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Ben Graham Net-Net Newsletter: Gencor (GENC) One Year Later

February 29, 2012 | About:
Geoff Gannon

Geoff Gannon

414 followers
I've decided not to sell net-nets after one year for the Ben Graham Net-Net Newsletter. This was always kind of a crazy idea. And there's no reason to do it. I still have to pick a new net-net every month. So what’s the point of selling an old pick just because it’s been a year? Ben Graham and Walter Schloss didn’t do that. We shouldn’t either.

Instead, I'm just going to reveal what stock the Ben Graham Net-Net Newsletter’s model portfolio bought in the same month last year and tell folks whether or not we will sell that stock. My procedure will be to revisit each stock only once a year. So, by deciding to keep the March 2011 pick for now – I won’t be revisiting the again stock until March 2013. That'll be the next time the Ben Graham Net-Net Newsletter can sell it.

I think the risk of high portfolio turnover is a big one in a net-net portfolio. And I want to do everything to discourage readers from developing this bad habit.

So, I’ll stick to this procedure…

Each month, the Ben Graham Net-Net Newsletter will:

· Pick a new net-net to buy

· And decide whether to sell an old net-net

The net-nets the newsletter already owns will only be revisited once a year. I’ll decide whether or not to sell the June 2011 pick in June 2012 – and then if I choose to keep it for another year – I’ll decide whether to sell it in June 2013. But I won’t sell the June pick in September.

I’m not reconsidering every pick every month. That just encourages portfolio churn. I’m not that good at selling anyway. I certainly can’t time a stock with a matter of months. A once a year checkup will be quite enough.

So, there will be a new pick every month. A new stock the Ben Graham Net-Net Newsletter’s model portfolio goes out and bids for. And we will revisit an old pick.

Also, one year after a net-net is chosen, I’ll write about it here in an article at GuruFocus. This way folks who aren’t subscribing to the Ben Graham Net-Net Newsletter can get a taste of what it’s like.

Okay. Let’s talk about the March 2011 pick.

Original Rationale (March 2011)

Here were the pros and cons of an investment in Gencor (GENC) – as I laid them out in the Ben Graham Net-Net Newsletter – one year ago:

Pros

· $8.22 a share in investments. 55% bonds / 41% stocks / 4% cash. All marked to market.

· Very few liabilities.

· Ultra-conservative accounting.

· 99 acres of land. 72 acres in Marquette, Iowa. 27 acres in Orlando, Florida.

· Buildings. Owns 352,000 square feet outright. 215,000 square feet in Florida. 137,000 square feet in Iowa.

· Property and equipment is over depreciated. Original cost of $23 million written down to $4.2 million.

· Large losses are rare in this business. Gencor’s balance sheet can easily absorb any downturn.

· Very long history as a public company. Decent long-term record. Established business. Not speculative.

Cons

· Controlled company

· Elliott family uses B shares to elect 75% of the board without needing majority economic ownership.

· Considering acquisitions and other uses for its investment portfolio.

· No real history of either paying dividends or buying back stock. Has no intention of paying dividends.

· Father and son are Chairman, CEO, and President.

· Worse yet – son is also CFO. No non-family members at the very top.

· Permanently mediocre business.

· Depends on continued infrastructure spending by financially weak federal and state governments in U.S.

· Management makes little effort to explain its accounting and capital allocation choices to shareholders.

Okay. So that’s what I said a year ago. How has the stock done?

In a word: badly.

Actual Performance

On March 7th, 2011 the Ben Graham Net-Net Newsletter’s model portfolio bought 77 shares of Gencor (GENC) at $7.90. And paid a $7 commission. For a total cost of $7.99 a share.

On February 29th, 2012 Gencor opened at $6.97 a share. So, the Ben Graham Net-Net Newsletter’s model portfolio lost 13% on Gencor over the past year.

Gencor: Sell or Hold?

Gencor was always a controversial pick. And I recently got a really good email – arguing against it – citing this 1999 court case:

September 2000 Class Action Complaint – Gencor (in PDF)

And asking this very good question:

“Just curious, why would you stay invested in this? Would you ever buy something if senior management had a reputation/history like this? Sure, maybe it's not all true and maybe they changed their lives, but realistically there is a fair chance that not all is clean and clear at Gencor…”

Gencor is a pick I made for the Ben Graham Net-Net Newsletter. Not for my personal portfolio. I would not buy Gencor if it was going to be a 10% or 25% position I intend to hold for a while. Which is basically what I try to do with my own money. I don’t encourage subscribers to the Ben Graham Net-Net Newsletter to think of the net-net I pick for the newsletter as good individual stock picks. Instead, they should think of net-nets as a group operation.

Ideally, subscribers should buy every net-net I pick for the newsletter. Then they would be averaging into the net-net market in equal installments every month. And they’d get a diversified group of net-nets. This was very much Ben Graham’s style. Buy a little all the time. And own many, many different net-nets.

Gencor is a lousy candidate for a top holding in anyone’s portfolio. For two obvious reasons:

1) Management

2) Business

I'm very reluctant to invest in a company with an operating business that detracts from the value of the company and perhaps adds quite a bit of risk. You could definitely see how that could be true here. Then there is management. Even before considering the possibility of fraud, I always imagined management in this situation will use the cash to make an acquisition I don’t care for.

So, why continue to hold Gencor?

Do you really think it is more risky than the average net-net?

It may be. I'm not sure I believe that. I mean I read what you sent and I know what they are reporting now in terms of their balance sheet, etc.

It's hard to assess the risk there.

We need to consider the probability that management is engaging in fraud. And the magnitude of the loss such fraud would cause us. For example, with a Chinese reverse merger stock I often consider the magnitude of the loss due to fraud to be 100% of the stock’s purchase price. Basically, I believe some of those reverse mergers are complete frauds. And they were frauds from the start. The business essentially never existed.

What is the likelihood of that kind of fraud here?

I’m no expert on frauds. I repeat this all the time, because it’s true. If I were an expert on frauds, I’d be a short-seller.

I consider the likelihood of that kind of complete fabrication to be small at Gencor. As you know from reading last year’s March issue of the Ben Graham Net-Net Newsletter where I picked Gencor, I did happen to look up some of Gencor’s assets in county records. (I wasn’t looking for evidence of a fraud. I was curious about something I found in the footnotes on depreciation of property and equipment). Rather than finding the carrying values of Gencor’s assets to be inflated – I found book value probably understated the value of some of Gencor’s assets. Namely, its buildings and inventory.

Gencor uses LIFO accounting. And it has a lot of fully depreciated assets still in service. It just seemed like depreciation was way too high at Gencor. So I wanted to check that out.

Now, it’s very possible I could be wrong in terms of what those facts mean to the likelihood of a complete fraud. But I wouldn’t go as far as to say a couple accounting choices are evidence against the existence of fraud. Rather, I’d say that in Gencor’s recent SEC reports, management doesn’t seem to have gone out of its way to present the company in an especially attractive light. In fact, Gencor accounts for certain things in a way that hurts their headline results. Of course, a company could still do that and be a fraud.

And let’s face it – although the Elliotts and Gencor did not admit guilt in the class action suit – they did wrong. That may not be a legal fact. But it’s an investment fact as far as I’m concerned. We should operate on the assumption that prior to its bankruptcy, Gencor engaged in fraud.

Investment analysis makes assumptions all the time. And conservatism is one of the principles of Ben Graham style value investing. So, for this entire discussion, we’re assuming that everything the plaintiffs alleged about Gencor was true.

So, why will the Ben Graham Net-Net Newsletter keep its shares of Gencor for at least another year?

The question isn’t whether I like Gencor or its management team. And it’s certainly not whether reading the archived documents makes me queasy – it does – the question is safety. Is the Ben Graham Net-Net Newsletter’s model portfolio safe without Gencor in it?

I’m not sure. But I actually don’t think the evidence is strong that the portfolio would be safer. The reprehensibility of a particular black mark against a stock is not a measure of that stock’s safety as an investment.

Most businesses fail with clean hands and good intentions. They still leave shareholders nothing. It is only the second part – the shareholder losses – we are concerned with here.

Gencor’s assets are – conservatively calculated – worth well in excess of the stock price. When I picked the stock for the Ben Graham Net-Net Newsletter, Gencor’s book value was $10.28 a share. I estimated the actual value of the company’s assets was more like $12 a share. The difference is caused by the value at which Gencor was carrying its buildings and inventory.

Obviously, to the extent you believe the assets shown are not accurately portrayed by the company – all that goes away.

Since the risk in Gencor – fraud – is quite clear and emotionally charged, it’s worth reminding folks where the safety in Gencor comes from.

We are talking about a company that claims to have $12 in current assets for every $1 of total liabilities. And $9 in cash and securities for every $1 in total liabilities. Those are very large margins of safety. I have to pick a net-net for this Friday’s Ben Graham Net-Net Newsletter – and the most likely candidate is a company that has maybe $1.25 in current assets for every $1 in total liabilities. I hate picking a stock like that. A very small operating loss suddenly puts them in a precarious financial position. That is not the case here. Gencor has very high liquid assets relative to total liabilities.

We're basically talking about an investment portfolio of $8.20 a share split between:

Cash: 7%

Stocks: 37%

Bonds: 56%

For that, you'd be selling out at $6.97 a share. The operating assets (current and non-current) seem perfectly appropriate to the level of total liabilities. In other words, putting aside the operating business, when you sell Gencor stock today – you really are selling someone a very balanced bond and stock portfolio at a 15% discount to what it was carried at on December 31st.

In addition, Gencor owns some buildings, land, etc. that have value.

Often, we're talking about net-nets where all the current assets backing the purchase are in inventories and receivables.

At Gencor, we're talking about a situation where investments alone cover more than the full price of the stock.

I don't know if this makes sense. But I think I'm maybe less sensitive to issues like this – potentially crooked management – than a lot of investors. And I'm a lot more sensitive to just the idea that an operating business run by perfectly well intentioned people could go bust when it's got a small cushion in terms of current assets to total liabilities.

I have to weigh the risk to safety posed by management – the risk of fraud especially – against the financial situation of the company. A lot of net-nets I pick for the Ben Graham Net-Net Newsletter are reporting much more precarious financial circumstances.

It's hard for me to say that Gencor is more risky than the stocks I could replace Gencor with in the Ben Graham Net-Net Newsletter’s model portfolio.

It's a lot less pleasant to think about Gencor than what I could replace it with. A management team you distrust is not something anyone wants to think about.

But, let's take an example like Sigmatron (SGMA) or Duckwall-ALCO (DUCK). These are the kinds of stocks that are near the top of the list of net-nets not already in the Ben Graham Net-Net Newsletter’s model portfolio. So they could be added in future issues.

(Quick note: These stocks are near the top of a list of potential net-net picks simply because they’ve been profitable in most years. A lot of net-nets have continual losses. I tend not to pick those for the newsletter.)

Sigmatron has $1.47 in current assets for every $1 of total liabilities. More than 90% of those current assets are in inventories and receivables. And this is not a predictable, profitable kind of company (or industry). So, there are substantial risks.

Is Sigmatron safer than Gencor?

Meanwhile, Duckwall-ALCO has $1.42 in current assets for every $1 of total liabilities. And more than 90% of ALCO’s current assets are in inventory. The company's inventory is about twice its book value and about 6 times its market cap. The business model is badly flawed and will have a hard time earning a decent return on equity even under optimal conditions.

ALCO’s capital is stuck in the form of low-earning inventory. This doesn't just limit the company's upside it also creates real risks to the downside.

Is Duckwall-ALCO safer than Gencor?

In both cases, I don't know. I certainly don't believe either Sigmatron or ALCO is clearly safer than Gencor. And these are the kind of net-nets I might add to the portfolio. Now, I do think some of the other net-nets that the Ben Graham Net-Net Newsletter already owns are safer. And I’ll talk about those in articles like this – that Premium Members and non-Premium Member alike can read – on those stocks’ one year anniversaries.

The Ben Graham Net-Net Newsletter is a group operation. I need to have some reason for believing that taking out Gencor or replacing Gencor with another currently available net-net increases the safety of the portfolio.

I feel there's not enough evidence to support that. You may feel differently on that point. Where the same management team settled a fraud allegation in the past – I totally understand why you feel the way you do.

But I don't see how selling Gencor here increases the safety of the Ben Graham Net-Net Newsletter’s model portfolio. That cash will be used to buy another net-net. And the idea is to diversify across net-nets.

There are problems with other stocks I could choose as well. They’re different. They usually don’t involve the risk of fraud. Sometimes they just involve dying industries, bad businesses, and low ratios of current assets to total liabilities. But those are real risks.

They don’t involve possible misconduct by living, breathing human beings – so there is no sense of potential betrayal attached to those risks. They are less emotionally charged. But they are still very real. And you can lose as much money betting on a bad horse as betting on a bad jockey.

Maybe you blame the jockey more than the horse. Your brain cares how you lose money. But your wallet doesn’t. A loss is a loss.

All that isn’t really a very strong endorsement of Gencor. Well, I don’t mean to endorse Gencor here. Certainly not as an individual stock.

What about as part of a group?

Let me explain the situation. The Ben Graham Net-Net Newsletter owns shares of Gencor. I have to decide what to do with those shares.

Here’s why I think we should hold our Gencor shares – and revisit the stock next March.

We have a stock – Gencor – that is still selling below NCAV, that is still selling below our purchase price, and which we've only held for a single year.

In general, that's a recipe for poor performance. Especially the last one. Selling after just a year. That’s not a good idea for any net-net portfolio.

You know the history of how Ben Graham and Walter Schloss invested in net-nets. We’re just as often talking about holding on to a net-net for 4 or 5 years rather than 1 year. The biggest systematic mistake I can make with the Ben Graham Net-Net Newsletter is always selling too soon.

If the Ben Graham Net-Net Newsletter holds on to its net-nets for long enough, and I do a decent job of picking more winners than losers – the model portfolio can survive a few of my screw-ups (which Gencor may very well be).

But if we start selling because it’s been a year, the stock is lower than where we bought it, and we feel icky whenever we think about the company and its management – we’re going to have really high turnover.

Because that describes a lot of net-nets. They keep going down for a while after you buy them, they make you feel icky, and you’re eager to just move on.

That’s most net-nets.

So I have to be disciplined in terms of procedure even if I get some stock picks wrong.

And I will get some wrong. Boy, will I get some wrong. Gencor may be one of those.

It’s down 13% so far. And we’re keeping it for another year.

Ask Geoff a Question about Selling Net-Nets

Check out the Ben Graham Net-Net Newsletter

Check out the Buffett/Munger Bargains Newsletter

About the author:

Geoff Gannon
Geoff Gannon


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