Tuesday, August 31, 2010

Managing Earnings or Managing The Business

Value investors are generally agreed that managements of going concerns should make their decisions based on long-term cash flow implications. Unfortunately, the pressures on managements to perform on a short-term earnings basis can push them to make decisions that are not in the best interests of shareholders. Consider Sterling Construction (STRL), a company that builds and repairs roads, highways and water infrastructure.

Due to the recession, the amount of work available for the company has declined, leaving it operating at a lower capacity. Idled equipment generates no revenue, but accrues charges for depreciation. This charge shows up on the income statement, but note that no actual cash charges occur (apart from any maintenance that is required).

However, if the company did sell this equipment, those depreciation charges would disappear, making the company's income statement look better! Considering the company is not hurting for cash, it would seem that Sterling is better off with the extra capacity, since the actual cash costs (as opposed to earnings costs) are minimal. The extra capacity could come in handy if competitors go under or if the government passes infrastructure stimulus bills.

Usually, minority public investors don't get to know what goes through a manager's mind when it makes a decision to reduce capacity. Sterling, however, illustrated on its last conference call how short-term earnings (as opposed to long-term cash flow) can influence decision-making. Here were management's comments on the topic of selling idled equipment that it believes it will eventually require:

"We're struggling with that issue. So far we are absorbing that extra cost...I have some on our management team that would prefer that we [sell idled equipment], mostly to enhance currently reported financial results. Most of us are of the opinion that that's shortsighted."

Warren Buffett has stated time again that managements must concentrate on long-term returns over short-term earnings management. He notes, "If a management makes bad decisions in order to hit short-term earnings targets...no amount of subsequent brilliance will overcome the damage that has been inflicted." All sorts of companies are busy trying to make earnings look better than they are; investors would be well served to find and stick with managements doing right by shareholders over the long term.

Disclosure: None

Monday, August 30, 2010

RIM As The Next Palm

There are no shortage of articles touting Research in Motion (RIMM) as the next Palm, which had to sell itself earlier this year as its current business model proved unsustainable. What all of these "analyses" seem to omit, however, is a comparison of the financial situation of the two companies. Instead, the comparisons appear to be made based on sentiment (which can change in a hurry - consider that RIMM stock traded about 70% higher just four months ago) and predictions several years out (which is almost impossible to do!), rather than on the financial data which could illustrate just how similar the two companies are. In this article, I attempt to make the financial comparison.

In the fifteen year record of Palm's existence, it generated an operating income in just 6 of those years. The best operating margin it could ever manage was 8.5% (1999) at the height of the tech bubble. In no single year did Palm ever generate a return on equity of over 10% (the closest was 7.8% in 1998), even though it was considered the leader in its industry during that period.

RIM, on the other hand, operates at very high margins and generates returns on equity that are extremely high. The following charts illustrate how RIM has been more profitable in each of the last five years than Palm was even in its best year:





When an industry grows at a 25% rate despite a recession, there is room for success for many companies. The success of one or two companies (e.g. Apple, Google) does not preclude the success of other companies. Investors who predict the demise of companies generating ROE's of 30% in growing industries are ignoring the most fundamental and basic aspect of whether a company is sustainable: its financials.

In a similar way, GameStop (GME) is often touted as the next Blockbuster. But an examination of the financials shows that these two companies are nothing alike, and never have been. While one barely snuck by, even in its "good years", the other continues to deal from a position of financial strength that the former never had. That again appears to be the case here with RIM and Palm. But investor sentiment is so low, that RIM trades at a P/E below 10 once its cash balance is factored in.

Disclosure: Author has a long position in shares of RIMM

Sunday, August 29, 2010

Reminiscences of a Stock Operator: Chapters 21 & 22

Reminiscences of a Stock Operator was originally written in 1922 as a first-person fictional account, but is now generally accepted as the biography of stock market whiz Jesse Livermore. The book is recommended to traders and value investors alike, for the lessons it teaches the reader in human behaviour as it pertains to securities trading and investing.

Livermore discusses some of the successes and failures he has had in selling stocks for clients with large blocks. Due to his reputation in the newspapers as a skilled trader, he has received many such requests.

In these chapters, Livermore goes into detail about which companies he sold under the requests of which stock owners. In some cases, he had luck on his side, as a prevailing bull market enabled him to employ the technique (of running up the price, and thus encouraging volume to grow) described in the previous chapter. But at other times, he simply advised his requester to sell, as he feared things would only get worse if he purchased more.

In one particular instance, Livermore was double-crossed by a consortium he was in league with to drive up the price of a security. The large holders (who wanted to sell) were actually adding to their positions, as they figured Livermore would be driving the stock up in an attempt to attract speculators. Livermore, however, noticed the market action and did nothing of the sort. This left the large holders with even more stock to sell, and thus eventually caused the price to get driven even lower. Livermore notes that hogs are bound to lose.

Saturday, August 28, 2010

Reminiscences of a Stock Operator: Chapters 19 & 20

Reminiscences of a Stock Operator was originally written in 1922 as a first-person fictional account, but is now generally accepted as the biography of stock market whiz Jesse Livermore. The book is recommended to traders and value investors alike, for the lessons it teaches the reader in human behaviour as it pertains to securities trading and investing.

Often, a speculator will acquire a large block of stock that he wishes to sell. Unfortunately, unloading a ton of shares on the market will often reduce the selling price, and can sometimes even cause a panic. As such, selling large chunks of shares to the market is an art form that Livermore argues only specialists should perform.

Livermore has been asked by large holders of stock to use his skill in selling their stock at a reasonable price. In return, Livermore asks for graduated call options on the stock, so that the higher he gets the price (resulting in a higher profit for the large holder), the more he gets paid.

Unlike many stock manipulators of his day, Livermore sees no need to spread false rumours to get a stock price moving. Cognizant of the fact that humans tend to supply their own reasons for occurrences that are taking place, Livermore simply increases the volume of the stock in question by both buying and selling. He finds that the increase in volume attracts buyers, offering him the ability to sell into the newfound demand.

Livermore also discusses the exploits of some of the famous stock manipulators of years past. Some would try to corner markets, though that was no guarantee of success. Others would create ponzi schemes that the public would buy into without thought. As Livermore used to read about past stock market manipulations, he used to believe that people of yesteryear were simply not as bright as people today. With enough experience, however, he saw that people of his day are just as likely to fall for false promises of easy money as people of years past.

Friday, August 27, 2010

Tweet Tweet!

I have started using Twitter in the last week, and I like it! It has shown itself to be a good way to get the latest info on stocks that aren't necessarily well-followed, and also a quick way of hearing about undervalued stocks that other value investors have uncovered. A lot of the questions I receive from readers by e-mail are asked by several different readers, so Twitter also offers me a decent way to answer questions to several people at once in a way that saves time.

I've only sent out a few tweets so far, so I'm still a bit of a novice. But I like what I see so far, so I expect my Twitter activity to continue. Some readers have already found me! For the rest of you who wish to track my discussions, you can do so by following this link. There's also a link to my twitter feed to the right of this post on the main page, next to the rss feed links.

For those who have no interest in joining yet another social media network, do not despair. There are no plans to make any changes to the site's content. Even if you do not join Twitter or do not follow my "tweets", you will still receive the kind of content from this site that you are accustomed to (for better or worse!)

To that end, I have made some changes to the site to make it easier to navigate the latest posts. If you have any suggestions regarding the site's format or its content or anything else, I'd be happy to hear from you. Please feel free to leave a comment or send an e-mail.

Thursday, August 26, 2010

When All The Problems Are Short-Term

Sterling Construction (STRL) builds and repairs roads, highways and water infrastructure for governments in Texas, Nevada and Utah. Sometimes, a stock will be down for reasons that are unknown. This is not the case here. Government budgets for infrastructure projects are weak, as states struggle with the lower tax receipts that the recession has brought. Competitors used to working on commercial and residential projects have entered the government market as a way to fill their excess capacity. Companies have been bidding for projects at extremely low, and sometimes negative margins!

Amidst all this bad news, why would anyone in their right mind be interested in a company like Sterling Construction? Well, a look at the company's problems reveals that they are all of a short-term nature. This industry, along with many others, has more capacity than it has demand. When that happens, prices fall and margins get squeezed. But this doesn't last forever. As some competitors fail (due to high debt levels or money-losing operations) and industry capacity shrinks (as depreciation far outweighs capex), conditions will eventually return to normal.

But margins and revenues will not return to normal overnight. Therefore, it is not enough for investors to find beaten down companies; they must ensure that these companies can last until such time as conditions are better. Sterling is such a company, with cash and short-term investments of $96 million against debt of $25 million.

Furthermore, the company appears to trade at a discount to its earnings. Subtracting its net cash position, the company trades for just over $100 million, yet it earned $25 million in 2009! Earnings this year will be substantially lower than they were last year, however, due to the reasons discussed above. However, this company has the ability to maintain its capacity for when industry conditions return to normal.

The market will beat down companies with poor near-term outlooks. Sterling Construction has proven to be no exception. However, as the company's problems are short-term, and as the company has the ability to outlast this downturn, investors with a long-term outlook may have here an opportunity for stellar returns with low risk.

Disclosure: None

Wednesday, August 25, 2010

Double-Counting Operating Leases

A prevailing theme on this site has been the idea that operating leases must be capitalized when valuing a company. But investors must be careful not to capitalize operating leases twice, which could soon become an easy mistake to make.

When a company acquires control of an asset, it can choose to buy it or lease it. If it buys the asset, but uses debt to finance the purchase, it is essentially the same thing as leasing it. Therefore, to make these two transactions identical on financial statements (since they are essentially the same thing), accounting rules require that longer leases be capitalized, so that the asset purchased and the lease payments owed are capitalized on the balance sheet, as if the asset was purchased using debt.

But some companies attempt to avoid capitalizing leases (and therefore don't have to show the future lease payments as obligations on their balance sheets) by structuring them as short-term leases, called operating leases. For this reason, many articles on this site advocate capitalizing operating leases. (To see how, see this article).

But recognizing that the capitalization of operating leases leads to more transparent financial statements, the accounting regulatory bodies are moving towards the capitalization of all leases, whether short or long. As such, investors will soon have to be careful not to capitalize operating leases when they have already been capitalized! This would lead to overstating the company's debt situation and understating the company's return on capital.

To determine whether a company already is capitalizing its operating leases, the investor will have to read the company's notes to its financial statements to determine the company's current policy (companies with different fiscal year end dates will likely have to adopt the capitalization requirements at different times).

Tuesday, August 24, 2010

What Makes The News? Not Accuracy!

What makes it as "news" in the mainstream financial media is what editors think will generate eyeballs and clicks; the media does not provide the kind of information that will make you money! The media makes nothing when you make money off of one of their forecasts, so why would they expend energy trying to make you money? But the media does make money when you click on an article, and so that's where they focus their energy. Understanding these incentives of the media is paramount to avoiding common pitfalls in investing.

For example, at the end of last week, Bloomberg ran an article that predicted oil was expected to fall in the coming week. Its thesis was reached with a poll that showed that more analysts see oil going lower in the next week than those who see it going higher. The article then went on to explain how global economic factors and higher inventories were contributing to this conclusion.

So should you short the oil market based on this article? Absolutely not! The survey has been conducted weekly since 2004 and has been correct just 48% of the time! The proverbial monkey throwing darts at a board divided into "higher" and "lower" halves would be right 50% of the time, so if anything this survey is a small contrarian indicator.

I'm not saying this because I expect oil to rise. (On the contrary, I've made it clear what I think will happen in cases where commodities, whether oil or gold or any other, deviate from their long-term averages for extended periods.) But the reality is, picking short-term directions in the prices of stocks or commodities is a crapshoot.

Articles in the financial news are meant to get you to read them, not to make you money. The sooner you realize this, the better the investment decisions you will make.

Disclosure: None

Monday, August 23, 2010

Undervalued and Underfollowed

Smith-Midland Corporation (SMID) manufacturers and sells concrete products (e.g. highway safety barriers, exterior wall panels etc.) for the construction and other industries. The stock has spent a good part of the last year trading above $2/share, but despite weathering the recession fairly well, it now trades at $1.40.

The company is not going to wow you with a steady earnings profile, as a couple of factors combine to make this a rather cyclical business. First, on the revenue side it relies on purchases from some industries that are rather cyclical. When the economy operates at overcapacity (as it does during a recession), construction projects get shelved. Second, the cost side of this business is rather fixed. In heavy manufacturing, certain amounts of fixed assets are needed to produce the finished goods, so cutting costs when revenue dries up is not an easy thing to do.

But for investors who can stomach the volatile earnings, the stock appears to trade at a discount to its potential earnings. While the company trades for just $6.5 million, it has pulled in net income of over $3 million in just the last 3 years. The company also trades at a 33%+ discount to its book value. Of course, as discussed above, if the economy remains weak, it would not be surprising to see net losses occur, but that's why the company trades at such a low price point; for those who think long term, this could be an excellent entry point.

One other point should be mentioned. This is one of the few Over-The-Counter (OTC) stocks discussed on this site. These stocks do not offer the same protections for investors as stocks traded on exchanges such as the NYSE or Nasdaq. Investors not familiar with these protections may wish to learn about them or stay away for now.

Disclosure: None

Sunday, August 22, 2010

Reminiscences of a Stock Operator: Chapters 17 & 18

Reminiscences of a Stock Operator was originally written in 1922 as a first-person fictional account, but is now generally accepted as the biography of stock market whiz Jesse Livermore. The book is recommended to traders and value investors alike, for the lessons it teaches the reader in human behaviour as it pertains to securities trading and investing.

Livermore speaks to the many tales that have been told about his trading prowess. Everyone from the media to his close friends have all exaggerated his ability. They speak of how he receives hunches in the middle of dinner that cause him to act just then, resulting in a sale (or purchase) right at the market top (or bottom).

These "hunches", Livermore argues, are nothing more than his mind (including, at times, his subconscious mind) mulling over the various facts that govern whether a security is to break higher or lower.

One of the pieces of information in which Livermore places great importance in forming his trading opinions is the level of insider buying/selling. But the information on insider buying/selling only comes out much later, and therefore Livermore tries to determine it right then and there by reading a stock's ticker (i.e. looking at past prices). In combination with a stock's fundamentals and the state of the macroeconomy and industry, Livermore tries to determine (with test trades described in an earlier chapter) whether insiders are participating. If insiders are not bolstering an undervalued stock with their own buying, for example, he often sees this as a signal that something is wrong with the company.
At other times, however, the economy and general market conditions will cause him to trade opposite insiders. Many times, insiders have promoted their stock by releasing positive news or spreading rumours that are bullish. In such cases, Livermore will again test the market to determine if insiders are actually buying. If there is no resistance (e.g. the price moves down as a result of his sale transaction), he will trade against the stock despite the actions of other market participants who are reacting to the news.

Saturday, August 21, 2010

Reminiscences of a Stock Operator: Chapters 15 & 16

Reminiscences of a Stock Operator was originally written in 1922 as a first-person fictional account, but is now generally accepted as the biography of stock market whiz Jesse Livermore. The book is recommended to traders and value investors alike, for the lessons it teaches the reader in human behaviour as it pertains to securities trading and investing.

When Livermore is wrong in his speculation, he has no problem with losing money as a result. When conditions change following a market bet he has made, he also has no problem losing money as a result. But Livermore does take exception to parties that weasel out of agreements.

In one particular case, it cost Livermore millions of dollars. During World War I, coffee importers held too much supply, and thus sold the commodity to Livermore. Once transportation for the commodity began to return, Livermore stood to make a killing as the price would begin to rise. The importers, however, went to Washington and convinced regulators to force the immediate settlement of contracts so that they could profit over Livermore, a supposed speculator and profiteer that added no value to the economy. Livermore counters that it was he who stabilized the price when it was falling (to the benefit of the economy), and therefore it should be his reward if/when the situation turns.

Livermore also tackles the uselessness of stock tips that are abound in the market. He claims to have received more than 100 tips per day! He never gave tips, for he recognized that in speculation, there is no sure thing. But the number of people willing to listen to and give away tips baffles him. Livermore recounts several stories where tips have led to disasters, and believes no speculator or investor should trade off them. One company president even gave a tip to Livermore's wife, and she traded on the info (only to lose her investment completely) unbeknownst to Livermore.

Friday, August 20, 2010

GameStop Isn't Standing Still

Yesterday, GameStop (GME) shares fell more than 8% after the company missed expectations by a penny and guided earnings estimates lower for its 3rd quarter. A variety of factors appear to be coalescing in the short-term to push the stock close to its 52-week low. But longer term investors should actually be encouraged by the company's results, as the company appears set to generate years of strong free cash flow relative to its current market cap.

First of all, a retailer like GameStop makes most of its money during the Christmas quarter, so a few cents here and there during the summer quarters says nothing about the health of the overall business. But still, how can one get excited by the company's long term outlook when short-term expectations are being lowered? Well, because of the reason for those lowered near-term expectations: namely, increased expenses associated with the national roll-out of initiatives that were very successful in their test locations.

First, the company's loyalty program appears to have generated excellent returns in the test locations, causing management to want to take this program national immediately. Participation rates are high, and customers enrolled in the program have increased their transactions at GameStop, both as buyers and as used-game traders. The company is also going national this quarter with its in-store download kiosks. Customers appear to have taken to this new form of distribution, as 5% of the company's transactions now take place through these kiosks, which is up 80% year-over-year.

But some skeptics no doubt wonder what good a couple of years of cash flow are worth, when the business model is out of date. Digital distribution is the way of the future; but the company is also focused on being the leader in this space. Its acquisitions show that the company will be a significant player when the market shifts from bricks-and-mortar to digital distribution. NPD reports that GameStop's online market share has grown 50% in the last year, and its online business was the fastest growing "dot com" in the gaming industry.

In this quarter, the company plans to continue to improve its online offerings. It will add "buy online, pickup in-store" e-commerce capabilities, fully extend the royalty program (described above) to the web, and offer full-game downloads. GameStop will be well-positioned to handle the transition to digital distribution as it occurs over the next several years.

In the meantime, the company appears to have a license to print cash. While the company trades for just $2.9 billion, it generates operating cash flow of over $600 million per year. It has a P/E (based on current year earnings estimates) of just 7, which doesn't take into account the fact that the company expects to finish the year with a cash position of $1 billion, representing one-third of the company's market cap!

Furthermore, management has not been shy about returning cash to shareholders. The company has purchased $300 million worth of stock in the last few months, and hinted on yesterday's conference call that it is developing a plan to return more cash to shareholders in the form of annual buybacks.

Of course, seeing how successful GameStop has been, the competition is trying to grab some of those profits. BestBuy's recent announcement that it will enter the used game space took some air out of the stock. (To see why the used game business is so important to GameStop, see this article.) But GameStop management is watching the situation closely, and is so far not seeing any impact. From the company's conference call:

"There have been several big-box competitors who have launched "used" business. And we measure the run rates and impacts of used sales of all the stores adjacent to them, and we simply have not seen an impact. Now, some of the big-box competitors have not really even begun yet. They've announced that they've started, but we haven't seen that.

And then another of the big-box competitors began with a small amount of stores. We haven't seen any expansion there. So on the competitor side, we just don't see the impact yet in our stores, but of course we take them seriously, we watch them closely. Believe us, a lot of the traffic in those competitor stores are our guys testing the process etcetera. So we're all over that."


While the competition attempts to steal share, however, GameStop is not standing still. In addition to the loyalty and kiosk programs (described above) that it plans to roll out before the holiday season, the company actually has some further retail opportunities. With Blockbuster's store closures (and the likelihood of continued closures, as it nears bankruptcy), GameStop is able to place locations in desirable areas that it was not able to before:

"Blockbuster has closed a lot of stores, so has Hollywood. And that has given us real estate opportunities into centers that heretofore we could not get into because they had exclusives...[A]s they continue to close stores, again, it gives us opportunities, especially into highly dense urban areas. If you take like the LA area etcetera, for example, which is a very difficult real estate market, it gives us opportunities to get into centers that we've not gotten into."

Is GameStop the next Blockbuster? Unlikely. But Blockbuster's former locations can help add to GameStop's profits.

When a stock is beaten down over short-term earnings, or even over long-term fears (that humans are very poor at predicting successfully, yet are very confident about), investors are often offered excellent companies at great discounts to their intrinsic values. GameStop appears to be one such company.

Disclosure: Author has a long position in shares of GME

Thursday, August 19, 2010

Useless Discussion

Financial statements can often use context. While the statements themselves can tell you that margins have changed, or that a balance sheet account has increased/decreased disproportionately, they can't tell you why. To fully understand the challenges a company faces, it's imperative that investors read management's discussion and analysis.

One of the most useful portions of management's discussion and analysis is management's outlook. Here, the investor can get a handle on what are the near term challenges facing the company. In so doing, the investor is able to determine whether the company's problems are of a temporary or more permanent nature, which is of the utmost importance for the long-term value investor.

But some companies aren't so great at relaying this kind of information, which leaves investors in the dark. Consider the outlook of C-Com Satellite (CMI), a company we have previously discussed for its lack of disclosure. The company's outlook is four paragraphs and includes the following:

"The Company continues to develop new products for new emerging markets. Some of these products will be introduced in 2010, while others are longer-range R&D projects that are ongoing and will target specific new vertical markets, which C-COM presently is not addressing...

C-COM is going to encounter more and more competitors on the way to these new markets. Some of them have already failed in their attempt to keep pace with new developments...We also expect some that are in it today to bow out. To date we are managing to keep a significant technological advantage as well as a price advantage over other established players in this market place... "

On the surface, there appears to be a good deal of information in the four paragraphs C-Com provides...until you look at the company's outlook from 3 months ago. The outlook from last quarter is virtually identical to that of this quarter: essentially a word-for-word copy and paste!

Okay, so maybe the situation hasn't changed much in the last quarter. Significant developments could be rare in this business. But wouldn't things have changed in the last five years?? The company's outlook is pretty much the same as it has been since 2006, when the company first published an outlook!

In fact, the company's outlook in 2006 contains the passages pasted above word for word. So the company wrote its outlook once (in 2006) and has been copying and pasting it ever since. (To the company's credit, it did remember to change the date to 2010 in the line "Some of these products will be introduced in 2006, while others are longer-range R&D projects that are ongoing and will target specific new vertical markets, which C-COM presently is not addressing... ", but otherwise the passage above is 100% identical!)

When management's discussion offers no information on the challenges a company faces (other than the same challenges the company faced five years ago, with nothing in the way of any updates), the investor is in the dark as to whether these challenges are of a temporary or permanent nature. This makes the company very opaque, and makes it difficult for value investors to value the company with a decent level of certainty.

Disclosure: None

Wednesday, August 18, 2010

Value Investing In Banks

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

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

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

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

Though many banks have been offering high dividend yields of late, it's extremely important to understand where that dividend is coming from in order to attain reasonable assurance that it is sustainable. Buying blindly for dividend yield is not an option. The dividend cuts that have taken place throughout this downturn have proven how susceptible this strategy is to an erosion of principal.

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

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

Tuesday, August 17, 2010

Turning Intangibles Into Cash

As value investors, we are trained to look at the "Goodwill" and "Intangibles" lines on a company's balance sheet with great skepticism. After all, these supposed company assets are not hard assets like equipment or land or receivables and therefore can't be used to generate cash flows and furthermore they have no salvage value. But the future cash flows of companies with large intangible assets listed on their balance sheets can often be underestimated unless those intangibles are taken into account.

As Warren Buffett has reminded us time and again, an investment is worth the discounted future stream of cash flows that accrue to the investor. Often, we use earnings as a proxy for cash flow, since earnings are meant to be a smoothed out version of cash flow, which can be volatile from quarter to quarter and year to year (e.g. cash flows can vary dramatically as a result of inventory build-ups/reductions, receivable/payable timing issues, capital purchases/sales, bank loans, tax refunds/payments etc.).

But it's important to keep in mind that intangibles (apart from Goodwill) are amortized on the income statement, even though the cash to buy these intangibles has already been spent. As such, shareholders who do not add back the amortized intangibles to the company's earnings are underestimating the company's cash flow.

As an example, consider Dorel (DIIB), a company we discussed last year as a potential value investment. The company's intangible assets fell $12 million in its most recent quarter, which is significant compared to the $35 million the company earned in the quarter (some of the $12 million change was likely due to currency effects, but the rest would have been amortized, thus subtracting from income). The extra cash "generated" by these intangibles contributes to the company's cash flow in a meaningful way, and can be used by the company to buy back shares, grow the business, or some combination of the two, which is what Dorel has been doing.

Of course, it's important to determine if the intangible assets being amortized need to be replaced with future cash flows. Often, a note to the financial statements will describe exactly what line items are included in the intangible assets (e.g. customer lists, non-compete agreements etc.). Amortization for items that need to be replaced to keep the business at its current level should not be added back to income in estimating cash flows, as they should instead be treated similarly to depreciation of capital assets.

The money to purchase intangibles has already been spent, but the expenditure is not yet recognized on the income statement. As such, future income statements often underestimate the actual cash flows of a business when large charges for amortization of intangibles are taken. But the cash flow benefits of these assets accrue to the current shareholder. As such, the current shareholder should take these cash flows into account in estimating the future cash flows of the business.

Disclosure: Author has a long position in shares of DIIB

Monday, August 16, 2010

How To Get Investment Returns In A Down Market

On Tuesday of last week, market negativity was pushing most stocks down. Quietly, however, Addvantage Technologies (AEY) released results that pushed its share price up 10% during the day. This price move also resulted in a 60% return over the last 8 months, allowing investors the opportunity to profit from this mis-pricing of the security despite a flat overall market over the same time frame.

Eight months ago, Addvantage Technologies (AEY) traded at a 30+% discount to its book value. This is despite the fact that the company was profitable throughout the worst of the economic crisis.

For many companies, book value is not a meaningful guide to its worth. For example, the book value of manufacturing equipment may not correlate well with the actual value of that equipment, and so basing a company's value on its book value when it has a large proportion of such assets becomes problematic.

But for Addvantage, most of the company's assets are in the form of inventory, which it sells (and thus turns into cash) over two or three quarters. The company buys its inventory from manufacturers; it is not counted on to innovate with new products, nor does it have large fixed assets with uncertain values (as would a manufacturer). As such, its book value is very much a decent base from which to value the company, as its inventory is mostly sold with a profit over the course of a few months.

Now that shares of Addvantage have appreciated, its outlook as an investment opportunity is more uncertain. But shares of other companies in situations similar to those of Addvantage eight months ago are out there!

Disclosure: Author has a long position in shares of AEY

Sunday, August 15, 2010

Reminiscences of a Stock Operator: Chapters 13 & 14

Reminiscences of a Stock Operator was originally written in 1922 as a first-person fictional account, but is now generally accepted as the biography of stock market whiz Jesse Livermore. The book is recommended to traders and value investors alike, for the lessons it teaches the reader in human behaviour as it pertains to securities trading and investing.

Throughout his trading career, Livermore has been used by others. In one instance in particular, Livermore was used by the president of a brokerage house to help out other clients. Since Livermore was known as a heavy short-seller (whether true or not, this was the public perception), he was offered favourable terms by this brokerage house, in order that when stock sales were executed by some of the long clients of this brokerage house, it could be explained away as Livermore's short sales (and result in a better execution price for the long clients).

At the time, however, Livermore did not see that he was being used, and instead found this president to be of immense generosity. This taught him an expensive lesson in human nature. The perceived kindness of this president caused Livermore to listen and accept this man's suggestions more than he should have. It is to this human trait, allowing someone who is kind more influence than someone otherwise unkind, that Livermore attributes to yet another wipe-out of his portfolio.

As a result of this particular bust, Livermore was over $1 million in debt to various brokers and friends. He found that psychologically he could not make money in the market with these debts hanging over him, and so he went to his debtors to ask for loan forgiveness, but with the full intention to pay back in the future. The newspapers bashed him for needing loan forgiveness, and this saddened him greatly.

With the loans forgiven, Livermore once again rose to prominence by running with a bull market and then successfully shorting a bear market. He paid off his forgiven debts, and having learnt a lesson in human nature, he set up irrevocable trusts to provide for his wife and child so that even if he were to beg his wife for money, legally even she could not alter the trust to grant him funds.

Saturday, August 14, 2010

Reminiscences of a Stock Operator: Chapters 11 & 12

Reminiscences of a Stock Operator was originally written in 1922 as a first-person fictional account, but is now generally accepted as the biography of stock market whiz Jesse Livermore. The book is recommended to traders and value investors alike, for the lessons it teaches the reader in human behaviour as it pertains to securities trading and investing.

Using examples from his own trading experiences, Livermore discusses some stock market lessons he has learnt. The first lesson has to do with the herd mentality that is often possessed by large groups of investors. At times, that a certain security will rise or fall is considered so certain by investors, that they will go long or short in droves. Often, no one in the group will take pause to question their actions; instead, they will simply believe themselves to be right because everyone else is doing the same thing. Livermore has made much money trading opposite these herders.

Another lesson Livermore has learned is that although he may be right about the future direction of a price, he may be wrong on whether he can convert his paper profit to an actual profit. This is because if one accumulates too many shares relative to the liquidity of the shares, the speculator may still have to take a loss even when he turns out correct on the price. Speculators should only take positions that they can get out of when they need to, or else they must be prepared to get out not on their own terms, but rather when an opportunity presents itself.

Finally, Livermore recommends that the reader not listen to experts that claim to know something you don't. Livermore has lost a pretty penny thinking that he was trading on information that was superior to his own analysis. All he found was that he lost money when banking on the analysis of others. No matter how convincing analysts are, Livermore recommends that the reader do his own homework and draw his own conclusions from that homework.

Friday, August 13, 2010

Cash Burn vs Churn

A company that burns through its cash makes for a dangerous investment, even if it appears cheap on an asset basis. But a declining cash balance does not mean a company is burning through cash. Investors have to look further into a company than simply its cash balance over time in order to determine if it is burning cash.

As an example, recently a reader commented that he is hesitant to buy shares of KSW Inc. (KSW) because it has been "burning cash in its operations for the last two quarters". While there may be a number of reasons to hesitate before buying this company, cash burn appears to be one of the least likely of those reasons.

Yes, the company has sported negative cash flow from operations in each of the last two quarters. And yes, the company's cash balance has declined. However, one cannot draw conclusions of cash burn simply using these summary line items. An analysis of the cash flow statement will illustrate the sources of these dips in cash flow. Only by delving into the details can one determine if the company is burning cash, or if there is some other explanation for the change in cash balance.

First of all, the first line of the cash flow statement shows that the company is making a net profit. But further down the cash flow statement it becomes clear that cash flow from operations is negative as a result of an increase in the company's receivables account. This is due to the large spike in the company's revenue (2nd quarter revenue was 50% higher than 1st quarter revenue), as it has begun to work through its backlog. When a company grows revenue quickly, it needs money to finance that growth until such time as the work is completed and the customer pays (unless, of course, the company has a negative cash conversion cycle).

But KSW has the money to finance the growth in revenue, and it is profitable; therefore, negative operating cash flow in this case does not suggest a dangerous situation. In addition, further down the cash flow statement it becomes apparent that the company's cash balance has also been lowered as a result of dividends the company has been paying.

A headline view of a company's cash flow statement does not yield the kind of information an investor must use in making an investment decision. Only by considering the financial statements in their entirety, along with their accompanying notes, can an investor get a true picture of a company's situation.

Disclosure: Author has a long position in shares of KSW

Thursday, August 12, 2010

The Risks To Earnings

Investments in individual companies can often be divided into two different types: asset plays and earnings plays. In an asset play, the investor believes the current share price is below what the company's assets are worth, and so he expects to benefit from those assets in some way (example here). In an earnings play, the investor believes future earnings are strong as compared to the stock's current price (example here). In each case, the risks to the investor are different; as such, the identification of the type of investment being made is important so that the investor can focus on the right risks in making an investment decision.

Consider ADDvantage Technologies (AEY), a company previously discussed on this site as a potential value investment. Eight months ago, the company was trading at a discount to its net current assets, and at a rather large discount to its book value. As such, the fact that the company sources 35% of its purchases from one company (Cisco Systems) was not a huge risk. After all, if Cisco severed its supply relationship with ADDvantage, the company could still turn its inventory into cash and would still trade at a discount to its assets, even if it incurred some losses as a result. We've seen this come to fruition at Nu Horizons (NUHC), where the stock fell following the release that Xilinx would no longer distribute through Nu Horizons; but the Xilinx inventory has been turned into cash, and the company remains an attractive asset play.

But today, ADDvantage's price has appreciated such that it is no longer an asset play. Nevertheless, the company remains an earnings play. But the risk profile has changed as a result. As an earnings play, the company's reliance on Cisco as a major supplier (and the impending negotiations that are on-going as a result of the contract's nearing end of term) becomes a major risk, because a major source of earnings for the company is its ability to purchase and sell certain Cisco products; without that ability, the earnings will have to be replaced by other products, or they will fall.

Asset plays and earnings plays have different risk characteristics. For example, in an asset play, risks to the quality/liquidity of the company's assets are much more important than they are in an earnings play. On the other hand, issues such as supplier risk (as is the case in the above example) are much more important when a purchase is made for a company's earnings. For the investor, it is important to identify the type of investment play that is being made (i.e. Is the investor after the company's future earnings, or its current asset position?) so that the right types of risk can be identified and brought into focus.

Disclosure: Author has a long position in shares of AEY

Wednesday, August 11, 2010

A Business Selling For Free

Tikcro Technologies (TIKRF) trades for just $7 million, but it has $7.4 million of cash on hand against just $240K of total liabilities. In addition, Tikcro owns between 20% and 30% of a public company in Israel named Biocancell (BICL). Tikcro's stake in Biocancell is worth about $8 million.

One way of looking at the above situation is as follows: upon purchasing a share of TIKRF, the investor is getting the rights to an amount of cash equal to his investment, and in addition he is receiving a stake in another public company for absolutely free. For the value investor, a free stake in a business comes at just the right price, as it offers good downside protection. Unfortunately, this investment is not without risks.

First of all, the free business is very much unproven, having shown no revenues as of yet. The company has some cancer-fighting products undergoing Phase I and Phase II FDA trials. Anyone familiar with this process knows that the progression from trials to a prescription-ready drug is a long and far-from-certain process. This isn't the type of business that one can put a value on easily, in contrast to a company that sells nuts and bolts for example. The company could be completely worthless in the near future. (On the other hand, it could also be worth a whole lot.)

Second, it is not clear what Tikcro management will do with the company's cash, as no definite plans have been offered. Should that cash be invested in another risky business, the investor's margin of safety is gone just like that.

Finally, this stock does not trade on a regular exchange. As such, it does not have the safeguards (which would be costly for a company of this size) that are offered to investors of companies on exchanges such as the Nasdaq or NYSE.

Despite these risks, some value investors might find this to be an offer too tempting to resist. For now, downside protection is present (e.g. even if the Biocancell business goes bust, the cash still protects the shareholder's entire investment). Should the drugs under study work safely, however, shareholders will be rewarded many times over.

Disclosure: None

Tuesday, August 10, 2010

Value Fail

Unfortunately, not every stock with value potential works out. This page is dedicated to these issues.

RadioShack - 3/14
Aeropostale - 12/13
SuperValu - 3/13
Meade - 10/12
Qiao Xing Mobile - 06/12
Blonger-Tongue Labs - 05/12
Vicon - 8/11
Audiovox - 5/11
Orsus Xelent - 4/11
Belzberg - 3/11
China Education Alliance - 12/10

Market Inefficiencies Explained

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

Consider KSW Inc. (KSW), a stock we have previously discussed as a potential value play. The company's CEO announced a plan to exercise 105,000 of his options, and then sell those shares in the market. The announcement was made several months ago at a time when he did not have inside information. Furthermore, the rest of his 750,000 shares will remain under his ownership, continuing to leave him a stake of over 10% in the entire company.

The plan was announced in March, and resulted in almost no change in the stock price. As the CEO has been selling the announced shares, however, the stock price has been dropping. The company only trades a few thousand shares per day; therefore, selling 100K+ shares over three or four months can result in significant price movements. In this case, shares have fallen some 20% since the share sales began. Now that the sales are practically complete, the share price can breathe again, as the supply and demand of the shares of KSW are free once again to find a more normal equilibrium.

Many financial experts regard stock prices as fully reflecting the values of the underlying businesses. This assertion must be thrown in doubt, however, in cases such as this one, where shareholders controlling large blocks of shares are dumping their stock over very short periods of time. The market is not efficient here; excess supply of shares is driving down the price, offering opportunities for those who don't believe the market is efficient.

Disclosure: Author has a long position in shares of KSW

Monday, August 9, 2010

Focus On The Short-Term Consequences

Value investors try to outperform the market in the long-term by taking advantage of the market's endless focus on the short-term. For whatever reason, institutional investors and stock market analysts appear to focus solely on the next quarter, instead of the next several years ("long-term" for them means thinking as far as the quarter after next).

This focus on the near-term appears especially prevalent in the outlook surrounding Western Digital Corp (WDC), a company we discussed last week as a potential value investment. The questions asked on a company's conference call can give an investor an idea of what the concerns are of the company's analysts. WDC's analysts appear only interested in the company's next six months. Consider these paraphrased questions asked of the company from the first seven callers:

1) Will the pricing that was set in June change during this quarter, or stay the same?
2) What will demand and pricing be through the fall? What are the key items that will impact the September and December gross margins? Can you take out any costs immediately to improve the gross margin in the September quarter?
3) Did European customers continue buying into start of the September quarter?
4) What's the inventory situation with respect to back-to-school demand?
5) Might some holiday inventory build get pulled into the fall?
6) What does industry capacity look like relative to demand for the next two quarters?
7) How much restocking did customers do in the March quarter?

Even on the rest of the call, almost every caller had at least one (and in some cases, all) of their questions based on the next quarter. I have never seen a group of analysts so concerned with the short-term. (Often, this can lead to a severe mis-pricing of a security, which may be the case here as the company trades with a P/E under 5.)

As a result, I wonder if there are particular attributes of this company which encourage or result in short-term thinking. Are there particular industries or companies which lend themselves to short-term thinking, for whatever reason? What are those reasons? Feel free to comment if you have any thoughts on this issue.

Sunday, August 8, 2010

Reminiscences of a Stock Operator: Chapters 9 & 10

Reminiscences of a Stock Operator was originally written in 1922 as a first-person fictional account, but is now generally accepted as the biography of stock market whiz Jesse Livermore. The book is recommended to traders and value investors alike, for the lessons it teaches the reader in human behaviour as it pertains to securities trading and investing.

Livermore describes his successful speculative trades that led to his being "king for a day" and making his first million in the market. Livermore had been bearish on the market for some time, due to many economic factors that he studied that showed liquidity to be at a premium. The rest of the market was bullish, however. Rather than do what he normally would have done, which is plow into the market because he believed himself to be right, he waited for the right opportunity, using the techniques described in the previous chapter.

When the bear market finally it came, it was so devastating to the market that extraordinary support from key banking officials was needed to keep the market from flat-lining completely. Livermore's legend grew as his net worth expanded, with traders around the country discussing his prowess. As the bear market continued and Livermore's gains continued to grow, Livermore was eventually asked by a key official to stop his selling out of patriotic duty, for the economy as a whole was likely to suffer if Livermore kept punishing the market. By that time, Livermore had already resumed covering his shares; but had he not, Livermore believes he singlehandedly could have destroyed the market (by continuing to short).

At this point, Livermore believed that he finally learned to trade properly. He had advanced from bucket shop trading to trading on the real market, whereby study of macroeconomic issues went hand-in-hand with "reading the tape" (studying past prices).

Livermore also discusses "resistance levels" and how he uses them in his trades. Often, a security will trade within a range, because as it rises, selling pressure increases, and as it falls, buying increases. But when a security breaks through a resistance point, it often continues to move in the same direction, according to Livermore. As such, he will take an initial position as the price moves through a resistance level and build on it as it continues in the same direction.

But Livermore finishes the chapter with an ominous note:

"The conclusion that I have reached after nearly thirty years of constant trading, both on a shoestring and with millions of dollars back of me, is this: A man may beat a stock or a group at a certain time, but no man living can beat the stock market! A man may make money out of individual deals in cotton or grain, but no man can beat the cotton market or the grain market. It's like the track. A man may beat a horse race, but he cannot beat horse racing. If I knew how to make these statements stronger or more emphatic I certainly would."

Saturday, August 7, 2010

Reminiscences of a Stock Operator: Chapters 7 & 8

Reminiscences of a Stock Operator was originally written in 1922 as a first-person fictional account, but is now generally accepted as the biography of stock market whiz Jesse Livermore. The book is recommended to traders and value investors alike, for the lessons it teaches the reader in human behaviour as it pertains to securities trading and investing.

Livermore now shares some of his speculating techniques, many of which he has learned from other speculators. Livermore clearly believes speculation to not be the same as gambling. He believes his method of trading contains little to no elements of gambling, and therefore is safe. One of his abilities relative to other traders is that he is able to separate his opinions from his portfolio. Livermore claims a great many investors are simply bulls because they own stocks, but what they own should not affect their outlook.

Livermore buys when the market (or a security) is going up, and sells short when the market (or a security) is going down. If he believes a stock is going up, he will buy it, but not all at once. He first tests the water by placing an initial order. If the order is easily absorbed by the market or the price falls (or rises if he is short) despite the order, he will consider himself wrong for now and will get out. If the price rises on his buy, however, he believes there are more buyers than sellers out there and he will re-enter the market with a subsequent order. When one is unsure about the market's (or a security's) direction, Livermore advises placing test orders to determine how well the market absorbs an order. If the market is not absorbing well, there could be a big move and Livermore would enter with larger orders.

Before Livermore learned to employ the above technique, however, he was wiped out once more. In 1907 he saw a bear market coming, but was too early in selling short three straight times. A bull market was on, and when it looked like it was ready to fizzle out, Livermore jumped in with large sell orders that he eventually had to buy back at higher prices. The last of these cleaned him out completely. Because he generated lots of commissions for his broker, they fronted him some more money, and Livermore was finally correct about his predicted bear market. He made back a ton of money in a huge market sell-off.

Friday, August 6, 2010

EBITDA Is Not Cash Flow

Earnings before interest, taxes, depreciation and amortization (EBITDA) is often used synonymously with cash flow. Relatedly, a reader recently took exception to an article about NovaMed, arguing that the company derives significantly more cash than the article implied, due to cash flow from depreciation. For most companies, however, using EBITDA as a proxy for cash flow will lead to serious errors in valuation.

In asset intensive businesses, depreciation is a large part of expenses. In many cases, managements will discuss EBITDA numbers to make results look better than they are. Yes, cash "provided" by depreciation can be used to pay down debts, and so comparing EBITDA to debt servicing requirements can be useful; however, using EBITDA in any shape or form related to a company's valuation should be used extremely cautiously. This is because in most cases depreciation is a very real charge, as assets must be replaced (at a real cost) for the business to continue earning. Unless the investor can determine that an asset is being depreciated faster than its useful life, it is very dangerous to assume any cash flows arising out of depreciation expenses.

Furthermore, due to inflation, the prices of most assets rise over time. As such, depreciation actually understates the required replacement costs of assets in the majority of cases. Therefore, instead of being counted out, depreciation should be counted up.


When estimating a company's future cash flows, allowances must be made for the replacement of depreciating assets. Otherwise, one is assuming that expensive, fixed assets the company owns are totally free, which will lead to great errors due to ridiculous valuations.

Disclosure: None

Thursday, August 5, 2010

Yes To Higher Tax Rates?

Western Digital Corp (WDC) trades at a P/E of just 4.5, despite having cash of $2.7 billion against debt of just $400 million. Subtracting the net cash position from the company's market cap (as we have previously done with other companies) gives the company a P/E of under 3! It is rare to find a large cap trading at such a low P/E, particularly in a growth industry (the company sells hard drives, which more and more of the devices we use rely on). But before jumping in, investors should be aware of a couple of caveats.

One may ask why the company is not busy buying back shares at these prices using its strong cash position. The first problem is that the $2.7 billion in cash is not freely distributable to company shareholders. The company earned this money through its international subsidiaries, and would be subject to a large tax payment (in excess of $1 billion) if it repatriated these funds. As a result, the company is incentivized to continually re-invest this money overseas, which could lead to poor allocation decisions and which can't be used to reward shareholders any time soon.

This same issue also affects the company's earnings, which are abnormally high relative to the company's operating income. This is because the company is using a very low tax rate, thanks to tax holidays in some of its foreign jurisdictions. But some of these tax holidays will expire soon. Furthermore, if shareholders ever expect to get paid, repatriation taxes (which are not currently accounted for by the company) will have to be paid. Therefore, the currently low tax rate, which is contributing to the high earnings, may not be sustainable.

Accounting for these tax issues raises the adjusted P/E of the company by a few points, but still leaves it looking grossly undervalued. Part of the reason is that the company is currently experiencing peak operating margins. The company has been better at cutting costs and being more productive than the competition, but as the competition catches up, margins for Western Digital should come down. Over the last 10 years, the company has averaged operating margins of under 8% of revenue, but this year the company pulled in margins of 15%. This has made this year's earnings high, but as competitors ramp up production, prices for hard drive units continue to fall, and in this somewhat commodity-like sector, Western Digital does not have a lot of control over pricing. Value investors prefer not to invest in companies that do not have a lot of control when it comes to pricing, and prefer to use average earnings over current earnings.

Despite these warnings, Western Digital may still hold appeal for value investors, particularly if its price continues to fall. For a good discussion of WDC's competitive position, have a look at Tom Armistead's article here.

Disclosure: None

Wednesday, August 4, 2010

Stock Returns Of 70%+

Yesterday, shares of Blonder Tongue Labs (BDR) rose by 70%. You won't find stock returns of this magnitude in large-cap companies, which is why for truly exceptional returns, investors should look for value among the thousands of small and micro-cap companies that are for sale to the public.

Many of these small, obscure companies trade at large discounts to their intrinsic values. Can these discounts be identified and exploited by value investors? Absolutely. Just four months ago, BDR was identified on this site as a potential value investment, and has been sitting on the Stock Ideas page ever since. Today, its price is more than 100% higher.

Sales of BDR's newest digital product have taken off, resulting in large 2010 Q2 profits which were announced yesterday. But investors did not have to see the success of this new product coming; for the last year, the company has been trading at a massive discount to its net current assets and its land under ownership. The patient value investor had protected his capital from downside erosion (the first rule of value investing) and had left himself plenty of room for upside should the outlook for this company change.

Sometimes, investor outlooks for companies don't change for years. In other cases, the outlook can change in a hurry. If the value investor concentrates on protecting the downside and leaving plenty of room for upside potential, he should do well in either case.

Disclosure: Author has a long position in shares of BDR

Tuesday, August 3, 2010

Split Accounting

Some market participants try to make money off of stock splits, expecting the supply or demand of shares to rise or fall following splits or reverse splits. On the other hand, value investors recognize that the intrinsic value of the company has not changed post-split, and therefore stock splits are considered irrelevant events. Unfortunately, however, splits can complicate one's valuation of a company; accounting for splits is not just a matter of adjusting the number of shares outstanding and the price per share. Recent splits can cause valuations to go haywire if not properly accounted for.

Last week, we discussed a company called NovaMed (NOVA), which operates surgery centres throughout the United States. Thanks to reader Jay for pointing out that a recent reverse split changes the conversion price of the company's convertible debt to an amount that materially changes their value.

The most recent quarterly report (dated May 10), lists the conversion price at $6.31 (ignoring the warrant sales/purchases which effectively alter the conversion price), which is lower than the current stock price of $8.00. But fifteen days later (May 25th), the company approved a reverse 1:3 stock split and a month later the reverse split took place, which changed the conversion price to almost $19.00 (if it is to be compared to the current stock price), reducing the chances of dilution considerably.

Don't do what I did in assuming the quarterly report has the most up to date information. You don’t need to be studying in the best online MBA programs to know this is common sense. Stock splits and reverse splits since a company's last report can falsely skew a valuation. Investors should ensure they are up to date on a company's most recent filings before concluding their valuations.

Disclosure: None

Monday, August 2, 2010

Distribution Potential

About eight months ago, Imation (IMN) was discussed on this site as a potential stock idea. It traded for $300 million and had $80 million worth of cash (with no debt). Today, Imation trades a little higher at $360 million, but now has $250 million worth of cash. The company has been breaking even on an earnings basis, but is getting positive cash flow from cutting its inventory/receivables and from cash earnings (since cash is not affected by Goodwill write-downs and amortization).

Many companies need to carry large cash balances (e.g. for capital outlays), but Imation is not one of those companies. Depreciation expenses have been almost twice as much as capital expenditures over the last several years, and the company settled a lawsuit a couple of quarters ago that reduced its cash obligations significantly. As such much of that money, which represents about 70% of the company's market cap, could be returned to shareholders without harming the business. But will that money be distributed?

Imation traditionally does return cash to shareholders, having distributed almost $200 million to shareholders over the last four years in the form of dividends and share buybacks. Therefore, history is on the side of the shareholder. (In 2009, however, it scrapped its dividend and didn't buy any shares in order to avoid a liquidity crisis. While that undoubtedly hurt the share price then, it has left the company with more cash to distribute now!)

Management comments have also suggested shareholders may see some of that cash, as the following statement from its CEO on last week's conference call indicates:

"We've recognized that the cash on our balance sheet is not getting the return our shareholders want. And we've looked at other strategies, including bulk share repurchase and dividends. That's not promising what we're going to do or when we're going to do it, except that we understand, we get the math, we understand that you don't want a lot of cash just sitting on the balance sheet and not deployed."

We've seen before the kind of price run-up that can occur when management returns cash to shareholders. Not only does the stock price often benefit because of the immediate cash distribution, but it also begins to trade up on the idea that management is shareholder-friendly and will therefore operate in a shareholder-friendly way in the future as well. On the other hand, nothing is guaranteed here, as Imation is also free to pursue acquisitions with the bulk of its cash as well. But at the current share price, hopefully shareholders will benefit no matter how that cash is deployed.

Disclosure: Author has a long position in shares of IMN

Sunday, August 1, 2010

Reminiscences of a Stock Operator: Chapters 5 & 6

Reminiscences of a Stock Operator was originally written in 1922 as a first-person fictional account, but is now generally accepted as the biography of stock market whiz Jesse Livermore. The book is recommended to traders and value investors alike, for the lessons it teaches the reader in human behaviour as it pertains to securities trading and investing.

No matter what one's methods of speculating in the market, Livermore advises that one be flexible. The market's action may change. As such, it is no good to have a method that continues to lose money just to remain consistent. As bear and bull markets come and go, the speculator must adapt, as did Livermore when he attempted for the third time to avoid losing all his money upon his return to New York.

As Livermore changed his methods as he tried to transfer his success from the bucket shops to the exchanges, he found that he now had to be more anticipatory as opposed to reactionary. Previously, he would simply study the ticker's past price changes to make his decisions. With the execution delays inherent in real trading, however, Livermore now had to anticipate the market's movements. He would do this by reading trade reports, railroad earnings, and financial and commercial statistics.

Livermore says that most of the market's speculators lose money. Some learn from their mistakes, but most others graduate to a level where they learn the conventional wisdoms that continually lose them money. It's those that can get past those so-called wisdoms that can truly profit, according to Livermore.

One example of this has to do with profit-taking. Conventional wisdom argues that no one has ever lost money taking profits (selling after a small gain). But Livermore argues he has made more money by sitting (on a position) than by thinking alone. It's easy enough to be right about the direction of a stock, according to Livermore, but the kind of person that can both be right and sit tight is uncommon and is the kind of person that can make real money in the market.

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