Sometimes Value Outweighs Sustainable Growth

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When the goal is to compound wealth for decades, there is a significant difference between dividend growth and sustainable dividend growth. While the difference is obvious enough, they are two distinctly different investments and should be treated as such. Although we believe that sustainable dividend growth is ultimately what builds wealth over time, that doesn't mean that other investment ideas should be ignored altogether. When a stock gets cheap enough, even if its dividend is questionable, sometimes you have to jump on it.

In this episode, Greg builds on the premise of Episode 18 and examines Oaktree Specialty Lending Corporation ($OCSL), a business development company with a 10%+ yield. At the risk of contradicting himself and the case he made against high yield, he argues that there comes a time when value beats dividend sustainability. While the risks of high-yield investments remain, he uses OCSL to compare dividend growth vs. sustainable dividend growth. Later on, Greg provides updates on companies we have covered in past episodes, and where we view them post-Q4 earnings. If you are interested in the original episodes where we went in-depth into each story, they are linked below:

The Clorox Company ($CLX): Ep. 8 - Dirty vs. Clean Opportunities & Ep. 9 - Greater Volatility and More Uncertainty...

Emerson Electric ($EMR): Ep. 17 - The Dilemma With Slow Growth

3M Co ($MMM): Ep. 15 - You Don't Need A "Winner" to 10x Your Income

United Parcel Service ($UPS): Ep. 19 - Do Dividends Care About Recessions?

Notes & Resources:

DCM Investment Reports & Models

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Transcript

Greg Denewiler  0:07  

This is Greg Denewiler and you're listening to another episode of The Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks and make each year's check larger than the last.

Greg Denewiler  0:34  

Welcome to Episode 20 of The Dividend Mailbox. In this episode, we're going to talk about a BDC or Business Development Corp. and specifically, we're going to talk about Oaktree. This is unique because it is had dividend growth in the last several years, but it is unsustainable. We're really going to try to draw a hard line between what is sustainable dividend growth and what is not. Specifically, in Oaktree and BDCs in general, it's virtually impossible for this thing to sustain dividend growth. It can't continue indefinitely just because of what they are and how they operate as businesses. But there's a second piece to these which is one of the reasons why we're talking about it — they're great value plays if you buy them right. Not only can you make excellent money on these things, just from a capital gains standpoint, but then you can also pick up great dividend income at the same time. You just can't confuse them and think that these are good buy and hold forever because they're not. And we're going to get into at what point are these things really worth looking at and then why at this point, it's probably time to start looking at selling. And then finally, since fourth-quarter earnings calls are pretty much over, we'll recap some of the companies that we've gone over in previous episodes and just give you an update on where we see the situations, where they're at, and what we continue to look at and what's important to us. 

So now, let's get into Oaktree. And if you listen to episode 18, we really were extremely negative on buying high-yielding investments for dividend growth. And our definition of high yield, if you don't remember or haven't listened to it yet, was really anything over 5% to a degree but especially when you start getting up to 7% and above. It's just you really have to be careful and you have to understand that you're now in a different world than when you're just buying long-term dividend growth stories. Oaktree has a very attractive dividend, it is over 10%. So it's got a great income, and then on top of that for the last several years, it's had a growing dividend. You may be asking, “Okay, why are you talking about this thing then? This just contradicts everything you just said.” The difference is these are stories where you buy them cheap. You can get great value there. It doesn't happen that often but the opportunities come up. But then there's a time when you got to start thinking about exiting because these things are not long-term sustainable dividend growth stories. These are not companies that are growing earnings over time, but if you buy them right, you can make a lot of money. 

So for those of you that aren't familiar with a BDC, there are several companies out there. In this space, there's definitely the ones that are fairly well managed, they're good at allocating capital, and the ones that aren't. Some of the better ones are —well we think Oaktree is one of the better ones, the symbol on it is OCSL. Then there's Hercules capital, Ares capital, Golub capital. Those are some of the bigger names that have some track record and have had pretty good success at managing their portfolios. What a BDC does is it loans money out to what they call mid-market companies, that’s what most of them do. Wall Street looks at a middle market company sort of as one that's too small for a JP Morgan or Merrill Lynch, Bank of America. They don't really want to do $100 million deal because it's not that big for them and they don't make that much money off of it. But it's kind of too big for a bank to because they don't want that kind of risk out there without something as collateral. These are ongoing businesses and they're in all different kinds of industries. Most of the time, you don't just have a hard asset, such as a piece of property or an apartment building that you can borrow against. So these BDCs basically specialize and fill the gap and loan money to these companies. And most of the time, they're variable-rate loans. So what happens here is Oakree has a fund and it's got $2.6 billion in it, that's the total investment. Part of it is leveraged — actually, about half of it or a little bit more. So they take the 2.6 billion and they loan it out. You look at the debt structure of Oaktree, they borrow money and turn around a loan it out. Well, they get a spread. They are investment grade rated, it's triple B or above, so they pay a lot less for their credit and then they loan it out to companies that pay them more so they earn the difference. We focused on Oaktree partly because they took over the management of this fund in 2016. Before that, it was really poorly managed. They were losing asset value over time, and Oaktree had a great opportunity to come in and take over the management of the portfolio. Basically, they bought the right to manage it. They sort of specialize in distressed debt and high-yield situations. They're a huge fund management company and this is just one of the things in their portfolio. They've got a great track record of managing high yield and distressed debt.

 And so, as I mentioned $2.6 billion portfolio. loaning the money out — total of 156 different companies in the portfolio. Loans are $20m, $50m, $100m $500,000,000. 72% of the loans are first lien, meaning if the company defaults, they are one of the first in line to get paid, so that's a positive. The top 10 investments are 19% of the fund. The next 15 are 20% and then the remaining roughly 130 of the companies represent about half the portfolio so it's relatively diversified. 16% of the portfolio is software, IT services is 6%, and then it goes down to financial services, pharmaceuticals, biotech healthcare, and specialty retail is 3.8%. That helps spread the risk out, and if you look at one of these companies, you really should know as far as what the concentration of risk is where it is. Is it industry specific? And then another thing is leverage. The average yield in the portfolio right now is 11.6%. They have average new commitments of about $250 million. And right now, the average yield of new loans that they're making to these companies is 13%. The weighted average interest rate on Oaktree’s debt is about 5.5% while I just told you the rate that they're loaning money out currently is 13%. So they make a lot of money just on what they borrow. So that gives you just a quick idea of what they actually do. 

Back to dividend growth, which is the core of what we do. For those OCSL, going back to 2016, the dividend was only 18 cents. Now it's up to 55 cents a quarter, so the dividend has grown by 20% a year and now it yields almost 11%. So you definitely have dividend growth there, and part of it's because of management reinvesting capital, and part of its just because interest rates have trended higher. In addition to that, since they pay out all their income, you received a special dividend last quarter, so the yield, in effect, is even higher. 

Now, here's the really important thing to remember, and this is what makes these things at times really great value plays — most BDCs trade as closed-end funds. The difference between a closed-end fund and a mutual fund is they issue a certain number of shares and it's fixed. They don't issue shares as more investors buy and don't sell shares as investors liquidate, so they can go to discounts or premiums. And you know, really the reason for that is because in a distressed situation, like in 2020, if they had to sell shares, then that means that they would have had to start selling part of their portfolios. And when you're in an environment where there's real distress and there's real panic, you can really almost wipe out an entire portfolio. As these things just start to spiral down, more selling creates more selling. So, if it's a closed-end fund, they just don't have that risk of having to go in and sell part of their portfolio because investors are selling. If the market is down and investors are getting worried and they're starting to worry about you know, “are these companies going to be able to pay off debt?” Then what happens is these things will go to discounts and they can go to significant discounts, up to 50% or more. You get a portfolio for half the cost of what it's actually worth. So, in 2018 we first started buying Oaktree and it was when the market was getting hit fairly hard. Oaktree was trading at around 75% of its asset value. So, it was trading at a somewhat significant discount. And the great thing about it is that the assets are marked to market so every quarter, so you know what they're worth. The only thing that can change at that point is if one of the companies defaults or the market goes up or down, the asset value is going to change but you know what it is at least once a quarter. If you buy a 55-cent dividend, and you only have to pay 75% for it, that means your yield is starting to look fairly attractive. But in 2020, we bought it at two different prices. Right now, it's trading at around $20 a share, we bought some at $11.85 and we bought some at $8.70. The discount in March of 2020 got down to 35 cents on the dollar. Well, right now, the net asset value of Oaktree is $19.63 a share and at $20, that means it's at a slight premium, a couple percent. So, you can start to understand that if you can buy these things at steep discounts, you can make a lot of money in them, and as I've illustrated just in the last few years for us, it's been a really great buy. 

But this is a part of where I want to really get into why this thing is now a red flag for us where we get into the difference of dividend growth versus sustainable dividend growth — and we're thinking about selling half of it or depending on what it does here over the near term, maybe all of it. 85% of Oaktree’s portfolio is variable, so every time the Fed raises the interest rate, the interest rate cost of these companies goes higher and now they're up to between 11 and 13%. If you're getting that kind of a yield, you're taking risk, and the risk is becoming much higher than what the potential reward is. At this point, personally, I think there's very little dividend growth that's left in it. If you remember the podcast a few months ago, we went through what you have to look at is what that implied yield represents. Triple C-rated bonds yield about 13.5%. Single B-rated bonds are yielding around 8.5%. So that basically implies that the new loans they are making, even though they're first lien loans (most all of them are), you've got relatively low credit ratings. The credit rating is basically their ability to pay back and the likelihood of default. When you're down in triple C, over a 10-year period, the likelihood of default is over 20%. So the likelihood of default over time is relatively high, and it's basically when we get the next recession, that is when it really starts to happen. Well, the problem is timing the market is extremely lucrative, but virtually nobody can do it. What you have to do is, basically, you have to decide that the upside in this thing just really isn't there anymore, and I'm not going to let this dividend yields seduce me into holding. So looking at when I bought it, $8.70, in 2020 it was paying $1.14 in a dividend for the year. That's a 13% yield on your money, and over the next three years, the dividend has more than doubled. But what happened was interest rates were much lower in 2008, 2009, 2010. And in 2020, the 10-year Treasury got below 1%. You had these variable rate loans which were much lower than they are now. There you have dividend growth because as the short-term interest rates started to go up over time, and especially in the last year, what happens is the income to this portfolio is going up. Short-term interest rates go up, the cost of money goes up, which is why their rates are now up to 13%. Here's the deal: basically the dividend on this thing has probably capped because companies — it's going to be hard for them to be profitable when they're paying 13% for debt in this kind of an environment. Especially if the economy slows down at all, defaults are going to spike and then at that point, you're going to have fewer people paying into the portfolio. And that's where we get into the difference of dividend growth versus sustainable dividend growth because what you want is a continued dividend payment. In fact, if you listen to the recent conference call just a few days ago, you actually hear management stating that a 13% yield is really not sustainable for a company long term. They recognize that they have to be careful in here at the rate of what some of these loans are being made. So, it's really in no one's interest for this dividend to go up any more than it is. They're not going to be able to raise dividends from this point on. Well you're going to see these things recommended by a lot of people because 10% is a very attractive yield. But just to kind of carry this out, if we go into a recession, and things really start to tighten up, two things happen. And the other thing we haven't mentioned is credit spreads. The simple definition of a credit spread is a Treasury, right now, yields about 3.7%. Well, I've already mentioned Triple C bonds right now yield about 13.5%. So that means the spread between those two is roughly 10%. That's what we refer to as the credit spread. Well, when the economy starts to get stressed those widen and they can widen dramatically, especially in the higher-risk debt area. And just to give you a clue of how bad it can really get, back in 2008, 2009, CCC bonds went to a yield of over 40% for a brief period of time. If that happens, the price of the bond goes down dramatically, and that leads to part of the reason why the value of the shares can get hit. And then the second thing is, not only do you have that happening, but you have investors that are just panicking to get out and they're selling the shares. They can really drop dramatically. You don't want to own a BDC when this happens, the situations can really play out fast because market declines tend to be much faster than market gains over time, and you don't want to be in them to ride him down because losing 50% of your capital in market value is a lot of dividend income. And it's just not Oaktree. A couple of the other ones out there— Hercules Capital, right now, it trades at a 40% premium to its net asset value. But in March of 2020, Hercules Capital got down to a discount of 66% to its asset value and Ares capital got as low as about 47% of its asset value. Golub Capital got down to around 58%. So the point of this is, in this case, a great dividend and you can get dividend growth, but you have to look at the picture the environment that you're in. Obviously, you can compound really fast with these things. Just to give you a feel of how well these things can go, the position that I took in 2018, five years later, I've gotten half my money out in dividends and the stock has gone from $13 to $20. In March in 2020 when we had pure panic, I have already gotten— in just three years, I've gotten half the money out in dividends plus the stock has basically doubled from what I paid for it. So it's been a very attractive investment. But this is not sustainable dividend growth. It was a great value play that paid a dividend. For these things, you really need to use discipline and you need to leave the party early, because when the market gets any hint of a problem, these things start to decline in value. So, in full disclosure, possibly by the time you actually hear this, we may have sold half the position, in Oaktree because we just don't want that much exposure in this at the moment. I think, you know, even if I'm two years early selling it, we saw great value there and we realized it and now we don't think there's that much left and so it's time to exit it. It's got a lot of risk built into it. Long-term, dividend growth is really where your ultimate wealth comes, from. Plus it's your margin of safety. These things don't have any real margin of safety anymore because they can't raise dividends, and they can't charge more for their loans. Sustainable dividend growth is a long-term play and it's a great way to create wealth. It's tied to earnings growth. It's tied to the economy and it's tied to higher-quality companies. And a BDC is not that situation, it's really that simple because there are different kinds of companies. They're not an investment that you can buy and 10 years later, you’re pretty much assured that the dividend is going to be up by 100% or more. BDCs just don't have that sustainable earnings growth. But there are cases where you can buy a great income stream, but you're valuing that income stream and you're looking at the risk of it. And you're treating that separately from just “oh, this is a company that's going to continue to create value.” You have to treat these investments separately from those of sustainable dividend growers. They have to take a different place in the portfolio. You can make some excellent money when you buy these things right. It's definitely worth keeping an eye on and just, you know, looking for opportunities and it's pretty easy to determine. The opportunities come in a recession or when credit spreads get really wide, and when those times come, These things are a great thing to add to a portfolio to really enhance yield. But you don't want to treat these things as a core part of the portfolio that you hang on to for years for sustainable dividend growth. So, we've talked about Oaktree extensively, and I want to stress that this is not the normal core part of our strategy. But I would like to at this point, switch gears to sustainable dividend growth. 

So we've covered several different companies in previous episodes, and our goal is to stay accountable and to track these stories over time, so that A: you get a better feel of how we execute the strategy and B: maybe pick up some ideas of what will work for you. We've talked about Clorox, we've talked about Emerson, 3M and some of the problems there. And then also UPS one of our recent stories. And since most of these companies have— virtually all of them have reported fourth-quarter earnings, now is a great time to review some of the stories and what's going on, what's working, and what is still a challenge. If you're curious about any of the individual stories, there will be a link in the show notes to where you can go back and listen to each one if you so choose. 

So Clorox was a story that in 2020, they were one of the businesses that had a huge positive impact from the whole pandemic, but the problem was business ramped up so fast margins got a little out of control, cost of goods, they had to bring in contract manufacturing, and profit margins really declined somewhat significantly. But this has been a steady growth story over decades. And it's really been a company that has been around for close to 100 years. So where we're at on it is, we think it's going to be a simple reversion to the mean, that they have the experience of managing margins. They've done it for decades, and they'll get it back on track, but it's just going to take a little bit of time. The update here is that we needed profit margins to improve and the gross margin profit in the latest quarter ending in December is showing a positive trend up now. After hitting a low of about 33% back in December of 21, the good news is now we're up to a little over 36% so it is starting to move higher. We're expecting that to lead to the higher income which directly feeds over into continuing to grow the dividend. But debt is flat, which is good. I'm a little disappointed in inventory. I thought they were going to get more cash out of reducing their inventory levels but they're only down about 5%, but they did come down a little bit. So with those higher trending margins, earnings are starting to pick up. The 2023 estimate is $4.21, for 2024 estimates are $5.35, and for 2025 estimates are $6.24. Now estimates are estimates, but Clorox is a little bit more of a dependable business and the more important thing is for Clorox — I hate to say this but it comes down to almost as simple as raising prices when they're able without losing market share. That's really the battle that they're facing right now. But to a degree, that's what everybody else is doing too. That's why I think we've got a pretty good probability that within the next few years, they're going to get back to that norm, where they've been for decades. Right now the dividend is $4.72, so they're roughly earning it not quite, but they've got free cash flow, and they have some cash on the balance sheet. So if they earn $6,24 in 2025, we're back to a payout ratio that's getting back to its long-term average. And at that point, we need 5-6% earnings growth, which is basically the economy, and we're right back on track. And just another side note, you know when you have a dividend yield that's up a little bit over 3%, depending on which day you look at it, between 3-3.25%, you're at the higher end to the kind of what I call the “sweet spot.” That 3% dividend yield buys a little bit of time to wait for the dividend to get back on track as far as seeing growth again. When we first did this story, I will admit I was hoping that the margins would improve a little faster, but they're trending in that direction. You know everything is still there for it to work. We think the long-term dividend growth there is going to be 6% but this year and maybe even next year, I totally expect that you're probably only going to see a penny and sometimes these things only raise the dividend by half a penny and it's just keep their track record. But the more sustainable dividend growth is coming out in the future if we get margins back, and if it does, it's one of those positions that you could potentially own for several decades.

So now we turn to Emerson. It's another one of those businesses that’s been around for a long time. They've been a great story over time, but lately, it's gotten a little bit more— or a lot more complicated depending on how you want to look at it. Here you had a great dividend growth story until about seven or eight years ago, and they sort of hit the wall. They started restructuring, they've been through a few restructurings since then. Dividends have only been growing by about— well some years only a half a cent a year. There was a point where you could say Emerson, if they were just tracking annual cash flow, they possibly should have cut the dividend but they're not going to do that when they have a 63— I believe it's a 63 year track record of raising the dividend every year. And they aren’t going to give that up unless they think they're really hurting the company. And in this case, they have the resources to manage through it as long as it eventually turns and that's what they're trying to do now. But the last time we really talked about it, this is one of the ones that, I'm going to call it, we're cautiously optimistic because they are really transforming the business to more of an asset light model where they're getting more into data management, going more into a high tech environment, instead of their old manufacturing model. Their hope is to get more growth out of the company longer term. Yeah, they are showing some good margin growth. In fact, pre tax income is actually down a little bit from where it was in the last few years. The update on Emerson is they continue to transition. But here's a red flag that we definitely want to keep an eye on and see how they handle this. Goodwill and intangibles make up over half the total assets of Emerson. Now, goodwill and intangible assets come from if — you buy a hotdog stand for $100 but the actual cart only costs $50, so you pay a premium, that goes on your balance sheet as goodwill. Now the theory is the person who had it before has built up a revenue stream, has built up a market, and now they're selling it to you and they want to get paid for that. That's goodwill. This has been researched to the nth degree. The problem is, basically companies that pay a big premium, more times than not end up writing off a lot of that goodwill down the road because they end up just paying too much and it dilutes shareholders. Companies always have great plans when they're out making acquisitions. It's always pretty much the same story. They're going to save costs when they integrated, where they're going to take their customers and integrate them with current customers of Emerson, and they're going to be able to cross-sell and generate more revenue from that. It may work we'll see. But this is just a red flag. When you've got $20 billion of goodwill and you've got a total of 36 billion in total assets. It puts pressure on their ability to earn a good return on their assets. And since goodwill is such a big number, it just translates into— they paid a lot for those assets. And with that, in trying to restructure or more kind of change directions, they've acquired a lot of companies and they've increased debt. Got long-term debt, it's now 8 billion. You go back four years, long-term debt was 4 billion. That’s part of what they're using to acquire these new companies. On the good side, they've got 2 billion in cash, so they do have some liquidity. But one thing that really kind of spooks me is they're trying to acquire another company and it's a fairly big one. It's around $7 billion. They're really going after some high growth. It's great if it works, but companies just historically tend to overpay and that can really hurt returns on capital down the road. So they don't have a whole lot of margin of safety. If this doesn't work out so good, you can only restructure so many times and then you're going to take a serious hit. You know, like I said, margins have really improved, but the balance sheet is stretched so cash flow really isn't there yet to support long-term sustainable dividend growth. You know, we're only looking for probably penny-growth in the next few years as this thing kind of shakes out. Just recently they raised the dividend by half a cent. We're just going to have to let several more quarters go by to see whether they're going to be able to execute. So what we need to see is, 2024 the earnings estimates are $4.50 a share. Historically what the payout has been, at $4.60, if they hit that in 2024, then we're pretty much back on track for 6% dividend growth. But if they struggle to get there and depending on what that looks like, this is one that we may consider exiting out of. 

Now to 3M. The 3M story is a little complicated also. The big thing here is lawsuits— where the military had earplugs that some of the military personnel are claiming that they didn't work effectively and affecting their hearing. And then also, you throw in inflation, you've had issues with supply chain disruptions. So the stock is under that cloud, but you're getting paid 5% while we wait and see how this plays out. And there are all kinds of numbers out there on how bad it could be or how bad it may not be. And usually, these things are not the end of the world and you always have outlier numbers, but this is the risk that 3M faces now. This one was obvious, we were probably only going to get a penny raise and that's what happened, and that's probably will be for at least another year. But again, you're getting paid 5% so it's so important that you get 6% dividend bumps here at this point. The company is doing the responsible thing, they're not raising the dividend by much but they're keeping their long-term track record in place and waiting to see how this lawsuit works out. You know, once there's clarity there, that's when we're going to see the dividend growth unless it is really a catastrophe. But that's why you want a portfolio and that's why you don't put too much into any one single of these things. This is a company that's been around for over a century and they've, in the past, had a track record of being a great product development company. They've got 1000s of products out there. Part of our assumption is A: lawsuit is not going to completely take them under and B: there's still a moat there of great potential technology and product development to come down the road. 

Now we get to look at a story that's working out well. UPS, we've covered it. They had a huge bump in the year or so ago, it was 50%. And they had been spending a lot on capex. They'd been really focusing on making their distribution center much more efficient. I hate to do this to you, but their investments have paid dividends. What we've seen recently is, no, you're not going to get 50% dividend bumps every year, but this one just continues to work and we're getting the growth that we need. They just bumped the dividend again from $1.50 to $1.62 and that's approximately 7%. And we continue to hold it and look for any dips to add to it. So not much more to say about UPS but it's always nice to see sustainable dividend growth play out the way you hope it does. 

These updates were mostly in regard to the companies that have some challenges right now, ut if you remember our model portfolio, which is a live portfolio, which has 13 companies in it right now, we've already had nine of them that are paying more than they did last year. They bumped the dividend either in the fourth quarter of last year or they bumped it at the beginning of this year. Well unless we get a cut and it's substantial, we're already guaranteed higher income this year. The key takeaway is it's a portfolio, you have to look at it that way. You have to understand what you own. You have to realize that some of them are going to be workouts while others are doing quite well. The overall portfolio is really still on track to get 6, 7, 8% growth and possibly a little higher. 

The point of this episode is to really look at, there's dividend growth and then there's sustainable dividend growth, and that they can both go in your portfolio but it's really these sustainable dividends that go up decade after decade. There's a lot of things you can do with your portfolio to enhance the income and grow long term. And we looked at an investment that is not a core component of what we do, but I will use the example of Warren Buffett he does things outside his his long term compounding that he really built his track record on, and there's always things that you can do to create value. When an investment comes up, like Oaktree you take advantage of it. Then you also have to really pay attention to the point where when the value is realized, you need to have an exit strategy. That's what can potentially get you into trouble. So, it does take a lot of discipline, just like it takes discipline to own something and let it compound. But we don't want to lose sight of the fact that we are about long term creation of wealth and you do that through compounding cash flow. And with that, we do want to remind you again that if you have a dividend related question, we'd be happy to try to answer it for you. If you send us an email and we use it in one of our future podcasts, we will send you a Dividend Mailbox Yeti tumbler so feel free to reach out. I hope you all enjoyed this episode and look forward to next month.

If you enjoyed today's podcast, please leave us a review and subscribe. If you would like more information regarding dividend growth or our investment strategy, please visit growmydollar.com. There you will find previous episodes and also our monthly newsletter. If you have any questions or anything to add to today's episode, please email Ethan— ethan@growmydollar.com. Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risks involved. Stocks, including dividend stocks, are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.