Thursday, December 31, 2009

Good Returns

For several months earlier this year and late last year, there was no industry investors hated more than the housing industry. Any stock that relied on growth in housing for growth in sales was severely punished by the market. Goodfellow (GDL), a distributor of flooring and other wood products, was no exception.

When we first discussed the stock, it traded at a sizable discount to its net current assets. Today, it trades near its book value, after more than doubling over the last few months. As such, it moves from the Stock Ideas page to the Value In Action page, as Mr. Market once again offers a reasonable price for this once unfavoured stock.

The lessons to be learned from Goodfellow's rise can be used to find and identify other potential value investments. First, industries with poor short-term outlooks are great places to look for stocks that have been beaten down beyond their intrinsic values. Second, intrinsic value should be calculated as if the purchase were of a private business (e.g. more weight should be placed on the value of assets being purchased over short-term earnings outlooks).

Finally, investors can benefit from studying the investments of other value investors. In the case of Goodfellow, Stephen Jarislowski, a value investor whose book we have summarized here, is a substantial shareholder and the company's chairman.

Companies trading at significant discounts still exist. Investors who apply these and other value investing principles to their future investments put themselves in a position to purchase the next set of stocks that hit intrinsic value.

Disclosure: None

Wednesday, December 30, 2009

Fixing The Average

When estimating a company's earning power, it's important to look at its annual earnings over the past business cycle, rather than assuming that its current earnings are representative of future earnings. In Security Analysis, Ben Graham and David Dodd discussed the need to smooth out fluctuations in annual earnings, and we have looked at some reasons for why that is the case. Sometimes, however, properties of a company have changed, and current earnings may actually be a better gauge of a company's earnings prospects going forward.

Consider Dover Downs Gaming (DDE), a hotel/casino/track operator in Delaware. In addition to corporate tax rates that are already quite high, the state government has been increasing the company's gaming fees and taxes. The fee changes are not minimal, and are not recorded as taxes, and therefore show up as increased operating expenses. Consider the following statement from the recent 10-Q:

Gaming expenses increased by $1,082,000, or 2.4%, primarily as a result of increased gaming taxes and slot machine fees that resulted from legislation passed in May of 2009 that became effective on May 28, 2009. The impact of this legislation resulted in an increase in our gaming taxes and slot machine fees of approximately $3,600,000 in the third quarter of 2009.

This $3.6 million per quarter of increased fees is not a trivial amount. It represents about 6% of the quarter's revenues, and as such results in taking a huge chunk out of the company's profit margin. These new fees eat up about $14 million on an annualized basis, compared to the company's operating earnings of around $40 million per year or so in the last four years!

The new fees had such an impact, that the company cancelled plans to expand:

We had previously completed architectural and engineering work related to a Phase 7 casino expansion that would have included, among other things, a new sports book facility and a parking garage. Given the recent decision by the US Court of Appeals for the Third Circuit to limit the extent of sports wagering in Delaware and the higher gaming tax rates that were recently legislated, we decided not to proceed with this project. During the third quarter of 2009, we wrote off $2,177,000 of capitalized costs related to these expansion projects.

While averaging past earnings do smooth out temporary fluctuations in annual earnings, the investor must still keep an eye out for recent changes to the business that render operating earnings obsolete. Adjustments to averaged earnings that take recent changes into effect will often need to be made to improve their predictability of future earnings power.

Disclosure: None

Tuesday, December 29, 2009

Jumps In Reported Equity

Investors who regularly update valuations of companies under their study will have noticed increased reported equity for many companies this year. This is not because companies have been particularly profitable, nor is this because a number of companies have issued new shares in a tepid capital market. Rather, it is simply the result of an accounting change to the treatment of minority interest.

Whereas most companies used to report minority interest as a liability, a new US GAAP accounting standard now requires companies to classify these line items as part of shareholder equity. As a result, shareholder equities of companies with consolidated subsidiaries not fully-owned have risen. Furthermore, to the extent that investors use P/B measures or screens, they will have to adjust book values for minority interests that are now incorporated as equity, but which the stockholder will not have financial rights to.

While the minority interest line item is separated on 10-Q and 10-K reports, this is often not the case for the more immediate 8-K updates. As an example, consider Best Buy (BBY). It recently reported its 3rd quarter results in an 8-K release, and shows equity (as a single line-item only) of $6.1 billion. At the beginning of the year, however, it reported equity of only $4.6 billion.

Unfortunately for shareholders, net income over the last nine months has not risen to such an extent so as to increase equity by 33%! Instead, the 8-K hides the fact that approximately $600 million of the equity is a minority interest, not belonging to the Best Buy shareholder.

While the accounting change seemingly puts investors at a disadvantage, there are benefits to the requirement that can be read about here. Nevertheless, to avoid inaccurate valuations, it is important that investors keep up with accounting changes of this nature. Accounting authorities around the world continue to work together to converge their standards; as such, further changes to US GAAP will continue, and investors must stay aware.

Monday, December 28, 2009

The Premium On Shareholder Friendly

In theory, there is no value created or destroyed as a firm issues a dividend. This is because the shareholder owns a portion of the company's cash; if he were to receive that cash, it's as if money is being moved from his right hand to his left, i.e. there is no net change (ignoring taxes). In practice, however, companies that pay out funds to shareholders enjoy higher valuations.

Nowhere is this more evident than at Acorn International (ATV), a company we discussed a few months ago as a potential value investment. For much of this year, the company has traded for not much more than its cash on hand (with negligible debt), despite the fact that it currently breaks even.

But on one day last week, the stock price soared 15+% as the company announced a special dividend that will see it pay out about 1/5 of its cash on hand (almost $1 per depository share). This clearly illustrates the premium shareholders place on companies that pay out. But it also illustrates the importance of control.

Together, management/directors/founders own about 40% of the company, not quite enough for control of the company. This is important because of the large number of options the company has doled out. In the past, management has also downwardly revised exercise prices for their options after the fact, so they have not been shy about transferring wealth from minority shareholders to themselves.

But the fact that they did not have control has likely kept them honest. Comments from a recent conference call made it clear that shareholders wanted a payout, and the threat that shareholders would exercise their rights probably forced management into doing something they did not want to do. If management had control of the company, this dividend may not have happened. The lesson here is that shareholders should be wary of companies where a minority of insiders own control, and at the same time have the incentives to benefit at the expense of shareholders.

Disclosure: None

Sunday, December 27, 2009

Common Stocks And Uncommon Profits: Chapter 3, Part 2

Warren Buffett has called himself "85% Graham and 15% Fisher". While the works of Graham are often cited, Fisher's book "Common Stocks and Uncommon Profits" is not. Here follows a summary of this work by Philip Fisher, known as one of the greatest investors of all time.

Fisher continues to list off more of the 15 properties he believes investors should look for in order to identify the stocks with the potential for astronomical returns:

4) Does the company have an above-average sales organization?

Fisher calls the making of repeat sales to satisfied customers the first benchmark of success. But investors pay far less attention to whether a sales staff is efficient than they do to research, finance, production or other corporate activities. Fisher attributes the reason for this to the lack of financial ratios that can be applied in order to measure the quality of a sales staff. But the information is available in a qualitative sense using the "Scuttlebutt" method Fisher described earlier in the book. Competitors and customers know the efficiency of the sales staff, and they are often quite willing to express their views on the subject.

5) Does the company have a worthwhile profit margin?

Fisher believes that the greatest long-range investment profits are made by investing in the companies with the highest profit margins in the industry. There are some caveats to look out for though. Margins should be looked at over a period of many years, since temporary effects can abnormally lower or raise a company's margins. Furthermore, fundamental changes may be occurring in a company (new product, increase in efficiency) with low margins that will turn it into a company with high margins; these may be unusually attractive purchases. Finally, some companies have low margins because they plow a lot of their profits into research and sales, so they are actually building for the future. Investors counting on this to be the case must make absolutely certain that investing for the future is indeed the real reason for the low margins.

6) What is the company doing to improve margins?

Inflation will continue to increase the costs of most companies, but companies of different abilities will see varying results in their profit margins over time. Some companies have the ability to increase price in order to maintain or increase margins. Fisher argues that this only encourages new competitive capacity, and therefore only temporarily increases margins. But some companies use far more ingenious means to increase margins. Some corporations have departments whose sole function is to review procedures and methods in order to find savings. "Scuttlebutt" will not work as well as speaking to company personnel directly about the amount of work being done by the company in this area. Fisher argues that the investor is fortunate that most top executives are willing to talk in detail about such topics, however.

Saturday, December 26, 2009

Common Stocks And Uncommon Profits: Chapter 3, Part 1

Warren Buffett has called himself "85% Graham and 15% Fisher". While the works of Graham are often cited, Fisher's book "Common Stocks and Uncommon Profits" is not. Here follows a summary of this work by Philip Fisher, known as one of the greatest investors of all time.

In this chapter, Fisher tells the reader how to determine if a company is one which will produce the outstanding returns alluded to in the previous two chapters. There are fifteen questions about each company under consideration that must be answered. If the answer is yes for most of them, the stock could very well be a super-performer. On the other hand, if the answer is no for many of them, Fisher considers it unlikely that the stock can generate the outstanding returns required. The idea is to separate the companies that are "able" from those that are fortunate, as the ones that are able will continue to prosper long after the ones that are fortunate have seen their growth stall.

The first three criteria are covered in this post, with the remaining twelve covered in subsequent posts:

1) Does the company have the market potential to grow sales for at least several years?

Here, Fisher is not interested in market conditions which offer the potential for a large surge in sales, even for years at a time. While he acknowledges that profits can be made from investing in such companies, these are not the home-run type companies he is looking for. For this to be possible, management must be skilled, and is always growing markets and product lines such that sales continue to increase even as its industries mature. An example of such a stock Fisher picked out in the 1950s is Motorola; he goes on to describe why Motorola fit this description and turned out to be the winner that it did.

2) Does management institute policies that that result in newly developed products?

Fisher stresses that this is not the same question as the one above. While the previous question has a factual answer, this question is related to management attitude. In other words, does management recognize that existing products will eventually reach their market potential?

3) How effective is the company's research and development?

Does management make the investments in R&D necessary to keep the company's growth trajectory high? Here, Fisher notes that it is not just the amount of R&D that is important (as a percentage of sales), but how well the processes are managed, how well the teams are motivated, and how well the research processes are integrated with the sales team. Fisher also believes that companies with research efforts in areas where the company already has a successful product have the most promise for future returns, as opposed to research in areas in which the company has no existing expertise. Furthermore, stability in funding research products is also important; companies that cut R&D at the bottom of the business cycle pay far more in the end than those who stay committed throughout, even if they need to use a business cash advance.

Friday, December 25, 2009

Common Stocks And Uncommon Profits: Chapter 2

Warren Buffett has called himself "85% Graham and 15% Fisher". While the works of Graham are often cited, Fisher's book "Common Stocks and Uncommon Profits" is not. Here follows a summary of this work by Philip Fisher, known as one of the greatest investors of all time.

Knowing that, as established in the first chapter of the book, the investor's goal is to find the incredible companies that will generate outstanding returns, Fisher describes two approaches for achieving this goal: the investor may hire someone to investigate potential companies, or he may follow what Fisher calls "Scuttlebutt".

Fisher strongly recommends the latter approach, as while the first approach sounds reasonable, in practice it does not work out well. For one reason, it takes an enormous amount of skill to find such companies, and those who have such skill will already have top managerial positions that pay well enough such that this venture would not interest them. Furthermore, it's doubtful that companies would allow anyone access to the information that is required to properly determine the company's potential position.

The "Scuttlebutt" method takes advantage of the business grapevine. Gathering a cross-section of opinions from various stakeholder groups of particular aspects of the company under study is immensely useful. Fisher recommends investors speak to competitors, suppliers, customers, researchers, trade associations, employees and former employees.

Fisher recognizes that most investors will have neither the time nor the inclination to go through the process described above. Nevertheless, he stresses that just knowing the relevant sources of information will be useful to the investor, so that at the very least he may ask the right questions of his financial advisor.

Thursday, December 24, 2009

Common Stocks And Uncommon Profits: Chapter 1

Warren Buffett has called himself "85% Graham and 15% Fisher". While the works of Graham are often cited, Fisher's book "Common Stocks and Uncommon Profits" is not. Here follows a summary of this work by Philip Fisher, known as one of the greatest investors of all time.

Fisher starts the book with the results of some of his research. While investors put great effort into timing the business cycle, the best returns in the market come from finding the great companies and holding them for many years. These companies were available year after year at attractive prices; in other words, it was not necessary to buy these companies during wide market panics. But for every company that generated such phenomenal returns, there were several times as many with average or below-average returns. As such, what was required was to be able to identify which companies could generate the uncommonly outstanding profits.

Fisher then moves to a discussion of whether such stocks will continue to exist. On this point, Fisher argues that stock investors have reason to be even more optimistic in the future as compared to the past, and for more than one reason.

First, more than ever before, corporate managements conduct themselves in a manner that is positive for shareholders. Never before have managements been so willing to seek outside advice, institute succession plans, self-analyze, and implement the most up-to-date practices. In the past, companies were closely held and managers were entrenched, with insiders taking advantage of minority stockholders.

In addition, corporations plow more money into research than they ever have before. These investments have borne fruit in the fact that a larger percentage of sales continues to come from products that did not exist only three years ago.

Finally, as compared to the first several decades of the last century, governments have shown an increased willingness to ensure that depressions to do not occur. Governments will go into deficit, and even bail out industries to ensure that business conditions are satisfactory.

All of these points bode well for the future of stock investment. With this strong future, combined with the knowledge that the investor must, either by luck or skill, identify the stocks that will generate abnormally high returns, Fisher takes the reader into Chapter 2.

Wednesday, December 23, 2009

Staying Power

As long-term investors, value investors must take care to invest only in companies with staying power. Cyclical companies are the most vulnerable to failing as a result of economic shocks, but this does not mean value investors must stay away from cyclical industries. On the contrary, cyclical companies can offer investors some of the most outstanding returns, as general sentiment can sour on entire industries, offering great prices for those with long-term outlooks. The investor must take care, however, to ensure the company is capitalized to survive.

Consider LCA Vision (LCAV) and TLC Vision (TLCV), two companies that use laser-eye surgery to treat vision disorders. Demand for this elective surgery is highly cyclical, ebbing and flowing with consumer confidence. But only one of these companies appears to have understood this dynamic. Consider the cash and debt levels of each of these companies at the end of 2007 (as the recession had not yet hit):
As both companies began to lose money when the recession arrived, LCA Vision's prudence placed it in a position to maintain its competitiveness. TLC Vision, on the other hand, began a battle to stay alive. This week, it lost that battle, finally declaring bankruptcy. It now trades for just 4 cents per share, suggesting shareholders will get approximately nothing in the restructuring.

When investing in cyclical companies, long-term oriented investors must be sure to invest in companies that are not over-leveraged. In good times, however, this is easy to forget; in 2007, TLC Vision issued $75 million of new debt, and bought back $115 million worth of shares. Those who understood the cyclicality of the business were offered a chance to exit, while those who stuck around learnt their lesson.

Disclosure: Author has a long position in shares of LCAV

Tuesday, December 22, 2009

Beyond The Numbers

Companies with strong ROIC and strong ROE numbers may have competitive advantages. On the other hand, there could be many reasons for high returns, which could trick the investor into believing a competitive advantage is present. Therefore, it's important for the shareholder to identify the competitive advantage before accepting it as true.

Rising (or falling) commodity prices could make companies which sell (or buy) commodities look like they have an advantage. Temporarily strong markets, or temporary weakness in competitors can also have the same effect. These occurrences will result in elevated returns for extended periods, occasionally for several years. Managements for these companies will of course take credit for such uncontrollable but favourable circumstances, and will claim that the abnormally high returns are due to their effectiveness in securing a competitive advantage for the company. Therefore, the shareholder must investigate the situation, and apply his own business sense to determine if the advantage is for real.

Unfortunately, there is no formula one can apply to determine if a competitive advantage exists. Investors must use good judgement, conduct diligent research, and educate themselves by reading the examples of successful investments of the past. Competitive advantages come in all shapes and sizes. For example, Dover Downs (DDE) discussed on the site yesterday, may have an advantage due to strong opposition from the state for new entrants to the gaming industry. Solitron Devices (SODI) may have an advantage due to the fact that its end customer (the military) prefers American manufacturers (even though the trend in the general industry is for low-cost, overseas products) and stresses reliability over price.

Philip Fisher's book Common Stocks with Uncommon Profits helps guide the investor in thinking about whether a company in question has a competitive advantage. We will be summarizing the book later this week.

Monday, December 21, 2009

Control Without Ownership

The need for investors to ensure that management incentives are aligned with those of shareholders is a topic that is often discussed, including on this site. But an equally troublesome incentive structure, though rarer, is that which occurs when certain shareholders have control without the corresponding level of ownership that justifies that control. Ben Graham wrote on this topic in Security Analysis, and while such structures are not as common today as they once were, they still exist.

Consider Dover Downs Entertainment (DDE), a gaming company in Delaware. Henry Tippie, the company's chairman, controls the company (i.e. has a majority of the equity votes). However, he actually owns a significantly smaller stake of the company's shares: Class A shares get 10 votes each, while common stock shares get one vote.

Such a divergence between control and ownership misaligns incentives. The controller could seek to enrich himself at the expense of the company, since company payouts do not hurt him as much as they would had he an ownership stake corresponding in size to his controlling stake. Furthermore, the controller could resist a takeover which would benefit financial shareholders, due to the loss of prestige and loss of control that would accompany a merger.

If an investor does encounter a company that one shareholder controls, the ideal scenario for the investor is such that the controlling shareholder also owns a large corresponding stake, does not receive large benefits from the company relative to his share of the company's earnings, and has a significant portion of his personal wealth tied up in the company's equity. Such structures may actually prove advantageous to the minority investor, and examples of such structures can be seen in Fairfax Financial and Berkshire Hathaway. Dover Downs, however, is no such example.

It should be noted, however, that Tippie may be obligated under contract to act in the best interest of the largest shareholder. Furthermore, for all we know he might be an upstanding citizen of the highest integrity; this article does not question his ethics. However, the point is that the incentive structure of the controlling shareholder does leave much to be desired.

That is not to say an investment in Dover Downs Entertainment may not payoff. The P/E is under 10, the company appears to have certain competitive advantages, and the company generates generous amounts of cash flow. However, investors should be aware of the risks that exist when a controlling shareholder does not own a majority stake in the business which he controls.

Disclosure: None

Sunday, December 20, 2009

A Random Walk Down Wall Street: Chapter 14

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

Once the investor has figured out what portion of his portfolio will be dedicated to equities (as per the last chapter), he is ready to consider the different ways in which he can go about investing in the equity asset class. In this final chapter of the book, Malkiel discusses the four main ways in which investors can participate in the equity market.

In the first edition of the book (back in 1973), Malkiel called for an index mutual fund that individual investors could buy into, as that product did not exist at the time. Now, however, investing in index funds has become the easiest way for investors to enjoy the market's return. Using this mechanism to invest, individuals will outperform most money managers after fees.

For those who must go it alone and invest in individual securities themselves, Malkiel has four rules of advice to help them beat the market:

1) Only buy companies that can grow earnings at an above-average pace for 5+ years
2) Don't pay more than the market's P/E ratio for a stock
3) Buy stocks with good stories on which other investors may jump
4) Minimize trading (subject to taxes, e.g. it is fine to sell losers at the end of the year to lower capital gains taxes)

Even following these rules, the investor is not guaranteed to outperform the index. But investing is fun, and for those who just have to play the game, these rules are designed to tilt the odds in the individual investor's favour.

The third manner by which the investor may enter the equity market is through a money manager. Malkiel does not believe investors can do well attempting this, as identifying the superior managers (of which there are few) appears only possible after the fact. Furthermore, in the studies Malkiel has conducted, good past performance does not persist into the future. Therefore, just because a manager's record is good does not seem to suggest that he will continue to be good. Malkiel does note that there are a few managers that are the exception to this, including Warren Buffett.

Finally, closed-end mutual funds that trade at large discounts to their net asset values are also considered good investments. Here, investors are offered the opportunity to buy shares in companies at a discount to the market. Sometimes, discounts can stretch as high as 40%, but the discounts do change over time. When the discount is above 25%, Malkiel suggests investing.

Malkiel ends the book with a discussion about how a great portion of one's returns from the stock market are due to luck, and that individuals wrongly attribute their returns, or lack thereof, to skill or a lack of skill.

Saturday, December 19, 2009

A Random Walk Down Wall Street: Chapter 13

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

This chapter is targeted to those looking to determine what their ideal asset allocations should be. The author argues that higher risk leads to higher return, and therefore an investor's asset allocations should be based on his risk tolerance. Here, Malkiel divides risk into two components: willingness to take risk (i.e. how well can you sleep at night with volatile investments?) and ability to take risk (e.g. can your future employment income take care of any investment losses?).

Risk (as measured by volatility) drops based on the time horizon of the investment. For example, while in one particular year, stock market returns could be quite negative, over 25-year periods there is very little volatility in returns. As a result, investors with long time horizons can take on more short-term volatility of returns.

For investors who invest their employment income, Malkiel strongly recommends dollar-cost averaging, where the same dollar-investment is invested no matter what is going on in the market. The benefits of this strategy are that fewer (more) shares will be purchased when the market is high (low), leading to a cost-basis for the investor that is below the average market price.

Finally, Malkiel stresses that the investor's ideal asset allocation should be based on each individual's present situation, and will evolve over time. He presents some example situations where investors should hold different asset classes, and presents some asset allocations that might apply to certain groups of investors. An investor's risk tolerance is also key to choosing an asset allocation, and therefore Malkiel includes a questionnaire meant to ascertain an investor's risk profile.

Friday, December 18, 2009

Free Advice

Every quarter, public companies are required to release their latest financial results. Along with their results, they hold conference calls and accept questions from the public. As we've discussed before, it's important for investors to listen to these calls to understand the challenges the company faces. Usually, analysts ask management about revenue outlooks for various products, margin expectations, overall strategy and other pertinent questions. Sometimes, however, analysts will feel the need to offer some "free" advice to management.

On a conference call for Build-A-Bear (BBW) last year when the stock price was near its lowest, here's what Mike Smith of Kansas City Capital had to say when prompted for his question:

"Well, one comment first before I ask a question. I would suggest you don’t buy any stock back because [insert fearful outlook here]"

His opinion is one which was rampant throughout a finance industry that was gripped with fear. At a time when value investors were buying, stock analysts were against buying back shares at the cheapest prices in over a decade. (Of course, the value of analysts is not so clear when you consider their ratings of Lehman Brothers the day before it went down).

Of course, when valuations are already high is when companies tend to buy back their stock, with wholehearted support from analysts. Consider the magnitude of the buybacks that took place a couple of years ago when the market was at its peak. Needless to say, it was not the best use of shareholder capital.

I don't necessarily know that BBW should have been buying back stock at that particular point in time, but that option should most certainly not be automatically discarded; if management sees a certain level of cash flow that more than covers the company's fixed obligations, buybacks at cheap prices may very well be in order, particularly for a company with a lot of cash on hand. Here's what BBW's founder, chairman and CEO had to say on the matter:

"We have to look at it week by week and we do. And I think that if there’s opportunities that present themselves because we can see that the cash is in excess of what we thought would need to operate our business in a normal basis. And we’re also trying to look and forecast into 2009 and how the economic issues will affect us there."

Free advice is worth its price!

Thursday, December 17, 2009

The Hidden Costs Of The Bailouts

The bailouts of the US financial and auto sectors cost the US taxpayer measurable amounts of money. Some of the companies that were lent to will go bankrupt, and some are in the process of paying back their government loans; in the end, the eventual taxpayer cost will be known.

But one issue which is largely ignored in the bailout vs no-bailout debates is the precedent that was set on international trade. The US has consistently imposed tariffs when it has felt that international government subsidies for foreign companies have disadvantaged American companies. By bailing out domestic auto makers, does the US lose all credibility in this regard?

It would now seem quite hypocritical for the US to argue that free markets should decide which companies should survive. Just last year, the US threatened sanctions against China for export subsidies on textiles. If China can make a case which parallels the arguments the US uses to justify bailing out domestic auto makers (e.g. the threat of widespread unemployment, serious harm to the economy etc.), does the US have any moral authority anymore?

It would seem that for the foreseeable future, countries will be able to justify bailouts of certain industries. Any government that wishes to bail out certain industries or companies which are headquartered in its jurisdiction is now free to do so.

Unfortunately, this strategy is harmful to overall productivity, which is the driving force behind our standard of living, as we discussed here. By sustaining the least profitable companies rather than allowing the superior companies to grow their market shares, we all lose in the long run. Unfortunately, it is a politically popular move, because it saves jobs in the short-term; but it represents a cost in the long-term that will largely go ignored.

Wednesday, December 16, 2009

Buybacks Are Back

It's not always a good thing when firms buy back their own shares. For example, under the pretense of creating value for shareholders, managements could use owner funds to increase the value of their stock options. But on the opposite end of the spectrum, there are also cases where buybacks have the potential to create enormous value for long-term shareholders.

Consider a company that breaks even that trades for $50 million and has cash of $100 million. It could pay out all its cash, resulting in an approximate 100% gain for existing shareholders. Or, it could nibble away at its shares. Consider an extreme case where the company spends $25 million buying back shares and the share price doesn't budge: the company would then trade for $25 million, but still have $75 million in cash; a cash distribution would now result in a 200% gain for the shareholders who stuck around! Value has been augmented for shareholders who hung on by transferring the value potential of those who sold early to those who stayed.

Now consider Quest Capital (QCC), a company we have previously discussed as a potential value investment. While it is not in the exact same enviable position as the hypothetical company described above, it does share some common traits that make it attractive as a "buyback target".

For one thing, it trades at a deep discount to its net asset value. While those assets are unfortunately not cash, the company is in the process of monetizing them. Since the end of the last reporting date, the company has issued updates announcing that another $20 million of preferred stock has been bought back. This appears to be a signal that monetization of assets is going well, since the company did not have that kind of cash as of its latest report.

Most recently, the company has now announced it plans to buy back common shares, as soon as this week. In its history, this company has not been one to buy back stock. But this time around, the reasons to do so are clear, and the motivations appear to coincide with what we discussed:

The Corporation’s directors believe that normal course issuer bid purchases of shares for cancellation may, by reducing the number of outstanding shares, reduce the discount that may exist between the market price of its shares and the Corporation’s net asset value per share.

Stock buybacks are not just catalysts for prices to align with intrinsic values. They can also boost value for shareholders, by transferring the potential price appreciation of the shares of exiting shareholders to the shareholders that hold on.

Disclosure: Author has a long position in QCC

Tuesday, December 15, 2009

What Is The CEO Worth?

Wage disparity between executives and workers has been on the increase for several decades. In 1982, the average CEO of large US firms made 42 times the wage of the average worker. By 2001, that number increased to a staggering 531 times *. Opponents of this disparity will argue that intervention is needed to force companies to have higher parity within their wage structures. Others argue that executives are worth every bit of their salaries or companies would not pay them.

Unfortunately, it's difficult to know what a CEO is actually worth. In theory, letting the market decide what to pay executives should establish reasonable ranges, as companies which pay their executives too much will suffer from lower profits than firms with better compensation practices. In practice, however, the market makes plenty of mistakes. When investors investigate the pay structures of executives in companies in which they are interested, there are several important items to look out for.

The first is whether the compensation package rewards a manager only for what he can control. For example, the profit performance of an oil producer is directly related to the price of oil, which is rather volatile. But the oil company's CEO has no control of that price. If bonuses and options are not indexed to the price of oil, the manager's compensation is unrelated to his skill and effort.

Compensation also appears to be sticky on the way down. While bonuses and salaries rise as a company does well, they do not decline when a company does poorly. This not only exacerbates the first point above, but it results in an incentive structure which is asymmetric (heads, I win big...tails, I don't lose) leading to excessive risk-taking. Golden parachutes also protect managers even following poor performance.

Finally, managers have company-specific knowledge that the rest of us don't, and so they are able to take advantage of situations with their superior information. For example, they can sell shares or even retire when expectations are at their peak relative to fundamentals.

The above issues can be counterbalanced. Restricted stock (when restricted until long after the end of a manager's employment), structures which are aligned with what an executive can control, and symmetric rewards/punishments are examples of how enlightened boards are ensuring they are getting a good deal for their money. Investors can protect themselves from falling victim to excesses in executive compensation by ensuring the companies in which they invest have sound practices where shareholder interests are maintained.

* McKinsey study: A New Era in Governance, McKinsey Quarterly 2, 2004

Monday, December 14, 2009

Provision Holding

Provision (OTC: PVHO.OB) is focused on the development and distribution of their patented 3D holographic displays. The systems display moving 3D holographic images up to forty inches in front of the display, projecting a digital video image out into space detached from any screen, rendering truly independent floating images featuring high definition and crisp visibility from distances up to 100 feet.

The nearest comparable to this technology can be remembered in motion pictures such as Star Wars and Minority Report, where objects and humans are represented through full-motion holograms.

With 3DEO, Provision is focusing its efforts on the $6 billion point-of-purchase and out-of-home advertising markets. Within these markets, Digital Out-Of-Home Media represents a $2.43 billion segment in 2008 and continues to grow at a pace of 12.9% in 2009, despite a slowdown in 2009 due to economic crisis (PQ Media 10/27/08).


The 3DEO platform uses Provision's patented 3D holographic displays to draw consumer attention to featured products and can dispense related coupons and promotions. Provision generates monthly recurring revenues from advertising across the 3DEO network of kiosks.

Current State of the Business

While continuing to accept hardware sales orders from distributors, Provision’s main focus is finishing the exceedingly successful market test of their 3DEO kiosks. Twenty-eight stores have installed the kiosks, with coupon redemption rates up to 43%, compared to industry standards of 1.5%. The network includes advertising from Warner Brothers, CBS Records, L’Oreal, and Kimberly Clark.

3DEO are currently deployed in Los Angeles as this market represents the #2 demographic market for national advertising and the #1 demographic market for Hispanic advertising in the country. Provision has a total of 1,686 additional retail locations under contract, which can potentially deliver an estimated annual total of $50 million dollars of recurring advertising revenue once investment capital has been received.

For more information visit and see the demo video below:

Disclosure: The above is a sponsored post from Diversified Web Holdings, which has made a strategic investment in Provision Holdings.

Energy Bolt

Bolt Technology (BOLT) sells equipment for measuring marine seismic activity. Despite a near 40% drop in revenue in the most recent quarter, the company has remained profitable throughout every quarter of this downturn. Furthermore, the company trades at a P/E of just 10 based on its last four quarters, and recently made it onto Forbes' 200 best small companies list.

The company clearly meets one of the most important criteria for value investments: solvency. The company carries no debt, has $33 million of cash (compared to a market cap of $95 million), and has shown an ability to scale down costs as revenues decline. Subtracting the company's cash from its market cap gives the company a trailing 12-months P/E ratio of just 6!

Looking only at the numbers, this company is a buy. Unfortunately, the numbers don't tell you the whole story. While the historical earnings record appears stable, the future is not so clear. This is because a huge part of the company's sales is based on strong energy prices. While not so obvious, this is an extremely important factor in the company's risk profile.

Energy prices are notoriously volatile, and while they have been quite high by historical standards in the last few years, there is no guarantee that this will continue. Historical earnings records are only useful as predictors of future earnings for products with stable demand (e.g. nuts/bolts, certain food/beverages etc.). This is why value investors prefer industries that are stable; the outlook can be predicted with more certainty, resulting in a much smaller range (or confidence interval) of the company's intrinsic value. Companies in energy exploration are in the exact opposite realm. Furthermore, Bolt's recent earnings history contains data only from years where energy prices have been relatively high, making their extrapolation into the future problematic.

That's not to say Bolt can't turn out to be a terrific investment. If the oil price remains high by historical standards, demand for Bolt's products may reward investors for years to come. Unfortunately, predicting the price of oil is a difficult task indeed. If the price moves below the range it has shown in the last few years, Bolt's historical earnings may prove to be a useless guide of the future, resulting in future earnings far below what the investor has come to expect. The value investor needn't place a bet as to the future direction of energy prices; instead, he can stick to stable industries with more predictable earnings to better guarantee that he is buying at an attractive price.

Disclosure: None

Sunday, December 13, 2009

A Random Walk Down Wall Street: Chapter 12

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

In this chapter, the reader is taken through the last several decades of stock and bond returns, and a method for predicting stock returns going forward is put forth.

Specifically, Malkiel divides the last 60 years into three periods, each of which contained a different set of circumstances that dictated the outcome of stock and bond returns. For example, periods with high unanticipated inflation would see poor bond returns, since bond prices would have to drop in order for bond buyers to receive a rate of return that was higher than inflation. While stock prices are believed to be rather neutral to inflation, history shows that stocks also performed poorly during bouts of high inflation.

The formula Malkiel uses to predict stock returns is as follows:

Stock return = Current Dividend Yield + Dividend Growth Rate + P/E change

The P/E change is the most difficult factor to predict. When the market is optimistic (pessimistic), market P/E's will rise (fall). Over the long-term, however, the effect of this valuation change reduces in significance; but over short periods, this factor can have a dominant effect. The current dividend yield is easily calculable, while the dividend growth rate can be approximated. (Malkiel appears to use recent history to estimate the dividend growth rate, but other methods also exist such as multiplying the market's aggregate return on equity by its retention ratio, the percentage of earnings that the market does not pay out in dividends.)

Saturday, December 12, 2009

A Random Walk Down Wall Street: Chapter 11

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

The author discusses various investment options that individual investors have at their disposal. Insurance is discussed, and within this section, the various types of insurance in which individuals should "invest", depending on their situations. Bonds (both investment grade, and junk), money-market funds and real-estate (both as the investor's home, and in the form of Real Estate Investment Trusts) are discussed as asset classes in which investors should participate. Malkiel also discusses the various tax deferral and (legal) avoidance strategies that are available to US investors (IRAs, Roth IRAs, Keogh Plans, annuities).

Malkiel also discusses how investors can protect against inflation. While he believes common stocks and real estate are the best hedges against inflation, Malkiel does not buy into the idea that investors should buy "things" like art, commodities and other assets for this purpose. For one thing, relying on a greater fool (who will buy the "thing" back later) is risky, while common stocks and real estate offer a claim on real cash flow. At the same time, Malkiel advocates that gold constitutes a part of the investor's total portfolio as a diversification mechanism because of its tendency to have low correlation with the US market. Treasury Inflation-Protection Securities are also discussed as inflation hedges.

Malkiel finishes with a word on commissions. There are many methods to buy the various securities that are available to investors, and some will charge more than others. Searching around for the best commission can result in shaving several percentage points from the fees investors pay. The discount brokerage business, for example, is extremely competitive, and doing a bit of research can go a long way towards achieving strong returns.

Friday, December 11, 2009

Cheap, But Look Behind The Numbers

New Dragon Asia Corp (NWD) looks like a straight-up steal. While the company hasn't made money in four quarters, the losses are dwarfed by the company's liquid assets; the company has a net current asset value $27 million, but trades for just $9 million at its current price of 12 cents per share. While you never know what will happen when a stock trades at a such a low level (it could easily increase by 50% or be cut in half just like that), there are enough warning signs behind the numbers to scare the average value investor away.

First of all, the potential for dilution is large. An astute reader pointed out that the outstanding stock warrants are far out of the money, so they are indeed practically worthless. Unfortunately, significant potential for dilution still exists in the form of convertible preferred stock. The pref share dividends can be paid in common stock (similar to a situation we saw for Quest Capital), and the pref share principle must be redeemed in the next few months. The company's shares outstanding have increased by almost 25% in the last 9 months in the conversion and payment of dividends for these pref shares!

Unfortunately, the company's problems are not only in its finance department. NWD mills and distributes flour and related products, including "instant noodles" (packet noodles and cup noodles for preparation at home) through its Long Feng brand. Considering the industry it's in, one would not expect a recession to have such a huge effect on revenues. This is not a company selling heavy-duty, expensive-to-finance equipment that can't be justified in the current environment. Sure, its customers may reduce inventories, so some sales compression can be expected, but the drop in sales the company continues to experience is extreme: instant noodles and flour revenue dropped 75% and 63% respectively in the most recent quarter. The company's only explanation is the "slowdown in the economy worldwide". What one would expect to be a stable business is not so, suggesting the company is being battered by competition or is out of favour with its customers, and management does not appear forthcoming with the details.
Finally, the company recently announced that its independent certified accountant has resigned. The reasons for this are not clear, but experienced investors will tread carefully when such an event has taken place.

A share purchase of NWD may indeed prove fruitful. If the asset numbers are correct, the company does appear to trade at a discount. However, considering the unexplained operational problems this company clearly faces, along with the threat of continued massive dilution, a purchase of shares at these low levels amounts to speculation as opposed to value investing.

Disclosure: None

Thursday, December 10, 2009

A Housing Comeback

When the government's housing statistics are reported, the media focus on the number of sales and the average or median selling prices of those sales. This is probably because they are focused on the health of short-term demand and current consumer confidence within the context of the overall economy. But for those specifically interested in gauging the health of the housing industry going forward, it is far more useful to consider inventory data.

For example, could you have seen (and thereby avoided) a housing bubble collapse, armed with the following inventory data at the beginning of 2007?

Clearly, new home inventories were out of line with even the recent historical past. But new home sales were brisk and prices were rising, so many simply believed the trend would continue.

Now fast forward a couple of years, and the opposite situation appears to exist. Home builders have stopped building over the last year, and new home sales have outpaced new home construction as a result. This has led to a drop in new home inventories to levels not seen since the 1960s:

Does this mean home builders can soon start charging a premium and can print money like its 2006? Absolutely not. In addition to the fact that demand for homes is low due to consumer confidence/unemployment issues, new homes are currently competing with foreclosed homes, of which there is an abundant supply. What this data does suggest, however, is that home builders that managed to survive the downturn will likely soon be in a position for healthy growth; in the medium-term, these inventories will have to rebound, which will have positive effects on the housing industry and the general economy.

Wednesday, December 9, 2009

Long Idea: Acme United

Acme United (ACU) is a multi-national supplier of cutting and measuring products to a diverse group of users, from schools to offices to industrial companies. The company trades for just $30 million, but has earned more than $15 million in net income over the last four years and has a current P/E under 10.

Usually, a company trading at such a discount to its recent earnings is going through a downturn of either a cyclical or secular nature. Acme is no exception in this regard, as sales and income are down as a result of the recession. But there is no reason to believe Acme's lower earnings are anything more than cyclical; the company has managed to stay quite profitable, and generates such strong returns that its low P/E is surprising. Consider the company's return on equity over the last several years:

Even in a down year, the company has still earned an ROE above 11%! Despite the fact that the long-term earnings picture for this company looks excellent, the stock dropped 15% after the last quarterly earnings report, as the numbers came in below expectations. As we've discussed before, Wall Street's focus on the short-term allows long-term investors opportunities to profit.

Management also appears to believe in the long-term future of the company, as it has spent almost $3.5 million buying back stock in the last few quarters, during a time when most companies have shut down their buyback programs due to a lack of confidence. Management collectively owns almost 25% of the company, so their interests are mostly aligned with those of shareholders.

When companies with high returns go on sale due to cyclical issues, long-term investors are offered the chance to profit. Acme appears to offer just such an opportunity.

Disclosure: None

Tuesday, December 8, 2009

Allocating Unused TARP Funds

With the US announcing that usage of TARP funds will be lower than anticipated, the government is currently looking for ways to effectively deploy some of those funds as further stimulus. Economists agree that the US is in for anemic growth for the next little while, as a result of high unemployment and a deleveraging business and consumer environment. For the US economy to start growing again, businesses must see new profit opportunities and must subsequently invest in these opportunities. One way to increase the number of available profit opportunities is to reduce or remove minimum wage requirements. While it may be a politically unpopular move, removing the minimum wage would encourage hiring, reduce unemployment and increase business profits (and thus incentives for expansion) through this downturn.

When minimum wage rates are set above what the market rates would ordinarily pay, costs per worker are held artificially high. This keeps businesses from hiring workers they otherwise would, thus reducing hiring and keeping unemployment levels at artificially high levels.

When costs are artificially higher than they otherwise would be, certain profitable projects are no longer profitable, and otherwise fruitful investments are not made as a result. The economy as a whole thus grows at a slower rate than it otherwise would.

While the benefits of removing minimum wage are felt by most of society, those who currently receive minimum wage would feel pain in an immediate removal of the minimum wage. A gradual announced phase-out of the minimum wage is the best method of reducing the impact on these workers. This would allow current workers to plan ahead and would encourage them to increase their productive value through education, while at the same time allowing businesses and the unemployed to benefit from new hires at a market rate.

If this move is deemed too politically unpopular, stimulus funds could be diverted from TARP in order to fund the difference between new worker wages and the current minimum wage. Of course, this method is much more susceptible to fraud, but it could be the only politically plausible method. Furthermore, methods could be put in place to minimize the scams (e.g. only a portion of the shortfall between the current wage and the minimum wage could be subsidized, and it could only apply to newly created positions).

For businesses to grow, profit opportunities must exist. An easy way to increase profit opportunities (and thereby ease the pain of this recession) is to remove the effect that minimum wage has on businesses: artificially higher costs that discourage investment. If the government has the political will to continue to stimulate the economy, TARP funds could be used to subsidize those who would be negatively affected.

Monday, December 7, 2009

Stocks That Can Only Go Up

When a company reports earnings that are stronger (weaker) than expected, the stock price will often rise (fall) in reaction. As a result, analysts spend a lot of time trying to predict a company's upcoming quarterly results in advance of the actual release date. Unfortunately, predicting quarterly results has proven to be a very difficult task. But there is a better way.

While individual investors are not in a better position than analysts to predict short-term earnings, the good news is they don't have to. The market offers investors the opportunity to buy companies where bad news can't sink a stock as much as good news can buoy it. This is because such stocks offer investors a margin of safety; in other words, the bad news is already baked into the stock price.

As an example, consider Key Tronic (KTCC), a stock we have previously discussed and a member of the Stock Ideas page. Last week, the company announced that 2nd quarter earnings per share would be closer to 12 cents rather than the earlier estimate of 3 cents. The next day, the shares closed 25% higher.

Of course, predicting the earnings surprise would have been impossible for the average investor, so let's consider what would have occurred had earnings disappointed. It is not likely that the stock would have fallen by the same dollar amount or the same percentage. This is because the company is profitable and has $60 million of current assets against total liabilities of $26 million (for a difference of $34 million) while the company traded for a grand total of just $25 million.

However, predicting the market's reaction is nearly impossible; it is entirely possible that an earnings disappointment of the same magnitude would have caused an equally negative reaction in this stock. Even in such a case, however, the stock would have become even cheaper, with further reduced downside and increased upside potential. Such was the case for many stocks in March, as the market decline took many stocks to levels where the downside was minimal and the upside potential was large.

Predicting earnings, and predicting the market's reaction to those earnings is a very difficult task indeed. Instead, investors should focus on buying businesses that trade at large discounts to their values. Such opportunities offer asymmetric returns: the downside risk is minimal, while the upside potential is high.

Disclosure: Author has a long position in shares of KTCC

Sunday, December 6, 2009

A Random Walk Down Wall Street: Chapter 10

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

In this chapter, Malkiel responds to the claims that the market offers various opportunities for returns above the average. The following observations are discussed:

1) Several studies demonstrate that stock prices do exhibit momentum. For example, a stock price rise in one week signals a greater than normal chance of a stock price rise in the following week.

2) Stocks that have performed poorly for several years tend to outperform the market as well.

3) Stocks exhibit seasonal moodiness: prices tend to rise in January, and at the end of the week.

4) Smaller stocks tend to outperform the market

5) Stocks with low P/E, low P/B, and higher dividend yields outperform

While Malkiel recognizes that behavioural finance elements do play a part in market forces, the anomalies listed above don't cause him to waver in his belief of an efficient market. In each of the above cases, he lists reasons for why these anomalies can exist in an efficient market. Some of the reasons are as follows: some of the outperforming stocks are more risky, some of these anomalies no longer occur as they have been exploited, and some of the out-performance is so small that there is no excess profit after trading costs.

Malkiel ends the chapter with data showing that the performance of the average mutual fund manager does not outperform the market after fees. He uses this as evidence to demonstrate that even though the anomalies may exist in theory, after taking into account transaction costs the anomalies cannot be exploited in practice.

Saturday, December 5, 2009

A Random Walk Down Wall Street: Chapter 9

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

This chapter contains further discussion of risk, as defined in the previous chapter. Risk is divided into two components: systematic risk (this is the volatility of the market as a whole, since stocks tend to move in concert to some extent) and unsystematic risk (this is the volatility of individual stocks unrelated to market factors).

The theory asserts that unsystematic risk can be diversified away, while systematic risk cannot. Therefore, investors will only be rewarded for the systematic risk they take (since unsystematic risk can be diversified away). As such, high importance is placed on systematic risk, which is measured using the Greek letter beta. A stock's beta is its volatility relative to the market. The higher the beta, the higher the risk, and therefore, the higher the reward, according to Modern Portfolio Theory.

In the second half of the chapter, Malkiel discusses beta's usefulness when taken out of the academic world and applied to the stock market. He quotes studies (including his own) that demonstrate that there is no relationship between a stock's beta and it's return! However, Malkiel still believes in volatility as a risk measure. But he attributes the apparent uselessness of applying beta with the fact that it is very difficult to measure.

Finally, Malkiel argues that since higher beta does not result in higher returns, beta is still useful in that it can allow investors to find low-beta stocks and generate similar returns to the market without the volatility.

Friday, December 4, 2009

Determining CEO Compensation

We've discussed here how misalignments can occur between CEO and shareholder interests. In fact, as we saw here, this misalignment may have contributed to the fiasco formerly known as Lehman Brothers. Before investing in a company, it's a shareholder's responsibility to ensure management's pay structure makes sense. For example, if stock options make up a huge part of a CEO's pay, be aware that management has incentives to take big risks to generate big paydays.

Disclosure of the salary, bonuses and compensation structure of the five top executives are an SEC requirement for all public companies in each company's annual proxy statement. As an investor, you can find this info for any US stock you own as follows:

1) Go to the EDGAR Company Search page
2) Enter the ticker symbol of your company and hit 'Find Companies'
3) Search for the latest filing called "DEF 14A"(this is the annual proxy statement)
4) Open that file, for all sorts of goodies about executive compensation

In there, you'll also find a discussion about how the pay/bonus and compensation structure was determined, including some company peer groups that were used as comparisons by the Compensation Committee.

Happy hunting!

Thursday, December 3, 2009

The Headline Misses The Point

Last week, Orsus Xelent (ORS) reported its third quarter results. The headline referred to an 8% year-to-date drop in annual revenues. But this is an exceedingly useless headline, for several reasons.

First of all, the first two quarters of the year have already been reported. As such, it would make more sense to headline third quarter data. But third quarter revenue was down 34%. The headline suggests a lack of candor from management and a will to sweep the latest numbers under the rug.

Still, for most value investors, I suspect the third quarter income data changes little in their valuations of the company. The mobile market in China was down some 30% this quarter, so the company's numbers are fairly consistent with an industry suffering from a cyclical issue. While infrastructure spending in China has kept GDP numbers high, consumer spending has left retailers dry, slowing down distributor orders.

Those who have read our previous discussions of Orsus Xelent will know what we are looking for: the management of its receivables balance. The company trades for just $20 million, but it carries receivables of $93 million contributing to shareholder equity of $55 million. The company has earned 20 cents per share in the first nine months of this year, but the stock trades for just 70 cents!

However, the profit numbers are rather deceiving: while the company continues to churn a "profit", it is not seeing the fruits of that profit in the form of cash from its main customer, which is a concern. And as a result of the slowdown in the mobile market, the receivables balance is going in the wrong direction. While the company sold $16 million worth of phones to its largest customer, the receivables balance to this same customer increased by $9 million! Not a great sign.

Of course, management assures shareholders that it believes it will collect on the full balance. If this is true, the company is deeply undervalued. The problem is, that's a big "if". The uncertainty of the situation going forward is a major reason why investors should be diversified; not every scenario with high upside potential will pan out.

Do these results lead me to give up on the company? Not quite. The company trades very cheaply compared to its assets and earnings (assuming, of course, you believe management is genuine), and the insurance the company took on the receivables does help mitigate some of the risk. Having said that, the risks to this company have increased with the increase in receivables, as the company's cash flow situation has become rather serious.

Disclosure: Author has a long position in shares of ORS

Wednesday, December 2, 2009

The Preferred Treatment

When lending standards toughen, companies work to improve their liquidity positions. One of the easiest ways to improve liquidity is by cutting dividend payments: unlike cutting marketing or research expenses, a company doesn't hurt its operations by saving money by way of stopping its dividend.

However, preferred stock dividends are often cumulative, meaning if payments are put on hold, they must eventually be paid out before common stockholders receive a dime. As such, it is important for investors of common stock to take into consideration the value of cumulative dividends owed. These will not show up as liabilities on the balance sheet, but for common stockholders they most certainly are liabilities! Therefore, they must be manually subtracted from an investor's valuation of a company, along with the value of the preferred shares themselves.

On the flip side, this represents an opportunity for investors willing to foray into the preferred stock space. As discussed in this chapter of Security Analysis, some healthy companies act conservatively and do not pay out preferred dividends for years at a time. As such, they have cumulative dividends owing. When the company is ready to pay common stockholders, these cumulative dividends in arrears have to be paid out first, to the current holders of the preferred shares. Therefore, purchasing preferred shares where large cumulative dividends are owed can represent great upside if the company's financials are sound.

Tuesday, December 1, 2009

Returns Not Always What They Seem

Measuring a company's return on equity (ROE) is a useful way to determine whether management is justified in retaining earnings for further investment, particularly for a company with low debt levels. For example, if ROE is above 15%, in most cases the company should attempt to re-invest its profits in order to grow; if ROE is consistently under 10%, management should pay out earnings so that capital can be allocated to more profitable ventures. Sometimes, however, the ROE numbers don't tell the whole story.

Consider ROE numbers for EnviroStar (EVI), a distributor of laundry equipment, over the last several years:

Note that the company has had no debt over this period. Returns look decent, and then turn downward as the recession hit. However, the company generated mounds of cash over this period that it has not distributed. As such, ROE numbers are held down because of the large cash balance - but unlike in other cases we have seen, this cash balance is not required to run the business. Subtracting the cash balance from equity in the ROE equation yields the following adjusted ROE:
Clearly, even through this recession, the company has earned excellent returns on its invested capital, suggesting the company's prospects going forward are positive.

Of course, the cash balance is stuck in the business and therefore from the point of view of the shareholder, actual returns are of the order of those seen in the first chart above. However, the business is clearly a profitable one, as it can generate strong returns even with most of its capital sitting idle in the form of cash. Furthermore, if/when that cash is either put to work in earning returns or returned to shareholders, the business' owners will benefit. This is a company we have previously discussed as a potential value investment.

When considering ROE numbers, adjustments may be required depending on exactly what the investor is attempting to determine.

Disclosure: Author has a long position in shares of EVI

Monday, November 30, 2009

Big Baths All Around Us

It is usually in economic times like these, where earnings are generally poor, that managements will incur asset write-downs and/or restructuring charges. This phenomenon is known as the "big bath". When earnings are negative, a further reduction in current earnings changes little in the way of currently non-existent management bonuses, but sets the company up for artificial earnings gains later, when bigger and better bonuses are to be had as a result.

A simple example presents itself in the form of the acceleration of an asset's depreciation. By writing said asset down now, earnings become more negative, but in the future this asset no longer needs to be depreciated to the same extent, resulting in an artificial earnings boost in the future.

When analyzing a company that is undertaking such charges/write-downs, investors should distinguish between asset impairments (like that of the depreciation example above) and restructurings, where changes to operations are expected to incur additional costs (severance pay, etc.). In the former case, the impairment is only of an accounting nature and is therefore a write-down of of past cash flows, while in the latter, future cash flows are affected.

In this paper by Francis, Hanna and Vincent (1996), asset write-downs were found to result in poor stock market returns, suggesting the write-downs were caused by poor business conditions (no shock there!). Restructurings, however, resulted in positive stock returns, as the market's perception implied an expectation of an improved profit outlook as a result of the upcoming operational changes.

While Wall Street may fall victim to this type of manipulation due to its focus on current earnings (as discussed on this site many times, as well as in this chapter of Security Analysis by Ben Graham and David Dodd), investors can protect themselves to some extent by focusing on average earnings over a business cycle, thereby smoothing out the effect of any earnings manipulations that might be taking place.

Sunday, November 29, 2009

A Random Walk Down Wall Street: Chapter 8

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

Modern Portfolio Theory (MPT) is the focus of this chapter. While previous chapters discussed how firms approach investing (using either the castle-in-the-air or firm-foundation theories), MPT is the approach employed by academics.

MPT asserts that the only way to achieve higher returns than the market is by taking higher risks. Furthermore, risk is defined as volatility. In other words, if a security's price changes by a larger percentage than the market (even if that change is positive), it is considered to be a higher risk than the market. Though Malkiel acknowledges that it is downside risk that is important (not upside), he shows that for indexes such as the S&P 500, the distribution of volatility is normal (meaning upside volatility is similar to downside volatility).

If you accept this definition of risk which lies as the basis for MPT, then there are some important implications. By diversifying, investors can reduce their risk for a given level of return. This concept is illustrated by Malkiel by way of example. If there are two businesses in town, an umbrella manufacturer and a resort owner, both with equal expected returns and equal volatility of those returns, an investment in either one of them could result in a loss (due to the volatility of returns). But because the umbrella manufacturer will do well when the resort owner does poorly, and vice versa, by owning both firms, the investor can achieve the same expected (or average) returns but without the volatility.

This concept is then extended to broader markets. An investor owning both US and Japanese stocks can achieve similar returns but with far less volatility than another investor who owns only one country's stocks. The concept can also be extended to other asset classes which don't have perfect correlation with the investor's portfolio (e.g. real estate). A criticism of this concept, however, is that when volatility rises (e.g. times of fear), correlations between asset classes tends to rise, and so the benefits of diversification are lost at the time in which they are needed most.

Later in the book, Malkiel will use MPT to create ideal asset allocations for investors of different age groups.

Saturday, November 28, 2009

A Random Walk Down Wall Street: Chapter 7

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

The author now turns his attention to discrediting fundamental analysis. The author discusses several academic studies (including some of his own work) that show how analysts add no value in predicting future earnings and how most mutual funds under perform the market.

Malkiel cites four reasons analysts can't get earnings growth predictions correct:

1) The influence of unpredictable events. Analysts can't forecast these, but analysts will believe strongly in their predictions anyway.

2) Creative accounting. Managements have a lot of leeway when it comes to producing their bottom-lines, making it difficult to predict the results in advance.

3) Incompetence. Malkiel cites several examples (including those which he has witnessed personally) where analysts simply do a poor job.

4) The promotion of the best analysts. Superior analysts don't stay at their jobs for too long.

While Malkiel recognizes that some fund managers do beat the averages consistently, he notes that these managers are so few that these incidences are not inconsistent with the laws of chance. He cites the example of a contest where 1000 people flip coins, where the "heads" move on to round 2 and the "tails" go home. After 5 flips, there will be approximately 30 people who flipped heads five times in a row, and their advice will be sought and their biographies will be written, despite the fact that they arrived at their rank by pure luck.

Despite the academic evidence that Malkiel cites throughout the chapter, he concludes by offering his personal opinion that the market is not completely efficient. He writes that "some gremlins are lurking about that harry the efficient-market theory and make it impossible for anyone to state that the theory is conclusively demonstrated." He vows to discuss these market anomalies in Chapter 10.

Friday, November 27, 2009

Taking It Personally

As this site has grown in reach over the last several months, the amount of reader feedback I have received has accelerated. Unquestionably, the articles that generate the most feedback are those related to particular securities (as opposed to a general article on investor this one). However, while the majority of sites stick to writing about stocks on which they are bullish, I also tend to write about stocks in which I'm not interested, in order to discuss the reasons that add to an investment's risk or subtract from its return. As a result, I've been in a position to observe some interesting reader behaviour.

If someone does not own a stock, and they come across a positive article about it, it doesn't seem to bother them much. I can tell because I have never received hate mail over this! On the other hand, if someone does own a stock, and they come across a negative article about it, they seem to take it personally! This results in my receiving racial slurs, demands for public apologies, and threats that I will be reported to the SEC.

But for everyone who actually initiates a personal attack, there are likely many others who managed to overcome the strong emotional reaction that they felt. Nevertheless, their decision-making ability with respect to this particular security may still have become marred with an emotional bias. I must admit that when I read a negative article about a stock on which I am bullish, I too feel a twinge of anger at the author (though this tendency has definitely dissipated over time as I have gained more experience). By recognizing this tendency, however, investors can take conscious steps to force themselves to have an open mind and to objectively consider the author's points. By doing so, investors can avoid some of the psychological investor pitfalls we've discussed previously.

There are a vast number of factors, many of which are quite subjective, that go into a decision to purchase a particular stock. As such, it follows that even people with similar investment philosophies will disagree on whether a particular security makes for a good investment. And that's okay: investors who turn out to be correct about one particular security will not necessarily be right about others. In the meantime, we can't tell who's right; all an investor can do is try to learn and thereby improve his "batting average", as Warren Buffett likes to call it. Key to this is overcoming the personal feelings involved in objective discussions of relevant securities.