Monday, January 31, 2011

PE10 Weaknesses Continued

The PE10 is a useful ratio that aids the investor in determining the relative price level of the aggregate stock market. But as discussed on this site last week, the metric is far from perfect, as the arbitrary use of a 10-year period can bump up or push down the measurement for normalized earnings, thereby biasing the ratio. Another major weakness of the PE10 as tool for making historical comparisons has to do with a change in how corporations have returned money to shareholders.

It used to be that dividends were the main method by which corporations paid shareholders. But for various reasons, buybacks appear to have become the preferred choice for corporations looking to return cash to shareholders.

As it pertains to current year earnings, whether corporations doled out returns in dividends or buybacks in the past makes little difference. But because of the way Standard and Poor's records the earnings of the index (using the sum of bottom-up earnings per share), this can have a major effect on past years' earnings.

For example, if the index earned $1 in EPS in 2001, and since then companies have bought back 50% of their outstanding shares, the real "earnings power" represented by that $1 is actually $2.

This concept is perhaps easier to grasp with respect to individual companies. Consider GameStop's quarterly earnings, which show just over $50 million in after-tax earnings in the third quarter of both this year and last year. While the absolute earnings are roughly similar for both years, GameStop has seen more than 15% growth in year-over-year diluted earnings per share as a result of share buybacks. Which number do you think is more relevant, GameStop's EPS pre-buyback, or the fact that it earned just over $50 million in both years? I would argue that the latter is more relevant, and that the former can bias the earnings estimate lower.

Considering the fervor with which companies bought back shares this past decade, this difference can have a significant impact on the estimate of the index's normalized earnings level. Unfortunately, it's difficult to quickly adjust the formula to correct for this problem. The level of share buybacks is inconsistent from year to year, and shares have been repurchased at various prices, ranging from extremely high to extremely low.

Related to this problem is fact that the size of the capital stock has changed. As companies have re-invested the earnings that they have not paid out in dividends or used to buy back shares, they now have larger capital bases from which to earn profits.

Fortunately, there are other methods that can be used that are in keeping with the spirit of the PE10, without suffering from these drawbacks. For example, one could average the index's ROE over the last ten years, and multiply that number by the index's current book value in order to arrive at an estimate for normalized earnings. My rough calculations with imperfect data suggest a PE10 of around 19, and a PE8 (see here for why a PE8 might be more relevant right now than a PE10) of around 18.

Of course, this method still suffers several drawbacks. The biggest problem with using ROE, for example, is that it doesn't correct for different levels of leverage. Higher debt can result in higher ROE, but that doesn't mean these higher levels are sustainable.

Fortunately for value investors, we don't have to spend a lot of time valuing the market. Knowing that it is approximately fully-valued or somewhat overvalued is good to know in general, but our money is made with individual stocks. Figuring out how to make money on the index is a lot harder than it is with individual stocks, since with individual stocks you only have to swing at the most attractive pitches.

Sunday, January 30, 2011

Irrational Exuberance: Chapter 4

In the year 2000, while many market pundits expected the market to rise continuously upward, Robert Shiller warned about the stock market bubble, though not that many paid attention. While most were blinded by optimism, Shiller demonstrated using fundamental analysis that the market would generate poor returns for years to come. Learning from and understanding Shiller's rational approach to market valuation is likely to aid the investor in avoiding falling prey to the bubbles of the present and future.

The media's role in the creation of the hi-tech stock bubble of the year 2000 is discussed in this chapter. Shiller points out that the history of speculative bubbles begins roughly with the advent of newspapers! While the media present themselves as detached observers of the stories they cover, they are a major player in these events.

Shiller argues that bubbles can only occur if there is similar thinking among large groups of people. The media helps make this happen. With everyone on the same page, markets are free to rise and/or fall by large amounts.

Shiller also takes issue with some of the media's explanations for market occurrences. For example, on a given day the financial media always has an explanation ready for why the market fell or rose. But Shiller presents data that suggests these after-the-fact links are fallacious. He argues that when there is a big market event, though the media will emphasize some news item it has picked to be the cause of the event, it is actually the price change itself that is the news. Shiller takes the reader through news items preceding the 1929 and 1987 crashes, demonstrating that nothing out-of-the-ordinary was occurring in the news, though the media did attribute the causes of the crash to various current events of the time.

Saturday, January 29, 2011

Irrational Exuberance: Chapter 3

In the year 2000, while many market pundits expected the market to rise continuously upward, Robert Shiller warned about the stock market bubble, though not that many paid attention. While most were blinded by optimism, Shiller demonstrated using fundamental analysis that the market would generate poor returns for years to come. Learning from and understanding Shiller's rational approach to market valuation is likely to aid the investor in avoiding falling prey to the bubbles of the present and future.

In this chapter, Shiller discusses the amplification mechanisms involving investor confidence and expectations that he believes are contributing in a major way to the speculative stock bubble of the year 2000. He argues that these amplification mechanisms work through a positive feedback loop, reinforcing each other until what he predicts will be a stock price collapse.

First, Shiller establishes through survey evidence that investor confidence has indeed increased in the late 1990's as compared to other periods. For example, groups of investors expected higher stock returns in the future than similar groups had in the past.

He then discusses why this may have happened, suggesting that regret (from not participating in the recent gains), a tendency to extrapolate short-term results into the long-term, the recounting of stories of those who have made riches in the market, and a tendency to ignore inflation (and therefore think of nominal stock returns only, which have been much higher than real returns over time) are leading to investor confidence that is currently higher than it should be.

Currently (at the time of writing, in the year 2000), Shiller argues that as prices continue to rise, investor confidence and expectations are going through a feedback loop. Higher stock prices are leading to higher expectations which are leading to higher prices. Shiller calls this process a naturally occuring Ponzi scheme: investors are presented with a plausible story about how great profits will be made (the reasons discussed in Chapter 2), they start by investing small, and as their returns rise, they become willing to invest more and more money. The payoffs to the investors come entirely from new money that is entering the market! A fraudulent manager isn't even required for this natural Ponzi scheme to grow wildly.

Friday, January 28, 2011

Chatting Messenger

Back by popular demand is a segment where Frank (author of value site frankvoisin.com) and I discuss a few news stories that caught our interest. Please provide your feedback; should this be a monthly segment, or would you prefer a discussion of a boring value stock in its stead?

Frank: State budgets are still in rough shape following the recession.
Saj: Obviously, states have to reduce their deficits by cutting spending and/or raising taxes.
Frank: Or, they can just steal from their citizens:
New Jersey lawmakers voted to allow the state to seize any gift cards that remained unused two years after their purchase.
Saj: That seems pretty fair. If you don't use something for 2 years, it really should belong to "the people".
Frank: Yeah, it can't be government spending that's causing the deficit problem, this is the fault of those patient people who don't immediately use up their entire gift card balances!
Saj: Why stop at gift cards? I have a savings account I haven't spent in a while...maybe that belongs in government coffers too!
Frank: Of course it does, along with that bike you're storing in the garage, and Grandma's jewelry set.
Saj: Oh well, at least they're giving us fair warning. From now on, I'll use my gift cards ASAP.
Frank: Actually, it's too late:
A key element of the legislation was that it would be retroactive, allowing the Treasury to seize money from travelers checks as far back as 1994.
Saj: Wow


Frank: Speaking of overzealous governments, it looks like China is looking at ways to ban Skype:
The Chinese move appeared to be aimed at protecting three government-controlled phone carriers -- China Telecom, China Unicom and China Mobile -- that provide the bulk of China's telephone services.
Saj: "Er, yeah we realize the average income of a Chinese citizen is $7500, but we're trying to run a business-I mean government here."
Frank: Besides, the average citizen has enough on his plate what with food inflation. He shouldn't be burdened with all these tough decisions that free markets provide!
Skype...has been growing in popularity among Chinese users and businesses to make cheap or free international phone calls over the Internet.
Saj: "Well sure, you can make those calls for cheaper...but calls through us are of higher quality! That's what you really want!"
Frank: If you'd like to experience the restrictions of communist rule without having to actually live under such a regime, try this board game.

Disclosure: Chatters have an ownership position in a couple of gift cards.

Thursday, January 27, 2011

Volt: The Business Looks Good, The Accounting Doesn't

Volt Information Sciences (VOL) provides staffing and other business services. It trades for $132 million, but has net current assets (current assets less total liabilities) of $200 million according to its latest full set of financial results. The problem is that these financials are more than a year old!

The company announced that it is undergoing an accounting review, and therefore it has had to miss some deadlines with respect to its financial reporting. However, it has provided some information to investors, even though it cannot provide all of it. For example, the company estimated its revenues by segment for 2010, and reports strong revenue growth and stable gross margins in its staffing business from 2009. It also reports progress towards closing down its money-losing telecommunications services segment.

But while business appears to be headed in the right direction, the accounting issues could result in poor results for investors. First and most obvious, it is not known what the effect of the accounting restatements will be. While the company did just recently report the size of its cash balance, it is not known whether other asset or liability accounts will change for the worse.

Second, this accounting review has directly cost the company a rather large amount of money. The company has had to spend an extra $22 million in 2010 to get its accounting right, and it's still not done! For some companies, this wouldn't get noticed. But when the company only trades for $130 million, this is a rather sizable amount that cuts into the investor's margin of safety.

Finally, the NYSE is tired of waiting for the financials. The exchange stated that it will commence de-listing procedures if the company does not meet the latest deadline. Volt does not anticipate being able to meet this deadline; therefore, investors buying the stock now could find themselves dealing with an over-the-counter stock very soon! This could actually present an opportunity for investors in the future, as the company has stated that it will continue to file with the SEC and plans to re-list on the exchange once its accounting house is in order.

If the price falls after de-listing, investors may want to think about getting in at a much more favourable price. Until then, the upside may not justify the risks.

Wednesday, January 26, 2011

Non-Buy Follow-Ups

Some time after you've purchased a stock, you probably have a pretty good idea as to whether you made a good decision or not. This is because you likely follow the stocks you have purchased fairly closely. This feedback mechanism allows you to fine-tune your stock purchase criteria so that you don't make the same mistakes again. But often, some of the best lessons to be learned come from the stocks you didn't buy, but considered buying!

Unfortunately, investors often forget about these stocks. These stocks don't make it onto their "follow" lists or spreadsheets, and have zero mind-share. As a result, they may never know if their thesis was correct. Not utilizing this potential feedback mechanism for a large number of stocks can prevent one from becoming a better investor.

Consider cataloging the stocks you were close to buying, but didn't. Check back to see if the reason you didn't buy came true. Note that for individual stocks, the result might be misleading. For example, a risk you foresaw may not have come to fruition, but may have been a legitimate reason for not buying. Looking at this "non-portfolio" in the aggregate and over several years, however, should help you improve your decision criteria.

Tuesday, January 25, 2011

Jewett Cameron: Timely Buybacks

Companies can and do destroy shareholder value by buying back stock when it is overvalued. Indeed, most companies seem to be poor allocators of capital on behalf of shareholders, choosing to buy stock or take on debt when it is expensive, and hoard cash when it should be investing. But there are companies out there who do it right, and the value they add for shareholders is tremendous! Consider Jewett-Cameron (JCTCF), a stock that has been previously discussed as a potential value investment.

In its latest quarter, Jewett-Cameron reported a loss of just under $1 million. The company's operations actually produced a small profit in the quarter, but the overall loss was the result of a court decision in the quarter for a matter that occurred back in 2003. As a result, the company added a $1.5 million reserve as a liability on its balance sheet. While this is not nearly enough to threaten the company's viability (the company has no debt and $7+ million of cash), the company only has a market cap of $18 million; as such, this lawsuit can have a significant effect on the company's intrinsic value.

But surprisingly, the shares of this company likely became not less but more valuable to value investors this quarter, despite the unfavourable court ruling. This is because the company bought back a huge number of shares this quarter at attractive prices. Over the course of the quarter, Jewett-Cameron spent $2.4 million (a fraction of its cash holdings) to buy back 15% of its outstanding shares. Excluding the cash balance from the company's market cap and the lawsuit charges to the company's earnings, Jewett-Cameron has a ttm P/E of about 6!

And the company is not yet done with the buybacks. Along with its quarterly report last week, the company also announced that it was initiating another share repurchase plan. The plan is scheduled to end in May, and is for another 17% of the company's outstanding shares!

Investors wondering why this management team is so bent on creating shareholder value rather than behaving like most other management teams should look at Jewett-Cameron's ownership structure. The company is owned by its managers, particularly its CEO. For this reason, agency costs are minimized as managers are likely to engage in actions that are beneficial to shareholders.

Disclosure: Author has a long position in shares of JCTCF

Monday, January 24, 2011

PE10 Weaknesses

The PE10 is increasingly becoming a common method for value investors to determine whether the broader market is cheap or expensive. Not only does this method have a logical appeal to it, but data suggests that the magnitude of the market's subsequent 10-year returns is related to its PE10 level.


But while there is a relationship between a market's PE10 level and its future returns, the following chart (courtesy of My Money Blog) illustrates that the relationship is rather approximate:


pe10 vs returns.gif


For example, in both 1902 and 1965, the PE10 stood around 23, which is near the PE10 level today. But in the ten years following 1902, the market's real return was 50%, while in the ten years following 1965, the market shrank by almost that much!


Why is there such wide divergence between the market's relative price level and its long-term returns? I would argue that part of the reason has to do with the arbitrary 10-year time period inherent in the PE10 calculation. What you actually want in the denominator of the P/E calculation is a normalized earnings number. Sometimes the E10 (the average earnings of the last ten years) does give you a good approximation for that figure. But other times, such as today, it may not.


For example, in many E10 periods, one recession and one market expansion occurs. These periods may result in an E10 that closely approximates a normalized earnings number. Today, however, two recessionary periods (2001-2 and 2008-9) are contained in the last ten years. I would argue that this arbitrarily biases the PE10 upwards, since the denominator of the PE10 includes only one economic peak period but two economic troughs.


If you throw out the 2001-2 period in the PE10 calculation (so more like a PE8), you get a ratio of about 20.7, compared to the headline number of 23.5, a 15% difference. The data used to create the PE10 is made freely available by Robert Shiller, and you can play with it yourself by downloading it here.

Sunday, January 23, 2011

Irrational Exuberance: Chapter 2

In the year 2000, while many market pundits expected the market to rise continuously upward, Robert Shiller warned about the stock market bubble, though not that many paid attention. While most were blinded by optimism, Shiller demonstrated using fundamental analysis that the market would generate poor returns for years to come. Learning from and understanding Shiller's rational approach to market valuation is likely to aid the investor in avoiding falling prey to the bubbles of the present and future.

Since the growth of the economy or firm earnings are not responsible for the stock market's huge growth rates in the late 1990's, Shiller attempts to determine other factors that may be playing a role in the market's growth. Shiller makes the point that there is likely no one single factor at play, but rather a confluence of a number of factors that are causing investors to bid up prices to never-before-seen ratios.

Shiller discusses the following twelve factors as possibly playing a role in the market's exuberance:

1) Arrival of the internet during a period of solid earnings growth
2) Decline of foreign economic rivals
3) Cultural changes favouring business success
4) Republic Congress and tax cuts
5) Perceived effect of the Baby Boom generation
6) Expansion in media reporting of business news
7) More optimistic analyst forecasts
8) Expansion of defined contribution pension plans
9) Growth of mutual funds
10) Decline of inflation
11) Increased trading volume (discount brokers, day traders, 24-hour trading)
12) Rise in will and willingness to gamble

Shiller warns that correlation between these factors and the stock market's growth should not be confused with causation. Nevertheless, he believes many of these are contributing to the market's growth, if only psychologically.

Saturday, January 22, 2011

Irrational Exuberance: Chapter 1

In the year 2000, while many market pundits expected the market to rise continuously upward, Robert Shiller warned about the stock market bubble, though not that many paid attention. While most were blinded by optimism, Shiller demonstrated using fundamental analysis that the market would generate poor returns for years to come. Learning from and understanding Shiller's rational approach to market valuation is likely to aid the investor in avoiding falling prey to the bubbles of the present and future.

Shiller begins by putting the stock market level, as it stood in the year 2000, in historical perspective. While the Dow Jones Industrial Average (the Dow) had more than tripled since 1994, GDP and personal income was only up 30%. Corporate profits were up less than 60% over the same period.

A chart is shown illustrating the level of two variables: the stock market level and the market's earnings. Earnings had continued on their steady path, but the market level had taken off on a vertical spike at the time of writing. Shiller illustrates that the ratio of stock prices to earnings (a 10-year average of earnings in order to smooth out volatility, as discussed here) is at an absurd level. The PE 10 ratio is at 44 at the time of writing; the closest parallel is the 33 PE 10 ratio the market hit in September of 1929, just before it crashed.

Shiller then explores the question of whether there is any relevance to the market's P/E. To do this, he plots the market's PE 10 for all years since 1890 against its subsequent 10-year real returns. The resulting graph demonstrates that there is a relationship between a market's PE 10 and its subsequent returns. Based on the graph, negative returns over the next 10 years could have been expected from the year 2000. (As it turns out, returns over the next 10 years were indeed negative.)

Friday, January 21, 2011

Can You Say No To Jiangbo?

Jiangbo (JGBO) is a pharmaceutical and health supplement company based in China. It trades for $86 million despite a net cash position (cash minus debt) of $95 million. If an American company traded at a similar discount to its net cash, it would either be March of 2009, or the company would be losing money hand over fist. But Jiangbo is not only not losing money, but has generated net income of $44 million over the last year. As such, the stock looks like a downright steal. So should value investors jump in with both feet, or is there more to this than meets the eye?

First of all, it's worth noting that Jiangbo is one of the many Chinese companies that listed in the US using a reverse merger. This is significant because a number of such companies have turned out to be frauds! As such, investors are currently shunning or shorting companies of that ilk, which is either creating a huge buying opportunity or exposing these companies for the frauds that they are. Jiangbo has seen its stock price fall almost 50% from its highs some five months ago.

Because of Jiangbo's apparent wide discount to its cash and earnings, the most important factor in determining whether this is a worthwhile investment is the accuracy of the company's financial statements. Investors here are not counting on some new product, new market or competitive advantage; they will make money without all that stuff as long as the company's financials are for real.

The first step in determining the veracity of the financials requires identification and study of the company's independent auditors. These guys are charged with, among other things, checking the company's bank balances (and not just relying on the company's paper statements, which can be falsified), so their character and integrity is important.

Jiangbo is audited by Moore Stephens Wurth Frazer and Torbet LLP, which just last month was barred from accepting new Chinese clients. The SEC found that the accounting firm "encountered audit conditions that should have caused them to exercise heightened skepticism, including the discovery of problems with China Energy's internal controls and difficulties completing audit field work, such as inventory not being located where the company said it would be." Not a good sign!

Besides the track record of the auditors, there are other signs that not all is well with the company. For example, the company has been unable to pay its debt holders, despite an apparent cash balance of $124 million! The company claims the money is there, but that the reason for the lack of payment is "partially due to the stricter foreign exchange restrictions and regulations imposed in the PRC starting in December 2008". Other Chinese companies have had no problem paying millions of dollars back to their North American investors. If Jiangbo can't even pay $4 million in interest, what hope do North American shareholders have of ever seeing that cash?

Value investors believe that to ensure strong long-term returns, they must first protect downside risk. But what looks good on the surface may look anything but underneath. Investors must dig under the hood to identify potential risks to what might otherwise seem like obvious winners. A deeper dive into Jiangbo reveals much more risk to the downside than a cursory look can provide.

Disclosure: None

Thursday, January 20, 2011

The Gap Down

Shares of The Gap (GPS) recently fell precipitously after the company reported that December same-store sales were down 3% from the year-ago period. As such, The Gap can be added to the list of retailers that currently trade at low P/E levels (some of which are discussed here); the company now has a trailing P/E of just 10.5 (based on its current market cap and its last four quarters of earnings). Adjusted for the company's large cash balance (it has no balance sheet debt), The Gap has a trailing P/E of just 9!

But investors should avoid making purchase decisions on the basis of P/E alone. It's important to look beyond the "headline" number to understand how the business is really doing. In The Gap's case, annual sales have been in decline for several years. But at the same time, the company has actually managed to increase profits, as shown in the following chart:


This is a rare sight indeed. At this rate the gap isn't going to have worry about getting an advance from http://www.nationalpayday.com anytime soon. Usually, when sales fall (especially same-store sales), operating income falls by a larger percentage, as fixed costs (e.g. rent, administrative staff etc.) stay stable. But management of The Gap has actually been able to reduce costs at a faster rate than its reductions in revenue. As a result, The Gap's operating profit margin (which measures a company's operating profit per unit of sales) has increased steeply, as per the chart below:


While The Gap's financial performance is impressive, this is not the kind of situation a value investor wants to buy into. The cash-adjusted P/E of 9 discussed above is the result of rather high margins the company has experienced over the last year, which may not be sustainable. The last time margins were even close to this level was in 2004, as they rose to 12.8% that year. But margins tumbled for the next two years, eventually falling to 7.4% in 2006.

Perhaps The Gap's current margins are sustainable. But if an investor is willing to invest on that basis, the company had better fall well within his circle of competence, and he had better be able to point to reasons for why these margins are not subject to competitive pressures that drive down high margins in this and almost every other industry.

For value investors, it's important to look at a company's margins over several years. Otherwise, if the most recent year's margins are higher than normal (which is currently the case for The Gap), investors could be buying at a time when the company's current earnings are abnormally high. This could set the investor up for a situation where earnings (and potentially sales as well, in The Gap's case) are in decline, which makes the firm's effective P/E a few points higher than its current P/E would indicate.

Disclosure: None

Wednesday, January 19, 2011

Value In Action: Glentel

I was honoured to have been chosen as a judge for CanTech Letter's Canadian Tech Stock of The Year. The company I voted for ended up taking home the top honours. Interestingly enough, it was a value stock when the year began, and saw tremendous price appreciation throughout 2010. Therefore, I did a write-up of the company (reproduced below) identifying its value traits to help us recognize similar situations in existence today:

Glentel (GLN) has seen its stock rise by approximately 100% in the last 12 months. Usually, stocks that see such sharp price increases have a speculative element to them that precludes long-term investors from participating. But this is not the case for Glentel, a company that traded at a low P/E twelve months ago, and yet generated strong returns on equity; instead, Glentel's stock performance illustrates how value investors can profit from such companies in two ways: earnings growth, and multiple expansion. When these two forces combine, as they did with Glentel over the past year, returns for investors can be phenomenal.

Glentel generates most of its revenue from selling mobile phones and related items through retail stores in shopping malls and other locations. Twelve months ago, the company traded for $150 million despite $30 million of cash, negligible debt, and trailing 12-month earnings of $12 million. Therefore, adjusted for its cash balance, the company traded at a P/E of 10.

Companies trading at P/E's of 10 or below tend to be in decline or in a lot of debt, but Glentel was neither of these. The company was generating returns on equity of around 20%, so its business model was working. As such, the company expanded and thus grew its profits throughout 2010.

As profits grew, so did the company's P/E multiple, providing the double-whammy effect on the stock referred to in the opening paragraph. Glentel now trades at a P/E of 16, which is much more reasonable considering the company's ability to generate earnings and cash flow.

Undoubtedly, Glentel's business has been helped by strong consumer demand for smartphones. But it should be noted that the company nevertheless faces competition in this space from both very strong retailers and upstarts who face low barriers to entry. The fact that the company is able to generate strong returns despite such competition is a tribute to management's capabilities.

Looking forward, Glentel may have room to grow profits, both organically and through acquisition (the company recently purchased a US chain of mobile phone retailers). But gains to the stock are unlikely to be nearly as strong. The company's P/E is no longer low, and the company is now more risky as it has taken on debt to expand (in contrast to the net cash position it enjoyed a year ago). As a result, investors would be well-advised to seek out companies that currently exhibit the low P/E and high ROE properties that Glentel experienced one year ago.

Disclosure: None

Tuesday, January 18, 2011

Seagate: Get It While It's Down

As a value investor, volatility is your friend. It can offer you great opportunities to buy when prices are low and equally great opportunities to sell when they are high. For whatever reason, some value stocks are more volatile than others. For example, LCA-Vision (LCAV) is a stock that has offered investors plenty of entry and exit points over the last two years. Another volatile stock with value potential appears to be Seagate Technology (STX).

Seagate designs and manufactures hard disk drives. These devices are currently incorporated into pretty much all servers, desktops, and laptops. Seagate's market share is about 30%, as it sold nearly 50 million hard drives last quarter. The company is pretty much debt free (it has almost as much cash as it has debt), and only once over the last business cycle has its annual operating margin fallen below 5.5%.

Despite the apparent stability of the business however, Seagate's stock price fluctuates wildly. In just the last two years, Seagate's stock price has gone from $23 to $3, back up to $21 and back down to $10. How can a company with low debt levels and a history of consistent profits lose 80% of its value and gain 600% of its value when its business hasn't really changed much?

It appears that the market is overly fixated on short-term outlooks in this particular industry. Only a few months ago, we saw how analysts were intensely focused on the short-term outlook for one of Seagate's competitors, Western Digital.

There are a couple of risks in this industry of which value investors should take note. Operating in a field where technological change can render companies obsolete over the course of just a few years, Seagate's future viability is somewhat uncertain. There are other devices with the potential to usurp the capabilities of hard disk drives, but currently such devices are too costly to take over the market. That could change.

Furthermore, the hard drive industry is somewhat "commoditized". If a competitor expands too quickly, prices for all disk drives fall. This means that to a large extent, Seagate does not control its own destiny. It also means that management must be on the ball, as the company must be a low cost operator to be successful.

Seagate reports its earnings tomorrow afternoon. If it disappoints in some way, a volatile stock such as this one could fall dramatically. Investors who are well-prepared beforehand could benefit in such a situation, as we saw with Kirkland's after its latest quarterly report.

Disclosure: None

Monday, January 17, 2011

The Snowball: Chapters 60, 61 & 62

Warren Buffett chose Alice Schroeder to be his biographer, granting her access to his personal life like no outsider has ever been granted. In The Snowball, she is rather frank and is not always complimentary of the investing legend, which has apparently led to a rift between the two. Here follows a summary of the book.

Under the microscope in the mid-2000's, Buffett was forced to deal with a number of adversities. His ex-wife, Susie, passed away. Schroeder details the effects her illness and death had on Buffett and the rest of the family.

For most of Buffett's life, he had felt it made more sense for him to accumulate wealth, for this way, when he passed away there would be more of it to give away. But at this point, Buffett starts to change his behaviour. He starts giving money more liberally to his kids and grandkids, and announces early donations to charities and foundations (including the Bill and Melinda Gates Foundation).

During this period, Buffett also dealt with severe problems at Coke. Management had lost control. Profits were down, the stock was down, and scores of protesters were taking over the annual meeting, from unions who felt unfairly treated to environmental rights activists. Even Jesse Jackson attended to accuse the company of racism. Buffett has always looked for companies that were so strong that they could be managed by a ham sandwich. He mused after this latest episode at Coke that the company may no longer be around had it not been one such company.

Finally, the book ends with a description of Buffett's actions as the recession of 2007 onwards was taking place. A few years earlier, Buffett had warned about the potential perils of derivatives. Now, those derivatives were wreaking havoc on the global economy. Buffett was granted an opportunity to buy stocks that he had not seen for a long time.

Sunday, January 16, 2011

The Snowball: Chapters 57, 58 & 59

Warren Buffett chose Alice Schroeder to be his biographer, granting her access to his personal life like no outsider has ever been granted. In The Snowball, she is rather frank and is not always complimentary of the investing legend, which has apparently led to a rift between the two. Here follows a summary of the book.

Throughout his career to this point, Buffett's reputation had been helpful for his investments. With increased fame and success, however, his reputation began to work against him in some ways. If he offered a price for a company, there was a perception that the sellers were getting ripped off, since Buffett only buys undervalued companies. Schroeder describes one case in particular with respect to Clayton Homes where nobody wanted the stock - until Buffett made an offer for the company. At that point, shareholders, the media, legal firms and other groups argued that the deal was unfair and that Buffett was trying to rip people off.

In other cases, Buffett's prominence made otherwise small companies big targets of special interest groups. For example, anti-abortionists boycotted a small company which Berkshire owned, because Berkshire was making donations to pro-choice groups. (The company being boycotted had nothing to do with abortions; it sold kitchen-ware.) Buffett caved to the pressure and stopped Berkshire's charity program.

These chapters also deal extensively with the health issues now experienced (circa 2003) by Buffett's ex-wife, who was diagnosed with cancer. Susie remained a big part of Buffett's life even though they had split up, so her battle with illness caused great strain on the entire family.

Saturday, January 15, 2011

The Snowball: Chapters 53, 54, 55 & 56

Warren Buffett chose Alice Schroeder to be his biographer, granting her access to his personal life like no outsider has ever been granted. In The Snowball, she is rather frank and is not always complimentary of the investing legend, which has apparently led to a rift between the two. Here follows a summary of the book.

Buffett had lost a lot of credibility during the technology bubble in the year 2000. Because he didn't have technology stocks, he didn't have the returns; for the first time, he had been outperformed by the market index over a five-year period! One media pundit even suggested that Buffett should apologize to shareholders. He was called a "has been", and attendance at his annual meeting dropped by 40%.

After the bursting of the bubble, people jumped back on the Buffett bandwagon. Crowds to the Berkshire annual meeting came back even stronger than before, as investors sought Buffett's wisdom. As he became more trusted as not just a wise investor but also as a wise person, his opinion was asked on a number of issues that were not related to investing. In response, Buffett did take up a couple of causes where his credibility could bring about actual change.

For example, Buffett fought for higher estate taxes, arguing that wealth passed down over several generations subtracted from the health of society. Buffett was also instrumental in the fight against those who opposed the expensing of stock options. Coke was one of the first large companies to start expensing stock option hand-outs, and eventually they became an accounting requirement.

In the years leading up to the 9/11 terrorist attacks, Buffett actually advised his insurance companies to avoid taking on terrorism risk, likely because such business was under-priced. Following the attacks, Berkshire made a lot of money selling insurance against future attacks, as customers were now willing to overpay (from an odds point of view) for protection.

Friday, January 14, 2011

Successful Companies Rather Cheap

Recently, a number of value investors have noted that large cap stocks appear rather cheap by historical standards. The P/E ratio is one of the most useful metrics for determining how cheaply a company may be purchased. But as we've discussed before, it cannot simply be applied blindly; company earnings may be temporarily depressed, or may be high due to one-time gains. But even if earnings are corrected or smoothed to reflect fluctuations in the business cycle, a company's balance sheet position may be so exceptional that it also has a material effect on a company's would-be P/E.

Consider some of the strongest cash generating businesses in the world: Apple, Google, Microsoft, and RIMM. Their P/E's are not that high considering the returns on capital that they generate. Furthermore, their P/E's are lower than they appear at first glance, as after adjusting for their cash balances, these companies appear even cheaper. The chart below illustrates this, by showing these four companies (along with cash-rich KSW, a company we have discussed as a potential value investment) with their P/E's after adjusting for their cash balances:


It is rare that a collection of cash-generating cash-rich companies such as those listed above are trading at such reasonably low P/E's. It should, however, be noted that on its own the P/E ratio does not convey enough information to determine whether an issue warrants purchasing. However, the higher the P/E, the more earnings must grow to justify the price, and the more the stock price will fall if earnings growth does not come to fruition. This is why value investors prefer stocks with low P/E's, as low expectations lower the potential for loss of capital and raise the potential for price appreciation.

Disclosure: Author has a long position in shares of RIMM, MSFT and KSW

Thursday, January 13, 2011

RadioShack Cash Back

There are currently a number of retailers trading at low P/E's (e.g. below 10) that generate strong returns on equity (ROE). Value investors know that these are the kinds of stocks that generate strong returns over the long term. RadioShack (RSH), a consumer electronics retailer at shopping malls, strip malls and in kiosks, is another example of a retailer that appears to trade at a discount.

Unlike a few other retailers trading at low P/E's and high ROE's, however, RadioShack is no one-year wonder. Over the last business cycle, its operating margin has fallen below 6.9% only once (3.3% in 2006). Through the recent recession, operating margins were strong and stable, at 7.6%, 8.6% and 8.9% for 2008, 2009 and 2010, respectively.

Because of the company's retail successes in recent years, it has been building up its cash balance despite consistent dividends and occasional buybacks. RadioShack has $720 million of cash, which is about one third of its market cap. As such, the higher-ups have decided to buy back a ton of stock. RadioShack spent $300 million last quarter (which is about 15% of the company's current market cap) buying back shares. Seeing as how the company's P/E is about 9 (based on its current market cap divided by the sum of its last four quarters of earnings), further buy backs at these prices could turn out very well for shareholders.

Investors may already have a bias towards certain competitors of RadioShack in the consumer electronics retailing space. For example, hhgregg (HGG) has shown strong revenue and earnings growth over the last several years, making it a favourite among growth investors. At the other end of the spectrum, strong and steady Best Buy (BBY) has attracted the attention of value investors with its low P/E.

But the important thing to realize is that there are enough spoils to go around. Every retailer will have short-term issues that have the potential to affect the stock price (For RadioShack at the moment, for example, that could be iPhone cannibalization and the loss of Sam's Club kiosks.) But the products being created for consumers, from internet and 3-D tvs to tablet computers to smartphones to video gaming innovations will keep this space growing for years to come. As such, all of these financially healthy companies (unlike Circuit City) appear likely to maintain or grow their profits. Therefore, value investors needn't choose between RadioShack and Best Buy; the fact that both are cheap allows investors to lower their risk by diversifying across the two companies. When the negative sentiment towards this industry and these companies abates, value investors will profit no matter which company posts relatively stronger results.

Disclosure: Author has a long position in shares of BBY and RSH

Wednesday, January 12, 2011

Acme United: Up For All The Wrong Reasons

Acme United (ACU) is a stock that has been discussed on this site as a potential value investment. In the last two days, on no news, the stock is up more than 10% on daily volume that is 10 times higher than normal. The reason for this appears to be a clerical error!

While market participants should strive to understand a company before investing in it, many of them don't. For example, there are a number of "Cramericans" out there who buy stocks blindly. This became quite clear this week as it appears followers of Jim Cramer's show Mad Money bought shares of ACU because of an errant article.

CNBC correctly reported that Cramer recommended a company by the name of Accuride on his show last Friday night. But CNBC mislabeled the company's symbol, referring to it as ACU instead of ACW. They corrected the error a few days later, but not before some blind followers bid up ACU's shares!

So now what? Should value investors sell, on the expectation that Cramericans will cause the stock to drop in the future once they realize their mistake? I would argue that value investors should only sell if they feel the stock price has reached its intrinsic value. They should not get bogged down in the short-term trading game; there are no assurances on what will happen in the short-term, which is why value investors are long-term oriented to begin with. For example, it is entirely possible that the stock now becomes a positive momentum play for another group of blind speculators.

It is scary that there are investors out there who don't even study a company enough to verify its name. It's even scarier that this group of investors is large enough to move a stock's price significantly. How's that for an "efficient market"?

Hat tip to Trevor Scott for noticing the error.

Disclosure: Author has a long position in shares of ACU

Tuesday, January 11, 2011

From The Mailbag: Comarco

Stocks trading at big discounts to their net current asset values can generate strong returns for shareholders. But as previously discussed, investors in such stocks should nevertheless fully vet these potential investments to ensure that downside protection is indeed present.

Consider Comarco (CMRO), a maker of power products (e.g. chargers) for consumer electronics such as mobile phones. The company trades on the Nasdaq for just $3 million, despite current assets of $16 million against total liabilities of $10 million. Unfortunately, despite the apparent discount to assets at which the company trades, Comarco's price could go lower still.

The company plans to de-list from the Nasdaq! While this will help the company reduce its annual expenses by several hundred thousand dollars, it may not help investors. Companies trading over-the-counter tend to trade at lower multiples (to earnings or book value etc.) than their exchange-listed peers, for a variety of reasons (e.g. lower trading volumes, lack of inclusion in an index, lower investor interest etc).

As value investors, however, we know not to make our purchase decisions based on what other investors may or may not do. However, even after the fee savings from de-listing, the firm may still not be profitable. The main problem is that the company appears to be losing out to its competitors. Portable consumer electronics are in demand, but for whatever reason, demand for Comarco's chargers are down significantly. The following statement from the company's press release from mid-December illustrates that Comarco is losing the competitive battle:

"...[W]e anticipate a pricing adjustment at retail that should help drive additional sales"

In other words, Comarco will try to cut prices to compete. But gross margins were only 13% last quarter, which doesn't leave a whole lot of room, if any, to pull out a profit.

Value investors are on the prowl for businesses selling on the cheap. But just because a company is cheap doesn't mean it can't get cheaper! Investors must investigate to determine whether their downside risk is indeed protected; if the company's intrinsic value has the potential to fall significantly, the investment isn't worth the risk.

Disclosure: None

Monday, January 10, 2011

Air Bankrupt

Recently, a number of airlines have announced their intentions to seek bankruptcy protection. In these relatively common situations, shareholders are mostly wiped out, as the company usually undergoes a restructuring that sees creditors (and nowadays, governments) own the beleaguered airline. Obviously, the immediate problem was that the billions of dollars of the company's losses prevented the company from paying back the billions of dollars of the company's debt. But more fundamental than this is the plague that afflicts the entire airline industry, and always has.

Warren Buffett is quoted as saying that the airline business in the US “has made no money.” Thanks to a forgettable investment Buffett had made in US Air, he even went so far as to suggest a capitalist should have shot down the Wright brothers during their historic "first in flight" moment.

Is there something particular about the airline industry that causes these companies to have been such bad investments? Why is it that every recession takes a few airlines down with it? The answer lies in the supply and demand characteristics specific to this industry.

Let's start on the demand side. When incomes fall (e.g. during recessions), airlines get hit particularly hard. This is measured by income demand elasticity, which determines the impact changes in incomes have on demand for particular products or industries. According to a study by Houthakker and Taylor, here are some U.S. income elasticities of demand:



Basically the chart is telling us that for every one percent drop in income, we see a drop in demand for each of these items corresponding to its chart entry. For example, at the bottom of the list, we see that for every 1% drop in income, food demand drops by just .14%. On the other hand, at the top of the list, we see that airlines are disproproportionately affected, with demand dropping by 6% despite only a 1% fall in income!

But the converse is also true, meaning that for each 1% rise in income, airline demand increases 6%! So shouldn't this cancel out the drop that occurs every now and then? To see what happens when times are good, let's look at the supply side.

When demand increases (and we see it increases disproportionately with incomes), airlines add to their capacity. This results in fixed costs for airlines, either in the form of lease payments or debt taken out to buy expensive increases in capacity. However, as all airlines do this, the one that increases too much or too fast ends up with overcapacity. Since customers generally choose their airline based on price (though there are exceptions), an airline with too much capacity will simply cut its price to fill its seats. Competitors are forced to follow suit, or carry overcapacity themselves, resulting in an erosion to profits despite strong economic times!

This effect prevents airlines from benefiting from their high income demand elasticity. To make matters worse, when the economy turns down, the airlines are left with large fixed cost obligations (aircraft lease or debt payments) that are tough to pay off, and especially tough considering the disproportionate drop in demand as compared to incomes, resulting in the annihilation of the weakest airlines.

The evidence? Consider this list of bankrupt US airlines since 1979. Airline bankruptcies are not just common in the US, either. Consider that Japan Airlines is undergoing its fourth government bailout since 2001! In most industries, a list of the companies that have gone bankrupt will contain a lot of fringe companies with the occasional fallen angel. In the case of this industry, however, the list reads as a who's who of airlines!

Of course, there are the low-cost innovators of the field that manage to stay above the pack. Companies like Southwest Airlines (LUV) and Canada's WestJet Airlines (WJA) have consistently generated returns that beat the competition. Unfortunately, the odds are stacked against them. Consider what happens when the competition goes under. The competition's debt gets wiped out, and it returns to the market as a leaner enterprise, better positioned to compete with the industry leaders. Because of this constantly re-occurring industry dynamic, well-performing companies must constantly innovate to stay ahead of the curve, lest they become the next entries on the list of shame.

Shareholders beware! Airlines are not the place to look for long-term investments. Investors are better off investing in companies that will first and foremost protect their capital from erosion.

Disclosure: None

Sunday, January 9, 2011

The Snowball: Chapters 49, 50, 51 & 52

Warren Buffett chose Alice Schroeder to be his biographer, granting her access to his personal life like no outsider has ever been granted. In The Snowball, she is rather frank and is not always complimentary of the investing legend, which has apparently led to a rift between the two. Here follows a summary of the book.

The Salomon debacle added stress to Buffett's life like no other business situation. He was sleepless at night, as he wondered how the billions of dollars of expiring debt would be paid as customers withdrew their funds and cancelled deals. But Buffett guided Salomon through the mess, and came out of it looking like an honest genius. From the start, he focused on turning the firm into an ethical powerhouse, which likely enabled it to avoid an indictment that would have finished the firm.

In 1991, Buffett meets Bill Gates for the first time. Neither had expected to have much in common with the other (other than the fact that they were #1 and #2 in the world's richest man rankings), but they hit it off immediately. They were so enthralled in private conversation that they left others at the party miffed. Gates, who understood the notion of competitive advantage very well himself, advised Buffett to buy Intel and Microsoft in 1991. Buffett only bought a token amount, 100 shares, of the latter. Gates also told Buffett that Kodak would go bust because of the digital age; at the time, Kodak was prosperous and saw no threat.

The author also describes Buffett's attempt to buy Long-Term Capital Management (LTCM) before it was bailed out. Because Buffett had been touring remote areas with the Gates', he was unable to consummate a deal that he believes would have been very lucrative. LTCM had equity of $500 million for which Buffett offered $250 million. The problem for LTCM was that it needed a capital injection to stave off default (due to leverage); Buffett was willing to make a capital injection of several billion dollars. However, for a couple of potential reasons (one being that LTCM was run by a man Buffett had fired for ethical violations at Salomon), Buffett believed that LTCM downplayed the likelihood of a private transaction and thereby forced the government to bail it out (in order to avoid panic in the capital markets).

As the year 2000 approached, Buffett had fallen to #4 in the world's richest man rankings, as the technology boom took center stage. People called him a has-been and a dinosaur as he would not invest in technology stocks, which were the hot investments of the day.

Saturday, January 8, 2011

The Snowball: Chapters 45, 46, 47 & 48

Warren Buffett chose Alice Schroeder to be his biographer, granting her access to his personal life like no outsider has ever been granted. In The Snowball, she is rather frank and is not always complimentary of the investing legend, which has apparently led to a rift between the two. Here follows a summary of the book.

In the 1980's, leveraged buyouts were all the rage. Interest rates had fallen as inflation had been brought under control, and so private firms were looking for bloated public firms that they could buy, make more efficient, and sell for a profit. Buffett is wary of the debt (including debt of 'junk' status) that is used to finance these purchases, and so he does not participate.

However, as his fortune and fame have risen, he is called upon by corporate managers as a white knight, to save them from hostile buyouts. Since Buffett does not micromanage, corporate managers are happy to have him take stakes in their firms, even if it means a lower price; private equity firms, on the other hand, are likely to fire the existing managers.

During this time, Buffett was also facing losses in his insurance businesses. The book details some of the management changes that took place, and how Buffett has dealt with poorly performing businesses. He will often single out managers who have done a good job in his annual letter to shareholders, but will omit praise when it is not due. Often, he will take the blame himself in his letters, but behind the scenes he will make management changes.

The author also goes into excruciating detail with the Salomon debacle that Buffett was involved in that almost bankrupted the firm. Ethical violations by top managers at the firm resulted in the government shutting the firm out from debt auctions. This would likely have sent financial markets on a downward spiral, as Salomon's bankruptcy would likely have spread to other firms, its counter-parties, who would go unpaid in the event of a bankruptcy. Drawing on the reputation Buffett had earned by this point, Buffett is able to get concessions from the government that allow the firm to stay solvent enough time to survive a run on the firm's paper.

Friday, January 7, 2011

Karsan Value Funds: 2010 Q4 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 fourth quarter ended December 31st, 2010, KVF earned $0.55 per share, bringing the value of each share to $13.05.

Once again, the market was strong this quarter, providing a tail wind for many stocks in the portfolio. As such, most portfolios will have made money this quarter. But the true test of whether this (or any other) fund is adding value will take place over a period of several years and through both bull and bear markets. So far, the fund has only been in existence for 1.5 years.

In addition to the rising markets, the following developments contributed to this quarter's positive results:

1) Fund holding Acorn International increased significantly in price, allowing for a profitable exit, as discussed here.

2) Fund holding TSR Inc. also saw a significant price increase, allowing for another profitable exit, as discussed here.

Depressing the fund's performance this quarter was a change in the USD/CAD exchange rate. Had the USD/CAD exchange rate finished the quarter at the same level at which it started the quarter, earnings would have been $0.24 higher than they were.

Currency movements that have negatively affected results have been a continuing trend over KVF's short history; were the USD/CAD exchange rate to immediately return to the level at which it was when the fund opened 1.5 years ago, the fund would see a $1.15 rise in its per share value! (Of course, this may not happen soon, or ever for that matter.) Currency movements are likely to continue to play a significant role in results taken over short (e.g. quarterly) reporting periods. However, their contribution to performance over the long term is likely to be muted.

Looking forward, market sentiment appears strong, which suggests downside risks have increased: sentiment can turn in a hurry, which could result in a pullback. Nevertheless, there appear to be pockets of opportunity in the market. For a discussion of these apparent pockets, see the latest additions to the Stock Ideas page.

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

Thursday, January 6, 2011

Rimage: All That Cash

Rimage (RIMG) provides equipment and software for the mass production of CD and DVD content. For example, if a company wants to distribute training software to hundreds of employees, it may use Rimage devices to efficiently burn and label a bunch of disks.

Rimage trades at $140 million, and has earned operating income of just over $60 million over the last four years. As such, at first glance the company may not look like a steal...until you consider that the company has a cash balance of about $110 million! If you subtract the cash from the company's market cap, the company appears to trade for just $30 million. Meanwhile, it has earned about $10 million in the last 12 months. Now it does look like a steal!

In addition, the company's margins have remained strong (10%+) throughout the recession. One of the reasons for this is the company's variable cost structure. The company outsources the manufacturing of the subcomponents of the systems it sells, so capital investment requirements are low. (The company had depreciation of just over $1 million on sales of $83 million in fiscal 2009.)

But an investment in Rimage is not without some risk either. For one thing, it may not be wise to simply subtract the cash from the company's market cap. Rimage has built up its cash balance over several years. Its buyback program, along with its actions within that program, have been pretty weak considering its cash hoard. Furthermore, the company does not pay a dividend. As such, investors may not see that cash for a while, if ever. (For example, the cash may be squandered in an empire-building acquisition.)

Furthermore, while the company continues to make foreign investments, notably in China, there is some question as to whether this industry will exist in a few years. For example, perhaps the hypothetical company depicted in the opening paragraph of this post will distribute its training video over the company intranet rather than by physical media. As broadband infrastructure continues to grow, Rimage's industry is at risk. As such, the company's revenue and margin contraction of the past three years may only be part cyclical, with the other part being secular.

Despite the strong cash balance and steady operating nature of this company's earnings, there are risks going forward which could impact Rimage's intrinsic value. Investors should be sure to understand and weigh these risks carefully before jumping in.

Disclosure: None

Wednesday, January 5, 2011

Betting Against The Shorts

A few weeks ago, potential sources of stock ideas were discussed on this site. The post made reference to contrarian indicators that signal that a stock is hated; this hatred can result in a low price, which value investors love. One such contrarian indicator is a stock's short interest.

Twice a month, the exchanges release how many shares of an issue are held short (with a two-week lag). This can be a helpful resource in not only identifying which stocks Mr. Market hates, but also which same stocks Mr. Market plans to buy later. This is because when a share is shorted, it must be bought back later; as such, a high number of short shares suggests a higher than normal demand for shares in the future.

Recently, the NYSE reported that short interest was lower than it has been in about a year. This suggests that sentiment is rather positive (at least by recent standards), which should sound a bit of a warning to investors. But information like this on aggregate market data is difficult to act on. Much more interesting to bottom-up investors is the short-interest level on individual stocks.

Highshortinterest.com offers a list of the most highly shorted stocks (relative to their floats) on the major US exchanges. It currently contains about 100 of the most hated stocks in the US, and plenty of stocks with value potential litter that list. For value investors looking for potential ideas worthy of further study, this is a decent place to start.

For example, currently at #4 on the list is Conn's Inc, which has come up a few times on this site. Further down the list are other names that have been bandied about on this site such as LodgeNet, DSW, and GameStop. Other names on the list which are currently in the news as potential value plays include Sears, Ebix, St. Joe, and Barnes and Noble.

When sentiment on a stock is extremely negative, value investors should pay attention. As such, one of the best places to look for stock ideas is the short interest list. Not only are these stocks unpopular and therefore cheap, these short shares will have to be bought back in the future.

Tuesday, January 4, 2011

Market Regulations Reducing Productivity

As recently as three or four decades ago, companies in the US were wary of buying back their own shares because this could be considered illegal price manipulation. In 1982, the SEC enacted a rule that gives companies repurchasing shares safe harbour from prosecution for price manipulation, and this has been a major contributor to the growth of buybacks. But regulations restricting the flow of capital continue to hamper the productive flow of capital, as the following are among the conditions for safe harbour protection, as set forth by the SEC in Rule 10b-18:

- No repurchase is made at a price exceeding the highest current independent bid
price or the last independent sale price, whichever is higher.
- Non-block repurchase volume does not exceed 25% of the average daily trading volume for the preceding four calendar weeks

Clearly, these could be major deterrents for small companies looking to repurchase shares. Fortunately, these are not requirements; they only protect the company from charges of price manipulation. Still, these conditions likely deter many small companies from using this option for returning cash to shareholders.

Furthermore, many of the large companies listed on US exchanges are also listed on exchanges in other countries. The regulations enforcing buybacks in most other countries are much more restrictive, and therefore the US issue can suffer as a result.

For example, consider Research In Motion, a company previously discussed as a potential value purchase. RIM is listed on both Canadian and US exchanges. As its stock fell to the $40 range in the summer, management was furiously buying back shares, but had to stop too soon: Canadian-listed companies can only buy back 10% of their shares on the open market in a year. As RIM's shares recovered to $60, shareholders were not rewarded from bargain buybacks as much as they should have been; RIM now sits on $2.5 billion of cash, but management is handcuffed from buying back any more shares until July of 2011!

This issue also came up a few months ago as the dual-listed (in both Canada and the US) Quest Capital was prevented from buying back shares when it traded at a large discount to its book value, which was made up of mostly current assets. While Quest's price did eventually trade up to the company's book value, the per-share book value (and therefore, the subsequent price appreciation) would have been higher had management been allowed to buy back more shares than the regulations stipulated.

For a table outlining the buyback restrictions imposed by various countries on their exchange-listed stocks, see Table 1 at the bottom of the following paper, Survey On Open Market Purchase Regulations.

Governments around the world currently lament the large cash accounts carried on corporate balance sheets, forcing governments to spend and/or print money to keep capital flowing. At the same time, however, government regulations are keeping corporations from buying back shares, which would send cash to more productive uses and reduce the onus on governments to stabilize capital markets.

Disclosure: Author has a long position in shares of RIMM

Monday, January 3, 2011

Envoy: The Backward-Looking Forward-Looking Statement

One of the problems with small-cap investing is that the financial reports come out much later than they do for large-caps. Auditors will first spend time on the large companies which pay the large fees, and small-caps don't appear to have the manpower to generate reports quickly. Some small-caps make up for this by providing an update on the current quarter when they relay their previous quarter results. But others, like Envoy Capital Group, leave shareholders completely in the dark.

Envoy Capital Group has a net current asset value of about $15 million, but trades for about $7 million on both the Nasdaq (under ECGI) and Toronto Stock Exchange (under ECG). Due to the large discount at which it trades to its assets, Envoy has already been discussed as a potential value investment on this site.

The company's fiscal year ends on September 30th, and the company does not release its 4th quarter results until it releases its annual report. Therefore, only last week did the company release its results from September 30th, meaning investors had to wait about 2.5 months after the end of the quarter to get the company's results.

Unfortunately, despite this, the company has offered no insight into how the current quarter (which is more than 80% complete) is going. This may be understandable if the company's operating situation were difficult to ascertain (for example, if revenue recognition was subject to the completion of various milestones). But for Envoy, the most important element of the company's financials is the current market value of its trading portfolio. Surely, it doesn't take much to provide an update on the portfolio's securities!

Instead, the company provided the following outlook:

"...the investment landscape in the near future may present some good opportunities."

In the near future? What about the near past? Is management speaking to its prospects for the current, almost-complete quarter, or is it simply ignoring the last 2.5 months altogether and instead speaking about the next half-month?

Further clouding this issue is that there have been a couple of important occurrences since September 30th that management did not raise as a "subsequent event". For example, one of Envoy's holdings from last quarter (Augen Gold) increased in market value by 150% since the end of the quarter. But whether Envoy still holds those shares is anybody's guess!

Small-cap companies often lament that they trade at discounts to their larger peers. But one of the likely reasons for this is the lack of disclosure that small caps provide. Some disclosures come at a cost and are therefore prohibitive; but when they are not, small-caps would be better served in providing information that would be of benefit to shareholders.

Disclosure: Author has a long position in shares of ECG

Sunday, January 2, 2011

The Snowball: Chapters 41, 42, 43 & 44

Warren Buffett chose Alice Schroeder to be his biographer, granting her access to his personal life like no outsider has ever been granted. In The Snowball, she is rather frank and is not always complimentary of the investing legend, which has apparently led to a rift between the two. Here follows a summary of the book.

As Buffett spent most of his time working, whereas his wife Susie tended to their children, community affairs, and a singing career, they began to grow apart. Buffett spent much of his time in Washington and New York with the female CEO of the Washington Post in which he owned a large stake, while Susie was spending time with other men. Once the kids were grown up, Susie moved to San Francisco while Buffett remained in Omaha.

According to the author, Buffett was a wreck after Susie left. They would talk for hours on the phone with Buffett weeping, wishing her to return. Susie enlisted Astrid Menks to look in on her husband and bring him hot meals every now and then. Buffett and Menks would soon lean on each other, and eventually move in together. This was not what Susie intended, but Astrid was willing to defer to Susie, who was the public wife, while Astrid was the private mistress.

During this time, Buffett purchased the Buffalo Evening News through Blue Chip Stamps. This was his largest purchase to date, at $35 million, and it was almost a complete failure. Buffett had stated publicly that most cities would end up with only one daily paper, and so he quickly went after the competition in Buffalo. While his paper led on weekdays, the competition had the Sunday paper market cornered. Buffett got his paper to print a Sunday edition, and offered it free and/or with heavy discounts in order to undercut the competition. This, along with his comments about him seeing only one daily paper in US cities would land him in hot water with anti-competitive laws. The competition asserted that Buffett had aimed to shut them down from the start, and they were winning in court. Legal restrictions that were subsequently placed on Buffett's paper were causing massive losses.

Buffett was ready to give up and liquidiate, but Munger (another owner of Blue Chip Stamps) wanted to fight on. With new management, the paper's fortunes improved, and court decisions were reversed on appeal after much legal wrangling. Five years, later, the Buffalo Evening News started generating huge profits relative to the purchase price.

In 1983, Buffett and Munger also agree on a price for Blue Chip Stamps, and Berkshire acquired the entire company. Thus, Munger and Buffett now officially became partners in Berkshire Hathaway.

Finally, the author details the incredible life story of Rose Blumkin, who started the Nebraska Furniture Mart that Buffett purchased in the 1980's. Blumkin was dirt poor in Russia, and traveled to the US to live out the American dream. Through hard work and perseverance, she and her husband started and grew their store to become the largest furniture retail store in North America.

When they first started, no suppliers would sell to them because the competition was complaining that they undercut on price. (She would only mark up inventory by 10%!) Undeterred, Blumkin was forced to travel around neighbouring states by train looking for overstock in order to stock her store. Her customers came to appreciate the value they were getting, and the competition was wiped out or crippled in the process. Buffett somehow purchased 90% of the company for $55 million, though its inventory at the time of purchase was $85 million. Blumkin turned away investors offering more money because managerial control going forward was important to her.

Saturday, January 1, 2011

The Snowball: Chapters 37, 38, 39 & 40

Warren Buffett chose Alice Schroeder to be his biographer, granting her access to his personal life like no outsider has ever been granted. In The Snowball, she is rather frank and is not always complimentary of the investing legend, which has apparently led to a rift between the two. Here follows a summary of the book.

In the early 1970's the market began to fall, and by a substantial amount. In 1973, Buffett and his friends saw their portfolios fall by significant margins. Munger's portfolio had halved, and Buffett's was down a third.

Of course, Buffett took advantage of the situation by buying even more stocks, and there were many bargains to be had. Buffett was able to buy many newspapers including a stake in the Washington Post. Shares in Berkshire had also fallen, causing some of Buffett's former partners to sell their shares. Buffett took advantage of the opportunity and snapped the shares up himself. It wasn't that the textile business at Berkshire was any good; Buffett was making a bet that he would be able to to deliver returns by buying other businesses through Berkshire.

At the same time as their portfolios were taking a hit, Buffett and Munger were also dealing with lawsuits from one of their businesses, and an SEC investigation into their operations. The SEC felt that Buffett and Munger's actions on a bank deal were illegal. (Buffett and Munger had convinced a bank's controlling shareholders to rebuff an offer and to instead sell to them.) The SEC also felt that the complicated ownership structure (which had Buffett, his family, and some of his friends and their families own shares of several companies, many of which had cross-holdings of the other companies!) was meant to hide and mislead. Eventually, the SEC relented, mainly on the favourable (towards Buffett) opinion of a lawyer whom the SEC investigator respected.

Shortly thereafter, GEICO shares drop from the 40's to $2 per share, as the company was on the verge of bankruptcy. Buffett had recognized that the previous management was poor, and set out to meet the new manager assigned with the task of bringing the company back to life. Buffett meets with John Byrne for two hours, asking him his plan for saving the company and for growing it thereafter. Buffett likes what he hears; he goes on to once again buy shares of this company he had followed ever since he bought and sold its shares decades ago. The author describes the business decisions Byrne undertook in order to right the ship, making Buffett a ton of money in the process.

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