Japan the ultimate trade, part 2

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

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

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

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

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

The scoring

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

• 10 years of positive EBIT
• 10 years of positive net income
• Pays a dividend
• No debt
• Stable or shrinking share count
• Revenue growth
• Earnings growth

If it seems like I'm looking for a needle in a haystack I am, but there are many needles to be found.  I scored 100 Japanese net-nets about eight months ago and found 20 or so that met all of the criteria mentioned above.

Here is a screenshot of the spreadsheet:

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

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

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

Volunteer to help score Japanese net-net stocks

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

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

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

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

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

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

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

The short, the quick, the long thesis

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

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

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

Here is the net-net worksheet for eOn:

Ruling it out

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

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

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

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

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

Pulling it together

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

As always thoughts and comments to the contrary are appreciated!

Talk to Nate

Disclosure: None

Investing in Horizon Kinetics through the back door with FRMO

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

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

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

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

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

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

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

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

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

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

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

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

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

Talk to Nate about FRMO

Disclosure: Long FRMO

Alternative information sources

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

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

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

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

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

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

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

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

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

Talk to Nate

Disclosure: Long SODI

Japan, the ultimate contrarian trade

Japan, the mere mention of the country for investors elicits disregard and apathy.  Mention a company in the UK trading for less than net cash and growing earnings and interest explodes.  Mention a company in Japan with the same metrics, and investors come up with reasons to not invest.  Japan is a fascinating place, a first world country, ultra modern, yet for investors something less than a third world market.

In 1939 John Templeton called his broker and asked him to buy $100 worth of every stock trading for less than $1, bankrupt or not.  His broker obliged, grudgingly and purchased 104 stocks for him.  That initial $10400 turned into $40,000 four years later, and got John started on his investment career.

In retrospect John Templeton's trade seems obvious, yet at the time is was something only an investor a few slices short of a loaf would undertake.  I think we see the same dynamics with Japan today.

For most investors Japan is a place where money goes to die.  Japanese bonds are famous for their widow maker trade, and Japanese equities have destroyed a few legacies themselves.  No self respecting investor takes a chance on Japanese equities, which have been in a bear market for the past 20 years.  A mention of a purchase in Japanese equities is usually met with a response that Japan is about to enter hyper-inflation, or the Yen is going to be destroyed, or the country is about to default on their debt.  I don't want to minimize the finances of the Japanese government, but these characterizations have been going on for the past decade or more.  That's not to say they won't come to pass eventually, but a lot of people have lost a lot of money trying to guess the timing.  Eventually Japan will have to deal with their debt problem, but so will the US, and so will Europe, so Japan is not unique in that regard.

So with all this I want to introduce what I call the greatest Japanese trade ever.

Long time readers know that I've toyed with the Japanese net-net market.  I've done numerous posts on Japanese equities, and even bought a few Japanese net-nets.  Each time though I keep coming back to the same problem, there are so many Japanese net-nets, how do I choose the ones to invest in?  I've translated financial statements in an effort to pick the "best" cheapest companies.  I've built out spreadsheets of various metrics, yet I've never had the feeling that I'm fully capturing the cheapest companies.  Do I purchase the ones at the lowest P/NCAV, or the ones with the highest ROE, or the ones with the best dividend yield?  I really don't know what will work the best in the future.

In thinking about Japan I've started to think about the John Templeton approach.  I've often thought that if I could buy ALL of the Japanese net-net's I'd be happy.  Sure, some would go bankrupt, but who cares, some would also quadruple.  I've told a number of investors that I'm convinced that someone buying the cheapest Japanese companies could not go wrong.  The trade might not work out over the next four to six months, but over the next four to six years it would for sure.  Why do I think this?  Because it's absurd that profitable companies are selling for less than net cash, or less than net current assets.

I've thought about this trade a lot, buying all the net-nets, the problem is one of both capital and commissions.  As of today there are 448 companies selling for less than NCAV, and with the funky Japanese rules regarding lot sizes, I estimate it would take close to $4.4m to buy every single one of these companies.  I don't have anywhere near $4.4m in capital, and at my broker the commission to enter an exit each trade would be a serious hamper to results.

Recently I found out that Schwab created a new Global Trading product as part of their brokerage account.  As a promotion for this new account they're offering free trades until March 2013.  Free trades on international equities got my attention, I started to think that maybe the ultimate Japan trade might be possible.

While Schwab trades all Japanese exchanges (Tokyo, Osaka, JASDAQ), they only trade securities where they offer an equity rating, which is 882 equities.

Using the Schwab platform I'm hoping to pull my own mini-Templeton trade.  I'm looking to buy 20-30 Japanese net-nets, in addition to the four I already own.  Doing this will more than double my exposure to Japanese net-nets.

So here is the plan: I am going to open a Schwab account and purchase 20-30 Japanese net-nets.  I'd like to purchase more, but my capital is already tied up in other great opportunities, and this is the most I can spare at this time.  I'm going to also hedge my exposure to Yen with a future or options in case of a Yen explosion.  This way I'll still get the market return these net-nets provide, but won't have to worry about the Japanese debt problems.  My hope is that I can forget about this account for three or four years, and at that point I'll have at least 2x my money if not more.

Some readers might wonder exactly how I'll pick 20-30 companies out of 448.  I'm going to approach this in a similar fashion as John Templeton.  I'm going to start with the lowest priced equities first before layering on any other criteria.  My second criteria will be discount to NCAV, my third criteria, discount to BV, and my fourth criteria ROE ex-cash.  I also want each of my holdings to pay a dividend, so I'm paid to wait this out.

Talk to Nate about the ultimate Japan trade

Disclosure: no equities mentioned

Certainty in investing

I will occasionally get an email from a reader saying they love my blog, then proceed to tell me about some great stock that's selling at 2x book, that's a "good earner", and has great potential.  I sometimes wonder how much these people have actually read what I write about.  I haven't received any emails like that recently, but I've been thinking about the role certainty plays in investment decisions.

I prefer certainty over uncertainty when making analyzing an investment.  It's such a simple thing to say, I doubt any readers would disagree, but the investment style exhibited by most market participants disagrees with this statement. When more certainty exists assumptions are minimized and minimizing assumptions leads to less errors.  I believe this is the reason I enjoy investing in net-nets, and companies on an asset basis.  On a balance sheet, cash is cash, no assumptions are presumed, the book value of cash and market value of cash are one in the same.  At the opposite end of the spectrum future earnings are at best a guess, maybe they fit a trend, but the truth is no one knows the future and what it holds.  For everyone projecting earnings five and ten years out I want to see your earnings models from 2006, and 2007, were they accurate?

For an asset based investment uncertainty starts to creep in the further we move down the balance sheet.  This is why when looking at net-net's Graham added a discount factor for receivables, and inventory, and finally property plant and equipment.  The uncertainty is the highest with fixed assets, so the discount is the greatest.

The same is true with earnings, there is little uncertainty (usually) with revenue, but by the time we get to earnings all sorts of assumptions are incorporated adding an uncertain factor.  This is also a reason that cash flow is preferable to earnings, cash is more certain and less prone to manipulation.

When I profile a cashbox, I get a lot of negative comments.  A cash box is a company where the cash is a significant component of the market cap, and in some cases exceeds it.  Usually the value of the actual business is small.  Most of the comments I receive discuss how terrible the business is, and question why I'd want to invest in something so bad.  I view it differently, a cash box minimizes uncertainty.  When I buy a cash box I know for certain what I'm buying, maybe it's a $1 for $.75, or even $1 for $.50.  The only uncertain thing is what the business might do, but my investment is protected against failure, because I purchased the certain thing cheap.

If I could buy a good company selling at a cheap price with the same amount of certainty as a cash box I would prefer the better company.  The problem is these situations don't exist.  There are no blue chip companies selling for NCAV, or a deeply discounted book value.  Even the cheapest blue chips have a high uncertainty factor.  Will earnings continue to be stable?  What if margins shrink?  What if demand for the product drops?  What if the internet changes the business model?  I do own some large caps, two actually, with high degrees of certainty.  Both of my large cap holdings have virtual monopolies, or duopolies in their respective market, the certainty level is high.

There is a trade-off though, a company with certainty's returns are usually limited.  A cashbox is never going to return 400%.  A net-net isn't going to become the next Apple, at most they might return 50-100%.  Occasionally a cheap certain stock will triple or quadruple, and very rarely more.  The opposite is true for uncertain stocks, Apple fell to the $70s when it was announced Steve Jobs had cancer.  That was the ultimate uncertainty, the market felt the company's future was cloudy, uncertainty was at a high, and the stock sold cheap.  Uncertainty lifted and the stock has almost gone up 10x since then.

I believe Graham tried to encapsulate this idea in his discussion of investment return, and speculative return.  An investment return is a certain thing, whereas a speculative return isn't certain, but it could be substantial.

I believe certainty is inversely correlated with a margin of safety.  If a cash box is liquidating dollars for $.95 I don't need a margin of safety, my return, and the value of the assets are almost guaranteed.  If I need to predict what car sales will look like in five years for an investment to work, I need to buy at a bigger discount to incorporate the chance that my prediction is wrong.

Sometimes investors fool themselves with the margin of safety concept.  I will read writeups on Seeking Alpha that go something like this: earnings will grow from $.95 to $3.25 in 10 years, and discounted back at 15% (to be conservative) means the stock is worth $85, but it's only selling or $65, so I have a strong margin of safety. Note to all math nerds, I have no clue if the numbers work, I just made them, and the discount rate up.

When I read something like that I don't see anything safe, unless the company has a contract for ten years of earnings, growth is a gamble.  And just because the current price is sitting below something a formula spit out doesn't make it "safe" even if there's a large discrepancy.  I don't mind buying companies for their earning power, but I like to do it in what I consider a more certain way.  As an example, a company has consistently earned $3-5 per share for years, even in down markets, and is selling for $15, would be considered "safe" to me.  It would be even safer if book value was $13 per share, something close to the current price.

In summary, I want to look for investments where assumptions I need to make are minimized, and my downside is certain.  I much prefer an investment where the absolute maximum loss is small to non-existant verses one where I have the potential to make 30x my money, or lose it all.  I'm not a 20 punch Warren Buffett investor, but I have found it's worthwhile to be patient and wait for the right types of investments.  And to anyone who thinks cheap companies aren't out there right now, there are over 60,000 public companies worldwide, some proportion of those are certain, and cheap.  In Japan alone there are over 300 companies selling for less than cash.  It always pays to be patient!

Talk to Nate

Disclosure: No positions mentioned

Automodular's pretty cheap eh?

Except for the bottom of a bear market, it always seems like there aren't many cheap stocks to be found.  Some cheap stocks (like most of the current net-nets) are full of warts, with one food in the grave, and the other on a banana peel.  In every market there's always someone who things stocks are overvalued and is willing to sit on their hands clutching cash waiting or the next crash, waiting, and waiting.  A preferable strategy is to find safe and cheap stocks in any market, buy, and be patient.  The stock I want to discuss today is a good classic cheap stock.  There is unfortunately no sexy story, full of mystery and intrigue surrounding it.

Automodular (AM.Canada) is a Canadian manufacturing company based in Ontario.  The company did have a small amount of operations in Ohio, but those have mostly been wound down.  Sales are now predominantly in Canada.  The company is an integral part of the car supply chain, they, supply assembled sub-modules for cars.  The modules are things such as an instrument panel, or powerpack.  The company receives orders every forty seconds, and ships the completed components within two hours.  The car assembly process at the destination plant cannot continue without Audomodular's components, so timing is critical.  Because of this the company is locates their facilities within 12 miles (20km) of the final assembly facilities.

The company relies on contracts with auto manufacturers, mainly Ford and GM.  Ford and GM use third party modular assemblers because historically it's been cheaper to outsource component production.  Automodular states that the price advantage gap has been closing over the past few years, and if the difference becomes inconsequential it's possible that Ford or GM might insource their work.  In an effort to diversify the company has sought new lines of business that might use some of the expertise they already employ.  Out of this initiative they have started to manufacture windmill components.

There are a few things that make Audomodular really interesting as a potential investment.  The company is trading slightly below book value, and has a P/E of 2.7x.  With a P/E this low ROE last year came in at 36%.  What makes the numbers even more impressive is that the company has continued to grow into 2012.  The 2011 annual report looked great, but the 2012 half year results are even better.  Sales are running 36% higher than last year, with earnings coming in 31% higher.  The company's sales weren't artificially high in 2011 due to a one time gain, they've been consistently strong coming out of the recession.

The large gain in year over year results come from the company's windmill fabrication efforts.  Unfortunately is the windmill production program is only a year long.  There's the possibility of extending it, if successful, but windmill demand relies on government subsidies, and renewable energy demand, two unknowns.

The company has the ability to generate strong cash flows, in 2011 they had free cash flow of $15,768k, and in 2011 free cash flow was $22,578k.  Free cash flow for the first half of 2012 was significantly lower at $2,920k.  The company attributes their strong free cash flow over the past few years to a significant rebound in orders from Ford and GM.

The company has been a responsible steward of cash, they have accumulated a sizable cash hoard, recently amounting to $15m.  Management has been shareholder friendly, paying a sizable dividend last year, and buying back shares, when appropriate.

Naturally for a company this cheap, with a history of sizable earnings the first question asked is: "what's wrong?"  There are two major forces working against Automodular, and they're the primary cause for cheapness.  The first was touched on briefly above, the current extraordinary results are from the temporary production of windmills.  It's possible this production could be extended, but as of now there isn't any visibility into that decision.  When windmill production ends, results will drop back down to where they had been in the past.

The second cause for the cheapness is that Automodular works on a contract basis for Ford.  They're currently contracted to produce subassemblies for a few different car models, but the contracts are set to expire in the next couple years.  The company is working hard to secure a future contract, but if they're unable to, Automodular will be a company with a lot of expenses and no revenue.

I believe it's the fear over the visibility into the company's future that's holding the price down.  While it would be nice to lock up 10 years of revenue in a long term contract it's aldo very rare for a company to do that.  Most companies are in the opposite position of Automodular, they don't know who will be making purchases tomorrow, and how many purchases will be made, there is no visibility.

A third and more minor concern is that management is looking for ways to diversify their lines of business.  This diversification effort led to the windmill project, but in the future it could lead to projects of dubious value.  Management has been a good steward of shareholder capital in the past, but that doesn't mean they can't make an ill-timed acquisition, or make a mistake in the future.

With all the potential negatives it's worth discussing a potential positive as well.  The company has a lawsuit pending against GM for breach of contract for the amount of $25m.  The lawsuit is pending in the Ontario courts, with an uncertain resolution date.  If Automodular wins the case the settlement amount would be material, and could be used to pay a dividend, or buyback more shares.

If an investor believes Automodular will be able to extend their contracts with Ford, or diversify into profitable side businesses this could be a very nice investment.  This could also be a great first international investment for an American.  The company has shares that trade on the pink sheets, as well as their Toronto listed shares.  All of the reports are in English, and Canada isn't that far away for most Americans for a quick visit to company facilities, if desired.  For American investors afraid of the shark infested international markets, Canada is a great baby step.  Not only do both countries share hockey, and baseball leagues, we also call our money the same thing.

Talk to Nate about Automodular

Disclosure: No position