Hidden Land Values

ML Macadamia Orchards (NNUT) grows and farms macadamia nuts in Hawaii. Like most producers of commodity products, its revenues are subject to wild price swings as droughts, infestations and other natural occurrences can play havoc with nut yields around the world. ML, however, has stabilized its business to some extent by contracting fixed prices at which it sells its products (to a subsidiary of Herchey's, HSY).

But what makes this company an interesting value play is not its farming operations, but the land on which these operations are conducted. The company has over 2200 acres of land in Hawaii that may be worth substantially more than the company's market value. A reader notes that nearby land, used for the same purpose, is selling for almost $20,000/acre. Applying that valuation to ML's land gives it a value of over $40 million. Meanwhile, the stock trades for just $18 million.

But wait! Before jumping on this opportunity, shareholders would be wise to consider whether that land value will ever be realized. In recent years, the company has been an acquirer of land, as it has grown its agricultural footprint. Furthermore, if the earnings off the land are not high (and they haven't been over the last few years), then perhaps the land is not worth as much as the above seller is asking. Unless the land can be used more efficiently, or future earnings for some reason are higher than past earnings, why should the land be worth so much?

Furthermore, two shareholders own almost half of this company, and their intentions are not clear. Unless one or both of these owners are interested in taking actions that would act as a catalyst, shareholder value might not be realized - even if the land is worth a lot right now - in this company for a long, long time.

Disclosure: None

Revenge Of The Options

As the stock market crashed in late 2008 and early 2009, many stock options held by managements of both large and small caps were made worthless. Even today, after most stocks have rallied strongly from their lows, many stocks still remain far below their pre-recession levels, effectively reducing (after-the-fact) salaries of managements during the boom years. But it appears that many managements will not take these salary hits lying down, choosing instead to make up for them by increasing option payouts now that prices are recovering.

Consider Quest Capital (QCC), which offers financing to commercial and residential builders. On a single day in January 2010, the company issued over 4 million options to management, more than it has in the previous five years! Has management done such a great job that it deserved more options this year than it has ever before deserved?

What is happening here appears to be a sidestep of the extremely unpopular practice of re-pricing options. As Quest Capital's share price has dropped significantly, the underwater options are expiring worthless. More than ten million options were cancelled or have expired in the last two years, but a big chunk of them have now been replaced at a much lower price! More may be on the way, as the company has a plan that allows it to issue options for up to 10% of the company's outstanding shares.

The value of options outstanding for many companies has dropped significantly since the stock market crashed over a year ago. Shareholders must be on the lookout, however, for companies that are recycling those options at much lower prices. Not only does this lower the value of a company's shares, but it sends a message that management wants all the upside that options have to offer, without taking any risk that the upside may not materialize.

Disclosure: Author has a long position in shares of QCC

Running Out Of Cash

When a stock has strong earnings growth, it can result in excellent stock returns, particularly if the investor paid a conservative price for the company's shares. What is often overlooked, however, is that earnings growth must be financed. That is, the company must spend on marketing, inventory, equipment and capacity before that growth can be realized. This can lead to a situation where a company runs out of cash, despite a rosy outlook, which can hurt investors caught unaware.

Consider Digital Ally (DGLY), a provider of in-car digital video equipment for law enforcement authorities. The company has grown its revenue sharply in the last five years, as demand for its products has grown considerably. Earnings appear poised to continue to grow, as the company has increased its sales staff internationally, and is starting to sell its products to new markets (e.g. taxis, private investigators, trucking companies, military, private security forces).

There's only one problem: liquidity. Even healthy companies that grow their earnings quickly need financing to fund that growth, and Digital Ally is no exception. Operating cash flow has been positive only once in the last five years, as cash has been needed to finance growth in the company's working capital. Cash requirements appear to continue to be high, as in the fourth quarter of 2009, the company had to spend on SG&A to grow its staff and capacity to take advantage of new market opportunities.

Now, however, with ambitious growth plans, the company sits with just $183 thousand of cash on hand. So what's it going to do? While the company does have an unused credit facility of $2.5 million, debt for a small company with volatile earnings could be expensive. Instead, the company appears to prefer to save cash by paying a large part of its expenses with stock options. In 2009 alone, the company paid $1.4 million of its SG&A in options, which is several times the company's current cash balance! As a result, the company has almost 5 million options outstanding, while the company only has 15 million shares!

Growing earnings are good, but shareholders must recognize that such companies require investment. If that investment cannot be made in cash, shareholders may be severely diluted, reducing the attractiveness of the investment. As a result, shareholders who don't consider the sources of cash that growing companies need may be unaware of the price they are paying.

Disclosure: None

Influence: Chapter 7

Value investors believe that Mr. Market's mood swings offer them excellent opportunities to buy low and sell high. But how does an investor avoid becoming Mr. Market rather than taking advantage of him? Influence, by Robert Cialdini, helps us understand the factors that influence us, which are exploited by, among others, the news media, our brokers, and research analysts, and thereby puts us in a position to protect ourselves from our own, hard-coded biases that we wouldn't otherwise know have been triggered.

The scarcity principle makes us desire items that are short in supply. Humans show tendencies towards this principle from as early as the age of two, as experiments have shown that young boys will go after toys that are fewer in number or that are blocked off over toys that are available.

Marketers will often feign scarcity in order to get customers to purchase a product. By pretending that an item is the last one in stock, or by intimating that another buyer is interested (e.g. a common tactic of real estate agents), a human emotion is triggered that often overrides sound analysis. This principle may even be a contributor to asset price bubbles (for tulips, real estate, and even stocks), as individuals fear that they must buy or they will not get any, even if reasoned thinking would suggest they don't need any!

Cialdini believes scarcity plays such a large role because humans tend to fight against restrictions, even if they wouldn't consume the object in question were it available. This fight against restriction is not limited to tangible objects, but ideas and speech as well. When censorship is employed to prevent the consumption of certain political or sexually explicit materials, psychologists show that the fact that these are forbidden actually increases interest in them, ironically leading to the opposite effect of what those who make the rules were intending.

Psychologists find that two additional factors can make our tendency to desire scarce items even more intense. First, if the availability of a scarce item is reduced to a level (rather than having been at that level the whole time), desire goes up. Secondly, if individuals are in competition for the scarce items, desire goes up as well.

This is a difficult tendency from which to defend ourselves. Cialdini advises readers to be on alert for the feeling of emotion that accompanies the thought that an item is scarce. When that feeling is recognized, individuals should be cognizant of what is taking place and try to calm themselves so that they may analyze the situation soundly.

Influence: Chapter 6

Value investors believe that Mr. Market's mood swings offer them excellent opportunities to buy low and sell high. But how does an investor avoid becoming Mr. Market rather than taking advantage of him? Influence, by Robert Cialdini, helps us understand the factors that influence us, which are exploited by, among others, the news media, our brokers, and research analysts, and thereby puts us in a position to protect ourselves from our own, hard-coded biases that we wouldn't otherwise know have been triggered.

People are likely to obey the commands of those in authority. Usually, this serves a useful purpose, as the one in power is often an expert in the relevant subject. The alternative to a society in which a chain of authority exists is one of anarchy, which is not nearly as productive. However, when those in authority make mistakes, this tendency to listen to them without thinking can lead to disastrous consequences.

In the famous Milgram experiments, subjects were willing to put other subjects through intense (fake) pain, simply because an authority figure was telling them it was okay. Many of the atrocities committed during World War II are attributed to this phenomenon.

This tendency to stop thinking because the authority figure must be right can also be taken advantage of by those in the know. Con artists will often pretend to be authority figures (e.g. policemen, bank officers) in defrauding their victims. "Experts" in the stock market will tell you to buy their services. Marketers will use paid actors dressed as doctors to tell you to use a product.

Even if viewers know its an actor playing a doctor, they are still more likely to buy the product being offered than if the actor is playing a layman, which is baffling! A person's title, clothes and trappings (e.g. the type of car they drive) have all shown to be significant determinants of whether people are likely to follow their instruction, often subconsciously!

Investors must be sure to think for themselves, and not purchase stocks or services simply because a perceived authority figure is claiming it's the right thing to do.

Investing And Uncertainty

Humans don't like ambiguity. This is demonstrated in the experiment Hersh Shefrin discusses where subjects are offered either a guaranteed $1000, or a 50/50 chance at $2000. Consistently, fewer than 50% of respondents prefer the gamble for $2000, even though the expected values (i.e. the average value of the result if it were conducted many times) of both offers are the same.

What if the 50/50 odds in the above experiment were instead unknown? This adds even further uncertainty to the situation, and results in even fewer people willing to gamble on the $2000.

Shefrin calls this phenomenon "aversion to ambiguity", and on Wall Street it results in downward pressure on the prices of securities with uncertain outlooks. In order to avoid uncertainty/ambiguity, humans will stay away, even if the odds are favourable (i.e. downside risk is low, upside potential is high).

In his book, Shefrin argues that this ambiguity aversion is the reason for government intervention, even when it is not needed. What would have happened had the government not bailed out the banks? Nobody really knows, but the fact that the outlook was uncertain made the government want to intervene, even at a high cost, in order to avoid the uncertain situation.

As Mohnish Pabrai notes in his book, risk is not the same as uncertainty. Uncertainty can drive down the prices of assets/securities, even if downside risk is low. By capitalizing on situations where uncertainty is high, but risk is low, the investor can put himself in a position to earn above-average returns.

Disclosure: Author would roll the dice on the $2000 as long as the odds were 50%+

Buybacks With Bite

Companies will often announce share buybacks, and then proceed not to execute the repurchases for years, much to the chagrin of shareholders looking for catalysts. Other companies will announce buybacks that are so small relative to the shares outstanding that one wonders if the effort is even worth the transaction costs. But companies that announce large buybacks and then promptly follow through with them send a signal that management means business when it comes to returning money to shareholders.

Consider GameStop (GME), which in January of this year announced that it would buy back up to $300 million worth of stock. This represented about 10% of the company's market cap, which is no small amount. Nevertheless, the company managed to exhaust most of this buy back in just two months, as it recently announced that it has already worked through $250 million of the buyback.

As a result, another buyback announcement may be on the way: the company's current projections show that it will end 2010 with $900M in cash (even as it opens 400 new stores this year), which is more than the value of the company's capitalized operating leases, and more than a quarter of the company's market cap!

Contrast this with another stock favourite of ours, Manhattan Bridge Capital (LOAN), which announced a buyback of a paltry 3% of outstanding shares, and subsequently repurchased less than 0.06% of the company's outstanding shares in the ensuing six months. In contrast to GameStop, this company's actions suggest a willingness to talk up the stock price without returning cash to shareholders.

Of course, not all buybacks are positive for shareholders. If a stock is overvalued, the buybacks could turn out to be a waste, and would have been better doled out as dividends, as we saw with several companies last year.

Disclosure: Author has a long position in shares of GME, LOAN