An asset and earnings discount for Nexeya

Sometimes it's easy to start off by answering the question why is this stock cheap?  Often a stock will have a story for its cheapness that requires a leap of faith on the part of the investor.  Other times a stock may fall out of favor due to neglect or fear.  Sometimes a company just fails to execute well, sentiment shifts and the stock begins to trade at a low valuation, that's the story of Nexeya.

Who is Nexeya?

If you go to Nexeya's website you're met with the generic business-speak answer of "NEXEYA combines the design, realization and support of most advanced electronic products and provides high value services."  I don't think I could have written a sentence that said nothing better than Nexeya's marketing department did.  Their description is like a horoscope, you could probably slap that little message on most company's websites and it would apply.

So let me try to craft a better description, Nexeya is a vertically integrated French technology firm that produces specialized equipment for the military and aviation markets.  They design, build, test and integrate their products with complex existing systems that require precision.  Nexeya is the type of company you contract with if you want to design and build a satellite, or a military software system.

The company began in 1997 and has slowly grown organically and through acquisitions.  They acquire small companies that are what most would consider "bolt-on" acquisitions.  This means the company has a nice slug of goodwill on the balance sheet, something a lot of value investors detest, but not necessarily a bad thing.

For American investors the best comparison I can make is that Nexeya is like an integrated defense manufacturer such as General Dynamics or Northrup Gruman but on a much smaller scale.

Napkin thesis

Nexeya is clearly undervalued selling at a discount to both book value and earnings power.  The following points support this assertion:

• The company is selling for €21m against working capital of €24.85m
• Book value is €62m and tangible book value €21m
• EV/EBIT of 3.57x
• EV/FCF of 3.77x
• P/E of 5x, P/B of .37x
• The stock yields 3.8%
• Sales grew at 18.9% annually over the past seven years, profits grew by 23% annually over the same period.
• The company has a debt to capital ratio of 30%

It's hard to imagine how a company could become this cheap, but it is, and there's a reason for it.  In the past semester the group's profits have dropped considerably due to problems in the mechanical and thermal systems group.  Sales fell off in those areas and the company expects to end the year flat, they made operational changes which they believe will resume the growth trajectory in 2012/2013.

So the company hits a bump in the road, the market seems to measure them on revenue growth and growth didn't slow, didn't stall, it fell.  For investors who fixated on this metric it was a sign to sell.  I'm not sure if missed expectations is enough of a reason for Nexeya's cheapness.  In the past I didn't put much weight to the idea that size and illiquidity could be a reason for a stocks discount.  I'm starting to slowly adopt the view, that those two factors do play a part.

Nexeya has a market cap of €23m where only 52% (€11.9m) is free floating and available for purchase by the public.  Couple that small float with the fact that the average volume is 5,000 shares (€29,000) daily and you have a stock most professionals wouldn't go near.  Maybe a small hedge fund, or a wealthy individual, but no major players are going to be buying Nexeya shares.

The two pillars of value

The idea behind the two pillars of value is that both the assets and earnings of a business give a reasonable valuation.  Earnings and asset values reinforce each other, it's always better to have both pillars supporting an IV calculation over just one pillar.  Both of these values work together to create a strong margin of safety.  It's preferable to have a margin of safety that exists both at the asset and earnings level.

Balance sheet

The first item an investor will see on Nexeya's balance sheet is Goodwill.  This isn't figurative they put that value at the absolute top, it currently stands at €40m.  Nexeya has a lot of great things going for it on it's balance sheet, great cash, little debt, but most people will get hung up on the goodwill, so I want to address it.

For a company that is a serial acquirer goodwill is going to naturally come as part of the package.  Some investors ignore goodwill or eliminate it from the balance sheet.  There's a reason it's there, Nexeya purchased something beyond some buildings that is real but not quite tangible.  The most important question to me isn't whether there goodwill, it's whether the is company earning a respectable return on the goodwill or not.  After all if Nexeya is acquiring companies for cash and debt and earning less than their cost of capital on these companies this is a value destroying investment.

Using my ROIC formula I come up with a TTM ROIC of 10.98% which is acceptable to me.  Just eyeballing a few other previous years the ROIC would actually have been a bit higher maybe in the 13% range.  I think it's clear Nexeya is using some of their goodwill whatever it is to generate a reasonable return.  Because of this I don't mind leaving it on the balance sheet and considering it part of book value.

So with that little discussion over Nexeya's book value stands at €15.73.  If you're uncomfortable with such a high figure you can lop off a 30% discount and it's still over €10 a share.  A side note, if I'm looking for a company to trade up to book value at some point I like to see if it ever traded at or above book value in the past.  The good news is that Nexeya traded above book back in 2007/2008.

Earnings power

Nexeya has been profitable every year over the past ten years with earnings ranging from €.62/sh on the low end to €1.48 on the high end.  Earnings have been steady, and steadily increasing so I don't think showing an average ten years EPS is unreasonable.  The company has a ten year EPS of €.77 which at a value destroying multiple of 8 is still above the current price.  The company has grown considerably and there's no reason to think they won't show some growth in the future.  The past four years earnings have been stable at an average of €1.23/sh.  A value destroying multiple of 8 on this is €9.88 a share.

I think a multiple of 8 is too low, but what do I know, apparently the market believes a multiple of 5 is preferable.  The market is viewing Nexeya as a company who's in decline and will be facing the bankruptcy judge soon.  I think the opposite is true, the same management who grew the company in the past is still in place, and I don't see any reason why they won't be able to execute at a similar level to the past.  If they can do that they should at least deserve to trade at the market multiple which is around 14.

Wrapping things up

If we put both pillars together there's an intrinsic value of something between €7.70 and €15 a share. That's a wide range, I think Nexeya has the ability to earn close to what they did over the past four years, and at a 10x that's in the €12 a share range.  In this case both earnings power and asset value support each other at €12-15 a share.  I don't know if Nexeya will ever trade above book value again, or close to their earning power, but I do know that buying at €5.80 gives me a wide margin of safety for something good to happen.

When I looked at Gevelot I took the two pillar approach as well but decided to walk away because Gevelot's earnings and margins were at an all time high.  Nexeya is different, their earnings are depressed and the two pillars are still supportive of a much higher value.  I decided to take a plunge this time and buy some shares.  Third quarter sales which were reported recently were up, so I'm hoping they've turned the corner and the market price will reflect that soon.

More info

If you've read this far you either have nothing else to do or you're actually interested in this company, interested enough to look further.  Here are some links that might help you:

Ticker: ALNEX.Paris
Website: English version (everything but the financial reports are in English)
2010/2011 annual report: link

Talk to Nate

Disclosure: Long Nexeya

When is value realized?

If you've been reading this blog for a while you know that I tend to cover a wide variety of stocks ranging from global net-net's to European small caps to unlisted American shares.  I really enjoy looking at unlisted companies in the US and I wanted to address something I've been asked multiple times regarding unlisted stocks; when will value be realized and how?

When will value be realized?

The biggest concern I think most readers have with unlisted stocks is that they'll buy into a company and then their money is "stuck" and they'll be unable to liquidate their position when they want, or at a good price.  The fear is even stronger when the company has a strong insider ownership, many readers feel like they'd be locking up their money eternally.

These are perfectly valid fears especially for an investment professional who's performance is graded on a yearly basis.  An individual investor's performance isn't graded on such a short time window, but most individual's have patience that lasts about two years at the most.

Warren Buffett talks about selecting companies that investors would be happy to own if the market was closed for 10 years or more.  I know a lot of people theoretically agree with the statement, but I doubt many people would actually commit to buying a stock if they knew they couldn't sell it for 10 years or more.

I did a very unscientific study using the two Walkers Manuals (discussed below) that I have. I own a copy of the Unlisted Stocks manual, and the 2nd edition of the Penny Stocks manual.  For this simple experiment I just looked at whether a company was tradable and had shares trade in the last year, at the time of writing all of the stocks in both books were trading.  The idea behind this is to get an idea of what a holding lifespan might be for some of these stocks.  Here are the results.

Unlisted stocks from 2003 (9 years)

Out of 400 listed companies 206 are still tradable.
48.5% of the unlisted stocks had some sort of value realization event either positive or negative.



Penny stocks from 1999 (13 years)

Out of 167 listed companies 63 are still listed.
62.2% of the penny stocks had some sort of value realization event either positive or negative.

The results are interesting, it would seem that an investor who wants an external event to realize value would be better served buying exchange traded stocks and avoiding unlisted and pink sheet stocks altogether.

So what are some of the ways value was realized for these companies?  I didn't follow up on all of the companies that I had marked as no longer trading, it would have taken too much time.  I did follow up on some, of the 194 I probably followed up on 30-40 companies.  Most of the time I found their fate through a simple Google search.  Here are some of the terms I jotted down in relation to their final fate: liquidated, bought out, went private, bankrupt, purchased by parent.

An example

One company that I think encapsulates the unlisted stock spirit, and at times absurd valuation and value realization is Western Lime (WLIC).  When Walkers dug up this company in 2003 they were trading for $721 a share and described as a company who was engaged in the manufacture and sale of various lime products.  The manual had the P/BV at 33% with book value per share at $2171.  Book value had grown from $1681 in 1998.  Western Lime would have probably caught the eye of a value investor back in 2003.  It would have also attracted the skeptic who would have said that the discount to book was permanent due to illiquidity or insider ownership or the way the stars aligned in October.

Western Lime's shares rose from $721 to around $6000 a share in 2008.  I don't have details for the intermediate period, but they did eventually rise to book value and above.  This is where things get interesting, the price languished for the next two years before jumping to $12,000 on the news they were going to be acquired.  The company was acquired for $25,000 a share in March 2012.  Even the person who purchased at $12,000 doubled their money!

Maybe Western Lime is an extreme case, over the past 9 years they grew at a 48% compounded rate due to the buyout.  If the buyout never happened and they were still trading at $8000 that would be a 30% compounded growth rate.

Even a 30% annual rate of return seems incredibly high, but it's not and here's why.  While Western Lime was only earning 8.72% on it's equity an investor buying at a 67% discount to book was earning 26% on their investment.  Over the ensuing nine years Western Lime continued to execute as they had in the past.  The investor buying at such an extreme discount was able to realize a consistently high rate of return.  You don't need to buy a great business that compounds at high rates, just a consistent business at a considerable discount.

Here's the longest chart I could find for Western Lime, if anyone has a longer chart email me and I'll replace this one:

Edit: A reader sent me an updated chart, WLIC opened at $29 a share and sold for $25,000 a share, almost a 1,000 fold gain, truly incredible.  A big thanks to the reader for the following chart.

Side note on finding unlisted stocks

A close followup to the first question I've received is how do I find these companies?  There was a publication called the Walkers Manual that compiled unlisted and penny stocks into a book format yearly.  The authors had a value bent, and a talent for finding peculiar and unusual stocks.  The company that published the book went out of business sometime in the middle of the decade and the 2003 edition of the Unlisted Stocks manual is the latest copy.

I purchased both of my copies used on Amazon, and they're old library editions.  The supply appears low on Amazon, but it was never that high to begin with.  When I purchased my copies there were only a few used editions available.

If you can't locate a used copy for sale the next best place to look is the public library.  I did a search in the library system near where I live and multiple locations have the Walker Manuals from differing years.  You can't mark up a library copy (well maybe you can, no one else will probably ever look at these books), but the information is available.

A second way to find unlisted stocks is by screening at otcmarkets.com.  They have a very basic screener where you can specify the type of listing.  Use the tab "Caveat Emptor Securities" and then search for "No Information" "Limited" and "Grey Market" securities.  These are the companies where you'll need to put in a lot of work to get information.  Most of the time the companies are marginal, but every once in a while you find a Western Lime.  You don't need to find too many Western Limes to do well for yourself.

Talk to Nate

Disclosure: Wish I would have owned Western Lime...

The cheapest stock I've ever seen, and why I'm not buying it

Wow, what a title, really the cheapest stock ever?  Let me quote a line from the annual report "However, if the impact of LIFO was excluded, the Company would have generated income before income tax of $1,745,692"  That profit before tax mentioned equals $4.04 a share, or more than double the current price of $1.95.

Most readers probably won't believe my claim that this is the cheapest company I've ever stumbled across, especially considering turn over a lot of left for dead stocks looking for cheap companies.  I'm going to lay out the bullish case first before I explain what I don't like about this company.  Please don't stop reading after the bull thesis summary, there is more to this story, and incredible numbers alone aren't a good reason to invest.


I will note here, if you have the capital to buy this company outright it appears there are a lot of inefficiencies that could be eliminated.  In addition if you can buy on the open market the barrier is low, maybe $1.6m of total capital for a bid 100% more than the last trade.

• Book value of $5m against a market cap of $820,000, if you add in the LIFO reserve a book value of $8m.
• Cash flow in 2011 exceeded the market cap.
• 2010's free cash flow almost exceeded the market cap
• LIFO adjusted earnings of $2.83 per share
• An adjusted P/E of .67
• Growing margins, operating and net margin both grew 2010 to 2011
• ROE of 12%
• NCAV of $8 a share and book value of $18 a share.

Background

So who is this mystical company?  It's Randall Bearings (RBRG) a company I dredged up in the Walkers Manual. I purchased a few shares and left a number of messages to get the annual report mailed, all without luck.  Then this week the company mailed all of their shareholders the 2011 annual report, and since I still held my shares I received a copy.  It was like Christmas morning, tearing through the packaging to find a....eh, not exactly that exciting.... 

Randall Bearings is a small Ohio company that makes bronze and metal bearings for various purposes.  The company can also do custom machined parts at a customer's request.  The company has a long history being founded in 1918 as a foundry, and eventually selling off all their non-core divisions until they were left with the bearings company.

The company has 431,680 shares outstanding, and shares have generally traded for less than $2 over the past year.  With such a low share price I figured the company was losing money, but I put in a small order anyways, the Walker description was interesting enough that I wanted to know more.

Why not invest?

Liabilities

The first thing I did with Randall once I realized they were selling at such a discount to their assets was plug their 2011 figures into my net-net worksheet:

I noticed two things right away, the first was that if I didn't include the LIFO inventory reserve the NCAV was something like $.38 a share, and the second thing was that the discounted NCAV and discounted book value were both negative (highlighted in yellow).

It's easy to fixate on the upside, the NCAV of $8.33 or the tangible book value of $18.74, but as long time readers know I'm always worried about losing money.  I want a margin of safety, and in some sort of liquidation event it doesn't seem like anything would be left over for shareholders.

It's easy to plug numbers into a spreadsheet and have a formula spit out a value, and just because the spreadsheet says there's nothing left for shareholders, does it mean it's true?  In the case of Randall I believe so.  The reason for this is found in the notes on their capitalization structure where the company discusses their debt.  Here are the lines that make me nervous:

"Note payable bank, collateralized by all business assets.."

"Note payable bank, collateralized by real estate..."

"Note payable bank, collateralized by all business assets.."

"Note payable SBA, collateralized by equipment.."

"Note payable bank, collateralized by all business assets.."

"Note payable Mercer County, collateralized by real estate, equipment, and stockholder guarantees.."

So what isn't guaranteed to the banks?  Seems like the real estate is, the equipment is, all of the business assets are, and if that's not enough Mercer County wanted shareholder guarantees!  Granted the Mercer County loan is only $13,069, but if they required that much assurance to give away less than $15,000 it makes me a bit worried.  The reason I'm worried is because maybe the value of the assets and stated book value aren't correct.  If a bank lending officer who can visit the plant, walk the grounds, and examine the inventory and requires collateral containing all the company assets it makes me think that the financial statement values are probably a bit overstated.  Or at least they won't be able to be liquidated in a timely manner and realize their book value.

Management

If the liability situation isn't bad enough I was doing some Googling on the CEO and found a shareholder lawsuit from a few years back.  It seems the company tried to issue 200,000 shares of stock at par ($.001) to the CEO and CFO.  They then engineered it so that the company would pay for the taxes on the issuance.  This is a company with 431,680 shares outstanding, issuing 200,000 shares increases the share count by 50%, and gives two officers control of 31% of the company.  In addition they signed an agreement with a shareholder who owned 20% of the company which stated that the shareholder would always vote along with management.

For $200 the CEO and CFO engineered a way to take control of the company!

The plan was killed, and the company still has the same amount of stock outstanding (minus 9,000 shares) as they did in 2001.

Reincorporation

When I received the annual report in the mail the first thing I noticed was how big it was, it had some serious girth for a small company.  Most unlisted company reports run about 10-15 pages at the most, Randall was in the 50 page range.  The reason for this is they included a proxy for shareholders to vote on a reincorporation from Delaware to Ohio.

The reason they gave was that Ohio relieved directors of a specific fiduciary duty and limited their liability at the corporate level.  They also gave a lot of stock reasons like they do business in Ohio so they want to support the state.  Normally I wouldn't think much about this, but in light of the offenses mentioned above something just didn't seem right.

I noticed a few things, first off the company already re-incorporated in Ohio, they included scans of the filings in the annual report.  They took action before shareholders approved it.  Second I noticed that the par value of the shares was removed meaning there is now zero cost for the company to issue new shares.

I'm not an expert in corporate governance, but my guess is there is some nuance between Delaware and Ohio that gives the company more latitude in Ohio and mutes shareholder rights.  Given management's previous power grab I have to wonder what the real purpose of the re-incorporation to Ohio is.

Summary

On the surface Randall Bearings has the marks of a great asset investment, buy a dollar for a dime.  The problem for me is I'm not comfortable investing with managers who try to take control for $200.  Some readers might question me on this point because I own shares in Hanover Foods where there is a CEO who isn't exactly working for shareholder interests.  The difference between Hanover and Randall is that Hanover has real actual assets in far excess of the current price giving me a margin of safety.  Randall has assets that exceed the current price but they're all spoken for by bank's whose place in line is much better than my own as a shareholder.  While the price is cheap I can't get over the issues that Randall has, while the actual company seems fine, that doesn't qualify it as a good investment.

Talk to Nate about Randall Bearings

Disclosure: I own a token position, enough to receive annual reports.  No plans to increase it.

Does this company deserve to hover just above net-net status?

I love unloved sectors in unloved countries with unloved markets, so it only makes sense that HF Company would be attractive to me.  If there's fear in the air, and a company's perceived to be on the brink of extinction Oddball Stocks is probably investigating.  Of course the facts in this case don't quite line up exactly, here's what I mean.  HF Company has been profitable for the past ten years, they're debt free, and hovering right above NCAV.  If you use a liberal definition of a net-net HF Company surely qualifies.  So what gives?  Why is a "decent" company selling as junk?

HF Company is a technology parts conglomerate, they manufacture and distribute little bits of technology that are essential to a finished product, but are also a commodity.  This means they churn out parts like GSM receivers, HDMI adapters, home security systems, ADSL TV reception equipment, and DSL filters among many other things.  HF Company is a price taker, and if the price of their product rises a consumer or manufacturer will just substitute a competitor product.  Obviously consumers aren't very brand conscious in this market, I remember buying DSL filters once back in the 90s, I browsed for the cheapest ones on the shelves.  I'm guessing I'm not alone in shopping like that, most consumers figure the products all work the same so buy the cheapest.

I think it goes without saying that the market for these devices in Europe is pretty rough right now.  In a world of austerity upgrading to the latest and greatest TV probably isn't the top priority of most Europeans.  It's not only the large European macro elements at play, HF Company expanded internationally which meant to Southern Europe.  In addition they've been squeezed in the last year on raw materials, a double whammy.  They saw sales drop off 1.5% and operating income drop 55%.  Clearly this is a company with an enormous amount of operating leverage, the knife cuts both ways.  In good times results are great, but in bad times a slight bump in the road can be disaster.

With all this in the background the investor needs to consider, do these problems merit such an undervaluation?  First let's take a look at the napkin investment thesis:

• Market cap of €18m with an enterprise value of -€6m, yes a negative EV stock in Europe.
• Book value of €72m
• 3.78% ROE 2011, 8.68% in 2010
• Generous 11% dividend covered amply by earnings
• P/CF 2.79x
• P/FCF 5.82x
• P/E of 5.39

Just looking at the simple thesis this is the sort of stock I love to buy, slapping a P/E of 10 on HF Company gives an investor a 50% gain right out of the gate.  If the stock ever decided to trade at book value this is a four bagger.  But even with those potentials I'm a bit cautious this time, I'll explain below.

I wanted to show my net-net worksheet for HF Company:

As you can see the company has no discounted net current asset value because the liabilities outweigh the discounted assets.  A lot of this is because HF Company's liquid assets are composed of receivables and inventory which while liquid might not bring full book value in a liquidation.  Of course I don't expect HF Company to liquidate so NCAV can be used as a reasonably conservative downside estimate, and book value a possibly optimistic assessment.  Although it's worth noting that HF Company did trade above book value back in 2008, so getting back there isn't out of the question.

The stability of earnings

I've talked in the past about the two pillars of an investment, book value and earnings power.  I'm not original in this, Ben Graham talked about this back in 1951 as well.  With a company like HF Company they have a book value of €20 a share, with a most recent earnings power at a 10x multiple of €7.3 a share.  It's generally wise to use the lower value, but both these numbers worth together, they reflect a potential value much higher than the current price.

Additionally if you look at the last ten years of earnings HF Company has proven they're able to turn a profit in all sorts of markets, the sign of a flexible company that's able to survive.

At this point if you've actually read this far you're probably wondering why I'm not head over heals for HF Company.  The company has a solid asset value, they have a record of earnings power that far exceeds their current price, and they're paying a generous dividend of 11% that appears well covered.  Why don't I like this stock?

The number for me was the 1.5% drop in revenue corresponding with a 55% drop in operating profit.  Here's the income statement, I didn't translate it because only two items matter which I describe below.

Chiffre d'affairs - Sales
Achats - COGS
Charges externes/de personnel - SG&A

The company doesn't have a lot of room to work to face the pressure of increasing raw material costs, and decreasing sales.  The operating margin was 3% in 2011, so another 1.5% sales decline and a 1.5% raw material increase and suddenly the company is facing losses.

Companies with low margins aren't necessarily bad, I own some Japanese companies that have almost no margins, they make everything up on volume as does HF Company.  The concern is with such low margins and cost pressures a small item can bump the company from profit to a loss.  The item which concerns me as well is 'Variation de stocks' (change in inventory).  It appears in 2010 they had a gain from inventory which really accounted for most of the difference in profit between the years.  Unfortunately profit based on inventory adjustments isn't the highest quality earnings.

In conclusion while HF Company has a solid discount to tangible assets, and considerable earning power I'm questioning the margin of safety.  I'm not entirely confident about HF Company, mostly due to earnings quality and the high operating leverage.  I'm passing for now, although with some really good evidence I could probably be persuaded to buy a small position.  If I was limited to just buying value stocks in France I would be adding HF Company for sure.

Ticker: HF.PA
Website - English available

Talk to Nate about HF Company

Disclosure: No position

Where's the risk?

I've been thinking a lot about risk lately someone in conjunction with my last post, and otherwise related to reminiscing on some of my investment failures.  I want to use this post to walk through some of my past failures as well as look at changes in how I evaluate investments, and how my portfolio is ordered.  In a way this post will probably be a digital rubber necking for most readers, gawking at some things I've invested in and thinking "really, how? why?"  No one is a perfect investor and I'd rather make mistakes I can learn from than repeat the same mistakes over and over.

Where I failed to see risks

I heard the expression somewhere "You haven't really invested until you've lost a significant amount of money."  If this quote is true, I surely qualify as an investor, losses hurt, let the bleeding begin..

Morgan Stanley

I invested in Morgan Stanley back in 2006 with the idea that they were a decent investment bank with a new CEO who was going to leverage their Chinese relationship into gold.  They were also doing shareholder friendly things like spinning off Discover and MSCI to focus on their core operations.

All was well and good with Morgan Stanley until this little hiccup called the subprime crisis started to appear in 2007.  I kept reading about it, but also read that we'd have a soft landing so I ignored the issue.  I purchased in the $60s and ended up selling out in the $40s sometime in 2008.  I realize I was lucky to not ride it all the way down, but it was still painful.

Seahawk Drilling

I loaded up on Seahawk shares in 2010 with the thesis that the Mocondo spill was a temporary downturn, drilling would be back soon and Seahawk was selling for less than the scrap value of their oil rigs.  I purchased shares all over the place from $7 to $10 and ended up selling in the $3-4 range after they declared bankruptcy.  My hit would have been even worse if I didn't buy a large chunk of shares on the day they declared bankruptcy and sell them for a 50% gain, a lucky trading gain.

What did I miss?  The company was bleeding cash and it was a battle against the clock.  Drilling didn't start back up quick enough and the company was called on a outside liability which they didn't have the ability to pay and forced them to seek bankruptcy protection.

E*Trade

Sometime in 2007 E*Trade started to run into problems with their home equity portfolio and the stock was punished.  Citadel ended up buying a large stake, and the company brought in a new CEO.  At this point I felt that their core franchise was good, and the home equity problems were behind them (see minimizing the subprime above, ugh) so I loaded up on LEAPs.  In the end my LEAPs expired before E*Trade's problems did and I probably ended up with a 80% loss or more.

Discover Financial

I purchased Mastercard back in 2006 and did very well as Mastercard's IPO liability overhang wasn't as severe as many people thought.  The company started to operate for a profit and shareholders were rewarded.  I foolishly thought the same would happen with Discover once it was spun out from Morgan Stanley.  I ended up with some Discover shares through my Morgan Stanley holding, and I believe I purchased more on the open market.

When I read the filing on the spinoff I shrugged off Discover's failed Goldfish card in the UK.  I also minimized the slowly rising default rates the company was seeing, I only saw gains ahead.  I ended up selling Discover at a loss when the financial crisis took a bigger bite out of the company than anyone thought.

Myrexis

A spinoff, and a company selling for less than net cash, what could go wrong?  It was a biotech!!  Myrexis was spun out of Myriad Genetics and given a wad of cash to develop a few new drugs.  I thought the net cash, and spin off situation made this the type of deep value stock investors dream of.  Unfortunately the company worked to squander their cash pile, abandon the drugs they were working on and tried to acquire another development stage company in a massively dilutive merger.

To add insult to injury the company Myrexis was going to merge with (Javlin) fell far below the merger price because the market doubted that the merger would compete.  Another company came in and bid far higher for Javlin giving shareholders a double and leaving Myrexis paying a breakup fee to end up with nothing but ill-will from shareholders.  Not only did I lose money on Myrexis, I could have doubled my money on Javlin.  I even pointed this out to a few other investors but never followed through myself.

What's the common thread?

So in the four examples above what is the common thread?  I either misunderstood, or misjudged the company's liabilities.  In some cases I thought time would heal problems, but when a company is burning cash time is the enemy not a healer.  In other cases a seemingly small liability was actually a bit of a death blow.  In my excitement over the investment I minimized these factors.

It's also worth noting that outside of Myrexis none of my mistakes were in Graham & Dodd deep value stocks.  I invested in two bio-tech stocks for less than net cash thinking these were Graham stocks, but I was deluding myself, a cash heavy biotech with massive negative cash flow doesn't have a margin of safety.  In all of the situations I've been disciplined in applying a margin of safety I've done ok, at the worst I've broken even.

What changed?

The combination of all of the above failures forced me to reconsider my strategies and how I look at investments.  I would previously look at something, and look for where the gain was and how was I going to make money.  I've changed and look at how I can lose money on any given investment.  Right away I look to see how I can poke holes in a company, and if I poke enough holes I walk away.  This makes it easy to look at a lot of companies, most companies I eliminate quickly.  Of course I don't always follow this perfectly, at times I've been prone to put a bit of money towards speculation (see CECO post), but for any substantial holding this is how I approach an investment.

The second change is I won't invest in any company that's not cash flow positive.  I know there are plenty of net-net or value investors who will invest in turnarounds, but that's not for me.  I've been burned a few times by companies that have negative cash flow.  If a company is reporting losses but is cash flow positive I won't exclude them.  In almost all cases if a company is cash flow negative they won't fit in my portfolio.  As of the beginning of last week I had no companies in my portfolio that were cash flow negative, this changed when Titon Holdings released their result, so now I have one.  I need to re-evaluate Titon soon.

How does this affect my portfolio?

I think some of the discussion above is hard to follow if you don't have the context of my portfolio to understand it in.  I don't run my portfolio in any sort of style, I'm not a Buffett investor, I'm not a Greenblatt investor, I don't concentrate like Berkowitz etc.  I will generally invest in anything that appears cheap, safe and has a margin of safety.  I also won't initiate a position bigger than 5%, I will let positions naturally grow bigger than 5%, but I'll never initiate anything higher than 5%.  I usually will start at 1-2% and scale in slowly.  I also like cash, I never let my cash fall below 5%, but I usually have around 10-20% in cash at any given time.  Maybe this is foolish and I sacrifice returns, but I always want to have the ability to buy something no matter the market condition.

Sometimes a 1% or 2% position stays that size, other times I've kept investing until I get to 5%.  I don't have a hard and fast rule as to how I do this.

So currently I have 38 positions not including mutual funds.  I hold a number of index funds and two mutual funds in a 401k and IRA, I don't count these as positions, they rarely change and are a 70/30 stocks/bonds allocation equally divided by US and international.

Of the 38 positions:

• 12 are net-net's.
• 3 are community banks trading below book value.
• 4 are tiny positions in unlisted stocks so I could receive the annual report.
• 2 are options positions, one a hedge, one a speculation.
• 2 are spinoffs, one I'm looking for margin expansion, and the second one I hope falls into the below category eventually.
• The rest are companies that have high ROIC that I'm content to hold while they grow earnings, book value and generally compound at nice rates.  These companies include things like Mastercard, America Movil, Installux, Precia Molen, Goodheart-Willcox and others.

I try to keep my portfolio balanced, I'm not concentrated in any one type of stock, any one sector, or any one country.  The idea is by staying somewhat diversified when I make mistakes in the future (which I will) the losses will be limited.  I've changed my mindset from looking for gains to focusing on how I can avoid losing money.  I've found that when I focus on a strong margin of safety in cash flows and a discount to actual earning power or assets I've done my best.  It's when I deviate from this that I start to notice losses creep into my portfolio.

I'm not even sure if this post will be useful to anyone other than to gawk at myself, but I've found it has been cathartic to write this down.  Thinking about my losses helps me focus on what I know, and what I can control, mainly ensuring a strong margin of safety before I click buy.

Talk to Nate about this post

Disclosure: Long the good stocks mentioned, no positions in any of the junk.

Think you're a contrarian? Then keep reading...

This post was written by a reader who I email back and forth with frequently.  The following idea is something we've tossed back and forth a lot, I asked them if they'd mind doing a post on it.  I made some minor changes and did some editing.  I want to say a big thanks to them for putting this together, and hopefully you the reader enjoy it (and make some money!)

One of the most unloved and despised sectors of the market is for profit education.  After all, everyone knows that if for profit education doesn’t already have two feet in the grave, one foot is in and the other foot is dangling over it ready to join its partner.  But the question is whether it’s in fact true that for profit education will go the way of buggy whip manufacturers.

Career Education Corp. (CECO) is an idea for those willing to be true contrarians.  It’s near its 52 week low and has seen its share of bad news.  The problems can be divided broadly into regulatory concerns and business concerns.  Even with all the problems CECO it's arguable that a lot of the issues are already priced in, consider the following:

• Market cap of $472m against cash of $441m, with an Enterprise value of $31m (no debt)
• The business generated an average of $263m in operating cash flow over the last three years.
• Past three years average free cash flow of $151m.
• EV/FCF of .2x

Regulatory Issues

The for profit education sector has tremendous headwinds at the present time.  Essentially, many of the for profit schools were accused of being nothing more than diploma mills.  That is, they take in tuition funds and churn out diplomas without any consideration for a “good” education or future job prospects.  There is some truth to this and there have been some egregious practices. 

Congress has made a point of showcasing the issues and coming down on the for profit schools.  Various regulatory schemes have been enacted over the years to “fix” the problems.  The regulatory schemes are in many ways onerous and quite difficult to comply with. 

Before listing those out, it’s important to understand that for profit schools receive the vast majority of their tuition funds from students who have received aid under Title IV.  That is, students typically take out government funded or sponsored loans to pay their tuition.  When they can’t repay their loans, it becomes the taxpayers’ burden.  Student loans have been in the news lately as they’ve reached the $1 trillion mark and with loan resets coming up on the horizon it could be a heavy burden.

The key to understanding the regulatory regime is that for each different scheme failure to comply can result in various consequences – anything from probation to fines and, the ultimate death penalty for for profit education, curtailment of Title IV funds.  Thus, in the event of the “death penalty”, these schools would be prohibited from receiving government funded or sponsored funds and that would essentially mean game over.

As for the major regulatory schemes:

1.      90/10 Rule – this rule provides that no more than 90% of a school’s funding can come from Title IV funds.  As with most of these rules, it is tested both on an individual school level and in the aggregate for all schools a company owns. 

2.     Cohort Default Rule – this rule provides that no more than a certain specified amount of students who are in their loan repayment period can be in default.  These rules have been changing of late.

3.     Gainful Employment Rule – this rule is new and provides that after graduating from a program for each student in repayment mode only a certain amount of their income can be used towards the repurchase of the loans.  I have thought and thought about this and have no clue how it will be applied in practice as it will require self-reporting from the individuals.  In any case, while it is currently in effect, there are no ramifications for a couple of years or so.

4.     Accreditation – in order to receive Title IV funds each school must be accredited by the applicable accreditation provider.

Business Issues

                  

Due to the regulatory headwinds and the poor economic environment, for profit schools have seen enrollment plummet.  But in many cases, students who attend for profit education schools would not usually be attending a four year university.  That is, for profits provide a useful skill for many people looking to improve their situation.

So this has been a lot of background.  CECO has suffered tremendously from all of these issues.  Enrollment is down and there have been problems as well with their accreditors.  Last year, CECO received a “show cause” directive from their accreditor as it related to their reporting of placement rates.  At the same time, CECO’s CEO resigned over some improprieties and the new CEO pledged to clean things up.  He immediately hired an outside law firm, Dewey & LeBouef, to audit their placement rates.  Upon receiving the report, they sent it to the accreditors and promised to rectify the situation.  The show cause directive was hanging over their head and they just received word that other than 4 schools being put on probation, there are no ramifications.

In terms of the various other regulatory schemes, what to say?  It would seem to be priced in at this point.  In my experience, take it for what it’s worth, Congress is a lot of bluster and not a lot of bite on these points.  That is, a lot of noise is made, but Congress isn’t really inclined in my view to shut down businesses that aren’t “harming” anyone, physically at least.  So while there will much wringing of hands, probation, fines even, etc., to receive the death penalty (i.e. not be able to obtain Title IV funds) would essentially mean that thousands of employees are put on the street and hundreds of thousands or even millions of students are left with a worthless education.  I don’t see that happening, but it’s possible of course.

Valuation

The best valuations are the most simple valuations.  As I write this the stock price is around $6.80.  Book value is $11.93 and tangible book value is $6.72.  The market cap is around $472 million and enterprise value is about $31 million; there is a lot of excess cash and no debt, although there are operating leases.

Interestingly enough, with all of these headwinds (and note too that much of this isn’t really new, but has been ongoing for quite some time), revenues have been fairly stable for the past 8 or 9 years.  The 4 year average is approximately $1.87 billion and the 8 year average is about $1.86 billion.  So more stable than one would think. 

Free cash flow margins have been relatively stable as well, although have been nipped a little bit recently with all of the overhang.  The FCF margins for the past 4 years have averaged about 8.6% while for the past 8 years it has averaged about 9.7%.  Using a value destroying multiple of 8, the stock on a FCF basis would be worth somewhere in the $21-23 neighborhood. 

There is a lot of margin of safety in that.  Think revenues will plummet?  Cut them in half.  The stock is still worth in $12 area.  Margins will come way down?  Cut them in half along with half the revenues and the stock is probably worth around what it’s at today, but if the multiple was higher obviously that could still work out.

At the end of the day, the stock is being priced as if it is going under.  If one thinks that’s the case, it isn’t worth an investment at any price.  But if they survive, it will almost certainly be in somewhat the form they currently are in.  This isn’t a stock without risk and a lot of it.  No recommendation is being made as to whether CECO or any other for profit education company should be purchased, held or sold.  Do your own due diligence and speak to whichever experts you feel is necessary.

Further resources

Latest 10-K

Latest accreditation news

Disclosure: The author of this post is long CECO, Nate is also long CECO

EV/FCF of 1.6x? ROE of 18%..only in Japan, net-net's part 3

This is a continuation of my series where I've been looking through 100 Japanese net-net's.  I narrowed down the initial list to 34 that I determined were worth a closer look.  The first two installments of this series can be found here:

Part 1

Part 2

As with the other two this post and subsequent ones will follow the same pattern.  The company name and description, investment highlights, and my net-net worksheet.  At the end of this post is the cumulative spreadsheet with data from all the companies I've looked at.

Sakai Trading (9967:JP)

Sakai Trading is a chemical additive company.  They make resins and plastic additives, some of their products are used in the production of flat panel TV displays.  The company has been in existence for 85 years.

Highlights

• Trading at a P/E of 5.38
• Negative EV
• No debt
• Osaka Exchange traded
• Eye popping 15% ROE (ex-cash)
• Negative cash flow last year due to working capital changes.

ICOM Inc (6820:JP)

ICom is a wireless radio manufacturer, their radios can be found in a variety of devices such as marine devices, aeronautical devices, amateur radio and transceiver radios.  The company has offices worldwide, but their main office is located in Japan.  The company website really played up their marine products such as this marine commander setup.  The commander has all the screens, radar and radios you'd need to completely outfit the deck of a boat.

Highlights

• The company throws off quite a bit of cash with free cash flow slight over ¥100 per share last year.
• EV/FCF of 1.68x
• EV/EBIT of 2.13
• Tokyo exchange traded
• The company was founded in 1954, and manufactures 100% of their products in Japan.
• US Dept of Defense is a customer, as well as the Japanese military.

Odawara Engineer (6149:JP)

Odawara Engineering manufactures winding motors, I read about their products and have absolutely no clue what they are.  Some sort of engine assemblies, they have a very nice English website with loads of technical literature.  The company was founded in 1950 and went public in 1979.  The company has subsidiaries in Italy, China, and the US (Ohio).

Highlights

• Negative EV, and only selling 33% above it's net cash value.
• The business appears to be decent, a ROE of 18%
• Net margin of 8.27%
• FCF is very lumpy, it appears the company has large working capital requirements every few years.
• The company actually appears to use some of their cash horde from time to time to finance expansion and working capital needs.

Summary spreadsheet

Here are all of the Japanese net-net's I've looked at since I undertook this project a month back.

Summary

I'm waiting to finish my project before buying anymore Japanese net-net's, but in this list I'd say Odawara Engineering possibly had the most business potential, while Icom looked the cheapest.  No matter what an investor who purchased any of these stocks below NCAV and sold at NCAV would do fine, all of these companies have considerable margins of safety.

Disclosure: No positions