A Legend: Marty Whitman from Third Avenue Funds
Explains His Take on “Net Nets” (aka companies trading below their net current asset value)

To me, Marty Whitman is truly a living legend in the world of value investing. Here’s the disclaimer: I’ve owned Third Avenues Small Cap Value Fund for several years. I’ve heard Marty speak, and I’ve spoken with him. So he’s a little cranky from time to time, that’s okay, he’s allowed. To be in this is business at his age (he’ll be 82 in September), as good as he’s been, and as much clarity as he’s brought to the world of value investing, a little crankyness is just fine with me. (Even your Cheap Stocks editor can be a bit of a curmudgeon from time to time. Just ask Mrs. Cheap Stocks editor…)

So I was very pleased upon receiving his latest letter to shareholders (dated January 31, 2006)
to notice his discussion on "net nets", otherwise known as companies trading below net current asset value. Whitman starts the "net net" discussion by disclosing that over 80 % of the Third Avenue Value Funds (the larger cap version of the fund I own) were bought at prices

" which at the time of acquisition, represented meaningful discounts from readily ascertainable net asset values.

After reading this I was astonished, wondering why I’d never discovered the plethora of companies Whitman has? The reason is because Marty is a genius who takes the whole concept of “net nets” to the next level…a level of sophistication, insight, and research that is far beyond the scope of our “Cheap Stocks” research. (Not that we couldn’t take it to that level, mind you, unfortunately our time is limited, and I only wish this was my full-time job).

Later, Whitman explains this better:

"Rarely (except for cash and equivalents) were these readily ascertainable asset values classified as current assets under Generally Accepted Accounting Principles ("GAAP"). The Fund’s definition of “Net-Nets” is taken from Graham and Dodd’s Security Analysis, but with a few twists. Graham and Dodd relied on a GAAP classified balance sheet to define current assets in order to ascertain if a common stock was a Net-Net. TAVF (Third Avenue Value Funds) uses its own judgement rather than GAAP classification to define current assets in order to decide what is a liquid, i.e., current asset."

Ahh..now we are getting somewhere. Here at Cheap Stocks, we are using Graham and Dodd’s interpretation, not that that is the only way. In Marty’s world, you can’t manage significant amounts of money looking for net-nets the way we do here at Cheap Stocks. There simply is not a big enough pool of them available and, the large majority are micro caps. That’s where we come in. Since most of the net-nets we research are far too small to have a great deal of institutional interest, they tend to languish, unnoticed by the market. Therein lies the opportunity for the small investor.

Back to Marty Whitman’s interpretation. He goes onto describe the differences between TAVF’s net-net process and Graham and Dodd’s:

"First the fund is not interested in Net-Nets unless the company is extremely well financed. A large quantity of current assets, especially if they consist of inventories, costs in excess of billings, or receivables from less than credit worthy customers, probably cannot help the common stock of a company which cannot meet its obligations to its creditors."

We certainly agree with Marty on these points. We place a much greater degree of value on cash and marketable securities than we do on other current asset accounts, but truth be told, here at Cheap Stocks, we do cover some companies that are not extremely well financed. That is one reason they are so "cheap", and its our charge to try and determine whether there’s any life left in these companies. We are not always right. But we don’t need to be. In this realm of deep value investing, it is not wise to concentrate too much money in too few companies.

Marty continues

"Second, many current assets classified as current assets under GAAP are really fixed assets of the worst sort. Take department store merchandise inventories. If the department store is to be liquidated, merchandise inventories are indeed a current asset, convertible to cash within 12 months at prices that conceivably could be close to book value, although much less than book value may be realized if the merchandise is disposed of in a GOB (Going Out of Business) sale."

Again, we couldn’t agree more. When current assets are primarily inventory, we are much more skeptical of whether the NCAV calculation reveals true undervaluation. All else being equal, we like our current assets in cash and short-term marketable securities.

Marty continues down the inventory path

:"On the other hand, if the department store is a going concern, merchandise inventories are a fixed asset of the worst sort. The merchandise inventories have to be replaced, are hard to value, and are subject to markdowns, obsolescence, shrinkage, seasonality and mislocation."

"Third, the Graham and Dodd formulation does not account for off balance sheet liabilities which may, or may not be disclosed in footnotes, nor do Graham and Dodd take into account excessive expenses or losses; at TAVF such expenses or losses are capitalized and added to liabilities."

The takeaway here is that is extremely important to read the footnotes in a companies SEC filing. You need to know what you are buying. Think of the footnotes as the "fine print".

"Fourth, Graham and Dodd only seem to recognize partially that certain fixed assets,e.g.m property, plant and equipment, can sometimes create cash."

Let me handle this one, Mr, Graham, and Mr. Dodd: we at Cheapstocks want to be aware of the non-current assets, we don’t ignore them. We simply don’t include them in the calculation. This creates a safety net of sorts, depending on how valuable these assets may be. Essentially, we value the company as (Current Assts) – (Current Liabilities) – (Other long term liabilities), "ignoring", at least in the calculation, the potential value of property, plant and equipment, and any other long-term assets. (Certainly, we are interested in those assets, and knowing what they are.)

Whitman closes with the following:

"When all is said and done, however, TAVF management owes an enormous debt of gratitude to Graham and Dodd for introducing the concept of Net-Nets. It remains the most important part of the Fund’s common stock portfolio."

Well said, Marty.

Back With Another List:
Profitable Companies Trading Below Their Net Current Asset Value

Once in awhile, your Cheap Stocks editor throws in a list, and today is no exception. Truth be told, the latest NCAV company I "discovered" was not actually trading below it's NCAV. I was halfway through writing my report when the numbers just did not look right, much to my disappointment. The company yields 3%, trades at less than 8 times earnings, and about 1.3 times NCAV. But, I scrapped that report afterall. Maybe I'll save it for another day.

This list is comprised of companies trading below their NCAV, that have positive trailing 12 month earnings. Avid readers will recognize a few of the names from previous posts. It is pretty slim pickings though, as evidenced by the fact that we went all the way down to $10 million in market cap.

Trans World Entertainment (TWMC)
Industry: Entertainment Products
Current Price: $5.57
Market Cap: $269 million
NCAV: $322 million
P/E: 80

Tandy Brands (TBAC)
Industry: Apparel
Current Price: $10.3
Market Cap: $69 million
NCAV: $73 million
P/E: 40

Lazare Kaplan (LKI)
Industry: Diamonds
Price: $7.80
Market Cap: $68 million
NCAV: $79 million
P/E: 32

Boss Holdings (BSHI)
Industry: Apparel
Current Price: $7.9
Market Cap: $15.6 million
NCAV: $16.8 million
P/E: 22.5

Hirsch Intl (HRSH)
Industry: Machinery
Current Price: $1.28
Market Cap: $11.15 million
NCAV: $10.86 million
P/E: 42.75



*The author has a position in Lazare Kaplan. This is neither a recommendation to buy or sell this security, or any others mentioned in this piece. All information provided believed to be reliable and presented for information purposes only.

New Positions

In the interest of full disclosure, yesterday we initiated positions in two NCAV stocks which we've reported on recently:

Discovery Partners(DPII)

Lazare Kaplan Intl(LKI)

We'll update you on their progress.

Thanks to all of you who have requested a PDF of the Bloomberg Personal Magazine article mentioned in our previous post.

Back Where it All Started

This past week, your Cheap Stocks editor spent some time reminiscing about articles gone by, thinking about the good old days, so to speak. In that process, I came across one of the articles, certainly not the first, that was at the forefront of my interest in companies trading below net current asset value. The magazine in which it was published, Bloomberg Personal Finance Magazine, one of the best on the market at the time, unfortunately bit the dust in early 2003. Hats off to any mainstream publication (this one had circulation of 400,000) willing to induldge a writer by printing a story on this strategy.

This particular article, published in May, 2002, was entitled “Raking Up Live Prospects: A 70-year-old strategy for choosing stocks is green again” and discussed a stock screen utilized to identify NCAV companies. The story ultimately featured seven promising examples of NCAV companies, each of which was either profitable on a trailing 12 month basis, had at least one profitable quarter in the previous year, or was sitting on a relatively significant amount of cash and marketable securities.

The selected NCAV companies from that article are printed below. We thought it would be interesting, nearly four years later, to see how these companies subsequently fared.
The Results
Audiovoxx(VOXX)- Up 81 percent
Blair(BL)- Up 140 percent
National Presto Industries(NPK)- Up 78 percent
Netro (now SR Telecom)- Down 71 percent
Tellium- (Acquired at $3.00/share in September 2003)- Flat
Titanium Metals(TIE)- Up 2130 percent
Valueclick(VCLK)- Up 522 percent


The average cumulative return was +411 percent. Obviously, Titanium Metals 2130 percent rise had a great deal to do with that. But otherwise, outside of Netro’s poor performance, the results were compelling.

What was very pleasing at the time of this articles publication, was to see this piece referenced in a Washington Post article by Jim Glassman (Yes, Dow 36000 Jim Glassman). That piece is still available on line, in the National Review archives: Hook, Line & Winner

The point of this post is to illustrate the fact that the NCAV strategy does have merit. It requires a great deal of patience, and has a high degree of risk, but the rewards can be outstanding: not just in dollar terms, but also in the thrill of successfully identifying an undervalued security that few investors know of, or care about. This is also a great example of an area of the market were small investors can succeed, and the institutions can’t.

If you’d like a PDF of the original Bloomberg Personal article, please e-mail your request to Cheapstocks@verizon.net.

*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.

Update: Discovery Partners
Discovery Partners
Ticker: DPII
Price: $2.40
P/E: NA
Market Cap: $63.3 million
Net Current Asset Value: $85 million


Since our March 2005 report shares of Discovery Partners are down 25 percent. We don't always get it right here at Cheap Stocks, or maybe our timing is not perfect, but we are not afraid to take our lumps.

As we noted in our initial post, Discovery had a sizable contract with Pfizer, whose renewal was in doubt. Indeed, Pfizer did not renew that contract, which has had a major impact on Discovery.

The company reported a net loss of $14 million for 2005. Revenues decreased 21 percent to 34.8 million. Not a pretty picture. The loss of the Pfizer contract is substantial, and as a result, the company has shut down and/or consolidated some of its facilities. Furthermore, the company is experiencing pricing pressure from outsourcing. That's quite a one-two punch.

Good News?
If there is any good news, its still the company's balance sheet. As of 12/31/05, the company had $83.5 million in cash and no debt to speak of. Thats about $3.20 in cash per share, while the stock trades at $2.40. Hold on, you might be saying, cash may be great, but if you have unprofitable operations, you'll burn through that cash quickly. Good point. In this case, the company is estimating a 2006 loss of from $15-$17 million, and cash burn of $12-$14 million. That would leave Discovery with $70 million (assuming company forecasts are accurate, a big assumption, we know)at year end 2006. Right now, the market is valuing the entire company at about $63 million. That's a fairly significant discount to cash, and a signal that the market has about given up on Discovery Partners.

Call Option?
Lets face it, its difficult to make a case for this company's operating businesses. Howevever, the cash level is interesting. If the company can truly end 2006 with $70 million in cash, purchase at current levels are essentially (ok, a stretch, we know) an in-the-money call, with a 1+ year expiration. The call being the possibility that Discovery turns the business around, even slightly over the next year, or perhaps that someone acquires them. I'd exchange $2.40 for $3.20 anyday, everyday, as often as possible. We know its not that simple. Any puffs left in this cigar butt? We'll see.

*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.

CBRL Group
Ticker: CBRL
Mkt Cap: 2.06 billion
Price: $44.23
Enterprise Value: $2.284 billion
Dvd Yield: 1.8 %
Total Restaurants: 661
Owned Restaurants: 447 (includes property)

As I noted a few months back, one area we’ve started to research is retail, or in this case restaurants, that actually own their locations. These days, many lease their stores. In light of the recent Sears-Kmart deal, which was largely real-estate focused, and similar chatter about Toys R Us and even McDonald’s, we’ve got our eyes open for similar situations, albeit on a much smaller, “Cheap Stocks” kind of scale. Our first report on the subject featured Bob Evans Farms. This report focuses on CBRL Group, well-known for its Cracker Barrel Old Country Store Restaurants.

You’ve probably heard of Cracker Barrel, maybe even eaten there a time or two, a casual dining chain and country store that owns and operates 534 Cracker Barrel Restaurants in 40 states, and 127 Logan’s Roadhouse restaurants in 16 states. And like Bob Evans, Cracker Barrel owns many—447 as of September 2005—of its location. Those that I’ve seen have been in very desirable locations as far as commercial real estate is concerned.

Better Late Than Never?
I know this will sound cliché, and hopefully readers know that honesty is important to us here at Cheap Stocks, but when we started this research, CBRL was trading in the $35 range. It gapped up sharply in January a report that suggested the company was stepping up efforts to maximize shareholder value. And yes, I was disappointed. My plan was to perhaps swap out of McDonald’s and into CBRL, or even hang onto MCD, and increase exposure to the restaurant sector, but I was too “late”. Irrational as it may seem, $45 CBRL just is not appealing as $35 CBRL. Anyway……

I’ve been to several Cracker Barrels in 3 or 4 different states. Every meal that I’ve ever had there has been excellent. It’s about as close as you can come to real country food from a chain restaurant. Part of the chains appeal is in the country store associated with each location. They sell a variety of goods, from old fashioned candy, to rocking chairs, to collectibles and some clothing items. I must admit, the stores are fun to wander through, but can’t imagine buying much of anything there (except for candy).

I’ve never been to a Cracker Barrel that was not packed with people, and there are often people waiting to be seated. This undoubtedly gives them the opportunity to shop in the Cracker Barrel store. While information on profitability of the retail side is not available, we do know that in 2005, it represented $494 million, or nearly 25 percent of total sales of $2.565 billion. Evidently, someone is buying merchandise, to the tune of an average $925,000 per store/per year, or $2500 per day.


What we don’t have a good feel for is how profitable the retail segment is., but according to a 1/25/06 research report from JP Morgan analyst Steven Rees, comparable same store sales for retail were down 10 of 12 months in 2005, and are projected negative for the first five months of 2006 ( as far out as projections went). Rees claims that despite the negative same store retail sales data, margins have actually improved due to better inventory management, higher markups, and a new sourcing partner.

Still, we wonder whether Cracker Barrel would be better served by reducing the space allotted to retail, in favor of a larger dining area, or perhaps doing away with retail altogether. While we understand the country store motif is part of the brand recognition, we at least have to raise the issue.

The Real Estate

Of course one of the reasons we are interested in CBRL is because of the company owned real estate. As of September, the company owned 384 Cracker Barrels and 63 Logan’s. Now, we don’t claim to know where each owned restaurant property is located, but do have a sense that they are typically in prime commercial real estate locations, in close proximity to major highways. With a current enterprise value of around $2.3 billion, EV/owned restaurant is about $5 million. We are certainly not suggesting that each owned location is worth $5 million. In fact, Rees puts forth a hypothetical analysis which values a spin-off of Logan’s at $385 million, and a land value of $1 million per owned CBRL location ($384 million). We don’t know if a Logan’s spin-off is in the works, CBRL acquired the company in 1999.

Fundamentals
CBRL has pretty sound fundamentals. The company has cut back on expansion, so cap ex is falling, and the company generates a nice amount of cashflow. 2005 sales grew 7.8 percent to $2.568 billion in 2005, from $2.381 billion in 2004. Net income grew 13 percent from $111.9 million to $126.6 million. Cash from operations jumped 40 percent in 2005 from $200 billion to $280 billion. Free cash flow (Our definition is Cash from operations minus cap ex- dividends) jumped from $40 million in 2004 to $86 million in 2005. Net profit margin was 4.9 percent in 2005, up from 2004s 4.7 percent. While CBRL’s profit margins are not all that impressive compared to some others in the restaurant segment, they certainly aren’t bad either. We wonder whether the retail segment is a drag on these margins?

Conclusions

A great dining concept, good food, real assets, nice cashflow. We like this company, but don’t currently own it. The recent 20+ percent run-up has us on the sidelines, for now.
Still, we wonder, would the company be better off if it were out of the retail business?

*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.

Below Average and Incomplete
Charles Schwab weighs in on your Cheap Stocks Editor’s Portfolio

As some of you may know, a few years ago, Charles Schwab developed a rating system for stocks, appropriately dubbed “Schwab Equity Rating”, which grades stocks as A, B, C, D, F, or NC (not covered). I’ve had a Schwab account for years- its where my stock portfolio resides, and I’ve been very happy with their service, and declining commission structure. There are cheaper discount brokers out there, but I’m sticking with Schwab.

So, it was quite interesting the other day when I viewed my portfolio holdings on a page that also displays Schwab’s rating for each stock. Boy was I in for a surprise. If I were to view each of the ratings as a “grade” reflecting my investment prowess, I am sadly below average. In fact, for the 18 “classes”, I received 2 B’s, 2 C’s, 5 D’s, and 9 “Not Covereds”, or as I view it, “Incomplete”. That averages out to a C-, or even D+!

I didn’t take I personally. My investment style is somewhat off the beaten path, and although there are some household names in the portfolio, many others, such as those we typically profile on this site, just are not on anyone’s radar. But therein lies the beauty. Some companies fall off the radar because they are either too small for the Street to care about, or they just fall out of favor, and languish with little or no coverage. That’s where we come in (We, meaning deep value investors). We have the ability to identify, and analyze these companies, and discover an interesting and potentially profitable story, that no one else has even cared to investigate.

Sure there are pitfalls…you need to be able to distinguish a diamond in the rough from a cigar butt, and that only comes with experience. Some bad experiences, no doubt. How do you know your analysis is accurate, especially given situations where there is little disclosure? You don’t always know, and you need to be careful. Furthermore, you should not concentrate too much of your money in any single name.

In any event, today, your Cheap Stocks editor bares his soul, revealing his report card. (NC=not covered, stocks in bold have been mentioned in previous Cheap Stocks)

Abbot Labs (ABT): C
Avoca Inc (AVOA): NC
BHP Billiton (BHP): NC
JG Boswell (BWEL): NC
Gallery of History (HIST): NC
Maui Land and Pineapple (MLP): C
McDonald’s (MCD): B
Merck (MRK): B
Northern Orion Resources (NTO): NC
PICO Holdings (PICO): NC
Plum Creek Timber (PCL): NC
Southwest Water (SWWC): D
St. Joes (JOE): D
Tejon Ranch (TRC): D
Tempur Pedic Intl (TPX): D
Tootsie Roll (TR): D
Vermont Pure Holdings (VPS): NC
Zapata (ZAP): NC

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