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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

Accomplishments

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.

Management      

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.  

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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.  

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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.

Lessons learned from holding FTR

Published on:
June 1, 2019
Last Update:

In Where the Financial Statements Reveal Little Economist Reality , I bragged that buying Frontier Communication was effortless. All one had to do, I proclaimed, was to compare the prior years price, which was in the triple digits, to the 2018 stock price of $5.

A year passed and the stock price more than halved - which issues a few lessons. In this essay I describe these lessons and explain why I am still holding the stock nonetheless.

The four lessons

The first lesson is that not all equity is created equal. What I failed to see last year was that the reported 2017 equity of $2,274 million consisted of $5,035 million in additional paid-in capital which was offset by $2,263 million in accumulated deficit (The remaining $497 million was related to treasury stock and OCI). What this means is that the equity balance consisted of proceeds from past stock issuances - not from profits.

The reported equity should have embarrassed management. But instead management had no problem diluting common shareholders by issuing additional shares. There were 66 million outstanding common shares five years ago. There were 78 million outstanding shares a year ago. There are now over 90 million outstanding shares. This 6% annual growth in common shares, likely to continue, is worrisome.   

The value of reported goodwill and intangibles assets is always questionable. But in FTR's case, these two accounts were no assets at all. In 2016 goodwill and intangibles were $12,336 million. Management had written down these assets to $7,877 million by 2018, a whopping $4,459 million loss that was fully recognized in the income statement.

FTR's goodwill and intangibles are over a third of the value of the reported assets. And if we are to remove these accounts, as any bidder for the company surely would, we would be left with exactly nil - zero, nadir, nothing, zilch - in common equity. FTR's tangible assets, which exclude the goodwill and intangibles accounts are $15,782 million or $17 per share. FTR's liabilities are $22,059 million or $24 per share. Since the liabilities are worth more than the assets, the common equity is worthless. The omission of thought related to the intangibles is lesson number two.

The third lesson was the lack of margin of safety. Even at $5 per share, which was historically low, FTR had too many concerns. To name a few: (a) the fixed coverage ratio was deteriorating. The ratio was over three times in prior years and is now less than two times; (b) leverage, defined as total liabilities divided by total assets, was historically at 75% but is now at 93%; (c) pension liability increased from $1,055 million in 2012 to $1,750 in 2018. And there is no sign of this liability but to grow; (d) the percentage of employees under labor agreement increased from 23% to 64% and (e) the wireline telecommunication industry is doing bad.

Practically all telecommunication companies’ stock prices dropped. Anixter (AXE on Nyse) now trades at $57 compared to $99 five years ago. Centurylink (CTL on Nyse) now trades at $10 compared to $37 five years ago. See the table below for more examples.  

How telecommunications companies are trading nowadays

That I bought too much stock is the fourth lesson. I started to buy FTR in March of last year, when the stock traded at $7.76 per share. Then I bought twice as much stock, at $4 per share in November. I finished 2018 with 8,000 shares at a weighted average cost of $5 per share. The FTR position represents 8% of my portfolio while no stock represents more than 2% in comparison.

Why I still hold FTR

Admittedly, I bought too much stock and was careless, too. Reviewing FTR's latest public filing, I was ready to sell the entire position and to recognize the loss. But I found enough reasons (or excuses) to keep it.

There is - and I project will be continued - a reasonable pre-tax cash flow. FTR gathered $3,752 million in after-tax cash flow, after capital expenditures that is, since 2011. In two years the company showed a cash flow deficit: in 2016 the deficit was $227 million, and in 2015 the deficit was $31. But in 2018 the pre-tax cash flow was $687, and the 7-year pre-tax cash flow was $525 million.

The pre-tax cash flow matters. It allows management to change the capital structure by reducing the total liabilities (indeed, management reduced total liabilities by $551 million over the year and is planning to sell asset according to Barron's.) The pre-tax cash flow will allow the company to  compete better as well.

Plus the operating data improved over the past decade. FTR now has more customers in both the consumer and the business segments. For example it had no broadband or video subscribers ten years ago and now reports on 4.7 million broadband and video subscribers. In addition, the churn rate, the annual percentage rate at which customers stop subscribing to a service, is at normal levels.

FTR's Growth in customer base over the past decade


So FTR still meets the cheap, distressed criteria of a stock that trades at less than 50% of the net asset value and of less than 10 times the adjusted earnings per share. The reported book value per share today is $18 and the adjusted pre-tax cash flow is $7.  

***
My brother asked if I had a stop loss in place. Stop loss means that if a stock drops below a certain price, say a drop by 40%, then it is automatically sold to prevent the investor from future losses.

No, I said. Investors, especially investors who target distressed companies, expect - and should be ready - to see much volatility in market prices of their  holdings. May the case of FTR serve as a case in point a year from today.

Why I decided to call Charles Schwab for market orders

Published on:
May 4, 2019
Last Update:

"We face danger whenever information growth outpaces our understanding of how to process it," wrote Nate Silver in The Signal and the Noise. "The last forty years of human history demonstrate that it can still take a long time to translate information into useful knowledge and that if we are not careful, we may take a step back in the meantime."

Indeed, I had taken a step back this week and wanted to bury my head in the sand. This was the result of the movements in my stock portfolio.

I was overwhelmed with information. Companies reported annual earnings this week - which set an immediate price reaction by Mr. Market. Frontier Communication, my largest position, and one that represents almost 10% of my stock portfolio, reported higher-than-expected revenue which translated to a $4,000 increase in unrecognized market gain. Mr. Market also welcomed news from management of Stericyle, a position I began in January, which described began its business transformation. The reported goods news resulted in an increase of $1,500 in recognized market gain.

But the stock of Oprah Winfrey's Weight Watchers (which I bought in January) tumbled by 27%. The 2018 earnings per share of over $3 per share were abnormally high noted management. Management also lowered the 2019 earnings per share forecast to be about a dollar per share. Management reported on a gloomy outlook (some would say realistic) given "competitive pressures." and the market was infuriated. The dreary news resulted in $4,000 unrecognized market loss.

Management of Victoria’s Secret, a position I started last year, reported to shareholders that it will close 53 Victoria's Secret stores this year. L Brands stock fell by 10% shortly after, to $25 from $28, a $2,000 unrecognized market loss for me.

The unrealized market gains were offset by unrealized market losses. But I was not dispassionate about the whole thing. On days my portfolio value was elevated by 30% gains, I felt great. I happily talked to everyone and even showed a somewhat, jovial stride.

Yet on days my portfolio was is down 30%, I shut the my offie's door. And instead of walking outside, admiring the beauty of San Diego weather, I made repeated trips to the break room to fill with coffee my empty cup. The emotional toll from market fluctuations was real and unpleasant.

The vagaries of Mr. Market

The emotional toll has a real emotional toll but hardly anyone in finance or in business talks about it. In The Psychological Price of Entrepreneurship, Jessica Bruder writes of "entrepreneurs who have begun speaking out about their internal struggles in an attempt to combat the stigma of depression and anxiety that makes it hard for sufferers to seek help."  

Yet Wall Street has not caught up with Silicon Valley. On Wall Street, you don't talk about emotions. "And if you do," said a Wall Street veteran who asked to remain anonymous, "It's a sign of weakness."

Over the weekend, after markets had closed, I realized how idiotic my behavior was. To track daily or even weekly the market value of my stock portfolio was sill. I had no plans to sell stocks so what investors were willing to buy the stocks for was meaningless. I manage my own money and no investors I need to report to on the portfolio value. And I never buy stocks on margin so there was no risk of a margin call.

Calling Charles Schwab

A few years ago I read in a book by Nassim Taleb that if I was to daily check the price movement of the stock portfolio, by the nature of statistics, the amount of losses would be greater than the gains.

In Fooled by Randomness, he wrote:

"A minute by minute examination of a portfolio means that each day you will have 21 pleasurable minutes against 239 unpleasurable minutes, amounting to 60,688 and 60,271, respectively, per year." 

Yet knowing that something is harmful and doing something about it is not the same. Hence, my solution going forward is to call Charles Schwab for market orders.

The problem with trading over the Internet is that it forces you to log into your brokerage account. That in turn forces you to see the price movement of your stock portfolio. And if that's not enough, all brokerage platforms add a visual cue. Just in case you don't remember what was your cost basis, they color the gains in shiny green and losses in bright red.

***  
In Jewish philosophy it is said that where penitents stand, even the wholly righteous do not stand. I bring this sentence of wisdom as a means of an excuse. I knew that watching price movements was wrong. Great investors, from Warren Buffett and Guy Spier to Nassim Taleb, commented on this issue in the past. But I had to feel for myself the emotional distress in the present to finally do something about it. Sometimes, lessons are learned only by experience.

How I lent my shares in Frontier Communications

Published on:
March 31, 2019
Last Update:

"Facts are stubborn things," said my favorite American founder, John Adams. "And whatever may be our wishes, our inclinations or the dictates of our passions, they cannot alter the state of facts and evidence." And so, I collected a few facts about Frontier Communication for this week's meditation.

 A few facts on Frontier are needed because Frontier’s stock is trading at 71% compared to a year ago. And as most analysts are rushing investors to cut their losses and sell Frontier position, I plan to do the opposite.  

The 2018 earnings estimate

After adjusting for non-cash expenses, I expect Frontier to report on a billion dollars of after-tax cash flow. The company’s average quarterly revenue was $2.1 billion in 2018, the average quarterly expense for interest was $400 million and the average capital expenditures were $320 million. 

If we remove non-cash charges, such as depreciation ($480 million each quarter) and goodwill expense ($400 million in the third quarter), we get a quarterly after-tax cash flow of $250 million. Multiplied by four quarters, we get the billion-dollar estimate.  It is a fact that these after-tax earnings, adjusted for non-cash items, are higher than the after-tax earnings when the stock was trading in the double digits.  

Another way to look at my estimate of Frontier's 2018 after-tax cash flow of a billion dollars is to say that the company profit margin is about 12% and that while the debt service coverage ratio is thin, it is adequate. The operating income to debt service ratio is slightly above two times. It is a fact that operating income for 2018 will be higher than $3.9 billion and that the interest expense will be $1.5 billion.

As of the third quarter of 2018 public filing, Frontier reported total assets of $24 billion. If we remove goodwill of $6.6 billion, we find tangible assets of $17.4 billion. And so, with a rate of return of capital of 5.75%, I cannot understand why there is an increased demand in investors who are shorting the company. 

Twelve months ago, the short interest, as reported by Nasdaq, was $2.9 million with average daily volume of $2.7 million. As of today, the short interest is $49.4 million. The stock price declined from $8 to $2, too.    

The 5-year operating performance and the 10-year earnings multiple valuation

While operating results slightly improved, Frontier's valuation is materially below what the stock was valued in the past. Between 2013 and 2017, revenue grew by 14% compounded annually. In 2013, revenue was $4.7 billion, and in 2017 revenue was $9.1 billion. Earnings before taxes (EBT) grew by 6% compounded annually. The 2013 EBT was $1.5 billion, and the 2017 EBT was $2.02 billion. It is true that the after-tax cash flow declined from $857 million in 2013 to $618 million in 2017, but to me, a drop of 30% in after-tax cash flow does not explain the gloomy outlook.  

If we expand our time horizon and look at the past decade we see that the stock traded as high as $194 (in 2008) and as low as $2 (current valuation). The earning multiple ranged from 6 to 12 the earnings. My estimate of a billion in after tax cash flow, alongside the reported outstanding shares of $103 million, translates a market valuation of less than one times the earnings multiple.    

The market's view

But the stock market’s focus is in future trends (for example, that employess are unhappy) and not in the historical record. "Quarterly revenues continue to decline at Frontier Communication," writes Wayne Nef of Value Line, an investing newsletter. "Both the consumer segment and the commercial business are under pressure. Management is optimistic that the revenue trend will turn in the fourth quarter due to new marketing programs and seasonality, but we are less sanguine."

In Seeking Alpha, the crowd-sourced financial website, you will read of a bearish outlook, too. Here are a few headlines I found: "Frontier Communications: Fundamentals Are Meaningless in a Bear Market" writes one author. "After A 60% Decline, Frontier Communications Offers Little Value," argues another. And picked by Seeking Alpha's editor as a favorite article is "Frontier Communications is uinvestable."

Ashraf Essa, who writes for The Motley Fool, is bearish, too. He warns us that "Frontier's business is on the decline, and the company had about $1 billion worth of long-term debt coming due within the next year." And that Frontier Communications shaky business fundamentals, coupled with its massive debt load, make it an extremely risk stock to own."    

Securities lending

Since I began to buy the common stock of Frontier in March of last year, I did not pay much attention to the company. In 2017 the stock price was in the two digits and it would surely climb again, I thought to myself. I did not plan to think about Frontier before it published its 2018 fiscal year-end results, which was reported on February 28, 2019 and which I have yet to read.  

But Jeff, a Charles Schwab representative, called this morning and asked whether I would be interested in lending the securities I owned. There is an increasing short demand, he said. He offered an interest rate of 10%, which is the equivalent of two Starbucks per today.

The math behind the two-Starbucks-per-day: Charles Schwab is borrowing from me 8,000 stocks at a rate of 10%. The stock is today worth $18,000 (I bought the stock for little over $40,000). This translates to an annual payment of $1,800, or daily payment of $5. The terms of the agreement between us are that Schwab may pay off the loan at any time and payments are made every month.

In 1774, Adams renounced tea drinking as unpatriotic and switched to coffee drinking according to a letter he wrote to his wife, Amelia. He would have been supportive with my securities lending practice, I am quite sure.

An Update

Published on:
November 9, 2018
Last Update:

"This past year did not go as planned," wrote Bruce Berkowitz earlier this year. "Although markets reached new highs in 2017, there was not much to celebrate as the securities of Sears wrecked the funds’performance. Sears realized billions of dollars from asset sales, as we predicted, but I did not foresee the operating losses that have significantly reduced values. Getting the asset values largely correct, but missing the company’s inability to stop retailing losses, has been hugely frustrating and fatiguing for me to watch."

Fund managers often write apologies. They explain to their audience of readers why they are right and why Mr. Market is (temporarily) wrong and that patience is a virtue. Too often they provide a narrative of the set of circumstances that should occur in the future. And too often they are dead wrong. These reports are typically dispatched when Mr. Market works against the fund managers. Read: when the stock price is down.

So while fund managers often write when the stock price, in this meditation I take the opposite approach. That is, I write when the stock price up. The irrationality of the Voting Machine (i.e. capital markets) is our topic at hand. And the company at issue is ARC Document Solutions, a reprographics firm.

In A Fair Company at a Wonderful Price I wrote about my purchase of ARC. For the okay-but-get-to-the-point reader: I bought 12,000 shares at an average cost of $2.15. What I saw then in ARC was a bargain stock: a low earnings per share multiple and a 2017 income statement that did not reflect the true intrinsic earnings power of the business. (One example is that the company booked a $16 million expense related to goodwill impairment, a non-cash expense.)

 But the Voting Machine did not see it that way. After I bought the stock, ARC dropped to record lows for six months. In numbers: the stock of ARC started 2018 at $2.50, reached a high of $2.59 and in July 13 of this year investors were able to purchase the stock as low as $1.64 - I associated the drop in price because Russell 2000 dropped ARC from its list of stocks. And this loss in the popularity contest scared the Voting Machine.  

Yet, as I type these words, the stock is trading hands at $2.90, 35% higher than the price I paid for the stock 6 months ago.

ARC's senseless uptick in value

Two things pushed the stock price. First, on July 16 management dispatched a press release where it foretold investors that for the first time in three years, it will report a growth in sales in the next quarter.

And management did not fail on its promise. On August 3 of this year, management reported that revenue increased from $102.3 million to $104.2 million; that earnings per share were up from $3.7 to $4.1; and that debt obligations declined from $152 million to $136.2 million.  

Overall it was less than a 3% improvement in operations, but the Voting Machine was irrationally exuberant nonetheless. Zacks, a stock research website, posted a bullish article titled Here's Why You Should Invest in ARC Document (ARC) Stock. And in Is It The Right Time to Buy ARC Document Solutions? Jodi Pearce of Simply Wall Street, recommended a buy.

But the improved quarterly results did not give grounds for the uptick in value. The company is still heavily dependent on the construction sector, a cyclical sector with much volatility. And it was reported that the reprographics industry is shrinking and that competitors continue to steal market share from the ARC.  

Can you see such a difference between perceived value and reported results in the world? Say you own a condominium rental and are able to increase the rent to your tenants by 5%, from $2,250 to $2,362 (this is how much I pay in rent for a two-room-one-bathroom apartment in San Diego). With the new, increased rent, can you think of a scenario that you would be able to sell the rental apartment for 50% more than what comparable sales were less than six months ago? In San Diego numbers, for a condo that sold for half a million in June 2018, you would list for $750,000.

The Voting Machine finds reasons for value in other places than the reported financial statements. The Voting Machine decides, based on growth expectations, whether a company is winning a popularity contest by Wall Street analysts. And there are other psychological factors such as investors who are now buying ARC simply because they believe and hope that other investors will buy ARC from them at a higher price.

What is also clear from the case of ARC is that the price from which the stock traded hands offers little insight to the true value of the stock. Dear readers who believe in the efficient market thery, please reflect how a company can value increase by more than half in less than two months when the economic fundamentals of the both the company and the industry have not materially changed.  

And if a company's stock price does not serve as guidance to intrinsic value, and if the Voting Machine simply does not care about the fundamental textbook accounting standards, where should we look for guidance on value? Leonard Cohen, the late Canadian folk singer-songwriter perhaps had the right answer. “Would like to know the true meaning of things?” he once asked in a live concert I attended. And as the crowd cheered and applauded for the ultimate answer to the greatest question of all, Cohen hummed back: “the answer, the true answer to the deep mystery is: doo dam doo dda di doo dam.”  

 

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.

Buying

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.

Selling

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.   

Dividends

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.  

Is Orchid a bargain stock?

Published on:
June 2, 2018
Last Update:

Benjamin Graham commented on the illogical relationship between the stock advisor and the client: 

“If the reason people invest is to make money, then in seeking advice, they are asking others to tell them how to make money. That idea has some element of naïveté. Businessmen seek professional advice on various elements of their business, but they do not expect to be told how to make a profit.”

And that veracious comment is rarely mentioned today - I find that to be strange.

Strange, too, is the stock market that we witness nowadays. I recently saw the market value of a stock I bought ten months ago increase to nonsensical levels. Less than a year ago, I bought 500 shares of Carver Bank at $3. But now the stock market decided that the stock is worth $6.

And it is a complete mystery why the sudden change in valuation. I wrote on my rationale behind the purchase of the stock in But I’ll be the first to admit - I am absolutely clueless why I did so well.

 The paper industry

Another unusual story I came across this week relates to the stock of Orchid Paper Company. Headquartered in Pryor, Oklahoma, the company is in the business of converting bulk tissue paper into paper towels, bathroom tissue and paper napkins. Over two thirds of its product is sold to just three retailers: Dollar General, Walmart and Family Dollar. Orchids Paper is a U.S.-based company with 2017 sales of $162 million, of which it generated $6.67 million in profits, an unheroic profit margin of less than 5%. 

I doubt whether you find the paper tissue industry fascinating. But it may interest you to know that Orchids Paper showed the steepest drop in market value for companies in the paper industry - it now trades at about $4, compared to $14 the year prior, a precipitous decline of about 70%.

Possible reasons for the decline in stock price

I sifted through Orchid’s latest annual report, trying to understand the drop in market value. What I found were five factors that may explain the loss in value.

First, Orchids Paper stopped paying dividends to shareholders as of the second quarter of 2017. Second, the company showed poor operating margins, and lower earnings per share, compared to its past performance.

Third, the company’s CFO, Mr. Rodney Gloss, had unexplainably resigned in March of this year. Fourth, its current liabilities balance increased by ninefold, from about $20 million the year prior to about $180 million this year. Fifth, Orchids Paper is a miniature company, with a current market valuation of merely $44 million. Its stock is thinly traded and does not draw the attention of Wall Street.

But the stock of Orchids Paper peaked my interest. Over the past decade the company had not reported a single loss. Its average 10-year were $1.15. So, its 10-year earnings multiple is 4 times. The company also reported $13.61 of tangible book value per share, which translates to a 70% discount to book value based on its current market value. And if you look at its stock price graph over from 2012 to 2017, you will see that the stock traded as low as $8 and as high as $36.

I was also attracted to the non-cyclical nature of the tissue paper industry. While most of the stocks I own are sensitive to the overall health of the U.S. economy, it seems to me that our use of paper tissue is not sensitive to how high or low is the Dow-Jones index.

The sale of paper towels composed about 50% of Orchids Paper’s sales. And the sale of bathroom tissue composes an additional 40% of its revenue. And unless the use of the Bidet completely changes how to spend our time in the bathroom, I am quite confident that we will keep using toilet paper in the bathroom for the foreseeable future.

Are capital markets rationale? 

While I was taught that capital markets are rationale; that there should be a reason behind a change in market prices, I often feel differently.

To remind myself that capital markets are frequently irrational in the short term, I recently hung the following quote from Berkshire’s 2018 annual
report:

 "Berkshire, itself, provides some vivid example of how price randomness in the short term obscure long-term growth in value. For the last 53 years, the company has built value by reinvesting its earnings and letting compound interest  work its magic. Year by year, we have moved forward. Yet Berkshire shares suffered four truly major dips. Here are the glory details:
March 1973 to January 1975:  High $93 and Low of $38. A 59.1% drop in stock price.
October 2, 1987 to October 27, 1987 as high as $4,250 as low as $2,675. A 37.05% drop in stock price.
June 19, 1998 to March 10, 2000 as high as $80,900 and low as $41,300. A 48.94% drop in stock price.
September 19, 2008 to March 5, 2009 high as $147,000 low as $72,400. A 50.7% drop in stock price.
This table offers the strongest argument I can muster against even using borrowed money to own stocks. There is simply no telling how far stocks can fall in short period.
Even if your borrowings are small and your positions are not immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions."

 Over the next few weeks, I will write more about Orchids Paper’s balance sheet, income statement and the paper tissue industry. If you would like to be notified when I post these meditations, please subscribe by clicking the button at the top of this page.

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

Buying

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.

Selling

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.

Epilogue

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.

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.  

The Lessons I Learned From Investing in Bon Ton Stores

Published on:
February 9, 2018
Last Update:

Anything within a mile radius of a shopping mall is now considered toxic on Wall Street. Toys 'R' Us, an American toy retailer, plans to close over 180 stores this year (read: a quarter of its stores) after it filed bankruptcy on September of last year. The common stock of Macy's, a department store chain, is now trading at about $25 compared to $64 three years ago. The stock of Sears Holdings, owner of retail store brands such as Sears and Kmart, is now trading at $2 compared to $33 three years ago. And CBL & Associates, a real estate investment trust founded in 1961, is now trading at about $5, a decline of 75% from three years prior.

Wall Street’s ominous outlook for the retail sector and its effect on stock prices did not bypass the stock portfolio of yours truly. On July 2017, I bought 2,000 shares  of Bon Ton Stores at a cost of $0.64 per share. The stock now trades at nine cents a share.

The investment thesis

I bought the stock in Bon Ton Stores for two reasons. First, I bought one dollar of the 2016 free cash flow for less than 50 cents. Compare that to the company's average free cash flow per share of $1.31 between 2016 and 2007 which was valued anywhere between 75 cents to $13. I thought it was a bargain.

The second reason was that I estimated that Bon Ton Stores had net tangible assets of about $5 per share. So, I assumed that in a case of bankruptcy there would be more than enough of a margin of safety to return capital. But I was utterly wrong. And the community at Seeking Alpha correctly brought to light my faulty analysis. I will skip the accounting related issue and get to the bottom line: while I assumed Bon Ton Stores had direct ownership in commercial real estate properties, the amount of real estate it owned was negligible. The company was leasing practically all of its stores.

"If you are in the market for cheap stocks, take a look at Bon Ton Stores, Inc." was the name of the article should you like to read more.

My error

I was wrong to make the adjustment to the reported deficit equity of about $23 million or an equity deficit of $1.14 per share. And not only did I not purchase the stock at a discount to book value, I bought the stock at a hefty, unjustified premium.

What the community in Seeking Alpha also pointed out to me was that I failed to discuss Bon Ton Stores’ right side of the balance sheet. Similar to the effect that attractive women have on me - of shrinking my analytical and reasoning capabilities to that of a chimpanzee - I was lured by the company’s cash flow measures and had glanced to briefly at the company's liabilities.

Take adjusted EBITDA after capital expenditures as an illustration.  For the five years prior to 2016, Bon Ton had over $82 million of adjusted EBITDA per year, while the average interest expense was $72 million. So I felt confident that the company could service its debt while gradually improving its operations. 

And one did not need a forensic investigation to see that a simple improvement in operations could revamp the income statement dramatically. For example, the sales, general and administrative to gross profit ratio was 90% when I bought the stock. But over the prior decade the ratio ranged from 79% to 88% with an average of 85%.

I recently learned about the Bon Ton stores’ liabilities, not out of a genuine curiosity, but as a major force. In mid-December of last year, the company failed to make a $14 million interest payment to a group of second-lien secured notes, according to its 8-k filing. And in less than 48 hours, the quoted price of the stock by declined by 70%, from about $0.50 to $0.15.

“According to the bankruptcy filing,” notes Thomas Onder of Stark & Stark, an attorney firm, “the debtor is seeking a strategic sponsor to invest. However, if it cannot find such a sponsor, then it intends to sell all of its assets.”   

The right side of the balance sheet

It is an old adage that debt is not your friend. And, in the case of retail, it is a practically a natural law. Retail is an industry that requires constant capital expenditures to attract customers. Debt also stiffens innovation. And without excess cash flow, alongside a constant need to please Wall Street each quarter, Bon Ton Store’s ability to invest for the long term was questionable. 

And I should have seen that.

But this is not an article about the use of debt, nor of the wolves of Wall Street, so let us go back to our topic of discussion. Bon Ton Stores has over $1.2 billion in outstanding debt (there is nothing outstanding about its debt, it is just business jargon, perhaps by genius marketers). There are about $700 million liabilities that are payable within one year, and this year, the company was going to refinance its maturing long term debt of about $500 million. The timing of the maturing long term debt could not be worse.

It should be obvious that, even at a quoted price of nine cents a share, now is not the time to invest in Bon Ton Stores. There is little chance the company will get out of bankruptcy without severely diluting or eliminating current shareholders. And the picture I tried to paint for you in the first paragraph is that there is even less of a chance that capital markets will view the retail sector and the shopping mall sector favorably any time soon.

A Review of The Stocks I Purchased Over The Past Six Months

Published on:
December 9, 2017
Last Update:

It is time to reflect on stock purchases. Over the past six months, I bought a total of 6,000 shares in 16 very different companies, at a total cost of $24,756. If we add their profits, the companies earned a total $1,012 and had a book value of $20,561. On the portfolio level, I paid a hefty price of about 20 times the past earnings and a more reasonable price to book value of 1.2 times.  

I invested in these companies for three reasons. First, companies such as Bon Ton Department Stores and Famous Dave traded at a valuation below their competitors. I expect that their values will align with the competition in the future. 

Second, other companies I found were trading below their 10-year historical multiple to earnings. Take Regal Entertainment Group, as an example. Over the past decade, the average earnings multiple was between 28 and 19 times. I purchased the position at 17 times the 10-year average earnings per share. 

The third category for stock purchases was dividend yield. Capstead Mortgage and Terra Nitrogen fit in this category wtih an expected dividend yield of 7% and 6%, respectively.

I would get back 93 cents for every dollar I invested in the portfolio of companies if I was to trade my portfolio of companies for cash. I experienced a substantial decline in market value with Vitamin Shoppe and RAIT Financial Trust. While the latter lost 32% in market value and the former lost 85% (ouch, that was painful to write), their overall negative effect on the portfolio was 5% and 4%, respectively. I received $388 in dividends from these companies to date and expect to receive an additional $848 in 2018, an expected yield of 3.5%.

While I am indifferent to a 7% decline in market value, I have one regret. I should never have purchased a position in RAIT Financial Trust. As I wrote to you, the company had a tremendous amount of liabilities with little equity. And while it was fairly easy to see that, I led myself to believe otherwise. I plan to keep this position in 2018 - just to remind myself of the potential, dire consequences of rash decisions.

Two lessons can be observed from these recent purchases. The first lesson is one stock should rarely represent more than 15% of your portfolio. By having this rule of thumb, the steep decline in value for RAIT Financial Trust had less than a 5% effect on the portfolio.

It is a popular cliché that the only assurance in life are death and taxes. I would add that mistakes are of certainty as well. So diversification, defined as an equity position in 15 to 30 companies, is one of the tools I use to allow for future mistakes.

The second lesson is that market fluctuations should be taken lightly. As long as you don't invest using a margin account or develop the bad habit of shorting stocks (some would argue that shorting stocks is a vice), the practical effect of the changes in the quoted prices, assuming you plan to hold them for three- to five-years, is nil.

If a person runs down your street, frantically yelling that he is willing to purchase all the homes on your block for 60 cents on the dollar, how would you react? Would you immediately sell your home? 

My guess is that you wouldn’t.  And similarly, quoted prices on stocks you purchase, if you are confident in your analysis and investment, are best to be ignored.

What's next? Other than to research and to write about investment topics, I don't expect much investment actions. Over the next months, I plan to write about the tools I use to find stocks, how I research stocks and what my criteria are to purchase a position in a company. 

If you would like to be notified when I post articles, please leave you email address below and if you have any questions, just write to me. It may take me awhile, but I reply to all emails. 

For now - Happy Holidays!