A few days ago I got this message from a friend at a news station in Pocatello, ID:
Mr. Phil - Happy New Year!
I have a question about Hoku Scientific. Big news with them lately, plenty of talk, I am wondering if you have taken the opportunity to run them through the Rule #1 model?
Well-run company, on-sale, etc?
Not part of a story, just background. Big time analysts are leary but their funding models are strong. You don't usually see companies like Sanyo willing to commit $370m for a product that has yet to be made at a plant that yet to be constructed. Speculative? Solid? I'm interested in your thoughts if you get the chance.
Look forward to talking with you again in '07. Plenty to talk about.
All the best,
Doug
Here's my take on it:
Hi Doug,
Thanks again for the great show. I'm looking forward to doing another one.
Here's how a Rule #1 investor would look at Hoku:
1. It's a new business without a long enough history to predict from, and it's in a highly speculative technology industry that is so early stage that predicting a long term winner is pure speculation (and remember as a Rule #1 investor I don't buy for 10 minutes unless I'm willing to hold this thing for ten years -- with the one exception below.)
2. That said, the only place in a Rule #1 portfolio is in the Risky Biz portfolio where I can speculate a bit with 10% of my capital. But even this portfolio requires excellent fundamentals and growth in a business that may be speculative and with a company that hasn't been around long enough. In that context, we'll continue looking at Hoku by looking at the 4M's.
3. MEANING: Do I like the industry that they are in? Does it match my value system? Do I understand it?
These guys are young entrepreneurs with a Sanyo and Navy contract to build clean fuel systems. Love that. So yeah, I get this area. But I don't really have much idea about who they compete with and they are tiny with a tiny budget which makes them very, very speculative. I'm not too happy about that.
4. MOAT: Obviously their moat is all about patent protection in an industry that is going to be huge. IF they have the goods, this could be a home run investment. A quick look at the Big Five Numbers tells me that they are growing consistently in all four growth categories: Sales, Earnings, Equity and Cash.
But while ROIC is getting better, it's still far below our required 10% -- but this is to be expected in an early stage business that is just becoming profitable. So the numbers indicate a growing moat.
5. MANAGEMENT: Like I said, these guys are young entrepreneurs. Which means the CEO has taken a shot at two other startups and it seems he's done well. Which also means that he may or may not be in this for the long run. He's a business guy, not a tech guy. And his tech guy is hard to evaluate. He may be a genius with the best ideas in the world for all I know.
Which means an investment with these guys is a roll of the dice. There is nothing in their resumes that would say they come to this business as already the best in the world at what they do. Seems to me more like a group of guys in Hawaii who correctly guessed that clean fuel research was going to be supported and would make a good story for an IPO. Which makes me skeptical of their long term success.
Of course, this is just a quick, off-the-cuff analysis. I'd want to know these guys a lot better before popping bucks into this one, since their integrity and skill is what we are investing in.
6. MARGIN OF SAFETY: Remember that Price is not Value. Figuring out the value of a business is so important to great investing results. But the catch is that many businesses can not be accurately valued, especially startup scientific businesses with a bunch of guys with no track record in their industry.
There are two analysts willing to put a five year growth number out there and both of them are going off of what the entrepreneurs say will likely happen, combined with the fact that Hoku is in a hot industry that is going to grow fast. Their estimate averages 40%. That's a big number that doubles Hoku's size every two years, but if they have the goods, it's very achievable because of the nearly certain growth of their industry.
And it's a number that the Big Four Growth numbers are hitting across the board, which makes it believable. But can we count on it? Is it "certain"? Hell, no! It's not even a little bit certain. It's a pure speculation.
Still, it gives us a working number to get a value with. Based on the trailing twelve months earnings of 8 cents and a historical PE of 40 (which is also in the ball park of the max 50 that I'd ever give a business), the computer tells me that if I want a 15% return, I'd better not pay more than $23 for this thing. Which makes my MOS price (50% off of value) about $11. And it's selling for $5. So yes, if the analysts are right, this thing has a big MOS.
So, Doug, what do I get for a decision about whether I'd buy it?
Let's review: I'm no expert in the clean fuel industry, so without a lot more research, this one is a no go for me even though I like the industry a lot.
But, assuming one is a knowledgeable investor in this industry, one would have to also determine that Hoku is the best of breed investment. So do that first.
The moat, for a start up, is as good as the patents.
Management is inexperienced but may be excellent. Time will tell.
And the price, if everything else is good, is excellent. For me, this is a no go at this time, but for an investor who wants into this industry, more research may dispel the science and management issues, in which case, the price is a go.
Now go play!
Phil
