Conrad Industries...unanswered questions

I've seen this company mentioned on two excellent blogs here and here.  So as I read these posts the investment thesis seemed pretty clear, this is a currently cheap business, undeservedly cheap.  As I read the two posts I kept thinking of three questions that I didn't really see answered, they are as follows:

So why is it cheap?
Is it normally this cheap?
Is it as attractive as it first looked?

Conrad seems like a really interesting stock, something I'd usually be interested in, so I thought I'd take a stab at answering my own questions with the hope that I'd be looking at a good investment.

First a bit of background

Conrad Industries is in the business of building and repairing ocean going vessels as well as fabricating oil rigs and the related oil rig support vessels.  The company's website seems to promote their role in the oil and gas industry but reading through the press releases I kept seeing orders for barges more than anything else.  In 2011 of the 47 boats delivered 42 were barges, I think it's probably safe to say that Conrad is a barge manufacturer.  The demand for barges is closely tied to commodity prices across a few different industries, energy, agriculture and construction.  The barges I see mostly near me are carrying coal and gravel.

Conrad's barges aren't limited to one specific industry or client set, here is the list of barges and ships they built in 2011:

During 2011 we delivered 47 vessel construction jobs comprised of 2 crane barges, 2 ferries, 9 LPG barges, 2 tow boats, 9 deck barges, a spud barge, 9 30,000 bbl. tank barges, 2 10,000 tank barges, 5 hopper barges, 3 striker barges, a push boat and 2 docking barges.

The investment thesis is pretty simple:

• Market cap of $112.8m and an enterprise value of $70.8m
• EV/EBIT of 2.44
• EV/FCF of 2.832
• EV/CF3 of 4.56 (avg cash flow from the last three years)
• ROE of 20%
• ROE ex cash of 36%

The numbers are eye popping, I had to double check my math, how could a company like this be selling so cheaply?  

Why is it cheap?

I always want to know why a company is cheap before I buy it.  I know some investors think this is unnecessary but I want to make sure I'm not buying into a "cheap" company at the top of it's cycle right before sales drop off.  Or buying into something cheap that has a lawsuit hanging over it that could wipe it out.  Sometimes a company is cheap because there's a CEO who has said he'd rather spend the cash on acquisitions than give it back to shareholders (see Rimage..).  There are a lot of reasons, but for my own piece of mind I like to know before investing.

The writer CP at Credit Bubble Stocks mentions they think the stock is cheap because it's unlisted and has a market cap below $100m.  This is a fairly canned answer that I think is a red herring.  I can find literally hundreds of pink sheet stocks with market caps under $100m that are over valued, heck most have a share price of under $5 the other canned reason for undervaluation.  I guess I should throw in lack of analyst coverage as well here.  The reality is while those things might play a part I don't think they're a real reason a stock trades cheaply.  The addition of an analyst won't make Conrad pop 45% overnight unless that analyst is paid by Conrad and sends out glossy fliers...

John at Portfolio14 says in his post that the stock was punished with the BP spill last summer undeservedly so, this seems more plausible.  Of course the overhang from the spill is over so while this was probably a past reason for cheapness I don't think it's currently one.  Note that John picked up Conrad during the which was a much better investment than mine in Seahawk Drilling.

So moving on, my first thought after crunching the numbers was that Conrad is a cyclical company and that it's at the top of it's cycle. So I went back through their annual reports and pulled a few figures from the years, here's what I got

I think looking at revenue, margins, income and cash flow actually tells quite a story here.  Conrad Industries is anything but predictable.  A double digit jump in any value isn't unheard of, it's actually common.  Likewise a double digit drop is just as likely.

Revenue for 2011 came in at $246m, the highest ever and an increase of 28.8% over the previous highest amount from 2008.  Revenue and income are highly dependent on when construction of certain ships are completed and that varies by the type of ships ordered.  So in two different years ten ships could be ordered but in the first year eight of the ships completed and in the second year maybe only six completed leading to very lumpy results.

Is it normally this cheap?

I pulled up the longest chart I could get on Conrad Industries:

Clearly investors were very excited about Conrad's results back in 2008 when they hit an all time high similar to today.  The good news is the market price of Conrad seems to trade the company's performance.  To me this says if the future looks better than now then Conrad has room to grow.  If for some reason revenue drops, or net income drops look out below.

Is it still attractive?

This is really the most important question, and honestly the one I couldn't answer.  The company seems to be in a great position financially, they have a strong balance sheet and are internally financed.  The big question is how does the future look, will results in the future look similar to the past?

I think there are really two variables to answering this question in my mind at least, the first is the age, condition and demand for river barges, and secondly the future backlog.  At year end 2011 Conrad Industries had $144m in booked backlog if this is the only work they complete in 2012 revenue will take a significant hit in comparison to 2011.  Although this would be a big hit it won't be all that surprising taking a longer term view.  If the company is able to complete their backlog plus additional watercraft revenue will obviously be higher.  The question is can they sell and build their backlog twice?

I'd love to hear reader's opinions on Conrad Industries, bulls, bears please comment!  For me the jury is still out as to whether this is the sort of stock I want to add to my portfolio.

Talk to Nate about Conrad Industries

Disclosure: No position

Three Japanese net-net's compared

After my last post reviewing the book Investing in Japan I figured it was only appropriate to highlight a few Japanese companies.

I'm working my way through a list of Japanese net-net's again and I'm scoring them against a simple criteria:

• 10 years of positive EBIT
• 10 years of positive net income
• No debt
• Pays a dividend
• Shares decreasing or stable

I know this seems really strict, but believe it or not out of 100 or so companies that passed a strict net-net screen I'm getting companies that match the above criteria.  Because my approach to Japanese net-net's is mostly mechanical in nature I want the best possible companies I can find.  I'll leave the turnarounds and special situations for a Japanese equities specialist.  I just want to find cheap companies that should be mean reverting.

I am going to do this post a little different than most, I want to go over three profitable net-net's.  I will give a short business summary and background, and a look at the balance sheet through my net-net template.  I'm also going to use this post to roll out something new, a Japanese net-net comparison spreadsheet.  As I look at these companies I'm compiling some relevant metrics into a big spreadsheet so I can compare over a variety of data points.

I know it seems a bit ironic that after doing a post on how stocks are businesses I'm now posting financial details on three Japanese companies with a focus on financials and not the actual business.  The reality is when looking at net-net's in Japan I'm taking a bit of a quant approach.  I don't read/speak Japanese, I've never been there, I don't understand the culture, so the best I can do is make a judgement based on some numbers.  Without further ado:

Ryoyo Electric (8068, last trade ¥939)

Ryoyo Electric is a semiconductor company, seems like most cheap stocks are these days.  The company has three segments, integrated circuits, application specific circuits, and large scale integration circuits.  Ryoyo's products are a commodity and they end up being a price taker so they're subjected to the whims of the market.  The company is located in Tokyo.

Highlights

• Net cash company if you include long term investments, ¥950/sh
• Negative cash flow one of the last five years.
• Tokyo Exchange
• Debt free
• EV/EBITDA of 1.73
• NCAV of ¥2183
• NWCC of ¥1770

Choukeizai Sha (9476, last trade ¥340)

Choukeizai Sha is a book publishing company, they publish five magazine subscriptions and over 450 throughout the years.  The books mostly related to economics, management, law, accounting and tax related subjects.  I realize the publishing industry isn't the best right now but this company is trading at an absurd valuation.

Highlights

• The company has been profitable the last ten years.
• Positive cash flow and FCF for the past five years.
• ROE ex cash of 10%, the overcapitalization is penalizing the business.
• Osaka traded
• Debt free
• NCAV of ¥813
• NWCC of ¥677
• Net Cash ¥395, slightly above the last trade.

Shinko Shoji (8141, ¥715 last trade)

Shinko Shoji is a small cap exporter of electronic components, they import components from abroad, assemble them and then resell them internationally.  They sell memory chips, LCDs, semi-conductors, capacitors, and complete PC systems.

Highlights

• While posting a positive EBIT and positive net income for the past 10 years the cash tells a different story.  Cash flow is lumpy with big years ¥6b yen, and then years of ¥7b losses.
• Capex requirements appear to be very minimal.
• Tokyo listed (easier purchase for some investors)
• Sizable dividend yield above 4%.
• Paltry net margin
• NCAV ¥1395
• NWCC ¥806

Comparison Spreadsheet

Here are the three companies compared, I plan on adding to this spreadsheet as I research more Japanese net-net's.  I'm guessing of the original 100 companies I'll end up researching 10-15 and maybe purchasing 2-5, we'll see how it turns out.

Disclosure: Long 9476, and trying to acquire more shares.  

Investing In Japan

I don't usually do book reviews on this blog mainly because I rarely read a book that I think most readers would benefit from.  At times I've mentioned books that I think go well with a certain topic, but so far I haven't done a full scale book review.  This post is a first, and because I write about Japanese equities often this book will probably appeal to most readers.

Investing In Japan was written by Steven Towns a member of the proxy exchange and author of the blog Active Investing where he writes about shareholder activism and Japanese companies.  He has been a long time holder of Internet Initiative Japan and through shareholder proposals and discussions with management was able to get IIJ to increase their dividend 50%.  One aspect of this book that I really loved is that Steven Towns is a value investor himself and presents Japan through the eyes of a value investor.

For this review, I want to hit a few highlights from the book to give you a taste of what it contains.  I've seen reviews on Amazon where people give a summary of each chapter and my own take is if you want that much detail just go buy the book.

How to invest in Japan with ETFs and mutual funds

This was an interesting aspect of the book I didn't really expect, Steven dedicates two chapters to discuss different exchange traded vehicles for investing in Japan.  Towns uses ETFs to walk the reader through some basics on the Japanese market such as the different market sections, relevant indexes and index composition.

What I found really fascinating was the concentration of investments by the value funds represented in Japan.  Most of the value funds own the same set of large cap exporter stocks such as Toyota, Canon etc.  What's interesting about this is that the top holdings in most international value mutual funds are the same as the top holdings in Japanese index funds.  In most cases a value investor is better served either diving in and investing in individual equities on their own or buying a Japanese index fund for inexpensive exposure.  I would say that if someone wanted a lot of Japanese exposure an index fund to capture large/mega caps along with some individual small cap stocks is probably the best approach.  Of course I'm biased because this is what I do.

Macro/Bearish outlook

I would say the biggest thing holding back most investors from putting money into Japan is macro economic fears.  These fears stretch from worries about government debt, zero interest rate policy, low GDP,  a declining birth rate and a whole host of other worries.  Of course the worst time to invest is when it seems like there aren't any problems, or all the problems have been solved.  Given all the worry about Japan valuations are at twenty and thirty year lows with profitable companies selling for less than the net cash on their balance sheet.

I'm not going to go into a counter point for each bearish argument against Japan because Towns does a great job.  He discusses how fears of a Yen drop are mostly exaggerated, just a few years back companies were managing just fine at the ¥120-130 level, and are now managing alright at the ¥80 level.

The chapter also discusses Japan's supposed demographic time bomb and has a quote that I love:

"My point is for readers not to be misled to believe that Japan is so gray as to be on its last breath and in such dire straits that masses of unemployed youths pass time by occupying ubiquitous internet cafes."

He ends the chapter with the exhortation that any reader interested in Japan should at least make a visit.  Lost in the bearish investment speak is that Japan is an extremely modern country that's very safe to live and travel.  It seems every country right now has some sort of macro overhang even the US.  There is no place perfectly safe, investors just need to be mindful of the risks.

The one area I wish he would have covered here some some advice on hedging the Yen.  A fall in the Yen would be good for Japanese business, but I wonder if the increase in business value would offset forex losses.  I would rather hedge or partially hedge and get the best of both worlds.

Stock market essentials

There were two chapters covering everything from the history on minimum trading units to Japanese dividend policy.  There was a lot of information in these two chapters that I wish I had in one place before I started investing in Japanese companies.  I spent a lot of time Googling trying to figure out some of the peculiarities of the Japanese market.

The chapters on the market essentials also covers the often discussed cross shareholdings that many Japanese companies have.  One form of cross shareholding that's popular is listed subsidiaries.  I own a listed subsidiary and wondered what that reason was for the listing.  In Japan spinning off a company has some tax consequences that make it unattractive.  Instead of spinning off a subsidiary a parent company will simply list the sub.  There's some catalyst potential in parents taking listed subsidiaries private if the sub is very profitable and the parent wants control of the income stream.

Low ROE problem

It's not a secret that most Japanese companies have low ROE's compared to most other developed countries.  A lot of investors will get excited by the cheapness of Japanese companies and then see a ROE of 3.5% and end up walking away from the stock.  The book digs into the multitude of reasons that many Japanese companies have low ROEs.  The biggest is that most companies are overcapitalized both with cash and assets.  A second aspect is that many Japanese companies will invest in plant and productivity rather than trim the workforce because that's the easiest path forward.  This results in lower returns and inflated assets, assets that might be used eventually if Japan regains it's mojo.

Shareholder rights

The chapter on shareholder rights was tucked in the back, I think unfortunately because most investors don't care much about any rights they hold.  With that said this chapter is pure gold, Towns knows what he's talking about when it comes to shareholder activism and rights.  Interestingly enough an investor who owns more than $2000 of any Japanese stock has quite strong legal rights including the ability to call a board meeting.  The chapter lays out some specific rights all shareholders above the threshold have as well as going into some details on executive pay.

I wish there were more stories and concrete steps for an investor to take.  One takeaway I had was that Japanese companies aren't opposed to shareholder proposals but that most foreign investors propose incorrectly and ask for demands that are too large.  Investors who understand Japanese culture have had a lot of success in initiating change in corporate Japan.

Who should read the book?

I think any value investor who's curious about the persistent undervaluation of Japanese equities should do themselves a favor and read this book.  For someone who has been investing in Japan for years they might not have as much to gain from this book.  One thing that's worth mentioning is that Steven Towns sprinkles the book with lots of examples of undervalued companies and just the examples in the book alone are a great hunting ground for an aspiring Japanese stock picker.

Buy Investing in Japan: There is no stock market as undervalued and as misunderstood as Japan from Amazon.com

Disclosure: I purchased the book on my own.  If you order through the links above I will receive a small commission.  The price for the product is the same if you enter through my site or go to Amazon.com directly.

A net-net that's liquidating...how unusual

I want to thank Theodor Tonca a principal at Graham Theodor & Co for sending me this idea.  Graham Theodor & Co is a value based Canadian money manager.  For any value investors in Vancouver Theodor runs a value investing interest group, if you're in the area it's worth checking out their next meeting.

With most articles I do on net-net's I include my liquidation analysis spreadsheet.  I include this not because I think the company in question will liquidate, but to show the maximum possible downside.  In some cases the biggest downside (outside of fraud, or massive asset squandering) is actually an upside.  Of the net-net's I've written about and researched I don't think I remember any actually liquidating.

While I haven't had a net-net liquidate, although some should, I have been involved in one liquidation situation.  I purchased EDCI stock a few years back once the decision to liquidate was made and I realized the liquidation value was in excess of the trading price.  I ended up selling out way too early but I know people who held on made 2-3x or their initial investment, I ended up with a 50% gain in about four months or so which I thought was spectacular.  I blew the gains on a trip to Florida, and while stocks are nice they don't compare to a sunny sandy beach but I digress...

Maxco (MAXC)

So what's the deal with Maxco you ask?  Well management realized a few years back the best way they could realize maximum shareholder value was to liquidate the company and distribute the proceeds.  The company has liquidated substantially all of their assets at this point and made four distributions to date.

At this point all that's left of Maxco is the CEO, an empty office and the receptionist.  At the bottom of the annual report filed at the end of March 2011 management indicated they expect a final liquidating distribution of $.60.  The final distribution is a result of a large IRS refund they received last year.

The situation seems pretty straight forward, and you're probably wondering at this point if there are no assets left to liquidate why hasn't the company paid out the final distribution?  The reason is a bit unique, due to the size of the tax refund a special committee needs to review it before the company is allowed to release the funds to shareholders.  The IRS guidelines state that a review of this type can take up to 18 months depending on the complexity of the return.  The company mentioned they would update their website when the audit process began.  It's been a year since the last posting on Maxco's website so I decided to call and see if there were any updates, unfortunately there aren't.  The audit still hasn't started, although the woman I talked to said she doubts it will take the full 18 months given the simplicity of Maxco.

A shareholders return in this liquidation depends on two factors, the price they pay, and the amount of time between the purchase date and the liquidation date.  I've included a graphic I put together showing how the longer the process drags on, or the higher the price paid the return drops.  I know this is intuitive for most readers, but often a graphic makes it much easier to understand both the potential and liability.

Maxco looks like the perfect investment, put in a bid $.02 above the last quote, hope things wrap up in a year and you're looking at a 200% return.  I agree, this looks excellent on paper, the problem is it's very difficult to actually purchase shares, trust me I've been trying.

Here is a screenshot I grabbed of ALL the trades going back to September 2011:

Most trades are less than 1,000 shares ($180!?!?!) and my guess is they're partial fills.  If you decide you want Maxco shares I would strongly encourage a limit order with an all or nothing specification.

Why cheap?

No post would be complete without me asking this question, for Maxco this is very easy to answer:
-The current market cap is $621,730, yup, smallest stock I've ever written about.
-The stock is very illiquid as mentioned above.
-Uncertainty regarding the timing of the final distribution.

Talk to Nate about Maxco

Disclosure: I have an order outstanding for Maxco shares at $.18, yup I'm optimistic.

A stock is a business

This post might seem a bit off the farm, if you're looking for company writeups stop reading and check back later this week.  Otherwise let me step on a small soapbox for a minute or two.

Whopper put up a post recently on McRae Industries discussing the investment potential.  Whopper does a nice job laying out why someone would potentially want to invest based on financial metrics.  My quibble with the post has nothing to do with his reasoning or any accounting aspects but with this line

"McRae sells boots. We could go into a further breakdown of what they do, but there’s honestly no need. As you might expect of a company in the boot industry, McRae is pretty much a commodity company with commodity company like returns."

I think often value investors get stuck in a rut, they do a lot of research, reading company financial statements, reading about competitors (through financial statements), and reading about industry segments.  Left out of this process is the thought or connection that the business under the microscope is a collection of real people who gather in an office each day, talk about American Idol, gossip about each other, surf Facebook, all while taking customer calls and complaining about their boss.  As Avner Mandelman talks about in the The Sleuth Investor (highly recommended) a business is a place where people send checks.  He asks whether the customer being served is worthy (do they deserve to be served?), and how they're served (the business process), along with things like who is the customer, and who are the managers.  The Sleuth Investor really dives into looking at the physical aspect of a company, visiting the plant, talking to workers on their lunch break, and buying their product like a customer would and talking to customers if possible.

I know these things seem strange for most investors, especially value investors who model their behavior after Ben Graham who rarely talked to a company or Walter Schloss who almost never talked to companies.  Ultimately though I don't believe either of them had the detached mentality that has developed amongst a lot of value investors today.

The result of this detached mentality and focus only on financials is what sucked a lot of value investors into China RTO stocks.  On paper these companies looked like absolute steals.  Companies trading for less than cash, growth rates of 30-40% a year selling toasters.  Ultimately a lot of these companies were undone by investors who did the physical checks of these companies.  While vilified there is a lot to be said about Carson Block who counted trucks, talked to customers and sleuthed factories.  It wouldn't surprise me if Block has read the Sleuth Investor a few times.  The physical reality didn't jive with the financial statements and everything came undone.  The opposite could also be true for some companies, the physical could be much better than statements suggest offering a great opportunity for an investor.

The ideas in the Sleuth Investor resonated with me, probably because I work in the business world, deal with small and large companies daily and am mostly detached from the investment world (outside of this blog, twitter, and some emails).  My friends all work for various companies in non finance roles, to them investing is reserved for smart people in New York and London who wear suits to work everyday.  Investment to most people isn't P/B, ROE, or ROIC, it's buying a new machine to reduce lead time, streamlining distribution channels, or removing inefficiencies from a business process.  These are the tangible, physical things that drive a company's financial return.

For a while now I try to answer the question "Why is a company cheap?" when I research a business.  In looking at this question I was getting part way to answering some of the questions about the business itself, but not all the way there.

Why is this important?

Looking at a business as a physical group of people who collect checks for doing some sort of task opens the mind to think about a company differently.  My main goal in investing is to not lose money.  If I find a cheap stock and then look at pictures of it's facilities and realize they are decrepit and in disrepair I stand a chance of losing my investment.  I want the physical reality to confirm the financial reality of the company.

Other times thinking outside financial statements gives reasons as to why a stock might be cheap.  Consider a company located far from an airport, railroad or major urban area.  They might need to truck parts in, and truck out a finished product.  If gas prices rise they are impacted to a much greater extent then a company located in a major city, or near an airport with a short haul.  None of these things are mentioned in the 10-K, but are easy to find just looking on Google Maps.

A lot of people will dismiss this post saying that if a stock is cheap it doesn't matter what the business does, or how it does it.  I can agree at a point, for Japanese net-net's I have had trouble getting a solid grasp of what these businesses do, so I will invest on metrics.  This is fine, but I recognize that it's a somewhat mechanical strategy.  Even so, some basic Googeling can result in a lot of information, even about businesses overseas.

It seems crazy but even for a net-net I think examining the physical business is important, I looked at this with my post on Hickok. A small amount of time, such as 30-45 minutes of looking at maps, street view, and reading about an area online can give great insight to an investment.  Often this sort of in depth research seems to be reserved to people who concentrate hundreds of thousands or millions of dollars into a few investments.  I think it should be considered by all investors regardless of the investment size.  Relatively simple physical checks can yield really good results.

If feasible I think it's even worth trying to buy a product, or at least examining it.  Call the company and act like a client.  I tried this with AEY, they ignored me.  I tried to get quotes on a few pieces of equipment.  If they ignored me why would my experience be any different from any other potential client?

I think the level of research outside of financials probably scales with the size of an investment.  For someone putting $500 into a net-net a quick look on Google Maps and reading product reviews is fine.  For a $100,000 investment I'd expect the investor to at least have handled the product (if possible).  Think of it like this, for a few hundred dollars you could avoid a potential thousand dollar loss or more.

Putting it in Action

So I want to just consider a few questions about McRae in the vein of this post.


Where are the boots manufactured? - The army boots are manufactured in the US, the cowboy boots appear to be manufactured overseas.  This raises a whole other host of questions regarding leather availability in China (an issue facing Danier Leather).

Who buys these boots? - Identifying the customer is critical.  It appears there are probably four customers, soldiers, horse riders, industrial users, and possibly fashion buyers.

How easy are they purchased? - I was unable to find a way to purchase the boots online, they appear to only be sold in stores (why is this?).  I did a search of stores near where I live.  The closest one is a western apparel store right up the road.  So here's my impression, this western store is a place that my wife and I comment about each time we drive by, there are never any cars there, and we don't know how they stay in business.  Other friends have made similar comments.

Looking at the western store prompted another thought, these boots will probably never be purchased as a fashion item.  I know if I was looking at boots I would not go to the western store due to the stigma attached, I'd probably look online.  So the product doesn't have a big general market from what I can see.

Is the brand known to people who would likely use the product? - No idea, this would need to be further researched.

Why buy McRae boots over a competitor? - Again no idea.

This is just a start, and these are some of the things we need to think about when looking at companies.  I know I'm guilty and have been of paying lip service to the fact that stocks are companies.  Heck, this post is more of a reminder to myself than anything else.  I think as investors we need to look at a stock as a business first, and the financial component as just that, a component.  I know one value investor who has been putting these sorts of questions into action is Richard Beddard over at the Interactive Investor Blog.  This is an area I want to get better at myself.

If you are interested in the financial aspect of McRae I'd check out the Whopper link above and the great post at OTC Adventures here.

Questions, comments?  Talk to Nate

Disclosure: I make a small commission if you buy the Sleuth Investor through Amazon.com.  There is no markup on the book if you visit through my link verses going to Amazon.com directly.  I purchased this book on my own on the recommendation of someone on the Corner of Berkshire and Fairfax message board.

Adams Golf gets a buyout and other net-net thoughts

I saw this morning that Adams Golf (ADGF) received a buyout offer at $10.80 a share, this is up from $5.54 when I first wrote about them.  I wrote in that post that Adams Golf had both a margin of safety and a catalyst, plus they were trading very close to NCAV.  I wish I could say that I am sitting on a two bagger and selling my gains today but that's not the case, I never ended up pulling the trigger on Adams Golf.

So why didn't I buy in?  When looking at why I didn't invest in Adams Golf investment I can identify two mistakes I made:

1) I mis-identified the margin of safety.  

When I looked at Adams Golf I was thinking about the company as a net-net.  I was looking for balance sheet safety and a tangible liquidation value.  I wasn't looking at liquidation value because I thought the company would be liquidated but because this would provide an absolute downside for my investment.

What I missed was that a margin of safety existed in the business.  The company was profitable and had a product that was well received in the niche hybrid golf club market.  I never examined the product or talked to any customers so I missed that people liked these clubs.  The products had brand value that another company in the market would want to acquire (as evidenced this morning).

2) For whatever reason the stock never felt comfortable to me.  

This is the hard one for me to quantify, but usually with an investment as I'm researching things will start to jump out at me and eventually I know the company I'm looking at is the type of company I want to own.  I never had that sense with Adams Golf, but I never stumbled on anything that would make me want to avoid them either.

This reason seems strange, especially for a value investor.  We're told over and over that the best investors are devoid of emotion, and we should learn to ignore our emotions.  I'm going to go against the grain here and say that I'm a very emotional investor.  When I see an undervalued business that fits what I'm looking for I get excited.  I get excited in the same way that I would if someone offered to sell me a successful restaurant on a busy intersection for pennies on the dollar.

Some investors can be mechanical, following checklists and investing by stringent rules.  That's not my personality, I go with guidelines and intuition.  Guidelines keep me focused, intuition is built on experience with similar businesses or similar investments.  If I can't get excited about a company or an investment I'm prone to forget about it six months later even if it's in my portfolio.  Not sure how much of my personality comes out in the blog, but I'm a pretty carefree, last minute decision, go with the flow person.  I think sometimes my investment style reflects that.  One day I'll be looking at a pink sheet company, the next a German hidden champion, then a Japanese net-net.  No reason, just following whims for value.  The advantage of this personality is that when I get excited about something I get focused and mildly obsessed.


Changes going forward?

As I've watched net-net's since the bottom of the crisis and invested in them worldwide my view has slowly changed in what makes a good net-net.  Initially my thought was that I wanted to buy $1 in cash for $.50.  This led me down the path of being attracted to cash heavy companies, shell companies, and utterly junky net cash stocks.  Some of these investments worked out ok, others not as much, and some were just disasters.

The problem was the market rarely rewards a cash position, the market rewards a business.  I had foolishly thought that since a company had a dollar on it's books the market should have that stock trading at face value.  The reality is that there is no rule governing the market that says that all companies must eventually trade at NCAV.  A company can sell below cash value forever, or it can sell above cash value forever.

In looking back at the net-net's I've owned that have done well I found that my best performance didn't come from companies suddenly trading up to asset value, but rather from improved business performance.  I can't actually think of any net-net's I've owned or followed that suddenly drifted up to NCAV for no reason, all of them had some sort of turn around, or perceived turnaround in the business that excited investors which in turn made the share price increase.

With Adams Golf I kept thinking in terms of asset safety, and less in terms of business value and turnaround potential.  Asset safety is important especially if a company is on the verge of liquidating or is burning cash and a liquidation seems likely.  If a company is profitable and has turn around prospects assets are important for a downside, but business performance is more valuable for the company to eventually trade at net asset value.

At this point you're probably wondering how the other net-net's in my portfolio look, will I be doing a wholesale purge?  Amazingly enough outside of one Japanese net-net all of the net-net's I own conform to this pattern.  They all have a downside protected by assets with varying degrees of liquidity but all have businesses that either have the potential to improve or are improving.

My last thoughts are that I've already been putting this process in place as I look for Japanese net-net's again.  I'm looking for assets that provide a downside, but my focus is on cash flow generation and hidden business value.  Hopefully I'll have a few companies to post about in the near future.

Talk to Nate about Adams Golf, or net-nets

The Value Mirage

Bowlin Travel Centers (BWTL)

Price: $1.19 (3/13/2012)

I found this stock a while back, made a notation to look into them further in my idea notebook and finally got around to it.  Bowlin is what I would consider a value mirage, a stock that looks excellent when first found but once under the covers is quite a bit different.

A value mirage is different from a value trap, very different.  A value trap is a stock that is a seemingly good value, it lures in value investors and once the pile on is complete rounds them up and takes them to the woodshed.  A value mirage is a stock that appears to be a good or great value at first glance but after some detailed investigation is at best fairly priced.  These stocks are good from afar, but far from good.

I want to break this post down into two parts, the value thesis, and then the mirage aspect.  First I should explain what Bowlin Travel centers are.

Bowlin Travel Centers is a company that owns 10 highway rest stops in the southwest US.  The rest areas are more than just a gas station and some bathrooms, Bowlin aims to have destination rest stops.  The rest stops are strategically placed on high traffic routes with few services.  Each stop has gas, a restaurant and usually a themed souvenir shop.  This style of rest area is very common in the west, if you've done any highway travel in the western US I'm sure you've stopped at a place like this.  If not it's hard to describe.  If you're from the east and have driven down I-95 the Bowlin plazas are similar to South of the Border.

Many of the Bowlin facilities have a wild west theme, some have indian themes and there is one called "The Thing".  "The Thing" advertises itself as the "Mystery of the Desert", where you can buy [link to their online store] homemade indian crafts, gold jewelry, pottery and treat yourself to some Dairy Queen.  Once you're done with your ice cream you can buy a gun and some luggage and a nice coffee mug.  The biggest of these rest stops in the US is an attraction in and of itself, Wall Drug, yes I've been to Wall Drug and yes I ate the famed buffalo burger.

For any non-American readers, or readers who have never driven on the interstate and seen these places my descriptions won't do justice.  As far as I know these kitschy places are unique to the US and probably Canada. Simply put they're strange.  I wouldn't say I'm an expert I but I have browsed my fair share of indian trading posts and wild west rest stops on road trips.

The Value Case

Here are some quick bullets with an expanded description below:

• Book value of $12m verses a $5.45m market cap
• $3.8m in cash and securities, or 70% of the market cap
• Management decided to initiate a buyback with a target of buying 25% of the shares outstanding.
• EV/CF of 2.14
• Management has actively been selling unused land.
• The company earns more as gas prices rise, and gas is at an all time high juicing earnings.

If I presented you with a company that had the above value proposition most people would jump at the chance to invest.  The management seems to be doing all of the right things, buying back stock, selling unused land.

On a valuation basis the company is cheap, trading at a low EV/CF, they're over capitalized, this seems like a perfect value stock.

The Mirage

If you just looked at recent results this company seems undervalued.  If you look at the long view Bowlin is doing what they've always been doing.

Revenue 2000: $26m
Revenue 2011: $26m


Cash from Operations 2000: $1m
Cash from Operations 2011: $727k


Price/Book ratio 12/31/2001: 62%
Price/Book ratio 3/13/2012: 45%

The mirage starts to fade away as you realize that Bowlin Travel Centers hasn't changed in the past decade, they're still selling trinkets, gas, and ice cream cones to travelers in the middle of no where.  Results have ebbed and flowed over the past ten years, but they've generally been in the same range.  The company doesn't break out gas and food separately but I have a note that states back in 2001 50% of their sales came from fuel.  So when gas prices are high Bowlin does a bit better, and when they're low their results aren't as good.

The problem is as long as Bowlin keeps the same number of rest stops business will most likely remain the same for the next three years, five years, fifteen years.  The problem isn't that there is no catalyst, it's that this is the business.  What Bowlin is today is what they'll probably be in ten years.  Within this constrain there isn't much management can do for shareholders outside of some buybacks and asset sales.  Even the share price hasn't moved in the past ten years, it traded for $1.35 on 12/31/01, and trades for $1.19 today.

At best a shareholder could hope for is a going private or buyout at book value.  My concern is that if management wanted to do a going private transaction why haven't they done it already?  The company is run by the founder's son who's been at the helm since 1972.

To me Bowlin seems like the perfect family business, it's stable, you could probably earn a good salary and it wouldn't be all that stressful managing the plazas.  Unfortunately it isn't really that good of an investment for shareholders.  The only thing that would get me to notice Bowlin is if their price cratered, maybe if it fell by 50% or so for no reason.  It would be worth considering buying and waiting for the price to rise back to it's seemingly natural resting place at $1.20 or so.

I'd be interested in hearing about other value mirages, leave a company name in the comments.

Talk to Nate about Bowlin Travel Centers

Disclosure: No position

A true oddball: Mills Music Trust

My goal when starting this blog was to find and profile companies far off the radar for most investors.  I usually profile small caps, net-net's, and a lot of foreign companies.  For most investors bombarded by the mainstream financial media the things I write about are really offbeat.  For investors who invest in deep value global small caps a lot of names I mention seem to be common.  After all there are only so many stocks globally and there are a lot of people picking through them.

From time to time I uncover a truly oddball stock, something that is both unknown and a different creature all together, Mills Music definitely qualifies.  I find these stocks interesting because due to complexity or details most investors pass over them.  Mills Music Trust qualifies as something hard to grasp, yet has the markings of a good opportunity.

Imagine a stock without any tangible assets, or a book value.  If it was liquidated it would be worth something yet there is no balance sheet.  The income statement is seven lines long, yes just seven lines.  This is the quick description of Mills Music Trust.

What is it?  Mills Music is a cash collection and distribution machine.  Where's the cash come from you ask?  It comes from EMI the music company.  Mills Music owns the rights to some "oldies" songs, nothing more, nothing less.  Every time a royalty event happens with a song Mills has the rights to EMI makes a note and eventually sends over a royalty.  Four times a year Mills Music pays out the cash received from EMI minus some bookkeeping fees to unit holders.

The business is simple enough, cash in, cash out.  The simplicity is fascinating, here is last year's income statement:

A random thought, I love the fact that they will keep less than $100 undistributed at the end of each year.

The first question to ask is why would anyone want to buy Mills Music Trust?  The answer is blindingly obvious, for the yield of course.  They have paid out $2.62 per share so far this year, and have paid out between $3 and $4.50 over the past five years.  The stock yields close to 9% currently.  Of course no one knows how much they'll pay out in the future because no one knows how many times The Little Drummer Boy will be played on the radio this Christmas either.

Here is the historic dividend history:

There really isn't much else to say about Mills Music Trust.  In short old songs are played on the radio or downloaded in iTunes and Amazon, the cash is sent to EMI, who sends it to Mills Music, who sends it to you.  Mills has rights to over 25,000 songs, but only about 1,500 songs actually generate royalties.  The next copyright of a top 50-income generating song expires in 2018.  Amazingly 66% of the royalties comes from the top 50 songs.  The rights Mills Music owns seem to be as obscure as the stocks I write about.

Oldies are probably pretty stable at this point meaning the dividend is probably pretty stable until some of the songs start rolling off the copyright rights.  For an almost 9% dividend this seems like a pretty safe bet.

Purchase Information:
Mills Music Trust (MMTRS.PK)
Avg Volume: 300 shares (use a limit order!!)
SEC Filings

Disclosure: No position

Trading slightly above net cash: KSK Co Ltd

KSK Co Ltd (9687.Japan)

Price: ¥450 (3/7/2012)

Following up on my last post regarding the performance of Japanese net-net's over the past year it's only appropriate the next company I talk about is a Japanese net-net.  I found out about this company when a reader emailed me asking my opinion of it.  I did some research and put my thoughts together in a post.

KSK is a Japanese company IT services company grouped as following, hardware and semiconductor design, network design and maintenance, and network construction.  The company is listed on the Jasdaq which is part of the Osaka Exchange.  The Osaka Exchange is known for being a derivatives exchange and a secondary stock exchange.

The company also has a few subsidiaries, one subsidiary is a tech support company.  The second is a company formed to manage and maintain networks for the health insurance industry.  There might be a third subsidiary that provides tech support for a specific local government, I couldn't understand if this was part of the first subsidiary or not but it was broken out separately.

The main line of business for KSK is software for semiconductors.  The software they design can be found controlling chips in everything from Android phones to cars.  They create some software on a contract basis for clients and other software as stand alone products they sell themselves.

Quick Thesis & Highlights

The investment thesis on KSK is pretty simple, this is a company with a negative enterprise value that's trading for less than 2/3 discounted net asset value.  The company is profitable, has no debt, and has a solid stream of free cash flow.  Management seems to be aware of the valuation disparity and has been buying back shares somewhat aggressively over the past few years with 16.5% of outstanding shares being repurchased.

Here are some key bullets on the stock if the above paragraph is a bit too much to read:

• ¥3.4b market cap ($42m)
• ¥5.2b in cash and securities, only ¥40m in short term debt
• Net cash of ¥439/sh and discounted NCAV of ¥709
• Profitable for the past nine years
• 3.3% dividend yield
• Management has been buying back shares in 100,000 chunks when possible.  About 16.5% of the total outstanding shares have been repurchased.

Companies like this only come along in Japan.  I have two pictures below, my net-net worksheet, and my earnings accruals worksheet.  When investing in Japan I want two things, a strong asset based margin of safety and solid earnings/cash flow to support my margin of safety.  The accruals worksheet is one way to check the quality of earnings.

There is really nothing all that surprising with the balance sheet, a large amount of cash and receivables with a small bit of inventory.  I would be concerned if an IT services company was carrying inventory but that's not the case.  Liabilities are mostly composed of payables and other working capital items.

The accruals worksheet shows that balance sheet accruals dropped over the past year whereas income based accruals were running in the 6% range.  Neither of these numbers raise any eyebrows.  The explanation for the drop in balance sheet accruals is due to a drop in inventory.

Checking accruals seems like such a simple task but you'd be amazed at how many companies I've rejected based on poor quality earnings.  For a Japanese net-net to get my investment I want high quality assets along with high quality earnings.  I'll put up with low quality earnings, or a turnaround in the US, but in Japan I can demand both and find companies that meet my criteria.

Why cheap?

This is a question I always want to ask of any potential investment, why are the shares cheap?  I think investors often get complacent on this point, but even on a very cheap stock like KSK I think the exercise has value.

KSK is trading at such a large discount to liquidation value, and a reasonable valuation for what I believe are a few reasons:

• The company is in a tough market, IT services is a commodity business and the semiconductor segment is struggling with overcapacity.
• KSK has seen revenue slip and continues to talk about the tough economic conditions it faces.  Clearly this isn't a company on the cusp of record breaking earnings.  Some economic commentators have stated they feel Japan is in a depression.
• The company trades on the Osaka Exchange which is a lot less visible and is more illiquid.  Many foreigners don't have the ability to purchase stocks on the Osaka Exchange.
• While management seems to be somewhat friendly in the sense that they pay a dividend and are buying back shares a liquidation or a buyout doesn't seem likely.

Even with all the potential negative company specific factors and larger Japan macro factors at play I think KSK's discount to liquidation value more than compensates for the downside.  This is a company that if liquidated today would give shareholders an immediate 80% return.

Without anything glaring that could possibly justify the valuation I decided to add KSK Ltd to my collection of Japanese net-net stocks.  With the language differences and my lack of in-depth of understanding of their business I will probably sell KSK when the stock hits NCAV. 

Talk to Nate about KSK Co Ltd

Disclosure: Long 9687 KSK Co Ltd

How about those Japanese net-net's?

I'm in California on vacation, and since I'm physically as close as I've ever been to Japan it seems appropriate to do a post looking back on the Japanese net-net's I've profiled and mentioned on the blog.

I put together a spreadsheet showing the performance of all of the Japanese stocks mentioned on this blog over the past year.  I also included all of the stocks I profiled in my Japanese net-net reports.

So first off the results are impressive.  An investor would have only lost money on one stock which is pretty remarkable.  If someone bought an even amount of each stock they would have had their portfolio return 32.6% against a index return of -4.2%.  

Let me put this in perspective.  Let's take a hypothetical investor who invests $5,000 into each of the stocks presented above.  As of May 1st 2011 they would have had $80,000 which was gradually invested into the 16 stock portfolio.  As of 2/28/2012 their portfolio would be worth $106,080, a very nice return.  US Dollar based investors would have had an extra boost from the Yen appreciation although for my purposes I did everything in Yen so currency movement wasn't a factor in my analysis.

An investor could have an even higher return if they would have kept their eye on the stocks throughout the year and sold when certain stocks hit their NCAV.  I held Dainichi for a while but sold when the price jumped into the high 900s and low 1000s.  The stock has since fallen back to 790 for a 30% gain, but an alert investor could have walked away with much more.

I didn't do anything special to get the list above, some of the stocks were net-net's others were trading close to gross cash.  Some were profitable, others weren't but overall these were a group of very cheap neglected stocks that the Japanese market left for dead.  

I'm sure some of you are wondering how did I do personally?  I didn't quite do as well as the group average although I did beat the median return; my own set of Japanese net-net's returned 24% since purchasing.  I sold off Dainichi when it made it's climb into the low 1000s.  

My take away from this is that net-net investing works, even in terrible markets when the market return is negative a portfolio of net-net's seems to do well.  Every market pundit I've read or heard talks about how Japan is a dead market that investors should avoid.  Prudent investors who went in seeking a margin of safety in the form of buying companies for less than liquidation value did very well for themselves. 

Disclosure: Long SPK, Sugimoto, Asics Trading