SMLR - Semler Scientific Is The Roadkill Your Portfolio Is Asking For

2023-07-28 09:31:00 ET

Summary

• Michael Burry is a renowned American investor and hedge fund manager. He gained fame for his successful bets against the U.S. housing market before the 2008 financial crisis.
• He is known for his contrarian investment approach and his investment strategy often focuses on "roadkill" companies, or those trading at heavily discounted prices due to being out of favor.
• His strategy focuses on small companies, downside protection, low EV/EBITDA ratios, and resilient industries.
• I believe Semler Scientific is one such company that may be a great fit for his strategy.

I enjoy reading Michael Burry on Twitter (Or should I call this X now?). Of late, I haven't seen that many tweets from him, but I always enjoy the perspective he provides. His record on predicting crashes aside (While he has been profitable from his prescience on the market, it can also be said the ratio of crashes he predicted to the number of actual crashes is quite high) there is definitely value in his investment strategy. He has been quoted that his strategy is "roadkill"; companies that have been out of favor and are trading at heavily discounted prices. Recently, I came across one such company, Semler Scientific ( SMLR ) that I thought might fit the bill.

Below, we will consider this investment by walking through multiple factors. Here's what I think, the stock is badly beaten down and this provides us a great opportunity to make an entry. The small size of the company suggests it is mostly undiscovered. I think the healthy balance sheet provides the safety I'm looking for when making investments in small companies. The low valuation provides us an opportunity to enter if the market has overreacted presently and the multiples start expanding again. Additionally, buying into a healthcare business means resiliency in an uncertain economy.

Company Overview

Semler Scientific is a medical technology company that specializes in developing and marketing products for non-invasive diagnostic testing. The company's flagship product is a vascular testing device used to diagnose peripheral artery disease (PAD) and other circulatory conditions.

Here is how the business operates and makes money:

QuantaFlo System Sales: Semler Scientific generates revenue primarily through the sale of its QuantaFlo System and related accessories to healthcare providers, hospitals, and clinics worldwide. It is a preventive system that is designed to efficiently and non-invasively detect PAD, enabling early diagnosis and better patient care.

Subscription-based Model: In addition to device sales, Semler Scientific also offers a subscription-based model, where customers pay a recurring fee to access data analysis and reporting services. These services help healthcare professionals interpret test results and track patient outcomes more effectively.

Trading Close to 52-Week Lows

Recent events surrounding this stock have been covered well here on Seeking Alpha. In short, there were announcements earlier in the year regarding changes to the medical code that may cause a material impact on revenues. This dropped the price of the stock. The stock is currently trading at over 80% down from its all-time highs.

It must be noted that Michael Burry is mostly a fundamental investor, and this is probably one of the only technical analyses he uses before entering a position.

Small Companies

Small companies are preferred and if the companies are trading in the micro-cap range then it could be an ideal target due to a few reasons. It could mean that the big institutions are not in yet, and the best returns could be ahead of it once the bigger players enter. In that regard, Semler Scientific has a market cap of around $160M and is not liquid. There aren't many shares traded, so it's difficult to build and exit a position without affecting the stock price. But some of the best alphas are generated in the most overlooked areas of the market.

Downside Protection

This is of paramount importance to any investing philosophy as one year of bad performance can reverse a lifetime of gains. For example, a 50% decline in a stock requires a 100% gain to break even. An investor going from $1M to $10M in ten years has a CAGR of 17.46%. A drawdown of 75% in Year 11 means the CAGR drops to 8.6%! All from just one year. Protecting your downside becomes even more important, especially when going after stocks in the microcap space. While every investor has their own style to build downside protection (stop loss, tail risk hedging, etc.), going only after companies with sound balance sheets coupled with stock trading at low valuations can also provide sufficient downside protection. When we look at Semler Scientific this is quite true.

• SMLR's short-term assets exceed its short and long-term liabilities
• The company is debt free and has remained so for the last 5 years

Enterprise Value, Cash Flows, and Valuation

A lot of importance is given to enterprise value, cashflows, and how well it connects with valuation, and we see that the company passes this test as well.

Cash from Operations has been consistent and steadily rising. The latest quarter did see a drop in CFO, but it wasn't too concerning. For the LTM, CFO stood at $16.8M. Due to hardly any debt in comparison with the Market cap, the EV stood at close to $120M.

Burry likes to screen companies based on their Enterprise Value to EBITDA. EV/EBITDA is at 6.2x, significantly down from double digits from a year ago. Even within the healthcare sector, it is quite far from its sector median of 15.2x. For a full perspective on valuation, I have the screenshot here from the SA valuation page.

Forward valuations are lower and present valuations are significantly lower when compared to the last five years. I think these extremely low valuations for the stock align well with the expectations laid out at the beginning of the "roadkill" thesis, i.e., buying a beaten-down stock with a sound balance sheet at discounted valuations. I think this becomes important when you realize that a stock being down 80% doesn't have to mean it's cheap.

ROE, Earnings, and Buying Recession-Proof Businesses

If ROE is above 20%, it can be construed as high. Although an extremely high ROE can be interpreted as a risk in some cases (this means equity is really small and hence this metric cannot be relied upon), it is a good sign to see the equity also improved in the last year, which puts our current ROE at 29%.

Also, looking at the trend of earnings for the last five years, the company has not only been consistent with its earnings but has also seen a big improvement over the time period.

The other fact that can be learned about some of Burry's recent statements and holdings is that he thinks that the economy could be headed for a downturn and hence wants to own businesses that are relatively safe.

Semler Scientific is in the healthcare industry, which is generally seen to be defensive and recession safe. The resilience comes from the fact that matter related to health cannot be delayed, is necessary (not a discretionary expense), and is covered by insurance. Additionally, the company touts its products as cost-saving and geared toward preventive care, which may make it favorable among patients and doctors alike.

Risks and Final Commentary

Although this could be a good candidate in terms of Michael Burry's "roadkill" strategy, it has to be understood that this is a microcap stock and hence by its very nature very risky. Microcap stocks trade at low volumes and price movements can be swift. But being specific to this company -

• Its top 2 customers account for almost 70% of the revenues and as such makes it overexposed in terms of customer concentration risk
• Markets only one FDA-cleared product (QuantaFlow) and any threat to its success means jeopardizing its biggest source of revenue (We already saw the impact of this threat earlier this year)

Risk management is of paramount importance when dealing with microcap stocks such as Semler Scientific, and this is also exacerbated by the developments we saw earlier in the year. I would view this as a speculative investment perfect for the barbell strategy.

In evaluating speculative plays, I mainly check the investment for its upside (highly asymmetric for microcap companies), and then make it part of my barbell portfolio. For this portfolio, you would have extremely safe investments on one end and extremely risky ones on the other end. The safe investments would carry no risk, even in the face of extreme market drawdowns (Ex: U.S. Treasury bonds). The aggressive side of the barbell while it has the full risk of losing your entire investment, it also has a high upside. The aggressive side also has its risk distributed between "N" such entities (where "N" is the number of investments an investor is comfortable with).

My thought for any potential investor in this stock would be to follow the same approach.

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