Friday, July 31, 2009

From The Mailbag: Glacier Media

Glacier Media (GVC) is a media and information company. The stock has a P/B of just over .5, with a P/E of 7, and a debt to capital ratio of 28%. Sounds cheap right? Not upon closer examination of its balance sheet.

While the company has a book value of equity of $300 million, included in that balance is an asset of $229 million of Goodwill. Also included in that equity balance is $162 million of intangible assets. These facts by themselves don't neccessarily mean that Glacier's book value is worthless; in fact, it's entirely possible that the company's true intangible assets are understated by these values. However, the fact that intangibles play such an important role in the company's book value raises the importance of the investor's understanding of the company.

The fact that there are no hard assets (such as cash/AR/real-estate) to fall back on in case earnings fall through means the company better have a moat of some sort to protect its earnings power. But the investor can only ensure that the company's earnings power will continue into the future if the company falls within the investor's circle of competence. If the investor isn't sure, then this type of investment is not for him: while intangible assets are sometimes worth substantially more than their balance sheet carrying values, sometimes they are worth substantially less. No matter what the company's current earnings may be, to avoid ending up on the wrong side of these two possibilities, the investor should stick to companies which either fall within his circle of comptence, or that have downside protection in the form of hard assets.

Because Glacier Media appears cheap across the standard value metrics, it serves as a perfect example of how stock screens are just a starting point for value investors. Traders and speculators may do no further analysis if a stock screen shows them what they're looking for. Value investors, however, need to understand the business before they can jump into a stock.

Interested in an alternative perspective on Glacier Media, or another stock of your choosing? Our sponsor,, is offering our readers a free analysis of a stock of their choosing here.

Disclosure: None

Thursday, July 30, 2009

Troughing Now Or Later?

During recessions, not all industries experience the pain (and the enusing recovery) at the same time. Some industries get hurt first, while others don't feel the ripple effect for several months. With Wall Street's over-emphasis on the importance of current earnings, understanding these cyclical troughs can help value investors profit.

Consider Hammond Power Solutions (HPS.A), a stock that has twice been discussed on our Value In Action page due to the fact that its price fluctuates far more than does its business value. In the last quarter of 2008, while banks and most companies related to the housing industry were struggling to meet their obligations, HPS reported record sales and profits, prompting its Chairman and CEO to state the following in late March of 2009:

"As our 2008 results illustrate, HPS has come through these challenging economic times relatively unscathed."

As a result, its stock price appeared to trade close to its intrinsic value in a pretty weak general market, as we discussed here. But fast forward four months, and it appears the company is all of a sudden experiencing a downturn. Net earnings dropped 87% year over year in the 2nd quarter of 2009. The Chairman and CEO has completely changed his tune, as evidenced by the following new statement on July 16th:

"Going forward, it is fair to say that the global economy is performing worse than even our most pessimistic forecasts of six months ago."

The stock price has of course responded to the current earnings environment for this company, rather than its long-term earnings power, as it is down over 20% in the last two months. If the stock continues to fall due to drops in demand that are of a short-term nature, it will once again provide the long-term investor the opportunity to purchase a good company at an excellent price! Buying companies that are in the midst of cyclical troughs is an excellent way to derive long-term profits*.

*The tricky part, of course, is ensuring a company is indeed going through a cyclical and not a secular downturn, and has a financial position and cost structure such that it can survive/thrive until better times return.

Disclosure: None

Wednesday, July 29, 2009

Volatility Offering Opportunity

In March of 2009, panic in the market led to an enormous number of value opportunities. Believers in market efficiency would be hard-pressed to justify some of the depressed valuations prevalent in the market at that time. Some companies have already posted tremendous gains in the four months that have passed. One such example is Spartan Motors (SPAR), designer and manufacturer of heavy-duty vehicle chassis.

The auto industry is clearly going through a tremendous slump, but investors went overboard in punishing the valuations of many of these stocks. Since hitting its low in March, the stock has already quadrupled. But how was an investor to know that SPAR was undervalued?

The company traded for just $75 million in March, but had cash of $14 million, receivables of $76 million, and inventory of $87 million, for a total of $177 million. Meanwhile, the company had total liabilites of just $90 million, for a difference of $87 million. In other words, the company could be purchased for its inventory, with its fixed assets, R&D, and customer relationships thrown in for free. For a company that has remained profitable throughout this downturn (including 2008 operating income of $69 million), this represented a tremendous bargain.

While most companies have recovered from their lows in March, many have not. Fifty-two week low lists continue to show investors which stocks are out of favour. Of course, not all out-of-favour stocks offer value, but the current environment still offers plenty of upside to those willing to make the effort to uncover the diamonds in the rough.

Disclosure: None

Tuesday, July 28, 2009

The Mainstream Media

We've not made it a secret on this site that we don't believe the mainstream financial media helps the average investor. Their focus on the short-term, their tendency to sensationalize/exaggerate (both to the positive and to the negative), their emphasis on their anchors' personalities (over the substance of the information provided), and their focus on the most popular/hot/trendy sectors and companies does a disservice to the investor looking to outperform.

Thanks to the internet, we can tell that we're not alone in taking this view. A pair of writers at Zero Hedge have written an eloquent article on the subject in the form of an open letter to the financial media. The letter serves as a must-read for those who rely on the mainstream media for any sort of investment advice.

Readers of CNBC online will also enjoy Zero Hedge's spoof of CNBC's website, located here.

Monday, July 27, 2009

Usual or Unusual?

As noted by Ben Graham, when analyzing a potential investment, it's important to incorporate several years worth of operating earnings. This is due to the fact that in any one year, various external or internal factors could lead to annual numbers that are not representative of future results.

In performing such an analysis, investors will note that many companies designate certain expenses as 'unusual'. Common types of 'unusual' expenses include Goodwill writedowns (i.e. the company purchased another company some years ago and now realizes it overpaid for that company) and restructuring costs.

For many companies, perhaps these are indeed unusual expenses and will not occur again. For other companies, however, 'unusual' expenses seem to be a perfectly normal part of business as usual.

Consider New Frontier Media (NOOF), producer and distributor of adult-themed video-on-demand programming. Excluding what the company deems as unusual expenses, the company has earned operating income of $87 million over the last 8 years, averaging to $11 million per year. In five of those eight years, however, the company recorded 'unusual' expenses. Incorporating these expenses, NOOF's average operating income over the last 8 years reduces to $8.5 million, a reduction in value of over 20%!

To avoid making valuation mistakes, it's important for investors to consider several years worth of earnings (preferably an entire business cycle) and to seriously consider unusual expenses to determine if they are relevant in determining the company's current earnings power.

Disclosure: None

Sunday, July 26, 2009

The Psychology Of Human Misjudgement: Authority Misinfluence

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Man has a follow-the-leader tendency. While this can often lead to effective group operation, particularly when the leader is proficient, it can lead to disaster if the leader is wrong or if the leader's communication is misunderstood. This is due to the fact that followers will often ignore logic in the belief that the action as suggested by the leader must be correct.

Munger describes several situations, from the humourous to the disastrous, where the instructions of leaders were clearly wrong or misunderstood, yet the followers would perform seemingly illogical acts in the belief that the leader must know what he's doing. Hitler's ability to convince a group of people to commit genocide is a particularly grave example.

Because people will follow leaders whether they are wrong or right, it is extremely important to choose good leaders. Many CEOs are able to remain in power because of the respect they are afforded due to their positions! Munger notes a specific example where a CEO was blind to reality but remained at the helm of his company simply because of the respect afforded to his position.

Saturday, July 25, 2009

The Psychology Of Human Misjudgement: Use It Or Lose It

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Skills degrade when not practiced. The antidote to this unfortunate reality is to frequently practice useful but rarely used skills. This is akin to how pilots use flight simulators to practice rarely-used skills that they can't afford to lose.

Munger argues that if man does not practice his existing skills, his learning capacity will also shrink. This is due to the fact that he creates gaps in the framework he needs for understanding new experiences. A wise man creates a checklist of his skills, to ensure they are kept sharp.

But this tendency does not treat all skill bearers equally. If a skill is practiced diligently until fluency is reached, it degrades much more slowly and is refreshed much more quickly than if a skill is quickly crammed to, say, pass an exam.

With advanced age also comes more severe deterioration of skill. But an individual can maintain well-practiced skills to even a very old age. Munger also argues that continuous thinking and learning can help delay the deterioration that is inevitable.

Friday, July 24, 2009

All Debt Not Created Equal

Regular readers know that, as value investors, we generally prefer companies with relatively low debt levels. The reason for this is that companies with low debt levels will fare much better than their competition during times of economic distress, providing for better downside risk protection. But looking only at a company's debt level does not provide a complete picture of a company's risk related to its debt, as even similar companies with identical debt levels can vary dramatically in their debt-related riskiness.

Consider Escalade (ESCA), the world's largest producer of table-tennis tables (and other gaming items). Escalade has long-term debt of $45 million. To give an idea of the relative size of this debt, consider the fact that Escalade has averaged $9 million of operating income per year over the last four years.

But while the debt is listed as "long-term" because it is not due within 12 months of the most recent financial statements, "long-term" is hardly an accurate description. All $45 million is due in May of 2010, just 10 months from today!

Practically speaking, this represents a huge difference to a situation where the debt is not due for 10 years. Added time to maturity allows the company to plan accordingly, building up cash reserves from operations or other sources of financing in due time. Instead, this company is reliant on a debt market that is shaky and expensive for this type of company. As a result, the company will likely have to sell some of its assets at the current market's firesale prices!

An important complement to what debt is due (found on the balance sheet) is when the debt is due, which can be found in the notes to the financial statements.

Disclosure: None

Thursday, July 23, 2009

Can You Trust Your Sources?

There's a plethora of information available to investors from brokers, analysts, the mainstream media, and financial bloggers. But there are conflicts of interest abound in this industry, resulting in the fact that you cannot trust anyone but yourself.

This became abundantly clear to me recently as I was approached by more than one agent presumably looking for exposure for their respective clients: the agents were offering to pay me to write about certain small companies. By itself, this is not such a bad thing. The small companies would get exposure, the readers would get my thoughts on a stock (presumably one of the reasons they read this site), and I would receive consideration. Everybody wins, right? Well, only if certain rules are followed.

But when I presented these rules (e.g. my opinion would be expressed rather than simply a favourable recommendation, the payment would be made upfront so as not to influence my opinion of the stock, the payment would be set ahead of time only rather than a bonus based on the stock's performance, the fact that I'm being compensated would be disclosed) the agents quickly declined and moved on. But that doesn't mean they disappeared; it likely means they searched, and perhaps found, another conduit for their message.

Unfortunately, this means that you should assume that everything you read is biased, because you don't know when you're getting an independent opinion and when you're not. The antidote to falling prey to this unscrupulous behaviour is to treat the information you read as a starting point, not a complete analysis. Investors must do their own research by reading the company's disclosures; only then can their conclusions be trusted. Do your homework!

Wednesday, July 22, 2009

Value Investing Arbitrage Pays!

A few weeks ago, we described an arbitrage situation involving two value stocks (both traded at discounts to net current assets, had minimal debt, and were generating earnings). One of these potential value stocks, TAT Technologies (TATTF), was buying the other, Limco-Piedmont (LIMC). But what reduced the risk of this transaction enormously was the fact that TATTF already owned 60% of LIMC, suggesting the deal would go through.

The transaction did close, with LIMC shareholders receiving half of one share of TATTF for every share they owned of LIMC. However, even one month before the scheduled close of this transaction, shares of LIMC were trading substantially below half the share value of TATTF ($2.90 vs $3.50), offering high returns relative to risk using the following transactions:

1) Short X number of TATTF shares for $7/share
2) Use the proceeds to buy 2X shares of LIMC at $2.90/share

The above transactions left the investor with $1.20 for every share transaction, despite the fact that the share positions in both 1 and 2 above were to be identical in just one month's time! No matter how the shares were to move in the interim, the above transactions would be profitable as long as the transaction closed.

When the transaction did close on July 2nd, shares of TATTF plummeted while shares of LIMC rose marginally, resulting in hefty returns for those who took advantage of the circumstances.

In an efficient market, one wouldn't expect opportunities like these to exist. But an opportunity this was, as the stocks had low enough spreads and high enough liquidity to make outsized returns, and the risk was muted due to the fact that the acquirer already owned 50%+ of the target. If you come across other value arbitrage plays of this nature, we would be happy to hear about them!

Disclosure: The author is long shares of TATTF

Tuesday, July 21, 2009

Uncertainty Can Kill You

CE Franklin (CFK) has the makings of a terrific value stock. It has a history of fairly stable revenues and earnings, and appears to trade at a discount to those earnings. From an asset point of view, the company's current assets cover all of its liabilities with enough room left over to cover the company's market value. There's just one problem: the company's industry.

CE Franklin distributes industrial supplies to the oil and gas sector. While maintenance and repair supplies, even to this sector, can be fairly stable, half of the company's revenue exposure relies on new capital spending by oil and gas companies. The amount of capital spending by oil companies can vary dramatically depending on the price of oil. While there are many who believe the oil price will rise again soon, and others who believe it will fall, there's no reason to make a bet in either direction if you don't have to.

Many intelligent people who follow the market will tell you that they don't know which way oil prices will move, and that's a perfectly fine position to take. We're not interested in guessing, but rather in finding opportunities with strong upside potential with minimal downside risk. CE Franklin certainly has the upside potential, as it trades at a discount to its assets, and a positive move in oil prices will likely result in strong price appreciation. Unfortunately, the downside risk is not minimal, as falling oil prices will result in shelved capital projects that would bring revenues dramatically lower.

An important theme of value investing is that one does not have to take a position on every stock. While other analysts tend to believe a stock will either go up or go down, value investors are content to say "I don't know" on a majority of stocks, and only invest in the ones they are relatively sure about.

Disclosure: None

Monday, July 20, 2009

Shipping Your Dollars Away

While a company may appear undervalued on an earnings basis, this does not mean the company has cash to distribute to shareholders. A quick way to help determine if a company has the cash flows needed to pay shareholders is to compare its depreciation expenses with its capital expenditures within the context of its operating income. For StealthGas (GASS), a provider of carriers and tankers for the oil and gas industry, the comparison is as follows:

Unfortunately, this profile is not dissimilar to that of other companies in the shipping industry. Clearly, it is unlikely that there is any cash left over after these massive capital investments are funded. Rather than using earnings to pay shareholders, the company has needed a source of financing to fund an expansion. That source has been debt financing, as the company has increased its D/E from a more reasonable 65% to its current 90%.

As this company has ramped up its expansion, it has put itself as risk. Despite what the growing earnings record may show, this company is in no position to reward its shareholders.

The high debt levels combined with the fact that the company is in a cyclical industry suggests trouble is ahead, especially if the industry is expanding while the economy is not. While in other industries capital expansion can be cancelled and in some cases capacity can even be cut, this is not the case in shipping. Due to high manufacturing lead times, GASS is contracted to buy several more ships through 2012! These contractual obligations will require another $135 million in financing!

Since other companies in this industry are in the same position, supplies of ships will continue to increase in the next few years, while goods that need to be transported are slowing. This leads to lower revenues and reduced fleet values...a situation investors should be wary of entering, despite the earnings growth profiles these companies have shown in the last few years. While stock market values of these companies are depressed (GASS' P/E is less than 5, and its P/B is .33), long-term investors should ensure their company is not too laden with debt and expensive commitments to outlast what could be a rough few years for this industry.

Disclosure: None

Sunday, July 19, 2009

The Psychology Of Human Misjudgement: Availability-Misweighing

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

When information is readily available, humans tend to put more emphasis on the value of that information. It is not only unavailable information that is underweighed as a result, but information that the brain can't remember or is blocked from using as a result of being influenced by another tendency.

Munger describes the main anitode to this tendency is the use of standard procedures (or checklists). Another antidote involves emphasizing factors for which numerical data is not available. Finally, one can hire intelligent, skeptical and articulate minds to argue against incumbent opinions.

While vivid and memorable evidence should be consciously underweighed (since it is subconsciously overweighed), such evidence can still be very useful. For one, it can be used constructively to persuade others of a correct conclusion. For another, it can be used to improve one's memory by attaching vivid images to items one does not want to forget, a technique of Greek and Roman classical orators who gave long, organized speeches without notes.

The lesson of this tendency is to understand that an idea or fact is not worth more simply because it is available.

Saturday, July 18, 2009

The Psychology Of Human Misjudgement: Stress-Influence

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

It is known to many that stress causes an adrenaline rush that results in faster, more extreme reactions. Furthermore, light stress can improve performance, but heavy stress can cause dysfunction. But Munger argues that few people understand the mental breakdowns that stress can help cause, apart from depression.

Munger discusses various stress-related experiments run by Pavlov on dogs that demonstrate the awesome power of stress. In these experiments, Munger discusses the fact that Pavlov was able to identify how easily a particular dog would succumb to a nervous breakdown, that any dog could be broken down, and that a breakdown could only be reversed by imposing more heavy stress.

Munger asserts that stress can be so powerful that it is the key ingredient in the success of cults. Some of Pavlov's work could conceivably be applied to help parents 'deprogram' children that have been broken down by cults.

While the business or investing implications of this human tendency are not immediately obvious in this discussion, Munger wished to bring up the subject of stress lest his examination of human tendencies be glaringly incomplete.

Friday, July 17, 2009

Concentrate...Or Don't

In the last few months, we've looked at a couple of examples of companies that have a significant percentage of their revenues tied to one or more customers. For example, JAKKS Pacific (JAKK) receives 33% of its revenue from Walmart, which, all else equal, is more risky than a company with evenly distributed revenues. Today we see an example of a company that has been burned by its reliance on Sears.

As we've discussed previously, Escalade (ESCA), maker of gaming tables, has looked cheap across a number of metrics. But shareholders paying attention to the company's disclosures would have seen a key risk in the fact that almost 20% of the company's sales were to Sears. While an astute reader pointed out that concentrated customers with contracts can actually provide revenue certainty, there were no contracts in this case, which reduces certainty dramatically.

In 2008, Escalade and Sears could not agree on terms for products representing a significant amount of sales, despite the fact that these companies have a 30-year relationship! As a result, the company lost 12% of its sales just like that, and the remaining sales to Sears are now at high risk of being discontinued.

While Escalade may recover from this revenue shock by cutting costs and selling assets, it is not out of the woods yet. The stock has dropped by 80% in the last year, and the company is considering removing itself from the Nasdaq to save on costs!

When confronted with companies reliant on a few concentrated customers, look for contracts! If there aren't any, proceed with caution and understand the risks.

Disclosure: None

Thursday, July 16, 2009

Erring With Air T

Air T (AIRT) has all the makings of a grossly undervalued stock. It has a P/B of .7, a P/E under 5, and a net cash position (cash minus debt) of over $7 million, while the stock trades for $18 million. The company has been able to maintain strong levels of profitability throughout this downturn, and even pays a dividend yielding over 4%. It operates in three distinct segments which, as we've discussed, helps diversify away risk. While AIRT could very well turn out to be a terrific long-term investment, further study indicates that there are some serious risks that could also dampen future returns.

First of all, 100% of AIRT's revenue in its largest segment is from one customer, Fedex. AIRT is charged with operating 82 aircrafts for Fedex, but these contracts can be cancelled by Fedex with just 30 days notice. While it is conceivable that Fedex will not cancel these contracts for several years, 50% of AIRT's consolidated revenue is reliant on this fact!

In the other segments, the situation is not dissimilar. About 25% of AIRT's consolidated revenue comes from the US military for the manufacture of airplane de-icing machines. While these are produced under contract, and have been since 1999, those contracts expired in June of this year. The military has issued a request for proposal, but the jury is still out on whether AIRT will be able to renew.

Finally, AIRT receives a majority of its revenue in its third segment, maintenance and support, from Delta Airlines. While these services are also performed under contract, this contract is set to expire in just over one year.

While AIRT is currently showing strong earnings in its most recent periods, these earnings may have peaked: the company's backlog at March 31st, 2009 was just $8 million, compared to $25 million in the year-ago period. Furthermore, an examination of the risks reveals that while the stock may trade at low levels relative to AIRT's earnings power, that earnings power does not have a whole lot of downside protection.

Disclosure: None

Wednesday, July 15, 2009

Scared Of Debt

If you're not the type of person that levers up his assets to the hilt (i.e. you would rather save up for a sizable downpayment for a car/house rather than borrow as much as you possibly can), you might apply that same mentality towards the businesses you own. Yet when it comes to stocks, many individuals who are not otherwise reckless with risk buy companies without regard for their levels of debt.

But while a company may look great from a net asset and earnings point of view, the company faces increased risk when it has levered itself up. Consider Thermadyne (THMD), a global supplier of cutting and welding products. Thermadyne trades for just $48 million, but its operating income in each of the last two fiscal years was above $40 million! Furthermore, its book value is $120 million.

The problem is, the company operates in a cyclical industry, meaning when a recession bites, it bites hard: revenue in the most recent quarter is down 35% from the same period last year and is at a level at which the company cannot make money. While revenues may eventually return to normal when the macroeconomic situation stabilizes, debt charges don't wait. The company is laden with $235 million in debt, for a debt to market equity ratio of almost 5!

To return to the personal asset example, this is akin to putting a 16% downpayment on a home (and taking on the rest as debt) when you don't have any income. You will likely find employment when the economic situation improves, but your creditors want their payments now!

Of course, this does not mean that Thermadyne does not make sense as an investment for those who specialize in such situations. It is cheap across several metrics, and a 2nd order analysis of its debt maturities reveals it has some time to repay much of its debt. But the fact that remains that high debt levels are akin to playing with fire. You may be able to get away with it for a while, but a Black Swan can leave you in a precarious position.

Disclosure: None

Tuesday, July 14, 2009

Is It Really Defensive?

Companies will often take credit when revenue growth outperforms economic growth, using sentences beginning with "Despite the current situation, we...". But these same companies will be quick to blame the economy in the face of lower than expected results (e.g. "The economic crisis caused..."). Therefore, the investor needs to be able to determine whether management is indeed outperforming.

Despite the general economic malaise currently gripping the global economy, it is still possible to find companies experiencing record sales and profits. But some companies may be beneficiaries of circumstance. These companies could be in industries with positive long-term trends (e.g. health, education), they could be in industries that aren't much affected by recessions (e.g. producers of consumer staples), or they could be operating in niche segments that for whatever reason are experiencing temporary bouts of strong demand or little in the way of competition. To avoid overpaying for such a company, it's important for investors to be able to identify that external factors (which may be temporary) are benefitting a company.

If a company is earning record profits in a recession, but is simply in a cyclical industry, it is likely attracting competition. When a company generates high returns on capital, it attracts competition looking to replicate those same returns. For most companies, this results in returns returning to normal levels, as the competition drives down margins. For some industries, this process can take years (e.g. high oil prices encourage drilling and innovation resulting in higher
oil supplies), while in others it can be a matter of weeks.

Consider Kewaunee Scientific (KEQU), maker of laboratory furniture. A combination of favourable factors for demand along with low competition has resulted in strong revenues for this company. But it's important to keep these numbers in perspective. Assuming the current revenue and profit levels will continue for the foreseeable future may result in an investor's overvaluation of its stock. In other words, it is easy to get sucked into believing that these numbers can only improve, considering that we are in a recession.

Indeed, management's comments suggest the company is resilient in the face of recession:

"Our programs and strategies over the past few years to make Kewaunee a stronger and more competitive company were put to the test. Despite [economic] and other challenges, year-over-year increases in sales and net earnings were achieved for each quarter of the year..."

As we've often discussed, however, investors must look at several years worth of data to determine if a company's current operating profits are indeed sustainable. If a company does not have a competitive advantage, high margins will simply encourage competition that drives margins back down to normal levels. A look at KEQU's revenue and margins over the last business cycle shows it is currently operating as well as it ever has:

Not long ago, however, the company suffered from low demand resulting in margin erosion. In 2005, revenues and earnings dropped sharply. Did the company blame itself, in what was otherwise a strong economic period? Not likely, as it issued the following commentary:

"We accomplished much in realizing cost reductions and improving our products, but were not able to overcome the unfavorable marketplace and declining sales...Uncertainties surrounding the November presidential election, significant increases in construction costs, and fewer state funds available for projects, all combined to reduce the number of laboratory projects..."

To determine whether current revenues and margins are sustainable, investors must consider the underlying business. Does the company have a competitive advantage which should allow it to hold onto its record profits, or is demand cyclical and/or will competition reduce profitability to more normal levels? Rather than accept the biased explanation of managements, investors must use their own judgement, and not only rely on current earnings (which may be abnormally high) in valuing a company.

Disclosure: None

Monday, July 13, 2009

Diamonds In The Mortgage Rough

Companies offering mortgages or related products are currently out of favour in the stock market, and often with good reason. Many companies spent the last few years borrowing money, and then lending it out carelessly, expecting to make profits on the spread resulting in high returns on minimal equity. When customers couldn't afford to pay back thanks to the downturn, the borrowed money remained due, resulting in strong chances of default for the lender. But not all mortgage companies find themselves in such high risk positions, but you wouldn't know it from their stock prices. Consider Quest Capital (QCC), a real-estate mortgage financier.

The company is owed $386 million from borrowers, all of which is secured by real-estate or corporate/personal guarantees. Based on the value of the underlying real-estate and the quality of these guarantees, the company estimates that it will recover $370 million of these outstanding loans. Even if you believe that mangement is not conservative enough with respect to estimating these losses, the losses would have to be 900% higher than management's estimates to justify the stock price of this company, as the stock trades as if the loans due are worth just $240 million.

The reason the value of QCC's loan portfolio can drop so much and still hold value for the equity holders is that extensive use of leverage is not in use. The company is financed with just $46 million of debt and $40 million of pref shares along with common equity of $290 million. But this equity trades on the market for just $120 million.

To reduce the risk of a cash crunch, the company has stopped originating new loans, and it issued the pref shares just six months ago to ensure adequate liquidity. So now the company will focus on collecting its loans receivable and paying down its debts and prefs, which should further reduce risk. For added flexibility, the company was allowed to pay pref shareholder dividends in the form of common stock, and did so for the last two quarters. Perhaps foreboding that the company's cash flow situation is now relatively safe, the company issued the following statement last week:

The Company currently plans to pay cash for any future dividends declared on the Preferred Shares.

Disclosure: Author has a long position in shares of QCC

Sunday, July 12, 2009

The Psychology Of Human Misjudgement: Contrast Misreaction

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

"Contract-Misreaction" causes people to take actions which are potentially detrimental, because they appear insignificant or appear positive when compared to other actions. Munger uses an analogy of the human eyes to illustrate how this tendency works: humans only see items which contrast with their environment. In the same way, humans find it difficult to differentiate perceptions where there is little in the way of contrast. For example, a man may buy a $1,000 leather dashboard, even if overpriced, when considered in combination with the fact that the vehicle cost is a much larger $65,000.

While the above example is a relatively minor one, Munger points to some examples where this tendency can have detrimental and long-lasting effects. In business, Munger has seen marketers use this practice to their advantage. Real-estate brokers may show clients awful properties at inflated prices for the purpose of closing a sale on merely a bad property at a merely partially inflated price. This practice is also seen frequently in mainstream advertising, with service/product providers asserting a phony price for a product and then promptly offering a 'discount' to a lower price. Munger argues that even though consumers recognize this practice, it still works! Therefore, being aware of psychological ploys does not prove to be a perfect defense!

While a minor mistep caused by this tendency is on its own not disastrous, Munger argues that a series of seemingly minor misteps can lead to disaster. This can occur because each step represents only a minor deviation (i.e. low contrast) from the current situation. Munger uses the example of the live frog that boils to death because it never jumps out of a pot of slowly heated water, not realizing that the temperature is changing because the changes are minute.

Ben Franklin said that a small leak will sink a great ship. Munger argues that this is due to the fact that the brain often misses the small leak in the large ship.

Saturday, July 11, 2009

The Psychology Of Human Misjudgement: Social Proof

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Humans do as other humans do. This tendency has likely been beneficial throughout Man's history (e.g. in running away from an unseen predator because everyone else is doing it), but it causes some intriguing actions. For example, psychology professors have observed men turning around and facing backwards in elevators after the others (in collusion as part of the experiment) in the elevator have done so. Social-proof tendency has also been frequently used to cause subjects of experiments to make wild measurement errors simply because they trust the group's conclusions more than their own.

Munger sees this tendency often in the business world. When one management purchases a mining company, the competitor's management will seek to follow suit. When several competitors are involved, this often leads to a bidding war and the overvaluation of target companies beyond logic.

Not only negative actions are contagious, however; both good and bad behaviours are copied as a result of social proof. Therefore, Munger stresses the importance for human societies to stop bad behaviour as well as stress/display good behaviour. Furthermore, it is not only actions that serve to perpetuate social proof, but also inaction. Munger sees many companies' boards of directors as excellent examples of copied inaction leading to detriment: many directors fail to object to the group's line of thought until some form of public embarassment has been felt.

Munger finishes his thoughts of this tendency by offering the following advice to readers: "Learn how to ignore the examples from others when they are wrong, because few skills are more worth having."

Friday, July 10, 2009

Karsan Value Funds: 2009 Q2 results

Although the Q2 period covers the days between the beginning of April and the end of June, because the fund is in its infancy (it launched June 1st), the period covered here is only one month. Also, considering the fact that the fund is of a long-term nature (i.e. not looking for quick, in-and-out-like trading profits), monthly reports are particularly unrevealing. Nevertheless, it is important that investors receive timely updates on their investments, and this will serve as the first such update.

The market value of one share of KVF rose by 0.25% over the month of June (compared to a -2.4% return of the benchmark index) bringing the value of each share to $10.03 versus the opening share value of $10.00. While it would be nice to say that the average stock in KVF increased by almost 3% in the month as compared to the benchmark, this was not the case. Portfolio returns were aided by favourable currency movements between the Canadian and US dollars. There are no plans for the fund to hedge USD/CAD currency fluctuations. As such, currency movements could affect returns over short periods, but are not likely to be a factor over the long term.

The top performing stock in the portfolio was up 18.1%, while the least performing stock dropped 7.3%. As perverse as it may sound, this dropping stock is good news for the fund's long-term returns, since it offers up an excellent security at better prices. The fund's balance sheet and income statement are included below. (Note that securities are classified as 'held for trading' for accounting purposes and are thus listed at market value, with unrealized gains and losses included in the income statement.)

Thursday, July 9, 2009

Building Profits One Site At A Time

KSW Inc. (KSW) provides ventilation and piping systems to owners of industrial, commercial and residential buildings in New York City. This is an inherently cyclical business, as the company is reliant to a large extent on new construction in pretty much the only city in which it operates, and new construction fluctuates dramatically depending on the economy's state. A look at KSW's highly cyclical revenue over the business cycle is depicted below:

The dramatic fall in revenues following the last recession might be exaggerated to some extent: while we give a lot of flak to companies for blaming "one-time" events (which actually tend to re-occur) for revenue/earnings shortfalls, if there ever was a good "one-time" excuse for a company in NYC reliant on construction, September 11th is it.

Nevertheless, the nature of the company's business is still cyclical: the company's backlog has been dropping fast, as several buildings contracted for development have been delayed or scrapped due to the recession. Therefore, what's important to consider is the company's lasting power, as measured by the flexibility of its cost structure. In the case of KSW, fixed costs are a small percentage of operations, as the company only purchases what it needs to install (therefore costs are largely variable) resulting in fixed assets comprising only a fraction of the company's total assets. Furthermore, debt servicing requirements are minimal, as the company has a debt position of $1 million, an amount which is dwarfed by its cash holdings of $17 million.

The stock, however, has been pummelled by the market, and trades for less than the company's cash on hand. Considering the fact that the company has a flexible cost structure and a cash position greater than its market price, investors are being offered the company's future earnings for free.

Disclosure: Author has a long position in shares of KSW

Wednesday, July 8, 2009

Profits Are Profits

When companies report earnings, analysts will often focus on how profit expectations were met, rather than what those numbers are. For example, even if a company beats earnings expectations, if revenues came in lower than expected, this is often viewed as a bearish sign. Similarly, earnings misses accompanied by higher revenues are often considered positive. However, this line of thinking sorely underestimates the value of a flexible cost structure.

After all, if profit expectations were beaten while revenue came in lower than expected, this means that costs were likely much lower than expected. A company that can control its costs is a company that can outlast its competitors when revenues unexpectedly fall, as they often do in recessions.

Furthermore, higher revenues and in-line earnings suggest that margins have degraded. This could be a sign that the company has had to offer incentives to customers in order to move products. Instead, investors should look for companies that have the ability to reduce or increase costs depending on revenues. This leads to higher predictability and therefore higher accuracy in determining whether a margin of safety exists.

As an example, consider Goodfellow (GDL), a stock we have discussed on this site as a potential value investment. In its most recent quarterly results ended May 31st, revenues dipped by about 15% from year-ago levels. Yet the company showed profits of 24 cents per share versus 20 cents one year ago. How did it do this? By paying down debt (and therefore reducing interest costs) and by slashing operating expenses: gross margin actually increased which is very rare when revenues decline, as fixed costs are spread out across fewer sold units.

One thing to keep in mind, however, is that revenues are more difficult (for managements) to manipulate than costs. However, manipulating revenues is far from unheard of, and as long as the assumptions used to calculate costs are reasonable, the arguments in this article still hold.

For a discussion on various points to consider when analyzing a company's cost structure, see here.

Tuesday, July 7, 2009

Price and Book Volatility

Last week, we looked at the historical price to book value of Melcor, and noticed that it sells today near historic lows. While this may suggest a buying opportunity to some, many would argue that varying levels of price to book ratios are appropriate based on changing expectations for the value of Melcor's book value. For example, if real estate prices are expected to increase, price to book values should be higher, since the company will experience gains as it sells land for higher than it is booked. Conversely, if prices are expected to contract, writedowns to book value should be expected, and therefore investors should only purchase at a discount to book value.

By separating out the components of P/B, we can get a good idea of whether this is what's driving the dramatic changes in Melcor's P/B (values in $millions):

Clearly, whether times are good or bad, Melcor's book value does not change dramatically. Even through this most recent downturn, which hit Western Canadian real estate prices hard due to their local economic exposure to commodity prices, Melcor's book value retreated only marginally or stayed flat. Through the commodity and real estate price run up from 2004 to 2007, book values did increase more than normal (as gains were realized), but not nearly enough to justify the dramatic price increases which made this stock fiercely overpriced!

Indeed, it would appear that while the market appears able to predict the direction of book values, it overreacts both when book values are rising and when they are not. This theme is not specific to Melcor. As we saw when we looked at several major US homebuilders, during times like these the market will often offer real estate at large discounts which are more than enough to offset any upcoming writedowns.

Determining whether a company or industry is historically cheap by looking at P/B values is not limited to home builders. We have previously seen how the relative valuations of banks can also be judged on this basis.

Disclosure: Author has a long position in MRD

Monday, July 6, 2009


Whether managing their own money, or having given it to a professional, investors want to know if the time/money/effort spent on security selection is worthwhile. To do that, a logical approach is to compare results with those of an appropriate benchmark. But what is an appropriate benchmark? The answer will vary by portfolio. For a small, value-oriented fund such as Karsan Value Funds (discussed here), the most appropriate benchmark may be the Russell 2000.

There are many sector-specific indexes for funds that operate within specific industries (for example, for portfolios that focus on alternative energy stocks, there's the S&P Clean Energy Index). There are few such indexes for funds that avoid certain sectors, however; but many value funds may tend to do just that, by staying away from commodities or financials or other sectors with high unpredictability.

As such, Karsan Value Funds may best be benchmarked against a general index. While indices that are covered often by the major media may make for the easiest comparisons, not every general index is appropriate. As we saw here, both the Dow Jones Industrials and the S&P 500 make for poor proxies, each for their own reasons.

The Russell 2000, on the other hand, is recognized enough for investors to find credible, yet it has a median market cap of just $325 million, which serves as an appropriate benchmark for a general fund that focuses on smaller companies.

Of course, even if an investor disagrees with the benchmark a fund manager has chosen, he is free to compare the fund's returns to a benchmark of his choosing. No matter what benchmark is chosen, however, an appropriate time frame must be applied (comparisons should be made over years, not months), whether results are negative or positive.

Sunday, July 5, 2009

The Psychology Of Human Misjudgement: Deprival

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

The tendency that Munger describes as "deprival" is the human tendency to hate losing more than liking winning. For example, the loss of a ten dollar bill seems to hurt much more than a gain of ten dollars seems to help.

The problem with this tendency is that man misprioritizes his problems. For example, a man with a brokerage account containing $10 million will agonize over missing $100 from his wallet. This irrational tendency to be intensely focused on small losses, whether to property, friendship, territory, status or other valued items is quite normal.

Munger notes that this tendency has ghastly effects in labour relations. When a corporation is in trouble, workers find it very difficult to give up benefits they currently enjoy, even if it is in everyone's best interest to do so (to make the company more competitive). As a result, many companies go bust when, had rational thinking prevailed, the situation could have been corrected.

This tendency also causes the form of business failure that encourages otherwise wise men to use up good assets in fruitless attempts to rescue a venture gone bad. Munger also believes this tendency is what drives gamblers towards ruin: once he has suffered a loss, the gambler becomes obsessed with breaking even in order to recover that loss. Being cognizant of this tendency can help one focus on making rational decisions rather than throwing good money after bad.

Saturday, July 4, 2009

The Psychology Of Human Misjudgement: Over-optimism

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Munger starts his description of man's tendency to be over-optimistic by quoting the Greek orator Demosthenes, who said "What a man wishes, that also will he believe." In addition to psychologically denying when things are going badly, man will tend to be overly optimistic when things go well.

For evidence of this tendency, Munger points to people happily buying lottery tickets despite having the odds stacked against them. People also believe in new business ideas that are often poor substitutes for efficient, existing companies.

Munger believes that while this tendency has likely been helpful for evolutionary reasons, it is best to approach issues more objectively. To do so, individuals are encouraged to make more use of the simple, high-school level, probability math of Fermat and Pascal. Munger likens avoiding the antidote to this tendency (the antidote being habitual use of probabilities) to letting natural evolution determine one's golf grip rather than taking golf lessons.

Friday, July 3, 2009

The Psychology Of Human Misjudgment: Excessive Self-Regard

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies (without having to grab an online psychology degree), we better equip ourselves to avoid psychological biases when investing.

Ninety-percent of Swedish drivers believe themselves to be above average drivers. This is an example of the tendency of man to overrate his own abilities. This tendency can also be extended to man's possessions: once a man owns something, he places a higher value on its worth than he otherwise would.

The repercussions of this tendency are visible in various forms. Lotteries where gamblers can pick their own numbers (as opposed to being offered a random set) are bigger draws. Man will also strongly prefer people like himself. In a "lost-wallet" experiment, subjects were found to be more likely to return a wallet to a stranger when that stranger resembled the subject.

In business, excesses of self-regard can often cause poor hiring decisions. (The hirer believes in his superior ability to select a candidate in a face-to-face, and therefore ignores more objective measures of a candidate's value.) Munger actually points to the hiring of the well-spoken Carly Fiorina as CEO of Hewlett-Packard as an example of a mistake due to this tendency.

Munger argues that the best antidote to falling victim to this tendency is to try to think objectively about oneself, one's family and one's possessions. While this is not easy, it is far preferable than allowing one's psychological biases to control one's thoughts.

Thursday, July 2, 2009

Doing Your Homework

Investors who buy stocks without reading the company's disclosures leave themselves open to risks of which they are not even aware. Consider Escalade (ESCA), a diversified producer of sporting goods and office equipment.

Escalade is cheap across a variety of metrics. It trades for just $10 million, despite having operating income exceeding $10 million in each of the years 2005, 2006 and 2007. Though the recession turned results negative in 2008, the company has cut costs aggressively and has a good chance of turning a profit in 2009. The company trades with a price to book value of just .12!

But the following tidbit from the company's annual report highlights a very important risk for shareholders:

"The Company is considering the potential for voluntary delisting of its common stock with NASDAQ".

Why might they be considering this?

"In complying with those reporting obligations and the additional requirements imposed upon public companies pursuant to the Sarbanes-Oxley Act of 2002, the Company incurs significant annual out-of-pocket costs. In addition, the time and attention required of management to comply with all such requirements is substantial."

Public companies usually have higher valuations than private companies, because the shares are more liquid, more accessible, and the reporting/compliance requirements instill a level of trust from the point of view of investors. Escalade's management doesn't appear too pleased with the current valuation, however:

"As a small public company, particularly in light of recent economic conditions, the Company has not been able to take full advantage of the potential benefits of being public yet must continue to satisfy all of the requirements to remain a public company."

The company ends this paragraph with a major understatement:

"No final decisions have been made in this regard, but such actions would have a material impact on stockholders if taken."

While the risk of delisting may not prevent some investors from being interested in a cheap-looking stock, for others this falls outside the bounds of what is considered an acceptable investment. As such, it is important that investors read a company's disclosures before deciding to invest, lest they be caught unaware of a potentially detrimental future event.

Disclosure: None

Wednesday, July 1, 2009

The Fund

I am pleased today to announce the launch of Karsan Value Funds (KVF), a long-term oriented, value investment fund that I will manage. The fund will take equity positions in public companies which trade at discounts to their intrinsic values and where downside risk is low compared to upside potential.

As it can take many years for such companies to return to trading at their intrinsic values, the investment horizon of the fund is of a long-term nature. To that end, investors will be discouraged from short-term dispositions of their securities. Investors will also be unable to sell securities to anyone other than the fund, since new investors may not fully understand the partnership's strategy, and there are certain legal restrictions.

Although the fund will report financial results every quarter, emphasis will be placed on long-term returns, not quarterly results. The fund will likely start out with a capitalization of approximately $400K. As such, using a registered dealer, registering as a dealer, or issuing a prospectus will be prohibitively expensive in the initial year(s). Therefore, the fund's shares are not currently available to the public.

We look forward to providing more information and publishing the first set of results in the near future. Of course, I am always looking for new ideas. If you have any stocks you favour that you believe may fit the investing profile of the fund described above, I'd be happy to hear about them in the comments section. Happy investing!