The Aggressive Conservative Investor: Chapter 7

Martin Whitman founded Third Avenue Value Fund some twenty years ago. Over that time period, the fund has beaten the returns of the S&P 500 by several points annually. In The Aggressive Conservative Investor, Whitman collaborates with Martin Shubik to discuss a concept that they call "safe and cheap" investing.

This chapter is about the various forms of accounting and their uses. The authors argue that accounting is the single most important tool in making sense of a business. It is the language of business, and investors who seek to understand companies must become fluent in it.

The distinctions between the following forms of accounting are discussed: cost accounting, tax accounting, and financial accounting. The authors argue that they each have their purpose, and noting the distinctions between them will help investors understand the limitations of financial accounting, which is the form of accounting used by investors.

For example, the authors argue that it is a misconception that the relative efficiencies of competing companies can be determined using financial accounting. There are too many assumptions that managements are free to make in financial accounting to allow for such direct comparison. To truly compare efficiencies between companies, one would have to have access to numerous internal (i.e. non-public) documents.

The authors also distinguish between financial accounting as used for corporate analysis and as used for market analysis. Market analysts focus on net income and earnings per share, on the expectation that changes to these numbers will lead to short-term changes to the stock price. Corporate analysts rely much more on financial position than current income numbers.

The authors also discuss circumstances where accounting describes the situation well, and where it doesn't. For example, financial statements are most useful when most profits are to come from the operations of a going-concern and there is heavy regulation limiting management leeway in the accounting assumptions. On the other hand, accounting is not so useful when a large portion of profits are to result from asset sales, imaginative financial techniques are employed, and managements throughout the industry make different accounting choices.

Chatting Messenger

It's the last Friday of the month, so Frank (author of value site frankvoisin.com) and I are chatting messenger, where we discuss stories from the web that caught our interest:

Frank: Check out AGX. Tons of cash on hand. Sort of a weird conglomerate structure, but very little debt.
Saj: I've written about it here
Frank: Dammit, Saj, I swear you've looked at 98% of public companies.
Saj: Just the ones with high cash to debt balances...I'm no match for Cramer!
Frank: Can you imagine if you were on that show? Cramer would be screaming and making cow sound effects, and then they'd cut to you, and you'd be totally calm and say something about a company's fundamentals.
Saj: And I'd be off the show at the first commercial break. "Sorry, but when we cut to you, our ratings drop 50%"
Frank: "Yeah, can u at least 'moo' or something? Our research indicates animal noises raise viewer interest levels and strengthen our relationships with advertisers"

Saj: So salesforce.com is now trading at a P/E of 300!
Frank: Seems pretty fair.
Saj: Looks like the late 90's are back...any company with a "dot com" in the name is worth 5 times what it would otherwise be worth.
Frank: And another 5 times that that if they are related to "cloud computing" in any way.
Saj: To be fair, the guy in this video makes a pretty good case for owning shares at the current price.

Saj: Chinese reverse-takeover (RTO) stocks continue to take a beating.
Frank: HQS shows us you don't even need to be an RTO to have those problems, as an independent director resigned after claiming management was stalling him as he had "difficulties in verifying information relating to company accounts and customer positions".
Saj: That's pretty bad on the auditor, which is a fairly sizable firm, if "company accounts" are in question.
Frank: People are always saying the auditor can't prevent fraud, but at the very least can't they verify that the cash account is for real??
Saj: Seriously! It's like they spend all their time getting to really specific inventory numbers, or confirming whether the depreciation method conforms to GAAP, when what we'd really like to know is whether the bank balance exists!
Frank: "Are you straight line or accelerating your depreciation of that mirage?"
Saj: We should be allowed to ask auditors questions. "What is your process for verifying cash balances?"
Frank: As much as short sellers get a bad rap, thank God for them. If short-selling were outlawed, as my lawmakers would like, we'd still be thinking some of these stocks look like good value, because the SEC certainly wouldn't uncover these frauds.

Danier Leather: Cheap And Accretive

Danier Leather (DL) is a vertically integrated designer, manufacturer and retailer of leather apparel and accessories. The company trades at a price to book value of about 0.75 and a P/E under 9 despite a healthy balance sheet.

Danier has a market capitalization of $60 million, but has generated more than $40 million of operating cash flow over the last four years. Because the company kept capital spending to less than $4 million in each of the last four years, most of this money accrued directly to shareholders.

Last year, the company spent more than $9 million buying back shares. This represents about 15% of the company's current market cap! In a particularly shrewd move, the company bought back a large number of shares via a Dutch Auction last year when the shares traded at about half their current level.

Currently, the company sits on $30 million worth of cash against no debt. The company should be eligible to buy back another 10% of its shares in just a few days, should it decide to continue along the path of buying back its shares, which would be consistent with its history of buybacks. This would have the effect of either pushing up the share price or lowering the company's P/E and P/B ratios even further.

But the perfect investment this is not, as there are some risks to the downside. For one thing, it has been a very profitable year for the company. While that's a good thing, investors should not rely solely on current earnings in calculating a company's earnings power. This was Danier's most profitable year since 2002, so counting on these profits as the new normal going forward may be a bit optimistic. Market forces (including competition, cost pressures etc.) could bring profits lower; they certainly have in the past.

Another potential drawback for shareholders is the company's dual-class share structure. This has allowed an ownership group to control the company without putting in the capital requisite with that level of influence. This structure results in a misalignment of incentives. It also makes it harder to oust management if it were to take actions that are not shareholder friendly.

Finally, this company has had quite an embattled history. It attempted and failed at a costly expansion plan, and managed to irk a few shareholders resulting in a costly lawsuit. While expensive, those incidents are now in the past and have already been paid for; but investors should note that the same management team is still in place, and so if they haven't learned any lessons, similar problems could cost shareholders in the future.

Disclosure: None

Jewett Cameron: Buybacks Pay Off

About one year ago, a company by the name of Jewett Cameron was brought up on this site as a potential value investment. At that time, the stock traded around $7/share, but over the last few weeks it has approached $11/share, offering investors the opportunity to exit at a return of approximately 50%.

Of course, there many stocks that have generated this kind of return (or more) in the last year. But what made Jewett a terrific investment was the limited downside risk to investors. That is, even if the economy or the market tanked, investors would likely have been protected. This is something you likely cannot say about the vast majority of securities that have returned 50% in the last year. If we look at some of the key elements that made Jewett's stock a low-risk, high-return type of investment, it can perhaps help us identify stocks that are undervalued right now:

1) Despite depressed earnings as a result of the recession, the company's P/E was under 10
ROE averaged 15% over the last 5 years

2) The company traded for its book value, despite strong ROE (above) and large land amounts carried at historical cost

3) Management had been in place for 25 years, and held a significant stake in the company relative to his salary

4) The company had no debt but lots of cash

Notably absent from these attributes is a "story" of why the shares should rise (predicting future market sentiment on a particular stock is practically impossible) and a known catalyst event that is expected to vault the stock upwards (if a catalyst is known, it's usually too late to buy the shares).

There's nothing overly complex about these attributes. All they signify is that the company was cheap and solvent, generated strong returns on capital, and had an experienced management team with incentives that were aligned with those of shareholders. And that's really all you need!

Disclosure: None

Orsus Xelent: Mistakes From Which To Learn

One and a half years ago, Orsus Xelent (ORS) was brought up on this site as a potential stock idea. Despite the numerous risks cited in that article, this author went ahead and invested good money in that company. The results were bad, as the stock has fallen by about 80% since that article. Perhaps by looking at what went wrong, it will be possible to avoid similar such mistakes in the future.

The first risk outlined in the article had to do with Orsus' customer concentration. Specifically, this distributor concentration led to a huge receivable balance on Orsus' balance sheet. The stock traded at a massive discount to net current assets, but this receivable balance was the largest component of the company's current assets. Unfortunately, this customer has been unable to make good on its obligations, and Orsus has now written down much of this balance.

Because of the size of the receivable due from this customer, Orsus did insure a large portion of it. Unfortunately, it did not insure enough of the receivable, as the write-down now brings the company to a negative equity position. In other words, the discount to net assets at which this company traded is not only gone, but the company's obligations now outnumber its assets! So while the margin of safety looked large numerically, it was in fact quite weak because it was dependent on the ability of a single customer to pay what it owed, and that didn't happen. Investors would do well to avoid companies heavily reliant on just one or two customers.

Another warning sign was that the company's former CEO was selling his shares at a rather frantic pace. Insider sales are often difficult to interpret, as insiders must often sell stock to lower their own risk (diversification) or to obtain/maintain the lavish lifestyles by which many managers are seduced. In this case, however, the pace of the sales was so strong (resulting in price pressure on the stock, which no seller would want to do unless he was very motivated) that maybe I should have gotten a clue.

But despite these adverse occurrences, I could have sold this stock for only a small loss. But I believe I instead fell victim to loss aversion bias, whereby I held out hope for a profit in order to avoid realizing a loss. Had I encountered this company a year after I did, I don't think I would have been interested in purchasing shares due to the company's inability to collect its receivables over this period. Nevertheless, I continued to hold the stock, which was a serious error in judgment that I believe is explained by this bias.

Unfortunately, knowing about this bias was not enough to prevent me from falling victim to it. Hopefully, having learned the lesson the hard way will save me from this error in the future. I hope this is a stock most readers avoided; and if they didn't, that they sold at a profit (which was possible) or at only a small loss.

Disclosure: None

Bassett Furniture: Asset Catalysts

Bassett Furniture (BSET) is a vertically integrated furniture company, as it imports, manufactures, wholesales and distributes a range of furniture. The company was profitable during the housing bubble, lost money for a while following the housing crash, and is now operating pretty close to break-even. But for value investors, it's not the earnings that are interesting, but the catalyst events surrounding some of the company's assets.

Bassett trades for $95 million, but has a deal in place (that is expected to close by the end of this month) to sell a company in which it has a minority interest for $74 million! This sale will produce a gain, which is subject to tax, but the company notes that it has "net operating loss carryforwards of [$18 million] that can be utilized to offset the taxes on the gain." In addition, the buyer will place $7 million in an escrow account that Bassett could receive over the next three years if no unexpected contingencies arise out of the company being sold.

In addition, Bassett has current assets of $83 million, long-term investments (money market and bonds) of $15 million, another minority investment carried at $5 million (equity method), and many tens of millions of dollars of retail real estate (including its own locations and locations it leases to licensees who are wholesale customers of Bassett), versus total liabilities of $83 million.

Of course, there are some risks with this type of investment. The most obvious is that the proposed deal may not close. But even if it doesn't, investors have a pretty good idea of what that minority investment is worth, which should act as a margin of safety.

But perhaps the biggest risk is what the company will do with all that money. Management didn't exactly narrow it down for shareholders when it stated it may use the money for "the retirement of debt and certain other long-term obligations, the settlement of various obligations related to closed stores and idle facilities, restructuring licensee debt, paying a dividend, judiciously funding expansion of our Company-owned store network, and/or funding stock buybacks and/or funding any potential future working capital needs."

While such a wide range of possibilities may be a bit scary for value investors, the company does have a history of paying out special dividends and buying back shares when it has extra cash. Unfortunately, management may only have done this because it had a gun to its head, thanks to activist shareholders who challenged the company's capital allocation. Management would probably rather grow the company than serve shareholders, as the company's CEO owns less than a million dollars worth of Bassett shares, but got paid almost half a million dollars last year.

On the other hand, management has not been taking wanton risks as of late to grow the company at the risk of profitability; the company has been closing the least profitable stores, and capex has been consistently below depreciation as the company has limited spending to store upgrades/refreshes rather than unjustified expansion. But management does appear to be pleased with the results of some new-concept stores it has been testing, so the possibility is there that management will use the bulk of this cash inflow to fund a growth program with uncertain results.

As Bassett shrinks down to its most profitable stores, it may be on the verge of returning to profitability. At the same time, it is likely to receive a major cash injection that the company may use to benefit shareholders. Value investors who believe this management team to be prudent may find this a stock worthy of investment, but those who don't will want to stay away.

Disclosure: None

The Aggressive Conservative Investor: Chapter 6

Martin Whitman founded Third Avenue Value Fund some twenty years ago. Over that time period, the fund has beaten the returns of the S&P 500 by several points annually. In The Aggressive Conservative Investor, Whitman collaborates with Martin Shubik to discuss a concept that they call "safe and cheap" investing.

The authors briefly discuss many of the disclosures public companies must release by SEC requirement, including financial statements and their notes. The usefulness of this paper trail of documents will vary by industry. For example, for a steady dividend-payer in a mature industry, more information will probably be released than the investor needs; however, for a miner or real estate company, GAAP financials are not as useful in determining a company's value.

For the investor to fully fathom the usefulness of these public disclosures, the authors argue it is useful to understand how they are created. For one thing, the lawyers and accountants who prepare many of the disclosure documents have no desire to risk their reputations on a third party (i.e. the company's management). As such, they are rather meticulous in making sure they disclose what they should, and are honest in doing so. Though frauds do occur, the authors believe they are few and far between, especially when compared with normal commercial transactions (where parties must always worry about the truthfulness of the party with which they are transacting).

Investors are also encouraged to obtain copies of the forms and mandated regulations required for filling them out. This will give investors a good idea of what those who fill out the disclosures must go through, and will therefore help the investor understand why a disclosure is laid out as such.

These disclosures also help identify which companies are not worthy of investment no matter what the price! Though many believe that every security is worth something at a low enough price, the authors argue against this line of thought. Some securities are too junior compared to the obligations of the company, and some managements are so egregious in their treatment of shareholders, that some securities should be discarded outright based on their disclosures.

Finally, it's important to recognize what's not contained in the disclosures. Internal budgets, management disagreements, marketing plans and other such matters in which shareholders might be interested are not normally disclosed. Often, projections, budgets and asset appraisals can be used for stock manipulation, so in some cases it is better that such "soft" details are left out. Nevertheless, the authors argue that in many cases these disclosures are so useful that they are all the investor will need to form an opinion of whether a security is worthy of investment.