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Thursday, April 25, 2013

Mechanical Value

Although my base approach to the markets should be pretty well known to all by now I am constantly investigating, testing and evaluating other approaches. Most are modifications and variations on a value theme as I am intellectually incapable of abandoning my value beliefs and vulture tendencies. I have no intention of missing a baseball game or my afternoon nap to stay peeled to screen trading all day and I am just not capable of paying of paying enormous multiples for hopes and dreams as many growth and momentum investors do on a regular basis. Almost all of my research involves at its buying core stocks that are beaten down contrarian ideas or buying cheap assets.

One idea that I have been working with of late involves buying stocks that trade for less than 90% of book value and have a reasonable capital structure. Most back testing uses the idea of holding over various time periods and reformatting the portfolio. In this case I have adjusted the approach to sell based on the variable itself. The stocks in the system are sold when the price crosses above book value or debt levels exceed certain thresholds. If book value grows faster than price you will hold the stock for a long period of time. If the price pops above book in a month or two then the stock is sold right away.

I began thinking about this approach after watching several stocks like Kimball International trade form a deep discount to book value, run up over book and then sell off once again to a discounted price. Some stocks continually improve and you get a long run as book value grows but others trade between cheap and fairly valued on a regular basis and selling based on variables rather than time helps catch these profits. It has a combination of long term core holdings and shorter term profit taking based on fundamentals that might allow us to catch the best of both worlds. It is also purely mechanical so it over rides some of my less than brilliant over rides.

It is instructive to spend some time looking at the stocks that currently qualify for this approach. The firs stock is one that I have applied my brilliant over rides to over the past two years and it has cost me money. Genworth Financial (GNW)is an insurance and financial services firm that has been struggling back from the depths of near failure and the stock has done well. It is still the cheapest stock in the system with the shares trading at just 30% of tangible book value. The mortgage insurance unit that caused most of the problems is now fueling the recovery of Genworth and has now been organized as a spate unit under the braider corporate umbrella. They plan to sell the Australian mortgage unit later this year in an IPO and are also selling the wealth management business. They will use the proceeds from both deals to reduce debt. The life insurance and long term care businesses will recover at a slow rate as it takes time for the economy to fully recover but the company as a whole should see decent earnings growth this year and next. The stock has to triple to hit book value and will be a huge winner for the system if it reaches that level over the next few years.

I haven’t purchased shares of Hutchinson Technology (HTCH) in the past couple of years either and the stock has performed well since a better than expected earnings report late last year. In spite of the price improvement the stock is still the second cheapest stock in our systems portfolio trading at just 50% of tangible book value. The company is the leading manufacturer of suspension assemblies for hard drives and is slowly recovering along with the computer business. They will probably continue to report losses for the next few quarters but could see a significant recovery as storage demand is going to increase at a strong pace and the PC business will eventually see pent up demand hit the marketplace.

These are the two cheapest stocks in the system. . The quick and dirty back tests of this approach show a long term return substantially better than the market and more than 10 times the markets feeble returns over the past decade. It seems to me that this is worth further research and consideration.

. I am fascinated by this approach and am planning to dedicate more research time and effort in this direction. It removes emotions and second guessing from the process and the early quick and dirty results are promising. My programming and data skills are sadly lacking but I think I can torture the data long enough to see how well this works over time As a bonus it also helps identify some cheap stocks I might have otherwise overlooked.

One of the benefits of a mechanical system is that it over rides the human element and buys stocks I might have avoided. This is certainly the case with shares of Career Education (CECO). Although I never shorted this particular stock I have been betting against the education stocks for the better part of three years and am still not excited about the industry. However this stock is uber cheap at 30% of tangible book value and management is attempting to right the ship amidst the storm. They are closing campuses and cutting jobs. The cost cutting measures should save them about %50 million a year. That is about a third of what they lost last year so the business will have to get better as well for the stock to recover. The for profit education business in the United States will continue to decline but the company is seeing growth in its international schools. The system doesn’t address profit or potential yet and the stock qualifies so into the portfolio it goes.

The same “probably not” characteristics apply to at least two other stocks in the portfolio. I have made money with Imation (IMN) in the past as it has been a perennial net-net and book value stock. As cheap as the shares are at 60% of tangible book value the business is terrible and they are selling the audio and video accessories business.  The tape storage business is in decline and the company’s attempts to enter the data security and mobile storage markets are going to be an uphill climb. However it qualifies so into the portfolio it goes.

Neutral Tandem (IQNT) would not have made it into my discretionary portfolio either as I tend to avoid the network services companies as it is a fiercely competitive field that I simply do not understand that well. However they do provide Internet Protocol (IP) transfer services and I am told that is a promising market. The have 120 Ethernet hubs on 4 continents and do business in 80 countries around the world. A large customer just revised its contract for voice services at much lower rates and that is going to pressure sales and profits this year. Analysts seem to expect the data business to improve next year and see the new EtherCloud connection product gaining greater acceptance. They have no long term debt and the shares are trading hands at 50% of tangible book value so we are mechanical buyers of the stock.

Tellabs (TLAB) is a stock I have owned for some time and often suspect I will own if forever as the company has struggled to remain profitable much less grow. Their relationship with AT&T for its telecommunication s voice and data equipment has been lessened over the past few years and the European markets will be slow for several more quarters at least. The stock rallied a bit last year when the company paid a special $1 a share dividend but the operating results have caused steady selling since the beginning of 2013. As is the case with many cheap stocks there is nothing going on expect the valuation itself. The stock trades at 70% of tangible book value, has no debt and trades for a little less than the cash per share on the balance sheet. I own it and so does our mechanical value portfolio.

Now lets examine a few of the models picks about which I am more enthusiastic and would be happy to include in discretionary accounts.

Hartford Financial Services (HIG) is one of the stocks that I hope misses’ earnings horribly and the stock takes a whacking. The restructuring is ahead of schedule, they have disposed of several wealth management divisions and the annuity run off appears to be going as expected. The individual life insurance business is gone and they are concentrating on the property and casualty business. They are one of the largest P&C companies in the United States and they have a robust commercial lines business. Most of their personal lines business comes from a relationship with AARP. The stock is cheap at 50% of tangible book value and the upside in the stock is enormous. Here is where a mechanical approach would serve me better as the stock is trading near 52 week highs and that makes it very hard psychologically for me to pull the trigger. I own a lot less of this stock than I should at this point.

I have a similar problem with Lincoln National (LNC). The stock is very cheap at 70% of tangible book and I was a buyer of the shares last year so I have a nice gain and I just have a natural repulsion to buying near the highs of the year. The company has managed its way through the very difficult few years of the credit crisis and business is picking up in their life insurance and retirement plans operations.  They have a heavy exposure to the stock market as many of their products are equity linked which could make the shares more volatile abut it is a solid company and the stock is cheap.

I owned shares of Real Network  (RNWK)back in 2010and did fairly well with them. The stock is now trading back down near the net cash levels and is worth adding to a long term value portfolio again. The company is searching for an identity and needs new products to reinvigorate any hope of growth but the parts here are worth more than the sum the stock market is attaching to the company. If you read the last years headlines carefully you will see that the makeup of the board has been changing and they have added experienced entrepreneurs and finance types as they try to remake the company. If they succeed the stock could be a huge winner. If they fail the company can be liquidated for about 30% more than the current stock price.

We had a solid winner last year with shares of Kimball International (KBALB) as I sold the stock after an incredibly fast double during the year. As series of unfortunate events including a large purchase of raw materials for an order that was never fulfilled and a slowdown in government sales in the furniture division have pushed the shares back down to 80% of tangible book value. The electronics manufacturing segment is seeing strong demand from several sectors most notably the auto industry and this could well be the driver of growth for now. The furniture division is probably going to see more weakness as result of sequester and budget changes. They have plenty of cash on hand and the balance sheet is solid. I like the stock and will be a buyer once again if and when the stock market finally has a pullback.

The mechanical quantitative approach to value investing is intriguing and I will be doing more research along these lines in the upcoming months. As a bonus researching the model is producing some stock picks that can be used even in the most discretionary of accounts.

originally published as series on Real Money 4-9 to 4_11

1 comment:

BB Canada said...

Interesting article and I've considered the same, but in my cursory looking, the I wonder if the large losses that could occur will overwhelm the generally steady profits - say buying Genworth at 90% of BV in 2007 in the high $20's, then watching it crash to under $2.

A couple of suggestions you probably have thought have, but wanted to mention anyhow:

Once stocks start falling below book value, they often continue far lower. I think you'd want to consider tiered purchases (eg. 1/3 at 90%, 1/3 at 80%, 1/3 at 60%) to minimize drawdowns.

Also, if you have the data, you might want to consider instead buying stocks which are at 50% of their traditional P/B to take into account that different valuation models.