Wednesday, March 31, 2010

Hidden Land Values

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

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

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

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

Disclosure: None

Tuesday, March 30, 2010

Revenge Of The Options

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

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

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

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

Disclosure: Author has a long position in shares of QCC

Monday, March 29, 2010

Running Out Of Cash

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

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

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

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

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

Disclosure: None

Sunday, March 28, 2010

Influence: Chapter 7

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

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

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

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

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

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

Saturday, March 27, 2010

Influence: Chapter 6

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

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

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

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

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

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

Friday, March 26, 2010

Investing And Uncertainty

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

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

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

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

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

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

Thursday, March 25, 2010

Buybacks With Bite

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

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

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

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

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

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

Wednesday, March 24, 2010

Licking Up The Profits

Blonder Tongue (BDR), a manufacturer of cable tv electronics, is a stock idea with some interesting elements to it. While the company has had a difficult time making money in recent years, it has begun shifting much of its production overseas, which should make it more cost competitive. However, it's not the company's earnings situation which makes this stock appealing, but rather its assets.

Blonder Tongue trades on the AMEX for under $7 million, but has current assets of over $14 million against total liabilities of under $6 million. In addition, the company owns several acres of land at its manufacturing site which is likely worth a few million dollars. Furthermore, the company has classified $4 million of its inventory as long-term (and therefore is not included in current assets) because it doesn't expect to sell it this year. While the risk of obsolescence in an industry such as this one is high, this extra inventory is offered to the current investor for free, since the company trades at a discount to its net current assets.

The most troubling thing about this company, however, is how its CEO manages money. Not so much the money within the business, but the money in his personal life. You see, CEO James Luksch declared bankrtuptcy less than a year and a half ago.

Should this kind of information be relevant in assessing a manager's on-the-job ability? It would certainly appear so. If one can't safely manage finances in one's own life, how can one be expected to do so for a public company?

It gets worse, however. Luksch had taken out interest-free loans from Blonder Tongue before declaring bankruptcy. Luksch's daughter and son-in-law are also executive officers of the company, and therefore the CEO's personal business is clearly company business; he has made it so!

In deciding whether to try to take advantage of this opportunity, investors will have to weigh the company's compelling price relative to its net assets against the murky earnings outlook and weak track-record of the chief executive officer.

Disclosure: Author has a long position in shares of BDR

Tuesday, March 23, 2010

Avoiding Energy

Isn't it crazy to avoid investing in energy stocks? After all, don't we all know that energy prices are going up in the long term? After all, as large, developing countries continue to grow, demand for oil is sure to sky-rocket. Furthermore, as a non-renewable resource, the world's oil supplies reduce every single day. Unfortunately, these stories don't tell the whole tale, and the reasons for value investors to stay away from investing in commodities like energy have never been stronger.

Energy prices are volatile, and the direction of price changes is hard to predict. While the factors described above (emerging economies, non-renewable resource) will play an important role in the future price of energy, they are over-emphasized by the media and those who are bullish on the price of oil. Under-emphasized, however, is the market reaction to the high (even relative to recent history) prices.

First of all, high oil prices result in increased exploration and increased production. But neither of these occur overnight. Instead, they take place over a period of several years, as labour and capital is shifted to the energy sector in order to derive strong returns. We saw this effect taking place in the early 1980s, and we are seeing it again.

Second, high oil prices result in consumer and business shifts towards conservation and the development of technologies that increase energy efficiency. As an example, consider the increase in energy efficiency of new American passenger vehicles sold in the last few years:

Note that the last time efficiency was jumping by this magnitude was in the early 1980s, when oil prices last spiked significantly. When oil prices were low, there was no need to purchase fuel-efficient cars and there was no need to invest in technologies that would increase efficiencies.

But once again, changes in efficiency don't happen overnight, which is why oil demand is relatively inelastic in the short term (e.g. one still has to fill up his car to get to work, no matter what the price) but elastic in the long term (e.g. the car-owner will consider fuel efficiency the next time he buys a car). Over the next several years, as higher efficiency vehicles replace older relatively inefficient vehicles, oil demand in this country will start to decline.

Will this offset emerging market growth and supply constraints? It is difficult to tell. This will depend on how fast developing countries grow, how quickly new supplies are found and at what cost, and the rate at which technologies that improve energy efficiency are brought to market. Simultaneously sorting through these variables to come up with a forecast is a difficult exercise riddled with traps.

The safest bet for the value investor is not to make one at all, since being wrong on the future price of oil is too easy to do. With the number one priority of value investing being "Never Lose Money", value investors should stay away from making investments that are heavily reliant on the price of energy, either on the cost or the revenue side. Instead, investors should focus on companies that face stable pricing of their products and have flexible cost structures.

Monday, March 22, 2010


Brink's (BCO) is the largest provider of secure transportation and security-related services in the US. The company has steadily generated excellent returns on capital over the years, but due to the recession demand from banks and retailers for cash and jewelry transport and security has slowed.

As a result, Brink's trades at a decent valuation for a company with a market cap above $1 billion. Shares of BCO trade with a P/E under 7, while the stock price doesn't trade much higher than it did at this time last year, when stocks dove to their lowest levels of this recession. Low P/E and high ROE stocks are exactly what investors should be looking for in order to outperform the market, as Joel Greenblatt has made a living discussing.

However, this stock illustrates an important lesson when it comes to applying the P/E formula. While the operating income of Brink's is depressed due to the recession, its income (the "E" part of the P/E formula) is well above its operating income in 2009, thanks to a one-time tax gain. This makes the P/E of Brink's appear larger than it should, and could entice an investor to purchase for the wrong reasons. As we've discussed before, earnings should be averaged over time in order to derive an estimate for earnings that is absent of one-time losses or gains.

Of course, this doesn't mean Brink's isn't still potentially undervalued. The company has a strong brand name and a lengthy history of operations that allows it to attract customers in an industry where reliability is a key success factor. Earnings are also likely temporarily depressed as the banking and retail sectors aren't seeing the transaction sizes that they used to; but Brink's has the balance sheet strength to outlast this downturn. But in coming to a conclusion as to whether the stock is undervalued, just don't be fooled by the headline earnings number!

Disclosure: None

Sunday, March 21, 2010

Influence: Chapter 5

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

We are more likely to buy a product when we like the seller. While this may be obvious, what is not so obvious is what makes us like a seller, as some of the factors that cause us to like are subconscious.

For example, people are more likely to like someone who is similar to them, across many dimensions: not only physically, but mentally as well (e.g. political affiliations, dress/fashion preferences etc.). This is why stock brokers are trained to look for clues about a person in order to engage in conversation that expresses a similarity with the potential buyer (e.g. "Where are you from? ...Oh my wife was born there!")

Attractive people also tend to be liked, and often this is on a subconscious level. Experiments have shown that attractive people can make a product (e.g a sports car, a stock) appear faster and more appealing to a group of subjects, even when the subjects swear afterwards that the appearance of an attractive person had no effect on their responses. Data shows that this subconscious liking leads to advantages for more attractive people that range from higher pay to shorter prison sentences.

Positive association also leads to liking something more. This is why marketers will associate their products to events people have positive feelings towards. After the moon-landing, many products were associated with rockets and outer-space even if there was no relevant link between space travel and the product. Today, advertisers are willing to pay big bucks for the right to associate with the Olympics or other sporting and concert events. In an interesting experiment, restaurant frequenters were found to tip more when the bill came in a tray with a "MasterCard" logo on it, even if the frequenters paid with cash! (However, only those with positive past associations with credit card companies were found to tip more, of course.)

Finally, the sharing of common goals and/or cooperation also leads to liking someone more. This is why salesmen will often pretend to be on your side while working against management to get you a good deal.

Saturday, March 20, 2010

Influence: Chapter 4

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

Investors like to know someone else has purchased a stock before they will consider doing so. They want to see that others think the stock is undervalued, before they will take the plunge. If many other people are doing something, we tend to assume they know something that we don't. As a result, we are likely to mimic their actions. This concept is known as social proof.

Often, following the actions of others can save us the time of figuring out the pros and cons of whether we should do something. Often, this is useful; on the other hand, in the few times when the actions of others are incorrect, it can lead to disastrous consequences.

Cialdini describes a number of historical events and experiments that show how potent is social proof, and how it can be exploited by anyone from marketers to tv executives to cult leaders. In one striking example, a bus strike caused residents of Singapore to gather at a bus stop that happened to be outside a new bank. As the residents considered alternative means of transportation, some of them began withdrawing money from the bank. As others saw large crowds withdrawing money from this bank, they too began to do so, in the assumption that this crowd must know something they didn't. The withdrawals continued until the bank was forced to close to avoid a major crash.

Commercials will often talk about how a product is the "fastest selling", and nightclubs will often create line-ups outside even if empty inside. In this way, these marketers realize that they don't have to convince you the product is good, they instead try to convince you that other people think the product is good! As another example, laugh tracks actually make people believe tv shows are funnier; the striking thing about this example is that this occurs even though the subjects know the laugh tracks are computer-generated and false.

There are two specific conditions which make people more susceptible to using social proof to govern their actions: uncertainty and similarity. When in the company of strangers, or in a new environment, individuals are much more likely to behave as do others. Furthermore, when the others are just like them (i.e. similar race, sex, age etc.), this also increases their chances of mimicking behaviour.

Cialdini advises that readers use their judgement when they see that they are behaving in a manner that is the result of social proof. Judgement might just eliminate many of the stock price crashes and bubbles that occur with the help of social proof.

Friday, March 19, 2010

Representing Winners And Losers

As value investors, we believe the market does not correctly price many of its issues. But what are the causes of this inefficiency, and can we profit by knowing some of these causes?

De Bondt and Thaler argue that a human method of interpreting data called "representativeness" causes prices to diverge from their fundamental values. More information on this human heuristic is available at Wikipedia, but basically "representativeness" is used to describe how humans use stereotypes to draw conclusions which are inappropriate.

In this way, the authors argue that stocks that outperform (underperform) the market for extended periods tend to continue to do so, and this results in relatively large deviations between price and value. In effect, people believe some stocks to be outperformers, and therefore they jump on them on the expectation that they will continue to do well (and the opposite is true for underperformers).

De Bondt and Thaler do offer some data to back up their theories. They grabbed the top and bottom decile of stocks over a three year period, and compared their returns over a subsequent 5-year period. The results are illustrated in the chart below:

The previous losers outperformed the previous winners by about 40% in the five-year period that followed the formation of the winner/loser portfolios! The authors argue that this is evidence that winners and losers both ran too far in the previous three-year period.

You may be discouraged from buying a stock you feel is at a decent price because for years its price has been under pressure. But consider that what is influencing you to feel this way could be "representativeness" and that the current dog of a stock could be tomorrow's (or the next five year's) darling!

Thursday, March 18, 2010

GameStop: The Next Blockbuster?

Blockbuster (BBI) shares lost nearly 30% of their value yesterday, as the company suggested that its ability to continue as a going concern remains in doubt. GameStop (GME) and Blockbuster do share some similarities, leaving investors to wonder if Blockbuster is not just a few years ahead of GameStop in the inevitable fall of both companies. Is GameStop also doomed?

A few years ago, Blockbuster had a seemingly viable business model. Since then, however, the world has passed it by. While the company trudged along as a bricks and mortar, other companies allowed movie viewers to download/order movies online or order movies on-demand through their cable boxes from the comfort of their homes.

It is not implausible to believe that a similar fate could befall GameStop. It's not a wild leap to assume that in the future, game consoles will allow gamers to browse online catalogues of games directly on their televisions, and purchase and download these games directly, by-passing the distribution network on which GameStop is so reliant.

Though this points to a grim future for GameStop, there are some important differences which make the GameStop / Blockbuster situations rather dissimilar. First of all, to the surprise of many, Blockbuster has never really made money, even when it should have been able to. From 1996 to 2000, when the company should have been raking it in, it lost over $700 million! The ensuing ten years were even worse, as the company rarely had a profitable year, and managed to lose several hundred million dollars in the process.

GameStop, on the other hand, is dealing from a position of financial strength: the company has made over $900 million over the last five years, and carries just $400 million of debt, while holding $300 million of cash. As such, instead of fighting fires and figuring out how to pay debt and expenses, GameStop can focus on pursuing profitable business opportunities.

GameStop also sells devices that make the software valuable. Without the consoles, and extra hardware in the form of controllers, balance boards, punching gloves, steering wheels, foot pedals and other contraptions, the innovative software is not as interesting. While margins on these items are currently low, as retailers try to make money on the software, these margins may have to rise to entice the retailers to continue to sell them if most of the software is downloaded.

Most importantly of all, however, GameStop is an innovative company. Management has consistently shown an ability to squeeze out profits, even in the face of strong competition from the likes of Wal-Mart and Best Buy. GameStop's successful foray into the used game market, where it essentially created a lucrative niche where no market previously existed, has allowed it to benefit from strong margins from used games as big box retailers have reduced the margins on new software titles. With able management, and dealing from a position of financial strength, with strong cash flow generation, a low debt to equity level, and strong returns on equity, GameStop is in a position to fight to stay around like Blockbuster never could.

But investors have priced the stock as if its death is around the corner. The company's demise, however, is far from a foregone conclusion. With a price to operating cash flow of just over 5 and almost no net debt, GameStop trades at bargain levels. At this price, the downside is priced in; but if the company is able to last a few years longer than expected, investors may find that this stock idea was worth the investment.

Disclosure: Author has a long position in shares of GME

Wednesday, March 17, 2010

Profits On The Horizon

Nu Horizons (NUHC) is a distributor of hi-tech electronic components. The stock dropped 25% in one day last week when a key supplier, Xilinx, cut Nu Horizons as a distributor in order to streamline Xilinx's distribution network. Xilinx's products accounted for over 30% of Nu Horizons' sales over the last three quarters, so this will have a material impact on Nu Horizons' operations and will hurt Nu Horizons' revenue if the Xilinx's products cannot be quickly replaced. However, the current market price of Nu Horizons is such that this seemingly negative announcement may actually be good news for the stock!

Before writing off the preceding statement as preposterous, consider the following: Nu Horizons trades for just over $60 million, while its net current asset value is over $100 million. Most of its current assets (approximately $225 million worth) are in the form of inventory and receivables, and so this negative announcement may actually be a catalyst for cash generation.

The company's Xilinx inventory is more than $40 million, so as the company either works through it or returns it (with expenses paid for by Xilinx), cash will be generated. If Nu Horizons' sales are reduced because it cannot replace Xilinx's products, further cash will be generated thanks to a reduction in the accounts receivable. Of course, if replacement products cannot be found, the severed relationship between Nu Horizons and Xilinx will reduce Nu Horizons' earnings. But when one is buying assets for a fraction of their worth, it's never a bad thing when those assets are converted to cash.

On the other hand, if the company can replace the Xilinx products quickly and easily, there will be little in the way of cash generation, but revenues and future earnings may also not change materially. In this case, the company will be able to continue to try and grow its profitability, and shareholders buying at this price are still minimizing downside risks, thanks to the discount the company trades at relative to its liquid assets.

Nu Horizons has not exactly been generating excellent returns for shareholders over the last few years; a shrinking of the business (and the cash that is generated along with that) is not necessarily a negative! As solely a distribution business, Nu Horizons should be able to adjust its cost structure to a level commensurate with lower revenues, if need be.

Disclosure: Author has a long position in shares of NUHC

Tuesday, March 16, 2010

Revenue Spikes

If a company has been able to grow its revenues over the last several quarters, it may be a sign of strong future growth. However, investors should be careful not to assume that future growth is a fait accompli, or that revenues will even stabilize at current high levels. While we've often discussed how investors should interpret one-time losses, occassionally one-time gains can occur as well.

Consider Alpha Pro Tech (APT), maker of a slew of protective products, from medical masks to roof underlay. The following chart depicts the company's revenues over the last several years:

Not only does the company's revenue growth appear unsustainable, but so does its revenue level. The company benefited in 2009 from responses to the H1N1 virus, which resulted in sales growth of its medical masks of 283%! This alone boosted sales by $13 million in 2009, and is not likely to continue, as the company's president noted that "...face mask sales started to slow down in the latter part of the fourth quarter and are expected to return to pre-H1N1 levels in 2010, unless concerns relating to the global H1N1 Influenza A pandemic resume."

That's not to say APT does not have a bright future. It's building products (underlayment and house wrap) are gaining share and growing distribution in an otherwise poor building environment. Furthermore, mask sales represent only a portion of the company's total sales, and the company's other protective products show potential to continue to grow.

But the lesson is that investors should not blindly incorporate a company's latest revenue figures as a company's new normal. Instead, investors should attempt to understand the nature of a company's products in order to arrive at a more accurate normalized revenue figure for valuation purposes. Otherwise, the investor's attempt to identify undervalued stocks may prove fruitless.

Disclosure: None

Monday, March 15, 2010

Bad Times Are Good Times

We've seen how some companies don't take quite as big a hit as do others during recessions, based on the cyclicality of the respective businesses. But surprisingly, some companies actually see business conditions improve during recessions. As an example, consider Daily Journal Corp. (DJCO), a publisher of specialized information services.

The company trades for $96 million, but has no debt and cash and marketable securities of $64 million. The company has been consistently profitable over the last several quarters, and it finished 2009 with operating income of $12 million, which results in a return on equity of 15%!

So how does the company manage to turn in such stellar results while most companies out there are struggling to cut costs to avoid large blots of red ink? The company saw large increases in public notice placements, due to the large number of foreclosures in California and Arizona. Public notice advertising for foreclosures is mandated by law, and so this company is likely to continue to benefit from the foreclosures that are continuing to occur in this tough labour market.

Worried about how the company is investing its large stable of marketable securities? How about its corporate governance structure, or how it allocates its retained earnings? We've recently seen a few companies that are not so shareholder friendly, could this be another one of them? Value investors and fans of corporate governance will be pleased to know that the company's chairman is none other than Charlie Munger, Warren Buffett's right-hand man at Berkshire Hathaway.

Disclosure: None

Sunday, March 14, 2010

Influence: Chapter 3

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

People have a need to act in a manner consistent with their beliefs, values, and prior commitments. This automatic behaviour serves a useful purpose: consistent conduct reduces the need to repeat the processing of information when an individual is faced with similar situations. Consistency provides a beneficial approach to daily life and is a trait that is valued by society.

However, this behaviour can also be exploited by others. Exploiters first seek to get individuals to take stands on issues. They will then use those "commitments" to elicit the behaviour that they seek. For example, home owners are much more likely to agree to having large "DRIVE CAREFULLY" signs on their lawns if a few weeks earlier they agreed that safe driving is desirable. The initial commitments lead to consistent behaviour most when they are active, public (e.g. a petition), require effort (e.g. a fraternity hazing ritual), and are viewed as internally motivated.

This need to be consistent can even "grow legs", as when people take a stand on a position, they tend to incorporate new information only if it strengthens their original position. This results in salesman tactics that offer more than they intend to give. In this manner, such tactics are based on the idea that once the buyer has decided that he wants the product/service, he will create more reasons to like the product, such that the initial offer can be reduced and the buyer will still be interested.

Recognizing that such exploitation is taking place is the best means by which to avoid falling prey to this automatic behavioural response. However, because people will often come up with justifications to proceed with certain courses of action, their line of thinking must be proactive to avoid being exploited. As such, Cialdini suggests that readers ask themselves this question when faced with a situation where one feels compelled to do something against one's wishes: "Knowing what I now know, if I could go back in time, would I make the same commitment?"

Saturday, March 13, 2010

Influence: Chapter 2

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

This chapter contains a discussion of the reciprocity and perceptual contrast theories, and how they are successfully used against unsuspecting individuals in order to derive abnormal profits. The human concept of reciprocation makes us more likely to do something for someone when they have done something for us. "Perceptual contrast" makes us more willing to agree to something when presented in comparison with something that appears worse.

We've already seen both of these human tendencies (here and here) when we looked at Charlie Munger's discussion of human tendencies, but in Influence, Cialdini demonstrates them a bit more clearly with examples and shows more thoroughly how they are used as weapons against us by those who exploit these tendencies.

The concept of reciprocity is deeply ingrained in all human cultures. Cialdini argues that this trait has been a major contributor to human evolution, as it has allowed humans to give favours and resources to others with the knowledge that they will be returned. This has created a "network of obligation" that has allowed humans to share goods and services in a manner that has allowed the group to prosper.

Cialdini delves into a large number of odd historical occurrences and purposeful psychological experiments that demonstrate how powerful these tendencies are. Under ordinary circumstances, there is a strong correlation between how much we like a person, and what favours we are willing to do for them. But once a favour has been done for us, the correlation between how much we like a person and what we'll do for them goes out the window: Cialdini shows that whether we like a person or not, we will do a favour for them if we have accepted one from them.

Furthermore, the favours do not have to be of the same magnitude, and the receiver of the initial favour need not even want the favour in order to feel the sense of obligation. This is a powerful tool that is exploited by salespeople, charities, and religions, all of whom offer gifts in order to instill a sense of obligation in the receiver. In this way, the initiator is choosing the gift, and then asking for a larger return, also of the choosing of the initiator, resulting in a very profitable outcome!

Exploiters achieve the highest profits, however, when reciprocity is combined with perceptual contrast. For example, if one is asked to volunteer one hour per week for a year, one may see a high rejection rate. But following this question, if one is asked to volunteer just once for one hour, one is likely to see much higher acceptance rates than if the first question was never asked. This is because the second request is seen as much more reasonable than the first request (perceptual contrast), and because the initiator has accepted the initial rejection, thereby instilling a sense of obligation in the subject.

Everyone from politicians (accepting campaign financing and then returning favours to the donors, voting for bills because they are sponsored by members to whom favours are owed) to consumers (receiving small gifts which lead to purchases, trying out samples which instill an obligation to purchase) to scientists (receiving funding from special interests that tend to influence experiment conclusions) are susceptible to being influenced by these factors. Understanding how these tendencies are being used is the best defense to feeling a sense of obligation to the exploiter.

Friday, March 12, 2010

When The Company Values Itself

Most investors in the market focus on earnings and earnings growth. As value investors, however, we spend a lot time valuing company assets, since earnings can be volatile whereas many types of assets (e.g. cash, trusted receivables, real-estate, re-usable inventory) can provide a margin of safety on an investment if the price is right.

But determining the market value of certain assets can be rather difficult, as in many cases a company's balance sheet will state the assets at cost, even if they were purchased decades ago. This issue is particularly pertinent for companies that hold a lot of real estate, as while land values have appreciated over time, the gains have gone unrecognized on company balance sheets. As a result, investors can put hours or days of effort into attempts to value a company's portfolio of real-estate holdings. When you consider that there may be several investors putting in this type of effort for companies with large land-holdings, it is not inconceivable that years of effort (in the aggregate) are put into valuing such assets.

One company that is making life easier for the investor is Genesis Land Development (GDC), a real-estate development company that plans to have its properties independently appraised and subsequently publish the results! I considered this company as an investment several months ago, but due to the fact that I did not feel confident in determining the value of the company's real-estate assets in combination with the company's debt level, I did not feel I could put a value on the company with any certainty.

What Genesis is doing, however, is beneficial to both investors and the company. Investors, in the aggregate, save time (that can better be spent scouting other investments) and the company makes it widely known what its assets are worth, which should help bring a stock price towards its net asset value. Presumably, Genesis management feels the stock is trading at an undervalued level, but investors don't know the properties as well as does management, so this is a way to bridge that gap.

This is a route more companies should go, even those that are not pure real-estate plays. Often, a company's headquarters may be worth far more than its stated value, but the information is not well-disseminated and shareholders that can't put a value on the real-estate may shy away. By providing up-to-date information on company asset values, companies that trade at discounts would likely to see stock price rises.

Disclosure: None

Thursday, March 11, 2010


When outside bidders are vying for control of a company, management and shareholders of the target will often hold out for a sufficient premium to the current price. After all, if shareholders can sell their shares right now for a certain amount, they should get more if they actually agree to.

On rare occasion, however, the target management and board will actually agree to a takeover price below the current market price! This may sound unbelievable, but it happened this week when Jones Soda (JSDA) agreed to be acquired for under $10 million. On the day before the announcement, however, the market cap of the stock was over $20 million!

Even after the announcement, shares of Jones Soda continue to trade above the value of the take-under price: the company still trades for over $14 million, even though Jones' board has agreed to the transaction!

So what is going on here? Has the market gone crazy, or does the market see potential in the share price that the board is missing? Shareholders must approve the take-under transaction before it can go through; but at the current price, you'd have to think buyers would be nuts to pick up these shares unless they can defeat the merger. Nevertheless, almost three million shares traded hands immediately following the announcement.

So are these buyers nuts, or can they defeat the merger? I can't really tell. However, a cursory look at the financial statements of Jones appears to suggest it is selling itself for less than its liquidation value. The filing of lawsuits appears imminent.

If you spend enough time watching the markets, you will come across rare, shocking stories every once in a while. But I haven't seen anything as weird as this take-under offer since this occurred in September of 2008.

Wednesday, March 10, 2010

Forecasting Forecasts

We spend a lot of time reading forecasts. The financial news media is rife with new articles every day that take a position on the near-term future of inflation, interest rates, and stock prices. But are these forecasts of any use? James Montier, an author on the topic of behavioural finance, says no.

He has compiled and aggregated past forecasts for a number of popular financial metrics. The following chart illustrates how well forecasts of inflation have approximated actual inflation over the last several decades:

Note that the forecasts of the deflator actually lag the actual deflator! This forecast is telling you what happened, rather than what is about to happen!

Next, consider forecasts of the US government 10-year bond yield:
Once again, the same thing seems to be occurring, where the forecast is simply telling us what has already happened! Finally, a similar phenomenon occurs when forecasts of the S&P 500 are considered:
Of course, it should be noted that these forecasts are considered in the aggregate, whereas some forecasters may be able to consistently outperform others. However, there does appear to be a lack of supporting evidence that some forecasters are clearly superior.

Sixth-century BC poet Lao Tzu remarked that "those who have knowledge don't predict" while "those who predict don't have knowledge". So if forecasts are so useless, why do we spend so much time making them and reading about them? This topic will be explored in a future post.

Tuesday, March 9, 2010

An Uphill Battle

As previously discussed, value investors can benefit from investing along with other value investors. But the presence of another value investor as a major shareholder does not guarantee that a company will be run in a shareholder-friendly way. Sometimes, management and board practices can make life difficult for even the most active of value investors.

As an example, consider ITEX Corporation (ITEX), which offers a marketplace for businesses to exchange goods and services. ITEX boasts two major value shareholders, including Sardar Biglari and The Polonitza Group, who own a combined 21% of the company. Unfortunately, the company is not currently structured to succeed, with an extremely poor governance structure that tilts the balance of the company's power towards management at the expense of shareholders.

First of all, there are only three board members, one of which is the CEO. Neither of the remaining two board members can reasonably be considered independent, having received compensation from the company in return for consultatory services. Furthermore, there has been no turnover at the director position in almost 8 years! When one of the aforementioned shareholder groups suggested a change at director due to a lack of independence, it appears the company responded that "they are not very close friends and maintain independent thoughts and ideas" and that "they do not frequent each other’s houses or family events". Unfortunately, this hardly assuages shareholder fears, as the issue is not how buddy-buddy these guys are, but how the board's incentives (due to the fact that they provide executive and consulting services to the company) are not aligned with those of shareholders.

As a result, the CEO sits on the audit committee! The other two directors, who receive or have received payment for consulting services from the company, sit on the compensation committee! For all we know, the board is doing a terrific job, but the structure reeks of conflict of interest. But is there any evidence that this might be hurting shareholders?

Well, as these value investors began buying up shares, it appears the board/management went into defensive mode. In 2009, the company protected the CEO from a buyout by guaranteeing some payments to him of a few hundred thousand in the event of a change of control. Furthermore, they recently amended company by-laws that restrict the rights of outside shareholders.

Finally, the company appears rather generous in handing out shares to management, which dilutes existing ownership. The company only has 18 million shares outstanding, but consider the following handouts:

  • In 2001, Mr. White received 250,000 shares for services rendered to ITEX as an independent consultant.
  • For services as a director of ITEX from 2003 through 2007, Mr. White was compensated by an annual grant of 40,000 shares of common stock.
  • For services as a director of ITEX in 2008 and 2009, Mr. White was compensated by an annual grant of 30,000 shares of common stock.
  • On May 3, 2004, and again on July 6, 2006, Mr. White was awarded 300,000 shares of common stock for services rendered ITEX as Chief Executive Officer.
  • On December 13, 2005, Mr. White was awarded 50,000 shares of common stock as consideration for his collateralized personal guarantee of ITEX obligations incurred in order to fund a corporate acquisition.
  • On October 8, 2009, Mr. White was awarded 195,000 shares of restricted common stock for services rendered ITEX as Chief Executive Officer.
Even though value investors may be major shareholders of a corporation, they may still face an uphill battle. Before jumping on board, potential shareholders would be wise to investigate whether management is playing nice, or entrenching themselves.

Disclosure: None

Monday, March 8, 2010

Professional Cost Cutters

We've discussed a couple of times now how same-store sales, Wall Street's most beloved retail metric, can be misleading. This is because it doesn't consider the company's cost structure, which may or may not be flexible. Sometimes, a company can do such an extraordinary job cutting costs that the effects of drops in revenue can be completely reversed.

As an example, consider Build-A-Bear (BBW), the make-your-own-stuffed-animal store. As the recession has reduced the ability of consumers to spend big money on little bears, revenues at Build-A-Bear have reduced. But costs have been reduced at an even higher rate, which has allowed the company to maintain its pristine balance sheet and return to profitability.

Build-A-Bear has done such a good job cutting costs, that they have done so in an area which is normally impossible: its operating leases. If operating lease commitments should be considered debt (something we have often advocated), Build-A-Bear's renegotiation of its leases is akin to having miraculously removed a bunch of debt from its books: the company reduced its leases by $140 million in the aggregate, which is more than the market cap of the entire company!

How was the company able to pull off such an enormous feat? Perhaps it is a desired tenant by the majority of the malls in which it operates. Or, perhaps the company overpaid for locations when they were opened. Whatever the case may be, considering changes in revenue without considering the corresponding changes in cost (or vice-versa), which is something Wall Street does often, is a mistake. Investors who avoid focusing on misleading metrics just because the rest of the market does, put themselves in a position to profit from market inefficiencies.

Disclosure: None

Sunday, March 7, 2010

Influence: Chapter 1

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

Researchers who study animal behaviour have documented the fact that many species react in pre-defined ways to various stimuli. For example, a bird will protect even a predator if it emits a taped recording of a chirping sound normally made by a baby bird.

This trigger and automatic response that disregards all other factors can be valuable, as it allows animals to make decisions quickly, without having to analyze a plethora of information, some of which is undoubtedly irrelevant. On the other hand, it can also result in costly mistakes, since only one piece of information is used in driving behaviour.

An example where humans apply this type of behaviour has to do with how people determine the value of various items (stocks, objects etc.): by basing its perceived value on its price. This method of value determination does have its advantages: if every time a new object was considered for purchase, humans researched it and studied it extensively, there would be little time for anything else. On the other hand, this can lead to foolish decisions in the cases where price and value are not matched properly.

Marketers and salespeople who understand these shortcuts humans have developed to expedite decision-making can profit by triggering the human responses they desire by arranging the appropriate stimuli to their advantage.

Saturday, March 6, 2010

Developing An Investment Philosophy: Chapter 4

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 the expanded version of this book, which includes 2 other works by Fisher including "Conservative Investors Sleep Well" and "Developing an Investment Philosophy".

This final chapter focuses on whether the market is efficient. Fisher is clearly in the "no" camp, though he notes that this philosophy has been gaining steam. He agrees that it is very difficult to make short-term profits and gain quickly from new, public information. However, for long-term investors he argues that the market is not even close to perfect.

To illustrate his point, Fisher points to the distribution of returns of various stock indexes. While the indexes themselves may move small amounts from day-to-day as the outlook for business conditions changes, individual stocks have far larger distributions of returns. Over five-year periods, the returns on an index may seem reasonable, but around 10% of stocks will show gains of thousands of percent. Fisher believes prudent investors can uncover at least some of these special stocks, leading to outsized profits in the long run.

As an example, Fisher takes the reader through a few years comparing the operations to the stock price of a company called Raychem Corporation. This was a company that only undertook projects if it could be the industry leader and if it possessed some knowledge or advantage that would make it difficult for competitors to copy. The company traded at 25 times forward earnings in 1975, as new products were expected to grow earnings in the years to come.

After a single major new product failure (resulting in a write-off that hurt earnings), followed by an unrelated restructuring meant to improve profitability, the stock dropped to one third of previous value over the course of a single year. Raychem management was upfront about both the positives and negatives facing the business, and yet the stock price stayed low, much to Fisher's bewilderment. Eventually, the price recovered. Fisher believes this to be a perfect example, though only one of many, of how the market is clearly inefficient.

Friday, March 5, 2010

Overconfidence And Anchoring

Noting that positive (negative) earnings surprises tend to be followed by more positive (negative) earnings surprises, economist Dr. Hersh Shefrin makes the point that this occurs because the investor/analyst tends to be overconfident, and furthermore fails to fully incorporate new information (i.e. he is "anchored" to his previous opinion).

To demonstrate how these two respective tendencies work, Hersh discusses two experiments where subjects are asked to provide answers to the following:

1) The Dow Jones Price Index does not include the effects of dividend re-investment. If dividends had been considered re-invested in the index since its inception in 1896, at what price level would the index be at today? Provide a 90% confidence interval around your answer (i.e. you are 90% confident that your interval includes the right answer).

2) There are 100 bags, each containing 1000 poker chips. 45 bags have 700 black chips and 300 red chips, while 55 bags have 700 red chips and 300 black chips. If you select a bag, what is the probability that most of the chips are black? If you pulled out 12 chips from that bag, and 8 of them are black and 4 of them are read, now what is the probability that most of the chips in the bag are black?

The answer to the first question is around 650,000, which lies far above the upper limit of the confidence interval of most subjects of whom this question is asked. If humans were well-calibrated, the number should have been inside the confidence interval of 90% of subjects. Instead, this experiment demonstrates that humans are over-confident, believing they know the answer (within a margin) when they don't, and believing they are more skilled than they are (e.g. 90% of car owners believe they are better-than-average drivers).

The answer to the first part of the second question is 45%, which most people get. What people fail to do is incorporate the new information (namely, that 8 of the 12 chips pulled out are black) successfully to determine the new probability required in the second question. While most guesses are between 45% and 75%, the real answer is north of 96%! Shefrin argues that people aren't even close in their answers because humans tend to anchor themselves to their previous opinions, and are unable to objectively incorporate new information.

This combination of overconfidence and anchoring leads to positive (and negative) surprises in earnings results that persist despite the presence of new information. This provides opportunities for investors who can overcome this bias. Needless to say, Shefrin is not one of those academics that believes in the Efficient Market Hypothesis.

Disclosure: Author did not answer either question correctly

Thursday, March 4, 2010

A Good Sport

Value investors tend to invest along with other value investors: investors looking for stocks with particular characteristics will tend to find the same stocks attractive. Furthermore, when value investors are significant shareholders in certain stocks, other value investors may find these investment opportunities particularly attractive, in the knowledge that their interests may be aligned with those of other shareholders.

With that in mind, consider Sport-Haley (SPOR), a designer and distributor of fashion golf apparel. Revenues for such high-end items have taken a nosedive as a result of the recession, but Sport-Haley's stock price may have overreacted to the downside.

While the company continues to mount losses, its cash flow situation is not as poor as its earnings would suggest. The company is reducing inventory, which is proving to be a source of cash, and that inventory can be purchased by the investor practically for free. The company trades for just 60 cents per share, but has about $1.50 in inventory! And these aren't the company's only current assets; the company trades at a discount to its net current assets of almost 80%, which is a massive discount by any stretch!

It is, however, important to note that this company does not trade on a regular exchange (e.g. NYSE, NASDAQ), unlike most of the stocks discussed on this site. Instead, it trades "over the counter" and therefore, investors are not afforded the same level of protection as they are for exchange-traded stocks, and the standards for the company's disclosure requirements are not as high. Investors new to this type of trading should ensure they understand the added risks before participating in such issues.

In addition to the discount to current assets, what adds appeal to this stock as a value investment is the involvement of North & Webster, an investment firm that follows the principles of Benjamin Graham. North & Webster has purchased a stake in the company, and has replaced the Chairman of the Board with a value investor. Last time we saw a situation like this was when we considered Goodfellow as a value investment. Goodfellow subsequently saw a price run-up, and as a result it can now be seen on the Value In Action page.

Disclosure: None

Wednesday, March 3, 2010

Paving The Way To Success

In general, makers of capital equipment see highly cyclical demand from their customers, as the will/ability of companies to finance expensive purchases during recessions disappears. Further adding to the already-pressured earnings situation for companies that manufacture heavy-duty capital goods is the fact that a large component of their costs are fixed, at least in the short-term. But often, this combination of negative factors in the short-term can result in a beaten down stock price, where upside potential is strong and downside risk is low in the long-term.

As an example, consider Gencor (GENC), a manufacturer of heavy-duty equipment for the highway construction industry. As one might expect, Gencor's revenue has taken a hit, and the fixed-cost nature of its business has resulted in several consecutive quarterly losses. But while the company has lost under $3 million in the last five quarters combined, it holds cash of $65 million against no debt, and it trades for just $68 million.

In addition, the company has another $32 million in inventory and accounts receivable against total liabilities of just $10 million. Inventory on the balance sheet is understated due to the fact that the company uses LIFO as its inventory method. (For further discussion of this issue, see the post on L.S. Starrett.)

This situation is eerily similar to that of Hardinge a few short months ago. One major difference, however, is that the catalyst that ended up bringing up Hardinge's price is not possible here. Management controls the company without actually owning a majority of the company's shares, due to a dual-class share structure. This is not an ideal situation for shareholders, and one of the problems with this is that it effectively prevents any hostile takeover attempts. As such, it is entirely possible that the price of the stock won't move up until the economy picks up steam, which could be a while. But for value investors who simply focus on purchasing businesses at discounts to their intrinsic values, Gencor appears to be an attractive candidate.

Disclosure: Author has a long position in shares of Gencor

Tuesday, March 2, 2010


Companies that are either primarily listed in countries outside of North America or that do much of their business outside North America are often discussed on this site. As a result, I receive many questions regarding additional risk factors such companies may face, and whether such risks would ever deter me from investing in such companies.

While I agree that stocks facing uncertain or anti-business regulatory environments can be more risky, they can also offer more opportunities (i.e. trade at larger discounts). Furthermore, one can diversify certain country-specific risks away by avoiding over-exposure to high-risk regions. As a result, I will generally stick to a bottom-up approach when it comes to international investing, subject to some region-specific portfolio allocation maximum. However, there is one exception to this: of the countries that represent a significant portion of worldwide trading, I will not invest in companies that have a material portion of their business in Russia.

I should first note that my opinions in this regard are not based in scientific fact or research, but are instead formed by a mosaic of information that I have accumulated or come across over several years. This is not because I haven't sought out formal literature on the subject, but rather it is the result of the fact that it is incredibly difficult to objectively ascertain which countries are the least investor-friendly. What data can you use to draw such a conclusion? Can you find reliable data of that nature?

Therefore, my conclusion may suffer from several biases, not the least of which is confirmation bias. But what I have found is that a systematic regulatory culture of entitlement and corruption has resulted in an anti-business climate in Russia for as long as I can remember. From the way Russia handled its arrest of the world's 16th wealthiest man, to IKEA's reaction to Russia's regulatory procedures, to the bizarre theft of Hermitage Capital's assets (that subsequently became owned by common criminals!), and the many incidents in between, Russia has shown itself to be an investing minefield. Below is a startling video where CEO William Browder describes how his VISA was cancelled and how his company was stolen from him by the Russian authorities:

What do the rest of you think of investing in Russia? Do you have any countries that you stay away from? What has prompted you to do this? Could you be suffering from one of these biases in your assessment, or would a reasonable, objective person find fault with your argument?

Monday, March 1, 2010

Acme In A League Of It's Own

On Friday, Acme United (ACU) reported year-end results. While their customer markets are still soft, Acme was able to grow revenues by expanding their product lines and customer base. While many companies do this by slashing prices resulting in reduced margins and profitability, Acme has proven itself to be a superior company, maintaining strong profitability as it grows.

You wouldn't know it from looking at Acme's stock price, however. The company trades with a P/E of just 11, despite excellent returns on equity. To see the company's valuation in perspective, consider the P/E ratios of the following companies with similar returns on equity over the last five years:

Acme is not as recognizable as the rest of the names, but this is precisely why investors are offered this company at a discount. Many would argue that because the company is small, its riskiness is higher than the companies above. While that may be true to some extent (for example, three customers each exceed 10% of Acme's sales), the upside is also higher as the company has room to grow. Acme has an on-going goal of generating 30% of its sales from products developed in the last 3 years. This is something that the large companies listed above would have great difficulty achieving.

In his book, The Little Book That Beats The Market, Joel Greenblatt discusses how the key to beating the market is to invest in companies with strong returns on capital when they trade at low P/E's. Acme fits this description well.

Readers interested in more information on Acme may want to give a listen to an interview CEO Walter Johnsen granted a couple of weeks ago.

Of course, investors cannot buy simply on the basis of a company's P/E. Further investigation of a company's risks and opportunities is necessary, as well as a careful reading of the company's notes to its financial statements.

Disclosure: Author has a long position in shares of ACU