Idea Brunch with Toff Capital

Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview Toff Capital!

Toff Capital, a full-time anonymous fund manager, focuses on investing in small-caps, special situations, and off-the-beaten-path ideas. They are also active sharing their research and idea generation @ToffCap on Twitter and on Substack.

Thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background and your ToffCap brand?

Thanks for having me on.

I’m currently about 15 years in the investment business. I started in Corporate Finance, which I consider to have been the perfect school for investing. Back then the Corporate Finance team of the firm was so large that they had divided it into three sub-teams; one focused on M&A, another on Financing, and the last one on Valuation. I was lucky to start working in the latter, which was a great experience. As you might imagine from the name, the focus was on valuation-related projects, such as company valuations – clearly – but also (intangible) asset valuations, tax- and audit-related valuations, dispute resolutions, divorces (when there are many assets involved, a court might call in a valuation expert to assess the value of the assets), and so on.

Interestingly, as the vast majority of companies and assets involved were private, it ingrained in me that value and price are two separate things, often tied together but regularly not. This is obvious for any (value) investor, but the experience had a large impact on my investment style and philosophy. The experience showed me how big a difference there can be between the perceived value of an asset and the realized price - how ‘absolute value’ does not exist most of the time. Pricing is dependent on a myriad of assumptions and can change in an instant. It also led to a relatively high level of insensitivity to large price fluctuations and made me often consider (high) volatility a good thing. I don’t want to imply that I’m insensitive to price fluctuations – certainly not – but it turned out to be a very good school for the occasionally irrational behavior of the public markets.

The idea that there could be big value-price discrepancies out there pushed me towards public markets. I was lucky enough to land a job as a portfolio manager relatively early in my career. Keep in mind I had no public market experience whatsoever, showing again the importance of luck in life (and investing). Another stroke of luck was that the fund had a pretty wide and flexible mandate; we were not allowed to short and had to take a few liquidity and size guidelines into account, but for the rest, we (my partner and I) could do whatever we wanted. And that’s exactly what we did.

We ran a relatively concentrated portfolio focused on situations where the gap between the price and our assessment of value was the greatest. We regularly found these in small, more complex, and/or volatile situations. That was often your edge. Despite being only two people, we were able to beat the benchmark for quite some time by just doing the work and staying focused on our strategy despite the sometimes relatively volatile periods.

I (co-)managed this fund for roughly a decade before it moved to a more ‘sustainable’ character. This move killed our edge. The advent of ESG reduced our universe from >2,000 stocks to a few hundred, mostly larger and more covered stocks. Suddenly we couldn’t play most of the interesting themes anymore. Imagine being forced to sell your best positions (energy and tankers at the time) just before the big moves, to buy already crowded names. We had adopted a negative alpha strategy.

The move to ‘sustainable’ investing also led to non-investing related auxiliary work, which detracted from our core jobs. This is when ToffCap started. To stay focused (and mentally sane) I figured that it would be a good idea to keep an investment journal. Just writing about what we researched and decided. I continued to do this after we left the fund and moved to manage a few client-specific mandates. Today, ToffCap is a platform where we write about interesting opportunities, and find and publish tons of potentially interesting event-driven ideas.

(By the way, the latter is also sourced from other fund managers and investors, hence the use of ‘we’ in some of the phrasing.)

A lot of people in your position as a professional investor prefer not to share their knowledge and ideas publicly. What benefits have you seen from being so open and generous with your content on both Twitter and Substack?

I come from a big entrepreneurial family, but they are mostly operational people and not so much financial. Even more, financial institutions were often looked down upon and considered to be ‘the bad guys.’ I’ve always had this inherent interest in the stock markets, but there was just nobody there to guide me or point me in the right direction. Because of this environment, it took me a relatively long time to move into the world of public equity markets. I was lucky to find a very good path and become a money manager relatively early, but I promised myself that if I succeeded, I would try to help people find their way in the investing world. I guess my way of contributing is to just put a lot of content out there and hope that some might find it useful.

But there’s also a more selfish reason. I’m a generalist and look at a lot of stuff all the time. One cannot know everything, so putting ideas out there is a way to get valuable feedback. It almost always leads to some useful comments and suggestions.

I didn’t take Twitter seriously at first, being skeptical of the quality I could find on a ‘social’ platform. But boy was I wrong, and very happy to be wrong. I’m amazed at the amount of quality feedback I receive and the interactions I have with a lot of smart people. It also creates lots of interesting opportunities. For example, this interview would never have happened if I didn’t start sharing content.

We’re already making a good (and fun) living doing our jobs, for which I’m grateful. Also, we’re doing the research anyway and we continuously find interesting event-driven opportunities. So why not just share it with others?

You’ve highlighted a lot of small promising overseas companies such as Lassila & Tikanoja (Helinksi: LAT1V — EUR391 million), a Finnish waste management and recycling services company, and Brodrene A&O Johansen (Copenhagen: AOJ — Kr1.59 billion), a Norwegian water supply company. Can you tell us a little about your process for finding and researching these off-the-beaten-path investments?

The companies you mentioned are from our Toffcap Monday Monitor (TMM), a regular publication on the blog highlighting interesting event-driven trades and companies. I’m not involved in these at the moment, but this is an example of the kind of sharing that I like to do. I’m continuously finding and analyzing companies and special situations, so why not share the interesting companies and situations I find? I try to keep it simple and accessible so pretty much everyone can understand what I’m talking about. A thesis should be without too much ‘fluff’ in my opinion. Plus, it helps bring the narrative down to the few KPIs that drive the thesis.

I have a very wide mandate. As a consequence, I’ve scanned through thousands and looked into hundreds of companies. You always keep watchlists. Often good opportunities are found by just keeping ‘interesting-but-not-that-interesting’ companies checked, so once one is cheap enough you can quickly pull the trigger. And when you’re looking at a company you always assess similar companies, competitors, etc., which then leads to new opportunities.

But there are many other valuable resources, such as blogs and Twitter. The important thing for me is casting as wide a net as possible and seeing what sticks. If you turn over enough rocks, you’re bound to find a few things that you’ll like.

Another great source of ideas is the network of investors and fund managers I’ve built over the years. Constantly sparring with others is key to developing and processing a thesis. As mentioned, our TMM covers interesting event-driven and special situations. A big part of these are sourced from this network. Just other people regularly sending us event-driven ideas that hit their screens. We screen them and publish them in our regular TMM. I cannot understate the amount of profitable special situations we’ve found this way.

How have you improved as an investor in these small special situations over the years?

I think that (smaller) special situations just sit well with my character and investment style, reflecting what I mentioned before. But I don’t want to paint the picture that the focus is only on event-driven opportunities. I love to find cheap companies with a long runway for growth. Companies that can stay in the portfolio for years to come. But I also just find many situations bound to a certain catalyst or event.

I try to build a portfolio that reflects a wide spectrum of differentiated opportunities. We all know that it’s extremely important to have a philosophy that resonates with your character. Otherwise, you might end up drifting everywhere and lose focus. Don’t get me wrong, style drifting is fine by me, as long as you have an ‘anchor’ that holds you grounded. That way you’ll still be around in the long term.

I’ve found that my sweet spot is 8-12 core positions. Definitely not more, as I want to remain concentrated. A 2% position that doubles adds very little to the total. Positions have to be at least 6% and can run up to whatever I feel confident, and that depends on the timing + conviction. Also, I tend to be more at peace with my position if a company grows into it. Let’s say a 7% position grows to 20% of the portfolio - I have no problem maintaining that position if I remain confident in its potential. But to initiate a new 20% position - that rarely happens as I would fret too much about the size. It’s a bit peculiar, but again, your philosophy must reflect your character.

It’s worth noting that over the life of a specific investment, I tend to think as much (and perhaps more) about portfolio positioning as on the initial research of the investment. How much am I already up/down on this investment? Is it large enough? Do I add if the thesis continues to improve, even if the shares performed well? Do I add to this investment that traded down? When do I sell?

I generally don’t hold until my target price (which is a fluid concept) is reached. For example, say I think that a certain investment should return, let’s say, 100% over two years, and it moves +60% in one year, I tend to sell; I normally have other opportunities with a higher return prospect – or even positions which went down that I’m still bullish about.

Lastly, my core positions are generally flanked by some securities with embedded leverage, such as options/warrants. These are more icing on the cake and never a core position. I’m also sector and region-agnostic, which massively increases my universe, though I tend to focus only on DMs – that’s more than enough stocks to cover.

You’ve written a lot about ADF Group (Toronto: DRX — CAD$280 million), a Canadian engineering and steel installation company that is up ~180% since your June 1, 2023 profile. Can you please tell us a little about the company, what went right, and where you think it goes from here?

ADF Group is a small wonderful company with plenty of upside potential left. I mentioned that (despite a strong focus on special situations) I love to find small, profitable, and rapidly growing companies where we can benefit from the explosive combination of earnings growth and multiple expansion. ADF fits this picture perfectly.

I’ve recently provided an update on the ADF thesis on the blog which you are welcome to check out. ADF is a North American company specialized in designing, engineering, and installing complex steel structures, heavy steel built-ups, as well as miscellaneous architectural metalwork. Operations have historically been rather cyclical, where large projects could lead to ‘gaps’ in earnings as one project finished and the next had yet to ramp up. Earnings have mostly waved up and down over the years, but overall little real growth.

That all changed a few years ago. The tide in the market has changed and the industry is now benefitting from several large secular tailwinds. Years of massive underinvestment in infrastructure have led to the need for big infrastructure spending. This tailwind just started and is expected to continue for many years. Furthermore, companies like ADF are benefitting from a strong onshoring trend as overseas manufacturing is being brought back to the States, driven by a push from the U.S. Administration to bring back manufacturing. These are no small tailwinds and helped to push the company’s EBITDA to $25m in FY23 (the year ending Jan. 2023) from $5m in FY20. ADF expects growth for at least the next 3-4 years based on continued strong industry tailwinds.

But the main trigger for (further) earnings growth, and the reason why the past is not anymore representative of the future, is the massive investment program in automation that ADF completed less than a year ago. ADF spent $30m over two years to acquire and install a brand-new robotic fabrication line. To put the size of this investment into perspective: ADF’s total fixed asset base in FY21 was roughly $85m. The installation of the new line was completed early last year and resulted in strong cost efficiencies almost immediately. The company is on track to generate $50m EBITDA in FY24 (ending Jan. 2024), ~100% YoY growth at record margins.

But more will come. The new automation equipment allows ADF to bid on (and win) larger, higher throughput projects. The company’s operations are shifting to a new level, opening up a whole new set of opportunities, at higher utilization rates (remember the original lumpiness of the business from the large projects). The order backlog is exploding.

This all bodes well for this year (FY25). ADF entered the year with a massive, record backlog. In addition, during Q1-Q3 of last year, ADF was still learning to properly utilize the new automation platform and now we have the recipe for another year of strong earnings growth. I conservatively estimate ADF could generate $70m EBITDA this year, potentially much higher. At that level, ADF would still be trading for ~4.5x EV/EBITDA, excluding generated cash.

Now, growth will slow down at some point, but the tailwinds are secular and strong. Visibility is as high as ever given the strength of the order book and end markets, and the full benefits from the automation platform are yet to be reaped. Also, this is a working capital-heavy industry: as growth slows, free cash flow conversion explodes. There is a realistic scenario that ADF could generate 30-50% of its market cap in cash over the next few years.

Bottom line, ADF is still trading <5x FY25 EV/EBITDA (c. $70m this year), for what I expect is >40% EBITDA growth this year and continued growth thereafter, as well as good cash flow generation. It’s not a micro-cap anymore and liquidity is strongly improving. What’s the right multiple? Other steel fabricators and Canadian industrials trade at 7-12x for (much) less growth. 7.5x on $70m is still ~70% upside – on arguably conservative estimates. Why can’t it trade at 10x?

What are some other interesting ideas on your radar now?

I’ll highlight two of them: DNO ASA (Oslo: DNO — Kr9.04 billion) and DGL Group (ASX: DGL — AUD$192 million).