Monday, November 26, 2012

The problem with linear thinking

Congratulations for actually reading this post, most people saw the title and clicked away thinking "I don't do that, it's not for me."  This post isn't breaking any new ground.  Maybe a few will learn something new, and while it's important to keep learning, it's also important to continue to refresh existing knowledge.  This is a refresher post.

Linear thinking is a shortcut for completely thinking through a problem.  It's easier to look at quarterly earnings of $.25 and multiply by 4 rather than estimate what they might actually be due to seasonal fluctuations.  Linear thinking and estimations are everywhere, a casual read of the news or research papers would leave one with the impression that we live in a linear world.  The problem is we don't, often trends reverse, or change due to some inflection point.  I think people like linear trends because it makes them feel like they can guess what the future might look like.  No one knows the future no matter how hard we try to predict it.

My favorite example of linear thinking is personnel assignment for projects.  If a project is estimated to take one person 80 hours there's this widespread myth that assigning two people will get it done in 40 hours, and four people in 20 hours.  The problem is that doesn't account for overlap, or communication overhead.  At a certain point adding an extra person on the team actually lengthens the time needed to finish a project.  There's a book on this topic dealing specifically with software engineering, but the principles are universal, The Mythical Man Month.

Mythical man months and linear thinking are everywhere in investing.  Just go back to any article from 2006 and you'll see the economy and stocks will follow a nice smooth path upwards forever.  I don't know why people accept this sort of reasoning.  Anyone who's lived for even a little bit knows it's not true.  Growth comes in spurts, a child grows very quickly the slows down with bits of fast growth.  Most businesses are similar, they grow fast for a while then mature.  Even nations grow in spurts, the baby boom in the US was a large spurt, the echo-boom a smaller one.  Between those population booms were years of lower than trend birth rates.  With regards to birth rates linear thinking abounds, every few months a story will appear saying Russians will disappear in 400 years, or the Japanese will cease to exist in 300 years at current rates.  When birth rates are high articles are written discussing when the world will run out of capacity, or strategies to slow down growth.

Very few companies have linear growth, for me this is the downfall of DCF calculations.  How do you model lumpy growth?  Some companies do have this predictability, I worked for one that signed all customers to long term contracts with 5% increases each year.  So for them it would be appropriate to model out 5% growth to eternity.  Or at least growth until technology blows up their market.

Warren Buffett, or his followers talk about only buying companies if you know what they will look like in 10 years.  This is great sound bite material for CNBC, but it's unrealistic.  Did Buffett really know what investment banking would look like in 2018 when he made his Goldman Sachs investment?  I doubt it.  We often look at things in a linear fashion when trying to estimate far into the future, and it can be a downfall.  The problem with a linear thought is it blinds us to uncertainty and potentially negative consequences.  The strong moat of Eastman Kodak in 2000 was worthless in 2010, but how many predicted digital cameras would be in cell phones in every pocket back in 2000?  I know I sure didn't.  I remember seeing my first digital camera in 1993, it could fit 100 pictures on a 3.5in floppy disk.  That means each picture was around 14k, the camera was huge and bulky, it was a hobby thing.  Serious photographers used film cameras.  Now about 20 years later I have a camera in my iPhone that's probably 100x or 1000x better than that bulky digital camera and at 1/10th of the cost or less, not to mention the size difference.

Some companies that look strong in the moment fall quickly to technological, or cultural shifts.  MySpace was the king of social networking a few years back.  Who would have thought they'd be complete irrelevant now?  I own a franchise company (Mastercard) and I think about this often.  They have a strong network, but very quickly a competitor could emerge and turn the industry on its side destroying Mastercard's moat.  My concern is that I'll spot this too late after my investment is impaired.

A parting thought before moving on is that the average lifespan of a company has shrunk from 67 years in 1920 to 15 years in 2012.  So when someone says to think 10 or 15 years out that means thinking about the successor or bankruptcy of the company you're examining, a sobering thought.

When I considered doing this post my first intention was to bring awareness to thinking that could be harmful to our investments.  The second goal was to show how this could be exploited.

I find that investors have a very strange fondness for linear thinking thar's often not found outside of investing.  When two sport teams play each other a non-committed bystander usually roots for the underdog.  A very common plot for American movies is an underdog achieving greatness against all odds.  Yet when it comes to an underdog company the standard expectation is it will just decline into oblivion in a straight line.  Conversely great companies like Apple or Starbucks will just grow to the sky forever with investors enjoying sunny days and endless dividends.

When presented with a tight situation people are able to dig down and find resolve to face a tough situation.  Ideas and strength not found in everyday life present themselves and can come to the rescue.  Not every desperate situation works out well, but enough do solely on human perseverance that others in dire straits can remain hopeful.  Investing in cigar butt companies can be similar to a down and out individual.  Not much needs to go right for things to change.  If the negative trend merely stops that can sometimes be enough.

Linear thinkers believe that all net-nets go to zero, why else would a company trade for less than NCAV?  Of course the evidence says otherwise.  Linear thinking says that big giant companies with steady growth will continue to grow forever, a quick look at the Dow over the past 100 years says otherwise.  Beware of linear thinking, and take advantage of it when the opportunity presents itself.

Talk to Nate

Friday, November 23, 2012

Bogen a spinoff with uncertain motivations

Unlisted companies are famously opaque, so it's no surprise when an unlisted company decides to spinoff a division that they're less than forthcoming with information.  The company in question is Bogen Communications International.  Thanks to a Twitter message, and a post from Inelegant Investor   at Stock Spinoffs I was alerted to the strange spinoff occurring at Bogen.

The company recently issued a press release stating they were spinning off a wholly owned subsidiary named Bogen Corporation.  The release is confusing to say the least, the company announced the spin of a subsidiary, except there is almost no mention of this sub in their annual reports.  The company announced the spin on November 20th, which is curious considering the record date for the spinoff was November 19th.  Shareholders will allegedly get to vote on this, but with management owning 70% the vote is nothing more than a token measure.

This transaction caught my attention for two reasons, the first is this is an unlisted stock, and I'm naturally attracted to these, and secondly after looking at the annual report is seemed like there might be some opportunity here.  The company barely makes mention of their two divisions except for a small section at the bottom of the notes in the annual report.

The company is an audio products company, they design, and manufacturer speakers, amplifiers, and sound systems.  The products all appear to have professional applications, from stadium speakers, to rack mountable mixing boards.  The company also sells products for intercoms and school broadcast systems.  Further evidence that the company targets a professional customer is the fact that the only way to purchase products is through a sales rep, or a very limited set of distributors.

In the US spinoffs are known to be an area of the market where outsized returns can be found.  I find it fascinating that spinoffs have generally only been profitable when American companies are doing the spinoff. I remember seeing some literature (don't remember where) a year or two ago that looked at global spinoffs and for the most part the stocks of the spun off companies resulted in a small loss.  My impression is that American companies spin off a division to unlock value; they provide incentives to management at the new spun off company to do well.  Non-American companies spinning off divisions do it to dump an underperforming division.

The motivation behind the Bogen spinoff is very unclear, but looking at the segment information from the past few annual reports we can get a glimpse of what management is thinking.


The above are the results for the Bogen Corporation division for the past six years.  The company's US operations have been profitable every year except for 2009.  The foreign operations haven't been profitably any of the past six years.

The company has a respectable gross margin and operating margin.  I didn't calculate the net margin because my net income figures are estimated.  The company carries a small amount of debt, and I'm not sure which division the debt belongs to, or how the interest costs might break down.

Maybe the company's international operations will turn around, it's possible, but I wouldn't want to speculate on it.  Instead I think the opportunity here lies in the domestic operations.  The company states that 58% of the total assets belong to the domestic operations.  The domestic subsidiary generates 100% of the profits.  Spinoffs are usually conducted on an asset basis not an earnings basis.  If we applied that formula to Bogen the domestic operations would have a market cap of $10.44m against a net income of $2.8m for a P/E of 3.73x.  Clearly the better investment is the Bogen Corp spinoff, and I think management realizes this.

Why would the company management suddenly decide to spin off the profitable operation?  Management owns 70% of the outstanding shares, and they can effectively do what they want with the company.  My guess is they are looking to sell one of the divisions and a potential acquirer said they would be interested but they only wanted to buy a portion of the company.  It was easier to spin off the undesired division rather than complete a purchase for a portion of the company.

After looking into Bogen the question I had was how do I buy the spun off shares?  I don't have an answer, I'm not sure if the Bogen Corp shares will even trade publicly after the spinoff.  If the Bogen Corporation shares do eventually trade I think they offer a very compelling opportunity, with an extremely low valuation, and a management that might be motivated to sell.  If anyone has more information regarding this spinoff I'd appreciate an email, or a comment.

Talk to Nate about Bogen

Disclosure: No position

Sunday, November 18, 2012

A profitable cash box, or a cash box with profits?

A common feature of most net-nets is a pile of assets with a tiny obsolete business attached.  While his isn't always the case, is the exception not the rule to find a good profitable business selling so cheaply.  Metalink (MTLK) was suggested to me by a reader (thank you!), they're a foreign issuer, a cash box, and a net-net, the siren call was strong, how could I not look at them?

There's a certain market cap threshold where even I get a little queasy.  I don't have a problem investing in a company with a $6m market cap, yet once the market cap drops below $3m I start to get nervous.  I get nervous because my pool of potential buyers shrinks.  I know that by investing in the microcap space I'm already limiting myself to retail investors, and small funds, but below a certain market cap I'm limiting myself to other individuals as crazy as myself.  Metalink falls below my psychological threshold of $3m, although only slightly.

Metalink might be the first investment that literally checks off every potential box for a net-net.  Profitable: yes, mostly cash: yes, obsolete business: yes, no debt: yes, no liabilities: yes, no leases: yes, no future direction: yes, and on and on.

The company is a DSL chipset manufacturer.  For anyone born after 1988 DSL is a technology that ushered the US onto the information superhighway.  DSL technology was an enormous improvement in internet connection speed.  Allow me to take a quick walk back in time.  I remember my first modem, it was 2400 baud, I had a friend with a 4800 baud of whom I was jealous.  I'm guessing a few readers are thinking "wow, 2400 baud, he's young" and the rest are clicking to Facebook while the thought "what's a baud" is forgotten.  Technology quickly went from 300 baud, to 1200, to 2400, to 4800, then 9600.  From there we jumped to 14.4, and finally 28.8 and theoretically 56.6.  When the dot-com bubble was booming most people were connecting to the internet at 28.8k or 56k speeds.  In about 10 years connection speeds had increased 10x.  This is the reason the internet boomed, we always had those networks (BBS anyone?) but they were so slow that anything more than colored text was unusable.  Telecom companies were looking to maximize connection speeds using existing technology, which were copper wires and DSL fit the bill.  When a human talks on the phone voice only utilizes a portion of the frequencies that the wire can carry, DSL sought to fill this extra space with data.  Customers used to have to install DSL splitters to block out the data frequencies on their land lines.

DSL technology seems so quant today where we can connect at speeds of 10 Mbps or 25 Mbps on a standard internet package.  But keep in mind the jump, a standard DSL connection was 768kbps verses the fastest model a 56k which at most could do about 43kbps.  Going from a fast modem to a DSL connection was almost a 20x increase in speed.  A similar jump was possible with cable, but not all neighborhoods were wired for cable, whereas anyone with a phone in theory could have DSL as long as there was a DSLAM installed at the local switchboard.  The limit to DSL was the drop distance, that is the distance from the DSLAM to the end point.  The longer the distance the slower the speed of the connection.  Warren Buffett claims all knowledge is cumulative, I never thought the things I learned about DSL 15 years ago would be relevant today, yet here we are...

Metalink comes into the picture in the sense that they coordinate manufacturing and distribution of DSL chipsets.  For years they were involved in the research and development of new chips, but as DSL has moved from the front to the back of the broadband line they eliminated all R&D.  The company has whittled themselves down to simply a distributor of their old DSL chipsets.  They outsource fabrication to third party chip fabs and sell to a few remaining customers.  The company end of lifed their chips back in 2008.

The company doesn't have much going for them in terms of a future outlook, they aren't developing any new products, and plan to continue selling existing products until clients don't need them anymore.  The business has stabilized and the current run rate should be expected into the future until demand ceases.  With a more normalized cost structure they've moved from losses to making a profit.

Let me summarize the high level discussion before diving into the details of this investment.  Metalink sells an outdated obsolete chip technology that's currently profitable with an uncertain outlook.

The starting point for analyzing Metalink is the balance sheet, here is their balance sheet summarized in my net-net template:


The company has an excellent balance sheet with $1.89 in NCAV, a discounted NCAV of $1.82 and a net cash position of $1.67.  It's worth mentioning that shares are trading at $1.04.  In other words, this is a profitable net-net selling for less than net cash outside of Japan.  Their location (Israel) isn't without risk, which I'll discuss below.

I want to call out a few things from the balance sheet, the first is the company doesn't have much inventory.  This is because chips are manufactured as customers demand them, and are shipped straight from the fabrication location.  The chips that have been manufactured but haven't been received by the customer are what's been captured on the balance sheet.

The second item I want to call out is the lack of liabilities.  The company has some accounts payable, that's it, no other liabilities.  I don't think I've ever seen a company with so few liabilities.

Metalink's record of profits has been much worse than their working capital management.  They were consistently unprofitable until they sold off a loss making division a few years ago.  Since then they've only had the DSL chip business that doesn't generate much revenue, but it's enough to cover fixed expenses with a tiny bit left over.  While the company is profitable the statement I'd make is caution needs to be taken when considering their future.  The business is unsustainable and it's possible sales could dry up, I don't know if that's in six months, or three or nine years, regardless of the timing it will happen eventually.

A discussion of Metalink wouldn't be complete without a discussion of management and their plans for the pile of cash.  Management owns 40% of the outstanding shares, which isn't a majority, but enough to push the company in any direction they want.  In the 20-F statement the company mentions they would like to use their cash for something strategic, possibly an acquisition.  This is where things get a little crazy in my mind.

The company only has one employee at this point, the CEO.  He's essentially arranging the fabrication, then the shipment of the completed chips to the destination location.  He's also in charge of filing the SEC statements, and whatever else a middleman does.  The company has $5m in cash and is looking to do something with it.  The problem is that while $5m is a lot of money in normal people terms, it isn't all that much in business terms.  I'm not sure what sort of company besides a smaller local one could be purchased for $5m or less.  And I can't imagine purchasing a company and trying to get up to speed and taking control with only one employee either.

Due to the logistical problem, and the low absolute level of cash I don't see an acquisition in the company's future, more likely is a tender, or a buyback to completely go private.

I'd be remiss if I didn't point out the biggest risk to this investment, which is Metalink's location.  The company is located in Tel-Aviv, which as of late isn't the safest place in the world.  The job the CEO is doing appears to be done from home, and in theory could be done anywhere in the world.  He's a plane ride away from moving the business to London or New York.

The second biggest risk is the uncertain future outlook.  We don't know if Metalink will be churning out DSL chips for the next three months, or the next three years.  We also don't know what the CEO will decide to do as his next move, will he tender for the outstanding shares, or will he go out and buy whatever he can for $5m?  If you can reconcile those two risks and are comfortable with them I don't think there's any problem purchasing shares of Metalink.

Talk to Nate about Metalink

Disclosure: None

Sunday, November 11, 2012

Japan the ultimate trade, part 2

Recently I wrote a piece on my desire to investing in a large number of Japanese net-net stocks.  I've received a lot of inquires from that post asking if I needed any help digging through the net-nets, and if I'd post what I purchase.  This post addresses the first question, to answer the second, yes I will post what I've purchased, and follow them.

It's been almost two weeks since that post and I hate to admit I still don't have my Schwab Brokerage account open yet.  I hope the account opening process with is no indication of what their accounts and features are actually like.  A global account requires a paper form, and money can only be transferred online once an account is established.  There's a chicken and egg problem with the funding, I'm still waiting to get the account opened.

In the meantime I am looking to solicit help from readers who are interested in this trade.  I have two lists of net-nets, one is 251 stocks long, the second 448 stocks long.  From what I can tell the first list contains net-nets traded on the Tokyo exchange, the second contains Osaka, and JASDAQ listed stocks.  In the first pass I'm going to focus on Tokyo Exchange listed stocks.

The plan is as follows, anyone who is interested in helping me score will get a Google Docs link to the spreadsheet.  There are seven categories I'm scoring, which I'll discuss below.  I will assign a chunk of stocks for scoring to whomever is interested and we'll divide up the work.  The reward for helping is access to the entire spreadsheet.

If there is an overwhelming interest in doing this we can go ahead and score both lists.

The scoring

There are almost 450 net-nets in Japan, and at most I want to purchase 30 of them, I already own five.  Because I'm looking at such a small subset I can be picky and demand the absolute best of them.  My goal is to find 20-30 that meet the scoring criteria set below.  Here are the items that will be scored:


  • 10 years of positive EBIT
  • 10 years of positive net income
  • Pays a dividend
  • No debt
  • Stable or shrinking share count
  • Revenue growth
  • Earnings growth
If it seems like I'm looking for a needle in a haystack I am, but there are many needles to be found.  I scored 100 Japanese net-nets about eight months ago and found 20 or so that met all of the criteria mentioned above.

Here is a screenshot of the spreadsheet:

If you're not interested in helping, but are interested in Japanese net-nets there are nine to get you started.

If this is at all interesting drop me an email at the link below.  My response might be delayed a bit as I'll be out of town this week for a training session.  I'll be able to respond in the afternoon or at night, but not right away.  The more volunteers we have the quicker we can get a list finalized.  I want to get a rough number of volunteers first before I split up the list.

If you're wondering where the data for this exercise will come from the answer is MSN Money.  MSN Money has 10 year financials for all listed Japanese stocks.  If anyone has access to a better database that is fine as well, but MSN Money is good enough.  It should go without saying that this is only a starting point for an investment, investors should do their own due diligence. 

Thursday, November 8, 2012

My investment process applied to eOn, a net-net trading at 3x FCF

eOn Communiations (EONC) typifies many of the current net-nets, cheap, but with some warts, but most importantly, tiny.  eOn has a market cap of $2.3m, 30% of the shares are locked up by insiders leaving only $1.61m available for purchase.  This investment is off limits to anyone who isn't a retail investor, which isn't always a bad thing.

I want to use this post to show the way I approach stocks.  My posts don't reflect the process I went through to invest or find a stock, only the final product.  My method is what I call the lazy way to research.  If you don't know I'm not a professional investor, I do this on the side, and I have a job and a family so I'm always looking for shortcuts.

I've heard of investors who will develop a circle of competence, they will target some industry and read all the material they can obtain to build a gigantic foundation.  Once the foundation is established they begin to look at players within the industry.  There are bank investors, insurance investors, tech investors, I'm none of those.  I don't have the desire, or the time to do something that exhaustive.  With my time and interest limitations I needed to devise a shortcut.  When I stumble on a name my goal is to exclude the company from consideration as fast as possible, the faster I rule out an investment the less time I waste.  Working in this manner lets me cover a lot of ground quickly.  I might miss some opportunities where I really need to dig in the weeds, but with 60,000 stocks worldwide I can afford to miss a few gems.  A great example of this is the current banking warrants.  I know a number of people who love certain banking warrants.  By the time I dig through the prospectus and really understand all of the details of the warrants I could have looked at five small caps.  Neither is right or wrong, just different.

The first step in my process is to form a thesis on why I'd be interested in going long in the first place.  Sometimes I can't do this, and I move on.  After having the thesis I work to figure out exactly how the company could go wrong, my thesis could go wrong, or any way I'd lose money.  It's usually in this process that I spot something that I can't overcome.  Sometimes it'll be too much debt, or a broken business model.  If I get to the end of this process and either I come to the conclusion that the investment can't go wrong, or it can go wrong and the risk is acceptable, I will buy shares.

There are two important points to remember, I establish a long thesis quickly.  The reason I can do this quickly is because I'm looking for obviously cheap companies.  If I have to work hard to determine why a company is a good investment it's not for me.  If I have to worry about how much the company is spending on toilet paper and utensils it's not cheap enough.  The second point is that after I establish the long thesis I work as quick as possible to discredit it.

Before looking at eOn I want to point out one last thing.  This process works well for me because it fits my personality.  If you're the exhaustive study type of person trying to adopt this is the quickest path to failure.  Learn how you operate, and invest accordingly.

The short, the quick, the long thesis

eOn is a VOIP communications provider, they manufacturer and sell their equipment and solutions across the US and Puerto Rico.  The company sells through distributors and to clients directly, a majority of their sales come from the distributor relationships.

The company has a $2.3m market cap against a NCAV of $4.3m, and a book value of $6.1m.  In the most recent year the company made $512,000 which is $.12 p/s.  The company generated $1m in cash flow, and $770k in free cash flow.  The company is clearly cheap, with a P/E of 6.6x, a P/FCF of 2.9x, and a P/B of .37x.

Management is heavily invested owning 29% which is an encouraging.  The second encouraging aspect is that management's salaries are normal.  The CEO makes $290k, and the CFO makes $140k, both acceptable salaries for officers who run a company with $22m in sales.

Here is the net-net worksheet for eOn:


Ruling it out

The first thing I looked at was what does eOn do?  As mentioned above the company is in the VOIP industry, both as a manufacturer, and as a solutions provider.  Their products are sold to call centers, businesses, and anyone else who needs a VOIP solution.  The hardware is custom designed, and the software is built on an OpenSource Linux platform.  The company doesn't appear to have any differentiating factor. There's no reason I couldn't buy five VOIP phones on Amazon, and install my own Asterisk server thus implementing the same solution cheaper than what eOn could provide.  The company's advantage over an Amazon purchase is the ability to offer a complete solution and an integrated package.  My problem is services are only 22% of their revenue, most of their money is made selling off the self commodity components.

One thing that concerns me a lot is how easily the company can move from a profit to a loss.  Investors naturally look at companies in percentage terms, and in multiples to improve comparability across companies.  I think it's helpful to look at things in absolute terms sometimes.  The difference between an operating profit this past year, and the prior year was about $800,000.  In general a VOIP telephone costs about $130, add in the back end server for a few grand more, and you have a system.  The price of a system to serve 10 users might cost $3500.  A system to serve 1,000 users might cost $150k.  This means the difference between a profit and a loss is five large accounts or 228 small accounts.  VOIP is a very saturated market, outside of very small companies it seems everyone's phone systems are already converted to VOIP.  In order for the company to remain profitable they need to continue to sell these devices to the shrinking unconverted consumer, or sell replacement devices.

An endgame for a lot of net-nets is an acquisition, that could be the case with eOn, but I doubt it.  There are already a number of large players in the VOIP market, and from what I can tell eOn doesn't bring anything unique that an acquirer would want.  The clients eOn has wouldn't move the needle at a larger VOIP provider like Cisco.  The VOIP market is very saturated with large players who all have differentiated offerings, and have economies of scale in manufacturing.  The only acquisition I could see would be if the CEO wanted to take the company private.  The company is too small for a private equity firm to purchase as well.

The last negative against eOn is found on the balance sheet.  There is an entry for notes payable to related parties.  When related parties are called out in the balance sheet my it gets my attention.  It turns out that eOn's founder had started a second company in addition to eOn to provide similar services.  A few years back eOn purchased that company and financed the purchase with a note to the founder.  It seems a little questionable that the founder used eOn to cash himself out of a previous holding.

The company also has some operating leases which aren't on the balance sheet and could be a problem in a downturn, but the leases are really minor compared to the other points above.

Pulling it together

None of the negatives completely kill the investment.  If eOn was trading at a P/E of 10x, or at 80% of book value the negatives would quickly kill this thesis.  But at half of NCAV with a P/E of 6x there is a lot of room for error.  The biggest factor holding me back from investing in eOn is really the dynamic of the industry they're in.  I realize the company is selling for too low of a valuation, but at the same time I can't see how they continue to grow as they're fishing in a quickly shrinking pond.

As always thoughts and comments to the contrary are appreciated!

Talk to Nate

Disclosure: None

Tuesday, November 6, 2012

Investing in Horizon Kinetics through the back door with FRMO

Most investors who travel through the pink sheets have stumbled upon FRMO Corp (FRMO) at some point.  The response is always the same, first disbelief that a company could grow book value at 76% a year for almost a decade, and secondly the thought "what the heck do they even do?"  To understand FRMO we need to understand Horizon Kinetics first.

Horizon Kinetics is a boutique investment firm that runs a number of mutual funds, aptly named the Kinetics Funds.  They provide institutional strategies, investment advisory, and boutique research.  Many value investors will be familiar with the Horizon Kinetics quarterly market commentary.  Two of the firms founders are Murray Stahl, and Steven Bregman.  Horizon Kinetics is a relatively recent combination with the company being formed in 2011.  The company is a merger of the prior companies: Horizon Asset Management, Kinetics Advisors, and Kinetics Asset Management.  Lastly Horizon Kinetics has approximately $7b in assets under management.

So what does Horizon Kinetics have to do with FRMO?  FRMO is also run by Murray Stahl, and Steven Bregman, and FRMO owns a portion of Horizon Kinetics.  In essence an ownership stake in FRMO gives an investor an ownership stake in Horizon Kinetics too.  And currently this is the only way to own a piece of the investment boutique.  If the story were that simple I probably wouldn't have done a post, there's a lot more to FRMO then a simple ownership stake in Horizon Kinetics.

FRMO started off as a strange structure, the company was a shell that owned intellectual property rights to funds and strategies that Horizon Kinetics employed at the advisory and in the funds.  As the funds and strategies did well FRMO received royalty income streams.  The Horizon Kinetics products were very successful, and FRMO's share of the revenue streams grew increasingly valuable.  At the end of 2002 FRMO had $185,745 in shareholders equity.  As of the most recent filing the company's shareholder equity is $55,938,847.  Just sit and think about that for a few minutes, in the last decade shareholder equity grew from less than $200k to almost $56m.  This clearly shows how valuable the ideas that Stahl and Bregman sold to Horizon Kinetics were.

FRMO isn't a net-net, or a deep value asset/earnings discount stock, it isn't really like much else actually.  Even without a deep value label FRMO is clearly an oddball stock.  The company is nothing more than a pile of assets, and a lot of raw brain power.  The company has no liabilities outside token amounts of accounts and taxes payable.  They employ no one, pay no salaries, and don't operate like any standard business.  Yet without employees the company continues to grow, which is a great example of how easily capital scales and grows once it reaches a critical mass.

The first question I had, and by extension a few readers will have, is if they've grown at such an incredible pace why are they trading on the pink sheets, and completely unknown?  The company ran into some problems a few years back with their unconsolidated holding.  The SEC wouldn't let them file without presenting audited statements for the holding because the holding size was above a certain ownership threshold.  The problem for FRMO was that they didn't have access to those statements, and as a result couldn't satisfy the SEC's requirements.  With the inability to file timely statements with the SEC they were forced off the exchange and into the pink sheets.   After the merger that resulted in Horizon Kinetics the FRMO shrunk as it became a holding in a much bigger company.  The holding size is now below the threshold that requires audited statements for unconsolidated holdings.  The company is working on getting a clean bill of audited financials for a few years so they can re-list.

I want to pause here and say that if you get nothing out of this post I hope you will at least head over to the FRMO website and read the annual shareholder letters, as well as spend some time in the research section.  Murray Stahl has published a lot of papers explaining some of his investment ideas, and his investment strategy.  One thing I share in common with Stahl is my preference for owner-operator companies.  Out of the 50 or so holdings I have 22 are owner-operator companies.  The research and shareholder letters contain some truly unique investment thinking, something rare in the markets these days.

Based on the description above FRMO might seem like a complicated story stock.  The type where if you don't read three hours of message board history you'll never quite "get it".  Or the type of stock that has a book written about it (JG Boswell).  FRMO isn't a story stock, they have a small amount of history, but they're very easy to understand.  Beyond that their valuation is actually very simple and straightforward.

The company has a $55.9m book value against a market value of $76.32m.  The company's assets consist entirely of cash and marketable securities.  From these securities, and from the residual revenue streams the company generated $3.2m in net income last year, and $1.05m this latest quarter.  The company derives roughly 25% of their revenue from consultancy and advisory fees, 50% from dividends and interest, and another 25% from investment partnerships.  The company's expenses are artificially high because they are required to accrue salary expenses even though there are no salaries paid out.

If we take the market value and subtract out the liquid assets we're left with $14.42m as the value the market is assigning to Stahl and Bregman's brain power, and investment acumen. It might seem like there's no way to value this brain power, but I would suggest there is.  These two men grew FRMO from under $200k to $55m, and Horizon Kinetics from a firm with zero AUM to $7b AUM.  The way I view this is that the two men running FRMO have been extremely successful twice in the past, and their plans for the future are similar to what they've done in the past.

One objection a lot of investors have with cash boxes, which FRMO roughly qualifies is that management might do something stupid with the cash.  For most net-nets and lower quality businesses this is certainly true.  The opposite is true in FRMO's case, the cash and securities are entrusted to two capable investment managers.  You can get an understanding of Stahl and Bregman's investment philosophy through the Horizon Kinetics quarterly letters, and the FRMO research page.  After reading through both of these, I'm happy to essentially let Stahl and Bregman manage a small portion of my portfolio.

One last thing I want to touch on is what FRMO might have in their future.  This was probably the murkiest topic for investors, the company gave little to no visibility into the founder's plans.  This has changed recently, FRMO held their first public annual meeting, and has started to hold quarterly phone calls.  I can attest that they'll even take questions from individual investors, I had a chance to ask a question on the last call.  There were two things mentioned on the call that I found very fascinating, the first was the mention that FRMO would consider an acquisition if it met strict criteria.  Given Stahl and Bregman's track records I don't have much concern they'd overpay.  The second item mentioned is that FRMO has been exchanging their revenue streams with Horizon Kinetics for shares in Horizon Kinetics.  There was even a brief mention of the possibility that at some point FRMO and Horizon Kinetics could merge somehow, although there are some legal and tax complications to that.

FRMO isn't an asset investment, or an earnings investment, or maybe even a value investment, it's a bet on the jockey investment.  At current prices it seems the market, is underpricing Murray Stahl and Steven Bregman's ability to turn pennies into Franklins (for non-US investors $100 bills).  Be forewarned, there are not many sellers of this stock, most people buying want to hold for the long term, so getting shares can be difficult.

Talk to Nate about FRMO

Disclosure: Long FRMO

Friday, November 2, 2012

Alternative information sources

Is more information better?  Is different information better?  Let's face it, as investors what we do is trade on information.  Some could be meaningful such as knowing that a company is selling for less than their cash.  Some could be meaningless, but seem useful, like the fact that the CEO just dumped a bunch of stock.  Our currency is information, having additional information should give an edge, and those with less information should be at a disadvantage.

I remember reading some story about Benjamin Graham and it talked about the fact that he was able to obtain detailed regulator reports showing that the company had far more assets than the market cap, and the investment was almost a sure thing.  When I read this story I had visions of being in the back of some old dusty library looking at an old book making a discovery like this.  Slowly turning a brittle page, and after sneezing realizing that a company had a pile of hidden assets squirreled away only known to a select few.  This is all a fantasy of course, I'm guessing any experience like this now would consist of sitting in front of a microfiche machine, getting bored, and scrolling past that vital piece of information quickly.

The truth is there are many different sources of information that investors can use to find out about a company beyond regulatory filings.  Most semi-intelligent investors are aware of regulatory filings, and read them, or at least have a subordinate read them before making an investment.  There is a cliche on Wall Street that if you read filings you'll do better than 90% of other investors.  Maybe this is a phrase investors like to tell themselves as a way to convince themselves that doing basic due diligence is a special task.  But beyond reading filings, and talking to management there are many avenues for information that few investors take.

The first avenue is former employees.  In the past doing this meant needing to get a hold of a company directory and placing a number of phone calls and networking.  That method of information gathering is as outdated as the the phonebook itself.  Today we have something called LinkedIn, which every person who's between 22 and 45, and either wanted a different job, or thought about a different job has signed up for.  It's easy to reach out to current and former employees via LinkedIn and just ask simple questions.  The idea is to get an opinion on a company from both former and current employees.  Even something simple such as, "what's your opinion of the company? Are you happy with the direction it's headed?" will reveal a lot.  If you get the same answers from both current and former employees you know you're onto something.  Maybe you'll learn nothing, but it's easy, and will usually only cost a simple email.  This method also has the most to lose, be sure to stay very clear of inside information.

For companies that do any government work details about their contracts should be available, if not online through the agency they work with.  Sometimes the contracts aren't all that interesting, but other times you might find out a small piece of information, such as how profitable a certain segment is, or the size of jobs the company bids on.  It could also be useful to know how a company and their competitor bid on the same project, why was one selected over the other?

One route I'm sure not many investors take is using the Freedom of Information Act (FOIA).  Jeff at ragnarisapirate used this to obtain the EPA agreement between the government and Solitron Devices.  Solitron continually referenced this agreement as the reason they couldn't pay a dividend, yet when Jeff got a copy there was no verbiage mentioning this restriction at all.  For an unlisted company that won't release financials the FOIA could be used to obtain tax records and financial information that could help make a more informed investment decision.

My favorite route for information is through local governments.  I was looking for the annual report on an unlisted company and I stumbled upon the finances for a local fire department.  In the fire department's annual report they showed the taxes paid by the largest tax payers in the municipality.  The taxes were shown for the company I was researching, and that small piece of information was enough to rule out a further search.  While I thought this particular company was very profitable, the pittance they were paying the fire department told otherwise.

Regulators are another great source of information.  Banks are required to file reports with the FDIC, insurance companies with the NAIC.  Various other regulated industries with their respective regulators.  Regulator websites can be somewhat clunky, but they often have all of the information you'd ever want to know buried deep within them.

To use a cliche from the business world, investors need to think outside the box when gathering information on companies.  Before leaving this subject I'd be remiss if I didn't mention that more information isn't always better.  My guiding rule has been if I'm looking for more and more information to confirm an investment thesis, the idea isn't cheap enough, or good enough.  When I look for companies I want to find things that I consider so cheap that it's unbelievable.  Once I find a company like this I spend most of my time looking for information that would provide a valid reason as to why this company deserves to trade so low.  Sometimes that information is in one of the above mentioned sources.  A company might look cheap on the surface, but everyone knows the CEO is a snake, or there's an outside shareholder with a crazy agenda.  Those sorts of stories aren't in any 10-K, but yet hold as much informational value as how much accounts payroll grew over the past two years.  I don't think it's necessary to go overboard with every investment, but in some cases it might be the difference between a 30% loss and a 300% gain.

Talk to Nate

Disclosure: Long SODI