With the economy fluctuating between a glass half full one week and bone dry the next we continue to focus on Value and special situations based upon our equity model. For all practical purposes its impossible to predict where the economy will be in a year, but we do know that this period in our history corporations have rock solid with frequent over capitalized balance sheets (lots of cash, little debt) while the consumer continues to de-leverage from decades of over consumption (which will take years).
Value continues to be exploited in the markets as one of our long term holdings Sports Supply Group has been acquired by private equity firm ONCAP LP, shareholders will be receiving cash in lieu of stock. This marks the third holding of ours in 2010 that has either been acquired, subject of a hostile takeover or considering sale of the company. Asset rich companies make attractive targets since the cash on the books is quantifiable and frequently the underlying business can be acquired for little or nothing. Frequently these companies are the targets for Value investors who love nothing more than predictable and boring companies in sleepy industries with hairless balance sheets.
Present market weakness has pressured the price of Audiovox symbol VOXX to an excellent entry point here at $6.55. VOXX has approximately $330 million in current assets and $118 million in total liabilities which net to $212 million but the market value is $148 million. The $64 million dollar difference with 18.5 million shares outstanding or $3.45 per share is a rock solid Margin of Safety to the patient investor willing to wait for the value to move in excess of the balance sheet. The stock holds the potential for a 50% or more rate of return assuming the balance sheet remains intact.
VOXX has been around since 1965 and makes some of the coolest audio equipment in the world but it isn’t always profitable. Earning expectations for 2010 are in the .35 per share range but the estimate is from only one analyst.
Products are marketed under the Audiovox brand name along with other brands such as Acoustic Research, Advent, RCA, Jenson, Road Gear and Spikemaster.
One aspect that caught our eye was the list of investors who own significant stakes in VOXX: Seth Klarman of Baupost Group, George Soros and Irving Kahn.
We expect owning shares of VOXX to be a long term investment, investors should have a multiyear expectation. It is the type of stock that you could rest easy when you go on that multi-year sabbatical to the Amazon.
Others may want to wring their hands with the potential for deflation, however with investor angst so high at the moment reflects that much of the deflation debate may be baked in the cake of the market for the interim, hence the potential for significant values is quite good.
Be careful out there.
Brad Pappas
Long VOXX
In the wake of the collapse of 2008 investors are frequently choosing to make radical and rapid decisions since the urge to do something can be overwhelming at times. While our accounts have made meaningful progress in the return to the values of 2007 the remaining balance will require persistence, patience and discipline from our clients and me. In times of stress I think back to a book I purchased solely due to the title: “Tough time’s never last, tough people do” by Dr. Robert Schuller. Sometimes the boldest move an investor can make is simply be patient and allow the haze to eventually burn itself off where clarity in begin anew.
Investors who would not allow themselves to be intimidated by fear and confusion should value the fact they did not lock in their losses by cashing in and taking 3% or less in government bonds. Many investors took permanent losses in failed banks, mortgage companies and home builders, not to mention toxic mortgage backed securities, areas we largely avoided. In due time should our economy begin to pass the current soft phase those 3% bonds could turn insult into injury as the value of those bonds would be in peril should our economy surpass its current weakness but in fairness more attention needs to be devoted to government bonds later in this letter.
While I am far more optimistic about the intermediate term return potential for equities with the current high levels of investor pessimism versus the universal optimism in January, the future is far from clear. Despite the present uncertainties, the degree to which these issues are factored into the prices of the stock market is of larger importance. While I do continue to expect second half weakness for the remainder of 2010 as the inventory buildup, housing recovery begins to waver and federal stimulus wanes. We face an unusual amount and degree of non- traditional headwinds from sectors that normally provided stability like local municipalities. The decline in tax receipts from real estate have hurt many states which in turn have actually resorted to laying off employees for the first time in decades. Adding to the headwinds are the rise in government debt in relation to GDP and the corresponding rise in the clamor for Austerity. While there are a multitude of issues many of these issues are already factored into share prices and the repeated drumbeat of fear from Deflation and a Double Dip recession has begun to lose its effect for 2010.
Austerity can take many forms from the withholding of unemployment benefits, elimination of tax benefits along with tax increases to cover the cost of entitlement programs in 2011. Japan should serve as reminder to the effects of snuffing out fledgling economies as every time there economy has shown signs of life they’ve killed it. In 1997 with the Japanese economy showing promise the government raised the consumption tax by 2% which threw the economy back into recession. The Austerity-Hawks do represent a risk to the emerging economy that harken back to the Great Depression. Christina Romer Chair of the Council of Economic Advisors gave a speech in 2009 highlighting six lessons learned from the Great Depression:
1. Small Fiscal Expansion has only small effects. This would imply that Paul Krugman’s editorials in the NY Times stating the needs for Stimulus II might be spot on, as Stimulus I was not enough.
2. Monetary Policy can help heal and economy even when interest rates are at zero.
3. Beware of cutting back on stimulus too soon.
4. Financial recovery and real recovery go hand in hand.
5. The world will share the benefits or burdens of expansionary or austerity policies.
6. The Great Depression eventually ended.
Should our government fail to continue the expansionary policies as espoused by Democrats but bow to favor Austerians by talking of the reduction of debt then Deflation could continue to be a dominating trend and the value of our overvalued government bonds with feeble yields could be of great value to our portfolios.
There is in fact a study authored by Alesina and Ardagna* which analyzed the effects of 107 fiscal retrenchment/austerity plans within OECD countries (Organization of Economic Cooperation and Development) between 1970 and 2007. The authors found that only 26 of the 107 periods of fiscal restraint occurred with growth and the rest were deflationary. The 26 did share the commonality of being small open economies with weak currencies but accommodated by worldwide economic growth, not quite the situation we face today.
Investment returns relative to Deflation or Inflation
Source: Leuthold Group 6/30/10
The potential for a wide variety of outcomes from our economy might be the greatest in our lifetime. Hence equity allocations are being reduced into strength from our 70% weight of 2009 and early 2010. Chmn Bernanke appears to have a firm grasp on the risks of Deflation and has hinted that the Fed could further add stimulus to the economy with the purchase of long term government bonds with the hopes of reducing long term interest rates, which would help the housing industry. **This potential action by the Fed would drive long term government bond prices higher and thus be a counter balance to equity risks. Timing is key as it always is and as we have slowly reduced our equity exposure we have held the proceeds in cash rather than invest in bonds as by our measures there could be a better entry point for bonds down the road. If the ten-year Treasury were to move to 3.6% in yield we’d be a buyer.
The fear of Deflation remains very real with our current jobless recovery which may take much longer than in past cycles and extend into 2012. However, a Double Dip recession does not appear in the cards at present as was noted in our blog at www.greeninvestment.com/blog. But the risks are rising that 2011 could be trouble when higher taxes begin to have an effect.
Ultimately this economic cycle will end and just as Warren Buffet is fond of saying: “You can’t tell who’s been swimming naked until the tide goes out”, the inverse is just as true with gold dealers harp on FOX about fear and the decline of our economy while gouging customers with exorbitant fees to purchase gold. Who can say they won’t be swimming naked as well when the tide turns back in?
The methods of investment selection we employ within the RMHI Equity Model date as far back as the days of the 1930’s and The Great Depression, but with a few modern quantitative changes. Benjamin Graham and “The Intelligent Investor” created the concept of Margin of Safety which is arguably the best quantitative method of investment selection ever devised. Our focus is on balance sheets and the traditional relationships of Price to Book Value and Net Current Assets in relation to the stock price. In such uncertain times the pursuit of high growth equities could represent a serious danger without the underlying protection of the “Margin of Safety” which is defined as the value of the equity in sharp discount to Net Current Assets (NCAV). The RMHI model is based on several very Old School techniques of valuation. The Margin of Safety concept may be easier to grasp to the non-financial geek, where ownership of a share is considered a stake in the company rather than a short term trading widget as espoused by the folks of Fast Money and James Cramer.
We need our clients to understand that risk reduction does not necessarily mean returns must suffer, that is if we’re able to buy a stock cheaply….the profit is essentially made on the purchase if we can buy the shares below the Net Current Asset Valuation and remain patient for the value to be discovered. At present there are no publically available Socially Responsible Investment (SRI) funds or management companies that actively employ the Margin of Safety concept.
Margin of Safety
An example of the Margin of Safety concept authored by Benjamin Graham is the shares of Gravity Co. Ltd where the cash per share on the books minus current liabilities is actually greater than the share price.
Gravity Co. Ltd. Symbol “GRVY”: Based in South Korea, develops and publishes online games. Owns flagship Internet game Ragnarok Online.
Data as of 12/31/09 Audited by Korean member firm of Pricewaterhouse Cooper
Total Current Assets $ 71 million minus Total Current Liabilities $ 7 million = Net Current Assets $64m
Debt $ 0
Shares outstanding 27.8 million
Net Current Asset Valuation per share $2.30
Stock price as of 07/27/10 $1.50 a share
Margin of Safety 34%
Despite this absurdly cheap along with an impeccable balance sheet, is the fact that revenue for GRVY grew approximately 20% in 2009 along with positive cash flow with earnings before taxes and interest of $11 million.
Our thesis: An investor has a form of downside protection offered by the cash on the books. The stock would have to rise by 34% to simply comply with the Net Current Assets, the underlying online game and software business along with future growth are thrown in for free.
I believe at some point in the future the shares of GRVY will trade for at least the NCAV or $2.30 a share which would be just over a 50% profit. However should the company continue to execute their business plan as they have recently the shares could travel farther than $2.30 per share. In addition, potential takeover by majority owner? Softbank-controlled Japanese game publisher GungHo (Gravity’s largest licensee, increased its stake to 59% in 2008). Gravity’s below-cash valuation may entice GungHo to make an offer.
As with any company Gravity is not without its risks. The company has long delayed the sequel to its Ragnarok Online franchise which is its largest source of revenue. Hopefully, the company will release the sequel within 6 to 12 months which would sharply boost revenues and earnings.
The Ragnarok franchise will satisfy many social profiles since the game does not include any violence, adult themes or explicit graphics.
Many of our present holdings have similar balance sheet / share price relationships and a few were outstanding performers thus far in 2010: within the past two months we have had two holdings be either the target of a good old 1980’s hostile takeover: RCM Technologies or have hired investment bankers to determine how to maximize the assets of the company: Hawk Corporation.
A third company telecom services company IDT Corp. was our best performer of the quarter. Shares were purchased on average between $10 and $12 a share. What brought it to our attention was the fact that IDT had $9.63 per share in cash with emerging profitability. The cash on the books was our Margin of Safety and at present shares trade for over $18.
In addition, we’re looking at several small holdings which pass the RMHI model but also have a very unique valuation where the Net Current Assets exceed the price per share. These are equities (in addition to Gravity)that have a cushion of safety inherent due to their current assets and become very attractive for sharp price appreciation due to mergers, takeovers or return of capital to shareholders (dissolution of the corporation).
Future considerations: What I’m about to write is considered financial blasphemy and the irony cannot be lost on even the most dense of investors. But I have a belief that as an investor I should look under every rock and every neglected corner of the world and not be bound solely to the U.S. market. With all the references being made to the US resembling Japan I did not just a double take but a quadruple take and shook my laptop in disbelief when in the process of running investment screens with the RMHI model I noticed a new crop of equities showing up in clusters. I won’t keep you waiting but here it is…………..what they had in common were they were Japanese stocks: Hitachi, Nippon Telegraph and Telephone, Interactive Initiative ads, Canon, Fujifilm, NTT Docomo.
Japan: The Land of the Rising Stocks
- Cheapest market valuation in the world on a Price/Book value basis at 1.2x book value which compares to over 3x book value for India and China while the US is just over 2x book value.
- The Nikkei topped out at nearly 40,000 in 1989 while today it rests just under 10000.
- The contrarian trade to Emerging Markets: In a recent Merrill Lynch survey over 60% of investment managers were overweight in their asset allocation to Emerging Markets while approximately 50% of managers surveyed revealed they were underweight Japan. Manager sentiment is frequently an inverse barometer of future performance.
- June 2010 the Wall Street Journal reported that for the first time in three years foreign investors are increasing their exposure to the Japanese stock market.
- Very little correlation to GDP growth and 7 year stock performance. For Japanese equities to perform relatively well very little growth in Japanese GDP will be required, it may just take growth regardless of the rate.
- Most major Japanese companies which took losses in 2010 are expected to produce profits in 2011 which coincides with new Japanese business reforms. 2011 earnings do not appear to be reflected in share prices as very high quality companies are selling cheaply. Hitachi sells for just 13x 2011 estimates and 1.3x book value.
- Byron Wien of Blackstone Group added Japan to his 2010 list of surprises with a prediction that the Nikkei would surpass 12,000 for a gain of over 20% based on its current value. Personally speaking a move to 11,000 seems more likely, which is still a very nice gain.
Summary: We face an unusual set of economic headwinds with a myriad of possibilities for the end result. But investors are still faced with the normal quest for retirement funds and a better life where investing in CD’s or bonds yielding 1% are not a realistic option for the investor with a long term horizon. In addition, while investor sentiment has deteriorated sharply (a very good thing going forward) we do not have the values present that existed in late 2008 and early 2009 which allowed us maximum equity exposure. Hence, I believe going forward equity positions should be reduced into market strength with our average equity allocation will be approximately 55%, ideally 30% for bonds and 15% in cash. “Ideally” is relative since the bonds class offering the best counter balance to equities would be US Treasuries in the 10-20 year range and are quite overvalued at present. Until the over-valuation is worked off we’d be better off holding cash in lieu of bonds.
As for equities, the RMHI model which identifies the best prospects for finding Value along with price appreciation potential. Top of the list in the RMHI equity model in recent weeks have been shares of major Japanese companies which have endured over 20 years of malaise and may be near a pivot point in performance going forward. As a statement of fact, the Nikkei is the most undervalued market based on price to book value in the world and investment managers worldwide are severely under allocated to Japanese shares.
Brad Pappas
August 1, 2010
RMHI is long shares of RCMT, HIT, HWK, NTT, IDT, GRVY
*Alesina and Ardagna, “Large Changes in Fiscal Policy: Taxes vs. Spending,”2009; forthcoming in Tax Policy and the Economy,available at http://www.economics.harvard.edu/faculty/alesina/recently_published_alesina
**Bullard, James of the St. Louis Federal Reserve. “Seven faces of The Peril” July 2010
The media has devoted a majority of attention to the current soft patch in the economy to the point where the rare Double Dip Recession seems a predetermined conclusion. Double Dip recessions are rare but talk about them is not. To add to the popularity of deflation chatter is the drumbeat of Bernanke-san economic commentary from Paul Krugman at the NY Times. However we must keep in mind that the data do not support a double dip recession at this time and talk of deflation in 2011 is simply too far out with too many potential variables to contend with. The irony is that last week the IMF raised its outlook for worldwide GDP growth for 2010 from 4.2% to 4.6% while keeping the 2011 estimates steady at 2011. Someone forgot to tell them of the impending double dip.
We live in a very confusing period and I’d be on guard for any person or firm that knows exactly what will happen in the future. To balance out this negative media attention is the fact that investor sentiment is now at the lowest level since March of 2009, and we know what that lead to. Negative sentiment is a good thing, especially from groups of investors who are notoriously wrong way traders who assume that the current trend will continue forward.
Last week the American Assoc. of Individual Investors (AAII) data revealed that only 21% of its members were bullish which is one of the lowest readings in the last 15 years. Bullish figures this low generally halted a move lower in stock but more frequently led to rallies of significance in 2003, 2005 and 2009 where six months later the average gain was 8.1%.
This data is confirmed by Rydex Traders who are now at a level of bearishness rarely seen. When the Bull/Bear ratio dips to .88 or below the forward return on the SP 500 has averaged 5.9% three months later with 79% of the time periods producing positive returns.
Too add to the incentive for a rally is the relative overvaluation of bonds relative to stocks along with the significant underexposure to equities by retail investors and hedge funds. Should a meaningful rally begin to form (we believe it already has) then both retail and hedge funds could pile on at a rapid rate using bonds as a source of funds. This asset allocation shift from bonds to stocks could be ferocious and rapid, about as fast as LeBron James plummet in popularity. Hence, beware of treasury bonds right now. Treasury bonds have their rightful place in portfolios but not at this time IMO.
According to Jason Goepfert at sentimenTrader.com: The last time S&P futures gapped up 1% after five straight up days was September 2006. There were two other times in history (March 2003 and September 1996) where this occurred. Both dates marked the launch of bull markets.
Be careful out there.
Brad
No positions
Bond markets can be a great barometer of whether we’re recession bound or not. While its impossible to defend the argument that the economy has softened rapidly over the last two months, the bond markets with the exception of the Treasury market do not indicate a recession. However, if you’re unemployed or significantly underemployed this is merely a matter of semantics.
We’ve noted the appearance with deference to the Gloom and Doomers, Bob Prechter and Nouriel Roubini. I’m afraid the days of economists in tweed hunkered down in their academic offices are long past, not when the bright lights of media attention beckon. But Roubini is back and without a conscience just as he was in the Spring of 2009 predicting doom. Does he acknowledge being wrong in 2009? Hardly not, not when he can milk the media for his call in 2008.
But if Mr. Roubini is correct in his depiction of doom in the economy then why are Baa and High Yield corporate bond yields not rising sharply? Corporate bond yields are a great barometer of impending economic turns. Yields have risen before almost every recession. Baa yields have risen less than 20 basis points recently and High Yield which can get downright whippy have risen only about 100 basis points from 9% to 10%. Clearly the message of the bond markets is much smoother than the message of the equity markets.
Well, that was quick……………TSLA breaks thru the offer price!
There may come a day when we’ll consider Tesla as a candidate for investment but in order for this to happen we’d need to see significant balance sheet improvement along with real revenue and profits. In the meantime it remains a developmental stage company.
If Rush and Sarah can extrapolate the conclusion that Conservationists are to blame for the BP disaster (by forcing rigs to go farther out to sea which induces a higher potential for hazard). Then, couldn’t the Left state that the austerity measures being promoted by World governments including the Obama administration based on pressures imposed by the Tea Party Movement and similar organizations could impose a severe Double Dip recession as theorized by Paul Krugman?
Be careful out there
BP
No Positions
A company we spoke of last week, Hawk Corporation HWK is surging on news that it has hired advisors to investigate possibilitity of increasing shareholder value which would include the potential sale of the company. Hawk is a diversified industrial goods company that also makes alternative energy fuel cells. It should be noted that Mario Gabelli of GAMCO Investors owns 13% of the shares.
Hawk becomes the second holding of ours that is “in play” in the past month. RCM Technologies RCMT is the target of a hostile takeover from CDI corp. This does take some of the bitter taste away from a miserable market.
Hawk Corp.
Market Cap $212 million
Book Value $9.68
Cash per share $10.13
Debt to Equity 1.0
Price to Sales 1.1
ROA 6%
ROE 11%
IBES est: 2010 $1.57
2011 $2.11
I’ve run a quick DCF calculation to get a feel for the value of HWK in a sale: Using 2010 eps of $1.50 with a 3% growth rate and a discount rate of 5% the value could approach $40 per share. The problem with Hawk is that its eps are very volatile but there is the fact of having a great deal of cash on hand. To be continued………………
Regarding the economy: The ISM manufacturing composite index feel to 56.2 (a number above 50 is pretty good) indicating a slower rate of expansion. ISM characterized the current expansion as “solidly entrenched”. While many including myself expected a slowing of the expansion in the second half of the year, the rate of the deceleration has been surprising. While the herd is screaming “double dip recession” the data does not support the mob.
From morning commentary of MKM Partners Mike Darda:
“To recess or not to recess, that is the question. Either way, we believe the stock market has essentially discounted a double-dip scenario, with our NIPA-based model showing a gap between equity earnings yields and corporate bond rates that rivals anything seen in nearly six decades. Even using a 10-year moving average for earnings (which implies a 12.4% decline in corporate profits from current levels), the S&P 500 has fallen to valuation levels below those seen at the market lows in October 2002, October 1990 and December 1987.
We would be more concerned if the credit markets were in worse shape. Yes, corporate spreads have widened, but all of the action has been in (declining) Treasury rates; corporate bond yields have been flat, unlike the situation in 2007-08. Three-month dollar-LIBOR has been in a flat to down trajectory since late May. Two-year swap spreads at 37 basis points suggest that both the VIX and corporate spreads have overshot significantly to the upside (implying that equities are overshooting to the downside).
The catalyst for today’s slide appears to be the upward move in first-time jobless claims and the miss on the June ISM Manufacturing Index, although both were consistent with a continuing, albeit slower, expansion.”
BP
Long HWK, RCMT
Both the US stock market and Treasury market are seeing non-confirmations in the most recent moves lower.
US stock market:
Advance / Decline line is not confirming the move lower as the average stock is not falling with the market indices.
New Lows: The number of new lows continues to shrink when compared to the two other times we’ve been this low in the past month.
VIX: The VIX which is a measure of volatility which peaked in this cycle at 45 in May closed yesterday at 34.
Sentimentrader.com’s Intermediate Term model has moved to excessive pessimism once again. Generally a good time to increase long exposure.
In the Treasury market:
Investor Sentiment is at the highest since December 2008, not one of the better times to be buying bonds. Plus we have to be concerned with the thought of worldwide investment managers buying US Treasuries to look good for their clients in light of the decline in Euro bonds, otherwise known as “Window Dressing”.
Lastly, the decline in US Treasury yields is not confirmed by the bonds of other G-7 nations.
The Tesla IPO has gained a great deal of attention but it has to be time to ring the register. There will be other times to buy this if it can deliver something other than losses. I just read the battery for the car costs $30,000 and does not work in cold weather. Well, that pretty much kills the potential for a Tesla at 8000 feet in Colorado.
No positions
