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Greenbackd Portfolio Q1 performance and update

Posted in About, ARC Wireless Solutions (NASDAQ:ARCW), Arrhythmia Research Technology Inc (AMEX:HRT), Audiovox Corporation (NASDAQ:VOXX), Autobytel (NASDAQ:ABTL), Avigen (NASDAQ:AVGN), Axcelis Technologies Inc (NASDAQ:ACLS), Barnwell Industries (AMEX:BRN), Borders Group (NYSE:BGP), Chromcraft Revington (AMEX:CRC), Cobra Electronics Corporation (NASDAQ:COBR), CuraGen Corporation (NASDAQ:CRGN), Ditech Networks Inc (NASDAQ:DITC), Greenbackd, Greenbackd Portfolio, Ikanos Communications Inc (NASDAQ:IKAN), InFocus Corporation (NASDAQ:INFS), Kona Grill Inc (NASDAQ:KONA), MathStar Inc (OTC:MATH), Multimedia Games Inc (NASDAQ:MGAM), Network Engines Inc (NASDAQ:NENG), Neurobiological Technologies Inc (NASDAQ:NTII), Northstar Neuroscience Inc (NASDAQ:NSTR), OrthoLogic Corporation (NASDAQ:CAPS), Soapstone Networks Inc (NASDAQ:SOAP), Stocks, ValueVision Media (NASDAQ:VVTV), Zale Corporation (NYSE:ZLC), tagged , , , , , , , , , , , , , , , , on March 2, 2009| 10 Comments »

March 1, 2009 marked the end of Greenbackd’s first quarter, so we thought we’d take the opportunity to update you on the performance of the Greenbackd Portfolio and the positions in the portfolio, discuss some changes in our valuation methodology since our first post and outline the future direction of Greenbackd.com.

First quarter performance of the Greenbackd Portfolio

We get many questions about the content and performance of the portfolio. We had originally planned to report on a six-monthly basis, but we have now decided to report on a quarterly basis so that we can address these questions on a more frequent basis. Although it is still too early to determine how Greenbackd’s strategy of investing in undervalued asset situations with a catalyst is performing, we’ve set out below a list of all the stocks we’ve included in the Greenbackd Portfolio and the absolute and relative performance of each at the close on the last trading day in our first quarter, Friday, February 28, 2009:

greenbackd-portfolio-performance-2009-q13The absolute total return across the current and former positions as at February 28, 2009 was -3.7%, which was +7.0% higher than the S&P500’s return over the same periods. A negative return for the first period is disappointing, but we are heartened by the fact that we outperformed the market by a small margin.

You may have noticed something odd about our presentation of performance. The S&P500 index declined by 18.0% in our first quarter (from 896.24 to 735.09). Our -3.7% performance might suggest an outperformance over the S&P500 index of +14.3%. We calculate our performance on a slightly different basis, recording the level of the S&P500 index on the day each stock is added to the portfolio and then comparing the performance of each stock against the index for the same holding period. The Total Relative performance, therefore, is the average performance of each stock against the performance of the S&P500 index for the same periods. As we discussed above, the holding period for Greenbackd’s positions has been too short to provide any meaningful information about the likely performance of the strategy over the long term (2 to 5 years), but we believe that the strategy should outperform the market by a small margin.

Greenbackd’s valuation methodology

We started Greenbackd in an effort to extend our understanding of asset-based valuation described by Benjamin Graham in the 1934 Edition of Security Analysis. Through some great discussion with our readers, many of whom work in the fund management industry as experienced analysts or even managing members of hedge funds, we have had the opportunity to refine our process. We believe that what started out as a pretty unsophisticated application of Graham’s liquidation value methodology has evolved into a more realistic analysis of the balance sheet and the relationship of certain disclosures in the financial statements to asset value. We’re not yet ready to send it into space, but we believe our analyses are now qualitatively more robust than when we started and that has manifest itself quantitatively in better performance (more on this below).

The two main differences between our early analyses and our more recent ones are as follows (these are truly cringe-worthy, but that’s why we undertook the exercise):

  1. We didn’t take account of the effect of off-balance sheet arrangements and contractual obligations. This caused us to enter into several positions we should have avoided, including BGP and VVTV.
  2. We were using overly optimistic estimates for the recovery rates of assets in liquidation. For example, we started using 50% of Gross PP&E. We now use 20% of Net PP&E. We now apply Graham’s formula as the base case and deviate only when we believe that Graham’s formulation doesn’t reflect reality.

The effect of these two broad errors in analysis was to create several “false positives,” which is to say that we added stocks to the portfolio that wouldn’t have passed our current, more rigorous standards. The performance of those “false positive” stocks has been almost uniformly negative, and dragged down the performance of the portfolio. As an exercise, we went back through all the positions we have opened since we started the site and applied our current criteria, which are more stringent and dour than our earlier standards. We found that we would not have opened positions in the following eight stocks:

  • BRN (-13.1% on an absolute basis and +4.9% on a relative basis)
  • BGP (-10.8% on an absolute basis and -21.6% on a relative basis)
  • COBR (-17.1% on an absolute basis and +3.6% on a relative basis)
  • HRT (-25.3% on an absolute basis and -9.7% on a relative basis)
  • KONA (+87.8% on an absolute basis and +81.9% on a relative basis)
  • MGAM (-24.2% on an absolute basis and -5.0% on a relative basis)
  • VVTV (-25.0% on an absolute basis and -23.1% on a relative basis)
  • ZLC (-72.0% on an absolute basis and -61.1% on a relative basis)

It seems we got lucky with KONA, but the performance of the balance of the stocks was wholly negative. The performance across all stocks listed above was -12.5% on an absolute basis and -3.9% on a relative basis. Excluding these eight stocks from our portfolio (i.e. treating the portfolio as if we had not entered into these positions) would have resulted in a slightly positive absolute return of +0.7% and a relative performance over the S&P500 of +12.5%. This is a compelling reason to apply the more dour and rigorous standards.

We like to think we’ve now learned out lesson and the more dour and rigorous standards are here to stay. Set out below is an example balance sheet summary (for Chicago Rivet & Machine Co. (AMEX:CVR)) showing our present base case discounts from book value (circled in red):

example-summary-2

Readers will note that these are the same base case discounts from book value suggested by Benjamin Graham in the 1934 Edition of Security Analysis, more fully described in our Valuing long-term and fixed assets post under the heading “Graham’s approach to valuing long-term and fixed assets.” Why we ever deviated from these standards in the first place is beyond us.

Update on the holdings in the Greenbackd Portfolio

Leading on from our discussion above, four of the stocks we picked using the initial, overly optimistic criteria no longer meet our more stringent standards but haven’t yet been removed from the portfolio. We’re going to take our medicine now and do just that. To make it clear, these stocks aren’t being removed because the value has deteriorated, but because we made a mistake adding them to the portfolio in the first place. As much as we’d like to treat these positions as void ab initio (“invalid from the beginning”), we’re not going to do that. We’ve made a full accounting of the impact they’ve had on the portfolio in the First quarter performance of the Greenbackd Portfolio section above, but we don’t want them affecting our future performance. The stocks to be removed from the Greenbackd Portfolio and their absolute and relative returns are as follows:

  • BRN (-13.1% on an absolute basis and +4.9% on a relative basis)
  • HRT (-25.3% on an absolute basis and -9.7% on a relative basis)
  • MGAM (-24.2% on an absolute basis and -5.0% on a relative basis)
  • COBR (-17.1% on an absolute basis and +3.6% on a relative basis)

We’ll provide a more full discussion of where we went wrong with these stocks at a later date, but suffice it to say for present purposes that all were errors from the second bullet point in the Greenbackd’s valuation methodology section above (i.e. overly optimistic estimates for the recovery rates of assets in liquidation).

There are fifteen stocks remaining in the Greenbackd Portfolio:

Eight of these positions (ABTL, ACLS, ARCW, CAPS, CRC, CRGN, NSTR, and VOXX) are trading at or below our nominal purchase price and initial valuations. The remaining seven positions (AVGN, DITC, IKAN, MATH, NENG, NTII, and SOAP) are trading above our intial purchase price but are still at varying discounts to our valuations. We’ll provide a more full update on these positions over the course of this week.

The future of Greenbackd.com

We are going to trial some small changes to the layout of the site over the next few weeks. We’ve already made the first change: the newest comments now appear at the top of the list. We’ll also be amalgamating some pages and adding some new ones, including a page dedicated to tracking the portfolio with links to the analyses. We’re also considering some options for generating income from the site. At the moment, Greenbackd is a labor of love. We try to create new content every week day, and to get the stock analyses up just after midnight Eastern Standard Time, so that they’re available before the markets open the following day. More than 80% of the stocks that are currently trading at a premium to the price at which we originally identified them (NTII, SOAP, IKAN, DITC, NENG, MATH and AVGN) traded for a period at a discount to the price at which we identified them. This means that there are plenty of opportunities to trade on our ideas (not that we suggest you do that). If you find the ideas here compelling and you get some value from them, you can support our efforts by making a donation via PayPal.

We look forward to bringing you the best undervalued asset situations we can dig up in the next quarter.

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Barron’s A Golden Age for Activist Investing

Posted in About, Activist Investors, Catalysts, Greenbackd, Net Cash Stocks, Share buy-backs, Stocks, tagged , on February 16, 2009| 1 Comment »

Ken Squire argues in a feature article in this week’s Barron’s magazine, A Golden Age for Activist Investing (subscription required), that the “political climate, shareholder sentiment and opportunities available to activists” means that “the sun, the moon and the stars have moved into alignment for activist investing.” Squire believes that the knowledge that investors “can’t rely on the markets to create value, so they will have to create it themselves” will turn many formerly passive investors into “reluctant activists.”

Squire makes some interesting points:

1. We are witnessing “the largest spreads ever between price and value”

While we don’t accept that we are yet witnessing “the largest spreads ever between price and value,” we believe that we are getting close. On long-term measures of value (for example, Graham’s 10-year trailing P/E ratio and corporate profits as a proportion of GDP) market prices are well below average and approaching all time lows (See Future Blind‘s post Market Valuation Charts prepared in October last year when the S&P500 was around 1160). More on this at a later date. (Note that this is not a declaration that we are nearing the bottom. We think there’s a good chance the markets will over-correct to the downside and stocks will be undervalued for an extended period).

2. The “economic and political climate will make it much easier for activist investors to succeed”

Squire argues that the “economic crisis has eroded confidence in boards and corporate leadership” and “[shareholders] have less patience for laggard management, indecisiveness and missteps, and are more likely to support an activist.” We don’t disagree with these points, but we dispute that this necessarily translates into success. Incumbent directors have a huge advantage over alternate slates. See, for example, Carl Icahn’s argument that boards and managements are entrenched by state laws and court decisions that “insulate them from shareholder accountability and allow them to maintain their salary-and-perk-laden sinecures.”

3. The “impaired credit markets will make it difficult to implement financial-engineering solutions”

Squire believes the environment will force activists to “focus on operations, strategy and governance, rather than stock repurchases and special dividends”:

There are many companies whose operations or strategy fell short, and activists will identify them and implement plans to improve operations, cut costs and redirect investment.

This is a particularly interesting point. It’s clearly more difficult for an activist investor to articulate to stockholders the benefits of improvements in operations or a redirection of investment than it is to simply promise a dividend or a buy-back, which should in turn reduce their chance of getting on the board. This might suggest that impaired credit markets actually reduce an activist investor’s chance of success.

4. We will see a “significant increase in corporate/strategic acquisitions”

Squire argues that “corporate acquirers have a low cost of capital” which will “compensate in part for the void in private-equity buyouts”:

Activists not only will be open to discussing potential transactions with strategic acquirers, but often will seek them out. The activist-investor board member will want to be involved in negotiating the transaction to assure that stockholders receive the best value.

5. Companies with net cash will attract activist investors

Squire writes that activists will target exactly the type of investments Greenbackd favors:

Given today’s backdrop, many activists are expected to emphasize net cash as an inducement to invest. Large amounts of cash give a company the financial flexibility to withstand economic stress, and make it a more attractive takeover target. Abundant cash also may be an indication that the stock is mispriced. In many cases, price/earnings ratios have been gravitating toward 10, without regard to cash balances.

Based on the foregoing, it’s hard to disagree with Squire’s conclusion that 2009 will be “a busy and exciting year for shareholder activism.” It’s certainly very good news investors like us. Lest we get a reputation for being blind cheerleaders for activist investment as an end in and of itself, we’d like to emphasize that Greenbackd’s focus is undervalued asset situations with a catalyst and we’re almost agnostic as to the source of the catalyst. Our ideal situation is a management prepared to recognize the discount of price to value and undertake some step to unlock that value or remove the discount. We remain ever optimistic that all directors – including those of smaller companies outside the glare of the analyst coverage and the mainstream media – fully embrace their fiduciary duties to stockholders. Our experience is that this doesn’t often happen in the absence of an agitating stockholder. This is the real reason that formerly passive investors become “reluctant activists.” Not because they “can’t rely on the markets to create value” but because they can’t rely on some boards and managements not to destroy value.

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Fundamental Value Investors: Characteristics and Performance

Posted in About, Activist Investors, Greenbackd, Liquidation Value, Stocks, Warren Buffett, tagged , on February 13, 2009| 3 Comments »

The Manual of Ideas has a copy of Empirical Finance Research’s paper “Fundamental Value Investors: Characteristics and Performance” (.pdf). The paper examines the investment methods of professional value investors (defined as the members of the valueinvestorsclub.com) and concludes that value investing is a broad church encompassing many different styles, but predominantly consists of “Warren Buffett-style growth investors:”

We find that investors are overwhelmingly concerned with assessing intrinsic value. Discounted cash flow models, earnings multiples, GARP, and other similar valuation techniques are overwhelmingly used (87.50% include this analysis in their recommendation). Based on these results, professional value investors tend to be Warren Buffett-style growth investors…

The paper seems to quantitatively confirm our qualitative (read, baseless) assertion in the About Greenbackd page that “assets are a contrarian measure of value.” Less than a quarter of professional value investors incorporate the value of tangible assets in their investment decisions:

[A]pproximately 24% of value investors do incorporate the classic value technique of focusing on tangible asset undervaluation. The other favorite tools of value investors are open market repurchases (12.12%), the presence of net operating loss assets (5.29%), restructuring and spin-off situations (5.12%), and insider trading activity (4.70%).

The paper also indirectly tackles the question oft posed by commenters on this site which, incidentally, questions the very raison d’etre of Greenbackd: why opportunities to invest below liquidation value and alongside activist investors persist even after the filing of the 13D notice:

According to efficient market logic (Fama (1970)), the rational arbitrager should act alone, drive the price to the fundamental level, and reap all the rewards of the arbitrage he has found. Unfortunately, arbitragers find this difficult in practice. Two primary reasons for this are capital constraints and the limits to arbitrage arising from the realities in the investment management business (Shleifer and Vishny (1997)).

The paper is typical of Empirical Finance Research’s rigorous approach and well worth the effort.

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Walter Schloss, superinvestor

Posted in About, Greenbackd, Liquidation Value, Warren Buffett, tagged , , on January 29, 2009| 5 Comments »

Walter Schloss might be one of Benjamin Graham’s lesser-known disciples, but to Warren Buffett, perhaps Graham’s most famous disciple, Schloss is a “superinvestor.” In The Superinvestors of Graham-and-Doddsville, an article based on a speech Buffett gave at Columbia Business School on May 17, 1984 and appearing in Hermes, the Columbia Business School magazine, Buffett said of Schloss:

Walter never went to college, but took a course from Ben Graham at night at the New York Institute of Finance. Walter left Graham-Newman in 1955 and achieved the record shown here over 28 years.

Here is what ‘Adam Smith’ – after I told him about Walter – wrote about him in Supermoney (1972):

He has now connections or access to useful information. Practically no on in Wall Street knows him and he is not fed any ideas. He looks up the numbers in the manuals and sends for the annual reports, and that’s about it.

…

Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. He doesn’t worry about whether it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. He owns many more stocks than I do – and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.

This is Schloss’ record, extracted from Buffett’s article (click to go the article for the full-size table on page 7):

walter-schloss-record1

Over 28 1/4 years between 1955 and the first quarter of 1984 (when Buffett wrote the article), WJS Limited Partners returned 5,678.8% and in the WJS Partnership returned an astonishing 23,104.7%. Annualised, that’s 16.1% in WJS Limited Partners and 21.3% in the WJS Partnership. Both dwarf the S&P’s gain of 887.2% or 8.4% annually over the same period.

Fast forward 24 years to a February 2008 Forbes article titled, Experience:

Although he stopped running others’ money in 2003–by his account, he averaged a 16% total return after fees during five decades as a stand-alone investment manager, versus 10% for the S&P 500–Schloss today oversees his own multimillion-dollar portfolio with the zeal of a guy a third his age.

The Experience article highlights a few things about Schloss that we really like (mostly because they coincide with Greenbackd’s views on investing). First, he’s an asset investor:

“Most people say, ‘What is it going to earn next year?’ I focus on assets. If you don’t have a lot of debt, it’s worth something.”

Schloss had earlier discussed his preference for assets over earnings at the New York Society of Security Analysts (NYSSA) dedication of the Value Investing Archives in November 2007 (from the article NYSAA Value Investing Archive Dedication: Walter Schloss by Peter Lindmark):

“We try to buy stocks cheap.” His investment philosophy is based on equities which are quantitatively cheap and he often holds over 100 securities. Although he expounds that, “Each one is different. I don’t think you can generalize……But I think you just have to look at each situation on its own merits and decide whether it’s worth more than its asking price.” He prefers to buy assets rather than earnings. “Assets seem to change less than earnings.”

Second, as Buffett pointed out in his article, he’s not particularly interested in the nature of the business:

Schloss doesn’t profess to understand a company’s operations intimately and almost never talks to management. He doesn’t think much about timing–am I buying at the low? selling at the high?–or momentum.

Lindmark’s article also notes Schloss’ disinterest in the underlying business:

Mr. Graham simply did not care, and tried to purchase securities strictly on a quantitative basis. Mr. Schloss advocated buying decent companies with temporary problems. He stated, ” Warren understands businesses – I don’t. We’re buying in a way that we don’t have to be too smart about the business….”

Finally, we have to admit that we admire Schloss’ gentlemanly approach to running his business:

Typical work hours when he was running his fund: 9:30 a.m. to 4:30 p.m., only a half hour after the New York Stock Exchange’s closing bell.

You can see Schloss speaking here at the Ben Graham Center For Value Investing, Richard Ivey School of Business. Our favorite line:

If this doesn’t work, we can always liquidate it and get our money back.

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Changes to Greenbackd’s presentation of summary balance sheets

Posted in About, Greenbackd, Liquidation Value, Net Current Asset Value, Net Quick Value, tagged , , , on January 20, 2009| 4 Comments »

We are trialing a change to our summary presentation of company financial statements. The new summaries will look like this (this is our summary balance sheet for Aehr Test Systems (NASDAQ:AEHR) – it’s cheap but there’s no catalyst):

aehr-summary-changes

A brief explanation of the various changes:

  1. A. shows the carrying value of the receivables ($14.8M), our estimate for the percentage of carrying value the receivables will yield in liquidation (80%), the liquidating value ($11.8M) and the liquidating value per share ($1.41).
  2. B. shows the net current asset value ($25.5M), which, when added to the non-current asset value ($0.9M), gives the liquidating value for the company ($26.4M).
  3. C. is the same calculation as B. but on a per share basis: the net current asset value per share ($3.03), which, when added to the non-current asset value per share ($0.11), gives the liquidating value per share ($3.15).
  4. D. is the amount of stock the company has on issue.
  5. E. shows the liquidating value of the company ($26.4M), the net cash value of the company ($7.9M) and the market capitalization ($15.12M). In this instance, the company is trading at approximately 60% of our estimate of its liquidation value.
  6. F. shows the same amounts as E. on a per share basis against the stock price.
  7. G. and H. are the estimated liquidating value on a company and per share basis, and the net cash value on company and per share basis.

We’re keen to hear what you think of the changes. We think it presents the discount applied to the carrying values and the net current asset values more clearly than the previous summaries.

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Ramius Capital’s white paper: The case for activist strategies

Posted in About, Activist Investors, Catalysts, Greenbackd, tagged , on January 16, 2009| 1 Comment »

The New York Times’ Dealbook has a copy of Ramius Capital’s recent white paper, The case for activist strategies. The paper seeks to explain how activist investment strategies create shareholder value and improve corporate governance by resolving conflicts of interest between shareholders, directors and management.

Perhaps most interesting for Greenbackd readers is the paper’s discussion of the results of two recent comprehensive studies about the effectiveness of activist strategies:

The first, “Hedge Fund Activism, Corporate Governance and Firm Performance,” conducted by four university professors, analyzed nearly 800 activist events in the US from 2001 to 2006. The authors found that success or partial success was attained in nearly 2/3rds of the cases. The study highlighted that the target firm typically outperforms the market by 7% to 8% over a four-week period before and after announced activist campaigns by hedge funds. If this boost in performance was temporary and activist funds did little to generate value, the stock price would have reverted back over the course of the investment but the study concluded that this was not the case. The study also found that the highest market performance response to activist activities were when the stated objective was strategic in nature whether intending to sell the company, divest non-core assets, or refocus the business strategy. It also found that the effects of activist activities improved long term operational performance at target firms, demonstrated by ROE and ROA increases, while evidence of positive financial and corporate governance effects were observed in the form of increased dividend payouts and lowered CEO compensation. Another interesting conclusion was that hostile activism, which was found in roughly 30% of the cases, typically received more favorable market responses than non-hostile activism. The second, “Hedge Fund Activism” by April Klein, an associate professor at NYU, examined a sample group of 155 activist campaigns. Her conclusion was that in many cases the perceived threat of a proxy fight was sufficient for the activist to achieve its goal. This study reaffirmed many of the same conclusions as the previously mentioned study, including the abnormal stock returns surrounding the initial announcement. This study also found that the abnormal return of activist targets during the subsequent year was even greater, roughly 11%, confirming that activists generate returns significantly beyond the initial market reaction.

The paper concludes that both of the studies confirm that activism creates value, and can augment returns for traditional passive value investors. We think it confirms the value proposition of our approach to investing alongside activist investors in deep value situations.

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Portfolio construction

Posted in About, Greenbackd, Greenbackd Portfolio, Liquidation Value, Net Current Asset Value, Net Quick Stocks, Net Quick Value, Stocks, tagged , , on January 15, 2009| 2 Comments »

In our last post, we discussed our approach to long-term and fixed asset valuation. We concluded that, given our inability to actually value any given asset or class of assets, the best that we could do is fix a point at which we feel that we are more likely to be right than wrong about a stock’s value but would also have enough opportunities to invest. We argued that magic point for us in relation to property, plant and equipment is 50%, based on nothing more more than our limited experience. We acknowledge that this method will cause us to make many mistakes, so in this post we set out our method for protecting ourselves from those mistakes.

We try to protect ourselves from our mistakes in three ways:

  1. We try to buy at a substantial (i.e. more than 1/3) discount to our estimate of the written down value. Sometimes our valuation will be so wrong that the discount will be an illusion, and the real value will be well south of our estimate (maybe somewhere near Antarctica). In those instances, if the liquidation becomes a reality, we will lose money. In other instances, the real value will be higher than our estimate, and we will make money. Our hope is that the latter occurs more frequently than the former, but we are certain that the former will occur regularly.
  2. We try to buy a portfolio of these securities and we don’t concentrate too much of the portfolio in any one security. The more certain we are about a security, the larger the portion of the portfolio it will command. This means that net cash stocks that have ceased trading and are in liquidation or paying a special dividend take up a larger proportion of our portfolio than cash-burning industrials in liquidity crises with value wholly concentrated in property, plant and equipment (that said, at a big enough discount, they might take up a lot of the portfolio). This means that if any one stock, or even a handful of stocks, go to zero or thereabouts, they don’t destroy our entire stake and we can live to invest another day.
  3. We try to follow investors much smarter than we are. From our perspective, there’s no shame in riding on someone else’s coat-tails, especially when those coat-tails are on the back of someone smarter, better resourced and more experienced. This is one of the main reasons we only invest when we can see a Schedule 13D notice filed with the SEC (the other reason is that the 13D filing is the precursor to the catalytic event that removes the discount). Often, the 13D notice will set out the investor’s rationale for the investment, which may include their view on the stock’s valuation. While we always do our own research, we are comforted when we see other value-oriented investors in the stock, and we hope that experienced, professional, value investors are right more often than they are wrong (even though we know that they will also make mistakes).

The first method above attempts to limit the effect of an error in valuation on any given investment. We hope that if we’re wrong about the value, it’s only by a matter of degree, and we can salvage some value from the investment. The second limits the damage that a total, or near total, destruction of value in any one investment does to the portolio as a whole. The third is a check on our thought process. If we’re right about a situation, we’d expect to see investors smarter than we are already in the stock. If they’re not there, we’d have to look deep into the abyss before jumping in. We haven’t had to do that yet.

We hope that this better explains our approach to investment. Once again, we’re always keen to hear other points of view, or to have someone point out the obvious holes in the argument.

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Valuing long-term and fixed assets

Posted in About, Greenbackd, Liquidation Value, Net Cash Stocks, Net Current Asset Value, Net Net Stocks, Net Quick Stocks, Net Quick Value, tagged , , , , , , on January 15, 2009| 14 Comments »

We’ve recently received several questions about our valuation methodology. Specifically, readers have asked why we include property, plant and equipment in our valuation, and why we only discount it by half, as opposed to a higher figure (two-thirds, four-fifths, one-hundred percent). They are concerned that by including property, plant and equipment in our assessment, or by failing to apply a sufficient discount to those assets, we are overstating the asset or liquidation value of the companies we cover and therefore overpaying for their stock. In this post, we better describe our approach to asset valuation. In the next post, we deal with our method for protecting ourselves from overpaying for stock.

Our valuation methodology is closely based on Benjamin Graham’s approach, which he set out in Security Analysis and The Interpretation of Financial Statements. Like Graham, we have a strong preference for current assets, and, in particular, cash. As we mention on the About Greenbackd page, our favorite stocks are those backed by greenbacks, hence our name: Greenbackd. We love to find what Graham described as gold-dollars-with-strings-attached that can be purchased for 50 cents. We believe that there is value in long-term and fixed assets, although not necessarily the value at which those assets are carried in the financial statements. The appropriate discount for long-term and fixed assets is something with which we (and we suspect other Grahamite / asset / liquidation investors) struggle. We think it’s useful to consider Graham’s approach, which we’ve set out below:

Graham’s approach to valuing long-term and fixed assets

Graham’s preference was clearly for current assets, as this quote from Chapter XXIV of The Interpretation of Financial Statements: The Classic 1937 Edition demonstrates:

It is particularly interesting when the current assets make up a relatively large part of the total assets, and the liabilities ahead of the common are relatively small. This is true because the current assets usually suffer a much smaller loss in liquidation than do the fixed assets. In some cases of liquidation it happens that the fixed assets realize only about enough to make up the shrinkage in the current assets.

Hence the “net current asset value” of an industrial security is likely to constitute a rough measure of its liquidating value. It is found by taking the net current assets (or “working capital”) alone and deducting therefrom the full claims of all senior securities. When a stock is selling at much less than its net current asset value, this fact is always of interest, although it is by no means conclusive proof that the issue is undervalued.

Despite Graham’s cautionary tone above, he did not necessarily exclude long-term and fixed assets from his assessment of value. He did, however, heavily discount those assets (from Chapter XLIII of Security Analysis: The Classic 1934 Edition “Significance of the Current Asset Value”):

The value to be ascribed to the assets however, will vary according to their character. The following schedule indicates fairly well the relative dependability of various types of assets in liquidation.

liquidation-value-schedule2

Graham then set out an example valuation for White Motor Company:

In studying this computation it must be borne in mind that our object is not to determine the exact liquidating value of White Motor, but merely to form a rough idea of this liquidating value in order ascertain whether or not the shares are selling for less than the stockholders could actually take of the business. The latter question is answered very definitively in the affirmative. With a full allowance for possible error, there was no doubt at all that White Motor would liquidate for a great deal more than $8 per share or $5,200,000 for the company. The striking fact that the cash assets alone considerably exceed this figure, after deducting all liabilities, completely clinched the argument on this score.

white-motor-example1

Current-asset Value a Rough Measure of Liquidating Value. – The estimate values in liquidation as given for White Motor are somewhat lower in respect of inventories and somewhat higher as regards the fixed and miscellaneous assets than one might be inclined to adopt in other examples. We are allowing for the fact that motor-truck inventories are likely to be less salable than the average. On the other hand some of the assets listed as noncurrent, in particular the investment in White Motor Securities Corporation, would be likely to yield a larger proportion of their book values than the ordinary property account. It will be seen that White Motor’s estimated liquidating value (about $31 per share) is not far from the current-asset value ($34 per share). In the typical case it may be said that the noncurrent assets are likely to realize enough to make up most of the shrinkage suffered in the liquidation of the quick assets. Hence our first thesis, viz., that the current-asset value affords a rough measure of the liquidating value.

Greenbackd’s approach to valuing long-term and fixed assets

The first thing to note is that we’ve got no particular insight into any of the companies that we write about or the actual value of the companies’ assets. The valuations are based on the same generalized, unsophisticated, purely mathematical application of Graham’s formula. Further, if the actual value of an asset is objectively known or determinable, then we don’t know it and, in most cases, can’t determine it. That puts us at a disadvantage to those who do know the assets’ real value or can make that determination. Secondly, we can’t make the fine judgements about value that Graham has made in the White Motor example above. Perhaps it’s blindingly obvious that “motor-truck inventories are likely to be less salable than the average,” but we don’t know anything about motor-truck inventories or the average. It’s specific knowledge that we don’t have, which means that we are forced to mechanically apply the same discount to all assets of the same type.

Given that we’ve disclaimed any ability to actually value an asset or class of assets, why not adopt the lower to middle end of Graham’s valuation range for those assets? (Editors note: What a good suggestion. From here on in, we’re taking Graham’s advice. It’s simply because, in our experience, as idiosyncratic as it has been, an 80% discount to property, plant and equipment is too much in most instances. We think that 50% is a conservative estimate. In our limited experience, commercial and industrial real estate rarely seems to sell at much less than 15% below book value, and that’s in the recent collapse.) At first blush, specialist plant and equipment might appear to be worthless because the resale market is too small, but it can also be sold at a premium to its carrying value. For example, in the recent resources boom, we heard from an acquaintance in the mining industry that mining truck tires were so scarce as to sell in many instances at a higher price second hand than new. Apparently entire junked mining trucks were purchased in one country and shipped to another simply for the tires. Without that specialist knowledge of the mining industry, one might have ascribed a minimal value to an irreparable mining truck or a pile of used mining truck tires and missed the opportunity. What these examples demonstrate, in our opinion, is that the sale price for an asset to be sold out of liquidation is extremely difficult to judge until the actual sale, by which time it’s way too late to make an investment decision.

The best that we can do is fix a point at which we feel that we a more likely to be right than wrong about the value but will also have enough opportunities to invest to make the exercise worthwhile. For us, that point is roughly 20% 50% for property, plant and equipment. That 20% 50% is not based on anything more than (Edit: Graham’s formula, which has stood the test of time and should be applied in most cases unless one has a very good reason not to do so our limited experience, which is insufficient to be statistically significant for any industry or sector, geographical location or time in the investment cycle.) We always set out for our readers our estimate so that you can amend our valuation if you think it’s not conservative enough or just plain wrong (if you do make that amendment, we’d love to hear about it, so that we can adjust our valuation in light of a better reasoned valuation).

We hope that this sheds some light on our process. We’d love to hear your thoughts on the problems with our reasoning.

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Greenbackd to become Seeking Alpha contributor

Posted in About, Greenbackd, tagged on January 13, 2009| 2 Comments »

We are pleased to announce that Greenbackd is to become a contributor to Seeking Alpha, which bills itself as “the premier financial website for actionable stock market opinion and analysis.”

Read more about Seeking Alpha here.

The gold Seeking Alpha badge to the right indicates Greenbackd has agreed in writing to abide by Seeking Alpha’s full compliance standards, which are listed below:

1. Author Qualification

* Authors attest that they have never been prosecuted for or sued about any securities-related issue, and that they have never been barred from the securities industry or convicted of a felony.

2. Disclosure of Positions

* Authors agree to disclose the existence at the time of writing of a long or short position (including stocks, options or other instruments) in any stock mentioned in an article. The suggested form of disclosure is to add the following to the bottom of articles: Full disclosure: Long GOOG at time of writing.
* Authors may not write about a stock with the intention to boost or reduce the stock’s price and sell (or buy) the stock into the resulting strength or weakness.
* If the author intends at the time or writing to sell or buy a stock within three days of publication of an article that discusses that stock, the author must disclose this.

3. Disclosure of Conflicts of Interest

* Authors agree to disclose any material relationships with companies whose stocks they write about or parties that stand to gain in any way from the viewpoint they are outlining. Examples: authors must disclose if they are employed by a company whose stock they are writing about; perform consulting for a company they write about; receive paid advertising revenue or any other form of sponsorship fee from a company they write about. This applies to narrow asset classes as well. For example, if an author is paid to promote a gold dealer, that must be disclosed in any article about gold.

4. Non-Infringement of Copyright

* Authors must attest that any articles submitted for publication to Seeking Alpha are their own work and do not infringe upon the rights of any other party. If other sources are quoted, the source must be cited and the quote must be within fair use.

5. Commitment to Accuracy

* Authors must certify that all facts in articles submitted to Seeking Alpha are accurate to the best of his/her knowledge.

6. Inappropriate Promotion and Other Material

* Authors’ web sites, which Seeking Alpha will be asked to link to, may not contain any illegal or  offensive material, such as racism and pornography.
* Authors must substantiate any claims about their investment track records on their web sites, if such a claims are made.
* Authors may not make any guarantees or explicit predictions regarding the market performance that subscribers to their paid newsletters can expect.
* Authors’ web sites must not contain misleading or excessively promotional language.

7. Anonymity and Accountability

* Authors must provide their real names and contact information to Seeking Alpha, even if they intend their articles to be published anonymously.

We hope that the association with Seeking Alpha is a profitable one. We will continue to post articles here first.

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Welcome back for 2009 and update on Greenbackd Portfolio holdings

Posted in About, Autobytel (NASDAQ:ABTL), Avigen (NASDAQ:AVGN), Barnwell Industries (AMEX:BRN), Borders Group (NYSE:BGP), Chromcraft Revington (AMEX:CRC), Greenbackd, Greenbackd Portfolio, InFocus Corporation (NASDAQ:INFS), Kona Grill Inc (NASDAQ:KONA), MathStar Inc (OTC:MATH), Stocks, ValueVision Media (NASDAQ:VVTV), Zale Corporation (NYSE:ZLC), tagged , , , , , , , , , on January 5, 2009| Leave a Comment »

Welcome back to Greenbackd and happy new year for 2009. We hope that you had a good break. There have been a number of positive developments in the companies we discussed last year. Set out below is an update on those positions we had open in the Greenbackd Portfolio at the close of 2008:

  • Trilogy has increased its stake in ABTL to 7.4%. ABTL is up 18.6% since our first post but we are maintaining our position because we think it’s still worth 50% more.
  • BVF has endorsed the MNOV offer for AVGN. AVGN is up 20% since our first post but we are holding on because we think the merger presents an opportunity for AVGN’s stockholders to receive around $1.20 per share in cash (almost 60% higher than AVGN’s $0.78 close Friday) and the possibility of “an extraordinary, uncapped return” if MNOV is successful post-merger.
  • BRN has filed its September 10Q and we believe that its liquidation value has increased from $6.52 per share to $6.91 per share. The stock is up 41% since our initial post. We still see the liquidation value some 40% higher than BRN’s Friday close of $4.95, so we will maintain our position.
  • CRC is down 6.3% from our initial post. Other than the retirement of the CFO, we have no other news to report. With CRC in a liquidity crisis, the retirement of the CFO is a worrying development. That said, we see CRC’s liquidation value at around $2.45 per share, which is more than 450% higher than its Friday close of $0.43, so we propose to maintain our position.
  • A group of “high-powered executives” plan to save INFS from “New York sharks.” The stock is up 15.9% to $0.73 since our initial post. Its liquidating value is still some 58% higher at $1.15 per share and so we are maintaining the position.
  • We’ve closed our position in KONA for an 88% gain in 18 days.
  • A new activist investor has filed a 13D for MATH and is lobbying the company to liquidate. MATH is up 17.7% since our first post but it’s still trading at half its liquidating value and a little more than half its net cash backing, so we’re maintaining our position.
  • ZLC is off 16.8% from our initial post. We’ve estimated its liquidation value at $7.63 per share, which is still 90% higher than its $4.01 close Friday, so we are maintaining our position in ZLC.

Although it is still too early to determine how Greenbackd’s strategy of investing in undervalued asset situations with a catalyst is performing, we’ve set out below a list of all the stocks we’ve included in the Greenbackd Portfolio and the absolute and relative performance of each. This is the standardized format we propose to adopt to track Greenbackd’s performance at 6-monthly intervals:

Current holdings (As at January 5, 2009)

greenbackd-portfolio-current-holdings-performance

Former holdings (As at date of our closure of the position)greenbackd-portfolio-former-holdings-performance

The absolute total return across the current and former positions as at January 5, 2009 is 14.2%, which is 8.4% higher than the S&P500’s return over the same periods. As we discussed above, the holding periods for Greenbackd’s positions has been too short to provide any meaningful information about the likely performance of the strategy over the long term (2 to 5 years), but we believe that the strategy should outperform the market by a small margin.

We look forward to bringing you the best undervalued asset situations we can dig up in 2009.

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