Screening 100 Microcaps: Two that Missed the Cut

Posted on August 30, 2012 by thevariantview

I mentioned in my last post that I recently went through ~100 microcaps. Before I get into the results, I want to briefly summarize some thoughts I have recently had about stock screens.

While many investors do stock screens, I think it is very important to always screen for a purpose. It is not enough to just enter the “perfect” screening criteria for stocks– high revenue growth, high ROE, low PE, etc.. Once you start entering too many criteria, you start generating results that look very cheap quantitatively, but often are cheap for a reason.

I prefer to screen for a purpose. Screen for a particular type of result, then search for something among those results. This allows you to really focus on what you are looking for (again, this comes down to having a clear investment philosophy and sticking to it – see my post on risk and eliminating investing mistakes).

Sometimes I screen for insider buying– often these stocks will look horrible, but if I can find a reason why an insider is buying a significant amount of stock before the market catches on, maybe I can get an edge. For example, in my recent screen for insider buying, I found that after a steep stock decline, nine insiders bought Kemet (KEM) stock in May 2012 for a total of $430 K:

I don’t know much about capacitors (their main product), but a screen like this might make me want to find out more (and if you happen to know anything about them or the stock, please comment on the post!).

Sometimes I screen for beaten down companies with lots of pessimism priced into the stock (crazy cheap valuations). Then I search for something positive. I start asking, “Is the market being overly pessimistic with this company/industry/sector?” Are there emotional sellers? This recently led me into the for profit education space, where I believe some stocks, such as Career Education (CECO), have been punished too hard by the market (this may be the subject of a future post). Lisa Rapuano of Lane Five Capital agrees.

Sometimes, like last weekend, I am screening for high quality companies that may be under the radar or underappreciated by the market. In this particular case, I was looking for microcap companies with greater than 15% ROE and greater than 20% ROC in the last twelve months with reasonable capital structures (I hate debt) that were within my circle of competence. While a plethora of these 100 stocks were really interesting, many of them were outside of my circle of competence, and I ultimately determined that only six of them were worth a deep dive. Of these six, I found that three were particularly interesting to me as an investor.

1) The stock that actually had me most intrigued was called Groupe Athena (OTCPK: GATA). The company claims to be a consulting company that helps Indian medical companies obtain FDA approval for their devices/ pharmaceuticals for sale in the U.S. This seemed like a pretty interesting niche—certainly a simple business model I could understand. Here were my initial notes:

Groupe Athena (OTCPK: GATA)

$6.6 mm mkt cap, $3.1 mm EV
0.5X EBITDA, 1.6X P/E, 0.7X TBV
Revenues grown 100% yoy the past two years, ttm EBIT is $4.9 mm
Higher than I would expect capex has led to negative FCF
They provide testing and regulatory consulting services to help Indian and Southeast Asian medical companies obtain regulatory approval and facilitate exports of pharmaceuticals to the U.S.
Based in Mumbai, India
http://www.ceocfointerviews.com/interviews/GATA-GroupeAthena12.htm

Questions

Number of customers?
Capex?/machinery?
Auditors?
Stock Split, dividend, buybacks?, increased IR?

You don’t find too many consulting businesses growing revenue 100% yoy two years in a row at .5X EBITDA and half the market cap in cash. With a $6.6 mm mkt cap, it was definitely worth doing more digging because at this point, I just wanted to find out if it was a fraud. With those metrics, if it wasn’t a fraud, it was likely to be a multi-bagger.

I contacted management of the company and they got back to me rather quickly. I started to ask many questions—about their auditor, their customers, their management, their buyback strategy, increased IR etc. As my questions became more detailed, however, they stopped answering some of my questions. For example, they claimed one of their managers worked at Johnson and Johnson for 12 years. This was a pretty important fact to me—this is something that could be verified and if someone left a reputable job at J&J after a decade, starting a small-time fraud in India seems unlikely.

However, when I followed up and asked who worked at J&J for 12 years, he said, “the name you are looking for is Ms. Pooja Rajpurohit.” However, this person graduated from Rutgers in 2007 and therefore could not have worked at J&J for 12 years.

Other red flags:

I could find no information surrounding Allianz Atlantis Partners, their largest and founding investor, who has been selling stock aggressively lately
Their website includes generic pictures from around the web
The listed website and email address of the accounting firm listed on their financials did not work. They now have a new website with new contact information, but when I contacted them, they refused to answer whether they were the auditor for any other publicly traded companies

I could go on and on as I studied this for a better part of a week, but I was very disappointed with the conclusions from my digging: they are most likely a fraud, and certainly something I am not comfortable investing in. While these are my initial takeaways, I am certainly open to continuing a dialogue with management if they continue to do so and are willing to answer all of my questions with clear responses.

This is just part of microcap investing. You have to do your due diligence and occasionally you will find a gem that is truly under the radar.

2) The second stock I found interesting was Vapor Corporation– (VPCO). Here were my initial notes:

$12 mm mkt cap, EV
0.6X Revenue
Vapor Corporation designs, markets, and distributes electronic cigarettes in the United States. The company’s electronic cigarettes are battery-powered products that enable users to inhale nicotine vapor without smoke, tar, ash, or carbon monoxide
- Very interesting, potentially lucrative market
Company has grown revenues tremendously over last few years. In 2008, they had less than $1 mm in revenue, but in ttm, nearly $20 mm
Company has never been profitable, but could on the verge of profitability with increased scale. There is also very little volume—would be difficult to establish a meaningful position
Insiders own 51% of stock

I liked a lot about this company: extremely high revenue growth, interesting (and addictive) market, and very much under the radar. However, the company has never generated FCF and I see very little long-term competitive advantages. It is unclear to me how the electronic cigarette market will unfold and even if it does take off I am not confident they will capture the economics. Ultimately, this is a company I will keep on my watch list. If they are able to continue to grow top line, but somehow build their brand and improve margins, then maybe it will be worth another look. With no evidence to suggest a competitive advantage, no meaningful FCF, and an uncertain business environment for their products, I’m not sure the stock deserves to trade much higher than its “cheap” revenue multiple. This could change, but it does not quite look like a “no-brainer” to me.

It’s getting late and this post is already getting long. There are two stocks that did make the cut that I will write about hopefully tomorrow, but I feel they deserve their own post. Don’t forget to subscribe to my blog and follow me on Twitter to make sure you don’t miss the next update.

Disclaimer: The content contained in this blog represents only the opinions of its author(s). I may hold long or short positions in securities mentioned in the blog. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. This blog is not a solicitation of business– the content herein is intended solely for the entertainment of the reader and the author.

Focus on Risk and Eliminating Mistakes

Posted on August 23, 2012 by thevariantview

“The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor” — Howard Marks

Investors are always looking for great stocks. You will find blogs, newsletters, and fund managers touting their favorite ideas. While finding great ideas is obviously important, avoiding bad ones is arguably even more important. I think that most investors (including myself) too often forget this fact, abandon their discipline, and allow mediocre (or bad) ideas into their portfolio.

When I recently reviewed my investment performance, I found that while I have had good overall performance, my returns were seriously dragged down by big losers. It is incredibly disappointing to put so much work and effort into finding a great stock, coming up with a clear and accurate thesis, and then making one rash mistake that cancels out all of, or most of, the previous gains. In this way, building an investment track record is kind of like building a reputation. It takes a long time to build, but it can be destroyed by just one terrible mistake. Therefore, while I have tried to learn from all of my investing mistakes, one would be wise to heed Eleanor Roosevelt’s advice: “Learn from the mistakes of others. You can’t possibly make them all yourself.”

With this in mind, I recently read two books that both focus on the importance of eliminating big investing mistakes. I read “The Most Important Thing Illuminated” by Howard Marks. I had already read the regular version of the book, but decided to read the illuminated version that included notes from Joel Greenblatt, Bruce Greenwald, Seth Klarman, and other respected investors. I also read “The Billion Dollar Mistake” by Stephen Weiss. It is also a worthwhile read about the worst investing mistakes of some of the most famous money managers. I highly recommend both books.

My overarching takeaway from these two books can be summarized as: the best way to avoid huge investment mistakes is to have a clear investment philosophy and maintain the discipline to pass on stocks that don’t fall into this investment criteria.

Howard Marks describes it well when he says, “A philosophy has to be the sum of many ideas accumulated over a long period of time from a variety of sources. One cannot develop an effective philosophy without having been exposed to life’s lessons. In my life, I’ve been quite fortunate in terms of both rich experiences and powerful lessons.” My investment philosophy has changed over time as I have learned more about investing and more about myself. Your investment philosophy is not supposed to be a rigid straitjacket, confining you to a single type of investment. However, there is simply so much “noise” in the investing universe — one can easily read 100 different stock ideas per day, and an investment philosophy helps you understand at any given point what you are trying to accomplish and how you are trying to accomplish it.

An investment philosophy loses its value if one succumbs to the temptation to abandon it. This may seem pretty basic, but some of the world’s greatest money managers have lost a lot of money because of this mistake. An example of this from Steve Weiss’ “The Billion Dollar Mistake” was Bill Ackman, one of the greatest investors in the world, and his investment in Borders and Target. Avoiding too much financial leverage was always one of Bill Ackman’s investment tenets, however he abandoned this core principle in his Borders investment where he decided that it was “good enough” and took the risk. In his analysis of this huge mistake, Steve Weiss puts forth, “perhaps it was the zeal to do so that made him bend, perhaps even waive, the selection criteria discipline he had so carefully and assiduously created. Whatever the reason, the deviation from discipline laid the groundwork for that unforced error in the book business and for a very big loss in the big-box megastore sector [Target]…And it had always been part of the Ackman discipline to avoid leverage– whether on the balance sheets of companies he invests in or on his own balance sheet. Ackman’s billion-dollar mistake, therefore, is that he departed from his own investing discipline. The differences in how this detour from discipline played out between Borders and Target are just variations on a theme.”

In my own investing experience, I often see many good write-ups on stocks that I almost immediately pass on because they simply do not fit in my investing style. For example, stocks like Best Buy, Radioshack, and other long-term secular decliners are simply not interesting to me. While they are admittedly potentially good investments, they just are not for me and it is always okay to “pass.” As Warren Buffet says, “In investments, there’s no such thing as a called strike. You can stand there at the plate and the pitcher can throw the ball right down the middle, and if it’s General Motors at $47 and you don’t know enough to decide General Motors at $47, you let it go right on by and no one’s going to call a strike. The only way you can have a strike is to swing and miss.”

Therefore, stocks that are outside my circle of competence such as bio-tech, mining companies, and most energy companies are also immediately discarded. One day, perhaps, I will learn enough about these industries to analyze them, but for now, it makes more sense for me to say “pass” and move on to ideas where I feel like I have the potential to gain an edge.

This past week I spent a lot of time going through about 100 growing micro-caps with strong returns on equity and capital. I was looking to find a few diamonds in the rough, and these principle reminders about discipline proved to be extremely helpful. While a plethora of these 100 stocks were really interesting, many of them were outside of my circle of competence, and I ultimately determined that only six of them were worth a deep dive. Of these six, I found that three are particularly interesting to me as an investor. I have reached out to the management of each of these three firms and will have an update to post by the end of next week (at the latest). I’m really excited about this update because these stocks include:

A foreign consulting business that has carved out a very profitable niche, is trading for less than 1X EBITDA, is growing over 100% yoy, has a strong net cash position, and has high insider ownership.

A medical device company with a strong competitive advantage that has led to 30%+ ROC, is growing over 20%/year, and is trading for less than 5X EBITDA

An innovative company in an old, stable business that is currently under the radar with breakeven operating results. With continued strong top line growth (revenue is up ~20X since 2008), this company could be on the verge of strong profitability that will force a re-rating in the stock (currently trading for .6X revenue)

I think it will be fascinating to find out more about these stocks through further research and from speaking to management. So, make sure to subscribe to the blog and follow me on Twitter to be notified of this update! In the meantime, remember: investors would be wise as Howard Marks notes to focus more on controlling risk and avoiding big losses, because ultimately the upside will take care of itself.

The Variant View: Reading International (RDI)

Posted on August 14, 2012 by thevariantview

Many value investors that I respect have been attracted to Reading International (RDI). Whopper Investments, Jae Jun, Andrew Shapiro, and now, a recent Barrons article, have all highlighted hidden value in the company well in excess of the current market value. RDI has previously been one of my largest positions, and I even won a Harvard stock competition with a friend pitching a sum of the parts story. While I agree that RDI is substantially undervalued when compared to its assets, I disagree that it represents a particularly compelling investment today because of management’s disregard for minority shareholders. I recommend small investors take advantage of the recent “no news” Barrons article pop to sell shares and buy into cheap businesses where management is more properly aligned with shareholder’s incentives.

For those unfamiliar with RDI, the story is rather simple. It operates a cinema business and owns real estate. It sells below what is a massively understated book value (their land is worth well in excess of the value held on the balance sheet). In other words, this ~$6 stock is conservatively worth over $10 (see presentation) if management wanted to unlock the value. However, they don’t. There is a dual class share structure with all of the voting power concentrated with James Cotter, the CEO and Chairman of the firm. This ensures that minority shareholders can have no say in what actually occurs at the company or any strategic direction.

I knew all of this before I pitched the company for the Harvard competition, so what has changed since?

First, shortly after my pitch, Capstone Equities made a $100 mm bid for two of RDI’s New York Properties, Union Square and Cinema 1, 2, 3. Note that these properties only have a combined gross book value on the balance sheet of $32 million. Capstone, a minority shareholder, repeatedly tried to negotiate with RDI but claimed their management was unresponsive (their letter is worth a read). This was an excellent opportunity for management to unlock value for shareholders, many of whom have put up with poor share price performance for many years. However, they again showed an unwillingness to sell their core properties and unlock value, saying they wanted an option to co-participate in any development.

The second thing that changed my mind is when I recently visited with the company’s CFO at their Los Angeles office. While he was very nice and I thank him for meeting with me, I must say that I was disappointed as a minority shareholder in many of the things he had to say. I think all minority shareholders deserve to understand the mentality of this management team.

When asked about share buybacks for such a clearly undervalued stock, the CFO basically did not have an answer. He acknowledged that the company is incredibly cheap and that buybacks would make sense, but clearly articulated that a meaningful buyback program is not in the works. This is just poor capital allocation. A real company without a dual class share structure would consider the opportunity cost of any capital allocation decision. When you are clearly selling below the value of your real estate, buying more real estate, rather than share buybacks, is an indefensible capital allocation strategy. The only explanation is that they care more about building a family-owned real estate empire than they do about minority shareholder interests.

When asked about asset sales, he admitted that the company often has an emotional connection with some of their properties that makes them less willing to sell. As an investor, I simply cannot put money with a management team that is emotional with my money—especially one that cannot be held accountable by shareholders because of the dual class share structure.

The recent Barrons article said nothing new—the company is cheap. I agree with that and all of the other investment sites I mentioned earlier agree with that. After all, it is hard to make a case they are not extremely undervalued. However, whether something is undervalued or whether it is a good investment is not always the same question. In this case, the stock is extremely cheap relative to its assets, but it should be (and has for many years)! Why should the company trade at full value when management is emotional with shareholders money and is clearly misallocating capital?

There are really two risks in investing in stocks. The first is what you are buying is worth less than what you are paying. There is almost zero risk of this with RDI. The second, less talked about risk, is that it takes too long for fair value to be realized, which dilutes your IRR on the investment. This risk is tremendous with RDI given management’s mentality. I fully understand why some investors might choose to stay in RDI and try and bet on the gap between the current value and fair value closing, but that is really speculation in my opinion. The company has owned these assets for many years now and I have no idea when management will decide to do the right thing for shareholders, but after my meeting with the CFO, my gut says the answer is not very soon.

Therefore, when I look around at the investment universe and ask myself whether RDI is one of the best opportunities in the market, I have to pass. While it could easily work out given the discount you are paying to fair value, the risk that the price flounders around over the next ten years as management continues to buy assets and never unlock value is too great in my opinion. If you are interested in learning about some of my favorite ideas that are both cheap and have a clear path to realizing value, subscribe to my blog, like the facebook page, and follow my twitter (all are found on the right-hand side).