Wednesday, June 30, 2010

Are Those Really Sales?

HQ Sustainable Maritime (HQS) cultivates tilapia and other marine life using aqua-farms. It then sells these fish as part of health and food products throughout Asia, Europe and North America. While the company trades for just $73 million, it reports net current assets of $92 million, and profits (in the latest fiscal year) of $8 million. But upon further examination of the company's financial statements, the actual value of the company's net current assets and profits comes into question.

In the last fiscal quarter, sales were up over 30% from the year-ago period. Sounds good, right? Until one notices that the "accounts receivable" balance is up almost 140% over this period! This suggests the company has been giving its product to anyone who will take it and counting those transactions as sales (which then flow through to profits) without regard for accepting payment. In fact, from the current numbers, it seems as though it takes a full year for the company to collect cash after a sale.

No big deal, one might say. So what if the company finances its customers a little bit, it's still a good deal right? It may indeed still be a good investment, but it does introduce new risks which mitigate its appeal. Only after understanding these risks can the investor make an informed decision as to whether to go ahead with this potential investment.

From an asset point of view, this situation increases the loss to the company should one or more of its customers default. There is some concentration of customers for this company (the top 5 customers account for 37.5% of sales), so without knowing more about the finances of these customers, there is a potential risk here. Receivables represent much more than half of the company's net current assets, so if the investor thinks he is buying assets, he should know there is some larger than normal downside risk attached to them.

From an earnings point of view, the high receivables suggest sales levels aren't actually elevated from year-ago levels. The company is potentially telling customers to take delivery on the product now (to be counted as a sale for the company) without having to pay any time soon. As such, customers are willing to take large deliveries, which pumps up the company's sales and profits without any real basis. Had the company's credit policy been the same as it was last year, the company might even be operating in the red for all we know!

A cursory look at a company's financials can tell an investor whether a company holds promise as a potential value investment. However, the analysis cannot end there. Further scrutiny should be applied to determine if the company's numbers may be overstated. In so doing, the investor can make the investment decision armed with a full knowledge of the risks a company is facing.

Disclosure: None

Tuesday, June 29, 2010

Best Buy Gets Sold

Following sub-par first quarter results, shares of Best Buy (BBY) have fallen to a level such that its P/E is now 11. Unlike some of the other low P/E stocks we have discussed on this site, however, Best Buy generates returns on capital of around 20% per year. And it does this consistently, as shown by the chart below:


What likely helps Best Buy maintain such steady returns is the nature of its competitive advantage. Unlike companies that have to continually invest to maintain their advantages (e.g. pharmaceuticals, smart-phone makers etc.), Best Buy gets to profit off of the product innovations of others, by relying on its already-established distribution network.

It does face competition from other retailers (both bricks and mortar as well as online), but the risks to its business are easier to see in advance and easier to protect against than say a company hoping to bring a new drug to market or a company trying to hit a home-run with a new technology it hopes consumers will adopt.

But despite the steady returns, Best Buy's stock price has been volatile (as we saw when we considered the company last year), allowing investors the ability to buy this company on the cheap. In 2008, the company was available for $18/share, a 60% discount from what it was a few months before. In 2009, the stock ranged from $25 to $45. How does the value of such a steady company change by as much as 100% in a single year?

This year appears to be shaping up in a similar way, as the stock has gone as high as $48, but has fallen by more than 25% from those levels. Much of that drop can likely be attributed to a shortfall in the latest quarter's earnings. But besides the fact that the first quarter is a nothing quarter for a retailer like Best Buy (almost 60% of the company's annual profit comes from the Christmas quarter), basing a company's value on any quarter is not a sound way to invest. This is exactly the kind of short-term thinking in which the market participates, however, which allows long-term investors to profit.

Joel Greenblatt has clearly spelled out for us the benefits of investing in high ROIC stocks when their P/E's are low. Best Buy appears to be once again (for the umpteenth time) creeping into that territory. As the price continues to fall, those who have not yet found their way into this steady performer on one of its previous price plunges may find a great price at which to do so.

Disclosure: Author has a long position in shares of BBY

Monday, June 28, 2010

Buying What Management's Selling

Research in Motion (RIMM) co-CEO Jim Balsillie is very bullish about his company's prospects in the second half of RIM's fiscal year (i.e. starting around August/September of 2010). He has been touting this time period for several months now on company conference calls, with comments like:

"...[Y]ou are going to see a lot of stuff in the fall. If you saw the roadmap you would be blown away."

"[W]e feel very, very strong and optimistic about what you're going to see coming out of us throughout the rest of the fiscal year."

"If you saw what we're coming along with for the back half of this calendar year, that's lined up and queued up..!"

"[O]nce you see the new platforms, like you'll be all very surprised."

"I'll think you'll just be amazed that how it's a quantum leap over anything that's out there.
I just wish I could wind the clock forward a few weeks, because...you would all say, I get it now...When you see the pieces come together, you'll say, now I see what they were doing...I can't say much more, but I couldn't feel better."

" And we might have a couple of surprises up our sleeves in addition to that...So yes, we feel fantastic about the business. We feel fantastic about the product set."

But should investors trust the outlooks of this nature that executives push? The market certainly isn't buying it, as RIM's stock fell more than 10% following the release of its first quarter results last week, despite the fact that year over year earnings were up on the order of 40%.

Perhaps a look at Balsillie's outlook history can be of help in evaluating whether he's talking up the stock or whether he means what he says. By looking at previous conference calls, it's clear that he has been optimistic about upcoming products, which have turned out to bump up sales and profits. But its fair to say that in previous conference calls, he has never been so excited about the product pipeline as he is showing to be now. As such, he appears to be making a huge bet with his reputation and his credibility, something he probably does not take lightly.

Should RIM's new products be anywhere near as great as Balsillie is making them out to be, shareholders will likely see great rewards, because expectations appear to be low. But if the products turn out to be just ho-hum, typical new introductions with a few more features, the downside risk appears minimal: RIM is the market leader in an industry expected to grow at double-digit rates (and has been doing so through a recession!) for the foreseeable future, but it trades at a P/E of just 10*! But investors appear to be pricing this security as if profits are in perpetual decline. As such, this stock may represent an investment opportunity where the downside risk is far outweighed by the upside potential.

Disclosure: Author has a long position in shares of RIMM

* The P/E ratio was arrived at by dividing the company's current market cap ($28.8B = 552M * 55.23) minus its cash and investments (much of which is currently being spent on share buybacks) by its earnings over the last four quarters ($2.6B = 769M + 710M + 628M + 476M)

Sunday, June 27, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 9

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

Dreman expands a bit on the low P/E strategy described in the previous chapter. His research suggests that the low P/E strategy even works (by a similar margin) within individual industries, which opens up many doors for investors who can't help but avoid unfavoured industries. As a result, Dreman argues that the investor can even participate in the most popular industries of the day, and buy the companies within that industry that trade at the lowest P/E (even if those stocks trade at premiums to the market) and still generating returns that are much stronger than that of the market!

Dreman also discusses the very difficult question of when to sell an investment. There are as many answers to this question as there are investors, Dreman argues. Furthermore, few stick to their sell targets, thanks to psychological forces. For instance, if a stock rises up through the target sell price set by the investor, he will tend to find reasons to bump up his valuation.

Dreman provides a rule for investors to follow that he highly recommends investors stick to. He advises that investors sell once the stock's valuation level has reached that of the market. For example, if the investor is following a low P/E strategy, he should simply sell when the stock is at the same P/E level of the market, and use the funds to buy a new contrarian stock.

Another difficult question to answer is when to give up on a stock that doesn't see any improvement in its valuation. Dreman advises that investors give a stock 2.5 to 3 years, or more if it's a cyclical stock (as it may take more time to recover from an economic slowdown). Other investors use different time periods, however, so the investor may need to reach his own decision on how comfortable he is with his "loser" investments. For example, value investor John Templeton will give his investments six years to come around (assuming no change in fundamentals).

Saturday, June 26, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 8

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

Based on the evidence described in the previous chapters, Dreman recommends four strategies for the retail investor. He suggests investors go with a low P/E, low P/B, low P/CF or high-dividend yield approach. If investors rebalance their portfolios every year such that they include twenty to thirty large stocks within the lowest 40% of each category, they should beat the market handily. Should they be willing to rebalance their portfolios every quarter, Dreman expects them to do even better, based on the data he has collected.

In addition to the criteria set out above, Dreman checks the following five additional criteria before an issue makes it into his portfolio:
  • A strong financial position (current assets vs current liabilities etc.)
  • Favourable operating and financial ratios
  • A higher rate of earnings growth (historically) vs S&P 500, plus the likelihood that earnings will not plummet in the future
  • Earnings are estimated conservatively
  • An above average dividend yield
In this chapter, Dreman also introduces GARP – growth at a reasonable price. GARP investments benefit shareholders in two ways. First, as earnings grow, so does the stock price. But investors further benefit as a result of the fact that as a company shows strong earnings growth, the stock’s P/E multiple will also expand.

Finally, Dreman discusses some actual investments he has made by applying these methods. He goes into detail on how the above ratios and criteria applied to his purchases of Galen Health, Eli Lilly, Ford, Fleet Financial and KeyCorp in the 1990s.

Friday, June 25, 2010

Marketing, The Wrong Way

Shareholders are best served when company resources are utilized to grow a company's earnings power. Or, as Warren Buffett likes to say, "Our managers focus on moat-widening". But when top management is busy spending its time touting the stock price rather than improving the business itself, shareholders are likely not well-served.

Consider China Marine Food Group (CMFO), a distributor of seafood products. The company's top management is going on a road show to NYC in the coming weeks. But there is no stock being sold on its road show! Apparently, the company simply wishes to talk up the stock to prospective and current investors. In other words, there's likely no increase in the company's intrinsic value by this use of company resources, only an attempt to pump up the stock price.

Perhaps an argument could be made that such actions make sense if management felt that shares were undervalued. That argument appears moot, however; apparently, management does not feel its shares are undervalued, as it recently issued almost $30 million worth of shares for "general corporate purposes" at what was the prevailing market price. The company has no debt, and would still have had $20 million of cash on hand without the offering (to put this amount in perspective, consider that the company's quarterly operating expenses are but $1.6 million). As such, it appears that there was no pressing need for the cash, suggesting that management did not care about dilution and is more interested in empire-building than in increasing each share's value.

And an empire-building spree appears to be what's going on, as recently the company spent $28 million for a control stake in a beverage company. Of major concern to shareholders is the fact that only $2 million of hard assets (net their liabilities) were acquired, meaning the company paid $26 million for intangibles! Some was classified as goodwill ($2.5 million) while the rest ($23.5 million) was actually classified as "Algae-based drink know-how"!

This acquisition and all its intangibles generated but $1 million of gross profit in the latest quarter, but the company sure has ambitious plans for it. The company issued a release claiming expectations of a 60% year-over-year growth in revenue for this acquisition, and "normalized long-term net profit margins of 25%". To put this in perspective, Coke (KO), which can be described as the most successful beverage company at keeping competitors at bay, generates net profit margins of just over 20%. As such, it's hard to believe that even CMFO management believes its own projections!

As a commenter on this site wrote recently, it is better when management focuses on intrinsic value rather than stock price, though the two will converge in the long run. Clearly, CMFO management is focused on the stock price, which is just the sort of situation value investors seek to avoid.

Disclosure: None

Thursday, June 24, 2010

Accounting For Business-Speak

I’m often told by visitors to the site that this content is rather advanced for the investing beginner. As such, a question I often receive is “Where do I start?” or “How do I become proficient enough to understand what makes for a good investment?” The answer is to learn and understand accounting.

Accounting is a language on its own. It’s not intuitive (at least, it wasn’t for me), but once mastered it is a very powerful tool for understanding a company’s past and present; it can even give the investor glimpses into a company’s future.

Every quarter, management will host conference calls and issue a release which describes the company’s progress. Often, the statements managements make through these media give a very rosy view of management’s progress. But investors who do not understand accounting have nothing else to go on. Meanwhile, an understanding of accounting can actually tell an investor much more about a company’s performance and prospects, both positive and negative.

One e-book that can help investors understand accounting is Mariusz Skonieczny’s The Basics of Understanding Financial Statements. The e-book covers the necessary elements, and does so from a value investor’s perspective, making it an ideal starting point for the aspiring value investor. The e-book is also free, coming in at just the right price for the value investor as well! The book is available here.

Wednesday, June 23, 2010

Warren Buffett's Sports Book

Warren Buffett continues to show us that when your portfolio gets too big, you have to get creative in order to generate market-beating returns. With Monday's loss by the French at the FIFA World Cup, Buffett is a few million dollars richer, as he is now showing us how to apply value investing to arenas outside of the normal investing world.

Surprisingly, this was not a personal bet that Buffett placed, which we've seen him do in the past. Instead, Berkshire Hathaway was on the hook for about $30 million had France won the World Cup! The fact that he used company money to place the bet suggests a seriousness to the wager that would not be present had this been a fun, personal side-bet.

So why would Buffett be taking serious sports bets of this nature, when there is a whole industry dedicated to working out the odds that will result in maximum profits? It's possible that this particular bet was so large that no casino would take it, and so Buffett was able to earn a premium on the regular odds for offering such a handsome payout.

On the other hand, maybe the Oracle of Omaha knew something about the French team that allowed him to offer better odds than the bookmakers. After all, not only did the French get ousted from the tournament early, but they completely embarrassed themselves as well. The actions of the players against their coach would normally seem astonishing, until you consider that their coach makes some of his personnel decisions based on astrology! Buffett has a lot of experience making money off of those practicing astrology, which is a trading "tool" that was often utilized by the earliest technical analysts.

More on the story is available here.

Disclosure: Author has no position in the fortunes of any World Cup team

Tuesday, June 22, 2010

From The Mailbag

In response to a post discussing the importance of return on invested capital (ROIC), a reader asked an interesting question which raises a number of points which are relevant to the value investor. The comment was as follows:

Lets say I would have to choose between two investments ..True Religion Apparel (TRLG) with a ROIC(TTM) of 50% and Joes Jeans (JOEZ) with a ROIC of 10% (TTM), you would favor TRLG even though JOEZ might be a young company with a "growth" story?

The question is seemingly simple, but the process to answer it is anything but! There are a number of items that must be considered, each of which has the potential to add substantial complexity (i.e. in a very non-linear manner, as discussed here).

First of all, while it is true that in general a higher ROIC is better than a lower ROIC, the time frame over which the ROIC is measured must be considered. Here, with the "TTM" notation, the commenter is stating that these ROIC numbers are based on the last twelve months ("Trailing Twelve Months"). But a lot can happen in twelve months, including asset sales (for both gains or losses), one-time drops/increases in demand, and other items that can affect whether the last year is truly representative of a company's earnings power. For this reason, value investors prefer to look at returns over longer time periods to assess a company's earnings power.

One's circle of competence must also be considered. For example, personally I know nothing of this industry nor of these companies. As such, I don't have the ability to attest as to whether one or both of the ROIC's of these companies is sustainable. This is very important because a high ROIC invites competition, which in turn brings down returns unless the company has a competitive advantage that keeps its competitors at bay. Past returns may be terrific, but here the investor must determine whether future returns are likely to be kind as well.

Relatedly, the fact that one company is labelled a "growth story" (as is done in the comment) is also worth noting. Value investors don't usually like "stories" unless they are backed up by ROIC numbers over the course of a number of years. In this case, it is the low ROIC company that is purported to be the growth story. But while earnings momentum looks great and the market tends to extrapolate growth rates going forward, value investors aren't willing to pay for expectations of future growth. The growth has to be borne out first, as value investors don't like to play the role of the venture capitalist.

Finally, this would not be a post on the subject of value investing if the question of price was not considered. One could have the best return on capital in the world, but if high expectations are baked into the price, the investment has little appeal to the value investor. To that end, the companies' respective debt/cash levels should also be considered to help determine the risk inherent in each investment.

Disclosure: None

Monday, June 21, 2010

Making Money Where There Is None

Can an investor make great returns from a company that continues to lose money? Absolutely. This may sound counterintuitive; it seems strange that a business owner can make money on a business that loses money, but in the end it all comes down to the price that is paid for that business. When the margin of safety is so large that the company can lose money for years and still not erode the investor's principal, big profits can come from even companies that are experiencing losses.

Consider Sport-Haley (SPOR), marketer and distributor of fashion golf apparel. When we last discussed this company, it was losing a few hundred thousand dollars per quarter. Fast forward to today and it is still losing money, having lost almost $500,000 in the quarter ended March 31st, 2010. And yet, its stock price has almost doubled over this time frame!

Is this stock return just a lucky outcome? After all, how often can a company's earnings and its stock price appreciation have so little in common? My contention is that while there are some elements of luck involved (e.g. the investor cannot determine whether the stock price will be up a certain amount in such a short period), the investor puts the odds firmly in his favour when he considers an investment's margin of safety first and foremost when making an investment decision.

In the case of Sport-Haley, three months ago the company traded at a massive 80% discount to its net current assets! This means the company could continue to lose money for several years, and the investment principal would still be protected. It also means the potential for stock price appreciation is rather high. After the recent stock price run-up, the stock still trades at around a 60% discount to its net current assets.

Of course, no investment return or time frame is guaranteed. But when the investor buys at the right price (i.e. utilizes a large margin of safety), the odds of generating market beating returns are on his side.

Disclosure: Author has a long position in shares of SPOR

Sunday, June 20, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 7

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

Dreman takes the reader through a multitude of studies conducted by different groups of researchers, spanning different decades, and across both bull and bear markets. The studies conclude that stocks with low Price to Book ratios, low Price to Earnings ratios, low Price to Cash Flow ratios, and high dividend yields outperform the market. Conversely, stocks with low yields and high P/B, P/E and P/CF ratios severely underperform the market. Many of these studies even accounted for the levels of systematic risk of the stocks under study, and came to the same conclusions.

In an all-encompassing study, Dreman studied the returns of a 25-year strategy (ending just before the book’s publication) involving annual switching into the quintile of the market’s lowest priced stocks. The study found that low P/E stocks returned an astonishing 19% per year (low P/B: 18.8%, low P/CF: 18%, high-yield: 16.1%) compared to the market’s return of 14.9%.

Seeing as how 1970 to 1996 was a fairly bullish period for the market, Dreman also studied price performance during bear markets, and once again cheap stocks outperformed. This time, the high-yield dividend stocks took the top honours (negative returns of 3.8% per year, versus the market’s return of negative 7.5%), but stocks with low P/E, low P/B and low P/CF ratios also outperformed the general market.

Despite all the evidence, why are contrarians and value investors a small minority of market participants? Dreman argues the problem is psychological. Investors get caught up in new ideas, and despite their better judgement (including all the evidence cited above), they can’t bring themselves to invest in companies that the market has beaten down. This makes them go for IPOs of glitzy companies like Planet Hollywood and SpyGlass at P/E ratios of 100+ times earnings instead of boring companies that have been around a while that trade with small P/E or P/B ratios.

Saturday, June 19, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 6

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

Having shown that surprises in EPS estimates are large in both frequency and magnitude on the stock market, Dreman now focuses on demonstrating the effect surprises have on stocks of differing levels of value.

In a study covering US stocks from 1973 to 1996, Dreman found that stocks with EPS surprises in the lowest P/E, P/B and P/CF quintiles vastly outperformed those with EPS surprises in the highest respective quintiles.

But earnings surprises can come in two flavours: positive and negative. Therefore, Dreman subsequently studied the effects of both of these types of surprises on the most popular (high price-to-X) and the most out-of-favour (low price-to-X) stocks. The results showed that negative earnings had a huge effect on the high-flying stocks (these stocks lost 4.3% of their value in the quarter following the disappointment, and 8.9% of their value in the year that followed), but little effect on the out-of-favour stocks (these stocks lost only .7% of their value in the quarter following the disappointment, and remarkably only .1% of their value in the year that followed, meaning they actually increased in value in the nine months after the first quarter following the poor results).

On positive earnings surprises, however, the out-of-favour stocks reacted very well, showing 3.6% gains in the first quarter following the good news, and 8.1% gains in the year following the good news. The high-flyers (those in the highest P/E quintile, for example) showed only small gains (1.7% in the quarter following, and 1.2% in the year following).

Dreman argues that the data clearly shows that stocks trading at premiums to earnings or book value have high expectations built into them. When earnings are positive, these stocks gain little, as strong news was already priced in. When they are negative, however, they take big haircuts. Meanwhile, stocks trading at low multiples of earnings or book values have the worst already priced into the stock. As such, disappointing data does not affect the price much, but positive data can generate strong returns! This research suggests the type of companies investors should be buying...

Friday, June 18, 2010

Bouncing Off Bad News

When a stock's earnings reporting date nears, its volatility can increase as anxious investors start betting on whether the past quarter was kind to the company. Some earnings misses can result in double-digit drops to a company's stock price, while earnings beats have the potential to be huge boosters for stock prices. Investors, of course, can't tell in advance whether an earnings report will deliver good news or bad news; nevertheless, the investor can put himself in a position such that he is somewhat protected from downside events.

Consider New Frontier Media (NOOF), a company we have previously discussed as a potential value investment. Last week, the company reported earnings which missed expectations, amidst a slew of write-downs, asset impairments and restructuring charges. Nevertheless, the stock price actually rose following the news, as investors did not rush to beat the stock down.

So what happened...did nobody know about the earnings release? After all, it is a small, little-followed company. That doesn't appear to be the case, as volume was three times normal, suggesting investors were acting, but they just weren't selling the stock off.

Why might this be? The company's valuation. When you're trading at five times cash flow (or three times cash flow once the effect of the company's cash balance is subtracted from its market cap), there isn't much further its price can fall. On the other hand, when a stock with huge expectations (e.g. a stock with a high P/E) misses its target, the stock price tends to take a huge hit.

But while this phenomenon can be found by observation, its results are based a little too much on one's own personal experiences which can then be affected by our personal biases. For this reason, in tomorrow's post we discuss a study which identified the responses of US stocks to both positive and negative surprises after dividing them into quintiles based on their P/E or P/B ratios. David Dreman explores this topic in Chapter 6 of his book, Contarian Investment Strategies.

Disclosure: Author has a long position in shares of NOOF

Thursday, June 17, 2010

Profits? Fine, But Where From?

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

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

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

As an example, consider Goodfellow (GDL), a stock we used to discuss on this site as a potential value investment (but has since graduated to the Value In Action page). Back when we favoured it as an investment last year at this time, revenues had dipped by about 15% from year-ago levels. Yet the company showed profits of 24 cents per share versus 20 cents one year ago. How did it do this? By paying down debt (and therefore reducing interest costs) and by slashing operating expenses: gross margin actually increased which is very rare when revenues decline, as fixed costs are spread out across fewer sold units.

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

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

Wednesday, June 16, 2010

Black, White or Gray TV?

Cyclical companies make for great value investing candidates. When revenue shortfalls hit cyclical companies, investors have been known to overreact to the downside, providing bargain opportunities for the value investor. When a recession hits, one of the easiest cuts for companies to make is to their advertising budgets. As such, firms reliant on advertising spending can see revenue shortfalls resulting in large earnings reductions or even losses.

Consider Gray TV (GTN), owner of several television stations, including many affiliates of CBS, ABC and NBC. As advertising budgets of America's corporations have been slashed, so too has Gray TV's revenue. But while revenue is down in the 10-20% range, the stock price is down some 75% from its 2007 level.

However, what's required for a cyclical company to qualify as a potential value play is its staying power. Unfortunately, whether Gray TV has the ability to stick around through this downturn is hard to say.

First of all, tv stations are not the oligopolies they once were. The big networks do not have the market power they had back when a "young" 49-year old Warren Buffett was scooping up ABC for its monopolistic characteristics. Today's advertisers have a variety of choice, as specialty channels have grown to steal share from the incumbents, and advertisers seek mediums which allow them to better target their customers (i.e. the internet). Therefore, even when marketing budgets return to normal, advertisers are not assured to return in droves to these particular channels.

Secondly, and perhaps more importantly, Gray TV has managed to cut costs to generate operating income, but it is still not profitable due to its high debt load. The company's debt to equity ratio is around 80%, which is generally a ratio only the most monopolistic of companies can maintain.

A monopolistic debt/equity ratio combined with a competitive (i.e. non-monopolistic) market for this company results in an investment opportunity with high downside risk. If things go well, the company may very well recover and pay off its debts. But who wants to make an even bet like that? Value investors want the upside potential without the downside risks.

Disclosure: None

Tuesday, June 15, 2010

Offending The Defensive

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

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

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

Consider Kewaunee Scientific (KEQU), maker of laboratory furniture. A combination of favourable factors for demand along with low competition resulted in strong revenues for this company in 2009. But it's important to have kept those numbers in perspective. Assuming that those revenue and profit levels would continue for the foreseeable future would have resulted in an investor's overvaluation of its stock. In other words, it was easy to have gotten sucked into believing that those numbers would only improve, considering that we were in a recession.

Indeed, management's comments at that time suggested the company was resilient in the face of recession:

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

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


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

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

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

Indeed, this type of analysis suggested the company's 2009 margins and revenue growth were not sustainable, and that turned out to be the case. In the latest quarter, the company saw sharply lower revenue and margins, and of course blamed "a soft market for small laboratory furniture projects, and unusually bad weather". This management behaviour of "take credit when things go well, blame others when things go badly" is nothing new and is not limited to this one company; rather, it is common business practice. As such, as investors it's our job to think beyond what we hear from the managers.

Disclosure: None

Monday, June 14, 2010

Jade Art

Jade is a stone used for a variety of ornamental purposes, especially in Asia. Demand for jade extends from the construction industry to the jewelry industry. Jade Art Group (JADA) is a distributor of jade with a market cap of $30 million, and an annual profit of $13 million.

Despite the seeming "commodity-ness" of this industry, Jada may actually have some competitive advantages. They acquired access to a jade mine for 50 years in return for selling its wood-carving business (which is no longer part of the company). As such, the company appears to be able to acquire jade on favourable terms (e.g. Jada is allowed to set the extraction rate, prices cannot rise by more than 10% from contract to contract, etc.).

But this investment is not without risk. Being reliant on one source of supply increases risk, as natural disasters or other unexpected incidents could result in supply disruptions. Furthermore, the company is also reliant on only a few customers, and even in Jada's short history, some of these have already defaulted on previous agreements, causing losses.

Jada's short history brings up another point. Usually, value investors prefer businesses that have been around a while. This helps investors evaluate the company over a period where many of the company's risks could come to light. Unfortunately, in this case the company has only been in this business for two years. Whether management is doing an adequate job at protecting and/or growing shareholder wealth is an open question for now.

Value investors like stocks with strong upside potential and low downside risk. While the upside potential is high here due to the low price to earnings at which this stock trades, the downside risks are also high due to the concentration of suppliers and customers and the lack of operating track record. This stock idea has potential, but investors should tread carefully and understand the risks.

Disclosure: None

Sunday, June 13, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 5

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

Dreman compares research analysts to dealers at the casino. The players ask the dealers, who seem to know the game well, what to play; unfortunately, the players are still destined to lose.

Investors rely on these "dealers" for their estimates in formulating their own investment decisions. However, in a paper Dreman himself authored, Dreman showed that analysts are off in their EPS estimates by about 40% per quarter. The dramatic difference is there even after removing companies with low earnings (to avoid large percentage effects just because earnings were small on an absolute basis).

Furthermore, the effect is prevalent even across industries, from cyclical to non-cyclical alike. The trend is also getting worse, with analysts in the most recent decades actually performing worse, despite their seeming informational advantages.

Analysts also tend to be overly optimistic. EPS growth from 1982 to 1996 was about 8% per year, but analyst forecasts taken at the beginning of each year suggested predictions over this period were for 21% per year.

Other studies have confirmed these findings, noting other interesting tidbits in the process. One study found that analyst estimates would be more accurate if they simply blindly assumed a 4% rise in earnings every year for every company.

Why might this be? For one thing, analysts are overconfident in their own research. Many expect their findings to be accurate within 5%, but they are not. Despite the research suggesting analysts are not accurate, each individual analyst seems to believe he is better at predicting than he really is. Furthermore, not a lot of emphasis is placed on being accurate. Analyst pay/bonus structures are often based on how much trading brokerage the analyst brings in. This helps explain why there are so many more buys than sells. (By comparison, few brokerage commissions are brought in for “sell” recommendations.) So, it’s not about being right; instead, it’s about bringing in clients.

This helps explains why one study showed that analysts that work at firms that also have investment banks issue 25% more “buy” recommendations and 46% fewer sell recommendations than their counterparts at firms without investment banks. (Investment banking clients have been known to shun firms that make negative recommendations about their stock.)

Dreman also discusses anecdotal evidence that further suggests analysts are not paid for their accuracy but for their clients. In one example, Donald Trump once requested that an analyst be fired after he issued a sell recommendation on Trump’s company. The analyst was fired, and won a few years’ worth of salary in court as a result, shortly after Trump’s company filed for bankruptcy.

Saturday, June 12, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 4

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

Dreman quotes many "experts" from military to political to corporate leaders that have made famous predictions that went terribly wrong. Experts in the stock market are no different. While people gather en masse to hear the opinion of experts, Dreman argues that this actually prevents investors from achieving superior returns. Like a bad golf swing that must be unlearned, investors must unlearn the way they currently use "experts" if they have any hope of earning superior returns.

The psychological research explaining the apparent inability of experts to forecast the future is discussed. The way humans best handle problems is in a linear fashion (e.g. Step 1 do this, Step 2 do that etc.). But more complex problems require interactive reasoning, whereby the interpretation of one input can change depending on how the other inputs are evaluated. Research suggests that humans tend to apply linear approaches to solving problems that are optimally solved interactively.

The more complex the problem (i.e. as more inputs need to be evaluated), the more this "line" of thinking can lead to poor results. But exacerbating the problem is that the more inputs that are provided, the more confident the decision-maker becomes. Studies testing respondent predictions for events that are highly uncertain show that when a decision-maker is provided with more information, his ability to predict stays flat (or rises moderately at best) but his confidence increases with every piece of new information, which can be a dangerous combination.

Dreman argues that stock research requires similar interactive thinking, and that the problems that must be solved (predicting a future stock price etc.) are complex, requiring the simultaneous evaluation of scores of data points. Despite the availability of unimaginable amounts of information, the outcome is nevertheless very difficult to predict, leading to low predictability, but overconfidence on the part of experts.

Friday, June 11, 2010

A Public Hedge Fund

Hedge fund investing is generally restricted to investors meeting minimum asset levels (i.e. rich people, the thinking being that they'll be all right if they lose a bunch of money) or those making large minimum investments (the thinking being that investors who plunk down $150K on an investment will do their due diligence, unlike the typical retail investor). But for all intents and purposes, it appears that Quest Capital (QCC) is trying to convert itself into a quasi hedge fund!

Long-time readers of this site will already know that Quest Capital has been a stock favourite of ours for a while now. In a move to increase its returns and stock price, Quest appears to be changing business lines, and is taking on a lot of characteristics that one normally associates with hedge funds.

Hedge funds are known for their high, but incentive-laden compensation structures and high management ownership levels, with the idea of aligning shareholder interests with those of managers. Quest is emulating this strategy with its proposed move.

Rather than pay salaries and offer bonus/option plans to managers, Quest will pay a management company 2% of its asset value (annually), and 20% of the excess returns it generates. Furthermore, this company will make a $25 million investment in the firm, thus better aligning its interests with those of shareholders. Unfortunately for existing shareholders, this investment will happen at a price that is below the company's current book value, thus diluting the shares of existing investors.

Quest shares rose around 15% yesterday on the news, further reducing the difference between this company's market value and its book value. But while the market cheered the news, value investors should be cautious going forward. The company is now entering a new line of business, and will have exposure to commodity prices. Commodity prices are inherently volatile, and their prices are very difficult to predict. If prices drop sometime in the future while Quest has a full book of loans receivable, there could be a slew of defaults and a significant loss in value.

For shareholders who are not interested in being a part of this new line of business, Quest is offering to buy back a number of investor shares tendered in a Dutch auction. Unfortunately, the maximum price for this auction is still a good 10% below book value, putting shareholders who want out, but who feel the price isn't quite right, in a bit of a quandary.

Disclosure: Author has a long position in shares of QCC

Thursday, June 10, 2010

Comment Dissection

Most readers of this site's articles are value investors. As such, their comments or questions related to specific posts are of a value-oriented nature (e.g. "How much is that inventory really worth?" or "Will management actually proceed with that buyback?"). But occasionally, there are comments that clearly illustrate the difference between value investors and the rest of the market.

One commenter on a recent post made so many logical missteps (from the perspective of a value investor, that is; to him, it is we who make the logical missteps), that they are worth bringing up to show the type of thinking that dominates the market (after all, we are in the minority in our line of thinking).

The following quotes are from a single comment on a post about Acorn. (Since it is not my intention to call out or ridicule anyone, no info on the commenter is provided.)

"I guess I'm not strong at heart then" (The headline of the article stated a stock is so volatile that it is only for the strong at heart)

This particular snippet is not related to investing, but is a logical error nonetheless. When all A's (e.g. owners of this stock) are also B's (e.g. people with strong hearts), it doesn't mean that all B's are A's! You can have a strong heart and having nothing to do with the stock!

"Clearly ATV is a value trap."

In this business, nothing can be known to such certainty. In investing, you want to put the odds in your favour by employing large margins of safety. Beyond that, the only thing that is clear is that the future isn't! Becoming overconfident in your assessments can burn you.

"The company is not making any profit on its net assets value. There is a strong correlation between companies real profit ratio (returns over cost of capital) to its market cap/to net asset value ratio."

The commenter is probably right about this, but this is exactly what creates opportunities in the market. Some companies will lose money sometimes, but the investor should not rely on current earnings. Instead, the investor must consider the company's earnings power.

"Companies trading below its investment capital do so because they deserve to."

This is the argument that the market prices everything correctly at its intrinsic value. If this is the case, there is no reason for anyone to do any research. But if nobody did any research, how would market prices be correct? Arguments that stocks are correctly priced prompted Warren Buffett to quip that it has worked in his favour that his competition doesn't think it helps to even try!

"They don't actually earn any profit on that investment capital. Take a closer look. ATV: Stockholder equity around 200M plus a minor debt capital of around 3M, but with the 200M (or so) capital at its disposal EBITs are approx -5M. Well, a company cannot be a value investment if its destroying its investment capital at that rate."

Market participants tend to extrapolate trends into the future. But this is an activity that can cause great losses. Rather than focusing on current earnings or earnings trends, value investors view buying a stock as they would a stake in a private business. If a company with readily discernible assets (e.g. real estate, cash, reliable A/R) of $200 million is selling for $100 million, the buyer is getting a good deal. Not all such investments will work out; sometimes managements will make poor investments and blow much of that capital cushion. But the margin of safety is present to put the odds in the buyer's favour.

Of course, almost all investors think their line of thinking is correct. But we can't all be right. Value investors may be just as out to lunch as the next investing style. But one of the most convincing arguments of its proficiency is this article, written by Warren Buffett.

Wednesday, June 9, 2010

Research In Motion

It may seem strange to see discussion of a stock like Research In Motion (RIMM) on a value-oriented site. After all, the company would be better classified as a growth stock, as revenues have grown from $3 billion to $6 billion to $11 billion to $15 billion in its last four fiscal years. Furthermore, the smart phone market is expected to continue to grow at double-digit rates going forward, fueling expectations that RIMM's revenue and earnings will continue to increase.

But startlingly, RIMM does not trade at a high premium to its earnings. While profits throughout this downturn have continued to ratchet up (RIMM's operating profit grew 38% in its last quarter, year-over-year) RIMM's stock price has continued to fall, currently trading near its 52-week low. With a P/E of just 13, RIMM's price is in value territory. Considering the company has no debt, and almost $3 billion in cash and equivalents, the company's P/E after subtracting cash is just 12.

Unlike many other successful tech companies, however, RIMM historically hasn't held onto a large cash balance, instead investing it at a stellar rate (ROE was 36% in its latest fiscal year!) or more recently using some of it to buy back shares (one quarter ago, the company bought back $800 million worth of stock).

The likely cause of this apparent discount is the fact that RIMM is going to head-to-head in the smartphone space with what's likely a superior foe, Apple (AAPL) and its iPhone. But RIMM has advantages that it can continue to exploit, such as its preference among corporations, its more efficient use of bandwidth (resulting in higher profitability for its sellers, the carriers, resulting in favourable pricing), and its international growth.

In other words, in the growing smartphone market, there's enough room for everyone to keep increasing profits while maintaining above average returns on capital and equity. At this price, investors appear to be offered the opportunity to participate in this growth without having to pay much at all.

Disclosure: Author has a long position in shares of RIMM

Tuesday, June 8, 2010

What's The Matter...Scared?

Warren Buffett has stressed many times that investor focus on quarterly earnings beats/misses is bad for both investors and companies. Rather than focus on the long-term, managers with such shareholders are implicitly encouraged to take all sorts of actions (e.g. cutting R&D expenditures) that increase short-term earnings at the expense of the company's future. At the recent Berkshire Hathaway annual meeting, Buffett pointed to a study (titled "Quadrophobia") that provides statistical evidence that suggests that the focus of management on short-term earnings is rather pervasive.

The paper is titled Quadrophobia due to management's apparent fear/avoidance of the number "4" as the third decimal in its earnings per share (EPS) reports. If the third decimal number is a four, the EPS number gets rounded down. The paper's authors scoured the universe of US public financial statements, however, and found that the number four (when dividing income by weighted average shares outstanding) is absent as the third decimal number by a statistically significant amount.

Why might this be the case? When management is close to rounding up its EPS number to the nearest penny (and having a four as the third decimal is as close as you can get), it will make the accounting adjustments it needs to in order to get there. Of course, not all companies engage in this sort of practice. But the authors found that the incidences of quadrophobia increase for companies that gain analyst coverage and where earnings come in close to analysts forecasts. Startlingly, the authors also found that persistent quadrophobes actually turn out to be more likely to be sued by the SEC!

What can the investor do with this knowledge? For one thing, it should reinforce the notion that one should not buy/sell a company if it beats/misses short-term earnings by a few pennies here and there. One might be tempted to check the third decimal of the companies in one's portfolio, but unfortunately even if the number four is absent from these calculations, the results for any one company would not be significant enough to draw any conclusions. As a whole, using EPS as a measure of a company's health has some definite drawbacks, and so investors would be wise to focus on other measures.

Monday, June 7, 2010

Internal Strife

Shareholders are not usually privy to the internal bickering that often takes place in corporate boardrooms. When companies communicate with shareholders via press releases, quarterly reports and other filings, they generally do so with one voice, implicitly conveying a sense of unity. As such, recent events at Genesis Land Development (GDC) are rather surprising!

As we discussed, Genesis recently issued a press release detailing some Special Committee findings that the company's CEO engaged in some wrongdoing and that the company wished to move towards a better corporate governance structure. Or so it seemed. To the surprise of shareholders, the release was rebutted by the company itself just a few days later:

"The Corporation not only does not ratify the releases, but disavows any responsibility for the actions of [company directors] Messrs Reed and Ferrel"

The company's rebuttal release even claims that the "Special Committee" referred to in the original release does not even exist! Apparently, two directors (Reed and Ferrel) decided to release a statement on behalf of the company that the other two directors did not agree with!

Further complicating the matter is the fact that the company's CEO (accused of perpetrating the wrongdoing) is also the Chairman of the Board! In many cases, this would constitute a major warning sign for shareholders, as the board is there to represent shareholders in overseeing management. But in this particular case, the CEO is also the major owner of the company, holding around 25% of the company's shares. His salary as CEO is around half a million dollars, but his ownership stake is almost $50 million, suggesting his loyalty lies with increasing shareholder value.

While the two sides have issued public statements that all is now well, the incidents raise questions for how small shareholders should react to these events. Who should investors side with, the directors pushing for more independence or those with large equity stakes? Should investors even remain in a situation where management actions appear to have been questionable?

The first question is a difficult one, as both board independence and large equity stakes (by both management and the board) should be desired features of small shareholders. But there's no reason why there can't be both. Since the spat, the company has appointed another independent director, which is hopefully another step towards a better corporate governance structure at Genesis.

To answer the second question, it's important for the value investor to consider an investment's price versus its value. Warren Buffett has looked for companies with such strong characteristics that even poor management would have a hard time reducing the moat. While Genesis is clearly no Coke (i.e. it will never generate the ROIC numbers), it does own valuable properties seemingly worth much more than the company's current stock price. Selling at this point because of a board-level spat ignores the large margin of safety that appears present at these prices. When the dust settles, the value of the properties will still belong to the company, even if the company isn't able to be all it can be in the interim.

An e-mail to Mr. Reed requesting comment sent May 31st has so far gone unreturned.

Disclosure: Author has a long position in shares of GDC

Sunday, June 6, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 3

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

Despite the wide following of technical analysis (described in Chapter 2), fundamental analysis is far more popular. Fundamental analysis is considered more sophisticated, as it relies on the study of accounting, investment, business and economic issues relevant to the security in question.

But despite the fact that fundamental analysis appears based on a solid foundation, these managers still underperform the market as a group! Dreman points to a number of problems in the way most fundamental investing is done. Instead of relying on past earnings as a guide, many analysts extrapolate growth trends into the future, which Ben Graham warned can be dangerous.

Growth investors point to the returns that would have been generated by investing in particular stocks when they became available, such as Wal-Mart in the 70s and Microsoft in the 80s. But for every successful growth stock, there are several dozen that don't pan out. For example, in the 1920s, everyone knew that the automobile industry would grow for years to come. But finding the three or four survivors from the hundreds of companies attempting to compete in the space was a near-impossible task. In the same way, with thousands of companies in the internet space, determining the winners from the losers before the rest of the crowd bids up the price is also fraught with error.

Dreman also notes that fundamental analysts increasingly rely on near-term outlooks, thus abandoning one of Graham's key principles. Graham noted that stocks should be looked at as if they were interests in private businesses; when considering the worth of private businesses, book value and replacement value are considered important measures. But when a stock goes public, all of a sudden the emphasis shifts towards current and extrapolated earnings.

After producing convincing evidence that technical analysis doesn't work, academics in the 1970s now came after fundamental analysis. Based on their measures of risk, academics purported to show that fundamental analysis does not yield positive returns. Dreman will discuss the problems with these assertions later on in the book.

Saturday, June 5, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 2

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

In this chapter, Dreman takes the reader through the history of technical analysis. Technicians try to determine the future prices of stocks by looking at charts of past prices. They look at items like moving averages and head-and-shoulders patterns to help gauge future prices. They care not if profit explodes or if a plant implodes, as they believe they can determine future prices from past prices only.

Many early technicians used astrology to guide their decisions, and some made some correct calls and ended up well-followed. Eventually, however, every famous technician has run into a bad streak. (One such example is the famous Joseph Granville, who made a few correct calls in a row and became so well followed that it is believed he single-handedly moved markets.) Today's technician uses the immense power of computers to help detect the patterns for which they are looking.

Technical analysis has survived despite the evidence that suggests its use is of no help. As early as 1900, a French PhD Student (using commodity and bond price/volume data) concluded that past prices could not predict future prices. Since 1960, many academics have come to the same conclusion across a number of different asset classes and markets, with no exception. It is from this work that the idea of the Efficient Market Hypothesis came to be.

Dreman concludes by instructing the reader not to use market-timing or technical analysis, as they will only cost you money.

Friday, June 4, 2010

Look At Returns, Not Profits

All too often, the media is concerned with a company's absolute profit level in determining how successful a company is. However, what's more important is the company's return on its invested capital, since that has a stronger effect on:

1) The cash flows to the shareholder, and
2) Whether the company has opportunities to grow going forward.

Let's say Company A and Company B both make $1000 / year, and have been growing their profits at 10% per year. Company A and Company B are in the same industry and are similar, except for the fact that Company A has assets worth $5000, while Company B has assets of $20,000. Assuming they were selling for the same price, which company would you rather own?

It may seem like Company B is more desirable. After all, who wouldn't want to own $20,000 worth of assets rather than $500? But actually, if you believe in the growth prospects of this industry, Company A is the better investment! It comes down to "return on assets" (which is sometimes substituted for it's cousin, return on invested capital), which is a measure of what kind of return an investor gets on his money.

For each dollar Company A invests in its assets, it gets $0.20 in earnings, while Company B only manages $0.05. If these companies were to grow their earnings by $100 this year, the owner of Company A would only have to invest $500 for that return, allowing the remaining amount to be paid as a dividend or to repurchase shares. On the other hand, the owner of Company B would have to invest $2000, which means he won't see any of that $1000 profit from last year, and the company would need further financing such as bank loans.

All too often, investors see growth in a company's future, but fail to consider the costs of that growth. All companies require investments in assets in order to support growth, whether it's in the form of fixed assets, working capital, or the acquisition of other firms. The companies with the best return on assets (or return on invested capital) are the ones that reward their investors with cash, not just paper profits.

Thursday, June 3, 2010

From The Mailbag: I.D. Systems

Ben Graham was the first to demonstrate that stocks that trade at large discounts to their net current asset values can generate strong returns for shareholders. Since then, many in the field have undertaken their own studies of this phenomenon with similar results. However, while this group of stocks may be expected to outperform the market, not every stock within the group will do so; some companies generate negative returns, thus bringing down the average. Investors, therefore, needn't invest in such stocks indiscriminately. Instead, investors can improve on the returns of the studies by avoiding the stocks with the highest risk.

Consider I.D. Systems (IDSY), provider of RFID technology for the management of heavy-duty mobile assets. A couple of months ago, the company was rather attractive from a net current asset perspective, trading at just $35 million versus net current assets of almost $50 million. But several risk factors combined to severely reduce the attractiveness of this investment.

First of all, the company has not shown that it can make money. It has not been profitable in any of the last four years, racking up operating losses of $35 million in the process.

While shareholders are shouldering these losses, they are also being diluted. The company hands out claims on its shares like candy, with restricted stock and options currently outstanding representing almost 30% of the company's actual shares!

Furthermore, the company is heavily reliant on a few customers for its revenues. Customers like Wal-Mart, that make a living from squeezing everyone with whom it does business (except consumers).

Management has also shown that it would rather spend the large cash reserve it has rather than return it to shareholders. The company recently partook in a $15 million acquisition that essentially removed the margin of safety on the company's discount to its net current assets.

Not all stocks trading at discounts to their net current asset values are bargains. Several troubled companies are on this list, and investors would do well to eliminate those that have great downside risk versus those that show potential for minimal downside risk.

Disclosure: None

Wednesday, June 2, 2010

Value Buybacks

When management's interests are aligned with those of shareholders, agency costs are minimized. Management and shareholder interests are most aligned when the chief executive has a large portion of his wealth invested in the business; in this way, the manager is also a shareholder. This incentive alignment leads to actions that are shareholder friendly, which is not the norm in many companies.

Jewett-Cameron (JCTCF) is a company we discussed two months ago that not only appears to have a well-aligned incentive structure, but appears to trade at a discount to its intrinsic value. When these two circumstances appear in combination, you are likely to see a share buyback. Indeed that's exactly what happened, as last week the company issued a release that it would re-purchase its shares. But while share buybacks are rather common, the level of communication (continuing with this theme, as we have recently discussed how management's communication with shareholders can lead to either positive or detrimental results, depending on the extent to which it is done) in this release was a step above what shareholders are accustomed to.

First of all, the company stated that it would only purchase shares at prices below $7/share. (The current price is around $6.70.) In almost all cases, shareholders are not given any information of this nature, making it difficult for shareholders to include buybacks as part of their valuation models since the purchase prices paid for shares do not become public until well after the fact.

Second, the buyback program covers a period of only 2.5 months. (Most buyback periods are one year long, and even then many are not completed during this time frame.) This sends a strong signal that the buyback will be immediate (subject to the paragraph above) in the company's budget worksheet, removing any fears that this is an attempt to talk the stock up rather than implement real action.

Finally, the buyback program covers a massive 18% of Jewett's outstanding shares, whereas most buyback programs cover less (sometimes far less) than 10% of the company's shares. As a result, it can serve to significantly increase the intrinsic value of each share.

When management has a stake in the company, it will make decisions that are good for shareholders. When those decisions are communicated in advance, investors can benefit, particularly if a stock is not well followed. (In Jewett's case, the stock price changed by just 0.3% on the day following the announcement.)

Disclosure: None

Tuesday, June 1, 2010

What's Old Is New Again

Stock price volatility benefits the value investor. Stocks that are especially volatile can provide investors with entry points that provide a margin of safety, and exit prices that reward the investor for "putting up with" the volatility. One stock exhibiting such tendencies is Acorn International (ATV), a distributor and marketer of hundreds of products through infomercials, catalogs and other channels.

Long-time readers of this site may recognize this company already. Last year, the company traded at a substantial discount to its net current assets. When business conditions stabilized, the stock price drove right through its net current asset value, and shareholders were further rewarded as the company paid out a portion of its cash reserves in a special dividend. The stock proceeded to trade at a range that made it difficult to tell if the company was under- or over-valued, allowing for an exit point for value investors.

Last week, however, as the company's first quarter results came in below expectations, the stock once again plunged to a level far below its net current asset value, to lows not seen since November of 2008. But while the company traded for under $100 million following the earnings report, it holds current assets of $194 million ($120 million of which is cash) against liabilities of just $35 million.

Often, a company trading at this kind of discount to its current assets is losing money hand over fist. But Acorn expects to pull in net income of over $12 million this year, even after a first quarter result that was below expectations. As the company has now worked through much of its older inventory, it can now focus on selling items with better margins and returns. With so many products to choose from, the company has an inherent advantage (compared to a one-product company, for example) in being able to choose to promote the most successful products, which helps ease the strain on the company's budget planner.

As an added bonus to investors, most of the cash the company holds is held in Chinese yuan, which may appreciate relative to the US dollar in the near future, as many are reporting. But while the short-term is inherently difficult to predict, over the long-term the Chinese yuan should definitely appreciate relative to the US dollar due to the high productivity gains Chinese workers are expected to experience relative to their US counterparts (due to the low starting point of the Chinese worker).

This stock is not for the faint of heart. Its price can fluctuate severely on a day-to-day, week-to-week or month-to-month period. As such, the mainstream finance industry would tag this stock as risky and leave it at that. But for value investors, price volatility is not the same as risk. To the value investor, the value of this company does not change nearly as dramatically as the company's price, offering opportunities to buy when the company trades at a discount.

Disclosure: Author has a long position in shares of ATV

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