Thursday, June 30, 2011

New Frontier Media: Pre-Catalyst

Companies with large depreciation charges usually require matching capital expenditures just to keep revenues stable. But in the rare instances where this is not the case, earnings are often a poor proxy for a company's free cash flow. New Frontier Media (NOOF) appears to be a prime example of this phenomenon, to such a large extent that its cash balance at the end of the year may exceed its market cap.

New Frontier Media is a small cap that trades for $25 million. While the company has approximately broken even on an earnings basis over the last three years, it has generated $21 million in operating cash flow against just $9 million of capital expenditures. That trend is set to continue this year, as the company anticipates effective capex spend of under $1 million ($2.3 million in building improvements plus $0.3 million in new equipment minus $1.7 million in tenant allowances that will flow through the income statement).

Since the company already has $18 million in net cash (compared to a trading price of $25 million), its net cash may actually exceed its market cap this year. This could prompt a dividend or buyback that generates strong returns for investors are the current price.

Unfortunately, the company's top executive doesn't own a significant number of shares; his annual salary is three times larger than his actual stake in the business. But to his credit, the company has bought back shares in the past. In 2008 and 2009, the company bought back a combined $13 million of stock. The way the company is building up its cash position at the present time, it is on track to comfortably afford a similar buyback.

Disclosure: Author has a long position in shares of NOOF

Wednesday, June 29, 2011

Asta Funding: Safe and Catalyzed

Asta Funding (ASFI) purchases consumer receivables at large discounts to face value, and then tries to collect more on those receivables than it paid for them. Asta was first discussed on this site as a potential value investment about eighteen months ago due to the significant discount to book value at which it traded. Today, it looks much more attractive.

The problem eighteen months ago was that virtually all of the company's assets were in the form of receivables. Despite the company's history of successful receivable purchases and collections, the high unemployment rate and the country's housing situation was making it hard to collect. Asta lost $90 million in 2009; meanwhile, the company's book value was only $157 million! Without knowing how much the company could actually collect of the receivables on its books, investors would be taking a big risk, despite the large discount to book at which the company traded.

Today, the situation is much improved. A significant portion of the company's receivables have been converted to cash. This lowers the investor's risk, as the company's book value is no longer totally based on uncertain receivables. As of the company's latest release, it has a cash balance of over $100 million. In the company's last quarterly release, it had a receivables balance of $133 million and total liabilities of $81 million. This company trades for only $120 million, however.

Furthermore, the company's book value appears understated due to how the company accounts for its receivables portfolio. As a result, the company is "profitable" as it is collecting on receivables which have already been written-off and are therefore not included in the company's book value.

The biggest risk to this company appears to be management's intentions with the large cash balance. Management noted in its latest quarterly filings that "we are actively seeking investments in, or acquisitions of, companies in the financial services industry." The good news for shareholders, however, is that the company's CEO does own more than 10% of the company, so he is probably more concerned with getting a good deal than growing just to increase his importance and salary.

To that end, the company just announced a $20 million buyback program as share prices fell. The company's stock price is 10% lower than it was last year even though the company's risk is substantially lower (due to its cash collections in the last year). For investors who prefer investing when a catalyst is present, this represents an opportunity, as the company may buy back as much as 15% of its shares at current prices.

In Asta, investors are offered a cash-rich company with management ownership that trades at a discount to a conservative book value. If management does go ahead and buy back shares, this could turn out very well for shareholders, with downside protection in the form of cash and receivables.

Disclosure: Author has a long position in shares of ASFI

Tuesday, June 28, 2011

RIM: The Analysts Were Right

Analysts have been chided quite a bit on this site for their poor predictions and focus on the short-term. So when they get it right, they deserve some credit.

As recently as two months ago, management of Research In Motion (RIMM) re-iterated that it expected earnings per share for the company's fiscal year of $7.50/share. Analyst estimates, on the other hand, clocked in significantly below this level. The difference in expectations between analysts and company executives is even larger in light of the fact that we were already 1/4 through the fiscal year in which these estimates were based!

Two weeks ago, we found out which of these groups would be correct in their assertions; it was not management. RIM shares tanked on the news; the stock now trades almost 60% lower than it did four months ago.

In high-tech industries where product life-cycles are short and disruptive technologies are the norm rather than the exception, company fortunes can turn very quickly. In this case, the sluggish pace at which RIM is bringing new products to market is causing it big problems. But the company's position doesn't appear as dire as market sentiment would suggest.

First, management appears to finally recognize that there is a problem. As of two weeks ago, the company is aiming to streamline its operations to become more nimble and efficient. Headcount reductions (in areas management believes to be non-vital to the company's strategy) have already taken place, and the company's acquisition and capex spree is likely to slow significantly. This should allow the company to generate more free cash flow, and focus management resources on existing assets.

It is also worth examining the main reason for the recent lull in new devices: the company is transitioning to a new platform. As RIM moves its new devices to Blackberry 7, it has been slowed up by delays in the certification process with carriers. The new devices carry more functionality (e.g. HD video) in a smaller package (e.g. the Bold 9900 will be only 0.4 inches thick). Problems have been experienced at the certification stage which have delayed all the new products; but as certification for the initial Blackberry 7 products is now almost complete, the rest of the products under the new platform should experience quicker carrier acceptance.

Despite the fact that the company has been slow to market and has an aged product portfolio which is arguably inferior to that of competitors, RIM is still very profitable as a result of some competitive advantages that have kept it in the game. First, it remains the preference of corporate customers where security is the number one priority. Second, its enormously popular messaging application likely has network effects. The company's commitment to an open platform (for example, RIM's playbook can run Flash, connect via USB and HDMI, and will soon support Android apps, none of which the iPad can do) could also become an advantage in the long-term.

Lost in the competitive shuffle, however, is the fact that this is a growth industry. The market for tablets, smart-phones and other devices and services these companies are working on is relatively nascent. As such, each of these companies will experience tailwinds just from being in an industry that is growing at incredible rates.

Finally, from a price vs fundamental point of view, RIM's stock price appears extremely cheap. Based on the midpoint of the new earnings estimate for the year, RIM trades at a P/E of just 5. After subtracting out the company's $3 billion in cash equivalents (against no debt) from the company's market cap, RIM's P/E becomes just 4.

Nevertheless, risks remain. Management may not be able to execute on its plan to speed up the pace at which it is able to bring new products to market. On this point, once again management appears to sound overly confident that it is doing everything right, as on the latest call both co-CEOs seem to think they have done nothing wrong despite the fact that the company is no longer the market leader. Considering these guys have built the company from scratch and continue to generate very strong returns on capital despite the lowered estimates, however, perhaps they deserve a little more credit than they have been receiving.

Furthermore, even if management does execute and deliver much-improved products to the market, the competition is not standing still either. Both Apple and Android-based competitors are constantly innovating, with Microsoft also looming as Nokia will soon enter the market with Windows phones. This industry is characterized by fast changes, which remains the biggest risk to this company for value investors.

With the lowered share price, profit potential for shareholders is remarkably high. But downside risks remain if the company's competitive situation continues to deteriorate.

Disclosure: Author has a long position in shares of RIMM

Monday, June 27, 2011

Asset vs Earnings Managers

Value investors can spend a lot of time evaluating the quality of a company's management. We look at management's track record, and attempt to gauge the level of management's candor in providing information to shareholders.

But when it comes to companies that trade at large discounts to their net assets, is this exercise worthwhile? Thanks to our capitalist system, managers who are not getting the most out of company assets will often be replaced, a process which can often serve as the catalyst that helps a stock's price converge with its intrinsic value. By avoiding the companies with poorly performing managers, shareholders may be missing out on the potential for large gains.

Consider RCM Technologies (RCMT), a company we discussed about a couple of years ago as one that traded at a deep discount to its net assets despite a flexible cost structure and therefore a decent earnings outlook. Nevertheless, management's poor capital allocation decisions in the past and their seeming intentions to continue to "build empires" had me avoiding the company.

But those who were willing to take the plunge despite the management situation would be rewarded. The company subsequently received a buy-out offer at a price which is about twice that of what it was when it was brought up on the site. This is a classic case of getting rewarded for buying assets for less than they are worth.

For companies expected/required to generate above-average returns on capital, the management team is likely a very important factor in determining whether the investment makes sense. But perhaps we place too much emphasis on the management team when it comes to companies trading at large discounts to their assets. After all, management teams can be replaced, and shareholders can get rewarded in the process. On the other hand, buyouts are difficult to predict and may not occur with enough frequency to remove every poorly performing management in a timely manner.

The right decision is not always clear, but investors should keep in mind that the importance placed on the management team in weighing an investment decision may change according to the type of investment (e.g. an earnings play vs an asset play) being made.

Disclosure: None

Sunday, June 26, 2011

How We Know What Isn't So: Chapter 8

Value investors believe the market is not perfectly rational. To understand why, an examination of human behaviour is required. In How We Know What Isn't So, which is recommended by a number of value investors and behavioural economists, Thomas Gilovich explores the fallibility of human reasoning. Only by understanding our flaws can we seek to improve on them, thereby ameliorating our decision-making processes.


This section of the book ties in some of the tendencies discussed in previous chapters in order to discuss some common beliefs in society that appear to be false. In this chapter, the field of alternative health practices is discussed. Alternative medicine includes categories of health treatments (e.g. homeopathy, holistic etc.) that fall outside of conventional medicine.

Many believe that there is nothing wrong with such beliefs in alternative medicines, as they can only help and not hurt. Gilovich takes issue with this argument. The author cites research that suggests medical quackery kills more people than those who die of violent crime. In addition, it costs Americans tens of billions of dollars per year that could otherwise be spent on more helpful medicines and research.

Despite the fact that many facets of alternative medicine have been debunked, it remains a popular choice for patients and their families. It is most popular when the limits of conventional medicine have been exceeded (e.g. incurable diseases). One reason for the popularity of alternative medicines is that there is a will to survive, and therefore patients are willing to cling to any idea that has even a remote chance of helping.

But a large percentage of illnesses for which we seek treatment are cured by the body by itself. Therefore, in many cases the administration of medicine may seem as though it cured an ailment when it did not. In such cases, a patient may be convinced that the treatment works; unfortunately, he is often not willing to consider outcomes he did not get to see (e.g. what would have happened had he not gotten the treatment).

Furthermore, anecdotal evidence suggesting that a treatment has worked is celebrated by the industry, whereas evidence against is often deeply scrutinized and explained away, often blaming the psychological makeup of the patient/victim.

A number of alternative medicine techniques are explored and discussed. A common element is that they rely on representativeness (like-like associates, such as matching symptoms with treatments that are plausible, but not scientific).

Saturday, June 25, 2011

How We Know What Isn't So: Chapter 7

Value investors believe the market is not perfectly rational. To understand why, an examination of human behaviour is required. In How We Know What Isn't So, which is recommended by a number of value investors and behavioural economists, Thomas Gilovich explores the fallibility of human reasoning. Only by understanding our flaws can we seek to improve on them, thereby ameliorating our decision-making processes.


This chapter is about how we are heavily influenced by what others think. For example, we think a movie to be worthy if others do.

The thoughts of others can be a terrific source of information. After all, if most people believe something to be true or false, they are usually right. Unfortunately, however, this reliance on others can lead to errors when the crowd is wrong.

Gilovich also argues that we believe others to have the same beliefs we do. This occurs because we lack proper feedback from others. Part of the reason for this is that we associate primarily with people who share our beliefs and values. But even when we do encounter people with different beliefs, we are rarely challenged. This is because people have a general tendency to avoid conflict.

(Interestingly, this applies only to adults. Children are much more brutally honest with each other, so children get a lot of feedback on how they affect others, whereas adults don't. For example, Gilovich argues that an adult is much more likely to return from a social function with broccoli-teeth or an unzipped fly, whereas these mishaps would be pointed out to an offending child at a social gathering for kids.)

Such tendencies can lead to Groupthink, which can have disastrous consequences. When groups of people are put under pressure to produce an action plan, personal reservations are often kept quiet in order to maintain consensus. This can lead to a poor, improperly vetted plan riddled with error.

Friday, June 24, 2011

Media Spin

When you are presented a story, it's quite likely you are not given the whole picture. The story teller usually has a motive; he wants to keep you interested. As such, he will filter from the story any factors that are likely to mitigate your shock and awe at what he has to tell you. Not only is the mainstream media not immune from this process, they may be its purveyors-in-chief. As an example, consider a recent story from the Globe discussing BP's annual Review of World Energy.

The headline of the story reads "BP report raises doubts about global oil supply" justified by the fact that the "global oil industry found the equivalent of only a fifth of the oil it used last year". If it were true that the oil industry only replenished one fifth of what it drew down, that would be rather alarming.

But according to the BP report, global oil reserves actually rose in 2010! Proven reserves increased by 6 billion barrels despite 2010 global consumption of about 32 billion barrels. Therefore, in actuality, the global oil industry found the equivalent of 120% of what it used last year, giving the world a reserve to production ratio of 46.2 years.

Of course, all of these numbers are based on the report. I make no attempt to prove or disprove the findings of the report; I simply take issue with the alarmist media claims.

In this case, the article probably crossed the line between fiction and reality. But the media can shock and awe just as easily even by remaining within the boundaries of truth. One of their favourite techniques is described in Thomas Gilovich's book How We Know What Isn't So.

Gilovich describes how confidence intervals are exploited by the media. For example, if the infection rate for a disease is estimated between 0.05% and 5%, the media will jump on the most extreme level with a authoritative headline such as "Scientist: Infection Rates as High as 5%" and an article meant to alarm.

There is media spin in everything you read, which will make you believe things that aren't true. Be skeptical. Look for what you're not being told. Often, you can also combat the spin by going straight to the source of the research on which the article was based. (For example, the BP Review of World Energy is available here.)

Disclosure: No position in oil stocks or derivatives

Thursday, June 23, 2011

Earnings Power When Assets Change

As demand fluctuates, companies with variable costs can scale up or scale down their operations as neccessary. Companies with fixed-costs, however, have tougher decisions to make. While they can cut costs by disposing assets in the face of waning demand, this ends up reducing capacity, which can bite them later. Over the course of this recession, many companies with high fixed costs that have earned tremendous profits over the last several years have had to dispose of assets at fire-sale prices in order to better align expenses with revenues. For the investor assessing whether a company's stock price trades at a discount to its intrinsic value, how is he to determine a company's earnings power in the face of such asset impairments and plant shutdowns?

For companies in stable industries, we have advocated employing Ben Graham's approach to determining a company's earnings power. While this approach of using a company's average earnings over a representative period is appropriate when the level of assets has not changed substantially, it may not be as useful at a time like this when companies are disposing of significant amounts of fixed assets.

Using the company's current earnings is also not an appropriate measure of a company's future earnings power. Current earnings are riddled with red ink due to current charges for labour reduction programs, asset impairments, and revenue drops that outpaced cost reductions.

While not perfect, a better method to estimating a company's future earnings power when assets have been impaired is by examining the company's record of return on assets. Provided the company is in an industry where technological advances are slow and where prices are stable, there will be, at the very least, a loose relationship between a company's earnings and its assets. By averaging a company's past return on assets over a representative period, and then applying this return to the company's current level of assets, the investor can get a better idea of the company's earnings power than if he estimated earnings power by simply extrapolating the company's current earnings, which are influenced by temporary effects.

The importance of limiting the application of this procedure to companies with price stability can not be stressed enough. For companies in commodity industries with volatile pricing, past returns are not neccessarily reflective of future earnings, and therefore the accuracy of this method reduces to the point where its usefulness is rather limited.

However, even if applied appropriately, it is important to note that this method of calculating a company's earnings power is by no means an exact science. Earnings will rarely be exactly proportional to a company's level of assets. However, for companies in slow-changing industries where price levels remain stable, an examination of the relationship between earnings and assets should assist the investor in making a more informed decision about the earnings power of a company under examination as a potential investment.

For a more advanced exercise, investors considering an investment in a capital intensive business may also try replacing return on assets with return on fixed assets, using a budget worksheet.

Wednesday, June 22, 2011

Adjusting For Working Capital

Many investors, value and non-value alike, subscribe to the idea that a company is worth the sum of its future cash flows discounted to present value, minus net debt. (The main difference for value investors is that they will attach little, if any, credence to predicted growth rates in estimating future cash flows.) But circumstances can alter the "net debt" amount such that it can have a substantial bearing on the overall valuation.

As an example, consider Dorel (DII.B), a maker of juvenile products (e.g. car seats), bicycles, furniture and related products. Sales in the fourth quarter of 2010 were weaker than expected, resulting in a build-up of inventory as retail customers curbed ordering.

Three months later (to March 31st), inventory has come down in a few product lines, but is still high as the company expects a strong upcoming quarter in its bicycle division and does not want to run out of product. This inventory build is seasonal, as spring weather ushers in renewed consumer interest in this category.

Further affecting Dorel's working capital is the fact that many of the company's sales in the first quarter occurred in March, the final month of the quarter. This has the effect of bloating the company's receivables account, since many products have been delivered but have not yet been paid for.

The final effect on working capital is significant. To the casual observer, Dorel could appear to be a company relaxing sales terms to hit volume targets (hence the increase in A/R) with looming potential writedowns on the way (due to a high inventory balance). But for investors who trust this weathered management team, an adjustment to working capital is in order; this is because once the company's inventory and receivable balances return to normal, the company's net debt position should decrease.

In estimating the intrinsic values of companies under study, investors should be sure to adjust for balances that are out of step. Just as earnings should be "normalized", so too should balance sheet accounts that are out of whack. This will ensure a more accurate estimate of the business' long-term value.

Disclosure: Author has a long position in shares of DII.B

Tuesday, June 21, 2011

Economic Data In Real-Time

Every week/month/quarter, a number of closely-watched economic indicators are reported that have the potential to move markets. For example, the monthly jobs report is hotly anticipated, while same-store sales numbers for individual retailers can move the stocks of these companies significantly. Gathering, formatting and then reporting this data takes time, however, resulting in lags between when the events are occurring and when they are reported to us. New technology, however, may be rendering these reports obsolete, by allowing us to access closely correlated proxies to these and other data in real-time.

Google Correlate allows users to submit a time series (e.g. monthly new house sales in the US over the last several years) and then spits out a search term that correlates best with that data (e.g. "real estate agencies"). Google Trends can then be used on the relevant search term (e.g. "real estate agencies") to predict what this month's new house sales are looking like, well before the official data is released following the end of the month.

Wharton economist Justin Wolfers takes us through an example. He uploaded weekly unemployment claims to Google Correlate, which offered him a search phrase which best fit this data: "filing for unemployment". The correlation was 0.91 (a correlation of 1 means perfect correlation, while a correlation of 0 means no correlation), suggesting that we can guess how many people are filing for unemployment based on aggregate data of how many people are searching using the term "filing for unemployment"! Here's how the data track over time.

In many cases, the economic reports we (eventually) receive are derived from survey and not actual data. As such, it is reasonable to believe that there are some instances where aggregated search (or other real-time) data may be a more accurate measure of the economic event that is being measured! If this is true, many of the economic reports we consider dear today may be obsolete relatively soon.

For more examples of this idea in action, see this paper from Choi and Varian.

Monday, June 20, 2011

Taitron: Promised Cash

Taitron Components (TAIT) has been discussed on this site as a potential value investment. The company has a bloated inventory position; inventory sits above $12 million, while annual sales are barely over $7 million. This is where the value opportunity comes from, however, as the company trades for significantly less than its inventory position.

Management recognizes that inventories are too high, as per the following statement in Taitron's most recent quarterly report:

"[W]e are focused on lowering our inventory balances and increasing our cash holdings."

But even as inventory has been slowly decreasing, the company's cash balance has not been rising. A major reason for this is that the company has been funneling money into joint ventures. Most recently, Taitron agreed to invest almost 10% of its market cap in cash for a minority stake in a Chinese company.

Only some of this money has already been invested, however. The bulk of it is committed (as per the notes to the financial statements) but remains listed under "cash" on the balance sheet. Investors should adjust their cash expectations for this company accordingly, as some of it has been promised away to other entities with rather uncertain returns.

For many companies, investments to expand the product/service portfolio should be encouraged. But when a company has a poor track record of allocating capital (Taitron has lost money in 8 of the last 10 years), shareholders should beware.

Consider the company's next largest commitment, a $150,000 investment (or 4% of the company's market cap) in a joint venture which "is not operational and as such, there has been no activity in this joint venture during 2010." In fact, that money has been tied up for years, as there was no activity in either 2009 or 2008. To the company's credit, management did respond to a call seeking comment, and asserted that they are pursuing a change in strategy and should get most of that money back (from the joint venture with no operations).

The good news for shareholders is that management owns a significant stake in this business. The bad news is that they don't appear obsessed with shareholder returns, to put it mildly. Based on the discount at which this company trades to its assets, each value investor must decide for himself whether the risks are worth the potential returns.

Disclosure: Author has a long position in shares of TAIT

Sunday, June 19, 2011

How We Know What Isn't So: Chapter 6

Value investors believe the market is not perfectly rational. To understand why, an examination of human behaviour is required. In How We Know What Isn't So, which is recommended by a number of value investors and behavioural economists, Thomas Gilovich explores the fallibility of human reasoning. Only by understanding our flaws can we seek to improve on them, thereby ameliorating our decision-making processes.


The previous chapters have spent a great deal of time discussing our own flaws in how we interpret and internalize information we encounter directly, but much of what we know comes not from direct experience but from what we have read or heard. This chapter examines biases in secondhand information that distort reality and reduce the reliability of information we come to count on.

"Sharpening and leveling" is what Gilovich calls the process that tends to obliterate the truth when it comes to secondhand information. When someone hears a story, for example, they focus and enhance (i.e. sharpen) the interesting elements of it and weed out (i.e. level) the inconsistencies. This process was demonstrated in an experiment where subjects were asked to describe a series of events that they witnessed. A new set of subjects was then asked to re-describe the events but this time based on the notes of the original subjects. The descriptions of the second set of subjects were much more extreme and one-sided than those of the original subjects, which Gilovich attributes to the fact that the original subjects sharpened and leveled what they saw.

There are many reasons sharpening and leveling takes place. Often, the teller of a story wants to entertain. Other times, he may be trying to make a point, or make a convincing argument (e.g. he may have a political axe to grind), which serves to distort the truth from ever reaching the listener.

Along with entertainment value, another factor that causes secondhand stories to propagate is how plausible, ironic or shocking they are, regardless of whether they are true. All of these issues are at play in the news media, where the demand for news is so strong that the supply grows to fill it. Gilovich takes us through a couple of examples where this occurs, including biased coverage of the AIDS epidemic from what are considered reliable news media sources.

To avoid falling prey to secondhand misinformation, Gilovich advises the reader to trust facts rather than projections, to look out for sharpening and leveling (for example, if scientists give a range such as 1% to 20% for an infection rate, the media will say something like "the infection rate may be up to 20%"), to consider the source, and to be wary of testimonials.

Saturday, June 18, 2011

How We Know What Isn't So: Chapter 5

Value investors believe the market is not perfectly rational. To understand why, an examination of human behaviour is required. In How We Know What Isn't So, which is recommended by a number of value investors and behavioural economists, Thomas Gilovich explores the fallibility of human reasoning. Only by understanding our flaws can we seek to improve on them, thereby ameliorating our decision-making processes.


No matter what their circumstances, people tend not to want to trade places with others. Part of the reason for this is believed to be the notion that we overvalue our assets (e.g. objects we own, but also extending to our personality traits). The other part of the reason for this appears to be how we perceive ourselves; about ourselves, we believe what we prefer to be true.

It has been proved that most people believe they are more intelligent, fair-minded, better-looking, less-prejudiced and more skilled than the average person. Obviously, by the definition of "average", all of these subjects cannot be correct.

According to Gilovich, a lot of these beliefs come from self-serving assessments. When we experience success, we attribute it to our actions and abilities. But when we experience failure, the root cause is blamed on an external factor we cannot control.

In such assessments, not only do we suffer from the biases discussed in the previous chapter, but we also explore negative information differently than we do positive (or pleasant to hear) information. For example, upon encountering failure, we look further and further for outside evidence that caused the failure; we don't just stop looking for evidence if we don't find it right away. For example, someone who has failed a test may first look for questions that were unfair. If they can't find any, they may look for others who found the test unfair. They will keep this process up until they have found evidence that justifies the pre-ordained conclusion.

We also tend to skew the criteria in our favour whenever we make judgments. For example, the personality traits which we believe we exhibit ourselves are similar to those which we consider to be the most valuable human traits.

Friday, June 17, 2011

For Investors, More Important Than English

I’m often told by visitors to the site that this content is rather advanced for the investing beginner. As such, a question I often receive is “Where do I start?” or “How do I become proficient enough to understand what makes for a good investment?” The answer is to learn and understand accounting.

Accounting is a language on its own. It’s not intuitive (at least, it wasn’t for me), but once mastered it is a very powerful tool for understanding a company’s past and present; it can even give the investor glimpses into a company’s future.

Every quarter, management will host conference calls and issue a release which describes the company’s progress. Often, the statements managements make through these media give a very rosy view of management’s progress. But investors who do not understand accounting have nothing else to go on. Meanwhile, an understanding of accounting can actually tell an investor much more about a company’s performance and prospects, both positive and negative.

Short of taking an accounting course, the best place for investors to start is probably a beginner's accounting textbook. Such a publication would cover the necessary elements, giving those with a value investor’s temperament the quantitative understanding necessary to be successful.

Thursday, June 16, 2011

Profit Sources

When companies report earnings, analysts will often focus on how profit expectations were met, rather than what those numbers are. For example, even if a company beats earnings expectations, if revenues came in lower than expected, this is often viewed as a bearish sign. Similarly, earnings misses accompanied by higher revenues are often considered positive. However, this line of thinking sorely underestimates the value of a flexible cost structure.

After all, if profit expectations were beaten while revenue came in lower than expected, this means that costs were likely much lower than expected. A company that can control its costs is a company that can outlast its competitors when revenues unexpectedly fall, as they often do in recessions.

Furthermore, higher revenues and in-line earnings suggest that margins have degraded. This could be a sign that the company has had to offer incentives to customers in order to move products. Instead, investors should look for companies that have the ability to reduce or increase costs depending on revenues. This leads to higher predictability and therefore higher accuracy in determining whether a margin of safety exists.

As an example, consider Goodfellow (GDL), a stock we used to discuss on this site as a potential value investment (but has since graduated to the Value In Action page). Back when it was considered a value investment on this site, revenues had dipped by about 15% from year-ago levels. Yet the company showed profits of 24 cents per share versus 20 cents one year ago. How did it do this? By paying down debt (and therefore reducing interest costs) and by slashing operating expenses: gross margin actually increased which is very rare when revenues decline, as fixed costs are spread out across fewer sold units.

One thing to keep in mind, however, is that revenues are more difficult (for managements) to manipulate than costs. However, manipulating revenues is far from unheard of, and as long as the assumptions used to calculate costs are reasonable, the arguments in this article still hold.

For a discussion on various points to consider when analyzing a company's cost structure, see here.

Wednesday, June 15, 2011

Deceptive Stock Compensation at Meade

It wasn't long ago that stock compensation wasn't considered an expense according to GAAP, which bloated the reported net income figures of many otherwise barely satisfactory companies. But common sense eventually prevailed, and so income statements now contain an estimate for stock compensation expenses. However, this expense item is not trivial in its application, and can lead to shareholder confusion and misinterpretation.

Consider the cash flow statement of Meade (MEAD), a company discussed a couple of weeks ago on this site as a potential value investment. Meade shows fiscal 2011 operating cash flows of just $88K, helped by a cash flow line item of $323K titled "stock-based compensation".

This sort of thing should set off red flags to shareholders, as it suggests that the company is only cash flow positive because it is paying its managers in options instead of cash. (This situation has been discussed on this site before with another company here.) If the $323K in compensation had been paid in cash instead of options, the company would not have the "benefit" of being able to add back this expense item in the cash flow statement.

But this line of thinking would be erroneous, because of a subtlety of how option expenses are accounted for. Options are not all expensed immediately, but are rather amortized over the life of the options' vesting period. In Meade's case, the company has stopped giving out large option awards; but the company still has to expense options from previous years that have not yet amortized.

This info is all available from the company's notes to its financial statements. Meade states that "As of February 28, 2011 and 2010, there was approximately $0.1 million and $0.4 million, respectively, of unrecognized compensation cost related to unvested stock options." The bulk of the difference between the $0.4 million and the $0.1 million is the $323K (referred to above) that was expensed this year.

Shareholders can also see how many options were granted this year in that same note (Note 10 to the 2011 financial statements) in a table listing details of the options that are outstanding. Meade started and ended the year with 78K outstanding options, having only granted 1K options all year (with 1K options also forfeited).

The implications of such an analysis are intriguing. While an initial glance at the cash flow statement suggested the company was diluting its shareholders in a bid to stay cash flow positive, this is actually not the case. Meade is only expensing options it gave out years ago, and because it is no longer giving out options, its net income today underestimates what the company earned this year (all else equal). Investors are encouraged to dig into the company's financials to confirm they understand this distinction.

Disclosure: Author has a long position in shares of MEAD

Tuesday, June 14, 2011

Universal Security Instruments: In Disguise

Universal Security Instruments (UUU) has been hit hard recently. As a seller of residential smoke alarms and related products, its business is inherently tied to that of the housing market. Predictably, sales in this industry have been relatively soft with no optimism on the horizon as the US housing market continues its downward trajectory following the expiry of federal tax incentives.

As if that weren't enough, the company has been hit by a double-whammy as heavily concentrated customer The Home Depot informed Universal Security last year that it would no longer sell its products in store. The Home Depot has represented almost half of the company's sales over the last few years, so this was a big blow to the company. (Owning companies with high customer concentration can be a large downside risk, as discussed here.) The result is a company that struggles to break even in its operations.

But it's also a company with a healthy balance sheet that trades at a significant discount to book value. Universal Security has $28 million in assets against just $1 million in liabilities, and trades for just over $16 million. Furthermore, the company has what appears to be a flexible cost structure, with little in the way of property, plant and equipment requirements; it buys in Asia and sells in North America.

Book value as a measure of worth, however, can be pretty meaningless, so it's worth digging into the nature of the assets to figure out if it's worth paying $16 million for this company. Almost $13 million of its assets are made up of current assets, including $7 million of cash, a quarter's worth of inventory and half of a quarter's worth of receivables.

But what's most interesting about this company is a joint venture it owns which is also its overseas supplier. This JV is quite profitable, not just from purchases from Universal Security, but also from other customers. The JV has been pushing Universal Security into the black as an overall company despite the tough environment. This year, Universal Security's share of the JV is on pace to deliver earnings between $1.5 million and $2 million.

At the current price, Universal Security offers investors a piece of a profitable business (the JV) at a P/E of around 10. In addition, shareholders receive a public company with a significant amount of cash and other current assets that has hit some temporary problems for free.

Disclosure: Author has a long position in shares of UUU

Monday, June 13, 2011

Not Buying The Explanations

Companies will often take credit when revenue growth outperforms economic growth, using sentences beginning with "Despite the current situation, we...". But these same companies will be quick to blame the economy in the face of lower than expected results (e.g. "The economic crisis caused..."). Therefore, the investor needs to be able to determine whether management is indeed outperforming.

Despite the general economic malaise currently gripping the global economy, it is still possible to find companies experiencing record sales and profits. But some companies may be beneficiaries of circumstance. These companies could be in industries with positive long-term trends (e.g. health, education), they could be in industries that aren't much affected by recessions (e.g. producers of consumer staples), or they could be operating in niche segments that for whatever reason are experiencing temporary bouts of strong demand or little in the way of competition. To avoid overpaying for such a company, it's important for investors to be able to identify whether external factors (which may be temporary) are benefitting a company.

If a company is earning record profits in a recession, but is simply in a cyclical industry, it is likely attracting competition. When a company generates high returns on capital, it attracts competition looking to replicate those same returns. For most companies, this results in returns returning to normal levels, as the competition drives down margins. For some industries, this process can take years (e.g. high oil prices encourage drilling and innovation resulting in higher oil supplies, but this takes a long time), while in others it can be a matter of weeks.

Consider Kewaunee Scientific (KEQU), maker of laboratory furniture. A combination of favourable factors for demand along with low competition resulted in strong revenues for this company in 2009. But it's important to have kept those numbers in perspective. Assuming that those revenue and profit levels would continue for the foreseeable future would have resulted in an investor's overvaluation of its stock. In other words, it was easy to have gotten sucked into believing that those numbers would only improve, considering that we were in a recession.

Indeed, management's comments at that time suggested the company was resilient in the face of recession:

"Our programs and strategies over the past few years to make Kewaunee a stronger and more competitive company were put to the test. Despite [economic] and other challenges, year-over-year increases in sales and net earnings were achieved for each quarter of the year..."

As we've often discussed, however, investors must look at several years worth of data to determine if a company's current operating profits are indeed sustainable. If a company does not have a competitive advantage, high margins will simply encourage competition that drives margins back down to normal levels. A look at KEQU's revenue and margins over the last business cycle shows that last year it was operating as well as it ever has:



Not long ago, however, the company suffered from low demand resulting in margin erosion. In 2005, revenues and earnings dropped sharply. Did the company blame itself, in what was otherwise a strong economic period? Not likely, as it issued the following commentary:

"We accomplished much in realizing cost reductions and improving our products, but were not able to overcome the unfavorable marketplace and declining sales...Uncertainties surrounding the November presidential election, significant increases in construction costs, and fewer state funds available for projects, all combined to reduce the number of laboratory projects..."

To determine whether current revenues and margins are sustainable, investors must consider the underlying business. Does the company have a competitive advantage which should allow it to hold onto its record profits, or is demand cyclical and/or will competition reduce profitability to more normal levels? Rather than accept the biased explanation of managements, investors must use their own judgement, and not only rely on current earnings (which may be abnormally high) in valuing a company.

Indeed, this type of analysis suggested the company's 2009 margins and revenue growth were not sustainable, and that turned out to be the case. In 2010, the company saw lower revenue and lower margins than it did in 2009, and of course blamed "a soft market for small laboratory furniture projects, and unusually bad weather". This management behaviour of "take credit when things go well, blame others when things go badly" is nothing new and is not limited to this one company; rather, it is common business practice. As such, as investors it's our job to think beyond what we hear from the managers.

Disclosure: None

Sunday, June 12, 2011

How We Know What Isn't So: Chapter 4

Value investors believe the market is not perfectly rational. To understand why, an examination of human behaviour is required. In How We Know What Isn't So, which is recommended by a number of value investors and behavioural economists, Thomas Gilovich explores the fallibility of human reasoning. Only by understanding our flaws can we seek to improve on them, thereby ameliorating our decision-making processes.


Some bias in decision-making is good. If every time we make a decision we had to re-evaluate all of the relevant data we had ever encountered, it would be extremely inefficient. For example, if we encounter an article claiming a swami has mastered levitation, it would be a mistake to throw out all of our previous biases that stem from our understanding of gravitational pull. But sometimes our biases influence our decisions more than they should, turning skepticism into closed-mindedness.

A number of studies are discussed which demonstrate how our biases cause us not to properly factor in evidence that disconfirms our existing point of view. Tradionally, it was believed that humans just forget disconfirming evidence. But Gilovich here argues that in many cases we remember disconfirming evidence quite well, but we place increased scrutiny on such evidence to the point where we explain it away.

A lengthy discussion of what factors determine whether we forget or just put little weight on disconfirming factors ensues. The full details of the relevant factors are too much to discuss here, but as an illustrative example, contrast the belief that it rains after one washes one's car with that of the sports gambler who believes he can win despite a history of losses. In the former belief, subjects are likely to simply forget the times it was sunny after one washed their car, as this did not invoke a sharp feeling, whereas they feel regret if it rains after a wash. In the latter belief, the sports gambler does feel the pain of a loss, so it is not that he forgets disconfirming evidence. However, he tends to analyze the causes of the losses and find reasons that explain away the losses (e.g. "If it weren't for that play/injury/call/mistake, I would have won") while the wins, however lucky, remain considered justified.

Gilovich also discusses scenarios where our biases can play particular havoc with our conclusions. When the conclusion is hard to define, we are susceptible to having our opinions succumb to plausible explanations that may have no attachment to the truth. For example, if the question is whether children who attend daycare have difficulty "adjusting", it is difficult to objectively test the conclusion, and therefore much credence appears to be given to plausible explanations that probably aren't true. But if the question is whether children who attend daycare underperform academically, it is much easier to test objectively and therefore biased explanations are less likely to persist.

Saturday, June 11, 2011

How We Know What Isn't So: Chapter 3

Value investors believe the market is not perfectly rational. To understand why, an examination of human behaviour is required. In How We Know What Isn't So, which is recommended by a number of value investors and behavioural economists, Thomas Gilovich explores the fallibility of human reasoning. Only by understanding our flaws can we seek to improve on them, thereby ameliorating our decision-making processes.


Humans appear to clearly recognize that evidence is required before something is believed. However, where they appear to be led astray, it is because of confusion between necessary evidence and sufficient evidence. Though items of evidence are necessary to prove a conclusion, such items may not be sufficient, and this is where humans often go wrong.

For example, humans put too much emphasis on positive instances when two variables are being intuitively tested for correlation or causality. To illustrate, Gilovich discusses a common belief that parents who adopt are more likely to conceive. Humans believe this because (positive) instances where they've known parents who have adopted and conceived stick out in their minds. Without considering the numbers and probabilities of other possible outcomes (adoption without subsequent conception, conception without adoption etc.), humans will believe this evidence to be sufficient.

Humans are also discriminatory about the kind of evidence they seek. Depending on how a question is phrased or what a human already believes, he will seek out confirmatory evidence and discard evidence that opposes the existing conclusion. (This has been discussed several times before on this site, and is known as confirmation bias.)

In many cases, however, the data on which humans often make faulty assumptions is not even available. This leads to its own set of challenges, including a lack of calibration. For example, school admissions personnel cannot know whether they rejected or accepted the right students, for they do not get to see what the performance would have been of the students whom they rejected. Research suggests that those in fields where feedback is provided (e.g. the sports management industry, where managers of one team have the benefit of seeing rejected players succeed or fail on other teams) are better calibrated.

A lack of evidence in the cases where we don't know "what would have happened" can also lead to self-fulfilling prophecies. For example, a market participant may start a rumour that a bank is under-capitalized. This could lead to a chain reaction that buries the bank. As such, the rumour's starter could turn out to be right by virtue of his stature or publicity. Here, we don't have the ability to know what would have happened had the rumour not been started, and therefore this could lead us to believe in things that just aren't so.

Friday, June 10, 2011

The Lower The Better

It's well understood that value investors prefer the stock price to be as low as possible before they buy in. But what isn't so obvious is what is desired of the stock once the investment has been made. The natural inclination for almost all investors is to hope that the stock price rises immediately after purchase. But is that in the best interest of the value investor? Perhaps not!

Many market participants are in it for the short-term. They cannot afford adverse price movements when the need or desire for liquidity trumps the long-term business value of the issuer. Compounding this is the fact that many such speculators invest using margin. In such cases, a market position can require additional cash infusions, which may not be available when required.

Psychologically, hanging in there when a stock price falls is also difficult. For those who hold Mr. Market in high esteem, or believe Mr. Market has deeper insight about a company than they do, a decline in sentiment from Mr. Market can invoke feelings of fear that in turn invoke an impulse to sell.

But the value investor ordinarily suffers from none of these factors. He is well capitalized; that is, he approaches every investment with the idea that he is in it for the long-term (or until price and value coalesce). He is not using borrowed money, so he has no additional cash requirements after his initial investment. Furthermore, he will only buy a company when he is convinced that he understands it; as such, the opinion of Mr. Market is unlikely to sway his own opinion of what a company is worth. The value investor, therefore, does not suffer from a stock price decline of an issue he owns.

In fact, he may benefit from such a phenomenon. A price decline offers investors the opportunity to buy more at a better price. Furthermore, a price decline over a long period allows the investor the opportunity to buy more when he is better capitalized at a later date (through the accumulation of capital through other income or other successful investments). As Warren Buffett has stated "[W]e expect to have funds available to be a net buyer of securities. And consistent attractive purchasing is likely to prove to be of more eventual benefit to us than any selling opportunities provided by a short-term run up."

But even if the investor has no interest in buying more of a given position (e.g. income is negative, or a stock's position is already large relative to the portfolio), he may still benefit from a lower rather than higher stock price. This occurs when the company is repurchasing shares. If the company is getting a better deal on its stock price, then so is the investor.

A recent example of this process in action is demonstrated by GameStop (GME), a company that has been repeatedly discussed on this site as a potential Stock Idea. Shares of GameStop would likely not be so high today had the company not been able to buy back shares at much more attractive levels just months ago. Long-term investors in this company would currently be better served by a lower current stock price, as the company has more cash coming in than it needs to invest in the company's growth areas.

If a stock price in which a market participant holds a position falls, this is bad news for almost all investors. But for the value investor, it is often, counterintuitively, good news. It increases the investor's opportunity for profit and increases the stock's potential upside.

Disclosure: Author has a long position in shares of GME

Thursday, June 9, 2011

No One Bidding For Bidz.com

Former high flyer Bidz.com (BIDZ) now has a stock price that puts the company firmly in net-net territory. Despite positive free cash flow over the last year, the online jewelry retailer trades for $19 million despite net current assets of $28 million.

But before Ben Graham investor-types get too excited, potential shareholders should consider a subsequent event to the company's quarterly report. The company just engaged a "consultant" to help it land a $10 million, 3+ year loan at an interest rate of 9% or less. In other words, there is a strong likelihood that whatever margin of safety the company currently has with respect to its net current assets will be spent by the company in an apparent bid to grow the business. Shareholders would likely benefit if the company cut its costs commensurate with its lower revenues, but unfortunately that course of action appears unlikely.

In return for their hard work as debt "brokers", the "consultants" will be paid with stock warrants. If a debt deal gets done in the next 90 days, the stock could get diluted by as much as 10%, which is another reason value investors may wish to stay away.

In public companies where value is consistently destroyed, shareholders can often revolt via vote and force the management team out. But not in this case. Bidz.com's CEO and his sister own a majority of the company's shares.

In most cases, management ownership is a good thing. But investors may not want to get in bed with this management team. The company has been badly mismanaged and the managers have been accused of being of questionable character and of having bad business practices.

Management's response to these accusations? It will no longer answer questions. The company's recent conference calls are rather bizarre, as there is no longer a question and answer session. Instead, management just reads prepared remarks, which are basically just regurgitations of the company's press release! In other words, the conference calls are now completely superfluous.

Some net-nets are more risky than others. In this case, you have a controlling management team that avoids accountability that is also looking to load up on debt for unjustified purposes. Buyer beware!

Disclosure: No position

Wednesday, June 8, 2011

Value Merger

Liquidation World (LQW) has been discussed in many value circles over the last few years as a potential value investment. Having traded below book value for the better part of four years, shareholders must have been delighted when news came out last week that the company has agreed to be taken over. But the shares plunged on the news, as the take-out price was lower than the stock's market value! How can value investors protect themselves from falling into such value traps?

There were a number of warning signs at Liquidation World which should have kept investors away. First, the company has not been profitable for a number of years. This can still be okay if there is ample cash to survive, but there wasn't. Not only was the company in debt, but it owed a ton in operating lease obligations.

Operating leases act like debt, as they are cash commitments that must be paid. Ignore them at your own peril! Furthermore, just as a debt-laden company can't afford to shrink (as the fixed debt payments then need to be serviced by smaller revenue amounts), a company with operating leases is forced to stay at locations even if the locations are burning cash. Incredibly, Liquidation World has more stores open now than it did in 2001, which was the company's most profitable year in the last decade; it has lost money in most years since then. Management was either unwilling or unable to shrink, which is what a retailer should do (to close unprofitable stores and free up capital and resources) when it can't make ends meet.

There does appear to be a smart value participant in all this, however, as the buyer (Big Lots, BIG) appears to be getting a good deal. Instead of having to grow slowly and organically, or pay a premium price for an acquisition, Big Lots is paying a pittance because Liquidation World is otherwise on the brink of bankruptcy. The cost for Big Lots is only about $400,000 per store, including every store's existing inventory, customer goodwill, and staff.

Big Lots is now free to make the changes it wants to make the Liquidation World stores as profitable as those of Big Lots. With an ROE 20% and a P/E of just 11 with no balance sheet debt, Big Lots may be worthy of consideration as a value play in itself.

Disclosure: None

Tuesday, June 7, 2011

Value In Action: KSW Inc

Shareholders of HVAC installation company KSW Inc. (KSW) have recently been able to exit their investment at quite a premium to what they paid. This stock has been one of the oldest members of this site's Stock Ideas page, but due to the strength of its stock price, it will now find itself on the Value In Action page. This investment has illustrated several important characteristics of value investing that can help investors identify and profit from the next opportunity.

First, it's okay to buy a cyclical business, even during a recession. The key is a strong financial position that allows a company to outlast the downturn. In KSW's case, it was flush with cash and had a flexible cost structure, with few requirements in terms of fixed costs and inventory.

When a recession hits, however, it is the companies in cyclical industries that see their stock prices hit the most, offering investors the opportunity to buy the ones with staying power at a big discount to intrinsic value. Just a few months ago, KSW could be had for a 20% discount to its book value. But it has recently traded for a 20% premium to its book value, as the company has continued to amass cash (thanks to a variable cost structure that has kept it profitable) and rebuild its backlog.

Just because I'm selling KSW, however, doesn't mean it's not still undervalued. At this price, however, I believe the easy money has been made and so I'm moving on the other ideas. Investors who understand the business well may continue to see value in this name and may continue to see strong returns.

Disclosure: None

Monday, June 6, 2011

Calian: Lower Risk Tech

Technology companies are generally more difficult to value than their counterparts in more stable industries. Because of the disruptive nature of change in the tech industry, it's very difficult to forecast earnings a few years out with any degree of certainty. But there are properties a company can possess, even one in the technology industry, that add some certainty to the valuation. A large cash balance is one of them.

Consider Calian Technologies (CTY), a provider of technology products and services for the communications industry. Calian has a cash balance of $25 million against no debt, which results in cash comprising 17% of the company's market cap!

So while the company trades at a price to earnings ratio of 11, it's price to earnings ratio becomes just 9 if the cash is backed out of the company's market cap. The P/E is low despite the high returns on equity the company generates; ROE has been around 20% for many years in a row. Meanwhile, the company paid out $15 million in cash to shareholders last year (in a combination of buybacks and dividends), which is about 10% of the company's market cap.

The cash balance is not the only thing helping stabilize the value of this business, however. The company signs a number of contracts in advance, so much so that it has a backlog of almost $900 million. Compare this to the company's 2010 revenue of just over $200 million.

Furthermore, most of the company's revenue (and a significant portion of profit) comes from supplying labour services (e.g. engineering professionals). This reduces the company's technology risk, as this segment does not have to constantly create a better mousetrap in order to stay competitive.

However, an investment in Calian is not without risk. Almost two thirds of the company's business comes from the Federal Government of Canada. As such, spending cuts or shifts in priorities away from initiatives requiring Calian's services would have a dramatic effect on the company's business and profitability. It's also worth pointing out that the large backlog number is not calculated conservatively, as it includes the value of buyer options, which may or may not be exercised.

To make money over the long-term, investors should seek out companies with high returns on equity with low P/E ratios, as discussed in Joel Greenblatt's book. At Calian's current price, it appears to fit the bill, with a large cash balance as a bonus.

Disclosure: None

Sunday, June 5, 2011

How We Know What Isn't So: Chapter 2

Value investors believe the market is not perfectly rational. To understand why, an examination of human behaviour is required. In How We Know What Isn't So, which is recommended by a number of value investors and behavioural economists, Thomas Gilovich explores the fallibility of human reasoning. Only by understanding our flaws can we seek to improve on them, thereby ameliorating our decision-making processes.


Humans look for patterns where there aren't any. Several examples of this phenomena are discussed in this chapter, including a detailed examination of the "hot hand" idea pervasive in the sport of basketball.

It is believed that players are streaky, in that if they have made (missed) a few shots in a row, they are more likely to make (miss) their next shot as well. Examining data from the NBA, the authors show that players do not exhibit "hot hands".

And yet there continues to be a belief in the existence of "streaky-ness" in player performance. Gilovich believes there are two likely explanations for this: the clustering illusion and the regression fallacy.

Clustering illusion describes the idea that humans see patterns in small samples of data that are not statistically significant. In small samples, however, there is a decent probability that all or a significant proportion of coin flips will turn up heads, for example. Humans extrapolate such phenomena to mean something more than it really does.

Regression fallacy describes the tendency for humans to ascribe some false explanation where all that is really occurring is normal regression, where regression refers to the fact that when two variables are correlated (e.g. parent's height with child's height), an extreme outcome in one variable (e.g. the parent is very tall) will not be accompanied by such an extreme outcome in the other variable (e.g. the child will not be as tall as the parent). This tendency can make people believe something has caused a sub-par performance following an outstanding performance, whereas in actuality the outstanding performance was out of the ordinary.

Lines of thinking that look for patterns have probably served our species well. We can capitalize on ordered phenomena in a way that we cannot when things are unordered. Over the course of history, the prediction of patterns has led to discovery and advance in all fields of study. As a result of our trying to find the order in things, however, we often force an order when none is justified.

Saturday, June 4, 2011

How We Know What Isn't So: Chapter 1

Value investors believe the market is not perfectly rational. To understand why, an examination of human behaviour is required. In How We Know What Isn't So, which is recommended by a number of value investors and behavioural economists, Thomas Gilovich explores the fallibility of human reasoning. Only by understanding our flaws can we seek to improve on them, thereby ameliorating our decision-making processes.


The introduction starts with a quote from Artemus Ward as follows:

"It ain't so much the things we don't know that get us into trouble. It's the things we know that just ain't so."

A few widely believed phenomena are discussed and debunked. For example, it is believed that more effective undergraduate admissions decisions are made with the help of (subjective) interviews, whereas research indicates that objective criteria alone are more effective. Nurses on maternity wards believe that more babies are born when the moon is full. This also is not true.

Such beliefs are costly. A number of examples are cited where human conflict and animal deaths/extinctions have been caused by such faulty beliefs. Faulty-believers not only hurt others though, but also themselves. For example, a number of cases have arisen where patients have refused recommended medical care in favour of "quack" medicines.

This book seeks to answer what it is about us that makes us believe such things. The author argues that it is not a lack of exposure to evidence and nor is it irrationality. Rather, it is faulty rationality that leads to such beliefs. This will be explored further in the book.

Friday, June 3, 2011

Meade's Discount Instrumental

Meade Instruments (MEAD) is a company that has lost money for years. Its business of designing and manufacturing telescopes and other optical consumer products is on the decline. But after some restructuring and new management, the company now finally appears to be returning to profitability after many long years. Despite this, the company trades at about half of its net current asset value, giving investors the opportunity to profit from this apparently turned around company.

After hemorrhaging cash over the last few years, the company finally managed to be free cash flow positive (albeit in a very small way) in fiscal year 2011. Production has been moved from California to Mexico, poorly performing units have been divested/discontinued and new products have been brought to market. The result is a company in good financial shape with no debt and $5 million of cash. Meanwhile, the company trades for just over $5 million, despite current assets of $14 million and total liabilities under $4 million.

In addition, the company's losses may be overstated. It appears the company is rather conservative with its accounting, as fixed assets have been largely written down through years of depreciation, but are still in use. Meade's property, plant and equipment account is now smaller than the company's depreciation charge for last year, while the company "had no material capital expenditure commitments at February 28, 2011."

You wouldn't be alone as a value investor in this company as Paul Sonkin is also an owner. Sonkin's Hummingbird Management owns more than 15% of this company, and Sonkin has been a director of the company since 2006. The company's CEO also owns 10% of the company.

Meade has come a long way since it was first discussed on this site, but there have been a few updates at ShadowStock tracking its progress. See here for more on Meade from ShadowStock.

Disclosure: Author has a long position in shares of MEAD

Thursday, June 2, 2011

Systemic Fraud In China?

China's high growth rates have encouraged foreign investment, which have in turn helped fund China's incredible growth. But such large capital inflows are bound to give way to sector imbalances and fraudulent behaviour. Recently, some fraudulent behaviour has been uncovered among small-cap Chinese stocks that trade in the US. But as the story continues to develop, it is beginning to increasingly appear as if the fraudulent behaviour could be operating on a much more massive scale.

Many of the reverse takeover stocks that have been uncovered as frauds have been small cap stocks with auditors with small operations. Perhaps these could be dismissed as a small number of one-off incidences of poor oversight and unethical management. But recent events make it clear that these occurrences are not limited to the small-cap space, and nor are they limited to mom-and-pop auditor operations.

The auditors of some of the recently uncovered fraudulent companies in China have been chided on this site and others. But more and more it is starting to look as if the facilitators of the fraud were not limited to employees of the companies themselves, but included the companies' banks as well. This, of course, makes it clear why auditors were signing off on such large cash balances when they didn't even exist.

For example, Longtop Financial Technologies (LFT) is a billion dollar Chinese company trading on the NYSE. It claimed to have a cash balance of over $400 million. Auditor Deloitte Touch Tohmatsu signed off on the company's financials for six years. This year, however, perhaps because of the recent fraud uncoverings (including that of China Media Express, a company which Deloitte also audited), the auditor went the extra mile. For one thing, it didn't just trust the statements the local bank provided; instead, it made further inquiries. The result was as follows, according to Deloitte:

"Within hours however, as a result of intervention by the Company’s officials including the Chief Operating Officer, the confirmation process was stopped amid serious and troubling new developments including: calls to banks by the Company asserting that Deloitte was not their auditor; seizure by the Company’s staff of second round bank confirmation documentation on bank premises; threats to stop our staff leaving the Company premises unless they allowed the Company to retain our audit files then on the premises; and then seizure by the Company of certain of our working papers.

"In that connection, we must insist that you promptly return our documents.

"Then on 20 May the Chairman of the Company, Mr. Jia Xiao Gong called our Eastern Region Managing Partner, Mr. Paul Sin, and informed him in the course of their conversation that “there were fake revenue in the past so there were fake cash recorded on the books”. Mr. Jia did not answer when questioned as to the extent and duration of the discrepancies. When asked who was involved, Mr. Jia answered: “senior management”.


Auditors are likely going to step up their game this year when it comes to auditing companies in China. As a result, more fraud uncoverings are likely, and the risk is there that one or more "Enrons" are about to go down. This could damage investor confidence, and seriously dampen investment flows into China, serving as a catalyst for a recession.

The economic miracle in China has lifted millions out of poverty and has been a great thing not only for Chinese citizens but for the rest of the world. It would be nice if the economy always grew in a straight line, but it doesn't. Investors counting on China to supply the kind of uninterrupted growth the world has become accustomed to are destined to be disappointed at some point. When that will happen, however, is unknown; but ignoring the warning signs that appear to be emerging could be disastrous for investors.

Wednesday, June 1, 2011

QXM: Motivated Seller

In his book The Aggressive Conservative Investor, Martin Whitman discusses the advantages of investing in a company which is majority-owned by a single entity. Such advantages appear to be coming to the forefront for Qiao Xing Mobile (QXM), which may offer an opportunity for a strong profit for the value investor.

QXM is majority-owned by Xing Resources (XING), a company in a completely unrelated field to QXM. Xing has made it clear that it wants to wind up QXM's business and deploy its assets (mostly cash) towards Xing's mining concerns. This is where the opportunity comes in for the minority investor, as any cash that comes out of QXM has to be shared pro-rata with minority shareholders of QXM. Since QXM trades at a large discount to its cash balance, such a transaction would result in great returns for investors.

To get at the cash, Xing first tried to buy out minority shareholders for a song. But Xing couldn't get the votes needed from minority investors to achieve quorum, so the deal fell through. Just a month later, however, it looks like Xing is looking at another way to pull out the cash, as per the following release:

"We...are currently considering options to divest of our remaining telecommunications business. We expect to formalize and announce our final decision in June 2011...Upon filing of its 2010 Annual Report on Form 20-F with the SEC and announcements of its final decision regarding the telecommunication business, the Company will hold a conference call with investors to discuss both items."

Considering we are already in June, the potential timeline for any transaction announcement (e.g. a sale or significant dividend) is almost upon us. Despite this, the company continues to trade at a large discount to cash and net current assets. But because of the motivated position of QXM's majority-owner, a catalyst to unlock value may be only a few days away.

Disclosure: Author has a long position in shares of QXM.

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