Keying In On Value

Key Tronic (KTCC) is a company that has come up a few times on this site, and has been a member of the Stock Ideas page for quite a while. A few months ago, it traded at a discount to its net current assets despite being a profitable company. Two months ago, it was discussed as a stock that could only go up, due to the fact that downside risks were minimal compared to upside potential.

Yesterday, investors hit pay dirt, as the stock showed a 20+% increase over the previous day's close following the company's quarterly results. This brings the stock's return to almost 400% over the last year. In a relatively short period of time, the stock went from a Ben Graham net-net to trading at a premium to its book value, meriting placement on the Value In Action page.

Could investors have foreseen the fact that the company would beat earnings estimates by 5 cents per share, which would subsequently blast the share price to a level not seen since mid-2007? Possibly, but that's not how value investors make money. When the share price would rise and under what circumstances was not really known. What was apparent here is that the market was not properly valuing the company.

First, investors were offered the opportunity to purchase the company's inventory and accounts receivable at a discount, with the rest of the company's assets thrown in for free. But this was not a company bleeding cash, either. The company had been profitable for 22 consecutive quarters! Furthermore, future earnings were not subject to US taxes, as discussed here. Finally, the company had a flexible cost structure, allowing it to scale down expenses should revenues decline.

Learning about value investments of the past can help the investor uncover what might be today's value investments. Key Tronic shows us that even stocks that trade with what appear to be high P/E ratios can still be extremely undervalued!

Disclosure: Author has a long position in shares of KTCC

Stocks That Can Only Go Up

When a company reports earnings that are stronger (weaker) than expected, the stock price will often rise (fall) in reaction. As a result, analysts spend a lot of time trying to predict a company's upcoming quarterly results in advance of the actual release date. Unfortunately, predicting quarterly results has proven to be a very difficult task. But there is a better way.

While individual investors are not in a better position than analysts to predict short-term earnings, the good news is they don't have to. The market offers investors the opportunity to buy companies where bad news can't sink a stock as much as good news can buoy it. This is because such stocks offer investors a margin of safety; in other words, the bad news is already baked into the stock price.

As an example, consider Key Tronic (KTCC), a stock we have previously discussed and a member of the Stock Ideas page. Last week, the company announced that 2nd quarter earnings per share would be closer to 12 cents rather than the earlier estimate of 3 cents. The next day, the shares closed 25% higher.

Of course, predicting the earnings surprise would have been impossible for the average investor, so let's consider what would have occurred had earnings disappointed. It is not likely that the stock would have fallen by the same dollar amount or the same percentage. This is because the company is profitable and has $60 million of current assets against total liabilities of $26 million (for a difference of $34 million) while the company traded for a grand total of just $25 million.

However, predicting the market's reaction is nearly impossible; it is entirely possible that an earnings disappointment of the same magnitude would have caused an equally negative reaction in this stock. Even in such a case, however, the stock would have become even cheaper, with further reduced downside and increased upside potential. Such was the case for many stocks in March, as the market decline took many stocks to levels where the downside was minimal and the upside potential was large.

Predicting earnings, and predicting the market's reaction to those earnings is a very difficult task indeed. Instead, investors should focus on buying businesses that trade at large discounts to their values. Such opportunities offer asymmetric returns: the downside risk is minimal, while the upside potential is high.

Disclosure: Author has a long position in shares of KTCC

Don't Be Fooled By High P/E Values

As the market has risen throughout most of this year, many market observers have noted that P/E values are looking rather inflated from a historical standpoint. But of course, earnings are lower than usual this year due to reduced revenue that was caused by financial shocks. So as investors, should we be willing to pay a higher P/E for now, on the assumption that earnings will soon pick up?

When considering the market in the aggregate, this is a very difficult question to answer. Some companies will have cost structures that prove too rigid, and will therefore be unable to adapt to a lower revenue environment. Other companies, on the other hand, will have flexible cost structures or will see revenue continue to grow, despite the downturn. But to determine which of these forces will exert more pull on the market's earnings in the coming quarters is not only extremely difficult, but unnecessary: unless you're trying to value the entire index, you don't have to answer this question for the market in the aggregate. Instead, you can try to answer this question for individual securities, which are much easier to understand.

For example, consider Key Tronic (KTCC), a manufacturer of electronic devices. The company has a P/E of 23, which makes it appear overvalued. But earnings are down because year-over-year quarterly revenue is down 15%. However, the company has little in the way of debt, and has the vast majority of its operating leases coming due in the near-term, giving it further flexibility in reducing its costs. Operating expenses are down 17% this year, and the company sees sales starting to rebound in January of 2010. In fact, based on KTCC's past margins and returns on assets (which it should be able to return to by continuing to cut costs and with a modest recovery in revenues in the years to come), it appears to trade at a normalized P/E much, much lower than the 23 that stock screeners currently display. (KTCC is a stock we've previously discussed here.)

Determining whether the market is over- or under-valued is a difficult exercise indeed. But by focusing only on those companies for which it is easier to compute earnings (circle of competence), and ensuring that companies trade at discounts to those earnings (margin of safety), investors put themselves in positions to profit in the long-term whether the aggregate market offers potential or not.

Disclosure: Author has a long position in shares of KTCC

Not Sharing The Gains

For most companies, both income gains and income losses are attenuated to a large extent by taxes. In this regard, the government acts as a business partner, reducing the risk of loss in any one period (as long as offsetting gains were achieved in the recent past or can be achieved in the future!), but also sharing in the gains. But in certain situations, investors can sometimes stumble upon companies that do not have to share such gains.

Consider Key Tronic (KTCC), a designer and manufacturer of keyboards and other computer input devices. Over the last 8 years (including this one), Key Tronic has been profitable, as it has garnered business from original equipment manufacturers participating in a trend towards low-cost outsourcing. But Key Tronic has barely paid any taxes over that period. In fact, due to a storied past, Key Tronic has net operating loss carryforwards (i.e. losses that can be applied to future income for the purposes of calculating taxes) of over $40 million. The company's market cap is only half of that, as it earned about $1.5 million this year!

Some of these carryforwards expire every year, but management believes it will be able to apply most of those losses, reducing the company's tax rate considerably. For many companies, every dollar of operating income translates to about 65 cents of income. For this company, each dollar of operating income translates directly into a dollar of income, representing a 50% bonus to shareholders! Such future benefits should have the company trading at a premium to its peers, yet this company trades at a discount to its net current assets.

By going beyond a company's headlines and by reading the notes behind a company's financial statements, investors put themselves in a position to find value that would otherwise go uncovered. Tax-loss carryforwards represent just one of the many useful items investors can find in the notes to the financial statements.

Disclosure: Author has a long position in shares of KTCC