Tuesday, August 7, 2012

Rethinking Titon Holdings

If rules are made to be broken, what's the point of creating rules?  That's the question I've been asking myself as I consider my position in Titon Holdings.  The rule that Titon breaks is that I only invest in net-nets that are profitable or cash flow positive.  I created this rule after losing my shirt on Seahawk Drilling, a net-net that was burning cash and always a quarter away from turning around.  The turnaround never happened and I ended up receiving a lesson in bankruptcy and distressed investing.  After my Seahawk experience I decided I didn't want to invest in any melting ice cubes; hoping and wishing for dramatic turnarounds.  To protect against this I created a rule that I'd only invest in net-nets that were cash flow positive.  I haven't had a problem finding new investments with this rule, but I hadn't been faced with what to do when a current holding goes negative either, until now.

Titon Holdings is a company that manufactures and sells vents for windows.  The vents are simple devices that let homes breath.  I have to make a confession, no matter how many times I've looked at Titon's website and talked to Britons I still don't understand why a window vent is needed.  I've accepted the fact that people outside the US (and Canada?) need little vents, whereas our windows open completely.

Titon sells most of their vents in the UK, they also have a joint venture in South Korea.  The South Korean joint venture's results have been a roller coaster with some years adding to Titon's bottom line, and other years subtracting.

How bad is it?

When I last profiled Titon they had a NCAV of 56p and a discounted NCAV of 36p.  This time around the values are a bit lower:


Since last year the company's NCAV has dropped from 56p/sh to 52p/sh, is Titon the proverbial melting ice cube?  A melting ice cube is a company or a net-net where company operations slowly chip away at a margin of safety.  Cash burn slowly eats into the buffer investors have on their initial investment.  If investors hang around long enough they could witness the stock move from being a net-net to being a cash burning company with negative equity.  An unfortunate feature of investing in net-nets is one comes across a lot of ice cubes.  If I had to venture a guess I'd say probably 70% of companies that qualify as net-nets also are in some stage of melting, some much quicker than others.

For me the art of investing in net-nets is separating the wheat from the chaff, finding the companies that are likely to see better days ahead where a real margin of safety exists, and isn't in a state of decline.

As I mentioned above what made me re-evaluate Titon was when they went from cash flow positive to cash flow negative.  I put together a small spreadsheet showing how revenue, various profitability metrics, cash, and current assets have changed over the past six semesters.  I looked at the past six semesters as it captures the company from the bottom of the crisis to now:



Readers will note that while revenue has remained somewhat steady nothing else has.  One semester net income shot up 58%, and the next it dropped 51%.  It's worth noting that even in past semesters when the company recorded an accrual loss they had positive cash flow from reducing inventory investment and tightening up on collections.

The profitability trend is concerning, but that's not what concerns me the most.  What's most concerning is the trend in the company's cash position.  The company has steadily spent down their cash reserves over the past year and a half as operations have deteriorated.  What's even more concerning is management has insisted on continuing to pay the dividend even though they expect the second half of 2012 to be the same or worse than the first half.  If management is to be taken at their word we could see cash drop below £2m and NCAV drop into the 48p range.

Conclusion

I'm split on what to do, part of me wants to just sell my holding, take a loss and move on.  Another part of me is a hopeless optimist thinking the company will turn around in a semester and all will be well.  I recognize patience is key to investing, yet at the same time being patient with an incorrect investment is foolish.  I would rather be patient with companies that don't have a shrinking margin of safety.  I'm going to continue to think about this position, but I think I'll end up selling at a loss.  Investors are often too quick to sell winners and too patient with losers.  In typing this post I recognized I've probably been too patient with Titon and it's time to move on.  Thoughts are always welcome!

Talk to Nate about Titon Holdings

Disclosure: Long Titon Holdings at the time of this post



7 comments:

  1. Hey Nate,

    Love your blog. Always great thoughts and interesting stocks. Great post here. I completely agree with you that the real trick to net net investing is being able to separate the wheat from the chaff. Furthermore I think it helps to have a more flexible definition of a net net. For instance the Marty Whitman example that a Class A Office Building can be sold in about an hour, and therefore one could re-categorize as a current asset. This is one stait-forward example, but the thought can be taken further (For Ex: Fin 48 reserves, contingent payments, JV off balance sheet cash, etc).

    I have to admit that I use many rules as well, but I think it's extremely important to break them from time to time. To me, investment rules are there to make you mentally have to cross a higher threshold... which is a good thing.. but by always following rules we give up the basic advantage of context and circumstance which we humans have over computers. If we simply always follow rules and never break them, then we're essentially practicing quantitative value investing, therefore should sit around programing all day, not reading SEC docs. For example, I have a rule to never investment in turnarounds (A rule that has served me well; this is somewhat similar to your no cash flow burning rule). However I made an exception a while back with a company that was burning cash since it had new management (CEO who was an accountant (CPA)... which I love to see because they are always watching expenses) who was simply going to 'right size' the expense structure of the company. Cutting costs and right sizing a business is a lot easier than turning around a business and expending sales or improving gross margins. This CEO simply went to town on SG&A and directors cost, all things that when you ran the numbers seemed doable and easy since there was a decent underlying business on a gross margin basis.

    So, are you right to follow your rule with Titon? I have no idea, but I do think rules are (to misuse a Buffett/Graham quote) "there to serve you, not instruct". I think we create and use rules, try to mitigate known behavioral bias all investors make, check our egos at the door, try to always be intelligently honest, admit mistakes... and break rules when context/facts/numbers/extenuating circumstances warrant the human touch. Maybe what I'm getting at is subtler than saying that we should "break our investment rules"... instead maybe at least make sure the rule applies, and give ourselves the flexibility and allowances to bend our rules given the circumstances.

    Just thinking out loud.

    Thomas

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    1. Thomas,

      Thanks for the comment, it was well thought out and insightful. I'm not sure I agree with the expanding definition of a net-net, but I don't limit myself to only net-nets, so a company with a high quality book value selling at a discount is attractive as well.

      You have a very good point about turnarounds which is it's much easier to cut expenses than raise revenue. Revenue might rise naturally if a whole industry or sector heats up, but for a poor company (what net-net isn't?) to suddenly increase sales is a tall order. So the best way to look at turnarounds really is are there expenses to be cut? If not is the sector ready to turn? If not why investing in a melting cube?

      Thanks again
      Nate

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    2. Hey Nate,

      Thanks for the reply. On your first paragraph.. I suppose Whitman's idea is actually a separate idea entirely (that is, his idea of re-categorizing the balance sheet given the actually liquidity of the asset/lia).. and what I'm really getting at is that there hidden net nets out there... and with a few accounting adjustments, or alternative information sources, like PACER or statutory filings, one can find some hidden net net gems.

      On your second paragraph.. I completely agree but would say that you have to be careful calling the trn in a sector. It's one thing if the company's sector in the doghouse and their cost structure is completely variable (therefore profitable or breaking-even through a trough) but I truly believe trying to call the turn in an industry is not really graham style value investing. I think we could add a few 1-800 numbers to Buffett's Air-aholics Anonymous: One for turnarounds, and another for calling turns in industries.

      There are definitely exceptions to the 'calling the turn' rule, but in my opinion I see too many value guys unable to make the distinction.

      Good Investing,

      Thomas

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  2. Just a thought ... I don't know about Seahawk Drilling, but from what little I've gathered, it seemed to be the victim of a one-off catastrophic event. So the risk characteristics are different between Seahawk and TON. That's still not a recommendation either way, of course.

    From my own perspective, I don't recall selling a share that I thought was a piece of garbage that I later went on to regret. I might have sold later than I should have, but I rarely regretted it. Having said that, net-nets are unlikely to have that "fresh-baked smell", shall we say.

    I've read a little bit about Buffett's approach to net-nets, and Geoff Gannon's approach. It seemed that Buffett had an "asset conversion" approach. Gannon's approach seems much more like Ben Graham - own a lot of them, and keep the faith, and keep keeping the faith. I think Gannon has expressed a spectrum of views as to the need for diversification on net-nets, so he may well dispute this point.

    One thing I'll note is this: with TON, you're in an illiquid security, with seeming little chance of asset conversion, and business prospects that could go either way (although most likely down, by the looks of things). Compare TON, with a yield of 5.71%, and VOD (Vodafone) with a yield of 5.75%. The prospects for VOD actually seem quite good. So put it this way: someone was to offer you a deal. They'd give you either £1000 of VOD, or £1000 of TON, with the proviso that you would have to hold for 5 years. Which would you take? If it were me, I'd take VOD.

    Something to think about. And best of luck with whatever you decide!

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    1. You're right that Seahawk and Titon are totally different beasts, but Seahawk taught me the lesson to stay away from companies that are eating themselves to survive, unfortunately Titon seems to have shifted into that camp.

      You have a good point on opportunity costs as well, but I'm not sure it's exactly as straightforward as you make it out to be. If Titon is worth NCAV this stock is a double, I'm not sure of VOD has the potential to double or not. If you look at both companies at an ongoing basis assuming they both have reasonable valuations then yes VOD is the better bet.

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  3. Hi Nate.

    I have commented on this post here: http://market-swings.com/index.php/the-cash-flow-titon-holdings/

    Marcel

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  4. Ok I initiated a small position this morning at 30.79p. Just 6,000 shares. Let's see how it works out over the next year or so. :O)

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