Jet Setting

Of the 4500 or so airports in the United States, the major airlines only service about 10% of them. Security concerns have also made passenger airplane travel a time-consuming endeavor. As such, for some companies it's quite likely that a business case can be made for the purchase of a corporate jet (though not always).

But increasingly, executives have begun to make personal use of the corporate jet, for which no business case can be made. This is a veiled attempt at increasing compensation, without the appearance of doing so. In some cases, an executive's personal (i.e. non-business related activities) use of the company jet costs the company more than his entire salary! In most of these cases, the company will also issue a bonus to the executive to cover his related tax bill!

A strong corporate governance process is of vital importance to shareholders looking to maximize their returns. Shareholders can get clues as to the quality of a company's corporate governance by examining the company's behaviour when it comes to items like corporate jets.

For example, consider Abercrombie and Fitch, a company we discussed last year as one that re-affirmed its strategy, only to seemingly change it a few weeks later. The company and its CEO recently entered an agreement whereby the CEO was limited to keeping his personal use of the company jet to $200,000 per year. This still seems fairly generous, as $200K for vacation travel in a year does seem rather excessive, but at least it's capped at something, right?

Unfortunately, in return for signing this agreement, the CEO was provided $4 million in cash! This makes you wonder...how much personal use of the jet was he getting before this agreement? A significant amount, if this payment for the $200K cap is any indication. His base salary is just $1.5 million, meaning his use of the corporate jet was a significant perk!

Managers will always try to glean what they can from the company kitty. It's human nature, and so they can hardly be blamed in the aggregate. But as a result, the importance of a governance structure that protects shareholders is instrumental, so that the managers are working for, rather than against, the shareholders. Frivolous use of company property should be a clear sign to shareholders that all isn't right with a company's governance structure, and so they may wish to avoid such companies.

Disclosure: Author has no corporate jet, and reserves the right to change his mind should his company acquire one.

Revenue Timing

Canam (CAM) has dropped some 15% in the last few days, as the company reported a loss in its first quarter earnings results last week. However, Canam has been discussed on this site as a stock idea with long-term potential for gains due to its stable operating model and growing backlog. As a result, temporary pullbacks in the form of revenue timing issues appear to offer long-term investors an excellent buying opportunity.

While the market appears focused on the fact that revenue dropped from $180M to $105M in the first quarter (a large drop by any standard), it's important for long-term investors to look behind the numbers to understand the long-term implications. As a company that designs and builds large-ticket construction products that require long lead times, recessions will hit this company later than it will most. As a result, the slowdown in the economy that occurred in 2009 has only hit the company now. The important indicators for forward-looking shareholders, however, are the company's booking rates.

For Canam, booking rates have been out-pacing revenue, as the company's backlog is now at a record level, though the company has been in existence for 50 years! The company's backlog over the last several quarters is shown below:

There are two main reasons for the large backlog. First, the company has been building roofing installations for two large stadiums (BC Place in Vancouver and Marlins' Stadium in Miami), but isn't scheduled to start delivery of those structures until the second quarter. (In this case, revenue cannot be booked until delivery has taken place.) These contracts alone are worth $180M; compare that to the company's first quarter revenue of $105M. In essence, revenue from the first quarter was simply pushed to revenues in future quarters, making first quarter revenue look poorer than it was, but making future quarters look better than they should.

Second, with prices depressed among competitors and complementary businesses, Canam has been at work acquiring companies, including Tennessee-based FabSouth, which added another $100M+ to the company's backlog. Since FabSouth was not fully consolidated in Canam's results until most of the first quarter was complete, these revenue numbers don't show the full impact of Canam's full business. But as the company works through its record backlog (and it expects to deliver all of its current backlog within a year), those revenue numbers will see strong sequential growth.

Investors focused only on quarterly earnings are sure to make poor decisions when it comes to making purchase decisions for the long-term. For companies dealing in large-ticket items, revenue timing issues can play a significant role in any one quarter's results. As such, it's important that investors think about the company's business from a long-term perspective to put themselves in a position to properly value a company's stock.

Disclosure: Author has a long position in shares of CAM

New Era Value Investing: Chapter 3

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

In this chapter, Tengler outlines a value strategy that she employs successfully, calling it Relative Dividend Yield (RDY).

With the increasing ability to use technology to compare various factors across a whole slew of stock issues in the 1970s, many investment ideas were spawned. Tengler believes RDY to be one that has much in the way of value appeal conceptually, along with a successful track record.

In RDY, a stock's dividend yield is compared to the market on a historical basis. If the stock's dividend yield beats that of the market by 25% or more, and the stock's yield is high on a historical basis (for this particular stock), it becomes an attractive buy. Should the stock rise to a point where the yield drops below the market's yield, it becomes a sell.

Tengler discusses several reasons that this strategy works. Dividends are more consistent than earnings, so while earnings can fluctuate, Tengler argues that dividends offer the best glimpse of management's view of a stable pay-out that the company can maintain for the long-term.

Furthermore, when a company's yield rises as compared to that of the market, it is a sign that it is not favoured by the market. Tengler argues that this is a good time to buy. She cites Coca-Cola and Johnson & Johnson as ideal examples of this in 2001-02.

Finally, Tengler notes that there are times when this strategy doesn't work. For example, if a stock's relative price to the market is uncorrelated with its RDY, Tengler notes that the strategy no longer outperforms.

New Era Value Investing: Chapter 2

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 takes the reader through the history of fundamental analysis in the stock market. While many value investors know the history as far back as Benjamin Graham and David Dodd's Security Analysis, Tengler goes further back to give credit to two New Yorkers who laid the groundwork that allowed Graham and Dodd to do their thing.

In the late 1800's, the stock market was akin to a casino, as fraudulent activities reigned throughout. Louis Guenther started a magazine in 1902 that reported on and exposed securities fraud, while Alfred Best published a service focused on reporting accurate information on insurance company financials, originally to allow customers to buy fire insurance from reputable companies that weren't going to go under. It was Best that first noted the concept of intrinsic value, whereby investors were encouraged to purchase stocks if they traded below the estimate of their intrinsic values.

In the 1930s came the groundbreaking work from Graham and Dodd, but even in subsequent editions of Graham's books did his methods evolve, though based on the same principles. This is because the market continued to evolve, as the methods that worked the best during the Great Depression were not the same as those that worked the best during WWII.

Over time, the dividend has also become less relevant. At one time, it was a mark of a great company that could continually reward its shareholders, but more recently it has become a sign that a corporation does not have profitable uses for its earnings. Dividend-focused value investors would be forced to change.

Short-Term Predictions

Frequent readers of this site know that we don't believe short-term market movements can be predicted profitably. This opinion is not unique, as it is shared by some of the market's brightest participants. Nevertheless, it appears as though there will always be providers of short-term predictions, both for people who think short-term movements can be predicted and for those who don't but who consume short-term predictions anyway.

Consider these comments from stock market prognosticator Jim Cramer two weeks ago, one day before Goldman Sachs (GS) lost 13% of its value (on the news that it was being sued by the SEC):

I did some work today behind the scenes. My understanding of the current talks is that the big banks are the winners, not the losers. You will read that story in the papers 72 hours from now. Big banks are about to get their way. That is what is going on behind the scenes...a huge victory for JP Morgan and Goldman Sachs, and the other big banks. Yes, a huge victory. The press will not write that. I know better; you just heard it first, right here.

Of course, it is easy to pick on tv personality Jim Cramer. It's been done on this site before, and his picks have been ridiculed elsewhere rather frequently. But the truth is, he is likely no worse than others who attempt to crystal ball stock prices using a time-frame of hours or days instead of years. But he's more famous and more followed, allowing for easier dissection of his misses. (For example, consider the pushers of airline stocks just one day before they began their long descent.)

Cramer and others like him are not there because of their investing prowess (or lack thereof), but because they can entertain. The important take-away for readers is that they not confuse their entertainment choices with their investment decisions, which should be made with a long-term, rather than a short-term, focus.

Disclosure: None

For What It's Worth

Just over a month ago, we saw that real-estate development company Genesis Land (GDC) hired a 3rd party appraiser to value its land holdings. The signal from management was clear that it believed the market was severely undervaluing its properties. The appraisal results did not disappoint; the company's stock price rose 25% on the day the appraisal results came out.

While the company trades for around $5/share, the appraiser puts the company's net asset value at $8.25/share, after taxes. As such, an opportunity may still exist for shareholders looking to buy real-estate at a discount. It should be noted, however, that while the appraiser is called "independent", common sense dictates that this is not the case. The appraiser was paid by the company, and will want the company's future business, and will therefore come out with results that are favourable. (Similarly, a director who consults for a company cannot be considered independent, because he is likely to agree with the CEO to keep the company's business coming his way.)

Nevertheless, this situation appears to illustrate that stock values do deviate wildly from net asset values. We saw this last year when we looked at the example of Melcor, not once but twice. For the enterprising investor who takes the time and effort to appraise company properties, there are likely huge gains to be made, as the market is clearly not efficient.

Disclosure: None

Earnings Persistence

Value investors love finding stocks trading at low P/E values, as this means the price that must be paid for the stock is low relative to the company's earnings. But the investor cannot assume that current or recent earnings will persist forever, as this could result in an overpayment for a stock. One warning sign in particular that may indicate that earnings may not persist are abnormally high returns on equity.

The same feature of capitalism that has provided continuous improvements in productivity and our standards of living will also erode the earnings of investors who do not pay attention to its power: competition. When firms are able to generate abnormally high returns, a plethora of copy-cats will attempt to replicate its success.

Consider Cambrex Corporation (CBM), maker of active ingredients for pharmaceutical products. In 2009, the company generated operating income of $26 million against a market cap of just $128 million. But can it keep those levels of earnings going? That depends on whether the company has any advantages that the competition cannot erode. As a producer of commodity products, the company has at least 25 competitors in Western Europe and the United States, and many more in low-cost regions such as Asia and Eastern Europe.

It's important to note that every company will claim to have a competitive advantage. In the case of Cambrex, it has patents covering various processes and claims to have superior manufacturing know-how. However, only someone who understands the industry and the companies within it quite well will be able to determine if these advantages are real, and if they may result in strong returns that are sustainable. This once again highlights the need for investors to restrict themselves to areas within their circle of competence.

Barring a competitive advantage, competition will erode the returns of a successful operation. Companies like Coke (KO), Intel (INTC), and Google (GOOG) clearly have competitive advantages that have allowed them to generate abnormally high returns for sustained periods. Of course, there are many more companies with competitive advantages, even small ones. But if the investor is counting on such returns to be persistent, he should be able to identify that advantage, lest he overpay for a company that is soon to see its earnings return to more normal levels.

Disclosure: None