Effecting Change

Which company inspires more confidence in its financial results, one that has had a publicized auditing misstep in the past, or one with a pristine history? Surprisingly, the first company may be more credible. The reason is that for positive corporate governance changes to occur, the problems with poor corporate governance often have to surface. The company that has experienced serious enough issues to take notice, but not so serious that they proved fatal, has been provided a catalyst for change.

Consider Genesis Land Development (GDC), a company we have previously discussed as a potential value investment. The company is preparing for its annual meeting by issuing press releases recommending "that a strong independent slate of directors be elected...to assist with the ongoing efforts to improve governance, oversight and shareholder value".

The release goes on to say that "additional steps must be taken to strengthen governance, management oversight and management itself" and "a strong independent board of directors is critical to the future success of the Corporation".

Of course, a strong independent board is something that shareholders would like to see at many companies, but it is not often made a point of focus by companies with otherwise poor governance.

But GDC has seen what poor governance can lead to. Two years ago, the company's CEO and CFO were dismissed with cause following findings that they misled auditors. As the recession started to threaten the company's viability, the CEO was re-hired and has engineered the company's return to profitability.

However, shareholders have not forgotten the mistakes of the past. Shareholder groups have stated that "it is clear that [CEO] Gobi Singh, with his inexcusable history when it comes to transparency and good governance, needs to report into a strong, independent Board" and that they will put forth an independent slate if the company does not.

This brush with the pitfalls of a poor corporate governance structure has provided Genesis shareholders with the burning platform they need to effectuate positive change. Hopefully, this will lead to a stronger company better able to raise its share price such that it is commensurate with the value of its assets.

Disclosure: Author has a long position in shares of GDC

Natural Barriers To Competition

Value investors are constantly on the look-out for businesses with "moats" that the competition cannot displace. Usually, this is the result of a competitive advantage that cannot be copied. But perhaps it can also be the result of being in a business that is shunned to the extent that no quality management wants to copy it.

Consider New Frontier Media (NOOF), producer and distributor of pornographic movies. The company has deals in place with the major cable providers which allows them to beam millions of dollars worth of adult pay-per-view content into homes throughout America and the world. Despite being a business that appears to be easily replicated, the company has enjoyed surprisingly good margins (approaching 20% on average) and returns (5-year ROE > 12%), beating up on its primary competitor, Playboy Enterprises (PLA).

Despite this, the company appears to trade at a substantial discount. New Frontier's market cap is just $38 million, while the company has earned operating income far in excess of that in the last four years alone, even after including a $12 million goodwill write-down that caused the company's 2009 net income to be negative. In addition, the company has $15 million of cash against just $3 million of debt.

The future is not without challenges, however. As consolidation in the cable industry throughout the United States has taken place, New Frontier's customers have become more concentrated and powerful. As a result, New Frontier's business would take a substantial hit if one of these operators switched to a different provider. More immediately, however, this has allowed the cable operators to push New Frontier on price, reducing domestic margins.

Furthermore, while the company's founder Michael Weiner (which could also pass for a screen-name in this business) is still the chief executive, his annual salary and bonus dwarf his stock ownership in the company, which doesn't say a lot for the company's incentive structure. Nevertheless, the company has succeeded for years with Weiner at the helm, and shareholders appear to be offered a price at this level with a substantial margin of safety.

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We first discussed this company a few months ago here.

Disclosure: Author has a long position in shares of NOOF

New Era Value Investing: Chapter 9

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

Various low P/B or low P/E indexes have been created in order to separate out value and growth stocks. However, separating out stocks based on a single metric can lead to misleading results. Tengler argues that investing in second-rate companies in slow-growth industries that trade at justifiably low P/E ratios does not constitute value investing. Instead, buying the best companies relative to their peers and their own valuation history is a more legitimate value-oriented strategy.

Furthermore, most companies will shift between value and growth categories repeatedly, making it difficult to pigeon-hole them into one particular style. Tengler illustrates this point using examples of defense stocks (which have gone from growth to value to back again depending on war policy) and technology stocks (which went from growth to value after the bubble of the late 90's).

Tengler discusses Buffett's purchase of Coke as a great example of there being a blend between growth and value. While Coke has been a growth stock for most of several decades, it has run into its share of temporary problems that made investors reduce its P/E ratio. This is a great example of a value purchase, even though the P/E was high enough to scare off investors who look only at P/E ratios.

Tengler argues that it doesn't matter whether a company is considered growth or value across a few metrics. What's important to investors is that it is a strong company that trades at a discount relative to its own history and relative to its peers. Whether that company is a growth stock or a value stock, it is attractive and should be purchased.

New Era Value Investing: Chapter 8

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

Now that the selection of individual stocks has been discussed, Tengler turns to portfolio construction.

The first thing the investor should determine is the level of concentration in the portfolio. Tengler argues that fewer than 20 stocks are needed for proper diversification, but in her institutional portfolio she carries between 25 and 35 issues. This is due to the fact that clients are decidedly against volatility. Spreading the wealth around helps reduce volatility, even if it means putting money in one's 35th favourite idea rather than putting more money in one's favourite idea.

Tengler argues that the second most important aspect to building a portfolio is buying only the "best" companies. Effort in fundamental stock research aids the investor in this endevour.

Tengler further argues that investors should incorporate both RDY and RSPR (described in Chapters 3 and 4) rather than choosing one or the other. Often, one of these forms will be out of favour while the other can boost results. Furthermore, as the universe of RDY-type stocks declines, investors will still have the ability to apply the value framework by employing the newer RSPR.

Investors should also consider the correlation between issues in their portfolios. Some sectors will do well while others will stall, and so stocks with low correlation to other stocks in a portfolio provide protection against volatility.

Finally, Tengler shares how she maintains buying and selling discipline. She prefers to average into a stock, since she doesn't believe she can predict the bottom. She will start with a position that's around .5% of the portfolio, and spread her buys over time until she has accumulated an amount representing about 3-5% of the total portfolio. At no point can one single position occupy more than 6% of her portfolio, therefore she will begin to sell if the prices moves up such that this occurs. Once the price hits the sell level, she will look to exit her position completely lest the price drop back down. Tengler will also use stop-losses (using money management software) to protect from large one-day or one-week declines.

Tengler closes the chapter by discussing some of the mistakes she has made in her portfolio. The lessons that are illustrated in these mistakes are:

1) Beware of newly merged companies with different operating profiles (e.g. AOL Time Warner)

2) Beware of new companies with short operating histories

Communication

Two companies may have the exact same financial statements, and yet one may be a value investment while the other is not. This is because management's intentions play a big role in determining what kind of investor would find a stock attractive. (For example, consider two companies with large cash balances. If one intends to to use the cash to buy back shares while the other intends to invest the cash to find a new blockbuster drug, the investor profile of each company should look very different.)

As such, it is important that management communicate its intentions with shareholders. Recently, we saw an example of the kind of backlash that can happen when shareholders don't know what to expect. On the other hand, when shareholders do know what to expect, it can lead to a win-win for all.

Few companies are as good at communicating their intentions as Quest Capital (QCC). When the economy turned south, Quest made it very clear that it would stop its lending operations and instead focus on collections. This may have caused shareholders who are primarily interested in earnings to sell their shares, but it also piqued the interest of those looking to buy loan portfolios at a discount. In this way, Quest altered its shareholder profile to one that is in harmony with management's objectives.

When cash inflows far outpaced cash outflows (since the company was no longer lending), Quest made it clear that it would use proceeds to pay down debt and buy out preferred shareholders. This would turn off those looking for leveraged real-estate real-estate returns, but would result in shareholders of a more conservative, value orientation.

Now that debts and preferred shares have been paid down, the company recently announced that it would seek to close the gap between its share price and its book value. The company then went on to buy up almost 10% of its shares in the last five months, doing exactly what it said it would do.

So what's next? Quest's chairman issued the following statement two weeks ago:

"We expect further [loan] monetization to occur and while we have recommenced lending on a cautious basis, we do not anticipate utilizing all of our cash over the near term. In the interim, we continue to look to enhance shareholder value and close the discrepancy between our book value of $1.82 per share and our trading price."

When it comes to some companies, management's intentions are difficult to figure out. For other companies, however, the publication of management's intent can bring along the right kind of shareholder - one who is there because they would do the same if they were in charge, which results in a natural alignment of management and shareholder interests. This can result in fewer surprises, and a much more content shareholder group!

Disclosure: Author has a long position in shares of QCC

CEO Gets A Stoning

Usually, company conference call participants are fairly polite in their questions and comments for company management. When a company has lost a lot of money, however, shareholders can turn nasty!

Belzberg Technologies (BLZ) is one such company. It recently reported a $2.5 million loss in its first quarter, which follows losses of $11 million, $2.5 million, $1.5 million, $2 million and $0.5 million in the previous five quarters! As such, shareholders have sold this company with a vengeance, so much so that the company trades for well below its cash balance, and thus became a potential value investment.

Illustrating the frustration of many shareholders with this company was Sam Stone, a private investor who gave it to the CEO on the latest company conference call. Here are some of his statements to management, who eventually had to cut him off:

Sam Stone: You had a year and a half to do something about turning around the company, but you've had one disastrous quarter after another and the cash keeps dwindling. Other than paying your salary, what reason is there to keep this company open?

CEO Judith Robertson: Well we have a plan to turn the company around, and we're executing on that plan, and we believe that the future value of the company is not reflective in the current operating performance.

Stone: At the current rate of burn, you're going to run out of money in the first quarter [of next year]. Other than hoping that someone will buy you while you're losing money, what viable options do you have?

Robertson: We have an operating plan that we're executing that is a combination of continued cost right-sizing for the size of our organization and changes in our industry, as well as pushing forward on targeted revenue initiatives...

Stone: ...If you have no substantial revenue generating sales in the pipeline, why don't you shut down the company now? Or is this just to maintain your salary and Chris Jackson's? Whose benefit are you running this company for, yours or the shareholders?

Robertson: I am running the company for the benefit of the shareholders, as is the Board.

Stone: Your results don't seem to match that. The previous company you ran went into bankruptcy; it seems that Belzberg is heading in the same direction. Why don't you close the company now and give what's left to shareholders. If you wait for the first quarter when you run out of cash, there'll be nothing left.

Robertson: The Board and I believe that the value of the company going forward is more than shutting it down. So we think that's the right decision.

Stone: Well, if you stay in business, how long are you going to be open for business until you run out of cash? How much cash do you have in the bank to weather the storm? How many quarters? As a shareholder, I'm appalled that the decision to shut down the company is not actively discussed in this call in a meaningful way...How is the way you're running this company different than how you ran your last company into bankruptcy?

While Sam Stone's approach is a tad aggressive, his frustration is likely echoed by many shareholders. Since the stock price of this company trades well below the company's cash balance, it makes sense to shareholders like Stone that the company should wind-up its operations and pay shareholders what they can.

Management, however, has decided to attempt to return to profitability. But they have not provided shareholders with any guidance on revenue/cost targets, resulting in much uncertainty. Until this changes, shareholders are in the dark as to what to expect.

Disclosure: Author has a long position in shares of BLZ

Dividends After The Fact

Investors will often rely on a company's most recent financial report in order to determine its current financial position. But that's not good enough. One reason for this is obvious: subsequent events may have occurred which are material to the company's position. But another reason is not so obvious: events which were previously announced but which had not yet taken place by the statement cut-off date could get missed!

Consider C-Com (CMI), a developer of mobile satellite technologies. In early April, the company announced a special, one-time dividend of 2 cents per share for shareholders who held the stock on April 6th. A month later, quarterly results for the period ending Feb 28th came out. Nowhere in either the financial statements or management's discussion & analysis was this dividend mentioned...even in the section titled "Subsequent Events"! The dividend payment had already taken place, but shareholders relying only on the most recent financial statements would think the company's cash balance is much higher than it really is!

While 2 cents per share is not a lot for most companies, it represents about 7% of this company's market cap. Furthermore, it is not difficult to envision this situation occurring for other companies that hand out larger, even more material one-time dividends.

When you're interested in investing in a company, read all the recent filings, not just the ones that came out following the last quarterly report. There may just be events in the closet that are material to your valuation.

Disclosure: None