Investing in Undiscovered Stocks and Saker Aviation

Hi reader,

I am currently reading the book containing Santa Monica Partners’ shareholder letters from 1982 until 2021 (I am around halfway through). This is the book in case you are interested (spoiler: it’s not cheap):

Santa Monica Partners was founded by Lawrence J. Goldstein in 1982 and has significantly beaten market averages by investing in good, undiscovered companies not listed in the main stock exchanges (like the Nasdaq, NYSE, etc). The fund remained so true to this goal throughout its history that it even trademarked the strategy under the following headline:

Stocks Overlooked or Ignored by Otherwise Intelligent Investors.

The book got me thinking about the following: 

Are there really such undiscovered companies trading at ridiculous valuations in the “secondary” exchanges?

Lawrence J. Goldstein argues this is indeed the case, and his argument makes sense. He argues that there are very few institutional investors (if any) that…

1. …are interested in such companies: institutional investors don’t enjoy the permanent capital advantage we (individual investors) enjoy, so they must more or less perform in line with their benchmark/peers to retain their AUM (Assets Under Management) and make money through performance and management fees. This incentive structure eventually leads to index hugging, which many judge to be the reason (together with passive inflows) why large and mega-caps have seen such tremendous outperformance in the past. Those kinds of stocks will always have potential buyers, although the opposite side of the coin is also true: they will always have potential sellers (more on this later).

2. …can invest in these companies even if they want to: large institutional investors face a problem as their AUM rises. To move the needle of a growing fund, the required size of the investment grows. This means that many of these institutional investors would never spend time on an investment where they could only invest, say, 0.01% of their AUM. It’s simply not worth it for them from an effort-reward perspective.

These two roadblocks institutional investors face should eventually (and rationally) lead to many good companies that are “left for dead” in the non-primary exchanges due to the absence of buyers. While the argument makes rational sense, I believe there are several caveats. 

First, as these companies don’t get a lot of buying interest, an investor must look for a catalyst that eventually makes the stock price rise. One might discover an excellent company that’s unappreciated by the market, but if this company is never appreciated by the market, then the investment might not be as profitable as previously anticipated. The only exception here is if a company returns significant amounts of its cash to shareholders, making the investment worthwhile even without stock price appreciation. By catalyst here we can understand something like a potential sale, an inclusion in one of the primary exchanges, or something very obvious that makes the market realize the “hidden” value in such companies.

Secondly, while I do understand that large and mega caps drive much more investor interest, I am skeptical about the fact that this heightened investor interest makes them always efficiently valued or overvalued. While it’s true that institutional investors tend to flock to such stocks, and many individual investors are aware that they exist, this heightened interest can potentially work both ways. While we might see these companies become overvalued in times of optimism, it’s almost a certainty that the opposite will happen in times of pessimism. This is simply a fancy way of saying that these stocks tend to be more volatile due to herd mentality among institutional and individual investors, and ETF rebalancing. This herd mentality, due to its nature, exaggerates the movement both ways.

This is something that Lawrence J. Goldstein is well aware of. His October 2000 shareholder letter points out the following:

You see, stocks that drop the most when the market is volatile are those most owned by institutions. The reverse is also true. Stocks that fall the least are those with the lowest levels of institutional ownership.

Contrary to popular belief, institutional investors are not interest in making money, earning income, protecting purchasing power or preserving capital. Rather they are more interested in being in the pack of other similar institutional investors. The institutional investor can not afford to be alone holding a stock its peers do not hold and also be wrong.

To this behavior from institutional investors we must add algorithmic trading (which wasn’t a “problem” back in the year 2000) permeating the market today, creating increasing levels of volatility. How this works is straightforward: a stock is sold by institutions, then the momentum factor turns south, leading to many algorithms selling their positions, which in turns leads to “panic” and other investors following suit. Nobody wants to be left “holding the bag.”

Then we must also add that information sharing is much more widespread today than it was 24 years ago, creating a quicker flow of information and quicker panics. This, in my opinion, means that while large and mega-cap stocks gather a lot of investor interest and are certainly not overlooked, they are guided at times by emotions, creating opportunities for those investors who understand what they are worth and who can control their stomachs. In short: inefficiency in the market is not correlated to market cap as much as it is to human nature.

What’s certainly true is that a great business is a great business regardless of investor interest and its market cap. When a great company is overlooked, it might definitely create an opportunity, but it’s critical to understand what the risk-reward ratio is (many of these stocks are cheap for a reason) and, most importantly: how or when the return might be materialized (ie., how long it’ll remain overlooked or why it doesn’t matter if it remains overlooked).

As most of you know, I don’t release a “pick” every week, month, or even every quarter. This doesn’t mean that I am not constantly reading about new companies (this is pretty much +50% of my work day). It’s just that good opportunities (at least those that I believe are good opportunities) seldom present themselves, especially in a market that’s not extremely cheap (judging by historical norms). It’s obvious that it was much easier to find an opportunity when the Nasdaq and the S&P 500 were significantly off ATHs a couple of years ago, although I am a firm believer that good opportunities are always present in the market regardless of the generalizations the financial press likes to make (things like: “stocks will go nowhere the next decade”). The intrinsic value of the great companies had not changed much in 2023, but their prices were driven lower by investor sentiment.

Lawrence J. Goldstein’s “theory” has intrigued me, so I have decided to, occasionally, look for undiscovered high-quality companies that are not listed in the main exchanges, or if they are, that they don’t gather significant investor interest. This is an example of such company.

In this article, besides telling you that I might, from time to time, bring an article about an interesting “overlooked” company, I wanted to bring a real-life example of a company that I briefly analyzed this weekend. Note that “looking” at these companies typically doesn’t take much time because there’s not much publicly available information about them, and the annual report is significantly shorter than those of other companies (this can be both good and bad). Let’s look at Saker Aviation.

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Saker Aviation (SKAS)

I didn’t even know where to start looking to search for these companies (or else these companies would not be overlooked!), so I decided to use Finchat’s screener. I screened for companies trading in non-primary stock exchanges that satisfied the following criteria:

1. Listed in the US or Canada

2. No Banks and Oil and Gas (completely out of my circle of competence)

3. Shares outstanding 3Y CAGR of at least -1%: so companies reducing their share count, not diluting shareholders

4. Positive operating margin

5. Revenue 3Y CAGR above 5%

6. Net cash position

I thought these criteria would bring interesting results, and this is how I got to Saker Aviation. The company has a market cap of $10.2 million (yes, it’s really small), with a net cash position of $9.5 million (yes, most of its market cap is cash), a 40%+ operating margin, and a 3Y revenue CAGR above 60%. No doubt it seemed interesting on the surface, especially since insiders own more than 20% of the company. This said, let’s dig a bit deeper because not all is good news.

Saker Aviation had two main business lines until 2022, both related to the aviation industry:

1. It was a fixed-based operator and a provider of maintenance and repair services (‘MRO’) in the Garden City Regional Airport in Kansas.

2. It held a monopoly granted by concession to operate the Downtown Manhattan Heliport. This heliport is not the only one in Manhattan that can operate charter flights, but it’s the only one that can operate tourist flights around the city.

The company sold the first of these business lines in 2022 for $1.6 million, so its sole business line today is the monopoly to operate the Downtown Manhattan Heliport, a concession which it has held since 2008:

The Downtown Manhattan Heliport

So, how does Saker Aviation make money? The company provides different services and products to the companies that use the Heliport to carry either charter or tourist flights. Due to the nature of its business, Saker has only four customers, which represented around 83% of the company’s 2023 total revenue. This customer concentration is somewhat logical as more customers would…

1. Probably be impossible to service in such a small location

2. Diminish the profit margins of the incumbents, reducing Saker’s value-added and therefore pricing power

Customer concentration is always a “problem,” but less so when you operate a monopoly, and your customers have nowhere to go. Revenue is divided into three streams:

1. Services and supply items: this is not disclosed in the SEC filings, but I imagine it has to do with fees that the companies using the heliport have to pay to Saker Aviation

2. Sale of jet fuel and related items: self-explanatory

3. Other revenue: mainly related to “non-aeronautical revenue” like advertising and photo shoots

We don’t get segment reporting, but I’d imagine that #1 and #3 (selling services as a monopolist) are much higher margin segments than #2 (selling a commodity). 

The company reported revenue of $8.8 million in 2023, with operating income of $3.5 million, so a close to a 40% operating margin. However, there are many moving parts in these numbers. For example, the company did not pay concession fees to the Government last year due to a special arrangement. The payment of such fees have been resumed this year, with the cost of revenue increasing by around 46% over the first six months. Over the first six months of 2024, the company has generated…

• Revenue of $3.96 million, up 6% year over year

• Operating income of $2.02 million, down 16% year over year

The reason the company managed to retain a higher proportion of operating income than gross profit despite the concession fees comes from SG&A, which has decreased significantly. This decrease is explained by the termination of an agreement the company had with a different provider. This brings the operating margin (which now seems more normalized after these two non-recurring items are behind us) to a whopping 51%. Pretty high but somewhat “expected” considering the monopolistic position of the company and the nature of its business (very Capex and Opex light since the real estate belongs to the Government).

If we go further down in the income statement, there is even better news. The company operates with a significant working capital surplus (around $8 million) which it invests in a high-yield savings account with UBS. This yields the company more than $200k of interest income a year (of course, this might not be the normalized level going forward, especially after the rate decreases). The company faced a litigation expense (non-recurring) related to the termination of the agreement I shared above of around $1 million in Q2, so LTM (Last Twelve Months) net income is not really normalized. All this said, and without making a much more detailed financial analysis, the company is very profitable and generates quite a bit of cash.

This begs the question…

Why is it trading marginally above its net cash position?

Well, for starters, a portion of this cash is in customer deposits (around $258k). This means that the true cash position available to shareholders is closer to $9.25 million rather than $9.5 million. Still, even taking this into account, this monopolistic business is trading only 10% above its adjusted net cash position while being able to generate at least $1 million in operating cash flow per year with minimal capital needs. Strange, right? Not so much.

The reason the company trades like it does is that its business might become permanently impaired this year. The regulatory bodies issued a new RFP (Request For Proposal) on November 2023, meaning that the concession is up for renewal, and there’s no assurance that the renewal will be granted to Saker (still no date here). The company is currently operating under a 6-month temporary agreement, that can be extended up to three times:

On July 13, 2023, the DSBS was granted approval by the Franchise and Concession Review Committee to enter into an InterimConcession Agreement (the "InterimAgreement”) with the Company to provide for the continued operation of the Downtown Manhattan Heliport. The InterimAgreement became effective upon registration with the Comptroller of the City of New York and commenced on December 12, 2023, the date set forth in a written notice to proceed received by the Company. The InterimAgreement provides for one (1) six-month term(the "Initial Period”), with two (2)six-month options to renew (the "Renewal Periods”). The Company is required to pay the greater of $1,036,811 or 30% of Gross Receipts during the Initial Term and the greater of $518,406 or 30% of Gross Receipts during both Renewal Periods.

The first renewal was successful so the company can operate until December 2024, although the agreement can be canceled at any time by the regulatory bodies. I imagine a reason behind a potential cancellation would be that a permanent decision is made before the expiry date.

The limit to present the request for proposal was February 2024 (the company complied with this deadline), but nobody knows when a decision will be reached. If the company is unsuccessful, then there will be no business to operate, so it’s somewhat of a terminal event. 

I imagine this is what the market is discounting, and while it makes sense, the timing of the decision also matters. If the company is able to generate an additional $600k in Operating Cash Flow over the next 6 months, this would bring the adjusted cash position to somewhere around $9.8 million, making the downside scenario quite limited. This said, I imagine that the business would incur some expenses if it were to stop operating, so a portion of the cash would obviously not be available for shareholders. If, on the contrary, the company is granted the new concession as has historically been the case, then the upside seems pretty significant with a lowish risk of permanent capital impairment.

Another thing that matters dearly here is what happens under the downside scenario. Does the company return all cash to shareholders? Or do they try to invest it elsewhere? This is a question I asked the management team (still no answer) and it’s obviously key to know the answer to as the downside scenario pretty much depends on this. 

I obviously don’t think Saker Aviation is a high-quality company (or, better said: it doesn’t fit my definition of a high-quality company). Its definitely a good business so long as it maintains the same number of operators in the Heliport and the concession is granted, but I don’t believe a high-quality company would rely on such a binary event like the one the company faces. The business also faces additional risks like regulation limiting the number of flights. For example, in 2016, regulators prohibited tourist flights on Sundays which obviously negatively impacted the business.

Still, this company was trading below net cash pretty much during all of 2023, making it quite an attractive risk-reward opportunity. One might argue that there’s significant opportunity cost here, but I would say that the later the decision is made, the better for shareholders as it still has 1 year to extend its temporary agreement, period through which it would generate significant cash:

Source: Finchat.io (you can grab a 15% off any paid plan using this link)

The market has since corrected some of this “inefficiency,” with the stock up almost 100% over the last year and around 200% since July last year:

Source: Finchat.io (you can grab a 15% off any paid plan using this link)

I imagine that looking in the pink sheets or among smaller cap stocks requires turning “a lot of rocks” before finding a good opportunity. At least, this has been my experience to date after finding many questionable businesses that were definitely cheap for a reason. Still, I think the example proves that, at times, one can find a good business trading significantly below where it should and completely disregarded by many investors. 

Like I mentioned at the beginning, I don’t think one should go to small caps or the pink sheets to find inefficiencies because inefficiencies are present in all parts of the market (many examples of this over the last years). However, as I also said earlier, a great company is a great company regardless of its size and/or where it’s trading and there are definitely advantages in looking in places where other people are not looking. A great company that is not recognized as one will probably have the two engines of stock appreciation at its disposal:

1. Multiple expansion if/when recognized by the market

2. Earnings growth

All while having a relatively “capped” downside. A great business that is recognized as such will probably have only one of these engines at its disposal, but it can still do relatively well. I like how Lawrence J. Goldstein puts it here:

Our experience has long been that if you buy the right stock at the right price and hold for the long pull you get rich and if you just buy the right stock and hold for the long pull you make money.

To this, I must add that investors can learn a lot by studying smaller businesses. These lessons can later be applied to the analysis of companies of any size. Maybe as one learns about this part of the market, it might make sense to dedicate 10% of a portfolio to such opportunities if they ever appear.

I hope you enjoyed this kind of somewhat special article and if you did be sure to let me know in the comments section and I’ll bring more in the future. And don’t worry because this doesn’t mean I am not studying high-quality companies, I am doing that and will also bring articles about them even if I don’t think they are worthy of inclusion in the portfolio.

In the meantime, keep growing!