's given away for free)
• • 40% of net income from the other core business is offset by the loss from Nuvera
  • P/E is only 10.4 for the core business in lift truck if excluding Nuvera
  • Nuvera is anticipated to breakeven in near to medium term with the tailwind from China's clean energy market
    

HY is known as a full-line lift truck manufacturer that operates its business across the globe. The company has 3 main business divisions, namely, lift truck, Bolzoni and Nuvera, all of which are expected to see some growth in the medium term.

Nuvera - fuel cell business for free

Nuvera is a manufactuer of hydrogen fuel cell systems acquired by HY in late 2014. I was very excited to discover this "hidden asset" within the company, because Nuvera is often ignored by the investment community as the core business in lift truck has taken almost all the attention. However, after years of investments in R&D in hydrogen fuel cells, Nuvera is close to approaching its inflection point to turn breakeven and contribute substantially to the overall business.

No other fuel cell players are profitable; the overall fuel cell industry is experiencing years and years of losses. Unlike all the other fuel cell companies that finance their operations through external fundings via share issuance, Nuvera, however, is fully subsidized from the other profitable core business within HY. This kind of setup provides a sustainable source of funds into the emerging field that is yet to be profitable and prevents a dilution of existing shareholders's interest. The table from their annual presentation shows that over 40% of the net income from the core business is offset by Nuvera's loss.

Not every investment will turn out successful, but I don't believe HY invests so much money year after year on this unprofitable business if this is not going to yield any returns on its investment. Nuvera is among one of the first movers to launch fuel cell productions in China where huge government investment is focused on developing clean energy. Although the break-even target has been delayed due to additional testing and certification required by the local governments in China (breakeven was originally planned in 2H 2019). The production line has been completed in 2019 with shipments expected to ramp up throughout the second half of 2020; the results are expected to improve significantly in the next 3 years.

Because of the investments in the emerging fuel cell market, the company's overall net income is reduced deceivingly on the book. If Nuvera is taken out from the company, HY has $3.64 EPS and is evaluated at a P/E ratio around 10 given the current price of $37.8 (market cap $635M). Not a bad price to pay for a stable mature business with steadily growing revenue AND you get another fuel cell business for free!

To put things into perspective, if you look at the market valuation at other fuel cell players, BLDP, PLUG and FCEL have market cap at $3.85B, $2.76B, and $549M, respectively (none of them are profitable). Nuvera may not be as prominent as the other names, but this promising business with a clear breakeven prospect is still a steal at the valuation of $0. The fact that HY is under-followed by analysts may be the main reason behind the undervaluation. This is a good news for investors like me to obtain a share at a low price, when the market seems to have completely ignored the strategic position the company has built over the years quietly.

Core business that is also improving

The good news doesn't stop at Nuvera - the other two business lines are also expected to improve over time.

The main lift truck business is the foundation of the company. The management team is competent and has a track record of growing its revenue from $1.8B in 2010 to $3.2B in 2019. The current operating profit margin is only 2.8% and their objective is to achieve 7% target over the medium term with stronger industry and market share growth.

Bolzoni is a smaller business line that manufactures attachments and accessories for forklifts. Bolzoni has recently completed a restructuring to relocate its manufacturing from Homewood, IL to Sulligent, AL. The restructuring is expected to improve the operation in the following years and its operating profit is expected to increase this year with the absence of the $2.5M restructuring charges.

What are the risks

COVID-19 pandemic has negatively impacted the demand side of the lift truck business. Lots of uncertainty exists in the company's core lift truck business as bookings have been down due to the lockdown. The company has taken actions to reduce the operating cost such as reducing the base salaries for all the salaried employees. The near-term results from the core business will not look pretty and the recovery time could be slow depending on the market condition. 

The management has been conservative and the debt level has been low with high interest coverage ratio. The risk of going out of business is not my concern.

On the other hand, the outlook of fuel cell business still looks positive as China is stimulating to recover its economy with a focus on the new infrastructure and clean energy adoption. This tailwind has been confirmed by the recent new high of BLDP.  Here is recent news about a new order received by BLDP in China: https://ca.finance.yahoo.com/news/fuel-cell-stock-rallies-17-161313923.html 

Last but not least - chart

HY seems to have hit the support level and is being traded around the historically low market cap. The MA lines are still trending down, which reflects a general pessimistic sentiment on the stock. 

If you are looking for a quick rebound in the near term, this is not the right place to enter. However, if you are willing to build a position and wait a couple of years for the market to discover this company, now is a good time to acquire some shares at current prices.

The smart money is very patient and can wait years for a full fruition to come. If the insiders paid $50/shares, I'm happy to pay less than $40 now especially when the inflection point is around the corner.