Tuesday, February 28, 2012

Hickok - Intangibly cheap

HICKA

Price: $1.85 (2/27/2012)

I ran across Hickok in the Walkers Manual and upon looking up their address realized I've driven past this place probably hundreds of times on the way to visit my grandparents while growing up.  I also used to drive near this area for a summer job I had during college as a painter.  To toss in another strange coincidence my brother works for a company that's located about a half mile east of Hickok.  So after realizing all of this how could I not look at the company?

To give some background Hickok is a company that manufactures automotive diagnostic equipment.  These are the sort of computers that your mechanic will have to read the diagnostic codes when the service engine light comes on.  Codes are specific to manufacturers so a shop that services domestic cars needs to have a Ford, Chevy, and Chrysler kit.

The company is small with 71 employees spread across two locations, Cleveland (what I referenced above), and Greenwood Mississippi.

So if the coincidences couldn't be enough at this point imagine my surprise when I realized this company was darn close to being a net-net as well.  Here is my worksheet:



There's more than a balance sheet

It's often heard in value circles that buying shares is buying a piece of a business.  Another expression is that we should be thinking like businesspeople.  These are two great expressions but rarely are they carried out.  Most of the time a few quick glances at a balance sheet or income statement are enough to get the Excel wheels turning.  And once Excel is roaring hours/days/weeks/months/lifetimes can be lost building financial models.

I think it's often useful to take a step back away from the financial statements after a very cursory overview and consider the question, "Would I buy this company outright if I had the ability?"  This is a loaded question, a lot depends on the price offered among other things.  But since the company is public we have a price and many investors never move beyond that point.  So the next question is "Would I buy this company outright at today's market price if possible?"  This seems like such a slam dunk question, especially in the case of a net-net.  Who wouldn't buy a company for less than working capital if given the opportunity?  Or even buying a company below book value, surely a nice margin of safety exists.

I wouldn't buy this company, and here's why

First off the company is losing money, but losses have been moderating and it's possible they will turn things around.  The problem is I think the environment they're operating in will make it hard to turn things around and be successful on a continual basis going forward.  This is of course what I'd be looking for as an owner, can this company turn around and operate profitably in the future?  If not will I be able to at least get my money back from the book value of assets?

The company's land and buildings are on the balance sheet with an original cost of $1.6m.  I'm not sure exactly when the building was purchased, the company was founded in 1915, and went public in 1959.  As I mentioned above I know the area, and only a fool would pay $1.6m for their location, especially today.  Hickok is located in a very undesirable area, a heavy industrial area that's seen better days.  Maybe they purchased the land and building during the better times when there wasn't as much overcapacity, maybe..

The problem is the value their facilities might have held when they were originally purchased is now gone.  Of course that's reflected in the balance sheet somewhat with the value of land/buildings/machinery depreciated down to $300k.  This would seem like a more appropriate amount but I still think it's too high.  If you look on Google Maps you can see that most of the area around Hickok is empty lots.  This is where knowing the backstory helps.

In parts of Cleveland there were problems with abandoned houses, drug dealers, and squatters.  The city started to take over abandoned homes and bulldozing the properties.  The lots are owned by the city and are available for sale if anyone wants them.  The problem is there are a lot of empty lots, and no one is really interested in buying.

The other problem is there are a lot of empty industrial buildings similar to Hickok's facilities up for sale as well.  I did a quick search and found a place with 3x the square footage of Hickok located less than a half mile away in a much more desirable location.  The property is listed for $499k or $3.78 per sq ft.  From the ad it looks like they throw in all the cranes and loading equipment as well, surely some scrap value there.

So what's my point?  The point is the location is in a bad neighborhood, an area with past problems so bad the city took over homes and demolished them.  An area with such a high industrial overcapacity that much better facilities can be found down the street for almost nothing.  These things don't mean that Hickok can't do well, but the odds are stacked against them.  Workers reporting to work drive past all of these things everyday.  I worked in a metal stamping shop in college, and the surroundings affect the workers.  Seedier parts of town don't attract the best talent, simply put.

The problem is none of this stuff is visible from a balance sheet, but it would be clear to a potential owner.  A potential owner would visit and see the location and start to think about having to move, or worrying about protecting the cars in the parking lot.  These are intangible costs, or intangible hurdles to an acquisition.  Sometimes as investors we wonder why a company isn't being bought out when everything appears in their favor, maybe there's a physical intangible known to everyone who visits but unknown to those of us who only read financial statements.

Summary

This has been a bit of an odd post, maybe different from most I do.  My point is that demanding a margin of safety isn't some sort of theoretical thing, there's a real world purpose to it.  If we demand a large margin of safety on our investments it compensates for some of these factors that are unknowable without local on the ground knowledge.  Some investments look incredibly risky from a financial statement point of view, but from a local knowledge standpoint might be entirely safe.  Other times something might look very safe on a 10-K but a bit of unknown local knowledge could make it terribly risky.

By definition a value investment is cheap, there is always a reason for cheapness.  I think most of the time we don't dig deep enough to understand or know why.  Understanding why a company might be cheap helps determine the margin of safety required.  I think understanding both of these points well is really the foundation of avoiding losses.  Many investors are surprised by events that shouldn't be all that surprising if we really understood what we were invested in.

Disclosure: No longer live in Cleveland, not a Browns fan, will cheer for the Indians if they make a playoff run.

Friday, February 24, 2012

Investment strategies for a devaluation

The idea for this post came from a thread on the Corner of Berkshire and Fairfax message board asking about Portuguese investment opportunities, and then a follow on email conversation with a blog reader.  One of the questions the reader asked was what were my thoughts on a devaluation in Portugal.

The question was interesting, and I've been thinking about this for while and wanted to put together some thoughts I have on it.  Mainly this would apply to European periphery countries right now but could really be any country at some point in the future.

If anyone has access to the data I'd be interested in knowing how companies that matched my criteria in Argentina back in 2001 did after the devaluation.

What is a devaluation?

Simply put a devaluation is when some sort of event takes place that makes a countries currency suddenly worth less.  On Monday 100 units of currency are required to buy an item and suddenly on Tuesday 150 units of the same currency are required to buy the same item.  This isn't inflation, it's when the currency is deemed to have less value.  The mechanism for this to happen isn't always the same, in the case of Portugal a devaluation would most likely occur if they left the Euro and began to use the escudo again.  In the case of a Portugal the country would be using the Euro on Monday, and suddenly on Tuesday all Euro deposits would be replaced by some escudo deposits possibly at a reduced rate, or at a much higher conversion rate.

How to invest?

The general idea is to find a company that will be unfairly punished in a devaluation, or a company that might benefit from a devaluation.  Here are a few bullet point thoughts on what might be good to look for.

  • Most important, the company needs to be export driven, most sales should come from out of the devalued country, greater than 75%.
  • The company should have a solid earnings stream, this closely relates to the above bullet.
  • Avoid companies that are cash heavy unless the cash is foreign denominated (and even still be wary).  
  • Avoid companies with large receivables in the new devalued currency.
  • Look for companies with payables in the new currency.
  • High debt isn't always bad if it's in the new currency, is devalued and can be paid off with export sales in a foreign currency.
  • Look for some sort of competitive advantage, or brand.  Will an exporter have a stigma attached because they operate out of a devalued country?  Global recognition should mitigate this risk.
  • Put limited emphasis on assets, these will be worth much less after a devaluation.
  • The exception to the above bullet is if the assets are extremely rare and supply is limited.  A priceless asset might apply as well.  
A devaluation could be a catalyst for a generally marginal business.  If the business has local denominated debt, local labor and exports their suddenly strong earnings stream will be able to quickly reduce debt and margins will increase with their new lower labor costs.

Here are two possible investments in Portugal

A decent business with a good earnings stream likely to be unharmed:
Corticeria Amorim, written about here , here and here.

A marginally profitable exporter that could be helped by a devaluation:

Disclosure: Long COR

Wednesday, February 22, 2012

SeaEnergy, lots of cash but no energy business....yet

SeaEnergy (SEA.UK)

Price: 26.25p (2/22/2010)

This is a stock I kept getting mentioned on Twitter and I finally got around to looking into it recently.  SeaEnergy is a Scottish company that used to own an energy company which they sold for £38.6m back in June of 2011.

When I first looked over the company's interim report I was a bit confused.  I kept seeing pictures of boats yet the long term asset account was non-existant.  I then looked for leases and didn't find that either.  I looked at the pictures closer and realized they were computer drawn, not real boats.  I surfed their website a bit more and discovered that the company is currently a shell of cash, and they hope to get into the business of servicing offshore wind farms with a fleet of service ships.

Balance sheet

SeaEnergy is a really simple company to understand, they're a pile of cash, plus a 24.68% stake in listed company Lansdowne Oil and Gas.  This is simple enough I'm just going to show my net-net worksheet below:


Looking at the spreadsheet there's obvious value here.  The shares are trading at 26.25p against a discounted net asset value of 45p and net cash of 42p.  What's attractive about SeaEnergy is that almost all of their assets are completely liquid.

What's really interesting is that management mentions with their interim results that they've restructured the balance sheet so they can return some of the cash to shareholders in the form of dividends or buybacks.  Management plans to make an announcement once the audit of 2011 results are complete, so I'd expect something in a few months.

Looking forward

The big selling point to SeaEnergy is the pile of cash that management has indicated they intend to return a portion of.  What I haven't discussed yet is the business plan that should soak up the rest of the cash.

Sometimes a value thesis will rest on a pile of cash and the fact the company is selling for less than cash, a thesis similar to the one for SeaEnergy.  The flaw with this is that unless the company plans on liquidating that cash has little purpose.  I prefer to buy businesses that are cash heavy, or selling below NCAV/cash, but rarely cash shells.  The problem with a cash shell is they either need to enter a business (using the cash), or liquidate which I mentioned is unlikely.  A typical net-net is just a dumpy business that has hit hard times and is trading at an absurd valuation.  A cash shell is similar to a venture firm, they have raised investment funds and are planning on launching a new business.

SeaEnergy has chosen to do a bit of both, give back some cash and use the rest to start a new business.  They have identified that offshore wind farms have some hurdles in maintainability that they feel could be solved with a fleet of service ships.

SeaEnergy plans on building ships customized specifically to service wind farms on the North Sea.  Conditions on the North Sea are rougher than other locations where wind farms currently exist making current servicing fleets ineffective.  In the shareholder letter they state that they plan on being in operation by 2014 but they are testing their concept this winter with a trial ship.

There really isn't enough information for me to go in depth on the potential for the business.  Management has put out a few slide decks discussing the problem and their potential solutions.  I like that they're taking on the servicing aspect of the renewable market.  Servicing isn't as capital intensive as constructing and maintaining the farm itself.  SeaEnergy has also talked to potential customers and they've expressed interested in their business model.  I want to press the pause button here to mention one thing. I've been involved in startups, and known a lot of startup guys, and let me state that ALL entrepreneurs talk to potential customers, and ALL potential customers express interest.  The problem is when payment is required that sudden expression of interest is more of a nice to have rather than a necessity.

What I don't like

The one thing that I really didn't like is that SeaEnergy is highly promotional, not unlike many US biotech cash shells.  The biotech's always have the next greatest drug that will cure the world of all disease with limitless profitability.  Unfortunately for most investors biotech's almost universally have two outcomes, 1) a buyout (rare, but good outcome) 2) management burns the cash, pays themselves well and investors are diluted to nothing.

SeaEnergy's website is all geared toward potential investors with lots of charts and news releases about how the company is poised for growth.  I'm not sure what the goal is outside of moving the share price.  I would think the management team would be intensely focused on the design of their ships rather than the share price.

Another intangible is that if management knew how explosive this potential servicing business was why aren't they happy to have the company selling below cash while they scoop up shares like crazy.  Instead they seem very concerned about the market discounting their share value.

This stock isn't without a conspiracy theory either.  There was a regulatory filing saying some third party was trying to scam shareholders into giving up shares or entering into phony warrant transactions.  I don't know how the UK works, but stuff like this in the US is always a red flag.  Since I'm not as familiar with the UK markets I'm going to just go yellow flag on this one.  This could be a result of the sometimes wacky investors who form a cult following around stocks like this.

I know these are intangible items, and for most investors these things might not matter much, but for me they're things I try to consider before an investment.

Summary

My last few paragraphs might have seemed a bit overly critical, but it's not common to find a company that's selling below cash without some sort of negative.  If there wasn't a negative aspect I'd be worried!

In short SeaEnergy is like buying into an overcapitalized venture investment.  There is too much cash for the future servicing business so some of it will be returned.  Future gains will be made as a result of the success of the servicing business.  The nice kicker here is that this is different from investing in a venture fund that's returning capital because this isn't your money that's being returned, it's someone else's initial investment being returned to you.

I'm going to watch SeaEnergy play out but hold off on an investment.  I don't know enough about the offshore renewables servicing business to take a gamble on it, and I haven't done very well investing in cash shells.  Some of the intangibles concern me as well.  I think this would be a great investment for someone who is more knowledgable with UK energy investments.

Talk to Nate about SeaEnergy

Disclosure: No position

Friday, February 17, 2012

A few thoughts on ROIC

"the cash return on cash spent for capital." - Ken Hackel

It never fails, if I include my return on invested capital calculation in a post I will invariably get a few comments or emails questioning it or asking for clarification.  This last post was no exception.

The ROIC calculation I use is a bit unique, but I can't take credit for it.  I use a calculation that Ken Hackel presents in his book Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making.  The book focuses on evaluating companies on a cash flow basis.  This means looking at free cash flow, cash return on invested cash, and sources and uses of cash.

Cash and cash flow are the focus of the book because cash flow based numbers show a true flow of what's moving in and out of a business not an accounting version.  Often the accounting picture can be gamed by adjusting estimates.  Some accounting metrics are just outlandish, my favorite is Adjusted-EBITDA.  It seems every company now has an Adjusted-EBITDA number that only includes good things and excludes any potentially bad items.  I've also noticed that executive bonuses are usually based on these fiction numbers as well.  Quite a nice gig if you can get it!

Ken Hackel gives this reason to use a cash flow based ROIC formula verses a more standard EBITDA/EBIT version:

"In essence, entities having a low ROIC or dependent on large capital expenditures resulting in small amounts of distributable cash flows deserve low valuation metrics despite their higher rates of growth in GAAP-related yardsticks.  This is why many investors are fooled, having invested in low-P/E companies." (Hackel, p252)

Hackel mentions that he searched EDGAR to find the most common ROIC formula that companies use to measure themselves, this was the result:


EBITDA + interest income * (1-tax rate) + goodwill amortization
-------------------------------------------------------------------------------
total assets - (current liabilities + short term debt + accumulated depreciation)



A more accurate cash based version presented in the book is as follows:

free cash flow - net interest income
------------------------------------------------------
invested capital(equity + total interest bearing debt + present value of leases - cash marketable securities)

Hackel provides some reasons why specific values are included in the calculation.  Instead of trying to summarize his points I'm just going to quote him, he says it much better than I would.

"
1. Intangible assets because those funds were used to aquire cash producing assets.
2. All interest-bearing debt because this too was sold to purchase productive assets.
3. Present value of operating leases because this represents contractual debt in exchange for required assets needed to produce revenue, hence cash flows.  To exclude operating leases would be to unfairly boost the ROIC and to distort the comparison between companies that buy assets or enter into capital leases and those which enter into operating leases.
4. Since free cash flow is uses, it includes the payment of cash taxes and the elimination of other accruals." (Hackel, p252)

Of course no formula is perfect and there are a few downsides to this formula.  Activities that go straight to the equity statement such as foreign currency translation adjustments, actuarial gains/losses, changes in fair value of available-for-sale assets/cash flow hedges, and revaluations of property, plant and equipment end up affecting the formula.  These changes would need to be backed out to get an accurate picture of the company's cash return on capital acquired for cash.

When I read this formula in the book it really resonated with me and I've been using it as I analyze companies.  Some investors might consider it a bit too stringent, but I don't mind that.  The formula has come in handy finding companies that end up directing most of their cash to working capital or capex.  I don't want to invest in companies that have great net income numbers but don't have the cash flow to back it up.

Disclosure:  If you purchase the book through Amazon I will receive a small commission.  There is no difference in book price entering Amazon through my link, or on your own.  I received this book as a gift from a family member, the author or publisher has never contacted me.

Wednesday, February 15, 2012

Branding this Canadian Leather Retailer as Cheap

Danier Leather (DL.Canada)

Price: C$10.70 (2/15/2012)

Recently a reader sent me an email asking for my opinion on a stock they were looking at.  The company is Danier Leather a Canadian retailer.  The company has retail locations located in malls and power centers which are large outdoor malls.  Danier is a vertically integrated leather company meaning they don't just sell leather apparel they also design and manufacture it.  They source their leather from China and then manufacture their designs domestically.

Before I dive into the weeds I want to make a small investment case for Danier Leather:
-Trading slightly above NCAV
-55% of market cap in cash
-EV/EBIT of 2.16
-EV/FCF of 11.02
-ROE of 12%

Asset value examined

I recently overhauled my net-net template to something that I think will be easier to read and contain more information.  Danier is a perfect company to trial the template on:



There are two columns, the first shows the balance sheet values for different assets.  The second column shows a discounted value of that asset.  Both columns have a per share breakdown as well.

So as you can see with Danier they have an NCAV of $9.06 a share, and a discounted NCAV of $6.08 per share.  Most of the company's assets are in cash and inventory which isn't surprising given they are a retailer.  It might seem strange that they don't have a large account receivable balance but this makes sense.  When a customer comes into a store they pay on the spot, the company shouldn't be waiting for a payment from customers at all.

The item that stuck out to me when reviewing the balance sheet was that there was a relatively small balance of fixed assets.  Knowing that most locations are in malls I figured Danier doesn't own any retails space.  So I searched the annual report for operating leases and voila an off balance sheet contingency.

Adding back the operating leases discounted to the present squarely knocks Danier out of the net-net category.  If they were to liquidate they could still contractually be on the hook for those leases, and the minimum lease amount is more than cash on hand eliminating that buffer.

Fortunately for the reader who asked about Danier all is not lost.  Even though Danier isn't a solid net-net it's not really a problem, the company has no plans to liquidate and in fact they have something most net-net's don't have, a decent business.

The operating business

The company has had a nice run of profitability outside of a small loss in 2009 which is a bit surprising because Canada only had a mild recession as a result of missing the housing bubble.  Some people argue that Canada is in a housing bubble now, but based on Danier's earnings it doesn't appear like too many people are borrowing on their homes to purchase leather goods.

The company has a nice summary in their annual report of the past few years results:


The key takeaway for me is that results aren't consistent but they've been profitable four out of the last five years.  The second key point is that shares outstanding has been declining at a pretty rapid pace, almost 30% fewer shares in 2011 than in 2007.

The next thing I did was to steal an idea from Richard Beddard at Interactive Investor Blog (a must read if you don't already).  He likes to show the growth in book value by breaking out tangible assets, intangible assets and cumulative dividends.  Danier doesn't pay a dividend so I decided to do two charts, one showing assets on a gross basis, and the second showing assets on a per share basis.  The second chart is what shareholders get as a result of buybacks, a steadily increasing book value per share.


Gross Assets
Assets per Share

The last thing I looked at was the return on invested capital.  I get questions about this all the time so I want to explain my calculation.  I take free cash flow divided by equity minus cash plus debt and operating leases.  So let me explain a bit, I use free cash flow because this is a realized return above what the company needs to operate.  This eliminates companies that eat up a dollar generating a dollar even if on a net income or EBIT basis returns look great there's nothing left over for shareholders.  Secondly I add in operating leases because this is an intangible asset the company needs for their business.  If Danier didn't have their leases they wouldn't have a place to sell their apparel.

In computing this for Danier I ended up with a 3.56% ROIC.  Here is the calculation:



Putting it all together

So what we have is a retailer that has a solid balance sheet operating leases not withstanding.  They have a stable sales history and a pretty good track record of profitability recently.  The company's free cash flow has fluctuated over the years with inventory build ups and draw downs.  When free cash is flush the company's used it to buy back shares which have increased the book value for shareholders.

I like to invest in businesses that have an absolute margin of safety which is something I'm not seeing with Danier.  The balance sheet at first appears to provide it but once all liabilities are considered the margin disappears.  The company is undeniably cheap trading below book, with a low P/E and EV/EBIT multiple.

Danier doesn't jump out to me as a fat pitch stock.  The stock is cheap, but there are a lot of cheap stocks out there.  The question to ask "Is Danier cheap due to it's business or something external?"  I don't know the answer.  I also recognized I'm biased because leather doesn't seem to be in style in the US, which means nothing for Canada and a Canadian retailer.  This is probably the type of stock for someone who likes to build a portfolio of low EV/EBITDA, EV/EBIT or P/CF stocks would own and do well with.

Talk to Nate about Danier Leather

Disclosure: No position

Wednesday, February 8, 2012

One heck of a hidden asset

Central Natural Resources (CTNR.OTC)

Price: $27 (2/7/2012)

Market Cap: $13,000,000

Often I will read an investment thesis that hinges on some sort of hidden asset.  A hidden asset is something a company might own that is either under monetized or maybe held on the books at an exceptionally low cost.  In theory most investors somehow skip over these hidden assets when doing their research leaving them as a pot of gold for enterprising or inquiring investors.

I have my doubts about how many hidden assets are truly actually hidden and missed by investors.  I own one company that could possibly qualify, Bowl America.  They own 17 bowling alleys in the DC area and Florida, the real estate is held on the books at cost.  The key is these centers were purchased in the 1950s, so presumably DC real estate is worth much more now than in 1950.  Even though the real estate would qualify as a hidden asset I'm not sure how hidden it is.  Most of the investment writeups on Bowl America all discuss the hidden value of the real estate.  If all investors are looking at the mis-priced real estate it's not all that hidden.

One example of a asset being truly hidden is the case of EDCI.  EDCI was a company that entered liquidation a while back that I owned and followed.  At one point in their liquidation process they announced they sold some patents they regarded as worthless for a few million dollars.

Readers might have noticed that recently I'm highlighting a lot of un-followed and mostly unknown companies.  For some background I've been working my way through a book the Walkers Manual of Unlisted stocks.  I started with the A's and have been steadily moving towards Z.  Some of the companies have gone private, for others there is no information available at all.  Some like Central Natural Resources don't file with the SEC but do put their financials out on their website.  The exercise has been fun, most of these companies are simple to research and it's fun to hunt down hard to find information.

For a quick background Central Natural Resources is a resource company based out of Kansas City.  They own some coal properties along with some gas wells.  Most of their income comes from mineral leases on the land they own.  The company is pretty simple and straight forward, price of gas/coal * amount extracted minus extraction costs and salary equals profit for investors.  The company has been pretty good about paying out a good chunk of profits to investors as dividends.

The hidden asset at Central Natural Resources is a bit more hidden than usual, it only appears in the annual reports as a single sentence.


This is curious, the company has a large coal deposit which hasn't been mined yet being carried for $700,000.  When I read about this I wondered what 92m tons of coal would go for on the spot market.  Using a NYMEX quote of $57.87 per ton that coal has a gross value of $5 billion dollars!  Sure there are mining costs, and transport costs and all sorts of other things but remember that Central Natural Resources's market cap is $13,000,000, there is a lot of wiggle room there.  The value of the coal alone is 400x the trading price of this company.

The problem I have with hidden assets is that while they're supposedly unknown to investors they are well known to the people running the company.  And it's not a far stretch to say insiders probably know the true value of the asset.  Sometimes an insider will be buying back stock trying to capitalize on this discrepancy.  But mostly insiders don't seem to care much, and are content to let a supposedly valuable asset lie idle or dormant.

As I was thinking about Central Natural I kept thinking that management knew they had a $13 million dollar company with a $5 billion dollar asset, so why didn't they get moving on mining it?  I skimmed a few of their annual reports and found some vague references answering my question.  It seems those 92m tons of coal aren't exactly easy to extract, the company has looked into mining it but there have been no mine operators who are interested in digging it out.

Maybe after all the $700k carrying value is overstated?  If there's a pot of gold in the ground that's impossible to extract does it have a value?  Maybe this coal will be like the shale gas, in a few years someone will discover a way to extract hard to reach coal cheaply and Central Natural Resources will make a lot of investors rich.

My conclusion is that relying on a hidden asset to make an investment thesis seems fraught with problems, most where were highlighted above.  This doesn't mean an investor should ignore an asset like the 92m tons of coal, but rather they should view it as an option on their investment.  If something lucky happens and the coal is dug out everyone wins. On the other hand if the investment thesis is based on the value of the coal there's the potential and likely outcome of disappointment when the coal remains in the ground forever.

At this point I should mention that Central Natural Resources actually looks attractive on a stand alone basis, they're overcapitalized with $4.6m in cash and a small amount of debt.  They're trading at a EV/FCF multiple of 6x.  If natural gas prices or coal prices rise again they should do very well.

Talk to Nate about Central Natural Resources

Disclosure: No position

Thursday, February 2, 2012

Rules for net-net investing

I often write about net-net's on this blog and from time to time I get questions asking for certain clarifications to my net-net investment process.  I don't have a written guide so I thought this would be a good place to put down some rules I try to follow.

I guess in a way this could be considered a checklist for investing in a net-net.  I prefer to think of these notes as my net-net guidelines.  Even though these rules are numbered there is no importance to the numbering.  The reason for this is that each investment is different, for some companies #6 might be the most important issue, whereas for others #2 might be more important.

1) All rules can be broken but only for a very good reason.  Good reasons must have a much higher burden of proof.

2) Always prefer cash to inventory and receivables unless:

  • Management is acquisitive, in general stay away.
  • There are restrictions on a dividend.
3) If there are securities on the balance sheet consider if they are encumbered by a relationship.  Are the securities a company in the supply chain, or a cross holding?

4) Prefer shrinking receivables and shrinking inventory accounts.

  • If inventory is shrinking too fast cash will need to be used to build it back up soon, beware.
5) Prefer cash flow and free cash flow over net income if a decision is forced.  Prefer both if possible.

  • Check the accruals ratio for both balance sheet and cash flow accruals.  High accruals are a concern.

6) Stay away from companies that continually change strategy and business line.

7) If operating results are poor is there a chance they will turn around?

8) Determine why the company is selling below NCAV.

  • Is it a good reason?
  • Is the general industry in decline?
  • How obvious is the reason?
  • What changed recently?

9) Would I loan this company my own money for a five year term?  How likely is it I would get it back?

10) Am I relying on non-liquid assets that need to be liquidated?  Is there a market for those assets?  How quickly do those assets sell?

11) If possible try to ascertain how long the company has been trading below NCAV.

12) Always check message boards and blogs if possible.  Current investors have much better insight into the ongoing operations and past struggles.

13) Are there a ton of value investors already invested in this stock?  If this is such a popular idea why is it still cheap?

14) Is there a catalyst on the horizon?  Have there been rumors of catalysts for years that have never materialized?

15) Do I need to rely on a catalyst to realize my investment?


If you have any more suggestions to add I'd love to hear them, leave them in the comments or feel free to send me an email.

Talk to Nate about net-net investing