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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.

Thursday, September 20, 2012

Buying on the Cheap

The business that I think is the most interesting and exciting over the next decade is the real estate business. We have seen prices collapse over the past four years as the credit crisis unfolded. Sales have shown some signs of picking up but are still well below the historical norm. Commercial Real Estate is still suffering from high occupancy rates and many have stayed foreclosure only by perfecting the game of extend and pretend. The brokers and agents I talk to around the country tell me that outside of major markets like New York, Boston and Washington DC it is much harder to make a living. The number of agents and brokers has declined over the past four years simply because it is a much tougher way to make a living than it was in the boom.

When an industry falls apart the way real estate has the most important question you have to ask is if the business is necessary and will come back when the cycle changes. In the case of buggy whip manufacturers or beta max video cassettes the answer was no, the business was no longer necessary and would not experience another positive cycle.  When the oil industry sold off in the 90s as oil went below $20 the answer was that the industry was necessary and would see an eventual turn upwards. A lot of money was made by long term investors who got into the oil business when the conditions were poor and the outlook muted. I think this is the case for the real estate business today.

Over the past several years I have been aggressively a buyer of real estate related securities with mixed results. Some like management and investment company WP Carey (WPC) have done very well. Others like Commonwealth REIT (CWH) have not done as well in the shorter term. In my personal and client accounts we own hotels, retail malls and office buildings though REITs like Sunstone (SHO), Ashford Hospitality (AHT), Kite Realty (KRG) and others. We have exposure to the brokerage and consulting business through our stake in BGC Partners (BGCP). We also have exposure to both CRE financing and residential mortgages through stakes in Northstar (NRF) and Invesco Mortgage (IVR). I love everything about the industry and have been able to get invested when the issues were safe and cheap. Unless the world truly ends I expect to do extremely well with these positions.

When I was running my cheap stock screens this week I noticed another name I will be adding to portfolios. Brookfield Office Properties (BPO) currently sells at just 80% of tangible book value. I think this is an attractive entry point for a collection of premier properties in some of the world’s best markets. They have 122 properties totaling over 80 million square feet of office space including some of the worlds best known buildings. In New York alone they have more than 19 million square feet and almost 8 million in the strong Washington DC marketplace.

Because of their prominent position in key markets they have a 93% occupancy rate and their average tenant has an A credit ratings. If not for the semi distressed LA Market the occupancy rate would be much higher. Even in that market it is worth noting that the company as a 15% vacancy rate while the average building is 20%. The average lease still has more than 7 years until expiration so much of their cash flow is locked in for a substantial period of time. The leases that are rolling over in the next few years are priced about 20% below current rates so there is some upside potential for revenues via rent increases. In 2013 they have more than 3 million square feet of space expiring in the World financial center in Manhattan. Although many view this as a significant challenge I think it may well turn out to be an upgrade in cash flow for the company. They have had no problem leasing space in other New York properties and I think that 3 million square feet will lease up quicker than many expect.

This is a world class collection of office properties available for less than the tangible book value of the underlying real estate. The dividend yield is a little lower than I like in a REIT and just 3.6% but if world does not end the dividend will gown and the value of these properties should take the shares much high rover the next decade. At the current price I think it is safe and cheap. Investors who like the real estate business should start scaling into the stock.

Friday, September 14, 2012

Pigs and Dividends

I made a remark the other day on twitter that has drawn a few comments from friends and associates during our never ending discussion of all things market and baseball. I said that the amount of intellect and energy spent on guessing the short term fluctuations in the value of corporation was staggering. Given that many, if not most, of those trying to game the underlying corporate value on a daily basis fail to beat the market itself it would seem to me that much of it is wasted. Some of my more active friends took umbrage to my remarks and insisted that my approach is not practical or realistic. Waiting for the markets to fall before becoming an aggressive buyer is foolish they scolded me and causes one to miss the big moves.

Clearly I disagree. Since I first read the story of Mr. Womack the pig farmer as a new broker back in the 1980s buying big down moves in the market just makes sense to me.  For those of you not familiar with my pig farmer friend he was introduced by John Train in an article in 1978. Mr. Womack would come into town when the markets were in a free fall and buy several profitable dividend paying companies that had fallen below $10 a share. He would hold them for a few years and when the news was all sunshine and candy he would sell his stocks for very large gains. He treated stocks like pigs and bought them when the market was weak and sold them during BBQ season. As a bonus Mr. Womack was quick to point out that pigs don’t pay dividends.

History is on my side of the argument as well. At least once a year we get a stock market decline of between 10 and 15% from the highs. Every couple of year we get one between 15 and 20% and around every three years or so we get one of those gut ripping bear markets that drag prices down more than 20% peak to valley. If you wait for prices to drop to the 10% level to really ramp up your buying activity and scale in as the market continues to fall you will be able to buy stocks far cheaper than the buy everyday crowd. If you plan to own them for a period of years, as I do, paying a lower price as a result of a market decline almost has to lead to higher returns.

I do not want to make this sound too easy. Look at the period from April to June of this year. The market fell roughly 10%, a regular occurrence if you are a student of market history. Yet if you were listening to the financial press or reading the papers it seemed that the world was going to end. In 2011 we saw a steeper selloff from August into October of roughly 19% and the doom and gloom was so thick you could cut it with a knife. Even if you started buying with the market down 10% and scaled in you have done much better than the market since that time. If you just added at every 5% additional decline you would have been in the market at a cost of 1160 on the S$P 500 and sitting on an 18% gain as of today. That’s better than almost all mutual funds over the past year and even bests the average hedge fund by a wide margin. That is accomplished by just buying the market itself without applying any valuation principles.

The real hard part comes from the simple fact that you will never catch the dead bottom of a market. If you do it was a fortunate accident. Consider the meltdown of 2008 to 2009. The ultimate drawdown was greater than 50%.  If you focus on safe and cheap stocks and believe that the world is not going to end the additional adverse excursion is just a chance to scale into sound investments at better prices.

An enormous amount of activity goes into try to trade and time the market on a daily basis. If you look at the overall returns of the hedge funds and mutual funds that engage in such activity most of them are not outperforming the buy despair and sell optimism distressed and value types like  Wilbur Ross and Howard Marks.  In my experience there are very few great traders and not many that good ones. The good ones all have extraordinary math skills and huge computing power that most of us cannot match. I cannot go head to head with James Simons and his specially cooled computer room. I can buy stocks with solid balance sheets below the realizable asset value when everyone is panicking and sell when Mr. Market cheers up.  History tells me that will fare better than most of the frenetic trading I see every day. 

Monday, September 10, 2012

Little Banks, Big Profits

Earlier this week I was lounging around Chez Melvin, contemplating the Orioles playoff chances, reading some brain candy novel and generally minding my own business. This was of course the moment that the Voo-Doo professor chose to share his latest project and sent me a spreadsheet of small bank with less than a billion in assets.  Dr. McNabb  is apparently looking at the same set of facts I used to establish my trade of the decade thesis. Increased compliance costs are going to make it difficult for these banks going forward so they are going to have to seek a merger partner in the very near future. When I spoke with him this morning he said, “With the writers of Dodd Frank favoring the same industry leaders that required a bailout, the small banks will become targets as they will find it easier to sell out than comply with the weight of regulatory excess and loss of business discretion and judgment to pursue opportunities in the marketplace.”

I also spoke to the good folks at FJ Capital the other day on this very subject. The firm runs a community bank stock focused hedge fund and views the market the same way. Managing Director Scoot Cottrell told me, “For many shareholders of community banks with a billion in assets and under, they will likely get better returns on their money from a sale of the bank.  In many cases, the returns that these banks post on equity will be single digits or worse – for a lot of investors, this is insufficient for the risk they take as equity investors.  Returns are going to be lower because many banks are being squeezed from all angles:  higher regulatory costs and higher capital requirements, compressed net interest margins, slow loan growth, still elevated credit costs and regulatory opposition to higher fee income.  While there is definitely a group of smaller banks that will be able to re-invent themselves or survive due to lack of competition or a unique business niche, many smaller banks will be faced with the choice of delivering high returns to shareholders through a sale or paltry-to-dismal returns to shareholders by remaining independent.”

There is another solid reason to focus on the smaller banks. Earlier this week many of the same concerns led the board of Hudson City Bancorp (HCBK) to approve a takeover by M&T Bank (MTB) at a price below tangible book value. The deal should work out in the long run as it is a good fit for both banks. However as a shareholder I made pennies where I should have made dollars. The directors and officers, as well as members of the local community, of the smaller banks tend to have a significant portion of their net worth invested in their bank and are less liley to accept a take under offer. The small deals should be done at a multiple of tangible book value and not a fraction.

In comparing the Professors list of little banks and mine of safe and cheap banks I find a lot of shared names. One of the more intriguing is Berkshire Bancorp (BERK). The 11 branch bank has 11 branches in the New York Metropolitan area and about &880 million of assets. Insiders own 80% of the outstanding shares so no deal that doesn’t fit their objectives will ever get done. The bank is incredibly healthy with equity to assets ratio north of 14 and a nonperforming assets ratio of just .06%, one of the lowest I have seen since the banking crisis began. There will be interesting acquiring the bank but insiders will want a premium price. They are very well run so they may be one of those smaller institutions able to simply grow their way into dealing with higher costs and increased regulations. Either way with the stock trading at just 88% of tangible book value the shareholder should be rewarded with a much higher price over time.

Most of the banks that meet my selection criteria and also have less than $1 billion in assets are way too small to mention on Real Money. As part of constructing portfolios for the Trade of the decade I have been buying community banks with market caps of as little as $10 million. The average capitalization of the merged lists of Dr. McNabb and me looks to be less than $50 million. Your best research on these will be at the local Chamber of Commerce Happy Hour not on Wall Street. You can also use the information available at WWW.FDIC.Gov to check the latest financials and ratios for small banks. Community banks may not be the most exciting investment you ever make but over time they may well be the most profitable.

Thursday, September 06, 2012

Einsteinian Investing

 I just started reading the new book, The Einstein of Money, a biography on Benjamin Graham by Joe Carlen. It is enjoyable read as in addition to being the father of value investing graham was a fascinating individual. His autobiography is long out of print so if you never read it, pick up this book as soon as you can. In my reading I was reminded that shortly before his death graham told interviewers from Forbes and Medical Economic magazine that he had developed a set of ten stock selection criteria that handily beat the market. 

The criteria include such metric as price to book, debt levels, price to earnings ratios, and balance sheet strength. Only at the bottom of sever bear markets have I ever found a stock that met all criteria but mixing and matching from the ten has also been proven to uncover undervalued market beating stocks. The selection criteria have been exhaustively tested by academics and practitioners and a couple of combinations have proven most profitable.

One of the most successful by far searches for stock whose:

 Earnings yield is twice the AAA bond rate

 Have solid earnings growth

Have a dividend yield of at least two thirds of the AAA bond rate

Have solid balance sheets with a current ratio of more than 2 and debt less than the book value of assets.

With bond yields as low as they are the threshold for earnings and dividend yield is not that high. It works out to a PE of less than 15 and a yield of more than 1.4%. You would think that there would be a cornucopia of companies that meet the criteria. Surprisingly that simply is not the case. Just 45 US companies meet the criteria to be included in the portfolio.

My favorite stock on the list is one that has shown up before on one of my undiscovered growth stock lists. Orchard Tissue (TIS) makes private label paper products including bathroom tissue, paper towels and napkins. They distribute their products though discount stores grocery stores and convenience stores in the Midwest and Texas. The company has grown earnings at an average rate of more than 40% the past five years. SO far this year both sales and earnings have continued to grow at a double digit rate. It is the most basic of businesses that is run efficiently and profitable selling for a respectable price. As a bonus they doubled the dividend last year and the shares now yield more than 4.5%. This stock sits at the very top of my “ load the boat” in a selloff stock list.

Some big tech names make t heist as old school tech companies begin got understand the value of retuning actual cash to shareholders. The recent dividend announcement by Cisco is something I have been suggesting for several years now. Although I am sure that I H ad no influence whatsoever it was a great move by the networking giant. Trading at 12 times earnings with a rock solid balance sheets, dominate position in its industry and a sparkling 2.91% dividend yield this is now a stock worth considering for long term value investors. The same can be said of Intel (INTC) at ten times earnings and a yield of 3.6%.

My favorite name among the big cap techs that make the Graham list is Corning (GLW). They will play a leading role in the strongest growth areas of the tech economy. The substrate division makes glass used in flat screen TVs and monitors and the fiber optics part of the company provides the fiber and cable needed to build out and improve high speed networks. Corning also has a presence in the potentially high growth environmental technology and life sciences industries. The company has more than $3 billion of net cash and no debt maturing until 2017. The have been using cash and cash flow to buy back stock and recently increased the dividend. The stock is one of the every few that fits almost all of the Graham criteria and I think it is a screaming buy at current level for long term investors. The stock trades below tangible book value and has a PE ratio of just 8.1.  At the current price the dividend yield is 2.57%. I think long term investors will experience some price volatility in the short term but be rewarded with spectacular gains over the next five year.

Grahams stock selection methods have stood the test of time and still uncover bargains that can reward investors with gains of multiple snot percentages over time.Before we move on from the Graham stock selection criteria, I want to look at another recombination of his criteria that has provided solid results over the past 25 years or so that I have been around the markets. Instead of earnings yield this time we will focus on my favorite tool, price to book value. We then look for those that are profitable and pay dividends to assemble our list of stocks. This has been part of my approach for many years now and it works as well for me as it did for Graham many years ago.

Curiosity got the best of me this morning so I ran a quick and dirty back test of the approach.. Over the past 25 years this approach has yield an average annual return of 40% more than the broad market.  Only four years staying of fully invested and using this approach showed a loss and in the year following a loss the asset based approach outperformed the market by an average factor 3 to 1.  It requires a great deal of patience and discipline but it works extraordinarily well.

My first observation upon looking at the current list is that is it absolutely dominated by small banks. Of the 81 names returned by screen 34 of them were small community and regional banks. Most of them are my tiny banks but a few are large enough to be familiar to readers. Republic Bancorp (RBCAA) has risen in price since I first talked about the Kentucky based bank but it is still statistically cheap. Fox Chase Bancorp (FXCB) is not the most exciting stock I have ever owned but it has moved steadily higher and is still very cheap.  The nest bargain issues however are the smaller institutions. The industry faces short term headwinds but many of the stock are too cheap not to own.

One of the cheapest non-financial stocks on a book value basis is Kelly Services (KELYA). The staffing company currently trades at just 70% of tangible book value as a weak global economy weighs on the business and stock price. Not only has the company been profitable since the end of 2009 in a very weak global economy, Kelly has reported a full year loss just twice in the past 10 years and that was in the near depression years of 2008 and 2009. There is a slow recovery starting in job in the US although Europe remains weak. Much of the hiring is temporary and that favors Kelly Services. This is a too cheap not to own stock and one of my top picks for a tough market.

American Greeting (AM) is also a very cheap stock with the stock at 70% of tangible book value. The entire greeting card industry has suffered as much of the communication world has gone on line, However there will always be birthdays, anniversaries and other occasion where online simply will not do and eventually American Greetings should see its business recover. They are the second largest global and only publicly traded greeting card manufacturer. It is not a sexy or exciting business but it is a cheap stock with a solid balance sheet as evidenced by it Altman Z score of over 3. Greeting card sales will grow in line with the economy and when this happens the cost reductions and structural changes implemented over the past few years will turn the company into a steady growth stock with an increased valuation.

The stock selection techniques outlined by Benjamin Graham back in the 1970s still work today. Although many talk about the Graham approach to picking stocks almost no one actually uses his approach and that suits me just fine. Buying cheap stocks requires a great deal of fortitude and patience. As an Orioles fan and value investor I have perfected both traits.