Archive for the ‘Liquidation’ Category

The CFAInstitute blog Inside Investing has a great post on the returns to negative enterprise value stocks. Alon Bochman, CFA has investigated the performance of all negative enterprise value (“EV”) stocks trading in the United States between March 30, 1972 and September 28, 2012. He used balance sheet data from Standard & Poor’s Compustat database and merged these data with price data from the database maintained by the Center for Research in Security Prices (CRSP). He then calculated historical EVs for every company every month, as well as matching forward 12-month returns. Says Alon:

I found 2,613 stocks that at one point or another traded at a negative enterprise value between 1972 and 2012 (Microsoft, unfortunately, was not among them). The list has one entry per stock-month. That is, a stock that has traded at a negative enterprise value three months in a row will appear on the list three times. Each time is a different investment opportunity with its own forward 12-month return. The average stock spent 10.17 months (not necessarily consecutive) in negative EV territory. Thus, the list shows a total of 26,569 opportunities to invest in negative EV stocks.

The average return across all 26,569 opportunities was 50.4%. That is, if you had diligently watched the market over the last 40 years and invested $1,000 into each negative EV stock each month, your average investment would be worth $1,504 after holding that investment for one year, not including trading costs, taxes, and so on. Not bad!

Most of the opportunities are in micro caps with limited liquidity:

Returns by Market Cap -- Negative EV Investing

Alon notes that these opportunities have come up with some regularity and have usually provided attractive returns but have on occasion lost a great deal as well:

Average 12M Returns on Negative EV Stocks by Entry Year

Read Returns on Negative Enterprise Value Stocks: Money For N0thing?

Order Quantitative Value from Wiley FinanceAmazon, or Barnes and Noble.

Click here if you’d like to read more on Quantitative Value, or connect with me on LinkedIn.


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FT.com’s Lex has an article (Sara Lee in play) on a possible bid for the food conglomerate Sara Lee (NYSE:SLE) by the old barbarians at the gates, Kohlberg Kravis Roberts:

Of course, a bid now might be opportunistic. Sara Lee has been without the architect of its restructuring since chief executive Brenda Barnes retired due to illness in August. Asset sales have brought debt down to moderate levels. And there is always a good price for a bad business. Sara Lee trades on about seven times prospective earnings before interest, tax, depreciation and amortisation – well below the double-digit multiples typical for attractive consumer goods acquisitions.

However, it is hard to see what might better be done with a collection of commoditised food businesses (bakery, meat processing and food service) and a low-growth coffee arm. Overall profitability has barely varied from a steady 8 per cent operating margin in two decades. Disposing of the North American bakery business, as management plans, should cause that to jump to 12 per cent, calculates CreditSights. But any sale also involves handing care of part of the Sara Lee brand to a third party, and buyers have not rushed to snap up an operation with expensive unionised labour. There seems little reason to linger at the gate.

I don’t think Lex will be buying the stock, but it’s still interesting. A portfolio of good brands with some commodity businesses thrown into the mix at ~7 times EBITDA. KKR could buy it, sell off the commodity businesses and do something with the brands (I don’t know, what am I, a PE guy?). It might be worth doing some work. Anybody got a buyout analysis they’d care to share?

No position.

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Charlie Rose has a fantastic interview with Wilbur Ross, who played Willy Tanner (the dad) on Alf before becoming an investor in distressed businesses, most notably in the coal, steel and auto parts industries. This profile describes Ross’s start thus:

In 2001, when LTV, a bankrupt steel company based in Cleveland, decided to liquidate, Ross was the only bidder. Ross suspected that President Bush, a free trader, would soon enact steel tariffs on foreign steel, the better to appeal to prospective voters in midwestern swing states. So in February 2002, Ross organized International Steel Group and agreed to buy LTV’s remnants for $325 million. A few weeks later, Bush slapped a 30 percent tariff on many types of imported steel—a huge gift. “I had read the International Trade Commission report, and it seemed like it was going to happen,” said Ross. “We talked to everyone in Washington.” (Ross is on the board of News Communications, which publishes The Hill in Washington, D.C.)

With the furnaces rekindled, LTV’s employees returned to the job, but under new work rules and with 401(k)s instead of pensions. A year later, Ross performed the same drill on busted behemoth Bethlehem Steel. Meanwhile, between the tariffs, China’s suddenly insatiable demand for steel, and the U.S. automakers’ zero-percent financing push, American steel was suddenly red hot. The price per ton of rolled steel soared, and in a career-making turnaround, Ross took ISG public in December 2003.

After pulling off a quick turnaround in the twentieth century’s iconic business—steel—Ross set about doing the same with the troubled iconic industry of the nineteenth century. In October 2003, he outdueled Warren Buffett for control of Burlington Industries, a large textile company that failed in late 2001. In March 2004, he snapped up Cone Mills, which, like Burlington, was based in Greensboro, North Carolina, and bankrupt. As with the steel companies, the PBGC took over some of the pensions, the unions made concessions, and thousands of laid-off workers were recalled. Most important, debt was slashed. Today, International Textile Group has just about $50 million in debt, less than the two companies were paying in interest a few years ago.

In the Charlie Rose interview Ross discusses his analysis of LTV, which is basically a classic Graham net current asset value analysis:

Ross: We’re in the business not so much of being contrarians deliberately, but rather we like to take perceived risk instead of actual risk. And what I mean by that is that you get paid for taking a risk that people think is risky, you particularly don’t get paid for taking actual risk. So what we had done we analysed the bid we made, we paid the money partly for fixed assets, we basically spent $90 million for assets on which LTV had spent $2.5 billion in the prior 5 years, and our assessment of the values was that if worst came to worst we could knock it down and sell it to the Chinese. Then we also bought accounts receivable and inventory for 50c on the dollar. So between those combination of things, we frankly felt we had no risk.

Charlie Rose: And then next year you bought Bethlehem.

Ross: Yes, but before that even, what happened, out came BusinessWeek asking, “Is Wilbur Ross crazy?”

The joke was, right when everybody was saying, “This is too risky. It’ll never work,” the big debate in our shop was, “Should we just liquidate it and take the profit or should we try to start it up?” That’s how sure we were that we weren’t actually taking a risk, but I wanted to start it up because if you liquidate it you make some money, but you wouldn’t change the whole industry and you wouldn’t make a large sum as we turned out to do.

Watch the interview.

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Sahm Adrangi and Jeff Borack of Kerrisdale Capital have provided a guest post on Coventree Inc. (TSXV:COF.H). Kerrisdale Capital  is a private investment manager that focuses on value and special situations investments. Here’s their take on COF.H:

Coventree Inc. is a liquidation-oriented investment. When it was operational, the company was a Canadian specialty finance company that would package and sell non-bank asset-backed commercial paper. When the asset-backed commercial paper market shut down in August 2007 because of the credit crunch, Coventree ceased operations and announced that it would wind down its business. Management intends to distribute net proceeds to shareholders. Before it can do that, however, it must resolve ongoing litigation with the Ontario Securities Commission. Based on our estimates of Coventree’s potential liability from the lawsuits, ongoing expenses and timing of the litigation / distributions, we think that shares of Coventree are attractive.

Accounts managed by Kerrisdale currently hold Coventree stock, and we may buy or sell shares at any time. We will not disclose our sale if and when we sell, and we will not necessarily disclose that we have changed our thesis if we discover something faulty with our analysis at a later date.

All dollar amounts in this analysis are in Canadian dollars. Coventree trades on the Toronto Stock Exchange.


Coventree most recently published financial statements on May 6th for the period ending March 31, 2010:

The company has $84mm of cash. It has $5mm of Other Investments which are comprised of shares of Xceed Mortgage Corp., a publicly traded company on the Toronto Stock Exchange. The $3mm of promissory notes on the assets side of the balance sheet are offset by $3mm of limited recourse debentures on the liabilities side.

To be conservative, we’ll use a zero value for restricted cash, accounts receivable, other assets and income taxes receivable. That leaves us with a Net Asset Value of $85mm for Coventree. Here are the relevant adjustments and pro forma “Shareholders equity”, which equates to our Net Asset Value as of March 31, 2010.

Potential Losses

Our net asset value will be reduced by potential losses from the Ontario Securities Commission (OSC) case, legal expenses, and ongoing administrative costs. The potential loss from the OSC case will likely be lump-sum, while the legal expenses and administrative costs will probably be ongoing until distributions are made.

First we’ll deal with the lump-sum litigation expenses regarding the outcome of the OSC trial. In the Statement of Allegations, we see four primary allegations, two of which are substantially the same.

  • Coventree failed to disclose the fact that the third party rating service it relied upon for credit ratings “adopted more restrictive credit rating criteria”.
  • Coventree misled investors regarding exposure to US subprime housing markets.
  • Coventree failed to disclose liquidity-related disruptions to the market in a timely fashion.

We can see in the Canadian Securities Act that the maximum penalty for these offenses is the greater of $5mm or triple the profit made or losses avoided as a result of prohibited actions. It would be difficult to prove that the allegations resulted in Coventree making a profit or avoiding losses, so it seems like even in the worst case scenario, Coventree would be penalized $20mm ($5mm for four allegations). If this results in a $20mm loss, the equity per share is still ~$4.30. Coventree would therefore need to incur an additional $10mm of legal and liquidation expenses (compared to $2.2mm of legal expenses in the first quarter) for Coventree investors to realize a loss.

Here is a link to an article from the Canadian Press claiming that Coventree refused a $12mm settlement offer. As our base-case scenario, we’re going to assume that losses (excluding legal fees) total $12mm. Upside scenarios exist, including the possibility that COF is acquitted of all charges and is awarded a restitution payment to cover at least a portion of their legal fees. Reporters at the hearing have indicated to us that the facts of the case as presented in the opening hearings seem to favor Coventree. But the hearings are ongoing and will continue for the next few weeks. A schedule can be found on the OSC website.

Other expenses include legal fees, which will likely continue for the next few quarters, and some managerial fees. We will assume (and we believe this is conservative) that legal expenses continue to be $2mm per quarter until the end of 2010, and then subside. We estimate managerial fees will continue to be $530k per quarter for as long as the company takes to liquidate.

On the upside, one source of funds for the company is a pair of insurance policies protecting the directors and officers against securities claims. One policy provides coverage for $1mm minus a $35k retention, and the other provides $5mm with a $500k retention. The insurer with the $1mm limit has advised that it will provide coverage for a portion of the defense expenses up to the limit of the policy. Negotiations with both insurers are ongoing. Because of this D&O insurance, it is possible that a portion of the legal fees will be returned even if COF loses the case.


Coventree has agreed not to make any distributions until the OSC case has been settled and they have redundantly agreed to give the OSC 45 days notice before any distributions are made. Proceedings are expected to continue into October and November of this year.


The assumptions behind our valuation table below include $2mm quarterly legal fees for the next 3 quarters and then smaller fees in subsequent quarters; a $530k quarterly expense indefinitely; a lump-sum litigation loss of $12mm; the smaller insurance policy paying out; and a discount rate of 15%. Below is the per-share present value of COF based on the quarter in which a distribution occurs (note that distributions will probably be made in multiple installments, whereas we are assuming a single lump-sum distribution):

If a distribution occurs in the first quarter of 2011, investors who buy at $3.74 will realize a 15% return on investment. But we also see that the NAV never falls below the present market cap of approximately $57mm, meaning investors wouldn’t suffer a real loss unless a) litigation losses are greater than we expect or b) this drags on far beyond 2012. If COF is acquitted, legal fees are returned by a cost order or insurance payout, and liquidation comes in the first quarter of 2011, shareholders could see a nearly 50% annualized return. Not bad for an investment uncorrelated with the rest of the market and with limited downside risk.


In conclusion, we’re expecting a return in the range of 15% with limited risk of loss and some respectable upside scenarios. The main risk is the opportunity cost as this is an illiquid investment and investors might not have an easy time getting out, especially if negative news is released regarding proceedings. But for investors with a 2-year+ time horizon, COF is a nice alternative to cash.

As usual, this email does not constitute investment advice or a recommendation of any sorts. Kerrisdale Capital may buy, sell or short any of the stocks mentioned at any time. I may be wrong; it would not be the first or last time.



[Full Disclosure:  I do no hold COF.H. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]

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Michael B. Rapps of Geosam Capital Inc has provided a guest post on WGI Heavy Minerals Inc (TSE:WG).

Michael recently joined Geosam Capital Inc., a Toronto-based private equity firm that focuses on small-capitalization activist investments and distressed debt investments. Prior to joining Geosam Capital Inc., he practiced law for 3 1/2 years at Davies Ward Phillips & Vineberg LLP where he focused on M&A and securities law. He is a graduate of McGill University with a BCL and L.LB (Bachelors of Civil and Common Laws).

Here’s his take on WGI Heavy Minerals Inc (TSE:WG):

WGI Heavy Minerals (“WGI”) operates two businesses: (i) the mining and sale of abrasive minerals; and (ii) the sale of aftermarket replacement parts for ultrahigh pressure waterjet machine cutting systems. WGI trades at $0.40/share on the Toronto Stock Exchange under the symbol “WG”. There are 23,617,610 shares outstanding for a market cap of approximately $9.4 million. I believe the upside in WGI’s share price is at least +65% and the downside is at least +22%.

Abrasive Minerals

WGI’s principal mineral product is garnet, which is used as an abrasive in sandblast cleaning and waterjet cutting of metals, stone, concrete, ceramics, and other materials. The majority of the company’s garnet is supplied pursuant to a distribution agreement with an Indian supplier that was formerly owned by WGI (WGI sold this company in 2008 and distributed the proceeds of the sale, together with a portion of its cash on hand, to shareholders). The distribution agreement guarantees WGI a supply of a minimum amount of garnet annually, with additional amounts to be supplied as mining capacity expands. This distribution agreement expires at the end of 2016. WGI also obtains garnet from its own mining operations in Idaho. Abrasive minerals represent 80-85% of WGI’s sales.

Waterjet Parts

WGI manufactures and distributes aftermarket replacement parts for ultrahigh pressure waterjet cutting machines under the “International Waterjet Parts” brand. Waterjet machines are used to cut a variety of materials using a thin, high pressure stream of fluid, often in very intricate and complex shapes. Waterjet technology continues to improve and take market share from older technologies, such as saws. According to WGI, the company competes in this market with OEMs, such as Flow International, Omax, Jet Edge, KMT and Accustream. Waterjet parts represent 15-20% of WGI’s sales.

Book and Liquidation Value

Below is an estimate of WGI’s book value and liquidation value:

Assuming additional liquidation costs of $500,000, the liquidation value would be reduced to $0.54/share (or $0.49/share on a diluted basis). As you can see, WGI trades at a meaningful discount to both its estimated liquidation value and its book value.


I generally prefer to rely on tangible asset values than estimates of future profitability when looking at an investment opportunity. In this case, WGI trades substantially below its book and liquidation values. However, it is also profitable. In 2009, WGI generated EBITDA of $1,896,449 as follows:

This implies an EV/EBITDA multiple of 1.8. Investors can argue about what an appropriate multiple is, but we would likely all agree that this multiple is too low. Applying an EV/EBITDA multiple of 5.0 (for the sake of conservatism), WGI’s equity value per share is $0.66/share (65% upside).


WGI has two large shareholders. Jaguar Financial Corporation owns 3,777,100 shares representing 16% of the outstanding shares (acquired at $0.35/share). Cinnamon Investments Limited owns 3,098,500 shares, representing 13.1% of the outstanding shares (a portion of these shares was acquired as recently as January 2010 at $0.41/share).

Jaguar is known in Canada as an activist investor and has launched a number of proxy contests and take-over bids to unlock value at Canadian companies. Jaguar recently successfully challenged the acquisition of Lundin Mining by Hudbay Minerals. In Q4 2009, Jaguar obtained a seat on WGI’s board and pushed for WGI to use a portion of it cash to repurchase shares, which it did in December 2009 (at a price of $0.395/share).

At WGI’s upcoming annual meeting, I would expect Jaguar and Cinnamon to vote against the confirmation of WGI’s shareholder rights plan. The plan was adopted after Jaguar announced its acquisition of shares but prior to the time Jaguar received a board seat. With 29.1% of WGI’s shares voting against the rights plan, there is a decent chance the rights plan will be defeated, allowing Jaguar to launch a take-over bid for WGI in order to put them in play (a tactic they use routinely). I would also expect Jaguar to push WGI to take additional value-enhancing actions, such as additional share buybacks, and for its patience to run out if such actions are not undertaken in the near term.


The principal risk I see in WGI relates to its Idaho mining operations. WGI’s disclosure indicates that the mineral resource at WGI’s operating mine in Idaho has been declining in recent years. Accordingly, WGI is undertaking exploration (and eventual development) of the lands contiguous to its current mine, which it believes contain additional garnet. A complete depletion of the existing garnet would negatively affect WGI as its Idaho mine currently contributes approximately 17% of revenues (although WGI increased the amount of garnet it receives annually from India last year, so this percentage should be lower now). Additionally, significant expenditures on exploration and development would reduce WGI’s cash on hand.


Given that WGI is a profitable and growing company, I would argue that WGI should trade at least at its book value (67-85% upside on a diluted/non-diluted basis) and we should look at its liquidation value to determine our downside protection (22-35% upside). On an EV/EBITDA basis, WGI should also trade at a minimum of $0.66/share, providing upside of at least 65%. In the case of an acquisition of each of WGI’s divisions, the upside could be even greater.

[Full Disclosure: I do not hold a position in WGI. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]

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Farukh Farooqi, long-time supporter of Greenbackd, founder of Marquis Research, a special situations research and advisory firm (for more on Farukh and his methodology see The Deal in the article “Scavenger Hunter”) and Greenbackd guest poster (see, for example, Silicon Storage Technology, Inc (NASDAQ:SSTI) and the SSTI archive here) has launched a blog, Oozing Alpha. Says Farukh:

Oozing Alpha is a place to share event driven and special situations with the institutional investment community.

We welcome and encourage you to submit your top ideas (farukh@marquisllc.com).

The only limitation we impose is that your recommendations should not be widely covered by the sell side and must not have an equity market capitalization greater than $1 billion.

The ideas will no doubt be up to Farukh’s usual high standards. The blog is off to a good start: the color scheme is very attractive.

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Jon Heller of the superb Cheap Stocks, one of the inspirations for this site, has published the results of his two year net net index experiment in Winding Down The Cheap Stocks 21 Net Net Index; Outperforms Russell Microcap by 1371 bps, S&P 500 by 2537 bps.

The “CS 21 Net/Net Index” was “the first index designed to track net/net performance.” It was a simply constructed, capitalization-weighted index comprising the 21 largest net nets by market capitalization at inception on February 15, 2008. Jon had a few other restrictions on inclusion in the index, described in his introductory post:

  • Market Cap is below net current asset value, defined as: Current Assets – Current Liabilities – all other long term liabilities (including preferred stock, and minority interest where applicable)
  • Stock Price above $1.00 per share
  • Companies have an operating business; acquisition companies were excluded
  • Minimum average 100 day volume of at least 5000 shares (light we know, but welcome to the wonderful world of net/nets)
  • Index constituents were selected by market cap. The index is comprised of the “largest” companies meeting the above criteria.

The Index is naïve in construction in that:

  • It will be rebalanced annually, and companies no longer meeting the net/net criteria will remain in the index until annual rebalancing.
  • Only bankruptcies, de-listings, or acquisitions will result in replacement
  • Does not discriminate by industry weighting—some industries may have heavy weights.

If a company was acquired, it was not replaced and the proceeds were simply held in cash. Further, stocks were not replaced if they ceased being net nets.

Says Jon of the CS 21 Net/Net Index performance:

This was simply an experiment in order to see how net/nets at a given time would perform over the subsequent two years.

The results are in, and while it was not what we’d originally hoped for, it does lend credence to the long-held notion that net/nets can outperform the broader markets.

The Cheap Stocks 21 Net Net Index finished the two year period relatively flat, gaining 5.1%. During the same period, The Russell Microcap Index was down 8.61%, while the Russell Microcap Index was down 9.9%. During the same period, the S&P 500 was down 20.27%.

Here are the components, including the weightings and returns of each:

Adaptec Inc (ADPT)
Weight: 18.72%
Computer Systems
Audiovox Corp (VOXX)
Weight: 12.20%
Trans World Entertainment (TWMC)
Retail-Music and Video
Finish Line Inc (FINL)
Nu Horizons Electronics (NUHC)
Electronics Wholesale
Richardson Electronics (RELL)
Electronics Wholesale
Pomeroy IT Solutions (PMRY)
Ditech Networks (DITC)
Communication Equip
Parlux Fragrances (PARL)
Personal Products
InFocus Corp (INFS)
Computer Peripherals
Renovis Inc (RNVS)
Leadis Technology Inc (LDIS)
Semiconductor-Integrated Circuits
Replidyne Inc (RDYN) became Cardiovascular Systems (CSII)
[Edit: +126.36%]
Tandy Brands Accessories Inc (TBAC)
Apparel, Footwear, Accessories
FSI International Inc (FSII)
Semiconductor Equip
Anadys Pharmaceuticals Inc (ANDS)
MediciNova Inc (MNOV)
Emerson Radio Corp (MSN)
Handleman Co (HDL)
Music- Wholesale
Chromcraft Revington Inc (CRC)
Charles & Colvard Ltd (CTHR)
Jewel Wholesale

Cash Weight: 8.58%

Jon is putting together a new net net index, which I’ll follow if he releases it into the wild.

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Jae Jun at Old School Value has a great post, NCAV NNWC Screen Strategy Backtest, comparing the performance of net current asset value stocks (NCAV) and “net net working capital” (NNWC) stocks over the last three years. To arrive at NNWC, Jae Jun discounts the current asset value of stocks in line with Graham’s liquidation value discounts, but excludes the “Fixed and miscellaneous assets” included by Graham. Here’s Jae Jun’s NNWC formula:

NNWC = Cash + (0.75 x Accounts receivables) + (0.5 x  Inventory)

Here’s Graham’s suggested discounts (extracted from Chapter XLIII of Security Analysis: The Classic 1934 Edition “Significance of the Current Asset Value”):

Excluding the “Fixed and miscellaneous assets” from the NNWC calculation provides an austere valuation indeed (it makes Graham look like a pie-eyed optimist, which is saying something). The good news is that Jae Jun’s NNWC methodology seems to have performed exceptionally well over the period analyzed.

Jae Jun’s back-test methodology was to create two concentrated portfolios, one of 15 stocks and the other of 10 stocks. He rolled the positions on a four-weekly basis, which may be difficult to do in practice (as Aswath Damodaran pointed out yesterday, many a slip twixt cup and the lip renders a promising back-tested strategy useless in the real world). Here’s the performance of the 15 stock portfolio:

“NNWC Incr.” is “NNWC Increasing,” which Jae Jun describes as follows:

NNWC is positive and the latest NNWC has increased compared to the previous quarter. In this screen, NNWC doesn’t have to be less than current market price. Since the requirement is that NNWC is greater than 0, most large caps automatically fail to make the cut due to the large quantity of intangibles, goodwill and total debt.

Both the NNWC and NNWC Increasing portfolios delivered exceptional returns, up 228% and 183% respectively, while the S&P500 was off 26%. The performance of the NCAV portfolio was a surprise, eeking out just a 5% gain over the period, which is nothing to write home about, but still significantly better than the S&P500.

The 10 stock portfolio’s returns are simply astonishing:

Jae Jun writes:

An original $100 would have become

  • NCAV: $103
  • NNWC: $544
  • NNWC Incr: $503
  • S&P500: $74

That’s a gain of over 400% for NNWC stocks!

Amazing stuff. It would be interesting to see a full academic study on the performance of NNWC stocks, perhaps with holding periods in line with Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update for comparison. You can see Jae Jun’s Old School Value NNWC NCAV Screen here (it’s free). He’s also provided a list of the top 10 NNWC stocks and top 10 stocks with increasing NNWC in the NCAV NNWC Screen Strategy Backtest post.

Buy my book The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market from on Kindlepaperback, and Audible.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on The Acquirer’s Multiple, or connect with me on Twitter, LinkedIn or Facebook. Check out the best deep value stocks in the largest 1000 names for free on the deep value stock screener at The Acquirer’s Multiple®.


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Regular readers of Greenbackd know that I’m no fan of “the narrative,” which is the story an investor concocts to explain the various pieces of data the investor gathers about a potential investment. It’s something I’ve been thinking about a great deal recently as I grapple with the merits of an investment in Japanese net current asset value stocks. The two arguments for and against investing in such opportunities are as follows:

Fer it: Net current asset value stocks have performed remarkably well throughout the investing world and over time. In support of this argument I cite generally Graham’s experience, Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update paper, Testing Ben Graham’s Net Current Asset Value Strategy in London, a paper from the business school of the University of Salford in the UK, and, more specifically, Bildersee, Cheh and Zutshi’s The performance of Japanese common stocks in relation to their net current asset values, James Montier’s Graham’’s net-nets: outdated or outstanding?, and Dylan Grice’s Are Japanese equities worth more dead than alive.

Agin it: Japan is a special case because it has weak shareholder rights and a culture that regards corporations as “social institutions with a duty to provide stable employment and consider the needs of employees and the community at large, not just shareholders.” In support of this argument I cite the recent experiences of activist investors in Japan, and Bildersee, Cheh and Zutshi’s The performance of Japanese common stocks in relation to their net current asset values (yes, it supports both sides of the argument). Further, the prospects for Japan’s economy are poor due to its large government debt and ageing population.

How to break the deadlock? Montier provides a roadmap in his excellent Behavioural Investing:

We appear to use stories to help us reach decisions. In the ‘rational’ view of the world we observe the evidence, we then weigh the evidence, and finally we come to our decision. Of course, in the rational view we all collect the evidence in a well-behaved unbiased fashion. … Usually we are prone to only look for the information that happens to agree with us (confirmatory bias), etc.

However, the real world of behaviour is a long way from the rational viewpoint, and not just in the realm of information gathering. The second stage of the rational decision is weighing the evidence. However, as the diagram below shows, a more commonly encountered approach is to construct a narrative to explain the evidence that has been gathered (the story model of thinking).

Hastie and Pennington (2000) are the leading advocates of the story view (also known as explanation-based decision-making). The central hypothesis of the explanation-based view is that the decision maker constructs a summary story of the evidence and then uses this story, rather than the original raw evidence, to make their final decision.

All too often investors are sucked into plausible sounding story. Indeed, underlying some of the most noted bubbles in history are kernels of truth.

As to the last point, arguably, the converse is also true. Investors have missed some great returns because the ugly stories about companies or markets were so compelling.

There are several points that are not contentious about an investment in Japan. The data suggests to me and to everyone else that there are a large number of net current asset value bargains available there. The contention is whether these net current asset value stocks will perform as they have in other countries, or whether they are destined to remain net current asset value bargains, the classic “value traps.” My own penchant for value investing, and quantitative value investing in particular, makes this a reasonably simple matter to resolve. I am going to invest in Japanese net current asset value stocks. Here are the bases for my reasoning:

  • I believe that value investing works. I believe that this is the case because it appeals to me as a matter of logic. I also believe that the data supports this position (see Ben Graham’s Net Current Asset Values: A Performance Update or Lakonishok, Shleifer, and Vishny’s Contrarian Investment, Extrapolation and Risk). Where a stock trades at a significant discount to its value, I am going to take a position.
  • I believe that Graham’s net current asset value works. In support of this proposition I cite the papers listed in the “Fer it” argument above.
  • I believe that simple quantitative models consistently outperform expert judgements. In support of this proposition generally I cite James Montier’s Painting By Numbers: An Ode To Quant. Where the data looks favorable to me, I am going to take a position, and I’m going to ignore the qualitative factors.
  • I believe that value is a good predictor of returns at a market level. In support I cite the Dimson, Marsh and Staunton research. I am not dissuaded from investing in a country simply because its growth prospects are low. Value is the signal predictor of returns.

The arguments militating against investing in Japan sound to me like the arguments militating against any investment in a NCAV stock, which is to say that they are arguments rooted in the narrative. I’ve never taken a position in a NCAV stock that had a good story attached to it. They have always looked ugly from an earnings or narrative perspective (otherwise, they’d be trading at a higher price). As far as I can tell, this situation is no different, other than the fact that it is in a different country and the country has economic problems (which I would ignore in the usual case anyway). While the research specific to NCAV stocks in Japan is not as compelling as I would like it to be, I always bear in mind the lessons of Taleb’s “naive empiricist,” which is to say that the data are useful only up to a point.

This is not to say that I have any great conviction about Japan or Japanese net current asset value stocks. Far from it. I fully expect, as I always do when taking a position in any stock, to be wrong and have the situation follow the narrative. Fortunately, the decision is out of my hands. I’m going to follow my simple quantitative model – the Graham net current asset value strategy – and take some positions in Japanese net nets. The rest is for the goddess Fortuna.

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Central to the discussion of sub-liquidation value investing in Japan is the ability or willingness of shareholders to influence management, and management’s willingness to listen. As Ben Graham noted in the 1934 edition of Security Analysis, in the US:

The whole issue may be summarized in the form of a basic principle, viz:

When a common stocks sells persistently below its liquidating value, then either the price is too low, or the company should be liquidated. Two corollaries may be deduced from this principle:

Corollary I. Such a price should impel the stockholders to raise the question whether it is in their interest to continue the business.

Corollary II. Such a price should impel the management to take all proper steps to correct the obvious disparity between market quotation and intrinsic value, including a reconsideration of its own policies and a frank justification to the stockholders of its decision to continue the business.

The perception is that, in Japan, these two corollaries do not flow from that basic principle. As The Economist notes in a February 2008 article, Samurai v shareholders: Japan’s establishment continues to rebuff foreign activist investors (subscription required):

Japanese businessmen and politicians fear that the activists are short-term investors keen to strip firms of their cash. The conflict highlights a fundamental divide: companies in Japan are social institutions with a duty to provide stable employment and consider the needs of employees and the community at large, not just shareholders.

And therein lies the rub. Companies in Japan are social institutions with a duty to provide stable employment and consider the needs of employees and the community at large, not just shareholders.

Can foreign investors not subject to the cultural expectation that companies consider the needs of employees and the community at large succeed?

According to a 2009 Knowledge@Wharton article, How the Environment for Foreign Direct Investment in Japan Is Changing — for the Better, the environment for foreign investors in Japan is improving, but continues to be more bureaucratic than in the US:

Despite the support shown by elected officials for increasing [foreign direct investment] in Japan, foreign investors still face a substantial amount of bureaucratic red tape, particularly with respect to protected industries. [Direct investment] is principally governed by the Foreign Exchange and Foreign Trade Control Law, which specifically prevents foreign investors from acquiring a majority stake in Japanese companies within industry sectors classified as closely related to national security and public safety. This includes industries as diverse as aeronautics, defense, nuclear power generation, energy, telecom, broadcasting, railways, tourist transportation, petroleum and leather processing.

Foreign investors intending to make direct investments in certain industries must file with the Japanese Ministry of Finance as well as the respective ministry governing the specific industry of the investment target. If issues are found in relation to the investment, either the Ministry of Finance or the industry-specific ministry has the authority to issue an official recommendation to revise the investment plan or to put a complete stop to the acquisition. Industry-specific regulations that, for example, limit foreign ownership to one-third for airline and telecom companies, further constrain foreign investors.

It’s worth considering the experience of two notable activist campaigns in Japan. The first, Steel Partners’ campaign for Sapporo, the brewer, is described in the Knowledge@Wharton article:

Steel Partners has imported its U.S. activist investment model to Japan and has shown a willingness to question publicly the strategy of current management at its investment targets and to litigate disagreements.

As a result of Steel Partners’ posture, the firm’s take-over bid for household-brand Bulldog Sauce met with resistance from the media and Japan’s legal system. The court to which Steel Partners appealed a failed injunction to prevent Bulldog’s poison-pill strategy stated: “[Steel Partners] pursues its own interests exclusively and seeks only to secure profits by selling companies’ shares back to the company or to third parties in the short term, in some cases with an eye to disposing of company assets…. As such, it is proper to consider the plaintiff an abusive acquirer.”

The Economist article discusses the The Children’s Investment Fund’s (TCI) battle for the Japanese power provider J-Power:

The biggest showdown between the activists and the establishment is at J-Power, the former state-run energy firm, which was privatised in 2004. [TCI] a British fund, which owns 9.9% of the firm, has been politely but firmly lobbying J-Power to appoint two TCI representatives to its board, improve margins and unwind cross-shareholdings with other firms. Having been rebuffed, TCI now wants to double its bet. In January it asked for permission to increase its stake to 20% (any holding above 10% requires government approval). John Ho, the head of TCI’s Asian operations, says the deal is a test of the integrity of Japan’s reform agenda. And it would be, except that Mr Ho has chosen a remarkably hard case. Japan, lacking natural resources, is worried about energy security and is reluctant to hand more control over its power infrastructure to foreign investors.

The Knowledge@Wharton article concludes:

After applying for approval to increase shareholdings to 20%, TCI met a wall of resistance: J-Power management cautioned that TCI could cut maintenance and investment costs in nuclear plants, and the Japanese media relayed sensationalist warnings about the potential for “blackouts.” The result: The Japanese government blocked the investment.

These are not encouraging outcomes. The final word is best left to Takao Kitabata, the vice-minister of Japan’s powerful Ministry of Economy, Trade and Industry (METI):

To be blunt, shareholders in general do not have the ability to run a company. They are fickle and irresponsible. They only take on a limited responsibility, but they greedily demand high dividend payments.

High dividend payments? We’re a long way from liquidation as a matter of course.

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