Posts Tagged ‘Net Net’

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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The superb Manual of Ideas blog has an article by Ravi Nagarajan, Marty Whitman Reflects on Value Investing and Net-Nets, on legendary value investor Marty Whitman’s conversation with Columbia Professor Bruce Greenwald at the Columbia Investment Management Conference in New York. I have in the past discussed Marty Whitman’s adjustments to Graham’s net net formula, which I find endlessly useful. Whitman has some additional insights that I believe are particularly useful to net net investors:

“Cheap is Not Sufficient”

At several points in the discussion with Prof. Greenwald, Mr. Whitman came back to a central theme:  It is not sufficient for a security to be “cheap”.  It must also possess a margin of safety as demonstrated by a strong balance sheet and overall credit worthiness.   In other words, there are many securities that may appear cheap statistically based on a number of common criteria investors use to judge “cheapness”.  This might include current year earnings compared to the stock price, current year cash flow, and many others.  However, if the business does not have a durable balance sheet, adverse situations that are either of the company’s own making or due to macroeconomic factors can determine the ultimate fate of the company.  A durable balance sheet demonstrates the credit worthiness a business needs to manage through periodic adversity.

Whitman also discusses an issue near and dear to my heart: good corporate governance, and, by implication, activism:

One other point that Mr. Whitman made while discussing corporate governance also applies to many net-net situations.  The true value of a company may never come out if there is no threat of a change in control.  This obviously makes intuitive sense because the presence of a very cheap company alone will not result in realization of value unless management is willing to act in the interests of shareholders either by liquidating a business that has no future prospects but a very liquid balance sheet or taking steps to improve the business.

Read the balance of the article at The Manual of Ideas blog.

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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 updated his great post back-testing the performance of net current asset value (NCAV) against “net net working capital” (NNWC) by refining the back-test (see NCAV NNWC Backtest Refined). His new back-test increases the rebalancing period to 6 months from 4 weeks, excludes companies with daily volume below 30,000 shares, and introduces the 66% margin of safety to the NCAV stocks (I wasn’t aware that this was missing from yesterday’s back-test, and would explain why the performance of the NCAV stocks was so poor).

Jae Jun’s original back-test compared the performance of NCAV and NNWC stocks over the last three years. He calculated NNWC by discounting 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”):

As I noted yesterday, excluding the “Fixed and miscellaneous assets” from the liquidating value calculation makes for an exceptionally austere valuation.

Jae Jun has refined his screening criteria as follows:

  • Volume is greater than 30k
  • NCAV margin of safety included
  • Slippage increased to 1%
  • Rebalance frequency changed to 6 months
  • Test period remains at 3 years

Here are Jae Jun’s back-test results with the new criteria:

For the period 2001 to 2004

For the period 2004 to 2007

For the period 2007 to 2010

It’s an impressive analysis by Jae Jun. Dividing the return into three periods is very helpful. While the returns overall are excellent, there were some serious smash-ups along the way, particularly the February 2007 to March 2009 period. As Klarman and Taleb have both discussed, it demonstrates that your starting date as an investor makes a big difference to your impression of the markets or whatever theory you use to invest. Compare, for example, the experiences of two different NCAV investors, one starting in February 2003 and the second starting in February 2007. The 2003 investor was up 500% in the first year, and had a good claim to possessing some investment genius. The 2007 investor was feeling very ill in March 2009, down around 75% and considering a career in truck driving. Both were following the same strategy, and so really had no basis for either conclusion. I doubt that thought consoles the trucker.

Jae Jun’s Old School Value NNWC NCAV Screen is available here (it’s free).

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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.

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Aswath Damodaran, a Professor of Finance at the Stern School of Business, has an interesting post on his blog Musings on Markets, Transaction costs and beating the market. Damodaran’s thesis is that transaction costs – broadly defined to include brokerage commissions, spread and the “price impact” of trading (which I believe is an important issue for some strategies) – foil in the real world investment strategies that beat the market in back-tests. He argues that transaction costs are also the reason why the “average active portfolio manager” underperforms the index by about 1% to 1.5%. I agree with Damodaran. The long-term, successful practical application of any investment strategy is difficult, and is made more so by all of the frictional costs that the investor encounters. That said, I see no reason why a systematic application of some value-based investment strategies should not outperform the market even after taking into account those transaction costs and taxes. That’s a bold statement, and requires in support the production of equally extraordinary evidence, which I do not possess. Regardless, here’s my take on Damodaran’s article.

First, Damodaran makes 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…

Then he explains why he believes market-beating strategies that work on paper fail in the real world. The answer? Transaction costs:

So, why do portfolios that perform so well in back testing not deliver results in real time? The biggest culprit, in my view, is transactions costs, defined to include not only the commission and brokerage costs but two more significant costs – the spread between the bid price and the ask price and the price impact you have when you trade. The strategies that seem to do best on paper also expose you the most to these costs. Consider one simple example: Stocks that have lost the most of the previous year seem to generate much better returns over the following five years than stocks have done the best. This “loser” stock strategy was first listed in the academic literature in the mid-1980s and greeted as vindication by contrarians. Later analysis showed, though, that almost all of the excess returns from this strategy come from stocks that have dropped to below a dollar (the biggest losing stocks are often susceptible to this problem). The bid-ask spread on these stocks, as a percentage of the stock price, is huge (20-25%) and the illiquidity can also cause large price changes on trading – you push the price up as you buy and the price down as you sell. Removing these stocks from your portfolio eliminated almost all of the excess returns.

In support of his thesis, Damodaran gives the example of Value Line and its mutual funds:

In perhaps the most telling example of slips between the cup and lip, Value Line, the data and investment services firm, got great press when Fischer Black, noted academic and believer in efficient markets, did a study where he indicated that buying stocks ranked 1 in the Value Line timeliness indicator would beat the market. Value Line, believing its own hype, decided to start mutual funds that would invest in its best ranking stocks. During the years that the funds have been in existence, the actual funds have underperformed the Value Line hypothetical fund (which is what it uses for its graphs) significantly.

Damodaran’s argument is particularly interesting to me in the context of my recent series of posts on quantitative value investing. For those new to the site, my argument is that a systematic application of the deep value methodologies like Benjamin Graham’s liquidation strategy (for example, as applied in Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update) or a low price-to-book strategy (as described in Lakonishok, Shleifer, and Vishny’s Contrarian Investment, Extrapolation and Risk) can lead to exceptional long-term investment returns in a fund.

When Damodaran refers to “the price impact you have when you trade” he highlights a very important reason why a strategy in practice will underperform its theoretical results. As I noted in my conclusion to Intuition and the quantitative value investor:

The challenge is making the sample mean (the portfolio return) match the population mean (the screen). As we will see, the real world application of the quantitative approach is not as straight-forward as we might initially expect because the act of buying (selling) interferes with the model.

A strategy in practice will underperform its theoretical results for two reasons:

  1. The strategy in back test doesn’t have to deal with what I call the “friction” it encounters in the real world. I define “friction” as brokerage, spread and tax, all of which take a mighty bite out of performance. These are two of Damodaran’s transaction costs and another – tax. Arguably spread is the most difficult to prospectively factor into a model. One can account for brokerage and tax in the model, but spread is always going to be unknowable before the event.
  2. The act of buying or selling interferes with the market (I think it’s a Schrodinger’s cat-like paradox, but then I don’t understand quantum superpositions). This is best illustrated at the micro end of the market. Those of us who traffic in the Graham sub-liquidation value boat trash learn to live with wide spreads and a lack of liquidity. We use limit orders and sit on the bid (ask) until we get filled. No-one is buying (selling) “at the market,” because, for the most part, there ain’t no market until we get on the bid (ask). When we do manage to consummate a transaction, we’re affecting the price. We’re doing our little part to return it to its underlying value, such is the wonderful phenomenon of value investing mean reversion in action. The back-test / paper-traded strategy doesn’t have to account for the effect its own buying or selling has on the market, and so should perform better in theory than it does in practice.

If ever the real-world application of an investment strategy should underperform its theoretical results, Graham liquidation value is where I would expect it to happen. The wide spreads and lack of liquidity mean that even a small, individual investor will likely underperform the back-test results. Note, however, that it does not necessarily follow that the Graham liquidation value strategy will underperform the market, just the model. I continue to believe that a systematic application of Graham’s strategy will beat the market in practice.

I have one small quibble with Damodaran’s otherwise well-argued piece. He writes:

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.

There’s a little rhetorical sleight of hand in this statement (which I’m guilty of on occasion in my haste to get a post finished). Evidence that the “average active portfolio manager” does not beat the market is not evidence that these strategies don’t beat the market in practice. I’d argue that the “average active portfolio manager” is not using these strategies. I don’t really know what they’re doing, but I’d guess the institutional imperative calls for them to hug the index and over- or under-weight particular industries, sectors or companies on the basis of a story (“Green is the new black,” “China will consume us back to the boom,” “house prices never go down,” “the new dot com economy will destroy the old bricks-and-mortar economy” etc). Yes, most portfolio managers underperform the index in the order of 1% to 1.5%, but I think they do so because they are, in essence, buying the index and extracting from the index’s performance their own fees and other transaction costs. They are not using the various strategies identified in the academic or popular literature. That small point aside, I think the remainder of the article is excellent.

In conclusion, I agree with Damodaran’s thesis that transaction costs in the form of brokerage commissions, spread and the “price impact” of trading make many apparently successful back-tested strategies unusable in the real world. I believe that the results of any strategy’s application in practice will underperform its theoretical results because of friction and the paradox of Schrodinger’s cat’s brokerage account. That said, I still see no reason why a systematic application of Graham’s liquidation value strategy or LSV’s low price-to-book value strategy can’t outperform the market even after taking into account these frictional costs and, in particular, wide spreads.

Hat tip to the Ox.

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Farukh Farooqi, a long-time supporter of Greenbackd and the 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”) provided a guest post on Silicon Storage Technology, Inc (NASDAQ:SSTI) a few weeks back. Farukh wrote:

Activist-Driven Situation Summary: Silicon Storage Tech. (SSTI; $2.78) dated January 6, 2010

SST is a fabless, designer and supplier of NOR flash memory chips which are used in thousands of consumer electronic products. It has two businesses – Products sales of $240 mm with 20% gross margin and licensing revenues of $40 mm with near 100% margin.

As of September 30, 2009, SST had cash and investments of $2.14 per share, net non-cash working capital of $0.41 per share and zero debt. This implies that the market is valuing its business at $0.23 per share or $22 mm. This is a Company which annually spends $50 mm on R&D alone!

Judging from last 10 years of SST’s history, valuation has suffered from (1) dismal bottom line performance and (2) Corporate governance issues.

After bottoming in Q109, Company revenues and margins have rebounded sharply. The Board has decided to take this opportune time to create “value” for shareholders by selling it to a private equity fund for … $2.10 per share. As part of the deal, the current CEO and COO are going to keep their equity interest in the private Company.

In response, an activist shareholder (Riley Invesment Management) resigned from the Board when the Go-Private deal was announced. Last week, he and certain other large shareholders formed SST Full Value Committee and have asked the Board to reconsider the transaction.

Given the governance issues (which could improve as a proxy fight to add independent members is underway), a discount to the peer group is warranted. However, whether you value it on EV/Revenue, EV/EBITDA or Price/Tangible Book Value, the stock has 50% to 200% upside potential.

Farukh has left a comment that I want to draw to your attention:

SSTI being acquired by MCHP for $2.85 per share.

Does this price make sense?

SSTI has $2.55 per share in cash, investments and net working capital. Which means, MCHP is really offering $0.35 per share in value or approximately $35 mm for a semiconductor business which generates $280 mm in sales and almost $50 mm per anum in gross profit and another $40 mm per year in license fees.

The license fees alone can be worth $200 mm using a 20% yield.

SST story reminds me of the Road Runners cartoon with management being the Wile E. Coyote, trying to sabotage shareholders every which way….. Beep Beep.

[Full Disclosure: I do not hold SSTI. 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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Zero Hedge has an article Uncovering Liquidation Value… In Japan? discussing SocGen’s Dylan Grice’s Are Japanese equities worth more dead than alive. The title is a nod to Benjamin Graham’s landmark 1932 Forbes article, Inflated Treasuries and Deflated Stockholders, where he discussed the large number of companies in the US then trading at a discount to liquidation value:

…a great number of American businesses are quoted in the market for much less than their liquidating value; that in the best judgment of Wall Street, these businesses are worth more dead than alive. For most industrial companies should bring, in orderly liquidation, at least as much as their quick assets alone.

Grice writes:

In the space of a generation, Japan has gone from the world economy’s thrusting up-and-coming superpower to its slowing silver-haired retiree. Accordingly, the Japanese market attracts a low valuation. The chart [below] shows FTSE Japan’s equity price to book ratio and enterprise price to book ratio, since equity P/B ratios alone can be distorted by leverage. Both metrics show Japan to be trading at a low premium to book compared to its recent history. So it’s certainly cheap. But does it offer value? The answer can be seen in the chart above, which shows corporate Japan’s RoEs and RoAs over recent decades to have averaged a mere 6.8% and 3.8% respectively. This is hardly the sort of earnings power which should command any premium over book value at all. Indeed, to my mind the question is one of how big a discount the market should trade at relative to book.

The fundamental problem in 1932 America, according to Graham, was that investors weren’t paying attention to the assets owned by the company, instead focussing exclusively on “earning power” and therefore “reported earnings – which might only be temporary or even deceptive – and in a complete eclipse of what had always been regarded as a vital factor in security values, namely the company’s working capital position.” Graham proposed that investors should become not only “balance sheet conscious,” but “ownership conscious:”

If they realized their rights as business owners, we would not have before us the insane spectacle of treasuries bloated with cash and their proprietors in a wild scramble to give away their interest on any terms they can get. Perhaps the corporation itself buys back the shares they throw on the market, and by a final touch of irony, we see the stockholders’ pitifully inadequate payment made to themwith their own cash.

In his article, Grice makes a parallel argument about valuations based on earnings in Japan now:

Regular readers will know I favour a Residual Income approach to valuation. It’s not perfect, and it’s still a work in process, but anchoring estimates of intrinsic value on the earnings power of company assets (relative to a required rate of return, which I set at an exacting 10%) helps avoid value traps. Things don?t necessarily come up as offering value just because they’re on low multiples. The left chart below shows Japan’s ratio of Intrinsic Value to Price (IVP ratio, where a higher number indicates higher value) to be only 0.6, suggesting that in an absolute sense, Japan is intrinsically worth only about 60% of its current market value.

Grice arrives at the same conclusion about Japan as Graham did in 1932 about the US:

But here the tension between “going concern” valuation and “liquidation” valuation becomes important. Let’s just imagine the unimaginable for a second, and that my IVP ratios are correct. Japan currently trades on a P/B ratio of 1.5x, but if it is only worth 60% of that, its “fair value” P/B ratio (assuming we value it as a going concern) would be around 0.9x. Of course, that would only be true on average. Nearly all stocks would trade either above or below that level. And of those trading below, some would trade slightly below, others significantly below. And of those which traded significantly below, some might be expected to flirt with liquidation values which called into question whether or not the “going concern” valuation was appropriate. Indeed, this is exactly what is beginning to happen.

It seems that there are quite a few stocks trading at a discount to net current asset value in Japan:

Grice likes the net current asset value strategy in Japan (sort of):

Not only are these assets cheap but, unlike the overall market, they probably offer value as well. My Factset backtest suggests such stocks trading below liquidation value have averaged a monthly return of 1.5% since the mid 1990s, compared to -0.2% for the Topix. There is no such thing as a toxic asset, only a toxic price. It may well be that these companies have no future, that they shouldn’t be valued as going concerns and that they are worth more dead than alive. If so, they are already trading at a value lower than would be fetched in a fire sale. But what if the outlook isn’t so gloomy? If these assets aren’t actually complete duds, we could be looking at some real bargains…

So should we be filling our boots with companies trading below liquidation value? Not necessarily. But I would say the burden of proof has shifted. Why wouldn’t you want to own assets that have been generating shareholder wealth yet which trade at below their liquidation values?

It is interesting that this article echoes another SocGen article, this one a September 2008 report by James Montier called Graham’’s net-nets: outdated or outstanding? in which Montier looked at Graham sub-liquidation stocks globally. Of the 175 stocks identified around the world, Montier found that over half were in Japan.

Now all we have to do is figure out how to invest in Japan.

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In October I introduced a “monthly” net-net watch list based on the GuruFocus Benjamin Graham Net Current Asset Value Screener (subscription required). I haven’t updated it on a monthly basis, so now it’s a quarterly net-net watch list.

July Net-Net Screen

I was prompted to introduce the October net-net watch list because of the performance of a watch list created on July 7, 2009 using the July 6, 2009 closing prices. The performance of the stocks in that first watch list to October 13 was nothing short of spectacular. Here is a screen grab (with some columns removed to fit the space below):

GuruFocus NCAV Screen

The average return to October across the nine stocks in the watch list was 45.5% against the return on the S&P500 of 20.05% over the same period, an outperformance of more than 25% in ~three months. Pretty impressive stuff.

Here is the performance NCAV screen updated to today:

While a 16.38% return over ~6 months is a good return, given that the watch list was up 45.5% to October, the last quarter was, to say the least, a little disappointing. It’s also underperformed the S&P500 by 5.12%.

October Net-Net Screen

The stocks in the October watch list are set out below (again, with a column removed to fit the space below):

GuruFocus NCAV Screen 2009 10 13

Here’s the performance of the October crop to yesterday’s close:

36.85% is a fantastic return for a quarter, more so given that the S&P500’s return was so anaemic at 1.21%. It was obviously helped by the performance of NLST, up more than 428% for the period. If we remove NLST from the portfolio, the portfolio return drops to 10.7%, which is still a good return, but nowhere near as impressive.

February Net-Net Screen

I have captured the February screen which I’ll track over the coming months. If you want to see complete list online in real time, go to GuruFocus Benjamin Graham Net Current Asset Value Screener (subscription required).

[Full Disclosure:  I have a holding in FORD and TSRI. 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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Daniel Rudewicz, the managing member of Furlong Samex LLC, has provided a guest post today on Paragon Technologies (PGNT.PK). Furlong Samex is a deep value investment partnership based on the principles of Benjamin Graham. Daniel can be reached at rudewicz [at] furlongsamex [dot] com.

Anyone Need a (Sanborn) Map?

In his 1960 partnership letter, Warren Buffett described his investment in Sanborn Map. At the time of his investment, Sanborn Map was selling for less than the combined value of its cash and investment portfolio. Additionally, the operating portion of the company was profitable. Opportunities like Sanborn Map are a dream for value investors.

The market downturn of 2008 had created some similar opportunities. But by early 2010 the market price of most of those companies had converged to at least the value of their cash and investment portfolio. One company that has managed to stay under the radar is Paragon Technologies. It was trading below its cash level when the company elected to be listed on the Pink Sheets. This also removed the requirement to file with the SEC and now the company is no longer on many of the databases and stock screens.

It’s a fairly illiquid company whose most recent quarter was profitable. As of 9/30/2009, Paragon had just over $6 million in cash, or $3.88 per share.

Cash and cash equivalents $6,094,000
Shares outstanding 1,571,810
Cash per share $3.88

Year to date, its stock has traded between $2.20 and $2.55, quite a discount from its cash. The Board and the interim CEO are looking at strategic alternatives and will consider shareholder proposals. Unfortunately, what we had hoped was a 1960 Buffettesque proposal was turned down. In the proposal we outlined the benefits of the company offering a fixed price tender at $3.88 per share. Maybe next time. To the Board’s credit, they have authorized a large share buyback and have increased the amount authorized several times. The problem is that authorizing an amount and buying back an amount is not the same thing.

While the interim CEO searches for opportunities, the company could conceivably end up buying back enough shares in the open market so that we’re the only shareholder left. The downside is that I’m not sure that we would want that. Even though it was profitable last quarter, the long term earnings record is not that impressive. Looking back at Buffett’s Sanborn Map investment, it seems like Sanborn’s Board should have encouraged Buffett to stay on and manage its investment portfolio. Our hope is that Paragon moves in the direction of becoming a tiny Berkshire or Fairfax by putting a great capital allocator in charge of the cash. It would be a great way to use some of the company’s operating losses to shield future investment gains. So if you’re the next Buffett — or even ‘Net Quick’ Evans — send them your resume. Maybe they’ll hire you (I doubt it).

Our firm’s portfolio is relatively small and we have purchased as much of Paragon as we would like to at this time. If you would like a copy of our letter to the Board or any of our research, feel free to contact us and we’d be happy to share it with you. There are risks involved with this company so do your own research before investing.

Disclosure: Long Paragon Technologies (PGNT.PK). 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.

[Full Disclosure: I do not hold PGNT. 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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