The Fund

Karsan Value Funds is a value-oriented investment fund. Read all about it.

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Security Analysis: Chapters 8 and 9

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.

As discussed in Chapter 6, choosing fixed-income securities is an exercise in exclusion. You start with a basket of possibilities, and discard those which do not meet a certain set of requirements. In these two chapters, and the two that follow, Graham and Dodd go into the details of what those requirements should be.

The most important requirement deals with earnings coverage, i.e. how well earnings cover the interest requirements of the company. There are three components to earnings coverage for an issue that the authors define:

1) The methodology for it's calculation
2) Its minimum requirements
3) The period of time we are interested in knowing earnings coverage

Graham and Dodd argue that the earnings coverage calculation of even the most senior debt should equal earnings over total interest, where total interest includes even the most junior interest obligations. They also argue for definite minimum coverage requirements that vary by industry. In order to avoid looking at only prosperous years for the company, the authors suggest using a length of time commensurate with including recessionary years.

The authors argue that a company's size is a determinant factor in its ability to pay off its debts, based on knowledge of the past, as discussed in Chapter 7, Part I. Small companies are more vulnerable to the unexpected, and lack strong banking connections and technical resources. Nevertheless, size is far from a guarantee of safety, and therefore a security must pass several more tests.

The authors argue against those who would ignore securities in certain industries or countries. Although more care has to be given to ensure larger safety margins in certain industries, to blanket out certain industries would leave the investor with too little to choose from, and thus encourage the purchase of weak securities simply because the company is a utility or in some other stable industry. In the same way, investments in many countries have proven to be unsound, but the authors argue that certain countries are proven to be safe and investors should not count these out.

The authors are also against throwing out securities without liens to fixed assets. As discussed in Chapter 6, in practice, debts secured against assets are of little value versus debts that are unsecured.

Often, investors will not have as stringent requirements for bonds of shorter maturity due to the fact that principal repayment is just around the corner, and so there are less years for something to go wrong with the company. Graham and Dodd argue that this is a mistake, since the company has the added burden of having to refinance fairly quickly, and thus must not have anything go wrong during this period. They therefore find no reason to differentiate between bonds of long and bonds of short maturity periods.

The authors also disagree with conventional wisdom that only companies that pay dividends should qualify as fixed-income investments. Though companies that pay dividends are often more successful than those that do not (since they can afford to pay out), often many companies are actually worse-off by paying out dividends that dwindle the company's financial resources, thus making them less attractive to bond holders.

Onto Chapter 10

Security Analysis: Chapter 7, Part II

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.

Certain fixed-income securities have higher yields due to their higher risk levels. Conventionally, it is accepted that the higher yields approximately make up for the occasional loss to the principals of these securities, suggesting there is no difference between investing in high-yield vs low-yield securities. Graham and Dodd argue that in practice there is no such simple relationship between the yield and the risk of a security.

Rather, the differences in yields between securities occur as a result of many factors, including the issue's popularity, its public familiarity, and its marketability.

They further argue that even if there were such a relationship between risk and yield, the income-seeking investor is in no position to make such tradeoffs. The fact is that many high-risk securities tend to lose their principals in bunches (i.e. during recessions), which income-seeking investors are neither psychologically nor financially prepared for. High-yielding securities are for those seeking gains in principal as opposed to those seeking income, and therefore guidelines for such investments are described in a later chapter.

Onto Chapter 8

Aldila: Is this a value play?

Aldila, a designer and manufacturer of graphite golf shafts (ALDA on the NASDAQ), is showing promising signs of being a value investment according to some basic measures of value.
Aldila's stock is trading with a trailing price to earnings ratio of less than 2.5, a price to book of less than 1 and pays a quarterly dividend of 15 cents, giving it a lofty dividend yield of around 11% based on the current stock price.

Looking at value indicators is only my beginning step in determining whether a stock qualifies as a value investment. Value indicators such as low P/E, low P/B and high dividend yields are used as signs of potentially undervalued securities. Following Benjamin Graham's lead, to truly understand whether the stock is undervalued, the intrinsic value of the company should be calculated and compared to its current market price before making a purchase decision.

In addition to calculating the intrinsic value of a company, I take notice of management's ability to allocate capital effectively. It's instructive to note that Aldila's management made a decision to pay out a special one time dividend of $5 per share to shareholders in March of 2008. This action demonstrates that management decided that it would be in the best interests of shareholders to pay out the excess cash. Readers of Warren Buffet's notes to shareholders know that capital allocation is a key management decision and managers that do this well are in short supply. I applaud Aldila's management for resisting the temptation to hoard the cash reserves or worse to squander it on capital assets or projects that would not create value for shareholders.

So why is Aldila's stock trading so cheap? It seems that one major reason is the slumping sales figures for the company. Revenues reached a peak for the company of $77M in 2005 and have fallen by 6% to $72.4M in 2006. Revenues continued to fall by 4.5% to $69.1M in 2007. The latest quarterly report in March 2008 shows a huge year over year period decline of 19% in total sales.

Trying to accurately predict what will happen to upcoming sales for a given company is anything but an exact science and yet this is one of the most popular activities on Wall Street. It's no wonder that predicting sales accurately has humbled many excellent analysts. Benjamin Graham has taught us to avoid forecasting and instead to use factual data in calculating company valuations. One approach to use with Aldila is to evaluate whether something fundamental has affected their business in a way that would permanently impair their operating margins. If the answer is no, one reasonable approach is to normalize the sustainable earnings over a complete business cycle and to use this result in calculating the intrinsic value of a company.

In my next post, I will continue to reveal my personal calculation of the intrinsic value of Adila's public stock.

Disclosure: None

Melcor's Price Drop and What It Means

Melcor (TSE: MRD), a land developer in Alberta, has enjoyed enormous gains over the past few years, but the shares have fallen of late. Alberta's hot economy had caused a tightness of supply in the real estate market, but recently the market has cooled off from its highs, and share prices of Melcor have plummeted, falling from highs of $29 to their current price of $13.25.

Is there something wrong with Melcor? Absolutely not. It's a well run company with valuable assets. The price drop is simply a result of the unjustified price run-up that preceded it! We saw here that home builders tend to track their book values over time. Here's a look at Melcor's price to book value over last several years:
We clearly see evidence that investors were not very discriminating throughout 2006 and 2007, as they were willing to pay several multiples of book value for this company. The stock price has since cooled to a more reasonable level of 1.5 times book.

However, investors who bought at the peak, and the analysts who pumped it, are feeling the pinch. Recently, Desjardins analyst Jeff Roberts re-iterated his buy rating, and a Globe and Mail article recently pumped this stock, suggesting the book value of Melcor understates the actual value of the real estate under ownership (since book value has land assets listed at cost, while those properties have increased in value over the last few years). Roberts believes the real estate market in Alberta is poised for continued growth.

While this may be true, nobody really knows. However, we do know that throughout the 90s and early 2000s, you could buy this company (and thus the land they owned) at great discounts to book value, as seen from the chart above, offering a tremendous margin of safety. There were, however, no analysts pumping this stock at that time. When a market is hot (such as it is in Alberta), there will be analyst coverage galore, and buyers willing to pay any price for a stock.

This is why value investors prefer industries that the market has discarded. As Alberta's real estate market was ignored in the 90s, a prudent buyer of Melcor at that time would have cashed in with incredible profits. Today, a value investor would seek out industries and companies that are out of favour and with low analyst coverage, in order to find the next generation of companies trading with large margins of safety to their intrinsic values, rather than follow the herd.

Security Analysis: Chapter 7, Part I

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.

The first half of Chapter 7 describes the reasoning behind the second principle of fixed-income investing:

Consider these investments on a Depression basis.

All fixed-income investments can do well when conditions are favourable, but investors must attempt to determine how safe these securities are when times are bad before they can make a purchase decision.

Graham and Dodd suggest there are two ways a security can be Depression-proof:

1) Its industry does not lose much earning power during bad times
2) Interest coverage is so high that despite a large drop in earnings, there is no resultant danger

The authors discuss the cyclicality of various industries, suggesting that certain utilities (electric, gas, water) show little earnings erosion during recessions, and would qualify under #1 above. Nevertheless, the authors demonstrate that an equal share of utilities went bankrupt during the Depression as did companies in other industries. However, this is demonstrated to be as a result of the capital structures of such safer industries. These companies loaded up on debt (expecting that they were recession-proof) such that even though they did not lose substantial earnings power, they were no longer able to cover their obligations.

Meanwhile, Graham and Dodd argue that in order to qualify as investments, most industrial companies would have to fall under category #2 above. However, despite having high coverage ratios in normal years, the drop in earnings (often into losses) during The Depression was such that insolvency was unavoidable for most of these companies. Their study of such industrials demonstrates that across industries, it was the largest companies that most avoided default.

The authors thus conclude that investments in fixed-income securities should be confined to reasonably capitalized companies in stable industries along with industrial companies of dominant size with substantial interest coverage ratios.

Onto Part II

Security Analysis: Chapter 6

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.

Having divided the various types of securities into the three categories described in the preceding chapter, Graham and Dodd delve into selection criteria for the first category of securities: Fixed Income Investments.

The authors take issue with how conventional wisdom has propagated the myth that fixed income instruments are by their nature safe investments. The authors argue for a more critical attitude toward bond selection than is currently done. Though they concede fixed income instruments are senior claims (to equity instruments), they argue that “neither priority nor promise is itself an assurance of payment”.

As fixed income instruments do not get to participate in the upside of the business, investors in such instruments need to be absolutely convinced in the ability of the company to pay its obligations.

Therefore, they view fixed income selection as a “negative art”, where investors look for reasons not to invest, throw those securities out, and are thus left with those worth investing in. Since there is little upside in these securities, the idea is to avoid any downside.

With this approach in mind, Graham and Dodd lay out the first of four principles to further guide the investor in selecting fixed income instruments: A lien is worth little

This principle goes against conventional wisdom. However, Graham and Dodd argue that in practice, the equipment/plant/property used to borrow against undergoes great devaluation at the same time as the company undergoes its business problems, thereby reducing the usefulness of a lien. Furthermore, they argue (and back up with examples) that delays and difficulties in asserting bondholders’ legal rights further render this lien almost worthless.

From this, it follows that if it is clear that a company can cover its obligations, investors should choose the security with the highest yield, however junior. If it is not clear that a company can cover its obligations, then a substantial yield advantage is required to go with the junior security.

Onto Chapter 7