Movements of stock prices do not follow any physical laws of nature, although they frequently exhibit tendencies which belie that fact. Occasionally, equity prices become misaligned with their underlying value; the condition is generally temporary in nature. It is during this transitory period that value investors make their living. The ability to discover temporary mispricings in equities is the essence of value investing.
The subject of this article is a discussion of uncommon circumstances which can supplement the formation of a temporary mispricing. Understanding the process of how a stock evolves into a value proposition provides an investor with a decisive advantage over his competition. Knowing where and when to hunt is just as important as the act of hunting.
Conditions and Characteristics of Value Formation
The best time to look for mispriced equities is during periods of extreme market pessimism. The best place to look for extreme mispricings is among the smallest publicly traded companies. Upon reflection the reason is clear; tiny companies are generally under followed, frequently undiscovered and generally under appreciated. Less competition exists among buyers since most funds or institutions can not or will not buy them. Furthermore, most investors view them as highly risky propositions lacking a margin of safety or simply too illiquid to purchase. Sometimes their fears are justified but many times they are not. Many of these tiny stocks represent longstanding companies which have existed for decades, frequently they possess outstanding balance sheets which accord investors a substantial margin of safety.
Next we will examine some specific circumstances which can turn an ordinary stock in a value proposition.
Broken IPOs or Secondary Offerings
I like to approach value investing from a balance sheet prospective rather then attempting to estimate underlying earnings power. When a company raises capital through an initial or secondary offering and subsequently drops precipitously, the company likely has evolved into an outstanding value.
Consider, Actions Semiconductor (ACTS) a Hong Kong-based ADR which trades on the Nasdaq. The company was IPOed in late 2005 for a price of $8 per share, raising more cash than the current market capitalization. Although the company is currently struggling as it attempts to replace its declining market niche (MP3 players), it has steadily bought back stock and created shareholder value. Currently, the stock trades at less than 80 percent of its cash and marketable securities minus its total liabilities. The company trades at .63x its tangible book value. The $200 million raised in the IPO coupled with the downturn in business and subsequent drop in price per share has turned ACTS into value proposition. It remains to be seen if the price per share will reflect the value of the assets in the future.
Hardinge, symbol HDNG, offered an even more compelling balance sheet value in 2009, largely as a result of a broken secondary offering in the late Spring of 2007. HDNG had fortified their balance sheet by nearly 50 million dollars, retaining over $22 dollars for each share they had issued in the stock offering. Two years later, the entire market capitalization of the company was less than the amount the secondary raised and the stock was trading at a tiny multiple of its tangible book value and a large discount to its net assets.
Without the timely secondary offering, HDNG may not have weathered the extreme recession in computerized machine tool sales during the financial crisis of 2008 and 2009. If they had survived, they would not have represented the compelling value which was offered in 2009. Instead, they would have become just another struggling financially-strapped business, hoping that the recession ended before they went under. They might have been able to raise capital but at what cost to the remaining shareholders?
The substantial margin of safety created by the large discount to current assets, was a direct result of the broken secondary offering issued in 2007 during a time of business prosperity. The financial crisis of 2008/2009 resulted in an extreme machine tool recession. Dropping revenues and accrual losses, sent the price of HDNG plummeting, creating the buying opportunity. This two-part evolutionary process created the extreme value proposition, both equally important but relatively insignificant when separate from one another.
Hidden Balance Sheet Assets
Stock screeners can pick up price to book value discounts which are overt in nature but it is up to the investor to undercover the covert discounts.
You may recall my tale of woe regarding Aztar in my initial article. http://www.gurufocus.com/news/127504/why-patience-is-vital-in-value-investing
Aztar was an example of a company which had a large hidden asset on their balance sheet. Specifically, the current real estate value of the Tropicana which was built in the mid 1950s, did not coorespond with the real estate value which was listed on the balance sheet. The value of the land was greatly enhanced when the Vegas strip moved south. Once upon a time, the "Trop" sat on an island, the only other casino within shouting distance was the Hacienda. All that changed when the MGN Grand decided to relocate on the same corner. The value of the land rose dramatically as the south part of the strip became populated with additional new casinos.
The evolutionary value process for Aztar was a result of owning substantial land on the corner of Las Vegas Blvd. and Tropicana Ave, coupled with the building of new casinos on their corner. The combination of two factors created the value proposition. Again, it was a duel process which created the value.
Many companies have hidden assets and not all of these asset are tangible. Warren Buffett's concept of economic goodwill is a perfect example of an extremely valuable intangible asset which can not be picked up with a traditional stock screener. I will leave a discussion of economic goodwill for another day.
Acquiring or creating a new line of business, then spinning it off into a separate entity through the issuance an IPO is a common method of creating value. Examples would be Wendy's spinning off Tim Horton's or McDonalds doing the same with Chipotle Grill.
Allow me to profile an example of how a tiny company created significant value for its shareholders by spinning off approximately 38% of one of its tiny subsidiaries during a period of peak earnings. TAT Industries, ticker symbol TATT, is a small Israeli holding company which owns aviation-related businesses.
During the Summer of 2007, business was booming at Limco Piedmont which was a wholly owned subsidiary of TATT. The management in place at that time had took advantage of the temporary earnings surge at Limco Piedmont to fortify their balance sheet. They sold approximately 38% of the business issuing shares at $11 dollars while spinning off Limco into a separate entity. They retained 62% of the remaining shares and control of the company. The spinoff resulted in raising the book value per share or TATT by over $4 a share in cash. Part of which was paid out subsequently in dividends. Note the book value per share gain from 2006 to 2007 http://moneycentral.msn.com/investor/invsub/results/compare.asp?Page=TenYearSummary&symbol=US%3aTATT
Whether or not this more was ethical is debatable but it created significant value for the shareholders of TATT. It should be noted that the old management of TATT has departed and the new controlling owner is KMN Holdings. KMN has since reassimilated the 38% share of Limco Piedmont which was spun off, issuing the Limco shareholders TATT stock.
TATT had fortified their balance sheet prior to the financial crisis which unfolded in 2008. Similar to HDNG their stock dropped precipitiously and the IPO funds they collected from Limco investors now represented nearly the entire market cap of TATT as the stock dropped to under $4 per share. TATT issued nearly a dollar a share in dividends in 2009 and at one point the stock price reached $10 per share. It has since declined to around $5 1/2 per share, trading at about .57x its tangible book value after encountering some earnings difficulties and recording some impairments.
Earnings Troughs in High Quality Cyclical Companies
Most of the companies I have described until now could be considered low in quality, lacking any real moats or decisive long term earnings power. That was not the case with Orbotech (ORBK), the world's leading manufacturer of automated inspection systems for printed circuit boards. Although the business is extremely cyclical, ORBK had a long history of earnings as reflected by their retained earnings on the balance sheet. Even after recording a loss of over $135 million on their 2008 income statement, $109 million of which were one time charges, the company still had over 211 million in retained earnings at year end of 2008. http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?lstStatement=Balance&symbol=US%3aORBK&stmtView=Ann
In late 2008 and early 2009 ORBK stock plummeted to well under $4 per share, reflecting a market capitalization of close to $100 million dollars. It was now trading at less than 50% of its net current assets, an absurdly low price. The extreme value was created by a combination of the global financial panic and the effects of the cyclical nature of ORBK's business. This was an example of the evolution of an extreme value in the form of a high quality company with a stellar balance sheet, trading at a price similar to quality companies during the depression era of the 1930s. A price that ORBK is not likely to see again.
Many investors are familiar with the salad oil scandal which involved American Express (AXP) in 1963. I am not going to recite the details of the scandal other than to say that it temporarily dropped the price of AXP stock around 50%. The scandal had little effect on the long term earnings power of the franchise and a young Warren Buffett began buying the stock, hand over fist.
The combination of panic selling and irrational worries about damage to the long term earnings power of American Express created the enormous value opportunity.
Discussing the evolution of a value proposition is much easier done when viewing the details through a rear view mirror. It is much more difficult to accomplish when equities are in full retreat and every emotion in your body is telling you to hold off buying. I hope that the above discussion will help investors tune their eyes and ears to the process in which value is created.
The following is a summary of the main points discussed:
1) Value is created by a temporary mispricing of an equity which is a result of certain conditions and circumstances.
2) Recognizing the circumstances which lead to the evolution of a value stock can help investors identify bargains.
3) Some of the circumstances which can lead to the evolution of a value stock are:
A) Broken ipos or secondary offerings
B) Hidden balance sheet assets
D) Earnings troughs in cyclical companies
4) Generally large value propositions do not unfold unless a combination of factors exist. Factors may include a sharp market downturn or some other event or catalyst combined with the aforementioned circumstances.
5) The best time to find values is during times of extreme market pessimism.
6) Small companies are much more likely than large ones to be mispriced.
Disclosure: I own ACTS, HDNG, ORBK, and TATT