Barel Karsan

Competition Demystified: Chapter 1

noreply@blogger.com (Saj Karsan) — Sun, 19 Feb 2012 11:04:00 +0000

The author of the excellent book for beginners, Value Investing: From Graham to Buffett..., is back, this time with a book about how to understand and analyze competitive advantages. Investors interested in better understanding what gives a company a competitive advantage must give this book a read.

The authors start by defining strategy. The word strategy is often evoked to describe long-term plans companies devise in order to make money. But the authors argue that not all such planning is strategic. It is only strategic if external responses by competitors are taken into account. If only internal actions are considered, the authors argue that an action is tactical.

For this reason, companies operating in industries where barriers to entry are low can't really come up with viable strategies. There are too many competitor actions to take into account. As such, companies can only focus their efforts internally on becoming as efficient as they can, as this is the only path to success in such industries.

The authors believe Porter's Five Forces was a useful framework, but they believe giving equal weighting to all forces makes analysis complicated. So they have prioritized the forces, with the single most important force being barriers to entry. Once the extent of that force has been determined for an industry, one can better understand how the other forces interact with competitive advantages.
strategy (takes competitor actions into account) vs tactics (internal)

The Upside Of Irrationality: Chapter 11

noreply@blogger.com (Saj Karsan) — Sat, 18 Feb 2012 11:55:00 +0000

Canadian Housing Bubble, or Vancouver Housing Bubble?

noreply@blogger.com (Saj Karsan) — Fri, 17 Feb 2012 11:28:00 +0000

When the US underwent its housing bubble (and subsequent burst) a few years ago, there were a few signs of trouble. New home inventories were high, as expectations were through the roof (never a good sign). Home builders traded several times their book values, suggesting extreme optimism and over-building (to capitalize on unsustainably high profit margins). Price to rent and price to income ratios skyrocketed.

Today, many are saying similar residential real estate bubbles are occurring in China, Australia and Canada to name a few. As a home owner in Canada, I'm interested in studying this phenomenon so as to ensure I don't end up on the wrong side of it, much like many of my unfortunate American brethren.

Clearly, Canadian house prices to incomes have fallen out of line with their historic norms, as have Canadian price to rent ratios.

But another thing we learnt from the US housing bust is that not all regions froth to an equal degree. Las Vegas and Phoenix, for example, saw massive declines when the bubble finally burst, while other places escaped with barely a scratch. Canada is a particularly geographically diverse (in terms of natural resource availability, types of industry etc.) nation, and so it's conceivable that the stress of any Canadian housing bust will be felt to varying degrees depending on the region.

To that end, I've compiled several years worth of new home inventory (source: CMHC) levels for three large Canadian cities (and their surrounding suburbs), Vancouver (which is the most expensive city), Toronto (the largest city), and Calgary (which is somewhat reliant on the oil market for its level of prosperity):

From this chart, it hardly looks as if inventories are out of control, as they are well-within their range of the last decade. In fact, there may even appear to be a shortage of homes in Toronto.

However, switching to the condo market, one does start to see some potential over-optimism on the part of builders, resulting in very high inventories of as-yet unsold new multi-family units:

Here we see how hot Vancouver is compared to the other cities. But wait! The above chart isn't adjusted for population. Toronto's population is more than double that of Vancouver's, and yet Toronto has only half as many condos available. Adjusting the inventory chart for population makes the situation look like this:

Clearly, there are a lot of new condos in Vancouver, both on a historical standard and compared with other cities. For now, there are enough sales taking place in Vancouver such that this inventory is not staying on the market long enough to significantly pressure prices. But that can change in a hurry. A rise in interest rates or a reduction in consumer confidence or some other shock could reduce demand, and that would leave a whole lot of properties on the market. Whether this situation will also affect the detached home market is anybody's guess, but if capital becomes tight as a result of fear in a certain part of the housing sector, it may take the whole sector down with it...who knows!

Danier: That's A Lot Of Leather

noreply@blogger.com (Saj Karsan) — Thu, 16 Feb 2012 11:39:00 +0000

Yesterday, Oddball Stocks had a great write-up of Danier Leather as a potential value investment. I wrote about Danier almost a year ago, but since then it has had a successful few quarters, accumulating cash while improving margins. At the same time, its price has actually fallen some 20%, making it much more attractive. If you're interested, go ahead and read the post at Oddball. The only thing I would add is that there is a dual-class share structure, and so the incentive for management may be skewed towards growing the company rather than returning the company's substantial cash hoard ($32 million in cash versus a market cap of $50 million) to shareholders.

Disclosure: No position

Shareholder Interests Aren't All The Same

noreply@blogger.com (Saj Karsan) — Wed, 15 Feb 2012 11:47:00 +0000

Management will act in its own best interests, and for this reason investors should ensure that management's interests are aligned with theirs. Sometimes, however, management may be swayed to act in the interests of major shareholders, whether under the threat of a hostile takeover or as part of a courtship process for a friendly merger. Investors armed with this knowledge are in a position to better understand what is about to take place, and may thus make investment decisions that are in tune with their investment strategies.

For example, value investors can take a hint as to the company's future capital allocation plans if a company under review already has a large shareholder with a history of a preference for companies which return capital to shareholders vs those which try to empire-build. But to the aspiring value investor, finding this information isn't always easy.

Shareholders who peruse SEC company filings will have come across Schedule 13d from time to time. This is a mandatory filing that must be submitted by anyone who owns more than 5% of a company. On this form, major shareholders are required to disclose who they are, their relationship to the company, and even the motivations behind the transaction (though that can be conveniently changed at a later time).

But even if the schedule itself does not make the motive of the purchase abundantly clear, researching the large investor's background may help clear up uncertainties with respect to the company's near-term future. For example, if Berkshire Hathaway has taken a large stake in a company, it may be seen as an endorsement of management. On the other hand, if Carl Icahn is the buyer, director and management changes may be on the way!

That management should act in the best interests of shareholders is often discussed, including on this site. Implicit in this idea, however, is the notion that all shareholder interests are the same. Unfortunately, this is not always the case. However, disclosures are available which can aid the shareholder in determining whether the interests of major shareholders are aligned with theirs.

Does Dacha Deserve To Be Your Valentine?

noreply@blogger.com (Saj Karsan) — Tue, 14 Feb 2012 11:57:00 +0000

Rare earth metals are used in all sorts of applications from lightbulbs to hybrid cars. Their prices are rather volatile, and have swung dramatically in recent quarters on supply/demand issues and export restriction news out of China. Value investors may not be interested in buying rare earth metals at market prices...but what if they could be purchased at a major discount?

That's the opportunity that's potentially available through the purchase of the stock of Dacha Strategic Metals (DSM). Dacha trades for $40 million, but has rare earth inventories valued at $100 million against very little in balance sheet liabilities. The investor is thus given the opportunity to buy rare earth metals at a considerable discount.

Management appears to be trying to do something about the discount, as it purchased 10% of the company's float in the last 8 months. It will be eligible to buy back more shares in June, which could help close the discount. Unlike most companies, Dacha reports on the market value of its inventory position weekly, so your not stuck sitting on a company with stale three-month-old financials.

But there are a few risks that could result in losses despite such an apparently large margin of safety. First, the prices of these metals are volatile. As such, they could fall abruptly, destroying any margin of safety in the process.

Further complicating the matter is that some estimates have to be made in order to determine the market value of the company's inventory. The bulk of this inventory is not sold frequently, reducing the transparency of the "market value" of these elements.

Finally, there are some options outstanding which will likely reduce the potential upside. There are 20 million options outstanding (compared to just 75 million shares), the vast majority of which have exercise prices lower than the current share price.

Nevertheless, some value investors who are not terribly bearish on rare earths may find Dacha to be of compelling value.

Disclosure: No position

Amtech Trades Like It's Broke

noreply@blogger.com (Saj Karsan) — Mon, 13 Feb 2012 11:58:00 +0000

You probably won't find a lot of value investors in the solar industry. As a relatively nascent industry, it hasn't yet proved its economic viability. Moreover, that viability is based on the prices of substitutes (e.g. natural gas, wind power etc.) and perhaps the support of the agents of taxpayers (i.e. politicians). Finally, there is a commodity-like element to this industry, as companies fight to provide relatively undifferentiated products to customers only interested in price.

This introduces a ton of risk into the equation for anyone trying to value a solar stock to any reasonable degree of certainty. But sometimes, could a balance sheet be so pristine that it trumps many of the downside risks, leaving only the upside potential of this volatile industry to the investor?

After falling almost 20% on Friday, Amtech Systems (ASYS) now trades for $85 million despite a net cash position of $55 million and earnings over the last two years totaling $30+ million.

In the near-term, however, earnings will not be pretty. The industry is currently in a state of oversupply, meaning Amtech's solar cell manufacturing customers are hurting. As a result, they have reduced or pushed back their plans to buy the capital equipment (which Amtech provides) needed to expand production. Management predicts revenue will fall some 66% y/y in the current quarter, pushing the company into a loss position.

But because of the company's fortress balance sheet, might it be an attractive purchase anyway? The company should be able to ride out any short-term oversupply the market is experiencing. Furthermore, the company also sells its capital equipment to semiconductor manufacturers, diversifying its revenue base to some extent.

The question for investors is how long such an oversupply in the solar industry may last. Answering this question isn't easy, as a lot of moving parts (including the competitiveness of solar vs traditional energy, which is changing due to technology improvements) have to be taken into account. For those who understand the industry well and who believe the downturn to be temporary, however, Amtech may be a bargain.

Disclosure: No position

The Upside Of Irrationality: Chapter 10

noreply@blogger.com (Saj Karsan) — Sun, 12 Feb 2012 11:35:00 +0000

The Upside Of Irrationality: Chapter 9

noreply@blogger.com (Saj Karsan) — Sat, 11 Feb 2012 11:35:00 +0000

Through a series of experiments, Dan Ariely documents the many ways in which humans behave irrationally. By understanding these human tendencies, we can both learn to behave more rationally when it is to our benefit, and better understand why those around us are behaving in the way they are.

Twenty-four hour news programming provides interesting insights into the tastes of media consumers. For example, people seem to be far more captivated by rescue attempts of a child that has fallen into a well than by genocides in other countries. Through a series of experiments that allowed subjects to donate their own money, Ariely discusses the factors that determine what makes us care more about some tragic events over others.

One important factor is how close we are to the victim, both physically and emotionally. Someone within our family, or that we know, or that is within some physical proximity is more likely to elicit our help than someone in a land far away.

Another important factor is the vividness (as opposed to vagueness) of the danger. A drowning child that is screaming or begging for help is a vivid signal, whereas a dry newspaper statistic is less likely to draw a response.

Finally, the amount that we personally can help is also a factor. If our efforts would amount to only a drop in the bucket we are less likely to help (e.g. we can help one starving child, but are discouraged when faced with mass starvation).

These findings have implications for a wide range of problems that humans face. Understanding these problems can help deal with the apathy confronted by those looking to fight against genocides, diseases and global warming, for example.

Western Union's Moat

noreply@blogger.com (Saj Karsan) — Fri, 10 Feb 2012 11:00:00 +0000

Western Union's (WU) P/E fell below 10 the other day as a weaker than expected outlook resulted in a share price fall of almost 10%. The stock now trades some 30% lower than it did in 2008 even though the company's profits are higher now than they were then as the company has clearly benefited from having a moat.

Western Union gets the vast majority of its revenues (and profits) from consumer to consumer money transfers. For example, an immigrant in the US will go to one of Western Union's 485,000 dealers with cash and send money to family in Mexico, where it can be picked up in a different currency from another Western Union dealer within minutes. Western Union has by far the widest dealer network and largest profits in this industry, giving it distribution and marketing scale that appears to have provided it with a competitive advantage.

As a result, consider the moat-like ROA and margins Western Union has enjoyed:

If Western Union's moat were to continue as is, it may make for a very profitable investment at a P/E under 10. However, could this moat be under attack? There may be a few ways in which Western Union's advantage may be eroded.

First, while Western Union does enjoy global economies of scale, other companies can take advantage of individual corridors without requiring global scale. For example, a company with distribution in the US and Mexico or India or China, for example, could become a regional competitor, matching Western Union in scale where it counts, on the most important money-transfer routes.

Second, while there are no larger competitors currently, there are larger potential competitors. Credit-card processing companies have worldwide distribution and could conceivably create competing products, while international banks could partner to offer competing services.

Third, potential disruption could occur through internet-based solutions. The growth of mobile communications is allowing developing countries to accept payment by mobile phone, whereas internet-based services like Paypal already enjoy significant mind-share in the developed world. As cash use declines and consumers migrate toward such solutions, Western Union's margins could erode further.

Finally, consider the extent to which these factors may already be playing a role. The charts above show that margins and ROIC have been declining of late. Further investigation also reveals that Western Union has recently reduced prices in some segments. A lack of pricing power suggests a moat may not be too strong. (Though in fairness, the price decreases could be the result of Western Union defending its moat from would-be entrants, which would lead to a stronger moat in the future.)

If Western Union's moat erodes, it could find itself in great difficulty. It has a ton of debt relative to equity, which it will be hard-pressed to pay off if Internet competitors erode margins quickly. If the moat stays how it is, however, the company will continue to throw off a ton of cash, using that money to buy back shares.

Whether you invest in Western Union, therefore, depends on whether it's in your circle of competence. If it is, you can determine whether their moat can be defended, or whether there is a strong chance that it may soon be eroded.

Disclosure: No position

Find Local Advantages

noreply@blogger.com (Saj Karsan) — Thu, 09 Feb 2012 11:32:00 +0000

I recently read a paper on competitive advantages in which many value investors will be interested. It's from 2005, so it does talk about Apple as being a company with no competitive advantage, but I think it has many useful elements nonetheless. The paper whet my appetite for Competition Demystified, which I look forward to reading very soon.

What do you think about the paper's conclusions? Do you buy this take on competitive advantages?

Follow Your Companies Full-Time

noreply@blogger.com (Saj Karsan) — Wed, 08 Feb 2012 11:19:00 +0000

Many value investors tend to favour quantitative over qualitative factors when evaluating stocks. Nevertheless, it is absolutely imperative that investors go beyond the quarterly reports in evaluating a company's prospects.

In the past, we have seen many instances where qualitative information gleaned from conference calls has been useful in determining the future direction of the business. For example, it was clear that Acorn International was under pressure to pay out some of its large cash balance. It was also clear that Quest Capital was intending to buy back shares as quickly as regulations allowed. Qualitative factors such as these allow investors to make more accurate quantitative assessments of a company's intrinsic value.

Throughout a quarter, in between conference calls and financial reports, companies will also release material filings. For example, companies often release filings that give an indication that buyout talks are ongoing, as Parlux has done several times. While this kind of filing may not change an investor's estimate of the company's value, it does certainly increase the likelihood of a catalyst.

For part-time investors, there are options that can make it easier to stay in touch. For example, one can subscribe via RSS to a company's filings or press releases. Investors then only have to consult their RSS feeder every now and then to see all the filings of all the companies they follow. Companies will make disclosures throughout the quarter, and the onus is on investors to follow along.

An mPad Is Cheaper Than An iPad

noreply@blogger.com (Saj Karsan) — Tue, 07 Feb 2012 11:45:00 +0000

Micropac Industries (MPAD) looks cheap...very cheap! It trades for $13.5 million despite net cash of $10 million and a profitable history: in the last four years it has total income of around $7 million. I read about this idea at Whopper Investments. If you don't already subscribe to that site, you should, as it has a number of actionable value ideas weekly.

Rather than just repeat everything he says about Micropac, I'll link just to his write-up of the company.

Disclosure: No position

I Don't Know

noreply@blogger.com (Saj Karsan) — Mon, 06 Feb 2012 11:29:00 +0000

What makes these three words (the title of this post) so hard to say? Does it suggest ignorance, incompetence or lack of intelligence? In the investing world, the phrase is probably not used enough, which may lead to the very dangerous state whereby one thinks one knows something, but really doesn't.

The author of Freakonomics (whose book is summarized here) takes a closer look at this phrase, and how its incentives are aligned in the business world.

You can listen to the podcast here, and check out the follow-ups here and here.

The Upside Of Irrationality: Chapter 8

noreply@blogger.com (Saj Karsan) — Sun, 05 Feb 2012 11:34:00 +0000

Through a series of experiments, Dan Ariely documents the many ways in which humans behave irrationally. By understanding these human tendencies, we can both learn to behave more rationally when it is to our benefit, and better understand why those around us are behaving in the way they are.

Markets are a useful way for coordinating buyers and sellers of a particular product/service. But they can sometimes fail. Ariely argues that they fail far more frequently than we realize, because we don't even know they fail a lot of the time.

To make his point, Ariely discusses a market that almost every human being goes through: the dating market. Years ago, families would engage the help of "market makers" to find mates for their young. But as the individualistic society in the West took hold, more and more responsibility fell on the potential mates themselves to find their partners.

This system may work well for some, but not for others. The world of online dating opened up new possibilities for these "others", but Ariely argues that the market still fails dramatically. Online dating sites treat people as products like cameras, where people list pictures and a bunch of searchable attributes. But just as you can't tell the taste of a cookie from a list of its ingredients, Ariely argues that people are experiential goods.

We have evolved certain ways of becoming comfortable with a potential partner, and the dating site market does not take these into account. Ariely ran a few experiments that showed greater satisfaction (from participants) when offered online dating that more resembles real-life dating (e.g. outside objects are introduced to the conversation, as would take place while at a meal or at a movie).

Such opportunities to improve markets are everywhere, according to Ariely. Creators of intangible objects often assume their users are fully rational beings that take all relevant info into perfect account. But as Ariely has helped to show, we make our choices based on emotion and other factors, and markets need to take this into account when they are designed.

The Upside Of Irrationality: Chapter 7

noreply@blogger.com (Saj Karsan) — Sat, 04 Feb 2012 11:03:00 +0000

Through a series of experiments, Dan Ariely documents the many ways in which humans behave irrationally. By understanding these human tendencies, we can both learn to behave more rationally when it is to our benefit, and better understand why those around us are behaving in the way they are.

Another way we adapt is in how we choose our mates or dating partners. Ariely notes that people of certain attractiveness levels appear to date others of similar levels (e.g. attractive people date attractive people, unattractive people date unattractive people), and he set out to find out how this happens.

Through experiments using Internet dating sites, Ariely was able to arrive at a few interesting conclusions. First, no matter how attractive we are (as judged by others), our scale of how attractive others are doesn't seem to change. That is, both unattractive people and attractive people rate others in a similar way.

But what does change is who we are likely to approach. We appear much more likely to approach people who are of a similar level of attractiveness to our own, even though we find others more attractive.

Through other experiments, Ariely finds that we do this by altering what we consider to be important in a mate. By stressing features other than attractiveness (e.g. sense of humour), we can actually make ourselves more attracted to someone who is nearer to our attractiveness level. This adaptation can serve to make us happy even when we are with someone whom we don't judge to be as attractive as others.

Virco Manufacturing Gets Smoked

noreply@blogger.com (Saj Karsan) — Fri, 03 Feb 2012 11:11:00 +0000

Virco Manufacturing's market cap has fallen from $50 million a few months ago to about $24 million today, giving it a P/B ratio of under 0.6. The company manufactures and distributes desks, tables, chairs and other furniture for the education sector. It is the largest such manufacturer for the preschool through grade 12 market in the US, and offers a range of services from installation to classroom design capabilities.

As state budgets have been hit hard since the recession, funding for schools has suffered. In turn, this has resulted in lower revenues for Virco, which has seen its sales decline steadily since 2008. Costs have not come down to the same extent as have revenues, as the company generated $12 million in operating income in 2008 but has lost $8 million in the last 12 months.

But that might be about to change. Following the busy summer season (which is when most sales to schools take place, in anticipation of the September start to the school year), Virco has taken action to cut costs in a serious way. Headcount is down 20% from the beginning of the year, as last quarter's results (a $3 million loss) include $4 million of expenses related to the job reductions.

As a result, the company may be in a position to post a profit in the next year, as long as revenues hold the line. To that end, the company's backlog for next year is up from last year at this time, though it is still early to draw any substantial conclusions. With a current price to sales ratio of just 0.15, however, it likely won't take much in the way of profits for current shareholders to benefit.

But an investment in Virco is far from easy money, as there are a number of risks. First, the company has a defined benefit plan that is underfunded by about $15 million. Second, 40% of the company's revenue is sold through a single contract (but to different customers). It doesn't expire until 2014, and the company believes that it can still sell to the same customers even without the contract, but there is a risk that it could lose some customers if the contract is not renewed.

But perhaps most important of all, the current management team doesn't seem to be particularly good. The company's founder, an astute and successful entrepreneur, left management of the company to his son. But things haven't gone so well lately. The company's book value has fallen from $90 million ten years ago to just $41 million today, with only about $15 million of that being due to buybacks and dividends. Sales are also 25% lower today than they were 10 years ago, and return on capital has been substandard.

It's also unlikely that someone can come in and clean up the mess. The family of the founder controls 40% of the company's shares, so it's unlikely that an unsolicited offer would be accepted.

Virco's shares haven't been this cheap since about 1993! Unfortunately, the company may deserve this valuation based on its record since the founder's retirement.

Disclosure: No position

Demystifying Advantages

noreply@blogger.com (Saj Karsan) — Thu, 02 Feb 2012 11:11:00 +0000

On this blog, you will mostly find discussion of low multiple stocks, as far as investment discussions go. That is, a company undergoing some temporary difficulty that trades at a low P/E or low P/S or low P/B will be discussed, with the hope or expectation that it will eventually return an average return on capital, thus rewarding shareholders.

While Warren Buffett has made money in this type of investing, he no longer practices it. Instead, he focuses on finding companies with competitive advantages. These companies generate superior returns on capital. But as a result, they don't trade as cheaply, prompting this quote from Buffett:

"It's far better to buy a wonderful business at a fair price than it is to buy a fair business at a wonderful price."

But how does one tell the difference between a wonderful and a fair business, assuming similar financials? If you can't tell the difference, you wouldn't be buying with a margin of safety.

csinvesting is a relatively new blog that focuses on just this type of investing. Request access to the site's Vault, where a number of resources (including books, case studies, lectures etc.) are available to help you in identifying and understanding competitive advantages.

Enjoy!

LS Starrett Shows Jump

noreply@blogger.com (Saj Karsan) — Wed, 01 Feb 2012 11:06:00 +0000

Almost two years ago, LS Starrett (SCX) was discussed on this site as a potential value investment. Having appreciated some 50% since that time, the stock now trades much closer to its intrinsic value than it did before. In so doing, it becomes the latest stock to join the Value In Action page, providing the following lessons along the way:

1) You've got to dig deeper than the financial statements. SCX was a net-net but you wouldn't know it from a surface glance. That's because the company has a significant amount of inventory classified as LIFO, whereas most financial statements (and a more accurate current view of inventory) is FIFO. This inventory difference was worth $30 million, whereas the company's market cap was only $60 million!

2) It can take time to realize value. Investors are obsessed with quarterly and sometimes even monthly performance, but that's what allows long-term investors to profit. Sometimes, there is no catalyst in sight, and no reason to believe shares will appreciate any time soon. But buying something for less than its worth, and applying a little patience can go a long way.

3) Don't worry about short-term price fluctuations. SCX shares fell more than 20% before they started moving higher. Prices may change frequently, but business values probably do not. Investors who don't just ignore Mr. Market's emotions, but also capitalize on them by buying more when even cheaper prices are offered would have done even better with this stock.

SCX may still be undervalued, as it continues to trade at a discount to book value. But returns on capital have been low, suggesting some discount is justified. As such, it might be a good time to pull capital out of this stock and apply it towards stocks trading at bigger discounts to intrinsic value.

Disclosure: No position

SuperValu LBO Update

noreply@blogger.com (Saj Karsan) — Tue, 31 Jan 2012 11:53:00 +0000

Several quarters ago, SuperValu was discussed on this site as a potential opportunity for regular investors to participate in what looked like a leveraged-buyout type investment play. A few months after that article, shares were higher by about 25%. But today, shares of SuperValu can be had for 20% cheaper than their price when that article was published, even though the company is less risky now than it was then!

The biggest risk to this company is its large debt load (as is common in LBO situations). This is what the company's debt maturities looked at the time of the original article (note that the company generates about $1 billion per year in operating cash flow):

Fast forward a few quarters, and now added to the above chart are the debt maturities the company faces today (in red):

Through a combination of repayments (from SuperValu's ability to generate steady cash flow) and refinancing, the company looks a lot safer today. But even though the debt is lower, so is the market value of equity! With operating income steady at around $1 billion per year (adjusted for Goodwill and intangible write-downs that were created through acquisitions of a previous management), this leads to an EV/EBIT ratio of just 7.5.

With further debt repayments on the way (management expects to pay down $750 million more over the next two years from internally generated funds), that ratio should continue to shrink unless the market value of equity rises or EBIT falls. On future EBIT, the company's cost-cutting efforts are going well, which has allowed SuperValu to cut prices while maintaining margins. This should lead to increased competitiveness, holding the company's EBIT steady at the very least.

SuperValu's LBO-like characteristics are still present, but the company is safer and cheaper now than it was in the past. This opportunity may offer strong upside potential for those willing to take on a bit of downside risk.

* Note that the charts do not include SuperValu's capital lease obligations of approximately $1 billion

Disclosure: Author has a long position in shares of SVU

Mirage Of Rimage's Cash

noreply@blogger.com (Saj Karsan) — Mon, 30 Jan 2012 11:44:00 +0000

Last year at this time, Rimage looked like an attractive stock. It had both a ton of cash relative to its market cap, and a steady source of cash flow such that it could generate a great return for shareholders. But as discussed here, what it lacked was a corporate structure conducive to creating wealth for shareholders. As a result, today the stock sits some 20% lower, and the value of the company has probably fallen by more than that.

Though Rimage had $118 million of net cash (compared to a current market cap of just $121 million), it blew more than $50 million in early October on an acquisition in a high-tech field (video communications). The acquisition generated revenue of just $2 million in the fourth quarter, but management appears to expect revenue growth of 40% per year for this business. (How could this possibly go wrong?)

Of course, anything's possible. Maybe this will turn out to be a great acquisition. The problem, though, is that certain returns (in the form of share repurchases that could have been done at a very cheap price) were traded for highly uncertain or non-existent returns. This likely occurred because of the corporate structure.

The company's CEO owns just over $1 million worth of Rimage stock, but his annual compensation is over $1 million as well. As such, he is likely to benefit far more from running a bigger company than from creating wealth for shareholders. He is also on the company's board of directors; but directors are supposed to represent shareholders! Clearly this is a conflict of interest.

Though a company may look cheap, an analysis of its corporate structure can help shareholders foresee the risks created by conflicts between principals and agents. Such an analysis of Rimage would have saved some value investors a lot of heartache.

Disclosure: No position

The Upside Of Irrationality: Chapter 6

noreply@blogger.com (Saj Karsan) — Sun, 29 Jan 2012 11:39:00 +0000

Through a series of experiments, Dan Ariely documents the many ways in which humans behave irrationally. By understanding these human tendencies, we can both learn to behave more rationally when it is to our benefit, and better understand why those around us are behaving in the way they are.

Humans underestimate their adaptive abilities. As a result, they overestimate the impact some event will have on their happiness.

Ariely tested people who have been through severe pain, and found that their pain thresholds were significantly higher than those of a control group. He surmises that subconsciously, humans even adapt to pain.

While we adapt very well (as do other animals), what we don't do well is account for our ability to adapt. For example, we make purchases thinking they will make us happier. But while that new car or new sofa makes us happy in the short term, in the long term we adapt to the new state and the temporary happiness wears off.

As a result of some experiments Ariely cited and conducted, he offers some ways to shorten pain and prolong pleasure as a result of our subconscious adaptations. The first thing to know is that interruptions slow adaptation. Therefore, get a painful task (e.g. your taxes) done all at once, but take a break from (and then return to) your warm bubble bath (assuming that's how you derive pleasure) if you want to enjoy it more.

We also adapt slower when we compare our situations to those of others. We like to "keep up with the Joneses", unfortunately, and feel bad if we don't. But the good news is, you do get to control who you keep close. So keep "Joneses" around with whom you don't feel bad in comparison!

The Upside Of Irrationality: Chapter 5

noreply@blogger.com (Saj Karsan) — Sat, 28 Jan 2012 11:38:00 +0000

More PE10 Shortcomings

noreply@blogger.com (Saj Karsan) — Fri, 27 Jan 2012 11:49:00 +0000

The PE10 is a useful ratio that aids the investor in determining the relative price level of the aggregate stock market. But as discussed on this site a few days ago, the metric is far from perfect, as the arbitrary use of a 10-year period can bump up or push down the measurement for normalized earnings, thereby biasing the ratio. Another major weakness of the PE10 as a tool for making historical comparisons has to do with a change in how corporations have returned money to shareholders.

It used to be that dividends were the main method by which corporations paid shareholders. But for various reasons, buybacks appear to have become the preferred choice for corporations looking to return cash to shareholders.

As it pertains to current year earnings, whether corporations doled out returns in dividends or buybacks in the past makes little difference. But because of the way Standard and Poor's records the earnings of the index (using the sum of bottom-up earnings per share), this can have a major effect on past years' earnings.

For example, if the index earned $1 in EPS in 2001, and since then companies have bought back 50% of their outstanding shares, the real "earnings power" represented by that $1 is actually $2.

This concept is perhaps easier to grasp with respect to individual companies. Consider GameStop's quarterly earnings, which show just over $50 million in after-tax earnings in the third quarter of both this year and last year. While the absolute earnings are roughly similar for both years, GameStop has seen more than 10% growth in year-over-year diluted earnings per share as a result of share buybacks. Which number do you think is more relevant, GameStop's EPS pre-buyback, or the fact that it earned just over $50 million in both years? I would argue that the latter is more relevant, and that the former can bias the earnings estimate lower.

Considering the fervor with which companies bought back shares this past decade, this difference can have a significant impact on the estimate of the index's normalized earnings level. Unfortunately, it's difficult to quickly adjust the formula to correct for this problem. The level of share buybacks is inconsistent from year to year, and shares have been repurchased at various prices, ranging from extremely high to extremely low.

Related to this problem is fact that the size of the capital stock has changed. As companies have re-invested the earnings that they have not paid out in dividends or used to buy back shares, they now have larger capital bases from which to earn profits.

Fortunately, there are other methods that can be used that are in keeping with the spirit of the PE10, without suffering from these drawbacks. For example, one could average the index's ROE over the last ten years, and multiply that number by the index's current book value in order to arrive at an estimate for normalized earnings. My rough calculations with imperfect data suggest a PE10 of around 19, and a PE8 of around 18.

Of course, this method still suffers several drawbacks. The biggest problem with using ROE, for example, is that it doesn't correct for different levels of leverage. Higher debt can result in higher ROE, but that doesn't mean these higher levels are sustainable.

Fortunately for value investors, we don't have to spend a lot of time valuing the market. Knowing that it is approximately fully-valued or somewhat overvalued is good to know in general, but our money is made with individual stocks. Figuring out how to make money on the index is a lot harder than it is with individual stocks, since with individual stocks you only have to swing at the most attractive pitches.

PS More shortcomings of the PE10 are available here.

Intimidation Tactics In The Market

noreply@blogger.com (Saj Karsan) — Thu, 26 Jan 2012 11:39:00 +0000

More frauds are being uncovered in China. This article tells the story of one hedge fund manager who is being sued for what appears to be a factual report. Some snippets:

"Everything Barnes wrote was backed up by veteran investigator accounts, photos, multiple onsite interviews and the company’s Chinese filings."

"If he stood by his report, as was his wont, his less than a year old fund would be engaged in a multi-year legal battle with a company that had nothing to lose and could use its working capital to pay its legal bills."

"On August 1, another person called the Absaroka lawyer and told them to drop the investigation or else the caller “Would come down hard on [the lawyer.]”

There is also the possibility that the fraud goes much higher up the food chain than this one company. Apparently, the company's statements filed in China (which were vastly different than those filed in the US in terms of claims of the company's size) have gone missing!