Thursday, June 28, 2012

Curious about my background?

I get emails from time to time asking about my background or how I got started investing.  I recently did an interview with Tim du Toit of Eurosharelab where we discussed how I started investing, how I manage my portfolio and a few other things.

I want to thank Tim for taking the time to interview me.

Interview with Tim du Toit from Eurosharelab

When readers email me with questions about my background a related question is usually if I could give a book recommendation or two.  I will occasionally mention books on the blog, but I've never formally recommended any.  I thought the link to the interview went well with a list of books I've enjoyed reading that I think readers might find useful.

If I had to make a recommendation it would be to skip anything related to finance and head to the books I have listed under niche and other.  Of course since I write a finance blog readers want to know what finance books I like so I've included them in the list as well.

Investing
Security Analysis 1940 - The classic investing book from Benjamin Graham, I prefer this edition.
Creative Cash Flow Reporting - Security Analysis covers the income statement and balance sheet, this book covers why cash flow is so important and how it can be manipulated.
Billion Dollar Lessons - Everyone likes to read books about success, but success is hard to repeat, failure is not.

General Finance
Lords of Finance - This book reads more like a novel than a history lesson from the early 20th century.
When Money Dies - Great book about the hyperinflation experienced by Germany in the 1920s, a great followup to Lords of Finance.
Manias, Panics, And Crashes - Everyone thinks a particular crash is unique, Kindleberger looks back through history and shows that even financial history repeats itself.

Niche Books
And The Wolf Finally Came - Excellent book on the death of the steel industry in the US.  The book takes place in Pittsburgh so I was able to relate with a lot of the places.  The sub-theme here is labor relations, neither management or labor can take the blame, they worked together to destroy themselves.
Merging Lines - A book about the growth industry of 100 years ago, the railroads.  The book follows the railroad book and regulation and then consolidation of the industry.  This and the sequel book really give the complete lifecycle of the railroads in America.  The book isn't heavy on train details, but more on corporate history.
The King of California -  A book beloved by pink sheet investors.  This book profiles JG Boswell and his agricultural empire in California.  I was almost convinced to pick up a few shares of BWEL for sentimental reasons after reading this book.

Other
The Spirit of St. Louis - Sounds cliche but this is a follow your dreams do something impossible type of book.  As Charles Lindberg shows having the best laid plans aren't always what brings success.
In Search of Powder - Close to my heart (I love to ski) this book talks about the changes aging baby boomers are having on ski resorts, and how money has really changed the industry.  Ski bums are becoming a lost species.
Ordinary Lives of North Koreans - Probably the best book I read last year.  The book takes the reader through the lives of North Koreans who had escaped to China discussing what life was actually like there.  I couldn't put this book down, incredibly sad but fascinating.
Monongahela National Forest Hiking Guide - If you live on the East Coast or Mid-Atlantic do yourself a favor and get to the Monongahela National Forest for a weekend.  There are some beautiful areas such as Dolly Sods along with miles of unspoiled wilderness.


Disclosure: I get a small commission if you purchase an item through Amazon.com using the links above.  The price for each item is the same regardless if you enter Amazon.com through my site or directly.

Tuesday, June 26, 2012

Hooker Furniture and the minutia of inventory

Hooker Furniture (HOFT) is not really an interesting business, they make and sell furniture.  The company isn't necessarily that cheap either it's selling slightly below book value and has a P/E of 22.  So why am I looking at this company?  For two reasons, the first is I want to build up a knowledge of companies that I might be interested in buying if they get cheaper, and secondly I think Hooker has a fascinating investment angle some readers might appreciate.

Quick Investment Thesis

-Market cap of $121m with $47m in cash and no debt
-Selling for slightly less than book value (4% less)
-EV/FCF of 2.62
-Dividend of 3.5%

Background

Hooker Furniture is as its name implies a furniture manufacturer located in Virginia.  They were founded in the 1920s and their products target a upper-medium price point.  The company claims toto innovate in the entertainment and home office segments where they are perceived to be a market leader.  They rolled out a new line recently that's targeted towards younger consumers with lower prices.

The company sources most of their furniture (roughly 75%) from China and Vietnam, the rest is made in the US.  The company releases over 1,000 new products each year and rolls off old models quickly.  If you're ever wondering why you can't fine replacement pillows for your two year old couch this might be part of the answer, the manufacturer wants you to buy a new couch!

The company breaks their products down into two divisions casegoods and upholstery.  Casegoods are things like a TV entertainment centers and desks.  Upholstery consists of items such as chairs and couches.  Casegoods make up 66% of sales with upholstery making up the rest (34%).

Sales are made through independent furniture stores nationwide including all of the Berkshire owned stores including Nebraska Furniture Mart and Star Furniture.  Hooker operates their own 95,000 sq ft showroom in High Point North Carolina.  I did a search on their website and found Hooker products in four well known furniture stores within five miles of my house.

Is it cheap?

The big question when looking at Hooker Furniture is how to value them?  Should we value them on a book value basis, a P/E or cash flow basis?  On a classic earnings basis Hooker isn't cheap at all, they have a P/E of 22.  If you take out the net cash they still have a P/E of 14, better but not spectacular.

Looking at the company from a book value perspective they aren't that cheap either.  At first glance the company is selling at a 4% discount to book value but inventory is understated because Hooker uses LIFO accounting.  Adding back in the LIFO reserve results in an adjusted book value of $144.15m.  Using the new adjusted book value Hooker is currently trading at a 15% discount which while nice isn't really enough to get me interested in the company.

The company's balance sheet is pristine, they have $40m in cash or $3.73 p/s and no debt.

Where things start to look interesting are on the cash flow statement.  The company reported just $5m for net income for 2012 yet had $32m in cash from operations and $28.2m in free cash flow.  As mentioned in the quick thesis the EV/FCF multiple is 2.62 which is the number that made my head turn.  I first wondered if this was sustainable, and second what had happened in the past.

If we dig into the details of cash from operations we find that "Inventories" under "Changes in Assets and Liabilities" contributed $23m towards operating cash flow.  So what is this inventories?  There are two possibilities, the first is these are inventory items that were sold in a different period and cash was finally received this year.  That might capture some, but the larger reason is found is explained by LIFO.  LIFO means "last in first out", meaning inventory purchased recently is captured in the cost of goods sold while depreciated inventory is what's reflected on the balance sheet.  Remember how I mentioned the company pushes out 1,000 new products a year, and they refresh their products twice a year?  This means if you have some bedroom furniture sitting in the warehouse for one year it's now three models behind, in accounting terms worthless.  Here's the catch, on a cash basis Hooker can probably still get full price.  Liquidating this old inventory results in ample cash flow yet almost no accounting profits.

I didn't initially intend to dive into the minutia of inventory accounting but as I researched I realized it was fundamental to understanding Hooker.  I also know that I have a large contingent of non-US readers who might be unfamiliar with what exactly LIFO is, hopefully my digression was useful.

Inventory liquidation isn't a sustainable strategy, over the last three years the company has had two years of liquidation and one year of rebuilding.  Inventory contributed $23m to operating cash flow this year but sucked up $21m last year.  Two years ago inventory liquidation contributed $24m in cash, similar to this past year.

One last point on inventory before moving on.  I wondered how quick their inventory was moving so I calculated their inventory turnover which came to 3.7.  I don't know how this compares to other furniture companies but it's reasonably high, the company is clearing out their inventory almost four times a year.

Is there a margin of safety?

This is a tough question, at this price I would say no.  The company doesn't exhibit strong earnings power, and they aren't selling at enough of a book value discount to warrant a purchase.

There's something else that caught my eye that concerns me with Hooker Furniture.  The company prides themselves on their dividend payouts.  Over fiscal 2012 the company paid out $4.3m in dividends against $5.067m in net income.  Another way to put it is the company has a 85% payout ratio.  Payouts this high can be concerning because they often don't leave the company enough money to reinvest, especially for a business that's capital intensive such as furniture.

Net income plus depreciation in 2012 doesn't cover the dividend and capital expenditure costs which concerns me.  The difference is only $500k which isn't much, and there is plenty of cash to cover it, but eating the cash to pay a dividend isn't a good policy.

The two yellow flags for me on Hooker Furniture are the facts that the company is generating excess cash flow from liquidating old inventory, and without a slew of non-cash charges and inventory liquidation the company can't cover their dividend and reinvest without dipping into the kitty.

So at the current price with the yellow flags there isn't a margin of safety.  Could these two items be a non-issue?  Sure at 50% of book value I would have a much different perspective on Hooker Furniture.

Summary

Hooker Furniture is the type of company that often appears on value screens, they are average, often not very cheap, but not expensive either.  Hooker Furniture is not the type of company I would buy for my son and stick in his brokerage account to compound for the next few decades.  But an average business doesn't have to be avoided as an investment, the investor just needs to take care to ensure they're buying at a very favorable price with ample downside protection.  At the current price I don't believe those factors are in place, but at some future date they might be.

Talk to Nate about Hooker Furniture

Disclosure: No position


Friday, June 22, 2012

Some sentimental investment ramblings and Boss Holdings

If there's one thing I'm really bad at in investing it's going back to see how old holdings I've sold are doing or revisiting stocks I'd researched in the past but passed on.  A company I owned for a while and sold about two years ago is the subject of this post Boss Holdings.  So why did I suddenly decide to revisit Boss?  I was emailing with an investor and I mentioned I was curious to see how some companies that had gone dark recently were doing.  The first company that came to mind was Boss Holdings, I took a look and saw enough to inspire a post.

My guess is many of my readers are familiar with Boss, they were one of the few net-nets back in the bull market of 2006 and 2007.  I remember Boss stood nearly alone with just a handful of other net-nets such as Concord Camera (LENS).  Just as a fascinating aside in the linked Concord Camera post there was a commenter who posted that it was pointless to invest in a net-net because these things never liquidated.  As a postscript Concord did liquidate in 2008 not even a year after that post, they eventually distributed $4.81 p/s to shareholders.  So while the poster's NCAV estimate of $6.81 was never realized purchasing with a margin of safety at $3.19 still resulted in a 50% gain.

Back to Boss Holdings (BSHI).  The company was a net-net when I first purchased them for the an odd lot tender.  I actually looked at them for an investment back in 2007 but ironically decided against it because the shares rarely traded.  I was worried I'd be "stuck" in the position without a way to sell.  My views on this have obviously changed and if I had invested in them back in 2007 and held on I would have had a gain similar to Concord Camera about 50%.

I apologize for the rambling, but there is value to looking at how things from the past have transpired.  One last thought before I actually look at Boss.  Sometimes I get the feeling investors are worried that a net-net strategy only works in certain markets.  When the market is high and net-nets are rare it's better to be in cash and wait things out.  Boss and Concord show that even buying two dumpy net-nets gave satisfying market beating returns through a market crash.  This isn't an endorsement to go buy up any and all the crappy net-nets out there, but there are good values in all markets.

Background

Boss Holdings is a very simple company, they make work gloves and protective gear (rain boots etc) that they classify into two categories, tagged and untagged products.  Tagged products are gloves made for retail sales, these gloves are destined for hardware stores and shopping centers.  Untagged products are targeted towards bulk sales, so a company might make a large purchase of untagged gloves for their employees.  Just browsing the company's catalog there are probably hundreds of glove models along with a few boot models of boots and raincoats.  Gloves appear to be the biggest product Boss produces.

Gloves are not a glamorous business, they're not high margin either, Boss earns just 2.48% on each dollar of sales.  What the company doesn't have in earnings or cash flow they do have in their balance sheet, here's a look:


Boss currently trades at about $8.50 against a NCAV of $13.67 and a tangible book value of $15.29.  On the face of things Boss seems like an incredible bargain; buy at a 50% discount to book value and a 40% discount to NCAV.  While the balance sheet looks great, I'm not sure this is such a great bargain.

Why not?

I've mentioned in the past that I group net-nets into two categories, operating net-nets, and balance sheet net-nets.  The first category contains decent companies hiding behind a pile of assets such as PC Connection, or George Risk.  With an operating net-net the composition of the assets doesn't matter to me as much because the business is halfway decent.

The other category are piles of assets with a business attached to them.  When I look at a net-net in this group I want high quality assets such as cash or marketable securities that have a realizable value.  I want to avoid net-nets that are mostly inventory with a crappy business attached, unfortunately that's what Boss Holdings is.  Why do I want to avoid this?  Think about the balance sheet for a minute, presume Boss had a big going out of business sale.  They have $23m in gloves they need to get rid of quickly, do you think if they did a 50% or 75% off sale they'd move the gloves?  I doubt it, if I go into my local hardware store and see that garden gloves are 75% off I'm not enticed to buy them, heck they're only a few bucks to start with.  When I start to think about clearing out Boss' inventory quickly I start to get the feeling there really isn't all that much value there.  Sure maybe it's worth $23m to an accountant, but try to sell it.

So if that isn't bad enough there was something else nagging me when I was looking at their latest annual report.  Not only is this a junky little business attached to some questionable assets, the business is making an accounting profit but losing money on a cash basis.  So where did the cash go?  It seems Boss just can't stop accumulating more inventory, $3m was spent on adding more gloves to the stash in 2011.  The second source of cash leakage is accounts receivable, $1.5m was billed and went uncollected as of the annual report.

Neither of these items are bad, but they're concerning.  When I want to see the quality of a company's earnings I like to run an accruals check, here it is for Boss:


It's good to see both the balance sheet and cash flow based accruals are the same, that's a good sign.  The actual accrual number isn't terrible either 7% is pretty common for most companies, so this isn't really the red flag I was expecting.

The item I just can't overcome is the lack of cash flow.  Here are the reported numbers for income and cash from operations for the past three years:


The difference between the two consists entirely of working capital changes.  In 2009 Boss spent down their inventory, and in 2010 and 2011 they rebuilt it.  I don't know what the future looks like but I wonder why they spent $3m on additional inventory when they already had $20m in gloves sitting around the warehouse.  It seems it would have been more prudent to work off those older models (as if anyone could tell a difference) rather than spend cash on keeping inventory levels high.  

None of the items I really highlighted are bad on their own, but the combination of all of them together make Boss a pass for me.  

Conclusions

There are a few things I find interesting about Boss Holdings as an investment.  The company hasn't appeared to actually trade above NCAV over the past five years or so, but that doesn't mean investors haven't been able to make money.  Just buying in 2007 and holding has resulted in about a 50% gain or 10% a year.

The second interesting aspect is the company took action to get their share price moving.  In 2010 the company went private at a price far higher than the last trade, and it seems the stock has moved up since then.  This is a good place to mention that they company has begun to execute a $1.5m share buyback, so maybe this is another catalyst that will continue to move it higher.

Boss Holdings isn't the worst investment in the world, but I feel there are many better net-nets to choose from so at this point I'm putting their dusty file back into my cabinet to be forgotten about for another two or three years.

Talk to Nate

Disclosure: None

Monday, June 18, 2012

The investor as a merchant or a collector

This post has come out of a few discussions with investors over the past few months and some introspection on my part as to how I want to run my portfolio.  I've come up with two analogies on how I think most investors tend to act with regards to their portfolio.  Neither is right or wrong, they're just different.

The Merchant

The merchant is always thinking about the sale price when they buy a product, there are labor costs, overhead costs and lastly no one wants to buy a stale product.  The merchant's store needs to be constantly turning over inventory to make a profit, and carrying odd or rarely purchased inventory just takes up valuable shelf space.

Who is the merchant in the investing world?  The merchant investor has the sale of a stock in mind when they purchase it.  If it goes up and hits their target price in a day they'd dump it without a second thought.  The merchant investor only wants to have stocks in their portfolio they can liquidate quickly, they're not interested in holding anything that they might have trouble selling.

The merchant is willing to buy anything if they know they can resell it later for a profit.  The merchant investor can't afford to be patient, they need to constantly be turning over their inventory to make a profit, stocks that sit around too long are "dead money" and need to be dumped.  Merchant investors are also worried about leaving a good impression on their customers, clients that aren't happy with their inventory will go to a different merchant to satisfy their needs.

The Collector

The collector is focused on adding to their collection without any thought on how they might get rid of the new addition.  The collector is patient and is looking for items they cherish.  Maybe the newest item is found at a garage sale and needs to be dusted off, cleaned up and framed for display, the collector doesn't care.  They're willing to work on the collection a bit to make it something they're proud of.  Of course a collector is always willing to part with an item given a fair price or a generous price, but they thoughtfully consider the sale.  They consider what it would be like to look at their collection each day and realize that prized item is missing, could they use the sale proceeds to buy something better?

Who is the collector investor?  The collector investor carefully considers the addition of each stock to their portfolio.  They search for something that's just the right fit to their collection and will pass over many good stocks that aren't the perfect fit.  The collector investor isn't worried about selling, they'll buy a company and hold onto it for years.  The collector investor isn't worried about liquidity, if a company is worthy of being in their collection they'll find a place and be happy to keep it for years as it grows.

The collector doesn't limit themselves to only obscure treasure pieces for their collection, they will also pick up items they know are in demand that they can get at a very attractive price.  The difference between the collector and merchant is patience.  If a fair price for an attractive piece isn't reached in six months or a year they'll continue to hold until a willing buyer appears with a fair price.

The collector is also emotionally attached to their collection, and why wouldn't they be?  The merchant only cares about their profit margin at the end of the day, but the collector is picking out items they will be living with for years.  The collector investor begins a relationship with a company they hold, through years of holding they learn more about the company and experience ups and downs with it.

Who are the collectors and merchants?

I think unfortunately most professional investors and most of Wall Street falls into the category of merchant investors.  They are only worried about reporting good performance numbers at the end of the day.  Unfortunately most Americans are happy to invest with merchants as well because they want to put their money with the person who's doing the best right now, not over the long term.  Merchant investors are happy to buy a stock with 20% upside, and turn things over every few months.

The collector investors are an eclectic group, some value investors fit this mold.  The old Tweedy Browne was a collector for sure, Warren Buffett is definitely a collector, and Ben Graham seemed to have some of it in him as well.  Some modern value investors are more merchants, buying and selling what's undervalued and in vogue today.  The type of investor who is willing to buy and collect businesses is rare, very rare.

I've been reading the book The Money Masters which talks about Warren Buffet, Ben Graham and Tweedy Browne amongst some other investors back in the 1970s.  The collector mindset has really struck me, Tweedy Browne would buy batches of illiquid stocks and hold them for decades patiently waiting for the right buyer to come along.  Buffett is similar, but he's taken it a step further, he has decided he enjoys collecting to much he will never sell anything.

I desire to be a collector investor.  This means at times my collection might be lean, maybe only a handful of stocks, but other times it might be full of great items I can't imagine selling.  The biggest difference between the merchant and collector is patience.  The merchant is always worried about the sale, the collector is content to hold something forever if need be, or is patient enough to wait for the correct buyer in due time.

I think all investors could benefit if they adopt the collector mindset.

Talk to Nate

Friday, June 15, 2012

A sleepy company to keep on the radar

Chicago Rivet and Machine is what I'd call an in between company, they're trading slightly above net current asset and slightly below book value, and at about an average P/E.  At this price I don't see something worth investing in, but that doesn't mean they're not worth researching.  The company's shares can be volatile, and an observant investor might be able to pick them up at NCAV and ride them to book value.  The goal of this post is to familiarize myself with this company so if the opportunity does arise to buy low I can quickly refer to this research, update it and pull the trigger.

Background

The company was founded in the 1920s and manufacturers fasteners and rivets for the automotive industry.  The company also manufacturers riveting machines as well as provides design and engineering, and maintenance services for their machines.  The company's fortunes are closely linked with the auto industry so in years when cars are selling fast CVR is doing well, and conversely when cars are sitting idle on the lot such as in 2008 and 2009 the company is recording losses.

The company has locations in Illinois, Iowa, Michigan and Pennsylvania, in total 221 people are employed across all of the locations.  Manufacturing takes place in the Iowa and Pennsylvania locations, the corporate headquarters is in Naperville, IL.

The industry landscape is competitive with cost pressures coming from rising raw material costs, and the inability to set pricing with customers due to fierce industry competition.  Fasteners are a very generic part, GM or Ford doesn't care if they have a Chicago Rivet and Machine rivet, or one from a competitor, all they care about is the lowest cost.  The company strives to create the highest quality parts for the lowest price which is the only way they will survive in a competitive industry.

The company has no debt and a significant amount of operating leverage like most manufacturing companies.  Small increases in sales can mean large increases in both operating and net income.  The company pays a solid dividend currently yielding 3.2%.

Finances

I have included my net-net worksheet because I think it clearly shows the balance sheet position
Chicago Rivet and Machine has.  They are debt free with almost $6m in cash, which amounts to 33% of their market cap.


As I mentioned in the intro the company is currently trading in between NCAV ($14.43) and tangible book value ($22.49).  Book value has remained extremely steady for the past ten years wavering between $21m and $25m spending the most time at $23m or $24m.  The company isn't compounding book value, they take their earnings, invest enough to keep the business running and pay the rest out as dividends.

Earnings have bounced between a loss of $1.33 a share and $2.69 a share (2002).  Most of the time mid-cycle earnings are in the $1.40-1.60 range, close to where they are now.

Positives

There was a recent insider transaction for 300 shares, a small amount but still a good sign.

The company returns all of the cash they aren't reinvesting in the business each year.  This is good in that an investor gets a cash return, the problem is not a lot of cash is returned, the stock currently yields 3.2%, reasonable, but not a high yielding stock.

The company's management is conservative and appears to be prudent.  They are focused on a strong working capital position, remaining unlevered (both debt and leases) and maintaining a cash reserve.  Having no debt and a lot of cash can be a drag on results in good times, but it allows the company to survive during downturns.  The long history is testament to this strategy.

Negatives

The company earns a very poor return on invested capital.  Using this formula the company earns 2.4% cash return on their invested capital base.  Return on equity was 5.67% last year, and ROE calculated without the CDs on the balance sheet was 7.72%.

This is clearly not a long term holding.  When I pulled up a chart over the past 15 years it appeared an investor could have purchased in the late 90s and sold it for the same price today excluding dividends.  In the meantime an investor would have experienced a wild ride shooting almost to $40 and dropping almost down to $10.  The company's stock price follows the company's fortunes pretty closely, which follow the broad US economy closely as well.

In capex heavy years the company needs to dip into their horde of certificates of deposit to fund capital expenditures.  This means the extra cash should be viewed more as a reserve instead of excess capital.  In most other years capex is paid out of operating cash flow, and the left over cash flow goes to pay dividends.

Summary

In looking at this post there really isn't a whole lot to say about this company, it's a sleepy company in a cyclical industry.  It seems we're chugging towards the peak of the cycle so this is a great company to keep on the radar, but there's nothing to do with it currently.  I would strongly consider buying them on a dip below NCAV which coincides with 2/3 of book value as well.  Until that dip happens I won't be doing anything with Chicago Rivet and Machine except keeping an eye on them.

Talk to Nate about Chicago Rivet and Machine

Disclosure: No position

Wednesday, June 13, 2012

Is it worth investing in net-nets?

I tend to post about net-net's fairly often on this site, they're an area of the market I think most people tend to avoid yet offer a lot of promise.  I often receive objections to companies I write about, and most are perfectly valid and apply to most non net-net investments.  I believe net-net's are a bit different than most investments and I want to take this post to address a few objections that I've seen with regards to net-net's.

What is a net-net

For all the writing I've done about net-net's I don't believe I've ever formally defined them.  A net-net is a stock that is trading below the value of it's current assets (cash, receivables, inventory) minus all liabilities (short term liabilities, long term liabilities, all debt).  A value this low is absurd, in theory a net-net could be liquidated and would give a positive return to shareholders if purchased at the current price.  Given that property, plant and equipment aren't included in the calculation those values could provide even more possible upside if a company actually decided to liquidate.

The reality is very few net-net's actually liquidate themselves because management would be out of a job.  So while a company might be trading below a conservative liquidation value it's unreasonable to actually expect a net-net to liquidate.  A better way to look at liquidation value is as an absolute downside.  Very few business sales that occur at arms length involve one company purchasing another for less than working capital, or for less than NCAV.  If it's unreasonable for a business to sell to a private buyer for less than net current asset value (NCAV) why do such things happen in the market?

The margin of safety concept is that as an investor makes assumptions about an investment, value of assets, future earnings, quality of management and as they do they need to build in padding to their estimates to account for errors.  A net-net gives a built in margin of safety, a business with a lot of warts is presented for sale at far less than a reasonable outside buyer would pay.  To use the extreme example if the company was wound down even in that situation the net-net buyer would expect a positive gain.

As I work through different objections I've heard keep in mind the idea that a net-net is a company selling for less than current assets minus all liabilities or a reasonable liquidation value.

Objections

1) The business has no competitive advantage.

When I hear this objection I often think of the phrase "To the man with the hammer everything looks like a nail."  There are many different approaches to investing, and the franchise style is just one of them.  Not every company has a competitive advantage, I would actually argue a true competitive advantage is very rare.  Investors are able to convince themselves they see one at every turn of the road, but I think that's just a bit of confirmation bias.  I've seen some writers even mention that a net-net has a competitive advantage, I have news, if a company has a true competitive advantage it's not selling for less than NCAV.

Most companies are in competitive industries and earn an normal profit, a franchise company might earn an economic profit (above average).  A net-net in all cases is not a company with a competitive advantage, if they had one why are they selling below NCAV?

A company doesn't need to have a competitive advantage to be successful.  There are millions of businesses in the world that continue to pay employees and make their founders rich that have no advantage whatsoever.  The companies have a small piece of market share in a crowded space, but it's enough to earn a profit, which is what matters.

A competitive advantage allows a company to earn an above average return, when evaluating a company selling below NCAV we don't need an above average return to be successful, any profit will be fine.  In some cases no profit at all is needed because the assets alone are valuable.

2) This is a bad business in a bad industry

This is either the most valid or second most valid claim along with the following one.  The problem is when people pose this objection they make it sound as if all bad companies and all bad industries expire eventually.  While this would be great, it's simply not true.  Many terrible industries continue to persist with companies happily making below average returns.  One industry that comes to mind is the traditional phone.  Landline phone calls are in steep decline yet there are companies that continue to exclusively serve this market, and will continue to serve it for years to come.  Even though the demographics are bad wirelines will be around for a long time.

It seems shortsighted to ignore a company in a bad industry or a bad business because of general industry trends.  I would agree with this notion if you're looking for a long term investment where you might want to buy an industry leader, but a net-net isn't that.  A net-net is a company that even in a bad industry is selling for an irrationally low price.

One other parting thought here, sometimes a bad industry is a passing phase.  In the 1970s railroads in the US were a very bad industry, they destroyed a lot of shareholder capital.  The industry eventually consolidated and now railroads are considered a good industry with a competitive advantage.  In the 1970s you could barely give away railroad stock, now Warren Buffett is buying railroads.

3) The company's management is bad

This is probably the most valid reason on the list, if a company's management steered the company into the current bad situation and the future course looks to be the same as the past it might be worth passing on the investment.

I don't think management's inclination to destroy shareholder value is isolated to net-net's, many large and well known companies bought back stock in 2007 at highs only to refuse to buy stock when their price cratered in 2009.  Some of those companies even took out expensive debt in 2009 so they could have liquidity.

I prefer net-net's where the cause of the undervaluation is external and not due to management action.  I specifically look for management that isn't going to spend excess cash on dubious acquisitions.

4) A company that cheap must be a fraud

I think this line of thinking has come out of the recent burst of China reverse merger stocks that are now showing up on net-net screens.

I don't think fraud is any more common with net-net's than with any other business.  In all situations an investor needs to look for signs of fraud, check the quality of earnings, check accruals, look to see if there are signs balance sheet items might be fudged.

5) Since a stock's value is the present value of future cash flows the company is worthless because it's not a significant cash generator.

My response to this objection is similar to the first one, there is more than one way to go about valuing a stock.  One way is to use a discount cash flow analysis which takes future guesstimated cash flows and assigns a present value to them.  The sum of the guesstimated cash flows is what the stock should be worth.  I know I'll probably get crap in the comments for using the word guesstimated, but unless the future cash flows are guaranteed by a bulletproof contract it really is a guess, maybe educated, but still a guess.

Another way is to attempt to buy a business for less than the hard tangible assets such as cash, inventory, factory, which is what buying a net-net is.  When looking at a net-net we're evaluating the company on the basis of its assets, is the discount to asset value merited?  Should this company be selling for less than a liquidation value?  At times no discussion of the actual business is warranted, other times estimating the business value is of vital importance.

Summary

I think the key to looking at net-net stocks is to keep them in perspective.  Yes these might not be great companies, but for the most part they are probably selling for incorrect prices.  Sometimes you can find a great company that's hidden behind a wall of cash or a company that's stumbled on temporary hard times.  In almost all cases these companies don't deserve their undervaluation.

Talk to Nate about net-nets

Disclosure: I own some net-nets.

Saturday, June 9, 2012

My letter to Solitron's Board of Directors

I mentioned in a previous post I was interesting in doing something to close the gap between the market value and intrinsic value of Solitron Devices.  I took a step in that direction by writing Solitron's Board a letter with two proposals.  I have the letter in its entirety (minus my address) below.  The company received the letter this week, and I'm intentionally posting this over a weekend so shareholders have time to digest it and think about it during non business hours.

If you are a shareholder I ask that you consider my proposals and if you agree with them please email or write the company letting them know you support my proposed actions.  If you do decide to contact the company please remember they are busy running a business so keep your communication short and to the point, please also be respectful.  As I outline in the letter Solitron is a good company that the market has trouble valuing.

I also want to note, I am not trying to create a formal shareholder group or association.  If you hold a large number of shares (15% or more) please consider that taking possible action with the company could result in the execution of the shareholder rights plan.  I hold a small position so my communication does not run this risk.  My proposals represent my shares, and my shares alone.

Lastly I want to thank a friend for helping me edit the letter, their advice was invaluable.

Disclosure: Long Solitron Devices

Please do not reproduce:



Nate Tobik
xxxxxxxxxxx
Pittsburgh, PA xxxxx

Board of Directors
Solitron Devices Inc.
3301 Electronics Way
West Palm Beach, FL 33407

Re:  Proposals to the Board of Directors of Solitron Devices Inc.
Dear Sir or Madam:

This letter is directed to the Board of Directors (the “Board”) of Solitron Devices Inc. (“Solitron” or the “Company”).  I am and have been a shareholder of the Company for the past two years.  I spoke to Mr. Saraf on the phone approximately one year ago, and at that time we discussed the Company and its future prospects.  While Mr. Saraf might not remember my call, this letter is a follow up to some of the items we discussed.

I want to thank Mr. Saraf for his hard work and service to Solitron. In the past 20 years he’s taken a company that emerged from bankruptcy and made it well capitalized and stable.  For example, in the past year the Company earned a 16% return on its invested capital.  That is quite impressive.  Mr. Saraf has demonstrated that he is a capable manager of Solitron’s core business through both good years and bad years. In addition, I would like to thank Mr. Saraf for being a good steward of the Company’s excess cash by refraining from making bad acquisitions and for taking a reasonable salary, two things which I appreciate as an investor.

The reason I’m writing this letter is because while I certainly realize the value the Company has created over the years, I don’t believe the market understands Solitron’s value.  

If Solitron were to undergo an outside valuation, an analyst would look at the facts of the Company such as its balance sheet and earnings record.  A valuation might take into account the earnings record over various periods of time and consider the stated book value of the assets, among many other things.  Assets not used in the core business to generate earnings might be considered excess, such as cash above prudent working capital requirements and unused real estate.  The value of the earnings stream would be added to the value of the excess assets resulting in what I consider to be the intrinsic value of the Company.

Please allow me to apply this to Solitron.  Let’s start with the average of the past five years earnings, which is $827,400 and apply a reasonable multiple such as 8x this results in a value of $6,619,200 (the “Earnings Figure”).  Secondly, we would take the excess assets and add it to the Earnings Figure.  Please note that the Company’s Treasury bond holdings should be counted as excess cash.  Adding the $6,460,000 of Treasuries to the Earnings Figure amounts to $13,079,200.  This is a conservative, but reasonable valuation figure that is close to what an outside valuation might put as the Company’s worth.

The problem is the stock market value of Solitron ($6,780,000 as of close of business on June 5, 2012) is significantly and materially lower than the intrinsic value of Solitron.  The difference in values appears to show that either the market considers Solitron to be going out of business by valuing it at roughly its cash value, or the market is giving the Company no credit for holding excess capital.

I think this market valuation is absurd.  Solitron is a strong and thriving company, well capitalized without any fear of going out of business, so clearly the market is incorrect.  Part of the reason I believe the market has trouble valuing Solitron is that the Company’s excess capital is masking the true business value of the Company.

I would like to propose two items to the Board that I feel might help close the gap between the market value of Solitron and the intrinsic value of Solitron. Before I list the proposals, I would like to be clear that my goal is not a short term gain, or to propose anything that would in any way harm the Company or reduce its competiveness.  I am a long-term shareholder and I expect to hold Solitron for many years to come.

My proposals to the Board are as follows:

1)  That Solitron initiate a modest share buyback plan using between $500,000 and $1,000,000 of the  Company’s excess cash to buy Solitron stock on the open market.
I understand the Company has a restriction on paying dividends until the environmental liabilities are settled in 2013, but my understanding is there are no restrictions on buying back the Company’s own stock.
The company currently has a 10% earnings yield (defined as the past year’s profit divided by the market price of the Company.)  If the Company used a modest amount of the Treasury holdings (yielding close to zero) to purchase stock it would realize a 10% return on invested capital.  I would much prefer the Company re-invest excess cash at 10% by buying their own shares over re-investing excess cash in Treasury bonds earning close to zero.
             2) That the Company hold an annual meeting open to shareholders to discuss issues relevant to the Company.
It concerns me that the Company hasn’t held an annual meeting for the past few years.  In light of increasing litigation in the financial and corporate markets, I’m concerned the lack of an annual meeting could open the Company up to potentially expensive litigation and liabilities.


I look forward to your response to both of these proposals. In the interest of full disclosure, please be aware that I am making this letter public by posting it on my website http://www.oddballstocks.com and that I will be soliciting other shareholders to comment and make their views known on these proposals.  I truly appreciate the work you are doing at Solitron and believe my proposals will further enhance the value of the business for all stakeholders involved.
Sincerely,


Nate Tobik

Disclosure: Long Solitron Devices

Thursday, June 7, 2012

Could value investors be the reason a stock's cheap?

Shareholder composition has to be one most disregarded aspects of researching an investment.  Most investors look to see what percentage insiders own, and maybe what percentage institutions own, but it rarely goes any further.  I have been thinking about this a lot recently in the context of smaller companies with larger majority shareholders.

The big issue I've been thinking about is what role does shareholder composition play in value realization, and as a cause for a depressed price?  I've read some articles on a company I recently posted about Guinness Peat Group.  The company is a busted growth company that's in liquidation, the shareholder base seems to be long time scorned holders who are so frustrated they're just selling on news of the liquidation.  Some might stick around, but this is a very disgruntled group.  This shareholder base could be helping to create the undervalued situation.

An example on the other end of the spectrum is a company like George Risk.  George Risk is small with a  $30m market cap.  The founder Ken Risk owns 58% of the company leaving $12.6m as the available float.  The company is cheap with $23m in net cash and on track to earn $2m this year.  A simple valuation of 10x * $2m plus $23m equals $43m as a reasonably conservative value for the company.  The company's profits have been stable, but this isn't a growth company by any measure, it's a sleepy Nebraska company trading close to net cash and securities.

So who are the shareholders of a company like George Risk?  The smaller float effectively locks out bigger funds and even medium size funds.  But a lot of funds won't invest in a company where after buying a sizable stake they can't affect change, and Ken Risk has a tight grasp on George Risk eliminating fund buying.  That leaves the shareholder base to smaller individual investors, and mostly value investors who like the cash story, and like the fact that there's about a 50% upside from here.  The company also used to be a net-net which means we have some of the deeper value Graham investors holding on as well (yours truly).

What's the problem with this?  I think the problem is value investors are disciplined buyers, so they're not going to pay $40m for a company worth $43m, that's left to readers of Barrons.  This means if the company trades close to NCAV there will probably be a lot of buying activity, but as the price gradually rises buyers dry up.  The same thing could happen as the stock gets close to fair value, the value investor base sees fairly priced shares and begins to sell driving the price back down.

I don't know if this is a real phenomena, but it intuitively seems so.  Some net-net's languish forever, eventually net-net investors give up, or management changes direction which forces deep value investors out.  A great example of this would be Audiovoxx, a perennial net-net that spent their excess cash on an acquisition.  A lot of value investors jumped ship when Audiovoxx transformed, but the acquisition was good, and the company generated some growth which propelled the share price higher.  This isn't to say that an acquisition is the way to a high share price, but the acquisition seemed to change the shareholder base from value investors to investors looking for growth.

I tend to invest and write about companies that have large majority shareholders, and attract value investors, companies such as Micropac, OPT Sciences, and Solitron Devices (1,2,3,4).  I'm wondering aloud if part of the undervaluation is that we value investors are our own worst enemies, we are keeping the price low, and if the price rises to close to intrinsic value herd selling begins which drives the price back down.

What's the solution?  I think in some of these cases the solution to the market valuation/intrinsic valuation gap needs to come from the company itself.  If the shareholder base isn't going to drive the price higher the company needs to be the catalyst.  This could mean a tender for shares, or a dividend, or even going private at a fair value.

I don't really have any answers, this post is more of a jumping off point for a discussion then anything else.  I'd love to hear confirming or contrary opinions, leave them in the comments.

Talk to Nate

Disclosure: Long all stocks mentioned in this post except Audiovoxx.

Tuesday, June 5, 2012

An oddball liquidation stock: Guinness Peat Group

Sometimes I feel that I don't cover enough stocks that live up to the namesake of this blog, fortunately for this post Guinness Peat Group is a true oddball.  The Guinness Peat Group is a bit interesting, and I'd love to take credit for uncovering it, but I'm not the first blogger to write about it; Richard Beddard at Interactive Investor Blog called it a Bargain within a Bargain.  I liked his post, but didn't think about them again until a reader mentioned the company to me, so thank you to the reader and Richard.  There are a lot of different angles with Guinness Peat Group, but I want to keep this post narrow.  It's easy to get lost in the weeds when looking at the company, but I think the investment really hinges on a few specific factors.  If those factors go right an investor does well, if they go wrong the investment is a bust.

Background

Guinness Peat Group (GPG) is New Zealand conglomerate that maintains a listing in three countries the UK, Australia, and New Zealand.  The company owns some companies outright as well as pieces of other listed companies.  GPG had operated for years with the conglomerate model over the past few years earnings began to drop precipitously.  The board of directors met last year and determined the best course of action would be to liquidate their investments and return the money to shareholders.

I want to pause for a second here and state that as someone who invests in a lot of companies that should be liquidated this is far too rare of an occurrence.  Too many managers pay lip service to shareholder value, if they acted on what they speak they would liquidate an underperforming business that's trading for less than liquidation value, or sell to a private buyer at a fair value.

The company's 2011 annual report is excellent, the management letter clearly articulates the goal of the wind down, and what shareholders should expect.  Management goes the extra mile and even breaks down liquidation value showing a simplified balance sheet.

There are really two components to this liquidation, the value of Coats, and the value of everything else.  Coats is the largest holding of GPG with a book value of £150m, £46m in profit, and £97m in cash from operations.  Currently GPG trades as if Coats is worth nothing, management realizes this is crazy and is working to expose Coats through the liquidation.  The end result will most likely be all of the periphery investments sold with the cash returned and Coats being the only remaining GPG investment.

The Listed Value

The 2011 annual report shows this simplified balance sheet with the book values for GPG's holdings:

On a book value basis GPG is worth £36p per share.  This statement isn't exactly correct though because since the finalization of the 2011 annual report cash increased and some of the debt was paid down.

I put together a small spreadsheet showing the value of GPG using the updated cash figures, the updated debt figure and the market value of their listed investments.  I then show two values, the mark to market asset value discounted by all liabilities which includes Coats' pension, and a value without Coats' pension.  You'll understand later on why I have both values.


The second figure 'Sum w/o Coats Pension' is the one we want to focus on first.  The Coats pension is non-recourse to GPG, meaning if Coats went bankrupt GPG wouldn't be on the hook for the pension deficit.

Just considering the listed assets GPG is trading at a nice discount to a readily realizable value.  There is a bit of a sweetener, most of GPG's assets are selling at a sizable discount to a private market realized value.  Management points this out, and an example is the case of Turners and Growers.  Turners and Growers had a book value of £66m but was sold for £72m in the first part of 2012.  The annual report states that management has no intention of liquidating their portfolio in a grocery store sale style, instead they will work slowly to realize a proper private market value.  Their track record so far shows they are intentional and have been successful with this.

In summary just looking at GPG's cash, and listed investments minus the top level liabilities this is already an attractive investment.  With a current market cap of £389m GPG is selling at an almost 20% discount to fair market value.

Coats

The market is strange, it's willing to offer £1 for 80p and throw in a profitable business for free.  Not only that, but the company is working to give back the £1 and make sure the market knows how valuable the free business is.  With this intro I bring you Coats.  Coats is a thread manufacturer and they claim to be the market leader in textiles, industrial threads and crafts.  I don't pay close attention to what yard in used in the clothes I wear, and I've never knitted so I'm completely unfamiliar with Coats.

The key question for me on this investment isn't whether Coats is a good business or not, it's whether Coats is worth more than zero.  Coats has this nice little graphic on their site showing their performance of the last three years:


There are a lot of things to knock about Coats, a 4% net profit margin, a high debt to equity ratio, a loss in 2009, but none of these things make me think the company is going out of business or completely worthless.  Coats reported a record profit of $71m in 2011, they have stated they expect 2012 to be lower, but still profitable.  Maybe we'll see something in the $50-60m range like 2010.  Even in the depths of the Great Recession Coats only had a slight loss and was in no danger of bankruptcy themselves.  This is a good sign for me, when demand drops like it did in 2009 the company was still able to operate without issue.

On a low end Coats is worth at least book value of £130m.  At a value destroying multiple of 8x applied to the average last three years of earnings I get £218m for Coats.  I know GPG paid £400m for Coats back in 2003 and a reader who seems plugged into this said he thinks Coats could go for 5x EBITDA.  If we use 5x operating profit instead of EBITDA for ease of example, and use the 2010 number because we expect profits to drop we're looking at a value of £383m for Coats which comes out to 22p per share.

The downsides

So if Coats is potentially worth anywhere from £130m to £383m and you add in the £475m in cash and investments why is this £605m to £858m company selling for £389m?  The big fear is the pensions both at the parent level and at Coats.  Here is the relevant graphic from the annual report:


The pension deficit grew from £25m in 2010 to £226m in 2011 and investors are worrying this pension is going to grow large enough to swallow all of GPG.

There are really three pension plans as shown, the Coats pension, the Brunel pension and the Staveley pension.  Both the Brunel and Staveley pensions are recourse to GPG so the parent is on the hook for these.  But notice that the revaluation between 2010 and 2011 wasn't that large for either of these pension plans.  Management notes that part of the cash they hold at the parent is held against the deficits of the Brunel and Stavely pensions so it can't be returned to shareholders until Brunel and Staveley are divested.  GPG has the cash to make both of these pensions whole today, I am discounting this cash in my calculations.  The hope is that Brunel and Stavely will both be divested and set free without a large cash contribution to the pension, that's the best case.  If that did happen it increases the upside a bit.

The Coats pension is a different story, the revaluation is large and most of it is due to increased benefits not falling asset values.  GPG has stated that they are working to make Coats a completely stand alone company and with that Coats is responsible for their own pension.  They are already paying an excess £9m a year for 10 years to satisfy a previous deficit.  The next evaluation of the Coats plan is in 2013 and unless the market rockets upwards it looks like Coats will be on the hook for further contributions.

The good news is that even if Coats is required to double their contribution to £18m it's easily covered by operating profit.

The pensions are worrisome but let's evaluate the worst case.  I believe the worst case is that Coats suddenly goes bankrupt and somehow the court finds GPG liable for the pension.  In that case we have GPG worth the £314m figure I noted in my spreadsheet above.  This would be a loss of 20% for the investor at current prices.

Of course there are more dire scenarios, maybe GPG can't realize the value on any of their assets, and they squander their cash while trying.  This is always a possibility, but I cover this scenario by diversifying my portfolio.  I'm not putting 100% of my money into the GPG liquidation.

Summary

When looking at GPG it reminded me of another investment that I took part in recently CIBL, a company that wanted to liquidate a portion of their portfolio and they did.  When I looked at CIBL I made sure I had a large margin of safety between my purchase price and the potential sale values.  I have been looking for the same thing with GPG, and I think it exists.  There is the potential for a small loss at the low end if a very unlikely dire and potentially impossible (legally) scenario unfolds, the sudden collapse of Coats.  Barring that it looks like an investor here stands to make a profit.

Website: http://www.gpgplc.com

Talk to Nate

Disclosure: No position as of this writing, but I will be acquiring one soon.