Monday, May 31, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 1

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

There are probabilities of success and failure in the market as surely as there are in gambling. But Dreman argues that the odds in the market can be put in your favour. This book is about how to do just that.

The professional money manager is often described as someone who should manage your money. Armed with the best team of analysts money can buy, he is expected to be able to buy low and sell high. Unfortunately, in practice this is not how it turns out. Dreman offers a slew of statistics demonstrating that the vast majority of managers under-perform their benchmarks.

As it became known several decades ago that managers could not beat the market, Efficient Market Hypothesis (EMH) emerged as a convenient explanation. Using computational power that was not previously possible, academics were able to "prove" that market prices were "correct" and that market-beating returns were not possible.

Dreman argues that this theory is built on a foundation of hot air, and likens it to the generations of scientists that believed the earth was at the centre of the universe. When situations occurred that seriously questioned the integrity of the theory (for EMH, the 1987 one-day point drop; for astronomers, the observation of planet locations inconsistent with their revolution around the earth), new parameters were added and the theory was made more complex to try to explain these phenomena.

Dreman sees the main problem with EMH is its built-in assumption that market participants behave 100% rationally. Psychology, however, affects all of our investment decisions. By understanding the behavioural traits that affect our decisions, however, investors put themselves in a position to put the odds in their favour.

Sunday, May 30, 2010

Contrarian Investment Strategies - The Next Generation: Introduction

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book from 1998. In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

It is 1998. As Dreman writes the book, the markets continue to rise. The way the market rises reminds him of 1929. To gauge the mood of that era, he has gone back and read newspaper clippings depicting the general sentiment before the great stock market crash that preceeded The Great Depression. Upon reflection, Dreman notes that the market euphoria of today (1998) appears to surpass that of the late 20's. He also argues that the price of stocks relative to fundamentals is higher in 1998 than it ever has been.

When he wrote his book in 1982, investors were interested in art, collectibles, precious metals and diamonds. At that time, he felt that stocks were undervalued...but investors weren't interested. Stocks went on to post massive gains in the years that followed.

There are ways to determine if the market is overvalued, Dreman argues, and this book will teach investors how. The contrarian methods Dreman describes and explains throughout the book are both of a fundamental and behavioural nature. Having a good strategy only gets investors part of the way towards making more money in the market; investors also need to understand their innate psychological tendencies that will try to prevent them from carrying out a sound strategy.

Investors overreact to events, both to the upside and to the downside. This is what provides contrarian investors with the opportunities to succeed.

The first function to the strategy Dreman will provide in the book is one based on the preservation of capital. The second function will be to capitalize on market mistakes in order to derive strong returns. Since no strategy should be followed blindly, Dreman will also spend time discussing why the strategies work. The first part of the book, however, will discuss why the widely-accepted, conventional strategies just don't work.

Saturday, May 29, 2010

New Era Value Investing: Chapter 10

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

In this chapter, Tengler discusses why an emotionless approach to investing is important. She describes 7 learning points she has picked up, the cognizance of which can help investors improve their returns:

1) Wall Street tends to extrapolate current trends to infinity

In the mid-1970s, when the US economy was mired in a prolonged recession, it seemed to many as if the US would never again enjoy prosperity. In the late 1990s, it was believed that recessions were a thing of the past.

2) It is rarely "different this time"

One of the biggest challenges faced by investors is being able to resist popular assumptions that stock markets will behave differently as a result of new forces.

3) Market pullbacks are great investment opportunities

Certain industries and sub-industries can become out of favour, but often unjustifiably so.

4) Go with your research, not Wall Street's

The best time to invest in a stock is when analysts are down on it.

5) Investment managers need to challenge their beliefs every day

Feeling uncomfortable about an investment is good, because it makes the investor search for more facts, keeping an open mind.

6) Use the financial media to your advantage

The "always-on" media can exacerbate declines, creating opportunities for those who remain disciplined.

7) It's all relative

While Graham and Dodd focused on absolute returns, Tengler argues that its relative valuation that matters

Friday, May 28, 2010

Info You Can't Get Anywhere Else

Investors who restrict their research of companies to text-based sources are missing out. While company conference calls can contain a lot of redundant and irrelevant data, there are often gems of useful info found on these calls that cannot be found anywhere else.

Yes, they can be quite boring. Many managers will start the call by reading out their entire press release, as if to somehow suggest that shareholders cannot read. And some managers speak at such a "leisurely" pace that they make William Shatner sound like an auctioneer. But it's not all management. For value investors, many of the analyst questions are simply not relevant. Whether an event (e.g. plant closure, new product launch etc.) will have its accounting impact in the 3rd quarter or the 4th quarter of 2016 is of no importance to us!

But on some calls, the questions that are asked or the insights management gives can result in the shareholder getting a great feel for certain aspects of the company. For example, on Quest Capital's most recent conference call, items that were not in any release were discussed, as a result of very specific questions that were asked. Quest is in the process of monetizing its loan portfolio. Listeners heard the following comments from the company Chairman:

"The cash on our balance sheet is ballooning, quite candidly. The issue is what to do with those ballooning cash reserves. We are cognizant of [having a] book value of $1.85/sh, and a stock price of $1.35/sh, and this discount is unacceptable. Our objective is to look at any and all alternatives to narrow the gap between net book value and market value."

When a caller asked if the company had any plans to buy back more shares, now that Quest's previously announced share repurchases have been completed, management replied that it was only allowed to do one Normal Course Issuer Bid per calendar year. If not for that, management claimed it would be buying back shares right now.

Management went on the say that the board is exploring what's called a Substantial Issuer Bid so that it can purchase more shares without waiting for the end of the year. Dividends were also discussed as a means for distributing cash. (Considering these options, however, I would venture a guess that dividends would not be management's favourite option right now.)

The conference call made it clear that cash is currently flowing in, and that management is exploring some very specific ways of distributing that cash that can result in a significant upward effect on the company's share price. None of this information is available in any press release!

Incidentally, cost-conscious investors can use Skype to listen to conference calls through their computers. Skype even provides touch-tone capabilities using the keyboard number pad, so users can fast-forward and re-wind at will as if they were using a normal phone. Ordinarily, listening to the Quest conference call referred to above would have cost me 15 cents/minute, but through Skype the whole call cost me only 50 cents.

Author has a long position in shares of QCC
Author has no position in Skype or EBAY

Thursday, May 27, 2010

What Is Risk?

The mainstream finance industry defines a company's riskiness by its stock price's volatility. For value investors, there is no such short cut; a company's riskiness is defined by a slew of factors that can affect the business. Previously, we have considered some items that can affect risk on the cost side. Today's post will discuss some items relevant to risk on the revenue side.

First of all, a company's revenue can have varying degrees of cyclicality. What this means is, during recessions, certain industries are hurt more than others. Conversely, these industries tend to do better when the economy is strong. Nevertheless, there is higher risk involved in a cyclical business, since poor conditions can persist and cause companies to be unable to meet their obligations. For a more detailed discussion of this topic, see this article.

Secondly, risk is lower when a company has a "moat" (as coined by Buffett) that essentially protects it from competition. In these instances, revenues are more stable, thereby reducing downside risk. Of course, companies with strong moats are hard to come by.

Revenue risk is also reduced when a company is not depedent on one product, as having multiple lines serve to diversify a company's risk should a competitor make inroads or should a product become obsolete. Having a diverse array of customers also helps, since that way a company's fortunes are not tied to the health of companies outside of its control. (This was an important factor when we answered a reader's question on auto parts suppliers a few months ago.)

Finally, it's important to understand how persistent current revenues are. Does the company need to keep innovating just to hold revenues steady, or has it already done most of the work? As an example, contrast Walmart with Apple. Apple's earnings are only as good as its latest products, and it must make sure to keep producing products that customers value, which won't be easy over the long-term. On the other hand, Walmart already has a presence where it can sell the products customers value, without having to innovate anew!

While it's impossible to predict the future, investors can better protect themselves from unforeseen events by choosing companies which are less susceptible to revenue declines. By considering the factors discussed above, downside risks can be reduced.

Wednesday, May 26, 2010

Small-Caps Rock

Our regular readers have undoubtedly noticed that we have a tendency to discuss small cap stocks quite a bit on this site. Why? Because among the small cap universe some of the most inefficiently priced stocks can be found. They carry little in the way of name recognition for retail investors, and they don't move the dial enough for institutional investors (their budget calculators show that the returns just aren't worth it).

As such, for those who can read/interpret/understand financial statements, small cap stocks offer up some great opportunities. As Charlie Munger stated at the Wesco Financial meeting a few weeks ago:

"Don't go after large areas. Don't try to figure out if Merck's pipeline is better than Pfizer's. It's too hard. Go to where there are market inefficiencies. You need an edge. To succeed, you need to go where the competition is low. That's the best advice I can give to small investors."

But while we've discussed stock investment research sources for individual investors, most of these sources are focused on large caps, as that's where the web traffic's at. One site, however, is devoted entirely to small caps: Agoracom is a site dedicated to providing information and promoting discussion of small cap stocks.

There is one caveat, however. Its business model derives revenue not from advertising, but from the small cap companies themselves. Many small caps struggle to get their names out there to investors, and so they are willing to pay Agoracom to discuss their companies. As such, it is unlikely you will find much in the way of negative information. Nevertheless, investors looking for info on small caps can find discussion forums, filings, quick facts and other useful information that could eventually lead to an investment decision.

If you use or have useful sources for small cap investing, please feel free to share them with others of like mind in the comments section below.

Tuesday, May 25, 2010

Effecting Change

Which company inspires more confidence in its financial results, one that has had a publicized auditing misstep in the past, or one with a pristine history? Surprisingly, the first company may be more credible. The reason is that for positive corporate governance changes to occur, the problems with poor corporate governance often have to surface. The company that has experienced serious enough issues to take notice, but not so serious that they proved fatal, has been provided a catalyst for change.

Consider Genesis Land Development (GDC), a company we have previously discussed as a potential value investment. The company is preparing for its annual meeting by issuing press releases recommending "that a strong independent slate of directors be assist with the ongoing efforts to improve governance, oversight and shareholder value".

The release goes on to say that "additional steps must be taken to strengthen governance, management oversight and management itself" and "a strong independent board of directors is critical to the future success of the Corporation".

Of course, a strong independent board is something that shareholders would like to see at many companies, but it is not often made a point of focus by companies with otherwise poor governance.

But GDC has seen what poor governance can lead to. Two years ago, the company's CEO and CFO were dismissed with cause following findings that they misled auditors. As the recession started to threaten the company's viability, the CEO was re-hired and has engineered the company's return to profitability.

However, shareholders have not forgotten the mistakes of the past. Shareholder groups have stated that "it is clear that [CEO] Gobi Singh, with his inexcusable history when it comes to transparency and good governance, needs to report into a strong, independent Board" and that they will put forth an independent slate if the company does not.

This brush with the pitfalls of a poor corporate governance structure has provided Genesis shareholders with the burning platform they need to effectuate positive change. Hopefully, this will lead to a stronger company better able to raise its share price such that it is commensurate with the value of its assets.

Disclosure: Author has a long position in shares of GDC

Monday, May 24, 2010

Natural Barriers To Competition

Value investors are constantly on the look-out for businesses with "moats" that the competition cannot displace. Usually, this is the result of a competitive advantage that cannot be copied. But perhaps it can also be the result of being in a business that is shunned to the extent that no quality management wants to copy it.

Consider New Frontier Media (NOOF), producer and distributor of pornographic movies. The company has deals in place with the major cable providers which allows them to beam millions of dollars worth of adult pay-per-view content into homes throughout America and the world. Despite being a business that appears to be easily replicated, the company has enjoyed surprisingly good margins (approaching 20% on average) and returns (5-year ROE > 12%), beating up on its primary competitor, Playboy Enterprises (PLA).

Despite this, the company appears to trade at a substantial discount. New Frontier's market cap is just $38 million, while the company has earned operating income far in excess of that in the last four years alone, even after including a $12 million goodwill write-down that caused the company's 2009 net income to be negative. In addition, the company has $15 million of cash against just $3 million of debt.

The future is not without challenges, however. As consolidation in the cable industry throughout the United States has taken place, New Frontier's customers have become more concentrated and powerful. As a result, New Frontier's business would take a substantial hit if one of these operators switched to a different provider. More immediately, however, this has allowed the cable operators to push New Frontier on price, reducing domestic margins.

Furthermore, while the company's founder Michael Weiner (which could also pass for a screen-name in this business) is still the chief executive, his annual salary and bonus dwarf his stock ownership in the company, which doesn't say a lot for the company's incentive structure. Nevertheless, the company has succeeded for years with Weiner at the helm, and shareholders appear to be offered a price at this level with a substantial margin of safety.

Interested in a different perspective on NOOF, or another stock you have your eye on? One of our sponsors,, is offering readers a free analysis of a stock of their choosing here.

We first discussed this company a few months ago here.

Disclosure: Author has a long position in shares of NOOF

Sunday, May 23, 2010

New Era Value Investing: Chapter 9

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

Various low P/B or low P/E indexes have been created in order to separate out value and growth stocks. However, separating out stocks based on a single metric can lead to misleading results. Tengler argues that investing in second-rate companies in slow-growth industries that trade at justifiably low P/E ratios does not constitute value investing. Instead, buying the best companies relative to their peers and their own valuation history is a more legitimate value-oriented strategy.

Furthermore, most companies will shift between value and growth categories repeatedly, making it difficult to pigeon-hole them into one particular style. Tengler illustrates this point using examples of defense stocks (which have gone from growth to value to back again depending on war policy) and technology stocks (which went from growth to value after the bubble of the late 90's).

Tengler discusses Buffett's purchase of Coke as a great example of there being a blend between growth and value. While Coke has been a growth stock for most of several decades, it has run into its share of temporary problems that made investors reduce its P/E ratio. This is a great example of a value purchase, even though the P/E was high enough to scare off investors who look only at P/E ratios.

Tengler argues that it doesn't matter whether a company is considered growth or value across a few metrics. What's important to investors is that it is a strong company that trades at a discount relative to its own history and relative to its peers. Whether that company is a growth stock or a value stock, it is attractive and should be purchased.

Saturday, May 22, 2010

New Era Value Investing: Chapter 8

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

Now that the selection of individual stocks has been discussed, Tengler turns to portfolio construction.

The first thing the investor should determine is the level of concentration in the portfolio. Tengler argues that fewer than 20 stocks are needed for proper diversification, but in her institutional portfolio she carries between 25 and 35 issues. This is due to the fact that clients are decidedly against volatility. Spreading the wealth around helps reduce volatility, even if it means putting money in one's 35th favourite idea rather than putting more money in one's favourite idea.

Tengler argues that the second most important aspect to building a portfolio is buying only the "best" companies. Effort in fundamental stock research aids the investor in this endevour.

Tengler further argues that investors should incorporate both RDY and RSPR (described in Chapters 3 and 4) rather than choosing one or the other. Often, one of these forms will be out of favour while the other can boost results. Furthermore, as the universe of RDY-type stocks declines, investors will still have the ability to apply the value framework by employing the newer RSPR.

Investors should also consider the correlation between issues in their portfolios. Some sectors will do well while others will stall, and so stocks with low correlation to other stocks in a portfolio provide protection against volatility.

Finally, Tengler shares how she maintains buying and selling discipline. She prefers to average into a stock, since she doesn't believe she can predict the bottom. She will start with a position that's around .5% of the portfolio, and spread her buys over time until she has accumulated an amount representing about 3-5% of the total portfolio. At no point can one single position occupy more than 6% of her portfolio, therefore she will begin to sell if the prices moves up such that this occurs. Once the price hits the sell level, she will look to exit her position completely lest the price drop back down. Tengler will also use stop-losses (using money management software) to protect from large one-day or one-week declines.

Tengler closes the chapter by discussing some of the mistakes she has made in her portfolio. The lessons that are illustrated in these mistakes are:

1) Beware of newly merged companies with different operating profiles (e.g. AOL Time Warner)
2) Beware of new companies with short operating histories

Friday, May 21, 2010


Two companies may have the exact same financial statements, and yet one may be a value investment while the other is not. This is because management's intentions play a big role in determining what kind of investor would find a stock attractive. (For example, consider two companies with large cash balances. If one intends to to use the cash to buy back shares while the other intends to invest the cash to find a new blockbuster drug, the investor profile of each company should look very different.)

As such, it is important that management communicate its intentions with shareholders. Recently, we saw an example of the kind of backlash that can happen when shareholders don't know what to expect. On the other hand, when shareholders do know what to expect, it can lead to a win-win for all.

Few companies are as good at communicating their intentions as Quest Capital (QCC). When the economy turned south, Quest made it very clear that it would stop its lending operations and instead focus on collections. This may have caused shareholders who are primarily interested in earnings to sell their shares, but it also piqued the interest of those looking to buy loan portfolios at a discount. In this way, Quest altered its shareholder profile to one that is in harmony with management's objectives.

When cash inflows far outpaced cash outflows (since the company was no longer lending), Quest made it clear that it would use proceeds to pay down debt and buy out preferred shareholders. This would turn off those looking for leveraged real-estate real-estate returns, but would result in shareholders of a more conservative, value orientation.

Now that debts and preferred shares have been paid down, the company recently announced that it would seek to close the gap between its share price and its book value. The company then went on to buy up almost 10% of its shares in the last five months, doing exactly what it said it would do.

So what's next? Quest's chairman issued the following statement two weeks ago:

"We expect further [loan] monetization to occur and while we have recommenced lending on a cautious basis, we do not anticipate utilizing all of our cash over the near term. In the interim, we continue to look to enhance shareholder value and close the discrepancy between our book value of $1.82 per share and our trading price."

When it comes to some companies, management's intentions are difficult to figure out. For other companies, however, the publication of management's intent can bring along the right kind of shareholder - one who is there because they would do the same if they were in charge, which results in a natural alignment of management and shareholder interests. This can result in fewer surprises, and a much more content shareholder group!

Disclosure: Author has a long position in shares of QCC

Thursday, May 20, 2010

CEO Gets A Stoning

Usually, company conference call participants are fairly polite in their questions and comments for company management. When a company has lost a lot of money, however, shareholders can turn nasty!

Belzberg Technologies (BLZ) is one such company. It recently reported a $2.5 million loss in its first quarter, which follows losses of $11 million, $2.5 million, $1.5 million, $2 million and $0.5 million in the previous five quarters! As such, shareholders have sold this company with a vengeance, so much so that the company trades for well below its cash balance, and thus became a potential value investment.

Illustrating the frustration of many shareholders with this company was Sam Stone, a private investor who gave it to the CEO on the latest company conference call. Here are some of his statements to management, who eventually had to cut him off:

Sam Stone: You had a year and a half to do something about turning around the company, but you've had one disastrous quarter after another and the cash keeps dwindling. Other than paying your salary, what reason is there to keep this company open?

CEO Judith Robertson: Well we have a plan to turn the company around, and we're executing on that plan, and we believe that the future value of the company is not reflective in the current operating performance.

Stone: At the current rate of burn, you're going to run out of money in the first quarter [of next year]. Other than hoping that someone will buy you while you're losing money, what viable options do you have?

Robertson: We have an operating plan that we're executing that is a combination of continued cost right-sizing for the size of our organization and changes in our industry, as well as pushing forward on targeted revenue initiatives...

Stone: ...If you have no substantial revenue generating sales in the pipeline, why don't you shut down the company now? Or is this just to maintain your salary and Chris Jackson's? Whose benefit are you running this company for, yours or the shareholders?

Robertson: I am running the company for the benefit of the shareholders, as is the Board.

Stone: Your results don't seem to match that. The previous company you ran went into bankruptcy; it seems that Belzberg is heading in the same direction. Why don't you close the company now and give what's left to shareholders. If you wait for the first quarter when you run out of cash, there'll be nothing left.

Robertson: The Board and I believe that the value of the company going forward is more than shutting it down. So we think that's the right decision.

Stone: Well, if you stay in business, how long are you going to be open for business until you run out of cash? How much cash do you have in the bank to weather the storm? How many quarters? As a shareholder, I'm appalled that the decision to shut down the company is not actively discussed in this call in a meaningful way...How is the way you're running this company different than how you ran your last company into bankruptcy?

While Sam Stone's approach is a tad aggressive, his frustration is likely echoed by many shareholders. Since the stock price of this company trades well below the company's cash balance, it makes sense to shareholders like Stone that the company should wind-up its operations and pay shareholders what they can.

Management, however, has decided to attempt to return to profitability. But they have not provided shareholders with any guidance on revenue/cost targets, resulting in much uncertainty. Until this changes, shareholders are in the dark as to what to expect.

Disclosure: Author has a long position in shares of BLZ

Wednesday, May 19, 2010

Dividends After The Fact

Investors will often rely on a company's most recent financial report in order to determine its current financial position. But that's not good enough. One reason for this is obvious: subsequent events may have occurred which are material to the company's position. But another reason is not so obvious: events which were previously announced but which had not yet taken place by the statement cut-off date could get missed!

Consider C-Com (CMI), a developer of mobile satellite technologies. In early April, the company announced a special, one-time dividend of 2 cents per share for shareholders who held the stock on April 6th. A month later, quarterly results for the period ending Feb 28th came out. Nowhere in either the financial statements or management's discussion & analysis was this dividend mentioned...even in the section titled "Subsequent Events"! The dividend payment had already taken place, but shareholders relying only on the most recent financial statements would think the company's cash balance is much higher than it really is!

While 2 cents per share is not a lot for most companies, it represents about 7% of this company's market cap. Furthermore, it is not difficult to envision this situation occurring for other companies that hand out larger, even more material one-time dividends.

When you're interested in investing in a company, read all the recent filings, not just the ones that came out following the last quarterly report. There may just be events in the closet that are material to your valuation.

Disclosure: None

Tuesday, May 18, 2010

Noble Profits

While Barnes and Noble (BKS) has averaged operating income of over $200 million per year over the last four years, the company trades for just $1.1 billion. Furthermore, Barnes and Noble has minimal balance sheet debt and low capital expenditure requirements, suggesting it has the potential for being a cash cow for investors.

Of course, the reason the market has shunned this stock is that the company faces a secular downturn. But like GameStop (incidentally, a spin-off from Barnes and Noble!), another stock we have discussed that faces a potential secular downturn, can it stave off the technologically-astute competition long enough to reward shareholders at the currently depressed stock price?

Unfortunately, Barnes and Noble's current financial statements may understate the rate of decline in this business. While operating profit was $146 million last quarter, which was $6 million higher than it was last year at this time, the company received a $39 million boost to its 2010 operating profit due to a new acquisition (B&N College) which played no role in last year's results. This acquisition removed a bunch of cash and added some debt to the company's balance sheet.

While some of the company's decline may be attributed to cyclical rather than secular effects, Barnes and Noble does face a secular decline on two fronts, which exacerbates and could therefore serve to accelerate its rate of decline. First, customers are changing how they purchase books, shifting more revenue dollars online from bricks and mortar purchases. More recently, however, customers are also changing how they interact with books, using devices such as the Kindle and the iPad. Furthermore, the company has almost $2 billion in operating leases that extend out several years. If much of the recent declines are secular, the company's bricks and mortar operations could yield substantial losses in the near future.

For its part, Barnes and Noble has been jumping into the new methods of distributing books, having released its own e-reader and having made a slew of acquisitions of platforms to support its online presence. Still, only 10% of the company's revenue is from online sources. As such, this foray against the strong competition that's out there adds risk to this investment; rather than receive the cash flow from Barnes and Noble's existing operations, shareholder funds are re-invested in products and services with uncertain outcomes against strong competition.

Barnes and Noble could be successful in transitioning to a method of distribution more suited to the current times. Unfortunately, these investments are fraught with risk. Shareholders seeking to capitalize from a low stock price and a cash generating business may never see a dime, due to the company's desire to invest to attempt to remain a large player in this space.

Disclosure: None

Monday, May 17, 2010

Getting The Growth For Free

Investors are willing to pay more for a company that holds the promise of growing its earnings. Even companies with unproven business models that can "sell a story" can often trade at high P/E multiples. Value investors, on the other hand, would rather not pay extra for earnings that are as yet unseen and difficult to predict. When the potential for increased earnings is offered for free, however, the price becomes right for even the stingiest of bargain hunters.

Consider Acme United (ACU), producer of measuring, cutting and safety products. Frequent visitors to the site will already recognize this company as a Stock Idea, due to its low P/E and high ROE. But what these financial metrics understate is the company's ability to grow its earnings.

Acme has set a goal of deriving 30% of its sales from products developed in the last 3 years. While this might sound quite reasonable for a hi-tech company with short product cycles and evolving customer needs, it is quite a challenge for a company that makes knives, pencil sharpeners and rulers such as Acme.

Nevertheless, the company is succeeding in this regard, attributing most of the 16% sales growth it realized in the last quarter to sales of new products. The company developed a non-stick coating that improves the performance of its line of blades, and thus saw increased sales of its iPoint pencil sharpeners and non-stick scissors. Furthermore, sales of the company's 2008-developed utility knife with replaceable cartridges continue to grow. The company also recently acquired the patents and intellectual property of Camillus, and has recently launched a new line of Camillus cutting knives enhanced with Acme's high-performance titanium carbonitride coating.

What Acme has going on is not easy replicated. As Philip Fisher (whom Warren Buffett describes as inspiration for 15% of his investing philosophy) has written in his book Common Stocks and Uncommon Profits, stocks with the potential to be home-runs have special qualities which can result in spectacular returns. The company must have policies which promote newly developed products, the company's R&D must yield useful and viable findings, and the company must focus on the long-term (among other things). Acme appears solid across many of these points.

While value investors don't like to pay for growth, sometimes growth is offered in the market for free. With a P/E of 12 derived from earnings during a recession, along with a low net-debt to equity level, Acme appears to offer investors just that.

Disclosure: Author has a long position in shares of ACU

Sunday, May 16, 2010

New Era Value Investing: Chapter 7

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

In a similar vein to the previous chapter, Tengler now describes specific stocks that she has bought as a result of using RSPR, the method described in Chapter 4. She notes that the types of stocks this method picks up, as opposed to RDY, tend to be more growth oriented, but are still fallen angels of sorts, since they would not qualify as bargains unless they had a relatively low price to sales ratios.

Throughout the technology boom, Tengler notes that RSPR underperformed the market, as the expensive, high-flying stocks were the securities that rose the most. But during the bust, RSPR stocks outperformed their peers, as stocks with high price to sales ratios came crashing down.

Intel (INTC) is a company that appeared cheap on an RSPR basis in 1988, 1991, and between 1995 and 1996. Despite a strong market position, Intel's earnings would be pressured near the end of a product cycle, as competition would compress the company's margins. This has allowed value investors to take advantage and get in at attractive prices. From 1999 to 2000, however, RSPR suggested Intel was a major "sell", and so the investor was afforded an opportunity to take profits prior to the crash.

Other stocks this method has resulted in identifying are Estee Lauder (EL) in 2002, Microsoft (MSFT) in 1995, Oracle (ORCL) in 1997, Disney (DIS) from 1999 to 2001, The Home Depot (HD) in the mid 1990s, Nike (NKE) in 1998, and Cisco (CSCO) in 1994, 1997 and 2002.

Occasionally, stocks will become undervalued according to both RDY and RSPR at the same time. These stocks are usually former high-flyers that have reached a stage of maturity. Tengler suggests investors switch to using the RDY method only for evaluating such stocks, as the RSPR method may not longer apply. RDY is also described as the more rigorous method.

Saturday, May 15, 2010

New Era Value Investing: Chapter 6

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

In this chapter, Tengler describes some specific stocks that she has bought as a result of using RDY, the method described in Chapter 3.

Exxon Mobile (XOM) is a stock with tremendous volatility due to changes in investor sentiment with respect to the price of oil. While earnings fluctuate significantly, the company's dividend is a much better gauge of the company's long-term earnings ability than any one year's earnings. As a result, Tengler has purchased this stock when the yield compared to that of the market was extremely strong, and has sold when the yield has been relatively weak.

Wyeth is another example of a company that RDY identified in the late 1990s. The company was coming off the news of a failed merger, and had run into a number of bad news issues with some of the drugs it had developed. The market punished the stock, allowing value investors a buy opportunity which was identified by the fact that Wyeth's yield compared to the market was far out of line.

Despite being a great company for many years, General Electric (GE) stayed at a price that did not make sense for the value investor. Finally, in 2002, amidst a slew of bad news (CEO step-down, failed Honeywell acquisition) the stock fell to a level, relative to its dividend, that made sense to Tengler.

Tengler goes on to describe other RDY-identified buy prices for 3M, Kimberly-Clark, Gillette, Wells Fargo, and Marsh & McLennan. In these cases, temporary problems plagued companies, which hurt the stock for short periods of time. Buyers at these prices were rewarded.

Tengler finishes the chapter by discussing two stocks, Verizon and Heinz, that looked like buys per the RDY method, but never ended up rewarding their investors.

Friday, May 14, 2010

Governing The Governors

In a previous post, we discussed the potential pitfalls of investing in companies with poor corporate governance structures. But how can an investor protect himself? There are two basic ways. First of all, the investor can become knowledgeable about what makes for good corporate governance, and then study up on each company in which he is interested in order to make sure it follows practices in accordance with sound corporate governance. The second method is to take advantage of the information published by the companies that specialize in rating and reporting on the governance practices of public companies.

A full discussion of what makes for good corporate governance is beyond the scope of what can be provided in this one article, and we have covered some of the basic points in previous articles on corporate governance. Therefore, this article will focus on what's available for those interested in pursuing the second method.

Governance Metrics International (GMI) is a company that has developed a proprietary corporate governance rating model that it has applied to over 4000 companies. The premise behind the company is that firms with superior corporate governance practices generate superior returns. GMI can be contacted for those who wish to receive a sample report.

Standard and Poor's also produces a Corporate Governance Score (CGS), based on the following criteria:
  1. Ownership structure
  2. Shareholder rights
  3. Transparency and disclosure
  4. Board effectiveness
Based on how a company is rated in the above four factors, it is given a CGS rating between 1 and 10. A sample report of S&P governance can be viewed here.

While it's easy to gloss over corporate governance elements, the wisest investors always keep them top of mind. With the first rule of value investing being "Never Lose Money", ensuring sound corporate governance practices can increase the likelihood of being able to follow that rule successfully.

Thursday, May 13, 2010

Forced Dividends

Sometimes a company will appear cheap, but whether the investor will ever see the benefit of the company's success is another story. If management controls the company, or shareholders are not well represented on the board, the company could hoard money, or spend it on empire-building acquisitions. But some companies are organized such that substantial payouts are required.

Consider PMC Commercial Trust (PCC), a real-estate investment trust (REIT). As a REIT (rather than a regular corporation), the company must pay out at least 90% of its annual income. In doing so, it is not taxed at the company level. Large tax savings can generate significant shareholder value, as we've seen with both Dorel and Key Tronic.

With PMC trading at just $85 million, however, that value may be up for grabs for current shareholders. The company's distribution currently yields 8% (though this may decline with lower earnings), but that's not even the most attractive aspect of this investment: shareholder equity is over $150 million.

The company's assets are mostly in the form of loans receivable from franchised hotel owner/operators. These assets are secured by real-estate and personal guarantees. Earnings are depressed because interest rates are low (and so the company cannot earn great returns on its assets) and because economic conditions have made it difficult for borrowers to pay their loans.

To the first point, temporary earnings shortfalls should not drive the investment decisions of value investors. This is precisely the type of situation that leads to depressed stock prices, allowing value investors to profit in the long term. To the second point, PMC has been a rather conservative lender, and as a result has suffered few loan losses. The company requires significant equity investments on the part of the borrower before a loan is made, and does not offer any riskier loan packages including interest-only or subordinated debt. As a result, its satisfactory loans (i.e. loans that are not delinquent, or aren't on any watch-list for being behind on tax or franchisee payments) comprise 92% of its loan portfolio, up from 89% one quarter ago.

As such, at its current price, PMC may offer investors both decent income and the potential for capital appreciation due to the large discount at which the stock trades relative to its loan portfolio. Companies in similar lines of business with similar discounts to PMC that we've already looked at include Quest Capital and Manhattan Bridge.

Disclosure: Author has a long position in shares of PCC

Wednesday, May 12, 2010

Candor Counts

When reading through the press releases that most companies issue to announce their quarterly financial results, one can get a pretty good idea of which companies are pleased with their earnings and which are not. Unfortunately, however, it often requires reading between, or in this case below, the lines.

When the earnings are positive, the company will usually lead with a statement listing its net income and describing how strong it is. When the earnings are negative, a whole slew of issues are likely to be discussed before the earnings number is deemed relevant.

Consider Nu Horizons (NUHC), a company we have previously discussed as a potential value investment. Two years ago, when earnings were positive, the company reported net income in the 3rd sentence of the press release, in a candid and matter-of-fact manner:

"Net income for the quarter was $1,155,000"

Fast forward to last week's results where the negative earnings number is not reported until the 7th paragraph, getting trumped by such items as sequential sales results, supplier updates, an update with respect to the strategy for Asia (this is a company based in NY), workforce reductions subsequent to the quarter end, a statement amount debt reduction expectations, sales by geographic region, and a discussion of the company's tax assets!

Managers of public corporations are just as human as the rest of us: nobody likes giving bad news. When management is not candid with its shareholders, however, it leaves a poor impression with investors. Here are Warren Buffett's comments on candor:

"We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value. Our guideline is to tell you the business facts that we would want to know if our positions were reversed. We owe you no less. Moreover, as a company with a major communications business, it would be inexcusable for us to apply lesser standards of accuracy, balance and incisiveness when reporting on ourselves than we would expect our news people to apply when reporting on others. We also believe candor benefits us as managers: The CEO who misleads others in public may eventually mislead himself in private."

This topic may be similar to one we've previously seen where managers blame externalities for negative surprises, and credit themselves when positive surprises occur.

Disclosure: Author has a long position in shares of NUHC

Tuesday, May 11, 2010

Volatility Sources

The mainstream finance industry equates price volatility with risk and believes the market to be efficient. That is, prices of stocks are fairly priced, and therefore the only way to generate higher returns is by taking more risk (i.e. buying stocks with higher volatilities).

Value investors, of course, not only reject the fact that the market is efficient (for a terrific essay on the subject by Warren Buffett, see here), but also find flaw with the definition of risk. To value investors, risk represents the potential that the underlying business is or becomes worth less than anticipated, and this is often times completely unrelated to a stock price's volatility. Value investors believe volatility could be caused by the market's general level of fear, supply/demand characteristics of various securities at particular points in time, and other psychological factors unrelated to the underlying business.

A study by Richard Roll has attempted to quantify the various components that comprise a given stock's volatility. His findings are depicted in the chart below:

According to Roll, company specific risks play only a very small role in a stock's volatility. If this information is accepted, it seems ludicrous to believe a stock's volatility - rather than the fundamental business/financial risk of the underlying company itself - is what governs an investment's risk level. Investor confidence, interest rates, and the stage of the business cycle all play far larger roles when it comes to volatility!

Value investors who take advantage of volatility, rather than fear it by equating it with risk, position themselves for market beating returns!

Monday, May 10, 2010

The Value Of The Right Incentives

Value investors have no problem investing in a company in which the manager controls a substantial stake - as long he also owns a substantial stake. If his own capital is committed, a manager is likely to make decisions which are in the best interests of other shareholders. On the other hand, if that manager is making decisions without consequence to his personal financial position, the incentives are not properly aligned: he's just playing with other people's money, like a mutual fund manager.

This is one of the few areas where value investors and the mainstream finance industry are in agreement. But how much is the removal of a "control-without-ownership" structure worth? By looking at a recent example, we can come up with an estimate.

Magna (MGA) is a global auto parts supplier we have previously discussed. Last week, the company announced a proposed deal between Frank Stronach (founder and controller) and the remaining shareholders, which Stronach has agreed to and on which shareholders will vote. Currently, Stronach only owns about 1% of the company's shares, but controls 66% of the shareholder votes!

So what would Stronach receive in return for relinquishing control? Not less than $300 million in cash, and 9 million regular shares, which is more than 10 times the number of shares he owns now! This package is worth almost $900 million, and that's not the end of it.

In addition, Magna will contribute $220 million for a 73% stake in a venture Stronach will...control! In other words, the control-without-ownership is being purchased from Stronach in part by giving him another business (in the growing field of hybrid and electric vehicle technology) where he has control without ownership!

The value of control without ownership should not be underestimated. As seen in this example, control of a company without the accompanying capital commitment is worth a substantial amount! Furthermore, the terms described above do not appear to be an overpayment, as Magna's stock price reacted very positively to the news in an otherwise down market.

As an example of the type of shenanigans that can take place in such control-without-ownership situations, Stronach has instituted consulting contracts with companies to which he is affiliated whereby Magna pays out 3% of its pre-tax profits to these firms every year! To remove Stronach's right to execute such contracts, shareholders now have to pay dearly.

Disclosure: None

Sunday, May 9, 2010

New Era Value Investing: Chapter 5

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

While RDY and RSPR (described in the previous two chapters) are great for identifying potential value stocks, the purchase decision must not be made until a company's fundamental factors have been looked at. After all, if the fundamentals are poor, a company could continue to appear cheap on a dividend or sales basis for many years to come.

Tengler discusses twelve fundamental factors she looks at for stocks that pass the RDY and RSPR screens. If a stock passes 2 of the 3 qualitative factors, and 5 of the 9 quantitative factors, it passes the test:

1) Are the company's products/services becoming obsolete? As an example, Tengler identifies JC Penny in 1998 as a company occupying a position in the retail market that no longer served a purpose.

2) Does the company have a franchise value? Nike and Gillette are cited as examples of companies with brands that help the company succeed. Other questions investors should ask to help answer this question include whether the company is growing market share profitably, and whether it can leverage its franchise to enter new markets successfully.

3) How good are management and the directors? Management should be accountable, should have low turnover, and should have their compensation tied to shareholder interests. Most directors should be independent.

4) Does the company consistently grow its sales? Sales growth serves as economic proof of the acceptance of the company's products.

5) What are the company's margins? Tengler advises looking at trends in operating margins over time and versus competitors.

6) What are the P/E ratios? Tengler looks at forward, trailing, normalized, peak and trough P/E ratios against those of competitors.

7) What is the company's free cash flow? Cash flow trends should be compared to those of earnings to establish the relationship there. Also, working capital turnover (using cash flow) should be examined relative to competitors.

8) What is the dividend situation? The payout ratio should be sustainable and in-line with the industry.

9) What is the asset turnover? Trends in this number should be examined to see if the company is paying too much for incremental sales growth.

10) What is the company's ROIC? Investors must determine if management is making good investments. Comparing the company's ROIC to its cost of capital should help in this regard.

11) Is the company over-leveraged? A company may be growing earnings only because it is utilizing leverage to grow its assets.

12) What is the company's financial risk? Off-balance sheet debt should be brought into the equation, and coverage ratios should be examined (e.g. EBIT/Interest).

Saturday, May 8, 2010

New Era Value Investing: Chapter 4

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

Though Tengler claims the method described in Chapter 3 works, it is heavily reliant on the dividend. But as the market has evolved, the magnitude of the dividend as well as the number of companies paying a dividend has declined. As productivity has increased, companies have found more profitable areas in which to invest their earnings, and as competition has increased in what were previously slow-growth industries (e.g. telecom), investment in future technologies has become a key success factor. As such, to expand the investment universe, Tengler developed a valuation method that would not be dependent on the dividend.

The obvious and most commonly used factor associated with a stock is earnings. However, Tengler avoids using earnings due to the fact that it is subject to judgement (by management, in its determination) and because it can fluctuate tremendously (particularly for cyclical companies). Therefore, the factor Tengler prefers to use in her value approach is sales. Sales cannot be manipulated, and are also subject to far less fluctuation than are earnings.

The valuation method Tengler uses is therefore Relative Price to Sales Ratio (RPSR). A company's price to sales ratio compared to the market's price to sales ratio is computed on a historical basis. When the company trades at a low price to sales ratio as compared to the market's price to sales ratio on a historical basis, it becomes a buy candidate.

Tengler recognizes that these "relative" value approaches differ from the original Graham and Dodd "absolute" approaches. But she has found using relative valuation approaches more useful, as they can be employed during any market environment. In this way, she argues that the spirit of value investing can be employed to a much larger universe of stocks.

Friday, May 7, 2010

"Fore"midable and Low-Risk Returns

Just nine months ago, we discussed Adams Golf (ADGF) as a potential value investment due to the severe discount at which the company was trading relative to its net current assets. Since that time, the stock has rallied over 40%. But more impressive than the return (after all, the general market has rallied over this period) is the low risk at which this return was achieved, due to the use of the all-important margin of safety.

What is important to realize is that this 40% jump in the stock price did not arise because the company had some positive surprise. To the contrary, the company has continued to rack up quarterly losses, and even settled a litigation dispute pretty close to the worst-case payment it would have had to make had it lost in court (though it likely did save on attorneys fees by settling).

The reason for the large rise in the stock's price is due to the fact that the market was totally mis-pricing the stock to begin with. Nine months ago, you could buy this company for $19 million even though it had cash of $3 million, $23 million owed to it by its customers and another $23 million of non-perishable inventory (golf clubs etc.) against just $14 million of liabilities.

In the last few months, the company has had to sell some of that inventory at a loss, and has agreed to pay $5 million to settle a lawsuit. As such, its net current assets reduced from about $35 million to $29 million. Despite this, the stock price has risen dramatically, as the company's market cap has recently spent some time trading just under $30 million. The massive margin of safety on this stock 9 months ago has allowed the investor to profit despite the absence of any company specific positive news!

Now that the stock trades for its net current asset value, ADGF becomes the latest stock to move from the Stock Ideas page to the Value In Action page. But the lack of discount to its net current assets doesn't mean all value investors who own it should sell it, however. An opportunity may remain for those who know the company well, including its products and its position relative to competitors. In other words, it may still be cheap relative to its intrinsic value. But at this price point, the value investor should ensure that the company is firmly within his circle of competence to avoid undue risk to his principal.

Disclosure: None

Thursday, May 6, 2010

Management Trolls

Investors who conduct stock research online (e.g. readers of this site, or those who use to access annual reports, as opposed to waiting for their snail mail copies) have likely spent at least some time in a stock message board. Unfortunately, there is a lot of misplaced advertising, spamming, falsities, and trolling that takes place on these boards that renders them virtually useless for the serious long-term investor. As such, it would seem highly unlikely that senior management would see it fit to spend any time perusing such non-valuable, non-credible arenas.

But that assumption would be wrong. The following exchange illustrates Blonder Tongue (BDR) COO Robert Palle's response to questions about management on the Yahoo! Message Board for BDR:

ajofny says: Where is this company going? The Chairman and CEO is 79, the COO is 63. What is its strategy?

newkram says: There is no strategy. management (such as it is) is just treading water till they retire or pass on ( whichever comes first). This is a company that should never have been allowed to go public. It is essentially a privately-held/family-owned company masquerading as a public company.

gands2 says: The family owned/family run image was reinforced when Palle, the co's president and largest shareholder, wasn't on the last CC, with Ms Nikoo the chairman's daughter as substitute. Nepotism an investor's red flag imo.

bobpalle22 says: At BT we are in the process of grooming the next generation of management. The last CC was reasonably benign as the numbers were in line with expectations. I chose to allow Ms Nikoo to represent me on this particular call. I think she performed wonderfully. Did you have any questions she could not answer? re my ownership....Come on girls, I am a buyer, and still a buyer, but the SEC window must be open to buy. Bob Palle

The other conversers are listed as male, leaving a question as to why Palle is referring to them as "girls".

How do we know this is actually Palle, and not some faker? The company issued a release to basically cancel his statement: "...[P]lease disregard Mr. Palle's message posted this morning and review the Company's press releases and SEC filings."

So here we have a company whose CEO recently underwent personal bankruptcy, and whose COO is going around responding to message board trolls. Meanwhile, just one day earlier, the company announced a new $4.1 million contract (last quarter's revenue: $7 million) for one of its brand new products. What to make of this company?

Disclosure: Author has a long position in shares of BDR

Wednesday, May 5, 2010

Transocean Oversold?

Value investors often look for opportunities where temporary circumstances have caused the market to unjustifiably depress prices. One such value-minded investor, Frank Voisin, may have uncovered such an opportunity. The following is a guest post where Frank makes his case for Transocean Ltd, a company whose stock has been punished as the massive oil leak on the Gulf of Mexico continues.

Transocean Ltd (RIG) is an international provider of offshore contract drilling services for oil and gas. Transocean is the largest such operator, with 138 mobile offshore drilling units, including 44 high-specification floaters which command the highest day-rates for use in the deepest, harshest drilling environments, 26 mid-water, 65 jack-ups, and 3 others.

On April 20, 2010, a Transocean rig leased to BP plc (BP), the Deepwater Horizon, suffered an explosion and sank two days later. The Deepwater Horizon was in the final stages of casing a well (adding a cement reinforcement liner to the well) when the explosion took place. The well was approximately 1 mile beneath the ocean surface, and extended approximately 5 miles underground. The explosion appears to have been the result of the cement casing not being fully cured, resulting in the release of a massive amount of pressure from the oil reservoir up through the well. Explosions of this sort are supposed to be prevented by a Blow-Out Preventer, a massive device (16m wide) with up to 12 different fail-safe mechanisms that can be manually activated to close over the well to prevent leaks and withstand the pressure. In this case, the Blow-Out Preventer was designed and built by Cameron International Corp (CAM).

The market appears to be expecting losses from this disaster to exceed a present value of $30 billion. This is based on the fact that BP, Transocean and Cameron have suffered market cap reductions of $25 billion, $5 billion and $1 billion respectively.

To put this in perspective, the Exxon Valdez disaster in Prince William Sound, Alaska, which, in 1989 resulted in 250,000 barrels being spilled, led to a jury award (in Baker v. Exxon) of $287 million actual damages + $5 billion punitive damages. The Deepwater Horizon disaster would have to continue, at a rate of 5,000 barrels per day (the current official estimate), for nearly two months to yield the same oil spillage as the Exxon Valdez, and the market would still be pricing a loss equal to 6x the Exxon Valdez.

It is important to note that the original $5,287m loss expected for the Exxon Valdez disaster was subsequently reduced to approximately $500m, and this was paid out 19 years later after substantial litigation, when the Supreme Court of the United States ultimately limited punitive damages to a 1:1 ratio with compensatory damages. At a 10% discount rate, this translates to a 1989 Present Value of less approximately $81m.

Based on the quantum of damages ultimately awarded in Exxon Valdez, and the relative size of the Exxon Valdez disaster to the Deepwater Horizon, we would expect the present value of future losses to be substantially smaller. However, the fact that the Deepwater Horizon disaster took place in a more heavily populated area of greater economic significance could support an argument that future losses will be substantially higher. For the sake of conservatism, we can assume the losses are substantially higher – closer to the amount the market is currently pricing ($30b) and now turn to loss apportionment to determine who would be responsible for these losses.

There are at least three categories of expenses associated with the disaster:

1) Personal Injury/Deaths
2) Loss of the Deepwater Horizon
3) Environmental remediation
4) Loss of revenue

My investigation has led me to conclude that Transocean will be responsible for the first two categories, and that BP will be responsible for the third category.

Transocean is fully insured for the loss of the Deepwater Horizon. The rig has an estimated replacement cost of $700m. Transocean’s 2009 Annual Report shows that it has a deductible of up to $1.5m on the loss of any rigs, and that is has a $10m-per-occurrence deductible on crew personal injury liability and $5m-per-occurrence on other third-party non-crew claims. These deductibles are for a $950m third-party liability coverage exclusive of the personal injury liability. Transocean is reputed to also have $700m in environmental remediation insurance. Thus, Transocean is fully insured for the first two categories, and partially insured for the third.

Given that Transocean is fully insured for the first two categories, the market appears to be pricing in a loss of approximately $5b above the $700m environmental remediation insurance cap. Will Transocean be responsible for environmental remediation? The answer appears quite clearly to be no, and that BP will be responsible for environmental remediation both due to common law, statutory law, and contract law.

Common Law

Under Maritime Common Law, there is an Anchored Tanker precedent, which states that the owner of an anchored tanker is liable for any damage resulting from it, even if that tanker is hit by another ship that was behaving in a reckless or negligent manner. BP, as the lessee of the Deepwater Horizon, is the owner of the anchored tanker, in this case.

Statutory Law

After Exxon Valdez, the US government passed the Oil Pollution Act, which clearly shows liability for the environmental damage to be BP’s responsibility.

Section 1002(a) of the Oil Pollution Act states that the “responsible party” for a facility from which oil is discharged is liable for removal costs and other specified damages.

Section 2701(32)(c) of the Oil Pollution Act states that the “responsible party” means, in the context of offshore facilities, the lessee of the area in which the facility is located, or the holder of a right to use and easement granted under the Outer Continental Shelf Lands Act.

Thus, BP, as the lessee of the facility, is the responsible party, and as such is liable for removal costs under statutory law.

Contract Law

With respect to contract law, various reports online state that a typical drilling contract used in the offshore drilling industry specifies that the lessor (Transocean) is not liable for blowouts. All liability in such situations is the responsibility of the lessee (BP), and that the lessee (BP) will indemnify the lessor (Transocean) even if they are shown to be reckless, negligent, or had behaved with gross misconduct. There has been no evidence presented to suggest that BP and Transocean did not use a standard contract. Given BP’s initial attempts at deflecting blame, it would seem that such an obvious opportunity to point blame at Transocean would have been utilized if available. Given that it was not utilized, I conclude that it is unlikely the contractual relationship between the parties contains anything out of the ordinary.

What The Involved Parties Are Saying

On April 29th, during a previously scheduled analyst call to discuss 2010 Q1 earnings, BP’s CFO, Byron Grote said the following:

"As far as the Gulf of Mexico goes, you asked about contracts, I believe are a kind of code word for here for where does liability lie. … [I]n general, Transocean was responsible for the operation of the rig vessel and its equipment including the blow-out preventer and for drilling the well. In general, the lease owner that’s BP and our partners in the field, are responsible for the cause of regaining control over the well and handling the related environmental cost."

On May 3rd, BP’s CEO, Tony Hayward told Good Morning America his company is “absolutely responsible” for the cleanup.

Transocean does not have insurance for loss of revenue associated with a lost rig. In September 2009, BP extended its lease of the Deepwater Horizon for an additional three years, for $544 million, which equates to approximately $181m per year. This is approximately 1.66% of Transocean’s 2009 revenue. Assuming for simplicity that this represents a similar portion of earnings, this translates to a decrease in earnings of approximately $53m. Using a 9x P/E multiple (the approximate multiple being used prior to the explosion), this should have wiped $477m off of Transocean’s market cap.

Instead, the market priced in 10x this amount. This appears to be an overreaction. This would be the maximum rational drop in market cap, however this figure is mitigated by two items:

1) One of the potential solutions to the continuing leak is to drill new wells into the old well, deep below the ocean floor, and inject cement into the original well. This process could take several months, and BP has begun drilling already. Media reports state that BP has hired Transocean rigs to drill these new wells, which would indicate that Transocean’s loss of revenue will be mitigated to some extent.

2) Since the Deepwater Horizon disaster, the price of oil increased from $84/barrel to $88/barrel. If this is due to the disaster itself, then this would be a persistent increase. Persistent increases in the price of oil have translated to higher dayrates, especially amongst higher specification rigs. Transocean has some of the most sophisticated rigs in the world, and may ultimately be able to charge higher dayrates on its other rigs, which would mitigate the loss of revenue from this one rig.


It appears that all of the parties involved, as well as numerous analysts and commentators, are confirming what the law states: BP will be responsible for environmental remediation, which will constitute the vast majority of expenses relating to this disaster. For those expenses which Transocean is responsible for, Transocean is adequately insured. With regard to the loss of revenues, the ultimate loss, regardless of how liberal they are expected to be, seems to be dwarfed by the amount the market is pricing into Transocean’s current market cap. There appears to be little by way of justification for such a decrease.

The market is being overly pessimistic with Transocean. I expect shares to return to their previous 9x multiple in the near future.

Disclosure: Guest author has a long position in shares of RIG

Sources: reporting on an expert panel organized by Morgan Stanley’s Oil Field Services analyst, Ole Sorer.

Tuesday, May 4, 2010

Jet Setting

Of the 4500 or so airports in the United States, the major airlines only service about 10% of them. Security concerns have also made passenger airplane travel a time-consuming endeavor. As such, for some companies it's quite likely that a business case can be made for the purchase of a corporate jet (though not always).

But increasingly, executives have begun to make personal use of the corporate jet, for which no business case can be made. This is a veiled attempt at increasing compensation, without the appearance of doing so. In some cases, an executive's personal (i.e. non-business related activities) use of the company jet costs the company more than his entire salary! In most of these cases, the company will also issue a bonus to the executive to cover his related tax bill!

A strong corporate governance process is of vital importance to shareholders looking to maximize their returns. Shareholders can get clues as to the quality of a company's corporate governance by examining the company's behaviour when it comes to items like corporate jets.

For example, consider Abercrombie and Fitch, a company we discussed last year as one that re-affirmed its strategy, only to seemingly change it a few weeks later. The company and its CEO recently entered an agreement whereby the CEO was limited to keeping his personal use of the company jet to $200,000 per year. This still seems fairly generous, as $200K for vacation travel in a year does seem rather excessive, but at least it's capped at something, right?

Unfortunately, in return for signing this agreement, the CEO was provided $4 million in cash! This makes you much personal use of the jet was he getting before this agreement? A significant amount, if this payment for the $200K cap is any indication. His base salary is just $1.5 million, meaning his use of the corporate jet was a significant perk!

Managers will always try to glean what they can from the company kitty. It's human nature, and so they can hardly be blamed in the aggregate. But as a result, the importance of a governance structure that protects shareholders is instrumental, so that the managers are working for, rather than against, the shareholders. Frivolous use of company property should be a clear sign to shareholders that all isn't right with a company's governance structure, and so they may wish to avoid such companies.

Disclosure: Author has no corporate jet, and reserves the right to change his mind should his company acquire one.

Monday, May 3, 2010

Revenue Timing

Canam (CAM) has dropped some 15% in the last few days, as the company reported a loss in its first quarter earnings results last week. However, Canam has been discussed on this site as a stock idea with long-term potential for gains due to its stable operating model and growing backlog. As a result, temporary pullbacks in the form of revenue timing issues appear to offer long-term investors an excellent buying opportunity.

While the market appears focused on the fact that revenue dropped from $180M to $105M in the first quarter (a large drop by any standard), it's important for long-term investors to look behind the numbers to understand the long-term implications. As a company that designs and builds large-ticket construction products that require long lead times, recessions will hit this company later than it will most. As a result, the slowdown in the economy that occurred in 2009 has only hit the company now. The important indicators for forward-looking shareholders, however, are the company's booking rates.

For Canam, booking rates have been out-pacing revenue, as the company's backlog is now at a record level, though the company has been in existence for 50 years! The company's backlog over the last several quarters is shown below:

There are two main reasons for the large backlog. First, the company has been building roofing installations for two large stadiums (BC Place in Vancouver and Marlins' Stadium in Miami), but isn't scheduled to start delivery of those structures until the second quarter. (In this case, revenue cannot be booked until delivery has taken place.) These contracts alone are worth $180M; compare that to the company's first quarter revenue of $105M. In essence, revenue from the first quarter was simply pushed to revenues in future quarters, making first quarter revenue look poorer than it was, but making future quarters look better than they should.

Second, with prices depressed among competitors and complementary businesses, Canam has been at work acquiring companies, including Tennessee-based FabSouth, which added another $100M+ to the company's backlog. Since FabSouth was not fully consolidated in Canam's results until most of the first quarter was complete, these revenue numbers don't show the full impact of Canam's full business. But as the company works through its record backlog (and it expects to deliver all of its current backlog within a year), those revenue numbers will see strong sequential growth.

Investors focused only on quarterly earnings are sure to make poor decisions when it comes to making purchase decisions for the long-term. For companies dealing in large-ticket items, revenue timing issues can play a significant role in any one quarter's results. As such, it's important that investors think about the company's business from a long-term perspective to put themselves in a position to properly value a company's stock.

Disclosure: Author has a long position in shares of CAM

Sunday, May 2, 2010

New Era Value Investing: Chapter 3

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

In this chapter, Tengler outlines a value strategy that she employs successfully, calling it Relative Dividend Yield (RDY).

With the increasing ability to use technology to compare various factors across a whole slew of stock issues in the 1970s, many investment ideas were spawned. Tengler believes RDY to be one that has much in the way of value appeal conceptually, along with a successful track record.

In RDY, a stock's dividend yield is compared to the market on a historical basis. If the stock's dividend yield beats that of the market by 25% or more, and the stock's yield is high on a historical basis (for this particular stock), it becomes an attractive buy. Should the stock rise to a point where the yield drops below the market's yield, it becomes a sell.

Tengler discusses several reasons that this strategy works. Dividends are more consistent than earnings, so while earnings can fluctuate, Tengler argues that dividends offer the best glimpse of management's view of a stable pay-out that the company can maintain for the long-term.

Furthermore, when a company's yield rises as compared to that of the market, it is a sign that it is not favoured by the market. Tengler argues that this is a good time to buy. She cites Coca-Cola and Johnson & Johnson as ideal examples of this in 2001-02.

Finally, Tengler notes that there are times when this strategy doesn't work. For example, if a stock's relative price to the market is uncorrelated with its RDY, Tengler notes that the strategy no longer outperforms.

Saturday, May 1, 2010

New Era Value Investing: Chapter 2

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

Tengler takes the reader through the history of fundamental analysis in the stock market. While many value investors know the history as far back as Benjamin Graham and David Dodd's Security Analysis, Tengler goes further back to give credit to two New Yorkers who laid the groundwork that allowed Graham and Dodd to do their thing.

In the late 1800's, the stock market was akin to a casino, as fraudulent activities reigned throughout. Louis Guenther started a magazine in 1902 that reported on and exposed securities fraud, while Alfred Best published a service focused on reporting accurate information on insurance company financials, originally to allow customers to buy fire insurance from reputable companies that weren't going to go under. It was Best that first noted the concept of intrinsic value, whereby investors were encouraged to purchase stocks if they traded below the estimate of their intrinsic values.

In the 1930s came the groundbreaking work from Graham and Dodd, but even in subsequent editions of Graham's books did his methods evolve, though based on the same principles. This is because the market continued to evolve, as the methods that worked the best during the Great Depression were not the same as those that worked the best during WWII.

Over time, the dividend has also become less relevant. At one time, it was a mark of a great company that could continually reward its shareholders, but more recently it has become a sign that a corporation does not have profitable uses for its earnings. Dividend-focused value investors would be forced to change.