“There is no great mystery in this matter,” he said, taking the cup of tea which I had poured out for him; “the facts appear to admit of only one explanation.”

“What! You have solved it already?”

“Well, that would be too much to say. I have discovered a suggestive fact, that is all. It is, however, very suggestive.”

- Sir Arthur Conan Doyle, The Sign of the Four

The greatest investment ideas often turn on a simple insight. Yet the simple insights are hard to find, which makes them rare and special. Useless information and noise often obscure them, like a carapace of barnacles stuck on the hull of a ship.

The origin of a good investment idea often begins when an investor has scraped away what doesn’t matter and has found what lies beneath. A simple “suggestive fact,” as Sherlock Holmes would say. The search for suggestive facts is worldwide and crosses many boundaries.

A hardscrabble camel dealer with 20 years in the business in the dusty outskirts of Cairo knows a few very good things about camels. He is easily able to separate what really matters from what is not so important. He is hard to fool with predictions and fancy talk. He knows what he is looking for and he knows what he will pay for it – or sell it for.

So too does the determined and hungry gold prospector working his pans on the steamy banks of the Amazon River deep in the jungles of Brazil. There is not much you can do to throw him off. He knows exactly what he is looking for. And he knows what it is worth.

All around the world, from the fishing waters of Vietnam to the mountains of South Africa, you find gritty indomitable spirits hunting for very specific things, for suggestive facts that may lead to their next payday.

One of my favorite “suggestive facts” is when you find a big difference between what private buyers are paying for whole companies versus what people are paying in the public markets for shares of these same companies. I’ve found many such disparities – and they’ve often become recommendations for readers of my Capital & Crisis newsletter and my newer service, Mayer’s Special Situations.

For example, take a look at Pioneer Companies, Inc. (PONR: NASDAQ).

Pioneer emerged from bankruptcy in 2002, a victim of the last downcycle. New management, especially CEO Mike McGovern, took over in autumn 2002. So began a process of cost cutting and selling off non-core assets. Also, the company dramatically paid back debt such that it is essentially debt-free as I write, with no net debt. It’s a new company today. I probably don’t need to say this, but it’s pretty hard to go bankrupt again when you have no debt and lots of cash. That’s the situation Pioneer is in today.

Pioneer is the sixth largest producer of chlor-alkali products in the U.S., with 5% of the North American market (which makes up about a quarter of the global total). It has productive capacity of 725,000 electrochemical units (ECU).

In Pioneer’s capacity of 725,000 ECU is where you find the disconnect between the public markets and the private markets.

It runs about $1,000 to create one ECU of capacity. In other words, if you were going to build Pioneer’s chlor-alkali production from scratch, it would cost you about $725 million. The whole enterprise value of Pioneer right now – that’s market cap plus debt less cash – is about $340 million. So that’s a 47% discount to replacement value.

Think of it this way: If you wanted 725,000 ECU of chlor-alkali capacity – that’s about 1.5 million tons – you could build your own factories from scratch for $725 million. Plus, you know it would take time to get the whole thing running. You would need to find workers and managers and all that.

Or you could go buy Pioneer. Now, you wouldn’t be able to buy Pioneer for $340 million. But you could pay $500 million for Pioneer. That’s a 47% gain for Pioneer shareholders. That would make them happy. And you’ve saved yourself another $225 million in the process. Not to mention that you don’t have to wait – Pioneer can start producing for you right away.

That, faithful reader, is the most compelling reason to buy some shares of Pioneer.

Even if the industry tanks, you’ve still got a lot of productive capacity that someone will want for when the market gets good again. Players like Dow Chemcical are well financed. It can write the check tomorrow without batting an eye.

So you’ve got definite downside protection to help you stomach the stock market volatility. You own a real asset here. And unless chlor-alkali products somehow go out of style, you’ve got capacity, which is worth something.

The second reason to own Pioneer is that it is so cheap, both on an absolute basis and compared with peers. Granted, Pioneer is cyclical – so is the whole industry. Therefore, there does not seem to be a lot of justification for a 40% discount from peers based on cash flow and earnings. But that is what we have. Pioneer sells for less than three times trailing EBITDA. So it seems the bearishness on Pioneer is overdone.

Some discount may be warranted because Pioneer is small and there are advantages of scale. But Pioneer has decent advantages of its own.

Its Becancour facility in Quebec is a low-cost producer because of the abundance of hydropower. Pioneer’s St. Gabriel plant, in Louisiana, has three pipelines to transport chlorine to the area efficiently. Chlorine is tricky to ship. And finally, its Nevada plant, located in Henderson, is the only chlor-alkali plant in the Southwestern U.S. Now I may be going out on a limb, but I think water treatment is bound to be a hot topic in the arid Southwest.

As an aside, more than 75% of the North American production for chlor-alkali comes from the Gulf Coast region. So if another hurricane rumbles up that way, expect chlor-alkali prices to shoot up.

Finally, about a third of sales are directly tied to water treatment. These sales get the benefit of the whole water emerging crisis I’ve talked about many times in other places. In the world of specialty chemicals, most companies have some exposure to water, but it is hard to say that the broad trends in the water industry are important. Many companies have rather low exposure.

Pioneer is a company generating gobs of cash flow. For 2007, it could generate $4 per share in free cash flow. That’s a 13% cash flow yield based on a $30 stock price. This cash flow could be used to pay a dividend or buy back stock – either of which would boost the stock price. It’s also a target for the bigger fish. And if the consensus is wrong and the current chlor-alkali cycle has legs yet, this company is going to earn a lot more cash. That could also help create value in the stock.

These are the kinds of suggestive facts (as Holmes would say) I spend countless hours searching for. These little nuggets form a compelling portrait of a potentially great investment. Finding such disconnects have led to many successful investments for my readers, and myself, over my investing career.

Sincerely,
Chris Mayer
February 1, 2007

P.S.: Recently, we’ve made 50% in a water pipe company in six months, 55% in a water utility in six months and we’ve doubled our money on a shipping stock I recommended in June.

Successful Small-Cap Investment Strategies was originally featured in the Penny Sleuth.