jebmo’s posthaven

Note: There is much greater liquidity on the German Stock Exchange XETRA under the ticker B8A.

Note: All figures in EUR unless otherwise stated.

Investment thesis

Bavaria Industries Group AG (OTC:BVIKF) utilizes a value investment strategy similar to my own, focusing on a probabilistic contrarian approach with emphasis on protecting the downside. The capital allocation is wise, with the company making opportunistic buybacks of its own shares when it is undervalued. With management heavily invested in the stock, I’m comfortable putting my own money into the company’s stock.

Even though the company has an impressive investment track record, it is currently trading at a large discount to the value of its assets. The strong investment result is illustrated by the CAGR of book value per share from 2012 to 2016, which was 22%. This means that the company clearly outperformed its benchmark index. Despite this impressive result, the company is currently trading at a 20% discount to the value of its assets.

The privately held investments are very conservatively valued at a P/S multiple of 0.11. If the company manages to turn these holdings around, there is likely large upside to the stock. At the current valuation, this looks like a free option.

About Bavaria Industries Group AG

Bavaria Industries Group AG is an industrial holding company that acquires companies which have performed poorly and boosts their performance through active management and restructuring. In addition to managing its own holdings, Bavaria also invests in publicly traded securities. The company was founded in 2002, and made its first acquisition in 2003. The stock IPOed in 2006 on the Frankfurt Stock Exchange. The company has its head-office in Munich, Germany.

Investment philosophy

The investment philosophy is clearly contrarian. In the annual report for 2016, CEO Reimar Scholz states:

To invest well means to act contrary to human nature. Humans have survived because they have learned to avoid losses and to orient themselves to the needs of the group. However, one only achieves outperformance as an investor if one acts differently from the majority and consciously takes losses into account. Ultimately, the probability that one's assessment will prove correct falls far below 100%, and the chance that a share's price will initially drop after the purchase is nearly 50%.

In the annual report for 2012, Reimar Scholz puts emphasis on protecting the downside when investing:

However, as is always the case when acquiring investments, the actual art lies in making the right purchase. In principle, in our transactions we attach value to the protecting of our downside, i.e. to ensuring that we cannot lose any money - in accordance with the motto: „protect your downside, the upside takes care of itself“.

I also like the probabilistic approach outlined in the annual report for 2012:

The model of buying undervalued companies is a game involving probabilities, meaning that errors are also possible in future. However, we must ensure that we never wager the company and accept that it is better to make ten small bets than one large one.

The investment philosophy, as I understand it based on the quotes above, is very similar to my own approach to the stock market. The investment philosophy is broken down into four different strategies:

Hidden gems: As an example, an investment in an Italian manufacturer of laser systems for medical applications is mentioned in the 2016 annual report. Bavaria bought into the company at an EV/EBIT multiple below 7, even though ROE was about 10% and EBIT growth about 8% per year. This is an example of growth at a very reasonable price.

Cheap shares worldwide: This is a quantitative strategy based on fundamentals. An example of screening criteria used is the following combination:

• developed industrial countries
• low EBIT multiple (<7)
• long-term high return on equity (>12%)
• low debt (<50% of equity capital)
• exclusion of real estate, banking and commodity companies

Bavaria has at regular intervals purchased shares in ten companies meeting the criteria with the same weighting. In recent years, this strategy has resulted in ownership in several smaller Japanese firms due to the fact that their cash balances are very high in international comparison.

Quality stocks: This strategy targets stocks that can achieve an excess return over the long term (e.g., ROE > 12%). These companies should ideally also be able to reinvest their earnings in order to achieve growth. Typically, the stocks meeting these criteria are expensive, and Bavaria tries to purchase them after profit warnings or during weak phases in the general market.

Holding companies: Bavaria likes to invest in companies similar to itself. The argument for doing this is that holding companies often trade at a discount to their fair value. One reason mentioned by CEO Reimar Scholz is that the market participants are strongly focused on current results and expected earnings growth. Earnings and sales numbers can fluctuate strongly for holding companies, since they often buy and sell businesses. The two most important factors used by Bavaria when valuing holding companies are the dividend yield in combination with the growth of net asset value per share. Management teams buying back their own stock when the company is undervalued are also highly appreciated by Bavaria. As examples of interesting holding companies, Berkshire Hathaway (BRK.A) (NYSE:BRK.B) and Brederode SA (OTC:BDDSF) are mentioned.

Privately held investments

For the privately held investments, the acquisition criteria are the following:

• Target industries: Manufacturing/processing or industrial services, including consumer goods and retail, but excluding real estate and financial institutions.
• Turnover: More than EUR 50 million.
• Stake: Majority stakes if improvements or turnaround potential have been identified, otherwise also minority stakes.

Bavaria pursues three objectives for its privately held investments:

1. Cutting costs
2. Developing new sources of revenue
3. Protecting jobs wherever possible

In 2017, Bavaria has sold the companies TriStone, BB Government Services and SIDES. TriStone was Bavaria’s largest holding, and it was sold in February 2017. TriStone is an automotive company with solutions for engine cooling, turbo charging and air intake. The motivation for selling was that Bavaria wanted to reduce its risk concentration as well a reduce its exposure to the combustion engine. Bavaria anticipates substantial, long-term declines in sales for traditional automotive suppliers. The sale leaves Bavaria with a large cash position to invest. The remaining privately held investments are briefly described below.

Arti Group is an Italian company in the printed products and promotional materials industry. The customers are publishers and B2B customers. Arti Group was added to Bavaria's portfolio in 2014. The company has revenues of 145.3 million TTM.

Asterion has operations in nine European countries, and provides document management solutions. Bavaria bought the company in July of 2013, and the company has revenues of 67.5 million TTM.

Carbody is a French automotive company, which develops, validates and manufactures sealing solutions, bumpers, and pedal systems. Bavaria bought the company in March of 2012, and the company has revenues of 50.3 million TTM.

Cobelplast NV is a Belgium based company specialized in the production of packaging for the food industry. Bavaria bought the company in 2014, and the company has revenues of 34.3 million TTM.

Hering is a German specialist for specific thermal transfer applications, which produces custom heat exchangers for international markets. Hering was one of the first acquisitions made by Bavaria back in 2004. Hering has revenues of 10.9 million TTM.

The summarized net income of the operative investments above amounted to -9.7 million in the first half of 2017. The summarized revenues TTM amount to 308.3 million. Bavaria estimated the value of this investment portfolio to 33.6 million on 30^th of June 2017. The holdings were all acquired at prices substantially below book value.

Publicly traded investments

In the annual report for 2016, the company stated that it is likely to primarily invest in exchange-listed securities in the near future, since the prices for company acquisitions are currently very high.

On 30^th of June 2017, Bavaria held 211.5 million in cash. The company also held publicly traded equities worth 117.6 million. The portfolio is concentrated, with the five largest equity positions making up 53.8 million. The largest positions are iShares Core DAX UCITS ETF, Berkshire Hathaway A, Vanguard F ETF, Euler Hermes Group S.A., and Brederode SA. The value of the five largest positions is up about 10% since 30^th of June 2017. If we assume that the remaining part of the portfolio has had a similar development, the publicly traded equities should currently be worth about 129 million.

Investment results

Looking at the book value of the company as a proxy for its performance, I’ve limited the time period to the five last years. The company stopped paying dividends in 2012, which means that the earnings have been kept in the company. Since a share repurchase program has been in place, I’ve looked at the CAGR of book value per share from 2012 to 2016, which resulted in a 22% CAGR. The company uses the German DAX equities index (DAX) as its benchmark. Over the same time period, the DAX equities index achieved a CAGR of 14%. Bavaria clearly outperformed its benchmark under that five-year period.

According to the annual report for 2016, the company claims to have achieved a cumulative return of 43.6% in the last four years with its financial investments. The comparable number for the DAX is 19.8%. Since the company only was invested at 37% of its available funds on average, and otherwise held cash, the company was only just able to keep up with the DAX. The decision to hold cash is of course also an investment decision, which for the last four years has punished the company’s performance. I still find the investment results impressive, and I see parallels to Berkshire Hathaway’s decision to hold a large cash position in the recent past.

Valuation

The privately held investments are valued at a P/S multiple of 0.11. Even if the companies are not profitable on an aggregated level, the valuation seems very conservative. Let us still accept the 33.6 million valuation. The publicly traded equities and the cash add up to about 340 million, assuming that no major changes have been done to the portfolio since the latest financial report. Summarizing these numbers, the company should be worth about 374 million. The current market cap is about 300 million, which translates into a discount of about 20%.

Capital allocation

The first couple of years after going public, the company payed large dividends to its shareholders. In 2010, the dividend was cut severely, and in 2012, the company stopped paying dividends completely. In the annual report for 2013, the management explains its capital allocation strategy:

The Management Board remains committed to reinvesting our own funding and paying out no dividends. Why? Because we are the main shareholders and intend to spend our working time investing our liquidity as well as we possibly can, leaving our free time to be devoted to non-monetary issues. All other shareholders can benefit from our activities through rising share prices – without having to pay the performance fee, which, for traditional capital investors, can easily amount to between 20 and 25% of the total value increase. In addition, there is always the option of selling the shares they hold.

To me this makes a lot of sense, especially given the strong investment results achieved so far. Instead of spending cash on dividends, the company has performed major share buybacks. This is also explained in the annual report for 2013:

For us, share buybacks are an important way of instilling discipline, and they are an option only for those who focus on intrinsic values and how to increase them. Over the last seven years, we have repurchased 987,015 shares with a total value of EUR 14.9 million – the equivalent of 14.9% of the shares outstanding at IPO. Buybacks have several important advantages over dividends for our shareholders: First, they can decide for themselves whether to opt for a growing share in the company’s profits or whether they would prefer to sell shares in the equivalent proportion to the buybacks to generate a “dividend”. The second advantage is that shareholders themselves can determine by setting their own sell date when their investment will be taxable and when to increase their liquidity. They also benefit from accumulated interest. If a shareholder invests their dividend and achieves an average return of 8% on their shares, their capital will actually only increase by 6% p.a. because earnings are taxed at 25% a year. If the company invests the same amount, they will receive the full 8% return because it is not liable to dividend tax. After ten years, the first of these scenarios will have generated a profit of 80%. The second will have delivered 115%. As a general rule, we buy back our shares only when their price has fallen below the estimated intrinsic value of our company (and we have the necessary cash to do so), which means earnings per share for all the remaining shareholders will rise.

The buybacks have continued also after 2013, and according to the annual report for 2016, the company has since March 2013 bought back EUR 16 million shares with an average price of EUR 35.8. Also in 2017, the company has bought back about 5.25% of shares outstanding. The purchases were made at about the current stock price, which also implies that management currently thinks that the stock is undervalued. I’ve seldom seen such a clear-minded management discussion on capital allocation, and I definitely like what I see.

Shareholder structure and management incentives

CEO Reimar Scholz is also the founder of the company. He holds 2.1% of the shares in his own name. Bavaria Industries Group AG is majority-owned by AS Beteiligungen und Vermögensverwaltungs GmbH, which holds 83.9% of the shares. AS Beteiligungen und Vermögensverwaltungs GmbH is a holding company without operations, and it is also led by Reimar Scholz, who is a major shareholder in the holding company. The executive board has had a very large position in the stock throughout the years. After the IPO in January 2006, the executive board held about 67% of the shares outstanding. Management is heavily invested in the stock, which should make their interests aligned with the interests of the other shareholders.

As the free-float is rather limited, trading is also thin. As a private investor, I see this as something positive since it most likely keeps institutional investors away from the stock.

Conclusion

Bavaria Industries Group utilizes a value investment strategy similar to my own. I’m impressed by the investment philosophy and the capital allocation. With management heavily invested in the stock, I’m comfortable putting my own money into the company’s stock. Considering the impressive investment track record, the current stock price at a large discount to the value of the company’s assets seems unwarranted. The privately held investments are very conservatively valued, which could lead to a large upside to the stock. With the large cash position and prudent investment approach, I view the downside as very limited. To me it seems reasonable that the stock should at least trade at a market cap close to its asset value. This would imply that there is room for the stock price to rise by 25%. If the company can continue to perform as well as it has in the past, the company has the potential to remain a strong compounder for the years to come.

Disclosure: I am/we are long BVIKF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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