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  • "The market can remain irrational longer than you can remain solvent" - John Maynard Keynes

    Monday, June 30, 2003

    I just finished listening to the Cavco conference call (link to the call and a set of slides). They highlighted that they have actually been cash flow positive for the last three years producing $3M,$4.5M and $7.9M in 01/02 and 03 respectively (year ending March 31st). They also identified some companies as competition, this helps to find comparable companies to compare valuations with. Comparing different company’s valuations by standard metrics provides only a Relative Value rather than discounting future earnings that gives an Absolute Valuation. Both have a role but in the end Absolute Valuation provides a more accurate long term outlook (all the stocks in an industry may be currently over or under priced, that is why a mixture of the two helps to provide a short and long term picture). Champion Homes (CHB), Fleetwood (FLE), Palm Harbor (PHHM) and Clayton (CMH) were all identified as competitors in at least Arizona.

    I generally have an issue with management receiving significant numbers of stock options as compensation. However Joel Greenblatt insists that it has been a great indicator that spin-offs will be successful and Cavco had allocated about 400k shares for executive compensation.

    I watched John Boggle on Kudlow and Cramer tonight. I am always interested in what he has to say. He founded the Vanguard group; they are a mutual fund that is effectively a non-profit. They have the lowest expense ratios and if you want to invest in any part of the market that Vanguard has offerings in I would strongly recommend them. Bogle was arguing that executive compensation should be voted on by shareholders and that investors be allowed to suggest directors. He had some addition thoughts on directors like having a minimum shareholding and potentially holding the stock for 2 years or more before you can propose a director. It boggles (pun intended) my mind that this isn't already the case.

    Some-how some-where along the line management lost sight of the fact that the OWNERS of the company are the stock holders and the company exists first and foremost to reward stock holders. It troubles me when I see corporate mission statements that have investors third or fourth down a list. Either the management is lying and pretending that Employees, local community and the environment are more important than share holder value or management is going to occasionally make decisions that are contrary to the objectives (and rights) of the owners. If you disagree, imagine that you own a small business like a restaurant and you have 5 staff. If you are only making enough money to support 4 staff do you borrow money or let one of them go. Whatever decision you make should be the same decision that the management you install (as the shareholder or the owner in a small business) should make. Sadly it doesn't work that way yet. Companies that show more commitment in these matters are more likely to get my investing dollars; companies that significantly diverge are very unlikely to see any investment from me. A great case study is AES before they crashed (maybe another time). In the end job creation and the environment are results of generating returns for shareholders, in communist countries where the employees and communities were supposed to be the top priority these stakeholders did very poorly.

    Thursday, June 26, 2003

    Special situation investing was introduced to me by Joel Greenblatt in his book “You too can be a stock market genius”. This is an absolutely amazing book and fits incredibly well with my investing style. Joel also created a website called the value investors club, an exclusive online message board.

    I have been looking for spin-off opportunities since I first read the book. has been pretty helpful in identifying candidates. The reason that these opportunities are so exciting include:

    1. The spin-off of an S&P 500 company usually causes a large sell off of the spun-off company by S&P 500 index funds as the spin-off is usually not added to the index.
    2. The “parent” company of the spin-off has no incentive to advertise or talk up the spin-off. They have not engaged investment banks to sell the equity and therefore there is no market buzz or generally any advertising what so ever.
    3. The spun-off company is generally some kind of drag on the parent company’s valuation; that is the spun-off company isn’t very exciting and may not even be such a good company.
    4. Great documentation on the to-be-spun-off company is filed with the SEC in a form-10.

    All in all that means that in the beginning after the spin-off shares in the spun-off company are usually trading at a large discount. Joel gives lots of examples but one that I followed recently was Car Max (KMX). KMX was spun off from Circuit City on October 1st 2002 and I came across it when someone on one of the shows I watch recommended shorting it as Circuit City is in the S&P 500 and KMX would not be; a sound technical reason. I did some research and the fundamentals said KMX was an undervalued company so I didn’t short it. Bottom line, it’s up 100%!

    On June 30th Centex (CTX) is spinning off CAVCO (CVCO – soon to be). I did a lot of research on CVCO using the Form-10 filed with the SEC (see EDGAR). They had an independent valuation done of CAVCO and this values CVCO at .6x sales. They also mention that similar companies usually have multiples in the low teens. This would value CVCO at $21.3-$28.6 (based off earnings from continuing operations of $2.20 or sales of $35.59 per share). The valuation company did a discount cash flow analysis and looked at various operational and financial ratios to determine how the company should trade compared to their peers. Interestingly CTX has publicly stated that they expect the value of CVCO to be about $10 - $14 (see here). They are expecting around a 50% discount to Intrinsic Value as a result of the factors above.

    There are some concerns with CVCO and I don’t consider them to be a great company. They produce manufactured homes and have some retail outlets to sell them. The retail outlets are performing poorly and shutting them down has been a large drag on their reported earnings (including one time charges their income has always been negative). Once they stabilize the retail stores then they have a reasonable manufacturing business that won’t easily be subject to foreign competition (something I worry a lot about).

    Additionally the market is quite depressed right now for manufactured homes though CVCO has dealt with this by dramatically reducing costs. Any up tick in demand (probably commensurate with an improving economy) should have an accelerated effect on their earnings. Many providers of floor plan financing have exited the market or greatly reduced their lending by tightening their terms. As lenders start to forget the bad times and competition returns (as always happens in the economic cycle) financing for these homes will probably return to the old days.

    Of course, current case valuation is $21-$28 with no improvements in their market. If their profitability decreased by 5% per year with a 12% discount rate they would still be valued at $12.94. With a 5% growth rate and 12% discount rate they would be worth $31.38.

    I’m excited to see where this trades over the next few weeks and if this is below $10 I expect to take a large position.

    Thursday, June 12, 2003

    I am starting to investigate investing in El Paso (EP). They hit one of my screens a dollar or so ago and I have now spent some time looking over the most recent 10Q in a bid to value them. This turned out to be quite an interesting exercise in valuation. In summary $13.3 - $18.5 is a reasonable valuation based on 8% growth for the next 10 years and 6% growth from there on, with an 18%/12% discount rate and starting earnings of $0.9(low) to $1.25(high) a year. Analyst estimates for this year are 81c. Whether this comes in at 81c or $1.25 is quite dependant on how the unwinding of their trading operation and divestiture of assets goes. Any margin expansion in their pipeline or Merchant Energy business could easily offset their unwinding losses. Even if it is in the 80c range this year over the next few years a significant run up to $1.2/$1.3/$1.4 in 04/05 and 06 seems reasonable based on my income statement analysis.

    They reported a large loss in 03Q1, primarily related to write downs in their Merchant Energy business and their efforts to unwind their energy trading operations. These write downs are probably coming to an end this quarter or next as the finish their program to divest non-core assets and focus on their pipeline business. My estimates assume a 60% contribution by their pipelines business, 33% by Production and 6% for both their Field Service and Merchant Energy businesses.

    As of June 7th their relative strength was 84 with 99 being the highest (price increase compared to the S&P). This is often used by momentum investors and not by me! But it does indicate that EP is currently in the midst of a run up. S&P evaluates their fair value at $12.5, this is really at the lowest end of my valuation.

    I wouldn't make a short term call on EP but within a year I would expect to see at least $13.3 which would be a 44% return from here.

    I am continuing to look out for spin off and other special situations to invest in; I've been coming up pretty dry of late.

    ALGX declared Chapter 11. I was surprised and it unfortunately happened while I was on vacation. It seems that the negotiations between the company and the bondholders went fine but ALGX had decided that much of the bank debt needed to be equitized and they could not get agreement on this. The shares are down to 7c today. Well I was right in that it was resolved by May 15th. The outcome was most similar to my option 2 below but there was not a pre-pack but rather a standard chapter 11. The company has a couple of months left to file their reorganization plan. I am waiting to see if an equity committee is encouraged by the company and allowed by the trustee. A valuation simply based on the book value of shareholders equity values the company at 30c. There is still some chance this works out well and I haven't sold and won't until I understand how to value this again.

    On to more interesting matters... Since I wrote about AES and OCA they are up in a big way. AES has gone form 4.29 to 8.05 (88%) and OCA from 5.82 to 8.08 (39%). The S&P is up from 868.30 (15%) and 898.81 (11%) respectively to 998.51 today. I have been buying OCA on the way up. I still think $12 is a reasonable target by the mid year earnings announcement.

    OCA PUTS: I took some time to look at writing puts on OCA. I was considering the $7.5 puts expiring in December. With the margin requirements the cash on cash return is 36.6% (63% annualized). The stock just has to close above $7.5 on the third Friday in December and $5250 is yours to keep. If it closes below $7.5 then you have effectively bought the stock at $6.45 a share instead of the $8.12 it is trading at now. I consider this to be an extremely low risk trade but a) additional cash could be required if there is a large drop in the stock price and b) the tax treatment of the income is short term capital gains.

    The alternative is just going long OCA at $8.12. If it hits $12 and you use 50% margin on the same $14,330 that is required for 50 put contracts (each contract covers 100 shares) then your profit would be $13,536 or 94% cash on cash return. If the stock dropped below $4 though, you may end up having to add up to $14,330 more cash. In the margin case though, you could have to add up to $37,500. So there is a risk 'a' as above but it is less of a risk and if I keep the shares for 12 months there is only a 15% long term capital gains tax (go Bush!!).


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    Disclaimer and Disclosure Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness. I am not paid by covered companies. Strategies or ideas are presented for informational purposes and should not be used as a basis for any financial decisions.
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