Trinseo: This Is Why Maybe You Should Catch A ‘Falling Knife’ (NYSE:TSE)

Background: Falling knives and investment thesis

Trinseo PLC (NYSE:TSE) has had a rough time on the stock market recently, but it fits the criteria for inclusion in a portfolio of small caps that could outperform the S&P 500 going forward. Here’s why.

In 2004, The Brandes Institute published a paper called “Falling Knives Around the World“. Having researched “falling knives” from 1980 through the end of 2003, the analysis found that while falling knives posted a relatively high bankruptcy rate over a three-year holding period following their initial drop, falling knives also outperformed the S&P 500 by wide margins.

The Brandes Institute which conducted the research was founded by billionaire value investor Charles Brandes whose investment firm at one point showed a ~20% average annual return over a 20-year period.

The performance observed seems counter-intuitive: Stocks that drop as much as those researched do so for a reason. Often, some major adversity struck the company: A pharmaceutical company failing to obtain FDA approval for a drug or a company consistently missing on estimates, eroding investor confidence, and companies not reaching whatever growth rate the investment community thought it would. The examples are numerous. With capital preservation being the most important investment feature, it’s easy to shy away from issues like those researched.

But the results presented in the study were convincing: US falling knives gained an annualized 11.2% over the three years following its initial fall, while the corresponding gain for the S&P 500 averaged only 4.6%.

Mind you that this study included the dot-com crash of 2000 and “Black Monday” of 1987 which helps explain why the S&P returned less through the duration of the study than it has been in more recent times.

The study also found that investing in US small caps (leaving out large caps) that met the criteria would boost the annual returns and the level of outperformance against the S&P 500. Choosing only those knives that had the lowest EV/S ratios would further strengthen the outperformance significantly.

In fact, those US knives that were in the bottom quarter percentile of the study in terms of EV/S showed an annualized outperformance – not just return, but outperformance over the returns of the S&P 500 – of an entire 11.6%.

The most remarkable result from the study was that not only did falling knives outperform over a 3-year holding period – they also outperformed over 1- and 2-year holding periods, suggesting a quite predictable behavior from such issues even over fairly short holding periods.

The basic criteria screened for were:

1. A drop in share price of at least 60% over the past 12 months.
2. A minimum market cap post the drop of $100 million.

Now there’s a practical issue with applying these criteria: During the course of the study, almost 2,000 stocks over a 23 year period would meet the criteria. It’s a lot to buy that many shares over such a long time.

So to limit the universe and optimize for stock picking, it was suggested that the basic results of the study could be boosted by the following limits:

1. Only buy small caps (a market cap less than $1 billion). This boosted annual outperformance over the S&P 500 by 0.8 percentage points.
2. Only buy those knives that had the lowest EV/S ratios. The bottom quartile measured had an average EV/S ratio of 0.8.

If by the beginning of December 2023, you had screened the US stock market for these criteria (all 4), the screener would have returned the stocks listed in the table below.

As you can see, the returns for that month have been extraordinary even against a strong benchmark (S&P 500). The portfolio was up 17.06% for the month with the S&P 500 up 3.81%. Numbers are excluding dividends.

I made this simulation for December 2023 with the screener having returned 29 stocks with EV/R ratios ranging from ~0.1 to ~0.9 (I used EV/R instead of EV/S for simplicity):

Click to enlarge

So far in January, the same stocks are down against the S&P 500, suggesting perhaps that a shorter holding time than the 3 years (as in the study) is worth considering – while you could also consider the opposite and hold such a portfolio through the ups and downs for the researched 3-year period or any period in between.

Of course, in any event, numbers from a single month don’t necessarily say much but could lay the foundation for further research.

As shown, Trinseo was part of the simulated portfolio for December 2023 – and remains a stock that fits the criteria to this day.

For that reason – and as I will explain in further detail below – I’m issuing a Buy rating for Trinseo, but at the same time stress the importance of diversification when dealing with these issues. Remember: Any one falling knife could drop to the floor. It’s the averages of a group that matter.

Trinseo is a falling knife – but fits the criteria found to generally outperform by wide margins

Over the past 12 months, Trinseo is down ~75%. That means it easily fits the first criteria of the Brandes study – a 1-year drop of at least 60%:

The second criterion is a minimum market cap of $100 million. Trinseo currently trades at a market cap of ~$230 million.

The third criterion is for the company to rank among those with the lowest EV/R ratios (enterprise value to revenue) of all falling knives returned in the screen. For the simulation, I chose the 29 stocks with the lowest EV/R ratios (those available at the time with an EV/R of less than 1). These stocks had EV/R ratios of anywhere between ~0.1 and ~0.9.

The enterprise value to revenue expresses what a buyer for control would need to pay to buy all equity and bonds at the market – thereby obtaining a full claim on the corporate assets cleared of creditor and equity claims.

This ratio often works better with distressed equities because they tend to not show earnings or free cash flow during their distress. So you have to go with something else that describes what you pay in relation to what you get.

Trinseo currently trades at an EV/R ratio of 0.6. This puts it well within the lowest quartile available on the US market.

This is what caused Trinseo’s poor price performance

Technically, you could follow the methodology presented in this analysis regardless of what issue the company is dealing with or what they are doing about it.

If you’re anything like me though, you would like to at least know what you’re getting your hard-earned money into. The trick is to not let the qualitative factors interfere with the “statistical buy signal” presented by the numbers I just walked through.

The idea of analyzing what caused the trouble and what management is doing is just to understand what causes these types of distressed situations, and to understand why others might have been scared away. In other words, how did it come to a point where the market may be ignoring a great opportunity?

In the case of Trinseo, several factors appear to have contributed to the drop in its share price, including, but not limited to:

• An instance of missing consensus estimates for Q1. Trinseo missed quite substantially on revenue and non-GAAP EPS.
• An instance of cutting its dividend (by more than 90%).
• Jefferies downgraded Trinseo from “Buy” to “Hold” and slashed its price target. This alone resulted in a 20%+ loss to Trinseo’s share price. In downgrading the issue, Jefferies pointed to headwinds likely continuing for several quarters. Jefferies now sees demand recovery for Trinseo’s products not happen until 2025. Jefferies further said that the demand uncertainty and high-for-longer interest rates could see the sale of Trinseo’s styrene business disappoint.

With these events unfolding, it’s not surprising that Trinseo has taken a beating by the market. It looks much like the story of most other falling knives.

At the same time, this is what creates fertile ground for mean reversion, especially if management is taking appropriate action.

What management has done to address the issues

As previously noted, you don’t necessarily have to pay attention to corporate actions if you’re buying an issue like Trinseo in a group for its statistical advantages.

But you could look at Trinseo as an individual issue or assess management actions to support your understanding of the company.

As laid out in Trinseo’s most recent earnings presentation, much of what management is focused on is restructuring efforts which can be summarized as follows:

• Efforts to restructure assets (including closing plants)
• Cost restructuring (including reduction of headcount)

The company summarized its past announcements in relation to asset restructuring in the following way:

In terms of cost reduction efforts, the company also summarized efforts:

A third “leg” of Trinseo’s efforts is the product mix of its offerings. Trinseo has invested heavily in specialty offerings such as rigid compounds, resins, sheets, and battery applications. These specialty items tend to produce higher variable margins versus commodities:

Whether management’s efforts are sufficient remains to be seen – but certainly it appears to be taking a while to work out.

Risks

Each individual falling knife situation may not work out. In fact, several of the falling knives simulated for December 2023 did not work out. Others went through the roof. The same is true for those researched over a 3-year holding period by Brandes.

In order to obtain an average result of what falling knives can do for your money, you have to diversify.

In my simulation for December 2023, I measured the results of a portfolio of 28 such issues. More or less could have probably also done it.

In the research done by Brandes, an entire ~2,000 US stocks were “held” over a 20+ year timeframe.

Based on this, I suggest managing the risk that any distressed equity such as Trinseo involves by holding it in a well-diversified portfolio.

Key takeaways

Falling knives are risky investments: They could keep falling and never reverse. That’s a recipe for substantial capital loss.

The no. 1 rule of investing is to never lose money – to preserve capital. That’s why investing in falling knives requires diversification.

In 2004, a study by The Brandes Institute proved that holding a group of such issues could over time outperform the market.

Trinseo is an issue that currently fits the criteria described in that study. It trades at a low EV/R ratio of 0.6. It’s a small-cap company but has a market cap over the threshold of $100 million. And it’s down more than 60% in the past 12 months, indicating that perhaps the market has overreacted and mean reversion – on a statistical level – might be imminent.

Such an issue should be held in a well-diversified portfolio, though: Any one of these distressing situations may not work out.