Tuesday, December 06, 2005

Bye Bye Big Sky

Sold out of Big Sky for the initiative, which pushed the portfolio over the under/over performance line. Thank heavens.

Monday, December 05, 2005

SFBC International, Inc.

This is a very interesting opportunity--momentum wise, contrarian-wise, and value-wise. Here's the story:

The stock went through a triple whammy over the past month, and dropped from around $40 bucks to $18.75 today.

Wammy #1: Hurricane Wilma affected some of their clinical trials for a couple of days, but management explicitly states that it has only a minor impact on their net income and finances.

Wammy #2: A scathing article alleging that the company has horrible testing facilities and environment, and treat human test subjects like dogs and doesn't have any respect what-so-ever. A second article came out after that one alleging that the CEO himself went to patients and forced them to sign dismissals of these allegations which were brought forth by journalists--cursing them out and threatening deportation (most test subjects are immigrants). Management took about a month to host conference calls and agreed to many regulatory probes with full confidence that none of the things in the articles were true and that the entire story was fabricated.

Wammy #3: On Thursday, there was an issue with the company's compliance with building regulations and they are forced to shut down about half of their facility down which took the stock down as well. On Friday, company came out saying that that would not affect their business at all, in that they weren't even operating that particular facility at full capacity and that they will have no future problems meeting capacity even if those beds were shut down.

I personally love these situations where the sale of stock is based on non-valuation metrics. This company is now trading at an EV/EBITDA multiple of 8X, and comparable companies are trading at 12 - 13X. SFBC has solid growth potentials and sustainable revenue (management explicitly stated that they are not expected to lose clients or test subjects as a result of the article because they have had a reputation for regulatory compliance and humane treatment of patients for 25-years and this is the first time anything like this has ever happened).

Thus, I believe that the company should at least be trading at the industry average of around 12X. 4th quarter earnings doesn't show any signs of slowing down. Management maintains their earnings guidance for the 4th quarter on Nov 3, saying GAAP EPS would be $1.66 to $1.72 and excluding non-cash amortization of intangibles and one time charges it would be $1.96 to $2.02.

I think we might have a pretty good investment on our hands.

Friday, December 02, 2005

Twiddle Dee

It certainly has been a very exciting trip managing the initiative over the past couple of weeks. I swear I dream in stock ticks and valuation fundamentals now. Sometimes, I think I even have deja vu when a stock goes up and down the following day. Of course, this is far from healthy, but I think I'm getting used to this more and more--and though the stocks are falling in the short term, I'm pretty comfortable holding them for the initiative. They are great companies, but volatile as hell since they are under-covered and small-cap. It wouldn't be half as bad I think if it weren't for the fact that I have the pressure of reporting an over performance every week. Sometimes, catalysts simply don't kick in, and until they kick in, your stocks keeps getting killed. I'm crossing my fingers that they will kick in by the end of February, or the portfolios are indeed going to be screwed this year. NO--actually, I take that back. Eternal Technologies won't have a 10-K out until March 30th historically, and they usually don't announce 4Q earnings before then. That's another 3 months of waiting.

So I better get crackin' on some Christmas ideas for 4th quarter.

Monday, November 28, 2005

Regarding the (underperforming) Initiative

It's no news that the initiative has been negative compared to the S&P 500 over the past couple of weeks (5% as of today). It gives me no pleasure to have to report these dismal results to you, and I am very worried myself at these seemingly horrible results. But I am nevertheless optimistic about the future performance of the portfolio. Let me first explain some of the things that have killed the initiative over the past couple of weeks:

Eternal Technologies Group (ETLT) came out with third-quarter earnings... and the results were less than satisfactory. Only five million dollars in revenue compared to the ten to fifteen that they enjoyed in the same quarter of last year. Market expectations have been disappointed and the stock was punished... hard. We went from our $0.75 high to a low today of $0.43. Ouch.

Big Sky Energy Corporation (BSKO) had some issues with Fraud from a former employee. He had tried to conspire with another company, pretending to be the president of Big Sky, and had tried to deal with the government in signing the rights of Big Sky's oil rights to him. In dealing with situation, the company has missed the filing of their 10-Q, and the stock took a huge hit, from about $1.20 to the current $0.96. Ouch again.

Those two were perhaps the most damaging to the performance of the portfolio. We lost around 300 basis points on these downfalls. The other 200 basis points was due to the fact that the markets have gained momentum and overtook the portfolio over the past couple of weeks.

But rest assured, all is not lost. I am going to say something that you guys probably hear everybody say when they are down, and that is: THIS IS SHORT-TERM. Except, I mean it. I can promise with a 95% certainty that the portfolio will eventually rebound. Let me explain:

The problem that Eternal Technology faced was that it had missed market expectations for the quarter. A very daunting press release came out, saying that its earnings and profits both were down some 50% over the same quarter last year. But please keep in mind that the earnings on the company is very volatile, and that whatever they don't make in Q3, they will make up in Q4--and that is just what we are expecting. I've gotten in touch with the firm in charge of investor relations for the company, and they have specifically stated that this quarter, and the year as a whole, is expected to over-perform last year's, and that due to the unexpected extension of warm weather, they had to delay fulfilling some of their Q3 contracts into Q4. What this means is, all else aside, fourth quarter earnings is expected to make up for all the underperformance of Q3. This means that despite some short term volatility with the realization of earnings, this company is ultimately still growing and turning a profit every quarter. And maybe we can expect to see that same degree of upside that we saw when we were at around 70 cents when the markets realize the potential again.

To tell you guys the truth, I actually plan to add more into the position if the stock drops any lower (anything below 40 to 41 cents). If you have any questions or big objections, please feel free to contact me. I am quite certain that the stock's drop is only temporary... although, that's only because none of the facts about the company's great performance has changed (the minute something changes, you can rely on me to be the first one out).

Now, for the other killer. Big Sky Energy Corporation (BSKO) has been very generous in giving me information regarding the current fraud issues that it is facing. I got on the phone with one of the board members today, and she has told me some things and assured me of some facts that have given some confidence to me regarding the future of the company. After all, how do you deal with fraud, and how should the markets discount for this sort of thing?

The board member kindly assured me that the fraud is not on Big Sky's part (thank heavens); they were actually the victims of it and is fighting to the death to defend their rights as victims (albeit in a Kazakh environment). Second, the whole fiasco has been a terribly embarrassing situation for the Kazakh government as a whole, and this is very advantageous to the firm because if they don't reinforce the laws and rule in favor of BSKO then it looks very bad on the international scene, and would scare away future investors which the government definitely does not want. Third, Big Sky is very confident that this issue will be resolved, although they declined to give a time-line. They don't feel that this impediment is too important to the production capabilities of the company in the long-run, and in the long-long run, this is but a blip in the stock ticker. They have also assured me that the non-timely filing will be filed sometime this week--that made me more comfortable holding the stock.

Again, I might even add more to Big Sky depending on where its stock takes us tomorrow. I will definitely add more before Thursday or Friday's end to take advantage of the upside we might derive from the 10-Q coming out which will probably reassure some investors of the company's solidity. When I do add, this stock will be no more than an 8% position, as the risk of Kazakhstan is still rather large.

So... why did I sell out of TransMontaigne and Bonso Electronics? To be completely honest with you guys, I haven't felt comfortable about these two stocks ever since I started owning them. Bonso wasn't that big of a position so I could still sleep at night, but TransMontaigne kept me awake pretty much this whole thanksgiving break. Both were pretty much bets on commodity sales and prices, and they both traded at pretty good multiples that I was comfortable when I first looked at it. But as the lack of "certainty" dawned upon me. TransMontaigne, for one, had all the things a value investor could want: 4x current earnings, near-monopoly in the southern oil pipeline transmissions, very high sales volume, but the thing that bothers me is the slim margins. A wrong bet in the derivatives markets can kill this company and tank it to the ground because they are literally holding all the inventory risk in the highly volatile oil markets. So I said fuck it. With BNSO it's the same ordeal, they have many inventories and production capabilities, except demand is slowly dying, and there are just way too many players out on the markets that do the same thing they do.

With both these companies, I reiterate, multiples are VERY attractive, but the certainty of the cash-flows were grossly miscalculated on my part, and I should have looked at the qualitative side of things more and discovered some really disgusting things that should have kept me away.

The initiative team has been working extra hard to mitigate these results and bring future performance upside all the while the portfolio has been hit. Please bear with the short-term underperformance, as we truly do not believe that this is permanent. While expecting ETLT and BSKO to normalize, we are continuously on the lookout for ideas that could benefit our portfolio. And we are sticking to our vision at the beginning of the semester: 10%+ overperformance by the end of the school-year.

Thank you all for your time and consideration. Again, if any of you have any questions or comments, or suggestions, please feel free to give me an e-mail or a ring.

Wednesday, November 23, 2005

Rishi's Concerns

I got an interesting e-mail from our beloved member Rishi Trivedi today, I thought I should share it on here (with his permission of course) Hope this helps some of the built up angst in IAG regarding the performance of our portfolios.

-----Original Message-----
From: Rishi H Trivedi [mailto:rt500@stern.nyu.edu]
Sent: Wednesday, November 23, 2005 2:30 PM
To: krish@stern.nyu.edu; mc2340@stern.nyu.edu
Subject: Portfolios

Krish & Ming,

How's it going? I thought last week sparked some of the most involved debate at IAG in a while. Take what I say in this e-mail, don't take what I say, I don't care. The portfolios are seriously lacking this year. I guess you guys need the money for obvious reasons, we can't fund a lot of our stuff without it also it's been sort of a thing where we outperform the S&P just because. There are NEVER a lack of investment ideas.

First off Ming--if a company is a good buy at $5, then it is a good buy at every price below that. If information comes out and changes the value and say you think then the company is below $5, you should have never invested in it in the first place because your margin of safety wasn't adequately accounted for. It is a logical and rational error to say that at $5 it's a good buy but at $2.50 it's not and I rather not have IAG members walking around thinking otherwise. If you're willing to buy milk at $5, of course you would buy it at $4.99 and every price below. You do not buy stocks because they have risen, this is when you sell. You do not sell stocks when they have sunk, this is when you buy. This of course, all adjusted for margin of safety. Stocks are bought like groceries and not jewelry as Charlie would say. At a lower price, we buy a little more bread, milk (stock up), at a higher price we do not. Secondly Ming, what are you doing to look for companies?

Krish, you're holding a lot of cash, I'd like to see you do something with it. What are you doing to look for companies?

I was over the S&P 500 by 10% and before I resigned last year I told Ming to sell for a reason. Then Ming fiddled with it and brought us under the 10% mark. Please do get back to me, I'd like to hear your thoughts. I also want to know exactly what you are doing to look for companies and if you want to fill me in on how you start to analyze companies (again--how you start to analyze companies), then that would be nice too.

You can forward this along to anyone who you please.



Thanks for your input Rishi. We appreciate the concern you are showing regarding the performance of the portfolios. We love to let you know more about the portfolios and you are more than welcome to stay after the club at anytime to come talk to either of us and we'd be more than happy to address anything you have to say or ask.

Regarding the "good buy" at $5 theory, while it's true for a carton of milk that I will still buy it, it's not so when we have a time horizon like we do at IAG. Remember, the markets can stay solvent much longer than we can... and to add to a losing position no matter how much is goes down is suicide in the short term.

I know you like using the example of me fiddling with the performance of the initiative last year, so I'll use that example to illustrate the previous paragraph. When RURL and CHAR was bought last year, RURL was 5.50, and CHAR was 2.60. When the year ended, RURL dropped to 4.40 and CHAR dropped to 1.90. The initiative did indeed underperform because of that.

But throughout the summer, RURL has risen to about 10.00 and CHAR has risen to 6.00, right in line with our target prices.

Considering that they are good stocks, and they would have eventually performed the way we wanted them to, buying more shares then--as buying more shares now--would be suicide for the IAG time horizon. Now, I know you love using Warren Buffet and Charlie Munger as the guru of investment quotes, and I know how Warren Buffet and Charlie Munger has pulled through some hard times adding onto their losing positions, but keep in mind that they had an unlimited time horizon to wait it out, while we only have about 8 months. The Warren Buffet and Charlie Munger strategy of adding to losses will not work for IAG. If last year's initiative portfolio could have been carried onto this year, it will probably be outperforming by about 30-40%, but we don't have that fortune here.

About what I'm doing to look for companies, you can check out http://initiativeming.blogspot.com for more info http://allstarkrish.blogspot.com is Krish's in case you are wondering what he's doing. We are also available anytime after the club to talk to you personally.


Also, please keep in mind that the way you are conducting yourself might be considered inappropriate by some standards. Krish and I are both working very hard for the sake of earning IAG's keep, and we are always out on the markets scouring for ideas. We really appreciate you giving us your opinion, but we aren't quite particularly taken with the way that you do so. However, again, we do appreciate your concerns, and it serves us a much needed reminder of how bad the portfolio has been performing. But believe us, we are well aware of the consequences of bad performance as much as you do, and we actively monitor the portfolios, and constantly try to find good ideas the best we can. The next time you have concerns, please let us know personally, and not through e-mail, because writing something is much more damaging than saying something, and there are a million ways in which we can take your e-mail the wrong way, though we know your intentions are good.

Anyway, enough said, Thank you again for your input. I hope you have a great thanksgiving!

Best regards,
Ming Che


Arg! ETLT is killing the initiative!!!
there will be no thanksgiving break for me :(

Thursday, November 17, 2005

Eternal Technologies Thesis Revision

Oh man.
Thanks to Steve, here is something really fishy about the stock:

"As of August 5, 2005, 30,679,630 shares of Common Stock of the issuer were outstanding.
As of November 14, 2005, 39,683,407 shares of Common Stock of the issuer were outstanding."

That completely dilutes the value of the company to cash level. Bastards!
I'm going to have a better explanation for this on Friday as I do more research into this.

Tuesday, November 15, 2005

Eternal Technologies 3Q

OMG, stock price tanked 32% today on 3rd quarter earnings... woe is me! I guess you really can't foresee these things. After a fateful long and arduous climb up over the past couple of weeks, we are right back where we started with this company--0.50, no gains and no losses... yet.

Now the earnings isn't exactly spetacular, especially compared to the figures from the same period last year in Q3. Some notable failings are: revenues decreased by 4m or 44.6% to 5m from 9m. Gross margin loss on sale of sheep of 17.3%. Leaving a EPS of .03 compared to .09 same quarter last year.

But should we really be worried?

If we take a look at the fundamentals again, this slow-down doesn't really seem to be anything out of the ordinary. Now, it's very easy to frame this company in a growth perspective--as in--well, the market expected the moon and now they have been failed. Punish this stock because it didn't live up to its expectations for the quarter. Yet, if we look closer, this stock shouldn't have been punished this much. After all, quarterly revenues and earnings are supposed to be sporadic... management discussed this throughly in previous statements. This is especially true when it comes to quarterly earnings, where the breeding cycle for animals and the demand for meat isn't too consistent over time. The markets love consistency and stability more than anything, but ETLT has failed this requirement this quarter because most of its contracted revenue did not occur from the months of June to September.

We should not consider this a failing though.

While 3Q earnings doesn't seem to live up to the legacy of the company. A 15m dollar contract "recognized mostly in the third and fourth quarter" is probably now going to be mostly recognized in the 4Q instead, making the REAL catalyst for growth in this company a year-over-year report or the 4Q report rather than this current quarterly report. In fact, year over year numbers have already beaten last year's in just three quarters. Meaning, if 10m in revenue is realized in 4Q, that will give us a year over year increase of over 30% in sales.

Not to mention, the cash position is probably going to increase even more.

I'm not without my due share of skepticism, however... but here is a summary of why I still like the company:

1.) 4Q Earnings will now come from high-margin Embryo transfers instead of meat sales
2.) $3m in cash have just been collected from accounts receivables, and 7m accounts receivable is still in the pipeline for collection over the next few months.
3.) Cash position is now $24m
4.) Costs are variable, so even though sales are down, ETLT still raked in 1.5m in earnings this quarter.
5.) Year over year increases and more news releases will be kinder to the stock in the future.

The stock is now trading at around 14m again... keep in mind they've actually EARNED 1/10th that this quarter, and will be expected to earn more in the 4Q... now, that fat cash position is still very attractive and real too. 14 million dollars to buy into this opportunity. Sounds like the stock is a great deal again...

This might be crazy, but I'm willing to place more bets now that I've seen the potential over the past few weeks.

Friday, November 11, 2005

Portfolio Update 11-5-2005

Sorry I can't be at IAG this week. Got an engagement going on with the girl :)
Here's a written portfolio update:

We are up quite a bit compared to last week.

The main drivers for this is the upside in ETLT, which amounted to a 50% increase.
- We plan to remain in the position until third quarter earnings which should be around Friday of next week (during which a portion of the $15m contract will be realized)
- Although we feel our fingers getting itchy, and want to sell out of this already very lucrative gain, we feel that we are currently do not have enough information to change our thesis of at least 100% upside from an earnings multiple standpoint.
- We maintain… “The show is not over until the third-quarter fat lady sings.”

Sold out of Ampex…
- Yes we did buy it only last Thursday
- But we feel that perhaps we were too trigger happy when we bought the company. Most of the licensing revenues they realized are actually not expected to repeat too much over the next couple of quarters, at least not until April, and even then, the revenues that they will be able to get from Sony remain very unpredictable.
- The low earnings multiples we are seeing currently is a result of one-time pre-payments from their licensees that are not expected to appear on subsequent statements, or if they are—they will be impossible to quantify.
- We hate things we cannot at least quantify to with a reasonable degree of certainty.

- We want to halve the position due to some uncertainty regarding some written agreements with the Kazakh government
- It has just dawned upon us that a 15% position might be a bit excessive considering the new political risks that have just surfaced.
- We plan on reducing the position until it comprises 5% in the portfolio.
- Plus… we feel that with the gains already made by the portfolio, the excessive risk with BSKO is unnecessary.

YELL… maintain position until price reaches target of $50

We will be approximately $70,000 cash soon, and we hope that we can find other ideas to put in the portfolio. We are well on our way to that 10% alpha :D

Monday, November 07, 2005

ADE Corp

This company has crazy cash on their balance sheets. Thats all I wanna say :D
Lets see if this is a good investment

Thursday, November 03, 2005

Yellow Roadway 3rd Quarter

Nothing feels better than having your thesis completely validated.
w00t w00t!

Tuesday, October 25, 2005

Friday's Presentation

Man, I'm really psyched about presenting ETLT with my man Krish (even if it's a battle). I think it's going to be a super interesting presentation that will hopefully keep the club awake :D

Friday, October 21, 2005

Eternal Technologies

Yo. Ticker ETLT. This is a company that does livestock breeding operations in Inner Mongolia of China. They run a breeding center, transplant embryos, and breed meet sheep and other livestocks. This must sound pretty nasty for all you animal rights people... but just because it's nasty doesn't mean it wouldn't be a good investment!

This is the biggest mind-boggling investment that I have found in a while.
They have 21m in cash, and is trading for 13m!!!

But don't be fooled, that cash is restricted only for uses in China. Meaning, management has specifically allocated this resource for uses inside the people's republic, and if the company wants to expand abroad, it will have to do so through new stock/debt financing. But hey... what's wrong with keeping the money where it's at?

Even if you really don't feel comfortable with where the cash is being kept... this company makes a pretty good value company in America look like shit. You got a P/E of 3.18 on this company that is expected to have more growth in the future due to increased demand. Well, I guess you could argue that the cash earnings they make can only be kept in China (see above paragraph) so it's not really "cash" in USD. Yes, definitely arguable...

But! The RMB is supposed to appreciate against the dollar from now on isn't it? What's wrong with buying into a premenant RMB asset? Unless you just hate China.

On top of it all, the Chinese have a zero-tax policy to companies like these because they operate in agriculture, and this isn't expected to end until July 2008. Sweet deal.

They are expected to come out with a pretty awesome Q3 and Q4 (historically good quarters) because of new contracts and orders, which a bulk of is usually realized in these two periods. So there's a pretty good 'catalyst' if you can call it that.

Alright, I'm almost sold on this stock.

Wednesday, October 12, 2005

Silverleaf Resorts

Here's an interesting company that might deserve the attention of some financial theorists:

There's a company out there that owns lots and lots of vacation land and resorts mainly down south (in fact, 45% of their sales come from good ol' Texas, the Long Star State) and they sell "timeshare" resort ownerships to interested purchasers who are willing to pay a certain amount of money to own a vacation spot for certain time-slots in the year. They are pretty much exactly like a real-estate company in that 1.) they sell mortgage notes and ownership to purchasers of time-shares 2.) they lever up financially to support the notes and various maintenance operations.

Their main sources of revenue are:

10% downpayment on ownership of timeshare resort
15% annualized rates on the principal owned to them though mortgage notes

Their main sources of expense are:

Cost of debt of around 6.5% per annum
Certain principal payments due (but theoretically this company can just keep borrowing money to build resorts and pocket the interest income/expense spread year on year)


Not quite... but before I get to that, I'd like to mention the implications this would have on MC/FCFE and EV/FCFF. As you've probably already guessed, the EV/FCFF ratio is going to be much higher than the MC/FCFE. Why?

Frequent readers might remember me mentioning the effects of "Financial Leverage" on the value of an equity security. As debt load decreases, interest expense decreases as well. What happens in this company is a BUTTLOAD of debt exists in the enterprise value calculation that makes the EV/FCFF ratio very large. Interest expense is by no means enough to increase FCFF enough to offset the effects of a large EV. Anyway, that's my story and I'm sticking to it...

*Gosh, who the hell stays up until 5:39 AM and writes in an investment blog anyway!?*


Im so tired. Let me wrap this up some other time... but the main points i'd like to make about this stock is:

It could have a very attractive forecast going forward provided that they can collect the debt owed to them on a consistent basis. But accoring to thier annual report a whopping 20% of their debt is delinquent, as people just default on the mortgage payments--in which case the company sells the timeshare back to someone else and gets a 10% downpayment anew. Still, the effects of this bad-debt provision is not too clear, but suppose new people keep replacing the old who default on the loan... it shouldn't have too much of an effect on the company's sales--what will be most worrisome is if no sales are generated as ownership turns over. And... that MIGHT JUST happen because of a slumping economy and an overall cloudy forecast for consumer spending and confidence.

But who knows?

The company is also exposed to very real interest rate risk. Remember the debt that the company has to keep on borrowing in order to finance its receivables? Well, we all know what's happening to interest rates these days. The spread on which the company makes its money (appx. 17% of their revenue) is going to get knocked pretty hard in the foreseeable future. But still, 70-80% of their revenue comes from principal payments, so I'm not TOO worried.

One very good thing about the company:

Holds REAL land that could be sold for multiples of what they bought at.

Now... if we can figure out what management plans to do with all their free cash generated from property sales and interest spreads then this would be a really cool investment. Paying down debt would be the best scenario.

Im out.


For anyone who doesn't understand what the heck the title of this blog entry means... you're not alone! Heck, I myself don't quite understand it fully either, but I'm going to try to explain anyway :) My latest idea deeply involves the conceptual knowledge that goes behind these two ratios--it'll be the first time I actually try to explain MC/FCFE and EV/FCFF what they mean to me. So here goes!


I suppose the easiest way to start is with a question: What happens when a firm is loaded up the wazoo on debt, but still manage to make cash quarter-over-quarter and year-over-year? How do you measure the firm's profitability in terms of how much profit it can generate for equity holders and both debt AND equity holders? Well, my friends, you've guessed it... that's why MC/FCFE and EV/FCFF exists. They are seperate ratios measuring different returns different kind of investors look at when they value a firm. One is from an equity perspective, and one is from a debt perspective. Now, let me go over some quick definitions:

MC/FCFE is an abbreviation for the ratio between a company's Market Capitalization Rate (MC) and its Free Cash Flow to Equity (FCFE). Now, market capitalization rate I'm sure you all are familiar with, but what is Free Cash Flow to Equity you ask? Well grasshopper, the general equation to figure out FCFE is "Operating Income + Depreciation + Amortization - Capital Expenditures - Net Change in Working Capital - Interest Expense - Tax Expense" and sometimes it has R&D, Operating leases, debt issuance/payments that we don't need to worry about too much for the sake of simplicity.

EV/FCFE is an abbreviation for the ratio between a company's Enterprise Value (EV) and its Free Cash Flow to FIRM (FCFF). The enterprise value of a company can be calculated quite simply: "Market Capitalization + Net Debt" (Net Debt = Long/Short-term Debt Issuances - Cash). What does EV mean in abstract? Well, let's pretend that there's a company, and all that exists in this company is a I.O.U. note for $50mm and a bag of gold bricks worth $20mm. The market is currently trading this company at $30mm because the company is expected to magically make some income over the next couple of years. In a simple Market Capitalization scenario, we would put the company's value at what is stated: $30mm. In an Enterprise Value scenario, we also like to take into account the I.O.U. note and the brick of gold, which nets out to be $10mm in debt. So when you buy this company, what are you REALLY paying? $30mm? or $40mm? I'll let you smarties figure that out :D -- Free Cash Flow to Firm is exactly like Free Cash Flow to Equity, except you put back in what you've subtracted as interest expense.


So what are the implications of these two distinctions? Well for starters, MC/FCFE measures the profitability to SHAREHOLDERS the best, while EV/FCFF measures the profitability of the ENTIRE BUSINESS (shareholders and debt-holders). So how do we know which one to use when we're valuing a business?

The key point in the answer to that question lies in whichever fits the company's current state of operations the best. I've generally followed three guidelines when comparing the relative importance of the two ratios on a company.

1.) If the company is a cash monster and has no debt, then use EV/FCFF because its basically the same as MC/FCFE except your getting "cash back" with the EV adjustment

2.) If a company is highly levered, then use MC/FCFE because interest payments and debt is financial leverage that could be paid down over time, reducing expenses incurred by shareholders. If a company has $100mm in debt, and pays $10mm in interest expense every year. But that company is able generate $20mm a year, and use the remaining $10mm to pay the $100mm debt down gradually, then it will 1.) have less interest rate at the end of every quarter compounded to pay 2.) have more money left over to pay the principal. Lower debt + lower interest = higher value for shareholders.

3.) If a company's debt and cash balances are quite similar, then value both ratios equally. Chances are, they will come down to a pretty similar ratio figure anyways.

By following these guidelines, in a way, you are putting more emphasis on what you are buying the entire firm for when the company is cash rich and debt poor, and emphasis on what you are buying equity in a firm for when the company is debt rich and cash poor. This is what my mentor Steve taught me back in the day. And he called the latter phenomenon where shareholders get progressively better returns as debt is being paid down "Financial Leverage"

Sunday, October 09, 2005

Tangible Book Value as Downside Cushion

Bonso Electronics, Inc. is a really great classic value stock that we don't ever expect to find on the market anymore, but nevertheless, it is there. I've looked everywhere for a possible reason why the stock can be so cheap, and here are some reasons I've found:

- Company operates in China, where the political/business environment is uncertain
- Company is losing sales in one of its seasonal segments
- Company relies too much on 7-8 large customers for its sales

True, these are very good reasons why a company would be trading at a discount. Currently the ratio of MC/FCFE on this company is around 6x... pretty steep, even for a company with that kind of risk.

Now, the China risk is understandable. This company incurrs around a 15% effective tax rate because of a special business status it holds in the ShenZhen area, should that change at anytime, they would be forced to pay higher taxes that would lower their profits.

But the fact that the sales on a seasonal segment is flailing should be no cause for concern--this is their telecommunications product segment by the way. The Scales segment is growing and is projected to more than make up for the losses there (Scales segment have better margins, and better scale 'no pun intended' har har har)

The 7-8 large customers is not a problem either because the company is actively seeking out new partnerships and also is integrating distribution channels to offset potential loss.


I like this stock not only because of the attractive discount, but also because of its limited downside. Even if all the worse case scenarios happen, the company still boasts a tangible book value of around 30m, which would more than cushion the downside. We have very little risk in that area.

What happens if the company starts losing money, you say? Well, due to the nature of the company's operations (a manufacturing facility in China), it is highly doubtful that the costs of running this company would be fixed to the extent that a reduction in sales could reduce its margins enough to go into the negative. As cruel as it sounds... Chinese labor is very expendable.

Anyway, I'm beginning to put a small position in the company for the Initiative...

Friday, October 07, 2005

Arbitrage Without a Long/Short is Stupid

Remember when I said that you could make some money on SPCHA because it's trading at a 16.5% discount relative to SPCHB? Unless you have a way of shorting SPCHB and longing SPCHA... forget it! That's the lesson I learned on $1000 lost! :D

I bought some shares in SPCHA the other day, thinking that there is absolutely no reason for the stock to go down because SPCHB is trading at a price that can't possibly go lower--what's my reasoning? The stock is illiquid enough so that thoughout its history, it has hovered around it's 11.00 value without much trading going on. A "stock split" shouldn't change the value of the B class too much right? WRONG!

For the sake of clarity, let me reiterate what happend:

- Class B shareholders have 1 vote for every share held
- And for every share held, they got a new Class A share which have 1/20th of a vote, but garners 110% of cash dividends paid to Class B shareholders...

Well, what's probably happening on the market right now is the origial Class B shareholders are selling their Class A shares like crazy, in order to use the proceeds to buy more Class B stock, so that their voting rights are not being diluted with the new split, or gain even more voting rights (hey the two stocks trade at almost the same price, why not have more of the one with more votes?)

Me, like an idiot, bought into the Class A shares, thinking the value of the two should converge on technicality, because a 16.5% discount is a little steep... AND I DID THIS WITHOUT SHORTING THE CLASS B SHARES--Ameritrade doesn't offer that option :( So, as the Class B gets lower and lower--probably from a strong selling reaction on the Class A--Class A followed suit. And I'm left with a big REFLEXIVITY fart.

For everyone who doesn't know what "shorting" means... it is generally a strategy that daring and intelligent investors use to make money on FALLING stock prices. The investor generally goes to a broker and asks to "borrow" shares of stock--say at $100, and he sells the shares on the open market at the current price--while paying some interest to the broker that's negligible if he makes a killing. If the stock indeed did fall--say to $50. The investor can buy the shares back, and give the "borrowed" shares back to the broker, and then keep the $50 spread minus interest per share (if this is done with millions of dollars, you generally double your money. Get it?) So if I had shorted SPCHB, I would have made some pretty good money, even though I lost money on SPCHA, and the difference would have came up to be around 0.

Anyway, I mentioned reflexivity too...

(reflexivity means when two things happen at the same time, and they both CORRELATE and REINFORCE one another. Some really good examples are: Hedge Funds pulling out of Asia thinking the economy is bad, making the economy bad at the same time... Me pulling out of SPCHA thinking the stock is going to fall, making the stock price fall as I sell on a lower dollar value... and M.C. Escher's drawings... for more details on reflexivity, The Alchemy of Finance is a good read, and so is Godel, Escher Bach)

So, I'm left with another chunky loss on my PA (parent's account)... ever since that humongoloid gain I've had with Omni, I've been more and more daring to try new things--since my cusion is bigger for the next quarter...

If only I took more wise risks instead of stupid ones like these... URG!!!


P.S. Will the stock price bounce back up as a result of a stronger SPCHB in the future as buying continues on this stock, reinforcing the Class A shares again? Maybe... but there are better opportunities out there and I'm not one to wait around for this turnaround!

Wednesday, October 05, 2005

Desperate Times & Screwed Shareholders

This post updates where we last left off with JWL... back when I said 1.38 might have been a good investment because liquidating it would give us a value approximately 34% of that. Lo and behold, it didn't work out that way, much like I predicted--instead of liquidating the company, the board and managers have decided to screw the current shareholders, continue running the company, and came up with a re-financing plan that takes all the value out of the company. Boy, am I glad I didn't buy! :D

Infact, what they did to the current shareholders should even be considered illegal. It completely dilutes the value of existing shares, in favor of the company simply "surviving". Just as I thought! After looking at the situation with our beloved Krish (the AllStar PM), we can pretty much summarize the whole investment situation for you:

Whitehall ran into some liquidity problems and was short on cash. They couldn't pay the interest on the $85m dollars debt they had and one of their lenders called default on them. Now Whitehall is refinancing the company, and the terms are:

- 30m Bridge Loan due Dec. 31 2005, on 18% interest
- 1,970,000 warrants, exercisable at $.75
- 50m Convertible debt, on 12% interest, at conversion price of .75 a share

The last two financing options is what completely screws the shareholders over. This dilutes the market capitalization rate so brutally, that there is absolutely no hope of recovering shareholder value again on this company--at least not for the next decade or so. The 50m convertible notes are used to pay down the 30m Bridge loan by the end of the year to save interest... and the rest of the cash will be used to finance their last round of jewelry purchasing and interest payments to make them barely survive past this year. This leaves about 20m more debt on their balance sheets, increasing the figure to roughly 100m. But that's not the killer... noo... the killer is this:

1,970,000 warrants, exercisable at $0.75, and 50m of convertible debt, exercisable at $0.75

Usually, the convertible rate on convertible notes are at least market value to make it fair to the current shareholders that their ownership would not be diluted. But this company issued $50m worth of both ownership of the company and debt, practically at a 35% discount (more if the share prices go up, in the bizarre and twisted event that it actually does go up). It's like Whitehall issued 68 millions shares of stock practically for free--plus they pay a 12% interest on $50 million dollars worth of those stocks. And when the interest is sucked dry, debt holders are sure to convert and realize the rest of the gains on the market.

And I'm not even going to mention the warrants. The warrants were FREE. Period--a thank you gift, rather... to the hedge fund that completely preyed on this company's shareholders.

Now, I re-iterate. At a market capitalization rate of around $20 million Management and the Board could have decided to liquidate the company, and Shareholders would have at least been able to realize 40% more of the stock's value.

This is now a debt-holder's company. Shareholders of Whitehall should sue this action! I just can't seem to get it through my head how wrong it is to deprive shareholders' value this way. Liquidating the company would have made much more economic, as well as moral & ethical sense.

Tuesday, October 04, 2005

Shareholder Class

Looked at an interesting company today called Sport Chalet, Inc. They sell sporting goods and provides various lessons on skiing and scuba diving in Nevada and California. From a fundamental standpoint, the company itself is nothing interesting. It's trading for about 12x earnings (though its a bit less than it's industry peers). But it just got done with an interesting stock split, where the "Common Stock" was made into Class B, and Class B shares got 7 Class A shares as a stock dividend.

Class A common stock holds 1/20th of a vote for every share, and Class B stock holds 1 vote for every share. Class A common stock also gets 110% of dividends that Class B gets, in order to offset for any discounts that it might be trading on the market.

Currently, the Class A share is trading at a discount of about 16.7% relative to the class B. How did I figure that out?

Well, the ratio of A : B shares outstanding was 7, and the ratio of A : B market capitalization is 6. Technically, there should be no discount due to the 110% dividend provision, but alas, there is. This is a classic arbitrage opportunity! Why don't we buy a million shares of Class A and short 900,000 shares of class B!

Wait... oh snap... this company only trades about 5,000 shares a day... poop.
The entire company is worth about 140m--A and B combined.

Pick it up for the PA and make some pocket change if you'd like, but this can't possibly go in the IAG porfolio (at 2% daily volume)--since the commissions will more than offset any gains.

Monday, October 03, 2005

Earthlink: A Lesson on Working Capital

So the newest little security in my lonely little investing world is Earthlink, Inc. (Ticker: ELNK). Many of you may know it as the formerly popular dial-up connection service that boasts 4x the speed of AOL. They aren't doing so well these days. Their subscriber bases are falling as more and more Americans switch to broadband, and the competitive branches Earthlink does have in broadband has terrible margins compared to traditional dial-up. This company is what I'd like to call a "transition" company.

If we take a look at its financials, we'll see a very strong balance sheet with virtually no debt and over 450m in cash and marketable securities. With a Market Cap of around 1.4b, that makes up close to 1/3 of their company value! Their income statement isn't so shabby either; in fact, it will probably make about 120m annually going forward if we annualize the latest quarter (but that may be a bit too liberal, since the summer months are usually the best for ISPs). With an enterprise value of around $1b, and earnings of say, 100m, it doesn't seem like too deep of a discount...

But take a look at their cash-generation. Net out the investments they put into marketable securities and the money they spend buying back their own stock... this company is generating around $100m in cash every quarter!!! Now, let this be a Working Capital lesson to all those who are interested in learning:

You see, a company's earnings, while they are important, is not the "accurate" way to measure how a company can generate money. In fact, I would argue that Income Statements serve the purpose of "normalizing" earnings instead of reporting what is actually there. For a more detailed analysis of the earning power of a company, we would have to turn to its balance sheets and its cashflow statements. Why on earth would we look at a balance sheet, you ask? What possibly can balance sheets tell me about a company's earning power? Ahh, you ask good questions, grasshopper... you see, the balance sheet is a snapshot of the financial condition of a company in a single moment in time. When you analyze the changes in the financial conditions of a business at different moments in time, you can more clearly see how assets, liabilities, and equity move around than you can with any earnings statement.

Now, let me define working capital for you. Working capital, traditionally, means Current Assets minus Current Liabilities. It's supposed to measure a firm's ability to finance it's debt or growth. Current Assets is assumed to be readily convertible into cash, and Current Liabilities is assumed to be debts that are coming due. If a firm has negative working capital in this sense, it usually is a bad sign, prognosticating the probability that a firm might go bankrupt because it will not be able to finance its operations.

But in order to measure how cash flows in and out of the business, we must let go of a traditional assumption, and assume a definition of working capital that is slightly different. Let's define working capital as All non-cash assets, minus All non-debt liabilities. We do this for one simple reason: because the changes in working capital period on period will give us a hint as to how the firm's cash flows in and out of asset and liability accounts, and how the net change affects the cash balance in the period.


Now why is Earthlink interesting? Well for one, changes in working capital has provided this company with about $15 - $100m dollars in free cash flow per quarter over the past couple of years. Now, theoretically, this should be impossible to sustain--and it probably is. Upon closer inspection, We find that the biggest changes in working capital comes from moving in and out of large investments. You see, the working capital increases when there are either 1.) an increase in the Assets, or two, a decrease in the liabilities. Similarly, when working capital decreases, either the assets decreased or the liabilities increased. Now, we should know that when non-cash assets increase, it is probably either financed by an increase in liabilities, or a decrease in cash. And also when non-debt liabilities increase, it is either due to an increase in assets, or a decrease in cash. What we are able to do with working capital is analyzing periodic changes in a businesses balance sheet to see how the cash changed. When we subtract the working capital of one period from another, we are literally seeing the difference in cash between the two. Since any changes in assets or liabilities would already be netted into the difference, it would only be the changes in cash that we see. Did you understand that? If not, read it again.

In the case of Earthlink, they sold investments and bought into investments constantly, creating gains for their assets, the "cash and marketable securities" account would keep getting bigger, allowing Earthlink to invest in new projects and make more and more investments. But this, as you all smarty-pants will know, would not exactly provide "free cash flow" in the form of working capital to Earthlink. What DOES provide "free cash flow" is the payment of liabilities. Just go look at Earthlink's liabilities, and you will see some crazy payments going in and out all the time.


Anyway, working capital aside... now that you know how it affects working capital... I've decided to value Earthlink without the effect of its working capital. In fact, I've even assumed a 10% loss on their investments (by decreasing the marketable securities total by 10%, and netting it into enterprise value) to see if this is a good company going forward.

What I found is interesting:
Declining margins, but increasing subscribers--attributable to decline of more profitable narrowband service and increase of less profitable broadband service. Increase in subscribers offsets decrease in margins, making the company's earnings seem constant. The question for this company is... what can make its broadband grow even more? Especially in light of all the competition from local cable service providers? This company trades at about 10x earnings going forward, about 7x cash (net out gains from investments)... The market is betting this company will be history in the next 7 years. What do you think? Can Earthlink successfully compete and provide consumer value in the highly competitive market of Broadband internet access?


No buy for the third quarter... traditionally, 3rd quarter is much worse than 2nd quarter (summer season).

Saturday, October 01, 2005

IAG's Alumni Presentations

Everyone in IAG should take some time out and look at the presentations done prior to the start of this year. You can drench yourself in self-pity at the wisdom of Steve, Tom, Rahat, Eric, and other brilliant financiers that aren't around anymore. It's going to be mighty hard living up to their legacies. There's a huge talent void/gap left by the brilliant people of last year who graduated. We sure have some big shoes to fill.


On a lighter note, third quarter earnings start coming out in the form of 10-Qs in the next couple of weeks or so. Usually, earnings season is very important catalysts for companies that are value-oriented or under the radar, and a tremendous upside potential could be realized in the next month or so if we play our cards right. Hopefully, we will be pretty invested soon--right now the initiative is currently at around 35% invested, and the All-Star I believe is only 30%... we really hope to increase that percentage in the coming weeks... but of course, not without good ideas first.

Thursday, September 29, 2005

Whitehall Jewellers

Now that Finlay is out of the way, I thought I'd take a look at one of its comparables called Whitehall Jewellers. Over the past couple of weeks, this stock has tanked from a high of 6 to 1.38 today--and I got to wondering, what the heck made this happen?

There has been nothing but bad news for this company over the past year, and starting September 8th, everything went down down down. Prior to the huge drop, Whitehall Jewellers has had a two-year history of corporate fraud and lawsuits regarding the transfer of money by the CFO. They paid approximately $20 million in legal and professional fees which pretty much killed their cash balances. And when the original executives left office, they put in place a new CEO nammed Raff. A little bit before September 8th, Whitehall Jewellers had asked the AMEX to suspend trading on their stock prior to the announcement of what they considered to be "significant news". Lo and behold, after a couple of days of investor suspense, a press release comes out stating the resignation of the newly appointed CEO who hasn't even started her term. This sent the stock tanking from around 4 to 1. And now, default notices from creditors are coming in as Whitehall straps itself for a rough ride. It has no cash reserves and looks to be on the brink of bankruptcy.

Why is this opportunity interesting? Just today, the stock went from 1 to 1.38 a share--and at first glance this may seem just like market madness. But could it be that the markets overreacted to all this news?

Looking at the balance sheet, one will notice a book value of approximately $80m on Yahoo! Finance... and the stock's total market cap is currently 19.88m. Whoa whoa. You can buy this company for 20 cents on the dollar? At least, when you think Jewelry store, you automatically think inventories filled with gold, riches and diamonds... Of course the markets have overreacted! How could they not have seen that even if the company did go bankrupt, it would still liquidate at a higher value than what investors are willing to pay for? Perhaps that the big realization of today...

Taking a much closer look at the balance sheets, one will notice that it's tangible book value actually derives from some things which aren't so "tangible" after all. There are 3m in deferred tax and deferred costs, and some other things that decreased the value of tangible equity. The biggest whammy was perhaps the 52m worth of "Property and Equipment". Property and equipment sounds misleading here, because the only "property" this company has is furniture and fixtures, and some leasehold improvements they probably won't be able to sell off unless it's at a significant discount, along with capitalized operating lease expense. Ha. Equipment is more like software development costs they've capitalized... in other words, property and equipment could probably only be realized at most 5 - 10% of its balance sheet value on liquidation.

This still puts us at a 26m real tangible book value however, and the market is currently pricing the company at 18.99m. Buy! You say... that's still a hefty upside! Ahh... that is where you must reconsider my investor friend--you see, this company is far from complete in paying off its legal expenses and recruiting expenses for a new executive going forward. It will probably end up losing money again if they don't go bankrupt. In fact, it's conservative to estimate that they will lose 10m again this year. So pricing in that expectation, in a year, the book will be worth 16m.

2m downside v. a 8m upside is a great bet, you say? Well, let me go a step further that default on credit doesn't necessarily mean "liquidation" (chapter 7). It could also mean "reorganization & restructuring" (chapter 11), which would put the debtors in charge of the company going forward--all debt converts into equity, with liabilities forgiven. Now, you might think it's still the same 26m left to equity shareholders going forward even with that happening, because now you have the decreased debt to make up for the dilution in equity. But ahh, think back again to the 10m they will be expected to lose on legal expenses for a longer time to come, or more generally, think of future losses this company will suffer without a proper management and cost structure. If that continues year on year, eventually, the original equity will be pushed near zero, and that, my friends, is the major downside risk.

No buy! (but will buy at $1.00 per share). That's our thesis and we're sticking to it :D

Wednesday, September 28, 2005

Sell Now, Buy Later

I never thought I'd turn into a trader... but I feel like I have to do something like this with Finlay. Press releases keep coming out that negatively affects the company--even though many of the things mentioned are already exhibited in their recent financial statements. 184 store closings as a result of the Federated and May mergers... Not until Mother's Day, and when they start they will go on until October 6th 2006.

The markets punished the stock pretty hardcore today, giving it a downside of 15%... putting our total losses in the initiative for this stock to about 30%ish--about a 3 and a half % downside for the portfolio as a whole can be attributable to FNLY.

I won't lie, this sucks. The most important lesson I've learned with this stock is that I really shouldn't think I'm smarter than the market. Yeah, sure, it makes no sense for a jewlery company with most of its tangible value in jewlery to be trading at below book value, but the market is also half hype and half numbers. It knows when it doesn't like something, and 184 store closings--although it doesn't affect the balance sheet at all (for all costs related to closing would be on the 'host' stores)--is still horrible news.

With the negative catalyst in the Sept. quarter--the losses of approximately 3m, I don't expect the market to take things more lightly, and the stock will probably get punished even more.

I will definitely look at the stock again Nov ~ Dec, when the price is at rock bottom. With Christmas earnings in sight, I will make a decision to buy or sell around that time instead. The downside risk is simply too much for me to take as of now.


Damn you Finlay! Damn you!!!!

Tuesday, September 27, 2005

Value... or is it?

I take back what I said earlier about there being a lack of "value" stocks on the market... in fact, there are a bunch of value stocks out there if by our definition value means cheap cash-flows. Just recently, for example I've found as many as 5 or 6 companies that fits the cheap cash-flows criteria. A cursory glance at their financial statments will reveal that they are trading at around 5x free cash (I have to confess, a stock I currently hold, Yellow Roadway, is an example of this 5x past and current financials)

Now, I didn't complain about there being a lack of value because I am having trouble finding companies that could potentially be value companies, I'm complaining because all the potentials turn out to be duds. It's not only cheap cash-flows that is important to the upside of a company... what's even more important is the company's ability to sustain those cash-flows for the long-run. It's hard to find solid, sustainable companies with certainty and clear business objectives going forward. See, there has too be a reason why the business is trading at the multiple it's trading at, and if a company is trading at 5x free cash flow, the main reason for buying into the company is that it should be able to generate at least the current cash flows for more than 5 years, and some of the rinky dink companies around that has the facade of being cheap at 5x probably will never get the chance to make 5x the current investment.




What the dang is with all this blogspot spam? I must have gotten comments from 4 bots by now.

Sunday, September 25, 2005


Well, I found a rather interesting company this weekend... with a pretty solid positive and negative thesis. I'd like to expound on it right now, pardon my french :D

YP.com is an internet yellow-pages service provider for local businesses in the U.S. They provide listing on the internet for free...

to be continued...


Actually, screw YPNT... they have some horrible short term costs that will probably screw their next quarter. I'd wait until after that to see what happens, and THEN I will buy :D

Saturday, September 24, 2005

The Value Manager's Tragedy

Sometimes, catalysts won't kick in for your value stock until the price tumbles a good dozen percentage points or two. And that my friends, is what I'd like to call, the Value Manager's Tragedy.

Friday, September 23, 2005

The Certainty Game

So this week I think I learned a valuable lesson on certainty, and it can be cited quite well with two investments that I've recently made in the initiative portfolio. One gained tremendously and the other lost tremendously... in both cases I've known the catalysts with a reasonable amount of certainty. But I diverted in the way in which I handled those certainties. Here were the two certainties I knew analyzed in 20/20 hindsight:

Certainty #1: Finlay Enterprises was going to write down $77m of goodwill and intangibles from their balance sheets, reducing their stockholder's equity down to $93m from $170m. Their accounts payable seems to outpace their accounts recievable, and from the outside this company looks like they are going to go bankrupt soon.

Certainty #2: Omni Energy Services has extensive operations in the environmental clean-up sector down in Lousiana, and the markets priced it as if Katrina would not affect profitability at all. While each and every one of its peers gained tremendously in the market, Omni Energy stayed put.


I handled certainty #1 with a bit of self-doubt. Goodwill and intangible writedowns are "non-cash" expenses, and would not really affect the business going forward in terms of its real operations and tangible profits. Shouldn't the markets have known that already? Before the write-down, the markets priced the security at 120m, and after the write down, it got pushed down to 90m.

The spread between before and after seemed like "priced in growth" to me, after all, the company makes about 25m a Christmas season on top of their losses in the previous quarters. Alas, when the write down made it onto the Yahoo! Financial sheets, the markets reacted strongly by pushing this stock down--way down. Now it trades at tangible book value with no priced in growth. Maybe some of you would be interested in investing right now? Because once February rolls around--the markets are going to make this company jump again! Unless, of course, their working capital and liquidity cannot sustain the interest payments that this company has to make... in which case, "Bankrupt!" There's a price to pay for this risk.

I bought this company at 12.01, and now its down into the high $9.80s... a pretty dramatic loss of approximately 20%. I truly didn't expect the markets to react so strongly to the goodwill. Maybe it's a combination of that, high oil prices, and Katrina, and the possibility of Rita decreasing consumer disposable income. Will consumers be buying much Jewelry for their loved ones this x-mas season?

We had 8% position in the portfolio, and with the loss, it's down to above 6%


Certainty #2 took the cake. Press releases came out Wednesday announcing the company's intention to acquire Preheat, a company with extensive clean-up equipment and personnel. The reason cited by management was "...to cope with increasing demand for Omni's environmental services". Can we say Katrina? The markets jumped at this stock, and needless to say, we made a hefty sum.

We had 3% position in the portfolio at the time, and now it's up to a little above 4%


The point I'm trying to make is that certainty can come in various forms. But the best kind of certainty is the positive kind with very little risk involved. With Finlay, it was a negative certainty that I tried hard to make positive with notions like "the markets are smart enough to figure out the expense is non-cash and intangible", but alas... I was punished for that! With Omni, it was a positive certainty, and I'll let you in on a little secret. I didn't have that big of a position in the portfolio because I wasn't too confident about the market recognizing that itty bitty environmental sector worth about 15m. Well... look how that turned out.

I made a mistake in evaluating risk in the two opportunities. The first certainty is riskier, and I dubbed it less risky. The second certainty is less risky but I dubbed it riskier.

Well, but like they say, Hindsight is always 20/20. But maybe we can all learn a little from this story :)

Tuesday, September 20, 2005

Terminal Value of Free Cash Flow

I've got to thinking a little bit about financial theory today while talking to my buddy Krish at Wendy's. As I was gobbling down my Jr. Bacon Cheeseburger, Krish brought up an interesting point about the discount rates used in the Terminal Value of an investment: Why is it that the factors affecting the discount rate (cost of capital, cost of debt, beta, etc.) discounted at a lower risk rate even though it is for a longer period of time--thus more possibility for risk and volatility? In other words, shouldn't "forever" be more risky than 5-7 years in the growth assumptions?

I was sitting on the toilet just now--ohh the discoveries we men make while thinking on the toilet, and I got to thinking about that. At the time of the conversation, I couldn't think up anything more intelligible than "it's probably some mystical financial theory that we simply have to adhere to"... but the more I think about it, the more I think I have an answer.

Traditional financial theory defines risk as the probability of short-term loss and volatility swings in the stock price, where-as we "value" managers like to think of risk as the "permenant loss of capital" rather than silly market reactions. The inherent difference between the traditional model and the value model is something that financial modeling has yet to capture. What we are assuming in a traditional discounted cash flow model when looking at the earnings of a firm is that it is going to inherently become more stable as the business grows to a point where it can only grow no more than GDP, at which point its margins stabilize and investors are less subject to "surprises" that would create uncertainty. If its anything the markets hate more--it's uncertainty. Yes, even positive uncertainty where companies earn more than they are supposed to... although that sort of hate primarily comes out as a result of companies not being able to keep up the wonderful "surprise" for many more quarters and fiscal years to come.

Of course, the factor in traditional finance theory that measures this sort of love-hate relationship in stock price volatility is the beta. The beta measures the ups and downs of a stock compared to a basket of other investments like it (most of the time, the beta of a stock is measured by comparing the risk of the security in question with the securities like it in the same industry). When an investment grows faster or slower than that basket, then the beta gets above or below 1, respectively. Now, any student of finance can tell you that a major factor that lowers the discount rate is the beta. In other words, a stock that is less volatile is also less risky. When the performance of a company gets projected into perpetuity, it is assumed that the stock becomes more and more like the larger whole, and thus its beta decreases while reducing the terminal cost of equity (and then WACC).

So in a nutshell, in traditional finance theory, risk is synonymous to volatility. A stock becomes stable as expectations of market expectations become normalized on a forward-going basis (which makes no sense I think--something I'll have to write on later). In exchange for less volatility, a firm is given less growth and shrunken margins to offset the gain in net present value as a result of lower risk.

Now... we value managers don't exactly look at the markets the same way as DCF enthusiasts. We are much too paranoid to feel comfortable projecting earnings on a perpetual basis. While I personally believe that the Present Value of Terminal Free Cash Flow might have some merit in extremely large, indestructible businesses (perhaps... the world economy itself), it certainly doesn't do much in light of reality. Reality is much more cruel, but cruel in a good way. If DCFs worked all the time, then there would be no value left anywhere!

The main difference between value and traditional finance theory is the way we view risk. While traditional finance theory is generally optimistic about growth opportunities and eternal survival of the firm, we value people tend to look at the downside much more. Our risk is not "volatility", our risk is "the permanent loss of capital". Value investing is a combination of relative valuation and fundamental valuation in that we hedge against our risk and expect most of our upside from comparables and tangible book value, not promises of future cash.


That's my story at least. Have you ever gotten a feeling that you teach yourself by talking or writing to yourself? Sometimes you find things you didn't even know you had... Well, I'll leave that for the metaphysicians to figure out :D

Monday, September 19, 2005

Yellow Roadway

I've been looking at this company the whole day: Yellow Roadway Corp. (Ticker: YELL), and found some very lucrative acquisitions and joint-ventures that this company is pursuing with its money. This is a company that makes its living transporting goods and arranging logistical supply lines for companies. What I love about this company, for the first time in a long time, may not be the existing fundamentals, but the promise of growth.


This is a company that is now dabbling into the Chinese supply-logistics market through a joint-venture with the second largest air-freight and transportation business in the Shanghai area. Not to mention it's recent acquisition of a business very much like its own... it hasn't even finished creating synergies yet there and we can expect to see some very nice productivity and margin gains once the overhead costs of corporate administration is cut.

What I love about the transportation business is that the more it acquires, the larger it's customer networks get. And the larger it's customer networks get, the more new customers can be acquired through buyer/supplier lines. This is a business that more or less grows organically, and with enough lock-in opportunities with database and software, they have pretty good retention strategies going forward.


The markets hate it when a company revises its own earnings estimates (especially when it is downwards) and that's exactly what happend with this particular stock. This company tanked 11% as soon as announcements were made that the EPS estimates would be adjusted from 1.60 to 1.40 for the 3rd quarter due to the effects of Hurricane Katrina on business, and due to the operational deficiencies and the longer-than-expected synergistic adjustments of Roadway Express.

Looking at the downward momentum, one gets a little scared whether or not the downward trend would continue into the future. I've decided to purchase this stock because of the very recent, very specific announcement of stock buy-backs stating specifically that the equity for this company is "significantly undervalued".

Just looking at the comparables also, this company seems to have a pretty good downside cushion, and since earnings will not be expected to go into the negative, I am not too worried about things "blowing up" as comparables will always be a nice cushion to land on when peer companies are trading for around 10x earnings.


I'm willing to hold this stock until earnings come out on Nov 9. Thats close to a month and a half from now... we'll just have to see what happens!

*crosses fingers

Saturday, September 17, 2005


Is it me? Or is "Value" investments getting harder and harder to find these days?
It used to be just going on hoovers, doing a couple of screens, and you'd be able to find a few ideas to research on, but now it's taking so much time just to find one or two!

The typical S&P 500 company is now trading at about 15 - 20x earnings--can we say overvalued? Companies trading for cheap these days actually have a good reason to be cheap, unless the investor can somehow hedge against the risks of downside of course. We are forced to become more creative and more sensical in our valuations, and not simply be able to project numbers on a forward basis. It's really tempting to just settle for the 10x cash and hope it will go to 15x soon enough... but we are sticking to our dicipline!

And nevertheless, since the IAG portfolios will be running "value" strategies this year, we are confident that in the areas where institutional investors and wall street at large do not see, we will be able to find good investments. Though nobody says that this is an easy process :(

First Meeting

Thank you everyone for coming to the first IAG meeting this year. I really enjoyed talking to many of you after the club. You guys asked many good questions and I really hope that I had answered them all to your satisfaction.

I'm very glad to know that many of the things Krish and I mentioned were not too complicated to you. As you know, IAG is a club that stresses the importance of investment competence and knowledge when it comes to making bets on the market. But again, if there is ever anything you guys don't understand, please feel free to ask any questions--we will answer them to the best of our abilities.

I hope that when we went over the companies we currently have in our portfolio, we were not overly brief in our speeches. If any of you are interested in finding about them further, please visit the IAG message forum. Krish and I have our trades posted and our reasons behind the trades. We generally don't hand out our excel valuations to the public, but if any of you want to look at valuations in depth, we would be more than happy to send them to you in .pdf format.


Since Krish started his book recommendations, I figure I should try and do the same. Reading books greatly increases the breadth of your knowledge, and I strongly suggest the following to get ahead in your investment careers:

- Bull's Eye Investing - John Mauldin
- The Alchemy of Finance - George Soros
- When Genius Failed, Rise and Fall of Long Term Capital Management - Roger Lowenstein
- You Can Be A Stock Market Genius - Joel Greenblat
- Security Analysis - Ben Graham & David Dodd
- Investment Valuation - Aswarth Damodaran (Free on his website :))
- Fooled by Randomness - Nicholas Nassir (sp) Taleb
- The Bull Hunter - Dan Denning

Also, some really great investment newsletters you should subscribe to:

The Daily Pfennig
John Mauldin's Weekly Newsletter
The Daily Reckoning
The Rude Awakening


By the way, I'm still trying to find someone fluent in Korean to help me read KEP news announcements, so if you are interested, please leave me a comment. The whole thing probably won't take more than 10 min (we will go on bloomberg, and then look at the Korean language articles together) :D

Tuesday, September 13, 2005

First post

Hello, I will be posting my investment musings here. Feel free to leave any feedback and comments you have :)