Written by

Jae Jun

Verdict

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

Business Description from the 10-K

IEC Electronics (IEC) is a provider of electronic manufacturing services (EMS) to technology companies. The Company specializes in the custom manufacture of circuit cards, system level assemblies, a range of custom cable and wire harness assemblies, and precision sheet metal.

Their business segments consists of Military and Aerospace, Industrial & Communications, Medical and other.

Why is it Cheap? / Is it Cheap?

The initial question I start with, but in this case, nothing jumped out screaming value.

On a side note, IEC is ranked number 3 in the 2011 Forbes Best Small Companies list and the companies that show up  on this list are usually growth orientated which is why I can’t conclude as easily whether it is cheap or not.

Management Check

The best place to get information about management is to read the Proxy. The code for the Proxy document is “DEF 14A”. You can then automatically track the SEC filings and use the method described in the tutorial for detecting changes in SEC documents.

Here are some points regarding management and their decisions.

• Insider ownership is high at 16.59%
• CEO is also chairman of the board
• Huge increase in salaries for insiders in 2011 vs 2010. CEO compensation increased 75%. Although performance targets were met, most of these numbers were possible only through acquisitions instead of actual organic business growth.
• Management does not buy back shares or buy their own stock even at low prices.

Another piece of interesting information is the debt acquired to finance acquisitions. The interest rate on these loans is between 2.5 to 4%. With such low interest rates, using debt instead of using their cash on hand is a no brainer. Nice move by management.

Growth Plans

The murky aspect of any analysis. Always filled with what if’s.

As a smaller company in a highly fragmented industry, acquiring companies to grow is a must and IEC has shown that it will acquire. As mentioned above, they have gone about it smartly the past couple of years.

IEC also has some additional potential because they do business in several segments. Revenue is diversified and if IEC locks down additional contracts for each segment, that should help drive further business.

Another aspect that is advantageous for IEC is that none of the their competitors are “giant” corporations, but on the flip side, it will be equally difficult for IEC to become a giant. At some point it will plateau.

Strategic Advantage/Moat

Companies like IEC could claim all sorts of strategic advantages, but in reality there is none.

By none, I mean none of the claims are durable. A competitor could easily do the same thing. Here are some strategic advantages the company claims. You judge for yourself.

• Company strategy is to focus on creating manufacturing partnerships with new and old OEM’s. This allows IEC to have a broader product line without a need to buy out every company.
• Another way of looking at it, IEC depends on having really good relations with customers. Help the customers save money, and then make it difficult for the customer to switch to another company because the service is so good. If a customer is saving money and happy with IEC, why would they want to change?
• By having multiple manufacturing partnerships, rather than just supplying a certain part of a product, IEC can provide parts for the entire supply chain and build the entire product for the customer.
• It would be better to be the low cost provider in this industry, but IEC is not.

Competitor Discussion

There are plenty of companies, both private and public, that provide the same type of service.

With a lack of durable strategic advantages as explained in the previous section, it’s expected that plenty of competitors exist.

The one thing I can see that sets IEC apart from their competitors is their military and aerospace business segment. Due to regulations, the government is not allowed to purchase from suppliers outside the USA.

Risks

Always protect the downside. Apply risk protection methods first and the upside will take care of itself.

Refer to the risks associated with the company.

Inventory Risk

• Does not hold too much inventory (could be an advantage actually).
• Has to purchase raw materials up front or receive them from customers. Uses turnkey services which could be a problem is the supplier does not have the required parts. Also it means IEC has to purchase small quantities regularly which is more expensive than buying in bulk.
• Obtained 53% of materials from two suppliers. If a relationship broke down with any one of the two, it would cause big delays and losses.

Concentrated Customers

• Concentrated customers. In 2011, Sigma represented 16% of revenue, GE represented 10% of revenue and the top 5 customers make up 45% of revenue.
• 56% of revenue come from military and aerospace. Any reductions in military and aerospace budget will affect IEC.
• Customers do not commit to long term production schedules. They could cancel, delay or change orders any time.
• Solvency will be an issue if they lose just one major account.

Valuation

IEC’s business has turned around since 2005. Margins have dramatically increased compared to early 2000’s and the company is  cheap on a P/S basis. P/B and P/Tangible Book is on the average side.

ROE has been excellent, but the use of debt has been helping. ROE since 2005 has been 23% average. Compare with CROIC which is 17% during same period. Still high but the number has dropped to 8.3% in 2011.

Long term debt has increased due to the acquisitions, but with such low interest rates, it shouldn’t be a problem.

Inventory turn has decreased from 2010 to 2011. This only confirms that the top line growth was from acquisitions.

Share dilution seems to be an issue. Increases by about 5% annually.

Has an extraordinarily high accrual buildup. Accounting isn’t very good. Red flag.

Using a couple of quick stock valuation tools to check out what the market is expecting from the current stock price;

• Reverse DCF shows the market is expecting about 5.5% growth with a 12% discount rate.
• A reverse Graham valuation with EPS of $0.68 so the expected growth to be 1%.

Possible Catalysts

Some potential business developments that could help IEC.

• Government defense budget is not cut
• USA gets involved in another war (hope not)
• Acquisitions proves to do well
• Partners with several additional suppliers to stabilize its distribution channel
• Diversifies customer base without losing sales

Other Pieces of Info of Interest

• Was created through a merger in 1990
• Founded in 1966
• Acquisitions in each of the past 3 years
• 33% higher backlog in 2011 vs 2010
• Acknowledges that employees are biggest assets
• Good relations with employees. No work stoppages, no unions. Only 1 review on glassdoor.com but it’s a good one.
• Certain “covenants in IEC’s credit agreement with Manufacturers and Traders Trust Company restrict the Company from paying cash dividends.”

Conclusion

Management looks capable but I have to question their shareholder friendliness. The company will never pay a dividend, salary spikes are enormous and there will be consistent share dilution without any buybacks or open market purchases.

It feels like the management team is more content with their corporate lives and benefits vs rewarding shareholders.

Growth is limited and will mainly come from acquisitions. Business has no moat with plenty of risks to consider.

Ultimately, the company is a little too much on the risky side, even though valuation based on earnings is low.

Other Links

http://seekingalpha.com/article/316036-iec-electronics-lining-shareholders-pockets-or-management-s

Disclosure

None

You may also be interested in:

1. MPAC: Typical Scenario of Ineffective Management
2. Portfolio Management and Asset Allocation
3. UFPT Savvy Acquisitions & Making it Work

Written by

Jae Jun

The Secret GRVY Recipe

• ADR – Small Korean online game development company
• Stock price below $5. “Was” trading below NCAV.
• Dirt cheap fundamemtals for a profitable company
• No chance for activism because of 51% owner
• 7+ years of delays for game release
• Catalyst of impending game release

Mix the ingredients together and you get a value investor’s dream dish in the name of Gravity Co (GRVY).

There is no need for me to go over everything again because I’ve written about GRVY numerous times. Several other value investors have also written detailed analysis of the company which I’ve linked to at the bottom of the page.

Right now, I just want to get straight into an updated valuation because YTD, GRVY has shot up 50% with increasing volume and it is a good time to review the probabilities of downside vs upside.

GRVY’s Impending Game Release is a Huge Catalyst

I am still very bullish on the company and the original thesis is still intact. GRVY is set to release the sequel to their blockbuster game after 7 long years of delays, redevelopment and more delays.

Waiting has been difficult because GRVY has a talent for announcing a release date and then delaying the date a month or so before the deadline.

But the company is finally entering their Open Beta test phase on Feb 22, which is a big step from Closed Beta testing and towards commercial launch set for March 2012.

It is one small step for GRVY, but one giant leap for shareholders.

7 years of disappointment and being ignored by Mr Market is about to end.

GRVY offers Downside Protection

First thing to consider is the downside. In the previous post where I detailed the market expectations of GRVY, I went through the NNWC, NCAV and tangible book value numbers to show the downside.

For a company that is

• profitable and FCF positive
• has very little debt
• has plenty of liquid assets and cash
• and has high margins

then the least it should be trading at is book value.

With the 50% jump since the beginning of the year, GRVY is now just above tangible book value.

Q4 results is not yet available to dig into, but based on Q3 results

• NNWC value is $1.50
• NCAV value is $1.78
• Tangible book value is $1.99
• Book value is $3.42
• Current price is $2.15

GRVY offers Upside Potential

The current price still reflects a business that is selling for close to tangible book value.

At the current price, you are getting the portfolio of games, future of RO2 as well as additional revenue streams from licensing to other countries and growing mobile gaming revenue for free.

So what is the upside? Here are a few possible scenarios to consider.

Book value scenario: Suppose the market accepts the fact that the game acquisition prices are fair. Then the stock price should be at least book value instead of tangible book value.

That makes 1x BV = $3.42 a very reasonable target price. There is still 59% upside from today’s price of $2.15 to reach $3.42.

• Zynga (ZNGA) is 11.5x BV
• Glu Mobile (GLUU) is 4.4x BV
• Majesco Entertainment (COOL) is 4.5x BV
• A company like KONG that is bleeding money is 0.7x BV

If you take time to go through more competitors, you will see that profitable gaming companies tend to trade at about 4x BV.

As the other gaming revenues continue bring in additional revenue and RO2 starts commercial business, there is no reason why GRVY can’t be valued at a paltry 1x or even 1.5x BV.

At 1.5x BV, GRVY would be worth $5.13 which is 140% from today’s price.

EBIT Multiple Scenario: If GRVY has another profitable fourth quarter, my estimate for full year EBIT is $9m.

Based on my rule of thumb, a company like GRVY should be trading at 10x EBIT. On a per share basis, it is worth$3.30, but this value is based on the current EBIT ignoring future revenue increases.

Earnings Multiple Scenario: I’m estimating that fiscal year EPS will be approx $0.30 to $0.32. Again, this is based on pre RO2 revenue. Slap a multiple of 10x EPS and the target price comes to $3.00 to $3.20.

Valuation Scenarios

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

Not saying that I am going to hold until $7 or even $5 because it all depends on how well the company markets and launches RO2 as well as expanding revenue from its other games.

But considering the bigger picture, the easy conclusion is that GRVY is still cheap at $2.15.

GRVY is still finger licking good.

Other Links

http://www.oldschoolvalue.com/blog/stock-analysis/the-expectations-built-into-grvy-is-dead-wrong/

http://www.oldschoolvalue.com/blog/forum/g-stocks/grvy-gravity-co-ltd/

http://www.gurufocus.com/news/152147/gravity-grvy–an-irresistible-force-

http://www.gurufocus.com/news/130916/is-a-5-stock-selling-for-under-2

http://longtermvalue.wordpress.com/2011/10/25/gravity-ltd-another-look/

Disclosure

Long GRVY at time of writing

You may also be interested in:

1. The Expectations Built into GRVY is Dead Wrong
2. Cheap Stock under $2: GRVY
3. (Exclusive) GRVY Video Conference Notes

MOD-PAC is a high value-added, on-demand print services firm that is focused on the design and manufacture of folding cartons.  It also has a personalized print product line.

The term folding cartons is the box packaging used for cereals and any other product with box based packaging with printed designs.

Personalized print is customized printing for such things as letterheads, business cards, posters, invitations and cards.

Why is it Cheap? / Is it Cheap?

• Very small company
• Operates in a very competitive industry
• Competition consists of both large corporations to small independent companies
• Exited commercial print business in 2009 as revenue deteriorated after losing VistraPrint contract in 2004. The impairment caused a drop in earnings.
• Was spun off from Astronics (ATRO) in 2003. A totally unrelated parent.

Management

• Daniel Keane is CEO. Kevin Keane is chairman of the board. Must be father and son combo. Not an independent board.
• Strong insider ownership but dual share structure. Inside executives and directors own 33.5% of class A stock.
• Daniel Keane and Kevin Keane own 48% of class B stock.
• Total executive compensation in 2010 made up 3% of revenue in 2010. 3% is borderline so the company is pushing it by my standards.
• Not much insider buying except in Oct 2011 where a few insiders bought in the open market. Majority of insider activities are stock option acquisitions.
• The company has never really outperformed its peers, but bonuses to executives are always given.
• CEO get his “club fees” of $13,858 paid by the company, personal finance planning fees paid, tax return preparation expenses paid. COO gets similar benefits. Useless perks that can be paid by themselves as it has nothing to do with the company.
• From what I can tell, management is looking out for their own interests first.

Growth

• Not much growth that MPAC can achieve. It is operating in a niche where it has basically filled the position that it is in. Only way to grow is to acquire other companies, but current financials do not support this.
• MPAC isn’t big enough to get national customers. Has to work within regions where they are located.
• The personalized print business is not a good business model. Competition is everywhere from a single person operation to big corporations.

Strategic Advantage/Moat

• No moat.
• MPAC does have a strategic advantage in that it is more nimble and efficient than bigger competitors, as well as being able to handle more capacity than the small companies to keep their prices low.
• The main advantage that comes up often in the annual report is that “MOD-PAC’s focus is on niche market opportunities requiring short print runs, which capitalize on our efficient processes and operations to meet customers’ highly variable needs.” – In other words, short run printing.
• Short cycle time means they don’t have to lock in futures contracts to purchase raw materials. They also don’t need to hold much inventory.

Competitors

• Highly fragmented and competitive industry.
• Unable to compete with bigger players.
• Bigger competition also have integrated paper business which makes them efficient and cost effective in long run printing.
• Competes with many other smaller mom and pop shops.

Risks

• Customer concentration. About 30% of sales come from two customers.
• Intense competition
• Needs to regularly upgrade equipment to maintain edge over smaller shops as well as keep up with bigger competitors.
• Company remains in stalemate mode and where shareholders will lose out.

Valuation

• Off balance sheet liabilities consists of leases.
• Revenue has remained flat for 5 years. TTM is better due to additional revenue from folding cartons business.
• Margins have declined for years and only now seeing some slight improvements.
• Shareholders equity has also been flat. No shareholder value growth.
• FCF hovers slightly above or below the zero line.
• Average ROE over 10 years is 3.8%
• Average ROA over 10 years is 1.9%
• Average CROIC over 10 years is 2%
• Inventory age increasing. In 2007, it was 31 days. In 2010 it is now 47 days.

Catalysts

• MPAC could be the one to get bought out.
• MPAC signs a new big contract that diversifies customers, but no such news of anything like this. Just a wild possibility.
• Management’s plan to increase growth in folding carton business succeeds.
• Company buys back shares

Conclusion

Became interested in the business after reading that it was spinoff, but from the looks of the company, the parent was the one with hidden value.

Operates as a niche player in a competitive industry with ineffective management. Company is not positioned to grow and does not have the firepower needed to generate growth.

Easy one to throw in the pass pile.

Verdict

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

Disclosure

None

You may also be interested in:

1. IEC: Capable Management but Shareholder Friendly?
2. Portfolio Management and Asset Allocation
3. UFPT Savvy Acquisitions & Making it Work

Written by

Jae Jun

UFP Technologies (UFPT) creates custom packaging, component and product solutions for the following markets: medical, automotive, aerospace & defense, industrial, electronics and consumer.

When you buy an electronic item, the foam or egg carton type cardboard protectors are the types of products UFPT makes. Visit their website to see exactly what I am talking about.

Why is it Cheap?

• Small cap in a highly fragmented and boring packaging industry
• Thinly traded and low float
• High insider ownership

Management

• Steady share dilution through options
• Approved 25k shares to CEO under the 2003 incentive plan.
• Strong insider ownership at 25%. CEO owns 14%. All directors own more than 1%. Very good. Acts in the interest of shareholders.
• CEO is also president and chairman of the board. Not much independence here as the CEO has influence on the company as a whole.
• Total exec compensation is 2.5%. Below my 3% maximum but still a little on the high side.
• CEO has held position since 1995. Been with the company since 1988 and worked his way up. Very familiar with business.
• No open market buys. Mostly selling between $14 – $17.

Growth

• Growth has come from organic + acquisition growth
• The only way to really grow is to get more contracts. To do this, they need customers. The easiest way to do this in a highly fragmented industry is to acquire other companies and consolidate it.

Strategic Advantage/Moat

• Requires in-depth knowledge of customer requirements as many orders are specially engineered and customized.
• It is not difficult for customers to leave UFPT and create new relationships with UFPT competitors.
• Designs own packaging equipment for increased efficiency instead of buying off the shelf machinery.
• Does not have a huge moat. Very competitive industry, but the fact that such a small company is highly specialized and able to move quickly and efficiently is going to help.
• Offers high quality at a fair price. Not the lowest cost provider.
• Relies on trade secrets and continues development of new products to maintain competitive advantage. Product life cycles are very short so R&D has to develop new and better products constantly to be ahead.

Competitors

• Highly fragmented and competitive industry.
• Competes with many other smaller package producers using different material.

Risks

• Regulatory risk to meet environmental standards and to become greener, which is always expensive.
• Top 10 customers make up 31% of sales.
• A single customer accounted for 14% of sales.
• Requires growth through acquisitions. If management is unsavvy, then acquisitions will be overpaid with a good chance it may not work out.
• Pricing of product is strongly dependent on raw materials.
• If customers move their manufacturing overseas or just outsource the packaging directly to China or other cheaper countries, then UFPT will lose business.

Valuation

• UFPT owns 26.32% of United Development Company Limited (UDT), a realty limited partnership but recognizes 100% of the revenue and balance sheet. In reality even if UFPT is it’s only customer, only 26.32% should be recognized.
• Inventory shows a big increase in work in process. Raw materials has increased a little with finished goods around the same. Seems like UFPT is getting ready for a big order.
• Off balance sheet liabilities are quite high starting in 2012. In 2012: $2.5m, 2013: $1.76m, 2014: $1.4m, 2015+: $5m
• Company really has seen a turnaround since 2005. Acquisitions have really added value. There has been a significant increase in margins and overall, just better numbers.
• Even with all those acquisitions, goodwill hasn’t increased. Intangible assets hasn’t increased. Management looks to be buying companies below book value.
• Balance sheet is fantastic. Just remember to include the off balance sheet liabilities.
• Reverse DCF with $9m and 12% discount rate implies 0% growth. $7m FCF with 12% discount rate implies growth rate of 4.5%.
• Using the new accrual method, stock could be worth around $23.
• Reverse Graham with TTM EPS of $1.50 implies EPS growth rate of 3.5%. Considerably undermining the company in my opinion.
• EPV shows it to be about $22 + cash = $26
• Range of valuation looks to be consistently around $23 ~ $26
• CROIC since 2005 is 15%
• FCF/sales in past 2 years is 7.7%
• ROE has now increased to 18%

Catalysts

• Continued acquisitions below book value driving an increase in cash flow and EPS.
• Analyst coverage will really move the stock price due to the low float.
• Overall nothing dramatic or exciting. Just a boring business continuing to execute.

Verdict

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

Conclusion

Most companies growing through acquisitions fail after several years. However, the biggest surprise is that management seems to buy companies below their book value.

Recent acquisitions have not added to goodwill and they are adding tremendous tangible book value, earnings and cash flow. Pre 2006, the company was horrible but since then, a remarkable turnaround has occurred.

Compared to a company like Timken (TKR) which also grows through acquisitions, there is close to no growth expected from UFPT.

Seems like the market hasn’t caught on yet.

Other Links

http://seekingalpha.com/article/33835-eye-on-ufp-technologies-consider-biodegradable-packaging

http://seekingalpha.com/article/192929-ufp-technologies-inflection-point-has-been-hit

http://seekingalpha.com/article/204111-ufp-technologies-sound-financial-management-results-in-good-growth

http://seekingalpha.com/article/245985-ufp-technologies-building-a-strong-portfolio-of-acquisitions

http://seekingalpha.com/article/261705-ufpt-a-small-cap-that-generates-giant-yields-on-free-cash-flow

Disclosure

Long UFPT

You may also be interested in:

1. Mergers and Acquisitions Arbitrage Activity
2. Making Decisions Without All The Facts
3. MPAC: Typical Scenario of Ineffective Management

Written by

Jae Jun

Here is a good case study to go through.

Diamond Foods (DMND) is being investigated by the SEC and DoJ for potential accounting fraud.

I will go through a few methods to detect earnings quality, manipulation and aggressive accounting to see how well it comes up against DMND.

So as we go through this, the question is, could you have identified DMND’s accounting shenanigans in advance by using such methods?

Accounting Fraud Accusation against DMND

From the Forbes article,

“Allegedly, the company delivered so-called “momentum payments” to walnut farmers in order cook their earnings filings.”

Momentum payments mean that DMND paid their suppliers in advance. Future expenses is shifted to an earlier period which will inflate earnings.

If the audit proves to be true, then based on a Bloomberg magazine article (no link sorry), DMND’s 2011 earnings will be reinstated from $2.22 to $1.14. That’s close to 50%. Ouch!

Earnings Shenanigans

In Financial Shenanigans, shifting expenses to another period is clearly defined as one of the shenanigans used to manipulate earnings. Now in the Bloomberg article, Mendes, the CEO, is portrayed as a very ambitious and business aggressive man. If the article is true, that “could” explain the aggressiveness in the accounting.

If you have read The Art of Short Selling, you will know that there have been many companies throughout history where such CEO characteristics have led to accounting frauds.

Balance Sheet Check

Let’s get down to the numbers.

Take a quick glance at the balance sheet. Even though a company like Diamond Foods is all about the brand of its products, the balance sheet is very unattractive. Just looking at the total intangibles should immediately raise red flags.

66% of total assets is made up of intangibles.

Accrual Ratios

Previously I went through examples of how to analyze accruals. One of the examples featured Dolby (DLB) where accruals were consistently above 25% for 4 years, yet DLB increased cash and reduced debt. DLB’s Sloan ratio was higher than the recommended 8%, but nothing jumped out and the result was inconclusive.

However, take a look at DMND below. (These numbers are from my stock analyzer and the model will be included in the next update.)

Cash balance is close to zero, debt has sky rocketed with all the acquisitions, net income is increasing but cash flow from operations is erratic. Dangerous signs already.

The accruals for 2009 and 2010 is shocking. In 2010 and 2011, there is a very good chance that DMND’s growth in EPS came from accruals. In other words, low quality and cookie jar type earnings.

Beneish M (Manipulation) Score

The third method you can use is the Beneish M score to detect earnings manipulation. Full details of how this model works is in the Beneish M Score article.

A score greater than -2.22 indicates a strong likelihood of a firm being a manipulator.

Coincidentally, the 2009 and 2010 numbers are red flagged.

Conclusion?

By checking the balance sheet, accruals and M score, warnings are flashing everywhere. DMND is innocent until proven guilty, but by my definition, shifting expenses to inflate earnings is fraud.

Summing up, do you:

• check the financial shenanigans checklist?
• look at the construction of the balance sheet ?
• analyze the accruals?
• calculate the Beneish M score?

Disclosure

No position in DMND

You may also be interested in:

1. Satyam Accounting Fraud Exposed
2. Agressive and Conservative Accounting Policies
3. Aggressive Accounting: Reserves, Allowances, Contingent Liabilities

Written by

Jae Jun

Darling International (DAR)

Darling International is a rendering company. A rendering company is one where it goes around collecting oil, waste and other animal by-products from meat processors, bakeries, grocery stores, butcher shops and restaurants to recycle it into things such as pet food, soap and bio fuel.

Why is it Cheap?

• Non-glamorous/dirty industry the business is in
• Very old company. Over 100 years in the business.
• Not cheap in my opinion
• Only national publicly traded company in the rendering business. No comps and therefore lack of coverage despite being over $1b in market cap.

Management

• Total executive compensation makes up 1% of revenue. Very good.
• A lot of insiders selling recently at $14 – $15
• Share count continues to increase. Lots of options to insiders. Not great.
• Insider ownership is only 2.53%. Feel it is better not to buy when insiders are selling.

Growth

• Can continue to grow by acquiring more contracts. There is a definite need for such a service and if DAR can efficiently expand its region, growth should come slowly and consistently.
• Acquisition of Griffin added a new business segment
• Growth could “possibly” could come from the joint venture with Valero in producing renewable diesel fuel but they are still several years away.
• The industry itself isn’t hot or growing, therefore overall growth will be limited to territories.

Strategic Advantage

• With the Griffin acquisition, it is now the biggest rendering company in the USA.
• DAR may have economies of scale but can’t be too certain because operations involve capital intensive costs that can’t be lowered even with big scale operations. You still need to go out to each store, factory or restaurant to collect the waste. There will always be fuel, labor and truck maintenance cost involved.
• Not a lot of competition due to nature of the industry. Not many entrepreneurs willing to start up a rendering company. No VC will fund them.

Competitors

• No comparable comp on the public market
• Final products compete with other commodities primarily corn, soybean oil and soybean meal. DAR’s product pricing depends on how these commodities are priced. If corn prices go down, they have to lower their price to compete. Riskiest part of their business as it is completely out of their control.

Risks

• Pricing pressure as mentioned above.
• Is the acquisition worth the price paid?
• Can DAR consolidate the acquisition properly?
• Relies on macro factors more than I thought. Such as commodity prices, energy prices because DAR uses a lot of natural gas to run boilers.
• “operating performance was challenged by extreme summer temperatures in the Midwest”. Is temperature a risk?
• A lot of FDA issues could arise based on how the animal feed is produced
• Fair amount of off balance sheet liabilities
• Underfunded pension plan + accrued liabilities

“As of October 1, 2011, the Company has an accrued liability of approximately $1.0 million representing the present value of scheduled withdrawal liability payments under this multiemployer plan”

Off balance sheet liabilities

Here are some sections from the 10-Q, 10-K.

“Company has commitments to purchase $27.8 million of commodity products consisting of approximately $19.9 million of finished products and approximately $7.9 million of natural gas and diesel fuel during the next twelve months, which are not included in liabilities on the Company’s balance sheet at October 1, 2011.”

“Company has committed to contribute approximately $93.2 million of the estimated aggregate costs for completion of the Facility in joint venture. Also has to pay 50% of everything overbudget.”

Expects to pay approximately $14.4 million in operating lease obligations during the next twelve months.

Total: $163m+ off balance sheet liabilities

Valuation

• Acquisition in Dec 2010 so prior numbers do not have the new revenue included.
• Looking at historical figures, DAR is not cheap at the moment.
• P/B in the 2.5 ~ 3 range
• P/FCF is greater than 20
• ROIC is average 11% over 10 years
• ROE average 18% over 10 years
• Balance sheet shows company to be capital intensive
• Debt from acquisition has been aggressively paid off but still remains
• Even assuming that DAR makes $100m in FCF, a discount rate of 15% gives a market implied growth rate of 17%. Too high.
• Based on last years EPS of $0.53, market implied growth is 20% using graham formula. EPS of $0.70 gives implied growth of 13%. Still too high.
• If I adjust numbers to include the acquisition and what I “think” it will be, reverse DCF gives growth rate of 10% and reverse Graham gives 5%. Debt is at 8% interest so their growth should be higher than this to cover leverage costs.
• All in all, looks fairly valued at current price of $13-14

Catalysts

• Griffin acquisitions makes big impact to business
• Macro tailwinds. If prices of corn goes up, DAR can increase their prices too. Energy price goes down, they will save money.
• Joint venture works out quicker than planned. (Don’t expect it though. Likely take minimum 3-5 years before anything happens.)

Conclusion

A dirty business off the radar on wall street. Business model is the type that value investors will enjoy, but whether management acts for shareholders is a concern. High capital business makes for slow growth in a slow industry.

Decent company overall but too much risk in the current stock price considering the growth expectations. Could easily keep running up as the acquisition proves to work itself out. If it drops to $10, then buy.

Verdict

• Management: B-
• Growth: B-
• Moat: B+
• Risk:B-
• Valuation: B
• Overall: B

Other Links

http://seekingalpha.com/article/99139-quick-take-darling-international-still-dirty-sexy-money

http://seekingalpha.com/article/317291-darling-international-inc-rendering-profits

http://seekingalpha.com/article/276290-darling-international-rendering-good-results

http://seekingalpha.com/article/287221-darling-international-strong-earnings-recent-acquisition-great-value-play

The Timken Company (TKR)

You may also be interested in:

1. Straight Line and Accelerated Depreciation Methods
2. 20 Stocks Round 2
3. 10 Cheap Value Net Net Stocks Available

Written by

Jae Jun

As I mentioned in an earlier stock analysis post, one of my goals this year is to write more analyses. I won’t limit the companies I analyze to strictly small caps, however, there are definitely sectors and countries that I won’t be able to cover.

Therefore, I want to bring to your attention two stock picking newsletters and a short term project offer that may interest you.

Classic Value Investors

One is by Mariusz Skonieczny, fund manager of Classic Value Investors and also the author of Why are we so clueless about the stock market.

Mariusz just launched his newsletter and if you have read his blog or any of his investment theses, you will know that he goes to extraordinary lengths in researching his companies. Expect the same quality in his newsletter. You can sign up and get a free sample.

Go check out his newsletter now.

Eurosharelab

Next up is Tim Du Toit from Eurosharelab. Tim has had a couple of guest articles on Old School Value. You may recall his 40 point investment checklist article and an older, art of selling stocks.

What I can’t do Tim does because he is based in Europe and focuses on European companies. Especially with the Europe crisis ongoing, Europe should be filled with bargains. I’m sure there are many high quality companies selling for dirt cheap in Europe as everything is being thrown out the window. Unfortunately, I don’t have the knowledge or the tools to efficiently find such gems.

Tim does a much  better job.

If you are interested in diversifying into Europe, go read the contents of his site and free newsletter to decide whether his service will be of value.

You can be involved in this new Project

A friend, who also happens to run his own financial firm is looking for somebody with VBA programming skills to help him improve his models and processes. He needs to have it automated and more robust. The ultimate goal is to customize my spreadsheet to pull in data from Bloomberg for global companies, which is fine since he paid for it and is customizing it.

If I had the time, I would love to tackle it, but I had to turn it down.

Here’s some more information.

• Joint project between Feinberg Capital, a value oriented investment firm and Timbervest, a multi billion timber firm.
• Incentives are negotiable. There is a budget for this so you can be paid or you could be more creative and ask for a 1 or 2 month internship or something.
• Need to be able to work with Bloomberg API to get data directly into a spreadsheet.
• The solution could be much simpler as I’m sure Feinberg Capital is flexible in finding solutions.
• contact mfeinberg@feinbergcapital.com if you are interested.

Disclosure

Not affiliated in any way with the websites or people mentioned. Not an endorsement. No responsibility held for loss of investment.

You may also be interested in:

1. Forbes 200 Best Small Companies Project
2. Forbes Best Small Companies Project: Part 2
3. Forbes Best Small Companies Project: Part 3

Written by

Jae Jun

A project that I’ve always had, was to improve on my stock portfolio tracking spreadsheets.

During this time, I’ve probably used 10 or so different portfolio trackers, but nothing met my needs. I don’t do complicated transactions, but still, nothing could really satisfy me.

But those four long years have passed, and I believe I finally have a version that will serve my needs and fulfill its purpose for a long time.

Main Needs from a Portfolio Spreadsheet

• Enter transactions into a single column without splitting up different transactions
• Spreadsheet should be able to automatically update how many shares I’m holding for any company
• Account for dividends
• Account for splits

I don’t do options so I have no need for such transactions. Don’t see why it would be hard for you to edit though.

Previous Versions

The original portfolio spreadsheet could only factor in simple buy and sell transactions and had to separate it.

Then a Google spreadsheet version was released which made it easier to track but not being able to automatically update the cumulative number of shares held for each position, made keeping track difficult.

The improved portfolio spreadsheet even had an interactive time line to track the portfolio growth but it never really took off. Too much hassle of having to update the portfolio values regularly. Also bad to look at your total portfolio that often as well.

Now this new stock portfolio tracking spreadsheet blows it all out of the water. It doesn’t solve everything but it does most of what I need.

New Stock Portfolio Tracker Spreadsheet

Full credit goes to Investment Moats for his amazing spreadsheet. See it in action.

The creator is a Singaporean investor and it will work right away with what he has, but I made some edits to tailor it for the US exchanges (including pink sheets, OTC and ADR’s) and to clean it up a little.

So you have two options. Use the original or use my edited version.

How to Use and Save a Copy

Full details and instructions can be found on Investment Moats’ website. Read the “Read me section” in the spreadsheet as well.

Yellow highlight cells is where you manually enter data. Aqua colored cells are formulas so do not overwrite.

To save a copy into your own account, do the following

• Sign into your Google Docs account
• Open Stock Portfolio Tracking Spreadsheet
• Go to File > Make a Copy
• Rename and press OK to save to your account

How to Edit the Charts

I’ve added three charts to the summary tab. For every new position, you will have to edit the ranges for it to be reflected in the graphs. I will show you how here.

There is a tab called “ChartsData” which holds and sorts the data for the graphs by market value. No need to change anything in the “ChartsData” tab. This tab is only used to display and sort data. Do not enter anything in this section.

Below is one of the graphs/tables in the Summary section.

Click on the table once and a “Chart” menu will appear. Click that and in the menu you can edit the chart.

Select Edit Chart to bring up the chart editor.

The data range is: ChartData!B1:B11, ChartData!D1:D11, ChartData!M1:N11, ChartData!Q1:R11

Columns B, D, M, N, Q and R are used in the table with values from row 1 to 11. In the spreadsheet, I only have 10 holding positions where row 1 is the table headings and the data is contained within row 2 to row 11.

E.g. if you have 20 current holdings and need to update the graph, the data ranges would be

ChartData!B1:B21, ChartData!D1:D21, ChartData!M1:N21, ChartData!Q1:R21

To see the ranges in more detail, click the grid icon next to the range values to bring up this window.

You can add more detail to your table by adding another range.

Press ok and save.

The other two graphs you will need to update include a pie chart displaying sizing and gain/loss.

Another Portfolio Tracker made in Java

Maybe you don’t like the idea of storing your information on the cloud.

Then as an alternative, here is a free, lite, portable and java portfolio tracker that you can use. Again thanks to Investment Moats for bringing it to my attention.

You need to have Java installed on your computer for this to run though. It is still in beta stage so expect bugs and limited documentation but a very good freebie.

Import feature doesn’t work too well so if you have hundreds of transactions to enter, it will take you a long time. But still, better than most.

Truly the Best Stock Portfolio Tracker

After plugging in all my historical transactions, all I can say is that I’m hooked with this version. It has made tracking so much easier. I will continue to add good features when it becomes a need, but until then, enjoy.

Don’t forget to Like, share or tweet it if you like this.

You may also be interested in:

1. Improved Investment Tracking Spreadsheet
2. Online Investment Tracking Spreadsheet
3. Benjamin Graham Formula Free Stock Valuation Spreadsheet

Written by

Jae Jun

What a great turnout. More than 400 votes were tallied in selecting the best stocks for 2012.

Each position starts with an equal $10k allocation. Total starting portfolio is $100k.

You can see the details of each holding such as unrealized gain/loss figures in absolute dollar and percentage terms on the Top 10 2012 stocks page. I’ve put up a 20 minute delayed, auto updating graph and table you can follow.

2 brains are better than one and that is the main objective for tracking these stocks. Each submission is supposedly a best idea. I want to see whether voting for the best of the best ideas will “normalize” the bad decisions by an individual. Hopefully this will lead to an awe inspiring portfolio.

Don’t get the wrong idea that this is some sort of “herd” investing. Herd investing is where you mindlessly follow other picks. Here, it is a silent debate over the best idea. Just like a ballot.

Top 10 Stocks for 2012 as Voted by You

click image to go to the page

Below are the short elevator pitches for each submitted idea that made the top 10.

1. Oracle [ORCL] - Stock declined 18% in 2011. Sell-off on recent earnings miss is overdone. Has a wide moat. Larry Ellison is a good CEO. Stock currently appears in Greenblatt’s magic formula screener. Cash earnings yield over 9%.

2. Bank of America [BAC] – Most hated stock in the DOW. Big institutions are bound to realize that BAC is well funded and isn’t dying anytime soon.

3. Western Digital Corp [WDC] – Sells for a Fwd P/E=6 and BV=1.27. For a tech company it’s really cheap.

4. Gravity [GRVY] – Once they have their new game up and running it’ll start inching up to something at least more in line with book value.

5. Dell [DELL]- $15 stock with $7 in cash. Company moving away from PC’s and into higher margin enterprise solutions.

6. Corning [GLW] - A great innovative company. The stock price has taken a deep hit this year.

7. Microsoft [MSFT] – Appears in Greenblatt’s magic formula screener with FCF Yield 13.85% and EV/EBITDA for 2012 at 5.52

9. Goldman Sachs [GS] – With share price at $90, company is buying back as much of itself as it can. All of that is accretive eventually and if anyone will find a way to make a good return on capital it will be GS despite obvious headwinds.

10. ADDvantage Technologies Group [AEY] – Profitable for last 25 years, Surplus Cash = 58% share price., TBV = 163% share price, NCAV = 127% share price. Avg. 10yr op. margin = 17%. ROA= 16%, Classic Graham Net-Net.

Disclosure

Long AEY, GRVY at time of writing

You may also be interested in:

1. 10 Cheap Value Net Net Stocks Available
2. The Art of Selling Stocks
3. Fortune Best Stocks to Retire On: Part 4

Keeping it simple. Just two links for you this weekend.

Netflix’s History and Its Business Transformation

In particular, the business model of Netflix is changing and its financial performance will be quite different in the future. Anyone investing in Netflix right now is essentially investing in a restructuring. However, unlike classic restructuring carried out at the last minute when the company is failing, Netflix is profitable and is trying to create a new market.

The Loser’s Game (pdf)

Most institutional investment managers continue to believe, or at least say they believe, that they can and soon will again “outperform the market.” They won’t and they can’t. And the purpose of this article is to explain why not… The investment management business (it should be a profession but is not) is built upon a simple and basic belief: Professional money managers can beat the market. That premise appears to be false.

You may also be interested in:

1. How to Find Ideas based on Industry & Competitors
2. Business Valuation of iGo Inc (IGOI):Part 1
3. Market Volatility And The Business

Written by

Jae Jun

What I’m going to try to do this year is to write more stock analyses. Whether it be official ones published on the blog or point form published on the forum, I want to keep training myself to continually read, write and come up with new and better ideas. I like to write in point form because it’s quick and straight to the point. I don’t have to worry about prettying it up like I do when writing on this blog.

Each of the below analysis was written after reading one 10-k or 10-Q. You know the 80-20 rule right? Well 80% of the information will come from one annual report which only takes 20% of the time.

Articles by other authors help to speed things up in getting to know the company. Financial analysis and stock valuation is then performed with the stock valuation tools.

So far, here are three that I have written.

1. ADDvantage Technologies Group (AEY)

2. Hibbett Sports (HIBB)

3. iGo Inc (IGOI)

ADDvantage Technologies Group (AEY)

ADDvantage Technologies Group, Inc., through its subsidiaries, distributes and services a line of electronics and hardware for the cable television (CATV) industry. The products, the Company sells and services are used to acquire, distribute, receive and protect the communications signals carried on fiber-optic, coaxial cable and wireless distribution systems.

Why is it Cheap?

• Boring business
• Reseller of equipment to companies such as Comcast, Direct TV, CenturyLink etc
• Industry risk. Consolidation could mean loss in revenue. Customers have slowed down their network upgrades.
• Builds up inventory of new and used equipment to sell
• Not followed or held by any of the big boys

Management

• Not much insider buying even at these low levels
• Total exec compensation was 2.4% of revenue in 2010. Below my 3% threshold which is good.

Growth

• Not much room for growth. But with such a healthy balance sheet, their returns do not have to be high to produce growth.
• Market is assuming that the max it can do is 4% growth by reverse engineering prices
• Acquisitions will help with growth. Their acquisitions are small and targeted based on the target’s distribution channel and product offerings.

Moat

• Niche player. Can’t beat the OEM’s in providing equipment, but does take advantage of the many black holes left behind by them.
• Sustainability is absent. A new competitor with money could come overnight and take them out.

Competitors

• Competitive business
• Trading at net net value means there are better competitors otherwise it wouldn’t trade below asset value

Risks

• Inventory valuation. If it had to be liquidated, how much would it be worth?
• Strategy of building up inventory – very low inventory turnovers. All costs money and working capital.
• New agreement with CSCO isn’t the best. They now have to resell CSCO products which will lower margins.
• No dividends. Just builds cash.
• Don’t see much chance of buyout for such a company

Valuation

• no matter what I try, I keep coming up with a low range of $2.80 to $3 which gives 34% upside potential as a minimum.
• Operating at low end of business cycle as the industry has slowed down. Cash flow will reduce.
• I’m estimating EPS of $0.28 for 2011 without doing much more work.

Catalysts

• Industry starts spending for network upgrades
• (hmm can’t think of many catalysts other than being cheap)

Conclusion

Quality net net currently operating at the down cycle. Room for revenue and cash flow growth if the industry picks up. A bit too reliant on external factors but management has been able to handle the business very well. Great ROE, CROIC for a net net. Not many profitable ones out there. Business is easy to understand and the biggest risk really comes down to whether the inventory is really worth what it is.

I wouldn’t call it a value trap because their business model is consistent.

Verdict

• Management: B
• Growth: C
• Moat: C
• Risk: A
• Valuation: A
• Total: B

Buy a small position and wait for a long time to play out.

Other links on AEY

http://www.whopperinvestments.com/addvantage-technologies-aey

http://seekingalpha.com/article/270351-addvantage-technologies-group-bad-quarter-good-price

http://seekingalpha.com/article/252702-the-safer-and-cheaper-addvantage

http://seekingalpha.com/article/237046-addvantage-technologies-high-quality-micro-cap

Hibbett Sports (HIBB)

Hibbett Sports, Inc. operates sporting goods stores in small to mid-sized markets, in the Southeast, Southwest, Mid-Atlantic and lower Midwest regions of the United States. The Company’s stores offer a range of athletic equipment, footwear and apparel.

iGo Inc (IGOI)

iGo, Inc. (iGo) is a provider of accessories and power management solutions for the electronics industry. As of December 31, 2010, the Company marketed its electronics accessory products in three categories: power, protection and audio. It also markets other mobile electronic accessories, including laptop cooling stands, mounts, and mini-projectors (also known as pico projectors) that attach to mobile electronic devices for displaying video.

iGo primarily sells its products through retailers, such as RadioShack, Walmart, Office Depot, Hudson News and Inmotion Entertainment; resellers, such as Ingram Micro, Inc., Microcel, and Superior Communications, and directly to end users through its iGo and Aerial7 websites.

Business Overview

• Company makes after market power (laptop power adapter, phone chargers), batteries, audio (ear phones), protection (skins, cases, screen protectors)
• Highly competitive and commodity business. No moat or advantage in any of the products. Maybe the power adapter, but not really.
• Theoretically for this type of business, the only competitive advantage would be distribution channels and pricing.

Risks

• Wal-Mart is the biggest customer. Lose Wal-Mart and the company is finished. They already lost Belkin a few years back.
• Revenue from Radioshack continues to decline
• Commodity business. A better competitor could come along any time. Batteries, audio, protection products all suck.
• Volatile business. Retail business. Subject to macro.
• Recent acquisitions worth it? Will it work?

Management

• Management compensation levels are fair. Does not exceed 3% of revenues.
• Open market purchase by President/CEO Heil in Dec.

Financials

• Historically lost more money than made
• SG&A rising offset by cost of revenues
• R&D expense decreasing
• Bad returns. ROE in the low single digits, CROIC regularly in negative territory
• DSO has increased dramatically
• Inventory turnover decreased

Valuation

• Same thoughts as when I held it in 2009. Business and management sucks.
• Only thing going for it is the asset valuation.
• NCAV is $0.88 vs current $0.77. Net net (NNWC) value is $0.62.
• Wouldn’t buy IGOI at anything other than 10-15% below NNWC value.

Other

A lot of hope seems to be placed in the partnership with Texas instruments in energy saving chips, but that is too far down the road. Even if you try to put a value on that relationship and the growth that “could” come out of it, it isn’t worth it.

Verdict

• Management: C
• Growth: B
• Moat: C
• Risk: B
• Valuation: B
• Total: B-

Not a company to value based on earnings. Best play would be when it falls below NCAV or NNWC. Anything else is too risky.

Disclosure

Long AEY.

You may also be interested in:

1. DIVX Negative Enterprise Value Stock Analysis
2. Investing Forum Stock Analysis by Members
3. Stock Research and Analysis: Mastech Holdings (MHH) Part 1

Written by

Jae Jun

Full 2011 Year End Value Stock Screen Performances

Compare with 2010 Value Stock Screens

Stock Screen Results Discussion

A much different story compared to 2010. It has been a brutal year for many investing strategies. Of the 13 value stock screens that I track, only two were positive for the year and one was breakeven. The remaining 10 value stock screeners underperformed by big margins.

I wanted to see whether it was just my strategies that did poorly but it seems like AAII didn’t have a good year as well. The most surprising difference between my screen results and AAII was the performance of the Piotroski stock screener. The standard version I have performed well again this year compared to AAII’s -36.7% return.

Screen Settings

For these performance measurements, I use just 15 stocks. On the screener pages, I list 30 just to keep ideas flowing for everyone. Certain volume and price requirements must be met and I’ve tried to weed out Chinese stocks. As always, I don’t include financial companies, REIT’s and holding companies.

Observations and Takeaways of each Stock Screener

Negative Enterprise: Companies that have negative enterprise value are always flush with cash. This criteria became a problem in 2011 when Chinese reverse mergers began popping up everywhere.

These Chinese companies were just loaded with cash and filled the screen. Since reverse mergers are not listed as ADR’s, I couldn’t find a way to weed it out. If this continues to happen, I am thinking of just deleting the screen entirely.

Altman Z Screen: Anything categorized as low quality took a big hit last year. Seems like the majority stuck with high quality stocks which Altman Z score screens for. The screen like all the others tend to focus on small caps and so a -5.8% is acceptable in my opinion.

CROIC and FCF Cows: I was surprised that these two did so poorly. Fundamentals of the companies were strong, returns high, cash flow is positive and strong. The end result was poor. I will have to take a look at the criteria and see whether I have to tweak it.

Graham Checklist & Graham Formula: Decent results. The best as the Graham checklist screen under performed and the Graham formula matched the S&P. Still did very well when compared to the others.

Graham emphasized that investing shouldn’t be rocket science and it was best to keep it simple. His methods are proving to be correct again.

Insider Buys: AAII also had a horrible year for their insider buy screen. Is it because management is over optimistic and that insiders do not analyze their own company objectively? One issue I found is that screens have a hard time of picking the difference between open market purchases and stock options.

NCAV, NNWC & NNWC incr: NCAV screen was actually a surprise this year. It was the best performer this year, partly due to the end of year run ups from PARL and other micro caps which even I find to be risky more than doubling in the year.

Seeing how NCAV did so well, I would have thought the NNWC stock screen would have done just as good, but since the companies on this screen are more asset based opportunities without a valid business model, it got crushed.

NNWC increasing stocks didn’t fair better. If tangible book value is increasing, then it is expected that the company would be able to earn a return off the increasing book value, leading to higher earnings and stock prices. Not true this year. More monitoring required on this.

Piotroski Screen: Has been a soldier. Consistent and steady. So far the screen has been able to outperform in the good years and not lose too much in bad years. Quality companies based on accounting figures seems to be working.

Share Buyback: Any stock that got hit hard bought shares. Some went onto to further losses. Remember what they say. “Just because it is cheap, doesn’t mean it can’t get cheaper.” How very true. A difficult lesson for me in 2011.

Low Expectations: The market may be expecting little from these companies, but as a contrarian strategy, it certainly did meet my expectations. Healthcare stocks which I would have avoided due to regulatory risk were some of the best performers. These cheap companies in out of favor industries looks like a good strategy to further enhance.

I have not published the low expectations screen yet. It’s on my todo list. Let’s see how these stock screens handle 2012.

You may also be interested in:

1. Value Stock Screen Q1 2011 Performance
2. Value Stock Screen Performance YTD Part 2
3. Piotroski Score Screen Performance

Few links to start off your week.

Value Traps and Investor Psychology

Value traps take the form of companies that seem inexpensive in terms of attractive valuation metrics. Despite this allure, these companies typically possess underlying fundamentals that suggest they are in secular (long-term), not cyclical (shorter-term), decline.

Why Best Buy is Going out of Business…Gradually – Forbes

Electronics retailer Best Buy is headed for the exits.  I can’t say when exactly, but my guess is that it’s only a matter of time, maybe a few more years. Consider a few key metrics.  Despite the disappearance of competitors including Circuit City, the company is losing market share. Its last earnings announcement disappointed investors.

Are you an asset based or franchise value investor?

Today, I want to talk about the two types of value investing and the differences between the two. In my mind, there are two types of investments, asset based or franchise (Bruce Greenwald’s Value Investing book mentions three: asset, earnings power, and franchise. I think the line between earnings based and asset based is too thin to distinguish between the two).

You may also be interested in:

1. Value Traps
2. Bankruptcy Investing: MMPIQ

Guest Post by

Daniel Sparks

Value Folio

Warren Buffett’s Berkshire Hathaway holdings (both subsidiaries and stocks) are all very different types of businesses. Consider these different industries which Berkshire has holdings in:

• Insurance
• Manufactured Homes
• Jewelry
• Fast Food
• Aviation
• Chemical
• Underwear
• Journalism
• TV Networks
• Furniture
• Banking
• Kitchenware
• Railroad

This list, of course, is only touching the surface.

Point being, Berkshire owns businesses in many different industries.

How, then, does Buffett still claim to stay within his “circle of competence”?

There must be some common factor among his holdings. As successful as Buffett has been during his investing career, the common factor should be regarded with great reverence. So what is it?

Many of you, I’m sure, have already guessed it. There is nothing complicated here. The answer is so simple that it almost seems like a waste of time. But perhaps there is power in simplicity.

This time, take a look at a list of actual businesses in Berkshire’s portfolio (subsidiaries and stock). The list is made up of many of Berkshire’s largest holdings:

• GEICO Auto Insurance
• Coca-Cola
• IBM
• American Express Co
• Burlington Northern Santa Fe Railroad
• Wells Fargo & Co
• Wal-Mart
• Procter & Gamble
• ConocoPhillips
• Dairy Queen
• Nebraska Furniture Mart

While I am sure it is possible to argue that there is more than one common characteristic between these businesses, the one screaming similarity is that they all have some sort of durable competitive advantage. None of these businesses would easily lose its competitive advantage overnight. Warren Buffett has clearly explained that he only invests in companies with an economic moat (his term for durable competitive advantage).

Recently, as Warren Buffett was justifying his $10 billion purchase of IBM stock, he used another word in place of economic moat. He explained that IBM has “continuity”. A close look at the definition shows a great resemblance to “economic moat” or at least it portrays the reason an economic moat is so necessary.

continuity: the unbroken and consistent existence or operation of something over a period of time

So for those of us Value Investors that are trying to emulate Warren Buffett, perhaps the most important question we could ask ourselves when considering our next purchase of a stock is

• Do the economics and competitive landscape of this investment allow for continuity?
• Does this business possess a wide and deep economic moat?

Answering this question, of course, is not easy. Two of the most common approaches include:

1. Looking for businesses that have higher gross margins than their competitors

2. Taking a good look at the business’ revenue stream, looking for (1) continuing demand, and (2) a promise of continuity. The best way to do this is to break down a business revenue stream by major products or services. Then you can get a better idea of where the revenue is coming from, how much demand there really is, and how sustainable it is.

Sometimes, however, just sitting back and thinking after you have done your research on the company might be your best option on deciding whether you think the competitive advantage is sustainable or not.

Warren Buffett and Charlie Munger have often said they spend much of their time simply thinking and reading. If the economic moat isn’t obvious, perhaps there is a good chance it doesn’t have an economic moat at all. That is at least the feeling I get when I look over Warren Buffett’s holdings.

About the author: Daniel Sparks is an MBA student at Colorado State University. He has a passion for value investing and runs a value investing blog at ValueFolio. He can be reached at danielsparks11@gmail.com

You may also be interested in:

1. Stock Research and Analysis: Mastech Holdings (MHH) Part 1
2. The Evolution of Warren Buffett as an Investor
3. Stop fooling yourself. You are not Warren Buffett.

Written by

Jae Jun

Let’s try an interesting experiment in 2012. I don’t know whether this has been done before, but I’ve set up a voting system where you can submit a short analysis (max 350 characters) of any stock.

You can then vote up or down a submission. Depending on the numbers of submissions and votes, the top 10 stocks will be tracked in a portfolio for 2012 and beyond.

This is where we get to see whether a community portfolio will outperform an individual portfolio or the index.

You can copy and paste a URL of a good stock analysis if you wish. Just make sure to minimize the URL via bit.ly

Go submit your best idea and vote for others by clicking this link.

Click the image to go to the page.

I’ve gotten the ball rolling with DACHA which I voted down just to be fair.

Voting will remain open for a week, or until I get enough samples.

Be sure to tell your friends about it. Share it on Facebook or Twitter.

This will be a fun experiment.

You may also be interested in:

1. Top 10 Stocks for 2012
2. How to Find Value Stocks and Ideas
3. 8 Cheap Stocks below Net Net Working Capital

Written by

Jae Jun

In adherence to my blog posting policy of quality and timelessness over quantity, I didn’t write as frequently as previous years but I’m happy that  you’ve found a lot of the content in 2011 useful.

I’m going to break down the most popular posts by category. Bookmark this page or save the links, because they are full of practical information.

Now let’s take a look back.

10 Most Popular Articles of 2011

Finally! 7 Ways to Achieve Mind Blowing Returns : A list of 7 characteristics you need to beat the market.

Now is the time to PANIC : In a volatile year, full of uncertainty, this is a call to get up and keep your head on straight.

Tutorial to Easily Auto Track Insider Transactions : One of the many tutorials and how to’s I wrote this year. Learn how to track all insider transactions without having to pay for anything.

Tutorial to Quickly Detect Changes in the Footnotes : An excellent technique to quickly find any changes in the footnotes of 10-Q’s and 10-K’s. Will save you tons of time.

My Highest Conviction Pick and Other Links : A discussion of Dacha along with other links timeless articles to help your investing.

The Business and Risk of Bolt Technologies & Here’s One Stock to Boost Your Portfolio : Deeper stock analysis of BOLT which I find to be a high quality company.

On Sale. 40% off my Highest Conviction Pick : Full stock analysis and discussion of Dacha Strategic Metals.

You Just Made These 5 Investing Mistakes : Find out whether you are making these simple mistakes when investing.

How about Going Through 200 Stocks with Me? : Each year, I go through the Forbes Best Small Companies. This year, I revisited the Forbes 2009 list consisting of 200 companies.

Basics Series

A collection of my experiences of how I went about learning to invest.

How to Invest In the Stock Market-Background

How to Invest In the Stock Market-Getting Started

How to Invest In the Stock Market-Getting Harder

How to Invest in the Stock Market-Reflections

Book Reviews

Increase your knowledge through good books.

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How Companies Misuse Capitalizing of Expenses

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1. Durable Competitive Advantages through the Cash Flow Statement
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3. Investing Book Review: Quality of Earnings

Written by

Jae Jun

A week or so ago, I had a guest post about accruals and determining quality of earnings. I hadn’t heard much about it before then so I did some reading am finding it increasingly interesting.

Interesting and useful enough to create an accrual analysis section in the stock valuation models.

Rather than going over the whole accrual topic again, read the article on determining earnings quality through accruals.

Signal of Future Stock Performance?

Based on a 6 page report (pdf) produced by Bernstein Investment Management and Research, companies with low balance sheet accruals out performed companies with high balance sheet accruals by 8-10%.

Other than the equations for finding the accrual ratios from the previous post, I don’t have any information on how Bernstein modified their conditions to get the results, but the theory is the same and is important to understand.

Cash Flow vs Accrual Accounting

Majority of my focus has been on cash flow where there is less room for accounting manipulation because in the real world, we pay cash for something and receive cash for products or services rendered.

This is an ideal scenario and is basically means that earnings should equal the change in cash.

However, this would cause accounting issues as a business could spend a lot of money building inventory one year and not selling it until the next.

Accrual accounting attempts to fix such issues by matching costs with related revenues but he problem is that this method introduces subjective judgments and assumptions.

Here are some other quick observations regarding accrual accounting you need to understand.

Accrual Accounting Observations

(Read the PDF for detailed explanations.)

• Earnings growth due to accrual growth is not sustainable. This is like cookie jar accounting where a company “borrows” earnings from the future to make earnings look good today.

• Balance sheet accrual can indicate whether capital is being used properly. A company with high accruals can come from acquiring or merging with companies which expands the asset base. Low balance sheet accrual companies tend to shrink their balance sheet through spin offs, share repurchases or large write offs. In these situations, it is usually removing bad performing assets or returning money to shareholders which is always a good use of capital.

• High accruals indicate that the company has expanded its asset base rapidly.

• Companies with high balance sheet accruals tend to have higher sales growth than low balance sheet accrual companies.

• High balance sheet accruals also have a higher ROE.

• Remember that maintaining a high sales growth or high ROE is difficult unless you have an entrenched moat. Such companies revert to the mean and disappoints analysts.

• Companies with low balance sheet accruals tend to have below average returns on equity. Analysts expect the company to lag.

All of this sounds a like regular value investing and contrarian investing principles.

Examples to Analyze

Let’s analyze an example to nail the concepts into our heads. You and I have the benefit of hindsight bias with these examples.

I’ve chosen DLB as my first example because it is a current holding of mine and it’s always a good idea to challenge current holdings with new ideas.

Both the balance sheet and cash flow accrual for DLB has been growing quickly. The accrual ratios suggest that DLB relies on accruals to post positive earnings. But the assumption can’t just end there.

Cash has been increasing with decreasing debt, total liabilities well under control with consistently increasing net income.

If net income drops with accruals increasing, watch out.

The Sloan ratio is best when kept below 8%. You see in 2007 – 2009, it was much too high. It may have been that all those accruals finally got to the stock price in 2010 as it hit $70. Then with news that DLB won’t be included in Windows 8, the stock reverted to the mean level where all future revenue for Windows 8 is removed.

Do Accruals Indicate Stock Performance?

I must have gone through about 20 companies to try and find a obvious example, but it is much harder to find that I thought. Many companies with horrible accruals ended up shooting up with a stock price still strong after 5 years.

I’m not surprised though because the accrual ratio is still just one way of analyzing a company’s health.

A better way to go about doing it would be to compare direct competitors to see how the ratios stand within the industry.

Your Homework

Here is your  mission. Go through the numbers quickly for Western Digital (WDC) and tell me what you think about its accruals.

You shouldn’t take more than 5 minutes.

There is no right or wrong answer as this analysis still involves some subjective thought processing.

Final Thoughts

Red warnings signs won’t show up for every stock that you look at. If you do this exercise with AAPL, you will notice that it breaks all rules. As a cash flow investor, I’ve focused most of my energy on the cash flow until now, but understanding how that cash flow is related to earnings is a great check to include in your analysis.

The accrual ratios won’t help you find killer investments, but it will help with building a healthy portfolio. I’ve yet to see how I can fully maximize the lessons from here myself, but I will definitely be including a check in the accruals in my investment process and stock valuation models to speed things up.

You may also be interested in:

1. You Need to Determine Earnings Quality Through Accruals
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Written by

Jae Jun

This time of the year is a special one.

You may have your own tradition, or maybe it’s time to start one.

Wherever you are, I wish you a Merry Christmas and a Happy New Year in 2012.

2011 has been a difficult year, both in the markets along with some recent family struggles. But as you may know, I am a Christian so Christmas has an extra special meaning for which I am thankful for.

But guess what? Thank YOU for your eagerness to visit this site and to learn alongside with me. I get to spend time studying, analyzing and teaching which I enjoy very much.

Posts:

Posting will be regularly once a week. I’ll try to avoid the peak holiday’s when posting articles.

Forums:

Forums are always open. The forum is still small, but it is chock full of information with rich content due to dedicated regulars willing to share and question conventional knowledge.

Shop:

The stock valuation models will continue to be available for purchase. The whole process is automated and you will receive a link to download with full instructions to your email.

A Dance Video from the Jun family:

Hope you get a laugh from this dance video of me and my family.

(RSS/email readers will have to come to the site to see)

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Written by

Jae Jun

I’ve recently been putting more weight to the question of “What are the expectations for this stock?”.

Rather than purely concentrating on a bottom up approach where I value the assets, cash flow and growth to come up with a range of intrinsic values, questioning what the markets expects out of the stock adds another dimension to the valuation process.

Based on Historical Data

When performing any stock valuation, you are extrapolating numbers based on historical data.

e.g. DCF could come out to $40, Graham’s formula shows the stock to be worth $65 and EPV gives a conservative $30.

Which one is correct? Can you assume that the range is $30 – $65 and invest in the company comfortably?

By figuring out what the expectations are, you can take it one step further. In other words, invert the valuation.

Understand What the Crowd is Saying

In Mauboussin’s book More than You Know, he writes of an experiment that was played out in a university  classroom. The professor has a large jar of jelly beans and asks a student to guess how many jelly beans were contained in that jar.

The first student gives an answer way off the mark.

The professor repeats this process for each student in the room.

At the end, not one student got the correct answer. The range of values were high, with many incorrect answers.

However, the average of all the answers turned out to be the closet to the jelly bean count.

The market works like this. You have millions of individuals offering differing opinions. Value investors will provide conservative estimates, growth investors will provides extreme estimates. No single person may be correct, but over time, the value will be recognized by the market.

I’m not putting forth an argument that the market is efficient. My point is that understanding how the market thinks about the stock is important. Does Mr Market know more than you or does he know less?

Reverse Engineering Valuation Methods

The additional questions you should now be asking  yourself are the following:

1) What is this stock worth?

2) What is this stock NOT worth?

And here are a few methods of how to go about answering these questions the inverse way.

Reverse DCF

A reverse DCF valuation will help you find the expected growth rate the market is pricing in.

Set the discount rate to something that is reasonable. For small caps, a discount rate of 12-15% is desired. For large caps, 9% discount rate is satisfactory.

However, an easy way to find your desirable discount rate is:

Discount rate = Risk Free Rate + Risk Premium

Asset Valuation

Use this simple equation to see what the expectations are.

stock price = assets + expectations (a.k.a growth or speculative value)

If the stock price is made up of a lot of assets, not much growth is expected. If the company can either perform at the GDP rate (around 4-5%) then you have a good chance of finding a winner.

If the stock price is made up of little assets, there is a likely chance that the company will disappoint in the near future.

Reverse Earnings Valuation

This reverse earnings power value next one is more complex and based off expected earnings power. Think of it as a reverse EPV.

1. Create your multiple

2. Calculate Excess Cash of interest bearing debt into a per share price

3. Deduct Excess Cash per share price from the current market price of the stock

4. Divide remaining amount by the multiple in step 1

5. Determine a proper earnings growth rate or use an analysts assumption to draw ideas on (don’t rely on the analysts information – just use it to see what information you can derive from it)

6. Find how long it would take to grow shares from what they are currently to what Step 4 produced using the assumed growth rate

7. Determine in your own mind using logic and rationality how feasible the proposition is based on the information at hand

Invert the Problem to See What the Market Expects

There are other ways of reverse valuation, which I’ll walk you through another time, but one thing that becomes clear is that once you start doing this, your questioning and thought process starts to change.

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Guest post by

James DeMasi

Seraphin Group

When you’re trying to value businesses then you’re primarily going to be trying to put a value on their earnings power.  We all like to see big earnings, but quantity is much less important than quality.  Earnings can be considered high quality when they are both repeatable and accurately represent the company’s operations.  This may not always be the case because of fraud, misreporting, and managerial accounting discretion.  You can begin to determine whether or not a company has high quality earnings by checking on its accruals.

Net income is a product of accrual accounting

Businesses make sales by either collecting cash or extending credit to their customers.  Therefore, in the simplest terms, a company’s accounting earnings are equal to its cash earnings plus accruals.  But, managers can manipulate accounting figures.

Executives decide how quickly to depreciate assets and how large the allowance for doubtful accounts should be (an estimate of how much customer credit is not likely to be repaid). They may also try to renegotiate terms with their suppliers to delay paying their bills, or try to recognize unearned revenue more quickly than would be considered appropriate.  In the long-run these measures are not sustainable because accruals and deferrals are mean-reverting.

For example, if a large portion of unearned revenue is recognized as earnings today then there will be less revenue recognition remaining for the future.  Likewise delaying bill payments today means that the company will show higher expenditures in the future.

When earnings are manipulated in these ways, then they are not representative of the company’s true earning power and are not repeatable.  Research shows that companies with lower levels of accruals and deferrals have more persistent earnings.  Moreover, “Earnings increases that are accompanied by high accruals, suggesting low-quality earnings, are associated with poor future [stock] returns [1].”

To monitor a company’s accruals, Scott Richardson of Barclays and Irem Tuna at London Business School developed the balance sheet aggregate accruals ratio and the cash aggregate accruals ratio [2].

These ratios can be used to view changes in a company’s accruals level over time and to make company-to-company comparisons.  Historical averages and cross-industry comparisons will help you determine what an appropriate level is.

Note that the balance sheet aggregate accruals ratio and cash aggregate accruals ratio will not perfectly match because of noncash transactions and other classification differences, but the two are highly correlated (0.80)^2.  Both should be used when making time-series and company comparisons.

Balance Sheet and Cash Aggregate Accrual Ratio

First calculate Net Operating Assets:

Next, subtract last period’s NOA from the current NOA figure to arrive at Balance Sheet Aggregate Accruals.

The Balance Sheet Aggregate Accruals Ratio is determined by dividing that number by the average accruals.

The procedure is similar when calculating Cash Flow Aggregate Accruals, as shown below.

Red Flags to Heed

Remember, a jump in earnings accompanied by a jump in the accruals ratio should raise a red flag; so too should a higher than industry-average growth rate with a higher than industry-average accruals ratio.

So, the next time you are looking at a stock then be sure to incorporate these ratios into your analysis.  Doing so may just prevent you from being caught on your heels the next time a company admits to having some skeletons in its closet.  Hopefully, you will have seen the signs and exited sooner than the general public.

About the Author

James DeMasi first became interested in the stock market at the age of thirteen and has pursued it as his career ever since.  In that time he has worked as an investment consultant at EnnisKnupp, where his clients included some of the largest public pension funds in the United States, served a brief stint as a Wall Street trader, and is currently the founder of Seraphin Group LLC, a value-oriented Registered Investment Advisor.

Follow James on Twitter @SeraphinGroup, on Facebook as well as Seraphin Group LLC.

References

[1] Chan, Konan, Louis K. C. Chan, Narsimhan Jegadeesh, and Josef Lakonishok. “Earnings Quality and Stock Returns.” Journal of Business 79, 3 (May 2006): 1041-82. Retrieved from http://www.nber.org/papers/w8308

[2] CFA Institute. Level II Financial Reporting and Analysis. 5th. 2. CFA Institute, 2011. Print.

You may also be interested in:

1. Investing Book Review: Quality of Earnings
2. Checking Accruals of a Company in 5 Minutes
3. Quality Systems Inc (QSII) is a Quality Company