Mastech Holdings (MHH: 4.28 0.00%) released their 2009 fiscal results back in Feb and the 2009 10-K report was recently just filed.

Back in August of 2009, I went through the 3rd quarter results and concluded that the intrinsic value of MHH was between $7-9. I targeted the upper range of $9 but the latest 10-K suggests that MHH is now closer to the lower range of $7.

Operational Results

From the 10-K, you can see that revenues declines substantially the past few years.

In 2007, 2008 and 2009, revenues were $104m, $96m and $71m respectively. But rest assured, the decline isn’t due to operational mishaps or bad management.

The first thing to address is that MHH is highly correlated with the economy and job data and there is still uncertainty in the economy. This goes the same for jobs.

When I first looked at MHH, unemployment hit the 9% mark and as of Feb 2010, the national USA unemployment rate is now above 10%. This is clearly out of Mastech’s control and on Wall Street, uncertainty leads to fear. So while the annual report shows an increase in cash, decline in accounts receivables, reduction of debt and positive cash flow, MHH is still well under the radar of any institution to see any stock appreciation for the time being.

The company also sold their brokerage unit for an undisclosed amount to their former vice president of brokerage operations in Jan 2010. From the results, it looks to have been a good move as the brokerage unit saw steep declines (53%) with very limited new orders.

Since the brokerage unit was not a core service to Mastech, I see this as a good sign by the company to cut excess fat. Mastech is lean as it is and it looks like they are going from 10% body fat to 3%.

Cost Cutting

Margins were consistent to the prior year but a lot of it had to do with cost cutting.

In Mastech’s line of work, the main capital expenditure comes from personnel and in 2009, headcount for the IT billable consultant department was reduced 20% from 475 to 379. However, the notes regarding the revenue had this to say about the headcount reduction.

Much of this billable headcount decline occurred during the fourth quarter (a loss of 58-consultants) and reflected a high level of project ends….It should be noted that much of the billable headcount declines during the fourth quarter did not fully impact our revenues for that period as much of the decline occurred during the latter part of the quarter. Accordingly, the full impact of this headcount decline will be reflected in our first quarter 2010 results.

From this statement, I know for sure that the first quarter of 2010 will be better than what analysts expect when the savings from the reduced headcount will be recognized.

It’s also important to keep an eye on SG&A and see how expenses are handled.

The reason why I like MHH so much is that despite the tough economy, the company does everything they are supposed to do “by the book”. When times are tough, they cut expenses by freezing bonuses, salaries, hiring, reducing staff, reduce debt, increase cash and so on.

The fundamentals exhibit pure discipline.

Tax Rate Changes

It’s a good thing I went through detecting the effect tax has on earnings because MHH is another prime candidate that we can look at.

Remember that MHH is a spinoff from iGate? While MHH was a subsidiary of iGate, they were sheltered by tax benefits and only had to pay about 15% in taxes each year. Now that they are a standalone company, their tax rate has increased to 38.5% and is expected to maintain this level as an independent company.

Thankfully, this isn’t something I didn’t know about. In my initial valuations, I had already taken into account the tax rate but the image below shows that the change in tax rate affected EPS by $0.15 compared to the prior year.

Again, the tax rate change shows that the decline in earnings is not at all related to the operations.

2009 Q4 Valuation

Moving on to valuation..

• The basic asset valuation of NCAV is $2.84 which is just more than half the current stock price.
• With declining revenues, higher taxes. My assumption is that the floor for FCF is $2m. Using this figure and projecting a low ball 0% growth rate with a 15% discount rate, the DCF valuation indicates an intrinsic value of $6.70.
• Using an EPS of $0.38 and applying Benjamin Graham’s formula, the intrinsic value comes out to $6.35.
• Applying the EPV method with an adjusted low ball income of $2m the EPV comes out to $7.62 which is also higher than the reproduction cost of $4.50.

Summary

Despite the tough economy, the balance sheet has been strengthened and rather than worry about how long the company can survive, MHH still remains profitable and operating superbly. MHH is a company that I hold comfortably despite volatility.
MHH Stock Summary

Disclosure

Long MHH

You may also be interested in:

1. Value Stock Mastech Holdings (MHH) Update
2. Portfolio Update December 2009
3. Portfolio Update Sep 2009

Things will be slow this week. I’m in Napa Valley enjoying the scenery and wine tasting. Drove about 16 hours to get here..

I’m still checking emails and trying to reply but the number of emails and forums posts are starting to get backed up.

Still finding time to read a few paragraphs of the MHH 10-K report and hope to at least get another post by this week.

You may also be interested in:

1. On Vacation
2. Update to Readers
3. What’s going on at OSV

Quality of Earnings Series

• Inventory & Accounts Receivables Analysis
• Earnings Made by Tax Rate Changes

Previously, I looked at analyzing the inventory and accounts receivables of a company which is a very simple yet highly effective method of detecting and predicting business performance. The method is not new but the extra work just isn’t performed by investors.

The good news is that I have created a stock spreadsheet version and I’ll be going through the methods described in the book ‘Quality of Earnings‘ to help detect warning signs and how much money a company is really making.

When this series is complete, and after some more thorough testing, the new updated financial statement spreadsheets will be released to existing spreadsheet buyers within their 1 year purchase timeframe as well as it being available for purchase.

Earnings Made by Tax Rate Changes

Wall Street is infatuated with EPS. If a company beats their estimates, the stock price is pushed up higher despite the fact that earnings is so easily manipulated by different accounting methods and hiding and/or delaying expenses.

Taxes also play a big role in the final EPS.

A company with a 40% tax rate one year, paying at 35% the next will create the illusion that growth has exceeded expectations, when in fact, the business did nothing but just get a tax break. The opposite is the same.

A company paying 35% in taxes and then 40% the next year will obviously report lower EPS and the consensus will be that the business is slowing down.

How to Calculate EPS Due to Tax Rate Change

Let’s use Boeing (BA: 70.07 +0.09%) as an example.

1. Calculate the tax rate

To calculate the tax rate of a company, find the income tax expense on the income statement and divide by the Earnings Before Income Taxes (EBIT).

Boeing’s tax rate was 33.7%, 33.6% and 22.9% in 2007, 2008 and 2009 respectively.

2. Calculate the difference in tax rates

Just subtract the previous year tax to the next year tax rate.

3. Calculate the gain or loss due to difference in taxes

Use the difference in tax % compared to the last period and multiply it by the income before tax (EBIT) number.

In BA case for 2009, multiply 10.7% and $1,731m to determine how much of EBIT was due to a lower tax rate.

You can see that BA made $185m in EBIT due to taxes compared to $4.16m the year before. In 2007, Boeing’s tax rate increased by 2.7% which is why the % difference is negative and shows a loss due to difference in tax.

4. Divide by Shares Outstanding and Adjust the EPS

Divide the gain or loss due to tax change by the number of diluted shares.

You can now see that in 2009, of the full year diluted EPS, $0.26 was made up due to a reduction in taxes. So while the market may have seen this as a great recovery, the actual EPS was actually $1.58.

Multiply the current PE of 36 to $1.58 and the stock price should be at $56.

The above method can be applied to quarterly results for comparisons and basically any other line item including non-operating and non-recurring expenses.

Let’s wrap things up with a stock valuation summary of Boeing for those that hold the company.
BA Boeing Stock Summary

Disclosure

None

You may also be interested in:

1. Choosing a Growth Rate
2. Bond Rate for Graham Formula
3. Calculating Maintenance Capital Expenditure

I was interviewed by Mariusz Skonieczny of Classic Value Investors and the author of “Why are we so clueless about the stock market” back in January and the interview is now up.

If you want to get some history on Old School Value and a feel for how I think when it comes to investing, be sure to check out the interview.

I’m no Buffett, Klarman, Ackman or Berkowitz but I tried to answer as best as I can

Read the interview.

You may also be interested in:

1. Wellpoint (WLP) Valuation from Value Investors Club
2. Accounting & Business Red Flags for Investors
3. Has Fear Blinded Investors to Value

Stock Screen Strategy and Backtest Series

• NCAV and NNWC Screen Strategy
• CROIC and ROIC Screen Strategy

Value Investing Screens

One of the most lacking aspects to all the widely available screens such as Yahoo, MSN, Morningstar etc are detailed screen criterias. They are all based on PE, PB, PS, ROE, BV and so on which don’t really help you find better investments than the next person.

This is where the Old School Value screeners try to fill this void. I’ve been working hard to come up with new value investing screen criterias and formulas to find the best strategies and opportunities.

One such strategy that I am very confident in is the CROIC screener.

CROIC – Cash Return on Invested Capital

As discussed in the previous CROIC and ROIC article, the formula for CROIC is shown below.

CROIC = FCF/Invested Capital

Invested Capital = Total Equity + Total Liabilities – Current Liabilities  – Excess Cash

Excess Cash = Total Cash – MAX(0,Current Liabilities-Current Assets)

CROIC and ROIC Above 10% Screen Strategy

In this test, I tried two different strategies.

The first one was where a portfolio of 15 stocks were selected based on the current year and prior 2 years CROIC and ROIC being above 10%. Anything less than 10% didn’t make the screen.

I always tend to try and find companies with CROIC in the sweet spot which is usually above 10% as it indicates a strong executive team and company.

In the NCAV screen and NNWC screen, I only selected companies that had trading volumes above 30k, but for CROIC, since many of the companies are not illiquid micro caps, I’ve lowered the volume criteria to 20k.

CROIC and ROIC Above 10% Criteria

• CROIC and ROIC is greater than 10% for the past 3 years
• No OTC and financial stocks
• 15 stocks max in portfolio
• Volume is greater than 20k
• Slippage set to 1%
• Rebalance frequency set to 6 months
• Test period of 3 year time-frames

CROIC and ROIC Above 10% Results

The results show that companies able to produce high returns will beat or be consistent with the market. There is a good amount of volatility involved but the results are very respectable except for the 2007-2010 period where it just kept up with the market.

Over a 9-10 year period, the result is outperformance by a huge margin for the CROIC strategy but looking at the screen in different time frames, you wouldn’t have known.

Then it dawned on me that everyone looks for the above average companies. So I modified some more formulas and criterias to get the next screen.

CROIC and ROIC Increasing for 3 Years Screen

In the second screen, I removed the minimum CROIC and ROIC limit. This means that any company can make the screen, even if the CROIC and ROIC is negative. But my reasoning is that regardless of what the actual CROIC and ROIC numbers are, if the company has been increasing this metric for the past 3 years, the business is not only improving but management has done a good job of turning the boat around.

In other words, the screen should result in successful turnarounds which are often explosive opportunities.

CROIC and ROIC Increasing Screen Criteria

• CROIC and ROIC has increased each year for the past 3 years
• No OTC and financial stocks
• 15 stocks max in portfolio
• Volume is greater than 20k
• Slippage set to 1%
• Rebalance frequency set to 6 months
• Test period of 3 year time-frames

CROIC and ROIC Increasing Screen Results

As you can see, this second screen completely annihilates the first screen.

Assuming you followed this strategy the only down period would have been from 2007-2010 but overall had you started in 2001, your $100 would have grown to $850 by 2010 using the CROIC method and $385 using the ROIC method.

One thing is for sure on both accounts. CROIC is a much better indication of performance and better metric even in a screener.

I also added another criteria where FCF is increasing each of the past 3 years which also yield great results which I won’t display here as the results are very similar to above.

I’ll be looking at FCF related screens and strategies in the next strategy review but first, here are the companies that showed up in the screen.

5 Stocks that Pass the Increasing CROIC Screen

Disclosure

No holdings.

You may also be interested in:

1. NCAV NNWC Screen Strategy Backtest
2. ROE ROIC and CROIC
3. NCAV NNWC Backtest Refined

Forget ROE and use ROIC

Most people use ROE (Return on Equity) as a measurement of performance but ROE has a big drawback.

ROE = Net Income / Book Value

As you can see, book value is the denominator which means that if book value was to be reduced, the ROE would in fact increase. How would this happen? If a company writes down any of its assets, the book value would immediately decrease which results in a higher ROE.

The same would happen if the company increased its debt since book value is calculated as assets – liabilities.

The company didn’t perform any better, yet you are given a false picture. So ROE isn’t that great to use. Not even in a screen because you have a high chance of getting value traps.

Instead, ROIC (Return on Invested Capital) is a much better alternative performance metric to find quality investments as it measures the return on all invested capital , including debt-financed capital. It is the effectiveness of the company’s employment of capital.

ROIC is a lot of math but luckily it’s simple stuff without any of the Greek symbols that make your head spin.

ROIC = NOPAT/Invested Capital

For the numerator (the top part of the fraction)

NOPAT = Net Operating Profit After Tax = Operating Income x (1 – Tax Rate)

The denominator (a variation used by F Wall Street)

Invested Capital = Total Equity + Total Liabilities – Current Liabilities  – Excess Cash

where

Excess Cash = Total Cash – MAX(0,Current Liabilities-Current Assets)

CROIC Cash Return On Invested Capital

An even better metric that you can use is CROIC which I use to great effect in my stock value spreadsheets. CROIC is a.k.a CROCI but they both stand for Cash Return On Invested Capital.

You can also check out the CROIC ROIC screen backtest to see how it performs.

CROIC shows how much free cash flow per dollar the business generates from invested capital. I find this to be the ultimate performance metric as it shows so clearly how effective management is and the strength of the business.

CROIC = FCF/Invested Capital

The higher the CROIC, the more cash the company is generating and it also indicates that the business is a profitable one. Rarely do you see a high CROIC but low or negative FCF.

Of course you can use owner earnings instead of FCF.

How to Use CROIC

Until recently I’ve been looking for companies with high CROIC, usually above 10%, but with my latest screen and backtests, I’ve concluded that it isn’t the level of CROIC that is important but whether CROIC is increasing.

This makes sense because if a business has a CROIC of 15% in year 1 but then in year 2 it drops to 12% followed by a drop to 10% in year 3, the average is 12.3% but the picture is different to why I first liked the company to begin with.

Instead, if CROIC is low or even negative, assuming CROIC was to increase, it indicates that management is getting things back on track which will make for a much better investment.

This is something I’ll be going over I’ll be going over in the posts to come. I’ll detail the strategy and performance of stock screens based on ROIC and CROIC.

Update: CROIC strategy backtest has been performed.

You may also be interested in:

1. CROIC ROIC Screen Strategy Backtest

Old School Value Stock Portfolio Performance

Portfolio Performance

Things moved back in the right direction this month. Up 10.67% compared to the market’s 2.71%.

On an absolute basis, I am up 48.65% and outperforming the market by 50% since Oct 2007.

Portfolio Movers

The world economy isn’t in such a healthy state as most people would like to think. The issues facing Greece and Japan is very real and the US isn’t in such a rosy state of affairs either. So despite the 10% gain for the month, it was still tough. In times like this, opportunities need to be focused on event driven investments.

The main event driven catalyst to my portfolio was on my largest holding GGWPQ. Followers of GGWPQ already know all the details so I’ll skip it here. You can catch up on what’s been happening at Pakiya Funds who has been doing a great job of providing updates.

(MHH: 4.28 0.00%) released their full year results and things are still going very well at the company. The stock price however, has been going down steadily the past month on no news and low volume and I want to point out again that price is not an indicator. When you look at your holdings, you should always compare the value to the price and buy or sell accordingly.

I’ll provide an update on MHH when the 10-k is filed. I emailed investor relations but got no response. Not impressed in that respect since I doubt investor relations is being flooded with emails and calls from investors.

Portfolio Trades

1. Bought more GGWPQ

Bought more as the price kept dropping and was rewarded with the huge jump due to the buyout offer from (SPG: 80.94 +0.21%).

2. Sold (PDII: 5.74 -1.03%) @ $5.05 for a 48.97% gain

PDII never reached my intrinsic value but with what’s going on in healthcare politics and the industry, I wanted to convert the position into cash for better opportunities.

3. Sold (ETM: 11.72 +2.00%) @ $8.67 for a 144.92% gain

I sold ETM without waiting for the full year results and it turned out to be a mistake. I was getting impatient and sold without comparing price to value. ETM is the best of breed in the radio industry and their results showed improvements in the business. I still hold (ROIAK: 3.14 +2.61%) which should also do well when results are released.

Cash is now back to around 12%.

Others

This month I finished reading Payback Time and A Random Walk Down Wall Street. I also read Quality of Earnings again in January so that’s 3 books read so far in 2010. I’ve got books stacked up waiting for me on my desk so my free time is spent reading rather than analyzing these days.

I originally bought A Random Walk Down Wall Street about a year ago without knowing what it was about. I should have read it as soon as I received it 1 year ago so that I could have returned it. While there are some interesting sections related to behavioral finance and history of bubbles, most of it is about efficient markets which I found no use for. That’s about as much time I’ll spend writing about a book I don’t recommend.

Disclosure

I hold all stocks mentioned except sold positions.

You may also be interested in:

1. Portfolio Update January 2010
2. Portfolio Update December 2009
3. Portfolio Update November 2009

I’ve seen the author Phil Town on TV a few times and his first book Rule #1 has a big following but I never got into it because it spent a lot of time on technical analysis, trading techniques and an analysis method that didn’t resonate with me.

But when I was contacted to receive an advance copy of Phil’s new book Payback Time, I was happy to hear it was more about value investing and analysis and was glad to take a read.

Payback Time

The title refers to two things throughout the book.

1. Mutual funds are a waste of time and money where only the managers and brokers get rich

2. It is the price of the business that will be repaid in x number of years out of earnings

As with most books, it starts off by explaining why mutual funds are a bad idea backed up by data and Phil’s own personal experiences from the industry and then moves onto the main concepts of what he calls “stockpiling”.

I have to admit I liked the section on the mutual fund and Wall Street bashing It’s why you need to fire your financial adviser.

Stockpiling

Stockpiling is a term used frequently in the book. It’s where an investor buys a company they truly understand and believe in with a MOS and then continues to buy more if the price falls. Essentially, it is a buy low and sell high strategy which so many people know, but fail to do.

However, Phil does a good job of explaining the difference between price and value so that a beginner investor won’t be overwhelmed by the fear that a falling stock price will make them bankrupt, but rather a perfect opportunity to load up more as long as price inefficiencies exist.

Value Investing Principles

To decide upon which company to buy, you first need to find a company that you can understanding and be willing to work on as well. The book makes it clear that work is required to invest successfully but you don’t have to be a genius. He boldly states that any normal person can make 25% annual returns compared to the average 6-8% you expect to see with mutual funds.

While looking for a company, you need to find awesome businesses that contains the 3+1 M’s.

• Meaning (understanding the industry, company and business model)
• Moat (competitive advantage)
• Management (passionate, ethical, dedicated, honest)
• and Margin of Safety (which is introduced later in the book)

Valuation

The valuation method that Phil uses is a very simple method. He doesn’t use DCF valuation, Graham based formulas or EPV like I do. It’s very simple math, or you can use the tools on his site, but to summarize the method, you need to:

• Find the average PE
• Check BVPS (book value per share), sales, EPS and cash growth rate
• How many years does it take to repay debt from earnings

If the company passes the criteria that each one is supposed to meet, you can now value the company.

• Use a discount rate of 15% aways
• Get the TTM EPS, growth rate calculated above, PE, and discount rate of 15%
• Follow the examples and instructions in the book or use the Payback Time calculator

A Very Practical Book

Payback Time, isn’t a value investing book per se, but for someone wanting to learn how to invest, it is an extremely practical book. In fact, it is more like an instruction manual.

The book provides step by step instructions and screenshots of Yahoo finance to show you how to find companies you are looking for. The valuation section is also dealt with in a clear step by step manner. It even goes into teaching you how to use the MSN screener.

The downside is that if the websites change, then the book is immediately outdated. Just like how the MSN screener is no longer available today.

Who is it For?

What I liked about the book is that it fills a big void by providing instructions on how to find, value and select a company. While the methods are not perfect (if there is one), I can see the book being valuable to many new investors. I see the book more as a skeleton to investing. This will be a good way for many people to start and learn from.

The book is conversational and very easy to read which I finished in 2 days by reading at a fast rate. If anything, I felt there was a little too much self promotion.

You may also be interested in:

1. Investment Book Review: F Wall Street
2. Earnings Power Value EPV and Book Review
3. Investing Book Review: Financial Statements

You may feel that you never have enough time to invest, but I believe otherwise. By utilizing time better and eliminating unnecessary distractions, you could increase the amount of time you spend analyzing a company.

Warning: You will be at risk of being called a geek.

1. Learn to Speed Read

What I want is to greatly improve the speed of my reading while still comprehending everything that I’ve read.

You may want to be a faster runner, so you practice and work at it to increase efficiency, or since you are reading this blog, you want to be a better investor, so you try to improve your skills.

Reading is the same, but a majority of people never realize.

Currently I can read about 400 wpm (words per minute) with a comprehension of 80%. The average person is 250wpm at 85% accuracy. My ultimate goal would be to get to 1000wpm.

Why: Rip through annual reports, conference call transcripts, letters to shareholders, books and other lengthy material.

2. Clean Up Your Blog List

If you read blogs, I bet you have far too many on your list. You don’t read more than 30% of them anyways.

Most blogs don’t help you with what you are trying to achieve. This goes the same for many of the news sites.

Why: You will never be a better investor by reading blogs. You may make some money following people’s moves, but you won’t understand why and your investing skill will be based on searching for people to follow.

3. Eliminate Noise

Is CNBC really that important to your investment and analysis?

Why: You learn nothing. Why not spend the 30min reading some good investment books instead?

4. Take reading Material with You

You likely spend your day with frequent idle times where you do nothing.

Try reading something when you are waiting in line at the bank or the post office, waiting for your wife while she is clothes shopping, doing your business in the toilet, waiting for your car to warm up, on the bus, train or plane etc etc

Print out an annual report, proxy, financial statement or take a book around everywhere you go.

Another way is to convert the sec filings to a PDF and then read it off your phone, e-book reader or any other capable gadget.

Why: You may only get to read 1 page at a time but it all adds up. It also sticks with you throughout the day and by the end of the day you could have read 20 pages.

That’s 20 pages more than the next guy complaining that they don’t have time to read and learn.

5. Eliminate Finance Podcasts

Listening to the news or an entertainment program via podcast is fine, but finance related podcasts I find to be a waste of time. Podcasts are much like verbal blogs so there is no set topic or structure that flows from one to the next.

I can never remember what was mentioned and it’s literally in one ear, out the other.

Why: Just another example of how impatient and demanding human nature is. Learn to speed read and you’ll never need podcasts, except maybe while you’re driving.

You may also be interested in:

1. How to Invest: Research and Valuation Process
2. Open Source Investing
3. All Intelligent Investing IS Value Investing

I first started the 2009 Forbes 200 small companies list in November of 09 and wanted to close out this series by listing all 200 companies in an easy to read and analyze format. You can view the previous analysis in each of the 7 parts below.

• 2009 Best Small Companies Part 1
• 2009 Best Small Companies Part 2
• 2009 Best Small Companies Part 3
• 2009 Best Small Companies Part 4
• 2009 Best Small Companies Part 5
• 2009 Best Small Companies Part 6
• 2009 Best Small Companies Part 7

Download the excel version or the pdf below.

You may also be interested in:

1. Forbes Best Small Companies Part 7
2. Stock Investments From Forbes 400 Best Big Companies
3. Forbes 200 Best Small Companies Project