Sunday, October 31, 2010

Buffett Partnership Letters: 1964

Berkshire Hathaway's letters to shareholders are oft-quoted and Berkshire's annual shareholder meeting is well-followed, as value investors try to glean the wisdom of the world's greatest investor. But before he ran Berkshire, Warren Buffett was far less followed and ran his partnership with a sum of money much smaller than he employs today. The issues he faced then are probably far more relevant to the individual investor today than are Berkshire's current challenges. The following series attempts to summarize the key takeaways from Buffett's partnership letters.

Low Risk And High Reward Are The Way To Go

Buffett describes an arbitrage situation in which he invested that generated a 20%+ annualized return with little risk. When Union Oil announced it was buying Texas National Petroleum, Buffett noted that there were no anti-trust issues and the transaction was negotiated by controlling shareholders of the target. As such, he appraised the risk at virtually nil.

Don't Invest Based On Rumours

Buffett had heard about the above transaction before it was even announced. Had he invested then, he would have made much more money on this deal. However, he implies that rumours are often wrong, and that investing on this basis is "somebody else's business, not mine".

Stick With It

Buffett describes a situation where he purchased stock in a company trading at a sharp discount to its net current assets that did not see gains for five years! Eventually, Buffett accumulated so many shares that he was in a control situation, and was able to effect change from the inside. This was not his intent from the beginning, but the growth of his fund allowed him to continue to purchase more and more of the undervalued shares, and he did so despite the fact that the company performed poorly for five years in a row.

Large Funds Can't Keep Up

When comparing performance to some of the country's largest funds, Buffett notes that the returns of these funds mostly lag the market. Buffett expects large funds such as these to mostly generate the same returns as that of the market, as all they do is buy the largest companies. It bewilders him that they take credit for their strong returns when the market goes up, for they don't control the market's performance.

Saturday, October 30, 2010

Buffett Partnership Letters: 1963

Berkshire Hathaway's letters to shareholders are oft-quoted and Berkshire's annual shareholder meeting is well-followed, as value investors try to glean the wisdom of the world's greatest investor. But before he ran Berkshire, Warren Buffett was far less followed and ran his partnership with a sum of money much smaller than he employs today. The issues he faced then are probably far more relevant to the individual investor today than are Berkshire's current challenges. The following series attempts to summarize the key takeaways from Buffett's partnership letters.

Judge Performance Over The Long Term

Buffett prefers to measure the performance of a fund over at least five years of returns relative to a benchmark specified in advance. At an absolute minimum, Buffett requires at least three years be considered before giving any credence to a fund's returns.

Manager And Investor Interests Should Be Aligned

Buffett makes clear to his investors that he, his wife and his children have, and will continue to have, substantially all of their net worth invested in this partnership.

Management Matters

Having invested enough money to acquire control of a company called Dempster Mill at a discount to net working capital, Buffett attempts conversations with management to get the company on the right track. Six months later, he notices that costs are still high, so he decides to hire his own manager, and compensates him based on his meeting specific cost-cutting goals. This manager was able to cut the company's break-even point in half. As a result, this company generated substantial returns for investors.

Don't Count On The Business Doing Well

In the business described in the previous paragraph, strong improvement in the business' operations resulted in considerable returns. But Buffett makes the point that the fact that the business did well was just a bonus. The price paid for that business was so low that even if business did not improve, Buffett would likely still have made money.

Friday, October 29, 2010

Cultural Underpinnings

Value investors, myself included, tend to prefer financials to "stories" about why a stock should outperform. But good financials are often the result of policies instituted by management that are not as easy to measure and compare as are financials. Investors who can identify companies on this basis have an opportunity to profit before the financials of said companies betray their success, resulting in extraordinary gains.

Philip Fisher was a pioneer who espoused methods of identifying such companies. (His book on the subject is available here, and a summary of all ten chapters of that book is available here.) Fisher's success in this regard brought him outstanding investment returns, and paved the way for Warren Buffett in this area, who calls his investing style 85% Graham and 15% Fisher.

One important aspect that distinguishes successful companies from also-rans is a corporate culture that encourages strong, co-operative relations between labour and management. In this way, employees are constantly striving for improved productivity, which leads to the success of the entire company.

How is this accomplished? Employee creativity and innovation should be rewarded. Decision-making responsibility should be made by individual units, rather than from the centralized, executive offices, making employees accountable but also rewarding them for success. The organizational structure should be flat (as opposed to a deep, hierarchical organization), leading to better communication between managers and workers, fewer bureaucratic layers, and a more nimble company. Employees should share in profits and should be trained across functions, resulting in a more flexible work force that takes an ownership rather than an employee view of their companies.

These features may indeed make a company stronger than its competition, but how can an investor ascertain these internal company workings? Obviously, poor labour relations will result in very public strikes. But Fisher recommends going beyond the public realm in order to determine how a company works. His scuttlebutt method seeks to answer whether the company has a long-term focus, how strong labour/executive relations are, how deep is management's talent pool, and other questions critical to a company's success.

As an example, such methods could probably have been applied to differentiate Southwest Airlines (LUV) and WestJet (WJA) from their unionized competition, long before their relative financial success was ever realized. (It should be noted that this is not an attempt to bash unions. Often times, companies will get the unions they deserve; but this results in an adversarial, rather than co-operative relationship between management and labour. By implementing the policies described above, however, employees will have no need for unions.)

Value investors cannot ignore company financials. But they can do quality, qualitative legwork to determine if strong financial results are sustainable or are subject to competitive erosion.

Disclosure: None

Thursday, October 28, 2010

Techprecision Corporation

Techprecision (TPCS) manufactures precision metal components at its 125K square foot facility in Massachusetts. The company has generated operating income of about $20 million in the last four years, yet it trades for just $15 million.

As a manufacturer of heavy-duty equipment, the company will experience highly cyclical revenue cycles. When capital spending is cut, as is the case during recessions, a company such as this one is likely to see negative profits for some time. This is what creates buying opportunities, since stock prices will often overreact to the downside. What's important to look for in such cases is a strong financial position, which allows a company to outlast downturns. Techprecision has $10 million of cash against just $6 million of debt, which should allow it to weather any revenue shortfalls.

Techprecision also has exposure to growth industries; that is helping it achieve profits even in this tough environment. Techprecision sells to customers in the nuclear, solar, wind and other alternative energy industries. As a result, revenues have rebounded somewhat, allowing the company to generate around $1.7 million in profit over the last three quarters.

Unfortunately, the company does not trade on an exchange, some of the risks of which are discussed here. However, the company appears interested in joining either the Nasdaq or AMEX, which could serve to boost its valuation should that occur. The company has asked shareholders to approve a reverse stock split split, so that its stock trades well above $1. Why is that important? The following statement from the company's proxy statement illustrates the company's motives:

"The Board believes that the Reverse Stock Split is an effective means of increasing the per share market price of our Common Stock in order to achieve the minimum per share stock price necessary to qualify for listing on well-recognized stock exchanges, such as the American Stock Exchange or the Nasdaq Capital Market. The Board will only effect the Reverse Stock Split in connection with an application to list our Common Stock on such stock exchanges. It will not effect the Reverse Stock Split for any other purpose."

There are some risks facing this company, however. First of all, it is heavily reliant on one customer for 60% of its revenue. If that customer were to lose market position, or realign its suppliers, it could seriously harm Techprecision. Thus, only investors who understand the persistence of Techprecision's market position should consider investing.

Furthermore, the company has a number of outstanding convertible pref shares that could dilute current shareholders considerably. While the company has only 14 million shares outstanding, it has 21 million diluted weighted average shares in its last quarter.

Techprecision appears cheap and could see a catalyst benefit were it to join a recognized exchange. However, its reliance on one major customer and the potential for some dilution could turn some potential investors off. Each investor must decide for himself if this company makes sense for his portfolio.

Disclosure: None

Wednesday, October 27, 2010

One-Timers On The Power Play

Companies are required to release their financial results according to GAAP. Often, however, companies will also release what they call "Pro Forma" statements, where certain "one-time" costs are often removed. These statements, managements say, better reflect the earnings power of the company. However, investors are urged not to take managements word, but rather to consider the "one-time" costs to make their own determinations as to whether these apply in the future.

For example, managements have often excluded early plant retirement costs or losses on the sales of equipment from pro forma statements. While these items may not occur annually, the investor must apply business sense to determine if these are likely to re-occur.

For example, does the company compete in an industry rife with technological change? If so, early plant retirements may be part of the cost of doing business. Does the company often have to sell equipment below book value? Management may be using a depreciation schedule that makes earnings look higher than they should be.

The best way to include non-recurring yet real business costs is to average out several years worth of earnings, as discussed in Chapter 37 of Security Analysis by Ben Graham and David Dodd.

As an aside, many companies have also used pro forma statements to exclude the expensing of stock options, which is now required by GAAP. As we discussed here, options have real value, and to avoid expensing them misleads investors about the true costs of operating the business.

The term "one-time costs" suggests investors need not concern themselves as these are unlikely to re-occur. Unfortunately, in many industries and companies, "one-time" costs are the norm rather than the exception. As such, investors need to strongly consider and account for the items that managements suggest should be ignored.

Tuesday, October 26, 2010

Acorn: Poor Results, Positive Returns

When most companies report poor results or show pessimism in their outlooks, their stocks will trade down for some period. However, there is a group of stocks that are likely to trade up (and sometimes significantly up) even when the news concerning it is bad. These are the deepest of the deep value stocks, whose prices are so low that they will often show stock returns even in the face of deteriorating operations. Acorn (ATV) International is an example of such a stock.

Five months ago, Acorn was discussed on this site as a potential value play, and it had remained on the Stock Ideas page ever since. It has traded down below $3.30 per share twice in the last five months, giving it a huge discount to its net current assets. Recently, however, the company has spent time near $5, offering investors the opportunity to sell at a price much closer to its net current assets.

Of course, the prices of certain stocks rise while others falls, but how is the investor supposed to know which ones are going to come out with the great results? Fortunately, the investor doesn't have to. Since the original article about Acorn five months ago, the company has come out with nothing but bad news:

1) Quarterly results were lower than expected
2) Expectations for the year were lowered
3) More recently, the company's chairman and CEO resigned, suggesting the company may not be progressing well towards its current targets

Despite this, the stock has recently traded some 40% higher than the lows described above. This stock serves as an excellent lesson about the importance of paying a low price for an investment. If you buy a company when it's cheap (relative to its assets and/or earnings), you don't need strong performance to achieve superior results. When strong performance does occur, however, the results can be extraordinary.

Disclosure: None

Monday, October 25, 2010

H&R Block Looks Attractive

H&R Block (HRB) makes about $500 million per year in net income, mostly by providing face-to-face tax services to individuals. But for several reasons, most of which are either immaterial or short-term in nature, it trades for just $3.3 billion, giving it a P/E of just 7. For long-term value investors, this may be an excellent entry point.

First, let's look at some of the risks facing this company:

1) Mortgage Put-Backs

The most immediate market fear with respect to this company is the same one facing many US financials today. During the housing bubble, Block used to originate mortgages. (It has since divested that operation.) Buyers of those bad mortgages (of which over $30 billion remain outstanding, down from $50 billion two years ago) can force Block to pay penalties or buy back mortgages where it can be proved that Block has made "valid breaches of representations and warranties".

The company originally set aside $243 million for this purpose, of which it has paid $55 million over the last two years based on a case-by-case examination of the loan documents. Recently, management has re-iterated that it is comfortable that the remaining $188 million reserve will cover future put-backs. But even if one doubles, triples or quadruples this reserve, it still doesn't justify the $4 billion in market cap this company has lost in the last few months!

2) Regulation

Another issue facing this company is the fact that governments don't like some of the services Block provides and has sought ways to curb them. Block has settled many of the lawsuits it has faced, however, some remain outstanding. But the problem isn't just restricted to lawsuits. Recently, the IRS announced that it would be withholding key credit information about filers, which will make it harder for Block to provide loans to some of its clients. We've seen this issue of government interference before with another extremely cheap stock, but in Block's case, its regulatory-friendly services are worth way more than its peripherals. For example, Block stated that the credit information withholding by the IRS is likely to cost earnings about 5 cents per share this year.

3) Do-It-Yourself Online Filing

The main long-term issue facing this company is the fact that over time, tax filers are shifting online and away from bricks and mortar companies. Intuit (INTU) has been successful in growing the use of its Turbo Tax software, and Block's software unit has not been able to keep pace. But due to changes in the last couple of months (discussed below), Block may actually have a bright future in this area.

This brings us to the end of the section on risks. Now for the positives affecting this company:

1) Do-It-Yourself Online Filing

Two weeks ago, Block announced that it has merged with the company that produces TaxACT, tax filing software that 5 million Americans used last year to file returns. The entrepreneur who started that company in 1998 and has been leading it since will now head Block's digital business unit, with a separate P&L. Where Block couldn't succeed on its own, it has acquired capable management that can.

2) Weak Bricks & Mortar Competition

While the recession has taken a bite out of H&R Block, it has taken an even bigger bite out of the competition. The next largest retail filer, Jackson Hewitt (JTX), is having trouble just staying solvent. Its current ratio is well below 1, its debt levels relative to income are very high, and it continues to shut locations, which should allow Block to increase share. Block's net debt level is only about half of one year's worth of net income.

3) Free Mortgage Assets

The market is sour on the mortgage market, but Block continues to receive cash from mortgage assets that it owns itself (not to be confused with mortgages it has sold, as per risk #1). It owns over $550 million of mortgages, after allowances for impairment, that the investor is getting absolutely free at the current stock price. Cash flows from these assets can no doubt help cover shortfalls that may occur with respect to risk #1.

4) Shareholder Friendly

This company returns cash to shareholders. The dividend yield is almost 6%, and the company has bought back $400 million worth of shares in the last year. This is a signal that management doesn't just say that its put-back reserves are adequate; its actions suggest that it truly believes it. The chairman of the board of directors owns $130 million worth of the company.

5) Potential For Services Growth

Block is able to use its retail presence to introduce and further grow client services other than tax filings. One area that is particularly ripe for growth according to management is the company's debit card program, which is providing debit services to tax clients who do not have bank accounts.

Block's stock price has not been this low since 2001. Because sentiment in the mortgage space is so poor, investors are perhaps being offered the opportunity to buy a strong franchise at a terrific price.

Disclosure: Author has a long position in shares of HRB

Sunday, October 24, 2010

Buffett Partnership Letters: 1962

Berkshire Hathaway's letters to shareholders are oft-quoted and Berkshire's annual shareholder meeting is well-followed, as value investors try to glean the wisdom of the world's greatest investor. But before he ran Berkshire, Warren Buffett was far less followed and ran his partnership with a sum of money much smaller than he employs today. The issues he faced then are probably far more relevant to the individual investor today than are Berkshire's current challenges. The following series attempts to summarize the key takeaways from Buffett's partnership letters.

Establishing the benchmark in advance

After the fact, a fund's performance can always be made to look good by comparing it to something that was worse. For this reason, Buffett prefers to set the benchmark ahead of time. Though noting that it has its flaws, Buffett has chosen the Dow Jones Industrial Average as a benchmark because it is widely known, has a long and continuous history, and reflects the experience of investors with the market. He notes that while it is an unmanaged index of 30 leading stocks, it still manages to beat most mutual funds.

Use a margin of safety

Most of the fund's assets are invested in securities representing companies in which Buffett has no control or influence. This has been the largest category of the fund's investments, and "more money has been made here than in either of the other categories". At the time of purchase, it is difficult to determine when or why these will appreciate in price. Yet, because of the lack of glamour and because there is nothing pending which would create favourable price action, these securities are available at very cheap prices.

Borrowing for investing is unnecessary

Buffett's preference is not to owe any money for his fund. However, he does note that situations he calls "work-outs" are particularly safe, and at times he does borrow against the portion of his portfolio invested in "work-outs". These are situations where Buffett invests in mergers, liquidiations or spin-offs, where the financial result can be calculated on a specific timetable, albeit with some risks. At any given time, he is invested in ten to fifteen such situations, and the results yield between ten and twenty percent (before borrowing).

Conservative investing is not what they say it is

A few years ago, Buffett writes in 1962, the purchase of municipal bonds was considered conservative. Today (1962), the purchase of blue chip stocks is considered conservative. Buffett disagrees: "There is nothing at all conservative, in my opinion, about speculating to just how high a multiplier a greedy and capricious public will put on earnings." Even though Buffett's portfolio is unconventional, he believes it to be conservative. He argues that the best test of conservatism in a portfolio is its performance when general market prices decline.

Saturday, October 23, 2010

Buffett Partnership Letters: 1961

Berkshire Hathaway's letters to shareholders are oft-quoted and Berkshire's annual shareholder meeting is well-followed, as value investors try to glean the wisdom of the world's greatest investor. But before he ran Berkshire, Warren Buffett was far less followed and ran his partnership with a sum of money much smaller than he employs today. The issues he faced then are probably far more relevant to the individual investor today than are Berkshire's current challenges. The following series attempts to summarize the key takeaways from Buffett's partnership letters.

Add Value Or Don't Do It

Buffett's objective is to achieve long-term returns superior to those of the Dow Jones Industrial Average. If he is unable to do that, he notes that there is no reason for the partnership to exist. Capital would be mis-allocated.

Long-term Focus

What happens in any one year is irrelevant. In fact, during bull markets, Buffett expects his returns to be lower than those of the market. What's important is whether the partnership can outperform over several years, cumulatively. Buffett is "much more geared towards five year performance, preferably with tests or relative results in both strong and weak markets."

Asset Values Are Sometimes Ignored

Buffett discusses a stock in which he invested 35% of the partner's funds. The company, Sanborn Maps, had lost a lot of earnings power in recent years. However, the company had stockpiled cash during its good years, and therefore had a portfolio of investments adding up to way more than the stock price. The company was on sale for just 70% of its investments (in the form of blue-chip stocks), with the map business thrown in for free!

Patience Is Key

Buffett has begun open market transactions of a "potentially major commitment". As such, he hopes the stock does not increase in price for the next year, in order that he may accumulate more shares. A stagnant stock in which the partnership holds a large position would most assuredly hurt the partnership's short-term performance, but that is irrelevant in the long term.

Friday, October 22, 2010

High Margin Consequences

We often talk about profit margins on this site. Analyzing the profit margins of a company can help you determine its profitability relative to its competitors. For example, if two competitors have equal net incomes but one has twice the profit margin of the other, then over time we may see the more efficient company steal market share and grow at a faster rate. (This can happen for several reasons, one being that it can simply lower its prices until its competitors are no longer profitable, thus dominating the market.)

One type of profit margin is a company's gross profit margin, which is its gross profit divided by its revenue. Gross profit gives a pretty good indication of a company's pricing power versus its product costs. In a previous post, we saw that Coke has a gross profit margin of 64%, indicating people are willing to pay quite a bit more for Coke's products than it costs Coke to produce them.

While Coke has been able to sustain a strong margin for a long period of time, for most companies, attractive margins don't last long. This is because competitors are attracted to industries where profitability is high. To illustrate this, consider the net profit margins of the industries depicted below as they were in 2005:



Notice the high profitability of financial and energy companies. This high profitability in the finance industry is likely one reason that all sorts of new financial products and structures came into being: profits were high, and therefore the industry grew by pushing product proliferation to new heights. In the energy sector, the strong profits depicted above helped spur new oil exploration and new investment in alternative energies. In the past, this has led to increased oil supplies and reductions in the cost of energy, though these changes have taken time. While it remains to be seen if this process will occur once more in the next few years, it remains a distinct possibility. Today, one is likely to see high margins in mining, healthcare and smartphones, to name a few examples, which should drive jobs and innovation in those fields, since high profit margins attract investment.

When analyzing a company, be sure not only to consider its net income, but also the profit margins that contribute to that income. Compare the margins to competitors, and consider whether the company has a "moat" that can protect its margins from the competition. While margins are important, note that they are not the end-all be-all when it comes to profitability, as they don't consider asset utilization. A company able to generate revenue and income on fewer assets is preferable to one that constantly needs capital infusions to grow.

Thursday, October 21, 2010

Looks Good, But How Does It Smell?

The Hallwood Group (HWG) produces fabrics and finishing processes for the textile industry. It trades at a P/E of less than 3, with just $4 million of debt against $10 million of cash. Last quarter, the company generated operating income of $7.5 million, while the company trades for just $55 million! This investment looks too good to be true. But does it pass the smell test?

The company is majority-owned and controlled by its CEO Anthony Gumbiner, which can be a good thing. But the good news ends there. From the 10-Q:

"The Company has entered into a financial consulting contract with Hallwood Investments Limited (“HIL”), a corporation associated with Mr. Anthony J. Gumbiner...The contract provides for HIL to furnish and perform international consulting and advisory services to the Company and its subsidiaries, including strategic planning and merger activities, for annual compensation of $996,000...The contract automatically renews for one-year periods if not terminated by the parties beforehand. Additionally, HIL and Mr. Gumbiner are also eligible for bonuses from the Company or its subsidiaries, subject to approval by the Company’s or its subsidiaries’ board of directors. The Company also reimburses HIL for reasonable expenses in providing office space and administrative services and for travel and related expenses to and from the Company’s corporate office and Brookwood’s facilities and health insurance premiums."

All of these consulting, office, travel and other expenses resulted in shareholders forking out almost $400K last quarter in return for such items as "international consulting services".

In addition, while the company is profitable now, it generated less than $1 million of operating income in 2006. While the growth trajectory is admirable, its sustainability must be called into question, particularly considering the company's level of customer concentration. More than 70% of the company's revenue is derived from military applications. Any time one customer accounts for a majority of revenue, this is a significant risk.

But perhaps the company's most significant risk is its inability to get along with others. The company is facing lawsuit after lawsuit from almost everyone it deals with. A lawsuit is on-going with Nextec, which claims Hallwood's coating process infringes on its patents. Minority shareholders have also filed a motion against the company and its directors for trying to rip minority shareholders off last year. (This is an example of why management control can also be a bad thing, as per the second last paragraph here.) FEI Shale is suing the company for not holding up its end of an investment agreement; FEI is suing for punitive damages of $100 million, which is twice Hallwood's current market cap!

And this is just the tip of the iceberg. Many others, from investors to government departments are suing this company. It has gotten to the point that the company's insurer has cut down on what it is willing to pay for costs relating to officer indemnity and legal fees.

A low P/E is great. But sometimes, the risks to the company are so high that even an extremely low P/E can't make a company's risk reward profile positive. The Hallwood Group may be an example of such a situation.

Disclosure: None

Wednesday, October 20, 2010

Tandy Not Trendy

Tandy Brands (TBAC) markets and sells belts, wallets and other accessories under a variety of brands including its own labels, brands it licenses, and private labels (retailer brands). The company has a book value of $44 million and a net current asset value of $30 million, but it trades for just $22 million.

The company has suffered losses through this recession, as retailers have cut inventory due to the tepid consumer spending environment. But at this price, there are certain elements that make this stock an attractive one.

First, the company is cutting costs to help it return to profits. It has closed distribution facilities, which should not only cut costs going forward, but which also released some of its owned property and equipment. Management believes it can sell these assets for at least $1.6 million, which should serve to increase the company's net current asset value by around that amount.

If the company has cut it costs sufficiently to return to profitability, it also has tax loss carry-forwards that should protect it from Uncle Sam for several years, due to its losses over the last two years. As we've seen before, at current US business tax rates, these can be a huge advantage to a company's valuation.

But all is not rosy with this Ben Graham special, as it does have its fair share of risks. The company sources goods from Asia, which helps reduce costs, but results in long lead times. Compounding this issue, the company does not have contracts with its customers, meaning Tandy is on the hook if retailers reduce purchases. The company notes that it attempts to mitigate this risk by "selling our products to a variety of retail customers throughout North America". But realistically, their customer concentration (which is a serious risk in itself) makes this virtually impossible: Walmart accounts for almost 50% of the company's sales.

Retailer purchase reductions and even bankruptcies have led to inventory and A/R writedowns in the past, as the company was forced to liquidate inventory at low prices and eat the bad debt it extended to its customers. Inventory and A/R continue to represent a significant portion of the company's assets, so the risk of this reoccurring is material.

Finally, the company's CEO has brought in annual compensation that has averaged almost $1 million over the last two years. But he only owns about $120K worth of the company. Anyone in that situation would be more likely to try to grow the company (and in so doing, see an increase in importance and salary) than increase shareholder value.

Sometimes, growing the company and increasing shareholder value are the same thing; but that's not so in a company earning low returns on capital. Shareholders may or may not see stock price appreciation in this potential value play.

Disclosure: None

Tuesday, October 19, 2010

LodgeNet: Out Of Control

Value investors prefer investing in companies that control their own destinies. That way, if things aren't going well, fixes can be implemented to avoid a loss in asset value or earnings power, either by existing management or a new one. When a company faces problems as a result of external factors beyond the company's control, however, there is nothing the investor can do but hope for the best. Needless to say, this is not ideal for the value investor, who prefers to minimize his downside risk.

The most common situation where external factors play a dominant role in a company's success occurs when a firm has a large portion of its revenue or costs based on a commodity product with a volatile price (e.g. oil, gold etc.). Changes in the commodity's price can often be the determining factor between a highly profitable few years and several years of persistent losses. But reliance on a commodity price is far from the only situation where a company's success is strongly influenced by external factors.

Consider LodgeNet Interactive (LNET), provider of interactive connectivity solutions to the hospitality industry (e.g. internet and cable services to hotels for their guests). The company trades for just $60 million, despite generating annual operating cash flows closer to $70 million in each of the last four years.

Despite the company's apparent attractive price relative to its cash flows, its fortunes are tied to those of the economy. This is due to the $400 million of debt the company has outstanding. This debt load is basically a self-induced amplification of the effects that external factors already have on the business.

The company is heavily reliant on hotel occupancy rates, and how much those guests wish to spend on video-on-demand and other services. As previously discussed, travel expenditures are highly sensitive to the economy. Due to the leverage effect of debt, LodgeNet's fortunes are highly sensitive to travel expenditures, which are in turn already highly sensitive to the economy.

Another external factor that affects the company is that it operates in an industry constantly undergoing change. To remain competitive, the company may face capital requirements it did not expect (e.g. with the popularity of High-Definition (HD), the company has to make capital investments to upgrade existing infrastructure). Furthermore, there is a risk that disruptive technologies reduce the demand for the company's services (e.g. the proliferation of mobile devices may reduce the need for the company's broadband offering).

If the economy remains as it is or even gradually improves, LodgeNet could turn out to be a steal at the current price. It generates enough cash flow to pay down its debt obligations despite interest payments that reduce the company's net profits to negative. However, this is nonetheless a risky situation, as the company is reliant on factors out of its control in order to stay afloat. If the economy recedes further and/or disruptive technologies bite into the company's existing revenues, the investor does not appear protected on the downside.

Disclosure: None

Monday, October 18, 2010

Just Give Me The Final Answer!

I have been getting more and more requests for my specific valuations and "buy" prices for particular stocks. Because I have declined to divulge such information, I have received many questions as to why I'm not willing to share such info. As such, I thought it best to share my thoughts on the subject with a post.

First of all, I don't want to get into debates with readers about the calculation of various components that form part of a valuation. Everyone will have their own opinion when it comes to valuation, and that's okay, as the purpose of this blog is not to converge on a single opinion but rather to discuss the relevant issues that can have an impact on a valuation. If I had to spend time discussing/debating/describing each of the various inputs that form part of my valuation, I wouldn't have enough time devote to more productive endeavours.

Furthermore, by sharing my valuation numbers, I am also opening the fund up to competition. Many of the stocks discussed on this site are not liquid, but even for the ones that are, I open the fund up to front-running: if readers are buying/selling ahead of me because they know my valuation, I'm doing a disservice to the fund's shareholders, which is not acceptable.

Also, while it would be nice to be right all the time, I am far from it. As such, I have no interest in opening myself up to future scrutiny for the stocks which just don't work out. The fund is intended to be used to judge performance, not individual securities whose returns can be taken out of context and for which someone may hold me liable.

Finally, one of the major themes of this site is that individual investors should learn how to make their own investment decisions, and not just count on the musings of analysts. If I was displaying my own valuations, I would be subtly encouraging readers to take it and run with it. This doesn't make me much different than the analysts we criticize, or the google ads that appear in the top banner of this page, where advertisers offer "hot penny stocks" and other items designed to acquire your e-mail address. While I'm happy to profit off of them by way of reader clicks (and I thank the reader for those, as they form a significant portion of the site's modest income), I don't aspire to become them.

Happy investing!

Sunday, October 17, 2010

Buffett Partnership Letters: 1959 - 1960

Berkshire Hathaway's letters to shareholders are oft-quoted and Berkshire's annual shareholder meeting is well-followed, as value investors try to glean the wisdom of the world's greatest investor. But before he ran Berkshire, Warren Buffett was far less followed and ran his partnership with a sum of money much smaller than he employs today. The issues he faced then are probably far more relevant to the individual investor today than are Berkshire's current challenges. The following series attempts to summarize the key takeaways from Buffett's partnership letters.

No Need to Forecast the Market

Buffett describes the market in the late 1950's as exuberant, as "investors" believe they can make easy money in the market. He does not know how long these speculators will be able to add to their numbers and keep prices moving higher, but he stresses that he does not attempt to forecast the market.

Illiquid Investments Not A Problem

Buffett notes that during bull markets, he would be satisfied just to match the performance of the general market. However, during bear markets he believes it is likely his fund will outperform. This is because he owns a lot of securities that don't move with the general market, including tiny companies that are owned by few people and don't trade often.

Willing to Sell Cheap To Buy Even Cheaper

Buffett describes one particular large investment his fund sold out of in the previous year. Buffett purchased a bank stock for around $50/share that he believed was worth $125/share. (It had earnings of $10/share.) Because he was so confident in his estimates, he wanted the stock price to remain low so that he could continue to purchase shares at a low price. He ended up selling out at $80, which is still undervalued in his estimation, in order to take advantage of an even more compelling situation.

Willingness To Bet Big

Buffett was willing to invest 35% of the partnership's assets in the new situation!

Influence Counts

Buffett did not consider this investment more undervalued than some of his other securities. However, becoming the largest shareholder of this stock, which comprised of investments worth substantially more than the stock price, has benefits that he hoped would help realize large profits in the following year.

Saturday, October 16, 2010

The Making Of A Market Guru: 2008 - 2009

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.

Ken's early comments of 2008 continue to expound his bullish stance. He argued that there is no credit crunch, because even though small firms may not be increasing debt levels and buying back shares, large companies are still making such announcements. He believed the stock market correction (at this point, it was still just a "correction") was offering investors an opportunity to buy large caps at great prices.

As the year dragged on and market losses started to increase, Fisher admitted that he had erred. Nevertheless, he remained bullish, arguing that pessimism is so strong (using a few examples of how bad news is emphasized while good news is ignored) that the market is unlikely to sustain or increase its losses.

As the market sustained and increased its losses, Fisher made the argument that lower prices make stocks less risky, not more risky (as is commonly believed). He continued to advocate that readers jump into stocks at fire-sale prices, as sharply falling markets tend to be followed by equally sharply rising markets.

Finally, the market started to rebound big in 2009, and Fisher argued that this trend is likely to continue as the global economy recovers. In his final column in the book (December 2009), Fisher remains optimistic for both stocks and the economic recovery.

Friday, October 15, 2010

The Info's Getting Worse

When Ben Graham was researching stocks, it wasn't easy to get information. Companies did not have to disclose the kind of info we take for granted today, and 3rd party analysis that was independent was hard to come by (okay, maybe that one's still a problem). Investors would have to send for snail-mail financial reports, and/or visit libraries to manually access printed data that was several weeks or months old. Today, all that info and then some is available to investors at the click of a button. But the challenge to investors has merely transformed from one of data availability to that of data filtration. With the plethora of information available, investors must determine how to identify sources of relevant information without getting bogged down by the irrelevant. That is getting more difficult!

One example illustrating this issue is the easy-to-use Google Finance, which is a powerful tool for investors despite some of its inadequacies. Whereas Google Finance used to contain useful, recent articles about individual stocks on the right-hand side of its individual stock pages, it now appears to mostly contain a large dearth of automated articles describing trends, MAC-D's, and moving averages leaving no room for articles that actually the discuss a company's business situation.

For example, articles from "Comtex SmartTrend" keep popping up on individual stock pages, discussing stock price trends, whereas articles discussing the company's prospects are nowhere to be found! As another example, consider this possibly automated article on Nu Horizons, which last month agreed to be bought out at $7/share (and therefore trades at $6.96 today). The article discusses Nu Horizons' upcoming earnings and how it might impact the share price, completely oblivious to the buyout and the fact that the share price is tied to the buyout price.

What used to be a good source of relevant information for value investors has turned into a far less useful resource. Are readers experiencing the same problem? How do you find relevant, value-oriented information about the stocks you follow? I have found following a bunch of value investors on twitter to be very useful in increasing the amount of relevant information I come across. What methods do you use?

Thursday, October 14, 2010

Betting On Bubbles

Investors with huge amounts of assets under management (e.g. pension funds, sovereign wealth funds etc.) are buying US government debt at an astonishing rate. As a result, the annual return one can expect on a US 10-year Treasury is around 2.5%! Keeping in mind that the US central bank attempts to keep inflation between 1% and 3%, the level of this fairly long-term issue appears rather unsustainable. Consider the yield of this bond over the last several decades:



As a result, some are saying Treasuries are in a price bubble. If one believes economic growth will return to normal, Treasury yields are likely to increase substantially in the coming years. If, on the other hand, one believes that it's different this time, and that deflation will take hold over the long-term despite all the stimulus, then maybe these yields make sense or could fall even lower.

A few years ago, there was nothing the small investor could have done to participate in what he may perceive to be a yield anomaly such as this one. Treasuries are traded with amounts starting in the hundreds of millions or billions of dollars. With the proliferation of ETFs, however, retail investors are offered the opportunity to bet against what appears to be a bubble.

One such ETF has ticker PST and seeks to profit from rising treasury yields. For every daily 1% price drop in an index of 7 to 10-yr Treasuries, PST attempts to return a positive 2% to investors. Because of this daily rebalancing (which we first discussed with an inverse Gold ETF), the security's value is unlikely to go to zero, allowing investors the opportunity to absorb short-term volatility.

In return for this protection from complete capital erosion, however, the investor is giving up some potential gains. (e.g. if the security is down 2% one day, and then up 2% the next day, the price level will now be lower than where it started, as less capital was at risk during the 2nd day).

There are two commonly cited bubbles in today's markets: gold and treasuries. Incidentally, they seem to contradict each other in their predictions. The price of gold would suggest high inflation is on the way, while the price of treasuries would suggest deflation is a more serious threat. As a result, those who bet that both are bubbles may be hedged to some extent. If inflation does get out of control, treasury yields will go higher and PST is likely to benefit. If deflation occurs, shorting gold may turn out to be a winning bet.

While contrarian investors may find one or both of these bubble bets compelling, strict value investors may prefer to stick to investing in individual companies that are undervalued. The option belongs to the investor!

Disclosure: None

Wednesday, October 13, 2010

Trans World Entertainment

Would you want an interest in a retailer that sells music CDs? Neither would I. But what if the price of that retailer is just a fraction of the company's inventory? Mr. Market is still not interested, which is why you might be.

Trans World Entertainment (TWMC) trades for $60 million but has inventory of $237 million. Even if you subtract all of the company's liabilities from its inventory, the retailer still trades for much less than this conservative valuation.

We've actually discussed this company last year, but found it risky because of the large operating lease obligations it had. But the company has done well to cut costs through this rough period.

First, it has let a great many leases expire, shutting down hundreds of unprofitable locations. Operating lease obligations have fallen from $220 million a couple of years ago to around $130 million today.

The company has also focused on its more profitable lines, as it dramatically cut sales of video game products, and has increased its share in DVD and Blu-Ray devices. Efficiency has also been improved, as inventory per square foot is coming down, and new, more profitable pricing schemes are being rolled out after successful runs in test stores.

Unfortunately, the company continues to lose money, as the company suffers from both cyclical (the economy) and secular (electronic sales of music) problems. As such, while it may trade at a discount to assets, those assets are being eroded. But for a retailer such as this one, the Christmas quarter is the most important. For this company, that's also the quarter where almost half of the store's locations appear to be at the end of their lease. As a result, this company bears watching over the next few months, as it will have an opportunity to generate cash and cut expenses, which could strengthen its case as a potential value investment.

Disclosure: None

Tuesday, October 12, 2010

Reprographers Rejoice

American Reprographics Company (ARP) provides document-management services primarily to the architectural, engineering and construction (AEC) industries. Since those are cyclical industries, demand for ARP's services has taken a beating, but not as much as the company's stock price. The company trades for $300 million, but has generated operating cash flow superior to that over the last four years, and expects to generate at least $65 million in cash flow this year as well.

The company's earnings picture is not so pretty, however, as it has taken large charges as a result of both Goodwill writedowns and annual intangible amortization. But these are non-cash charges, so while they make the company's P/E look high and/or negative, they are for items the company has already paid for, i.e. they do not affect current cash flow.

These "items the company has already paid for" are other firms ARP has acquired. ARP's strategy is to grow by acquisition and benefit from economies of scale that such a market share advantage allows (including spreading out R&D costs over more customers, lowering equipment purchase prices etc). The company is doing well in that regard, as it has approximately nine times as many locations as its nearest competitor.

But despite the fact that the company is profitable in a trough-revenue environment and trades cheaply relative to its cash flow, there are some risks facing potential investors of this stock. First, the company financed its acquisition growth using debt. While the company's strong cash flow has allowed it to reduce its total debt by almost $75 million in the last five quarters, it still has a net debt position (including operating leases) of around $300 million. Much of that debt is due in just over 2 years. As a result, if things turn south for the economy or the company, it does not have a lot of financial leeway. On the other hand, management has stated that if revenues do drop further, it does have the ability to reduce expenses by closing the least profitable of its almost 300 locations.

In general, the company hasn't made great decisions with respect to capital allocation. It did a stock buyback in 2007 when the share price was much higher, and now has to focus on debt repayment when the stock price is much lower. Furthermore, it ratcheted up its Goodwill balance during the boom years by buying high (resulting in recent writedowns), and now lacks the gumption to make acquisitions while target companies likely sit at much more attractive prices.

As a result, the company's tangible assets are actually negative! Therefore, one really has to believe in the earnings power of this company before one invests. That requires understanding this industry, including the technological risks that are both threats and opportunities for this company. (Technological advances are making it cheaper to print higher quality documents, for example. This could increase volumes for the company, but could also be a disruptive force in the industry if the company is not on the ball.)

Management incentives do seem aligned with shareholders, as the CEO effectively owns 17% of the company's shares, dwarfing his salary (which is a good thing). Many executives also took temporary pay cuts over the last two years as part of the company's cost reduction plan. At the same time, however, it should be noted that the company did exchange a bunch of options with exercise prices averaging $24.50 for options with exercise prices of just $8 during April of 2009, when the stock market was in rough shape. This reeks of an employee cash grab, but was fully expensed, and considering the CEO's ownership position and subsequent pay cut, may have been an important incentive offering on his part to retain key employees through the downturn.

Finally, it is worth noting that the company is managing to increase market share despite the drop in revenue. This is because of new initiatives ARP has been pushing, including expanding in markets outside of AEC by taking advantage of technological advances that are lowering colour printing costs. The company is also growing (albeit from a small base) in its Chinese operations, and has been successful in a new initiative where it offers services at the customer's own location. As such, management is confident that the company is well-positioned to grow revenues once the AEC market returns to normal.

When tangible book value is low (or in this case, non-existent), investors cannot rely on a margin of safety in the form of assets. Only if the company falls within the investor's circle of competence can he properly evaluate whether the company's earnings power does in fact offer that margin of safety. If earnings in the future are as they were in the past, this company is a strong candidate for a value investment.

Disclosure: None

Monday, October 11, 2010

Advanced America's Operating Cash Flow

Last week we discussed a potentially undervalued company in Advance America (AEA). For the purpose of illustrating how cheap the company is relative to its price, it was noted that the company earned $200 million in the last four years. But a reader pointed out that cash flow is even better, as the company has brought in $350 million in just the last two years. There is clearly a large difference between the company's earnings and its operating cash flow. So which metric is the one that investors should use to estimate the firm's potential?

Sometimes operating cash flow is more useful in determining a company's potential, and sometimes net income is more useful. When there is a large difference between the two, the investor must examine the elements of each statement and apply his business sense to determine which one (or combination thereof) describes the firm's future cash flows better. We recently looked at a company where operating cash flows were potentially more useful than net income due to the company's amortizing intangible assets.

With Advance America, the major difference between net income and the company's cash flow is a provision for bad debt expense of around $130 million every year. Advance America makes loans to people who aren't the most credit-worthy. As a result, a large chunk of their loans get written off ever year, of an amount that the company has become pretty good at predicting. However, because this provision is a non-cash expense, it gets added to net income to form part of the company's operating cash flow. But these bad debts are real, and get charged off every year; they just don't form part of "operating cash flows" as the company defines them. Ignoring this very real cost is a mistake that could result in a major overestimation of this company's earnings potential.

Investors must avoid an over-reliance on any one of the company's financial statements. Instead, they should be used together to form a descriptive picture of a company's operating situation. Only then can the investor understand what is going on inside the business, which puts him in a better position to determine the business' intrinsic value.

Sunday, October 10, 2010

The Making Of A Market Guru: 2006 - 2007

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.

As the bull market continued through these years (having begun in 2003), Fisher continues to remain bullish. His primary arguments are that sentiment is still not prevalently bullish, and that yields on bonds remain lower than yields on stocks. Ten-year bonds yielded about 5% at the time, while market earnings over price (the inverse of the P/E ratio) yielded about 6.5%. Fisher argued that this would result in more M&A and more buybacks, since the cost of funds was lower than the return on their investment.

Fisher also made the call in 2007 that housing is not in a bubble. He believed the market pessimism surrounding sub-prime was overblown and would be over shortly, and took all the pessimism as a bullish signal. He cited the fact that housing stocks were out-performing as a sign that the fears that there is a bubble in housing have no basis! In September of 2007 he writes "a few months from now, we'll be wondering what all the fuss was about".

In his final column of 2007, Fisher disagrees with those who say that after strong returns of the last few years, the market is ripe for a correction. Fisher writes "I want to be the first to say we definitely are in a New Era of above-average returns." He doesn't believe the end of the bull market can happen without extreme positive sentiment. Finally, he rifles off a few factors that he doesn't fear heading into 2008, including further collapses in the mortgage market and a credit crunch.

Fisher made a lot of correct calls over the years, but he was clearly off during this period, and not just by a little bit.

Saturday, October 9, 2010

The Making Of A Market Guru: 2004 - 2005

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.

As the economy recovered slowly from the recession that followed the bursting of the tech bubble, many observers were bearish on the US because of its deficits, both fiscal (government) and trade. But Fisher takes the opposite view: that America should be borrowing even more. Based on the country's aggregate income over its equity (the country's assets minus its debt), the company is earning far more than the cost of borrowing. As long as this is the case, Fisher argues that America should continue to borrow and invest in assets that continue to generate returns for its citizens.

Ken also takes issue with those who argue that stock returns over the next decade are destined to be flat. Those who make that suggestion show you that they don't know a lot about what drives security prices: supply and demand. Over the short-term, security supply is fairly inelastic, as new securities take time to be issued. As such, the market's daily movements are due mostly to demand factors. But over long periods of time, companies can choose to IPO or list more shares based on prevailing market prices. Fisher does not believe one can predict what will happen to the supply of securities 5 to 10 years out to be able to make a prediction about security prices a decade away.

In his July 2005 column, Fisher also predicts that the housing market is not in a bubble. He argues that interest rates are low, justifying the increased activity and prices in housing. Furthermore, he argues that because there is so much fear about a bubble, that we couldn't be in one. It will be interesting to see whether his position changes in the next two years...

Friday, October 8, 2010

Karsan Value Funds: 2010 Q3 Results

Karsan Value Funds (KVF) is a value-oriented fund, as described here. Due to securities regulations, the fund is not open to the public at this time. Should that change in the future, there will be an announcement on this site.

For the third quarter ended September 30th, 2010, KVF earned $0.74 per share, bringing the value of each share to $12.50.

There were three main reasons for the fund's strong performance this quarter:

1) The market in general was up, and a rising tide lifts (almost) all boats
2) The fund benefited from its position in Blonder Tongue Labs (BDR). More details on this are available here.
3) The fund benefited from its position in Nu Horizons (NUHC). More details on this are available here.

The news was not all positive, however, as some of the fund's positions decreased in price. In many cases, this was seen as an opportunity to increase fund positions at what are believed to be even more attractive prices. Hopefully, these investments lay the groundwork for strong returns in future periods.

Another negative for returns this quarter was the currency exchange rate between Canada and the US. Had the USD/CAD exchange rate finished the quarter at the same level at which it started the quarter, earnings would have been $0.23 higher than they were. Currency volatility is likely to continue to have a significant bearing on short-term, quarterly results. However, over the long-term, currency volatility is not expected to be a material factor in the fund's overall performance. For this reason, the fund employs no hedging positions despite the short-term volatility that has been and likely will continue to be experienced by the fund.

KVF's income statement and balance sheet are included below. Note that securities are marked to market value, and amounts are in $CAD:

Thursday, October 7, 2010

Independent Opinions Are Key

Almost exactly two years ago, Washington Mutual basically declared bankruptcy, resulting in shareholders losing pretty much their entire investments. A day before the bank went down, here's what analyst recommendations looked like:


Though it makes little sense that there were so many "hold" recommendations, at least a good number of analysts rated it a "sell". This represents an improvement over analyst recommendations for Lehman Brothers as it went down.

There are a couple of interesting notes, however. Goldman Sachs upgraded WaMu about 2 weeks before it went down. "Capital and reserves appear to be stable," wrote analyst Brian Foran.

Fox Pitt, a firm that "provides clients with equity research and capital markets expertise", actually had this rated "Outperform" as it went down, according to Yahoo! Finance.

The bottom line? When you invest, know what you're buying; the "experts" have their own agendas.

Wednesday, October 6, 2010

Abatix Corp

Finding companies trading at discounts to their net current assets is not as easy as it was last year. However, such companies do exist. For example, Abatix Corp (ABIX), distributor of safety equipment and tools, trades for $10 million despite net current assets of $15 million. Furthermore, the company is profitable, having earned $400K and $500K in the first 3 months and first 6 months of this year, respectively.

What's unfortunate, however, is that management does not communicate with shareholders - at all. When the company publishes its quarterly financial statements, it offers no discussion, no outlook and no conference call. Basically, shareholders have no way of knowing what's on management's mind. Under these circumstances, it's hard to believe anyone can understand this business enough to warrant a purchase.

For example, while the company's sales are up year-over-year, the company's inventory and receivable balances are up a disproportionate amount. This could occur for many reasons, including any combination of the following:

- the company sees an opportunity for expansion
- the company is offering more favourable terms to encourage customer purchases
- sales were lower than anticipated
- some customers are in financial trouble
- simple timing issues related to quarter-end dates

But since management doesn't offer any colour on the above issue (or any other), shareholders are left to make guesses as to the challenges currently facing the company. Unfortunately, a guessing shareholder is not one who is likely to be able to protect his downside risk with any certainty.

The company is able to legally get away with avoiding disclosures of this nature because it de-listed from the Nasdaq in 2007, and thus is not bound by its previous reporting requirements. It now trades on the pink sheets, which contain companies of varying quality. Investors are warned to avoid such companies unless they fully understand the risks. Investor protections for exchange-listed companies are there for a reason!

Disclosure: None

Tuesday, October 5, 2010

Sell While You Can

Investors in undervalued small-cap companies are occasionally offered significant premiums to their share prices by potential acquirers. The most recent example discussed on this site is that of Nu Horizons. When such an offer occurs, the investor may be tempted to wait for a better offer or wait for the share price to converge with the offer price. This is likely to be a mistake.

As an example, consider GTSI Corp (GTSI), a provider of IT solutions to government customers. It had looked undervalued for a number of months, but was never discussed on this site because of its reliance on a single customer. (Having only a few customers is a source of revenue risk.) Nevertheless, because of the extremely low stock price, some value investors may have considered the risk-reward to be compelling.

These investors were rewarded last month when an offer to buy GTSI was revealed, sending share prices 40% higher. Unless one is a merger arbitrage expert, this was the opportune time to exit for the value investor. But for those who held out for a higher offer price, the news would not be good.

On Friday, the customer on which GTSI is reliant announced that GTSI would be suspended from new business due to violations in how it has performed work in the past. Since this source represents around 75% of GTSI's revenues, this is a major blow to the company's future earnings if it is not quickly rectified. The offer to purchase the company was withdrawn, and GTSI's shares subsequently fell below its pre-offer level.

If the investor is an arbitrage expert and can understand the downside risk versus the upside return of such investments, perhaps remaining in post-offer GTSI shares made sense. For the vast majority of owners of GTSI, however, there was no need to stay in such a risky company (due to its revenue risk as a result of its customer concentration) once the price point was no longer compelling.

The investor should allocate his capital in a manner consistent with his investing strategy. If putting large amounts of capital at risk (which is what a decision not to sell amounts to) for a 5% - 10% gain is not consistent with the investor's strategy, holding on for an arbitrage gain is probably a mistake. A good rule of thumb for the investor is to consider whether he would buy into such an arbitrage situation, or whether he is simply staying in because he already owns the stock. If the latter, the investor is likely better off putting the appreciated capital to work on his next undervalued idea.

Disclosure: None

Monday, October 4, 2010

Secular Or Cyclical?

When a company's current earnings are low or negative, and the near-term industry outlook is negative or uncertain, Mr. Market will generally pummel the stock. But when said company has the ability to outlast a downturn, this pummeling of the stock price can result in a great opportunity for the long-term oriented, value investor. One stock currently being beaten down due to its earnings situation and near-term outlook is Baldwin Technologies (BLD).

Baldwin produces equipment for the newsprint industry. The preceding statement implies a double whammy of explanations for why the company's current earnings are low to negative:

1) Companies cut back on capital equipment during recessions, hence Baldwin's revenues will have taken a hit as newspaper companies cut large-scale expenditures

2) As a maker of capital equipment, Baldwin likely has a number of fixed costs that cannot be easily reduced when revenues fall

However, cyclical stocks present opportunities as sentiment often becomes far too negative. After all, this is a company whose stock trades for just $19 million, but which earned exactly that amount (combined) in the three years prior to this recession! Furthermore, the company has the ability to outlast this recession (i.e. its debt levels are not onerous), which is of the utmost importance for cyclical companies.

However, this company is not without risks. For one thing, there is a third "whammy" not listed above: the newspaper industry is in secular decline. As such, some of the decline in revenue may not simply be cyclical dips that will eventually return, but rather a secular or permanent dip. Determining the terminal value of a company in secular decline is not easy, and adds to the investment's risk.

Furthermore, this company has a number of non-cancelable operating lease obligations it must make good on, further reducing its flexibility should the secular declines arrive with more ferocity than expected.

Trading at a large discount to its pre-recession earnings, Baldwin has the potential to be a value investment. However, investors should be sure to understand this company's risks before taking the plunge.

Disclosure: None

Sunday, October 3, 2010

The Making Of A Market Guru: 2002 - 2003

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.

One theme Fisher often repeats throughout the book is that US markets often rise in the third and fourth years of the US Presidency. As reader skepticism about this indicator is abound (many readers compare this indicator to the Superbowl indicator in that it may have worked historically, but that there is no cause and effect tying the two), Fisher sets out to defend the cause and effect relationship at work here.

Fisher re-iterates that the current market P/E is useless on its own in predicting the future direction of stock prices. While most experts argue that a low P/E is bullish for stocks, Fisher's research indicates that in reality stocks can go either way whether the P/E is high or low. The reason is that high P/E's are often the case when earnings are temporarily depressed (i.e. in a recession, when writedowns lower earnings temporarily).

As the years 2002 and 2003 were particularly volatile as the US emerged from recession, Fisher spends a lot of time guessing the direction of the market. He was mostly right in his calls, which, as discussed earlier in the book, are mostly based on investor sentiment. When sentiment is positive (negative), this sentiment is built into stock prices, so Fisher goes negative (positive).

Saturday, October 2, 2010

The Making Of A Market Guru: 2000 - 2001

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.

As the tech bubble continued to heat up through early 2000, Fisher declares that tech stocks are in a bubble and that investors should reduce their exposure to this space. Fisher arrived at his conclusion by comparing the tech sector as it stood in 2000 to oil stocks of 1981. Across a range of benchmarks (IPO percentage, sector weight in the overall market, price to book values) tech stocks looked a lot like oil stocks of 1981, which collapsed shortly afterward.

Fisher argued that the bubble would burst when some of the less useful companies (dot-coms without earnings) would run out of cash. By his calculation, some 140 companies were on schedule to run out of cash in the next 12 months. These companies would need cash infusions, which would cause investors to start exiting companies at risk of needing more cash. Fisher notes that his column describing the tech bubble received the most hate-mail of any column he has previously written, which only served to confirm his view, as sentiment on this sector was far too positive.

As the bubble burst and readers looked to Fisher for direction in the ensuing year, Fisher maintained that he was bearish due to market sentiment. Too many forecasters were predicting a mild recession and were bullish on the market, expecting it to rise towards pre-recession levels. Fisher notes that this is not the kind of sentiment that occurs at market bottoms. At the bottom, there is no M&A (unlike in 2001, where HP bought COMPAQ in a massive deal, to use one example), and forecasters are predicting a glum future, where headlines discussing a potential depression and declaring that it's the end for stocks are rampant.

Friday, October 1, 2010

Discount To Artifacts

When a company trades at a discount to its cash/receivables/inventory/real-estate etc., it piques the interest of the value investor. But what about when a company trades at a discount to the artifacts it owns? Premier Exhibitions (PRXI) was just awarded the rights to various items it has recovered over the years from the famous Titanic wreckage. When the court rendered its decision last month that the artifacts do indeed belong to Premier, the company's stock price increased by some 40%. But the stock price of this small-cap may not have increased as much as it should have.

The court placed a conservative estimate of the value of the artifacts at $110 million. In addition, Premier already owns artifacts from the vessel valued at approximately $35 million. Yet the company trades for just $85 million, despite the fact that the company has no debt and only $13 million of liabilities.

As such, it trades at a discount to its net assets. But will investors benefit from these assets in a timely enough manner to make an investment in the company worth it? The answer is far from a sure thing. There are several risks which may prevent the investor from seeing the cash value of the company's net assets.

First, the company as it currently stands appears more interested in exhibiting the artifacts for display than selling them for their court-assessed liquidation value. The court may decide to award the cash to the company, but the company has taken steps designed to encourage the court to simply give the company title to the assets, rather than cash. Furthermore, the company intends to invest some $10 million this year in capital expenditures (depreciation is only about half of that) to revitalize its business.

But the company's exhibition of these (and other) artifacts has not been profitable since 2007. Even though the company had already been displaying the artifacts for which it was just granted ownership, it has been losing a few million dollars every quarter (Some of that was restructuring and downsizing charges, however.) Previous management has been replaced, and new management appears on the right track, but whether the company can get a return on these assets that is satisfactory is far from a foregone conclusion. (It should be noted that at least a couple of value investors do believe in this turnaround, however. Their well-written write-ups are available here and here.)

Finally, the company's ownership situation is in doubt. The company's largest shareholder (owning 46% of the company) has been forced to sell his shares (for reasons unrelated to the company). He currently seeks a private buyer, but nothing prevents him from liquidating his shares on the open market should an adequate price not be found. On the other hand, this sale could be the catalyst that allows shareholders to realize the value of this company's assets. In advance, it's difficult to determine whether this forced sale will turn out to be a positive or negative for remaining shareholders.

A company trading at a discount to its realizable assets is what value investors are constantly seeking. But if the company has no interest in monetizing these assets in the near future, shareholders are incurring more risk than they would otherwise have to. This company appears to be trying to monetize these assets over the long-term, by running a profitable, global exhibition company. Shareholders will have to reach their own conclusions as to whether or not this endevour is likely to be successful.

Disclosure: None

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