Risk Is Back

It is difficult to judge the market's appetite for risk simply on the basis of the equity markets' price levels, as determining what constitutes "too high" or "too low" a price is challenging. One can compare a market's price to its earnings or its book value, but earnings are a moving target and are subject to large non-recurring costs (even in the aggregate) while the efficiency with which assets and leverage are employed also changes.

Dividend yields are often used as an indicator of the market's appetite for risk, but increases/decreases in the utility of retained earnings (that is, do companies have opportunities to generate solid returns on earnings they do not pay out?) can render yield-comparison exercises ineffectual. Furthermore, the increasing and volatile use of stock buybacks as an alternative means of returning capital to shareholders adds uncertainty to such comparisons.

Nevertheless, there are means by which the market's general appetite for risk can be estimated. One such method uses the TED Spread, which measures the difference between inter-bank lending rates and US government debt, which is currently considered by many to be risk-free. A high spread (or large difference between bank rates and government rates) suggests investors are scared of lending, as perceived risk is high.

Consider the TED Spread over the last five years:

From the chart above, it is easy to see why economists were warning of a liquidity crisis in the fall of 2008, as spreads widened dramatically from their previous levels, and continued to rise until the end of the year. At such times, the cost of borrowing is exceedingly high as owners of cash were in no mood to provide capital.

But since May of 2009, spreads have declined dramatically. Not only have they recovered to their pre-crisis levels, they are below the spread levels seen in the last boom-cycle! Considering the economy is still in recovery mode, this eager willingness on the part of capital providers to take on risk is rather surprising. Lenders of capital to banks are currently asking just 15 basis points of return above what government debt returns, despite a rather fragile economy!

What does this mean for the stock market? Maybe nothing, maybe a lot! If investors are once again pricing assets such that they perceive little to no risk in them, prices could fall significantly the next time the market is spooked. The current level of the TED Spread suggests providers of capital are doing just that.

source: http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP:IND

Net-Nets: Beyond Liquidation

Companies trading at discounts to their net current assets are often valued by estimating their liquidation values. For many years, this may have made sense, as only companies in extremely terrible shape would ever trade at such levels. Since the market crash of 2008-2009, however, even companies with decent prospects of profitability have traded at such abysmal levels. As a result, it would be imprudent to value net-nets based only on their estimated liquidation values; instead, for the majority of cases, effort should also be exerted in valuing the company as a going-concern.

When a stock's estimated liquidation value is compared to its share price, the investor can get a decent idea of the stock's downside risks. But the upside in a stock is not limited to its liquidation value; assuming this to be true could result in an investor selling a stock for far below its intrinsic value.

Consider H Paulin (PAP), a manufacturer and distributor of automotive hardware components. The stock has doubled from its lows in 2009, and yet it remains an attractive purchase. To place a sell value on this stock that is equal to its estimated liquidation value would appear to be a little too conservative, even for the strictest of value investors. The company trades for $28 million, but earned $2.4 million in 2009 under very poor industry conditions.

Recall that this is a company that operates in two business lines, one of which is doing well while the other is faring poorly. By ceasing to invest in the poorly performing business, while increasing investment to the business that is growing profits and market share, the company is positioning itself for continued success. Indeed, based on a number of operating metrics, the company appears poised to add value for shareholders by continuing to grow its distribution business. As such, placing an upper-bound on this company's price that reflects only its estimated liquidation value could result in underestimating this company's actual worth.

Various research (one example here) suggests that buying a portfolio of stocks trading at discounts to their net current assets, and selling them when market values and net current assets converge, will beat the market. To value investors, this is old news. But it is likely possible to even outperform such a portfolio by not forcing stock sales in cases where a company's intrinsic value clearly exceeds its estimated liquidation value.

Disclosure: Author has a long position in shares of PAP.A

Freakonomics: Chapter 5

Charlie Munger says the most important rule in management is "Get the incentives right". Munger argues that the power of incentives is constantly underestimated. In Freakonomics, Steven Levitt shows us how pervasive incentives are in society, and what we can learn from that. Value investors who can grasp the power of incentives put themselves in a position to understand which companies are utilizing the full potential of their managements.

Levitt makes an argument that we do not use data enough to come to the conclusions that we come to. We rely on our pre-determined beliefs and biases to draw conclusions, and rarely seek out objective information. Nowhere is this more apparent than in the management of offspring: parenting.

In a house that contains both a gun and a swimming pool, children are roughly 100 times more likely to die in the swimming pool than at the hands of a gun. But our beliefs about the dangers of guns ensures the focus is on the gun rather than the more apparent danger, drowning.

Levitt uses economic tools (namely, regression analysis) to figure out the role of various parent initiatives. A regression analysis is a statistical tool that allows the scientist to control several variables from within a mountain of data, thus allowing us to determine which variables have an effect on the output.

From this analysis, Levitt was able to determine that genetics plays a much larger role than it is given credit for. Furthermore, when holding all other variables constant (e.g. incomes, school quality etc.), a child's race does not determine its financial future. Specifically, these are the factors that are strongly correlated to a child's test score performance in the US:

1) Educated parents

2) Parents have high socioeconomic status

3) Mother was 30 or older at the time of her child's birth

4) Low birth weight (negative factor)

5) Parents speak English in the home

6) Child is adopted (negative factor)

7) Parents are involved with the PTA

8) Many books in the home

According to the data, the following factors do not matter:

1) Family is intact

2) Family recently moved to a better neighbourhood

3) Mother didn't work between child's birth and kindergarten

4) Attended Head Start

5) Is regularly taken to museums

6) Is spanked regularly

7) Watches television frequently

8) Is read to frequently

It's important to note that a regression analysis can only show correlation, not causation. That is, the first eight factors above may not cause higher test scores, as there could be another factor that causes both one of these eight factors and the higher test scores to occur simultaneously, or the causation could be reversed (e.g. higher test scores could cause a higher interest in books, leading to more books in the house).

Freakonomics: Chapter 4

Charlie Munger says the most important rule in management is "Get the incentives right". Munger argues that the power of incentives is constantly underestimated. In Freakonomics, Steven Levitt shows us how pervasive incentives are in society, and what we can learn from that. Value investors who can grasp the power of incentives put themselves in a position to understand which companies are utilizing the full potential of their managements.

In this chapter, Levitt illustrates a great number of economics-related lessons that can be learned from the national drop in crime that took place in the mid-1990s and the media reaction to it.

Certain members of the media will always extrapolate trends into the future without understanding the underlying causes of those trends. Crime was on the rise for several years preceding its peak, and "experts" were proclaiming that the worst was yet to come. When a stock or market rises or falls, the media will make headlines with scary and astonishing predictions of the future.

When "experts" are proven wrong, they will often remain overconfident in their abilities to predict, explaining away their faulty predictions with excuses. When crime did not rise as anticipated, many experts claimed it was the alarms they raised that put into motion counter-effects that helped quell crime. When stock market analysts are wrong, they use a range of excuses from ceteris paribus to if-only defenses.

When an event has occurred, the media and experts will all try to explain it, but many will do so on hypotheses without basis. To explain the drop in crime, the media cited several specific reasons. Levitt, however, goes on to show that only three could have contributed to the drop in crime, while the others cannot be shown to be effective from the data. Every day, we are offered explanations for why certain markets/stocks/commodities went up/down, when in reality very little evidence is offered up to back these claims.

Levitt also provides his own theory of the major reason for the crime drop in the mid-1990s, and backs it up with a great deal of data interpretation.

Leveraging Net-Nets

Hanwei Energy (HE) is a Canadian-headquartered company that operates in the industrial pipe business (for oil, gas and water transmission) primarily in Asia. The company trades at about a 30% discount to its net current assets, but has seen its revenue decline as a result of a combination of factors (more competition in one of its major markets, the global recession, transformation of one unit into a joint venture, etc.).

Unlike most net-nets, however, the company is mostly breaking even, and therefore may appear to be an attractive investment for value investors. Further investigation, however, reveals some caveats to look out for even for profitable companies trading at discounts to their net current assets.

First of all, the company's accounts receivable constitutes a large part of its current assets. While the company believes strongly in its ability to collect on it, the size of the receivables equate to over a year's worth of sales, meaning many customers are likely significantly overdue on their payments.

Adding to the risk of the receivables situation is the company's debt. Indeed, two companies with differing debt loads can have the same level of net current assets, but one is still more risky than the other. Consider two companies, each with net current assets of $50 million, but where Company A has $50 million of current assets and no liabilities, while Company B has current assets of $200 million against $150 million of debt. If half of both company's current assets become in doubt, Company A is still in a position to survive; Company B, however, becomes underwater, with shareholders at serious risk of losing their entire principal.

Furthermore, it appears Hanwei is intent on adding to its debt load and continuing to grow, thus increasing the risk for the investor. From the company's latest quarterly report:

"The Company’s 2010 growth plan requires additional working capital of Renminbi (“RMB”) 150 million ($23 million). This mainly includes working capital to support the growth in the pipe business. Management plans to finance these working capital and investment needs with cash on hand, cash from operations and debt facilities which have been arranged with Chinese banks. Management also believes that it has the ability to access additional equity financing if needed..."

So rather than reduce risk by paying down debt where possible, the company is actually planning to continue to lever. If business operations are indeed successful, the reward to shareholders at this price could be handsome. Unfortunately, the risk of principal loss (which value investors seek to avoid) also appears high.

Where possible, value investors should try to determine a company's plans going forward, and should be wary of investments with too much or increasing leverage, as the risk of principal loss increases in such situations.

Disclosure: None

ITEX Major Shareholder Interview

Last month, we discussed ITEX Corporation (ITEX) and noted that even though a couple of value investor groups hold significant percentages of the company, management seemed intent on protecting its own interests over those of shareholders. Last week, I had the opportunity to interview David Polonitza of The Polonitza Group, a group of shareholders that owns/controls 13% of ITEX's shares:

What is the investment philosophy of The Polonitza Group?

"The Polonitza Group consists of a number of ITEX shareholders who believe certain strategic decisions and acquisitions made by the Company in recent years have strayed from the focus of expanding and supporting the company’s #1 asset, its franchisee network. We have made a number of proposals which we believe will improve the long term value of the ITEX Corporation."

How would you characterize your relationship with ITEX’s Board of Directors? Have they been open to input, or do they see you as a threat to their positions? I see they have accepted some of your suggestions, such as authorizing a share repurchase plan...is this because of arm-twisting, or are they genuinely open to incorporating other ideas?

"Based upon communications we have received from members of ITEX’s Board of Directors, they do not seem to be interested in entering into a constructive dialogue with our group."

Do you have contact with the other major outside shareholder of ITEX, value investor Sardar Biglari? Would you say his investor interests are aligned with yours?

"The Polonitza Group has no affiliation with Mr. Biglari or any of his entities but we welcome any suggestions made by ITEX members, franchisees, or other shareholders."

Why should the readers be interested in ITEX stock? You've been on a buying spree of ITEX...what do you think shares of ITEX are worth?

"I cannot comment on ITEX’s stock price or my personal opinion on its value. In general, all shareholders, as part owners of any corporation, should take an interest in how a company operates and is governed."

What are the top 1 or 2 things you would like to see management do that it is not currently doing, or what would you like to see management improve on? Your letter of March 23rd outlines a number of initiatives, but give us THE priority in your opinion.

"ITEX’s number one priority needs to be the success of its franchisee network. This includes ensuring franchisees increase their profitability while having the incentive to expand their operations. Acquisitions or initiatives not aimed at improving or expanding the franchisee network need to be carefully examined. Additionally, we believe that ITEX must do a better job at recruiting new franchisees into the system.

"The current economic environment is one that is beneficial to ITEX’s business model. I refer to a 1992 NY Times article that profiled ITEX and the barter industry during another significant recessionary period in the U.S. The ITEX broker in the story, who is still a franchisee today, stated that when times were good he had difficulties signing up new members, but as the economy declined, he had to turn some businesses away. Like some of ITEX’s competitors, we should be seeing a measurable increase in the overall number of members and transactions taking place within ITEX’s marketplace, but based on publicly available financial information, this is not taking place. We believe that this is in part due to decisions made by the company over the past few years that have resulted in the ITEX Corporation not being able to capitalize on all of its potential opportunities.

"The second priority is to improve ITEX Corporation’s corporate governance. As we detailed in our letter sent to ITEX’s Board, there presently exists outside business relationships between the three directors and their various companies.

"We also feel it is necessary for ITEX to hire a separate CFO in either a full-time or part-time capacity to allow the CEO to focus on his responsibilities while ensuring that the proper internal checks and balances exist.

Are you personally interested in being on the Board of ITEX?

"It is our belief that independent board members who do not have outside business relationships with one another will help to ensure good governance practices are in place while also introducing ideas and initiatives to improve the company."

What do you see as some possible reasons (both negative and positive) that might make you sell your shares?

"I cannot comment on reasons we might buy or sell the stock."

In addition to granting the interview, Mr. Polonitza also kindly agreed to answer follow-up questions from readers on the topic of ITEX. If you have any questions you would like to see answered by Mr. Polonitza, please post them in the comments section, and a follow-up interview will be posted on this site in the near future.

A Lot To Like

Imagine a company that doesn't hand out stock options, but where management owns a significant but non-controlling stake in the company. Now imagine that its CEO has been at the helm for almost 25 years, slowly building up his personal wealth by growing the company's stock by double-digits annually, employing little to no leverage in the process.

Such situations are rare, but they do exist. Now imagine that you can buy a stake in such a company at an attractive price, due to the fact that its industry is going through a cyclical downturn.

Consider Jewett Cameron (JCTCF), a company that sells wood, metal, seeds and industrial products to retailers, manufacturers, and builders. Revenues for this company have plunged, as it was exposed to two groups that have been particularly hard-hit by this recession: boat manufacturers and home builders.

But Jewett has shown an uncanny ability to weather the storm, as it remains profitable despite a 30+% drop in revenue. The company was able to reduce its headcount by over 20%, and fold in some of its operations into its owned facilities, thereby reducing leasing costs.

While the company both trades for and has shareholder equity of $18 million, its book value is likely understated due to the value of its land holdings. Most of its land holdings were acquired and built in 1995, and have been carried at cost since then. But the company owns over 18 acres of land, including over 140,000 square feet of office, manufacturing and warehouse space just a 25 minute drive from downtown Portland, Oregon. The fact that the company has been able to derive average returns on equity of 15% over the last five years suggests that either the company is getting more use out of its land than the land carrying value would suggest its worth, or that it has some competitive advantage. After subtracting the company's cash balance, the stock trades with a P/E under 10.

When the incentive structure for an able management is properly set up, the potential for success increases significantly. In the case of Jewett Cameron, management shares with other shareholders both the downside risk that comes with failure, and the upside potential that comes with success. Furthermore, with a strong record of success over the long-term, management has proven its ability. With the current economic situation keeping revenues low, shareholders may currently be offered an opportunity to buy into this company at an attractive price.

Disclosure: None