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 " 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 :)

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