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Monday, May 13, 2013

Follow The Teacher

All eyes have been on Warren Buffett since the Berkshire meeting where he is lauded as the greatest investor ever. Thats probably true but it is not correct to call him a value investor these days.Warren Buffett has not been a Graham like value investor for decades now. Although he launched his fortune using that approach he simply became too large to stick with it. Warren is not really even a stock market guy any longer as his business is run more like a private equity conglomerate than anything else. He is a very good investor to be sure. He is however the greatest business man in history. He no longer picks stocks, he runs businesses.

I have seen more money lost by would be Warrens than anything except poorly executed momentum investor over the course of my career. Individual investors simply cannot do what Warren does. Much is made of Warren’s affection for high operating earnings and a wide moat around the business. Any publicly traded company with those attributes is most likely valued at a very generous level. Warren values those because he plans to buy the whole company and control the cash flows. You and I cannot do that. As outside investors we have no influence over what is done with the cash flow. I have seen a lot of it squandered by bad management over the years and cannot rely on that alone when valuing a company. Unless I can be sure that the cash flow is going to be returned to me in the form of dividends and growth in book value, operating earnings are a secondary concern in the valuation process.

Warren also sees deals long before you and I are even aware they exist. He often, as in the case of Goldman Sachs and Bank of America cuts a special deal for himself with high yielding preferred stocks convertible into common stock. You and I as individual investors do not have that luxury.

He laos has access to some $70 billion in insurance float that is free money if the insurance operations at Berkshire turn an underwriting profit. They have every year for the past decade giving Warren a source of leverage that is not just free. He gets paid to use it to buy businesses and add to his stock holdings. You and I do not have that advantage either.

Warren also has a long history of advising investors to do thing he does not actually practice. Warren does not, in fact, have the bulk of his money in index funds. He trades derivatives in spite of calling them weapons of mass destruction. He once told investors to act as if they have a punch card with only 20 punches in it over their lifetime. I assure you that Warren has owned far more than 20 securities over his lifetime  He is not on Goldmans speed dial because he doesn't move money around in arbitrage trades and other such activities. He has made an awful of of money doing the very things he advises us not to do with our money.

There are some takeaways from Warrens approach that would benefit us all as investors. Buffett is most active after a full-fledged market crash. At the bottom in 2009 Warren was cutting deals and snapping up interests in businesses he wanted to won because prices were so advantageous. He pays little weight to quarterly progress reports because he understands that it’s the decade’s results that lead to enormous profits not a short term comparison. He reads constantly about a wide range of subjects that give him deeper insights into markets and companies than those who rely on research reports from Wall Street or the media.

Warren Buffett started as a great investor and grew along with his own success into a brilliant businessman. His stock selection methods today are of little use to the individual investor. Individuals would be better off studying his early career and that of his mentor Ben Graham and some of his other super investors who were in that famed classroom at Columbia University.

Buffett used the Ben Graham cheap stock approach to build the first part of the fortune that is Berkshire today and those techniques can be used by most of us still today. The idea of buying stocks that trade for less than asset value and have a margin of safety is still a successful approach and one that give individuals an edge they can use to profit even in today’s snake pit of a stock market.

One stock that I think might attract Grahams attention is an old favorite we haven’t discussed in a while. We still haven’t seen completely audited financial form Volt Information Sciences (VISI) but unless they have committed massive fraud we can piece together some information form their periodic updates. Business is not setting the world on fire but the staffing company is holding its own in a weak economy. Revenues are flat and the company has a small profit in the first quarter according to their recent release. If I put it all together it looks to me like the stock trades at about 4 times operating cash flow and 60% of tangible book value. Because of the long delay in restating the financials no one cares about the stock, Wall Street is not following it and very people outside a select group of asset based types have been buying it. If you do not own it I would start scaling into the stock at current prices.

There a whole bunch of parts in motion at MFC Industrial (MIL) but the stock appears to be safe and cheap right now. The company has snapped up oil and gas related assets in Canada and abandoned its Indian mining operations entirely. The increased their operations in the commodity supply chain business with acquisitions in Mexico at what appear to be bargain prices. While it take a little sorting out the stock is cheap based on the most recent numbers. The shares fetch about 4 times earnings and are at 60% of the tangible book value. The challenge for the company now is to integrate its recent acquisitions while continuing to look for cheap commodity operation to buy while they are out of favor. MFC has $280 million of cash and short term securities compared to just $118 million in long term debt so they appear to have an adequate margin of safety right now. The company also just increased its dividend by 9% and the stock now yields 3%.

I would be a buyer at the current price. Much as falling real estate prices led to being heavily invested in REITs and Real Estate operating companies back in 2009-10, the collapse of commodities is leading to a heavy concentration of those stocks in 2013. I do not make market or sector calls as such but there are times when the focus on cheap takes me into a specific sector. I have no idea when commodity and resource stocks will recover but I am pretty sure than buying them at the current low prices will end very well for me.

 Spending a portion of the week thinking about how Ben Graham might behave in the current era is challenging to say the least. In Graham’s era we did not have the institutional dominance that exists today, there were no futures or options markets for equity traders. It was a much more lax operating environment in terms of regulation. There was no high frequency trading or discount brokers. There was no financial television blaring a wide range of thoughts and meaningless predictions at us all day. Could Grahams approach work today in the new, much more complex version of the financial markets?

Obviously I think they would. The caveat here is that if you want to use Grahams methods in today’s equity markets you are not going to be the biggest kid on the block. If you want to be a billionaire fund manager who is on Page 6 of the NY post with executive jets this is not the approach for you. Even the best value managers today who are closest to the Grahams methods apply his approach to markets beyond equities. Seth Klarman at Baupost reminds me most of Graham and his portfolio is only about 20% equities with the rest in other assets such as real estate and distressed debt.

I have spent some time worrying and chewing on this and I figure that somewhere between $100 and $200 million is the most you can manage using a pure deep value asset based approach. If you add earnings and cash flow based techniques you can probably ramp that up to $400 to $500 million. While you can make a very nice living at the asset level with today’s fee structure you will not be the biggest kid on the block.
In considering how Grahams approach might apply in today’s world I went back and revisited the Margin of Safety Chapter in The Intelligent Investor. Graham outlines the simple fact that margin of safety should be the central principle of a successful investment operation. Specifically applied to the search for bargain issues the concept means that the business value is in excess of the market value and the business can withstand adverse conditions. He points out that you may not necessarily love the business but it a stock is cheap enough and has a margin of safety its generally best to own it anyway.

I sat down this morning and ran some quick screens to look for stocks that are cheap and have a fairly rigid margin of safety. The stocks had to trade below tangible book value of course, have a current ratio of more than 1.5, a Piotroski F Score of 5 or more and finally, an Altman Z score of greater than 3. The combination should give us a list of cheap stocks with a very high survivability factor.

As you can imagine given the run in the market the past couple of years we did not get a huge list of stocks. In fact among US based companies we found just 67 stocks that meet our strict criteria. As with almost every other screen we have run the past few months the results skew towards smaller companies. Just 15 stocks with market caps of over $100 million make the list. 46 of the companies have a market cap of less than $50 million. The deep value stocks in today’s world are smaller and trade far away from the valuation distortions caused by index traders and HFT gang.

While the rest of the Value World turns its attention towards Omaha the next few days I will devote my attention to the three things that matter most in my version of the value universe: The Kentucky Derby, My Birthday weekend and this list of cheap stocks.

I found 15 stocks that trade below book value and have high F scores and Z scores as measure of safety that have market caps over $100 million. The first, Kelly Services (KELYA, we have covered often and own. The second stock on our is Multi-Fine Electronics (MFLX) a electronics company providing electronic circuit boards and component assembly. Business is not fantastic for the company as sales have fallen off a bit and margins are compressed in the ongoing global slowdown. However the company trades for less than 80% of tangible book value and has an F-Score of 5 and a  score of 3.3 The have $130 million of cash on hand and no long term debt so they should be able to muddle through until we see a real economic recovery.

Seneca Foods (SENEA) is not exactly an exciting company. The company cans fruit that is then sold under the Libby label and a few other brand names. They also pack frozen and canned vegetables of the green Giant label owned by General Mills (GIS). The company is profitable and has been on an annual basis for the past decade. The company has an f-Score of 8 and a Z-score of 3.3 so there is a margin of safety and the potential for a solid return. The stock currently trades at 90% of tangible book value and is trading just 10% off the annual highs. I might wait for a bit if a selloff in the stock but it looks like a solid holding to me.

Renewable Energy Group (REGI) barely makes the cut at about 97% of tangible book value. Some of my friends who know this space tell me that biofuels could take a leading role in the alternative energy markets in the years ahead and this company could actually become a market darling at some point. For now it is just cheap enough with an F-score of 5 and a Z score of 3.7. In his book Graham pointed out that bargain issue buyers would often find themselves owning businesses they didn't really like that much based on safe and cheap you own them anyway. With my distrust of alternative energy this is such a stock for me.

Two of the stocks on the list are ones I already own and have discussed at length in prior columns. I have started buying back into contract electronics manufacturer and furniture concern Kimball International (KBALB) at the current 70% of tangible book value. Volt Information Sciences (VISI) remains one of my favorite holdings and I think the stock easily doubles over the next few years. Both trade well below tangible book and have Z and F scores that provide an adequate margin of safety.

I am also not a huge fan of the small semiconductor companies but Alpha and Omega Semiconductors (AOSL) is in a segment of the industry that should do well. They provide power chips that are used in computers, smart phones, gaming systems and battery packs. Their chips are also used in industrial and lighting applications. More importantly with the shares trading at just 60% of tangible book value the stock is cheap. Score is a neutral 5 and the Z score of 3.8 indicates a healthy balance sheet. More than half of the market cap is in cash on the balance sheet right and the company is profitable.

Shares of John B. Sanfilipo (JBSS) have done pretty well since I first suggested them back in February of 2012 but they are still cheap enough to make the grade. They have a strong F score of 8 and a Z-score of 3.8 so the safety factor is strong as well. Peanuts and tree nuts are not the world’s most exciting business but I know I have several cans of them around the house and I bet you do as well. At 90% of tangible book the stock is still a buy. Management has done a fabulous job of growing book value and should continue to do so.

In The intelligent Investors Graham mentions that often investors will find businesses for which they have no particular enthusiasm but the bargain nature and margin of safety make the worth buying anyway. That has certainly been the case with this list.

Trans World Entertainment (TWMC) is a company for which I have no enthusiasm at all. The company operates video and music stores which is just not a very good business. The company is undergoing something of a transformation with more focus on selling trendy products including clothing and has developed an online presence as well. The founder and CEO still owns about 50% of the stock so he has a vested interest in getting things turned around. In the meantime the stock trades at 75% of tangible book value and an F Score of 6. The Z-score is 3.4 and the company’s market cap pretty much equals its cash balances.

There is some signs of a housing turnaround although I suspect hedge fund buying of single family homes is skewing the numbers. If housing does rebound strongly then the furniture business should improve markedly. That will be great news for two of the company’s on our list of cheap stocks. Flexsteel Industries (FLXS) trades at 99% of tangible book value with an F score of 5. The rock solid balance sheet gives them a Z score of over 6. Basset Furniture (BSET) comes in at 98% of TBV with an F-score of 6 and a Z score of 3.8.I am something of a skeptic on housing and the consumer but they are safe and cheap.

I have mentioned before that I am not a huge fan of small semiconductor companies. However Pericom Semiconductor (PSEM) is the second such companies to make the list. The company makes chips that are used in networking as well as data and telecom applications. Like so many of these companies business is basically flat as global PC sales and IT spending remains weak. The company has introduced a range of new products that give them exposure to higher growth markets like smart phones and cloud computing that management hopes can ignite growth. In the meantime the stock is just cheap at 75% of tangible book value. Most of that is in cash as the company has over $5 a share on cash and liquid securities on the books. The stock gets and F score of 5 and a Z score of 4.3. The company is buying back stock and as much as I hate buybacks above book value, I love them at this deep a discount.

Our final selection is another of those “gee I really hate this business” stocks. Rex American Resources (REX) is in the ethanol business. The company has interests in 7 ethanol plants and also has a real estate division. The real estate division still owns 11 former retail locations they are attempting to lease or sell. When you add up all the cash property and equity interests in the plants the company is selling at just 60% of tangible book value. The stock has an F score of 6 and Z score of 3.6 so there is a decent margin of safety in the shares. They are also buying back stock at a healthy discount to asset value.

You and I cannot due what Warren Buffett does today. We can however do what he was taught to do by Benjamin Graham and became the cornerstone of the vast fortune he controls today.

Originally published as a series on Real Money

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