Approximately half of our portfolio is higher-quality companies that should compound growth over multiple years, “generals,” as Buffett would call them. The other half are special situations such as spinoffs or rights offerings; Buffet would call these “workouts.” Spinoffs are a constant source of opportunity as the story is often non-existent or, as in the case of Associated Capital (discussed in the last letter), untold. Associated Capital has no investor presentation, no investor relations activity, no sell side coverage, no conference calls: effectively no awareness at all.

Our second new investment in Q1 was Nuvectra (NVTR), which was off the beaten path like Associated Capital. I became aware of Nuvectra when one of the spinoff notification sites that I follow pointed out that there may be “uneconomic” selling at a recent spinoff. Those words are like catnip to me. As a person focused on fundamentals, selling unrelated to fundamentals = potential opportunity. That tiny kernel of information set off a treasure hunt for facts and basic information to construct a narrative of what could be driving the selling and why it could be misguided. These hunts typically lead nowhere, but we have to look under a lot of rocks and always learn along the way.

Nuvectra had recently spun off from Greatbatch (GB), an outsourced contract manufacturer in the medical device space. Greatbatch itself is a small company with a $1B market capitalization. As small as Greatbatch is, the spinoff is far, far smaller. By the time I became aware of NVTR, shares were down 40% and trading at just over $4 with a market capitalization below $50M. This is where the math starts to enter the picture. The spinoff ratio was such that for every 3 shares of the parent company (GB) an investor owned, the investor received 1 share of the spinoff (NVTR). This 3:1 ratio, when combined with a $4 share price for the spinoff and a $30+ price for the parent company, meant that for every $90+ an investor held in the parent company, they now held a $4 stake in the spinoff. For any investor who was not purchasing Nuvectra, it was less than 1/20 the size of their Greatbatch investment. In addition, at $4 per share, NVTR had a sub-$50M market capitalization and might not be allowable in certain funds with restrictions against owning such small companies. Those funds would be forced sellers due to their mandate/rules, not their assessment of the situation. Other funds’ constraints help to create our opportunities. Lastly, Nuvectra has an FDA-approved medical device that needs to go to market, and Greatbatch’s core business is contract manufacturing of medical devices. These are quite different businesses that can attract different shareholders. Thus, there were several conditions in place for uneconomic selling. Greatbatch shareholders were presented with a tiny stake in a tiny company in a different business than what attracted them to Greatbatch. To add credence to the uneconomic selling thesis, the company had done virtually nothing to tell its story since spinning off, based on observations from repeated website visits. At the time, there was no company presentation on the website, no management bios, and no history. To want to own this company, an investor had to do work; there was no spoon-feeding by a promotional management team.

Given Nuvectra shareholders likely did not know what they were actually selling, a little detective work could bear fruit. There were no indications of any material changes in the company. No press releases, no seismic shifts in the competitive landscape. What about the fundamentals? The company had two salient financial facts. The most important one was a strong balance sheet – Greatbatch had stuffed $7 per share in cash into Nuvectra. For a company selling at only a little over $4 per share, to have $7 per share in cash and no debt is quite remarkable. In other words, shares could appreciate more than 50% and still be valued at less than cash. The second salient number is the burn rate, or how fast the company is consuming cash. Unfortunately, Nuvectra will likely need all of the cash it has and more over time. The company has a medical device that received FDA approval and is now building out a sales force and will burn $25M this year. They look to have about three years of cash on the balance sheet and, if all goes well, that will be enough to become a healthy and prosperous company. This is by no means assured. There is a lot of execution risk with Nuvectra. However, the discount to cash at the time of our investment was certainly very attractive.

When I started working on Nuvectra, I happened to be at Farnam Street’s Think Week with Chuck Royce. As you might imagine, when two stock geeks are stuck on an island reading all day, a stock trading at a significant discount to cash is a welcome distraction. Chuck kept asking, “why the spinoff?” In essence, he was asking how confident we could be that this was not a “garbage barge” where the parent shipped the liabilities off of its balance sheet. After running through a dozen scenarios we came to believe that the most likely reasons were twofold: The primary one was that Greatbatch wanted to remain a manufacturer and did not want to compete with its customers’ products. If Nuvectra’s product was going to be successful, they would by definition compete with Greatbatch customers. The second reason was, again, math-related. Nuvectra is in a growth phase, attempting to gain acceptance for its devices. If the company remained part of Greatbatch, their $25M+ loss would result in a 40 cents per share drag on earnings. If you apply a price to earnings multiple of 10X to that 40-cent drag on earnings, it adds up to $4 in share price. The stock price should increase just by subtracting the money-losing division. In addition, during the course of diligence, we were able to speak with Greatbatch’s investor relations team and get a copy of an unposted investor slide deck, providing a degree of asymmetric information. Even though we were new to the story, we now had more information than most in the marketplace. We understood the motivations, the economics, and the incentives, and we had a plausible explanation for the uneconomic selling.

The final piece of math for the Nuvectra investment was related to position sizing. A careful reader will notice that absent from any of the analysis above was an understanding of the quality of the product, the value proposition to patients or doctors, or where the company fit in the competitive landscape. These factors were either negative, in the case of insider ownership, or unknowable/outside my circle of competence. As a result, I made the position very small (approximately 2.5%) and decided to hold until the shares approached the level of cash on the balance sheet. The further shares trade above the cash on hand, the more it becomes an investment in the future of the company as opposed to an opportunistic special situation. Fortunately, the share price rose relatively quickly and we were able to exit after the quarter ended. Subsequently, Nuvectra has started to tell their story and there is some rosy sell side research that has pegged the value at $25 per share. My ability to predict market adoption on medical devices is limited, so we are happy with the return we had. We had a greater than 40% return on our investment in well under a month, making it one of the highest IRR investments we have ever had. With our small size and flexible mandate, if we continue to look off the beaten path at small spinoffs, we will find others spinoffs that are in more attractive industries and make far larger investments over time. This business rewards patience, persistence, and pattern recognition to connect the dots when there is not story being told.

Scott Miller is an instructor at Wide-Moat Investing Summit 2016.

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This post has been excerpted from the Greenhaven Road Capital Q1 2016 Letter.

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