Wednesday, September 30, 2009

Talk About Gold

Not long ago, major media outlets would post daily articles reporting the price of oil and how demand is far exceeding supply. Not long before that, these same outlets were saying things like "they're not making any more land" as housing prices rose through the roof. A few years before that, the rising stock prices of technology companies were making daily headlines as the stock market had entered what was claimed to be a "new paradigm shift, where traditional methods of valuation no longer apply". Today, it's the price of gold that is the talk of the town.

Why does the topic of gold garner so much interest today from major media outlets and bloggers alike? Because so many readers are interested (thus generating traffic), and the readers are likely interested because they own gold themselves. Indeed, demand for this asset has risen to such an extent that the price of gold now flirts with its all-time high:


Does this represent an asset bubble? To answer that, we must try to determine the intrinsic value of gold. The intrinsic value of any investment is the sum of the discounted future cash flows the investment will generate. Unlike a bond or a stock, however, there is no future cash flow expected from a bar of gold. In effect, the only reason one would purchase it as an investment is because one believes someone else will be willing to pay even more for it in the future.

In his book Margin of Safety, super-investor Seth Klarman argues that this form of investing is not really investing at all, but rather speculating. As the price of any asset rises, speculators enter the market expecting to unload the asset on someone else at a future date at a higher price. While this process can go on for months and even years, with speculators accumulating small profits along the way, eventually a large group of buyers will be left holding the bag when the party is over, with massive losses.

There are, of course, industrial and commercial uses for gold. But has the supply/demand dynamic for this metal changed so much in the last few years so as to warrant the large price run-up? Not likely. Therefore, the price has been pushed up by speculators.

Gold bugs/speculators argue that gold acts as a safe haven when currencies lose value. As central banks around the world add liquidity to stimulate the world economy, currencies should be worth less, they argue. However, due to the fact that the velocity of money has slowed (i.e. money isn't changing hands as quickly as it did during the boom) and capacity utilization is low, inflation numbers are tame despite the large amounts of currency being generated. Therefore, gold is running up on the expectation that the Fed will not be able to control inflation later. Even if one is correct about this (and it is far from a foregone conclusion), how does one quantify what gold is worth under such a scenario? When one buys a security without knowing its underlying value, one is susceptible to large losses. Buying "because the price is going up" is not an acceptable reason to buy for the Intelligent Investor.

For value investors, it is wise to avoid falling prey to these psychological frenzies. Investors should stick to buying securities which trade at discounts to their intrinsic values, intrinsic values which can be conservatively estimated. As such, gold is currently not an area where the value investor should foray.

Disclosure: None

Tuesday, September 29, 2009

Why Not Let Inflation Be?

With all the fiscal and monetary stimulus that has been poured into the economy, there is a lingering fear that inflation will rear its ugly head somewhere down the line. We've discussed how unanticipated inflation can take a bite out of both stock prices and free cash flow. But if inflation is allowed to creep higher, and is stabilized at a higher level, would that be a problem going forward for the broader economy? Assuming retirement benefit payments are linked to CPI, if our inflation target was 10% instead of 3%, would that be an issue? Common sense suggests nominal interest rates would adjust, and in the long-term this would have little effect on the country's real GDP (i.e. after adjusting for inflation). However, digging a little deeper we do find extra costs associated with a higher inflation rate, even when that rate is expected and anticipated!

First of all, a higher inflation rate (even when stable and fully anticipated) results in something called "shoe leather costs". These are the result of increased spending due to the fact that money loses value. Workers spend their paychecks as soon as they get them, since they could not buy as many goods next month with the same amount of money. Economist opinions of the relative quantity of these transaction costs range anywhere from 0% to 2% of GDP for a stable inflation rate of 10%.

One might think that a worker would get paid higher savings interest rates, therefore why would he spend his paycheck immediately? Unfortunately, tax consequences for savings distort incentives drastically. We pay taxes on our savings at nominal rates (i.e. the rate the bank posts). So if inflation is 10%, you would require at least that rate for your savings account. However, if your savings interest rate is 12%, after taxes your earnings would not be enough to offset the losses from inflation! As such, the savings rate has to increase dramatically, raising borrowing costs, which lowers investment and hurts long-term growth.

Finally, even with a stable inflation rate at a higher level, higher uncertainty persists. Will the inflation rate stay high, or will it come down? This uncertainty leads to lower investment, and a misallocation of resources, as portions of the economy will spend time and effort trying to profit from forecasting inflation rather than creating products and services that add value to society.

These are some of the main reasons why the Fed targets a low rate of inflation, and does everything in its power to keep it that way.

Monday, September 28, 2009

Xing Mobile

Many Chinese stocks appear to currently trade at relatively lofty levels, but not so much in the mobile phone segment, as consumers have held off purchasing expensive units and inventory contraction has pushed down margins. A few weeks ago, we looked at a company in this industry that appears to trade at a rather large discount to its value. But while the discount appears large, that company is rife with risks. For those looking to exploit the negativity currently surrounding this industry, there are other options available. One such option that a reader has mentioned is Qiao Xing Mobile (QXM), a Chinese manufacturer of mobile handsets.

Once again, this isn't a company you would want to bet your life on. Earnings reports are not at all timely (for example, second quarter results are still not yet available), control rests with a father/son duo, and the company recently changed auditors (rarely a good sign). Furthermore, the company has some convertible debt which is potentially dilutive to shareholders, however, thanks to the company's low share price the stock would have to rise significantly before shareholders would be diluted.

As part of a diversified portfolio, however, this stock does have downside protection and strong upside potential. While the company trades for just $150 million, the company's net current asset value is closer to $350 million. While in the case of Orsus Xelent, most of the liquid assets were in the form of receivables from a single distributor, for QXM the largest liquid asset is cash; cash net all liabilities is approximately $200 million!

This divergence between what the company owns and what the company trades for appears to have caught the attention of activist investor Himanshu Shah. Shah recently filed a statement of acquisition showing he owns over 7% of the company. Here's an article describing how he has gone about inducing management to increase shareholder value in another company in which he owns a significant interest: Raleigh Investor Gets His Way

QXM is also quite a bit larger than Orsus, and as such it does not rely on only one distributor (though customer concentration is still rather high). Furthermore, despite inventory markdowns and liquidations resulting from the economic turmoil, the company has remained profitable.

Ordinarily, this would not be an industry to which value investors would flock. The mobile handset market is frought with both low-cost domestic competition in China, as well as high-end competition from abroad (e.g. Nokia, Samsung, Sony etc.). All of these companies are under constant pressure to produce new and innovative designs with product life cycles often under one year. (Compare this to a company like WD-40, which doesn't have to invent anything...it's already done!) However, we have now discussed two companies in this space that are trading at significant discounts to their liquid assets. Without having to take risks on only one company, investors are being offered a chance to take part in a growing industry in an emerging economy at very attractive prices.

Disclosure: None

Sunday, September 27, 2009

The Dhandho Investor: Chapter 16

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 admits that the returns from investing in stock indexes will be better than returns generated by most active managers. In the aggregate, active managers are the market, and therefore after including frictional costs, active managers in the aggregate will always be outperformed by the market.

However, Pabrai argues that Dhandho investors will always outperform the market, and therefore he suggests that individual investors (who don't have the time or the inclination to invest in a Dhandho manner themselves) find such a manager.

For those interested in finding the investments themselves, Pabrai recommends 10 places where "50 cent dollars" (i.e. investments worth one dollar but selling for 50 cents) can be found:
  1. magicformulainvesting.com : stocks are ranked by P/E and ROIC. Pabrai recommends this as a terrific screening process
  2. valueinvestorsclub.com : contains the stock ideas of other value investors
  3. Value Line's bottoms list : stocks that have lost the most value in the last week, stocks with the lowest P/E's etc
  4. 52-week low lists
  5. Outstanding Investor Digest and Value Investor Insight : both contain interviews with great value investors who offer up some ideas every once in a while
  6. Portfolio Reports : This publication lists the buying activity of some of North America's top money managers
  7. Guru Focus : a site dedicated to tracking the buying and selling of some of the world's top value investors
  8. Super Investor Insight : tracks the 13-F filings of the top money managers
  9. Major business publications (e.g. Wall Street Journal, BusinessWeek, etc.)
  10. Attend the Value Investing Congress
By using the above resources, you are bound to find a few good ideas. Considering the value investor does not need many ideas to succeed, Pabrai argues that these resources are invaluable.

Saturday, September 26, 2009

The Dhandho Investor: Chapter 15

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 investment world, there is much discussion devoted to determining when to buy a stock. Comparatively very little time is spent on when to sell. Indeed, the first fourteen chapters of this book provided information with a leaning towards buying. This chapter discusses the process investors should go through to determine whether to sell.

First of all, Pabrai advises that investors have their selling plan for a stock in place before they buy. Without a plan in place, once an investor has purchased, he will then be subject to the psychological strains of stock ownership that can cause irrational behaviour; a plan can help avert a poor decision.

Once a stock is purchased (presumably at a discount to intrinsic value), Pabrai advises holding it for at least two years. While he admits this number is rather arbitrary and that he has no empirical data to back it up, he argues that a few months is not long enough for a business' value to have changed significantly (and therefore intrinsic value could not have fallen by such a large amount), and 5-6 years is too long to have money tied up due to opportunity costs. The only times Pabrai believes an investor should sell within two years are if:

1) One can estimate the business' intrinsic value 2 years out with a high degree of certainty, and
2) The price offered is higher than that estimated value

Note that in cases where the future has become uncertain since the stock purchase, Pabrai advises investors to hold on (as rule 1 above is not met), as he believes the clouds of uncertainty tend to clear over the course of several months. To illustrate this point, Pabrai takes the reader through an example of a theoretical gas station whose future cash flows become uncertain, as well as a real example he encountered in his fund.

Furthermore, if after three years a security has not reached intrinsic value, Pabrai argues that the investor is likely wrong about his valuation or intrinsic value has likely fallen. On the other hand, should the stock rise to within 10% of intrinsic value, Pabrai recommends investors strongly consider selling. Should the stock price rise above intrinsic value, Pabrai recommends immediate sale (with the only exception being tax considerations, if neccessary).

Friday, September 25, 2009

Stopping In The Name Of Losses!

Stop-loss orders are often recommended to investors of all types, especially those who aren't always watching the market. For value investors, however, the benefits of stop-loss orders are not as high as they are for other market players, yet value investors still fully suffer from the drawbacks of stop-loss orders. The question therefore becomes: should value investors use stop-loss orders?

On the one hand, stop-loss orders can still serve a purpose. For example, if bad news for a company gets released at 10:06 am, and the stock goes into free-fall, a stop-loss could get an investor, still unaware of the news, out of the company at 10:09 am.

On the other hand, value investors tend to understand what they are buying (lowering the risk of an unexpected impairment), prefer companies with low debt to capital levels (lowering the risk that a company can't unexpectedly make a payment), and prefer to take advantage of volatility (rather than fall victim to momentum trading). As such, they are less likely to benefit from the protections offered by a stop-loss.

On the other hand, value investors are still prone to the negative effects of stop losses: when the market panics unjustifiably, stop loss orders kick in and investors are exited from their positions at prices far inferior to what they may have been willing to sell for!

Consider what happened one year ago to the parent company of United Airlines (NASDAQ: UAUA). Panic swept the market after a false rumour of bankruptcy spread throughout, causing the stock to drop 99.92% (from $12 to one penny!). Following news that the rumour was false, the stock returned near its original level. Those with stop-losses got exited at terrible prices, as the stock dropped like a rock. Even if an investor had a stop loss at $10, it would have been filled at a much lower price, since there were no buyers at $10 during this panic.

While we've previously discussed the idea that airlines do not make for very good value investments, the example depicted above can happen to any company when a market panic occurs, even if there has been no change in a company's fundamentals.

Before deciding whether or not to use stop-losses, value investors should ensure they understand both the (possibly reduced) benefits as well as the drawbacks.

Thursday, September 24, 2009

From The Mailbag: American Claims Evaluation

American Claims Evaluation (AMCE) is a small cap company that trades for just over half of its cash balance, even after subtracting its minimal liabilities. Apart from its low liquidity, which isn't a huge issue from the viewpoint of a value investor who 1) buys as if the markets will be closed for the next five years and, 2) purchases stock from the point of view of a buyer of a private business, there are still some risks the value investor should consider.

While the company has been around since 1982, it only recently (fall of 2008) divested its main business and purchased a new one. As a result, the company's main business has changed from one which provides rehabilitation services for injured workers (PPI claims etc) to one which provides services to children that suffer from slow development. As such, its previous operating results mean very little, which makes it very difficult to estimate its earnings power.

Furthermore, of the short operating history with the new business line that is available, the company does not show any profits. As a result, investors may be buying into a company that will burn cash in the years to come. To be fair, however, the red ink posted in the last few quarters pales in comparison to the company's cash balance mentioned above. However, management does not appear to have any plans to return that cash to shareholders. Instead, it is quite possible management will instead embark on an acquisition binge. Taken from the annual report:

A key feature of our growth strategy is strategic acquisitions...We have never paid a cash dividend and do not presently anticipate doing so in the foreseeable future, but expect to retain earnings, if any, for use in our business.

When the company trades at a 50% discount to its cash position, this strategy does not appear to be the sign of a management that is friendly to shareholders. While the company is clearly trading at a discount to its assets, the deployment of those assets in a shareholder-friendly manner does not appear forthcoming. As such, despite the discount, this stock does not appear to represent a value investment.

Wednesday, September 23, 2009

Consumer Meltdown, Or Temporary Lull?

While the cash for clunkers program did provide consumers with a temporary incentive to open their wallets, consumer spending is expected to remain tepid over the next few months. Consumer confidence is low, unemployment continues to rise, and consumers are increasingly using their incomes to pay down debt. As a result, the market has punished many stocks that sell leisurely consumer goods. But conditions like these tend not to persist for long. In the meantime, investors are offered the opportunity to buy such companies for what appear to be tremendous discounts to their intrinsic values.

Consider Adams Golf (ADGF), designer and distributor of golf clubs. The company has lost money in three of the last four quarters, as customer inventory reductions and reduced consumer demand has caused revenue to drop significantly. But is the company in such dire straights as to warrant its current market valuation? You be the judge.

ADGF trades for just $19 million, but has current assets of $50 million versus liabilities of $14 million, which includes just $5 million of debt. Due to Mr. Market's obsession with current earnings, ADGF offers investors a chance to purchase a cash flow positive (referring to second quarter cash flow from operations) going concern at a discount to its liquid assets.

It could be a while before consumer spending returns to levels where Adams Golf can once again generate net income of several million dollars per year. But with the stock price at this level, investors don't need that to take place in order to make money. As the company aligns its cost structure to the lower level of demand, it will likely return to profitability in the near future, rewarding investors who focus on the long term and who cover their downside risk by purchasing liquid assets with a healthy margin of safety.

Disclosure: Author has a long position in shares of ADGF

Tuesday, September 22, 2009

Twin Obligations

Twin Disc (TWIN) is a company we discussed a few months ago as an example of a value investment where patient investors were rewarded: in the last 2.5 months, the shares are up by about 2.5 times! As a result of its recent price run-up, however, the company no longer appears to offer investors a generous margin of safety. In fact, it may be just the opposite; the company has a looming pair of obligations that are a material threat to investor returns - its pension and post-retirement requirements.

When reading through a company's financial statements, one of the items investors should look for is the status of the pension plan, if applicable. As Twin Disc recently disclosed in its annual report, the difference between its pension plan assets, and its pension and post-retirement obligations is about $60 million, up from $34 million last year. (For a company with a market cap of just $160 million, this $60 million obligation is indeed significant!)

The company clearly recognizes this as a problem, as three months ago management decided to freeze benefit accruals for employees. Nevertheless, the looming obligations remain. Shareholders running discounted cash flow estimates into the future must be certain to subtract these obligations from the estimated value of the company's equity - shareholders who ignore them are likely to overpay for this company.

Pension obligations of this nature are included in the balance sheet, and so the company's price to book ratio (of around 1.5) does take these requirements into account. However, the company's P/E (of around 15) does not, and therefore investors estimating the value of this company based on earnings projections must be sure to take factors such as this one into account.

Twin Disc is far from the only company suffering from this phenomenon, as many companies have seen their pension assets shrink, resulting in significant shortfalls.

Disclosure: None

Monday, September 21, 2009

Price To Cash Flow: A Useful Metric

The other day, we re-iterated the importance of the price to book metric by discussing the study undertaken by Bauman, Conover, and Miller that demonstrated superior returns of stocks in the lowest Price to Book quartile. In the same study, the trio studied relative returns of stock quartiles separated by Price to Cash Flow (P/CF). Cash flow is quite a volatile number, as it can be affected by a number of accounts including working capital, investments, loans, dividends etc. For the purposes of this study, Bauman et al. defined cash flow as simply earnings with depreciation (a non-cash charge included in earnings) added back.

Despite the simplicity of the concept, the value group (those defined as having the lowest P/CF) once again clearly outperformed the other three quartiles over the period of study as depicted below:
Returns
Unlike what we saw in the P/B study, the highest standard deviations actually belong to the companies with the highest P/CF. Changing predictions of expected future cash flows for this group may be causing relatively wild gyrations in its stock prices.

One of the conclusions drawn from this study is that investors are far too willing to overpay for "growth" companies. The median P/CF for the value quartile was 4.4 while it was a whopping 34.2 for the high P/CF group! This is why as value investors we prefer buying companies with stable cash flows and prices to those cash flows which are at reasonable multiples.

Sunday, September 20, 2009

The Dhandho Investor: Chapter 14

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.

Many companies are devoted to innovating of some sort, and many investors are looking to find the next big innovation that will generate superior returns on investment. Pabrai argues, however, that investors should focus not on companies that innovate but rather on companies that excel at copying and scaling.

Pabrai goes through a couple of case studies to illustrate his point. Ray Kroc purchased McDonald's restaurant from a pair of brothers. He didn't invent the concept, but saw its potential and expanded it. Furthermore, many of the menu items and processes that made McDonald's into the restaurant we see now did not come from corporate headquarters, but rather from its franchisees and other restaurants. McDonald's is successful because it has been able to scale up the innovations of others.

Microsoft is another company Pabrai describes as a non-innovator that is excellent at scaling up the successful innovations of others. Microsoft's own inventions have often failed, but when it has taken a competitor's existing idea and applied Microsoft's know-how is when it has been at its most successful. It took the idea of the computer mouse and graphical user interface from Apple, Excel from Lotus, Word from Word Perfect, networking from Novell, Internet Explorer from Netscape, XBOX from Playstation and the list goes on. In these cases, Microsoft waited for a product/service to demonstrate a certain acceptance by customers, and then went after this now proven market.

Pabrai Funds is also a copy of Warren Buffett's funds to a large extent. From the fee structure, to the philosophy on identifying good investments, to the reporting scheme, to the investor profiles, to the personnel structure, Pabrai has tried to emulate the partnerships of Buffett's past.

Too many investors make the mistake of looking for innovators in the public equity markets. Instead, Pabrai advises to focus on companies run by people who have repeatedly shown they can lift and scale existing ideas.

Saturday, September 19, 2009

Small-Cap Conference

We've made it no secret on this site that we believe small-cap companies are the most inefficiently priced, thus offering the potential for greater returns for investors who can recognize companies trading at discounts to their intrinsic values. But many small-caps are unknowns, leaving investors with an information shortfall. One way to alleviate this shortfall is to attend various conferences that are targetted at investors looking to learn more about small companies in which they can invest. One such conference I plan to attend takes place in Vancouver next week. The description of the event is as follows for those interested:

The Small-Cap Conference is a prestigious investment conference held bi-annually across Western Canada. The Conference is an informative one-day event with prominent guest speakers who share their investment knowledge, tools, outlook, and top picks. There are also corporate presentations from a variety of quality, small-cap companies from many different industries. The conference is focused on fundamental companies generating cash flow and earnings - many of which post better per share numbers than well-known blue-chip companies. Refreshments, drinks and door prizes complement the evening session. The conference is free to attend and is open to all investors. Pre-registration is preferred.

The fundamental focus of the companies coming to the Vancouver conference provide solid investing opportunities even in uncertain market conditions. We have witnessed a significant rally in the larger stocks this year and the small-caps are now gaining increased attention. This is an excellent time to learn where to put investment dollars from the guest speakers and company presentations at The Small-Cap Conference. At this year’s conference, we are pleased to have popular speakers such as Louis Paquette, editor of Emerging Growth Stocks, and Brent Todd, Canaccord Capital. There will also be several company presentations ranging from Oil and Gas, Healthcare Technology, Construction, Aerospace, Mining, Manufacturing, and Green Technology firms. The full schedule and list of presenting companies is on our website at www.smallcapconference.ca.

The Fall Symposium is being sponsored by Capital Transfer Agency, QIS Capital, SmallCaps.ca, Emerging Growth Stocks, Fundamental Research, Baystreet.ca, Small-Cap Discovery, AlphaTrade.com, and the CNSX Stock Exchange.

Admission is FREE with pre-registration.

Please visit www.smallcapconference.ca for more information

The Vancouver Small-Cap Conference
September 23, 2009
6pm-9pm
Vancouver Convention and Exhibition Centre - Canada Place (West Building)
604 438 4010 636

The Dhandho Investor: Chapter 13

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.

The theme of this chapter is that high uncertainty does not equal high risk. Wall Street will often shun companies with uncertain outlooks, but this is exactly what allows value investors to swoop in and make outsized profits. Pabrai walks the reader through three examples of Pabrai fund purchases, and how excellent returns were realized.

Stewart Enterprises was an over-leveraged funeral home operator that traded at 50% discount to its tangible book value. Wall Street punished the stock because its debt was coming due; but in Pabrai's estimation, the chances of bankruptcy were slim. The company was earnings and cash flow positive, and was comprised of several businesses. Stewart was able to sell off businesses that were not cash positive and thus pay off its debt without hurting cash flows.

Despite the fact that Level 3 had cash of $2.1 billion, some of its debt was selling for under 20 cents on the dollar, as the company was cash flow negative and the industry outlook was uncertain. Careful analysis of management's plan, however, indicated that cap ex would not be spent unless revenues justified expansion. This meant that the company's cash reserve could continue to meet interest payments for another three years. Due to the low bond price, the investor could recover his initial investment in interest payments alone!

Frontline, and shipping company, sold at a massive discount to the scrap value of its ships in 2002. Furthermore, Pabrai argues it had enough liquidity to last several months at the depressed shipping prices that prevailed in the market at the time. Needless to say, the company outlasted the downturn and Pabrai was rewarded for his investment.

While all of the above companies were in different industries and with different surrounding circumstances, each investment represented an investment in a highly uncertain but still low-risk position. Due to Wall Street's opposition to high uncertainty, value investors can profit by finding investments that fall within this group.

Friday, September 18, 2009

A Diluted Operating History

Wuhan General (WUHN) manufactures industrial blowers, turbines and other industrial machinery. While the company trades for just over $50 million, it has a tangible book value north of $80 million and has earned a combined operating income of about $15 million in its last four quarters. While the company looks cheap on this basis, two completely separate but important factors reduce the attractiveness of this company.

The first problem is the company's limited operating history. While the company has seen strong growth rates over the last three years, value investors prefer companies that have consistently demonstrated an ability to withstand the competition. The company underwent major changes in 2004, but only recently has it demonstrated decent returns on capital. Were these returns simply due to an overheated economy or can they be sustained? Unfortunately, without a stable and consistent operating history, it's difficult for the investor to tell. For further discussion on this topic, see Chapter 37 of Security Analysis.

The second major problem with this investment is its share structure. Large blocks of preferred shares not only rank ahead of the common shareholder, but are convertible into common shares on a one-to-one basis. For the investor, this means not only will any upside will be shared, but downside risk is increased, because of the junior ranking of common shares. Furthermore, the magnitude of this impact is huge: if all shares were converted today, the number of shares outstanding would double, effectively halving the investor's share of the company.

While investments can look cheap on the surface, investors must dig deeper. For example, Google Finance does not show the preferred shares (let alone their convertibility) for this company. To avoid overpaying for stocks, investors much ensure they take the time and effort to do their homework, and not simply rely on what looks cheap at first glance.

Disclosure: None

Thursday, September 17, 2009

Banks And Value Investing

We often get asked if we see value in some banks at these price levels. Some value investors purport to be able to value banks. Some may actually be able to, while others may only think they are able to. For the average retail investor, however, it is just too difficult to determine the intrinsic values of these "black boxes", for several reasons.

First of all, determining the value of the assets of these institutions is a guess at best, without a deep understanding of the bank's loan portfolio. As we've discussed before, some businesses are easier to understand than others. With the complex behemoths banks have become, their business models are very difficult to understand. I can't honestly say that they fall within my circle of competence.

But even if one could determine what the assets are worth to some range of values, the amount of leverage used by the banks seriously clouds the value of the equity. For example, for Bank A, you may believe the assets are worth $10,000 plus or minus 10%; but if Bank A uses $9000 in debt to fund those assets, the remaining equity value could be anywhere from $0 to $2000. As long as the shares trade in that range, you have no idea if you're buying at a discount to intrinsic value.

Needless to say, the high debt levels used by banks also make them much more susceptible to collapse during downturns, which is a phenomenon we are seeing right now. Value investors much prefer companies with low debt as they have much greater power to weather downturns.

Though many banks have been offering high dividend yields of late, it's extremely important to understand where that dividend is coming from in order to attain reasonable assurance that it is sustainable. Buying blindly for dividend yield is not an option.

Are there circumstances under which we could buy banks? Certainly. Under a situation where the entire industry is undervalued for example, a purchase of a basket of several banks helps diversify away the risk of failures here and there. This is a similar situation to our approach on pharmaceuticals, where large amounts of research money are being spent, but it's unclear which companies will reap the rewards.

The bottom line is, buying individual banks is a risk unless you understand the value of what it is you're buying. Buying because stocks are down, or because momentum is up, or because yields are high does not adequately protect your capital.

Wednesday, September 16, 2009

Explaining The Market Inefficiency

There are many reasons why a particular stock's price might differ from its value, not the least of which is a motivated seller. A motivated seller will drop the price of any asset (e.g. real-estate, vehicles etc.) and stocks are no exception - particularly small-caps, where a lack of liquidity can result in dramatic price drops.

Consider Orsus Xelent (ORS), a stock we have previously discussed as a potential value play. The former CEO and a former director of the company owned about 30% of the outstanding shares of this company just a few months ago; but in the last several months, they have started to unload their shares.

Former director Wang Zhibin has unloaded some 6 million shares between April and September alone, representing 20% of the company's outstanding shares. Over the course of that period, that represents almost 40% of the company's trading volume (though many of the transactions took place off-market). Similarly, since Wang Xin resigned as CEO in March, he has been unloading his 3 million shares at a frantic pace. Compare his daily market transactions to Orsus' average daily trading volume; he has clearly had a large effect on the stock price.

Do these sellers know something we don't? It's entirely possible. But at the current stock price, a lot would have to go wrong for the investor to lose his principal. It's also important to remember that these are not insiders - they began to liquidate their stock only after they left their posts. As such, it's entirely possible they are selling their shares for personal reasons, or because they can no longer influence the company.

Many financial experts regard stock prices as fully reflecting the values of the underlying businesses. This assertion must be thrown in doubt, however, in cases such as this one, where shareholders controlling large blocks of shares are dumping their stock over very short periods of time.

Disclosure: Author has a long position in shares of ORS

Tuesday, September 15, 2009

Never Lose Money

The following is a guest post by Manish Chauhan. Please note that the opinions expressed in this article do not necessarily correspond with those of Barel Karsan.

Manish is the blogger behind Jagoinvestor, a site dedicated to Financial Planning and Money Engineering. In this post, he will talk about an important rule investors in the stock market must remember.

Warren Buffett's Rule

Warren Buffett says there are two rules in stock market:

Rule 1 : Never Lose Money
Rule 2 : Never forget Rule 1


Most investors have heard this and read it numerous times, but have thought "how can one never lose, and how can that be the single most important rule in stock market?"

The real meaning of these two rules lies behind those words and if we dig deep behind them, we will understand the real value of those rules. Let me decode it for you here; read it with full concentration, as these two rules are really worth everything in stock market.

What Warren Buffett really means when he says "Never Lose"


No one in this world can only win, one has to sometimes lose and this is also true in the stock market. No one can ever trade or invest in such a way that he/she never loses. What Warren Buffett actually means by "never lose" is that every time we lose , it has to be an insignificant loss i.e. the quantum of loss has to be so limited or small that it's not going to affect us psychologically. If we make a profit of 100 every time we win, and lose 20 or 30 every time we lose, we are actually not losing if you aggregate the trades.

If you win 100 and lose 20, you are actually winning 40 for every trade in a series of 2 trades. But if you are letting your losses mount and never controlling them, then you are really losing and then those losses can impact you in big way.

What he means when he says "Never Forget Rule Number 1"

By this he wants to emphasise how important controlling losses is. Here's another one liner of his: in the stock market and in life, you don't need to do lot of things right as long as you are not doing lot of things wrong. So as long as you remember that controlling your losses is the most important rule, you otherwise just need to be an average investor and the power of compounding will take care of the rest.

So in the end, I would summarize these rules again and what you should actually read:
Rule 1 : Never Lose Money (Control your losses and cut them soon enough so that you don't feel them)

Rule 2 : Never forget Rule 1 (Controlling your losses is the top priority you should have. The rest will take care of itself.)
Let's look at an example. There are two investors, Ajay and Robert, that both make 1000 trades over the course of their lives: 500 losing trades and 500 winning trades.

Ajay makes a profit of 6% on winning trades and a 3% loss on losing trades. He has $11.9 billion dollars at the end.

On the other hand, Robert concentrates more on controlling his losses. As a result, he is able to control his losses to just 1% per losing trade, and also makes 5% on winning trades . At the end of his career, he would have $25 billion.

Conclusion

It's only controlling losses which made Robert more money than Ajay. Remember this: you need to concentrate on "not messing it up" rather than making it "rock".

If you enjoyed this post, you can subscribe to Jagoinvestor blog through Email or RSS Reader. Some of the other articles from Manish are here.

Monday, September 14, 2009

The Fallacy Of Earnings Per Share

Too many investors blindly incorporate earnings per share (EPS) as a primary component of their valuations. EPS gets multiplied by a P/E multiple, or it is used as a base for growth rate multipliers to be discounted back to present value. However, for several reasons, investors must avoid using such short cuts in company valuations.

First of all, EPS can fluctuate wildly from year to year. Writedowns, abnormal business conditions, asset sale gains/losses and other unusual factors find their way into EPS quite often. Investors are urged to average EPS over a business cycle, as stressed in Security Analysis Chapter 37, in order to get a true picture of a company's earnings power.

EPS, averaged or otherwise, still does not provide adaquate information regarding a company's debt levels. Two companies could have the same EPS, but one could be capitalized with 99% debt while the other could have 0% debt. While the earnings to the shareholder is the same in both cases, one company is extremely risky and susceptible to bankruptcy should anything unexpected occur. To factor in debt levels, investors are encouraged to value a company based on its operating earnings (instead of its EPS) and subtract debt obligations from this value, and compare debt/equity values.

Finally, EPS does not give adaquate information regarding dilutive securities that have not yet been converted into common shares. "Diluted EPS" is a required reporting component of an income statement, but it only incorporates those options that are above water. For example, if a company has 100,000 shares that have averaged trading at $2.00/share, and 500,000 options outstanding at an exercise price of $2.01/share, not a single one of these options will be recognized in the diluted EPS calculation, despite the fact that these securities are potentially extremely dilutive! To avoid this trap, investors must subtract the value of options outstanding from the arrived at intrinsic value of the company.

EPS is a quick and easy way to refer to a company's earnings. It does not, however, serve as a replacement for prudent analysis of a company's true earnings power and obligations.

Sunday, September 13, 2009

The Dhandho Investor: Chapter 12

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.

This chapter stresses the importance of only purchasing investments with a healthy margin of safety. Once again, Pabrai quotes Buffett to back up this point:

"Make sure that you are buying a business for way less than you think it is conservatively worth."

Pabrai also refers to the writings of Ben Graham in The Intelligent Investor (which we've summarized here) by pointing out that Graham discussed the following joint benefits of employing a margin of safety: lower downside risk, and higher upside potential.

The entrepreneurs described at the beginning of Pabrai's book had likely never read the writings of Graham. Nevertheless, it is clear to Pabrai that their decisions were always taken with the idea of risk minimization in mind. Business schools, on the other hand, teach that reward comes from risk, and do a great disservice to their students, Pabrai argues.

The idea that higher rewards can only be achieved through higher risk is a common argument made by those who believe that the market is efficient, and therefore that it does no good to look for low-risk, high-reward situations. On this topic, Pabrai quotes Buffett again:

"We are enormously indebted to those academics: what could be more advantageous in an intellectual contest - whether it be bridge, chess, or stock selection than to have opponents who have been taught that thinking is a waste of energy?"

Saturday, September 12, 2009

The Dhandho Investor: Chapter 11

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 advises investors to "fixate on arbitrage", especially those situations where downside risk is eliminated, even if upside potential is limited. He discusses the following types of arbitrage, with particular emphasis on the last one:
  1. Traditional: Buying gold on one exchange and selling it for a higher price on another
  2. Correlated: Buying shares of a Class B stock while shorting the Class A if there's a price/value discrepancy
  3. Merger: Buying a company about to be bought-out by another. It's important to note that this type of arbitrage is generally not risk-free.
  4. Dhandho Arbitrage
Dhadho arbitrage is the central theme of this chapter. Dhandho arbitrage allows businesses to earn above normal profits for a limited time, before competitors or substitutes enter and destroy these higher returns. An enduring Dhadho arbitrage is what Buffett would call a moat.

Pabrai goes on to describe the Dhandho arbitrage spreads of several businesses. Some have spreads of just a few months, while others have spreads that span decades. While Pabrai argues that the "Dhadho arbitrage spreads" of all businesses will eventually be eroded, two important factors can allow investors to earn excellent returns in the interim: the size of the spread (or moat), and its duration.

To that end, Pabrai describes a couple of businesses owned by Warren Buffett that no longer have moats, Blue Chip Stamps and World Book. Nevertheless, the "aribitrage spread" earned by these companies over the years has made Buffett a lot of money - for example, Buffett's purchase of See's Candy was partially bought by money earned from Blue Chip. Pabrai advises investors looking for superior returns to invest in companies with wide and durable Dhandho arbitrage spreads.

Friday, September 11, 2009

Of Options And Klarman

The realm of stock option trading is usually left in the hands of speculators and traders. Value investors don't purport to be able to time stock price movements, and since options expire, there is an important timing element to most option trading. However, there are a couple of types of options strategies that can actually add value for value investors. Over on Jonathan Goldberg's site (which we've discussed here), he has an article explaining the details and the caveats of these options strategies for value investors.

While you're there, you might also want to check out his discussion of a Seth Klarman speech he recently attended. Klarman is one of our favourite value investors, as while his book (which we summarized here) is easy to understand, it nevertheless discusses very clearly some important value investing concepts.


Thursday, September 10, 2009

Incentives Gone Awry

Stock options are intended to align the interests of management with those of shareholders. As we've previously discussed, however, they don't always work like that. Nowhere is this more clear than at Acorn (ATV), an infomercial marketer. Acorn trades for $100 million, but holds $140 million in cash.

Shareholders are imploring management to pay that cash out, as last quarter's conference call contained the following statements:

"...[W]hy not consider a special dividend to shareholders and for this reason, when I look at the Shanghai Composite Index, year-to-date, it is up 55%, the Hang Seng China Equity Index is up 46% and your stock is up less than 1% this year...I would highly encourage you to consider a special dividend."

"I'd like to also support the thought of a one-time cash dividend, which would distribute your overcapitalized cash for the benefit of all shareholders without impairing your trading volume. You may recall, I mentioned that in our meeting back in July."

Management assured these shareholders that they will consider these suggestions. But upon closer inspection, it is clear to see why management would be so hesitant to pay out: there are almost 15 million options outstanding, while the company only has 87 million shares outstanding. If a one-time dividend were to be paid, option holders would get nothing, and their claim on the company would be much lower in two respects:

1) It is less likely that the company's share price would exceed a given option's exercise price, thus reducing the number of options that may be exercised and,
2) Each exercised option will also be worth less, since there will be less cash on the balance sheet than otherwise

But while management does own a significant stake in the company, they do not control it. As such, the rumblings of these small shareholders might win out in the end, forcing management to eat options they would prefer to exercise.

Disclosure: Author has a long position in shares of ATV

Wednesday, September 9, 2009

Spending Liquid Assets

As a reader recently commented in another article., China 3C Group (CHCG), a retailer and wholesaler of a diverse range of electronics products, trades at a discount to its liquidation value. The company trades for $33 million, but has a cash balance and receivables of $25 million each, along with another $9 million of inventory, against total liabilities of just $5 million. Furthermore, the company has remained profitable through this downturn, and has likely added to its profits with the recent acquisition of a company that earned $2 million in its last fiscal year.

There are some signs, however, that all is not well with its business. Year-over-year sales were down 35% in the most recent quarter, and the company expects this quarter's sales to drop by over 40%. In addition to the economic malaise plaguing the industry, the company is having trouble with new competition: 3C has had to lower prices to remain competitive. Furthermore, the company has also had to extend its credit terms to customers. As a result, even though sequential quarterly sales were down 30+%, accounts receivable are actually higher now than they were last quarter - this is usually a bad sign!

Recognizing that the business is facing some problems, 3C management has started taking the firm in a new direction: rather than grow its existing store-in-store retail model, the company plans to shrink those locations in favour of opening up its own retail stores as well as franchised stores. This transformation is not free, of course. To finance the investment, 3C will have to draw down on what value investors would consider to be the company's margin of safety! The company summarizes it best:

"[T]here are no plans for paying dividends in the foreseeable future. We intend to retain earnings, if any, to provide funds for the implementation of our new business plan."

And because this is a new direction for the company, investors don't have a great indication of what the financials will look like for this company's new format. Value investors, on the other hand, prefer companies that have been operating in the same line of business for years, since their cash flows can be predicted with more confidence. Indeed, there is a risk that the new business plan will not work out well.

So in summary, what we have is a company trading at a discount to its liquidation value that will be spending some (but we don't know how much) of that discount on a relatively new business segment for which previous financials don't neccessarily apply. While it may be more likely than not that the investor has downside protection, there is nevertheless a fair amount of risk associated with this stock. Investors may still find value in this stock at its depressed level, but they should ensure they understand and recognize these risks.

Disclosure: None

Tuesday, September 8, 2009

The Importance Of The Price to Book Metric

We discuss the Price to Book values of various stocks quite often on this site, but how useful a metric is it? From a logical standpoint, as a purchaser of a business (which is how we view all our stock purchases), a prudent buyer ensures - barring certain exceptional circumstances - that he does not pay too much more for a company than the value of its assets. In this way, he receives downside protection to a certain extent. Though book value is not a perfect measure of the value of a company's net assets, it does provide at least some level of a proxy for it.

That's all well and good in theory, but does this practice actually hold up against empirical data? Do stocks with low P/B values indeed outperform the market? There have been several studies that suggest that historically, stocks with lower P/B values have in fact outperformed, however, there are certain caveats to keep in mind.

One study that has gained industry credence was carried out by Bauman, Conover, and Miller. The authors used an international sample of stocks and divided them into quartiles based on P/B. They observed over the ten-year period of their study that the quartile of the lowest P/B stocks had mean returns of 18.1%, while those of the highest P/B had mean returns of 12.4%, representing an annual spread of 5.7%.

Based on this data, buying a basket of low P/B stocks may get you outstanding returns, but you may do even better if you can determine which of the low P/B stocks are worth purchasing and which are about to go bankrupt: the standard deviation of the returns for the lowest P/B stocks was 70 as compared to 57 for the highest P/B quartile, suggesting the low P/B space contained some big winners along with some big losers.

This is why looking for companies with low debt and good liquidity among issues trading at discounts to their book values can present great investment opportunities, some of which we discuss here.

Monday, September 7, 2009

The Dhandho Investor: Chapter 10

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.

The basic idea underlying this chapter is that when opportunities exist, it's important to bet big. Pabrai is not an advocat of investing frequently, with amounts of money that won't significantly move the needle. Instead, he suggests disproportionate amounts should be invested when the odds are significantly in one's favour.

To calculate how much an investor should bet on a given opportunity, Pabrai suggests using the Kelly Formula, which he discusses in detail. A major weakness of using this formula, however, is that it requires the payout and odds to be known in advance. This knowledge is available in gambling games (where the Kelly Formula is perhaps more relevant), but stock returns are not calculated with assurance so easily. To better understand how investor's should think about how much to invest in a particular opportunity and why, Pabrai recommends William Poundstone's book, Fortune Formula.

Though the motel-buying Patels described in earlier chapters of the book had likely never heard of the Kelly Formula, Pabrai argues that they nevertheless recognized the fundamental concept behind it, and that's why they were so successful: when a great opportunity presents itself, bet big. Pabrai also analyzes the statements and writings of Warren Buffett and Charlie Munger and concludes that they employ the very same credo. Said Charlie Munger in a speech at the USC business school:

"The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple."

And wrote Warren Buffett in his partnership letters from 1964 to 1967:

"We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could change the underlying value of the investment."

In light of the above, Pabrai finds it puzzling that the average mutual fund holds 77 positions, and that the top 10 holdings represent just 25% of assets. Dhandho, on the other hand, as Pabrai describes it, is "about making few bets, big bets, infrequent bets".

Sunday, September 6, 2009

The Dhandho Investor: Chapter 9

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 no moat can last forever, Pabrai suggests readers invest in businesses with competitive advantages that can last for several years. There is an endless list of businesses with durable moats, and Pabrai goes on to name some including: Chipotle, American Express, Coca-Cola, H&R Block, Citigroup, BMW, Harley-Davidson, and WD-40.

Pabrai also lists a few companies with no moat at all: Delta Airlines, General Motors, Cooper Tires, Encyclopedia Britannica, and Gateway Computers.

Sometimes the moat is not so clear. The example of Tesoro Corporation, an oil refiner, is highlighted. While Tesoro has no control over the price of its supplies (crude oil) or the price of its principal product (gasoline), it does have an advantage: refineries on the west coast. While the number of refineries has declined over the years, Tesoro holds a growing advantage due to environmental regulations for gasoline products that are specific to the West Coast.

While a business' moat is often hidden, whether a company has one is usually clear from its financial statements: good businesses generate high returns on invested capital. For example, if opening a Chipotle store costs $700,000 and it generates $250,000 per year in free cash flow, in Pabrai's words "it's a damn good business."

While some moats are more durable than others (e.g. American Express was founded 150 years ago, and still has a strong moat.), it's important to note that all moats erode over time. As noted by Charlie Munger, "Of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business...". Even seemingly invincible businesses today such as eBay, Google, Microsoft, Toyota and American Express will all eventually decline and then disappear. Pabrai notes the results of Arie de Geus' study that showed the average life of a Fortune 500 company is just 40 to 50 years (and it takes about 25 to 30 years from inception for the typical company to get to the Fortune 500, meaning the typical company ceases to exist after spending less than 20 years on the list). The implication of this is that discounted cash flow estimates into the future should be kept to relatively short timeframes.

Saturday, September 5, 2009

The Dhandho Investor: Chapter 8

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 this chapter, Pabrai extolls the virtues of investing in distressed businesses in distressed industries. While he believes the market is mostly efficient, he believes that investors paying close attention can find the situations where it is not. When a business (or its industry) is distressed, it can often sell at large discounts to its intrinsic value due to the fear that is prevalent in the market. It is precisely this phenomenon that offers investors the opportunity to buy stocks at large discounts.

For those who believe the market is always efficient, Pabrai offers the following Warren Buffet quotes:

"I'd be a bum on the street with a tin cup if the markets were always efficient"

"Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn't do any good to look at the cards."

"It has been helpful to me to have tens of thousands [of students] turned out of business schools taught that it didn't do any good to think."

Pabrai discusses several ways for investors to find distressed industries/businesses. For one thing, business headlines are often filled with negative news and outlooks for particular businesses and industries. Examples include Tyco's stock during the Kozlowski scandal, Martha Stewart's stock following her prison sentence, and H&R Block's stock following Elliot Spitzer's investigations.

Another useful place to find distress is Value Line's weekly summary of the stocks that have lost the most value. It also publishes a list of the stocks with the lowest P/E and P/B values. Pabrai also recommends looking at 13-F disclosures to see what other value investors are buying, and using Value Investor's Club. Pabrai also recommends that investors read Greenblatt's The Little Book That Beats The Market for help in this area.

From the above sources, a plethora of troubled industries and businesses can be identified. From this group, Pabrai recommends investors eliminate those businesses which are not simple to understand or which fall outside the investor's circle of competence. For the remaining stocks, the Dhandho framework (as discussed in the rest of the book) should be followed to determine which of these stocks should be purchased.

Friday, September 4, 2009

Being Wary Of Retailers

The financial statements of various retailers can look very clean in some cases: decent cash balances, low debt levels, and dropping inventory levels acting as a source of cash in this tepid retail environment. In many cases, the stock prices of these retailers can seem like veritable bargains in relation to their financial statements. After all, what value investor wouldn't want to buy a company for half of what it owns in inventories alone?

However, when valuing company assets, retailers should not be placed on the same playing field as companies operating in a different space, even if the financial statements suggest two companies are identical. This is because of an accounting standard that does not require retailers to include on their financial statements a most material of liabilities: their operating leases.

Consider Trans World Entertainment (TWMC), a retailer with about 700 stores across the US. The company trades for just $30 million, even though it has current assets (mostly inventory) of around $360 million, and total liabilities of under $200 million, for a net current asset value of around $160 million.

If a manufacturing company had the types of numbers depicted above (and some do have similar), it would likely be a straight up steal, as the company could cut costs (reduce output/headcount/facilities) while sourcing cash from its inventory. Retailers, on the other hand, are burdened with fixed operating leases that in some cases don't expire for years, reducing the ability to cut costs. While manufacturers can also have operating leases, the magnitude of these leases are normally not nearly as material as they are for retailers.

For example, Trans World has operating lease obligations of $220 million over the next five years or so. (Compare this to the company's market cap of $30 million!) Trans World lost $17 million last quarter, and it will likely continue to lose money (eating into its current assets) as its cost structure is not flexible enough to allow for a quick turnaround, thanks to these leases.

Not all retailers have such daunting operating leases, however. Some, like Office Depot (ODP), own land and buildings outright, which provided ODP some much-needed flexibility during a cash crunch earlier this year. Furthermore, the expiration of operating leases can empower management with the ability to reduce costs: companies can cherry-pick which leases to renew based on store-by-store profitability, thus improving overall results. Finally, we've also seen how some companies (e.g. Build-A-Bear as described here) have been able to re-negotiate their lease requirements lower as the lessors would rather work with them rather than lose a valued client.

Nevertheless, when viewing the financials of a retailer, alarm bells should go off because of the fixed-cost nature of this industry: what is this company contractually obligated to pay in the future, and does it have the ability to make those payments? While a company may trade at a discount to its net current assets, that is no good to investors if it will continue to lose money. To avoid falling into the trap of buying such companies, it's important to consider the company's cost structure thoroughly, no matter what the financial statements say.

Thursday, September 3, 2009

From The Mailbag: Brinx Resources

Brinx Resources (BNXR) is an oil exploration and development company. The discount the company trades at to its cash balance (about 25%) prompted a reader to ask about its suitability as a value investment. Personally, I would stay away.

As we've seen before, it's not enough that a company trade at a discount to its cash balance in order to qualify as a suitable investment. Outside of its cash balance, Brinx does not have any other material current assets. On the other hand, it does have some liabilities which reduce its net current assets to a value barely above its market cap.

The company is also looking to use that cash to buy oil properties. This is a note from their latest quarterly report:

We are attempting to expand our property base by locating other resources properties. Accordingly, we have hired consultants to gather data on properties that may be of interest to us. As of the date of this filing, we have not found a suitable acquisition.

In the meantime, the company does not currently generate enough revenue to meet its costs (having sold some of its assets), which acts as another drain on its cash. Furthermore, as the company is heavily reliant on the price of oil, the value of its resource properties (which have already been impaired to some extent due to the reductions in the expected future cash flows of these resources) could fluctutate dramatically.

As such, the assets of this company just don't provide enough of a margin of safety. When buying a company this small and this illiquid, buying net current assets, even if predominantly cash, at a small discount just doesn't cut it. The price of oil could go up or Brinx could discover a great oil resource on its land, either of which would serve to reward shareholders. In both cases, however, the investor needs something positive to happen in order to realize a large upside, making this a speculative play rather than a value investment. Before investing in a company such as Brinx, value investors should look for a massive margin of safety, not a small discount, in order to ensure both upside potential and downside protection.

Disclosure: None

Wednesday, September 2, 2009

Reward vs Risk

Orsus Xelent (ORS) is a Chinese cell phone maker that trades for $22 million on the AMEX. The company has a ton of risks:

  • Almost all of its sales are to one distributor. Having one customer is always a risk, though this risk is somewhat tempered by the fact that many consumers purchase Orsus' phones.
  • This distributor owes Orsus $76 million, or more than three quarters worth of sales at the current pace!
  • As a foreign-owned entity in China, its taxes are about to double.
  • The company prides itself on being innovative and meeting end-user needs, yet its R&D budget was about $11,000 in the latest quarter.
  • It has guaranteed a $17 million bank loan to one of its suppliers.
In many cases, these risks would be enough to turn a value investor away from a company like this. But as Mohnish Pabrai notes, value investing is about investing in companies with upside potentials larger than the downside risks. Clearly, there is some risk with Orsus Xelent, so what possible upside is there that can trump these risks? The answer is the company's low price on several levels.

First of all, Orsus trades for a P/E of around 2! Companies normally trade at such levels if earnings are expected to fall drastically. For Orsus, however, earnings and revenue this year are expected to be even higher than they were last year, as the company continues to supply more and more of rural China with mobile phones.

The company also trades for about half of its liquid assets. While those assets do include a ridiculously large sum due from its main distributor, that number has come down in the last quarter. Furthermore, the company has taken out a 3rd party insurance policy on the overdue receivables, which should provide some protection. The distributor is also guaranteeing a portion of Orsus' outstanding loan, whatever that's worth.

Orsus can hardly be considered a risk-free stock. Nevertheless, despite a huge number of risks, the upside potential of this company was too high for this value investor to ignore. This penny stock trades at a massive discount to its earnings and to its assets. Time will tell if that discount is justified.

Disclosure: Author has a long position in shares of ORS

Tuesday, September 1, 2009

When Bad Times Are Good

Demand for goods and services generally drops during recessions. It is for this reason that value investors prefer companies structured to withstand such drops. When incomes fall, certain industries suffer disproportionately. For example, we saw that for every 1% drop in US incomes, airlines actually lose about 6% of their revenue!

But on the other side of the coin, it should be noted that there are actually products for which demand increases as incomes drop! These products/services are referred to as inferior goods, since people buy these instead of buying a product they actually want but can't afford! Tutor2u classifies frozen veggies, processed cheese and tinned meat among this group of inferiors.

With US job losses climbing to local highs and continually rising unemployment, companies that provide such products may actually find themselves in boom times! Such companies tend to be non-cyclical, and can therefore take on more debt and still remain safe, thus offering shareholders a tax break. For example, consider Kraft (KFT). Although Kraft provides a wide variety of products, one could argue that many of their processed and packaged foods are precisely the inferior goods which see demand increases when incomes drop.

Indeed, Kraft's stock is only down about 20% from its 2007 high, as it continues to post increases in operating income. But as a largely followed, well-covered stock, it doesn't offer the same value as many smaller businesses that also benefit from recessions but that have seen their stock prices get pummeled. What small companies appear poised to see increases in revenue and earnings in this environment thanks to the types of products they sell?

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