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Tuesday, September 25, 2012

Be in the Business

I am just finishing up the new Ben Graham biography, The Einstein of Money, and I have to say it is a pretty good read.  One point that the author really brings home is Graham’s belief, later adopted by Warren Buffett and other successful value investors, is that we should look at a stock as if we are buying the entire company. All too often today stocks are viewed as just an electronic bet on the popularity of a particular company, sector or overall market. The average holding period for many investors is a period of days or even hours and such pure speculation is a difficult enterprise for individual investors computing against Doctors of Physics and Statistics armed with super computers.

I view my portfolio as a conglomerate of companies not a collection of bets.  When I find a cheap stock I ask several questions. Why is it cheap? Do the credit scores indicate a high likelihood of survival? What needs to happen for conditions to improve? And last, is this a business I want to be in for the long term? Adding this qualifier often keeps me out of value traps and companies with no real recovery hopes. A list to statistically cheap stocks usually includes small biotech’s trading for less than cash but no viable product and third tier semiconductor companies with no niche and decaying margins.  It also helps me cast a cynical eye towards potential buggy whip industries like brick and mortar computer stores and one hit wonder retailers on the way out.

Everything starts with valuation for me. Before a stock ends up in my portfolio it has to be safe and cheap before I will buy no matter how much I love the underlying business. I love everything about Amazon (AMZN) but will never pay a triple digit earnings multiple for a stock. Most of the time I look for company valuation first, and then consider the underlying business and industry. As with every rule there are exceptions to that rule.

There are some businesses I want to be in for the long run. I keep lists of companies in that business on my desk with the valuation calculations for each one. I compare my lists to the stock prices on a regular basis and look for an entry point into the stocks on a safe and cheap basis. I watch Mr. Market’s mood regarding these companies very closely hoping he will enter a temporary depressive sate and allow me an entry point.
One such industry is the community and regional banks.  The short term headwinds facing the industry are substantial as we all know. The higher cost of regulation and compliance combined with a seemingly permanent low net interest margin makes community banking a tough business right now. However those banks that have solid balance sheets, low loan losses and excess capital will be in the proverbial catbirds seat over the next decade. They can grow at the expense of weaker competitors; take market share from larger banks or just stay as they are and grow book value and dividend payouts. They can also just simply exit the business via a sale of their bank. Given their strong condition and local presence in their market they should be able to do so at a sizable premium to book value in a few years. I keep a list of these banks on my desktop and when they trade at 80% of tangible book, I buy the stock.

I also keep a list of infrastructure stocks on my desk. In spite of the current fiscal and political conditions in the US and around the globe I do not think the world will end. I think it will be difficult and as we have seen take longer than anticipated to get on back on track but we will eventually. When we do there will be enormous pent up demand for infrastructure projects. In the US we need an upgrade of our highways roads and bridges. The water supply and disposal systems of many of our major urban areas are practically antiques and need substantial repair and replacement work.  The electrical grid needs to be completely reworked to not only provide better service but improve our national security. Keeping a list of companies close helped me jump into stock like Granite Construction (GVA) and Mueller Water (MWA) in last year’s late summer sell off. At some point these stocks will be a boom sector with rapid profit and stock price growth and I want to buy them when the hit my price levels.

I base all my decisions first and for most on valuation but there are some businesses I want to be in and watch closely for the value to appear.Recently, amidst the flurry of pennant baseball, I spent some time thinking about other businesses and industries I might want to be in for the long term. I do not invest based solely on trends and expectations but I do keep lists of stocks that I think will benefit from social, demographic and economic trends over the next decade. If and when they fit the definition of safe and cheap I will gleefully buy them as I get a chance to double dip on value and anticipated growth opportunities. It is clear to me after some deep thought that the ravens will make another playoff run and I want to be in the energy business for a long time.

I know that many think that the alternative and green energy technologies are the place to be and I agree with them to a degree. However the time and place to be in that business is still a long way away as the technology is still not far enough along to provide the majority of our energy needs. At some point in the future I can see solar, biofuels, wind and other technologies providing most of our daily needs but I think that will happen in my son’s lifetime not mine. For now and the next two decades I want to be in the messy, dirty, grimy energy business, the one that digs up oil, gas and coal to meet the energy demands of the nation. Lower cost energy form domestic sources can go a long way to boosting out economy and at some point our energy policy will reflect that fact.

I want to own stock in a company like Tesco Corporation (TESO) for a long time. The company provides drilling technologies and services including top drives and tubular services. They sold their casing segment to Schlumberger (SLB)in April for $45 million in cash. The company pretty much invented the top drive rental market and continues to dominate that space today. Management has repeatedly stated that they are aiming at becoming the number one provider of top drive by 2015. They are also committed to further international expansion particularly in the tubular services division. It is also reasonable to assume that as Schlumberger continues to roll out case drilling units that Tesco will pick up incremental tubular products business as a result of their familiarity with the new technology.

The company has enormous growth potential but the stock is cheap at the current time. Tesco shares trade right at tangible book value with no long term debt and a current ratio of almost 3. The company has a Z score of over 4 and an F score of 6 so the company passes the standard metric for credit and potential. Viewing this though my going concern lenses, the stock trades at an EV/EBITDA ratio of less than 4 and at about 60% of my intrinsic value calculation. If energy demand were to pick up in the future a takeover announcement by a larger competitor would be less than a surprise to me.

The stock has fallen as a result of missing earnings and revenue expectation and is trading near the 52 week lows. I think you can either begin buying the stock outright at the current price or consider trying to sell the December $10 puts between the bid and the ask of $.70 to $.90. If you do decide to sell the puts use day orders only and check you option pricing daily until filled.

When I look to over the next decade it is clear to me that a recovering global economy will eventually drive energy demand growth. We are going to need to dig and drill to meet that need at a cost effective efficient basis. I want to be in the digging and drilling business by owning companies like Tesco that provide the tools and those that use the tools like EXCO Resources (XCO) and Nabors (NBR).Economic perceptions and oil market realities will provide some steep selloffs that create multiple chance to own the oil and gas business on a safe and cheap basis and I want to be ready to take advantage fo every opportunity Mr. Market creates.

Before we move on form the idea of being in the business you own I want to talk about some of the companies I have my eye on right now. I own a little of these in some accounts but am waiting for a pullback that gives me a chance to get loaded up on these names. The stocks are safe and cheap and their long term business prospects are just flat out exciting. These companies are out of favor at the moment but it looks to me like they have what it takes to be global growth leaders over the next decade. These are stocks I expect to be selling to momentum guys at many multiples of the current stock price at some point in the future.
I have a rule against falling in love with stocks but it is very hard not to break that rule when it comes to shares of Corning (GLW). This company’s products are used in what should be some of the most exciting markets over the next decade. The company provides glass for flat screen TV’s computer monitors and handheld devices including smartphones. That’s a huge market in and of itself that will substantial growth when the economy recovers over the next few years.  However this is only 35% of the total company.
Corning also manufactures optical Fiber and cable to the global telecommunications industry. Even in a weak economy the worlds demand for greater band width is insatiable and Corning provides the products that expand bandwidth.  Why take a chance buying Chinese stocks when you can own Corning and benefit from the demand for higher bandwidth and greater broadband penetration in the world’s largest country? It is no secret that I am not a tech guy but even I can understand the demand for broadband and increased bandwidth will be with us for quite some time to come. As a global leader in the space Corning will get its share of that growth.

The Environmental division makes glass for filters such as catalytic converters. Regulations in Europe japan and the United Sates make these types of filters mandatory for all newly manufactured autos and trucks. They also make ceramic supports that are used to scrub air form refineries, power plants, chemical plants and other pollution emitting fixed locations. Again increasing pollution control regulations throughout the globe will help drive sales and earnings growth for this division of the company.

8% of revenues come from products made for the life sciences industry. Corning glass products are used for a wide range of devices and tools used in biotechnology research and the production of bio products. Although a small division of the company the growth potential is obvious as more research is done every day for biotech answers to health and even energy problems around the globe.

Every segment of Corning’s business has exciting growth prospects over the next decade but the stock has been weak because they missed estimates and had a few soft quarters where business was below expectations. As a result of Wall Street’s short term attitude and forecasting difficulties the stock is cheap. Right now Corning shares trade at about 90% of tangible book value even after a recent bounce. The company has a total of more than $6 billion in cash and after subtracting debt they still have more than $3 billion of net cash. They are using the cash to buy back stock and also recently hiked the dividend by 20%.  The company should be able to increase free cash flow and earnings rapidly as the economy recovers and consumer demand for its glass products increases. A stronger global economy will also focus more attention on environmental concerns and that will help that division grow sales and profits.

The stock is safe and cheap and the company has almost unlimited growth prospects across its major business lines. I think you can buy a little here and scale in on market declines. This also a great candidate for backing into along position by selling the puts on cash secured basis. I would look at the January $12.50 contract to potentially create a long position below the current market price. Please not that although I like everything about this company and the stock price I am still going to stay small and move slower and scale into the stock allowing Mr. Markets mood swings to get me a better average cost.

Originally published as a Real Money series of articles.

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