De-registration Opportunities

When a US company announces that it will de-register its shares, it no longer has to file annual and quarterly reports with the SEC. While this can reduce expenses significantly for certain small companies, it is invariably followed by a drop in the company's share price, since the appeal of investing in a company that doesn't have to make such reports is quite low.

Three months ago, we discussed a company called Boss Holdings (BSHI) that proposed to deregister, but that had avoided a massive drop in its share price. Its proposal included a payout of $7.65 per share for shareholders owning fewer than 100 shares. So while some downward pressure on the stock was undoubtedly placed by shareholders exiting the soon-to-be-deregistered company, upward pressure was created by new buyers looking to make an arbitrage profit by buying fewer than 100 shares.

Last week, shareholders voted to approve the measures, which is no surprise considering management controls the company. But even though this proposal is now on the verge of going through, an arbitrage profit still exists! That is, the shares still trade for less than $7.65, allowing shareholders who buy up to 99 shares the opportunity to cash in for more than they pay for their shares.

But out of all this comes another opportunity. Because of the $7.65 offer, the shares may well immediately drop soon after the reverse-split/re-split takes place, since there will no longer be upward pressure on the stock. As such, owners of BSHI who plan to stick with the company even as it de-registers may wish to sell at the current price and buy back following the transaction, presumably at a lower price. Investors in a risky mood may also consider shorting the company at its current price, on the expectation that the shares will drop following the $7.65 payout. Of course, liquidity could pose a significant challenge to such an endeavor.

Unique situations can sometimes offer investors profit opportunities. I look forward to re-visiting this situation post-transaction to observe the results.

Disclosure: None

Quicker Paybacks

Before they can make money, companies must make capital investments. But since the future is always uncertain, investments with longer payback periods are often more risky than those with shorter payback periods. This is because the shorter the payback period, the lower the risk that market conditions can render the initial investments obsolete/useless.

One company towards which this idea has a useful application is GameStop (GME), a retailer of new and used video games. As we've previously discussed, the future of the retail video game business model may be very different than it is today. As such, large capital outlays with payback periods many years out would be a risky endeavor for this bricks and mortar business. However, based on the company's disclosures, investors can actually estimate how long it takes for a new store to pay for itself.

This year, the company will spend $75 million to open 400 new stores, which equates to opening costs of just under $190K per store. In addition, it appears as though the company spends about $20K per year per location sprucing up its stores. But the company's annual operating cash flow suggests that the average store generates about $100K annually. As such, it appears as though it only takes about two years for the average GameStop location to pay for itself!

Of course, these are only rough calculations and are likely far from perfect. For one thing, the calculations assume new stores can generate as much cash as existing stores, whereas the markets for new stores are probably not as attractive as the markets that have already been established, which could increase the payback period going forward. On the other hand, there are likely economies of scale such that revenues from new stores can grow at a faster rate than do corporate-level expenses, which would reduce the payback period.

In some industries, investments are made with payback periods many, many years out. (For example, consider how the oil and gas industry operates.) For a company like GameStop, short payback periods reduce the risk that a changing industry can turn GameStop into the next Blockbuster Video. Short payback periods allow GameStop to be nimble and shut down locations that should turn unprofitable, without the large costs that would otherwise be borne by shareholders.

Disclosure: Author has a long position in shares of GME

New Era Value Investing: Chapter 1

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

Tengler starts the book by discussing how value investors don't get sucked in by the "It's different this time" crowd. When certain industries or companies are out of favour in the market, that is often the best time to buy them.

Nevertheless, the market has changed in some ways over time, and value investors can refine their methods to identify more undervalued stocks. Some of the methods employed by traditional value investors can be more difficult to apply as the market evolves. For example, the percentage of companies in high-tech or growth areas has increased over the years, while the relative size of dividends has decreased. For example, technology and health care stocks have doubled to 30% of the S&P 500 since 1990. This has served to reduce the playing field for value investors looking to apply traditional methods of company analysis.

Despite these new methods that Tengler will discuss in this book, the principle of having a disciplined approach to buying stocks that trade at discounts to their intrinsic values still remains. As such, she argues her new methods are not suggesting that "it's different this time", but are rather meant to expand the securities in which value investors may show an interest.

Freakonomics: Chapter 6

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 continues to use the economic tool of regression analysis to illustrate some correlations which are not widely known. Levitt notes that in the aggreggate, white and black parents give their children very different names. Therefore, he sets on the task of determining whether the names of children tend to affect their socioeconomic status later in life.

Some startling research has shown that job applicants with "black" names are less likely to get call-backs from potential employers (This research was done by sending out large resume samples to employers, some with black names and some with white names.) Furthermore, Levitt finds that an adult with a "black" name does end up with a lower socioeconomic status.

But using regression analysis, Levitt explains that after holding other factors constant (e.g. race, income, education etc.), a person's name actually matters not in his future success or lack thereof. Parents, however, spend great time and resources coming up with a name that will set their child up for success. In doing so, Levitt has found that popular names filter down the status levels, with popular names among high-income earners becoming popular names among the general population some years later.

People (illustrated here in the last two chapters using parents as an example) routinely put resources into factors that they cannot control. In doing so, they will often ignore factors that are important. Managers should seek to educate themselves so that they may apply their time towards efforts that yield positive results.

Masking Poor Results

A rather large percentage of companies experienced declines in revenue in both 2009 and 2008, as the general level of aggregate spending declined in most markets. For most of these companies, these declines can be considered temporary. However, investors must take care not to assume that all firms with revenue declines are experiencing only temporary issues; for some firms, the drops in revenue are part of a secular (rather than cyclical) decline.

The determination of whether a firm's decline in revenues is temporary is part art and part science. We've previously discussed the analysis of the more subjective parts, which involved considering the company's line of business and determining its sustainability. In addition, the investor can take direct clues from the company's financial statements and management's discussion and analysis to help determine the state of the business.

Consider Reliv (RELV), producer and marketer of nutritional supplements and skin care products. The company blamed its poor performance in both 2009 and 2008 on the economic crisis, but further study indicates that the company had problems way before then. Revenues have declined for several consecutive years, and though the company remains profitable, assuming the company's average profits over the last several years represents its earnings power going forward could lead to a poor investment result.

Examination of management's discussion over the last several years does not help assuage fears that the company is on the decline. In both 2007 and 2006, otherwise good years for the economy and companies selling health products, management blamed lower sales numbers on the fact that fewer distributors were able to move its product, and that certain products saw drops in demand. In effect, "our sales were lower because our sales were lower".

Further study of the company's business model also suggests the company's past returns are not sustainable. In 2006, the company generated an ROE of over 30%. Considering most of these products can be copied, and the company's business model can be completely replicated, these kinds of returns invite competition into this category. And that's what appears to have happened, as despite rising health awareness country-wide, the company has experienced several years of decline.

Companies experiencing temporary declines in revenues/earnings can be picked up at bargain prices by value investors. Investors must take care, however, not to assume that all declines are of a temporary nature. Some industries (e.g. the newspaper industry) and some companies are in secular decline, and the identification of such companies is not always trivial.

Disclosure: None

Pfizer Over The Long Haul

"Patent expirations" are the two words most commonly used to dissuade investors from investing in pharmaceutical stocks. With respect to Pfizer specifically, 20% of its revenues are expected to be significantly affected by the loss of patent on flagship cholesterol drug Lipitor. But the market's pessimism combined with some changes at the company may result in extraordinary gains for long-term shareholders at the current price.

While patent expiries on existing drugs will continue to spook investors as long as Pfizer has drugs worth selling, it would be naive to expect that Pfizer will not be able to replace some or all of these drugs with new ones. The company has been working hard for many years to improve its pipeline, having spent around $8 billion per year on R&D efforts. The results may be starting to show, as the number of drugs Pfizer is able and willing to take to Phase III trials has been growing steadily as follows:

Of course, such a chart does not give a complete picture of the future, as many drugs will fail their trials, and the potential market size of each drug is not illustrated, but these results are certainly encouraging on their own. CEO Jeff Kindler, who has been with Pfizer for 9 years, noted in the company's last conference call that "[W]e are more enthusiastic about our late stage pipeline than we have been in years."

Of course, such comments from CEOs must be taken with a grain of salt, as managements have incentives to boost confidence in their own company's stock. But an analysis of Kindler's previous statements over the years suggests this comment may be genuine. Pfizer's average return on equity over the last five years of 13% also confirms that management is not reckless with its investments, and is prudent with capital allocation decisions.

In previous years, Pfizer has managed to generate these strong returns even while holding a relatively large net cash position. With the acquisition of Wyeth a couple of quarters ago, however, the company is now employing all of its shareholder capital - and then some. The company now has a net debt position of $20 billion, compared to a net cash position of $8 billion at this time last year. As a result of this swing, the company now has almost $30 billion of additional earning assets. The acquisition of Wyeth also adds steadier products such as Advil, Robitussin and ChapStick to Pfizer's portfolio, which mitigates the risk that accompanies larger debt balances.

From a valuation point of view, the pessimism surrounding this company has made it look cheap. Management estimates earnings per share of approximately $2.30 in 2012, versus a current stock price of $16. Investors should note, however, that management's numbers are significantly higher than the GAAP numbers, as management likes to report a number that excludes various items; shareholders should ensure they understand these differences, as non-recurring charges in this industry tend to be the norm rather than the exception.

When we met with value investor Francis Chou almost two years ago, he was bullish on the pharmaceutical sector as a long-term value investment. Since that time, valuations for many of the large pharma companies (Pfizer included) are down, while changes in companies like Pfizer are likely to have a positive effect on future earnings. As the market continues to be pessimistic on this sector due to upcoming patent expirations, much of the downside risk is already priced in. At this price level, companies like Pfizer could offer superior long-term returns.

Disclosure: None

Significant Regulatory Changes

Some regulatory changes make minimal impact on company valuations - at least in the short-term. Other regulatory changes, such as tax rate changes, affect almost all companies equally. But some regulatory changes affect only a small group of companies, and in a big way!

In late 2009, a new federal law was enacted that significantly expands the Net Operating Loss carry-back opportunity for businesses. In effect, this allows companies that experienced large losses in 2008 and 2009 to offset them against gains they experienced in the five previous years, allowing them to recuperate tax payments they have previously made.

For most companies, this regulatory change may mean nothing at all; for companies that broke even or incurred only small losses in 2008 and 2009, or for companies that incurred large losses in 2008 and 2009 but don't have correspondingly large gains in immediate prior years, this tax treatment change makes little difference. But for some companies, the change can turn a company from a sell into a buy!

Consider Chromcraft Revington (CRC), producer and distributor of residential and commercial furniture. The company has had a particularly rough couple of years. In 2008 alone, it lost $25 million on revenue of just $99 million! In previous years, however, it has been rather profitable. As such, the refund the company is to receive based on the regulatory change is $6.5 million. To put this in perspective, the company's market cap is just $15 million! The regulatory change alone turns this company into one that trades at a discount to its net current assets!

Paying constant attention to regulatory changes can be an arduous task. Most changes make little to no difference in the vast majority of company valuations. For those paying close attention, however, opportunities can arise when a regulatory change has a significant affect on a company's finances.

Disclosure: None