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How to best prepare for a lifetime of good investing

Posted in About, Behavioral economics, Quantitative investment, Strategy, tagged , on June 11, 2012| 5 Comments »

Greenbackd was honored to be one of the bloggers asked to participate in Abnormal Returns “Finance Blogger Wisdom” series. Tadas asked a range of questions and will publish them on Abnormal Returns over the course of the week. The first question is, “If you had a son or daughter just beginning to invest, what would you tell them to do to best prepare themselves for a lifetime of good investing?”

I answered as follows:

Inspired by Michael Pollan’s edict for healthy eating (“Eat food. Not too much. Mostly plants.”), for good investing I’d propose “Buy value. Diversify globally. Stay invested.”

I feel that I should justify the answer a little in the context of the “What to do in sideways markets” post about Vitaliy Katsenelson‘s excellent book “The Little Book of Sideways Markets“. To recap, Vitaliy’s thesis is that equity markets are characterized by periods of valuation expansion (“bull market”) and contraction (“bear market” or “sideways market”). A sideways market is the result of earnings increasing while valuation drops. Historically, they are common:

We’ve clearly been in a sideways market for all of the 2000s, and yet the CAPE presently stands at 21.22. CAPE has in the past typically fallen to a single-digit low following a cyclical peak. The last time a sideways market traded on a CAPE of ~21 (1969) it took ~13 years to bottom (1982). The all-time peak US CAPE of 44.2 occurred in December 1999, all-time low US CAPE of 4.78 occurred in December 1920. The most recent CAPE low of 6.6 occurred in August 1982. I’m fully prepared for another 13 years of sideways market (although, to be fair, I don’t really care what the market does).

If you subscribe to Vitaliy’s thesis – as I do – that the sideways market will persist until we reach a single-digit CAPE, then it might seem odd to suggest staying fully invested. In my defence, I make the following two points:

First, I am assuming a relatively unsophisticated beginner investor.

Second, this chart:

Source: Turnkey Analyst Backtester.

A simple, quantitative, “cheap but good” value strategy has delivered reasonable returns over the last decade in a flat market. I don’t think these returns are worth writing home about, but if my kids can dollar cost average into an ~11-12 percent per year in a flat market, they’ll do fine over the long run.

The other responses are outstanding. See them here.

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Searching for Rational Investors In a Perfect Storm: Value Investing Through 1999-2003

Posted in About, Value Investment, tagged on May 25, 2012| 3 Comments »

Yesterday I covered a 2006 talk, “Journey Into the Whirlwind: Graham-and-Doddsville Revisited,” by Louis Lowenstein*, then a professor at the Columbia Law School, in which he compared the performance of a group of “true-blue, walk-the-walk value investors” and “a group of large cap growth funds”.

Lowenstein based the talk on an earlier paper he had written “Searching for Rational Investors In a Perfect Storm:”

In October, 1991, there occurred off the coast of Massachusetts a “perfect storm,” a tempest created by a rare coincidence of events. In the late ‘90s, there was another perfect storm, an also rare coincidence of forces which caused huge waves in our financial markets, as the NASDAQ index soared, collapsed, and bounced part way back.

What had happened to the so-called “rational” investors, the smart money, whom economists have for decades said would keep market prices in close touch with the underlying values? Despite the hundreds of papers on markets and their efficiency, it is a remarkable fact that no scholar, not one, has looked to see who are these rational, i.e., value, investors, how they operate, and with what results.

In the paper, Lowenstein decided to see how a group of ten value funds, selected by a knowledgeable manager, performed in the turbulent boom–crash–rebound years of 1999-2003. Did they suffer the permanent loss of capital of so many who invested in the telecom, media and tech stocks? How did their overall performance for the five years compare with the returns on the S&P 500?

To bring a group of rational/value investors out of the closet, I asked Bob Goldfarb, the highly regarded chief executive of the Sequoia Fund, to furnish the names of ten “true-blue” value funds, those which, as they say on the Street, don’t just talk the talk but walk the walk. (Had I prepared the list, I would have included Sequoia, but Goldfarb’s ten is Goldfarb’s ten.) They are all mutual funds, except for Source Capital, a closed-end fund which invests much like a mutual fund. The funds are as follows:

  • Clipper Fund
  • FPA Capital
  • First Eagle Global
  • Mutual Beacon
  • Oak Value
  • Oakmark Select
  • Longleaf Partners
  • Source Capital
  • Legg Mason Value
  • Tweedy Browne American Value

How did they perform?

For most managers, mimicking the index, it was difficult not to own Enron, Oracle and the like, but the ten value funds had stayed far away. Instead, they owned highly selective portfolios, mostly 34 stocks or less, vs. the 160 in the average equity fund. Reflecting their consistent and disciplined approach, they turned their portfolios at one-sixth the rate of the average fund. Bottom line: every one of the ten outperformed the index over the five year period, and as a group they did so by an average of 11% per year, the financial equivalent of back-to-back no-hitters.

The five-year 1999-2003 average annual returns were as follows:

Here’s a link to the article.

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Which price ratio best identifies value stocks?

Posted in Enterprise Multiple, Enterprise Value, Stocks, Strategy, tagged , , , , , , , , , on April 30, 2012| 26 Comments »

Which price ratio best identifies undervalued stocks? It’s a fraught question, dependent on various factors including the time period tested, and the market capitalization and industries under consideration, but I believe a consensus is emerging.

The academic favorite remains book value-to-market capitalization (the inverse of price-to-book value). Fama and French maintain that it makes no difference which “price-to-a-fundamental” is employed, but if forced to choose favor book-to-market. In the Fama/French Forum on Dimensional Fund Advisor’s website they give it a tepid thumbs up despite the evidence that it’s not so great:

Data from Ken French’s website shows that sorting stocks on E/P or CF/P data produces a bigger spread than BtM over the last 55 years. Wouldn’t it make sense to use these other factors in addition to BtM to distinguish value from growth stocks? EFF/KRF: A stock’s price is just the present value of its expected future dividends, with the expected dividends discounted with the expected stock return (roughly speaking). A higher expected return implies a lower price. We always emphasize that different price ratios are just different ways to scale a stock’s price with a fundamental, to extract the information in the cross-section of stock prices about expected returns. One fundamental (book value, earnings, or cashflow) is pretty much as good as another for this job, and the average return spreads produced by different ratios are similar to and, in statistical terms, indistinguishable from one another. We like BtM because the book value in the numerator is more stable over time than earnings or cashflow, which is important for keeping turnover down in a value portfolio. Nevertheless, there are problems in all accounting variables and book value is no exception, so supplementing BtM with other ratios can in principal improve the information about expected returns. We periodically test this proposition, so far without much success.

There are a variety of papers on the utility of book value that I’ve beaten to death on Greenbackd. I used to think it was the duck’s knees because that was what all the early research seemed to say (See, for example, Roger Ibbotson’s “Decile Portfolios of the New York Stock Exchange, 1967 – 1984,” Werner F.M. DeBondt and Richard H. Thaler’s “Further Evidence on Investor Overreaction and Stock Market Seasonality”). Josef Lakonishok, Andrei Shleifer, and Robert Vishny’s Contrarian Investment, Extrapolation and Risk, which was updated by The Brandes Institute as Value vs Glamour: A Global Phenomenon reopened the debate, suggesting that price-to-earnings and price-to-cash flow might add something to price-to-book.

A number of more recent papers have moved away from book-to-market, and towards the enterprise multiple ((equity value + debt + preferred stock – cash)/ (EBITDA)). As far as I am aware, Tim Loughran and Jay W. Wellman got in first with their 2009 paper “The Enterprise Multiple Factor and the Value Premium,” which was a great unpublished paper, but became in 2010 a slightly less great published paper, “New Evidence on the Relation Between the Enterprise Multiple and Average Stock Returns,” suitable only for academics and masochists (but I repeat myself). The abstract to the 2009 paper (missing from the 2010 paper) cuts right to the chase:

Following the work of Fama and French (1992, 1993), there has been wide-spread usage of book-to-market as a factor to explain stock return patterns. In this paper, we highlight serious flaws with the use of book-to-market and offer a replacement factor for it. The Enterprise Multiple, calculated as (equity value + debt value + preferred stock – cash)/ EBITDA, is better than book-to-market in cross-sectional monthly regressions over 1963-2008. In the top three size quintiles (accounting for about 94% of total market value), EM is a highly significant measure of relative value, whereas book-to-market is insignificant.

The abstract says everything you need to know: Book-to-market is widely used (by academics), but it has serious flaws. The enterprise multiple is more predictive over a long period (1963 to 2008), and it’s much more predictive in big market capitalization stocks where book-to-market is essentially useless.

What serious flaws?

The big problem with book-to-market is that so much of the return is attributable to nano-cap stocks and “the January effect”:

Loughran (1997) examines the data used by Fama and French (1992) and finds that the results are driven by a January seasonal and the returns on microcap growth stocks. For the largest size quintile, accounting for about three-quarters of total market cap, Loughran finds that BE/ME has no significant explanatory power over 1963-1995. Furthermore, for the top three size quintiles, accounting for about 94% of total market cap, size and BE/ME are insignificant once January returns are removed. Fama and French (2006) confirm Loughran’s result over the post- 1963 period. Thus, for nearly the entire market value of largest stock market (the US) over the most important time period (post-1963), the value premium does not exist.

That last sentence bears repeating: For nearly the entire market value of largest stock market (the US) over the most important time period (post-1963), the value premium does not exist, which means that book-to-market is not predictive in stocks other than the smallest 6 percent by market cap. What about book-to-market in the stocks in that smallest 6 percent? It might not work there either:

Keim (1983) shows that the January effect is primarily limited to the first trading days in January. These returns are heavily influenced by December tax-loss selling and bid-ask bounce in low-priced stocks. Since many fund managers are restricted in their ability to buy small stocks due to ownership concentration restrictions and are prohibited from buying low-prices stocks due to their speculative nature, it is unlikely that the value premium can be exploited.

More scalable

The enterprise multiple succeeds where book-to-market fails.

In the top three size quintiles, accounting for about 94% of total market value, EM is a highly significant measure of relative value, whereas BE/ME is insignificant and size is only weakly significant. EM is also highly significant after controlling for the January seasonal and removing low-priced (<$5) stocks. Robustness checks indicate that EM is also better to Tobin’s Q as a determinant of stock returns.

And maybe the best line in the  paper:

Our results are an improvement over the existing literature because, rather than being driven by obscure artifacts of the data, namely the stocks in the bottom 6% of market cap and the January effect, our results apply to virtually the entire universe of US stocks. In other words, our results may actually be relevant to both Wall Street and academics.

Why does the enterprise multiple work?

The enterprise multiple is a popular measure, and for other good reasons besides its performance. First, the enterprise multiple uses enterprise value. A stock’s enterprise value provides more information about its true cost than its market capitalization because it includes information about the stock’s balance sheet, including its debt, cash and preferred stock (and in some variations minorities and net payables-to-receivables). Such things are significant to acquirers of the business in its entirety, which, after all, is the way that value investors should think about each stock. Market capitalization can be misleading. Just because a stock is cheap on a book value basis does not mean that it’s cheap 0nce its debt load is factored into the valuation. Loughran and Wellman, quoting Damodaran (whose recent paper I covered here last week), write:

Damodaran shows in an unpublished study of 550 equity research reports that EM, along with Price/Earnings and Price/Sales, were the most common relative valuation multiples used. He states, “In the past two decades, this multiple (EM) has acquired a number of adherents among analysts for a number of reasons.” The reasons Damodaran cites for EM’s increasing popularity also point to the potential superiority of EM over book-to-market. One reason is that EM can be compared more easily across firms with differing leverage. We can see this when comparing the corresponding inputs of EM and BE/ME. The numerator of EM, Enterprise Value, can be compared to the market value of equity. EV can be viewed as a theoretical takeover price of a firm. After a takeover, the acquirer assumes the debt of the firm, but gains use of the firm’s cash and cash equivalents. Including debt is important here. To take an example, in 2005, General Motors had a market cap of $17 billion, but debt of $287 billion. Using market value of equity as a measure of size, General Motors is a mid-sized firm. Yet on the basis of Enterprise Value, GM is a huge company. Market value of equity by itself is unlikely to fully capture the effect GM’s debt has on its returns. More generally, it is reasonable to think that changing firm debt levels may affect returns in a way not fully captured by market value of equity. Bhojraj and Lee (2002) confirm this, finding that EV is superior to market value of common equity, particularly when firms are differentially levered.

The enterprise multiple’s ardor for cash and abhorrence for debt matches my own, hence why I like it so much. In practice, that tendency can be a double-edged sword. It digs up lots of little cash boxes with a legacy business attached like an appendix (think Daily Journal Corporation (NASDAQ:DJCO) or Rimage Corporation (NASDAQ:RIMG)). Such stocks tend to have limited upside. On the flip side, they also have happily virtually no downside. In this way they are vastly superior to the highly leveraged pigs favored by book-to-market, which tends to serve up heavily leveraged slivers of somewhat discounted equity, and leaves you to figure out whether it can bear the debt load. Get it wrong and you’ll be learning the intricacies of the bankruptcy process with nothing to show for it at the end. When it comes time to pull the trigger, I generally find it easier to do it with a cheap enterprise multiple than a cheap price-to-book value ratio.

The earnings variable: EBITDA

There’s a second good reason to like the enterprise multiple: the earnings variable. EBITDA contains more information than straight earnings, and so should give a more full view of where the accounting profits flow:

The denominator of EM is operating income before depreciation while net income (less dividends) flows into BE. The use of EBITDA provides several advantages that BE lacks. Damodaran notes that differences in depreciation methods across companies will affect net income and hence BE, but not EBITDA. Also, the McKinsey valuation text notes that operating income is not affected by nonoperating gains or losses. As a result, operating income before depreciation can be viewed as a more accurate and less manipulable measure of profitability, allowing it to be used to compare firms within as well as across industries. Critics of EBITDA point out that it is not a substitute for cash flow; however, EV in the numerator does account for cash.

The enterprise multiple includes debt as well as equity, contains a clearer measure of operating profit and captures changes in cash from period to period. The enterprise multiple is a more complete measure of relative value than book-to-market. It also performs better:

Performance of the enterprise multiple versus book-to-market

From CXOAdvisory:

  • EM generates an annual value premium of 5.8% per year over the entire sample period (compared to 4.8% for B/M during 1926-2004).
  • EM captures more premium than B/M for all five quintiles of firm size and is much less dependent on small stocks for its overall premium (see chart below).
  • In the top three quintiles of firm size (accounting for about 94% of total market capitalization), EM is a highly significant measure of relative value, while B/M is not.
  • EM remains highly significant after controlling for the January effect and after removing low-priced (<$5) stocks.
  • EM outperforms Tobin’s q as a predictor of stock returns.
  • Evidence from the UK and Japan confirms that EM is a highly significant measure of relative value.

The “value premium” is the difference in returns to a portfolio of glamour stocks (i.e., the most expensive decile) when compared to a portfolio of value stocks (i.e., the cheapest decile) ranked on a given price ratio (in this case, the enterprise multiple and book-to-market). The bigger the value premium, the better a given price ratio sorts stocks into winners and losers. It’s a more robust test than simply measuring the performance of the cheapest stocks. Not only do we want to limit our sins of commission (i.e., buying losers), we want to limit our sins of omission (i.e., not buying winners). 

Here are the value premia by market capitalization (from CXOAdvisory again): Ring the bell. The enterprise multiple kicks book-to-market’s ass up and down in every weight class, but most convincingly in the biggest stocks.

Strategies using the enterprise multiple

The enterprise multiple forms the basis for several strategies. It is the price ratio limb of Joel Greenblatt’s Magic Formula. It also forms the basis for the Darwin’s Darlings strategy that I love (see Hunting Endangered Species). The Darwin’s Darlings strategy sought to front-run the LBO firms in the early 2000s, hence the enterprise multiple was the logical tool, and highly effective.

Conclusion

This post was motivated by the series last week on Aswath Damodaran’s paper ”Value Investing: Investing for Grown Ups?” in which he asks, “If value investing works, why do value investors underperform?” Loughran and Wellman also asked why, if Fama and French (2006) find a value premium (measured by book-to-market) of 4.8% per year over 1926-2004, mutual fund managers couldn’t capture it:

Fund managers perennially underperform growth indices like the Standard and Poor’s 500 Index and value fund managers do not outperform growth fund managers. Either the value premium does not actually exist, or it does not exist in a way that can be exploited by fund managers and other investors.

Loughran and Wellman find that for nearly the entire market value of largest stock market (the US) over the most important time period (post-1963), the value premium does not exist, which means that book-to-market is not predictive in stocks other than the smallest 6 percent by market cap (and even there the returns are suspect). The enterprise multiple succeeds where book-to-market fails. In the top three size quintiles, accounting for about 94% of total market value, the enterprise multiple is a highly predictive measure, while book-to-market is insignificant. The enterprise multiple also works after controlling for the January seasonal effect and after removing low priced (<$5) stocks. The enterprise multiple is king. Long live the enterprise multiple.

Buy my book The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market from on Kindle, paperback, 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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McDonald’s Corporation (NYSE:MCD) field trip report from 1965

Posted in About, Value Investment, tagged , on August 31, 2010| 1 Comment »

Michael Bigger’s Bigger Capital blog has a great “field trip” report on McDonald’s Corporation (NYSE:MCD) from 1965. You could have picked up MCD then for a split-adjusted $0.06 per share, giving you a twelve-hundredfold return to date. Says Michael:

A good friend of mine, a talented research analyst, covered McDonald’s (MCD) in the sixties. One of his field reports is posted below. My friend liked the company and bought the stock at a price of $.06 (post split). He still holds a major portion of his original stake. The investment has returned more than one thousand times.

The lesson of this story is that you will most likely stumble upon one or two great companies like MCD in your lifetime. If that happens and your insight leads you to buy the stock, hold on to it for a long period of time. Don’t get shaken out of your position.

Indeed.

Read the report.

No position.

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Dover Motorsports Inc (NYSE:DVD) and Mario Cibelli’s 13D amendment

Posted in Activist Investors, Stocks, tagged , , , on April 29, 2010| 2 Comments »

Mario Cibelli’s recent 13D amendment for Dover Motorsports Inc (NYSE:DVD) is interesting reading. Cibelli controls around 17.5% of DVD through Marathon Partners and Cibelli Capital Management. His most recent 13D amendment filed Wednesday annexes a letter setting out a (huge) case study of DVD “partly as a contribution to public education but also to obtain a clearly objective review of the Dover Motorsports situation for our own investment purposes:”

Via Fed-Ex

April 26, 2010

Trustees of RMT Trust
Michele M. Rollins
R. Randall Rollins
Henry B. Tippie
Board of Directors, Dover Motorsports, Inc.
Henry B. Tippie, Chairman
Denis McGlynn, Chief Executive Officer
Patrick J. Bagley
Kenneth K. Chalmers
Jeffrey W. Rollins
John W. Rollins, Jr.
R. Randall Rollins
Eugene W. Weaver
Dover Motorsports, Inc.
1311 N. DuPont Highway
Dover, Delaware 19903

RE: Dover Motorsports, Inc. Case Study

Dear Trustees of RMT Trust and Board Members:

Please find enclosed a study that we sponsored, partly as a contribution to public education but also to obtain a clearly objective review of the Dover Motorsports situation for our own investment purposes.

We believe this objective and thorough review confirms our position that Mr. Tippie has not been performing his duties satisfactorily, and cannot be relied upon to do so in the future. We recognize that Mr. Tippie’s past accomplishments are significant and worthy of admiration, but whatever tribute is due cannot be imposed on the company’s long-suffering shareholders. Under these circumstances, it is the fiduciary responsibility of the company’s directors as well as of the trustees of its controlling shareholder to act in the interest of those who rely upon them to assure the competent management of Dover Motorsports.

If you are reluctant to take the necessary actions yourselves, you should at least allow me to do so. As you know from our reports, I have made sound preparations to assume this responsibility.

Sincerely,

Mario D. Cibelli
Managing Member

Enclosure

Cibelli’s DVD case study:

Isaac C. Flanagan

April 26, 2010

Dancing on the Deck of the Titanic:
Henry B. Tippie and Dover Motorsports, Inc.

As the first decade of the 21st century rapidly drew to a close, the motorsports industry in the United States faced shifting internal dynamics, and was buffeted by the macroeconomic environment. The third-largest public player in a sector whose decades-long cycle of consolidation was largely complete, Dover Motorsports, Inc. (NYSE: DVD) (“Dover Motorsports,” “Dover” or the “Company”) was not immune.

By the time Henry B. Tippie was elected Chairman of Dover’s Board of Directors in 2000 following the death of Company founder and Chairman John W. Rollins, he had distinguished himself through nearly fifty years of service to the Rollins family and their group of companies. In his career, Mr. Tippie had developed a reputation for consistently organizing and growing companies in a diverse group of industries, frequently taking them public. Mr. Tippie was known not only as a successful manager and a nimble rescuer of companies, but also as a leader with unimpeachable integrity. The University of Iowa described Henry Tippie in the following manner on the biographical web page entitled Who is Henry Tippie?:

“Integrity. Innovation. Impact.

Those words not only apply to the Tippie College and its offerings, they also apply to its benefactor, Henry B. Tippie. A native of Belle Plaine, Iowa, Henry Tippie is a man of integrity, who has built his personal and professional life on the principles of hard work and doing the right thing. He is a living and breathing illustration of the word ‘integrity.'”1

1 http://tippie.uiowa.edu/about/henry.cfm

It is in this context that the circumstances surrounding Dover Motorsports could have been confusing to those familiar with the situation starting in 2007. The management decisions made over a long period of time at Dover seemed contradictory to the legacy of both Mr. Tippie and the Rollins group of companies and left Dover at a major crossroads in 2009.

Company Description

Dover Motorsports, Inc., headquartered in Dover, Delaware, marketed and promoted motorsports entertainment in the United States via the following four raceways:

1. Dover International Speedway in Dover, Delaware

2. Gateway International Raceway near St. Louis, Missouri

3. Memphis Motorsports Park in Memphis, Tennessee

4. Nashville Superspeedway in Lebanon, Tennessee

The Sprint Cup Series was NASCAR’s premier racing series, with 36 races scheduled in 2009 and 36 more scheduled in 2010. Dover International Speedway hosted two Sprint Cup Series race weekends each year, and was the only one of the Company’s four tracks to host a Sprint Cup Series event. All four facilities hosted NASCAR Nationwide Series and Camping World Truck Series events, although these events drew much smaller crowds and generated significantly lower sponsorship, event-related, and broadcast television revenues compared to Sprint Cup events.

Dover Motorsports was one of three publicly traded racetrack operators, along with International Speedway Corporation (NASDAQ: ISCA) (“ISCA”) and Speedway Motorsports, Inc. (NYSE: TRK) (“SMI”). ISCA was controlled by members of the France family and SMI was controlled by O. Bruton Smith.

Motorsports Industry Overview

NASCAR

Founded by Bill France, Sr. in 1948, the National Association for Stock Car Auto Racing, Inc. (NASCAR) was the premier motorsports sanctioning body. NASCAR consisted of three national series (the NASCAR Sprint Cup Series, NASCAR Nationwide Series, and NASCAR Camping World Truck Series), a road racing series, and a variety of regional, local, and international racing series. The France family controlled the sanctioning body, and Brian Z. France served as CEO and Chairman of the Board of NASCAR.

By the fall of 2009, racetrack operations in the United States had begun to display many of the classic signs of sector maturity. Most significantly, nearly all of the country’s major media markets and population centers boasted an established NASCAR-affiliated track by this point, with the notable exception of New York City. Given the lack of de novo growth prospects and NASCAR’s outspoken reluctance to expand the current race schedule, profit-expansion opportunities were largely driven by more efficient marketing and management of tracks, offering enhanced experiences to race attendees, and successful acquisition and integration of competitors.

Pocono Raceway was owned by the Mattioli family with the asset held in a generation- skipping trust2, and the historic Indianapolis Motor Speedway, known for its open-wheeled racing, was owned by the George/Hulman family.

2 Speed Channel (6/13/04), reported by http://www.jayski.com

Corporate History

The Company was founded in 1969 as racetrack operator Dover Downs, and launched with a NASCAR Sprint Cup Series race won by Richard Petty. Dover Downs Entertainment, Inc., which included both the motorsports and gaming businesses, went public on the New York Stock Exchange in 1996 under the ticker symbol DVD. In 2002, the gaming portion of the Company’s operation was separated and went public on the New York Stock Exchange as Dover Downs Gaming & Entertainment, Inc. under the ticker symbol DDE. The Company’s motorsports operations were renamed Dover Motorsports, Inc. following the divestiture and retained the DVD ticker symbol. Despite the separation into two distinct businesses, the management teams of each company remained nearly identical.

Share Classes and Voting Structure

Dover Motorsports maintained a dual class share structure, which included common stock and Class A common stock. The Class A shares, owned by a small group of Rollins family members and management, carried ten votes per share. Common shares carried a single vote per share. Dividends on Class A shares could not exceed those of common shares, but under certain circumstances common dividends could exceed those of the Class A shares. In addition, the common and Class A common shares were part of a shareholder rights plan, also known as a “poison pill.” In the event that an outside investor accumulated over 10 percent of the company’s total shares, or tendered a takeover offer without prior approval, existing shareholders had the right to purchase additional shares in order to prevent a takeover.

RMT Trust

Following the death of John W. Rollins, Senior on April 4, 2000, Henry Tippie (at the time, Vice Chairman of Dover) was named executor of Mr. Rollins’ vast estate, and thereafter, Mr. Tippie possessed more than 50% voting control of the Company. The Last Will and Testament of John W. Rollins, Senior, established the RMT Trust as the primary vehicle to transfer assets to his wife, Michele M. Rollins. Among many of its stakes in property and operating assets, the RMT Trust held 8 million shares of Class A Common Stock in 2009, which represented approximately 39.4% of the voting control of Dover Motorsports. The Last Will and Testament stipulated that the RMT Trust would be administered by three trustees, presently Michele M. Rollins, R. Randall Rollins, and Henry B. Tippie. Through an agreement which renews annually, Michele Rollins and Randall Rollins yielded sole discretion over the voting power of shares held by RMT Trust to Henry Tippie. Therefore, at the behest of the Rollins, Henry Tippie maintained the dual role of Chairman of the Company and voting trustee of RMT Trust and was able to single-handedly determine the outcome of any and all shareholder votes. As the Company disclosed in its Annual Report:

“We are a controlled corporation because a single person…controls in excess of fifty percent of our voting power. This means he has the ability to determine the outcome of the election of directors at our annual meetings and to determine the outcome of many significant corporate transactions….Such a concentration of voting power could have the affect of delaying or preventing a third party from acquiring us at a premium.”

Business Overview

Key Executives

Henry B. Tippie, Chairman of the Board

Henry Tippie serves as Chairman of the Board of Dover Motorsports, as well as controlling Trustee of RMT Trust (Dover’s largest shareholder), and in these capacities exercises control over 54.4% of the combined voting power of the two classes of the Company’s common stock.

A Belle Plaine, Iowa farm boy, Henry B. Tippie enlisted in the United States Army Air Force at the age of 17, and enrolled at the University of Iowa upon completion of his military service. After earning his degree in Accounting in two years in 1949, Mr. Tippie pursued work as an accountant in Des Moines and Omaha, eventually earning his CPA in 1951. Shortly thereafter, he was hired by Delaware-based John W. Rollins, Associates as a controller. In his decades with the Rollins family and the diverse group of companies they control, Mr. Tippie has been instrumental in the growth and management of a number of firms across many unrelated industries.

For his many achievements in business, Mr. Tippie has been recognized with induction into the Horatio Alger Association of Distinguished Americans and has been the recipient of several distinguished alumni awards from the University of Iowa. In 1999, the University of Iowa renamed its College of Business Administration the Henry B. Tippie College of Business. The Henry B. Tippie College of Business was the first academic division of the University of Iowa to be named after an alumnus.

Mr. Tippie also serves as Chairman of the Board of Dover Downs Gaming & Entertainment and is a Director of three other public companies controlled by the Rollins family.

R. Randall Rollins, Director

In addition to his role as Trustee of RMT Trust and Director of Dover Motorsports and Dover Downs Gaming & Entertainment, Mr. Rollins was the Chairman of the Board of Rollins, Inc. (NYSE: ROL), Marine Products Corp. (NYSE: MPX), and RPC, Inc. (NYSE: RES) and maintained shared voting control of each of these public companies with his younger brother, Gary Rollins. As the eldest son of the late O. Wayne Rollins (brother of John W. Rollins, Senior) and as the sole Rollins family member involved with each of the five public companies controlled by the Rollins family, Mr. Rollins appeared to be the de-facto patriarch of the Rollins family.

Denis McGlynn, President, CEO and Director

Jeffrey W. Rollins, Director, son of John W. Rollins, Sr.

Kenneth K. Chalmers, Director

Patrick J. Bagley, Former CFO; Director

John W. Rollins, Jr., Director, son of John W. Rollins, Sr.

Eugene W. Weaver, Former SVP, Administration; Director

With the exception of Eugene Weaver, seven of the eight Directors of Dover Motorsports also served on the board of Dover Downs Entertainment. Mr. Tippie and Mr. McGlynn, maintained their respective directorships and/or management positions at Dover Downs Gaming & Entertainment as well, and received separate compensation from that entity.

DVD Directors – Overlap with Companies Controlled by the Rollins Family

Shareholder Concerns

Scale

Driving the consolidation wave of the late 1990’s through late 2000’s was Dover Motorsports’ largest competitor, International Speedway Corporation, or ISCA. Owning 13 active tracks, ISCA hosted 19 of the 36 NASCAR Sprint Cup Series races by 2009. By comparison, competitor Speedway Motorsports occupied a distant second place with eight racetracks, while Dover rounded out the third position with its four tracks and two Sprint Cup races. Consolidating a sizable portfolio of tracks and race dates under a single umbrella provided the leading players with sustainable competitive advantages in the form of superior ability to negotiate with NASCAR, lobby municipal and state governments and regulators, maintain pricing power for sponsorships and ticketing, and spread marketing and corporate expenses across a broader revenue base.

While the benefits of scale accrued to each of the top three market participants to some extent, International Speedway’s position as the industry leader had become increasingly difficult to challenge.

Dover Motorsports’ efforts to increase its size and competitive position, via both acquisitions and de novo expansion, were met with significant challenges. The 1998 acquisition of the Grand Prix Association of Long Beach for a pro-forma price of approximately $91 million included the Grand Prix of Long Beach, Gateway International Raceway and Memphis Motorsports Park. The Company later acquired the Grand Prix of Denver and Grand Prix of St. Petersburg and folded them into this business unit. These acquisitions resulted in a steady stream of asset impairments and goodwill writedowns of over $106 million between 2002 and mid-2009, and by 2005, only the Gateway and Memphis tracks remained part of Dover Motorsports.

In April 2001, Dover Motorsports inaugurated the Nashville Superspeedway, a 1.33 mile racetrack with a permanent seating capacity of 50,000, built at a cost of approximately $100 million (net of subsidies from the state of Tennessee). The facility was built for the purpose of attracting a NASCAR Sprint Cup Series race, which had yet to occur. In the 2009 NASCAR racing season, the Nashville Superspeedway played host to two NASCAR Nationwide Series races, the Pepsi 300 and Nationwide Auto Parts 300, and bore the unique distinction of being the only track to host two NASCAR Nationwide Series events without also hosting a Sprint Cup Series race.

By 2006, it was evident that Nashville would not attract a Sprint Cup series race, which resulted in nearly $20 million of asset impairments between 2006 and 2008.

In addition to the multitude of goodwill writedowns and asset impairments which occurred over the decade, it was believed that the Gateway, Memphis, and Nashville tracks collectively operated at a $5-$6 million annual loss and had never been profitable. An exact figure has never been available given the Company had never publicly provided any track level operating data or classified the Midwest assets as a separate operating unit.

Chairman Tippie’s business philosophy on cutting losses was highlighted in a 1999 interview from the Tippie School of Management at the University of Iowa.

“Being detail-oriented has always been important to me. I believe in getting all the facts, looking at different points of view, from different angles. It makes me a 24-hour “sleep on it” type of a decision-maker. I think it out, then go forward. If it doesn’t work, fine. I’m not one to stay with it if it doesn’t work– I cut my losses and try something else. I don’t let decisions keep me awake at night.”

“I’m probably at my best when things are toughest. When things get tough, I feel the need to organize and straighten things out. I’m strong on planning wherever I’m going. I’m also known as an ‘attack dog.’ I’m for attacking a problem, not running from it.”3

Declining Fundamentals

NASCAR experienced tremendous growth in popularity over a 15 year period, peaking at an estimated 75 million NASCAR fans in 2005. In the 2006 racing season, however, NASCAR began to experience declines in both television ratings and race attendance. Television ratings declined in 32 of 36 races, with declines of more than 10% for 16 of those races. In addition, NASCAR reports estimated that attendance decreased at a third of Sprint Cup races. At that time, it was estimated that fewer than half of the Sprint Cup races were sold out.45

The macro-economic fallout arising from the bursting of the United States’ housing bubble in 2007 continued to plague the consumer discretionary sector well into 2009. As a result, ticket demand for race events, corporate spending and sponsorship budgets, concession sales and other revenue streams generally remained soft across the motorsports industry, and Dover was no exception. Revenue and operating profit declines, which began in Fiscal 2006, had yet to reverse course. While the broad economic malaise affected Dover’s competitors as well, the Company’s lack of scale, its unprofitable tracks, and its reliance on a single facility (Dover) for its operating profit left the Company more vulnerable to undesirable economic conditions and underperformance. The reliance on a single track for its profits also subjected the Company to variability in results due to potential adverse weather conditions on its two Sprint Cup weekends per year.

Ticket sales presented a unique barometer for changing market conditions in the motorsports industry. Attendance at Dover International Speedway, never again sold out its 140,000 seated capacity, yet management continued to resist cutting ticket prices in 2009, opting instead to focus on package deals combining race admission, food and lodging.6 With 53% of NASCAR fans earning less than $50,000 annually, and 32% earning less than $30,000, many operators began to pay attention to what was becoming an increasingly elastic demand base.7 Competing racetracks aggressively cut prices in an attempt to revive volumes, with noteworthy examples such as Daytona International Speedway cutting grandstand prices to $40, the lowest level since 1996.8

The first wave of sponsorship terminations by corporate advertisers began in late summer and early fall 2008 with the abrupt exit of long-time supporters such as Chevron, General Motors and Chrysler. By July 2009, all four automobile manufacturers affiliated with the sport had reduced their support or announced plans to do so. Many of the sponsors who continued their involvement with NASCAR cut their commitments, forcing teams and track operators to seek multiple parties to split sponsorship deals.

While the early wave of sponsorship cancellations was weighted heavily towards the most beleaguered industries and marginal teams, by May 2009, speculation had begun that even brand-name players such as Jeff Gordon might be affected. Media sources were reporting that even DuPont chemical may not renew its NASCAR deal upon expiration, following other advertisers such as GM Goodwrench, Tide, Kodak, Jack Daniel’s and Jim Beam, among others.

Beyond the challenges faced by the prestigious Sprint Cup Series, the lower-tier events, such as the NASCAR Nationwide Series and Camping World Truck Series were hit even harder. With widespread sponsor exits and a number of teams sitting idle, industry observers are not convinced these lower tier series will survive in their current form over the intermediate term.

3 Business at Iowa, Henry Tippie Interview, Spring 1999

4 http://www.jayski.com/pages/tvratings2006.htm

5 USA Today, “NASCAR’s Growth Slows After 15 Years in the Fast Lane

6 Delaware News Journal, January 16, 2009

7 USA Today, “Tracks Go Extra Mile to Keep Fans Coming Back,” April 28, 2008

8 Revenues From Sports Venues, “Prices Drop for NASCAR Tickets in Daytona,” July 9, 2009

The slashing of corporate budget allocations to NASCAR, its raceways, races and teams led to multiplicative effects. As sponsor budgets fell, race teams were forced to cut their number of cars, number of races entered, merge with competitors, or cease operations altogether.

Many NASCAR track, event and team sponsors were in hard-hit sectors of the economy, such as automotive and construction. While some sponsorships were replaced by upstarts such as GoDaddy.com and Cash4Gold, serious questions remained about the ability of the industry to permanently replace lost revenue.

Transparency or Lack Thereof

The Company reported its financial results under a single operating segment, and did not disclose track-level information to any finer degree of granularity, making third-party analysis of the relative performance of various tracks a daunting task. The Company did not host an analyst day nor did its management participate in investor conferences. Dover Motorsports eliminated the Q&A portion of its quarterly earnings conference calls after the Q2 2008 event, eliminating the only public forum for shareholders to communicate with management. With no earnings guidance provided by the Company and minimal coverage provided by the equity research community, shareholders were seriously challenged to forecast future performance.

Failed Shift in Strategy

On January 28, 2009, Dover publicly announced it had entered into an agreement to sell Memphis Motorsports Park to Gulf Coast Entertainment, L.L.C. (“Gulf Coast”) for $10 million in cash, subject to financing conditions, with an expected closing date of April 30, 2009. Gulf Coast had announced its intention in September 2006 to build a major motorsports and entertainment facility in southern Alabama, with an initial expected completion date of fall 2009. By spring 2009, however, it became apparent that the financing for the Memphis acquisition might be at risk when Dover announced on April 24, 2009 that their agreement with Gulf Coast had been amended to provide for a closing on or before June 29, 2009. On July 8, 2009, Dover announced that Gulf Coast did not finalize its project financing in time for the scheduled June 29, 2009 closing date and further extended the closing date until September 29, 2009.

On September 30, 2009, the Company announced that its agreement to sell Memphis Motorsports Park to Gulf Coast had been terminated due to Gulf Coast’s inability to secure financing.

Public Market Valuation

From October 1, 2008 to October 1, 2009, Dover experienced a precipitous share price decline, falling nearly 72 percent, from $5.20 to $1.48 per share. This was more than double the percentage decline in the share prices of its two nearest competitors, International Speedway and Speedway Motorsports, whose share prices lost 30 percent and 26 percent, respectively.

While the $340 million price SMI paid for the New Hampshire International Speedway (a close comparable to Dover International Speedway) in 2008 may not be easily replicated in the environment of late 2009, even a fraction thereof would have eclipsed Dover’s total enterprise value, at that time, of roughly $91 million.

Investor Sentiment

By 2007, Dover’s outside shareholders had become increasingly concerned with the Company’s performance and strategy, voicing concerns about the Company’s prospects as a stand-alone entity. One of the most vocal shareholders was Marathon Partners, L.P., a New York City-based investment partnership founded by Mario Cibelli, the largest outside shareholder of the Company. In a series of letters addressed to Dover’s board of directors beginning in May 2007, Marathon articulated the concerns of Dover’s shareholders: namely, the Company’s weakened financial and operating position relative to its competitors and the resulting need to divest assets up to and potentially including the Company as a whole.

Marathon sent several letters to Dover’s board of directors during the period from 2007 to 2009. When Dover ultimately responded via letter on September 9, 2009, the Company’s General Counsel indicated that Dover had participated in merger talks with a consortium consisting of Speedway Motorsports and International Speedway, Dover’s primary competitors, on May 2, 2007. According to Dover Motorsports, the consortium offered to acquire Dover Motorsports for a five-cent per share premium to market value. Based on the May 1, 2007 adjusted closing price of $5.57, the stock went on to lose approximately seventy percent of its market value by late October 2009.

Voting Results of 2009 Annual Meeting

At the Company’s annual meeting which took place on April 29, 2009, shareholders voted on the re-election of three directors (including Mr. Tippie) and a stockholder proposal submitted by Marathon Partners to eliminate the Company’s poison pill.

Regarding Mr. Tippie’s re-election, 95.7 percent of the voting shares were cast in favor of Mr. Tippie’s re-election, with 4.3 percent of the votes being withheld. However, adjusting for the voting impact of the Class A shares, a very different result was apparent. Assuming all insiders had voted for the re-election of Mr. Tippie, the remaining non-insider votes would have totaled 65.2 percent withheld against Mr. Tippie’s re-election.

The number of “Withheld” votes related to the re-election of Chairman Tippie to the Board of Directors over his past three re-elections seemed to reflect a deterioration of support by outside shareholders.

Regarding the Stockholder Proposal, Marathon Partners argued in its supporting statement that the Rights Agreement served no other purpose than to arbitrarily limit the number of shares a current or prospective shareholder could own at 10% of the combined classes of stock.  Similar to the results of Mr. Tippie’s re-election, the vote of the non-insiders was drastically different than those of the insiders, with 90.7% of outside shareholders in favor of eliminating the poison pill.

Increasing Level of Shareholder Concern

Exchange Listing Warnings

On February 20, 2009, Dover Motorsports received a notice from the New York Stock Exchange indicating that it failed to meet the NYSE’s $75 million minimum market capitalization requirement and was in danger of being de-listed. On June 2, 2009, Dover received notice that it had regained compliance due to a reduction in minimum thresholds to $50 million. In early October of 2009, with a market capitalization of roughly $54 million, a mere 7.5 percent decline in the share price would once again put the Company in danger of being de-listed by the NYSE.

Suspension of Dividend

On July 29, 2009, Dover Motorsports announced that its Board of Directors voted to suspend the Company’s quarterly dividend on all classes of its common stock. As a result, Dover became the second Rollins-controlled public company in 2009 to suspend its regular dividend. The suspension of the dividend triggered the following salient provision in the Last Will and Testament of John W. Rollins, Senior.

“My wife shall have the power at any time and from time to time to require Trustee to convert any non income-producing property held at any time by the RMT to income producing property by delivering to Trustee a written direction to that effect.”9

Therefore, despite the Voting Agreement in force, the suspension of dividend enabled Ms. Rollins to compel Mr. Tippie to convert RMT Trust’s Dover shares from ‘non-income producing’ to ‘income producing’ at any time if so desired.

Debt Covenants

On August 21, 2009 the Company amended its revolving credit agreement with PNC Bank in order to avoid violating covenants attached to the revolver. As of the Company’s June 30, 2009 financial statements, $34.8 million was outstanding. The revised agreement increased interest rates on this facility to roughly LIBOR + 350 basis points, depending on certain external factors such as the current prime rate. In addition, the revised agreement granted the lender a lien on the Company’s assets and prohibited it from resuming its dividend.

Management Reticence to Discuss Sale

Setting itself apart from many companies which have wrestled with failed acquisitions and divestitures, concerns over debt repayment and de-listing notifications, Dover chose not to entertain any formal, public discussion of a potential sale process, nor did it publicly discuss the possibility of retaining an outside advisor to evaluate its options with respect to maximizing shareholder value. With the exception of CEO Denis McGlynn’s passing comment that “the Board has to look at [every potential offer]” during the Company’s July 24, 2008 earnings call (the Company’s final Q&A session), management had yet to publicly address the notion of a sale.

Management Non-Compete & Change in Control Provisions

As of the close of Fiscal Year 2008, the Company had $7.6 million to $9.2 million in contingent liabilities related to non-compete and change in control provisions relating to Dover’s senior management. Given the struggles endured by the Company, and subsequent evaporation of shareholder value, these agreements had appeared to become increasingly questionable. Independent observers may have wondered if a truly arms-length board would have continued to approve such agreements in the face of the Company’s ongoing challenges.

9 Last Will and Testament of John W. Rollins, Sr., paragraph 10(A)(1)

Strategic Alternatives

By October 2009, Dover Motorsports was at a crossroads with three simple options: it could maintain the status quo, continuing its present course of action and attempting to pay down debt out of cash flow; it could attempt to become a scale player through an acquisition or acquisitions, or it could retain a financial advisor and conduct a sales process.

Status Quo

Returning to profit growth via a “stay the course” strategy would first and foremost depend on a favorable macroeconomic environment. In the fall of 2009, industry observers expected headwinds to persist at least through 2010. Furthermore, the Company would need to sell its loss-generating business units in order to make more rapid progress on debt reduction and an eventual resumption of dividend payment. The failed sale of Memphis Motorsports Park to Gulf Coast Entertainment after nearly one year of public, and as much as three years of behind-the-scenes effort by the Company cast doubts on Dover’s ability to raise funds by selling any tracks except for its marquee asset, Dover International Speedway. With a strong likelihood of a continuing weak economic environment, incremental revenue and profitability expansion resulting from uplift in attendance, increased ticket prices and/or more favorable corporate sponsorship deals were becoming increasingly unlikely. In the event that NASCAR decided to reduce the number of races in future years, Dover Motorsports would potentially find itself at a disadvantage in its efforts to retain onto its Sprint Cup Series race weekends given its status as a small, independent operator.

During fiscal 2009, the Company was faced with a de-listing warning from the New York Stock Exchange which was only overcome due to a favorable change in requirements, and was forced to renegotiate its revolving credit agreement at less favorable terms when it appeared the Company would likely violate its debt covenants. Between these ongoing pain points, consolidation trends in the industry, and the Company’s position of weakness relative to its competitors, it was difficult to envision a scenario in which Dover Motorsports was capable of thriving as a stand-alone entity. By failing to articulate a forward-looking plan for a stand-alone Dover, management had done nothing to shed light on the viability of maintaining the status quo.

Acquisitions

Dover Motorsports had an extremely limited ability to pursue acquisitions due to a minimal cash position and diminished ability to fund acquisitions using debt. The Company’s experience with the Grand Prix Association of Long Beach cast doubts about its ability to successfully integrate an acquisition regardless of financing considerations.

Sale of Company

As the third largest public racetrack operator in the US, Dover Motorsports’ most credible potential acquirers were International Speedway Corporation and Speedway Motorsports. Each company had the financial and organizational capabilities to acquire and successfully integrate Dover Motorsports into a larger platform.

Potential Acquirers

International Speedway Corporation (“ISC”):

International Speedway Corporation was far and away the dominant racetrack operator in the US from the late-1990’s onward. In addition to its 13 racetracks, ISC was unique among track owners in the fact that its controlling shareholder, the France family, also owns the NASCAR organization. International Speedway had been a key partner of NASCAR in its attempt to expand and modernize the sport of automobile racing, and the two organizations have worked in tandem for over a decade to increase the number of high profile races and penetrate new media markets. NASCAR’s France family controlled more than two-thirds of the voting stock of International Speedway, and the two companies shared many of the same individuals among their executive ranks. While some of ISC’s competitors have alleged that this situation violated antitrust statutes, the courts had thus far shown little willingness to sever the relationship between these companies.

In early 2007, ISC acquired the remaining 62.5 percent of Raceway Associates it did not already own, giving it 100 percent of the Chicagoland Speedway and its Sprint Cup race weekend, for approximately $102 million. By acquiring nine tracks from 1999 to 2009, International Speedway demonstrated its competence at successfully valuing, purchasing, integrating and operating a nationwide portfolio of racetracks.

Speedway Motorsports Incorporated (“SMI”):

Speedway Motorsports Incorporated became the first publicly traded racetrack operator in the United States following its Initial Public Offering on the New York Stock Exchange in 1995. After pursuing a multi-year strategy of growth through the acquisition and closure of tracks in order to obtain NASCAR race dates, SMI operated eight racetracks by the fall of 2009. Speedway Motorsports boasts one of the largest permanent seat totals in the motorsports industry, and the highest average number of seats per raceway. In addition to its primary business of selling tickets to racing events, sponsorship and advertising placement and concessions sales, Speedway was also involved in the marketing and distribution of licensed and unlicensed souvenir and apparel merchandise and also operated a racing broadcast network through its Performance Racing Network subsidiary.

In January 2008, Speedway Motorsports closed on the $340 million acquisition of New Hampshire International Speedway, a racetrack with striking similarities to Dover International Speedway. Both facilities were home to two Sprint Cup race weekends, although New Hampshire International Speedway seats roughly 40,000 fewer attendees. Furthermore, New Hampshire International Speedway occupied a lower tier of TV revenue participation than the Dover racetrack for one of its two Sprint Cup races.

In December 2008, SMI closed on its acquisition of Kentucky Speedway for $78 million. Although it was designed with Sprint Cup Series events in similar fashion to Dover’s Nashville track, the facility did not host a Sprint Cup race weekend at the time it was purchased. Given Speedway’s objective of hosting one or two Sprint Cup race weekends at each of its qualified facilities, this transaction gave SMI a powerful incentive to obtain additional Sprint Cup races through an acquisition.

Transaction Rationale

A buyout offer could potentially arrive in the form of an all-stock offer at a premium to the Company’s current trading price, with a potential share repurchase designed to neutralize the dilutive effects of an all-stock transaction. Given recent retrenchments in the share prices of Dover’s two publicly-traded competitors, shareholders would derive additional upside in a subsequent recovery. Given the events of the first decade of the 21st century, it would be hard for any observer to conceive of a scenario in which Dover shareholders would be more successful as a standalone entity. Swapping Dover’s shares for those of a competitor who possessed a lower likelihood of underperforming the overall motorsports industry would mitigate any potential argument questioning the wisdom of what could be viewed as “selling at the bottom.”

Potential Obstacles

External obstacles to a transaction would be minimal. NASCAR demonstrated a willingness to endorse these roll-up acquisitions by transferring the race event sanction agreements to the acquirer. Both International Speedway and Speedway Motorsports have made no secret of their desire to acquire additional racetracks which host Sprint Cup Series events.

Internal obstacles to a transaction would be more formidable. The poison pill and non-compete agreements would need to be overcome before any possible transaction. Ultimately, the one and only relevant barrier to a Company-saving transaction appeared to be Mr. Tippie. His acquiescence would facilitate the board’s clear-headed assessment of the Company’s situation and realistic future progress, potentially forming an independent special committee and retaining an advisor.

Which Way Forward?

By all measures, the trajectory of Dover Motorsports under Mr. Tippie’s control left much to be desired. The remaining question for board members in 2009 was “What now?” Would the Company be best served by putting its future in the hands of a larger, stronger competitor, or by hoping to prevail in a battle of David versus two Goliaths?

If a board member felt a merger was the best course of action, how would he or she go about convincing Mr. Tippie that the history of Dover Motorsports and the jobs of its employees would be best secured through a merger, and that this transaction would be a fitting coda to an illustrious career spanning over six decades?

If, on the other hand, you elected to stay the course, how would you respond to concerns that you had neglected the concerns of the shareholders?

Given R. Randal Rollins role as a Director of Dover, a Trustee of RMT Trust (the largest shareholder), and apparent patriarch of the Rollins family, how might non-family board members attempt to convince Mr. Rollins to effect change at Dover?

How might Mr. Rollins best alter the current path of Dover given the long-standing relationship between Mr. Tippie and the Rollins family?

Subsequent Events

On October 30, 2009, the Company announced that it was ceasing all operations at Memphis Motorsports Park and that it would not promote any events in Memphis in 2010. Concurrently with the announcement, the Company announced it secured approval from NASCAR to realign the Memphis Nationwide Series race to Gateway International Raceway and the Camping World Truck Series race to Nashville Superspeedway.

On November 2, 2009, the Company reported its quarterly earnings for the period ended September 30, 2009. At that time, the Company disclosed that it made a further asset impairment charge of $7.5 million related to Memphis Motorsports Park.

On November 9, 2009, Marathon Partners sent a letter to the Trustees of RMT Trust, offering to acquire RMT Trust’s 8,000,000 shares of Class A common stock for $2.35 per share, a 35% premium to the day’s closing price of $1.75. While a sale of RMT Trust shares would not have resulted in Marathon Partners controlling the Company, it would have resulted in a shift of control from Mr. Tippie to other Rollins family members and management.

On November 17th, 2009, Mr. Tippie responded via letter to Marathon Partners indicating that the three Trustees of RMT Trust had no interest in pursuing Marathon Partners’ offer.

On November 25, 2009, Marathon Partners submitted a shareholder proposal to Dover Motorsports, seeking to amend the Bylaws of Dover to eliminate the transferability restrictions of Dover’s Class A Common Stock.

On December 1, 2009 Kansas Entertainment, LLC, a 50/50 joint venture between International Speedway and Penn National Gaming, was selected by the Kansas Lottery Gaming Facility Review Board to develop and operate a Hollywood-themed entertainment destination overlooking Turn 2 at ISCA’s Kansas Speedway, with a planned opening of 2012. Included within the joint venture’s winning proposal was ISCA’s commitment to add a second Sprint Cup race to Kansas Speedway in 2011.

On December 11, 2009, the United States Court of Appeals for the Sixth Circuit affirmed the lower court’s ruling in which it dismissed, in its entirety, the civil antitrust action brought by Kentucky Speedway, LLC against ISC and NASCAR. Jerry Carroll announced on behalf of the plaintiffs that the founding track ownership group will not exercise remaining legal options in the case of Kentucky Speedway, which largely cleared the way for SMI to move a Sprint Cup date to Kentucky Speedway as early as 2011.

Mr. Tippie was awarded an honorary doctorate from the University of Iowa at their December 19, 2009 commencement ceremonies. In the official University of Iowa press release dated December 3, 2009, Dean Curt Hunter describes Mr. Tippie as follows:

“Henry Tippie is a man of humble demeanor but extraordinary achievement, and he is a role model for University of Iowa students,” said Hunter. “He has built his businesses the right away [sic], with hard work and ethical considerations always foremost. His generosity with the University ensures that he will continue to inspire our students for generations to come.”10

10 http://tippie.uiowa.edu/news/story.cfm?id=2248

Although the information contained in this case study has been obtained from public sources that the author believes to be reliable, the author cannot guarantee its accuracy. The case study is for academic purposes only, and does not constitute an offer or solicitation to buy or sell any securities discussed herein. Marathon Partners, LP supported the costs of completing this study and had an investment interest in Dover Motorsports, Inc. as of the time of this writing.

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ROIC and reversion to the mean: Part 3

Posted in About, Behavioral economics, Contrarian investment, Net Current Asset Value, Net Quick Stocks, Net Quick Value, Stocks, Value Investment, tagged , on April 27, 2010| Leave a Comment »

Recently I’ve been discussing Michael Mauboussin’s December 2007 Mauboussin on Strategy, “Death, Taxes, and Reversion to the Mean; ROIC Patterns: Luck, Persistence, and What to Do About It,” (.pdf) about Mauboussin’s research on the tendency of return on invested capital (ROIC) to revert to the mean (See Part 1 and Part 2).

Mauboussin’s report has significant implications for modelling in general, and also several insights that are particularly useful to Graham net net investors. These implications are as follows:

  • Models are often too optimistic and don’t take into account the “large and robust reference class” about ROIC performance. Mauboussin says:

We know a small subset of companies generate persistently attractive ROICs—levels that cannot be attributed solely to chance—but we are not clear about the underlying causal factors. Our sense is most models assume financial performance that is unduly favorable given the forces of chance and competition.

  • Models often contain errors due to “hidden assumptions.” Mauboussin has identified errors in two distinct areas:

First, analysts frequently project growth, driven by sales and operating profit margins, independent of the investment needs necessary to support that growth. As a result, both incremental and aggregate ROICs are too high. A simple way to check for this error is to add an ROIC line to the model. An appreciation of the degree of serial correlations in ROICs provides perspective on how much ROICs are likely to improve or deteriorate.

The second error is with the continuing, or terminal, value in a discounted cash flow (DCF) model. The continuing value component of a DCF captures the firm’s value for the time beyond the explicit forecast period. Common estimates for continuing value include multiples (often of earnings before interest, taxes, depreciation, and amortization—EBITDA) and growth in perpetuity. In both cases, unpacking the underlying assumptions shows impossibly high future ROICs. 23

  • Models often underestimate the difficulty in sustaining high growth and returns. Few companies sustain rapid growth rates, and predicting which companies will succeed in doing so is very challenging:

Exhibit 12 illustrates this point. The distribution on the left is the actual 10-year sales growth rate for a large sample of companies with base year revenues of $500 million, which has a mean of about six percent. The distribution on the right is the three-year earnings forecast, which has a 13 percent mean and no negative growth rates. While earnings growth does tend to exceed sales growth by a modest amount over time, these expected growth rates are vastly higher than what is likely to appear. Further, as we saw earlier, there is greater persistence in sales growth rates than in earnings growth rates.

  • Models should be constructed “probabilistically.”

One powerful benefit to the outside view is guidance on how to think about probabilities. The data in Exhibit 5 offer an excellent starting point by showing where companies in each of the ROIC quintiles end up. At the extremes, for instance, we can see it is rare for really bad companies to become really good, or for great companies to plunge to the depths, over a decade.

For me, the following Exhibit is the most important chart of the entire paper. It’s Mauboussin’s visualization of the probabilities. He writes:

Assume you randomly draw a company from the highest ROIC quintile in 1997, where the median ROIC less cost of capital spread is in excess of 20 percent. Where will that company end up in a decade? Exhibit 13 shows the picture: while a handful of companies earn higher economic profit spreads in the future, the center of the distribution shifts closer to zero spreads, with a small group slipping to negative.

  • Crucial for net net investors is the need to understand the chances of a turnaround. Mauboussin says the chances are extremely low:

Investors often perceive companies generating subpar ROICs as attractive because of the prospects for unpriced improvements. The challenge to this strategy comes on two fronts. First, research shows low-performing companies get higher premiums than average-performing companies, suggesting the market anticipates change for the better. 24 Second, companies don’t often sustain recoveries.

Defining a sustained recovery as three years of above-cost-of-capital returns following two years of below-cost returns, Credit Suisse research found that only about 30 percent of the sample population was able to engineer a recovery. Roughly one-quarter of the companies produced a non-sustained recovery, and the balance—just under half of the population—either saw no turnaround or disappeared. Exhibit 14 shows these results for nearly 1,200 companies in the technology and retail sectors.


Mauboussin concludes with the important point that the objective of active investors is to “find mispriced securities or situations where the expectations implied by the stock price don’t accurately reflect the fundamental outlook:”

A company with great fundamental performance may earn a market rate of return if the stock price already reflects the fundamentals. You don’t get paid for picking winners; you get paid for unearthing mispricings. Failure to distinguish between fundamentals and expectations is common in the investment business.

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Grantham on the potential disadvantages of Graham-and-Dodd investing

Posted in About, Stocks, Value Investment, tagged , on April 26, 2010| 11 Comments »

Jeremy Grantham’s 2010 first quarter investor letter (.pdf) appends the first part of a speech he gave at the Annual Benjamin Graham and David Dodd Breakfast at Columbia University in October last year. The speech was titled Friends and Romans, I come to tease Graham and Dodd, not to praise them. In it Grantham discussed the “potential disadvantages of Graham and Dodd-type investing.” It seems to have struck a chord, as I’ve received it from several quarters. As one of the folks who forwarded it to me noted, we learn more from those who disagree with us.

Hat tip Toby, Raj and everyone else.

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ROIC and reversion to the mean: Part 2

Posted in About, Stocks, Value Investment, tagged , , on April 22, 2010| 4 Comments »

Yesterday I discussed Michael Mauboussin’s December 2007 Mauboussin on Strategy, “Death, Taxes, and Reversion to the Mean; ROIC Patterns: Luck, Persistence, and What to Do About It,” (.pdf) about Mauboussin’s research on the tendency of return on invested capital (ROIC) to revert to the mean.

Mauboussin’s report has three broad conclusions, with significant implications for modelling:

  • Reversion to the mean is a powerful force. As has been well documented by numerous studies, ROIC reverts to the cost of capital over time. This finding is consistent with microeconomic theory, and is evident in all time periods researchers have studied. However, investors and executives should be careful not to over interpret this result because reversion to the mean is evident in any system with a great deal of randomness. We can explain much of the mean reversion series by recognizing the data are noisy.
  • Persistence does exist. Academic research shows that some companies do generate persistently good, or bad, economic returns. The challenge is finding explanations for that persistence, if they exist.
  • Explaining persistence. It’s not clear that we can explain much persistence beyond chance. But we investigated logical explanatory candidates, including growth, industry representation, and business models. Business model difference appears to be a promising explanatory factor.

How to identify ROIC persistence ex ante

The goal of the investor is to identify businesses with future, sustainable, high ROIC. Mauboussin explores three variables that might be predictive of such persistent high ROIC: corporate growth, the industry in which a company competes, and the company’s business model.

Corporate growth

Mauboussin identifies some correlation between growth and persistence, but cautions:
The bad news about growth, especially for modelers, is it is extremely difficult to forecast. While there is some evidence for sales persistence, the evidence for earnings growth persistence is scant. As some researchers recently summarized, “All in all, the evidence suggests that the odds of an investor successfully uncovering the next stellar growth stock are about the same as correctly calling coin tosses.” 16

Industry

Mauboussin finds that industries that are overrepresented in the highest return quintile throughout the measured period are also overrepresented in the lowest quintile. Those industries include pharmaceuticals/biotechnology and software. He concludes that positive, sustainable ROICs emerge from a good strategic position within a generally favorable industry.

Business model

This is perhaps the most useful and interesting variable considered by Mauboussin. He relates Michael Porter’s two sources of competitive advantage – differentiation and low-cost production – to ROIC by breaking ROIC into its two prime components, net operating profit after tax (NOPAT) margin and invested capital turnover (NOPAT margin equals NOPAT/sales, and invested capital turnover equals sales/invested capital. ROIC is the product of NOPAT margin and invested capital turnover.):

Generally speaking, differentiated companies with a consumer advantage generate attractive returns mostly via high margins and modest invested capital turnover. Consider the successful jewelry store that generates large profits per unit sold (high margins) but doesn’t sell in large volume (low turnover). In contrast, a low-cost company with a production advantage will generate relatively low margins and relatively high invested capital turnover. Think of a classic discount retailer, which doesn’t make much money per unit sold (low margins) but enjoys great inventory velocity (high turnover). Exhibit 8 consolidates these ideas in a simple matrix.

Mauboussin examined the 42 companies that stayed in the first quintile throughout the measured period to see whether they leaned more toward a consumer or production advantage:

Not surprisingly, this group outperformed the broader sample on both NOPAT margin and invested capital turnover, but the impact of margin differential (2.4 times the median) was greater on ROIC than the capital turnover differential (1.9 times). While equivocal, these results suggest the best companies may have a tilt toward consumer advantage.

An analysis of the poor performers reveals that they posted NOPAT margins and invested capital turnover “symmetrical” with the high-performing companies i.e. below the full sample’s median.

Mauboussin concludes:

Our search for factors that may help us anticipate persistently superior performance leaves us little to work with. We do know persistence exists, and that companies that sustain high returns over time start with high returns. Operating in a good industry with above-average growth prospects and some consumer advantage also appears correlated with persistence. Strategy experts Anita McGahan and Michael Porter sum it up: 22

It is impossible to infer the cause of persistence in performance from the fact that persistence occurs. Persistence may be due to fixed resources, consistent industry structure, financial anomalies, price controls, or many other factors that endure . . . In sum, reliable inferences about the cause of persistence cannot be generated from an analysis that only documents whether or not persistence occurred.

More to come.

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ROIC and reversion to the mean: Part 1

Posted in About, Stocks, Value Investment, tagged , on April 21, 2010| 10 Comments »

In Michael Mauboussin’s December 2007 Mauboussin on Strategy, “Death, Taxes, and Reversion to the Mean; ROIC Patterns: Luck, Persistence, and What to Do About It,” (.pdf) Mauboussin provides a tour de force of data on the tendency of return on invested capital (ROIC) to revert to the mean. Much of my investing to date has been based on the naive assumption that the tendency is so powerful that companies with a high ROIC should be avoided because the high ROIC is not sustainable, but rather indicates a cyclical top in margins and earnings. This view is broadly supported by other research on mean reversion in earnings that I have discussed in the past, which has suggested, somewhat counter-intuitively, that in aggregate the earnings of low price-to-book value stocks grow faster than the earnings of high price-to-book value stocks. I usually cite this table from the Tweedy Browne What works in investing document:

tweedy-table-3

In the four years after the date of selection, the earnings of the companies in the lowest price-to-book value quintile (average price-to-book value of 0.36) increase 24.4%, more than the companies in the highest price-to-book value quintile (average price-to-book value of 3.42), whose earnings increased only 8.2%. DeBondt and Thaler attribute the earnings outperformance of the companies in the lowest quintile to mean reversion, which Tweedy Browne described as the observation that “significant declines in earnings are followed by significant earnings increases, and that significant earnings increases are followed by slower rates of increase or declines.”

Mauboussin’s research seems to suggest that, while there exists a strong tendency towards mean reversion, some companies do “post persistently high or low returns beyond what chance dictates.” He has two caveats for those seeking the stocks with persistent high returns:

1. The “ROIC data incorporate much more randomness than most analysts realize.”

2. He “had little luck in identifying the factors behind sustainably high returns.”

That said, Mauboussin presents some striking data about “persistence” in high ROIC companies that suggests investing in high ROIC companies is not necessarily a short ride to the poor house, and might actually work as an investment strategy. (That was very difficult to write. It goes against every fiber of my being.) Here’s Mauboussin’s research:

Mauboussin’s report has three broad conclusions, with significant implications for modelling:

  • Reversion to the mean is a powerful force. As has been well documented by numerous studies, ROIC reverts to the cost of capital over time. This finding is consistent with microeconomic theory, and is evident in all time periods researchers have studied. However, investors and executives should be careful not to over interpret this result because reversion to the mean is evident in any system with a great deal of randomness. We can explain much of the mean reversion series by recognizing the data are noisy.
  • Persistence does exist. Academic research shows that some companies do generate persistently good, or bad, economic returns. The challenge is finding explanations for that persistence, if they exist.
  • Explaining persistence. It’s not clear that we can explain much persistence beyond chance. But we investigated logical explanatory candidates, including growth, industry  representation, and business models. Business model difference appears to be a promising explanatory factor.

ROIC mean reversion

Here Mauboussin charts the reversion-to-the-mean phenomenon using data from “1000 non-financial companies from 1997 to 2006.” The chart shows a clear trend towards nil economic profit, as you would expect:

We start by ranking companies into quintiles based on their 1997 ROIC. We then follow the median ROIC for the five cohorts through 2006. While all of the returns do not settle at the cost of capital (roughly eight percent) in 2006, they clearly migrate toward that level.

And another chart showing the change:

Mauboussin has this elegant interpretation of the results:

Any system that combines skill and luck will exhibit mean reversion over time. 7 Francis Galton demonstrated this point in his 1889 book, Natural Inheritance, using the heights of adults. 8 Galton showed, for example, that children of tall parents have a tendency to be tall, but are often not as tall as their parents. Likewise, children of short parents tend to be short, but not as short as their parents. Heredity plays a role, but over time adult heights revert to the mean.

The basic idea is outstanding performance combines strong skill and good luck. Abysmal performance, in contrast, reflects weak skill and bad luck. Even if skill persists in subsequent periods, luck evens out across the participants, pushing results closer to average. So it’s not that the standard deviation of the whole sample is shrinking; rather, luck’s role diminishes over time.

Separating the relative contributions of skill and luck is no easy task. Naturally, sample size is crucial because skill only surfaces with a large number of observations. For example, statistician Jim Albert estimates that a baseball player’s batting average over a full season is a fifty-fifty combination between skill and luck. Batting averages for 100 at-bats, in contrast, are 80 percent luck. 9

Persistence in ROIC Data

“Persistence” is the likelihood a company will sustain its ROIC. If the stocks are ranked on the basis of ROIC and then placed into quintiles, persistence is likliehood that a stock will remain in the same quintile throughout the measured time frame. Mauboussin then measures persistence by analysing “quintile migration:”

This exhibit shows where companies starting in one quintile (the vertical axis) ended up after nine years (the horizontal axis). Most of the percentages in the exhibit are unremarkable, but two stand out. First, a full 41 percent of the companies that started in the top quintile were there nine years later, while 39 percent of the companies in the cellar-dweller quintile ended up there. Independent studies of this persistence reveal a similar pattern. So it appears there is persistence with some subset of the best and worst companies. Academic research confirms that some companies do show persistent results. Studies also show that companies rarely go from very high to very low performance or vice versa. 13

These are striking findings. In Mauboussin’s data, there was a 64% chance that a company in the highest quintile at the start of the period was still in the first or second quintile at the end of the 10 year period. Further, it seems that there is a three-in-four chance that the high quintile stocks don’t fall into the lowest or second lowest quintiles after 10 years. It’s not all good news however.

Before going too far with this result, we need to consider two issues. First, this persistence analysis solely looks at where companies start and finish, without asking what happens in between. As it turns out, there is a lot of action in the intervening years. For example, less than half of the 41 percent of the companies that start and end in the first quintile stay in the quintile the whole time. This means that less than four percent of the total-company sample remains in the highest quintile of ROIC for the full nine years.

The second issue is serial correlation, the probability a company stays in the same ROIC quintile from year to year. As Exhibit 5 suggests, the highest serial correlations (over 80 percent) are in Q1 and Q5. The middle quintile, Q3, has the lowest correlation of roughly 60 percent, while Q2 and Q4 are similar at about 70 percent.

This result may seem counterintuitive at first, as it suggests results for really good and really bad companies (Q1 and Q5) are more likely to persist than for average companies (Q2, Q3, and Q4). But this outcome is a product of the methodology: since each year’s sample is broken into quintiles, and the sample is roughly normally distributed, the ROIC ranges are much narrower for the middle three quintiles than for the extreme quintiles. So, for instance, a small change in ROIC level can move a Q3 company into a neighboring quintile, whereas a larger absolute change is necessary to shift a Q1 and Q5 company. Having some sense of serial correlations by quintile, however, provides useful perspective for investors building company models.

So, in summary, better performed companies remain in the higher ROIC quintiles over time, although the better-performed quintiles will still suffer substantial ROIC attrition over time.

More to come.

Hat tip Fallible Investor.

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Endangered species update: The extinct, the survivors, and the new watch list

Posted in About, Activist Investors, Catalysts, Chromcraft Revington (AMEX:CRC), Stocks, tagged , , , , , on April 13, 2010| 1 Comment »

In March I highlighted an investment strategy I first read about in a Spring 1999 research report called Wall Street’s Endangered Species by Daniel J. Donoghue, Michael R. Murphy and Mark Buckley, then at Piper Jaffray and now at Discovery Group, a firm founded by Donoghue and Murphy (see also Performance of Darwin’s Darlings). The premise, simply stated, is to identify undervalued small capitalization stocks lacking a competitive auction for their shares where a catalyst in the form of a merger or buy-out might emerge to close the value gap. I believe the strategy is a natural extension for Greenbackd, and so I’ve been exploring it over the last month.

Donoghue, Murphy and Buckley followed up their initial Wall Street’s Endangered Species research report with two updates, which I recalled were each called “Endangered Species Update” and discussed the returns from the strategy. While I initially believed that those follow-up reports were lost to the sands of time, I’ve been excavating my hard-copy files and found them, yellowed, and printed on papyrus with a dot matrix 9-pin stylus. I’ve now resurrected both, and I’ll be running them today and tomorrow.

In the first follow-up, Endangered species update: The extinct, the survivors, and the new watch list (.pdf), from Summer 2000, Murphy and Buckley (Donoghue is not listed on the 2000 paper as an author) tested their original thesis and provided the “Darwin’s Darlings Class of 2000,” which was a list of what they viewed as “the most undervalued, yet profitable and growing small cap public companies” in 2000.

As for the original class of 1999, the authors concluded:

About half of the Darwin’s Darlings pursued some significant strategic alternative during the year. A significant percentage (19 of the companies) pursued a sale or going-private transaction to provide immediate value to their shareholders. Others are attempting to “grow out of” their predicament by pursuing acquisitions, and many are repurchasing shares. However, about half of the Darlings have yet to take any significant action. Presumably, these companies are ignoring their current share price and assuming that patient shareholders will eventually be rewarded through a reversal in institutional investing trends or, more likely, a liquidity event at some later date. The path chosen clearly had a significant impact on shareholder value.

Here’s the summary table:

There are several fascinating aspects to their analysis. First, they looked at the outstanding performance of the sellers:

The 19 companies that pursued a sale easily outperformed the Russell 2000 and achieved an average premium of 51.4% to their 4-week prior share price. The vast majority of transactions were sales to strategic buyers who were able to pay a handsome premium to the selling shareholders. In general, the acquirers were large cap public companies. By simply valuing the profits of a Darwin’s Darling at their own market multiple, these buyers delivered a valuation to selling shareholders that far exceeded any share price the company might have independently achieved. Note in the summary statistics below that the average deal was at an EBIT multiple greater than 10x.

Here’s the table:

Second, they considered the low proportion of sellers who went private, rather than sold out to a strategic acquirer, and likely causes:

Only three of the Darwin’s Darlings announced a going-private transaction. At first glance, this is a surprisingly small number given the group’s low trading multiples and ample debt capacity. With private equity firms expressing a very high level of interest in these transactions, one might have expected more activity.

…

Why isn’t the percentage higher? In our opinion, it is a mix of economic reality and an ironic impact of corporate governance requirements. The financial sponsors typically involved in taking a company private are constrained with respect to the price they can pay for a company. With limits on prudent debt levels and minimum hurdle rates for equity investments, the typical financial engineer quickly reaches a limit on the price he can pay for a company. As a result, several factors come into play:

• A Board will typically assume that if a “financial” buyer is willing to pay a certain price, a “strategic” buyer must exist that can pay more.

• Corporate governance rules are usually interpreted to mean that a Board must pursue the highest price possible if a transaction is being evaluated.

• Management is reluctant to initiate a going-private opportunity for fear of putting the Company “in play.”

• Financial buyers and management worry that an unwanted, strategic “interloper” can steal a transaction away from them when the Board fulfills its fiduciary duty.

In light of the final two considerations, which benefit only management, it’s not difficult to understand why activists considered this sector of the market ripe for picking, but I digress.

Third, they analyzed the performance of companies repurchasing shares:

To many of the Darwin’s Darlings, their undervaluation was perceived as a buying opportunity. Twenty companies announced a share repurchase, either through the open market, or through more formalized programs such as Dutch Auction tender offers (see our M&A Insights: “What About a Dutch Auction?” April 2000).

As we expected, these repurchases had little to no impact on the companies’ share prices. The signaling impact of their announcement was minimal, since few analysts or investors were listening, and the buying support to the share price was typically insignificant. Furthermore, the decrease in shares outstanding served only to exacerbate trading liquidity challenges. From announcement date to present, these 20 companies as a group have underperformed the Russell 2000 by 17.5%.

For many of the Darlings and other small cap companies the share repurchase may still have been an astute move. While share prices may not have increased, the ownership of the company was consolidated as a result of buying-in shares. ‘The remaining shareholders were, in effect, “accreted up” in their percentage ownership. When a future event occurs to unlock value, these shareholders should reap the benefit of the repurchase program. Furthermore, the Company may have accommodated sellers desiring to exit their investment, thereby eliminating potentially troublesome, dissenting shareholders.

One such company repurchasing shares will be familiar to anyone who has followed Greenbackd for a while: Chromcraft Revington, Inc., (CRC:AMEX), which I entered as a sickly net net and exited right before it went up five-fold. (It’s worth noting that Jon Heller of Cheap Stocks got CRC right, buying just after I sold and making out like a bandit. I guess you can’t win ’em all.) Murphy and Buckley cite CRC as an abject lesson in why buy-backs don’t work for Darwin’s Darlings:

I’m not entirely sure that the broader conclusion is a fair one. Companies shouldn’t repurchase shares to goose share prices, but to enhance underlying intrinsic value in the hands of the remaining shareholders. That said, in CRC’s case, the fact that it went on to raise capital at a share price of ~$0.50 in 2009 probably means that their conclusion in CRC’s case was the correct one.

And what of the remainder:

About half of the Darwin’s Darlings stayed the course and did not announce any significant event over the past year. Another 18 sought and consummated an acquisition of some significant size. While surely these acquisitions had several strategic reasons, they were presumably pursued in part to help these companies grow out of their small cap valuation problems. Larger firms will, in theory, gain more recognition, additional liquidity, and higher valuations. However, for both the acquirers and the firms without any deal activity, the result was largely the same: little benefit for shareholders was provided.

Management teams and directors of many small cap companies have viewed the last few years as an aberration in the markets. “Interest in small caps will return” is a common refrain. We disagree, and our statistics prove us right thus far. Without a major change, we believe the shares of these companies will continue to meander. For the 53 Darwin’s Darlings that did not pursue any major activity in the last year, 80% are still below their 1998 high and 60% have underperformed the Russell 2000 over the last year. These are results, keep in mind, for some of the most attractive small cap firms.

This is the fabled “two-tier” market beloved by value investors. While everyone else was chasing dot coms and large caps, small cap companies with excellent fundamentals were lying around waiting to be snapped up. The authors concluded:

The public markets continue to ignore companies with a market capitalization below $250 million. Most institutional investors have large amounts of capital to invest and manage, and small caps have become problematic due to their lack of analyst coverage and minimal public float. As a result, these “orphans” of the public markets are valued at a significant discount to the remainder of the market. We do not see this trend reversing, and therefore recommend an active approach to the directors and management teams at most small cap companies. Without serious consideration of a sale to a strategic or financial buyer, we believe these companies, despite their sound operating performance, will not be able to deliver value to their shareholders.

Tomorrow, the 2001 Endangered species update.

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