Last week, Hardinge (HDNG), maker of precision machinery, received a cash offer for its shares that was a 45% premium to its closing price on the previous day. Predicting when such offers are going to occur is a difficult task indeed; but to make money, the investor needn't be clairvoyant: Hardinge has been on our Stock Ideas page for the last four months because of the discount it traded to its assets.

Hardinge's poor stock performance was a result of the company's poor operational performance over the last business cycle, as previously discussed. But the market's reaction was clearly overboard. As a result, investors were basically offered a stock with strong upside potential and minimal downside risk.

The offer came from a private company in Brazil that operates in a similar line of business. This company is looking to buy Hardinge in its entirety for an absolute steal: the bidder has offered to buy the company for about $90 million, which is not much more than Hardinge's net current assets! The company's fixed assets (which are substantial in this line of business, with a book value of $180 million!), access to the company's markets, customer relationships and engineering know-how would all be thrown in for free!

As can be imagined, Hardinge management is not co-operating with the buyer and will likely come out with a release stating that the offer grossly underestimates the company's value. Recognizing that this would occur, the bidder is likely ready to make a higher offer to appease shareholders and/or receive management's blessing. As a result, the stock price actually currently exceeds the current offer!

But while the bidder and Hardinge management battle it out to determine a fair price for the company, it should be noted that those who invested before the bidder showed up are the real winners. Catalysts are not always visible, and when they are, most of the price appreciation will have already occurred. Investors who simply focus on buying companies that trade at large discounts to their values put themselves in positions to generate outstanding returns.

Disclosure: Author has a long position in shares of HDNG

Warren Buffett has called himself "85% Graham and 15% Fisher". While the works of Graham are often cited, Fisher's book "Common Stocks and Uncommon Profits" is not. Here follows a summary of the expanded version of this book, which includes 2 other works by Fisher including "Conservative Investors Sleep Well" and "Developing an Investment Philosophy".

Having covered the essential elements of a conservative investment, along with a discussion of the people required to achieve those elements, Fisher now discusses a third dimension of a conservative investment: is the company in an industry with economics that are favourable to its firms? If the company cannot do anything that others cannot quickly and easily copy, the company will see its profits erode.

High profit margins attract competition. To protect itself from competition, a company must operate so much more efficiently than others that there are no incentives for current or potential competition to upset the situation. Some industries lend themselves to making this a possibility far more than do others.

One characteristic that can help a business stay number one is an economy of scale. In some lines of business, producing more units can lower the average cost per unit, whereas in others higher production rates can make little difference in average cost. Since larger companies are more difficult to manage efficiently, the advantage of scale will only exist if the larger company is exceedingly well-run.

In certain industries, companies can also have advantages if they are first to the market. Once this is done, it becomes very difficult for a competitor to displace the innovator. The first to market can thus end up with a disproportionately large share even when competitors exist. Fisher uses the pharmaceutical industry as an example of where this advantage can exist.

There are other more unusual ways for companies in certain industries to sustain advantages. For example, a company may have products that are difficult/uneconomical for the customer to switch from, resulting in a consistent stream of re-orders. Fisher discusses the criteria required for this to occur with an example in the electronics industry.

Warren Buffett has called himself "85% Graham and 15% Fisher". While the works of Graham are often cited, Fisher's book "Common Stocks and Uncommon Profits" is not. Here follows a summary of the expanded version of this book, which includes 2 other works by Fisher including "Conservative Investors Sleep Well" and "Developing an Investment Philosophy".

In this chapter, Fisher discusses how the four important criteria described in Chapter 1 come to be within an organization. Basically, it has to do with the people within the company. While it is somewhat easier to come up with the characteristics of an individual one would want running a small business (a determined, entrepreneurial personality with drive, innovative ideas and skill), it is a somewhat more complex matter to gauge the criteria required for large businesses.

The corporate chief must not only be able, but he must have surrounded himself with able people. One way for the investor to determine if this is taking place is by looking at the salaries of the chief executive versus the rest of the executives. High disparity suggests one person is running the show. Furthermore, the team must not be engaged in a struggle for power, but rather must be working together to achieve corporate goals.

Management must also be constantly grooming juniors who can grow into larger roles as the company expands. While hiring from outside may be necessary at times as a company moves into new product lines or requires new functions, Fisher believes that successful firms that are able to hire from within have a tremendous advantage. Fisher basically claims that a large company that must bring in a new chief executive from the outside is a sign that something is wrong with existing management.

Working as a team is not enough, however. Collectively, management must guide their actions by the following three key elements for a business to be successful:

1) The world is changing at an increasing rate

2) Employees must feel that their company is a good place to work

3) Management must be willing to sacrifice today for sound long-term growth

Fisher uses examples at Dow Chemical, Texas Instruments, and Motorola to illustrate how they have managed to be successful on the items listed above.

Last week, Canada's largest national newspaper ran an article with the headline "ScotiaFunds Is Tops". Presumably, one might expect this to mean that mutual funds commissioned by Scotia outperformed other funds when it comes to returns. Perhaps the article would then go on to compare the returns ScotiaFunds generated against those of the market, to see whether and by how much this group of funds generated in value for investors after fees. Unfortunately, these types of metrics are not at all what the mutual fund industry is focused on, and the content of this article illustrated that perfectly.

Instead of "Tops" (in the article's headline) referring to the fact that Scotia generated the best return, it referred to the fact that ScotiaFunds had the highest net sales! In fact, the article did not even mention the returns of the group of funds, either the absolute returns, the returns compared to peers, or returns relative to the market itself. What is mentioned in the article, however, is by how much assets under management grew for Scotia, and at what level assets under management currently stands.

Investors who pay attention recognize that the incentive structure of the mutual fund industry is not conducive to generating returns for investors: managers are paid based on sales, not investment returns. As a result, mutual funds are effectively marketing companies rather than investment funds.

Certainly, excellent returns do help market a fund, but there is enough wiggle room for managements in this area to throw off the majority of investors. For example, funds with below-average returns can simply be shut down, leaving the company's remaining funds looking terrific on a historical basis. This creates a survivorship bias in the results, and practically guarantees that future results will not be as good as those of the past appear to be.

Furthermore, fund returns are only a small component of the overall marketability of a fund. Paying high commissions to agents can result in fund sales, as many investors don't take the time to do the research themselves, preferring to take the advice of an "expert" or relationship manager. This advisor just gets a piece of the action, like a credit card processing service such as North American BanCard or Paypal. Unfortunately, that "expert" is getting paid to push certain products, and investors who don't recognize this are probably not putting enough thought into their investment decisions.

When buyers purchase homes or cars, they do put in some time and effort to understand what they are buying. For whatever reason, many appear less inclined to do so when it comes to investing their savings. Those who are willing to do some research are at a distinct advantage as a result. These investors are able to buy undervalued stocks, closed-end mutual funds trading at large discounts, and ETFs with their significantly lower management fees.

Yesterday, Parlux reported a net loss of over $5 million. The company has recently faced a slew of negative information that has pushed the stock price down significantly. Since Parlux (PARL), producer and marketer of celebrity fragrances, was first brought up on this site, it has fallen almost 20% while the broader market has risen. But for investors who purchased this company for the reasons outlined some six months ago, the current price offers even more reason to buy.

The company appears to have made some bad calls leading into the quarter that just ended. With consumer spending on the decline, the company had locked itself into some expensive marketing campaigns that didn't pay off in the current economic environment. The resignation of the company's CEO last month further wore on the company's shares, as the company's future strategy became uncertain.

However, the reason this company is attractive as a buy remains unrelated to its short-term earnings outlook or even its corporate strategy, which are the two major reasons for the stock's poor performance of late. Instead, what investors are buying is a company with assets that far exceed the company's current asking price. While the stock trades for just $35 million, the company has cash, receivables and current inventories totaling $87 million against total liabilities of just $17 million. As a Ben Graham net-net, the company offers upside potential at this price that is far superior to its downside risk.

Of course, there are risks that the company will not be able to profitably collect on all of these accounts. Inventories have been written down in the past, and some of the receivables are from a related entity that is losing money. (Fortunately, this entity is a public company, so its ability to pay can be judged by the investor.) But there is a sufficient margin of safety present to protect the investor from such issues. Furthermore, despite the company's troubles of late, it has actually managed to increase its cash position as it has liquidated inventory and reduced its receivables. With a new CEO promising to be more cautious when it comes to spending, the company may be able to turn in better results that push the stock price back to a more reasonable level.

Decent returns on capital and substantial earnings growth are not necessarily in the cards for this company. But nor are they required for the investor to see strong returns. The company is being sold at such a large discount to its assets that even mediocre results in the coming quarters should result in decent cash flow and a share price that better balances downside risk with upside potential.

Disclosure: Author has a long position in shares of PARL

Avatar Holdings (AVTR) owns and develops land for a variety of uses, including single-family homes. As most of its operations are in Florida and Arizona, its business conditions, as well as its stock price, have taken a beating in the last couple of years. While it might represent value at its current price, in a way similar to which Melcor (MRD) traded at a large discount to its value not too long ago, management's intentions make the situation a little bit unclear.

The company has lost almost $10 million per quarter in 2009, as it struggles to sell its units for more than their carrying value. While this is by no means a pretty situation, consider the depressed level of the stock relative to the company's assets:

Stock Market Value: $200

Cash on hand: $219

Land/Inventory: $287

Total Liabilities: $156

In other words, the company could lose $20 million per quarter (double its current rate) for five more quarters, and still sell at a 15%+ discount to just its cash and land assets (i.e. excluding its other assets including A/R and prepaid expenses).

Despite the company's strong balance sheet, however, management is making some interesting decisions. While they have curbed new construction in favour of converting inventory into cash, they recently issued $40 million worth of shares! Selling shares when the company trades at only half of its book value is quite dilutive, and seems hardly necessary when the company has far more cash than it has debt - until one considers the company's plans for the future: the company appears to be clearing the way to make a $150 million investment in a new highway!

Is this highway a profitable venture in which management sees a bright future? It would not appear so, as the company has twice written down this project's $47 million initial outlay. So the profits aren't there, but is the company obligated by contract to complete this project? Yes and no. There is a contract with the government, but it appears it would only cost the company $1.9 million to break it.

While management has not made it clear that it will go ahead with the project, the share issuance described above, along with the fact that it recently re-negotiated its contract with its existing lenders that would allow the company to borrow an additional $140 million, suggests this is management's preferred course of action. Unfortunately, from the outside looking in, it would appear that management is chasing a sunk cost (its $47 million initial outlay) rather than adding value for current shareholders by cancelling the contract and buying back shares to close the gap between the company's price and its value.

Interested in another perspective on AVTR, or another stock you have your eye on? One of our sponsors, INO.com, offers our readers a free analysis of a stock of their choosing here.

Disclosure: None

Revenue certainty is a good thing. We've discussed a few examples where stocks appear undervalued and where investors can rest easy because companies have backlogs or have signed contracts that provide some assurances. Such revenue certainty allows companies visibility into the future, which translates into an ability to set their costs such that a profit will be made. But investors must take care to ascertain whether the agreements will indeed be honoured.

Consider Global Ship Lease (GSL), a lessor of container ships. The company leased away its fleet of ships in 2007 and 2008 over long-term periods, locking in future revenue rates. As a result, despite the fact that the shipping industry has been hit hard and shipping rates have fallen industry-wide, GSL continues to turn in profits. This should continue, as no leases are set to expire until December of 2012, and even then only 2 of the company's 16 ships will need new contracts. The following chart illustrates how long the company's ships have been leased out for at guaranteed rates:

Despite this, the company trades for $110 million while it brings in operating income of almost $15 million per quarter. So what gives...is this a screaming buy? Unfortunately, GSL's entire fleet is leased to a single customer, it's former parent company. The customer is a private company, so very little data is available, apart from the fact that the company experienced "substantial losses" in 2009. This is not surprising, as the shipping industry has been particularly decimated by the recession, as overcapacity has put downward pressure on prices. As a result, shipping companies are having trouble making ends meet, and so many of GSL's contracts may cause extreme hardship for their customer.

Adding to the risk of GSL's situation is the fact that it has over $600 million in debt, and has two more ships due to be delivered this year, which will require further financing. This doesn't leave a lot of room for error; if GSL needs to renegotiate its leases so that its customer can survive, it could have serious difficulties meeting its obligations.

A contract guarantee is only as good as the guarantor's ability to meet that guarantee. Considering that information regarding GSL's customer is limited, and that GSL has significant obligations to meet, an investment in this company appears to be rather speculative, with considerable downside risk.

Disclosure: None