When Ben Graham wrote "The Intelligent Investor", he saved the most important chapter for last; Chapter 20 of the investment classic directly addresses the concept known as margin of safety. I consider the last chapter of the book to be the single most important piece ever written about value investment philosophy.
The concepts of the aforementioned chapter are so pervasive that it is nearly impossible to listen to any Buffett interview or read any quality value investing manual without recognizing the ever present references to the chapter. The numerous investment concepts described in the chapter have become so mainstream in value philosophy that I believe many modern day value investors do not even recognize the source of their methods.
Chapter 20 also provides writers with a wealth of quotations. Indeed, many of Ben Graham's best quotes can be lifted from the 12 pages which constitute the chapter. When I reread those few pages are am frequently struck with a sense of awe. Simply stated, the chapter illuminates in a concise manner, the essence of value.
The purpose of today's essay is to apply several of the most important concepts of Chapter 20 of The "Intelligent Investor" in order to analyze whether Imperial Sugar (IPSU) represented an intelligent investment in the period from 2005 to 2007. These concepts deal directly with low-quality companies.
Risk Associated with Low Quality Stocks
Prior to Graham's initial publication of Security Analysis, the prevailing view existed that the purchase of bonds represented a "safe" investment while the purchase of common stocks represented a "risky" speculation. Risk was frequently not equated with arithmetic nor logic; instead it was equated with the type of investment which a person pursued.
Common stocks were deemed as risky and speculative by their very nature, where as bonds were deemed to safe since they paid a regular dividend. Individuals who purchased common stocks were frequently referred to as "stock operators" who dealt in an unsavory arena of manipulation and double-dealing while "investors" pursued bonds. The pejorative connotation of investing in common stocks versus bonds was reflected in Andrew Mellon's famous quote "gentleman prefer bonds". Of course the onset of the Great Depression quickly destroyed the misconception that all bonds were safe without regard to the concept of margin of safety.
It seems that arithmetical concepts such as interest coverage were foreign to most bond investors at the time. Further, it seems that the logical concept of cyclically-adjusted earnings eluded the stock and bond investors as well. A lesson that was once again forgotten by many value investors leading up to the credit crisis of 2008-2009. The list included Jeffrey Gendell, Bill Miller and Bob Olstein as well as other noted value proponents. All three of the aforementioned value gurus forgot to account sufficiently for the ephemeral nature of earnings when analyzing the future cash flows of cyclical stocks.
So what exactly does Chapter 20 tell us about risk? After all, the concept of margin of safety is directly related to risk since the primary focus of all successful value investors is to minimize downside risk while being able to fully participate in upside market potential.
According to Graham: "Observation over many years has taught us that the chief losses to investors come for the purchase of low-quality securities at times of favorable business conditions."
Without question, the most common blunder investors make is failing to realize that the earnings power of a business is frequently temporary in nature. More specifically, the cyclical nature of earnings is generally under estimated and the duration of the competitive advantage of a business is frequently over estimated. In such cases, the trailing price to earnings ratio presents investors with a mirage rather than a margin of safety.
Graham's aforementioned quote applied in spades during the latter period of the housing boom which propelled earnings of the homebuilders, the building material and commodity stocks, as well as the banks before their stock prices abruptly crashed in 2008 during the credit crisis. The long-term earnings power of the businesses was dramatically misrepresented by the temporary windfall created by an overheated housing market.
Imperial Sugar (IPSU) provided a perfect example of a low-quality business which benefited by a temporary set of circumstances which belied its long term earnings power during the 2006 and 2007 fiscal years.
An active hurricane season had destroyed a significant portion of the 2005 US sugar cane crop as well as severely damaging one of the competing cane refineries in Louisiana. Those factors coupled with domestic protectionist policies and a reduced US sugar beet crop in 2005 provided IPSU with a temporary windfall just as sugar demand peaked for the holiday baking season.
Additionally, Imperial's industrial customers which accounted for over half of their revenues, were contracting high prices for the upcoming year to ensure that they would have sufficient quantities of refined sugar. IPSU had sufficient inventories of raw sugar purchased at low prices for the current year while securing forward purchases of raw sugar at favorable prices. Little supply relief would be provided until the new cane crop could be harvested in the late summer or early fall of 2006 giving IPSU a temporary competitive advantage. Further, IPSU had locked in high sales contracts to industrial customers for the following fiscal year at the same time the prices they were receiving for their wholesale sales were going through the roof. The existing spread between raw vs. refined sugar prices had never been more favorable for IPSU. This perfect storm had provided IPSU with a temporary earnings bonanza which would last for two fiscal years as raw vs refined spreads reached record levels.
However, investors who purchased IPSU in mid to late 2006 or 2007 based upon their most recent trailing earnings, were in for a rude awakening when the operating results suddenly turned negative as the spread between U.S. raw versus refined sugar suddenly began to contract. The "perfect storm" had ended abruptly resulting in a steady decline in the stock price of IPSU. As an aside, the record 2010 fiscal year profits are not relevant since they were a result of an insurance settlement following an explosion and fire at one of the companies' sugar refineries. In reality, the operating results for that year were highly negative.
Income Statement - 10 Year Summary (in Millions)
|Sales||EBIT||Depreciation||Total Net Income||EPS||Tax Rate (%)|
Low-Quality Companies as Investment Opportunities
Now that we know that the recent trailing earnings of low-quality companies offer investors little in the way of a margin of safety, it is time to define some situations that Graham would consider to be low risk propositions in regard to such companies.
Interestingly enough, Graham provides the following observation about low-quality companies: "It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment — provided that the buyer is informed and experienced and that he practices adequate diversification."
Using Graham's aforementioned quote as a guide, is it possible that in 2005 before its quick price appreciation, IPSU represented a sound investment? Let's look at the details more closely.
The following tables summarize the valuation metrics of IPSU at the end of each fiscal year following its emergence from bankruptcy in 2001:
|Avg P/E||Price/ Sales||Price/ Book||Net Profit Margin (%)|
|Book Value/ Share||Debt/ Equity||Return on Equity (%)||Return on Assets (%)||Interest Coverage|
By year end of 2005 anyone who was following IPSU was privy to the impending profit windfall for the company as its Louisiana refinery narrowly escaped the wrath of of one of the worst hurricane seasons in US history. The annual report succinctly described the convergence of factors which set up the perfect storm of events which would allow IPSU to record exaggerated profits in the next two fiscal years.
From the IPSU annual report filed on 12/14/2005:
Fiscal 2005 was a tumultuous time in the domestic sugar industry. Several years of large domestic crops and soft demand led to surplus inventory levels, particularly of refined beet sugar, resulting in very aggressive pricing in the refined sugar markets during the critical industrial contracting season that began during the preceding fiscal year. This resulted in substantial reductions in margins available in the markets that we serve during most of the fiscal year.
Conversely, neither industry nor government analysts forecasted the demand growth realized in fiscal 2005, nor the full extent of the damage to the Florida sugar cane crop caused by hurricanes that impacted that state during 2004. The USDA set import levels under the Tariff-Rate Quota (“TRQ”) and the amount of domestic sugar that can be marketed under the Overall Allotment Quantity (“OAQ”) based upon early estimates, and the result was a market that was under-supplied by the second half of the fiscal year. Raw sugar prices began to move higher in the late spring as the tight raw sugar supply began to be recognized, creating further pressure on margins. After a lag, refined sugar prices also began to rise in response to a growing recognition of a supply/demand imbalance.
In reaction to these conditions, as well as reports from some beet processors that they would delay the start of their fall 2005 harvest because of a small crop, the USDA acted rapidly and made a series of announcements beginning in mid-August 2005, to increase the OAQ and to increase imports of both raw and refined sugar. However the lateness of the USDA actions and logistics obstacles limited their effectiveness in bringing meaningful supplies to an increasingly short market. Hurricane Katrina in late August and Hurricane Rita in September added to the already tight situation as they damaged standing cane crops in Louisiana and shuttered key refining capacity. Our Gramercy, Louisiana refinery west of New Orleans, which suffered minimal physical damage, was closed a total of seven days because of the hurricanes. Our transportation systems across the South continue to experience disruptions because of the availability of truck and rail equipment. Hurricane Katrina seriously damaged a competitor’s refinery, forcing its closure for more than three months, exacerbating an already tight refined sugar market. Hurricane Wilma struck an important sugar cane producing area in south
central Florida in October, further damaging the domestic crop and temporarily closing two refineries owned by competitors. Domestic refined prices have risen significantly since the mid summer 2005. These market conditions have allowed us to raise our prices and achieve improved margins on spot sales across all markets and on industrial contracts negotiated late in fiscal 2005 and continuing into the first quarter of fiscal 2006, although it is difficult to predict how long these conditions will last. We sell a significant portion of our industrial sugar volume on fixed price forward sales contracts for up to a year, many of which are on a calendar year basis. As a result, our realized sales prices tend to lag industry trends.
The table reveals that by the Fall of 2005, IPSU had a book value of over 14 dollars a share and an extremely low price to sales ratio of .18. Further, the table showed that the company had eliminated almost all of its debt; although it had not been profitable in accrual terms since it emerged from bankruptcy in fiscal 2002.
The new management of IPSU had made a series of asset sales which removed the company from the beet sugar business. The sales left its operating profit dependent upon on two large cane sugar refineries.
Schultze Asset Management and Lehman Brother were its two largest shareholders. Schultze was getting impatient and apparently wanted the company to sell the remaining assets of the business and redistribute the profits to the shareholders. Earlier in 2005 they had made a bid to acquire the business. During every conference call Schultze had made their displeasure with the current management a matter of public record.
Ultimately, the pressure applied by Schultze resulted in a distribution of special dividends of 5.5 dollars per share over a two year period, following the windfall profits of fiscal 2006 and 2007.
Now back to the question of whether IPSU represented a sensible investment in late 2005 and early 2006 after the prospects of temporary earning bonanza became apparent. The historical prices reveal that IPSU was available for sale below its book value for a period of about a month following the release of its 10K on 12-14-2005. http://finance.yahoo.com/q/hp?s=IPSU&a=11&b=14&c=2005&d=01&e=28&f=2006&g=d
On Jan. 31, of 2006, IPSU released their first quarter results and the period to purchase the stock at a discount abruptly ended. The company had recorded over a dollar per share in net income for the first quarter of the fiscal 2006 quarter and the price per share reacted accordingly.
Without question IPSU should be considered a low-quality company due to it's inability to generate earnings on a consistent basis. However, in late 2005 I believe it represented an outstanding value proposition based upon the following criteria:
1) The company had virtually no long-term debt and sufficient liquidity to run its business; therefore it seemed likely that profits would be returned to the shareholders.
2) The company was available for purchase below book value and its was highly likely that the replacement value of its refineries were much higher than the stated book value. The latter part of the statement was supported by the increase in book value of IPSU which resulted in a 70% increase the equity of the company from the period of fiscal 2002 to 2004. This increase in book value was a direct result of asset sales. It is important to note that the company incurred negative operating results during that period. Simply stated, the market value of the companies refineries was much greater than the price reflected on the balance sheet.
3) It was apparent to investors who studied the company's annual report that a perfect storm was brewing which was almost certain to result in large profits for the company for a period of at least 12 to 18 months.
IPSU turned out to be a perfect example of a low-quality business that qualified as an outstanding value proposition based upon the principles of Graham as expressed in Chapter 20 of the Intelligent Investor. Specifically, the low price of IPSU (in terms of book and replacement value) in late 2005, coupled with the likely onset on an earnings explosion (the set of circumstances which temporarily boosted their raw vs. refined spreads) qualified the company as sound investment. In other words, the security had reached a sufficiently low price that it merited consideration as an investment when a sizable earnings catalyst presented itself.
As you may have guessed, I made a large investment in IPSU in 2005. I subsequently sold all my holdings in the company in early 2007 after receiving a $3 special dividend while recording large long-term capital gains. It turned out to be the largest percentage position that I ever held in an equity at that point in my investing career. It also resulted in my largest profit at that point in time.
Several years later I repurchased the company following the tragic fire at its Port Wentworth facility when once again the raw versus refined spreads turned positive and the company was trading at an even larger discount to book value. Only this time I ended up recording a capital loss on my investment.
Although large spreads existed between the raw vs. refined spreads, the company was unable to record profits due to their inability to run efficient operations during that period. Specifically, the Port Wentworth facilities consistently ran significantly under capacity and operating costs shot up as manufacturing problems steadily plagued the refinery. Ultimately, the company blew the opportunity to record extreme free cash flow while the sugar spreads were highly favorable.
With the opportunity lost and the probability that sugar spreads would soon be in decline, I sold my entire position at slightly over ten dollars a share. The transaction resulted in a sizable capital loss. It turned out to be a wise decision as the company now trades slightly north of $3 a share.
IPSU is currently trading at a near record low in terms of price to book value; however, it is currently suffering from an extreme liquidity crisis. Recently they were forced to sell their joint investment with Cargill, their former Louisiana refinery.
Current sugar spreads make it impossible for the company to turn a profit for the foreseeable future. It is no time to invest in IPSU unless one is privy to information that all the company's assets will be sold and the business will liquidated in a timely manner. Thus any purchase of IPSU at this time would be pure speculation in my humble opinion. You see, without the vision of profits on the horizon, the record discount to book value becomes meaningless when accessing IPSU as a sound investment versus a speculative play.
Disclosure: no position IPSU