Thursday, September 30, 2010

How To Short Gold "Safely"

When the cost of a commodity is well below its asking price, something is amiss. Such is the case with gold, as major producers are able to dig it out of the ground for around $500, and sell it for $1300 (and rising). This has encouraged majors like Barrick, Newmont, and Goldcorp to increase production and increase exploration. As a result, they have about 15-20 years (and rising) worth of proven reserves left at current production rates. As the price of gold continues to rise, that process will accelerate, increasing supplies.

On the demand side, sentiment is raging bullish, as discussed here. (For an additional example, consider the wildly positive comments towards gold on any Seeking Alpha article on the subject.) As contrarian investors know, when the investment world is bullish on a security, the price is soon headed in the opposite direction.

But for the long-term investor, it's impossible to know when that will happen. Perhaps some owners of gold will decide to sell at the same moment, causing a panic. Perhaps economic data will turn positive, and increase the likelihood of rate hikes, sending investors out of securities that earn no interest. Whatever the case may be, however, it could take years to happen.

Yet, those who wish to short gold often do so with puts. But puts expire, and since the long-term investor does not know when gold is going to head back to normal space, this is a dangerous game to play - even with LEAPS puts. Of course, one could buy a series of LEAPS puts, staggered several years out, but such a position can become expensive for the retail investor.

Going short physical gold or a gold fund is also a common option. But should gold's run continue or even accelerate, the investor is subject to margin calls and to principal loss. This may be perfectly fine for a trader looking to time the gold decrease, but is not suitable for the long-term investor who wishes to avoid the risk of losing his entire principal before the price drop occurs.

The best option for such an investor may be the purchase of an ETF that is short gold (using puts, derivatives etc). There are three commonly used ETF/ETNs of this nature, including DGZ, DZZ and GLL. The benefit here is that even if gold rises to astronomical heights and takes many years before it comes back down to a reasonable level, it is not likely that the investor will have lost his entire investment. The reason for this is that as gold rises, the positions of these ETFs are adjusted so that each percentage move in gold results in a similar percentage move (in the opposite direction) in the ETF. DGZ and DZZ are adjusted monthly, while GLL is adjusted daily. The retail investor would experience much in the way of transaction costs were he to construct a short position and attempt to re-adjust its size daily.

One thing to watch out for, however, is that DZZ and GLL attempt to double the percentage change in gold (in the opposite direction). For example, if gold rises 5%, DGZ is likely to fall 10%. As such, a 50% move in gold in a single month (for DGZ) or a single day (for GLL) will wipe out the investor's entire position. This is unlikely, especially for GLL which is adjusted daily, but not impossible, particularly if bubble frenzy catches fire at some point. There are also other risks involved with these ETFs, so investors should be sure to have read and understood the fund prospectus before making a decision.

Once the decision is made to choose one of these short ETFs, it also becomes a difficult task to determine when to sell. While value investors may agree the current price of gold is higher than it should be (due to the wide difference between production costs and price), it's difficult to know exactly what the price should be. This inability to determine a sell point is another challenge when it comes to shorting gold, though one that is not all that unfamiliar to value investors. (e.g. Sometimes one can tell that a stock is undervalued, even though one can't put a number on its exact worth.)

Bubbles can take years to pop. As such, many who are not gold bulls choose to sit on the sidelines rather than risk their capital going short. For those who are willing to wait years (if necessary) and who understand the fact that the price of gold could rise substantially in the interim, going long a short ETF may be a better option.

Disclosure: None

Wednesday, September 29, 2010

Everything Looks Great...Except The Law

Two parties can want to make a deal, but a third party (namely, the government) can prevent that deal from taking place. Such is the case for Advance America (AEA) provider of very short-term loans in Canada and the United States. At the current price, the company looks like a steal.

The company's P/E is under 5, and while the company trades for $230 million, it has earned over $200 million in the last four years! The company has been able to generate returns on equity in the mid-to-high 20 percents, showing that it's got an economic moat.

But that moat is under pressure from the government, at more than one level. For many years, it was the states that have gone after this industry. State legislation has forced Advanced America out of several states, most recently Arizona. Now, however, the federal government is stepping in, further clouding the regulatory environment.

Short-term and even same day loans are often made to those with poor credit. Furthermore, the loans are much smaller than regular loans, both in amount and in length (often extending only to the borrower's next pay day). As a result, companies that advance loans do so at relatively high lending rates. Governments are trying to prevent what they see as predatory lending practices that seek to exploit a group that is already poor. Industry groups argue that these borrowers don't have other options, and so the existence of this industry is better than the alternative (illegal loan sharks).

Wherever the investor's political leanings lie, the difficulties facing this company and industry are undeniable. Governments will be looking to directly reduce the profits of companies like Advance America through caps on lending rates, fees and borrower frequencies, which will likely cause reduced profitability for this company. Furthermore, the mounting legal costs to constantly fend off government lawsuits is likely to continue to increase. The company's description of its legal proceedings in its annual report is five pages long, and still doesn't cover every lawsuit in which the company is involved.

Advance America may still be undervalued even after accounting for the regulatory environment. However, that conclusion is far from certain. Rather than attempting to predict the effect of past, current and future legislative proceedings, value investors may be better off not swinging at this particular pitch.

Disclosure: None

Tuesday, September 28, 2010

Director Incentives

Recent developments in the previously discussed offer by XING to acquire Stock Idea QXM illustrates a major flaw in current corporate governance standards.

XING is offering $200 million to pick up more than $265 million in liquid assets (mostly in the form of cash). But the Special Committee of the Board of Directors has so far offered no opinion on this offer. Why? Because these directors own no shares in the target company. As such, they have no incentive to force an increase in the share price offered. Instead, these directors are incentivized to befriend the acquirer so that they can continue to land lucrative director fees in the future.

Companies listed on the NYSE are required to have a number of independent directors. But these directors are not acting in the company's best interests if their financial incentives are not aligned with those of shareholders. In the case of QXM, the independent directors own no shares, while the rest of the directors own 60% of QXM.

But the minority shareholders are fighting back. The Special Committee has "received...communications from several institutional shareholders of QXM in which such shareholders have indicated that they did not believe the Proposed Offer was sufficient and that they did not support the Proposed Offer, noting among other things that as of June 30, 2010 both the net asset value per share, and the cash value per share, of QXM was substantially in excess of the value per share of QXM represented by the Proposed Offer."

Nevertheless, the acquiror is pushing forward to force the transaction through. Had the directors had the financial incentive they should have, they may have demanded (publicly or otherwise) a higher offer price. Instead, shareholders may get ripped off.

Warren Buffett has often spoken of the need to correctly incentivize directors. These paragraphs are from Berkshire's 2002 letter to shareholders:

"[W]e will add a test that we believe is important, but far from determinative, in fostering
independence: We will select directors who have huge and true ownership interests...expecting those interests to influence their actions to a degree that dwarfs other considerations such as prestige and board fees.

"That gets to an often-overlooked point about directors’ compensation, which at public companies
averages perhaps $50,000 annually. It baffles me how the many directors who look to these dollars for perhaps 20% or more of their annual income can be considered independent when Ron Olson, for example, who is on our board, may be deemed not independent because he receives a tiny percentage of his very large income from Berkshire legal fees. As the investment company saga suggests, a director whose moderate income is heavily dependent on directors’ fees – and who hopes mightily to be invited to join other boards in order to earn more fees – is highly unlikely to offend a CEO or fellow directors, who in a major way will determine his reputation in corporate circles. If regulators believe that “significant” money taints independence (and it certainly can), they have overlooked a massive class of possible offenders.

"At Berkshire, wanting our fees to be meaningless to our directors, we pay them only a pittance.
Additionally, not wanting to insulate our directors from any corporate disaster we might have, we don’t provide them with officers’ and directors’ liability insurance (an unorthodoxy that, not so incidentally, has saved our shareholders many millions of dollars over the years).

"Basically, we want the behavior of our directors to be driven by the effect their decisions will have on their family’s net worth, not by their compensation. That’s the equation for Charlie and me as managers, and we think it’s the right one for Berkshire directors as well.

"To find new directors, we will look through our shareholders list for people who directly, or in their family, have had large Berkshire holdings – in the millions of dollars – for a long time."

Monday, September 27, 2010

ADF Group

ADF Group (DRX) designs and builds steel structures for the non-residential market. This company operates in a very cyclical industry, as it is reliant on a construction industry that is in no mood to build as a result of the recession. But market pessimism has pushed this stock to a price to book value of just 0.66, despite the fact that it has remained profitable throughout this downturn!

ADF had some rough years following the last recession in 2001, as its capital structure was far too aggressive (i.e. it had too much debt). As we've discussed in the past, cyclical companies should not carry a lot of debt. Since then, ADF has added some equity and reduced its debt, resulting in its current net cash position (cash minus debt) of $10 million.

Subtracting the net cash position from the company's market cap suggests the market is valuing the company's remaining assets at $50 million. But this is a company that has earned operating income of $57 million in just the last four years. Yes, the next couple of years will be slow, as the market for steel structures is not exactly booming. But the company is in no danger of going bust. When the industry returns to normal, ADF is in a position to return to growth.

There are a couple of caveats worth noting, however. The shareholders who control the company don't have a financial stake commensurate with their controlling stake. This results in misaligned incentives, as discussed here. Also, the level of customer concentration is high, with two customers making up more than two thirds of the company's business of late. High customer concentration adds to a company's risk level.

Undoubtedly, investors are afforded the opportunity to buy this company's assets on the cheap. However, it is not known when the market for this company's services and products will turn positive. But the company has a financial position (more cash than it does debt) that will allow it to outlast this downturn, potentially rewarding long-term investors in the process.

Disclosure: None

Sunday, September 26, 2010

The Making Of A Market Guru: 1998 - 1999

Ken Fisher manages $35 billion in individual and institutional funds and is value-focused. His father wrote a terrific investment book discussed here, but this book is about Ken's investment philosophy, which evolved over his career. This book chronicles that value-focused evolution over his 25 years as a Forbes columnist.

While stocks experienced extraordinary returns during the tech bubble, Fisher remained bullish through most of this period. In his columns, he fights against reader mail that assail him for abandoning his "value" roots.

Fisher explains why he remains bullish despite the high P/E level of the market. His reasons include:

- US stocks rarely fall in the President's third and fourth years

- The level of interest rates remains low, so liquidity is abound

- The dollar remains strong due to foreign flows as a result of lower foreign interest rates, further increasing liquidity

Speaking to the issue of the high P/E (which at the time was 34 for the S&P 500), Fisher argues that high P/E's are actually less risky than low P/E's. Usually, high P/E's are the result of high earnings on the horizon. When those high earnings are realized and the P/E subsequently drops as a result (due to the increase in the denominator), that's when risks increase, according to Fisher.

Fisher is also quite bullish on mega-cap stocks during this period, which are the largest of the large US stocks. His research (including the fact that mega-caps outperform other stocks at the end of bull markets and the beginning of bear markets) indicates that this trend should continue, and so he advises readers to buy big.

Saturday, September 25, 2010

The Making Of A Market Guru: 1996 - 1997

Ken Fisher manages $35 billion in individual and institutional funds and is value-focused. His father wrote a terrific investment book discussed here, but this book is about Ken's investment philosophy, which evolved over his career. This book chronicles that value-focused evolution over his 25 years as a Forbes columnist.

Fisher argues that he cannot predict market tops, so he doesn't try. Instead, he looks for evidence after-the-fact that a top has already been reached. In his experience, bull markets don't end with a bang, they end with a whimper, meaning the market declines slowly, not with a sharp downward spike.

In contrast to his views a couple of years prior, Fisher now becomes bullish on gold. As prices have fallen through the mid 1990s, Fisher believes the gold market has capitulated. Prices are low, and Fisher has his eyes on a low-cost producer that trades at a P/E of 12.

During this time period, there are those who are bearish on the economy in Europe. But monetary policy had become very accommodative, and Fisher argues that this works at stimulating the economy, but with an unpredictable time lag. The newly printed money first flows to financial markets, and only later does the actual economy pick up.

Fisher also gives readers a couple of methods he uses to determine whether a bear market is on the way. Many people think stock buybacks are bullish for stocks, but when buybacks are at high levels for the market, Fisher believes there is too much optimism and this is a bad sign for stocks. Also, Fisher polls his clients on their market optimism, and if they're optimistic (pessimistic) he finds the market does poorly (well).

At the end of 1998, as the tech bubble heats up, Fisher writes that stocks are clearly overvalued, but that he does not see a bear market coming just yet.

Friday, September 24, 2010

Making Money The Wrong Way

Last year, we discussed a small-cap company called Daxor (DRX) that claimed to be a medical device manufacturer. Unfortunately, it made no profits from this operation, but it did generate profits from trading securities, including millions of dollars worth of short positions! By marketing itself to investors as a medical device firm, the company was not being very up-front with investors, which is why we originally discussed the company. Apparently, the SEC agrees.

Last week, the SEC issued cease-and-desist enforcement proceedings against Daxor for illegally operating as an unregistered investment company. Investment companies must provide disclosures to increase transparency for investors. Daxor skipped that process by purporting to be in the medical device industry. The SEC notes that Daxor's investment income has amounted to 750% of Daxor's gross operating revenues over the last five years. Furthermore, 90%+ of the company's assets are investment securities, rather than assets related to medical device manufacture.

When we first looked at the company last year, it traded at a 50% premium to its book value, which mainly consisted of the aforementioned short-term investments. In other words, there was no discount to be had. Since then, however, the price has fallen significantly, while the book value has been relatively stable. As a result, investors are now offered the opportunity to buy this company's short-term investments at book value, with the company's regular operations thrown in for free.

But are those regular operations worth anything? Perhaps not. As the SEC explains:

"Although it claims to be a medical device manufacturing company and its principal product has been developed and available for sale since at least 1998, Daxor has never realized an operating profit or even significant operating revenue."

Furthermore, there may even be material penalties or costs to pay associated with the SEC allegations should a hearing go against the company. As such, investors are not offered much of a margin of safety on this stock. If investors can take anything away from this situation it's that they must understand the sources of a company's profits. Otherwise, they are buying assets they don't understand.

Disclosure: None

Thursday, September 23, 2010

6 Reasons RIM Is A Buy Right Now

This article originally appeared at Cantech Letter, the online authority on Canadian Tech stocks.

The global smartphone market is growing at 30%+ per year. RIM is a huge player in this industry, and the company is benefiting from the industry's growth. Two weeks ago, it released a stellar 2nd quarter earnings report that blew away expectations. Nevertheless, the stock has lost almost 2/3 of its value over the last two years. As a result, the stock has now become a value opportunity, for the following six reasons:

1) Returns On Capital

RIM is highly profitable. Profitability is not about market share momentum, but that's what the market is focused on. Profitability is about generating returns on investment. RIM generates extremely strong returns, as its trailing twelve months return on average equity is 38%! (This is superior to Apple, though Apple is also in businesses other than phones, so a direct comparison is difficult. Google, on the other hand, gives Android software away free, currently generating nothing in the way of returns.)

A 38% return on equity is enormous. To put it in perspective, Google, Microsoft and Exxon, three very profitable companies at the moment, generate returns on equity of just over 20%.

2) Cheap

RIM's P/E is under 9, based on trailing twelve month firm earnings and the company's current market cap, following its recent share buybacks. This is extremely cheap for a company growing revenue 30% year-over-year that has outstanding returns on equity. As Joel Greenblatt has shown time and again, a stock with a high ROE and a low P/E is a recipe for success.

3) Safety in financial position

The company has no debt, and sits on a couple of billion dollars of cash. Furthermore, the company generates about a billion dollars in cash per quarter, leaving it free to make further return-generating investments or return cash to shareholders (of which it does both).

Often, companies see high returns on equity by levering up with debt. RIM generates the strong equity returns described above even though it typically carries a few billion dollars in cash!

4) New products

Right now, the company's earnings reports include costs associated with products not yet on the market (e.g. the company is reportedly coming out with a tablet computer in November). The company now spends $300 million per quarter in R&D, but the benefits (in the form of revenues) for the new products are obviously not yet reflected in the current financials, even though the costs are. As such, the company is even more profitable than it appears, as many of its current expenses are for future products.

5) Buybacks

The company knows its shares are cheap, and so it is reducing its outstanding share count at a price that is beneficial to current shareholders. In the first six months of this year, RIM has spent $2 billion buying back shares, whereas its market cap is only $25 billion.

6) Confirmation Bias

RIM blew earnings estimates away when it reported 2nd quarter results two weeks ago (revenues, units, prices, and earnings all beat expectations). But the market focused on two items, and kept the stock price down: 1) subscriber growth was lower than was guided, and 2) the company will no longer guide on ASP's and subscribers. The focus on these particular items is taking place because existing market sentiment on the company is already negative, and our tendency to be influenced by confirmation bias causes us to selectively place undue importance on items that confirm our original opinion. In this case, the market is negative on RIM, so it is focusing on any negative that it can find.

Market sentiment can change quickly, but it has not done so on this stock, despite the stellar earnings report. But the best time to invest is when market sentiment is negative, because that's when the investor is offered a great price. That time is now for Research In Motion.

For more on why RIM is not the next Palm, see this article.

Wednesday, September 22, 2010

Profiting From NOLs

A net operating loss (NOL) can be carried forward to offset future income for the purposes of calculating a company's taxes. The market doesn't always properly recognize these assets (which are often not on company balance sheets), as we've seen a couple of examples where investors were offered great discounts on NOLs. A current example may be ADPT Corp. (ADPT), formerly known as Adaptec.

ADPT trades for $350 million, despite net current assets of $380 million. In addition, the company has over $50 million of tax assets (due to NOLs) that it can carry forward.

Unfortunately, the company is currently burning cash; however, new management has been shrinking the business, selling off patents and assets to realize shareholder value. (For more on this, see this article at the Motley Fool.)

But with almost no operations now, the company cannot use its NOLs as it currently stands, leaving it with two options. It can sell the company to someone who can utilize the assets, or it can buy a profitable company in the same business line and apply the NOLs to the new business.

In the former case, the gains realized are immediate and can benefit shareholders with little risk. Unfortunately, management appears to have decided to pursue* the latter option, which spreads the gains out over time (in the form of reduced taxes owing) and subjects the investor to operating risk (i.e. if business is not so good, the gains may never be realized!) Likely contributing to management's decision in this regard is that there are legal restrictions on the amount of NOLs that an acquiring company can apply (to avoid having successful companies buy failed companies simply for their NOLs).

ADPT trades at a discount to cash less liabilities, and has a bunch of NOLs as well. But this is no ordinary situation for investors looking to capitalize on these NOLs; in order to capture them, management appears intent on spending the cash, which would otherwise act as a margin of safety. As a result, the downside risk to this stock is not limited despite the upside potential.

* From the company's latest 10-Q: "Going forward, our business is expected to consist of capital redeployment and identification of new, profitable business operations in which we can utilize our existing working capital and maximize the use of our net operating losses"

Disclosure: None

Tuesday, September 21, 2010

Value In Action: Nu Horizons

Six months ago, we discussed Nu Horizons (NUHC) as a potential value investment. Yesterday, it rose 102% after receiving a buyout offer with a hefty premium. Therefore, today the stock moves off of the Stock Ideas page and onto the Value In Action page. Here are four lessons one can take from this type of investment that reinforce "value investing" principles.

1) Basing a company's value on its current earnings is a poor idea

Current earnings fluctuate. Particularly during a recession, current earnings are not a good gauge of what a company can earn, or what a company is worth. Instead, investors should look at normalized earnings as well as assets (particularly liquid ones) in forming a valuation opinion.

2) Identifiable catalysts are not necessary

There was no reason to believe that Nu Horizons would be bought out. If there were, the stock probably would not have traded at such a large discount to its assets. When investors buy businesses for much less than what they are worth, the odds are very much on their side when it comes to receiving a favourable return. Subjectively applying catalyst values could result in missed opportunities.

3) Book value matters

Many investors believe book values to be completely irrelevant. Value investors know that just isn't correct. In buyout cases such as this one, where return on capital has been around or below the cost of capital, the transaction price is often quite close to book value. This is because it would take the acquirer around that much money to build up the assets that they seek internally. But they do save time by making an acquisition, and they do acquire intangibles such as customer/supplier relationships and know-how, which is why this type of acquisition often takes place at a premium to book value.

4) A variable cost structure helps

The recession and the ensuing loss of a supplier took a bite out of Nu Horizons' revenues. But because the company is not burdened with a high percentage of fixed costs, the company was able to adjust and return to profitability relatively quickly. Undoubtedly, this helped it secure an asking price that was above, rather than below, book value.

Disclosure: None

Monday, September 20, 2010

Too Good To Be True?

China Education Alliance (CEU) provides onsite training and online education to both children and adults in China. The company trades for $120 million, but earned $15 million in 2009, expects to increase revenues by 30% this year, and has a $75 million net cash position. Its P/E drops to 3 once you subtract out its cash position. This is a very cheap asking price for a growing company in a needed field in a high-growth economy, but it does have a few risks.

For one thing, the company may appear too good to be true for some investors wary of fraud. The company is not audited by a big-name firm; however, the auditors of this company do have several other clients, and do pick up their phones in both their New York and Florida offices, confirming their existence. However, they have been accused of being a little bit on the negligent side in the past. China Education Alliance management did state on their last conference call that it is considering switching to a more recognizable auditor now that it has grown considerably.

Another item that may scare investors is the dilution of the company's stock. The company has gone from 25 million to 31 million shares in the last year, due to conversion of preferred shares into common, and the exercise of warrants and options. The share count should be more stable going forward, as no more pref shares exist, there are no more warrants outstanding, and options are being issued at a more reasonable clip (and only 400,000 remain outstanding).

The company does trade at a premium to book value, so the investor does have to believe this company has some sort of advantage that can keep competition at bay. But there are other, well-capitalized companies that appear to compete with CEU.

Despite the fact that management believes its shares to be undervalued, it appears intent on using its large cash balance to continue to grow, which could be very good (if returns on that capital continue as they are currently) or very bad (if competition forces returns to more normal levels) for investors.

The upside for this company appears quite high. Investors will have to determine whether the downside risks are worth accepting in return.

Disclosure: None

Sunday, September 19, 2010

The Making Of A Market Guru: 1994 - 1995

Ken Fisher manages $35 billion in individual and institutional funds and is value-focused. His father wrote a terrific investment book discussed here, but this book is about Ken's investment philosophy, which evolved over his career. This book chronicles that value-focused evolution over his 25 years as a Forbes columnist.

In 1994, gold was somewhat of a popular investment. Investors were wary about inflation, and were bullish on emerging markets China and India, not unlike today! Fisher argues that gold relies on the greater fool theory, as prices were well-above production costs, which cannot last.

On the subject of inflation, Fisher argues that it can remain tame even as the monetary base rises, which is what was occurring in the mid-1990s. This is because even though the monetary base may be high, if banks are unwilling or unable to lend money out, then inflation can remain low.

Fisher also has some advice for those who believe in the stock-picking ability of the Beardstown Ladies. For several reasons, he argues that they likely have no idea what they are doing (despite their record of success). A few years later, it was determined that they were not nearly as good as they said they were!

Finally, Fisher has some pointers for investors when it comes to having investment ideas peer reviewed. He argues that if most people agree with you on the future price direction of a security, you should not take it as confirmation that you are right. In fact, it is likely confirmation that you are wrong! The best investments are usually those that are out of favour.

Saturday, September 18, 2010

The Making Of A Market Guru: 1992 - 1993

Ken Fisher manages $35 billion in individual and institutional funds and is value-focused. His father wrote a terrific investment book discussed here, but this book is about Ken's investment philosophy, which evolved over his career. This book chronicles that value-focused evolution over his 25 years as a Forbes columnist.

Fisher advises that investors stay away from most mutual funds. Apart from the hefty fees, he argues that they invest with the crowds. His research shows that mutual funds own stocks with the highest P/B and highest P/E ratios, making them destined to underperform in the future.

Fisher also warns against owning the pharmaceutical companies at their price levels of the early 1990s. They trade at high P/E levels (above 20 in many cases) and profit margins that are at the high end (i.e. unsustainable). As such, they have room to fall as both profit margins and P/E levels contract.

While high P/E levels are often correctly associated with poor future returns, counter-intuitively, Fisher notes that when investors have bought the market at a P/E level greater than 25, they have done very well historically. This is due to the fact that earnings become so depressed during recessions that P/E levels rise, even tho market prices are low! The lesson here is that P/E levels alone are not a good indicator of market price levels.

Fisher also discusses what he thinks is the best indicator of future economic performance (in the short-term), the ratio of coincident to lagging indicators. This indicator will be discussed in a future post.

Friday, September 17, 2010

Context To Consumer Debt

One of the reasons many market observers believe this recession will be a long one is the growth in consumer debt over the years. As consumers now focus on paying down debt levels, they won't be able to spend to the same extent; thus, fewer goods will be produced, acting as a drag on GDP. But what is worth mentioning is that this argument is used in every recession by those who anticipate a depression, so are things really that different this time?

In an article in Forbes magazine in 1991, Ken Fisher responded to those who argued that the recession of the early 1990s was to turn into a depression because mountains of consumer debt had to be paid back before the economy could once again grow. In Fisher's view, this argument was nothing more than fear mongering, as it ignored consumer income. While absolute debt levels were high, debt as a percentage of income was not.

Today, we hear similar arguments about consumer debt levels. But as debt has risen over the years, so has productivity (thanks to education, innovation and investment). So let's consider these debt levels in relation to income. The following chart illustrates the consumer household debt service ratio (DSR), which is the ratio of required mortgage and consumer debt payments to disposable personal income:



The DSR is clearly not out of line with what it has been over the last 3 decades. Though it is still higher now than it was in the early 1980s and early 1990s, how is one to know what is the "right" level of consumer debt? Fisher argued that as long as there are assets that generate substantially more returns than the cost of debt, there will be people who exploit such opportunities, thus driving up the level of debt.

Whether the DSR will turn upward soon, or continue downward for some time is anybody's guess. The point is, debt levels are not way out of line with what they have been in the past, and that the ideal consumer debt level for this economy may well be higher than debt levels stand right now.

Reading articles from previous recessions can offer investors perspective. Often, the same situations are seen again and again, but are claimed to be "different this time". Educating oneself is the best defense against spurious arguments. However, timing when debt levels will start to once again expand is very difficult to do. As such, investors are better off keeping perspective with respect to the market, and putting their energy towards investing in companies trading at discounts to their intrinsic values.

source: Federal Reserve

Thursday, September 16, 2010

It's Hard To Lose Money In This Business

TSR Inc. (TSRI) provides IT personnel to its clients for contract work. As companies have aggressively cut costs, TSR has seen reductions from its clients in both hours of work requested as well as price, as the supply of labour in many areas outstrips the demand for labour. But the nature of this industry is such that this company can still make money, even in hard times!

Most businesses see losses when revenues drop by over 10%, as a result of cost structures which contain a large element of fixed costs (e.g. Consider an airline, which has almost the same costs when a plane is full as when it is almost empty.) But TSR does not have to employ workers that are not needed at client locations (i.e. contract workers that are not earning revenue are not causing losses). Therefore, when revenues fall, so do costs.

In a particular quarter, however, losses can of course occur. The company does have some fixed costs (it's impossible to have none), and so if revenue comes in lower than expected, there could be some red ink. But over longer periods, this company is incredibly flexible in how it can manage its costs versus its revenues, which is very important when the outlook is unclear. No management guesses are required in the form of capital outlays (e.g. no plants need to built) which could turn out to be underutilized; the company can simply cut costs or ramp up as is deemed necessary.

When this flexible cost structure is combined with the company's assets, TSR becomes a strong candidate for a value investment. The company trades for just $8 million, but has net current assets of $12 million. Often, companies trading at such discounts to their assets are losing money hand over fist. Due to the weak labour situation, the market appears to be treating this company as if it will lose money. But TSRI's cost structure makes losing money a difficult thing to do, protecting the investor's downside at this price.

Disclosure: Author has a long position in shares of TSRI

Wednesday, September 15, 2010

Valuing Gold

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

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

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

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

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

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

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

Disclosure: None

Tuesday, September 14, 2010

A Stock To Short For Value Investors

Most value investors don't short stocks, and with good reason. The science behind buying undervalued stocks is not as easily applied to selling overvalued stocks. An overpriced company can rise for years, constantly requiring margin injections. (An undervalued, languishing stock requires no such cash infusion.) A company with poor fundamentals can also be bought out for more than it's worth, resulting in a loss to short-sellers. But very rarely, a situation can come along that eliminates many of the risks of shorting, while at the same time offering strong potential for upside for the investor. One such opportunity may involve going short Xing Resources (XING) and going long Qiao Mobile (QXM).

Xing has made an offer to acquire each share of QXM in exchange for 1.9 shares of Xing and 80 cents in cash. Today, that adds up to $3.75. But each share of QXM currently trades for just $3.35, resulting in an arbitrage opportunity of 11%. But the risk of this transaction falling apart has to be considered low, as Xing already owns more than 60% of QXM's shares, and therefore controls the company.

In this arbitrage play, however, owning the target (QXM) is not enough to guarantee success. Because the offer is share-based, if Xing shares were to fall, the gain for QXM investors could easily disappear or go negative. But by shorting 1.9 shares of Xing for every share of QXM that the investor is long, an arbitrage profit will be made as long as the transaction goes through. (Even if the transaction does not go through, the investor is still somewhat hedged as Xing's 60% ownership of QXM makes the fortunes of the two companies.)

Before making their investment decision with respect to QXM and Xing, however, investors may wish to wait until QXM's independent board committee responds to the offer.

Long-time readers may recall a similar situation to this one occurring last April, when TATT offered to buy up the shares of Limco that it did not already own.

Disclosure: Author has a long position in shares of QXM

Monday, September 13, 2010

Economic Indications Aren't So Bright

There are many indicators which attempt to gauge the health of the economy. They are broadly divided into three categories: leading (e.g. building permits), coincident (e.g. retail sales) and lagging indicators (e.g. employment data). Focusing on a single indicator, or even a single category, does not give the analyst a good enough gauge of the future of the economy. For this reason, many (including value investor Ken Fisher) consider the ratio between the coincident and lagging indicators to be the single best measure of the direction of the economy.

A chart of this index over the last five years is below:


Source: Bloomberg

Back in 1992, Fisher argued that "when this ratio is rising sharply, always be bullish" and "when it is falling, adopt your most bearish posture". Based on those assertions, it would appear that this indicator started to warn of the current recession in late 2006, well before the market recognized that there were any problems. Furthermore, this ratio started to tick up in early 2009, which was exactly the right time to buy stocks.

Unfortunately, the ratio appears to be on a downward slope once again, which isn't a good sign for the economy. At the same time, however, the downward slope is not steep, perhaps resulting in the "unusual uncertainty" language economists have been using to describe the near-term future.

Investors interested in determining the strength of the economy in the short-term should keep an eye on this ratio, and can do so here.

Sunday, September 12, 2010

The Making Of A Market Guru: 1990 - 1991

Ken Fisher manages $35 billion in individual and institutional funds and is value-focused. His father wrote a terrific investment book discussed here, but this book is about Ken's investment philosophy, which evolved over his career. This book chronicles that value-focused evolution over his 25 years as a Forbes columnist.

Heading into the 1990-1991 recession, most economists were predicting that a recession would be avoided. Fisher notes that economists in the aggregate never correctly predict recessions. As a group, never more than 15% of economists have ever predicted a recession, according to Fisher.

As the recession of 1990-1991 did in fact hit, however, Fisher saw a buying opportunity. The markets had fallen, with small-caps having been particularly hit hard. Doom and gloom and talk of a depression were rampant, leading Fisher to become bullish on stocks.

Talk was rampant that America was in too much debt, but Fisher did not buy those arguments. Consumer debt to income was just a couple of points higher than what it was in the last recession, and Americans were still earning returns that were higher than the costs of debt, suggesting there was room for more debt still for years to come.

While many were bearish on America (and high on Japan), Fisher was decidedly bullish on America, arguing that the 1990s would be America's decade, for two main reasons. First, America was #1 when it came to innovation, as all the newly invented products used around the world came from the United States, and Fisher expected that to continue. Second, demographic changes were to be in America's favour. As Europe and Japan were becoming older (higher retiree to worker ratios), America's baby boomers were entering their peak producing/earning years (45 - 54).

At the same time, Fisher warned investors to stay away from Japanese stocks, which were shown to be way overvalued on measures such as P/E and P/S.

Saturday, September 11, 2010

The Making Of A Market Guru: 1988 - 1989

Ken Fisher manages $35 billion in individual and institutional funds and is value-focused. His father wrote a terrific investment book discussed here, but this book is about Ken's investment philosophy, which evolved over his career. This book chronicles that value-focused evolution over his 25 years as a Forbes columnist.

Following the 1987 stock market crash, investor sentiment suggested the event was a one-off that would not affect the economy. While it is believed that Main Street can affect Wall Street, the converse was not generally believed to be true. Fisher argues this assumption to be false. When liquidity dries up in the capital markets, companies focus on cash flow and paying down debt rather than expansion. As a result, a recession often follows stock market crashes.

Rising interest rates also lead to recessions, Fisher argues. But rates are often ratcheted up when sentiment is bullish, and so the upcoming lack of liquidity is often unnoticed. But the lack of liquidity catches up to the market eventually, often resulting in a violent downward readjustment of prices.

Fisher also devotes an entire column to the benefits of investing in companies where managements own significant stakes. The incentives of management are aligned here with shareholders (as opposed to when management is receiving most of its gains from salary), which often leads to great results for shareholders.

Finally, Fisher discusses the merits of a research technique termed "Scuttlebutt". The technique was first discussed by Fisher's father, Philip, in a book we have previously summarized.

Friday, September 10, 2010

Over 1M Jobs Likely Created In August

The US private sector likely created over one million jobs in the month of August. That's in stark contrast to the paltry number reported last Friday by the major media outlets. That confusion can arise because the media outlets omit the word "net" when they report the latest job numbers. While everyone focuses on the "net" jobs figure, the Bureau of Labor and Statistics (BLS) also issues far-less-followed reports detailing total jobs created and destroyed.

Why is this an important distinction? Because the reality is that many American businesses are strong and growing, adding to their payrolls despite the slow-growth economy. But at the same time, companies operating in industries for which demand is no longer what it used to be (e.g. home-building, financial services) have been reducing in size. By looking only at the "net" number, the entire country looks like it's standing still. But in reality, jobs are essentially being transferred from where they are not needed to where they are.

This process is a slow one, however, as many workers require re-training to join different industries. Many workers also lack the qualifications required to start work with some of America's fastest growing employers, which is why unemployment rates vary significantly by worker education levels.

On the first Friday of every month, the financial media will place great emphasis on the net jobs number that is reported for the previous month. But while the word "net" is often omitted, it is important to recognize that it is implied. In actuality, the US economy is likely producing over a million jobs every month, but excess jobs in industries operating with too much capacity have to be wound down, resulting in an uninspiring "net" number. For investors and job seekers, however, there are companies out there that are growing; they just have to be found.

Thursday, September 9, 2010

Acquirer Buys Cash At A Discount

Qiao Xing Mobile (QXM) has been on the Stock Ideas page for almost one year now, due primarily to the discount at which the company trades to its large cash balance. The good news is that shares rose almost 40% yesterday as an offer came in to buy out shareholders at a premium to the current price. The bad news is that the offer is still well below the company's net cash position!

QXM more or less breaks even on an operating basis due to intense competition in the mobile handset market in China. But cash is still cash! The company has $265 million of cash on its balance sheet even after subtracting all of the company's liabilities! But the buyout offer only values the company at $206 million. Furthermore, the company has another $120 million of current assets (receivables, inventory etc.) that the acquirer would receive absolutely free.

Usually, acquisitions are made at a premium to, at the very least, a company's net current assets. So why is this offer such a weak one? The reason may be that the acquirer already owns a majority of QXM's shares. As such, it only has to deal with minority shareholders, who don't control the company and who may be powerless to avoid selling cash at far less than cash value.

Recognizing that minority shareholders can get bullied by those in control, the SEC does offer minority shareholders some protections. It remains to be seen whether those protections are enough in this case to keep QXM shareholders from getting ripped off.

Disclosure: Author has a long position in shares of QXM

Wednesday, September 8, 2010

The CEO's A Liar

We've spent some time on this site discussing how investors can tell if management is behaving in a questionable manner. There are some tip-offs based on EPS rounding, as well as some clues based on management candor. But recently, two researchers pored over conference call verbiage and determined that conference call discussions can reveal whether there is a greater likelihood that management is being deceitful.

Investors are encouraged to listen to conference calls, as they contain a dearth of information that is not available in written releases. But according to Stanford researchers Larcker and Zakolyukina, they reveal much more than originally thought. They contend that deceptive CEOs:

"have more references to general knowledge, fewer non-extreme positive emotions, and fewer references to shareholders value and value creation. In addition, deceptive CEOs use significantly fewer self-references, more third person plural and impersonal pronouns, more extreme positive emotions, fewer extreme negative emotions, and fewer certainty and hesitation words."

Investors interested in looking out for some of these tendencies of deceptive managements can download the entire paper here.

Tuesday, September 7, 2010

Contraction Expansion

SIFCO (SIF) engages in various metalwork processes primarily for the aerospace industry. The stock is down almost 40% from the market's peak in April, and therefore looks cheap across a few value metrics. Even when a company's numbers look good however, investors must dig under the surface to uncover any risks that may be present. SIFCO does have some business risks that could give investors pause.

SIFCO trades for just $54 million despite having a net cash position of $25 million and 2009 net income of $8 million, making it seem incredibly cheap. Of course, 2010 income will be lower than it was last year, as the company has worked through much of its backlog and revenue continues to out-pace new orders.

But while the company now operates well under capacity, it appears to be undertaking an expansion strategy! When capacity utilization is low, one expects companies to allow capacities to fall or actively shrink capacity to reduce fixed costs. But in this case, the company will spend approximately $6 million this year on capital expenditures to expand its ACM group (for a description of the company's industry and segments, see this article), versus 2009 company-wide depreciation of under $2 million. Revenues are down in the ACM group, and operating income is about half of what it was last year, suggesting the expansion is ill-timed. However, due to the company's large cash reserves, it can afford to think long-term; perhaps management is seizing some sort of opportunity, but that is not clear.

A risk that we have previously discussed on this site is customer concentration. Technically, SIFCO's customer concentration is not that bad, with about two customers each representing about 15% of revenues. However, almost 40% of the company's revenue is due to military wartime demand, even if there are various companies in-between SIFCO and the military. It's never likely that a "peace scare" will be upon us anytime soon, however, the risk to this company is rather high under such a scenario.

Finally, it's worth noting that while the company has no debt "officially", its "other liabilities" do contain $5 million worth of pension shortfalls on its defined-benefit plan. This is essentially borrowed money which shareholders will have to cover (barring an incredible surge in the pension asset portfolio).

SIFCO appears to have a lot going for it, from a price vs value point of view. However, the company's expansion strategy when demand for its services are low, along with its heavy reliance on military projects increases its risk for value investors.

Disclosure: None

Monday, September 6, 2010

The Making Of A Market Guru: 1986 - 1987

Ken Fisher manages $35 billion in individual and institutional funds and is value-focused. His father wrote a terrific investment book discussed here, but this book is about Ken's investment philosophy, which evolved over his career. This book chronicles that value-focused evolution over his 25 years as a Forbes columnist.

Fisher likens professors of finance to witch doctors because of the absurd way in which they (and now the finance industry in general) believe beta to be the measure of a stock's risk. Fisher does not believe that volatility equals risk, and cites research showing that beta as a measure of risk is flawed.

As the stock market continues its rise through most of this time period (culminating in the crash in October of 1987), Fisher warns that the market appears overvalued. Nevertheless, he advises readers not to try to time the market, but instead to continue to buy undervalued stocks. To avoid being too invested in an overvalued market, however, Fisher recommends having a maximum percentage (e.g. 5%) in one's portfolio spent on any one stock. As such, if the market becomes overvalued, the investor will not be fully invested as there will be a shortage of undervalued stocks to fill the portfolio.

During that time period, investors appeared to be concerned with the federal deficit. Fisher makes an interesting point that government accounting and corporate accounting is very different, making deficits seems worse than they are. When a corporation acquires an asset (e.g. a building or equipment), it capitalizes it and depreciates the expense over several years in the future. The government, however, expenses its acquisitions (even in the case of land!) right away, making deficits seem larger than they are, since in actuality there are assets present.

Just one month before the big crash in October, Fisher suggests that a bear market is coming, even though he can't predict when. Market P/E's were too high (20), and interest rates were rising, suggesting there was a shortage of liquidity. Following the crash, Fisher shared his thoughts on how it felt to have been invested during that week in October, and how his firm reacted to the market shocks.

Sunday, September 5, 2010

The Making Of A Market Guru: 1984 - 1985

Ken Fisher manages $35 billion in individual and institutional funds and is value-focused. His father wrote a terrific investment book discussed here, but this book is about Ken's investment philosophy, which evolved over his career. This book chronicles that value-focused evolution over his 25 years as a Forbes columnist.

Buying glamour stocks does not pay, Fisher argues. At this point in his investing career (as his fund was still small in 1984), Fisher prefers small, out-of-favour stocks. How does he identify stocks that are out of favour? Using the price-to-sales ratio (PSR). Often times, companies have low or negative earnings for short-term reasons that cause the P/E value to be meaningless. This is why Fisher prefers price-to-sales, since sales are much more stable from year to year. He shows empirical data demonstrating that stocks with low PSR and strong balance sheets outperform the market significantly.

When evaluating small-caps qualitatively, Fisher argues that investors place too much emphasis on the company's product quality and not enough on the company's marketing quality. More often than not, Fisher finds that strong marketing is far more important than superior technology. Fisher also argues that investors should prefer companies with leading market share in their industries. Fixed costs can be spread out over a larger customer base, leading to a competitive advantage. Too often, investors look at companies with low market shares on the assumption that the growth potential is higher, without regard to this scale disadvantage.

Fisher also describes some strategies to make money off of bankruptcies, and offers a recommended reading list of mostly value-oriented books. Included on that list are several of the books that are already summarized on this site, including his father's book, The Intelligent Investor, Security Analysis, Contrarian Investment Strategy, and Reminiscences of a Stock Operator.

Saturday, September 4, 2010

Reminiscences of a Stock Operator: Chapters 23 & 24

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.

While thousands of people speculate on stocks daily, Livermore argues that few of them do so profitably. In his opinion, the speculator's deadly enemies are ignorance, greed, fear and hope.

Making it difficult to make money is the amount of noise reported by the media. Livermore makes fun of a few headlines and articles where market pundits state their case, but for which there is no basis.

But the public loves to receive (and act on) tips. As such, there will always be people there to provide them, for their own gains of course. Brokers are one example of a class of citizen which prospers when the public buys. As such, whether times are good or bad, brokers just want commissions, and so they will offer advice that gets the public to purchase stock.

Livermore ends the book by stating his belief, with all of his years of experience now, that no trader can consistently and continuously beat the market.

Friday, September 3, 2010

Value Investors: Stopping The Losses

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

On the one hand, stop-loss orders can still serve a purpose. For example, if bad news for a company gets released during market hours and the stock goes into free-fall, a stop-loss could get an investor, still unaware of the news, out of the stock just minutes later.

On the other hand, value investors tend to understand what they are buying (lowering the risk of an unexpected impairment), prefer companies with low debt to capital levels (lowering the risk that a company will have some sort of negative credit event), and prefer to take advantage of volatility (rather than fall victim to momentum trading). As such, they are less likely to benefit from the protections offered by a stop-loss.

So while the benefits to stop-loss orders may not be as large for value investors, they still suffer from the negative effects of stop losses: when the market panics unjustifiably, stop loss orders kick in and investors are exited from their positions at prices far inferior to what they may have been willing to sell for!

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

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

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

Thursday, September 2, 2010

Excessive Earnings

Investors love companies that generate high returns on capital. Companies that can do so sustainably are destined to grow shareholder value, as they can grow earnings while rewarding shareholders at the same time. But some companies that generate excess returns can be traps that can cost shareholders dearly! Only if the business falls within the investor's circle of competence can he ascertain whether the company can continue to generate high returns.

Consider Access Plans (APNC), a marketer of various consumer health and insurance products. The company has a book value of just $13 million, but it generates about $1 million in after-tax income per quarter.

As a result of the company's stellar returns, it trades at a market cap of $18 million. As such, if the earnings fall, investors have no downside protection in the form of assets, unlike the case in other companies we have discussed. If competition, attracted by these returns, is able to erode margins, the company's stock price will fall towards its book value.

At the same time, however, if the company is able to continue to generate such returns, shareholder gains will be enormous. Companies with sustainable competitive advantages trading at discounts are the ones off of which fortunes are made, as Warren Buffett and Philip Fisher can attest.

Therefore, the question comes down to whether the stellar returns on capital can be sustained. To answer this question with any reasonable level of confidence, the investor must understand the business. He must be able to determine the key success factors in selling these products, and what advantages Access Plans has which will allow them to continue to generate excess returns in the future. Without this understanding of the industry, the investor is just guessing, and is therefore at risk of violating the first two rules of value investing!

When a company's value based on its earnings is far higher than its book value, investors will end up paying too much for a company if they wrongly assume the strong returns on capital will continue to persist. Competition will reduce earnings to a normal level in time, unless the company has a competitive advantage. But only by understanding the company's business thoroughly can the investor determine if a competitive advantage exists.

Disclosure: None

Wednesday, September 1, 2010

When Average Earnings Are Not Representative

For various reasons, value investors are encouraged to use an average of several years worth of earnings as an estimate of a company's earnings power. But when a company grows quickly (e.g. through the acquisition of a competitor), average earnings are no longer representative of earnings power. In such cases, other methods of estimating a company's earnings may be more useful.

Consider Canam Group (CAM), a company that has gone on a buying spree in the last year or so. As competitors have been shutting down units to conserve cash, Canam has been strategically purchasing competitor plants at attractive prices. As many industries are currently at overcapacity, the benefits of these acquisitions won't be seen for years. But the costs of these acquisitions (i.e. the cash used to finance the purchases) are seen immediately. How does one value the fact that future earnings will be higher than past earnings?

One method applicable to manufacturing companies is based on a company's historical return on its fixed assets. If similar assets to the company's current assets have been purchased, the company may be expected to generate the same type of returns on those fixed assets that it generated over the last business cycle. Of course, this exercise only results in a starting point for estimating future earnings. Adjustments may have to be made based on the age of the assets acquired, their quality, and a whole slew of other factors (e.g. geography).

When times are good, companies will often fall over themselves in bidding wars to acquire potential targets or business units. Value investors realize, however, that the best time for companies to acquire such assets is when business conditions are poor (financing in general is hard to come by, there is overcapacity in many industries, and sellers are desperate to raise cash), due to the great price discounts that are available.

This recession has offered many companies with great balance sheets the opportunity for future growth at excellent prices. However, valuing these companies is a challenge. Using past, average earnings (as is often advocated for value investors) would be inadequate, since an acquiring company's earnings power is now greater than its past earnings have shown. Estimating earnings power based on a return-on-fixed-assets measure may provide better accuracy, leading to more profitable investment decisions.

In a similar vein, we have previously discussed using this method when a company has reduced its capacity in this recession, as in this case, average earnings of the past would overestimate the company's earnings power.

Disclosure: Author has a long position in shares of CAM

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