Is Value Dead? Again?

For the past five years, value has trounced growth. The S&P 600 Smallcap Barra Value Index, for instance, is up an average of 13.1 percent per year during the past five years, versus just 5.4 percent for the S&P 600 Smallcap Barra Growth Index. For the past year, however, the gap has narrowed, with value barely beating growth (7.68 percent versus 7.62 percent). Are the days of value outperforming growth coming to an end?

The folks at Tweedy Browne & Co. recently sent a sobering letter to shareholders, which announced that both of the company’s funds, Tweedy Browne American Value, and Tweedy Browne Global Value will close to new investors on May 4, 2005. “What’s the big deal” you may wonder? Funds close all the time, usually because there’s too much cash coming in, and not enough places to put it and maintain the funds objective, right? True as that may be, in Tweedy’s case, it’s the stated reasons for closure that have this value investor scratching his head.

The letter quotes fund manager Chris Browne saying:

“Current stock market levels worldwide present few investment opportunities selling at an attractive discount to intrinsic value. Moreover, certain holdings of both Funds have risen to levels of full value in our view, resulting in both funds being net sellers of securities”.

As a long-time shareholder of Tweedy Browne American Value, and believer in the firm’s investment process, that statement is scary.

The fact that Tweedy can no longer find investment ideas that fit its stringent criteria, may mean that value is dead, at least Tweedy’s definition of value. While their honesty is refreshing—and I believe these guys always tell it like it is, a rare virtue in this industry—I can’t help but question whether to cut and run. Afterall, if they can’t find any suitable investments, does that translate into lackluster returns for these funds in the next couple of years?

Chris Browne’s comments continue:

“Since the collapse of the technology, media and telecommunications bubble in 2000 wrung out the grossly inflated excesses of the so-called growth sectors of the market, the more mundane value stocks have risen to levels at or near their private market values. The result is that the price difference between the most expensive and the least expensive stocks is narrower than we can recall in more than 30 years. Current cash levels at both funds provide more than enough “dry powder” to take advantage of buying opportunities when they present themselves. At the present time, having no limits on allowing new investors into the Funds could excessively dilute existing Funds shareholders’ investments in a limited pool of cheap stocks.”

To put Browne’s comments into perspective, thirty years takes us back to the mid 70’s, not a great time for investors. Browne’s words are certainly disheartening.

For those of you who are not familiar with Tweedy Browne, this firm once served as Ben Graham’s brokerage firm. They are true dyed in the wool value investors, seeking to buy firms well below intrinsic value: companies trading at low price to cash flow, low price to book, low P/E ratios, low price to sales ratios. They like management to have a stake in the company, and that insiders are buying, not selling. The Investment Research and Reports section of their website is a must for anyone interested in value investing. One report entitled "What Has Worked In Investing" provides excellent insight into the company’s investment philosophy, and even discusses one of the topics this site is devoted to—companies trading below their net current asset value.

The author has had a position in Tweedy Browne American Value for years, and continues to add to it on a monthly basis. The fund is not a high flyer, but provides decent risk adjusted returns. For the past 5 years through March 31, the fund has averaged 5.45 percent per year versus (3.16) percent for the S&P 500. That’s a spread of more than 8 ½ percent.

I think I’m coming back to my senses. Value isn’t dead, value never dies. Maybe it’s on hiatus. When it returns, the boys at Tweedy will pounce. I’m keeping my Tweedy Browne American Value shares. Thank you (managing partners) Chris Browne, Will Browne, John Spears, Tom Shrager, and Bob Wyckoff for your honesty. We need more like you in this industry.

Inforte Corp: Not Quite Below NCAV, but close, and compelling
Ticker: INFT
Price: $3.33
P/E: NM
Market Cap: $37 (million)
Net Current Asset Value (estimated): $31
Average daily volume: 38,000

Inforte is a Chicago based consulting company, specializing in customer management, business intelligence and analytics and operational stratregy. In 2004, according to the company’s 10K, the top 5 clients represented 39 percent of total revenue, while the top 10 represented 56 percent. Clients include NASA, Cadbury Schweppes, Guardian Life Insurance, Sony Pictures, and Vodafone, among others.

Not Quite Below NCAV
Our initial research recently identified this company as trading below its NCAV. But after further research, we determined that the reason it appeared on our screen, is because the company recently paid a special cash dividend of $1.50 per share (or $17.3 million in total), which is reflected in the company’s price and market cap, but not in the company’s latest financial statements. Confused? There is a simple explanation. Companies file quarterly reports, so any transactions affecting the financial statements that are done between quarters don’t show up until the next quarterly filing. Meanwhile, transactions that effect price, such as a dividend, are reflected immediately. So, while Inforte’s price and market cap (an integral part of the NCAV equation) have dropped because of the dividend payment, it’s most recent balance sheet data (another integral part of the NCAV calculation) has not yet been adjusted. Feel free to e-mail us at Cheap Stocks if this still does not make sense.

The Numbers
Fiscal year 2004 sales were $50.5 million, up 35 percent from 2003’s $37.4 million. Net loss was $560 thousand in 2004, versus net income of $1.75 million in 2003. However, 2004’s net loss included an after tax loss of $1.3 million, so income from continuing operations was $.07 for 2004 versus $.16 for 2003. First quarter 2005 sales were down 21 percent to $9.5 million, from the same quarter last year ($12.1 million). Sales declines were due to the loss of a significant client, however, there was no surprise here. Management guidelines for sales were met.

The Balance Sheet
As of 3/30/05, the company had $46 million in cash and short-term marketable securities, $6.1 million in long-term marketable securities, and no debt. If we subtract the $17.3 million special dividend payment-we are assuming it was paid out of cash and short-term securities-that leaves $34.8 million in cash and securities, or $3.04 per share. Keep in mind that the stock is trading at just $3.48. All in all, this is a strong balance sheet.

The NCAV Calculation (in millions)
As we stated above, this company is not trading below it’s NCAV, but here’s the calculation, anyway
Current Market Cap: $37.1
Current Assets: $40 (estimated, after paying special dividend)
Current Liabilities: $9
Long Term Liabilities: $0
Net Current Asset Value: $31
NCAV/Market Cap: .84

The Street/Institutional Ownership
Currently, just two analysts are covering this company. There is however, some institutional ownership.
Fidelity: 9.7%
Dimensional Fund Advisors: 8.3 %
Bank of America: 8.1%
Royce & Associates: 6.8 %
Vanguard: 1.7%
Bridgeway Capital: 1.6%
(Several Others are at or below 1%)

Conclusion
2004 showed nice sales growth for this company. However, as 2005’s first quarter displayed, one of the risks here is the dependence on a handful of clients. Lose one or two, and sales will take a hit. On the positive side, Inforte’s balance sheet is rock solid, and offers a great deal of downside protection. If you purchase the stock at todays closing price of $3.33, you are theoretically buying $3.04 in cash and securities, and getting the business, and its other assets for $.29. That’s the kind of story that we like here at Cheap Stocks.

*The author does not have a position in this stock. This is neither a recommendation to buy or sell this security. All information provided believed to be reliable and presented for information purposes only.

What Should Warren Buffet Buy Next?

Warren Buffet’s
annual letter to shareholders is a must read. The content is both informative and entertaining. The Oracle of Omaha truly has a way with words. This is not your ordinary letter to shareholders from any ordinary Chairman. This is 24 pages of financial poetry, from the man who has led Berkshire Hathaway to an average annual gain of 21.9 percent from 1965-2004. To put that into perspective, a $100 investment in 1965 would now be worth more than $275,000!

Buffet is classic because he pulls no punches. His honesty is refreshing, his common sense approach to investing is timeless. He assigns no blame for what went “wrong” (???), other than to himself.

Perhaps the most interesting part of this years letter was a list of acquisition criteria that he and Charlie Munger (Vice Chairman) will be using in their pursuit to spend some of the Berkshire Hathaway’s massive amount cash--$43 billion at year end 2004. The following is from Berkshire Hathaway’s 2004 annual report:

BERKSHIRE HATHAWAY INC.
ACQUISITION CRITERIA
We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:
(1) Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),
(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations),
(3) Businesses earning good returns on equity while employing little or no debt,
(4) Management in place (we can’t supply it),
(5) Simple businesses (if there’s lots of technology, we won’t understand it),
(6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily,
about a transaction when price is unknown).
The larger the company, the greater will be our interest: We would like to make an acquisition in the $5-20 billion range.We are not interested, however, in receiving suggestions about purchases we might make in the general stock market.
We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer —customarily within five minutes — as to whether we’re interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. We don’t participate in auctions.
Charlie and I frequently get approached about acquisitions that don’t come close to meeting our tests: We’ve found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: “When the phone don’t ring, you’ll know it’s me.”

We at Cheap Stocks were excited when we saw this. It presented us with a challenge; to try and identify companies meeting Buffet’s criteria. Unfortunately, there are a lot of unknowns here, and we can’t get inside Buffet’s mind. That’s where the true selection criteria live, that’s where the decisions are made. It’s not all about the numbers, it’s the gut, the experience, the intelligence that Buffet possesses. But we thought we’d take a crack at it anyway.

We narrowed our list based on the following criteria:
1. Pretax income of at least $75 million—we screened for this in both 2003 and 2004
2. High returns on equity—-we looked for at least 20% ROE in 2003 and 2004
3. Simple businesses——we eliminated any technology companies, or any others that lack simplicity, in our minds, anyway.
4. Cost of Acquisitions in the $5-20 billion range—For this, we used enterprise value (Market cap + Debt – Cash), because that is a better representation of how the market currently values a company, than market cap alone. We also assumed that the offering price would include a premium. So instead of searching between $5 and $20 billion, we set the criteria between $ 3 and $17 billion. This allows room for a premium over the current enterprise value
5. Relatively low level of debt-We eliminated companies that have a total debt to equity ratio of more than 50 percent.
6. High level of profitability-Net profit margins had to be at least 10 percent for the latest trailing twelve months, fiscal year 2003, and fiscal year 2004.

The Results

Twenty one companies made the initial cut, 12 of which we eliminated as being either too complicated, or not Buffet’s style (in our minds, anyway). Those we eliminated included the following: (Prices are as of 4/13 close)
Mcgraw Hill (MHP), $83.96
Adobe Systems (ADBE), $65.07
Electronic Arts (ERTS), $49.64
St Jude Medical (STJ), $35.25
Forest Labs (FRX), $34.77
Biomet (BMET), $37.86
Rockwell Collins (COL), $45.35
Varian Medical (VAR), $33.68
American Pharmaceutical (APPX), $56.5
Lincare Holdings (LNCR), $43.72
Eaton Vance Corp (EV), $22.45
SEI Investments (SEIC), $34.365

The Final List
That left us with nine companies. Some of these may be a stretch as well. For instance, we know WB has bought retailers in the past (See’s Candy, Nebraska Furniture Mart, Dairy Queen), but would he be interested in a clothing retailer? I’m not convinced that he would, but we’ll leave them on the list anyway. Remember, this was for fun.
Harley–Davidson (HDI) ($48.93)-Well-known motorcycle manufacturer
Wrigley (WWY)($64.7)- Extremely profitable gum powerhouse. The author has a small position in this stock)
Apollo Group (APOL)($74.89)-On-line secondary education pioneer
Coach Inc (COH) ($27.57)- Marketer of leather goods, premium handbags
Mattel (MAT)($20.69) - Toy manufacturer best known for the Barbie line, Matchbox cars, and Fisher Price products
Abercrombie & Fitch (ANF)($57.68) - Retailer of casual apparel.
Chico’s FAS (CHS)($27.71) - Retailer of casual women’s clothing
Brown & Brown (BRO)($44.30) - Insurance and reinsurance products
Paychex (PAYX)($32.16) - Payroll and recordkeeping services.

If nothing else, this exercise has done one thing: Identified a list of highly profitable companies, both in terms of net profit margins, and ROE’s, with low levels of debt. We’ll see what Warren Buffet ends up buying in the coming year, if anything.

I do have one suggestion for him. Your editor is a shareholder of a highly profitable, well-known brand name company that he could probably pick up for between $2 and $ 3 billion. It’s business is fairly simple, it’s profit margins are consistently above 15 percent, and it’s owners may be looking to get out. Sound like anything you read about in a previous Cheap Stocks post? If you guessed Tootsie Roll, you’d be correct. WB loved Dairy Queen, and ultimately bought the company. Wonder if he likes Charleston Chews, Tootsie Pops, Dubble Bubble gum, or Andes mints? We can only hope.

Company Update
Tootsie Roll Industries
Ticker: TR (A shares), TROLB (B shares)
Price: $32.27(A shares)

Shares of Tootsie Roll were up more than 8 percent yesterday ($2.47) based on a Business Week article that echoed sentiment we featured in our January 28th column Rolling Towards a Takeover that presumed that due to aging owners, and a very strong brand name, Tootsie Roll may be an attractive takeover target.

The Business Week article quotes Elliot Schlang, an analyst with LJR Great Lakes Review who follows the company, projecting a takeout price of between $35 and $37 per share. Your editor has taken a position in Tootsie Roll within the past two months, but is not satisfied with the takeout range Schlang suggests.

A caution here for readers who are interested in this company. While Tootsie Roll had a nice gain yesterday, this was due to the Business Week article, obviously. There is no new information to suggest that a takeover is imminent. While we at Cheap Stocks expect it in the future, no one knows when (or if, for that matter).

While we are happy to be up 12 percent since purchasing the shares in the $29.50 range (return includes the recent 3% stock dividend, and $.07 cash dividend), we would not be surprised to see shares pull back once again, when the markets realize that while the Business Week article has merit in principle, the timing is uncertain.

Company Update:
PICO Holdings
Ticker: PICO : $26.10
Market Cap: $322.76 million
Average Daily Volume: 18000

We featured PICO Holdings in our January 21st column: PICO Holdings, Mini Berkshire Hathaway?, and wanted to give an update, based on a recent event.

On April 5th , the company’s subsidiary Vidler Water Company, announced an agreement to sell 15,470 acres of Arizona land, along with 42,000 acre feet of water, to an unnamed Arizona developer, for $95.25 million in cash, or $6157.10 per acre. The carrying cost of the assets being sold is $35 million.

That’s a $60 million capital gain for PICO. More relevant, though is the purchase price, relative to PICO’s market cap of $323 million. I continue to be impressed by PICO management, and their ability to identify and purchase undervalued assets, and ultimately convert them into cash. (The author does have a position in PICO Holdings)

It is not clear, at this point, the tax consequences of the property sale. Nor is it clear how PICO will utilize the proceeds. There really are just four possibilities: A share buyback (unlikely), acquisitions, institution of a dividend (also unlikely), further investment in undervalued (in management’s eyes) securities, or a combination. Stay tuned.

*The author has a position in this stock. This is neither a recommendation to buy or sell this security. All information provided believed to be reliable and presented for information purposes only.