Sunday, February 28, 2010

Developing An Investment Philosophy: Chapter 3

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

As Fisher's philosophy has matured, he has further refined his investment processes. In this chapter, Fisher takes the reader through his thought process, and recommended mode of action, on several points.

Following World War II, Fisher's research led him to believe that the chemical industry would do well in the coming decades. As such, he spent some time researching various businesses in this industry in order to find the one that offered the most promise for outstanding returns. In the end, he chose Dow Chemical as his investment choice, and he was greatly rewarded.

There were many reasons for his choice. Throughout the organization, Fisher was getting the impression that there was excitement from employees and the belief that greater growth lay ahead. Fisher was tremendously impressed with the CEO's response when asked the most important long-range problem facing his company (which is one of Fisher's favourite questions):

"It is to resist the strong pressures to become a more military-like organization as we grow very much larger, and to maintain the informal relationship whereby people at quite different levels and in various departments continue to communicate with each other in a completely unstructured way and, at the same time, not create administrative chaos."

Dow also limited its involvement to product lines wheer it was or had a reasonable chance of becoming the most efficient manufacturer. Research was a priority, and individuals of unusual ability were identified and elevated. Some of the sayings of Dow's late founder were also quoted to Fisher by a number of employees, two of which Fisher incorporated into his own investment business:

"Never promote someone who hasn't made some bad mistakes, because if you do, you are promoting someone who has never done anything."

"If you can't do a thing better than others are doing it, don't do it at all."

While Fisher was wildly successful with his investments in the ensuing decades, he did make a few mistakes. He spells out some of his errors, as these are often the most worthy experiences from which to learn. One problem is that success breeds complacency: on one particular occasion, Fisher only completed part of an analysis on a company before buying in. With more effort, he would have uncovered the problems that would cause the stock to subsequently drop in the coming year.

Fisher also states that he has been far more successful in industries which he knows well, which are manufacturing and high-tech companies that serve manufacturers. In other industries, he believes his methods can be applied, but believes investors with more knowledge of those particular industries are in the best position to thrive. Finally, Fisher recommends that investors not sell in anticipation of predicted market downturns, for predictions of this nature are extremely difficult to make.

Saturday, February 27, 2010

Developing An Investment Philosophy: Chapter 2

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

In this chapter, Fisher discusses how his investment philosophy has changed over time as he has learned from experience. Fisher shares some of his learnings, as well as some corollaries of those learnings which can be of use to investors.

First, Fisher has a three-year rule when it comes to selling investments. Unless he uncovers information which makes him doubt his original thesis, Fisher will not give up on a company before this time. However, if a company has not fulfilled its promise after three years, he will sell it immediately. Too often, he has seen companies underperform for a year or more, but when the gains do arrive, they come quickly and to a large extent. Rarely will it get to a point where Fisher has to sell after three years; this is not because all his investments pay off handsomely, but rather as a result of the fact that he will often uncover information that is not to his liking before that time is reached.

After a couple of early mistakes, Fisher vowed never to invest significantly in a company without getting to know its management first. There are two traits Fisher believes make for a top-notch management. The first is business skill. For superior business skill, management must not only be above-average handlers of the company's day-to-day tasks (e.g. finding more efficient ways to produce, managing receivables with sufficient diligence etc.), but must also have the ability to look ahead and make long-range plans that will produce future growth without taking huge financial risks. The second trait management must have is integrity, as they will always be closer to the business' affairs than stockholders.

Many are of the view that to make the most money in the market, one must be a contrarian, zigging when the market zags. However, this is not enough: the contrary opinion must also be correct. Simply going against the prevailing opinions will not result in outperformance, and can result in detriment. For example, as it became obvious that the automobile would replace the streetcar, shares in the latter sold at ever-lower P/E values; nevertheless, it would have been costly to buy these securities simply on the grounds that they were not favoured by the market. It is for this reason that Fisher came up with the three-year rule, as a quantitative check to stop him from continuing to be go against the market for too long.

Fisher has also played around with market timing. However, he found that the gains that were to be made (if there were any) were small relative to what could be made from trying to find the truly homerun stocks that are out there.

Friday, February 26, 2010

Common Comes Last

Endwave (ENWV) has cash of $66 million and total liabilities of just $5 million, yet the stock trades for just $24 million. The company does show losses; however, in recent quarters these losses have been small in comparison with what appears to be a gigantic margin of safety. But despite the large cash balance, investors who dig deeper into the company's financial statements would find that the margin of safety is not what it appears to be!

Many of Endwave's financial updates use a single line to represent shareholder's equity, but that can be misleading. This is because Endwave is financed by a large block of preferred stock which has a larger aggregate value than the company's common stock! Once this preferred stock is subtracted from the company's cash balance (since preferred stockholders are higher in the pecking order than common stockholders), the margin of safety reduces to a paltry sum. The company's quarterly losses now become a material issue, and if they continue, they can play a large role in further reducing the value of the common stock.

Stock screens and financial statement summaries such as those found on Yahoo! and Google can be useful in identifying companies trading at discounts to their intrinsic values. However, investors cannot buy on this basis alone. A careful reading of the company's audited financial statements, and notes to its financial statements, including the composition of the company's share capital, is imperative. Securities that rank ahead of common shareholders, not just liabilities, must be identified and accounted for before an accurate valuation of the common stock is possible.

Interested in another perspective on Endwave or any other stock that's on your mind? One of our sponsors,, is offering our readers a free analysis of a stock of their choosing here.

Disclosure: None

Thursday, February 25, 2010

Making Sense Of The Business

Occasionally, companies will appear to have terrific business models, but for some reason the profits just aren't forthcoming. On the other hand, a company's business model may seem downright silly, but it may continue to show profits. Venture capitalists may take interest in the former, while speculators may be interested in the latter. On the other hand, long-term investors should limit themselves to situations where the business model makes sense and the company shows profits.

As an example, consider Money4Gold (MFGD), a company based out of Florida. With the run-up in the price of gold over the last several years, many companies have popped up looking to profit from this trend, from mining companies looking to re-open shutdown mines to new gold and precious metals funds looking for a larger share of the investor's dollar. One company taking an interesting approach to profiting from the high gold price is Money4Gold.

Money4Gold has taken out a substantial marketing campaign to convince individuals to mail-in their unwanted gold in return for cash back based on what was mailed in. No details are given to the mailers as to how the amount of cash they receive will be determined, and so it appears unlikely at first glance that anyone of sound mind would willingly mail away their valuables in this way.

Nevertheless, the company exists and shows a market cap of over $50 million! Is this bewildering business model actually profitable? The financials suggest that it may very well be profitable in the near future. The company's income statement is improving, and in the last quarter the company actually managed to turn a profit in its Canadian operations!

However, a company that shows profits without a business model that makes sense may trade at a valuation that appears attractive, but could turn out to be a value trap. It is for this reason that it is of the utmost importance that investors understand the business, so that there are no negative surprises. While Money4Gold might continue to improve its profitability in the near-term, it seems unlikely that it can continue to do this over the long haul. The company appears to pay its "suppliers" less than 30% of the market value of their gold, which hardly seems sustainable! Long-term investors should beware of such situations and only invest in companies with easy-to-understand, time-tested, profitable business models.

Disclosure: None

Wednesday, February 24, 2010

Double Vision

Consider the following 1-year stock chart:

Notice the extreme volatility in this company's stock. In the last year, the company has quadrupled in value, shed 50% of its value, doubled again in price, almost halved itself again, and has recently almost doubled yet again.

What kind of company would see so much volatility? One might expect this to be a highly speculative company. Perhaps it is a troubled bank, with high leverage and an uncertain future. Or, perhaps it is a commodity company that sells a product with extreme price movements.

Surprisingly, however, the above stock chart belongs to a company with neither of those characteristics. In fact, the company has cash far in excess of its debt, and has traded for less than its cash value over a significant part of the period depicted above. The company is LCA-Vision (LCAV).

LCA-Vision has already shown up on the Value In Action page because of its huge price run-up in September of 2009. In the months following, it subsequently returned most of those gains, and therefore once again offered investors the chance to buy the company at what appeared to be a discount. As a result, it has resided on the Stock Ideas page since late last year.

As seen from the above chart, however, the stock has once again shown tremendous gains in a very short amount of time, resulting in strong gains for investors who took advantage of the highly volatile price. Fundamentally, however, the business has not changed much in the last year. The company continues to make cost cuts in an attempt to remain cash flow positive until revenue growth returns, while maintaining its strong competitive position.

So while the business has been relatively stable over the last year, the stock price has been anything but, allowing the value investor to buy low and sell high. While stock price volatility is considered risky in the mainstream financial industry, it is the friend of the value investor.

Disclosure: None

Access Pharma (ACCP.OB) Product Development

The following is a guest post from IR GRO:

Access Pharmaceuticals (OTC: ACCP.OB, “Access”) develops and commercializes products for the treatment and supportive care of cancer patients, including:

- MuGard, an FDA-approved rinse for the management of patients with oral mucositis, a debilitating side effect of various cancer treatments

- ProLindac, now in Phase II clinical testing of patients with ovarian cancer

- The Cobalamin Platform, a drug delivery system for the oral administration of large molecules that are currently administered via injection (insulin, human growth hormone, fertility drugs, etc.)

MuGard has been commercially launched by Access' partner, SpePharm, in six European countries, including the UK, Germany, Italy, Norway, Greece and Sweden. Over 15,000 bottles of MuGard have been used by over 2,000 patients to date. Access is now conducting pre-marketing activities, including ramping of commercial production, with the goal of a U.S. commercial launch by April 2010.

ProLindac is a next-generation DACH platinum anti-cancer compound which includes a proprietary nano-polymer drug delivery vehicle that allows for over ten-times the dose of platinum to be delivered in a targeted manner to cancer cells, with a much better safety profile compared to standard platinum-based drugs which cause significant and cumulative neurotoxicity.

Access will conduct a combination study evaluating ProLindac with Taxol (paclitaxel) for second-line treatment of platinum pre-treated patients with advanced ovarian cancer. This is a multi-center study being conducted in Europe in up to 25 patients with primary efficacy endpoint goal of achieving at least a 63% response rate. Access expects to begin patient dosing by April 2010.

The Cobalamin Platform is a drug delivery technology that involves coating a nano-particle with a vitamin B-12 analog (cobalamin) that binds to intrinsic factor in the gut and triggers binding to cellular receptors which absorb the entire package, resulting in exponential increases in absorption through the gut of large molecule drugs/hormones typically administered by injection.

In June 2009, Access announced that two bio-pharmaceutical companies would conduct preclinical, proof-of-concept studies in animals (rat and dog models of diabetes) before proceeding to more formal negotiations for the Company's oral, long-acting (basal) insulin product candidate. Final results from the non-exclusive collaborators are possible during Q1 2010.

For more information on Access, visit the ProActive Capital Newsroom at

Disclosure: The above is a sponsored post, and may not express the opinions of the site author(s).

Tuesday, February 23, 2010

Dung Heaps

InterOil (IOC) has a market cap of $3 billion, 40% of which is institutionally owned. A company of this size is expected to maintain some standard of decorum in dealing with the public, which is what makes the following e-mail quotations (directed at a company critic) from the company's Senior Manager for Media Relations extremely surprising:

"As far as I am concerned you are a gutless coward of the highest order, a jealous and envious SOB...You are a loser, a non-achiever and a sour-grape."

"Frankly, you are a known crook, conman, convicted felon, a psychopath and a pathological liar...You are a scum of the earth, a creepy-crawlie who should have been locked away and the key thrown away too so that you rot away like the dung heap you are. You are a coward of the highest order"

"Who gave you the authority to investigate InterOil, you piece of shitty non-entity? You are nothing more than an internet pirate, a low-life manipulator who is out to profit by your dishonest, fraudulent, slanderous and cowardly methods. Up yours."

No, these comments were not directed at me, though I have received my fair share of angry e-mails since starting this site! The full e-mail exchange between the participants is available here.

Of course, it is possible that this bewildering exchange never actually took place. Consider the source of the allegations, Barry Minkow. If the company representative was right about one thing, it's that Minkow is an ex-con, as he defrauded a slew of stakeholders in the 1980s in a Ponzi scheme.

Minkow's claim is that InterOil has boosted its stock price to absurd valuation levels with misleading and inappropriate use of press releases. Whether this is true or not, InterOil's response is clearly inappropriate (if true).

Some investors avoid investing in companies who don't respond to inquiries. Even more investors are likely to spurn a company that reacts in this manner, which is what makes the comments so surprising.

So far, investors don't appear concerned. The company continues to trade at many multiples of its book value, in the hope of future earnings growth. For value investors, however, the company's response would reek of trouble!

Disclosure: None

Monday, February 22, 2010

Treating Research at EA and Coke

When companies spend money on capital expenditures (as opposed to spending on operating expenses such as marketing, salaries, repairs etc.), these amounts are ignored on the income statement. In other words, these capital investments are not subtracted from revenue to come up with the company's net profit, since these investments represent investments which may generate revenue (or losses) in the future. For understandable reasons, however, research and development (R&D) is classified as an expense under GAAP, even though the benefits (if any) of such R&D will occur in the future. How should the prudent investor treat such expenditures in determining a company's earnings power?

As usual, the answer is: it depends. The question comes down to the nature of the R&D expense; is it really an investment that (if successful) would add to revenues in the future, or is it a necessary expense that is needed just to keep up with the competition and keep profits stable? In the former case, the R&D can be rightfully added back to the company's profits in determining the company's true earnings power. In the latter case, however, the "investment" acts more like a current expense: it is needed simply to keep the business running as it currently is.

Unfortunately, distinguishing between these two types of R&D expenditures can be difficult for the outside investor looking in. For this reason, Philip Fisher recommends a technique he termed Scuttlebutt to help make this determination. An understanding of the company's industry can also be useful in this regard.

To illustrate, consider an example using two unlikely candidates for comparison, Electronic Arts (ERTS) and Coca-Cola (KO). EA competes in an industry with short product cycles, requiring companies to continually innovate and come up with successful new software titles, or suffer severe decreases in revenue. On the other hand, Coke's product set is rather stable, and therefore new R&D investments are likely spent on developing products that would add to the company's profits if successful. Coke's R&D spend would therefore be categorized as more similar to a capital expenditure, while EA's R&D spend would more likely be categorized as an expense the company cannot do without.

Of course, rarely is the situation completely black and white. For example, EA does have some software franchises that keep customers returning year-after-year for new versions of popular titles. At the same time, some of Coke's R&D spend is likely spent on improving current products just to maintain consumer appeal in the face of constantly improving competitors. Determining which portion of R&D is 'maintenance' and which portion is an 'investment in the future' is a difficult task indeed.

Only by understanding the business and industry can the investor make a somewhat accurate judgement as to the true earnings power of the company, by determining whether (or which part of) R&D expenditures are investments, or whether they are better classified as ongoing expenses. Nevertheless, such estimates are subject to substantial error due to the lack of information available to the investor; as such, when in doubt, investors are encouraged to remain conservative.

Disclosure: None

Sunday, February 21, 2010

Developing An Investment Philosophy: Chapter 1

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

An investment philosophy (unless copied from someone else) does not develop in a day or even a year. Instead, it evolves over time using logical reasoning, experience and research. In this the first chapter, Fisher describes how his investing philosophy evolved by taking the reader through the major experiences that influenced his interaction with the stock market.

Fisher first gained interest in the market as a young boy who witnessed his grandmother's discussions with her nephew about her stock investments. As the roaring 1920s continued, Fisher dabbled in the market and made a few dollars himself, but he realizes now that at that time he learned nothing of value when it came to investing.

Fisher learned more about evaluating business potential while at Stanford's Graduate School of Business. He would have weekly discussions with one professor in particular about specific companies that the class would visit in order to evaluate.

As the stock market continued to ramp up, financial firms were looking for warm bodies to sell securities. Fisher took a job at an investment bank doing something he now calls "intellectually dishonest". As a Wall Street statistician (which analysts were called back then, until the market crash made statisticians so unpopular that a name change was required), Fisher would pump out reports, without doing any proper research, about new security issues that would allow salesmen to push the issues on their customers. It was here that Fisher realized that there must be a better way to do this.

Fisher began to study companies more thoroughly to test if this was true. In one of his first experiments, he spoke to retailers about some of their radio products. Much to his surprise, everyone he spoke to across a number of different firms all had similar things to say. As a result, Fisher was able to predict the demise of a popular company on the basis that it's products were not doing very well.

Furthermore, in August of 1929 Fisher's evaluation of the stock market was so bearish that he issued a report to the officers of his bank that the next six months would see the beginning of the greatest bear market in a quarter of a century. Nevertheless, Fisher did not put his money where his mouth was, and lost a lot of money in the ensuing stock market collapse.

Following the crash, jobs in the finance industry were hard to come by. Fisher realizes now that it was a great time to start his own firm, but back then he had little choice, as only menial jobs were available. Therefore, in a small office with expenses of $25/month, Fisher started his own advisory firm. In the first year, he made a profit of just $3/month, and in the following year it would grow to $30/month. This is the kind of money he could have made as a newsboy selling papers, but it laid the foundation for a business that would prove to be extremely profitable.

Saturday, February 20, 2010

Conservative Investors Sleep Well: Chapter 6

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

The issue of an investment's price is so important that Fisher devotes a third chapter to its discussion. While in the previous chapter Fisher discussed how the financial community's appraisal of the industry can have a strong effect on the price of an issue, now he discusses how the community's appraisal of stocks in general can affect a company's price.

Fisher discusses a few extreme examples to illustrate his point on this issue. One example occurred from 1927 to 1929, where a so-called "new era" was upon us: earnings grew tremendously, a businessman was elected President, the future looked bright, and stock prices grew to ridiculous levels. At the opposite end of the spectrum, but just as spectacularly wrong, common stocks sold at high discounts from 1946-1949 despite strong company earnings. Fisher argues that determining whether the market is about to enter such a period is a good way to avoid buying at the wrong price, and the best way to ascertain the future of the financial community's outlook on stocks is by correctly estimating coming changes in interest rates.

Though the financial community's feeling toward the market and the company's industry both have an effect on a stock's price, the strongest influence of an issue's price is still the appraisal of company-specific fundamentals. Fisher reminds the investor to compare the company's P/E to the first three dimensions of a company (discussed in the first three chapters) to determine whether it is under- or over-valued. In other words, just because one company's P/E is 10 and another's is 20 does not mean the one with the lower P/E is cheaper. If the company with the higher P/E will still command a higher P/E in five years (due to strong performance against the first three dimensions) and will have grown earnings to a large extent within that period (again, for the same reasons), it is actually the more conservative investment.

Friday, February 19, 2010

Catching Up With Innovation

Where management has a significant portion of its net worth invested along with shareholders, agency costs are likely to be at a minimum. Shareholders can easily determine how invested management is in a company by looking in the same place that a company's executive compensation can be found. Unfortunately, the use of equity swaps, becoming more common in the financial world, can render the information on management's stake in the company essentially useless.

Equity swaps are a financial innovation that allows one party to swap the returns of one asset for the returns of another asset. Consider an example of how this might be useful:

Andre Preneur started a company from scratch, and recently took it public. His net worth is now several hundred million, but all of his wealth is invested in just this one company, a risky portfolio no matter how strong the company. Andre has family commitments and wants to lock in some of this gains, however, and this undiversified portfolio could result in a significant loss of capital should something go wrong. Selling 20% of his holdings in order to diversify would drag down the stock price, hurting all investors in the process. But a swap in which he trades the returns on a portion of his holdings to a dealer that pays him the return on the S&P 500 (minus a fee) allows him to achieve some diversification without high transaction costs.

Clearly, this type of swap serves a useful purpose. Unfortunately, regulators must constantly play catch-up to avoid unforeseen problematic consequences. For one thing, Mr. Preneur would owe a substantial sum of taxes if he actually sold his shares, so when this product first came out, it would have saved him a tidy sum (regulators have since closed this loophole). Furthermore, an insider could effectively sell his shares in a company - without having to report any insider sales, which shareholders often count on as a clue towards management's outlook! (This loophole has been closed as well.)

Unfortunately, one loop hole that has not (yet?) been closed has to do with the fact that management may show ownership of a number of shares, but may have swapped the returns away. Shareholders wouldn't know unless they pieced together disclosures of insider sales, insider buys, restricted stock issuances, stock option issuances, and stock option exercises - and even then, these particular disclosures are not likely to form a complete picture of exactly how much a manager owns. In an extreme case, this could lead to a problematic situation where a manager has voting control, but suffers no consequences as a result of his actions (for he has swapped the returns away), while shareholders believe that the manager has a full stake in the company!

Innovation in the banking and financial industry has benefited us all. Of course, if unchecked, things can go awry in a hurry, as evidenced by the bank-induced recession that took the world by storm last year. This doesn't mean innovation should be stifled, but it does mean investors and regulators must stay abreast of what's going on, and take corrective action when publicly disclosed information is unintentionally suppressed as a collateral result.

Thursday, February 18, 2010

Pensions Reverse Course

What a difference a year can make! Last year at this time, as the market set low after low, investors were cautioned to be aware of companies with defined benefit pension plans. Since shareholders are on the hook for the pension obligations, any drop in pension plan assets (as a result of the market declines) should result in a drop to a company's valuation.

This year, the opposite effect is taking place. As companies with fiscal years ending on December 31st will release their annual reports in the coming weeks, companies with defined benefit plans will likely see improved financial positions! Since pension asset values are only reported once a year, investors using 3rd quarter reports are likely underestimating the value of their companies under study. In other words, companies with defined benefit plans are likely worth more than investors are giving them credit for!

As an example, consider Twin Disc (TWIN), a company we discussed as a potential value investment last year. Last year, the value of the company's pension assets fell by $24 million, pushing the company to cease accruing pension benefits for employees. For a company with a market cap of just $100 million, this change in the value of its pension assets is clearly material to the value of the stock.

Since the broad market has gained significantly in last several months, Twin's assets have likely experienced a material gain as well. Unfortunately, until the 10-K comes out (and for TWIN, that is not for several months, as their fiscal year-end is not the same as the calendar year-end), all the investor can do is estimate the gains.

Unfortunately, estimating gains is not easy. While companies do disclose their planned asset allocations, determining the rise in values of private equity or real-estate investments is not an easy task. Furthermore, in the interests of conservatism, investors are cautioned from being overly optimistic when estimating returns. However, in cases where pension assets are material, recognition of this issue can help the investor improve the accuracy of his valuation.

Disclosure: None

Wednesday, February 17, 2010

Disguised Net-Nets

All value investors are familiar with the fact that stocks that trade at discounts to their net current assets tend to outperform the market. However, companies have substantial leeway when it comes to creating their financial statements, which can make it difficult for investors scanning financial statement data to identify stocks trading at such discounts.

For example, consider L.S. Starrett (SCX), manufacturer of a range of industrial and consumer products. The company trades for $60 million, and also shows net current assets of $60 million. From this standpoint, the company does appear cheap, but without further information it does not meet the requirement of having a large margin of safety.

However, careful reading of the company's notes to its financial statements reveals that it accounts for some of its inventory using LIFO accounting (FIFO, on the other hand, is used by the vast majority of companies). As a result, inventory is understated (compared to FIFO) by over $30 million! This is no rounding error, as $30 million is half of this company's market cap!

FIFO accounting likely more accurately reflects the actual value of inventory, and is therefore probably the more useful measure for investors looking to value companies by their balance sheets. LIFO accounting tends to make accounting profits lower in comparison to FIFO accounting, and is therefore employed by companies to reduce the amount of taxes owing.

After making this adjustment, L.S. Starrett goes from being just another cheap company, to a net current asset stock! Unfortunately, a quick scan of the company's financial statements would reveal none of this, requiring the investor to dig deep to uncover this situation.

By the way, L.S. Starrett is far from the only stock in such a situation. A few months ago, we saw that A.M. Castle (CAS) also had these properties, and as such could have been had at a significant discount to its net current assets. The stock subsequently appreciated in price and now sits on the Value In Action page.

Disclosure: Author has a long position in shares of SCX

Tuesday, February 16, 2010

Setting The Linktone

Linktone (LTON) is a Ben Graham net-net, with current assets of $125 million, total liabilities of just $11 million, and a market cap of $70 million. Most of the current assets are in the form of cash, which is the result of a share offering at a significantly higher price. The stock price has shown itself to be quite volatile, which is a good thing for value investors (and keeps other investors away). The company's market cap has ranged from $45 million last year to over $100 million a few short months ago. While it is not losing money hand-over-fist as many other net-nets are, there are some risks of which investors should be aware.

Linktone not only operates in a very competitive arena, offering value-added applications to mobile phone users in China, but is also subject to severe market pressure from its customers, the three state-run Chinese telecom operators. These large players dominate the market and use their market power to extract high and escalating fees on Linktone and it's competitors. Furthermore, these companies have been making progress in vertically integrating, offering popular applications to their user-base, thereby taking away Linktone's share of the market.

Linktone is extremely dependent on one of these operators in particular, with 70% of its revenue coming from China Mobile. While there are contracts in place to secure Linktone's position temporarily, these contracts are short-term in nature and as discussed in the previous paragraph, all the power lies with the customer. Finally, the company is controlled by a single shareholder, which makes it more difficult for shareholders to encourage activities that may result in price and value convergence (a very different situation than the one we saw with Acorn a couple of months ago).

The earnings situation for this company may be grim due to the weak market position in which Linktone sits. However, from a liquid asset and cash perspective this company is very attractive. The question investors will have to watch for going forward is whether the new management team is able to mitigate the risks (mentioned above) facing this company so that they may conserve the company's strong balance sheet position.

Disclosure: None

Monday, February 15, 2010

When Debt Isn't Okay

Companies with lower risk can afford to take on more debt than the average company, as their low-risk nature allows them to service debt even when the going gets tough. In the finance industry, the term "low-risk" in this case usually equates to stable revenues and costs. But stable revenues and costs of the past cannot on their own constitute a sign that a company has low risk, for there are many oft-ignored elements that combine to form a company's risk.

Consider Cinram (CRW), producer of the DVDs and CDs on which music, movies and games are distributed. One would expect this to be a fairly steady industry (with the exception of the requirement to adopt new portable media technologies as they go mainstream) and the company has shown very steady revenues over the last few years. As a result, the company has loaded up on debt, both to lower the cost of capital and to fund acquisitions to increase its market reach and scale.

Unfortunately, despite the stable outlook for the industry and the company's stable history, there was a large risk embedded in this company that both creditors and the company's managers appear to have overlooked when they loaded up on debt a few years ago (and subsequently made the problem worse with share dividends and buybacks that further weakened the company's financial position): the concentration of its customers.

A large amount of business coming from just one customer represents a significant risk. Companies in this position should be wary of taking on too much debt, on the chance that the major customer has a change of heart. In Cinram's case, 28% of revenues came from Warner Brothers, who earlier this month had a change of mind about its DVD supplier. What you have now is a company with operating leverage suffering a large revenue cut, with debt obligations it can no longer afford. On the news of the loss of the major customer, the stock dropped 60%.

Since the first rule of value investing is "never lose money", situations like these must be avoided. While large amounts of debt can be okay for some companies, a superficial glance at the company's industry and operating history do not suffice in evaluating whether the company merits a low-risk moniker. Some additional revenue risks are considered here.

Disclosure: None

Sunday, February 14, 2010

Conservative Investors Sleep Well: Chapter 5

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

Fisher continues with his discussion of what he calls the fourth dimension of a conservative investment: its price.

So far, Fisher has only discussed company-specific factors in determining the financial community's appraisal of an investment. However, Fisher notes that there are two other appraisals that can have a strong effect on a company's price: the financial community's appraisal of both the industry and of stocks in general.

Of course, as an industry matures, the P/E ratios of companies within it are expected to fall. But Wall Street's industry appraisals often overreact; at times, the financial community is overly positive, while at other times it is too negative.

Industry conditions do not change so quickly, but the financial community's appraisal does! Since the conditions prevailing in the industry do not change, Fisher believes it is the conditions that are emphasized that change, and thus the P/E ratios for industries can move dramatically.

To illustrate this point, Fisher discusses a few examples in the chemical and electronics industries, where Wall Street's emphasis shifted once and then back again, offering the investor opportunities to profit. In the chemical industry, for example, innovation can result in cheaper or higher quality materials or substances that can result in new and larger markets. At the same time, however, many chemical components can be replicated, and bouts of overcapacity can thus result in price wars and margin erosion. These properties of the industry don't change considerably over time, but the appraisal of the industry can change dramatically.

The challenge for investors is to determine whether Wall Street's appraisal of an industry is on the money, or too low or too high. Only then can the investor accurately predict the future direction of the market price.

Saturday, February 13, 2010

Conservative Investors Sleep Well: Chapter 4

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

After discussing the three essential dimensions that make a stock worthy of investment, Fisher now discusses Dimension #4: the investment's price. Fisher's explanation of why stock prices change is as follows:

"Every significant price move of any individual common stock in relation to stocks as a whole occurs because of a changed appraisal of that stock by the financial community."

For the companies in which Fisher is interested, the "appraisal" is most easily measured in the price to earnings ratio the market accords a particular stock. Fisher looks for price appreciation in two ways: first, from growth in the company's earnings, and second, from the increase in the stock's P/E ratio. Fisher offers that the latter source of appreciation can often play the larger role in a stock's price appreciation.

Fisher argues that there are wide variations between the financial community's appraisal of a stock and the true set of conditions surrounding it. Sometimes, this divergence can last for a few months, while at other times it can persist for years. When this divergence exists, the investor should take advantage of the situation.

The lowest risk investment opportunity exists when a company measures high in regard to the first three dimensions, but has a lower P/E than fundamentals warrant. Next risky, though still suitable for investment, are companies that again rate high on the first three dimensions, and have a P/E in line with these fundamentals. If a company truly has the desired attributes of the first three dimensions, the stock shall nevertheless appreciate in price.

The most dangerous group of stocks are those with a financial-community appraisal far higher than is justified by the fundamentals. Purchase of these shares cause sickening losses and can cause individuals to avoid stock ownership in droves. There are many such examples, and Fisher goes on to name a few.

Fisher continues his discussion of the right price at which to buy a stock in the next chapter.

Friday, February 12, 2010

Figure Out Who's With You

That management should act in the best interests of shareholders is often discussed, including on this site. Implicit in this idea, however, is the notion that all shareholder interests are the same. Unfortunately, this is not always the case. However, disclosures are available which can aid the shareholder in determining whether the interests of major shareholders are aligned with theirs.

Shareholders who peruse SEC company filings will have come across Schedule 13d from time to time. This is a mandatory filing that must be submitted by anyone who owns more than 5% of a company. On this form, major shareholders are required to disclose who they are, their relationship to the company, and even the motivations behind the transaction (though that can be conveniently changed at a later time).

But even if the schedule itself does not make the motive of the purchase abundantly clear, researching the large investor's background may help clear up uncertainties with respect to the company's near-term future. For example, if Berkshire Hathaway has taken a large stake in a company, it may be seen as an endorsement of management. On the other hand, if Carl Icahn is the buyer, director and management changes may be on the way!

Management will act in its own best interests, and for this reason investors should ensure that management's interests are aligned with theirs. Sometimes, however, management may be swayed to act in the interests of major shareholders, whether under the threat of a hostile takeover or as part of a courtship process for a friendly merger. Investors armed with this knowledge are in a position to better understand what is about to take place, and may thus make investment decisions that are in tune with their investment strategies.

Thursday, February 11, 2010

Expanding When It Should Be Contracting

American Metal & Technology (AMGY) is rather undervalued on an asset basis: the company trades for under $5 million, but has cash of $7 million and receivables and inventory of $3 million against total liabilities of just $2 million. Whether shareholders can realize value out of this situation is very much in the air, however, as a result of some questionable management decisions.

As sales dropped amidst the recession, the company began an aggressive capacity expansion program. During 2008 and 2009, the company added tens of thousands of square feet of manufacturing capacity along with several million dollars worth of equipment. However, whereas the company used to run three shifts a day, it is now down to one shift a day, as quarterly sales have dropped 80% year-over-year. The larger capacity means larger fixed overhead at a time when demand is suffering, which explains why the company's margins continue to fall despite layoffs.

If this were the only problem, and management was taking steps to remedy it, perhaps the company would still warrant consideration. Unfortunately, this seems like a company bent on continuing to expand when there appears to be a lack of demand for its products. Furthermore, a slew of questionable smaller transactions appear to be taking place as well.

An account labeled "other receivables" has increased $500K in the last two quarters, without much of an explanation. For most companies, this would be a drop in the bucket; for a company this size, however, this jump is significant and particularly worrisome considering the huge drop in sales.

Additionally, two of the company's customers account for the majority of its sales, which adds risk as discussed here. Complicating this matter is the fact that the company's CEO and a director are shareholders in these two customers. Multi-ownership situations such as these make it difficult to determine management incentives. Further exacerbating this question is the fact that management loans were recently forgiven, and a payment due to another company in which the CEO has a significant stake was increased as a result of depreciation in the US dollar!

Companies that trade at discounts to their liquid assets can appreciate in price significantly. However, questionable decisions can also cause value to be lost, and therefore investors should research companies thoroughly before exercising investment decisions.

Disclosure: None

Wednesday, February 10, 2010

GameStop: Filtering Out The Useless Information

Research analysts receive a lot of flack when their predictions are dead wrong. Since they are supposed to spend their working hours immersing themselves in the vagaries of the various businesses under their study, investors hold them to a higher standard when events occur that went unforeseen. But the research analyst has two separate jobs, and in only one of these can realistic expectations exist.

First, the research analyst must predict the company's future results. To do this, the analyst must understand the industry and business risk and success factors. Analysts will study and speak to the company's customers, competitors, suppliers and management. Much useful info can be gleaned from such study, as discussed by Philip Fisher, one of the pioneers of this approach.

But the world's greatest investors will tell you that the analyst's second task is virtually impossible. Unfortunately, they all try it anyway. Accompanying each analyst report is a target price, where the analyst tries to make sense of market movements and estimate not what he thinks the company is worth, but what the market will think it is worth. If there ever was a futile exercise, this is it. But the analyst will spend enormous amounts of time stringing together long calculations of high precision - and low accuracy - in formulating an expected price as soon as a few months out.

Predicting the market's short-term movements is a difficult task indeed. Even if it can be done, which would be disputed by Warren Buffett and a slew of top investors and market observers, diagnosing short-term market movements isn't within the research analyst's expertise. At times, this can lead to a divergence between the analyst's opinion of a company's business conditions and stock expectations.

For example, consider a note yesterday issued by Gary Balter of Credit Suisse. Balter downgraded GameStop (GME) to "neutral" even though the share price is more than 20% below his price estimate. So despite an "exceedingly exciting valuation" and a "limited downside", Balter doesn't see the market recognizing these factors, as he is worried about a situation where "even better results do not expand the multiple".

Analyst reports can be extremely useful, offering business and industry insights from those who have spent months studying companies under their research umbrella. However, investors must separate what information in the report is useful (business risks and opportunities) and what is nothing more than rampant speculation (estimates of short-term market prices).

GameStop certainly has business challenges; that part is not in dispute. Pricing pressure from big-box retailers, and the potential for digital downloads to grab share in the future all have investors scurrying to the exit. The point, however, is that investors should base their investment decisions on what the business is worth, and not on what they predict the short-term market price to be, for the latter cannot be done.

Disclosure: Author has a long position in shares of GME

Tuesday, February 9, 2010

Heelys' Stock Builds In The Bad News

A few years ago, Heelys' footwear product for children was all the rage. The company had designed a sneaker with a removable wheel on the heel that had taken the consumer market by storm. Below is a demonstration of the dual-purpose footwear in action:

The company's 2006 IPO was accompanied by much fanfare, as the company had high hopes of expanding its markets and designing innovative new product lines. Consensus analyst estimates suggested the company would grow its earnings 20+% per year for the next five years. When the fad was exposed for what it was (i.e. sales began to drop, and insiders started selling) the stock price took a huge hit, falling from almost $40 to the $2 it is today.

However, it continues to hold much of the cash it took in as part of the IPO at a much higher price. The company trades for $58 million, but has $90 million in current assets (including almost $70 million of that in cash!) and just $11 million in liabilities.

Unfortunately, the company largely remains a one-trick pony. However, it appears to have cut its costs to adjust to the much lower revenue environment, as the company is now close to break-even levels on an operating basis. The company also recently settled a slew of lawsuits related to its IPO, as angry investors who lost a lot of money received some consolation (mostly from the company's insurance providers).

The risk of course, is that the company uses its large cash holdings on a foolish investment that never pays off. Fortunately, however, the company appears to have made no such plan. In fact, the company under new management has shown a willingness to return cash to shareholders, with a $1 dividend at the end of last year. If the company continues to make progress in cutting its costs, it may be more willing to dish out more of its cash holdings to shareholders in the near future. With a stock price of $2, and cash on hand of almost $3 per share, this could bode well for shareholders.

Disclosure: None

Monday, February 8, 2010

Hardinge Makes It Easy

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

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

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

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

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

Disclosure: Author has a long position in shares of HDNG

Sunday, February 7, 2010

Conservative Investors Sleep Well: Chapter 3

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

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

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

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

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

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

Saturday, February 6, 2010

Conservative Investors Sleep Well: Chapter 2

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

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

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

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

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

1) The world is changing at an increasing rate
2) Employees must feel that their company is a good place to work
3) Management must be willing to sacrifice today for sound long-term growth

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

Friday, February 5, 2010

The Focus Of Mutual Funds

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

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

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

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

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

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

Thursday, February 4, 2010

Parlux Gets Cheaper

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

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

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

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

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

Disclosure: Author has a long position in shares of PARL

Wednesday, February 3, 2010

Avatar: Not Just A Movie

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

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

Stock Market Value: $200
Cash on hand: $219
Land/Inventory: $287
Total Liabilities: $156

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

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

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

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

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

Disclosure: None

Tuesday, February 2, 2010

Revenue Certainty Uncertainty

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

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

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

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

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

Disclosure: None

Monday, February 1, 2010

TravelCenters Of America: It's Complicated

Across several value metrics, TravelCenters of America (TA) appears to have potential as a value investment. While the company trades for just $85 million, it holds $185 million worth of cash and trades at a price to tangible book value of about .25. However, a slew of factors combine to make the outlook for this company highly uncertain, even for the most long-term of investors.

First of all, the company operates in an intensely competitive industry, primarily offering diesel and other services aimed at truckers traveling the highways. Like The Pantry (PTRY), which we discussed last week, it makes slim margins on its petrol products, often entering into price wars with the competition. Recently, one of its competitors entered bankruptcy and was bought out by another competitor, which now has a much stronger competitive position.

While one might argue that TA's locations along prime highway junctions act as a competitive advantage, such advantages are but temporary in nature: TA does not own it's own locations, but rather rents them. As such, the landowner is free to kick TA to the curb if it's not willing to pay market prices for its locations. As such, it is imperative in this industry to be a low-cost operator. Unfortunately, many of TA's major competitors are private companies, making it difficult to determine how well TA is positioned to defend its market.

Furthermore, management's incentives are not entirely clear. Not only does management not own a significant stake in TA relative to what it makes from TA in bonus and salary, but management also has heavy involvement in TA's landlord and a company that does servicing work for TA. For example, TA's CEO and CFO are both executives of TA's servicing company. Management also has ownership stakes in these related companies.

Finally, for those more interested in an asset play than an earnings power outlook, the company's balance sheet is not nearly as pristine as it appears. A great majority of the cash is earmarked to pay back huge rent liabilities that are over and above the company's stated debt. The company has been recognizing rent expenses on the income statement over the last little while, but hasn't been paying much of that rent as of yet! This has made the balance sheet look temporarily better than it deserves to be, as these deferrals are not likely to continue, resulting in a cash outlay to cover these liabilities.

For further discussion of this company's risk factors and potential, see the articles at Variant Perception here.

Disclosure: None