Oddball Stocks

Questions for the Solitron Board of Directors

2013-06-17T09:35:00.002-04:00

I am in Palm Beach mentally preparing myself for the Solitron annual meeting tomorrow. This means I've been sitting on the beach, enjoying the sun, relaxing and eating fresh seafood. I wanted to post the questions I intend to ask at the meeting tomorrow, and solicit other questions from shareholders. I'm not sure how many questions I will get to ask, but I will try to get in as many as I can.

I'm expecting to post again tomorrow with a summary of how the meeting goes, so stay tuned. For anyone new to the Solitron situation I have a short summary below. For everyone else skip straight to the questions.

Solitron Recap

In 2010 I discovered a tiny profitable net-net, with a slug of cash on their balance sheet. The company had a number of liabilities stemming from their bankruptcy in the 1990s. I wrote a number of posts detailing the investment case for the company, and ultimately waited for something to happen.

I eventually wrote a letter to the Board, urging a stock buyback and encouraged them to hold an annual meeting. After hearing an outcry from investors (including one filing a lawsuit) the company acquiesced .

In the meantime the company paid off all of their known environmental liabilities stemming from their bankruptcy. The company is now a pile of Treasury bonds with a profitable electronics manufacturing company attached. It's worth noting they are still undervalued, according to some measures significantly so.

The annual meeting is tomorrow at 9am at the firm's law offices in central Miami. I was disappointed by the location considering their facility and headquarters are than 10 miles from where I traditionally stay when in Florida. I would have been nice to see their facility from the inside as well.

I have written too many posts on Solitron to link to each, so here is the Google link for all of them.

Solitron Board Questions

Are there any residual liabilities from the bankruptcy that are off balance sheet or haven't been noted?
Why hasn't the company grown in the last decade? Especially in light of the extraordinary defense spending and growth rich environment.
What is your approach to target new markets?
Has your customer list changed much in the last decade? Have you gained new customers?
How has the sequester affected your business?
What accounted for the $190k increase in SG&A this past year?
How do you measure the business?
What is your standard of success?
Do you consider Solitron successful?
Why haven't you hired a CFO?
[Statement] As a shareholder I, and others would be happy if the company paid more per year for an audit if the auditor would remain the same year over year.
Have you considered taking the company private?
Is the company more likely to execute a dividend or buyback with the excess cash?
What is holding the company back from distributing excess cash to shareholders?
If the company pays a dividend or buys back shares, and shareholders become less vocal will you discontinue annual meetings and stop listening to shareholders again?
Have you considered an acquisition?
What would you look for in a potential acquisition?
Would you consider using debt to finance an acquisition?
How would you evaluate a potential acquisition target?
[Statement] As a shareholder, seeing how the business has failed to grow in the past decade I would prefer the company give cash back to shareholders, instead of attempting to grow the business through an acquisition.

If anyone has anything they wish to add to this list leave a comment. Fair warning, I might be slower to approve comments, I will have my phone at the beach, but won't be checking it as often, please be patient!

Talk to Nate

Disclosure: Long Solitron

Purchasing Bexil at a discount through Winmill

2013-06-14T01:30:00.003-04:00

I've never had a reader email me asking what I consider an oddball stock. Maybe my posts do the talking for themselves. I find most of the companies I research and write about are not all that odd, they're just not mainstream mid/large cap names that most investors are familiar with.

Many investors appear to be drawn to complexity. There is a certain intellectual challenge to a complex situation. Complexity doesn't interest me that much, I prefer simplicity, but what I really enjoy are things that are hidden. Complexity is good for experts, hidden things are good for individuals, professionals (most) can't be bothered to look. I enjoy researching stocks where information is very hard to find. The research process is like a treasure hunt, each piece of knowledge I pick up is either discarded as useless, or exceedingly valuable. Anyone can go on these treasure hunts, but most would rather not waste their time. Some of my favorite stocks are very simple investments, but very hidden. For many outside investors this process appears complex, it's not complex, just different.

The stocks I want to talk about in this post might appear complex, but keep in mind the above paragraph. The investment story is very simple, it's unraveling the details that's difficult. Winmill (WNMLA) and Bexil (BXLA) are hidden, but not complex, what they are is utterly fascinating. This post might seem complicated, but I would encourage you to read to the end, I think the reward is ample.

I was alerted to Winmill & Co almost exactly one year ago by a reader. I read their website, and eventually ended up on the Bexil website. Recently another reader suggested I take a look at them. I look at a lot of stocks, but if I find myself drawn into a story, and spending an inordinate amount of time reading and researching an idea, I will usually write it up.

Winmill & Company is an investment advisor to a number of mutual funds, both open and closed end. The company's funds pursue very narrow strategies, such as gold funds. Of the Midas Funds, one invests in the Harry Browne perpetual portfolio. A second one, the Midas Magic held 25% of its assets in Berkshire Hathaway, and 20% of its assets in Mastercard. Incredibly 45% of the funds assets are in two stocks, which by the way are both holdings of mine as well, although I'd never recommend anyone make 45% of their portfolio out of those stocks.

When visiting Winmill's website, one might get the impression the company focuses on asset management. This might actually be the second impression a visitor might get, the first is the feeling that they were transported back to the information superhighway circa 1996. The only thing missing from Winmill's site was some blinking text and little animated gifs of spinning dollar bills. This is a complete total digression, but I'd love it if some finance researcher did a study on the stock performance of companies that have dumpy websites vs companies with slick websites. My gut says that the dumpy website companies would come out ahead.

The value of Winmill's asset management business is unknown, but what is known is their stakes in two much larger companies, Bexil and Tuxis Corporation. All three companies are controlled to various degrees by members of the Winmill family.

Tuxis is a self-storage and real estate company located in Connecticut. They are non-reporting, but as of 2007 they had an equity value of $7m. As of 2007 Winmill owned 25% of Tuxis, I haven't been able to find further details, but given the Winmill family's tight reign on this operation I would presume the stake hasn't shrunk.

The much more interesting Winmill holding is Bexil Corporation. Bexil is a holding company that is engaged in securities trading, investment management, and mortgage banking. Winmill owns 222,644 shares of Bexil.

The company trades securities on their own account, and manages a dividend and income closed end fund. Close to 50% of the company's revenue is attributed to their trading and investment management activities.

Bexil's annual report will be a familiar read for investors who have read the Berkshire Hathaway annual report. Bexil considers themselves successful if they are able to grow book value per share over the long term. Because so much of the company's results are due to trading gains, and the sale of subsidiary companies, management feels that book value is a justifiable measure. I agree with a few caveats, the first is that while book value has been growing the share count has been growing almost as fast. The second caveat is there appears to be some wiggle room as to what the company's exact book value is due to the nature of their operations. This isn't necessarily a bad thing, but just something to watch out for.

The story with Bexil became much more interesting late in 2012. The company decided that they wanted to enter the mortgage origination business. Mortgage origination is a business where a company finds a borrower, lends them the money for their mortgage, then sells the mortgage to the government. The originator can service the mortgage and make a profit on servicing. Bexil wanted to enter this market, but didn't have the resources to do it on their own. They formed a subsidiary Bexil American Mortgage and funded it partially themselves, and partially with outside investor money. The outside investor is Alex B. Rozek, a name that probably isn't familiar to most. Alex is Warren Buffett's great nephew, the B in his name stands for Buffett. Alex manages a hedge fund in Massachusetts called Boulderado Partners LLC. A side note is that Alex proposed to his then girlfriend at the end of a Berkshire shareholders meeting a few years ago. Alex not only provided seed capital for the mortgage origination business, but he's also a significant shareholder in Bexil.

Attached to Bexil's 2012 annual report is a two page discussion by Alex explaining why he believes mortgage servicing and mortgage origination are the perfect businesses to be entering right now. The short summary is there are few companies qualified to do this business, and government barriers to entry are so high it takes years to complete an application to compete. Bexil American already has all of the required certifications and approvals to operate.

Bexil's balance sheet is hard to parse due to the consolidation with their mortgage origination business, the CEO even states this in his annual letter. The important parts worth noting are that Bexil has $30.7m in equity, and $15m in cash and securities. They have a lot of debt, but it's warehouse borrowing related to the mortgages they originate. A balance sheet is a snapshot in time, and the mortgage subsidiary's books are always fluid with loans moving in and out quickly. So the snapshot preserved for the annual report most likely bears no resemblance to their current balance sheet.

Bexil American isn't profitable yet, but if an investor believes the story that Alex and management are promoting it should be profitable soon, and when it is the company will be gushing money. Alex states that a mortgage originator can expect 100% returns on their capital if they do things right.

When examining Bexil through the filter of their latest results, they don't look that cheap at current prices. The company has a market value of $49m against a book value of $30.7m. The company has consistently lost money, and until recently was steadily growing book value per share.

The twist in this investment comes with Winmill, they own 222,644 shares of Bexil which at current prices is worth $11.187m. They also own 25% of Tuxis, which is worth about $400k. An interesting side note, Tuxis might be worth a look, they are trading at 18% of their 2007 book value. Both of Winmill's public subsidiaries are worth $11.5m in total. Winmill's own market cap is $3.045m, meaning they are trading for less than the value of their subsidiary stakes alone. The market is valuing their investment management business at less than zero. Winmill also historically had some cash and securities on their balance sheet, let's call it $2m. Their historic liabilities were close to zero.

When you add all of the holdings up, and toss back in Winmill's presumed cash and securities the investment starts to look like a dollar selling for $.22. Investors are able to purchase Bexil at a steep discount by purchasing Winmill. Additionally if the Bexil mortgage origination business does as well as management thinks it will both Bexil and Winmill will benefit.

Talk to Nate

Disclosure: Long Mastercard, Berkshire Hathaway

The importance of expectations

2013-06-10T01:04:00.005-04:00

I've had a post on a Greek net-net bouncing in the back of my head for a few weeks now. As I've thought about writing that post I kept reading articles and blog posts where either readers or authors had unreasonable expectations. It occurred to me that I've never clearly talked about my expectations for investments, and why they are important to the investing process.

This post probably crosses into the life advice category as well, but I've found that most life advice that's good advice is applicable to investing, good advice is universal.

Nothing can demotivate as quickly as unreasonable expectations. This is just as true in finance as it is in marriage, or in a career. Twenty-two year old's who expect to be sitting behind the mahogany desk on the top floor in three years are in for a rude awakening. Individuals who expect marriage to be all bliss will be disappointed. Investors who dig deep and do a lot of work on ideas and expect them to all go up will be disappointed.

There are two sets of expectations when it comes to investing, the investor's own expectations, and other investor expectations. I want to talk about both.

Other investors

This is the easiest set to talk about; the expectations of others. When the expectations of the market don't align with reality an opportunity exists. Generally expectations are either overwhelmingly negative, or overwhelmingly positive.

An example of positive expectations can be seen when looking at any media darling growth stock. The stock is modeled to have 15-20% earnings growth from now until eternity. Simple models like this fail the Peter Lynch test. Lynch talks about thinking of real world implications. He mentions in his book reading a growth forecast and realizing that every person in the US would need to buy the product for the forecast to come true. An expectation like that is unrealistic, and thus the stock is selling with too rich of a valuation. Think about how many units would need to be sold to make estimates reasonable as a way to test the market.

Where I spend most of my time is evaluating negative expectations. Many companies I decide to invest in have been left for dead by other investors. Investors either expect the company to remain dead money, or to always trade in some tight range that's perennially low.

The key to being a successful value investor is determining the expectations the market or other investors are making regarding a stock, and then comparing those expectations to the facts, or the truth.

Sometimes investors have bad expectations because they don't have all of the information needed to make a correct decision. Missing information leads to an informational advantage for investors with the information. The better information also allows better estimates for what an investor might expect to happen in the future for a company.

I think too many investors get hung up on getting an information advantage. Instead investors should aim for creating a patience advantage. In many value stocks the selling owners are shareholders who've owned the stock since it was a high flyer. The stock has fallen, the company has deteriorated, and they are finally throwing in the towel. These are ideal sellers. I get nervous when I see that most of a stock's ownership basis is value investors, or the only people talking about a stock are value investors.

Our own expectations

Here is a simple life lesson, people will talk endlessly about things that don't affect them. People will talk about things that affect them if action isn't required. If there is an issue that affects someone, and it requires the person to act it will be met with silence.

To become better investors we need to face our own expectations. I've received emails from readers who tell me they're only interested in stocks that will triple, or go up 5x in three years. Sure, I'm interested in those stocks as well. If someone can email me where to find only those stocks I will sell everything I have for them. I've had readers tell me they only want 20% returns, or they only want high quality net-nets. A high quality net-net is an oxymoron, they don't exist, if a company is trading below NCAV there is a problem, guaranteed.

Why are our expectations regarding returns so incorrect? I think some can be traced to Buffett, he famously quipped that he could guarantee 50% returns on $1m invested. This is like Michael Jordan guaranteeing that he could single handedly beat any high school team in game of pick up ball. With sports we recognize that superstars are naturally talented, and no matter how many hours we practice, 10,000, 20,000, we will never be able to perform at their level.

Yet Buffett seems so simple, he has this folksy wisdom, and he talks about how he just buys these good businesses and somehow he'd do 50% a year. The sale pitch is enticing, and we start to believe if he could do 50% why can't we? Just like we're not Michael Jordan, we're not Buffett either. Knowing ourselves sets the basis for creating reasonable expectations.

Setting reasonable return expectations should lead to better investing decisions. If my bogey is 25% a year and I'm only able to do 18% I might start to take on extra risks in an effort to juice returns to meet my goal. I remember seeing a quote that 40% of investments fail, it's keeping the number of failures to a minimum that drives returns, not a few 30-baggers. It's fairly easy for a company to go to zero, all they need to do is stop selling and spend down all of their cash, default on their debt and setup an appointment with the bankruptcy court. It's very difficult for a company to double their sales, or triple earnings.

The second area of personal expectation setting is the time frame required for an acceptable return. A friend of mine sent me a note months back stating that he set up a test portfolio in Yahoo with a number of stocks he had given up on. He went back and looked at it and they were all trading higher, many at or above his original estimate of IV. My friend is extremely patient, but no one is patient forever. The longer we're willing to wait the better chance we have of an investment idea working out well.

I want to take a journey down a tiny rabbit trail for a second here. I've had a few comments asking why I prefer to invest in profitable net-nets when research shows that the unprofitable ones end up doing better return-wise over the long term. The reason I prefer profitable net-nets, or profitable low BV companies is because the profit gives me time for the investment to work out. I can sleep well at night knowing a company isn't frantically spending down their cash pile. Impending doom can be a motivator, but impending doom is also a stressor. I prefer investments that might return less, but the tradeoff is I am willing to hold on to them over a long period and be patient.

I've come to appreciate that investments always take much longer than I expected to work out. This is why investors seek out catalysts, it's an effort to reduce patience. I'd rather work on my patience skills, because there are a lot more investments without catalysts out there, than with them.

Another pet peeve expectation is liquidity. I realize that I probably have some readers who are tossing around serious money in the market, this isn't for you. This is for everyone else who wishes they had a Ferrari, but really only has a Corolla. It's possible to build, and liquidate positions in illiquid stocks with smaller amounts of money. The key is patience and having a reasonable expectation. In the past selling a stock used to involve going to the bank, taking the certificate out of the safe deposit box, driving to the post office, mailing it, and waiting. Now we click a button on the computer and complain how illiquid a stock is when we don't have a fill in 15m.

We could all use a deep peer into our souls and examine our expectations. Are we expecting too much, are we expecting too little? Are our expectations causing us to make bad decisions? The secondly look at the expectations others in the market have for companies we own. Are there opportunities to take advantage?

Talk to Nate

Solitron proxy voting guide

2013-06-03T00:56:00.002-04:00

I have written about Solitron Devices extensively on this blog. I write about the company, not because I have a large position in them, but rather because the story is so interesting. For readers who don't wish to spend their morning trolling the archives I will give a very quick summary below.

Solitron is a Delaware corporation that makes electronic diodes and components for the aviation and defense industries. The company went through a bankruptcy in the early 1990s and recently settled their remaining outstanding liabilities related to the bankruptcy. For years the company traded below NCAV, where most of their NCAV consisted of Treasury bonds, and cash. The company's operations are small, but efficient, and most importantly profitable.

After owning the stock for a while I became fed up, I was off-put by the brash CEO, and the lack of shareholder focus. I eventually wrote the company a letter asking for a share buyback and the instatement of an annual meeting. My letter got the ball rolling, other shareholders began to contact Solitron and push company into action. One small fund sued the company as a means to force them to establish a date for the annual meeting (June 18th, 9am in Miami FL.) I have felt that my letter, and subsequent posting of it on this blog got the snowball rolling. I can't take credit for anything subsequent my letter, but I do feel that I got the process moving.

I have a lot more thoughts on this topic in general, and with regards to the shareholder/management relationship problem, but I want to keep this post focused. I will save those thoughts for some point in the future.

I received my annual report and proxy in the mail recently:

Both are available online through EDGAR as well.

I thought it might be helpful to walk through a few issues in the proxy that are up for a vote, and voice my opinions on them. It would be much easier to say "Vote Yes on a,b,c.. No on d,e,f.." but instead of spoon feeding my views I'd rather share my opinion on these issues.

Director Election - Up until recently the Board of Solitron could be summed up as follows: a CEO and two empty leisure suits. Of the three members of the Board, two seemed to be missing in action, they will not be getting my vote. One of my goals in establishing an annual meeting was so the company would allow shareholders to vote on the Board. We need fresh faces on the Board, removing Jacob A. Davis, and Joseph Schlig is essential.

The company recently nominated two other new directors for a short term, they are also up for re-election at the annual meeting. I voted against the two new candidates as well. I don't wholly trust the current Board's judgement, and since the new nominees were nominated by the current Board by proxy I don't like them either.

Another reason to vote against Joseph Gerrity and Sidney Kopperl is that the company changed their bylaws so that director elections are staggered. It would take three years for the full Board to be replaced. The last thing I want are two more potential bad Board members voted in for three years.

I voted for Saraf to remain on the Board, I voted against the other four nominees.

Ratification of Accountants - This is often the easiest item to vote on a proxy. Most companies keep the same accounting firm year to year and the vote is more of a formality.

Solitron is different, they have a habit of firing their accounting firm yearly and bringing in someone new as a way to save costs. This is a practice I'd like to see discontinued, and an item that's hopefully raised at the annual meeting. If no one else raises it, I plan to. I voted for the ratification, but intend to question the Board as to why they think this is a good practice to save a few thousand dollars, but alienate themselves from the investor community.

Say on Pay vote - Shareholders are allowed a non-binding vote on executive compensation. The company doesn't have to listen to shareholders, but this is a way for the company's owners to loudly voice their view on what management takes out of the company each year. Smart companies listen to their shareholders, and if shareholders vote against pay they revise it.

I voted against this item. The only executive is Shevach Saraf, the CEO, who made $403k last year. This was up from $380k the year before. I recognize that in the grand scheme of things $403k isn't an egregious salary for the CEO of a company that does $8m in sales. On the other hand Soliton has been treading water for almost two decades in terms of profitability. I don't see why shareholders should regard a CEO who is essentially babysitting a company with a paycheck for $403k. If the company were growing, or shareholder friendly I would reconsider in the future.

Frequency of pay advisory vote - With the passage of Say on Pay shareholders have the choice on how often they want to voice their view of management compensation. The choices are 1 year, 2 years, or 3 years. Naturally management doesn't want the owners meddling in their affairs, Solitron has suggested that every three years is an appropriate time for shareholders to vote.

I disagree with this and firmly believe shareholders should be voting on compensation yearly.

Conclusion

I am interesting in any differing thoughts or views on the proxy that shareholders, or any readers have.

I will be attending the annual meeting in person, the meeting is on June 18th at 9am at the offices of Akerman Senterfitt in Miami Florida. I have informally talked to a few other shareholders and we are planning on grabbing something to eat after the meeting. If anyone is planning on being there you're invited to join us and talk about Solitron, micro-cap stocks, value investor, or really anything afterwards. If anyone has any suggestions on where to eat within walking distance of the SunTrust building in Miami they would be helpful too.

Talk to Nate

Disclosure: Long Solitron

Advice for newly minted college graduates

2013-05-29T00:28:00.002-04:00

This time of the year is college graduation season, and attending a graduation party this weekend put me into a reflective mode. I've been thinking about my own trajectory after college, and what things I might do different if I could go back 10 years and re-live my 20s.

In most posts I put a little disclosure at the bottom stating if I'm long a stock or not. For college advice my disclosure has been moved up top. I'm not the person to take college advice from, or probably even career advice. My university was probably glad to have me gone because I was dragging down the student body GPA average. If school GPA meant anything in life I've be sweeping floors or flipping burgers right now, fortunately it doesn't.

1. Be open minded - Life never goes the way anyone plans, so be open minded and look for new opportunities.

When I graduated 10 years ago I didn't know what a stock or a bond was, and I didn't really care to know. If someone would have told my then-self what I would be interested in today I would have wondered what happened to interest me in such boring things. I remember some friends taking finance classes in college, at the time their studies looked like some sort of prison torture. Now ten years later I enjoy researching and writing about investments.

Interests change, be willing to change with them. No one's life is pre-destined to go a certain route, no matter what your parents might say. Be adaptable and be willing to try new things.

2. Get out of debt and stay out - You graduates are deep in the hock, I feel bad, and I'd recommend paying your debt off as quick as possible. Sure, maybe those loan payments are small and affordable. Sure, maybe that payment for a brand new car is small and affordable. Sure, maybe the mortgage is small and affordable. Small payments start to add up quickly into a large fixed obligation that needs to be paid monthly or else some banker will come and take all of your things.

Being debt free means being flexible. It gives you the ability to take a lower paying job if you need to, or save more for a rainy day. Our culture is one of debt and living for today, saving and paying cash are things our grandparents did, it's not a bad habit to get into. It always seems like the spendthrifts get the last laugh, but to live a debt-fueled life means living with considerable stress. Remember, if you pay off all your debt and decide it was a mistake you can always borrow again.

Here's something else not many people will tell you. You just escaped four years of living in a barn, er dorm and with your new found riches want to experience a little luxury. Don't waste your time keeping up with the Joneses. All those luxury items you have been craving aren't all that great, the feeling of euphoria wears off quickly.

3. Enjoy your youth - You are only young once, so enjoy it. This doesn't mean partying late into the night as most people think, but doing things that are best enjoyed while young. If you have any inclination for endurance sports now is the time to get involved. As you age your body doesn't recover quite as quickly, and things that used to be easy become harder.

Last year a friend and I decided to ride our bikes to DC in a weekend. We covered 200 miles in two days, it was a lot of fun, but my body paid the price. I injured my knee and it's taken almost a year to recover. I'm back to running and biking again, but I've also realized I'm not 16 or 22 anymore, I now ease into things and build up mileage slowly.

Travel is easier when you're younger and don't have kids. Almost anything is easier before you have kids, do those things now.

4. Don't marry your job - No matter how hard you work your company will never love you. All those all-nighters and 80 hour weeks will mean nothing when layoffs come.

Work hard at your job and use it as an opportunity to learn. When you've learned as much as you can, or feel it's time to move on do so without hesitation. If the company felt it was time to move on they would eliminate you without hesitation.

5. It's not what you know, but who you know - I went to an entrepreneurship conference back in college and I remember a millionaire entrepreneur walk through this little exercise. He asked all of the A and B students to stand-up (I continued to sit) and look around at everyone sitting. He then said "Everyone standing, those sitting will be your future bosses." His reasoning was that people with lower grades were most likely partying or hanging out building personal connections instead of studying. In the real world it's the people with the biggest network who get ahead, not the person with the biggest brain.

We're taught all through school that the brightest do the best, and that intelligence is rewarded. If that were so why aren't scientists rich, or the people from NASA living in the Hamptons? The truth is if someone has average intelligence but great people skills and some hustle they will do very well for themselves. Even below average intelligence and above average hustle is a successful combination.

A former boss had some relatives who weren't the brightest, one even had trouble reading. What these guys lacked in the brain department they had in the hustle and street-smart department. They turned their summer lawn mowing business into a multi-million dollar landscaping empire. These guys together are worth close to $10m, yet one of them has to have his wife read him the menu at a restaurant.

For anyone out there who didn't graduate in the top of their class there is hope. Not having an Ivy League education isn't going to be the hinderance that Ivy League schools try to tell you it will be.

6. Remember your family - This is lower on the list, but the list isn't in any particular order. Right now you probably only have parents and siblings, no wife or kids. As you get older family should become a top priority.

Friends will come and go, but your family will always be around. Make sure to invest in these relationships. You'll probably come to realize over the next few years that your parents really weren't out of touch, and they are a lot smarter than you ever realized. This will be hammered home once you have kids.

For most the legacy they leave is their children. A few very wealthy people build libraries and fancy buildings, the rest of us don't have that. I'd prefer to touch people's lives rather than have my name plastered on some granite building. Someone who was influenced remembers you, most people don't actually know what Carnegie or Rockefeller did. My legacy is the two little boys who greet me each night when I come home. It's hard to build character in children if you're never around, always traveling or working late.

7. Find your purpose - A person without a purpose in life is like a ship adrift being knocked in any direction with the waves. Find a purpose and anchor yourself to it. This is a tough question that most people don't want to face, but it's imperative. Our purpose is what drives us through life, it gives meaning to what we do, even the mundane.

8. You will make mistakes - No one is perfect, you will mess up, and you will probably mess up big time. If you strive for perfection you will live a life of disappointment. Everyone makes mistakes, own up to them quickly and be honest, then work to correct them.

Hopefully something in here will encourage someone! The truth is some of the ideas in this post will be far more profitable than any company I ever profile on this blog. These lessons pay dividends for life.

Talk to Nate

A retail turnaround with asset backing, and a catalyst

2013-05-24T11:39:00.000-04:00

A struggling retailer with a large amount of fixed real estate assets; a few companies come to mind like JC Penny and Sears Holdings. While both of those companies fit the stereotype, the company I want to look at in this post is Kirkcaldie & Stains, a New Zealand retailer.

Kirkcaldie & Stains (KRK.New Zealand) is a retailer (department store) that has been in business for 150 years in Wellington, New Zealand. The company originally owned the building they were located in, but over time sold it off. The company doesn't actually own the building that holds their flagship retail store, and in 2001 to rectify the situation purchased the building adjacent to themselves. The company breaks results into two segments, retail and property. Both have struggled for the past few years, but there are signs things are turning around.

I'm not usually a fan of turnarounds, there are too many variables that need to come together for an investment to work out. For a retail turnaround to work the retailer either needs to reduce expenses if they're bloated, or more likely bring in new brands and increase store traffic. For Kirks, who is experiencing declining sales volume, cutting expenses alone won't bring the company to profitability.

In terms of a retail turnaround the company has a lot of low hanging fruit changes that they are implementing in an effort to gain customers. Up until this past year the company didn't have an online store, they just recently started selling online. They have also started to carry well known international fashion brands. In an effort to reduce costs the company moved their back office operations to a lower rent area nearby. With all of these changes it's hard to know if any one of them will help change the company's sale momentum. If they do it would be a boon to investors, but if they don't the investment story isn't destroyed. The story of Kirks is more of an asset story than a retail turnaround story.

As I mentioned above the company owns Harbor Centre which is located in the prime business district of Wellington. The company purchased the building in 2001 and holds the building on their balance sheet at historical cost. Typically when a company has an asset worth far more than its balance sheet value the asset is considered hidden. Harbor Centre's value isn't hidden in the slightest. The company has the building valued yearly and includes the latest appraisal value in the annual report. As of the annual report the building had a carrying value of $26.8m but was appraised at $46.5m.

I put together a small summary adjusted balance sheet to show the difference between reported book value, and appraised book value.

The adjusted balance sheet clearly shows that the company is trading at book value for the property company alone. In investor parlance you buy a building and get a retailer thrown in for "free". It's worth noting this isn't an empty building, they do have tenants paying rent, vacancy is 9.6%.

At this point in the post the Kirks story is no different than what someone might write about Sears or JC Penny or any other asset heavy struggling retailer. The difference is that Kirks has been working to monetize their Harbor Centre property.

The company put Harbor Centre on the market and received a bid last fall. The bidder wasn't announced but took their time to complete due diligence. When the sale of the building was announced shares ran up to $3.20, which is about 50% higher than where they trade now. Once investors realized the company might do something with their undervalued asset they suddenly started to price it closer to reality. Unfortunately the bidder on the building fell through, and along with it the share price collapsed.

The company engaged a consultant to advise them on how they could split apart the companies. Kirks will spin-off the Harbor Centre property and the associated management company into a separately listed company this year.

A lot of readers might be wondering if the company is going to split off their property group, then why is the company so cheap? The answer is located in the results section of the annual report, the company's returns have been poor to say the least. On a headline level it's understandable to see why investors are scared and fleeing the stock.

At the retail level the company's sales have been in decline for the last five years, and investors have apparently lost hope. The company's property division has provided support for earnings up until the New Zealand earthquake. Since the earthquake the property division has had to invest significant amounts into earthquake strengthening. They have also invested in an expensive remodeling effort to attract a new client. While many one time costs will roll off for the property division soon they have also been hit with much higher insurance rates, most likely in connection with the earthquake.

Even with the poor earnings there significant value resides in the Kirks property division. If the company were to split today I would consider the stock's current price close to fair value for the property division alone. That means that either the retailer is worth nothing, which is a possibility, or it's a gross mis-pricing. Usually what sinks retail turnarounds is the company isn't able to right the ship quickly and takes on debt to finance operations. The company's debt starts small but grows with deteriorating conditions eventually pushing the struggling retailer into bankruptcy. Kirks has debt on their balance sheet, but it's all associated with the property division. The Kirks retail division has no associated debt, which gives the company additional runway to recover.

Talk to Nate

Disclosure: No position, although I do intend to buy shares.

Macro & Market Musings..

2013-05-20T00:24:00.001-04:00

I've begun to receive a number of emails recently with the market at all time highs questioning the wisdom of keeping money invested at these levels. As the market races higher it's natural to start to think about when the next downdraft might occur and what it might look like. The most important point in this post isn't thinking about the future, it's what to do right now, when opportunities appear scarce.

There's a common cliche that value investors are to ignore the macro noise and only look at companies from the bottom up. I'm not sure where this meme started, but it doesn't seem right. It seems we should always be aware of the environment we are investing in, but we shouldn't let that awareness dictate our decisions.

The problem with macro focused investing is that one needs to get the forecast correct, but also the timing of the forecast correct. I remember one story in the Snowball where Buffett's uncle was so worried about the government defaulting it prohibited him from making sound decisions. I believe he convinced Buffett to purchase a farm just in case something bad happened. Of course Buffett continued to invest in the face of the fear, and if his uncle would have invested with him he would have been rich, instead he was poor and worried.

With the most recent financial crisis the focus seems to have shifted to investors who had the uncanny ability to predict the future and earn outsized profits. Guys like Michael Burry, who foresaw a housing crash, and were able to profit from it. In hindsight everyone "knew" there was a housing bubble. The human ability to re-write memory is amazing, I can't remember talking to anyone post 2008 who has said "I never saw this coming, I thought we were going to have a soft landing." Right now in Canada where there appears to be a housing bubble, a familiar pattern emerges. A few people are predicting a crash, most people are ignoring it, and some cable TV stations have decided to flood viewers with Canadian real estate shows. Even if housing prices are high, the question is one of timing, when will the market finally pop?

How I think of macro elements as they relate to how I invest might best be described by an analogy. My house needs a new roof, it's undeniable to anyone who looks at it. Some of the shingles have lost their grit, and in sunny spots the ends are turned up. It's been like this for a while, and we haven't had any leaks so far. I had a roof guy inspect it who said it might last two years, or seven or eight years. I don't know if it will last five years worth of storms, or two weeks worth of storms. But since I'm the thrifty type I'd rather ride this roof out until I see signs of failure. Why upgrade when I don't need to? In the meantime I'm not putting any housework on hold because of the imminent roof replacement. We have made changes to rooms directly underneath the roof, it's possible we might get a leak and need to repair it, but it hasn't stopped us. At some point I will have to fork out a LOT of money for a roof, or get up there and do it myself.

How does my story relate to investing? I think investors always need to be aware of their surroundings, but don't let the cart drive the horse. At times things might look dire, and maybe it really is worth selling everything and going cash. But my experience has been that the turning point is usually unexpected and sudden, and impossible to time. There are a lot of macro related things that are a mathematical certainty. There is too much debt and not enough money to pay it off, at some point it will need to be reconciled. At some point Japan will have to face its debt problems. At some point the US will have to face its debt/pension problems, and at some point Europe will have to decide how to handle their debt problems. These aren't opinion page ideas, by the math these things will need to be reconciled at some point, either through defaults, inflation, higher taxes, all, none, or something innovative no one has thought of yet.

When the easy opportunities start to dry up my radar goes up with regards to the level of the market. Right now the selection of net-nets in the US is poor at best. Outside of some unlisted net-nets the pickings are very slim. This isn't some sort of timing indicator, but it's just a general acknowledgement of the environment we're in. Instead of going to cash I continue to look for opportunities in offbeat places. Right now there are plenty of banks that are cheap, as well as plenty of unlisted and foreign stocks.

My only caution in the current environment is to ensure that what appears to be a margin of safety is a true margin of safety. A lot of value investors were wiped out in financials in 2008. They thought they had a margin of safety but didn't forecast what would happen. A good gut check is to ask what would need to happen to put a potential investment out of business. I have some companies with so much cash they could operate for more than a decade at current levels with zero revenue. Debt is a margin of safety killer, beware of it, it's not always bad, but it can be worse than it initially appears on a balance sheet.

When I first started to get interested in investing a common theme that re-appeared in books was that investors needed patience. Patience to purchase stocks and hold them through thick and thin for the long term. Growth investors are always being stereotyped into being short term focused watching for the latest earnings beat or surprise news. Value investors are no different, we've been hooked on the notion of a catalyst. A catalyst is a substitute for patience. When we don't have patience to actually hold a company for years we look for one with a catalyst that will hopefully shorten the holding period.

Investors need more patience, patience to wait for value to be realized, and patience to wait for more opportunities. I think a market like the current one is a great test of patience. It's hard to hold cash and wait for better opportunities in a rising market. It's also hard to hold flat or declining stocks when seemingly everything is heading higher.

Use the rising market as a gut check, assess each company in the portfolio and re-evaluate their margin of safety. If it doesn't exist anymore, or the company is fairly valued then sell into the rising market and move on. If the daily new highs are worrisome, or if macro fears are causing panic I would recommend closing down the computer and taking a walk outside. The weather has turned and it's a beautiful time of the year to get outside and relax. After-all, if your portfolio is full of safe and cheap stocks watching the market minute by minute won't change a thing, except to raise your blood pressure.

One final note, as things like this always go I'm sure the market will probably crash in a few weeks or Japan will default, or in the US rates will spike and someone will email me "I told you so!" Maybe that will happen, or maybe nothing will happen for another three years as we drift higher. I don't know, and anyone who claims to know is lying.

Talk to Nate

Anacomp at 1x earnings?

2013-05-16T00:58:00.002-04:00

Sometimes it seems pointless trolling through tiny little no-name stocks looking for value. A friend sent me an email recently saying that one thing that stuck out to him from the Buffett shareholder letters was that Buffett found drop-dead cheap ideas. There wasn't any question that the things he was buying at the time were undervalued, it was so obvious all one had to do was buy and wait. The company in today's post illustrates that there is significant value in unlisted companies, and that that drop-dead cheap companies still exist in today's market.

Explaining why Anacomp is cheap could easily be done on a napkin, if I were to write it on a napkin I'd write:

Earned $.75 p/s last year, trades at $.75, 1x earnings
$.61 p/s in FCF, 1.22x FCF
$27 p/s in NOLs
Deleveraging, building cash

First off Anacomp (ANCPA) is not a Chinese company, a reverse merger or anything shady as far as I can tell. For curious readers the company's RFP's are available online, I was able to find some contracts in a government database as well. The company is simply small and forgotten, trading far on the fringes of the market.

Anacomp is a document management company that's been in existence for 40 years. The company's business is fairly simple, they scan in documents for customers and provide indexing and online document management services. This is especially important for customers that are paper heavy, such as the government (who happens to be their largest customer.) The company provides a valuable service in centralizing document digitalization, storage, and retrieval. Clients can continue to be paper heavy but offer digital copies if necessary. The company has two locations, one in Washington DC, the other in Southern California.

With a company trading at 1x earnings not much time needs to be spent determining that they're actually cheap. Most research time should be spent evaluating what could go wrong, and if the price is low enough to compensate for any problems, known and unknown.

Anacomp is far from perfect, there is plenty of hair on this investment, but go back and read the little thesis again before each hairy item, they look a little less scary each time. I'm going to go through the biggest issues I see one by one and knock them out.

All earnings, no assets - This isn't the biggest ding against the company, but it's a fairly large one. The company has $4.3m in cash, and $2.2m in accounts receivable, current assets are $7.1m. The company's current liabilities aren't all that terrible either at $2.5m. The company has a pension and some debt that negate any positive value from their assets. Total shareholder deficit is -$759,000.

The company has something peculiar with regards to their pension, the pension that's zero-ing out assets. The pension is held for an in-active German subsidiary with a liability of $8.8m. The pension has $5.8m in assets, mostly bills, bonds and insurance, which is disallowed by GAAP. It appears that the company purchased annuities for some pensioners, that's what the insurance contracts are. Under GAAP insurance isn't a valid pension asset, so the company appears to have a $8m pension shortfall even though they have taken care of most pensioners via annuities. The real shortfall is $3m, although it could be considerably less. The company's discount rate and expected return are both very low at 3.5%.

Debt - I alluded to this in the above bullet point. The company has $3.6m in debt related to an acquisition. It appears the company struggled to integrate the acquisition which led to operating performance problems. The company had trouble repaying the promissory note on the original repayment schedule. They were able to re-negotiate and extend the terms twice. The company is now on track, paying down the debt, and appears able to pay it off with cash on hand currently.

Earnings clarity - The US Government accounts for 99% of the company's business. According to the notes it appears that sales are locked up for the next two years. If this is true that the next two years look like the most recent this would mean that the company will have earned over $4m, repaid most of their debt, and would have a positive book value of over $3m in 2015.

The biggest issue investors have is there is no earnings clarity beyond two years. If the government decides to not renew, Anacomp will be generating losses and looking to hit up the credit markets to survive. Fortunately this dire scenario presumes that management is completely idle and happy to milk the cash cow for two more years before deciding their next steps. Since the company's annual report came out there have been a flurry of news items on the company's website. They inked a five year deal with the VA, earned an award with Northrup Grumman and hired a healthcare executive to sell to health organizations.

Instead of sitting idle management appears to be pro-active in searching out new business opportunities. I don't know if it'll be enough to replace the current revenue and earnings, but with two years of runway there is plenty of time.

Final Thoughts

The question investors need to ask themselves is whether at 1x earnings Anacomp is cheap enough to compensate for all of the above risk factors? I think it is, my margin of safety is in the low earnings multiple. If earnings drop 50% I still own a stock with a P/E of 2. If earnings drop 75% the stock would have a P/E of 4x. It would be hard for anyone to argue that at a P/E of 4x a company is fairly valued.

I didn't discuss the NOLs in my post outside of the brief mention in the thesis. The company won't be paying taxes on any earnings for a very long time, so long that they most likely won't ever use them up unless earnings significantly grow. The bonus here is that management might find a way to structure a deal so that those NOLs take on tangible value. If that were the case there is a lot of room for this to be re-valued.

I have no idea what a fair value for Anacomp is, but I know it's not 1x earnings, even 5x earnings seems low. If the market ever revalues this company, even just a little bit investors could experience some massive gains. I'm along for the ride on this one..

Talk to Nate

Disclosure: Long Anacomp

I passed on these two, now they're worth considering

2013-05-09T00:27:00.002-04:00

Information, investors are starved for information. What were sales last month? How many items shipped? Did costs rise or fall? The more detail the better, the more granular the better, investors crave as much information as possible. The biggest hurdle for most investors to investing in small unknown companies is the illiquidity, but that's a false argument for many. Most investors aren't running millions of dollars, and buying and building a $25,000 position is possible in every stock I've ever written about. The real hesitation comes from the lack of information, current and frequent information is a security blanket for investors. It seems unbelievable that anyone could invest in a company that only publishes an annual report once a year.

As a blogger my goal isn't to cover the universe of overlooked stocks with exhaustive write-ups. While this blog provides a good amount of analysis it also provides something else, something more valuable, detailed information on companies that are so hidden that some don't even have websites. I view myself as a cross between an analyst and a journalist. I uncover interesting opportunities and analyze them, yet at the same time I convey a story about the company to readers. I recognize that maybe 1-5% of my readers might be interested in investing in any given idea, I provide enough for them to get started and hit the main points. Yet I try to keep the attention of the other 95-99% by explaining why this company is worth looking at, and why certain items are important.

In this post I want to follow up on two companies I wrote about over the past year, both were worth further investigation. Over the course of the past year the results from both companies are considerably better than expected and each company is probably a better purchase now rather than when I first posted about them. Without further ado…

CoStar

Back on January 10th I wrote about Costar, a company that produces security related products such as cameras and surveillance systems. For this post I re-read my January 10th post and I'll be honest I'm not that proud of it. In a lot of ways I think I disagree with myself from January. The essence of the post was why I avoided Costar. The items in the post are all true, and they probably all make sense, but looking back I realize why I really passed on the company. In early January my youngest son was in the hospital for a period of time, during that time I read the Costar filings on my iPad while he napped. Trying to focus on an investment idea while a baby is in a perilous situation is not wise. I don't think I was in the right frame of mind to truly reflect on Costar as an investment, or think clearly about the situation. Additionally there was the emotional link of this company to sitting in the ICU. For inquiring readers my son is a perfectly healthy 10mo old now, for that I'm extremely thankful.

I'm glad I took a look again, their annual report is out and the company looks very interesting. Here are the highlights:

NCAV of $3.89 against a last trade of $2.06.
They earned $.41 a share last year
P/E of 5
FCF of $1.88 p/s in 2012
The company used all of their free cash flow to repay debt.

One of the biggest issues I had against the company was their debt, management wisely repaid it and cleaned up the balance sheet. Additionally sales and earnings are growing. It appears the company's operating leverage is now working in their favor, sales grew 12% and operating income grew 1459%.

Not much else has changed except that the company is in much better shape financially than they were five months ago. There is no reason this company should be trading below NCAV, as a stretch they might even be worth book value ($5.55).

Randall Bearings

If there is a poster child for unlisted companies, Randall Bearings is it. The company is cheap beyond reason, in my post last year I noted that without a LIFO reserve they would have earned $4.04 a share, double the market price at the time. Over the past year the stock price has also doubled, my $200 position became $400, beer money as some call it, maybe if they're drinking Chimay.

Randall Bearings is a manufacturing company located in Lima Ohio. They manufacture bronze machined parts.

Here's why they're interesting:

Book value of $14.20 p/s vs. $4.60 last trade.
EV/EBIT 4.48
EPS $2.58 p/s
P/E 1.78

I passed for a number of reasons the three biggest being, the debt, their reincorporation, and a shareholder lawsuit.

The company's debt situation has become worse over the past year. The company added $1.55m in additional debt. The company invested $1.5m into their facilities to position themselves for future growth. In theory the new debt should pay for itself with increased earnings. Unfortunately it appears no matter how much the company earns the market doesn't care.

The second item holding me back was the company's reincorporation from Delaware to Ohio. As a commenter on the last post noted, Ohio has stringent anti-takeover laws. I have done further research on this point, and talked to someone with a copy of the shareholder register. From what I understand now there is no possibility for any merger or corporate action unless the CEO himself initiates it. The CEO and the largest shareholder, which is also the company's largest supplier own more than 50% of the company.

The last issue pertains to a shareholder lawsuit that entangled the company for years. A shareholder sued the company with a records request lawsuit in the Delaware courts. The suit dragged on for years with the resolution being that Randall is required by the court to distribute an annual report to shareholders yearly. More than anything the lawsuit speaks to the quality of management at the company. When a CEO is willing to use company resources and fight shareholders, who have a legal right to financials it speaks volumes.

With all these things considered it's still worth noting how cheap the stock is. The company has $2-4 p/s of earning power on a conservative basis. Randall is easily a two pillar stock, one where earnings and book value support each other. It's conceivable that Randall could be worth $15-20 a share.

It seems that management has no interest in unlocking value for shareholders, but that doesn't mean they aren't focused on growing value. Management has continued to grow book value, and is focused on growing earnings as well. If shareholders can get comfortable with managers who are only focused on themselves they might be able to ride along for a wild ride.

Final Thoughts

I want to spend a minute talking about the role stocks of these type play in an investor's portfolio. I am not a believer in investing concentration unless the investor has a control position at a company. If they don't I believe it's wise to spread investments across many holdings with similar return profiles. Companies like Randall and Costar could fit in a portfolio where there are numerous other deep value or net-net type investments. In a portfolio with 10 such holdings it's reasonable to think that one position might reach full value each year. It might seem crazy to wait 10 years for full value, but if that means a stock might quintuple, maybe it's worth the wait.

Talk to Nate

Disclosure: Long Randall, I might buy Costar shares.

What's holding you back?

2013-05-02T23:27:00.000-04:00

Ever find yourself over analyzing a trivial purchase? We all do this, spend hours reading Amazon reviews and looking at dozens of different models of some item where the difference between models is irrelevant. What I find fascinating is I will research some product to death before spending $100 to purchase it, then I'll turn around and read a few annual reports and invested thousands into a company. There are companies in my portfolio where I spent more time researching baby video monitors than I did researching them. Why is that?

I read a blog post about six months ago where the author praised procrastination. They stated that anytime someone procrastinates there is an underlying reason that they don't want to proceed. Maybe the task is boring, or they don't have all the information, but there's always a reason. I'm not sure if this is true or not, but it was something to think about. I've continued to think about it within the context of investing.

Many times I have researched a company, had them check out on paper, and then fail to initiate an investment. If a computer were to follow my criteria and look at these investments the computer would have purchased. For some inexplicable reason I never proceeded with the purchase because something didn't "feel right." Often I'd invent a flimsy excuse as to why I passed "a net-net selling Paris Hilton perfume won't do well" (Parlux), of course it's not going to do well, it's selling below liquidation value. But these excuses helped satisfy me as I walked away from perfectly good investments.

I've recently been thinking about this phenomenon within the context of procrastination. Of the last few companies I've looked at and purchased two I hesitated on. As I hesitated I spent a day or two asking myself what exactly was it that was giving me hesitation? If it was some actual item I could research it further. In the first case I was concerned by the strange listing situation the company had, but after further reading on the company's history I was satisfied.

I've also had many times where I hesitate on some item, research further and then avoid the investment. Some of these avoided investments end up going to the moon with me sulking in the distance. The truth is whether or not an investment works out isn't how we should measure if our decision was correct. Benjamin Graham states that investors are right when their facts and reasoning are right, not their results.

Something I've observed amongst value investors is they use a feeling of hesitation to over-research a company. You might be asking, how is it possible to over-research something? I feel that something is being over-researched when the data and details overwhelm the actual investing thesis. Case in point someone sent me a link to a writeup on a net-net a month ago. The writeup was probably 10-12 pages long, it detailed all sorts of industry trends, and contained historical results from seemingly the beginning of time. Towards the end there was a brief mention that the company was selling for less than NCAV. Instead of spending hours inputting data into Excel they should have started off asking: is this company truly worth NCAV or more, or is it fairly valued? When a company is selling for less than book value the first two things I want to know are why, and is it even worth book value? If an elaborate justification is required to show that book value is obtainable I'm most likely not interested. Somewhere beyond two or three assumptions any prediction becomes worthless.

Before my next paragraph I want to point out the caveat that some investors have a complexity edge. They can research bankruptcy filings or rat nests of obfuscated transactions and discover a nugget of gold lying on the ground. I don't have the time or the brain power to handle those things. So to the types of people who enjoy Trivial Pursuit and can answer who won the mens doubles championship in the 1936, complex situations are probably for you, while this post is for the rest of us.

The tendency to over-research is strong, for many investors over-research is more a form of professional job insurance rather than a desire to understand the underlying details of a company. Over-research can also lead to confirmation bias, or the bigger problem in my view, analysis paralysis. People get into binds where they feel that if they can't fully understand a company they can't invest. Here's a wake up call, no investor can fully understand a company they're invested, if they believe they can they're lying. Not even the CEO knows everything happening at their company unless it's a one man operation. Desiring to know every nitty gritty detail about an investment is a faulty attempt to control something uncontrollable. Investors believe that if they know all the details then they'll make better decisions or their investment ideas won't fail. No matter how much you know about a company your knowledge can never prevent failure, especially if humans are involved. Never underestimate the amount of destruction a negligent or careless employee can wreak on a company.

I know this post is rambling, I will cut to the essence of my message:

1. Strive for simplicity, look for investments that are easy to understand and easy to explain. The reason for investing should not require much justification.

2. Know when enough is enough, at some point research hits diminishing returns. I am guilty of this, I've burned many nights Googling mid-level managers at potential investments, or reading feel good news stories about company charity donations. These things have never helped me, except to convince some part of myself that I made a good decision.

3. Identify the cause of your hesitation. Are you hesitating because there is a missing piece of vital information? If so go find it.

Investors talk about a circle of competence, I say strive for a circle of simplicity. Look for simple investments with minimal assumptions. Look for similar patterns of simplicity that worked well in the past. Everyone claims to know that simply buying low P/E or P/B or P/FCF or EV/EBITDA stocks beat the market, so why are we complicating things so much?

Talk to Nate

Does it get any more stereotypical than this?

2013-05-01T00:21:00.001-04:00

I've come to appreciate that it's not losses that investors avoid, it's dead money. Investors will line up like pigs for a slaughter for an investment that is almost a sure loser if someone shouts that it has a small chance of tripling or more. The losses are chalked up as the cost of doing business with investor proclaiming "just imagine if it did triple or quadruple, then it would have been worth it." A high risk high reward investment will always have people edging each other out to get a piece of the action. The types of investments that even company management is embarrassed to associate with are the dead money investments.

Show someone a clearly undervalued company with a history of undervaluation and no catalyst and even the most veteran value managers will turn and run the other way. A strong bias exists against net-nets with the perception that all of them are dead money, whether or not that's actually true. I remember listening to a podcast with Geoff Gannon and Jon Heller of Cheap Stocks where Jon mentioned that he thought Audiovoxx was a perennial net-net and might never trade above NCAV. I owned Audiovoxx at the time and remember grimacing when I heard that. If this guy who was clearly more experienced in this market thought this investment was dead what do I do? I didn't do anything, within six months it hit a bout of momentum and traded up to NCAV and then well above, I took advantage of the enthusiasm and sold.

I took a walk at lunch today with my friend Dave, the author of OTCAdventures. At some point the conversation turned to complex investment thesis and Dave pointed out the simplicity of net-nets, something is worth $2 and you can buy it for $1, nothing more, nothing less.

Net-nets exhibit a return profile that's enviable, in theory buying something for 50% off means a double if the asset reprices. While the returns are nice the attraction to the theory is investor asset protection. I realize that by purchasing cash boxes and net-nets I will probably never have world beating investment returns. Investors buying growing companies at 3x EV/EBITDA will beat the pants off my returns without a doubt. I'm fine with that, my goal isn't to maximize my returns, but to minimize my losses. All of the money I have invested is money I saved from working, when I look at my portfolio I can see many stressful projects and remember the hard work required to enable the purchase of my portfolio.

All of this sets the stage for the company I want to talk about in this post, Jemtec (JTC.Canada). Jemtec is a Canadian company that has staked out a fairly unique niche, they lease out GPS transceivers to monitor prisoners and citizens placed under house arrest. Jemtec goes to show that having a niche alone doesn't guarantee wild profits and a successful business. The company has steadily lost money over the past few years. While the company has lost money at an increasingly slower pace it's still a concern.

The company's management has cut expenses as revenue has dropped. At first glance it appears the company is grossly over compensating executive management until one realizes that the only employees left at the company are executives.

Jemtec could be classified as a stereotypical net-net, a pile of cash, a poor business, no catalyst, and dead money as far as the eye can see. Investors are justified in running for the exits on Jemtec as the company slowly circles the drain towards a tax losses.

The company trades for slightly more than 50% of NCAV and losses are so steady that management has predicted down to the thousands how much they'll lose next year! The company is headline bad, but behind the scenes they aren't as terrible. While the company lost $138k last year they only had an operating cash outflow of $3800. Considering that the company has slightly more than $3m in cash, they have close to 100 years of runway to figure out what to do next.

In my view the absolute worst case scenario, and the one most investors are scared of is one where management somehow finds a way to squander or run away with the cash. Considering that management hasn't done this already, rather they've cut costs in an attempt to save the company, I don't think this merits much concern. The worst case scenario for management is that they're forced to liquidate and return cash to shareholders, if that happened investors would end up with twice the money they initially invested.

The truth is I, and no one else has any idea what happens next. An investment like Jemtec is impossible to model, there is no model that handles infinite possibilities. The company is just as likely to wind down as they are to start selling slap bracelets or pet rocks. That's the beauty of a net-net though, investors are provided asset protection while they wait to be surprised. Maybe the company will discover a new way to market their product driving earnings. Or maybe they'll acquire a completely different company that provides earnings, we just don't know. As long as whatever happens next isn't as terrible as the market expects the company's stock could react favorably.

Talk to Nate about Jemtec

Disclosure: No position

On value investing...

2013-04-25T23:49:00.001-04:00

I had the pleasure of getting together with two other value investors in Pittsburgh this evening. We had a great time discussing a wide variety of topics. Our conversation drifted from international investments, to nano cap stocks, to how crazy the real estate market is in Pittsburgh. After I left I was thinking about how great it is to get together with like minded people and speak the same investing language.

To other investors we often make sense, something at "5x EBITDA and below book" is worth looking at, whereas to the non-investing population it doesn't even sound like English. Maybe it was Munger or some other famous investor who said if you can't explain a concept to a 12 yr old you might not understand it. In the spirit of that I want to share some analogies I've used to explain investing and how I invest to non-investors. In all the times I've used my analogy I haven't encountered anyone who didn't have the lightbulb moment and say "oh I get it now."

How I invest

Imagine an area of town with an industrial area, the area is fairly well worn, but not in total disrepair. There are a number of companies with names no one remembers doing somewhat specialized activities. The owners of these businesses appear to do well for themselves raising their families in a solid middle class environment.

An owner of one of these businesses decides he's had enough of the stress and daily grind and he wants to sell. He knows how to make widgets, and isn't much of an investor himself. He lists his business on a public market.

Investors in town know that the area the business is located is grimy, and when they look at the accounts they see the company isn't all that profitable. It seems like a lot of work is involved to make such a tiny profit.

I come along and examine the business, I agree with the other investors that they aren't that profitable, but I notice something different. While they aren't turning a profit they do have a valuable building and the owner has undervalued his warehouse of old inventory. I purchase the company for less than the property and machinery cost alone. Once I visit my new purchase I realize what the owner thought was old rusty inventory in the warehouse is actually recently purchased inventory. The owner was a bit of a pack rat and I start to find envelopes full of cash around the facility he'd stashed for rainy days. When all is said and done my purchase price for the business is less than the inventory, receivables and cash net of liabilities, I get the building and aging machinery thrown in for free. The company is marginally profitable, but it's not a big concern considering the discount I already received on my purchase.

To me that's the essence of asset based value investing. When I've told this story people marvel that these sort of deals actually exist. I explain they exist in the markets the same place they exist in real cities and towns, not on the main streets, or in the central business district. Rather these deals are found on the back roads, sometimes far away from town, neglected by everyone often even their owners.

How Buffett invests

Warren Buffett used to invest as I described above but he's changed as he's become more successful. Buffett buys that restaurant in town that everyone goes to, there are always two hour waits no matter what day of the week or time of the year. Buffett prefers when these businesses are run conservatively and have strong staying power. He isn't interested in buying the hottest restaurant this month, he's buying the restaurant that's been hot for a decade.

Buffett will then go on and buy the bank in town, and then the local gas station, and the grocery store, and whatever else is for sale. Eventually it will be hard for anyone in town to go a day without using one of his products, or services.

How most investors invest

Imagine yourself at a cookout in the summer. You're standing by the grill and your brother-in-law comes and starts chatting. He starts talking about how this guy he works with is onto a really great investment. It's some new technology he doesn't really understand, but it doesn't matter, it's going to sell really well. Not many people know about it yet so you have to keep quiet. He thinks it's going to be big, almost everyone in the world needs this product, if they can only capture 1% of that market they'll be billionaires. It's a good thing you found out about this early so you can get in on the ground floor. Just imagine being able to pay off the house and pay for the kids college all while sitting on the beach drinking mai tai's.

Final thoughts

I find it fascinating that most non-investors can spot a good local business without a problem. People instinctively know when someone has a model that's minting money. Yet a disconnect happens between a local tangible market and the public markets. Most people wouldn't invest with the wacky science-y guy promoting some new fusion technology down the street, yet they'll pour money into high tech startups. People are also able to identify when a company has a strong brand and staying power verses a company without it.

I love when people say things like "how did that restaurant go under, it was always crowded?" because it exposes that while people understand a good brand, they don't understand the finances behind a business. I always say that companies go under for two reasons, too much debt, and mispriced products. Those two go hand in hand, products priced too low eventually lead to debt problems. Maybe the restaurant is packed because the prices aren't high enough.

Talk to Nate

Shareholder rights…did you know you have them?

2013-04-22T00:09:00.002-04:00

"It is a notorious fact, however, that the typical American stockholder is the most docile and apathetic animal in captivity. He does what the board of directors tell him to do and rarely thinks of asserting his individual rights as owner of the business and employer of its paid officers. The result is that the effective control of many, perhaps most, large American corporations is exercised not by those who together own a majority of the stock but by a small group known as 'the management.'" Graham, Benjamin. Security Analysis 1941.

Americans are raised with a strong sense of rights; starting with the inalienable rights of life, liberty and the pursuit of happiness. These rights extend from the Declaration of Independence to the Constitution and beyond through codified laws. Americans are quick to proclaim loudly when their rights are infringed upon. It doesn't matter if these rights are true rights, or presumed rights not backed by law, Americans feel strongly about rights!

There is a strange disconnect between citizenship rights and shareholder rights, a disconnect I don't fully understand. As a citizen we have rights granted to us by a government, rights that are very hard if not impossible to change. Citizens only get one vote, and the only way to affect change is to petition an elected official or become one, and even then change is slow. The same can't be said about corporations. A shareholder can buy more votes by buying more shares, and if they own enough shares can fire management or take over the company driving change themselves.

Benjamin Graham's quote from the 1940s still rings true today. Most shareholders are docile, most fail to vote proxies and those who do vote often side with management. Shareholders with small positions on mega-cap companies might view their votes as futile, even still, why throw away something you purchased? The types of companies I typically invest in are smaller, some very small where a significant position can be built quickly, and shareholder votes meaningful.

I recently finished a book The White Sharks of Wall Street, which I highly recommend. The book details the history of a group of modern corporate raiders who began taking over companies in the 1930s up through the 1960s. These men, including Thomas Mellon Evans, invented many of the modern takeover techniques we know about today, yet their stories have been lost to the sands of time. Tom Evans was known as a liquidator, he bought companies for less than NCAV or book value and liquidating divisions for a gain. The author is a financial journalist for the New York Times, which means what could have been dry material reads quickly and is fascinating. This isn't a textbook, but rather an informative history. It's worth noting that Tom Evans apparently ran in some of the same circles as Benjamin Graham.

In the spirit of the book I wanted to discuss a number of rights shareholders have that they might not know about. The rights I'm detailing below are for shareholders of Delaware corporations, which most public companies are. Companies are governed by the state they incorporate in, and the state they reside in. Some states have different rules and regulations, with some like Nevada being notoriously shareholder unfriendly, whereas Delaware is very shareholder friendly. If you plan on undertaking any action against a company you own please find the relevant state first, small nuances can lead to significant differences.

I am not a lawyer which is probably evident by my readable writing, but I wanted to state it anyways. I have read the Delaware corporate law along with the corporation law for a few other states, they were available free online. If any of this is wrong please make a note in the comments and I'll edit the post.

Shareholder vote - By law shareholders are entitled to one vote per share unless stated otherwise for a specific series of shares. This might seem like the simplest of all the rights, yet it's the most powerful. Shareholders are not restricted to one vote per person as in a governmental election, shareholders can purchase as many votes as they want by acquiring shares.

Companies are required to put directors up for election every so often as determined by the company's bylaws. When directors are up for re-election the shareholders have the responsibility of evaluating their qualifications and voting, or not voting them in. If a director isn't qualified shareholders can vote that director out and propose their own director.

Some companies have cumulative voting which is extremely powerful, one holding of mine has cumulative voting. An example is the best way to explain what cumulative voting is. Take a director election with five directors up for re-election, a shareholder with one share has five votes, one for each director. The shareholder can vote yes or no on each individual director, but they get one vote per director. In a cumulative election that shareholder can take those five votes and direct them all at one director or nominee. This is important when a minority shareholder has enough votes cumulatively to get a seat, but not enough votes overall to secure a seat on the board.

Annual meeting - Delaware companies are required to hold a meeting annually. Not all companies comply, and there isn't anyone policing compliance besides shareholders. If a company fails to hold an annual meeting a shareholder can go to the Delaware court to compel one. Case law is very clear on this issue, if a company has failed to hold a meeting the court will compel it almost without question.

An interesting side-note to this section of the law is that Delaware law also requires companies to prepare a list of shareholders who are allowed to vote during the meeting. The company is supposed to have this list available at the meeting and allow shareholders to view it and copy it if they desire.

Appraisal rights - If a company becomes party to a merger or take over shareholders can obtain what are called appraisal rights. Appraisal rights give the shareholder the ability to contest the value offered as consideration in the transaction.

For example Company A comes along and offers Company B shareholders $10 per share to acquire the company. If Company B has $5 per share in earnings shareholders might feel like the price offered isn't fair and exercise their appraisal rights.

When a shareholder exercises these rights their shares become frozen and they are not allowed to vote for or against the corporate action. If the shareholder votes for or against the action in most cases they invalidate this right. Filing for appraisal rights needs to happen after the action is announced, but before any vote takes place.

The rights are a bit odd, it's possible a shareholder could exercise them and win with the court saying the shares are indeed undervalued. The company might then be forced to pay the exercising shareholder a higher consideration. What's strange is that all of the other shareholders who didn't exercise this right receive the initial consideration they agreed to, even if the court rules they were offered an unfair deal.

Worth noting is a history of long drawn out court battles over appraisal value. Long court battles mean high lawyer costs, which the shareholder is responsible for alone. Also worth considering is the valuation methodology that the state uses. If the state uses DCF and the company is fairly valued on a DCF basis it doesn't matter that they're selling for 1/3 of net cash, the shareholder will lose in court.

Right to inspect books and records - A shareholder is the legal owner of a corporation, just like a homeowner is the legal owner of their home. Likewise it isn't strange if a homeowner were to walk through their home looking at what they own, yet in the corporate world owners are treated like outsiders on their own property.

As a legal owner a shareholder is granted through law the ability to inspect the company's books and records. For SEC filing companies this isn't an issue, companies disclosure anything an investor might want to inspect to all shareholders through EDGAR. For non-filing companies, and private companies things are different. Shareholders have the legal right to see a company's financials no matter what the CFO says. I've talked to companies where the CFO flat out lies and claims shareholders don't have this right which is a shame.

The Delaware courts look favorably upon shareholder record inspection requests if a valid reason is given, and if the company hasn't made information available. The requestor is responsible for paying the costs associated with obtaining this material and at times traveling to the company's headquarters or Delaware to inspect the records.

In addition to inspecting a company's books shareholders also have the right to examine and make copies of the shareholder register. This is the list of who owns the shares, and how many shares they own.

A company by law has five days to respond to a records request, if they don't respond within five days the shareholder has the right to petition the court to view the records.

How to use?

This is probably the trickiest part of the post. For all actions besides voting on a company issued proxy action needs to be taken on the part of the shareholder. A complicating factor is that most shareholders are not in the shareholder register because they hold their shares in street name (at a broker). If you wish to exercise any of the above rights and you hold your shares in certificate form you won't have any issues, proof of ownership and a letter to the company with your intentions is a good starting point. Some rights, such as a records request have specific requirements such that the request be provided in writing and the requestor sign under oath.

If you are a shareholder in book entry form and wish to undertake any of the above actions cooperation on the part of your broker is required. The Delaware court does recognize beneficial holders as legal owners, but a letter from the brokerage verifying ownership is required.

Talk to Nate about shareholder rights

Disclosure: I get a small commission if you purchase an item through the Amazon link above. The prices are the same through my link and when you go directly to Amazon.com.

Anyone can invest in this above average hedge fund

2013-04-18T01:06:00.001-04:00

Hedge funds, bastions of wealth, accessible to the rich and famous and well connected. These purported money machines are so sophisticated that they're off limits to anyone who isn't an accredited investor, supposedly someone who's wealthy enough that they know how to not lose money. The truth is much different from the myth, most hedge funds, like most mutual funds do poorly. In aggregate hedge funds and mutual funds are the market, it's impossible for all of them to outperform. The largest ones have managers who are constantly in the news promoting their views. Who in finance doesn't know who David Einhorn, Bill Ackman, or Carl Icahn are?

I'm guessing all my readers are familiar with hedge funds, and most probably work at one, but not many can actually invest in one, let alone one with a record of outperformance. Of course all my hedge fund readers work at outperforming funds, you're all headquartered in Lake Wobegon right? There actually are many funds that outperform each year, and some outperform for decades. Most of these funds fly under the radar and away from the news. Most are not household names like the company in this post.

The selling point for a hedge fund is an investor is gaining access to a vehicle that has the ability to outperform the market through going long and short stocks with a judicious amount of leverage. To gain access to such a dream machine investors pay steep fees upwards with the standard being a 2% management fee and 20% of profits going to the fund. In theory the fund will do well enough after fees that the gross fee amount doesn't matter. This is certainly true for some funds, but others don't do well enough to justify their fees.

Senvest Capital (SEC.TO, SVCTF) is an asset manager based in Montreal Quebec. The company started off as a manufacturer of electronic theft systems, listing on the TSX in 1971. Starting in the 1980s and into the 1990s the company morphed from being an electronics company to a holding company for various investments. Management realized that they were better at understanding business and allocating capital than running an electronics company.

From the early 90s to 1997 the company primarily invested capital through their New York subsidiary. In 1997 they launched their first limited partnership, Senvest Partners. Again in 2003 the company seeded a partnership, Senvest Israel Partners. The funds have done well, Barrons noted in 2011 that Senvest Partners was the best performing long-short fund over the 2008-2010 time period. Bloomberg cited Senvest Israel as the best performing fund for the five year period ending February 28th 2011. In a world with thousands of hedge funds remarks like this are significant.

Senvest Capital is a bit of an oddball stock. Senvest Capital is the asset manager that owns Senvest Partners and Senvest Israel along with a grab bag of other assets. If this company simply were an asset manager with some outside holdings they wouldn't be any more interesting than any of the dozens of other public asset managers. The difference is that a large part of Senvest Capital's holdings are in their own funds, and that investors can buy these assets at a significant discount.

Here are the company's assets from their latest annual report:

The three biggest items on the balance sheet are their investments, their investments in their hedge funds (investments in associates), and some miscellaneous real estate investments. The company has almost no liabilities, they amount to $95m and consist mostly of liabilities related to equities sold short.

The company isn't exactly transparent when it comes to explaining their own investments. They make the following disclosure:

The company has $184m in listed securities and $32m in unlisted securities. The notes explain that the unlisted securities are positions in private companies that have no public market. Inquiring minds are probably dying to know what securities the company holds in their listed portfolio. Unfortunately the notes in the annual report don't reveal anything, but there is a way to get a peek. Senvest manages their money through a subsidiary in New York. The subsidiary in New York is required to file their holdings with the SEC regularly. While the filing doesn't disclose all of their holdings it does give a good picture as to what they hold. The link to those filings is here.

Some of the unlisted holdings are non-traded REITs, and shares in non-public banks.

What makes this investment so interesting is how cheap the holding company is, and how well they've performed over the years. The company is trading at a discount to NCAV, a significant discount. Shares last traded at C$81.85 against a book value of C$117.50. A friend who is very familiar with this stock estimates that book value is above $120 p/s currently.

It's almost strange that the management company of outstanding hedge funds would trade at 2/3 of BV. What's even more incredible is that book value consists of mostly liquid investments, equity securities, stakes in hedge funds, and some illiquid real estate investments. What I find even more incredible is that Senvest as a company has a history of providing solid returns, this isn't a one time undervalue of a mediocre money manager. I have a table showing book value and earnings per share back to 2004 below:

From 2004 to 2012 the company grew book value from $22 to $117, that's a compound growth rate of 22.8%. The company's funds have performed similarly over the same period of time.

Readers will note that earnings per share are very volatile. The company earns a revenue stream from fees associated with the funds. Unfortunately the fund fees don't cover all of the company's operating expenses meaning the difference ($10m) is made up from equity holding gains. Given the company's investment performance over the past eight years making up this shortfall hasn't been an issue. In years when their company's investments do poorly their earnings take a significant hit, like in 2011. In years when their investments do well earnings do well too, like in 2012. The company is trading for a P/E of 3x, although I'm not sure earnings are the best way to value the company.

I've explained the math in the past on investing in companies below book value that are consistently growing book value. Using this math an investor today buying at 2/3 of BV with the company's 22.8% growth rate is actually earning a 34.5% return on their investment if the future looks somewhat close to the past.

Investing in Senvest Capital isn't a normal value investment, it's more of a mutual fund, value stock, and hedge fund hybrid investment. An investor gets the chance to own pieces of Senvest's mutual funds, along with some of their private investments, all at a 2/3 discount. Along with this the common equity investor pays no fees, rather they are a beneficiary of the fees that the company's fund investors pay. Even with all these things investors are still provided a margin of safety, they're buying at 2/3 of a very tangible and liquid book value.

Talk to Nate about Senvest Capital

Disclosure: Long Senvest

A liquidation with a huge hidden asset

2013-04-13T00:51:00.000-04:00

Liquidation..that elusive thing all net-net investors hope for but never expect to happen. A friend sent me a note a few weeks ago suggesting I take a look at Alpine Group (APNI), he said they were cheap at 44% of NCAV and profitable. We traded a few notes after I looked at the company and then he sent an email last week saying they announced they were liquidating.

Alpine Group is nothing more than a collection of four companies, Exeon, Wolverine Tube, Synergy Cables, and Posterloid. Posterloid makes signboards like the ones you'd see at the McDonalds drive-thru. Wolverine Tube manufactures copper tube used in HVAC, refrigeration, and power generation applications. Synergy Cables is an Israeli traded company that manufactures power cabling, and Exeon manufactures copper wire.

The company has had a turbulent history of profitability, but in a liquidation that doesn't matter much anymore. The company recently released their 2012 annual report which contained an adverse opinion from their accountants. It appears that Alpine Group refused to consolidate Synergy Cables even though they owned 50.4% of the company. Instead they chose to record their Synergy Cables holding using the equity method. The accountants point out this isn't allowed under GAAP, management responded that they intended to sell down their stake so they shouldn't be required to adhere to the letter of the law. What management doesn't seem to understand is that financial statements are not meant to reflect management's intentions but rather take a snapshot of the company on a particular date. Management did stay true to their word reducing their stake below 50%.

The company invested in Wolverine Tube at the top of the housing market, the exact wrong time to invest in a housing related stock. Wolverine eventually went bankrupt, Alpine ended up with a pile of options on Wolverine in exchange for their worthless equity investment. Additionally the company purchased 4.5% of the company on the open market after it re-emerged from bankruptcy. Alpine wrote off their initial Wolverine investment, and subsequent options as well. Wolverine is held at zero on the balance sheet, but the holding is worth something. The company has been profitable since emerging from bankruptcy. It's hard to know what the company might receive for their 4.5% stake in the company.

Alpine has had a long history of continued capital commitments to Synergy Cables. This is most likely because the CEO of Alpine is also the CEO of Synergy Cables. To make a long story short Alpine loaned a lot of money to Synergy over the years all of it which was subsequently lost. This resulted in the write down of their Synergy investment to zero. From the financial statement perspective there is no value to the Synergy investment, but this isn't accurate from an economic perspective. Alpine owns 40% of Synergy Cables, and since Synergy Cables (SNCB.Tel Aviv) is actively traded on the Israeli stock exchange it's fairly easy to determine how much their stake is worth, it's close to $5m. This is considerable for a company with a market cap of $8m.

Valuing Alpine is very straightforward, determine the value of the assets and subtract the liabilities. Most liquidations take longer than expected, Alpine expects theirs to be mostly complete by mid-2014. Many liquidating companies are burning cash which needs to be taken into account when doing a valuation. Alpine is cash flow positive, although barely. Looking through the cash flow statement it's entirely possible that the company won't burn cash as they liquidate. After all Alpine is simply a holding company, their holdings will continue to operate and conduct business next year as they are today. The only thing being dissolved is the holding company.

The first valuation is the most aggressive, I took Alpine's equity value and added the value of their Synergy Cables holding.

If this valuation holds there is clearly a lot of value here, liquidation value is $1.24 a share and the company is trading for $.73. Both of these valuations don't include Wolverine which could be worth something.

The problem with book value is it's opaque, the company has close to $1m in PP&E, but investors have no idea what it is. They own $27k worth of land somewhere, maybe a few acres, a $232k building and then $1.7m worth of machines. Are these components part of a consolidated subsidiary or the holding company? What will happen to them? We don't really know, so I created a conservative scenario based off of NCAV and a discounted NCAV:

The company is trading right around unadjusted NCAV, and well above a discounted NCAV.

To determine if this is a good investment at the current price an investor needs to assess whether the company's long term assets have value, and whether the company will realize their full current asset value. If they do both and their holdings continue to generate profits up to the end of the liquidation this is an extremely attractive investment at the current price. If neither of these assumptions pan out then someone buying today could end up with a loss.

Talk to Nate about Alpine Group

Disclosure: No position

Cash boxes

2013-04-10T01:04:00.001-04:00

I prefer three types of investments, net-nets, cash boxes, and two pillar stocks. My reasoning behind investing in net-nets is pretty well covered throughout the blog. I've covered two pillar stocks through a few examples, such as Nexeya, Gevelot, Hanover etc. While I've covered a number of cash boxes I have never expressly discussed why I like them and why they're worth considering as investments.

This post came about as I looked over my portfolio and realized that I own 20 holdings in my portfolio that are cash boxes and they all fit a similar investment profile. Some of these cash boxes are net-nets as well, but not all are.

It might help to define what I'm talking about when I mention a cash box company. Most investors when they hear the term think of the stereotypical cashbox: an old obsolete company barely making a return that has hoards of cash at their disposal. The company is of secondary concern to the pile of money in the company's possession. I prefer to define a cash box as a business where a significant, if not majority of the company's market cap consists of cash. For example if a company were to have a market cap of $50m and held $30m in cash in addition to their operating business this would be a cash box. Additionally my sort of cash box has a decent business attached which I'll cover below.

To me there's a fine line between a cash box, and a pile of cash. A pile of cash in the investing world is usually a bio-tech or some startup company peddling promise. The company starts with a pile of cash that they slowly and methodically work down to zero as they develop the next greatest thing. Very few piles of cash work out, but the ones that do work out spectacularly so. The successes are supposed to counteract the failures, in theory. My experience has been a few lucky people invest in the success and most everyone else chasing success ends up in the failures. I have invested in a few piles of cash before, I have never met success, but I know failure well. A pile of cash is often a very efficient transfer mechanism to take cash from equity investors and turn it into salaries for professional executives.

The biggest question when it comes to cash boxes is why doesn't management reinvest the cash profitably somewhere else? The answer to this question leads to my favorite type of investment, the profitable niche business bolted onto a pile of cash.

Floating out there in the market are companies that have tiny moats in small niches of the marketplace. These are companies like Conrad Industries, a barge builder in Louisiana. Conrad exhibits a competitive advantage, but there is a limit to how many barges can be made in a year, and a lot of that depends on external demand. The company is extremely profitable and earns excellent returns on their invested capital, the problem is they have nowhere to reinvest that excess cash. With management worrying about running the company and not managing an investment portfolio the excess cash builds. Sometimes management will try to justify the cash saying they're on the lookout for an acquisition, or it helps them to be flexible. When managers repeat that they're on the hunt for an acquisition, but one never happens it's a pretty good sign one will never happen. I liken this to the person who only wants to golf on a day when it's 75 and sunny without a breeze and not a weekend. If the golfer is lucky they might find that day once a year at most.

The best cash box companies are actually good businesses. If excess cash is removed from the balance sheet these companies make reasonable returns on equity. Management is prudent and invests in the business wisely. There is often some growth in both revenue and earnings. The problem is the business isn't able to support the amount of cash that's being generated.

For many investors excess cash is a worrying sign, it's read as a signal that management doesn't know how to reinvest. I see excess cash differently, to me the excess cash in many cases is a sign of prudence on the part of management. Instead of wasting money on dubious investments they prefer to let it sit idle for some point in the future. For many of these companies if the cash were paid out as a dividend the companies would suddenly become extremely attractive.

I like to look at a company, back out the cash and then evaluate the company on the reduced basis. Suddenly a company with a 5% ROE can have a 18% ROE once the excess cash is taken into account.

So what are the things to look for in finding the ideal cash box?

1.) A business that's stable and possibly growing, not in decline.
2.) Management that isn't hasty to spend the excess cash and is conservative in operation.
3.) Management that is invested in the business.
4.) Management that is aware of shareholder value.
5.) A low valuation, I prefer cash boxes selling for less than book value, or less than cash (gross not net, but I'll take net if it's available)
6.) Consistent earnings, but more importantly consistent cash flow.
7.) A business model that can survive the test of time.
8.) A debt free, or very low debt amount on the balance sheet.
9.) A cash balance that's growing and has grown over time, not the result of a one time sale or other event.

When all of these factors come together it is usually the type of company I will invest in.

The second biggest question with a cash box is what happens next? What's the point of investing in a business even if it's decent if it continues to accumulate excess cash and go no where?

Many of these companies do eventually do something good with the cash. A cash box I own, Goodheart-Willcox repurchased a significant amount of their shares at less than book value. They trade at $72 and are on track to earn about $6 this year. That doesn't seem that impressive until you back out the $60 or so in excess cash, suddenly the company is selling at a P/E of 2x. And their cash is piling back up, they have shown a willingness to repurchase shares, they might do it again.

Some cash boxes eventually pay out large dividends. A number of them paid special dividends around December of last year before proposed dividend tax increases were supposed to go into effect. A company barely cash flowing their debt isn't able to pay out a large special dividend, a cash box has that flexibility.

I believe value is it's own catalyst. When I buy a company for less than book value, of which 70% is excess cash, and the company's operations are profitable, earn reasonable returns, and management is honest and shareholder friendly, I don't see how an investor can go wrong. These are boring companies that might languish in a portfolio for years. But if an investor's goal is to buy safe companies cheaply cash boxes surely play a role in the portfolio.

Talk to Nate

Disclosure: Long Conrad, Goodheart-Willcox, and 18 other cash boxes!

LAACO, store this company for the future

2013-04-06T00:26:00.002-04:00

Given the name of this blog it's unusual that I don't actually cover that many esoteric investments. I'm not writing about strange derivative trades or unveiling hidden resource companies; mostly I write about small cheap stocks. Most of the companies are boring and forgettable, but they all share a characteristic, they're cheap. Unfortunately in today's market a tiny obsolete manufacturing company selling for less than book value is considered an oddball stock. The stock in this post is actually worthy of being called an oddball, it's a mess of assets wrapped in a partnership structure with a very high price per share. The company is LAACO (LAACZ).

LAACO is a California limited partnership with ownership interests in a variety of assets in the West. The partnership mainly owns storage unit facilities, as well as the Los Angeles Athletic Club and the California Yacht Club. Part of the Los Angeles Athletic Club is a 72 room hotel. Additionally the company owns two buildings in downtown LA, and some surface parking lots. Measuring by revenue the storage units deliver 65% of the partnership's revenue, and the club, hotel, buildings, parking lots and boat club provide the rest.

The company has been in the storage unit business since the 1970s and has slowly grown to 47 locations. The majority of the facilities are located in California, some in Nevada, Arizona and now Texas. The company has identified Houston as an area where they are targeting growth. They purchased a facility there in 2012 for $6.3m and are looking for further acquisitions.

Storage units qualify as a boring business, that is unless you factor in the crazy TV show focused on them, Storage Wars. I would wager that at least one of LAACO's facilities has been the host of loud antique collectors bidding high prices for units full of junk at least once given the location of the show, and the location of the partnership's units. Where else but in America can someone make a TV show out of people standing around a storage unit bidding like crazy for items they can't even see? When I've watched the show I've been struck by the parallel, that everywhere there is value in cheap junk. It might be cheap companies for some, and old lamps and bed frames for others. Anything purchased cheap gives the possibility of a reasonable return.

When I first found LAACO I had two thoughts, the first was hidden assets, the second inflation play. As far as I can tell neither of these impressions were true. Let's tackle the asset angle first. Using the $6.3m paid for the Houston facility as a metric, and then extrapolating it to the other 46 locations results in a value of $296m, higher than what the balance sheet shows. But further in the annual report there is a comment that two facilities together are only worth $5m, or $2.5 each. Of course the $296m is only the storage units, the company also owns the athletic club and yacht clubs, both worth something, and possibly a lot. Just going back of the napkin I'm not seeing a fat enough pitch on the real estate. If the storage facilities are worth $4.4m each (average of $6.3m and $2.5m) the value of the storage units would be $206m. Book value for PP&E is $267m, leaving $61m for the assortment of other assets. This seems like a fair estimation.

There is some shareholder out there reading this that is going to email me a spreadsheet with the detailed value of each asset proclaiming this is the investment of a lifetime. The caveat will be that shareholder purchased at a much lower price.

Because the company is a collection of assets it makes sense to value them as such and piece their values together. Currently the company is trading for $1074 a share, and book value is $915 per share. And based on my assumptions that book value is mostly correct buying these assets above book value doesn't seem like that great of an investment. If the price of shares suddenly dropped to $600 I would be a very interested buyer.

So to that shareholder, I appreciate the spreadsheet, and I probably don't disagree on your valuation, but at this price I don't have enough wiggle room.

What's impressive about LAACO is that the company is earning a respectable return, they had a 8% ROE in 2012. The company is very generous about paying out a portion of earnings as a dividend, this past year they paid $47 a share in dividends. When evaluating their earnings remember to compare them to real estate rentals, a hotel, and athletic/boat clubs. In that context 8% is reasonable, although some of that return is due to the company's leveraged balance sheet. The company included a five year results table in their annual report reproduced below:

I mentioned earlier my second thought about the company was that they could be a possible inflation hedge. My thought was this company owns real estate, something tangible, and they could possibly raise rates each year at or above inflation. The company is a way to hold Los Angeles real estate, but unfortunately the collection of companies they run haven't been successful at continually raising rates. Part of this is a capacity problem, the storage units are 79% filled. Presumably most other storage locations in the area with similar prices would have similar occupancy rates. This means if LAACO suddenly raised their rates significantly a tenant could easily move their stuff a few miles and save a lot of money. Over the past few years the company has been able to raise rates at roughly 1% a year, far below the rate of inflation.

The company noted in the CEO letter that they had trouble raising rates in the poor economy. The company's athletic club membership grew last year, but a decline in yacht club membership balanced out the gain resulting in no net change.

Usually companies like this are structurally cheap for a few reasons. The first is the company is a partnership meaning shareholders receive a K-1 each year which complicates taxes. The second is the share price is high. At $1k per share prospective buyers are locked into buying in $1k increments. Lastly as a collection of assets the company doesn't fit into a mold. They're not a hospitality company because they have storage units. They aren't a pure storage unit company either because they own a boat club, hotel and athletic club.

For now shares of the company aren't cheap, but this is the type of company I want to keep on my radar, and if shares do drop I'd consider picking them up and tucking them away into a corner of my portfolio.

Talk to Nate about LAACO

Disclosure: No Position.

A misguided activist at DT Interpreting

2013-04-02T00:50:00.002-04:00

This would be an appropriate April Fools post, but unfortunately this post isn't a joke, it's real. Usually the appearance of a catalyst is good for a stock, unfortunately in this case it's just confusing. There are so many strange things about this investment that I'm not even sure where to begin, I'll start with a little background.

The company is named Deaf Talk, but does business as DT Interpreting. They're located in Carnegie, Pennsylvania, which is about eight miles from where I'm typing this. I've driven past their location a number of times. For me there's an added intangible element to knowing about the physical location of a company. In DT Interpreting's case I know they are in a sketchy part of town that was hard hit by steel mill closures and a flood in 2004. This is all to say the company isn't soaking shareholders by renting out glamorous digs in a ritzy part of town, management appears somewhat frugal, at least in their choice of location.

The company went public in 2010 after being privately held for 12 years. They became a public company utilizing a reverse merger wherein the company merged with an empty shell company that had a ticker symbol. The company doesn't file statements with the SEC, they trade on the pink sheets and volume is light.

The company itself is interesting, they started out as an interpretive service for individuals with hearing problems. The company would have calls sent to them where an interpreter listens and signs into a camera. The deaf individual watches a video of the DT Interpretive interpreter to understand what was discussed. I couldn't figure out from their website if there is two way interaction via video camera. The company has 400 installations of their technology and has branched into other interpretive ventures. They provide translation services for documents as well as general translation for a number of languages.

The company is small, earning just $2.5m in revenue last year and $2.3m in revenue the year before. Their earnings have grown dramatically, they earned $65,000 in 2011 and $141,000 in 2012. The increase in earnings were due to a decrease in ASL and interpretive service expenses. The financial statements can be found on their website, or at this link, they will be uploaded to unlistedstocks.net soon too. I have never seen such detailed statements for a public company; this level of detail is common for a private company, but never a public company. For instance they note that they spent $141.67 for subscriptions and dues, the magazines in the lobby perhaps. They also spent $38.47 on repairs, it doesn't mention the type, but whatever was fixed came cheap. The company even reports the penny they earned in interest on their bank account.

The company isn't trading at a jaw dropping valuation, they trade at 5.85x book value and 13x net income. Granted for their growth this might be cheap, but it isn't the typical low P/E, or low P/B multiple seen with many unlisted stocks.

Enough with the background, let's get straight to the interesting part of this story. A reader sent me an email mentioning that he saw that a 13-D was filed for the company last week. The 13-D is extremely strange, first the filer mentions that his purpose is to buy the company outright. He then details that he plans on increasing revenue by entering into partnerships with "symbiotic companies of equal or greater gravitas."

The filing then goes onto state that the investor intends to announce a buyback of all of the company's shares at substantially higher prices. To top things off the filer owns 450,000 shares, which is a $10,000 position that he claims is 5% of the company's shares. The problem is he made a small mistake, the 8m shares he lists is only the company's public float, the company actually has 42,552,700 shares outstanding, meaning this guy only owns 1.06% of the company.

I did some Googling on the filer and he appears to be an 86 year old who lives in a nice apartment east of the city. The reader who alerted me to this situation tried to contact him, but his phone number is disconnected. The filing has a name and address to receive notices which is different from the filing person. The notice name and address is associated with someone who according to LinkedIn owns a small investment banking partnership that I couldn't find any information on (outside of his LinkedIn page).

It doesn't make sense to me why this person is filing a 13D for an unlisted company in the first place. If a company isn't SEC filing my understanding was they were viewed no differently than a private company. In a private company if ownership changes the exact changes aren't announced to the world, that's they the company is private. Often management likes to take companies dark so they can have the same level of secrecy. In this case it's nice that the aspiring acquirer announced their intentions to the world. My concern is will they follow through? I can imagine a number of scenarios here. The first is I can imagine an older gentleman looking at these overly detailed financials and ranting "They paid $205,000 on phones last year, my phone from Verizon is $45 a month, those idiot managers…" The second scenario is one where this is an older man who's investments and affairs are being taken care of by a broker or a family member, and the family member is orchestrating this whole thing. It's impossible to know given that the investor's phone number is disconnected, if he is being scammed there's no way to contact him.

Even if the investor isn't getting scammed this is pretty poor strategy to announce to any and all investors that he intends to purchase shares at a significantly higher price very soon. My guess is if he entered in his significantly higher order with a broker he would probably get a fill from all the investors who are tired of owning this stock.

For the brave souls that think this thing might be real this is an opportunity to front run a massive tender. After some digging I'm questioning what's actually going on here, and I doubt there will be a massive tender or a buyout. I'm actually concerned enough that this is an older man getting scammed that I'm thinking about writing a letter and mailing it across town asking about this whole situation.

Talk to Nate

Disclosure: No position

Bonal: A failed merger and an unbelievable high ROE

2013-03-27T01:16:00.001-04:00

A sudden press release, screams of undervaluation; the dreaded take-under. How can investors protect themselves? Often they can't and they're at the mercy of management or controlling shareholders with ulterior motives. Mistakenly many investors believe take-unders are a feature of small or micro-cap stocks. The storyline goes:"I won't invest in a tiny company because management will steal it" is probably the most touted strawman argument for avoiding tiny stocks. Take-unders aren't a feature of small stocks, they're a feature of any stock with a less than genuine controlling shareholder. For evidence of this just take a look at Michael Dell's offer to purchase his namesake company, if that's not a take-under I don't know what is.

A take-under rarely falls through giving investors a second chance, like the one Bonal International (BONL) shareholders are receiving. For anyone looking for a great background on the company I'd recommend reading the post at OTCAdventures. If you don't read OTCAdventures yet I'd highly recommend adding it to your weekly reading. I'm friends with the author who unfortunately needs to remain anonymous due to his job, otherwise I'd post it here to get the word out. If you're ever in Pittsburgh drop me or him a line, we'd love to meet up to talk cheap value stocks.

The quick two minute synopsis on Bonal is that they sell a patented metal stress test technology. The technology was patented by the Chairman and now CEO (story on that later) decades ago. The level of current patent protection is ambiguous, they might have a newer related patent, but I'm not sure.

As a result of their patents, their sales, or their niche the company has incredible margins, and has recently been growing substantially. Here is a glimpse at their current results:

The company is earning 20% and greater returns on equity. This is even more impressive when one realizes that most of equity is made up of cash and investments that aren't actually needed to generate any of their income. I have a field called ROE-adj on my spreadsheet showing the company's return on equity employed to generate the returns, the numbers are unbelievable.

The company is selling for close to 2x book value, but given that they lease their premise, and don't have many fixed assets this isn't an unreasonable multiple. The correct way to view Bonal is as an income stream. On that note they're trading for close to 10x earnings which is probably a low multiple for such a profitable company. The company has earned $.18 per share this year so far, if things continue on track it isn't a stretch to assume they could make $.20 per share. At a 10x multiple on earnings, plus the excess cash of $.56 per share the company's value is close to $2.50 at the low end. Additionally the company pays a generous dividend giving the stock a current yield of 15%.

Given what we know about the company's growth and margins it should come as no surprise to hear that shareholders were outraged when they received an offer on Feb 8th to merge with DePierre Management & Manufacturing for $.86 per share, plus a special dividend of $.20-30 per share. Backing out cash the deal valued the company at about 3x earnings.

It seemed like there was no way for the deal to fail with the founding family owning 65% of the company, except that it did, so what happened?

It's important to realize that the controlling shares don't reside with any one person, they're spread across a trust and five relatives. Together these family members own 65%, but individually no one controls more than 24% of the shares.

I believe the key to understanding why the deal failed is buried in the press release announcing the deal itself. Towards the end of the release there is a small paragraph mentioning that two Board members resigned, and the CEO was relieved of his duty and is now in charge of the marketing department. The Chairman and former CEO has reassumed the role of CEO.

I want to put forth a theory that could explain this, it seems reasonable to me, but I don't have any solid evidence to back this up besides conjecture. My guess is three of the Board members didn't want to do the deal and were working to stop the transaction. Somehow the Chairman forced two of them to resign and demoted the third removing them all from the Board. By doing this he was able to vote to accept the transaction with whatever yes men were left. The transaction itself is a bit suspicious, the company agreeing to merge happens to have the exact same address as Bonal itself. This appears to be a Chairman take-under that's going private.

Private shareholders were rightfully surprised and incensed at the proposed merger, and along with the three ousted Board members there were enough votes to block the merger from taking place.

The strange turn of events places the company in a very unique position. The Chairman clearly wants control of the company back, yet minority shareholders, and other family members are unwilling to sell the company at the price he's willing to pay. Right after the company announced their take-under they also announced record quarterly earnings. Earning momentum is headed in the right direction, and as long as the results are sustainable this is a fast growing little company.

I'm not sure where things go from here, but at this point minority shareholders appear to be in control. This is a story I'm going to continue to watch.

Talk to Nate about Bonal

Disclosure: No position

First Aviation, a catalyst wrapped in a mystery

2013-03-21T15:49:00.002-04:00

Luck is often described as where preparation meets opportunity. I'd like to consider myself lucky with my First Aviation Services (FAVS) investment, but it's really too early to know. I prefer simple investments if possible, they're easier to understand, and eliminate opportunity for mistakes. But often opportunities lies in hard to understand or complicated situations, First Aviation Services qualifies as both.

Sometimes I get emails asking where I find my ideas, some readers believe I have a secret source for finding undervalued ideas. Unfortunately I don't, I just do simple things often enough that I eventually become lucky. Wednesday I was browsing the OTCMarkets.com website and noticed on the front page under that a OTC - Limited Information company had sold a division. I clicked the news link and noticed that the stock hadn't traded any shares, and the price was unchanged. I smelled opportunity.

After reading the news release I started to realize why there was no quick market reaction to the divesture news. The release had no price information, and it was difficult to understand exactly what was being sold. Beyond that the company never broke out any historical sales information making it even harder to guess what the specific division might be worth. I took this as a challenge, with the company selling for less than half of book value, and for less than NCAV I realized there might be considerable value with the company selling a division.

The history

Before estimating what the Aerospace Products International (API) division might be worth we need to go back a little in time and look at how the company became what they are today. In some cases history is important, with First Aviation understanding their history is vital.

First Aviation is an aviation company, they specialize in parts supply and repair. The company is really three independent subsidiaries, Aerospace Products International (API), a parts and service distributor. Piedmont Propulsion (PPS) the last remnant of Piedmont Airlines, they specialize in aircraft overhaul and maintenance based out of their North Carolina location. The third subsidiary is Aerospace Turbine Rotables (AeTR), which designs and manufacturers aviation components such as landing gear, wheels, brakes, and other components for propeller aircraft.

When most people think of propeller aircraft they think of recreation aircraft, it's worth noting that First Aviation's market is mainly turboprops and smaller corporate propeller aircraft. They are not selling parts to the recreation flyer, but rather airlines and companies with corporate aircraft. The company recently was certified to work on the Bombardier Dash-8 turboprop (Q400).

Up until 2009 the company was only the Aerospace Products International division. Towards the end of 2009 they entered into a transformative transaction, from which we can extrapolate details regarding the division sold.

In 2009 the company entered into a transaction with a company familiar to most readers TAT Technologies (TATT). TAT purchased $750k worth of First Aviation preferred shares, and 288,333 shares of class B non-voting stock. In exchange for the investment First Aviation received Piedmont Propulsion. The transaction is a little unusual but at this point it's still straightforward. Here are where things get strange, simultaneously as the company entered into the transaction with TAT they also entered into another one with Kelly Aerospace. The company used the TAT investment as guarantee for a loan to purchase the AeTR division from Kelly.

Let me recap the last paragraph if your head is spinning. First Aviation purchased PPS from TAT, but didn't pay right away. Instead they issued new stock and preferred shares to TAT that have to be held for five years. Then they took that equity injection and used it to guarantee a loan to purchase AeTR from Kelly Aerospace. The end result of the financial engineering is First Aviation before March 20th.

The terms of the deal in 2009 provided a balance sheet for PPS, AeTR, and API. From that balance sheet here are the equity values for each division:

API is on the left, PPS in the middle, and AeTR on the right.

At the time of the merger API had a book value of $13m, PPS of $7.9m and AeTR of $4.8m, keep in mind that API is what's being sold currently. When I looked at this stock First Aviation had a market cap of $8m.

The results haven't been all that great since the 2009 merger, demand fell off 59% over the past three years and the company went from profitable operations to reporting losses. Additionally the company discovered that PPS's results were overstated at the time of the merger. The company thought they were buying a profitable company but were stuck with a loss making division instead. The current management has been in fire fighting mode but their efforts have been successful with the company reporting profits the past two years.

So what is Aerospace Products worth?

Given everything above the task is to consider what is API worth, and at the current price (or the price I paid) is it a savvy buy?

Before looking at what API is worth I want to highlight why this is worth a reasonable speculation. The company was trading below NCAV meaning that my investment was protected by liquid tangible assets. Even with the complicated capital structure, and the outstanding debt if the company were to sell all of their current assets the amount received would have been greater than the level I invested in. From that foundation I knew that my investment was protected and that most likely whatever value the company receives for API is greater than what I paid.

My starting point was the equity amount for API from 2009, which was $13m. The company hasn't performed up to expectations since then, and assets have been depreciated over the past four years. After considering that I thought that API had to be worth at least $6-8m. I speculated that the company would receive at least 50% of it's marketcap in cash from this deal. And given that the company will continue to own the two most profitable divisions after the sale things were looking up.

The company's book value is $23 per share, and it was trading at $9 when I purchased shares. I estimated at $9 and below NCAV I had a hard time going wrong buying. The company is probably worth book value, but this transaction will at least help unlock some of that value.

The company has been paying down debt at a rapid pace and I would presume proceeds from the sale would be used to pay down more debt thereby increasing book value. Investors will own a company with a vastly improved balance sheet, and will continue to own the remaining two profitable divisions and hold a small equity interest in API. The purchaser of API is a private equity group from Cleveland Ohio that specializes in aviation turnarounds. If they are successful the equity interest that First Aviation holds could become increasingly valuable.

Of interest to likely no one but myself is that the private equity firm buying API is located one street away from Ancora Advisors, the fund that has purchased an activist stake in Solitron and is pushing for a $1.50-2.00 p/s dividend.

In the end I picked up a small position in First Aviation, I'm now patiently awaiting updated financials showing what the company will look like post-sale, and what the price of the sale was. It's worth noting I've contacted the CFO asking when we might expect to see the updated financials and I'm still awaiting a response.

Talk to Nate about First Aviation

Disclosure: Long First Aviation

A name brand at a cigar butt price

2013-03-16T00:45:00.003-04:00

What investor wouldn't want to own a piece of a name brand company? Selling an investment story on a recognizable name is much easier than selling the story on Murphy's Midwest Muffler Repair, no matter how cheap the company is. Harry & David (HARR) is unique in that they have a well known brand and the company is cheap being newly issued equity from a bankruptcy re-organization.

For anyone who isn't familiar, Harry & David sells specialty gift baskets. The company's known for gift baskets that include their Royal Riviera pears. For anyone doubting the power of their brand just browser their catalog, they sell nine pears in a nice box for $24! Like with most things it would be much cheaper to assemble a gift basket oneself, but that would defeat the point. Gift baskets are an easy way for someone to pay a small fee and send a message to person that they're appreciated (or they appreciate their business). The company has a variety of baskets for holidays throughout the year, but the Thanksgiving to Christmas period is when the company sells most of their baskets.

The majority of the company's sales are through their catalog and the internet. They also operate 55 stores located throughout the country. The stores accounted for 12% of sales last quarter. The company also operates orchards to grow their famous pears. The company's orchards contain 725,000 pear trees located in the Rogue River Valley of Oregon.

In a cyclical business that's highly levered a small downturn in demand can result in a company tripping their debt covenants; which is what happened to Harry and David in 2011. The company experienced reduced demand in Q2 2011 and the result was a default on a $105m loan. The company went through bankruptcy and restructured their balance sheet resulting in $276m worth of pre-petition obligations settled and wiped clean. The company now has no long term debt, and no pension liabilities. The company does have a few settlement payments left to the PBGC, but they will be completely satisfied in 2014.

Out of the bankruptcy re-organization senior note holders were offered rights to purchase 76% of the newly issued common stock. As part of the restructuring process the company qualified for fresh start accounting. This means the entity was revalued given a specific point in time coinciding with the emergence from bankruptcy. The valuers looked at the company from the perspective of what might they be worth in a sale today? Here is a picture of the valuation, and the numbers that went into it:

What makes Harry & David interesting is not their story but their valuation, their market cap is $84m. The current balance sheet had $89m in cash, and if an enterprise value were calculated off their last balance sheet it would be close to $4m. And based on the most recent quarter they have a EV/EBIT of .07x. As I mentioned above the company is extremely seasonal, they make most of their money around the holidays then steadily lose money the rest of the year. This year was no different, they made $41m in the last quarter, and will most likely lose $10m in each of the other three quarters.

I have a spreadsheet with results going back to the emergence from bankruptcy below. A general note, if you try to add the quarterly numbers for 2011 together to match the fiscal numbers they won't match. One of the quarters had different dates from the fiscal year meaning the time periods aren't the exact same. That detail doesn't matter specifically, I put this together to grab the seasonal trend.

The trend in the results is clearly apparent. The company makes a haul at Christmas and then steadily spends down the cash and loses money the rest of the year. If the losses are less that what they made at the holidays they turn a profit at the end of the year.

A side effect of this feast and famine cycle is as the company spends down their cash each quarter they end up in a position where it becomes hard to finance working capital. Especially in preparation for the holiday season. Because of this the company carries a revolver which they tap each June to December. In January the revolver is paid back and the company operates on a cash basis until June.

Valuing Harry & David

When I'm looking at a company's earnings I like to use the EV/EBIT multiple because it cuts through extra cash, includes financing and shows what I consider core earning power. This metric is especially useful when looking at little cash boxes, something I do often.

Calculating an accurate enterprise value for Harry & David is difficult, what point in time should an investor use? Should we extrapolate a $12m loss forward for the next two quarters and use a projected $65m cash balance for the end of the fiscal year? Figuring out earnings or EBIT is much easier because the proper way to view them is over the entire year.

I re-valued the company using the same methodology that was used when they emerged from bankruptcy but I used figures from the latest quarter:

While I've never tried to value a company with this method before it's nice to see that the number it generated is very close to the company's book value for the last quarter. If nothing else the fresh start valuation methods reinforce the company's book value.

One other item worth noting is the company's liabilities could be potentially overstated as they carry $36m in deferred revenue on the balance sheet. It's likely they will recognize this revenue considering they received most of the cash for it already.

Worth it?

The company appears cheap, they're trading at 71% of book value, or 60% of adjusted book value taking into account the deferred revenue they've received as cash. On an asset basis the company certainly merits consideration as an investment.

Unfortunately for me the story stops there, while the company has considerable brand power, and is trading at a large discount to asset value there is an intangible that I can't ignore, their financing decisions. Due to the nature of the company's business they are forced to continue the same patterns that led them into bankruptcy the last time. They still have a revolver they tap in the summer and pay back after New Years. If sales were to decline again like they did in 2011 the company could find themselves in a position again where they might be in breach of a debt covenant.

The other issue I have is while the company has a profitable niche that's all they have. Unfortunately their cost structure for this niche doesn't leave much profit left over for shareholders at the end of the full year. The company has pushed harder into the online marketplace, but they've had to reduce prices to push volume impacting margins.

I think Harry & David holds a lot of potential for many value investors, but for me it's a pass.

Talk to Nate

Disclosure: No position

Quantitative Value: Insightful, but more questions than answers

2013-03-12T00:19:00.000-04:00

I finished reading Quantitative Value a few days ago, a friend read it, liked it and sent me a copy asking my thoughts. The book has been making the rounds on value blogs and the subject tied into something I wrote about recently on quantitative investing. As you'll see in my review the book was extremely thought provoking, yet by the end I had more questions about the approach than answers. I haven't seen anyone pose these questions, and I thought they might be worth posing to readers for consideration. This review is broken into two parts, first is an overview of the book, and second are my specific quibbles, or questions.

Overview

The book is written by Wesley Gray and Toby Carlisle both managers of hedge funds. Toby used to write daily on the Greenbackd blog which I read habitually when he was posting about net-nets and deep value stocks. That site along with others motivated me to investigate these strange creatures called "net-nets". I am indebted to Toby for illuminating such a lucrative area of the market for me.

The authors originally set off to understand why they couldn't replicate the results from the Magic Formula investment system. The Magic Formula is a system to high high quality stocks at low prices. Joel Greenblatt the author of the system wrote about it in The Little Book That Beats The Market. The results shown in the book are simply unbelievable, and unfortunately no one has been able to replicate them either.

Carlisle and Gray like the concept of buying the highest quality cheap stocks. They present a lot of evidence that supports the notion that buying the cheapest stocks outperforms glamour stocks. They they consider whether they can improve upon the notion of just buying cheap and eliminating frauds and accounting manipulators (you can). They also look into why certain types of glamour stocks perform the way they do. One observation I found fascinating was that the quality metric that the Magic Formula is based on actually picks the wrong time of quality (high priced glamour vs high quality) which in turn drags down the Magic Formula returns.

As the authors walk through their model they show their research into each metric they decided to use. For me most of the value of the book lies in these chapters. There were lots of fascinating points that prompted me to think about my approach.

Questions

1.) Does the quality metric really measure quality? The authors posit that the best metric to measure the quality of a business is gross margin divided by total assets. This formula is supposed to eliminate company financing decisions and focus on companies that earn the highest gross margins on the smallest invested capital.

I spent a long time thinking about this equation and my conclusion was it would bias quality towards franchisers, software companies, and any service company where personnel not fixed assets generate a return. The equation also fails to capture lease expenses, so given two of the same companies one that leases all of their assets would be considered higher quality over the one that owned all of their assets.

I also thought about what I would prefer as a business owner, a company with high gross margins that has significant SG&A expenses or a low margin product that has almost no marginal costs. The low margin product in this case would result in more profits but would be captured by the formula as low quality.

2.) Who is the intended audience? Throughout the book the authors appeared to be writing to investors who wished put their investment theory into practice. They discuss portfolio considerations with regards to small and illiquid stocks. Yet later in the book the authors disregard certain types of stocks because they aren't considered academically pure. As an investor I want the highest returns regardless of if they are respected by academics or not. One of the authors Wesley Gray is a professor at Drexel, and I presume decisions like this are the influence of his academic finance background. There are a few other academic finance-isms scattered throughout the book that detracted from the main story.

3.) Why ignore small caps? There are two specific places in the book where the authors mention strategies that far outperform both the market and Quantitative Value, yet they're both dismissed almost immediately as uninvestable because they deal with smaller stocks. The authors maintain that any stock below a market cap of $1.4 billion is a small cap. They categorize small caps as almost impossible to trade.

The first strategy they discussed was one where an investor would buy all of the stocks trading below book value and divide them into two parts based on F_SCORE (a measure of financial strength). The investor would buy the stocks with high F_SCORES and short the ones with low F_SCORES. This strategy outperformed the market by an astounding 23% during the period tested.

The second discarded strategy is one near and dear to my heart, Graham's net-net strategy. Graham maintained that an investor could earn north of 20% a year investing in a handful of net-nets. The book confirms this and then goes on to say that net-nets are near impossible to find and invest in.

While I understand that pension funds, and large mutual funds can't invest in smaller stocks I would wager that most investors, and professional investors are actually working with sums of money that could easily invest in stocks at the $1.4b level and below.

Paradoxically the book shows over and over that smaller stocks have higher returns over any test they run, yet the book pushes readers towards larger cap stocks. The website associated with the book only lists stocks $10b and larger.

4.) How is performance compared to fundamental indexes? The Quantitative Value strategy appears to be a different type of fundamental index. It would have been nice to see the strategy compared to the Research Affiliates or WisdomTree indexes. The Quantitative Value approach seems like a costly approach (transaction costs/taxes) especially if there is an fundamental index that performs closely.

5.) Is there more? The book went to great lengths to describe the authors strategy and thesis, but unfortunately they didn't touch on how anyone would actually implement it short of investing with them. Both authors run hedge funds that are out of investment reach by everyone outside of institutional and accredited (wealthy) investors. If an investor with $500k wanted to implement Quantitative Value the book doesn't give much detail on where to start.

The biggest issue with implementation is gathering and crunching the data. My sense is that an investor would need a Bloomberg or CapitalIQ to gather the required data to implement this strategy. Maybe the authors plan on unveiling a product similar to Formula Investing and that's why they were light on implementation details.

Conclusion

This review is probably sending a mixed message; parts of the book are great, yet there are some fundamental issues I had as well. While I don't think investing is as easy as programming this formula into a computer and sitting back as the money prints, there is a lot that's worthwhile in this book.

While I'm not quantitative value practitioner I did recognize that I apply some of the patterns discussed in the book. I will find pools of the market that are cheaper than the rest and fish accordingly. I try to watch for fraud and accounting manipulation, and I buy as cheap as possible in quantity. I'd rather own five cheap semiconductor stocks rather than the best cheapest semiconductor stock.

I also realized as I read the book that I've applied a psuedo-quant strategy to parts of my portfolio. I've purchased Japanese net-nets based on a simple formula, less than 2/3 NCAV, profitable, pays a dividend, and is a business that will be around in 10 years. I've invested in other areas like this as well.

I enjoyed reading the book, it was quick, and it made me think. I also had some lively discussions with some friends about concepts in the book. On the whole if one approaches the book as Gray and Carlisle's thesis on their investment method I think a reader will be satisfied. If one approaches the book looking for something that could be applied to their own portfolio I think they'll be left wanting, at least until the QuantitativeValueApplied fund launches.

Talk to Nate

Disclosure: I receive a small commission if you click and buy through the Amazon link. Think of this as a way of supporting the site, so if you enjoy my work go ahead and buy a big screen TV, or a luxury watch! I'd recommend you buy a car or a house through Amazon if I could figure out a way to do it

There are two types of net-nets...

2013-03-06T23:45:00.001-05:00

This post was inspired by a comment and a tweet about my last post on Micropac. Two readers asked why I would even consider earnings when looking at a net-net. I look at earnings because I believe there are two types of net-nets, some that are piles of assets, others are operating businesses selling at too low of a value.

The idea behind investing in net-nets is that a business shouldn't be worth less than their net current assets (NCAV). Net current assets is defined as current assets minus all liabilities. If such a business were to liquidate investors would realize a gain beyond their initial investment.

The idea of a net-net first appeared in Graham and Dodd's 1934 edition of Security Analysis. At the time the market was littered with companies selling below NCAV, some estimate almost 40% of the market sold below NCAV at one point. Today not as many net-nets exist in the US, most are smaller cap stocks with questionable businesses. Many market historians claim net-nets don't exist anymore, or are out of reach for most investors. While the US market isn't full of net-nets a variety do exist worldwide with the biggest concentration in Japan. Japan's current market is similar to what the US was like in the 1930s. Many companies in Japan trade below NCAV, companies with solid business models, long histories of profits, and sound management. There are always a number of reasons investors try to justify why a company is selling below NCAV but whatever the reason it seems strange. Investors who are managing hundreds of millions of dollars might be precluded from investing in net-nets, but for any investor managing less than $30-40m there are plenty of opportunities globally.

Forget the financial markets and for a moment imagine a local business with one location on a sparsely travelled secondary road. The owner has run the business for years and has done ok for themselves, but the business isn't growing, and the location is in need of updates. The owner has been prudent and saves most of the excess cash and has no debt. Now imagine walking into the business and offering to purchase the entire business for less the cash and inventory and receivables. The owner would laugh you out of the place, but this is what many net-nets are like. The wallpaper needs to be replaced, the seats need new cushions, and the pictures from the 1980s need to go. Some net-nets are the equivalent of walking into the local business and offering to buy the company for less than the cash on hand. Making an offer like this would be insulting no matter how marginal the business is. Yet in the financial markets stocks trade like this every day, and even worse investors somehow trick themselves into justifying these low valuations.

The premise of Graham's original net-net investment thesis was that a reasonable company shouldn't be worth less than NCAV. He recommended investors purchase net-nets at 2/3 of their NCAV or below and sell them when they reached 1x NCAV. On the basis of this investment process alone he claimed 20% annual returns. In Security Analysis Graham discusses that a prudent net-net investor should prefer companies that are profitable and that do not exhibit an eroding NCAV.

Based on the Graham criteria it should be fairly simple to value a net-net. Take the current assets, subtract all liabilities and invest when the price is below 2/3 of NCAV. When the price eventually rises above NCAV sell the stock.

While this is a simple and sound strategy the truth is the market doesn't evaluate companies based on their asset values. This is why companies sell below book value or NCAV in the first place. The market is earnings and future focused. This isn't a new phenomenon either, Graham himself discusses it in Security Analysis.

I have explained in posts over the past few years that I separate net-nets into two categories:

Asset net-nets - These are companies with a pile of assets where the investment value resides within those assets. The goal with asset net-nets is to buy ones with businesses that aren't destroying the asset value.

Operating net-nets - These are companies that sell below NCAV but their value isn't found in their assets, but rather their operating business. An example of this type of company might be an industrial company with marginal operations and a large inventory and receivable balance.

Valuing asset net-nets is simple, calculate NCAV and buy when the price is less than 2/3 of NCAV, the same as Graham preached.

Operating net-nets are viewed differently, while these companies are selling below NCAV they do have value beyond their asset value. Net-nets of this type could be companies that fell on hard times and their earnings suffered. Or companies that are experiencing cyclical slowdowns. Eventually earnings will recover.

Because the value in an operating net-nets is found in the business not the NCAV valuing them should be done the same way one might value any other business. The NCAV in this case provides a margin of safety. If the company were to hit hard times it's reasonable to think they could liquidate and the investor would still realize a positive return. The investor isn't investing on the basis of a liquidation, they're investing with the hope that the company's results will eventually recover, or the market will warm up to the company.

Determining the best way to value a net-net means determining what the investment thesis rests on, asset value or an operating business. Of course it would be hard to go wrong simply following Graham's original strategy of buying below 2/3 NCAV and selling at 1x NCAV. The reason to view an operating net-net as more than a pile of assets is because some businesses are such, and once the market realizes this NCAV might become a distant memory as the stock rises.

I own both types of net-nets, I don't discriminate or have a favorite type. Asset net-nets are more of a sure thing in terms of safety, whereas operating net-nets seem to have more of an upside. Both are worthy additions to a value investor's portfolio.

Talk to Nate

Micropac, worth another look?

2013-03-05T00:58:00.002-05:00

It's tough writing a blog at times. I've written about a number of companies and I'm always striving to bring something new and fresh for readers. Yet the reality is outside of a few fanatics (and I love you guys) most people haven't read the blog from start to finish. So if I wrote about a company two years ago most readers are unaware of it. The challenge is writing updates to old companies in a way that's engaging for newer readers and is still informative for readers who remember the first post. Micropac is a company I wrote about almost two years ago. They're a net-net that's still trading below NCAV. I received the annual report in the mail today (yes, I love receiving hard copies) and after reading all 29 pages I felt that they were worth a new post.

For the uninitiated Micropac is a electronics manufacturing company located in Garland Texas. They develop electronics for the defense, aeronautics and space industries. You'll immediately notice their biggest customers are all government related. The company's products are split with 35% being custom designs and 65% being commodity designs. The company hopes that many custom designs will eventually become useful in creating new commodity designs, but it's far from certain that this will ever happen.

When I first wrote about them the company they were much more attractive. Earnings and margins were much higher than they are now, although NCAV was lower then. So in the past two years the company earned $.64 p/s last year, and $.18 p/s this past year. They've grown NCAV from $5.86 to $6.17. Here is the net-net worksheet:

The company is still selling for a discount to their NCAV, although with the recent earnings drop a solid argument could be made that maybe they're not worth NCAV.

The company is closely held with directors owning 76% of the company. This number is a bit misleading, there is one shareholder, a German industrialist who owns 75% of the shares. It's unclear what his relationship is to the company, but apparently years ago he spotted something he liked in Micropac and purchased most of the company.

The company's earnings fell due to lower sales volume in their high margin space related product. Without the higher margin items the company needs to boost their sales level if they want to bring earnings back to what they'd been in years past. The concerning aspect of this is that 65% of the company's sales are to the DoD and NASA, two organizations that aren't exactly experiencing a growth phase right now.

Most of the company's clients are defense contractors, meaning that Micropac's revenue will ebb and flow with government spending. As of this post it's mostly an ebb and not much of a flow, although that could change.

Even with reduced earnings the company is still profitable, although this past year there was some cash drain. The company ate into almost $1m worth of savings investing in plant, paying dividends, and letting receivables expand.

The good news is that Micropac has a backlog of $9m in orders that they expect to fill in 2013. This means they only need another $8m in new sales throughout the year to equal 2012's performance. If they can kick their sales team into high gear they could maybe notch revenue back up to the $20m plus range where earnings per share would be over $.50 again.

The investment case when Micropac was selling below NCAV with loads of cash and selling for a P/E of 8x was much easier to make than now. This past year the company has burned down some of their cash reserves and earnings fell off a cliff. They now have a P/E of 32x and a EV/EBIT multiple of 6.9x.

I'm re-evaluating what I want to do with my Micropac position. If earnings continue at the pace they were at for 2013 I would consider selling them at NCAV or NCAV plus PP&E. If earnings recover to the pace they were at over the past few years I would hold on for a sale price close to $10. So right now I'm just continuing to be patient, but I do have one finger on the trigger pending the next few quarters results.

Talk to Nate about Micropac

Disclosure: Long Micropac

Solitron proxy fight, my thoughts

2013-03-03T00:39:00.002-05:00

I've posted about Solitron Devices (SODI) many times on this blog. They're an undervalued electronics manufacturer located in Florida. The company is a perennial net-net that froze investor dollars in place for years at a time. The undervaluation is due to two factors, a complicated bankruptcy in the 1990s with associated environmental liabilities and corporate governance issues.

I took action and wrote the company a letter urging them to resolve the undervaluation, and in response the company repurchased some shares and announced the intent to hold an annual meeting this year. It wasn't as easy as writing a letter, my letter woke up the sleepy shareholder base. Once the company realized people actually cared about them, and were watching their every move they started to take action.

It seemed things were moving in a good direction, the company was resolved to hold an annual meeting, and with environmental liabilities finally settled maybe cash would be returned. Then out of no where a small hedge fund (Furlong Fund) in DC filed a lawsuit against the company. You can read the actual suit here on Jeff's blog.

The lawsuit appears strange to my non-lawyer eyes. It's really a mix of a few items. First, the fund is suing to compel Solitron to hold their annual meeting in April. Second, the fund is trying to force Solitron to pay their legal fees, and finally they bundled a proxy with this whole thing.

To the first argument the fund states that Solitron hasn't picked a date for their annual meeting yet and they want the Delaware court to force them to hold a meeting in April. The company responded that this wouldn't give them enough time to release their annual report before the annual meeting and they'd prefer to hold it in June. I am personally in favor of June because I plan on spending a few extra days in Florida around the annual meeting swimming and sitting at the beach. While the water is acceptable in April I prefer June. Further I would prefer to attend an annual meeting where the company could discuss their full year results.

I believe the reason the fund wants the meeting in April is so they can speed along their proxy agenda. They are pushing the company to change bylaws and push through their slate of directors.

The third item is concerning as a shareholder, and a little strange. If this fund wanted to maximize their investment in Solitron they wouldn't sue the company and then ask for the legal fees. Any legal costs Solitron pays diminishes what they could ultimately receive from the company. Solitron could play the scorched earth strategy and spend all of their excess cash on lawyers defending themselves.

The fund's position is small, they own 18,000 shares worth $67500. If they spend $45k in legal fees a 100% return on investment becomes a ~25% return for fund shareholders. If Solitron doesn't pay the fund's legal fees it's hard to imagine them earning a good return at all. I am wary of an investment thesis which includes suing a target company and the company paying legal expenses for things to work out.

As for the proxy I would encourage all shareholders to read the filing here with the descriptions of directors. If this fund got their way they would effectively control the company after buying 18,000 shares and filing a suit. If the fund is serious about Solitron I don't know why they don't put their money where their mouth is. For filing a suit I'd expect at least a 5-10% position if not more. Either this fund isn't serious, or they don't have much money, I'm not sure which it is.

I'm worried this fund is using Solitron as something to build their resumes. The problem is as a shareholder they're using my money to build their resume, not something I take lightly. I've talked with some of the major holders of Solitron and can say they aren't exactly warm to the proposals either.

There have been indications that Solitron was moving in the right direction on their own without costly lawsuits and some simple prodding from shareholders. Holding a company accountable doesn't require an appearance in a Delaware court. Many CEO's are reasonable people, Saraf included, and with some prompting and discussion do the right thing.

Talk to Nate

Disclosure: Long Solitron