Monday, February 28, 2011

Real Estate On The Cheap

The real estate downturn in the US has resulted in low land values in many parts of the country. But in some cases, prices are perhaps too low. Consider Income Opportunity Realty Investors (IOT), a public company that invests in real-estate.

The company has a book value of $72 million (comprised mostly of land and notes receivable) and yet it trades for between $11 million and $18 million! (The reason for the big spread there is that the stock is rather volatile!) The land is composed of 203 acres of undeveloped land in Farmer's Branch, Texas, carried at just under $30 million. It is about a 20 minute drive from downtown Dallas, and is situated 15 minutes from the Dallas/Fort Worth International Airport. The land was acquired in May of 2006, so it may be overvalued; but is it worth only one sixth of its carrying value?

The company's notes receivable are mostly the result of recent land/building sales. The main risk with the notes is that they are due from related and affiliated parties. At least one of these parties has a very high debt to equity ratio, and happens to be the parent company of IOT, owning 80%+ of the company!

On that subject, a potential risk to the company is its ownership/management structure. The parent company will likely do what it needs to do to benefit itself, so IOT's actions may not always benefit its minority shareholders. There appear to be conflicts of interest on the board of directors as well, as the company appears to be governed by employees of the company's advisor, which is rarely a good thing for shareholders.

IOT's stock price has absolutely tanked in the last few months, however, offering the company's shares on the cheap. When TCI acquired a large number of shares of IOT in July of 2009, it noted that "The Company’s fair valuation of IOT assets and liabilities at the acquisition date approximated IOT’s book value." Since that time, IOT stock is down 60% and its book value hasn't changed much. In the meantime, the company continues to break even, mostly by collecting interest on the notes outstanding. (This amount is then offset against interest payments and operating expenses.)

Many investors like to identify potential catalysts before investing in a stock. There don't appear to be any catalysts on the horizon here, however. That land could sit undeveloped for a long time, and most of the notes don't mature until 2027! However, it appears clear that the company is trading at a massive discount to its assets, so value investors with long-term outlooks who require no catalyst may find this stock worthy of owning.

Disclosure: Author has a long position in shares of IOT

Sunday, February 27, 2011

You Can Be A Stock Market Genius: Chapter 2

Value investor Joel Greenblatt takes the reader through a number of categories of investing examples where market inefficiencies exist. This book has numerous case studies, giving the investor a chance to learn and then apply the lessons to current and future market opportunities


Greenblatt discusses some requirements that investors must follow if they plan to outperform in the market. First, they need to do their own work. The opportunities offering the best rewards will not be covered by the media or Wall Street. Investors must also not take advice from others, including brokers and analysts. These advisers are paid based on how much they generate in business for their firms, and not by how well you do.

Greenblatt also argues against too much diversification. For one thing, he cites research suggesting that as the number of stocks in the portfolio increases, the benefits of diversification drop quickly. For example, he argues that the diversification benefit between owning eight stocks and owning five hundred stocks isn't that large; but the benefit of owning eight stocks is that you can really pick your spots in terms of choosing stocks with potential upside that is higher than the potential downside. A better method of diversifying, Greenblatt argues, involves keeping some money out of the stock market (e.g. in cash, bonds, home equity etc.).

Greenblatt also advises that investors avoid looking at an investment in terms of its upside potential. Instead, look at the downside, and employ a margin of safety with all purchases. If you look after the downside, the upside usually takes care of itself.

Finally, Greenblatt discusses the fact that there are many ways to make money in the stock market. Every investor cannot possibly participate in even a fraction of the opportunities that are out there. Furthermore, there are many different methods by which investors can be successful. For example, Ben Graham used a quantitative, statistical approach, whereas Warren Buffett identifies and exploits competitive advantages. Greenblatt goes through a number of situations in the following pages that demonstrate the ways in which enterprising investors can profit from the market.

Saturday, February 26, 2011

You Can Be A Stock Market Genius: Chapter 1

Value investor Joel Greenblatt takes the reader through a number of categories of investing examples where market inefficiencies exist. This book has numerous case studies, giving the investor a chance to learn and then apply the lessons to current and future market opportunities


In the opening chapter, Greenblatt explains how the ordinary investor has a chance against all the portfolio managers who dominate the market.

For one thing, many of the well-educated MBA-types subscribe to the Efficient Market Hypothesis, which makes them measure risk in an absurd way according to value investors. Price volatility is considered the best measure for risk for these market participants, and since value investors evaluate risk upon better measures (e.g. risk of bankruptcy, revenue risk etc.), opportunities are out there.

Second, institutional managers have a much smaller domain in which to invest. A billion-dollar fund can only buy positions in billion-dollar companies, or else the positions will either be so small that they will not affect returns, or the position sizes would be large and market-moving. Ordinary investors, on the other hand, have thousands more stocks to choose from, increasing the chances of finding a diamond in the rough.

In order to benefit from these advantages, ordinary investors have to look in places that no one else does, since the opportunities available to them will not be publicized. Greenblatt compares this kind of investing to antique shopping for bargains. Antique shoppers that have some knowledge of the market for certain objects can often find bargains in out-of-the-way places where others of their ilk aren't competing with them. Greenblatt argues that small investors must employ a similar strategy, and this book is dedicated to illustrating how.

Friday, February 25, 2011

Chatting Messenger

It's the last Friday of the month, so Frank (author of value site frankvoisin.com) and I are chatting messenger, where we discuss stories from the web that caught our interest:

Saj: We talk a lot about company balance sheets and market positions, but that's all useless according to this article in a national newspaper:
"One look at the charts tells the whole story at Cisco Systems...balance sheet strength, their cash position, R&D spending and their position in their industry don’t amount to a hill of beans."
Frank: Sounds like the media is providing a great education to investors.
Saj: This "hill of beans" metric sounds important.
Frank: Maybe we should focus more on it! And:
"As investors we need to be alert to changes in trend...Until CSCO moves convincingly through the upper resistance of the channel the down trend is still in place"
Saj: Yeah, that makes sense. As "investors" we should ignore the actual company, and instead just copy what other investors are doing by going with the trend.
Frank: Yeah, that's not a recipe for disaster.

Saj: So a government is funding the construction of yet another sports arena, this time in Quebec.
“We have a window of opportunity of only a few months to attract an NHL franchise. It will be gone in a year."
Frank: It's great how the government intervenes in such important areas, where the private sector constantly lets us down.
Saj: Absolutely. Millionaire professional athletes and billionaire team owners need to be subsidized by tax payers...where else is the money supposed to come from??

Frank: While one government spends superfluously, another nation can't afford its interest payments.
Saj: But they're not admitting defeat just yet:
“We do have the money of course...I don’t have a date yet but we will definitely pay.”
Frank: They sound like the degenerate gambler in every mobster movie
Saj: "Come on, you know I'm good for it! The money's no problem, I've got some cash coming my way real soon!"

Frank: How about this chart from Egypt.
Saj: Step 1 in defending a dictatorship: Don't let your citizens assemble/communicate.
Frank: Should governments have internet "kill switches"? This chart says probably not.

Thursday, February 24, 2011

Keys To The Lexmark

Lexmark International (LXK) has a P/E of just 9. In addition, the company has more cash than it does debt by about $600 million. If you back out the net cash position from the company's market cap, the company's P/E falls to just 7! In addition, the company produces returns on equity that are well above its cost of capital. So is this an obvious value buy? Not so fast.

First of all, it's important to consider more than one year's worth of earnings. Last year just happened to be one of Lexmark's better years, as profits more than doubled over the year before, and were even 10% higher than they were in 2007. So how sustainable are these newfound profits? This brings us to an important point regarding the company's competitive position.

Lexmark has had a great year because customers are buying again, and because its recent slate of products is outperforming those of the competition. But in the highly competitive industry of printing solutions, Lexmark is unlikely to always outshine the competition. The company has to continuously innovate just to maintain its market share. Therefore, the risk is ever-present that the company will be bested by competitor products.

This illustrates the idea that just because two companies trade at the same P/E, they are not necessarily similarly priced. One company may have to be both good and lucky to generate its earnings, while another can still profit strongly even if it has an off-year. For example, if Microsoft comes out with a sub-par version of Windows, there is little change to the company's finances; competitors may make some inroads, but customers will largely eagerly await future upgrades. Lexmark, on the other hand, has to keep inventing a better mousetrap in order to stay competitive. This kind of fast-changing industry evolution is the major reason why value investors prefer to stay away from technology companies. When you're trying to predict a company's earnings power, more predictability is better.

Of course, that doesn't mean Lexmark can't pull it off. The company may have excellent internal processes that lead to innovation, marketing and manufacturing prowess that is superior to the competition. But because of the nature of this industry, value investors should be able to confidently assert that these advantages are present before plunging in.

Disclosure: None

Wednesday, February 23, 2011

Time To Remove Those Cash Discounts?

It's no secret that many of America's largest companies are carrying massive cash balances. Unfortunately for basically all company stakeholders (including shareholders, employees, potential employees, governments, customers, suppliers etc.), much of this cash was earned by overseas subsidiaries. But America's tax rules require that such earnings be taxed again if that money is repatriated. As such, in their estimations of a company's intrinsic value, prudent value investors may discount the cash balances of companies which would be subject to repatriation taxes. Fortunately, there are signs that this policy may change, which could provide a boost to the intrisic value estimates of a slew of large corporations.

In Cisco's quarterly conference call last week, CEO John Chambers had some interesting comments about the future of repatriation. Cisco has $40 billion of cash versus a market cap of $120 billion, so this is an important issue for this company. Having attended meetings with President Obama geared towards rejuvenating job growth in America, Chambers is in a position to know how receptive the government is to changing the country's currently punitive repatriation taxes. Here's what Chambers had to say:

"In terms of our country's understanding of the importance of bringing back foreign earnings into our own country's investment for jobs, for plant and equipment, even for acquisitions, I think you're now seeing political leaders at all levels understand that...I think this one has well over a 60% probability of being resolved in a positive way and I do believe that people in the administration are much more receptive to this than they were just six or 12 months ago for combinations of reasons."

Such a move by the government would not be unprecedented. In 2004, the US drastically cut repatriation taxes in order to stimulate the economy. But it was a one-year wonder. Perhaps this administration has a more long-term solution in mind.

Either way, if a relaxation of repatriation taxes were enacted by this regime, whether temporary or permanent, shareholders owning companies with such large foreign cash balances (e.g. Cisco, Intel etc.) would benefit. Value investors who discount the cash holdings of overseas company subsidiaries may be underestimating the value of those companies, particularly in cases where those companies are carrying large cash balances relative to their market caps.

Disclosure: Author has a long position in shares of CSCO

Tuesday, February 22, 2011

Kirkland's: The Falling Knife Turns Upward

Just three months ago, shares of Kirkland's (KIRK) fell 17% to nearly $10/share. At that price, the stock was brought up as a potential stock idea as its P/E was only 6 after subtracting out the company's net cash position. Last week, however, the shares traded up close to $16/share, resulting in a very strong return over a very short period. The lesson for investors is simple: catch the falling knife, and sell it to Mr. Market once it's no longer falling.

There is a multitude of research that suggests that stocks that underperform the market tend to outperform the market in subsequent periods. Despite this, the mainstream media and analysts continually advise against buying a stock that is falling. This is terrible advice. Panic-selling can often create just the opportunity the value investor is waiting for.

Of course, this doesn't mean one should buy just any falling knife. All investments must be studied and vetted carefully. A company's current financial position and future earnings power must always be considered relative to its asking price. But "falling knives" should be welcomed as potential opportunities, and not situations to be avoided.

Near $16/share, Kirkland's stock is no longer the steal it was just three months ago. The company's P/E (now near 10) faces upward pressure as same-store sales are declining in the high single-digits. However, the company's financial position remains strong, as Kirkland's has $60 million of cash against no balance sheet debt. Nevertheless, the company likely trades a lot closer to fair value than it did when it was identified as a potential value opportunity. (And even if it is still slightly undervalued, it is likely better to be approximately right than precisely wrong.) This offers value investors a chance to get out and deploy their capital towards the next opportunity.

Disclosure: No position

Monday, February 21, 2011

Irrational Exuberance: Chapter 11

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 final chapter, Shiller warns of the dangers of ignoring the high price level of the market. While to the observer it may seem that all a stock market crash would do is bring prices back in line with where they were a few short years ago, Shiller notes that the losses would be particularly harsh on certain groups. For example, someone who invested early and has been selling will do just fine; but someone who invested all their money at the end of the bull market will face devastation.

Shiller discusses a few factors which could derail the market. Among them are the following (keep in mind that he wrote this in the year 2000):

- foreign competition
- an oil crisis
- newly discovered problems with the longer-run consequences of incentive-based compensation for employees
- a war
- a terrorist attack (this was written just a few months before 9/11)
- systemic problems due to a failure of major banks

Sunday, February 20, 2011

Irrational Exuberance: Chapter 10

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.

There is another prevailing theory at the time of writing (the year 2000) that has been used to justify the apparent high stock prices: the public has learned about the benefits of investing in the stock market. Shiller explores this idea in this chapter.

Armed with historical statistics spanning decades and even centuries, investors of the year 2000 may have finally learned that stocks do provide strong returns over the long-term. As such, the theory would argue that stocks will no longer go down to their previous levels, as the risk premium built into stocks is now all but gone.

Shiller notes that this "learning" that has apparently taken place in the late 1990's also took place at other points in history. He cites numerous publications where these arguments have been made in previous bubbles decades earlier! Shiller points out that if the public did indeed learn that stocks provide strong returns over the long-term, they have learned it before, and they have also un-learned it during periods of deep decline.

Shiller also debunks the myth that investors have accepted that stocks outperform bonds over all lengthy periods. Furthermore, his surveys of both institutional and individual market participants demonstrate that investors have learned an awful lot of untruths that they may soon unlearn.

Saturday, February 19, 2011

Irrational Exuberance: Chapter 9

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 attempts to debunk the Efficient Market Hypothesis (EMH). The idea behind this theory is that if there were profit opportunities in the market, smart people would exploit them, and therefore the wealth of these people would grow, resulting in a bidding up (down) of undervalued (overvalued) assets. In such a scenario, there would no longer be profit opportunities; thus, capital markets correctly reflect available information.

Shiller argues that this interpretation does not allow for periods of mispricing that take years or decades to correct; in such situations, smart people could not make money rapidly, and therefore these opportunities would not neccessarily disappear.

As counter-examples, the author discusses a few companies of the day that cannot possibly be priced correctly. For example, eToys traded for $8 billion in 1999, despite sales of just $30 million and negative profits. Shiller also discusses some of the other bubbles that have occurred in history, including Tulip Mania in Holland.

Finally, Shiller cites extensive research that has shown various systemic problems with EMH. For example, low P/E, low P/B, and high-dividend paying stocks appear to outperform the market. Furthermore, stock price volatility appears not to correlate well with dividend volatility; instead, price volatility is extreme in relation to dividend volatility, which should not occur if stocks are supposed to be worth the present value of future dividends.

Friday, February 18, 2011

Are Your Fellow Shareholders With You?

Management will act in its own best interests, and for this reason investors should ensure that management's interests are aligned with theirs. Sometimes, however, management may be swayed to act in the interests of major shareholders, whether under the threat of a hostile takeover or as part of a courtship process for a friendly merger. Investors armed with this knowledge are in a position to better understand what is about to take place, and may thus make investment decisions that are in tune with their investment strategies.

For example, value investors can take a hint as to the company's future capital allocation plans if a company under review already has a large shareholder with a history of a preference for companies which return capital to shareholders vs those which try to empire-build. But to the aspiring value investor, finding this information isn't always easy.

Shareholders who peruse SEC company filings will have come across Schedule 13d from time to time. This is a mandatory filing that must be submitted by anyone who owns more than 5% of a company. On this form, major shareholders are required to disclose who they are, their relationship to the company, and even the motivations behind the transaction (though that can be conveniently changed at a later time).

But even if the schedule itself does not make the motive of the purchase abundantly clear, researching the large investor's background may help clear up uncertainties with respect to the company's near-term future. For example, if Berkshire Hathaway has taken a large stake in a company, it may be seen as an endorsement of management. On the other hand, if Carl Icahn is the buyer, director and management changes may be on the way!

That management should act in the best interests of shareholders is often discussed, including on this site. Implicit in this idea, however, is the notion that all shareholder interests are the same. Unfortunately, this is not always the case. However, disclosures are available which can aid the shareholder in determining whether the interests of major shareholders are aligned with theirs.

Thursday, February 17, 2011

Envoy Capital: Now Trades For What It's Worth

Seven months ago, Envoy Capital was brought up on this site as a potential value opportunity. Today, the stock price sits some 60% higher, even though the value of the business has actually declined over this period. This was no fluke. Investors who paid attention saw a situation where upside potential clearly trumped downside risk, thanks to a massive margin of safety.

Envoy Capital traded for just $8 million despite net current assets of $16 million. Most of the current assets were in cash or various market securities. The company protected its portfolio to some extent by purchasing put options on the general market, which can be a drag on returns but adds a level of safety. In addition, the company has over a million dollars worth of real estate property in Toronto.

Management clearly recognized the disparity between the company's price and the value of its holdings. As such, it initiated share-buybacks and followed through on many of them, raising the value of each share in the process (thanks to the large discount to book value).

Furthermore, there were signs that the market value of the company's securities was worth more than its stated value. This was due to the fact that one of the company's holdings showed strong price appreciation before the company announced its latest results. Based on the company's price action, the market appears to have only caught on to this after Envoy's results came out, allowing astute investors the opportunity to profit ahead of time.

Finally, what gave the company's price its final push toward intrinsic value was a private sale of 19% of the company's shares to a new management team that is taking the helm. The price the major shareholder received in the transaction was $1.55/share, which is still far below the company's book value (as of its latest financials) of $2.18. However, the company also announced a restructuring of about $0.70 per share, most of which will likely take the form of cash payouts to the ousted management, since the company doesn't have a lot of fixed assets to write down.

As such, the private stock transaction took place at about the same price as the company's new book value after taking the "restructuring" costs into account, which is about what you'd expect. But the shares currently trade a little bit above that level, offering current investors the opportunity to get out at a fair price.

Over the years, shareholders in Envoy Capital have lost a lot of money. However, those who invested when the price traded at a significant discount to its value (which has been possible for most of the last year, including just last month) managed to make a ton. Now that cash should likely be pulled out and deployed towards the next opportunity.

Disclosure: No Position

Wednesday, February 16, 2011

Hint, Hint!

Value investors tend to favour quantitative over qualitative factors when evaluating stocks. Nevertheless, it is absolutely imperative that investors go beyond the quarterly reports in evaluating a company's prospects.

In the past, we have seen many instances where qualitative information gleaned from conference calls has been useful in determining the future direction of the business. For example, it was clear that Acorn International was under pressure to pay out some of its large cash balance. It was also clear that Quest Capital was intending to buy back shares as quickly as regulations allowed. Qualitative factors such as these allow investors to make more accurate quantitative assessments of a company's intrinsic value.

Throughout a quarter, in between conference calls and financial reports, companies will also release material filings. For example, last week GameStop released a filing that gives a strong suggestion that the company is in buy-out talks. The filing stated that contracts with certain executives (including both GameStop's CEO and CFO) were amended such that these key employees could not terminate their contracts following a change-in-control of the company's shares. This suggests a buyer has expressed interest, and wants assurances in writing that he'll be able to keep the current management team. While this particular filing may not change an investor's estimate of the company's value, it does certainly increase the likelihood of a catalyst, for those who are into such things.

For part-time investors, there are options that can make it easier to stay in touch. For example, one can subscribe via RSS to a company's filings or press releases. Investors then only have to consult their RSS feeder every now and then to see all the filings of all the companies they follow. Companies will make disclosures throughout the quarter, and the onus is on investors to follow along.

Disclosure: Author has a long position in shares of GME

Tuesday, February 15, 2011

Imation: Mr. Market Cheers, But Risk Goes Up

Sometimes a company is so cheap, that a value investor can make a significant amount on it even when its management pursues strategies which are "anti-value". Consider shares of Imation, a company that has been previously discussed on this site as a potential value investment. The shares rose significantly last week after the company reported its latest results. But while the company's cash position is still 2/3's of its market cap, management appears to be making decisions that are increasing the company's risk.

Imation has decided to undertake a "new strategic direction as a global technology company dedicated to helping people and organizations store, protect, and connect their digital world". This certainly sounds like great news for global citizens with disconnected digital worlds, but what does it mean for value investors?

1) "The Company announced today a new $35 million restructuring...The restructuring will result in approximately $30 million of future cash expenditures."

Imation is a perennial "restructur-er". Write-downs in 2010 included $78 million, made up of some Goodwill write-downs, some severance pay, property writedowns, equipment sales etc. What's unattractive about this new restructuring is that it is not just a write-down of some long-lived asset that is not performing; it will require a cash outlay.

2) "[In addition], the Company expects incremental organic investment of $15 million focused on technology; expanded sales and marketing coverage for the VAR (value added reseller) and OEM channels; improved decision-support tools in IT, and international expansion, focused on China."

Imation is not very profitable, and hasn't been for a while. So when management is deciding to continue to invest, rather than return its strong cash flows to shareholders, risk increases.

3) "The Company also anticipates investments through acquisitions...with the potential for several acquisitions each ranging from a few million dollars to $50 million."

More cash (of amounts unknown at this time), will be expended on high-tech products with uncertain futures.

4) "[A] stock buyback, restarting share repurchases under the Company's existing board authorization of 2.3 million shares"

This is a case of too little, too late. This authorization represents just 5% of the company's outstanding shares, and has already been in place for a while. While the company has generated $200 million of cash from operating activities in the last two years (which is almost half of today's market cap!), Imation has paid no dividends and bought back no shares over this period, even though shares were a lot cheaper a few months ago than they are today.

So rather than return cash to shareholders, management appears bent on growing the business even though it has shown an inability to do so thus far. At the current price, and considering the uncertain investments management wants to make going forward, value investors who purchased (for the reasons discussed here) back when the stock was 30-40% lower last year or the year before may want to cash out and look for more value-friendly investments.

Disclosure: None

Monday, February 14, 2011

The Safer and Cheaper ADDvantage

While most stocks are rising in this heated market, there are still a few names that investors are kicking to the curb in favour of the hot numbers. Following the company's earnings release last week, shares of ADDvantage fell 10%+, offering investors an entry point for the stock at a fairly cheap price.

The last time ADDvantage Technologies was discussed on this site, the stock was significantly more expensive, and its business risk was significantly higher. In just a few short months, however, both of these issues have been corrected!

First, the company's stock price has fallen 25% from its December high. The company now trades for just $27 million, despite operating income of $34 million (including $7+ million in fiscal 2010) over the last four years. This company is a steady earner, as operating margin has only fallen below 15% once in the last 8 years. (In 2009, operating margin fell to a still healthy 13.7%.) Considering the strong and steady earnings, the company is also conservatively capitalized, with cash of $10 million against debt of $13 million. (There is a $1 million penalty for prepayment of debt, which is why the company is maintaining both a high cash and debt balance.)

But in the months leading up to December, the worry for value investors about ADDvantage was the upcoming expiry of its contract with Cisco, which supplies 35% of the products ADDvantage sells. But late last year, ADDvantage and Cisco finalized a new agreement whereby ADDvantage is now allowed to sell more Cisco products than it was previously!

As a result of price appreciation last year, ADDvantage is a stock that already currently appears on the Value In Action page, following a stint on the Stock Ideas page. But as a result of its recent price drop, along with the reduction in risk associated with the new Cisco agreement, it returns to the Stock Ideas page anew, as the stock once again appears to trade at a discount to the company's earnings potential.

Disclosure: Author has a long position in shares of AEY and CSCO

Sunday, February 13, 2011

Irrational Exuberance: Chapter 8

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.

This chapter is about herding and epidemics. Shiller explores the idea that humans (including investors) do not necessarily think independently, which leads to similar thinking and therefore similar investment decisions.

Shiller cites experiments by Deutsch and Gerard that illustrate that individuals will side with the opinions of a large group of people over even their own opinions! The experiments demonstrate that people believe the majority view to be accurate even when it conflicts with their own independent conclusions.

Even rationally-behaving people can fall victim to herding as a result of an "information cascade". Shiller describes an example where a customer encounters two empty, identical restaurants. He must choose randomly between the two, with no other information to go on. But the next customer that arrives has the benefit of seeing the choice of the first customer, which, absent other information differentiating the restaurants, may sway him to choose the same restaurant, on the basis that the first customer knew something he didn't. This cascade can continue as more customers arrive, resulting in one full and one empty restaurant, despite there being no discernible difference between the two.

People also accept long-standing sayings as fact, as a result of trusted word-of-mouth communication. Such myths usually start with the words "They say that...", and are believed by those who both hear and speak them. Shiller debunks a few of these common sayings: that only 10% of the human brain is used by most people, that the birth rate jumped after a power blackout, and that there were an unusually high number of suicides during the 1929 crash. People prefer to take a free ride on items like these; they will believe that some expert has confirmed it, and so they will go along with it. They are likely employing these same behaviours when they invest.

Saturday, February 12, 2011

Irrational Exuberance: Chapter 7

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 now takes on the question of why the market is at the level it is at. This is an interesting question because it is not known to any degree of accuracy what the right market level should even be.

First, Shiller takes issue with popular accounts of investing psychology. These accounts would have you believe that investors are euphoric during booms, and panic-stricken during busts. But Shiller argues that this is not the case; instead, investors during these periods are trying to be sensible, but perhaps have certain modes of behaviour that guide their actions during periods of uncertainty.

But why would the Dow be priced at 14,000 as opposed to 4,000? What is causing the market to choose one level over another? Shiller believes two psychological anchors in particular play prominent roles: quantitative anchors and moral anchors.

Quantitative anchors have to do with what prices or price changes investors may believe to be appropriate, even if those beliefs are sub-conscious. Examples include yesterday's price, P/E levels of similar companies, and previous highs or lows. Quantitative anchors make the investor think an asset's price should be at a certain price.

Moral anchors, as defined by Shiller, have to do with the investor's opportunity cost for his money. Would the investor rather have X number of dollars tied up in the market, or has it reached such a level that he believes he should sell some shares to improve his standard of living? Moral anchors in the aggregate make this determination for the market.

Friday, February 11, 2011

There's Good Debt and Bad Debt

Companies with lower risk can afford to take on more debt than the average company, as their low-risk nature allows them to service debt even when the going gets tough. In the finance industry, the term "low-risk" in this case usually equates to stable revenues and costs. But stable revenues and costs of the past cannot on their own constitute a sign that a company has low risk, for there are many oft-ignored elements that combine to form a company's risk.

Consider Cinram (CRW), producer of the DVDs and CDs on which music, movies and games are distributed. One would expect this to be a fairly steady industry (with the exception of the requirement to adopt new portable media technologies as they evolve) and the company had shown very steady revenues over the last few years. As a result, the company loaded up on debt, both to lower the cost of capital and to fund acquisitions to increase its market reach and scale.

Unfortunately, despite the stable outlook for the industry and the company's stable history, there was a large risk embedded in this company that both creditors and the company's managers appear to have overlooked when they loaded up on debt a few years ago (and subsequently made the problem worse with share dividends and buybacks that further weakened the company's financial position): the concentration of its customers.

A large amount of business coming from just one customer represents a significant risk. Companies in this position should be wary of taking on too much debt, on the chance that the major customer has a change of heart or goes belly up. In Cinram's case, 28% of revenues came from Warner Brothers, who last year had a change of mind about its DVD supplier. What you have now is a company with operating leverage suffering a large revenue cut, with debt obligations it can no longer afford. On the news of the loss of the major customer, the stock dropped 60% and has dwindled ever since.

Since the first rule of value investing is "never lose money", situations like these must be avoided. While large amounts of debt can be okay for some companies, a superficial glance at the company's industry and operating history do not suffice in evaluating whether the company merits a low-risk moniker. Some additional revenue risks are considered here. Only companies that pass such considerations with flying colours should have high debt to equity levels.

Disclosure: None

Thursday, February 10, 2011

Urbana: I Snooze, I Lose

Yesterday, I was all set to buy shares of Urbana Corporation. Unfortunately for me, the stock rose some 40%, and I was too late getting in there. It would have been an incredible rate of return had I just been ready to buy it one day earlier; but instead it turned out to be a missed opportunity. Here's the post about Urbana that I had ready to go; alas, it is now out of date because of the one day change in the stock price:

Stock exchanges like the NYSE and NASDAQ have moats that help them earn above-average returns in normal years. During trading hours, they offer investors, institutional and individual alike, an unparalleled environment by which trades may be executed. As such, stock ownership of these exchanges comes at a premium price, unless that ownership is made through shares of Urbana Corporation (URB).

Urbana Corporation owns $160 million worth of securities, almost all of which relate to the ownership of various exchanges around the world. For example, Urbana's top three holdings are NYSE Euronext, Chicago Board Options Exchange, and Bombay Stock Exchange, which respectively comprise 36%, 25% and 16% of Urbana's portfolio.

So far, there is no reason for investors to get excited. After all, every investor could purchase shares in public exchanges himself. But what should get value investors excited is the fact that Urbana only trades for $100 million! This means investors are getting a 38% discount on this basket purchase of a few exchanges.

Due to the large discount to net asset value, the company has begun buying back shares. In the last six months, it has repurchased and cancelled about 5% of its shares, and authorization remains in place for continued buybacks of a similar amount over the next six months. Due to the large discount to net assets at which Urbana trades, this has served to increase the net asset value of each share.

But a large discount doesn't necessarily mean investors will make money. The exchanges Urbana owns could drop in price. Competition is growing for alternative trading platforms, which could erode the moat of some of the mainstream exchanges. Not only are after-hours exchanges gaining in importance, but so is the trading of unconventional investment vehicles on niche platforms.

But the good news is that even if you believe there is a chance that the major exchanges are on the decline, you can still make money off Urbana by hedging your bet. Almost 70% of Urbana's portfolio consists of publicly traded securities, allowing investors the opportunity to neutralize their portfolio effects by shorting the ones they believe trade at premiums to intrinsic value. As for the remaining 30% of Urbana's portfolio, which consists of privately-held shares, those are thrown in for free at Urbana's current price anyway!

It is also worth noting that shares of Urbana that are available to the public (Class A shares) have no voting power. So if management stinks it up and shares lose value, investors as a group won't be able to oust management; Instead, all they can do is sell their shares in the hope that somebody else will take them.

Nevertheless, Urbana offers investors assets at a large discount to their publicly traded values. As such, this appears to be a situation where upside potential trumps downside risk. Investors concerned with the viability of certain public exchanges are even offered the opportunity to hedge those specific returns out of their investment in Urbana, which reduces risk even further.

Thanks to Trevor Scott for the find!

Disclosure: No Position

Wednesday, February 9, 2011

Hidden Assets

We've focused a lot on hidden liabilities on this blog, because they are important. Company liabilities that don't show up on the balance sheet (such as operating leases and outstanding stock options) must be accounted for, or investors could be way off in their estimations of a company's value. But sometimes, companies have tangible hidden assets as well.

For example, consider Lorex Technology (LOX), a provider of security camera solutions. In its last quarter, the company earned $2.7 million on a market cap of just $10 million. But it's important to realize that much of those earnings were not sustainable; the company only earned operating income of $1.8 million. A large part of the earnings, therefore, came from the realization of an asset that wasn't even on the balance sheet: tax losses from previous years.

This is a tricky one, because sometimes companies do include future tax benefits as assets, and sometimes they don't. It comes down to how likely management thinks gains will be realized to offset the losses. But even if a conservatively-inclined management doesn't include the tax assets on the balance sheet (by taking a valuation allowance against them), they will still be written about in the notes to the financial statements. Armed with the knowledge of the company's tax losses, investors can then make their own decisions about how realizable those tax benefits are, and thus incorporate these assets into their company valuations.

In most cases, these valuation allowances against tax assets won't amount to much. But in other cases, they can be a large and determining factor, particularly as many companies emerge from a recession where they saw large losses. Therefore, it's important for investors to know to look for such accounts when formulating their valuations.

Disclosure: None

Tuesday, February 8, 2011

GameStop: Buyback Game Theory?

Why do companies extend buyback authorizations when they haven't yet completed buybacks under previous authorizations? For example, last week GameStop announced that it was increasing its buyback authorization to $500 million. But under the previous authorization for $300 million, $138 million still remained available. Considering that buyback announcements usually result in an immediate stock price gain (and sure enough, shares of GameStop did rise a few percentage points following the announcement), wouldn't it make more sense to exhaust the remaining $138 million at lower prices, and then later announce a new authorization for the remaining $362 million?

Instead, by going the route it did, management is making it evident that it does not want to spend that $138 million now, but may want to spend it, and then some, sometime soon. Under what scenario would such actions make sense? Perhaps in the case of an upcoming earnings miss!

GameStop's latest fiscal quarter ended last week, and so by now management likely has a rough idea as to how the quarter went in relation to expectations. If management anticipates a negative market reaction to the company's latest results, perhaps they feel they can get a better deal on the remaining $138 million by buying back those shares post-announcement.

At the same time, insider sales activity also shows that a director and major shareholder recently sold $30 million worth of shares. Could this be confirmation that management expects to disappoint when it reports holiday season earnings?

Of course, the above hypothetical scenario is only speculation and cannot be assumed as fact. There are other potential explanations for the dollar increase in authorization for the uncompleted buyback plan. Perhaps the company wishes to purchase debt or shares in a large block transaction (and $138 million is smaller than the block desired), or perhaps management wanted to make the announcement to temporarily boost the stock price. (The latter suggestion does appear improbable, however, as it does not jive with GameStop management's historical long-term perspective.)

But the extension of a buyback authorization when the previous one is incomplete does seem like a strange thing to do, though for whatever reason companies appear to do it all the time. In this case, we shouldn't have to wait long to see how it plays out. Fortunately for shareholders, even a miss by tens of millions of dollars still leaves them owning a company that trades at a very low multiple to its cash flow.

Disclosure: Author has a long position in shares of GME

Monday, February 7, 2011

M&F Worldwide Looks Cheap

M&F Worldwide (MFW) trades for just $466 million despite earnings over the last twelve months of $96 million, for a P/E of just 5. Furthermore, M&F's earnings understate its cash flow, as the company amortizes a ton of intangible assets on its income statement; the firm amortizes about $100 million a year from previous acquisitions, mostly under the "customer relationships" account. As such, the company's operating cash flow has been at least $200 million in each of the last three years, making it appear dirt cheap at its current market cap.

But this example illustrates one of the pitfalls of the P/E ratio: it ignores a company's financial risk. In the case of M&F, the company is loaded with debt. The firm owes $2.3 billion to its creditors, the bulk of which is borrowed against M&F's line of credit. Interest payments are based on a floating rate, so the company's net income looks good right now because rates are low. However, should rates tick up, the cost of debt has the potential to increase significantly.

The good news is that the revolver doesn't come due until 2014. So if the business can be counted on to continue to provide stable cash flow, and management applies that cash towards debt repayment, perhaps the company could be looked at as a sort of "public" leveraged buy-out situation, as seen with Supervalu. Unfortunately, neither of those two factors appear to be on the side of M&F.

First, the company derives a large portion of its operating income from check printing. But this industry is in decline, as electronic forms of cash transactions grow in popularity. Second, management is not showing any interest in debt repayment; the firm continues to make acquisitions. Following the release of its latest financials, M&F agreed to purchase a private company for $140 to $160 million. Obviously, acquisitions could bolster the company's earnings. But they also increase the company's risk, as leverage is already rather high.

Finally, there are some ethical considerations of which investors should be aware. A large portion of M&F is owned by Ronald Perelman, who a few years ago tried to sell a company he owned personally to M&F for four times its market value! A string of lawsuits eventually prevented this transaction from closing, but such self-dealing in the future could be harmful to shareholders.

M&F is cheap enough such that it may reward current shareholders handsomely. However, there is enough risk present such that the threat of permanent capital loss is still present. Should the company face operational difficulties at the same time as its debt comes due, an ugly situation could present itself.

Disclosure: No position

Sunday, February 6, 2011

Irrational Exuberance: Chapter 6

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 examines the 25 largest stock market index moves around the world, both over one-year and five-year periods. He then tracks the subsequent returns that occurred following these periods of abnormally strong and weak returns.

Following the strongest one-year returns around the world, subsequent one-year returns for the same markets have been all over the map. Often, extreme strength in these markets has been the result of a regime change that has seen a citizenry oust a dictator or military and regain control of its government.

In the one-year period following the largest one-year declines, however, stock returns around the world are decidedly positive, with only 6 of the 25 instances showing negative in the subsequent year.

Subsequent five-year results following extreme five-year price changes are far more convincing of the "bubble" effect. Following the largest five-year increases, almost all five-year subsequent returns were negative. There were exceptions, however. For example, in the Philippines, a 1253% increase over five years (starting in 1984) was followed by another 43% increase over the next five years. This was the result of a regime change in which a Communist dictator was ousted. In the other exceptions, extreme price gains were the result of extreme losses in previous years.

What went up (down) usually came back down (up). From this evidence, and considering the huge stock run-up of the late 1990's, Shiller surmises that the possibility that the US is currently (at the time of writing, in the year 2000) in the midst of a major speculative bubble cannot be ignored.

Saturday, February 5, 2011

Irrational Exuberance: Chapter 5

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.

It is generally believed that times of extreme optimism result in booming stock markets. The author, however, turns this theory around and argues that strong stock prices cause a society to look for reasons to explain the booming market. In this chapter, the author takes the reader through some of the "new era" thinking that has pervaded the stock market booms throughout the last 100 years.

In 1901, there was huge optimism about how technology was about to change lives for the better. The first transatlantic radio transmission occurred in 1901, and the future was seen as bright: "trains [will be] running at 150 miles per hour,...newspaper publishers will press the buttons and automotive machinery will do the rest,...phonographs as salesmen will sell goods in the big stores while automatic hands will make change."

Furthermore, a recent spell of mergers had reduced competition and increased profit margins. But the level of profits was too high for the people. Antitrust legislation was used against monopolistic companies, and corporate taxes were instituted.

The 1920s were another time of renewed optimism on the basis of technology. The number of automobiles on the road tripled during this period, and US homes had become wired for electricity, resulting in soaring sales for items such as light bulbs, vacuum cleaners and washing machines. Shiller quotes a number of extremely positive articles and books from the period, where the expectation is that civilization is embarking on a new era. Stock projections were parabolic.

"New era" thinking once again permeated during the mid-1950's and 1960's. Growth in the use of devices such as televisions helped fuel exuberance. Ideas that stocks were now held in "strong hands" (mutual funds and institutions) gave confidence that crashes were now a thing of the past. Demographics (namely the Baby Boomers) were cited as further reasons for why "it's different this time".

Following each "new era" came a bout of extreme pessimism. Feelings were often widespread that the US was losing its preeminence to other countries (e.g. Japan). Interest in Communism grew following each crash. Capitalism was often seen as having failed.

Friday, February 4, 2011

Mutual Funds Have It All Wrong

Canada's largest national newspaper notes that "ScotiaFunds Is Tops". Presumably, one might expect this to mean that mutual funds commissioned by Scotia outperformed other funds when it comes to returns. Perhaps the article would then go on to compare the returns ScotiaFunds generated against those of the market, to see whether and by how much this group of funds generated in value for investors after fees. Unfortunately, these types of metrics are not at all what the mutual fund industry is focused on, and the content of this article illustrated that perfectly.

Instead of "Tops" (in the article's headline) referring to the fact that Scotia generated the best return, it referred to the fact that ScotiaFunds had the highest net sales! In fact, the article did not even mention the returns of the group of funds, either the absolute returns, the returns compared to peers, or returns relative to the market itself. What is mentioned in the article, however, is by how much assets under management grew for Scotia, and at what level assets under management currently stands.

Investors who pay attention recognize that the incentive structure of the mutual fund industry is not conducive to generating returns for investors: managers are paid based on sales, not investment returns. As a result, mutual funds are effectively marketing companies rather than investment funds.

Certainly, excellent returns do help market a fund, but there is enough wiggle room for managements in this area to throw off the majority of investors. For example, funds with below-average returns can simply be shut down, leaving the company's remaining funds looking terrific on a historical basis. This creates a survivorship bias in the results, and practically guarantees that future results will not be as good as those of the past appear to be.

Furthermore, fund returns are only a small component of the overall marketability of a fund. Paying high commissions to agents can result in fund sales, as many investors don't take the time to do the research themselves, preferring to take the advice of an "expert" or relationship manager. This advisor just gets a piece of the action, like a credit card processing service such as Paypal. Unfortunately, that "expert" is getting paid to push certain products, and investors who don't recognize this are probably not putting enough thought into their investment decisions.

When buyers purchase homes or cars, they do put in some time and effort to understand what they are buying. For whatever reason, many appear less inclined to do so when it comes to investing their savings. Those who are willing to do some research are at a distinct advantage as a result. These investors are able to buy undervalued stocks, closed-end mutual funds trading at large discounts, and ETFs with their significantly lower management fees.

Thursday, February 3, 2011

Blyth Inc: Flaming Value?

Blyth (BTH) sells an extensive collection of accessories including candles and lotions. The company trades with a P/E of just 7, despite a ttm return-on-equity of almost 15% and despite having more cash than it does debt.

Blyth derives the majority of its sales in an unusual way: at home parties. The company has about 20,000 active US sales "consultants" who organize parties for their friends/acquaintances and make a commission of sales they generate at these parties. For those unfamiliar with this selling model, it may appear to be fad-ish or pyramid-like, but the company has been successful/profitable in this way for over a decade as a public company.

But while the company's P/E ratio is low and its return-on-equity is impressive, there are a couple of noteworthy items that may interest the value investor. For one thing, sales have been declining long before the recession hit. The company is facing competition for similar products from regular retailers and, of course, online channels (where Blyth competes as well). Therefore, while some of Blyth's sales declines are no doubt cyclical, there is likely also a secular component to the declines as well. The good news is that the company has been cutting expenses quickly as well; recently, its profits have risen despite lower sales levels, suggesting the company has had some success with some of its productivity-growth initiatives.

Second, the company's earnings are artificially high over the last twelve months as a result of a large tax benefit. In the last holiday quarter, Blyth paid taxes of just $2.5 million on earnings before taxes of $34 million. Ordinarily, Uncle Sam would not put up with such a low payment for long. However, in Blyth's case, the silver lining is that the company has tens of millions of dollars in losses that it can carry forward for tax purposes, but these are jurisdiction-specific and not a sure thing by any means.

Blyth is cheap and may offer investors both potential upside and decent downside protection. However, potential investors should be sure to have a strong grasp of the company's true earnings power before jumping in.

Disclosure: No Position

Wednesday, February 2, 2011

Cash Levels High Or Low?

If you follow the markets, you have no doubt heard the bull argument that companies are holding record levels of cash, and therefore that should eventually translate into future dividends, buybacks and investments, all of which should drive the market higher. A quick look at S&P 500 cash levels over the last few years does indeed show this to be the case:


But is the index's cash level, by itself, of any use? At the very least, it should be compared with index debt levels. Index debt levels have been on the increase for several years, and only recently have companies in the aggregate decided to start paying it down. By subtracting aggregate cash levels from aggregate debt levels, we can get an idea of how indebted the index is. The following chart shows the net debt level of the S&P 500:


While net debt (debt less cash) is on the way down, it only recently returned to early 2007 levels. Was the market in early 2007 undervalued? Future historians will probably say no. And yet if the index's cash position, relative to its debt, is high today, so it was in early 2007 as well.

The media jumps on attention-grabbing stories such as the record cash levels that corporations are currently holding. But the onus is on you, the investor, to put their stories in proper context. Does record cash mean a whole lot when the capital stock is also at record levels? Does the size of aggregate cash holdings mean anything without a comparison to the size of debt levels? Investors must always go beyond the superficial sound bytes to figure out what's really going on.

Tuesday, February 1, 2011

Diana: Shipping For Dollars

Diana Shipping (DXS) transports dry-bulk cargo using its fleet of 20+ ships. The state of the industry is pretty poor right now, with shipping rates, as measured by the Baltic Dry Index, having fallen quite a bit:


Rates are quickly approaching those of March 2009! (For a description of how this index works, see here.)

Because of the negativity surrounding this industry, the market may have overreacted to the downside. Shares of companies such as Diana Shipping have fallen significantly; the company trades at a P/E of just 7 and at a 15% discount to book value, which is mostly made up of previously purchased ships. But this company is capitalized to outlast a downturn, with a current debt to total capital ratio under 25%.

Unfortunately, this isn't an open-and-shut case, as there are a few risks here. First, Diana relies on four customers for more than 2/3's of its revenue. If Diana were to lose one of these charterers as a customer, it may not be able to secure equivalent terms on new leases.

There are also risks to the company's short-term profits. The company has mostly chartered out its fleet on 2-3 year contracts. If these contracts expire while shipping rates remain low, the company's profits are likely to fall; so while the current P/E is 7, the future P/E could be higher even without price appreciation.

But perhaps the biggest risk to this company is what it can't control, namely the prices of the goods it transports and, perhaps more importantly, the prices of the services it provides. Similar to the airline industry, which is a terrible industry for long-term investors, shipping transportation companies are enormously affected by the mistakes of their competitors. If some shipping companies over-order new ships (which history shows to be quite likely to occur every now and then), all companies, including Diana, will be forced to cut prices.

To succeed in such an environment, Diana must be one of the lowest-cost operators. The problem with this is that it's not an easy thing to do. As Warren Buffett has stated, value investors want to own companies that can be managed by a monkey. But a company that needs to be the low-cost operator needs a skilled management.

Diana looks cheap and may even be cheap. The upside is likely larger than the downside, based on the company's strong financial position and near-term earnings power. Unfortunately, the company's long-term potential is somewhat out of its control, which increases its risk profile for the value investor.

Disclosure: None

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