Noble Profits

While Barnes and Noble (BKS) has averaged operating income of over $200 million per year over the last four years, the company trades for just $1.1 billion. Furthermore, Barnes and Noble has minimal balance sheet debt and low capital expenditure requirements, suggesting it has the potential for being a cash cow for investors.

Of course, the reason the market has shunned this stock is that the company faces a secular downturn. But like GameStop (incidentally, a spin-off from Barnes and Noble!), another stock we have discussed that faces a potential secular downturn, can it stave off the technologically-astute competition long enough to reward shareholders at the currently depressed stock price?

Unfortunately, Barnes and Noble's current financial statements may understate the rate of decline in this business. While operating profit was $146 million last quarter, which was $6 million higher than it was last year at this time, the company received a $39 million boost to its 2010 operating profit due to a new acquisition (B&N College) which played no role in last year's results. This acquisition removed a bunch of cash and added some debt to the company's balance sheet.

While some of the company's decline may be attributed to cyclical rather than secular effects, Barnes and Noble does face a secular decline on two fronts, which exacerbates and could therefore serve to accelerate its rate of decline. First, customers are changing how they purchase books, shifting more revenue dollars online from bricks and mortar purchases. More recently, however, customers are also changing how they interact with books, using devices such as the Kindle and the iPad. Furthermore, the company has almost $2 billion in operating leases that extend out several years. If much of the recent declines are secular, the company's bricks and mortar operations could yield substantial losses in the near future.

For its part, Barnes and Noble has been jumping into the new methods of distributing books, having released its own e-reader and having made a slew of acquisitions of platforms to support its online presence. Still, only 10% of the company's revenue is from online sources. As such, this foray against the strong competition that's out there adds risk to this investment; rather than receive the cash flow from Barnes and Noble's existing operations, shareholder funds are re-invested in products and services with uncertain outcomes against strong competition.

Barnes and Noble could be successful in transitioning to a method of distribution more suited to the current times. Unfortunately, these investments are fraught with risk. Shareholders seeking to capitalize from a low stock price and a cash generating business may never see a dime, due to the company's desire to invest to attempt to remain a large player in this space.

Disclosure: None

Getting The Growth For Free

Investors are willing to pay more for a company that holds the promise of growing its earnings. Even companies with unproven business models that can "sell a story" can often trade at high P/E multiples. Value investors, on the other hand, would rather not pay extra for earnings that are as yet unseen and difficult to predict. When the potential for increased earnings is offered for free, however, the price becomes right for even the stingiest of bargain hunters.

Consider Acme United (ACU), producer of measuring, cutting and safety products. Frequent visitors to the site will already recognize this company as a Stock Idea, due to its low P/E and high ROE. But what these financial metrics understate is the company's ability to grow its earnings.

Acme has set a goal of deriving 30% of its sales from products developed in the last 3 years. While this might sound quite reasonable for a hi-tech company with short product cycles and evolving customer needs, it is quite a challenge for a company that makes knives, pencil sharpeners and rulers such as Acme.

Nevertheless, the company is succeeding in this regard, attributing most of the 16% sales growth it realized in the last quarter to sales of new products. The company developed a non-stick coating that improves the performance of its line of blades, and thus saw increased sales of its iPoint pencil sharpeners and non-stick scissors. Furthermore, sales of the company's 2008-developed utility knife with replaceable cartridges continue to grow. The company also recently acquired the patents and intellectual property of Camillus, and has recently launched a new line of Camillus cutting knives enhanced with Acme's high-performance titanium carbonitride coating.

What Acme has going on is not easy replicated. As Philip Fisher (whom Warren Buffett describes as inspiration for 15% of his investing philosophy) has written in his book Common Stocks and Uncommon Profits, stocks with the potential to be home-runs have special qualities which can result in spectacular returns. The company must have policies which promote newly developed products, the company's R&D must yield useful and viable findings, and the company must focus on the long-term (among other things). Acme appears solid across many of these points.

While value investors don't like to pay for growth, sometimes growth is offered in the market for free. With a P/E of 12 derived from earnings during a recession, along with a low net-debt to equity level, Acme appears to offer investors just that.

Disclosure: Author has a long position in shares of ACU

New Era Value Investing: Chapter 7

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 a similar vein to the previous chapter, Tengler now describes specific stocks that she has bought as a result of using RSPR, the method described in Chapter 4. She notes that the types of stocks this method picks up, as opposed to RDY, tend to be more growth oriented, but are still fallen angels of sorts, since they would not qualify as bargains unless they had a relatively low price to sales ratios.

Throughout the technology boom, Tengler notes that RSPR underperformed the market, as the expensive, high-flying stocks were the securities that rose the most. But during the bust, RSPR stocks outperformed their peers, as stocks with high price to sales ratios came crashing down.

Intel (INTC) is a company that appeared cheap on an RSPR basis in 1988, 1991, and between 1995 and 1996. Despite a strong market position, Intel's earnings would be pressured near the end of a product cycle, as competition would compress the company's margins. This has allowed value investors to take advantage and get in at attractive prices. From 1999 to 2000, however, RSPR suggested Intel was a major "sell", and so the investor was afforded an opportunity to take profits prior to the crash.

Other stocks this method has resulted in identifying are Estee Lauder (EL) in 2002, Microsoft (MSFT) in 1995, Oracle (ORCL) in 1997, Disney (DIS) from 1999 to 2001, The Home Depot (HD) in the mid 1990s, Nike (NKE) in 1998, and Cisco (CSCO) in 1994, 1997 and 2002.

Occasionally, stocks will become undervalued according to both RDY and RSPR at the same time. These stocks are usually former high-flyers that have reached a stage of maturity. Tengler suggests investors switch to using the RDY method only for evaluating such stocks, as the RSPR method may not longer apply. RDY is also described as the more rigorous method.

New Era Value Investing: Chapter 6

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 describes some specific stocks that she has bought as a result of using RDY, the method described in Chapter 3.

Exxon Mobile (XOM) is a stock with tremendous volatility due to changes in investor sentiment with respect to the price of oil. While earnings fluctuate significantly, the company's dividend is a much better gauge of the company's long-term earnings ability than any one year's earnings. As a result, Tengler has purchased this stock when the yield compared to that of the market was extremely strong, and has sold when the yield has been relatively weak.

Wyeth is another example of a company that RDY identified in the late 1990s. The company was coming off the news of a failed merger, and had run into a number of bad news issues with some of the drugs it had developed. The market punished the stock, allowing value investors a buy opportunity which was identified by the fact that Wyeth's yield compared to the market was far out of line.

Despite being a great company for many years, General Electric (GE) stayed at a price that did not make sense for the value investor. Finally, in 2002, amidst a slew of bad news (CEO step-down, failed Honeywell acquisition) the stock fell to a level, relative to its dividend, that made sense to Tengler.

Tengler goes on to describe other RDY-identified buy prices for 3M, Kimberly-Clark, Gillette, Wells Fargo, and Marsh & McLennan. In these cases, temporary problems plagued companies, which hurt the stock for short periods of time. Buyers at these prices were rewarded.

Tengler finishes the chapter by discussing two stocks, Verizon and Heinz, that looked like buys per the RDY method, but never ended up rewarding their investors.

Governing The Governors

In a previous post, we discussed the potential pitfalls of investing in companies with poor corporate governance structures. But how can an investor protect himself? There are two basic ways. First of all, the investor can become knowledgeable about what makes for good corporate governance, and then study up on each company in which he is interested in order to make sure it follows practices in accordance with sound corporate governance. The second method is to take advantage of the information published by the companies that specialize in rating and reporting on the governance practices of public companies.

A full discussion of what makes for good corporate governance is beyond the scope of what can be provided in this one article, and we have covered some of the basic points in previous articles on corporate governance. Therefore, this article will focus on what's available for those interested in pursuing the second method.

Governance Metrics International (GMI) is a company that has developed a proprietary corporate governance rating model that it has applied to over 4000 companies. The premise behind the company is that firms with superior corporate governance practices generate superior returns. GMI can be contacted for those who wish to receive a sample report.

Standard and Poor's also produces a Corporate Governance Score (CGS), based on the following criteria:

1. Ownership structure
2. Shareholder rights
3. Transparency and disclosure
4. Board effectiveness

Based on how a company is rated in the above four factors, it is given a CGS rating between 1 and 10. A sample report of S&P governance can be viewed here.

While it's easy to gloss over corporate governance elements, the wisest investors always keep them top of mind. With the first rule of value investing being "Never Lose Money", ensuring sound corporate governance practices can increase the likelihood of being able to follow that rule successfully.

Forced Dividends

Sometimes a company will appear cheap, but whether the investor will ever see the benefit of the company's success is another story. If management controls the company, or shareholders are not well represented on the board, the company could hoard money, or spend it on empire-building acquisitions. But some companies are organized such that substantial payouts are required.

Consider PMC Commercial Trust (PCC), a real-estate investment trust (REIT). As a REIT (rather than a regular corporation), the company must pay out at least 90% of its annual income. In doing so, it is not taxed at the company level. Large tax savings can generate significant shareholder value, as we've seen with both Dorel and Key Tronic.

With PMC trading at just $85 million, however, that value may be up for grabs for current shareholders. The company's distribution currently yields 8% (though this may decline with lower earnings), but that's not even the most attractive aspect of this investment: shareholder equity is over $150 million.

The company's assets are mostly in the form of loans receivable from franchised hotel owner/operators. These assets are secured by real-estate and personal guarantees. Earnings are depressed because interest rates are low (and so the company cannot earn great returns on its assets) and because economic conditions have made it difficult for borrowers to pay their loans.

To the first point, temporary earnings shortfalls should not drive the investment decisions of value investors. This is precisely the type of situation that leads to depressed stock prices, allowing value investors to profit in the long term. To the second point, PMC has been a rather conservative lender, and as a result has suffered few loan losses. The company requires significant equity investments on the part of the borrower before a loan is made, and does not offer any riskier loan packages including interest-only or subordinated debt. As a result, its satisfactory loans (i.e. loans that are not delinquent, or aren't on any watch-list for being behind on tax or franchisee payments) comprise 92% of its loan portfolio, up from 89% one quarter ago.

As such, at its current price, PMC may offer investors both decent income and the potential for capital appreciation due to the large discount at which the stock trades relative to its loan portfolio. Companies in similar lines of business with similar discounts to PMC that we've already looked at include Quest Capital and Manhattan Bridge.

Disclosure: Author has a long position in shares of PCC

Candor Counts

When reading through the press releases that most companies issue to announce their quarterly financial results, one can get a pretty good idea of which companies are pleased with their earnings and which are not. Unfortunately, however, it often requires reading between, or in this case below, the lines.

When the earnings are positive, the company will usually lead with a statement listing its net income and describing how strong it is. When the earnings are negative, a whole slew of issues are likely to be discussed before the earnings number is deemed relevant.

Consider Nu Horizons (NUHC), a company we have previously discussed as a potential value investment. Two years ago, when earnings were positive, the company reported net income in the 3rd sentence of the press release, in a candid and matter-of-fact manner:

"Net income for the quarter was $1,155,000"

Fast forward to last week's results where the negative earnings number is not reported until the 7th paragraph, getting trumped by such items as sequential sales results, supplier updates, an update with respect to the strategy for Asia (this is a company based in NY), workforce reductions subsequent to the quarter end, a statement amount debt reduction expectations, sales by geographic region, and a discussion of the company's tax assets!

Managers of public corporations are just as human as the rest of us: nobody likes giving bad news. When management is not candid with its shareholders, however, it leaves a poor impression with investors. Here are Warren Buffett's comments on candor:

"We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value. Our guideline is to tell you the business facts that we would want to know if our positions were reversed. We owe you no less. Moreover, as a company with a major communications business, it would be inexcusable for us to apply lesser standards of accuracy, balance and incisiveness when reporting on ourselves than we would expect our news people to apply when reporting on others. We also believe candor benefits us as managers: The CEO who misleads others in public may eventually mislead himself in private."

This topic may be similar to one we've previously seen where managers blame externalities for negative surprises, and credit themselves when positive surprises occur.

Disclosure: Author has a long position in shares of NUHC