We believe that the value investing style is frequently overlooked by Green, Clean and Socially Responsible Investors. Meade Instruments Corp. the manufacturer of telescopes and telescopic products could be classified as a Clean Investment with negligible environmental impact.
Meade Instruments Corp (symbol: MEAD) is a classic Benjamin Graham Net Net stock which we are long in equity portfolios. Meade is a manufacturer of telescopes and telescopic instruments, with hardly a taint of excitement or sex appeal. Meade is your typical boring, mundane, blase…well you get the picture, its a boring company in a boring industry.
Unless you’re a financial geek in search of Margin of Safety stocks where looking at the company’s balance sheet Net Current Asset Value (NCAV) is larger than the valuation of Meade’s market value by a sizable amount.
As of 9/2/2010 Meade shares are trading at $3.24 a share. They have 1.17 million shares outstanding and the total market cap is a nano-sized $3.79 million dollars.
Cash on hand amounts to $3.33 a share, which is a drop of $1.2 million from last year due to losses in the company’s operations.
Inventory amounts to $6.72 a share
Book Value $10.18 a share
Current Assets $12.27 minus Current Liabilities $3.42 = $8.85 a share
At present Meade is losing money and the cash drain might tap out current cash levels in one to two years, assuming no reduction to inventory levels which could be converted to cash. The company is faced with increasing foreign competition resulting in lower sales, reduced distribution outlets and the reality of being the manufacturer of a discretionary item in a weak domestic economy. Higher end and more profitable telescopes are less favored by consumers nowadays than lower end, lower margin scopes.
To compensate Meade is cutting costs on many levels ranging from administration and employment costs, reduction to R&D and reducing manufacturing costs. In addition, Meade has sold three divisions: Simmons, Weaver and Redfield for gross proceeds for approximately $15 million.
It would be hard to make a valid rationale for the purchase of shares from a growth perspective since there is no growth, quite the opposite in fact. Meade is facing the reality that the manufacture of telescopes with competition from lower cost manufacturers in China is likely going to be a losing proposition.
The investment appeal: Management has a great deal of incentive to at least preserve the value of the company and its shares. Management owns approximately 36% of the shares. Based on the latest SEC filings Hummingbird Capital (a private small stock value oriented hedge fund) Paul Sorkin owns at least another 10% of MEAD shares. There are a few other value managers who might take an activist role who’ve purchased shares.
My belief is the company is preparing itself for the potential of being sold. The disparity between the share price and current cash + inventory of $10 a share is much too great a gap. The majority of shareholders have a great incentive to close the gap, preserve the Meade brand name and allow it to operate as a division of a larger company.
Estimates to the potential sale price might largely depend on the value given to their sizable inventory of $6.72 a share. If we were to reduce the value of inventory to half or $3.35 a share then add back the current cash of $3.33 we arrive at $6.68 which could be a conservative estimate. The aggressive estimate would likely be closer to the current book value of $10.18.
This is a risky stock and shares are thinly traded. The company may choose to nothing which would drain their cash reserves and further reduce book value. The company could sell off its entire operations and convert to an all cash company and reinvent itself. Time will tell but I do feel the rewards could be in the range of 100% to 200%.
Be careful out there
Brad
Long MEAD
Green and SRI investors along with investing professionals are always asked to make the best decisions under pressure, and the most common one we face today is should “Socially Responsible Investors abandon stocks in favor of bonds?”
It is my opinion based on close to thirty years of trading that the best trades are those done when you’re in the minority not the majority opinion, otherwise who’s left to buy or sell?
For this question of stocks sold off in favor of bonds, bad news has to be considered good news. Any good news on the economy will be treated negatively at this point in time for bonds. Today’s stock market strength and weakness in bonds is due to the better than expected August PMI report which came in at 56.3 versus the consensus of 52.9 and the August report is an improvement upon July’s 55.3. Adding fuel to the rally is survey from Investors Intelligence which shows that just 29% of newsletter writers are bullish which is the lowest percentage since the crash in 2008. Remember folks, the more extreme the consensus the greater chance of a reversal in market direction. A bull figure at just 29% might be enough to halt the decline at worst…..but its certainly in the range to mark the bottom where a new rally can emerge.
Good news is bad news for bonds. The 10 year Treasury has moved from 2.48% to 2.6% today while the 30 Year Treasury Bond has moved from 3.53% to 3.68%. Bond yields are now at levels seen in late 2008 and very early 2009 and we all know how productive it was to buy bonds in February of 2009.
The stampede into bonds has been nothing short of epic and the Consensus Survey of bond investors maxed out at approximately 80% recently. Rarely has such a consensus opinion been profitable. These are the kinds of surveys we frequently see at major market tops which begs to ask whether bonds are in a Bubble. Bubble talk has been pervasive in the media much just as talk of Deflation has been over commented upon.
Frankly there’s more contradictory information and confusion in the media to rival a Republican politician who wants to reduce the deficit while maintaining tax cuts. The bottom line is we do not have Deflation in the U.S. at present as Deflation is a very rare event here.
But are bonds really in a Bubble? My answer would be “not at present”. My definition of Bubble for the any investor including the Green Investor or the Socially Responsible Investing community is that for a Bubble to truly exist the risk of a significant and permanent loss of capital must be present. A Treasury bond will eventually pay off at par upon maturity, so while its very possible to lose 20% or more in a bond, the loss would be temporary if you were patient enough to wait till maturity. The reality is only a very few investors have that kind of patience. In addition, many of the investors who are retirees and have been buying Treasuries will not be around in time for their bonds to mature, so a loss could be taken.
With Consensus opinions at present in the range of 70% to 80% Bullish on Bond prices, should the tone of economic data change (I believe its starting to happen now) the rush to exit bonds could be swift and very dramatic, especially in this day of algorithmic and program trading.
A by product of the rise in bond prices and drop in yield is the relative valuation of bonds to stocks.
As the chart above highlights, the relative valuation of bonds to stocks is at extreme levels and the other two times in the past century this relationship was reached, buying bonds in lieu of equities was a significant mistake. Can we say that in the two past examples that bond investors lost money? No, not unless they held to maturity but they lost “opportunity” to be in equities as the mean relationship between stocks and bonds eventually asserted itself once more.
We’re faced with the challenge of “getting back to pre-crash levels” and by over allocating to bonds now is essentially giving up that goal at time when the odds are stacked against you.
To be a successful Green or Socially Responsible Investor sometimes means enduring pain and the pressure of the media, not to mention friends who offer their opinions in an effort to “help”. Diversification between bonds and equities is always a good thing and proper re-balancing when one asset class becomes overvalued is essential, but to join the mass entrance into bonds at this stage may very well lead to a mass exit when the weak patch of our economy passes and moderate growth re-emerges.
Too few individual investors how to use Investor Sentiment to their advantage. Last week when the New York Times ran a front page story regarding individual investors fleeing equity mutual funds in favor of bond mutual funds, it should have made any long term Socially Responsible Investor giddy with glee.
Why?
Extreme negative sentiment as depicted in the NY Times should be used as an inverse barometer of when to invest. However, more often group think sets in and investor is intimidated by being the lone wolf buying shares while the herd is stampeding in the other direction.
Right now, sentiment as expressed by the American Association of Individual Investors is getting extremely negative….and thats a good thing. Who’s left to sell when only 21% of members polled are positive on the markets? 21% happens to be one of the lowest polls recorded in the past 15 years. You may be right in your views of why you want to sell…….but, and this is the tricky part that the majority of investors never learn to master: You may be right in your thesis but if you’re in the majority with your views, chances are your opinions have already been absorbed by the markets.
Using data supplied by www.sentimentrader.com:
Since 1987, there have been 47 instances where AAII sentiment fell to 21% or below. The results are:
3 months later: the average return was 5.8% for the S&P 500 with 98% of the 47 instances positive.
6 months later: the average return was 10.9% for the S&P 500 with 91% of the 47 instances positive.
In conclusion, many investors think they can manage their assets completely on their own but unfortunately do not know how to interpret sentiment data. Going against the herd is never easy but you must be able to master your emotions in order to be a successful investor, otherwise you might consider hiring an adviser who’s weathered a great many storms in their career.
It wasn’t supposed to be this way, the Double Dip Recession and inevitable Deflation were a sure thing, but today’s Industrial Production figures of growth of 1% in July versus the consensus of .7% make want to give you pause if you’re loading up on Treasuries. The figures were led by a big 9.9% surge in motor vehicles, the trend in vehicle production is the most since 1984 while year to year PPI growth is the greatest since 1998.
While this data is very good news for equities its quite bearish for Treasury bonds which are probably leaning too much to the side of buying exuberance.
Consider the following charts from SentimenTrader.com, all three show far too much bullish sentiment to make a potential investment profitable. Investment profits are very seldom made when sentiment is so extreme as the data suggests it’s likely wiser to be a seller rather than a buyer.
These remain very uncertain times but we feel its in error to chase strength, let any market correct itself where you can make your buys on your terms not the market’s.
Allow me to put this another way: With the yield on the 10-year Treasury now at 2.58% it has a P/E (Price divided by Earnings) of 38.7 which is quite close to the bubble era for the NASDAQ in 1999. The current P/E of the S&P 500 is now 12.
Be careful out there
Brad Pappas
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
