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Au Contraire, The Best Way to Invest in the Egg Business

May 04, 2011 | About:
John Emerson

John Emerson

141 followers
"When someone cries "fire" in a crowded theater, a contrarian is the person who first checks to see if there really is a fire before rushing to the door." — Anonymous

If your favorite Stooge is Shemp, you are definitely a contrarian and you may have an excellent future as an investor, although your sense of humor may be drawn into question. Contrarians simply possess a different worldview, innately moving in the opposite direction of mainstream thought. Such is the life of a contrarian — always running into the face of the crowd while trying to avoid being trampled by the stampede. When the stampede passes, the contrarian dusts off his pants and examines what the panicked crowd has left behind. Frequently it turns out to be most of their riches and the riches now belong to this obstinate individual.

Their are two types of contrarians: The first is the pain-in-the-rear type, the "devil's advocate." This person always takes the opposite side without regard to serious merit, his contrarian nature exists merely for the sake of argument. The personality type of this individual is better suited to practicing law rather than investing.

The successful investing contrarian does not take the unpopular side merely to draw another into an argument, rather this type of individual seeks value and opportunity. The "value-seeking" contrarian is the subject of today's discussion.

Sir John Templeton and Contrarian Investing

Templeton literally followed the philosophy: “The time to buy is when there’s blood in the streets.” Templeton bought shares of every European publicly-traded company at the onset of World War ll. After a few years he sold the shares at a large profit.

Since many investors have no cash to invest during market crashes and leveraging is rarely a good idea, I would revise the famous quote to read the time to hold stocks is when there's blood in the street. Certainly the worst time to sell is during periods of market panic as many investors learned in late 2008 and early 2009.

Templeton's philosophy was truly contrarian in nature; he actively pursued investment opportunities in countries whose markets had imploded. If he was alive today I am sure that he would be transferring money into the Japanese stock market. It was more of a macro-approach to investing rather than a stock-picking approach. Jim Rogers uses a very similar investing style although he is just as apt to short a currency, market sector or country as he is to go long. Today the approach is much easier to implement with the extensive ETFs which allow investors to buy a basket of stocks, commodities or currencies in virtually any sector or country, either short or long.

To reiterate, the contrarian approach involves identifying extremely over-bought or over-sold areas of the market then taking a long or short position which goes against the momentum of the market. John Paulson not only became rich but famous, by employing contarian philosophy at the height of the US housing bubble.

It All About Market Valuations, Stupid

The most overused truism in investing is "buy low sell high;" I swore to myself that I would never use the phrase in one of my articles. Unfortunately, when it comes to contrarian investing, referencing the concept becomes unavoidable. Buying low, selling high in this case means purchasing when the market valuation of a security reflects "temporary insanity" on the low side or selling short when valuations become extremely stretched. Frequently, the mispricing of a stock or a bond is a direct result of fear, greed or momentum, which can be super-charged by excessive leverage or short-covering rallies. Taking advantage of this "temporary insanity" is imperative if one hopes to outperform the market indices on a long term basis.

Readers of my articles are well aware of my affinity for price to tangible book ratios rather than earnings ratios. Price to tangible book ratios do not require an investor to extensively evaluate the quality of a particular business in regard to its intrinsic value. By eliminating that process, the investor immediately reduces his margin of error by a considerable degree. In regard to contrarian investing, historically low price to book ratios in either a country, a sector, or better yet an individual stock represents a "treasure map" which leads to retirement security.

Contrarian investors have long understood if they follow their favorite valuation metrics, entering a stock, bond, or an ETF when the price becomes favorable, then exercise patience until the security rebounds; they are virtually assuring themselves of a winning investment. If it is the simpleton's formula for getting rich, call me Mr. Simpleton! Buffett's quote sums up the process succinctly: "Value investing is simple but not easy."

The Cyclical Nature of Earnings

Virtually every business is cyclical to some degree. The ones Wall Street labels as "cyclicals" simply experience a higher average degree of earnings volatility due to the nature of their business.

Fortunately for most Americans, they have grown up "when the price of baloney was cheap." However, as rising commodity prices remind us, that is a privilege, not a right. At some point almost every consumer changes their buying habits if the price of a good or service exceeds a certain level. The change may be reflected in a move from branded merchandise to a private label, less consumption of meat as opposed to eggs, or shorter vacation trips as the price of gas rises. The point being, most businesses experience periods of fluctuating earnings and during these periods and the opportunity for a a temporary mispricing of a company is much more likely to occur.

Let's study the case of Cal Maine (CALM), a prominent U.S. egg producer and supplier as an example of an opportunity which was presented to astute contrarian investors several times in the last decade.

CALM

Cal Maine is a company which I have never traded; however, it is a perfect example of the extreme nature of earnings volatility and a perfect example of how the price per share of a company frequently does not represent its intrinsic value. It is exactly this type of stock which should pique the interests of a contrarian investor. The following is a ten year trailing earnings history of Cal Maine and the accompanying chart:

Income Statement - 10 Year Summary (in millions)

SalesEBITDepreciationTotal Net IncomeEPSTax Rate (%)
05/10910.14103.4931.7967.822.8436.68
05/09928.81121.3329.5679.53.3434.21
05/08915.94231.5724.97151.866.434.34
06/07598.1355.980.036.661.5535.02
06/06477.56-1.640.0-1.01-0.040.0
05/05375.27-15.4116.37-10.36-0.430.0
05/04572.33106.2416.5266.442.7337.46
05/03387.4619.1416.3712.210.5136.19
06/02326.17-16.3617.07-10.57-0.450.0
06/01358.4110.7217.016.820.2836.31




chrtsrv.dll?symbol=calm&E1=0&LPR=2&C1=0&

In the last ten year Cal Maine has experienced two periods when their accrual earnings turned negative: fiscal years 2002, and fiscal 2005 through 2006. During those periods the stock price dropped to low levels and stayed low until the company experienced a large temporary earnings spike in fiscal 2004 and fiscal 2008. The earnings surges resulted in multibaggers for savvy investors as well as large dividend distributions.

Without regard to the specifics of the business, the following observations can be drawn by studying the companies' annual reports: Periods of poor earnings are reflected by periods of below average retail selling prices of eggs. Periods of above average retail selling prices for eggs result in substantial increases in egg revenues as well as net income. For example, in fiscal 2008 the company sold 678 million dozens of eggs at an average price of about $1.38 per dozen, resulting in $6.40 per share in earnings. In fiscal 2010 they sold considerably more eggs, about 805 million dozens, but the average price was only about $1.12 per dozen, resulting in earnings per share of $2.84 per share.

Astute contrarian investors noted the falling retail prices in eggs at the supermarket, reviewed the annual reports of Cal Maine, and determined that temporary gluts in egg supply tend to hinder the profits of the company. These temporary conditions resulted in a huge buying opportunity for investors in CALM. When the retail egg price recovered and subsequently surged, it was a signal for the contrarian investor to declare his/her profits; the result was a multibagger plus dividends.

Dare I utter the phrase buy low sell high again? This was exactly the opposite course which most Cal Maine investors took; instead they focused on the current earnings rather than their ephemeral nature; selling when the earnings were poor and buying when they were outstanding, the result for the non-contrarian investors was a capital loss.

Conclusions

1) Successful contrarians are "value seekers," not merely people who play "devils advocate."

2) Sir John Templeton was a classic contrarian who advanced the notion of purchasing securities in foreign markets.

3) Successful contrarian investors monitor valuation metrics to determine bargains.

4) Almost all companies experience some degree of cyclicality in earnings; astute contrarians take advantage of temporary earnings shortfalls or surges.

5) Cal Maine is a perfect example of a company which experiences extreme earnings volatility and has been an excellent contrarian trade.

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 4.1/5 (18 votes)

Comments

Alex Morris
Alex Morris - 3 years ago
Any thoughts on current litigation? Haven't heard much lately about it, but Land-o-lakes egg business settled for $25 million, and also gave up information on the case as part of the settlement. I remember calculating at the time (I used to own CALM) by looking at comparable sales (far from a perfect estimate obviously) that CALM's cost would be in the $70-90 million range.

Any thoughts on what is happening with the suit? Thanks!
John Emerson
John Emerson - 3 years ago
No Alex, I have not been following the stock since the price ran away several years ago. I was just reviewing the company as another example of a stock I missed but should have traded since I was familiar with its MO.

I thought you were referring to the samonella problems in Iowa last year but I googled the stock and found they also have a price-fixing suit. If the price of eggs and the share price drops sufficiently I will certainly take the lawsuits into consideration before investing. Now the price is too high for my liking and the K won't be out until late summer anyways. At this point, I am finding little to buy and I am holding a larger cash position than normal. That frees up my time to impart "wisdom". Thanks for the comment
Alex Morris
Alex Morris - 3 years ago
Hey John,

Yeah, I've stopped following since I sold a while back, but have been waiting to hear about the result of the price fixing litigation. If you hear anything additional, would you mind passing it on to the good old readers of GuruFocus.com? Thanks!

Please leave your comment:


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