Marketdepth

My 1970's Equity Screen

Born in the 1960’s, my personal memories of the 1970’s inflation depend more on a few keepsakes than on direct experience.  In a dusty photograph album I have a picture of my then shaggy-haired father holding an ice cream in front of a Kelowna bank window which had been painted to highlight a savings account rate of 8 ½%.  In a box of old papers, my wife and I recently found a cardboard slide-rule that a Vancouver Island credit union handed out as a freebie to aid their borrowers in calculating monthly mortgage payments.  The bottom end of the slide-rule showed payments for 6% mortgage rates and the top end went as far as 15%.  On the back, in small font, a date is printed – 1974.

It is hard to say which is more outdated these days, the cardboard “calculator” (although the circular one shown below is still available by mail order) or the notion that 6% represents some kind of lower-bound interest rate for home loans.  Here at Marketdepth, if offered a choice of which of these two 1970’s throwbacks has a chance on returning to a bank near you, our money is most solidly on the side of the higher interest rates.

 

Figure 1:  An obsolete calculator, but the rates may return.

 

 

That the inflation and the higher rates will arrive eventually, appears a certainty.  Now that the buzz of a 20-year credit boom is wearing off, we are slowly awakening to the realization that debts pretty much everywhere have been accumulated far beyond sustainable levels.  The option of tightening our belts for years, maybe decades, in order to pay back massive obligations is not viable.  The real solution has to be that a major portion of the big economies’ debts are repaid with diluted currency created from thin air.

 

Cracks in the edifice of monetary discipline are already appearing.  Will it be Greece, or Spain, or perhaps even America, where we shall first encounter an angry mob, united in a chant led by some Palin-esque figure, “Print, baby, print!”

 

What Likes Inflation?

 

It is getting late in the day to start positioning oneself to take advantage of the near term deflationary crush – the one which will announce the return of recession and the futility of stimulus, Version 1.0.  That was last term’s homework (we handed in our assignments here, here and here).   But when the headlines get ugly, and we find markets approaching or even breaking the 2009 lows, we need to be ready to ditch the deflation-leveraged positions.  It may take the central bankers and their political masters some time to figure out how to speed up the printing presses, but money will flow.  At that point, when vast quantities of cash start seeking real assets, we will need to own inflation-loving positions.  But what likes inflation?

 

The go-to position is always gold.  Gold works in an inflationary environment for two reasons.  First, precious metals are not interest-rate sensitive.  Unlike houses these days, gold is not priced based on its monthly carrying cost based on a 5% down-payment.  Second, precious metals do not get diluted by money printing.  Create more paper currency and an ounce of gold is still an ounce of gold.  The only thing that changes in such circumstances is that there are more available dollars for each gold ounce…and the price of gold rises accordingly.

 

But, depending on how delicately the printing press operation can be managed, gold may not be the only thing that works.  Other inflationary cycles have had numerous strong performers.  If, instead of a crash and Weimar scenario, we instead get a relatively gentle inflation following a slow and grinding equity market decline, it may make sense to think about buying stocks.  In such an environment, I would prefer unlevered stocks which have significant inventories.  Better still if they were to be undervalued, and have business assets of unquestioned future utility.

A few thoughts on business inventories.  In my studies of 1970’s markets, one finds fairly frequent references to the role of inventory adjustments in driving corporate earnings through the 1970’s.  One 1978 study by American economist Walter Varvel  noted that in 1974 more than 31% of the reported profits of the largest 600 American non-financial companies came from upward inventory re-valuation.

 

In the same way that short term bonds are better investments during inflationary periods than long bonds, current assets like inventory are better than fixed assets.  Fixed assets need to be valued against long-term discounted cash flows, and the hefty discount rates applied in inflationary periods tend to reduce multiples on these assets.  Inventories, on the other hand, need only be valued off what people are willing to pay for something right now.  Double the cash in my pocket and the price of a chocolate bar doubles (or maybe triples if I hear that chocolate bars are being hoarded).

 

Screening for Stocks – 70’s Style

 

With the above points in mind, I screened North American exchanges for stocks with low debt (less than 10% of capital) and relatively low EV/Assets.  Recall that we are expecting a lot of economic volatility in the short run, so we ignore such transitory statistics like earnings and yields.

  

The screen generated 500 stocks above $100 million market cap meeting the balance sheet and asset price criteria.  I then picked through the cheaper third, looking for companies possessing large quantities of useful inventories.  To be frank, the list doesn’t yet show bargains similar to lists we might have generated in Q4 2008 or early 2009, but then again, we are only starting our homework.

 

 

Figure 2:  Screen Output: Inflation-Loving Stocks

Company	Industry	Ticker	Market Cap	EV/Sales	EV/Assets
Core-Mark Holding	Grocery Wholesale	US: CORE	$306M	0.04	0.4
Ridley Inc	Agriculture – Feed	CN: RCL	$112M	0.2	0.5
Aceto Corp	Specialty Chemical Distribution	US: ACET	$170M	0.4	0.6
Seaboard Corp	Meat Production & Distribution	US:SEB	$1.9B	0.4	0.7
MGP Ingredients	Ingredients (Distillery focus)	US:MGPI	$124M	0.5	1.1

 

 

Heading the list of interesting ideas is Core-Mark Holding (NASDAQ: CORE), a San Francisco-based wholesaler to smaller convenience, grocery and liquor stores.  This company’s $300 million market capitalization is nearly completely accounted for by its net working capital, which includes $275 million of packaged goods inventory.  Why hoard cans of sardines in a storage locker when you can achieve the same end (and attract fewer stray cats) through owning shares of Core-Mark?

 

Another interesting potential inflation-beater may well be Winnipeg-based Ridley Inc (TSX:RCL), one of the larger cattle feed businesses on the prairies.  With approximately half of its $100 million market capitalization accounted for by grain inventories, Ridley seems a fairly solid bet to hold its own in a high inflation scenario.

 

Aceto Corp (NASDAQ: ACET) is a distributor of specialty chemicals, pharmaceuticals and crop protection products.  It jumped off the screen to me because its net working capital of $120 million at the end of last quarter was quite close to its market cap of $150 million.  It is certainly worth understanding more about the end markets that Aceto plays in, but this is another one that seems to merit further consideration.

 

Seaboard Corporation (AMEX:SEB) is a hog producer, processor and distributor based in Shawnee Mission, Kansas.  In addition to its classic hog production business, it also has a trading division and operates a transportation network including a small merchant marine fleet.  Net working capital approaches $1 Billion and EV/Assets is an attractive 0.7X, with few intangible assets.

 

The last of the five that caught my interest is MGP Ingredients (NASDAQ: MGPI), another Kansas company.  It processes grains and corn products into food ingredients, mostly for use in distilleries.  Hubris and levered balance sheet expansion of a couple of years ago has apparently been brought under some control.  Inventory is a somewhat smaller factor of late but has been a significant part of the value equation in prior years.

A cracking credit market can deliver wicked deflationary shocks such as we witnessed last year.  But the bigger, long-term picture screams inflation.  Looking back to the 1970’s, we might consider a variety of inflation-protective assets in our continuing struggle to earn real returns.  This handful of stocks may be a good starting point for positioning if a gentle inflation period arrives.

EV-to-Assets: Investment Yardstick of Today's Hedgehog

“The fox knows many things, but the hedgehog knows

one big thing.”  Archilochus (7th century BC)

 

Over the centuries, many¹ have dwelled upon this observation on foxes and hedgehogs by the Greek poet, Archilochus.  As he didn’t write much more on the subject, we can only infer his meaning.  The fox, blessed with cleverness, knows a thousand ways to stalk his prey.  Yet, somehow, the much duller hedgehog survives in abundance.  Disadvantaged in a battle of wits, a hedgehog knows one big thing – no fox wants a mouthful of quills.

 

The field of investing is populated by a variety of hedgehogs and foxes.  The foxes know all about next quarter’s earnings projections, about product trends and developments, and they know who is buying or selling which company, and why.  The hedgehogs of investing, while they generally perform due diligence of some sort, tend to rely on one basic insight – investments acquired at low prices tend to result in superior returns.

 

 

Figure 1.  A Hedgehog Knows One Big Thing – Price Matters

 

 

 

The life of the investing hedgehog, also known as a value investor, sounds simple.  But there is a catch.  What constitutes a low price?  This is a critical question.

 

In recent times, identifying a low priced business has meant finding a stable or growing company which is priced to offer a relatively high current earnings yield.  As a screen, one would start with something simple like P/E ratios or EV/EBITDA and inspect good candidates in greater detail.  The deep value player may have sought out companies with temporarily depressed earnings resulting from a transitory crisis, but in effect he was looking for the same thing.

 

From the market depths of 1982 until the heights of 2007, such high yielding investments generally benefited from a triple play.  The low-rated business, if carefully selected, got marked up on par with other comparable companies.  At the same time earnings tended to be higher than expected due to a buoyant economy.  And, as a bonus, the markets got used to the good news and continued to expand trading multiples.

 

EV-to-Assets

 

Some things have changed of late.  I would argue that the most interesting days for yield investing may be behind us, possibly for several years.  Perhaps more interesting to the contemporary hedgehog investor are business assets that trade substantially below cost.  Book value is a useful flag in this regard, but the best simple identifier may well be the little used metric Enterprise Value-to-Assets.

 

One of the most important reasons to start screening on assets, is that earnings just aren’t what they used to be.  In the long run, every cost may be variable, but most businesses today are somewhat behind the curve.  Revenue is coming in below expectations while costs such as debt-service, rent and salaries are showing themselves to be rather stubbornly fixed.  If we are in a deep protracted recession, similar to what Japan experienced in the wake of its 1989-90 bubble burst, then we may find ourselves continually disappointed by earnings.  Assets, on the other hand, tend to be more enduring.  And while cash burn can whittle down even our estimate of value on the margin, assets are generally a more stable basis on which to anchor an understanding of corporate worth.

 

The second reason to look at assets is because, frankly, the crowd around the businesses which are still generating solid cash flows appears a little too big and much too enthusiastic.  Consumer staples players like Wal-Mart, McDonald’s and Shoppers Drug Mart have continued in profitability through the downturn and remain trading in line with recent normal multiples of 13-17X earnings.  There are no “Sell” reports written on Wal-Mart.  However, measured by assets, the go-to consumer names look a little expensive. EV/Assets for these companies is in the range of 1.5 to 3.0X. 

 

Just as a point of comparison, in my May 11 post, one of the highlighted companies was Cray Computer, whose claim to fame is making the fastest computer in the world.  Cray has some issues, not the least of which has been a lack of steady profits.  However, in early May, Cray was trading at 0.14X EV/Assets.  Capital invested in Wal-Mart assets might throw off higher returns, but 10X higher?  I wonder.

 

EV/Assets is also a more inclusive way of looking at investing in a company from a capital structure point of view.  By adding debt to market cap and netting out cash, we are really using the market value of the company’s capital as our numerator.  Levered or unlevered, are the assets priced below replacement cost?  If bankruptcy looks to be a high possibility and we are afraid to hold the equity, we at least have a measure that addresses the value of the total capital structure and helps us think about whether buying the debt at face value is an attractive proposition.

 

Like any ratio, EV/Assets is not perfect.  For one thing, it would be handier if we were able to add the market-priced debt to market priced equity.  (Mr.Bloomberg, please do something about this!)  Asset value also needs some serious qualifying.  Intangible assets have a nasty habit of evaporating, while fixed assets can turn out to be stranded worse than a beached whale at low tide.  Deficiencies acknowledged, but this ratio may be the best measure of price available to us in today’s market.

 

 

Every Hedgehog’s Dream

 

As a final, but not unimportant consideration, EV/Assets may be of some use to investors in times of extraordinary inflation.  I’m not really talking about 9% inflation here, but more in the order of the big numbers that we have seen before in Argentina, Mexico, Russia and Germany at various times, that were the result of systemic financial stress.  In these crisis moments, profits could just disappear across the board and asset ratios will be our best guide. 

 

Now, despite all the hyperbole about government debt of late, I doubt that we will see hyper-inflation in the G-7 soon.  This recession just hasn’t been as deep as the recessions preceding those other crises were.  Even if it does happen, I expect that owning precious metals might prove to be a better holding going into such a crisis than any stock or bond.  However, from the climax of such a crisis, and we will be very aware of the climax should it arrive, EV/Assets might just be a very useful number to be on top of.  Good businesses going begging at pennies on inflation-adjusted assets?  Every hedgehog’s dream might one day arrive.  There’s no harm in being mentally prepared.

 

Note

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1. A more well-know treatise on the subject of hedgehogs and foxes is Isaiah Berlin's excellent essay on Tolstoy.

The Vancouver Value Investor's 100 Mile Diet

Value investors and die-hard environmentalists may not have many things in common, but perhaps one common thread they share is a tendency to go with what they know.  I was thinking the other day about the newly trendy “100 mile diet” and how its key principles may apply (at a fundamental level) to the investing world.  Consider the following excerpt from the website promoting the popular diet book by Alisa Smith and J.B. McKinnon:

 

Buying food today is complicated. What pesticides were used? Is that corn genetically modified? Was that chicken free range or did it grow up in a box? People who eat locally find it easier to get answers. Many build relationships with farmers whom they trust. And when in doubt, they can drive out to the farms and see for themselves.

 

Substitute “accounting assumptions” for “pesticides”, and “executives” for “farmers” and the underlying similarities become more clear.  The 100 mile diet is only the culinary expression of sound investing due diligence.

 

 

Figure 1:  Digging for Value on the West Coast

  Digging for Clams by Martin Driscoll (www.martindriscoll.com)

 

I decided to play this theme in digging for investment ideas slightly closer to home than Japan and Massachusetts.  Starting with a simple area code screen, I pulled data which yielded 476 public companies from British Columbia with a market capitalization of more than $5 Million as well as 94 public companies from Washington state above that threshhold.  It’s not often that we so thoroughly trounce our neighbouring state in a form of business activity, but the legacy of Vancouver as an – ahem – centre of innovative finance, leaves its mark in the sheer magnitude of our company listings.

 

As an aside, the situation is not as one-sided when one takes aggregate market capitalization into account.  The total value of those 476 BC public companies is only about a third of those in Washington state, and even after taking out Microsoft from the pile, the greater value is still south of the border.

 

 

Screen #1 Cheap Assets of the West Coast

 

Screening for cheap assets, I created a factor to combine Price-to-Book and Enterprise Value to Total Assets.  At least in accounting terms, this ought to highlight any undervalued assets.  From this list, I also excluded companies with heavy debt loads and regional banks.  I will attach the full list in a file below, which includes companies with market capitalizations of below $50M, but here are the cheap asset leaders of the Pacific Northwest as of May 8, 2009. 

 

 

Figure 2: Low P/B and EV/Assets, Low Debt, Screen Results

Company (TKR)	Market Cap	Total Assets	Enterprise Value	EV/Assets
Canaccord (CCI.TO)	408 M	1,679 M	-212 M	-0.12
Western Uranium Corp. (WUC.TO)	53 M	75 M	0.6M	0.01
QLT Inc. (QLT.TO)	137 M	438 M	7.5 M	0.02
Baja Mining Corp. (BAJ.TO)	65.8 M	198 M	6.5 M	0.03
SeaBright Insurance Holdings (SBX.US)	189 M	896 M	162 M	0.18
RealNetworks (RNWK.US)	358 M	789 M	137 M	0.17
Northland Resources (NAU.TO)	122 M	182 M	31 M	0.17
Sierra Wireless (SW.TO)	204 M	462 M	141 M	0.30
Cray Inc. (CRAY.US)	135 M	261 M	38 M	0.14
Cardiac Science (CSCX.US)	84 M	170 M	50 M	0.29

 

 

A screen output such as this requires a few caveats.  First of all a book value of an asset does not necessarily reflect its true economic value.  Obsolescence, uncompetitive operating cost structures, overpaying, and other such malfeasances can make what you originally paid for something not a particularly good guide for what it’s worth.  Secondly, many of these businesses may have significant long-term liabilities which, although not debt in a strict sense, should be netted from assets to give a clearer picture.

 

Having said that, we are at least starting with a group of ten local companies which are trading at less than half of their net accounting asset values, which goes a long way to providing a margin of safety. Furthermore, these companies definitely win the crown for the local cash pigs of the stock market.  The first ten companies in that list have an average net cash to market cap ratio of 72%.  This is not quite Japan territory, but you certainly aren’t paying a lot for the other assets of these businesses.

 

Of this list, I am quite familiar with Cray, the supercomputer company which I have owned for a few months now.  Canaccord, the Vancouver-based brokerage, is of interest to me and certainly possesses the potential to take advantage of bull market conditions.  The rest I don’t know particularly well and intend to follow up on a separate post.

 

 

Screen # 2 Cheap and Sustained Cash Flows in BC and Washington

 

Remember the old days when people invested for yield?  Of course, too many promoters got hold of that one and so an industry was created that sold a kind of bogus yield.  I was looking the other day at a retailer in an industry where 5-6% EBIT margins are the norm, and yet management was paying out investor distributions to the tune of 12% of sales.  That company, and many like it, were really borrowing to pay dividends, even before the recession hit.  No wonder there was such a collapse in income trusts.  However, I wonder whether the reaction to disappointments on income producing securities has now created opportunity.

 

Rather than look at dividend yields, I would rather look at cash flow yields.  Ideally we are looking for a business which is throwing off strong cash flows which can either be re-invested or paid back to shareholders.  Again, I cut out the companies where debt represented more than half of enterprise value and also went back though history to exclude those companies which did not have a consistent record of generating cash from operations, including through the 2001-02 period.  The result, not surprisingly, is a different list.  Here are, in my view, some of the cheaper cash flows of the Northwest.

 

Figure 3: Low EV/EBITDA, Low Debt, Consistent CFO History

Company (TKR)	Market Cap	Cash from Operations (2008)	Enterprise Value	EV/EBITDA
Vecima Networks(VCM.TO)	103 M	19 M	100 M	2.74
Ambassadors Group (EPAX.US)	206 M	24 M	165 M	3.26
Glentel (GLN.TO)	112 M	27 M	97 M	3.66
Peer 1 Network (PIX.TO)	146 M	22 M	137 M	4.79
Northgate Minerals (NGX.TO)	487 M	65 M	425 M	4.94
Microsoft (MSFT.US)	171 B	21.6 B	164 B	6.31

 

 

Interestingly, income trusts were nowhere near the top of the list in terms of cash flow yields.  Instead we see a funny collection of software companies, technology players, low-cost mines and telecoms.

 

It’s certainly funny to see Microsoft sharing the limelight with such household names as Vecima Networks, but these are not usual times.  True, Microsoft cannot boast the 19% cash flow yield that Vecima produced in 2008 (on current prices, I should add), but 12% is not that shabby and implies that the market expects substantial deterioration in that business over time.

 

Other than Microsoft, these are not well-covered businesses.  However, at these valuation levels, I believe the cheap local companies should be known much better.  I will go into more depth in a further post.

 

I’m attaching the screens here.

 

 Download May 8 Screen BC and Washington

 

 

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