One technique to play with during times of duress

Published on:
April 25, 2020
Reading time: 4 Minutes.
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COVID-19 impact on the first quarter of 2020 capital markets results was felt by all of us. And every profession slowly finds ways to respond and to adapt.  

In this essay, I write that treating your portfolio of stocks as a portfolio of businesses - and not a collection of ticker prices - may help you see things differently. 

A random walk on the Indices

Imagine an investor placed a $10,000 bet on a S&P 500 mutual fund on January 1. By the end of January, the value of bet would $9,984. The value would further drop to $9,144 by the end of February. The portfolio would drop to $8,000 by the end of the quarter [1]. In short, the investor's bet would be down 20% for the quarter.

The fall in market prices was felt across the indices. Nasdaq started 2020 at 9,151 points and ended the month of January at 9,190 points. By February, the index dropped to 8,667 points and ended the quarter at 7,459 points. A drop of 1,692 points or an 18% drop. One more example is the Dow Jones Industrial Average. The Dow started 2020 at 28,638 and ended the quarter at 21,227, down 7,411 points, about a 25% drop. 

Global markets were down, too. The MSCI World index dropped by 21% during the first quarter of 2020. And the MSCI Emerging Market dropped by 23.6%. (Try not to laugh next time you hear about the benefits of global diversification.) 

So it took just three months to bring back the five indices two to market levels seen over two years ago. Can we assume that's likely the time frame for the indices to return to the early 2020 levels? 

"No,"  nervous investors would say. They would further note that if we annualize the market loss over the past three months, the initial $10,000 bet in the SP&500 will be worth $4,096 by the end of 2021. 

Bearish investors would remind us that it can take a long time - much longer than two years - for indices to recover. They would recite that on December 31, 1964, the Dow was at 874 points. And that if we fast forward 17 years later, The Dow stood at 875 in exact on December 31 [2].   

COVID-19 effect on my portfolio

My portfolio of stocks was not immune to the vicissitudes of the market. Out of sheer luck, before the market fell, I didn't own any restaurants, cruise lines, hotels, retail, or restaurant businesses. I also didn't have any material positions in the gas and oil industry and airlines.

I did own three companies in the Gas and oil business (Gulfport Energy, Noble Energy, and CNX Energy). I also owned one Airline company (Hawaiian Airlines, which I wrote about in June 2019).  While the market value of the four positions more than halved, the overall effect was small. The four companies represent less than 7% of the portfolio. 


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But the portfolio's value took a hit nonetheless. It dropped by 38% over the past quarter. So I opened Excel and fooled around with a few "what if" scenarios, hoping this exercise may alleviate my mood. 

The 'What If's

My highly-concentrated portfolio of common stocks consists of 19 companies. The first ten names are three-quarters of  the value. 

Let's imagine one conglomerate had owned the 19 companies. Let's name the conglomerate G.H. Here is what G.H. would report to shareholders for yearend 2019: 

G.H. 2019 revenue [3] was $5,847 million, with an operating income of $1,184, a reasonable 20% operating margin [4]. The pre-tax earnings were $416 million, and the after-tax earnings were $330 million, a 5% profit margin.

With a market valuation of $6,867 million as of yearend 2019, the market valued the 2019 earnings at 21 times. 

Ganel Holdings 2019 Income Statement
G.H 2019 Income Statement

If G.H profit margin stays at 5% over the next five years, then the annual return between 2019 and 2023 will be a loss of one percent. This gloomy result assumed a 10 times earnings valuation in 2023 [5].

Ganel Holdings 2019 Balance Sheet
G.H. 2019 Balance Sheet

If G.H net profit is 10% sometime over the next five years, then the 5-year annual return will be 10%. Again, the earnings multiple assumption is 10 times the earnings.

Let's increase the earnings multiple valuation assumption from 10 times to 15 times the earnings. At a gutsy 15 times, the 5-year annual return will be 8%, assuming a 5% profit margin and 24% assuming a profit margin of 10% [6].


"While we see ourselves as rationale machines, constantly weighing the cost and benefits of our decisions, current research says otherwise," I wrote in January 2019 in The Ten Commandments of Value Investing. "It is only a matter of time before something drastically bad will happen to us. And it is important to prepare for times when we will recite that these are times that try men's souls." 

Indeed, these are times that try men's souls.

[1] The S&P 500 lost 0.16%, 8.41%, and 12.51% during those months, respectively. [2] Read more in Tap Dancing to Work written by Carol Loomis. [3] Figures are weighted average to reflect the proportional positions in each company. [4] Driven upwards because of GrafTech's operating margin of 53%. [5] For reference, the S&P500 earnings multiple was 18 times at the end of 2019 and 13 times at the end of the first quarter of 2020. [6] According to Factset, the S&P 500 profit margin is about 10%.

Whirlpool's business is dull. But at a $90 a share, it's a thrill.

Published on:
April 18, 2020
Reading time: 7 Minutes.
Last Update:

Whirpool's revenue grew by 10% over the past 50 years. But at $90 per share, I thought I could earn a higher rate of return. Here's why. 

On Whirlpool's competitive advantage

Whirlpool (WHR on Nyse) operates in an industry that is shared by a small number of producers [1]. According to IndustryWeek, the five major appliance companies are Whirlpool, Electrolux, GE, LG, and Samsung. 

Yet Whirlpool is the only American-domiciled company. Out of its 36  locations in 13 countries worldwide, ten sites are in the United States. And the ability to manufacture products in the U.S. allows Whirlpool to be a low-cost producer, as shown by the better-than-average operating margins. 

Whirlpool 2019 to 2015 business results. Source: company filings.

Between 2019 and 2017, Whirlpool's operating margin [2] was 12% in the United States. In other countries, the company's operating margin was tiny. In Latin America, the average revenue was $3,580 million, with an average operating income of $210 million, a 6% ratio. In Asia, Whirlpool's revenue was $1,547 million, with an operating income of $57 million, a minuscule margin of about 4%. 

Also, LG reports on an operating margin of 2.6% for the home appliance division. Samsung said in 2019 on a 5% operating margin for the consumer electronics division. 

The same ol' business

The top-line has not changed much over the past few years. In 2015, revenue was $20,891 million and pre-tax earnings were $1,306 million. In 2019, revenue was $20,419 million and pre-tax earnings were $1,204 million.

The balance sheet didn't change much, either. In 2015, total assets were $19,010 million, and the assets slightly declined to $18,881 million in 2019. Long term debt was $5,592 million five years ago and grew to $6,394 million in 2019. Reported equity was down to $4,118 million in 2019 compared to $5,674 million in 2015 [3].

What dramatically changed was Whirlpool's market valuation. In yearend 2015, Whirlpool sold at $149 a share. At that price, for every dollar of revenue, investors paid 56 cents, and for every dollar of book value, they paid $2.4. In short, investors paid $15 for every dollar of earnings. 

Today, you buy a dollar of the 2019 revenue for 30 cents. You pay $1.4 for one dollar of book value and about $7 for one dollar of the 2019 earnings per share. That makes all the difference in the world.

You would think something changed about the quality of the business.  But in 2015, Whirlpool generated $617 million in free cash flow, and in 2019, it made $672 million in free cash flow [4]. And long debt represented 30% of the total assets in 2015 and 34% in 2019. 

So, perhaps, the gloomy valuation is because of something else? 

The lack of appeal

The home appliance industry sells a commodity [5] that it is costly to make, with rising labor and retirement costs, and with low, single-digit profit margins. Compared to other businesses, the home appliance business is unappealing. 

Whirlpool revenue breakdown
Whirlpool's revenue breakdown. Source: company filings.

The industry also lacks sex appeal. We describe these products as "useful" or "helpful." But you wouldn't describe your wash and dryer as "disruptive" or "innovative." 

This reminds me how author Bill Bryson once commented of people's fascination with particular machines, such as cars, but that we are completely oblivious to others.

"I can't for the life of me understand why anyone would want to know all this about a machine [car]," he wrote in Notes from a Small Island. "You don't take that kind of interest in anything else. I've been waiting for years for somebody in a pub to tell me he's got a new refrigerator so I can say, 'Oh really? How many gallons of freon does that baby hold? What's its BTU rating? How's it cool?. " 

The home appliance industry is not winning the popularity contest.  But as we deal with the first, large-scale uncertainty in the 21 century [6], the necessity and predictability of the home appliance business is attractive to me. 

In a decade, we will need to clean our clothes and to refrigerate our foods. We will need appliances such as food processors and blenders to help us cook our food. And we will need to replace these items every 8 to 12 years.  

Whirpool's 20-year business track record (from 2000 to 2019)

Between the year 2000 and 2019, the average operating margin was between 5% to 7%, and the pre-tax earnings margin was about 3% to 4%. Since the operating margins will invariably stay the same, to grow earnings, Whirpool will need to increase revenue over time. 

The average 5-year revenue, between 2004 and 2000, was $11,416 million. Revenue almost doubled to $20,863 million between the average 5-year revenue between 2019 and 2015. The company expanded to markets such as Latin America and Asia. 


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Over the past two decades, Whirlpool improved the operations margins. The average 5-year pre-tax earnings between 2004 and 200 were $480 million; between 2009 and 2005, the average pre-tax earnings were $513 million; between 2014 and 2014, pre-tax earnings were $583 million, and between 2019 and 2015, pre-tax earnings were $913 million. 

Whirlpool revenue from 2019 to 2000
A look at business results over a 5-year interval. Source: company filings

The earnings grew while the costs to produce the appliances went up almost two-fold. This is using plastics material and resin price data by the Federal Reserve Bank of St. Louis. Also, visit the cold-rolled steel sheet for data on metals. 

What's it worth? 

In Common Stocks and Common Sense, value investor Ed Wachenheim writes: 

Our conclusion was that the company's [Whirlpool] revenues and operating profits could be about roughly $25 billion and 10 percent, and thus its operating profits could be about $2,500 million. We estimated that the company's 2016 interest costs, effective tax rate, and diluted share count would be $275 million, 28%, and 80 million, respectively. Given these educated guesses and projections, Whirlpool would earn about $20 per share in 2016. 

Five years passed. And we can now update our expectations, following Wachenheim's logic. 

Here is how the prior paragraph would read in 2019:

The 2019 company's revenues and operating profits were $20 billion and 7%. The interest costs, effective tax rate, and diluted share count were $187 million, 23%, and 64.2 million, respectively. Given these reported numbers, Whirlpool earned $1,184 million or $18.4 per share in 2019. 

How should we value the $18.4 earnings per share? Again, let's follow Wacheniem's logic. He writes: 

On balance, my best guess was that Whirlpool was not worth more than 12 times its earnings, and therefore that the shares might be worth $250 to $300 in 2016. However, I finally decided that my current valuation made little difference. If Whirlpool came close to earning $20 per share in 2016, the shares (which we were selling at about $80 in the spring of 2011) would be an exciting investment regardless of whether they were worth 15 times earnings or 12 times earnings or even ten times earnings. 

In sum, and let the record show, that I believe that over the next 3- to 5- years, assuming earnings are between $18 to $20 per share, the market will value the shares at about $200. 

I believe that over the next 3- to 5- years, assuming earnings are between $18 to $20 per share, the market will value the shares at about $200. 

The risks

I see three concerns. The first issue is the lack of revenue growth. Second, the fierce competition. And third, the Grenfell saga. A brief on the three points follows. 

Lack of growth: Since 2015, the top-line at Whirlpool hadn't changed. The 2015 revenue was $20,891 million, and the 2019 revenue was $20,419 million. The same can be said for the operating margins of $1,560 million in 2015 and $1,391 million in 2019. Since 1949, Whirlpool compounded revenue growth at about 11% [7]. 

The competition: It is difficult to distinguish one brand of washer and dryer to others; they all have similar cycle times, size, features, weight, and pricing. And practically all of them break within 8 to 12 years.

It is also likely that the industry will experience a disruption. Think Casper's penetration to the mattress business. Think Harry's or Dollar Shave Club to the razor blade business. I don't know when and how the disruption to the home appliances business will arrive, but it is a matter of time.

The Grenfell Tower: In June 2017, London's Metropolitan Police released a statement that it had identified a Hotpoint-branded refrigerator as the initial source of the Grenfell Tower fire in West London. "The model in question was manufactured by Indesit Company between 2006 and 2009," wrote Whirlpool's management in response. 

While Whirlpool bought Indesit five years after the incident, they are likely to be liable. And indeed, the saga is not helping Whirlpool win the popularity contest in the U.K. Read this Insurance Journal article as an example. 


Pen&Paper is never about stock recommendations or trade ideas. Instead, it's about sharing business stories and attempting to understand what they can teach us about life. There are three lessons behind the story of Whirpool that I would like to highlight. 

The first lesson is that price matters. A lot. Investors often chase popular names such as Netflix or Amazon. But I doubt you can earn a reasonable return over the long term when you buy a company at a multiple of 63 times the trailing earnings (Netflix) or 60 times the trailing earnings (Amazon). Why a hefty price will result in an unsatisfactory rate of return will be a topic for future discussion. 

The second lesson is that predictable, understandable businesses bring comfort at stressful moments. One of my dearest friends bought ProShares Trust Ultra Vix Short three years ago, expecting the ETF to go up as capital markets would cool. But now that markets not only cooled but froze, the ETF is down 90% of its value three years prior.  

If Whirlpool will halve in market price, I will not sell the stock. Understanding a business removes the need to react to market conditions. Also though the price of resin and metal, the main cost ingredients, was volatile in past decades, the company slowly grew earnings. Whirlpool shows that it is better to rely on business fundamentals than on capital markets. 

The more you understand the business, the less you need to react to the market.

Finally, the third lesson is that cultivating patience is one of the great tools they don't teach you in business school. In the stock market, you are not awarded for making fast decisions. You are awarded for good ones. As Charlie Munger said, "The big money is not in the buying and the selling, but in the waiting." 

FOOTNOTES: [1] An oligopoly in business nomenclature. [2] Operating income divided by revenue. [3] Even after a hefty goodwill impairment charge. [4] The average 5-year free cash flow was $620 million. [5]  I have yet to see a shopper that treats a home appliance product to an Apple product.  [6] The effects of COVID 19. [7] An impressive growth rate for investors who are looking for a rate of return of 15% to 20%. 

Teva's common stock is only for the contrary-minded investor

Published on:
February 8, 2020
Reading time: 9 Minutes.
Last Update:

Buying Teva is the classic contrarian position. There are fears because of management turnover. There is an anxiety over declining sales. Mr. Market is now selling Teva at $10 a share because of the pending, opioid lawsuits while I am buying the stock. Paradoxically, both of us feel we got a bargain!  

Buying Actavis was wrong

When Erez Vigodman, Teva's former CEO, pitched to shareholders that he wanted to buy Actavis, the generic arm of Allergan plc, he said the combined entity would benefit from a diversified revenue stream, cost synergies, tax savings, and economies of scale. The typical m&a nomenclature.  

In a pitch deck titled the 2016-2019 Preliminary Financial Outlook, he estimated revenue to be between $26.7 billion and $27.8 billion by 2019, an Ebitda compounded growth of 14%, and to report on earnings per share of $7.5 to $8.1 per share.

Teva's board of directors bought the story. And no later than three weeks after the initial discussions, Teva announced a whopping, $40.5 billion purchase price. To fund the Actavis purchase, Teva's board gave away 100 million of the common stock [1] and $33 billion in cash. The right side of the balance sheet mushroomed to $34 billion as a result.

Teva not only leveraged the balance sheet, but Teva had no trouble paying up. The press release noted that "Actavis Generics had net revenues and total direct expenses of $6,184.4 million and $5,367.4 million of expenses."

Actavis reported total assets of $12 billion - of which half of intangibles and goodwill – and total liabilities of $3 billion. Teva, in short, bought Actavis at eight times the sales and four times the book value.

Did Vigodman ever read Benjamin Graham?

How companies grow

"I firmly believe that acquisitions are an addiction, that once companies start to grow through acquisitions, they cannot stop," lamented Professor Aswath Damodaran at the CFA Institute Equity Research and Valuation Conference. "Everything about the m&a process has all the hallmarks of an addiction."

In that presentation, Damodaran brought data from a McKinsey study, showing that "the very best approach of creating growth historically has been to come up with a new product," he noted. "Look at Apple. Between 2001 and 2010, Apple went from being a $5 billion company to a $600 billion company, and they built it on the iPhone, the iPad."

In addition to inventing new products, companies grow by expanding into new markets. For example, with hardly anywhere to grow in the United States, Costco is building stores globally and recently launched a store in China.

The only other option is to grow or maintain market share in an expanding market. "Think of Apple and Samsung between 2011 and 2015 in the smartphone market," Damodaran said. "Apple's market share decreased between 2011 and 2015, but its value increased. Why? Simply because the smartphone market itself was growing."

What is worrying about Teva

Teva now faces three challenges: pricing-fixing and opiod-related lawsuits, loss in revenue because the patent behind Copaxone had expired, and a leveraged balance sheet. More on Teva's worrisome future below: 

The lawsuits

You can't avoid shaking your head when reading about Teva's current troubles. Not only did the pro forma numbers never materialize, but also Teva's lawyers are  busy defending the company on price-fixing and opioid-related charges.

(To get a sense of how serious is the U.S opioid crises, read aboutThe Family That Built an Empire of Pain.)

Analysts estimate that Teva will be liable to pay anywhere between $2 billion and $10 billion in the future. According to CNN, an Oklahoma judge approved $85 million settlement with the opioid drugmaker.

"In the first nine months of 2019, Teva recorded an expense of $1,171 million in legal settlement and loss contingencies," writes management in the 2019 third-quarter filing. "The expense in the first nine months of 2019 was mainly related to an estimated settlement provision recorded in connection with the remaining opioid cases."

I wrote about the difference between risk and uncertainty in a prior essay. Wall Street analysts, often with a background in math, attempt to understand risk with probability theory and statistics. But they hate uncertainty because it is difficult to quantify in numbers. So, capital markets are frustrated by Teva's unknown future.


"Our leading specialty medicine, Copaxone, faces increasing competition, including from two generic versions of our product," writes management in the risk section of the annual report. Indeed, the FDA approved in October 2017 and February 2018 two generic versions of the medicine, and Teva's revenue from Copaxone was immediately hit. In 2016, Copaxone's revenue was $4,223 million. It dropped to $2,365 million in 2018.

"Invert, always invert!" says Charlie Munger. And if we invert this data point, that branded drug sales fall when the generic version enters the marketplace, we see Teva's competitive position. The company is world-leading in generics.

The financial statements

There are red flags all over the balance sheet, the income statement, and management's turnover. Consider the balance sheet: before the Actavis purchase, Teva reported $8 billion in liabilities on $30 billion in equity, a debt to equity ratio of 25%. After the acquisition, liabilities mushroomed to $32 billion on reported equity of $35 billion, a debt to equity ratio of 91%.

While risk in investing is difficult to define, let alone calculate precisely, it is not good when the debt to equity ratio increases by three times.

The income statement tells a similar tale. Interest expense went up threefold, from $313 million in 2015 to $1,000 million in 2016. And over the past three years, the annual interest expense remains high, at about $950 million a year. The operating income to interest expense ratio used to be over ten times; it is now in 2 to 3 times range.

And there has been a management shake up: Kare Schultz replaced Erez Vigodman [2] two years ago and immediately announced a restructuring plan that included reducing the labor force and divesting assets. Before joining Teva, Schultz served as president and vice CEO of Novo Nordisk, multinational pharmaceutical products company.    

The ensemble of the three concerns resulted in an over 80% drop in Teva's market price. In 2016, the stock traded hands at $60 a share. It now trades at $10 a share.


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The pharmaceutical industry

You could hardly tell of any fundamental changes to the pharmaceutical industry based on the Dow Jones U.S. Select Pharmaceutical index return. The index shows a total return of about 13% over the past decade and a 10% return over the past year.

Current investors are paying up for this return. If you buy the iShares U.S. Pharmaceutical Index (IHE on Arca) for example, you are buying an equity interest in the 46 pharma companies at a price to sales ratio and price to book value of four times.

But the return is not smooth for individual companies. For example, Akorn, Inc. (AKRX on Nasdaq) lost over 90% in market value over the past five years and halved in price in 2019. It is rumored to go bankrupt because of opioid-related litigation.

Another company caught up in the opioid scandal is Endo International (ENDP on Nasdaq). Its market valuation dropped by over 90% in the past five years, and just in the last year, the stock dropped by 60%. The same market loss can be demonstrated with Mallinckrodt (MNK on Nyse), Amneal (AMRX on Nyse), Myland (MYL on Nasdaq.)

According to statistica.com, there is an increase in the proportion of generic versus branded drugs. In 2005, about 40% of prescriptions dispensed were brand name drugs, and around 50% were unbranded generic drugs. In contrast, in 2018, only 10% of orders were brand-name drugs, while over 85% were unbranded generic drugs.  

Other trends in the global healthcare trends include an aging population, chronic diseases, and growing pressures from the government to provide affordable healthcare solutions. It seems those trends are muted compared to the opioid-related charges.

Trends in prices of generic prescription drugs
Trends in retail price of generic prescription. Source: AARP Public Policy Institute.

A stroll over Teva's past five years (2018 – 2014)

Teva's current challenges, drop in operating margins, and impairment losses, immediately show on the income statement. In 2014, revenue was $20 billion, gross sales were $11 billion, and net earnings were $3 billion. After years after, revenue was $19 billion, gross sales were $8 billion, and loss $2.4 billion [3].

The drop in revenue is because of increased competition and price pressure in generics and a decline in sales in Copaxone, as I noted in the investor concerns section.

Teva's income statement shows that the business requires little capital expenditures. If we remove the accounting charges (asset and impairment loss) and look at the total 2018 to 2014 pre-tax earnings, we find $17 billion in pre-tax earnings. During these five years, the reported capital expenditures [4] was $6 billion, less than a third.

(The last time Teva paid a dividend was November 17, 2017.)

Teva's 2019 quarterly earnings.
Teva's 2019 earnings. Source: public filings.

From a stroll over TEVA's balance sheet, two items jump at you. The first is the change in intangible and goodwill accounts between 2015 and 2016. In 2015, management reports on $26 billion in total for both accounts. A year after, the number is up over twofold to $65 billion. Long term debt went up fourfold to $33 billion in 2016 from $8 billion the prior year.

One year after, between 2016 and 2017, the goodwill account was cut by $16 billion. Management effectively halved the book value of equity.  

Financial results (first three quarters of 2019) 

In 2019, management reported $4 billion in quarterly revenue with net earnings of one billion. I expect the fourth-quarter results to be similar. So TEVA's 2019 results are likely to be roughly $16 billion in revenue and $4 billion in net earnings, about $3.50 to $4.0 per share [5]

The Europe segment has the highest operating margin, followed by North America's segment and the International segment. In numbers: the operating margin was 57% in Europe.  The ratio was 51% in North America, and 40% in International markets.


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Teva's owner earnings

In the 1986 letter to shareholders, Warren Buffets explains owner earnings. He writes:

These [owner earnings] represent reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges less the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.

We can compare owner earnings to GAAP earnings using Teva as an example. I used Buffett's formula with a slight modification. Because Teva has a legal cost - every year - I removed from the owner earnings an arbitrary one billion in legal expenses. The table below summarizes the results:

We can see that between 2014 and 2016, investors paid a premium over the owner-earnings value per share. But their appetite waned in 2017 and 2018 when you could buy the stock less than half the implied value.

In February 2020, at about $10 per share, Teva trades at a quarter of the implied 2018 value.

Over the next 3- to 5-year period, I estimate that Teva's top line will be $18 billion, with a 25% operating margin, resulting in owner earnings of $3 billion or $3 per share. From that, I estimated the value of the Company to be anywhere from $15 billion (5x the implied value) to $45 billion (15x the implied value). I also estimate the opioid-related lawsuit will cost Teva anywhere from $2 billion to $10 billion, which results in a valuation range of $20 to 28 per share.

Teva's owner earnings 2018 to 2014.
Teva's owner earnings. Source: My calculations.

Teva's generic and specialty medicine

Teva sells generic medicine and specialty medicine. Generics aim to provide the same chemical and therapeutic solution of a branded medicine. There are over 300 generics that Teva sells.

Specialty medicine category includes solutions for the central nervous system such as  Copaxone, Ajovy, and Austedo, and solution for the respiratory system such as Proair and Qvar. Teva also sells medication such as Bendeka and Trisonex in oncology.

Last year, generics were about 40% of the revenue; Copaxone was about 20% of the revenue, and Bendeka, Proair, Quar, and Austedo et al., were the remaining about 40% of the revenue. Teva manufactures products using 55 pharmaceutical plans in 22 countries. Last year, the Company produced 80 billion tablets.

The best profit margins are in Europe, followed by North America and the international markets. Over the past three quarters, the profit margin in Europe was 57%; in North America, it was 51%; and 40% in International markets. The difference in profit margins is the result of competition, pricing power, and regulatory red tape.

You can now buy the generic form of Copaxone (see more in the investor concerns sections) in North America. Teva's revenue was hurt as a result. The Company reported revenue of $12 billion in 2016, which dropped to $9 billion in 2018; profits in 2016 were $5.5 billion compared to $2.8 billion in 2018, and Copaxone revenue was $3.5 billion in 2016 compared to $1.8 billion in 2018.

In North America, Teva introduced 22 generic versions of branded drugs in 2019. And it was meeting regulatory approvals for about the same number of generic medicines. Two new products that I believe will be important for Teva are Ajovy and Truxima.

Ajovy was approved in September 2018 and is protected until 2026 in Europe and 2027 in the United States. TruixmTruxima was approved in November 2018 [6]

Biosimilar is a biologic medical product highly similar to another already approved biological medicine, says Wikipedia. Teva writes: "Biosimilar products are expected to make up an increasing proportion of the high-value generic opportunities in upcoming years."  

There is going to be a lot of competition in the biosimilar medication in the future. And whether Teva will win over its competitors is unknown. But a few trends, working in favor of companies such as Teva, are clear. Our population is aging; there is an increasing amount of chronic diseases that need solutions; governments are pressured to provide affordable healthcare; there are scientific and technical discoveries that require unique manufacturing capabilities.

FOOTNOTES: [1] In 2016, the stock traded at about $60 a share. [2] In contrast to Vigodman, Schultz has pharmaceutical background. [3] Teva recognized $5.6 billion in non-cash, impairment losses. [4] Does not include business acquisitions. [5] I took out non-cash expenses such as asset impairment loss. [6] I couldn't find until what year Truxima will be protected.

Why both active and passive investors should expect market swings

Published on:
November 13, 2019
Reading Time: 3 Minutes
Last Update:

Timing the markets is hard; perhaps, impossible. But it is easy to see that market prices widely swing.

In this essay, I describe the investing performance of past and current value investors. As you will shortly read, all legendary investors reported poor results at times. The active investor should know that even great investors failed to correctly time markets. 

For the passive investor, I bring the historical record of indices such as the S&P 500 and the Dow Jones. Here, my goal is to show you that if history is any evidence of the future, then markets swing in price. 

So if you invest in an active mutual fund or an exchange-traded fund (ETF), unless you can calmly withstand market swings,  you are best to buy assets that do not have a daily market quotes.

The active record

Even great investors reported paper losses [1]. The legendary Walter Scholls wrote to investors of a 5% loss in 1957, followed by a 9% loss in 1969 and an 8% loss in 1970. 

During 1973 and 1974, Scholls reported a loss of 15% during each of those two years; Sequoia fund, another legendary fund,  reported a loss of 38% during those years. Even Charlie Munger lost over 53% [2].

Let's fast forward to current examples. Between July 2007 and June 2008, Mohnish Pabri lost 32%, and in the following year, he suffered an additional 25% paper loss. In other words, in two years, the market value of a $100,000 investment was halved. 

Pabrai, whom I admire and who much influences my thinking, also reported a loss of 22% in June 2012. So let the record show that even great minds experience bad years.

Another investor whom I consider to be one of the greatest is Guy Spier.  In 2008, he reported on a 47% loss and a 16% loss in 2015. He writes in The Education of Value Investor 

"2008 was something else. I'd never experienced an avalanche like this within my portfolio. The serious damage began in June when the fund fell by 11.8%. The following month, I was down another 3.5%. And then things started to get ugly. In September, it tumbled by another 12.5%. For the year as a whole, I was down 46.7%. On paper, almost half of my shareholders' money and my family's money had gone up in smoke."

(To clarify: by no means is this an attempt to embarrass Pabrai or Spier. The goal here is to show you that it is a certainty that you will see paper loss if you invest in the stock market. Whether you invest on your own or let others manage your money.) 

The next section is for readers who are disinterested in neither investing on their own nor in a fund. This section is for those who choose to invest in the stock market using ETFs. 

The passive record

If you were bullish [3] on the United Stated economy and, say, a decade ago placed a $100,000 bet in an ETF that tracks the performance of the S&P 500 index, the value of your position would now be $271,000.

And compounded growth of about 12% over ten years may now affect your expectation levels. Yet it is unlikely you will get double digits return from a single-digit growth economy. 

In Bull!, Maggie Bahahr shows why. She provides three examples of market cycles. First, between 1882 and 1897, 15 years, the S&P 500 total return was 3.4%. Between 1903 and 1921, 18 years, the total return was 0.6%. More recently, the S&P 500 annual return between 1967 and 1982, 15 years, was 0.2%. And between 2000 and 2004, the annual total return was negative 5%.

Can you imagine the frustration of parting with cash for 15 to 18 years only to realize that you are no better off than when you started?

Not only do market cycles affect return, but the annual return also affects the investor's psyche. For example, between 2000 and 2003, the S&P 500 lost value. If you had $100,000 in the stock market, the value of your portfolio would be $60,000 three years after. In 2008, the market lost that same amount of value in a single year - the S&P 500 lost 38% in 2008.

Both the Dow Jones Industrial Average and the Russell 2000 show similar results. Between 2000 and 2003, the Dow lost 28% in total, and in 2008 it lost 34%. The Russell 2000 dropped 21% in 2012 alone and 35% in 2008.


There is little we can do to stop, delay, or change the natural swings of markets. But two things are in our control. First is an awareness. Knowing that you will have a significant paper loss at some point should leave you less troubled when the day arrives. You will know that this too shall pass [ 4] .

Secondly, keep cash handy. It is one thing to see the market price of your portfolio drop - yet it is terrific when price declines allow you to buy great businesses at excellent prices.

[1] Paper loss is the unrecognized loss in a stock's market value. 
[2] Performance results taken from The Superinvestors of Graham and Doddsville as written by Warren Buffett in 1984.
[3] Bullish in a sense you believed the economy would become stronger.
[4] This adage was notably employed in a speech by Abraham Lincoln before he became the sixteenth President of the United States.

Value Line Investment Survey: A Review

Published on:
October 12, 2019
Reading time: 9 Minutes
Last Update:

Value Line's history

How the Value Line report started is the story of turning setbacks to blessings. Arnold Bernard, the company's founder, was fired at the peak of the Great Recession. "You can have no idea what it meant to be out of a job in 1931," he said. "Nothing like today, when you can read and write, you can get some work - and you can get Social Security too." The Great Crash led him to work on what would eventually become the value line rating theory [1].

Value Line's early days were humble. Bernard reached out to local banks and other financial institutions and could not make a single sale; he valued the product, at the time a book, at $200. But L.L.B. Angas marketed the book for $55. Even at that low ball price, there we no buyers.

Fast forward fifty years. The New York Times wrote about Bernahrd that "His [Bernhard] approach contradicted the 'efficient market hypothesis,' which holds that information is reflected in stock prices so quickly that no attempt to beat the market can succeed in the long run." Indeed, Bernhard was one of the first investment contrarians simply because he was skeptical of the markets being efficient.  

The Value Line company

The Bernhard family still holds 89.34% of the common stock. Value Line became a publicly-traded company in 1983 and trades under the symbol VALU on Nasdaq. Subscription revenue was $28 million in fiscal yearend 2019 [2]. Revenue from print subscribers was $13 million, and revenue from digital subscribers was $15 million. In 2019, Value Line was able to attract 13% new members; renewal fees were 87% of the revenue.

Value Line does not publish the number of subscribers. I estimate the amount of subscribers today is about 70,000 to 80,000 [3]. While a significant number, the company had a much larger subscriber base in the late 80s. In the Bernhard's obituary, written over three decades ago, it was said that the subscriber base was 134,000.  

While the Value Line company is mostly associated with the Value Line Investment Survey, it has substantial investment management services business. In 2019  this business contributed $7 million - about 25 percent of  - the company's revenue. Value Line, through its various mutual funds, oversees over $3 billion has in assets.


Look for a second opinion, especially when considering big changes to your portfolio or strategy. Unbiased, professional insights can help you reexamine your assumptions and reduce emotional decisions.

Join the waitlist to learn more.


The Value Line reports

The flagship product is the Value Line Investment Survey (VLIS), which comes in both print form and digital form. The print version arrives weekly, and the digital version is updated daily. VLIS covers about 1,700 stocks, from small-capitalization stocks to large-capitalization stocks [3]. In a typical Value Line report, you will find coverage of household companies such as Amazon and Apple, but more often than not, you will discover under-the-radar companies such as Raven Industries or Stantec Inc.

The VLIS is a one-page report that covers a lot. It has 15-years' financial information;  it highlights profitability metrics such as net profit margin and returns on equity during; it allows the reader to quickly sift through the company's key growth metrics.; And it shows how much investors valued in the company over the past decade. The bottom section includes details such as recent developments in the company's business and valuation.

The VLIS report's brevity allows the reader to understand an industry and its key players quickly. Consider the human resources industry.  The Value Line report covers 12 companies in this line of business. Reviewing the one-page reports allows the reader to quickly answer questions such as what is the operating margin for the industry as a whole? Are sales increasing? Which company has been growing the most? What is the current valuation of the Human Resources Industry compared to a decade ago?

Value Line Investment Survey allows the reader to quickly understand an industry's operating fundamentals.

Value Line offers other niche products. Since June 2011, it sells readers a report focused on dividend and growth companies. This report aims to find companies expected to provide above-average earnings yield glossary.

In May 2017, Value Line began to publish a report which recommends the best exchange-traded funds (Write to me if you would like to know more about exchange-traded funds.)

The company also offers a special situation report which aims to find undervalued small- and mid-cap stocks with upside potential.

The print version of the Value Line report costs $598 a year. Adding digital access will increase the annual price to $718. The dividend income & growth, which is a separate report, costs $795. The Value Line Select ETF costs $395. The Value Line Special Situations costs $198.

Download .PDF version of the Value Line report to experience the look and feel.

How Value Line is different from Morningstar

Three features make Value Line different from Morningstar. First is the design of the product itself. Or what can also be understood as 'The medium is the message', a term the late Marshall McLuhan coined in Understanding Media: The Extensions of Man. His main point was to understand a message you need first to understand the medium. The logic applies here.

Value Line reports resembles a book. Not a trading floor.

The Value Line Report was designed for print while Morningstar was intended for the web. Print content cultivates patience. Digital content rushes us to act. And today, more than ever, "Patience is the thing in short supply," said value investor Joel Greenblatt told to the Wall Street Journal in A Value Investor Defends Value Investing.

Visit the Morningstar website, and you will see the flashing color of red and green, various calls to "act now or miss out." Value Line, on the other hand, with its dull, plain black and white format, resembles a book, not a trading floor quote.

Morninstar website has too much information
Too much information on Morningstar.

Another difference is that Value Line allows us to understand an industry while Morningstar's emphasis is on individual companies. For instance, if you believe the investment management industry is experiencing tailwinds [4] then Value Line allows you to sift through the key players in the investment management industry and to compare their operating fundamentals.

The fourth difference between Value Line and Morningstar is scope. Value Line focuses on U.S. based companies, specifically on the common stock of these businesses. The philosophy behind Value Line is that individual investors can understand enterprises and can decide on their own.

Readers of Morningstar, however, have a broader interest in capital markets. Morningstar covers capital markets topics from fixed income products to option trading. And Morningstar's philosophy is that investors are best to let investment professionals make the decisions.

Hence, Morningstar's emphasis on rating mutual funds and their yearly performances. Ultimately, this chase after the best performing funds leaves investors with poor results. Visit Business Insider's discussion on the topic: past performance of a mutual fund is not an indicator of future outcomes.

Valueline will fit nicely in a value-investor's desk
Valueline will fit nicely in a value-investor's desk

How to use the Value Line Investment Survey

To me, the Value Line Investment Survey is a stock screener. Every week I review about 50 one-page reports and typically find a company or two that I would like to understand more [5].

For every 50 one-page reports, I typically find three- to five companies that have great business models but are just too expensive to buy. So I add these companies to a list called inventory of ideas, an idea I copied from Michael Shearn's excellent book, The Investment Checklist.

My secondary use of the Value Line Investment Survey is just game-playing. I like to compare and argue with Value Line analysts' estimate of what the company will be worth in three- to five years. For example, Simon Shoucair of Value Line estimated that Ethan Allen (ETH on Nyse) would show $39.6 in revenue per share by 2022 to 2024, a 5-year CAGR of 6.5%. But to me, that was odd assumption since in 2014, revenue per share was $25.81, and in 2018 revenue per share was $28.9, merely a 5-year CAGR of 2.5%.

Reviewing competitors on the Value Line Investment Survey is now an integral part of my onboarding process [6]. Not unlike real life, it is easy to fall in love. If I spend a week or two researching a particular stock, it is difficult not to buy the stock since I invested so much time and effort in understanding the business and its management.

But that is a mistake. So now, I read about competitors while researching a specific business. The constant comparison allows me to find similar companies that are trading at a comparable price with, perhaps, better growth opportunities.

Finally, the Value Line Investment Survey is an educational tool. It exposes the reader to unpopular industries. Value Line not only comments on the industry as a whole but allows us to compare the industry's fundamentals via a review of the major players. I don't know of a better resource for that academic exercise.

I have other uses of the Value Line Investment Survey. Write to me if you would like the complete list.


Founded in 2004, by Charlie Tian PHD, GuruFocus provides institutional-quality financial stock research for the individual investor.

GuruFocus hosts many value screeners and research tools and regularly publishes articles about value investing strategies and ideas. One of the features I use most is the 30-year financial information on businesses. For example, see how easy it is to review AT&T balance sheet.


Who else uses the Value Investment Survey  

In the Berkshire Hathaway 1998 annual meeting, Marc Gerstein asked Warren Buffett how does he manage to review the whole spectrum of choices in equity markets. Buffett's answer was:

"I have yet to see a better way, including fooling around on the internet or anything, that gives me the information as quickly. I can absorb the information on - about a company - most of the key information you can get - and probably doesn't take more than 30 seconds in glancing through Value Line, and I don't have any other system that as good."

Charlie Munger added:

"Well, I think the Value Line charts are a human triumph. It's hard for me to imagine a job being done any better than is done in those charts. An immense amount of information is put in a very usable form. And if I were running a business school we would be teaching from Value Line charts."

I learned about Value Line while reading Mohnish Pabrai's The Dhandho Investor. There he wrote that "Value Line publishes a weekly summary of the stocks that have lost the most value in the preceding 13 weeks.

The Value Line Investment Effect

Not unlike Berkshire Hathaway, The Value Line Investment Effect is considered a market anomaly [7]. In 1982, researchers Copeland and Mayers found that between 1965 and 1978, the Value Line rankings showed statistically significant abnormal returns when compared to the market model. Researchers David Porras and Melissa Griswold then extended their work to the period between 1982 to 1995 and found that indeed, the market anomaly held. Read their findings in The Value Line Enigma Revisited.

Not unlike the performance pf Berkshire Hathaway, The Value Line Investment Effect is considered a market anomaly.

What Porras and Griswold found was that Value Line did well in picking out "winner stocks" but did excellent work in removing "loser stocks." The loser group of stocks had deteriorating financials. If there one thing you take from this article, it is that Value Line keeps the reader informed.

Staying informed is important. It is quite easy to buy a stock; it is much harder to hold it and mainly when to sell the stock. For Marty Whitman, founder of Third Avenue Management, one of the selling triggers was an impairment loss. On page 110 of Value Investing, ✨ he wrote:

"Permanent impairment means that there has been a fundamental deterioration of the business: good finances have been dissipated, new products and new competitors are beaten up, and the industry is becoming obsolete, key management members are lost, and so on."

A few concerns about the Value Line report

The Value Line report overlooks global markets. And to look at U.S.- based companies only is akin to searching for something where it is easiest to look, the streetlight effect. (Write to me if you would receive a few resources on global investing.)

Value Line proprietary ranking for Timeliness and Safety is not absolute. There is no universal definition of what an attractive stock is. What may be appropriate for a 40-year investor may not be right for a 70-year old investor. Value Line readers must come up with their own, unique ranking for what constitutes an appropriate investment.  

Readers of Value Line should have their own ranking system.

For example, when I wrote about Bon Ton stores I defined cheap stocks as "a stock that trades: (1) at an earnings multiple that is lower compared to its earnings multiple over the past decade, (2) at a substantially lower earnings multiple compared to its peer companies, and (3) at a purchase price below its net tangible asset per share."

Finally, the one-page report should serve as the starting point and not as the endpoint. Today, in our service-oriented economy, the book value of companies reveals little about their economic worth. For instance, you will not find the value of Google's engineers and company culture [8] in their reported book value. Also, investors must understand the quality of earnings and not just the reported earnings.

Reported earnings are subjective. They include too many assumptions: from loan loss projections for financial institutions to impairment loss. The only way to get closer to the economic truth is to read the notes to the financial statements found in the publicly-available annual reports and to understand the earnings quality.


Value Line did not sponsor any of the content written in this article. Pen&Paper is independently and wholly-owned by Noam Ganel, C.F.A.

Our freedom allows us to write about what we believe may be valuable to you. We don't earn affiliate marketing revenue without letting you first know about it.  And when we do, for example, if you purchase any of the books mentioned in this article, we give back 100% of the proceeds. Contact us if you have any questions.

We also don't have any positions in the common stock of Value Line. This article, like many others, is part of what constitutes the value- investor mindset: sharing with the community valuable information.

Or, as Charles Schwab said, "making investing accessible to all." 

FOOTNOTES: [1] The rating theory uses regression analysis to value stocks. [2] Value Line fiscal year ended April 30, 2019. [3] Capitalization is the number of outstanding shares multiplied by the share price. [4] If the wind is at your back, helping you to move forward, you experience tailwinds. [5] Understanding means reading the 10-K, 10-Q and 8-K financials, among other things. [6] The onboarding process is a set of checklist items I go through before buying a stock.[7] Market anomaly demonstrates inefficient markets. [8] Company culture is one of Google's competitive advantage rankings such as Timeliness and Safety.

Why I bought a few CLUB shares

Published on:
September 22, 2019
Last Update:

"Gyms need their members not to come, but they can't just lock the doors," notes Caitlin Kenney in Planet Money, NPR's economics podcast. "So they have to rely on consumer psychology to get you excited enough that you'll sign up for a gym membership, but not so excited that you'll get up an hour early to do some crunches before work."

Indeed, ask any physical trainers and Yogis: owning a fitness center is a straight forward business model. You lease 2,000 to 20,000 SF space, buy or lease some fitness equipment and get as many customers signed up. 

The fitness industry's rule of thumb is that if you can sign up 20 times the capacity of the studio, you will be in good shape [1]. 

But it's a tough business. First, not unlike the hotel business, customers' expectations and standards increase with time. Hotel guests now demand flat-screen TVs and a queen-sized bed at a minimum.  And gym members expect Peloton machines and shiny, new barbells. In short, you always reinvest cash in the business.

The fitness business is tough. Owners have to reinvest earnings and customers are unwilling to pay more for the upgrades.

Another drawback is that the operating costs - specifically, lease payments and labor wages - increase over time. And while these expenses rise, customers are unwilling to pay more than roughly $40 a month.

If gym owners increase prices, there are plenty of alternatives. People can exercise outside at no cost; they can subscribe to an app [2] for a fraction of the cost, or they may go on a diet and give up on physical exercise.

Buying a few CLUB shares      

While the fitness business is competitive with little barriers to entry [3], I bought a few shares in Town Sports International Holdings (CLUB on Nasdaq), a fitness company with a pygmy market capitalization of $54 million or about $2 per share.

I calculated the 2018 free cash flow to be $15.1 million or $0.57 per share and the 2017 free cash flow to be $18.9 million or $0.73 per share. In other words, if the last two years serve as a proxy, Town Sports' cash flow will pay back investors their original investment in less than four years.

Town Sports International: income statement snapshot
Snapshot of CLUB's income statement

There are a few publicly-traded fitness companies. A glance at Planet Fitness shows that buying Town Sports is for the bargain hunter.

In 2018, Planet Fitness traded as low as $29 and as high as $57. The company generated pre-tax earnings of $131.8 million, or $1.51 per share, which translates to price to pre-tax earnings ratio range of 19 times to 38 times.

Compare that to Town Sports, which earned $38.6 million in pre-tax earnings, or $1.45 per share. CLUB's stock traded as low as $5 and as high as $15 - a range of 10 times to 3 times the price to pre-tax earnings. Today, at about $2 per share, CLUB is trading at 1.4 times the 2018 earnings.

Trading at four times the enterprise value to free cash flow, Town Sports is for the bargain- hunters.

Where's the catch? 

CLUB's bargain stock price comes alongside serious red flags. The list of concerns includes:
(1) The company's CFO, Carolyn Spatafora, has been selling the stock. She sold about 96 thousand shares this year [4], over 60% of her vested interest in the company.
(2) The company's debt matures in August 2020. Read: if the U.S. economy is in recession in a year, it is questionable whether lenders will finance the operations.
(3) Two-thirds of CLUB's gym members are on a month-to-month basis. To me, this shows that there is hardly any brand loyalty and that customers are unwilling to commit.
(4) Management decided this year to hide critical information from the financial statements. For many investors, that act alone would deter investment. I hope that management action is because it would like to hide information from competitors.

Town Sports International debt to assets ratio is high
CLUB's alarming debt to assets ratio

But that is probably wishful thinking. Michael Shearn, who wrote the excellent The Investment Checklist: The Art of In-Depth Research would be appalled by my action. In his words: 

I have learned that if the strategy of the business is based more on hiding information from competitors rather than outperforming competitors, it is far less likely that the business will have a long term success.

Careful readers of CLUB's prior annual reports would detect a deterioration in key metrics. So, it is little surprise why management would want to hide them.

A few examples: in 2013, the average revenue per member was $78 per month. As of 2017, the metric dropped by 24%, to $59. In 2013, the annual attrition [5] was 41.9%, while in 2017, it was 47%.

Finally, in 2013, the revenue per weighted average club was $2.97 million. The revenue dropped to 11% in 2017 to $2.64 million.

Management decided this year to hide key information from readers of its financial statements. The action alone deters investment.

The remedies

Patrick Walsh, who Forbes Magazine describes as a "Warren Buffett enthusiast," writes to CLUB's shareholders that "patience is a minor form of despair, disguised as a virtue."

I take a less cynical approach and estimate that there are few things good happening now and a few things worthwhile to be patient for.

First, Walsh is fiercely buying the stock. He bought 643 thousand shares this year at a weighted cost of $2.5. This amount was added to his already 3.1 million shares, which represent about 14% of the common stock outstanding.

Second, managing gym clubs does not require sophistication or expertise. I believe it is a matter of time before financial results return to a net profit margin of 10%, with Walsh in leadership or without him.


A year ago, the sports center across the street from my office, increased by almost two-fold the monthly membership rate, from $32 to $57. Infuriated by the price increase, I said to Jillian, the members' relationship manager at the time, that I would take my business elsewhere.

I never did. The convenience of having the JCC across the street from my office, and the community of people I became friends with, far outweighed the price hike. It is my hope members of CLUB fitness centers have the same experience.   

FOOTNOTES: [1] No pun intended. [2] I recently downloaded XPT Life, an app designed by legendary waterman Laird Hamilton. [3] Barriers to entry are the obstacles that make it difficult to enter a given market. [4] If the shares are, indeed, such a bargain at $2, would she not have preferred to hold them?[5] Page 37 in the 2017 10-k report notes that annual attrition is total member losses for the year divided by the average monthly member count. Read: the higher the ratio, the worse it is.

One method to deal with uncertainty

Published on:
September 14, 2019
Last Update:

Mathematicians give names to numbers that cannot be expressed as common fractions. Consider the constant Pi [1] or the square root of two as examples. In this week's essay, I make the case that stock investors should copy how mathematicians dealt with uncertainty [2].

A sense of unease

A few weeks ago I bought shares in Gulfport Energy. At about $4 a share, GPOR traded at  four times the trailing 10-year average earnings per share of $1.84 and at less than a third of its reported tangible book value.

Peer companies traded at much higher valuation. Southwestern Energy (SWN on Nyse) traded at four times the 2018 earnings per share but the 10-year average earnings per share we negative[3]. Southwestern traded at roughly the reported tangible book value.

Another peer company, SM Energy (SM on Nyse), with reported book value per share of $2 and 10-year average earnings per share of $0.26, was trading at 60 times the earnings per share and at about two-thirds of book value.

Yet I felt discomfort after buying Gulfport. I attribute the unease to my inability to understand where Gulfport operations will be in five years. There are three factors that drive Gulfport's business. And all three factors are practically impossible to predict over a five-year time frame.

Three factors that affect natural gas price

First are the macroeconomic issues. These macro factors are heterogeneous and myriad in scope: from consumer spending and confidence levels to employment statistics such as Mass Layoff Statistics (MLS). From prices, productivity and wages variables as indicated by the Consumer Price Index (CPI) to international economic indications such as the German Industrial Production.

Macro factors also include supply and demand variables. For U.S- based natural gas investors, that means a visit to the U.S. Energy Information Administration website, and a review of the domestic production [4].

Then gas investors are expected to determine the trends in each of the demand drivers - those being industrial use, electric power, consumption and exports - a Sisyphean  task. Read Forbes' article about Oklahoma gas and oil industry as example.

The second factor relates to natural gas reserves. The natural gas company will determine how long the company's revenue can continue without incurring additional debt or equity issuance. Uri Geller, a psychic known for his trademark television performances of spoon bending, was once employed to predict how much natural gas reserves could be found. This antidote serves as example that it is, at the end of it all, somewhat of a guessing game.

In a May 2019 presentation to investors, Gulfport Energy's management reported on 92,000 in net reservoir acres in SCOOP (read about SCOOP on Enversus blog) and 210,000 net acres in Utica Shale. Management also reported that as of fiscal year end 2018, it had reserves of 1.3 net Tcfe in SCOOP and 3.4 net Tcfe in Utica Shale. But who can tell how much is still buried in the ground?  

Uri Geller was once employed to predict how much natural gas reserves can be found; estimating future gas reserves is, indeed, a guessing game.

The third issue is the regulatory and political environment which greatly affects the price of natural gas. A recent example from the state of Israel demonstrates how. The exploration for the Tamar gas field began in 1999, then a decade after, in January 2009, "Tamar was the largest find of gas or oil in the Levan bain of the Eastern Mediterranean Sea and the largest discovery," reported the Jerusalem Post. Noble Energy joined the drilling activity in 2006 and was the primary benefactor of the discovery.

Nobel's energy investors were thrilled but the Israelis threw a fit. The Israelis blamed their government of dire misuse of natural resources, which belonged to citizens and not in the hands of foreign, private interest groups, and that forfeiting such a national treasure was, in effect, a security threat. This political debacle began five years ago and continues to this day. In short, political and regulatory concerns are real.

GPOR's margin of safety

Merriam-Webster dictionary explains gambling as "to bet on an uncertain outcome." And if we were to use their narrow definition of the word then indeed buying Gulfport was a gamble. But I will propose a wider definition. Let us expand on Webster's definition with "without any margin of safety."

Buying Gulfport Energy was speculative; but at least there is somewhat of a margin of safety.

The wide margin of safety was the result of the low price to earnings ratio and low price to book value ratio. It was the result of today's investors receiving $24 billion of proved developed and undeveloped per share, while five years ago investors received $8.7 billion, and ten years ago they received $740 million. The margin of safety also results from management's buy back strategy and reduced planned capital expenditures for 2019.


"You've got to have models in your head," said the famed value investor, Charlie Munger. "And you've got to array your experience - both vicarious and direct - onto this latticework of mental models." My main point in this essay was to advocate that investors should observe how mathematicians had dealt with irrational numbers: they defined the phenomena and moved on with the analysis.    

While researching Gulfport, I understood how uncertain the future price of natural gas would be. So I looked for a wide margin of safety. I then moved on to read about the company.

[1] Pi is also known as Archimedes' constant.
[2] By giving uncertainty a name and then moving on.
[3] Southwestern Energy reported a 10-year average loss of $1 per share.
[4]  the domestic production is 80 billion cubic feet per day while comparing to the demand is about 90 billion cubic feet per day.

Why I bought a few shares

Published on:
September 7, 2019
Reading time: 3 Minutes
Last Update:

It is a matter of time before stock investors bet on what they believe is right. Warren Buffett bought Burlington Northern in 2009, at the height of the financial crises. He called the acquisition, "an all-in wager on the economic future of the United States." Another example was the bet placed by Bill Ackman in 2012. He called Herbalife (HLF on Nyse), a nutritional supplements company, "a pyramid scheme that would eventually go to zero" and shorted the stock.

The purchase of Hyster-Yale Materials Handling (HY on Nyse) is my bet on the future of global trade. I begin this essay with an attempt to explain why HY is now trading at a five-year low price. It is not only market sentiment that penalized HY but also deterioration in the reported financials. In the second part of this essay, I discuss why the current operating results are transitory and why I bought the shares.

The bad news on Hyster-Yale

Wall Street is now bearish on companies that trade with China. Consider the stock of Flexsteel Industries (FLEX on Nasdaq) that dropped over 40% this year. So did the stock price of Micron Technology (MU on Nasdaq) fell as one of the company’s suppliers was banned from trading with the United States. Hyster-Yal, our topic of discussion, showed an even steeper fall lately - it dropped to $44 from $66 in less than a month.

Uncertainty of trade wars affect Hyster-Yale in two ways. First, Hyster-Yal's operating profit is sensitive to the price of steel, lead and copper. And it is the nature of these commodities to be volatile in terms of uncertainty.[1]

Second effec comes from the price of foreign currencies which is now widely swinging. Any loss in foreign currency value will be reflected in the Other Comprehensive Account (OCI). Hyster-Yal reported $88 million of currency translation devaluation, 16% of its equity balance.    

There are not only concerns with the materials-handling industry macro factors but Hyster-Yal's operations declined as well. Gross profit is down to $126.2 million from $132.1 million the prior year; operating profit is $3.4 million from $19.2 million the prior year; diluted earnings per share are now 20 cents compared to 90 cents a year ago.

Operating margins are down, too. Five years ago, the company reported pre-tax earnings of $150 million on $2,767 million of revenue, a 5% ratio. The ratio more than halved in 2018 when the company reported on pre-tax earnings of $13.8 million on revenue of $3,174 million, a 4 basis points ratio.

In addition, the reported ratio of total liabilities to total assets was 62% in 2014 compared to 68% as of the latest annual public filing. In short, the company is facing trouble ahead.    

HY's earnings over past three years
HY's earnings over past three years

The good news on Hyster-yale

Yet in the long run, the lift truck market is expected to grow. Consider, for example, data from the World Bank's website, the World Integrated Trade Solutions (WITS). There were 546,832 orders in 2009; there were 1,093,961 orders in 2014 and 1,460,000 orders in 2018.

Another point of interest to those who are interested in Hyster=Yale is that insiders to Hyster-Yal are buying the stock. Last month insiders placed 271 buy orders compared to a single sell order. Visit form 4 filings for reading.

And HY's management is aware of the operating challenges and has a plan in place. Management is focused on achieving 7% operating profit, which it plans to reach, over the next three to five years, by increasing prices and reducing operating expenses. Assuming no growth in revenue, that may translate to pre-tax earnings of $211 million or $13 per share. Since eight times pre-tax earnings valuation is reasonable, management is, in effect, targeting a $104 stock price.

Yet the stock market hates uncertainty so the stock traded for $45 when I bought it - this is roughly the adjusted book value.

As of the first quarter of 2019, Hyster-Yal reported equity balance of $551.4 million or $33 per share. If we adjust the equity balance by adding back the foreign currency devaluation, which was $88.2 million or $5.51 per share, and if we add back the pension adjustment, which to me was an accounting shenanigan[2], we arrive at $719.6 million in equity or $43 per share.

HY equity balance
A breakdown of HY equity balance


Throughout history, there were bad and good ideas. It was a bad idea to define people by their race, color or creed. It was a bad idea to have a central authority to control the economy and to dictate prices. In the 20th century, the two ideas miserably failed - at a devastating price.

But global trade belongs to the good ideas list. While the argument for global trade gained influence by David Ricardo in the 19th century, it has been practiced since ancient history.

There is evidence, for example, of the exchange of obsidian and flint during the Stone Age, estimated to have taken place in Guinea around 17,000 BCE . It is too bewildering that in the 21 century, we have to defend the idea of global trade.

While Ricardo argued for global trade using utilitarian reasons (how each side would eventually gain from the trade), to me, global trade is much more than that. Global trade allows countries and citizens to live in peace. As Voltaire once wrote:

Enter into the Royal Exchange of London, a place more respectable than many courts, in which deputies from all nations assemble for the advantage of mankind. There, the Jew, the Mahometan and the Christian bargain with one another as if they were of the same religion, and bestow the name of infidel on bankrupts only… Was there in London but one religion, despotism might be apprehended; if two only, they would seek to cut each other’s throats; but as there are at least thirty, they live together in peace and happiness."
FOOTNOTES: [1] The price of these copper and steel increased in 2018 compared to the year prior. [2] Read Howard Schilit's Financial Shenanigans for illustrations.

On the outlook for the gas and oil industry

Published on:
August 31, 2019
Last Update:

The gas and oil industry is not for the faint of heart. The S&P Oil and Gas Equipment services halved this year and is down 80% compared to five years ago. And from the macro to the micro: Noble Corporation (NE on Nyse), whose price is now less than two dollars a share, traded for $28 per share in five years ago. Gulfport Energy (GPOR on Nasdaq), which I bought a few months ago, now trades at $3 compared to $60 five years ago. At least the two firms are still in business. Atwood Oceanics, Inc., Hercules Offshore, Inc. and Paragon Offshore PLC - all filed for bankruptcy protection.

It is a cyclical business per se. In The Investment Checklist , Michael Shearn writes that "certain industries operate independently of the economic cycle. In such case, the product or service may be more of a necessity." He lists tobacco companies, pipelines carrying oil and gas and student housing REITs as examples. And as the U.S. economy continues to expand (the longest expansion recorded), the oil and gas industry contracts. What goes down must go up?      

To answer, we should first look at the demand variables. I refer the reader to page 12 of the NE's 10-K report for example, where management discusses 25 factors that affect the price of oil and gas and the level of activity in offshore exploration.

To name just a few of the factors: the level of production in non-OPEC countries, merger and divestiture activity among oil and gas products, the political environment of oil-producing regions (including uncertainty or instability resulting from civil disorder) and the discovery rate of new oil and gas reserves either onshore or offshore.

In short, to foresee where the oil and gas industries are heading is to prognosticate.

The gas and oil industry is depressed because the price of crude oil is down and because oil supply exceeds demand. Is it temporary? 

So instead let us name a few of the current reasons why the industry and its shareholders are depressed. First is the price of oil. Five years ago a barrel of WTI Crude Oil[1] cost over $90. It is now about $55. And not unlike the gold rush, if commodity price is down, no one tries to dig it out of the ground.

WTI average price since 1969
WTI's 10-year average price since 1969

The second reason is that daily crude oil production increased to four million from one and half million barrels. So, the demand of service from offshore fields, which are more expensive, declined.

The third reason is the demand and supply equation. There are simply too many rig suppliers and too little demand for them.

Yet I think the imbalance is temporary. Visit the Macrotrend website to see that over the past decade, the price of oil moved - and at times, frantically up and down - but upwards was the overall trend. Or instead of staring at the computer screen, you can just ask anyone older than sixty-five if gas prices were cheaper or more expensive when they were thirty.

Noble Energy  

So I speculate that the price of oil will rise again and that the price of gas and oil companies will eventually follow. I made this bet by buying a few shares in Noble Energy.

While Noble is now fraught with many risks (to name a few: the company is being sued; it is burning cash flow and the leverage ratio[2] and interest expense ratio are higher than ever before), I focused most of the reading about the company before the gas and oil industry turned sour.

Noble's management is shareholder-friendly with a successful track record. But major risks lie ahead.

And when times were good, Noble operated with a shareholder-oriented management as it never made acquisitions using equity but instead used debt and internal cash flow; It ran a conservative balance sheet with a leverage ratio of less than 40%.

More numbers: Five years ago Noble was valued over one times the company's 2014 revenue. It now trades at less than half the 2018 revenue. It is also trading at historically significant discount to book value. At the end of 2014 the book value per share was $26, and during that year the stock traded hands as high as $33 and as low as $14. The minimum price to book value was 54%. Contrast that with today's pricing. Today, the company reports a book value of $18 per share and a two-dollar price tag is 89% discount to book value.

NE's price to book value per share over past decade
NE's price to book value per share over past decade


Before I bought the stock of Gulport and Noble, I knew little about the gas and oil industry. The following two books tremendously helped: Written by Jens Zimmermann, The Oil and Gas Industry Guide: Key Insights for Investment Professionals  contains key valuation methods and industry knowledge. It is a somewhat technical book.

For broader understanding of the business, Bryan Burrough’s The Big Rich: The Rise and Fall of the Greatest Texas Oil Fortunes is a colorful portrayal of the industry's eccentric characters.

[1] West Texas Intermediate (WTI) crude oil is the most popular oil benchmark.  
[2] For example, the 2014 leverage ratio was 45%; it is now 51%. The adjusted interest coverage ratio was over ten times in 2014; it is now one times.  

Why I bought a few shares

Published on:
August 16, 2019
Reading Time: 4 Minutes.
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"The presence of lower prices, not surprisingly, is frequently associated with a relatively poor, near-term outlook for an industry, company or country," wrote Matthew Fine and Michael Fineman of Third Avenue Value Fund. "So this approach [bargain stock shopping] requires a multi-year investment horizon."

The description above of the relationship between cheap price and business outlook, nicely describes why I bought Mednax, Inc. (MD on Nyse) this week. In this essay, I describe the key reasons for the gloominess for the U.S health care and how they drove down the price of Mednax.

The medical industry's gloominess

Mednax and peers now face three uncertainties. First is U.S. Government's tracking of medical costs which force hospitals to disclose prices. Read more under the Centers for Medicare and Medicaid Services' price transparency law. From health-care companies perspective, hospitals, their customers, are becoming price-conscious buyers, which will hurt future earnings.

The second concern comes from the The Affordable Care Act (ACA) which contains provisions such as establishment of health insurance exchanges that adversely affect the earnings of health-care companies (unsurprisingly the ACA risk is listed second in the risk factors section of the MD's annual report.)

Businesses are taking health insurance costs to their hands.

The third worrisome trend is that businesses are taking health insurance costs to their hands. CNBC reports that Amazon, Berkshire Hathaway and JP Morgan partnered to improve health care for their 1.2 million employees. Branded under the name Haven, their partnership aims to "create new solutions and work to change systems, technology, contracts, policy and whatever else is in the way of better health care."    

Mednax dismal performance

Yet it was not only uncertainty fear that halved the price of Mednax over the past year. The drop in price was also because of the company's own doing. This is because pre-tax earnings and net earnings fell each year since 2015.

Four years ago Mednax reported $599 million in pre-tax earnings and $336 million in net earnings. In 2018 it reported $468 million in pre-tax earnings and $268 million in earnings.

Management increased the right side of the balance sheet. Its appetite for leverage is clearly noticed.

Also of concern is that Mednax has been increasing the right side of the balance sheet. In 2015 for every dollar of equity it carried 86 cents of liabilities. But as of the first quarter of 2019 Mednax reported that for every dollar of equity it carried a dollar and five cents of liabilities.

And management's appetite for leverage is clearly noticed if we use a wider (time) lens. In 2009 total liabilities to total assets ratio was 30%; the ratio increased to 37% in 2014 and to 48% in 2018. It is now 51%.

MD's decline in stock price
A Google screenshot of MD's price decline

Three ways to look at Mednax current valuation

So given the gloomy U.S. health care industry landscape and the company's lackluster operating performance, Mednax share price today should be lower than it was a year ago.

But how much discount should we require? a price tag of $22 was enough for me to buy the stock. In the remaining part of this essay, I explain why.

The income statement explanation

In 2018 Mednax reported on revenue of $3,647 million. Now its market capitalization is $1,820 million. In other words Mednax now trades at about half the 2018 revenue. More impressing, perhaps, is the fact that over the past decade Mednax market capitalization was never below the company's prior year's reported revenue.

The highest premium was 1.56 times in 2010 and the lowest premium was 1.1 times in 2017. To put in perspective, even in 2009, in the Great Recession, Mr. Market valued Mednax at 1.3 times its revenue.  

MD's premium to revenue over past five years
MD's five-year premium to revenue

The balance sheet explanation

The same argument, of current valuation significantly below the historical valuation, can be seen by glancing at the balance sheet too. At $22 per share Mednax is trading at two thirds of the book value as of its most recent filing.

This is a ten-year low as during the past decade Mednax shares traded at premium to book value. The 10-year average range premium to book value was as low as 0.95 times and as high as 3.27 times.

MD's five premium to book value
The five-year premium to book value

The operating statistics explanation

Without diluting shareholders (there were 92 million outstanding shares a decade ago while today there are 89 million shares), management had done reasonably well in increasing its revenue resources[1].

The number of physicians increased by 11% compounded annually, from 1,484 physicians in 2009 to 4,213 physicians in 2018. And the number of anesthesia operations increased by 22% compounded annually, from 244,127 in 2009 to 1,844,451 in 2018.

MD's growth in key revenue drivers
The growth in key revenue drivers

Over the past decade, revenue increased to $3,647 million from $1,288 million and reported assets grew to $5,706 million from $1,689 million. And the company's boss and co-founder, Roger Medel, still holds 1.6 million of the outstanding shares[2].    


On page 2 of the quarterly report to shareholders, the portfolio managers of Third Avenue summarize their portfolio: P/E ratio is 12 times. Price to book is 0.87 times. Price to sales is 1.05 times. And price to cash flow is 5.83 times.

Mednax, at current valuation, would nicely fit their portfolio: P/E ratio is 8 times. Price to book value is 0.74 times. Price to sales is 0.60 times. And price to cash flow is 7 times.  

FOOTNOTES: [1]Mednax revenue is 36% from Neonatology, 35% from Anesthesiology and 12% from Radiology with the remaining 17% from Maternal-fetal medicine, management services and Pediatric cardiology. [2] Medel holds 1,558,878 shares, which represents 1.8% of the outstanding common shares.

A look at Signet's operations

Published on:
July 21, 2019
Last Update:

Corporate America cannot stand still. Executive management reports to shareholders on growth expectations and on future strategy. Middle management reports to executive management on upcoming changes to processes and to efficiency measures. And each employee, as anyone who has worked in an office knows, is permanently busy.

This phenomenon, the need to act, can be seen in balance sheets. Consider the balance sheet of Signet Jewelers (SIG on Nyse), a company whose common stock I bought this week, is a prime example.

Signet's main balance sheet changes

First, between 2015 and 2014, the goodwill and intangible accounts increased to $966.3 million from $26.8 million. On the right side of the balance sheet, Signet’s long-term debt increased to $1.3 billion from practically nil. These changes occurred because Signet had bought Zales, an online jewelry store. Forbes magazine described the acquisition in February 2014.

Second, 2016 and 2017, Signet reported on a preferred stock of $611.9 million. It also reported that it would be selling the receivables portfolio (read: the loans Signet provides, partly through third parties, when customers purchase jewelry). And indeed a year after the receivables dropped to $779 million from $1.9 billion. The cash flow from the receivable sale was used to pay down the long term - it dropped to $688 million from $1.3 billion.

Third, between 2018 and the first quarter of 2019, Signet continued to sell the receivables portfolio. As of its recent public filing it reported on $96.2 million in receivables, down from $779.7 million the year prior. Another major balance sheet change was that that goodwill and intangible accounts, dropped to $561 million from $1.3 billion. The drop in the goodwill account was due to an impairment loss related to the Ret2Net purchase. Read about the acquisition here.

These are my notes: taken while sifting through Signet's reported financial results. Bolded with exclamation marks are three milestones in Signet's life over the past five years

Signet over the past five years

How should we understand this pace of activity? One group of investors cheers for Signet's Animal Spirits while the other prefers if the company would operate in a conservative fashion. What is worrisome to both groups is probably the company’s long-term trend.  

Five years ago when Signet traded as low as $75 and as high as $151 (at an average earnings multiple greater than 15 times the trailing earnings per share), investors argued that Signet's market share of the bridal segment was increasing alongside the consumer’s demand for jewelry. The conventional wisdom was that, in the long-term, shareholders would be awarded.

But in the long term we are all dead*. Signet is not the same company it was five years ago. In numbers: the pre-tax return on tangible assets ratio was 15% in 2014. It has steadily declined to a minuscule ratio of 3% in 2019. The pre-tax profit margin, defined as pre-tax net income divided by revenue, was 10% five years ago. It is now less than 2% (even after removing the non-cash impairment charge related to Ret2Net acquisition).

The balance sheet tells a similar tale: in 2014 for every dollar of common equity, Signet reported 57 cents of liabilities. Today the ratio increased by fivefold: for every dollar of common equity, Signet now reports $2.60 of liabilities. Another way to look the company's leverage is that Signet had zero long-term debt five years ago. It now has $650 million. For the long-term investor, in short, Signet in 2019 is not what Signet was in 2014.    

2019 leverage ratios compared to 2014

Active management

Three lessons present themselves. First, investors with an investment outlook of three- to five-years must allocate time, perhaps quarterly, to review management decisions. They should review and question management's capital expenditures decisions, find out what the business strategy is and closely monitor how management reports on operations in the each of the quarterly earnings calls.

Second, Investors should look for industry trends and for regulatory changes. For those who invest in jewelry companies, or more broadly, in consumer discretionary segments, the regulatory environment greatly matters (Signet's sales are largely driven by the consumer's ability to take personal loans).    

The third lesson is that whether to buy a stock should be based on present circumstances, using historical financial statements so that future estimates and pro forma projections should not sway the attention. And why I bought the common stock of SIG, based on the present conditions, will be the topic of s future essay.  


In our business environment, which reveres Andy Grove, former Intel CEO, chronicler of paranoia in the Only the Paranoid Survive, executive management will make poor decisions due to hasty decisions driven by a need to act.

In the case of Signet, by merely looking at the balance sheet, we see an executive management that has been wearing too many hats. They wore the financier hat when they replaced long-term debt with preferred equity. They wore the visionary hat when they acquired Zales in 2014. Too bad that they recently had to wear the accountant's hat, the least attractive of the three, when they took an impairment loss of $740 million this year.

In this article, my main argument was to highlight that investing for the long-term is no excuse to let stock investments idly sit in the the portfolio. Corporate America’s behavior is such that every few years a large transaction will occur**. That transaction will dramatically change the business fundamentals and the company’s outlook, be it a restructure, an acquisition or a change in capital structure. More so, it is the nature of capitalism, in which yours truly is ardent believer, that in a free market system, profitable enterprises will lose competitive advantage***. Often too quickly. And brutally often.

A review of the last year

Published on:
July 7, 2019
Last Update:

In 2009 I began to write a weekly journal so that I could have a better appreciation of the present and a greater sense of direction for the future.

But until this week, I never took the time to look back at my actions in the stock market. So this week's essay is a summary of these activities. Not unlike a horse race, below is my scorecard.

The stock portfolio

I now own the common stock of 21 publicly-traded companies that operate in various industries; from airlines (Hawaiian Holdings) to specialty retail (Signet Jewelers); from media companies such as Beasley Broadcast Group to Carriage Services, a death care company.

Some are large companies - L Brand market capitalization is $7 billion for example - and some companies are small (Lifeway Food, the maker of Kefir milk, has market capitalization less than $50 million.)  

Practically all my positions are less than a year old; Patterson Companies is the only company I've held for 14 months. Over the past year, on average, I bought two positions every month and reduced my position in three companies: Diversified Restaurant Holdings, Lifeway Food and ARC Documents Solutions.

A screenshot of positions I now hold

Not unlike the Russell 2000 index, my portfolio market price dropped in May of this year and in December of last year. In May, the portfolio lost 6% in (unrealized) market price compared to 8% in market loss for the Russell 2000. In December, the portfolio market price fell by 11% while the Russell 2000 lost 12%.  On an annual comparison, my portfolio is down 7.6% while the Russell 2000 is down 6.4%.

Down 7.6%

The reason for the drop in market value is due to two positions The first is Orchid Paper, a position with which I started with 4,000 shares in July 2018 and then bought 6,000 more shares in October 2018. Orchid filed for bankruptcy in May of this year. While I did not sell my Orchid position, I "wrote down" to zero the value of this position. This was an unforced error on my part. Click here to read why.

Frontier Communications was the second reason for the market loss. I bought 2,500 shares in July of last year and then bought 5,500 more shares in November. My cost basis is $4 and the market price of the stock is now 70% lower. I am holding 8,000 shares, but I am uncertain where Frontier will be in two or three years. I am certain, however, that today I would never have bought Frontier in the first place.    

The 2019 Noam

I learned more about stock investments over the last 12 months than I did over the past decade. As with many other things in life, there is no substitute for actual, real world experience (can you imagine learning to ride your bike by  reading about it?)

Last year, I generated stock ideas mainly by observing price movements; today, I research what other value investors are buying. Last year, I was watching the list of 52-week low; today I watch daily the market price of over 50 stocks and built stock screens.

I also think on the portfolio-level. While a year ago I had 8 positions that represented 55% of the portfolio, today the entire 21 positions represent 52% of the portfolio (the rest is in cash). A year ago, I was running a very concentrated portfolio. Today, no stock represents more than 5% of the portfolio.    

Tracking the portfolio

So I evolved. Because I used to follow the adage that "investing is not looking at the market price of the stocks;” - I never tracked the portfolio's value. But as preparation for this essay, I reviewed the portfolio and found the process valuable.

It now takes less than 20 seconds to answer questions, such as how did the portfolio return compare to the benchmark return in December, and which stocks performed best or worse during that month?

A screenshot of the last 12 months


I invested over 750 hours over the last year in screening, researching, reading, analyzing, reviewing, comparing and thinking about stocks. If we assume that my hourly rate is $60, then I could have earned $45,000 pre-tax had I bought an ETF that tracks the value of the Russell 2000 instead of hand picking stocks myself.

But I expect at least 5 stocks to double in price over the next three years. Should that be the case, it will make up for the $45,000 in "opportunity cost,".

Some of these names include Hyster-Male, a lift truck company, Superior Industries, an aluminum wheel manufacturer, Gulfport Energy, a natural gas company and Flexsteel Industries, a furniture company.  

That is just the economic side of the things. There is no price, or perhaps it was priceless, to find a craft which I am passionate about.

In a recent meeting I attended, my greatest strength was assessed as a passion for study - stock investing is one of the most enjoyable avenues to exercise this skill.

Similar to physical exercise, over the last year I overcame hurdles and now feel mentally stronger. For example my stock portion of the portfolio dropped by 40% in December of last year (but because I had reserved cash, the total effect on the portfolio was less than 10%). Not only did that not scare me, I bought Seritage Growth Companies and Voxx International during that month.

In short, tracking the portfolio allows to live with the past, not in the past.

Shaving off SAUC shares

Published on:
June 24, 2019
Last Update:

This week I sold 10,000 shares of Diversified Restaurant Holdings (SAUC on Nasdaq) at $0.73 per share. As I type these words, two days after my first stock sell in 2019, SAUC climbed to $1.03. So not only did I lose money since as my cost basis was $1.40 per share, but also I lost $2,500 by trading on Tuesday instead of Thursday.

I have zero regrets. I sold the shares because I was wrong in buying shares in SAUC in the first place. In this week's essay I explain why.

The lure of SAUC's historical price

Between 2013 and 2018, SAUC traded as low as $2 and as high as $4. So when I bought the stock at $1.40, I assumed that price was low enough to serve as a margin of safety. I was wrong. A closer look at the publicly available financial statements would reveal that SAUC in 2018 was not the same company it was in 2016. This was because 26 of Dave and Buster's restaurants were no longer part of the company.

Score: Noam: 0. Mr. Market: 1.

Ignoring the market capitalization

I did not factor in SAUC's minuscule market capitalization of $25 million. Mistake number two. Companies with less than $100 million in market capitalization are riskier than larger capitalized companies. This is because it is tougher for pygmy companies to obtain debt or equity financing without diluting shareholders. Another risk is that small cap stock is usually off the radar screen of larger capitalized stock. So, unless the market readjusts the small cap stock valuation, the investor has no exit strategy.

As a rule, if a billion in market capitalization is selling at 10 times the earnings per share, then 25 million in market capitalization stock, given the risks detailed above, should sell at no more than 4 times the earnings the per share. But I had not discounted for size.

Score: Noam: 0. Mr. Market: 2.

Buying the stock at par

SAUC owns 64 franchises of Buffalo Wild Wings. I estimated that the value of each franchise was $2.5 million. This value was based on how much it would cost to build and open a Buffalo Wild Wings franchise and based on the price franchises were selling in the market place.

So, the replacement cost was $160 million. With total liabilities of $118 million I estimated equity to be $40 million or $1.38 per share. I paid about par of the net asset value which dear valuation. Purchasing the equity at 50% - 80% would be sensible according to Marty Whitman, founder of Third Avenue Management. But not only did I disappoint one of the masters of value investing, I overlooked the right of the balance sheet.

Score: Noam: 0. Mr. Market: 3.

SAUC's right of the balance sheet

"The company cannot conclude that it is probable that it will secure a credit facility," warned management on page 29 of its latest 10-k filing. "This raises substantial doubt that the company's ability to continue as a going concern."

SAUC may not be a company a year from today. Management had agreed to debt covenants that raise two problems. The first problem is that SAUC's debt is variable. It is based on LIBOR plus a margin that depends on the company's leverage ratios. This condition is a two-edged sword because as operations deteriorate, the cost of capital will increase. The combination of two will tarnish earnings.

The hidden liabilities are the second problem. When SAUC spanned off Bagger Dave's it continued to guarantee the leases. In the event Bagger Dave's decided to give the keys back to lenders, SAUC will be liable for the rent. This is like selling your home and then guaranteeing tax authorities that if the buyer is not able to pay the appropriate taxes, they can come after you.

Score: Noam: 0. Mr. Market: 4.


SAUC’s senior management is invested in the company but lacks disclosure to shareholders. Michael Ansley owns 2.2 million shares, Jason Curtis 1.1 million shares and David Bruke owns 580 thousand shares. Together, the shares represent about 20% of the available stock. Yet they are not reporting enough about the company operations.

To understand the performance of the restaurant business, you need to understand more than revenue and profit trends. All shareholders of a company should know what the guest satisfaction is, what the hourly compensation costs are and how the cost of food affects margins. But management provides none of this information.

Other industries, such as the airline industry, share information on a granular level (read my recent purchase of Hawaiian Airlines as example). It was a mistake to buy shares in a company that does not value transparency.

Score: Noam: 0. Mr. Market: 5.


In A Senseless Market Capitalization for Diversified Restaurant Holdings link, I wrote that:

"Animal Spirits may explain why an investor would prefer to franchise a Buffalo Wild Wings restaurant as opposed to simply purchasing Diversified Restaurants Holdings stocks."

I was positive that Mr. Market was wrong and that I was right. That I was wrong is obvious and not worthwhile to further mention. What is important, though, using the game of tennis as an analogy, is to highlight that all the mistakes were unforced errors.

The 5 mistakes highlighted above were not due to unforeseen changes in industry or by remarkable performance of competition. Investing in SAUC was a mistake that could have easily been avoided.

As a resolution I began this month to spend an extra 10 hours reviewing an “unforced error” checklist. During this review, I answer questions such as: Does the company have variable or fixed rate debt? Is management sharing with shareholders how they evaluate business performance? For every dollar of retained earnings over the past year, has management increased the value of the company? Hopefully, going forward, this will improve my scorecard against Mr. Market.

An update on Patterson Companies

Published on:
June 15, 2019
Last Update:

In investing one group cheers while the other fears. When Patterson Companies (PDCO on Nasdaq) was delisted from the S&P 500 index, in the course of 90 days, Patterson’s common stock price dropped by 42%, to $22 from $38. Shareholders were disappointed.  

The S&P 500 composers replaced Patterson with three companies. The first company was SVB Financial Group (SIVB on Nasdaq), a bank holding company. Take-Two Interactive (TTWO on Nasdaq), whose business is video games, was the second company. And Nektar Therapeutics (NKTR on Nasdaq), a pharmaceutical, was the third. Shareholders were pleased.    

It is unconventional to buy the stock of a delisted company - not only has the stock lost momentum, pundits argue, but also the delisting follows some deterioration in the business fundamentals. "The results we report today clearly do not meet our expectations," said Patterson's boss, Mark Walchirk, a year ago. "They fall short of what we know the business is capable of achieving."

The original investment thesis

I wrote about Patterson Companies in May 4, 2018. My original thesis was that while the company's operating performance was poor over the second quarter of 2018, if investors had saw the company's operations over the prior decade, a different view would emerge – that the company had materially improved both its market share and operating performance.

PDCO earnings over past decade
A 10-year outlook on PDCO's earnings

One of the reasons I bought Patterson was that employees are shareholders of the company. In the 2018 proxy statement, on page 23, management reported that employees of the company owned 11.7 million shares, about 12% of the outstanding stock.  

Another reason for buying Patterson were tailwinds of the two industries in which Patterson operates in - veterinary and dental products. Its website  summarized the bull case for the dental and animal industries: "95% of adults say they value keeping their mouth healthy. 68% of U.S. households own a pet. And 200 million tons of protein will need to be produced by 2050."

I estimated that management would restore the operating margins. The average pre-tax income to revenue ratio was over 10% between April 2004 and April 2012. It steadily declined over the following 7 years. The most recent ratio reported was a minuscule 4%. In addition, the pre-tax income on tangible assets over the past decade was greater than 10%, a reasonable ratio for a company in the distribution business.  


Webflow is the way to design, build, and launch powerful websites visually — without coding. While working full-time, at nights I developed Pen & Paper using Webflow.Webflow empowers you to create for the web.

In their words: "In today's web, the means of production lie in the hands of the few. We want to change that, and help create a more beautiful, diverse web. We want to democratize access to the tools and knowledge required to build beautiful, well-coded websites, web apps, and - eventually - digital products of all kinds."


Last year

With no corporate restructures, major refinancing efforts or corporate shakeups, it is little surprise that Patterson's stock price has not moved since May 2018. Patterson is trading at the same price it traded hands a year ago, at about $22 per share. Over the past year, the stock climbed to $26 in November 2018 and dropped to $19 in December 2018.

PDCO Stock price over past year
PDCO's stock price over past year (Screenshot from Google)

Mark Walchirk has been the President and Chief Executive Officer since November 2017. Don Zurbay has been the Chief Financial Officer since June of last year, effectively when I began to buy the stock, and Kevin Pohlman has been running the animal health division since July 2017. The only new addition to the executive team is Eric Shirley who began to head the dental division 5 months ago.

In regard to financials: as of the third quarter of this year, Patterson reported on $1,472 million or $15.77 per share in equity compared to $1,461 million or $15.65 per share in 2018. Revenue is $4,137 million or $44.31 per share for the last 9 months ending in January 26, 2019 compared to $4,065 million or $43.56 the prior year. The main shortfall is that pre-tax income is down by $79 million because of an increase both in cost of sales and in expenses.  


Founded in 2004, by Charlie Tian PHD, GuruFocus provides institutional-quality financial stock research for the individual investor.

GuruFocus hosts many value screeners and research tools and regularly publishes articles about value investing strategies and ideas. One of the features I use most is the 30-year financial information on businesses. Visit the 30-year analysis on Patterson Companies to see more.


In a year or two

Unless Patterson's stock trades hands at over $30 per share a year or two from today, I will sell the position. The reason for the $30 price tag is that over the past decade, investors paid between 15 to 20 times for one dollar of pre-tax income per share. At the time of this writing, given the lackluster operating performance, investors are paying less than 10 times one dollar of pre-tax income.  

Should Patterson's financial performance improve, so will its stock price. But when - and if - the increase will happen is unknown to me. Since my return objective is 15% to 25% each year, unless the stock appreciates to $30 in two or three years the position will be sold for "time is money" reasons.

In business, random, short-term driven decisions have a long-term impact. A friend of mine recently described his work environment as akin to a tank, in that senior management was reacting to obstacles along the way without any strategic thought. This was eroding the company's culture.

What appear to be random decisions also affect prices. The S&P 500 composers believed replacing Patterson with three companies would be a boon for the index over the long term.

Yet, collectively, the stock price of the three companies tumbled by 25% over the past year. SIVB traded for $320 a year ago and now trades for $213. NKTR traded for $53 a year ago and now trades for $37. TTWO fell from $120 to $109 over this period.

Judged by the rules of the stock market, that prices are paramount, replacing Patterson with a trifecta of a pharma company, a video game company and bank was a mistake. And owners of the S&P 500 index would be better off  had Patterson never was delisted. But then I would not cheer for the stock.

Why I bought a few shares

Published on:
June 11, 2019
Reading time: 2 Minutes.
Last Update:

The economics of the furniture business is not rosy. Sift through the financials of any publicly- traded furniture company and you will see that for every $100 of sales, $80 is consumed by building and delivering the furniture, $15 is paid to managers and about $5 to $8 are left to pay taxes to the U.S. government. Common shareholders are left with $2 to $3, a minuscule profit margin.

Outlook for the furniture business is gloomy, too. Recent tariffs enacted by the U.S. Congress raised the price of furniture imported from China by over 10%. And it is questionable how likely companies will succeed in passing the extra cost to consumers. How ecommerce will shape the future of buying and delivering furniture is a guessing game, too.  What is certain is that the demand for furniture will weaken should the economy soften.

It is simply a tough business to be in. A typical furniture-maker must keep up with current consumer trends, work with few distributors that have bargaining power (think Home Depot, Costco and Amazon) and deal with many unforeseen challenges. One visible challenge is that selling furniture online is not easy, as management teams had thought. This year, for example, Flexsteel (FLXS on Nasdaq) took a $18.7 million impairment charge due to "software integration difficulties."  

Whether you visit the website of Bassett Furniture (BSET on Nasdaq), Hooker Furniture Corporation (HOFT on Nasdaq) or La-Z-Boy Incorporation (LZB on Nyse), you will not find any visible difference in their product offerings - neither in price nor in style. Popular today is the rustic, natural wooden feel, compared to the slick and modern style of the early 2000s. For the untrained eye, the furniture business is a commodity business.  

In numbers: Ethan Allen’s (ETH on Nyse) growth in revenue over the past 5-years was less than 1%. The company traded hands for $25 five years ago and now trades at $24 per share; Bassett Furniture’s 5-year CAGR growth was 6%, but shareholders who bought 5-years ago at the stock price of $13 can now sell their positions at $14. Flexsteel showed a 2%, 5-year CAGR growth and its stock price has halved over the past 5-years, from $35 to $18.

Flexsteel Industries

At a low price, even the most depressed company can become attractive. Flexsteel is now trading at less than 60% of the reported book value. It is trading slightly less than 10 times the 10-year average earnings per share of $1.98, and it’s yielding 5%, exactly 3 times higher than the yield on a 5-year Treasury (Flexsteel has consistently paid dividends to its shareholders since December 15, 1988).

A 10-year outlook on the equity

So, why did the stock market slash by half its value? Two causes, I believe, are at fault. First, when Flexsteel closes its books for 2019 this month (its fiscal year ends June 30, 2019), it is likely to report a decline in revenue. So, the stock market fears that the unfortunate trend will continue. Second, management will report at least $27 million in expenses related to impairment losses and costs related to exiting the commercial office and the custom-designed hospitality products as management explained in May 15 of this year link.

For a company whose average 5-year, pre-tax income was $32 million and in June 2018 pre-tax income of $25.1 million, the expected $27 million in losses will completely wipe earnings for 2019, and the company is likely to report a loss, the first to be reported since 2009.

In addition, there's been a shakeup in management. Jerald Kittmer, Flexsteel's President and CEO, joined the company less than 6 months ago; Marcus Hamilton, Flexsteel's CFO, joined the firm in January 2018, and it is still uncertain how well the two will get along.

Why I bought a few shares

I plan to patiently wait a few years. Kitmmer is a veteran in the furniture business and Hamilton has over 20 years’ experience in finance, accounting and supply chain management. I also don't foresee any changes in the near term, because Flexsteel hardly carries any debt. As of March 2019, its third quarter filing, the company reported total assets of $265 million and total liabilities of $39 million, a 15% debt to asset ratio.

My handwritten notes on FLXS

Competitors who offer similar products are trading at much higher valuations. For example, with a stock price of $27, Hooker Furniture is trading at 1.3 times its reported book value. With a stock price of $31, La-Z-Boy stock is trading at a whopping 2.4 times its reported book value. If Flexsteel was to trade at par, its stock price would be about $30.

While Flexsteel is trading at a ratio of 5 times the pre-tax income per share, the average price of pre-tax income per share ratio for its peer group is 10 times. If Flesteel was to trade at 10 times the pre-tax income, the stock price would be $35.

Flexsteel also passes the "four-proxy rule" coined by Charlie Dreifus of RoyceFunds link. When buying shares of publicly traded firms, Dreifus looks for management compensation metrics that are tied to GAAP earnings and not adjusted earnings (check). He also looks for folks with deep financial backgrounds that serve in the audit committee (Eric Rager meets his definition - check). He also reviews how often the audit committee meets (Flexsteel’s audit committee meets quarterly - check). And he verifies that senior management does not have extreme executive perks (check).

Dreifus, the 51-year stock picker veteran, was one of the reasons why I bought Flexsteel stock. His Special Equity Fund link owns 775,000 shares in Flexsteel. (RoyceFunds owns a total of 1,126,078 shares, 14.3% of the outstanding stock per the latest proxy statement). Perhaps, Dreifus, like yours truly, saw something beyond the gloominess of the furniture business.

Why I bought GPOR shares

Published on:
May 26, 2019
Last Update:

"Four bucks a gallon - that's insane!," said Jim, a colleague. "My commute is over 25 miles each way. Let me tell you Noam, and I did the math, my monthly gas bill just increased by $300."

I had no idea that gas prices were up. I often cycle to work and when I do drive a car, I rarely pay attention to the gas bill; the Subaru is gas-efficien enough. Intrigued byJim's lamentation, I went to the local gas station in California and saw that a gallon of gas, indeed, now costs $4.55.

A raising gas price is a business problem[1] for certain industries. So I returned to my desk and looked for publicly-traded companies that explore, develop and sell the commodity.

What gas companies are selling for

The initial results were unexciting. WPX Energy (WPX on Nyse), a natural gas liquidity company with market capitalization of $5,230 million, traded at 23 times the trailing earning and at a 20% premium to reported book value.

Cabot Oil & Gas (COG on Nyse), with a market capitalization of $11,000 million, traded at a more reasonable, 15 times the trailing earnings but at a whopping 5 times the reported book value.  

QEP Resources (QEP on Nyse)market capitalization of $1,760 million, was slightly at a discount to book value. But QEP reported losses in 2018, 2016 and 2015.

So did Oasis Petroleum (OAW on Nyse). With a market capitalization of almost $2,000 million, the company traded at par but reported losses in 2018, 2016 and 2015.

Frustrated for wasting two hours of sifting through the financial statements of natural gas companies, I screened for companies - without a specific industry in mind - that traded at 90% below their-5 year stock price high[2].

Finding Gulfport Energy

One of the first companies that appeared on the list was Gulfport Energy Corporation (GPOR on Nasdaq). The stock traded as high as $75 in 2014 and was now exchanging hands for about $6 a share, a drop of over 90%. Curious to understand the reason for the sharp decline, I downloaded the 10-k report.

Gulfport's share price decline over past five years

I  learned three of three things: First was the reason for the decline in stock price. Over the past ten years the price dropped for all the commodities sold by Gulfport: Oil price per barrel is down to $49 from $68; natural gas price is down to 53 cents from 96 cents; and gas price is now $2.47 from $6.90.  

The second issue was that the company's assets wildly grew. Gulfport's total assets increased to $5.8 billion from $2.7 billion five years ago, a compounded growth of 16%. But the equity increased to $3.3 billion from $2.69 billion, a compound growth of 4% [3].

Third, management had repurchased the stock at $8.81 at the end of last year and had budgeted to buy additional stock, up to $200 million worth, in the next two years.

I estimate that the company may buyback the stock without incurring any debt, simply by using free cash flow and perhaps selling non-core assets, such as the 9,829,548 shares Gulfport owned in Mammoth Energy (TUSK on Nasdaq.)

Gulfport Energy 5-year financial results

A back of the envelope calculation tells us that just the share repurchase program may result in an increase of 30% to 50% from the current price of $7 (write to me if you would like to see how I calculated this).  

The gatekeepers

Yet what stands between the investor, yours truly now owns 1,500 shares, and the income from the natural gas and oil reserves is a board of directors that could easily win the worse capital allocator award, if there ever was one.

Since 2010 Gulfport’s board issued 138 million shares (read: diluted shareholders) at weighted price of $30. Since 2010, the company added to its equity base $3.19 billion; now the entire company can be bought for $1.19 billion, about a third of the price.

Surprisingly, perhaps, half of the board, four of the available eight board seats, is still running the show. Mr. David Houston has been a director since 1998. Mr. Ben Morris has been with the company since 2014. Mr. Craig Groeschel has been with the company since 2011. Mr. Scott E. Streller has been with the company since it became publicly traded in August 2006. As I wrote in A Docile Animal in Captivity, it is not easy to replace the gatekeepers - even ones with such dreadful track records.

In an industry fraught with technical terms such as "Proved Reserved" (page 3 of the recent 10-k report) and "Midstream Gathering"(page 62 of the recent 10-k report), natural gas investors, by default, know less about the business than the gatekeepers.

There are also uncertainties that management cannot plan for but only react to. Among those include supply and demand imbalances and future regulatory and political changes.


Why is there such a wide gap between GPOR's market price and value? Why did investors not complain about the board’s dismal performance? The advent and popularity of passive[4] investing, I believe, is at fault.

Blackrock, via its iShares ETF product, owns 24 million Gulfport shares. Dimensional Fund Advisors, another ETF provider, owns 15 million Gulfport shares. The quantitative firm, LSV Asset Management, owns 9 million shares. In total, over 58 million shares (about 36%) of the available 159 million shares are owned by passive investment funds.

It is little surprise they haven't noticed the gap.

FOOTNOTES: [1] The legendary value investor, Phillip Fisher, once said that "The successful investor is an individual who is inherently interested in business problems. [2] In other words if a stock reached $100 over the past 5 years and was now trading at $10 - it would appear on the list. [3]This was a decent growth track record, especially when considering the company took an impairment loss (which reduced the equity balance) of $715 million in 2016 and $1.44 billion in 2015. [4] Passive investing is performed by those who track quoted prices, and not quoted values.

A docile animal in captivity

Published on:
March 16, 2019
Last Update:

Bored, without anything better to do, I looked which investment funds own the stock of Seritage Growth Properties (SRG on Nyse). The list in Seritage is the all-star dream team of value investing. Owners of Seritage common stock include Warren Buffett (owns 2 million shares), Bruce Berkowitz (owns 3.2 million shares), Mario Gabelli (owns 114 thousand shares) and Victor Cunnigham of Third Avenue Management (owns 291 thousand.)

Yet I had never heard of Seritage's largest investor, a mutual fund provider by the name of  Hotchkins & Wiley. Founded in 1985 in Los Angeles, California, Hotchkins describes itself as "boutique asset management firm with an orientation for long-only value investing." It manages $27 billion and it offers mutual fund products, from large capitalization stocks to small capitalization stocks.

One of its funds, the Small Cap Value Fund, looks for companies with market capitalization from $100 million to $4 billion. Since its inception, the annual return of the fund, net of fees, was 11%. That means that a dollar invested in the fund in 1985 would now be worth 31 dollars. Not bad, I reckoned.

I looked at the companies owned by Hotchkins, hoping to copy from them a few stock ideas. Their largest poisiton is in First Hawaiian Inc (FHB on Nasdaq) which seemed to trade at a reasonable price to value. I could not understand what lured the fund managers to own the stock. The second largest holding was Seritage Growth Properties, a stock which I already bought a few months ago. Enstar Group, their third largest holding, is an insurance company that trades at a fair price. A marketing firm by the name of MDC Partners (MDCA on Nasdaq) was the one company that caught my attention.

MDC Partners      

Described as "the first advertising hedge fund" by Adweek a few years ago, MDC buys established marketing companies and lets the original owners decide how to best run their business. MDC defines itself as "a partner company, not a parent company." 

According to its website, MDC’s business model "fuels the entrepreneurial nature of agency parents and provides collaboration and continued support to ensure that each partner achieves their greater ambitions." You would expect such marketing language from an ad company. But the operational results are quite good, too.  

In numbers: over the past three years, revenue grew by 4% compounded annually, from $1.3 billion in 2015 to $1.5 billion in 2017. I estimated that the 2018 revenue (which will be publicly disclosed in one week) will remain stagnant at $1.5 billion.

The company's normalized after-tax free cash flow increased by 24%, from $32 million in 2015 to $61 million in 2017. I estimate that the company’s normalized after-tax cash flow will be $50 million, or about 70 cents per share in 2018. With a current price tag of $2.30 and an earnings multiple of less than 5 times, the stock of MDC seemed attractive to me.

Yet the stock market feels differently. Over the past year the stock price slashed by over 70% from $8.45 as of February 2018. After MDC reported on a loss in the first quarter of 2018, the stock dropped by 40% in less than a week and throughout 2018, without significant improvement to report to shareholders, the stock tumbled.  

The (strange) reason why I bought shares in MDC Partners

Readers of this blog know that I refrain from social media and hardly know of our popular culture icons. This makes me the last person to understand how digital marketing works, let alone which marketing company has a brighter future than its peers. So to be clear: owning shares in the marketing industry is beyond my circle of competence.

Yet perhaps it is not beyond the abilities of a discrete hedge fund, FrontFour. Managed by Stephen Loukas, David Lorber and Zachary George, FrontFour owns over 5% of the common shares of MDC Partners. 

According to its 13D filing glossary, the company, through its various funds, bought - over the past year - 3,009,500 shares for $13.73 million, which are now worth $10.08 million. This is a market loss of $3.65 million, or 26% loss on paper.

FrontFour decided to do something about the loss in value and is now calling for a significant change to the board of directors. Its energy and enthusiasm are the reason I decided to buy a few shares in MDCA. Loukas, as an individual, bought 3,500 MDCA shares at a price of $4.2, and I bought a few weeks ago the same amount of stock at slighly lower price of roughly $3.


"The choice of a common stock is a single act," lamented Graham and Todd in their seminal work Security Analysis. "Its ownership is a continuing process. Certainly there is just as much reason to exercise care and judgement in being a stockholder and in becoming a stockholder. It is a notorious fact, however, that the typical American stockholder is the most docile and apathetic animal in captivity."

They continued: 

"In good part his docility and seeming apathy are results of certain traditional but unsound viewpoints that he seems to absorb by inheritance or by contagion. These cherished notions include the following: (1) The management knows more about the business than the stockholders do and therefore its judgment on all matters of policy is to be accepted. (2) The management has no interest in or responsibility for the prices at which the company's securities sell. And (3) If a stockholder disapproves of any major policy of the management, his proper move is to sell his stock."

Kudos to FourFront for proving otherwise and for also eliminating my boredom.

The bullish case for Weight Watchers

Published on:
March 2, 2019
Reading time: 4 Minutes.
Last Update:

"The staples of today's diet - cereals, dairy products, refined sugars, fatty meats, and salted, processed foods - are like diesel fuel to our bodies' metabolic machinery," writes Loren Cordain in The Paleo Diet"These foods clog our engines, make us fat, and cause disease and ill health." 

Indeed attempts to fight off the modern diet have been many. Consider, for example, William the Conqueror who refused to leave his room and drank only alcoholic drinks. Or according to Maimonides: 

"Anyone who conducts himself in the way specified, I guarantee that he will never get sick his entire life until he reaches a hoary old age and dies. He will not need a doctor, and his body will be perfect, and he will remain strong his whole life." 

And you probably heard of the low-carbohydrate Atkins diet, the Apple Cider Vinegar diet [1], or the strange Breatharian Diet that suggests that we can live off the nutrients in the air.

Most of the ideas are fads. They initially appeal and are marketed to our perpetual need to better ourselves and to look like the actors on our television. The goal behind trendy diets is invariably the same: to quickly lose weight so that we will feel better about our lives.

But the mindset to diet is now changing. Diet experts are replacing the word "diet" with "wellness." And according to Merriam-Webster Dictionary, while a diet is "a special course of food to which one restricts oneself, either to lose weight or for medical reasons," the word "wellness" is about the state of being in good health.

With $1.5 billion in market capitalization, Weight Watchers International (WTW on Nasdaq) has played a significant role in this evolution. You will not see the word diet on the company's website, but you will see many associations with wellness. 

Weight Watchers advertisements read: "Our philosophy is to help participants to lose weight by forming health habits, eating smarter, getting more exercise, and receiving support."

Magic Formula

I accidentally found Weight Watchers while looking atJoel Greenblatt's Magic Formula. (The website lists companies with high earnings and high returns on capital. You can read about Greenblatt's formula inThe Little Book That Beats The Market.)

WW is in the Magic Formula.

Between 2008 and 2017, Weight Watchers' average earnings per share were $2.52. As of its most recent filing, the company reported earnings per share were $3.49. And management has been buying its stock: In 2008 there was 78.5 million common stock compared to 69.8 million as of the third quarter of 2018.

During this decade, the stock traded hands as low as $9 in 2016 and as high as $87 in 2012. The average earnings multiple was between 8 and 22. The ratio peaked at 50 times in 2015 and troughed at five times in 2017.

It seemed worthwhile to read more about the company. So I downloaded the 10-k filings to learn a bit more about Weight Watchers; about its capital structure and management.

Weight Watchers  subscription model 

Weight Watchers sells three types of subscriptions: the Digital Subscription gives access to an app that tracks food habits and suggests recipes; a 3-month plan costs $13.30. 

The Studio Subscription includes all the benefits of the Digital Subscription and an in-person workshop. A friend of mine has attended one of these workshops and found them to be effective. It costs $29.96 for a 3-month package.

The Coaching Subscription provides unlimited phone calls and messages to a personal coach. It costs $54.95 per month. 

I was happy to see that the company grew its subscriber base by 30% in 2018 compared to 2017 and by 50% compared to 2016. But the company's capital structure is alarming. It reports on $1.4 billion in total assets and $2.22 billion in total liabilities. 

The quarterly trend in operating income to interest expense ratio was not promising either. Over the past two quarters, the ratio was about three times [2]. But I overlooked this negative trend because of Weight Watchers' management.

I am glad to own share in a company that is advocating wellness.

Defined as a "controlled company" link per Nasdaq rules, Ms. Oprah Winfrey and the Artal Group own over 50% of the voting rights. Considered one of the most influential people from 2004 and 2011 by TIME magazine, Winfrey does not need any introduction. But the Artal Group does. 

Headed by Raymond Debbane, this little and unheard of private equity firm is rumored to have accomplished one of the best private equity deals of the last two decades. The $224 million that Artal Group invested in Weight Watchers in 1999 is now worth over $5.2 billion.


That the leading cause of death in the United States - responsible for 35 percent of all deaths - is heart and blood vessel disease should bother us all because it is preventable. 

According to Loraine's book, 73 million Americans have high blood pressure, 34 million have high cholesterol levels, and 17 million have type 2 diabetes. I am glad to own shares in a company that is fighting these statistics.

[1] The Apple Cider Vinegar diet prescribes the consumption of three teaspoons of the tonic before each meal. [2] I expect the operating income to interest expense to be two times in 2019

An update on my largest positions

Published on:
February 23, 2019
Last Update:

Frontier Communications

I bought the stock of Frontier in March of last year. In that article, I smugly wrote that, "sometimes, all we really need is one good investment idea."

But a year passed and I am not as confident. When I bought the stock, Frontier's valuation was low, I thought, compared to prior years. But I did not study the telecommunication industry enough to understand what an appropriate valuation would be.

I own 8,000 shares in Frontier and my cost basis is about $5 per share. The stock now trades at $2.55, which results in a 50% loss in market value or $20,000.

Orchid Paper Company

When I bought the stock of Orchid I overlooked important information. One example is that Orchid had only four customers. More so, Benjamin Graham would find it disgraceful that I utterly ignored the right side of Orchid’s balance sheet.

I did learn about securities lending by investing in Orchid. A few months after I had purchased the stock, a Charles Schwab representative called and inquired whether I would lend my Orchid shares to short sellers at a rate of over 52%. Sure, I replied, and you can read about it in “The Time Charles Schwab Asked for a Loan From Me”.

I own 10,000 shares in Orchid; my cost basis is about $3 and the stock trades at $1, an $18,000 paper loss and almost a 40% loss in market value.  

Lifeway Food

Lifeway's management is highly invested in the company, the company carries little debt obligations, generates ample after-tax cash flow and I consume their product on a weekly basis.

In August of last year I described the normalized earnings for the business - my opinion of the company did not change.

I own 10,000 shares in Lifeway, which I bought for $3 a share; the stock trades for $2.36, a $6,300 or 21% paper loss.

Tupperware Brands  

I learned about Tupperware from Guy Spier who described his purchase of the company in The Education of a Value Investor. But what Spier hated about Tupperware when the stock traded at $45, I did not mind as much as when it was trading at $36.

So, I bought 600 shares in August of last year and comically wrote to Tupperware's management about its ill use of leverage.

My cost basis is $36 and the stock trades at $31, a 14% paper loss or $3,024.  

Diversified Restaurant

I bought 17,000 shares of Diversified at a cost of $1.25. I estimated the value of the stock to be roughly $2 per share. In A Senseless Market Capitalization I explained my investment thesis; mainly, that the cost of buying shares in SAUC was much less than developing similar restaurants. And that I was confident that Paul Brown, who had revamped Arby's, is an excellent manager. The stock price is $0.93 which results in a paper loss of $4,446 and the stock is down 25% from my cost basis.  

L Brands

Not the lure of attractive women walking down an aisle while wearing laundry convinced me of buying shares in the L Brands - it was the accounting profession. In September of last year,  I wrote about the deficit in the equity account that was related to the company buying its own shares.

I had bought 1,000 shares, at $30 per share, and the stock trades for $27, a paper loss of $2,921 or 10% per share.  

The remaining companies

I have a paper gain on the remaining 6 stocks. I will write more on each stock when I sell them. Purchased in May of last year, Patterson Companies, which I wrote about in One Advantage of Short Term Thinking? A Cheap Stock Price is worth slightly more than when I bought it.

Stericycle, which I bought last month, is trading at roughly the same price and so is the common stock of Voxx International, which I wrote about in January of this year

I purchased in that month, too, the stock of Carriage Services which is up 19% and so is the stock of Seritage Growth Properties, which is up 10% and ARC Documents Solutions, which is up 15%.

It is not by accident that I write about my paper loss and hardly mention the stocks with a paper gain. The reason for the disproportionate attention is that there is nothing to be learned when a stock is purchased less than year ago and is now randomly trading at a higher price. To hold such positions does not take any mental energy.

But that it is different when positions are trading at 50% - and even 60% - below the cost basis. Such paper loss forces me to reflect on why I had bought the stock in the first place; to observe why the stock market is bearish on the future of the company, and to assess whether I was wrong in buying the shares in the first place. 

Most of all: a paper loss requires the attributes of patience and conviction. The last two are not easily attained.

Why I bought SRCL

Published on:
February 10, 2019
Reading time: 3 Minutes.
Last Update:

After less than two days of research [1], I bought a few shares ofStericycle, a medical waste management company. At about $44 per share, Stericycle (SRCL on Nasdaq) is selling today at a much lower price compared to the past three years.

In 2018, SRCL traded between $75 and $45. In 2017, it changed hands between $88 and $61. And in 2016, the stock traded in the triple digits, between $152 and $111 per share.

Buying a few Stericycle shares

The loss in popularity is because of an abnormally high selling, general, and administrative costs (SG&A). You can see that by looking at the company's gross earnings of $1,486.9 million in 2016 and $2,462.5 in 2017.  While the 2016  SG&A were $1,053.1 million, they had mushroomed to $1,470.1 million in 2017. So, Stericycle reported earnings of $433.8 million in 2016 and a reported loss of $7.6 million in 2017.

Page 43 of the 10-k report provides more details about the $417 million difference in the SG&A expenses: because of a class-action lawsuit, the company paid $295 million and charged a $65 million goodwill impairment charge.

The income statement includes non-operating expenses which results in the understatement of earnings.

But these expenses were unrelated to on-going business. And without these non-operating expenses, the company would have reported earnings of $168 million, or $1.96 per share, in 2017.

Stericycle's valuation

Over the past decade, the company reported earnings each year. And during these ten years, investors valued the stock at earnings multiple as low as 21 times and as high as 62 times. The average earnings multiple range was 40 to 28 times the earnings.

I estimate the normalized earnings of the company to be $174 million or $2 per share, so the implied current valuation is 22 times. While still high, it is much less than the 10-year average.

Stericycle's runaway

Three factors are forming the runaway [2]. First, the amount of medical waste produced by hospitals is increasing. As the U.S. population ages, there are more operations. And that increases the number of tests, which increases the amount of medical waste.

Second, hospitals are slashing payroll expenses by outsourcing functions to third parties. Paying someone else to take care of waste management not only reduces overhead costs but reduces the liability associated with waste disposal.

The third factor is the regulation of medical waste. Most aspects of our lives, I believe, are becoming regulated and will become even more regulated. From how we marry to how we get a loan, there are more and more rules by which we must abide. And the more regulated the environment in which we live, the more attractive the service offered by companies such as Stericycle.

The amount of medical waste, a reduction in payroll expenses, and regulation will grow, a boon to Stericycle investors.

Stericycle's return on equity test and debt coverage test were reasonable

To quickly calculate the return on equity, I used the following definitions. In the numerator: to the reported earnings, I added back depreciation and amortization and removed capital expenditures.

In the denominator: to estimate capital deployed, I removed from the reported assets the long-term debt. 

The average 3-year cash flow was $382 million, and the average 3-year capital was $4.1 billion, a reasonable return on equity of 9%.

For every dollar of asset, Stericycle had about 60 cents of debt - reasonable leverage, especially for a company that signs a multi-year contract with its customers.

The 5-year average gross earnings were $499 million, and the interest expense was $100 million, an adequate debt service coverage of about five times. While I expect Stericycle to report gross earnings to be $250 to $300 million in 2019, it is still at a reasonable debt service coverage of about three times.


A reader asked how I find stock ideas. Two sources are the Value Line Investment Survey and newsletters written by investment managers.

I learned about Stericycle from the Industry Perspective section of Diamond Hill Capital Management. I visited their website because I initially looked into buying shares of Diamond (DHIL on Nasdaq), a publicly-traded asset manager that reported tremendous growth in earnings over the past decade. 

Diamond earned $1.36 per share in 2008, $5.44 in 2012, and $14.48 in 2017. The stock is trading hands at about ten times the earnings per share, but I decided against buying the common stock [3].

In short, I investigated buying shares in Diamond, decided against it, and ended up buying 300 shares in a company Diamond had bought for their portfolio. And all this happened in less than two days.

FOOTNOTES: [1] I usually need weeks of research, at minimum, before I buy a stock. [2] From Mohnish Pabrai, I learned to look for 'the runaway of a stock.' What he means is to ask whether the industry in which the company operates will grow. [3] It is hard to predict the profits of a mutual fund such as Diamond. This is because their earnings are dependent on the amount of assets under management. And those in return are dependent on the performance of the mutual fund itself.

My return to the waste management business

Published on:
February 2, 2019
Last Update:

One way to find stock ideas is to look at yourself. From the restaurants that you eat at to the clothing stores that you visit, these companies are often publicly traded. While writing to you, I am drinking coffee from Starbucks (SBUX on Nasdaq), checking (too often) my iPhone (AAPL on Nasdaq) and looking at a Dell computer screen (DELL on the New York Stock Exchange).

It is an endless list: I lease a Subaru (FUJHY on the over the counter market). Later on today I’ll pick up a package from Amazon (AMZN on Nasdaq). This evening I'll probably watch an episode of Jerry Seinfeld’s Comedian in Cars Getting Coffee on Netflix (NFLX on Nasdaq) while heating up leftovers using a General Electric Company (GE on the New York Stock Exchange) microwave. Even my electric toothbrush was manufactured by a publicly traded firm - Procter & Gamble (PG on the New York Stock Exchange).

Because many investors follow this principle of investing in products they use, the stock price of these companies is steep. Apple is trading at over 15 times the trailing earnings multiple, with a price to book value of 6 times. It is a somewhat high valuation, but it is minuscule compared to Netflix - its price to earnings multiple was over 100 times, with a price to book value of 27 times. Amazon is trading at 84 times the 2018 earnings and at 23 times the book value. These dear valuations would leave Benjamin Graham aghast.  

My work as a recycler

Frustrated by the lack of new stock investment ideas, I took out the trash. While sorting and dividing into recyclables and nonrecycles, I suddenly thought of the time I worked in Santa Ana, California, at a computer recycling company. It was about ten years ago and - for a minimum wage of $7.25 per hour - I stood on my feet for ten hours and tore apart old computers.

It was a lousy gig. By inhaling dust and gases, I reduced my life expectancy. Try to remove platinum chip from the CPU and you will see what I mean. I also had never before stood on my feet for such an extended amount of time, and to this day I empathize with cashiers at supermarkets. 

Thinking about that yearlong period of work as a recycler, I now realize how busy we were. The phone would constantly ring with local businesses inquiring about whether or not we could recycle their computer hardware (in California, the donation of old computers is a tax-deductible event). And there was no limit how much recycled parts we could sell in the market place.

I decided to call the owners of the business, two brothers who worked together. I asked them how their business was doing. “You wouldn’t recognize the place,” said Jacob, the older brother. “We now have over 200 employees; we increased our warehouse space by ten-fold, and we still cannot keep up with demand. We are even considering going public in 2019.” And that’s when I realized I needed to be back in the waste management business.

The lure of the waste management business

Three things are attractive about the waste management business. First, it is a growing industry with a growing need for companies to responsibly handle waste while meeting regulatory requirements. Second, in an economic down cycle, which we are likely to see in the coming years, the demand for recyclables will still be high in my opinion. Consider companies in medical waste, for example. The amount of waste they collect is unrelated to the business cycle.

Third, it is not a sexy business. I don’t imagine recent Ivy-league school graduates submitting their resumes to HR departments for middle management positions in waste management firms. I also don’t see young, famed-starved entrepreneurs pitching to angel investors how passionate they are about trash and its disposal. It is this lack of appeal that leads me to believe that no company will disrupt the waste management business any time soon.

So I researched a few publicly traded companies and quickly learned that I was not the only one in search of cheap waste management stocks. Appearantly they are in high demand and are trading at high valuations. Clean Harbors, that provides companies hazardous waste disposal, traded between $72 and $45 over the past year. It now trades at $60. Covanta Energy traded, during this time, between $18 and $13. It now trades for $16. Republic Services, which focuses in waste management for the energy sector, traded between $78 and $60. It now trades at $76. In short, all the waste management companies  were trading at the upper bound of the one-year valuation.


I did buy a few shares in Stericycle, a waste management company with $4 billion in market capitalization. While I was looking for waste management stocks, I accidentally found Diamond Hill Capital Management’s discussion about Stericycle and thought it was an appropriate buy. I will write more about  Stericycle in next week’s post.

Returning to my desk the morning after buying shares in Stericycle, I thought about the difference between principles and specific details. Principles stand the test time of time and guide us in the present. But they are often too general and universal so, specific details are the ones that really guide us.

In the Tanakh there are specific instructions as to how the principal of “love thy neighbor” is to be performed. “If you see your enemy’s ass sagging under its burden, you shall not pass by. You shall surely release it with him.” [Exodus 23:5]. It is a specific requirement following the general principle. Returning to stock investing, the principle I followed was to “invest in companies in which you are familiar with their product.” The specific detail was, “Look everywhere. Even in your trash.”

Why I bought CSV

Published on:
January 25, 2019
Last Update:

Carriage Services, a funeral home company, has two lines of business. Funeral homes operations, the first of the two, consists of: (1) ceremony and memorial services, (2) disposition of remains either through burial or cremation and (3) memorialization through monuments or inscriptions. Funeral homes operations are about 80% of Carriage's revenue.  

The second line of business is cemetery operations. Carriage operates 32 cemeteries in 11 states. Cemetery operations generate revenues through sales of internment rights and memorials, installation fees, finance charges from installment sales, contract and investment income from preeneed cemetery merchandise trusts and perpetual care trusts.    

Preneed programs

These programs enable families to establish in advance the type of service to be performed and the products to be used. Preneed contracts permit families to eliminate issues of making death care plans at the time of need and allow input from other family members before the death occurs. The contracts are paid on an installment basis. The performance of preneed funeral contracts is usually secured by placing the funds collected in trust for the benefit of the customer.

Carriage sold about 7,500 preneed funeral contracts over the past five years. As of 2017, the company had a backlog of 93,712 preneed funeral contracts and 63,523 cemetery contracts to be delivered in the future.

The two risks Carriage faces

Two trends are and will continue to hurt companies that operate in the funeral and cemetery business. The first negative trend is that we bury less people today, as I noted last week.

In 2017, the number of burials in the United States decreased by an estimated 0.8%. The burial rate was estimated to be 48.5% and is estimated to fall to 43.3% in 2022. It is estimated that there will be about 1.3 million burials in 2021, declining from 1.36 million in 2017, according to the 10-k report.

The second negative trend is that the number of cremations is increasing. The number of cremations increased by 5% in 2017 following increases of 4.3% in 2016 and 7.4% in 2015. In 2021, it is estimated that there will be about 1.7 million cremations in the United States and a cremation rate of 56.7%. "Nobody is yet writing undertaking's epitaph," wrote The Economist in Great News for dead: the funeral industry is being disrupted", "but the industry will have to adapt."  


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Could Carriage be an exception to the rule?

Carriage has done a reasonable job fighting off these two industry trends. Over the past five years, revenue increased by 4% compounded annually, to $201 million from $163 million. Net earnings, adjusted for non-cash items such as depreciation and amortization, increased by almost 8%, to $36 million in 2017 from $25 million in 2013. Equity balance increased by about 5%, to $198 million in 2017 from $156 million in 2013.

Carriage generates plenty of cash to meet debt service obligation, too. In 2017, for example, Carriage gross revenue was $104 million; it had general and administrative cost of $26 million and $13 million in costs. There was $65 million in cash flow to service the reported interest expense of $13 million, an adequate coverage of about 5 times. 

The company reported $121 million in long term liabilities, compared to tangible total assets of $615 million, a ratio of 20%. To get to the tangible total assets, I removed the intangible goodwill assets of $306 million.

Why I bought the stock

While a faux pas to buy shares in a company whose industry tailwinds are working against, I decided to buy 1,000 shares of Carriage at a total price of $16,000. My investment thesis is as follows: A reasonable market valuation for Carriage, in my opinion, is a price to earnings multiple between 15 to 10 - the average trailing three years earnings per share.

Since the average earnings per share over the past three years were $2, I estimated the value of Carriage to be $20 to $30. My cost basis was $16 per share, and I intend to hold the stock for at least two years. This translates to a 2-year expected return between 12% and 37%.    


The number of deaths in the United States over the past three years increased by 2% each year. This is the result of a rapidly growing and aging population, which is expected to increase the numbers of deaths in the foreseeable future. Americans 65 and older are the fastest-growing segment of the population, with 48.2 million, expected to increase to 55.7 million in 2021, an average annual growth rate of 2.9%.

While many investors would regard the preceding statistic as tailwind for the industry, I would like to point out to the reader that often statistics do not translate to earnings for the investor.

Consider the airline industry, for example. This technological innovation has completely changed how we think about travel and how global trade is performed. And yet, the airline industry proved to be a poor investment vehicle for the investor.

Investors in the airline industry learned, over the past 50 years, of customers’ lack of loyalty to a brand, the rising cost of both labor unions and regulation and the challenging, volatile landscape facing buyers of fuel. Benjamin Zhang, writing for Business Insider, adds that congestion, passenger comfort and pilot shortage are increasing problems, too.  

For the funeral stock investor, a similar investing outcome may prevail. Workers at funeral homes provide a humane service, filled with emotion and empathy. It is important work. 

Yet this humane profession will not necessarily translate into stellar returns over equity ratios or net profit margins. In short, macroeconomic trends should not drive your investing decisions. In Peter Drucker’s own words, “No single piece of macroeconomic advice given by experts to their government has ever had the results predicted.”

Why the Kahn Brothers own Voxx International

Published on:
January 5, 2019
Reading time: 3 Minutes.
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***April 29, 2020 summary: I bought 2,000 shares on December 18, 2018 for a total of $9,099 or $4.55 per share. Less than a year after, on November 29, 2019, I sold all shares at $4.64 a share. I didn't understand Voxx business and didn't have any interest in learning more about it***

It is one thing to watch a live soccer game, and it is quite the other when we know already which team had won the match. In the former, we try to make sense of what we don't know, and in the latter, we make sense of what we already know.

So it is in stock investing. When you know that General Electric (GE on Nyse) was $15 and now trades at $7 - it is simple to see the decline in price. GE had a shakeup in management; the spot price of energy dropped, and the prospects of solar energy are not as alluring as they were when Al Gore ran for president [1]. 

But determining whether in a year's time GE's stock will again halve in price is a different task. I once heard that as opposed to Physics - where three formulas explain 99% of the observed phenomena - in stock investing, 99 formulas explain less than 3% of what eventually happens. 

There are too many unknowable and unforeseeable variables that will cause a stock price to move up or down. And to predict price movement is to predict the future. Rarely a success.


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Voxx largest shareholders 

This week I came across Voxx International, a small-capitalization stock of $108 million that is controlled by its founder, the 86-year old Mr. John Shalam. 

Voxx sells audio accessories across the globe and holds an umbrella of 30 brands that it has acquired over the past decade. The company earned about one dollar per share in 2017 and is expected to earn roughly the same in 2018. It is trading at about five times the 2017-2018 average earnings per share.

More intriguing about Voxx are its owners. I mentioned already that Shalam owns the majority of the outstanding shares, and had rarely sold shares over the past 15 years (less than 1% in dilution, compounded annually). 

Voxx International Largest Shareholders
Voxx Largest Shareholders. Resource: Proxy 2018 filing.

More of interest is that Kahn Brothers Group (KBG), the flagship investment arm of the legendary value investor Irving Kahn, of blessed memory, not only holds about 15% of the outstanding common stock but has also been a shareholder in Voxx International for 15 years.

Why the long hold period, I wonder. Nothing appears to be unique about Voxx International. The operating margins are slim, and the business model has not been consistent either. 

Fifteen years ago, the strategy was to leverage the brand Audiovox Corporation. But the business model completely changed over the past decade as management realized that capital markets preferred that management grew earnings via mergers and acquisitions. And the company had enough years of operating losses that Benjamin Graham would warrant its stock to be a speculative position.

Why Kahn Brothers Group has owned the stock for 15 years

Initially, I estimated that this was a classic loss aversion case. Based on the 13-F filings, the average cost per share for KBG was $9, and since the paper loss is now about 50%, KBG is merely waiting until the stock climbs to a reasonable price.

Or perhaps KBG cannot quickly sell the shares in Voxx. If a company owns over 5% of the outstanding shares in a publicly-traded firm, the company must publicly disclose its intention to sell shares.

Finally, I concluded that KBG must understand something that I do not. Perhaps Mr. Market is unhappy with the controlling member or maybe the value of the business, as an umbrella that holds many brands is worth much more than the price of the brands individually. Perhaps KBG believes the intrinsic value is much higher than what the basic discounted cash flow approach reveals.

Is Voxx International a Bargain Stock? 

While on the surface, Voxx appears to be a bargain at a price to earnings ratio of five times, at a closer look, management reported that only 3 cents of the reported earnings of $1.41 are from continuing operations. 

Last year's earnings were primarily the result of the selling of Hirschmann Car Communication. The sale of Hirschmann is an example of why the Kahn Brother Group continues to hold the stock is my final guess.

Voxx, in numbers

At its most recent annual filing, the company reported assets of $575 million with associated liabilities of $125 million. The equity is $450 million or $20 book value per share, resulting in a price to book value per share of 22%. 

Voxx 2018 to 2014 operating results. Resource: Public filings.

Removing goodwill and intangible assets of $250 million, which are 43% of the reported assets, the equity balance is $200 million or $9 per share, a price to book value of 49%.

So I went ahead and bought a few shares in Voxx. While I understand little about the consumer sector (I did not recognize a single brand owned by Voxx), I am hoping for two things. 

First, that KBG knows something about the business that I have yet to discover, and second, that, indeed, the value of the assets is worth more than what Mr. Market is now willing to pay for them at the moment.

FOOTNOTES: [1] GE traded at $45 a share at the time.

NAFTA And Core Molding Technologies

Published on:
October 20, 2018
Last Update:

That things are not always what they seem and that first appearance may deceive many was already understood by Plato over two millenniums ago. In this meditation I will describe what at a first glance appeared to be a bargain stock, was an ill-advised purchase upon a careful review. My purpose in writing this meditation is to demonstrate that financial numbers and the prices of stocks are the starting point, but not the final word in stock investing.  

Core Molding Technologies Inc., which trades on the New York stock exchange, appeared to be a bargain stock. Management had increased the number of outstanding shares by one percent compounded over the past decade. In 2008 there were 6.8 million common shares outstanding and today there are 7.7 million common shares outstanding. The average 10-year earnings per share was 93 cents - the stock traded at roughly 9 times the decade-long average earnings per share. The book value per share increased by three-fold during this time. And Benjamin Graham would be proud of my discovery, I thought.      

Its rags to riches story is remarkable. CMT sells a particular niche product called reinforced plastics. The top industries that use the product are transportation, construction and industrial. The company’s major customers include Navistar, Volvo, Paccar, Yamaha and Bombrader Recreation Production. As of the end of last year, these customers were responsible for over 90% of CMT's sales.  

What drove the stock price down

So here is a company with a reasonable product that traded hands at a cheap price. The company's common stock started at $20 in 2018 and had halved recently. The culprit was Mr Market's fear of how changes in the North American Agreement on Environment Cooperation (NAFTA) will affect the company.

NAFTA targets the relationship between America, Mexico and Canada, the same countries in which CMT predominately operates. In 2017 CMT revenue from Uncle Sam’s land was $103.5 million in the United States, $52.5 million from the land governed by Enrique Pena Nieto and $5.6 million in the land of Maple syrup. It also owns and leases manufacturing plants in all three countries.

As many of you know NAFTA is now being renegotiated. And while final details have yet to be published, it will be of little surprise to see red tape and additional costs in the auto industry (in which the majority of CMT’s customers operate.) And business logic dictates that if the customer of a company is suffering, then the company’s business will be hurt too. In short, the expected macroeconomic changes in policy penalized the stock price of CMT.    

But while the looming NAFTA uncertainty is not helping companies like CMT, the is more to the the decline in the stock price. I argue that CMT’s stock price to decline its purchase of Horizon Plastics International, which was announced in January of this year.

Using a combination of cash and debt, CMT paid $63 million for Horizon. "The purpose of the acquisition was to increase the company's process capabilities," explained management. "They will now include structural foam and structural web molding, expand the geographical footprint and diversify the company's customer base."

All nice and well, I thought. But at what premium? Instead of waiting to see whether the future value of companies that operate in Canada and Mexico will deteriorate given the new NAFTA agreement, CMT's management was eager to move forward and paid a premium for Horizon Plastics.

On an increase in goodwill and debt

In CMT’s10-Q filing as of year end 2017, the company recorded $2.9 million in goodwill and intangible accounts. Compare that to the second quarter of this year where it recorded a whopping $40.1 million in intangible assets. Yet what should truly scare current shareholders (yours truly is not included in that group) is the debt level.

Long term debt as of last year was only $3.75 million. Yet as of the second quarter of this year, long term debt was $39.4 million, a little over nine times as much. Evidently, management's appetite for debt affected the income statement. The interest expense this year was 8 times higher compared to the same period last year. In numbers: In June the interest expense was $1.07 million compared to $129 thousand a year ago. So operating income to interest expense deteriorated to 2.37 times, compared to 44.38 times a year ago.

In our rising interest rate environment, it is puzzling why management had added fuel to the fire by taking a variable debt obligation and not a fixed debt obligation. Since management had not addressed the matter in its recent earnings call, I will offer a few explanations for the variable versus fixed debt conundrum.

First, the bankers would not finance the acquisition of Horizon Plastic with fixed debt. Second, management does not consider this to be a rising interest rate environment. Third, the cost of variable debt payments was much cheaper than fixed debt payments. Fourth, management was just careless and does not see the variable-versus-fixed debt as a material issue. Fifth, and most likely in my opinion, management did not have other options.

All roads lead to Rome. And no matter the justification, current shareholders should be appalled by CMT’s management's past business decisions. To pay a premium for a company that operates in Canada and Mexico was wrong. To finance the acquisition using variable debt was wrong. And to reduce the cash balance to practically nil was wrong too.

Reading About Risk Factors in The 10-k Report Filing

Published on:
October 12, 2018
Last Update:

One of the unsolved mysteries of stock analysis is how to learn about stocks in the first place. Some investors hear about stocks at cocktail parties ("Tesla is going to be 10x in 3 years") and rush to buy the stock. Other investors carefully read buy-side analyst reports. And some investors just follow a gut feeling (I know a portfolio manager who regularly visits a fortune teller.)

I argue that one of the best methods to understand a stock is by reading the risk Factors section of the 10-K report. This section of the annual report describes much more than risks - it provides a snapshot of the company and its industry. In short, the section details that keep management up at night. 

In this meditation, I will share what can be gleaned from the Risk Factors section of Orchids Paper Company, a company I invested in a few weeks ago. 

Debt and variable payments

On page 10 of the 2017 annual report, management wrote "We have significant indebtedness, which subjects us to restrictive covenants relating to the operation of our business." Management expected $22.9 million in total debt payments for 2018. And for a company that reports on an adjusted EBITDA of about $15 million, that is a hefty debt burden. A closer look at the income statement reveals that while in 2016, the interest expense was $1.7 million, debt services mushroomed by over twofold, to about $5 million in 2017.

The cost of debt in numbers: Orchid paid a weighted interest rate of 2.6% in 2016. But in 2017 it paid a weighted interest rate of 7.3%. And as of the second quarter of this year, the rate on its debt crept up to over 9%.

Why the rising cost of debt? Risk number 12 in the Risk Factors section explains: Orchids is paying its debt based on variable payments. That is, the debt service fluctuates according to the level of the interest rate environment, specifically, the 30-day LIBOR index, an interest rate index that is almost twice as high compared to a year ago. (The 30-day LIBOR is now 2.06%, compared to 1.23% twelve months ago.)  

Rising debt costs is an important issue for the common stock investor, and this section of the annual report immediately cuts to the chase.  

Customer concentration

"A substantial percentage of our net sales is attributable to three large customers," noted management, "any or all of which may decrease or cease purchases at any time." Listed as risk number 4 out of a list of 15 risks, the risk explains that between Dollar General, Wallmart and Family Dollar, about 67% of 2017 sales occurred.

To illustrate how sensitive capital markets are to this risk, I will remind current shareholders, yours truly is included in that camp, that Orchid's share price declined from about $4 to 80 cents a few weeks ago because management disclosed that a major customer would terminate its relationship with Orchid in 2019.

In Let my People Go Surfing, Yvon Chouinard boasted that Patagonia worked with one manufacturer in Japan. And because of the single concentration to one supplier, many of his peers regarded him to be mad. David Tran, founder of Sriracha, followed the same practice and relied on just one producer of hot peppers.

But what works for one-of-a-kind companies, such as Patagonia or Huy Fong Foods (the company behind the hot chili sauce), is inapplicable to the rest of us. Most businesses are better having an ample number of customers, a group of heterogenous suppliers and a host of manufacturing facilities in case one is out of commission. Orchid, selling a commodity product, cannot afford the customer concentration and the risk section, again, lets us quickly understand that.

Capital expenditures

To operate a paper mill requires constant work. And in Risk Factor number 7, management disclosed that "Our operations require substantial capital, and we may not have adequate capital resources to provide for all of our cash requirements." When I purchased the stock of TIS, I entirely ignored this risk factor. But you should not. Especially as we saw in prior paragraphs that most of the operating cash flow is expected to go to service the debt.

Between 2013 and 2017, the average capital expenditure was $48 million each year. If we want to go back even further, for the decade between 2008 and 2017, the average capital expenditure was $30 million. Compare that to the average EBITDA of $22 million for the past five years, or $20 million for the average EBITDA over the past decade. 

And capital expenditure is a real expense for Orchid. And more worrisome, given the amount of variable debt, Orchid's ability to continue to pay for the expense is questionable.

Cost of sales

I learned from Guy Spier how important it is to understand a company's cost structure. In The Education of Value Investor, he wrote, "It is critical to discern whether a business is overly exposed to parts of the value chain that it can't control." Returning to the business of running a paper miller, Orchid has two dominant costs of good items. The first item is energy cost and the second is solid bleached sulfate paper, also known as SBS paper.

The cost of both are rising. And rising costs are lethal when a company sells a commodity product as it is practically impossible to pass through the rising costs to the customer.  

Between the SEC definition and my use

According to the Securities and Exchange Commission (SEC), the risk factors section in the 10-K includes information about the most significant risks that apply to a company. My purpose in this meditation was to argue that the risk section is much more than that.  The risk factors section should be looked at as an index to story of the company.

A Quality Product. But Shareholders Should be Wary of the Debt Level

Published on:
August 31, 2018
Last Update:

My best friend’s house went up in flames. The fire was the result of malfunction in the oven. Fortunately no one was hurt. That is except for the 2,800 square foot home that smelled like a barbecue sauce for two years after the incident.

When the insurance agent arrived to assess the damage from the fire, the first item my best friend’s mom reported on was her Tupperware. She later mentioned to me that it took a long time to convince the insurance agent that she had owned so many Tupperware items.

My best friend’s mom is a wonderful cook and has a remarkable taste for quality. I used to spend many Shabbat dinners at her meticulously clean and well-organized home, admiring her sense of style. 

In contrast at my home we didn’t buy Tupperware items. My mom, a corporate attorney felt that cooking was a huge waste of time. “You cook for hours and the feeling lasts for less than twenty minutes,” she would lament.

My Dad who is an orthopedic surgeon, could never understand why one would spend money on Tupperware. There were practically free alternatives out there, he would say.

So, with one side indifferent about cooking in general and the other thrifty about its preparation, we would use the free, plastic containers from takeaway orders.

The alternatives to Tupperware

Known for being somewhat of a cheapskate myself, when I left my parent's house and started to live on my own, I bought box containers that I found at the local Vons store. I was lured by a promotional of “10 containers for the price of 2.”

But I am not rich enough to be as cheap as I am. And none of the containers lasted more than a few months. One set of containers for example, had permanently turned red because I used it to store pasta with red sauce.

Another set of containers never sealed propertly. Frustrated by the ordeal, I finally succumbed and purchased a Tupperware container in 2009. I bought a green, mid-size Tupperware Impression Classic Bowl for what seemed at the time an outrageous price of $19.

My original Tupperware
My Tuppeware

I couldn't see any difference between Tupperware and any of the containers I had bought for $2, but I reminded myself that if my friend's mom was using the product, there had to be a reason. 

Evidently she was right. That container has now served me for a decade. I use it just about every week and its lid seals the container as good as it did the first day.

A letter to Tupperware

Dear management of Tupperware, I could not believe that your ticker symbol appeared on the list of stocks that traded at a 52-week low. It is known by many investors that Tupperware is a company that is selling a $20 product that costs $2 to make. That Tupperware generates plenty of cash flow; that it has a remarkable method to sell its products through home parties, and that the company needs to invest very little capital expenditure to maintain its operations.

I also didn’t mind the 2017 operating results you reported on. To me, the reported loss of $265 million or $5.22 per share did not make any sense. As a matter of fact, if it wasn't for the accounting-related shenanigans, I believe you earned about $197 million or $3.8 per share.

TUP's earnings per share over past decade
TUP's earnings per share over past decade

Not only am I not disappointed with your operating results in 2017 but I applaud you for continuing to pay out dividends. In 2012 you paid $77.6 million in dividends; in 2015 you paid $138 million in dividends; and in 2017, even with all your trials and tribulations, you distributed $139.5 million in dividends. That is praiseworthy.

You probably don't know this dear management, but I did not purchase your company’s common stocks based on the expected dividend yield. To me, if you can think of ways how to use those retained earnings that would be even better. But I was pleasantly surprised to see an expected 7% dividend yield on my cost basis of $36 per share.

And now that I am a shareholder (I bought 600 shares of your stock), after I voted with my own money about the prospects of your company, I think it is only fair to let you know that I do worry about the debt.

TUP's leverage ratio is up
TUP's leverage ratio is up

Now, I know what you are going to say. That your earnings before taxes to interest ratio is above 7 times. And that coverage has not changed since 2012. I know that you are also likely to say that your assets are understated as the land you own in Orlando is worth much more than the reported book value.

But no matter the reason and justification, we both know that your current leverage is penalizing the stock price. In 2017 you reported on $1,388 million in assets and a whopping $1,507 million in liabilities. We also know that many investors will not take the time to read your notes about the goodwill impairment and the tax expense related to the Tax Cuts and Jobs Act of 2017.

Dear management, you have a good product. Don't let debt ruin your future.   

Why I Am Long Probiotics

Published on:
August 17, 2018
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In Nutrition Made Clear, Professor Roberta Anding tells how important a healthy digestive system is to our overall well being. There are over 4,000 different types of micro organisms in our gut flora and these little creatures boost our immune system and help us to fight bacteria. Mesmerized by her class and teaching style, I also learned that unless we are actively eating fermented food and seeking products that contain probiotics, our modern diet is weakening our immune system.

As I was reading how antibiotic medicine kills these essential micro organisms, Lifeway Foods, a company that fights the war against the modern diet, had appeared on the list of the companies that are trading at a 52-week low. A serendipitous encounter, I thought to myself and downloaded Lifeway Foods’ most recent public filings. I was intrigued to find out more about the company and why the stock price had recently halved in price.

The stock biography

LWAY traded hands as low as $5 and as high as $22 over the past decade. The average stock price range was between $8 to $16 during this time . Compare that to the current stock price of little less than $4. And since the December 2017 stock price of $10, LWAY stock value has sharply declined. 

I attributed the loss in market capitalization to an overreaction by Mr Market due to the 2017 reported loss of $346,000 or $0.02 per share. It was the first reported loss in over a decade.

It does not take a financial wizard to understand why the company reported a loss in 2017. Sales declined from $124 million to $119 million while the cost of sales had not changed (in both 2016 and in 2017, cost of sales were $86 million). And it seems management is slow to change its operating expenses as the general and administrative expenses were $14 million in both 2017 and 2016.

Free cash flow

While capital markets focused on the decline in revenue and reported loss, I looked for the normalized free cash flow. Defined as cash flow from operations less the cost of debt and fixed capital expenditures, the 2017 normalized free cash flow was not materially different compared to prior years. In 2017 management reported on a loss in free cash flow of $1.3 million and in 2013 it had reported an even steeper loss in free cash flow of $2.5 million.

But in 2013, while showing a loss in free cash flow, the company’s income statement reported earnings of $5 million or $0.31 per share. Unsurprisingly - because capital markets focus on earnings per share at the expense of free cash flow - the stock traded hands in the range of $24 and $32 during that year.

But in 2017 the loss in free cash flow coincided with a reported loss in the income statement. This infuriated Mr. Market and consequently the stock price was severely hit.

To me, both accounts are nonsensical. The loss in free cash flow in both years was due to abnormally high capital expenditures and not because of a fundamental change in the business of selling kefir. I estimated that the annual, normal capital expenditures are $3 million. But in 2013 they were $8.5 million and in 2017 they were $5.4 million.

13D filings

Submitted to the SEC within ten days by anyone who has more than 5% of any class of publicly traded stock in a public company, 13 D filings should not be overlooked.

Visit the 13D for LWAY and you will read that the Smolyansky family owns about a half of the outstanding shares of the company. And that in 2017 Lydia Smolyansky, who is the majority shareholder and owns of a third of the company, gifted to her two brothers 1.5 million shares from her own pocket. I viewed that as a positive sign.

LWAY's coverage ratio

LWAY's ability to pay back debt was excellent as of its recent public filling. The cash flow from operations to interest expense ratio was over 15 times. Between 2017 and 2013, the ratio ranged from 15 times to 37 times, a remarkably conservative ratio.

LWAY finances its operations prudently. Over the past four years, the average book value was $48 million, and outstanding total liabilities were $18 million, resulting in debt to asset ratio of less than 40 percent.

The company holds enough cash to pay about 20 years of the current interest payments. A praiseworthy achievement.


"This is one of the most important things you can do to increase your overall health," notes Doctor Ax, a YouTuber. "And if you can increase the amount of good bacteria and balance the level of microorganisms in your body, it can have tremendous benefits. Probiotics are essential to healing any condition out there today."

If you learned one thing from this essay, I hope it is a new appreciation of the gastrointestinal tract and an awareness of our need for probiotics. If you would like to know more about the benefits of probiotics and which foods contain them, I suggest that you read Probiotics Benefits, Foods and Supplements - a Vital Part of Any Diet and 7 Kefir Benefits and Nutrition Facts that Boost Immunity & Heal the Gut.

Another excellent article I found was written by The Academy of Nutrition and Dietetics and you can read an article about priobiotics by clicking here. Doctor Patricia Hibberd of the National Center for Complementary and Integrative Health has a free lecture on the topic.

GE's World is Fairy Tale Story That Will Not End Well

Published on:
August 3, 2018
Last Update:

General Electric's recent annual report left readers scratching their head. The company operates in nine, materially different segments, and comments on each segment as if the reader is expected to understand the risk facing the oil industry and the healthcare industry.  To analyze the financial statement of a company with one operating segment is a challenging task; it is exponentially harder in the case of GE.

To explain its operating results, GE came up with its own definition of financial performance metrics. Those metrics include imaginative terms such as "EPS from continuing operations", "GE Industrial plus verticals EPS" and "Adjusted GE Industrial CFOA". With so many adjustments to reported earnings, we must wonder whether they are meaningful at all.

Not only is it difficult to understand the meaning behind the definitions, the annual report contains typos. On page 102 of the annual report, management makes an error as it reports on $9,698 million in adjusted GE industrial CFOA. It should be $9,168 million.  

GE's mistake from page 102 of the 2017 annual report

The past

There is no way around it: GE reports on a deteriorating financial health. If we look at the revenue from the sales of goods and services over the past six years, we find a compounded annual growth of 2% per year, from $101 billion in 2012 to $113 billion in 2017. But the operating expenses increased by three times as much. The operating expenses compounded growth was 6% during that time, from $75 billion in 2012 to $107 billion in 2017.

Another troubling fact is that GE's debt service increased from $1.3 billion to $2.7 billion during the 2012 to 2017 time period. So the gross revenue to interest expense ratio has steadily declined over the past six years. It was 19 times in 2012; six times in 2015; and merely two times in 2017. In numbers: GE revenue was $113 billion; its operating expenses were $107 billion; gross revenue was $6 billion and with an interest expense of $2.7 billion, the coverage ratio is 2.2 times.

The dismal trend in operating performance is found in GE's balance sheet too. In 2012, the company had $600 billion in tangible assets and $557 billion in liabilities for a tangible equity balance of $43 billion. In 2015, total tangible assets were $410 billion, and liabilities were $389 billion, for a tangible equity balance of $21 billion, a drop of 51%. Two after, in 2017, the tangible assets were $274 billion and liabilities were $292 billion. A deficit in the reported equity account. In other words , the accountants reported that GE will not be able to pay off its liabilities (let alone the common shareholder) if it is to sell all of its assets as reported on the balance sheet. Yikes.

The future?       

It is practically impossible to proselyte where GE will be in five years. A month ago, GE announced that it will be selling its 62.5% interest in Baker Hughes. A year ago, Jeffrey Immelt retired as Chief Executive Officer and three and half years ago, on April 10, 2015, GE announced it would sell most of the assets of GE Capital. 

There have been so many changes; how can one see the distant horizon? With no idea where GE will be in the future, I thought about valuing GE by simply adding up the market value of its subsidiaries, as if they were separately owned entities. But here too I ran into a difficulty. Separately, GE does not report who is the competition for each of its subsidiaries, and given its behemoth size, GE is simply too big for a competitor to purchase its assets entirely.

In a day-to-day business transaction, a prospective buyer usually asks: What am I getting by investing my cash in this business? The answer is usually how much cash flow will be returned, and what is the value of the asset being acquired after any liabilities are paid off. In the case of GE, it is guessing a game to determine either of the two.   

The (opaque) valuation

Between 2012 and 2017, the stock traded as low as $17 (in 2017) and as high as $33 (in 2016). I believe there are many investors who estimate that the stock value is now somewhere worth somewhere between $20 to $25 per share. Let us assume that it is the case for the remaining paragraphs.

Even if the stock is worth $25 per share, given the uncertainty, GE is not a bargain. Grab your HP12C and you will find that assuming that GE's stock price will reach $25 five years from today, the expected rate of return is 14%. Including the expected dividend per share of $0.48, the expected rate of return is 17%. A less than adequate return given the amount of uncertainty.


 This meditation is an example of when the best investing idea is the one you do not invest at all. What drew my attention to GE in the first place was a precipitous decline in the stock price. Excited about the opportunity of purchasing stock for $14, I quickly learned some hard truths; that management halved the dividend rate in the last quarter of 2017 from $0.25 to $0.12 per quarter; and that management took a significant impairment expense of $6.2 billion last year with little explanation. 

In February of this year, I bought 100 shares of GE at a total cost of $1,474. (It represents about 0.59% of the total cost of my portfolio of stocks.) I bought those shares just to force myself to read more about the company. I am glad I learned more about GE and I am also glad I am no longer a common stock holder. The word of GE is simply too confusing for me.

A Senseless Market Capitalization

Published on:
July 13, 2018
Last Update:

Animal Spirits may explain why an investor would prefer to franchise a Buffalo Wild Wings restaurant as opposed to simply purchasing the stock Diversified Restaurant Holdings. Below is an argument for the latter option using a simple, cost-benefit analysis between the two alternatives. 

Building 65 Franchises Versus Purchasing The Stock

The expected cost to open a Buffalo Wild Wings restaurant ranges from $2.6 to $3.7 million. Let's multiply the expected cost by 65 (the number of restaurants SAUC franchises.) Let's further assume that we require a minimal 5% return on our capital of $201 million, which would bring us to an expected profit of $10 million.

Management of SAUC noted that the costs to open a restaurant are
somewhat lower. On page 7 of the 2017 annual report, management wrote that
"the average cash investment per restaurant ranges from approximately $1.7
million to $2.6 million."

So let's use their lower estimated cost of $2.1 million to open a store and calculate the expected profit as we did in the first paragraph. We conclude on a total cost of $136 million, on a profit of $7 million and on an annual revenue of $137 million, in line with what SAUC earned last year. 

While the cost to open 65 franchises is between $136 million to $201 million, SAUC’s current market capitalization is $34 million, about 3/4 lower. In 2017, sales were $165 million and profit generated was $8 million (the profit excludes an $18 million tax provision, which I will further discuss, below.) In short, to build 65 franchises, the expected cost is about $6 per share, while the price of SAUC, representing a similar economic outcome, trades at about 1/5 of that. 

diversified restaurant holdings financials
Source: Public filings and my calculations

Why The Decline in SAUC's Stock Price?

Since May of 2017, shareholders watched the price of SAUC decline each month. At fault, I believe, are three events. The first event is higher costs for chicken wings. Traditionally, the price of chicken wings was around $1.25 per pound.  But last year, it reached over $2 per pound. And since chicken wings are 25% of the total cost of sales for Buffalo Wild Wings, it impacts earnings. Last year Tim Carmen of the Washington Post wrote

The second event was that SAUC sold restaurants operating under the name
While this was an underperforming segment, its absence going forward lowered future revenue guidance. In numbers: the 2015 revenue, which included income from Bagger Dave’s, was $172 million compared to the 2016 revenue of $166 million, a decline of 3.5%.

The third event at fault for the lower stock price is an obscure change in accounting rules. Because of changes related to, management reported on a $19 million loss in their income statement.Without the reported tax provision loss, I estimated earnings would have been $8 million, or $0.30 per share.

diversified restaurant holdings
Source: Public filings and my calculations

My Appetite for Wings

 My interest and fascination in the restaurant business is limited. I never visited a Buffalo Wild Wings restaurant and frankly wouldn't know the difference between a chicken wing and thigh - I hardly ever eat meat.  

But the rationale to purchase SAUC as strong as DAVE because there were additional forces at work. Besides the low current valuation of the stock relative to its past valuation, the acquisition of Buffalo Wild Wings, may bring good news. This entity is 82% owned by Roark Capital Group, named after infamous character of Ayn Rand's novel,

The key force behind Inspire Brands is its boss, Paul Brown, who has with a proven track record in the restaurant business (he revamped Arby's).

Inspire purchased Buffalo Wild Wings for $2.9 billion, and that at the time of purchase, there were 1250 restaurants (about half were owned by the company). This equates to an average purchase cost of $2.3 million per restaurant or franchise. Keep this number in mind as you read the concluding section below.

The Math

To me, a reasonable price for the stock of SAUC is $2 per share. Another way to look at the valuation is to assume $2 per share. From there, you can say that the market value of the equity would be $56 million, and if we add back the liabilities of $131 million, we get a value of $187 million for assets that compose of 65 franchise stores, or $2.8 million per restaurant. This price aligns with what I believe is the replacement cost of the portfolio.

An April - June 2018 update on positions I bought and sold

Published on:
July 6, 2018
Last Update:

In this article, I detail my activities in the stock market over the past three months. I explain why I bought and sold certain common stocks and how my stock portfolio performed in comparison to the return of the S&P 500 index.

Comparison to the S&P 500

The market value of my portfolio is $40,906 compared to my cost basis of $39,018. This represents an appreciation of 4.8% on my cost basis and a difference of 6.1% compared to the S&P 500. I will remind new readers that to track the S&P 500 index, I bought one share of VOO, an exchange traded fund by Vanguard. I paid $253 for the ETF in the last week of 2017, and as of the second quarter of this year, it is worth $249.  Including the $1.51 of dividend I received, the S&P 500 index declined by 1.50%.

While my portfolio return is not impressive, it is not a poor one either. As a comparison, In a talk to the CFA Society of Switzerland, Guy Spier noted that over the past two decades, after fees, he had beaten the S&P 500 by an average 2.0%. And if you read his letter to shareholders, you will observe the tremendous effect that 2% achieves - that is, over a long period of two decades.


200 shares of Patterson Companies (PDCO) at $23.54. The company operations suffered over the past few quarters, but on a 5-year basis, I thought the company had done reasonably well. I bought the stock because of relative valuation: it traded at a multiple of less than 10 times the earnings, while over the past decade, the earnings multiple ranged from 13 to 19 times.

I am interested in purchasing in companies with a business model that is independent of the economy cycles. I believe Patterson meets that definition, as it distributes dental and veterinary products. You can read more about the position in The one advantage of short term thinking? A cheap stock price

200 shares of Caesarstone at $15.32. I started to purchase Caesarstone in December of last year. At that time, I thought it a bargain at $23 per share. While the Quartz-manufacturer had little debt, it showed deteriorating operating margins which capital markets felt were unforgivable. With the additional purchase, my cost basis is now $17 per share which is less than 10 times the 5-year average earnings of $1.90 per share. Read more about Caesarstone and what I saw in its common stock in My romantic love story with Caesarstone.      

500 shares of Orchids Paper Products at $4. While Wall Street analysts often ignore discussing micro companies - defined as companies with a market capitalization of less than $50 million - yours truly found Orchids to be of quite the interest. The 2008-2017 average earnings per share was $1.15 and Orchids did not report on a single loss over the past decade. I felt my position was safe from any principle loss, even if Orchids was bought by a competitor at a discount to book value. That is because my cost basis is less than 70% its book value. If you don't listen to Wall Street wisdom, I suggest you read about Orchids in Capital markets have reason, which reason does not know.


20 shares of Terra Nitrogen at $84, compared to a cost basis of $80. In the second quarter of this year, Terra purchased all its outstanding shares at $84 and delisted from the New York Stock Exchange. My preference would be to hold the stock for a few years, but Terra apparently did not care much for my opinion. I wrote about this in Terra in Greed in Times of Fear: The Case of Terra Nitrogen in October of last year.     

500 shares of Carver federal savings bank at $6, compared to a cost basis of $3. To my knowledge, there is no apparent rationale for the sudden, unexpected increase in the stock price. I bought the position 8 months ago because I thought Carver could easily improve its operating financials. But it is impossible that operations improved that quickly. Because Carver lends to non-profits – a tricky business to be in - I happily got rid of the entire position. Read the aptly named article from July of last year: If You Need Excitement and Cheap Thrills, Going Long on Carver Federal Savings Bank May Do the Trick.

100 shares of Independence Realty Trust (IRT) at $9 compared to a cost basis of $9, and 50 shares of Hudson Pacific Properties (HPP) at $34 compared to a cost basis of $32. I bought both stocks in October of 2016. While the companies were a decent place to place cash, I wanted to reduce the number of companies in my portfolio.   


This quarter, I was paid a total of $217 in dividends from 9 companies. On a portfolio level, some company’s dividend yield was 3% (DKS, SRG, GE), but for some it was 14% (mainly, CB&L Associates). I expect to receive about $800 in dividends in 2018, which is a 2% dividend yield. While dividend payout policy does not guide my stock investing, it is a comforting, reasonable yield. The annual yield on a Certificate of Deposit in comparison, is roughly 2%. 

A few housekeeping notes

I encourage you to join the Reader Community to receive premium content about stock investing. To 5 subscribers over the next quarter, I will send copies of “The Intelligent Investor.” If you haven't read it, - by far - it is the best book on investing.

By subscribing, you will join a reader base that includes institutional money managers, private wealth advisers, and students of finance.

As it is one of my goals to better explain the world of stock investing, I encourage you to write to me if you have questions.  

How capital markets react when a CEO changes a plan

Published on:
June 29, 2018
Last Update:

"We recently announced our decision to abandon the new nuclear project. Since making this filing, members of our senior management team and I have been meeting with a variety of stakeholders, Governor McMaster, and members of the South Carolina General Assembly, to discuss their concerns," said Kevin Marsh, boss of Scana Corporation. "We recognize that this process creates some uncertainty regarding the timing and impact of our abandonment decision."

When Wall Street analysts hear the word “uncertainty" a punishment to the stock price soon follows. Since that August 2017 earnings call, the stock price has been declining each month and now trades at a 12-month low of $37. It traded for $65 prior to that call.

The saga continued as the company surprisingly reported a loss of $172 million or $0.83 per share, for year-end 2017. I think it caught many of us by surprise because the 2008 - 2016 average earnings per share was $3.50 (during that 9-year period, earnings per share ranged between $2.95 and $4.16). Capital markets are merciless when management reports on a loss.  

The cost of abandoning a nuclear project

The 2017 loss in earnings was due to an impairment loss of $1.12 billion. The non-cash expense was directly related to the abandonment of the nuclear project as mentioned in the first paragraph. Excluding the impairment loss, I estimate that earnings would have been about $805 million, or $5.67 per share.

I was planning to purchase shares in SCG. To me, the non-cash cost (though it is a real cost for current shareholders who are looking to sell their positions) resulted in mispriced stock and, with the abandonment of the nuclear plant, would likely have freed future capital to be distributed as dividends. But the story is much more complicated.

The company had charged its South Carolina based customers much higher than average utility prices for over decade. Effectively, the consumer had paid for the construction of the nuclear plant. And Scana will not be able to charge these utility prices in the future. In short, the abandonment of the plant was a true cost, not just an accounting convention. It was a cost in the time and energy (no pun intended), the present devaluation of the stock, and for future profits.

The past

This is a story where the past is not indicative of the future.  While the company has been paying dividends to its shareholders since 2000 it is uncertain whether it will continue to do so in the future.

Second, the operating performance was adequate, but it is questionable whether it will continue; the 2017 revenue was $3.07 billion, compared to $2.84 billion in 2013; the adjusted earnings (which exclude the impairment loss) increased to $805 million from $633 million during that five-year period. But as mentioned, future utility charges will have to be lower.

2017-2013 adjusted earnings for SCG 

The present

SCG is now selling in the market place at about par. This is a relatively low valuation compared to past valuation. In 2016, with a book value of $39, SCG traded between $74 and $37, an average premium of 140%. In 2015, with a book value of $36, the stock traded between $76 and $59, a premium of 190%. 

Its earnings multiple is lower than other energy companies. Take Southern Company (SO) as an example. The company reported on $24 equity per share and the stock trades for $46, a 190% premium. Another example is Duke Energy Corp (DUK) - the stock changed hands for $79, with a reported book value of $60 per share, a premium of 130%. NextEra Energy (NEE) stock price was $167, with a book value of $60, a 278% premium.

Using the adjusted earnings of $5.6 per share, SCG trades at about 7 times the earning multiple, or 12 times the 2008-2017 earning multiple, which includes the 2017 loss. During that decade, the earning multiple was as low as 9 times and as high as 18 times. The average multiple was 13 times. 

An earnings multiple comparison between SCG and peer companies

The future

It is likely that in 2019, current SCG shareholders will own the stock of Dominion Energy (D). In December of last year, Dominion announced that it would replace all of the outstanding shares of Scana with its own stock, at an exchange price of 0.669. Dominion may be a terrific stock to own, but I know very little about the company.

What capital markets love

Capital markets often value stocks using past trends and penalize stocks when surprises occur. A 2016 investor in SCG, who had listened to Wall Street analysts, may have been tempted to purchase the stock as  earnings increased for 9 consecutive years (the annual compounded growth was 4%).

With the belief that the earnings trend must continue, the 2016 investor would have purchased the stock at a price range of $59 and $76, representing an earnings multiple of 18 to 14 times the 2016 earnings, or the 170% premium to book value. A dear valuation. 

But the nature of business is that as industries become profitable, either (1) more competition will enter the market place, squeezing future margins, or (2) the concept of diminishing return to capital kicks in.

In the energy sector there is additional risk. Energy-related businesses face constant scrutiny from regulators (read: If regulators realize that margins are abnormally high, they will likely opine that the business is a monopoly and break down its parts.)  

In sum, as earnings increase, the probability grows that future earnings will suffer. Against common convention, this is the point in time when you, the rationale investor, should be wary of the stock and less excited about where it will be.

The Liquidation Value of LSB Industries

Published on:
June 22, 2018
Last Update:

When accountants look at the operating financials,
they assume that the company will continue to operate in the future. By definition, The
reassures them that an asset
is "a resource controlled by the enterprise as a result of past events and
from which future economic benefits are expected to flow to the

Yet at times, what the investor may look for in a company's
financials is the exact opposite; that is, what the financial condition and
value of a company will be should it cease to operate. To look at a company
that way, one must look at its liquidation value.

LSB Industries

To explain liquidation value, I will use the operating financials of an
Oklahoma-based chemical manufacturer. In 2017, the management of
 reported on $1.2 billion in tangible assets and on $576 million in liabilities.
The equity balance - at first glance - was $438 million or $14 per share.

In 2017, revenue was $427 million but it reported a loss of
over $70 million; In 2016, revenue was $374 million but again management
reported on a loss of over $120 million; And in 2015, revenue was $438 million but the net loss was over $30 million. 

Let's take a quick detour and discuss the liquidation value
strategy. We will return to LSB Industries in four paragraphs.

The Liquidation Value Strategy

The thesis is simple: because a company has been losing
money, management is likely to either sell assets in the future so that the company
will (1) continue to service its debt, or that frustrated shareholders, tired
of management earning a salary at their expense, will (2) require management to
get rid of all the company’s assets; i.e. liquidate the firm.

Anticipating this scenario is an investor that believes that
after management sells its assets and pays off its lenders, there will be an
ample amount of capital left.

Some of the great investors practiced liquidation value strategy.
, Benjamin Graham mentions that
between 1926 and 1956, liquidation strategy was a major part of his investment
operations. He eloquently defined liquidation as the "the purchase of shares that
received one or more cash payments in liquidation of the company's assets."

, famously known to purchase a majority interest in Sears. He began to acquire position in the company in 2005. And told his investors that the company at the time did not reflect any of the value of Sears real estate

From discount to premium

As LXU trades at about $5, it appears to be a mouth-watering, cheap stock price relative to the book value. Like purchasing a $100,000 home for $36,000. But capital markets had reason to discount LXU’s book value since management reported losses for over three consecutive years. 

Excited about the steep discount to book value, I read the latest

. On page 63, you can read that $1.01 billion of
the $1.2 in assets is related to property, plant and equipment, net of
depreciation. And if you flip to page 80, you will read that this book entry is
related solely to machinery and equipment (buildings and land are less than
5%). And management reports the value based on the cost of the equipment and not the market value.

But what is value of the equipment?

In liquidation, the
equipment - or any other assets, except for cash - is often sold anywhere between 70%
to 50% of its cost. Let's put the last sentence in numbers. If LXU were to sell
its equipment at a 70% discount of the reported cost, the equity per share
would be $112 million tangible net worth or $3.23 net worth per share. 

were to sell its equipment at a 50% discount of the reported cost, the equity
per share would be negative. Read: at a 50% discount, the common shareholder
interest in LXU would be completely wiped (the deficit would be about $90
million, or a loss of $3 per share).

For the accounting enthusiastic reader, here is how I calculated the
book value per share. I removed intangible assets such as goodwill. In
the case of LXU, that amounted to $11.4 million of intangibles. I also added to the liabilities the liquidation preference of the preferred shares. Since LXU issued 140 thousand of cumulative, redeemable preferred
shares, with a liquidation preference of $185 million. (What this means is that,
in the case the company liquidates, lenders would be paid $576 million, and
then preferred shareholders would be paid $185 million.) 


Founded in 2004, by Charlie Tian PHD, GuruFocus provides institutional-quality financial stock research for the individual investor.

GuruFocus hosts many value screeners and research tools and regularly publishes articles about value investing strategies and ideas. One of the features I use most is the 30-year financial information on businesses. Visit the 30-year analysis on LSB Industries to see more.


Three lessons

The story of LXU teaches us three lessons. First, stock investing
requires more than a quick glance at financial ratios. Unless you had carefully
read the 10-K report, the $185 million in liquidation preference would be
hidden. That is to say, in the case of liquidation, there were 32% more liabilities than reported by the accountants.

Second, accounting statements are the starting point for analysis but are not the final word. In the case of LXU, because of three years of
consecutive operating losses, the possibility exists that the management will
decide to sell the company’s assets, so the investor must ask: how much capital
will remain – if any - after a sale?

Third, while the purpose of the liquidation value strategy is to find
stocks, its real value at time lies in telling us which
stocks to avoid.  

The one advantage of short term thinking? a cheap stock price

Published on:
May 4, 2018
Last Update:

"The results we report today clearly do not meet our expectations," said Mark Walchirk, boss of Patterson Companies (PDCO on Nasdaq). "They fall short of what we know the business is capable of achieving."

Here are a few disappointing facts: sales were down 2.7% compared to the prior year; gross profit margin declined by 2.20%; adjusted operating profit declined to 36.2%; and the company reported a loss of $49 million in free
cash flow.

Capital markets must have paid close attention to the March 1, 2018 earnings call, because PDCO's stock price  dropped by about 20% shorty after. The stock closed for that day at price of $25 a share, compared to $32 a share the week prior.

Based on the question raised by the analysts, I am guessing Wall Street is concerned with three issues.  First, management is planning to sell private
label products. This is a new, uncharted territory for the firm that may prove to be more expensive than expected.

Second, there is a concern that the decline in operating margin will continue for a long time (Management explained that this was the result of "a change in the sales division and a disruption related to our ERP implementation and sale of digital equipment."). Third, future earnings will be lower compared to past earnings. Management lowered the guidance to $1.65 from $1.70. A faux pas on Wall Street.      

Five-year comparison

Yet on a five-year basis, PDCO showed different results. For the first nine months of this year, PDCO reported on $180 million or $1.94 earnings per share. Compare that to 2013 operations where the company earned $210 million or $2.03 per share.

Put differently, in nine months, the company earned 85% of what it had earned five years prior. Also, in terms of revenue, Patterson sales were slightly over $4 billion compared to $3.6 billion in 2013. And for the is-management-shareholder-friendly-minded reader, total outstanding shares declined to $92.6 million from $103.8 million, a decline of about 10% in outstanding shares.

Let us go back a decade in time and compare the operating results between 2008 and 2013. In 2008 PDCO earned $225 million or $1.69 per share, compared to $119 million or $1.75 per share in 2003.

Total sales in 2008 were $2.99 billion compared to $1.7 billion in 2003. And reported outstanding common shares in 2008 were $132 million compared to $86 million in 2003. In short, the company had done substantially better in terms of revenue and profit but because it had issued a large amount of outstanding shares, on a per share basis, it showed unimpressive results.    

To summarize 15 years of operations:  revenue increased to $5.6 billion from $1.7 billion, an increase of 229%. Earnings increased to $171 million from $119 million, an increase of 43%. And the number of outstanding shares only grew by 10%, to $92.6 million from $86 million.

And a few more praiseworthy notes: the company did not report a single year of loss in earnings; since 2010, it had returned $615 million in dividends (at purchase price of $23 per share, the is over 4%), and PDCO operates in an industry where time is your friend. Read: the need for dental and veterinary products is likely to increase with time. 

The earnings multiple 2017 - 2008

Should the reader need a classic example of the difference between a short term view and a long term view of a business, I believe PDCO serves as one of the best illustrations out there.

Over the past month the stock traded hands at a price between $23 to $22. That translates to about 11 times the reported earnings of $1.94 as of January 27, 2018 (which again only represented nine months of operating financials!). Compare that to period between 2017 and 2013, when the stock traded as low as $32 and as high as $53. During this five-year period, investors happily paid an earnings multiple between 28 times and 12 times the earnings per share.

Or we can go back even further in time and see that between 2012 and 2008, the stock traded as low as $16 and as high as $37. And during the five-year period, investors were paying an earnings multiple between 19 and 9 times the earnings per share. If one were to exclude the years, the stocked traded between $37 to $28 and the earnings multiple ranged from 13 to 19 times the earnings per share.


 It is a fact of life that the present dominates our thoughts and feelings. But to become a successful investor to see the long, distant horizon is key.   

A January - March 2018 update on positions I bought and sold

Published on:
April 13, 2018
Last Update:

In this article, I detail my activities in the stock market over the past three months. I explain why I bought and sold common stocks and how my stock portfolio performed in comparison to the performance of the S&P 500 index


I bought the common stock of five companies:

· 200 shares of CBL & Associates at $5 and 1,000 shares of ARC Document Solution at $2. I thought both companies were trading at current low earnings multiples and that capital markets would eventually return to value both companies at a higher, more reasonable earnings multiple in the future;

· 300 shares of Frontier Communications at $8. I thought the goodwill impairment expense, which resulted in a precipitous decline in the stock price, did not reflect the economic reality. You can read what I wrote about Frontier Communication’s accounting shenanigans by clicking here;

· 100 shares of Seritage Growth at $35. I detailed the rationale explanation in How to Understand the Economics of a Business; the irrational explanation was that Warren Buffett had invested in the company; 

· 100 shares of GE at $15. I had bought the position simply to force me to follow the future operations of the company - think of it like paying for dinner on the first date, when you know that you want to discover more about the person but not sure what just yet.


I sold the common stock of three companies:

· 500 shares of Famous Dave at $7 compared to my cost basis of $3.5 per share. I sold the position because I earned a hefty, annual return. And because I didn't think I could earn a higher annual return it in the future. Sadly, I will have to pay short term capital gains, which are twice as expensive as long term capital gains. Mike Piper, an accountant, explains the concept simply and clearly;    

· 2,000 shares of bon ton stores at 7 cents compared to my cost basis of $1.50. I sold the position to offset the tax payable on Famous Dave. In February 9 of this year, I wrote openly about the mistake I made and you can read about it by clicking here; and

· 100 shares of Regal Entertainment Group at $23. Cineworld bought my shares when it announced its acquisition of Regal. While I was frustrated that I would pay short term capital gains again, I was pleased with the overall result: I had paid only $15 a share in August 2017.  

Nine different companies paid me a total of $207 in dividends. And the only interesting thing to note is how uninteresting dividend payments are. First, not only did the nine companies (except for the REITs) pay income tax on these distributions, but yours truly now has to pay taxes again, and in the same tax bracket as ordinary income. Second, I have no idea where to allocate this cash. I would have much preferred the companies retain their earnings and invested at their management’s discretion.

My stock portfolio performance compared to the S&P 500 performance

For the time-pressed reader, the bottom line is that the value of my portfolio of stocks increased by 67 basis points, while the value of the S&P 500 declined by 3.2%. And, in theory, if the quarterly performance continues for the rest of the year, then my performance for the year will be 3%, while the S&P 500 will decline 12%.

An unheroic record.

I will remind new readers that to track the portfolio of the S&P 500 index, I bought one share of VOO, an exchange traded fund by Vanguard that tracks the performance of the index. I paid $246 for the ETF in the last week of 2017 and as of last March it was worth $237. And I received $1.07 in dividends .       

I calculated the return on my stock portfolio as follows: my cost basis was $27,157 on the last day of 2017. I added $5 thousand in cash (my goal is to allocate $5,000 each quarter in 2018. More explanation can be found in Why I am Doing This). So, if you add the two, the cost basis is $32, 157. As of the last day of March, the value of my stock portfolio was $31,730, and I had $644 in cash. The value of my portfolio was $32,374.


This was the first time that I took the time to write about my past actions in the stock market. I found the process insightful. First, I was able to see that passive investing, my purchase of VOO, led to a reasonable result. While I spent (or invested, depending on how you view it) over 120 hours reading annual reports and analyzing financial statements over the past three months, by investing in VOO, my time would have been free for other things. I could have used the 120 hours to play the piano.

Finally, the careful reader will note that I placed only 9 trades over the past three months (I know of stock traders that execute more orders by the time they finish their first cup of coffee). And if there is one thing I hope you will take away from this article, it is that just because in the long term we are all dead, does not mean that in the short term we should trade feverishly.

Financials metrics are worth more than a thousand words

Published on:
April 6, 2018
Last Update:

Look at the price history of a few companies operating in the shopping mall sector and you will see the ominous outlook for the industry. In 2017 Simon Property Group (SPG) traded as high as $188 and as low as $150. It now trades at $154. Realty Income (O) traded between $64 and $53 during the same period; it now trades at $52 GGP Incorporated (GGP) traded between $26 and $19, and now trades at $20. And Seritage Growth Properties (SRG), a real estate company which I bought last week, traded in 2017 between $50 and $38. It now trades at $35.

Because a loss in popularity is a signal for opportunity, I decided to compare the operating performance of four real estate companies, hoping to find undiscovered insights. And this essay is about what I learned.

Profitability, dividend policy and growth trends


With a ratio of funds from operations (FFO) to sales of 72%, Simon Property showed the highest ability to translate revenue to after-tax cash flow. GGP and Realty Income also demonstrated reasonable ratios of 65% and 63%, respectively. Seritage, on the other hand, had the lowest FFO to sales ratio at 51%. The optimist investor may regard the latter as the highest potential for a future increase in the ratio though. 

It was also apparent that Simon Property earned the highest amount of FFO per dollar of equity. In 2017 Simon Property earned or $16.89 FFO per share, using a $17.8 book value and a ratio of 40%. Compare that to Seritage, which generated FFO of $2.48 that year, using a $34 book value, a ratio of 7%. The ratio of FFO to equity book value is important: the higher the ratio the greater the likelihood of an increase in book value per share, which ultimately drives stock value.

Dividend policy

As I write these words, shopping mall REIT dividend yield is higher than the yield the dividend yield on the S&P 500. But is it high enough? Visit bankrate.com and you will find that in today’s capital markets, a certificate of deposit - insured by the FDIC - yields 2.75% for five years. In that light, investors in shopping mall REITs should focus on capital appreciation, not a dividend yield, because the latter can be easily achieved with a simple and much safer certificate of deposit.   

Growth trends

Over a five year period, Simon Property grew its average 3-year FFO per share from $8.29 to $15.94, or 14% compounded annually. GGP Inc. had a 16% growth in FFO and Realty Income had done slightly better, with a 17% growth in FFO. This is a wonderful performance but I am uncertain how much is related to superior management and stellar operations compared to that in 2012 the average 3-year FFO was simply at rock bottom because of the Great Recession. I excluded Seritage from the discussion because the company became available to the ownership of the public only in July 2015

The most striking ratio is the price to book value. Recent investors in Simon Property or Realty Income had no difficulty paying between 10 times and 2 times the book value per share. Can you see their illogical valuation? On one hand, as indicated by the overall price decline for all companies, we deduce that capital markets view the future of owning shopping mall as a tricky business.

But on the hand, recent investors in Simon Property or Realty Income had no difficulty paying a hefty premium for the book value of the companies. In other words, those who invested in Simon Property or Realty Income, implicitly valued the net worth of the companies more than what management had reported.

Three summary points

“The test of learning psychology is whether your understanding of situations you encounter has changed, not whether you have learned a new fact,” said the Dean of Behavioral Finance, Daniel Kahneman. And in that light, I hope what you take from this article is a perspective on how the comparison of companies can serve as a good starting point to understand the relative strength between the companies and the economics of their business model in terms of profitability and leverage. Three summary points: 

First point: the four companies’ use of debt was reasonable. No company had financed its operations with debt greater than 65% of the capital structure. And in the world of real estate, where debt is prevalent and easy to get addicted to, it is a noble achievement. Seritage, in which I bought, had a ratio of debt to assets of 48%, which I expect to increase in time.

Second point: the price investors were willing to pay for a shopping mall REIT was anywhere between 10 times and 21 times the FFO per share. And so, if you are looking to purchase a shopping mall REIT, there has to be a rational reason why you would pay above or below that multiple.  

Third point: financial numbers are a good starting place. But they are never enough. While a review of the price to FFO and price to book value provided some guidance as to the relative attractiveness of Seritage compared to the other three real estate companies, to understand the investment merit behind Seritage, of bringing a portfolio of shopping malls to market rents, you would need to read the annual report. 

Where the financials statement reveals little economic reality

Published on:
March 23, 2018
Last Update:

**This week I became a lawful permanent resident. And so, I am celebrating with a hot dog, Budweiser, and apple pie.**

It is a misconception to think that each stock purchase involves an elaborate, detailed analysis. If you would have asked me how to analyze a company immediately after my business school days, my answer would be: "First, you HAVE to understand the balance sheet and income statement. Then you NEED to make sure that the cash flow statements reconcile to the balance sheet. After that, you MUST prepare a SWOT analysis, KNOW the competition, LISTEN to analyst calls with management and then READ everything Wall Street has to say." 

But my answer, filled with action verbs, would be utterly wrong because all you really need is one, good investment idea. The great investors of our times realized this principle a long time ago. When Mohnish Pabrai purchased the stock of BYD, a Chinese manufacturer of automobiles, I doubt how much he understood the underlying economics of the company. Yet, I am confident that he was following what Charlie Munger said about the company’s founder, Wang Chuyan-Fu.

In Charlie’s words: 

“Wang is a combination of Thomas Edison and Jack Welch - something like Edison in solving technical problems, and something like Welch in getting done what he needs to do. I have never seen anything like it.”

So Pabrai’s idea was to follow the footsteps of Munger. And it worked.  

Frontier Communications

Last week I placed a position in Frontier Communications (FTR) that now represents about 7% of my stock portfolio. The investment idea is a mispricing, due to the 2017 goodwill expense and a change in the dividend policy.

Adjusted for a 15-to-1 stock split in 2017, over the past decade, FTR traded as low as $46 and as high as $241, with a 10-year average stock price of $90. Compare that to 2017, when the stock traded for as low as $6 and as high as $57. At the time of this writing, FTR trades at about $7. 

I attribute the steep decline in stock price to two reasons. First, management reported a loss of about $2 billion in 2017. This was the steepest reported loss over the past decade. Details on the reported loss can be found on page 70 of the 10-k report, where you will read that management took about $2.75 billion in a goodwill impairment. And if you would like to see how it affected the balance sheet, just flip to page 69 and you will see that the account titled "Goodwill, net" declined to $7 billion from $9.7 billion the year prior.

The second reason for the steep decline in stock price is that management decided to no longer distribute dividends to common shareholders. On page 48 of the 2017 annual report, they wrote:

"The Board of Directors has suspended the quarterly cash dividend on the Company’s common stock beginning with the first quarter of 2018. The declaration and payment of future dividends on our common stock is at the discretion of our Board of Directors, and will depend upon many factors, including our financial condition, results of operations, growth prospects, funding requirements, payment of cumulative dividends on Series A Preferred Stock, applicable law, restrictions in agreements governing our indebtedness and other factors our Board of Directors deem relevant."

Goodwill expense

Management explained that the goodwill expense was taken because the reported balance sheet value of the company was higher than the price shareholders would receive if the company was sold in real life. To arrive at a fair value for FTR, management reduced their EBITDA multiple from 5.8 times the EBITDA to 5.5 times.

Do you see the disproportion? Management lowered the EBITDA multiple by 5%, and the stock price declined by 90% from its average price over the past three years. What is even more peculiar is that in 2014, management reported an EBITDA of $2.1 billion (the stock traded for as low as $63 and as high as $127 during that year) and the EBITDA for 2016 was $3.3 billion.

Let me remind the reader that a goodwill expense is, by definition, a non-cash expense. It is no different than if the real estate market told you that the home you purchased for $100,000 a year ago is now worth $50,000. Yet, while your bank account would be unaffected by the change in your home’s market value, in the case of GAAP accounting for public companies, you would realize a loss. 

Dividend Policy  

To explain how little I care about FTR's elimination of dividends to common shareholders I will use a thought experiment. Let’s imagine that instead of buying shares in FTR, I lent out the money to my friend, John. In the loan agreement, John promised to return 1/5 of the loan at the end of each year. But in year 4, John explained to me that instead of returning the 1/5 of the loan amount owed to me, he wanted to invest the money by opening, say, a food truck, in which he would give me an interest percentage.

Just as it would be unreasonable for me to conclude that John was a deadbeat for not returning the 1/5 of the original loan amount, I don’t see any issues with FTR retaining profits for future endeavors.

What is considered a praiseworthy practice by Wall Street is often not in the best interest of the shareholders. When FTR acquired the wireline operations of Verizon Communications, it used debt in the form of preferred stock to finance the acquisition.  This was not a cheap source of financing. To date, the total interest expense paid to the preferred common shareholder is $550 million. And had management refrained from paying dividends on the common stock between 2017 and 2015 (it paid $1.2 billion in dividends during that time), the entire acquisition of Verizon could have been with cash.

A note on valuation

The careful reader will note that I did not write about FTR’s true, intrinsic value. This was not an omission of thought, but due to the simple reality: I have no idea at this point. I know little about the wireless industry and even less about Frontier Communication’s market share. Yet, as I alluded to in the second paragraph, sometimes all that we need as investors is just one good idea.  

ARC Document Solutions is A Fair Company at a Wonderful price

Published on:
March 9, 2018
Last Update:

It takes a long time to know another person’s inner thoughts. But it doesn’t take much to know if you would even be interested in knowing those thoughts in the first place.  And what is true in real life often applies to the abstract world of investing. This week, looking at stocks that traded at a 52-week low, I found a company that had all the right qualities.

In the following paragraphs, I will briefly go over what led me to buy shares in ARC Documents Solutions, which I will refer to as ARC.

At a price of about $2, ARC’s purchase price is less than 10 times the adjusted earnings per share

 To arrive at the adjusted earnings per share, I changed the reported figures. Specifically, I added back the depreciation expense and goodwill impairment expense to net income. From that number, I deducted the annual capital expenditure to arrive at what I estimated were normal earnings for the company. If you look at the reported income statement, you will see that ARC had a loss of $65 million in 2017, a loss of $13 million in 2016 and a loss of $27 million in 2015. 

Some of the reported losses were nonsensical to me. Take the deduction of the goodwill amortization as an example - it is an expense with little economic reality in the case of ARC. So, after subjective adjustments, I had estimated that ARC earned an average of $30 million or $0.65 per share over the past three years. 

Discount to book value

 I estimated that the 2017 tangible equity was $116 million or $2.52 tangible equity per share and that in 2016, the tangible equity per share was $119 million or $2.58 tangible equity per share. Similar to the reported income statement, my estimate was different than what was reported in the annual report. I adjusted the balance sheet in two ways. First, I completely removed the goodwill account from the asset side of the balance sheet; second, I added back 50% of the accumulated depreciation related to property and equipment.

Reasonable financial leverage

 For every dollar of debt, ARC earns about two dollars of free cash flow. It is not a stellar financial leverage coverage ratio - a coverage ratio of five times the interest expense is more befitting of a conservative company - but a fair one. I estimated the company's free cash flow using the following formula: cash flow from operations minus capital expenditures minus capital lease expense. Over the past five years, the average free cash flow was $12 million, compared to an interest expense of $6 million.

As a side note, I do not expect the 2017 capital lease expense of $66 million to be repeated over the next few years. While I rarely prognosticate about future capital expenditures, I make this prediction based on ARC’s historical record. Between 2016 and 2011, the capital lease expense range was $12 to $25 million.

A stock price at a ten-year low

 Here is the “biography” of ARC’s stock: the company listed its shares to the public in 2005 at about $30 per share. For the following two years, the stock price climbed to $35 and descended to $15. With the Great Recession, ARC lost its popularity, and during the next five years, between 2008 to 2012, the average price of the stock was $8. The following five years were even worse in terms of quoted price: between 2013 to 2017, the average price of the stock was $6.

Let us look more carefully at 2017. In that year, ARC’s stock traded as low as $2.30 and as high as $5.55. As I write these words, the stock is trading at about $2.20. If you look at the period between 2007 and 2017, you will be able to count four periods in which ARC traded at roughly twice the current price. And more importantly, in each year, the stock price climbed back to twice that level.

Capable management

Kumarakulasingam Suriyakumar, boss of ARC, has been with the company in various roles for over 25 years. The technology officer, Rahul Roy, has been in the reprographics industry since 1993. It should be obvious: the two of them are industry veterans. Compare that to yours truly, who had to look up the word “reprography” (the science and practice of copying and reproducing documents and graphic material). 

Given my abysmal knowledge of the industry and its prospects, I rely on management. I trust management when they explain ARC’s competitive position:

No other national service provider possesses the document management and technology expertise that we have. Construction professionals have highly specialized needs in document capture, short-term storage, management, fulfillment, distribution, and archival services. We believe our domain expertise is unmatched thanks to our legacy in reprographics and software development. 

Reasonable product

ARC focuses on a niche segment. I do not believe the company faces an immediate threat from competitors such as Dropbox or Box. The latter two companies focus on businesses and individuals to store their files while ARC is a brand name in the architecture, engineering and construction industry, where “customers look for a partner that can manage the scale, complexity and workflow of their documents management,” reports management.  Click here to see a video of what ARC does.

Higher expected yield than a three-year certificate of deposit

 And finally, I expect that over the next three years, ARC will earn more than I would receive if I was to purchase a 3-year certificate of deposit. As I wrote in the past, my goal in 2018 is to save and to allocate to stocks $20,000. And whenever I purchase a stock, I compare its expected return over a three year period compared to what I would earn if I passively purchased a certificate of deposit. Last time I checked, the three-year CD yield ranged between 2.40% and 2.55%. In buying shares in ARC, I expect to earn at least 25%.  

Why I bought SRG shares

Published on:
January 12, 2018
Last Update:

I haven’t been to a shopping mall since 2015. Like many of you, the day I subscribed to Amazon Prime was the day my shopping behavior changed dramatically. No more waiting in line to be assisted by a disgruntled teenager; no more mindlessly spending my hard earned cash at the Apple Store; no more having to remember where I parked the car.

While the problems related to physical shopping had pretty much disappeared, digital problems have crept up. As I type these words, I am wearing a pair of jeans that are not quite my size, and the color of my dress shoes is a shade of dark gray, an unpopular choice to say the least (but this esoteric color was on sale and I could not resist the bargain).

But overall, I am a convert to online shopping and the first to admit that a visit to a shopping mall in the future, will not be the same as it was in the past. But that does not necessarily mean that companies that own shopping malls are doomed to fail.

Take CBL & Associates Properties as an illustration. The company manages a commercial real estate portfolio of 75 million square feet that consists of over 70 malls in over 27 states. Its stock commenced to trade in 1993 and management paid an average of a dollar of dividends for over twenty years. And while the ratio of operating earnings to interest expense is thin (a mere ratio of 1.38 times between 2012 and 2016) and declining (from a ratio of 1.52 times in 2012 to 1.17 in 2016), I just had to purchase a few shares in the company.

Here is what I saw: net income available to common shareholders was $128 million in 2016 compared to $84 million in 2012. And during that five-year period, earnings per share increased to $0.75 from $0.54 with an average earnings per share of $0.58. And funds from operations available to common shareholders tell a similar story: $460 million or $2.69 a share in 2016 compared to $373 million or $2.41 per share in 2012. 

But there are other publicly-traded real estate companies that show a growth in earnings. To me, what is special about CBL & Associates is its declining stock price. 

CB&L Stock Price

At the end of 2012 the stock price was $21 a share. At the time, the company earned $0.54 a share as I mentioned, had $40.88 of net real estate investments; $31.06 of liabilities; and $9.82 of book value equity. Take from the prior two sentences that the stock traded at (1) an earnings multiple greater than 40 times and (2) over two times the equity book value.

In 2016 the company’s stock price had declined but was still expensive at $11 a share. That year, the company had earned $0.24; had $32.31 of net real estate investments; $24.46 of liabilities; and $7.85 of book value equity. In short, at yearend 2016, the stock traded (1) at a reasonable earnings multiple of about 15 times and still (2) at a premium to the equity book value.

But at a stock price of $5.50 quoted as of this week, I just had to purchase a few shares. I estimated that the 2017 earnings (yet to be disclosed) will be over $0.70 earnings a share, and so my purchase was at about 8 times the expected 2017 earnings and slightly below the $6.79 equity book value per share.

That is in the past. For the rest of this article let us focus on the future. I assume two things: (1) the management will continue to pay a dollar of dividends per share and (2) capital markets will value the company at an earnings multiple of, say, 15 times the earnings, sometime over the next five years. And should the two assumptions hold to be true, the expected return range is between 110% and 23%.

Expected return over the next five years

That is on the numbers-side. On the spiritual, gut-feeling side, I purchased shares in CBL & Associates because the founder’s last name is Lebowitz, which is only an “i” away from Leibowitz. And while the two families are unrelated, the Leibowitz family which lived in Israel at the turn of the 20th century is one of the wisest, most impressive dynasties – in terms of intellect, not power - and certainly a family that I admire. Here is a brief overview of the family. 

Yeshayahu Leibowitz was an intellectual, professor of biochemistry, organic chemistry and neurophysiology at the Hebrew University of Jerusalem and a polymath known for his outspoken opinion on Judaism, religious and politics. Read Judaism, Human Values, and the Jewish State if you are interested in his writings.

His sister, Nechama Leibowitz, was a noted Israeli bible scholar and commentator who rekindled my interest in bible study. Read her commentaries on the weekly Parasha if you need to rekindle an admiration to bible study and are seeking wisdom in general.    

Professor Elia Leibowitz, Yeshayahu’s son, is an astrophysicist who spends his time studying research photometry with high temporal resolution of novae near maxium light, at the Faculty of Exact Sciences at Tel Aviv University.

Elia’s sister, Mira Ofran, is a physicist at Jerusalem University. And the list goes on and on. Research the family and you will find a neurobiologist, a mathematician, a chemist and a lawyer. I will spare you their details but mention Yeshayahu’s grandson, Yoram Yovell, who is a psychologist and a researcher of the mind. I highly recommend his books on the science of love.  

I got side tracked. Let us return to a few last paragraphs on CBL & Associates and the business of managing shopping malls. In Paired Analysis: The case of Regal Entertainment, I wrote

I purchased a few shares in RGC, and not in AMC, because of two arithmetic reasons and one ego-related reason. First, the average earnings multiple over the past decade ranged between 28 and 19 times. With the current market price of about $15, I purchased RGC at an earnings multiple of 17 times the 10-year average earnings per share. 
Second, RGC had not showed a loss over the past ten years. Third, I wanted to be in the entertainment business. Many of my friends have movie scripts hidden in their drawers; some have even auditioned. And the lure of the entertainment business has not bypassed yours truly.

The same rationale applies to CBL and Associates. And if I was to copy and slightly edit the above sentence  it would read: I purchased a few shares in CBL & Associates because of two arithmetic reasons. First, the average earnings multiple over the past decade ranged between 33 and 30 times the earnings. With the current market of about $5.5, I purchased CBL at an earnings multiple of less than 10 times the expected 2017 earnings and 13 times the 10-year average earnings per share. Second, only in 2009 CBL showed a loss of $0.35 a share.

And now I hope you will go read books about love.

My romantic, love story with Caesarstone

Published on:
December 29, 2017
Last Update:

Every week, I glance at the financials of 15 to 20 companies that are trading at a 52-week low. Many of the stocks I purchase appeared first in that list. Famous Dave is an example that comes to mind. Regal Entertainment is another.

By focusing explicitly on the list, I do two implicit things. (1) Stocks in the list are usually unpopular and I get to learn about new businesses (Amazon was never on the list), and (2) the list forces me to think and understand why the stock is on the list in the first place. 

And there is always a reason. 

It is my job – or some would argue, hobby - to find out why; to reflect whether I agree or not with the market determination, and whether to do something about it or not.

Compare that to the typical manner in which some investors purchase stocks. Often, it is because they realize their least favorite brother-in-law made a killing on Bitcoin. Or they read in Barron’s that company ABC has tremendous growth potential. Or, if they have a brokerage account, they read a sell-side equity report about company’s XYZ market share potential and how capital markets have yet to comprehend that.

The careful reader will observe that the latter process is passive compared to the former. Looking at stocks using the 52-week low list forces you to look for answers.

So that’s how I found Caesarstone this week. Caesarstone (CSTE) profited an average of $1.90 over the past five years. During that time, its stock traded at an earnings multiple between 20 to 43 times the earnings with an average earnings multiple of 22 times. With Caesarstone at a price of about $22 it is trading at 12 times the earnings multiple. So I became interested in knowing more about the company.

My first two questions were: how much leverage does the company have and why is the company trading at a 52-week low?

I learned that the company hardly uses debt. As of the third quarter of 2017, the company could pay all its debt obligations with its cash in the bank. Its operating earnings represented over 10 times the interest expense. As a comparison, our average household income to debt in the U.S. is less than 2.5 times the interest expense.

The company’s stock traded at a 52-week low because (1) operating gross margins are down, (2) legal fees are up, and (3) unsurprisingly, perhaps, earnings per share are down to $0.92 as of the third quarter, compared to $1.70 last year.

But management’s explanations seemed reasonable to me. Management reported that polyester prices were up, that they had to produce from a pricier manufacturing plant, and that Hurricane Irma and Harvey affected U.S. demand. They further noted that the increase in legal fees was a non-cash expense. It was one-time reserve adjustment of $4.3 million related to development in outstanding product liability claims. 

It seemed like a normal business course of action to me. Besides, as I was reading the Q3- report, I was beginning to (financially) fall in love with the company. Here are a few love notes from the company’s financial statements: 

Annual revenue was $538 million in 2016 compared to $296 million in 2012; the 2016 profits were $76 million compared to $40 million five years prior. And management is thrifty on diluting its shareholders, a quality I admire. Shares outstanding are about 35 million compared to 33 million five years ago. Am I the only one getting goose bumps reading this?

As I was beginning to fall in love, I stopped myself and asked: what does Caesarstone even do? From where does it operate? Should I bring it into my life?

Here is what I learned in less than 15 minutes (they say to fall in love, you need less than 5 seconds, so I took my time!): Headquartered in Israel, the company was founded in 1987. It sells engineered quartz surfaces that management describes as high quality. (I wouldn’t know the difference between low and high quality quartz. I thought quartz was a word related to watches). In March 2012, its shares began to trade on Nasdaq.

The company sells its product in over 50 countries. 40% of its product is sold in Asia Pacific and 26% is sold in North America. And while quartz serves 15% of the world demand, solid surface and granite are 51% in comparison. The company has a 14% market share in the US, 45% in Australia; and over 85% in Israel. The bulls in us will read the prior sentence and say: “Ah! A lot more room to grow.”

So I bought a few shares in Caesarstone - not because I know much about the business - but because I am intrigued by it. I want to know what my dear friend, a 15-year veteran as a general contractor, Ron Wagner, is thinking about the use of quartz versus other solid surfaces. And what he thinks about Caesarstone’s quartz quality and price compared to its competitors.

I also want to know more about the industry. How dependent is it on the real estate market (my guess – very much)? Is there a strategy to hedge this sensitivity? Besides, it just so happens that the company is based out of Israel; specifically, two miles from the town in which I grew up, Ramat Hasharon.

I realize that my romantic purchase of Caesarstone may baffle the numbers-minded reader. So over the next six months, I will look more carefully at its income statement and balance sheet. And I will compare Caesarstone financials to its competitors.

For the story-minded reader, I plan to be in Israel in April and hope to visit the company headquarters. I hope that management will be gracious enough and let me tour its offices.

If you would like to be notified when I do, just click on the orange button on the top of this page.

Greed In Times Of Fear: The Case Of Terra Nitrogen

Published on:
October 3, 2017
Last Update:

There is little glamour in the business of fertilizing soil. The product, whether it be ammonia or nitrate solutions, is a commodity. There are many competitors, both inside and outside of America, that demonstrate a similar industrial capacity. Buyers are known to be thrifty and bargain-hunters and over the past decade the industry has seen a higher level of scrutiny and red tape by governmental agencies. 

In short, if you are in the business of selling soil nutrients, you are most likely not bragging about it over a cocktail party. But that doesn't mean it is an unimportant industry in the present nor an unprofitable enterprise in the future.

Two are two “big picture” reasons for an expected future increase in demand. First, the more people live on planet earth, the more food will need to be extracted from the ground. Second, as developing countries become wealthier, the appetite for a protein-based diet will continue to increase.  

But capital markets see things differently. Over the past five years, the valuation of companies in the fertilizer industry have lost significant market value. Here are a few notable examples: CV Partners (UAN) declined to $3 from $26; Mosaic Company (MOS) declined to $21 from $59; Potash Corporation of Saskatchewan (POS) declined to $19 from $43 and Terra Nitrogen Company (TNH) declined to $80 from $216. 

When capital markets are fearful about an industry’s outlook is when I typically become greedy. So, last week, I decided to purchase a position a company that operates in the fertilizer industry (my dear friend, Tomer Kilchevsky, who has committed to a chemical-free-vegan-only-lifestyle would be disgusted by my decision). 

But I knew little about the industry and even less about its competitive landscape, so I decided to purchase a position using a six-rule formula. Here it is:   

1. Adequate size, greater than $100 million in market capitalization.

2. Sufficient financial condition, working capital ratio greater than 1.5 times.

3. A consistent dividend record over the past decade.

4. No earnings deficit over the past decade.

5. 10-year growth rate of at least a third.

6. No more than 15x the average three-year earnings per share 

Only Terra Nitrogen met the criteria. Market capitalization was about $1.50 billion. Current assets to current liabilities ratio was 1.90 times. The company had not skipped a beat, and paid dividends to its shareholders (or unit holders to be exact) over the past decade. 

Terra Nitrogen had positive earnings throughout the past decade and grew earnings to $9.90 (the earnings average from 2016 to 2014) compared to the three-year average earnings of $2.61 (the earnings average from years 2006 to 2004). And at current valuation of about $80 per share, I paid 11 times the 2016 earnings per share.

After purchasing a few shares of Terra Nitrogen, I read some of the public disclosures. I learned that 2016 earnings were much lower compared to earnings over the past five years. But once I included capital expenditures as an expense item, 2016, on a five-year outlook, appeared to be just an average year. 

Specifically, if you had looked back five years, the lowest earnings reported were $10.06, compared to the 2016 earnings of $7.56. But if you had looked back five years at the earnings-after-capital-expenditures, the lowest earning reported was in 2013, with $3.62 earnings per share, while in 2016, the earnings after capital expenditures were $6.57. 

Before I leave you to research the company and the industry on your own, let me comment on the use of capital expenditures. While the income statement excludes the expense with the dreary title of "additions to property, plant and equipment" (which can be found on page 38 of the 2016 annual report), in the particular case of Terra Nitrogen, capital expenditures are meaningful as they reduced – and will continue to reduce - about 30% of earnings available to common unit holders. 

On a current purchase price of $80, I expect the earnings-after-capital-expenditures yield to be about 8%, a reasonable yield in my opinion.


After thoughts: Over the next few months, I will write more about Terra Nitrogen's income statement, balance sheet and corporate capitalization. And if you think the latter is a dull and archaic topic, I will have you know that Terra Nitrogen’s  had the same amount of shares outstanding in 2016 as it did in 2007. 

An Oscar-award-shareholder-friendly-act if there was one to dedicate to corporate decisions. If you would like to be notified when I post articles, click on the orange button at the top of this page.

In the meantime, there is plenty to read about Terra Nitrogen and the fertilizer industry on Seeking Alpha. Bob Ciura in "Terra Nitrogen: Feeding The World With Fertilizer, Feeding Investors With An 8% Dividend Yield," shares my view that capital markets may change their opinion of the firm in the future. John P. Reese, in "As Inflation Looms, These Commodity Stocks Could Shine," discusses how the relationship between a commodity price and inflation may affect companies like Terra Nitrogen.

 I would also suggest reading about the industry's primary cost component: energy. For that, I would suggest that you start your reading with the article "Energy Recap: 'Breaking Clean,'” written by Seeking Alpha's own editor, Michael Crini.

How Rait Financial Taught Me A Lesson

Published on:
August 28, 2017
Last Update:

A few weeks ago I purchased common shares in Rait Financial Trust (RAS). I had looked at the 10-year free cash flow and figured that with an average $1.44 of free cash flow per share, alongside an average stock price of about $6 over the past five years, I didn’t need to read any public filings since the $2 price tag stock price would eventually correct itself. 

The only effort I exercised was a quick Google search where I learned that the company was founded in 1997. From that, I rashly deduced that management must be capable since it survived the Great Crash of 2007. I happily called my broker and ordered 500 shares at-what-I-thought-to-be-a no-brainer-price of $2.

That was a mistake. When I finally leafed through the operating financials, I saw these were the financial records of a company no longer in existence. 

The company had moved from the business of real estate ownership and management in the interest of becoming a leaner, focused company (“disposition of non-core assets” was the business lingo). It had sold the bulk of its commercial real estate last year and plans to get rid of the property management business this year. Rait will be originating commercial real estate loans to middle market clients solely.

As I was trying to put into numbers the change in business strategy, I came across a second surprise. Rait Financial has funded its operations over the years by issuing preferred stock, which the company carried on its books at par. But since these preferred issues had a liquidation preference of $25, I added them as a liability. 

The adjustment added about $233 million to the company’s outstanding liabilities, or an additional $2.55 per share. When I purchased the stock for $2 in July of this year, I thought I had bought $2.29 of tangible book value per share. Yet after the adjustment, I purchased the stock at an outrageous premium!

While I reflected over my rash, idiotic decision, the stock price had halved. At first, prior to reading the public filings carefully, I saw the drop in price to be a fastidious opportunity to reduce my cost basis by purchasing additional common shares (perhaps, the word “opportunity” should be replaced with “excuse”). 

While I eventually did not increase my position, I intend to keep the position in Rait Financial as a self-reminder of what happens when I am careless about a stock purchase. Three observations can be gleaned from this story. I will leave you to conclude on the possible lessons learned.

First, the balance sheet an accountant prepares does not always reflect an economic reality. Ask the head of any household and he or she will tell you that savings for the children’s education is an unrecorded liability. So are retirement savings. While the personal net worth statement the accountant prepares each year may hide these obligation, they are real. 

Similarly, while the accounting convention is to record preferred shares at par, even when they have a liquidation preference, these should be added as liabilities, especially from the perspective of the common stock shareholder.

Second, the past is not necessarily a road map to the future. Even worse, as my case should demonstrate to you, it may give a false sense of security. Let us count the assumptions I made based on the past: (1) Since Rait Financial navigated through the turbulent times of 2007, I thought it could do so in the future (this assumption was faulty since the majority of management is relatively new). (2) With three lines of business, real estate ownership, property management and loans origination, I was certain there were sufficient, diversified streams of income. This also proved to be untrue, given management’s desire to become a lender.

Three, it is tough to sell at a loss. My experience is that selling a position that lost 10% is equally frustrating as selling a position that lost 50% of its price. It is much easier and comforting to find reasons why a losing position should be held. 

Here are few: management may eventually reduce G&A enough to return to profitability; the company could become a main player in commercial real estate loans origination; or perhaps someone out there will purchase Rait’s operations at a rich premium. Finally, if you think it is hard to sell a position at loss, just imagine how hard it is to write about it.

Epilogue: As with any controversial, risky position, there are opposing views. There are still those who view the common shares of Rait Financial to be of investable value (to state the obvious, yours truly is not one of them).

 Norman Roberts calls the company a cockroach, which he defines as a company that is favorable to the preferred shareholder at the expense of the common stock holder. Sam Lin has countered that opinion. In “Rait Financial: Forgive the Past and Buy for 50% upside,” he scrutinizes the securitization portfolio and concludes that there is plenty of upside.

DHI Group Is Not Winning The Popularity Contest

Published on:
August 7, 2017
Last Update:

Fool.com suggested that I buy the following five stocks this week: Apple (AAPL), Canadian National Railway (CNI), Corning (GLW), Stamps.com(STMP), and Vail Resorts (MTN). Their investment reports explained that now would be a good time to purchase shares in the companies because of their expected future growth in sales or their stellar historical earnings trend. 

Yet the reports left me baffled, as no attention was paid to whether price paid for a share was justified relative to the value given in return. I think that purchase price as an investment criteria lost popularity. And if we live in an investing world where purchase price is no longer relevant, your financial advisor may argue that paying attention to peak price today is nonsense since in the future, the peak price will be higher.

But relying on future growth and earnings trend is tricky. First, when the market unanimously expects a company’s earnings to grow in the future, the current price of the stock typically reflects that expectation and excellent earnings trend in the past tend to draw competition that may squeeze profits in the future. 

Besides, to rely on a future outcome to justify a present valuation rarely amounts to a welcoming outcome. Here is an analogy: because you would not marry anyone based solely on what you expect them to behave in the future, you should not purchase a stock based on what you expect it perform.

But I won’t leave you with just a rant against the popularity of some stocks nor with the palpable tip of how not to find a spouse. This week I found a stock that may interest the investor that finds the adjectives “frugile”, “cheapskate”, to be compliments rather than insults.

 If you are not sure you meet the definition of a cheapskate, I offer the following three-step verification process: If you drive a car that was manufactured before year 2010; your closet is filled with cloths that you can’t remember when you bought them; and you often find yourself bragging at a cocktail party about a gas station nearby that charges a nickel less per gallon than the competition, I welcome you to join me in the cheapskate club (you won’t be getting a welcome gift though.)

If you met the criteria, I suggest you take a look at DHI Group (DHX). As shown in the table above, over the past decade the stock traded as high as $19 per share and as low as $2 per share. And with an average 10-year free cash flow of 91 cents and current valuation of about $2.50, it should warrant your passion for thrift. 

During the past decade the company traded at multiple between 24 and 4 times the free cash flow. Compare that to less than 3 times the 10-year free cash flow based on current valuation. If you read my prior posts, you will remember that I define free cash flow is operating income less capital expenditures for the sake of simplicity.

It is always a good practice to watch if earnings reported in the income statement give a somewhat or a similar picture as what the free cash flow metrics show. It is hard to say how the relationship between free cash flow and net income should look like, but a lack of relationship should be a red flag. DHI Group passed that test. 

And I felt the company had plenty of adjusted earnings to service its liabilities. Adjusted earnings are earning taken from the income statement as reported on the company’s annual filing with the SEC after my subjective removal of non-cash expenses such as depreciation, impairment of goodwill and intangible assets.

Before I leave you to reflect on “to be a cheapskate or not to be”, I remind you that this post should be read as a starting point. It is my goal to bring to your attention certain securities that I find of interest, but not by any means recommend you to purchase them as that decision is based on your personal goals, risk tolerance, and financial circumstances that I know nothing about. 

For Seeking Alpha premium members, I would suggest reading Anythony Rago’s article about the company. And if you were too frugal to purchase the premium subscription, an article by the the pseudonym Shadowstock offers some details on the company as well.

Brings Joy To Both Omnivores And Vegans

Published on:
August 4, 2017
Last Update:

In theology, if you acted sinfully, you got punished. In the world of business, if management loses shareholders' money, then management is punished by a devaluation of the company by the marketplace. 

So, it is unsurprising that the common share of Famous Dave (NASDAQ:DAVE), a barbecue restaurant chain, has plummeted recently. The company had earned over $110 million in revenue for nine consecutive years - between 2007 and 2015. And in 2016, sales dropped to about $99 million, a record low. As you can imagine, the drop in sales did not go unnoticed.

The drop in sales was about 10%. How much should the stock decline be? 10%? 30%? 50%? If markets are logical and efficient, then stock prices should relate to expected earnings. So, we should be able to see a somewhat close relationship between a decline in sales and operating margins and a decline in stock price. In practice, that rarely occurs. So, I thought of an arbitrary rule of thumb. 

Here it is: a reasonable price decline, following a loss in sales, should be close to the difference between the 10-year average earnings and the current earnings. If the price decline is higher, then market price has been penalized too heavily. For Famous Dave, the average 10-year net earnings after capital expenditures, was $0.61. The 2016 net earnings after capital expenditures was $0.37, a decline of about 40%. The stock price, however, lost 72%.

The price decline seemed harsh, I thought. But a bearish price may be the result of the restaurant industry economics, unrelated to the operations of a specific company. And it is obvious that the industry is fraught with an increasing amount of risk. 

Have you lately tried to open in California a restaurant? The amount of red tape and regulation you will experience will leave you with a similar outcome as that of a boat buyer. Where your happiest day will be when you sell the business. But red tape for the restaurant industry is not the only problem.

Ask anyone in the restaurant business and they will tell you of flaky clientele, of increased competition and of the client’s palate that follows whatever the current nutrition gurus say. Today, owners of restaurants will tell you that to differentiate your restaurant, you should focus on organic produce; yet five years ago, all you had to do was avoid high fructose corn syrup; and before that, it was trans fats. 

In short, to budget your ingredients for the next fad will be difficult. But I have side tracked from our topic of discussion. So, before I further advise you to eat only what your grandparents would recognize as food (Michael Pollan talks about it in his wonderful book, “In Defense of Food”), let us get back to the analysis of Famous Dave.

Purchasing a common share at Famous Dave at about 6 times the 10-year average net earnings after capital expenditures met my cardinal rule of investing, which is that I rarely pay above 10 times the earnings per share. Yet, as I told you, I felt the decrease in market valuation was due to industry trends. 

So, I played the following game thought: How much would I have earned, over the past three years, if I had owned the competition (which I subjectively defined as DineEquity (DIN) that franchises and operates Applebee’s, Denny's (DENN), Nathan’s Famous (NATH), and Brinker International (EAT) that owns Chilli’s) versus owning a share in Famous Dave. The answer was about 9% earnings yield for the competition and about 20% earnings yield for Famous Dave. 

Put differently, without any price appreciation, I would get my money back in four years with Famous Dave, while it would take about nine years with the competition. That was enough for me to make a decision.

In short, I bought some common shares in Famous Dave. I did not make the purchase because Famous Dave won the 2013 “Best in the West Cook-Off” national competition; frankly, I have never been to a Famous Dave. I hardly eat meat and am somewhat allergic to barbecue sauce. 

But I felt the price of the stock was low enough compared to the company’s past valuation and compared to its peer competition. And, perhaps, this purchase was less rational than I care to admit: perhaps I wanted to please my mom as she often nags me with “Did you get any meat this week?”

And now for the usual disclaimer: please remember to read this article as a starting point. My goal is to share with you the stocks that are on my mind and…well…pockets. But not by any means to encourage you to follow blindly what I do. You should research the company, industry and its prospects on your own. Investing is an art as much as it is a science, and just as you and I may not share the same enthusiasm for, say, the Impressionism movement, our opinions on companies may not be the same. 

Besides, Seeking Alpha has for you other excellent commentators on the company, with a line of reasoning that differs from mine. For example, the author using the pseudonym Courage & Conviction will provide you with their impression of the company after attending its annual shareholder meeting. And Mark Gottlieb questioned Famous Dave’s management as to why they still owned a few of their restaurant (37 to be exact) and did not transform their business to be franchised restaurants only.

Is Bon Ton Cheap?

Published on:
July 31, 2017
Last Update:

Investors typically have different definitions of cheap stocks. One investor may look at the price quoted in the marketplace and argue that a stock that trades at a dollar per share is cheaper than a stock that trades at ten dollars per share. Another investor may define a cheap stock as one that has fallen below its 52-week price range. 

There are many more definitions. But in this post, I will attempt to define a cheap stock as a stock that trades: (1) at an earnings multiple that is lower compared to its earnings multiple over the past decade, (2) at a substantially lower earnings multiple compared to its peer companies, and (3) at a purchase price below its net tangible asset per share.

Bon-Ton Stores (BONT) meets that definition. The company shows an average free cash flow of $26 million, or $1.31 of free cash flow per share, over the past decade. And during that time, a dollar of free cash flow was valued by the marketplace anywhere between 75 cents and $13. 

As of July 2017, the common stock traded at a price of about $0.65 per share, which is the value of the 10-year average free cash flow per share at about 50 cents. Because the purchase earnings multiple is below the ten-year earnings multiple, our first criteria is met.

It is a low earnings multiple, especially when compared to peer companies. Over the past year, peer companies traded at a multiple of 4 times to 29 times their free cash flows, as the table below shows.

As a side note, I find earnings measurements, such as net income and EBITDA, to be spurious metrics, especially when a company has a large position in real estate. Instead, I use free cash flow as an earnings measurement because it includes capital expenditure expenses, which the other two measurements seem to ignore.

 In the Bon-Ton Stores analysis, I used a simple definition for free cash flow: operating cash flow less capital expenditure.

Now back to our third criteria, which is that a cheap stock is a stock that is trading below net tangible assets per share. In the case of Bon-Ton Stores, I estimated that for a purchase price of $0.65, you get about $5.47 of tangible assets. 

But before you go over the numbers in the table below, I would like to briefly go over the etymology of the word “tangible” - in its simplest form, it means “of what is capable of being touched.” And, in the context of business investing, the numbers reported on the balance sheet have to be adjusted to values that can actually be touched (read: taken back by the investor in liquidation). And here, they were materially different:

You will note that I arrived at a much higher tangible value per share of $5.47 compared to the reported deficit in equity of $3.93 per share. The main reason is that I value Bon-Ton's real estate properties and fixtures much higher than accountants. While my adjustments, which ignore accumulated depreciation, get us to a crude measure of value, they represent a probable price for what the real estate is worth. 

Again, as with most of my analyses, this is entirely subjective and each analyst should use his or her own judgment as to how to view the various balance sheet items.

Finally, while this is the concluding paragraph, I would like to suggest that you view it as a starting point. You may want to ask further questions to determine if this stock is of investment value, and not just a cheap stock. 

I would also suggest that you read what other analysts have written in Seeking Alpha. For example, Damitha Pathmala warns us that Bon-Ton is one of the ten most likely retailers to default this year. And a team of writers, using the pseudonym Elephant Analytics, commented on the company’s lackluster financials over the past few quarters.

Why I bought Carver Federal

Published on:
July 13, 2017
Last Update:

Tardiness in filing financial statements is often seen as a red flag. Implicitly, capital markets tend to suspect that late filing is more than a timing issue, and rather, is some dark, flawed accounting practice, or some questionable managerial capability. Explicitly, late-filing almost never looks good for the price of the common share. This week, I visited datasimply.com, a website that among other things reports on such companies. Out of a list of 32 companies, I took a random sample of 5 with varying lines of business, and compared their current price to the share price a day before the late notice was given. All companies lost value.      

The Risk Carver Federal Savings Bank Faces

Carver federal savings bank (CARV), a commercial bank with less than a billion in assets, filed a late-notice in July of this year, and its share price has been low ever since. From 2012 to 2015, the stock price average was about $6 a share, ranging from as high as $18 to as low as $3. Compare that to the stagnant average price of $3 over the past few months. Being a sucker for low price compared to historical stock price, I delved further into Carver’s annual reports.

It was not a pretty sight. Carver faces so many risks that I almost wrote to the organizers of the World Memory Championship, where participates are daunted with the task of memorizing lists of random names, suggesting to add the risks Carver faces as a potential list to memorize. To name a few: the average annual earnings over the past decade were negative; because of inability to pay for junior debt, the company may cease operations in September 2017; the company lends out to borrowers, such as churches and non-profits, which are borrowers that depend on donations to pay back their loan obligations. If you are not convinced of Carver’s dire circumstances, the five-year financial results should do the trick.        

Why I bought a few shares of Carver Federal Savings Bank

While no value-bargain by any means, I still bought a position in the company, representing about 5% of my portfolio in investable securities. I had two reasons (perhaps the word “reasons” should be replaced with “excuses”). First, I felt that if a competitor, such as Dime Community Bank (DIME), with a stock price that is trading at high levels, would offer Carver’s management a lowball bid, say, 50% of tangible book value, I would still come out of this position alive (in its last public filings, Carver reported tangible book value per share of about $14).

Second, the advantage of being last in the class is that you have plenty of room to improve. And, with the right attitude and fortitude, Carver’s management can achieve much. For example, management can focus on reducing its non-interest expense; essentially, its wages. Is asking a company to become more efficient with its resources unreasonable? Management may also want to focus on providing better credits in the future, since it has done a terrible job in the past. Carver’s nonperforming assets to total assets ratio was 5.66%, about 30 times higher than the ratio for Dime.    

Now, to my usual disclaimer: by any means, this article should not be a catalyst for you to speculatively purchase shares in Carver. In fact, the reverse is true: reading my report should have deterred you from having anything to do with the company and its management. My goal in writing is to share with you how I view a position in a common stock, but not to encourage you to follow what I do.  Anytime you are interested in purchasing an investment position, at minimum, you should read about the company, you should view the company in terms of your overall portfolio objectives and, finally, form your own independent opinion.

How Mr. Market Is Wrong To Discount Capstead Mortgage's Book Value

Published on:
February 14, 2017
Last Update:

Let us estimate $0.60 of dividends per share over the next three years and a share price of $13.80 in 2019. And with a discount rate of 10%, Capstead Mortgage (NYSE:CMO) is trading at 90% its estimated present value.

Not bad for a mortgage REIT that invests in securities backed by the full faith and credit of the U.S. government.

What is hidden from Uncle Sam's balance sheet is the implicit control in the largest bond market in the world, also known as the U.S. mortgage-backed securities (MBS). Government agencies', such Fannie Mae and Freddie Mac, market share in MBS is greater than two-thirds of the total mortgage-related debt. Established by the U.S. congress in 1938 as a mechanism to make mortgages available to low-income families, these government-sponsored entities have the peculiar responsibility to make loans affordable to the public on one hand and to be shareholder-minded on the other.

Such a dichotomy would confuse anyone. And whether the regulatory environment clarified matters is questionable. The subprime sector, notoriously known to have played a major role in the 2007 recession, was catalyzed by regulatory changes. For example, in 1982, the Alternative Mortgage Transaction Parity Act permitted variable-rate mortgages and balloon payments. The Tax Reform Act of 1986 prohibited the deduction of interest on consumer debt. The combined effect increased mortgages' affordability and appeal to consumers.

The interest rate environment, securitization and floating-rate mortgages had malefic roles as well. Because interest rates rose and prime originations fell, mortgage companies and brokers moved to subprime markets to maintain volume. And securitization started to gain popularity at about the same time. Alongside the advent of adjustable-rate mortgages (ARMs) that made borrowing easy, a tulip mania was in the making. How the story unfolded is known, but few companies took the time to study its lessons.

Capital markets seem to ignore that Capstead Mortgage had done its homework. With earnings per share of $0.91 as of the third quarter of 2016, the company is trading at 12 times its earnings per share, at 0.80 times its equity book value and with a trailing-12 month dividend yield of over 10%. Also, its balance sheet is poised to benefit, should rates increase in the next few years (because refinancing will be lessened). Lastly, let us not forget that Capstead invests in floating-rate securities backed by the full faith and credit of the U.S. government.

Yet, risk is looming. Because Capstead Mortgage continues to finance its operating activities by repurchase agreements, and because historically repurchase agreement financing tends to dry up at times when it is needed the most, you should be startled. Repurchase agreements involve the sale of a simultaneous agreement to repurchase the transferred assets at a future date. But as opposed to a conventional loan, the risk that the counterparty will not return its collateral is higher. Because in early 2016, the Federal Home Loan Bank (OTCPK:FHLB) of Cincinnati halted mortgage REITs' access to borrow from the FHLB, the reliance on repurchase agreements is unlikely to change.

Executive Summary

Management: Headed by newly appointed chief executive officer, management reduced salaries and general administration expenses as earnings per share declined in the past five years. The former CEO was with the company for 28 years. And if the future resembles the past, Capstead shareholders should look forward to celebrate a silver anniversary with the company.

Assets: Capstead invests in securities backed by the full faith and credit of the U.S. government. The company increased its loan portfolio to $147 notes per share from $127 notes per share five years prior. But an increase in loan portfolio size did not translate to higher-yielding assets. In 2011, loan yield was 3.33% compared to a recent loan yield of 3.17%, a pittance yield compared to corporate securities (which carry credit risk, though).

Liabilities: Capstead finances its residential mortgage investments by borrowing under repurchase agreements with financial institutions. Repurchase agreements involve the sale of a simultaneous agreement to repurchase the transferred assets at a future date. And a parallel upward movement in interest rates will have a net benefit to the company, because its liabilities are less sensitive to interest rates.

Income: Revenue per share decreased to $2.25 from $3.04 five years ago. Earnings per share decreased as well to $2.11 from $2.83. This was because homeowners, expecting interest rates to rise, rushed to refinance the mortgages on their homes. Interest rate expense increased due to the increase in the 1-year LIBOR index.

Cash flow: Financing activities generated $57 a share and operating activities generated $14 a share over the past five years. And investing activities - the purchase of residential ARMs securities - were $74 during this time period. Financial spreads decreased to 0.81% from 1.56%. If interest rates increase, cash flow will likely be higher, because the premium amortization expense will be lessened.

Risk: Capstead is a highly levered mortgage REIT. While its peer group average debt-to-asset ratio was 70%, the company is leveraging its portfolio by 90%. At that level of leverage, management is left with little margin of safety to error. In addition, future earnings will be squeezed, should homeowners rush to refinance loans. Lastly, the Federal Home Loan Bank of Cincinnati halted mortgage REITs' access to borrow from the FHLB in early 2016. As a result, Capstead migrated almost $3 trillion of FHLB advances to repurchase agreements.

Capstead's market price is reasonable in terms of price-to-equity. The company is trading at a multiple of 12 times its earnings, while its peer group trades at a multiple of 16 times. And Capstead's dollar of equity traded at 80 cents on the dollar, while in 2011, it traded slightly above par.

To measure how the company is sensitive to the interest rate environment is more art than science. Yet, with that disclaimer in mind, an upward shift in the yield curve should be a boon to the mortgage sector, and in particular, to mortgage REITs such as Capstead.

A Fair Location To Park Cash

Published on:
February 2, 2017
Last Update:

Investment Thesis

The margin of safety is minimal, but given the high valuation of other office REITs, Hudson Pacific Properties (HPP) is a fair location to park cash. Management is cost conscious and, to date, has been bringing greater value compared to cost of the shareholder dilution.


Office REITs are trading at a dear valuation. Over 90% of the office companies that compose the NAREIT index are trading at higher multiples than book value. And to purchase a position in an office REIT, at the current average multiple of 15 times the funds from operations, would leave thin room for error and should serve as a reminder of the past. Since the '80s, the only time REITs traded at a multiple higher than 15 times was in 2006-2007. The exorbitant market price is not due to a stellar performance. In total, office REITs' average return on equity was 10% in the past two years.

Risk is looming. First, oversupply is apparent in major metropolitan markets. In Washington, DC, there is twice the development activity and available office space than demand, reports JLL, a real estate brokerage firm. Second, future monetary pressures (read: inflation) may increase the interest rate environment, squeezing profits. Third, competition from shared-office companies, such as WeWork and Mindspace, continues to challenge the traditional business model.

Yet the investing public seemingly ignores any future warnings. "The biggest trend for commercial real estate in 2017 - and beyond - is the ongoing technological disruption of the industry. E-commerce is taking roughly 50% of the growth in overall retail sales, which is eroding the underlying value of retail real estate," notes David Shulman, an economist. "On the office side, square footage per employee continues to come down, creating latent vacancies in its wake, and hoteliers have to deal with the fact that Airbnb is here to stay."

The exorbitant prices are apparent in large, small and mid-size office REITs. Boston Properties (NYSE:BXP), with $16 billion in real estate assets and $918 million in funds from operations, traded at 2 times the book value and had a multiple of 21 times the funds from operations. Smaller REITs, such as First Potomac Realty (NYSE:FPO), with little over a billion in real estate assets and $55 million in funds from operations, traded at 1.5 times the book value, with a multiple of 18 times the funds from operations. Midsize companies, such as Equity Commonwealth (NYSE:EQC), with $3 billion in assets and $200 million in funds from operations, traded at par the book value and 18 times the funds from operations.

What can be done? For the passive investor to purchase an index fund, one such as the iShares U.S. Real Estate ETF (NYSEARCA:IYR), would be sensible. The office asset class represented 10% of the index composition, so, perhaps, opportunities would unfold in other asset classes such as medical office buildings or data centers. For the active investor, catalyzed by a low interest rate environment and a 7-year increase in market value, continued development of office properties could be the right course of action. But your correspondent has chosen to focus the attention on a single office company, Hudson Pacific Properties.

Executive Summary

Management: Victor J. Coleman, boss of Hudson, knows a thing or two about selling at the right time. In 2006, he sold his former company, Arden Realty, Inc., to GE Real Estate at a $5 billion valuation. It is rumored that he pocketed over $20 million from the deal. And if true, then Hudson is run by an individual who could golf and relax, but has chosen to do otherwise. It is a rare quality that often spreads throughout the company and management team. Also, whether or not the 2006 sale was sheer luck, timing the market is a quality that often sticks.

Real Estate: Gross real estate per share (excludes depreciation) increased to $67 from $36 a share. Hudson owns 54 office properties and 2 media properties, totaling 14.9 million square feet. The weighted average lease term is 4.9 years, and the weighted base rent is $38.84 per year. Tech companies such as Google (GOOGL), Square (SQ) and Cisco (CSCO) represent 36% of the annual base rent. The real estate portfolio occupancy rate is over 90%. Hudson has 886 leases, of which 70% represent leases of 10,000 square feet or less.

Liabilities: Liabilities increased to $29 from $15 a share over the past 5 years. Hudson modestly leverages its real estate portfolio. It has $1.55 billion in unsecured loans and $723 million in mortgages, and only 8 properties carry mortgages. In 2015 the company redeemed 5.8 million of preferred shares that carried an interest rate of 8.375%. Proceeds of $147.3 million from an unsecured line of credit were used to retire the preferred shares. More important than the annual savings of $5 million, the preferred shares redemption demonstrates a cost-conscious management.

Income Statement: Revenue increased to $5.9 from $3.77 a share, while operating expenses per share remained at $2.65. Operating expenses include expenses from the operations of the office and media buildings, and general and administration expenses. Funds from operations increased from $1.07 to $2.13 per share, and net operating income, a performance measure which does include the interest expense, increased to $3.85 from $2.35 a share. Rental income from office properties represented 88% of total revenue.

Cash flow: Hudson invested in over $3 billion of real estate properties over the last 5 years. And, typical to a real estate investment trust, the investing activity was financed by issuing debt. In 2015, the company invested in $1.8 billion of properties and issued notes payable for $1.65 billion. And operating cash flow increased to $2.03 from $1.09.

Valuation: Peer companies, such as Equity Commonwealth, Gramercy Property Trust (NYSE:GPT), Columbia Property Trust (NYSE:CXP), Piedmont Office Realty Trust (NYSE:PDM) and Brandywine Realty Trust (NYSE:BDN), traded at 1.13 times the book value in 2015 in line with Hudson's market valuation of 1.13 times book value. The company's 5-year average price to funds from operations ratio was 17 times, and the company traded at 15 times in 2015. Premium to net asset ratio was 1.88 times.

Risk: Given the high occupancy rate, further growth in funds from operations will be dependent on property development and acquisition. These endeavors are often risky compared to purchasing and stabilizing a portfolio of real estate. And risky endeavors often command a steep shareholder dilution. Because the margin of safety (the difference between the cost and value) is barely visible, a share price decline, or a minimal share price increase, is likely.


Solvency: measures the percentage of total assets financed with debt. The higher the ratio the higher the financial risk. A troubling ratio would be above 65%. Leverage is defined as line of credits plus mortgage divided by gross real estate.

Profitability: reflects a company's competitive position in the market, and by extension, the quality of its management. Operating margin is rental income minus operating expenses divided by rental income. FFO margin is funds from operations divided by revenue. The lower the amount, the higher the difference between revenue and FFO.

Valuation: relates the share price to the earnings measure such as funds from operations. All calculations are divided by the number of shares outstanding. Cap rate is defined as net operating income divided by share price. Price to book value is share price divided by total assets minus total liabilities.

Peer Group: Includes: Equity Commonwealth , Gramercy Property Trust , Columbia Property Trust , Piedmont Office Realty Trust and Brandywine Realty Trust .

Figure 1: HPP Share Price

Figure 2: Total Return Comparison

Figure 3: Property Distribution

Figure 4: Trading Statistic


Hudson Pacific Properties should grab your attention. Over the past 5 years, real estate per share increased to $67 from $36, while liabilities per share increased to $29 from $15. Its income statement entails a similar tale. Revenue increased to $5.90 from $3.77, while operating expenses remained at $2.65. Given the alternatives, a share in Hudson may be a reasonable location to park cash.