By Scott Ronalds

The Steadyhand Equity Fund consists of no more than 25 stocks. This is one of the manager’s (CGOV Asset Management) disciplines that we love. It ensures that we’re only getting their best ideas. Nalco is one of these ideas.

The Nalco story is a little different than most of the fund’s other holdings. As we emphasize in our reporting, CGOV favours companies with strong cash flows, proven management teams, clear competitive advantages and little debt. Nalco scores top marks in all of these, except the last one.

First a little background. Nalco (NYSE: NLC) is an Illinois-based water treatment giant. The company also owns a majority stake in a leading emissions control business (Nalco Mobotec). Nalco’s applications are used by mining, paper and petroleum companies, as well as hospitals, schools, and hotels, among others. Its products and services help prevent contamination, increase efficiency, and reduce pollutants. The company is also active in developing new environmentally-friendly technologies that improve efficiencies while reducing pollutants.

There is a lot to like about the company, as illustrated by CGOV’s investment thesis:

  • Water is becoming an increasingly scarce resource and Nalco is twice the size of its nearest competitor in the water treatment and water related services market.
  • The company operates on a service based model where 80% of revenue is recurring, providing better than average predictability in the business.
  • There are high switching costs, resulting in a very loyal customer base.
  • The company generates a lot of cash.
  • With 70,000 customers and a diverse client base, they can offer new services easier than a new entrant.
  • The business model is “green” yet also sustainable, as opposed to many solar and wind companies that depend on subsidies and do not have the same competitive advantage as Nalco enjoys.

Yet, Nalco has had a mixed record of delivering strong and consistent earnings and has been saddled with debt – a notable strike against the stock that kept CGOV on the sidelines until recently. In 2008, a new CEO took the reins (J. Erik Frywald) and implemented an aggressive strategy that focused on reducing costs, increasing productivity and trimming debt. His efforts have paid off. Over the past year, cash flows have improved, costs have been reduced, expensive debt has either been paid off or restructured (the balance sheet has been de-levered) and more energy has been focused on higher-growth areas such as advanced technologies and projects in the emerging markets.

Nalco has long been an attractive business, but its improving balance sheet finally made it an attractive investment idea to CGOV. Given there is still more risk associated with the company relative to some of the manager’s holdings with rock solid balance sheets (e.g., Rogers Communications, Cisco Systems, TD Bank), CGOV accumulated the stock in tranches. They initiated a small position last July and purchased additional shares in November and last month, as they became more comfortable with the new management team’s ability to execute.

Investments like Nalco come with higher return expectations. Yet, they also come with greater risk. To compensate for this, the manager typically maintains a smaller position size (e.g., 3%) and purchases the stock at what they believe to be a much greater discount to its true value.

Given the fund’s low turnover (11% in 2009) and the manager’s high level of conviction in their investments, a new holding often generates some discussion and buzz around the proverbial water cooler here at Steadyhand. In Nalco’s case, this seemed particularly fitting.