Monday, July 19, 2010

To Grow Or To Buy Shares?

Companies trading at large discounts to their net asset values have an additional decision to make when it comes to allocating their capital. Should they buy back shares, or focus on growing the business? Unless there are debt (or other immediate liability) concerns to worry about, value investors would generally prefer that a company return money to shareholders, as this is a lower risk method for generating a strong return for investors. But should value investors still be interested in a company that trades at a large discount to its net current assets even if management has no intentions of returning cash to shareholders?

This decision cannot be made in isolation, as several other factors play an important role in this determination. Investors should consider the nature of the intended investments, the company's ownership/control structure, the level of its management/board ownership, and management's abilities or track record.

As an example, consider Nu Horizons (NUHC), a company discussed on this site last week as one that trades at a discount to its net current assets but where management's intentions are to re-invest its capital in the business rather than return money to shareholders.

For Nu Horizons, these re-investments are not in the form of specialized fixed assets with uncertain returns. Instead, as Nu Horizons is a distributor of electronic components, these re-investments are in the form of inventory. The company is able to generate a gross margin on this inventory, and is currently profitable while simultaneously growing sales, suggesting the investments will earn immediate returns for shareholders.

Often, when management controls a company, it doesn't have to pay attention to shareholder returns and can instead focus on growing the size of its empire, whether shareholders benefit from that or not. In this case, however, management controls just 10% of the votes, leaving the company vulnerable to a takeover if returns are not adequate.

Nevertheless, the company's Chairman and COO own a combined $4.6 million of the company, so they do have a vested interest in seeing the company make decisions that are in the best interests of shareholders. Comments on the conference call confirm that the company is not making this decision to re-invest lightly:

"[Buying back shares is] something we talk about quite fairly, but we discussed it all on a number of occasions particularly in Board meetings, but if you look at the growth that we have in business today and you look at our new facilities that we have that Kurt talked about, then the truth is we are using our facility to fund the growth, which is our belief: that we have to fund the growth... And I think today that’s the right use of our cash. And I understand the concept of buying back stock and as I said, something we discussed on a regular basis."

It's certainly riskier for the value investor when management of a company trading at a large discount to its net current assets chooses to invest in the business rather than return money to shareholders. But under circumstances where management does not control the company's voting direction (and yet has a significant ownership position) and investments are not of a specialized or uncertain nature, a stock may still make for a great value investment. It will be interesting to see how this one turns out!

Disclosure: Author has a long position in shares of NUHC

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