Monday, August 31, 2009

Earnings Capacity: An Example

Last week, we discussed a method for estimating a company's earnings power after it has undergone a restructuring. In such cases, the company's past earnings may not serve as the best proxy for its future earnings, as capacity reductions shrink the company's ability to derive profits. Today, we apply this methodology to a company that fits this criteria.

LCA-Vision (LCAV) provides laser vision corrective surgeries at its LasikPlus locations. This elective surgery has a very cyclical demand structure that closely mimics consumer confidence indices. As such, demand for this surgery has dropped considerably in the last year, in keeping with its correlation to consumer confidence levels. As a result, LCAV has had to close several locations.

Seeing as how the company no longer has the same capacity to earn as it did last year, investors must recognize this or risk overpaying as a result of overestimating the company's profit potential. To estimate the company's current earnings capacity (for which the company's current earnings are not an adequate proxy, due to demand shocks and severance/impairment charges), we look at the company's historical return on its fixed assets. We use fixed assets instead of total assets, since items in total assets such as cash and prepaid expenses don't have much effect on earnings yet they have comprised a relatively large portion of this company's assets in the past.

Over the last business cycle, LCAV's annual operating earnings have averaged around 20% of its net fixed assets. Since the company has closed locations and reduced the number of services it offers, its net fixed assets have dropped from about $120 million to just $90 million. Applying the 20% returns suggests the company current operating earnings power is around $18 million.

Of course, this analysis serves only as an estimate and contains many assumptions. For one thing, it assumes business conditions in the next earnings cycle will mimic those of the last cycle. However, strong economic conditions may not return as fast as they did in the last cycle, and competitive pressures may increase. As such, the investor must make adjustments to this rudimentary estimate. Net fixed assets are also subject to accounting estimates and management judgments, both of which can distort the calculation. Furthermore, not all fixed assets earn returns, as companies utilize certain portions for corporate use.

However, this estimate does serve as a useful starting point in estimating a company's earnings power, which is an important step in determining the intrinsic value of a stock.

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

Disclosure: Author has a long position in shares of LCAV

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Sunday, August 30, 2009

The Dhandho Investor: Chapter 7

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

Now that Pabrai has established that the best place to look for returns is in the stock market, he turns his attention to discussing why investors should restrict their investments to simple and predictable companies.

A stock will sell on the market for a particular value. The investor must compare this selling price to the actual worth of the underlying business. The worth of the underlying business is determined based on the business' future cash inflows and outflows.

To demonstrate this, Pabrai takes the reader through a quick valuation of Bed, Bath and Beyond in 2006. While the stock sells with a market value of about $11 billion, the estimate of the worth of the underlying business conducted by Pabrai reveals the company is probably worth between $8 billion and $20 billion. As such, this investment should not excite the reader much.

By changing the expected estimates of the cash inflows and outflows of a business, however, its valuation can change dramatically. It is for this reason that it is of utmost importance to stick to simple and easy-to-understand businesses. If a business' future can be predicted, an investor can calculate its intrinsic value with more accuracy. In turn, this allows the investor to know that he is buying a company at a discount.

Saturday, August 29, 2009

The Dhandho Investor: Chapter 6

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

Of all of the asset classes that investors have the option in which to invest, Pabrai argues that common stocks have proven to offer the best returns. While investors also have the option of buying (and selling) individual businesses, Pabrai offers the following advantages of the stock market:

  1. With an entire business, you have to run it, or find someone who can. To be successful, this requires an enormous amount of dedication.
  2. In the stock market, you're buying a business that is already staffed, yet you still get to share in the earnings.
  3. With whole businesses, often the sellers know a lot more about the business than the buyers, and furthermore the prices offered are not usually as attractive as they can be in the stock market.
  4. Buying an entire business requires a large investment. In the stock market, however, you can start with just a tiny amount of capital, and add to that capital over the years - a tremendous advantage.
  5. The selection offered to buyers of private businesses does not compare to that offered by the stock market. With a few brokerage accounts, the investor has the option to purchase from 100,000 companies worldwide. On the other hand, how many private businesses are for sale with a 25 mile radius of the investor?
  6. In the purchase of a private business, transaction costs can add a good 5 to 10% to the price of the transaction. The frictional costs in the stock market, however, even for an extremely active investor, are extraordinarily low.
As long as investors follow the "Dhandho" approach to investing (as described in the previous and subsequent chapters), the stock market offers the best potential for realizing excellent returns on investment.

Friday, August 28, 2009

Smells Like Value

Parlux (PARL) originates, markets and distributes "prestige" fragrances licensed from celebrities. The company pays royalties to Paris Hilton, Kanye West and other celebrities to sell perfumes headlined with these stars' names.

While the company has been through some rocky times (its subsequently-departed president actually won the award of "Worst CEO" in 2006), the company appears to be back on track. Sales were up last quarter (year over year) in a very tough retail environment, and costs were lower. Sales are expected to be up this quarter as well, as the company has been hard at work bringing in new celebrity fragrances that augment and diversify its product portfolio.

It's not clear that customers will embrace PARL's new products. But what is clear is that PARL is priced such that investors don't have to pay for these profits: the company trades for just $40 million, while it has net current assets of $100 million.

The company does, however, have some risk factors to consider. For one thing, it is owed $10 million by a related retailer that has defaulted on some payments. Furthermore, its rather large inventory of GUESS products ($20 million+) may have to be destroyed if not sold in the next six months. The company has also maxed out its current loan agreements (at $6 million) and is trying to find a new source of debt financing. Finally, while there are just 20 million shares outstanding, there are warrants outstanding for another 5 million shares.

Despite these risks, the market appears to have overpunished this stock. A reading of the notes to the financial statements reveals that 4 million of the outstanding warrants have a strike price of $5, meaning the current price would have to more than double before current shareholders are affected. Furthermore, even after writing off all moneys owed by Perfumania ($10 million) and all inventory related to GUESS ($20 million), the company still offers investors a generous margin of safety. While it's not neccessary that the company execute successfully on its new brands in order for the current shareholder to be rewarded, such success could serve to generate outstanding returns at the current stock price.

Disclosure: Author has a long position in shares of PARL

Thursday, August 27, 2009

Earnings Capacity

As demand fluctuates, companies with variable costs can scale up or scale down their operations as neccessary. Companies with fixed-costs, however, have tougher decisions to make. While they can cut costs by disposing assets in the face of waning demand, this ends up reducing capacity, which can bite them later. Over the course of this recession, many companies with high fixed costs that have earned tremendous profits over the last several years have had to dispose of assets at fire-sale prices in order to better align expenses with revenues. For the investor assessing whether a company's stock price trades at a discount to its intrinsic value, how is he to determine a company's earnings power in the face of such asset impairments and plant shutdowns?

For companies in stable industries, we have advocated employing Ben Graham's approach to determining a company's earnings power. While this approach of using a company's average earnings over a representative period is appropriate when the level of assets has not changed substantially, it may not be as useful at a time like this when companies are disposing of significant amounts of fixed assets.

Using the company's current earnings is also not an appropriate measure of a company's future earnings power. Current earnings are riddled with red ink due to current charges for labour reduction programs, asset impairments, and revenue drops that outpaced cost reductions.

While not perfect, a better method to estimating a company's future earnings power when assets have been impaired is by examining the company's record of return on assets. Provided the company is in an industry where technological advances are slow and where prices are stable, there will be, at the very least, a loose relationship between a company's earnings and its assets. By averaging a company's past return on assets over a representative period, and then applying this return to the company's current level of assets, the investor can get a better idea of the company's earnings power than if he estimated earnings power by simply extrapolating the company's current earnings, which are influenced by temporary effects.

The importance of limiting the application of this procedure to companies with price stability can not be stressed enough. For companies in commodity industries with volatile pricing, past returns are not neccessarily reflective of future earnings, and therefore the accuracy of this method reduces to the point where its usefulness is rather limited.

However, even if applied appropriately, it is important to note that this method of calculating a company's earnings power is by no means an exact science. Earnings will rarely be exactly proportional to a company's level of assets. However, for companies in slow-changing industries where price levels remain stable, an examination of the relationship between earnings and assets should assist the investor in making a more informed decision about the earnings power of a company under examination as a potential investment.

For a more advanced exercise, investors considering an investment in a capital intensive business may also try replacing return on assets with return on fixed assets.

Disclosure: None

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Wednesday, August 26, 2009

Not Sharing The Gains

For most companies, both income gains and income losses are attenuated to a large extent by taxes. In this regard, the government acts as a business partner, reducing the risk of loss in any one period (as long as offsetting gains were achieved in the recent past or can be achieved in the future!), but also sharing in the gains. But in certain situations, investors can sometimes stumble upon companies that do not have to share such gains.

Consider Key Tronic (KTCC), a designer and manufacturer of keyboards and other computer input devices. Over the last 8 years (including this one), Key Tronic has been profitable, as it has garnered business from original equipment manufacturers participating in a trend towards low-cost outsourcing. But Key Tronic has barely paid any taxes over that period. In fact, due to a storied past, Key Tronic has net operating loss carryforwards (i.e. losses that can be applied to future income for the purposes of calculating taxes) of over $40 million. The company's market cap is only half of that, as it earned about $1.5 million this year!

Some of these carryforwards expire every year, but management believes it will be able to apply most of those losses, reducing the company's tax rate considerably. For many companies, every dollar of operating income translates to about 65 cents of income. For this company, each dollar of operating income translates directly into a dollar of income, representing a 50% bonus to shareholders! Such future benefits should have the company trading at a premium to its peers, yet this company trades at a discount to its net current assets.

By going beyond a company's headlines and by reading the notes behind a company's financial statements, investors put themselves in a position to find value that would otherwise go uncovered. Tax-loss carryforwards represent just one of the many useful items investors can find in the notes to the financial statements.

Disclosure: Author has a long position in shares of KTCC

Tuesday, August 25, 2009

Price vs Value

Hardinge (HDNG) and Hurco (HURC) both design and manufacture computerized machine tools. During downturns, one of the most common decisions undertaken by companies looking to preserve capital is cutting capital expenditures. As such, both of these companies operate in very cyclical industries and therefore do not carry much debt. While these companies have some important differences between them, their approximate returns on invested capital are compared below to illustrate a point:

In the last several years, HURC has managed to generate solid returns while HDNG has struggled even during periods of relatively strong macroeconomic growth. Over the period displayed above, HDNG returned an average of 3.7% on its invested capital while HURC returned an average of 10.4%, meaning HURC was able to generate more income out of its assets.

While HURC appears to be the better run company, which one is the better investment? "Buy best of breed companies" is the oft-repeated investing mantra that many investors blindly follow. But what this advice fails to take into consideration is the asking price: while HURC trades for its book value, HDNG trades at about a 60% discount to its book value. Therefore, if the businesses perform the same as they have in the past, buyers of HDNG will see similar returns on their investments as will buyers of HURC, thanks to the discount being offered on HDNG's book value.

But what if returns are not the same? HDNG has recently taken on new management following its poor performance and is in the process of attempting to improve its cost structure. Should the company increase efficiencies such that returns on capital return to respectable levels, shareholders should see enormous price appreciation as the current discount is erased. But what if returns should fall? Fortunately, at this price, investors are protected by the company's cash, inventory and accounts receivable, which sum to a level higher than the current stock price, even after subtracting all liabilities.

Neither company will likely see its sales levels grow for some time, as their customers continue to cut expenditures to boost their bottom lines. But from a business value standpoint, one company does appear to offer an enticing price to long-term investors, even though it has been a poor performer. But investors needn't bet on a turnaround, as the discount to book already offers investors the prospects of decent returns, while a margin of safety exists such that capital appears to be relatively safe. We have previously seen another example of this phenomenon as Office Depot traded at a massive discount while best-of-breed Staples maintained a fair price level.

Disclosure: Author has a long position in shares of HDNG

Monday, August 24, 2009

Illogical OrthoLogic

The number one rule of value investing (as coined by Warren Buffett) is: Don't lose money. Hence the appeal of net-nets (stocks trading below their net current asset values), since they offer a dollar of tangible, liquid assets at a discount. But that number one rule is at a high risk of being violated if the net-net under consideration does not even have an established or proven business model.

Consider OrthoLogic (CAPS), a biotechnology company. It trades for $28 million despite having minimal liabilities and a cash balance above $40 million. The company has been around for a number of years, but investors must be careful to note a significant change in its business lines. In 2003, the company sold its revenue generating segment and decided to focus on developing therapeutic peptides. As a result, the company has had no revenue for the last several years. Furthermore, the company intends to keep investing in R&D to push one of its products to market.

In essence, an investment in CAPS represents purchasing a startup. Despite the fact that CAPS is a net-net, it is clearly not a value investment. Investors in startups tend to be venture capitalists with deep industry expertise who are willing to accept the risk of loss. Value investors, on the other hand, make money by making it a priority not to lose money.

While investors are offered the opportunity to buy a company that has done extensive research for only a fraction of what that research originally cost, the future is still very much in doubt. Despite the fact that the possibility exists that the company will eventually be successful and see its profits soar, the possibility also exists that the company will continue to burn cash until there is none left. Value investors look for asymmetries between the downside risk and the upside reward; unfortunately, this stock could go either way.

Disclosure: None

Sunday, August 23, 2009

The Dhandho Investor: Chapter 5

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

While the low-risk / high-reward businesses described in the first four chapters were varied in type, they did share some commonalities. These commonalities form the basis for the rest of the book, where Pabrai discusses these features in detail:
  1. Buy an existing business: each of the businesses described in the first four chapters had defined business models; nothing new was being invented.
  2. Buy businesses in simple industries with a low rate of change: all of the businesses described were necessary and were not about to be replaced.
  3. Buy distressed businesses in distressed industries: the very best time to buy a business is when it is hated and unloved.
  4. Buy businesses with a durable competitive advantage: this advantage can come from being low-cost to having a brand to having captive customers.
  5. Bet heavily when the odds are in your favour: in the businesses described, sometimes the investor did not make moves for several years, but when the opportunity was clear (odds in favour, with excellent returns), he invested much.
  6. Focus on arbitrage: in all cases, the investors saw a discrepancy between price and value that they exploited.
  7. Buy businesses at big discounts to their intrinsic values: the odds of a permanent loss are low when this approach is followed.
  8. Look for low-risk, high-uncertainty businesses: the uncertainty leads to severely depressed prices.
  9. It's better to be a copycat than an innovator: "innovation is a crapshoot, but scaling carries far lower risk."

Saturday, August 22, 2009

The Dhandho Investor: Chapter 4

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

In 2005, Forbes listed Lakshmi Mittal as the third richest man in the world. Unlike many others on the rich list, Mittal operated in an industry with extremely poor returns on capital - steel mills. As an owner of a steel mill, you have no control over the selling price of your products, and in order to have theh capacity to keep producing your end product, you need a constant supply of capital. As a result, the steel industry has been one of the worst places to invest over the last few decades, with bankruptcies abound around every corner.

Mittal was able to transform his steel mills into efficient steel-producing machines. But if he had grown organically, he likely would never have managed to get his net worth to $20 billion. Instead, he grew by acquiring steel mills that were going under. In some cases, he was acquiring for 10 cents what other investors had built for $1. Once he applied his operational efficiencies to the plants, he had restored the value of the assets to $1 or more, thus generating incredible returns on investment. Once again, Pabrai's "Dhandho" theme echoes through: the downside is minimal, and the upside is tremendous.

Pabrai also takes us the reader through his own experience applying "Dhandho". When he started his business, he had $30K in cash, and $70K in credit card maximums. If his investment went south, he would have to declare bankruptcy and will have lost $30K and would simply have returned to his old job. In other words, his downside risk was minimal. But his upside was not. Within a few years, he had sold his business for several million dollars. This represents another example of Pabrai's "Heads, I win; Tails, I don't lose much" philosophy.

Friday, August 21, 2009

Counting (On) Inventory

EF Johnson (EFJI) designs and markets wireless communication devices. Even before the economic storm, the company had been losing money, as it has reported negative operating income in each of the last three years. As a result of these losses, the company's market value has fallen tremendously: the company trades for just $20 million, while its net current assets (current assets minus total liabilities) are almost $40 million.

In the past, we have discussed why not every company that trades at a discount to its net current assets warrants an investment. After all, if a company is burning through its assets (i.e. losing money), then the net current asset value is a moving target...downward. But in the case of EFJI, it may have been able to turn things around. The company managed to turn a profit in its latest quarter, and has dramatically reduced expenses while at the same time maintaining strong levels of R&D.

But the fact that the company may be profitable in the future is not enough. After all, the benefits of being able to buy a company at a discount to its liquid assets are only as good as the liquid assets themselves. In the case of EFJI, inventory is by far the largest single component of its current assets, making up $34 million dollars of its $40 million in net current assets.

For companies in slow-changing industries (e.g. for a net-net that sells screws, bolts and other standard supplies), the inventory level can be more readily trusted. For companies in high-tech fields, however, the value of the inventory is much more in question. In the case of EFJI, management has already reduced its inventory value by $4 million due to obsolescence. With order backlog levels far lower than they have been in years, the risk of that inventory becoming even more obsolete increases further.

For some investors, the products this company makes may fall within their circle of competence such that they can estimate the value of this company's inventory with some level of certainty. For the rest of us, however, it is better to focus on companies for which we can estimate their values with more confidence. In this way, we know that we are getting a good deal.

Disclosure: None

Thursday, August 20, 2009

Acquisitions Gone Right

On this site, we have been pretty wary of companies that use cash to fund acquisitions...cash that could have otherwise been returned to shareholders. We've highlighted a few companies that, while they look cheap, have squandered more on bad acquisitions than they have earned over the last decade, which doesn't bode well for current shareholders unless the company has changed how it allocates capital. But that doesn't mean all acquisitions are bad. When management makes smart decisions when it comes to acquiring other companies, shareholder value is enhanced.

Consider Dorel (DIIB), a designer and manufacturer of bicycles and various juvenile products. When we last looked at this company, its sales were suffering due to the fact that retailers were reducing inventories (2008 Q4). Nevertheless, the company remained profitable. Some of its competitors had not been able to maintain profits, however, and some of them found themselves overleveraged. Dorel has taken advantage of the situation, as it has purchased the assets of companies that have gone bankrupt.

The best acquisitions are not those made in overheated economies through massive bidding wars comprising several suitors; rather, they are made when nobody has the money to buy and when the target is in dire need of immediate financial assistance. These acquisitions position Dorel to continue to grow even if the economy does not.

In previous articles, we've discussed some ways of detecting whether a company's acquisitions have been squandering cash. Acquisitions made on good terms for the buyer, however, can lead to awesome profit opportunities. Companies with strong balance sheets that are able to take advantage of the current economic situation position themselves to be the leaders of tomorrow.

Disclosure: Author has a long position in shares of DIIB

Wednesday, August 19, 2009

Buying Back At The Wrong Price

Stock buybacks have their advantages. In many cases, their tax treatment is more favourable to investors than are dividends. Furthermore, buybacks are not expected to be as regular as dividends, and therefore they offer more flexibility to companies (i.e. when a company has business opportunities, it can invest, and when it doesn't, it can pay out).

But as investors, we are conditioned to believe that the announcement of share buybacks is good news for a company, the prevailing wisdom being that such an announcement represents management's confidence in the fact that the share price is undervalued.

While these arguments are almost always completely accepted by shareholders, the investor must consider the fact that management and shareholder interests do not always align (as discussed here), resulting in a great deal of cases where buybacks actually destroy shareholder value rather than create it.

Consider a company which pays its management in stock options (indeed it is rare
not to find such a company today). If management were to pay a dividend, shareholders would receive cash, but the value of management's options would drop. (For an explanation of this phenomenon, see this discussion.) On the other hand, when a company buys back and cancels its own shares, each share ends up owning a proportionately larger amount of the company, which
can result in an increase in the value of an option. Managements may have no malicious intent, yet it is nevertheless impossible for their actions to be completely detached from their personal well-being.

Stock options aside, managements are in their positions because of their abilities in running the operations of the business. They are not experts at capital allocation, nor are they good predictors in the field of macroeconomics. Yet when they buy back shares at certain times but don't at others, they are implying that they can allocate capital better than shareholders. Rather than give the cash to the shareholder, at which point the shareholder can decide what's best for himself, management has made this decision for him.
As an example, here is a look at the dividends and buybacks of the four quarters ending mid-2008 for some of America's most prominent retailers. The dividends are small, but the buybacks are enormous. Unfortunately, investors would have been much better off with the cash in their hands. The chart shows what the dividend yield would have been had the money used for buybacks been paid out. It also shows the average price at which companies bought back shares, and compares it to their current prices:

Each of these companies save for Wal-Mart (NYSE: WMT) paid significant premiums over the current stock price. In the case of Home Depot (NYSE: HD), had it paid out the cash used in its buyback, the dividend yield would have represented a staggering 27% of the current stock price. Certainly, this dividend represented a one-time outlay and is not sustainable, but it would have represented a shareholder-friendly action from a company looking to regain shareholder confidence after a difficult few years.

But this chart only shows the premium these companies paid over their
current stock prices. During the stock market lows of late 2008 and early 2009, their prices dropped even lower. Nevertheless, most of these companies did not buy back a single share in the first half of this year, with Walmart being the exception once again.

This process of buying high and not-buying low has cost shareholders dearly. This shows all too clearly that managements are not proficient capital allocators and are no better at timing the market than anybody else, despite their inside knowledge. As such, managements should focus on operations, and direct free cash flow (i.e. cash earned above what is required for capital expenditures) into the hands of shareholders as it is earned, rather than trying to time the market.

Tuesday, August 18, 2009

Humble Humboldt

KHD Humboldt Wedag (KHD) is an international industrial engineering and equipment supplier for the cement processing industry. Thanks to reduced demand for its products due to the recession, the company is pretty close to just breaking even. However, the company has negligible debt and a cash position of about $350 million, yet it trades for just $273 million! Sounds like a steal, right?

Perhaps not. The strangeness of this company's name is matched only by the strangeness of its balance sheet: if one were to remove that net cash balance, the company would have negative equity of about $100 million! Meanwhile, the company is trying to sell its fixed assets in order to raise even more cash. What gives? Can shareholders expect a massive payment?

It would not appear so. KHD appears to operate in such a highly cyclical environment that not only is it not sufficient to not have any debt (as we've discussed is important for cyclical companies), but it needs an extremely large cash buffer to boot!

To understand this phenomenon, we have to understand the cash conversion cycle for this company. When a company contracts KHD to design/build a plant, it makes a large chunk of the payment upfront. KHD doesn't get to count this as revenue yet, since it hasn't performed any services. But using these funds, KHD will pay its suppliers, workers and other expenses associated with performing its end of the contract.

When a cyclical downturn hits, however, not only does it hit hard (order intake in the second quarter was a full 90% lower than that of the year-ago period), but it means there's no cash coming in! Even though KHD will be booking revenue in future quarters as it fulfills its backlog, it won't be receiving cash, but will still be spending cash on its costs.

The highly cyclical nature of this business combined with the fact that cash is paid upfront means there can be long periods of low cash intakes for this company. But during these long periods, the company still has to perform on its end of the contracts. As a result, the company has to maintain a large cash hoard just to stay in business, even though shareholders might think the cash can be paid out! It would appear that sometimes cash is not king: do not automatically believe that companies with strong cash positions offer a margin of safety.

Disclosure: None

Monday, August 17, 2009

When Goodwill Turns Evil

RCM Technologies (RCMT) is an IT and engineering consulting company that warrants strong consideration as an investment. It looks like a bargain at its current price, as the stock trades for $30 million, while the company has $65 million in current assets (mostly in the form of receivables from clients) and just $13 million in total liabilities. The company is also managing to break even, despite the downturn.

The next few quarters are looking up for this company from a profitability standpoint as well, due to the company's ability to match revenues with costs. As a consulting company, the vast majority of RCM's costs are in the form of wages. When billable hours (revenues) drop as they do in downturns, RCM can reduce its labour costs accordingly. As such, while competition and reduced demand could disrupt profitability from quarter to quarter or year to year, the risk that this company could lose money for extended periods of time is quite low.

But there still remains a major red flag with this company: how it handles its profits. In the last 8 years (since the last recession), the company has earned about $50 million in after-tax income from its consulting work. Unfortunately, it has squandered every penny of that money on acquisitions that have ill-performed: Goodwill writedowns amount to over $50 million over that same period.

While most of that Goodwill was written down last year as the recession took hold, it doesn't appear as though management has learnt its lesson. Despite winning a lawsuit for $9 million (or almost one third of its market cap) several months ago, RCM has not announced any plans to distribute that money. In fact, it has continued to acquire companies, as a subsequent event to the second quarter report shows it has already spent some of that cash and issued more shares for the purpose of acquiring another company.

Furthermore, its annual report offers little hope for a change in policy:

The Company has never declared or paid a cash dividend on the Common Stock and does not anticipate paying any cash dividends in the foreseeable future. It is the current policy of the Company’s Board of Directors to retain all earnings to finance the development and expansion of the Company’s business.

Despite the fact that RCM is likely an undervalued company, shareholders may never see a dime. While the company might manage to grow its earnings through acquisition, it's entirely possible that it will squander its earnings in attempting to do so. As such, the risk is there that this promising value stock will never provide value to its shareholders.

Similarly, we recently looked at another company with "unusual" expenses over the years which significantly impacted its valuation.

Disclosure: None

Sunday, August 16, 2009

The Dhandho Investor: Chapter 3

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

In the first two chapters, Pabrai described how hard-working immigrants with few expenses managed to go from poverty to millions over the course of their lifetimes. Is this the only way to make money with little risk? Absolutely not.

In this chapter, Pabrai tells the story of Virgin, and how its founder Richard Branson is also a Dhando investor. Branson has managed to take several business ideas that have come to him over the years, invest in them with minimal risk, and generate high rewards. How has he done this? Pabrai gives details about how Branson:
  • Started Virgin Airlines with a one-year low-cost lease on single airplane
  • Developped Virgin Pulse with guaranteed distribution and outsourced manufacturing
  • Launched Virgin Mobile with no cell-phone network
  • Offered Virgin Mortgage without a banking infrastructure
In all of the cases Pabrai describes, the overriding theme continues to be: "Heads, I win; tails, I don't lose much". Branson's businesses don't take on the risk because they don't require investment in infrastructure. Instead, they leverage existing infrastructure or outsource to other companies that have to take on the risk. What Branson does get, however, is the upside. With that risk-reward profile, Branson is crowned by Pabrai as a Dhandho investor.

Saturday, August 15, 2009

The Dhandho Investor: Chapter 2

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

To dispel the idea that the story described in Chapter 1 was simply a matter of fortunate timing and luck, Pabrai describes another successful entrepreneurial venture where the risks were low but the potential upside was high. The story is that of Manilal Patel, a man who immigrated as an accountant, but could not land a job due to his broken English.

For several years Manilal worked for minimum wage, slowly building wealth while biding his time and searching for a business to own and run. For twenty years he worked nearly around the clock and began to invest in residential real-estate. After September 11th, however, he would get the break he was waiting for. Travel was down, and the hotel market was suffering once again. Manilal was able to take advantage by finding some partners and putting much of his own capital towards the purchase of a Best Western hotel. The hotel required a downpayment of $1.4 million, which Manilal borrowed against his house to help fund.

Pabrai goes into further detail about various scenarios of the hotels return's. But the lessons Pabrai is attempting to illustrate are clear:

1) When a terrific investment opportunity is available, a bigger investment should be made. As Pabrai calls it: "Few bets, big bets, infrequent bets".

2) Participate in investment opportunities that have minimal downside risk but high upside potential: "Heads, I win; Tails, I don't lose much."

Friday, August 14, 2009

Valuation Methodologies

We discuss a lot of big picture items related to individual companies on this site, such as revenue risks, debt levels, and cost structures. What we don't do is get into a lot of details regarding valuations. While we did explore this topic in our chapter-by-chapter summaries of Ben Graham's book Security Analysis, we haven't demonstrated any valuation methodologies applied towards any current companies.

A new site, www.jonathangoldberg.com, aims to fill that void. Jonathan and I received our MBAs from the same school, and therefore we have both taken the same finance and value investing courses. Jonathan has already described some valuation methodologies, and will be demonstrating specific valuations, recommendations and discussions of various companies. Since he will not be posting at regular intervals, readers may prefer to subscribe to his RSS feed so that they are aware of any new articles posted to his site.

Thursday, August 13, 2009

Consumer Debt In A Historical Context

Many economists project a slow recovery from this recession, as consumer spending, which makes up more than two thirds of the economy, is not expected to rebound any time soon. On what basis are economists making these projections? Mounting job losses are a major reason why consumer spending is not expected to be strong, and serves as a risk to the economy going forard as we discussed here. Another reason is that consumers have started to reduce their debt levels (i.e. rather than spending, they are saving).

Last Friday, the Federal Reserve reported that consumer debt levels continued to fall in June. While this de-leveraging of the consumer has been occurring for several months, it still has a long way to go from a historical point of view. The following chart illustrates how consumer debt levels have evolved over the last 70 years:


Clearly, consumer debt levels are quite elevated in a historical context, despite the recent well-publicized reductions. This indicates that there could be more debt reductions in store, which would reduce the consumer's ability to spend.

Will consumer debt return to the levels that they were in the year 2000, when the last recession took place? Nobody really knows. But investors should ensure they are prepared for debts to continue to reduce, by owning companies with flexible cost structures.

Wednesday, August 12, 2009

Getting Dirty With Soapstone

Last week, the shareholders of Soapstone Networks (SOAP) elected to liquidate the company. It was determined that the shareholders of record on Friday, July 31st would receive the final dividend (if any) of the liquidation proceeds, which are expected to be doled out in the first quarter of 2010. On the company's last day of trading on the Nasdaq, SOAP traded for $7 million. Did this represent a value investment?

On its last set of financial statements, SOAP showed $82 million of cash against $3 million of liabilities. But that was before the company paid out a special dividend of $3.75/share, which comes out to about $56 million. So that leaves the company with about $23 million. The latest statements are from March 31st, however, and the company burned about $7 million in the first quarter. Since there was no mention of liquidation in the quarterly report for Q1, it's probably safe to say the company burned some more cash in Q2. If we're conservative and assume the company burned the same amount in Q2 as it did in Q1, that brings our running total to about $16 million.

From these numbers, it would appear as though investors could realize a 100% return in the course of a few months. However, in the interim, the company will also likely have to pay lawyers, consultants, bankers and other fees in order to complete its liquidation. It may also have to pay some amounts to settle some outstanding lawsuits. While these will likely subtract from the cash balance, the company will also have the opportunity to trade some of its property and equipment for cash. This is where someone who knows the value of the assets has an investing advantage.

Will shareholders of record on July 31st make money on their purchase? Probably. But nevertheless, there's a risk involved. If the company's assets fall within the circle of competence of the investor, there may be a margin of safety to be had. Otherwise, it may be more of a speculation play than a value investment.

Disclosure: None

Tuesday, August 11, 2009

Cruising For Profits

Twin Disc (TWIN) manufactures and sells power transmission equipment (torque converters, propellers, clutches etc) to the marine industry. Due to the fixed-cost nature of such heavy manufacturing, one might expect this company to have dipped deeply into the red in its fiscal year ended June, 2009. Indeed, as recently as four weeks ago, the company traded for just $6.50 per share, after earning $2 per share in its 2008 fiscal year!

In the last four weeks, however, the shares have almost doubled, after the company reported earnings per share of $1 for its fiscal year ended June, 2009. But all the signs were there that the company's profitability was more buoyant than its share price. Astute value investors enjoyed the dramatic gains in this company's stock.

What has helped the company stay profitable through this downturn is its diversified customer base. While the mega yacht market may be taking a breather for a while, backlog for military customers has remained strong and in some cases increased from last year.

As evidence of the company's financial viability, its earnings through the first three quarters of fiscal 2009 remained relatively solid. Through the first 9 months of the year, TWIN generated operating income of $14 million; yet its market cap hovered around $70 million just three weeks ago, despite the company's reasonable debt to total capital ratio of 37%.

Despite the market's recent runup, for those looking for value, plenty of gems remain available.

Disclosure: Author has a long position in shares of TWIN

Monday, August 10, 2009

Diamonds: An Investor's Best Friend?

Lazare Kaplan (LKI) acquires, cuts, polishes and sells diamonds to wholesalers and retail jewellers. What makes this company an intriguing value play is the discount at which it sells to its liquid assets. Current assets are $225 million (including $125 million worth of diamonds) versus total liabilities of $169 million, for a difference of $56 million. Meanwhile, the company's market cap is just $19 million. While this may make the company look like a buy on the surface, the power of this company's supplier is a major risk to the future of this stock.

De Beers controls most of the world's diamond supply, and exerts pressure on its customers (cutters like LKI) by only selling diamonds to companies called "sightholders", of which there are approximately 80 companies including LKI. The sightholder contract is only three years long, however, and so it is vital to these 80 companies that they stay in De Beers' good books. As such, their gross margins are low. Perhaps more importantly, however, "In order to maintain their purchasing relationship, [De Beers'] clients have traditionally been expected to purchase substantially all of the diamonds offered to them by the [De Beers]."

During recessions, demand for some items tends to stay relatively stable. Diamonds do not fall in this category, however, as customers downgrade their selections, resulting in lower sales. In the latest quarter, LKI has seen its sales drop by almost 50% year-over-year. Usually, a company with a large inventory can stop making purchases and convert that inventory to cash, thus rewarding shareholders who purchased at a discount to the net current assets. If the excerpt from LKI's annual report in the previous paragraph is correct, however, LKI's actions may be governed by De Beers' best interests, not those of LKI's shareholders. Indeed, despite the major dropoff in sales, LKI's inventory last quarter remained flat, and is 15% above year-ago levels!

While De Beers may in fact stop forcing inventory on its clients considering the drop in demand, banking on this may not be a risk worth taking. Furthermore, if De Beers decides that LKI no longer meets its short list of 80 companies, LKI will have a difficult time sourcing its supply of diamonds. While this stock may be cheap and will likely reward shareholders, there is a risk that things could go south, as De Beers, rather than management, controls the future viability of this business.

Disclosure: None

Sunday, August 9, 2009

The Dhandho Investor: Chapter 1

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

Pabrai starts the book by discussing the term "dhandho" (pronounced "dhun-doe"), which is a Gujerati word meaning "endevours that create wealth" or "business". Gujerat is a coastal province in India that has served as a hotbed for trade with Asia and Africa. The Patels are a subsection of Gujeratis that are particularly entrepreunerial (they were chosen by the rulers to run the operations of the farm and collect the taxes), and their entrepreneurial ventures led to them forming a dominant part of the East African economy by the early 1970s. When Asians were thrown out of Uganda in 1972 on the basis of their race, a flurry of Patel immigrants landed in Canada, England and the United States.

The Patels now make up about 0.2% of the American population. Yet they own over half of the motels in the entire country, which comprises $40 billion in assets and $725 million in annual taxes. Pabrai attributes this to particular conditions which led the Patels to recognize and benefit from the minimal downside risk and upside potential that existed in the motel business when they immigrated to the United States.

The first Patels arrived during a recession. Motel owners were being foreclosed due to low occupancy rates. With just a few thousand dollars in hand, Patels could kill two birds with one stone by finding room and board for their families and a job at the same time by buying a motel. Since the assets are hard, banks would finance 80-90% of the purchase, so the initial investment required was low.

From here, Pabrai discusses some of the financial details that made these investments value investments: low risk (the few thousand dollars initial investment) and high reward (with their low living expenses and hard-working attitude, Patels could make back their initial downpayment in the first four months!). This introduction to low risk / high reward sets the theme for the rest of the book.

Saturday, August 8, 2009

The Psychology Of Human Misjudgement: Lollapalooza Tendency

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.

Lollapalooza tendency is Munger's name to describe the many tendencies already described when they act in concert. When tendencies work together and reinforce each other, extreme outcomes can occur. As examples, Munger cites the Milgram experiments and the formation of cults as extreme outcomes due to the fact that many tendencies are at play.

But according to Munger, most psychology textbooks look at tendencies in oversimplified forms, where other tendencies are not present. In the fields of chemistry and physics, students learn the effects of several forces acting in combination. In the field of psychology, however, Munger believes there is much to be learned by studying the effects of these tendencies when seen in combination.

Munger describes a real world example of how several tendencies acted together to cause an unfortunate event that could have been prevented if antidotes had been applied. At McDonnell Douglas, an evacuation accident causing paralysis was caused by tendencies towards rewards, doubt-avoidance, authority-misinfluence, inconsistency-avoidance, social proof, and deprival.

Munger finishes the talk by making it clear that these tendencies have likely been more helpful than not to mankind over time, or they wouldn't exist. However, that doesn't mean rational individuals can't improve their situations by using antidotes where appropriate.

Friday, August 7, 2009

It Trades For Less Than It Owns

Retail Ventures (RVI) is a holding company that owns 63% of another public company, DSW Inc (DSW). While RVI does have certain liabilities (related to its divestitures of other businesses) and its own corporate costs, its ownership in DSW is now the dominant determinant of RVI's value as a company.

DSW trades on the NYSE for almost $600 million, meaning RVI's ownership share is currently being valued by the market at $368 million. But RVI trades for only $169 million, less than half of its stake in DSW!

Buying RVI stock, however, is not guaranteed to return 100% even if these stocks converge over the next few years. This is due to the fact that it's entirely possible the market is overvaluing DSW and that it's price will eventually come down.

But by simultaneously buying RVI stock and shorting DSW, however, the investor is protecting himself from a decline in the value of DSW. As long as the values in these companies eventually converge, which will happen if RVI starts liquidating its shares or sells its stake in DSW, the investor will make money.

This trade, however, is not without short-term risks. Who knows how long it will take for the prices to eventually converge? In the meantime, the prices of these stocks may diverge even further, testing the mettle of the investor. Furthermore, the investor should understand the complex nature of RVI's other liabilities and expenses, to ensure they are manageable and don't represent a good reason for the price difference.

Investors appear well aware of this opportunity already. The short interest in DSW is 27% of its float, while the comparable number is just 1.5% for RVI. Nevertheless, the price divergence has persisted for many months. How much longer will it last?

We saw another arbitrage opportunity a few weeks ago. Here's how it ended.

Disclosure: None

Thursday, August 6, 2009

Home Builders Stable

The debate on whether the housing market has hit bottom continues to rage. But what makes it even harder to reach consensus is that there are so many definitions on what it means to have hit "bottom" (e.g. prices, sales, starts, completions, homes under construction etc). But one thing that does appear clear is that (in general) home builder book values appear stable. A look at new home inventories reveals new home inventories are as low as they've been in a long time:

When measured per capita, new home inventories are as low as they've been in the last 50 years. Of course, this doesn't mean prices are going to rise any time soon. Continued foreclosures as a result of continued job losses will likely act as a drag on prices. However, these low inventory numbers (which continue to decrease) on new homes suggest the days of massive writedowns are also over. As such, investors can likely trust the book values of most home builders. As we saw earlier, stock prices of home builders tend to rotate around their book values over time, offering profit opportunities for those who buy at discounts.

Of course, this doesn't mean all home builders are safe. Of the list we compiled showing homebuilder debt levels, several have already gone out of business. Further uncertainty also remains for builders who have large payments coming up and/or those who are dependent on specific regions. But for well-capitalized, diversified builders, the worst is likely over, and discounts to book value should serve as opportunities.

Wednesday, August 5, 2009

Risks Going Forward

As the free fall in GDP has ebbed, a certain level of optimism appears to have returned to the market. Corporate earnings in Q2 have also exceeded expectations, further fueling the market's buoyant tendency of late. But going forward, risks to this economy remain. One risk in particular that may be underestimated in the financial media is the unemployment rate.

The rising unemployment rate (US unemployment currently sits at 9.5% and continues to rise) is often dismissed by the media as a "lagging" indicator of the economy and therefore not relevant to deciphering the current economic picture. Historically, businesses have held off shedding workers until after they have been hit by recessions, and they have been reluctant to add employees even as GDP growth has returned, hence the "lag". But an examination of specific factors relevant to this particular recession may reveal some important differences between this recession and the ones of the recent past.

When members of the labour force have lost their jobs in the past, they have been able to draw equity from their homes or borrow in order to maintain spending. While recessions usually have several causes, among the major causes of this recession was a credit crunch and a bursting housing bubble. As such, lending institutions have tightened their standards, and a larger than normal deleveraging has taken place, which suggests the unemployed will act as more of a drag in this recession than in those of the recent past.

Furthermore, while second quarter corporate earnings did come in better than expected, this was primarily due to cost-cutting: while 82% of companies beat the earnings expectations, only 50% of companies beat the revenue expectations. But the cost cuts of one company are the revenue cuts of another. The magnitude and speed of the job cuts in this recession have been particularly harsh. As a result, the rising unemployment rate will act as a drag against the fiscal and monetary stimulus being provided by the government.

Will this drag be enough to cause a double-dip recession? In the near term, it is not clear whether high unemployment will help cause such a dip in the GDP. However, investors should be aware that the risks of this taking place are indeed present, and should therefore avoid getting too carried away with the market's recent runup.

Tuesday, August 4, 2009

Auto Inventories Can't Drop Forever

Like the housing industry, the auto industry is currently in the midst of a cyclical downturn. In a cyclical downturn, a drop in demand (caused by a drop in consumer confidence, for example) leads to bloated inventories, which results in output cuts (plant closures, job losses etc.) as auto manufacturers try to reduce inventories. These output cuts then affect the revenues of all auto parts manufacturers. By tracking auto inventories, we can get a feel for how much longer these depressed revenue levels at auto parts manufacturers will persist.

The following graph depicts auto inventory levels alongside seasonally adjusted annualized auto sales in the US since 1993:

When demand is abnormally higher (or lower) than expected, inventories become depleted (or bloated) as a result. Auto manufacturers adjust output, bringing inventory levels back in line. Clearly, a major adjustment took place in late 2008 and early 2009. Sales seemingly fell off a cliff. As a result, the country was left with a pile of inventory. As retail sales stabilized, however, manufacturers cut output so drastically that even though retail sales remained low, inventories nevertheless fell quickly!

But inventories cannot fall forever. Auto makers will soon have to increase production such that inventory levels stop free falling. When they do, auto parts manufacturers will see their revenues rise. They won't rise to 2007 levels until retail sales show signs of returning to those levels, but they will not stay at their 2009H1 levels either, barring another shock to consumer confidence that causes retail sales to drop even further.

During this process, companies with fixed costs (e.g. debt/pensions/leases) that cannot be met will go bankrupt. Value investors are looking for the companies with the staying power (i.e. the cost structures and low debt levels) that will allow them to pick up this dropped market share and thus benefit disproportionately when output stabilizes.

Source: BEA

Monday, August 3, 2009

Subsequent Events

Investors looking to understand a company's current financial position (i.e. the company's debt levels, its cash balance, what it owns and what it owes) will often flock to the financial statements contained in the company's most recent quarterly report. After all, quarterly financial statements are required to be fairly comprehensive, and therefore contain most of the information an investor needs in order to determine a company's current financial position. However, subsequent events that have occured since the cut-off date of the last financial statements can dramatically alter the value of the company in question. As such, it is important that investors not stop at the statements; subsequent disclosures need to be taken into account.

Consider Fortunet (FNET), creator of gaming platforms and networks for casinos and other customers. Fortunet trades for just $13 million, but is profitable, has no debt, and shows a cash balance of $25 million. This cash balance, however, is as of the latest financial statements. An investor buying in using this information would get a rude awakening in the company's future statements: since the cut-off date for the last financials, the company has issued a special dividend of $28 million!

Existing shareholders have already received this payment. Shareholders buying in now, however, are buying into a company that's $28 million poorer.

To avoid falling prey to such a situation, there are two items investors should check. First, even though the quarterly financial statements have a cutoff date, the text of the quarterly report will contain a section labelled "subsequent events" that contains material information that occurred just after the cutoff date. Secondly, investors should read the company's subsequent disclosures since the quarterly report was issued so that they can include any material changes that have occurred since the quarterly report was issued.

Disclosure: None

Sunday, August 2, 2009

The Psychology Of Human Misjudgement: Reason Respecting

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 enjoy mental exercises, puzzles and games. Munger attributes this to the fact that humans have a natural love for accurate cognition. As such, one of the best ways to convince a man to do something is to explain the reasons for why it must be done.

As an example of this tendency put to great use, Munger describes the philosophy of Carl Braun, the skilled designer of oil refineries. Whenever an order was given within his company, the order must always be accompanied by the reason why. Braun would fire those who didn't give the 'why', because he understood the positive influence it would carry down the line.

Because of this human preference for reason, even meaningless or incorrect reasons will increase compliance. Munger references a psychology experiment where people budge to the front of the line with meaningless excuses that are better received than they should be!

Marketers and various corporate departments will of course use this loophole within this reason-respecting tendency by offering up various claptrap reasons to help them get what they otherwise would not. As such, the student would be wise to investigate/analyze reasons before accepting them as valid.

Saturday, August 1, 2009

The Psychology Of Human Misjudgement: Twaddling

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.

To twaddle: to talk in a trivial, feeble, silly, or tedious manner; prate.
To prattle: to talk in a foolish or simple-minded way; chatter; babble.

Munger clearly does not have much time for twaddlers and prattlers. As a social animal, however, man is prone to twaddle even when serious work is being attempted. But some humans are more prone than others to twaddle, and those are the ones Munger believes should be kept far away.

To make himself appear more tactful, Munger quotes a very blunt Caltech professor who said "The principal job of an academic adminstration is to keep the people who don't matter from interfering with the work of the people that do."

Munger says he has suffered backlash due to the fact that he has expressed his view on this subject. Munger tells the story of a honeybee in an experiment who tried to convey the location of nectar to the other bees. Typically, the honeybee's dance serves as a map for the other bees to find the nectar. In the case of the experiment, however, the nectar had been placed straight up in the air, so that there was no existing communicative gesture in the honeybee language. The honeybee in the experiment proceeded to perform a completely incoherent dance. Munger says he has been dealing with the human equivalent of that honeybee all his life.

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