The first rule of value investing is to never lose money. An investment in H Paulin (PAP.A), a manufacturer and distributor of nuts, bolts and 75,000 other stock keeping units, appears to offer investors such an opportunity. The company's inventory and accounts receivable add up to $82 million, while all of its liabilities total just under $39 million, for a difference of $43 million. Meanwhile, the company trades for just $20 million on the market.
Therefore, even in a liquidation situation, investors are protected to a great extent. As a going-concern, one can look at this situation as akin to buying the inventory and receivables of this company for half price while still getting all the fixed assets and customer relationships for free!
A couple of days ago, we saw a similar situation to this when we looked at Shermag, which was burning through cash. However, this is not the case for Paulin: its operating income continues to be positive as its distribution business profits make up for its manufacturing losses.
As such, the fixed assets of this company may not be worth much (but remember, you're getting them free!), as the auto industry customers the company serves are going through a tremendous downturn. On the other hand, the customer relationships (another freebee!) appear very valuable: Paulin has managed to position itself as a supplier of choice to The Home Depot (HD).
As The Home Depot concentrates on consolidating its suppliers, Paulin has been a clear winner, having secured valuable sales contracts with this customer until at least 2011. As a result, despite slowing sales at Home Depot, Paulin's sales to Home Depot have increased year over year in the double digits thanks to market share gains within the stores.
As such, a big component of Paulin's sales and accounts receivable are from The Home Depot. Therefore, it's worthwhile ensuring HD is financially stable and able to pay its debts. As we looked at here, despite the exceptional downturn in HD's industry, it is in no danger of going away: interest coverage, cash flow, and liquidity appear strong enough to outlast even the most severe downturn.
There's no such thing as guarantees. H Paulin may make mistakes causing HD to cancel its contracts, or it may blow its profits on what turns out to be unprofitable ventures. But a portfolio of companies made up of "Paulins", trading at discounts to liquid assets and having positive earnings and cash flow, is sure to offer investors outstanding returns over the long term.
Disclosure: The author owns long positions in both PAP.A and HD.
Thursday, December 4, 2008
Wednesday, December 3, 2008
The Warren Buffett Way: Chp 7 Part 3: Equity Marketable Securities
In 1990, General Dynamics (GD) was the second largest U.S. defence contractor in the United States. The company focused on building nuclear submarines and armored vehicles. In 1990, the Berlin Wall was brought down signalling the end of America's cold war. Soon after the event, General Dynamics CEO, William Anders, realized that the defense industry had significantly changed and decided to reorganize GD's business.
Anders started selling off GD's business units and assets that did not display franchise like characteristics. Ander's only wanted GD to be in businesses that were market leaders and that could achieve a balance between research and development and production capacity. With significant cash on hand generated from the rationalization of GD's assets, Anders declared the company would buy back 30% of its shares as way of a Dutch auction. Warren Buffett took an interest in GD after Anders' announcement of the company's intent to buy back its shares.
By July 1992, Berkshire had acquired 4.3 million shares of GD. Buffet explains that "seeing an arbitrage opportunity, I began buying the stock for Berkshire, expecting to tender our holdings for a small profit." Buffett explains that after studying the company more intently, he became very interested in holding onto the shares due to the rational strategy that Anders was executing and the sense of urgency that Anders displayed in executing his tasks. Buffett also liked the fact that Anders was shareholder friendly.
Berkshire invested in GD's common stock at $72 per share and within two years, received $52.60 of dividends for each share held and witnessed the share price rise to $103 per share. Anders' actions of divesting the company's underperforming assets and returning the excess cash to shareholders resulted in a tremendous increase in shareholder value.
Anders started selling off GD's business units and assets that did not display franchise like characteristics. Ander's only wanted GD to be in businesses that were market leaders and that could achieve a balance between research and development and production capacity. With significant cash on hand generated from the rationalization of GD's assets, Anders declared the company would buy back 30% of its shares as way of a Dutch auction. Warren Buffett took an interest in GD after Anders' announcement of the company's intent to buy back its shares.
By July 1992, Berkshire had acquired 4.3 million shares of GD. Buffet explains that "seeing an arbitrage opportunity, I began buying the stock for Berkshire, expecting to tender our holdings for a small profit." Buffett explains that after studying the company more intently, he became very interested in holding onto the shares due to the rational strategy that Anders was executing and the sense of urgency that Anders displayed in executing his tasks. Buffett also liked the fact that Anders was shareholder friendly.
Berkshire invested in GD's common stock at $72 per share and within two years, received $52.60 of dividends for each share held and witnessed the share price rise to $103 per share. Anders' actions of divesting the company's underperforming assets and returning the excess cash to shareholders resulted in a tremendous increase in shareholder value.
Easy Win: Curb Rent Ceilings
For the US economy to start growing again, many believe the housing market must reach a bottom. Overbuilding coupled with a drop in demand has resulted in an oversupply in the housing market, causing a huge drop in construction. As we saw here, historically this type of construction boom and bust is nothing new to the housing market.
One easy way for certain cities to increase construction in the private sector is to abolish rent controls. Many US cities including New York, Los Angeles, and San Francisco currently have some form of rent control. While these controls are meant to protect tenants against rising housing costs, in the long-term they actually have the opposite effect, as housing supply is left artificially low since there is no incentive to build, and thus new tenants are forced to overpay for scarce supply.
While abolishing rent controls at the present time would cause certain tenants to have to move to more affordable housing, it would only do so where price ceilings are lower than rent market values. In such areas, the overall economy stands to benefit from an increased incentive for builders, resulting in a growing construction industry. The controls don't have to be abolished immediately, but instead implemented to phase out over time, which offers builders incentives to break ground now, while tenants are afforded time to adjust.
One easy way for certain cities to increase construction in the private sector is to abolish rent controls. Many US cities including New York, Los Angeles, and San Francisco currently have some form of rent control. While these controls are meant to protect tenants against rising housing costs, in the long-term they actually have the opposite effect, as housing supply is left artificially low since there is no incentive to build, and thus new tenants are forced to overpay for scarce supply.
While abolishing rent controls at the present time would cause certain tenants to have to move to more affordable housing, it would only do so where price ceilings are lower than rent market values. In such areas, the overall economy stands to benefit from an increased incentive for builders, resulting in a growing construction industry. The controls don't have to be abolished immediately, but instead implemented to phase out over time, which offers builders incentives to break ground now, while tenants are afforded time to adjust.
Tuesday, December 2, 2008
The Warren Buffett Way: Chp 7 Part 2: Equity Marketable Securities
Gilette is a company known to be a global leader in the manufacturing and distribution of razor blades and toiletries. The company has been a market leader in the shaving market since 1923.
In early 1974, a competitor, Bic, introduced a disposable shaving blade that quickly took 50% of the shaving market. Gilette swiftly countered with their own disposable blade but in the process they found themselves cutting into their own profit margins. Eventually Gilette realized that they would be better off focusing on the higher-end shaving market and thus they abandoned the disposable shaving blade market.
During the period when Gilette was offering a "disposable blade", the company appeared to be a mature, slow growing company and a potential takeover target. During this time, Gilette's CEO fought off multiple takeover attempts. It was at this time that Warren Buffett solicited a friend on Gillette's board to see if Gillette would be interested in a capital injection from Berkshire Hathaway. The board agreed to do a deal with Berkshire.
In 1989, Berkshire made a deal with Gilette for convertible preferred shares and soon after, Buffett joined Gilette's board of directors. Berkshire bought $600 million of Gilette's convertible preferred shares. Within two years, Berkshire converted their Gilette preferred shares into Gilette common shares, which were then worth $875 million.
Buffett understood Gilette's business economics and felt he could make a reasonable estimate about its future. In 1991, Buffett compared Gilette to Coca-Cola and said "Coca-Cola and Gilette are two of the best companies in the world", and "we expect their earnings to grow at hefty rates in the future". For this reason, Buffett, along with Munger, decided that Berkshire should hold onto Gilette's common shares.
In early 1974, a competitor, Bic, introduced a disposable shaving blade that quickly took 50% of the shaving market. Gilette swiftly countered with their own disposable blade but in the process they found themselves cutting into their own profit margins. Eventually Gilette realized that they would be better off focusing on the higher-end shaving market and thus they abandoned the disposable shaving blade market.
During the period when Gilette was offering a "disposable blade", the company appeared to be a mature, slow growing company and a potential takeover target. During this time, Gilette's CEO fought off multiple takeover attempts. It was at this time that Warren Buffett solicited a friend on Gillette's board to see if Gillette would be interested in a capital injection from Berkshire Hathaway. The board agreed to do a deal with Berkshire.
In 1989, Berkshire made a deal with Gilette for convertible preferred shares and soon after, Buffett joined Gilette's board of directors. Berkshire bought $600 million of Gilette's convertible preferred shares. Within two years, Berkshire converted their Gilette preferred shares into Gilette common shares, which were then worth $875 million.
Buffett understood Gilette's business economics and felt he could make a reasonable estimate about its future. In 1991, Buffett compared Gilette to Coca-Cola and said "Coca-Cola and Gilette are two of the best companies in the world", and "we expect their earnings to grow at hefty rates in the future". For this reason, Buffett, along with Munger, decided that Berkshire should hold onto Gilette's common shares.
All Net-Nets Not Created Equal
Ben Graham, oft considered the father of value investing, found that buying companies trading at a 33% discount to their Current Assets minus Total Liabilities offered investors great returns. The idea is that even at liquidation the investor will get more than his investment, but chances are things will turn around before that's required. For many years, stocks trading at such discounts were near impossible to find in North American markets. Today is a different story, however, as fear has driven the market to such levels that once again stocks such as these exist in droves.
But not all such companies are worth investing in. If the company is burning its assets due to floundering operations, well its liquidation value won't be worth much at all! Consider Shermag (SMG), a furniture manufacturer and distributor. Last year, it had current assets of $48 million and total liabilities of $36 million, yet it was trading at a market cap of just $6 million.
Great value? Hardly not. The company has lost about $15 million per year for the last three years. As it burns through its assets in this manner, it quickly erodes any balance sheet value it appears to have.
When looking through net-nets, be sure to keep in mind that not all of them offer great value. It takes patience and an understanding of the underlying business to ascertain whether you've found a diamond in the rough.
But not all such companies are worth investing in. If the company is burning its assets due to floundering operations, well its liquidation value won't be worth much at all! Consider Shermag (SMG), a furniture manufacturer and distributor. Last year, it had current assets of $48 million and total liabilities of $36 million, yet it was trading at a market cap of just $6 million.
Great value? Hardly not. The company has lost about $15 million per year for the last three years. As it burns through its assets in this manner, it quickly erodes any balance sheet value it appears to have.
When looking through net-nets, be sure to keep in mind that not all of them offer great value. It takes patience and an understanding of the underlying business to ascertain whether you've found a diamond in the rough.
Monday, December 1, 2008
The Intelligent Investor: Chapter 18
The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.
This is a long and detailed chapter. To do it justice, I would have to reproduce great portions of it, and I think that is beyond the scope of this review. Instead, I will outline some of the key points from the comparisons, without getting into detail about the different pairs of companies.
Look for companies with long histories of dividend payments, prudent investing and moderate growth through conservative debt financing.
Stay away from conglomerates comprised of unrelated companies, that have achieved phenomenal growth through interesting financing methods.
Look for companies selling at a bargain compared to their asset backing (book value). Look for companies with comfortable working capital. Low multiplier companies tend to outperform high multiplier companies.
Be careful when looking at previous growth. Small companies are capable of growing at greater rates than large companies, and as these small companies grow, their growth curves will flatten out. The market may overreact to the previous growth and overvalue the company, believing such growth is sustainable, and this will destroy any bargain opportunities.
Graham’s general observations suggest that, while it is logical for companies with better growth records and higher profitability to command higher multiples of earnings, the intelligent investor must be careful in considering whether the specific differentials in earnings multiples are justified. In many cases, the market becomes overly optimistic and may ignore the underlying soundness of the company while pushing the price high on mere speculation alone.
Again, it is better for most investors to just focus on companies with low P/E multiples. This is a message Graham continuously repeats throughout the book. Zweig does a good job of summarizing this: “If you buy a stock purely because its price has been going up - instead of asking whether the underlying company’s value is increasing - then sooner or later you will be extremely sorry. That’s not a likelihood. It is a certainty.”
From The Mailbag: AutoNation Inc.
This economic slowdown will cause many companies in the auto sector to go under. As such, stocks related to this industry have taken a huge hit over the last year or so. This offers us the opportunity to buy companies that will outlast the recession at large discounts to their intrinsic values. Last week, we looked at certain criteria to look for in order to determine whether a company in this industry represents a good long-term purchase. More than one reader offered up AutoNation (AN) as a company possibly meeting these criteria.
AutoNation owns and operates over 200 car dealerships in the Southern United States. AN is not reliant on only selling cars, however. New car sales make up 56% of revenue, vs 24% used cars and 17% parts and service. As one might imagine, exposure to parts and service helps stabilize a company through hard times: revenue from this segment dropped only 1% through the first nine months of this year, versus a 17% drop in new car sales.
The nature of this company's business requires it to have many fixed costs. Dealerships must be operated and kept in good condition containing a variety of product makes and models in order to make sales. As such, when there's a drop in demand, costs can't automatically be scaled back and thus losses occur. The company lost $1.4 billion last quarter as a result of slowing sales and a Goodwill writedown.
Considering profits will likely be negative for the next while as revenues drop and fixed costs remain, the debt level becomes an important factor in determining the company's lasting power. The balance sheet shows a debt to equity ratio of 66%, but this jumps to 90% after including off balance sheet debt (operating leases, purchase commitments etc. as discussed here) which cannot be ignored.
The company has been mitigating this situation by negotiating buy-outs of their operating leases, reducing inventory (which releases cash) and paying down debt, however, many risks remain. If the recession is short, this company will be just fine and its stock price will rebound. However, if you think the recession will be long, or like us have no idea how long it will be and prefer to play it safe, this leveraged company, both in terms of fixed operating costs and high debt requirements, may not be the one for you.
For those interested in more info on auto dealership analysis, here's a look at interest coverage ratios for various dealers. For those interested in a beaten down auto-related stock with little debt and a flexible cost structure, you may be interested in this article.
Disclosure: None
AutoNation owns and operates over 200 car dealerships in the Southern United States. AN is not reliant on only selling cars, however. New car sales make up 56% of revenue, vs 24% used cars and 17% parts and service. As one might imagine, exposure to parts and service helps stabilize a company through hard times: revenue from this segment dropped only 1% through the first nine months of this year, versus a 17% drop in new car sales.
The nature of this company's business requires it to have many fixed costs. Dealerships must be operated and kept in good condition containing a variety of product makes and models in order to make sales. As such, when there's a drop in demand, costs can't automatically be scaled back and thus losses occur. The company lost $1.4 billion last quarter as a result of slowing sales and a Goodwill writedown.
Considering profits will likely be negative for the next while as revenues drop and fixed costs remain, the debt level becomes an important factor in determining the company's lasting power. The balance sheet shows a debt to equity ratio of 66%, but this jumps to 90% after including off balance sheet debt (operating leases, purchase commitments etc. as discussed here) which cannot be ignored.
The company has been mitigating this situation by negotiating buy-outs of their operating leases, reducing inventory (which releases cash) and paying down debt, however, many risks remain. If the recession is short, this company will be just fine and its stock price will rebound. However, if you think the recession will be long, or like us have no idea how long it will be and prefer to play it safe, this leveraged company, both in terms of fixed operating costs and high debt requirements, may not be the one for you.
For those interested in more info on auto dealership analysis, here's a look at interest coverage ratios for various dealers. For those interested in a beaten down auto-related stock with little debt and a flexible cost structure, you may be interested in this article.
Disclosure: None
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