My Trip to the McRae Industries Annual Meeting

After owning McRae (MCRAA) for two years, I've seen the stock double. After such a runup, it is always prudent to re-evaluate the investment. To help me re-evaluate MCRAA I decided to trek to North Carolina for the company's annual meeting held on Dec 18.

The trip was a success for me. First and foremost, I got a basic education about the company. I am surprised at how little I know about the company! I mainly put the most weight on the the financial statements for my investment decisions. But McRae's core business of selling boots has nearly doubled in the last 5 years. And anyone that invests in the company now must understand what the company does. The company is no longer a simple balance sheet purchase like it was when I bought two years ago; the stock is so much higher now.

The following from the company's website sums up its history well.

McRae Industries was founded in 1959 by Branson J. McRae with the primary focus of manufacturing high quality children’s shoes. In 1966, during the height of the Vietnam War, McRae received a contract award from the U. S. Government to manufacture military combat boots for the United States Army using the “direct molded sole” design. As a result, McRae Industries’ Footwear division has provided quality combat boots to the men and women serving in the U. S. Army for more than 40 years.

In a strategic move in 1996, McRae Industries purchased American West Trading Company, a manufacturer and seller of a variety of western boot products. During the 2002 to 2006 time period, the array of western boot products was significantly enhanced by the acquisition of several popular brand names – Dingo, Dan Post and Laredo. Also, during this same period of time, the company’s name was changed to the Dan Post Boot Company to more closely identify our products in the western boot market. In 2005, Dan Post Boot Company became a licensee of John Deere and began to design and market men’s and women’s work boots along with a line of children’s shoes and boots. Dan Post continued to expand its product mix in 2008 with the addition of the durable, price effective McRae Industrial line of work boots.

The company gets 1/3 of its sales from its commercial line and 2/3 from its western/lifestyle line. But the latter only started in 1996 and really took off in the mid 2000's when it purchased several companies in financial troubles. So the company, despite being in business for over 50 years, really took off in the last 10 years or so. And it makes talk about expansion more believeable. The company's FCF is around $6-8 mil a year, and management is thinking of using that money prudently for expansion. Initially, I was skeptical because I didn't realize that the company's western sales only got started in the last 20 years. And I thought if you haven't successfully expanded much in 55 years, why do you think you can now? But now I am willing to think of the company in the present form as only about 15 years old. It was only in the last 15 years that Gary McRae has run the company and has divested itself of the printer and bar code machine business. And most importantly in the last 15 years the company bought the various western boot businesses.

I personally don't have knowledge of the western boots that McRae is known for. In the future I'll definitely pay more attention to the boots that women wear, especially when I am in the South. So, I do not have an informed opinion of McRae's industry. Anyway, fashion market and trends are difficult to predict even for the experts. So really the only thing I can go by is the past results. And the past results show that McRae has expanded prudently, the company has executed well and management has been spot on diving into a lucrative market. The company did $104 M, $97M and $76 M in revenues in 2014, 2013 and 2012, respectively. The company also just reported Q1 revenue of $29.2M versus $31.7 M a year earlier. I wouldn't be surprised if revenue is slightly down this year versus 2014. However, this is still satisfactory considering where revenues were just a few years ago. If earnings plateau, the stock is a reasonable value. But if management can grow revenues and earnings over the next several years like they have for the last several years, this company can turn into a growth stock and would be ripe for acquisition. In that scenario I think a larger player must offer at least $60 a share for company. Compare this with Justin, one of the biggest players in the western boot business. Justin was a public company until 2000 when Warren Buffett bought out the company for $600M. At the time of his purchase, Justin was selling at about 20 times earnings and two times book. To buy McRae with those kinds of multiple would mean more than $60 a share.

I think this trip was invaluable for me. It also didn't feel like work. It was more like a learning experience and vacation rolled together. I saw the factory where they made their military boots — their western boots are outsourced to overseas suppliers. The management is very respectful and friendly towards the employees. But they are also capable of making the tough but necessary decisions to move manufacturing jobs overseas.

I also learned their VP of finance Marvin Kaiser will be stepping down. His replacement-in-waiting is now bringing up the Enterprise Resource Planning (ERP) software. Management is making an effort to improve the company. Ultimately, the results should show up in the books through improved margins, lower inventory levels, etc. Margins have dropped slightly in the last year and it definitely isn't due to pricing pressure. Management told me they are working on reversing the margin trend. This is probably my biggest area of concern.

Microcaps like this have very little coverage and insight into management. Furthermore, management in largecaps probably have no time for small individual investors. But for small companies this isn't so. I have heard of several successful smallcap money managers who regularly visit company management. Warren Buffett in his younger days used to drive around the country visiting management. Lynch also used to crisscross the country when he ran the Magellan Fund, And Francoi Rochon of the Giverney Capital also visits management regularly. This is my second company visit and I hope in doing so to emulate a bit of their success.

What Just Happened in Hong Kong?

On Monday morning Nov 24th Hong Kong time, the market opened with New Century Group Kong Kong (HK:234) opening up slightly at around HK$ 0.16. But 15 minutes into the trading session, all hell broke loose. The stock jumped to HK$ 0.40! That is a 160% rise! But it was too good to last. After two hours it fell back to around HK$ 0.25, which was still up 66%. There it stayed for the rest of the day.

The spike was ostensibly because of an early announcement that H1 earnings are up 390% yoy which, on the face of it, sounds great, until you realize that still means only 0.65 HK ¢. But I guess some investors didn't bother to download last years H1 to see what the announcement really meant, and bid up the stock to HK$ 0.40. For the next three weeks the stock slowly drifted slower to just HK$ 0.166! The falling chart shows the painful descent.

HK:234 Daily Closing Stock Price

And no, I didn't sell it all at the top! I was napping when it happened! Now that the stock is back to just 10% above the level before all this happened, I wonder how could a stock spike up 150% and then drop 60%. Who could have made such a colossal mistake by buying at such high levels? In hindsight, I am sure I didn't miss some behind-the-scenes event. My theory is it happened partially because some buyers did not understand initially that earnings was just up to 0.65 HK ¢, and partially because of an influx of new buyers from Shanghai through the Shanghai-Hong Kong Stock Connect.

The Shanghai-Hong Kong Stock Connect is a pilot program to help China open up its capital markets. Up until Nov 17, Chinese citizens cannot normally invest outside China, nor can outsiders invest in exchanges in China. When I say China I am referring to mainland China excluding Hong Kong. So many chinese companies list on foreign exchanges to get access foreign capital. Alibaba is probably the most well-known example.

The Connect allows any investor in the Hong Kong Exchange to buy certain securities in the Shanghai Exchange. It also allows qualified investors in China to invest in Hong Kong Stocks through the Shanghai exchange. This is the path for China to be a free capital market. However, there is a caveat. On each day there is a limit of how much Shanghai stocks and Hong Kong stocks can be bought by the other market. And there is also an aggregate limit. The aggregate limit is RMB 300 bil for Shanghai to purchase on the Hong Kong Exchange and RMB 250 bil for Hong Kong to purchase on the Shanghai Exchange. The aggregate limit is like the seating limit in a restaurant. Once the limit is reached, waiting customers have to wait for seated customers to leave before getting service. So, once the RMB 250 bll limit is reached, investors in China can no longer purchase Hong Kong stocks until investors in China sell some Hong Kong shares. This means the maximum outflow of capital from China is RMB 250 bil, which is a just 1% of the total RMB 24 bil market capitalization of the Hong Kong exchange. But this may just be enough to tip stocks significantly higher, like what happened to New Century Group. After all, Chinese retail investors are probably less savvy than Hong Kong investors and are much more prone to speculation. And what happened is clearly a case of speculators gone wild.

The current aggregate quote for purchasing Shanghai stocks is RMB 241 bil out of RMB 250 bil. So, it is at the limit meaning there is still pent up demand for Hong Kong stocks.

The current aggregate quote for purchasing Hong Kong stocks is RMB 235 bil out of RMB 300 bil.

	HK:0234
Price	HK$ 0.166
Market Cap	HK$ 957.82 M ($ 123 M USD)
P/E TTM	16.1 x
Div yield	3.9 %
P/BV	0.65
ROE	4.0 %
LT Debt/Equity	0.11

New Century Group has three main lines of business. One is cruise lines; they own two cruise ships. But that business is low margin and often not profitable. The other is real estate, mostly hotels in Hong Kong and Singapore. One contributor to the increased earnings was the disposal of a hotel in Indonesia. The company properties are valued at HK$629M. The third line of business is securities trading. The biggest contributor of the increased earnings was fair value gains in this line of business. The value of the cash and securities on the books is HK$993 M. The company's equity is HK$1.5 bil, the market cap is HK$ 957M. Note that the market cap is less than the cash and investments on the books! So a shareholder can pay for his shares with the liquid assets on the books and get the profitable real estate minus a small amount of debt for free!

In hinhsight, I should have sold the shares at HK$ 0.25 when it was trading about book, but no point in crying over split milk. I think the shares now are undervalued because of the price to book ratio. In addition I feel Hong Kong stocks can be a play on a more open China capital market as the events of the last three weeks showed. And finally, I feel the Hong Kong stock market is undervalued in general, so investing in this company is like buying a undervalued close-ended equity fund.