Thursday, July 31, 2008
These chapters cover the topic of dividends. The authors are critical of the way corporations handle dividend payments, as managers use criteria in determining the dividend rate which are not aligned with shareholder benefits. Investors appear to recognize this, as two identical companies except for their dividend rates will show a higher valuation for the company with the larger dividend. Unfortunately, investors do not hold managers up to a better standard of dividend policy.
Specifically, one reason corporations withhold dividends is to ensure its stability. If earnings gyrate, dividend payments would also gyrate, which is not in the interest of the stock owner. To an extent, the authors agree with this argument, however, they cite numerous examples where this line of reasoning is abused, where average earnings far outsize the stable but artificially low dividend.
Another reason corporations keep dividends low is to re-invest and thus grow the business. In some cases, this may be of advantage to shareholders. However, in the majority of cases, the increment in profit derived from the re-investment of profits does not justify the investment. This is a clear case of interest misalignment: managers benefit in wages and reputation as the size of the business increases, but in many cases shareholders would be better off had they received the dividend. In many examples, companies ended up going bankrupt (after hard times had hit) having not paid out dividends as they should have, as they had instead re-invested in capital equipment which is now worthless.
The authors finish the topic on dividends by discussing the benefits and drawbacks of various forms of stock dividends, where investors receive stock instead of cash.
When looking at P/B ratios as value indicators, it's important to follow up the analysis by actually looking at the quality of the assets on the balance sheet. It's also prudent to understand the earnings power of the company to determine if future heavy operating losses are going to deteriorate the balance sheet significantly. For TAT Technologies, I analyzed the company assets and took a very conservative view by considering their liquidation asset value to establish a value floor for the stock.
The results are in the table 1 below but I will annotate a few comments here. First, cash and marketable securities are taken at par since they are extremely liquid (what is more liquid than cash?). Even though accounts receivable already has an allowance built in for doubtful accounts, I took 70% of that value to be more accurate of what could occur in a liquidation event. There was around 158 days inventory on the books and it was largely made up of work in progress, spare parts and raw material. I discounted inventory (which is already at lower of cost or market) to 60% of its carrying value.
Land is often on the books at a discount to current values (since land generally appreciates) so my further discount to 80% of book value is definitely not taking a rosy view of things. I completely wrote off the goodwill and intangibles from the balance sheet, since if you assume that a liquidation event will occur, there is a good chance most of this value is going to vanish faster than a free cup of coffee at MBA school!
Table 1: Net liquidation value of assets and writedown factors
I took at par value all the balance sheet liabilities, minority interest and added in the "off balance" sheet operating lease. I used a present value formula to approximate the operating lease liability. The written down value of assets minus the liabilities yields a liquidation value of ~ $48 million dollars for the shareholders. Considering the dilution effect of stock options and the current shares outstanding, the final liquidation value (assuming no transactional fees) is around $6.87 per share.
The last closing price for TAT Technologies was $5.57 on the Nasdaq and this represents a 19% discount to the estimated liquidation value of the assets! If TAT Technologies is going to continue operating as a going concern, the value of their assets is very likely going to exceed this liquidation value calculation and makes the stock price look even cheaper!
Wednesday, July 30, 2008
He points out that paying a difference between .5% or 1% of asset fees and assuming a 5-6% real long term rate of return for stocks will make a 10% difference to the net worth of the investments over 10 to 20 years. Therefore, he counsels that even a .25% difference in annual investment expense is significant and investors need to minimize these costs.
Jarislowsky advises mutual fund investors to seek out low cost funds but also to invest in funds where the decisions are based on sound long term policies and good research. Don't sell just because a good fund had a bad year, as even the best funds experience that. Be careful if analysts and fund managers get large short term performance bonuses because it might cause them to take actions which will not be long term rewarding for investors.
Today, we see a combination of the two above situations! Buried in a footnote on page 24 of its quarterly financial statements, Monaco Coach (NYSE: MNC), a leader in the RV market, makes reference to obligations as part of an operating lease on an airplane. Since it's an operating lease, it's not included on the balance sheet, so you'd never know about it unless you read the notes.
A careful reading of the notes to the financial statements of last year's annual report reveals the company owes $1.3 million annually for this aircraft for the next four years. But the real kicker happens in Year 5. If the counter-party can't sell the aircraft for a certain price, Monaco is on the hook for up to $11 million. Considering both fuel prices as well as current economic conditions, it wouldn't be a surprise if aircraft are selling for a lot less than Monaco thought they would be when they originally signed this deal. If it turns out that Monaco does have to make this payment, the cash amount represents Monaco's combined earnings before tax of about the last 10 quarters!
If this plane is a required cost of doing business, then an investor can't really complain too much. But for an RV manufacturer which is already in an industry characterized by high fixed costs, it seems rather strange that an in-house airplane is required. Therefore on the surface this expense appears to be a remnant from when good times were rolling and management spending was over-the-top, and this obligation is something investors should be aware of.
Tuesday, July 29, 2008
In these chapters is discussed the theory of common stock investment. The authors state that for the typical public company, it is very difficult to tell whether a stock is currently over- or under-priced. However, there are nevertheless many individual cases whereby this answer is clear (to be discussed specifically in later chapters).
A divergence of public behaviour when it comes to stock analysis is discussed. Before the roaring 1920s, stocks were valued in a similar manner to investments in private enterprises: an investor would consider the asset values, the earnings history, and a determination of the company's weaknesses in being able to continue its business going forward.
At a certain point during the 20s, however, investment turned into speculation. Asset values and earnings power were seen to have no relationship, and past earnings were used only as a measuring stick against future earnings (and this "trend" used to extrapolate dangerously into the future).
Furthermore, stocks of a certain breed, termed "blue chips", were viewed as good investments regardless of price. As "investors" paid no attention to price, stocks continued to rise, and as they rose, arguments were laid forth that stock purchases were the fastest path to prosperity, since the historical record served as proof.
The authors make it clear that price is an integral part of any stock investment. Furthermore, they will go so far as to say diversification is also an integral part of investment. Purchasing just one or two securities, even on sound principles, is speculative because the buyer cannot be sure of the results, whereas with diversification along with sound principles, there is reasonable assurance of returns.
Monday, July 28, 2008
Jarislowsky feels that large shareholders and institutions with significant ownership in companies should not be afraid to rock the boat and appoint board members that will keep management in check. He feels this makes sense since board directors are legally obligated to represent the shareholders and its prudent to install a competent director mindful of their responsibilities to shareholders.
A board needs to treat all shareholders in the same fair manner. It needs to look after shareholders interests by ensuring that the executive team is operating well and ethically in order to produce the best possible long term results. A entire board appointed by the management team might not uphold their shareholder duties if the going gets rough. He feels that a lot of the "rot" (as he says) in corporations is a direct consequence of large shareholders not exerting enough influence with management when it is needed. Jarislowsky feels that a lot of common good for all shareholders would come from large shareholders being more influential with management.
To help improve corporate governance in Canadian companies, Jarislowsky and Claude Lamoureux formed the Canadian Coalition for Good Governance. This organization includes many leading Canadian institutional investors managing more than $600 billion in assets. Jarislowsky knows that these institutional investors have enough collective clout to positively influence governance practices within corporations. The main goal of this coalition is to align the interests of boards and management with those of the shareholders.
Some of Jarislowsky's recommendations include that the CEO be a different person than the chairman of the board. He feels that board members should not be preoccupied with share prices as that is the role of the market. Boards need to ensure that all shareholders are treated fairly and that implies that information regarding significant events needs to be communicated to all shareholders. Jarislowsky doesn't like boards that are too large as there is no real time for meaningful participation.
Jarislowsky also feels that securities regulators need to promote shareholder protection by helping to bring about more appropriate laws. He feels that the laws in existence today almost completely fail to protect the Canadian shareholders. Specifically he cites that "majority owners can buy out the minority without paying a fair price". He also recommends that dual-class shares should have a clause that allows multiple voting power shares to convert into common stock during a takeover. In addition, he feels that securities violation penalties need to be much tougher in Canada. He makes it clear that he is still in favor of investing in individual stocks but that small investors need to be aware of the issues facing them.
He feels that the OSC (Ontario Securities Commission) is far too inactive. However Jarislowsky does give them credit for responding to his critical attack on the unfairness of the attempted Canadian Tire Corporation takeover. In that deal, there was a massive difference between the offer price for the multiple-vote common shares and what was offered for the subordinate class A shares. The OSC allowed Jarislowsky and his associates to elect a board director (Jarislowsky's friend) and this was the catalyst for dramatically improved corporate governance at Canadian Tire. He has other examples of teaming up with major shareholders to fight the inequities during takeover events involving shares owned by the prominent Thompson family and the Desmarais family.
As we can see, Equus is used to trading at a discount to its NAV, but recent negativity across the US market has taken it to even newer lows relative to what it owns.
One of Equus' key holdings (in fact, it makes up almost one third of its portfolio) is an equity position in Infinia Corporation. For those who aren't hardcore alternative energy aficionados, Infinia is a company aspiring to mass produce a low-cost solar power converter. The fair value of one of Equus' investments in Infinia (based on follow-up venture capital investments) recently jumped from $3 million to over $20 million, as the company demonstrated a protype late last year which converts solar energy into electricity at twice the efficiency and at a lower cost than existing products.
One way to look at a purchase of Equus' stock at this discount level is that for the price one share at $6.90, you're getting all of its other assets (which are worth about $8.30/sh) for a slight discount, and on top of that getting the investment in Infinia (valued at $3.50/sh) for free! Of course, before jumping in blindly you'll want to make sure you read Equus' latest reports along with its financial statements and their notes, as we've discussed here.
In reading these reports, I found that Equus does carry some debt on its balance sheet, which is somewhat rare for a fund. This has the effect of amplifying any changes in the values of their investments, both to the upside and the downside (the effect of leverage). Furthermore, most of the investments are in companies that aren't public, and therefore Equus is not as liquid as those funds that invest only in the stock market (undoubtedly, this liquidity premium contributes to the larger than average historical discount we see in the chart above). The lack of market quotations also makes it more difficult for management to value each of it's holdings.
Infinia is one such example, as it doesn't trade on the stock market and so it's not available for an individual investor to buy. Although the drawback is that Equus' investments are illiquid, it provides an investor the opportunity to get into a company like Infinia when it's otherwise limited to venture capital firms only. The discount is a bonus that makes this an intriguing play from a value investing point of view.
Disclosure: The author has no ownership in Equus
Sunday, July 27, 2008
In this chapter, the authors discuss investing in senior securities of questionable safety, for the purpose of achieving gains in principal. Of course, such securities must be trading at discounts to their par values, and even under great recoveries, they can not go much higher than par. As such, they have an upper bound that stocks do not have. Graham and Dodd argue that such a ceiling is not a real drawback in practice, since gains achievable on stocks much higher than they are on bargain bonds lend themselves to over exuberance.
The authors argue that bonds trading at bargain prices can be looked at in relation to two different viewpoints: 1) fixed-income standards (as discussed in previous chapters) and 2) stock standards (to be discussed in the next few chapters). The common stock standard is the approach the authors believe to be more fruitful, as it offers a more thorough understanding of the corporate picture.
Therefore, the authors do not discuss separate standards just for investing in fixed-income for gains (since investors can apply the framework for stocks that will be discussed in the next section). Instead, they offer some important distinctions between stocks and senior issues from the point of view of an investor looking for principal appreciation.
Senior issues derive important advantages over stocks due to their contractual rights. The obligation of a company to pay interest, no matter how difficult, is one such advantage. The authors also demonstrate the importance of net quick asset coverage over the senior issue as a gauge of the safety of a senior issue.
Finally, investors are warned about the lack of safety in preferred stocks, and how the market treats them quite paradoxically. Often, preferreds of companies in trouble can have accumulated large dividends, and the market tends to overemphasize the value of these securities as a result. The authors put forth a principle that the market value of preferred shares (or any type of security for that matter) cannot be more than what the market value of common stock would be of this same company if there were no securities more senior than common.
What we really wanted to know was whether we ourselves could best the performance of the low P/E quartile stocks from our previous study by using primarily value investing techniques we learned from George Athanassakos at the Richard Ivey school of business (tweaked a bit). To answer this question, we did full valuations on Toronto stock exchange low P/E stocks on the randomly selected years 1998-2000, 2003 and 2006. We randomly selected these years using an excel rand() function for years between 1995-2006 . Our sample dataset had been pruned down using various constraints in order to keep the exercise manageable but yet relevant! Since the purpose in this post is to share our results, I will defer a full explanation of how we filtered down to the working set in another post.
Our approach involved doing a complete intrinsic business valuation for each of the 55 stocks in our dataset. Saj and I did our own independent valuations using the same framework and then would then discuss (mostly in a civil way), each valuation to ensure we had similar valuations. After completing all the valuations we would find the price data and compare to our entry prices. If our entry price on a stock exceeded the current stock price, we would record it as a buy, otherwise it was not a buy for us but remained in the low P/E quartile basket.
Assuming a holding period of only 1 year and accounting for dividend payments, our selective buys yielded an average compound return of 29.1%! The low P/E basket of stocks averaged results of 20.6% during the same period. We found these results very encouraging and are currently valuing securities in (primarily) North America for the purposes of establishing an investment fund this year.
Saturday, July 26, 2008
One of his recommendations is that the top executive pay should be a bit higher but fairly close to the other company executives' pay. If the top job pays ten times that of other executives, it is unfair and does not promote team work amongst the management team. Instead, he argues that it sets up an environment where the other executives are gunning for the top job. He believes that the top executive jobs are way overpaid and that most executives would perform just as well or better with even less pay. He observes that the high executive pay is not helping to reduce the frequency or size of writedowns experienced with companies in the markets. He feels that salaries for employees should allow a comfortable lifestyle, but that bonuses (not exceeding the annual salary), should pay for the perks.
Jarislowsky would prefer that stock options didn't exist at all. However, since they do, he recommends that stock options not exceed 5% of the common share float. Also, he wants to see stock options fairly shared amongst all the rainmakers in a company.
To get CEOs to effectively manage a company they need to be given incentives to think like long term shareholders. For this reason, he suggests requiring the CEO and other top executives to be heavily invested as long term shareholders in the companies they work. This will get them to work for the common good of the company.
Often, however, many of these funds trade at discounts to what they actually own. For example, here's a list of some of the largest discounted funds currently on North American exchanges (according to CEFA on July 28th):
There are many papers devoted to the topic of explaining the discounts (and premiums) that closed-end funds trade at. These discounts represent an opportunity to buy the assets under management for pennies on the dollar. Often these assets represent public companies that an investor can buy himself. Therefore, arbitrage opportunities, which we've discussed here, can emerge. However, in most cases the investor will not know the changes the fund has made to its portfolio until after the quarter is over, which can make his arbitrage attempts difficult if there's a lot of churn.
In other cases, the fund's assets are not invested in public companies. As such, the market values of the holdings are unknown, and so investors often punish the market value of the fund, creating a discount, since the fund's holdings are illiquid and of relatively unknown value.
Value investors may appreciate the fact that they can buy assets for a discount in the form of closed-end funds, but they should always do their homework (i.e. read the fund's quarterly reports) to ensure they understand what they are buying.
Friday, July 25, 2008
In the next several chapters, the authors discuss the purchase of senior issues not for fixed-income (which was covered in the last several chapters) but instead for capital gains. But first, Graham and Dodd demonstrate by example that hybrids between fixed-income and investments in senior securities for gains do exist. Because the market is inefficient, sometimes securities which do fall under all the fixed-income requirements discussed in previous chapters still sell for bargains.
In these four chapters, securities which have large upsides due to conversion privileges are discussed. These securities are the most attractive in form of any security, as they enjoy the seniority of bonds with the upside of stocks. However, their track records have been less than stellar. Graham and Dodd surmise that this is due to the fact that it is companies which are in trouble that need to enhance offerings in such manner in order to induce investment.
The authors argue that if a convertible security sells close to par, then it must meet either the criteria for fixed-income investment (as discussed in previous chapters), or for stock investment (to be discussed in later chapters). If the investor relaxes certain requirements because the issue is convertible, he will find himself in trouble. Whether the investor purchased the security from the point of view of a fixed-income investment or from the point of view of gains also determines when he should sell. For example, someone who bought a convertible under the criteria of fixed-income at $100 has no business holding onto the security to $150, as this has now become a speculative issue, and so his downside is no longer protected.
Finally, the authors examine various criteria of privileged securities which add or remove the relative attractiveness of a security: namely, the extent of the profit-sharing, the proximity the security is to achieving those profits, and the duration of the privilege (the longer the duration, the larger the chance that the conversion will yield a profit). Within this discussion, the relative merits of participating (debtholders receiving dividends along with stockholders) vs convertible (debtholders switch to stockholders) vs warrants (debtholders remain as such, but also receive stock) are also discussed.
Table1: % Price drop from the 52 week highs in the Aerospace and Defense sector:
My question is, how do we find value with individual stocks in this sector? In my opinion, a cheap stock equates to one that is trading at a price below its intrinsic value. One way to find those companies is to start looking for stocks that have been oversold, are currently out of favor with the market or are just generally being overlooked. Essentially, we want to look at stocks that are not behaving price efficient and as discussed here, its reasonable to start looking at small cap stocks. Table 2 shows what has happened to some of the small cap companies in the aerospace and defense sector.
Table 2: % Price drop from the 52 week highs for some small cap Aerospace and Defense stocks:
Looking over the sample of selected small cap stocks, we observe some extremely sharp price drops from the 52 week highs and this might be an indication of value. However, a relatively low price alone doesn't equate to value. The value comes from a low stock price relative its intrinsic value. One way to find potential value is to look at value indicators, such as price to earnings or price to book values. I have calculated the price to book values for our small cap aerospace and defense companies in the table 3.
Thursday, July 24, 2008
Jarislowsky feels that worldwide debt is so high that a major increase in the money supply is inevitable. Increasing the money supply would have the effect of higher inflation and increased inflation would lessen the burden of debt (contrary to deflation). He is not optimistic about standards of living being maintained into the future which are largely fueled today from debt or from redeemed capital holdings.
Excessive taxation is a problem in many countries. Since taxation reduces the savings rate, there is less money remaining for savers to reinvest into the economy. Since investments precedes jobs, increased taxation lowers employment rates. He is strongly against high taxes on investment income since it reduces capital allocated to investment, thereby reducing employment and leading to a waste of human capital. He blames the politicians for killing jobs and the economy and that we are letting it happen.
The high taxation in Canada is a contributing factor to having many of our brightest minds leaving for lower taxed countries. So Canada uses tax dollars employed through our education system to train young people, only to see many of them become tax payers in other countries.
Since Jarislowsky feels we are headed for higher inflation in Canada he poses the question what should we do for financial protection? He thinks people should live within their means and not overconsume. Additionally he feels that it will be much better to invest wisely in stocks than hold monetary assets. The reason is that historically real assets have always outperformed monetary assets.
He makes reference to real assets that have increased tremendously in value such as a can of coke that used to cost 5 cents when he was a boy that now costs around $2. Paintings that he purchased for $300 are years later now worth $100,000. His house that he paid $20,000 for in Montreal is now probably worth around $500,000. He states that monetary assets would not have kept up with the price increases of these real assets.
He claims that stocks over any 25 year period for the last century, stocks have outperformed bonds. This makes sense to him since because without the incentive of extra earnings, who would start a business if you could make more with a government bond?
Jarislowsky believes that a diversified portfolio of stocks is the answer to protect yourself against purchasing power loss in the future. He also suggests that with investing its the downside you need to be cognizant of because the risks are what you need to protected against. Stick with investing in good quality stocks and you will be better off regardless of the world situation.
Could this create a buying opportunity? Often, cyclical downturns allow long-term investors to pick up decent companies at bargain prices. In the case of auto retailers, when the economy returns to normal, people may not buy trucks and SUVs at the same pace as they had a couple of years ago, but we can nevertheless expect vehicle sales to recover from their current lows. Unfortunately, it's difficult to determine just how long a downturn will last.
Because downturns of unpredictable magnitude occur every few years, value investors tend to prefer buying companies with low debt levels, since these are the most likely to be able to last through a recession and re-emerge from it in strong positions as compared to the competition. Therefore, in these uncertain times, when examining the depressed auto retailing sector, it may be wise to consider which companies must focus on making ends meet just to make their next debt payments, and on the other side, which companies can afford to take advantage of the situation to position themselves for future growth. With that in mind, here are some major US auto retailers ranked by their interest coverage ratios:
From the chart, it appears that both CarMax and America's Car-Mart are positioned to outlast their competitors should this be a prolonged downturn. They may even choose to make further investments without risking the viabilities of their companies and thus emerge in better positions than the rest of the group.
At the bottom of the list we have Lithia, who swung to a loss last quarter simply due to their interest payments. Management of this company can hardly focus on the long-term health of the company when they are busy trying to find ways to make the next several interest payments.
Most of the companies lie somewhere in between, though their interest coverages are somewhat on the low side. As we've discussed here, Asbury is an example of a company that doesn't have a lot of leeway when it comes to making the payments it has committed to.
Of course, this is only an initial, cursory look at these companies. One still has to dig into the financial statements to make a full and proper assessment, as discussed here. For example, there may have been special items last quarter that caused operating income to be higher or lower than it would otherwise normally be, and this would skew the interest coverage ratio. Nevertheless, this is a good starting point to determine which stocks look safe enough to last through a downturn of unknown magnitude.
Wednesday, July 23, 2008
The authors believe the concept of investing without worry for long periods of time does not exist. All issues should be reviewed periodically (for the criteria described in earlier chapters). Graham and Dodd recognize that the investor's required effort is substantial not only in finding fixed-income investments as per their advice, but also in reviewing them. As such, an argument may be made that the benefit of a small increment in income (say 5% instead of 3.5% earned in a savings account) along with the added risk of principal loss is just not worth the hassle. However, the authors recognize the psychology of investors. They will go for that extra return, and therefore this section has served as their guide.
When an issue no longer meets the requirements set out in earlier chapters, an investor should switch into a security that does, and the investor should be prepared to take small losses in doing so. If the investor does not possess the psychological ability to fathom such a loss, he should buy securities with even larger margins of safety. In such a case, should earnings coverage drop, the investor will have confidence in the income stream despite a small drop in the value of the security. Should earnings coverage evaporate and the instrinsic value of the bond suffer a dramatic decline, perhaps the investor would be willing to exchange into securities trading at bargain prices, the subject of the next section!
The authors list numerous sources of advice for the investor: his commercial bank, an investment bank, a stock exchange firm, an advisory firm, and independent counsel. A commercial banker, however, can hardly be expected to put in the time and effort to be able to be of worthwhile assistance. An investment bank will be happy to provide this service, but since this firm has incentives to sell its inventory, its information comes not without bias. While a stock exchange firm also receives commissions from sales, the authors believe its incentives lie not so much in profits from investors, but in maintaining sound reputation. Advisory firms and counsel provide the most impartiality, but their drawback is that their services require pecuniary recompense.
Time to learn how to invest in debt for the purpose of capital appreciation, starting in Chapter 22!
Tuesday, July 22, 2008
He bluntly lays out many of his social and political views by stating pros and (a lot) of cons in the different major regions in the world. He likes the productivity in the US but feels that Canada is lagging the US because we don't strive for excellence enough. Europe is seen to have problems with high unemployment and high taxes. Japan is loaded in government debt and the cultural norms there are hurting ingenuity because they don't stress individualism enough. In his opinion, Asia needs to get away from selfish politics and improve their ethical standards.
Jarislowsky takes Bush to task with his war on terrorism stating that this is destoying what America stands for. He feels that Amercia's war on terror is giving rise to increased terrorism in Afghanistan and Iraq. In his view, the war on terrorism has "hijacked" the focus away from economic realities in America.
He explains that if the US dollar contines to fall, then non US holders of US cash and bonds will continue to want to sell these assets. He feels that the US would need to respond to liquidation of their bonds and cash by foreigners by significantly raising interest rates. The only way out of the US debt to foreigners in his opinion is via higher inflation. For these reasons, Jarislowsky thinks the worse economic conditions are yet to come in the US.
Jarislowsky goes hard on the Canadian government stating that the country has been largely mismanaged and that there is no reason why our standard of living shouldn't be as high as the Americans. Apathy and low expectations are major problems in Canada and reasons why the government is not held to task. He would like the Canadian government to focus on long term economic progress for the country.
He concludes with his view that other parts of the world need to emphasize individual rights to create a force able to balance against the goverments power leading to economic progress.
H. Paulin is a company nobody is going to tell you about (well, except for us, to illustrate an example). It has a market cap of just $25 million, and distributes and manufactures bolts, nuts, screws and other such components. It's small, it's boring, and therefore it's on no "analyst" or institution's radar screen.
But is it undervalued? To illustrate, I've highlighted a few items from its latest balance sheet (numbers are in thousands):
So the company trades for $25 million, but if it did nothing but collect A/R, and sell off its inventory to pay off its debts, it would provide its owners with $40 million! Plus, you would be getting all its land, buildings and manufacturing equipment in addition to that!
Of course, you never want to leave an analysis at that. As pointed out by Reyer here, you'll want to make sure to read the notes to the financial statements to make sure you understand what's going on in the company. Paulin's manufacturing operations are losing money, as their car part manufacturing customers have had to cut back due to the problems of the Big 3 US automakers.
But not all the news is bad. The distribution business is growing, as evidenced by increasing sales amid a new contract with Home Depot, as Paulin is stealing market share. Recent profits in this division are down in the short term as Paulin has had to increase its investments in Home Depot's retail locations as part of its share growth.
So all in all, the company pretty much broke even in Q1. Companies trading at discounts to what looks like real realizable value get us excited about investing! Paulin looks like it may be one of those companies.
Monday, July 21, 2008
In these three chapters, Graham and Dodd discuss various covenants and protective provisions for fixed-income investments. Though the health of the company is the most important factor in the determination of the health of a fixed-income investment, sometimes a company can run into trouble, and so debt holders need further protection as backup. (Note that we will discuss from the point of view of bond holders, but these covenants and protections are equally important for those who hold preferred shares.)
The most common provision allows a bond to become due upon a default event, for example if a company cannot pay its interest. The authors argue that current rules (as they were at the time of writing) are either too strong or too weak, as the status quo is harmful to both the company as well as bondholders. The fact that stockholders rights are considered during a bankruptcy puts uncertainty on the bonds, and as such they often sell for far lower than they should, considering their senior position. At the same time, if bondholders could not enforce their rights, a company might be able to avoid bankruptcy for enough time to get its act together. The authors express hope, with caveats, that new bankruptcy legislation which allows a re-emergence upon agreement by 66% of each stakeholder group will help remedy this problem.
Often, bond indentures will also prohibit the launching of new debt with senior liens on an existing property. However, most indentures will allow unlimited debt placed on newly purchased property. The authors argue that this could put all bondholders in a precarious position if the company uses this to lever past the point of where it should.
A sinking fund should also be setup wherever bonds are secured against a depleting asset. The authors cite numerous examples where depletion of assets along with a lack of a sinking fund resulted in bond holders receiving subpar redemptions, while in the preceding years common stockholders had received dividend payouts from profits made on now depleted assets. Serial maturities (where some principal is due each year) can act as an alternative to sinking funds, but require securities of different market quotations, which add complexity and costs.
Further, Graham and Dodd argue that companies should be required to maintain working capital (and/or capital stock) at certain levels above the value of its bonds. Often, a bond will be issued with a certain margin of safety below the value of working capital. However, indentures often do not require that this level be maintained throughout the life of the bond.
In order to ensure these covenants are met, bond holders require the ability to enact some sort of punishment on a company. It should not be such that it cripples the company, but must be substantial enough to provoke a company into meeting its obligations. Various forms of protection are discussed, from default (the harshest) to disallowing commond dividends. The authors argue that a group whose covenants have been violated should have the right to voting control of the board of directors, in order to see to it that their covenants are enforced.
The provisions described above offer protection to the investor. But if that protection is not enforced, then the ensuring of the protective measures were an exercise in futility. The authors cite numerous examples where marketable securities had dropped below minimum thresholds (e.g. less than 120% of debt) and where trustees did not act. Often, bond holders were left with less than par value as trustees acted when it was too late. It is essential that trustees are vigilant in defending security holders.
Doing some quick calculations on operating margins just to get an idea of what the trend was, we see an incredibly steady climb from 11% in 1999 to 29% operating margins in 2007. Wow! This tremendous increase in operating margins occurred while management was busy sloughing off lower margin food businesses for higher margin premium drink businesses. The data suggests that increasing exposure to the premium drinks business has helped lift Diageo's operating margins substantially and supports my previous claim.
Sunday, July 20, 2008
The author explains some of his childhood, living in the Netherlands, France and the USA. He took an early interest in collecting art books which is explained to be a lifelong passion. He was well travelled, well trained in the classics and proficient in several languages before starting University.
At the age of 16, Stephen enrolled in mechanical engineering at Cornell University in Ithaca, New York. He graduated from Cornell at 19 years of age and applied to the Harvard Business School at 22 years old. The author explains a desire to study issues systematically and in depth and was somewhat disappointed with the case study discussions at business school. The author graduated from Harvard with an MBA (distinction in Finance) in 1949.
As part of the US Counter Intelligence Corps, the author explains his new found interest and intrigue in learning about the East Asian cultures. The experience of studying Oriental culture led Stephen to devoting his life to being an example to others. He explains how he learned about the importance of “precedent” from the Japanese culture and the importance of “leadership” from the Western culture and his idea to bring these two concepts together in the way he lives his life.
Stephen explains a definite difficulty in spending money and still lives in the same house for the past 32 years (sounds a lot like Warren Buffett to me).
After a brief stint as a young rising executive he explained how he grew tiresome of company politics and decided to try starting various enterprises with friends. Eventually he started a statistical service that delivered data on various companies and sold it to brokers and investment dealers. This was the genesis of Jarislowsky-Fraser. Even with 200 subscriptions sold he and his partner saw the need to develop something else in order to make enough money. From their investing industry relationships and their skills in research, the author explains the natural transition to managing pension funds.
The author explains that it took almost 10 years to start earning a decent income. He explains that it is a very slow process if you start from nothing, no clients, no experience and the need to build this up. He and his partner just picked a direction that they believed in and kept moving in that direction. They were never in a hurry, they just kept building piece upon piece in their business. He explains how they have founded their business upon conservative time-proven investing principles and that now their business is one of the five largest private fund management companies in Canada.
Stephen speaks about how their mission and Jarislowsky-Fraser has never been only about business. They have been very strong proponents of good Canadian corporate governance and have fought numerously for what is right for investors, not for self-serving interests. Stephen discusses how over 40 as the chief research analyst in his company how he has covered pretty much every industry and knows a lot about judging a business and appraising the management team. He is a believer in not using exclusively quantitative models but rather to do a thorough analysis of all aspects of a company’s business.
Stephen expresses displeasure in how many clients get taken advantage of in the investment industry for example through high fees. He seems to express some pride in having the lowest fees in the industry purportedly done in the best interests of his clients. He shows disdain for organizations and people that rip off clients and works hard to expose these actions. He dislikes the greed factor present in the investment industry.
He explains how his work has been like his hobby since he loves it so much and asks the question what he should do in retirement since most people look to their hobbies and he is already doing that.
Let's take a look at shipments versus retail sales for the last few years to see if this is occurring (numbers in thousands):
(Note that it's difficult to get accurate worldwide retail sales for Buell, so both of these numbers include strictly Harley-Davidson bikes.)
According to the table, since 2004 Harley has tacked onto dealers 28,000+ more bikes than dealers have sold. However, the number of dealerships within the US as well as around the world has continued to grow...so is it possible that these new dealerships have absorbed these bikes as part of their showrooms?
Based on data within the annual reports, I estimate Harley has increased its number of dealerships by about 42 since the end of 2003. Spreading those 28,000 bikes across the 42 new dealerships gives us about 679 bikes per new dealership. Considering analyst Craig Kennison at Robert W. Baird estimates US dealers carry about 50 bikes each (source: 2008 Q2 Conference Call), 679 is a bit excessive, suggesting earnings since 2004 for HOG have been higher than what is sustainable.
But in the first half of 2008, it appears Harley has already more than reversed this trend. First half retail sales are almost 34,000 more than shipments, bringing shipments over retail sales to a negative 5,000 since 2004. That means on average each dealer is carrying 3 bikes less than it was in 2004.
Could this be good news for HOG going forward? Well the US economy is still behaving badly, bringing down Harley's worldwide retail sales in the quarter by 3.6% year over year, so challenges still remain. But at least the overhang of a shipment reduction due to channel-stuffing is behind us.
Disclosure: Author has a long position on HOG
Saturday, July 19, 2008
In these two chapters, the authors discuss various other types of fixed-income investments (apart from straight bonds and preferred stocks).
Income bonds sit somewhere between straight bonds and preferreds. They have a definite maturity at which point the principal must be paid back. (In this regard, they are similar to bonds.) However, interest payments are discretionary. They're supposed to be paid as long income is sufficient, but in actuality, companies can set aside money for capital expenditures or other items before having to make these payments.
Despite the seniority income bonds enjoy over preferred stocks, their track records have been awful in comparison to both bonds and preferred stocks. The authors theorize that this is because this form of investment is only used when companies are in dire straights. The very fact that interest payments need to be based on income suggests the income itself is in doubt.
The authors also discuss the benefits and drawbacks of guaranteed issues. These issues are backed by at least one other company. Graham and Dodd remind investors that guarantees are only as good as the viability of the guarantor. Investors are also cautioned to be wary of the type of guarantee: often, a guarantee will cover only interest payments, not principals.
Joint guarantees are fully backed by several individual companies. This rare occurrence is quite a valuable form of guarantee, as it can happen that one company is unable to follow-through on its guarantee, but unlikely that several cannot at one point in time.
A popular type of guaranteed security is common in the real-estate mortgage market. A bank will sell investors a mortgage, and will guarantee payments on that mortgage. Unfortunately, for this type of self-guarantee to be worth anything, the following principles must be kept:
1) Loans must be conservatively financed
2) The guarantee must come from a company well-diversified
If loans are not conservative, then declines in real-estate values will result in deterioration in loan values. If the guarantor is not diversified, a general decline in real-estate values will serve to place the guarantor in receivership, which makes for a most dubious guarantee.
As simple as these principles are, in practice problems have arisen. In the roaring 20s, new and aggressive firms provided loans at levels so as to leave very little equity in the mortgaged property, despite the fact that appraisals were made at dubiously high levels. In order to compete with these firms, reputable ones would be forced to lower their standards. The industry spiraled out of control, and guarantees turned out to be useless in the ensuing carnage as firms were forced into receivership.
Finally, the authors discuss required lease payments. Two companies may appear to have similar financial statements, but if one has large leases that may not be canceled, it sits in a precarious position. When rental rates drop, or when business declines, such a company is in the unenviable position of wanting to shrink but being unable to.
From the consolidated statement of earnings, there is a reference to the item "Income tax recovery" (note 8) for the amount of $11.23M. This is more than 10 times the net income before income taxes value! Investors in Wilmington counting on the net income per share value of $2.06 as likely in the future may be unpleasantly surprised.
We notice that the line item in question is recorded as operating earnings which is normal considering it is a tax related item. However, to value a company based on its free cash flows, we will want to use sustainable values that have a high probability of being repeatable into the future. If one works out free cash flows starting from the net income figure for Wilmington 2006, it will have included the massive income tax recovery value in the valuation. Is this income tax recovery item sustainable? Not likely but lets look at the financial notes to see what is going on here.
In note 8 to financial statements the corresponding disclosure is that this income tax recovery income item is actually in recognition of previously unrecognized tax assets. Great, how much more of those do they have? If there are substantially more tax assets available, we could account for these as reductions on future tax when we calculate future cash flows. Looking through all the fine print in note 8 we find that all tax assets are fully accounted for now on the books. There is a $0.2M future income tax asset on the balance sheet included under "Other assets" and that is it. No more delightfully huge "previously unrecognized tax items" ready to pop up and magically grow net income by a factor of 10.
Think of the Wilmington 2006 net income figure to remember that financial statements notes are a must read to understand the quality of existing earnings.
Friday, July 18, 2008
I believe that premium alcohol beverage producers are fantastic businesses to own (on the cheap of course). Firstly, premium spirits are associated with strong brand loyalty amongst consumers. Secondly, the premium global spirits industry is quite concentrated (the word "oligopoly" comes to mind). Probably my favorite reason for liking the premium spirit business is that operating margins are generous and demand for the products do not appear to be highly cyclical with economic conditions. The logic of "why not drink more when times are bad" has a certain appeal.
Diageo has been focusing on the premium alcohol beverage business and improving their margins. They are achieving sales growth both organically and via acquisitions. Their operational efforts have been contributing towards an increasing operating margin over the past several years. Their average operating margin over the past 4 years is around 26%. I believe these operating margins are sustainable going forward based on their excellent brands, global operations, customer loyalty and management's operational focus (they have been exiting lower margin fast food businesses).
Diageo has also been buying back its own shares in the company. So if you believe in the "signalling theory" of share buybacks, it is instructive to observe that 141M shares were purchased in 2006-2007 for an average price (including fees) of approximately 996 pence per share. Converting to US dollars and adjusting for the 4:1 ratio between LSE shares and the ADR shares (NYSE: DEO), this would make the share re-purchase price today somewhere in the neighborhood of $79.50 per share. Currently shares are trading for $73.40 on the NYSE. This is a potential indication that the stock is trading cheap to its intrinsic value.
If Diageo repeats the share repurchase of 141M shares, that would represent just over 5% of the total shares outstanding. In addition, Diageo has been increasing their dividend payments over (at least) the last 10 years and is currently yielding a 3.6% dividend payout. If you could buy Diageo stock with a margin of safety on their intrinsic business value and see the share float decrease by 5% and receive a 3.6% dividend, that's not bad!
In my next post I will present my calculation of the intrinsic value of Diageo's earning power to determine if this stock is currently priced attractively in the public markets.
Disclosure: The author has no shares in this company
Recently, the stock has gotten pummeled, from a high of £6.76 last last year to its current price of £3.05. So what happened? They had a few operational issues in 2007 which appear to have shaken investors. Their internet site is getting pummeled by the competition, and while they spent millions trying to improve it, they ended up giving up on that project and taking a write-down on it, after spending exorbitant consultant fees for a little advice. As a result of these issues and more, management offices have had a bit of a revolving door lately.
Nevertheless, this company has valuable licenses and a strong retail presence within a highly protected/regulated industry. It might be worthwhile to see whether there is value to be found here as a result of a depressed stock price due to a doom and gloom outlook from investors.
Yes their internet site is getting beaten up, but this company's strongest business line is its retail operations. More than 80% of both its revenue and its profits come from its 2,294 LBO locations, and in 2008 this operation should continue to be strong, as the company benefits from regulations allowing for longer operating hours.
The company has been buying back shares, pays a dividend yield of 5%, and has a P/E of less than 7. Seems like a clear buy, doesn't it? Unfortunately, there are a couple of risks that make this investor unwilling to place a wager on this company.
In 2007, the UK unveiled a new Gambling Commission, and as such has clarified the rules concerning the granting of new licenses. In fact, if you want a UK gaming license, just apply here! William Hill has enjoyed decent returns on capital in the last few years, but as new entrants apply for and receive new licenses (so that they too can achieve these returns), their returns should be driven to more normal levels. Considering the stock still trades at at more than 4 times book value, there's still a ways to fall if competition gets intense.
Another worry is the company's debt level. With debt representing 85% of invested capital, there isn't a lot of leeway to allow for a downturn in this company, either due to competition or a downturn in the economy. Many people believe that this industry is immune from economic cycles, but they are sorely mistaken according to Dr. Bill Conerly, whose research in his book, Businomics, suggests that gambling is a cyclical industry. (An article he wrote on the subject is here for those who are interested.)
The stock looks cheap, but the risks are too high. This one's a no buy.
Thursday, July 17, 2008
Still on the subject of fixed-income investing (for a description of the various groupings of investment types, see Chapter 5), Graham and Dodd add some special notes for investors when it comes to preferred stocks.
In most cases, preferred stocks (at par) enjoy the privileges of the worst of both worlds. They carry no upside (like bonds), yet offer no guarantee of payment (like stocks). As such, by their very setup, they are an unattractive form of investment.
Studies carried out by the authors demonstrate that pref shares have fallen from economic peaks to troughs far more than have bonds, despite the fact that both are ordinarly "fixed-income" type investments.
Nevertheless, in the finance industry, preferreds are considered close in form to bonds. If a company does well, preferred dividends are paid easily, and if a company does poorly, the bonds don't get paid either, and as the authors have discussed, liens are worth little. However, this argument fails to take into consideration the middle-ground: companies that are neither great nor poor. In practice, pref dividends are often withheld merely when payment is inconvenient as opposed to impossible. This results in wild fluctuates in market values of pref stocks, and as such does not make sense for an investor looking for stable fixed-income investment.
Therefore, before making fixed-income investments in preferred shares, the authors require that the prefs not only meet all the requirements of a safe bond (as discussed in Chapters 8 to 11), but have a larger margin of safety such that dividends will likely always be paid, and that the company's stability be of utmost importance, since during bad years if earnings turn downward or negative, the pref dividends will take a hit.
The authors' analysis of public markets demonstrates that only 5% of preferred shares actually meet these requirements. In such cases, the companies would be better off issuing bonds in order to obtain tax benefits and a lower cost of capital. History shows, however, that these safe preferreds are left over from a time when the companies were not as strong as they are today, and so they were not in a position to issue bonds.
In most cases, therefore, preferreds are an unattractive form of investment, as they lack the upside of common shares, and lack the stability of bonds. The fixed-income investor must search for the exceptions: where the stability and coverage of earnings is so high that prefs behave as though they are bonds.
Wednesday, July 16, 2008
One step I took in calculating the earnings power value was to investigate the average operating margin (operating earnings / sales) for the company during the period between 1997 and 2007. It’s important to take a full business cycle in calculating average operating margins because any given year could produce uncommon financial results. For example, during this 10 year period, the highest operating margins occurred in 2004 and 2005 and the lowest margins occurred in 1999, 2001 and 2002. The highest operating margin years over this period coincided with Aldila’s most successful product launch to date with their “NV” line of golf shafts. While shareholders can be hopeful for a repeat of the “NV” shaft success with the recently launched “VooDoo” shafts, for valuation purposes, you will want to use values that you feel reasonably sure will be sustainable in the future. I don’t feel reasonably sure that Aldila will duplicate the success of 2004 and 2005 on an annual basis, but I feel much more confident that they could reproduce the average results obtained during the entire 10 year period.
Fundamental changes to a business model need to be evaluated for significance. It's best to avoid using historical data that doesn’t take into account the recent fundamental business changes as the results can be misleading. Aldila has made some fairly recent changes over the past few years such as selling their joint venture interest in Carbon Fiber Technology LLC (CBT) as well as exiting the hockey stick manufacturing business. My opinion is that both of these changes will not significantly alter future operating margins from the average operating margins calculated during the 1997 - 2007 period. Firstly, external sales of CBT were insignificant contributions to Aldila’s total revenues. Secondly, Aldila has secured purchase agreements guaranteeing the amounts of carbon fiber available to them over the next 5 years. Thirdly, there has been a carbon fiber industry capacity expansion and if this trend continues, it becomes more likely that future supply will be available. Lastly, the hockey segment was a very small component of Aldila’s overall operations and shouldn’t significantly affect operating margins by much. Hockey shaft sales were under 3% of the Aldila’s total sales.
One other important aspect in my earnings power calculation is that I did not account for any growth in sales. I wanted to use a conservative view of Aldila’s earning power potential and not inflate the valuation with what would likely be inaccurate estimates of sales growth. In addition to being conservative, I also believe that this valuation is grounded in facts since I used the average operating performance that Aldila actually produced over the past 10 years.
One potential problem with my earnings power valuation is that Aldila has 3 major customers that account for nearly 65% of their total sales. This concentration of customer sales affords negotiating power to the customers that might have a negative impact on Aldila’s operating margins going forward. One way to deal with this is to more thoroughly investigate the relationships and contracts that exist between Aldila and the their top customers. Another approach is to play the “what if” game and calculate the valuation impact under a slew of different scenarios. In any event, I valued Aldila’s earning power with the top 3 customer relations intact but assumed no growth of sales.
In summary, Aldila is an interesting value play. The stock is trading at less than both book value and earnings power value, it has a trailing P/E ratio of less than 2.5 and it pays 60 cents per share dividend. If Aldila is able to at least replicate the operating success of the past decade into the future then Mr. Market is currently offering this stock at a discount to its intrinsic value.
DISCLOSURE: The author does not have a position in Aldila
From our research, this is not the case. As examples, we've discussed here and here how a diligent investor could have profited from both Melcor in the 90s and Hammond Power in 2005. But you will have to find companies trading at such discounts yourself. You won't hear analysts pushing these stocks, as their market caps are small and their industries aren't hot. But those are the kinds of stocks we like to invest in.
Another great example of a company that flew under the radar is Phoenix Canada Oil of 2005. It traded at a market cap of around $6.3 million as recently as June 2005. Its oil operations were losing a bit of money each year, but that's not really the source of our interest. A closer look at some of the larger balance sheet items reveals the following:
Cash + Marketable Securities..........9,000,000
So this company was already trading at a discount to just its cash on hand! All told, this company was trading at about a 30% discount to its book value, with cash being the bulk of that book value!
But we're not done there. A closer look at the "Investments" line item reveals that 83,290 represents the cost of certain investments. Buried in the notes, the market value of these investments is revealed to be $1.8 million. Allowing for some taxes on the gains (which would occur if they decided to sell these investments), the discount now becomes about 40%.
The benefit of looking at some of these stocks in the past is that we can see what happened after! Well, six months later, the stock jumped to a market cap of more than $30 million, representing almost a 500% gain. It certainly overshot our estimates, but nevertheless an investor would have made a nice gain selling on the way up, had he recognized this disparity between the company's market value and its intrinsic value.