Monday, July 29, 2013

Simple, boring, and cheap; ROE Plastics at 55% of BV and EV/EBIT 2

Nobody loves a boring investment writeup, yet the bread and butter of my investment philosophy are average companies selling at below average prices.  Today's company is a great example of a quality unlisted company selling at an irrationally low price.

REO Plastics is a injection molding plastics manufacturer.  Injection molding is a fairly simple concept, a mold is developed for an item, the company then injects liquid plastic into the mold, cools it and packages it, or ships it to the next step in the manufacture process.  Anyone with an injection molding machine can injection mold, so to compensate for this companies offer valued added services, REO Plastics is no different in this regard.

The company was founded in 1960 by Robert E. O'Connor, hence REO.  The company was run by Earl A. Patch from 1975-2008, and is now run by his daughter Carrie Sample.

What's so great about REO Plastics?

  • Trades at $15, although it hung around $12 for the past year.
  • Earned $3.07 p/s last year, and $.79 p/s the prior year.
  • NCAV is $15.39
  • Book value $27.66, grew 12% from the previous year.
  • EV/EBIT 2.12
  • P/E 4.88
  • ROE ex-excess cash 12.86%
I should just end my post here, but I feel like it's worth explaining a few things about the company, first a summary of their financials provided by http://www.unlistedstocks.net


The first item of discussion is the company's sales and earnings this past year, they were the highest in the company's history.  This could mean two things, the first is that they'll never be repeated and will become a high water mark.  Astute readers will notice they recorded a loss in 2011, although they do have a large retained earnings account.  The second possibility is that something has changed and the company is building sales momentum.  This is clear if you look at the last three years, sales rose from $17m to $25m bringing increased profits along with it.

Injection molding is not a high margin business, but the results show that as the company's operating leverage increases their margin becomes respectable topping out at 5.37% this past year.

The company's profits and growth are interesting, but what attracted me to the company is their balance sheet.  They have $2.4m worth of cash on their balance sheet with no debt and essentially no liabilities except for accounts payable and accrued compensation.

It is easy to argue that book value is a worthless metric for an industrial company, a lot of digital ink has been spilled over this issue.  I have no interest in starting an argument, but want to point out a few items that I find interesting.  The first, the company is investing heavily in their plant, in the last three years they have spent $4m in capex.  The company is proud of their machinery, they have a list of every machine make and model available on their website.  The type of company that lists their equipment models and posts pictures of them on their website is also the type of company that problem keeps them well maintained.  A negative against the company is that injection molding is a commodity business, a positive for book value is there are plenty of other companies that could purchase old equipment that is in great shape at a good price.

The last point I want to make with regards to book value is that the CEO considers this a valuable metric.  A CEO is the person who knows the business the best, and the metric they use to value it themselves (if rational and conservative) is one investors should consider as well.  Investors value Berkshire Hathaway on book value because this is what Buffett uses.  The CEO of REO Plastics considers book value to be important enough to highlight in the annual letter to shareholders.  This is significant because the letter is three sentences long, and one of those sentences is asking for questions and comments.  The CEO highlighted book value in last year's annual letter (also three sentences) too.

The investment case for REO Plastics is very simple, the company is selling for slightly less than NCAV, and for 55% of book value.  The CEO considers book value a fairly important metric, so it could be reasonably presumed that the company is possibly worth something close to book, maybe 80% or more.  Throw in growing sales and growing earnings as an investment sweetener.

The downside is the stock is extremely illiquid, it will go months without trading.  I purchased shares with a GTC order at the price I wanted to pay, I believe I had a fill in less than a week.  The second downside for many investors is they won't be flooded with information.  You will receive a nine page annual report once a year.  It's not a stretch to say it takes 10 minutes a year to follow this investment.  

Disclosure: Long REO Plastics

Saturday, July 27, 2013

Why small caps?

I have a confession to make, I'm a lousy analyst.  I can't project earnings, or figure out why earnings will shrink because the cost of some obscure thing is going up.  I'm not good at discount cash flow analysis, and most sell-side research I've read seems heavy on facts but short on anything else.  The good news for my portfolio is I've adopted an investment methodology that doesn't rely on any of my weaknesses, and it exploits my strengths.

I've had people ask me if I invest in large caps but just don't discuss them on the blog.  I own one, Mastercard, they have a tried and true moat (I can spot an oligopoly..), and they're growing nicely.  I purchased years ago and continue to hold them, if I have a chance to buy other monopolies cheap I would.  Otherwise my portfolio is a motley crew of tiny stocks that are unloved and under appreciated. I have invested in large caps in the past, but as I've grown as an investor, and seen the opportunities presented in the small cap space compared to the large cap space, I've drifted to a smaller and smaller capitalization portfolio.  This doesn't mean I avoid large caps, but the deal needs to be considerably more enticing before I'd be interested.

It's a heresy to talk about efficient markets with value investors, but I'm going to break the rules.  My feeling is that with larger stocks the market generally gets things right.  It doesn't always get it right, but it generally does.  To outwit the market in larger stocks one needs to be either a "situational investor" or have a superior understanding of the industry.  Most value investors in large caps are situational investors, these are the people who are buying BP after the spill, or buying BAC at $5.  A situation has arisen which has led to a temporary undervaluation of a large and well known company.  Investors who can spot these temporary blips can do well.  To take advantage of the blips an investor doesn't have to be an expert in the field or have an information advantage, they just need a stomach of steel, and the conviction that the market is wrong.

What's interesting about efficient markets is that Graham expressed a similar notion in the 1940s.  He claimed in Security Analysis that most analysts would be be able to add much value with leading issues (large caps), but value could be added by looking at secondary stocks (small caps, pink sheets etc).

It's rare for a large company to be forgotten by the market, I'd even go a step further and say that any company in the S&P is not forgotten and can't be.  Companies in the S&P at the minimum have their local city paper cheering for them.  In the Pittsburgh newspaper earnings for a company like Allegheny Technologies is a big story in the business section.  While they're a minor blip in the index the paper treats them like kings along with other listed regional companies.  It's hard to argue that even small members of the indexes are ignored.

Investor interest drives the search for information.  There might be 25 investors digging in the weeds to find out information on Regency Affiliates, and many of them are part time investors.  Contrast this to a stock like Coca-Cola Enterprises with 16 paid professionals following the company, and countless other investors.  In total there might be thousands or tens of thousands of people interested in CCE looking for any scrap of information.

It's possible for investors to gain a true informational advantage in small cap companies.  I own one company who publishes their annual report on their website once a year.  They remove the previous annual report and replace it with the current one.  Someone looking at the stock fresh might only be able to see two years worth of information.  With some creative URL manipulation I figured out that I could get a number of past annual reports, I now had a large advantage compared to someone coming in cold looking at the company.

The second advantage of small companies is they're much easier to understand.  A large company might really be equal to 5-10 (or more!) small companies.  For the most part many small companies buy raw goods, do something to them and sell the finished product.  A company making aircraft engines is simply making aircraft engines, they don't have a hedge fund hidden in the back room making mortgage bets.  I will grant that some of these small companies are personal investment vehicles with a tiny business attached, but at least they're transparent.

The third advantage is small companies are accessible.  Unless you're a big investor you'll never be able to call Mastercard and get the CFO on the phone.  I have called countless small companies and spoke directly to the CFO, usually with one transfer from the secretary.  Management at small companies is proud to talk about themselves and their accomplishments.  Most small companies never get shareholder phone calls, because of this management is usually willing to talk to shareholders as they should because they work for them.

For growth/moat investors it's worth considering that all large companies started out as small companies one day.  Why invest in a company with an established moat who's growth is slowing when the next Oracle is just germinating and trading at a cheap valuation?  I have often argued with GARP investors that they're wasting their time looking at large companies growing at 10%, instead they should be finding the small companies with moats that are growing at 30-50%.  Instead of investing in the rear view mirror this is investing looking out the front window.

I have told friends that the only reason I am able to do well investing is because I'm seeking out opportunities that not many others are.  I am truly looking for the oddball stocks of the market, the hidden assets, the strange situations, the stocks that don't trade, and companies in markets no one cares about.  By going against the grain, and digging in the smallest end of the market I find that even small pieces of information can lead to a huge information advantage.  Consider Jeff Moore, he looked at Calloways and instead of seeing a failing nursery operator saw a company with valuable land.  He built out a spreadsheet of their land holdings and realized one property is worth more than their market cap.  These sorts of things don't happen with Fortune 500 companies, if they have an un-monetized asset the writers at Barrons are discussing how they expect to unlock value with it.  Small companies have valuable hidden assets often, the only people who are aware are insiders who are usually working to protect the secrecy, and a few investors who are purchasing as many shares as they can get their hands on.

The best opportunities in the market aren't the ones that no one else understands, they're the ones no one else sees.

Disclosure: Long Mastercard

Sunday, July 21, 2013

Could a net-net strategy like I used in Japan work in the US?

In response to the post on my experience investing in Japanese net-nets I received a fair number of emails from readers asking whether I thought such a strategy could work in the US.  I want to explore the answer to that question in this post, and use it as a platform to discuss why net-nets even exist.

I used a simple model to select net-nets in Japan, I picked companies trading for 2/3 of NCAV or less, that were profitable, paid a dividend and were stable.  The stability is the least quantifiable, but actually the one that mattered the least.  I looked each potential investment up in the Japan Company Handbook and read their business summary.  If the company sounded like it would be around in a few years I considered it a mark of approval and continued my research.  What types of companies might be eliminated with this simple check?  A manufacturer of pet rocks, pog, slap bracelets, mexican jumping beans...essentially fad companies.

To answer the question of if this could work in the US I pulled a list of all US net-nets trading at 2/3 of NCAV or less from grahaminvestor.com.  I then removed all of the Chinese listed companies, and companies with data errors.  The spreadsheet is below, companies in red are Chinese, and companies in yellow are data errors.  A data error is where a company might appear to be a net-net, but after 20s of examination an investor realizes they aren't.



From the initial 38 companies 29 were removed leaving us with a list of nine potential investment candidates.  There are a few companies on the list that meet some of the investment criteria, but none meet all of them, especially the qualification of paying a dividend.  If that criteria were removed it would be possible to build a portfolio of around a few companies in the US trading below 2/3 of NCAV.  It would be downright risky and irresponsible to invest an entire portfolio in the four companies that are selling below 2/3 NCAV and are profitable.

In light of how few candidates exist I don't think the same strategy could be used in the US as in Japan. But just looking at a screen is only part of the reason, the larger part is why these companies are net-nets in the first place.

The US is the deepest and most liquid market in the world.  I write about obscure stocks and almost half of my readership is non-US readers.  Sit back and think about that for a few minutes, that means that there are people in far flung places on the world that consider US micro cap unlisted stocks attractive enough to research.  There are of course Americans researching them as well, but the smallest and most hidden stocks in the US are still popular enough to garner attention from international investors.  The same can't be said about most other markets outside of possibly London.

Outside times of market distress most net-nets in the US are companies where investors have either given up, or have expectations that are so low the company is perceived to be on life support.  There are times when this isn't true, such as in 2008-2011, at the time many net-nets were companies that were sold down to irrationally low prices from the financial crisis.  Many were average companies that were profitable and weren't on death's doorstep, they've since recovered.

Whereas the US market is loved, and every inch is being researched by investors worldwide, Japan is a different story.  Japan experienced their day in the sun during the 1980s, at that time no Japanese equity was left unturned, most were selling at irrationally high prices on the back of investor enthusiasm. Those high investor expectations came to a crashing halt in 1990, and haven't recovered for the past 23 years.

Much like the US during the Great Depression, investors have completely lost hope in Japan.  Japan as a country and an economy is modern and a participant in the world economy, the same can't be said for their equity market.  The crash of 1990 left a strong impression on Japanese investors, they haven't been seen in the market since then, domestic market participation is 4% of the population.

As investors fled Japan neglect and complacency set in.  Twenty three years is a long time, that's a large part of many people's careers.  A whole generation of investors grew up investing where Japan was a place where money went to die.

Markets are ultimately human driven, and humans are driven by emotions, hence markets are reflections of mass emotion.  This general negative market emotion led to many average or even above average companies selling very cheaply in Japan.  A market where neglect reigns is a value investor's dream, but potentially also a nightmare.  There is no time limit on a long running bear market.  My timing in Japan was completely lucky, or maybe I have been participating in a giant bear market rally, only to see the market dip back to where it was a year ago.

The difference between Japan and the US is there is no neglect or negative view on the US market, rather even the tiniest US stocks attract worldwide attention.  Japan is just the opposite, but as emotions turn opportunities dry up quickly.  When I ran my first Japan net-net screen I found 450 net-nets, a year later the number was 250.  The number is surly lower now, I'd guess less than 100, maybe even less than 75.

This is a really long answer to a somewhat simple question, I guess I could have always just answered "no" and moved on, but those who know me in person recognize how unlikely a one word answer is.


Disclosure: None

Wednesday, July 17, 2013

Negative Enterprise Value and Titanium Holdings

Earlier today I read about the SumZero Value Investing Challenge.  Contestants submit an analysis of a company, contestants are judged on the quality of their research.  The winner receives $50k and a few other perks.  Whenever I come across contests like this for equity analysis I start to think that I should enter.  A few seconds later I remind myself that I have no chance of winning, winners are judged on the quality of their research, not their ideas.

I'm always impressed by the winning research, analysts will go into lengthy discourses about why the cost of toilet paper is going to increase because taxi drivers in London are now using iPhones.  The thoroughness and depth of research is impressive.  These research reports remind me of a quote by Jean-Marie Eveillard in the book The Value Investors: "After I retired in 2006, I helped teach a value investing course at Columbia University.  I had about 12 students, and what struck me was that 11 out of 12 thought qualitative analysis had to involve 25 pages of writing.  What I tried to stress to them was that they needed to think hard and then list no more than three to four strengths and weaknesses of the business."

The only compensation I receive for my own investment research is what returns I make as a result.  If I were paid to write reports maybe I'd have a different perspective, but as it stands I want to do the least amount of work to achieve acceptable results.  My entire investing philosophy can be summed up in the following phrase "purchase real assets cheaply, and earnings cheaper."  The beauty with value investing is a simple thesis can be just as effective as a 450 page tome.  As long as an investor buys cheaply enough, and has patience to see the idea through they will do well.

Many of my investments fall into three categories, low price to book value stocks, net-nets, or cash boxes, which could also be considered low EV or negative EV stocks.  There has been a lot of discussion on negative EV stocks recently as the CFA Institute came out with a research article regarding them.  The author's research showed that the average return was 50.4% for all negative EV stocks, and 60.5% for stocks with market caps under $50m.

I would guess some of the return is due to benign neglect on the part of value investors.  Investors understand low book value stocks, or net-nets.  These are companies selling for less than the sum of their assets, machinery, buildings, real estate etc.  A negative EV stock is easy to grasp, it's a giant pile of cash with some semblance of a business attached.  While easy to understand, my impression is negative EV stocks are the ones value investors avoid the most.  There was a lively discussion at OTC Adventures about this recently, with most commenters disagreeing with me that these types of stocks should be considered.

The main objection to a low or negative enterprise value stock is "what will happen to the cash?" and secondly that if an investor isn't in a position to control the company their cash value should be discounted, or possibly not even considered at all.  Only in the equity markets can an investor convince themselves that $1 is only worth $.80 or $.50 or something less.  After my posts on book value, and the discussion at OTCAdventures I think I'm done trying to convince people that assets, and especially cash have value. Instead I am going to continue to hope that people sell their cash to me at a discount, I'll hold it for a while, and then sell for full value, which according to the research happens fairly often.

The company I want to talk about in this post is fairly typical of a negative enterprise value stock.  Titanium Holdings (TTHG) isn't a junior mining company, or anything related to metals, they're a pile of cash with a cleaning supply business attached.

The company is located in Texas and operates Cleaning Ideas Corp, a janitorial supply chain.  The company's market cap is $1.061m.  The company has $1.8m in cash, giving them a negative EV of $800k or so.  The company also happens to be a net-net, their NCAV is $2.8m, so they are currently selling for 37% of NCAV, quite a discount.

The company's cleaning supply business makes up a small portion of the company's current assets, about $1m spread across accounts receivable and inventory.  The cleaning supply subsidiary also has $250k in fixed assets on the balance sheet.

The company has no earnings to speak of.  Last year they had an operating loss of $46k, and the year before an operating loss of $50k.  At the rate they're losing money it will take a decade or more before they burn through their cash pile.  The company's earning history is spotty, they have years of profits mixed with losses stemming back to 2006, which is as far back as I looked.  The company's most recent profits were in 2009 and 2010, where they earned close to $100k each year.

It would be foolish to think the cleaning supply business will ever be anything spectacular, but they might return to profitability in the future.  Maybe they eventually sell, who knows.

If we forget about the cleaning supply business we're left with a pile of cash and some marketable securities.  The marketable securities are a small foray that the CEO had into attempting to diversify the cash.  The pattern of investments shows a CEO who wants to earn some returns, but is afraid to take on too large of a position, the investments are 3% of assets.

There are two questions investors should be asking themselves about Titanium Holdings:

  1. Is this company really only worth 37% of NCAV?
  2. Is their $1.8m worth of cash really only worth $1m or less when the cleaning supply business is factored in?
For me both answers are no, and while I don't love the business, I do love the valuation, so I opened a position.

"That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else.  We know from experience that eventually the market catches up with value.  It realizes it one way or another." - Benjamin Graham Senate Testimony 1955


Disclosure: Long Titanium Holdings

Friday, July 12, 2013

Update on the Japan net-nets, and a quandary I found myself in

This post is two independent lines of thinking that are related in the end.  If you're short on time, or get tired of my writing each can be read alone, although I'm biased, I think you should read the entire thing..

Japan update

Back in October/November I wrote a post detailing (part 1, part 2) how I wanted to try to buy as many Japanese net-nets as I could using John Templeton's experience as my guide.  My plan was to use Schwab, who at the time was offering free international stock trades.  My plan fell apart when it came to light that Schwab only offered Japanese large caps, they deem small caps too risky for investors apparently.

I was forced to revise my plan.  Because I was going to be paying full commission at Fidelity my position sizes would need to be larger.  To assist in my research I purchased The Japan Company Handbook, which is the Moody's manual for the Japanese market.  The book has a description of each company, historic financials and a number of metrics.  I took the stocks that were scored through the blog, and looked them up in the book.  I then plowed through all of the JASDAQ stocks while commuting to work and picked out the "best".

I was inundated with cheap companies, more than I had capital for.  I started to experience analysis paralysis, I couldn't decide which cheap companies were the best, or what "best" even meant.  Did I want better FCF yields, or a lower NCAV, or better dividends?  In the end I decided that I needed a sound system, one that could be followed and one that was simple.  I decided to buy stocks trading at 2/3 of NCAV, that were profitable, paid a dividend, and were stable companies.  The stable companies criteria is important, I can't tell you how many descriptions in the handbook read like this: "XYZ company was in marketing, now expanding to hotel and car wash ownership, also manufactures headlights, expects new ventures in concession vending."  A company with a description like that is a pass for me no matter how cheap they are.

When I last posted on the Japan companies there was a lot of discussion on whether I should hedge my Yen or not.  I don't have a large enough portfolio that any standard hedging would make sense (futures etc.)  I decided, well inertia decided that I would do nothing.  In hindsight a mistake, but then again if I knew the future I'd be investing differently altogether.

Since the end of November my net-nets have done extremely well, they've almost doubled in Yen terms, and gone up 62% in dollars.  I put together a small comparison spreadsheet showing other potential Japan investments denominated in USD across the same time period.  I even included the hedged Japan ETF as a way to show how the Yen impacted these holdings.

It's worth noting that I didn't start investing in Japan in November of 2012.  I've had a portfolio of net-nets over there for over two years now.  I wrote a Japan net-net retrospective on companies I'd written about last March, at the time those net-nets were up a median of 12.4% against a negative Topix.


Before anyone credits my investing acumen I want to clearly point out that I had nothing to do with these results.  I essentially randomly picked companies that fit my simple criteria and purchased them.  I never read any annual reports, or built any models.  I told myself that I would sell each company when it hit NCAV and recycle the funds into a new position.  I've recycled gains a number of times already.  The performance is my net-net portfolio as a whole, meaning I've had enough gains to offset the two -20% positions I'm still holding, and another -9% position I'm holding as well.

The conclusion from this is that investing in cheap companies works.  As a whole these companies have outperformed the market, and outperformed the currency depreciation.  Yes I could have made more if I hedged, but an argument could have been made just as easily that Japan and the Yen were dead and wouldn't be moving anywhere but up.  Of course everyone now claims they knew the Yen was going to crash, just like everyone claims they saw the housing bubble, or the dot-com bubble.

The quandary

As the Japanese market has heated up I've noticed something strange in my portfolio, most of my stocks will stay flat and then suddenly one will take off like a rocket.  I've had this four times now, it seems to be a weird market pattern.  A net-net will languish below NCAV, and then suddenly in a week or less rise to, or above NCAV on heavy volume.

In staying true to my investment philosophy in Japan I would sell once I realized the stock was trading for more than NCAV.  Recently though a friend was telling me about an experience he had with a Japanese net-net, the stock doubled and he sold it.  It then went on to triple, and eventually quadruple, in a very short timeframe.  During this time one of my holdings Zuken (6947) had taken it's turn to outperform.  The stock was limiting up nightly which is always exciting.

The stock raced past NCAV and I started to think about what to do next.  The problem was as I thought about selling I kept thinking about my friend's experience.  The thought crept in, "I wonder if Zuken will be a double or triple?"

I decided that I would research Zuken, and see if I could figure out why the company was appreciating, and determine a valuation independent of NCAV.  Lucky for me the company had an analyst covering them who said that their 3D printing technology was exciting and investors should wait until the stock hit book value to sell.  The mention of 3D printing further worked to implant the idea that maybe this lowly net-net I had was suddenly going to be a 10-bagger, or maybe even better!

I also found a presentation on the company's website where they discussed their current technology situation and plans for the future.  I don't read or speak any Japanese, leaving me at the mercy of Google Translate.  Unfortunately graphics heavy powerpoint is very hard to translate automatically.  I resorted to copying and pasting in characters a few at a time.

For all my work I came away with the understanding that Zuken believes their profits will double in three years, and that they are doing something with 3D printing in Germany.  The 3D printing seems exciting, although I'm not exactly sure what it is, or what it entails, but the market is happy with this news.

The research also confirmed why I'm investing in Japan by the numbers.  The language barrier is so high that I have trouble completing even enough basic research to be confident in an investment.  Google Translate is excellent at translating European languages, but stumbles badly on Asian languages.

After a few hours of futile Googling and translating I realized that holding Zuken for anything beyond NCAV was being speculative and greedy.  This was a company that had been valued as dead, and now was being lifted high on irrational optimism for their 3D technology.  The market swung from negative to positive so fast I almost missed the move altogether!

I decided to stick to my strategy and sold for more than NCAV, but at about 83% of book value.  I'm happy with my gain, and if the stock goes on to double or triple from here I won't regret selling.  I don't know enough to be confident in my holding, any gains I would have had from here would be purely luck.  I don't mind luck, but I also don't consider it a strategy.

Putting it together

After reading these stories the reasonable question to ask is "what next?"  I'm going to continue to do the same things I've been doing for the last two years in Japan.  I am going to recycle my gains into more net-nets, be patient, and sell when the companies reach NCAV.  I've had some readers ask me what I hold over there, I decided to post it here.  The companies are always in flux.  With the recent gains I'm expecting to add four or five new positions.  The following are my current positions:


If nothing else my experience in Japan has reinforced my experience with net-nets.  The companies are often lousy, and investors shun them, yet the courage to invest and be patient often pays well in the end.  


Disclosure: I own all the companies in the bottom spreadsheet.

Tuesday, July 9, 2013

Biological assets with an emerging market twist

I was profiled this weekend in an article by Norm Rothery in the Globe and Mail, the article has two French stocks I think are attractive. (Norm also writes at the Stingy Investor, I'd recommend bookmarking his site.)  After reading the article I thought it would be nice to do a follow up post on another French name, so I went searching.  I came across some interesting French names, but stumbled on a British listed stock that I found far more fascinating, Narborough Plantations (NBP.London).

Readers ask me all the time how I find "oddball stocks", I really don't know, it's more like they find me.    Narborough Plantations is clearly a stock that found me, I could trace the twisted path I took before I encountered it, but it wouldn't really be useful to anyone.  The quick summary is I constantly turn over lots of rocks, when I want to look for something new I'll create a broad search and pick companies off one by one.  I probably looked briefly at 10-12 companies before I started to read Narboough's annual report.  As an aside, I noticed there appear to be a number of attractively priced Polish companies, I need to explore this further at some point.

Narborough Plantations is a fascinating stock, if the company hadn't been founded 103 years ago, it might arouse suspicion of fraud.  The company is listed in London, and proudly exclaims that they were incorporated in England and Wales in 1910.  Outside of the company's listing they appear to have no ties to England, their operations are all located in Malaysia.  Back when they were founded Malaysia was firmly in the hands of British control, and was a colonial territory.  If British Malaysia doesn't ring a bell then the name Singapore might, it was a city founded in the same general area (globally speaking) as Narborough's Plantations.

The company's business doesn't appear to have changed since its founding, they grow oil palm trees in order to produce palm oil.  Long before traders in New York and London were trading oil, the Egyptians and Arab traders were trading in palm oil.  If you ate any processed food today it likely contained palm oil as an additive.  The irony to this is the company uses organic farming methods as a way to keep costs down, yet the organic product when used as an additive is potentially harmful.

The company caught my eye for a number of reasons:

  • Debt free
  • Selling for 60% of book value
  • A P/E of 6
  • A dividend yield of 3.33%
  • The company has a bit of intrigue surrounding them, who can resist that?
  • Their annual report is very colorful with a lot of pictures of their fields and processing.  I've noticed this is common with other emerging market companies as well.
From the company's annual report here are some relevant statistics:


From the stats table this appears to be an absolute dream stock, cheap assets, cheap earnings, cheap growth, incredible margins, why isn't everyone in the palm oil business?

I didn't have to look very far in the annual report to realize why this company was cheap.  The company's earnings are about as sturdy as a palm branch in a hurricane, the assets aren't too far behind.

Narborough owns two things, their own plantations, and an interest in another palm oil company.  The associate company is never named, but in the notes it states that the company has significant influence over them. 

The company's earnings appear reasonable at first glance:

The company has a fantastic operating margin, especially for an agricultural company.  But operational earnings are less than half of reported earnings for 2012.  The conclusion is that the associate must be just as profitable, right?  Maybe not:


The associated made just £86,266 before adjustments were made to their earnings.  The adjustments are revaluations of both biological assets (the trees) and their property (the land the trees are on).  The company, and apparently their associate undertake a full valuation once every five years.  The property and trees are held on the books at fair value.

Asset adjustments are not sustainable earnings, unless management wants to continually adjust asset values.  It's also strange the company passes asset revaluations through the income statement.  They note that if property values were to decline they would report a loss.  Management states that it's very unlikely this would happen, and their land will continue to appreciate into the future.

A statement like this is something I would expect from a Vancouver California resident during boom years.  I don't think management is riding a wave of increasing palm oil land prices, I think they know the appraisers, and "know" that prices will continue to go up.  Maybe I'm reading between the lines, but it seems strange to me that the company's trees and land would suddenly double in value.

The good news is the company's cash flow backs their operational earnings.  Free cash flow is £542,099, of which £536,469 was paid out as dividends.

The problem is the company is only attractive on an earnings basis when their associate's earnings are included.  The opaque nature of the associate and their earnings leave me unsatisfied.

If the earnings aren't what they initially appeared to be, then maybe it's still a good stock at 60% of book value?  The issue I have with this is closely related to my issue with earnings, the company's assets increased from £10m to £20m over the last year due to their asset revaluation.  This is an enormous jump, and warrants caution if nothing else.  The company's assets might not provide a level of protection that investors desire.

What initially appeared to be a great investment turned into an average agricultural company after a deeper look.  For an investor who understands the industry, product, and Malaysia there might be a lot of value here.  Unfortunately I'm not that investor, so I'll be taking a pass.


Disclosure: No position


Monday, July 1, 2013

A wine company at 53% of BV and 4.6x earnings, plus a little industry background

I'm sure a few readers are wine connoisseurs, a few more think they're connoisseurs, a number simply like to drink wine, and then the rest who can't tell the difference between a fine wine and grape juice.  No matter the vintage, grape type, or brand all wine has two things in common: if you drink enough it'll all have the same effect, and secondly they are all created with the same raw material, grapes.

It's interesting how as I've invested I've picked up knowledge of certain industries.  I've never set out to study a specific industry, but as a number of cheap names cluster in industries I start to become familiar them.  Wine and winemaking is an industry I never expected to be familiar with, but did after making a few investments in the industry, such as Corticeira Amorim, and Treasury Wine Estates.

Scheid Vineyards (SVIN) is an interesting company, their vineyards cover over 70 miles near Monterrey California, yet only 2% of their grapes are bottled and sold under their own brand.  Adding to the intrigue the company's top six customers accounted for 53% of their sales.  What's going on here?

When most people think of a winery they think of a quant little estate with a nice wine tasting room and row upon row of grapes.  The grapes are harvested on site, then crushed, fermented and turned into wine, which is sold in the store and through distributors.  The reality is a bit more complicated.  There are indeed wineries that conduct business like this, but they are the exception rather than the rule.  Most wine is grown and processed on wineries like Scheid, and then shipped as bulk grapes to customers who then ferment, filter and bottle the wine with their own label.

I first encountered this when I visited a local winery as part of a company event a few years ago.  The winery had a few rows of vines up front for nothing more than show.  We received a tour of the winery and the proprietor told us that it's far cheaper to buy grape stock verses cultivating a vineyard and harvesting grapes.

Think of it this way, wine making is really two components, an agricultural component, and the actual winemaking process (fermenting, filtering, testing, bottling).  Kurt Gollnick, Scheid's COO explains the company like this: "This is a production winery in Monterrey County, not a ridge-top winery in Napa Valley planning to make money on wine-tasting events."  The company is more of an agricultural company than a winery.

The company's facilities are relatively new, they were featured in an article in Practical Winery & Vineyard, an industry publication in 2007. (link here)

The company's stock is unlisted, I picked up my tracker share earlier this year and contacted the company for an annual report.  The first item I want to highlight is their revenue breakdown.  The following graphic shows that Scheid generates most of their revenue from bulk grape sales, actual wine sales are a much smaller component of revenue.


For the years I have seen reports for the company lost money in 2011 and 2012, and then in 2013 swung to a large gain.  Here is a small summary snapshot I put together:


Earning $9.13 a share is significant given their most recent share price of $24.23.  Not all of the company's recent earnings can be attributed to continuing operations, the company reported a $5.7m gain on a $7.5m sale of a 238 acre vineyard.

Backing out the one time gain lowers operating income to $4.5m or $5.17 per share.  The company's operating cash flow was $4.08m which tracks nicely with their adjusted income, meaning this company is trading with a P/E of 4.68.

Stocks at low earnings multiples are interesting, but as I discussed in some previous posts earning power can change rapidly, whereas assets change slowly.  What does Scheid's balance sheet look like?

The company unsurprisingly has a large inventory, accounts receivable, and property, plant and equipment balance.  Most of the company's assets consist of those three items, which is expected for an agricultural company.

An important determinant to the value of a company's equity is the condition of their property, and equipment.  As noted above the company's facilities are state of the art as of a few years ago.  The company is also willing to monetize their real estate holdings, selling 20 acres in 2011, and 238 acres in 2012.

The company plans on spending $3m over the next year to develop a 240 acre vineyard, and an additional $3m on winemaking equipment.

None of the book value discussion would matter if the stock weren't cheap, fortunately it is, trading at 53% of book value.  Considering the company's book value is possibly understated this might be cheaper than it initially appears.

The company isn't without risk, they do have a substantial debt load.  The debt was my biggest concern when considering an investment, I was worried that in a down year the company might have trouble making interest payments forcing them to declare bankruptcy or liquidate assets.  

The company has $50m worth of long term debt, with most of it coming due in 2015.  The company is paying 3.06% on their debt, which is held by Rabobank, a bank known for winery lending.  Interest was covered 3.8 times this past year.

I was asking myself two questions as I looked at Scheid, the first was whether their assets had any value, and secondly whether I thought the earnings were sustainable?

Besides the information I dug up on the company's facilities I reached out to someone I know in the wine industry in California.  He claimed that most likely the company's assets are understated due to the strength of the winery real estate market, which Scheid is apparently taking advantage of by selling acreage.

The second question is a little more difficult to answer without a larger earning history.  I'm encouraged that the company's earnings improvement was due to a drop in the cost of goods sold.  I don't know what's driving the change in COGS, but it could be efficiency gains from pushing through larger volumes at their facility.  The company's facilities were built to handle twice the volume they were doing in 2007, which means that fixed costs could initially be high until volumes improve and the costs are spread more evenly.

If the company is able to maintain the $4m in earnings then they have the potential to fall into a category of stocks I love to purchase, two pillar stocks.  These are stocks where the company's earning power capitalized at 10x is equal to their book value.  When this occurs there are two variables supporting a book value valuation.  

Regardless, the discount to book, and earnings were too good for me to pass up, I took a position in Scheid when I read their latest annual report.  The stock has run up 32% since I purchased, but even at these prices it's still attractive.


Disclosure: Long Scheid