Friday, August 31, 2012

A strike or a gutterball?

I wrote a post a few months back detailing some of my investing mistakes.  I think it's more important to avoid mistakes than it is to find big winners.  My obsession with avoiding mistakes is one of the reasons I seek out large margins of safety when I make a new investment.  The investment I talk about below was a mistake, I probably should have never purchased it, yet I was lucky and in a way it sort of worked out.

Back in 2007 I was screening for stocks and came across Bowl America (BWL.A), I couldn't even tell you the criteria I used to find them, some value screen.  After some Googling I ended up finding an excerpt from the book A Weekend with Warren Buffett: And Other Shareholder Meeting Adventures that had a chapter devoted to the Bowl America annual meeting.  A note, I don't recommend the book, I read the excerpt online, then paged through the book in a book store, not much beyond the Bowl America chapter.  Bowl America seemed like a nice little sleepy company, they run 19 bowling alleys across the Mid-Atlantic and Florida, with a CEO who writes classic shareholder letters.  The company cares about shareholders, the CEO takes a small salary and pays out most of the profits in dividends.  The CEO is the son of the company's founder and runs the company very conservatively.  Here is a quote from the 2007 annual report that I love:

"Bowl America was not the only company that capitalized on the arrival of the automatic pinsetters to create bowling chains. Many of them went public in the late 1950's and 1960's. We are, however, the only one of those companies surviving today. We went public in order to finance expansion. We were bowling people, not stock market people, and our objective was to create a secure profitable bowling company to generate income for our families' futures. We, therefore, valued survival of the company as our top priority. We proudly reported paying off each mortgage. We bought two of our most profitable leased centers so that in the event of a downturn we would never again face rental demands when money was short. We selected dividend payments as the most equitable way of treating each stockholder the same when it came to the rewards of the business."

My thesis for investing in Bowl America broke down into three pieces, the cash and securities, understated real estate, and the business.  At the time of my investment:

  • The company had earned an average of $.76 p/s over the past five years, business was very steady.
  • $2.14 per share in cash
  • $1.04 in an investment portfolio (almost exclusively telecom stocks)
  • Two controlling shareholders in their late 70s (the CEO and his sister).
  • A lot of undervalued real estate
To me Bowl America was a company with a hidden asset, most of the bowling lanes were on the books at the 1950's purchase prices.  Readers not familiar with US accounting might be surprised to learn this fact.  In the US assets can be held at purchase price no matter how long ago they were purchased.

I looked at a competitor and looked at some franchise presentations on how much it would cost to build a bowling alley.  I found a per lane cost, multiplied it by the number of lanes Bowl America had, added in the cash and securities and arrived at $24 a share.  With shares at $15-17 depending on the day it was about a 50% upside, so I jumped.

I've now held Bowl America for a bit more than five and a half years and I'm finally showing a gain on my position.  The company's business fell off a cliff during the downturn and never came back, the share price followed business down dropping 25% and remaining flat.  The only reason I have a gain is due to dividend reinvestment, and a small bit of averaging down two and a half years ago.

I mentioned in the intro that this investment sort of worked out.  I looked at the Russell Value index and the Russell Microcap index and they both have losses over the same time period as Bowl America.  While Bowl America hasn't really done well, in a sense I just get my money back I haven't lost anything either.  Not losing money on an investment right before the financial crisis is significant in my mind.

What went wrong?

One of the biggest bullet points in my thesis was the real estate was undervalued; it still is.  How do I know this? I went online and found assessed values for 50% of the company's holdings.  With my spreadsheet only 50% populated the value exceeded the current carrying value.  A note, if anyone is in Virginia and able to get the missing information I'd greatly appreciate it.  Virginia doesn't offer easily accessible assessment data online.

Edit: Someone emailed me with the Virginia assessment information so the sheet has been updated.


There was also the issue of replacement cost as mentioned previously.  Bowl America paid $5m to build the Short Pump facility a few years ago.  At $5m a pop rebuilding their entire portfolio would cost $95m.  The fallacy of replacement cost is the assumption that facilities are replaced.  An acquirer is buying what exists today, not some theoretical version of the facilities.  A new bowling alley might cost $5m but it doesn't have the charms of the current ones like the ingrained cigarette smoke, the permanent sticky floors from Bud Light, and hoards of greasy cast off bowling balls.  That's why the buildings are worth less than replacement cost.

I thought that by using a replacement cost, both what the company spent, and what it would cost to a new franchiser, I was determining an accurate value from which Bowl America could be measured.  My mistake was replacement cost isn't what a potential acquirer cares about.  They might pay above book value for the assets, but nowhere near as high as what it might cost to build new, the facilities aren't in new condition.  Some have been broken in since the 1950s!

My second mistake was assuming that an aging CEO might want to step down at some point or sell the company.  I didn't think it through Leslie Goldberg's identity is his company.  His father founded the company, he worked as a pin setter as a child, then moved up as he aged.  How could this man give up the business?  I don't blame him either.

My third mistake was not investing with enough of a margin of safety.  I thought the undervalued assets would be my salvation.  Unfortunately land under old bowling alleys owned by a company with a life long President isn't easily salable.  Just because numbers on a page make something appear attractive doesn't mean it's so.

Going forward

I still hold my shares, which have slowly grown with the growing dividend over the past five years.  Most of the reasons for my initial investment still stand, the real estate is still cheap, there are significant cash and security holdings, and the CEO isn't getting any younger (he's 85 now).  I think Bowl America really speaks to having patience with undervalued companies.  It also was a great lesson on the difference between a salable asset discount, and an illiquid asset discount.  It's no surprise that in the past five years I've leaned more towards net-nets or cash boxes with readily liquid assets over land traps like Bowl America.

Usually when I write a post I'll sit down and decide on a theme or message I want the post to convey.  While I didn't have one specifically for this post I hope my experience and mistakes can make others better investors.  Just remember if you're tempted to invest in something illiquid, a stock, or land, or anything make sure it pays cash out regularly.  Without Bowl America's 5% dividend I would have been sunk, instead I've been paid to wait.  Maybe I should sell this position, but I'm inclined to inertia.  I already own it, I know the history, at this point I'll just keep ignoring it.  That is until I get their quarterly earnings in the mail on their retro letterhead.  Maybe it's not retro, maybe it just hasn't been updated in a few decades, seems to be a common theme for this company…..

Talk to Nate about Bowl America

Disclosure: Long Bowl America

Monday, August 27, 2012

Thinking about diversification

There are not many things as divisive in the investing world as the term diversification.  The opinions range from concentrating in a few best ideas to owning the entire market, and everything in between.  There seems to be an unwritten consensus that the best value investors hold concentrated portfolios, and to do otherwise would be return destroying.  I've also seen a second trend where people talk about a guru investor's holdings and how they purchased a "basket" of stocks.  Monish Pabrai bought a "basket" of Japanese net-net stocks, and other gurus have purchased other baskets.  Calling a dog a duck doesn't make it a duck, it's just a dog with a funny name.  In this post I want to discuss a few myths on diversification, so the next time an investor wants to add one more stock to their portfolio they don't feel ashamed.  Maybe we can eradicate the investing world of baskets..

Warren Buffett says to concentrate

It is apparently well known that Buffett believes in a concentrated portfolio. Googling for this returns 3.59m results, but no direct quote.  If there is a direct quote maybe a Buffett groupie who reads the blog can leave a comment.

Warren Buffett also recommends that most investors should put their money in index funds.  There is actually a quote for this one "A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money" (source)  My guess is most readers aren't heading off to their brokerages to dump their stocks and buy index funds.  So why pick and choose what Buffett says to do when creating your own portfolio?

As David Merkel notes Warren Buffett is different than the rest of us.  I would submit to readers that Buffett's idea of concentration is a bit different than is commonly accepted.  Berkshire Hathaway's website lists 50 independent subsidiaries.  The annual report shows 14 major equity positions.  It seems to me that owning 64 different companies in a variety of different industries is the very definition of diversification.

Only invest in your best ideas

The saying goes "Why invest in your 11th best idea when you can put money in your top ten?"  This sounds great, but let's just take the question to the logical conclusion.  Why invest in your second best idea when you can put all your money in your best idea?  If as an investor you really have the ability to know your absolute best investment idea why waste money in anything but the top idea?  The problem is we think we might know our best idea, but we really don't.  My two best investments where companies that I thought at most could double, I just held and they became 10-baggers.  I waffled on buying one of them, and I almost sold the other the day it doubled.

Diversification is protection against ignorance

This is another Buffett quote where he states that "Diversification is nothing more than protection against ignorance."  Now I recognize in comparison to Buffett I am ignorant, I'd venture to guess most investors are.  Not all of my investments go straight up, and I make plenty of mistakes.  I would rather be ignorant, and understand my weakness than suffer from over confidence.  I look for a large margin of safety when I invest because I know that it's easy to make a mistake.  Buying with a bigger discount allows me to make more mistakes and avoid losing money.  I'd prefer to never make a mistake, but that's just a dream, and nothing more.

My returns will be ruined if I spread my bets

This is my favorite myth, and one that I feel is misunderstood, just like how average companies are good investments.  When I invest in a company at the point of purchase I look for a 25% discount to tangible assets (for a 50% return), or a 10-15% return hurdle.  Why the 10-15% range and not something higher?  Some companies growing at 6% might also be selling at 35% of book value, I'm happy to take the lower ongoing return for a bigger asset discount.  Likewise some companies are selling close to book or above book, so I look for a higher earnings yield.

Every stock I add to my portfolio has the same return characteristics, either a 50% upside or 10-15% ongoing growth, or both, or both and more.  Some companies have higher earning yields, but they might be less stable than a lower yielding company.  As long as every company I add to my portfolio meets my minimum return potential how does adding one more company dilute my returns?  It doesn't.

At this point some readers will point out that searching for stocks that match strict criteria such as profitable net-nets lowers my investable universe.  This is true, but there are still plenty of very cheap stocks.  As an example this weekend in Barrons there was an article that mentioned there are 183 small cap Japanese stocks selling for less than net cash.  Putting a profitability filter on those stocks might reduce the set to 100; why not just buy them all?  It would be hard to imagine an investor having trouble building a portfolio from 100 companies all selling for less than net cash and not earning a positive return.

What it all means

I think most investors would agree that extreme diversification is pointless unless it's the goal, such as in an index fund.  Paying a manager to mimic an index is akin to throwing away returns.  As a value investor the money is made at the time of purchase.  As long as I stick to my process and look for a solid margin of safety, a tangible asset discount, and a discount to earnings I don't see how adding one more company that fits my criteria can do anything but help my portfolio.  I doubt this post will change anyone's mind, but it might make people think a bit deeper about their style and assumptions.

Talk to Nate about diversification

Disclosure: none

Wednesday, August 22, 2012

Chromcraft, a net-net, but not a buy..at any price?

I spend a lot of time writing about companies that are potential candidates for a long position in a portfolio.  What I don't do is spent much time writing about is companies I've avoided or pass on, so this post is a bit different.  Just because a company is a net-net doesn't always mean it's a good investment.  There are plenty of companies trading below NCAV that I wouldn't touch at any price, unfortunately Chromcraft Revington is one of those.

Chromcraft Revington falls into the category of what Jon Heller calls a perennial net-net.  These are companies that always seem to appear on net-net screens year after year.  A cigar butt that's just a little too soggy for the last puff.  Chromcraft manufacturers and sells office furniture and waiting room furniture for health care institutions.  To say this isn't a great business is a bit of an understatement, Chromcraft hasn't turned a profit since 2005.  What would compel someone to invest in a company that hasn't profited for the past seven years?  Probably the fact that it's trading at $.72 against a NCAV of $1.92 and a book value of $3.22.

So what we have is a company that can't turn a profit yet is trading at such a substantial discount to NCAV that investors can't help but turn their heads and consider the company, I understand the attraction.  Here is a quick snapshot of their balance sheet as seen through the eyes of my net-net template:


The losses at Chromcraft are an issue, but they're really not the reason I walked away from this company.  There were two items that were troubling enough on the balance sheet that once I saw the continued and sustained losses I decided to pass.

Structure of assets

The structure of assets is important for a net-net.  A company with a high amount of cash relative its NCAV might be safer with a smaller discount to NCAV.  Likewise a company with a high receivables or inventory balance might need to trade at a substantial discount to NCAV to be considered as "safe" as a cashbox company.  In all cases safety is defined as a minimized risk of investment loss.

In Chromcraft's case their asset structure is a little bit scary.  The company holds no cash but has significant receivables and inventory.  What's unfortunate is the lack of cash isn't a recent occurrence.  As far back as I can see (last 5 quarters) the company hasn't had any cash, at year end 2010 they had $4m, but that appears to have been spent trying to remain afloat.

When a company doesn't have cash they need to either liquidate inventory or receivables to pay for expenses or borrow against said current assets for working capital.  Chromcraft has done both, borrowed on a credit line, and liquidated a portion of receivables.

The lack of cash and reliance on credit to fund day to day operations introduces a level of risk that I'm not comfortable with as an investor.

Structure of liabilities

As mentioned above the company has a credit line that they use for working capital needs.  Chromcraft's credit is all short term, presumably because the company has posted negative operating income and is unable to secure anything longer term.  The rest of the company's liabilities consist of payables, a small deferred compensation item, and $200k in a long term note payable.

If the point hasn't come across yet, Chromcraft has a very risky capital structure.  The structure is so risky in fact that they're in breach of a covenant on their revolving credit line as of the last quarter.  The company has promised to make amends, and the bank waived the covenant for now.  The lender is Gibraltar Business Capital, a group that says they are creative in finding solutions for small and middle market companies that find credit hard to access.  There is only one reason credit is hard to access, the borrower is in a precarious financial state.  The borrower with pockets full of cash and the ability to repay doesn't have any problem finding credit.  The borrower with losses as far as the eye can see and a shaky balance sheet needs a creative lender.

Is it worth anything?

Some readers might look at the above and say "who cares?"  The company is trading below NCAV so in a liquidation the bank would liquidate the receivables, inventory, PP&E, pay off the note and give the rest to shareholders.  First off a liquidation is unlikely, it seems current management is happy to run this beast into the ground.  They're currently not that far from impact, and they have shown no signs of pulling up.  To continue the airplane analogy it seems the landing gear has sheered off and sparks are starting to fly, yet management is still walking around taking drink orders.

The problem I have when thinking about a theoretical liquidation is I'm not sure the slug of unsold office furniture is really worth all that much.  If we discount both receivables and inventory as my worksheet does above the discounted NCAV figure becomes $.17 p/s, and discounted tangible book value $.30 per share.  What the per share figures hide is the low absolute figure which in this case is important.  Discounted NCAV is $877,000.  That's not all that much money, and a small expense such as a lawyer or bankruptcy expert could suck that up quickly billing at $200/hr.

After looking at all the factors above I just don't see any margin of safety in Chromcraft at any price.  Management has shown no indication of trying to do anything other than increase sales.  The value of the assets is murky, and the company has some significant liabilities including a credit line that's in breach of a covenant.

I could be proven wrong, and the company could turn around earning $1.66 per share as they did in 2005, but then again if not in 2006,2007,... or 2011, why now?  Chromcraft is a pass for me, and hopefully other investors can find this post educational.

Talk to Nate about Chromcraft

Disclosure: No position

Monday, August 20, 2012

How an average business can be a great investment

Value investing is usually described in one of two ways, the first is buying assets at a discount a la Ben Graham.  The second is buying good businesses at low or fairly low prices and letting the superior business compound, the Warren Buffett approach.  I want to explore a third option in this post that's overlooked and misunderstood.

I've heard some value investors describe value investing as "buying something for less than its worth (intrinsic value)."  I was skiing last winter and rode a lift at Solitude with a Kiwi who was a stock broker.  I mentioned I did some investing and searched for undervalued stocks, looking to buy for less than intrinsic value.  The guy laughed and said "that's the name of the game, who isn't trying to do that?"  Which is of course true, what sort of investor looks to buy companies at high prices and hope things work out?

In economic terms a company that earns abnormal returns must have some sort of competitive advantage or as Buffett calls it a moat.  If the business didn't have an advantage entrepreneurs and other companies would see the fantastic returns, enter the business, compete and lower everyone's returns.  I think it's indisputable that some companies have moats, the ultimate moat is a monopoly or oligopoly situation.  Another great form of a moat is government regulation.  A regulator serves as a gate keeper to an industry.  It's no coincidence that Berkshire has been investing in regulated companies over the past few years.

There are plenty of ordinary businesses that earn abnormal returns as well.  Why aren't there competitors reducing the abnormal return down to an economic return?  Consider an example, a bait and tackle shop on the only access road to a state park with a nice lake.  The shop has no pricing power over suppliers, has a low barrier to entry, and doesn't even require specialized skills.  Yet the location of the shop, being the only one on a specific road allows it to charge a bit more and earn above average returns.  The bait shop has a small niche, serving fishermen at the local state park, yet they don't have any classic competitive advantages, there are many businesses like this.

I believe the difference between a niche and an economic moat is the ability to scale.  The bait and tackle shop can earn abnormal returns at their original location it's unlikely they will be able to replicate it unless they find a second location with the exact same characteristics as the first one.  I can think of a few companies off the top of my head that I own that fall into this category.  They operate in a niche and earn excellent returns yet they don't have additional reinvestment opportunities and will most likely remain the same size forever.

Niche companies are moat impostors and most investors get them mixed up.  I'd say the biggest mistake I've seen investors make is to see competitive advantages where only a small niche exists.  Paying a moat price for a niche is a mistake.  If a company appears to have a competitive advantage yet they can't scale their business I would guess the company only has a niche.

The third way

What about all those companies just earning normal returns on equity?  For the most part they're ignored, these are not great businesses.  You'll never wow anyone at a party announcing you own shares of a tiny plastics manufacturer, or a family held leather boot company.  So are companies earning lower steady rates of return un-investable?  I would say definitely not, with a caveat, and additionally they offer great hunting grounds because most investors ignore these companies.

To understand why and how a company with average returns can be a great investment it's helpful to consider a little example:

Example:
A company earns 8% on their equity, pays no dividends, book value grows 8% per year.
Book value is $100 per share
A investor pays $100 per share for a piece of the company.

Each year book value grows 8%, so the first year book value increases from $100 to $108, and then to $116.64, $125.97 and so on.  An investor buying at book value will see their investment compound at 8% a year.

Buying shares in our example company at anything less than book value will result in a higher compounding figure.  So buying shares at $75 p/s will result in 10.6% compounded per year.  Why is this?

Book value is still compounding at the same rate of 8%, but since the investor pays less than book value their basis is lower.  So let's look at the math:

Year 1 the company grows book value from $100 per share to $108 per share an increase of $8.  The key is the investor only paid $75 per share, an $8 return on their $75 investment is 10.6%.

The math here is very simple, buying at lower multiples of book value result in a higher return on investment.  While the company is only growing at 8%, buying at 50% of book value is a 16% return a year.  The bigger the discount to book value the bigger the return on investment.

If this is the first time you've ever seen this you're probably not still reading, you're probably playing with a screener looking for 8% book value growth with a P/B of .5x.  The rest are probably thinking these sorts of investments might exist on paper but not in real life.  I would disagree, I posted a while back about Hanover Foods (part 1, part 2).  They're a very boring frozen food company earning around 8% a year, yet  they're only selling at only 35% of book value.  This means buying at today's price results in a 22% per year return on investment.  A nice benefit of these lower return companies is the investor doesn't have to worry about competition as much, the industry is mature.  There will be innovation, but it's not like every high school kid in a garage is dreaming of how to freeze veggies better, they're all thinking about how to invent the next Facebook.

I mentioned these stable but low returning companies can be great investments with a caveat.  The caveat is to not overpay.  A nice bonus with this strategy is an investor doesn't need to be a genius or even that fast moving to implement it.  Be patient, buy a few steady companies at sizable discounts a year, and be patient.

Conclusion

I like to buy companies at a discount, either a net-net with a tangible asset discount, or a company with a stable return at a discount to book value.  I post more frequently about net-nets, but I really don't have a preference between a stock like I describe above and a net-net, both are profitable.  This method is probably more hands off and will result in lower portfolio turnover, but is just as safe.  The key is to ensure the company is actually growing book value.  Of course if they earn 8% on equity and return 50% of it as a dividend book value only grows at 4%, but as an investor you still get your 8%.

As the universe of net-nets dries up beyond its already parched state I'll probably be posting more about stocks that fit the characteristics of this post.

Talk to Nate

Disclosure: Long Hanover

Friday, August 17, 2012

A European net-net with a P/E of 2x and African upside

It's not often a stock like Conduril is found; they are almost the perfect value investment.  A P/E of 2x, a ROE of 14%, trading at 42% of NCAV, and they're exchange traded on the NYSE Euronext.  Of course the company isn't perfect, but what company is at this low of a valuation.  They are located in Portugal (half of my readers just closed their tabs), they do business in Africa (the other half leaves) and they're family owned (crickets).

Quick Thesis

Conduril is a family owned company that has operated profitably in Portugal and abroad for the last fifty years.  They're consistently ranked as one of the best companies in Portugal.  The following items just don't seem to fit a well renowned company:
  • Insanely cheap valuation
    • P/E 2x
    • EV/EBIT < 1x
    • P/B .25x
  • A return on equity of 14%
  • A NCAV of €47.24/sh
  • A consistently strong earning power, six year average EPS €11/sh
Background

Conduril (CDU.Portugal) is an engineering and construction firm located in Portugal.  The company is owned by the Martins family.  The family is related to the Amorim family which owns another Portuguese investment of mine.

The company bids for and supervises large scale engineering work such as hydroelectric dams in Africa, or the construction of new rail lines in Spain.  The projects can take years to complete and cost hundreds of millions of euros.

The company employes 2169 employees spread across Portugal, Spain, Angola, Mozambique, Botswanna, and Morocco.  The majority of Conduril's work is in Africa (67%) with the rest in Portugal and Spain (33%).  The company has long operated in Africa and is well known and respected in the area.

The company trades in Portugal and publishes their financials in English on their website.  The stock doesn't trade often, but there are a lot of shares available at the current price.

Conduril is the type of company I was thinking about when I read the book Africa The Ultimate Frontier Market.  They have European roots, some business in Europe but most of the company's operations are in Africa.  The shares are easy to purchase in Lisbon and don't require any crazy African bank accounts or brokerages.  The company is also subject to better regulation in Europe than Africa, yet at the same time is very exposed to African growth.  While Conduril isn't a pure African investment at 67% of their revenue they're most of the way there.  And being able to buy this African growth cheap is just a bonus.

What's the problem?

Conduril is clearly cheap, both on an earnings and asset basis.  One question I always like to ask is "why is the company cheap?"  Conduril has all of the obvious factors such as being located in an out of favor country, doing business in an emerging market, and having a large majority shareholder.  They're also somewhat illiquid and trade fairly infrequently.  Combined with all of these factors is the company's accounting is a little different than usual because they use percentage of completion to account for long running projects.  As a result receivables appear large and forboding, and operating cash flow doesn't always match net income year to year.  To make sense of this let's look at receivables first.

The best way to depict this is with the net-net template:


Conduril is a company with a €32m market cap, and an accounts receivable that's 8x the size of their market cap.  What's glaring is if this value is discounted NCAV drops from €47.24 down to €3.56.  The difference in those two values is the hope that the company can collect on their accounts receivable.

The receivables are a scary number, and it's easy to see a large number like this and walk away, but I think that would be passing judgement too quickly.  As I mentioned above the company does large scale construction projects that span multiple years.  Clients on large construction projects pay similar to how a homeowner pays a local contractor.  A deposit to start, a portion as some work is completed, and the rest upon completion.  Conduril gets paid in a similar manner.  The company uses percent of completion to account for revenue recognition as a project is underway.  This method attempts to match revenue with approximate costs through time.  Unbilled revenue is recorded as an account receivable, and likewise cash paid upfront but unbilled is recorded as a liability.  Conduril's statements are consistent with this sort of accounting, they have a large accounts receivable, and a fairly large "Advances from clients" liability.  As a project works towards completion the receivables will move to revenue and the cash advance liability will be reduced.

I looked at Conduril over a year ago, tried to get shares but was unsuccessful.  At the time the item that concerned me wasn't the receivables, it was the cash flow.  I wondered how could a company that earned €19m in accounting profits only have €3.5m in operating cash flow?  My failure to understand exactly how the company accounts for projects led me to think this was a company on the edge of a fiscal meltdown, or was run by shady operators.

The percentage of completion method of accounting captures an approximation of how costs and revenues might be spaced in a project, but it doesn't have any bearing on real world cash flows.  In Conduril's case their cash flow is lumpy, very lumpy.  Over the past six years they've had years where they brought in €98m in cash, and years where operating cash flow was only €1m.  Just looking at a single year can lead to incorrect conclusions.  Since Conduril is constructing and managing over multi-year intervals it's helpful to look at their cash flow on a longer term basis.

I want to thank a reader for assembling the following stats, we've been going back and forth on Conduril after I mentioned them in my Africa book review.  On a six year basis the company recorded net income of €121m and operating cash flow of €98m.  Cash flow is super charged in years when projects are completed, then much lower until the next completion.  This might make some investors uncomfortable, especially ones who love smooth trends, but Conduril's cash flow pattern is a byproduct of the industry they work in.


Catalysts

Everyone loves catalysts.  If I put the word catalyst in a headline I will have almost double the readers for a post.  It's silly, but it's true, supposedly patient value investors want some sure sign that value will be recognized in a short period of time before investing for the long haul (notice the irony).  No one wants to be told they need to wait six years before they realize their return, but it is possible.  I have no idea when value might be realized with Conduril, but there are two things that I find hopeful.

The first is in 2009 the company petitioned the CMVM (Portuguese regulator) to go private and were denied.  The company stated in their annual report they didn't see the benefit of being public.  It's unclear whether they might try again in the future. The company realizes they aren't deriving much of any benefit from being public and would prefer to be private.  Going private could result in a sizable premium paid for the outstanding public shares.

The second is the company mentions in their annual report that they have a 600€m backlog.  The company is expanding into the Cape Verde market and is expecting business to rapidly grow in Africa.  I'm not sure if this is necessarily a catalyst, but it's more of a sign the company expects business to remain strong.

Conclusion

Conduril isn't the type of company I'd concentrate a portfolio around, but they're almost too cheap to not own.  I find safety in the large discount to NCAV and the discount to earning power.  The company has a thriving African operation which could benefit from growth on the continent over the next decade.  This stock isn't going to give a fantastic return in the next six months or even in the next three years, but for the patient investor I don't think you can go wrong buying a piece of Conduril.


Disclosure: Long Conduril

Tuesday, August 14, 2012

Book Review: Africa The Ultimate Frontier Market

I prefer to find investments in out of the way places, this means small niche areas of markets, and sometimes out of the way markets in general.  When I heard about a book pertaining to African investing I knew it was something I had to read.

Most investors don't have a very positive impression of Africa, at best it's the wild west, at worst it's lions, zebras, and people living in mud huts.  The author stated up front that the purpose of his book was to put those misconceptions aside and show Africa's potential.  While the continent makes the news fairly regularly for tragedy very few people are talking about the promise the future of the continent has.  David Mataen set out to change that by writing a purposefully optimistic about the future in Africa.

The book is broken into three major sections, the first describes what the author titles megatrends, the second are the enablers for the megatrends, and the third are areas of opportunity.

Megatrends are issues such as rapid urbanization, population and demographic growth, growth of credit, capital market development, and many others.  Megatrends can sometimes be described as problems for Africa, but Mataen is able to cast a positive light on the issues.  I loved this section of the book, I felt like it changed my worldview of Africa.

Mataen devotes the second part of the book to what he titles "The Enablers".  These are the issues that need to be solved to both fulfill the megatrends, and also create a ripe environment for investment opportunity within Africa.  These are things like infrastructure, technological networking, human resource development, and reforms to the business environment.

An example of an enabler is the history of poor education for rural Africans.  The book talks about why this was the case and how it's changing, and what that means for business.  One area Mataen focused on was infrastructure, both physical transportation (roads, railroads, cars) and digital.  Africa has an advantage in that they're developing after the rest of the world has experimented with the best way to do things and learned from mistakes.  This means Africa jumped from almost a non-existant telecom network to a ultramodern wireless system.  Transportation networks are being built with intermodal and mixed use in mind meaning no costly retrofits at a later date.

The last portion of the book describes different industries and the opportunity for investment or development in each.  Areas such as transportation, banking, agricultural, logistics, retail and manufacturing were covered.  This section of the book was the most actionable, but needed the context of the first two sections to make sense.

Key takeaways

I think to many the thought of African investing means finding businesses catering to the growing middle class.  While this is certainly true it seemed to me opportunity exists in many other places that could potentially be much more lucrative.  For example Africa has a power problem, they don't have enough of it, they also have a water problem, the water isn't where the people are.  One solution is to build hydroelectric dams both creating electricity and providing a source of water.  Currently 3% of the continent's hydroelectric capacity is being used, this is an opportunity for a construction firm, or engineering firm such as Condruil a Portuguese firm with extensive African operations.

A second takeaway was that logistics and shipping will be vital as the continent grows.  In most of the action chapters it was mentioned how there's a lack of warehouse space for agriculture, shipping, storage, and manufacturing.  This seemed like such a simple solution for so many problems.  If I had the capital and wherewithal I would be building warehouses in major Africa cities tomorrow.

Who should read it?

The target audience seemed to be an entrepreneur or a divisional manager who was looking to physically expand or start a business in Africa.  There was one chapter with a high level overview of African capital markets, but at this point they're very immature and underdeveloped.  The best investments in Africa are direct investments.  The book spoke directly to direct investors.

If you're a fund manager looking to invest in Africa, an entrepreneur, or an executive with African expansion ideas I'd highly recommend this book.

As an outside passive minority investor there wasn't that much actionable information in the book.  It did pique my interest enough to look at some African exchanges for cheap stocks.  Before opening a number of accounts across Africa I think I'm going to target European companies with African operations.

Amazon link for the book

Disclosure: I asked the publisher for a copy of the book.  If you purchase the book through Amazon I will receive a small commission, your cost is the same whether you enter through my site or directly.

Friday, August 10, 2012

A catalyst that could make this company fly

While Boeing gets the final credit for assembling the Dreamliner there are many nameless companies that contribute parts, without those parts the Dreamliner would never fly.  Kreisler Manufacturing (KRSL) is one of those nameless companies.  Kreisler describes their product as high quality tubing that can carry oil, water, air, or hydraulic fluid.  Kreisler's balance sheet was originally what had me interested in the investment, but the closer I looked the more the company seemed interesting beyond being a simple asset play.

The company has a patchy history of profitability, moving from a loss early in the last decade to sizable profits and then back to a loss during the financial crisis.  Kreisler took a bit longer than most companies to recover, returning to profitability in the last few months.  The company had always been a cash box with a manufacturing business attached until September 2010 when they announced a large expansion of capabilities in Poland.  The company signed a 10 year purchasing contract with two customers in Poland and committed to build out a $12m facility.  The facility qualified for government development grants totaling $6m, Kreisler paid the rest out of cash.  The Polish subsidiary did $4.5m in sales in the past fiscal year, unfortunately the company doesn't break out any further details.

Here are relevant key stats for the past eight years:



Why is this attractive?

As I researched Kreisler I found multiple aspects of the company and their future that made them attractive.  Unfortunately for me none of them worked together into a grand narrative I could use as a theme for a post.  I want to outline three distinct points that taken as a whole make this a potentially attractive investment.

1. The company is selling at 71% of book value.  The company's balance sheet is fairly clean.  The most significant liabilities are accounts payable.  There is a small bank credit line amounting to $600k, and an environmental liability accrual in the sum of $482k.

The company has $1.9m in cash, and trades at 125% of NCAV.

2. When times have been good they were very good for Kreisler.  The company's past results show they have the know-how and the ability to generate significant profits.  For the 9mo ending March 31st the company has already recorded $1.4m in profits.  

In 2007 and 2008 the company generated over $2m in free cash flow on sales which are similar to what they're doing now.  If Kreisler's cash generation this fiscal year is anything like the past the free cash flow yield at these prices would be close to 20%.  When I see a company with volatile cash flow like Kreisler it makes me wonder if over time they actually generate anything above capital replacement costs.  I totaled free cash flow for the past eight years and the sum is a positive $429,000.  Not a significant amount of money, but at the same time positive, which is more than can be said about many companies.

3. The company announced July 9th that they are selling the Polish subsidiary.  Terms of the deal weren't disclosed, but I would imagine Kreisler will get some of their $6m investment back if not all of it.

I think the sale of the Polish subsidiary has a bigger impact besides the balance sheet improvement.  The company's results appear to have been negatively impacted by the Polish expansion in 2010 and 2011.  It's possible now with the Polish operations handed to someone else that the company can get back to solid profitability.  The Polish sub contributed $4.5m in sales, but my guess is their costs were significantly higher dragging the entire company down.  I believe the sale of the Polish subsidiary is the catalyst needed to unlock value in the company.  If profitability can be restored there is no reason this company should trade below book value.

If the company just merely traded to book value an investor at today's price would realize a 31% gain.  If the company can earn $1/ps or more again there's no reason why this stock couldn't trade near $10 which is almost a 100% gain from the current price.

Why is it cheap, where's the safety?

The company is cheap for what I consider obvious factors.  At a time when the aerospace industry is booming they're failing to turn a profit.  The company expanded in Poland, but the division doesn't appear to be as successful as the company might have imagined.  Without a revenue breakdown it's hard to tell what the Polish results were exactly.  The fact that the company has a growing foreign net operating loss carry forward tells me the Polish division isn't carrying its weight.

I don't believe Kreisler's issues are insurmountable, especially in light of the sale of the foreign subsidiary.  My speculation is that sale will restore their earnings power and provide a nice boost to the balance sheet as well.  

Investing at the current price affords a margin of safety in the price to book value discount.  The item that concerns me is the company's cash flow was negative at the last filing.  My hope is the sale of the Polish sub will restore their cash generation ability.  The problem is that's all speculation, maybe the company wanted to get out of Poland so bad they handed over the keys, we don't know.   

I haven't decided if I want to take a position or not, if I do it would fall under the speculative category, speculative at least until more details are released.


Disclosure: No position

Tuesday, August 7, 2012

Rethinking Titon Holdings

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

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

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

How bad is it?

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


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

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

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



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

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

Conclusion

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

Talk to Nate about Titon Holdings

Disclosure: Long Titon Holdings at the time of this post



Saturday, August 4, 2012

There is something sweet with this fruit company

Kiwis are great, every New Zealander I've met has been friendly and likable.  Oh did you think I was talking about the fruit?  Well the mistake is understandable, when most of the world hears "kiwi" they think the fruit not the people.  This is good news to Satara Cooperative a kiwi and avocado company located in…New Zealand!  Not only are the company's products delicious the company has a lot going for it as well.

I stumbled on Satara as I marched through all 141 New Zealand listed companies in the IRG New Zealand Investment Company Yearbook.  I've found some of the best stocks going through lists from A-Z looked at everything.  For some reason New Zealand has appealed to me, it seemed like a forgotten market living in the shadows of Asia and Australia.  This impression was reinforced when I received the yearbook and saw that of the 240 pages 141 were New Zealand companies and 99 were Australian companies.  The investment yearbook has a page per company with company history, some financials and the current year outlook.  While I'm no expert on New Zealand just going through each company gave me a feel for the NZ market.  I didn't find any net-nets, but I did find some companies with interesting potential.

A little insight into my process, as I went through each company I marked companies I wanted to research further into a notebook with a small note or two.  I made notes to follow up on 30 companies.  Of those ultimately I expect 3-5 to be investment worthy.  For Satara I made the following note: "EV/EBITDA 2x, P/B .29x".  One company I already invested in and reviewed was Guinness Peat Group.

Quick Thesis

Satara Cooperative is extremely cheap on an asset basis, an operating earnings basis, and relative to the other large kiwi fruit company in New Zealand.

Note all dollar figures New Zealand Dollars (NZD).
  • Book value of $1.55 per share with a last trade at $.45
  • EV/EBITDA 2.22x
  • Debt has been reduced from $22m in 2007 to $6m in 2011
  • Lumpy earnings over the years, but earnings before special items of $.15 in 2011
  • Management is open to unlocking shareholder value by putting to vote a merger offer from Seeka Kiwifruit which was rejected by shareholders (rightfully so, it was a lowball offer).


Background

Satara Cooperative is an agricultural company with facilities located across the North Island of New Zealand.  The company packages kiwi and avocado, they also lease and manage 790 acres of kiwi canopy (320 hectares).  A grower who joins the co-op can decide what level of interaction they want with Satara from complete land management to just packaging and shipping of fruit.  Since the company is a cooperative growers share in a portion of profitability.  I'm not 100% certain, but I believe growers are higher in the capital structure than shareholders.  The company is listed in New Zealand under the ticker SAT.

The problems

When I see a company trading at a large discount to book value I wonder if book value is justified.  And if book value is reasonable, why isn't the company trading near it?  This is another way of asking  why is the stock cheap?

In a past post I highlighted how one or two numbers can be a pivot point for an investment.  In the case of Satara the pivot numbers are fruit loss, and trays packed.  Fruit loss is the measure of how much product is lost between the purchase from the grower and export.  The difference in fruit loss can mean the difference between profit or a loss for the year.  Fruit loss for the industry is volatile, and Satara's fruit loss is even more volatile.

Trays packed was in the 12m range before dropping to 9.3m in 2010.  The number of trays packed has recovered to 11m, but there are dark clouds ahead.  There has been a kiwi vine disease (Psa-V) across New Zealand putting pressure on growers.  I found estimates online that expect the kiwifruit industry to lose up to $885m in 2012, this is a daunting number.

So why is this stock cheap? The company has a spotty past of efficient operation and is in an industry with an uncertain future due to disease.  Agricultural diseases can do terrible things to industries.  In the US in the early 20th century the southern cotton industry was wiped out by the boll weevil.  Of course the decimation of the Southern cotton industry led to the rise of the peanut industry since peanuts weren't susceptible to boll weevils.

Is it worth book value?

To me this is the million dollar question with Satara, is the company worth book value?  If the company is worth book value purchasing the stock at this price would result in a ~4x gain, quite respectable.  Determining if a stock is worth book value breaks down to two pieces, earning power, and book value composition.

I have a term I use on this blog to identify stocks where earning power and book value support each other; a two pillar stock.  The idea is if a company has earning power equal to or in excess of book value then the company's book value is justified and the shares should trade at least at book value if not above.  If a company's earning power is consistently below book value then book value might not be a reasonable value, or a justifiable value.

Looking at Satara from a two pillar perspective the company is interesting.  They certainly have the potential earning power, but there are strong headwinds.  In 2010 the company lost $4.8m, and $214,000 in 2011.  Clearly results are improving.  The 2011 annual report shows that core earnings without one time subtractions would have resulted in $.15 per share.  If the company were to earn $.15 a share at a 10x multiple book value is easily supported.  The question is can Satara execute on this level?

Looking at straight book value the answer is much clearer, book value appears conservative and mostly devoid of intangibles.  Most of the company's assets consist of biological assets (kiwi and avocado), a small amount of cash and a large amount of PP&E.  For an agricultural operation the large PP&E is expected, it consists of growing land, warehouses, packing plants, machinery and other necessary equipment.

The company had their assets re-evaluated this past year in light of the Psa-V outbreak.  The Psa-V can wreak havoc on the kiwi vines and the company wanted to ensure the carrying value of their assets was correct.  At the end of the assessment the company marked down their assets by $4.9m due to the likely affect of the Psa-V.  It's worth noting that the Psa-V didn't have a very large affect on operations in 2011, but it could potentially have an impact which led to the writedown.

Satara's largest competitor is trading at .45x book value with a EV/EBITDA of 4.81.  Both companies face the same uncertain outcome from Psa-V.  Both companies grow kiwifruit in the same area of the country, and if Seeka is being valued at .45x book value I would expect Satara to be valued at least in a similar manner.

Conclusion

Satara appears to be on the right track, management is focused on profitability and paying down debt.  If the company continues to execute as they plan, and Psa-V isn't as harmful as some expect there is a lot of potential upside for this stock.  Satara has all the signs of a lucrative turnaround stock, and the potential to buy in before shares are valued higher.  It is worth noting here that a New Zealand value investor is on the Board of Directors and has been pushing for more transparency and for management to realize shareholder value.  Looking back through old annual reports the investor has made large strides on transparency, and it's hoped value realization as well.

Talk to Nate about Satara

Disclosure: No position