When You Can't Trust Market Cap

Editor's note: The markets and our offices are closed on Monday, May 27, for Memorial Day. Because of this, we won't be publishing Altimetry Daily Authority. Please look for your next edition on Tuesday, May 28.

Quite frankly, turbocharger maker Garrett Motion (GTX) looked scary...

Garrett Motion was a business segment of multinational conglomerate Honeywell (HON) until a spinoff in late 2018. And from the start, it was basically set up for failure...

Honeywell tacked on billions of dollars' worth of asbestos-related liabilities that Garrett Motion was supposed to pay (even though it had nothing to do with the liabilities).

Garrett Motion promptly filed for bankruptcy. It emerged with more than $1.6 billion in debt.

That was enough for a lot of investors to lose interest. By November 2021, the company's market cap was only about $470 million... far less than its debt.

Most folks wouldn't have touched Garrett Motion with a 10-foot pole. And that's because most folks were only scratching the surface of the business.

While the majority of Wall Street was heading for the exits, we were "all in." As you'll see, there was a hidden opportunity in this tiny, hated stock... and market cap alone didn't show it.

As part of its bankruptcy restructuring, Garrett Motion offered its creditors 248 million shares of preferred stock...

Preferred stock is a sort of "hybrid" security that acts like a cross between bonds and equities. It pays a steady stream of income like a bond. And on a set date in the future, it can be converted to shares of common stock.

In Garrett Motion's case, its preferred shares could be converted to common stock starting in April 2023.

Even though these shares were a debt issue, they didn't show up as debt on the balance sheet... because they're technically stock.

And because they weren't common stock, most investors wouldn't have seen them in Garrett Motion's market cap, either.

Put simply, this preferred stock didn't show up anywhere... unless you knew to look for it.

The preferred stock should have completely changed how investors valued Garrett Motion...

Instead, it was mostly just scaring them off.

If you only looked at market cap, you were missing the bigger picture. Garrett Motion had less than 70 million shares outstanding in 2021.

When the preferred stock converted in April 2023 (what we called the "dilution event"), that number would jump to 313 million overnight.

So even though Garrett Motion's market cap was a mere $470 million or so... it would be $2.3 billion in a few years. At that point, it would be big enough for institutional investors to buy in.

And to know this was coming, you had to dig through hundreds of pages of complex filings.

To properly value Garrett Motion, you had to treat the dilution event like a given. We assumed the company's market cap included all of its preferred equity. This approach gave us a much clearer picture...

Plenty of investors were likely scared Garrett Motion was too small... or that it had too much debt. They weren't accounting for all those preferred shares.

When you factored in the dilution event, this was a decent-sized business. And it was still pretty cheap, too. That's why we urged our Microcap Confidential subscribers to buy shares back in November 2021.

Garrett Motion's dilution event took place in mid-June last year...

The preferred stock would only convert once the common stock traded above $7.78, starting in May 2023. So we expected the stock might hover around that level until then.

Garrett Motion had a solid business. Turbochargers are an important part of automobile fuel efficiency. They're a great stopgap measure while the world transitions to electric vehicles. So we were happy to hold on for a few years.

Once that "secret" dilution event was over... investors would finally get the picture. They'd realize the company's actual market cap was higher than its debt obligations. It was a lot safer than many folks realized.

Plus, in the world of Wall Street, $2 billion is considered a "sweet spot" for market cap. At those levels, more institutional investors can start buying in. Garrett Motion was a prime candidate for an additional boost after conversion.

That's exactly what happened... It didn't take long for investors to come around once the shares converted. Our position is now up from around 10% to a healthy 28% gain in less than a year.

As an investor, you can't afford to take the numbers at face value...

Even something as simple as market cap can be misleading. And that makes it a lot harder to make sound investing decisions... unless you cover all your bases first.

That goes double for small companies like Garrett Motion. A seemingly small debt issue more than quadrupled its market cap. It sits around $2 billion today.

It's easy to brush off less-common nuances like preferred stock – or miss them altogether.

And those exact situations could completely change how you value the business... and give you an edge over the inexperienced masses.

Wishing you love, joy, and peace,

Joel
May 24, 2024