Archive for October, 2010

The Fall 2010 edition of the Graham and Doddsville Newsletter, Columbia Business School‘s student-led investment newsletter co-sponsored by the Heilbrunn Center for Graham & Dodd Investing and the Columbia Investment Management Association, has a fascinating interview with Donald G. Smith. Smith, who volunteered for Benjamin Graham at UCLA, concentrates on the bottom decile of price to tangible book stocks and has compounded at 15.3% over 30 years:

G&D: Briefly describe the history of your firm and how you got started?

DS: Donald Smith & Co. was founded in 1980 and now has $3.6 billion under management. Over 30 years since inception our compounded annualized return is 15.3%. Over the last 10 years our annualized return is 12.1% versus −0.4% for the S&P 500.

Our investment philosophy goes back to when I was going to UCLA Law School and Benjamin Graham was teaching in the UCLA Business School. In one of his lectures he discussed a Drexel Firestone study which analyzed the performance of a portfolio of the lowest P/E third of the Dow Jones (which was the beginning of ―Dogs of the Dow 30). Graham wanted to update that study but he didn‘t have access to a database in those days, so he asked for volunteers to manually calculate the data. I was curious about this whole approach so I decided to volunteer. There was no question that this approach beat the market. However, doing the analysis, especially by hand, you could see some of the flaws in the P/E based approach. Based on the system you would buy Chrysler every time the earnings boomed and it was selling at only a 5x P/E, but the next year or two they would go into a down cycle, the P/E would expand and you were forced to sell it. So in effect, you were often buying high and selling low. So it dawned on me that P/E and earnings were too volatile to base an investment philosophy on. That‘s why I started playing with book value to develop a better investment approach based on a more stable metric.

G&D: There are plenty of studies suggesting that the lowest price to book stocks outperform. However, only 1/10 of 1% of all money managers focus on the lowest decile of price to book stocks. Why do you think that‘s so, and how do people ignore all of this evidence?

DS: They haven‘t totally ignored it. There are periods of time when quant funds, in particular, use this strategy. However a lot of the purely quant funds buying low price to book stocks have blown up, as was the case in the summer of 2007. Now not as many funds are using the approach. Low price to book stocks tend to be out-of-favor companies. Often their earnings are really depressed, and when earnings are going down and stock prices are going down, it‘s a tough sell.

G&D: Would you mind talking about how the composition of that bottom decile has changed over time? Is it typically composed of firms in particular out of favor industries or companies dealing with specific issues unique to them?

DS: The bulk is companies with specific issues unique to them, but often there is a sector theme. Back in the early 1980‘s small stocks were all the rage and big slow-growing companies were very depressed. At that time we loaded up on a lot of these large companies. Then the KKR‘s of the world started buying them because of their stable cash flow and the stocks went up. About six years ago, a lot of the energy-related stocks were very cheap. We owned oil shipping, oil services and coal companies trading below book and liquidation value. When oil went up they became the darlings of Wall Street. Over the years we have consistently owned electric utilities because there always seem to be stocks that are temporarily depressed because of a bad rate decision by the public service commission. Also, cyclicals have been a staple for us over the years because, by definition, they go up and down a lot which gives us buying opportunities. We‘ve been in and out of the hotel group, homebuilders, airlines, and tech stocks.

Performance of the low-price-to-tangible book value:

Read the Graham and Doddsville newsletter Fall 2010 (.pdf).

Hat tip George.

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For a period from late 2008 through mid 2009 the GSI Group (PINK:LASR) was prima facie the cheapest stock on my net net screen, but I couldn’t pull the trigger because it was delinquent a few quarterly filings. The company entered Chapter 11 due to the technical default of not filing financial statements and is now an extremely interesting prospect post reorganization. The superb Above Average Odds Investing blog has a guest post from Ben Rosenzweig, an analyst at Privet Fund Management, titled The GSI Group (LASR.PK) – Another Low-Risk, High-Return Post Reorg Equity w/ Substantial Near-Term Catalyst(s), which really says it all. Here’s the summary:

Thesis Summary: Privet Fund LP is long GSIGQ common stock. Our post-emergence price target is $5.00 per common share, an internal rate of return of 123% based on closing price of $2.70 and right to purchase .99 shares for every 1 share currently owned at a price of $1.80 per share. The market has failed to fully price in the impact of the Plan of Reorganization that was confirmed on Thursday, May 27, 2010.

We believe GSI is an attractive investment opportunity for the following reasons:

  • Due to the efforts of the equity committee throughout the bankruptcy process, the pre-emergence equity holders will be able to maintain an 87% ownership in the post-emergence company, up from an initial distribution of 18.6% in the first Plan of Reorganization
  • The end markets for the Company’s precision technology and semiconductor products are coming out of the trough of a cycle and, as a result, GSI’s bookings have been increasing at an exponential rate
  • The purging of the previous management regime opens the door for an experienced operator to run the Company much more efficiently and make strategic decisions with a view toward enhancing the value of the enterprise
  • The significant reduction in debt gives management the needed flexibility to focus solely on improving operations. This should result in significant fixed cost leverage going forward as evidenced by the Q1 2010 EBITDA margin of 14%, a figure that previous management suggested was not achievable until the end of 2011
  • The current market valuation, which includes the right to buy .99 shares at $1.80 per share, implies a 2010 sales figure and discounted cash flow valuation that is simply not possible even if the Company’s financial performance does not follow through on the radical improvements that have been shown during the past two quarters

Read the post in full.

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James P. O’Shaughnessy’s What works on Wall Street is one of my favorite books on investing. The thing that I like most about the book is O’Shaughnessy use of data to slaughter several sacred value investing cows, one of which I mentioned yesterday (see The Small Cap Paradox: A problem with LSV’s Contrarian Investment, Extrapolation, and Risk in practice).

Another sacred cow put to the sword in the book is the use of five-year earnings-per-share growth to improve the returns from a price-to-earnings screen. O’Shaughnessy describes the issue in this way:

Some analysts believe that a one-year change in earnings is meaningless, and we would be better off focusing on five-year growth rates. This, they argue, is enough time to separate the one-trick pony from the true thoroughbred.

So what does the data say?

Unfortunately, five years of big earnings gains doesn’t help us pick thoroughbreds either. Starting on December 31, 1954 (we need five years of data to compute the compound five-year earnings growth rate), $10,000 invested in the 50 stocks from the All Stocks universe with the highest five-year compound earnings-per-share growth rates grew to $1,287,685 by the end of 2003, a compound return of 10.42 percent (Table 12-1). A $10,000 investment in the All Stocks universe on December 31, 1954 was worth $3,519,152 on December 31, 2003, a return of 12.71 percent a year.

O’Shaughnessy interprets the data thus:

Much like the 50 stocks with the highest one-year earnings gains, investors get dazzled by high five-year earnings growth rates and bid prices to unsustainable levels. When the future earnings are lower than expected, investors punish their former darlings and prices swoon.

The evidence shows that it is a mistake to get overly excited by big earnings gains.

Five-year growth rates are clearly mean reverting, and I love to see an intuitive strategy beaten by a little reversion to the mean.

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Yesterday’s post on LSV Asset Management’s performance reminded me of the practical difficulties of implementing many theoretically well-performed investment strategies. LSV Asset Management is an outgrowth of the research conducted by Josef Lakonishok, Andrei Shleifer, and Robert Vishny. They are perhaps best known for the Contrarian Investment, Extrapolation, and Risk paper, which, among other things, analyzed low price-to-book value stocks in deciles (an approach possibly suggested by Roger Ibbotson’s study Decile Portfolios of the New York Stock Exchange, 1967 – 1984). They found that low price-to-book value stocks out perform, and in rank order (the cheapest decile outperforms the next cheapest decile and so on). The problem with the approach is that the lowest price-to-book value deciles – that is, the cheapest and therefore best performed deciles – are uninvestable.

In an earlier post, Walking the talk: Applying back-tested investment strategies in practice, I noted that Aswath Damodaran, a Professor of Finance at the Stern School of Business, has a thesis that “transaction costs” – broadly defined to include brokerage commissions, spread and the “price impact” of trading – foil in the real world investment strategies that beat the market in back-tests. Damodaran made the point that even well-researched, back-tested, market-beating strategies underperform in practice:

Most of these beat-the-market approaches, and especially the well researched ones, are backed up by evidence from back testing, where the approach is tried on historical data and found to deliver “excess returns”. Ergo, a money making strategy is born.. books are written.. mutual funds are created.

The average active portfolio manager, who I assume is the primary user of these can’t-miss strategies does not beat the market and delivers about 1-1.5% less than the index. That number has remained surprisingly stable over the last four decades and has persisted through bull and bear markets. Worse, this under performance cannot be attributed to “bad” portfolio mangers who drag the average down, since there is very little consistency in performance. Winners this year are just as likely to be losers next year…

Damodaran’s solution for why some market-beating strategies that work on paper fail in the real world is transaction costs. But it’s not the only reason. Some strategies are simply impossible to implement, and LSV’s low decile price-to-book value strategy is one such strategy.

James P. O’Shaughnessy’s What works on Wall Street is one of my favorite books on investing. In the book, O’Shaughnessy suggests another problem with the real-world application of LSV’s decile approach:

Most academic studies of market capitalization sort stocks by deciles (10 percent) and review how an investment in each fares over time. The studies are nearly unanimous in their findings that small stocks (those in the lowest four deciles) do significantly better than large ones. We too have found tremendous returns from tiny stocks.

So far so good. So what’s the problem?

The glaring problem with this method, when used with the Compustat database, is that it’s virtually impossible to buy the stocks that account for the performance advantage of small capitalization strategies. Table 4-9 illustrates the problem. On December 31, 2003, approximately 8,178 stocks in the active Compustat database had both year-end prices and a number for common shares outstanding. If we sorted the database by decile, each decile would be made up of 818 stocks. As Table 4-9 shows, market capitalization doesn’t get past $150 million until you get to decile 6. The top market capitalization in the fourth decile is $61 million, a number far too small to allow widespread buying of those stocks.

A market capitalization of $2 million – the cheapest and best-performed decile – is uninvestable. This leads O’Shaughnessy to make the point that “micro-cap stock returns are an illusion”:

The only way to achieve these stellar returns is to invest only a few million dollars in over 2,000 stocks. Precious few investors can do that. The stocks are far too small for a mutual fund to buy and far too numerous for an individual to tackle. So there they sit, tantalizingly out of reach of nearly everyone. What’s more, even if you could spread $2,000,000 over 2,000 names, the bid–ask spread would eat you alive.

Even a small investor will struggle to buy enough stock in the 3rd or 4th deciles, which encompass stocks with market capitalizations below $26 million and $61 million respectively. These are not, therefore, institutional-grade strategies. Says O’Shaughnessy:

This presents an interesting paradox: Small-cap mutual funds justify their investments using academic research that shows small stocks outperforming large ones, yet the funds themselves cannot buy the stocks that provide the lion’s share of performance because of a lack of trading liquidity.

A review of the Morningstar Mutual Fund database proves this. On December 31, 2003, the median market capitalization of the 1,215 mutual funds in Morningstar’s all equity, small-cap category was $967 million. That’s right between decile 7 and 8 from the Compustat universe—hardly small.

The good news is, there are other strategies that do work.

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Insider Monkey has a great analysis of LSV Asset Management’s Value Equity Fund returns and alpha (LSVEX). LSV Asset Management is a quantitative value shop founded by Josef Lakonishok, Andrei Schleifer, and Robert Vishny, authors of the landmark 1994 Contrarian Investment, Extrapolation, and Risk paper, which is a favorite topic of mine (for more, see the archives on LSV and quantitative investment). Insider Monkey’s conclusions are not particularly positive for LSV:

LSV’s Value Equity Fund (LSVEX) uses quantitative methods to pick out-of-favor value stocks and does not employ any market timing strategies. LSV describes its investment process as follows:

A proprietary investment model is used to rank a universe of stocks based on a variety of factors we believe to be predictive of future stock returns. The process is continuously refined and enhanced by our investment team although the basic philosophy has never changed – a combination of value and momentum factors. We then overlay strict risk controls that limit the over- or under-exposure of the portfolio to industry and sector concentrations.We also limit exposures in individual securities to ensure the portfolios are broadly diversified, further controlling risk.

The competitive strength of this strategy is that it avoids introducing the process to any judgmental biases and behavioral weaknesses that often influence investment decisions.

Portfolio turnover is approximately 30% for each strategy.


Insider Monkey downloaded LSV Value Equity Fund’s returns from Yahoo to calculate their alpha by using Carhart’s four factor model:

The LSV Value Equity Fund has $1.7 Billion under management, but the strategy is actually used to manage $22.2 billion in assets in various LSV funds. The fund’s objective is to achieve 200 basis points in excess returns before expenses. Considering that the LSV Value Equity Fund has an expense ratio of 0.65%, its alpha should not be less than 1.35%. The minimum investment is set at $100,000, so this fund is really not for small investors.

We calculated LSVEX’s alpha for the Oct 1999-Jun 2010 period. Though they call themselves a value fund, the LSV Value Equity Fund isn’t one. It had a slight value tilt in the first five years of the fund, but now it has a growth tilt. Neither of these are statistically significant though. Also during the first five years, the fund was investing in smaller companies. LSVEX had a monthly alpha of 31 basis points after expenses. This is exceptional for a mutual fund; usually mutual funds don’t have any alpha after expenses. But as assets grew, LSVEX was naturally tilted towards the large cap space. It doesn’t follow a momentum strategy. Unfortunately, the LSV Value Equity Fund’s alpha dropped to 10 basis points as assets grew, between 2005 and Jun, 2010. This level of alpha is actually 15 basis points below their goal of 1.35% annual alpha.

The top holdings of LSV funds are Chevron (CVX), Pfizer (PFE), AT&T (T), Conoco Philips (COP), Bank of America (BAC), and JP Morgan (JPM). Notice a theme here? This is the fundamental problem with talented mutual fund managers- they siphon most of their alpha into their pockets by inflating assets under management, because it pays to have large AUM but it doesn’t pay to have a large alpha. LSV could opt to manage a $3 Billion hedge fund and maintain a respectable 10% alpha. Instead of doing this, LSV added another $20 Billion of assets that follow the index funds and got a 1% alpha. Then they charged a 0.65% management for managing a $20 Billion index fund. That 0.65% fee from that $20 Billion is not much different from what could be collected from managing a hedge fund. LSV’s alpha is around $300-350 Million per year. They take $100-$150 Million from that in performance fees and leave the rest for their mutual fund investors.

See the article from Insider Monkey.

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Oozing Alpha has a write-up on the valuation of Aviat Networks, Inc. (NASDAQ:AVNW) (see the post archive here). AVNW is an interesting Ramius activist target trading at a small premium to net current asset value. Here’s the write-up from Oozing Alpha:

Investment Thesis
AVNW is an excellent opportunity to invest in a leading wireless backhaul producer at 19% EV/Sales and below tangible book value, while backhaul traffic continues to grow rapidly, bookings have bottomed and North American business activity begins to pick up.

AVNW has a very overcapitalized balance sheet with $137mm of net cash ($2.30/share) as of 6/30, a returning CEO who has tremendous knowledge and background in the business, and a new cost cutting program that will boost operating margins inline with business conditions and yield sustainable profitability at current trough revenue levels. Not to mention a recently announced active 6% shareholder Ramius, which outlines the opportunity well in a recent 13D filing.

I believe an investment in AVNW today has very little downside risk and 100%+ upside potential over next 1-2 years. Last night’s quarterly results and large guidance range for next quarter may provide a great entry point tomorrow.

Developed market wireless subscriber growth appears to have stalled, but developing markets are growing rapidly and in many cases, the entire telecom infrastructure is wireless, providing a nice tailwind for Aviat. The keys for Aviat are new network placements and add on capacity as backhaul bottlenecks continue to occur globally.

60% of Aviat’s revenue is outside of North America currently, with Africa revenue being volatile the last 23 years as only 2 real customers historically and consolidation of carriers has hurt Aviat. Europe is having problems and it appears both it and Africa are currently losing money in their operations. Russia activity is picking up and is a key region for AVNW. Asia Pac continues to grow and management is optimistic in its future and ability to generate sound profitability, albeit exact margins there now are tough to determine.

The 10k breaks out North America vs. International operators and it appears N.A is breakeven, but a lot of costs associated with N.A. are really International given AVNW is based in CA and a lot of corporate costs associated with running the International ops are baked into the N.A. #s. Tough to say how much but management acknowledges this issue.

The general consensus is networks are moving rapidly to 4G/LTE, however, in reality Aviat believes there still exists a very large market for TDM/3G equipment, as voice uptime is more critical than data uptime. Aviat is very strong in TDM and will continue to leverage this as they build out there 4G/WIMAX abilities, given backhaul networks require more and more traffic provisioning cellular base station traffic is up 10 fold in 3 years and expected to double every 2 years, according to Yankee Group.

There is quite a bit of competition in this area with Ceragon and Dragonwave being 2 pure play comps and obviously Ericsson and Alcatel/Lucent. Ceragon is a very good competitor with strong product portfolio and have been aggressively recruiting Aviat personnel, especially in sales. Huawei in Taiwan has been a thorn in the industry’s side so to speak as Bank of China has offered them absurd financing and Huawei is financing their sales at or below cost, trying to capture market share. It has hurt industry pricing but can’t last forever.

Customers are aware of this and continue to want multiple vendors. Generally customers seem happy with Aviat (candidly, have only talked to 2 and most feedback is from analyst community), continue to require multiple vendors and Aviat should get a nice share of the market going forward given its strong customer list, global footprint and competitive product portfolio.

The new CEO Chuck Kissner was the CEO of Stratex Networks and due diligence on him over the last few weeks has come back pretty positive. He seems to be a no nonsense guy who realized the cost structure was too bloated for current business conditions and has an aggressive plan in place to adjust it the next few months. He has been there a month but knows from the board level that many investors were fed up with Harold’s growth ambitions that weren’t in sync with customer’s spending plans and the overall economic environment.

Recent changes
New strategic plan highlights and cost cutting program, per last night’s release and conference call:

* Focus on wireless transmission and their microwave backhaul solutions, where they have a strong presence and portfolio.
* Make WIMAX part of the wireless product offering, not a separate business.
* Expand its service businesses network mgmt, design, implementation.
* Achieve profitability on current revenue run rate levels of $110-120mm per quarter.
– Reduce overall cost structure by $30-35mm annually; $6-8mm per quarter in SG&A and rest in COGS through manufacturing efficiencies.

The company took major charges this quarter and made it a kitchen sink quarter dropped intangibles $71mm and PP&E $10mm, sold TX manufacturing facility, announced plans to close Raleigh facility and are moving to a 100% outsourced manufacturing model. D&A will drop $12mm annually as a result. Moved to Santa Clara will save $1.5mm annually, took $2mm of cash to do it however but still a smart move.

Company produced $28.3mm of operating cash flow in FY2010 (June), lower than previous years but decent given poor operating performance and bloated cost structure.

$10-12mm of cash will be burned to complete this restructuring, mainly over next 2 quarters. Gross margins will be weak in the 1Q due to scrap inventory charge on India WIMAX equipment, but will return to 32-33% range by 2H. If not for this charge, GM%would be up nventory charge on India WIMAX equipment, but will return to 32-33% range by 2H. If not for this charge, GM% would be up QoQ over last quarter. OPEX was $43mm last quarter and will be down $6-7mm by Q311 (3/31/11).

Worst case, if not turned around and successful by end of next year, I see 2 scenarios:

1) Deemphasize WIMAX altogether and shun Telsima acquisition operations, focus purely on TDM/3G microwave business that continues to be the core and most successful product offering, thereby reducing costs even further; or

2) Close down Africa and Europe, focus on North America and AsiaPac, dramatically reducing cost structure and running a 10% EBIT margin, albeit on $250-300mm of revenue. Less growth prospects, but highly profitable. This is a drastic move and most likely wouldn’t happen until 2012. Shareholder pressure may also cause this or a cleanup of the business to dress it up for a sale to strategic. Private equity would also be interested, especially today, but shareholders wouldn’t be rewarded enough as private equity would want the upside of the cost cuts and restructuring.

Balance sheet/Liquidity
Pristine condition with $137mm of net cash, $189mm of net working capital (current asset minus total liab) and $80mm untapped credit facility.

Buyback would be a good use of cash and board has considered it, as well as tuck in acquisitions, but neither is in the cards for now until business turns and cost structure is reset. If stock doesn’t respond in a reasonable amount of time, I fully expect the board to feel pressure to consider a sale to either a strategic like Juniper or Cisco, or to private equity worst case, both of which should be at nice premiums to today’s quote.

$500mm revenue business with 33-35% gross margins and nice medium-long term prospects for $90mm enterprise value. Stock has traded on balance sheet value principally the last few months and appears to have bottomed.

Once cost cutting is complete and assuming revenue stays flat, AVNW should do $40-50mm of EBITDA on $450-500mm in revenue. Did $20mm on $479mm last year, plus $30-35mm of cost reductions. This would be conservative as management fully expects to grow revenue in the future given backhaul traffic growth and excellent microwave product portfolio and R&D team.

At 6x, $270mm EV would yield $6.62/share. That is my base case. D&A will be down $12mm annually so I am assuming $25mm in annual D&A and $15mm of annual capex, and 25% tax rate. At $45mm in EBITDA, that would be $15mm in net income, or $.25/share, and $25mm in FCF or $.42/share.

Please see below comp chart with Ceragon and Dragonwave. Ceragon is a better comp as Dragonwave is principally a WIMAX business even thought they are focused on expanding. DRWI blew up recently as its main customer Clearwire cut back its growth capex.

{My note: The table presented in the write-up is really “busy” and unreadable. Instead, just look up the EV/2010 Estimated EBITDA multiples of the two comps, CRNT and DRWI, on FirstCall. CRNT is trading at 12x and DRWI at 10x.}

* Bookings remain soft in Africa and N.A. doesn’t turn.
* Cost cutting cuts muscle, not just fat, hurting product portfolio, performance and company’s reputation.
* Huawei continues to take share with unprofitable bids.
* Continued pushout of deal closings and supply shortages causes further revenue weakness below $110-120mm quarterly.

* Achieving cost cutting program in size and on target, generating profitable quarters once again.
* Bookings and revenue growth return.
* Market recognizes turnaround and growth potential, assigning a reasonable earnings and sales multiple.

Long AVNW.

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Matt Schifrin’s Forbes “Buffetts next door” blog shines the spotlight on Tim Eriksen, one of Marketocracy’s best stock pickers (see his track record). Eriksen identifies a few stocks that I hold, and for the same reasons:

Vodafone (VOD). Vodafone is one of the world’s largest mobile communications providers in the world.  Vodafone owns 45% of Verizon Wireless, which it has not been getting any dividend from due to cash flow being used to pay down debt.  Verizon Wireless is expected to be debt free relatively soon, leaving the business with significant cash flow that can be distributed to the owners (Verizon and Vodafone). Shares trade at approximately 10 times earnings and the stock has a near 6% yield.

Reading International (RDI). RDI is in the business of owning and operating cinemas, as well as developing real estate in the U.S., Australia and New Zealand. RDI has 23 million shares outstanding and trades just under its book value of $4.85 per share.  It recently announced that it is selling a large property in Australia.  I believe the sale could bring close to $100 million, or a $50 million pre-tax gain.  The sale should increase book value by $1.50 per share.  More importantly the sale will provide the company with $80 million in cash, after taxes, which the company can use to reduce debt, develop other real estate parcels, and repurchase stock.

See the RDI archive here.

Long VOD and RDI.

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