Arohan’s investing life

This of course is not a new revelation. However, many readers and investors do not grasp the amount of risk that may be present in smaller companies. A big part of this risk may be just volatility due to illiquid nature of stock, but there are some other more basic risks that an investor needs to be cognizant of when investing in this asset class

To illustrate the points that I am making in this article, I will take an example of two stocks that the readers of this blog are already familiar with. Both these stocks have been discussed here in the past

Syntax-Brillian (BRLC)

This is a major egg on the blog author’s face. However, the case study on this company is worth reviewing to learn where we went wrong.

The rationale for investing in this company was many fold. Syntax-Brillian makes excellent quality HD LCD tvs (brand name Olevia) and sells it at a value price while maintaining great margins due to its optimized supply chain. The market for LCD TVs is growing and the future of the sector looks bright due to a potential for substantial increase in demand in the US due to forced HD conversion in 2009 as well as increased demand in China due to the upcoming olympics. Both markets where Syntax-Brillian is a significant player. The stock was trading at 10-11 PE when it was purchased and had just finished the year with triple digit revenue increases (YOY) and was on the verge of announcing two large big box retailers in US. So what could go wrong???

Well, plenty did go wrong. I would not dwell on BRLC’s history of missing projections to the street (after all if the stock is undervalued and still showing extremely high growth in business, why worry if the analysts estimates are missed. The stock price has to catch up to the potential, right!). No, the problem with the company was (is) really basic. It is in the execution and financial controls

Anyone who has owned a small, fast growing business, or for that matter worked in such business understands that growth requires working capital. If a company plans to grow (as an example) by 50% next year and sports 3-5% net profit margins, not enough cash is generated today to finance the growth for tomorrow. The shortfall needs to be made up by external financing (working capital)

Syntax-Brillian was constantly in need for financing to support its growth. The situation was made worse by the significant amount of business it did in China, where apparently the payment terms of 120 days is common place. This means that the product sold in China did not actually result in cash inflow until 120 days later. Meanwhile the company still has to pay its employees, its vendors (who are typically on a shorter payment term), etc.

And as the sales grew, the cash flow gap became wider and wider and recently it became so acute that one of the institution (Silverpoint)  funding Syntax-Brillian started the process to rein the company in by tightening the controls and increasing the cost of financing. The company, now it appear, has to review its finances on a weekly basis with its lenders and a lot of business planning discretion now no longer rests with the company executives

Ah, the pitfalls of debt financing!

It is not as if Syntax-Brillian did not try equity financing. Over the last 2 years, the equity holders were diluted numerous times to a total of greater than 50% dilution. A part of the stock price decline IS due to the dilutive effect of incremental equity sales.

In short, the company and the stock has been killed by extreme growth (I say killed, but the company is still solvent, although the future looks difficult)!

Generally a growing company picks a growth rate that is sustainable and can be funded either organically or even externally if the company is able to manage its fundamental ratios. But a steady and manageable growth rate did  not appear to be what the company was after as it raced to gain market share as the olympics and the forced HD conversion in US draw closer

There are only two outcomes that can be positive for a company in this situation. Slow the growth down and steady the ship, or, become a thorn in an incumbents boots so much that one of them choses to acquire the company. Sadly, enough shareholder value has already been destroyed before any of these possibilities can come to fruition

Growth at a reasonable price (GARP) is not enough. What we need is Sustainable Growth at a Reasonable Price (S-GARP)

I have exited this name with substantial losses

WSI Industries (WSCI)

This is a company in the metal service industry that we have discussed a few times in the past on this blog. As was reported earlier, the company had announced a significant increase in future business due to new customer acquisition. Subsequent to that, the company reported its quarterly earnings that bettered the estimates and more importantly, showed that the new customer has already started to become accretive to its earnings. The stock responded appropriately, jumping as high as $11s and finally settling down in the $8 range. This stock was purchased in $4-$5 range so there is a good capital appreciation already on my books. I am holding on to the investment for the time being

The important lesson from this is, when investing in micro/small cap companies, one needs to keep a close eye on the investments. The best rewards come to those who hold long term but it is also necessary to monitor the company’s business performance for signs of weakness and act accordingly

PS: Sorry for the brief unintended hiatus from posting! Sometimes life interrupts without warning! 

Economists are generally an optimistic bunch. A lot of them would not speak the R word unless it is staring them in the face. The Institute of Supply Management (ISM) service sector report shows a drop in business activity, first such drop in nearly 5 years. This has caused some economists to finally agree that Recession may already be here.

On this site we insisted that the recession is already here, even though it may be in pockets, in an earlier article.

Wasn’t this also the message the feds were sending when they aggressively started cutting the interest rates. The message was, as I saw it, that recession was now a bigger threat to the economy than, say, inflation

Recessionary cycles are normally self correcting, the only question remains how quickly will the economy turn. Since this time around the genesis appears to be in the credit markets, it is logical (and indeed happening now) that the credit will become scarce for most except the most credit worthy businesses.

These are the times when the mind wanders in the direction of asset preservation rather than growth. Nothing wrong with that.But remember, Toyota continued to grow as a company throughout the decades that Japan has been in its extended recession

What should an investor do in recessionary times?

First of all, if you are a patient value investor with a long time horizon, the best advice is to wait it out (or rather be opportunistic and add to your holdings). Here I assume that you do not depend on your portfolio for your living expenses

If you are a short term speculator (technical traders), than you need to be careful as the volatility trends that you may have come to rely on may not work as well. Bankruptcies, sudden changes in fortune, etc are singular events which can distort any system that you may be employing.

For most though, it may be wise to evaluate what companies you may want to remain invested in. Besides looking for undervalued securities, you should look for companies with the following characteristics

• Cash flow generating companies with highly rated debt. These companies have flexibility to manage their operations and cash  based on the economic environment
• Cash rich companies
• Companies with a diversified product portfolio, that includes what may be necessities for most people to live on
• Companies that are geographically diverse
• And strong companies in weak sectors, where new market share can be gained

These are the kind of businesses that will not only survive recession but can come out stronger

Additionally, you may wish to look for a good dividend yield, which you should promptly reinvest. Most brokers now offer free dividend reinvestment so this should not be a problem. One of the benefits of this recession is that the low taxes on dividends in US are more likely to continue

Many of the established consumer staples and  pharmaceutical companies qualify according to these guidelines. My favorite in this sector is Johnson and Johnson (JNJ)

Some financials also qualify. Bank of America (BAC) is my favorite

There are two other types of companies that can do well but may be for a slightly more adventurous investor.

1. Companies that make their profits preying on weak and restructuring them. Leucadia National (LUK) is one. American Capital Strategies (ACAS) is another one with a very attractive and increasing dividend yield to boot
2. Companies that make money insuring risk. Markel (MKL) is one speciality insurer I really like, if only because they have excellent investment credentials in addition to a top notch underwriting team

Added benefit is that all these companies currently trade at an attractive valuation.

I will be interested to know what you think and what steps you are taking (if any) as we settle into this winter of recession

Believe it or not, the best way to buy Bank of America today may be to buy Countrywide Financial

Bank of America’s previously announced deal to buy Countrywide was a stock deal. For every share of Countrywide stock, the holder will receive 0.1822 shares of Bank of America stock when the deal closes. The deal is expected to close in 3rd quarter of this year.

As of the time of this writing, BAC was trading at $44.14 per share and CFC was trading at $6.83 per share. 0.1822 shares of BAC represents a value assigned to CFC by BAC of $8.04 per share at these prices. Countrywide stock is therefore trading at a 15% discount to the acquisition price. In the past week the stock has traded as much as 25% below the price offered by BAC

What this means is that an investor buying Countrywide stock today can expect atleast 18% appreciation by Q3 IF the stock price of Bank of America stays at $44.14

Here are two points worth noting:

1. If you believe as I do that Bank of America is undervalued today, you can expect that the Bank of America stock will actually appreciate quite a bit by the time this deal closes
2. If you decide to purchase Countrywide stock today, Countrywide will pay you 9.5% dividend (annualized) for you to wait until the deal closes. Buying Bank of America stock today directly will only give you a 6.1% annual yield

That being said, there are certain risks involved. Countrywide can actually cut or eliminate their dividend in the interim. This is likely but even if this happens the discount on offer today is simply too attractive.

The bigger risk of course is that Bank of America may decide to pull out of the deal. Apparently this is what many in the market are afraid of and that is why this discount exists. However, Ken Lewis (BAC CEO) has reiterated that there is no question of BAC pulling out. Truthfully, since BAC is hitting the deposits cap in US, this acquisition is probably one of the few ways the bank can continue its growth domestically. Bank of America has also coveted Countrywide franchise for a long time and it is not likely to just give it up

The rate cuts of the last two weeks also work to make the Countrywide asset quality a little less risky and will function as a trigger to bring the mortgage buyers back in the market. I believe that the deal just became less risky for Bank of America with the rate cuts

There are many ways to play this discount. One is to arbitrage on the  pricing gap by selling short the BAC stock and buying CFC. This is apparently a riskless way to capture the spread assuming the deal will close as it is immune to how the BAC stock price performs. Another variation would be to use options to get the same result. I however am of the opinion that the BAC stock is keepers for the long term (and also I tend to be a long-only investor) and therefore would like to keep it simple and just buy CFC at current prices, let it convert to BAC stock and let it ride

At the first blush it appears that as goes the US economy, so goes the world market. If the hiccups in the US economy can have such an effect on the markets elsewhere, than it would appear that the markets are now highly correlated. Does this mean that there is no value in diversifying internationally?

I would say that is not true. What we are seeing is how the markets act on a daily basis. True, that over a short horizon, the markets may be correlated. After all, we now live in a global economy where many companies are traded on exchanges in many different countries. However, over a longer term, each market performs based on its own fundamentals. Many emerging economies are growing today based on the fundamental changes in the business processes and political environment. Unless there is a drastic change in these, which I do not see happening any time soon, these markets will continue to do well

At the same time, do not write off the US economy. There have been countless such cycles in the past. It is true that the baby boom factor may not be present anymore, but the US economy is now driven by innovation, risk taking, and generally sound economic principles. These are still here (although one may question the soundness of economic principles involved in the subprime situation, but that is just a small component of the economy, it will probably do some damage in the short term but it will soon pass)

Regardless of the macro-economic picture, the basic value investing credo of finding value at a cheap price has stood the test of time and will likely continue to yield market beating results over a long investing horizons

I own businesses in the metal working sector and I believe that this sector is overdue for some structural changes. Metal working (I include machining, fabrication, sales and brokerage and scrap recyclers as part of metal working sector) is a fragmented industry in North America with many small players sprinkled all across the map. It is interesting to take a look at one example: The Purchasing.com top 100 Metal services companies. The list includes the top ranked company Ryerson with about $6 B in annual sales, to the 100th ranked company with about $26 million in annual sales. There is a wide gulf between the largest and the smallest companies with very few companies with sales > $1B. There are maybe another few thousand small companies that are not represented on this list. The basic themes that run across this industry are:

1. Small shops with customers concentrated in one or two industries
2. Limited geographic reach
3. Heavy reliance on repeat business from existing customers
4. Metal working businesses serving some sectors, such as automotive clients, have generally seen their margins thin over the years due to relentless cost cutting pressures
5. Most of the businesses are privately held

The larger and mid-sized companies in this sector have a different problem: most of them manage several thousand customer accounts. This fragmentation in customer accounts becomes difficult to manage

An ideal and efficient company in this sector would be one that has several hundred large customer accounts that are diversified across different industries with multiple locations (so they can optimize inventory, capacity utilization, shipping and logistics across the network).

The industry is ripe for consolidation but most of all it also needs to restructure its customer base and geographic profile

From an economic perspective, a lot of value is currently being created on the raw material side (mining and mills). There is a large and increasing demand at the finished product side due to the growth in the emerging markets (as well as future domestic demand as the US infrastructure starts its upgrade cycle). The metal working/service industry sits right in the middle and will see a lot of value being created here in the next decade or so if the right restructuring and consolidation takes place

And the valuation of the companies in this industry is shockingly low. Most private companies can be purchased for a valuation of about 3 times EBITDA or about 0.2 to 0.4 times sales. Even some of the public companies like Reliance Steel and Aluminum (which has a metal service business) can be had for about 0.5 times sales. Of course, like any other industry, you do have some companies that are richly valued and we tend to stay away from them.

Finding good solid companies in this industry and taking a position in them should produce excellent returns over the next 10 years

In the next few posts, I will highlight a few of these companies that I am finding worthy of investment today. So stay tuned …