Shareholders of HVAC installation company KSW Inc. (KSW) have recently been able to exit their investment at quite a premium to what they paid. This stock has been one of the oldest members of this site's Stock Ideas page, but due to the strength of its stock price, it will now find itself on the Value In Action page. This investment has illustrated several important characteristics of value investing that can help investors identify and profit from the next opportunity.
First, it's okay to buy a cyclical business, even during a recession. The key is a strong financial position that allows a company to outlast the downturn. In KSW's case, it was flush with cash and had a flexible cost structure, with few requirements in terms of fixed costs and inventory.
When a recession hits, however, it is the companies in cyclical industries that see their stock prices hit the most, offering investors the opportunity to buy the ones with staying power at a big discount to intrinsic value. Just a few months ago, KSW could be had for a 20% discount to its book value. But it has recently traded for a 20% premium to its book value, as the company has continued to amass cash (thanks to a variable cost structure that has kept it profitable) and rebuild its backlog.
Just because I'm selling KSW, however, doesn't mean it's not still undervalued. At this price, however, I believe the easy money has been made and so I'm moving on the other ideas. Investors who understand the business well may continue to see value in this name and may continue to see strong returns.
Disclosure: None
Tuesday, June 7, 2011
Monday, June 6, 2011
Calian: Lower Risk Tech
Technology companies are generally more difficult to value than their counterparts in more stable industries. Because of the disruptive nature of change in the tech industry, it's very difficult to forecast earnings a few years out with any degree of certainty. But there are properties a company can possess, even one in the technology industry, that add some certainty to the valuation. A large cash balance is one of them.
Consider Calian Technologies (CTY), a provider of technology products and services for the communications industry. Calian has a cash balance of $25 million against no debt, which results in cash comprising 17% of the company's market cap!
So while the company trades at a price to earnings ratio of 11, it's price to earnings ratio becomes just 9 if the cash is backed out of the company's market cap. The P/E is low despite the high returns on equity the company generates; ROE has been around 20% for many years in a row. Meanwhile, the company paid out $15 million in cash to shareholders last year (in a combination of buybacks and dividends), which is about 10% of the company's market cap.
The cash balance is not the only thing helping stabilize the value of this business, however. The company signs a number of contracts in advance, so much so that it has a backlog of almost $900 million. Compare this to the company's 2010 revenue of just over $200 million.
Furthermore, most of the company's revenue (and a significant portion of profit) comes from supplying labour services (e.g. engineering professionals). This reduces the company's technology risk, as this segment does not have to constantly create a better mousetrap in order to stay competitive.
However, an investment in Calian is not without risk. Almost two thirds of the company's business comes from the Federal Government of Canada. As such, spending cuts or shifts in priorities away from initiatives requiring Calian's services would have a dramatic effect on the company's business and profitability. It's also worth pointing out that the large backlog number is not calculated conservatively, as it includes the value of buyer options, which may or may not be exercised.
To make money over the long-term, investors should seek out companies with high returns on equity with low P/E ratios, as discussed in Joel Greenblatt's book. At Calian's current price, it appears to fit the bill, with a large cash balance as a bonus.
Disclosure: None
Consider Calian Technologies (CTY), a provider of technology products and services for the communications industry. Calian has a cash balance of $25 million against no debt, which results in cash comprising 17% of the company's market cap!
So while the company trades at a price to earnings ratio of 11, it's price to earnings ratio becomes just 9 if the cash is backed out of the company's market cap. The P/E is low despite the high returns on equity the company generates; ROE has been around 20% for many years in a row. Meanwhile, the company paid out $15 million in cash to shareholders last year (in a combination of buybacks and dividends), which is about 10% of the company's market cap.
The cash balance is not the only thing helping stabilize the value of this business, however. The company signs a number of contracts in advance, so much so that it has a backlog of almost $900 million. Compare this to the company's 2010 revenue of just over $200 million.
Furthermore, most of the company's revenue (and a significant portion of profit) comes from supplying labour services (e.g. engineering professionals). This reduces the company's technology risk, as this segment does not have to constantly create a better mousetrap in order to stay competitive.
However, an investment in Calian is not without risk. Almost two thirds of the company's business comes from the Federal Government of Canada. As such, spending cuts or shifts in priorities away from initiatives requiring Calian's services would have a dramatic effect on the company's business and profitability. It's also worth pointing out that the large backlog number is not calculated conservatively, as it includes the value of buyer options, which may or may not be exercised.
To make money over the long-term, investors should seek out companies with high returns on equity with low P/E ratios, as discussed in Joel Greenblatt's book. At Calian's current price, it appears to fit the bill, with a large cash balance as a bonus.
Disclosure: None
Sunday, June 5, 2011
How We Know What Isn't So: Chapter 2
 | Value investors believe the market is not perfectly rational. To understand why, an examination of human behaviour is required. In How We Know What Isn't So, which is recommended by a number of value investors and behavioural economists, Thomas Gilovich explores the fallibility of human reasoning. Only by understanding our flaws can we seek to improve on them, thereby ameliorating our decision-making processes. |
Humans look for patterns where there aren't any. Several examples of this phenomena are discussed in this chapter, including a detailed examination of the "hot hand" idea pervasive in the sport of basketball.
It is believed that players are streaky, in that if they have made (missed) a few shots in a row, they are more likely to make (miss) their next shot as well. Examining data from the NBA, the authors show that players do not exhibit "hot hands".
And yet there continues to be a belief in the existence of "streaky-ness" in player performance. Gilovich believes there are two likely explanations for this: the clustering illusion and the regression fallacy.
Clustering illusion describes the idea that humans see patterns in small samples of data that are not statistically significant. In small samples, however, there is a decent probability that all or a significant proportion of coin flips will turn up heads, for example. Humans extrapolate such phenomena to mean something more than it really does.
Regression fallacy describes the tendency for humans to ascribe some false explanation where all that is really occurring is normal regression, where regression refers to the fact that when two variables are correlated (e.g. parent's height with child's height), an extreme outcome in one variable (e.g. the parent is very tall) will not be accompanied by such an extreme outcome in the other variable (e.g. the child will not be as tall as the parent). This tendency can make people believe something has caused a sub-par performance following an outstanding performance, whereas in actuality the outstanding performance was out of the ordinary.
Lines of thinking that look for patterns have probably served our species well. We can capitalize on ordered phenomena in a way that we cannot when things are unordered. Over the course of history, the prediction of patterns has led to discovery and advance in all fields of study. As a result of our trying to find the order in things, however, we often force an order when none is justified.
Saturday, June 4, 2011
How We Know What Isn't So: Chapter 1
| Value investors believe the market is not perfectly rational. To understand why, an examination of human behaviour is required. In How We Know What Isn't So, which is recommended by a number of value investors and behavioural economists, Thomas Gilovich explores the fallibility of human reasoning. Only by understanding our flaws can we seek to improve on them, thereby ameliorating our decision-making processes. |
The introduction starts with a quote from Artemus Ward as follows:
"It ain't so much the things we don't know that get us into trouble. It's the things we know that just ain't so."
A few widely believed phenomena are discussed and debunked. For example, it is believed that more effective undergraduate admissions decisions are made with the help of (subjective) interviews, whereas research indicates that objective criteria alone are more effective. Nurses on maternity wards believe that more babies are born when the moon is full. This also is not true.
Such beliefs are costly. A number of examples are cited where human conflict and animal deaths/extinctions have been caused by such faulty beliefs. Faulty-believers not only hurt others though, but also themselves. For example, a number of cases have arisen where patients have refused recommended medical care in favour of "quack" medicines.
This book seeks to answer what it is about us that makes us believe such things. The author argues that it is not a lack of exposure to evidence and nor is it irrationality. Rather, it is faulty rationality that leads to such beliefs. This will be explored further in the book.
Friday, June 3, 2011
Meade's Discount Instrumental
Meade Instruments (MEAD) is a company that has lost money for years. Its business of designing and manufacturing telescopes and other optical consumer products is on the decline. But after some restructuring and new management, the company now finally appears to be returning to profitability after many long years. Despite this, the company trades at about half of its net current asset value, giving investors the opportunity to profit from this apparently turned around company.
After hemorrhaging cash over the last few years, the company finally managed to be free cash flow positive (albeit in a very small way) in fiscal year 2011. Production has been moved from California to Mexico, poorly performing units have been divested/discontinued and new products have been brought to market. The result is a company in good financial shape with no debt and $5 million of cash. Meanwhile, the company trades for just over $5 million, despite current assets of $14 million and total liabilities under $4 million.
In addition, the company's losses may be overstated. It appears the company is rather conservative with its accounting, as fixed assets have been largely written down through years of depreciation, but are still in use. Meade's property, plant and equipment account is now smaller than the company's depreciation charge for last year, while the company "had no material capital expenditure commitments at February 28, 2011."
You wouldn't be alone as a value investor in this company as Paul Sonkin is also an owner. Sonkin's Hummingbird Management owns more than 15% of this company, and Sonkin has been a director of the company since 2006. The company's CEO also owns 10% of the company.
Meade has come a long way since it was first discussed on this site, but there have been a few updates at ShadowStock tracking its progress. See here for more on Meade from ShadowStock.
Disclosure: Author has a long position in shares of MEAD
After hemorrhaging cash over the last few years, the company finally managed to be free cash flow positive (albeit in a very small way) in fiscal year 2011. Production has been moved from California to Mexico, poorly performing units have been divested/discontinued and new products have been brought to market. The result is a company in good financial shape with no debt and $5 million of cash. Meanwhile, the company trades for just over $5 million, despite current assets of $14 million and total liabilities under $4 million.
In addition, the company's losses may be overstated. It appears the company is rather conservative with its accounting, as fixed assets have been largely written down through years of depreciation, but are still in use. Meade's property, plant and equipment account is now smaller than the company's depreciation charge for last year, while the company "had no material capital expenditure commitments at February 28, 2011."
You wouldn't be alone as a value investor in this company as Paul Sonkin is also an owner. Sonkin's Hummingbird Management owns more than 15% of this company, and Sonkin has been a director of the company since 2006. The company's CEO also owns 10% of the company.
Meade has come a long way since it was first discussed on this site, but there have been a few updates at ShadowStock tracking its progress. See here for more on Meade from ShadowStock.
Disclosure: Author has a long position in shares of MEAD
Thursday, June 2, 2011
Systemic Fraud In China?
China's high growth rates have encouraged foreign investment, which have in turn helped fund China's incredible growth. But such large capital inflows are bound to give way to sector imbalances and fraudulent behaviour. Recently, some fraudulent behaviour has been uncovered among small-cap Chinese stocks that trade in the US. But as the story continues to develop, it is beginning to increasingly appear as if the fraudulent behaviour could be operating on a much more massive scale.
Many of the reverse takeover stocks that have been uncovered as frauds have been small cap stocks with auditors with small operations. Perhaps these could be dismissed as a small number of one-off incidences of poor oversight and unethical management. But recent events make it clear that these occurrences are not limited to the small-cap space, and nor are they limited to mom-and-pop auditor operations.
The auditors of some of the recently uncovered fraudulent companies in China have been chided on this site and others. But more and more it is starting to look as if the facilitators of the fraud were not limited to employees of the companies themselves, but included the companies' banks as well. This, of course, makes it clear why auditors were signing off on such large cash balances when they didn't even exist.
For example, Longtop Financial Technologies (LFT) is a billion dollar Chinese company trading on the NYSE. It claimed to have a cash balance of over $400 million. Auditor Deloitte Touch Tohmatsu signed off on the company's financials for six years. This year, however, perhaps because of the recent fraud uncoverings (including that of China Media Express, a company which Deloitte also audited), the auditor went the extra mile. For one thing, it didn't just trust the statements the local bank provided; instead, it made further inquiries. The result was as follows, according to Deloitte:
"Within hours however, as a result of intervention by the Company’s officials including the Chief Operating Officer, the confirmation process was stopped amid serious and troubling new developments including: calls to banks by the Company asserting that Deloitte was not their auditor; seizure by the Company’s staff of second round bank confirmation documentation on bank premises; threats to stop our staff leaving the Company premises unless they allowed the Company to retain our audit files then on the premises; and then seizure by the Company of certain of our working papers.
"In that connection, we must insist that you promptly return our documents.
"Then on 20 May the Chairman of the Company, Mr. Jia Xiao Gong called our Eastern Region Managing Partner, Mr. Paul Sin, and informed him in the course of their conversation that “there were fake revenue in the past so there were fake cash recorded on the books”. Mr. Jia did not answer when questioned as to the extent and duration of the discrepancies. When asked who was involved, Mr. Jia answered: “senior management”.
Auditors are likely going to step up their game this year when it comes to auditing companies in China. As a result, more fraud uncoverings are likely, and the risk is there that one or more "Enrons" are about to go down. This could damage investor confidence, and seriously dampen investment flows into China, serving as a catalyst for a recession.
The economic miracle in China has lifted millions out of poverty and has been a great thing not only for Chinese citizens but for the rest of the world. It would be nice if the economy always grew in a straight line, but it doesn't. Investors counting on China to supply the kind of uninterrupted growth the world has become accustomed to are destined to be disappointed at some point. When that will happen, however, is unknown; but ignoring the warning signs that appear to be emerging could be disastrous for investors.
Many of the reverse takeover stocks that have been uncovered as frauds have been small cap stocks with auditors with small operations. Perhaps these could be dismissed as a small number of one-off incidences of poor oversight and unethical management. But recent events make it clear that these occurrences are not limited to the small-cap space, and nor are they limited to mom-and-pop auditor operations.
The auditors of some of the recently uncovered fraudulent companies in China have been chided on this site and others. But more and more it is starting to look as if the facilitators of the fraud were not limited to employees of the companies themselves, but included the companies' banks as well. This, of course, makes it clear why auditors were signing off on such large cash balances when they didn't even exist.
For example, Longtop Financial Technologies (LFT) is a billion dollar Chinese company trading on the NYSE. It claimed to have a cash balance of over $400 million. Auditor Deloitte Touch Tohmatsu signed off on the company's financials for six years. This year, however, perhaps because of the recent fraud uncoverings (including that of China Media Express, a company which Deloitte also audited), the auditor went the extra mile. For one thing, it didn't just trust the statements the local bank provided; instead, it made further inquiries. The result was as follows, according to Deloitte:
"Within hours however, as a result of intervention by the Company’s officials including the Chief Operating Officer, the confirmation process was stopped amid serious and troubling new developments including: calls to banks by the Company asserting that Deloitte was not their auditor; seizure by the Company’s staff of second round bank confirmation documentation on bank premises; threats to stop our staff leaving the Company premises unless they allowed the Company to retain our audit files then on the premises; and then seizure by the Company of certain of our working papers.
"In that connection, we must insist that you promptly return our documents.
"Then on 20 May the Chairman of the Company, Mr. Jia Xiao Gong called our Eastern Region Managing Partner, Mr. Paul Sin, and informed him in the course of their conversation that “there were fake revenue in the past so there were fake cash recorded on the books”. Mr. Jia did not answer when questioned as to the extent and duration of the discrepancies. When asked who was involved, Mr. Jia answered: “senior management”.
Auditors are likely going to step up their game this year when it comes to auditing companies in China. As a result, more fraud uncoverings are likely, and the risk is there that one or more "Enrons" are about to go down. This could damage investor confidence, and seriously dampen investment flows into China, serving as a catalyst for a recession.
The economic miracle in China has lifted millions out of poverty and has been a great thing not only for Chinese citizens but for the rest of the world. It would be nice if the economy always grew in a straight line, but it doesn't. Investors counting on China to supply the kind of uninterrupted growth the world has become accustomed to are destined to be disappointed at some point. When that will happen, however, is unknown; but ignoring the warning signs that appear to be emerging could be disastrous for investors.
Wednesday, June 1, 2011
QXM: Motivated Seller
In his book The Aggressive Conservative Investor, Martin Whitman discusses the advantages of investing in a company which is majority-owned by a single entity. Such advantages appear to be coming to the forefront for Qiao Xing Mobile (QXM), which may offer an opportunity for a strong profit for the value investor.
QXM is majority-owned by Xing Resources (XING), a company in a completely unrelated field to QXM. Xing has made it clear that it wants to wind up QXM's business and deploy its assets (mostly cash) towards Xing's mining concerns. This is where the opportunity comes in for the minority investor, as any cash that comes out of QXM has to be shared pro-rata with minority shareholders of QXM. Since QXM trades at a large discount to its cash balance, such a transaction would result in great returns for investors.
To get at the cash, Xing first tried to buy out minority shareholders for a song. But Xing couldn't get the votes needed from minority investors to achieve quorum, so the deal fell through. Just a month later, however, it looks like Xing is looking at another way to pull out the cash, as per the following release:
"We...are currently considering options to divest of our remaining telecommunications business. We expect to formalize and announce our final decision in June 2011...Upon filing of its 2010 Annual Report on Form 20-F with the SEC and announcements of its final decision regarding the telecommunication business, the Company will hold a conference call with investors to discuss both items."
Considering we are already in June, the potential timeline for any transaction announcement (e.g. a sale or significant dividend) is almost upon us. Despite this, the company continues to trade at a large discount to cash and net current assets. But because of the motivated position of QXM's majority-owner, a catalyst to unlock value may be only a few days away.
Disclosure: Author has a long position in shares of QXM.
QXM is majority-owned by Xing Resources (XING), a company in a completely unrelated field to QXM. Xing has made it clear that it wants to wind up QXM's business and deploy its assets (mostly cash) towards Xing's mining concerns. This is where the opportunity comes in for the minority investor, as any cash that comes out of QXM has to be shared pro-rata with minority shareholders of QXM. Since QXM trades at a large discount to its cash balance, such a transaction would result in great returns for investors.
To get at the cash, Xing first tried to buy out minority shareholders for a song. But Xing couldn't get the votes needed from minority investors to achieve quorum, so the deal fell through. Just a month later, however, it looks like Xing is looking at another way to pull out the cash, as per the following release:
"We...are currently considering options to divest of our remaining telecommunications business. We expect to formalize and announce our final decision in June 2011...Upon filing of its 2010 Annual Report on Form 20-F with the SEC and announcements of its final decision regarding the telecommunication business, the Company will hold a conference call with investors to discuss both items."
Considering we are already in June, the potential timeline for any transaction announcement (e.g. a sale or significant dividend) is almost upon us. Despite this, the company continues to trade at a large discount to cash and net current assets. But because of the motivated position of QXM's majority-owner, a catalyst to unlock value may be only a few days away.
Disclosure: Author has a long position in shares of QXM.
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