Sutor Technology Group Ltd. (SUTR)

I just found this one today via a stock screen. Sutor Technology Group Ltd. (SUTR) is trading well below net current asset value per share (NCAVPS).

Share Price: $2.06 / Share

Shares: 40.7 Million

Market Cap: $83.8 Million

Current Assets: $219 Million

Total Liabilities: $121 Million

Net Current Asset Value: $98 Million

Net Current Asset Value Per Share: $2.41 / Share

I'm unclear why SUTR is trading a full 14.5% below its net current asset value. My cursory review of financial statements lead me to believe the company is relatively healthy; Revenues are up year over year, there is a history of positive operating income and net profit, and of course current assets more than cover all liabilities.

On the other hand, earnings per share have declined over the past three years as shares outstanding have risen. But still, there would need to be substantial dilution before the NCAVPS would dip below the current market price of $2.06. We're not talking about a just few million newly issued share here.

On closer inspection, current assets includes approximately $97 million in advances to related party suppliers and just over 50% of revenues come from related parties. However, according to the 10-K:

We believe the terms obtained or consideration that we paid or received, as applicable, in connection with the transactions described… were comparable to terms available or the amounts that would be paid or received, as applicable, in arm’s-length transactions.

Although, that may be a little bit hard to swallow given the fact that gross profit from un-related parties decreased by 14.2% from FYE 2009 to 2010, while over the same period gross profit from related parties increased by 14.3%. On the face of it, that doesn't exactly scream "arms-length."


Anyhow, SUTR is worth some additional study. I'm keeping an eye on it.  September 30, 2010 quarterly results will be released in about a week and hopefully I'll have more time to read through the 10-K more thoroughly soon as well.

Check out the company's SEC filing's here and the Morningstar quote here.

Purchase of Manhattan Island for $24? You Might as Well Flush Your Money Down the Toilet!

Grab a cup of coffee and a biscuit for this one. Below are excerpts from Warren Buffett's 1963 - 1965 letters to his partners concerning the "Joys of Compounding" in which he makes case for the incredible power of compounding returns over a long period of time. By the time you finish reading through, Buffett will have you entirely convinced that Peter Minuit was unequivocally swindled by the Manhattan Indians in 1626 when they sold him the Island of Manhattan for $24.

In these examples, Buffett takes the idea of compounding returns to absurd heights which is exactly why this is such a devastatingly convincing argument. If nothing else, I'm convinced that I would be wise to live a very long time.

Credit to the Above Average Odds blog and the East Coast Asset Management 3rd quarter 2010 letter to investors for unearthing and revisiting these wonderful letters. Enjoy:

January 18, 1963 – Warren Buffett 

“I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter's rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like 2,000,000,000,000 (that's $2 trillion for those of you who are not government statisticians) by 1962. Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living  long time, or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point.

The above table indicates the compounded value of $1,000,000 at 4%, 8% 12, and 16% for 10, 20 and 30 years. It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.”

January 18, 1964 – Warren Buffett

“Now to the pulse-quickening portion of our essay. Last year, in order to drive home the point on compounding, I took a pot shot at Queen Isabella and her financial advisors. You will remember they were euchred into such an obviously low-compound situation as the discovery of a new hemisphere.

Since the whole subject of compounding has such a crass ring to it, I will attempt to introduce a little class into this discussion by turning to the art world. Francis I of France paid 4,000 ecus in 1540 for Leonardo da Vinci’s Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the ecu 4,000 converted out to about $20,000. If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000. That's $1 quadrillion or over 3,000 times the present national debt, all from 6%. I trust this will end all discussion in our household about any purchase of paintings qualifying as an investment. However, as I pointed out last year, there are other morals to be drawn here. One is the wisdom of living a long time. The other impressive factor is the swing produced by relatively small changes in the rate of compound. Above are shown the gains from $1,000,000 compounded at various rates. 

It is obvious that a variation of merely a few percentage points has an enormous effect on the success of a compounding (investment) program. It is also obvious that this effect mushrooms as the period lengthens. If, over a meaningful period of time, Buffett Partnership can achieve an edge of even a modest number of percentage points over the major investment media, its function will be fulfilled.”

January 18, 1965 – Warren Buffett

“Our last two excursions into the mythology of financial expertise have revealed that purportedly shrewd investments by Isabella (backing the voyage of Columbus) and Francis I (original purchase of Mona Lisa) bordered on fiscal lunacy. Apologists for these parties have presented an array of sentimental trivia. Through it all, our compounding tables have not been dented by attack. Nevertheless, one criticism has stung a bit. The charge has been made that this column has acquired a negative tone with only the financial incompetents of history receiving comment. We have been challenged to record on these pages a story of financial perspicacity which will be a bench mark of brilliance down through the ages.

One story stands out. This, of course, is the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12 1/2 billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6 1/2% return (The tribal mutual fund representative would have promised them this.) to obtain the last laugh on Minuit. At 6 1/2%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion. So much for that.  Some of you may view your investment policies on a shorter term basis. For your convenience, we include our usual table indicating the gains from compounding $1,000,000 at various rates.

This table indicates the financial advantages of: 

(1) A long life (in the erudite vocabulary of the financial sophisticate this is referred to as the Methusalah Technique) 

(2) A high compound rate 

(3) A combination of both (especially recommended by this author)  

To be observed are the enormous benefits produced by relatively small gains in the annual earnings rate. This explains our attitude which while hopeful of achieving a striking margin of superiority over average investment results, nevertheless, regards every percentage point of investment return above average as having real meaning.”

Talecris Biotherapeutics Holdings Corp (TLCR)

As you may recall, Talecris Biotherapeutics Holdings Corp (TLCR) is one I'm looking at currently in merger arbitrage, scheduled to close in the 4th quarter 2010. Reportedly, Grifols will be buying TLCR for $19 plus 0.641 shares of newly issued Grifols stock for each share of TLCR.

See my earlier post for the specifics, but at the time I wrote, we were looking at a current discount on the closing price of $2.36 dollars per share of Talecris when it was trading at $24.00. Assuming the deal closes before December 31, 2010 that is a non-annualized return of 9.8%, or 47% annualized from the date of my post.

Today, trading is up on TLCR to $24.34 on release of strong 3rd quarter earnings. No further news yet about the merger, but strong 3rd quarter earnings for TLCR is definitely a positive. I'll be anxiously awaiting further details.

Stay tuned!

Tips for Value Investors - #3: Understanding Net Current Asset Value Per Share

If you're going to understand only one financial indicator of a company's intrinsic value compared to its market price, Net Current Asset Value Per Share (NCAVPS) is it. It's not a terribly difficult concept to master, but understanding it completely is one of the best ways to get a basic fundamental understanding of what it means to be concerned with value investing.

Value investing, at its core, is the search for investment opportunities in which the current market price of a security lies beneath intrinsic value. As with most indicators, NCAVPS cannot be considered in a vacuum when purchasing securities, but if I was forced to choose one indicator alone to rely on, this would be it. So take your time through this explanation.

First, what is Net Current Asset Value?

[Net Current Asset Value] = [Current Assets] - [Total Liabilities]

Net Current Asset Value, or NCAV, is a very simple value to calculate and by itself is not incredibly useful to the value investor. It is simply the difference between a company's current assets over its total liabilities. Essentially, all we can tell from the NCAV is to what extent a company's total liabilities can be satisfied by its current assets (i.e. cash, investments, accounts receivable, inventory etc.).

In other words, were the company forced to liquidate immediately (in an orderly fashion, but quickly), how much  of a company's liabilities can be satisfied by its current, liquid assets without the need to liquidate long-lived assets such as land, buildings, equipment, long-term notes receivable, etc.

You will find companies on both ends of the spectrum here. Some companies can more than cover all of their liabilities with current assets and still some other companies could barely make a dent. While you can get some vague idea of a company's overall financial health from the NCAV, no significant investment decisions can be made solely based on this measure.

Here is where it starts getting interesting, though. Once you've found the Net Current Asset Value, you can then calculate...

Net Current Asst Value Per Share


[Net Current Asset Value Per Share] = [Net Current Asset Value] / [# of Shares Outstanding]

So, for example, assume the following facts about a company:

Current Assets: $100 million
Total Liabilities: $30 million
Shares Outstanding: 10 million

We would calculate the company's NCAVPS as follows:

Net Current Asset Value Per Share = ($100 - $30) / 10
Net Current Asset Value Per Share = $7 per share

This means that there is $7 of Net Current Asset Value for ever 1 share of the company. Or, put another way, if the company liquidated today, there would be $7 left over after satisfying all liabilities for every 1 share of stock. Remember, this is before taking long-lived assets into account. We are only considering current assets.

With this information, I know that if I were to purchase a single share of this company's stock today for $7 and the company subsequently liquidated on the same day, I should expect to at least break even before considering the salvage value of the company's long-term assets.

What we are looking for then are stocks that are currently priced below NCAVPS. Based on the example above, suppose that the company was trading at $5 per share instead of $7. In simple terms, buying one share of that company would get you an immediate return on investment of $2 or 28.5% (assuming instant liquidation, of course).

It was Benjamin Graham's idea that investing solely in companies trading at or below 67% of its NCAVPS would prove to be very profitable for investors and later independent research studies have shown this to be essentially true. And while there certainly are no completely fool-proof plans, a NCAVPS strategy probably comes as close as you can get to one.

A word of caution, however. Having read this does not automatically make you the next Warren Buffett. Diversification is still important and a sound understanding of the securities in which you invest is essential. Buying the stock of a company tail-spinning out of control is never a good idea no matter how far below NCAVPS it is trading. My advice is take what you've learned here as a starting point for further research and study. Knowledge is power, but a little bit of knowledge is dangerous.

Terreno Realty Corporation (TRNO)

I've put together a preliminary look at Terreno Realty Corporation (TRNO). The September 30 10-Q should be out in about a month and I'm anxious to see results of operation after acquiring some new real estate in the third quarter. Specifically, it will be interesting to see whether they've managed to secure additional tenants for their existing San Fransisco Bay property and what the occupancy rate of the newly acquired New Jersey property is.

TRNO is a newly organized corporation focused on acquiring, owning and operating industrial real estate in Los Angeles, New Jersey/New York, San Fransisco Bay, Seattle, Miami, and D.C./Baltimore. Financing for property buys in the first two quarters was 100% equity and it looks like financing in the third quarter was planned to be approximately 50/50 debt/equity.

An aerial view of the balance sheet at June 30, 2010:

Current Assets : $162.3 million
Land & Building: $12.6 million
Other Assets: $1.3 million
Total Assets $176.2 million

Liabilities: $7.9 million
Equity: $168.3 million
Total L&E: $176.2 million

TRNO reported a net loss for the first two quarters of 2010 and as with most real estate ventures, I don't anticipate a profit for some time to come. But considering that TRNO is so far leveraging these buys at less than 0.5 debt to equity, we should see cash flow from operations sooner rather than later if they can secure some solid real estate with high occupancy.

Without knowing enough about TRNO's current and prospective properties, it's difficult to say with certainty in this case, but in a broad sense the markets TRNO is attacking are arguably the most distressed real estate markets in the country. In theory, TRNO should have been (and should be) able to snatch some prime real estate at rock bottom prices. On the other hand, rock bottom relative to what? The hyper inflated prices before the crash or intrinsic value?

As for their leverage strategy, according to the June 30 10-Q the New Jersey property will be $36 million leveraged 50/50 at an interest rate of 5.19%. At current rates, one could argue that heavier leverage may be worth the risk for a potentially greater return on equity. Unless of course, further deflation is on the horizon.

Time will tell. I'm going to keep an eye on it for now.

Terreno Realty Corporation website

Warren Buffett's Big-Ass Blunder: Berkshire Hathaway

This interview with Warren Buffett from CNBC is a fascinating read. The moral of the story is that even the most successful investor of all time makes big-ass mistakes now and then. The only difference between Buffett's blunders and yours is that he takes that mistake and turn it into a $200 billion conglomerate. But you both put your pants on one let at a time; And that's what counts, right?

Warren Buffett says Berkshire Hathaway is the "dumbest" stock he ever bought.

He calls his 1964 decision to buy the textile company a $200 billion dollar blunder, sparked by a spiteful urge to retaliate against the CEO who tried to "chisel" Buffett out of an eighth of a point on a tender deal. 

Buffett tells the story in response to a question from CNBC's Becky Quick for a Squawk Box series on the biggest self-admitted mistakes by some of the world's most successful investors.

Buffett tells Becky that his holding company (presumably with a different name) would be "worth twice as much as it is now" — another $200 billion — if he had bought a good insurance company instead of dumping so much money into the dying textile business. 

Here's his story, as it appeared this morning in edited form on Squawk Box: 

BUFFETT:  The— the dumbest stock I ever bought— was— drum roll here— Berkshire Hathaway.  And— that may require a bit of explanation.  It was early in— 1962, and I was running a small partnership, about seven million.  They call it a hedge fund now. 

And here was this cheap stock, cheap by working capital standards or so.  But it was a stock in a— in a textile company that had been going downhill for years.  So it was a huge company originally, and they kept closing one mill after another.  And every time they would close a mill, they would— take the proceeds and they would buy in their stock.  And I figured they were gonna close, they only had a few mills left, but that they would close another one.  I'd buy the stock.  I'd tender it to them and make a small profit. 

So I started buying the stock.  And in 1964, we had quite a bit of stock.  And I went back and visited the management,  Mr. (Seabury) Stanton.  And he looked at me and he said, ‘Mr. Buffett.  We've just sold some mills.  We got some excess money.  We're gonna have a tender offer.  And at what price will you tender your stock?’ 

And I said, ‘11.50.’  And he said, ‘Do you promise me that you'll tender it 11.50?’  And I said, ‘Mr. Stanton, you have my word that if you do it here in the near future, that I will sell my stock to— at 11.50.’  I went back to Omaha.  And a few weeks later, I opened the mail— 

BECKY:  Oh, you have this? 

BUFFETT:   And here it is:  a tender offer from Berkshire Hathaway— that's from 1964.  And if you look carefully, you'll see the price is— 

BECKY:  11 and— 

BUFFETT:   —11 and three-eighths.  He chiseled me for an eighth.  And if that letter had come through with 11 and a half, I would have tendered my stock.  But this made me mad.  So I went out and started buying the stock, and I bought control of the company, and fired Mr. Stanton.  (LAUGHTER) 

Now, that sounds like a great little morality table— tale at this point.  But the truth is I had now committed a major amount of money to a terrible business.  And Berkshire Hathaway became the base for everything pretty much that I've done since.  So in 1967, when a good insurance company came along, I bought it for Berkshire Hathaway.  I really should— should have bought it for a new entity. 

Because Berkshire Hathaway was carrying this anchor, all these textile assets.  So initially, it was all textile assets that weren't any good.  And then, gradually, we built more things on to it.  But always, we were carrying this anchor.  And for 20 years, I fought the textile business before I gave up.  As instead of putting that money into the textile business originally, we just started out with the insurance company, Berkshire would be worth twice as much as it is now.  So— 

BECKY:  Twice as much? 

BUFFETT:  Yeah.  This is $200 billion.  You can— you can figure that— comes about.  Because the genius here thought he could run a textile business. (LAUGHTER) 

BECKY:  Why $200 billion? 

BUFFETT:  Well, because if you look at taking that same money that I put into the textile business and just putting it into the insurance business, and starting from there, we would have had a company that— because all of this money was a drag.  I mean, we had to— a net worth of $20 million.  And Berkshire Hathaway was earning nothing, year after year after year after year.  And— so there you have it, the story of— a $200 billion— incidentally, if you come back in ten years, I may have one that's even worse.  (LAUGHTER) 

Nod to Greenbackd for picking up on this.

Impairment Loss: School Specialty, Inc.

School Specialty, Inc. (SCHS) may be worth looking at. The company recorded a huge $441 million non-cash impairment loss in the quarter ended July 2010 which annihilated operating income.

I'll never understand how an impairment loss can be considered part of operating income, but nevertheless, that loss, coupled with decreased revenue due to state and local budget deficits and funding pressure has depressed SCHS stock price considerably in 2010, perhaps far below intrinsic value.

SCHS closed at $13.87 vs. the $34 it was trading at in August of 2008.  The company has a solid history of financial health, profitability and free cash flow. Though it remains to be seen if SCHS's slow recovery is a product of a slow recovery by state and local governments, or if the company's current troubles are an indication of a more fundamental problem in its product and strategy.

Check out Seeking Alpha for more about School Specialty, Inc. and its industry or you can check out the SEC filings here for your own further research.

Talecris Biotherapeutics Holdings Corp (TLCR)

Grifols is set to acquire Talecris Biotherapeutics Holdings Corp (TLCR) by the end of 2010 for $19 per share plus and 0.641 shares of newly issued Grifols stock for each share of TLCR.

It's a moving target, but I'm calculating $2.36 profit per share of TLCR based on the following as of the closing bell on October18, 2010:

TLCR:

Current price of TLCR: $24.00 / share

Shares of TLCR: 122.88 million

Market Cap: $2.95 billion

Closing Price:

Cash per share: $19 per share

Total cash: $2.33 billion

Current price of Grifols: $11.50 / share

Share value: $0.91 billion

Total closing price (cash and shares): $3.24 billion

Purchase Premium: $290 million

Premium Per Share of TLCR: $2.36

That's a non-annualized return of 9.8% or 47.0% annualized if closing happens by December 31, 2010.

More about the acquisition from Grifols' website:

Financial Details and Closing Conditions 

Grifols will acquire all of the common stock of Talecris for $19.00 in cash and 0.641 newly-issued non-voting Grifols´ shares for each Talecris share. Based on the closing price of Grifols´ ordinary shares as of June 4th 2010 and prevailing Euro-Dollar exchange rates, this represents an implied price of $26.16 per Talecris share, which constitutes a premium of 53% to the average closing price of Talecris common stock over the last 30 days. The total implied offer value for Talecris is $3.4bn (€2.8bn) and the resulting transaction value, including net debt, is approximately US$4.0 billion (€3.3 billion). 

The newly-issued non-voting Grifols shares will be listed on the NASDAQ Global Market and the Mercado Continuo (Spain) and will carry the same dividend and economic rights as Grifols´ ordinary shares. The Boards of Directors of both Grifols and Talecris have unanimously approved the transaction and recommended it to their respective shareholders. 

The acquisition is expected to generate approximately $230 million in operating synergies from a more efficient plasma collection network, optimized manufacturing sales, marketing and R&D, which Grifols expects to realize over the next four years with an associated one-time cost of $100 million. The transaction is expected to be accretive to earnings in the first year and produce meaningful accretion from year two. The combined company will have pro-forma annual revenues of approximately $2.8 billion with 58% coming from North America, 28% from Europe and 14% from the rest of the world. 

The transaction´s financing is fully committed by a syndicate led by Deutsche Bank, Nomura, BBVA, BNP Paribas, HSBC and Morgan Stanley. The merger agreement has no financing contingency. After the transaction, Grifols anticipates that its initial net debt to EBITDA ratio will reach approximately five times. Grifols expects the combined company to generate significant free cash flow over the near term, which together with the synergies will enable it to reduce leverage rapidly. Grifols expects a progressive reduction in debt ratios to approximately three times EBITDA by year-end 2012 and below two times by year-end 2014 even as key capital programs are sustained. 

The transaction is subject to customary closing conditions, including antitrust and regulatory review, and requires the approval of each company´s shareholders. The leading shareholders of Grifols have agreed to vote their shares in favor of the transaction and an affiliate of Cerberus Capital Management, L.P., which owns approximately 49% of the outstanding Talecris common stock, has entered a similar agreement. The transaction is expected to close in the second half of 2010. 

Astro-Med, Inc. (ALOT)

I'm going to take a closer look at this one soon, but in the mean time, here are some quick stats on Astro-Med, Inc. (ALOT):

Market stats

• Shares: 7.36 million
• Price: $6.75/share
• Net current asset value: $5.16/share
• Average volume: 3,000 shares

Commentary on financial health:

• Revenue growth 4 out of the last 5 years, although it dipped by 11% in fiscal year end Jan-2010.
• Operating and net income have been steady and in the black for the last 5 years.
• Positive free cash flow 4 out of 5 years. The one off year was prior to the recession.
• 4.15% dividend yield.

I'm not sure what to make of this one yet. Two things that piqued my interest are that 1) it looks like the company decided to forgo their 4th quarter dividend in year-end January 2010 and 2) the trading volume is at rock bottom. So, at first glance I see a solid company financially that may have been unfairly judged by the market for skipping a dividend; and I see that the company is virtually ignored with an average trading volume of 3,000 shares per day.

That sounds like a recipe for value. As always, though, I'm withholding judgement until I have a chance to do some due diligence. I like to publish these ahead of time in case you want to follow along and compare the results of your own research.

Follow-up: Actions Semiconductor Co., Ltd. (ACTS)

In a recent post, I identified ACTS as a potential bargain buy, conditionally.

At the time of my last post, ACTS's ADS shares were trading at $2.10 or 0.828 of net current asset value. The company has a history of positive free cash flow and operating income so it looked at least promising.

Well, as I said I would, I had a chance to read through the FYE 2009 statements today and it turns out ACTS is not quite as attractive as it sounded at first. Here's why:

Actions Semiconductor Co., Ltd. is a Chinese company that makes semiconductors (surprise, surprise) for portable media devices. ACTS had a fair amount of success with a product line that provided for tremendous growth of the company in the early and mid 2000's. But they are struggling now for a few reasons:

1. ACTS's semiconductors apparently only work in dedicated portable media devices. In other words, their product is not compatible with newer smart devices that perform a range of functions like telephone, text, internet, music, etc. This may not have been a problem in 2002, but times have changed and depending on who you ask, the stand-alone mp3 player is on its way out.
2. ACTS is behind the technological curve when it comes to multi-function portable devices. They simply do not have product to compete in that market. They need new semiconductors and it's going to take a pile of R&D time and money to make this problem go away (if they can make it go away). Management has acknowledged that they are nowhere near accomplishing this and new product development will likely take years with no guarantee of success.
3. The company grew too fast and developed too many customer and vendor concentrations. Now that the mp3 player industry has come back to reality from its golden age in the mid 2000's and consumers are starting to demand devices with more functionality, ACTS, its customers, and its vendors are finding themselves at a serious crossroads where adapting to the changing market is crucial.

My conclusions are as follows:

Yes, ACTS is trading below net current asset value, but with too much baggage for me to consider it a low risk investment. The company is having trouble keeping up with technological advances but does not have the option of simply riding into the sunset on a cash cow; their cash cow is quickly becoming obsolete. So their only viable option is to throw research and development at the wall and see what sticks, or liquidate. It doesn't sound like ACTS is going to throw in the towel anytime soon, and I'm not willing to finance their cold and lonely climb back into technological relevance.

It looks like at the very least ACTS will need to operate at a loss for a few more years before seeing the benefits from an increase in R&D expenditures. At that point, we're no longer talking about value; we're talking about speculation.

Actions Semiconductor Co., Ltd. (ACTS)

UPDATE: read my follow-up to this post here.

I'm going to have a look at the reports tomorrow, but from what I've gathered so far, ACTS appears to be a steal.

Current Price: 2.10
Shares: 86M
Market Cap: 180.6M
Cash, A/R, & Investments: 230M
Total Liabilities: 12M
Net Current Asset Value: 218M

Which means, ACTS is currently trading at 0.828 of net current asset value.

More on the plus side: although steadily decreasing, operating income and free cash flow have been in the black for at least 5 years, 3 years of stock buy-backs, and they do not appear to be taking on new debt in order to finance their declining revenues.

My reservations so far: I haven't been able to see YTD financials yet, revenues have trailed off steadily (significantly) over the last 5 years, and the company had a net loss for the first time in 5 years in 2009. Not sure what's up there.

I'll post again when I've had a chance to check it out further.

Whose Means?

What can someone else do with my $10 that I am not able to do myself?

Well, quite a bit actually. In fact, when you get right down to it, this is essentially why stock market exists.

When I purchase a stock, I am engaging in the transaction based on an assumption that the company I am investing in is better suited to make effective use of my capital than I am. I am wagering that my $10 will be put to better use by the company than I would otherwise on my own.

In theory, every time one considers a new investment, the question should be asked, "can I achieve a greater return on capital by my own means, or do I believe that this company will employ my capital in a more efficient and effective manner than I can?"

To illustrate my point, imagine that I own and manage a successful accounting practice. One day, a friend offers me a role as a silent partner in his new lemonade stand franchise if I would be willing to provide some venture capital to get his business off the ground.

Assuming that I have limited capital, how do decide whether financing my friend's lemonade stand is a sound investment decision?

There are two kinds of questions I should be prepared to answer before I make my decision:

The obvious questions

1. What kind of return on equity do I expect from my friend's lemonade stand?
2. Does my friend seem to have a good business model?
3. Do I know anything about my friends business history? Has he done well in the past? Do I anticipate he will succeed in the future?
4. Will I receive a fair share of equity in the lemonade stand proportionate to my investment?
5. Will the lemonade stand pay a dividend from earnings?
6. Etc.

The not-so-obvious questions

1. What is the current return on equity of my accounting practice?
2. Is there room for growth in my accounting practice or do I feel that acquiring additional market share will be costly?
3. How is my accounting practice's cash flow? Do I need the extra capital to satisfy my current or long-term liabilities?
4. Will an infusion of capital in my accounting practice allow me to better position myself for industry changes?
5. Am I diversified, or does having my capital tied up in my accounting practice leave me exposed to sudden changes in the market or extraordinary events?
6. Etc.

Of course this process will be different for everyone and for every investment decision, and indeed, unless you manage your own business the scale will usually weigh heavily in favor of investing beyond your own means of production, but the questions should be asked nevertheless. If nothing else, it is a good exercise in evaluating the viability of an investment.

Stock Pick: Exterran Partners, LP

EXLP: Exterran Partners, LP

Here is a stock I've been having success with for the past few months:

I got in most recently at about $21.60 on that upswing from the low trough in September. Since then, EXLP has risen to $23.43 at the closing bell on October 12, 2010. That is about 8.5% in just a few weeks! Not bad!

What I like about EXLP is that it is a solid company with very healthy financials. Here are some key stats for FYE 2009:

P/E Ratio: 34.56 

Capital Expenditures: 18M

Free Cash Flow: 38M

Current Ratio: 1.2

Debt/Equity: 2.01

3 Yr Revenue Growth: 31%

3 Yr Operating Income Growth: 5%

The consistent growth in revenue and operating income is a good sign, no-brainer. But considering also that the company continues to invest in capital assets (capital expenditures of 18M) and maintains positive free cash flow (38M) and a healthy current ratio, I'd say we have at least a candidate for value.

The P/E Ratio concerns me a little, but I'm still anticipating a rebound from the most recent low back to $26 or $27 before the next dividend early November. I'll probably exit partially at $24.50 and the rest somewhere between $25.25 and $26.00.

Oh, and I almost forgot to mention. EXLP maintained a steady dividend through the 2008 crash and in fact increased its dividend in December 2008 when the market was at its lowest.

I think there is considerable opportunity to ride this one further, but watch out for a brief retraction after dividends are declared in November. After that, it will probably be worth taking another look for re-entry.

Chart courtesy of freestockcharts.com

Tips for Value Investors - #2: Understand the Price-Earnings Ratio

The P/E Ratio of a stock is simply its current share price divided by the company's earnings per share for the previous twelve months.

(P/E Ratio) = (Stock Price) / (Earnings Per Share)

For example, Stock A is trading at $48 per share, and reported $2 earnings per share for the trailing twelve months, i.e. the most recent twelve months. We then calculate Stock A's P/E ratio at 24.

Great... So what does this mean, exactly?

To help explain why this is a fundamentally important concept for value investors, let's look at two similar stocks in the same industry. We'll call them Stock A and Stock B.

Example 1: Assume that Stock A and Stock B are identical in all areas: financial health, dividend yield, current ratio, revenue growth, etc. Except that, Stock A has a Price-Earnings Ratio of double that of Stock B. Now take another look at the formula above. If Stock A's P/E is double Stock B, what does that tell us? Well, it tells us that one of two things (or a combination of both) must be true: either Stock A is trading at a higher price than Stock B, or its earnings per share is less than Stock B's.

Think about that for a minute. If, as we have already said, the two companies are nearly identical, why should we be willing to pay more for Stock A returning a lower earnings per share?

What makes the P/E Ratio so useful is that it allows the investor to take two similar companies in the same industry and compare their prices on even terms.

Here is another example:

Example 2: Assume the same facts as in example 1 above, except that now we know that Stock A is currently trading at $50 per share and reported earnings per share of $2 per share in the trailing twelve. And we also know that Stock B is trading at $24 and reported earnings per share of $0.50.

The novice investor might look at the two similar companies and suppose that Stock B trading at $24 is the better deal. However, if we compare the two stocks' P/E Ratio, we find that Stock A has a P/E of 25 ($50 price / $2 EPS) and Stock B has a P/E of 48 ($24 price / $0.50 EPS). Knowing this, we must reevaluate the situation and consider that Stock A may in fact be the better bargain, even though it is trading at a higher price.

Of course in the real world, we don't find identical companies so the P/E Ratio cannot provide us with the be-all end-all measurement for stock value. But here are a few take-aways when you're looking at P/E Ratios:

1. Always compare a company's P/E Ratio with the average for other companies in its industry.
2. Look at the company's most recent earnings and consider whether any abnormal fluctuations in earnings may have skewed the P/E Ratio. For example, if a company reported profits for the trailing twelve months of far greater than it averaged over the last five years, you have to ask yourself whether the P/E may be artificially deflated as a result, making the stock look more attractive than it actually is.
3. A great way to screen stocks for value is to look at the P/E Ratio along with the Price to Book Ratio and Price to Sales Ratio. I will add posts on these soon, here.
4. With all this said, my last piece of advice is that you not place too much emphasis on the P/E. You may hear other investors quote rules of thumb like "anything above 20 P/E is overpriced." Forget that. Just remember that no one indicator is the most import. Value investing and stock analysis is a big-picture process. Don't get yourself bogged down in the details.

Happy investing!

What do you think about the P/E Ratio? Is there anything I missed or got wrong, in your opinion? Let me know in the comments.

The Power of Compound Interest

It has been said that:

The most powerful force in the universe is compound interest. - Albert Einstein 

And just in case you do not yet grasp exactly how right Einstein was, I'd like to show you something:

The Power of Compounding Interest

Scenario # 1: Paul P. Procrastinator

Assume that Paul has a lot going on in his life an he just can not spare any cash to invest until he turns 40. At age 40, paul has a mid-life crisis because he realizes he hasn't saved a dime for retirement. So Paul makes some life changes and starts investing $5,000 per year, for 20 years until age 59. Assuming Paul earns a return on investment of 7%, he will have a modest little nest egg of $219,326. That is $100,000 invested over 20 years, plus earnings of $119,326.

Not bad, you say

Now here is the fun part.

Scenario # 2: Frederick F. Frugal

Fred has his life together from the day he leaves college and he wants to start investing for retirement immediately. Fred starts socking away $5,000 per year, just like Paul. However Fred starts at age 22 and saves for only 10 years. If Fred enjoys the same 7% return on his investment that Paul earned, Fred will have a whopping $491,469 by the time he reaches age 59, or $50,000 of principal invested and $441,469 earned.

Now think about that. By starting early, Fred was able to save $50,000 less than Paul and still out-pace Paul's retirement savings by $272,143.

Read that again until you fully grasp what Einstein was saying. Then take a good hard look at your life and where you stand financially. I'm not telling you this to freak you out; you should always remember that it's never too late to start saving. I'm just trying to get the point across that, perhaps more importantly, it's never too early either.

Tips for Value Investors - #1: What is Value Investing?

What is value investing?

Value investing in the most simplest of terms is an investing strategy that involves purchasing securities that are perceived to be undervalued at their current price based on an underlying fundamental analysis of the company and the price of its securities.

The philosophy is based on the the idea that certain securities will be undervalued by the general public for two reason:

1. The security has been neglected, i.e. the market has largely not considered the security and therefore a lack of demand for the security has caused an inconsistency between its current market price and its fundamental underlying value.
2. Or, the security has been judged unfavorably by the market for one reason or another that the value investor may consider unwarranted or exaggerated. For example, the vastly deflated prices we saw after the 2008 crash was likely the result of a market overreaction and the value investor sees this as an opportunity to find solid securities at bargain prices.

With that said, the various strategies for exactly how one might identify these undervalued securities can be somewhat more complicated and will be the subject of my ongoing series: Tips for Value Investors.

Value investing is usually attributed to Benjamin Graham and David Dodd who began teaching the philosophy of investing in 1928 and eventually put their ideas forth in the now famous book Security Analysis originally published in 1934.

You might suspect that a book on securities investing published in 1934 might be somewhat outdated at this point. And, to an extent, you would be correct. Certainly the investing landscape has changed since then and indeed a strict adherence to value investing as Graham and Dodd have put it forth would be a less than comprehensive investing approach.

However, the fundamental concept of buying securities of financially sound companies at bargain prices remains to this day a solid basis for investing. In fact, many of the most successful investors have been students and proponents of value investing, including Warren Buffett, one of the richest men in the world.

Stay tuned for upcoming tips for value investors!