By Scott Ronalds

Nalco, the world’s leading water treatment company, recently entered into a merger agreement with Ecolab (a provider of cleaning, food safety and infection prevention products and services). CGOV, the manager of our Equity Fund, sold the stock following the announcement. They originally purchased shares in Nalco in the summer of 2009 and by the time they sold the stock late last month, it had gained over 85%.

We initially reported on Nalco in March, 2010. We highlighted the stock because it was an example of an opportunistic investment. The company scored top marks in three areas that CGOV pays close attention to – cash flow, competitive advantage, and management. Nalco also carried a large amount of debt, however, which was a notable strike against the company.

This follow-up posting is a summary of how the investment played out.

A new CEO, Erik Frywald, took the reins as chief executive of Nalco in 2008. His mission was to increase the company’s revenue growth from existing levels of 3-4% per year to a target of 6-8%. He also set new productivity targets and aimed to reduce the company’s debt.

After gaining a level of comfort with the new CEO and watching his words turn into actions through better financial results and an improving balance sheet, CGOV purchased the stock at a price they felt was significantly below its true value.

Nalco was positioned in the right markets (energy, mining & mineral processing, chemicals & fertilizers, etc.) and Frywald and his team were able to increase revenues by raising prices on their products and winning new business. The company’s balance sheet also improved as a result of refinancing high-cost debt at more attractive terms, and cost cutting. The stock appreciated significantly and CGOV’s investment thesis proved correct.

Following news of the proposed merger, the stock gained nearly 30%. CGOV sold it at roughly $36. At a buyout price of $38.90, the stock still had upside potential of 8%, but if the merger falls through, they believe there is downside potential of 30%, so they felt the sale was the wise course of action (the merger is expected to close in the fourth quarter). If the stock continues to fall in a jittery market, the manager would consider buying it again.

Nalco is a story of buying into a business with a wart or two on it at the right price. While the bulk of the holdings in the Equity Fund have stronger balance sheets and more consistent earnings growth than Nalco did at the time of purchase, there are a few other companies in the Equity Fund that represent similar opportunistic plays, meaning they have attractive attributes and operate in a desirable industry, but have a strike against them which can range from debt issues to problems with a segment of their business to overly-negative sentiment (e.g., Kinross Gold, Manulife Financial). The end result won’t always be as profitable, nor come as fast as it did for Nalco, but when it does the water tastes that much sweeter.