Stock Valuation Software

Why Does Value Investing Work?

Jae Jun — Mon, 14 May 2012 08:00:59 +0000

Guest Post by

It seems like a silly question to ask on a site devoted to value investing. Of course, value investing works. All of the academic studies say so! Which might very well be true, but there is unfortunately a gap between what happens in theory and in practice.

Aswath Damodaran in a recent paper examined the actual results of value fund managers and noted a gap between the performance of those managers and underlying value indices. I recommend you visit Greenbackd who in a series of posts takes a much closer look at the Damodaran paper. Damodaran concludes:

“If you are an individual value investor, you can attribute this poor performance to the pressures that mutual funds managers operate under, to deliver results quickly, an expectation that may be at odds with classic value investing. That may be the case, but it points to the need for discipline and consistency in value investing and to the very real fact that beating the market is always difficult to do, even for a good value investor.”

As I write in my book, Abnormal Returns: Winning Strategies From the Frontlines of the Investment Blogosphere, “Investing is hard.” Value investing is not exempt. In fact I argue that value investing works, to the degree that it does, because it is in fact very difficult to do in practice. (One could argue the same for momentum investing as well.)

Don’t take my word for it. In my book I quote two much more accomplished investors on the topic. David Swensen, head of the Yale University endowment wrote in his book Pioneering Portfolio Management:

“In many instances, value investing proves fundamentally uncomfortable, as the most attractive opportunities frequently lurk in unattractive or even frightening places.”

This is why active value investors often underperform. By their nature they are unwilling to buy those stocks that are the most ugly, which by definition provide the greatest opportunity. Howard Marks weighed in on this topic of why value investing works in his recent book The Most Important Thing:

“To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do.”

The fact is that most people don’t want to be value investors. Even value investors find it difficult to invest in those situations that are the “ugliest” and therefore the most ripe with opportunity. Hence the under-peformance of value fund managers.

Therefore aspiring value investors need to decide whether they are going to simply embrace some sort of quantitative discipline or tread carefully into “frightening” territory on their own.

About the Author

Tadas Viskanta is the founder and Editor of Abnormal Returns. Tadas is a private investor with over 20 years of experience in the financial markets. He is the co-author of over a dozen investment-related papers that have appeared in publications like the Financial Analysts Journal, Journal of Portfolio Management among others. Tadas is also the author of the forthcoming book: Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere* which culls lessons learned from his time blogging.

Reference Links

Damodran: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2042657

Greenbackd: http://bit.ly/JkzcTF

Amazon: http://amzn.to/wdjuru

Valuation Continued… 3 Good Reads

Jae Jun — Fri, 11 May 2012 16:00:41 +0000

Written by

Jae Jun

Starting off with a couple of ancient articles from 1999 and 2000 by Whitney Tilson when he was still a tiny operation and writing on Fool.com

Buffett’s Prescient Market Calls

To the best of my knowledge, Warren Buffett, the chairman of Berkshire Hathaway, has only expressed strong opinions about the market’s valuation levels on six occasions in the past 42 years. In the first four cases where we know the outcome, he was uncannily accurate, so investors would be wise to carefully consider his latest warning in a recent issue of Fortune…

Valuation Matters. How to beat the market.

For a number of years now, we have been in a remarkable bull market where valuation hasn’t mattered. In fact, I believe that the more investors have focused on valuation in recent times, the worse their returns have been. But this hasn’t been true over longer periods historically, and I certainly don’t think it’s sustainable. While the laws of economic gravity may have been temporarily suspended, I do not believe that they have been fundamentally altered…

Bank Valuation made Simple

For those that want to know how to value banks. I still don’t get it.

Bank valuation can be made a great deal more complicated than it needs to be. Sure, you can value deposits, use varying price to book ratios for different quality banks, look at the latest takeover prices, play with many more styles and average them all together, but I like to stick to a discounted cash flow model based on a ten year average of return on average assets (ROAA). If you’re dealing with just the good banks, valuation is pretty simple.

TARO Shares are Mispriced Compared to Competitor

Jae Jun — Thu, 10 May 2012 06:44:59 +0000

Guest post by

Retail Investor

Taro Pharma (TARO) And Perrigo (PRGO)

Both the companies are public.
Shares of both the companies trade in reputed US exchanges.
Both compete in generic Rx and over-the-counter pharmaceuticals space.
Both have significant presence in the dermatology/topical space.
Both have Israeli connections.

Company A has higher Operating margin, higher 3-year Sales growth rate, higher 3-year EBIDTA growth rate and better ROE.

Company A has a better balance sheet with significantly lower debt and lower leverage ratio compared to company B, giving company A significant flexibility to take on debt and grow by acquisitions.

Yet, incredibly, company B trades anywhere between 2 to 2.9 times the market multiple (Enterprise Multiple/EBIDTA) that company A trades at. Company B is also into Nutritionals, API and is a bigger player in OTC.

Below is the comparison of the 2 companies in terms of performance on my spreadsheet which you can view here.

The numbers for Teva Pharmaceuticals (TEVA) are shown for reference as well.

(Click image to enlarge)

Which is Company A and which is Company B?

Company A is Taro Pharma.

Company B is Perrigo.

How can such a Huge Mispricing be Possible?

If Taro pharma was to trade based on Perrigo’s market multiple, its share price would be $85 or $120, considering TTM earnings or annualized Q4 2011 earnings, respectively.

Taro deserves a higher valuation multiple considering its superior 3 year performance and its unleveraged balance sheet.

Explanation for the Mispricing

1. Taro Pharma’s board has been evaluating an offer to buy out minority shareholders for many months now.

The offer seems so grossly inadequate based on current market multiples (both peer valuation and precedent transactions) that one would think the board would have rejected it right away.

However, Taro Pharma’s board, with the assistance of Citi, has chosen to continue evaluating this offer even after ~4 months of review. Note the recent Actavis acquisition was at 13.8 ttm EBIDTA.

2. Taro Pharma’s board has a significant representation from SUN Pharma.

SUN also has around 77% voting interest (around 66% financial interest) in Taro Pharma. There is a perceived threat of minority shareholders being fleeced from majority shareholders. There are many minority shareholders that have publicly written about this.

The addition of agenda items 4 to 8 for the annual general meeting regarding director liability protection proposals have concerned minority shareholders. Statements from the company like the below in Taro Pharma’s press release have not helped either.

At the time of the appointment of Taro Pharma’s Board, new Chairman Mr Kal Sundaram, Taro’s press release had this rather confusing statement:

“This role is also in line with his new responsibility for Sun Pharma group’s strategic business interests in North and South America.”

This begs the following question: Is this pre-eminent Taro appointment in the interest of ALL Taro shareholders ?

Mr. Kal Sundaram was the CEO of Sun pharma in 2010.

Disclosure Standards of TARO vs PRGO

While Taro meets the regulatory standards for public listing in terms of quarterly and annual financial filings, Taro Pharma’s disclosure standards pales in comparison with Perrigo.

Suffice to say, most market participants (US healthcare funds) know Perrigo. However, Taro is still relatively unknown to market participants even after its recent NYSE relisting.

The most important statistic to corroborate that is here: The average daily dollar volume of Perrigo is 64 times that of Taro. Taro’s average daily volume of 32k shares*$44 =$1.4m versus Perrigo’s 859k shares*$106 =91m.

Here is a comparison of Perrigo and Taro in terms of disclosure standards.

How can the real market price of Taro or the fair value of Taro be found? How can Taro maximize the value for ALL its shareholders including minority shareholders ?

Taro’s press release on Jan 12th had this:

The Special Committee recognizes its primary objective is to maximize value for the minority shareholders of Taro and will take all steps necessary to ensure this objective is achieved.

Recommendation to Board of Directors

1. Stop the evaluation of offer from Sun Pharma.
2. Remove Items 4 through 8 from the agenda of the upcoming annual shareholder meeting.
3. Put a moratorium on buy-out for a period of 12 months.
4. Conduct investor day(s) with full and fair disclosure of 3 year business and restructuring plan of Taro. Such business plan could include among other things:

a. Potential synergy savings from Sun Pharma’s closer integration with Taro
b. Potential savings from transfer of manufacturing of any of Taro’s products from Israel to India
c. Potential Taro product sales growth in countries outside of it’s current major sales territory of US/CAN/UK/Israel
d. Sun Pharma’s potential use of the premium Taro brand for sales and marketing of Sun’s products in the US/CAN including high margin OTC business
e. Value of Taro’s pipeline assets, including 24 pending ANDAs and potential OTC Switches
f. Value of the near term R&D pipeline
g. Value of the recently approved sNDA Daranide
h. Value of potential NDA(s) – including the purified version of Malathion that is undergoing Phase 3 testing

The above steps are needed so the fair value of Taro can be found by the market.

While on one hand the long time Taro minority shareholder needs to thank the current board and the management for having restored some of the value that the prior management had almost destroyed, the recent actions including addition of liability protection proposals, and the continued evaluation of Sun Pharma’s offer creates a great degree of ambivalence and circumspection.

Disclosure

The author is long TARO.

Disclaimer

This article is not a recommendation to buy or sell any equity.

About the Author

The author is a value, special situation and occasionally event-based retail investor for 10 years.

Past multi-baggers include: RDY,AMRN, HLSH, GGP.

Visit my website for more such articles.

Valuation Matters. Here are 7 Ways to Value Stocks

Jae Jun — Mon, 07 May 2012 16:00:46 +0000

Written by

Jae Jun

Valuation Matters

You could purchase the best stock in the world, but if you buy it at a lofty premium, it is a bad investment.

Vice versa, the stock could be the worst company in the world, but if bought it cheap enough, it could work out to be an excellent and profitable investment.

Valuation matters.

To help you figure out the value of your stock, here is a compilation of 7 valuation methods I have written about to refresh your memory.

The problem I fell into as I began valuing stocks was trying to use a single valuation method for every company.

But that is wrong.

A gold miner cannot be valued the same way as a tech company, just as how you cannot use the same valuation technique to value a capex heavy company and FCF cow.

Valuation is an Art

Most important of all is to remember that valuation is an art.

Anything that involves assumptions will be difficult to formulate, but provided you understand the assumptions and the disadvantages of each, you will be able to utilize each tool to great effect.

1. Net Net Working Capital and Net Current Asset Value

Type: Balance sheet and tangible asset valuation

When to Use: Net net stocks, when trying to determine where a company’s stock price is priced relative to its net assets. Can’t be used for service or low asset companies such as software.

Description: When Graham was around, the only types of companies that existed were industrial businesses. Mainly factories, manufacturers and retailers. There were no consulting, software, or high tech companies you see today. This made analyzing the balance sheet very easy and worthwhile because mostly all companies fit into this mold.

Because there were no computers, stock market radio, tv shows, news etc, information was slower in circulating and more inefficiencies existed which Graham could take advantage of and allowed Graham to buy companies at or below liquidation value.

For you and me, knowing the liquidation value of a company is advantageous because it gives you a reference point for a floor value of the stock.

Companies where the stock price is below this floor value are called net nets.

There are two ways to calculate this.

Net Current Asset Value

NCAV = Current Assets – Total Liabilities

Net Net Working Capital

A stricter version of the NCAV because it discounts certain items from the balance sheet.

NNWC = Cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) – total liabilities

Provided the company has a decent business model and not burning cash, a net net stock could work out to be a fantastic investment.

Read the original article: Graham Net Net Asset Valuation

2. Asset Reproduction Value

Type: Balance sheet valuation

When to Use: To figure out how much a competitor would have to spend in order to replicate the company’s business. Sort of like a moat test.

Description: To rephrase “asset reproduction value”, it is to find how much it would cost a competitor to replicate the assets of the business.

This method is really part 1 of the Earnings Power Value (EPV) explained further down.

To calculate the reproduction value of the assets, you need to go through each line in the balance sheet and see whether anything needs adjustment. This method involves quite a bit of work, because you need understand the industry in order to adjust the balance sheet appropriately.

Unlike Graham where he just slapped a discount percentage of 50% to inventory and ignored things such as goodwill, the asset reproduction value requires you to include goodwill because it is something that a brand new competitor will not have and will therefore be required to spend money in order to acquire such things as brand recognition, partnership agreements, and patents.

To really get a better understanding, go through the detailed tutorial I wrote via the link below.

Read the original article: How to Perform an Asset Reproduction Value Analysis

3. Benjamin Graham Valuation Formula

Type: Earnings stock valuation method

When to Use: Cyclical companies, volatile cash flows, and young companies where there is not much history.

Description: Graham has always been a balance sheet analysis investor who wanted to buy a basket of companies at a cheap price. However, he offered a formula in his book The Intelligent Investor which uses earnings to value a company.

The formula he introduced is

where V is the intrinsic value, EPS is the trailing 12 month EPS, 8.5 is the PE ratio of a stock with 0% growth and g being the growth rate for the next 7-10 years.

However, this formula was later revised as Graham included a required rate of return.

The formula is essentially the same except the number 4.4 is what Graham determined to be his minimum required rate of return. At the time of around 1962 when Graham was publicizing his works, the risk free interest rate was 4.4% but to adjust to the present, we divide this number by today’s AAA corporate bond rate, represented by Y in the formula above.

But after using this formula, I found that the valuation numbers were far too optimistic. Back in Graham’s days, all companies were industrial and so growth was limited. 20% to 30% growth was unrealistic whereas you see many companies able to achieve this standard in today’s era.

With that, I further modified Ben Graham’s formula to

For a deeper look at how this formula is read the original article below.

Read the original article: How to value a stock with Benjamin Graham Formula

4. Earnings Power Value (EPV) by Bruce Greenwald

Type: Earnings stock valuation method

When to Use: To find good companies. Also can be used for cyclical companies, volatile cash flows, and young companies where there is not much history.

Description: It is best to use EPV in conjunction with the Asset Reproduction Value above. Although the formula for EPV is quite simple, arriving at the adjusted earnings number is a little more difficult.

You saw how the balance sheet had to be adjusted to make Asset Reproduction Value work. For EPV, you need to do it for the income statement which will give you a no growth value of the company.

Again, go through the article below to get the detailed step by step instructions of how this works.

But see below for a quick idea of how how Asset Reproduction Value and EPV come together.

With just the asset reproduction value alone, you see that it is the minimum required level for free entry into an industry.

The middle bar shows that having a competitive advantage will create an EPV that is higher than the asset reproduction value with zero growth assumption.

If you include growth, you get the total value, but since growth is so difficult to predict, sticking with the EPV alone is good enough.

However, there are different cases which could break the model above. See below.

In case A, you have a company where the asset value is much higher than the EPV. In this case, the company has no moat, no strategic advantage, bad management and is in a bad industry.

In case B, asset reproduction value is equal to EPV. Such a company has no moat and is in a competitive industry where companies usually earn only their cost of capital.

Case C is the type of company to look for, where asset value is less than EPV which means that the business has a moat, strong advantages, brand recognition and good management. Think KO, MSFT or AAPL.

Read the original articles:

5. PE Model for Stock Valuation

Type: PE multiplier stock valuation method

When to Use: Robust method that can be used for any company.

Description: An absolute, instead of relative, PE valuation model that Vitaliy Katsenelson created and explains in his book Active Value Investing.

There are subjective inputs required in this model with the intrinsic value of the stock based on the following five conditions.

1. Earnings growth rate
2. Dividend yield
3. Business risk
4. Financial risk
5. and earnings visibility

For each of the 5 points above, the idea is to assign it a value and then to calculate the fair value PE with the following formula.

Fair Value PE = Basic PE x [1 + (1 - Business Risk)] x [1 + (1 - Financial Risk)] x [1 + (1 - Earnings Visibility)]

Full description and examples are provided in the link below.

Read the original article: PE Model Stock Valuation Technique

6. Discounted Cash Flow (DCF) Stock Valuation

Type: Cash flow valuation

When to Use: Consistent free cash flow, bigger companies, predictable companies.

Description: Many people dislike the DCF method of valuing stocks. But many people also like it, and I am one of them.

The weakness is that you have to project future cash flows, calculate a discount rate and predict the growth rate, but with realistic assumptions instead of inputting numbers to match what you want it to be, it is a valuable tool.

Just don’t abuse it.

Think of it like golf. If regular guys like me try to play with pro clubs, the ball will go anywhere. I first have to understand the mechanics of the golf swing as well as the characteristics of the club. Blindly swinging a pro golf club will result in shots that are way off the mark.

That’s how it is with DCF. It is very useful as long as you know what you are doing. Thankfully, it isn’t difficult.

The version of DCF is not the standard method that Wall Street or business school teaches. I learned investing through Joe Ponzio’s F Wall Street and so my DCF is also based on his and has been tweaked over the years.

Joe’s DCF is a very practical, real world business like version. Here is the quick version I wrote a while back.

How to Find the Intrinsic Value of a Business

Here is the long version from F Wall Street.

And to get a better understanding of the mechanics involved in a DCF and how to apply it, read the link below.

Read the original article: How to value a stock with DCF Method

7. Reverse Discounted Cash Flow

Type: Cash flow valuation

When to Use: Figure out market expectations embedded in stock price

Description: If you dislike DCF, then maybe reverse DCF is for you as the purpose is to identify what expectations the market has for the stock.

As mentioned above, the three main weaknesses of a DCF are;

Projecting future cash flows
Figuring out what discount rate to use
Predicting the business growth rate

All three involve assumptions.

With the reverse DCF however, you use the stock price as the starting point to figure out what the market expects.

The purpose then becomes not on what the company is worth, but whether the expectations are reasonable.

On May 16, 2011, with CSCO priced at $16.88, the stock price was reflecting a growth rate of -9.6%. The stock price did go down another 12% or so, but with such low expectations, CSCO managed to beat Wall Street’s expectations and has outperformed the market since.

Read the original article: How to value a stock with Reverse DCF

Tutorials using the Intrinsic Value Spreadsheets

If you already own the stock value spreadsheets or use the free version, here is a PDF with examples on how the valuation methods are used.

Download: How to value stocks using the stock value spreadsheets (pdf)

The Complete & Practical Guide to Mastering the DEF 14A Proxy

Jae Jun — Tue, 01 May 2012 07:20:37 +0000

Written by

Jae Jun

Navigating through the SEC documents can be confusing and intimidating, especially when you encounter a document that is 100 pages long and is full of text.

Hopefully this tutorial will be your ultimate and practical guide to help you glide through the Proxy document in no time.

Before getting started, see below for a previous tutorial on how to read the SEC Form 3, 4 and 5.

How to Read SEC Forms 3,4 and 5

What is the Proxy Document?

The official term for the proxy document is Form DEF 14A.

DEF stands for “definitive”, and is required under Section 14(a) of the Securities Exchange Act of 1934. So it makes sense to be called “DEF 14A”.

This purpose of filing this form helps the SEC ensure that shareholders’ rights are upheld as well as when shareholder votes are required. It is required that the company files its annual proxy statement no later than the date the proxy materials are first sent or given to shareholders.

It includes a whole bunch of information related to shareholder meeting, rights, insiders, compensation, stock options and more. It is through the proxy where you will find out whether the CEO of your company receives special perks such as a private jet costing the company hundreds of thousands of dollars, or whether the compensation is being fairly reviewed by an independent committee.

What is the purpose of reading the Proxy?

The proxy is one of the three main documents you should always try to read. The other two include the annual and quarterly reports which I will get to next time.

Where the annual and quarterly reports help you gain an understanding of the business and how the company is doing financially, the proxy gives you an insider look at the company structure, its executives and other bits and pieces of information including items that the company may not want you to know about.

To put your money into any investment requires conviction in the analysis, and part of that process involves reading the proxy document.

It’s all there buried in the pages of small text, so let’s get started.

How to Find a Proxy from the SEC

Go to the company search on the SEC website (http://www.sec.gov/edgar/searchedgar/companysearch.html)

Enter a ticker symbol, and then type “DEF” in the box labeled “Filing Type”. This will filter the results to only show the proxy documents.

(As you go through various types of companies, you may come across different types of DEF forms such as DEFA, DEFC, DEFM, DEFN, DEFR and DEFS. The only ones I have come across are DEFA, where additional information is added to the proxy, DEFR, which is a revised proxy, and DEFM, which is filed when the company intends to perform a merger or acquisition.)

Click on the “Documents” button next for the document you wish to read and then on the next page, select the document where the filename has a “.htm” extension to load the proxy.

Best Method to Read Any Two Proxies Simultaneously

Rather than just reading one document at a time, you can read any two proxies at the same time and see the differences between the two by performing this simple neat trick using Microsoft Word or Open Office.

View the tutorial on how to read two documents simultaneously.

Two Methods to Read the DEF 14A

There are two ways to read the proxy document.

1. Go through it from beginning to end
2. or search the document based on what you are trying to find

Both have advantages and disadvantages.

1. Going Through the Proxy from Beginning to End

If you are fairly new or unaccustomed to reading proxy statements, you will want to at least go through the document from start to end. That doesn’t mean you have to read every word.

Simply scanning the document from top to bottom will help you recognize and get used to the format of the proxy. All forms submitted to the SEC must follow certain guidelines so you will start to see a pattern quite quickly.

Advantages

You get all the details
You learn more about the company

Disadvantages

Possible information overload
Time consuming

As you read the document you want to keep questioning statements made.

E.g. in the Diamond Foods (DMND) DEF 14A, there is a section under “Compensation Decisions for the 2010 Fiscal Year” where it says the following

Base Salary: In June 2009, the Committee recommended, and the Board approved, a 6% increase in base salary for Mr. Mendes from $610,000 to $646,600, effective in mid-August 2009. Prior to the adjustment, Mr. Mendes’ salary was 14% below the median of the benchmark data for our peer group companies (after adjusting for size), and the increase better aligned his salary with the median competitive range and recognized his individual performance during the 2009 fiscal year.

As you read this, you may question how the company recognized that Mr Mendes’ pay was 14%, what is the median benchmark, and who are the peer group companies?

You would then try to answer this question as you continue reading.

If by the time you reach the end of the proxy there is no information that answers your questions, you have already uncovered information that the company may be trying to gloss over, hoping that shareholders do not question or search for answers.

Thorton O’Glove mentioned in his book Quality of Earnings, that a good idea is to read SEC filings backwards because the important information the company wants to hide are usually at the end. Companies know that not many people will read the entire document and so they squeeze all of their hidden notes to the footnotes at the bottom of the document.

By now, I hope you are motivated to read the proxy statements, but what if you are already know this but just want a better way to to go through the proxy filings?

2. Searching based on your Objective

If you have a good grasp of how the proxy document is laid out and comfortable with navigating through the entire document, this method is for you.

When you are performing any type of research, you have a clear objective in mind.

Just the other day, I concluded I needed to organize my papers in my room. Currently I have it in all sorts of folders lying around everywhere. My objective was to organize it all.

If I break it down into steps it would look like this.

Objective: Organize my papers
Process: Find something to organize the papers
Steps: Purchase a filing cabinet, hanging folders and labels

How is this relevant to reading proxy documents?

Unlike reading a document from beginning to end where you are essentially diving into a black box and looking for answers, by clearly stating your objectives first and then breaking that process down into manageable pieces, navigating through the proxy will be much quicker. Note that you may have more than one objective. Here are examples of what I mean.

The process for searching the proxy would be as follows.

Objective: Learn about company organization
Process: Go to management section of the document
Steps: Read about the executives, board of directors, who controls the company, who established the company, what the company culture is like.

Objective: Find management compensation
Process: Go to compensation table
Steps: Look up how much executives are getting paid, how compensation is calculated, what the performance threshold for bonuses are.

Objective: Find “hidden” or off the book compensation
Process: Go to footnotes of compensation table
Steps: Look for additional compensation perks such as limos, expensive personal services that the company is paying such as $10,000 golf club fees

As you can see, breaking it down like this makes it much easier to process and navigate.

The “process” and “steps” section seem obvious and redundant, but that is only because you are already doing it subconsciously.

Over time, you will only be thinking about the objective and the process and steps will come automatically.

Advantages

Quickest method
Creates good habit and process

Disadvantages

Possible to skip information
Could end up looking for the same information all the time

7 Questions I want to Answer with the DEF 14A

Here is a list of questions/objectives that I like to search for in the DEF 14A.

What is the background of each of the executive team?
Is the board independent or are there lots of executives on the board?
How much of the stock do insiders own?
What are the compensation levels?
What perks do the insiders receive?
Are there any related party transactions?
Are there any unpaid pensions?

Which Sections Do I Read? LULU Example.

Whether you follow method one of reading the entire filing, or navigate to the desired sections, the table of contents is your friend.

Here is the table of contents for lululemon athletica’s (LULU) from the 2010 DEF 14A. (Click on the image to enlarge)

I have split up the table of contents into two sections. The red section comprised of the information related to what the company wants you to vote on and the purple section which contains the meat of the document.

I’ll go through each item in the table of contents and discuss whether it is an important section to read or not.

Topics to Read in the Proxy Voting Section

The following sections may be overkill for the majority. Feel free to skip it to the end.

However, this will be a good starting base if you are completely new to reading these filings and don’t know what is important and what isn’t.

As you read from here on, remember that each DEF 14A may differ slightly. LULU just came to mind and it turns out their proxy was short yet detailed enough to be used as a good example.

The following are contents from the proxy voting section (highlighted in red) for LULU with a brief comment of each one.

>>NOTICE OF 2011 ANNUAL MEETING OF STOCKHOLDERS

Recommend to Read

What it is: A summary of the proposals the shareholders will be voting for, instructions on how to vote, rights of shareholders and other general information.

>>PROPOSAL NO. 1 – ELECTION OF DIRECTORS

OK to Skip

What it is: A table with the director names up for election.

>>CORPORATE GOVERNANCE

OK to Skip

What it is: Short biography of each director up for election.

The bio of the executive team is more important.

>>PROPOSAL NO. 2 – RATIFICATION OF APPOINTMENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

OK to Skip

What it is: vote to keep the current independent accounting firm.

>>PROPOSAL NO. 3 – ADVISORY VOTE ON EXECUTIVE COMPENSATION

OK to Skip

What it is: a brief summary explaining a vote is required for executive compensation.

>>PROPOSAL NO. 4 – ADVISORY VOTE ON THE FREQUENCY OF HOLDING A STOCKHOLDER VOTE ON EXECUTIVE COMPENSATION

Recommend to Read

What it is: a proposal to see how often executive compensation should be voted upon.

>>PROPOSAL NO. 5 – APPROVAL OF THE PERFORMANCE-BASED COMPENSATION MEASURES USED UNDER THE 2007 EQUITY INCENTIVE PLAN, AS REQUIRED BY SECTION 162(M) OF THE INTERNAL REVENUE CODE

Recommend to Read

What it is: a brief summary of any option or compensation plans.

>>PROPOSAL NO. 6 – APPROVAL OF THE MATERIAL TERMS OF THE EXECUTIVE BONUS PLAN, AS REQUIRED BY SECTION 162(M) OF THE INTERNAL REVENUE CODE

OK to skip

What it is: general information stating eligibility and objectives that must be met for bonuses.

>>PROPOSAL NO. 7 – APPROVAL TO AMEND OUR CERTIFICATE OF INCORPORATION TO EFFECT A TWO-FOR-ONE FORWARD STOCK SPLIT, WITH A PROPORTIONATE INCREASE THE NUMBER OF AUTHORIZED SHARES OF COMMON STOCK AND SPECIAL VOTING STOCK AND A PROPORTIONATE REDUCTION IN THE PAR VALUE OF SUCH STOCK

Recommend to Read

What it is: details of a two for one stock split the company intends to move forward with and how it will work.

Most of these proposals are generic and are repeated in the main body of the document.

Topics to Read in the Body of the DEF 14A

>>REPORT OF THE AUDIT COMMITTEE

OK to skip

What it is: details of a two for one stock split the company intends to move forward with and how it will work.

The audit committee is always going to say they did approve the financial reporting responsibilities. Same goes for independent auditors. Don’t make my mistake of blindly trusting auditors. Look at how the Diamond Foods audit committee was late to the party with their audit.

>>EXECUTIVE COMPENSATION

Must Read

What it is: Get the details on the elements of compensation.

Anything, compensation related, you should read.

>>SUMMARY COMPENSATION TABLE

Must Read

What it is: Compensation of executives over the past two or three years.

You must read the footnotes for this table to find additional “hidden” compensation information.

>>2010 GRANTS OF PLAN-BASED AWARDS & 2010 OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END

Recommended to Read

What it is: Table of stock options awarded to executives.

>>2010 OPTION EXERCISES

Must Read

What it is: Table showing stock options exercised and the value realized.

The more important section is the employment agreement included in the option exercises where detailed agreements with each executive is included such as severance packages, benefits and reimbursements.

>>DIRECTOR COMPENSATION

Must Read

What it is: Compensation table for the board of directors.

Best to do a Google search on the board to see what their previous track record is.

>>CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

Must Read

What it is: Information on any transactions with company insiders.

>>PRINCIPAL STOCKHOLDERS AND STOCK OWNERSHIP BY MANAGEMENT

Must Read

What it is: Table listing the ownership as a percentage.

Make sure to read the footnotes.

E.g. the CEO may own 1% under his name, but his trust could be a 30% holder, which makes the CEO a 31% owner.

>>SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

OK to Skip

What it is: Compliance requirements for 10% or more owners in reporting to the SEC.

>>TRANSACTION OF OTHER BUSINESS

Recommended to Read

What it is: If the company performs any other business, it will be noted here.

Rarely do you see anything. A quick glance is all you need.

>>STOCKHOLDER PROPOSALS TO BE PRESENTED AT THE 2012 ANNUAL MEETING OF STOCKHOLDERS

OK to Skip

What it is: General information about attending the annual meeting of stockholders.

>>APPENDIX

Recommended to Read

What it is: Not required but good idea to go through. There could be additional information that hasn’t been clearly explained in the body of the document.

Additional Resource

Check out footnoted. It is a site that goes through filings and brings to light unusual footnotes found within. It will help you tune your thinking and interpretation of notes from the documents.

Closing Summary

Hopefully this truly is a complete guide for anyone new to proxy documents.

I admit that every piece of this article is not required reading, but I hope that it covers all grounds. If there are additional thoughts I have missed, please leave a comment below so that I can update it. After all, I’m trying to create the ultimate guide.

10 Slam Dunk Value Investing Blogs to make You an Investing All Star

Jae Jun — Tue, 24 Apr 2012 08:00:02 +0000

Written by

Jae Jun

For the past 14 days, I’ve been sweating and tearing my hair out while writing an ultimate guide on reading the DEF 14A proxy document and to break my writers block, I’m sharing my list of slam dunk value investing blogs.

These are all value investing orientated sites, listed in alphabetical order, that will surely help you on your way to becoming an all star investor.

Get your bookmarks ready.

Cheap Stocks

Type: Net Nets

Summary: A blog that tracks a model portfolio of stupid cheap companies and provides weekly updates.

Why I like it: Provides concise and straight to the point updates and reasoning. You will have to do your own work with the names that come up here but a great place to get ideas.

Cheap Stocks: Below NCAV, Real Estate and other Value Strategies

Type: Net Nets

Summary: A blog dedicated to discussing net net stocks.

Why I like it: Provides a bit more detail than Cheap Stocks above, but purely focused on net net stocks and tracks a net net index. It’s a shame that the blog is updated only once a month.

Classic Value Investors

Type: Traditional

Summary: Features highly detailed and full out analysis of unloved stocks that the author owns.

Why I like it: If you hold any of the same positions and want some of the best researched analysis, Classic Value Investors is a great source.

Kelpie Capital

Type: Traditional

Summary: An investor working in a large wealth management firm in the UK writing a good blog focusing on detailed and well researched stock analysis from varying angles.

Why I like it: Provides awesome and complete analysis. You get everything about the industry as well as the company.

I have only read the blog on and off because I couldn’t find the sign up or RSS link for the longest time. Here is the RSS link though.

Long Term Value Blog

Type: Traditional

Summary: Writes about his own stock positions, provides insightful details and reasoning.

Why I like it: Insightful thoughts instead of the same cop out phrases you see a lot. May not provide a full analysis, but provides thoughts on a topic or issue that you may not have thought about.

Musings on Markets

Type: Educational

Summary: Written by Professor Aswath Damodaran a heavy weight champion when it comes to valuation and business.

Why I like it: You learn a lot. Professor Damodaran is able to convey a complex idea into an understandable and digestible explanation.

Shadow Stock

Type: Deep Value

Summary: Provides deep value stock ideas with fundamental data to back it up.

Why I like it: One of the best sources of deep value ideas.

Value Uncovered

Type: Deep Value

Summary: Specializes in stock analysis of illiquid, deep value stocks.

Why I like it: Deep value is where the greatest market inefficiencies lie. Stock picks from value uncovered have regularly exceeded 100% returns.

Value Slant

Type: Traditional

Summary: Much like Classic Value Investors and Kelpie Capital providing excellent stock analysis.

Why I like it: Important to read and learn from good stock analysis. You get to see new methods you may not have thought about.

White Collar Fraud

Type: hmmm… Detective?

Summary: Raises questions and challenges companies related to questionable accounting and securities fraud.

Why I like it: Ex criminal CFO of Crazy Eddie. What’s not to like? He knows the ins and outs of fraud and is now out there helping to catch the bad guys.

GRVY Volatility causes Heart Attack

Jae Jun — Mon, 16 Apr 2012 07:11:23 +0000

Written by

Jae Jun

It was too early to pop the cork and celebrate GRVY’s climb. After hitting a high of $3.30 or $3.40, the stock price is back down to the low $2’s.

But it does not matter and should not matter.

This post was originally just going to be a brief message to ignore short term volatility but that changed as soon as I wrote the first line.

Because I have a lot riding on GRVY and I know many of you also hold the stock as well. I also know exactly how I feel about the movement and maybe my reflections will benefit you too.

Backing up to 2010 and 2011

When my first full season of investing began in 2008, I attributed all of my success to my “rookieness”. Someone commented that I must have an iron stomach to handle huge swings and to be able to buy when down 50%. But looking back, it was more lack of experience and not know anything that allowed me to glide by such volatility and to ultimately profit from it handsomely.

Then after the 2009 season of huge gains, everything came to a halt starting in 2010.

Ironically, my stock picks were fantastic, if I had held it longer. I would have had multiple baggers as well as one that eventually went up 1,000%. But the point is that I missed out on everything.

I missed out because I cared too much. I was trying to continue the strong performance from the previous year. It was just trying too hard and too much.

Well, that is what I thought.

What Really Happened

Half way through 2010, I was extremely frustrated because nothing was working. It felt like I had the anti Midas touch.

But during that mid 2010 season, upon some deep reflection, everything pointed to one issue, and it was quite clear what it was. I was just so arrogant that I didn’t even think it could be a possibility.

I couldn’t handle volatility.

The Next Step

Knowing what the issue was and finally being able to admit it to myself, I did what I had to do.

I did nothing. I didn’t buy or sell or research anything. I did nothing in terms of activity.

What I did do was start reading behavioral finance books. Buffett’s letters are fantastic for that. I read other books and letters by prominent investors.

All of a suddent, it felt like I had an experienced coach beside me giving advice.

If this was sports, it was my turn to bat, and with my rookie season over, I wanted to impress everyone to cement my position on the team. The only problem was, I kept wildly swinging at everything, but thankfully there was somebody who had experienced it all, telling me to slow the game down because I was all over the place.

Turning Point

And so I was finally able to break free. That was the pivot point I needed. Believe it or not, it now feels like I am numb to volatility. My mind is back to how I handled things back in my rookie season, except that I now have a lot of tools and knowledge to go with it.

Maybe you never went through the little struggle I did, but I’m sure many have or are still struggling.

So here’s my advice. Slow it down. Take a deep breath, take your eyeballs off the stock price and refocus on the big picture.

Now, let’s talk about GRVY.

GRVY’s Big Picture

The recent drop has nothing to do with the business. I repeat it has nothing to do with the business and I am going to address the main concerns that I am hearing about.

1. Bad Game Reviews

To set the record straight, I have not read any reviews of the game on some national tabloid that is slamming the game. Now that would be a big concern, but there is none of that.

RO2 went live less than a month ago only in Korea. The future is bright. The first RO certainly wasn’t a hit within 2-3 weeks of release. Gravity kept improving the game and made it into many different formats and still lives on today.

It is just a small minority of unhappy gamers complaining. More noise comes from complainers than happy gamers. It’s a fact of life. Dislike a product and you will try to tell the world. Be happy about something, and you’ll likely only tell people when asked about it.

I’m sure the huge hit World of Warcraft had plenty of complaints during its Beta stage and immediately after launch. Taking gamer complaints as a sign that the game will be a failure is a huge mistake.

It is important to differentiate noise and valid information, because not all information is good information.

2. Lack of Management Communication

Management has no reason to reassure investors of stock price movements.

The stock and the business are two separate matters. I would sell my position if management showed more importance in trying to comfort and please investors about the falling stock price instead of spending that time to run the company.

When I went on the yahoo board, there are a few people who constantly contact Investor Relations to try and get info. This is really a waste of time and more of a step to reassure yourself.

I prefer companies that do not hold investor conferences or even give earnings guidance. Lack of communication by management is a plus for companies who are meeting milestones.

3. Steep Decline in Stock Price

There was clearly a huge buying spree leading up to the date of RO2 official launch in Korea which pushed prices above $3.

The game is released only in Korea. This is not a world wide launch and is therefore not receiving wide spread attention. This must have been a huge disappointment for many, especially those who were trading on momentum.

The beauty of GRVY lies in the future as the game matures and RO2 expands to other countries.

Look at GRVY’s Big Picture

If it was 2010 or 2011, I’m sure I would have sold at $3 and have been proud about it. But my selling philosophy doesn’t revolve around selling just to pocket some gains when I am confident the value is much higher.

This is a topic for further debate, and taking profits is not a bad thing, but personally, I find it more difficult to buy back in after having sold a position. Easier to add to my position when the stock price has dropped vs creating a new position after having exited.

If I didn’t see much upside with GRVY once it hit $3, then it is an easy sell decision, but I am more than content to hold and ride it out.

Whenever you read about the really successful investors, they all preach the same principle. Use volatility as your friend, not your enemy.

The people who bought Berkshire Hathaway in the beginning and didn’t sell after it appreciated 100% are probably still holding their positions for a 18,000% return or something.

Definitely wrong to compare GRVY to Berkshire, but the concept is the same. I’m willing to wait for the big picture to unfold.

Consider that RO2 will be localized and released in about 6-7 additional countries. Licensing revenues will continue to pour in, additional income from providing support will also drop to the FCF line. Its newly purchased games are doing well and adding to profits.

RO2 doesn’t have to be a huge success. A mild success is enough for the company to look completely different than it is now.

I valued GRVY as below a couple of months back.

Conservative value: $3.00 range
Normal value: $5.00 range
Aggressive value: $7.00 range

Continue to focus on the big picture and you will realize that we are still at the very beginning. It just felt long because the game has been delayed for 7 years.

Disclosure

Long GRVY

Stunning Growth but Questionable Management

Jae Jun — Mon, 09 Apr 2012 07:01:11 +0000

Written by

Jae Jun

[edit] Certain parts of this article has been reworded/rephrased as it seems like MED is more focused on threatening bloggers with civil suits to retract opinion articles as opposed to focusing on improving their own business or business model.

This article was written based on the 2010 10-K which you can find in the SEC.

What lawyers don’t understand is that an investment requires an analysis of the past and present. This article was written based on the 2010 annual report and proxy because I felt that it provided good pieces of information.

Obesity in USA has increased dramatically. USA is the most obese country in the world by a large margin and there is a long way to go before this fact changes.

30.6% of the USA population is obese, with Mexico coming a distant second at 24.2%. If you include Americans falling into the overweight category, 70% of the population fall into this category.

Obesity is not age specific and this is not surprising because children now sit at home, eat and play games. Many adults work a desk job and then relax at home with family without much exercise.

Life gets busier it seems with each year, and to compensate, people eat fast food to stay on schedule.

This sets the scene for the business. The weight loss industry is worth approximately $55bn. This includes diet foods, drinks, low calorie sweeteners, health clubs, workout videos, weight loss programs, children’s weight loss camps, diet books , appetite suppressants and more.

As you can see, there is a lot of competition and a huge variety of weight loss/management.

Medifast (MED) Business Description

This brings me to Medifast (MED). Medifast is #12 in the 2011 Forbes 100 Best small companies list (was #1 in 2010).

The company makes, sells and offers products for weight management, meal replacement and vitamins. All this is done through the following subsidiaries:

Medifast direct – direct to consumer through website (www.choosemedifast.com)
Take Shape for Life – Personal coaching – direct selling
Medifast Weight Control Centers – brick and mortar clinic channel. Also offers franchise opportunities.
Medifast Wholesale Physicians – physicians carry Medifast products and resell to patients

Medifast Spider Graph

Management: ???
Growth: A
Moat: C
Risk: C
Valuation: B
Overall: You decide. I’m not touching this.

Where did/will Growth come from?

Revenue growth has been huge but the main driver has been from Take Shape for Life, which is the single level direct selling MLM (Multi Level Marketing aka pyramid scheme) arm of the business.

Take Shape for Life is a direct selling company and not an MLM so I’ll retract my comments on MLM. Direct selling is where a salesperson is paid only for the sales he makes himself. MLM is where the salesperson is paid for selling and for sales made by people he recruits or sponsors.

The annual reports do not specifically state that they use a pyramid MLM operation but doing a little search shows that the business model is indeed based on MLM.

This concerns me on multiple fronts. MLM is all about making money. The product could be good, but because of the “opportunity” presented to make money, a lot of new members are in it for the money vs the actual benefits of the product. Somewhat confirming my sneaking suspicion is that the rest of the business is losing money.

However, the rest of the business is losing money.

MED clearly wanted me to mention this statement from the annual report about them losing money. This is from the 2011 10-K.

MWCC and Wholesale Segment: This segment decreased net profitability in 2011 as compared to 2010 by $9.5 million. The decrease in net profitability is primarily due to the hiring of expertise in key areas to build the internal infrastructure to open new Medifast Weight Control Centers in 2011 and beyond. Hires included regional trainers, district managers, area managers, mobile managers, Dietitians, HR recruiters, operations support, and marketing. In addition, thirty-one new corporate centers were opened in 2011. Start up costs such as rent, other office expenses and new employee hires contributed to the decreased profitability of the Centers.

My response is, so what?

Losing money is losing money. I wrote that the business is losing money based on the 2010 annual report, but it is the same in 2011. Actually it is worse. The numbers state that “all other businesses” is losing money.

In 2011, all other segments was down 21% compared to being down 18% in 2010. Just because you hire like crazy, does that mean it is OK to lose money?

The real question is, is the increasing revenue due to an awesome product? Or is it due to the MLM make money aspect?

Strategic Advantage or Moat

Medifast says that they compete through their science and research on weight loss, but if you give the same budget to another company, I’m sure they could do the same. Science and research is not an advantage.

I see no real advantage MED has over its competitors.

Lots of Competitors

Competition is huge in this business. Everything from supplement makers, gyms, workout instructional guides/videos, personal trainers, diet cook books etc.

Anything sold related to weight loss or weight management is competition.

Current direct competitors include:

Nutrisystem (NTRI)
eDiets.com (DIET)
Herbalife (HLF)
USANA Health Sciences (USNA)
Weight Watchers International (WTW)

Severe Risks

If a new weight loss trend appears, Medifast will be affected.
Government regulation risk
Not one single mention of MLM yet many blogs show that Take Shape for Life clearly is MLM. I don’t know whether that is the norm. I could look up Herbalife and compare since they are MLM too.
Huge cookie jar increase. In Dec 31, 2010 the provision for returns was $207k compared to $70k in 2009. Not a good sign.

Valuation

Strong earnings, fantastic margins and returns, very strong balance sheet, big FCF growth
Huge cookie jar increase
Days Payable Outstanding more than doubled from 2009
Rough calculations show the company to be worth $23-$30.

Things to think about Regarding Management

Current chairman of the board was the previous CEO until 2007. He was also responsible for turning the company around. The chairman also co founded Take Shape for Life and received an “Entrepreneur of the year” award. I like founding CEO’s much better than corporate CEO’s.

The previous Current CEO was only 33 years old and left the company in Feb 2012. He became CEO in 2007 which means he was 28 years old. He originally joined the company in 2002 at the age of 23. Before that he was a senior analyst for the Blackstone Group.

I wonder how old you have to be before becoming a senior analyst at Blackstone.

What I find troubling is why and how did he become CEO with such a short history with the company?

I want to know what the board of directors were thinking, how this decision was made. Having 4 executives on the board can make it lenient and more attractive for executives.

What’s more, his team consisted of a CFO 33 years of age and COO who is 33 years of age. Again, according to the 2010 docs, I find it very troubling about this direction from the company.

This was one of the youngest management team I have ever encountered.

There are lots of young entrepreneurs in their 20’s and 30’s but the CEO in 2010 did not create the company, and I just don’t see how a person without any prior relationship with the company and only background as a senior analyst rise to CEO in 5 years at 28 years of age. Impressive but questionable.

Moving on…

Compensation in 2010 is as follows, expect more in 2011;

Chairman made $1.31m
CEO made $1.66m
CFO made $1.45m
Total Revenue is $257m

Compared to total revenue, compensation is “ok” but the sum is still huge.

Herbalife (HLF) has taken a big hit by famous value investor, David Einhorn, questioning their disclosures. It also turns out that the HLF is one of the highest paid CEO’s. It seems like huge compensation packages are considered acceptable in direct selling business model business.

Concerns

If you only read the latest 2011 10-K report, you would have missed this, but right from the beginning of the 2010 annual report, you are give an explanatory note about accounting issues regarding how the company recorded expenses.

“Certain costs and expenses affecting SG&A expenses and cost of sales, to include shipping expenses and certain web advertising expenses, which due to growth and evolution in the business model were consistently expensed in the following month after services were rendered, rather than being accrued in the proper period.”

This means that expenses were recorded when they were paid instead of when it was incurred. The accounting was deemed material and requires restatement for the years 2008 and 2009. (Actually the report shows reinstated numbers back to 2006.)

Net income in 2009 and 2008 was reduced by $606k ($0.04 eps diluted) and $523k ($0.04 eps diluted).

Nothing illegal, but if it was immaterial enough to reinstate for several years, other accounting policies must be questioned. Look at what happened to Diamond Foods. Their accounting methods were not illegal, but it was shady enough to warrant an investigation and ultimately a restatement wiping out millions of dollars in the company value.

Fraud Claims

(It seems like MED and their lawyers don’t like anyone linking to the below sites. In any case, it is best to check out what these people have to say. Do your due diligence in looking at each one.)

I came upon some links claiming that MED is a fraudulent business to which MED filed a civil complaint on Feb 17, 2010.

Tracy Coenen is a forensic accountant and fraud examiner in Chicago and Milwaukee who investigates white collar crimes, including cases of financial statement fraud, embezzlement, tax fraud, and insurance fraud. She has been raising questions about Medifast since 2009.

The fraud files blog

It also concerns me when other noted criminals come out and question Medifast’s business practices.

In the book The Art of Short Selling, there is a case study on Crazy Eddie and coincidentally, I found the blog of former Crazy Eddie criminal CFO who also discusses Medifast.

I’m a firm believer that it takes a criminal to know a criminal.

White collar fraud blog

Here is what it says in the 2011 10-K about the civil suit MED initiated.

The Company filed a civil complaint on February 17, 2010 in the U.S. District Court (SD, Cal) against Barry Minkow, his Fraud Discovery Institute, Inc., its subsidiary iBusiness Reporting, its editor William Lobdell, as well as Tracy Coenen, her Sequence, Inc., “Zee Yourself”, and Robert L. Fitzpatrick for defamation and violations of California Corporation Code Sections 25400 et seq and 17200 et seq, alleging a scheme of market manipulation of Medifast stock for Defendants’ monetary gain, by damaging the business reputation of Medifast and its meal replacement weight loss products. Bradley T. MacDonald, Executive Chairman of Medifast, who is also a large shareholder of the Company, joined the lawsuit individually. The suit seeks at least $270 million in compensatory damages, punitive damages, and ancillary relief. The Company continues prosecution of this civil suit. The Company also continues to pursue its pending complaints filed in March, 2009 with the SEC, Maryland Securities Commissioner, and the U.S. Attorney against most of these same named defendants with respect to the related matter.

Looks like it is still ongoing. No conclusion is stated in the document yet.

But you get the idea. They want to try and do the same thing for this article.

Conclusion

From a numbers standpoint, the company is seeing excellent growth, but the earnings quality is horrible especially in light of the huge cookie jar increase. Personally, one too many questions were raised in my mind that I am not comfortable with.

I have no opinion of whether Medifast is legit or not, but this is an easy pass as an investment for me. I’d rather be safe than sorry. Lots of other fish in the sea.

If they are this picky over an investment article, I don’t want to touch or even trust the company. Why would I want to own a company that spends its money on hiring lawyers to retract articles from seeking alpha?

External Links and Other Opinions

http://philtown.typepad.com/phil_towns_blog/2011/07/medifast-is-a-value-trap-for-rule-one-investors.html

http://industry.bnet.com/healthcare/10001126/medifast-part-two-weight-loss-miracle-or-pyramid-scheme/

http://seekingalpha.com/symbol/med?source=search_general&s=med

http://www.gurufocus.com/articles.php?symbol=MED

Disclosure

No position.

3 Tools by Value Investors for Value Investors

Jae Jun — Fri, 06 Apr 2012 07:01:33 +0000

Written by

Jae Jun

In addition to the recommended reading lists, sometimes I’ll highlight projects other investors are working on in order to help them gain traction with what they are doing.

I don’t get paid for mentioning any of these, nor do I take commissions. It’s just a way of “passing it on”. You guys helped create Old School Value to be a valued resource, so I will try to do the same for others provided the service, tools or information adds value, and the person involved in the project is truly passionate about what he/she is doing. The last thing I want is for you to sign up to something, only to see it vanish a few months later.

With that intro out of the way, here are 3 items to check out.

Multi-Strategy Journal (MSJ)

The Multi-Strategy Journal is an options transaction log in spreadsheet form.

I don’t do options, but from what I can see, you can document all sorts of option strategies such as

Singles
Verticals
Iron condors
Butterflies
Diagonals

I have no idea what that means maybe it’s something that will interest you.

Download this trial version and contact the creator if you are interested. He has good supporting documents to guide you. I have no idea how much this costs, so ask him.

No website available. Only email.

Email: Jim Lunceford

jamesdl@windstream.net

Can IBM make you Rich?

The author goes by the name Victor Freeman, and has written an e-book on IBM using Phil Fishers 15 points to look for in a common stock.

If you are an Amazon prime member, you can read it for free.

Here is a sample you can download and read. Contains a couple of chapters.

View it on Amazon or click on the book image.

Triage Investing Blog

Brad Ferris is the author of Triage Investing Blog. Old School Value and Triage Investing literally “grew up” together. He has always written in great depth and detail. Quality is what you get with Brad.

I have posted a couple of his stock analyses previously.

He recently wrote another one and has made it into an e-book.

To get it as well as future stock research reports for free to your inbox, consider signing up to his blog.

Disclosure

No compensation received for anything.

2012 Top 10 Stocks Q1 Returns 29.7%

Jae Jun — Wed, 04 Apr 2012 07:01:56 +0000

Written by

Jae Jun

The first quarter of 2012 is already over and the portfolio I am most curious about, isn’t Berkowitz or Buffett, but the portfolio of the ten best stocks picked by you and other readers.

Michael Mauboussin mentioned in his book More than you Know, of an experiment where a classroom of students were asked to guess the number of jelly beans in a jar.

Every guess was incorrect. The closest answer was the average of all the answers, and that is precisely what I want to test; whether a small group of investors with similar investing methods can beat the market.

For the brief reasoning for each stock, go to the original 2012 stocks selection page.

2012 Q1 Performance Results

The Q1 performance is 29.7%.

So far so good but still 3 more quarters to go. But a good start is better than a lousy start. I’m interested in doing this each year to see how a collaborative effort performs over the long term.

Individual Performance

GRVY: 75.7%
BAC: 63.5%
WDC: 34.3%
GS: 28.6%
MSFT: 19.2%
AEY: 13.8%
ORCL: 13.5%
FRX: 13.3%
DELL: 10.8%
GLW: 6.3%

Disclosure

Long GRVY, AEY

My 3 “Best” Ideas

Jae Jun — Tue, 03 Apr 2012 07:01:22 +0000

Written by

Jae Jun

Geoff Gannon from Gurufocus has recently written about how Warren Buffett made his first $100k by concentrating on his best idea, GEICO.

I’m not Buffett, and I’m not ready to put 75% of my portfolio into a single idea, but I do consider myself to be highly concentrated. A very volatile portfolio which most people cannot stomach.

I have 50% of my portfolio in 3 positions. This is the latest sizing after the big run up we have had this year.

Gravity Inc (GRVY): 21%
Retail Holdings (RHDGF): 16%
Dacha Strategic Metals (DCHAF): 13%

Howard Hughes Corp (HHC) is no longer in the top 3 after I sold half to raise cash for another purchase. If I hadn’t sold, my top four positions would have made up about 65%.

GRVY, RHDGF and HHC is showing excellent returns since my initial investment. DCHAF, not so much.

In fact, I labeled DCHAF my highest conviction pick and wrote a detailed analysis of it, but so far, I only have mud on my face to show for it.

Here is a list of good links to let all the newer readers of Old School Value catch up on my “best” ideas.

Gravity Inc (GRVY)

A company that I have beaten to death lately on the Old School Value Facebook page.

After 7 LONG years of delays, GRVY has finally released their flagship sequel game in Korea. The first catalyst has played out and I am anticipating a greater stream of revenues from licensing deals for other countries.

Retail Holdings (RHDGF)

For me, RHDGF was one of those investments where I could just immediately tell that it was cheap.

The company should be valued on a sum of parts analysis and management has clearly expressed their intention to monetize the assets and return it to shareholders.

Management has demonstrated their commitment by distributing big special dividends (14% payout last year) each year and I expect it to grow as RHDGF continues to report excellent numbers.

You only need to read a short letter to shareholders by them and you will see what I mean. Here is an excerpt;

“ReHo’s medium- to long-term strategy remains unchanged–to maximize and monetize the value of its assets, with the objective of liquidating the Company and distributing the resulting funds and any remaining assets to its shareholders. The Company’s objective is to ultimately distribute to its shareholders at least the equivalent of its net asset value of $16.51 per Share, but potentially up to and possibly in excess of its derived market valuation of $35.20 per Share. Consistent with this strategy, the Company intends to continue its dividend/distribution program, including an anticipated distribution this year of at least $1.00 a Share, bringing total dividends/distributions paid to shareholders to at least $6.25 a Share.

Dacha Strategic Metals (DCHAF)

The trouble maker of the three.

The mid term view for Heavy Rare Earth Elements (HREE) is still attractive, with no company able to produce HREE’s in adequate quantities outside of China.

Some companies are in the process of trying to mine for REE’s but they are limited to Light REE’s and will be at least 3-4 years out before any feasible mining of HREE will come to production.

In that sense, the stage is set for DCHAF, but the market for HREE has weakened and management has not been able to improvise outside of its business model of holding then selling the metals.

Stock price is very much below net asset value.

Disclosure

Long all at time of writing.

Links of Interest: April Fools Edition

Jae Jun — Sun, 01 Apr 2012 18:45:29 +0000

Written by

Jae Jun

In case you missed the last line of the recent Sad News.. OSV Up for Sale and Shutting Down, Happy April Fools.

But you got me instead because I now have a ton of emails to respond to… The most I’ve ever received in a day, and it’s not even lunch time…

There are a lot of skim readers or headline readers and all I can say is that unfortunately, you are stuck with me and my writing for a long time. But I must give a big thank you to the well wishers. If any opportunity does come up, it will be providing you with full time service, better tools and information.

Now back to business.

Calculating Owners Earnings

The only, yes only, determination of a strong company is its ability to generate cash for its stakeholders. To determine if the company has been historically strong, we employ Owner’s Earnings (as used by Warren Buffett), which is the approximated cash earnings available to the stakeholders in the company. How are these earnings different than what Wall Street reports?

Expressing the EPV

At its core, the EPV looks at a company’s return on capital relative to its cost of capital. Companies which report returns higher than their costs deserve an EPV higher than their NARV, while companies with returns unable to recoup the costs of capital aren’t even worth the trouble to continue operating, and should thus trade at less than their NARV. Ideally, a fairly-valued company would have an Enterprise Value (market cap + interest-bearing debt) that equals its EPV. The EPV is simply calculated using the following formula:

A Financial Sleuth Finds – Barrons.com

At the beginning of 2011, Rakuten (4755.Japan) disclosed that it had changed its depreciation method from the straight-line method to the declining-balance method. Over the life of the asset, depreciation will basically be the same number. Straight-line depreciates an equal amount to each period; the other takes bigger deductions in the early years, and small ones later on. In U.S. dollars, that change added $13 million to Rakuten’s operating profit, through a lower depreciation expense. Is there any place in the GAAP rule book that says: ‘Thou shall never change your depreciation method?’ No. But, in my interpretation, that stinks. It had nothing to do with selling additional products or having stronger margins.

GeoEye (GEOY) Analysis

GeoEye is a provider of high resolution and low resolution global space-based and aerial imagery and geospatial information through their processing and distribution network to customers around the world. I’m sure you have seen the high resolution maps on Google maps. Some are taken by GEOY.

I wrote this in July 2008 and the company is down from its highs and slightly higher than when I first saw them.

You may want to check it out yourself.

20 April Fools’ Must-See Websites From Google to Sony to YouTube

Can’t have a April Fools edition without some good jokes.

Sad News.. OSV Up for Sale and Shutting Down

Jae Jun — Sun, 01 Apr 2012 07:06:54 +0000

Written by

Jae Jun

It has been close to 5 years since I started this site and it has been an amazing journey.

I have learned so many valuable lessons, found new truths about myself and had the opportunity to meet many new people along the way.

I went from a frightened new investor to one who can confidently analyze his own companies and invest with conviction. There are a handful of you who were with me from the beginning and I am humbled by that.

This pride and joy of mine went from a single blogger to thousands of readers and downloads. I still feel it is small, but we are a tight knit community and I’ve loved every minute of it.

Below is a screen shot of what Old School Value looked like in the beginning. It sure has come a long way. (click to enlarge)

I introduced the premium stock analyzer spreadsheets with people from Canada, UK, Mexico, Netherlands, Asia and all across USA using it on a daily basis. Maybe you need to get it before I take it all down too. Of course I will continue to support the premium users though.

The predefined screeners has helped people with new ideas and the opportunity to profit from it.

And it breaks my heart to let it all go, but I was suddenly offered an opportunity this weekend that I just cannot pass. More details on that at a later date.

The new endeavor is going to require my full time attention and I have blessings from my wife to pursue it.

It’s been a fun ride and I will send out another update as things wind down.

Disclosure

Happy April Fools’! Gotcha!

This Stock Won’t Reach Intrinsic Value Anytime Soon

Jae Jun — Thu, 29 Mar 2012 01:43:37 +0000

Written by

Jae Jun

Twin Disc makes transmissions, shift controllers, propellers, water jets and other industrial power transmission products for marine and industrial vehicles. You can get an idea of what products they sell from the links below.

http://www.twindisc.com/MarineProducts/MarineProducts.html
http://www.twindisc.com/IndustrialProducts/IndustrialProducts.html

Their customers are primarily in the following industries:

Pleasure craft (boats)
Commercial and military marine market
Energy and natural resources
Government and industrial markets

I wrote this in January because TWIN was a name that came up in the Forbes best small companies a couple of years back. My numbers may not be the latest, but it should be similar.

The stock dropped 18% on earnings announcement in January and is now down 27% YTD.

But, does it offer any value?

Twin Disc Spider Graph

Verdict

Management: B
Growth: B
Moat: C
Risk: C
Valuation: B
Overall: B-

Findings on Management

Michael E. Batten owns 22.7% of the company. Batten is chairman and CEO.
Remaining 10 executives and directors own 3%
From the Def-14A: “The Corporation believes that its executive officers should hold a meaningful stake in Twin Disc in order to align their economic interests with those of the shareholders.” - Ironic that 10 insiders hold 0.3% of shares each given this statement.
From 2008 – 2009, company hired an independent consultant to review salaries. In 2010, due to recession and to reduce cost, salaries were cut by 5-15% without independent review. In 2011, salaries were restored to previous levels without independent review. In 2012, independent consultant was rehired.
Funny thing is that the list of comparable companies in the compensation survey includes hundreds of non related companies like Coach, Heinz, Time Warner, 7-Eleven and health insurance companies.
Comparing 2009 to 2011 (since 2010 was a paycut), Batten increased his total compensation by 32%. Batten’s son, the President and COO increased total compensation by 31%. CFO increased compensation 40%. The pay reduction in 2010 seems to have been more strategic than anything else.
Executive pay comes out to 2% of sales.
Barely any insider buys.

Company Growth

TWIN sells to the oil industry and at the moment with oil prices increasing, their 6 month backlog as of June 2011 was $146.9m vs $84.4m.

This is quite a big jump in the 6 month backlog. Shows that there is potential and demand for their products provided the economy helps.

However, TWIN is better than most small industrial companies because they design specially engineered products to meet and serve market demand. If they continue to research and develop products, they can grow but it is difficult to differentiate from competitors.

Add in the fact that the majority of company growth has to come from an improving economy. These types of companies are under heavy economic influences. Unless there is a total product in a truck or boat, customers are not inclined to purchase their products. Or if money is tight, it is easy to get a part serviced or fixed versus replaced.

Strategic Advantage/Moat

I cannot think of or find any strategic advantages.

Even the goodwill section in the annual report does not show anything significant in terms of hidden assets or relationships which could be interpreted as a moat.

Competitors

There are lots of competitors both domestically and internationally selling power transmission products. Up to this point, I don’t find TWIN attractive enough to go through their competitors.

Risks

TWIN does 59% of sales outside USA. A majority of that comes from Canada and Europe. The Europe crisis wil damper sales. Currency exchange rates is also important with international sales. They have international manufacturing operations in Belgium, Italy and Switzerland.
Some products are sold to the oil industry. Dependent on oil prices.
Company sells to the government, which means that any budget cuts will hurt them.
Cyclical business.
Most of their products are made of steel. If steel prices go up, margins will compress.

Financial Numbers and Quick Valuation

Healthy balance sheet
Inventory is valued using the LIFO method
Inventory of raw materials and works in progress has increased, which is expected based on the increase in backlog.
Capital intensive. TWIN needs to upgrade or maintain their equipment. They have to constantly invest in R&D for new and better products.
The 2011 sales and margin is misleading. 2011 gross margin is around 39%, but that should come down to 34%.
Capex has also returned to normal levels.
During recessions, CROIC is avg 3.7% and ROE is 3.8%. Will most likely lose money in a recession. Makes investing during a down cycle very tough.

Performing a reverse DCF with the owner earnings from 2011 (which is a good number), with a discount rate of 12% (TWIN calculates their cost of capital to be 9%), market implied growth rate is about 18%.

Even if I use 9% discount rate, the expected growth rate is 14%. Much too high for a cyclical company.

Performing a reverse Graham with EPS of $1.60, the implied growth rate is 9%. Achievable but difficult in my opinion given the risk and the environment in which it does business.

The reproduction value of the business comes out to around mid to high $20’s so there is potential in terms of maximizing value out of its assets.

But overall, valuation wise, it looks fairly to slightly overvalued purely based on these numbers.

Catalysts

Increase in demand from emerging markets.
Improvement in economy
Continued expansion of product line through research and development
Increasing sales in the US

Other Pieces of Info

From the Proxy: “Cost of Capital is defined as the weighted average expectation of Twin Disc’s sources of capital, debt and equity. For FY2011, the cost of capital has been calculated at 9%”
From the 10-K: “business is not considered to be seasonal” but they are very cyclical
top ten customers accounted for approximately 43% of sales
Involved in several product liability litigation. Not material.

Conclusion

There are hints here and there that management isn’t the most shareholder friendly, but my opinion is arguable because they pay a very small dividend and bought back shares during the lows of 2008 for an average price of $7.25.

If the company announces a share buyback, it will be a clear indicator that management believes their stock price to be cheap. I would prefer to see other insiders other than the CEO to purchase shares.

Fundamentally, the company is average, but management has done a good job of maximizing the potential during the good years.

With that said, the upside does not outweigh the downside. Far too many things could go wrong before upside could materialize.

Think of it as probabilities. Even with the big drop YTD, the upside is maybe 30-40% max whereas the downside percentage is easily 40% and could be greater if the economy continues to slide.

Disclosure

None

Downtime on Free Investing Spreadsheets

Jae Jun — Sun, 25 Mar 2012 19:21:35 +0000

Written by

Jae Jun

I received word that the free investing spreadsheets are not working at the moment. Looking into the matter, it turns out that the website I was using to get the data from (Smartmoney.com) changed the structure of the financial statements.

For the time being, some spreadsheets may not work while others will.

Once I finish supporting all the paid users, I’ll get to fixing the spreadsheets and upload it. I will let you know.

To: Premium Users

Updated versions for Premium users have been sent. Please check your email. If you have any questions or comments

To: Starter and Lite Users

Send me an email and I will send you the updated version.

Sorry for the inconvenience everyone.

Reading Accounting Quality and EPV Case Studies

Jae Jun — Sat, 24 Mar 2012 18:26:43 +0000

Written by

Jae Jun

It’s been a while since I included some good reads.

The types of articles I look for are not the latest. Like antiques, sometimes the best things come from the past.

This week I bring you a round of articles focusing on accounting and earnings quality as well as a deep dive into Earnings Power Value.

Financial Shenanigans: Detecting Accounting Gimmicks that Destroy Investments

During the past few years, I have been shocked and disappointed by the way corporations have increased the use of manipulative accounting gimmicks when their management presents information to investors. Such behavior occurs in both reputable and disreputable companies. In fact,many of the companies that I cite in my examples are highly regarded companies, so I am not pointing fingers at any particular type of company.

Is There Any Value In Stella Jones?

The value analysis I will conduct today is based on the methodology outlined in the book Value Investing: From Graham to Buffett and Beyond. If you are interested in finding out more about value investing, this is the perfect guide. It explains the philosophical approach to value investing, and provides enough information for you to build your own value analysis model in a stock analysis spreadsheet.

Berkshire Hathaway and GEICO:an M&A case study

This case shows the potential for utilizing the modern Graham and Dodd (G&D) valuation approach in a corporate setting to improve the odds of successful M&A. G&D valuation differs from other methodologies in that it addresses valuation through a unique construct,the value continuum. This continuum not only focuses on assets and earnings, but also on competitive advantage and growth. By evaluating these elements within an overall framework the G&D method frequently produces more insightful valuations than other methods. Furthermore, those valuations can be proactively utilized to effectively guide due diligence.

The Power of Earnings

One method we’ve found to be very useful in determining the value of a company’s current cash flow is earnings power value, or EPV. In contrast to valuation methods that require making uncertain growth projections, EPV is based only on a company’s actual (trailing 12 months) cash flow. We can actually ignore growth estimates when using this tool, so this makes it a great starting point for analyzing a stock.

Where You’ll Find the Next Killer Short

These are companies with questionable management teams, eroding competitive advantages (assuming they had them to begin with), and business models so bad they’d make a 5-year-old’s lemonade stand look like genius. Execs at these companies desperately try to hit their numbers every quarter and sometimes, when they just can’t make ‘em … well, they might just be inclined to fudge ‘em. The good news is that you have the power to spot these potential snakes in the grass — you just need to know what to look for.

40% Upside on Corning (GLW) – Part 2

Jae Jun — Wed, 21 Mar 2012 07:00:23 +0000

Guest post by

Joakim Aske

This is part two of an investment thesis on Corning (GLW).

Every Company has Risks

Lawsuits

GLW and its subsidiary Dow-Corning are involved in several lawsuits regarding different health issues. Corning through another subsidiary is exposed to an asbestos lawsuit and Dow-Corning is exposed to a lawsuit from former creditors before they went in chapter 11 in the 1990’s.

The potential losses they could incur if they were to lose these lawsuits are not material in the way that they will not interfere with GLW’s business operations. It could be a non-recurring loss in the magnitude of 200-800 million depending on the result of the lawsuits.

LCD Slowdown affecting Profitability

The setback in LCD business that started in 4th quarter 2011 could change the profitability level in the business.

There is likely to be a reduced level of profitability and I have considered this in the analysis. Assuming a 30% decline EBIT across the whole business to be on the conservative side. Management has estimated that net income could be reduced by 30% from the SCP subsidiary due to this slowdown.

A positive note is that supply chain inventory levels have been reduced to 2008-2009 levels, 12-13 weeks of inventory, a level where the LCD industry experienced stock outs due to lack of glass when demand picked up again.

Currency Risk

A plus or minus 10% movement in the USD – JPY exchange rate would result in a change to net income of 146 million and a plus or minus 10% movement in the USD – EUR exchange rate would result in a change to net income of 34 million for 2011.

The effect of currency movements can have adverse effects on GLW`s bottom line, however it is not enough to make it incur losses or decrease its FCF to an unattractive level based on the current price.

At the end of 2011, they had 309 million in foreign exchange gains due to favorable rates. Therefore, this buffer would first have to be eliminated before it would have a negative effect on the business. I have excluded the exchange gain from my valuation of GLW to be conservative.

(there is a table displaying the different scenarios based on changes in currency value. The pdf link is provided at the end of this analysis.)

Underfunded Pension Fund

Currently the combined pension plans are underfunded by 1650 million. The obligations are spread out over time so this is not a lump sum that needs to be paid in the short term. Majority of their plan assets are in US corporate bonds or investment funds. Due to this, there is a small likelihood that the plan will have large increases in plan assets due to a recovery in the stock market. The investment funds performance depends on their degree of fixed income to equity.

I expect GLW will need to contribute to the plans to fund them going forward. However, the contributions will not be beyond 100 million, per annum, and will not affect the underlying business strength.

Financial Risk

There is a low risk of default for Corning as they have been at an average Altman Z score of double the safe ratio for the last 6 years.

Their statements also carry a low likelihood of earnings manipulation according to the Beneish M score as well as I found no indication of it reading through the last 10 years of financial reports.

They are capable of paying off their total debt in less than 1.5 years using their free cash flow of 2284.49M, assuming the do not use cash, as cash to debt is: 3.77. Therefore, there is little risk from a financial leverage standpoint.

Valuation

In valuing GLW, I have used three methods: Asset Replacement Value, Earnings Power Value (EPV) and Value of Growth.

These methods are ideal as forecasting is kept to a bare minimum.

Replacement Value: This is what it would cost to create a clone of GLW. What an entrant would have to spend to create an equal to GLW. Below is the book values found for GLW on a consolidated basis. I have included my assumptions for each adjustment I
have made. The replacement value of GLW is 30 Billion, or $19.80 per share. This is an upside of 48.83% from the current price of $13.30.

The second valuation method was calculating the earnings power value for GLW assuming 0% growth.

The numbers for EPV and assumptions are in the table below. I use a required return of 10%, which yields, after adding cash and subtracting debt, a value of $18.65 per share for GLW, an upside of 40.23%.

*Assumes a 30% reduction in overall EBIT going forward due to a tougher environment for display, SCP, Dow-Corning and Hemlock and subtracts 309 million of currency exchange gains
**Assumes a 35% tax charge going forward, however management estimates taxes around 20% for 2012
*** Maintenance capex for Corning is 600M, I assume the ratio holds for GLW`s subsidiaries.

The final valuation method assumes profitable growth from the base scenario created for the EPV method.

I assume that GLW will be able to grow at a rate equal to the 20-year US GDP moving average growth rate of 2.5%. ROC is derived from the base scenario laid out for the EPV method above. This method gives GLW a value of $19.44 per share, an upside of 46%.

Risk Reward Ratio

Even with a downside of 32.8% that requires a 10-year negative growth of 2.80% in FCF replacement value reward/risk is 1, EPV is 0.942 and PV is 0.982 – Assuming required return of 12% for the investor.

In the range of 15% downside to current price as max downside the potential return ranges from: 26.5%-46.2%

These returns are based on very conservative assumptions regarding GLW`s ability to grow profitable and the effect of the current slowdown in the LCD segment and Dow-Corning subsidiary.
This conservative assumption is 30% decline in consolidated EBIT across all segments.
35% tax rate is assumed while GLW is expecting 20% for 2012

Relaxing the assumptions to 15% decline in EBIT across all segments and 25% tax rate with a profitable growth rate of 3.5% gives this range:

26.5% – 102.3% for 15% downside to current price

Corning will have to experience an extreme decline in its business fundamentals for intrinsic value to decline to or below its current market price.

Catalysts

The effect of the decline in the LCD segment materializes – Uncertainty of its effect is removed

The uncertainty that is depressing the price currently will be retreating as the next quarterly reports are released. They will shed light on the results of the decline in LCD profitability and show unencumbered earnings due to restructuring charges.

Free cash flow is utilized to increase dividends or buy back shares

GLW’s free cash flow is strong, even during a ramp up in capital expenditures to finish several new plants to meet demand. As time progresses this will enable GLW to increase its dividend and maintain a healthy balance sheet. If the price stays at where it is the board has signaled that it is willing to commit funds to buy back shares as the share price is significantly below intrinsic value.

Pay off Target Price: $18.65. Upside 40%

At the time of this writing the stock price was $13.30.

Corning is a 71-cent dollar assuming zero growth in its free cash flows.
It has compelling fundamental factors such as a 7 year average profit margin of 22% and 3 year average ROE of 21.67%.
It has little debt with total debt to capital at 10%, market cap of 19.5B and a quick ratio of 3.32.
Conservative assumptions for the valuation methods yield values significantly above market price.
It is currently trading at 0.93 P/B and 7.48 P/E.
GLW has initiated a 1.5billion share repurchase and has spent half of that so far.
Its current dividend yield is 2.30%.

Download original PDF of the investment report

40% Upside on Corning Right Now

Jae Jun — Mon, 19 Mar 2012 07:08:39 +0000

Guest post by

Joakim Aske

This is a continuation of Joakim Aske’s very detailed analysis of Corning. You can read the first one that answers Fisher’s 15 Scuttlebutt questions.

Investment Snapshot

Investment Thesis: BUY
Current Price: $13.30 (at the time of writing)
Target Price: $18.65
Upside: 40%

Corning has 40% Upside Investment Case Overview

Corning is a 71-cent dollar assuming zero growth in its free cash flows.

It has compelling fundamental factors such as a 7 year average profit margin of 22% and 3 year average ROE of 21.67%. It has little debt with total debt to capital at 10%, market cap of 19.5B and a quick ratio of 3.32.

Conservative assumptions for the valuation methods yield values significantly above market price. It is currently trading at 0.93 P/B and 7.48 P/E.

GLW has initiated a 1.5billion share repurchase and has spent half of that so far. Its current dividend yield is 2.30%.

These factors combined creates a valuable investment opportunity where there is little downside and significant upside even with conservative valuation methods.

Donald Yacktman has recently purchased shares in GLW and Oakmark holds GLW shares, both are high performing value oriented funds.

Gordon Gund, director, purchased shares for 1.9 million March 6th 2012. Last time he bought shares was in Nov. 2008.

Margin of Safety

Base Scenario

Assuming 2011 EBIT declines with 30%. Guidance is 30% reduction in subsidiary EBIT, not on a consolidated basis.
Tax rate is 35% but management assumes 20%
With FCF of 2284.49M, assumed growth rate of 0% and using required return of 10% the upside is 40.23%
It takes a required return of 15.5% to eliminate the EPV(earnings power value) upside

Reducing EBIT by 65% is required to get to an equal value to today’s share price with the EPV method, using a 10% required return

Factors Depressing the Price

Psychology

There has been a barrage of bad news for GLW regarding the excess capacity in the LCD substrate market.

This combined with a significant inventory trimming in the supply chain to levels not seen since the market crash in 08-09 have caused reduced profitability and sales for the SCP subsidiary and GLW’s display segment.

Complex Financial Structure

Corning has two large subsidiaries, which is not included in its consolidated financial statements.

These two are important to GLW, however, only their revenues are reported through other income in GLW’s consolidated statements. Their impact on a truly consolidated cash flow, balance sheet and income statement is less available for the lazy analyst/investor.

Short term focus

The issues that have emerged within the polysilicon industry and the excess capacity within the LCD substrate market are serious, however, they are short-term problems that are not causing losses for GLW.

This combined with the high degree of uncertainty in the world is causing investors not to see through the fog that clouds the intrinsic value of GLW.

There is also an expected decline in subsidiary EBIT of 30%.

Gorilla glass appears unprofitable due to an impairment write down of 130 million.

Company Profile

Corning is a global, technology-based corporation that operates in five reportable segments and has two material subsidiaries.

Display Technologies

Produces glass for screens(LCD/OLED/AMOLED). Tablets, computers, TVs, Cars, Architectural opportunities are markets for Corning’s Glass.

Telecommunications

Producer of fiber optics and wireless internet equipment

Environmental Technologies

Manufactures emission filters for diesel engines and other end users. The world’s fleet of trucks and cars will be requiring emission filters until a different fuel source is developed, not to mention regulations worldwide is tightening to fight CO2 emissions.

Specialty Materials

Gorilla Glass is a durable and scratch resistant type of glass currently used by more than 30 major brands, designed into hundreds of product models, and featured on more than 600 million devices.

Life Sciences

Corning have been a leading developer, manufacturer and global supplier of scientific laboratory products for more than 90 years.

Dow-Corning (50% ownership)

Dow Corning provides performance-enhancing solutions to serve the diverse needs of more than 25,000 customers worldwide. A global leader in silicones, silicon-based technology and innovation, Dow Corning offers more than 7,000 products and services via the company’s Dow Corning® and XIAMETER® brands.

Dow-Corning is involved in the research and sales of silicone material for solar cell manufacturing, assembly and installation.

Hemlock Semiconductor Group (GLW`s ownership 31.5%) is the third largest polysilicone producer worldwide. A supply gut has currently started and is estimated to last a few years as the industry has entered a shakeout period. Hemlock is one of the lowest cost producers and is expected to weather the period.

Samsung Corning Precision(SCP) (50% ownership)

SCP is a leading LCD high quality glass-substrate producer. Joint venture with Samsung, one of the world’s leading LCD TV producers.

Corning newly formed an equity venture with Samsung that plans to produce OLED glass solutions using Corning’s Lotus™ Glass substrate technology.

Management

Wendel P. Weeks CEO/Chairman
Current management has a clean record.
Management is developed internally; current CEO has been with GLW for 29 years.
Proven long-term commitment – See appendix 3 for analysis of 10 years shareholder letters.
Focused on the factors that increases value for the shareholders. I.E. increased FCF, higher profitability, stability in financials, profitable growth
They have launched a share repurchase program, in the last half of 2011, for 1.5 billion USD that they intend to utilize while their stock price is below its intrinsic value.
Increased dividends and share repurchases remains an option, they have more than 8 billion in cash and securities, as the fog of uncertainty is lifted its likely that either one of these will be selected by the board.
Management has a good share of their compensation in form of long-term options.
Gordon Gund, director, purchased shares for 1.9 million March 6th 2012. Last time he bought shares was in Nov. 2008.

Competition

Below is an overview of the 3 key players in the glass industry, which is GLW’s main business segment (+80% of income derives from it).

It is clear that GLW is in a completely different position than Nippon and Asahi based on the margins. GLW has been able to charge a premium on its products due to the quality. It also holds a majority market share in the glass market it supplies.

Competitive Advantage

Formidable Research Company

Invented Edison light Bulb, Television Tube, Glass ceramic, Low loss optical fiber, Ceramic filters for diesel/gasoline engines, LCD glass and in 2007 the Gorilla Glass.
Corning increased its patent count by 19% and holds twice as many patents granted in the last year than its closest competitor. The company also improved its Science Strength™ by 37%, and maintains an Industry Impact™ almost double the industry average.

Economies of Scale

“You’ve never outsourced manufacturing. How come? We are the world’s lowest-cost producer of everything we make, so manufacturing is a significant competitive advantage for us. Much of our competition is based in Asia, and 70 percent of our revenue comes from outside the U.S. We have plants in most areas where we have customers.” (GLW CEO, March 2010)
GLW is constantly moving its glass production towards producing thinner glass while keeping the quality of it the same. Combine this with the cost of producing glass is measured by the pound and you have GLW`s ability to keep its margins high while average selling price for LCD TV’s and other products are declining steadily. The trend is also for larger and larger screens, which functions as a tailwind for GLW.
Holds significant market share in diesel filter market, potentially +50%.

Brand – Superior Quality

In its optical fiber, LCD glass substrate, scratch resistant glass, ceramic filter markets, it is the leading manufacturer with first mover advantage, furthest along the learning curve, have the products with the highest quality in the market and is the original inventor of the product itself.

This enables GLW to charge premiums in many of its markets compared to its competitors. These are defended with superior quality compared to its competitor and its position ahead of them in research and know how.

Customers Requirement Continue to Increase

The products GLW produces may seem from an initial glance as commodity products; however, every year customers for these products demand improvements and increased standards. It is very hard for an entrant to be able to set up the necessary business operations and stay up to date on the newest standard that GLW constantly is improving. An entrant cannot just beat GLW’s current products and start producing them, as by the time they become fully operational to deliver to customers the product they were beating GLW on will be outdated.

Part 2 is next

Risks, valuation, risk/reward discussion, catalysts and more coming in the next part…

Stay tuned.

Fisher asks 15 Scuttlebutt Questions to Corning

Jae Jun — Tue, 13 Mar 2012 06:53:55 +0000

Written by

Jae Jun

In Philip Fisher’s book Common Stocks and Uncommon Profits , he goes through 15 points to look for in a stock in order to understand it as much as possible.

Most, if not all, the questions are qualitative which requires in depth digging.

The internet has changed the way information is gathered and scoured, but Fisher would do things like stand outside the building of his investment company and ask employees questions or look at the furniture to see whether management is lavishly spending money.

Quite uncommon in terms of investment analysis, but for him, it worked and it did yield uncommon profits.

The following answers to Fisher’s 15 points with respect to Corning (GLW) was written by Joakim Aske. He sent me an 11 page investment thesis on Corning which he plans to submit to Value Investors Club and has graciously allowed me to post it. I will break it up in to several pieces and post it to make it easier to read.

It really is excellent so I’m glad that he was kind enough to send it to me.

Plus, if you have an investment idea or article you wish to share, send it to me and I’ll be more than happy to post quality content.

Fisher Asks 15 Questions about Corning (GLW)

1. Does the company have the products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?

Glass for screens (LCD/OLED/AMOLED) are likely to be in high demand for the foreseeable future. Tablets, computers, TVs, cars, glass for architectural uses are all markets for Corning’s Glass.
The world’s fleet of trucks and cars will be requiring emission filters until a different fuel source is developed. Regulations worldwide is tightening to fight CO2 emissions. Corning also invented the ceramic filter and is producing filters for trucks and cars.
Bandwidth need is increasing at a healthy pace as more and more devices are connected to the internet, which drive data consumption. Corning invented fiber connections and is continuing to develop new solutions that will enable increased bandwidth.
Dow-Corning is involved in the research and sales of silicone material for solar cell manufacturing, assembly and installation.

In conclusion – a brief overview of Corning’s Products reveals that there is a healthy potential for growth.

2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?

GLW spent around 10% of revenues on R&D and aims to create 4 new markets with new products each decade.
Yes, they are working to expand their Gorilla glass into other uses such as automotive and architectural uses.
Designing bacteria and virus killing glass surface for the medical industry
Develop glass as material for solar cells

3. How effective are the company’s research and development efforts in relation to its size?

Basic overview – They have an efficient research & development team as they have had a string of successful products and internal process developments in the last years.
Long history of extraordinary research results

4. Does the company have an above average sales organization?

From my research there is little evidence that they have a superior sales organization.

5. Does the company have a worthwhile profit margin?

Yes, even under the worst scenarios their profit margin stays above 10%.

6. What is the company doing to maintain or improve profit margins?

Focused research efforts and moving to thinner and thinner glass as that increases their gross margins.
Building economies of scale within their new strategic business units such as – Emissions, Gorilla Glass
Maintaining the ability to charge premiums compared to the competition.

7. Does the company have outstanding labor and personnel relations?

From my research, their labor and personnel relations are good.

8. Does the company have outstanding executive relations?

Yes, all of the C-level executives have been employed in the company for several decades and have long tenures as C-level executives. The CFO has served under four CEO`s.

9. Does the company have depth to its management?

The company has a focus on developing managers and do not fire them based on external influences that they cannot control such as recessions and similar. The current CEO was the head of the optical fiber division in the dotcom crash and was tasked with turning the company around as that crisis unfolded.
Most of the management has worked their way up from the bottom.

10. How good are the company’s cost analysis and accounting controls?

There is no evidence that they are incompetent at this. It is hard to say anything more as this form of information is close to impossible to attain without being an insider.

11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?

GLW has had a constant leadership in engineering and research over their competitors the last decade and remains well positioned to continue doing so.
They have also a significant patent portfolio, which dwarfs their competitor’s portfolios.

12. Does the company have a short range or long range outlook in regards to profits?

Yes, short term the profitability of its display segment and its Dow-Corning subsidiary will decline and reset at a lower level than seen before.
Long term they are aiming for 10 billion dollars in revenue by 2014.

13. In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?

No, they have a strong balance sheet and a healthy free cash flow.

14. Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointments occur?

No, they have been candid with what they are doing to remedy the external influences and their actions internally. They have not had troubles admitting errors in their research and development efforts.

15. Does the company have a management of unquestionable integrity?

There is nothing to indicate lack of integrity in the current management from my research.

Do you use Fisher’s 15 Point Checklist?

When I did the same thing a few years back on a small company called Aerogrow, which is basically bankrupt now by the way, all the information got to me and I fell into confirmation bias. Be careful of this when applying these points.

Be objective. Or better yet, try to answer the questions in order to “break” the investment.

My Portfolio Notes of the Week

Jae Jun — Thu, 08 Mar 2012 01:24:58 +0000

Some quick updates on stocks I own.

Gravity (GRVY)

Gravity is top on the list because it is my biggest position at 20%. Regardless of how much it has gone up this year, it is still below book value and does not include the future revenue stream of RO2 or the other games in fact.

Non consolidated report was released. Just read it for reference. Do not base your investment decisions based off non consolidated reports as there isn’t enough information.

It is good to see the balance sheet getting stronger but I have no idea how the net income jumps 250%.

Dacha Strategic Metals (DCHAF)

There is still a big disconnect between the stock price and asset value. The stock price is still at about 40-50% below net current asset value without much progress in terms of the value being realized.

This is a very frustrating investment because management words and actions do not particularly match up all the time.

Getting difficult to completely trust management which is a bad sign.

UFP Technologies (UFPT)

Company continues to perform well with new contracts and sales growth. Consistent growth in profitability and assets which are positive signs.

“We achieved record sales and profits even while phasing out the largest contract in the Company’s history… In addition, we continue to enjoy very strong demand for our molded fiber product line. To meet those new requirements, we have ordered new state-of-the-art equipment that should be online by the third quarter of 2012.”

Retail Holdings (RHDGF)

Expecting 2011 full fiscal year results soon. Last year they announced the results in March, so I’m expecting it sometime towards the end of March again.

Solid and strong business performer through subsidiary Singer Asia and I expect the same this year.

I don’t bother Talking with Investor Relations

On a different note, I just wanted to bring up a quick point about investor relations.

I do not talk to them unless I want to clarify a simple thing such as when I have to tender my shares by or asking for a hard copy of annual reports and nothing more.

Why?

Because investor relations cannot give you any more information than what is publicly available. A lot of traders and pumpers have been plastering emails received from GRVY investor relations on forums and comments in order to create hype so that’s something to be aware of.

Use investor relations to get information about your company, and not your investment. So easy to cloud your judgment thinking you have hot off the press news.

Good Reading List

Here is a good reading list I shared on the OSV Facebook page. It’s a great list of daily updated articles helpful for investing. Do check it out at Reddit Value Investing reads.

Guest Posts?

If you have a stock idea that you wish to share, send it over and if I feel that other readers will benefit from either the way you’ve analyzed or the idea itself, I’ll put it up.

Great way for you to get known, get your idea out there and have your investment critiqued.

Disclosure

Long all stocks mentioned at time of writing.

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