This is a continuation of the series of valuing each of the 200 Forbes Best Small Companies

2009 Forbes 200 Best Small Companies Part 1 | Part 2 | Part 3 | Part 4

In this list, I’ll list up the valuation results of companies 51-70.

DXP Enterprises (DXPE)

Sells maintenance, repair and operating products to industrial customers.

Positive and increasing FCF since 2001. CROIC is also above average 17%. Although FCF has been increasing every year, long term debt has increased dramatically as well.

One thing that caught my eye is that the company has a habit of increasing accounts receivables and inventory while if there were reductions, the percentage amounts were very small.

I’m not sure whether it is just DXPE or industry specific, but COGS is very high and although gross margins at consistent around the 28% mark, net margins are quite thin at 3.5%. This is why I can see that DXPE has trouble converting sales into FCF.

• Price as of writing: $11.96
• DCF: $19.92
• Graham Formula: $19.23
• EPV: $13.89

Portfolio Recovery Associates (PRAA)

PRAA still looks to be a good company. I figured the company would be worth around $47-$60 last year so it seems to have reached its intrinsic value.

The business collects payment from delinquent consumers..

After looking at ASFI, I’ve realized what a profitable niche industry this is if done correctly. Profitable because these types of companies buy bad receivables from many companies at a discount to its true value.

PRAA could buy a list of accounts where consumers are not meeting payments on their visa card, at a price significantly cheaper than the real value.

e.g. if PRAA buys a portfolio from visa for $1m where the original value of the receivables is $2m. So even if they can’t get the full 100% from consumers, if the company can collect about 80%, they are still making profit because the business buys 50c dollars.

• Price as of writing: $47.09
• DCF: $47.45
• Graham Formula: $65.94
• EPV: $25.62

j2 Global Communications (JCOM)

Currently debating with myself whether JCOM will make a good investment.

The company offers messaging services such as fax, voicemail, email and call handling services.

FCF has been increasing since 2002 and even in 2008 and 2009, seems like revenue is at an all time high. Even in the previous dot com recession, JCOM was able to continually increase their profit.

Gross margins are above 80% and net margin just around 30%. That’s quite impressive. It indicates the company can increase prices .

No matter what the economy, businesses and people will still need to use email or fax something. With the internet it has become even easier now that you can fax documents through the internet.

Fundamental numbers are just mouth watering.

• Price as of writing: $20.87
• DCF: $33.85
• Graham Formula: $28.12
• EPV: $22.52

Pre-Paid Legal Services (PPD)

I won’t explain what PPD does as you can read a good PPD analysis by a reader that posted his thesis on my value investing forum.

Recently PPD received a complaint from the FTC which caused the price drop 20% to $30. At current prices, it doesn’t offer much margin of safety but at $30, it should have been a no  brainer.

The only concern I have is the result of the complaint. Prices could fall again from $39 to $30. $30 should protect a lot of the downside.

• Price as of writing: $39.38
• DCF: $46.44
• Graham Formula: $51.12
• EPV: $54.83

List of the Best Small Companies

View all of the first 75 companies in the following spreadsheet
Forbes200 Small Companies 4

Disclosure

No positions in any stocks mentioned at time of meeting.

You may also be interested in:

1. 2009 Best Small Companies Part 3
2. 2009 Forbes Best Small Companies Part 1
3. 2009 Best Small Companies Part 2

Valuing a Stock with the DCF Method

You may have found a great company that you feel has outstanding potential but always end up getting stuck at what price you should purchase the company. Finding the value of a stock is a critical part of investing successfully. Valuing stocks is not hard, but it does require logic and practice.

Calculating stock values surprising should not consist of lengthy and complicated formulas. If you understand the concepts of how to go about thinking through a stock valuation, you will understand that you don’t need to understand the derivation of the formula to apply it well and to achieve profits off your investments.

Let me give you an example.

The real formula to perform a discounted cash flow is:

DCF = CF₀ x SUM[(1 + g)/(1 + r)]ⁿ (for x = 0 to n)

Now this formula will excite a few, but for the rest, my advice is to just understand what a DCF calculation is and what variables you need to include and adjust.

I won’t explain what a DCF or discounted cash flow is as you can follow the link for a fuller discussion.

How to Value a Stock with DCF

DCF Discount Rate

The purpose of a discounted cash flow is to find the sum of the future cash flow of the business and discount it back to the present value. To do this you need to decide upon a discount rate.

Simply put, a discount rate is another phrase for “rate of return”. i.e. what is your return requirement for this investment to be worth the risk?

You wouldn’t expect a return of 3% off your stock investment because you could easily get that from a Certificate of Deposit (CD) or even just your normal bank account. A treasury bond will probably give you a better return.

If the bank and fed are risk free investments at 3%, then why bother using 3% as a discount rate?

So what would be a good rate?

Considering that the “average” market return is about 9-10%, a minimum discount rate should be set to 9%. I use 9% as a minimum for stable and predictable companies such as KO while 15% is a good return for less predictable companies such as NTRI.

A somewhat more difficult and confusing definition of discount rate would be, how much emphasis you place on the future cash in terms of today’s dollars rather than the future dollars.

E.g. What price would you pay for an investment today if company XYZ future cash flow is worth $100 after 1 year?

Discount Rate: 5% = 100/1.05 = $95.24

Discount Rate: 10% = 100/1.1 = $90.90

Discount Rate: 15% = 100/1.15 = $86.96

Discount Rate: 30% = 100/1.3 = $76.92

As you can see the higher the discount rate, the cheaper you have to purchase the stock because your required rate of return is much higher. This means that since you are willing to pay less now, you are placing more emphasis on the current cash flows of the company.

DCF Growth Rate

Growth rate is going to be the Achilles heel to any stock calculation. By growth rate, I mean the FCF growth rate.

I prefer to value stocks based on the present data rather than what will happen in the future. Anything could happen even in 1 year, and if the growth rate is too high and the company cannot meet those expectations, there is no where to go but down.

The best practice is to keep growth rates as low as possible. If the company looks to be undervalued with 0% growth rate, you have more upside than downside. The higher you set the growth rate, the higher you set up the downside potential.

Look at what happened to SPWR and FSLR. Solar energy was the rage in 2008 and growth was estimated to be at 50% and above, but these lofty expectations only make the fall harder.

Growth rates doesn’t have to be accurate. Just be reasonable and use common sense.

On most of the stocks I value, I rarely go above 20%, and that’s only for something like AAPL.

Adjusting Numbers

What I failed to do in the beginning when I started valuing stocks was to adjust the FCF numbers for cycles and one time events.

If you start a discounted cash flow calculation based on either a year with higher than normal FCF or much lower FCF, as is the case in 2008, the stock calculation will also be wrong.

Be sure to consider taking the median or average for the past few years to determine the normalized free cash flow.

The point of the stock valuation is to be realistic, not pessimistic or optimistic.

Margin of Safety

Whatever rate you choose, never, never forget to apply a margin of safety. This is the equivalent of a kill switch on the treadmill. It’s there to prevent you from getting hurt.

An important point is to not confuse a high discount rate for a margin of safety.

For lower discount rates it is advised that you use at least 50% margin of safety while for discount rates of 15%, a 25% margin of safety may be adequate.

This is because since you are requiring a higher return immediately off your investment, you are trying to pay much less than a discount rate of 9%. So by placing more emphasis on a higher return, you are in fact reducing the risk of the investment which is why a 25% margin of safety may be enough.

Practice your valuation with the free dcf stock analysis spreadsheet with all the things discussed.

Summary

• A discount rate is your rate of return. Higher discount rate means you are trying to pay less for the future cash flows at the present time.
• Growth rates are the fuzziest aspect of valuing stocks and should be applied conservatively.
• Adjust numbers to remove one time events and cycles. Always consider a normal operating environment.
• Never for a big margin of safety. The best of us get it wrong as well.

I’ll discuss valuing stocks using Benjamin Graham’s formula in an upcoming post.

You may also be interested in:

1. 3 More Value Stocks to Consider
2. Ben Graham Net Net Deep Value Stocks
3. Fortune 40 Best Stocks to Retire on:Part 2

With the increasing popularity of the free stock analysis tools as well as the premium stock analysis spreadsheets, helping people troubleshoot and install the stock spreadsheets is beginning to take up more and more time.

So with all future updates, I have now changed the SMF Add-in location from “C:\program files\SMF Add-in” to “C:\SMF”

I have had instances where people

• use non english windows which messes up the location
• use _ instead of -
• installed under D: instead of C:
• forgot the space between SMF and Add
• unzip to another folder within the SMF Add-in
• etc etc

For those of you well familiar with excel, there is no harm in moving the add in to C:\SMF and then re-pointing the add-in from excel.

If you are uncomfortable with the whole process, you can wait for the next update.

If you do decide to go ahead, follow the instructions in the latest revised installation manual which includes a new step by step section on how to update links.

Important Point

If you move the add-in to C:\SMF and then get the update links box but the “Change Source” button is grayed out, make sure you close the prompt and unprotect all the worksheets first. If a worksheet is locked, then excel won’t allow you to update links.

Or like I said, just wait for the  next release which should be easier.

Join the forum discussion on this post - (1) Posts

You may also be interested in:

1. Value Stock Mastech Holdings (MHH) Update
2. Insmed Q3 Net Net Stock Analysis and Valuation
3. Update and Upcoming on OSV

This is a continuation of the series of valuing each of the 200 Forbes Best Small Companies

2009 Forbes 200 Best Small Companies Part 1 | Part 2 | Part 3 | Part 4

In this list, I’ll list up the valuation results of companies 35-50. Keep in mind that my valuations are only as correct as my assumptions and knowledge of the company and industry. Since this is a quick rundown of each company, I’m definitely going to be wrong on many of these companies. As long as my accuracy is above 50% and I apply a big margin of safety, in my final analysis, I should be able to own good companies and make money.

GulfMark Offshore (GLF)

Provides offshore marine services to offshore oil and natural gas exploration and production companies.

Not much growth in FCF due to the industry cycles and the CROIC isn’t great as well. Many down cycles as there are up.

However, margins are increasing at a fast rate while debt is being reduced. The company has been reducing costs over the past few years which has helped their margins and profits.

Another point to look into is their tax rates. By the numbers, I would assume they operate in regions beyond US borders and ranges from as high up as 24% to receiving tax breaks. Since taxes also affect the net income, making adjustments to tax numbers will also affect the intrinsic value.

Looks to be undervalued at current prices. Because of the cyclical and capital expenditure nature, we need to adjust FCF

• Price as of writing: $28.01
• DCF: $41.94
• Graham Formula: $48.30
• EPV: $37.33

Ensign Group (ENSG)

Young public company just under 5 years of operating history but it is a profitable business.

ENSG provides nursing and rehab services throughout California, Arizon, Texas, Washington, Utah and Idaho.

While FCF and CROIC growth are average, it seems to be predictable.

There has been big drops in gross margins and without a long history, it is difficult to determine whether it is just temporary and a result of the economy or the company losing ground to competitors.

• Price as of writing: $14.53
• DCF: $13.52
• Graham Formula: $19.84
• EPV: $10.97

Chattem Inc (CHTT)

Sells OTC healthcare products, toiletries and dietary supplements.

Having a small portfolio and not being a dividend investor, CHTT would be a company that I wouldn’t mind owning instead of JNJ or PG.

The company has great fundamentals. FCF and CROIC growth is above 26% over the past 5 years, margins are consistent, good returns off its equity and assets, steady inventory turnover.

In 2008, I incorrectly valued CHTT to be worth around $30. Revisiting an intrinsic value calculation of the company and its performance 1 year later, it’s clear that the value is much higher than $30.

• Price as of writing: $66.44
• DCF: $71.70
• Graham Formula: $66.39
• EPV: $26.95

LSB Industries (LXU)

Climate control segment sells a range of heating, ventilation and air conditioning products. Chemical Business manufactures and sells nitrogen based chemical products for the industrial. mining and agricultural market.

Big jump in FCF in 2007 which doesn’t seem to be repeatable so that needs to be adjusted. Managements use of assets and capital seems to be only average.

LSB industries is a holding company so a quick valuation won’t do it justice as you have to go through the two business segments. Selling air conditioners and chemical products are completely different and will require separate analysis of each to come up with a proper value.

• Price as of writing: $11.85
• DCF: $14.64
• Graham Formula: $16.79
• EPV: $16.64

NutriSystem (NTRI)

Sells weight management meals.

NTRI started to sell their products in Wal-Mart which boosted their stock price and reached its intrinsic value. While a stock price of $60 in 2006-2007 was was over optimistic, mid $20’s is about where I see NTRI.

Management has done a great job in utilizing capital to generate large returns. In 2008, the company was able to return $0.39 for every $1.00 invested. Amazing.

The one thing to be careful with a company like NTRI is growth. From experience, growth is the worst variable to try and predict or fiddle around with. Common sense is required. Just keep in mind that no company will ever sustain a growth rate of over 50% for years on end. 1-2 years maybe but don’t get caught with your pants down by being over optimistic.

• Price as of writing: $22.79
• DCF: $21.12
• Graham Formula: $27.90
• EPV: $31.39

PDF of the First 50 Best Small Companies

2009 Forbes 200 Best Small Companies no.1-50

Disclosure

No positions in any stocks mentioned.

You may also be interested in:

1. 2009 Best Small Companies Part 2
2. 2009 Forbes Best Small Companies Part 1
3. 2009 Best Small Companies Part 4

Investment Book: Why are we so clueless about the stock market

Many people are clueless about the stock market. I was as well in the beginning. I didn’t know where or how to start.

Considering the amount of noise in the media and people flogging that you are not smart enough or good enough to know how to pick your own stocks, it’s no wonder people have a misconception about getting started in stock investing. Value investing is also another language to them at this point.

Why Are We So Clueless about the Stock Market? is a great little book on how to start investing in the stock market and a fine book for the seasoned investor to organize their explanations and analogies when explaining supposedly simply concepts such as discount rates, growth rates, basic concepts of business, diversification and so on.

Easy to Read & Understand

The book is written in a very simple and clear manner. It makes reading very easy to follow and understand. So easy in fact that it would be a great first book for young budding investors.

Each chapter of the book is very concise and to the point with a short summary at the end of each chapter. A good way to maintain the flow of your reading and learning.

It’s probably on the same level as Greenblatt’s The Little Book That Beats the Market. The big difference being that there is more detail and it covers a wider range of topics and answers many questions that new investors are sure to encounter.

What types of questions does it answer? Let’s see below.

What’s the Book About

Why Are We So Clueless about the Stock Market? follows on the old school investing concepts of Warren Buffett. That is, stocks are small pieces of businesses and we should approach picking and buying stocks as if we were purchasing a real business.

The book will help beginner investors to answer and guide them through questions such as

• What is a good business?
• How do you identify a good business?
• When do you buy?
• How do you value a company? (note I didn’t say analyze)
• When do you sell?

I especially like the chapter that discussed the concept of using debt in a company. It’s definitely something that will help learning investors.

The book discusses other ideas such as how the economy affects the market, why investing in IPO’s is a bad idea and offers 4 good case studies of Burlington Northern Santa Fe (BNI), Thor Industries (THOR), Wells Fargo (WFC) and Moody’s (MCO).

Personal Comments

The one big topic that I felt was missing was a discussion on margin of safety. Even though the author shows the reader how to value a company using the discounted cash flow method, there is no mention of the all important margin of safety.

Another point is that while there is a chapter dedicated to valuing companies, there isn’t one on how to analyze a company. I mention this because I know from first hand the dangers of just “knowing” how to value stocks without understanding or knowing how to analyze them.

Summary

Overall, the book is a superb primer for the new investor and will help to open their eyes to the bigger picture of investing.

It’s also a great book if you’re a seasoned veteran but have trouble clearly explaining or teaching investing concepts.

The author, Mariusz Skonieczny, also has a website and blog at Classic Value Investors. You can listen to his radio interviews (interview 1 & interview 2) brought about by his due diligence on Mastech Holdings (MHH).

You may also be interested in:

1. Investing Book Review: The Art of Short Selling
2. Investing Book Review: Quality of Earnings
3. Investing Book Review: Financial Statements

This is a continuation of the series of valuing each of the 200 Forbes Best Small Companies

2009 Forbes 200 Best Small Companies Part 1 | Part 2 | Part 3 | Part 4

In this list, I’ll list up the valuation results of companies 11-34 from the stock value spreadsheet. You can also calculate the stock value yourself with the free dcf spreadsheet as well as the free Benjamin Graham formula spreadsheet.

Dolby (DLB)

Dolby is the type of company you just cannot go wrong with whenever you buy the stock at the right price. The only difficultly is that DLB rarely trades at a cheap enough price.

I’ve been following DLB for a couple of years now and the company just continues to perform excellently. As long as people have ears and listen to things, DLB will be there somehow. The company collects royalties from its sound technology licenses and with Dolby technology in the cinema, tv, blu ray, Windows and the list goes on.

DLB has always had excellent fundamentals and organic growth. FCF over for the past 5 years has grown by about 56% and management has been able to make a return of 18.4c off every $1 of cash invested.

Capex is very low compared to its revenue which is why every 20c from $1 of sales is converted to FCF.

All I can do is just wait for the price I’m hoping for.

• Price as of writing: $42.06
• DCF: $42.06
• Graham Formula: $40.19
• EPV: $34.41

Synaptics (SYNA)

Another company that looks to be continually improving. Synaptics sells user interface devices such as the touchpad on your laptop, the iPod, touch screen devices and so on.

Despite the recession 2009 the company posted it’s highest revenue backed by big positive flows of cash to the bottom line. This may be due to the huge exponential demand for innovative user interfaces in devices.

While CROIC is average at 8.9%, cash growth from operations increased by 29.4% over the past 5 years while FCF grew at 20.7%.

Margins are also improving while at the same time they’ve been reducing debt.

• Price as of writing: $25.14
• DCF: $27.48
• Graham Formula: $21.55
• EPV: $17.96

Jos. A. Bank Clothiers (JOSB)

One of the many missed opportunities of 2008. In part 3 of the 2008 Forbes best companies list, JOSB was one of the few rare companies to be trading a what I considered to be a margin of safety. Now, it seems like the company value continues to advance with the new estimate now up to the $50’s compared to the mid $40’s last year.

Over the past 5 years, the company exhibits excellent fundamentals with great FCF growth, good consistent CROIC and returns.

Margins is super steady and consistent.

Capex seems to be hanging steady at the $30m range while revenues continue on up. JOSB seems to be a great example of price meeting value.

• Price as of writing: $42.62
• DCF: $50.18
• Graham Formula: $51.99
• EPV: $53.20

Capella Education Company (CPLA)

Education stocks are effective recession proof investments but I’m just not sure why they all trade at such high premiums. Of all the education stocks I’ve gone through, they all look to be trading much higher than intrinsic value.

While the future may be rosy, growth is just too murky to try and estimate which is why my conservative values of future predictions indicate CPLA well over intrinsic value.

I personally have yet to meet a value investor that owns a big position in education companies.

• Price as of writing: $71.91
• DCF: $43.25
• Graham Formula: $41.53
• EPV: $44.51

Middleby Corp (MIDD)

Makes commercial cooking equipment. MIDD regularly makes the list and always seems to defy the odds by producing excellent results.

The company has never been at a loss during the past 10 years. Capex is very low at less than $10m but their net asset book value is negative as a big portion is made up of goodwill and other intangibles.

• Price as of writing: $47.52
• DCF: $50.06
• Graham Formula: $67.09
• EPV: $20.32

Summary

Despite a large portion of the list being made up of growth stocks, a handful of companies are worthy of studying and keeping an eye on. We’ll see what the next bunch can offer.

Disclosure

No positions in any stocks mentioned.

You may also be interested in:

1. 2009 Forbes Best Small Companies Part 1
2. 2009 Best Small Companies Part 3
3. 2009 Best Small Companies Part 4

2009 Forbes 200 Best Small Companies

It’s finally that time of year again where I go through 200 companies that made it to Forbes 200 Best Small Companies list.

There has been a big shuffle this year with 71 companies from last year falling out of the list. The requirement is that the company have annual revenue between $5 million and $750 million, be publicly traded for at least a year and have a stock price no lower than $5.

The one big issue I see with the Forbes list is that they refer to “best” as growth in sales which isn’t something value investing considers.

2009 Forbes 200 Best Small Companies Part 1 | Part 2 | Part 3 | Part 4

The Screening Filter

Since all the companies are supposedly growing and profitable, there are no net nets or other cheap stocks.

1. Immediately exclude financials (outside circle of competence)
2. Run the companies through the investment spreadsheet with the PE as the growth rate, but capped at 15%. The selected companies shall exhibit;

- Positive, consistent and growing cash flows.

- Consistent margins. Fluctuating/decreasing margins over several years will not be accepted unless the other criterias are outstanding. Above average returns from capital investments (CROIC, ROE, ROA)

- Strong balance sheet

3. Companies should have at least 5 years of operating history

The List of Companies

I’ll only be going through and commenting on each of the first 10 companies in this initial post. Future posts will only discuss fundamentally good companies.

1. Lumber Liquidators (LL)

Specialty retailer of hardwood flooring.

Too short history but the company makes good FCF and excellent CROIC. Looks to be trading a big premium with the growth it has exhibited but a company to keep an eye on should prices fall one day.

DCF Calculation: $14.31

Graham Formula Calculation: $11.32

EPV: $12.71

2. Allegiant Travel (ALGT)

Operates a low-cost airline serving resort locales such as Las Vegas and Orlando.

Never liked airline companies. Top line may have increased but bottom line is still weak with barely any FCF consistency or growth.

DCF Calculation: $14

Graham Formula Calculation: $18.71

EPV: N/A

3. Quality Systems (QSII)

Creates software designed to automate and streamline administrative functions required for operating a medical or dental practices.

My previous analysis of QSII showed how much I was wrong. My intrinsic value estimate was between $22-$36 while it is now trading at $63. QSII continues to grow at an amazing pace on both the top and bottom line.

• Awesome FCF generation, CROIC, ROA, ROE with zero long term debt
• It’s growing at such a fast organic rate that I feel uncomfortable in trying to value the company as I have no way of knowing how long this growth will continue.

4. LHC Group (LHCG)

Provides post-acute health care services to patients through its home nursing agencies, hospices and long-term acute care hospitals.

• Big drop in tangible shareholders equity
• Excellent CROIC
• Excellent FCF growth
• Margins are volatile yoy but increasing trend

DCF Calculation: $33

Graham Formula Calculation: $28.14

EPV: $25.81

5. Green Mountain Coffee Roasters (GMCR)

Sells over 100 whole bean and ground coffee selections, hot cocoa, teas and coffees in K-Cup portion packs, Keurig single-cup brewers and other accessories.

The Keurig single-cup brewers may be selling like hotcakes but I still don’t see how it could be worth $73 as the market implies. A pure growth stock. I do not see fundamentals supporting it at all.

DCF Calculation:$4

Graham Formula Calculation: $10.19 (even with a 20% growth rate!)

EPV: $17.76

6. Transcend Services (TRCR)

Provides medical transcription services to the healthcare industry.

• FCF fluctuating. No growth.
• Not a consistent performer
• Past 4 years has seen dramatic growth

DCF Calculation:$12.20

Graham Formula Calculation: $10.33

EPV: $7.26

7. Rackspace Hosting (RAX)

Business of hosting and cloud computing.

Maybe I should switch my value investing blog to Rackspace.. hmm

• IPO’d last year
• Huge growth in customers, especially in the cloud computing area
• Another big growth stock in a growing industry/sector
• Not enough history and results to offer any reliable valuations

8. NVE (NVEC)

Develops and sells devices that use spintronics, a nanotechnology that relies on electron spin rather than electron charge to acquire, store and transmit information.

• Small company so the growth has been huge. Organically fast growing company.
• FCF growth huge
• CROIC is excellent as well
• Tangible shareholders equity has been increasing at an incredible rate
• Margins increasing at impressive rate

DCF Calculation:$37.45

Graham Formula Calculation: $24.67

EPV: $23.66

9. American Public Education (APEI)

Provider of online postsecondary education directed at the needs of the military and public service communities.

• Short history to conclude but past 2 years has seen big improvements
• Big FCF growth past 2-3 years
• Tangible shareholders equity increasing
• Issued lots of stock in 2007
• No long term debt
• Growing cash position
• Big increase in margins

DCF Calculation:$15.55

Graham Formula Calculation: In the $7-8 range

EPV: $17.49

10. American Science & Engineering (ASEI)

Develops, manufactures, markets, and sells X-ray inspection and other detection solutions for homeland security and other targeted markets.

• Growing cash balance
• Strong fundamental numbers
• FCF growth excellent at 33%
• CROIC is 13%
• Conversion from Sales to FCF is at 12%
• Cash from operations growth shows big increases
• Seems to be cyclical every 3 years

DCF Calculation:$62.49

Graham Formula Calculation: $70.01

EPV: $56

Summary

The first 10 companies all fall into the growth stock category. As a value investor, I wouldn’t be placing any bets with these companies just yet. Some look to be selling for much too high a premium.

I do like ASEI as it looks to have a solid balance sheet and is able to convert its top line to the bottom.

Look out for the next set of Forbes Best Small Companies.

Disclosure

No positions in any stocks mentioned.

You may also be interested in:

1. Stock Investments From Forbes 400 Best Big Companies
2. Forbes Best Small Companies: Part 4
3. Forbes 200 Best Small Companies Project

Insmed Inc continues to be a Benjamin Graham Net Net stock. As I mentioned in my October portfolio update, I was waiting for the quarterly results to be released before I took further action.

INSM Still a Net Net Stock

After a full quarter, INSM still remains as a net net selling below liquidation prices despite the market run up during October.

My initial cost basis of Insmed was at $0.86 based on a liquidation value of $0.91 at the time and now with prices in the mid 70c range, a look at the financial statements will provide a good indication of whether it will be worthwhile to double down on my existing small position or just hold onto it until more information breaks out.

Q3 Recent Developments

In my initial stock analysis of INSM, I stated my concern the company may easily burn through its cash received from the sale of its follow-on biologics (FOB) to Merck. I’ll get to the detailed numbers in later.

On the conference call, there was no Q&A session but a lot of the topics that people would have obviously asked were addressed. The most interesting point to note was that the board mentioned a merger or reverse merger.

This is something more similar to the impression I received in my initial analysis. INSM is basically running like a shell company. Lots of cash, a single product but no way to leverage it to its potential in its current state.

Since the company is looking to increase “shareholder value” a buyout is unlikely as current prices does not offer much shareholder value at all. It also seems like the board is more interested in continuing the operations of the company in some form or other.

I could endlessly continue speculating whether the company will merge or sell itself but that isn’t what’s important. Analyzing the financial statements to determine whether I can maintain my position is more important. The undergoing strategic review and results will come, it’s just a matter of time.

INSM Financial Statement Analysis

Since INSM has changed dramatically since one year ago, it’s pointless to compare with the previous years. Right now, the focus has to be on quarter versus quarter.

Income Statement Analysis

(Click for larger version)

• Since the company’s only product, IPLEX, is being conserved for existing ALS patients, revenues decreased.
• SG&A is still fairly high due to the legal fees but due to external finance, legal and consulting services with the ongoing strategic review.
• Lower R&D expense now that FOB has gone to Merck.
• Interest income would be a low earnings quality in a normal company but for INSM, consistent interest income is a must. Increase is good.

Balance Sheet Analysis

• While accounts receivables and prepaid expenses went up, the big increase in percentage is because the numbers are fairly small so any small change will seem big. Compare this to the amount of decrease in liabilities.
• Overall, liabilities decreased 22% compared to the previous quarter so the current management has been doing a good job.
• Accoutns payable is down 18%
• Payroll liabilities down 59% now that there are only 15 full time employees
• Big reduction of income taxes. Probably due to the lack of revenue from now on.

Cash Flow Statement Analysis

When looking at the cash flow statement, keep in mind that the numbers are for the past 6months and 9months total cash flows. These numbers are not stated value except for certain items.

• No warning signs in the cash flow statement. The cash burn seems to be steady at around $1m per quarter. i.e. at this rate, the company can basically keep the company going as it is for the next 110 quarters, which is 27 years. But that’s just a hypothetical number. Either way, I know INSM can stick around for a long time without going bankrupt.
• The only reason why the cash at the end of period is reduced is because the company purchased more short term investments. As long as they are safe investments, I’m fine with it.

INSM Stock Price Calculation

INSM’s current stock price is still below net net working capital by a decent amount. I still believe it to be very undervalued.

There is no point in running the discounted cash flow spreadsheet because I have to view INSM as a quarter by quarter basis. No reason to try and project cash flows. The same reason goes for the Benjamin Graham spreadsheet.

However, I can use an EPV valuation because the valuation technique looks at a snapshot of the company’s value at a specific given time.

(Click to enlarge)

With a quick earnings power value, the value comes out to $1.40.

Considering all the numbers and the current situation of the company, I was quite glad that the company is operating better than I expected. While the company is losing money, it is being offset by reductions in expenses as the business continues to wind down. While a buyout isn’t as likely, any good news, however small, should send INSM back to shareholder value recovery.

The current valuation is very cheap compared to even the worst distressed situation so there is plenty of margin of safety.

INSM is still a small part of my portfolio but I doubled my position after earnings and am considering building a larger position.

Disclosure

I own shares at the time of writing.

You may also be interested in:

1. Graham Net Net Stock Insmed Inc (INSM)
2. Stock Research and Analysis: Mastech Holdings (MHH) Part 2
3. SYY: Stock Analysis for Dividend Growth Portfolio

I’ve been hearing a lot about Buffett’s purchase of BNI.

Whether the choice of a partial stock deal means that Buffett considers Berkshire shares to be overvalued, or whether Buffett is going “all in” in American stocks and commodities, or is he just making a last hurrah of asset allocation before retiring? Maybe he is simply bearish on the entire economy.

Whatever the reason, it will be easier to just wait until Buffett says something.

In the meantime, let’s take a look at whether Buffett is getting a good deal on BNI or paying a reasonable price.

Back in August as I went through each of Warren Buffett’s stock picks in the Berkshire portfolio, I posted the following on BNI.

Burlington Northern Santa Fe (BNI) Stock Value

Burlington Northern Santa Fe is a holding company and engaged primarily in the freight rail transportation business.

• Impressive FCF growth previous 4 years and especially last year
• High capex but latest annual result was extraordinary
• lower sales and margins but improved efficiency in returns and turnover
• CROIC is on the low side at 3%
• Top line growth is also above average at 14%
• Debt to equity ratio is above 200% which isn’t uncommon for capex heavy companies

I came to the conclusion that the intrinsic value of BNI was $80-$140.

When I first calculated the intrinsic value of BNI, I chose to be conservative and reduced the latest year FCF by a significant amount as it was just too good compared to previous years. Not knowing about the details of BNI, I just left it at that and concluded that the intrinsic value had been reached at $87.

If I now go back to the intrinsic value calculator and leave the FCF number as is with a default 11.6% growth rate and 9% discount rate, the stock price calculation shows the following:

DCF Intrinsic Value: $104.30

Benjamin Graham Value: $102.67

From these numbers I can conclude that

• Buffett is either paying a small premium to the intrinsic value of $87. About 15% and not the 25-30% people are led to believe based on the closing date price of the announcement.
• or Buffett is paying a fair price for a company that will generate future cash for Berkshire Hathaway.

Typical Old School Buffett

Whatever the reason for the purchase, one thing is clear. The purchase of BNI wasn’t a cheap one. But like his investment in See’s, it could turn out to be  one of his best ideas. He didn’t overpay by too much so the margin of safety should still be there.

Price is what you pay, value is what you get. - Buffett

Disclosure

No holding

You may also be interested in:

1. Warren Buffett Stock Picks: Eaton (ETN)
2. Warren Buffett Stock Picks: Part 4
3. Book review: Warren Buffett Speaks

Old School Value Stock Portfolio Performance

October 2009: S&P -1.98%

October 2009: OSV 10.18%

October was certainly an eventful month, but overall, I am happy that I did not lose money.

Rule #1: Never lose money

Rule #2: Never forget rule #1

With the crazy run up in the market it’s easy to believe making money in the stock market is easy, but at least the end of the month reminded us to keep emotions in check and to be brutally cold and emotionless when dealing with Mr Market.

Portfolio Performance

I was up over 30% for the month as the DOW flirted around with 10,000 but ended October at 10.18% with the S&P500 finishing October at -1.98%.

But honestly, enough of the 10,000 mark nonsense. It’s all I hear on the radio and the news.

Portfolio Movers

Strong performers included all 4 of my radio stocks but the value of these companies are getting closer and closer to intrinsic value lately.

I missed out on my opportunity to sell SALM in the $4’s as I had no internet access for over a week and just couldn’t keep up.

Insmed (INSM) is now down about 19% from my average buy price which means that it is even cheaper compared to it’s net net value.

When I made my purchase, it was at a 13% discount to net net working capital. So with the price in the low 70c range, INSM is becoming a truly cheap stock when comparing it to the value of the balance sheet.

Nevertheless, the risk is that I still do not fully understand  everything about the drug and business, and as much as I am tempted to add a little more, I’ll stick it out for a little longer until I get some new info on the balance sheet and cash flow statement and what the company plans to do with the cash when the quarterly results come out on Nov 6.

Mastech Holdings (MHH) released earnings Oct 28 followed by a 20% drop during the day. You can find out more about the value stock proposition of MHH and the updated 2009 Q3 discussion.

Portfolio Trades

1. Bought Insmed (INSM) @ $0.86

I wrote about it previously because INSM is a cheap value stock and also a pure Benjamin Graham net net stock after running it through the spreadsheet.

2. Sold iGo Inc (IGOI) @ $1.25 for a 127.27% gain.

I mentioned in the forum that I was planning to sell.

If I feel the company is improving its business, I usually hold but in this volatile and range bound market, I believe selling the stock at intrinsic value is the correct choice.

3. Bought DryClean USA (DCU) @ $1.00

After reading up on DCU I came to the conclusion that DCU is another boring business selling commercial drycleaning machines.

I’ll write up an analysis in the near future after I complete building up my position.

Check out a quick discussion on DCU.

4. Bought Emmis Communications (EMMS) @ $0.90.

Missed out on buying EMMS in the $0.60 range buy a few cents. The following day it shot up 50%.

EMMS is now 4th radio stock but recent news have come out that they are close to losing their radio licences in Hungary.

With the Hungary station making about 6-10% of revenues , this does affect the business and I will now have to make a decision as to whether I will sell or hold.

On October 28, 2009, the Hungarian National Radio and Television Board (the “ORTT”) announced that it was awarding to another bidder the national radio license currently held by our majority-owned subsidiary, Slager Radio Co. PLtd. (”Slager”). We believe the award of the license to the other bidder violates, among other things, the ORTT’s own national radio license tender rules, the Hungarian Media Law and European Commission Treaty to which Hungary became a party in 2004, and are vigorously exploring avenues for having the award set aside, including but not limited to litigation in Hungary and in the European Union. If the award remains in effect, Slager would be required to cease to broadcast effective November 19, 2009.

5. Sold Atwood Oceanics (ATW) @ $39.10 for a 2.15% gain

Sold ATW according to my intrinsic value. I’ve held ATW for over 2 years and it recovered extremely well throughout the past 6-7 months.

I was up 50% when oil was in the $100 range but that was during my early days of investing and I just didn’t have the discipline to sell.

6. Bought MHH @ $4.60

Doubled my MHH position after earnings during the drop. Now my 2nd biggest holding.

7. Cash is at about 23% so I have money available to buy more of my best ideas or new ideas.

Disclosure

I hold all stocks mentioned except sold positions.

You may also be interested in:

1. Portfolio Update Sep 2009
2. Portfolio Update August 2009
3. Portfolio Update July 2009